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Dr. M.D.

Chase
Long Beach State University
Advanced Accounting 520-45B Intercompany Leases:Adjumstments & Eliminations Page 1
I. INTERCOMPANY LEASES
A.General Considerations: Intercompany leases generally follow the same rules as non-related party leases. The exceptions deal with
situations in which the lease "significantly effected" by the affiliated relationship. In these instances, the lease may not qualify for
capital lease treatment between independent parties. In these situations the substance of the lease takes precedence over the form,
and the lease would be capitalized even if all of the qualifications are not met. In general, if the terms of an intercompany lease
technically classify the lease as operating lease but could not be reasonably expected between unrelated parties, the lease should
be capitalized.
B.Special issues: Non-related party influences: When intercompany leases contain non-related party effects such as
guarantees by
non-related parties or unguaranteed residual values expected by the lessor, special problems are created because the cash flows
created by these outside non-related parties are "arms length" and as such have economic substance. On the other hand, from the
consolidated viewpoint, the lease doesn't exists and the substance of the transaction is that the lessee is purchasing the asset using
funds borrowed from the lessor. This means that the elimination procedures must eliminate the effects of the intercompany lease
and while treating the transaction as an intercompany sale. Recall that in intercompany sales of depreciable property, all gains are
deferred at the time of sale and recognized ratably over thelife of the asset.
C.Elimination procedures for intercompany leases: The effects of intercompany leases must be completely eliminated from the
consolidated financials. In addition it is necessary to reclassify the leased asset and A/D-leased asset; PP&E and A/D-PP&E.
1. Operating leases: Operating leases are in essence simply rental agreements. This means that from the intercompany viewpoint all
traces of the lease must be eliminated on the consolidated financials. Because lease revenue exactly offsets rental expenses in
operating leases, there is no MI income effect.
a. adjusting and elimination entries:
Reverse booked revenues/expenses:
Lease revenue.......................... xxxx
Lease expense.......................
xxxx
Reverse booked lease payable and receivable:
Lease payable..........................xxxx
Lease receivable....................
xxxx
Reclassify the leased asset and A/D:
Equipment.............................. xxxx
A/D--leased equipment........ xxxx
Leased equipment....................
xxxx
A/D--equipment......................
xxxx
2. Capital leases: Intercompany capital leases are viewed as the purchase of an asset using funds borrowed from the lessor.
RULE: The lease does not exist from a consolidated standpoint so all traces must be eliminated but those
items that would properly be adjusted in an intercompany sale of depreciable assets must be reflected.
Procedure: (all capital leases)
a. Reconstruct the amortization tables for both lessor and lessee; remember that lessor may include unguaranteed residual values or
guarantees by third parties in the computation of MLP; these items would not be included by the lessee; the difference in
any given period is the interest on the unguaranteed residual or other item and is balanced against the lease receivable
account.
NOTE: The presence of up and downstream transactions must be noted to facilitate the distribution on net income.

Dr. M.D. Chase


Long Beach State University
Advanced Accounting 520-45B Intercompany Leases:Adjumstments & Eliminations Page 2
CONSOLIDATED ELIMINATION ENTRIES: DIRECT FINANCING LEASES:
b. Eliminate the current year intercompany interest revenue/interest expense effects booked by the parties.
Interest income (per lessor table)....................................................
xxxx
Interest expense (per lessee table)................................................
xxxx
Unguaranteed residual (current year interest on unguaranteed residual).............
xxxx
c. Eliminate interest on unguaranteed residual booked in prior years:
"P"-RE (P%)(lessor interest-lessee interest per tables)...............................
xxxx
"S"-RE (S%)(lessor interest-lessee interest per tables)...............................
xxxx*
Unearned interest income (interest on unguaranteed residual booked prior years).
*upstream transactions
d. Eliminate the lease accounts and reclassify the asset:
Lease payable (CV EOY per lessee table))..............................................
xxxx
Interest payable (per lessee table)...................................................
xxxx
Unearned interest income (all intrst on ung. resid. + future lessee interest).. xxxx
PP&E (cost or carrying value to lessor)...............................................
xxxx
Lease receivable (gross receivable EOY)............................................
Asset under lease (PV MLP to lessee at inception of lease).........................
e. Reclassify Accumulated depreciation:
A/D-leased asset (PV MLP lessee/life)years............................................
xxxx
A/D-PP&E ((cost or CV to lessor - Unguaranteed residual)/life)years................
Depreciation expense (current year difference).....................................
"P"-RE (P%)(sum of prior year differences).........................................
"S"-RE (S%)(sum of prior year differences).........................................
*upstream transactions

xxxx

xxxx
xxxx

xxxx
xxxx
xxxx
xxxx*

CONSOLIDATED ELIMINATION ENTRIES: SALES TYPE LEASES:


b. Eliminate the current year intercompany interest revenue/interest expense effects booked by the parties.
Interest income (per lessor table)....................................................
xxxx
Interest expense (per lessee table)................................................
xxxx
Unguaranteed residual (current year interest on unguaranteed residual).............
xxxx
c. Eliminate interest on unguaranteed residual booked in prior years:
"P"-RE (P%)(lessor interest-lessee interest per tables)...............................
xxxx
"S"-RE (S%)(lessor interest-lessee interest per tables)...............................
xxxx*
Unearned interest income (interest on unguaranteed residual booked prior years)...
*upstream transactions
d. Eliminate the lease accounts and reclassify the asset:
Lease payable (CV BOY per lessee table))..............................................
xxxx
Interest payable (per lessee table)...................................................
xxxx
Unearned interest income (all intrst on ung. resid. + future lessee intrst).... xxxx
PP&E (cost or carrying value to lessor)...............................................
xxxx
Sales (PV MLP lessor).................................................................
xxxx
CGS (cost or CV to lessor + IDC - PV of unguaranteed residual).....................
sales profit on lease..............................................................
Lease receivable (gross receivable EOY)............................................
Asset under lease (PV MLP to lessee at inception of lease).........................
e. Reclassify Accumulated depreciation:
A/D-leased asset (PV MLP lessee/life)years............................................
xxxx
A/D-PP&E ((cost or CV to lessor - Unguaranteed residual)/life)years................
Depreciation expense (current year difference).....................................
"P"-RE (P%)(sum of prior year differences).........................................
"S"-RE (S%)(sum of prior year differences).........................................
*upstream transactions

xxxx

xxxx
xxxx
xxxx
xxxx

xxxx
xxxx
xxxx
xxxx*

Dr. M.D. Chase


Long Beach State University
Advanced Accounting 520-45B Intercompany Leases:Adjumstments & Eliminations Page 3

f. Recognize gain allowable to date on lease (difference between Sales and CGS)
Sales profit on lease (eliminate the profit on the lease)...........................
xxxxx**
Accum Deprec-PP&E (recognize total gain allowable to date (7298/8 yrs).. xxxxx
PP&E (eliminate gain included in PP&E)...........................................
Depreciation Expense (recognize gain allowable in current year)..................

xxxxx
xxxxx

**In subsequent years this would be to "P" RE (downstream sale) or allocated between "P" RE and "S" RE (upstream sale)

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