leases

1. Chapter 15 leases

2. Accounting by the Lessor and Lessee A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessee = Renter Lessor = Owner of property

3. Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

4. Inception of the Agreement January 1

5. First Semi-Annual Payment Date June 30

6. Ownershiptransfers 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 moreof the expected economic life of the asset, or . . . The PV of the minimum lease payments (MLP) is 90% or more of the fair valueof the asset. Lease Classification Operating Lease Capital Lease A capital leasemust meet one of four criteria:

7. Classification Criteria A 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 lease term is normally considered to be the non-cancelable term of the lease plus any periods covered by 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.

8. Additional Lessor Conditions • 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 lease: • The collectibility of the lease payments must be reasonably predictable. • If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete. Lessor = Owner of the property subject to the lease.

9. Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. CapitalLease

10. Nonoperating Leases - Lessee 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: • Its incremental borrowing rate, or • The implicit interest rate used by the lessor.

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

12. On January 1, 2009, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease specifies annual payments of $6,000 beginning 1/1/09 and at each December 31st through 2012. The equipment has an economic life of 5 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment. Nonoperating Leases

13. The lease term meets the “75% of the economic life” test. Nonoperating Leases - Lessee

14. The PV of the payments ³ 90% of the equipment’s fair value Nonoperating Leases - Lessee

15. Matrix makes the following entries at inception of the lease. Nonoperating Leases - Lessee

16. Nonoperating Leases - Lessor In addition to the information given earlier, the lessor (RentPro) knows that the collectibility of the lease payments is reasonably predictable, and there are no future costs to be incurred. RentPro’s performance is substantially complete as far as the lease is concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is $25,873 (rounded).

17. Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair value, the lease is classified as a Direct Financing Lease.

18. Lease Amortization Schedule $19,873 × 8% = $1,590 $19,873 - $4,410 = $15,463 $6,000 - $1,590 = $4,410

19. December 31, 2009, entry by Matrix. December 31, 2009, entry by RentPro. Nonoperating Leases

20. Depreciation by Lessee Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets. If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase option, the asset is depreciated over theasset’seconomic life; otherwise, it is depreciated over thelease term.

21. $25,8735 years = $5,175 Depreciation by Lessee At December 31, 2009, Matrix prepares the following entry to recognize depreciation expense for the year.

22. If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset. Sales-Type Leases At inception of the lease, the lessor will record theCost of Goods Soldas well as the Sales Revenue(PV of payments).

23. On January 1, 2009, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease specifies annual payments of $6,000 beginning 1/1/09 and at each December 31st through 2012. The equipment has an economic life of 5 years and a fair value of $25,873. The equipment has a cost basis in the hands of RentPro of $19,873. Title to the leased equipment passes to Matrix at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment. Sales-Type Leases

24. Matrix makes the following entries at inception of the lease. Sales-Type Leases: Lessee

25. Sales-Type Leases: Lessor Because the cost of the asset is not equal to its fair value, the lease is classified as a Sales-Type Lease.

26. Residual Value The residual value of a leased asset is an estimate of what its commercial value will be at the end of the lease term. We need to determine the proper accounting for residual value by both the lessee and lessor.

27. Residual Value Lessee Obtains Title to Leased Asset The only impact on the lessee is the determination of depreciation expense. The cost of the asset will be reduced by the estimated residual value and depreciated over the economic life of the asset.

28. Residual Value Lessor Retains Title to Leased Asset In determining the lease payment amount, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payments.

29. Residual Value Guaranteed by Lessee • The accounting for a direct financing lease will be the same as without the residual value, with two exceptions: • The lessee reduces the cost basis of the asset by the guaranteed residual value to calculate depreciation expense, and • If at the end of the lease term the appraised value of the asset is less than guaranteed amount, the lessee must pay the difference between appraised value and guaranteed residual value to the lessor.

30. Executory Costs Executory costs include costs of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible for the executory costs, they are treated as expenses by the lessee. In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

31. Initial Direct Costs Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. • Operating Leases− Capitalize and amortize over the lease term by the lessor. • Direct Financing Leases− Include as part of investment balance.

32. Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

33. Lessee Disclosures • For capital leases, disclose • Gross amount of assets recorded under capital leases. • Future MLP in the aggregate and for each of the five succeeding years. • Total minimum sublease rentals to be received in the future under non-cancelable subleases. • Total contingent rentals.

34. Lessee Disclosures • For operating leases in excess of one year, disclose • Future minimum rental payments required in the aggregate and for each of the five succeeding fiscal years. • Total of minimum rentals to be received in the future under non-cancelable subleases. • For all operating leases, disclose rental expense, with separate amounts for minimum rentals, contingent rentals, and sublease rentals.

35. Lessee Disclosures • Provide a description of the lessee’s leasing arrangements including, but not limited to • The basis on which contingent rental payments are determined. • The existence and terms of renewal or purchase options and escalation clauses. • Restrictions imposed by lease agreements such as those concerning dividends, additional debt, and further leasing.

36. Lessor Disclosures • For operating leases, disclose • Cost and carrying amount of property on lease or held for leasing. • Minimum future rentals on non-cancelable leases in the aggregate and for each of the five succeeding years. • Total contingent rentals included in income. • Provide a general description of the lessor’s leasing arrangements.

37. Lessor Disclosures • For sales-type and direct financing leases, disclose • Components of the net investment in sales-type and direct financing leases • Future MLP to be received. • Unguaranteed residual values. • Unearned Interest Revenue. • Future MLP to be received for each of the five succeeding fiscal years. • Total contingent rentals included in income.

38. Balance Sheet and Income Statement • Lease transactions impact several financial ratios • Debt to equity ratio – Lease liabilities are recorded. • Rate of return on assets – Lease assets are recorded. • Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

39. Special Leasing Arrangements • Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately. • Real Estate Leases: • Leases of Land Only • Leases of Land and Building • Leases of Only Part of a Building • Leveraged Leases – a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment.

40. End of Chapter 15