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Accounting for leases in the United States is regulated by the Financial Accounting Standards Board (FASB).
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Accounting for leases by the lessee
A lease is defined as a contractual agreement between a lessor and lessee that gives the lessee the right to use specific property, either owned by or in the possession of the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payment.
The accounting profession recognizes leases as either an operating lease or a capital lease (finance lease). An operating lease records no asset or liability on the financial statements, the amount paid is expensed as incurred. On the other hand, a capital lease is recorded as both an asset and a liability on the financial statements, generally at the present value of the rental payments. To distinguish the two, the Financial Accounting Standards Board (FASB) provided criteria for when a lease should be capitalized, and if any one of the criteria for capitalization is met, the lease is treated as a capital lease and recorded on the financial statements.
The basic criteria for capitalization of a lease by lessee are as follows:
A bargain purchase option is given to the lessee. This is an option that allows the lessee, upon termination of the lease, to purchase the leased asset at a price significantly lower than the expected Fair market value of the asset. (Intermediate acct. 11th ed, Kieso Weygandt Warfield)
The life of the lease is greater than 75% of the economic life of the asset.
The present value of the minimum lease payment (MLP) is equal to or greater than 90% of the fair market value of leased property. To understand and apply this criterion, you need familiarize yourself with what is included in the minimum lease payment and how the present value is calculated. The minimum lease payment includes the minimum rental payments minus any executory cost, the guaranteed residual value, the bargain purchase option, and any penalty for failure to renew or extend the lease. The amount calculated is then discounted using the lessee’s incremental borrowing rate. However, if the lessee knows the implicit rate used by the lessor and the rate is less than the lessee’s rate, the lessee should use the lessor’s rate to discount the minimum lease payment.
If any of the criteria for capitalization previously discussed are met, the lease should be capitalized and reported on the financial statements by the lessee. For a more in depth explanation, see the accounting textbook Intermediate Accounting, 11th ed, Kieso Weygandt Warfield.
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Lessee Accounting
Under an operating lease, the lessee records rent expense (debit) over the lease term, usually on a straight-line basis and a credit to either cash or rent payable.
Other lessee financial accounting issues:
Leasehold Improvements: Improvements at the discretion of the lessee; Permanently affixed to the property; Reverts back to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life
Lease Bonus: Prepayment for future expenses; Classified as an asset; Amortized using the straight-line method over the life of the lease.
Rent Kicker: Only if the lessee is extremely profitable. This is a premium rent payment that the lessor requires and is treated as a period expense. For example, it may be stated in the contract that if sales are over $1,000,000, any excess over this amount will have 2% taken out as a rent kicker.
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Lessor Accounting
The lessor records rent revenue (credit) and a corresponding debit to either cash/rent receivable. As the operating lease is not a capital lease, the lessor is the one that records depreciation expense over the life of the asset.
Other Issues
Usually, when a lease is entered into, a security deposit is required. There are two types of security deposits:
Nonrefundable security deposits: Deferred by the lessor as unearned revenue; Capitalized by the lessee as a prepaid rent expense until the lessor considers the deposit earned.
Refundable security deposits: Treated as a receivable by the lessee; Treated as a liability by the lessor until the deposit is refunded to the lessee.
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