Leases

Learning Objectives
1. Explain the nature, economic substance, and advantages of lease transactions. 2. Identify and explain the accounting criteria and procedures for capitalizing leases by the lessee. 3. Identify the lessees disclosure requirements for capital leases. 4. Identify the lessees accounting and disclosure requirements for an operating lease.

Learning Objectives
5. Contrast the operating and capitalization methods of recording leases. 6. Calculate the lease payment required for the lessor to earn a given return. 7. Identify the classifications of leases for the lessor. 8. Describe the lessors accounting for direct financing leases. 9. Describe the lessors accounting for sales-type leases.

Learning Objectives
10. Describe the lessors accounting for operating leases. 11. Identify the lessors disclosure requirements. 12. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. 13. Describe the effect of bargain purchase options on lease accounting. 14. Describe the lessors accounting treatment for initial direct costs.

Learning Objectives
15. Describe the lessees accounting for saleleaseback transactions (Appendix 21A). 16. Explain the classification and accounting treatment accorded leases that involve land as well as buildings and equipment (Appendix 21A).

Leases
Basics of Accounting by Lessees Leasing Capitalization criteria Advantages Accounting for a capital of leasing lease Conceptual Capital lease method nature of a illustrated lease Reporting and disclosure-capital leases Accounting for an operating lease Reporting and disclosure-operating leases Perspectives Illustration of disclosures Accounting by Lessors Economics of leasing Classification Capitalization criteria Direct financing lease Sales-type lease Operating leases Reporting and disclosure Illustration of lessor disclosures Illustrations Special of Lease Accounting ArrangeIssues ments Residual Harmon, values Inc. Bargain Ardens purchase Oven Corp. options Initial direct Mendotta Truck Corp. costs Appleland Current Computer versus noncurrent Unsolved problems

Leasing: Basics The lease is a contractual agreement between the lessor and the lessee The lease gives the lessee the right to use specific property (owned by the lessor) The lease specifies also the duration of the lease and rental payments The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee or divided

Advantages of Leasing
100 percent financing at a fixed rate
No down payment required Rate charged is fixed for the term of the lease

Protection from obsolescence

Property can be upgraded

Flexibility
Lease may be structured to meet different needs (e.g., cash flow)

Less costly financing (lessee); incentives (lessor) Off-balance sheet financing

Impact on ratios

tax

Differing Views on Capitalization of Leases Do not capitalize any leased assets

Since lessee does not own the property, capitalization is considered inappropriate Since executory contracts are not capitalized, leases should not be either

Capitalize leases that are similar to instalment purchases

If instalment purchases are capitalized, so should leases with similar characteristics

Differing Views on Capitalization of Leases

Capitalize all long-term leases

The long-term right to use property justifies its capitalization (property rights approach)

Capitalize firm leases where the penalty for nonperformance is substantial

Capitalize only firm /non-cancellable contractual rights and obligations

Current Accounting Standard

CICA standard is consistent with approach similar to instalment purchases A lease that transfers substantially all the benefits and risks of property ownership should be capitalized

Current Accounting Standard

Basic Conclusions:
1. Characteristics indicating transfer of risks and benefits of ownership must be identified 2. Same characteristics should apply to the lessee and lessor 3. Leases that do not transfer substantially all benefits and risks of ownership should not be capitalized

Lease Classification
Capital Lease
Where the benefits and risks of ownership have effectively been transferred to the lessee
Accounted for as a purchase by the lessee

Journal Entries:
Lessee Leased Equipment XXX Lease Obligation XXX Lessor Lease Receivable (net) XXX Equipment XXX

Lease Classification
Operating Lease
Where the rights and risks of ownership have not been transferred
A rental-only has occured

Journal Entries:
Lessee Lease Expense XXX Cash XXX Lessor Cash XXX Rental Revenue XXX

Capital vs. Operating Lease

Lease Agreement

Is there a Transfer of Ownership or Bargain Purchase Option?

No

Is Lease Term 75% of Economic Life

No

Is Present Value of Payments 90% of Fair Value Yes

No

Yes

Yes

Capital Lease

Operating Lease

Capital Lease Criteria

Transfer of ownership Economic life PV of payments
If the PV of minimum lease payments is 90% of the fair value of the asset minimum lease payments (lessee) defined:
Minimum rental payments + Guaranteed residual value + Penalty for not renewing or extending lease + Bargain purchase option

Minimum Lease Payments

Minimum rental payments
Regular payment made to lessor, excluding executory costs
Executory costs include insurance, maintenance and tax expenses. If these payments made by the lessor, they are estimated and excluded from the minimum rental payment calculation

Guaranteed residual value

The amount at which the lessor has the right to require the lessee to purchase the asset; or The amount the lessee (or 3rd party guarantor) guarantees that the lessor will realize

Discount Rate
The rate the lessee would have incurred if they had borrowed the funds to purchase the asset (incremental borrowing rate)
Under similar term (length) Similar security (same type of asset)

This rate is not used when

The lessee knows the implicit rate lessor used to calculate the lease payment, and it is less than the lessees incremental borrowing rate In this case, use implicit rate

Accounting for a Capital Lease Asset & liability recorded at the lower of:
PV of the minimum lease payments, or FV of the asset at the inception of the lease Depreciation of the asset is amortized over: The economic life of the asset if ownership transfers to lessee at the end of the lease or there is a bargain purchase option The term of the lease if title does not transfer or there is no bargain purchase option Otherwise over the term of the lease

Accounting for a Capital Lease Interest expense resulting from the lease transaction is recorded following the effective interest method
The discount rate used to establish the initial PV is used to amortize the lease

Journal entries required to record a capital lease transaction are as follows:

Accounting for a Capital Lease

At the inception of the lease Dr. Asset Cr. Obligations under capital lease
To record interest amortization Dr. Interest Expense Cr. Interest Payable Using the Effective Interest Method

Using method To record asset amortization appropriate to Dr. Amortization Expense Cr. Accumulated Amortization the asset To record the lease payment Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under capital lease Cr. Cash

Capital Lease - Example

Lease Terms Given:
Term of 5 years, non-cancellable Annual payments $25,981.62 (due at beginning of each year) Fair value of asset $100,000 Economic life = 5 years; Residual value = Zero Lease payments include $2,000 property taxes (executory cost) Lease has no renewal option, and asset reverts to Lessor at termination of lease Lessees incremental borrowing rate = 11% Lessors implicit rate =10% (known to lessee)

Capital Lease - Example

Does this qualify as a capital lease? Only one of the tests must be met
Is there a Transfer of Ownership or Bargain Purchase Option? No Is Lease Term 75% of Economic Life? Is Present Value of Payments 90% of Fair Value?

Yes Yes Capital Lease PV of payments (n=5, i=10%) 25,981.62 - 2000.00 = 23,981.62 x 4.16986 = $100,000.00

Capital Lease - Example

Entry to record initial lease transaction
Leased Equipment Lease Liability 100,000 100,000

Entry to record initial payment (Jan 1/05)

Property Tax Expense Lease Liability Cash 2,000.00 23,981.62 25,981.62

As this is a capital lease the following must also be recorded (at year end or in each reporting period)
Interest expense Asset amortization

Capital Lease - Example

Interest amortization (December 31, 2005)
Interest Expense Interest Payable 7,601.84 7,601.84
(100,000-23,981.62)*10% = 7,601.84 (Interest Payable is debited in all subsequent lease payment entries)

Asset amortization (December 31, 2005)

Amortization expense 20,000 Accumulated amortization 20,000
(100,000 / 5 years = 20,000) (There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset)

Disclosure Requirements Capital Lease

Gross amount of assets and related accumulated amortization Amortization expense may be disclosed, methods and rate should be disclosed Lease obligations reported separately from other liabilities Current portion of lease obligation=current liability Minimum lease payments in total and for the next five fiscal years; executory costs and imputed interest disclosed separately Interest expense from the lease may be separately disclosed; or included with other interest expense May disclose any related contingencies

Accounting by the Lessor

Leases are classified as either:
Operating Lease Direct financing Lease Sales-type Lease
These are capital leases

The determination of a capital or operating lease depends on answering a series of questions

Lease Classification - Lessor

Lease Agreement Remaining unreimburseable Risk associated Yes costs to Lessor with collection estimatible? normal? No Yes No

Yes

Does Lease meet any of Lessees Capital Lease criteria?

No

Does Asset Fair Value = Lessors Book Value?

No

Yes
Direct Financing Lease

Operating Lease

Sales-Type Lease

Lease Classification - Lessor

Both the direct financing lease and the salestype lease are capital leases The difference is whether or not there exists a manufacturers or dealers profit The sales-type lease incorporates a profit hence the final question on the previous map A lease may qualify as a capital lease by the lessee and as an operating lease by the lessor

Direct Financing Lease - Lessor

Lessor replaces investment in asset to be leased with a lease receivable Over lease term, the receivable is collected, and interest is earned Net investment in the lease = lease payments receivable unearned interest revenue

Calculation of Lease Payment by Lessor

Step 1: Calculate the payment required to provide lessor with required rate of return Cost/FMV of asset to be recovered $100,000 Less: PV of expected residue value -0Amount to be recovered through lease payments $100,000

Calculation of Lease Payment (Contd)

Amount to be recovered $100,000

Payments: (n=5, i=10)

$100,000 4.16986
= $23,981.62

Lease payments receivable: 5 x $23,981.62

= $119,908.10

Direct Financing Lease (Lessor)

The lease payments receivable are equal to: Lease payments (net of executory costs) + salvage (residual) value The unearned interest revenue is the difference between the lease payment receivable and the asset cost (FMV) The journal entries are then:

Direct Financing Lease (Lessor)

January 1, 2005 Lease Payments Receivable 119,908.10 Equipment for Lease 100,000.00 Unearned Interest Revenue 19,908.10 January 1, 2005 (first payment) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable 23,981.62 December 31, 2005 Unearned Interest Revenue 7,601.84 Interest Revenue 7,601.84

Direct Financing Lease (Lessor)

At Dec. 31/05 year end, Lessor recognizes interest earned: Amount originally financed $100,000.00 Paid on principal Jan. 1/05 (23,981.62) Balance outstanding $ 76,018.38 Interest : 10% x 76,018.38 x 12/12 = $7,601.84 Unearned Interest Revenue 7,601.84 Interest Revenue 7,601.84

Sales-Type Lease - Lessor

Entries are the same as for the direct financing lease, except for:
Entry at the inception of the lease must record the sale and cost of goods sold Recall that the sales-type lease includes a manufacturers/dealers profit margin

Lessor earns a gross profit on sale + interest as the sale is financed

Sales-Type Lease Example

Take the same data as in our example, except the asset has been recorded in the Lessors inventory at a cost of $85,000 (FMV=$100,000) All previous lessor entries remain the same except for the entry at the lease inception
Sales and Gross Profit are recorded

Sales-Type Lease Example

January 1, 2005 Lease Payments Receivable 119,908.10 Sales 100,000.00 Unearned Interest Revenue 19,908.10 Cost of Goods Sold 85,000.00 Inventory 85,000.00 January 1, 2005 (first payment-remains the same) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable 23,981.62 December 31, 2005 (remains the same) Unearned Interest Revenue 7,601.84 Interest Revenue 7,601.84

Disclosure Requirements - Lessor

Disclose the net investment in the lease (classified as current and non-current) How the investment is calculated for purposes of income recognition Finance income amount
Operating Leases
Separate disclosure of the cost and accumulated amortization of the property Amount of rental (lease) income earned

Other Lease Accounting Issues

Residual Value Lessor
Direct Financing Lease: whether guaranteed or unguaranteed, the residual is included in the lessor calculations Sales-Type Lease: with unguaranteed residual value the Sales Revenue and COGS are reduced by the PV of that unguaranteed residual value Residual value is part of Sales Revenue (and COGS) if guaranteed

Other Lease Accounting Issues

Residual Value Lessee
If guaranteed by lessee, p.v. of residual is included in asset cost and lease obligation recognized (i.e. is included in definition of minimum lease payments) If not guaranteed by lessee, residual value is not included in definition of minimum lease payments not in asset or liability amounts recognized

Other Lease Accounting Issues

Bargain Purchase Option
With direct financing and sales-type leases, the bargain purchase price is included in the net investment calculations by Lessor Lessee accounting assumes bargain option price will be paid: p.v. of amount included in asset cost and obligation recognized

Initial Direct Costs of Lessor

Application of Matching Principle
Operating lease over term of lease Direct financing lease over term of lease Sales-type lease in same period as gross profit on sale recognized

Current and Noncurrent

Current portion = principal amount to be received/paid within 12 months from balance sheet date + interest accrued to the balance sheet date Long-term = principal amount not recoverable/payable within 12 months from balance sheet date