ACCOUNTING FOR LEASES

1. ACCOUNTING FOR LEASES CHAPTER 15 LEASES

2. Learning Objectives • Overview : Lease. • Types of Leases • Lease Agreements • Classification criteria in order to distinguish between the types of leases • Accounting for types of leases: • Both lessee and lessor • Disclosure & Presentation

3. Economic Advantages to Leasing • No down payment. • Avoid risks of ownership. • Flexibility. • Protection against obsolescence • use of an asset without showing the resources/sources.. Off-balance-sheet financing • …….

4. Accounting by the Lessor/Lessee A lease is a contractual agreement: lessor (Owner of Property) conveys the right to use property to lessee (User/Renter) in return for periodic cash payments For stated period of time Classification of leases>>>

5. Accounting for Leases and classifications: FASB 13 • Fundamental Rights and Responsibilities • Recognize the true Substance over the Form of the lease The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do.

6. CLASSIFICATION OF LEASE LEASES LESSOR LESSEE CAPITAL LEASE CAPITAL LEASE OPERATING LEASE OPERATING LEASE transfers ownership rental agreements DIRECT FINANCING SALES TYPE Classification Criteria:…>

7. CLASSIFICATION OF LEASE LEASES PART I PART II LESSOR LESSEE CAPITAL LEASE OPERATING LEASE transfers ownership rental agreements Classification Criteria:…>

8. 1. FASB (13) CRITERIA 1. Transfer of Ownership The lease contract includes a provision that the title to the leased asset passes to the lessee by the end of the lease term • Bargain Purchase Option (BPO) Makes it reasonably assured that the lessee will acquire asset allows the lessee to buy the leased asset at a price significantly lower than the asset’s fair value when the option is exercisable (BARGAIN PRICE) • Term: 75% of economic Life – Lease term is equal to 75% or more of the economic life of the leased asset 4. Asset Value: Present value of the minimum lease payments is greater than or equal to 90% of the FMV of the leased asset on the lease signing - what is included in Lease payments

9. CLASSIFICATION OF LEASE:LESSEE MUST MEET JUST ONE CRITERIA Lease Agreement Non-Cancellable Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease Determine if the risks/rewards of ownership transferred to lessee

10. ACCOUNTING FOR CAPITAL LEASEPURCHASE/OWNERSHIPLESSEE (books) • Determine the criteria: • 1. Ownership transfer • 2. Bargain purchase option • 3. PV of MLP (minimum lease payment) is equal to 90% of more • 4. Lease term 75% or more of estimated economic life

11. Calculation of CAPITAL LEASELESSEE (books) • Determine the criteria: (any one…) • Lease is classified as: CAPITAL LEASE LESSEE’S BOOKS DR. ASSET: LEASE PROPERTY CR. LEASE OBLIGATION (PAYABLE)

12. CAPIALIZED AMOUNTLessee • The Lessee records the lease an asset/liability: LESSER OF: 1. FAIR VALUE of the asset at the inception of lease or 2. PV of MLP (PVMLP) Question: what should be included in the PVMLP

13. Residual Value (RV)Guaranteed or Unguaranteed • Estimated Value at the end of the lease term! • GUARANTEED RV is additional payment at the end of the lease term • If Bargain Purchase Option: • GRV becomes irrelevant • UNGUARANTEED: not required to make additional payment at the end of the lease term

14. Accounting by the Lessee PV OF MINIMUM LEASE PAYMENTS (PVMLP) Minimum lease payments: • PV rental payment (usually beginning of the period) • Plus: PV Guaranteed residual value • (unguaranteed : NOT included in PVMLP)

15. CAPITAL Leases - Lessee The amount recorded (capitalized) is the PVMLP. However, the amount recorded cannot exceed the fair value of the leased asset. • the interest rate used by the lessee is the lower of: • Its incremental borrowing rate, or • The implicit interest rate used by the lessor.

16. ACCOUNTING FORCAPITAL LEASE: LESSEE LESSEE Asset user • Asset & Liability are recognized • Amount: PV of Lease payments • Including any BPO or Guarantee Residual Value (GRV) Lease payments reduction in Lease Liability & Increases to interest expense (relates to liability) Let’s Illustrate… Asset is subsequently Depreciated *

17. Depreciation of Asset:Rules*: • Transfer of Ownership: Depreciate over asset life (Legal form) • Bargain purchase option: Depreciate over the asset life (legal form) • Term (75%) : Depreciate lease term (substance over form) • Asset Value (90% FV): Depreciate over lease term (substance over form)

18. Executory Costs • Ownership of the asset is responsible for Insurance, maintenance, etc Capital Lease: Lessee gets the benefit of using the asset (LESSEE’s expense) Dr. Maintenance expense (executory costs) Cr Cash • (if included in lease payment – deduct to calculate PV MLP) • If lessor makes the payment, these costs are reimbursed by lessee by recording the expense

19. LEASEPART IIAccounting for Leases- Lessor • Classification of Lease: LESSOR’S BOOK

20. CLASSIFICATION OF LEASE: LESSOR LEASES LESSOR LESSEE CAPITAL LEASE CAPITAL LEASE OPERATING LEASE OPERATING LEASE DIRECT FINANCING SALES TYPE Classification Criteria:…>

21. Accounting by the Lessor Classification of Leases by the Lessor

22. Accounting by the Lessor Classification of Leases by the Lessor If any costs to the lessor to be incurred, are reasonably predictable A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

23. 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- DIRECT FINANCING LEASE 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 – SALES TYPE LEASE

24. Direct-Financing Lease: Lessor

25. Depreciation: NOT RECORDED BY LESSOR • Asset is removed from the Lessor’s books Illustration: DIRECT FINANCING…. LESSOR-

26. Initial Direct Costs costs incurred by the lessor in negotiating/preparing a lease agreement. e.g. Legal fees, commissions • Operating Leases− Capitalize and amortize over the lease term by the lessor. • Direct Financing Leases− not expensed ; deferred and recognized over the lease term • Sales type leases: expensed at the inception of the lease (selling expense)

27. How should the lease be classified by LESSOR • Since the fair value equals the lessor’s carrying value, there is no dealer’s profit, making this a direct financing lease. • Prepare appropriate entries for Canfor (lessor)

28. Sales-Type Lease: LESSOR Total payments – sale price = interest

29. Accounting for Sales-Type LeaseLESSOR Record: • Receivable (PV) & Sales • Cost of goods sold / reducing the inventory • Any Initial Direct Costs recognized as an expense immediately • Reimbursement of executory costs – same as direct financing

30. Sales Type Lease with Guaranteed Residual Value • Guaranteed Residual Value: Both Lessee and Lessor include Guaranteed Residual Value in calculating MLP • If RV is not guaranteed by Lessee (Lessee exclude in MLP) • LESSOR: • Lessor : even if it is not guaranteed by lessee, lessor expects to receive from 3rd party • Includes residual value in their receivable • But the sales revenue and COGS are reduced by the same amounts

31. 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.

32. (continued)

35. International Accounting of Leases • IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases.