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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.”.

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Accounting for leases

Accounting for Leases

ACCTG 5120

David Plumlee


What is a lease
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.”


Accounting for leases1

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


Classification of leases
Classification of Leases agreements. Why was this accounting found lacking ?

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


Accounting for capital leases
Accounting for Capital Leases agreements. Why was this accounting found lacking ?

  • Accounting reflects economic substance, not legal form

  • Make it appear as though company purchased an asset with borrowed funds

    • an asset and an obligation

    • interest expense on obligation

    • depreciation on asset


Is this a capital lease

Does it meet ANY ONE of the four criteria? agreements. Why was this accounting found lacking ?

Is this a Capital Lease?

  • Lease transfers ownership of asset

    • automatically by end of lease term or

    • through a bargain purchase option

  • Lease term is at least 75% of asset’s estimated economic life

  • PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term


Minimum lease payments

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 assured

Minimum Lease Payments

Leases without a BPO


Mlp continued
MLP continued agreements. Why was this accounting found lacking ?

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?

NO!


Minimum lease payments1
Minimum Lease Payments agreements. Why was this accounting found lacking ?

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.


Capital lease example
Capital Lease Example agreements. Why was this accounting found lacking ?

  • 6-year lease

  • Annual payment due at year end = $18,287

  • No BPO and legal title does not pass at the end of lease term

  • FMV of leased asset = $75,185

  • Economic life of asset = 10 years

  • Appropriate interest rate = 12%

  • Est. salvage value = $3,185


Present value of mlp

$18,287 agreements. Why was this accounting found lacking ?

$18,287

$18,287 $18,287 $18,287 $18,287

1 2 3 4 5 6

Present Value of MLP

PV = $18,287 x PVIFA(n=6, r=12%)

= $18,287 x 4.11141

= $75,185


Lessee journal entries

Inception of lease: record leased asset and lease obligation at present value of MLP

Record payments

At period end accrue:

depreciate asset

record interest expense

Lessee Journal Entries


Inception of lease term

JE to record leased asset and lease obligation at present value of MLP?

Inception of Lease Term

leased asset $75,185

lease obligation $75, 185


Depreciation expense
Depreciation Expense value of MLP?

On what does the depreciation period used depend?

  • If bargain purchase option exists or title passes during lease term, use economic life

  • Otherwise use lease term


Basis for depreciation
Basis for Depreciation value of MLP?

What ending values are used for depreciation?

Salvage value if depreciating over economic life

Guaranteed residual value if depreciating over lease term


Record depreciation expense
Record Depreciation Expense value of MLP?

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



Lease amortization table1

PV of the min. lease payments value of MLP?

Lease Amortization Table



Record first lease payment

interest expense ($75,185 x 12%) $9,022 value of MLP?

lease obligation 9,265

cash $18,287

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


Lessor capital lease types
Lessor Capital Lease Types value of MLP?

  • Direct financing leases

    • PV of minimum lease payments equals the FMV of the leased asset

    • No “profit” is recorded; considered to be a financing arrangement.

  • Sales-type leases

    • PV of minimum lease payments less the FMV of the leased asset equals the “dealer profit”

    • Profit is recognized as revenue at the inception of the lease


Initial direct costs

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


Accounting for initial direct costs
Accounting for particular leaseInitial Direct Costs

  • Operating -

  • Sales-type -

  • Direct financing-

defer and allocate over lease term in proportion to rental income

expense in same period as profit on sale recognized

  • add to gross investment in the lease

  • amortize over lease as a yield adjustment


Example direct financing
Example - Direct Financing particular lease

  • 3 year lease

  • $20,000 payments due at end of year

  • implicit interest rate = 10%

  • FMV (lessor’s cost of asset) = $49,737

  • initial direct costs = $1,000


Net investment in lease
Net Investment in Lease particular lease

What is the PV of the MLP (without initial direct costs)?

20,000 x PVIFA(n=3,r=10%)

  • $49,737 = cost (this is a direct financing lease)

Do initial direct costs affect this calculation?

Yes, they are added and a new interest rate is found.


Impute new effective yield

$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%



Including initial direct costs
Including Initial Direct Costs particular lease

Reduction in income = 10,263 - 9,263

= 1,000

= initial direct costs



Journal entry
Journal Entry particular lease

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


Journal entries
Journal Entries particular lease

Entries to record first payment and amortization of income and costs

cash 20,000

lease receivable 20,000

unearned interest income 4,974

interest income 4,974

initial direct expense amortization 463

deferred initial direct costs 463


Sale leaseback

Leaseback: seller retains use of the asset particular lease

Sale:

Legal title

Transfers

Sale/leaseback

Should the gain or loss on sale be recognized when asset “sold” to lessor?

Seller/lessee

Buyer/lessor

Account for lease according to classification tests.


Sale leaseback operating lease

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 payments

Sale/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


Sale leaseback capital lease

defer gains only (losses are recognized immediately) particular lease

amortize to depreciation expense over lease term in proportion to amortization of leased asset

Sale/leaseback -- capital lease

Lessee Retains Right To Use Asset


Minor leaseback
“Minor leaseback” particular lease

  • Lessee Loses Most Rights To Use Asset

  • Defined as PV of rental payments is 10% or less of asset’s fair value

  • Recognize gain or loss on sale immediately