leases (chapter 15) learning objectives 1. identify and describe the operational, financial, and tax...

LEASES (Chapter 15)Learning Objectives

1. Identify and describe the operational, financial, and tax objectives that motivate leasing.

2. Explain why some leases constitute lease agreements and some represent purchases/sales accompanied by debt financing.

3. Explain the basis for each of the criteria and conditions used to classify leases.

4. Record all transactions associated with operating leases by both the lessor and lessee.

5. Describe and demonstrate how both the lessee and lessor account for a capital lease.

6. Describe and demonstrate how the lessor accounts for a sales-type lease.

LEASES

A lease is usually a non-cancelable agreement A lease is usually a non-cancelable agreement in which the in which the lessorlessor conveys the conveys the right to use right to use propertyproperty, , plant,plant, or or equipment,equipment, usually for a usually for a

stated period of timestated period of time, to the , to the lesseelessee..

Lessor = OWNER of propertyLessor = OWNER of propertyLessee = USER of propertyLessee = USER of property

Lessee LessorOperating lease Operating leaseCapital lease Capital lease

Direct financing lease Sales-type lease

Lessee LessorOperating lease Operating leaseCapital lease Capital lease

Direct financing lease Sales-type lease

The issue of how to report leases is The issue of how to report leases is the case of the case of substance versus formsubstance versus form. .

Lessee = USER of property; Lessor = OWNER of property

Although technically legal title may Although technically legal title may not pass, not pass, the the benefits from the benefits from the use use of the property do.of the property do.

Conceptual Nature of a Lease Conceptual Nature of a Lease

A variety of opinions exist regarding the manner in which certain long-term lease arrangements should be accounted for.

These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized.

The FASB Statements dealing with lease accounting can be characterized as advocating capitalization of lease arrangements that are similar to installment purchases.

Conceptual Nature of a Lease Conceptual Nature of a Lease

Capital Leases and Installment Notes Compared

Matrix, Inc. acquires equipment from Apex, Inc. by paying $100,000 every year for the next ten years. The interest rate associated with the agreement is 0%.

Let’s look at the arrangement as an installment salesand as a capital lease agreement.

The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease.

Therefore, according to FASB it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase.

Therefore, the accounting (the balance sheet presentation of the LIABILITY) for Installment Note Payable or Lease

Payable should be exactly the same and NOT Off-Balance Sheet.

LEASES

We are tracking the question of LIABILITY and it is 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.

Leases that do not produce debtor/creditor relationships, but instead are accounted for as rental agreements are designated as operating leases.

Capitalize a lease that transfers substantially all

of the benefits and risks of property ownership,

provided the lease is non-cancelable.

Leases that do not transfer substantially all of the

benefits and risks of ownership are operating

leases.

Conceptual Nature of a LeaseConceptual Nature of a Lease

ASC 840 (FAS 13, Accounting for Leases,” 1980)ASC 840 (FAS 13, Accounting for Leases,” 1980)

LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

TransferofOwnership

Bargain Purchase

Lease Term>= 75%

PV of Payments>= 90%

Operat ing

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.

Accounting by the LesseeAccounting by the LesseeAccounting by the LesseeAccounting by the Lessee

Operating Leases

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Lease Lease agreement agreement

exists.exists.

Lease Lease agreement agreement

exists.exists.

Record lease as Record lease as an Operating an Operating

Lease.Lease.

Record lease as Record lease as an Operating an Operating

Lease.Lease. CapitalLease

Operating Leases

On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation.

The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.

The useful life of the copier is estimated to be six years.

Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%.

On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation.

The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.

The useful life of the copier is estimated to be six years.

Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier, the interest rate would have been 10%.

How should this lease be classified?

Operating LeasesHow should this lease be classified? We apply the four classification criteria:

1Does the agreement specify that ownership of the asset transfers to the lessee? NO

2 Does the agreement contain a bargain purchase option? NO

3Is the lease term equal to 75% or more of the expected economic life of the asset? {4 yrs < 75% of 6 yrs} NO

4Is the present value of the minimum lease payments equalto or greater than 90% of the fair value of the asset? NO Calculations:PV of MLP = $348,685 = $100,000 x 3.48685**

Lease present payments value

** present value of an annuity due of $1: n=4, i=10%

$348,685 < 90% of $479,079 = $431,171

Since none of the four classification criteria is met, this is an operating lease.

Operating LeasesAt Each of the Four Payment Dates:

Sans Serif Publishers, Inc. (Lessee)Prepaid rent 100,000 Cash 100,000

CompuDec Corporation (Lessor)Cash 100,000 Unearned rent revenue 100,000

At the End of Each Year:Sans Serif Publishers, Inc. (Lessee)Rent expense 100,000 Prepaid rent 100,000

CompuDec Corporation (Lessor)Unearned rent revenue 100,000 Rent revenue 100,000

Depreciation expense x,xxx Accumulated depreciation x,xxx

Leasehold Improvements

Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease.

Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.

Exercise 1Brief Exercises 1-3

Exercise 2

Advantages of LeasingA. Leasing is used as a means of “off-balance-sheet financing.” 1. Can avoid negatively affecting the debt-asset ratio and other mechanical indicators of riskiness.

2. Market is naive, and is “fooled” by off-balance-sheet financing.

B. Achieves operational objectives by facilitating asset acquisition to overcome: 1. Uncertainty or cash flow problems.

2. Fear of obsolescence.

C. Achieves tax objectives: Lower lease payments for LESSEE if it allows the lessor to retain ownership and thus benefit from ITC and Depreciation deductions when:

1. The lessee has little or no taxable income and will get little benefit from depreciation deductions.

2. The lessee has sufficient taxable income to take advantage of the depreciation deductions, but is in lower tax brackets than lessor.

Classification Criteria (Lessee)

OwnershipOwnership transfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The non-cancelable lease term is equal to The non-cancelable lease term is equal to 75% or more of the expected economic life of the of the expected economic life of the asset, or . . .asset, or . . .

The PV of the minimum lease payments (MLP) The PV of the minimum lease payments (MLP) is is 90% or more of the fair value of the asset.of the asset.

OwnershipOwnership transfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The non-cancelable lease term is equal to The non-cancelable lease term is equal to 75% or more of the expected economic life of the of the expected economic life of the asset, or . . .asset, or . . .

The PV of the minimum lease payments (MLP) The PV of the minimum lease payments (MLP) is is 90% or more of the fair value of the asset.of the asset.

A capital leasecapital lease must meet oneone of four criteria:

Operating Lease

Operating Lease

Capital Lease

Capital Lease

LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

TransferofOwnership

Bargain Purchase

Lease Term>= 75%

PV of Payments>= 90%

Operat ing

Lease

NoNo NoNo NoNo

NoNo

Yes

Capital Lease

Lease Agreement

Yes Yes Yes

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.



1. The transfer of ownership criteria is straightforward and easy to apply in practice.

IF THE LEASE TRANSFERS OWNERSHIP OF THE ASSET TO THE LESSEE, IT IS A CAPITAL LEASE


2. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable.

At the inception of the lease, the difference between the option price and the expected FMV must be large enough to make the exercise of the option reasonably assured.

Example: Lease Honda Accord for $599/Month for 40 monthswith an option to purchase for $100 at the end of the 40th month when the estimated FMV then is $3000. => Clearly a BARGAIN

*Difficult to determine what is a BARGAIN: BOA or HERTZ


3. The 75% of economic life test is based on the belief that when a lease period equals or exceeds 75% of the asset’s economic life, the risks and rewards of ownership are transferred to the lessee and capitalization is appropriate.

BARGAIN RENEWAL OPTION can extend the lease term. *Difficult to determine what is a BARGAIN

A major exception to the 75% rule is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% test should not be used.


4. The reason for the 90% of fair market value test is that if the present value of the minimum lease payments are reasonably close to the market price (FMV) of the asset, the asset is effectively being purchased.

A major exception to the 75% and 90% rules is when the inception of the lease occurs during the last 25% of the asset’s life. When this occurs the 75% and 90% tests should not be used.

Recovery of Investment Test (90% Test):


PV of Minimum lease payments: (>=90% of FMV) Minimum rental payment Guaranteed residual value Penalty for failure to renew Bargain purchase option

Executory Costs: Insurance Maintenance Taxes

Exclude from PV of Minimum Lease Payment calculation

Included in PV of Minimum Lease Payment calculation

Based on the examples provided in ASC 840, executory costs are costs incurred for

operating the leased property or that otherwise protect the value of the leased property.



The residual value of a leased asset is the estimated fair value of the asset at the end of the lease term.

The residual value may be guaranteed or unguaranteed by the lessee.

A guaranteed residual value is said to exist when the lessee agrees to make up any deficiency below a stated amount in the value of the asset at the end of the lease term.

A guaranteed residual value affects the lessee’s computation of the minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation.

The lessor assumes the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed.

Recovery of Investment Test (90% Test)


To understand the accounting implications of a guaranteed residual value, assume a lessee guarantees the residual value of an asset will be $8,000.

If, at the end of the lease, the fair market value of the residual value is less than $8,000, the lessee will have to record a loss for the difference.

For example, if the lessee depreciated the asset down to its residual value of $8,000 but the fair market value of the residual value was $4,000, the lessee would have to record a loss of $4,000.

If the fair market value of the asset exceeds the $8,000, a gain may be recognized.



Executory Costs include the cost of insurance,

maintenance, and tax expense related to the

leased asset.

If the lessor makes these payments, such amounts

should reduce the present value of the minimum

lease payments.

When the lease agreement specifies that

executory costs are assumed by the lessee, the

rental payments can be used without adjustment

in the present value computation.



Discount Rate

Lessee computes the present value of the

minimum lease payments using its incremental

borrowing rate, with one exception.

If the lessee knows the implicit interest rate

computed by the lessor and it is less than

the lessee’s incremental borrowing rate, then

lessee must use the lessor’s rate.

Accounting by the LesseeAccounting by the Lessee

For the lessee, a capital lease is treated For the lessee, a capital lease is treated as if it is a purchase of an asset as if it is a purchase of an asset – the – the lessee records lessee records both an asset and liabilityboth an asset and liability at inception of the lease.at inception of the lease.

Asset and Liability Recorded at the lower of:

1. the present value of the minimum lease

payments (excluding executory costs) or

2. the fair-market value of the leased asset.


Capital Leases – Lessee• On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First

Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079.

• The lease agreement specifies annual payments of $100,000, beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier.

• First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%.

• We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable.

• Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease.capital lease.

*PV of an annuity due of $1: n = 6, I = 10% => 4.79079

$100,000 × 4,79079* = $479,079 lessee’s cost

*PV of an annuity due of $1: n = 6, I = 10% => 4.79079

$100,000 × 4,79079* = $479,079 lessee’s cost

Capital Leases – Lessee

Inception Of Lease (January 1, 2011)

San Serif Publishers, Inc. (Lessee)Leased equipment (PV of payments) 479,079

Lease payable (PV of payments) 479,079

First Lease Payment (January 1, 2011)

San Serif Publishers, Inc. (Lessee)Lease payable 100,000

Cash 100,000

Capital Leases – Lessee and LessorAmortization Schedule for the Lease

Effective Decrease in OutstandingDate Payment Interest Balance Balance

1/1/11 479,079$ 1/1/11 100,000$ -$ 100,000$ 379,079

12/31/11 100,000 37,908 62,092 316,987 12/31/12 100,000 31,699 68,301 248,686 12/31/13 100,000 24,869 75,131 173,554 12/31/14 100,000 17,355 82,645 90,910 12/31/15 100,000 9,090 * 90,910 -

600,000$ 120,921$ 479,079$ *Rounded.

$379,079 × 10% = $37,908$379,079 × 10% = $37,908

$100,000 - $37,908 = $62,092$100,000 - $37,908 = $62,092

$379,079 - $62,092 = $316,987$379,079 - $62,092 = $316,987

Capital Leases – Lessee and Lessor

Second Lease Payment (December 31, 2011)

San Serif Publishers, Inc. (Lessee)Interest expense 37,908Lease payable 62,092

Cash 100,000

Depreciation Recorded at (December 31, 2011)

San Serif Publishers, Inc. (Lessee)Depreciation expense 79,847

Accumulated depreciation 79,847

($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

-Exercise 3-EX 3: Fin. Stmt. 12/31/11-Exercise 7 -Exercise 8 + F/S 12/31/11

A lessor determines the amount of the rental, based

on the rate of return needed to justify leasing the asset.

If a residual value is involved (whether guaranteed or

not), the company would not have to recover as

much from the lease payments.

Economics of Leasing

Accounting by the LessorAccounting by the LessorAccounting by the LessorAccounting by the Lessor

a. Operating leases.

b. Direct-financing leases.

c. Sales-type leases.

Classification of Leases by the Lessor


A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.



LO 4 Identify the classifications of leases for the lessor.

A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.

Illustration 21-11



LO 4 Identify the classifications of leases for the lessor.

A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

Illustration 21-12

Capital Leases – Lessee and Lessee

When the When the lessor is a manufacturer or lessor is a manufacturer or dealer, the fair value of the property dealer, the fair value of the property at at the inception of the lease is the inception of the lease is likely to be likely to be

its its normal selling price.normal selling price.=> Sales-type Lease=> Sales-type Lease

When the When the lessor is a manufacturer or lessor is a manufacturer or dealer, the fair value of the property dealer, the fair value of the property at at the inception of the lease is the inception of the lease is likely to be likely to be

its its normal selling price.normal selling price.=> Sales-type Lease=> Sales-type Lease

If the lessor is not a manufacturer or If the lessor is not a manufacturer or dealer, the fair value of the leased dealer, the fair value of the leased asset typically is the asset typically is the lessor’s cost.lessor’s cost.

=> Direct Financing Lease=> Direct Financing Lease

If the lessor is not a manufacturer or If the lessor is not a manufacturer or dealer, the fair value of the leased dealer, the fair value of the leased asset typically is the asset typically is the lessor’s cost.lessor’s cost.

=> Direct Financing Lease=> Direct Financing Lease

Capital Leases – Lessee and Lessor• On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First

Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079.

• The lease agreement specifies annual payments of $100,000, beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier.

• First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%.

• We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable.

• Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease.capital lease.

• This lease also qualifies as a direct financing lease direct financing lease to First Lease. To achieve its objectives, First Lease 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.

Lessor’s Determination of Rental payments:

$479,079 ÷ 4.79079* = $100,000 rental payments.*PV of an annuity due of $1: n = 6, I = 10%

Lessee’s Determination of Lease liability and asset:

$100,000 × 4,79079* = $479,079 lessee’s cost*PV of an annuity due of $1: n = 6, I = 10%

Lessor’s Determination of Rental payments:

$479,079 ÷ 4.79079* = $100,000 rental payments.*PV of an annuity due of $1: n = 6, I = 10%

Lessee’s Determination of Lease liability and asset:

$100,000 × 4,79079* = $479,079 lessee’s cost*PV of an annuity due of $1: n = 6, I = 10%

Capital Leases – Lessor

Direct Financing Lease (January 1, 2011)

First Lease Corp. (Lessor)Lease receivable (PV of payments) 479,079

Inventory of equipment (Lessor’s cost) 479,079

First Lease Payment (January 1, 2011)

First Lease Corp. (Lessor)Cash 100,000

Lease receivable 100,000

Capital Leases – Lessee and LessorAmortization Schedule for the Lease

Effective Decrease in OutstandingDate Payment Interest Balance Balance

1/1/11 479,079$ 1/1/11 100,000$ -$ 100,000$ 379,079

12/31/11 100,000 37,908 62,092 316,987 12/31/12 100,000 31,699 68,301 248,686 12/31/13 100,000 24,869 75,131 173,554 12/31/14 100,000 17,355 82,645 90,910 12/31/15 100,000 9,090 * 90,910 -

600,000$ 120,921$ 479,079$ *Rounded.

$379,079 × 10% = $37,908$379,079 × 10% = $37,908

$100,000 - $37,908 = $62,092$100,000 - $37,908 = $62,092

$379,079 - $62,092 = $316,987$379,079 - $62,092 = $316,987

Capital Leases – Lessee and Lessor

Second Lease Payment (December 31, 2011)

First Lease Corp. (Lessor)Cash 100,000

Lease receivable 62,092Interest revenue 37,908

Exercise 4 (JEs ONLY)Exercise 9 (JEs & FSs)

Sales-Type Leases

If the lessor is a manufacturer or dealer, If the lessor is a manufacturer or dealer, the fair value of the leased asset generally the fair value of the leased asset generally is higher than the cost of the asset.is higher than the cost of the asset.

At inception of the lease, the lessor will At inception of the lease, the lessor will record therecord the Cost of Goods SoldCost of Goods Sold as well as as well as the the Sales RevenueSales Revenue (PV of payments).(PV of payments).

At inception of the lease, the lessor will At inception of the lease, the lessor will record therecord the Cost of Goods SoldCost of Goods Sold as well as as well as the the Sales RevenueSales Revenue (PV of payments).(PV of payments).

In addition to interest revenue earned over the In addition to interest revenue earned over the lease term, lease term, the lessor receives a manufacturer’s the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.or dealer’s profit on the “sale” of the asset.

Sales-Type Leases

On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from CompuDec Corp. at a price of $479,079.

The lease agreement specifies annual payments of $100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through 2015. The six year lease term ending December 31, 2016, is equal to the estimated useful life of the copier.

CompuDec manufactured the copier at a cost of $300,000. CompuDec’s interest rate for financing the transaction is10%.

Sales-Type LeasesLease Classification

1. The lease term (6-years) is equal to 100% of the useful life of the copier, and

2. Fair market value is different from cost of the leased asset.

3. CompuDec is certain about the collectibility of the lease payments, and

4. No costs are to be incurred by CompuDec relating to the lease agreement,

SOSOThe lease agreement is classified as:

-a Sales-Type lease from the viewpoint of CompuDec (lessor) and

-a capital lease from the viewpoint of Sans Serif Publishers (lessee).

Sales-Type Leases: LesseeSales-Type Leases: Lessee

At inception of the Lease – January 1, 2011

CompDec Corp. (Lessor)Lease receivable 479,079Cost of goods sold 300,000

Sales revenue 479,079Inventory of equipment 300,000

Receipt of the First Lease Payment – January 1, 2011

CompDec Corp.(Lessor)Cash 100,000


Exercise 5Exercise 10 (JEs & F/Ss)

HOME WORK (Due Next Week)

Problem 3 (As is),

Problem 5 (Requirement 1 & Financial Statements* -Lessee)

Problem 6 (Financial Statements -Lessor)

Problem 7 (Requirement 1 & Financial Statements* -Lessor)

*Financial Statements include (in GOOD form): -Income Statement, -Balance Sheet, and

-Statement of Cash Flows

Bargain Purchase OptionsA 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:

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 leased asset and a lease liability.

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.

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 leased asset and a lease liability.

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.

Bargain Purchase Options

In a bargain purchase option (BPO) lessee depreciates the asset using its useful life and NOT Lease Life.

Bargain Purchase Option (BPO)On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 there after through 2016. The estimated useful life of the copier is seven years. On December 31, 2016, at the end of the six year lease term, the copier 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 copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

Lessor's calculation of rental payments:Fair market value of asset 479,079$ Less: PV of BPO 60,000$ × 0.56447 = (33,868) Amount recoverd through payments 445,211$ PV annuity due factor, n = 6, I = 10% ÷ 4.79079Rental payments at beginning of period 92,931$

Lessee's calculation of PV of MLP:PV of periodic payments 92,931$ × 4.79079 = 445,211$ Plus: PV of BPO 60,000 × 0.56447 = 33,868 PV of MLP 479,079$

Bargain Purchase Option (BPO)Effective Decrease in Outstanding

Date Payment Interest Balance Balance1/1/11 479,079$ 1/1/11 92,931$ -$ 92,931$ 386,148

12/31/11 92,931 38,615 54,316 331,832 12/31/12 92,931 33,183 59,748 272,084 12/31/13 92,931 27,208 65,723 206,361 12/31/14 92,931 20,636 72,295 134,067 12/31/15 92,931 13,407 79,524 54,542 12/31/16 60,000 5,458 54,542 -

557,586$ 133,049$ 424,537$

Exercise of BPO at the end of the lease term:$54,542 × 10% = $5,458*$60,000 BPO payment - $5,458 = $54,542$54,542

Bargain Purchase Option (BPO)

End of Lease – December 31, 2016

Sans Serif Publishers, Inc. (Lessee)Depreciation expense ($479,079 ÷ 7) 68,440


Interest expense 5,458Lease payable 54,542

Cash (BPO payment) 60,000

CompDec Corporation(Lessor)Cash 60,000


End of Lease – December 31, 2016

Sans Serif Publishers, Inc. (Lessee)Depreciation expense ($479,079 ÷ 7) 68,440



Cash (BPO payment) 60,000

CompDec Corporation(Lessor)Cash 60,000


Refer the amortization schedule and computations on the previous screenRefer the amortization schedule and computations on the previous screen

Exercise 17Exercise 18

Effect on the Lessee of a Residual Value

Guaranteed Residual ValueGuaranteed Residual Value

Sometimes the 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 lessor’s 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.

Sometimes the 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 lessor’s 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.

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term.

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term.

Residual Value

On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079.

The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2016.

The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2016, the copier is expected to be worth $60,000.

CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

Effects on the Lessor of a Residual ValueGuaranteed Residual ValueGuaranteed Residual Value

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.

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.

Lessor's calculation of rental payments:Fair market value of asset 479,079$ Less: PV of residual value 60,000$ × 0.56447 = (33,868) Amount recoverd through payments 445,211$ PV annuity due factor, n = 6, I = 10% ÷ 4.79079Rental payments 92,931$


Guaranteed Residual ValueGuaranteed Residual Value

Lessee's calculation of PV of MLP:PV of periodic payments 92,931$ × 4.79079 = 445,211$ Plus: PV of residual value 60,000 × 0.56447 = 33,868 PV of MLP 479,079$

PV factor of an annuity due of $1: n=6, i=10%PV factor of an annuity due of $1: n=6, i=10%PV factor of $1: n=6, i=10%PV factor of $1: n=6, i=10%

Guaranteed Residual Value Effective Decrease in Outstanding

Date Payment Interest Balance Balance1/1/11 479,079$ 1/1/11 92,931$ -$ 92,931$ 386,148

12/31/11 92,931 38,615 54,316 331,832 12/31/12 92,931 33,183 59,748 272,084 12/31/13 92,931 27,208 65,723 206,361 12/31/14 92,931 20,636 72,295 134,067 12/31/15 92,931 13,407 79,524 54,542 12/31/16 60,000 5,458 54,542 -

557,586$ 133,049$ 424,537$

Exercise of GRV at the end of the lease term:$54,542 × 10% = $5,458*$60,000 GRV payment - $5,458 = $54,542$54,542

Residual Value Guaranteed

Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value.

Sales-Type Lease – January 1, 2011

San Serif Publishers, Inc. (Lessee)Leased equipment 479,079

Lease payable 479,079

CompDec Corporation (Lessor)Lease receivable 479,079Cost of goods sold 300,000

Sales revenue 479,079Inventory of equipment 300,000

Residual Value Guaranteed

First Lease Payment – January 1, 2011

San Serif Publishers, Inc. (Lessee)Lease payable 92,931

Cash 92,931

CompDec Corporation (Lessor)Cash 92,931


Residual Value GuaranteedDecember 31, 2015

San Serif Publishers, Inc. (Lessee)Depreciation expense 69,847

Accumulation depreciation 69,847


Cash 92,931

CompDec Corporation (Lessor)Cash 92,931

Interest revenue 13,407Lease receivable 79,524

Recorded cost of leased asset 479,079$ Guarantted residual value (60,000) Basis for depreciation 419,079 Useful life in years ÷ 6 Annual depreciation 69,847$

See amortizationschedule


Unguaranteed Residual ValueUnguaranteed Residual Value

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.

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.

Treatment of Residual Value

Lessee

Residual value in leased asset?Computation of Lease Payment

Minimum Lease Payment

Minimum Lease Payment

Lessee gets the residual value (by transfer of title or a BPO) No No NoLessor get the residual value (title does not transfer; no BPO) Residual value is not guaranteed. Yes No No Residual value is guaranteed by lessee. Yes Yes Yes Residual value is guaranteed by a third party. Yes Yes No

Lessor

Executory CostsOne 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 costsexecutory costs.

The The lesseelessee records executory costs as incurred: records executory costs as incurred:Sans Serif Publishers, Inc. (Lessee)Maintenance expense 2,000

Cash 2,000

Based on the examples provided in ASC 840, Executory

Costs are costs incurred for operating the leased property

or that otherwise protect the value of the leased property.



Executory Costs include the cost of insurance,

maintenance, and tax expense related to the

leased asset.

If the lessor makes these payments, such amounts

should reduce the present value of the minimum

lease payments.

When the lease agreement specifies that

executory costs are assumed by the lessee, the

rental payments can be used without adjustment

in the present value computation.

Discount RateOne 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 lessor’s implicit rate or can infer it from the asset’s fair value.

When the lessor’s 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.

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 lessor’s implicit rate or can infer it from the asset’s fair value.

When the lessor’s 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.

Lessor’s Initial Direct Costs

Incremental costs incurred by the lessor in negotiatingIncremental costs incurred by the lessor in negotiatingand consummating a lease agreement.and consummating a lease agreement.

They include legal fees, commissions, evaluating theprospective lessee's financial condition, and preparing andprocessing lease documents.

The method of accounting for initial direct costs dependson the nature of the lease:

Operating Leases Operating Leases −− Capitalize and amortize over the lease Capitalize and amortize over the leaseterm by the lessor.term by the lessor.

Reason: Reason: Since the only revenue an operating lease produces is leaserevenue, and that revenue is recognized over the lease term, initialdirect costs also are automatically recognized over the lease term tomatch these costs with the rent revenues they help generate.


For Capital Leases, the method of accounting for initial Direct Costs depends on the nature of the lease:

Direct Financing Leases Direct Financing Leases −− Include as part of investment balance. Include as part of investment balance. In direct financing leases interest revenue is earned over the lease term, so

initial direct costs are matched with the interest revenues they help generate.

Therefore, initial direct costs are not expensed at the outset, but are deferred and recognized over the lease term.

This can be accomplished by increasing the lessor’s lease receivable by the

total of initial direct costs. Then, as interest revenue is recognized over the lease term at a constant effective rate, the initial direct costs are recognized at the same rate (that is, proportionally).


The method of accounting for initial direct costs depends on thenature of the lease:

Sales-Type Leases Sales-Type Leases – The initial direct costs are expensed at– The initial direct costs are expensed atthe inception of the lease.the inception of the lease.

Since the usual reason for a sales-type lease is for amanufacturer or a dealer to sell its product, it’s reasonable torecognize the costs of creating the transaction as a sellingexpense in the period

Contingent Rentals

Sometimes rental payments may be Sometimes rental payments may be increased (or decreased) at some future increased (or decreased) at some future time during the lease term, depending on time during the lease term, depending on

whether some specified event occurs.whether some specified event occurs.

Contingent rentals are Contingent rentals are not included not included in the in the minimum lease paymentsminimum lease payments. .

However, they are disclosed in the notes However, they are disclosed in the notes to the financial statements.to the financial statements.

Lease Disclosures

Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For allall 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.

Lease Disclosures

The lessorlessor must disclose its net investment inthe 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.

Balance Sheet and Income Statement

Lease transactions impact several financial ratiosLease transactions impact several financial ratios

1.1. Debt to equity ratio – Debt to equity ratio – Lease liabilities are Lease liabilities are recorded.recorded.

2.2. Rate of return on assets – Rate of return on assets – Lease assets are Lease assets are recorded.recorded.

Whether leases are capitalized or treated as an Whether leases are capitalized or treated as an operating lease affects the income statement and operating lease affects the income statement and balance sheet. balance sheet.

The greater impact is on the balance sheet.The greater impact is on the balance sheet.

Lease transactions impact several financial ratiosLease transactions impact several financial ratios

1.1. Debt to equity ratio – Debt to equity ratio – Lease liabilities are Lease liabilities are recorded.recorded.

2.2. Rate of return on assets – Rate of return on assets – Lease assets are Lease assets are recorded.recorded.

Whether leases are capitalized or treated as an Whether leases are capitalized or treated as an operating lease affects the income statement and operating lease affects the income statement and balance sheet. balance sheet.

The greater impact is on the balance sheet.The greater impact is on the balance sheet.

Criticisms of the existing accounting modelThe existing accounting model fails to meetthe needs of users of financial statements.

• Operating leases give rise to assets & liabilities that should be recognized. -Form over Substance Issue

• Similar transactions can be accounted for very differently-Comparability Issue

• Rules can easily be manipulated:-Use of Higher Interest Rate;-Transfer of Residual Value Guarantees.-Payment arrangements: MLP vs. Executory Costs

-Off-Balance Sheet Financing Issue

FASB and IASB Convergence Project on Leases

FASB Discussion Paper —Leases (03/2009)

Conceptual Issues:

• Conceptual basis for Assets & Liabilities

Characteristics of an asset:

(a) The entity controls an economic resource or benefit.

(b) It arises out of a past event.

(c) Future economic benefits are expected to flow to the entity.

Characteristics of a liability:

(a) There exists a present obligation of the entity.

(b) The obligation arises out of a past event.

(c) The obligation is expected to result in an outflow of economic benefits.

The board tentatively decided that in a simple lease the lessee obtains a right to use a property (the leased item) that meets the definition of an asset and a liability. Consequently, the boards tentatively decided to adopt a new accounting model for leases that results in recognizing:

(a) an asset representing its right to use the property (leased item) for the lease term(b) a liability for its obligation to pay rentals.

This is a significant departure from the current basis of transferring substantially all the risk and rewards of ownership.

leases (chapter 15) learning objectives 1. identify and describe the operational, financial, and tax...

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