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Leases - Learning Objectives

Leases - Learning Objectives. 1 . Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2. Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction.

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Leases - Learning Objectives

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  1. Leases - Learning Objectives 1. Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2. Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction. • Outline the types of contractual provisions typically included in lease agreements.

  2. Learning Objectives 4. Apply the lease classification criteria in order to distinguish between capital and operating leases. 5. Properly account for both capital and operating leases from the standpoint of the lessee (asset user). • Properly account for both capital and operating leases from the standpoint of the lessor (asset owner). • Prepare and interpret the lease disclosures required of both lessors and lessees.

  3. Lease A lease is a contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party. Parties: • Lessee - he party granted the right to use the property under the terms of a lease. • Lessor- The owner of the property that is rented (leased) to another party.

  4. Advantages of Leasing To the Lessee To the Lessor • No down payment • Avoid risks of ownership • Flexibility • Increased sales • Ongoing business relationship with lessee • Residual valued retained

  5. Simple Example Owner Company owns a piece of equipment with a market value of $10,000. User Company wishes to acquire the equipment for use in its operations. Continued

  6. Simple Example One option for User Company is to purchase the equipment from Owner by borrowing $10,000 from a bank at an interest rate of 10%. Owner would repay the principal and interest by making five annual payments of $2,638. Continued

  7. Simple Example Alternatively, User Company can lease the asset from Owner Company for five years, making annual “rental” payments of $2,638. Buy $2,638 annually Lease $2,638 annually Continued

  8. Simple Example • Has effective ownership passed? • Does Owner Company have any significant responsibility remaining? • Is Owner Company reasonable certain that they five annual payments can be collected? Continued

  9. Simple Example Scenario 1 The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease. Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase. Continued

  10. Simple Example Scenario 2 The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1. Offering the equipment to User Company for a bargain price at the end of the lease indicates that this arrangement is in substance a purchase. Continued

  11. Simple Example Scenario 3 The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else. Because the life of the asset and the term of the lease are identical, this arrangement is in substance a purchase. Continued

  12. Simple Example Scenario 4 The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date. When the present value of the lease payments is close to the market value of the leased item, the arrangement is in substance a purchase. The exact rules will be discussed later in this chapter.

  13. Simple Example Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee. Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease.

  14. Nature of Leases Specifies under what circumstances the lease may be canceled. Cancellation Provision Grants lessee the right to purchase the asset at the end of the lease term for less than the residual value. Bargain Purchase Option Delineates the time period the lease is to be in force. Lease Term Continued

  15. Nature of Leases Market value of leased asset at end of lease term. Residual Value Rental payment required over lease term plus any payment for residual value as well as any bargain purchase option. Payments for insurance, maintenance and taxes incurred for the leased property Minimum Lease Payment Executory Costs

  16. Nature of Leases Minimum lease payments: Rental payments ($3,000 – $500) x 36 $ 90,000 Guaranteed residual value 10,000 Total minimum lease payment $100,000 Minimum Lease Payment Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed a residual value of $10,000 by the lessee. Continued

  17. Minimum Lease Payment Computation Present value of minimum lease payment $82,258 Assuming an implicit rate of 1% per month: Present value of 36 monthly payments of $2,500 at 1% interest paid at the end of the month: PMT = $2,500, N = 36, I = 1% $75,269 Present value of $10,000 guaranteed residual value at the end of 10 years at 12% compounded monthly: FV = $10,000, N = 36, I = 1% 6,989

  18. Lease Classification Criteria A lease is classified as a capital lease by the lessee if it is noncancelable and meets any one of the following criteria:

  19. Lease Classification Criteria 1) The lease transfers ownership of the leased asset to the lessee by the end of the lease term. 2) The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price. 3) The lease term is equal to 75 percent or more of the estimated economic life of the asset. 4) The present value of the lease payments at the beginning of the lease is 90 percent or more of the fair market value of the leased asset. Continued

  20. Lease Classification—Lessee No Bargain Purchase Option? Yes No Term >75% of Useful Life? Yes No PV Payment >90% of FMV? Yes No Transfer of Ownership? Yes Capital Lease Operating Lease

  21. Lease Classification—Lessor Additional revenue recognition criteria applicable to lessors. 1. Collectibility of the minimum lease payments is reasonably predictable. 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.

  22. Exhibit 15-2 Exhibit 15-2 in the textbook provides four lease provision situations. We will go through Lease 1 together. Understanding the lease classification criteria is important. We strongly urge you to analyze Lease 2 through Lease 4. Continued

  23. Lease 1 Lessee This is a test to see if the lease qualifies as a capital lease. If it doesn’t, then it is an operating lease. Does the lease transfer ownership at the end of the lease term? No! So, we move to Criteria 2. Continued

  24. Lease 1 Lessee Does the lease contain a bargain purchase option? No! So, we move to Criteria 3. Continued

  25. Lease 1 Lessee Is the lease term equal to 75 percent or more of the estimated economic life of the asset? No! The 10-year lease covers approximately 72 percent of the economic life of the asset. So, we move to Criteria 4. Continued

  26. Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? Before we answer this question, let’s pause and review two terms related to interest on a lease. Continued

  27. Lease 1 • Implicit Interest Rate:Rate that would be used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease. • Incremental Borrowing Rate:Rate at which lessee could borrow the amount of money necessary to purchase the leased asset. Continued

  28. Lease 1 Lessor always uses the implicit rate to discount rental payments. Lessee uses the lesser of the implicit rate (if known) and the incremental borrowing rate. Continued

  29. Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? No, the lessee only knows the incremental borrowing rate, which provides a present value of less than 90 percent. Continued

  30. Lease 1 Lessor The lessor answered negatively to the first three criteria, so let’s analyze the fourth criteria. Continued

  31. Lease 1 Lessor In addition to meeting at least one of the four criteria, the lessor must meet both of a second set of criteria. Continued

  32. Lease 1 Lessor Is the collectibility of the minimum lease payment reasonably predictable? AND Are there important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor? Continued

  33. Lease 1 Lessor Collectibility is predictable and there are no important uncertainties about reimburseable cost… …so this is a capital lease to the lessor and an operating lease to the lessee.

  34. Accounting for Operating Leases—Lessee Bob Jones signs a two-year lease which requires a monthly payment of $1,000. When the lease expires, Bob will either move out or negotiate a new lease. Rent Expense 1,000 Cash 1,000

  35. Operating Leases With Varying Lease Payments The terms of a lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years and $250,000 for each of the next three years. Continued

  36. Operating Leases With Varying Lease Payments Entry Each Year for Years 1 and 2: Rent Expense 210,000 Cash 150,000 Rent Payable 60,000 Entry Each Year for Years 3-5: Rent Expense 210,000 Rent Payable 40,000 Cash 250,000

  37. Accounting for Capital Leases

  38. Accounting for Capital Leases Lessee Minimum payment (in advance) including $5,000 executory costs $65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 5 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Continued

  39. Accounting for Capital Leases Entries on January 1, 2005 Leased Equipment 250,192 Obligations under Capital Leases 250,192 PMT = $60,000; N = 5; I = 10% Lease Expense 5,000 Obligations under Capital Leases 60,000 Cash 65,000 Continued

  40. Accounting for Capital Leases Entries on December 31, 2005 Amortization Expense on Leased Equipment 50,038 Accumulated Amortization on Leased Equipment 50,038 ($250,192 – $60,000) x 10% Prepaid Executory Costs 5,000 Obligations under Capital Leases 40,981 Interest Expense 19,019 Cash 65,000

  41. Accounting for Leases With a Bargain Purchase Option BARGAIN DEAL Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price. The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.

  42. Accounting for Leases With a Bargain Purchase Option Lessee Minimum payment (in advance) including $5,000 executory costs $65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Bargain purchase option $75,000 Continued

  43. Accounting for Leases With a Bargain Purchase Option Present value of minimum lease payment $296,761 Minimum Lease Payment Present value of five payments at the beginning of each year for five years: PMT = $60,000, N = 5, I = 10% $250,192 Present value of the bargain purchase option of $75,000 at the end of 5 years: FV = $75,000, N = 5, I = 10% 46,569 Continued

  44. Accounting for Leases With a Bargain Purchase Option Entries on December 31, 2009 Obligations under Capital Leases 68,182 Interest Expense 6,818 Cash 75,000 ($296,761 ÷ 10) x 5 years $68,182 x 10% Equipment 148,381 Accumulated Amortization on Leased Equipment 148,380 Leased Equipment 296,761

  45. Treatment of Leases on Lessee’s Statement of Cash Flows Investing Activities No impact Financing Activities Principal portion of lease payment Operating Activities (indirect) Net income (includes reduction for Lease interest expense) + Amortization of leased asset Continued

  46. Treatment of Leases on Lessee’s Statement of Cash Flows Operating Activities (direct) Investing Activities Financing Activities - Lease interest expense No impact - Principal portion of lease payment

  47. Accounting for Leases The Lessor

  48. Accounting for Leases—Lessor Type of Lease Accounting Treatment of Costs Operating Capitalize and amortize over lease term. Capital (Direct Capitalize and amortize, financing) with unearned interest, over lease term. Capital (Sales Immediately recognize cost – -type) as reduction in profits.

  49. Accounting for Operating Leases—Lessor Minimum payment (in advance) including $5,000 executory costs $65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost to lessor $400,000 Direct costs incurred $15,000 Continued

  50. Accounting for Operating Leases—Lessor At Inception of Lease (1/01/05): Deferred Initial Direct Costs 15,000 Cash 15,000 At Receipt of First Payment (1/01/05: Cash 65,000 Rent Revenue 60,000 Executory Costs (contra effect) 5,000 Continued

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