1. © 2013 The McGraw-Hill Companies, Inc. LEASES Chapter 15

2. 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

3. 15 - 3 Finance Leases and Installment Notes Compared Matrix acquires equipment from Apex by paying $193,878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a finance lease agreement. First, let’s prepare an amortization schedule for the payments.

4. 15 - 4 Inception of the Agreement At inception January 1 Installment Note Equipment1,000,000 Notes payable 1,000,000 Finance Lease Leased Equipment1,000,000 Lease payable 1,000,000 First payment, June 30 Installment Note Interest expense 45,000 Notes payable 148,878 Cash 193,878 Finance Lease Interest expense 45,000 Lease payable 148,878 Cash 193,878

5. 15 - 5 Classification Criteria For example: 1.The agreement transfers ownership of the asset to the lessee by the end of the lease term. 2.The agreement contains a bargain purchase option. 3.The non-cancelable lease term forms a major part of the economic life of the asset. For example: 1.The agreement transfers ownership of the asset to the lessee by the end of the lease term. 2.The agreement contains a bargain purchase option. 3.The non-cancelable lease term forms a major part of the economic life of the asset. “transfers substantially all the risks and rewards of ownership of an asset to the lessee”: Operating Lease Finance Lease

6. 15 - 6 Classification Criteria 4.The present value of the “minimum lease payments” at the start of the lease is equal to or greater than a substantial proportion the fair value of the asset. 5.The leased asset is of a specialized nature such that only the lessee is able to use the asset without major modifications. 4.The present value of the “minimum lease payments” at the start of the lease is equal to or greater than a substantial proportion the fair value of the asset. 5.The leased asset is of a specialized nature such that only the lessee is able to use the asset without major modifications. Operating Lease “transfers substantially all the risks and rewards of ownership of an asset to the lessee”: Finance Lease

7. 15 - 7 Professional Judgment Lessor = Owner of the property subject to the lease. The examples given earlier are by no means comprehensive. We should record a lease as a finance lease if indicators indicate that “substantially all the risks and rewards of ownership” is transferred to the lessee. The indicators include the following: 1.In a cancelable lease, the lessee bears the losses suffered by the lessor as a result : 2.The lessee enjoys the gains and absorbs the losses arising from the fluctuations of the fair value of the residual of the leased asset. 3.The lessee is able to continue the lease for a secondary period at a rent that is substantially lower than market rent.

8. 15 - 8 Classification Criteria 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 lease term is normally considered to be the non- cancelable term of the lease plus any periods covered by bargain renewal options. Periods covered by bargain renewal options are not included in the lease term if a BPO is present. For the lessee, a finance lease is treated as an effective purchase of an asset – the lessee records both an asset and liability at inception of the lease.

9. 15 - 9 IFRS versus U.S. GAAP Lease classification rules. 1.Transfer of title. 2.Contains a BPO. 3.75% or more of assets life. 4.90% or more of fair value. Lease accounting under IFRS and U.S. GAAP provides a good general comparison of “principles-based accounting” as IFRS often is described and “rules-based accounting” which often is the description assigned to U.S.GAAP. Situations that normally would lead to classification as a finance lease are: 1.Transfer of title. 2.Contains a BPO. 3.Term is “major portion” of asset’s life. 4.PV of MLP greater than “substantially all” of the fair value of the asset. 5.Specialized asset.

10. 15 - 10 Operating Leases Criteria for a finance lease not met. Lease agreement exists. Record lease as an Operating Lease. Finance Lease

11. 15 - 11 Operating Leases On January 1, 2011, Sans Serif Publishers, a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%. On January 1, 2011, Sans Serif Publishers, a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%. San Serif Publishers (Lessee) Prepaid rent100,000 Cash 100,000 CompuDec Corporation (Lessor) Cash100,000 Unearned rent revenue 100,000 At End of the Four Payment Dates

12. 15 - 12 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.

13. 15 - 13 Finance 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: 1.The implicit interest rate used by the lessor (if known) or 2.Its incremental borrowing rate (if the lessee does not know 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: 1.The implicit interest rate used by the lessor (if known) or 2.Its incremental borrowing rate (if the lessee does not know the implicit interest rate used by the lessor).

14. 15 - 14 Finance Leases – Lessee and Lessee 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. 15 - 15 Finance Leases – Lessee and Lessor $479,079 ÷ 4.79079* = $100,000 rental payments. *PV of an annuity due of $1: n = 6, I = 10% $100,000 × 4,79079* = $479,079 lessee’s cost $479,079 ÷ 4.79079* = $100,000 rental payments. *PV of an annuity due of $1: n = 6, I = 10% $100,000 × 4,79079* = $479,079 lessee’s cost On January 1, 2011, Sans Serif Publishers, leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016,is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. finance leaseSince the lease term is equal to the expected useful life of the copier (e.g. >75%), the transaction must be recorded by the lessee as a finance lease. direct finance leaseThis qualifies also as a direct finance lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000.

16. 15 - 16 Finance Leases – Lessee and Lessor Direct Finance Lease (January 1, 2011) San Serif Publishers (Lessee) Leased equipment (PV of payments)479,079 Lease payable (PV of payments) 479,079 First Lease Corp. (Lessor) Lease receivable (PV of payments)479,079 Inventory of equipment (Lessor’s cost) 479,079 First Lease Payment (January 1, 2011) San Serif Publishers (Lessee) Lease payable100,000 Cash 100,000 First Lease Corp. (Lessor) Cash100,000 Lease receivable 100,000

17. 15 - 17 Finance Leases – Lessee and Lessor Amortization Schedule for the Lease $379,079 × 10% = $37,908 $100,000 - $37,908 = $62,092 $379,079 - $62,092 = $316,987

18. 15 - 18 Finance Leases – Lessee and Lessor Second Lease Payment (December 31, 2011) San Serif Publishers (Lessee) Interest expense37,908 Lease payable62,092 Cash 100,000 First Lease Corp. (Lessor) Cash100,000 Lease receivable 62,092 Interest revenue 37,908 Depreciation Recorded at (December 31, 2011) San Serif Publishers (Lessee) Depreciation expense 79,847 Accumulated depreciation 79,847 ($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

19. 15 - 19 Finance 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 finance lease situations occurs), the asset should be depreciated over its useful life.

20. 15 - 20 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 minimum lease 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.

21. 15 - 21 Sales-Type Leases On January 1, 2011, Sans Serif Publishers, leased a copier from CompuDec Corp. at a price of $479,079. The lease agreement specifies annual payments of $100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through 2015. The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier. CompuDec manufactured the copier at a cost of $300,000. CompuDec’s interest rate for financing the transaction is10%.

22. 15 - 22 Sales-Type Leases Lease Classification 1.The lease term (6-years) is equal to 100% of the useful life of the copier, and 2.Fair market value is different from the cost of the leased asset.SO The lease agreement is classified as a Sales-Type lease from the viewpoint of CompuDec (lessor) and a finance lease from the viewpoint of Sans Serif Publishers (lessee).

23. 15 - 23 Sales-Type Leases: Lessee At inception of the Lease – January 1, 2011 CompDec Corp. (Lessor) Lease receivable479,079 Cost of goods sold300,000 Sales revenue 479,079 Inventory of equipment 300,000 Receipt of the First Lease Payment – January 1, 2011 CompDec Corp.(Lessor) Cash100,000 Lease receivable 100,000

24. 15 - 24 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.

25. 15 - 25 Bargain Purchase Option (BPO) On January 1, 2011, Sans Serif Publishers, leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 there after through 2015. The estimated useful life of the copier is seven years. On December 31, 2016, at the end of the six year lease term, the copier is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

26. 15 - 26 Bargain Purchase Option (BPO) Exercise of BPO at the end of the lease term: $54,542 × 10% = $5,458* $54,542 $60,000 BPO payment - $5,458 = $54,542 *adjusted for rounding of numbers throughout the schedule

27. 15 - 27 Bargain Purchase Option (BPO) End of Lease – December 31, 2016 Sans Serif Publishers (Lessee) Depreciation expense ($479,079 ÷ 7)68,440 Accumulated depreciation68,440 Interest expense 5,458 Lease payable 54,542 Cash (BPO payment)60,000 CompDec Corporation(Lessor) Cash60,000 Lease receivable 54,582 Interest revenue 5,458 End of Lease – December 31, 2016 Sans Serif Publishers (Lessee) Depreciation expense ($479,079 ÷ 7)68,440 Accumulated depreciation68,440 Interest expense 5,458 Lease payable 54,542 Cash (BPO payment)60,000 CompDec Corporation(Lessor) Cash60,000 Lease receivable 54,582 Interest revenue 5,458 Refer the amortization schedule and computations on the previous screen

28. 15 - 28 Residual Value The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. On January 1, 2011, Sans Serif Publishers, leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2016, the copier is expected to be worth $60,000. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

29. 15 - 29 Effect on the Lessee of a Residual Value Guaranteed Residual Value Sometimes the lease agreement includes a guarantee by the lessee or the lessee’s related party that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. PV factor of an annuity due of $1: n=6, i=10% PV factor of $1: n=6, i=10%

30. 15 - 30 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.

31. 15 - 31 Effects on the Lessor of a Residual Value Guaranteed Residual Value When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both.

32. 15 - 32 Residual Value Guaranteed Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value. The guarantee is provided by the lessee. Sales-Type Lease – January 1, 2011 San Serif Publishers (Lessee) Leased equipment479,079 Lease payable 479,079 CompDec Corporation (Lessor) Lease receivable479,079 Cost of goods sold300,000 Sales revenue 479,079 Inventory of equipment 300,000

33. 15 - 33 Residual Value Guaranteed First Lease Payment – January 1, 2011 San Serif Publishers (Lessee) Lease payable92,931 Cash92,931 CompDec Corporation (Lessor) Cash92,931 Lease receivable 92,931

34. 15 - 34 Residual Value Guaranteed December 31, 2015 San Serif Publishers (Lessee) Depreciation expense68,847 Accumulation depreciation68,847 Interest expense13,407 Lease payable79,524 Cash92,931 CompDec Corporation (Lessor) Cash92,931 Interest revenue13,407 Lease receivable 79,524 See amortization schedule

35. 15 - 35 Treatment of Residual Value

36. 15 - 36 Executory Costs executory costs One of the responsibilities of ownership that is transferred to the lessee in a finance lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs. The lessee records executory costs as incurred: Sans Serif Publishers (Lessee) Maintenance expense2,000 Cash2,000

37. 15 - 37 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.

38. 15 - 38 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.Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Finance Leases − Include as part of investment balance.Direct Finance Leases − Include as part of investment balance. Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.

39. 15 - 39 Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

40. 15 - 40 Lease Disclosures Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For finance and noncancelable operating leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and in three bands comprising of payments (i) within one year (ii) after one year and less than five years and (iii) after five years.

41. 15 - 41 Lease Disclosures lessor The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value). Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs.

42. 15 - 42 Statement of Financial Position and Income Statement Lease transactions impact several financial ratios 1.Debt to equity ratio – Lease liabilities are recorded. 2.Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and statement of financial position. The greater impact is on the statement of financial position. Lease transactions impact several financial ratios 1.Debt to equity ratio – Lease liabilities are recorded. 2.Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and statement of financial position. The greater impact is on the statement of financial position.

43. 15 - 43 Special Leasing Arrangements Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. The lessee is the seller and the lessor is the buyer of the asset. Can the seller- lessee recognize the profit or loss on sale immediately?

44. 15 - 44 Special Leasing Arrangements Sale-Leaseback Arrangements Can the seller-lessee recognize the profit on sale? It all depends! Sale-Leaseback Arrangements Can the seller-lessee recognize the profit on sale? It all depends! If the lease is a finance lease, risks and rewards are still with the lessee, there is no “sale” as such. Any gain on the sale of the asset is deferred and amortized over the lease term. However, a loss is recognized immediately if the asset is impaired. If the lease is an operating lease and the terms are at arms’ length pricing (fair values), the real profit or loss on the sale of the asset is recognized immediately. “Artificial” profit or loss are deferred and recognized as adjustments to future rent expense. If the lease is a finance lease, risks and rewards are still with the lessee, there is no “sale” as such. Any gain on the sale of the asset is deferred and amortized over the lease term. However, a loss is recognized immediately if the asset is impaired. If the lease is an operating lease and the terms are at arms’ length pricing (fair values), the real profit or loss on the sale of the asset is recognized immediately. “Artificial” profit or loss are deferred and recognized as adjustments to future rent expense.

45. 15 - 45 Special Leasing Arrangements Real estate lease – finance or operating lease? Lease of land – is a finance lease only if there is a transfer of title or a bargain purchase option (the first two situations) Lease of land and buildings – the minimum lease payments have to be separated for land and buildings (using proportion of fair values) and tested for the lease classification. If it is not possible to separate the two, the entire asset is to be accounted for as finance lease. Lease of part of a building – usual lease accounting process applies but requires extra effort to determine the fair value and cost of part of the building Lease of land – is a finance lease only if there is a transfer of title or a bargain purchase option (the first two situations) Lease of land and buildings – the minimum lease payments have to be separated for land and buildings (using proportion of fair values) and tested for the lease classification. If it is not possible to separate the two, the entire asset is to be accounted for as finance lease. Lease of part of a building – usual lease accounting process applies but requires extra effort to determine the fair value and cost of part of the building

46. End of Chapter 15