Intermediate Accounting,17E Stice | Stice | Skousen Intermediate Accounting,17E Leases PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2010 Cengage Learning

Economic Advantages to Leasing Over Purchasing For the Lessee No down payment Avoid risks of ownership Flexibility For the Lessor Increased sales Ongoing business relationship with lessee Residual value retained

Simple Example Owner Company owns a piece of equipment with a market value of $10,000. User Company wishes to acquire the equipment. User Company can borrow $10,000 from the bank at 10% interest. Payments would be $2,638 each year for five years. (continues)

Simple Example User Company can lease the equipment from Owner Company for five years and make five annual “rental” payments of $2,638. Owner maintains title throughout. At the end of the lease, the equipment is no longer useful. Should Owner Company recognize an equipment sale when the lease is signed? (continues)

Simple Example Key accounting issues for Owner Company Has effective ownership of the equipment been passed from Owner to User? Is the transaction complete? Is Owner Company reasonably certain the five annual payments can be collected from User Company? (continues)

Simple Example Key accounting issues for User Company. On the date the lease is signed, should User recognize the lease equipment as an asset and the obligation to make the lease payment as a liability? The answer hinges on whether effective ownership, as opposed to legal ownership, of the equipment changes hands when Owner and User sign the lease agreement. (continues)

Simple Example The economic substance of this lease is that the lease signing is equivalent to the transfer of effective ownership, and the fact that Owner retains legal title of the equipment during the lease period is a mere technicality. The arrangement should be treated as a sale by Owner and a purchase by User.

Simple Example Scenario One The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease. Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase.

Simple Example Scenario Two The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1. Offering the equipment to User Company for a bargain price at the end of the lease indicates that this is in substance a purchase.

Simple Example Scenario Three The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else. Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

Simple Example Scenario Four The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date. When the present value of the lease payments equals the lease item’s market value, it is in substance a purchase.

Capital vs. Operating Lease Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to lessee. Operating leases are accounted for as rental agreements.

Cancellation Provisions Some leases are noncancelable, meaning that these lease contracts are cancelable only on the outcome of some remote contingency or that the cancellation provisions and penalties of these leases are so costly to the lessee that cancellation will not occur.

Bargain Purchase Option If a lease includes a provision giving the lessee the right to purchase the leased property at a price that is expected to be considerably less than the fair value, the option is called a bargain purchase option.

Lease Term The lease term is the time period from the beginning to the end of the lease. The beginning of the lease term occurs when the leased property is transferred to the lessee. The end of the lease term is at the end of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised.

Residual Value The market value of the leased property at the end of the lease term is referred to as its residual value. Some lease contracts require the lessee to guarantee a minimum residual value. If the market value falls below the guaranteed residual value, the lessee must pay the difference.

Minimum Lease Payments The rental payments required over the lease term plus any amount to be paid for the residual value are referred to as the minimum lease payments. Lease payments sometimes include charges for insurance, maintenance, and taxes on the leased property. These are referred to as executory costs.

Lease 1 The implicit interest rate is used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease. The lessor always uses the implicit rate to discount rental payments. The interest rate that the lessee could use to borrow the amount of money necessary to purchase the leased asset is the incremental borrowing rate. (continues)

Lease 1 The lessee uses the lower of the implicit interest rate or the incremental borrowing rate to compute present value of minimum lease payments.

Lease Classification Criteria A lease is classified as a capital lease by the lessee if it is noncancelable and meets any one of the following criteria: The lease transfers ownership of the leased asset to the lessee by the end of the lease term. The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price. The lease term is equal to 75% or more of the estimated economic life of the asset. The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset.

IASB Approach IAS 17, “Accounting for Leases,” states simply: “A lease is classified as a finance (i.e., capital) lease if it transfers substantially all the risks and rewards incident to ownership.” This places the responsibility of distinguishing the type of lease on the accountant.

General Classification Criteria— Lessee and Lessor The four general criteria that apply to all leases for both the lessee and lessor relate to— transfer of ownership bargain purchase option economic life fair value of the leased asset

Lease Classification―Lessor Additional revenue recognition criteria applicable to lessors: Collectibility of the minimum lease payments must be reasonably predictable. Any unreimbursable costs yet to be incurred by the lessor can be reasonably estimated at the lease inception date.

Accounting for Operating Lease—Lessee The lease terms for manufacturing equipment are $40,000 a year on a year-to-year basis. The entry to record the lease payment for the year would be: Rent Expense 40,000 Cash 40,000

Operating Leases with Varying Lease Payments The terms of the lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years of the lease and $250,000 for each of the next three years. The total lease payments would be $1,050,000, or $210,000 a year on a straight-line basis. (continues)

Operating Leases with Varying Lease Payments The required entries in the first two years would be as follows: Rent Expense 210,000 Cash 150,000 Rent Payable 60,000 current liability The entries for each of the last three years are as follows: Rent Expense 210,000 Rent Payable 40,000 Cash 250,000

Accounting for Capital Leases—Lessee Marshall Corporation—Lessee Lease period: 5 years, beginning January 1, 2011, noncancelable Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs Estimated economic life of equipment: 5 years Expected residual value of equipment at end of lease period: None (continues)

Accounting for Capital Leases—Lessee Marshall Corp. Entries on January 1, 2011 Leased Equipment 250,192 Obligations under Capital Leases 250,192 (PMT = $60,000; N = 5; I = 10%) Lease Expense 5,000 Obligations under Capital Leases 60,000 Cash 65,000 (continues)

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Accounting for Capital Leases—Lessee Marshall Corp. Entries on December 31, 2011 If normal company depreciation policy for this type of equipment is used, the amortization entry for 2011 is shown below: Amortization Expense on Leased Equipment 50,038 Accumulated Amortization on Leased Equipment 50,038 $250,192 ÷ 5 (continues)

Accounting for Capital Leases—Lessee Entries on December 31, 2011 Prepaid Executory Costs 5,000 Obligations under Capital Leases 40,981 Interest Expense 19,019 Cash 65,000 ($250,192 – $60,000) × 0.10

Accounting for Leases with a Bargain Purchase Option Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price. The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.

Accounting for Leases with a Bargain Purchase Option Lessee Lease period: 5 years, beginning January 1, 2011, noncancelable Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs Estimated economic life of equipment: 5 years Expected residual value of equipment at end of lease period: None There is a bargain purchase option of $75,000 exercisable after five years These are the same facts as before, but with one new item.

Accounting for Leases with a Bargain Purchase Option Minimum Lease Payment Present value of five payments at the beginning of each year for five years: PMT = $60,000, N = 5, I = 10% $250,192 Present value of the bargain purchase option of $75,000 at the end of 5 years: FV = $75,000, N = 5, I = 10% 46,569 Present value of minimum lease payment $296,761

Accounting for Leases with a Bargain Purchase Option Entries on December 31, 2015 Obligations under Capital Leases 68,182 Interest Expense 6,818 Cash 75,000 To record exercise of bargain purchase option. $68,182 × 10% Equipment 148,381 Accumulated Amortization on Leased Equipment 148,380 Leased Equipment 296,761 To transfer remaining balance in leased asset account to Equipment. ($296,761 ÷ 10) × 5 years

Accounting for Leases with a Bargain Purchase Option If the equipment is not purchased and the lease is permitted to lapse, the following entry is required on December 31, 2015: Loss from Failure to Exercise Bargain Purchase Option 73,381 Obligation under Capital Leases 68,182 Interest Expense 6,818 Accumulated Amortization on Leased Equipment 148,380 Leased Equipment 296,761 .

Accounting for Purchase of Asset During Lease Term On December 31, 2013, the lessee purchased the leased property in the Marshall Corporation example for $120,000. At that date, the remaining liability recorded on the lessee’s books is $114,545 and the net book value of the recorded leased asset is $100,078 [capitalized value of $250,192 less $150,114 amortization ($50,038 × 3)]. (continues)

Accounting for Purchase of Asset During Lease Term Given the facts in Slide 15-38, the entry to record the purchase on the lessee’s books would be as follows: Interest Expense 10,413 Obligation under Capital Leases 104,132 Equipment 105,533 Accumulated Amortization on Leased Equipment 150,114 Leased Equipment 250,192 Cash 120,000 [$100,078 + ($120,000 – $114,545)]

Treatment of Leases on Lessee’s Statement of Cash Flows In 2011, Marshall Corporation’s income before any lease-related expenses is $200,000. Net income for the year is computed as follows: Income before lease-related expenses $200,000 Lease-related interest expense (19,019) Lease-related amortization expense (50,038) Net income $130,943

Accounting for Leases—Lessor Direct financing leases involve a lessor who is primarily engaged in financing activities, such as a bank or finance company. Sales-type leases involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products.

Revenue Generated by a Sales-Type Lease A sales-type lease generates two different types of revenue: An immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease Interest revenue earned over time as the lessee makes the lease payments

Accounting for Operating Leases—Lessor Universal Leasing Co. (Lessor) Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning Jan. 1, 2011) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0 Implicit rate 10% Incremental borrowing rate 10% Cost to lessor $400,000 Direct costs incurred $15,000 (continues)

Accounting for Operating Leases—Lessor Universal Leasing Co. (Lessor) To record the payment of the initial direct costs and the receipt of the lease payment on January 1, 2011: Deferred Initial Direct Costs 15,000 Cash 15,000 Cash 65,000 Rent Revenue 60,000 Executory Costs 5,000 (continues)

Accounting for Operating Leases—Lessor Universal Leasing Co. (Lessor) To record the amortization of direct costs over five years and the depreciation of equipment over ten years using the straight-line basis: Amortization of Initial Direct Costs 3,000 Deferred Initial Direct Costs 3,000 Depreciation Expense on Leased Equipment 40,000 Accumulated Depreciation on Leased Equipment 40,000

Accounting for Direct Financing Leases Refer to Slides 15-27 and 15-28 for details concerning Marshall Corporation’s leasing arrangement with Universal Leasing Company. The cost of the equipment to Universal was the same as the fair value, $250,192 and Equipment Purchased for Lease was charged when the equipment was acquired. Left click on the button to go to Slide 15-27, then type “46” and press the “Enter” key to return to this slide. (continues)

Accounting for Direct Financing Leases Receivable Recorded at Gross Amount To record initial lease on January 1, 2011: Lease Payments Receivable 300,000 Equipment Purchased for Lease 250,192 Unearned Interest Revenue 49,808 To record first payment on January 1, 2011: Cash 65,000 Lease Payment Receivable 60,000 Executory Costs 5,000 (continues)

Accounting for Direct Financing Leases To record receipt of payment on December 31, 2011: Cash 65,000 Lease Payment Receivable 60,000 Deferred Executory Costs (a liability) 5,000 Unearned Interest Revenue 19,019 Interest Revenue 19,019 (continues)

Lessor Accounting for Direct Financing Leases with Residual Value Assuming the same facts as the last illustration, except that the asset has a residual value at the end of the 5-year lease of $75,000. Assume the cost to Universal Leasing Company was $296,761 (which is also its fair value).

Lessor Accounting for Direct Financing Leases with Residual Value Receivable Recorded at Net Amount To record initial lease on January 1, 2011: Lease Payments Receivable 296,761 Equipment Purchased for Lease 296,761 To record first payment on January 1, 2011: Cash 65,000 Lease Payment Receivable 60,000 Executory Costs 5,000 (continues)

Lessor Accounting for Direct Financing Leases with Residual Value To record payment on December 31, 2011: Cash 65,000 Lease Payments Receivable 36,324 Deferred Executory Cost 5,000 Interest Revenue 23,676 To record recovery of the leased asset on December 31, 2015: Equipment 75,000 Lease Payment Receivable 68,182 Interest Revenue 6,818

Accounting for Sales-Type Leases—Lessor If there is no difference between the sales price and the lessor’s cost, the lease is not a sales-type lease. The lessor will also recognize interest revenue over the lease term for the difference between the sales price and the gross amount of the minimum lease payments.

Accounting for Sales-Type Leases—Lessor (1) Minimum lease payments Financial Revenue (Interest) (2) Fair value of leased asset Manufacturer’s or Dealer’s Profit (Loss) (3) Cost or carrying value of leased asset to lessor

American Manufacturing Co. (Lessor) Accounting for Sales-Type Leases—Lessor American Manufacturing Co. (Lessor) Fair value of equipment $250,192 Lease period (beginning Jan. 1, 2011) 5 years Economic life of asset 10 years Estimated residual value at end of lease $0 Implicit rate 10% PV of future lease payments $250,192 Cost to lessor $160,000 Direct costs incurred $15,000 (continues)

Accounting for Sales-Type Leases—Lessor Minimum lease payments: ($65,000 – $5,000) × 5 $300,000 $49,808 (Interest Revenue) Fair value of equipment $250,192 $75,192 (Mfr.’s Profit) Cost of leased equipment to lessor, plus initial direct costs $175,000 (continues)

American Manufacturing Co. (Lessor) Accounting for Sales-Type Leases—Lessor American Manufacturing Co. (Lessor) To record entries on January 1, 2011: Lease Payments Receivable 250,192 Sales 250,192 Cost of Goods Sold 175,000 Finished Goods Inventory 160,000 Deferred Initial Direct Costs 15,000 Cash 65,000 Lease Payments Receivable 60,000 Executory Costs 5,000

Accounting for Sales-Type Leases—BPO or Guaranteed R/V The minimum lease payments will include the following if they are part of the agreement: A lump sum (from a bargain purchase option) at the end of the lease term OR A guaranteed residual value The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

Accounting for Sales-Type Leases—BPO or Guaranteed R/V Using the data from Exhibit 15-5, American Manufacturing offers a bargain purchase option of $75,000 at the end of five years. (continues)

American Manufacturing Co. (Lessor) Accounting for Sales-Type Leases—BPO or Guaranteed R/V American Manufacturing Co. (Lessor) To record entries on January 1, 2011: Lease Payments Receivable 296,761 Sales 296,761 Cost of Goods Sold 175,000 Finished Goods Inventory 160,000 Deferred Initial Direct Costs 15,000 Cash 65,000 Lease Payments Receivable 60,000 Executory Costs 5,000

Accounting for Sales-Type Leases—Unguaranteed R/V When a sales-type lease does not contain a bargain purchase option or a guaranteed residual value, but the economic life of the leased asset exceeds the lease term, the residual value will remain with the lessor. This is called an unguaranteed residual value.

Accounting for Sales-Type Leases—Unguaranteed R/V Compare the entries below with the ones on Slide15-56. To record entries on January 1, 2011: Lease Payments Receivable 250,192 Sales 250,192 Cost of Goods Sold ($175,000 – $46,569) 128,431 Finished Goods Inventory ($160,000 – $46,569) 160,000 Deferred Initial Direct Costs 15,000 Lease Payments Receivable 46,569 Finished Goods Inventory 46,569 Left click on the button to go to Slide 15-56, then type “61” and press the “Enter” key to return to this slide.

Sale of Asset During Lease Term If the leased asset in Exhibit 15-8 below is sold on December 31, 2013, for $140,000 before the rental payment is made (the Lease Payments Receivable balance is $104,132),… (continues)

Sale of Asset During Lease Term …the following journal entry would be recorded on December 31, 2013, to record the sale: Cash 140,000 Interest Revenue 10,413 Lease Payments Receivable 104,132 Gain on Sale of Leased Asset 25,455

Treatment of Leases on Lessor’s Statement of Cash Flows In 2011, American Manufacturing’s income before any lease-related items is $200,000. Net income for the year can be computed as follows: Income before lease-related items $200,000 Lease-related sales 250,192 Lease-related cost of goods sold (175,000) Leased-related interest revenue 19,019 Net income $294,211

Disclosure Requirements for Leases For an operating lease, the lease-related asset and liability are off-balance-sheet items. It is important for the financial statement user to be able to interpret the associated note. Lessee is required to provide enough note disclosure to allow the users to quantify the magnitude of the operating leases. Lessor is required to provide enough disclosure to allow the financial statement user to figure out the extent to which lease-related sales and rentals have impacted the lessor’s financial statements.

International Accounting of Leases IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases. A proposal, titled “Accounting for Leases: A New Approach,” suggests that all lease contracts longer than one year be accounted for as capital leases. This proposal is still under discussion.

Sale-Leaseback Transactions On January 1, 2011, Hopkins Inc. sells equipment having a carrying value of $750,000 to Ashcroft Co. for $950,000 and immediately leases back the equipment. Terms of the lease are: The term of the lease is 10 years, noncancelable. A down payment of $200,000 is required plus equal lease payments of $107,107 at the beginning of each year. The implicit rate is 10%. (continues)

Sale-Leaseback Transactions The equipment has a fair value of $950,000 and an expected life of 20 years. Straight-line depreciation is used. Hopkins has an option to renew the lease for $10,000 per year for 10 years, the rest of its economic life. Title passes at the end of the lease. (continues)

Sale-Leaseback Transactions (continues)

Sale-Leaseback Transactions