Intermediate accounting 17e stice skousen cengage chapter 15

Scenario TwoScenario Two The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period Use

Intermediate Accounting,17E

Stice | Stice | Skousen

PowerPoint presented by: Douglas Cloud

Leases

Economic Advantages to Leasing Over Purchasing

1 No down payment

2 Avoid risks of ownership

3 Flexibility

For the Lessee

For the Lessee

1 Increased sales

2 Ongoing business relationship with lessee

3 Residual value retained

For the Lessor

For the Lessor

Simple Example

• Owner Company owns a piece of

equipment with a market value of

$10,000

• User Company wishes to acquire the

equipment

• User Company can borrow $10,000 from

the bank at 10% interest Payments

would be $2,638 each year for five

years

(continues)

Simple Example

• User Company can lease the equipment

from Owner Company for five years and make five annual “rental” payments of

$2,638 Owner maintains title

throughout At the end of the lease, the equipment is no longer useful

• Should Owner Company recognize an

equipment sale when the lease is

signed?

(continues)

Simple Example

• Has effective ownership of the

equipment been passed from Owner to User?

• Is the transaction complete?

• Is Owner Company reasonably certain

the five annual payments can be collected from User Company?

(continues)

Key accounting issues for Owner

Company

Simple Example

• On the date the lease is signed, should

User recognize the lease equipment as

an asset and the obligation to make the lease payment as a liability?

• The answer hinges on whether effective

ownership, as opposed to legal

ownership, of the equipment changes

hands when Owner and User sign the

lease agreement

Key accounting issues for User

Company.

The economic substance of this lease is

that the lease signing is equivalent to the transfer of effective ownership, and the

fact that Owner retains legal title of the

equipment during the lease period is a

mere technicality

Simple Example

The arrangement should

be treated as a sale by Owner and a purchase by User

Scenario One

Scenario One

The lease agreement stipulates that

Owner Company is to maintain legal

title to the equipment for the 5-year

lease period, but title is to pass to User

at the end of the lease

Even though this is a leasing

arrangement, the transfer of title at the end indicates that this is in substance a

purchase.

Simple Example

Scenario Two

Scenario Two

The lease agreement stipulates that

Owner Company is to maintain legal title

to the equipment for the 5-year lease

period, but at the end of the lease period User has the option to buy the equipment for $1.Offering the equipment to User Company

for a bargain price at the end of the lease indicates that this is in substance a

purchase.

Simple Example

Scenario Three

Scenario Three

The useful life of the equipment is just

five years Accordingly, when the lease

term is over, the equipment can no

longer be used by anyone else

Because the life of this asset and the

lease term are the same, this

arrangement is in substance a purchase.

Simple Example

Scenario Four

Scenario Four

The present value of the lease

payments equals the $10,000 market

value of the equipment on the lease

signing date

When the present value of the lease

payments equals the lease item’s market

value, it is in substance a purchase.

Simple Example

Capital vs Operating Lease

• Capital leases are accounted for

as if the lease agreement transfers ownership of the asset from the lessor to lessee.

• Operating leases are accounted for as rental agreements.

Cancellation Provisions

meaning that these lease contracts are cancelable only on the outcome

of some remote contingency or that the cancellation provisions and

penalties of these leases are so

costly to the lessee that

cancellation will not occur.

Bargain Purchase Option

If a lease includes a provision

giving the lessee the right to

purchase the leased property at a

price that is expected to be

considerably less than the fair

value, the option is called a

Lease Term

• The lease term is the time period

from the beginning to the end of the lease

• The beginning of the lease term occurs

when the leased property is transferred

to the lessee

• The end of the lease term is at the end

of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised

Residual Value

• The market value of the leased property

at the end of the lease term is referred

to as its residual value

• Some lease contracts require the lessee

to guarantee a minimum residual value

If the market value falls below the

guaranteed residual value, the

lessee must pay the difference

Minimum Lease Payments

• The rental payments required over

the lease term plus any amount to

be paid for the residual value are

referred to as the minimum lease

• Lease payments sometimes include charges for insurance, maintenance, and taxes on the leased property

These are referred to as executory costs

Lease 1

• The implicit interest rate is used to

discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease

• The lessor always uses the implicit rate to

discount rental payments

• The interest rate that the lessee could use

to borrow the amount of money necessary

to purchase the leased asset is the

incremental borrowing rate

(continues)

Lease 1

• The lessee uses the lower of the implicit

interest rate or the incremental borrowing rate to compute present value of minimum lease payments

Lease Classification Criteria

1. The lease transfers ownership of the leased

asset to the lessee by the end of the lease term.

2 The lease contains an option allowing the lessee

to purchase the asset at the end of the lease

term at a bargain price.

3 The lease term is equal to 75% or more of the

estimated economic life of the asset

4 The present value of the lease payments at the

beginning of the lease is 90% or more of the fair market value of the leased asset.

A lease is classified as a capital lease by the

lessee if it is noncancelable and meets any one of the following criteria:

This places the responsibility of

distinguishing the type of lease on the accountant.

General Classification Criteria

— Lessee and Lessor

The four general criteria that apply

to all leases for both the lessee

and lessor relate to—

Lease Classification―Lessor

Additional revenue recognition criteria

applicable to lessors:

1 Collectibility of the minimum

lease payments must be

reasonably predictable.

2 Any unreimbursable costs yet to

be incurred by the lessor can be

reasonably estimated at the lease inception date.

Accounting for Operating Lease

—Lessee

The lease terms for manufacturing

equipment are $40,000 a year on a

year-to-year basis The entry to

record the lease payment for the

year would be:

Rent Expense 40,000

The terms of the lease for an aircraft

by International Airlines provide for payments of $150,000 a year for the first two years of the lease and

$250,000 for each of the next three years The total lease payments

would be $1,050,000, or $210,000 a year on a straight-line basis

(continues)

Operating Leases with Varying

Lease Payments

Operating Leases with Varying

Rent Payable current liability 60,000

The entries for each of the last three years

are as follows:

Rent Expense 210,000

Rent Payable 40,000

• Lease period: 5 years, beginning January

1, 2011, noncancelable

• Rent amount: $65,000 per year payable

annually in advance; includes $5,000 to

cover executory costs

• Estimated economic life of equipment: 5

years

• Expected residual value of equipment at

end of lease period: None

Marshall Corporation—Lessee

Marshall Corporation—Lessee

Accounting for Capital

Leases—Lessee

Leased Equipment 250,192

Obligations under Capital Leases 250,192

Marshall Corp Entries on January 1, 2011 Marshall Corp Entries on January 1, 2011

(continues)

Marshall Corp Entries on December 31, 2011

Marshall Corp Entries on December 31, 2011

Accounting for Capital

If normal company depreciation policy for

this type of equipment is used, the

amortization entry for 2011 is shown below:

(continues)

Prepaid Executory Costs 5,000

Obligations under Capital

($250,192 –

$60,000) × 0.10

Accounting for Leases with a

Bargain Purchase Option

• Frequently, the lessee is given the

option of purchasing the property in

the future at what appears to be a

bargain price.

• The present value of the bargain

purchase option would be added to

the present value of the minimum

lease payments to establish the

initial asset and liability.

• There is a bargain purchase option of

$75,000 exercisable after five years

Lessee Lessee

Accounting for Leases with a

Bargain Purchase Option

• Lease period: 5 years, beginning January 1,

2011, noncancelable

• Rent amount: $65,000 per year payable

annually in advance; includes $5,000 to cover executory costs

• Estimated economic life of equipment: 5 years

• Expected residual value of equipment at end

of lease period: None

These are the same facts as

Minimum Lease Payment Minimum Lease Payment

Present value of five payments at the

beginning of each year for five years:

PMT = $60,000, N = 5, I = 10% $250,192

Present value of the bargain purchase

option of $75,000 at the end of 5 years:

FV = $75,000, N = 5, I = 10% 46,569

Present value of minimum lease payment $296,761

Accounting for Leases with a

Bargain Purchase Option

($296,761 ÷ 10) ×

5 years

Accounting for Leases with a

Bargain Purchase Option

Accounting for Leases with a

Bargain Purchase Option

If the equipment is not purchased and the lease is permitted to lapse, the following

entry is required on December 31, 2015:

Loss from Failure to Exercise Bargain

Accounting for Purchase of Asset During Lease Term

On December 31, 2013, the lessee

purchased the leased property in the

Marshall Corporation example for $120,000

At that date, the remaining liability

recorded on the lessee’s books is $114,545 and the net book value of the recorded

leased asset is $100,078 [capitalized value

of $250,192 less $150,114 amortization

($50,038 × 3)]

Given the facts in Slide 15-38, the entry to record the purchase on the lessee’s books would be as follows:

In 2011, Marshall Corporation’s income

before any lease-related expenses is

$200,000 Net income for the year is

computed as follows:

Income before lease-related expenses $200,000

Lease-related interest expense (19,019)

Lease-related amortization expense (50,038)

Net income $130,943

Treatment of Leases on Lessee’s Statement of Cash

Flows

Accounting for Leases—Lessor

lessor who is primarily engaged in

financing activities, such as a bank

or finance company.

manufacturers or dealers who use

leases as a means of facilitating the marketing of their products.

Revenue Generated

by a Sales-Type Lease

A sales-type lease generates two

different types of revenue:

1 An immediate profit or loss, which is

the difference between the cost of the property being leased and its sales

price, or fair value, at the inception of the lease

2 Interest revenue earned over time as

the lessee makes the lease payments

Accounting for Operating Leases—Lessor

Minimum payment (in advance) including

$5,000 executory cost $65,000/year Lease period (beginning Jan 1, 2011) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0

Incremental borrowing rate 10% Cost to lessor $400,000 Direct costs incurred $15,000

Universal Leasing Co (Lessor) Universal Leasing Co (Lessor)

(continues)

Accounting for Operating Leases—Lessor

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

To record the payment of the initial direct

costs and the receipt of the lease payment

Accounting for Operating Leases—Lessor

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

To record the amortization of direct costs

over five years and the depreciation of

equipment over ten years using the line basis:

straight-Amortization of Initial Direct Costs 3,000

Deferred Initial Direct Costs 3,000

Depreciation Expense on Leased

Accumulated Depreciation on Leased

Accounting for Direct Financing Leases

Refer to Slides 15-27 and 15-28 for details concerning Marshall Corporation’s leasing arrangement with Universal Leasing

Company The cost of the equipment to

Universal was the same as the fair value,

$250,192 and Equipment Purchased for

Lease was charged when the equipment

was acquired

Left click on the button to go to Slide 15-27 , then type “46”

and press the “Enter” key to return to this slide.

To record initial lease on January 1, 2011:

Lease Payments Receivable 300,000

Equipment Purchased for Lease 250,192 Unearned Interest Revenue 49,808

Accounting for Direct Financing Leases

Receivable Recorded at Gross Amount

Receivable Recorded at Gross Amount

To record first payment on January 1, 2011:

Lease Payment Receivable 60,000 Executory Costs 5,000

Accounting for Direct Financing Leases

To record receipt of payment on December 31,

Lease Payment Receivable 60,000 Deferred Executory Costs (a liability) 5,000 Unearned Interest Revenue 19,019

Interest Revenue 19,019

Lessor Accounting for Direct Financing Leases with Residual Value

Assuming the same facts as the last illustration, except that the asset

has a residual value at the end of

the 5-year lease of $75,000 Assume the cost to Universal Leasing

Company was $296,761 (which is

also its fair value).

Lessor Accounting for Direct Financing Leases with Residual Value

To record initial lease on January 1, 2011:

Lease Payments Receivable 296,761

Equipment Purchased for Lease 296,761

(continues)

Receivable Recorded at Net Amount

Receivable Recorded at Net Amount

To record first payment on January 1, 2011:

Lease Payment Receivable 60,000 Executory Costs 5,000

Lessor Accounting for Direct Financing Leases with Residual Value

To record payment on December 31, 2011:

Lease Payments Receivable 36,324 Deferred Executory Cost 5,000 Interest Revenue 23,676

To record recovery of the leased asset on

December 31, 2015:

Lease Payment Receivable 68,182 Interest Revenue 6,818

Accounting for Sales-Type

Leases—Lessor

• If there is no difference between

the sales price and the lessor’s

cost, the lease is not a sales-type

lease.

• The lessor will also recognize

interest revenue over the lease

term for the difference between

the sales price and the gross

amount of the minimum lease

Accounting for Sales-Type

Leases—Lessor

(3) Cost or carrying value of

leased asset to lessor

Manufacturer’s

or Dealer’s Profit (Loss)

(1) Minimum lease payments

(2) Fair value of leased asset

Financial Revenue (Interest)

Accounting for Sales-Type

Leases—Lessor

Fair value of equipment $250,192 Lease period (beginning Jan 1, 2011) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0

PV of future lease payments $250,192

Direct costs incurred $15,000

American Manufacturing Co (Lessor)

American Manufacturing Co (Lessor)

Accounting for Sales-Type

(3) Cost of leased equipment

to lessor, plus initial direct

costs $175,000

$75,192 (Mfr.’s Profit)