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Accounting for Leases

Accounting for Leases. ACC4305. Leases. 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.

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Accounting for Leases

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  1. Accounting for Leases ACC4305

  2. Leases • 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.

  3. Advantages of Leases • Leases may not require any money down. • Lease payments are often fixed. • Leases reduce the risk of obsolescence to the lessee. • Leases may contain less restrictive covenants than other types of lending arrangements. • Leases may be a less costly means of financing. • Certain leases may not add to existing debt on the balance sheet. Off Balance Sheet Financing

  4. Tax Advantages • The lessee can write off the full cost of the asset, including the part that relates to land. • The deduction may be accelerated since it is often spread over the period of the lease rather than the actual economic life of the property.

  5. Defining Leases • According to the FASB: • a lease transferring substantially all of the benefits and risks of ownership should be capitalized. • Transfer of ownership can be assumed only if there is a high degree of performance to the transfer, that is, the lease is non-cancelable. • Leases that do not substantially transfers benefits and risks are operating leases.

  6. Accounting by Lessee • Leases that meet any of the following four criteria are capital leases for the lessee: • Leases, transferring ownership • Leases with bargain purchase options • Leases with lease terms equal to 75% or more of the economic life (75% rule) • Leases where the present value of lease payments is equal to 90% or more of the fair market value (90% rule)

  7. 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

  8. Accounting by Lessee • In a capital lease transaction, the lessee records an asset and a liability. • The asset is depreciated by the lessee over the economic life of the asset. • The effective interest method is used to allocate the rental payments between principal and interest. • Depreciation of the asset and discharge of the lease obligation are independent accounting procedures.

  9. Illustration

  10. An introductory example • To illustrate accounting for lease transactions, we will use a simple case involving three parties: • 1. Meknes Farms SA • Needs a Combine Model SX • Expected useful life of six years with no salvage value

  11. An introductory example • 2. Meknes First Bank • Currently charging 12% interest on long-term equipment loans • 3. Said Tractors, SA • Manufactures the Model SX combine at a cost of dh 400,000. • Selling price is dh 500,000 • It also has a few units for trial use which rent for dh 5000 per week

  12. Operating Lease • If Meknes Farms rents a combine for one week from Said Tractors, the journal entries would follow the usual pattern for a rental: Meknes Farms Equipment rent expense 5,000 Cash 5,000

  13. Operating Lease • Said Tractors • Cash 5,000 • Rental Revenue 5,000 • Since Said Tractors is the owner of the combine, it would record depreciation: • Depreciation expense 1,282 • Acc’d depreciation 1,282[400,000/6 years/52 weeks]

  14. Operating leases- Summary • Assign rent expense or revenue to period benefited • Subject to accruals • No liability on lessee’s balance sheet • Lessor depreciates the asset • Lessor is probably responsible for insurance, property taxes and maintenance

  15. Purchase with LT loan • Assume Meknes Farms decides to purchase the combine and borrows the full purchase price of Dh 500,000 from Meknes First Bank at 12% interest on the unpaid balance of the loan. • Meknes Farms agrees to make annual payments of Dh 100,000 for five years. • Again, the journal entries follow the normal pattern.

  16. Securing the Loan • Meknes FarmsCash 500,000 Note Payable 500,000 • Meknes First Bank • Loan receivable 500,000 Cash 500,000

  17. Purchasing the Equipment • Said Tractors SA.Cash 500,000 Sales 500,000 • COGS 400,000 Inventory 400,000 • Meknes FarmsCombine 500,000 Cash 500,000

  18. End of the Year 500,000/6 years • Meknes FarmDepreciation Expense 83,333 Acc'd Depreciation 83,333 • Interest Expense 60,000 Interest Payable 60,000 [500,000 * 12%] • Meknes First BankInterest Receivable 60,000 Interest Revenue 60,000

  19. First Installment Payment • Meknes First Bank • Cash 160,000 Loan Receivable 100,000 Interest Receivable 60,000 • Meknes FarmsInterest Payable 60,000Notes Payable 100,000 Cash 160,000

  20. Capital Lease • For various reasons either (or both) Meknes Farms and Meknes First Bank might prefer a lease arrangement to an outright purchase & long-term loan • Assume that the bank agrees to purchase the combine from Said Tractors for MAD 500,000 and lease it to Meknes Farms for five years. • Meknes Farms gets to keep the combine at the end of the lease.

  21. Capital Lease • The bank must determine how much to charge to earn its desired rate of 12% interest. • Assuming the first annual payment comes at the end of the first year (after harvest). • PV = 500,000, n = 5, i = 12% • Payment must be 138,710

  22. Direct Financing Lease • The lessor calls this a “direct financing lease” because it is essentially an installment sale. • The only money the lessor makes from the lease is interest revenue.

  23. Bank buys combine: • Meknes First Bank • Asset to be leased 500,000 Cash 500,000 • Said Tractors SA.Cash 500,000 Sales 500,000COGS 400,000 Inventory 400,000

  24. Asset is transferred to lessee: • Meknes FarmsLeased Asset 500,000 Lease Payable 500,000 • Meknes First Bank Investment in lease 500,000 Asset to be leased 500,000

  25. End of the Year 500,000/6 years • Meknes FarmsDepreciation Expense 83,333 Acc'd Depreciation 83,333 Acc. Dep to be applied against Leased Asset account

  26. First Lease Payment • Meknes First Bank • Cash 138,710 Investment in Lease 78,710 Interest Revenue 60,000 • Meknes FarmsInterest Expense 60,000Lease Payable 78,710 Cash 138,710

  27. Is Said Tractor missing out on a business opportunity? • By offering a lease option, Troy Tractor gains the following advantages: • 1. a way of indirectly making a sale,and • 2. an alternative means of obtaining a profit opportunity.

  28. Sales Type Lease • Accordingly, Meknes Farms may be able to arrange a similar or better lease arrangement with the manufacturer of the Model SX combine. • This is called a “sales-type lease” for the lessor because Said Tractors will make a profit from “selling” the combine and it will earn interest revenue over the lease term. • We will assume that the lease terms are the same for purposes of illustration.

  29. Sales Type Lease • NOTE: The first step in doing lease accounting involves finding the present value of the cash flows which will be transferred between the lessee and lessor. • This "present value of the minimum lease payments" [PVMLP] will give you the SALES amount for the lessor (assuming a sales-type lease) and the ASSET amount for the lessee. • COMPUTE PVMLP: [n = 5, i = 12%, pymt = 138,710] • PV = MAD 500,000

  30. Sales Type Lease • Meknes Farms • Leased Asset (PV of MLP) 500,000 Lease Liability 500,000 • Depreciation Expense 83,333 Acc'd Depreciation 83,333 • Interest Expense 60,000Lease Liability 78,710 Cash 138,710

  31. Sales Type Lease • Said Tractors • Lease Receivable 500,000 Sales 500,000COGS 400,000 Inventory 400,000Cash 138,710 Interest Revenue 60,000 Lease Receivable 78,710

  32. Accounting by Lessor • Lessor classifies leases as one of the following: • Operating lease • Direct financing lease • Sales-type lease

  33. Classification of Lease for Lessor • To be classified as an operating lease: • The lease doesn’t meet any group 1 criteria (same as lessee’s), OR • Collectibility of payments isn’t reasonably assured, OR • Lessor’s performance isn’t substantially complete.

  34. Classification of Lease for Lessor • To be classified as a direct financing lease the lease must meet group 1 criteria (same as lessee’s), and the following, group 2 criteria: • Collectibility of payments must be reasonably assured, and • Lessor’s performance must be substantially complete, and • Asset’s fair value must be equal to lessor’s book value

  35. Does lease meet Group 1 criteria? No No yes Is collectibility of payments assured? No Sales type yes Is lessor’s performance substantially complete ? No Does asset FMV equal lessor’s book value? yes yes Summary Lease Agreement Operating Lease Direct financing

  36. Accounting Issues • Residual values • Sales-type leases • Bargain purchase options • Initial direct costs • Disclosure

  37. Bargain purchase options (BPO) • Many leases are equivalent to a purchase financed with a long-term loan. We have assumed, so far, that Meknes Farm got to keep the tractor at the end of the lease (TITLE TRANSFER). • Another way a lease is equivalent to a purchase is if the lessee can purchase the asset for a bargain price at the end of the lease. Consider the following lease terms:

  38. Inception date: 1/1/02 Lessor: Said Tractors Inc. Fair value of combine at 1/1/02: MAD 500,000 Cost to manufacture combine: 400,000 Estimated fair value at end of lease is 100,000 Fixed non-cancelable lease term: 5 years. First payment due on 12/31/02 Lessee: Meknes Farms Incremental borrowing rate (lessee): 12% Implicit interest rate (known to lessee): 12% Option to buy at end of lease term for 50,000 Estimated useful life of combine: 8 years BPO - Lease

  39. Bargain Purchase Option • What amount should Said Tractors charge? • Amount to be recovered (PV) = MAD 500,000 • n=5, i=12%, FV (BPO) = 50,000 • What is PV of 50,000? • .5674 * 50,000 = 28,370 • Amount to be recovered with annual payments = 500,000 – 28,370 =471,630

  40. Bargain Purchase Option Therefore, PV-OA = 471,630 PMT * PVIF-OA = PV-OA PMT * 3.6048 = $471,630 471630/3.6048 = 130,830

  41. Bargain Purchase Option MEKNES FARMSCombine (at PVMLP) 500,000 Lease Liability 500,000 Interest Expense 60,000 Lease Liability. 70,830 Cash 130,830 Depreciation Expense 62,500 Acc'd Depreciation 62,500 Useful life = 8 years

  42. Bargain Purchase Option SAID TRACTORS SA. Lease Receivable 500,000 Sales 500,000 COGS 400,000 Inventory 400,000 Cash 130,830 Lease Receivable 70,830 Interest Revenue 60,000 Note: Last Payment includes BPO payment

  43. Leasing in Moroccan Accounting • A lease is a rental contract, and thus is always off balance sheet financing! • Growing use • Medical equipment • Royal Air Maroc • Ship operators • Individuals • Limited use for real estate • No interest charges presents an interest for Islamic banking • New IAS standards with implicit interest rates! Dossier de l’Economiste Number 2208

  44. Leasing in Moroccan Accounting • www.chaabileasing.co.ma • Salafin • Credit du Maroc Leasing

  45. Leases in Moroccan Accounting • Royal Air Maroc has filed for and obtained an exemption from Moroccan regulations to capitalise its aircraft leases • Motivations?

  46. Lease Backs • An agreement whereby a company sells its asset to a lessor and rents it back under the form of a lease • Motivations: • Cash infusion (at market value rather than book value!) • Risk: use the cash to a productive investment purpose! • Off balance sheet balancing • Down to the nature of the contract! • Systematic with MA/FR accounting

  47. Lease Backs • Can be used, legally, to “window dress” accounts • Example: • Company in financial difficulty • Fully amortized asset on the books (or not) • Lease back • Liquidity increases, solvency increases! • COMANAV in 2003 • Not possible with IFRS

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