Leases

1. Acct 414 – Fall 2008 – Prof. Teresa Gordon Leases PV Computations Classification of Leases Under US GAAP & IFRS

2. Inception date: 1/1/12 Lessor: Troy Tractors Inc. Fair value of combine at 1/1/02: $50,000 Cost to manufacture combine: $40,000 Estimated fair value at end of lease is $10,000 Fixed non-cancelable lease term: 5 years. First payment due on 12/31/12 Lessee: Farview Farms Incremental borrowing rate (lessee): 12% Implicit interest rate (known to lessee): 12% Option to buy at end of lease term for $5,000 Estimated useful life of combine: 8 years BPO - Lease 1E 1e

3. Bargain Purchase Option 1e PAYMENT INTEREST "PRINCIPAL" BALANCE 0 50,000.00 1 $13,083 $6,000.00 $7,083.00 42,917.00 2 13,083 5,180.04 7,932.96 34,984.04 3 13,083 4,198.08 8,884.92 26,099.12 4 13,083 3,131.89 9,951.11 16,148.01 5 18,083 1,934.99 16,148.01 0.00 Note that the last payment willinclude the $5,000 BPO

4. Bargain Purchase Option 1e PAYMENT INTEREST "PRINCIPAL" BALANCE 0 50,000.00 1 $13,083 $6,000.00 $7,083.00 42,917.00 2 13,083 5,150.04 7,932.96 34,984.04 3 13,083 4,198.08 8,884.92 26,099.12 4 13,083 3,131.89 9,951.11 16,148.01 5 18,083 1,934.99 16,148.01 0.00 $13,083 - $6,000 $50,000 * 12% $50,000 - $7,083 An ordinary annuity situation – the first line includes interest

5. 1. Inception date: 1/1/12 2. Lessor: Troy Tractors Inc. 3. Fair value of combine at 1/1/12: $50,000 4. Estimated fair value at end of lease is $10,000 5. First payment due on 1/1/12 6. Lessee: Farview Farms 7. Fixed non-cancelable lease term: 6 years. 8. Option to buy at end of lease term for $2,000 9. Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40,000. Example 1F 1f What amount should the payment be given that the lessor requires a 12% return?

6. 1. Inception date: 1/1/12 2. Lessor: Troy Tractors Inc. 3. Fair value of combine at 1/1/12: $50,000 4. Estimated fair value at end of lease is $10,000 First payment due on 1/1/12 6. Lessee: Farview Farms 7. Fixed non-cancelable lease term: 6 years 8. Option to buy at end of lease term for $2,000 9. Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40,000. 12. Payment = 10,638 Example 1F 1f Now, classify the lease

7. Example 1f 1f PAYMENT INTEREST "PRINCIPAL" BALANCE $50,000.00 0 $10,638 $ 0.00 $10,638.00 39,362.00 1 10,638 4,723.44 5,914.56 33,447.44 2 10,638 4,013.69 6,624.31 26,823.13 3 10,638 3,218.78 7,419.22 19,403.91 4 10,638 2,328.47 8,309.53 11,094.38 5 10,638 1,331,33 9,306.67 1,787.71 6 2,000 212.29 1,787.71 0.00 Note that the first payment is ALL principalsince no interest has yet been incurred 10,638 - 4,723 39,362 * 12% Note that there is interest on the BPO 39,362 - 5,915 This is an annuity due situation – the first payment is 100% principal.

8. A quick comparison IFRS vs. US GAAP IAS 17 vs. FAS 13 as amended many times

9. IFRS uses “indicators” that are considered as a whole • Indications that a contract is a FINANCE lease • Title transfer • Bargain purchase option • Term of lease covers a majority of leased asset’s economic life • Present value of minimum lease payments is equivalent to nearly all of the leased asset’s fair value Note that IFRS has no “bright line” rules But there’s more!

10. Indications that a contract is a FINANCE lease (continued) • Leased assets are of a specialized nature and are only usable by the lessee unless substantial costs are incurred to modify (nothing comparable in US GAAP) • Upon early termination of lease, lessee is responsible for lessor’s losses • Any gains & losses due to fluctuations in fair value of leased asset are attributed to the lessee • Lessee has option to renew for below market cost

11. Terminology Differences

12. 1. Inception of the lease: January 1, 2012 2. Term: 3 years 3. Implicit interest rate (known to lessee) 10% 4. Fair value of asset $100,000 5. Incremental borrowing rate: 12% 6. No collection or cost uncertainties for lessor 7. First payment due 1/1/12 8. Estimated useful life of asset: 5 years 9. Lessor retains ownership of asset at end of lease 10. Cost of asset $100,000 11. Payments of $36,556 per year Example 2 2

13. What to use for “i” • To do present value computations, we need an interest rate. • Lessors always use the interest rate implicit in the lease • The lessee uses the LOWER of the implicit interest rate and their own incremental borrowing rate • Under IFRS: • “The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall be used.

14. 1. Inception of the lease: January 1, 2012 2. Term: 3 years 3. Implicit interest rate (NOT known to lessee) 10% 4. Fair value of asset $100,000 5. Incremental borrowing rate: 12% 6. No collection or cost uncertainties for lessor 7. First payment due 1/1/12 8. Estimated useful life of asset: 5 years 9. Lessor retains ownership of asset at end of lease 10. Cost of asset $100,000 11. Payments of $36,556 per year Example 2a 2a What if the lessor’s rate were NOT known to lessee? What would be the PVMLP?

15. 1. Term: 3 years 3. Implicit interest rate (known to lessee) 10% 5. Fair value of asset $130,000 7. Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2. Payments of $46,836 4. Est. fair value of asset at end of lease $2,500 6. Cost of asset $100,000 8. First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 4a Classify lease under US GAAP and IFRS

16. 1. Term: 3 years 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $130,000 7. Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2. Payments of $46,836 4. Est. fair value of asset at end of lease $5,000 6. Cost of asset $100,000 8. First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 4b What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.

17. 1. Term: 3 years 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $130,000 7. Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2. Payments of $46,836 4. Est. fair value of asset at end of lease $5,000 6. Cost of asset $100,000 8. First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 4c What if the fair value of the asset is $5,000 at end of the lease? Find the PVMLP.

18. Complications Initial Direct Costs Residual Values

19. Initial Direct Costs

20. Residual Value and MLP • Include guaranteed residual value of property when computing PVMLP • If guaranteed by lessee • If guaranteed by third party, only lessor includes as part of minimum lease payments • Unguaranteed residual value is NOT included in MLP Remember that the UnGRV is part of lessor’s receivable and therefore is included in the amortization table!

21. Term: 4 years Payments of $83,099 Implicit interest rate (known to lessee) 10% Lessor retains ownership of asset at end of lease Fair value of asset $300,000 Cost of asset $250,000 Incremental borrowing rate: 12% First payment due 1/1/02 Estimated useful life of asset: 5 years No collection or cost uncertainties for lessor Est. fair value of asset at end of lease: $15,000 The residual value is guaranteed by a third party at a cost of $500 (initial direct cost) On 1/1/12, Micronomics Inc. and Ozark Oscillators entered into a lease with the following terms: 6

22. Two different tables needed! 6

23. 1. Term: 3 years 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $100,000 7. Incremental borrowing rate: 14% 9. Estimated useful life of asset: 5 years 11. Est. fair value of asset at end of lease: $10,000 2. Payments of $33,809 4. Lessor retains ownership of asset at end of lease 6. Cost of asset $100,000 8. First payment due 10/1/02 10. No collection or cost uncertainties for lessor 12. The residual value is NOT guaranteed by lessee On October 1, 2002, Seiler Systems and Computer Leasing of America sign a lease with the following terms: 8

24. Example 7 - Lessor 7 • Now we’re ready for the HARDEST type of journal entries: a sales-type lease with unguaranteed residual value • If there is an UnGRV, the lessor has not “sold” the entire asset • This means we need to reduce sales and cost of goods sold for the present value of the unGRV

25. More complications . . . Lease Term Renewal Periods Executory Costs

26. Determining the Lease Term • Always ends at a bargain purchase option (including ordinary renewal periods up to BPO). • Includes renewal periods covered by • bargain renewal options • penalty large enough to assure renewal • renewal or extensions at option of lessor • guarantees by lessee of lessor's debt related to property

27. Excluded from MLP • Exclude contingent rentals • Exclude all rental payments past date of bargain purchase option • Exclude renewal penalty big enough to assure renewal • Exclude executory costs paid by lessor: • maintenance • property taxes • insurance

28. 1. Term: 4 years 3. Interest rate used to compute payments = 12% 5. Fair value of asset $200,000 7. Incremental borrowing rate: 14% 9. Estimated useful life of asset: 6 years 11. Est. fair value of asset at end of lease: $10,000 13. Initial direct costs to arrange lease: $3,000 2. Payments of $61,924 4. Cost of asset $200,000 6. First payment due 6/1/12 8. No collection or cost uncertainties for lessor 10. The payments include $5,000 for insurance. 12. The lessee can purchase asset for $10,000 at end of lease, otherwise, asset is returned to lessor. On June 1, 2012, Fantasia Funnels, Inc. and Idaho First Bank sign a lease with the following terms: 11

29. Finding the Effective Interest Rate for Direct Financing Lease with IDC 11

30. Lessor Amortization Table 11

31. Term: 4 years with possible renewal (see #12) Implicit interest rate (NOT known to lessee) 10% Fair value of asset $200,000 Incremental borrowing rate: 14% Estimated useful life of asset: 6 years The residual value is NOT guaranteed by lessee, asset is expected to be worth $25,000 at end of 4 years, and $15,000 at end of 5 years. Payments of $49,523 Lessor retains ownership of asset at end of lease Cost of asset $200,000 First payment due 1/1/02 No collection or cost uncertainties for lessor At the end of the lease, HGJB can renew for one more year at same annual amount of $49,523. This is certainly no bargain. There is a $15,000 penalty for non-renewal of the lease. However, this amount is probably not large enough to assure that HGJB will renew. On January 1, 2012, Hells Gate Jet Boats and Washington Leasing Co. sign a lease with the following terms: 12

32. 1. Term: 4 years, with possible renewal (see #11) 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $260,000 7. Incremental borrowing rate: 12% 9. Estimated useful life of asset: 6 years 11. Lease can be renewed for one more year at $17,000. The actual value is probably $25,000. 13. There are no guarantees of residual value 2. Payments of $68,565 4 . Lessor retains title tothe asset at end of lease 6. Cost of asset $200,000 8. First payment due 1/1/12 10. No collection or cost uncertainties for lessor 12. Est. fair value of asset at end of original lease term is $35,000. It should be worth $15,000 at the end of 5 years. Inception = 1/1/12 13