1Leases

2  Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase.  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. Learning Objectives

3  Apply the lease classification criteria in order to distinguish between capital and operating leases.  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). Learning Objectives

4  Prepare and interpret the lease disclosures required of both lessors and lessees.  Compare the treatment of accounting for leases in the United States with the requirements of international accounting standards.

5 Learning Objectives  Record a sale-leaseback transaction for both a seller-lessee and a purchaser- lessor.  Recognize the special characteristics of real estate leases. EXPANDED MATERIAL

6 Lease A contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.

7 Assets Acquired by Leasing Lessee: The 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. Operating Lease: A simple rental agreement. Capital Lease: A leasing transaction that is recorded as a purchase by the lessee.

8 Economic Advantages of Leasing No down payment. Avoid risks of ownership. Flexibility. No down payment. Avoid risks of ownership. Flexibility.

9 Advantages to Lessor Increased sales. Ongoing business relationship with lessee. Residual valued retained. Increased sales. Ongoing business relationship with lessee. Residual valued retained.

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

11 Lease Provisions Residual Value Market value of leased asset at end of lease term. Rental payment required over lease term plus any payment for residual value. Minimum Lease Payment

12 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:

13  The lease transfers ownership of the leased asset to the lessee by the end of the lease term.  The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.  The lease term is equal to 75 percent or more of the estimated economic life of the asset.  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. Lease Classification Criteria

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

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

16 Example: Operating Lease 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 (or Lease) Expense 1,000 Cash 1,000 To record monthly rent on office building. Lessee

17 Example: Operating Lease 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. Cash 1,000 Rent Revenue 1,000 To record monthly rent on office building. Lessor

18 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.

19 Operating Leases With Varying Lease Payments Entry Each Year for Years 1 and 2: Rent Expense210,000 Cash150,000 Rent Payable60,000 Entry Each Year for Years 3-5: Rent Expense210,000 Rent Payable40,000 Cash250,000

20 Interest Rates for Discounting Lease Payments  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.

21 Interest Rates for Discounting Lease Payments Lessor always uses the implicit rate to discount rental payments. Lessee uses the lesser of the implicit rate and the incremental borrowing rate.

22 Accounting for Capital Leases The Lessee

23 Example: Leases Minimum Payment$1,000/year Executory Costs $100 Term 10 years Useful Life of Asset 10 years Implicit Rate 10% Incremental Borrowing Rate 12%

24 Example: Inception of the Lease Leased Equipment6,759 Obligations under Capital Leases6,759 (PV of $1,000 in arrears for 10 years at 10%.) Lease Expense 100 Obligations under Capital Leases1,000 Cash1,100

25 Example: End of Year 1 Prepaid Executory Costs 100 Obligations under Capital Leases 424 Interest Expense 576 Cash1,100 Amortization Expense 615 Acc. Amortization 615 (Straight-line amortization of leased asset.)

26 Choosing an Amortization Period for Leased Assets FASB 13 Criterion Met Amortize Over Useful Life Lease Term Title passes at end of lease termX Lease contains bargain purchase option X Term of life  75% of asset’s useful life X Present value of payments  90% of asset’s fair market value X

27 Bargain Purchase Option Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price.

28 Bargain Purchase Option 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.

29 Impact of a Capital Lease on Lessee’s Statement of Cash Flows Operating Activities (indirect) Net income (includes reduction for Lease interest expense Lease amortization expense) + Amortization of leased asset Investing Activities No impact Financing Activities Principal portion of lease payment

30 Impact of a Capital Lease on Lessee’s Statement of Cash Flows Operating Activities (direct) - Lease interest expense Investing Activities No impact Financing Activities - Principal portion of lease payment

31 Accounting for Capital Leases The Lessor

32 Treatment of Initial Direct Costs Type of Lease Accounting Treatment of Costs OperatingCapitalize and amortize over lease term. Direct Capitalize and amortize, Financingwith unearned interest, over lease term. Sales-TypeImmediately recognize cost as reduction in profits.

33 Accounting for Direct Financing Leases Minimum Payment$1,000/year Executory Costs$100 Term 10 years Useful Life of Asset 10 years Implicit Rate 10% Incremental Borrowing Rate 12%

34 Example: Direct Financing Lease Lease Payments Receivable10,000 Equipment Purchased for Lease6,759 Unearned Interest Revenue3,241 At Inception of Lease: Cash1,100 Lease Payments Receivable1,000 Executory Costs100 At Receipt of First Payment:

35 Example: Direct Financing Lease Cash1,100 Lease Payments Receivable1,000 Deferred Executory Costs100 At End of the First Year: Unearned Interest Revenue576 Interest Revenue576

36 Direct Financing Lease If the lessor incurs any initial direct costs, those costs are recorded as a separate asset.

37 Accounting for Sales-Type Leases Minimum Payment$1,000/year Executory Costs$100 Term 10 years Useful Life of Asset 10 years Implicit Rate 10% Incremental Borrowing Rate 12% Cost of Equipment$5,000 (Continues example introduced in lessee section)

38 Sales-Type Lease Transaction Components Minimum Lease Payments Fair Market Value of Leased Asset $10,000 $ 6,759 $ 3,421 Financing Revenue (Interest)

39 Sales-Type Lease Transaction Components Minimum Lease Payments Fair Market Value of Leased Asset $10,000 $ 6,759 Cost of Leased Asset to Lessor $ 5,000 $ 3,421 Financing Revenue (Interest) $ 1,759 Manufacturer’s or Dealer’s Profit

40 Sales-Type Lease Lease Payments Receivable10,000 Unearned Interest Revenue3,431 Sales6,569 Cost of Goods Sold5,000 Finished Goods Inventory5,000 To Record the Sale: To Remove the Inventory and Record Cost:

41 Sales-Type Lease With BPO or Guaranteed Residual Value If the agreement provides for the lessor to receive a lump sum (from a bargain purchase option) at the end of the lease term or a guaranteed residual value, the minimum lease payments include these amounts.

42 Sales-Type Lease With BPO or Guaranteed Residual Value The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

43 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Financing Method Method Activities Activities Lessee: Operating lease payments Capital lease: Lease payments-- interest Lease payments-- principal Amortization of asset NI- Cash - Cash + NINo impact

44 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Method Method Activities Lessor: Operating lease: Initial direct costs (IDC) Amortization of IDC Lease receipts Direct financing lease: Initial direct costs Amortization of IDC Lease receipts--interest Lease receipts--principal - Cash +NINo impact NI+ Cash - Cash + NINo impact NI+ Cash + Cash

45 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Method Method Activities Lessor: Sales-type lease: Initial direct costs Manufacturer’s or dealer’s profit (net of IDC) Lease receipts--interest Lease receipts--principal - Cash - NINo impact NI+ Cash + NI+ Cash

46 Sale-Leaseback Transactions An arrangement whereby one party sells property to a second party, and then the first party leases the property back is a sale- leaseback transaction.

47 Real Estate Leases Does lease meet criterion 1 and 2? Yes Is lease for land only or building only? Is lease for land only or building only? Yes Capitalize lease if lessee. Report as a sales-type or a direct financing lease if lessor and supple- mentary criteria met.

48 Real Estate Leases Does lease meet criterion 1 and 2? Yes Is lease for land only or building only? Is lease for land only or building only? No Allocate rents to land and building Next slide

49 Real Estate Leases Allocate rent to land and building Land Building Capitalize lease if lessee. Lessor reports a sales-type or a direct financing lease if supplementary criteria met.

50 Allocate rents to land and building Yes Real Estate Leases Does lease meet criterion 1 and 2? Is land more than 25% of total value? No Next slide

51 Real Estate Leases Allocate rent to land and building Building Land Does lease meet criterion 3 or 4? Yes Capitalize lease (lessor must meet supplementary criteria).

52 Real Estate Leases Allocate rent to land and building Building Land Does lease meet criterion 3 or 4? No Operating lease

53 Real Estate Leases Does lease meet criterion 1 and 2? Is land more than 25% of total value? No Does lease meet criterion 3 or 4? No Operating lease

54 Real Estate Leases Does lease meet criterion 1 and 2? Is land more than 25% of total value? No Does lease meet criterion 3 or 4? Yes Capitalize lease (lessor must meet supplementary criteria).

55 The End