Leases A lease is an agreement in which

Leases

A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessee = Renter Lessor = Owner of property

Matrix, Inc. acquires equipment from Apex, Inc. by paying $193, 878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

At inception January 1 Installment Note Equipment Notes payable 1, 000 Capital Leased Equipment Lease payable 1, 000, 000 1, 000 First payment, June 30 Installment Note Interest expense Notes payable Cash 45, 000 148, 878 Capital Lease Interest expense Lease payable Cash 45, 000 148, 878 193, 878

Operating Lease Capital Lease A capital lease must meet one of four criteria: Ownership transfers to the lessee at the end of the lease term, or. . . A bargain purchase option (BPO) exists, or. . . The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or. . . The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.

A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured. The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: 1. The collectibility of the lease payments must be reasonably predictable. 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete. Lessor = Owner of the property subject to the lease.

Lease accounting under U. S. GAAP and IFRS provides a good general comparison of “rules-based accounting” as U. S. GAAP often is described and “principles-based accounting” which often is the description assigned to IFRS. • Lease classification rules. 1. 2. 3. 4. 5. 6. Same as IFRS. “Major portion” means 75% or more. “Substantially all means 90% or more. No similar situation. • Situations normally leading to classification as finance lease are: 1. Transfers ownership 2. Contains a BPO 3. Term is “major portion” of asset’s life. 4. PV of MLP greater than “substantially all” of the fair value of the asset. 5. Specialized nature of asset. 6. Other circumstances impact classification.

Lease agreement exists. Record lease as an Operating Lease. Criteria for a capital lease not met. Capital Lease

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

The amount recorded (capitalized) is the present value of the minimum lease payments. However, the amount recorded cannot exceed the fair value of the leased asset. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1. Its incremental borrowing rate, or 2. The implicit interest rate used by the lessor.

If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price.

� On January 1, 2016, Sans Serif Publishers, Inc. , leased a copier from First Lease Corp. First Lease purchased the equipment from Compu. Dec Corporation at a cost of $479, 079. � The lease agreement specifies annual payments beginning January 1, 2016, the inception of the lease, and at each December 31 thereafter through 2020. The six year lease term ending December 31, 2021, is equal to the estimated useful life of the copier. $479, 079 ÷ 4. 79079* = $100, 000 rental payments. � First Lease acquires electronic equipment for lease to other firms. *PV of anroutinely annuity due of $1: n = 6, I = 10% The interest rate In these financing arrangements is 10%. � Since the lease ×term is equal = to $479, 079 the expectedlessee’s useful lifecost of the copier $100, 000 4, 79079* (>75%), the transaction must be recorded by the lessee as a capital lease � We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479, 079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100, 000.

Direct Financing Lease (January 1, 2016) San Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) Lease payable (PV of payments) 479, 079 First Lease Corp. (Lessor) Lease receivable (PV of payments) 479, 079 Inventory of equipment (Lessor’s cost) 479, 079 First Lease Payment (January 1, 2016) San Serif Publishers, Inc. (Lessee) Lease payable Cash 100, 000 First Lease Corp. (Lessor) Cash Lease receivable 100, 000

Amortization Schedule for the Lease $379, 079 × 10% = $37, 908 $100, 000 - $37, 908 = $62, 092 $379, 079 - $62, 092 = $316, 987

Second Lease Payment (December 31, 2016) San Serif Publishers, Inc. (Lessee) Interest expense Lease payable Cash First Lease Corp. (Lessor) Cash Lease receivable Interest revenue 37, 908 62, 092 100, 000 62, 092 37, 908 Depreciation Recorded at (December 31, 2016) San Serif Publishers, Inc. (Lessee) Depreciation expense Accumulated depreciation 79, 847 ($479, 079 ÷ 6 = $79, 847 Assuming straight-line method. ) 79, 847

Depreciation Period The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i. e. , either of the first two classification criteria is met), the asset should be depreciated over its useful life.

If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset. At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of payments). In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.

On January 1, 2016, Sans Serif Publishers, Inc. , leased a copier from Compu. Dec Corp. at a price of $479, 079. The lease agreement specifies annual payments of $100, 000 beginning January 1, 2016 (the inception of the lease), and at each December 31 thereafter through 2020. The six year lease term ending December 31, 2021, is equal to the estimated useful life of the copier. Compu. Dec manufactured the copier at a cost of $300, 000. Compu. Dec’s interest rate for financing the transaction is 10%.

Lease Classification 1. The lease term (6 -years) is equal to 100% of the useful life of the copier, and 2. Fair market value is different from cost of the leased asset. 3. Compu. Dec is certain about the collectibility of the lease payments, and 4. No costs are to be incurred by Compu. Dec relating to the lease agreement, SO The lease agreement is classified as a Sales-Type lease from the viewpoint of Compu. Dec (lessor) and a capital lease from the viewpoint of Sans Serif Publishers (lessee).

SALES-TYPE LEASES: LESSEE At inception of the Lease – January 1, 2016 Comp. Dec Corp. (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment 479, 079 300, 000 Receipt of the First Lease Payment – January 1, 2016 Comp. Dec Corp. (Lessor) Cash Lease receivable 100, 000

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

On January 1, 2016, Sans Serif Publishers, Inc. , leased a color copier from Compu. Dec Corporation at a price of $479, 079. The lease agreement specifies annual payments beginning January 1, 2016, the inception of the lease, and at each December 31 there after through 2020. The estimated useful life of the copier is seven years. On December 31, 2021, at the end of the six year lease term, the copier is expected to be worth $75, 000, and Sans Serif has the option to purchase it for $60, 000 on that date. The residual value after seven years is zero. Compu. Dec manufactured the copier at a cost of $300, 000 and its interest rate for financing the transaction is 10%.

Exercise of BPO at the end of the lease term:

End of Lease – December 31, 2021 Sans Serif Publishers, Inc. (Lessee) Depreciation expense ($479, 079 ÷ 7) Accumulated depreciation Interest expense Lease payable Cash (BPO payment) Comp. Dec Corporation(Lessor) Cash Lease receivable Interest revenue Refer the amortization schedule and computations on the previous screen 68, 440 5, 458 54, 542 60, 000 54, 582 5, 458

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. On January 1, 2016, Sans Serif Publishers, Inc. , leased a color copier from Compu. Dec Corporation at a price of $479, 079. The lease agreement specifies annual payments beginning January 1, 2016, the inception of the lease, and at each December 31 thereafter through 2020. The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2021, the copier is expected to be worth $60, 000. Compu. Dec manufactured the copier at a cost of $300, 000 and its interest rate for financing the transaction is 10%.

Guaranteed Residual Value Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. PV factor of an annuity due of $1: n=6, i=10% PV factor of $1: n=6, i=10%

Unguaranteed Residual Value A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445, 211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

Guaranteed Residual Value When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both.

Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value. Sales-Type Lease – January 1, 2016 San Serif Publishers, Inc. (Lessee) Leased equipment 479, 079 Lease payable 479, 079 Comp. Dec Corporation (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment 479, 079 300, 000

First Lease Payment – January 1, 2016 San Serif Publishers, Inc. (Lessee) Lease payable 92, 931 Cash 92, 931 Comp. Dec Corporation (Lessor) Cash Lease receivable 92, 931

December 31, 2020 San Serif Publishers, Inc. (Lessee) Depreciation expense 69, 847 Accumulation depreciation 69, 847 Interest expense Lease payable Cash Comp. Dec Corporation (Lessor) Cash Interest revenue Lease receivable 13, 407 79, 524 92, 931 13, 407 79, 524 See amortization schedule

One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs The lessee records executory costs as incurred: Sans Serif Publishers, Inc. (Lessee) Maintenance expense 2, 000 Cash 2, 000

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

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

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

Lease transactions impact several financial ratios 1. Debt to equity ratio – Lease liabilities are recorded. 2. Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

� IASB and FASB Boards have agreed on a “right to use” model. � The lessee recognizes as asset representing the right to use the leased asset for the leased term and a corresponding liability. � May mean that most, if not all, leases will be recorded at the PV of the lease payments. � May eliminate the concept of operating leases.

� Lessee � Lessor � Operating lease � Capital lease � Direct financing lease � Sales-type lease � Bargain purchase option � Executory costs � Guaranteed residual value � Unguaranteed residual value � Leasehold improvements