Intermediate Financial Accounting for Leases Accounting for Leases

Intermediate Financial Accounting for Leases

Accounting for Leases n According to FASB statement No. 13 , a lease is defined as “an agreement conveying the right to use property, plant, or equipment for a stated period of time”. Accounting for Leases 2

Accounting for Leases : (contd. ) n n A lease involves a lessee and a lessor. A lessee acquires the right to use the property, plant and equipment and a lessor gives up the right. A lease is a contractual agreement and therefore the parties involved can incorporate any provision in the contract. All kinds of assets can be leased. Among the most popular are photocopies, computer, airplanes, and warehouses. Accounting for Leases 3

Lessors (source: Kieso, Weygandt, and Warfield ) • • • Lessors who own the property: Banks: The largest lessors in the leasing industry. They provide general finance for companies. Examples: Wells Fargo, Chase, Citigroup. Captive leasing companies: subsidiaries whose primary business is to perform leasing operations for the parent company (i. e. , structure lease contracts for the parent companies and their customers). Examples: Chrysler Financial (for Daimler-Chrysler), IBM Global Financing (for IBM), Boeing Capital. Accounting for Leases 4

Lessors (contd. ) • Independents: leasing companies whose primary business is to perform general finance for other companies. Their market share of leasing business has declined as the other two types of lessor’s market share has increased. Some independent lessors have become the captive finance companies for other companies without a leasing subsidiary. Accounting for Leases 5

Accounting for Leases : (contd. ) n This chapter emphasizes the long-term non-cancelable leases involving depreciable personal property such as equipment, machinery, trucks and other movable assets. Accounting for Leases 6

Accounting for Leases : (contd. ) n The objectives of the chapter include: 1. Accounting for lessees: a. Operating leases. b. Capital leases: . without bargain purchase option. with bargain purchase option. With guaranteed residual value Accounting for Leases 7

Accounting for Leases : (contd. ) n The objectives of the chapter include: 2. Accounting for lessors: a. Operating leases. b. Capital leases: . direct-financing leases. sales-type leases Accounting for Leases 8

Advantages of Leasing from Lessees' Viewpoint (source: Kieso and Weygandt) 1. Financing benefits: a. The lease provides 100% financing (no down payment is needed). For companies with cash shortage, lease is a good alternative to purchase; b. The lease contract may contain fewer restrictive provisions than other debt agreement; and c. The lease agreement creates a claim that is against only the leased asset , not against all assets. Accounting for Leases 9

Advantages of Leasing from Lessees' Viewpoint : (contd. ) 2. Risk benefit: Reduce the risk of obsolescence. 3. Tax benefit: Tax deduction may be accelerated since it is often spread over the lease term (rather than the economic life of the property). The full cost of the leased asset can be written off including the part that relates to land. Accounting for Leases 10

Advantages of Leasing from Lessees' Viewpoint : (contd. ) 4. Financial reporting benefit (off-balancesheet financing): For an operating lease, the lease does not add a liability or an asset to the balance sheet, and therefore does not affect financial ratios. By maintaining these ratios, the company's borrowing capacity can also be maintained. Off-balance-sheet financing: acquiring the right to use assets but not reporting the assets and liabilities on the balance sheet Accounting for Leases 11

Advantages of Leasing from Lessees' Viewpoint : (contd. ) 5. Billing benefit: Leasing permits higher charges because the interest element contained in the rental payments is treated as an expense. 6. Less Costly Financing: The income tax savings on depreciation expenses for the leasing company(the lessor) may pass on to the lessee in the form of a reduced rental payment. Accounting for Leases 12

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n An example of using leasing to achieve off balance sheet financing: assuming that in 20 X 1, two identical companies, A and B, have the following data prior to any new acquisitions: current assets $3, 000 noncurrent assets 5, 000 current liabilities 2, 000 noncurrent liabilities 2, 500, 000 stockholders’ equity 3, 500, 000 Accounting for Leases 13

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n On December 31, 20 X 1, A company purchases an equipment with a 5 -year life costing $3, 018, 400 by signing a 5 -year, 8% note requiring $755, 923 to be paid at the end of each year staring December 31, 20 X 2. The payments include interests at 8% on the beginning-of-year principal balance. The remainder of each annual payment reduces principal. Accounting for Leases 14

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n A company records the asset purchased and the note payable. A's financial data show the following changes: Accounting for Leases 15

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n noncurrent assets: $5, 000 + 3, 018, 400 = $8, 018, 400 current liabilities: $200, 000 + 755, 923 * 0. 926 = $2, 699, 985 noncurrent liabilities: $2, 500, 000+ (3, 018, 400 - 699, 985) = $4, 818, 415 The rest remains unchanged. Accounting for Leases 16

Advantages of Leasing from Lessees' Viewpoint : (contd. ) Therefore; acquisition Before Acquisition After current ratio $3, 000/$2, 000 $3, 000/2, 699, 985 =1. 5 = 1. 11 debt to stockholder equity $4, 500, 000/3, 500, 000 Accounting for Leases 17

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n n The current ratio falls significantly(from 1. 5 to 1. 11) while the debt to stockholders’ equity ratio increases 67% after the acquisition. The rate of return on investment in 20 X 2 could also be impaired (due to the increase of noncurrent assets). These adverse impacts on financial ratios will damage the borrowing capacity of A company and may also affect it's ability to sell stock. Accounting for Leases 18

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n On the other hand, assume that B company leases identical equipment by the use of a lease and agrees to pay $755, 923 rent each year for the next 5 years. If interest rate is 8%, the present value of the equipment is $3, 018, 400. If the lease is classified as a capital lease, B records an asset and a liability and the effects on it's B/S are the same as the effects of purchase on A's B/S. Accounting for Leases 19

Advantages of Leasing from Lessees' Viewpoint : (contd. ) n n n However, if the lease is classified as an operating lease, B does not have to record an asset or a liability. Therefore, the financial ratios (i. e, the current ratio) will be same as before the acquisition. In sum, two identical economic events can have very different impact on key ratios of financial statement(F/S). Accounting for Leases 20

Advantages of Leasing from Lessors' Viewpoint : (contd. ) 1. A way of indirectly making a sale. 2. An alternative means of engaging in a profit opportunity. The lease agreement enables the lessor to earn a normal rate of return (in a form of interest) on the cost of leased asset. Accounting for Leases 21

Classification of Personal property Leases n n A lease that transfers substantially all the risks and benefits of ownership to the lessee represents a purchase by the lessee and a sale by the lessor and should be treated as a capital lease (SFAS 13). SFAS 13 provides criteria for determining the classification of leases by both lessees and lessors. Accounting for Leases 22

Classification of Leases Involving Personal Property General Criteria for classifying leases Exhibit 1 Column A Criteria Applicable to Both Lessee and Lessor Column B Criteria Applicable to Lessor Only a. The lease transfers ownership a. The collectibility of the minimum lease payments of the property to the lessee is reasonably assured (i. e. , by the end of the lease term. predictable). b. The lease contains a bargain b. No important uncertainties purchase option surround the amount of c. The lease term is equal to or unreimbursable cost yet to greater than 75% of the be incurred by the lessor estimated economic life of the under the leased property. d. The present value of the minimum lease payments (MLP) is equal to 90% or more of the fair value of the leased property to the lessor. Accounting for Leases 23

Classification by the lessee n n Capital lease: Lease that meets one or more of the criteria in column A. Lessee should treat capital lease as a purchase of asset; recognize leased asset and obligation under capital lease. Operating lease: Lease that does not meet any of the criteria in Column A. Accounting for Leases 24

Classification by the Lessor n Operating lease: Lease that meets none of the criteria in col. A, or does not meet both criteria in col. B. n Direct Financing lease: Lease that meets these three criteria: 1. One or more of the four criteria in col. A; 2. Both criteria in col. B; and 3. No manufacture's or dealer's profit. Accounting for Leases 25

Classification by the Lessor (Contd. ) n Accounting for Leases 26

Classification by the Lessor : (contd. ) n n A profit for lessor exists when the fair market value of the leased property is greater than its cost or carrying value. Items c and d of column A do not apply if the beginning of the lease term falls within the last 25% of the total estimated economic life. Accounting for Leases 27

Key Terms Related to Leases n n Bargain Purchase Option A provision allowing the lessee to purchase the leased property at the end of the life of the lease at a price so favorable that the exercise of the option appears, at the inception of the lease, to be reasonably assured. Estimated Economic Life The remaining life of leased assets for its intended usage at the inception of the lease contract with normal repair and maintenance. Accounting for Leases 28

Key Terms Related to Leases : (contd. ) n n Fair Value of Leased Property Price for which the property can be sold in an arm's length transaction between unrelated parties. For manufacturers and dealers, the fair value is the selling price. For others, the fair value is the cost of the asset to the lessor. Accounting for Leases 29

Key Terms Related to Leases : (contd. ) n n Minimum Lease Payments(MLP): Payments that are required to be paid by the lessee to the lessor over the life of the lease. For a lease with a bargain purchase option (BPO), the MLP include (for both lessee and lessor): 1. The minimum periodic payments required by the lease over the lease term; and 2. The payment required by the BPO. Accounting for Leases 30

Key Terms Related to Leases : (contd. ) n Otherwise, the MLP include: 1. The minimum periodic payments, plus 2. Any guaranteed residual valuea, and 3. Any payments on failure to renew or extend the lease if the agreement specifies that the lease must be extended or renewed. Accounting for Leases 31

Key Terms Related to Leases : (contd. ) n n n a. for a lessee, the residual value must be guaranteed by the lessee; for a lessor, it can be guaranteed by either the lessee or a third party. Thus, a lessee's MLP could be less than a lessor's when the residual value is guaranteed by a third party. Leased Assets for a lessee = the Present Value (PV) of the MLP, Not to exceed the fair market value of the asset. Accounting for Leases 32

Key Terms Related to Leases : (contd. ) n Executory costs are ownership-type costs (I. e. , insurance, maintenance and property taxes). It is expected to be paid by the party with the ownership. n In the case of capital lease (lessee assumes the ownership), if portion of the lease payment is for the reimbursement of the executory costs to the lessor, it should be subtracted from MLP computation. n Accounting for Leases 33

I. Accounting for Leases Treatment of operating lease: Terms and provisions of lease agreement between landlord company (lessor) and tenant company (lessee) dated January 1, 1995 1. The lease term is 5 years. The lease is noncancelable and requires equal rental payments of $50, 000 at the beginning of each year. 2. The cost, and also fair value, of the equipment to the Landlord Company at the inception of the lease is$400, 000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time. n Accounting for Leases 34

I. Accounting for Leases Treatment of Operating Lease: (contd. ) 3. There is no guarantee of the residual value by the Tenant Company. 4. The Landlord Company agrees to pay all executory costs. 5. The equipment reverts to the Landlord Company at the end of the 5 years; 6. The Tenant Company's incremental borrowing rate is 12. 5% per year. 7. For the Landlord Company, the interest rate implicit in the lease is 12%. 8. The present value of an annuity due of 5 payments of $50, 000 each at 12% is 4. 037349 * $50, 000 = $201, 867. 45 Accounting for Leases 35

Application of Criteria for Determination of Lease Classification by Lessee Classification Criteria Met? Remarks 1. Transfer of ownership at end of lease No 2. Bargain purchase option No 3. Lease term is 75% of economic life No It is 50% 4. Present value of lease payments is 90% of fair value No The present value is $201, 867. 45, or 50. 5% of fair value Conclusion: the lease is an operating lease. It meets none Accounting for Leases 36

Journal Entries – Operating Lease for Lessee n The only journal entry recorded by the lessee is: 1 -1 -95 Rent Expense 50, 000 Cash 50, 000 Similar entries will be recorded at the beginning of 1996 through 1999. Under the operating lease, neither an asset nor a liability is recognized. n Accounting for Leases 37

Accounting and Reporting by Lessor Types of leases classified by lessor: 1. Operating lease. A lease that meets none of the criteria in col. A or does not meet both criteria in col. B of Exhibit 1. 2. Direct-financing lease. A lease that meets one or more of the criteria in col. A and both criteria in col. B of Exhibit 1. Also the lease involves no manufacturer's or dealer's profit. n Accounting for Leases 38

Accounting and Reporting by Lessor: (Contd. ) 3. A Sales-type lease. A lease meets one or more of the criteria in col. A and both criteria in col. B of Exhibit 1. Also, the lease involves the recognition of a manufacturer's or dealer's profit (or loss). 4. Leveraged lease. A special three-party lease which is considered to be a direct-financing lease. Accounting for Leases 39

Operating Lease: (Lessor) Under an operating lease, lessor retains substantially all the risk and benefit of ownership. n The leased equipment is reported on the balance sheet in Property, Plant and Equipment subsection entitled “Equipment Leased to Others" and record depreciation. n. The lessor usually pays the executory fees and records them as operating expenses. n Accounting for Leases 40

The Accounting Treatment of an Operating Lease -Lessor n Example: assume that landlord Company (lessor) Leases a piece of equipment to Tenant Co. (lessee) for 5 years under the terms described on pages 32 and 33. Tenant agrees to pay $50, 000 at the beginning of each year. The equipment was purchased by Landlord at a cost of $400, 000. It has an estimated life of 10 years. Accounting for Leases 41

Operating Lease- Lessor (contd. ) n n n Landlord uses straight-line depreciation method. On 1/10/95, the lessor pays the annual insurance premium of $2, 000 and on 12/15/95, it pays for repair expense of $1, 500. Assuming no initial direct costs, the preceding information is recorded in the following journal entries: Accounting for Leases 42

Operating Lease-Lessor (contd. ) 1. Purchase of equipment to be leased on 1/1/95: Equipment leased to others 400, 000 n Cash (or Equipment)* *if equipment was already owned 400, 000 2. Collection of annual payment on operating lease on 1/1/95: Cash 50, 000 Rental Revenue 50, 000 (or Unearned rent) Accounting for Leases 43

Operating Lease- Lessor (contd. ) 3. Payments of annual insurance premium on 1/10/95: (an executory cost) Insurance expense Cash 2, 000 4. 12/15/95 Repair expense Cash 1, 500 5. Recognition of Annual depreciation expense: Depr. Exp. : Equip. leased to others 40, 000 Acc. Depr. : Equip. leased to others 40, 000 (400, 000/10 = 40, 000) Accounting for Leases 44

II. Accounting for Leases Treatments for Capital Lease When a lease is reported as a capital lease, Lessee records an asset (i. e. , leased equipment) and a liability (i. e. , lease payable). n The amount of leased asset equals liability and is calculated as the present value of the minimum lease payments (MLP). n Accounting for Leases 45

Accouning Treatments for Capital Lease n n In a capital lease, the lessee is usually responsible for the executory costs. If these costs are paid by the lessor, these costs should be deducted from the lease payments in computing the present value of MLP. Accounting for Leases 46

Discount Rate used in computing the present value of MLP In computing the PV of the MLP, lessee should use the lower of a. The lessee's incremental borrowing rate, or b. The lessor's implicit rate. n If b is unknown to lessee, lessee uses a. n. The discount rate used by lessor is lessor’s implicit interest rate. n Accounting for Leases 47

Discount Rate used in computing the present value of MLP (cont. ) The present value of f MLP may be different for a lessee and a lessor when different discount rates are used in computing the PV. n. The lower the rate is, the greater the PV of MLP. n Accounting for Leases 48

Depreciation or Amortization Criteria for Leased Assets- for Lessee Lease Agreement No Yes Ownership Transferred? No Yes Bargain Purchase Option No Yes Lease Term >= 75% of Asset’s Life No Yes MLP 90% of FV No Lessor Depreciates Asset Over Economic Life a. Lessee Depreciates Assets Over Economic Life b. Lessee Depreciates Assets Over Lease Term Accounting for Leases 49

Depreciation or Amortization Criteria for Leased Assets – for Lessee(contd. ) a. Depreciates to the estimated residual value. b. Depreciates or amortizes to the lessee guaranteed residual value (if there is any) If not, depreciate to zero. * Both "Amortization" and "depreciation term can be used. FASB uses "Amortization “ more often due to leased asset is an intangible. Accounting for Leases 50

Examples and Accounting Treatments for Capital Leases Example A 1: Equipment is leased under an agreement without a transfer of ownership, a bargain purchase option or a guaranteed RV. n Terms and provisions of lease agreement between Gardner company (lessor) and Martin company (lessee) dated January 1, 1995: n 1. The lease term is 4 years. The lease is noncancelable and requires equal payments of $32, 923. 45 at the end of each year. Accounting for Leases 51

Example A 1 (contd. ) 2. The cost, and also fair value, of the equipment to Gardner (lessor) at the inception of the lease is $100, 000. The equipment has an estimated economic life of 4 years and has a zero estimated residual value at the end of lease term. 3. There is no guarantee of the residual value by the Martin Company. 4. The Martin (lessee) Company agrees to pay all executory costs. Accounting for Leases 52

Example A 1 (contd. ) 5. The equipment reverts to Gardner at the end of the 4 years; 6. Martin Company's (lesee) incremental borrowing rate is 12. 5% per year. 7. For Gardner Company (lessor), the interest rate implicit in the lease is 12%. Martin Company knows this rate. 8. Martin Company uses the straight-line method to record depreciation on similar equipment's. Accounting for Leases 53

Example A 1 (contd. ) 9. The annual lease payment charged by the lessor is calculated as follow: $100, 000 a/ 3. 037349 b = 32, 923. 45 a. If there is any RV or BPO, the P. V. of the RV (guaranteed or not) or BPO should be subtracted from the cost of $100, 000 in computing the lease payment. b. P. V. of an ordinary annuity of $1 for 4 periods at 12% interest rate Accounting for Leases 54

The Accounting Treatments for Capital Lease-Lessor 10. The present value of an ordinary annuity of four payments of $32, 923. 45 at 12% is $100, 000, calculated as follows: 3. 037349 *$32, 923. 45 = $100, 000. 11. The collectiblity of rental is reasonably assured and no uncertainties involved in the lease; 12. No initial direct costs; . Accounting for Leases 55

The Accounting Treatments for Capital Lease-Lessor (contd. ) The cost or the fair market value of the leased equipment for the lessor can be derived as: P. V. of lease payment a + P. V. of residual value (guaranteed or not) _____ cost of leased equipment a. if portion of the lease payment is to cover the executory costs paid by the lessor, it should be subtracted. n Accounting for Leases 56

Application of criteria to determine the lease classification by Lessee and Lessor: Classification Criteria Met? Remarks 1. Transfer of ownership at end of lease No reverts to lessor 2. Bargain purchase option No 3. Leas term is 75% or more of economic life 100% of estimated life 4. Present value of MLP is 90% or more of fair value Yes Present value is $100, 000, or 100% of fair value Accounting for Leases Title Yes The 57

The Accounting Treatment for Capital Lease (Lessor): (contd. ) The lease is a capital lease for lessee because it meets two of the four criteria under Column A (on p 21). n The lease is a direct financing lease for lessor because : n 1. it meets two of the four criteria under Column A and both criteria under coloumn B (on p 21) ; and n 2. No dealer or manufacturer’s profit. n Accounting for Leases 58

Journal Entries for Example A 1 - Lessee n The journal entries to record the acquisition of the leased asset, the amortization (depreciation) for 4 years by the lessee are as follows: 1. Initial Recording of capital lease on 1/1/95 Leased Equipment 100, 000 Obligation Under Capital Lease 100, 000 (or Lease Payable) (PV of MLP = $32, 923. 45 * 3. 037349 = 100, 000) Accounting for Leases 59

Journal Entries for Example A 1 – Lessee (cont. ) 2. First payment (on 12/31/95): Interest Expense Obligation under C. L. Cash 12, 000* 20, 923 32, 923 * 100, 000 * 12% = 12, 000 Interest Expense under effective interest method Interest Expense = P. V. of liability. * effective interest rate. Accounting for Leases 60

Journal Entries for Example A 1 - Lessee (contd. ) 3. Recognition of annual depreciation (or amortization)of leased equipment on 12/31/95: Depreciation Expense: Leased Equip. * 25, 000 Acc. Depreciation: Leased Equip. 25, 000 * The asset is amortized over the lease term because the lease does not include a transfer of ownership or a BPO. Depreciate to zero due to no guaranteed residual value. Accounting for Leases 61

Journal Entries for Capital Lease (Lessee): (contd. ) Reporting: Balance Sheet (12/31/95) Assets Liabilities: PPE Current Liability: Leased Equipment lease 23, 434 a 100, 000 Obligation under capital Acc. Depr. : Leased Equip (25, 000) Long-Term Liability: Obligation Under C. L: a. 32, 923. 45 -(100, 000 -20, 923)*0. 12=23, 434 55, 643 b b. 100, 000 - 20, 923 - 23, 434 = 55, 643 Accounting for Leases 62

Journal Entries for Example A 1 - Lessee (contd. ) 4. Payment on 12/31/96: Interest Expense Obligation Under Cap. Lease Cash 9, 489. 19 a 23, 434. 26 b 32, 923. 45 a. P. V. of liability at the beginning of 1996 * 12% = (100, 000 -20, 923. 45) * 12% = 9, 489. 12 b. 32, 923. 45 -9489. 19 = 23, 434. 26 5. Depreciation Expense of 96: Depreciation Expense: Leased Equip. Acc. Depreciation : Leased Equip Accounting for Leases 25, 000 63

Journal Entries for Example A 1 - Lessee (contd. ) n 1997: Interest Expense Obligation Cash Depreciation Expense : L. E. Acc Depreciation: L. E 6, 677. 17 26, 246. 38 32, 923. 45 25, 000 1998: Interest Expense Obligation Cash Depreciation Expense : L. E. Acc Depreciation: LE 3, 527. 54 29, 395. 91 32, 923. 45 25, 000 n Accounting for Leases 64

Journal Entries for Example A 1 Lessee (contd. ) Selected account balance at the end of the lease term: Obligation (lease payable) = $0 Acc. Depreciation = $100, 000 Leased Equipment = $100, 000 Journal entry on 12/31/98: Acc. Depre. 100, 000 Leased Equip. 100, 000 n Accounting for Leases 65

Exhibit. A 1: Summary of lease payments and interest expense of Example A 1 Payments at End of Year Accounting for Leases 66

Comparison of Capital Lease Expense and Operating Lease Expense (pre-tax) Year Operating Lease Rental Expense Capital lease Expense (Interest Expense +Depre. Exp. ) Difference (impact on income) 1995 $32, 923 (12, 000+25, 000) -$4. 077 -$4, 077 1996 $32, 923 (9, 489+25, 000) -$1, 566 -$5, 643 1997 $32, 923 (6677+25, 000) $1, 246 -$4, 396 1998 $32, 923 (3, 528+25, 000) $4, 395 Accounting for Leases Cumu. Difference (impact on R/E) $0 67

Comparison (contd. ) § Capital lease expense is greater than that of operating lease expense for 1995 and 1996. However, this phenomenon is reversed in 1997 and 1998. § The income impact of lease capitalization is negative for 1995 and 1996, but is positive for 1997 and 1998. § The lease capitalization impact on retained earnings is always negative during the lease term and is zero when the lease term is up. Accounting for Leases 68

Summary of Lease Payments and Interest Expense of Martin company (contd. ) a. Column 5 at beginning of year * 12 %, the effective interest expense b. Column 2 - Column 3 c. Column 5 at beginning of year - Column 4 d. adjusted for rounded error of 0. 03. For capital leases, executory costs paid by the lessee are recorded as operating expenses. n If these costs are paid by the lessor, they should be deducted from the computation of MLP. n Accounting for Leases 69

Journal Entries for Example A 1 - a direct financing Lease for a Lessor: The journal entries to record the lease of the equipment and the receipts of 4 lease payments for the lessor are as follows: n 1. Initial Recording of capital lease on 1/1/95 Lease Receivablea Leased Equipment b 100, 000 Unearned Revenuec 31, 694 Accounting for Leases 131, 694 70

Example A 1 – Lessor (cont. ) a. Lease Receivable (Gross Investment)= annual Lease Payment x lease terms + residual value (guaranteed or not) or BPO b. Equipment = PV of lease receivable at lessor’s rate = cost of leased asset=fair market value of lease asset under direct financing c. Unearned interest = Lease Receivable – PV of lease receivable Accounting for Leases 71

Example A 1 – Lessor (contd. ) Other notes: Net Investment =lease Receivable – Unearned Interest = lease liability of lessee Interest revenue for lessor = int. rate x net investment = interest exp. Of lessee=int. rate * lease lia. of lessee Accounting for Leases 72

Example A 1 –Lessor (contd. ) For lessee: MLP = lease payment + guaranteed RV by lessee only or BPO. Leased Asset = PV of MLP at the lower of two interest rates. Lease liability = leased assets. Interest Exp. of lessee = int. rate x lease liablity = interest revenue of lessor. Accounting for Leases 73

Journal Entries for Example A 1 ( a direct financial Lease for a Lessor (contd. ) 2. First payment received by lessor (on 12/31/95): Cash 32, 923* Lease Receivable Unearned Interest Revenue 32, 923 12, 000 * 100, 000 (net invest. = lease lia. )* 12% = 12, 000 see p 64 and p 75 Accounting for Leases 74

Example A 1 - Lessor (contd. ) Reporting LR is divided into current and noncurrent portions for B/S reporting purposes. n Current Noncurrent Total LR 32, 923. 45 a 65, 840. 90 b 98, 770. 35 (9, 489. 19) c (10, 204. 60) (19, 693. 80) Net Inv. 23, 434. 26 55, 636. 30 79, 076. 55 a. The lessee's annual payment of 1996 b. 98, 770. 35 -32, 923. 45 c. 79, 076. 55 (Net Investment) * 12% Accounting for Leases 75

Journal Entries for Example A 1 -Lessor (contd. ) 1996: Cash Lease Receivable Unearned Interest Revenue n 1997: Cash Lease Receivable Unearned Interest Revenue n Accounting for Leases 32, 923 9, 489 32, 923 6, 677 76

Journal Entries for Example A 1 -Lessor (contd. ) n 1998: Cash 32, 923 Lease Receivable 32, 923 Unearned Interest 3, 528 Interest Revenue 3, 528 Accounting for Leases 77

Journal Entries for Example A 1 - Lessor (contd. ) At the end of the lease term, n lease receivable =0 and n unearned revenue=0. n Assume the market value of the reverted leased asset is $2, 000, the following entry will be recorded(due to zero residual value is assumed for the leased asset) by the lessor: Equipment 2, 000 Gain 2, 000 § Accounting for Leases 78

Summary of lease payments received and interest revenue : Exhibit A 1 Lessor n Receipts at End of Year Accounting for Leases 79

Summary of lease payments received and interest revenue earned by Gardner company (Lessor): Exhibit A 1 -Lessor a. Column 7 at beginning of year * 12% b. Column 2 - Column 3 c. Annual lease payment * Number of years remaining on lease d. Previous balance - Column 3 e Column 5 - Column 6 =lease liability of lessee Accounting for Leases 80

The Accounting Treatments for Capital Lease. Lessor(contd. ) n The MLP for both lesser and lessor equals: The annual payments + guaranteed residual value a or BPO a. For a lessee, the RV needs to be guaranteed by the lessee. For a lessor, the RV can be guaranteed by a lessee or by a third party. Accounting for Leases 81

The Accounting Treatment for Capital Lease -Lessor n n Thus, it is possible that a lease is reported as an operating lease by the lessee while is reported as a capital lease by the lessor. Method: with a large amount of RV guaranteed by a third party. Accounting for Leases 82

Example A 1 – Lessor (using the method in the 5 th Edition of the Textbook) 1. Initial Recording of capital lease on 1/1/95 Lease Receivable 100, 000 Leased Equipment 100, 000 2. First payment received by lessor (on 12/31/95): Cash 32, 923 Lease Receivable Interest Revenue. Accounting for Leases 20, 923 12, 000 83

Example A 1 -Lessor (5 th Edition Method) 1996: Cash Lease Receivable Interest revenue 1997 Cash Lease Receivable Interest Revenue n 32, 923 23, 434 9, 489 32, 923 Accounting for Leases 26, 246 6, 677 84

Example A 1 -Lessor Edition Method) th (5 1998: Cash 32, 923 Lease Receivable 29, 395 Interest Revenue 3, 528 • Assume the market value of the reverted leased asset is $2, 000, the following entry will be recorded(due to zero residual value is assumed for the leased asset) by the lessor: Equipment 2, 000 Gain 2, 000 n Accounting for Leases 85

Capital Leases : Payments in Advance with Zero RV – Example A 2 n n Example A 2: Assume all the lease provisions are the same as in example A 1 except that the lease payments are made at the beginning of each year. Also, the cost also the fair value of the equipment is $112, 000, not $100, 000. Accounting for Leases 86

Capital Leases : Payments in Advance with Zero RV – Example A 2 Lessor will compute the lease payment as follows: $112, 000/ 3. 401831 a = 32, 923. 42 a. P. V. of an annuity due of $1 for 4 periods at 12% discount rate. P. V. of MLP for both lessee and lessor => $32, 923. 42 x 3. 401831 = $112, 000. The lease is a capital lease for lessee and a direct financing lease for lessor. Accounting for Leases 87

Journal Entries for Example A 2 - Lessee 1. Initial Recording Leased Equip under C. L. Obligation under C. L. 112, 000 2. Payment on 1 -1 -95 (the inception of the lease) Obligation under C. L. 32, 923. 45 Cash 32, 923. 45 3. Recording of Depreciation on 12 -31 -95 Depreciation Expense: Leased Equipment 28, 000 Acc. Depreciation: Leased Equipment 28, 000 Accounting for Leases 88

Example A 2 –Lessee (Cont. ) 4. Recording accrued Interest Expense: 12 -31 -95 Interest Expense 9, 489. 19 a Accrued Interest on Obli. 9489. 19 a. (112, 000 -32, 923, 45) * 12% 5. Second annual payment in advance on 1/1/96: Accrued Interest on Obligation 9, 489. 19 Obligation under C. L. 23, 434. 26 Cash 32, 923. 45 Accounting for Leases 89

Example A 2 -Lessee n n Similar Entries will be recorded for 12/31/96, 1/1/97, 12/31/97, and 1 -1 -98. Journal entry on 1/1/98 (the last MLP): Accrued Interest Obligation under C. L. Cash 3, 527 29, 395 32, 923. 45 Note: No accrued interest on 12/31/98 due to the lease liability has been paid off on 1/1/98. 12/31/98 Acc. Depre. 112, 000 Leased Equip. 112, 000 Accounting for Leases 90

Summary of lease Payments and Interest Expense of Martin company (Lessee): Exhibit A 2: Payments in Advance Accounting for Leases 91

Journal Entries for Example A 2 -Payments in Advance with zero RV-Lessor 1. Initial Recording Lease Receivable Equipment Unearned Interest 131, 694 112, 000 19, 694 2. Payment on 1/1/95 (at the inception of the lease) Cash. 32, 923. 45 Lease Receivable 32, 923. 45 3. Recognize the interest on 12/31/95 Unearned Interest 9, 489 Interest Revenue 9, 489 Accounting for Leases 92

Example A 2 - Lessor(Contd. ) 4. The following entry will also be recorded on 1/1/96 , 1/1/97 and 1/1/98 Cash. 32, 923. 45 Lease Receivable 32, 923. 45 5. Interest revenue will also be recognized on 12/31/96, and 12/31/97 (information is based on p 84) : 96 Unearned Interest 6, 677 Interest Revenue 6, 677 97 Unearned Interest 3, 528 Interest Revenue 3, 528 Accounting for Leases 93

Example A 2 – Lessor (contd. ) At the end of lease term: Lease Receivable = 0 Unearned Interest =0 §When the lease asset is reverted back to the lessor on 1/1/99, the following entry will be recorded if the market value of the leased equipment is $300: Equipment 300 Gain on Capital Lease 300 Accounting for Leases 94

Guaranteed Residual Value n n Guaranteed residual value (RV): The RV of the leased property which is guaranteed by the lessee (or by a third party not related to the lessor). For lessee, only when the RV is guaranteed by the lessee, it would be included in the MLP. For lessor, the RV will be included in the MLP as long as it is guaranteed. Accounting for Leases 95

Guaranteed Residual Value (contd. ) n n If the residual value is guaranteed, when the fair market value of the leased property at the end of the lease term is less than the guaranteed amount, the guarantor has to pay the difference to the lessor. Lease provision will include guaranteed residual value only if no ownership transfer and no BPO. Accounting for Leases 96

Payments in Advance with Guaranteed Residual Value n n Example A 3: Assume all the lease provisions are the same as in Example A 2 except that there is a guaranteed residual value of $1, 000 by the lessee. Also, the cost also the fair value of the equipment is $112, 635. 5, not $100, 000 or $112, 000. Accounting for Leases 97

Payments in Advance with Guaranteed Residual Value (contd. ) A Lessor calculates the lease payment as: (Cost – PV of residual Value)a/ 3. 401831 => (112, 635 - 1, 000 x 0. 6355)/3. 401831= 32, 923 n a. guaranteed by anyone or not guaranteed § § Residual value (RV) is used as a factor to determine the amount to be recovered from the lessee. Major factors determining the implicit interest rate of a lessor: the risk of the lessee, whether the RV is guaranteed and the conditions of the credit market. Accounting for Leases 98

Payments in Advance with Guaranteed Residual Value (contd. ) § § P. V. of MLP for both lessee and lessor is => $32, 923. 42 * 3. 401831+$1, 000 * 0. 6355 = $112, 635. 5 The lease is a capital lease for lessee and a direct financing lease for lessor. Accounting for Leases 99

Journal Entries for Lessee. Example A 3 1. Initial Recording Leased Equip under C. L. Obligation under C. L. 112, 635. 5 2. Payment on 1 -1 -95 (the inception of the lease) Obligation under C. L. 32, 923. 45 Cash 32, 923. 45 3. Recording of Depreciation on 12 -31 -95 (similar entr will be performed for 96, 97 and 98) Depreciation Expense: Leased Equipment (112635 -1, 000)/4 27, 909 Accounting for Leases 100 Acc. Depreciation: Leased Equipment 27, 909

Journal Entries for A 3 - Lessee (contd. ) 4. Recording accrued Interest Expense: 12 -31 -95 Interest Expense 9, 565. a Accrued Interest on Obli. 9565. a. (112, 635. 5 -32, 923, 45) * 12% 5. 2 nd annual payment in advance on 1/1/96: Accrued Interest on Obligation 9, 565 Obligation under C. L. 23, 358 Cash 32, 923 Accounting for Leases 101

Payments in Advance with Guaranteed Residual Value-lessee (contd. ) 6. Recording accrued Interest Expense: 12 -31 -96 Interest Expense 6762 a Accrued Interest on Obli. 6762. a. (112, 635. 5 -32, 923, 45 -23, 358) * 12% 7. 3 rd annual payment in advance on 1/1/97: Accrued Interest on Obligation 6762 Obligation under C. L. 26161 Cash 32, 923 Accounting for Leases 102

Payments in Advance with Guaranteed Residual Value-Lessee (contd. ) 8. Recording accrued Interest Expense: 12 -31 -97 Interest Expense 3623 a Accrued Interest on Obli. 3623 a. (112, 635. 5 -32, 923, 45 -23358 -26161) * 12% 9. 4 th annual payment in advance on 1/1/98: Accrued Interest on Obligation 3623 Obligation under C. L. 29300 Cash 32, 923 Accounting for Leases 103

Payments in Advance with Guaranteed Residual Value – Lessee (cont. ) 12/31/98: Interest Exp. 107 a Accrued Interest 107 a. (112, 635. 5 -32, 923, 45 -23358 -26161 -29300) * 12% = 107 § 1/1/99 (if FV of leased asset greater or equal $1, 000) § Accrued Interest 107 Obl. Under C. L. 893 Accumulated Depreciation 111, 635 Leased Equip. 112, 635 n Accounting for Leases 104

Payments in Advance with Guaranteed Residual Value-lessee (contd. ) § § § 1/1/99 (if FV of leased asset = $300) Accrued Interest 107 Obl. Under C. L (or lease payable) 893 Accumulated Depreciation 111, 635 Leased Equip. 112, 635 Loss from Guaranteed RV 700 Cash 700 Accounting for Leases 105

Payments in Advance with Residual Value Guaranteed by a third party or not Guaranteed-lessee § § If the residual value is not guaranteed or guaranteed by a third party, the component of MLP is only the annual lease payment. Residual value is excluded from MLP for lessee. The accounting treatment for lessee is the same as in the case of zero residual value (I. e. , A 2) if it is still qualified as a capital lease. Accounting for Leases 106

Summary of lease Payments and Interest Expense of Martin company (Lessee): Exhibit AA 3: Payment in Advance with GRV Accounting for Leases 107

Journal Entries of Example A 3 (Payment in Advance with Guaranteed Residual Value by Lessee) -Lessor 1. Initial Recording Lease Receivable. 132, 692 a Equipment 112, 635. 5 b Unearned Int. 20, 053 a. 32, 923 x 4 +1, 000 (guaranteed RV) (RV will be included regardless guaranteed or not) b. PV of lease payment + PV of RV or BPO (= cost) 2. Payment on 1 -1 -95 (at the inception of the lease) Cash. 32, 923. 45 Lease Receivable 32, 923. 45 Accounting for Leases 108

Journal Entries for A 3 -Lessor 4. Recording accrued Interest revenue on 12/31/95: a. b. Unearned Interest 9, 565. a Interest rev. 9565 Accrued int. =net investment *12% = interest expense (see Exhibit on p 99) Accrued interest will be recorded for 12/31/96 12/31/97, and 12/31/98 (see Exhibit on p 99) Accounting for Leases 109

Journal Entries for A 3 -Lessor 4. Recording accrued Interest revenue on 12/31/96, 12/31/97 and 12/31/98: 96: Unearned Interest 6, 762 Interest rev. 97: Unearned Interest rev. 98: Unearned Interest rev. 6, 762 3, 623 107 Accounting for Leases 3, 623 107 110

Example A 3 (Payments in Advance with Guaranteed Residual Value by Lessee) -lessor (contd. ) 5. Second lease payment on 1/1/96: Cash 32, 923 Lease Receivable 32, 923 Similar entry will be recorded on 1/1/97 and 1/1/98 Accounting for Leases 111

Example A 3 (Payments in Advance with Guaranteed Residual Value) -lessor (contd. ) At the end of the lease term, the Lease Receivable = $1, 000 (the guaranteed RV) and the Unearned Interest = 0. § The following entry will be recorded when the leased asset is reverted back to the lessor with a market value of $700: Equipment 700 Cash 300 Lease Receivable 1, 000 § Accounting for Leases 112

Payments in Advance with Guaranteed Residual Value-lessor (contd. ) § The difference of $300 will be paid by § § whoever (the lessee or a third party) guarantees the residual value. If the residual value is not guaranteed by anyone, the cash account will be replaced by a loss account. Therefore, JE for lessors are the same regardless whether the RV is guaranteed or not. Accounting for Leases 113

Payment in Advance with BPO n Example A 4: Assume all the lease provisions are the same as in example A 2 except that there is a bargain purchase option at $1, 000 with the eco. life of the leased asset increased from 4 to 10 years. The expected (not guaranteed) residual value is $2, 635. 5. The cost also the fair value of the equipment is $112, 635. 5. P. V. of MLP = $32, 923. 42 * 3, 401831+$1, 000 * 0. 6355 = $112, 635. 5 = 100% of the cost The lease is a capital lease for the lessee and a direct financing lease for the lessor. Accounting for Leases 114

Journal Entries for A 4 (Payment in Advance with BPO) - Lessee 1. Initial Recording Leased Equip under C. L. Obligation under C. L. 112, 635. 5 2. Payment on 1 -1 -95 (the inception of the lease) Obligation under C. L. 32, 923. 45 Cash 32, 923. 45 3. Recording of Depreciation on 12 -31 -95 (similar entr will be recored for 96, 97 and 98) Depreciation Expense: Leased Equipment (112635 -2635/10) 11, 000 Accounting for Leases Acc. Depreciation: Leased Equipment 11, 000 115

Journal Entries for A 4 (Payment in Advance with BPO)-Lessee (contd. ) 4. Recording accrued Interest Expense: 12 -31 -95 Interest Expense 9, 565. a Accrued Interest on Obli. 9565. See Exhibit on p 97 for interest information. 5. 2 nd annual payment in advance on 1/1/96: Accrued Interest on Obligation 9, 565 Obligation under C. L. 23, 358 Cash 32, 923 Accounting for Leases 116

Journal Entries for A 4 (Payment in Advance with BPO)-Lessee (contd. ) 6. Recording accrued Interest Expense: 12 -31 -96 Interest Expense 6, 762. a Accrued Interest on Obli. 6, 762 a see P 97 for interest information. 7. Third lease payment on 1/1/97: Accrued Interest on Obligation under C. L. Cash Accounting for Leases 6, 762 26, 161 32, 923 117

Payments in Advance with BPO (contd. )-Lessee 8. Recording accrued Interest Expense for , 12/31/97: 12 -31 -97 Interest Expense 3, 623 Accrued Interest on Obli. 3, 623 9. 4 th payment on 1/1/98 : Accrued Interest on Obligation under C. L. Cash Accounting for Leases 3, 623 29, 300 32, 923 118

Payments in Advance with BPO (contd. )-Lessee 10. Recording accrued Interest Expense for , 12/31/98: 12 -31 -98 Interest Expense 107 Accrued Interest on Obli. 107 Accounting for Leases 119

Payments in Advance with BPO (contd. ) -Lessee § § § 1/1/99 (Lessee exercises the BPO by paying $1, 000) Accrued Interest 107 Obl. Under C. L (or lease payable) 893 cash 1, 000 Equip. 112, 635 Leased Equip. Accounting for Leases 112, 635 120

Payment in Advance with BPO -Lessor 1. Initial Recording 1/1/95 Leased Receivable. Equipment. Unearned Int. 132, 692 112, 635 20, 057 2. Payment on 1 -1 -95 (at the inception of the lease) Cash. 32, 923. 45 Lease Receivable Accounting for Leases 32, 923. 45 121

Payment in Advance with BPO -Lessor Similar entries as in the case of guaranteed RV (A 2 b) would be recorded for 1/1/96, 1/1/97, 1/1/98 (receipts of lease payments), 12/31/95, 12/31/96, 12/31/97 and 12/31/98 (recognition of accrued interest revenue). §At the end of lease term, Lease Receivabe = 1, 000, Unearned Revenue =0 and the following entry will be recorded by the lessor: §Cash 1, 000 Lease Receivable 1, 000 § Accounting for Leases 122

BPO Is Exercisable before the End of the lease Term • • • For accounting purposes, the lease life ends when the BPO becomes exercisable. Therefore, the lease term needs to be set to end when BPO becomes exercisable. The PV of MLP needs to be calculated accordingly. Accounting for Leases 123

Lessors' Initial Direct Costs n n Initial direct costs are costs that result directly from acquiring a lease. It would not have been incurred had that lease transaction not occurred For example, costs related to evaluating the lessee's financial condition, costs of negotiating terms, preparing and processing lease documents, and closing the transaction Accounting for Leases 124

Lessors' Initial Direct Costs (cont. ) For an operating lease, these costs are recorded as a prepaid asset and are allocated over the lease term as operating expense(in proportion to the rental received). n Accounting for Leases 125

Lessors' Initial Direct Costs (cont. )_ n n n For a capital lease a. direct financing type: these costs are deferred and allocated over the lease term (matching principle). b. a sales type lease: these costs are expensed at the inception of the lease because sales revenue is recognized at the inception. Accounting for Leases 126

Lessors' Initial Direct Costs (cont. )_ n n In addition, employees' compensation and benefits associated with the time spent on performing those activities should also be included in as part of the direct costs. All other lease related costs (i. e. , advertising, serving existing leases, unsuccessful lease origination, supervision and administration) are expensed as incurred. Accounting for Leases 127

Lessors' Initial Direct Costs (cont. )_ The lessor needs to determine a new (lower) implicit rate that will discount the remaining future minimum lease payments to the net investments as of the inception of the lease. n Assuming the lessor incurred $5, 000 of initial direct costs on a direct financing lease, it will record the costs as follows: Unearned interest: Lease 5, 000 Cash (or A/P) 5, 000 n Accounting for Leases 128

Lessors' Initial Direct Costs (cont. )_ Consequence: The debiting of unearned interest for the direct costs will increase net investment and decrease the implicit rate (due to future cash flows remain unchanged). n. The lower rate would result in less interest revenue recognition each period and achieve the goal of deferring direct costs and including them as a reduction of income over the life of the lease. n Accounting for Leases 129

Sales-Type Leases (for lessor) n The major differences between a salestype lease and a direct financing lease are: a. the presence of a manufacturer's or dealer's profit or loss in a sales-type lease, and b. the accounting for initial direct costs. Accounting for Leases 130

Sales-Type Leases (lessor) n The manufacturer's or dealer's profit is measured as the difference between (1) the present value of MLP (net of executory costs), and 2) the cost or carrying value of the asset plus the initial direct costs less the present value of the unguaranteed residual value accruing to the benefit of lessor. Accounting for Leases 131

Sales-Type Leases (lessor): (contd. ) n n The accounting treatment for a sales-type lease is the same as for a direct financing lease except for recognizing the profit at the inception of the lease. Example B 1: on 1/1/95, the York Company (the lessor) leases an equipment to the Lake Company (the lessee) with the terms and provisions as indicated in the following slides: Accounting for Leases 132

Example for Sales-type Leases (Lessor) 1. The cost of the equipment is $120, 000. The fair market value is $190, 008. 49. 2. No initial direct costs are incurred by the York Company. 3. The term of the lease is 10 Years, with annual payments of $30, 000* received at the beginning of each year. The estimated economic life of the equipment is also 10 years. *Lessor's computation of the lease payment: (190, 008 - PV of BPO $500)/6. 3283 = 30, 000 Accounting for Leases 133

Sales-type Leases (Lessor) 4. The Lake Company agrees to absorb all executory costs. 5. The Lake Company is given an option to buy the equipment at the end of the lease term at $500. 6. The interest rate implicit in the lease is 12%. 7. The present value of 10 payments of $30, 000 at 12% on an annuity basis plus the present value of the bargain purchase option is $190, 008. 49, calculated as follows: Accounting for Leases 134

Sales-type Leases (Lessor) Present value of 10 rents in advance at 12% (6. 3283 * $30, 000) = 189, 847. 50 Plus: Present value of $500 discounted at 12% (0. 321973 * $500) = 160. 99 Total present value = $190, 008. 49 8. The collectibility of the payment is reasonably assured, and there are no uncertainties involved in the lease. Accounting for Leases 135

Application of criteria for determination of lease classification by York company (lessor) Accounting for Leases 136

Application of criteria for determination of lease classification by York company (lessor): (contd. ) Conclusion: The lease is a sales-type lease. Since appropriate criteria are met and there is a manufacturer's or dealer's profit. n The amount used as the selling price ($190, 008. 49) exceeds the cost ($120, 000). n. That is, the present (fair) value of the lease payments is greater than the cost of the property. n Accounting for Leases 137

Journal Entries for Sales-type Lease (Lessor) n Assuming that the York Company (the lessor) uses the perpetual Inventory system. it records the information relevant to the lease as follows: 1. Initial Recording of the sales-Type lease on 1/1/95: Accounting for Leases 138

Journal Entries for Sales-type Lease (Lessor) (Contd. ) 1/195 Lease Receivable 300, 500 Cost of Goods Sold 120, 000 Sales Revenue* 190, 008. 49 Unearned Interest: Lease**110, 491. 51 Equipment Held for Lease 120, 000 * Sales revenue=PV of lessor's MLP. Thus, Sales reveue= P. V. of lease receivable(LR)=fair value of leased assets if all R. V. is guaranteed. **Unearned int. = LR - P. V. of LR (or fair value of leased assets). This is always true regardless RV is guaranteed or not. Accounting for Leases 139

Journal Entries for Sales-type Lease (Lessor) (Contd. ) n n If portion of the RV is unguaranteed, both the cost of goods sold and the sales revenue accounts will be reduced by the PV of the unguaranteed RV (see P 15 -9). The unguaranteed RV is treated as the portion of the asset which is not sold. Accounting for Leases 140

Journal Entries for Sales-type Lease (Lessor) (Contd. ) 2. Collection of first annual lease payment on 1/1/95: Cash 30, 000 MLPR 30, 000 3. Recognition of interest revenue on 12/31/95: Unearned Interest: Lease 19, 201. 02* Interest Revenue 19, 201. 02 * [(300, 500 - 30, 000) - 110, 491. 51] * 12% Accounting for Leases 141

Journal Entries for. Sales-type Leases (Lessor) (Contd. ) The journal entries for the next 9 years for the lessor will follow similar pattern as to the entries of 1995. n After the entries for the 10 th year are made, the balance of LR (net investment) on 12/31/2004 will be $500 (Exhibit 10): n. Journal entry on 12/31/04: n Cash 500 n Lease Receivable 500 n Accounting for Leases 142

Other Comments Related to Sales-Type Leases n The lessor does not record any depreciation on the leased asset since a sale is deemed to have taken place (due to BPO price is so low). n The lessee will depreciate the leased asset and pay for the executory costs. Accounting for Leases 143

Other Comments Related to Sales-Type Leases n Initial Direct Costs (IRD) Involved in a Sales. Type Lease: The IRD under the sales-Type lease should be expensed at time of occurrence in order to match with the revenue recognition at the inception of the lease. This can be done by including these costs in the cost of goods sold or as a selling expense. n Accounting for Leases 144

Exhibit for Sale-Type Lease Accounting for Leases 145

Reporting on Statement of Cash Flows Operating Leases: both lessee and lessor report cash flows related to lease payments as cash flows from operating activities. Capital Leases: Lessee: reports cash flows for payments toward interest exp. as cash flows from operating activities and reports the payments toward the principal (i. e. , lease payable) as cash flows from financing activities. Accounting for Leases 146

Reporting on Statement of Cash Flows (contd. ) Capital Leases (contd. ): Lessor: reports cash flows of the interest portion as cash flows from operating activities and the cash receipts toward the principal portion as cash flows from investing activities. Accounting for Leases 147

Contingent Rentals • • • Lease payments may be increased if a future event occurs (i. e. , an increase of revenue over 30%; or an increase of usage on the leased property). The potential incremental lease payments are referred to as contingent rentals. Contingent rentals are not included in the MLP because they are not determinable at the inception of the lease. Accounting for Leases 148

Contingent Rentals (contd. ) • • Contingent rentals are included in income when they occur. However, any contingent lease payments depend only on the passage of time are included in the MLP. Accounting for Leases 149

Lease Disclosures § § A general description of the leasing arrangement. Minimum future payments in the aggregate and for each of the five succeeding year (see GRAPHIC 15 -16 of the 4 th edition of textbook for example). § § § Residual values. Contingent rentals. Unearned interest. Sublease rentals. Executory costs. Accounting for Leases 150

Sale and Leaseback Arrangements § § The owner of an asset sells it and leases it back from the new owner immediately. Possible Reasons: 1) to generate cash; 2) to refinance the asset at a lower interest rate when the interest rate is declining. § Accounting for Leases 151

Gains and Losses for a Sale. Leaseback • • Gains on the sale of the asset in a salesleaseback transaction is deferred and amortized (i. e. , offset with the depreciation expense of the leased asset in a capital lease). A loss on the sale of the asset, however, is recognized immediately. Accounting for Leases 152

Sale and Leaseback: Example (capital lease for lessee) • Clear Water Corp. was in need of cash. To solve the problem, it sold its two equipments for $700, 000, then lease back the equipments for its continuous usage. The equipments had a carrying value on Clear Water’s books of $520, 000 (original cost $720, 000). The sale date is 1/1/2007. Other information: • 1. The noncancelable lease term is 10 years and requires the annual payments of $103, 566 beginning 1/1/2007. Accounting for Leases 153

Sale and Leaseback: example (contd. ) 2. The estimated remaining useful life of the warehouses is 10 years. 3. The implicit interest of the lessor and the incremental borrowing rate of the lessee are 10%. 4. No residual value was expected and a straight-line depreciation method is used by Clear Water. Accounting for Leases 154

Sale and Leaseback: example (Contd. )-Capital lease for Lessee 1/1/2007 (capital lease for lessee) Cash 700, 000 Acc. Depr. 200, 000 Equipment 720, 000 Deferred Gain on Sale-leaseback 180, 000 Leased Equip. 700, 000 Lease Payable 700, 000 (PV of MLP= 103, 566 x 6. 759) Lease Payable • Cash 103, 566 Accounting for Leases 155

Sale and Leaseback: example (contd. ) • 12/31/07 • Interest Expense • • • 59, 643 Interest Payable Depreciation expense 59, 643 70, 000 Accu. Depreciation 70, 000 Deferred Gain 18, 000 Depreciation Expense 18, 000 Note: if this is an operating lease, the deferred gain is used to offset the rent expense. Accounting for Leases 156

Sale and leaseback: example (contd. ) • 1/1/08 Interest Payable 59, 643 • Lease Payable 43, 923 • • Cash 103, 566 Accounting for Leases 157

Real Estate Leases • • Leases of Land only: Due to the unlimited life of land, the 75% rule and 90% test will not apply to land in determining the lease type. Therefore, only if criteria a (ownership transfer) or b (with BPO) is met, a lease of land will be reported as a capital lease, otherwise, an operating lease. Under the capital lease reporting, no depreciation for land is recognized. Accounting for Leases 158

Real Estate Leases (condt. ) • • Lease of Land Building: 1) Either criterion a or b is met, the lease of land building will be recorded separately and the MLP of the lease would be allocated between the land building based on their separate relative market values. 2)Neither criterion a nor b is met: a. the market value of land is equal or less than 25% of the combined fair value => Accounting for Leases 159

Real Estate Leases (condt. ) the lease is treated as a lease of building only and therefore, both land building will be depreciated by the lessee when it is reported as a capital lease. b. the market value of land is more than 25% of combined value: the lease will be treated as a lease of land a lease of building. . Accounting for Leases – • • 160

Real Estate Lease (contd. ) • The classification of the lease type of the building is similar to the criteria described earlier and the land is an operating lease. • Accounting for Leases 161

Leveraged Leases • • A third party (i. e. , a creditor) provides financing for a lease agreement between a lessor and a lessee. The lessor relies heavily on borrowing to buy the leased assets. The liability of the lessor would be offset against the lease receivable. Payments from the lessee are applied to the note payable to the creditor. Accounting for Leases 162