An electronic presentation Pepperdine University 20 hapter Accounting for Leases An electronic presentation by Douglas Cloud Pepperdine University 1 1 1 1

Objectives 2. Understand key terms related to leasing. 1. Explain the advantages of leasing. 2. Understand key terms related to leasing. 3. Explain how to classify leases of personal property. 4. Account for a lessee’s operating and capital leases. 5. Understand disclosures by the lessee. Continued 2 2 2 4

Objectives 8. Explain the conceptual issues regarding leases. 6. Account for a lessor’s operating, direct financing, and sales-type leases. 7. Understand disclosures by the lessor. 8. Explain the conceptual issues regarding leases. 9. Understand lease issues related to real estate, sale-leaseback issues, leveraged leases, and changes in lease provisions (Appendix).

Advantages of Leasing from Lessee’s Viewpoint Financial benefits Risk benefit Tax benefit Financial reporting benefit Billing benefit

Advantages of Leasing from Lessee’s Viewpoint 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 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, 2004 Company A 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, 2005. After Acquisition Current Ratio: $2,100,000 $1,446,429 = 1.45 Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 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 On December 31, 2004 Company B leases identical equipment to that leased by Company A, 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). The acquisition is treated as an operating lease. After Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 Before 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.

Key Terms Related to Leasing FASB Statement No. 13 as Amended 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 Minimum lease payments receivable Unguaranteed residual value Unreimbursable cost

Key Terms Related to Leasing Become familiar with these terms. They are critical to discussing leases.

Classification of Leases Involving Personal Property Column A 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 75% or more of the estimated economic life of the leased property. D. 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. Criteria applicable to both lessee and lessor.

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

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

Classification of Leases Involving Personal Property It must involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor. A sales-type lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. 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, 2004 and continuing through January 1, 2008. The lease terms are given in Exhibit 20-4.

Operating Lease (Lessee) Examine Exhibit 20-4 and determine how many of Group A criteria are met. Since none are met, this is an operating lease. Exhibit 20-4 Terms and Provisions of Lease Agreement Between Owners Company (Lessor) and User Company (Lessee) Dated January 1, 2004 1. The lease term is 5 years. The lease is noncancelable and requires equal payment of $50,000 at the beginning of each year. 2. The cost, and also fair value of the equipment to the Owner Company at the inception of the lease is $300,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time. 3. There is no guaranteed of the residual value by the User Company. 4. The Owner Company agrees to pay all executory costs. 5. The equipment reverts to the Owner Company at the end of the 5 years; that is, the lease contains no bargain purchase option. 6. The User Company’s incremental borrowing rate is 12.5% per year. 7. For the Owner Company, the interest rate implicit in the lease is 12%. 8. The present value of an annuity due (in advance) of 5 payments each at 12% is $201,867 *4.037349 x $50,000 = $201,867.45).

Operating Lease (Lessee) If you incorrectly concluded that it was a capital lease, examine Exhibit 20-5 carefully. Exhibit 20-5 Application of Lease Classification Criteria by User (Lessee) Classification Criteria Criteria Met? Remarks 1. Transfer of ownership at end of lease No 2. Bargain purchase option No 3. Lease term is 75% or more of economic life No It is 50%. 4. Present value of lease payment is 90% or more of fair value No The present value is $201,867.45, or 67% of fair value Decision: A capital lease must meet one or more of the classification criteria; otherwise the lease is an operating lease. Conclusion: The lease is an operating lease. It does not meet any of the criteria.

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.

Capital Lease (Lessee) The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2004 that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2004.

Capital Lease (Lessee) First, examine Exhibit 20-7 to determine why this is a capital lease. To check your response, click the button in the corner.

Capital Lease (Lessee) Initial Recording of Capital Lease on January 1, 2004 Leased Equipment Under Capital Leases 100,000.00 Obligation Under Capital Leases 100,000.00 December 31, 2004 Interest Expense 12,000.00 Obligation Under Capital Leases 20,923.45 Cash 32,923.45 12% x $100,000 $32,923.45 – $12,000.00 Continued

Capital Lease (Lessee) Recognition of Depreciation, December 31, 2004 Depreciation Expense: Leased Equipment 25,000.00 Accumulated Depreciation: Leased Equipment 25,000.00 $100,000 ÷ 4 Second Annual Payment, December 31, 2005 Interest Expense 9,489.19 Obligation Under Capital Leases 23,434.26 Cash 32,923.45 $79,076.55 x 0.12 $32,923.45 – $9,489.19 The depreciation entry on December 31, 2005 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

Capital Lease (Lessee) Initial Recording of Capital Lease on January 1, 2004 Leased Equipment Under Capital Leases 112,000.00 Obligation Under Capital Leases 112,000.00 First Payment in Advance, January 1, 2004 Obligation Under Capital Leases 32,923.45 Cash 32,923.45 Continued

Capital Lease (Lessee) Recognition of Depreciation, December 31, 2004 Depreciation Expense: Leased Equipment 28,000.00 Accumulated Depreciation: Leased Equipment 28,000.00 $112,000 ÷ 4 Recognition of Interest Expense, December 31, 2004 Interest Expense 9,489.19 Accrued Interest on Obligation Under Capital Leases 9,489.19 $79,076.55 x 0.12 Continued

Capital Lease (Lessee) Second Annual Payment in Advance, January 1, 2005 Accrued Interest on Obligation Under Capital Leases 9,489.19 Obligation Under Capital Leases 23,434.26 Cash 32,923.45 Recognition of Depreciation, December 31, 2005 Depreciation Expense: Leased Equipment 28,000.00 Accumulated Depreciation: Leased Equipment 28,000.00

Bargain Purchase Option Does this qualify as a capital lease? Yes…because of the bargain purchase option. Redd Company leases equipment for four 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.

Bargain Purchase Option Leased Equipment Under Capital Leases 128,160.63 Obligation Under Capital Leases 128,160.63 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

Guaranteed Residual Value Karpas Company leases equipment for four 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 Obligation Under Capital Leases 30,000.00 At the end of the lease, both parties agree that the equipment is worth only $20,000. Accumulated Depreciation: Leased Equip. 117,284.99 Obligation Under Capital Leases 30,000.00 Loss on Disposal of Leased Equipment 10,000.00 Leased Equipment Under Capital Leases 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 20-11 provides the disclosure requirements for a lessee.

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 Leverage lease

Operating Lease (Lessor) Owner Company leases a piece of equipment to User Company for five 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, 2004 it pays for repairs of $1,500. None of the criteria in Column A (Exhibit 20-2) 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 January 1, 2004 Equipment Leased to Others 300,000 Cash (or Accounts Payable) 300,000 Collection of Annual Payment on January 1, 2004 Cash 50,000 Rental Revenue 50,000 Payment of Annual Insurance Premium, January 10, 2004 Insurance Expense 2,000 Cash 2,000 Continued

Operating Lease (Lessor) Payment of Repairs on December 15, 2004 Repair Expense 1,500 Cash 1,500 Recognition of Annual Depreciation, December 31, 2004 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. 1. The undiscounted minimum lease payments to be received by the lessor (net of executory costs paid by the lessor) plus 2. The unguaranteed residual value accruing to the benefit of the lessor.

Direct Financing Leases (Lessor) Gardner Company leases equipment to the Martin Company for four 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 four 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) It is a direct financing lease because it meets the three requirements: (1) one or more of the items listed in Column A (Exhibit 20-2)—Items 3 and 4. …(2) both of the criteria listed in Column B (Exhibit 20-2), and (3) there is no manufacturer’s or dealer’s profit.

Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2004 Minimum 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, 2004 Cash 32,923.45 Minimum Lease Payments Receivable 32,923.45 Continued

Direct Financing Leases (Lessor) Recognition of Interest Revenue on December 31, 2004 Unearned Interest: Leases 12,000.00 Interest Revenue: Leases 12,000.00 $100,000 x 0.12 Collection of Annual Payment on December 31, 2005 Cash 32,923.45 Minimum Lease Payments Receivable 32,923.45 Recognition of Interest Revenue on December 31, 2005 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) On January 1, 2004 the Watkins Company leases equipment that cost $391,371.20 (which is also the fair value) to the Hutton Company. The term of the lease is five years, with annual payments of $100,000 received in advance. The economic useful life is five 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. $100,000 x 3.913712

Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2004 Minimum 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, 2004 Cash 100,000.00 Minimum Lease Payments Receivable 100,000.00 Continued

Direct Financing Leases (Lessor) Recognition of Interest Revenue on December 31, 2004 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 Exhibit 20-19. Why is this a sales-type lease? Click on the button to check your response.

Sales-Type Leases (Lessor) Initial Recording of the Lease on January 1, 2004 Minimum Lease Payments Receivable 300,500.00 Sales Revenue 190,008.49 Unearned Interest: Leases 110,491.51 ($30,000 x 10) + $500 $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 Held for Lease) 120,000.00 Continued

Sales-Type Leases (Lessor) Collection of Annual Payment on January 1, 2004 Cash 30,000.00 Minimum Lease Payments Receivable 30,000.00 Recognition of Interest Revenue on December 31, 2004 Unearned Interest: Leases 19,201.02 Interest Revenue: Leases 19,201.02 12% x [($300,500 – $30,000) – $110,491.51]

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?

Disclosure Requirements for the Lessor Before leaving this chapter, be certain that you have a good grasp of Exhibit 2-4.

C 20 hapter The End

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 (Exhibit 20-2) are met and both items from Column B, and there is a manufacturer’s or dealer’s profit. Return