LEASES (Chapter 15) Learning Objectives

LEASES (Chapter 15) Learning Objectives
1. Identify and describe the operational, financial, and tax objectives that motivate leasing. 2. Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing. 3. Explain the basis for each of the criteria and conditions used to classify leases. 4. Record all transactions associated with operating leases by both the lessor and lessee. 5. Describe and demonstrate how both the lessee and lessor account for a capital lease. 6. Describe and demonstrate how the lessor accounts for a sales-type lease.

LEASES 12. Oct. 2011 CPA Exam Coverage Learning Objectives:
7. Explain how lease accounting is affected by the residual value of a leased asset. 8. Describe the way a bargain purchase option affects lease accounting. 9. Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs, and contingent leases. 10. Explain sale-leaseback agreements and other special leasing arrangements and their accounting treatment. 11. Discuss the primary differences between U.S. GAAP and IFRS with respect to leases. 12. Oct CPA Exam Coverage

Lessee = USER of property
A lease is usually a non-cancelable agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessee = USER of property Lessor = OWNER of property The lessee receives the beneficial use of property in the lease. The lessor owns the property, and the lessee is the party who uses the assets and makes lease payments. From the perspective of the lessee, we have two types of leases. The first lease is referred to as an operating lease, and the second is known as a capital lease. We view a capital lease as an in-substance purchase of an asset. From the perspective of the lessor, we have three types of leases. We have an operating lease, a direct-financing-type lease, and a sales-type lease.

Conceptual Nature of a Lease
The issue of how to report leases is the case of substance versus form. Lessee = USER of property; Lessor = OWNER of property Although technically legal title may not pass, the benefits from the use of the property do.

A variety of opinions exist regarding the manner in which certain long-term lease arrangements should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB Statements dealing with lease accounting can be characterized as advocating capitalization of lease arrangements that are similar to installment purchases.

Capital Leases and Installment Notes Compared
Matrix, Inc. acquires equipment from Apex, Inc. by paying $100,000 every year for the next ten years. The interest rate associated with the agreement is 0%. Let’s look at the arrangement as an installment sales and as a capital lease agreement. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. Therefore, according to FASB it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase. Therefore, the accounting (the balance sheet presentation of the LIABILITY) for Installment Note Payable or Lease Payable should be exactly the same and NOT Off-Balance Sheet. At the heart of the rules for lease accounting is a concept of “substance over form.” As accountants and business people, we believe that is the transaction is “in substance” a purchase of property, plant, and equipment, we should recognize it as a purchase no matter how difficult the guidelines are to development for the proper accounting. While the “form” of the transaction may say that it is a lease, we go beyond “form” to look at the “substance” of the transaction. From the perspective of the lessee there is a direct comparison between a capital lease and an installment note. In this example, Matrix purchases equipment from Apex, agreeing to pay $193,878 (rounded), every six months for the next three years. The interest rate associated with this agreement is 9%. Let’s prepare an effective interest amortization table for this note. The effective interest is determined by multiplying the carrying value of one million dollars times four and a half percent. Remember that payments are made every six months.

LEASES We are tracking the question of LIABILITY and it is arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales type leases by the lessor. Leases that do not produce debtor/creditor relationships, but instead are accounted for as rental agreements are designated as operating leases.

Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is non-cancelable. Leases that do not transfer substantially all of the benefits and risks of ownership are operating leases. ASC 840 (FAS 13, Accounting for Leases,” 1980)

Accounting by the Lessee
Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Lease agreement exists. Criteria for a capital lease not met.
Operating Leases Lease agreement exists. Criteria for a capital lease not met. Record lease as an Operating Lease. From the viewpoint of the lessee, when a lease agreement exists and the criteria for classification as a capital lease are not met, we treat the lease as an operating lease. Capital Lease

How should this lease be classified?
Operating Leases On January 1, 2011, Sans Serif Publishers, Inc., 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, Inc., 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 a teach 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%. The lease fails all four of the capital lease tests, and is classified as an operating lease. At the end of the four payment dates, the lessee, San Serif, will debit prepaid rent and credit cash for $100,000. The lessor will debit cash and credit unearned revenue for $100,000. Because the lessor keeps the asset on its books, it is the lessor that records depreciation of the asset. How should this lease be classified?

Operating Leases How should this lease be classified? We apply the four classification criteria: Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO Is the lease term equal to 75% or more of the expected economic life of the asset? {4 yrs < 75% of 6 yrs} NO Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the asset? NO Calculations: PV of MLP = $348,685 = $100,000 x ** Lease present payments value ** present value of an annuity due of $1: n=4, i=10% $348,685 < 90% of $479,079 = $431,171  Since none of the four classification criteria is met, this is an operating lease. On January 1, 2011, Sans Serif Publishers, Inc., 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 a teach 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%. The lease fails all four of the capital lease tests, and is classified as an operating lease. At the end of the four payment dates, the lessee, San Serif, will debit prepaid rent and credit cash for $100,000. The lessor will debit cash and credit unearned revenue for $100,000. Because the lessor keeps the asset on its books, it is the lessor that records depreciation of the asset.

Operating Leases At Each of the Four Payment Dates:
Sans Serif Publishers, Inc. (Lessee) Prepaid rent 100, Cash ,000 CompuDec Corporation (Lessor) Cash 100, Unearned rent revenue ,000 At the End of Each Year: Sans Serif Publishers, Inc. (Lessee) Rent expense 100, Prepaid rent ,000 CompuDec Corporation (Lessor) Unearned rent revenue 100, Rent revenue ,000 Depreciation expense x,xxx Accumulated depreciation x,xxx On January 1, 2011, Sans Serif Publishers, Inc., 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 a teach 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%. The lease fails all four of the capital lease tests, and is classified as an operating lease. At the end of the four payment dates, the lessee, San Serif, will debit prepaid rent and credit cash for $100,000. The lessor will debit cash and credit unearned revenue for $100,000. Because the lessor keeps the asset on its books, it is the lessor that records depreciation of the asset.

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. 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.

Exercise 1 Brief Exercises 1-3
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.

Advantages of Leasing A. Leasing is used as a means of “off-balance-sheet financing.” 1. Can avoid negatively affecting the debt-asset ratio and other mechanical indicators of riskiness. 2. Market is naive, and is “fooled” by off-balance-sheet financing. B. Achieves operational objectives by facilitating asset acquisition to overcome: 1. Uncertainty or cash flow problems. 2. Fear of obsolescence. C. Achieves tax objectives: Lower lease payments for LESSEE if it allows the lessor to retain ownership and thus benefit from ITC and Depreciation deductions when: 1. The lessee has little or no taxable income and will get little benefit from depreciation deductions. 2. The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessor.

Classification Criteria (Lessee)
Operating Lease Capital Lease A capital lease must meet one of four criteria: Ownership transfers to the lessee at the end of the lease term, or . . . A bargain purchase option (BPO) exists, or . . . The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or . . . The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset. A lease is accounted for as either a rental agreement (known as an operating lease) or a purchase/sale accompanied by debt financing (known as a capital lease). The choice of accounting method hinges on the nature of the leasing arrangement. From the viewpoint of the lessee, a capital lease must meet one of the four following conditions: First, ownership to the leased asset must transfer to the lessee at the end of the lease term. Second, the lease may contain a bargain purchase option payment at the end of the lease term. Third, the non-cancelable lease term must be equal to 75% or more of the expected economic life of the leased asset. Finally, the present value of the minimum lease payment is 90% or more of the fair value of the leased asset. Remember, to be classified as a capital lease the agreement must meet only one of these four conditions.

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Agreement Operat ing Lease Transfer of Ownership Bargain Purchase Lease Term >= 75% PV of Payments >= 90% No No No No Yes Yes Yes Yes Capital Lease LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

1. The transfer of ownership criteria is straightforward and easy to apply in practice. IF THE LEASE TRANSFERS OWNERSHIP OF THE ASSET TO THE LESSEE, IT IS A CAPITAL LEASE

2. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable. At the inception of the lease, the difference between the option price and the expected FMV must be large enough to make the exercise of the option reasonably assured. Example: Lease Honda Accord for $599/Month for 40 months with an option to purchase for $100 at the end of the 40th month when the estimated FMV then is $ => Clearly a BARGAIN *Difficult to determine what is a BARGAIN: BOA or HERTZ

3. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the asset’s economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate. BARGAIN RENEWAL OPTION can extend the lease term. *Difficult to determine what is a BARGAIN A major exception to the 75% rule is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% test should not be used.

4. The reason for the 90% of fair market value test is that if the present value of the minimum lease payments are reasonably close to the market price (FMV) of the asset, the asset is effectively being purchased. A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% and 90% tests should not be used.

Recovery of Investment Test (90% Test): PV of Minimum lease payments: (>=90% of FMV) Minimum rental payment Guaranteed residual value Penalty for failure to renew Bargain purchase option Executory Costs: Insurance Maintenance Taxes Included in PV of Minimum Lease Payment calculation Exclude from PV of Minimum Lease Payment calculation Based on the examples provided in ASC 840, executory costs are costs incurred for operating the leased property or that otherwise protect the value of the leased property.

Recovery of Investment Test (90% Test): The residual value of a leased asset is the estimated fair value of the asset at the end of the lease term. The residual value may be guaranteed or unguaranteed by the lessee. A guaranteed residual value is said to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the end of the lease term. A guaranteed residual value affects the lessee’s computation of the minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. The lessor assumes the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.

Recovery of Investment Test (90% Test) To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees the residual value of an asset will be $8,000. If, at the end of the lease, the fair market value of the residual value is less than $8,000, the lessee will have to record a loss for the difference. For example, if the lessee depreciated the asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee would have to record a loss of $4,000. If the fair market value of the asset exceeds the $8,000, a gain may be recognized.

Recovery of Investment Test (90% Test) Executory Costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation.

Recovery of Investment Test (90% Test): Discount Rate Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception. If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessee’s incremental borrowing rate, then lessee must use the lessor’s rate.

For the lessee, a capital lease is treated as if it is a purchase of an asset – the lessee records both an asset and liability at inception of the lease. A bargain purchase option gives the lessee the right to acquire the leased asset at the end of the lease term at an amount significantly lower than expected fair value. The lease term is normally considered to be the non-cancelable term of the lease plus any option to renew the term at the end of the original lease term. When a lease is classified as a capital lease, the lessee records both the asset and liability at inception of the lease. We saw this accounting when we compared accounting for a capital lease to an installment note payable.

Asset and Liability Recorded at the lower of: the present value of the minimum lease payments (excluding executory costs) or the fair-market value of the leased asset.

Capital Leases – Lessee
On January 1, 2011, Sans Serif Publishers, Inc., 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 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. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. Part I On January 1, 2011, Sans Serif Publishers, Inc., 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 is 10%. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing 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. Part II Here are the calculations of the $100,000 rental payments, and the lessee’s cost of the copier. Notice that we found the present value of an annuity due because the payments are made at the beginning of the period.

*PV of an annuity due of $1: n = 6, I = 10% => 4.79079
$100,000 × 4,79079* = $479,079 lessee’s cost

Capital Leases – Lessee
Inception Of Lease (January 1, 2011) San Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) 479,079 Lease payable (PV of payments) ,079 First Lease Payment (January 1, 2011) San Serif Publishers, Inc. (Lessee) Lease payable ,000 Cash ,000 On the date of inception, the lessee will debit leased equipment for $479,079 and credit lease payable for the same amount. In addition, the lessor will debit lease receivable for $479,079, and credit inventory of equipment held for lease for the same amount. On January 1, 2011, the first payment is due. The lessee will lease payable for $100,000, and credit cash for the same amount. The lessor will debit cash for $100,000, and credit lease receivable for the same amount.

Capital Leases – Lessee and Lessor
Amortization Schedule for the Lease The amortization shows all the values that will be needed to record the journal entries in connection with the lease for both the lessee and lessor. Pay particular attention to the calculations shown on your screen. $379,079 - $62,092 = $316,987 $379,079 × 10% = $37,908 $100,000 - $37,908 = $62,092

Second Lease Payment (December 31, 2011) San Serif Publishers, Inc. (Lessee) Interest expense 37,908 Lease payable 62,092 Cash ,000 Depreciation Recorded at (December 31, 2011) Please refer to the amortization schedule on the previous slide. Notice that interest expense and interest revenue have been calculated to be $37,908, with a total payment of $100,000. At the second lease payment, the lessee will debit interest expense for $37,908, debit lease payable for $62,092 (again refer back to the amortization schedule), and credit cash for the total lease payment of $100,000. The lessor with debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908. Assuming the lessee uses the straight-line method of depreciation for similar owned assets, depreciation on the copier will have to be recorded. The journal entry is to debit depreciation expense for $70,847 ($479,079 ÷ 6 years), and credit accumulated depreciation for $79,847. San Serif Publishers, Inc. (Lessee) Depreciation expense ,847 Accumulated depreciation ,847 ($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

-Exercise 3 -EX 3: Fin. Stmt. 12/31/11
-Exercise 8 + F/S 12/31/11

Accounting by the Lessor
Economics of Leasing A lessor determines the amount of the rental, based on the rate of return needed to justify leasing the asset. If a residual value is involved (whether guaranteed or not), the company would not have to recover as much from the lease payments.

Classification of Leases by the Lessor Operating leases. Direct-financing leases. Sales-type leases. A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.

Classification of Leases by the Lessor Illustration 21-11 A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. LO 4 Identify the classifications of leases for the lessor.

Classification of Leases by the Lessor Illustration 21-12 A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease. LO 4 Identify the classifications of leases for the lessor.

Capital Leases – Lessee and Lessee
If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost. => Direct Financing Lease 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. => Sales-type Lease If the lessor is not a manufacturer or dealer of the asset being leased, the fair value of the leased asset usually will be equal to the lessor’s cost. However, when the lessor is a manufacturer or dealer, the fair value of the leased property at inception of lease will usually be more than the cost of the asset in the hands of the lessor.

On January 1, 2011, Sans Serif Publishers, Inc., 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 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. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. This lease also qualifies as a direct financing 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. Part I On January 1, 2011, Sans Serif Publishers, Inc., 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 is 10%. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing 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. Part II Here are the calculations of the $100,000 rental payments, and the lessee’s cost of the copier. Notice that we found the present value of an annuity due because the payments are made at the beginning of the period.

Lessor’s Determination of Rental payments:
*PV of an annuity due of $1: n = 6, I = 10% Lessee’s Determination of Lease liability and asset: $100,000 × 4,79079* = $479,079 lessee’s cost

Capital Leases – Lessor
Direct Financing Lease (January 1, 2011) 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) On the date of inception, the lessee will debit leased equipment for $479,079 and credit lease payable for the same amount. In addition, the lessor will debit lease receivable for $479,079, and credit inventory of equipment held for lease for the same amount. On January 1, 2011, the first payment is due. The lessee will lease payable for $100,000, and credit cash for the same amount. The lessor will debit cash for $100,000, and credit lease receivable for the same amount. First Lease Corp. (Lessor) Cash ,000 Lease receivable ,000

Amortization Schedule for the Lease The amortization shows all the values that will be needed to record the journal entries in connection with the lease for both the lessee and lessor. Pay particular attention to the calculations shown on your screen. $379,079 - $62,092 = $316,987 $379,079 × 10% = $37,908 $100,000 - $37,908 = $62,092

Second Lease Payment (December 31, 2011) First Lease Corp. (Lessor) Cash ,000 Lease receivable ,092 Interest revenue ,908 Please refer to the amortization schedule on the previous slide. Notice that interest expense and interest revenue have been calculated to be $37,908, with a total payment of $100,000. At the second lease payment, the lessee will debit interest expense for $37,908, debit lease payable for $62,092 (again refer back to the amortization schedule), and credit cash for the total lease payment of $100,000. The lessor with debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908. Assuming the lessee uses the straight-line method of depreciation for similar owned assets, depreciation on the copier will have to be recorded. The journal entry is to debit depreciation expense for $70,847 ($479,079 ÷ 6 years), and credit accumulated depreciation for $79,847.

Exercise 4 (JEs ONLY) Exercise 9 (JEs & FSs)

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. At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of payments). If the lessor is a manufacturer or dealer of the leased assets then the fair market value is generally not equal to the cost of the asset in the hands of the lessor. At the inception of the lease the lessor will recognize sales revenue and cost of goods sold associated with the transaction. 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. 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.

Sales-Type Leases On January 1, 2011, Sans Serif Publishers, Inc., 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 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%. On January 1, 2011, Sans Serif Publishers, Inc., 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 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 is 10%.

Sales-Type Leases SO Lease Classification
The lease term (6-years) is equal to 100% of the useful life of the copier, and Fair market value is different from cost of the leased asset. CompuDec is certain about the collectibility of the lease payments, and No costs are to be incurred by CompuDec relating to the lease agreement, SO The lease agreement is classified as: -a Sales-Type lease from the viewpoint of CompuDec (lessor) and -a capital lease from the viewpoint of Sans Serif Publishers (lessee). The asset leased by the lessee is a depreciable asset. It should be depreciated in a manner used for similar owned assets. If title to the leased asset passes to the lessee at the end of the lease term, or if the lease contains a bargain purchase option, the asset should be depreciated over the asset’s economic life. If neither of these conditions are met, the asset should be depreciated over the lease term.

Sales-Type Leases: Lessee
At inception of the Lease – January 1, 2011 CompDec Corp. (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue ,079 Inventory of equipment ,000 Receipt of the First Lease Payment – January 1, 2011 CompDec Corp.(Lessor) Cash ,000 Lease receivable ,000 At inception of the lease agreement, CompDec Corporation (the lessor), will prepare two journal entries. The first entry is to record the lease of the asset. CompDec will debit lease receivable for $479,079, and debit Cost of goods sold for $300,000 (the cost basis to CompDec). The company will complete the entry with a credit to sales revenue for $479,079, and credit inventory of equipment for $300,000. CompDec will recognize a gross profit from the “sale” of the lease asset of $179,079 (revenue of $479,079 less cost of goods sold of $300,000). Also, on January 1, 2011, CompDec will record the receipt of the first lease payment with a debit to cash for $100,000, and a credit to lease receivable for the same amount.

Exercise 5 Exercise 10 (JEs & F/Ss)

HOME WORK (Due Next Week)
Problem 3 (As is), Problem 5 (Requirement 1 & Financial Statements* -Lessee) Problem 6 (Financial Statements -Lessor) Problem 7 (Requirement 1 & Financial Statements* -Lessor) *Financial Statements include (in GOOD form): -Income Statement, -Balance Sheet, and -Statement of Cash Flows

Bargain Purchase Options
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 as 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. 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: The 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. The 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.

Bargain Purchase Options
In a bargain purchase option (BPO) lessee depreciates the asset using its useful life and NOT Lease Life. 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: The 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. The 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.

Bargain Purchase Option (BPO)
On January 1, 2011, Sans Serif Publishers, Inc., 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 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%. On January 1, 2011, Sans Serif Publishers, Inc., 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 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 is 10%. We have developed a table to show the computation of the present value of the minimum lease payments for the lessee, and the determination of the lease payments by the lessor. We need to use the present value of an annuity due of $1, for 6 periods, at 10% interest, and the present value of $1, for 6 periods, at 10% interest. Remember, the lessor determines the periodic lease payment and the lessee may accept or reject the contract.

After the last lease payment, the balance in the obligation balance is $54,542, which represents the amount, that when compounded at 10% to the end of the lease, will equal the amount of the BPO. We will look at the journal entries relating to the payment of the BPO on the next slide. Exercise of BPO at the end of the lease term: $54,542 × 10% = $5,458* $60,000 BPO payment - $5,458 = $54,542

End of Lease – December 31, 2016 Sans Serif Publishers, Inc. (Lessee) Depreciation expense ($479,079 ÷ 7) 68,440 Accumulated depreciation 68,440 Interest expense ,458 Lease payable ,542 Cash (BPO payment) 60,000 CompDec Corporation(Lessor) Cash ,000 Lease receivable ,582 Interest revenue ,458 At the end of the lease term Sans Serif exercises the bargain purchase option paying $60,000 cash to CompDec. The interest and obligation reduction were developed on the previous slide. Sometimes the lease contract specifies that a BPO becomes exercisable before the designated lease term ends. Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. All calculations would be modified accordingly. Refer the amortization schedule and computations on the previous screen

Exercise 17 Exercise 18

Effect on the Lessee of a Residual Value
Guaranteed 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. Sometimes the lease agreement includes a guarantee by the lessee 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. A lease agreement may contain a guaranteed residual value. Such a lease agreement includes a guarantee by the lessee 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. Examine the calculation of the present value of the minimum lease payments under the lease terms shown on the previous screen.

Residual Value On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479, The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 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, CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%. The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Let’s examine the impact of residual value on accounting for leases. On January 1, 2011, Sans Serif Publishers, Inc., 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%.

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. 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. The lessor will subtract the present value of the residual value from the fair value to determine the amount to be recovered through lease payments. In our example, the lease payments will be $92,931,

Guaranteed Residual Value PV factor of an annuity due of $1: n=6, i=10% PV factor of $1: n=6, i=10% A lease agreement may contain a guaranteed residual value. Such a lease agreement includes a guarantee by the lessee 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. Examine the calculation of the present value of the minimum lease payments under the lease terms shown on the previous screen.

Guaranteed Residual Value
After the last lease payment, the balance in the obligation balance is $54,542, which represents the amount, that when compounded at 10% to the end of the lease, will equal the amount of the BPO. We will look at the journal entries relating to the payment of the BPO on the next slide. Exercise of GRV at the end of the lease term: $54,542 × 10% = $5,458* $60,000 GRV payment - $5,458 = $54,542

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. Sales-Type Lease – January 1, 2011 San Serif Publishers, Inc. (Lessee) Leased equipment 479,079 Lease payable ,079 CompDec Corporation (Lessor) Lease receivable 479,079 Cost of goods sold 300,000 Sales revenue ,079 Inventory of equipment ,000 Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value. On January 1, 2011, San Serif Publishers, Inc. will debit leased equipment for $479,079, and credit lease payable for the same amount. On the same date, CompDec Corporation, the lessor, will debit lease receivable for $479,079 and cost of goods sold for $300,000, the finish the entry, the company will credit sales revenue for $479,079, and inventory of equipment for $300,000.

First Lease Payment – January 1, 2011 San Serif Publishers, Inc. (Lessee) Lease payable 92,931 Cash 92,931 CompDec Corporation (Lessor) Lease receivable ,931 On January 1, 2011, San Serif will debit lease payable and credit cash for $92,931, while CompDec will debit cash and credit lease receivable for $92,931. Now let’s look at the end of the lease term.

December 31, 2015 San Serif Publishers, Inc. (Lessee) Depreciation expense 69,847 Accumulation depreciation 69,847 Interest expense 13,407 Lease payable 79,524 Cash 92,931 CompDec Corporation (Lessor) Interest revenue 13,407 Lease receivable ,524 On December 31, 2015, San Serif, the lessee, will record depreciation of $68,847. Look at the calculation of this amount in the schedule on the top right of your screen. Both the lessee and lessor will record the final lease payment. Refer back to the lease amortization schedule for the amounts included in the journal entries. See amortization schedule

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. 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.

Treatment of Residual Value
The schedule summarizes the effect of the residual value of a leased asset for each of the various possibilities regarding the nature of the residual value.

The lessee records executory costs as incurred:
One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs. Based on the examples provided in ASC 840, Executory Costs are costs incurred for operating the leased property or that otherwise protect the value of the leased property. One of the responsibilities of ownership that is transferred to the lessee in a capital 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. The lessee records executory costs as incurred: Sans Serif Publishers, Inc. (Lessee) Maintenance expense 2,000 Cash 2,000

Recovery of Investment Test (90% Test) Executory Costs include the cost of insurance, maintenance, and tax expense related to the leased asset. If the lessor makes these payments, such amounts should reduce the present value of the minimum lease payments. When the lease agreement specifies that executory costs are assumed by the lessee, the rental payments can be used without adjustment in the present value computation.

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. 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.

Lessor’s Initial Direct Costs
Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. They include legal fees, commissions, evaluating the prospective lessee's financial condition, and preparing and processing lease documents. The method of accounting for initial direct costs depends on the nature of the lease: Operating Leases − Capitalize and amortize over the lease term by the lessor. Reason: Since the only revenue an operating lease produces is lease revenue, and that revenue is recognized over the lease term, initial direct costs also are automatically recognized over the lease term to match these costs with the rent revenues they help generate. Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct-financing type lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct-financing type lease, we must calculate a new implicit interest rate that previously was unknown to the lessor. For a sales-type lease the initial direct costs are expenses at the inception of the lease agreement.

For Capital Leases, the method of accounting for initial Direct Costs depends on the nature of the lease: Direct Financing Leases − Include as part of investment balance. In direct financing leases interest revenue is earned over the lease term, so initial direct costs are matched with the interest revenues they help generate. Therefore, initial direct costs are not expensed at the outset, but are deferred and recognized over the lease term. This can be accomplished by increasing the lessor’s lease receivable by the total of initial direct costs. Then, as interest revenue is recognized over the lease term at a constant effective rate, the initial direct costs are recognized at the same rate (that is, proportionally). Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct-financing type lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct-financing type lease, we must calculate a new implicit interest rate that previously was unknown to the lessor. For a sales-type lease the initial direct costs are expenses at the inception of the lease agreement.

The method of accounting for initial direct costs depends on the nature of the lease: Sales-Type Leases – The initial direct costs are expensed at the inception of the lease. Since the usual reason for a sales-type lease is for a manufacturer or a dealer to sell its product, it’s reasonable to recognize the costs of creating the transaction as a selling expense in the period Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct-financing type lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct-financing type lease, we must calculate a new implicit interest rate that previously was unknown to the lessor. For a sales-type lease the initial direct costs are expenses at the inception of the lease agreement.

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. Contingent rentals may increase or decrease the minimum lease payment. However, contingent rentals are not included in the minimum lease payment. Instead, contingent rentals are disclosed in the notes to the financial statements.

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 all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years. Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.

Lease Disclosures 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. 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.

Balance Sheet and Income Statement
Lease transactions impact several financial ratios Debt to equity ratio – Lease liabilities are recorded. Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet. Lease transactions have a profound impact on motive ratios. The first is the debt to equity ratio. The lease liability is included in the denominator of this equation. The second ratio is the rate of return on assets. The leased asset is included in the numerator of this ratio.

Criticisms of the existing accounting model
The existing accounting model fails to meet the needs of users of financial statements. Operating leases give rise to assets & liabilities that should be recognized. -Form over Substance Issue Similar transactions can be accounted for very differently -Comparability Issue Rules can easily be manipulated: -Use of Higher Interest Rate; -Transfer of Residual Value Guarantees. -Payment arrangements: MLP vs. Executory Costs -Off-Balance Sheet Financing Issue

FASB and IASB Convergence Project on Leases
FASB Discussion Paper —Leases (03/2009)

Conceptual basis for Assets & Liabilities
Conceptual Issues: Conceptual basis for Assets & Liabilities

Characteristics of an asset:
(a) The entity controls an economic resource or benefit. (b) It arises out of a past event. (c) Future economic benefits are expected to flow to the entity.

Characteristics of a liability:
(a) There exists a present obligation of the entity. (b) The obligation arises out of a past event. (c) The obligation is expected to result in an outflow of economic benefits.

The board tentatively decided that in a simple lease the lessee obtains a right to use a property (the leased item) that meets the definition of an asset and a liability. Consequently, the boards tentatively decided to adopt a new accounting model for leases that results in recognizing: an asset representing its right to use the property (leased item) for the lease term (b) a liability for its obligation to pay rentals. This is a significant departure from the current basis of transferring substantially all the risk and rewards of ownership.

LEASES (Chapter 15) Learning Objectives

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