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LEASES (Chapter 15)

LEASES (Chapter 15). Learning Objectives 1. Identify and describe the operational, financial, and tax objectives that motivate leasing. 2. Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing .

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LEASES (Chapter 15)

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  1. LEASES (Chapter 15) • Learning Objectives • 1. Identify and describe the operational, financial, and tax objectives that motivate leasing. • 2. Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing. • 3. Explain the basis for each of the criteria and conditions used to classify leases. • 4. Record all transactions associated with operating leases by both the lessor and lessee. • 5. Describe and demonstrate how both the lessee and lessor account for a capital lease. • 6. Describe and demonstrate how the lessor accounts for • a sales-type lease.

  2. LEASES Learning Objectives: 7. Explain how lease accounting is affected by the residual value of a leased asset. 8. Describe the way a bargain purchase option affects lease accounting. 9. Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs, and contingent leases. 10. Explain sale-leaseback agreements and other special leasing arrangements and their accounting treatment. 11. Discuss the primary differences between U.S. GAAP and IFRS with respect to leases. 12. Oct. 2011 CPA Exam Coverage

  3. A lease is usually a non-cancelable agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessor = OWNER of property Lessee = USER of property

  4. Conceptual Nature of a Lease The issue of how to report leases is the case of substance versus form. Lessee = USER of property; Lessor = OWNER of property Although technically legal title may not pass, the benefits from the use of the property do.

  5. Conceptual Nature of a Lease A variety of opinions exist regarding the manner in which certain long-term lease arrangements should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB Statements dealing with lease accounting can be characterized as advocating capitalization of lease arrangements that are similar to installment purchases.

  6. Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $100,000 every year for the next ten years. The interest rate associated with the agreement is 0%. Let’s look at the arrangement as an installment salesand as a capital lease agreement. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. Therefore, according to FASB it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase.Therefore, the accounting (the balance sheet presentation of the LIABILITY) for Installment Note Payable or Lease Payable should be exactly the same and NOT Off-Balance Sheet.

  7. LEASES We are tracking the question of LIABILITYand it is arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales typeleases by the lessor. Leases that do not produce debtor/creditor relationships, but instead are accounted for as rental agreements are designated as operating leases.

  8. Conceptual Nature of a Lease Capitalize a lease that transfers substantially allof the benefits and risks of property ownership, provided the lease is non-cancelable. Leases that do not transfer substantially all of the benefits and risks of ownership are operating leases. ASC 840 (FAS 13, Accounting for Leases,” 1980)

  9. Accounting by the Lessee Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

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

  11. 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%. How should this lease be classified?

  12. Operating Leases • How should this lease be classified? We apply the four classification criteria: • Does the agreement specify that ownership of the asset transfers to the lessee? NO • 2 Does the agreement contain a bargain purchase option? NO • Is the lease termequal to75% or more of the expected economic life of the asset? {4 yrs < 75% of 6 yrs} NO • Is the present value of the minimum lease payments equalto or greater than 90% of the fair value of the asset? NO • Calculations:PV of MLP =$348,685 = $100,000 x 3.48685** Lease present payments value** present value of an annuity due of $1: n=4, i=10% • $348,685 <90% of $479,079 = $431,171 •  Since none of the four classification criteria is met, this is an operating lease.

  13. Operating Leases At Each of the Four Payment Dates: Sans Serif Publishers, Inc. (Lessee) Prepaid rent 100,000 Cash 100,000CompuDec Corporation (Lessor)Cash 100,000 Unearned rent revenue 100,000At the End of Each Year:Sans Serif Publishers, Inc. (Lessee)Rent expense 100,000 Prepaid rent 100,000CompuDec Corporation (Lessor)Unearned rent revenue 100,000 Rent revenue 100,000 Depreciation expense x,xxx Accumulated depreciation x,xxx

  14. 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 expenseover 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

  15. Exercise 1Brief Exercises 1-3 Exercise 2

  16. Advantages of Leasing A. Leasing is used as a means of “off-balance-sheet financing.” 1. Can avoid negatively affecting the debt-asset ratio and other mechanical indicators of riskiness. 2. Market is naive, and is “fooled” by off-balance-sheet financing. B. Achieves operational objectives by facilitating asset acquisition to overcome: 1. Uncertainty or cash flow problems. 2. Fear of obsolescence. C. Achieves tax objectives: Lower lease payments for LESSEE if it allows the lessor to retain ownership and thus benefit from ITC and Depreciation deductions when: 1. The lessee has little or no taxable income and will get little benefit from depreciation deductions. 2. The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessor.

  17. 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 moreof the expected economic life of the asset, or . . . The PV of the minimum lease payments (MLP) is 90% or more of the fair valueof the asset. Classification Criteria (Lessee) Operating Lease Capital Lease A capital leasemust meet one of four criteria:

  18. Accounting by the Lessee Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

  19. Accounting by the Lessee • 1. The transfer of ownership criteria is straightforward and easy to apply in practice. • IF THE LEASE TRANSFERS OWNERSHIP OF THE ASSET TO THE LESSEE, IT IS A CAPITAL LEASE

  20. Accounting by the Lessee 2. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable. At the inception of the lease, the difference between the option price and the expected FMVmust be large enough to make the exercise of the option reasonably assured. Example: Lease Honda Accord for $599/Month for 40 monthswith an option to purchase for $100 at the end of the 40th month when the estimated FMV then is $3000. => Clearly a BARGAIN *Difficult to determine what is a BARGAIN: BOA or HERTZ

  21. Accounting by the Lessee • 3. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the asset’s economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate. • BARGAIN RENEWAL OPTION can extend the lease term. *Difficult to determine what is a BARGAIN • A major exception to the 75% rule is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% test should not be used.

  22. Accounting by the Lessee 4. The reason for the 90% of fair market value test is that if the present value of the minimum lease payments are reasonably close to the market price (FMV) of the asset,the asset is effectively being purchased. A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% and 90% tests should not be used.

  23. Accounting by the Lessee Recovery of Investment Test (90% Test): PV of Minimum lease payments: (>=90% of FMV) • Minimum rental payment • Guaranteed residual value • Penalty for failure to renew • Bargain purchase option Executory Costs: • Insurance • Maintenance • Taxes Included in PV of Minimum Lease Payment calculation Exclude from PV of Minimum Lease Payment calculation Based on the examples provided in ASC 840, executory costs are costs incurred for operating the leased property or that otherwise protect the value of the leased property.

  24. Accounting by the Lessee Recovery of Investment Test (90% Test): The residual value of a leased asset is the estimated fair value of the asset at the end of the lease term. The residual value may be guaranteed or unguaranteed by the lessee. A guaranteed residual value is said to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the end of the lease term. A guaranteed residual value affects the lessee’s computation of the minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The lessor assumes the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.

  25. Accounting by the Lessee Recovery of Investment Test (90% Test) To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees the residual value of an asset will be $8,000. If, at the end of the lease, the fair market value of the residual value is less than $8,000, the lessee will have to record a loss for the difference. For example, if the lessee depreciated the asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee would have to record a loss of $4,000. If the fair market value of the asset exceeds the $8,000, a gain may be recognized.

  26. Accounting by the Lessee Recovery of Investment Test (90% Test) Executory Costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation.

  27. Accounting by the Lessee Recovery of Investment Test (90% Test): • 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 lessor and it is less than the lessee’s incremental borrowing rate, then lessee must use the lessor’s rate.

  28. Accounting by the Lessee For the lessee, a capital lease is treated as if it is a purchase of an asset – the lessee records both an asset and liabilityat inception of the lease.

  29. Accounting by the Lessee • Asset and Liability Recorded at the lower of: • the present value of the minimum lease payments (excluding executory costs) or • the fair-market value of the leased asset.

  30. 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 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. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable. 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. Capital Leases – Lessee

  31. *PV of an annuity due of $1: n = 6, I = 10% => 4.79079 • $100,000 × 4,79079* = $479,079 lessee’s cost

  32. Capital Leases – Lessee Inception Of 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 Payment (January 1, 2011) San Serif Publishers, Inc. (Lessee) Lease payable 100,000 Cash 100,000

  33. 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

  34. 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 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.)

  35. -Exercise 3-EX 3: Fin. Stmt. 12/31/11 -Exercise 7 -Exercise 8 + F/S 12/31/11

  36. Accounting by the Lessor Economics of Leasing A lessordetermines the amount of the rental, based on the rate of return 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.

  37. Accounting by the Lessor Classification of Leases by the Lessor • Operating leases. • Direct-financing leases. • Sales-type leases. A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.

  38. Accounting by the Lessor Classification of Leases by the Lessor Illustration 21-11 A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. LO 4 Identify the classifications of leases for the lessor.

  39. Accounting by the Lessor Classification of Leases by the Lessor Illustration 21-12 A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease. LO 4 Identify the classifications of leases for the lessor.

  40. 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. => Direct Financing Lease 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.=> Sales-type Lease

  41. 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 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. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable. 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. This lease also qualifies 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

  42. Lessor’s Determination of Rental payments: $479,079 ÷ 4.79079* = $100,000 rental payments. *PV of an annuity due of $1: n = 6, I = 10% Lessee’s Determination of Lease liability and asset: $100,000 × 4,79079* = $479,079 lessee’s cost *PV of an annuity due of $1: n = 6, I = 10%

  43. Capital Leases – Lessor Direct Financing Lease (January 1, 2011) 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) First Lease Corp. (Lessor) Cash 100,000 Lease receivable 100,000

  44. 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

  45. Capital Leases – Lessee and Lessor Second Lease Payment (December 31, 2011) First Lease Corp. (Lessor) Cash 100,000 Lease receivable 62,092 Interest revenue 37,908

  46. Exercise 4 (JEs ONLY)Exercise 9 (JEs & FSs)

  47. 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 theCost of Goods Soldas 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.

  48. 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

  49. 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 different 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).

  50. 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

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