Post on 03-Apr-2018
7/28/2019 Accounting for Leases2
1/44
Leases
7/28/2019 Accounting for Leases2
2/44
7/28/2019 Accounting for Leases2
3/44
5. Contrast the operating and capitalization methodsof recording leases.
6. Calculate the lease payment required for thelessor to earn a given return.
7. Identify the classifications of leases for the lessor.
8. Describe the lessors accounting for direct
financing leases.9. Describe the lessors accounting for sales-type
leases.
Learning Objectives
7/28/2019 Accounting for Leases2
4/44
10. Describe the lessors accounting for operatingleases.
11. Identify the lessors disclosure requirements.
12. Describe the effect of residual values,guaranteed and unguaranteed, on leaseaccounting.
13. Describe the effect of bargain purchase optionson lease accounting.
14. Describe the lessors accounting treatment forinitial direct costs.
Learning Objectives
7/28/2019 Accounting for Leases2
5/44
Learning Objectives
15. Describe the lessees accounting for sale-leaseback transactions (Appendix 21A).
16. Explain the classification and accountingtreatment accorded leases that involve landas well as buildings and equipment(Appendix 21A).
7/28/2019 Accounting for Leases2
6/44
Leases
Basics ofLeasing
Advantagesof leasing
Conceptualnature of alease
Illustrationsof Lease
Arrange-ments
Harmon,Inc.
ArdensOven Corp.
Mendotta
Truck Corp.ApplelandComputer
Accounting by LesseesCapitalization criteria
Accounting for a capitallease
Capital lease methodillustratedReporting anddisclosure-capitalleases
Accounting for an
operating leaseReporting anddisclosure-operatingleasesPerspectivesIllustration ofdisclosures
Accounting byLessorsEconomics ofleasing
ClassificationCapitalizationcriteriaDirect financingleaseSales-type leaseOperating leasesReporting anddisclosureIllustration oflessor
disclosures
SpecialAccountingIssuesResidualvaluesBargainpurchase
optionsInitial direct
costsCurrentversusnoncurrentUnsolvedproblems
7/28/2019 Accounting for Leases2
7/44
Leasing: Basics
The lease is a contractual agreementbetween the lessorand the lessee
The lease gives the lessee the right to
use specific property (owned by thelessor)
The lease specifies also the duration of
the lease and rental payments The obligations for taxes, insurance, and
maintenance may be assumed by the
lessor or the lessee or divided
7/28/2019 Accounting for Leases2
8/44
Advantages of Leasing
100 percent financing at a fixed rate No down payment required Rate charged is fixed for the term of the lease
Protection from obsolescence
Property can be upgraded Flexibility
Lease may be structured to meet differentneeds (e.g., cash flow)
Less costly financing (lessee); taxincentives (lessor)
Off-balance sheet financing
Impact on ratios
7/28/2019 Accounting for Leases2
9/44
Differing Views onCapitalization of Leases
Do not capitalize any leased assets Since lessee does not own the property,
capitalization is considered inappropriate
Since executory contracts are notcapitalized, leases should not be either
Capitalize leases that are similar to
instalment purchases If instalment purchases are capitalized, so
should leases with similar characteristics
7/28/2019 Accounting for Leases2
10/44
Differing Views onCapitalization of Leases
Capitalize all long-term leasesThe long-term right to use property
justifies its capitalization (property
rights approach)Capitalize firm leases where thepenalty for nonperformance issubstantial
Capitalize only firm /non-cancellable
contractual rights and obligations
7/28/2019 Accounting for Leases2
11/44
Current Accounting Standard
CICA standard is consistent with approachsimilar to instalment purchases
A lease that transfers substantially all thebenefits and risks of property ownershipshould be capitalized
7/28/2019 Accounting for Leases2
12/44
Current Accounting Standard
Basic Conclusions:
1. Characteristics indicating transfer of risks
and benefits of ownership must be identified2. Same characteristics should apply to the
lessee and lessor
3. Leases that do not transfer substantially all
benefits and risks of ownership should notbe capitalized
7/28/2019 Accounting for Leases2
13/44
Lease Classification
Capital Lease
Where the benefits and risks of ownership
have effectively been transferred to the lessee Accounted for as a purchase by the lessee
Journal Entries:
Lessee LessorLeased Equipment XXX Lease Receivable (net) XXX
Lease Obligation XXX Equipment XXX
7/28/2019 Accounting for Leases2
14/44
Lease Classification
Operating Lease
Where the rights and risks of ownership havenot been transferred
A rental-only has occured
Journal Entries:
Lessee LessorLease Expense XXX Cash XXXCash XXX Rental Revenue XXX
7/28/2019 Accounting for Leases2
15/44
Is there aTransfer ofOwnershipor BargainPurchaseOption?
Is Lease Term 75% ofEconomic Life
Is PresentValue ofPayments 90% of FairValue
Capital Lease OperatingLease
YesYes Yes
No NoNo
LeaseAgreement
Capital vs. Operating Lease
7/28/2019 Accounting for Leases2
16/44
Transfer of ownership
Economic life
PV of payments If the PV ofminimum lease payments is 90%
of the fair value of the asset
minimum lease payments (lessee)defined:
Minimum rental payments +
Guaranteed residual value +
Penalty for not renewing or extending lease +
Bargain purchase option
Capital Lease Criteria
7/28/2019 Accounting for Leases2
17/44
Minimum rental payments Regular payment made to lessor, excluding
executory costs
Executory costs include insurance, maintenance andtax expenses. If these payments made by the lessor,they are estimated and excluded from the minimumrental payment calculation
Guaranteed residual value The amount at which the lessor has the right to
require the lessee to purchase the asset; or
The amount the lessee (or 3rd party guarantor)guarantees that the lessor will realize
Minimum Lease Payments
7/28/2019 Accounting for Leases2
18/44
The rate the lessee would have incurred ifthey had borrowed the funds to purchase theasset (incremental borrowing rate) Under similar term (length)
Similar security (same type of asset)
This rate is not used when
The lessee knows the implicit rate lessor used tocalculate the lease payment, and it is less thanthe lessees incremental borrowing rate
In this case, use implicit rate
Discount Rate
7/28/2019 Accounting for Leases2
19/44
Asset & liability recorded at the lower of: PV of the minimum lease payments, or FV of the asset at the inception of the lease
Depreciation of the asset is amortized over: The economic life of the asset if ownership
transfers to lessee at the end of the leaseor there is a bargain purchase option
The term of the lease if title does nottransfer or there is no bargain purchaseoption
Otherwise over the term of the lease
Accounting for aCapital Lease
7/28/2019 Accounting for Leases2
20/44
Interest expense resulting from thelease transaction is recorded followingthe effective interest method
The discount rate used to establish theinitial PV is used to amortize the lease
Journal entries required to record acapital lease transaction are asfollows:
Accounting for aCapital Lease
7/28/2019 Accounting for Leases2
21/44
Accounting for aCapital Lease
At the inception of the leaseDr. Asset
Cr. Obligations under capital lease
To record interest amortization
Dr. Interest ExpenseCr. Interest Payable
Using the EffectiveInterest Method
To record asset amortizationDr. Amortization Expense
Cr. Accumulated Amortization
Using methodappropriate to
the assetTo record the lease payment
Dr. Related Executory Expense (if any)Dr. Interest PayableDr. Obligations under capital lease
Cr. Cash
7/28/2019 Accounting for Leases2
22/44
Capital Lease - Example
Lease Terms Given: Term of 5 years, non-cancellable Annual payments $25,981.62 (due at beginning of
each year)
Fair value of asset $100,000 Economic life = 5 years; Residual value = Zero
Lease payments include $2,000 property taxes(executory cost)
Lease has no renewal option, and asset reverts toLessor at termination of lease
Lessees incremental borrowing rate = 11%
Lessors implicit rate =10% (known to lessee)
7/28/2019 Accounting for Leases2
23/44
Capital Lease - Example
Does this qualify as a capital lease?
Only one of the tests must be met
Is there aTransfer ofOwnershipor BargainPurchase
Option?
Is Lease Term 75% ofEconomic Life?
Is Present Valueof Payments 90% of FairValue?
No
Capital Lease
Yes
PV of payments (n=5, i=10%)25,981.62 - 2000.00 =23,981.62 x 4.16986 =$100,000.00
Yes
7/28/2019 Accounting for Leases2
24/44
Entry to record initial lease transactionLeased Equipment 100,000
Lease Liability 100,000
Entry to record initial payment (Jan 1/05)Property Tax Expense 2,000.00Lease Liability 23,981.62
Cash 25,981.62 As this is a capital lease the following must alsobe recorded (at year end or in each reporting period)
Interest expense
Asset amortization
Capital Lease - Example
7/28/2019 Accounting for Leases2
25/44
Interest amortization (December 31, 2005)Interest Expense 7,601.84
Interest Payable 7,601.84
(100,000-23,981.62)*10% = 7,601.84(Interest Payable is debited in all subsequent lease payment entries)
Asset amortization (December 31, 2005)Amortization expense 20,000
Accumulated amortization 20,000(100,000 / 5 years = 20,000)(There is no transfer of ownership or bargain purchase option, so theterm of the lease is used to amortize the asset)
Capital Lease - Example
7/28/2019 Accounting for Leases2
26/44
Gross amount of assets and related accumulatedamortization
Amortization expense maybe disclosed, methods and
rate shouldbe disclosed Lease obligations reported separately from other
liabilities
Current portion of lease obligation=current liability
Minimum lease payments in total and for the next fivefiscal years; executory costs and imputed interestdisclosed separately
Interest expense from the lease may be separatelydisclosed; or included with other interest expense
Maydisclose any related contingencies
Disclosure Requirements
Capital Lease
7/28/2019 Accounting for Leases2
27/44
Leases are classified as either:
Operating Lease
Direct financing Lease Sales-type Lease
These arecapital leases
Accounting by the Lessor
The determination of a capital or operatinglease depends on answering a series ofquestions
7/28/2019 Accounting for Leases2
28/44
Operating
Lease
Sales-Type
Lease
DirectFinancingLease
Does Leasemeet any ofLesseesCapital
Leasecriteria?
No
Riskassociated
with collectionnormal?
Yes
LeaseAgreement
No
Remainingunreim-burseablecosts to
Lessorestimatible?
YesDoes AssetFair Value =
LessorsBook Value?
Yes
YesNo
No
Lease Classification - Lessor
7/28/2019 Accounting for Leases2
29/44
Both the direct financing lease and the sales-type lease are capital leases
The difference is whether or not there exists amanufacturers or dealers profit
The sales-type lease incorporates a profithence the final question on the previous map
A lease may qualify as a capital lease by thelessee and as an operating lease by thelessor
Lease Classification - Lessor
7/28/2019 Accounting for Leases2
30/44
Lessor replaces investment in asset to be leasedwith a lease receivable
Over lease term, the receivable is collected, andinterest is earned
Net investment in the lease = lease paymentsreceivable unearned interest revenue
Direct Financing Lease - Lessor
7/28/2019 Accounting for Leases2
31/44
Step 1:
Calculate the payment required to provide lessor withrequired rate of return
Cost/FMV of asset to be recovered $100,000
Less: PV of expected residue value -0-
Amount to be recovered throughlease payments $100,000
Calculation of Lease Payment by
Lessor
7/28/2019 Accounting for Leases2
32/44
Amount to be recovered $100,000
Payments: (n=5, i=10) $100,0004.16986
= $23,981.62
Lease payments receivable:5 x $23,981.62 = $119,908.10
Calculation of Lease Payment
(Contd)
7/28/2019 Accounting for Leases2
33/44
The lease payments receivable are equal to:Lease payments (net of executory costs) +
salvage (residual) value The unearned interest revenue is the difference
between the lease payment receivable and theasset cost (FMV)
The journal entries are then:
Direct Financing Lease (Lessor)
7/28/2019 Accounting for Leases2
34/44
January 1, 2005Lease Payments Receivable 119,908.10
Equipment for Lease 100,000.00
Unearned Interest Revenue 19,908.10January 1, 2005 (first payment)
Cash ($23,981.62+$2,000) 25,981.62Property Tax Expense 2,000.00Lease Payments Receivable 23,981.62
December 31, 2005Unearned Interest Revenue 7,601.84
Interest Revenue 7,601.84
Direct Financing Lease (Lessor)
7/28/2019 Accounting for Leases2
35/44
At Dec. 31/05 year end, Lessor recognizes interestearned:
Amount originally financed $100,000.00
Paid on principal Jan. 1/05 (23,981.62)Balance outstanding $ 76,018.38
Interest : 10% x 76,018.38 x 12/12
= $7,601.84
Unearned Interest Revenue 7,601.84
Interest Revenue 7,601.84
Direct Financing Lease (Lessor)
7/28/2019 Accounting for Leases2
36/44
Entries are the same as for the directfinancing lease, except for:
Entry at the inception of the lease mustrecord the sale and cost of goods sold
Recall that the sales-type lease includes amanufacturers/dealers profit margin
Lessor earns a gross profit on sale +interest as the sale is financed
Sales-Type Lease - Lessor
7/28/2019 Accounting for Leases2
37/44
Sales-Type Lease Example
Take the same data as in our example,except the asset has been recorded in the
Lessors inventory at a cost of $85,000(FMV=$100,000)
All previous lessor entries remain the sameexcept for the entry at the lease inception
Sales and Gross Profit are recorded
7/28/2019 Accounting for Leases2
38/44
Sales-Type Lease Example
January 1, 2005Lease Payments Receivable 119,908.10
Sales 100,000.00Unearned Interest Revenue 19,908.10
Cost of Goods Sold 85,000.00Inventory 85,000.00
January 1, 2005 (first payment-remains the same)Cash ($23,981.62+$2,000) 25,981.62
Property Tax Expense 2,000.00
Lease Payments Receivable 23,981.62December 31, 2005 (remains the same)
Unearned Interest Revenue 7,601.84Interest Revenue 7,601.84
7/28/2019 Accounting for Leases2
39/44
Disclose the net investment in the lease(classified as current and non-current)
How the investment is calculated forpurposes of income recognition
Finance income amount
Operating Leases Separate disclosure of the cost and
accumulated amortization of the property
Amount of rental (lease) income earned
Disclosure Requirements - Lessor
7/28/2019 Accounting for Leases2
40/44
Residual Value Lessor
Direct Financing Lease: whether guaranteed orunguaranteed, the residual is included in the
lessor calculations
Sales-Type Lease: with unguaranteed residualvalue the Sales Revenue and COGS are reducedby the PV of that unguaranteed residual value
Residual value is part of Sales Revenue (andCOGS) if guaranteed
Other Lease Accounting Issues
7/28/2019 Accounting for Leases2
41/44
Other Lease Accounting Issues
Residual Value Lessee
If guaranteed by lessee, p.v. of residual is
included in asset cost and lease obligationrecognized (i.e. is included in definition ofminimum lease payments)
If not guaranteed by lessee, residual value is
not included in definition of minimum leasepayments not in asset or liability amountsrecognized
7/28/2019 Accounting for Leases2
42/44
Bargain Purchase Option
With direct financing and sales-type leases, thebargain purchase price is included in the net
investment calculations by Lessor Lessee accounting assumes bargain option price
will be paid: p.v. of amount included in asset costand obligation recognized
Other Lease Accounting Issues
7/28/2019 Accounting for Leases2
43/44
Initial Direct Costs of Lessor
Application of Matching Principle
Operating lease over term of lease
Direct financing lease over term of lease Sales-type lease in same period as gross
profit on sale recognized
7/28/2019 Accounting for Leases2
44/44
Current and Noncurrent
Current portion = principal amount to bereceived/paid within 12 months from balance
sheet date + interest accrued to the balancesheet date
Long-term = principal amount notrecoverable/payable within 12 months from
balance sheet date