Accounting Chapter 15 Addendum

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CHAPTER 15

Leases

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Leases

Where Were HeadedPreview

A Chapter Addendum

The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This Addendum is based on their joint Exposure Draft of the new leases standard update and tentative decisions of the Boards after receiving feedback from the Exposure Draft as of the date this text went to press. 1 Even after the new Accounting Standard Update is issued, previous GAAP will be relevant until the new ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the new Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon.

RIGHT-OF-USE MODEL

Because the ASU had not been finalized as of the date this text went to press, it is possible that some aspects of the ASU are different from what we show in this Addendum. Check the FASB Updates page (http://lsb.scu.edu/jsepe/fasb-update7e.htm) to see if any changes have occurred.

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SECTION 3

Financial Instruments and Liabilities

GAAP Change The new guidance for lease accounting eliminates the concept of operating leases.

From your own experience of leasing an apartment or a car or knowing someone who has, you know that a lease is a contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset for a specified period of time. In return for this right, the lessee agrees to make stipulated, periodic cash payments during the term of the lease. In the right-of-use model introduced in the new standards update, all leases are recorded as an asset and liability (with the exception of short term leases as described later), and the concept of operating leases is eliminated. The right to use the leased property can be a significant asset. Likewise, the obligation to make the lease payments can be a significant liability. Appropriately, the lessee reports both the right-of-use asset and the corresponding liability in the balance sheet: Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ... xxx xxx

The lessee records both a right-of-use asset and a liability to pay for that right.

GAAP Change The new ASU eliminates the concept of direct financing and sales-type leases. The lessor records a receivable for the lease payments it will receive and derecognizes the asset being leased. If only a portion of the right of use is leased, the lessor also records a residual asset.

On the other side of the transaction, the lessor reports a receivable for the lease payments it will receive and removes from its records (derecognizes) the asset (or portion thereof) for which it has given up the right of use. We no longer employ the concept of direct financing and sales-type leases. If the lease receivable represents only a portion of the total fair value of the asset, the lessor also records a residual asset for the portion related to the right of use not transferred to the lessee: Lease receivable (present value of lease payments) ...... Asset (carrying amount of asset being leased) ........ OR Lease receivable (present value of lease payments)....... Residual asset (carrying amount of portion retained) ..... Asset (carrying amount of asset being leased) ......... xxx xxx xxx xxx xxx

When the Lessor is a Financial IntermediaryEither of these two scenarios is typical for most leases in which the lessors primary role is to acquire an asset and then finance it for a lessee during all or a portion of the assets useful life. The lessor, in this case, is a financial intermediary that earns interest revenue for providing financing of the asset for the lessee. Look, for example, at Illustration 15- 24:

CHAPTER 15 ILLUSTRATION 1524 Right of Use Model

Leases

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LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and leases it to UserCorp for lease payments whose present value is $100,000. UserCorp Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ... LeaseCo Lease receivable (present value of lease payments) ..... Asset (carrying amount of asset being leased) ........

100,000 100,000 100,000 100,000

Two potential characteristics of a lease arrangement can complicate the lessors accounting: (1) retaining a residual asset and (2) earning a profit on the lease. We first discuss each individually and then discuss them in combination.

When the Lessor Retains a Residual AssetSometimes the lessee obtains the right to use the asset for only a portion of its useful life or to use only a portion of the asset. In that case, the lessor retains a residual asset that represents the carrying amount of the asset not transferred to the lessee.ILLUSTRATION 1525 Residual Asset

LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and leases it to UserCorp for lease payments whose present value is $40,000. UserCorp Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ...

40,000 40,000

Only a portion of the right to use the asset is being transferred. Accordingly, a portion is being retained. The portion transferred is:$40,000

/ $100,000 x $100,000 = $40,000.

So, the portion retained (residual asset) is the remainder: $100,000 40,000 = $60,000.The lessor derecognizes the asset under lease and replaces it with two assets a lease receivable and a residual asset.

LeaseCo Lease receivable (present value of lease payments) ..... Residual asset (carrying amount of portion retained) ... Asset (carrying amount of asset being leased) ........

40,000 60,000 100,000

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Financial Instruments and Liabilities

When the Lessor Earns a Profit from the LeaseIn some scenarios, the lessor earns an immediate profit from the lease transaction in addition to the interest revenue earned over the term of the lease. Often, the lessor in this type of transaction is a manufacturer or a merchandiser that is using the lease as a means of selling its product. We account for these situations similar to the way we account for sales-type leases in earlier GAAP. See Illustration 15-26 for an example.ILLUSTRATION 1526 Profit from the Lease

ManuCom manufactures a machine at a cost of $80,000 with a retail selling price (fair value) $100,000. Rather than selling the machine, it leases the machine to UserCorp under an agreement in which the present value of the lease payments is $100,000. Either way, ManuCom generates a gross profit of $20,000: Lease receivable (PV of lease payments) ..................... Asset (carrying amount of asset being leased) ........ Profit (difference2 between the PV of lease payments and the carrying amount of asset) ...................... 100,000 80,000 20,000

If the PV of the lease payments exceeds the carrying amount of the asset transferred, the lessor has a profit from the lease.

We can think of (a) the present value of the lease payments to be received as being the selling price of the right to use the asset and (b) the carrying amount of the portion related to that right of use, and thus transferred, as the cost of goods sold, with the difference being the profit on the sale.

When the Lessor Earns a Profit and Retains a Residual AssetAs we saw earlier, the lessee sometimes obtains the right to use the asset for only a portion of its useful life or to use only a portion of the asset and retains a residual asset. This can happen also in a situation in which the lessor earns a profit on the lease: Lease receivable (PV of lease payments) ....................... Residual asset (carrying amount of portion retained, if any) Asset (carrying amount of asset being leased) ........ xxx xxx xxx

CHAPTER 15

Leases

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Profit (difference, if any, between the PV of lease payments and the carrying amount of portion transferred) ...

xxx

In Illustration 15-27 we modify our previous example to include a residual asset in a lease involving a profit.

In the rare instance that this is a debit difference, we would have a loss rather than profit. Companies might choose to separate this profit into its two components: Sales revenue and cost of goods sold, which is the gross method demonstrated for sales-type leases in the main chapter.

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Financial Instruments and Liabilities

ILLUSTRATION 1527 Profit from the Lease and Residual Asset The fraction of the $80,000 carrying amount deemed transferred is:PV of payments

ManuCom manufactures a machine at a cost of $80,000 with a retail selling price (fair value) of $100,000. Rather than selling the machine, it leases the machine to UserCorp under an agreement in which the present value of the lease payments is $90,000. Because the lessor is not receiving the full value of the machine, only a portion of the right to use the asset is being transferred. Accordingly, a portion is being retained. The portion transferred is:$90,000

/ FV of asset

/ $100,000 x $80,000 = $72,000.

So, the portion retained (residual asset) is the remainder: $80,000 72,000 = $8,000. Lease receivable (PV of lease payments) ....................... Residual asset (carrying amount of portion retained) ........ Asset (carrying amount of asset being leased) ........ Profit ($90,000 72,000)..................................... 90,000 8,000 80,000 18,0003

APPLICATION TO CHAPTER ILLUSTRATIONSLets look back to the situations we discussed in the main chapter in which we applied current GAAP, but instead now see how the new guidance would compare. We start with a rather straightforward situation and then look at the three variations we just discussed: (1) the lessor retains a residual interest, (2) the lessor recognizes some immediate profit, and (3) the lessor both retains a residual interest and recognizes some immediate profit. In Illustration 1528 we have the same straightforward lease agreement we saw earlier in Illustration 15-6. Accounting under the new lease guidance is quite similar to what would appear under current GAAP. Conceptually, though, we view the situation differently than we would under current GAAP. Rather than thinking of Sans Serif as having purchased the asset from First LeaseCorp, we think of the company as having acquired the right to use the asset, in this case, for its entire useful life. Thats why Sans Serif records a right-of-use asset instead of an asset to be depreciated as if it were owned. Otherwise, though, the accounting is much the same. On the other side of the transaction, First LeaseCorp again derecognizes the asset (removes it from the3

GAAP Change

Companies might choose to separate this profit into its two components: Sales revenue ($90,000) and cost of goods sold ($72,000), which is the gross method demonstrated for sales-type leases in the main chapter.

CHAPTER 15

Leases

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books) as it records a receivable for the lease payments to be received.ILLUSTRATION 1528 Right-of-Use Model

Using Excel, enter: =PMT(.10,6,479079,, 1) Output: 100000

Using a calculator: enter: BEG mode N 6 I 10 PV 479079 FV Output: PMT 100000

On January 1, 2013, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease Corp purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments beginning January 1, 2013, the inception of the lease, and at each December 31 thereafter through 2017. The sixyear lease term ending December 31, 2018, is equal to the estimated useful life of the copier. First Lease Corp routinely acquires electronic equipment for lease to other firms. The interest rate in these financing arrangements is 10%. To achieve its objectives, First LeaseCorp 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: $479,079 4.79079* = $100,000 Lessors cost Rental payments

*Present value of an annuity due of $1: n = 6, i = 10%.

Of course, Sans Serif Publishers, Inc., views the transaction from the other side. The price the lessee pays for the copier is the present value of the rental payments: $100,000 4.79079* = $479,079 Rental payments Lessees cost

*Present value of an annuity due of $1: n = 6, i = 10%.

Commencement of the Lease (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Right-of-use asset (present value of lease payments) ................... 479,079 Lease payable (present value of lease payments) ................. 479,079 First LeaseCorp (Lessor) Lease receivable (present value of lease payments) ..................... 479,079 Inventory of equipment (carrying amount of asset being leased) 479,079 First Lease Payment (January 1, 2013)* Sans Serif Publishers, Inc. (Lessee) Lease payable ............................................................................. 100,000 Cash ..... .................................................................................. 100,000 First LeaseCorp (Lessor) Cash ............................................................................................ 100,000 Lease receivable ..................................................................... 100,000* Of course, the entries to record the lease and the first payment could be combined into a single

Notice that the lessors entries are the flip side or mirror image of the lessees entries.

The first lease payment reduces the balances in the lease payable and the lease receivable by $100,000 to $379,079.

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Financial Instruments and Liabilities entry since they occur at the same time.

A leased asset is recorded by the lessee at the present value of the lease payments.

Interest is a function of time. It accrues at the effective rate on the balance outstanding during the period.

Notice that as the lessee assumes the obligation to pay for the assets use (lessees lease liability), the lessor acquires the right to receive those payments (lease receivable). Recording the first payment above emphasizes that relationship; the $100,000 reduces both the lessees lease liability and the lessors lease receivable. Unless the lessor is a manufacturer or dealer, the fair value typically will be the lessors cost ($479,079 in this case). However, if considerable time has elapsed between the purchase of the property by the lessor and the inception of the lease, the fair value might be different. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease ordinarily will be its normal selling price. More on that later. In unusual cases, market conditions may...