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S t I c e | S t I c e | S k o u s e n. Leases. Intermediate Accounting 16E. Chapter 15. Prepared by: Sarita Sheth | Santa Monica College. Learning Objectives. Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase.

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leases

S t I c e | S t I c e | S k o u s e n

Leases

Intermediate Accounting

16E

Chapter 15

Prepared by: Sarita Sheth | Santa Monica College

COPYRIGHT © 2007

Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

learning objectives
Learning Objectives
  • Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase.
  • Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction.
  • Outline the types of contractual provisions typically included in lease agreements.
learning objectives3
Learning Objectives
  • Apply the lease classification criteria in order to distinguish between capital and operating leases.
  • Properly account for both capital and operating leases from the standpoint of the lessee (asset user).
  • Properly account for both capital and operating leases from the standpoint of the lessor (asset owner).
learning objectives4
Learning Objectives
  • Prepare and interpret the lease disclosures required of both lessors and lessees.
  • Compare the treatment of accounting for leases in the United States with the requirements of International Accounting Standards.
  • Record a sale-leaseback transaction for both a seller-lessee and a purchaser-lessor.
lease
Lease

Lease- a contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.

parties involved in a lease
Parties Involved in a Lease
  • Lesse- the party granted the right to use the property under the terms of a lease.
  • Lessor- The owner of the property that is rented (leased) to another party.
economic advantages to leasing
Economic Advantages to Leasing
  • No down payment.
  • Avoid risks of ownership.
  • Flexibility.
advantages to the lessor
Advantages to the Lessor
  • Increased sales.
  • Ongoing business relationship with lessee.
  • Residual value retained.
simple example
Simple Example

Owner Company owns a piece of equipment with a market value of $10,000.

User Company wishes to acquire the equipment for use in its operations.

simple example10
Simple Example

One option for User Company is to purchase the equipment from Owner by borrowing $10,000 from a bank at an interest rate of 10%.

Owner would repay the principal and interest by making five annual payments of $2,638.

simple example11
Simple Example

Alternatively, User Company can lease the asset from Owner Company for five years, making annual “rental” payments of $2,638.

Buy

$2,638

annually

Lease

$2,638

annually

simple example12
Simple Example
  • The key accounting issues for Owner Company:
  • Has effective ownership passed?
  • Does Owner Company have any significant responsibility remaining?
  • Is Owner Company reasonable certain that they five annual payments can be collected?
  • The key accounting issue for User Company:
  • Should User recognize the leased equipment as an asset and a liability to make the lease payments?
simple example13
Simple Example

Scenario One

The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease.

Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase.

simple example14
Simple Example

Scenario Two

The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1.

Offering the equipment to User Company for a bargain price at the end of the lease indicates that this is in substance a purchase.

simple example15
Simple Example

Scenario Three

The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else.

Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

simple example16
Simple Example

Scenario Four

The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date.

Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

different lease types
Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee.

Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease

Different Lease Types
nature of leases

Specifies under what circumstances the lease may be canceled.

Cancellation Provision

Grants lessee the right to

purchase the asset at the end of the lease term for less than the residual value.

Bargain Purchase Option

Delineates the time period the lease is to be in force.

Lease Term

Market value of leased asset at end of lease term.

Residual Value

Rental payment required over lease term plus any payment for residual value.

Minimum Lease Payment

Nature of Leases
lease classification criteria
Lease Classification Criteria
  • The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
  • The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.
  • The lease term is equal to 75% or more of the estimated economic life of the asset.
  • The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset.

A lease is classified as a capital lease by the lessee if it is non-cancelable and meets any one of the following criteria:

lease classification criteria20

No

BargainPurchase

Option?

Yes

No

Term >75% of

Useful Life?

Yes

No

PV Payment >90%

of FMV?

Yes

No

Lease Classification Criteria

Transfer of Ownership?

Yes

Capital

Lease

Operating

Lease

stop and think
Stop and Think

How exactly does using a higher incremental borrowing rate reduce the likelihood that a lessee will be required to account for a lease as a capital lease?

lease classification lessor
Lease Classification-Lessor

Additional revenue recognition criteria applicable to lessors.

  • Collectibility of the minimum lease payments is reasonably predictable.
  • No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.
lease 1
Lease 1

Lessee

This is a test to see if the lease qualifies as a capital lease. If it doesn’t, then it is an operating lease.

Does the lease transfer ownership at the end of the lease term?

No! So, we move to Criteria 2.

lease 124
Lease 1

Lessee

Does the lease contain a bargain purchase option?

No! So, we move to Criteria 3.

lease 125
Lease 1

Lessee

Is the lease term equal to 75 percent or more of the estimated economic life of the asset?

No! The 10-year lease covers approximately 72 percent of the economic life of the asset. So, we move to Criteria 4.

lease 126
Lease 1

Lessee

Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset?

Before we answer this question, let’s pause and review two terms related to interest on a lease.

lease 127
Lease 1
  • Implicit Interest Rate- used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease.
  • Lessor always uses the implicit rate to discount rental payments.
  • Incremental Borrowing Rate- rate that the lessee could borrow the amount of money necessary to purchase the leased asset.
  • Lessee uses the lesser of the implicit rate (if known) and the incremental borrowing rate.
lease 128
Lease 1

Lessee

Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset?

No, the lessee only knows the incremental borrowing rate, which provides a present value of less than 90 percent.

lease 129
Lease 1

Lessor

In addition to meeting at least one of the four criteria, the lessor must meet both of a second set of criteria.

This is a capital lease to the lessor and an operating lease to the lessee.

Is the collectibility of the minimum lease payment reasonably predictable

AND

Are there important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor?

operating lease
Operating Lease

Bob Jones signs a two-year lease which requires a monthly payment of $1,000. When the lease expires, Bob will either move out or negotiate a new lease.

Rent Expense 1,000

Cash 1,000

operating leases with varying lease payments
Operating Leases with Varying Lease Payments

The terms of a lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years and $250,000 for each of the next three years.

operating leases with varying lease payments32
Operating Leases with Varying Lease Payments

Entry Each Year for Years 1 and 2:

Rent Expense 210,000

Cash 150,000

Rent Payable 60,000

Entry Each Year for Years 3-5:

Rent Expense 210,000

Rent Payable 40,000 Cash 250,000

accounting for capital leases
Accounting for Capital Leases

Minimum payment (in advance)

including $5,000 executory cost $65,000/year

Lease period (beginning 01/01/07) 5 years

Economic life of asset 5 years

Estimated residual value at end of lease $0

Implicit Rate 10%

Incremental Borrowing Rate 10%

accounting for capital lease
Accounting for Capital Lease

Leased Equipment 250,192

Obligations under Capital Leases 250,192

Entries on January 1, 2007

PMT = $60,000; N = 5; I = 10%

Lease Expense 5,000

Obligations under Capital Leases 60,000

Cash 65,000

accounting for capital leases35
Accounting for Capital Leases

Entries on December 31, 2007

Amortization Expense on Leased

Equipment 50,038

Accumulated Amortization

on Leased Equipment 50,038

$250,192 ÷ 5

($250,192 – $60,000) x 10%

Prepaid Executory Costs 5,000

Obligations under Capital

Leases 40,981

Interest Expense 19,019

Cash 65,000

bargain purchase option bpo

BARGAIN DEAL

Bargain Purchase Option (BPO)
  • Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price.
  • The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.
accounting for capital leases with a bpo
Accounting for Capital Leases with a BPO

Minimum payment (in advance)

including $5,000 executory cost $65,000/year

Lease period (beginning 01/01/07) 5 years

Economic life of asset 5 years

Estimated residual value at end of lease $0

Implicit Rate 10%

Incremental Borrowing Rate 10%

Bargain purchasing option $75,000

Lessee

accounting for capital leases with a bpo38
Accounting for Capital Leases with a BPO

Minimum Lease Payment

Present value of five payments at the

beginning of each year for five years:

PMT = $60,000, N = 5, I = 10%$250,192

Present value of the bargain purchase

option of $75,000 at the end of 5 years:

FV = $75,000, N = 5, I = 10% 46,569

Present value of minimum lease payment$296,761

accounting for capital leases with a bpo39
Accounting for Capital Leases with a BPO

Entries on December 31, 2012

Obligations under Capital Leases 68,182

Interest Expense 6,818

Cash 75,000

$68,182 x 10%

($296,761 ÷ 10) x 5 years

Equipment 148,381

Accumulated Amortization on

Leased Equipment 148,380

Leased Equipment 296,761

lessee s cash flow statement indirect impact
Lessee’s Cash Flow Statement (Indirect) Impact

Operating Activities

Net income

(includes reduction for

Lease interest expense

Lease amortization expense)

+ Amortization of leased asset

Investing Activities

No impact

Financing Activities

Principal portion of lease payment

lessee s cash flow statement direct impact
Lessee’s Cash Flow Statement (Direct) Impact

Operating Activities

- Lease Interest Expense

Investing Activities

No impact

Financing Activities

- Principal portion of lease payment

accounting for operating leases
Accounting for Operating Leases

Minimum payment (in advance)

including $5,000 executory cost $65,000/year

Lease period (beginning 1/1/07) 5 years

Economic life of asset 10 years

Estimated residual value at end of lease $0

Implicit Rate 10%

Incremental Borrowing Rate 10%

Cost to lessor $400,000

Direct costs incurred $15,000

Lessor

accounting for operating leases lessor
Accounting for Operating Leases- Lessor

At Inception of 1/ 1/07

Deferred initial Direct Costs 15,000

Cash 15,000

At Receipt of First Payment 1/1/07

Cash 65,000

Rent Revenue 60,000

Executory Costs 5,000

accounting for operating leases lessor45
Accounting for Operating Leases- Lessor

At End of the First Year 12/31/2007

Amortization of Initial Direct Costs 3,000

Deferred Initial Direct Costs 3,000

Depreciation Expense on Leased

Equipment 40,000

Accumulated Depreciation on

Leased Equipment 40,000

$400,000 ÷ 10

direct financing lease
Direct Financing Lease

Accounting for a direct financing lease for lessors is similar to that used for capital leases by the lessee—only in reverse.

Minimum payment (in advance)

including $5,000 executory cost $65,000/year

Lease period (beginning 1/1/07) 5 years

Economic life of asset 5 years

Estimated residual value at end of lease $0

Implicit Rate 10%

Incremental Borrowing Rate 10%

Cost and fair market value of equipment $250,192

accounting for direct financing leases lessor
Accounting for Direct Financing Leases- Lessor

At Inception of 1/1/07

Lease Payment Receivable 250,192

Equipment Purchased for Lease 250,192

At Receipt of First Payment 1/1/07

Cash 65,000

Lease Payment Recievable 60,000

Executory Costs 5,000

direct financing lease48
Direct Financing Lease

At End of the First Year 12/31/2007

Cash 65,000

Lease Payment Receivable 40,981

Interest Revenue 19,019

Deferred Executory Costs 5,000

A Liability

accounting for direct financing leases with residual value
Accounting for Direct Financing Leases with Residual Value

Minimum payment (in advance)

including $5,000 executory cost $65,000/year

Lease period (beginning 1/1/07) 5 years

Economic life of asset 5 years

Estimated residual value at end of lease $75,000

Implicit Rate 10%

Incremental Borrowing Rate 10%

Cost and fair market value of equipment $296,761

Lessor

direct financing leases with residual value lessor
Direct Financing Leases with Residual Value- Lessor

At Inception of 1/1/07

Lease Payment Receivable 296,761

Equipment Purchased for Lease 296,761

At Receipt of First Payment 1/1/07

Cash 65,000

Lease Payment Recievable 60,000

Executory Costs 5,000

direct financing lease with residual value
Direct Financing Lease with Residual Value

At End of the First Year 12/31/2007

Cash 65,000

Lease Payment Receivable 36,324

Interest Revenue 23,676

Deferred Executory Costs 5,000

At End of the Lease Term 12/31/2012

Equipment 75,000

Lease Payment Receivable 68,182

Interest Revenue 6,818

slide52

Minimum Lease Payments

Financing

Revenue

(Interest)

Fair Market Value of Leased Asset

Manufacturer’s

or Dealer’s

Profit

Sales-Type LeaseTransaction Components

Cost of Leased Asset to Lessor

slide53

Minimum Lease Payments

Financing

Revenue

(Interest)

Fair Market Value of Leased Asset

Manufacturer’s

or Dealer’s

Profit

Sales-Type LeaseTransaction Components

($65,000 – $5,000) x 5 = $300,000

$49,808

$250,192

$75,192

Cost of Leased Asset to Lessor

$175,000

slide54

Sales-Type LeaseTransaction Components

At Inception of 1/1/07

Lease Payment Receivable 250,192

Sales 250,192

Cost of Goods Sold 175,000

Finished Goods Inventory 160,000

Deferred Initial Direct Costs 15,000

Cash 65,000

Lease Payment Receivable 60,000

Executory Costs 5,000

sales type lease with bpo or guaranteed residual value
Sales-Type Lease With BPO or Guaranteed Residual Value
  • The minimum lease payments (to the lessor) will includethe following if they are included in the agreement:
    • A lump sum (from a bargain purchase option) at the end of the lease term OR
    • A guaranteed residual value
  • The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.
summary of lease impact on statement of cash flows
Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing Financing

MethodMethodActivitiesActivities

Lessee:

Operating lease payments

Capital lease:

Lease payments-- interest

Lease payments-- principal

Amortization of asset

NI - Cash

NI - Cash

- Cash

+ NI No

impact

slide57

Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing MethodMethodActivities

Lessor:

Operating lease:

Initial direct costs (IDC)

Amortization of IDC

Lease receipts

Direct financing lease:

Initial direct costs

Amortization of IDC

Lease receipts--interest

Lease receipts--principal

- Cash

+NI No impact

NI + Cash

- Cash

+ NI No impact

NI + Cash

+ Cash

slide58

Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing MethodMethodActivities

Lessor:

Sales-type lease:

Initial direct costs

Manufacturer’s or dealer’s profit (net of IDC)

Lease receipts--interest

Lease receipts--principal

- Cash

- NI No impact

NI + Cash

+ NI + Cash

disclosure requirements for leases
Disclosure Requirements for Leases
  • For and operating lease, the lease-related asset and liability are off the balance sheet items.
  • It is important for the financial statement user to be able to interpret the associated note.
  • Lessee is required to provide enough note disclosure to allow the users to quantify the magnitude of the operating leases.
  • Lessor is required to provide enough disclosure to allow the financial statement user to figure out the extent to which lease- related sales and rentals have impacted the lessor’s financial statements.
international accounting of leases
International Accounting of Leases
  • IFRS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases.
  • A proposal, titled “Accounting for Leases: A New Approach,” suggests that all lease contracts longer than one year be accounted for as capital leases.
  • This proposal is still under discussion.