LEASES (Chapter 15)

Learning Objectives
1. Identify and describe the operational, financial, and tax objectives that motivate leasing. 2. Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing. 3. Explain the basis for each of the criteria and conditions used to classify leases. 4. Record all transactions associated with operating leases by both the lessor and lessee. 5. Describe and demonstrate how both the lessee and lessor account for a capital lease. 6. Describe and demonstrate how the lessor accounts for a sales-type lease.

LEASES
Learning Objectives:
7. Explain how lease accounting is affected by the residual value of a leased asset. 8. Describe the way a bargain purchase option affects lease accounting. 9. Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs, and contingent leases. 10. Explain sale-leaseback agreements and other special leasing arrangements and their accounting treatment.

11. Discuss the primary differences between U.S. GAAP and IFRS with respect to leases.

12. Oct. 2011 CPA Exam Coverage

A lease is usually a non-cancelable agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee.
Lessee = USER of property Lessor = OWNER of property

Lessee Operating lease Capital lease

Lessor Operating lease Capital lease Direct financing lease Sales-type lease

Conceptual Nature of a Lease

The issue of how to report leases is the case of substance versus form.
Lessee = USER of property; Lessor = OWNER of property

Although technically legal title may not pass, the benefits from the use of the property do.

Conceptual Nature of a Lease

A variety of opinions exist regarding the manner in which certain long-term lease arrangements should be accounted for.
These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB Statements dealing with lease accounting can be characterized as advocating capitalization of lease arrangements that are similar to installment purchases.

Capital Leases and Installment Notes Compared

Matrix, Inc. acquires equipment from Apex, Inc. by paying $100,000 every year for the next ten years. The interest rate associated with the agreement is 0%.
Lets look at the arrangement as an installment sales and as a capital lease agreement. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. Therefore, according to FASB it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase. Therefore, the accounting (the balance sheet presentation of the LIABILITY) for Installment Note Payable or Lease Payable should be exactly the same and NOT Off-

Balance Sheet.

Conceptual Nature of a Lease

Capitalize a lease that transfers substantially all

of the benefits and risks of property ownership, provided the lease is non-cancelable.
Leases that do not transfer substantially all of the benefits and risks of ownership are operating leases.

ASC 840 (FAS 13, Accounting for Leases, 1980)

LEASES
We are tracking the question of LIABILITY and it is arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales type leases by the lessor. Leases that do not produce debtor/creditor relationships, but instead are accounted for as rental agreements are designated as operating leases.

Advantages of Leasing
A. Leasing is used as a means of off-balance-sheet financing. 1. Can avoid negatively affecting the debt-asset ratio and other mechanical indicators of riskiness.
2. Market is naive, and is fooled by off-balance-sheet financing. B. Achieves operational objectives by facilitating asset acquisition to overcome: 1. Uncertainty or cash flow problems. 2. Fear of obsolescence. C. Achieves tax objectives: Lower lease payments for LESSEE if it allows the lessor to retain ownership and thus benefit from ITC and Depreciation deductions when: 1. The lessee has little or no taxable income and will get little benefit from depreciation deductions. 2. The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessor.

Accounting by the Lessee

Lease Agreement

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.
No No
Lease Term >= 75% PV of Payments >= 90%

No
Transfer of Ownership Bargain Purchase

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Capital Lease

LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Operating Leases Lease agreement exists.

Criteria for a capital lease not met.

Record lease as an Operating Lease.

Capital Lease

Operating Leases
On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014. The useful life of the copier is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%.

How should this lease be classified?

Operating Leases
How should this lease be classified?
We apply the four classification criteria: 1 Does the agreement specify that ownership of the asset transfers to the lessee? 2 Does the agreement contain a bargain purchase option? 3 Is the lease term equal to 75% or more of the expected economic life of the asset? {4 yrs < 75% of 6 yrs}

NO
NO NO NO

4 Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the asset?
Calculations: PV of MLP = $348,685 = $100,000 x 3.48685**
Lease present payments value ** present value of an annuity due of $1: n=4, i=10%

$348,685

< 90% of $479,079 = $431,171

Since none of the four classification criteria is met, this is an operating lease.

Operating Leases
At Each of the Four Payment Dates: Sans Serif Publishers, Inc. (Lessee) Prepaid rent Cash CompuDec Corporation (Lessor) Cash Unearned rent revenue At the End of Each Year: Sans Serif Publishers, Inc. (Lessee) Rent expense Prepaid rent CompuDec Corporation (Lessor) Unearned rent revenue Rent revenue Depreciation expense Accumulated depreciation

100,000 100,000

100,000 100,000

100,000 100,000

100,000 100,000 x,xxx x,xxx

Leasehold Improvements
Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.

Exercise 1 Brief Exercises 1-3 Exercise 2 (HW)

Classification Criteria (Lessee)

Operating Lease Capital Lease

A capital lease must meet one of four criteria: Ownership transfers to the lessee at the end of the lease term, or . . .

A bargain purchase option (BPO) exists, or . . . The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or . . . The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.

Accounting by the Lessee

Lease Agreement

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.
No No
Lease Term >= 75% PV of Payments >= 90%

No
Transfer of Ownership Bargain Purchase

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Capital Lease

LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee

1. The transfer of ownership criteria is straightforward and easy to apply in practice. IF THE LEASE TRANSFERS OWNERSHIP OF THE ASSET TO THE LESSEE, IT IS A CAPITAL LEASE

Accounting by the Lessee

2. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the propertys expected fair value at the date the option becomes exercisable.

At the inception of the lease, the difference between the option price and the expected FMV must be large enough to make the exercise of the option reasonably assured.
Example: Lease Honda Accord for $599/Month for 40 months with an option to purchase for $100 at the end of the 40th month when the estimated FMV then is $3000. => Clearly a BARGAIN *Difficult to determine what is a BARGAIN: BOA or HERTZ

Accounting by the Lessee

3. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the assets economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate.
BARGAIN RENEWAL OPTION can extend the lease term. *Difficult to determine what is a BARGAIN

A major exception to the 75% rule is when the inception of the lease occurs during the last 25% of the assets life. When this occurs the 75% test should not be used.

Accounting by the Lessee

4. The reason for the 90% of fair market value test is that if the present value of the minimum lease payments are reasonably close to the market price (FMV) of the asset, the asset is effectively being purchased.
A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the assets life. When this occurs the 75% and 90% tests should not be used.

Accounting by the Lessee

Recovery of Investment Test (90% Test):
PV of Minimum lease payments: (>=90% of FMV)

Minimum rental payment Guaranteed residual value Penalty for failure to renew Bargain purchase option

Included in PV of Minimum Lease Payment calculation

Executory Costs:

Insurance Maintenance Taxes

Exclude from PV of Minimum Lease Payment calculation

Accounting by the Lessee

Recovery of Investment Test (90% Test): The residual value of a leased asset is the estimated fair value of the asset at the end of the lease term.
The residual value may be guaranteed or unguaranteed by the lessee. A guaranteed residual value is said to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the end of the lease term.

A guaranteed residual value affects the lessees computation of the minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The lessor assumes the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.

Accounting by the Lessee

Recovery of Investment Test (90% Test)
To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees the residual value of an asset will be $8,000. If, at the end of the lease, the fair market value of the residual value is less than $8,000, the lessee will have to record a loss for the difference.

For example, if the lessee depreciated the asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee would have to record a loss of $4,000.
If the fair market value of the asset exceeds the $8,000, a gain may be recognized.

Accounting by the Lessee

Recovery of Investment Test (90% Test)
Executory Costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation.

Accounting by the Lessee

Recovery of Investment Test (90% Test):
Discount Rate

Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception.
If the lessee knows the implicit interest rate

computed by the lessor and it is less than the lessees incremental borrowing rate, then lessee must use the lessors rate.

Accounting by the Lessee

For the lessee, a capital lease is treated as if it is a purchase of an asset the lessee records both an asset and liability at inception of the lease.

Accounting by the Lessee

Asset and Liability Recorded at the lower of:

1. the present value of the minimum lease

payments (excluding executory costs) or

2. the fair-market value of the leased asset.

Capital Leases Lessee

On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments of $100,000, beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable.

Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease.

*PV of an annuity due of $1: n = 6, I = 10% => 4.79079

$100,000 4,79079* = $479,079 lessees cost

Capital Leases Lessee

Inception Of Lease (January 1, 2011)
San Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) Lease payable (PV of payments) 479,079 479,079

First Lease Payment (January 1, 2011)

San Serif Publishers, Inc. (Lessee) Lease payable Cash 100,000 100,000

Capital Leases Lessee and Lessor

Amortization Schedule for the Lease
Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
*Rounded.

Payment $ 100,000 100,000 100,000 100,000 100,000 100,000 $ 600,000

Effective Interest $

Decrease in Balance

$ 100,000 37,908 62,092 31,699 68,301 24,869 75,131 17,355 82,645 9,090 * 90,910 $ 120,921 $ 479,079

Outstanding Balance $ 479,079 379,079 316,987 248,686 173,554 90,910 -

$379,079 10% = $37,908 $100,000 - $37,908 = $62,092

$379,079 - $62,092 = $316,987

Capital Leases Lessee and Lessor

Second Lease Payment (December 31, 2011)
San Serif Publishers, Inc. (Lessee) Interest expense Lease payable Cash
37,908 62,092 100,000

Depreciation Recorded at (December 31, 2011)

San Serif Publishers, Inc. (Lessee) Depreciation expense Accumulated depreciation 79,847

79,847

($479,079 6 = $79,847 Assuming straight-line method.)

Exercise 3 Home Work:

EX 3: Fin. Stmt. 12/31/11 Exercise 7 (HW) Exercise 8 (HW) + F/S 12/31/11

Accounting by the Lessor

Economics of Leasing
A lessor determines the amount of the rental, based on the rate of return needed to justify leasing the asset. If a residual value is involved (whether guaranteed or not), the company would not have to recover as much from the lease payments.

Accounting by the Lessor

Classification of Leases by the Lessor
a. Operating leases. b. Direct-financing leases. c. Sales-type leases. A sales-type lease involves a manufacturers or dealers profit, and a direct-financing lease does not.

Accounting by the Lessor

Classification of Leases by the Lessor
Illustration 21-11

A sales-type lease involves a manufacturers or dealers profit, and a direct-financing lease does not.
LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor

Classification of Leases by the Lessor
Illustration 21-12

A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.
LO 4 Identify the classifications of leases for the lessor.

Capital Leases Lessee and Lessee

If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessors cost. => Direct Financing Lease When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price. => Sales-type Lease

Capital Leases Lessee and Lessor

On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments of $100,000, beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. This lease also qualifies as a direct financing lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000.

Lessors Determination of Rental payments: $479,079 4.79079* = $100,000 rental payments.

*PV of an annuity due of $1: n = 6, I = 10%

Lessees Determination of Lease liability and asset: $100,000 4,79079* = $479,079 lessees cost
*PV of an annuity due of $1: n = 6, I = 10%

Capital Leases Lessor

Direct Financing Lease (January 1, 2011)
First Lease Corp. (Lessor) Lease receivable (PV of payments) 479,079 Inventory of equipment (Lessors cost) 479,079

First Lease Payment (January 1, 2011)

First Lease Corp. (Lessor) Cash Lease receivable 100,000 100,000

Capital Leases Lessee and Lessor

Amortization Schedule for the Lease
Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
*Rounded.

Payment $ 100,000 100,000 100,000 100,000 100,000 100,000 $ 600,000

Effective Interest $

Decrease in Balance

$ 100,000 37,908 62,092 31,699 68,301 24,869 75,131 17,355 82,645 9,090 * 90,910 $ 120,921 $ 479,079

Outstanding Balance $ 479,079 379,079 316,987 248,686 173,554 90,910 -

$379,079 10% = $37,908 $100,000 - $37,908 = $62,092

$379,079 - $62,092 = $316,987

Capital Leases Lessee and Lessor

Second Lease Payment (December 31, 2011)
First Lease Corp. (Lessor) Cash Lease receivable Interest revenue

100,000 62,092 37,908

Exercise 4 HW: Exercise 9 (JEs & FSs)

Sales-Type Leases
If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset.
At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of payments).

In addition to interest revenue earned over the lease term, the lessor receives a manufacturers or dealers profit on the sale of the asset.

Sales-Type Leases
On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from CompuDec Corp. at a price of $479,079. The lease agreement specifies annual payments of $100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through 2015. The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier. CompuDec manufactured the copier at a cost of $300,000. CompuDecs interest rate for financing the transaction is10%.

Sales-Type Leases
Lease Classification
1. The lease term (6-years) is equal to 100% of the useful life of the copier, and 2. Fair market value is different from cost of the leased asset. 3. CompuDec is certain about the collectibility of the lease payments, and 4. No costs are to be incurred by CompuDec relating to the lease agreement,

SO
The lease agreement is classified as: -a Sales-Type lease from the viewpoint of CompuDec (lessor) and -a capital lease from the viewpoint of Sans Serif Publishers (lessee).

Sales-Type Leases: Lessee

At inception of the Lease January 1, 2011
CompDec Corp. (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue Inventory of equipment

479,079 300,000

Receipt of the First Lease Payment January 1, 2011

CompDec Corp.(Lessor) Cash Lease receivable

100,000
100,000

Exercise 5 HW:
Exercise 10 (JEs & F/Ss)

Bargain Purchase Options

A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result:
LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded as leased asset and a lease liability.
LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.

Bargain Purchase Options

In a bargain purchase option (BPO) lessee depreciates the asset using its useful life and NOT Lease Life.

Bargain Purchase Option (BPO)

On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 there after through 2016. The estimated useful life of the copier is seven years. On December 31, 2016, at the end of the six year lease term, the copier is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.
Lessor's calculation of rental payments: Fair market value of asset $ 479,079 Less: PV of BPO $ 60,000 0.56447 = (33,868) Amount recoverd through payments PV annuity due factor, n = 6, I = 10% Rental payments at beginning of period Lessee's calculation of PV of MLP: PV of periodic payments $ 92,931 Plus: PV of BPO 60,000 PV of MLP $ 445,211 4.79079 $ 92,931 4.79079 = $ 445,211 0.56447 = 33,868 $ 479,079

Bargain Purchase Option (BPO)

Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 Payment $ 92,931 92,931 92,931 92,931 92,931 92,931 60,000 $ 557,586 Effective Interest 38,615 33,183 27,208 20,636 13,407 5,458 $ 133,049 $ Decrease in Balance $ 92,931 54,316 59,748 65,723 72,295 79,524 54,542 $ 424,537 Outstanding Balance $ 479,079 386,148 331,832 272,084 206,361 134,067 54,542 -

Exercise of BPO at the end of the lease term: $54,542 10% = $5,458* $60,000 BPO payment - $5,458 = $54,542

Bargain Purchase Option (BPO)

End of Lease December 31, 2016
Sans Serif Publishers, Inc. (Lessee) Depreciation expense ($479,079 7) Accumulated depreciation
Interest expense Lease payable Cash (BPO payment) 68,440 68,440 5,458 54,542 60,000

CompDec Corporation(Lessor) Cash Lease receivable Interest revenue

60,000

54,582 5,458

Refer the amortization schedule and computations on the previous screen

Exercise 17 Exercise 18 (HW)

Effect on the Lessee of a Residual Value Guaranteed Residual Value

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term.

Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessors risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value.

Residual Value
On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2016. The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2016, the copier is expected to be worth $60,000.

CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

Effects on the Lessor of a Residual Value Guaranteed Residual Value

When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both.
Lessor's calculation of rental payments: Fair market value of asset $ 479,079 Less: PV of residual value $ 60,000 0.56447 = (33,868) Amount recoverd through payments $ 445,211 PV annuity due factor, n = 6, I = 10% 4.79079 Rental payments $ 92,931

Effect on the Lessee of a Residual Value Guaranteed Residual Value

Lessee's calculation of PV of MLP: PV of periodic payments $ 92,931 Plus: PV of residual value 60,000 PV of MLP
PV factor of an annuity due of $1: n=6, i=10%

4.79079 = $ 445,211 0.56447 = 33,868 $ 479,079

PV factor of $1: n=6, i=10%

Guaranteed Residual Value

Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 Payment $ 92,931 92,931 92,931 92,931 92,931 92,931 60,000 $ 557,586 Effective Interest 38,615 33,183 27,208 20,636 13,407 5,458 $ 133,049 $ Decrease in Balance $ 92,931 54,316 59,748 65,723 72,295 79,524 54,542 $ 424,537 Outstanding Balance $ 479,079 386,148 331,832 272,084 206,361 134,067 54,542 -

Exercise of GRV at the end of the lease term: $54,542 10% = $5,458* $60,000 GRV payment - $5,458 = $54,542

Residual Value Guaranteed

Lets use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value.

Sales-Type Lease January 1, 2011

San Serif Publishers, Inc. (Lessee) Leased equipment 479,079 Lease payable

479,079

CompDec Corporation (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment

479,079 300,000

479,079 300,000

Residual Value Guaranteed

First Lease Payment January 1, 2011
San Serif Publishers, Inc. (Lessee) Lease payable 92,931 Cash 92,931

CompDec Corporation (Lessor) Cash Lease receivable

92,931 92,931

Residual Value Guaranteed

December 31, 2015
San Serif Publishers, Inc. (Lessee) Depreciation expense 69,847 Accumulation depreciation 69,847
Interest expense Lease payable Cash 13,407 79,524 92,931
Recorded cost of leased asset $ 479,079 Guarantted residual value (60,000) Basis for depreciation 419,079 Useful life in years 6 Annual depreciation $ 69,847

CompDec Corporation (Lessor) Cash Interest revenue Lease receivable

92,931

13,407 79,524

See amortization schedule

Effect on the Lessee of a Residual Value Unguaranteed Residual Value

A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments.

As a result, the present value of the minimum lease payments recorded as a leased asset and a lease liability is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

Treatment of Residual Value

Residual value in leased asset? Lessee gets the residual value (by transfer of title or a BPO) Lessor get the residual value (title does not transfer; no BPO) Residual value is not guaranteed. Residual value is guaranteed by lessee. Residual value is guaranteed by a third party. Lessor Computation of Minimum Lease Lease Payment Payment No No Lessee Minimum Lease Payment No

Yes Yes Yes

No Yes Yes

No Yes No

Exercise 14 Exercise 15 (HW)

Executory Costs
One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs.

The lessee records executory costs as incurred:

Sans Serif Publishers, Inc. (Lessee) Maintenance expense 2,000 Cash 2,000

Accounting by the Lessee

Recovery of Investment Test (90% Test)
Executory Costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation.

Exercise 19 Exercise 20 (HW)

Case: NeedsSpace

Discount Rate
One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessors implicit rate or can infer it from the assets fair value. When the lessors implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

Lessors Initial Direct Costs

Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. They include legal fees, commissions, evaluating the prospective lessee's financial condition, and preparing and processing lease documents. The method of accounting for initial direct costs depends on the nature of the lease: Operating Leases Capitalize and amortize over the lease term by the lessor.

Reason: Since the only revenue an operating lease produces is lease

revenue, and that revenue is recognized over the lease term, initial direct costs also are automatically recognized over the lease term to match these costs with the rent revenues they help generate.

Lessors Initial Direct Costs

For Capital Leases, the method of accounting for initial Direct Costs depends on the nature of the lease:

Direct Financing Leases Include as part of investment balance.

In direct financing leases interest revenue is earned over the lease term, so initial direct costs are matched with the interest revenues they help generate. Therefore, initial direct costs are not expensed at the outset, but are deferred and recognized over the lease term. This can be accomplished by increasing the lessors lease receivable by the total of initial direct costs. Then, as interest revenue is recognized over the lease term at a constant effective rate, the initial direct costs are recognized at the same rate (that is, proportionally).

Lessors Initial Direct Costs

The method of accounting for initial direct costs depends on the nature of the lease:

Sales-Type Leases The initial direct costs are expensed at the inception of the lease.
Since the usual reason for a sales-type lease is for a manufacturer or a dealer to sell its product, its reasonable to recognize the costs of creating the transaction as a selling expense in the period

Contingent Rentals
Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

Lease Disclosures
Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.

Lease Disclosures
The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value). Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs.

Balance Sheet and Income Statement

Lease transactions impact several financial ratios 1. Debt to equity ratio Lease liabilities are recorded.

2. Rate of return on assets Lease assets are recorded.

Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

Criticisms of the existing accounting model

The existing accounting model fails to meet the needs of users of financial statements.
Operating leases give rise to assets & liabilities that should be recognized. -Form over Substance Issue Similar transactions can be accounted for very differently -Comparability Issue Rules can easily be manipulated: -Use of Higher Interest Rate; -Transfer of Residual Value Guarantees. -Payment arrangements: MLP vs. Executory Costs -Off-Balance Sheet Financing Issue

FASB and IASB Convergence Project on Leases

FASB Discussion Paper Leases (03/2009)

Conceptual Issues:

Conceptual basis for Assets & Liabilities

Characteristics of an asset:
(a) The entity controls an economic resource or benefit. (b) It arises out of a past event. (c) Future economic benefits are expected to flow to the entity.

Characteristics of a liability:
(a) There exists a present obligation of the entity. (b) The obligation arises out of a past event. (c) The obligation is expected to result in an outflow of economic benefits.

The board tentatively decided that in a simple lease the lessee obtains a right to use a property (the leased item) that meets the definition of an asset and a liability. Consequently, the boards tentatively decided to adopt a new accounting model for leases that results in recognizing: (a) an asset representing its right to use the property (leased item) for the lease term (b) a liability for its obligation to pay rentals. This is a significant departure from the current basis of transferring substantially all the risk and rewards of ownership.