Chapter 21 1 CHAPTER 21 ACCOUNTING FOR LEASES

Chapter 21 -1

CHAPTER 21 ACCOUNTING FOR LEASES Intermediate Accounting 13 th Edition Kieso, Weygandt, and Warfield Chapter 21 -2

Learning Objectives 1. Explain the nature, economic substance, and advantages of lease transactions. 2. Describe the accounting criteria and procedures for capitalizing leases by the lessee. 3. Contrast the operating and capitalization methods of recording leases. 4. Identify the classifications of leases for the lessor. 5. Describe the lessor’s accounting for direct-financing leases. 6. Identify special features of lease arrangements that cause unique accounting problems. 7. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. 8. Describe the lessor’s accounting for sales-type leases. 9. List the disclosure requirements for leases. Chapter 21 -3

Accounting for Leases Leasing Environment Accounting by Lessee Accounting by Lessor Who are players? Advantages of leasing Conceptual nature of a lease Capitalization criteria Accounting differences Capital lease method Operating method Comparison Economics of leasing Classification Chapter 21 -4 Direct-financing method Operating method Special Accounting Problems Residual values Sales-type leases Bargainpurchase option Initial direct costs Current versus noncurrent Disclosure Unresolved problems

The Leasing Environment A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. Largest group of leased equipment involves: Information technology Transportation (trucks, aircraft, rail) Construction Agriculture Chapter 21 -5 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment Who Are the Players? Three general categories: Banks. Captive leasing companies. Independents. Chapter 21 -6 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment Advantages of Leasing 1. 100% Financing at Fixed Rates. 2. Protection Against Obsolescence. 3. Flexibility. 4. Less Costly Financing. 5. Tax Advantages. 6. Off-Balance-Sheet Financing. Chapter 21 -7 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment Conceptual Nature of a Lease Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases. Chapter 21 -8 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do. Operating Lease Journal Entry: Rent expense Cash xxx Capital Lease Journal Entry: Leased equipment Lease liability xxx A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized). Chapter 21 -9 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Accounting by the Lessee If the lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the present value of the rental payments. Records depreciation on the leased asset. Treats the lease payments as consisting of interest and principal. Typical Journal Entries for Capitalized Lease Chapter 21 -10 Illustration 21 -2 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee To record a lease as a capital lease, the lease must be noncancelable. One or more of four criteria must be met: 1. Transfers ownership to the lessee. 2. Contains a bargain-purchase option. 3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. Chapter 21 -11 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Lease Agreement Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Illustration 21 -4 Chapter 21 -12 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Capitalization Criteria Transfer of Ownership Test Not controversial and easily implemented. Bargain-Purchase Option Test At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured. Chapter 21 -13 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Capitalization Criteria Economic Life Test (75% Test) Lease term is generally considered to be the fixed, noncancelable term of the lease. Bargain-renewal option can extend this period. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. Chapter 21 -14 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Capitalization Criteria Recovery of Investment Test (90% Test) Minimum Lease Payments: l l Minimum rental payment Guaranteed residual value Penalty for failure to renew Bargain-purchase option Executory Costs: l l Chapter 21 -15 l Insurance Maintenance Taxes Exclude from PV of Minimum Lease Payment Calculation LO 2

Accounting by the Lessee Capitalization Criteria 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. Ø If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessee’s incremental borrowing rate, then lessee must use the Chapter 21 -16 lessor’s rate. LO 2

Accounting by the Lessee Asset and Liability Accounted for Differently Asset and Liability Recorded at the lower of: 1. present value of the minimum lease payments (excluding executory costs) or 2. fair-market value of the leased asset. Chapter 21 -17 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Asset and Liability Accounted for Differently Depreciation Period If lease transfers ownership, depreciate asset over the economic life of the asset. If lease does not transfer ownership, depreciate over the term of the lease. Chapter 21 -18 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Asset and Liability Accounted for Differently Effective-Interest Method The effective-interest method is used to allocate each lease payment between principal and interest. Depreciation Concept Depreciation and the discharge of the obligation are independent accounting processes. Chapter 21 -19 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee E 21 -1 (Capital Lease with Unguaranteed Residual Value): On January 1, 2011, Adams Corporation signed a 5 -year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9, 968 at the beginning of each year, starting January 1, 2011. The machine has an estimated useful life of 6 years and a $5, 000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adams’s incremental borrowing rate is 10%, and the Lessor’s implicit rate is unknown. Instructions (a) What type of lease is this? Explain. (b) Compute the present value of the minimum lease payments. (c) Prepare all necessary journal entries for Adams for this lease through January 1, 2012. Chapter 21 -20 LO 2

Accounting by the Lessee E 21 -1: What type of lease is this? Explain. Capitalization Criteria: Capital Lease, #3 1. Transfer of ownership NO NO 2. Bargain purchase option 3. Lease term => 75% of economic life of leased property 4. Present value of minimum lease payments => 90% of FMV of property Chapter 21 -21 Lease term Economic life YES 5 yrs 6 yrs 83. 3% FMV of leased property is unknown. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee E 21 -1: Compute present value of the minimum lease payments. Payment $ 9, 968 Present value factor (i=10%, n=5) 4. 16986 PV of minimum lease payments $41, 565 1/1/11 Journal Entries: Leased Machine Under Capital Leases 41, 565 Lease Liability Cash Chapter 21 -22 41, 565 9, 968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee E 21 -1: Lease Amortization Schedule Chapter 21 -23 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee E 21 -1: Journal entries for Adams through Jan. 1, 2012. 12/31/11 Depreciation Expense 8, 313 Accumulated Depreciation—Capital Leases 8, 313 ($41, 565 ÷ 5 = $8, 313) Interest Expense 3, 160 Interest Payable 3, 160 ($41, 565 – $9, 968) X. 10] Chapter 21 -24 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee E 21 -1: Journal entries for Adams through Jan. 1, 2012. 1/1/12 Lease Liability 6, 808 Interest Payable 3, 160 Cash Chapter 21 -25 9, 968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Operating Method The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. Illustration: Assume Adams accounts for it as an operating lease. Adams records this payment on January 1, 2011, as follows. Rent Expense Cash Chapter 21 -26 9, 968 LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessee E 21 -1: Comparison of Capital Lease with Operating Lease Chapter 21 -27 LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessor Benefits to the Lessor 1. Interest Revenue. 2. Tax Incentives. 3. High Residual Value. Chapter 21 -28 LO 4 Identify the classifications of leases for the lessor.

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 Chapter 21 -29 LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor E 21 -10 (Computation of Rental): Fieval Leasing Company signs an agreement on January 1, 2010, to lease equipment to Reid Company. The following information relates to this agreement. 1. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. 2. The cost of the asset to the lessor is $343, 000. The fair value of the asset at January 1, 2010, is $343, 000. 3. The asset will revert to the lessor at the end of the lease term at which time the asset is expected to have a residual value of $61, 071, none of which is guaranteed. 4. The agreement requires annual rental payments, beg. Jan. 1, 2010. 5. Collectibility of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. Chapter 21 -30 LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor E 21 -10 (Computation of Rental): Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. x - ÷ Chapter 21 -31 LO 4 Identify the classifications of leases for the lessor.

E 21 -2 (Lessee Computations and Entries, Capital Lease with Guaranteed Residual Value) l Brecker Company leases an automobile with a fair value of $10, 906 from Emporia Motors, Inc. , on the following terms: 1. Noncancelable term of 50 months. l 2. Rental of $250 per month (at end of each month). (The present value at 1% per month is $9, 800. ) l 3. Estimated residual value after 50 months is $1, 180. (The present value at 1% per month is $715. ) l Brecker Company guarantees the residual value of $1, 180. l 4. Estimated economic life of the automobile is 60 months. l 5. Brecker Company’s incremental borrowing rate is 12% a year (1% a month). Emporia’s implicit l. Chapter rate is unknown. l 21 -32

l l l Instructions: (a) What is the nature of this lease to Brecker Company? (b) What is the present value of the minimum lease payments? ($10, 515) (c) Record the lease on Brecker Company’s books at the date of inception. (d) Record the first month’s depreciation on Brecker Company’s books (assume straightline). (e) Record the first month’s lease payment. Chapter 21 -33

E 21 -3 (Lessee Entries, Capital Lease with Executory Costs and Unguaranteed Residual Value) Assume that on January 1, 2011, Kimberly-Clark Corp. signs a 10 -year noncancelable lease agreement to lease a storage building from Trevino Storage Company. The following information pertains to this lease agreement. l 1. The agreement requires equal rental payments of $90, 000 beginning on January 1, 2011. l 2. The fair value of the building on January 1, 2011 is $550, 000. l 3. The building has an estimated economic life of 12 years, with an unguaranteed residual value of $10, 000. Kimberly. Clark depreciates similar buildings on the straight-line method. l 4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor. Chapter l 21 -34

l l 5. Kimberly-Clark’s incremental borrowing rate is 12% per year. The lessor’s implicit rate is not known by Kimberly-Clark. 6. The yearly rental payment includes $3, 088. 14 of executory costs related to taxes on the property. Instructions: Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2011 and 2012. Kimberly. Clark’s corporate year end is December 31. Chapter 21 -35

Accounting by the Lessor Classification of Leases by the Lessor a. Operating leases. b. Direct-financing leases. c. Sales-type leases. Chapter 21 -36 LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor Classification of Leases by the Lessor Illustration 21 -10 A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. Chapter 21 -37 LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor Classification of Leases by the Lessor Illustration 21 -11 A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease. Chapter 21 -38 LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor Direct-Financing Method (Lessor) In substance the financing of an asset purchase by the lessee. Chapter 21 -39 LO 5 Describe the lessor’s accounting for direct-financing leases.

Accounting by the Lessor E 21 -10: Prepare an amortization schedule that would be suitable for the lessor. Chapter 21 -40 LO 5 Describe the lessor’s accounting for direct-financing leases.

Accounting by the Lessor E 21 -10: Prepare all of the journal entries for the lessor for 2010 and 2011. 1/1/10 Lease Receivable 343, 000 Equipment 1/1/10 Cash 343, 000 64, 400 Lease Receivable 12/31/10 Interest Receivable Interest Revenue Chapter 21 -41 64, 400 27, 860 LO 5 Describe the lessor’s accounting for direct-financing leases.

Accounting by the Lessor E 21 -10: Prepare all of the journal entries for the lessor for 2010 and 2011. 1/1/11 12/31/11 Cash Lease Receivable 36, 540 Interest Receivable 27, 860 Interest Receivable Interest Revenue Chapter 21 -42 64, 400 24, 206 LO 5 Describe the lessor’s accounting for direct-financing leases.

Accounting by the Lessor Operating Method (Lessor) Records each rental receipt as rental revenue. Depreciates the leased asset in the normal manner. Chapter 21 -43 LO 5 Describe the lessor’s accounting for direct-financing leases.

Accounting by the Lessor Operating Method (Lessor) Illustration: Assume Fieval accounts for the lease as an operating lease. It records the cash rental receipt as follows: Cash 64, 400 Rental Revenue 64, 400 Depreciation is recorded as follows: Depreciation Expense Accumulated Depreciation Chapter 21 -44 57, 167 $343, 000 / 6 years = 57, 167 LO 5 Describe the lessor’s accounting for direct-financing leases.

E 21 -4 (Lessor Entries, Direct-Financing Lease with Option to Purchase) Krauss Leasing Company signs a lease agreement on January 1, 2011, to lease electronic equipment to Stewart Company. The term of the non-cancelable lease is 2 years, and payments are required at the end of each year $ 130, 666. 42. The following information relates to this agreement: l Stewart has the option to purchase the equipment for $16, 000 l The equipment has a cost and fair value of $240, 000 to Krauss Leasing Company. The useful economic life is 2 years, with a salvage value of $16, 000. l Stewart Company is required to pay $7, 000 each year to the lessor for executory costs. l Krauss Leasing Company desires to earn a return of 10% on its investment. l Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. l Instructions: l (a) Prepare the journal entries on the books of Krauss Leasing to reflect the payments received under the lease and to recognize income for the years 2011 and 2012. l (b) Assuming that Stewart Company exercises its option to purchase the equipment on December 31, 2012, prepare the journal entry to reflect the sale Chapter 21 -45 on Krauss’s books.

Special Accounting Problems 1. Residual values. 2. Sales-type leases (lessor). 3. Bargain-purchase options. 4. Initial direct costs. 5. Current versus noncurrent classification. 6. Disclosure. Chapter 21 -46 LO 6 Identify special features of lease arrangements that cause unique accounting problems.

Special Accounting Problems Residual Values Meaning of Residual Value - Estimated fair value of the leased asset at the end of the lease term. Guaranteed Residual Value – Lessee agrees to make up any deficiency below a stated amount that the lessor realizes in residual value at the end of the lease term. Chapter 21 -47 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Residual Values Lessee Accounting for Residual Value The accounting consequence is that the minimum lease payments, include the guaranteed residual value but excludes the unguaranteed residual value. Chapter 21 -48 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2011, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2011. The terms and provisions of the lease agreement, and other pertinent data, are as follows. The term of the lease is five years. The lease agreement is noncancelable, requiring equal rental payments at the beginning of each year (annuity due basis). The loader has a fair value at the inception of the lease of $100, 000, an estimated economic life of five years, and no residual value. Chapter 21 -49 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Sterling pays all of the executory costs directly to third parties except for the property taxes of $2, 000 per year, which is included as part of its annual payments to Caterpillar. The lease contains no renewal options. The loader reverts to Caterpillar at the termination of the lease. Sterling’s incremental borrowing rate is 11 percent per year. Sterling depreciates on a straight-line basis. Caterpillar sets the annual rental to earn a rate of return on its investment of 10 percent per year; Sterling knows this fact. Caterpillar estimates a residual value of $5, 000 a the end of the lease. Chapter 21 -50 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Caterpillar would compute the amount of the lease payments as follows: Illustration 21 -16 NOTE: For the Lessee, the minimum lease payment includes the guaranteed residual value but excludes the unguaranteed residual value. Chapter 21 -51 Solution on notes page LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Computation of Lessee’s capitalized amount Illustration 21 -17 Chapter 21 -52 Solution on notes page LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Computation of Lease Amortization Schedule Illustration 21 -18 Chapter 21 -53 LO 7

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): At the end of the lease term, before the lessee transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. Illustration 21 -19 Chapter 21 -54 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Assume that Sterling depreciated the leased asset down to its residual value of $5, 000 but that the fair market value of the residual value at December 31, 2015, was $3, 000. Sterling would make the following journal entry. Loss on Capital Lease Interest Expense (or Interest Payable) Lease Liability Leased Equipment under Capital Leases Chapter 21 -55 454. 76 4, 545. 24 Accumulated Depreciation—Capital Leases Cash 2, 000. 00 95, 000. 00 100, 000. 00 2, 000. 00 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Unguaranteed Residual Value – Lessee Accounting): Assume the same facts as those above except that the $5, 000 residual value is unguaranteed instead of guaranteed. Caterpillar would compute the amount of the lease payments as follows: Illustration 21 -20 Chapter 21 -56 Solution on notes page LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Unguaranteed Residual Value – Lessee Accounting): Computation of Lease Amortization Schedule Illustration 21 -21 Chapter 21 -57 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Illustration (Unguaranteed Residual Value – Lessee Accounting): At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. Illustration 21 -22 Chapter 21 -58 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Comparative Entries, Lessee Company Chapter 21 -59 Illustration 21 -23

Special Accounting Problems Lessor Accounting for Residual Value The lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. Illustration: Assume a direct-financing lease with a residual value (either guaranteed or unguaranteed) of $5, 000. Caterpillar determines the payments as follows. Illustration 21 -24 Chapter 21 -60 LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Lessor Accounting for Residual Value Illustration: Lease Amortization Schedule, for Lessor— Guaranteed or Unguaranteed Residual Value Illustration 21 -25 Chapter 21 -61

Special Accounting Problems Lessor Accounting for Residual Value Illustration: Caterpillar would make the following entries for this direct-financing lease in the first year. Illustration 21 -26 Chapter 21 -62 Solution on notes page LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Special Accounting Problems Sales-Type Leases (Lessor) Primary difference between a direct-financing lease and a sales-type lease is the manufacturer’s or dealer’s gross profit (or loss). Lessor records the sale price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable. Difference in accounting for guaranteed and unguaranteed residual values. Chapter 21 -63 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Sales-Type Leases (Lessor) Illustration: To illustrate a sales-type lease with a guaranteed residual value and with an unguaranteed residual value, assume the same facts as in the preceding directfinancing lease situation. The estimated residual value is $5, 000 (the present value of which is $3, 104. 60), and the leased equipment has an $85, 000 cost to the dealer, Caterpillar. Assume that the fair market value of the residual value is $3, 000 at the end of the lease term. Chapter 21 -64 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Sales-Type Leases (Lessor) Illustration: Computation of Lease Amounts by Caterpillar Financial—Sales-Type Lease Chapter 21 -65 Illustration 21 -28 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Sales-Type Leases (Lessor) Illustration: Caterpillar makes the following entries to record this transaction on January 1, 2011, and the receipt of the residual value at the end of the lease term. Illustration 21 -29 Chapter 21 -66 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Sales-Type Leases (Lessor) Illustration: Caterpillar makes the following entries to record this transaction on January 1, 2011, and the receipt of the residual value at the end of the lease term. Illustration 21 -29 (January 1, 2012) Chapter 21 -67 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Sales-Type Leases (Lessor) Illustration: Caterpillar makes the following entries to record this transaction on January 1, 2011, and the receipt of the residual value at the end of the lease term. Illustration 21 -29 Chapter 21 -68 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Bargain Purchase Option (Lessee) Present value of the minimum lease payments must include the present value of the option. Only difference between the accounting treatment for a bargain-purchase option and a guaranteed residual value of identical amounts is in the computation of the annual depreciation. Chapter 21 -69 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Initial Direct Costs (Lessor) The accounting for initial direct costs: For operating leases, the lessor should defer initial direct costs. For sales-type leases, the lessor expenses the initial direct costs. For a direct-financing lease, the lessor adds initial direct costs to the net investment. Chapter 21 -70 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Current versus Noncurrent FASB Statement No. 13 does not indicate how to measure the current and noncurrent amounts. It requires that for the lessee the “obligations shall be separately identified on the balance sheet as obligations under capital leases and shall be subject to the same considerations as other obligations in classifying them with current and noncurrent liabilities in classified balance sheets. ” Chapter 21 -71 LO 8 Describe the lessor’s accounting for sales-type leases.

Special Accounting Problems Disclosing Lease Data 1. General description of the nature of the lease. 2. Nature, timing and amount of cash inflows and outflows associated with leases, including payments for each of the five succeeding years. 3. Amount of lease revenues and expenses reported in the income statement each period. 4. Description and amounts of leased assets by major balance sheet classification and related liabilities. 5. Amounts receivable and unearned revenues under lease. Chapter 21 -72 LO 9 List the disclosure requirements for leases.

Chapter 21 -73 Ø Leasing was on the FASB’s initial agenda in 1973 and SFAS No. 13 was issued in 1976 (before the conceptual framework was developed). SFAS No. 13 has been the subject of more than 30 interpretations since its issuance. Ø The i. GAAP leasing standard is IAS 17, first issued in 1982. This standard is the subject of only three interpretations. One reason for this small number of interpretations is that i. GAAP does not specifically address a number of leasing transactions that are covered by U. S. GAAP. Examples include lease agreements for natural resources, sale-leasebacks, real estate leases, and leveraged leases.

Chapter 21 -74 Ø Both U. S. GAAP and i. GAAP share the same objective of recording leases by lessees and lessors according to their economic substance —that is, according to the definitions of assets and liabilities. Ø U. S. GAAP for leases in much more “rule-based” with specific bright -line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; i. GAAP is more general in its provisions.

Chapter 21 -75 LO 10

Solution on notes page Illustration 21 A-2 Chapter 21 -76 LO 10 Understand apply lease accounting concepts to various lease arrangements.

Chapter 21 -77 Solution on notes page

Illustration 21 A-3 Chapter 21 -78 LO 10 Understand apply lease accounting concepts to various lease arrangements.

Chapter 21 -79 LO 10 Understand apply lease accounting concepts to various lease arrangements.

Illustration 21 A-4 Chapter 21 -80 LO 10 Understand apply lease accounting concepts to various lease arrangements.

Chapter 21 -81 LO 10 Understand apply lease accounting concepts to various lease arrangements.

Illustration 21 A-5 Chapter 21 -82 LO 10 Understand apply lease accounting concepts to various lease arrangements.

The term sale-leaseback describes a transaction in which the owner of the property (seller-lessee) sells the property to another and simultaneously leases it back from the new owner. Advantages: 1. May allow seller to refinance at lower rates. 2. May provide another source of working capital, particularly when liquidity is tight. 3. By selling the property, the seller-lessee may deduct the entire lease payment, which is not subject to alternative minimum tax considerations. Chapter 21 -83 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Determining Asset Use To the extent the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing. Ø Lessor should not recognize a gain or loss on the transaction. If the seller-lessee gives up the right to the use of the asset, the transaction is in substance a sale. Ø Gain or loss recognition is appropriate. Chapter 21 -84 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Lessee If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee should Ø Account for the transaction as a sale and the lease as a capital lease. Ø Defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease. Ø Amortize profit over the lease term. Chapter 21 -85 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Lessee If none of the capital lease criteria are satisfied, the seller -lessee accounts for the transaction as a sale and the lease as an operating lease. Ø Lessee defers such profit or loss and amortizes it in proportion to the rental payments over the period when it expects to use the assets. Exceptions: Ø Losses Recognized and Minor Leaseback Chapter 21 -86 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Lessor If the lease meets one of the criteria in Group I and both of the criteria in Group II, the purchaser-lessor records the transaction as a purchase and a directfinancing lease. If the lease does not meet the criteria, the purchaserlessor records the transaction as a purchase and an operating lease. Chapter 21 -87 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Sale-Leaseback Example American Airlines on January 1, 2011, sells a used Boeing 757 having a carrying amount on its books of $75, 500, 000 to Citi. Capital for $80, 000. American immediately leases the aircraft back under the following conditions: 1. The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10, 487, 443 at the beginning of each year. 2. The aircraft has a fair value of $80, 000 on January 1, 2011, and an estimated economic life of 15 years. 3. American pays all executory costs. 4. American depreciates similar aircraft that it owns on a straight-line basis over 15 years. Chapter 21 -88 5. The annual payments assure the lessor a 12 percent return. 6. American’s incremental borrowing rate is 12 percent. LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Sale-Leaseback Example This lease is a capital lease to American because Ø lease term exceeds 75 percent of the estimated life of the aircraft and Ø present value of the lease payments exceeds 90 percent of the fair value of the aircraft to Citi. Capital. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist in relation to unreimbursable costs yet to be incurred by Citi. Capital, it should classify this lease as a direct-financing lease. Chapter 21 -89 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Sale-Leaseback Example Chapter 21 -90 Illustration 21 B-1 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

Sale-Leaseback Example Chapter 21 -91 LO 11 Describe the lessee’s accounting for sale-leaseback transactions.

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