Chapter 15


Leases are contracts specifying the terms under which the owner of property (the lessor) transfers the right to use the property to a lessee. Leases are classified as capital leases (debt-financed purchases of property) or operating leases (rentals). The accounting treatment and required disclosures differ strongly for the two classes. FASB Statement 13, issued in 1976 and since much amended and interpreted, covers the subject. An ongoing problem is the abuse of leases to avoid recognizing future payment obligations as a liability: so-called “off-balance-sheet financing”.


Nevertheless, leases have important legitimate business uses. Three primary advantages for the lessee to lease rather than purchase fixed assets  are no down payment (on many but not all leases), avoiding the risks of ownership, and the added flexibility afforded by the short-term renewability of many leases. There are also advantages for the lessor, such as increased sales opportunities resulting from the advantages to the lessee, the ongoing business relationship with the lessee, and in many cases, a substantial residual value retained by the lessor, allowing the property to be leased again or sold at a profit at the end of the lease term.


Upon signing a lease, accounting issues arise for both the lessor and the lessee. The fundamental question is this: does the transaction represent an effective transfer of ownership of the property, or merely a rental? The accounting principle of “substance over form” provides guidance, but the decision can be quite difficult. Transfer or retention of legal title to the property is significant but not necessarily conclusive. Other factors involved are: does the lessor retain significant responsibilities regarding the property (that is, is the transaction complete); how certain is the collectibility of the payments; how does the length of the term of the lease compare with the useful life of the property; and how does the present value (suitably discounted) of the lease payments compare with the actual fair value of the property?  A capital lease is an effective transfer of ownership of the property and is accounted for by the lessor by recognizing the sale of the property on the lease signing date and by recognizing earned interest revenue as the regular lease payments are collected, and by the lessee on the lease signing date by recognizing the value of the asset and the liability for the future lease payments on the balance sheet. An operating lease requires the lessor only to recognize the rental revenue as collected, and the lessee only to recognize the periodic rental expense, with no asset or liability appearing on its books.


Contractual provisions of lease contracts are quite diverse, reflecting the ingenuity many companies apply to try to get their leases to qualify as operating leases rather than as capital leases. These provisions may include cancellation provisions and penalties, bargain renewal and purchase options, lease term, economic life of assets, residual asset values, minimum lease payments, implicit interest rates, and the degree of risk assumed by the lessee, which may include payment of such costs as maintenance, insurance, and taxes. All these provisions can affect the determination of the proper accounting treatment.  FASB has tried to establish precise classification criteria to aid in the determination of whether a lease is a capital or an operating lease. 


A lease is noncancelable if cancellation is allowed only upon the occurrence of some remote contingency, or if the cost to the lessee is prohibitively costly to the lessee. All cancelable leases are operating leases; some but not all noncancelable ones are capital leases.


The lessee may enjoy the right to purchase leased property at a future date at a price specified by the lease contract. If the price is expected to be considerably less than the fair market value as of the purchase option date, the option is called a bargain purchase option. (Here the parties to the lease must be able to reasonably estimate the fair market value of the leased asset at the end of the lease.) The expectation is that the option will be exercised, and therefore an effective transfer of ownership is likely. Accordingly noncancelable leases with bargain purchase options are classified as capital leases.


The lease term begins when the property is transferred to the lessee. When it ends may depend on provisions allowing the lessee to extend the lease period for accounting purposes. The end of the lease term is therefore defined as the end of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised. If a renewal option has such an attractive lease rate, or other favorable provision, that at the inception of the lease it is likely that the lease will be renewed beyond the fixed lease period, it is called a bargain renewal option. If the lease contract includes a bargain purchase option, the lease term must include any renewal periods preceding the date of the bargain purchase option but does not extend beyond the date of the bargain purchase option. In a capital lease the lease term can determine the period over which the leased asset is depreciated.


 Residual value is the market value of the leased property at the end of the lease term. When the lease term is substantially less than the economic life of the asset or the period in which the asset continues to be productive, the residual value will be material. If the lessee can purchase the asset at the end of the lease term at a price materially less than its residual value, a bargain purchase option is present and the lessee may be expected to exercise it and purchase the asset. If the lease contract requires the lessee to guarantee a minimum residual value and the guaranteed residual value is greater than the fair market value of the asset at the end of the lease term, the lessee must pay the difference.  This protects the lessor from loss due to unexpected declines in the market value of the asset. When there is no bargain purchase option or guaranteed residual value, the lessor recovers the property at the end of the lease term and may offer to renew the lease, lease to another lessee, or sell the property. Although the actual amount of the residual value is unknown until the end of the lease term, it must be estimated at the inception of the lease; in this case the residual value is called the unguaranteed residual value.


The rental payments required over the lease term plus any amount to be paid for the residual value either through a bargain purchase option or a guarantee of the residual value is together called the minimum lease payments. These do not include charges in the lease payment for expenses such as maintenance, insurance, and taxes incurred for the leased property (called executory costs), or additional payments on building lease payments based on sales by the lessee. The lessor’s calculation of the minimum lease payments involves a so-called implicit interest rate. The appropriate discount rate for the lessee to use is the lower of the implicit interest rate and the lessee’s own incremental borrowing rate, which is the rate at which the lessee could borrow the amount of money needed to purchase the leased asset, in view of the lessee’s financial condition and the current market conditions. If the lessee does not know and cannot reasonably estimate the implicit interest rate, the incremental borrowing rate may be used instead. See page 897 for an illustration.


FASB Statement No. 13 contains the criteria for classifying leases as capital or operating. See Exhibit 15-1 on Page 899.


General Criterion

Capital Lease

Operating Lease

Title Transfer?



Bargain Purchase Option?



Lease Term >= 75% of Life?



Present Value of Payments >= 90% of Fair Value?




Additional revenue recognition criteria applicable to lessors:

  1. Collectibility of the minimum lease payments is reasonably predictable.
  2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor.


    • Lessee: Capital lease if any one of general criteria is met.
    • Lessor:  Capital lease if any one of general criteria is met and both revenue recognition criteria are met.


The application of the fourth general criterion (present value of payments) is sensitive to the rate used to discount the future minimum lease payments. Use of a higher rate make it more likely that the lease will be classified as an operating lease; consequently lessees prefer to use the borrowing rate, which is often higher than the implicit interest rate, and make no attempt to estimate the implicit interest rate. FASB’s proposal to tighten the rules to require estimation of the implicit interest rate had to be dropped when lessees protested. The second revenue recognition criterion (unreimbursable costs) essentially requires substantial completion of performance by the lessor. The international rule for classifying leases (IAS 17) is much simpler: “A lease is classified as a finance (i.e. capital) lease if it transfers substantially all the risks and rewards incident to ownership”. This leaves the decision to the accountant’s judgment. See pages 900 – 901 for examples.


A lessee’s accounting for operating leases is fairly straightforward: the only minor complication is to account for varying payment amounts using Rent Payable or Prepaid Rent accounts; however, in February 2005 the chief accountant of the SEC wrote a letter to the AICPA complaining that very many U.S. companies have been neglecting the accrual adjustments involved.


A lessee’s accounting for capital leases is essentially the same as for purchase of an asset with long-term credit terms. The present values of the future minimum lease payments, discounted at the lower of the implicit interest rate (if known) or the incremental borrowing rate. The minimum lease payments include the total rental payments, bargain purchase options, and lessee-guaranteed residual values. See pages 903 – 909 for details and a comprehensive example.


The effect of an operating lease on the lessee’s statement of cash flows is simple. The lease payments reduce the net income under the indirect method and therefore require no adjustment except for prepaid or accrued rent expense; under the direct method, cash payments represent operating expense outlays. Capital leases are more complicated for the lessee. Under the indirect method, amortization of the leased asset must be added back in, not being a cash transaction. Under the direct method, amortization is ignored but the interest expense portion of the cash payment is included in interest expense outlays of operating activities. Under either method, the reduction of the lease liability included in the cash payment would be a financing activity cash outlay. The signing of the capital lease would be ignored as a non-cash transaction. The supplemental disclosure to the statement of cash flows would include the present value of the minimum future payments as a significant non-cash transaction, and the amount of cash paid for interest.


Lessors often want to treat leases as capital leases in order to recognize a sale immediately. Otherwise the property will still be carried on the books, and depreciation will offset the revenue. The accounting rules as they presently stand allow a lessor to treat the same lease as a capital lease that the lessee is permitted to treat as an operating lease.


The lessor must classify a capital lease either as a direct financing lease or as a sales-type lease. Direct financing leases are used by lessors primarily engaged in financing activities and are viewed as investments; the revenue they generate is interest revenue. The lessors of sales-type leases (for example, sales of new cars), on the contrary, are manufacturers or dealers who use them to facilitate marketing their products; they generate not only interest revenue, but also an immediate profit or loss, equal to the difference between the cost of the leased property and its sales price, or fair value, at the inception of the lease. Under operating or either kind of capital lease, the lessor may incur so-called initial direct costs in connection with obtaining the lease: these include costs of negotiation, the cost of the credit check on the lessee, and cost of preparing the lease documents. Accounting for initial direct costs differs for the types of leases:

Type of Lease

Accounting Treatment of Initial Direct Costs


Recorded as an asset and amortized over lease term.

Direct financing

Recorded as an asset and amortized over lease term, reducing interest revenue.

Sales type

Immediately recognized as a reduction in manufacturer’s or dealer’s profit.


A lessor accounts for an operating lease much as the lessee does. Revenue is recognized as payments ore received; significant variations in the payment terms, if any, require adjusting entries to reflect a straight-line pattern of revenue recognition. Initial direct costs are deferred and amortized over the lease term on a straight-line basis, thus matching them against rent revenue. See page 910-1 for an example.


A lessor accounts for direct financing capital leases similarly to the way the lessee does, with interest revenue credited and lease payments receivable debited initially, then credited as payments are received, in place of interest expense debited and obligations under capital leases credited initially and then debited as payments are made. Notice that unlike the treatment of an operating lease, no depreciation is recorded because the asset has been substantially sold and is off the books. See page 911 for details and examples.


The main differences for the lessor in accounting for a sales-type lease from the treatment of a direct-financing lease are, first, in the extra revenue item: the immediate profit or loss from the difference between the sales price of the leased property and the lessor’s cost to purchase or manufacture the asset, and secondly, in the intere6st revenue over the lease term for the difference between the sales price and the gross amount of the minimum payments. See pages 913 – 6.


The treatment of leases on the lessor’s statement of cash flows is straightforward for operating leases except that initial direct costs are reported as investing cash outflows. Under the indirect method of calculating operating cash flows for operating leases, amortization of initial direct costs would be added back to net income as a non-cash expense.  Capital leases must be dealt with carefully. Notice that the transaction is viewed as an investing activity for the lessor and as a financing activity for the lessee. Exhibit 15-9 summarizes the lessor’s treatment of cash flows:


On Pages 918-21 the authors detail the disclosure requirements for leases on the part of the lessee and the lessor.


The chief difference between US GAAP concerning lease and the IASB’s IAS 17 is that The IASB leaves the distinction between operating and capital leases to the accountant’s judgment, on the understanding that a capital lease (called by the IASB a “finance lease” is one which “transfers substantially all of the risks and rewards incident to ownership of an asset”. This is an example of a “principles-based standard”. A proposal now being discussed by world standard setters is to classify all leases with terms over one year as capital leases.


A sale-leaseback is a type of lease arrangement in which one party sells an asset to another, then immediately leases the asset back and continues to use it. It is attractive to the seller-lessee as a means of taking assets and liabilities off the books while continuing to enjoy their use, though it also has legitimate business purposes. The accounting problem it raises is whether the profit to the seller-lessee from the original sale should be recognized immediately or deferred over the lease term. The FASB recommends immediate recognition of a loss, and deferred recognition of a profit, with amortization either in proportion to the amortization of the leased asset in the case of a capital lease, or in proportion to the rental payments in the case of an operating lease. See pages 923-4 for details and examples.