2013 Lease Exposure Draft: Type A Leases

In this post I will explain Type A leases in detail from the lessee perspective. We will discuss how to calculate the initial and subsequent values of the lease liability and the initial and subsequent values of the Right of Use (ROU) Asset. In a later blog we will discuss how lessees will address the transition from leases that are classified as operating leases under current GAAP to Type A leases under the lease exposure draft.

Examples of Type A Leases

Examples of Type A Leases

Recall that in general, leases of personal property (for instance, vehicles and equipment) are Type A leases, while leases of real property (land and buildings) are generally Type B leases. The best way to explain how the lease liability and right of use (ROU) asset are determined is by using an example. So here goes:

Example 1: Entity A (Lessee) enters into a 10 year lease of equipment with payments of $10,000/yr in years 1 through 5, and $15,000/yr in years 6 through 10. Assume that the lessee’s incremental borrowing rate is 6%, and payments are made in advance. Assume the useful life of the equipment is 20 years, and the fair value is $150,000.
Analysis of Example 1: The first thing to notice here is that the underlying asset in this lease is Equipment, which is personal property. Recall from our previous post that leases of personal property are classified as Type A leases unless:

1) the lease term is insignificant compared to the total economic life of the asset, or
2) the present value of the minimum lease payments is insignificant compared to the fair value of underlying asset.

The lease term is 50% of the useful life of the asset. This is not insignificant. The present value of the minimum lease payments is $94,700. (This is how the present value of the mimimum lease payments was calculated). This is over 60% of the fair value of the equipment, which is not an insignificant amount.
Because the exceptions in 1) and 2) above are not met, this is a Type A lease.

On the lease commencement date (not the execution date), company would record the ROU asset and the Lease Liability. The entry would be a debit to the ROU asset and a credit to the lease liability for the present value of the minimum lease payments, as follows:

Dr. ROU Asset 94,700
Cr. Lease Liability 94,700
To record ROU asset and Lease liability at commencement.

The ROU asset would be depreciated straight-line, so each year the following entry will be made:

Dr. Depreciation Expense 9,470
Cr. Accumulated Depreciation ROU Asset 9,470
To record amortization of ROU asset at year end.

The Lease Liability would be amortized using the effective interest method according to the following table:

 

Period Cash Expense Liab Reduction Liab Balance

0

-

-

-

94,700

1

10,000

-

10,000

84,700

2

10,000

5,082

4,918

79,782

3

10,000

4,787

5,213

74,569

4

10,000

4,474

5,526

69,043

5

10,000

4,143

5,857

63,185

6

15,000

3,791

11,209

51,977

7

15,000

3,119

11,881

40,095

8

15,000

2,406

12,594

27,501

9

15,000

1,650

13,350

14,151

10

15,000

849

14,151

-

The cash column represents the cash paid, the expense is the interest rate times the previous month’s liability balance, the liability reduction is the difference between the cash and the expense, while the liability balance is the difference between the previous month’s liability balance and the liability reduction.

Based on the table above, the following entry would be made to represent the first month’s payment:

Dr. Lease Liability      10,000
Cr. Cash                 10,000
To record first lease payment.

Note that the first payment has no interest expense recorded. This is because interest is a function of time, and if a payment is made at the beginning of the lease term then no time has passed for interest to accrue. As such, the entire payment goes against the principal. The entry to record the second lease payment will be as follows:

Dr. Interest Expense 5,082
Dr. Lease Liability 4,918
Cr. Cash 10,000
To record second lease payment.

Notice that after year 10, the lease liability will be at zero, and the lease asset would be fully amortized. Also notice that the expense associated with the lease hits the income statement twice; once as amortization (depreciation expense) of the ROU asset, and another as interest expense from the lease liability. As a result, rather than having rent expense evenly recorded through the lease term (as is currently the case with operating leases), the expense is “front loaded,” meaning that there is greater expense recorded in the earlier years of the lease term than in the latter years.

Now that we have covered Type A leases, I will move on to explain Type B leases in a separate post. I will also cover transition guidance from current GAAP to Type A leases in another post.

About LeaseQuery:

LeaseQuery, LLC provides a cloud-based, lease accounting software and lease management system which enables companies who lease real estate and/or equipment to easily comply with lease accounting guidelines. Visit us at www.LeaseQuery.com

This entry was posted in Approach 1, Lease Liability, New Lease Accounting Rules, Present Value of Minimum Lease Payments, ROU Asset, Type A Lease and tagged . Bookmark the permalink.

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