- CFA Exams
- 2025 Level I
- Topic 4. Financial Statement Analysis
- Learning Module 8. Topics in Long-Term Liabilities and Equity
- Subject 3. Accounting and Reporting by the Lessee
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Subject 3. Accounting and Reporting by the Lessee PDF Download
Suppose a non-cancelable lease begins on Dec. 31, 20X0 with annual lease payments of $10,000 made at the end of each year for four years. Ten percent is assumed to be the appropriate discount rate.
Operating Lease (OL) for a Lessee
- No entry is made at the inception of the lease.
- Over the life of the lease, only the annual rental expense (an operating expense) of $10,000 will be charged to income and CFO.
Capital/Finance Lease (CL) for a Lessee
- At the inception of the lease, an asset (leasehold asset) and liability (leasehold liability) equal to the present value of the lease payments, $31,700, is recognized. The implicit interest rate of the lease is the discount rate that sets the aggregate present value of lease payments to be equal to the fair market value of the leased asset.
- Over the life of the lease:
- The annual rental expense of $10,000 will be allocated between interest and principal payments on the $31,700 leasehold liability according to the amortization schedule.
- Interest payment = Beginning lease obligation x implicit discount rate. It is accounted for as interest expense, which reduces income and cash flow from operating activities.
- Principal repayment = Lease payment - Interest payment. It reduces lease liability and cash flows from financing activities. It has no effect on the income statement.
- Ending lease obligation = Beginning lease obligation - principal repayment
- The $31,700 cost of the leasehold asset is charged to operating expense (annual depreciation is $7,925) using the straight-line method over the term of the lease. Depreciation is charged to income but has no effect on cash flows.
- The annual rental expense of $10,000 will be allocated between interest and principal payments on the $31,700 leasehold liability according to the amortization schedule.
Amortization schedule:
Financial effects:
- When a lease is a finance lease, gross ($31,700) and net amounts are reported at each BS date. CL increases asset balances, resulting in lower asset turnover and lower ROA than OL classification.
- The current liability is the principal portion of the first lease payment. Non-current liability is the rest of the principal. At the lease's inception, leased assets and liabilities (A&L) are equal at $31,700.
- The most important effect of a CL is the impact on leverage ratios, which results in an increase in debt to equity and other leverage ratios. As lease obligations aren't recognized for OL, leverage ratios are understated.
Summary (For a Lessee):
User Contributed Comments 5
User | Comment |
---|---|
papajeff | well, that's totally clear....and now forgotten. |
Diruuk | lol |
Sheeb | Amen brother. |
Ewan2015 | Don't worry it changes in a year anyway and the differences will become negligible between the two. |
sdm1981 | For operating leases. If the lessor holds the asset do they also depreciate it on their BS? I know they record the revenue earned from the lease |
Your review questions and global ranking system were so helpful.
Lina
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