Accounting for Leases ACC 4305 Michel Leseure Leases

Accounting for Leases ACC 4305 Michel Leseure

Leases • The lease is a contractual agreement between the lessor and the lessee. • The lease gives the lessee the right to use specific property. • The lease specifies the duration of the lease and rental payments. • The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee. ACC 4305 Michel Leseure

Advantages of Leases • Leases may not require any money down. • Lease payments are often fixed. • Leases reduce the risk of obsolescence to the lessee. • Leases may contain less restrictive covenants than other types of lending arrangements. • Leases may be a less costly means of financing. • Certain leases may not add to existing debt on the balance sheet. Off Balance Sheet Financing ACC 4305 Michel Leseure

Tax Advantages • The lessee can write off the full cost of the asset, including the part that relates to land. • The deduction may be accelerated since it is often spread over the period of the lease rather than the actual economic life of the property. ACC 4305 Michel Leseure

Defining Leases • According to the FASB: – a lease transferring substantially all of the benefits and risks of ownership should be capitalized. – Transfer of ownership can be assumed only if there is a high degree of performance to the transfer, that is, the lease is non-cancelable. – Leases that do not substantially transfers benefits and risks are operating leases. ACC 4305 Michel Leseure

Accounting by Lessee • Leases that meet any of the following four criteria are capital leases for the lessee: – Leases, transferring ownership – Leases with bargain purchase options – Leases with lease terms equal to 75% or more of the economic life (75% rule) – Leases where the present value of lease payments is equal to 90% or more of the fair market value (90% rule) ACC 4305 Michel Leseure

Accounting by Lessee Lease Agreement Is there transfer of ownership? No Capital Lease Yes Is there a bargain purchase option? No Yes Is lease term equal to or greater than 75% of economic life ? Yes No Operating Lease Is present value of payments equal to or more than 90% FMV? ACC 4305 Michel Leseure

Accounting by Lessee • In a capital lease transaction, the lessee records an asset and a liability. – The asset is depreciated by the lessee over the economic life of the asset. – The effective interest method is used to allocate the rental payments between principal and interest. – Depreciation of the asset and discharge of the lease obligation are independent accounting procedures. ACC 4305 Michel Leseure

Illustration ACC 4305 Michel Leseure

An introductory example • To illustrate accounting for lease transactions, we will use a simple case involving three parties: • 1. Meknes Farms SA » Needs a Combine Model SX » Expected useful life of six years with no salvage value ACC 4305 Michel Leseure

An introductory example • 2. Meknes First Bank » Currently charging 12% interest on long-term equipment loans • 3. Said Tractors, SA » Manufactures the Model SX combine at a cost of dh 400, 000. » Selling price is dh 500, 000 » It also has a few units for trial use which rent for dh 5000 per week ACC 4305 Michel Leseure

Operating Lease • If Meknes Farms rents a combine for one week from Said Tractors, the journal entries would follow the usual pattern for a rental: Meknes Farms Equipment rent expense Cash 5, 000 ACC 4305 Michel Leseure

Operating Lease • Said Tractors – Cash – Rental Revenue 5, 000 • Since Said Tractors is the owner of the combine, it would record depreciation: – Depreciation expense 1, 282 – Acc’d depreciation 1, 282 [400, 000/6 years/52 weeks] ACC 4305 Michel Leseure

Operating leases- Summary • Assign rent expense or revenue to period benefited – Subject to accruals • No liability on lessee’s balance sheet • Lessor depreciates the asset • Lessor is probably responsible for insurance, property taxes and maintenance ACC 4305 Michel Leseure

Purchase with LT loan • Assume Meknes Farms decides to purchase the combine and borrows the full purchase price of Dh 500, 000 from Meknes First Bank at 12% interest on the unpaid balance of the loan. • Meknes Farms agrees to make annual payments of Dh 100, 000 for five years. • Again, the journal entries follow the normal pattern. ACC 4305 Michel Leseure

Securing the Loan • Meknes Farms Cash 500, 000 Note Payable 500, 000 • Meknes First Bank • Loan receivable 500, 000 Cash 500, 000 ACC 4305 Michel Leseure

Purchasing the Equipment • Said Tractors SA. Cash Sales • COGS Inventory 500, 000 400, 000 • Meknes Farms Combine Cash 500, 000 ACC 4305 Michel Leseure

End of the Year 500, 000/6 years • Meknes Farm Depreciation Expense 83, 333 Acc'd Depreciation 83, 333 • Interest Expense 60, 000 Interest Payable 60, 000 [500, 000 * 12%] • Meknes First Bank Interest Receivable 60, 000 Interest Revenue 60, 000 ACC 4305 Michel Leseure

First Installment Payment • Meknes First Bank • Cash 160, 000 Loan Receivable 100, 000 Interest Receivable 60, 000 • Meknes Farms Interest Payable Notes Payable Cash 60, 000 100, 000 160, 000 ACC 4305 Michel Leseure

Capital Lease • For various reasons either (or both) Meknes Farms and Meknes First Bank might prefer a lease arrangement to an outright purchase & long-term loan – Assume that the bank agrees to purchase the combine from Said Tractors for MAD 500, 000 and lease it to Meknes Farms for five years. – Meknes Farms gets to keep the combine at the end of the lease. ACC 4305 Michel Leseure

Capital Lease • The bank must determine how much to charge to earn its desired rate of 12% interest. – Assuming the first annual payment comes at the end of the first year (after harvest). – PV = 500, 000, n = 5, i = 12% • Payment must be 138, 710 ACC 4305 Michel Leseure

Direct Financing Lease • The lessor calls this a “direct financing lease” because it is essentially an installment sale. • The only money the lessor makes from the lease is interest revenue. ACC 4305 Michel Leseure

Bank buys combine: • Meknes First Bank • Asset to be leased 500, 000 Cash 500, 000 • Said Tractors SA. Cash 500, 000 Sales 500, 000 COGS 400, 000 Inventory 400, 000 ACC 4305 Michel Leseure

Asset is transferred to lessee: • Meknes Farms Leased Asset Lease Payable 500, 000 • Meknes First Bank Investment in lease 500, 000 Asset to be leased 500, 000 ACC 4305 Michel Leseure

End of the Year • Meknes Farms Depreciation Expense Acc'd Depreciation 500, 000/6 years 83, 333 Acc. Dep to be applied against Leased Asset account ACC 4305 Michel Leseure

First Lease Payment • Meknes First Bank • Cash Investment in Lease Interest Revenue • Meknes Farms Interest Expense Lease Payable Cash 138, 710 78, 710 60, 000 78, 710 138, 710 ACC 4305 Michel Leseure

Is Said Tractor missing out on a business opportunity? – By offering a lease option, Troy Tractor gains the following advantages: • 1. a way of indirectly making a sale, and • 2. an alternative means of obtaining a profit opportunity. ACC 4305 Michel Leseure

Sales Type Lease • Accordingly, Meknes Farms may be able to arrange a similar or better lease arrangement with the manufacturer of the Model SX combine. – This is called a “sales-type lease” for the lessor because Said Tractors will make a profit from “selling” the combine and it will earn interest revenue over the lease term. – We will assume that the lease terms are the same for purposes of illustration. ACC 4305 Michel Leseure

Sales Type Lease • NOTE: The first step in doing lease accounting involves finding the present value of the cash flows which will be transferred between the lessee and lessor. – This "present value of the minimum lease payments" [PVMLP] will give you the SALES amount for the lessor (assuming a sales-type lease) and the ASSET amount for the lessee. – COMPUTE PVMLP: [n = 5, i = 12%, pymt = 138, 710] – PV = MAD 500, 000 ACC 4305 Michel Leseure

Sales Type Lease • Meknes Farms • Leased Asset (PV of MLP) Lease Liability 500, 000 • Depreciation Expense Acc'd Depreciation 83, 333 • Interest Expense Lease Liability Cash 60, 000 78, 710 138, 710 83, 333 ACC 4305 Michel Leseure

Sales Type Lease • Said Tractors • Lease Receivable Sales 500, 000 COGS Inventory 400, 000 Cash Interest Revenue Lease Receivable 138, 710 60, 000 78, 710 ACC 4305 Michel Leseure

Accounting by Lessor • Lessor classifies leases as one of the following: – Operating lease – Direct financing lease – Sales-type lease ACC 4305 Michel Leseure

Classification of Lease for Lessor • To be classified as an operating lease: – The lease doesn’t meet any group 1 criteria (same as lessee’s), OR – Collectibility of payments isn’t reasonably assured, OR – Lessor’s performance isn’t substantially complete. ACC 4305 Michel Leseure

Classification of Lease for Lessor • To be classified as a direct financing lease the lease must meet group 1 criteria (same as lessee’s), and the following, group 2 criteria: – Collectibility of payments must be reasonably assured, and – Lessor’s performance must be substantially complete, and – Asset’s fair value must be equal to lessor’s book value ACC 4305 Michel Leseure

Summary Lease Agreement Does lease meet Group 1 criteria? yes No Sales type No Is collectibility of payments assured? yes No Is lessor’s performance substantially complete ? No yes Operating Lease Direct financing Does asset FMV equal lessor’s book value? yes ACC 4305 Michel Leseure

Accounting Issues • • • Residual values Sales-type leases Bargain purchase options Initial direct costs Disclosure ACC 4305 Michel Leseure

Bargain purchase options (BPO) • Many leases are equivalent to a purchase financed with a long-term loan. We have assumed, so far, that Meknes Farm got to keep the tractor at the end of the lease (TITLE TRANSFER). • Another way a lease is equivalent to a purchase is if the lessee can purchase the asset for a bargain price at the end of the lease. Consider the following lease terms: ACC 4305 Michel Leseure

BPO - Lease • Inception date: 1/1/02 • Lessor: Said Tractors Inc. • Fair value of combine at 1/1/02: MAD 500, 000 • Cost to manufacture combine: 400, 000 • Estimated fair value at end of lease is 100, 000 • Fixed non-cancelable lease term: 5 years. • First payment due on 12/31/02 • Lessee: Meknes Farms • Incremental borrowing rate (lessee): 12% • Implicit interest rate (known to lessee): 12% • Option to buy at end of lease term for 50, 000 • Estimated useful life of combine: 8 years ACC 4305 Michel Leseure

Bargain Purchase Option • What amount should Said Tractors charge? • Amount to be recovered (PV) = MAD 500, 000 • n=5, i=12%, FV (BPO) = 50, 000 • What is PV of 50, 000? • . 5674 * 50, 000 = 28, 370 • Amount to be recovered with annual payments = 500, 000 – 28, 370 =471, 630 ACC 4305 Michel Leseure

Bargain Purchase Option Therefore, PV-OA = 471, 630 PMT * PVIF-OA = PV-OA PMT * 3. 6048 = $471, 630 471630/3. 6048 = 130, 830 ACC 4305 Michel Leseure

Bargain Purchase Option MEKNES FARMS Combine (at PVMLP) Lease Liability Interest Expense Lease Liability. Cash Depreciation Expense Acc'd Depreciation Useful life = 8 years 500, 000 60, 000 70, 830 130, 830 62, 500 ACC 4305 Michel Leseure

Bargain Purchase Option SAID TRACTORS SA. Lease Receivable Sales COGS Inventory Cash Lease Receivable Interest Revenue 500, 000 400, 000 130, 830 70, 830 60, 000 Note: Last Payment includes BPO payment ACC 4305 Michel Leseure

Leasing in Moroccan Accounting • A lease is a rental contract, and thus is always off balance sheet financing! • Growing use – – Medical equipment Royal Air Maroc Ship operators Individuals • Limited use for real estate • No interest charges presents an interest for Islamic banking – New IAS standards with implicit interest rates! Dossier de l’Economiste Number 2208 ACC 4305 Michel Leseure

Leasing in Moroccan Accounting • www. chaabileasing. co. ma • Salafin • Credit du Maroc Leasing ACC 4305 Michel Leseure

Leases in Moroccan Accounting • Royal Air Maroc has filed for and obtained an exemption from Moroccan regulations to capitalise its aircraft leases • Motivations? ACC 4305 Michel Leseure

Lease Backs • An agreement whereby a company sells its asset to a lessor and rents it back under the form of a lease • Motivations: – Cash infusion (at market value rather than book value!) • Risk: use the cash to a productive investment purpose! – Off balance sheet balancing • Down to the nature of the contract! • Systematic with MA/FR accounting ACC 4305 Michel Leseure

Lease Backs • Can be used, legally, to “window dress” accounts • Example: – Company in financial difficulty – Fully amortized asset on the books (or not) – Lease back • Liquidity increases, solvency increases! • COMANAV in 2003 • Not possible with IFRS ACC 4305 Michel Leseure