Accounting for Leases

1. Accounting for Leases ACCTG 5120 David Plumlee

2. What is a Lease? “ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”

3. Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ? Accounting for Leases Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset

4. Classification of Leases What is the economic nature of a capital lease? One that transfers substantially all the risks and benefits of ownership to the lessee. What is the economic nature of an operating lease? One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement

5. Accounting for Capital Leases • Accounting reflects economic substance, not legal form • Make it appear as though company purchased an asset with borrowed funds • an asset and an obligation • interest expense on obligation • depreciation on asset

6. Does it meet ANY ONE of the four criteria? Is this a Capital Lease? • Lease transfers ownership of asset • automatically by end of lease term or • through a bargain purchase option • Lease term is at least 75% of asset’s estimated economic life • PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term

7. Minimum rental payments plus Any guaranteed residual value plus amount the lessee guarantees lessor will realize on the asset at the end of the lease term Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured Minimum Lease Payments Leases without a BPO

8. MLP continued What are executory costs? Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance Are they included in MLP? NO!

9. Minimum Lease Payments What is a bargain purchase option? An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured What is the MLP for leases with a BPO? PV of rental payments and the BPO at the end of the lease term.

10. Capital Lease Example • 6-year lease • Annual payment due at year end = $18,287 • No BPO and legal title does not pass at the end of lease term • FMV of leased asset = $75,185 • Economic life of asset = 10 years • Appropriate interest rate = 12% • Est. salvage value = $3,185

11. $18,287 $18,287 $18,287 $18,287 $18,287 $18,287 1 2 3 4 5 6 Present Value of MLP PV = $18,287 x PVIFA(n=6, r=12%) = $18,287 x 4.11141 = $75,185

12. Inception of lease: record leased asset and lease obligation at present value of MLP Record payments At period end accrue: depreciate asset record interest expense Lessee Journal Entries

13. JE to record leased asset and lease obligation at present value of MLP? Inception of Lease Term leased asset $75,185 lease obligation $75, 185

14. Depreciation Expense On what does the depreciation period used depend? • If bargain purchase option exists or title passes during lease term, use economic life • Otherwise use lease term

15. Basis for Depreciation What ending values are used for depreciation? Salvage value if depreciating over economic life Guaranteed residual value if depreciating over lease term

16. Record Depreciation Expense What is the depreciable basis of this asset? $75,185 (Salvage value is irrelevant because the asset reverts to the lessor.) $75,185/6yrs = $12,531 depreciation expense $12,531 accum. depreciation $12,531

17. Lease Amortization Table

18. PV of the min. lease payments Lease Amortization Table

19. Lease Amortization Table

20. interest expense ($75,185 x 12%) $9,022 lease obligation 9,265 cash $18,287 Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower. Record First Lease Payment

21. Lessor Capital Lease Types • Direct financing leases • PV of minimum lease payments equals the FMV of the leased asset • No “profit” is recorded; considered to be a financing arrangement. • Sales-type leases • PV of minimum lease payments less the FMV of the leased asset equals the “dealer profit” • Profit is recognized as revenue at the inception of the lease

22. Includes costs directly associated with negotiating a particular lease amounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees) amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents) Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead) Initial Direct Costs

23. Accounting forInitial Direct Costs • Operating - • Sales-type - • Direct financing- defer and allocate over lease term in proportion to rental income expense in same period as profit on sale recognized • add to gross investment in the lease • amortize over lease as a yield adjustment

24. Example - Direct Financing • 3 year lease • $20,000 payments due at end of year • implicit interest rate = 10% • FMV (lessor’s cost of asset) = $49,737 • initial direct costs = $1,000

25. Net Investment in Lease What is the PV of the MLP (without initial direct costs)? 20,000 x PVIFA(n=3,r=10%) • $49,737 = cost (this is a direct financing lease) Do initial direct costs affect this calculation? Yes, they are added and a new interest rate is found.

26. $50,737 = $20,000 x PVa (n=3,r=?) 2.53685 = PVa (n=3,r=?) Impute New Effective Yield Why add to the initial direct costs? We want the interest rate the equates the net investment to the cash flows $49,737 = -$1,000 + $20,000 PVa (n=3,r=??) by trial and error: r=8.89%

27. Ignoring Initial Direct Costs

28. Including Initial Direct Costs Reduction in income = 10,263 - 9,263 = 1,000 = initial direct costs

29. Amort. of Initial Direct Costs

30. Journal Entry Entries to record lease: deferred initial direct costs 1,000 cash (etc.) 1,000 lease receivable 60,000 unearned interest income 10,263 leased asset 49,737

31. Journal Entries Entries to record first payment and amortization of income and costs cash 20,000 lease receivable 20,000 unearned interest income 4,974 interest income 4,974 initial direct expense amortization 463 deferred initial direct costs 463

32. Leaseback: seller retains use of the asset Sale: Legal title Transfers Sale/leaseback Should the gain or loss on sale be recognized when asset “sold” to lessor? Seller/lessee Buyer/lessor Account for lease according to classification tests.

33. Lessee Retains Right To Use Asset defer gains only (losses are recognized immediately) amortize to rent expense over lease term in proportion to rental payments Sale/leaseback- operating lease Why do you think we defer any gains? Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future

34. defer gains only (losses are recognized immediately) amortize to depreciation expense over lease term in proportion to amortization of leased asset Sale/leaseback -- capital lease Lessee Retains Right To Use Asset

35. “Minor leaseback” • Lessee Loses Most Rights To Use Asset • Defined as PV of rental payments is 10% or less of asset’s fair value • Recognize gain or loss on sale immediately