Leases

1. S t I c e | S t I c e | S k o u s e n Leases Intermediate Accounting 16E Chapter 15 Prepared by: Sarita Sheth | Santa Monica College COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

2. Learning Objectives • Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. • Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction. • Outline the types of contractual provisions typically included in lease agreements.

3. Learning Objectives • Apply the lease classification criteria in order to distinguish between capital and operating leases. • Properly account for both capital and operating leases from the standpoint of the lessee (asset user). • Properly account for both capital and operating leases from the standpoint of the lessor (asset owner).

4. Learning Objectives • Prepare and interpret the lease disclosures required of both lessors and lessees. • Compare the treatment of accounting for leases in the United States with the requirements of International Accounting Standards. • Record a sale-leaseback transaction for both a seller-lessee and a purchaser-lessor.

5. Lease Lease- a contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.

6. Parties Involved in a Lease • Lesse- the party granted the right to use the property under the terms of a lease. • Lessor- The owner of the property that is rented (leased) to another party.

7. Economic Advantages to Leasing • No down payment. • Avoid risks of ownership. • Flexibility.

8. Advantages to the Lessor • Increased sales. • Ongoing business relationship with lessee. • Residual value retained.

9. Simple Example Owner Company owns a piece of equipment with a market value of $10,000. User Company wishes to acquire the equipment for use in its operations.

10. Simple Example One option for User Company is to purchase the equipment from Owner by borrowing $10,000 from a bank at an interest rate of 10%. Owner would repay the principal and interest by making five annual payments of $2,638.

11. Simple Example Alternatively, User Company can lease the asset from Owner Company for five years, making annual “rental” payments of $2,638. Buy $2,638 annually Lease $2,638 annually

12. Simple Example • The key accounting issues for Owner Company: • Has effective ownership passed? • Does Owner Company have any significant responsibility remaining? • Is Owner Company reasonable certain that they five annual payments can be collected? • The key accounting issue for User Company: • Should User recognize the leased equipment as an asset and a liability to make the lease payments?

13. Simple Example Scenario One The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease. Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase.

14. Simple Example Scenario Two The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1. Offering the equipment to User Company for a bargain price at the end of the lease indicates that this is in substance a purchase.

15. Simple Example Scenario Three The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else. Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

16. Simple Example Scenario Four The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date. Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

17. Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee. Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease Different Lease Types

18. Specifies under what circumstances the lease may be canceled. Cancellation Provision Grants lessee the right to purchase the asset at the end of the lease term for less than the residual value. Bargain Purchase Option Delineates the time period the lease is to be in force. Lease Term Market value of leased asset at end of lease term. Residual Value Rental payment required over lease term plus any payment for residual value. Minimum Lease Payment Nature of Leases

19. Lease Classification Criteria • The lease transfers ownership of the leased asset to the lessee by the end of the lease term. • The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price. • The lease term is equal to 75% or more of the estimated economic life of the asset. • The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset. A lease is classified as a capital lease by the lessee if it is non-cancelable and meets any one of the following criteria:

20. No BargainPurchase Option? Yes No Term >75% of Useful Life? Yes No PV Payment >90% of FMV? Yes No Lease Classification Criteria Transfer of Ownership? Yes Capital Lease Operating Lease

21. Stop and Think How exactly does using a higher incremental borrowing rate reduce the likelihood that a lessee will be required to account for a lease as a capital lease?

22. Lease Classification-Lessor Additional revenue recognition criteria applicable to lessors. • Collectibility of the minimum lease payments is reasonably predictable. • No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.

23. Lease 1 Lessee This is a test to see if the lease qualifies as a capital lease. If it doesn’t, then it is an operating lease. Does the lease transfer ownership at the end of the lease term? No! So, we move to Criteria 2.

24. Lease 1 Lessee Does the lease contain a bargain purchase option? No! So, we move to Criteria 3.

25. Lease 1 Lessee Is the lease term equal to 75 percent or more of the estimated economic life of the asset? No! The 10-year lease covers approximately 72 percent of the economic life of the asset. So, we move to Criteria 4.

26. Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? Before we answer this question, let’s pause and review two terms related to interest on a lease.

27. Lease 1 • Implicit Interest Rate- used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease. • Lessor always uses the implicit rate to discount rental payments. • Incremental Borrowing Rate- rate that the lessee could borrow the amount of money necessary to purchase the leased asset. • Lessee uses the lesser of the implicit rate (if known) and the incremental borrowing rate.

28. Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? No, the lessee only knows the incremental borrowing rate, which provides a present value of less than 90 percent.

29. Lease 1 Lessor In addition to meeting at least one of the four criteria, the lessor must meet both of a second set of criteria. This is a capital lease to the lessor and an operating lease to the lessee. Is the collectibility of the minimum lease payment reasonably predictable AND Are there important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor?

30. Operating Lease Bob Jones signs a two-year lease which requires a monthly payment of $1,000. When the lease expires, Bob will either move out or negotiate a new lease. Rent Expense 1,000 Cash 1,000

31. Operating Leases with Varying Lease Payments The terms of a lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years and $250,000 for each of the next three years.

32. Operating Leases with Varying Lease Payments Entry Each Year for Years 1 and 2: Rent Expense 210,000 Cash 150,000 Rent Payable 60,000 Entry Each Year for Years 3-5: Rent Expense 210,000 Rent Payable 40,000 Cash 250,000

33. Accounting for Capital Leases Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 01/01/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10%

34. Accounting for Capital Lease Leased Equipment 250,192 Obligations under Capital Leases 250,192 Entries on January 1, 2007 PMT = $60,000; N = 5; I = 10% Lease Expense 5,000 Obligations under Capital Leases 60,000 Cash 65,000

35. Accounting for Capital Leases Entries on December 31, 2007 Amortization Expense on Leased Equipment 50,038 Accumulated Amortization on Leased Equipment 50,038 $250,192 ÷ 5 ($250,192 – $60,000) x 10% Prepaid Executory Costs 5,000 Obligations under Capital Leases 40,981 Interest Expense 19,019 Cash 65,000

36. BARGAIN DEAL Bargain Purchase Option (BPO) • Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price. • The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.

37. Accounting for Capital Leases with a BPO Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 01/01/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Bargain purchasing option $75,000 Lessee

38. Accounting for Capital Leases with a BPO Minimum Lease Payment Present value of five payments at the beginning of each year for five years: PMT = $60,000, N = 5, I = 10%$250,192 Present value of the bargain purchase option of $75,000 at the end of 5 years: FV = $75,000, N = 5, I = 10% 46,569 Present value of minimum lease payment$296,761

39. Accounting for Capital Leases with a BPO Entries on December 31, 2012 Obligations under Capital Leases 68,182 Interest Expense 6,818 Cash 75,000 $68,182 x 10% ($296,761 ÷ 10) x 5 years Equipment 148,381 Accumulated Amortization on Leased Equipment 148,380 Leased Equipment 296,761

40. Lessee’s Cash Flow Statement (Indirect) Impact Operating Activities Net income (includes reduction for Lease interest expense Lease amortization expense) + Amortization of leased asset Investing Activities No impact Financing Activities Principal portion of lease payment

41. Lessee’s Cash Flow Statement (Direct) Impact Operating Activities - Lease Interest Expense Investing Activities No impact Financing Activities - Principal portion of lease payment

42. Accounting for Leases- Lessor • Insert exhibit 15-7

43. Accounting for Operating Leases Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost to lessor $400,000 Direct costs incurred $15,000 Lessor

44. Accounting for Operating Leases- Lessor At Inception of 1/ 1/07 Deferred initial Direct Costs 15,000 Cash 15,000 At Receipt of First Payment 1/1/07 Cash 65,000 Rent Revenue 60,000 Executory Costs 5,000

45. Accounting for Operating Leases- Lessor At End of the First Year 12/31/2007 Amortization of Initial Direct Costs 3,000 Deferred Initial Direct Costs 3,000 Depreciation Expense on Leased Equipment 40,000 Accumulated Depreciation on Leased Equipment 40,000 $400,000 ÷ 10

46. Direct Financing Lease Accounting for a direct financing lease for lessors is similar to that used for capital leases by the lessee—only in reverse. Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment $250,192

47. Accounting for Direct Financing Leases- Lessor At Inception of 1/1/07 Lease Payment Receivable 250,192 Equipment Purchased for Lease 250,192 At Receipt of First Payment 1/1/07 Cash 65,000 Lease Payment Recievable 60,000 Executory Costs 5,000

48. Direct Financing Lease At End of the First Year 12/31/2007 Cash 65,000 Lease Payment Receivable 40,981 Interest Revenue 19,019 Deferred Executory Costs 5,000 A Liability

49. Accounting for Direct Financing Leases with Residual Value Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease $75,000 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment $296,761 Lessor

50. Direct Financing Leases with Residual Value- Lessor At Inception of 1/1/07 Lease Payment Receivable 296,761 Equipment Purchased for Lease 296,761 At Receipt of First Payment 1/1/07 Cash 65,000 Lease Payment Recievable 60,000 Executory Costs 5,000