1. CHAPTER 15
Leases

2. Lessor = Owner of property
Basic Lease Terms
A lease is an agreement where 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. Lease Classifications

4. Capital Lease Classification
A capital lease must meet one of three criteria:
Ownership transfers to the lessee at the end of the lease term, or the agreement contains a bargain purchase option (BPO).
The noncancellable lease term is equal to 75% or more of the expected economic life of the asset.
The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.
Must include a noncancellable lease term.

5. Capital Lease Classification
A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price sufficiently lower than the expected fair value of the property and the exercise of the option appears reasonably assured.

6. Capital Lease Classification
The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply.
For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

7. Additional Lessor Conditions
The three conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease:
The collectibility of the lease payments must be reasonably predictable.
If any costs to the lessor have yet to be incurred they are reasonably predictable. Performance by the lessor is substantially complete.

8. 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

9. Operating Leases
On January 1, 2005, Sans Serif leased a colour copier from CompuDec. The lease specified four $100,000 payments commencing January 1, The useful life of the copier is estimated at six years. The cash price of the copier is $479,079 and if Sans Serif were to use borrowed funds the cost would have been 10%.

10. Prepare the entry on the books of Sans Serif on January 1.
Operating Leases
Prepare the entry on the books of Sans Serif on January 1.

11. Operating Leases
Prepare the entry the CompuDec would make to record receipt of the January 1 payment.

12. Operating Leases The December 31 adjustment by Sans Serif.
The December 31 adjustment by CompuDec.

13. Operating Leases - Amortization
Lessee does not record amortization
Lessor retains title and therefore records amortization

14. We’ll look at non-operating leases for Lessee and Lessor in some detail.

15. Nonoperating Leases - Lessee
The amount recorded (capitalized) is the present value of the minimum lease payment. However, the amount recorded cannot exceed the fair value of the leased asset.
In calculating the present value of the minimum lease payment, the interest rate used by the lessee is the lower of:
Its incremental borrowing rate, or
The implicit interest rate used by the lessor.

16. Nonoperating Leases - Lessor
If the lessor is not a manufacturer or dealer, the fair value of the leased assets is typically the lessor’s cost.
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.

17. The equipment has a economic life of 6 years.
Nonoperating Leases
On December 31, 2004, Sans Serif, Inc. signed a 6-year lease with First LeaseCorp who acquired the copier from CompuDec for $479,079.
The equipment has a economic life of 6 years.
First LeaseCorp routinely leases equipment and the financing rate is 10%.

18. Nonoperating Leases - Lessee
The lease term does meet the “75% of the economic life” test.

19. Nonoperating Leases - Lessee
Is the PV of the minimum lease payments (MLP) ³ 90% of the equipment’s fair value?

20. Nonoperating Leases - Lessee
Sans Serif makes the following entries at inception of the lease.

21. Nonoperating Leases - Lessor
In addition to the information given earlier, the lessor (First LeaseCorp) knows that the collectibility of the lease payments is reasonably predictable, and there are no future cost to be incurred. First LeaseCorp’s performance is substantially complete as far as the lease is concerned. First LeaseCorp is not a manufacturer or dealer and its cost of the equipment is $479,079.

22. Nonoperating Leases - Lessor
Because the cost of the asset in the hands of the lessor is equal fair market value, the lease is classified as a Direct Financing Lease.
$100,000 × 6 = $600,000

23. Nonoperating Leases - Lessor
Because the cost of the asset in the hands of the lessor is equal fair market value, the lease is classified as a Direct Financing Lease.

24. Lease Amortization Schedule

25. Nonoperating Leases December 31, 2005, adjustment by Sans Serif.
December 31, 2005, adjustment by CompuDec.

26. Amortization by Lessee
Amortization expense is recorded in a manner consistent with the company’s usual policy concerning Amortization of other operational assets.
If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase option, the asset is amortized over the asset’s economic life; otherwise, it is amortized over the lease term.

27. Amortization by Lessee
At December 31, 2005, Sans Serif prepares the following entry to recognize amortization expense for the year.
$479,079 6 years
= $79,847

28. Nonoperating Leases - Lessee
Sans Serif records the second payment on January 1, 2006.
From the December 31, 2005, accrual.

29. Nonoperating Leases - Lessor
CompuDec records the receipt of $100,000 on January 1, 2006 as follows:

30. Now let’s look at sales-type leases.
Nonoperating Leases
Now let’s look at sales-type leases.

31. Sales-Type Lease
Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to 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 MLP).

32. Sales-Type Lease
On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.
Other relevant information:
Six annual payments of $100,000 commencing December 31, 2004.
6-year term is equal to useful life of copier.
CompuDec’s manufactured cost is $300,000.
CompuDec’s interest rate for financing is 10%.

33. Sans Serif treats this as a capital lease.
Sales-Type Lease
This is a sales-type lease. It differs from a direct financing lease since the lessor (CompuDec) earns a profit on selling the item in addition to interest.
Sans Serif treats this as a capital lease.

34. Sales-Type Lease - Lessor
Entry at inception of the lease
($100,000 × 6) = $600,000

35. Sales-Type Lease - Lessor
First receipt

36. Let’s look at how we handle residual value.

37. Residual Value
The residual value of a leased asset is an estimate of what its commercial value will be at the end of the lease term. Let’s see how residual value impacts the accounting for leases by both the lessee and lessor.

38. Lessee Obtains Title to Leased Asset.
Residual Value
Lessee Obtains Title to Leased Asset.
The only impact on the lessee is the determination of amortization expense. The cost of the asset will be reduced by the estimated residual value and amortized over the economic life of the asset.

39. Lessor Retains Title to Leased Asset.
Residual Value
Lessor Retains Title to Leased Asset.
In determining the lease payment, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payment.

40. Residual Value Let’s calculate the lease payment!
On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.
Other relevant information:
Six annual payments of $100,000 commencing December 31, 2004.
Lease term is 6 years. Estimated useful life is 7 years.
CompuDec’s manufactured cost is $300,000.
CompuDec’s interest rate for financing is 10%.
Let’s calculate the lease payment!

41. Calculation of the lease payment.
Residual Value
Calculation of the lease payment.

42. Residual Value Guaranteed by Lessee
Lessee pays any difference between guaranteed residual value and the appraised value.
Let’s use the previous information, except that Sans Serif (Lessee) guarantees to pay the residual value and the custody of copier reverts to lessor at end of lease.
In this case, the annual lease payments are unchanged.
However, there will be a payment of $60,000 at the end of the lease.

43. Residual Value Guaranteed by Lessee

44. Residual Value Guaranteed by Lessee
Sans Serif records the asset at the present value of the payments.

45. Residual Value Guaranteed by Lessee
CompuDec records the sale as follows:

46. Residual Value Guaranteed by Lessee
First lease payment by Sans Serif.
Receipt of first payment by CompuDec.

47. Residual Value Guaranteed by Lessee
Amortization recorded by Sans Serif.
Final periodic payment made by Sans Serif.

48. Residual Value Guaranteed by Lessee
Receipt of final payment by CompuDec.
Recording of revenue on final periodic payment.

49. Residual Value Guaranteed by Lessee
At the end of the lease term the lessee must remove the asset and related amortization in addition to recording the interest.

50. Residual Value Guaranteed by Lessee
Lessor records receiving copier at end of lease.
Also records final amount of interest revenue.

51. Residual Value Not Guaranteed by Lessee
Lessee is only obligated to make periodic rental payments.
Present value of lease payments is recorded as leased asset and lease liability.
Same method applied if residual value is guaranteed by a third party.

52. Residual Value Not Guaranteed by Lessee

53. Residual Value Not Guaranteed by Lessee
Recording the asset and liability by Sans Serif.
First lease payment by Sans Serif.

54. Residual Value Not Guaranteed by Lessee
CompuDec makes the following entry at the start of the lease.

55. Let’s look at how we handle Bargain Purchase Options

56. Bargain Purchase Options
This is a provision in a lease that gives the lessee the option of purchasing the asset at a price below fair market value at the end of the lease.
The accounting and calculations are similar to residual values.

57. Bargain Purchase Options
On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.
Other relevant information:
Six annual payments commencing December 31, 2004.
Lease term is 6 years. Estimated useful life is 7 years.
Copier is expected to be worth $75,000 at end of lease.
Sans Serif has option to buy at end of lease for $60,000.
Residual value at end of lease is zero.
CompuDec’s interest rate for financing is 10%.
Let’s calculate the lease payment!

58. Bargain Purchase Options
Calculation of the lease payment.

59. Bargain Purchase Options
Calculation of the PV of lease payments by lessee .

60. Bargain Purchase Options

61. Bargain Purchase Options
Recording amortization by Lessee.
Entry to record payment of BPO at end of lease.

62. Bargain Purchase Options
What happens if BPO is exercisable before end of lease?
Lease term ends when option becomes exercisable.
All calculations modified to consider shorter lease term.

63. Executory Costs
Executory costs include cost of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible for the executory costs, they are treated as expenses by the lessee.
In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

64. Discount Rate
Implicit rate is the effective interest rate the lease payments provide the lessor over and above the price that the asset is sold under the lease.
If this rate is not known by lessee, the lessee should use its own incremental borrowing rate, which is the rate the lessee would expect to pay if the funds were borrowed from the bank.

65. Initial Direct Costs
Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.
Operating Leases − Capitalize and amortize over the lease term by the lessor.
Direct Financing Leases − Expense as incurred and a portion of unearned income equal to costs should be recognized as income in same period. Remainder deferred and taken to income over lease term.
Sales-Type Leases – expense at inception of lease.

66. Contingent Rentals
Sometimes rental payment may be increased (or decreased) at some future time during the lease term, depending on whether or not 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.

67. Lessee Disclosures For capital leases, disclose
Gross amount of assets recorded under capital leases and related accumulated amortization.
Separately from other long-term obligations.
Amounts due within one year of balance sheet date are disclosed as current liabilities.
Future MLP in the aggregate and for each of the five succeeding years.

68. Lessee Disclosures For capital leases, disclose
Amortization expense disclosed separately or part of amortization of capital assets.
Interest expense related to leases disclosed separately or as part of interest on long-term debt.
Total minimum sublease rentals to be received in the future under noncancelable subleases. (Desirable)
Total contingent rentals. (Desirable)

69. Lessee Disclosures
For operating leases in excess of one year, disclose
Future minimum rental payments required in the aggregate and for each of the five succeeding fiscal years and other commitments.
Total of minimum rentals to be received in the future under noncancellable subleases. (Desirable)
For all operating leases, disclose rental expense, with separate amounts for minimum rentals, contingent rentals, and sublease rentals. (Desirable)

70. Lessee Disclosures
Provide a description of the lessee’s leasing arrangements including, but not limited to
The basis on which contingent rental payments are determined.
The existence and terms of renewal or purchase options and escalation clauses.
Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing.

71. Lessor Disclosures
For sales-type and direct financing leases, disclose
Lessor’s net investment, segregated between current and long-term portions.
Finance Income.
Computation of investment in leases for purposes of recognizing income.

72. Lessor Disclosures
For sales-type and direct financing leases, disclose (Desirable)
Components of the net investment in sales-type and direct financing leases
Future MLP to be received.
Unguaranteed residual values.
Unearned Interest Revenue.
Future MLP to be received for each of the five succeeding fiscal years.
Total contingent rentals included in income.

73. Lessor Disclosures For operating leases, disclose
Cost of property held for leasing and the related accumulated amortization.
Rental income from operating leases.
Minimum future rentals on noncancellable leases in the aggregate and for each of the five succeeding years. (Desirable)
Total contingent rentals included in income. (Desirable)

74. Balance Sheet & 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 most impact is on the balance sheet.

75. Statement of Cash Flows
Operating leases - Rent expense is a cash outflow to the lessee and a cash inflow to the lessor.
Capital & Direct Financing Leases – Lessee reports interest expense as an outflow from operating activities and principal payment as an outflow from financing activities. The lessor has a cash inflow from operating activities and investing activities.

76. Statement of Cash Flows
Sales-type leases – The lessor recognizes the interest revenue in the operating activities section of the statement and the principal reduction in the investing section. In addition, the lessor has sales revenue and cost of goods sold recognized in the operating activities section.

77. Sale-Leaseback – Capital Lease
Owner of asset sells it and immediately leases it back from new owner.
Very common form of financing.
Seller-lessee receives cash from sale of asset.
Seller-lessee pays periodic rents to buyer-lessor to retain use of asset.

78. Sale-Leaseback – Capital Lease
Teledyne sells its four warehouses for $900,000.
Original cost $950,000; book value $600,000.
Sale date Dec 31, 2005.
Noncancellable lease term is 10 years.
Annual payments $133,155 starting Dec 31, 2005.
Rental payments provide 10% return, which is equal to incremental borrowing rate.
Straight-line amortization used.

79. Sale-Leaseback – Capital Lease
Prepare the entry to record the sale on December 31, 2005.

80. Sale-Leaseback – Capital Lease
Record asset and liability on Dec 31, 2005.
Record payment on Dec 31, 2005.

81. Sale-Leaseback – Capital Lease
Prepare the entry on Dec 31, 2006, to record the payment.

82. Sale-Leaseback – Capital Lease
Amortization on December 31, 2006.
Reduction of deferred gain on Dec 31, 2006.

83. Sale-Leaseback – Operating Lease
In this case, the gain is deferred and recognized as a reduction in rent expense instead of amortization.
There is no lease to amortize.

84. Sale-Leaseback – Losses
In accordance with the conservatism principle a real loss on the sale of the property is recognized immediately.
A real loss results when the fair value is less than the carrying value.
An artificial loss results when fair value exceeds carrying amount and asset is sold for less than carrying amount.
Defer and amortize artificial loss if it is a prepayment of rent in substance.

85. Land is never amortized.
Real Estate Leases
Land is never amortized.
If land and building are leased you must account for separately, based on market value proportions.
However if fair value of land is < 25%, it is ignored and lessee and lessor treat land as a single unit.

86. Accounting is similar to non leveraged leases.
Occurs when a third party provides nonrecourse financing for lease between lessor and lessee.
Accounting is similar to non leveraged leases.
Lessor records lease receivable net of nonrecourse debt and reports income in years when receivable exceeds liability.

87. End of Chapter 15