Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Leases Chapter 15

15-2 Accounting by the Lessor and Lessee A lease is an agreement in which 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 in which 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

15-3 Classification Criteria  Ownership to the lessee at the end of the lease term, or...  Ownership transfers to the lessee at the end of the lease term, or...  A (BPO) exists, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to of the expected economic life of the asset, or  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or  The PV of the minimum lease payments is of the asset.  The PV of the minimum lease payments is 90% or more of the fair value of the asset.  Ownership to the lessee at the end of the lease term, or...  Ownership transfers to the lessee at the end of the lease term, or...  A (BPO) exists, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to of the expected economic life of the asset, or  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or  The PV of the minimum lease payments is of the asset.  The PV of the minimum lease payments 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

15-4 Classification Criteria to the lessee at the end of the lease term, or...  Ownership transfers to the lessee at the end of the lease term, or...  A (BPO) exists, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to of the expected economic life of the asset, or  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or  The PV of the minimum lease payments is of the asset.  The PV of the minimum lease payments is 90% or more of the fair value of the asset. to the lessee at the end of the lease term, or...  Ownership transfers to the lessee at the end of the lease term, or...  A (BPO) exists, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to of the expected economic life of the asset, or  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or  The PV of the minimum lease payments is of the asset.  The PV of the minimum lease payments 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

15-5 Classification Criteria A 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. 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 is normally considered to be the non- cancelable term of the lease plus any periods covered by. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. 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.

15-6 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.

15-7 U. S. GAAP vs. IFRS

15-8 Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. Capital Lease

15-9 Leasehold Improvements Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.

15-10 Capital Leases – Lessee and Lessor 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.

15-11 Capital Leases – Lessee and 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 typically is the lessor’s cost.

15-12 Capital Leases – Lessee and Lessor Depreciation Period The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i.e., either of the first two classification criteria is met), the asset should be depreciated over its useful life.

15-13 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). In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.

15-14 Bargain Purchase Options and Residual Value A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result: LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability. LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments. LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability. LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.

15-15 Effect on the Lessee of a Residual Value Unguaranteed Residual Value A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

15-16 Discount Rate One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

15-17 Lessor’s 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.  Direct Financing Leases − Include as part of investment balance.  Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.

15-18 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 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

15-19 Leases: Where We’re Headed The FASB and the IASB are collaborating on a joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon. In the right-of-use model introduced in the proposed standards update, all leases are recorded as an asset and liability (with the exception of short term leases as described later), and the concept of operating leases is eliminated.

15-20 End of Chapter 15