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Leases

Leases. 15. Learning Objectives. Identify and describe the operational, financial, and tax objectives that motivate leasing. LO1. Lessor = Owner of property. Lessee = Renter. Basic Lease Terms.

kennan-summers
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Leases

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  1. Leases 15

  2. Learning Objectives Identify and describe the operational, financial, and tax objectives that motivate leasing. LO1

  3. Lessor = Owner of property Lessee = Renter Basic Lease Terms A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee.

  4. Lease Classifications

  5. Learning Objectives Explain why some leases constitute rental agreements and some represent purchase/sales accompanied by debt financing. LO2

  6. Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 (rounded) every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

  7. Inception of the Agreement January 1

  8. First Semi-Annual Payment Date June 30

  9. Learning Objectives Explain the basis for each of the criteria and conditions used to classify leases. LO3

  10. Ownershiptransfers to the lessee 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 (MLP) is 90% or more of the fair valueof the asset. Capital Lease Classification A capital lease must meet one of four criteria:

  11. Capital Lease Classification 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 lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

  12. Additional Lessor Conditions • The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as 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. Lessor = Owner of the property subject to the lease agreement.

  13. Learning Objectives Record all transactions associated with operating leases by both the lessor and lessee. LO4

  14. Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. CapitalLease

  15. On December 1, 2006, Matrix, Inc. signed a two-year operating lease with RentPro, Inc. for office equipment. The lease called for $500 per month, payable at the beginning of each month. The first payment was due on December 1, 2006. Matrix paid three months of rent in advance on December 1, 2006. Operating Leases

  16. Prepare the entry on the books of Matrix on December 1, 2006. Operating Leases

  17. Prepare the entry the RentPro would make to record receipt of the December 1, 2006. Operating Leases

  18. The December 31st adjustment by Matrix. The December 31st adjustment by RentPro. Operating Leases

  19. Learning Objectives Describe and demonstrate how both the lessee and lessor account for a nonoperating lease. LO5

  20. We’ll look at non-operating leases for both the lessee and lessor as we move through our examples.

  21. Nonoperating Leases - Lessee The amount recorded (capitalized) is the present value of the minimum lease payments. However, the amount recorded cannot exceed the fair value of the leased asset. • In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: • Its incremental borrowing rate, or • The implicit interest rate used by the lessor.

  22. 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. 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.

  23. On January 1, 2006, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease calls for $6,000 per year, payable at the beginning of each year starting on 1/1/06. The equipment has an economic life of 5 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment. Nonoperating Leases

  24. The lease term meets the “75% of the economic life” test. Nonoperating Leases - Lessee

  25. The PV of the MLP ³ 90% of the equipment’s fair value Nonoperating Leases - Lessee

  26. Matrix makes the following entries at inception of the lease. Nonoperating Leases - Lessee

  27. Nonoperating Leases - Lessor In addition to the information given earlier, the lessor (RentPro) knows that the collectibility of the lease payments is reasonably predictable, and there are no future costs to be incurred. RentPro’s performance is substantially complete as far as the lease is concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is $25,873 (rounded).

  28. $6,000 × 5 = $30,000 Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair market value, the lease is classified as a Direct Financing Lease.

  29. Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair market value, the lease is classified as a Direct Financing Lease. Receipt of the first lease payment.

  30. Lease Amortization Schedule

  31. December 31, 2006, adjustment by Matrix. December 31, 2006, adjustment by RentPro. Nonoperating Leases

  32. Depreciation by Lessee Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets. If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase option, the asset is depreciated over theasset’s economic life; otherwise, it is depreciated over thelease term.

  33. $25,8735 years = $5,175 Depreciation by Lessee At December 31, 2006, Matrix prepares the following entry to recognize depreciation expense for the year.

  34. Matrix records the second payment on January 1, 2007. Nonoperating Leases - Lessee From the December 31, 2006, accrual.

  35. Nonoperating Leases - Lessor RentPro records the second receipt on January 1, 2007.

  36. Learning Objectives Describe and demonstrate how the lessor accounts for a sales-type lease. LO6

  37. Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to the cost of the asset. Sales-Type Lease At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of MLP).

  38. Sales-Type Lease On 1/1/06, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The lease calls for payments of $118,516 at the end of each of the next three years. The equipment has a 3-year economic life, a fair value of $300,000 and cost to RentPro of $222,500. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection with the lease.

  39. This is a sales-type lease because the lease term is 100% of the economic life of the asset (3 years), the MLP will be collected, no further costs will be incurred by RentPro, and the cost of the asset to RentPro is not equal to its fair value. Matrix treats this as a capital lease because the lease term is 100% of the economic life of the asset. Sales-Type Lease

  40. Calculation of the lease payment. Lease Amortization Table Sales-Type Lease

  41. Entry at inception of the lease ($118,517 × 3) = $355,551 Sales-Type Lease - Lessor

  42. Capital Lease - Lessee Entry at inception of the lease

  43. First payment Sales-Type Lease - Lessee

  44. Record first year depreciation Sales-Type Lease - Lessee $300,000 ÷ 3 (lease term) = $100,000

  45. Sales-Type Lease - Lessor First receipt

  46. Learning Objectives Explain how lease accounting is affected by the residual value of a leased asset. LO7

  47. Residual Value The residual value of a leased asset is an estimate of what its commercial value will be at the end of the lease term. Let’s see how residual value impacts the accounting for leases by both the lessee and lessor.

  48. Residual Value Lessee Obtains Title to Leased Asset. The only impact on the lessee is the determination of depreciation expense. The cost of the asset will be reduced by the estimated residual value and depreciated over the economic life of the asset.

  49. Residual Value Lessor Retains Title to Leased Asset. In determining the lease payment, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payment.

  50. Residual Value On January 1, 2006, RentPro, Inc. signed a 10-year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the equipment is retained by RentPro and it is estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro requires an 8% return on leased equipment. Let’s calculate the lease payment!

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