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Accounting for Leases

PART III: Decision Tools. Lecture 28. Accounting for Leases. Instructor Adnan Shoaib. Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for capitalizing leases by the lessee.

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Accounting for Leases

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  1. PART III: Decision Tools Lecture 28 Accounting for Leases Instructor Adnan Shoaib

  2. Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for capitalizing leases by the lessee. Contrast the operating and capitalization methods of recording leases. Identify the classifications of leases for the lessor. Describe the lessor’s accounting for direct-financing leases. Learning Objectives

  3. Accounting for Leases Leasing Environment Accounting by Lessee Accounting by Lessor Special Accounting Problems Who are players? Advantages of leasing Conceptual nature of a lease Capitalization criteria Accounting differences Capital lease method Operating method Comparison Economics of leasing Classification Direct-financing method Operating method Residual values Sales-type leases Bargain-purchase option Initial direct costs Current versus noncurrent Disclosure Unresolved problems

  4. The Leasing Environment A leaseis a contractual agreement between a lessor and a lessee, that gives the lesseethe right to use specific property, owned by the lessor, for a specified period of time. • Largest group of leased equipment involves: • Information technology • Transportation (trucks, aircraft, rail) • Construction • Agriculture LO 1 Explain the nature, economic substance, and advantages of lease transactions.

  5. The Leasing Environment Who Are the Players? Captive Leasing Banks Independents • Wells Fargo • Chase • Citigroup • PNC • Caterpillar Financial Services Corp. • Ford Motor Credit (Ford) • IBM Global Financing 23% 47% Market Share 26% LO 1

  6. The Leasing Environment Advantages of Leasing • 100% financing at fixed rates. • Protection against obsolescence. • Flexibility. • Less costly financing. • Tax advantages. • Off-balance-sheet financing. LO 1 Explain the nature, economic substance, and advantages of lease transactions.

  7. The Leasing Environment Conceptual Nature of a Lease Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases. LO 1 Explain the nature, economic substance, and advantages of lease transactions.

  8. A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Accounting by the Lessor and Lessee Lessor = Owner of property Lessee = Renter

  9. The Leasing Environment Substance versus Form Operating Lease Rent expense xxx Cash xxx Although technically legal title may not pass, the benefits from the use of the property do. Capital Lease Leased equipment xxx Lease liability xxx LO 1 Explain the nature, economic substance, and advantages of lease transactions.

  10. Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

  11. Inception of the Agreement At inception January 1 Installment Note Equipment 1,000,000 Notes payable 1,000,000 Capital Lease Leased Equipment 1,000,000 Lease payable 1,000,000 First payment, June 30 Installment Note Interest expense 45,000 Notes payable 148,878 Cash 193,878 Capital Lease Interest expense 45,000 Lease payable 148,878 Cash 193,878

  12. Ownershiptransfers to the lessee at the end of the lease term, or . . . A bargain purchase option (BPO) exists, or . . . The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or . . . The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset. Classification Criteria Operating Lease Capital Lease A capital lease must meet one of four criteria:

  13. Classification Criteria A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured. The lease term is normally considered to be the non-cancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

  14. Additional Lessor Conditions • The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: • The collectibility of the lease payments must be reasonably predictable. • If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete. Lessor = Owner of the property subject to the lease.

  15. Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. CapitalLease

  16. Operating Leases On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%. At End of the Four Payment Dates San Serif Publishers, Inc. (Lessee) Prepaid rent 100,000 Cash 100,000 CompuDec Corporation (Lessor) Cash 100,000 Unearned rent revenue 100,000

  17. Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term. Leasehold Improvements

  18. Capital Leases – Lessee and Lessor The amount recorded (capitalized) is the present value of the minimum lease payments. However, the amount recorded cannot exceed the fair value of the leased asset. • In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: • Its incremental borrowing rate, or • The implicit interest rate used by the lessor.

  19. Capital Leases – Lessee and Lessee If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price.

  20. On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016,is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000. Capital Leases – Lessee and Lessor • $479,079 ÷ 4.79079* = $100,000 rental payments. • *PV of an annuity due of $1: n = 6, I = 10% • $100,000 × 4,79079* = $479,079 lessee’s cost

  21. Capital Leases – Lessee and Lessor Direct Financing Lease (January 1, 2011) San Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) 479,079 Lease payable (PV of payments) 479,079 First Lease Corp. (Lessor) Lease receivable (PV of payments) 479,079 Inventory of equipment (Lessor’s cost) 479,079 First Lease Payment (January 1, 2011) San Serif Publishers, Inc. (Lessee) Lease payable 100,000 Cash 100,000 First Lease Corp. (Lessor) Cash 100,000 Lease receivable 100,000

  22. Capital Leases – Lessee and Lessor Amortization Schedule for the Lease $379,079 - $62,092 = $316,987 $379,079 × 10% = $37,908 $100,000 - $37,908 = $62,092

  23. Capital Leases – Lessee and Lessor Second Lease Payment (December 31, 2011) San Serif Publishers, Inc. (Lessee) Interest expense 37,908 Lease payable 62,092 Cash 100,000 First Lease Corp. (Lessor) Cash 100,000 Lease receivable 62,092 Interest revenue 37,908 Depreciation Recorded at (December 31, 2011) San Serif Publishers, Inc. (Lessee) Depreciation expense 79,847 Accumulated depreciation 79,847 ($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

  24. If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset. Sales-Type Leases At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of payments). In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.

  25. On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from CompuDec Corp. at a price of $479,079. The lease agreement specifies annual payments of $100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through 2015. The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier. CompuDec manufactured the copier at a cost of $300,000. CompuDec’s interest rate for financing the transaction is10%. Sales-Type Leases

  26. Sales-Type Leases Lease Classification The lease term (6-years) is equal to 100% of the useful life of the copier, and Fair market value is difference from cost of the leased asset. CompuDec is certain about the collectibility of the lease payments, and No costs are to be incurred by CompuDec relating to the lease agreement, SO The lease agreement is classified as a Sales-Type lease from the viewpoint of CompuDec (lessor) and a capital lease from the viewpoint of Sans Serif Publishers (lessee).

  27. Sales-Type Leases: Lessee At inception of the Lease – January 1, 2011 CompDec Corp. (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue 479,079 Inventory of equipment 300,000 Receipt of the First Lease Payment – January 1, 2011 CompDec Corp.(Lessor) Cash 100,000 Lease receivable 100,000

  28. Accounting by the Lessee • If the lessee capitalizesa lease, the lessee records an asset and a liability generally equal to the present value of the rental payments. • Records depreciation on the leased asset. • Treats the lease payments as consisting of interest and principal. Journal Entries for Capitalized Lease LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  29. Accounting by the Lessee • For a capital lease, the FASB has identified four criteria. • Lease transfers ownership of the property to the lessee. • Lease contains a bargain-purchase option. • Lease term is equal to 75 percent or more of the estimated economic life of the leased property. • The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. One or more must be met for finance lease accounting. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  30. Accounting by the Lessee Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  31. Accounting by the Lessee Capitalization Criteria • Transfer of Ownership Test • Not controversial and easily implemented. • Bargain-Purchase Option Test • At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  32. Accounting by the Lessee Capitalization Criteria • Economic Life Test (75% Test) • Lease term is generally considered to be the fixed, noncancelable term of the lease. • Bargain-renewal option can extend this period. • At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  33. Accounting by the Lessee Illustration: Home Depot leases Dell PCs for two years at a rental of $100 per month per computer and subsequently can lease them for $10 per month per computer for another two years. The lease clearly offers a bargain-renewal option; the lease term is considered to be four years. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  34. Accounting by the Lessee Capitalization Criteria Recovery of Investment Test (90% Test) Minimum Lease Payments: • Minimum rental payment • Guaranteed residual value • Penalty for failure to renew or extend the lease • Bargain-purchase option Executory Costs: • Insurance • Maintenance • Taxes Exclude from PV of Minimum Lease Payment Calculation LO 2

  35. Accounting by the Lessee Capitalization Criteria Discount Rate • Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception. • If the lessee knows the implicit interest ratecomputed by the lessorand it is less than the lessee’s incremental borrowing rate, then lessee must use the lessor’s rate. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  36. Accounting by the Lessee Asset and Liability Accounted for Differently • Asset and Liability Recorded at the lower of: • present value of the minimum lease payments (excluding executory costs) or • fair-market value of the leased asset. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  37. Accounting by the Lessee Asset and Liability Accounted for Differently • Depreciation Period • If lease transfers ownership, depreciate asset over the economic life of the asset. • If lease does not transfer ownership, depreciate over the term of the lease. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  38. Accounting by the Lessee Asset and Liability Accounted for Differently • Effective-Interest Method • Used to allocate each lease payment between principal and interest. • Depreciation Concept • Depreciation and the discharge of the obligation are independent accounting processes. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  39. Accounting by the Lessee On January 1, 2012, Adams Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9,968 at the beginning of each year, starting January 1, 2012. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adams’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown. • Instructions • What type of lease is this? Explain. • Compute the present value of the minimum lease payments. • Prepare all necessary journal entries for Adams for this lease through January 1, 2013. LO 2

  40. Capitalization Criteria: Transfer of ownership Bargain purchase option Lease term = 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property Accounting by the Lessee What type of lease is this? Explain. Capital Lease, #3 NO NO Lease term 5 yrs. Economic life 6 yrs. YES 83.3% FMV of leased property is unknown. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  41. Accounting by the Lessee Compute present value of the minimum lease payments. Payment $ 9,968 Present value factor (i=10%,n=5) 4.16986 PV of minimum lease payments$41,565 1/1/12 Journal Entries: Leased Machine (under capital leases) 41,565 Lease Liability 41,565 Lease Liability 9,968 Cash 9,968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  42. Accounting by the Lessee Lease Amortization Schedule LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  43. Accounting by the Lessee Journal entries for Adams through Jan. 1, 2013. 12/31/12 Depreciation Expense 8,313 Accumulated Depreciation 8,313 ($41,565 ÷ 5 = $8,313) Interest Expense 3,160 Interest Payable 3,160 ($41,565 – $9,968) X .10] LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  44. Accounting by the Lessee Journal entries for Adams through Jan. 1, 2012. 1/1/13 Lease Liability 6,808 Interest Payable 3,160 Cash 9,968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  45. Accounting by the Lessee Operating Method The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. Illustration: Assume Adams accounts for it as an operating lease. Adams records this payment on January 1, 2012, as follows. Rent Expense 9,968 Cash 9,968 LO 3 Contrast the operating and capitalization methods of recording leases.

  46. Accounting by the Lessee Comparison of Capital Lease with Operating Lease LO 3 Contrast the operating and capitalization methods of recording leases.

  47. Accounting by the Lessor Benefits to the Lessor • Interest revenue. • Tax incentives. • High residual value. LO 4 Identify the classifications of leases for the lessor.

  48. Accounting by the Lessor Economics of Leasing A lessor determines the amount of the rental, based on the rate of return—the implicit rate—needed to justify leasing the asset. If a residual value is involved (whether guaranteed or not), the company would not have to recover as much from the lease payments LO 4 Identify the classifications of leases for the lessor.

  49. Accounting by the Lessor Fieval Leasing Company signs an agreement on January 1, 2012, to lease equipment to Reid Company. The following information relates to this agreement. • The term of the non-cancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. • The cost and fair value of the asset at January 1, 2012, is $343,000. • The asset will revert to the lessor at the end of the lease term, at which time the asset is expected to have a residual value of $61,071, none of which is guaranteed. • The agreement requires equal annual rental payments, beginning on January 1, 2012. • Collectability of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. LO 4 Identify the classifications of leases for the lessor.

  50. Accounting by the Lessor Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. x - ÷ LO 4 Identify the classifications of leases for the lessor.

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