C 21 Accounting For Leases hapter Intermediate Accounting 10th edition Nikolai Bazley Jones An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Objectives Explain the advantages of leasing. Understand key terms related to leasing. Explain how to classify leases of personal property. Account for a lessee’s operating and capital leases. Understand disclosures by the lessee. 2 2 2 4

Objectives Account for a lessor’s operating, direct financing, and sales-type leases. Understand disclosures by the lessor. Explain the conceptual issues regarding leases. Understand lease issues related to real estate, sale-leaseback issues, leveraged leases, and changes in lease provisions (Appendix)

Definition of Lease A lease is an agreement between a lessor and a lessee that conveys to the lessee the right to use specific property, real or personal, owned by the lessor, for a stated period of time. In return for this right, the lessee agrees to make periodic cash payments to the lessor.

Advantages of Leasing from Lessee’s Viewpoint Financial benefits Risk benefit Tax benefit Financial reporting benefit-no liability recorded Billing benefit-pass through on contracts, including interest

Advantages of Leasing from Lessee’s Viewpoint Financial Benefits The lease provides 100% financing, so that the lessee acquires the asset without having to make a down payment. The lease contract contains fewer restrictive provisions and is more flexible than other debt agreements. The leasing arrangement creates a claim that is against only the leased equipment and not against all assets.

Advantages of Leasing from Lessee’s Viewpoint Financial Reporting Benefit Companies A and B have identical financial data: Current assets $2,100,000 Noncurrent assets 2,900,000 Current liabilities 1,000,000 Noncurrent liabilities 1,600,000 Stockholders’ equity 2,400,000 Continued

Advantages of Leasing from Lessee’s Viewpoint On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10

Advantages of Leasing from Lessee’s Viewpoint On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. After Acquisition Current Ratio: $2,100,000 $1,446,429 = 1.45 Continued

Advantages of Leasing from Lessee’s Viewpoint On December 31, 2007, B Company leases similar equipment to that leased by A Company, agreeing to pay $500,000 rent each year for the next 10 years. Assuming 12% interest, the present value of the lease is $2,825,112 ($500,000 x 5.650223). Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 After Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 The ratio of debt to stockholders’ equity would remain at 1.08-to-1.

Advantages of Leasing from Lessee’s Viewpoint On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. $2,600,000 $5,425,112 $2,400,000 $2,400,000 = 1.08 = 2.26 The ratio of debt to stockholders’ equity would increase from 1.08 before acquisition to 2.26 after acquisition. Continued

Advantages of Leasing from Lessee’s Viewpoint Current liabilities-LEASE $1,000,000 Plus: Noncurrent liabilities 1,600,000 Equals: $2,600,000 Divided by: Stockholders’ equity 2,400,000 Equals: Debt to Equity ratio 1.08 Current liabilities-PURCHASE $1,500,000 Plus: Noncurrent liabilities 3,925,112 Equals: $5,425,112 Divided by: Stockholders’ equity 2,400,000 Equals: Debt to Equity ratio 2.26

Key Terms Related to Leasing FASB Statement No. 13 as Amended and interpreted defines a number of lease terms. Bargain purchase option Bargain renewal option Estimated economic life of leased property Estimated residual value of leased property Executory costs Fair value of leased property Guaranteed residual value Inception of the lease Initial direct costs There’s more.

Key Terms Related to Leasing Interest rate implicit in the lease Lease term Lessee’s incremental borrowing rate Manufacturer’s or dealer’s profit or loss Minimum lease payments- present value Minimum lease payments receivable- gross Unguaranteed residual value Unreimbursable cost

Classification of Leases Involving Personal Property Criteria applicable to both lessee and lessor. Column A The lease transfers ownership of the property to the lessee by the end of the lease term. The lease contains a bargain purchase option. The lease term is equal to 75% or more of the estimated economic life of the leased property. The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased property to the lessor.

Classification of Leases Involving Personal Property Criteria applicable only to lessor. Column B The collectibility of the minimum lease payments is reasonably assured. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.

Classification of Leases Involving Personal Property A capital lease meets one or more of Column A criteria. An operating lease does not meet any of the Column A criteria. Classification by the Lessee

Lease Criteria and Classifications

Classification of Leases Involving Personal Property A sales-type lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. It must involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor. Classification by the Lessor Sale-type lease

Classification of Leases Involving Personal Property A direct financing lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. It must not involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor. Classification by the Lessor Direct financing lease

Classification of Leases Involving Personal Property An operating lease meets none of the criteria in Column A or does not meet both criteria in Column B. Classification by the Lessor Operating lease

Operating Lease (lessee) User Company signed a lease agreement with Owner Company whereby User Company agrees to pay $50,000 each year beginning on January 1, 2007, and continuing through January 1, 2011.

Operating Lease (Lessee) Go to Example 21-1 and determine how many of Group A criteria are met. Since none are met, this is an operating lease.

Operating Lease (Lessee)

Operating Lease (Lessee) As an operating lease, User Company simply records the annual payment as a rent. Rent Expense 50,000 Cash 50,000 If User Company prepares quarterly interim statements, it reports the unexpired portion of the expense as an asset.

Minimum Lease Payments The term “minimum lease payments” includes the present value of Minimum rental payments. Guaranteed residual value. Amount payable for failure to renew. 4. Any bargain purchase option. Ignore residual, if there is a bargain purchase option.

Capital Lease (Lessee) The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2007, that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2007.

Lessee Martin Company (page 1077) Is this a capital lease?

Capital Lease (Lessee) Is this a capital lease? To check your response, click the button in the corner. The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2007, that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2007. Wait

Decrease Liability in Balance Dr Example 21-5 2. Lease Payment Cr Interest 12% Expense Dr Decrease Liability in Balance Dr Balance 100,000.00 32,923.45 12,000.00 20,923.45 79,076.55 32,923.45 9,489.19 23,434.26 55,642.29 32,923.45 6,677.07 26,246.38 29,395.91 32,923.45 3,527.54 29,395.91 0

Capital Lease (Lessee) Initial Recording of Capital Lease on January 1, 2007 Leased Equipment 100,000.00 Capital Lease Obligation 100,000.00 12% x $100,000 December 31, 2007 Interest Expense 12,000.00 Capital Lease Obligation 20,923.45 Cash 32,923.45 $32,923.45 - $12,000.00 Continued

Capital Lease (Lessee) $100,000 ÷ 4 Recognition of Depreciation, December 31, 2007 Depreciation Expense: Leased Equipment 25,000.00 Accumulated Depreciation: Leased Equipment 25,000.00 Second Annual Payment, December 31, 2008 $79,076.55 x .12 Interest Expense 9,489.19 Capital Lease Obligation 23,434.26 Cash 32,923.45 $32,923.45 - $9,489.19 The depreciation entry on Dec. 31, 2008, again would be for $25,000.

Capital Lease (Lessee) Assume that Martin Company is required to make lease payments in advance on January 1 of each year,... …and that the cost and fair value of the equipment is $112,000. Present value of four payments of $32,923.45 in advance at 12% = $32,923.45 x 3.401831 = $112,000

Decrease Liability in Balance Dr Example 21-6 2. Lease Payment Cr Interest 12% Expense Dr Decrease Liability in Balance Dr Balance 112,000.00 1/1/07 32,923.45 79,076.55 2007 32,923.45 9,489.19 23,434.26 55,642.29 2008 32,923.45 6,677.07 26,246.38 29,395.91 2009 32,923.45 3,527.54 29,395.91 0

Capital Lease (Lessee) Initial Recording of Capital Lease on Jan. 1, 2007 Leased Equipment 112,000.00 Capital Lease Obligation 112,000.00 First Payment in Advance, January 1, 2007 Capital Lease Obligation 32,923.45 Cash 32,923.45 Continued

Capital Lease (Lessee) Recognition of Depreciation, December 31, 2007 Depreciation Expense: Leased Equipment 28,000.00 Accumulated Depreciation: Leased Equipment 28,000.00 $112,000 ÷ 4 Recognition of Interest Expense, December 31, 2007 Interest Expense 9,489.19 Accrued Interest on Capital Lease Obligation 9,489.19 $79,076.55 x 0.12 Continued

Capital Lease (Lessee) Second Annual Payment in Advance, January 1, 2008 Accrued Interest on Capital Lease Obligation 9,489.19 Capital Lease Obligation 23,434.26 Cash 32,923.45 Recognition of Depreciation, December 31, 2008 Depreciation Expense: Leased Equipment 28,000.00 Accumulated Depreciation: Leased Equipment 28,000.00

Bargain Purchase Option Redd Company leases equipment for 4 years and agrees to pay $2,000 at the end of the fourth year to purchase the asset. Redd is reasonably assured that it will exercise the option. Redd’s incremental borrowing rate is 11% and the lessor’s implicit interest rate is 10%. The cost and fair value of the equipment is $128,160.63. Does this qualify as a capital lease? Yes…because of the bargain purchase option.

Bargain Purchase Option The minimum lease payments, based on the lower 10% rate, is calculated as follows: Present value of the annual payments discounted at 10% ($40,000 x 3.169865) $126,794.60 Add: Present value of the single sum of $2,000 (the bargain purchase option) discounted at 10% ($2,000 x 0.683013) 1,366.03 Present value of the minimum lease payments $128,160.63 Leased Equipment 128,160.63 Capital Lease Obligation 128,160.63

Guaranteed Residual Value Karpas Company leases equipment for 4 years that cost the lessor $147,284.99 (its fair value) and agrees to pay an annual rent of $40,000 at the end of each year. Karpas Company agrees to guarantee the estimated residual value of $30,000 at the end of the fourth year. Assume a 10% interest rate.

Guaranteed Residual Value Leased Equipment Under Capital Leases Accumulated Depreciation: Leased Equipment 117,284.99 147,284.99 117,284.99 At the end of the lease, both parties agree that the equipment is worth only $20,000, but the guaranteed residual was $30,000. Obligation Under Capital Leases 30,000.00 Accumulated Depreciation: Leased Equip. 117,284.99 Capital Lease Obligation 30,000.00 Loss on Disposal of Leased Equipment 10,000.00 Leased Equipment 147,284.99 Cash 10,000.00

Guaranteed Residual Value If the fair value is more than $30,000, the lessee pays the liability in full by returning the asset to the lessor.

Disclosure Requirements for Lessee Exhibit 21-5 provides the disclosure requirements for a lessee.

Cost Given-Find Rental Payments On January 1, 2007, Brahms Inc. leases equipment with a fair value of $100,000, an economic life of four years and a lease term of three years. Brahms incremental borrowing rate is 10%. There is a bargain purchase option at that time of $10,000. The first payment is due immediately. Find the payment and the amount to be capitalized.

Cost Given- Find Rental Payments Cost or fair value of leased asset (amount capitalized if residual guaranteed) Less: Present value of residual or bargain purchase Yields: Present value to be recovered through rental payments (amount capitalized if residual unguaranteed) Find: Lease payment for principal and interest Plus: Executory costs (not present valued) Equals: Minimum rental payment (regardless of whether residual guaranteed)

Cost Given- Find Rental Payments Cost or fair value of leased asset $100,000 (amount capitalized if residual guaranteed) Less: Present value of residual or bargain purchase 7,513 Yields: Present value of rental payments $92,487 (amount capitalized if residual unguaranteed) Find: Lease payment for principal and interest 33,809 Plus: Executory costs (not present valued) 0 Equals: Minimum rental payment (regardless of whether residual guaranteed) $33,809

Lessee Schedule-Lessee Annual Interest Reduction of Lease Payment Expense Obligation Obligation 1/1/07 $100,000 1/1/07 $33,809 0 $33,809 66,191 1/1/08 33,809 6,619 27,190 39,001 1/1/08 33,809 3,900 29,909 9,092 12/31/08 10,000 908 9,092 0 Lessor’s Receivable $111,427 Lessor’s unearned interest $11,427 The lessor’s schedule will have the same numbers as the lessee’s schedule with a guaranteed residual.

Payments Given- Find Amount to be Capitalized On January 1, 2007, Rutter Inc. enters into a lease agreement, which qualifies as a capital lease. Their borrowing rate is 10%, the lease term is three years, the residual value is $5,000, and executory costs are $2,000 per year. The first payment of $37,182.62 is due immediately. How much should Rutter capitalize if the residual value is not guaranteed, and (2) the residual value is guaranteed?

Payments Given- Find Amount to be Capitalized Minimum rental payment Less: Executory costs (not present valued) Yields: Lease payment for principal and interest Gives: Present value to be recovered through rental payments (amount capitalized if residual unguaranteed) Plus: Present value of residual or bargain purchase Equals: Amount to be capitalized if residual is guaranteed

Payments Given- Find Amount to be Capitalized Minimum rental payment $37,182.62 Less: Executory costs (not present valued) 2,000 Yields: Lease payment for principal and interest $35,182.62 Gives: Present value to be recovered through rental payments (3 years) $96,243.46 (amount capitalized if residual unguaranteed) Plus: Present value of residual or bargain purchase 3,756.55 Equals: Amount to be capitalized if residual is guaranteed $100,000

Depreciation With a capital lease, the lessee records depreciation using the firm’s normal depreciation method. Over the economic life if title is transferred or the is a bargain purchase option. Over the term of the lease if the lease term is equal to 75% or more of the economic life, or the present value of the minimum lease payments is at least 90% of the fair value. Any residual (salvage) is ignored if the residual is not guaranteed. Any residual is not discounted (present valued) if the residual is guaranteed.

Depreciation In the Brahms example above the lease term was three years, the economic life was four years and there was a bargain purchase option. Amount capitalized less salvage = depreciation Economic life $100,000 - $10,000 = $22,500 per year Four years

Depreciation Assume that there was no bargain purchase option and the residual was not guaranteed. Amount capitalized = depreciation Lease term $92,487 = $30,829 per year 3 years

Lessor’s Classifications A leveraged lease is a special three-party lease that is always considered to be a direct financing lease. Operating lease Sales-type lease Direct financing lease Leveraged lease

Operating Lease (Lessor) Owner Company leases a piece of equipment to User Company for 5 years. User Company agrees to pay $50,000 at the beginning of each year. Owner Company purchased the equipment for $300,000. The equipment has an estimated life of 10 years and Owner Company uses straight-line depreciation. Owner pays the annual insurance premium of $2,000, and on December 15, 2007, it pays for repairs of $1,500. None of the criteria in Column A (Example 21-2) were met; therefore, this lease should be treated as an operating lease. Why is this an operating lease?

Operating Lease (Lessor) Purchase of Equipment to Be Leased on Jan. 1, 2007 Equipment Leased to Others 300,000 Cash (or Accounts Payable) 300,000 Collection of Annual Payment on January 1, 2007 Cash 50,000 Rental Revenue 50,000 Payment of Annual Insurance Premium, Jan. 10, 2007 Insurance Expense 2,000 Cash 2,000 Continued

Operating Lease (Lessor) Payment of Repairs on December 15, 2007 Repair Expense 1,500 Cash 1,500 Recognition of Annual Depreciation, Dec. 31, 2007 Depreciation Expense: Equipment Leased to Others 30,000 Accumulated Depreciation: Equipment Leased to Others 30,000

Direct Financing Leases (Lessor) The gross receivable of the lessor includes the sum of-- Under a direct financing lease, the lessor “sells” the asset at no gain or loss. The net amount at which the lessor records the receivable must be equal to the carrying value of the property. The undiscounted minimum lease payments to be received by the lessor (net of executory costs paid by the lessor) plus The unguaranteed residual value accruing to the benefit of the lessor.

Direct Financing Leases (Lessor) Gardner Company leases equipment to the Martin Company for 4 years. The lease is noncancelable and requires equal payments of $32,923.45. This equipment cost Gardner $100,000. There is no guaranteed residual value. Martin agrees to pay all executory costs. The equipment reverts back to Gardner at the end of 4 years. Martin’s incremental borrowing rate is 12.5%, while Gardner’s is 12%. Martin Company uses straight-line depreciation. All requirements for Column B are met. Why is this a direct financing lease? $100,000 ÷ 3.037349

Direct Financing Leases (Lessor) …(2) both of the criteria listed in Column B (Example 21-2), and (3) there is no manufacturer’s or dealer’s profit. See Example 21-7 for more detail. It is a direct financing lease because it meets the three requirements: (1) one or more of the items listed in Column A (Exhibit 21-2)—Items 3 and 4.

Decrease Liability in Balance Dr Example 21-8 2. Lease Payment Cr Interest 12% Expense Dr Decrease Liability in Balance Dr Balance 100,000.00 32,923.45 12,000.00 20,923.45 79,076.55 32,923.45 9,489.19 23,434.26 55,642.29 32,923.45 6,677.07 26,246.38 29,395.91 32,923.45 3,527.54 29,395.91 0

Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 131,693.80 Equipment 100,000.00 Unearned Interest: Leases 31,693.80 $32,923.45 x 4 Collection of Annual Payment on December 31, 2007 Cash 32,923.45 Lease Payments Receivable 32,923.45 Continued

Direct Financing Leases (Lessor) Recognition of Interest Revenue on Dec. 31, 2007 Unearned Interest: Leases 12,000.00 Interest Revenue: Leases 12,000.00 $100,000 x 0.12 Collection of Annual Payment on Dec. 31, 2008 Cash 32,923.45 Lease Payments Receivable 32,923.45 Recognition of Interest Revenue on December 31, 2008 Unearned Interest: Leases 9,489.19 Interest Revenue: Leases 9,489.19 ($100,000 - $20,923.45) x 0.12

Direct Financing Leases (Lessor) Let’s look at a direct financing lease where the payments will be received in advance.

Direct Financing Leases (Lessor) $100,000 X 3.913712 On January 1, 2007, the Watkins Finance Company leases equipment that cost $391,371.20 (which is also the fair value) to the Hutton Company. The term of the lease is 5 years, with annual payments of $100,000 received in advance. The economic useful life is 5 years. There is no BPO or guaranteed residual value. The lease receipts will yield Watkins a 14% return. The collectibility is reasonably assured, and there are no uncertainties involved in the lease.

Lease Payment Received Reduction in Net Investment Example 21-10 2. Lease Payment Received Interest 14% Revenue Reduction in Net Investment Net Investment Balance PV of rental payments but residual not guaranteed 391,371.20 100,000 291,371.20 2007 100,000 40,791.97 59,208.03 232,163.17 2008 100,000 32,502.84 67,497.16 164,666.01 2009 100,000 23,053.24 76,946.76 87,719.25 2010 100,000 12,280.75 87,719.25 0

Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 500,000.00 Equipment 391,371.20 Unearned Interest: Leases 108,628.80 $100,000 x 5 Collection of Annual Payment on January 1, 2007 Cash 100,000.00 Lease Payments Receivable 100,000.00 Continued

Direct Financing Leases (Lessor) Recognition of Interest Revenue on Dec. 31, 2007 Unearned Interest: Leases 40,791.97 Interest Revenue: Leases 40,791.97 $291,371.20 x 0.14

Sales Type Leases (Lessor) Take a moment to examine the data in the next slide. Why is this a sales-type lease? Click on the button to check your response.

Sales Type Leases (Lessor) Cost of Goods Sold Sales Revenue Lease Payments Receivable ($30,000 x 10) + $500

Sales Type Leases (Lessor) ($30,000 x 10) + $500 Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 300,500.00 Unearned Interest: Leases (plug) 110,491.51 Sales Revenue 190,008.49 $30,000 x 6.328250 = $189,847.50 $500 x 0.321973 = 160.99 $190,008.49 Cost of Goods Sold 120,000.00 Merchandise Inventory (or Equipment) 120,000.00 Continued

Sales Type Leases (Lessor) Collection of Annual Payment on January 1, 2007 Cash 30,000.00 Lease Payments Receivable 30,000.00 Recognition of Interest Revenue on December 31, 2007 Unearned Interest: Leases 19,201.02 Interest Revenue: Leases 19,201.02 12% x [($300,500 - $30,000) - $110,491.51]

Initial Direct Costs for Lessor Costs that a lessor would not have incurred if it had not entered into the lease contract. Operating lease Expense in proportion to the receipts from the lease over the term of the lease. Direct financing lease Reduce “Unearned Interest” and calculate a new (lower) implicit interest rate. Sales-type lease Expense in period of sale.

Why would a lessee or lessor want to avoid capitalizing a lease? Conceptual Issues The motivation usually comes from the lessee who wants to avoid reporting the liability. Why would a lessee or lessor want to avoid capitalizing a lease?

C 21 hapter The End Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

The lease meets two of the criteria: (a) The lease term is 75% or more of the asset’s economic life and (b) the present value of the lease payments is 90% or more of the asset’s fair value. Return

Three of four criteria from Column A (Example 21-7) are met and both items from Column B, and there is a manufacturer’s or dealer’s profit. Return