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Leases

Leases. Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso. Basics of Leasing. Lease Contractual agreement between lessor and lessee Gives lessee right to use specific property Specifies duration and rental payments Executory costs

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Leases

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  1. Leases Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso

  2. Basics of Leasing • Lease • Contractual agreement between lessor and lessee • Gives lessee right to use specific property • Specifies duration and rental payments • Executory costs • Taxes, insurance and maintenance • May be assumed by either party

  3. Advantages • 100% financing at fixed rates • Protection against obsolescence • Flexibility • Less costly financing • AMT problems avoided • Off-balance-sheet financing

  4. Classification of Leases • Capital leases • If lease transfers substantially all of the benefits and risks of ownership • Must be noncancelable • Operating leases • Do not substantially transfer benefits and risks of ownership

  5. Accounting by Lessee • Capitalize if noncancelable, and • Transfers ownership to lessee, or • Contains bargain purchase option, or • Lease term equal to 75% or more of estimated economic life of property, or • PV of minimum lease payments equals or exceeds 90% of fair value of property

  6. Accounting by Lessee

  7. Bargain Purchase Option • Allows lessee to buy leased asset • Price significantly lower that expected fair value at date of option • Determined at inception of lease • Must render option reasonably assured

  8. Economic Life Test • Lease period equals or exceeds 75% of asset’s economic life • Lease term is considered the fixed noncancelable term of lease • Bargain renewal options are included • If lease starts during last 25% of life of asset, test cannot be used

  9. Recovery of Investment • PV of minimum lease payments equals or exceeds 90% of fair value • Minimum lease payments • Payments • Guaranteed residual value • Penalty for failure to renew or extend • Bargain purchase option

  10. Discount Rate • The lesser of • Lessee’s incremental borrowing rate, or • The implicit interest rate

  11. Executory Cost • Insurance, maintenance and taxes • Should be excluded from minimum lease payments

  12. Residual Values • Estimated fair value at end of lease • Guaranteed residual value • An additional lease payment • Unguaranteed residual value • Same as no residual value to lessee • Lessor assumes residual value will be realized whether guaranteed or not

  13. Capitalized LeasesAccounting by Lessee • Asset and Liability • Recorded at the lesser of the PV of minimum lease payments or FMV • Depreciation Period • Economic life • Lease transfers ownership • Lease has bargain purchase option • Term of lease

  14. Fact Pattern • Date: January 1, 2006 • Lease term: 10 years • Discount rate: 8% • Annual lease payments: $12,000 • Executory costs: $1,000 • Title transfers at end of lease term • Economic life of asset: 12 years • Residual value: $0

  15. Operating Leases Accounting by Lessee • Lessee assigns rent to periods benefiting • Ignores any commitments for future payments • Note disclosure • For all operating leases that have noncancelable lease terms in excess of one year

  16. Classification of Leases Accounting by Lessor • Direct financing leases • Sales type leases • Operating leases

  17. Direct Financing Lease • Must meet group I capitalization criteria and • Collectibility of payments must be reasonably assured • Lessor’s performance must be substantially complete • FV of asset equal to lessor’s book value

  18. Sales Type Lease • Must meet group I capitalization criteria and • Collectibility of payments must be reasonably assured • Lessor’s performance must be substantially complete • FV of asset should not be equal to lessor’s book value • Lease contains a dealer’s gross profit

  19. Operating LeaseAccounting by Lessor • Does not meet criteria for capitalized lease • Rental receipts recorded as rental receipts • Leased asset depreciated • Leased equipment and accumulated depreciation separately classified

  20. Accounting by Lessor

  21. Direct Financing Lease • Debit, Lease receivable • Gross sum of lease payments • Credit, Unearned interest revenue • Lease receivable less FMV of asset • Credit, Inventory of equipment • Lessor’s cost of the asset

  22. Fact Pattern • Date: January 1, 2005 • Inventory of equipment: $103,500 • Lease term: 6 years • Implicit interest rate: 8% • Payments: $20,000 • Residual value: $5,786

  23. Sales Type Leases • Debit, Lease Receivable • Lease payments plus residual • Debit, Cost of Goods Sold • Lessor’s cost • Credit, Sales Price of Asset • PV of minimum lease payments • Credit, Unearned Interest Revenue • Lease Receivable less FMV of asset • Credit, Inventory • Lessor’s cost

  24. Fact Pattern • Date: January 1, 2005 • Inventory of equipment: $60,000 • FMV of equipment: $103,500 • Lease term: 6 years • Implicit interest rate: 8% • Payments: $20,000 • Residual value: $5,786

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