Rights Under Lease

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. Each of these lease types will be defined below.

The FASB has wrestled with issues around leases for a long time, beginning with a time when some companies were leasing assets and recording them as purchased and other companies were recording the lease payments as expenses without recognizing the asset.

The initial solution was to categorize some leases as capital leases, which are essentially purchases of the asset. More recently, the FASB issued accounting guidance that requires assets and liabilities arising from almost all leases to be recorded on the balance sheet, along with additional disclosures are required regarding the amount, timing, and uncertainty of cash flows from leases.

If you look at Facebook:

See the balance sheet long description here.

And The Home Depot:

See the balance sheet long description here.

You can see the effect of this new GAAP. There is a line called “operating lease right-of-use-assets” that did not exist in prior years. This reflects the value of being able to use assets, like buildings, automobiles, and equipment, that are not included in property, plant, and equipment because the leases are not classified as capital leases.

The process of developing this new accounting pronouncement and the logic behind it are outlined in the Update 2016-02—Leases (TOPIC 842) SECTION C—Background Information and Basis for Conclusions.

The final major asset category we will examine in detail is notes receivable, which, like investments, can either be a short-term or long-term asset, depending on the maturity date.

Notes Receivable

A note (also called a promissory note) is an unconditional written promise by a borrower to pay a definite sum of money to the lender (payee) on demand or on a specific date. On the balance sheet of the lender (payee), a note is a receivable. A customer may give a note to a business for an amount due on an account receivable or for the sale of a large item such as a refrigerator. Also, a business may give a note to a supplier in exchange for merchandise to sell or to a bank or an individual for a loan. Thus, a company may have notes receivable or notes payable arising from transactions with customers, suppliers, banks, or individuals.

Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a period. To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest is a revenue. A borrower incurs interest expense; a lender earns interest revenue. For convenience, bankers sometimes calculate interest on a 360-day year; we calculate it on that basis in this text. (Some companies use a 365-day year.)

The basic formula for computing interest is:

[latex]\text{principal}\times\text{interest rate}\times\text{frequency of a year}[/latex]

Principal is the face value of the note. The interest rate is the annual stated interest rate on the note. Frequency of a year is the amount of time for the note and can be either days or months. We need the frequency of a year because the interest rate is an annual rate and we may not want interest for an entire year but just for the time period of the note.

To show how to calculate interest, assume a company borrowed $20,000 from a bank. The note has a principal (face value) of $20,000, an annual interest rate of 10%, and a life of 90 days. The interest calculation is:

[latex]\$20,000\text{ principal}\times10\%\text{ interest rate}\times\left(\dfrac{90\text{ days}}{360\text{ days}}\right)=\$500[/latex]

Note that in this calculation we expressed the time period as a fraction of a 360-day year because the interest rate is an annual rate and the note life was days. If the note life was months, we would divide by 12 months for a year.

The maturity date is the date on which a note becomes due and must be paid. Sometimes notes require monthly installments (or payments) but usually all of the principal and interest must be paid at the same time. The wording in the note expresses the maturity date and determines when the note is to be paid. A note falling due on a Sunday or a holiday is due on the next business day. Examples of the maturity date wording are:

• On demand. “On demand, I promise to pay…” When the maturity date is on demand, it is at the option of the holder and cannot be computed. The holder is the payee or another person who legally acquired the note from the payee.
• On a stated date. “On July 18, 2015, I promise to pay…” When the maturity date is designated, computing the maturity date is not necessary.
• At the end of a stated period.
  1. “One year after date, I promise to pay…” When the maturity is expressed in years, the note matures on the same day of the same month as the date of the note in the year of maturity.
  2. “Four months after date, I promise to pay…” When the maturity is expressed in months, the note matures on the same date in the month of maturity. For example, one month from July 18 is August 18, and two months from July 18 is September 18. If a note is issued on the last day of a month and the month of maturity has fewer days than the month of issuance, the note matures on the last day of the month of maturity. A one-month note dated January 31, matures on February 28.
  3. “Ninety days after date, I promise to pay…” When the maturity is expressed in days, the exact number of days must be counted. The first day (date of origin) is omitted, and the last day (maturity date) is included in the count. For example, a 90-day note dated October 19 matures on January 17 of the next year, as shown here:

Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from the conversion of an overdue account receivable. When a customer does not pay an account receivable that is due, the company may insist that the customer give a note in place of the account receivable. This action allows the customer more time to pay the balance due, and the company earns interest on the balance until paid. Also, the company may be able to sell the note to a bank or other financial institution.

To illustrate the conversion of an account receivable to a note, assume that Price Company had purchased $18,000 of merchandise on August 1 from Cooper Company on account. The normal credit period has elapsed, and Price cannot pay the invoice. Cooper agrees to accept Price’s $18,000, 15%, 90-day note dated September 1 to settle Price’s open account. Assuming Price paid the note at maturity and both Cooper and Price have a December 31 year-end, the entries on the books of Cooper are:

Note: Maturity date calculated as November 30 since it was a 90 day note − 29 days left in September (30 days in Sept − note day Sept 1) − 31 days in October leaves 30 days remaining in November.

The $18,675 paid by Price to Cooper is called the maturity value of the note. Maturity value is the amount that the company (maker) must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any.

Sometimes the maker of a note does not pay the note when it becomes due. The next section describes how to record a note not paid at maturity.

A dishonored note is a note that the maker failed to pay at maturity. Since the note has matured, the holder or payee removes the note from Notes Receivable and records the amount due in Accounts Receivable.

At the maturity date of a note, the maker is responsible for the principal plus interest. The payee should record the interest earned and remove the note from its Notes Receivable account. Thus, the payee of the note should debit Accounts Receivable for the maturity value of the note and credit Notes Receivable for the note’s face value and Interest Revenue for the interest.