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Strategic Accounting

Strategic Accounting. Accounting for Leases. Basic Lease Terms. A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee . Lessor: Owner of property. Lessee: User of property. Lease Classifications.

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Strategic Accounting

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  1. Strategic Accounting Accounting for Leases

  2. Basic Lease Terms A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee. Lessor: Owner of property Lessee: User of property

  3. Lease Classifications Finance lease if the lease transfers substantially all the risks and rewards incident to ownership to the lessee. Otherwise, it is an operating lease.

  4. Ownershiptransfers to the lessee A bargain purchase option(BPO) exists The noncancelable lease term is for a major portion of the expected economic life of the asset The PV of the minimum lease payments is substantially all of the fair valueof the asset The leased asset is of a specialized nature such that only the lessee can use itwithout major modifications being made Finance Lease Classification Situations that normally indicate a finance lease :

  5. The lessee is entitled to cancel the lease and the lessor's losses associated with the cancellation are borne by the lessee Gains or losses from changes in the fair value of the residual value go to the lessee The lease contains a bargain renewal option whereby the lessee can continue the lease for a secondary period at a rent that is substantially lower than market rent Finance Lease Classification Situations that might indicate a finance lease :

  6. Finance Lease A finance lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease. Leased Asset PV Lease liability PV

  7. IFRS/U.S. GAAP Difference • Under U.S. GAAP, identification of a finance lease (capital lease) is more objective • Less judgment, more specificity • If it meets any one of four criteria • “Rules-based” vs “principles-based”

  8. Ownershiptransfers to the lessee during or at the end of the lease term, or . . . A bargain purchase option(BPO) exists, or . . . The noncancelable lease term is equal to 75% or moreof the expected economic life of the asset, or . . . The PV of the minimum lease payments is 90% or more of the fair valueof the asset. The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options. IFRS/U.S. GAAP Difference A capital lease if it meets one of four criteria: A BPO gives the lessee the option to purchase the leased asset at a price sufficiently less than the expected fair value of the asset that the exercise of the option appears reasonably assured.

  9. Additional Lessor Conditions • The four classification apply to both the lessee and lessor. However, for the lessor, the agreement must meet two additional conditions for the lease to be a non-operating lease (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.

  10. Simply record rent over the lease term Operating Leases Not considered a finance lease. Record lease as an Operating Lease

  11. OPERATING LEASES On January 1, 2009, Sans Serif Publishers, Inc., leased a color copier from CompuDecCorporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2009, the inception of the lease, and at each January 1 through 2012. The useful life of the copier is estimated to be six years. 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%.  How should this lease be classified?

  12. JUDGMENT 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease termat least equal to the major portion of the expected economic life of the asset? ?{4 yrs vs 6 yrs} 4 Is the PV of the lease payments substantially ?of the fair value of the asset? {$348,685 vs $479,079} $100,000 x 3.48685** = $348,685lease present payments value ** present value of an annuity due of $1: n=4, i=10% 5 Is the leased asset of a specialized nature so only the lessee can use it without major modifications? NO • Key question is whether the lease arrangement transfers substantially all the risks and rewards of ownership to the lessee. • Substance over form.

  13. Operating Leases At Each of the Four Payment Dates Sans Serif Publishers, Inc. (Lessee)Prepaid rent 100,000 Cash 100,000 CompuDec Corporation (Lessor)Cash 100,000 Unearned rent revenue 100,000 At the End of Each Year Sans Serif Publishers, Inc. (Lessee)Rent expense 100,000 Prepaid rent 100,000 CompuDec Corporation (Lessor)Unearned rent revenue 100,000 Rent revenue 100,000 Depreciation expense x,xxx Accumulated depreciation x,xxx

  14. Operating Leases ADVANCE PAYMENTS  Advance payments are considered prepayments of rent. Theyare deferred and allocated to rent over the lease term. LEASEHOLD IMPROVEMENTS Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease.  If a lessee constructs a new building on or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets, its cost is allocated as depreciation expense over its useful life to the lessee, which will be the shorter of the physical life of the asset or the lease term.

  15. Let’s look at finance leases now.

  16. Finance Leases – Lessee and Lessor Calculations On Jan.1,2009, Sans Serif leased a copier from First LeaseCorp. which purchased the equipment from CompuDec at a cost of $479,079. • Annual payments beginning Jan. 1, the inception of the lease, and at each Dec. 31 through 2013. • The 6-year lease term is equal to the estimated life of the copier. • The interest rate is 10%. Lessor: $479,079 ÷ 4.79079** = $100,000 lessor’s rental cost payments Lessee: $100,000 x 4.79079** = $479,079 rental lessee’s payments cost ** present value of an annuity due of $1: n=6, i=10%

  17. IFRS/U.S. GAAP Difference Present value of minimum lease payments. Under IAS 17, both parties to a lease generally use the rate implicit in the lease to discount minimum lease payments. Under U.S. GAAP, lessors use the implicit rate, and lessees use the incremental borrowing rate unless the implicit rate is known and is the lower rate.

  18. Finance Leases – Lessee and Lessor Entries Inception of Lease [Jan. 1, 2009] Sans Serif Publishers, Inc. (Lessee) Leasedequipment (present value of payments) 479,079Lease payable (present value of payments) 479,079 First LeaseCorp (Lessor) Lease receivable (present value of payments) 479,079 Inventory of equipment (lessor’s cost) 479,079 First Lease Payment [Jan. 1, 2009] Sans Serif Publishers, Inc. (Lessee) Lease payable 100,000Cash 100,000 First LeaseCorp (Lessor) Cash 100,000Lease receivable 100,000

  19. Second Lease Payment[Dec. 31, 2009] Sans Serif Publishers, Inc. (Lessee) Finance expense (10% x [$479,079 – 100,000])37,908 Lease payable (difference) 62,092Cash (lease payment) 100,000 First LeaseCorp (Lessor) Cash (lease payment) 100,000Lease receivable (difference) 62,092 Finance revenue (10% x [$479,079 – 100,000]) 37,908 Effective Rate Outstanding Balance

  20. LEASE AMORTIZATION SCHEDULE Effective Decrease Outstanding Payments Interest in Balance Balance 10% x Outstanding Balance 1/1/09 479,079 1/1/09 100,000 100,000 379,079 12/31/09 100,000 .10 (379,079) = 37,908 62,092 316,987 12/31/10 100,000 .10 (316,987) = 31,699 68,301 248,686 12/31/11 100,000 .10 (248,686) = 24,869 75,131 173,555 12/31/12 100,000 .10 (173,555) = 17,355 82,645 90,910 12/31/13100,000.10 (90,910) =9,09090,910 0 600,000 120,921 479,079 No interest yet; no time has passed.

  21. DEPRECIATION End of Each Year Sans Serif Publishers, Inc. (Lessee) Depreciation exp. ($479,079 ÷ 6 years*) 79,847Accumulated depreciation 79,847 * if the lessee depreciates assets by the straight-line method The lessee normally should depreciate a leased asset over the term of the lease. However, if: (a) ownership transfers, or (b) a bargain purchase option is present (i.e., either of the first two classification indicators is present) the asset should be depreciated over the asset's useful life.

  22. Manufacturer or Dealer Lessors Finance Lease On January 1, 2009, Sans Serif Publishers, Inc. leased a copier from First LeaseCorp at a “price” of $479,079. On January 1, 2009, Sans Serif Publishers, Inc. leased a copier from CompuDec at a “price” of $479,079.  The lease agreement specifies annual payments of $100,000 beginning Jan.1, 2009, the inception of the lease, and at each Dec. 31 through 2012. The six-year lease term 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 is 10%. Lease receivable (PV of lease payments) 479,079 Cost of goods sold (lessor’s cost) 300,000 Sales revenue (PV of lease payments) 479,079 Inventory of equipment (lessor’s cost) 300,000 First Lease Payment Cash 100,000 Lease receivable 100,000  First LeaseCorp purchased the copier at a cost of$479,079.  First LeaseCorp’s interest rate for financing the transaction is 10%. 479,079 Now, let’s make it a dealer lease Since the lessor’s cost is $300,000, a dealer’s profit exists.

  23. Sale-Leaseback Arrangements • The owner sells an asset and immediately leases it back from new owner. • 1. The seller-lessee receives cash from the sale of the asset. • 2. The seller-lessee makes payments to the buyer-lessor. • Finance Lease • Teledyne Distribution Center sold its four warehouses for $900,000, then leased them back. • Carrying value:$600,000 (original cost $950,000) • Sale date: December 31, 2009. • Lease term: 10 years, Annual payments: $133,155 beg. Dec. 31, 2009. • Est. remaining useful life: 10 years • Annual lease payments (PV $900,000) provide the lessor with a 10% rate of return on the financing arrangement. Teledyne’s incremental borrowing rate is 10%. • Teledyne depreciates its warehouses on a S-L basis.

  24. Sale-Leaseback Arrangements December 31, 2009 Cash 900,000Accumulated depreciation ($950,000 - 600,000) 350,000 Warehouses (cost) 950,000Deferred gain on sale-leaseback (difference) 300,000 Leasedequipment (PV of lease payments) 900,000 Lease payable (PV of lease payments) 900,000 Lease payable 133,155 Cash 133,155 December 31, 2009 Finance expense (10% x [$900,000 - 133,155]) 76,684Lease payable (difference) 56,471 Cash (payment) 133,155 Depreciation expense ($900,000 ÷ 10 years) 90,000 Accumulated depreciation 90,000 Deferred gain on sale-leaseback ($300,000 ÷ 10 yrs) 30,000 Depreciation expense 30,000

  25. Sale-Leaseback Arrangements Operating Leases If the leaseback portion of the previous sale-leaseback transaction were classified as an operating lease, the gain would be recognized immediately and reported in the income statement. (There is no leased asset to depreciate.): Cash 900,000Accumulated depreciation ($950,000 - 600,000) 350,000 Warehouses (cost) 950,000Gain on sale-leaseback (difference) 300,000

  26. IFRS / U.S. GAAP Difference Operating Leases Under U.S. GAAP, the leaseback portion of the previous sale-leaseback transaction were classified as an operating lease, the gain still would be deferred, but would be recognized as a reduction of rent expense rather than depreciation. (There is no leased asset to depreciate.): December 31, 2009 Deferred gain on sale-leaseback ($300,000 ÷ 10 yrs) 30,000 Rent expense 30,000

  27. Real Estate Leases Leases of Land Only  Since the useful life of land is indefinite, the risks and rewards of ownership cannot be presumed transferred unless title is expected to transfer—outright or by the expected exercise of a BPO (indicator 1 or 2).  Classified as operating leases unless title to the land is expected to transfer. Depreciation is inappropriate. Leases of Land and Building  When ownership is expected to transfer, each leased asset is recorded separately (on the basis of their relative market values).  Otherwise, the land lease is an operating lease, and the building lease can be either.  Exception: when the FV of the land is immaterial, the land and building are treated as a single unit.

  28. IFRS / U.S. GAAP Difference Leases of Land and Buildings. • Under IAS 17, land and buildings elements are considered separately unless the land element is “not material”. • Under U.S. GAAP, materiality is defined precisely and with a higher threshold. Land and building elements are accounted for separately unless land represents more than 25% of the total FV. • If the land’s value is less than 25% of the combined FV, it is in effect ignored and the land and building are treated as a single unit.

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