FA3 Lesson 5: Leases 1.Capitalization criteria 2.Lessee: Basic lease accounting 3.Lessee: Fiscal year and capitalization cap 4.Lessee: Sale and leaseback 5.Lessor: Lease accounting 6.Cash flow statement review

1. Capitalization criteria Central objective: Accounting should capture the economic essence of the lease transaction. Is the transaction essentially a rental or a sale? Capitalization guidelines 1.Lessee owns asset at end of lease term 2.Lease term > 75% of asset useful life 3.PV of min. lease payments at least 90% of FMV of asset If not a capital lease, then operating lease.

Lease vocabulary Min. lease payments: total periodic rental payments (less executory costs) plus bargain purchase option (BPO) or guaranteed residual or failure to renew penalty Interest rate: lessee incremental borrowing rate or rate implicit in lease, whichever is lower Residual value: value of leased asset at end of lease Lease term: all terms prior to exercise date of BPO, all bargain renewal terms, all renewal terms at lessor’s option

2. Lessee: Basic lease accounting For an operating lease, lessee records only rent expense (plus any prepaid rent/rent payable) For a capital lease, lessee must record an asset and liability equal to PV of min. lease payments For a capital lease, lease payments represent interest and capital repayment; asset must be amortized over period lessee will use the asset EXAMPLE: A18-1

3. Lessee: Fiscal year and capitalization cap The amortization table for lease payments will not necessarily correspond to the fiscal year; interest expense could be a combination of interest from two different lease payments Lessee cannot record the leased asset at a value higher than its market value; if the lessee incremental borrowing rate is too low, must use rate implicit in the lease (the one that sets PV of min. lease payments equal to FMV of asset) Example: A18-7

4. Lessee: Sale and leaseback Sale and leaseback: The former owner (now lessee) sells the asset and leases it back immediately from lessor Any gain on sale to the lessee is amortized over the lifetime of the lease, proportionately to amortization of leased asset; any loss on sale is recognized immediately EXAMPLE: A18-27

5. Lessor: Lease accounting From lessor point of view, two types of leases: 1.Direct financing lease: lessor is a finance company that purchased the asset at fair market value and leased it immediately to lessee; lessor reports only financing revenue, recognized over lifetime of lease 2.Sales-type lease: lessor is a manufacturer or retailer who earns (1) gross profit on sale of asset, recognized at time of sale; and (2) financing revenue, recognized over lifetime of lease

5. Lessor: Lease accounting (cont’d) Accounting for direct financing leases: 1.Establish lease receivable at gross value 2.Remove leased asset from books 3.Create unearned finance revenue account for difference between (1) and (2), a contra account to lease receivable; any initial direct costs charged to unearned finance revenue 4.Annually, record finance income, lessee payment, and any other lease-related costs. EXAMPLE: A19-25

5. Lessor: Lease accounting (cont’d) Accounting for sales-type leases: 1.Establish lease receivable at gross value 2.Record sales revenue = fmv of asset 3.Remove asset from books and record COGS 4.Create unearned finance revenue account for difference between (1) and (2) 5.Initial direct costs expensed as incurred 6.Annually, record finance income, lessee payment, and any other lease-related costs. EXAMPLE: A19-25

6. Cash flow statement review EXAMPLE: A19-27