Intermediate Accounting II Chapter 15 Leases Intermediate Accounting II Chapter 15

Leases Lease – contractual agreement where the lessor provides the lessee the right to use an asset for a specified period of time in return for periodic cash payments Lessor – party who owns the asset Lessee – party using the asset

Basic Lease Classifications For accounting purposes, a lease is accounted for as either a lease agreement (operating lease) or a purchase/sale accompanied by debt financing. The choice of accounting method hinges on the nature of the leasing arrangement. Finance/Sales-type leases are agreements that we identify as being formulated outwardly as leases, but which are in reality installment purchases. LESSEE LESSOR Finance lease Sales-type lease without selling profit with selling profit Operating lease Operating lease 

Lease Classification Criteria A lessee should classify a lease transaction as a finance/sales-type lease (formerly known as a capital lease) if one or more of five classification criteria are met: 1. The agreement specifies that asset ownership transfers to the lessee. 2. The agreement contains a purchase option that the lessee is reasonably certain to exercise. The lease term is for the “major part” of the remaining economic life of the underlying asset. The present value of the total of the lease payments equals or exceeds “substantially all” of the fair value of the underlying asset. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. Otherwise, the lease is accounted for as an operating lease.

Finance/Sales-type Lease or Operating Lease? On January 1, 2018, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2018, the inception of the lease, and at each January 1 through 2022. The useful life of the copier is estimated to be six years and ownership of the asset will revert to CompuDec at the end of the lease. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier the interest rate would have been 10%. How should this lease be classified? Account for this lease as an Operating Lease Does the agreement specify that ownership of the asset transfers to the lessee? No Does the agreement contain a purchase option that the lessee is reasonably certain to exercise? No Is the lease term for the “major part” of the remaining economic life of the underlying asset No 4/6 years = 67% Does the present value of the total of the lease payments equal or exceed “substantially all” of the fair value of the underlying asset. Present Value MLP = $100,000 X 3.48685 = $348,685 FV = $479,079 No Is the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term? No

Finance Lease or Operating Lease? Brief Exercise 15-2 Corinth Co. leased to Athens Corporation for an eight-year period, at which time possession of the leased asset will revert to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the minimum lease payments of both the lessor and lessee is $20.6 million. The first payment was made at the inception of the lease. How should Athens classify this lease? Account for this lease as an Finance Lease Does the agreement specify that ownership of the asset transfers to the lessee? No Does the agreement contain a purchase option that the lessee is reasonably certain to exercise? No Is the lease term for the “major part” of the remaining economic life of the underlying asset No 8/12 years = 67% Does the present value of the total of the lease payments equal or exceed “substantially all” of the fair value of the underlying asset. Yes Present Value MLP = $20.6/22.4 = 92% Is the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term? No

Sales-type Lease or Operating Lease? Brief Exercise 15-1 Corinth Co. leased to Athens Corporation for an eight-year period, at which time possession of the leased asset will revert to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the minimum lease payments of both the lessor and lessee is $20.6 million. The first payment was made at the inception of the lease. How should Corinth classify this lease? Account for this lease as an Sales-type Lease with a profit Does the agreement specify that ownership of the asset transfers to the lessee? No Does the agreement contain a purchase option that the lessee is reasonably certain to exercise? No Is the lease term for the “major part” of the remaining economic life of the underlying asset No 8/12 years = 67% Does the present value of the total of the lease payments equal or exceed “substantially all” of the fair value of the underlying asset. Yes Present Value MLP = $20.6/22.4 = 92% Present Value MLP = $20.6 million > Lessor’s cost of $16 million Is the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term? No

Accounting for Operating Leases The fundamental rights and responsibilities of ownership are retained by the lessor and that the lessee merely is using the asset temporarily. A “sale” is not recorded by the lessor. A “purchase” is not recorded by the lessee but an asset (right-of-use asset) and liability (lease payable) is still recorded. Lease payable is considered a non-debt liability. Interest expense is recorded using the effective interest method. The right-to-use asset is amortized using the effective interest method. The periodic lease payments are accounted for as Lease Revenue by the lessor. Lease payments received at the beginning of the year are recorded as Deferred Lease Revenue (unearned revenue). The cost of a leasehold improvement is depreciated over its useful life by the lessee.

Exercise 15–17, page 878

Accounting for Finance/Sales-type Leases: Lessee In a finance lease, the lessee records a “right-of-use” asset at the present value of the lease payments. Interest expense accrues at the effective rate on the balance outstanding during the period. Lease payments (except the first) include interest on the outstanding balance as well as a residual portion that reduces that outstanding balance. An amortization schedule is helpful to keep up with changing interest and lease obligation amounts. Amortization is recorded for “right-of-use” assets Straight-line amortization is usually applied Normally over the term of the lease. Over the asset's useful life, if: Ownership transfers or A bargain purchase option is present

Accounting for Finance/Sales-type Leases - Lessor In a sales-type lease, the lessor records a lease receivable at the present value of the lease payments. The leased asset is removed from the lessor’s books (by crediting the asset account) Interest revenue accrues at the effective rate on the balance outstanding during the period. Lease payments (except the first) include interest on the outstanding balance as well as a residual portion that reduces that outstanding balance. An amortization schedule is helpful to keep up with changing interest and lease obligation amounts. A sales-type lease contains a profit if the fair value of the asset exceeds the cost of carrying value of the asset. Profit from a sales-type lease is recognized at the beginning of the lease period. The sale is journalized with a debit to COGS (for the cost of the asset) and a credit to Sales Revenue (for the present value of lease payments) No depreciation or other costs for the asset are recorded by the lessor.

Sales-type Leases Lessor When there is a selling profit, all lessor entries, other than the entry at the beginning of the lease to include the selling profit, are precisely the same as the entries for a sales-type lease without a selling profit. Lessee The lessee’s accounting is not impacted by whether or not the lessor recognizes a profit. The journal entries made by the lessee are precisely the same with or without a selling profit for the lessor.

Exercise 15–3, page 878 Calculation of the present value of lease payments   $562,907 x 5.32948 = $3,000,000 (rounded) present value of an annuity due of $1: n=6, i=5% Date Account Debit Credit June 30, 2018 Right-of-use asset 3,000,000 Lease Payable 562,907 Cash December 31, 2018 Interest Expense 121,855 441,052 Amortization Expense 500,000 Right-of-use Asset

Exercise 15–4, page 878 Calculation of the present value of lease payments   $562,907 x 5.32948 = $3,000,000 (rounded) present value of an annuity due of $1: n=6, i=5% Date Account Debit Credit June 30, 2018 Lease Receivable 3,000,000 Equipment Cash 562,907 December 31, 2018 441,052 Interest Revenue 121,855

Exercise 15–5, page 878 Calculation of the present value of lease payments   $562,907 x 5.32948 = $3,000,000 (rounded) present value of an annuity due of $1: n=6, i=5% Date Account Debit Credit June 30, 2018 Lease Receivable 3,000,000 Cost of Goods Sold 2,500,000 Sales Revenue Equipment Cash 562,907 December 31, 2018 441,052 Interest Revenue 121,855 Present Value MLP $3,000,000 Cost of Asset 2,500,000 Profit 500,000

Reporting Lease Expense and Lease Revenue After recording the lease entries, the lessee will have two lease-related expenses – interest expense and amortization expense. The lessee combines these two accounts into a single lease expense and reports a single amount each year in its income statement. This is consistent with the key objective of reporting a straight-line lease expense for an operating lease. In a finance lease, the lessee will report interest expense and amortization expense separately in the income statement. The lessor has only a single lease revenue account in an operating lease and reports that straight-line amount, $100,000, each year in its income statement.

Short-term Leases A lease is considered a short-term lease if it meets both of the following criteria: Has a lease term of twelve months or less Does not contain a purchase option that the lessee is reasonable certain to exercise, which would extend the term beyond twelve months. In a short-term lease, the lessee may elect not to record a right of-use asset and lease payable. Instead, the lessee simply records Lease Expense for the amount of the lease payment.

Brief Exercise 15–10, page 878 Date Account Debit Credit Beginning of lease No entry End of each of 8 months Lease Expense 10,000 Cash

Residual Value Amount an asset is worth at the end of the lease agreement. The lease agreement may include a guarantee by the lessee for residual value. Guaranteed residual value is considered an additional lease payment that is to be paid in property, cash, or both. When calculating minimum lease payments, deduct the present value of the residual value from the fair value of the leased asset. If the lessee obtains title to the leased asset, the lessor’s computation of lease payments is unaffected by any residual value.

Effect of Residual Value on Lease Payments - Example On January 1, 2018, Sans Serif Publishers leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation at a cost of $479,079. Assume the lease includes six annual payments beginning January 1, 2018, and at each December 31 thereafter through 2022. At the end of the six-year lease term ending December 31, 2023, the equipment is expected to have a residual value of $60,000. The estimated useful life of the equipment is seven years. If the six lease payments are of an equal amount, what payment amount would provide First LeaseCorp with a return of 10%? Amount to be recovered (fair value) $479,079 Less: Present value of the residual value ($60,000  0.56447*) (33,868) Amount to be recovered through periodic rental payments $445,211  4.79079** Lease payments at the beginning of each of the six years: $ 92,931 * Present value of $1: n = 6, i = 10%. **Present value of an annuity due of $1: n = 6, i = 10%.

Beginning of Lease [Jan. 1, 2018] The lessee’s accounting is unaffected by the residual value other than its causing the payments to be lower. (Unless cash payment is expected; then it’s considered another payment) Beginning of Lease [Jan. 1, 2018] Sans Serif Publishers, Inc. (Lessee) Right-of-use asset (present value of payments) 445,211 Lease payable (present value of payments) 445,211 First LeaseCorp (Lessor) Lease receivable (present value of payments) 479,079 Inventory of equipment (lessor’s cost) 479,079

(10% x Outstanding balance) Lessor’s Amortization Schedule Receipts Effective Interest Decrease in Balance Outstanding Balance (10% x Outstanding balance) 1/1/18 479,079 92,931 386,148 12/31/18 0.10 (386,148) = 24,869 54,316 331,832 12/31/19 0.10 (331,832) = 33,183 59,748 272,084 12/31/20 0.10 (272,084) = 27,208 65,723 206,361 12/31/21 0.10 (206,361) = 20,636 72,295 134,066 12/31/22 0.10 (134,066) = 13,407 79,524 54,542 12/31/23 60,000 0.10 (54,542) = 5,458* 617,586 138,507 *Adjusted for rounding of other numbers in the schedule. The lessor expects to receive the residual value ($60,000) in the form of equipment at the end of the lease term.

End of the Lease (December 31, 2023) Residual Value: Lessor Perspective (cont.) At the end of the lease term, the lessor would record the following entry: End of the Lease (December 31, 2023) First LeaseCorp (Lessor) Equipment (residual value) 60,000 Lease receivable (account balance) 54,542 Interest revenue (10% x outstanding balance) 5,458

Nonlease Components of Lease Payments Examples of nonlease components include: Service contracts Maintenance Hazard insurance Property taxes Nonlease components that represent a transfer of a good or service to the lessee are expensed by the lessee Nonlease components may be paid by the lessor (example: maintenance) but are in effect, indirectly paid by the lessee—and expensed by the lessee Lessee records a right-of-use asset and lease liability for the present value of the lease payments excluding the nonlease components. Hazard insurance and property taxes do not transfer to the lessee a separate good or service and thus are part of the lease payments.

First Payment (January 1, 2018) Nonlease Component Example On January 1, 2018, Sans Serif Publishers leased equipment from First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation at a cost of $479,079. Six annual payments of $102,000 beginning January 1, 2018. Payments include $2,000 which First LeaseCorp will use to pay an annual maintenance fee. The interest rate in these financing arrangements is 10%. Finance lease to Sans Serif. Sales-type lease to First LeaseCorp. First Payment (January 1, 2018) Sans Serif Publishers (Lessee) Maintenance expense (2018 fee) 2,000 Lease payable 100,000 Cash (lease payment) 102,000 First LeaseCorp (Lessor) Cash (lease payment) 102,000 Lease receivable 100,000 Maintenance fee payable* 2,000 *This assumes the $2,000 maintenance fee hasn’t yet been paid to the outside maintenance service.

Lease Disclosures Lease disclosure requirements are quite extensive for both the lessor and lessee.  Virtually all aspects of the lease agreement must be disclosed. Lessees and lessors must provide disclosures that enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. Information disclosed is both qualitative and quantitative. See pages 868-869 for additional details of lease disclosures.

Bargain Purchase Option A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a “bargain” price. When a BPO is present, both the lessor and the lessee view the option price as an additional lease payment. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. That additional payment is included as a component of minimum lease payments for both the lessor and the lessee. The lessor, when computing periodic lease payments, subtracts the present value of the BPO price from the amount to be recovered (fair market value) to determine the amount that must be recovered from the lessee through the periodic rent payments. The lessee adds the present value of the BPO price to the present value of periodic payments when computing the amount to be recorded as a leased asset and a lease liability The lease term effectively ends when the BPO is exercisable. Thus, if a BPO in a six-year lease could be exercised at the end of the fifth year, the effect will be to change the lease term to five years, from six.

Executory Costs Executory costs are maintenance, insurance, taxes, and any other costs usually associated with asset ownership. In a capital lease, the lessee is responsible for executory costs. Sometimes, as an expediency, a lease contract will specify that the lessor is to pay executory costs, but that the lessee will reimburse the lessor through higher lease payments. Any portion of lease payments that represents executory costs is not considered part of minimum lease payments and interest is not incurred for executory costs. The lessee expenses executory costs as incurred.

Executory Costs Example Problem Branif Leasing leases mechanical equipment to Branson Construction. The lease agreement specified 20 annual payments of $100,000 beginning December 31, 2014, the inception of the lease. The estimated useful life of the leased equipment is 20 years with no residual value. Its cost to Branif was $936,500. The lease qualifies as a capital lease to Branson. Maintenance of the equipment was contracted for through a 20-year service agreement with Midway service Company requiring 20 annual payments of $3,000 beginning December 31, 2014. Both companies use straight-line depreciation. Prepare journal entries for the second lease payments, depreciation, and executory costs for the lessee and lessor under each of the following assumptions: The lessee pays executory costs as incurred. The lease agreement specifies that the lessor pays executory costs as incurred. The lessee’s lease payments were increased to $103,000 to include reimbursement for these costs.

Executory Costs Example: Item a – Solution Lessee (Branson) Lessor (Branif) Date Account Debit Credit 2015 Dec 31 Lease Payable 16,350 Interest Expense* 83,650 Cash 100,000 Maintenance Expense 3,000 Depreciation Exp (936,500/10 yrs) 46,825 Accumulated Depreciation Date Account Debit Credit 2015 Dec 31 Cash 100,000 Interest Revenue 83,650 Lease Receivable 16,350 *Interest Expense: ($936,500 - $100,000) X 10% = $83,650

Executory Costs Example: Item b – Solution Lessee (Branson) Lessor (Branif) Date Account Debit Credit 2015 Dec 31 Lease Payable (to balance) 16,350 Interest Expense (836,500 X 10%) 83,650 Maintenance Expense 3,000 Cash 103,000 Depreciation Exp (936,500/10 yrs) 46,825 Accumulated Depreciation Date Account Debit Credit 2015 Dec 31 Cash 103,000 Lease Receivable 16,350 Interest Revenue 83,650 Maintenance Fee Payable 3,000

Intermediate accounting ii - Chapter 15 End of presentation Leases Intermediate accounting ii - Chapter 15 End of presentation