Slide 15-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Chapter Fifteen Leases

2 Basic Lease Terms A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee. A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee. Lessor: Owner of property Lessee: User of property

3 Lease Classifications LesseeLessor Right-of-use approachPerformance obligation approach Derecognition approach Short-cut method

4 Illustration On Jan. 1, 2011, Sans Serif Publishers leased printing equipment from First LeaseCorp who purchased the equipment from CompuDec Corporation for $479,079.  4 annual payments of $100,000 beginning Jan. 1, 2011, and at each Dec. 31 through  Useful life of the equipment is 6 years.  Lessor calculated payments using a rate of 10%. Record the lease.

5 Lessee: Right-of-Use Approach Lessor: Performance Obligation Approach Commencement of Lease [Jan. 1, 2011] Lessee Right-of-use asset 348,685 Lease liability (present value of payments) 348,685 Lessor Lease receivable (present value of payments) 348,685 Performance obligation 348,685 First Lease Payment [Jan. 1, 2011] Lessee Lease liability100,000 Cash100,000 Lessor Cash100,000 Lease receivable 100,000

6 Second Lease Payment [Dec. 31, 2011] Lessee Interest expense (10% x [$348,685 – 100,000]) 24,869 Lease liability (difference) 75,131 Cash (lease payment) 100,000 Lessor Cash (lease payment) 100,000 Lease receivable (difference) 75,131 Interest revenue (10% x [$348,685 – 100,000]) 24,869 Outstanding BalanceEffective Rate

7 LEASE AMORTIZATION SCHEDULE EffectiveDecrease Outstanding Payments Interest in BalanceBalance 10% x Outstanding Balance 1/1/11 348,685 1/1/11 100, ,000248,685 12/31/11 100, (248,685) = 24,86975,131173,554 12/31/12 100, (173,554) = 17,35582,645 90,909 12/31/13 100, (90,909) = 9,09190, ,000 51, ,685 No interest yet; no time has passed.

8 Amortization Lessee: Right-of-Use Approach Lessor: Performance Obligation Approach The lessee incurs an expense as it uses the asset. The lessor earns income as it satisfies its obligation to provide the asset’s use. Dec. 31, 2011 and End of Next 3Years Lessee Lease expense ($348,685 ÷ 4 years) 87,171 Right-of-use asset 87,171 Lessor Performance obligation 87,171 Lease income ($348,685 ÷ 4 years) 87,171

9 Lessor Depreciation At the end of each of the 4 years of the lease term as well as the 2 additional years of the 6-year estimated life of the equipment being leased, the lessor will record depreciation on the equipment: Lessor Depr. exp.–equip for lease ($479,079 ÷ 6 yrs) 79,847 Accumulated depreciation 79,847

10 Discount Rate In calculating the PV of the payments, the discount rate used by the lessee is: The rate the lessor charges the lessee (rate that causes the sum of PV of lease payments and the PV of the residual value of the underlying asset to equal the fair value of the asset today). If the lessor’s rate is not known, use the lessee’s incremental borrowing rate. If the lessor’s rate is not known, use the lessee’s incremental borrowing rate. In calculating the PV of the payments, the discount rate used by the lessee is: The rate the lessor charges the lessee (rate that causes the sum of PV of lease payments and the PV of the residual value of the underlying asset to equal the fair value of the asset today). If the lessor’s rate is not known, use the lessee’s incremental borrowing rate. If the lessor’s rate is not known, use the lessee’s incremental borrowing rate.

11 What if the Lease Term is Uncertain?  The lease term for both the lessee and the lessor is the longest possible term that is “more likely than not” to occur, taking into account any options to extend or terminate the lease.

12 What if the Lease Term is Uncertain? Illustration: A 10-year lease can be renewed for two additional 5-year periods, but it also can be terminated after only 5 years. Management probabilities: 5-year10-year15-year20-year 25%20%20%35% The likelihood that the lease term will be at least 5 years is 100%, and 75% (20% +20% +35%) that it will be 10 years or longer. The chance that it will extend 15 years or longer is 55% (20% +35%), but only 35% that it will be 20 years. The most likely of the choices is that it will be 10 years or longer (75%). But is that our choice? No. The probability that it will extend 15 years or longer is 55%, which also is more likely than not, but a longer term. So, we consider the lease term to be 15 years.

13 What if the Lease Payments are Uncertain?  If the amounts of future lease payments are uncertain due to contingencies or otherwise, we estimate the expected outcome of those payments.  The expected outcome is the PV of the probability-weighted average of the cash flows for a reasonable number of possible outcomes.

14 What if the Lease Payments are Uncertain?  Suppose the lease payments are $100,000 each for four years, but that if the lessee’s net income exceeds a prespecified amount in the second year (40% likelihood), the payments the last two years will be $120,000 each.

15 What if the Lease Payments are Uncertain? Possible Outcomes: Probability- Weighted Year 1Year 2Year 3Year 4PVProbabilityOutcome $100,000$100,000$100,000$100,000$348,68560%$209,211 $100,000$100,000$120,000$120,000$380,24040% 152,096 Expected Outcome:$361,307 (probability-weighted average) $100,000  * = $348,685 * PV of an annuity due of $1: n = 4, i = 10%. $100,000  * = $190,909 * PV of an annuity due of $1: n = 2, i = 10%. $120,000 .82645* = 99,174 * PV of $1: n = 2, i = 10%. $120,000 .75131* = 90,157 * PV of $1: n = 3 i = 10%. $380,240

16 Reassessing the Lease Term and the Expected Lease Payments If circumstances later indicate that a significant change has occurred in the amounts measured for the lessee’s liability to make lease payments or the lessor’s right to receive lease payments, we should  Reevaluate the lease term and the expected amount of lease payments and  Make necessary adjustments.

17 Short-Term Leases – A Short-Cut Method  A lease that has a maximum possible lease term (including any options to renew) of 12 months or less is a “short-term lease.”  Lease-by-lease option to choose a short-cut approach. Lessee:  can elect not to use PV and measure the right-of-use asset and the lease liability simply as the total of the payments  recognizes lease payments as amortization expense over the lease term. Lessor:  can elect not to record the lease receivable or the performance obligation.  continues to recognize the asset being leased  recognizes lease payments as revenue over the lease term.

18 Initial Direct Costs —Lessee and Lessor  The costs incurred that are associated directly with originating a lease and are essential to acquire that lease are initial direct costs.  Include legal fees, commissions, evaluating the prospective financial condition of the other company, and preparing and processing lease documents.  Add to the asset recorded at the inception of the lease:  the lessee’s right-of-use asset for costs paid by the lessee  the lessor’s lease receivable for costs paid by the lessor.

19 Derecognition Approach Lessor retains exposure to significant risks or benefits associated with the leased asset? Performance Obligation Approach DerecognitionApproachDerecognitionApproach YesYesNoNo

20 Derecognition Approach On Jan. 1, 2011, Sans Serif leased equipment from CompuDec.  6 annual payments of $100,000 beginning January 1, 2011, and at each Dec. 31 through  The 6-year lease term, is equal to the estimated useful life  CompuDec does not retain exposure to significant risks or benefits.  CompuDec manufactured the equipment at a cost of $300,000. Lessor: $479,079 ÷ * = $100,000 lessor’s rental cost payments Lessee: $100,000 x * = $479,079 rental lessee’s payments cost * present value of an annuity due of $1: n=6, i=10%

21 Derecognition Approach On Jan. 1, 2011, Sans Serif leased equipment from CompuDec.  6 annual payments of $100,000 beginning January 1, 2011, and at each Dec. 31 through  The 6-year lease term, is equal to the estimated useful life  CompuDec does not retain exposure to significant risks or benefits.  CompuDec manufactured the equipment at a cost of $300,000. January 1, 2011 Lease receivable (PV of lease payments) 479,079 Sales revenue 479,079 Cost of goods sold 300,000 Inventory of equipment (lessor’s cost) 300,000

22 Derecognition Approach January 1, 2011 (First Payment) Cash100,000 Lease receivable 100,000 December 31, 2011 (Second Payment) Cash100,000 Lease receivable 62,092 Interest revenue [10%  ($479,079 - –100,000)] 37,908  Accounting by the lessee is not affected by how the lessor classifies the lease. All lessee entries are precisely the same as in the previous illustrations.

23 If PV of Payments is Less than Asset's Fair Value If the PV of the payments is less than the FV of the asset, not all the rights to the asset are transferred; the lessor retains a portion of those rights. The lessor divides the carrying amount into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as what we call a residual asset. Allocation based on the ratio of the PV of the payments to the FV of the asset Illustration: Suppose the fair value of the printing equipment is $500,000. January 1, 2011 Lease receivable (PV of lease payments) 479,079 Sales revenue 479,079 Cost of goods sold 287,447 Inventory of equipment ($300,000 x 479,079 / 500,000 ) 287,447 Residual asset 12,553 Inventory of equipment ($300,000 – 287,447) 12,553

24 Purchase Option  A purchase option gives the lessee the option to purchase the leased property at a specified exercise price.  If (a) the purchase option is exercisable before the designated lease term ends, and (b) the exercise price is sufficiently below the property’s expected FV that exercise appears “more likely than not,” we assume the lease term ends for accounting purposes when the option becomes exercisable.

25 Residual Value The residual value of a leased asset is an estimate of what its commercial value will be at the end of the lease term. Let’s see how residual value impacts the accounting for leases by both the lessee and lessor.

26 RESIDUAL VALUE   At the end of the 4-year lease term the copier is expected to be worth $191,000. Lessee guarantees a residual value of $241,000.   The excess guaranteed residual value ($50,000) is viewed as an additional cash flow and its PV is included: PV of periodic payments ($100,000  *) $348,685 Plus: PV of the estimated payment under residual value guarantee ([$241,000 – 191,000]  † ) 34,151 PV of expected lease payments $382,836 † present value of $1: n=6, i=10% * present value of an annuity due of $1: n=6, i=10%

27 Lease Disclosures general description of the leasing arrangement minimum future payments, for each of the next 5 years, distinguishing those attributable to contingent rentals, term option penalties and residual value guarantees amounts in financial statements and how leases may affect future cash flows schedule reconciling opening and closing balances of, for lessees, the (a) right-of- use assets and (b) lease liabilities and, for lessors, the (a) lease receivables, (b) performance obligations, and (c) residual assets contingent rentals, renewal and termination options purchase options, residual value guarantees, initial direct costs, discount rate used significant subleases, sale and leaseback arrangements recognized amount of short-term leases significant service obligations related to its leases impairment losses The lessor discloses its exposure to the risks or benefits used in determining whether to apply the derecognition approach.

28 Statement of Cash Flows Lessee classifies cash payments for leases as financing activities - separately from other financing cash flows. Lessor classifies the cash receipts from lease payments as operating activities. Lessee classifies cash payments for leases as financing activities - separately from other financing cash flows. Lessor classifies the cash receipts from lease payments as operating activities.