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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.

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 minimum 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 t

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