ACG 3141 Installment Notes (Ch. 14) & Leases (Ch. 15)

1. ACG 3141Installment Notes (Ch. 14) &Leases (Ch. 15)

2. Installment Notes & Leases • Class 11: • Accounting for Installment Notes (Chapter 14) • Lease Accounting Issues in General • Lessee Lease Classification (Operating vs. Capital) • Accounting for Operating Leases (Lessee and Lessor) • Accounting for Capital Leases (Lessee) • Class 12: • Lessor Lease Classification (Operating, Direct Financing or Sales-Type) • Accounting for Direct Financing Lease (Lessor) • Accounting for Sales-Type Lease (Lessor) • Other Issues (Discount Rates, Bargain Purchase Options, Residual Value, Sale-Leaseback)

3. When debt is an installment note, in addition to interest paid, each payment has a portion of principal paid. At the end of the term, there is no balance left in the note payable account. A mortgage is an example of an installment note. To compute cash payment (i.e., annuity), the Note Payable (i.e., FV of asset transferred) must be known. Use present value tables (PVAD if payment is made up front; PVA if payment made at the end of the period). For example, if on 2/1/08 Mary purchases a computer for a note payable of $10,000 to be paid in three equal installments starting on 2/1/08. The amount of the payments would be calculated by dividing $10,000 by the PVAD Discount factor (n= applicable interest rate, i=3). To compute Note Payable, the cash payment must be known. MULTIPLY the cash payment x PVAD (or PVA) factor to compute. Interest expense (for debtor) or revenue (for creditor) each period: Effective interest rate × Outstanding balance of debt = Interest expense or revenue Principal reduction (reduction in payable for debtor & reduction in receivable for creditor): Cash payment – Interest component = Principal reduction per period Installment Notes

4. PV of annuity of $1, n = 4, i = 9% Installment Notes On January 1, 2006, Matrix, Inc. purchased a truck by issuing a 4-year note payable to Apex Motors. The truck cost $50,000 and is financed at a 9% interest rate. Payments are made at the end of each of the next four years. Let’s calculate the annual payment. $50,000 ÷ 3.23972 = $15,433 (rounded)

5. Installment Notes Here is our loan amortization table. Effective interest = prior outstanding balance x interest rate (9%) Decrease in Debt = Cash payment – Effective Interest

6. Apex Motors - Seller Installment Notes The entries on date of purchase are: Matrix, Inc. - Purchaser

7. Apex Motors - Seller Installment Notes Date of first payment. Matrix, Inc. - Purchaser

8. Installment Notes & Leases If a lease is a “capital lease” under GAAP rules, it is accounted for in a manner similar to an installment note.

9. Leases Lease Basics and Operating Leases

10. LEASE BASICS

11. Advantages of Leasing • Leasing is used as a means of “off-balance-sheet financing.” • Can avoid negatively affecting the debt-equity ratio and other mechanical indicators of risk. • Assumes market is naive, and is “fooled” by off-balance-sheet financing. • Achieves operational objectives by facilitating asset acquisition to overcome: • Uncertainty or cash flow problems. • Time constraints and/or bureaucratic control systems. • Fear of obsolescence. • Achieves tax objectives: A lessee often can negotiate lower lease payments if it allows the lessor to retain ownership and thus benefit from depreciation deductions when: • The lessee has little or no taxable income and will get little benefit from depreciation deductions. • The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessors.

12. Conceptual Nature of a Lease This is an example of “substance over form” determining the accounting for a transaction. If a lease is a capital lease then, in substance, it is more of a sale transaction than a lease transaction.

13. Classification of Leases • From the perspective of the lessee, we have two types of leases. The first lease is referred to as an operating lease, and the second is known as a capital lease. We view a capital lease as an in-substance purchase of an asset. • From the perspective of the lessor, we have three types of leases. We have an operating lease, a direct-financing-type lease, and a sales-type lease. Similarly, Direct Financing and Sales-Type leases are viewed as in-substance sales of an asset.

14. Classification of Leases: Lessee Lessee classifies leases as one of the following: • Operating Lease • Capital Lease

15. Accounting for Operating Leases - Lessee • Operating Lease • If Rent Due at the Beginning of a Period: • At inception: If rent is paid up front at inception, the lessee: Dr. Prepaid Rent (a current asset account) Cr. Cash for the amount paid. As prepaid rent expires, Dr. Rent Expense Cr. Prepaid Rent for the amount used/expired. • During the term: If rent is due at the beginning of each year, the entries each year are the same as above. • If Rent is Due at the End of a Period: If rent is not paid up front, the lessee: Dr. Rent Expense Cr. Cash or Rent Payable* *depending upon whether payment is made first, or a period end occurs before rent for the period is paid. • Depreciation: Because this transaction is a “true lease,” the leased asset remains on the lessor’s books and the lessee should not record an asset or accrue depreciation expense with respect to the leased asset.

16. Accounting for Operating Leases - Lessor • Operating Lease: • If Rent Due at the Beginning of a Period: • At inception: If rent is paid up front at inception, the lessor: Dr. Cash Cr. Unearned Rent Revenue (a current liability account) for the amount paid. As prepaid rent expires, Dr. Unearned Rent Revenue Cr. Rent Revenue for the amount used/expired. • During the term: If rent is due at the beginning of each year, the entries each year are the same as above. • If Rent is Due at the End of a Period: If rent is not paid up front, the lessor: Dr. Rent Receivable or Cash* Cr. Rent Revenue *depending upon whether payment is made first, or a period end occurs before rent for the period is paid. • Depreciation: Because this transaction is a “true lease,” the leased asset remains on the lessor’s books and the lessor continues to accrue depreciation expense on the asset (if it is depreciable).

17. Operating Lease Example: • On January 1, 2006, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDecCorporation. • The lease agreement specifies four annual payments of $100,000 beginning January 1, 2006, the inception of the lease, and at each January 1 through 2009. The useful life of the copier is estimated to be six years. REQUIRED: What are the entries for both the Lessee (Sans Serif) and the Lessor (CompuDec) at the lease inception and at each of the four payment dates and at the end of each year (assuming that both companies have a 12/31 year end)?

18. Operating Lease Example, cont’d At inception and at each payment (1/1); Sans Serif Publishers, Inc. (Lessee)Dr. Prepaid rent 100,000 Cr. Cash 100,000CompuDec Corporation (Lessor)Dr. Cash 100,000 Cr. Unearned rent revenue 100,000

19. Operating Lease Example, cont’d On each 12/31 (2006 – 2009) Sans Serif Publishers, Inc. (Lessee): As prepaid rent expires, it become rent expense (i.e., decreases net income). Dr. Rent expense 100,000 Cr. Prepaid rent 100,000CompuDec Corporation (Lessor): As unearned revenue is earned, it is becomes rent revenue (i.e., increases net income) Dr. Unearned rent revenue 100,000 Cr. Rent revenue 100,000 Dr. Depreciation expense x,xxx Cr. Accumulated depreciation x,xxx

20. Non-operating Leases (Lessee) Capital Lease

21. Classification of Leases: Lessee, cont’d If a lease is not a capital lease under any of these criteria, it is classified by the lessee as an operating lease

22. Classification of Leases: Lessee, cont’d Bargain Purchase Option 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.

23. Accounting by the Lessee Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement 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

24. Lessee Accounting for Leases, cont’d • Capital Lease • In a capital lease transaction, the lease transaction is treated as a sale (i.e., substance over form). The lessee records an asset (Leased Equipment) and a liability (Lease Payable). The amount recorded is the present value of minimum lease payments. • Over the term of the lease, there will be an interest component (i.e., the PV of the lease payments at lease inception will be less than the gross amount of payments due under the lease). The effective interest method is used to allocate the rental payments between principal and interest (this accounting is identical to the accounting for installment notes – see Chapter 14) • As payments are made, the lessee will Debit the Lease Payable, Debit Interest expense and Credit cash. • The asset is depreciated by the lessee over the economic life of the asset.

25. Lessee Accounting for Leases, cont’d • Present Value of Minimum Lease Payments: • Minimum lease payments can include the rent due under the lease and any bargain purchase option. • Bargain Purchase Option: 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 amount of any bargain purchase option to be paid by the lessee will be included in minimum lease payments. • Calculating PV of minimum lease payments: PV of the stream of rent payments plus the PV of any BPO calculated by the applicable discount rate (interest rate). • PV of Rent Payments: Use the PVA table if rent is paid at the end of a period and the PVAD table if rent is paid at the beginning of a period. • PV of Bargain Purchase: Use the PV of $1 table to calculate

26. Lessee Accounting for Leases, cont’d Depreciation by Lessee • Depreciation expense is recorded in a manner consistent with the lessee’s usual policy concerning depreciation of other operational assets. • Lessee useful life: If title passes to the lessee at the end of the lease term, or if the lease contains a bargain purchase option, the asset is depreciated over the asset’s economic life; otherwise, it is depreciated over the lease term.

27. Lease Classification Example: • On January 1, 2006, 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, 2006, the inception of the lease, and at each January 1 through 2009. 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%. REQUIRED: How should this lease be classified?

28. Lease Classification Example, cont’d. APPLY THE FOUR CRITERIA: • Does the agreement specify that ownership of the asset transfers to the lessee? NO • Does the agreement contain a bargain purchase option? NO • Is the lease termequal to75% or more of the expected economic life of the asset? NO {4 yrs < 75% of 6 yrs} • Is the present value of the minimum lease payments equalto or greater than 90% of the fair value of the asset? NO {$348,685 < 90% of $479,079} $100,000 x 3.48685** = $348,685lease presentpayments value ** present value of an annuity due of $1: n=4, i=10% Since none of the four classification criteria is met, this is an operating lease. Note that since the lease is an operating lease to the lessee, it must also be an operating lease to the lessor. The first criteria to a sales-type or direct financing lease to a lessor is that the lease is a capital lease to the lessee. Lessee and Lessor Accounting for Operating Leases is shown above.

29. Capital Lease: Lessee • On January 1, 2006, Sans Serif Publishers, Inc. leased a copier from First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease is noncancelable. The lease begins 1/1/2006 and ends 12/31/2011. • The lease agreement specifies annual payments of $100,000 beginning January 1, 2006, the inception of the lease, and at each January 1 through 2011. The lease term is equal to the estimated useful life of the copier. The interest rate is 10%. • Assume both parties use straight-line depreciation. • Lease Classification: Title doesn’t transfer, and there is no bargain purchase under the lease. However, because lease term is equal to the useful life of the asset, the lease meets the 75% test and is classified as capital to the lessee. Also, as shown on the next slide, the lease meet the 90% test. • REQUIRED: 1) Prepare the lessee’s lease amortization schedule, 2) the lessee’s entry at lease inception, 3) the lessee’s entry for the first rent payment on 1/1/2006, and d) the lessee’s entries at year-end on 12/31/2006.

30. Capital Lease: Lessee, cont’d. PV Minimum Lease Payments: $100,000 x 4.79079** = $479,079 annual rental lessee’s payments cost ** present value of an annuity due of $1: n=6, i=10% Note: The Annuity Due table (PVAD) is used because the lease payments are made at the beginning of the lease period. Note: If First LeaseCorp acquired the copier immediately before it was leased to Sans Serif, the PV of the minimum lease payments would be equal to 100% of the FV of the asset and the lease would also qualify as a capital lease under the 90% test.

31. Capital Lease: Lessee, cont’d Lease Amortization Schedule (Lessee) Jan 1

32. Capital Lease: Lessee, cont’d. Entries at Lease inception 1/1/2006: Sans Serif Publishers, Inc. (Lessee)Dr. Leasedequipment (PV of payments) 479,079 Cr. Lease payable (PV of payments) 479,079 First Lease Payment [January 1, 2006] Sans Serif Publishers, Inc. (Lessee)Dr. Lease payable 100,000 Cr. Cash 100,000 Note that there is no interest component to the first rent payment if the payment is made at the beginning of the lease term because no time has passed during which interest would have accrued.

33. Capital Lease: Lessee, cont’d Entries at 12/31/2006 (Financial Statement Reporting): Interest must be accrued: Interest expense must be accrued at the effective rate x the outstanding balance at the beginning of the period x # months outstanding /12. At 12/31/2006, this is: 379,079 (bal. on 1/1/2006) x 10% x 12/12 = 37,908 Debit Interest Expense 37,908 Credit Interest Payable 37,908 At 12/31/2006 12 months of Depreciation must be accrued: Debit Depreciation Expense 79,847 Credit Accumulated Depreciation 79,847 Annual Depreciation Expense = Asset Cost (479,079) ÷ lease term (6 years) = $79,846.50 per year. Because title doesn’t transfer and there is no BPO, the lease term is the useful life.

34. Capital Lease: Lessee, cont’d. Second Lease Payment January 1, 2007 Sans Serif Publishers, Inc. (Lessee) Dr. Interest Payable 37,908 Write off payableDr. Lease payable (difference) 62,092 Cr. Cash (rental payment) 100,000 The interest expense was recognized in the financial statements in 2006, thus, the interest payable is written off when the rent is paid.

35. Other Issues: Discount Rate Used by Lessee • The lessor’s implicit rate is the effective interest rate the lease payments provide the lessor over and above the “price” at which the asset is “sold” under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the rental payments. • Usually, the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair market value. • Lessor’s Rate Unknown by Lessee: When the lessor’s implicit rate is unknown, the lessee should use its own rate (the “lessee’s incremental rate” - this is the rate the lessee would be expected to pay a bank if funds were borrowed to buy the asset) • Lessor’s Rate Known by Lessee: When the lessor’s implicit rate is known,the lessee should use the lower of the two rates. NOTE: The lessor will always use its implicit rate. If the lessee’s incremental rate is lower, the lessee will use its own rate. This will result in different amounts recorded by the lessee and the lessor – e.g., interest expense and interest revenue will be different.

36. Non-Operating LeasesLessor Direct Financing or Sales-Type

37. Classification of Leases: Lessor

38. Classification of Leases: Lessor, cont’dOperating Lease

39. Classification of Leases: Lessor, cont’dDirect Financing Lease

40. Classification of Leases: Lessor, cont’dSales-Type Lease To be classified as a sales-type lease, the lease must meet group 1 criteria (same as lessee’s), and the following group 2 criteria: • Collectibility of payments must be reasonably assured, and • Lessor’s performance must be substantially complete, and • Asset’s fair value DOES NOT equal the lessor’s book value.

41. Classification of Leases: Lessor, cont’d Note: A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

42. Lessor: Operating Lease • Operating Lease: • Rent is paid in advance: Dr. Cash / Cr. Unearned Rent Revenue (a liability) upon payment. As unearned rent is earned, the Unearned Rent Revenue account is debited and Rent Revenue (a revenue account) is credited. • Rent is paid at the end of a term: Dr. Cash / Cr. Rent Revenue as payments are received. • Depreciation: Because the asset is not considered transferred under an operating lease, the lessor continues depreciating the asset under its usual method.

43. Direct Financing Lease: Lessor • Direct Financing Lease: A DF lease is a lease where the FMV of the leased property at the inception of the lease is equal to the lessor’s cost or carrying amount of the property. In these cases, the lessor is usually not a manufacturer or dealer. The lessor is likely a leasing company that has acquired the asset to lease (so the time between acquisition and leasing is short). • At inception: • Lease Receivable: The lessor records a lease receivable equal to the gross payments it will receive under the lease (i.e., undiscounted amount). • Writes off Asset: Credits an asset account for the cost of the asset deemed transferred (e.g., if equipment is leased, Inventory of Equipment will be credited for the COST of the asset) • Unearned Interest Revenue: The difference between the lease receivable and the asset cost is credited to an Unearned Interest Revenue account • Classification: This account is a contra account to Lease Receivable), it IS NOT a liability account. • During the lease term: At the time of each rent receipt • Records the receipt of cash (Dr. Cash / Cr. Lease Receivable) in the amount of the cash received, and • Accrues Interest Income (Dr. Unearned Interest Revenue / Cr. Interest Revenue) using the effective interest method.

44. Direct Financing Lease: Lessor • On 12/31/2005 First LeaseCorp purchased a copier for $479,079. On January 1, 2006, Sans Serif Publishers, Inc. leased the copier from First LeaseCorp. • The lease agreement specifies annual payments of $100,000 beginning January 1, 2006, the inception of the lease, and at each January 1 through 2011. The six-year lease term is equal to the estimated useful life of the copier. The interest rate is 10%. • REQUIRED: Classify this lease for the lessor. Prepare the lessor’s entries for 1) inception, 2) the first lease payment on 1/1/2006, 3) year-end at 12/31/2006, and 4) the second lease payment on 1/1/2007.

45. Direct Financing Lease: Lessor, cont’d Classification as a Direct financing lease: • Is the lease a capital lease to the lessee? Yes. This lease meets both the 75% and 90% tests. • Is the collectibility of payments reasonably assured? Assumed yes. • Is lessor’s performance substantially complete? Assumed yes. • Does the asset’s fair value equal the lessor’s book value (cost)? Yes. • Because items 1-4 are met, the lease is a direct financing lease.

46. Direct Financing Lease: Lessor, cont’d Direct Financing Lease 1/1/2006 First LeaseCorp (Lessor) Dr. Lease receivable* (gross sum of payments) 600,000Cr. Unearned interest revenue (difference) 120,921Cr. Inventory of equipment (lessor’s cost) 479,079 * On the balance sheet the lease receivable is reported as the lessor’s “gross investment in the lease.” First Lease Payment [1/1/2006]: First LeaseCorp (Lessor) Dr. Cash 100,000 Cr. Lease receivable 100,000 Note that there is no interest component to the first rent payment if the payment is made at the beginning of the least term because no time has passed during which interest would have accrued.

47. Direct Financing Lease: Lessor, cont’d Year-end Entries related to the lease: Dr. Unearned Interest Revenue 37,8708 Cr. Interest Revenue 37,808 The interest associated with the second payment is earned at 12/31/2007. The amount is the Lease Receivable @ 12/31/2006 (500,000) – Unearned Interest Revenue Balance @ 12/31/2006 (121,921) x .10 x 12/12 = $37,808 (or, look on the amortization table). Second Lease Payment [January 1, 2007] First LeaseCorp (Lessor)Dr. Cash (rental payment) 100,000Cr. Lease receivable 100,000

48. Sales Type Lease • Sales-Type Lease: In a sales-type lease, the FMV of the leased property at the beginning of the term is different from the lessor’s cost. The lessor in a sales-type lease is generally a manufacturer or dealer. • At inception: • Lease Receivable: The lessor records a lease receivable equal to the gross payments it will receive under the lease (i.e., undiscounted amount). • Manufacturer’s Profit: • Revenue: The lessor records sales revenue equal to the FMV of the leased item (this is usually equal to the PV MLP). • COGS / Write off Inventory: The lessor records the COGS associated with the leased item (Dr. COGS / Cr. Inventory). • Unearned Interest Revenue: The lessor records the amount needed to balance the entry (“plug”) to unearned interest revenue (a contra account to lease receivable). This amount = Lease Receivable – Revenue. • During the lease term: At the time of each rent receipt • Records the receipt of cash (Dr. Cash / Cr. Lease Receivable) in the amount of the cash received, and • Accrues Interest Income (Dr. Unearned Interest Revenue / Cr. Interest Revenue) using the effective interest method.

49. Sales-Type Lease: Lessor • On January 1, 2006, Sans Serif Publishers, Inc. leased a copier from CompuDec Corporation when the fair market value of the asset was $479,079. • The lease agreement specifies annual payments of $100,000 beginning January 1, 2006, the inception of the lease, and at each January 1 through 2011. 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%. • REQUIRED: 1) Classify the lease to the lessor, 2) Prepare the lessor’s entry at lease inception, 3) Prepare the lessor’s entry at the first lease payment, 4) prepare the lessor’s entry at year-end (12/31/2006), and 5) prepare the lessor’s entry for the second lease payment on 1/1/2007.

50. Sales-Type Lease: Lessor, cont’d Classification as a Sales-type lease: • Is the lease a capital lease to the lessee? Yes. This lease meets both the 75% and 90% tests. • Is the collectibility of payments reasonably assured? Assumed yes. • Is lessor’s performance substantially complete? Assumed yes. • Does the asset’s fair value equal the lessor’s book value? No. The asset’s fair value is greater than the lessor’s book value (cost). Because items 1-3 are met, and item 4 is not, the lease is a sales-type lease.