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Chapter 21

Chapter 21. DEFINITION:. Agreement conveying the right to use property, plant or equipment for stated periods of time. Lessor:. Is the OWNER of the property. Lessee:. Is the RENTER of the property. Capital vs. Operating Leases. Capital Lease.

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Chapter 21

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  1. Chapter 21

  2. DEFINITION: Agreement conveying the right to use property, plant or equipment for stated periods of time. Lessor: Is the OWNER of the property. Lessee: Is the RENTER of the property.

  3. Capital vs. Operating Leases. Capital Lease Transfers essentially ALL risk/rewards of ownership to the lessee: • Lessee gets property on B/S as asset • Debt is recorded as a liability. • The asset is even depreciated. Operating Lease Does not essentially transfer all risks/rewards to lessee. • Do not report on B/S. • Rents are charged as they become due. • This is OFF-BALANCE SHEET FINANCING. THIS IS WHAT FIRMSWANT!!

  4. 1-1-08: Receipt of first payment Accounting for OPERATING LEASES Cash…………….. $4,800 Unearned Revenue……… $4,800 Grafix Inc. (LESSEE) leases a computer from Comfast Inc. (LESSOR) for 2-years beginning January 1, 2008. Grafix will pay Comfast $4,800/ yr, payable in advance on January 1 of each year. Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance). Lessee incurs only one risk (payment of rents) and one benefit (temporary use of asset). Lessor’s cost was $30,000, 10 year life and st line depreciation with no salvage). LESSOR 12/31/08 EOY ADJS Unearned Rev… $4,800 Rent Revenue…. $4,800 LessOR depreciates the asset because they didn’t relinquish ownership. Depreciation Expense.. $3,000 Accumulated Dep… $3,000

  5. 1-1-08: First payment Accounting for OPERATING LEASES Prepaid rent………… $4,800 Cash……………..$4,800 Grafix Inc. (LESSEE) leases a computer from Comfast Inc. (LESSOR) for 2-years beginning January 1, 2008. Grafix will pay Comfast $4,800/ yr, payable in advance on January 1 of each year. Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance). Lessee incurs only one risk (payment of rents) and one benefit (temporary use of asset). Lessor’s cost was $30,000, 10 year life and st line depreciation with no salvage). LESSEE 12/31/08 EOY ADJS Rent Expense………. $4,800 Prepaid………………$4,800

  6. CAPITAL LEASES If a lease meets ANY ONE of the following 4 criteria at the inception of the lease, the lease is a CAPITAL LEASE. * TRANSFER OF OWNERSHIP. Explicitly states a transfer of ownership at EOL without payment of additional compensation. * BARGAIN PURCHASE OPTION (BPO). • LEASE TERM EQUAL TO 75% OR MORE OF THE • ASSETS REMAINING USEFUL SERVICE LIFE. • MINIMUM LEASE PAYMENTS (pv) ARE AT LEAST • 90% OF THE ASSETS MARKET VALUE.

  7. CAPTIAL LEASE IS RECORDED AT: The LOWER of: Assets Fair Value VS. PV of MINIMUM LEASE PAYMENTS

  8. Example: • January 1, 2008 LESSOR CO. and LESSEE CO. sign a 3-year, non-cancelable • lease for an asset with an estimated economic life of 3 years. • There are no collection uncertainties and the lessor’s performance is • complete. • There are (3) lease payments worth $36,556 each. They are payable on • January 1 of 2008, 2009 and 2010. • The fair value of the asset at inception of the lease is $100,000 (which is • also the carrying value on the lessor’s books). • The lease DOES NOT contain a renewal or Bargain Purchase Option (BPO) • and the asset reverts to the lessor at the end of the three year period. • Lessee and Lessor depreciation on a ST LINE basis for book purposes. • Residual value (salvage) is –0-. * The lessee’s incremental borrowing rate is 10%

  9. * The accounting year ends on December 31 for each party. * The Lessor’s IMPLICIT interest rate is 10%. Is this a capital lease? YES • Lease term is equal to 75% or > of the assets remaining • useful life. 3/3 = 100% • Minimum lease payments (PV) are at least 90% of the assets • market value. $36,556 x 2.73554 = $100,000 FMV = $100,000 $100,000/$100,000 = 100%

  10. LESSEE ENTRIES TO RECORD THE LEASE Leased Asset………….. $100,000 Lease Liability………$100,000 TO RECORD THE FIRST PAYMENT ON THE FIRST DAY Lease Liability……… $36,556 Cash………………..$36,556 Date Payment Interest 10% LL adj LL Bal. 1/1/08 $100,000 1/1/08 $36,556 $0 $36,556 $63,444 1/1/09 $36,556 $6,344 $30,212 $33,232 1/1/10 $36,556 $3,323 $33,233 $0

  11. LESSEE ENTRIES TO RECOGNIZE INTEREST EXPENSE FOR 1/1/09 Interest Expense………… $6,344 Lease Liability………….$6,344 TO RECORD DEPRECIATION EXPENSE ($100,000 - $0 SALVAGE) / 3 YEARS = $33,333 Depreciation Expense……….. $33,333 Accumulated Depreciation……… $33,333

  12. LESSOR ENTRIES THE LESSOR MUST NOT ONLY MEET (1) OF THE FOUR PREVIOUSLY MENTIONED CAPITAL LEASE CRITERIA BUT ALSO BOTH OF THE CRITERIA LISTED BELOW: COLLECTIBILITY OF THE MINIMUM LEASE PAYMENTS IS REASONABLY ASSURED. NO IMPORTANT UNCERTAINTIES SURROUND THE AMOUNT OF ANY REIMBURSEABLE COSTS YET TO BE INCURRED BY THE LESSOR UNDER THE LEASE. The Lessor classifies capital leases in one of two ways: Direct Financing Sales-Type Lease

  13. Direct Financing • Does NOT provide a gross profit to the lessor • at the time the lease is signed. Lessor earns profits from interest revenue during lease Value of the leased asset equals its MARKET VALUE at the inception date. LESSOR ENTRIES • The lessor uses this to compute rent • payments. Example from above: Now continued for the LESSOR. * This is a DIRECT FINANCING lease. FMV = $100,000 which equals the cost on the lessor’s books. We know the rent payments are $36,556, but how was this established? FMV OR PV OF MIN LEASE PAYMENTS = RENT X FACTOR

  14. FMV OR PV OF MIN LEASE PAYMENTS = RENT X FACTOR $100,000 2.7354 (10%, 3 YRS ANN DUE; T 6-5) $36,556 Lessor Entries TO RECORD The RECEIVABLE at 1/1/08 Lease Receivable… $100,000 Asset…………… $100,000 RECORD The FIRST PAYMENT ON The DAY The LEASE IS SIGNED at 1/1/08 Cash……….. $36,556 Lease Receivable…….. $36,556

  15. Lessor Entries RECORD The SECOND RECEIPT OF CASH at 1/1/09 Cash…….. $36,556 Earned Interest Rev $6,344 Lease Receivable….. $30,212

  16. Sales-Type Lease Provides a GROSS PROFIT to the lessor at the inception of the lease. Value of leased asset is greater (or less than) the lessor’s cost (or carrying). LESSOR ENTRIES Lessor wants to earn a profit on the sale of the leased asset and interest during the period. Example continued: Assume that the FMV of the asset at inception of this lease is $100,000 and that the carrying value on the lessor’s books is $80,000. DEALER’S PROFIT $100,000 FMV - $80,000 carrying = $20,000 profit

  17. RECORD The LEASE INCEPTION Sales-Type Lease same as before Lease Receivable… $100,000 COGs…………. $80,000 Inventory....................... $80,000 Sales Revenue………. $100,000 FMV of asset LESSOR ENTRIES From here other entries are the same..

  18. In Sales Type leases there is a DIFFERENCE in accounting for Guaranteed vs. Unguaranteed Residual Values. THE WAY PROFIT IS RECORDED GUARANTEED RV is considered part of the sale. UNGUARANTEED RV is not considered part of the sale. • inserting any residual value into the previous example would change • too many things so we’ll use the book example to illustrate this.

  19. Basically since an UN-guaranteed salvage value can’t be considered part of a sale its PRESENT VALUE needs to be subtracted from the SALES and the COG. But that actually leaves the GP unchanged. Assume estimated RV is $5,000 with a PV of $3,104.60 Assume leased equipment has an $85,000 cost to the dealer. Rent payments are $23,237.09 FMV of asset at time of leasing $100,000 PV of minimum lease payments = (R x f) + (RV x f) $100,000 = ($23,237.09 x 4.16986) + ($5,000 x .62092)

  20. Basically since an UN-guaranteed salvage value can’t be considered part of a sale its PRESENT VALUE needs to be subtracted from the SALES and the COG. But that actually leaves the GP unchanged. Assume estimated RV is $5,000 with a PV of $3,104.60 Assume leased equipment has an $85,000 cost to the dealer. Rent payments are $23,237.09 FMV of asset at time of leasing $100,000 Guaranteed Residual Value Unguaranteed Residual Value Lease Receivable.. $100,000 Lease Receivable.... $100,000 COG...................... $ 85,000 COG........................ $81,895.40 (85K – 3,104.60) Sales Rev.......... $100,000 Sales Rev............. $96,895.40 (100K – 3,104.60 PV of RV) Inventory.......... $85,000 Inventory............ $85,000 Sales...........$100,000 - COG...........$ 85,000 -------------------------- GP.............. $15,000 Sales...........$96,895.40 - COG...........$ 81,895.40 -------------------------- GP.............. $15,000

  21. Other Miscellaneous Lease Issues

  22. Bargain Purchase Options (BPOs) Assume the BPO is $10,000, exerciseable at the end of the three year lease. (BACK TO OUR ORIGINAL EXAMPLE) The residual value is now $15,000, at the BPO date. At the end of the 4th year its –0-. Assume we are dealing with the DIRECT FINANCING type lease. annual rent is now FMV = RENT (FACTOR) + BPO (FACTOR) $100,000 = Rent (2.73554) + $10,000 (.75131) $33,809

  23. Bargain Purchase Options (BPOs) DEPRECIATION TIMETABLES ALSO CHANGE WITH BPOS • The lease depreciates over the EXPECTED USEFUL LIFE not • the life of the lease, since they are expected to own it at the EOL. Residual Values Unguaranteed Guaranteed

  24. Guaranteed When the lessee agrees to makeup any deficiency in the stated amount realized for an asset at the end of the lease. REALLY IMPORTANT A RESIDUAL VALUE IMPACTS The AMOUNT OF The ANNUAL RENT WHETHER ITS GUARANTEED OR NOT Originally we calculated the rent as follows: $100,000 = Rent x 2.7354 (10%, 3yrs) RENT = $36,556 Now if we assume there is also a $10,000 residual value $100,000 = (rent x 2.7354) + ($10,000 x .75132) RENT = $33,809

  25. What the guaranteed or unguaranteed status of the salvage does impact is the amount of the MINIMUM LEASE PAYMENTS in terms of finding an amount for the capitalized asset. Guaranteed is capitalized. Unguaranteed is not capitalized.

  26. LESSEE Guaranteed Returning to the original example, now consider the following changes: • The actual residual value at the EOL is $9,000 (rather than the $10K • expected earlier). • The salvage value is FULLY guaranteed (lessee must pay $10,000 • cash if necessary). • The $10,000 estimated salvage value has resulted in annual • payments of $33,809. What amount does the lessee capitalize? ($33,809 x 2.73554) + ($10,000 x .75131) = $100,000

  27. LESSEE Guaranteed ENTRY TO RECORD The LEASE Leased asset…… $100,000 Lease liability……. $100,000 Date Lease pay Interest 10% LL adj LL bal 1/1/08 $100,000 1/1/08 $33,809 $0 $33,809 $ 66,191 1/1/09 $33,809 $6,619 $27,190 $ 39,001 1/1/10 $33,809 $3,900 $29,909 $9,092 12/31/10 $909 $10,001 • The last year builds interest and then the residual value remains in • the lease liability. ENTRY FOR FIRST RENT PAYMENT SECOND PAYMENT Lease liability……. $33,809 Cash…………..$33,809 Interest expense.. $6,619 Lease Liability… $27,190 Cash…………..$33,809

  28. LESSEE Guaranteed ($100,000 - $10,000)/3 = $30,000 ENTRY FOR 1ST DEPRECIATION Life of LEASE, asset reverts to lessor Depreciation expense…… $30,000 Accumulated Depreciation…..$30,000 TERMINATION OF The LEASE Actual residual is $9,000 LOSS on lease.. $1,000 Accum Dep….. $90,000 (remove) Lease liability… $10,000 (remove) Cash……….. $1,000 (pay) Leased asset… $100,000 (remove)

  29. LESSOR Guaranteed The LESSOR’s accounting is the same, with a guaranteed or an unguaranteed residual value. The INCEPTION OF The LEASE Lease receivable: $100,000 = (rent x 2.7354) + ($10,000 x .75132) Lease Receivable…… $100,000 Asset……… $100,000

  30. LESSOR Guaranteed RECEIPT OF The FIRST RENT (DAY LEASE IS SIGNED) Cash…….. $33,809 Lease Receivable……. $33,809 RECEIPT OF SECOND RENT (ONE YEAR LATER) Cash……. $33,809 Interest Revenue…. $6,619 Lease Receivable….. $27,190 TERMINATION OF The LEASE Asset…….. $9,000 (get it back) Cash………. $1000 (receive guaranteed payment) Lease receivable……. $10,000

  31. LESSEE UNGuaranteed Lessee capitalizes ONLY the lease payments (NOT the salvage) Assume there is now a $10,000 un-guaranteed salvage value at the EOL. Note: The rent payment will STILL be $33,809 because the salvage reduces it whether its guaranteed or not. $100,000 = (RENT x 2.73554) + $10,000 (.75131) The AMOUNT CAPITALIZED FOR The LEASED ASSET IS: $33,809 (2.73554) = $92,487 DON’T capitalize salvage Leased asset… $92,487 Lease liability……$92,487

  32. LESSOR UNGuaranteed Remember, whether the salvage value is guaranteed or not, it is ALWAYS deducted in order to compute the AMOUNT of the rent payment. Recall, however, that the lessee will not capitalize the amount of the salvage because they do not promise to pay it. The LESSOR HOWEVER WILL CAPITALIZE The SALVAGE VALUE AS IT COMES TO HIM/HER AT The EOL REGARDLESS OF WHETHER ITS GUARANTEED OR NOT (AT LEAST IN THEORY IT DOES). LEASE RECEIVABLE RECORDED Lease Receivable.. $100,000 Asset……. $100,000 $100,000 = (rent x 2.7354) + ($10,000 x .75132)

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