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Leases

Leases. Chapter 15. Accounting by the Lessor and Lessee. 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. Lessor = Owner of property. Lessee = Renter.

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Leases

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  1. Leases Chapter 15

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

  3. Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every 6 months for the next 3 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.

  4. 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

  5. Ownershiptransfers to the lessee at the end of the lease term, or . . . A bargain purchase option(BPO) exists, or . . . The noncancelable lease term is equal to 75% or moreof the expected economic life of the asset, or The PV of the minimum lease payments is 90% or more of the fair valueof the asset. Classification Criteria Operating Lease Capital Lease A capital leasemust meet one of four criteria:

  6. Ownership transfers to the lessee at the end of the lease term, or . . . A bargain purchase option (BPO) exists, or . . . The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or The PV of the minimum lease payments is 90% or more of the fair value of the asset. Classification Criteria Operating Lease Capital Lease A capital leasemust meet one of four criteria:

  7. 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.

  8. 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.

  9. U. S. GAAP vs. IFRS

  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, 2013, Sans Serif Publishers, Inc., a computer services and printing firm, leased printing equipment from First LeaseCorp. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2013, the inception of the lease, and at each January 1 thereafter through 2016.The useful life of the equipment is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the equipment for its cash price of $479,079. If funds were borrowed to buy the equipment, the interest rate would have been 10%. At the End of Four Payment Dates San Serif Publishers, Inc. (Lessee) Prepaid rent 100,000 Cash 100,000 First LeaseCorp (Lessor) Cash 100,000 Unearned rent revenue 100,000

  12. 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

  13. 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.

  14. Capital Leases – Lessee and Lessor 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.

  15. On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment 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, 2013, the inception of the lease, and at each December 31 thereafter through 2017.The six year lease term ending December 31, 2018,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 equipment (>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 payments. *PV of an annuity due of $1: n = 6, I = 10% $100,000 × 4,79079* = $479,079 lessee’s cost

  16. Capital Leases – Lessee and Lessor Direct Financing Lease (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) 479,079 Lease payable (PV of payments) 479,079 First LeaseCorp. (Lessor) Lease receivable (PV of payments) 479,079 Inventory of equipment (Lessor’s cost) 479,079 First Lease Payment (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Lease payable 100,000 Cash 100,000 First LeaseCorp. (Lessor) Cash 100,000 Lease receivable 100,000

  17. 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

  18. Capital Leases – Lessee and Lessor Second Lease Payment (December 31, 2013) Sans Serif Publishers, Inc. (Lessee) Interest expense 37,908 Lease payable 62,092 Cash 100,000 First LeaseCorp. (Lessor) Cash 100,000 Lease receivable 62,092 Interest revenue 37,908 Depreciation Recorded at (December 31, 2013) Sans Serif Publishers, Inc. (Lessee) Depreciation expense 79,847 Accumulated depreciation 79,847 ($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

  19. Capital Leases – Lessee and Lessor Depreciation Period The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i.e., either of the first two classification criteria is met), the asset should be depreciated over its useful life.

  20. 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.

  21. On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corp. at a price of $479,079. The lease agreement specifies annual payments of $100,000 beginning January 1, 2013 (the inception of the lease), and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment. CompuDec manufactured the equipment at a cost of $300,000. CompuDec’s interest rate for financing the transaction is10%. Sales-Type Leases

  22. 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).

  23. Sales-Type Leases: Lessee At Inception of the Lease – January 1, 2013 CompuDec 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, 2013 CompuDec Corp. (Lessor) Cash 100,000 Lease receivable 100,000

  24. Bargain Purchase Optionsand Residual Value A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result: LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability. LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.

  25. Bargain Purchase Option (BPO) On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2013, the inception of the lease, and at each December 31 there after through 2017. The estimated useful life of the equipment is seven years. On December 31, 2018, at the end of the six-year lease term, the equipment is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is10%.

  26. Bargain Purchase Option (BPO) Exercise of BPO at the end of the lease term: $54,542 × 10% = $5,458* $60,000 BPO payment - $5,458 = $54,542

  27. Bargain Purchase Option (BPO) End of Lease – December 31, 2017 Sans Serif Publishers, Inc. (Lessee) Depreciation expense ($479,079 ÷ 7) 68,440 Accumulated depreciation 68,440 Interest expense 5,458 Lease payable 54,542 Cash (BPO payment) 60,000 CompuDec Corporation(Lessor) Cash 60,000 Lease receivable 54,582 Interest revenue 5,458 Refer the amortization schedule and computations on the previous screen

  28. Residual Value The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2013, the inception of the lease, and at each December 31 thereafter through 2017.The estimated useful life of the equipment is seven years. At the end of the six-year lease term, ending December 31, 2018, the equipment is expected to be worth $60,000. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is10%.

  29. Effect on the Lessee of a Residual Value Guaranteed Residual Value Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. PV factor of an annuity due of $1: n=6, i=10% PV factor of $1: n=6, i=10%

  30. Effect on the Lessee of a Residual Value Unguaranteed Residual Value A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

  31. Effects on the Lessor of a Residual Value Guaranteed Residual Value When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both.

  32. Residual Value Guaranteed Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value. Sales-Type Lease – January 1, 2013 Sans Serif Publishers, Inc. (Lessee) Leased equipment 479,079 Lease payable 479,079 CompuDec Corporation (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue 479,079 Inventory of equipment 300,000

  33. Residual Value Guaranteed First Lease Payment – January 1, 2013 Sans Serif Publishers, Inc. (Lessee) Lease payable 92,931 Cash 92,931 CompuDec Corporation (Lessor) Cash 92,931 Lease receivable 92,931

  34. Residual Value Guaranteed December 31, 2017 Sans Serif Publishers, Inc. (Lessee) Depreciation expense 69,847 Accumulation depreciation 69,847 Interest expense 13,407 Lease payable 79,524 Cash 92,931 CompuDec Corporation (Lessor) Cash 92,931 Interest revenue 13,407 Lease receivable 79,524 See amortizationschedule

  35. Treatment of Residual Value

  36. Executory Costs One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs. The lessee records executory costs as incurred: Sans Serif Publishers, Inc. (Lessee) Maintenance expense 2,000 Cash 2,000

  37. Discount Rate One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

  38. Lessor’s Initial Direct Costs Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. • Operating Leases − Capitalize and amortize over the lease term by the lessor. • Direct Financing Leases − Include as part of investment balance. • Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.

  39. Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

  40. Lease Disclosures Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description ofthe leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.

  41. Lease Disclosures The lessormust disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value). Other required disclosures are specific to the type of lease and include residual values, contingent rentals, sublease rentals, and executory costs.

  42. Balance Sheet and Income Statement • Lease transactions impact several financial ratios • Debt to equity ratio – Lease liabilities are recorded. • Rate of return on assets – Lease assets are recorded. • Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

  43. Special Leasing Arrangements • Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately. • Real Estate Leases: • Leases of Land Only • Leases of Land and Building • Leases of Only Part of a Building

  44. Summary of the Proposed Lease Standard Update

  45. Leases: Where We’re Headed The FASB and the IASB are collaborating on a joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon. In the right-of-use model introduced in the proposed standards update, all leases are recorded as an asset and liability (with the exception of short term leases as described later), and the concept of operating leases is eliminated.

  46. Right-of-Use Model

  47. Lessee and Lessor Entries

  48. Second Lease Payment [Dec. 31, 2013] Effective Rate Outstanding Balance

  49. Lease Amortization Schedule 0 No interest yet; no time has passed.

  50. The lessee amortizes its right-of-use asset over lease term (or the useful life of the asset if it’s shorter). Using the asset results in an expense for the lessee. Amortization of the Right-of-Use Asset (Lessee)

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