1. Intermediate Accounting,17E
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Intermediate Accounting,17E
Leases
PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University
© 2010 Cengage Learning

2. Economic Advantages to Leasing Over Purchasing
For the Lessee
No down payment
Avoid risks of ownership
Flexibility
For the Lessor
Increased sales
Ongoing business relationship with lessee
Residual value retained

3. Simple Example
Owner Company owns a piece of equipment with a market value of $10,000.
User Company wishes to acquire the equipment.
User Company can borrow $10,000 from the bank at 10% interest. Payments would be $2,638 each year for five years.
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4. Simple Example
User Company can lease the equipment from Owner Company for five years and make five annual “rental” payments of $2,638. Owner maintains title throughout. At the end of the lease, the equipment is no longer useful.
Should Owner Company recognize an equipment sale when the lease is signed?
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5. Simple Example Key accounting issues for Owner Company
Has effective ownership of the equipment been passed from Owner to User?
Is the transaction complete?
Is Owner Company reasonably certain the five annual payments can be collected from User Company?
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6. Simple Example Key accounting issues for User Company.
On the date the lease is signed, should User recognize the lease equipment as an asset and the obligation to make the lease payment as a liability?
The answer hinges on whether effective ownership, as opposed to legal ownership, of the equipment changes hands when Owner and User sign the lease agreement.
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7. Simple Example
The economic substance of this lease is that the lease signing is equivalent to the transfer of effective ownership, and the fact that Owner retains legal title of the equipment during the lease period is a mere technicality.
The arrangement should be treated as a sale by Owner and a purchase by User.

8. Simple Example
Scenario One
The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease.
Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase.

9. Simple Example
Scenario Two
The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1.
Offering the equipment to User Company for a bargain price at the end of the lease indicates that this is in substance a purchase.

10. Simple Example
Scenario Three
The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else.
Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

11. Simple Example
Scenario Four
The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date.
When the present value of the lease payments equals the lease item’s market value, it is in substance a purchase.

12. Capital vs. Operating Lease
Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to lessee.
Operating leases are accounted for as rental agreements.

13. Cancellation Provisions
Some leases are noncancelable, meaning that these lease contracts are cancelable only on the outcome of some remote contingency or that the cancellation provisions and penalties of these leases are so costly to the lessee that cancellation will not occur.

14. Bargain Purchase Option
If a lease includes a provision giving the lessee the right to purchase the leased property at a price that is expected to be considerably less than the fair value, the option is called a bargain purchase option.

15. Lease Term
The lease term is the time period from the beginning to the end of the lease.
The beginning of the lease term occurs when the leased property is transferred to the lessee.
The end of the lease term is at the end of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised.

16. Residual Value
The market value of the leased property at the end of the lease term is referred to as its residual value.
Some lease contracts require the lessee to guarantee a minimum residual value. If the market value falls below the guaranteed residual value, the lessee must pay the difference.

17. Minimum Lease Payments
The rental payments required over the lease term plus any amount to be paid for the residual value are referred to as the minimum lease payments.
Lease payments sometimes include charges for insurance, maintenance, and taxes on the leased property. These are referred to as executory costs.

18. Lease 1
The implicit interest rate is used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease.
The lessor always uses the implicit rate to discount rental payments.
The interest rate that the lessee could use to borrow the amount of money necessary to purchase the leased asset is the incremental borrowing rate.
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19. Lease 1
The lessee uses the lower of the implicit interest rate or the incremental borrowing rate to compute present value of minimum lease payments.

20. Lease Classification Criteria
A lease is classified as a capital lease by the lessee if it is noncancelable and meets any one of the following criteria:
The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.
The lease term is equal to 75% or more of the estimated economic life of the asset.
The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset.

21. IASB Approach IAS 17, “Accounting for Leases,” states simply:
“A lease is classified as a finance (i.e., capital) lease if it transfers substantially all the risks and rewards incident to ownership.”
This places the responsibility of distinguishing the type of lease on the accountant.

22. General Classification Criteria— Lessee and Lessor
The four general criteria that apply to all leases for both the lessee and lessor relate to—
transfer of ownership
bargain purchase option
economic life
fair value of the leased asset

23. Lease Classification―Lessor
Additional revenue recognition criteria applicable to lessors:
Collectibility of the minimum lease payments must be reasonably predictable.
Any unreimbursable costs yet to be incurred by the lessor can be reasonably estimated at the lease inception date.

24. Accounting for Operating Lease—Lessee
The lease terms for manufacturing equipment are $40,000 a year on a year-to-year basis. The entry to record the lease payment for the year would be:
Rent Expense 40,000
Cash 40,000

25. Operating Leases with Varying Lease Payments
The terms of the lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years of the lease and $250,000 for each of the next three years. The total lease payments would be $1,050,000, or $210,000 a year on a straight-line basis.
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26. Operating Leases with Varying Lease Payments
The required entries in the first two years would be as follows:
Rent Expense 210,000
Cash 150,000
Rent Payable 60,000
current liability
The entries for each of the last three years are as follows:
Rent Expense 210,000
Rent Payable 40,000
Cash 250,000

27. Accounting for Capital Leases—Lessee
Marshall Corporation—Lessee
Lease period: 5 years, beginning January 1, 2011, noncancelable
Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs
Estimated economic life of equipment: 5 years
Expected residual value of equipment at end of lease period: None
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28. Accounting for Capital Leases—Lessee
Marshall Corp. Entries on January 1, 2011
Leased Equipment 250,192
Obligations under Capital Leases 250,192
(PMT = $60,000; N = 5; I = 10%)
Lease Expense 5,000
Obligations under Capital Leases 60,000
Cash 65,000
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29. (continues)

30. Accounting for Capital Leases—Lessee
Marshall Corp. Entries on December 31, 2011
If normal company depreciation policy for this type of equipment is used, the amortization entry for 2011 is shown below:
Amortization Expense on Leased
Equipment 50,038
Accumulated Amortization on
Leased Equipment 50,038
$250,192 ÷ 5
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31. Accounting for Capital Leases—Lessee
Entries on December 31, 2011
Prepaid Executory Costs 5,000
Obligations under Capital
Leases 40,981
Interest Expense 19,019
Cash 65,000
($250,192 – $60,000) × 0.10

32. Accounting for Leases with a Bargain Purchase Option
Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price.
The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.

33. Accounting for Leases with a Bargain Purchase Option
Lessee
Lease period: 5 years, beginning January 1, 2011, noncancelable
Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs
Estimated economic life of equipment: 5 years
Expected residual value of equipment at end of lease period: None
There is a bargain purchase option of $75,000 exercisable after five years
These are the same facts as before, but with one new item.

34. Accounting for Leases with a Bargain Purchase Option
Minimum Lease Payment
Present value of five payments at the
beginning of each year for five years:
PMT = $60,000, N = 5, I = 10% $250,192
Present value of the bargain purchase
option of $75,000 at the end of 5 years:
FV = $75,000, N = 5, I = 10% ,569
Present value of minimum lease payment $296,761

36. Accounting for Leases with a Bargain Purchase Option
Entries on December 31, 2015
Obligations under Capital Leases 68,182
Interest Expense 6,818
Cash 75,000
To record exercise of bargain
purchase option.
$68,182 × 10%
Equipment 148,381
Accumulated Amortization on
Leased Equipment 148,380
Leased Equipment 296,761
To transfer remaining balance in
leased asset account to Equipment.
($296,761 ÷ 10) × 5 years

37. Accounting for Leases with a Bargain Purchase Option
If the equipment is not purchased and the lease is permitted to lapse, the following entry is required on December 31, 2015:
Loss from Failure to Exercise Bargain
Purchase Option 73,381
Obligation under Capital Leases 68,182
Interest Expense 6,818
Accumulated Amortization on
Leased Equipment 148,380
Leased Equipment 296,761 .

38. Accounting for Purchase of Asset During Lease Term
On December 31, 2013, the lessee purchased the leased property in the Marshall Corporation example for $120,000. At that date, the remaining liability recorded on the lessee’s books is $114,545 and the net book value of the recorded leased asset is $100,078 [capitalized value of $250,192 less $150,114 amortization ($50,038 × 3)].
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39. Accounting for Purchase of Asset During Lease Term
Given the facts in Slide 15-38, the entry to record the purchase on the lessee’s books would be as follows:
Interest Expense 10,413
Obligation under Capital Leases 104,132
Equipment 105,533
Accumulated Amortization on
Leased Equipment 150,114
Leased Equipment 250,192
Cash 120,000
[$100,078 + ($120,000 – $114,545)]

40. Treatment of Leases on Lessee’s Statement of Cash Flows
In 2011, Marshall Corporation’s income before any lease-related expenses is $200,000. Net income for the year is computed as follows:
Income before lease-related expenses $200,000
Lease-related interest expense (19,019)
Lease-related amortization expense (50,038)
Net income $130,943

41. Accounting for Leases—Lessor
Direct financing leases involve a lessor who is primarily engaged in financing activities, such as a bank or finance company.
Sales-type leases involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products.

42. Revenue Generated by a Sales-Type Lease
A sales-type lease generates two different types of revenue:
An immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease
Interest revenue earned over time as the lessee makes the lease payments

43. Accounting for Operating Leases—Lessor
Universal Leasing Co. (Lessor)
Minimum payment (in advance) including
$5,000 executory cost $65,000/year
Lease period (beginning Jan. 1, 2011) 5 years
Economic life of asset 10 years
Estimated residual value at end of lease $0
Implicit rate 10%
Incremental borrowing rate 10%
Cost to lessor $400,000
Direct costs incurred $15,000
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44. Accounting for Operating Leases—Lessor
Universal Leasing Co. (Lessor)
To record the payment of the initial direct costs and the receipt of the lease payment on January 1, 2011:
Deferred Initial Direct Costs 15,000
Cash 15,000
Cash 65,000
Rent Revenue 60,000
Executory Costs 5,000
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45. Accounting for Operating Leases—Lessor
Universal Leasing Co. (Lessor)
To record the amortization of direct costs over five years and the depreciation of equipment over ten years using the straight-line basis:
Amortization of Initial Direct Costs 3,000
Deferred Initial Direct Costs 3,000
Depreciation Expense on Leased
Equipment 40,000
Accumulated Depreciation on Leased
Equipment 40,000

46. Accounting for Direct Financing Leases
Refer to Slides and for details concerning Marshall Corporation’s leasing arrangement with Universal Leasing Company. The cost of the equipment to Universal was the same as the fair value, $250,192 and Equipment Purchased for Lease was charged when the equipment was acquired.
Left click on the button to go to Slide 15-27, then type “46” and press the “Enter” key to return to this slide.
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47. Accounting for Direct Financing Leases
Receivable Recorded at Gross Amount
To record initial lease on January 1, 2011:
Lease Payments Receivable 300,000
Equipment Purchased for Lease 250,192
Unearned Interest Revenue 49,808
To record first payment on January 1, 2011:
Cash 65,000
Lease Payment Receivable 60,000
Executory Costs 5,000
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48. Accounting for Direct Financing Leases
To record receipt of payment on December 31, 2011:
Cash 65,000
Lease Payment Receivable 60,000
Deferred Executory Costs (a liability) 5,000
Unearned Interest Revenue 19,019
Interest Revenue 19,019
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49. Lessor Accounting for Direct Financing Leases with Residual Value
Assuming the same facts as the last illustration, except that the asset has a residual value at the end of the 5-year lease of $75,000. Assume the cost to Universal Leasing Company was $296,761 (which is also its fair value).

50. Lessor Accounting for Direct Financing Leases with Residual Value
Receivable Recorded at Net Amount
To record initial lease on January 1, 2011:
Lease Payments Receivable 296,761
Equipment Purchased for Lease 296,761
To record first payment on January 1, 2011:
Cash 65,000
Lease Payment Receivable 60,000
Executory Costs 5,000
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51. Lessor Accounting for Direct Financing Leases with Residual Value
To record payment on December 31, 2011:
Cash 65,000
Lease Payments Receivable 36,324
Deferred Executory Cost 5,000
Interest Revenue 23,676
To record recovery of the leased asset on December 31, 2015:
Equipment 75,000
Lease Payment Receivable 68,182
Interest Revenue 6,818

52. Accounting for Sales-Type Leases—Lessor
If there is no difference between the sales price and the lessor’s cost, the lease is not a sales-type lease.
The lessor will also recognize interest revenue over the lease term for the difference between the sales price and the gross amount of the minimum lease payments.

53. Accounting for Sales-Type Leases—Lessor
(1) Minimum lease payments
Financial
Revenue
(Interest)
(2) Fair value of leased asset
Manufacturer’s
or Dealer’s
Profit (Loss)
(3) Cost or carrying value of
leased asset to lessor

54. American Manufacturing Co. (Lessor)
Accounting for Sales-Type Leases—Lessor
American Manufacturing Co. (Lessor)
Fair value of equipment $250,192
Lease period (beginning Jan. 1, 2011) 5 years
Economic life of asset 10 years
Estimated residual value at end of lease $0
Implicit rate 10%
PV of future lease payments $250,192
Cost to lessor $160,000
Direct costs incurred $15,000
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55. Accounting for Sales-Type Leases—Lessor
Minimum lease payments:
($65,000 – $5,000) × 5 $300,000
$49,808 (Interest Revenue)
Fair value of equipment $250,192
$75,192 (Mfr.’s Profit)
Cost of leased equipment
to lessor, plus initial direct
costs $175,000
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56. American Manufacturing Co. (Lessor)
Accounting for Sales-Type Leases—Lessor
American Manufacturing Co. (Lessor)
To record entries on January 1, 2011:
Lease Payments Receivable 250,192
Sales 250,192
Cost of Goods Sold 175,000
Finished Goods Inventory 160,000
Deferred Initial Direct Costs 15,000
Cash 65,000
Lease Payments Receivable 60,000
Executory Costs 5,000

57. Accounting for Sales-Type Leases—BPO or Guaranteed R/V
The minimum lease payments will include the following if they are part of the agreement:
A lump sum (from a bargain purchase option) at the end of the lease term OR
A guaranteed residual value
The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

58. Accounting for Sales-Type Leases—BPO or Guaranteed R/V
Using the data from Exhibit 15-5, American Manufacturing offers a bargain purchase option of $75,000 at the end of five years.
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59. American Manufacturing Co. (Lessor)
Accounting for Sales-Type Leases—BPO or Guaranteed R/V
American Manufacturing Co. (Lessor)
To record entries on January 1, 2011:
Lease Payments Receivable 296,761
Sales 296,761
Cost of Goods Sold 175,000
Finished Goods Inventory 160,000
Deferred Initial Direct Costs 15,000
Cash 65,000
Lease Payments Receivable 60,000
Executory Costs 5,000

60. Accounting for Sales-Type Leases—Unguaranteed R/V
When a sales-type lease does not contain a bargain purchase option or a guaranteed residual value, but the economic life of the leased asset exceeds the lease term, the residual value will remain with the lessor. This is called an unguaranteed residual value.

61. Accounting for Sales-Type Leases—Unguaranteed R/V
Compare the entries below with the ones on Slide15-56.
To record entries on January 1, 2011:
Lease Payments Receivable 250,192
Sales 250,192
Cost of Goods Sold ($175,000 – $46,569) 128,431
Finished Goods Inventory ($160,000 –
$46,569) 160,000
Deferred Initial Direct Costs 15,000
Lease Payments Receivable 46,569
Finished Goods Inventory 46,569
Left click on the button to go to Slide 15-56, then type “61” and press the “Enter” key to return to this slide.

62. Sale of Asset During Lease Term
If the leased asset in Exhibit 15-8 below is sold on December 31, 2013, for $140,000 before the rental payment is made (the Lease Payments Receivable balance is $104,132),…
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63. Sale of Asset During Lease Term
…the following journal entry would be recorded on December 31, 2013, to record the sale:
Cash 140,000
Interest Revenue 10,413
Lease Payments Receivable 104,132
Gain on Sale of Leased Asset 25,455

64. Treatment of Leases on Lessor’s Statement of Cash Flows
In 2011, American Manufacturing’s income before any lease-related items is $200,000. Net income for the year can be computed as follows:
Income before lease-related items $200,000
Lease-related sales 250,192
Lease-related cost of goods sold (175,000)
Leased-related interest revenue ,019
Net income $294,211

65. Disclosure Requirements for Leases
For an operating lease, the lease-related asset and liability are off-balance-sheet items.
It is important for the financial statement user to be able to interpret the associated note.
Lessee is required to provide enough note disclosure to allow the users to quantify the magnitude of the operating leases.
Lessor is required to provide enough disclosure to allow the financial statement user to figure out the extent to which lease-related sales and rentals have impacted the lessor’s financial statements.

66. International Accounting of Leases
IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases.
A proposal, titled “Accounting for Leases: A New Approach,” suggests that all lease contracts longer than one year be accounted for as capital leases.
This proposal is still under discussion.

67. Sale-Leaseback Transactions
On January 1, 2011, Hopkins Inc. sells equipment having a carrying value of $750,000 to Ashcroft Co. for $950,000 and immediately leases back the equipment. Terms of the lease are:
The term of the lease is 10 years, noncancelable. A down payment of $200,000 is required plus equal lease payments of $107,107 at the beginning of each year. The implicit rate is 10%.
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68. Sale-Leaseback Transactions
The equipment has a fair value of $950,000 and an expected life of 20 years. Straight-line depreciation is used.
Hopkins has an option to renew the lease for $10,000 per year for 10 years, the rest of its economic life. Title passes at the end of the lease.
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69. Sale-Leaseback Transactions
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70. Sale-Leaseback Transactions