Lecture Issues in financial accounting – Lecture 28: Accounting for leases

In this chapter students will be able to: Explain the nature, economic substance, and advantages of lease transactions; describe the accounting criteria and procedures for capitalizing leases by the lessee; contrast the operating and capitalization methods of recording leases;...

Accounting for Leases

PART III: Decision Tools

Lecture 28

1 Explain the nature, economic substance, and advantages of lease

transactions.

2 Describe the accounting criteria and procedures for capitalizing leases by

the lessee.

3 Contrast the operating and capitalization methods of recording leases.

4 Identify the classifications of leases for the lessor.

5 Describe the lessor’s accounting for direct-financing leases.

Learning Objectives

Learning Objectives

Accounting by Lessor

Special Accounting Problems

Capitalization criteria

Accounting differences Capital lease method

Operating method Comparison

Residual values Sales-type leases

purchase option Initial direct costs Current versus noncurrent Disclosure Unresolved

Bargain-Economics of leasing

Classification Direct-financing method

Operating method

Accounting for Leases

Accounting for Leases

LO 1 Explain the nature, economic substance, and

A lease is a contractual agreement between a lessor and a

lessee, that gives the lessee the right to use specific

property, owned by the lessor , for a specified period of time.

The Leasing Environment

The Leasing Environment

Who Are the Players?

The Leasing Environment

The Leasing Environment

Captive Leasing Independents

► Ford Motor Credit (Ford)

► IBM Global Financing

Market Share

47%

23%

26%

1 100% financing at fixed rates

2 Protection against obsolescence.

The Leasing Environment

The Leasing Environment

LO 1 Explain the nature, economic substance, and

Advantages of Leasing

Capitalize a lease that transfers substantially all of the

benefits and risks of property ownership, provided the

lease is noncancelable.

The Leasing Environment

The Leasing Environment Conceptual Nature of a Lease

Leases that do not transfer

substantially all the benefits

and risks of

ownership are operating leases.

Accounting by the Lessor and Lessee

Accounting by the Lessor and Lessee

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.

Lessor = Owner of property

Lessee Lessor Operating lease Operating lease Capital lease Capital lease

Direct financing lease Sales-type lease

Although technically legal

title may not pass, the

benefits from the use of

the property do.

The Leasing Environment

The Leasing Environment

Substance versus Form

Capital Leases and Installment Notes

prepare an amortization schedule for the payments

Effective Decrease Outstanding Date Payment Interest in Balance Balance

-Inception of the Agreement

Inception of the Agreement

At inception January 1

Installment Note

Equipment 1,000,000 Notes payable 1,000,000

Capital Lease

Leased Equipment 1,000,000 Lease payable 1,000,000

Classification Criteria

Classification 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.

 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 capital lease must meet capital lease one of four criteria: one

Operating Lease

Operating Lease

Capital Lease Capital Lease

Classification Criteria

Classification Criteria

A

A bargain purchase option (BPO) 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

The lease term lease term is normally considered to be the non-cancelable

term of the lease plus any periods covered by

term of the lease plus any periods covered by bargain renewal 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.

Additional Lessor Conditions

Additional Lessor Conditions

Lessor = Owner of the property subject to 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

Operating Leases

Operating Leases

Criteria for a capital lease

not met.

Criteria for a capital lease

not met.

Lease agreement

exists.

Lease agreement

Operating Leases

Operating Leases

On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation.The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is estimated to be six years Before deciding to lease, Sans Serif

considered purchasing the copier for its cash price of $479,079 If funds were borrowed to buy the copier, the interest rate would have been 10%

On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation.The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is

estimated to be six years Before deciding to lease, Sans Serif

considered purchasing the copier for its cash price of $479,079 If funds were borrowed to buy the copier, the interest rate would have been 10%

San Serif Publishers, Inc (Lessee) Prepaid rent 100,000

CompuDec Corporation (Lessor)

Unearned rent revenue 100,000

At End of the Four Payment Dates

Leasehold Improvements

Leasehold Improvements

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.

Capital Leases – Lessee and Lessor Capital Leases – Lessee and Lessor

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.

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.

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.

Capital Leases – Lessee and Lessee

Capital Leases – Lessee and Lessee

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.

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.

If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost.

If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost.

Capital Leases – Lessee and Lessor Capital Leases – Lessee and Lessor

 On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First

Lease Corp First Lease purchased the equipment from CompuDec

Corporation at a cost of $479,079.

 The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through

2015.The six year lease term ending December 31, 2016,is equal to the

estimated useful life of the copier.

 First Lease routinely acquires electronic equipment for lease to other firms The interest rate In these financing arrangements is10%.

 Since the lease term is equal to the expected useful life of the copier (>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.

Capital Leases – Lessee and Lessor Capital Leases – Lessee and Lessor

Direct Financing Lease (January 1, 2011)

San Serif Publishers, Inc (Lessee) Leased equipment (PV of payments) 479,079

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, 2011)

San Serif Publishers, Inc (Lessee) Lease payable 100,000

First Lease Corp (Lessor)

Capital Leases – Lessee and Lessor Capital Leases – Lessee and Lessor

Amortization Schedule for the Lease

Effective Decrease in Outstanding

1/ 1/ 11 $ 100,000 $ - $ 100,000 379,07912/ 31/ 11 100,000 37,908 62,092 316,98712/ 31/ 12 100,000 31,699 68,301 248,68612/ 31/ 13 100,000 24,869 75,131 173,55412/ 31/ 14 100,000 17,355 82,645 90,91012/ 31/ 15 100,000 9,090 * 90,910 -

Capital Leases – Lessee and Lessor Capital Leases – Lessee and Lessor

Second Lease Payment (December 31, 2011)

San Serif Publishers, Inc (Lessee) Interest expense 37,908 Lease payable 62,092

First Lease Corp (Lessor)

Lease receivable 62,092 Interest revenue 37,908

Depreciation Recorded at (December 31, 2011)

San Serif Publishers, Inc (Lessee) Depreciation expense 79,847

Accumulated depreciation 79,847

Sales-Type Leases

Sales-Type Leases

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).

At inception of the lease, the lessor will record

the Cost of Goods Sold as well as the Sales

Sales-Type Leases

Sales-Type Leases

On January 1, 2011, Sans Serif Publishers, Inc., leased

a copier from CompuDec Corp at a price of $479,079 The lease agreement specifies annual payments of

$100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through

2015 The six year lease term ending December 31,

2016, is equal to the estimated useful life of the copier CompuDec manufactured the copier at a cost of

$300,000.

CompuDec’s interest rate for financing the

transaction is10%.

Sales-Type Leases

Sales-Type Leases

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 difference from cost of the leased asset.

3 CompuDec is certain about the collectibility of the lease

payments, and

4 No costs are to be incurred by CompuDec relating to the

lease agreement,

SO

The lease agreement is classified as a Sales-Type lease from the

viewpoint of CompuDec (lessor) and a capital lease from the

viewpoint of Sans Serif Publishers (lessee).

Sales-Type Leases: Lessee

Sales-Type Leases: Lessee

At inception of the Lease – January 1, 2011

CompDec Corp (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue 479,079 Inventory of equipment 300,000

Receipt of the First Lease Payment – January 1, 2011

CompDec Corp.(Lessor)

Lease receivable 100,000

If the lessee capitalizes a lease, the lessee records an asset

and a liability generally equal to the present value of the rental

payments

 Records depreciation on the leased asset

 Treats the lease payments as consisting of interest and

principal

Accounting by the Lessee

Accounting by the Lessee

LO 2 Describe the accounting criteria and procedures

Journal Entries for Capitalized Lease

For a capital lease , the FASB has identified four criteria.

1 Lease transfers ownership of the property to the lessee.

2 Lease contains a bargain-purchase option.

3 Lease term is equal to 75 percent or more of the estimated

economic life of the leased property

Accounting by the Lessee

Accounting by the Lessee

One or more

must be met for finance lease

accounting

4 The present value of the minimum lease

payments (excluding executory costs)

equals or exceeds 90 percent of the fair

value of the leased property

Lease Agreement Leases that DO NOT meet

any of the four criteria are accounted for as Operating Leases.

Accounting by the Lessee

Accounting by the Lessee

LO 2 Describe the accounting criteria and procedures

Capitalization Criteria

Accounting by the Lessee

Accounting by the Lessee

Transfer of Ownership Test

 Not controversial and easily implemented

Bargain-Purchase Option Test

 At the inception of the lease, the difference between

the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured

Accounting by the Lessee

Accounting by the Lessee

Economic Life Test (75% Test)

 Lease term is generally considered to be the fixed,

noncancelable term of the lease

 Bargain-renewal option can extend this period

 At the inception of the lease, the difference between the

renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured

LO 2 Describe the accounting criteria and procedures

Capitalization Criteria

Illustration: Home Depot leases Dell PCs for two years at

a rental of $100 per month per computer and subsequently

can lease them for $10 per month per computer for another

two years The lease clearly offers a bargain-renewal

option; the lease term is considered to be four years

Accounting by the Lessee

Accounting by the Lessee

Recovery of Investment Test (90% Test)

LO 2

Accounting by the Lessee

Accounting by the Lessee

Minimum Lease Payments:

 Minimum rental payment

 Guaranteed residual value

 Penalty for failure to renew or extend the lease

Capitalization Criteria

Accounting by the Lessee

Accounting by the Lessee

Discount Rate

Capitalization Criteria

Lessee computes the present value of the minimum lease

payments using its incremental borrowing rate, with one

exception

► If the lessee knows the implicit interest rate computed

by the lessor and it is less than the lessee’s incremental

borrowing rate, then lessee must use the lessor’s rate