Summary of the Proposed Lease Standard Update

*Several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This Supplement 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.

15-*

Leases: Where Were HeadedThe FASB and the IASB are collaborating on a joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed 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 proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon.

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). One project is their joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed 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 proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon.

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.

15-*

Right-of-Use Model

*On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from First Lease Corp. First LeaseCorp 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 six-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment. First LeaseCorp 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. The periodic rental payment is determine by dividing the cost of the leased equipment ($479,079) by the present value of an annuity due of $1, for 6 periods, at and interest rate of 10 percent (4.79079).

15-*

Lessee and Lessor Entries

*At inception of the lease both the lessee and lessor are required to make two separate journal entries. The first entry deals with treatment of the right to use of the asset and the second entry deals with the payment required.

In our example, the lessee (Sans Serif) will debit right-of-use asset for $479,079 and credit lease payable for the same amount. The lessor, First LeaseCorp, will debit the asset account lease receivable and credit the inventory of equipment for $479,079.

The second entry required by the lessee is to debit lease payable for $100,000 and credit cash for the same amount. This is the first payment by the lessee to the lessor. The lessor, First LeaseCorp, will debit cash and credit lease receivable for $100,000.

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).

15-*

Second Lease Payment [Dec. 31, 2013]Effective RateOutstanding Balance

*In the entries at the inception of the lease, the entire $100,000 first lease payment is applied to principal reduction.

At the date of the second rental payment date, December 31, 2013, one years interest has accrued on the $379,079 balance outstanding during 2013, recorded by the lessee with a debit to interest expense for $37,908, a debit to lease payable for $62,092, and a credit to cash for $100,000. The interest is determined by multiplying the effective interest rate of 10 percent times the outstanding balance of the lease obligation ($479,079 less the first payment of $100,000). The debit to lease payable represents the difference between the calculated interest expense and the cash payment of $100,000.

The lessor, First LeaseCorp, will debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908.

15-*

Lease Amortization Schedule0

*The amortization schedule is no different from what we would use under current GAAP. It shows how the lease balance and the effective interest change over the six-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of principal. Because the first payment is made at the inception of the lease, no interest is associated with the first payment. Because no time has passed, no interest is recognized.

15-*

Amortization of the Right-of-Use Asset (Lessee)

The lessee amortizes its right-of-use asset over lease term (or the useful life of the asset if its shorter). Using the asset results in an expense for the lessee.

*The lessee amortizes its right-of-use asset over lease term (or the useful life of the asset if its shorter). Using the asset results in an expense for the lessee. This usually is on a straight-line basis unless the lessees pattern of using the asset is different.

At the end of each of the next five years, the lessee, Sans Serif, will prepare a journal entry to debit amortization expense for $79,847 ($479,079 divided by 6 years) and credit right-of-use asset for the same amount.

15-*

When the Lessor Retains a Residual Asset On January 1, 2013, Sans Serif Publishers leased printing equipment from First LeaseCorp who purchased the equipment from CompuDec Corporation at its fair value of $479,079. Now assume 4 annual payments of $100,000 beginning January 1, 2013, and at each December 31 through 2015. Useful life of the equipment is 6 years. Lessor calculated payments using a rate of 10%.

*On January 1, 2013, Sans Serif Publishers leased printing equipment from First LeaseCorp who purchased the equipment from CompuDec Corporation at its fair value of $479,079. Assume the lease agreement requires 4 annual payments of $100,000 each, beginning on January 1, 2013. The useful life of the asset is determined to be 6 years and the lessor uses a 10 percent interest rate to determine the lease payments.

15-*

When the Lessor Retains a Residual Asset Commencement of Lease [Jan. 1, 2013]

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

*Now lets look at an example of the accounting for a right-of-use asset in which the lease term is only four years of the assets six-year life. The lessor retains a residual interest in the asset. Using the four beginning of period payments of $100,000 and a discount rate of 10 percent, the lessor determines the present value of the right-to-use asset to be $348,685.

The lessee, Sans Serif, will debit right-of-use asset for $348,685, and credit lease liability for the same amount.

From the viewpoint of the lessor, the asset as a cost basis of $479,079, and the present value of the lease payments of $348,685, so there is a residual value retained by the lessor of $130,394. The lessor, First LeaseCorp, will debit lease receivable for $348,685, debit residual asset for $130,394, and credit inventory of equipment for $479,079.

15-*

When the Lessor Retains a Residual Asset

*The first payment will be made on January 1, 2013, the date of inception of the lease. The lessee, Sans Serif, will debit lease liability for $100,000 and credit cash for the same amount. Recall, that no time has past, so no interest has been accrued.

The lessor, First LeaseCorp, will debit cash and credit lease receivable for $100,000.

15-*

Second Lease Payment [Dec. 31, 2013]

*The second payment is made on December 31, 2013. Interest is calculated by applying the effective interest rate of 10 percent to the outstanding balance which is $248,685 ($348,685 less the first payment of $100,000). So, the interest associated with the second payment is $24,869, and the cash payment is $100,000. The difference between these two amounts represents the reduction in the lease asset or liability.

The lessee, Sans Serif, will debit interest expense of $24,869 ($248,685 times 10 percent interest), debit lease payable for $75,131 ($100,000 less $24,869), and credit cash for $100,000.

The lessor, First LeaseCorp, will debit cash for $100,000, credit lease receivable for $75,131, and credit interest revenue for $24,869.

15-*

Lease Amortization Schedule0

*The amortization schedule shows how the lease balance and the effective interest change over the four-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance. The periodic reduction is sufficient that, at the end of the lease term, the outstanding balance is zero.

15-*

Lessee: Amortization of ROU AssetLessor: Accretion of the Residual Asset

The lessee incurs an expense as it uses the asset.The lessor will record accretion of the residual asset using the interest rate implicit in the agreement (10%).

*The lessee incurs an expense as it uses the asset. The asset will be amortized over 4 years, and the lessee, Sans Serif, will debit amortization expense of $87,171 ($348,685 divided by 4 years), and credit right-of-use asset for the same amount.

The lessor will record accretion of the residual asset using the interest rate implicit in the agreement (10%). The lessor, First LeaseCorp, will debit residual asset for $13,039, and credit revenue from asset accretion for the same amount ($130,394 times 10 percent).

15-*

Accretion? Why?Consider this:To determine the lease payments, the lessor subtracts from fair value the present value of the four-years-away residual value:

How does the lessor recover its $479,079 investment?

Assets residual value at end of 4-yr lease term

*Assume that First LeaseCorp anticipates that the fair value of the residual asset will be $190,911 at the end of the lease term. Given that knowledge, and First LeaseCorps required 10% rate of return, what amount should First LeaseCorp charge for the four lease payments? Remember, the $479,079 is the fair value now, so to determine the amount that needs to be recovered from the four lease payments, First LeaseCorp subtracts from $479,079 the present value of the residual assets anticipated fair value to be received in four years, and then computes lease payments to provide a return of 10%. The calculation of the lease payment is shown on this slide. Notice the present value of estimated residual value of the asset is subtracted from the fair value of the asset, to determine the amount to be recovered through periodic lease payments.

Now lets look at how the lessor recovers its investment in the leased asset.

15-*

Accretion? Why?So, First LeaseCorp expects to recover its $479,079 investment as follows:

At commencement of the lease, the lessor recorded its residual asset at $130,394. At the end of the lease term, that amount will have risen to $190,911. The process of increasing the assets balance is called accretion. Since $130,394 is the PV of $190,911 discounted at 10%, the balance (PV) will increase annually by 10%.

*At commencement of the lease, the lessor recorded its residual asset at $130,394. At the end of the lease term, that amount will have risen to $190,911. The process of increasing the assets balance is called accretion. Since $130,394 is the PV of $190,911 discounted at 10%, the balance (PV) will increase annually by 10%. The present value of the sum of the accretion in the residual value and the periodic lease payments totals the total amount to be recovered (fair value of the leased asset).

15-*

Accretion? Why?The residual asset accretes at the 10% discount rate to its anticipated value at the end of the lease term:

First LeaseCorp earns a 10% rate of return on both the portion of its asset transferred (interest revenue) and the portion retained as a residual asset (accretion revenue).

*This schedule shows the calculation of the revenue from accretion of the residual value of the asset. The lessors revenue is (a) the interest revenue from financing the portion transferred and (b) the revenue from accretion of its residual asset not transferred, both at the 10% interest rate implicit in the lease. Thus, First LeaseCorp earns a 10% rate of return on both the portion of its asset transferred and the portion retained as a residual asset.

15-*

Leases Effect on the Income of Lessee And LessorThe residual asset accretes at the 10% discount rate to its anticipated value at the end of the lease term:

*Ignoring tax effects, the leases effect on the earnings of the lessee and lessor are depicted on this page. The lessee recognizes interest expense and amortization expense, and the lessor recognized interest revenue and accretion revenue over the life of the lease.

15-*

When the Lessor Earns a Profit from the Lease

*On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDecs interest rate for financing the transaction is 10%.

Based on the terms of the agreement, the lessor calculates the periodic lease to be $100,000. All lessor entries we have seen will be the same under this lease agreement except on January 2, 2013, The lessor (CompuDec) will debit lease receivable for $479,079, credit inventory of equipment for $300,000 (the carrying value of the asset), and credit profit for $179,079 ($479,079 less $300,000).

Accounting by the lessee is not affected by how the lessor records the lease.

15-*

When the Lessor Earns a Profit and Retains a Residual Asset

*On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), after which the equipment is anticipated to have a fair value of $100,000. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDecs interest rate for financing the transaction is 10%.

Notice that when we calculate the periodic lease payment, we first subtract the present value of the residual value from the fair value of the asset. Next, we divide the amount to be recovered through lease payments ($433,632) by the present value of an annuity due of $1, for 6 periods, at a 10% interest rate. The periodic lease payment is calculated to be $88,218. As you can see, the lessor expects to recover the fair value of the asset ($479,079).

15-*

When the Lessor Earns a Profit and Retains a Residual Asset 6 payments of $88,218; assets cost $300,000; FV $479,079. The equipment is expected to have a fair value of $100,000 at lease end.

*On January 1, 2013, the lessor will debit lease receivable for $422,632 (the fair value of the assets less the present value of the $100,000 residual value), debit residual asset for $35,347 ($300,000 less $264,653), credit inventory of equipment for $300,000, and credit profit for $157,979 ($422,632 less 264,653).

15-*

Accretion of the Residual Asset When there is profit in a lease, the carrying amount of the residual asset (the $35,347 portion of the equipment retained) is less than the fair value of the residual asset ($56,447). The difference ($56,447 35,347 = $21,100) is the deferred profit on the portion of the asset not transferred.To record accretion of the residual asset from its current fair value to its anticipatedfair value at the end of the lease term, first increase the balance of the residual asset from its carrying amount to its current fair value at the commencement of the lease:

We also can view the deferred profit as the portion of the total profit if the equipment were to have been transferred in its entirety minus the profit actually recognized currently:

Total profit (479,079 300,000) $179,079 Less: Profit recognized at commencement (157,979) Deferred profit $ 21,100

*When there is profit in a lease, the carrying amount of the residual asset (the $35,347 portion of the equipment retained) is less than the fair value of the residual asset ($56,447). The difference ($56,447 35,347 = $21,100) is the deferred profit on the portion of the asset not transferred. To record accretion of the residual asset from its current fair value to its anticipated fair value at the end of the lease term, first increase the balance of the residual asset from its carrying amount to its current fair value at the commencement of the lease the lessor will debit residual asset for $21,000, and credit deferred profit for the same amount.

15-*

Accretion of the Residual Asset CompuDec will report a net residual asset in the balance sheet, which is the gross residual asset offset by the deferred profit. So, initially the reportable amount is:

But since the gross amount is accreted (increased) over the term of the lease, the reported amount (equal to the gross amount minus deferred profit) increases as well.

*CompuDec will report a net residual asset in the balance sheet, which is the gross residual asset offset by the deferred profit. But since the gross amount is accreted (increased) over the term of the lease, the reported amount (equal to the gross amount minus deferred profit) increases as well.

15-*

Accretion of the Residual Asset The balance in the gross residual asset accretes at the 10% discount rate to its anticipated value at the end of the lease term.

*The increase in the gross residual assets balance through accretion is shown in this table. Remember, in addition to the accretion revenue during the lease term, the lessors earnings also will be increased by the profit recorded at the leases commencement, the interest revenue earned during the lease term, and the deferred profit when the equipment is sold or leased again after the lease term.

15-*

Accretion of the Residual Asset To help visualize the relationship among the different ways to measure the residual asset as of the commencement of the lease:

*To help visualize the relationship among the different ways to measure the residual asset as of the commencement of the lease review the table show above. As the residual asset is accreted over the lease term, both the gross residual asset and the net residual asset increase, and the gross residual asset eventually equals the anticipated fair value.

15-*

Summary of Lessee / Lessor Accounting

LesseeRight-of-use asset (present value of payments) xxxLease liability (present value of payments)xxxLessorLease receivable (present value of payments)xxxResidual asset (carrying amount of portion retained, if any *)xxAsset (carrying amount: derecognized) xxxProfit (difference, if any, between the PV of lease payments and the carrying amount transferred*) xx

* Carrying amount of asset x [Lease receivable / Fair value of asset] = Amount transferred

Carrying amount of asset Amount transferred = Residual asset

* In the rare instance that this is a debit difference, we would have a loss rather than profit. Also, only recognize profit if it is reasonably assured. Otherwise, defer and recognize over life of lease.

*On this slide we provide and summary of accounting by the lessee and lessor for a right-of-use lease agreement.

15-*

Discount RateIn calculating the PV of the payments, the discount rate used by the lessee is:

The rate the lessor charges the lessee (rate that causes the sum of PV of lease payments and the PV of the residual value of the underlying asset to equal the fair value of the asset today).If the lessors rate is not known, use the lessees incremental borrowing rate.

*In calculating the PV of the payments, the discount rate used by the lessee is:

The rate the lessor charges the lessee (rate that causes the sum of PV of lease payments and the PV of the residual value of the underlying asset to equal the fair value of the asset today).

If the lessors rate is not known, use the lessees incremental borrowing rate.

15-*

Initial Direct CostsCosts associated directly with originating a lease that would not have been incurred had the lease agreement not occurred are. Include legal fees, commissions, evaluating the prospective lessees financial condition, and preparing and processing lease documents. Added to the carrying amount of the right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the lessor.

*Initial direct costs are:Costs associated directly with originating a lease that would not have been incurred had the lease agreement not occurred are. Include legal fees, commissions, evaluating the prospective lessees financial condition, and preparing and processing lease documents. Added to the carrying amount of the right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the lessor.

15-*

What if the Lease Term is Uncertain?

The lease term is the non-cancellable period, plus any options where there is a significant economic incentive to extend or not terminate the lease.Factors that might create an economic incentive for the lessee include bargain renewal rates, penalty payments for cancellation or non-renewal and economic penalties such as significant customization or installment costs.

*In many cases, the new definition would result in shorter lease terms for accounting purposes than the Boards initial proposal. For example, assume a retailer has a lease that includes a non-cancellable term of 10 years and four five-year renewal options. Based on its experience and expectations, the retailer may determine that the longest possible lease term that is more likely than not to occur is 20 years. However, if there is no significant economic incentive for the retailer to exercise the renewal options, the lease term for accounting purposes, under the revised definition, would be 10 years.

15-*

What if the Lease Payments are Uncertain?

Lease payments include:payments that depend on an index or rate (e.g., increase with inflation rate)contingent payments that are reasonably assured.

*Lease payments include:payments that depend on an index or rate (e.g., increase with inflation rate)contingent payments that are reasonably assured.

15-*

Guaranteed Residual ValueIf a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as a lease receivable. It is simply seen as an additional lease payment.

*If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as a lease receivable. It is simply seen as an additional lease payment.

15-*

Short-Term Leases A Short-Cut MethodA lease that has a maximum possible lease term (including any options to renew) of 12 months or less is a short-term lease. Lease-by-lease option to choose a short-cut approach.

Lessee can elect: not to recognize a right-of-use asset or a lease liability.to recognize lease payments as expense over the lease term.

Lessor can elect: not to record the lease receivable or to derecognize the asset being leased.to recognize lease payments as revenue over the lease term.

*A lease that has a maximum possible lease term (including any options to renew) of 12 months or less is a short-term lease. Lease-by-lease option to choose a short-cut approach.

The lessee can elect: not to recognize a right-of-use asset or a lease liability.to recognize lease payments as expense over the lease term.

The lessor can elect: not to record the lease receivable or to derecognize the asset being leased.to recognize lease payments as revenue over the lease term.

15-*

End of Chapter 15

End of Chapter 15.

Chapter 15: Leases

In this chapter we continue our discussion of debt, but we now turn our attention to liabilities arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales-type leases by the lessor. We also will see that some leases do not produce debtor/creditor relationships, but instead are accounted for as rental agreements.The lessee receives the beneficial use of property in the lease. The lessor owns the property, and the lessee is the party who uses the assets and makes lease payments.

From the perspective of the lessee, we have two types of leases. The first type of lease is referred to as an operating lease, and the second is known as a capital lease. We view a capital lease as an in-substance purchase of an asset.

From the perspective of the lessor, we have three types of leases. We have an operating lease, a direct-financing lease, and a sales-type lease.At the heart of the rules for lease accounting is a concept of substance over form. If the transaction is in substance a purchase of property, plant, and equipment, we should recognize it as a purchase. While the form of the transaction may say that it is a lease, we go beyond form to look at the substance of the transaction.

From the perspective of the lessee, there is a direct comparison between a capital lease and an installment note. In this example, Matrix purchases equipment from Apex, agreeing to pay $193,878 (rounded), every six months for the next three years. The interest rate associated with this agreement is 9%. Lets prepare an effective interest amortization table for this note.

The effective interest is determined by multiplying the carrying value times the interest rate for the period of time, in the case of the first payment, of one million dollars times 4.5 percent (9% yearly rate divided by 2). Remember that payments are made every six months.

If this transaction is to be treated as an installment note, the entry to record the acquisition of the equipment would be to debit equipment for one million dollars and credit notes payable for the same amount.

If this transaction will be treated as a capital lease, the entry to record the acquisition of the equipment is to debit leased equipment for $1 million, and credit lease payable for one million.

Viewing this transaction as an installment note, the first payment is due on June 30. The required journal entry is to debit interest expense for $45,000, debit notes payable for $148,878, and credit cash for $193,878.

If we view this transaction as a capital lease, the first payment would be made on June 30. The required journal entry would be to debit interest expense for $45,000, debit lease payable for $148,878, and credit cash for $193,878.A lease is accounted for as either a rental agreement (known as an operating lease) or a purchase/sale accompanied by debt financing (known as a capital lease). The choice of accounting method hinges on the nature of the leasing arrangement.

From the viewpoint of the lessee, a capital lease must meet one of the four following conditions:

First, ownership to the leased asset must transfer to the lessee at the end of the lease term.

Second, the lease may contain a bargain purchase option payment at the end of the lease term.

Third, the noncancelable lease term must be equal to 75% or more of the expected economic life of the leased asset.

Finally, the present value of the minimum lease payment must be 90% or more of the fair value of the leased asset.

Remember, to be classified as a capital lease the agreement must meet only one of these four conditions.Since our objective is to determine when the risks and rewards of ownership have been transferred to the lessee, the first criterion is self-evident. If legal title passes to the lessee during, or at the end of, the lease term, obviously ownership attributes are transferred.

A bargain purchase option (BPO) is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a bargain price. This is defined as a price sufficiently lower than the expected fair value of the property (when the option becomes exercisable) that the exercise of the option appears reasonably assured at the inception of the lease. Because exercise of the option appears reasonably assured, transfer of ownership is expected.

If an asset is leased for most of its useful life, then most of the benefits and responsibilities of ownership are transferred to the lessee. GAAP specifies, quite arbitrarily, that 75% or more of the expected economic life of the asset is an appropriate threshold point for this purpose.Although the intent of this criterion is fairly straightforward, implementation sometimes is troublesome. First, the lease term may be uncertain. It may be renewable beyond its initial term. Or the lease may be cancelable after a designated noncancelable period. When either is an issue, we ordinarily consider the lease term to be the noncancelable term of the lease plus any periods covered by bargain renewal options. A bargain renewal option gives the lessee the option to renew the lease at a bargain rate. That is, the rental payment is sufficiently lower than the expected fair rental of the property at the date the option becomes exercisable that exercise of the option appears reasonably assured. Noncancelable in this context is a lease that is cancelable only by (a) the occurrence of some remote contingency, (b) permission of the lessor, (c) a new lease with the same lessor, or (d) payment by the lessee of a penalty in an amount such that continuation of the lease appears, at inception, reasonably assured.

If the lease payments required by a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease equivalent to an installment purchase. This situation is considered to exist when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease. In general, minimum lease payments are payments the lessee is required to make in connection with the lease and consist of the total of periodic rental payments any guaranteed residual value any bargain purchase option price.A bargain purchase option gives the lessee the right to acquire the leased asset at the end of the lease term at an amount significantly lower than expected fair value.

The lease term is normally considered to be the noncancelable term of the lease plus any option to renew the term at the end of the original lease term.

When a lease is classified as a capital lease, the lessee records both the asset and liability at inception of the lease. We saw this accounting transaction when we compared accounting for a capital lease to an installment note payable on a earlier slide.To properly classify the lease from the viewpoint of the lessor, two additional conditions must be met. First, the collectibility of the minimum lease payments must be reasonably predictable. Second, if any costs yet to be incurred by the lessor exist, they must be reasonably predictable.

Remember, the lessor must meet one of the first four conditions that apply to the lessee, plus these two additional conditions. Thats because a capital lease to the lessor means the lessor will account for the agreement as a sale. Look closely, the two additional lessor conditions are essentially the usual revenue recognition criteria.Lease accounting under U.S. GAAP and IFRS provides a good general comparison of rules-based accounting as U.S. GAAP often is described and principles-based accounting which often is the description assigned to IFRS. Where the FASB issued rules to determine the classification, the IFRS permits management to analyze and determine the classification.

From the viewpoint of the IFRS:Situations that normally would lead to classification as a finance lease are:Title to the leased asset transfers to the lessee at the end of the lease.Contains a BPO.The term is a major portion of the assets life.The PV of MLP is equal to or greater than substantially all of the fair value of the asset.The leased asset is of such a specialized nature that only the lessee could use it without major modifications.The lessors losses are borne by the lessee upon cancellation.Gains or losses from changes in fair value of the residual value go to the lessee.

However, the FASB has the following rules for classification of capital leases:Contains a BPO.The lease term is 75% of more of the economic life of the asset.PV of MLP is 90% or more of the fair value of the asset.Title to the leased asset transfers to the lessee at the end of the lease.

If a lease does not meet any of the criteria for a capital lease it is considered to be more in the nature of a rental agreement and is referred to as an operating lease. We assume that the fundamental rights and responsibilities of ownership are retained by the lessor and that the lessee merely is using the asset temporarily. In keeping with that presumption, a sale is not recorded by the lessor; and a purchase is not recorded by the lessee. Instead, the periodic rental payments are accounted for merely as rent by both parties to the transactionrent revenue by the lessor; rent expense by the lessee.

The term operating lease got its name long ago when a lessee routinely received from the lessor an operator along with leased equipment.On January 1, 2013, Sans Serif Publishers, Inc., a computer services and printing firm, leased printing equipment from First LeaseCorp. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2013, the inception of the lease, and at each January 1 thereafter through 2016.The useful life of the equipment is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the equipment for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%.

The lease fails all four of the capital lease tests, and is classified as an operating lease.

At the end of the four payment dates, the lessee, Sans Serif, will debit prepaid rent and credit cash for $100,000. The lessor will debit cash and credit unearned revenue for $100,000.

Because the lessor keeps the asset on its books, it is the lessor that records depreciation of the asset.Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. If a lessee constructs a new building or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets, its cost is allocated as depreciation expense over its useful life to the lessee, which will be the shorter of the physical life of the asset or the lease term. Theoretically, such assets can be recorded in accounts descriptive of their nature, such as buildings or plant. In practice, the traditional account title used is leasehold improvements. In any case, the undepreciated cost usually is reported in the balance sheet under the caption property, plant, and equipment. Movable assets like office furniture and equipment that are not attached to the leased property are not considered leasehold improvements.If the agreement contains an option to renew, and the likelihood of renewal is uncertain, the renewal period is ignored.

Also, traditionally, depreciation sometimes is labeled amortization when in connection with leased assets and leasehold improvements. This is of little consequence. Remember, both depreciation and amortization refer to the process of allocating an assets cost over its useful life.From the viewpoint of the lessee, the amount recorded as the asset will be the present value of the minimum lease payments. However, the amount recorded as the asset can never exceed the fair value of that asset.

In calculating the present value of the minimum lease payment, the interest rate used will be the lower of the lessees incremental borrowing rate, or the implicit rate used by the lessor to set the lease payment amount.If the lessor is not a manufacturer or dealer of the asset being leased, the fair value of the leased asset usually will be equal to the lessors cost. However, when the lessor is a manufacturer or dealer, the fair value of the leased property at inception of lease will usually be more than the cost of the asset in the hands of the lessor.On January 1, 2013, Sans Serif Publishers, Inc., leased a printing equipment from First LeaseCorp. First LeaseCorp 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 six-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment. First LeaseCorp routinely acquires electronic equipment for lease to other firms. The interest rate in these financing arrangements is 10%. Since the lease term is equal to the expected useful life of the equipment (>75%), the transaction must be recorded by the lessee as a capital lease. When we believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are not yet incurred are reasonably predictable, this qualifies also as a direct financing lease to First LeaseCorp. 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.

Above are the calculations of the $100,000 rental payments, and the lessees cost of the equipment. Notice that we found the present value of an annuity due because the payments are made at the beginning of the period.On the date of inception, the lessee will debit leased equipment for $479,079 and credit lease payable for the same amount. In addition, the lessor will debit lease receivable for $479,079, and credit inventory of equipment held for lease for the same amount. On January 1, 2013, the first payment is due. The lessee will debit lease payable for $100,000, and credit cash for the same amount. The lessor will debit cash for $100,000, and credit lease receivable for the same amount.The amortization schedule shows how the lease balance and the effective interest change over the six-year lease term. Each rental payment after the first includes both an amount that represents interest and an amount that represents a reduction of principal. The periodic reduction of principal is sufficient that, at the end of the lease term, the outstanding balance is zero.Please refer to the amortization schedule on the previous slide. Notice that interest expense and interest revenue have been calculated to be $37,908, with a total payment of $100,000.

At the second lease payment, the lessee will debit interest expense for $37,908, debit lease payable for $62,092 (again refer back to the amortization schedule), and credit cash for the total lease payment of $100,000.

The lessor will debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908.

Assuming the lessee uses the straight-line method of depreciation for similar owned assets, depreciation on the equipment will have to be recorded. The journal entry is to debit depreciation expense for $70,847 ($479,079 divided by six years), and credit accumulated depreciation for $79,847. The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i.e., either of the first two classification criteria is met), the asset should be depreciated over its useful life. The lessee should use the same depreciation method used for similar owned assets.If the lessor is a manufacturer or dealer of the leased assets, then the fair market value is generally not equal to the cost of the asset in the hands of the lessor. At the inception of the lease, the lessor will recognize sales revenue and cost of goods sold associated with the transaction. In addition to interest revenue earned over the lease term, the lessor receives a manufacturers or dealers profit on the sale of the asset.On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corp. at a price of $479,079.

The lease agreement specifies annual payments of $100,000 beginning January 1, 2013, the inception of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment.

CompuDec manufactured the equipment at a cost of $300,000.

CompuDecs interest rate for financing the transaction is 10%.The asset leased by the lessee is a depreciable asset. It should be depreciated in a manner used for similar owned assets. If title to the leased asset passes to the lessee at the end of the lease term, or if the lease contains a bargain purchase option, the asset should be depreciated over the assets economic life. If neither of these conditions are met, the asset should be depreciated over the lease term.At the inception of the lease agreement, CompuDec Corporation (the lessor), will prepare two journal entries. The first entry is to record the lease of the asset. CompuDec will debit lease receivable for $479,079, and debit cost of goods sold for $300,000 (the cost basis to CompuDec). The company will complete the entry with a credit to sales revenue for $479,079, and credit inventory of equipment for $300,000. CompuDec will recognize a gross profit from the sale of the lease asset of $179,079 (revenue of $479,079 less cost of goods sold of $300,000).

Also, on January 1, 2013, CompuDec will record the receipt of the first lease payment with a debit to cash for $100,000, and a credit to lease receivable for the same amount.

Note that the lessee entries will be the same as described in the prior example.A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result:

The lessee adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability.

The lessor, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price 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 estimated useful life of the equipment is seven years. On December 31, 2018, at the end of the six-year lease term, the equipment is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is 10%.

We have developed a table to show the computation of the present value of the minimum lease payments for the lessee, and the determination of the lease payments by the lessor. We need to use the present value of an annuity due of $1, for 6 periods, at 10% interest, and the present value of $1, for 6 periods, at 10% interest. Remember, the lessor determines the periodic lease payment and the lessee may accept or reject the contract.After the last lease payment, the balance in the obligation balance is $54,542, which represents the amount, that when compounded at 10% to the end of the lease, will equal the amount of the BPO. We will look at the journal entries relating to the payment of the BPO on the next slide.At the end of the lease term, Sans Serif exercises the bargain purchase option paying $60,000 cash to CompuDec. The interest and obligation reduction were developed on the previous slide.

Sometimes the lease contract specifies that a BPO becomes exercisable before the designated lease term ends. Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. All calculations would be modified accordingly.

The lessee adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded as a leased asset and a lease liability.

The lessor, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Lets examine the impact of residual value on accounting for leases.

On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price 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 estimated useful life of the equipment is seven years. At the end of the six-year lease term, ending December 31, 2018, the equipment is expected to be worth $60,000. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is 10%.

A lease agreement may contain a guaranteed residual value. Such a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessors risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value.

Examine the calculation of the present value of the minimum lease payments under the lease terms shown on the previous screen.A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments recorded as a leased asset and a lease liability is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. The lessor will subtract the present value of the residual value from the fair value to determine the amount to be recovered through lease payments. In our example, the lease payments will be $92,931.Lets use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value.

On January 1, 2013, SansSerif Publishers, Inc. will debit leased equipment for $479,079, and credit lease payable for the same amount. On the same date, CompuDec Corporation, the lessor, will debit lease receivable for $479,079 and cost of goods sold for $300,000, and credit sales revenue for $479,079, and inventory of equipment for $300,000.On January 1, 2013, Sans Serif will debit lease payable and credit cash for $92,931, while CompuDec will debit cash and credit lease receivable for $92,931. Now lets look at the end of the lease term.On December 31, 2017, Sans Serif, the lessee, will record depreciation of $68,847. Look at the calculation of this amount in the schedule on the top right of your screen. Both the lessee and lessor will record the final lease payment. Refer back to the lease amortization schedule for the amounts included in the journal entries.This schedule summarizes the effect of the residual value of a leased asset for each of the various possibilities regarding the nature of the residual value.One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs. The lessee records executory costs as incurred. These expenditures simply are expensed by the lessee as incurred: repair expense, insurance expense, property tax expense, and so on. One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessors implicit rate or can infer it from the assets fair value. When the lessors implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct financing lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct financing lease, we must calculate a new implicit interest rate that previously was unknown to the lessor. For a sales-type lease, the initial direct costs are expensed at the inception of the lease agreement.Contingent rentals may increase or decrease the minimum lease payment. However, contingent rentals are not included in the minimum lease payment. Instead, they are included as components of income when (and if) they occur or when they are considered probable. Contingent rentals are disclosed in the notes to the financial statements. Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value).

Other required disclosures are specific to the type of lease and include residual values, contingent rentals, sublease rentals, and executory costs.Lease transactions have a profound impact on several financial ratios. The first ratio is the debt to equity ratio. The lease liability is included in the numerator of this equation. The second ratio is the rate of return on assets. The leased asset is included in the denominator of this ratio.In a sale and leaseback arrangement, the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately.

Many leases involve real estate. The fact that land has an unlimited life causes us to modify how we account for some leases involving real estate.

For a lease of land only the risks and rewards of ownership cannot be presumed transferred from the lessor to the lessee unless title to the land is expected to transfer, either outright or through a bargain purchase option. Depreciation of land is not appropriate in accounting.

When the leased property includes both land and a building and the lease transfers ownership or is expected to by exercise of a bargain purchase option, the lessee should recorded each leased asset separately. The present value of the minimum lease payments is allocated between the leased land and leased building accounts on the basis of relative market values.

Some of the most common leases involve leasing only part of a building. Despite practical difficulties like the determination of the fair value of the portion of the building leased, normal lease accounting treatment applies.*Several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This Supplement 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.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). One project is their joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed 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 proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon.

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.*On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from First Lease Corp. First LeaseCorp 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 six-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment. First LeaseCorp 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. The periodic rental payment is determine by dividing the cost of the leased equipment ($479,079) by the present value of an annuity due of $1, for 6 periods, at and interest rate of 10 percent (4.79079).*At inception of the lease both the lessee and lessor are required to make two separate journal entries. The first entry deals with treatment of the right to use of the asset and the second entry deals with the payment required.

In our example, the lessee (Sans Serif) will debit right-of-use asset for $479,079 and credit lease payable for the same amount. The lessor, First LeaseCorp, will debit the asset account lease receivable and credit the inventory of equipment for $479,079.

The second entry required by the lessee is to debit lease payable for $100,000 and credit cash for the same amount. This is the first payment by the lessee to the lessor. The lessor, First LeaseCorp, will debit cash and credit lease receivable for $100,000.

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).*In the entries at the inception of the lease, the entire $100,000 first lease payment is applied to principal reduction.

At the date of the second rental payment date, December 31, 2013, one years interest has accrued on the $379,079 balance outstanding during 2013, recorded by the lessee with a debit to interest expense for $37,908, a debit to lease payable for $62,092, and a credit to cash for $100,000. The interest is determined by multiplying the effective interest rate of 10 percent times the outstanding balance of the lease obligation ($479,079 less the first payment of $100,000). The debit to lease payable represents the difference between the calculated interest expense and the cash payment of $100,000.

The lessor, First LeaseCorp, will debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908.*The amortization schedule is no different from what we would use under current GAAP. It shows how the lease balance and the effective interest change over the six-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of principal. Because the first payment is made at the inception of the lease, no interest is associated with the first payment. Because no time has passed, no interest is recognized.*The lessee amortizes its right-of-use asset over lease term (or the useful life of the asset if its shorter). Using the asset results in an expense for the lessee. This usually is on a straight-line basis unless the lessees pattern of using the asset is different.

At the end of each of the next five years, the lessee, Sans Serif, will prepare a journal entry to debit amortization expense for $79,847 ($479,079 divided by 6 years) and credit right-of-use asset for the same amount.

*On January 1, 2013, Sans Serif Publishers leased printing equipment from First LeaseCorp who purchased the equipment from CompuDec Corporation at its fair value of $479,079. Assume the lease agreement requires 4 annual payments of $100,000 each, beginning on January 1, 2013. The useful life of the asset is determined to be 6 years and the lessor uses a 10 percent interest rate to determine the lease payments.*Now lets look at an example of the accounting for a right-of-use asset in which the lease term is only four years of the assets six-year life. The lessor retains a residual interest in the asset. Using the four beginning of period payments of $100,000 and a discount rate of 10 percent, the lessor determines the present value of the right-to-use asset to be $348,685.

The lessee, Sans Serif, will debit right-of-use asset for $348,685, and credit lease liability for the same amount.

From the viewpoint of the lessor, the asset as a cost basis of $479,079, and the present value of the lease payments of $348,685, so there is a residual value retained by the lessor of $130,394. The lessor, First LeaseCorp, will debit lease receivable for $348,685, debit residual asset for $130,394, and credit inventory of equipment for $479,079.*The first payment will be made on January 1, 2013, the date of inception of the lease. The lessee, Sans Serif, will debit lease liability for $100,000 and credit cash for the same amount. Recall, that no time has past, so no interest has been accrued.

The lessor, First LeaseCorp, will debit cash and credit lease receivable for $100,000.*The second payment is made on December 31, 2013. Interest is calculated by applying the effective interest rate of 10 percent to the outstanding balance which is $248,685 ($348,685 less the first payment of $100,000). So, the interest associated with the second payment is $24,869, and the cash payment is $100,000. The difference between these two amounts represents the reduction in the lease asset or liability.

The lessee, Sans Serif, will debit interest expense of $24,869 ($248,685 times 10 percent interest), debit lease payable for $75,131 ($100,000 less $24,869), and credit cash for $100,000.

The lessor, First LeaseCorp, will debit cash for $100,000, credit lease receivable for $75,131, and credit interest revenue for $24,869.*The amortization schedule shows how the lease balance and the effective interest change over the four-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance. The periodic reduction is sufficient that, at the end of the lease term, the outstanding balance is zero.*The lessee incurs an expense as it uses the asset. The asset will be amortized over 4 years, and the lessee, Sans Serif, will debit amortization expense of $87,171 ($348,685 divided by 4 years), and credit right-of-use asset for the same amount.

The lessor will record accretion of the residual asset using the interest rate implicit in the agreement (10%). The lessor, First LeaseCorp, will debit residual asset for $13,039, and credit revenue from asset accretion for the same amount ($130,394 times 10 percent).

*Assume that First LeaseCorp anticipates that the fair value of the residual asset will be $190,911 at the end of the lease term. Given that knowledge, and First LeaseCorps required 10% rate of return, what amount should First LeaseCorp charge for the four lease payments? Remember, the $479,079 is the fair value now, so to determine the amount that needs to be recovered from the four lease payments, First LeaseCorp subtracts from $479,079 the present value of the residual assets anticipated fair value to be received in four years, and then computes lease payments to provide a return of 10%. The calculation of the lease payment is shown on this slide. Notice the present value of estimated residual value of the asset is subtracted from the fair value of the asset, to determine the amount to be recovered through periodic lease payments.

Now lets look at how the lessor recovers its investment in the leased asset.*At commencement of the lease, the lessor recorded its residual asset at $130,394. At the end of the lease term, that amount will have risen to $190,911. The process of increasing the assets balance is called accretion. Since $130,394 is the PV of $190,911 discounted at 10%, the balance (PV) will increase annually by 10%. The present value of the sum of the accretion in the residual value and the periodic lease payments totals the total amount to be recovered (fair value of the leased asset).*This schedule shows the calculation of the revenue from accretion of the residual value of the asset. The lessors revenue is (a) the interest revenue from financing the portion transferred and (b) the revenue from accretion of its residual asset not transferred, both at the 10% interest rate implicit in the lease. Thus, First LeaseCorp earns a 10% rate of return on both the portion of its asset transferred and the portion retained as a residual asset.*Ignoring tax effects, the leases effect on the earnings of the lessee and lessor are depicted on this page. The lessee recognizes interest expense and amortization expense, and the lessor recognized interest revenue and accretion revenue over the life of the lease.*On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDecs interest rate for financing the transaction is 10%.

Based on the terms of the agreement, the lessor calculates the periodic lease to be $100,000. All lessor entries we have seen will be the same under this lease agreement except on January 2, 2013, The lessor (CompuDec) will debit lease receivable for $479,079, credit inventory of equipment for $300,000 (the carrying value of the asset), and credit profit for $179,079 ($479,079 less $300,000).

Accounting by the lessee is not affected by how the lessor records the lease.*On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), after which the equipment is anticipated to have a fair value of $100,000. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDecs interest rate for financing the transaction is 10%.

Notice that when we calculate the periodic lease payment, we first subtract the present value of the residual value from the fair value of the asset. Next, we divide the amount to be recovered through lease payments ($433,632) by the present value of an annuity due of $1, for 6 periods, at a 10% interest rate. The periodic lease payment is calculated to be $88,218. As you can see, the lessor expects to recover the fair value of the asset ($479,079).*On January 1, 2013, the lessor will debit lease receivable for $422,632 (the fair value of the assets less the present value of the $100,000 residual value), debit residual asset for $35,347 ($300,000 less $264,653), credit inventory of equipment for $300,000, and credit profit for $157,979 ($422,632 less 264,653).*When there is profit in a lease, the carrying amount of the residual asset (the $35,347 portion of the equipment retained) is less than the fair value of the residual asset ($56,447). The difference ($56,447 35,347 = $21,100) is the deferred profit on the portion of the asset not transferred. To record accretion of the residual asset from its current fair value to its anticipated fair value at the end of the lease term, first increase the balance of the residual asset from its carrying amount to its current fair value at the commencement of the lease the lessor will debit residual asset for $21,000, and credit deferred profit for the same amount.*CompuDec will report a net residual asset in the balance sheet, which is the gross residual asset offset by the deferred profit. But since the gross amount is accreted (increased) over the term of the lease, the reported amount (equal to the gross amount minus deferred profit) increases as well.*The increase in the gross residual assets balance through accretion is shown in this table. Remember, in addition to the accretion revenue during the lease term, the lessors earnings also will be increased by the profit recorded at the leases commencement, the interest revenue earned during the lease term, and the deferred profit when the equipment is sold or leased again after the lease term.*To help visualize the relationship among the different ways to measure the residual asset as of the commencement of the lease review the table show above. As the residual asset is accreted over the lease term, both the gross residual asset and the net residual asset increase, and the gross residual asset eventually equals the anticipated fair value.

*On this slide we provide and summary of accounting by the lessee and lessor for a right-of-use lease agreement.*In calculating the PV of the payments, the discount rate used by the lessee is:

The rate the lessor charges the lessee (rate that causes the sum of PV of lease payments and the PV of the residual value of the underlying asset to equal the fair value of the asset today).

If the lessors rate is not known, use the lessees incremental borrowing rate.*Initial direct costs are:Costs associated directly with originating a lease that would not have been incurred had the lease agreement not occurred are. Include legal fees, commissions, evaluating the prospective lessees financial condition, and preparing and processing lease documents. Added to the carrying amount of the right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the lessor.

*In many cases, the new definition would result in shorter lease terms for accounting purposes than the Boards initial proposal. For example, assume a retailer has a lease that includes a non-cancellable term of 10 years and four five-year renewal options. Based on its experience and expectations, the retailer may determine that the longest possible lease term that is more likely than not to occur is 20 years. However, if there is no significant economic incentive for the retailer to exercise the renewal options, the lease term for accounting purposes, under the revised definition, would be 10 years. *Lease payments include:payments that depend on an index or rate (e.g., increase with inflation rate)contingent payments that are reasonably assured.

*If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as a lease receivable. It is simply seen as an additional lease payment.*A lease that has a maximum possible lease term (including any options to renew) of 12 months or less is a short-term lease. Lease-by-lease option to choose a short-cut approach.

The lessee can elect: not to recognize a right-of-use asset or a lease liability.to recognize lease payments as expense over the lease term.

The lessor can elect: not to record the lease receivable or to derecognize the asset being leased.to recognize lease payments as revenue over the lease term.

End of Chapter 15.