1 accounting for leases acctg 5120 david plumlee

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Accounting for Leases

ACCTG 5120David Plumlee

What is a Lease?

“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”

Accounting for Leases

Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?

Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset

Classification of Leases

What is the economic nature of a capital lease?

What is the economic nature of an operating lease?

One that transfers substantially all the risks and benefits of ownership to the lessee.

One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement

Accounting for Capital Leases

Accounting reflects economic substance, not legal form

Make it appear as though company purchased an asset with borrowed funds an asset and an obligation interest expense on obligation depreciation on asset

Is this a Capital Lease?Does it meet ANY ONE of the four criteria?

•Lease transfers ownership of asset •automatically by end of lease term or•through a bargain purchase option

•Lease term is at least 75% of asset’s estimated economic life•PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term

Minimum Lease Payments

Minimum rental payments plus Any guaranteed residual value plus

amount the lessee guarantees lessor will realize on the asset at the end of the lease term

Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured

Leases without a BPO

MLP continued

What are executory costs?

Are they included in MLP?

NO!

Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance

Minimum Lease Payments

What is the MLP for leases with a BPO?

What is a bargain purchase option?

An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured

PV of rental payments and the BPO at the end of the lease term.

Capital Lease Example

6-year lease Annual payment due at year end =

$18,287 No BPO and legal title does not pass at the

end of lease term FMV of leased asset = $75,185 Economic life of asset = 10 years Appropriate interest rate = 12% Est. salvage value = $3,185

Present Value of MLP

1 2 3 4 5 6

$18,287 $18,287 $18,287 $18,287 $18,287 $18,287

= $18,287 x 4.11141 = $75,185

PV = $18,287 x PVIFA(n=6, r=12%)

Lessee Journal Entries

Inception of lease: record leased asset and lease obligation at present value of MLP

Record payments At period end accrue:

depreciate asset record interest expense

Inception of Lease Term

JE to record leased asset and lease obligation at present value of MLP?

leased asset $75,185lease obligation

$75, 185

Depreciation Expense

On what does the depreciation period used depend?

If bargain purchase option exists or title passes during lease term, use economic life

Otherwise use lease term

Basis for Depreciation

What ending values are used for depreciation?Salvage value if depreciating over economic life

Guaranteed residual value if depreciating over lease term

Record Depreciation Expense

What is the depreciable basis of this asset?

$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)

$75,185/6yrs = $12,531

depreciation expense $12,531accum. depreciation

$12,531

Lease Amortization Table

Date Payment Interest Reduction BalanceIn Obligation

0123456

Lease Amortization Table

Date Payment Interest Reduction BalanceIn Obligation

0 75,1851 18,2872 18,2873 18,2874 18,2875 18,2876 18,287

PV of the min. lease payments

Lease Amortization TableDate Payment (a) Interest (b) Reduction Balance

In Obligation (a-c)

0 75,1851 18,287 9,022 9,265 65,9202 18,287 7,910 10,377 55,5443 18,287 6,665 11,622 43,9224 18,287 5,271 13,016 30,9055 18,287 3,709 14,578 16,3276 18,287 1,959 16,328 -1

Record First Lease Payment

interest expense ($75,185 x 12%) $9,022lease obligation 9,265

cash $18,287

Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.

Lessor Capital Lease Types Direct financing leases

PV of minimum lease payments equals the FMV of the leased asset

No “profit” is recorded; considered to be a financing arrangement.

Sales-type leases PV of minimum lease payments less the

FMV of the leased asset equals the “dealer profit”

Profit is recognized as revenue at the inception of the lease

Initial Direct Costs Includes costs directly associated with

negotiating a particular lease amounts paid to third parties (e.g.

lawyer’s fees, appraisal fees, finders fees) amounts incurred internally (e.g. time

spent negotiating lease terms, preparing and processing documents)

Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)

Accounting forInitial Direct Costs

Operating -

Sales-type -

Direct financing-

defer and allocate over lease term in proportion to rental incomeexpense in same period as profit on sale recognized

add to gross investment in the leaseamortize over lease as a yield adjustment

Example - Direct Financing

3 year lease $20,000 payments due at end of

year implicit interest rate = 10% FMV (lessor’s cost of asset) =

$49,737 initial direct costs = $1,000

Net Investment in Lease

20,000 x PVIFA(n=3,r=10%)=$49,737 = cost (this is a direct financing lease)(this is a direct financing lease)

What is the PV of the MLP (without initial direct costs)?

Do initial direct costs affect this calculation?Yes, they are added and a new interest rate is found.

Impute New Effective Yield

$50,737 = $20,000 x PVa (n=3,r=?)2.53685 = PVa (n=3,r=?)

by trial and error: : r=8.89%

Why add to the initial direct costs?We want the interest rate the equates the net investment to the cash flows$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)

Ignoring Initial Direct Costs

payment interest principal balanceopening (10%) 49,737 yr. 1 20,000 4,974 15,026 34,711 yr. 2 20,000 3,471 16,529 18,182 yr. 3 20,000 1,818 18,182 (0) total interest income 10,263

Including Initial Direct Costs

payment interest principal balanceopening (8.89%) 50,737 yr. 1 20,000 4,511 15,489 35,248 yr. 2 20,000 3,134 16,866 18,381 yr. 3 20,000 1,619 18,381 0 total interest income 9,263

Reduction in income = 10,263 - 9,263 = 1,000 = initial direct costs

Amort. of Initial Direct Costs

interest interestat 10% at 8.89% amortization

yr. 1 4,974 4,511 463 yr. 2 3,471 3,134 337 yr. 3 1,818 1,618 200 total 10,263 9,263 1,000

Journal Entry

Entries to record lease:

deferred initial direct costs 1,000cash (etc.)

1,000lease receivable 60,000

unearned interest income 10,263

leased asset49,737

Journal Entries

Entries to record first payment and amortization of income and costscash 20,000

lease receivable20,000unearned interest income 4,974

interest income 4,974

initial direct expense amortization 463deferred initial direct costs 463

Sale/leaseback

Seller/lessee

Buyer/lessor

Sale:Legal titleTransfers

Leaseback: seller retains use of the assetAccount for lease according to classification tests.

Should the gain or loss on sale be recognized

when asset “sold” to lessor?

Sale/leaseback- operating lease

Lessee Retains Right To Use Asset defer gains only (losses are recognized

immediately) amortize to rent expense over lease term in

proportion to rental payments

Why do you think we defer any gains?Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future

Sale/leaseback -- capital lease

defer gains only (losses are recognized immediately)

amortize to depreciation expense over lease term in proportion to amortization of leased asset

Lessee Retains Right To Use Asset

“Minor leaseback”

Lessee Loses Most Rights To Use Asset

Defined as PV of rental payments is

10% or less of asset’s fair value

Recognize gain or loss on sale immediately

1 accounting for leases acctg 5120 david plumlee

Documents

lease obligation

operating lease

asset slide

beginning of lease term

lease term penalties

time lease agreements

page9 minimum lease

bpo slide