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 required disclosures regarding the amount, timing, and uncertainty of cash flows from leases.

If you look at Facebook:

And The Home Depot:

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

As discussed earlier, 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]

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.

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.

You can view the transcript for “Interest Bearing Notes Receivable Entries (Intermediate Financial Accounting I #10)” here (opens in new window).