Intermediate accounting 19th by stice stice chapter 15

Operating Lease • Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to lessee.. Residual Value • The market value of the leased

• A lease is a contract specifying the terms

under which the owner of property, the

lessor , transfers the right to use the property

to a lessee

• A major challenge for the accounting

profession has been to establish standards that prevent companies from using the legal form of a lease to avoid recognizing future

payment obligations as a liability.

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

with a market value of $10,000 and an

estimated useful life of five years

equipment

bank at 10% interest Payments for principal and interest would be five equal annual

installments of $2,638

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

$2,638

and will still make payments of $2,638 per

year

not just selling the equipment but is also

substituting for the bank in providing financing

(continued)Simple Example

• Has effective ownership of the equipment

been passed from Owner to User?

Owner have any significant responsibilities

remaining in regard to the equipment?

annual payments can be collected from User

On the date the lease is signed, should Owner Company recognize an equipment sale?

The key accounting issues for the lessor are:

Simple Example

• Answer: 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.

(continued)Simple Example

• The economic substance of the 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

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, with no transfer of

effective ownership associated with the

lease.

Why Leasing Over Purchasing?

• Keeping the asset off the balance sheet

improves financial ratio measures of

efficiency.

• Keeping the liability off the balance sheet

improves measures of leverage.

• For companies that lease a large portion of the assets they use, the accounting

standards associated with leasing are the most critical standards that they apply.

Cancellation Provisions

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

operating leases

accounted for as capital leases

Bargain Purchase Option

• If the specified purchase option price is

expected to be considerably less than the fair value at the date the purchase option

may be exercised, the option is called a

bargain purchase option

• By definition, a bargain purchase option is one that is expected to be exercised.

• Noncancelable leases with BPO are

accounted for as capital leases.

Lease Term

• The lease term is the time period from the

beginning to the end of the lease

the leased property is transferred to the

lessee

because many leases include provisions

allowing the lessee to extend the lease

period

(continued)

Lease Term

fixed noncancelable lease period plus all

renewal option periods that are likely to be

exercised

• A bargain purchase option is one with

such an attractive lease rate, or other

favorable provision, that at the inception of

the lease, it is likely that the lease will be

renewed beyond the fixed lease period

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.

(continued)

Residual Value

• If there is no bargain purchase option or

guarantee of the residual value, the lessor reacquires the property.

• If the actual amount of the residual value is unknown until the end of the lease term, it must be estimated at the inception of the

lease The residual value under these

circumstances is referred to as an

unguaranteed residual value

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 payments

• Lease payments sometimes include charges for items such as insurance, maintenance,

and taxes on the leased property These are referred to as executory costs and they are not included as part of the minimum lease

payment

Nature of Leases

• The implicit interest rate is the rate used by the lessor in calculating the desired lease

payment.

• For purposes of computing the present value

of the minimum lease payments, the lessee uses the lower of the implicit interest rate

used by the lessor and the lessee’s own

incremental borrowing rate

(continued)

Nature of Leases

• The lessee’s incremental borrowing rate is the rate at which the lessee could borrow

the amount of money necessary to

purchase the leased asset, taking into

consideration the lessee’s financial

situation and current conditions in the

marketplace.

General Classification Criteria—

Lessee and Lessor

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

option making it reasonably assured that the property will be purchased by the lessee at a future date

The four general criteria that apply to all leases for both the lessee and lessor relate to transfer of ownership, bargain purchase option, economic life, and fair value

General Classification Criteria—

Lessee and Lessor

property

payments at the beginning of the lease

market value of the leased asset

• This type of standard places the

responsibility of distinguishing the type of

lease on the accountant.

IAS 17 gives the following examples of

situations that “would normally lead to a

lease being classified as a finance lease”:

IASB Approach

a) The lease transfers ownership of the asset

to the lessee at the end of the lease term.

b) The lessee has the option to purchase the

asset at a price that is expected to be

sufficiently lower than the fair value at the date the option becomes exercisable.

(continued)

IASB Approach

c) The lease term is for the major part of the

economic life of the asset even if title is not transferred.

d) At the inception of the lease the present

value of the minimum lease payments

amount to at least substantially all of the

fair value of the leased asset.

Note the similarity between the

IAS 17 guidelines and those of the FASB They are the same in spirit.

Revenue Recognition

Criteria—Lessor

In addition to meeting one of the four general

criteria, a lease must meet two additional

revenue recognition criteria to be classified by the lessor as a capital lease:

by the lessor under the terms of the lease

are known or can be reasonably estimated

at the lease inception date

Accounting for Leases—Lessee

• All leases as viewed by the lessee may be divided into two types: operating leases

and capital leases.

• If the lease meets any one of the four

criteria, it is treated as a capital lease

Otherwise, it is an operating lease.

• Accounting for operating leases involves

the recognition of rent expense over the

term of the lease.

Accounting for Leases—Lessee

• Accounting for a capital lease essentially

requires the lessee to report on the

balance sheet the present value of the

future lease payments, both as an asset

and a liability.

• The asset is amortized as though it had

been purchased by the lessee.

• Lease period: 5 years, beginning January 1,

2013 Noncancelable

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

lease period: None

Marshall Corporation—Lessee

Marshall Corporation—LesseeAccounting for Capital

Leases—Lessee

Obligations under Capital Leases

250,192

To record the lease.

Marshall Corp Entries on January 1, 2013

Marshall Corp Entries on January 1, 2013

PMT = $60,000;

N = 5; I = 10%

(continued)Accounting for Capital

Leases—Lessee

• The term lease expense is used to record the executory costs related to the leased

equipment, such as insurance and taxes.

• When a lease is capitalized, the asset is

included on the balance sheet and written off over time The word amortization,

instead of depreciation , is typically used

when describing the systematic expensing

of the cost of a leased asset.

Accounting for Capital

Leases—Lessee

Marshall Corp Entries on December 31, 2013

Marshall Corp Entries on December 31, 2013

Amortization Expense on Leased

Accumulated Amortization on

Leased Equipment

If normal company depreciation policy for this

type of equipment is used, the amortization entry for 2013 is shown below:

(continued)Accounting for Capital

Leases—Lessee

Prepaid Executory Costs 5,000 Obligations under Capital

Leases 40,981 Interest Expense 19,019 Cash

regardless of whether the lease is

accounted for as an operating lease or a

capital lease.

(continued)

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 is part of the minimum lease

payments and should be included in the

capitalized value of the lease.

(continued)

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

lease period: None

Accounting for Leases with a

Bargain Purchase Option

(continued)

Minimum Lease Payments

Minimum Lease Payments

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 payments

$296,761

Accounting for Leases with a

Bargain Purchase Option

To transfer remaining balance in

leased asset account to equipment.

$68,182 ×

10%

($296,761/10) × 5

years

Accounting for Leases with a

Bargain Purchase Option

(continued)

If the equipment is not purchased and the lease

is permitted to lapse, the following entry is

required on December 31, 2017:

Loss from Failure to Exercise

Bargain Purchase Option 73,381

Obligation under Capital Leases 68,182

Accounting for Leases with a

Bargain Purchase Option

Accounting for Purchase of Asset During Lease Term

the lease payment due, the lessee purchased the leased property in the Marshall

Corporation example for $120,000

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)]

(continued)

The entry to record the purchase on the

lessee’s books would be as follows:

Accounting for Purchase of

Asset During Lease Term

Treatment of Leases on Lessee’s

Statement of Cash Flows

to the lessee in preparing a statement of cash flows

of leased assets would be treated the same as depreciation

interest expense would require no adjustment

under the indirect method and would be

reported as part of the cash payment for interest expense under the direct method

(continued)

In 2013, 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

Treatment of Leases on Lessee’s

Statement of Cash Flows

In addition, the supplemental disclosure to the statement of cash flows would include the

following two lease-related items:

the company leased equipment under a

capital lease arrangement The present value

of the minimum future payments under the

lease was $250,192 on the lease-signing

date

Treatment of Leases on Lessee’s

Statement of Cash Flows

Accounting for Leases—Lessor

• Direct financing leases involve a lessor

who is primarily engaged in financing

activities, such as a bank or finance

company The lessor views the lease as an investment.

• Sales-type leases involve manufacturers or dealers who use leases as a means of

facilitating the marketing of their products.

(continued)

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 that pay off the lease obligation plus interest

Accounting for Leases—Lessor

• For either an operating, direct financing, or sales-type lease, a lessor may incur

certain costs, referred to as initial direct

costs , in connection with obtaining the

lease.

• These costs include the costs to negotiate the lease, perform the credit check on the lessee, and prepare the lease documents.

Initial Direct Costs

(continued)

Accounting for Operating Leases—Lessor

Minimum payment (in advance) including

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

The entries to record the payment of the initial

direct costs and the receipt of the lease payment

on January 1, 2013 would be as follows:

Deferred Initial Direct Costs 15,000

To record the amortization of direct costs over five years and the depreciation of equipment over ten years using the straight-line basis:

Amortization of Initial Direct Costs 3,000

Deferred Initial Direct Costs

Universal Leasing Co (Lessor)

Universal Leasing Co (Lessor)

• 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 The cost to Universal Leasing Company was

again the same as its fair value, $296,761

the fair value in the previous example because,

in the previous example, the asset was

assumed to be worthless at the end of the

lease term

Lessor Accounting for Direct Financing Leases with Residual Value

To record initial lease on January 1, 2013:

Lease Payments Receivable 296,761

Equipment Purchased for Lease

296,761

(continued)

Receivable Recorded at Net Amount

Receivable Recorded at Net Amount

To record first payment on January 1, 2013:

To record payment on December 31, 2013:

To record recovery of the leased asset at the end

of the lease term on December 31, 2015:

Accounting for Sales-Type

Leases—Lessor

• In a sales-type lease, an immediate profit

or loss arises from the difference between the sales price of the leased property and the lessor’s cost to manufacture or

purchase the asset.

• If there is no difference between the sales

price and the lessor’s cost, the lease is

not a sales-type lease.

(continued)

Accounting for Sales-Type

Leases—Lessor

• 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

payments.

(continued)