Accounting for Leases

Accounting for Leases

Accounting for Leases • According to FASB statement No. 13 , a lease is defined as “an agreement conveying the right to use property, plant, or equipment for a stated period of time”. Accounting for Leases

Accounting for Leases :(contd.) • A lease involves a lessee and a lessor. • A lessee acquires the right to use the property, plant and equipment and a lessor gives up the right. • A lease is a contractual agreement and therefore the parties involved can incorporate any provision in the contract. All kinds of assets can be leased. • Among the most popular are photocopies, computer, airplanes, and warehouses. Accounting for Leases

Lessors (source: Kieso, Weygandt, and Warfield ) • Lessors who own the property: • Banks: The largest lessors in the leasing industry. They provide general finance for companies. Examples: Wells Fargo, Chase, Citigroup. • Captive leasing companies: subsidiaries whose primary business is to perform leasing operations for the parent company (i.e., structure lease contracts for the parent companies and their customers). Examples: Chrysler Financial (for Daimler-Chrysler), IBM Global Financing (for IBM), Boeing Capital. Accounting for Leases

Lessors (contd.) • Independents: leasing companies whose primary business is to perform general finance for other companies. Their market share of leasing business has declined as the other two types of lessor’s market share has increased. Some independent lessors have become the captive finance companies for other companies without a leasing subsidiary. Accounting for Leases

Accounting for Leases :(contd.) • This chapter emphasizes the long-term non-cancelable leases involving depreciable personal property such as equipment, machinery, trucks and other movable assets. Accounting for Leases

Accounting for Leases :(contd.) • The objectives of the chapter include: 1. Accounting for lessees: a. Operating leases. b. Capital leases: .without bargain purchase option .with bargain purchase option . With guaranteed residual value Accounting for Leases

Accounting for Leases :(contd.) • The objectives of the chapter include: 2. Accounting for lessors: a. Operating leases. b. Capital leases: .direct-financing leases .sales-type leases Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint (source: Kieso and Weygandt) 1. Financing benefits: a. The lease provides 100% financing (no down payment is needed). For companies with cash shortage, lease is a good alternative to purchase; b. The lease contract may contain fewer restrictive provisions than other debt agreement; and c. The lease agreement creates a claim that is against only the leased asset , not against all assets. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) 2. Risk benefit: Reduce the risk of obsolescence. 3. Tax benefit: Tax deduction may be accelerated since it is often spread over the lease term (rather than the economic life of the property). The full cost of the leased asset can be written off including the part that relates to land. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) 4.Financial reporting benefit (off-balance- sheet financing): For an operating lease, the lease does not add a liability or an asset to the balance sheet, and therefore does not affect financial ratios. By maintaining these ratios, the company's borrowing capacity can also be maintained. Off-balance-sheet financing: acquiring the right to use assets but not reporting the assets and liabilities on the balance sheet Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) 5. Billing benefit: Leasing permits higher charges because the interest element contained in the rental payments is treated as an expense. 6.Less Costly Financing: The income tax savings on depreciation expenses for the leasing company(the lessor) may pass on to the lessee in the form of a reduced rental payment. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • An example of using leasing to achieve off balance sheet financing: assuming that in 20X1, two identical companies, A and B, have the following data prior to any new acquisitions: • current assets $3,000,000 noncurrent assets 5,000,000 current liabilities 2,000,000 noncurrent liabilities 2,500,000 stockholders’ equity 3,500,000 Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • On December 31, 20X1, A company purchases an equipment with a 5-year life costing $3,018,400 by signing a 5-year, 8% note requiring $755,923 to be paid at the end of each year staring December 31,20X2. • The payments include interests at 8% on the beginning-of-year principal balance.The remainder of each annual payment reduces principal. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • A company records the asset purchased and the note payable. A's financial data show the following changes: Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • noncurrent assets: $5,000,000 + 3,018,400 = $8,018,400 • current liabilities: $200,000 + 755,923 * 0.926 = $2,699,985 • noncurrent liabilities: $2,500,000+ (3,018,400 - 699,985) = $4,818,415 • The rest remains unchanged. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) Therefore; Before AcquisitionAfter acquisition current ratio $3,000,000/$2,000,000 $3,000,000/2,699,985 =1.5 = 1.11 debt to stockholder equity $4,500,000/3,500,000 (2,699,985+4,818,415) $3,500,000 = 1.29 = 2.15 Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • The current ratio falls significantly (from 1.5 to 1.11) while the debt to stockholders’ equity ratio increases 67% after the acquisition. • The rate of return on investment in 20X2 could also be impaired (due to the increase of noncurrent assets). • These adverse impacts on financial ratios will damage the borrowing capacity of A company and may also affect it's ability to sell stock. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • On the other hand, assume that B company leases identical equipment by the use of a lease and agrees to pay $755,923 rent each year for the next 5 years. If interest rate is 8%, the present value of the equipment is $3,018,400. • If the lease is classified as a capital lease, B records an asset and a liability and the effects on it's B/S are the same as the effects of purchase on A's B/S. Accounting for Leases

Advantages of Leasing from Lessees' Viewpoint :(contd.) • However, if the lease is classified as an operating lease, B does not have to record an asset or a liability. • Therefore, the financial ratios (i.e, the current ratio) will be same as before the acquisition. • In sum, two identical economic events can have very different impact on key ratios of financial statement(F/S). Accounting for Leases

Advantages of Leasing from Lessors' Viewpoint :(contd.) 1. A way of indirectly making a sale. 2. An alternative means of engaging in a profit opportunity. The lease agreement enables the lessor to earn a normal rate of return (in a form of interest) on the cost of leased asset. Accounting for Leases

Classification of Personal property Leases • A lease that transfers substantially all the risks and benefits of ownership to the lessee represents a purchase by the lessee and a sale by the lessor and should be treated as a capital lease (SFAS 13). • SFAS 13 provides criteria for determining the classification of leases by both lessees and lessors. Accounting for Leases

Column A Criteria Applicable to Both Lessee and Lessor a.The lease transfers ownership of the property to the lessee by the end of the lease term. b.The lease contains a bargain purchase option c.The lease term is equal to or greater than 75% of the estimated economic life of the leased property. d.The present value of the minimum lease payments (MLP) is equal to 90% or more of the fair value of the leased property to the lessor. Column B Criteria Applicable to Lessor Only a.The collectibility of the minimum lease payments is reasonably assured (i.e., predictable). b.No important uncertainties surround the amount of unreimbursable cost yet to be incurred by the lessor under the lease. Classification of Leases Involving Personal PropertyGeneral Criteria for classifying leasesExhibit 1 Accounting for Leases

Classification by the lessee • Capital lease: Lease that meets one or more of the criteria in column A. Lessee should treat capital lease as a purchase of asset; recognize leased asset and obligation under capital lease. • Operating lease: Lease that does not meet any of the criteria in Column A. Accounting for Leases

Classification by the Lessor • Operating lease:Lease that meets none of the criteria in col. A, or does not meet both criteria in col. B. • Direct Financing lease:Lease that meets these three criteria: 1. One or more of the four criteria in col. A; 2. Both criteria in col. B; and 3. No manufacture's or dealer's profit. Accounting for Leases

Classification by the Lessor (Contd.) • Sales-Type leaseLease that meets these three criteria: 1.One of more of the four criteria listed in col. A; 2. Both criteria in column B; and 3. Transaction involves a manufacturer or dealer's profit (or loss) for the lessor. Accounting for Leases

Classification by the Lessor :(contd.) • A profit for lessor exists when the fair market value of the leased property is greater than its cost or carrying value. • Items c and d of column A do not apply if the beginning of the lease term falls within the last 25% of the total estimated economic life. Accounting for Leases

Key Terms Related to Leases • Bargain Purchase Option A provision allowing the lessee to purchase the leased property at the end of the life of the lease at a price so favorable that the exercise of the option appears, at the inception of the lease, to be reasonably assured. • Estimated Economic Life The remaining life of leased assets for its intended usage at the inception of the lease contract with normal repair and maintenance. Accounting for Leases

Key Terms Related to Leases :(contd.) • Fair Value of Leased Property Price for which the property can be sold in an arm's length transaction between unrelated parties. • For manufacturers and dealers, the fair value is the selling price. For others, the fair value is the cost of the asset to the lessor. Accounting for Leases

Key Terms Related to Leases :(contd.) • Minimum Lease Payments(MLP): Payments that are required to be paid by the lessee to the lessor over the life of the lease. • For a lease with a bargain purchase option (BPO), the MLP include (for both lessee and lessor): 1.The minimum periodic payments required by the lease over the lease term; and 2. The payment required by the BPO. Accounting for Leases

Key Terms Related to Leases :(contd.) • Otherwise, the MLP include: 1. The minimum periodic payments, plus 2. Any guaranteed residual valuea, and 3. Any payments on failure to renew or extend the lease if the agreement specifies that the lease must be extended or renewed. Accounting for Leases

Key Terms Related to Leases :(contd.) • a. for a lessee, the residual value must be guaranteed by the lessee; for a lessor, it can be guaranteed by either the lessee or a third party. • Thus, a lessee's MLP could be less than a lessor's when the residual value is guaranteed by a third party. • Leased Assets for a lessee = the Present Value (PV) of the MLP, Not to exceed the fair market value of the asset. Accounting for Leases

Key Terms Related to Leases :(contd.) • Executory costs are ownership-type costs (I.e., insurance, maintenance and property taxes). • It is expected to be paid by the party with the ownership. • In the case of capital lease (lessee assumes the ownership), if portion of the lease payment is for the reimbursement of the executory costs to the lessor, it should be subtracted from MLP computation. Accounting for Leases

I. Accounting for Leases -Treatment of operating lease: • Terms and provisions of lease agreement between landlord company (lessor) and tenant company (lessee) dated January 1,1995 1.The lease term is 5 years. The lease is noncancelable and requires equal rental payments of $50,000 at the beginning of each year. 2.The cost, and also fair value, of the equipment to the Landlord Company at the inception of the lease is$400,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time. Accounting for Leases

I. Accounting for Leases -Treatment of Operating Lease: (contd.) 3.There is no guarantee of the residual value by the Tenant Company. 4.The Landlord Company agrees to pay all executory costs. 5.The equipment reverts to the Landlord Company at the end of the 5 years; 6.The Tenant Company's incremental borrowing rate is 12.5% per year. 7.For the Landlord Company, the interest rate implicit in the lease is 12%. 8.The present value of an annuity due of 5 payments of $50,000 each at 12% is 4.037349 * $50,000 = $201,867.45 Accounting for Leases

Application of Criteria for Determination of Lease Classification by Lessee Classification CriteriaCriteria Met?Remarks 1. Transfer of ownership at end of lease No 2. Bargain purchase option No 3. Lease term is 75% of economic life No It is 50% 4. Present value of lease payments is 90% of fair value No The present value is $201,867.45, or 50.5% of fair value Conclusion: the lease is an operating lease. It meets none of the criteria. Accounting for Leases

Journal Entries – Operating Lease for Lessee • The only journal entry recorded by the lessee is: 1-1-95 Rent Expense 50,000 Cash 50,000 Similar entries will be recorded at the beginning of 1996 through 1999. • Under the operating lease, neither an asset nor a liability is recognized. Accounting for Leases

Accounting and Reporting by Lessor • Types of leases classified by lessor: 1.Operating lease. A lease that meets none of the criteria in col. A or does not meet both criteria in col. B of Exhibit 1. 2.Direct-financing lease. A lease that meets one or more of the criteria in col. A and both criteria in col. B of Exhibit 1. Also the lease involves no manufacturer's or dealer's profit. Accounting for Leases

Accounting and Reporting by Lessor:(Contd.) 3. A Sales-type lease. A lease meets one or more of the criteria in col. A and both criteria in col. B of Exhibit 1. Also, the lease involves the recognition of a manufacturer's or dealer's profit (or loss). 4. Leveraged lease. A special three-party lease which is considered to be a direct-financing lease. Accounting for Leases

Operating Lease: (Lessor) • Under an operating lease, lessor retains substantially all the risk and benefit of ownership. • The leased equipment is reported on the balance sheet in Property,Plant and Equipment subsection entitled “Equipment Leased to Others" and record depreciation. • The lessor usually pays the executory fees and records them as operating expenses. Accounting for Leases

The Accounting Treatment of an Operating Lease -Lessor • Example: assume that landlord Company (lessor) Leases a piece of equipment to Tenant Co. (lessee) for 5 years under the terms described on pages 32 and 33. Tenant agrees to pay $50,000 at the beginning of each year. The equipment was purchased by Landlord at a cost of $400,000. It has an estimated life of 10 years. Accounting for Leases

Operating Lease- Lessor (contd.) • Landlord uses straight-line depreciation method. • On 1/10/95, the lessor pays the annual insurance premium of $2,000 and on12/15/95, it pays for repair expense of $1,500. • Assuming no initial direct costs, the preceding information is recorded in the following journal entries: Accounting for Leases

Operating Lease-Lessor (contd.) • 1. Purchase of equipment to be leased on 1/1/95: Equipment leased to others 400,000 Cash (or Equipment)* 400,000 *if equipment was already owned 2.Collection of annual payment on operating lease on 1/1/95: Cash 50,000 Rental Revenue 50,000 (or Unearned rent) Accounting for Leases

Operating Lease- Lessor (contd.) 3. Payments of annual insurance premium on 1/10/95: (an executory cost) Insurance expense 2,000 Cash 2,000 4.12/15/95 Repair expense 1,500 Cash 1,500 5. Recognition of Annual depreciation expense: Depr. Exp.: Equip. leased to others 40,000 Acc. Depr.: Equip. leased to others 40,000 (400,000/10 = 40,000) Accounting for Leases

II. Accounting for Leases - Treatments for Capital Lease • When a lease is reported as a capital lease, Lessee records an asset (i.e., leased equipment) and a liability (i.e., lease payable). • The amount of leased asset equals liability and is calculated as the present value of the minimum lease payments (MLP). Accounting for Leases

Accouning Treatments for Capital Lease • In a capital lease, the lessee is usually responsible for the executory costs. • If these costs are paid by the lessor, these costs should be deducted from the lease payments in computing the present value of MLP. Accounting for Leases

Discount Rate used in computing the present value of MLP • In computing the PV of the MLP, lessee should use the lower of a.The lessee's incremental borrowing rate, or b.The lessor's implicit rate . • If b is unknown to lessee, lessee uses a. • The discount rate used by lessor is lessor’s implicit interest rate. Accounting for Leases

Discount Rate used in computing the present value of MLP (cont.) • The present value of f MLP may be different for a lessee and a lessor when different discount rates are used in computing the PV. • The lower the rate is, the greater the PV of MLP. Accounting for Leases

Lease Agreement No Yes Ownership Transferred? No a. Lessee Depreciates Assets Over Economic Life Yes Bargain Purchase Option No Yes Lease Term >= 75% of Asset’s Life b. Lessee Depreciates Assets Over Lease Term No Yes MLP  90% of FV No Lessor Depreciates Asset Over Economic Life Depreciation or Amortization Criteria for Leased Assets- for Lessee Accounting for Leases

Depreciation or Amortization Criteria for Leased Assets – for Lessee(contd.) a.Depreciates to the estimated residual value. b.Depreciates or amortizes to the lessee guaranteed residual value (if there is any) If not, depreciate to zero. * Both "Amortization" and "depreciation term can be used. FASB uses "Amortization “ more often due to leased asset is an intangible. Accounting for Leases

Accounting for Leases