1. Accounting for Leases
ACCTG 5120
David Plumlee

2. What is a Lease?
“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”
let’s start by just defining a lease
a lease is ....
so the lessor is the owner of the property and the lessee is the renter that will be entitled to use the property for some period of time in return for rental payments

3. Accounting for Leases
Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?
before 1976 most companies accounted for leases as straight rental agreements
which means that as the rental costs were incurred they debited rent expense and credited cash
but over time lease agreements became more and more elaborate and in some cases began to resemble installment purchases of assets as opposed to just straight rental agreements
eventually the problem became widespread enough that the FASB decided some action needed to be taken because the above accounting approach was lacking when the rental agreement really was more like and installment purchase than a straight rental
why was it viewed as lacking?
because under an installment purchase the company is in effect borrowing money to buy an asset
but the above accounting does not reflect the acquisition of an asset or the assumption of a liability
in other words, simply by structuring a purchase of an asset as a lease agreement a company could finance an asset purchase off-balance sheet
i.e. the company would not have to report the obligation or the asset
eventually it was decided that leases can be categorized as either straight rental agreements - we call these operating leases or something more similar to a purchase on credit - we call these capital leases
Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset

4. Classification of Leases
What is the economic nature of a capital lease?
One that transfers substantially all the risks and benefits of ownership to the lessee.
What is the economic nature of an operating lease?
more formally however, a capital lease is a lease that transfers substantially all of the risks and benefits of ownership to the lessee
in form we have a lease - legal title to the asset has not passed and so some might argue that the lessee should not record an asset or an obligation for the present value of the future lease payments
however, in substance the terms of a capital lease provide the lessee with virtually the same risks and benefits that would come with ownership
in addition, the lease commits the lessee to a noncancellable payment for the term of the lease very similar to the commitment the company would face if it had borrowed the money to purchase the asset
under capital lease accounting we treat the lease transaction as though the lessee purchased the asset and borrowed the money to do so
which means that the lessee is going to record an asset and an obligation at the beginning of the lease term
during the lease term the lessee will recognize interest expense on the lease obligation
and will record depreciation expense on the leased asset
so capital lease accounting is really an attempt to account for the lease transaction is such a way that the economic substance of the transaction is emphasized over the legal form
One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement

5. Accounting for Capital Leases
Accounting reflects economic substance, not legal form
Make it appear as though company purchased an asset with borrowed funds
an asset and an obligation
interest expense on obligation
depreciation on asset
before we get into the actual computations let’s just summarize what it is that we will want our capital lease accounting to do for us
we want a capital lease to be accounted for such that it appears that the company purchased an asset and borrowed the funds to do so
so at the inception of the lease term we will record an asset and an obligation
over the lease term we will record the payments made just like they were loan payments and record interest expense on the obligation
finally the asset acquired will have to be depreciated
remember that the primary objective of capital lease accounting is not to reflect the legal form of the transaction but the economic substance of the transaction

6. Is this a Capital Lease? Does it meet ANY ONE of the four criteria?
Lease transfers ownership of asset
automatically by end of lease term or
through a bargain purchase option
Lease term is at least 75% of asset’s estimated economic life
PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term
the first question we need to ask ourselves is, is this a capital lease
does it meet any of our four criteria?
it meets none of them until we hit the last one
the present value of the minimum lease payments is greater than 90% of fair value
in fact in this case it’s equal to 100% of fair value
how do we calculate fair value???
PV of the annuity...

7. Minimum Lease Payments
Leases without a BPO
Minimum rental payments plus
Any guaranteed residual value plus
amount the lessee guarantees lessor will realize on the asset at the end of the lease term
Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured
if the lease agreement does not include a BPO then it might include a guaranteed residual value or penalties for failure to renew the lease
a guaranteed residual value is the amount that the lessee guarantees the asset will be worth at the end of the lease term
so the lessee must either return an asset worth that amount to the lessee or make a cash payment for the shortfall
by including the full amount of the guarantee in the computation we are taking the conservative stance and assuming that the asset will not be worth anything at the end of the lease term and the full guarantee will have to be paid in cash
penalties for failure to renew the lease must also be included in the minimum lease payments if at the beginning of the lease term renewal does not appear reasonably assured

8. MLP continued What are executory costs? Are they included in MLP?
Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance
one thing that the minimum lease payment does not include are executory costs
sometimes under the lease agreement the lessee will be required to make payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance
these are not payments made towards the “purchase price” of the asset
they are operating costs and so such payments should be charged to operating expenses as incurred and not included in the the minimum lease payment computation
any questions so far?
Are they included in MLP?
NO!

9. Minimum Lease Payments
What is a bargain purchase option?
An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured
the last criteria refers to something called the minimum lease payments
since this may not be a term you’ve confronted before it may be worth while discussing how it is computed
minimum lease payments is a measure of the amount that we reasonably expect the the lessee to have to pay over the lease term
you can sort of view these as the amounts that the lessee is paying on behalf of the asset
if the lease agreement includes a bargain purchase option then the lessee is going to make two kinds of payments over the lease term
rental payments as specified by the agreement and the BPO at the end of the lease term
where a BPO is defined as an option to purchase the asset at the end...
What is the MLP for leases with a BPO?
PV of rental payments and the BPO at the end of the lease term.

10. Capital Lease Example 6-year lease
Annual payment due at year end = $18,287
No BPO and legal title does not pass at the end of lease term
FMV of leased asset = $75,185
Economic life of asset = 10 years
Appropriate interest rate = 12%
Est. salvage value = $3,185
to illustrate capital lease accounting consider the following data
say we are the lessee and we have just signed a six year lease
we have agreed to 6 annual lease payments in the amount of $18,287 which are due at the end of each year
the fair value of the leased asset is 75,185
and the economic life is 10 years
also assume that the appropriate interest rate that the lessee should be using in his/her computations is 12%
why do we need to include and interest rate?
Because part of the lease payments will be considered interest if it is a capital lease...

11. Present Value of MLP PV = $18,287 x PVIFA(n=6, r=12%)
$18,287
$18,287 $18,287 $18,287 $18,287
this is computed on the next slide
since the lease does not contain a BPO minimum lease payments consists of the minimum rental payments plus penalties for failure to renew plus guaranteed residual values
well we will have to assume that the latter two are not applicable in this lease since we have no information to the contrary
so the MLP is equal to the minimum rental payment
the present value of the MLP is computed by discounting the six payments at the “appropriate” rate of 12%
in this case it works out to be equal to fair value
this is not always going to be the case but often will be
PV = $18,287 x PVIFA(n=6, r=12%)
= $18,287 x
= $75,185

12. Lessee Journal Entries
Inception of lease: record leased asset and lease obligation at present value of MLP
Record payments
At period end accrue:
depreciate asset
record interest expense
now that we know we have a capital lease all that remains is to start accounting for it consistent with how we would account for the purchase of an asset on credit
the present value of the obligation is the present value of all of the payments that we have agreed to make on behalf of the asset i.e. the MLP’s
this amount is debited to the leased asset account and credited to the lease obligation for the present value of the lease payments
with this entry and from here on in you need to put yourself in the mind set of an asset purchase
and if you can do that everything we do should make perfect sense because when you hit the end of the year you have an asset now that needs to be depreciated and an obligation on which you need to record interest expense

13. Inception of Lease Term
JE to record leased asset and lease obligation at present value of MLP?
leased asset $75,185
lease obligation $75, 185
now that we know we have a capital lease all that remains is to start accounting for it consistent with how we would account for the purchase of an asset on credit
the present value of the obligation is the present value of all of the payments that we have agreed to make on behalf of the asset i.e. the MLP’s
this amount is debited to the leased asset account and credited to the lease obligation for the present value of the lease payments
with this entry and from here on in you need to put yourself in the mind set of an asset purchase
and if you can do that everything we do should make perfect sense because when you hit the end of the year you have an asset now that needs to be depreciated and an obligation on which you need to record interest expense

14. Depreciation Expense On what does the depreciation period used depend?
If bargain purchase option exists or title passes during lease term, use economic life
Otherwise use lease term
well whenever you compute depreciation expense you should ask yourself three questions
first what depreciation method should I use
any one of the typical methods is fine
second what period should I depreciate the asset over
well that should be the period of the use
in the case of a leased asset the period of use will be the economic life if we are going to end up owning the asset
otherwise the period of use will be the lease term

15. Basis for Depreciation
What ending values are used for depreciation?
Salvage value if depreciating over economic life
Guaranteed residual value if depreciating over lease term
and finally what is the cost basis that needs to be depreciated
well generally we depreciate cost minus salvage value at the end of the economic life and it stands to reason that this is what we want to do if we are going to end up owning the asset
but if we are not going to end up owning the asset and we have guaranteed a residual value then we would not want to depreciate more than the cost minus the guaranteed residual value since we have promised that we won’t consume that portion of the asset

16. Record Depreciation Expense
What is the depreciable basis of this asset?
$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)
$75,185/6yrs = $12,531
depreciation expense $12,531
accum. depreciation $12,531
in this case we are not going to end up owning the asset so we will depreciate over the lease term of 6 years
and since there is no guaranteed residual value we will depreciate the full cost
the second entry I’m making is to record interest expense on the obligation for the year and the first lease payment i.e. payment on our “loan”
note that in this example I have used an annuity in arrears
more typically leases call for payments at the beginning of the period and so the text generally uses examples with payments made up front

17. Lease Amortization Table

18. Lease Amortization Table
PV of the min. lease payments

19. Lease Amortization Table

20. Record First Lease Payment
interest expense ($75,185 x 12%) $9,022
lease obligation ,265
cash $18,287
Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.

21. Lessor Capital Lease Types
Direct financing leases
PV of minimum lease payments equals the FMV of the leased asset
No “profit” is recorded; considered to be a financing arrangement.
Sales-type leases
PV of minimum lease payments less the FMV of the leased asset equals the “dealer profit”
Profit is recognized as revenue at the inception of the lease

22. Initial Direct Costs
Includes costs directly associated with negotiating a particular lease
amounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees)
amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents)
Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)
often the lessor incurs costs related to negotiating and signing the lease with the lessee
some of these costs are directly related to a particular lease agreement
these would include both amounts paid to parties external to the firm like lawyer’s fees, appraisals and the like
and amounts incurred internally but still directly related to a particular lease like the time spent preparing and processing the lease documents
the matching principle would suggest that these direct costs should be charged to expense in the same period as the related revenue
however, the lessor will also incur some costs that are not directly related to a particular lease agreement but are incurred regardless of whether the lessor is currently working on a new lease agreement or not
things like overhead, rent and administrative expenses
these are period expenses and should be charged to income in the period they are incurred
they are not directly related to the generation of a specific revenue stream and so the matching principle does not apply in this case
so initial direct costs include only costs that can be traced directly back to a specific lease transaction

23. Accounting for Initial Direct Costs
Operating -
Sales-type -
Direct financing-
defer and allocate over lease term in proportion to rental income
expense in same period as profit on sale recognized
since we want to match these costs to the related lease revenue we have to consider when that lease revenue will get recognized
if the lessor classifies the associated lease as an operating lease then the lessor will recognize rental income over the term of the lease
in this case we would want to defer the initial direct costs and recognize them as a deduction from income over the lease term in proportion to the rental income recorded
if the lessor classifies the lease as a sales-type lease then profit is recognized on signing the lease (i.e. the manufacturers or dealers profit) and over the lease term
since there is some income recognition up front we simply expense all of the initial direct costs immediately thereby matching it against the manufacturers’ profit
finally if the lessee classifies the lease as a direct financing lease then once again the income will be realized over the lease term as interest income
in this case we would want to defer the initial direct costs and amortize it over the lease term in proportion to the interest income recorded
this is done by adjusting the yield on the lease
add to gross investment in the lease
amortize over lease as a yield adjustment

24. Example - Direct Financing
3 year lease
$20,000 payments due at end of year
implicit interest rate = 10%
FMV (lessor’s cost of asset) = $49,737
initial direct costs = $1,000
to illustrate this we’ll do an example
say we have a three year lease with the lease payments due at the end of the year
the interest rate implicit in the lease is 10%
the cost of the asset to the lessor is 49,737
and we’ll assume that 1,000 of direct costs were incurred in negotiating the lease

25. Net Investment in Lease
What is the PV of the MLP (without initial direct costs)?
20,000 x PVIFA(n=3,r=10%)
$49,737 = cost (this is a direct financing lease)
we saw last day that we compute the net investment in the lease by taking the present value of the minimum lease payments plus the unguaranteed residual value
this works out to 49,737 which is the same as the lessor’s cost so this is a direct financing lease
to figure out the yield adjustment we start by adding the initial direct costs to the net investment in the lease
why do we add this to the net investment
because what is happening is that we are giving up an asset which in today’s dollars is worth 49737
in return we are receiving 3 payments of 20,000 and we are paying out 1,000 up front in direct costs
if we ignore the 1,000 the interest rate that would bring this into balance would be 10%
but if we consider the impact of the 1,000, we know that the interest rate will no longer be 10% but something else
to figure out what that something else is we take the 1,000 over to the other side (i.e. add the indirect costs to the net investment in the lease and then solve the resulting equation for the PVIFA
Do initial direct costs affect this calculation?
Yes, they are added and a new interest rate is found.

26. Impute New Effective Yield
Why add to the initial direct costs?
We want the interest rate the equates the net investment to the cash flows
$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)
$50,737 = $20,000 x PVa (n=3,r=?)
= PVa (n=3,r=?)
like this
so I know that the PVIFA,n=3,r=appropriate rate is
by trial and error just fiddling with the amortization table I figured out the new effective yield, taking the indirect costs into consideration to be 8.89%
by trial and error: r=8.89%

27. Ignoring Initial Direct Costs
well now let’s compare what the amortization looks like if we ignore the indirect costs
we start off with a net balance of 49,737
we compute interest at a rate of 10%
total interest income recorded over the term of the lease would be 10,263

28. Including Initial Direct Costs
if we include the initial indirect costs in the computation the opening balance increases by 1,000 to 50,737
the interest rate is our new effective yield of 8.89%
under this scenario the total income recorded over the lease term is only 9,263 or $1,000 less
the 1,000 difference is the initial direct costs
so the difference between the interest income on this table and the interest income on the previous table is the initial direct cost amortization
Reduction in income = 10, ,263
= 1,000
= initial direct costs

29. Amort. of Initial Direct Costs
so to get the initial direct cost amortization for each year just take the difference in the interest income amounts reported on these two amortization tables
any questions so far?

30. Journal Entry Entries to record lease:
deferred initial direct costs ,000
cash (etc.) ,000
the lessor’s journal entry to record this direct financing lease would look like this
the first entry is identical to the one we did last day
debit lease receivable for the gross investment in the lease
credit unearned interest income for the interest to be generated over the lease term based on the interest rate implicit in the lease
then debit the amounts expended for initial direct costs to a deferred charge account
could be reported as an asset or perhaps netted against the unearned interest income account
lease receivable ,000
unearned interest income ,263
leased asset 49,737

31. Journal Entries
Entries to record first payment and amortization of income and costs
cash ,000
lease receivable 20,000
unearned interest income ,974
interest income ,974
finally here are the entries to record the first payment (received at the end of the year) and the first year’s amortization of the unearned interest income and the deferred initial direct expenses
any questions on this?
this is not covered very well in the text
so don’t be surprised if you haven’t read the chapter yet
when you do they basically just say do a yield adjustment and leave it at that
initial direct expense amortization 463
deferred initial direct costs

32. Sale/leaseback
Should the gain or loss on sale be recognized when asset “sold” to lessor?
Seller/lessee
Leaseback: seller retains use of the asset
Sale:
Legal title
Transfers
with a sale-leaseback the owner loses title to the property but still ends up getting to the use the property
so the accounting issue is whether or not the owner should be allowed to record the gain or loss on sale of the asset when the asset is “sold” to the lessor
the answer to that question depends on how extensively the original owners gets to use the asset after the sale
if the owner (now lessee) retains the right to use the asset then the transaction is viewed not as a sale but as a financing transaction
as a result, gains from the “sale” are not recognized in income immediately but are deferred and amortized to income over the lease term
losses on the other hand are recognized immediately
why? due to the conservatism principle
if the lessee loses most of the rights to use the asset then the transaction is viewed as a sale and gains and losses both must be recognized immediately
in a moment we will see that we call the situations where most of the right to use the asset has been lost a minor leaseback
Buyer/lessor
Account for lease according to classification tests.

33. Sale/leaseback- operating lease
Lessee Retains Right To Use Asset
defer gains only (losses are recognized immediately)
amortize to rent expense over lease term in proportion to rental payments
Why do you think we defer any gains?
but first lets look at the case where the lessee retains the right to use the asset
if the lessee classifies the lease as an operating lease then he/she would defer the gain on sale and amortize it to rent expense over the lease term in proportion to the rental payments
any idea how company’s might abuse the system if they didn’t have to defer the gain?
before this rule owners would strike deals where they “sold” the asset for an inflated price upfront and book a huge gain on sale and in return they promised to make unreasonably large lease payments in the future
the net effect was that they successfully shifted income through time and got to recognize it earlier
if the lessee classifies the lease as a capital lease then once again they must defer any gains (losses are recognized immediately) and amortize the gain to depreciation expense at the same rate that they are depreciating the leased asset
any questions on this
Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future

34. Sale/leaseback -- capital lease
Lessee Retains Right To Use Asset
defer gains only (losses are recognized immediately)
amortize to depreciation expense over lease term in proportion to amortization of leased asset
but first lets look at the case where the lessee retains the right to use the asset
if the lessee classifies the lease as an operating lease then he/she would defer the gain on sale and amortize it to rent expense over the lease term in proportion to the rental payments
why do you think we do this? any idea how company’s might abuse the system if they didn’t have to defer the gain?
before this rule owners would strike deals where they “sold” the asset for an inflated price upfront and book a huge gain on sale and in return they promised to make unreasonably large lease payments in the future
the net effect was that they successfully shifted income through time and got to recognize it earlier
if the lessee classifies the lease as a capital lease then once again they must defer any gains (losses are recognized immediately) and amortize the gain to depreciation expense at the same rate that they are depreciating the leased asset
any questions on this

35. “Minor leaseback” Lessee Loses Most Rights To Use Asset
Defined as PV of rental payments is 10% or less of asset’s fair value
Recognize gain or loss on sale immediately
that is what we do when the owner now lessee retains the right to use the asset
the situation where they lose most of the rights to use the asset is called a minor leaseback
so minor that it does not interfere with the sellers right to recognize the gain or loss on sale when the asset is sold to the lessor
a minor leaseback is defined as one in which the present value of the rental payments is 10% or less of the asset’s fair value
do E22-15