Introductory Lecture – Includes Flow Charts Accounting for Leases Chapter 21 Also includes slides from 11th edition prepared by Jep Robertson and Renae Clark - New Mexico State University And has slides added by Teresa Gordon (University of Idaho) Intermediate Accounting 12th Edition Kieso, Weygandt, and Warfield Prepared by Coby Harmon, University of California, Santa Barbara

Learning Objectives Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for capitalizing leases by the lessee. Contrast the operating and capitalization methods of recording leases. Identify the classifications of leases for the lessor. Describe the lessor’s accounting for direct-financing leases. Identify special features of lease arrangements that cause unique accounting problems. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Describe the lessor’s accounting for sales-type leases. List the disclosure requirements for leases.

Teresa’s Specific Objectives Be able to classify a lease from the perspective of lessor and lessee Be able to prepare journal entries for lessor and lessee – for both operating and capital-type leases Be able to research FARS to resolve complications not mentioned in text

Special Accounting Problems Accounting for Leases Leasing Environment Accounting by Lessee Accounting by Lessor Special Accounting Problems Who are players? Advantages of leasing Conceptual nature of a lease Capitalization criteria Accounting differences Capital lease method Operating method Comparison Economics of leasing Classification Direct-financing method Operating method Residual values Sales-type leases Bargain purchase option Initial direct costs Current versus noncurrent Disclosure Unsolved problems

The lease gives the lessee the right to use specific property. The lease is a contractual agreement between the lessor and the lessee. The lease gives the lessee the right to use specific property. The lease specifies the duration of the lease and rental payments. The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee. LEASE = A contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party. The “Parties” to a Lease Lessee: The party granted the right to use the property under the terms of a lease. Has possession and use of the asset Lessor: The owner of the property that is rented (leased) to another party. The legal owner of the asset

Cancellation Provision Lease Contracts Cancellation Provision Specifies under what circumstances the lease may be canceled. Rental payment required over lease term – may include planned increases. Lease Payment Lease Term Delineates the time period the lease is to be in force. May include renewal periods. 22 6

Lease Contracts Residual Value Purchase Option Who is responsible for market value of leased asset at end of lease term? Purchase Option Grants lessee the right to purchase the asset at the end of the lease term. The option price may or may not be a bargain. 24 7

Other Terms You Will Learn Contingent rentals Bargain renewal option Bargain purchase option Nonrenewal penalty Guaranteed residual value Interest rate implicit in the lease Unguaranteed residual value Executory costs Initial direct costs Minimum lease payments Incremental borrowing rate

The Leasing Environment Advantages of Leasing 100% Financing at Fixed Rates. Protection Against Obsolescence. Flexibility. Less Costly Financing. Tax Advantages. Off-Balance-Sheet Financing.

The Leasing Environment Benefits to the Lessor Interest Revenue. Tax Incentives. High Residual Value. Making a sale that would otherwise go to a competitor that provides a leasing option

The Leasing Environment 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. Operating Lease Capital Lease Journal Entry: Rent expense xxx Cash xxx Journal Entry: Leased equipment xxx Lease obligation xxx Largest group of leased equipment involves: Information technology, Transportation (trucks, aircraft, rail), Construction and Agriculture. A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized). Statement of Financial Accounting Standard No. 13, “Accounting for Leases,” 1980 LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Accounting by the Lessee Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement 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

Accounting by Lessee Capital Lease Operating Lease Lease Agreement Is there transfer of ownership? Yes Is there a bargain purchase option? Yes No Is lease term equal to or greater than 75% of economic life ? Yes No Is present value of payments equal to or more than 90% FMV? Yes No My students in previous semesters found this slide particularly helpful Operating Lease 11th Ed Slide

Accounting by the Lessor Classification of Leases by the Lessor Illustration 21-11 A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.

Accounting by the Lessor Classification of Leases by the Lessor Illustration 21-12 A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

Accounting by Lessor Operating Lease Sales type Direct financing yes Lease Agreement Does lease meet Group 1 criteria? No Operating Lease Is collectibility of payments assured? No yes Is lessor’s performance substantially complete ? No yes My students in previous semesters found this slide particularly helpful No Sales type Direct financing yes yes Does asset FMV equal lessor’s book value? 11th Ed Slide

Later we’ll talk about International Financial Reporting Standards IFRS Flowchart

From KPMG webcast Spring 2008 Additional indicators are things like: Cancellation losses borne by lessee Changes in fair value of residual borne by lessee Bargain lease renewal option

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