PV Computations Classification of Leases Acct 414 – Fall 2008 – Prof. Teresa Gordon

1. Inception date: 1/1/12 2. Lessor: Troy Tractors Inc. 3. Fair value of combine at 1/1/02: $50, Cost to manufacture combine: $40, Estimated fair value at end of lease is $10, Fixed non-cancelable lease term: 5 years. 7. First payment due on 12/31/12 8. Lessee: Farview Farms 9. Incremental borrowing rate (lessee): 12% 10. Implicit interest rate (lessor’s desired rate of return): 12% 11. Option to buy at end of lease term for $5, Estimated useful life of combine: 8 years 1e

Note that the last payment will include the $5,000 BPO 1e

$50,000 * 12% $13,083 - $6,000 $50,000 - $7,083 1e An ordinary annuity situation – the first line includes interest

1e

1/1/12 12/31/12 Useful life = 8 years 1e

1/1/12 12/31/12 1e

1.Inception date: 1/1/12 2.Lessor: Troy Tractors Inc. 3.Fair value of combine at 1/1/12: $50,000 4.Estimated fair value at end of lease is $10,000 5.First payment due on 1/1/12 6.Lessee: Farview Farms 7.Fixed non-cancelable lease term: 6 years. 8.Option to buy at end of lease term for $2,000 9.Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40,000. 1f What amount should the payment be given that the lessor requires a 12% return?

1.Inception date: 1/1/12 2.Lessor: Troy Tractors Inc. 3.Fair value of combine at 1/1/12: $50,000 4.Estimated fair value at end of lease is $10, First payment due on 1/1/12 6.Lessee: Farview Farms 7.Fixed non-cancelable lease term: 6 years 8.Option to buy at end of lease term for $2,000 9.Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40, Payment = 10,638 Now, classify the lease 1f

Note that the first payment is ALL principal since no interest has yet been incurred 39,362 * 12% 10, ,723 39, ,915 This is an annuity due situation – the first payment is 100% principal. 1f

Note that there is interest on the BPO This is an annuity due situation – the first payment is 100% principal. 1f

IFRS vs. US GAAP IAS 17 vs. FAS 13 as amended many times

But there’s more! Note that IFRS has no “bright line” rules

Leased assets are of a specialized nature and are only usable by the lessee unless substantial costs are incurred to modify (nothing comparable in US GAAP) Upon early termination of lease, lessee is responsible for lessor’s losses Any gains & losses due to fluctuations in fair value of leased asset are attributed to the lessee Lessee has option to renew for below market cost

IFRSUS GAAP For LessorOperating lease Finance leaseDirect Financing Lease Finance leaseSales-type lease Finance leaseLeveraged lease For LesseeOperating lease Finance leaseCapital lease

1. Inception of the lease: January 1, Term: 3 years 3. Implicit interest rate (known to lessee) 10% 4. Fair value of asset $100, Incremental borrowing rate: 12% 6. No collection or cost uncertainties for lessor 7. First payment due 1/1/12 8. Estimated useful life of asset: 5 years 9. Lessor retains ownership of asset at end of lease 10. Cost of asset $100, Payments of $36,556 per year 2

1. Inception of the lease: January 1, Term: 3 years 3. Implicit interest rate 10% (NOT known to lessee but could be estimated) 4. Fair value of asset $100, Incremental borrowing rate: 12% 6. No collection or cost uncertainties for lessor 7. First payment due 1/1/12 8. Estimated useful life of asset: 5 years 9. Lessor retains ownership of asset at end of lease 10. Cost of asset $100, Payments of $36,556 per year 2a What if the lessor’s rate were NOT known to lessee? What would be the PVMLP? What if we follow IFRS?

1. Term: 3 years 3. Implicit interest rate (known to lessee) 10% 5. Fair value of asset $130, Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2, Payments of $________________ 4. Est. fair value of asset at end of lease $2, Cost of asset $100, First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4a

1. Term: 3 years 3. Implicit interest rate = 10% (known to lessee) 5. Fair value of asset $130, Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2, Payments of $46, Est. fair value of asset at end of lease $2, Cost of asset $100, First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4A Classify lease under US GAAP and IFRS

1. Term: 3 years 3. Implicit interest rate = 10% (NOT known to lessee but could be estimated) 5. Fair value of asset $130, Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2, Payments of $46, Est. fair value of asset at end of lease $2, Cost of asset $100, First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4B What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.

1. Term: 3 years 3. mplicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $130, Incremental borrowing rate: 12% 9. Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2, Payments of $46, Est. fair value of asset at end of lease $5, Cost of asset $100, First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4c What if the fair value of the asset is $5,000 at end of the lease? Find the PVMLP.

Initial Direct Costs Residual Values

Type of Lease Accounting Treatment for Initial Direct Costs Operating Recorded as an asset and amortized over the lease term* Direct Financing (US) Finance (IFRS) Recorded as part of investment in lease and amortized over lease term by reducing interest revenue (find new implicit rate)* Sales-type Lease (US) Finance if lessor is manufacturer or dealer (IFRS) Immediately recognized as cost of goods sold (reduces profit or increases loss on sale of leased asset)

Remember that the UnGRV is part of lessor’s receivable and therefore is included in the amortization table!

1. Term: 4 years 2. Payments of $83, Implicit interest rate (known to lessee) 10% 4. Lessor retains ownership of asset at end of lease 5. Fair value of asset $300, Cost of asset $250, Incremental borrowing rate: 12% 8. First payment due 1/1/12 9. Estimated useful life of asset: 5 years 10. No collection or cost uncertainties for lessor 11. Est. fair value of asset at end of lease: $15, The residual value is guaranteed by a third party at a cost of $500 (initial direct cost) 6

6 Lessee Date Lease Payment InterestPrincipalBalance 01/01/12289, /01/1283, , /01/1383,09920,66562,434144, /01/1483,09914,42268,67775, /01/1583,0997,55475,5450

1. Term: 3 years 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $100, Incremental borrowing rate: 14% 9. Estimated useful life of asset: 5 years 11. Est. fair value of asset at end of lease: $10, Payments of $33, Lessor retains ownership of asset at end of lease 6. Cost of asset $100, First payment due 10/1/ No collection or cost uncertainties for lessor 12. The residual value is NOT guaranteed by lessee 8

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Lease Term Renewal Periods Executory Costs

IFRS has the same “rule” about the end of the lease term

1. Term: 4 years 3. Interest rate used to compute payments = 12% 5. Fair value of asset $200, Incremental borrowing rate: 14% 9. Estimated useful life of asset: 6 years 11. Est. fair value of asset at end of lease: $10, Initial direct costs to arrange lease: $3, Payments of $61, Cost of asset $200, First payment due 6/1/12 8. No collection or cost uncertainties for lessor 10. The payments include $5,000 for insurance. 12. The lessee can purchase asset for $10,000 at end of lease, otherwise, asset is returned to lessor. 11

Date Lease Payment InterestPrincipalBalance 6/01/02203,000 06/01/0256,924 16/01/0356,924 26/01/0456,924 36/01/0556,924 46/01/0610,000

11

1. Term: 4 years with possible renewal (see #12) 2. Implicit interest rate (NOT known to lessee) 10% 3. Fair value of asset $200, Incremental borrowing rate: 14% 5. Estimated useful life of asset: 6 years 6. The residual value is NOT guaranteed by lessee, asset is expected to be worth $25,000 at end of 4 years, and $15,000 at end of 5 years. 7. Payments of $49, Lessor retains ownership of asset at end of lease 9. Cost of asset $200, First payment due 1/1/ No collection or cost uncertainties for lessor 12. At the end of the lease, HGJB can renew for one more year at same annual amount of $49,523. This is certainly no bargain. There is a $15,000 penalty for non- renewal of the lease. However, this amount is probably not large enough to assure that HGJB will renew. 12

1.Term: 4 years, with possible renewal (see #11) 3. Implicit interest rate (NOT known to lessee) 10% 5. Fair value of asset $260, Incremental borrowing rate: 12% 9. Estimated useful life of asset: 6 years 11. Lease can be renewed for one more year at $17,000. The actual value is probably $25, There are no guarantees of residual value 2. Payments of $68, Lessor retains title to the asset at end of lease 6. Cost of asset $200, First payment due 1/1/ No collection or cost uncertainties for lessor 12. Est. fair value of asset at end of original lease term is $35,000. It should be worth $15,000 at the end of 5 years. 13