Accounting for Leases
ACCTG 5120
David Plumlee
1

What is a Lease?
“ A lease is a contractual agreement between a lessor (owner) and a lessee
(renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.” page2

Accounting for Leases
Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?
Over time lease agreements began to resemble installment purchases where
Companies were in effect borrowing money to buy an asset page3

Classification of Leases
What is the economic nature of a capital lease?
One that transfers substantially all the risks and benefits of ownership to the lessee.
What is the economic nature of an operating lease?
One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement page4

Accounting for Capital Leases

Accounting reflects economic substance, not legal form

Make it appear as though company purchased an asset with borrowed funds


 an asset and an obligation interest expense on obligation depreciation on asset page5

Is this a Capital Lease?
Does it meet ANY ONE of the four criteria?
• Lease transfers ownership of asset
• automatically by end of lease term or
• through a bargain purchase option
• Lease term is at least 75% of asset’s estimated economic life
• PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term page6

Minimum Lease Payments



Leases without a BPO
Minimum rental payments plus
Any guaranteed residual value plus
 amount the lessee guarantees lessor will realize on the asset at the end of the lease term
Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured page7

MLP continued
What are executory costs?
Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance
Are they included in MLP?
NO!
page8

Minimum Lease Payments
What is a bargain purchase option?
An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured
What is the MLP for leases with a BPO?
PV of rental payments and the BPO at the end of the lease term.
page9

Capital Lease Example
 6-year lease
 Annual payment due at year end = $18,287
 No BPO and legal title does not pass at the end of lease term
 FMV of leased asset = $75,185
 Economic life of asset = 10 years
 Appropriate interest rate = 12%
 Est. salvage value = $3,185 page10

Present Value of MLP
$18,287 $18,287 $18,287 $18,287 $18,287 $18,287
1 2 3 4 5 6
PV = $18,287 x PVIFA(n=6, r=12%)
= $18,287 x 4.11141
= $75,185 page11

Lessee Journal Entries



Inception of lease: record leased asset and lease obligation at present value of MLP
Record payments
At period end accrue:
 depreciate asset
 record interest expense page12

Inception of Lease Term
JE to record leased asset and lease obligation at present value of MLP?
leased asset lease obligation
$75,185
$75, 185 page13

Depreciation Expense
On what does the depreciation period used depend?
 If bargain purchase option exists or title passes during lease term, use economic life
 Otherwise use lease term page14

Basis for Depreciation
What ending values are used for depreciation?
Salvage value if depreciating over economic life
Guaranteed residual value if depreciating over lease term page15

Record Depreciation Expense
What is the depreciable basis of this asset?
$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)
$75,185/6yrs = $12,531 depreciation expense $12,531 accum. depreciation $12,531 page16

Lease Amortization Table
Date Payment Interest Reduction
In Obligation
0
1
2
3
4
5
6
Balance page17

Lease Amortization Table
PV of the min. lease payments
Date Payment Interest Reduction
In Obligation
0
1
2
3
4
5
6
18,287
18,287
18,287
18,287
18,287
18,287
Balance
75,185 page18

Lease Amortization Table
Date Payment (a) Interest (b) Reduction
In Obligation (a-c)
0
3
4
1
2
5
6
18,287
18,287
18,287
18,287
18,287
18,287
9,022
7,910
6,665
5,271
3,709
1,959
9,265
10,377
11,622
13,016
14,578
16,328
Balance
75,185
65,920
55,544
43,922
30,905
16,327
-1 page19

Record First Lease Payment interest expense ($75,185 x 12%) $9,022 lease obligation 9,265 cash $18,287
Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.
page20

Lessor Capital Lease Types


Direct financing leases

PV of minimum lease payments equals the FMV of the leased asset

No “profit” is recorded; considered to be a financing arrangement.
Sales-type leases

PV of minimum lease payments less the FMV of the leased asset equals the “dealer profit”

Profit is recognized as revenue at the inception of the lease page21

Initial Direct Costs


Includes costs directly associated with negotiating a particular lease

 amounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees) amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents)
Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead) page22

Accounting for
Initial Direct Costs

Operating defer and allocate over lease term in proportion to rental income

Sales-type -

Direct financingexpense in same period as profit on sale recognized
 add to gross investment in the lease
 amortize over lease as a yield adjustment page23

Example - Direct Financing


3 year lease
$20,000 payments due at end of year implicit interest rate = 10%



FMV (lessor’s cost of asset) = $49,737 initial direct costs = $1,000 page24

Net Investment in Lease
What is the PV of the MLP (without initial direct costs)?
20,000 x PVIFA(n=3,r=10%)
=
$49,737 = cost (this is a direct financing lease)
Do initial direct costs affect this calculation?
Yes, they are added and a new interest rate is found.
page25

Impute New Effective Yield
Why add to the initial direct costs?
We want the interest rate the equates the net investment to the cash flows
$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)
$50,737 = $20,000 x PVa (n=3,r=?)
2.53685 = PVa (n=3,r=?) by trial and error: r=8.89% page26

Ignoring Initial Direct Costs opening yr. 1 yr. 2 payment interest principal balance
20,000
20,000
(10%)
4,974
3,471 yr. 3 20,000 1,818 total interest income 10,263
15,026
16,529
18,182
49,737
34,711
18,182
(0) page27

Including Initial Direct Costs opening yr. 1 yr. 2 yr. 3 payment interest principal balance
20,000
20,000
20,000 total interest income
(8.89%)
4,511
3,134
1,619
9,263
15,489
16,866
18,381
50,737
35,248
18,381
0
Reduction in income = 10,263 - 9,263
= 1,000
= initial direct costs page28

Amort. of Initial Direct Costs interest interest at 10% at 8.89% amortization yr. 1 4,974 yr. 2 3,471
4,511
3,134
463
337 yr. 3 1,818 total 10,263
1,618
9,263
200
1,000 page29

Journal Entry
Entries to record lease: deferred initial direct costs 1,000 cash (etc.) 1,000 lease receivable unearned interest income leased asset
60,000
10,263
49,737 page30

Journal Entries
Entries to record first payment and amortization of income and costs
20,000 cash lease receivable unearned interest income interest income
4,974
20,000
4,974 initial direct expense amortization 463 deferred initial direct costs 463 page31

Sale/leaseback
Sale:
Legal title
Transfers
Seller/lessee
Buyer/lessor
Should the gain or loss on sale be recognized when asset “sold” to lessor?
Leaseback: seller retains use of the asset
Account for lease according to classification tests.
page32

Sale/leasebackoperating lease
Lessee Retains Right To Use Asset

 defer gains only (losses are recognized immediately) amortize to rent expense over lease term in proportion to rental payments
Why do you think we defer any gains?
Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future page33

Sale/leaseback -capital lease
Lessee Retains Right To Use Asset

 defer gains only (losses are recognized immediately) amortize to depreciation expense over lease term in proportion to amortization of leased asset page34

“Minor leaseback”

Lessee Loses Most Rights To Use Asset

Defined as PV of rental payments is
10% or less of asset’s fair value

Recognize gain or loss on sale immediately page35