ACCOUNTING FOR LEASES CHAPTER 15 LEASES

Learning Objectives Overview : Lease. Types of Leases Lease Agreements Classification criteria in order to distinguish between the types of leases Accounting for types of leases: Both lessee and lessor Disclosure & Presentation

Economic Advantages to Leasing No down payment. Avoid risks of ownership. Flexibility. Protection against obsolescence use of an asset without showing the resources/sources.. Off-balance-sheet financing …….

Accounting by the Lessor/Lessee A lease is a contractual agreement: lessor (Owner of Property) conveys the right to use property to lessee (User/Renter) in return for periodic cash payments For stated period of time The lessee receives the beneficial use of property in the lease. The lessor owns the property, and the lessee is the party who uses the assets and makes lease payments. From the perspective of the lessee, we have two types of leases. The first lease is referred to as an operating lease, and the second is known as a capital lease. We view a capital lease as an in-substance purchase of an asset. From the perspective of the lessor, we have three types of leases. We have an operating lease, a direct-financing-type lease, and a sales-type lease. Classification of leases>>> 4

Accounting for Leases and classifications: FASB 13 Fundamental Rights and Responsibilities Recognize the true Substance over the Form of the lease The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do.

CLASSIFICATION OF LEASE LEASES LESSOR LESSEE CAPITAL LEASE CAPITAL LEASE OPERATING LEASE OPERATING LEASE transfers ownership rental agreements DIRECT FINANCING SALES TYPE Classification Criteria:…>

CLASSIFICATION OF LEASE LEASES PART I PART II LESSOR LESSEE CAPITAL LEASE OPERATING LEASE transfers ownership rental agreements Classification Criteria:…>

1. FASB (13) CRITERIA 1. Transfer of Ownership The lease contract includes a provision that the title to the leased asset passes to the lessee by the end of the lease term Bargain Purchase Option (BPO) Makes it reasonably assured that the lessee will acquire asset allows the lessee to buy the leased asset at a price significantly lower than the asset’s fair value when the option is exercisable (BARGAIN PRICE) Term: 75% of economic Life – Lease term is equal to 75% or more of the economic life of the leased asset 4. Asset Value: Present value of the minimum lease payments is greater than or equal to 90% of the FMV of the leased asset on the lease signing - what is included in Lease payments

MUST MEET JUST ONE CRITERIA CLASSIFICATION OF LEASE:LESSEE MUST MEET JUST ONE CRITERIA Lease Agreement Non-Cancellable Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease Determine if the risks/rewards of ownership transferred to lessee

ACCOUNTING FOR CAPITAL LEASE PURCHASE/OWNERSHIP LESSEE (books) Determine the criteria: 1. Ownership transfer 2. Bargain purchase option 3. PV of MLP (minimum lease payment) is equal to 90% of more 4. Lease term 75% or more of estimated economic life

Calculation of CAPITAL LEASE LESSEE (books) Determine the criteria: (any one…) Lease is classified as: CAPITAL LEASE LESSEE’S BOOKS DR. ASSET: LEASE PROPERTY CR. LEASE OBLIGATION (PAYABLE)

CAPIALIZED AMOUNT Lessee The Lessee records the lease an asset/liability: LESSER OF: 1. FAIR VALUE of the asset at the inception of lease or 2. PV of MLP (PVMLP) Question: what should be included in the PVMLP

Residual Value (RV) Guaranteed or Unguaranteed Estimated Value at the end of the lease term! GUARANTEED RV is additional payment at the end of the lease term If Bargain Purchase Option: GRV becomes irrelevant UNGUARANTEED: not required to make additional payment at the end of the lease term

Accounting by the Lessee PV OF MINIMUM LEASE PAYMENTS (PVMLP) Minimum lease payments: PV rental payment (usually beginning of the period) Plus: PV Guaranteed residual value (unguaranteed : NOT included in PVMLP)

CAPITAL Leases - Lessee The amount recorded (capitalized) is the PVMLP. However, the amount recorded cannot exceed the fair value of the leased asset. the interest rate used by the lessee is the lower of: Its incremental borrowing rate, or The implicit interest rate used by the lessor. Part I From the viewpoint of the lessee, the amount recorded as the asset will be the present value of the minimum lease payments. However, the amount recorded as the asset can never exceed the fair value of that asset. Part II In calculating the present value of the minimum lease payment, the interest rate used will be the lower of the lessee’s incremental borrowing rate, or the implicit rate used by the lessor to set the lease payment amount.

ACCOUNTING FOR CAPITAL LEASE: LESSEE Asset user Asset & Liability are recognized Amount: PV of Lease payments Including any BPO or Guarantee Residual Value (GRV) Lease payments reduction in Lease Liability & Increases to interest expense (relates to liability) Let’s Illustrate… Asset is subsequently Depreciated *

Depreciation of Asset: Rules*: Transfer of Ownership: Depreciate over asset life (Legal form) Bargain purchase option: Depreciate over the asset life (legal form) Term (75%) : Depreciate lease term (substance over form) Asset Value (90% FV): Depreciate over lease term (substance over form)

Executory Costs Ownership of the asset is responsible for Insurance, maintenance, etc Capital Lease: Lessee gets the benefit of using the asset (LESSEE’s expense) Dr. Maintenance expense (executory costs) Cr Cash (if included in lease payment – deduct to calculate PV MLP) If lessor makes the payment, these costs are reimbursed by lessee by recording the expense

LEASE PART II Accounting for Leases- Lessor Classification of Lease: LESSOR’S BOOK

CLASSIFICATION OF LEASE: LESSOR LEASES LESSOR LESSEE CAPITAL LEASE CAPITAL LEASE OPERATING LEASE OPERATING LEASE DIRECT FINANCING SALES TYPE Classification Criteria:…>

Accounting by the Lessor Classification of Leases by the Lessor

Classification of Leases by the Lessor Accounting by the Lessor Classification of Leases by the Lessor If any costs to the lessor to be incurred, are reasonably predictable A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

Nonoperating Leases: - Lessor If the lessor is not a manufacturer or dealer, the fair value of the leased asset is typically the lessor’s cost- DIRECT FINANCING LEASE When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price – SALES TYPE LEASE If the lessor is not a manufacturer or dealer of the asset being leased, the fair value of the leased asset usually will be equal to the lessor’s cost. However, when the lessor is a manufacturer or dealer, the fair value of the leased property at inception of lease will usually be more than the cost of the asset in the hands of the lessor.

Direct-Financing Lease: Lessor

Depreciation: NOT RECORDED BY LESSOR Asset is removed from the Lessor’s books Illustration: DIRECT FINANCING…. LESSOR-

e.g. Legal fees, commissions Initial Direct Costs costs incurred by the lessor in negotiating/preparing a lease agreement. e.g. Legal fees, commissions Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Financing Leases − not expensed ; deferred and recognized over the lease term Sales type leases: expensed at the inception of the lease (selling expense) Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct-financing type lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct-financing type lease, we must calculate a new implicit interest rate that previously was unknown to the lessor.

How should the lease be classified by LESSOR Since the fair value equals the lessor’s carrying value, there is no dealer’s profit, making this a direct financing lease. Prepare appropriate entries for Canfor (lessor)

Sales-Type Lease: LESSOR Total payments – sale price = interest

Accounting for Sales-Type Lease LESSOR Record: Receivable (PV) & Sales Cost of goods sold / reducing the inventory Any Initial Direct Costs recognized as an expense immediately Reimbursement of executory costs – same as direct financing

Sales Type Lease with Guaranteed Residual Value Guaranteed Residual Value: Both Lessee and Lessor include Guaranteed Residual Value in calculating MLP If RV is not guaranteed by Lessee (Lessee exclude in MLP) LESSOR: Lessor : even if it is not guaranteed by lessee, lessor expects to receive from 3rd party Includes residual value in their receivable But the sales revenue and COGS are reduced by the same amounts

Lessee Disclosures For capital leases, disclose Gross amount of assets recorded under capital leases. Future MLP in the aggregate and for each of the five succeeding years. Total minimum sublease rentals to be received in the future under non-cancelable subleases. On the next three screens, we will outline the lessee’s disclosure requirements for leases. Be sure you read each screen carefully.

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International Accounting of Leases IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases.