Page 463 - Accounting Principles (A Business Perspective)

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A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The
person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease
are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.

Capital leases A capital lease transfers to the lessee virtually all rewards and risks that accompany
ownership of property. A lease is a capital lease if, among other provisions, it (1) transfers ownership of the leased
property to the lessee at the end of the lease term or (2) contains a bargain purchase option that permits the lessee
to buy the property at a price significantly below fair market value at the end of the lease term.
A capital lease is a means of financing property acquisitions; it has the same economic impact as a purchase
made on an installment plan. Thus, the lessee in a capital lease must record the leased property as an asset and the
lease obligation as a liability. Because a capital lease is an asset, the lessee depreciates the leased property over its

useful life. The lessee records part of each lease payment as interest expense and the balance as a payment on the
lease liability.
The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We
leave further discussion of capital leases for an intermediate accounting text.
Operating leases A lease that does not qualify as a capital lease is an operating lease. A one-year lease on an
apartment and a week's rental of an automobile are examples of operating leases. Such leases make no attempt to
transfer any of the rewards and risks of ownership to the lessee. As a result, there may be no recordable transaction
when a lease is signed.
In some situations, the lease may call for an immediate cash payment that must be recorded. Assume that a

business signed a lease requiring the immediate payment of the annual rent of USD 15,000 for each of the first and
fifth years of a five-year lease. The lessee would record the payment as follows:
Prepaid Rent (+A) 15,000
Leasehold (+A) 15,000
Cash (-A) 30,000
To record first and fifth years' rent on a five-year
lease.
Since the Leasehold account is actually a long-term prepaid rent account for the fifth year's annual rent, it is an
intangible asset until the beginning of the fifth year. Then the Leasehold account becomes a current asset and may
be transferred into a Prepaid Rent account. Accounting for the balance in the Leasehold account depends on the
terms of the lease. In the previous example, the firm would charge the USD 15,000 in the Leasehold account to
expense over the fifth year only. It would charge the balance in Prepaid Rent to expense in the first year. Thus,
assuming the lease year and fiscal year coincide, the entry for the first year is:
Rent Expense (-SE) 15,000
Prepaid Rent (-A) 15,000
To record rent expense.
The entry in the fifth year is:
Rent Expense (-SE) 15,000
Leasehold (-A) 15,000
To record rent expense.
The accounting for the second, third, and fourth years would be the same as for the first year. The lessee records
the rent in Prepaid Rent when paid in advance for the year and then expenses it. As stated above, the lessee may

Accounting Principles: A Business Perspective 464 A Global Text