Introductory Lecture – Includes Flow Charts Accounting for Leases Chapter 21 Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara
Learning Objectives • Explain the nature, economic substance, and advantages of lease transactions. • Describe the accounting criteria and procedures for capitalizing leases by the lessee. • Contrast the operating and capitalization methods of recording leases. • Identify the classifications of leases for the lessor. • Describe the lessor’s accounting for direct-financing leases. • Identify special features of lease arrangements that cause unique accounting problems. • Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. • Describe the lessor’s accounting for sales-type leases. • List the disclosure requirements for leases.
Teresa’s Specific Objectives • Be able to classify a lease from the perspective of lessor and lessee • Be able to prepare journal entries for lessor and lessee – for both operating and capital-type leases • Be able to research FARS to resolve complications not mentioned in text
The lease is a contractual agreement between the lessor and the lessee. • The lease gives the lessee the right to use specific property. • The lease specifies the duration of the lease and rental payments. • The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee.
Cancellation Provision Specifies under what circumstances the lease may be canceled. Rental payment required over lease term – may include planned increases. LeasePayment Delineates the time period the lease is to be in force. May include renewal periods. Lease Term Lease Contracts
Who is responsible for market value of leased asset at end of lease term? Residual Value Grants lessee the right to purchase the asset at the end of the lease term. The option price may or may not be a bargain. Purchase Option Lease Contracts
Contingent rentals Bargain renewal option Bargain purchase option Nonrenewal penalty Guaranteed residual value Interest rate implicit in the lease Unguaranteed residual value Executory costs Initial direct costs Minimum lease payments Incremental borrowing rate Other Terms You Will Learn
The Leasing Environment Advantages of Leasing • 100% Financing at Fixed Rates. • Protection Against Obsolescence. • Flexibility. • Less Costly Financing. • Tax Advantages. • Off-Balance-Sheet Financing.
The Leasing Environment Benefits to the Lessor • Interest Revenue. • Tax Incentives. • High Residual Value. • Making a sale that would otherwise go to a competitor that provides a leasing option
The Leasing Environment The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do. Operating Lease Capital Lease Journal Entry: Rent expense xxx Cash xxx Journal Entry: Leased equipment xxx Lease obligation xxx A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized). Statement of Financial Accounting Standard No. 13, “Accounting for Leases,” 1980 LO 1 Explain the nature, economic substance, and advantages of lease transactions.
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
Is there transfer of ownership? Yes Yes No Is there a bargain purchase option? Yes Yes No Is lease term equal to or greater than 75% of economic life ? Is present value of payments equal to or more than 90% FMV? No Accounting by Lessee Lease Agreement Capital Lease Operating Lease 11th Ed Slide
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.
Accounting by the Lessor Classification of Leases by the Lessor Illustration 21-12 A lessor may classify a lease as an operatinglease but the lessee may classify the same lease as a capitallease.
Does lease meet Group 1 criteria? No Sales type No yes Is collectibility of payments assured? Direct financing No No yes Is lessor’s performance substantially complete ? Does asset FMV equal lessor’s book value? yes yes Accounting by Lessor Lease Agreement Operating Lease 11th Ed Slide
Later we’ll talk about International Financial Reporting Standards IFRS Flowchart