Accounting for Leases2

7/28/2019 Accounting for Leases2

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Leases


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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


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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


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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).


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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:



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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


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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)


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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


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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



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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)



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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


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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


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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


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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


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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


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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


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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)


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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)


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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



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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



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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


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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


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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


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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


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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


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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


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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



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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


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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

Accounting for Leases2

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