Accounting for Leases. ACCTG 5120 David Plumlee. What is a Lease?. “ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”.
“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”
Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?Accounting for Leases
Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset
What is the economic nature of a capital lease?
One that transfers substantially all the risks and benefits of ownership to the lessee.
What is the economic nature of an operating lease?
One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement
Does it meet ANY ONE of the four criteria? agreements. Why was this accounting found lacking ?Is this a Capital Lease?
Minimum rental payments plus agreements. Why was this accounting found lacking ?
Any guaranteed residual value plus
amount the lessee guarantees lessor will realize on the asset at the end of the lease term
Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assuredMinimum Lease Payments
Leases without a BPO
What are executory costs?
Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance
Are they included in MLP?
What is a bargain purchase option?
An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured
What is the MLP for leases with a BPO?
PV of rental payments and the BPO at the end of the lease term.
$18,287 agreements. Why was this accounting found lacking ?
$18,287 $18,287 $18,287 $18,287
1 2 3 4 5 6Present Value of MLP
PV = $18,287 x PVIFA(n=6, r=12%)
= $18,287 x 4.11141
Inception of lease: record leased asset and lease obligation at present value of MLP
At period end accrue:
record interest expenseLessee Journal Entries
leased asset $75,185
lease obligation $75, 185
On what does the depreciation period used depend?
What ending values are used for depreciation?
Salvage value if depreciating over economic life
Guaranteed residual value if depreciating over lease term
What is the depreciable basis of this asset?
$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)
$75,185/6yrs = $12,531
depreciation expense $12,531
accum. depreciation $12,531
PV of the min. lease payments value of MLP?Lease Amortization Table
interest expense ($75,185 x 12%) $9,022 value of MLP?
lease obligation 9,265
Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.Record First Lease Payment
Includes costs directly associated with negotiating a particular lease
amounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees)
amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents)
Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)Initial Direct Costs
defer and allocate over lease term in proportion to rental income
expense in same period as profit on sale recognized
What is the PV of the MLP (without initial direct costs)?
20,000 x PVIFA(n=3,r=10%)
Do initial direct costs affect this calculation?
Yes, they are added and a new interest rate is found.
$50,737 = $20,000 x PVa (n=3,r=?) particular lease
2.53685 = PVa (n=3,r=?)Impute New Effective Yield
Why add to the initial direct costs?
We want the interest rate the equates the net investment to the cash flows
$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)
by trial and error: r=8.89%
Reduction in income = 10,263 - 9,263
= initial direct costs
Entries to record lease:
deferred initial direct costs 1,000
cash (etc.) 1,000
lease receivable 60,000
unearned interest income 10,263
leased asset 49,737
Entries to record first payment and amortization of income and costs
lease receivable 20,000
unearned interest income 4,974
interest income 4,974
initial direct expense amortization 463
deferred initial direct costs 463
Leaseback: seller retains use of the asset particular lease
Should the gain or loss on sale be recognized when asset “sold” to lessor?
Account for lease according to classification tests.
Lessee Retains Right To Use Asset particular lease
defer gains only (losses are recognized immediately)
amortize to rent expense over lease term in proportion to rental paymentsSale/leaseback- operating lease
Why do you think we defer any gains?
Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future
defer gains only (losses are recognized immediately) particular lease
amortize to depreciation expense over lease term in proportion to amortization of leased assetSale/leaseback -- capital lease
Lessee Retains Right To Use Asset