1. 1 Accounting for Leases C hapter 20

2. 2 1. Explain the advantages of leasing. 2. Understand key terms related to leasing. 3. Explain how to classify leases of personal property. 4.Account for a lessee’s operating and capital leases. 5.Understand disclosures by the lessee. 6.Account for a lessor’s operating, direct financing, and sales-type leases. Objectives

3. 3 7.Understand disclosures by the lessor. 8. Explain the conceptual issues regarding leases. 9.Understand lease issues related to real estate, sale-leaseback issues, leverage leases, and changes in lease provisions (Appendix). Objectives

4. 4 Advantages of Leasing from Lessee’s Viewpoint Financial benefits Risk benefit Tax benefit Financial reporting benefit Billing benefit

5. 5  The lease provides 100% financing, so that the lessee acquires the asset without having to make a down payment.  The lease contract contains fewer restrictive provisions and is more flexible than other debt agreements.  The leasing arrangement creates a claim that is against only the leased equipment and not against all assets. Advantages of Leasing from Lessee’s Viewpoint Financial Benefits

6. 6 Advantages of Leasing from Lessee’s Viewpoint Financial Reporting Benefit Companies A and B have identical financial data: Current assets$2,100,000 Noncurrent assets2,900,000 Current liabilities1,000,000 Noncurrent liabilities1,600,000 Stockholders’ equity2,400,000 Companies A and B have identical financial data: Current assets$2,100,000 Noncurrent assets2,900,000 Current liabilities1,000,000 Noncurrent liabilities1,600,000 Stockholders’ equity2,400,000 ContinuedContinued

7. 7 Advantages of Leasing from Lessee’s Viewpoint On December 31, 2001 A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2002. Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 After Acquisition Current Ratio: $2,100,000 $1,446,429 = 1.45 The ratio of debt to stockholders’ equity would increase from 1.08 before acquisition to 2.26 after acquisition. ContinuedContinued

8. 8 Advantages of Leasing from Lessee’s Viewpoint On December 31, 2001 B Company leases similar equipment to that leased by A Company, agreeing to pay $500,000 rent each year for the next 10 years. Assuming 12% interest, the present value of the lease is $2,825,112 ($500,000 x 5.650223). Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 After Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 The ratio of debt to stockholders’ equity would remain at 1.08-to-1.

9. 9 Key Terms Related to Leasing Bargain purchase option Bargain renewal option Estimated economic life of leased property Estimated residual value of leased property Executory costs Fair value of leased property Guaranteed residual value Inception of the lease Initial direct costs There’s more. FASB Statement No. 13 as Amended and Interpreted defines a number of lease terms.

10. 10 Interest rate implicit in the lease Lease term Lessee’s incremental borrowing rate Manufacturer’s or dealer’s profit or loss Minimum lease payments Minimum lease payments receivable Unguaranteed residual value Unreimbursable cost Key Terms Related to Leasing

11. 11 Classification of Leases Involving Personal Property Column A A.The lease transfers ownership of the property to the lessee by the end of the lease term. B.The lease contains a bargain purchase option. C.The lease term is equal to 75% or more of the estimated economic life of the leased property. D.The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased property to the lessor. Column A A.The lease transfers ownership of the property to the lessee by the end of the lease term. B.The lease contains a bargain purchase option. C.The lease term is equal to 75% or more of the estimated economic life of the leased property. D.The present value of the minimum lease payments is equal to 90% or more of the fair value of the leased property to the lessor. Criteria applicable to both lessee and lessor.

12. 12 Classification of Leases Involving Personal Property Column B A.The collectibility of the minimum lease payments is reasonably assured. B.No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. Column B A.The collectibility of the minimum lease payments is reasonably assured. B.No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. Criteria applicable to lessor only.

13. 13 Classification of Leases Involving Personal Property A capital lease meets one or more of Column A criteria. An operating lease does not meet any of the Column A criteria. Classification by the Lessee

14. 14 Classification of Leases Involving Personal Property A sales-type lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. Classification by the Lessor Sale-type lease Classification by the Lessor Sale-type lease It must involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor.

15. 15 Classification of Leases Involving Personal Property A direct financing lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. Classification by the Lessor Direct financing lease Classification by the Lessor Direct financing lease It must not involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor.

16. 16 Classification of Leases Involving Personal Property Classification by the Lessor Operating lease Classification by the Lessor Operating lease An operating lease meets none of the criteria in Column A or does not meet both criteria in Column B.

17. 17 Operating Lease (Lessee) Exhibit 20-4 Terms and Provisions of Lease Agreement Between Owners Company (Lessor) and User Company (Lessee) Dated January 1, 2001 1.The lease term is 5 years. The lease is noncancelable and requires equal payment of $50,000 at the beginning of each year. 2.The cost, and also fair value of the equipment to the Owner Company at the inception of the lease is $300,000. The equipment has an estimated economic life of 10 years and has a zero estimated residual value at the end of this time. 3.There is no guaranteed of the residual value by the User Company. 4.The Owner Company agrees to pay all executory costs. 5.The equipment reverts to the Owner Company at the end of the 5 years; that is, the lease contains no bargain purchase option. 6.The User Company’s incremental borrowing rate is 12.5% per year. 7.For the Owner Company, the interest rate implicit in the lease is 12%. 8.The present value of an annuity due (in advance) of 5 payments each at 12% is $201,867 *4.037349 x $50,000 = $201,867.45). Go to Exhibit 20-4 and determine how many of Group A criteria are met. Since none are met, this is an operating lease.

18. 18 Operating Lease (Lessee) Classification Criteria Criteria Met? Remarks 1.Transfer of ownership at end of leaseNo 2.Bargain purchase optionNo 3.Lease term is 75% or more of economic lifeNoIt is 50%. 4.Present value of lease payment is 90% or more of fair valueNoThe present value is $201,867.45, or 67% of fair value Decision: A capital lease must meet one or more of the classification criteria; otherwise the lease is an operating lease. Conclusion: The lease is an operating lease. It does not meet any of the criteria. Exhibit 20-5 Application of Lease Classification Criteria by User (Lessee) If you concluded that it was a capital lease, examine Exhibit 20-5 carefully.

19. 19 Operating Lease (Lessee) As an operating lease, User Company simply records the annual payment as a rent. Rent Expense50,000 Cash50,000 If User Company prepares quarterly interim statements, it reports the unexpired portion of the expense as an asset.

20. 20 Capital Lease (Lessee) The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2001 that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2001. First, examine Exhibit 20-7 to determine why this is a capital lease. To check your response, click the button in the corner.

21. 21 Capital Lease (Lessee) Initial Recording of Capital Lease on January 1, 2001 Leased Equipment Under Capital Leases100,000.00 Obligation Under Capital Leases100,000.00 December 31, 2001 Interest Expense12,000.00 Obligation Under Capital Leases20,923.45 Cash32,923.45 12% x $100,000 $32,923.45 - $12,000.00 ContinuedContinued

22. 22 Capital Lease (Lessee) Recognition of Depreciation, December 31, 2001 Depreciation Expense: Leased Equipment25,000.00 Accumulated Depreciation: Leased Equipment25,000.00 Second Annual Payment, December 31, 2002 Interest Expense9,489.19 Obligation Under Capital Leases23,434.26 Cash32,923.45 $100,000 ÷ 4 $79,076.55 x 0.12 $32,923.45 - $9,489.19 The depreciation entry on December 31, 2002 again would be for $25,000.

23. 23 Assume that Martin Company is required to make lease payments in advance on January 1 of each year,... Capital Lease (Lessee) …and that the cost and fair value of the equipment is $112,000. Present value of four payments of $32,923.45 in advance at 12% = $32,923.45 x 3.401831 = $112,000

24. 24 Capital Lease (Lessee) Initial Recording of Capital Lease on January 1, 2001 Leased Equipment Under Capital Leases112,000.00 Obligation Under Capital Leases112,000.00 First Payment in Advance, January 1, 2001 Obligation Under Capital Leases32,923.45 Cash32,923.45 ContinuedContinued

25. 25 Capital Lease (Lessee) Recognition of Depreciation, December 31, 2001 Depreciation Expense: Leased Equipment28,000.00 Accumulated Depreciation: Leased Equipment28,000.00 Recognition of Interest Expense, December 31, 2001 Interest Expense9,489.19 Accrued Interest on Obligation Under Capital Leases9,489.19 $112,000 ÷ 4 $79,076.55 x 0.12 ContinuedContinued

26. 26 Capital Lease (Lessee) Recognition of Depreciation, December 31, 2002 Depreciation Expense: Leased Equipment28,000.00 Accumulated Depreciation: Leased Equipment28,000.00 Second Annual Payment in Advance, January 1, 2002 Accrued Interest on Obligation Under Capital Leases9,489.19 Obligation Under Capital Leases23,434.26 Cash32,923.45

27. 27 Bargain Purchase Option Redd Company leases equipment for 4 years and agrees to pay $2,000 at the end of the fourth year to purchase the asset. Redd is reasonably assured that it will exercise the option. Redd’s incremental borrowing rate is 11% and the lessor’s implicit interest rate is 10%. The cost and fair value of the equipment is $128,160.63. Does this qualify as a capital lease? Yes…because of the bargain purchase option.

28. 28 The minimum lease payments, based on the lower 10% rate, is calculated as follows: Present value of the annual payments discounted at 10% ($40,000 x 3.169865)$126,794.60 Add: Present value of the single sum of $2,000 (the bargain purchase option) discounted at 10% ($2,000 x 0.683013) 1,366.03 Present value of the minimum lease payments$128,160.63 Present value of the annual payments discounted at 10% ($40,000 x 3.169865)$126,794.60 Add: Present value of the single sum of $2,000 (the bargain purchase option) discounted at 10% ($2,000 x 0.683013) 1,366.03 Present value of the minimum lease payments$128,160.63 Leased Equipment Under Capital Leases128,160.63 Obligation Under Capital Leases 128,160.63 Bargain Purchase Option

29. 29 Guaranteed Residual Value Karpas Company leases equipment for 4 years that cost the lessor $147,284.99 (its fair value) and agrees to pay an annual rent of $40,000 at the end of each year. Karpas Company agrees to guarantee the estimated residual value of $30,000 at the end of the fourth year. Assume a 10% interest rate.

30. 30 Guaranteed Residual Value Leased Equipment Under Capital Leases 147,284.99 Accumulated Depreciation: Leased Equipment 117,284.99 Obligation Under Capital Leases 30,000.00 At the end of the lease, both parties agree that the equipment is worth only $20,000. Accumulated Depreciation: Leased Equip.117,284.99 Obligation Under Capital Leases 30,000.00 Loss on Disposal of Leased Equipment10,000.00 Leased Equipment Under Capital Leases147,284.99 Cash10,000.00

31. 31 Guaranteed Residual Value If the fair value is more than $30,000, the lessee pays the liability in full by returning the asset to the lessor.

32. 32 Disclosure Requirements for Lessee Exhibit 20-11 provides the disclosure requirements for a lessee.

33. 33 Lessor’s Classifications Operating lease Sales-type lease Direct financing lease Leverage lease A leveraged lease is a special three-party lease that is always considered to be a direct financing lease.

34. 34 Operating Lease (Lessor) Owner Company leases a piece of equipment to User Company for 5 years. User Company agrees to pay $50,000 at the beginning of each year. Owner Company purchased the equipment for $300,000. The equipment has an estimated life of 10 years and Owner Company uses straight-line depreciation. Owner pays the annual insurance premium of $2,000, and on December 15, 2001 it pays for repairs of $1,500. Why is this an operating lease? None of the criteria in Column A (Exhibit 20-2) were met; therefore, this lease should be treated as an operating lease.

35. 35 Operating Lease (Lessor) Purchase of Equipment to Be Leased on January 1, 2001 Equipment Leased to Others 300,000 Cash (or Accounts Payable)300,000 Collection of Annual Payment on January 1, 2001 Cash50,000 Rental Revenue50,000 ContinuedContinued Payment of Annual Insurance Premium, January 10, 2001 Insurance Expense2,000 Cash2,000

36. 36 Operating Lease (Lessor) Payment of Repairs on December 15, 2001 Repair Expense 1,500 Cash 1,500 Recognition of Annual Depreciation, December 31, 2001 Depreciation Expense: Equipment Leased to Others30,000 Accumulated Depreciation: Equipment Leased to Others30,000

37. 37 Direct Financing Leases (Lessor) Under a direct financing lease, the lessor “sells” the asset at no gain or loss. The net amount at which the lessor records the receivable must be equal to the carrying value of the property.  The undiscounted minimum lease payments to be received by the lessor (net of executory costs paid by the lessor) plus  The unguaranteed residual value accruing to the benefit of the lessor. The gross receivable of the lessor includes the sum of--

38. 38 Direct Financing Leases (Lessor) Gardner Company leases equipment to the Martin Company for 4 years. The lease is noncancelable and requires equal payments of $32,923.45. This equipment cost Gardner $100,000. There is no guaranteed residual value. Martin agrees to pay all executory costs. The equipment reverts back to Gardner at the end of 4 years. Martin’s incremental borrowing rate is 12.5%, while Gardner’s is 12%. Martin Company uses straight-line depreciation. All requirements for Column B are met. $100,000 ÷ 3.037349 Why is this a direct financing lease?

39. 39 Direct Financing Leases (Lessor) It is a direct financing lease because it meets the three requirements: (1) one or more of the items listed in Column A (Exhibit 20-2)--Items 3 and 4. …(2) both of the criteria listed in Column B (Exhibit 20-2), and (3) there is no manufacturer’s or dealer’s profit. See Exhibit 20- 13 for more detail.

40. 40 Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2001 Minimum Lease Payments Receivable 131,693.80 Equipment100,000.00 Unearned Interest: Leases31,693.80 Collection of Annual Payment on December 31, 2001 Cash32,923.45 Minimum Lease Payments Receivable32,923.45 ContinuedContinued $32,923.45 x 4

41. 41 Direct Financing Leases (Lessor) Recognition of Interest Revenue on December 31, 2001 Unearned Interest: Leases12,000.00 Interest Revenue: Leases12,000.00 Collection of Annual Payment on December 31, 2002 Cash32,923.45 Minimum Lease Payments Receivable32,923.45 $100,000 x 0.12 Recognition of Interest Revenue on December 31, 2002 Unearned Interest: Leases9,489.19 Interest Revenue: Leases9,489.19 ($100,000 - $20,923.45) x 0.12

42. 42 Direct Financing Leases (Lessor) Let’s look at a direct financing lease where the payments will be received in advance.

43. 43 On January 1, 2001 the Watkins Company leases equipment that cost $391,371.20 (which is also the fair value) to the Hutton Company. The term of the lease is 5 years, with annual payments of $100,000 received in advance. The economic useful life is 5 years. There is no BPO or guaranteed residual value. The lease receipts will yield Watkins a 14% return. The collectibility is reasonably assured, and there are no uncertainties involved in the lease. Direct Financing Leases (Lessor) $100,000 x 3.913712

44. 44 Direct Financing Leases (Lessor) Initial Recording of the Lease on January 1, 2001 Minimum Lease Payments Receivable 500,000.00 Equipment391,371.20 Unearned Interest: Leases108,628.80 Collection of Annual Payment on January 1, 2001 Cash100,000.00 Minimum Lease Payments Receivable100,000.00 ContinuedContinued $100,000 x 5

45. 45 Direct Financing Leases (Lessor) Recognition of Interest Revenue on December 31, 2001 Unearned Interest: Leases 40,791.97 Interest Revenue: Leases40,791.97 $291,371.20 x 0.14

46. 46 Sales-Type Leases (Lessor) Take a moment to examine the data in Exhibit 20-19. Why is this a sales-type lease? Click on the button to check your response.

47. 47 Sales-Type Leases (Lessor) Initial Recording of the Lease on January 1, 2001 Minimum Lease Payments Receivable 300,500.00 Sales Revenue190,008.49 Unearned Interest: Leases110,491.51 Cost of Goods Sold120,000.00 Merchandise Inventory (or Equipment Held for Lease)120,000.00 ContinuedContinued ($30,000 x 10) + $500 $30,000 x 6.328250 =$189,847.50 $500 x 0.321973 = 160.99 $190,008.49

48. 48 Sales-Type Leases (Lessor) Collection of Annual Payment on January 1, 2001 Cash30,000.00 Minimum Lease Payments Receivable30,000.00 Recognition of Interest Revenue on December 31, 2001 Unearned Interest: Leases19,201.02 Interest Revenue: Leases19,201.02 12% x [($300,500 - $30,000) - $110,491.51]

49. 49 Disclosure Requirements for the Lessor Examine Exhibit 20-1 for a summary of the lessor’s disclosure requirements (as stated in FASB Statement 13 as Amended).

50. 50 Conceptual Issues Why would a lessee or lessor want to avoid capitalizing a lease? The motivation usually comes from the lessee who wants to avoid reporting the liability.

51. 51 C hapter 20

52. 52 The lease meets two of the criteria: (a) The lease term is 75% or more of the asset’s economic life and (b) the present value of the lease payments is 90% or more of the asset’s fair value. Return

53. 53 Three of four criteria from Column A (Exhibit 20-2) are met and both items from Column B, and there is a manufacturer’s or dealer’s profit. Return