McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. LEASES Chapter 15

Slide Accounting by the Lessor and Lessee A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessor = Owner of property Lessee = Renter

Slide Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

Slide Inception of the Agreement January 1

Slide First Semi-Annual Payment Date June 30

Slide Lease Classification  Ownership transfers to the lessee at the end of the lease term, or...  A bargain purchase option (BPO) exists, or...  The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or...  The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.  Ownership transfers to the lessee at the end of the lease term, or...  A bargain purchase option (BPO) exists, or...  The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or...  The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset. capital leaseone A capital lease must meet one of four criteria: Operating Lease Capital Lease

Slide Classification Criteria A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured. The lease term is normally considered to be the non- cancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

Slide Additional Lessor Conditions Lessor = Owner of the property subject to the lease. The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: 1.The collectibility of the lease payments must be reasonably predictable. 2.If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete.

Slide Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. Capital Lease

Slide Nonoperating Leases - Lessee The amount recorded (capitalized) is the present value of the minimum lease payments. However, the amount recorded cannot exceed the fair value of the leased asset. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor.

Slide Nonoperating Leases - Lessor 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. If the lessor is not a manufacturer or dealer, the fair value of the leased asset is typically the lessor’s cost.

Slide Nonoperating Leases On January 1, 2009, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease specifies annual payments of $6,000 beginning 1/1/09 and at each December 31 st through The equipment has an economic life of 5 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment.

Slide Nonoperating Leases - Lessee The lease term meets the “75% of the economic life” test. The lease term meets the “75% of the economic life” test.

Slide Nonoperating Leases - Lessee The PV of the payments  90% of the equipment’s fair value

Slide Nonoperating Leases - Lessee Matrix makes the following entries at inception of the lease.

Slide Nonoperating Leases - Lessor In addition to the information given earlier, the lessor (RentPro) knows that the collectibility of the lease payments is reasonably predictable, and there are no future costs to be incurred. RentPro’s performance is substantially complete as far as the lease is concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is $25,873 (rounded).

Slide Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair value, the lease is classified as a Direct Financing Lease.

Slide Lease Amortization Schedule $19,873 × 8% = $1,590 $6,000 - $1,590 = $4,410 $19,873 - $4,410 = $15,463

Slide Nonoperating Leases December 31, 2009, entry by Matrix. December 31, 2009, entry by RentPro.

Slide Depreciation by Lessee Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets. If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase option, the asset is depreciated over the asset’s economic life; otherwise, it is depreciated over the lease term.

Slide Depreciation by Lessee At December 31, 2009, Matrix prepares the following entry to recognize depreciation expense for the year. $25,873 5 years = $5,175

Slide Sales-Type Leases If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset. If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset. At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of payments).

Slide Sales-Type Leases On January 1, 2009, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease specifies annual payments of $6,000 beginning 1/1/09 and at each December 31 st through The equipment has an economic life of 5 years and a fair value of $25,873. The equipment has a cost basis in the hands of RentPro of $19,873. Title to the leased equipment passes to Matrix at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment.

Slide Sales-Type Leases: Lessee Matrix makes the following entries at inception of the lease.

Slide Sales-Type Leases: Lessor Because the cost of the asset is not equal to its fair value, the lease is classified as a Sales-Type Lease.

Slide 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. We need to determine the proper accounting for residual value by both the lessee and lessor.

Slide Residual Value The only impact on the lessee is the determination of depreciation expense. The cost of the asset will be reduced by the estimated residual value and depreciated over the economic life of the asset. Lessee Obtains Title to Leased Asset

Slide Residual Value In determining the lease payment amount, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payments. Lessor Retains Title to Leased Asset

Slide Executory Costs Executory costs include costs of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible for the executory costs, they are treated as expenses by the lessee. In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

Slide Initial Direct Costs Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Operating Leases − Capitalize and amortize over the lease term by the lessor. Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Financing Leases − Include as part of investment balance. Direct Financing Leases − Include as part of investment balance. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Operating Leases − Capitalize and amortize over the lease term by the lessor. Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Financing Leases − Include as part of investment balance. Direct Financing Leases − Include as part of investment balance.

Slide Special Leasing Arrangements 1.Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately. 2.Real Estate Leases: Leases of Land OnlyLeases of Land Only Leases of Land and BuildingLeases of Land and Building Leases of Only Part of a BuildingLeases of Only Part of a Building 3.Leveraged Leases – a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment. 1.Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately. 2.Real Estate Leases: Leases of Land OnlyLeases of Land Only Leases of Land and BuildingLeases of Land and Building Leases of Only Part of a BuildingLeases of Only Part of a Building 3.Leveraged Leases – a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment.