1 Leases Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso

2 Basics of Leasing Lease –Contractual agreement between lessor and lessee –Gives lessee right to use specific property –Specifies duration and rental payments –Executory costs Taxes, insurance and maintenance May be assumed by either party

3 Advantages 100% financing at fixed rates Protection against obsolescence Flexibility Less costly financing AMT problems avoided Off-balance-sheet financing

4 Classification of Leases Capital leases –If lease transfers substantially all of the benefits and risks of ownership –Must be noncancelable Operating leases –Do not substantially transfer benefits and risks of ownership

5 Accounting by Lessee Capitalize if noncancelable, and –Transfers ownership to lessee, or –Contains bargain purchase option, or –Lease term equal to 75% or more of estimated economic life of property, or –PV of minimum lease payments equals or exceeds 90% of fair value of property

6 Accounting by Lessee

7 Bargain Purchase Option Allows lessee to buy leased asset Price significantly lower that expected fair value at date of option Determined at inception of lease Must render option reasonably assured

8 Economic Life Test Lease period equals or exceeds 75% of asset’s economic life Lease term is considered the fixed noncancelable term of lease Bargain renewal options are included If lease starts during last 25% of life of asset, test cannot be used

9 Recovery of Investment PV of minimum lease payments equals or exceeds 90% of fair value Minimum lease payments –Payments –Guaranteed residual value –Penalty for failure to renew or extend –Bargain purchase option

10 Discount Rate The lesser of –Lessee’s incremental borrowing rate, or –The implicit interest rate

11 Executory Cost Insurance, maintenance and taxes Should be excluded from minimum lease payments

12 Residual Values Estimated fair value at end of lease Guaranteed residual value –An additional lease payment Unguaranteed residual value –Same as no residual value to lessee Lessor assumes residual value will be realized whether guaranteed or not

13 Capitalized Leases Accounting by Lessee Asset and Liability –Recorded at the lesser of the PV of minimum lease payments or FMV Depreciation Period –Economic life Lease transfers ownership Lease has bargain purchase option –Term of lease

14 Fact Pattern Date: January 1, 2006 Lease term: 10 years Discount rate: 8% Annual lease payments: $12,000 Executory costs: $1,000 Title transfers at end of lease term Economic life of asset: 12 years Residual value: $0

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19 Operating Leases Accounting by Lessee Lessee assigns rent to periods benefiting Ignores any commitments for future payments Note disclosure –For all operating leases that have noncancelable lease terms in excess of one year

20 Classification of Leases Accounting by Lessor Direct financing leases Sales type leases Operating leases

21 Direct Financing Lease Must meet group I capitalization criteria and –Collectibility of payments must be reasonably assured –Lessor’s performance must be substantially complete FV of asset equal to lessor’s book value

22 Sales Type Lease Must meet group I capitalization criteria and –Collectibility of payments must be reasonably assured –Lessor’s performance must be substantially complete FV of asset should not be equal to lessor’s book value –Lease contains a dealer’s gross profit

23 Operating Lease Accounting by Lessor Does not meet criteria for capitalized lease Rental receipts recorded as rental receipts Leased asset depreciated Leased equipment and accumulated depreciation separately classified

24 Accounting by Lessor

25 Direct Financing Lease Debit, Lease receivable –Gross sum of lease payments Credit, Unearned interest revenue –Lease receivable less FMV of asset Credit, Inventory of equipment –Lessor’s cost of the asset

26 Fact Pattern Date: January 1, 2005 Inventory of equipment: $103,500 Lease term: 6 years Implicit interest rate: 8% Payments: $20,000 Residual value: $5,786

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29 Sales Type Leases Debit, Lease Receivable –Lease payments plus residual Debit, Cost of Goods Sold –Lessor’s cost Credit, Sales Price of Asset –PV of minimum lease payments Credit, Unearned Interest Revenue –Lease Receivable less FMV of asset Credit, Inventory –Lessor’s cost

30 Fact Pattern Date: January 1, 2005 Inventory of equipment: $60,000 FMV of equipment: $103,500 Lease term: 6 years Implicit interest rate: 8% Payments: $20,000 Residual value: $5,786

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