Capital Lease Accounting: A Comprehensive Example

Capital Lease Accounting

In today’s blog post, we will discuss and explain capital lease accounting. We will utilize a detailed example to illustrate the accounting entries involved, but let us stress that this example covers capital lease accounting under CURRENT accounting rules by the FASB and IASB –Topic 840/FAS 13 and IAS 17 respectively. In a subsequent blog post, we will address “Finance” lease accounting under the NEW Lease Accounting Standards issued by the FASB and IASB—Topic 842 and IFRS 16, respectively (under Topic 842, capital leases will be called finance leases).

As a refresher, a capital lease is one in which a lessee records the leased asset as if it purchased the asset using funding provided by the lessor. As a result, capital lease accounting under current GAAP is actually comprised of two transactions: A purchase of the underlying asset by the lessee AND a loan to the lessee from the lessor to fund the purchase of said asset.

A lessee should record a lease as a capital lease and therefore apply capital lease accounting if ANY of the following criteria are met:

  • First Criterion: Ownership of the underlying asset transfers to the lessee after the lease term; or
  • Second Criterion: There is a “bargain purchase option”, meaning that the lessee has an option to buy the underlying asset after the lease term at a price that’s below-market; or
  • Third Criterion: The lease term is 75% or greater than the useful life of the underlying asset; or
  • Fourth Criterion: The present value of the minimum lease payments is at least 90% of the fair value of the asset.

To continue reading on capital lease accounting, click here

This article was contributed by LeaseQuery:  LeaseQuery is lease management software that helps companies manage their leases.  Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.  Contact here.

Tax effect of Deferred Rent under current GAAP lease accounting rules

Deferred rent under topic 840

 

In this blog post, we will explain how deferred rent affects income tax under current lease accounting rules. We want to stress that this blog post covers it and income taxes under CURRENT rules of lease accounting (Topic 840). In a subsequent post, we will cover income taxes under Topic 842, which is the new lease accounting rules.

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Before we delve into an example, let us recall the definition of deferred rent:

It is the liability that is created as a result of the difference between the actual cash paid and the straight-line expense recorded on the financial statements.  


One of the basic principles of Topic 740 (Income Taxes) is that deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. To put it another way, these deferred taxes are recognized for future tax consequences of events recorded in either the financial statements or the tax return, but not yet in both. Deferred tax liabilities are recorded for taxable temporary differences while deferred tax assets are recorded for deductible temporary differences.

The vast majority of the time, the deferred rent recorded is the difference between the straightline rent recognized for book purposes and the rent deductible for tax purposes (which is usually the cash paid). Under CURRENT GAAP for lease accounting, a lessee would generally record a deferred tax asset for the deferred rent liability recorded on the books. In addition, initial direct costs (IDC) are capitalized for tax purposes unless they are de minimus (meaning that they do not exceed $5,000 in the aggregate for US Federal purposes).

To demonstrate how deferred rent works in practice, let’s work through a simple illustrative example:

  • Lessee leases a building from a lessor, and the lease is classified as an operating lease.
  • Lease term is 10 years.
  • Rent payments are $100,000 in the first year, escalating 3% per year. Payments are made in arrears.
  • Lessee incurred $10,000 in initial direct costs (IDC) related to the lease.
  • Lessee has a tax rate of 30%
  • Assume the lease is a true tax lease for income tax purposes and that rent is deductible as paid for tax purposes.

In Yr 1, the lessee will make the following entries:

Account Debit Credit
Rent Expense1 115,639
Cash 100,000
 IDC2  1,000
Deferred Rent3 14,639

Note 1: Total lease payments of 1,146,388 + 10,000 IDC divided by 10 years.

Note 2: 10,000 IDC divided by 10 years.

Note 3: The deferred rent in this example is a plug that will make the entry balance, or it can be calculated as the straight-line expense less the cash paid each year. (Deferred rent here equals total lease payments of 1,146,388 divided by 10 years less cash paid of 100,000).

At the end of the first year, the Lessee’s deductible expenses for tax purposes is 101,000 (actual cash paid plus Year 1 amortization of the IDC), as a result, the lessee would record a current tax benefit of 30,300 (101,000 X 30%). The journal entry to record this is:


Account Debit Credit
Income Taxes Payable 30,300
Current Income tax expense 30,300

As noted in the second paragraph of this post, deferred taxes have to be recognized for temporary differences between the financial statements and tax returns. The lessee’s deductible expenses for tax purposes is 101,000; while lease expense for book purposes is 115,639 (see note 1 above). The deferred rent of 14,639 constitutes a temporary difference that needs to be tax-effected to determine the associated deferred tax asset. The deferred rent would be multiplied by the tax rate to give the following entry:

 

Account Debit Credit
Deferred Tax Asset4 4,392
Deferred Income Tax Expense 4392

Note 4: Deferred rent of 14,631 multiplied by tax rate of 30%.

Based on the entries above, note that the total income tax benefit is 34,692, which equals 30% of the recorded book expense of 115,639.

Once again, the entries above reflect the journal entries for deferred rent and the related tax effect under current lease accounting rules. In a subsequent post, we will explain the tax effect of leases under topic 842.

 

This article was contributed by LeaseQuery:  LeaseQuery is lease management software that helps companies manage their leases.  Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.  Contact here.

If you liked this post, consider reading the following:  How To Transition From Current to the New Lease Accounting Rules: A Comprehensive Example.

6 Lease Accounting Errors You’re Probably Making (And How to Fix Them) – PART 2

Lease Accounting Errors under current standards

This is the second of a two-part series: 6 Lease Accounting Errors You’re Probably Making (And How to Fix Them). Our previous post addressed the first 3 common accounting errors we have found after reviewing thousands of leases. To summarize, those common errors were:

1) Errors in accounting for tenant improvement allowances (TIAs)

2) Errors in accounting for TIAs when a lease is renewed or modified

3) Errors in accounting for prior deferred rent when a lease is renewed or modified

In today’s article, we will show you the next 3 lease accounting errors (errors 4 to 6) we have found after our evaluation of numerous leases.

To continue reading, click here.

This article was contributed by LeaseQuery:  LeaseQuery is lease management software that helps companies manage their leases.  Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.  Contact here.

6 Lease Accounting Errors You’re Probably Making (And How to Fix Them).

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To err is human. To forgive is against company policy. Our last blog addressed how to Account for Lease Amendments that Expand the Leased Premises. In today’s article, we will explain the 6 common lease accounting errors we have found after reviewing thousands of leases.

One thing that makes LeaseQuery different from other lease management software providers is that we are not just real estate professionals; we are also accountants. Why is that important? Well, when you start using our software, we perform two tests on your leases to ensure the following:

1st Test: We make sure that you are making the correct payments based on the lease documents and,

2nd Test: We make sure that your existing leases are complying with GAAP.

While most of the existing lease software out there can perform the first test, the second assessment is more important because even though the correct payments are being made, the entries being recorded may be incorrect. Only accountants can make that determination.  In today’s column, we will show you the top 6 accounting errors we have found after our evaluation of numerous leases.

To continue reading, click here.

Contributed by LeaseQuery:  LeaseQuery is lease management software that helps companies manage their leases.  Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.  Contact here.

How to Account for Lease Amendments that Expand the Leased Premises

Accounting for lease amendments

In a prior post, we explained how to account for leases when the tenant MUST expand the premises under the terms of the initial lease. In this blog post, we will explain how to account for a lease when the tenant expands a lease, but that expansion was NOT required under the terms of the initial lease. That is, how to account for a lease when the tenant leases a space, decides it needs to expand, and then signs an amendment to the initial lease expanding the leased space.  Once again, the difference between this scenario and the prior post we wrote is that in the prior scenario, the tenant was obligated to take the additional space under the initial lease. Under this scenario, the tenant decided to expand the leased premises but it had no obligation to do so.

To continue reading, click here.

Contributed by LeaseQuery:  LeaseQuery is lease management software that helps companies manage their leases.  Rather than relying on excel spreadsheets, our clients use LeaseQuery to get alerts for critical dates (renewals, etc), calculate the straight-line amortization of rent and TI allowances per GAAP, provide the required monthly journal entries (for both capital and operating leases) and provide the commitment disclosure reports required in the notes and the MD&A.  Contact here.