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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

Leases

Sid Glandon, DBA, CPA

Associate Professor of Accounting

University of Texas at El Paso

basics of leasing
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
advantages
Advantages
  • 100% financing at fixed rates
  • Protection against obsolescence
  • Flexibility
  • Less costly financing
  • AMT problems avoided
  • Off-balance-sheet financing
classification of leases
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
accounting by lessee
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
bargain purchase option
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
economic life test
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
recovery of investment
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
discount rate
Discount Rate
  • The lesser of
    • Lessee’s incremental borrowing rate, or
    • The implicit interest rate
executory cost
Executory Cost
  • Insurance, maintenance and taxes
  • Should be excluded from minimum lease payments
residual values
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
capitalized leases accounting by lessee
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
fact pattern
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
operating leases accounting by lessee
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
classification of leases accounting by lessor
Classification of Leases Accounting by Lessor
  • Direct financing leases
  • Sales type leases
  • Operating leases
direct financing lease
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
sales type lease
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
operating lease accounting by lessor
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
direct financing lease25
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
fact pattern26
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
sales type leases
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
fact pattern30
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