15
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

15 - 2
A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee .
Lessee = Renter
Lessee
Operating lease
Capital lease
Lessor = Owner of property
Lessor
Operating lease
Capital lease
Direct financing lease
Sales-type lease

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Capital Leases and Installment Notes Compared
Matrix, Inc. acquires equipment from Apex, Inc. by paying
$193,878 every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.
Date Payment
Effective Decrease Outstanding
Interest in Balance Balance
Initial value . . . . . . . . . . . . . . . . . . .
1 $ 193,878 $ 45,000 $ 148,878
$ 1,000,000
851,122
4
5
2
3
6
193,878
193,878
193,878
193,878
193,878
38,300
31,300
23,983
16,338
8,346
155,578
162,578
169,895
177,540
185,532
695,544
532,966
363,071
185,532
-

15 - 4
At inception January 1
Installment Note
Equipment
Notes payable
1,000,000
1,000,000
Capital Lease
Leased Equipment
Lease payable
1,000,000
First payment, June 30
Installment Note
Interest expense
Notes payable
Cash
45,000
148,878
1,000,000
193,878
Capital Lease
Interest expense
Lease payable
Cash
45,000
148,878
193,878

Operating
Lease
Capital
Lease
15 - 5
A capital lease must meet one of four criteria:

Ownership transfers to the lessee at the end of the lease term, or . . .

A bargain purchase option (BPO) exists, or . . .

The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset, or . . .

The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.

15 - 6
A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured.
The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options . If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply.
For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

15 - 7
The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease:
1.
The collectibility of the lease payments must be reasonably predictable.
2.
If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete.
Lessor = Owner of the property subject to the lease.

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.
• Lease classification rules.
1.
Same as IFRS.
2.
75% or more of assets life.
3.
“Substantially all means 90% or more.
4.
Title transfers.
• Situations that normally would lead to classification as a finance lease are:
1.
Contains a BPO
2.
Term is “major portion” of asset’s life.
3.
PV of MLP greater than
“substantially all” of the fair value of the asset.
4.
Other circumstances impact classification.
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15 - 9
Capital
Lease

15 - 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%.
At End of the Four Payment Dates
San Serif Publishers, Inc. (Lessee)
Prepaid rent
Cash
100,000
100,000
CompuDec Corporation (Lessor)
Cash
Unearned rent revenue
100,000
100,000

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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.

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The amount recorded (capitalized) is the present value of the minimum lease payments.
However, the amount recorded cannot exceed the fair value of the leased asset.
In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of:
1. Its incremental borrowing rate, or
2. The implicit interest rate used by the lessor.

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If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost.
When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price.

•
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 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
$479,079 ÷ 4.79079
* = $100,000 rental payments.
•
First Lease routinely acquires electronic equipment for lease to other firms.
•
The interest rate In these financing arrangements is10%.
$100,000 × 4,79079 * = $479,079 lessee’s cost the transaction must be recorded by the lessee as a capital lease .
• We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a 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.
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15 - 15
Direct Financing Lease (January 1, 2011)
San Serif Publishers, Inc. (Lessee)
Leased equipment (PV of payments)
Lease payable (PV of payments)
479,079
479,079
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)
San Serif Publishers, Inc. (Lessee)
Lease payable
Cash
100,000
100,000
First Lease Corp. (Lessor)
Cash
Lease receivable
100,000
100,000

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Date
1/1/11
1/1/11
12/31/11
12/31/12
12/31/13
12/31/14
12/31/15
Amortization Schedule for the Lease
Payment
$ 100,000
100,000
100,000
100,000
100,000
100,000
$ 600,000
Effective
Interest
$ -
37,908
31,699
24,869
17,355
9,090
$ 120,921
*
Decrease in Outstanding
Balance Balance
$ 100,000
62,092
68,301
75,131
82,645
90,910
$ 479,079
379,079
316,987
248,686
173,554
90,910
-
$ 479,079
* Rounded.
$379,079 × 10% = $37,908
$100,000 - $37,908 = $62,092
$379,079 - $62,092 = $316,987

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Second Lease Payment (December 31, 2011)
San Serif Publishers, Inc. (Lessee)
Interest expense
Lease payable
Cash
37,908
62,092
100,000
First Lease Corp. (Lessor)
Cash
Lease receivable
Interest revenue
100,000
62,092
37,908
Depreciation Recorded at (December 31, 2011)
San Serif Publishers, Inc. (Lessee)
Depreciation expense
Accumulated depreciation
79,847
79,847
($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

15 - 18
Depreciation Period
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 .

15 - 19
If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than the cost of the asset.
At inception of the lease, the lessor will record the Cost of Goods Sold as well as the
Sales Revenue (PV of payments).
In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.

15 - 20
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%.

15 - 21
Lease Classification
1. The lease term (6-years) is equal to 100% of the useful life of the copier, and
2. Fair market value is difference 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,
SO
The 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).

15 - 22
At inception of the Lease – January 1, 2011
CompDec Corp. (Lessor)
Lease receivable
Cost of goods sold
Sales revenue
Inventory of equipment
479,079
300,000
479,079
300,000
Receipt of the First Lease Payment – January 1, 2011
CompDec Corp.(Lessor)
Cash
Lease receivable
100,000
100,000

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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:
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.
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.

15 - 24
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 2015. 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%.
Lessee's calculation of PV of MLP:
PV of periodic payments $ 92,931
Plus: PV of BPO
PV of MLP
60,000
× 4.79079 =
× 0.56447 =
$ 445,211
33,868
$ 479,079
Lessor's calculation of rental payments:
Fair market value of asset
Less: PV of BPO $ 60,000 × 0.56477 =
Amount recoverd through payments
PV annuity due factor, n = 6, I = 10%
Rental payments at beginning of period
÷
$ 479,079
(33,886)
$ 445,193
4.79079
$ 92,927

Date
1/1/11
1/1/11
12/31/11
12/31/12
12/31/13
12/31/14
12/31/15
Payment
$ 92,931
92,931
92,931
92,931
92,931
92,931
$ 557,586
Effective
Interest
$ -
38,615
33,183
27,208
20,636
13,407
$ 133,049
Decrease in Outstanding
Balance Balance
$
59,748
65,723
92,931
54,316
72,295
79,524
$ 424,537
$ 479,079
386,148
331,832
272,084
206,361
134,067
54,542
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Exercise of BPO at the end of the lease term:
$54,542 × 10% = $5,458*
$60,000 BPO payment - $5,458 = $54,542

End of Lease – December 31, 2016
Sans Serif Publishers, Inc. (Lessee)
Depreciation expense ($479,079 ÷ 7)
Accumulated depreciation
Interest expense
Lease payable
Cash (BPO payment)
68,440
68,440
5,458
54,542
60,000
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CompDec Corporation(Lessor)
Cash
Lease receivable
Interest revenue
Refer the amortization schedule and computations on the previous screen
60,000
54,582
5,458

15 - 27
The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term.
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
2015.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%.

15 - 28
Guaranteed 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.
Lessee's calculation of PV of MLP:
PV of periodic payments $ 92,931
Plus: PV of residual value 60,000
PV of MLP
× 4.79079 = $ 445,211
× 0.56447 = 33,868
$ 479,079
PV factor of an annuity due of $1: n=6, i=10%
PV factor of $1: n=6, i=10%

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Unguaranteed 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.

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

15 - 31
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
Cost of goods sold
Sales revenue
Inventory of equipment
479,079
300,000
479,079
300,000

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First Lease Payment – January 1, 2011
San Serif Publishers, Inc. (Lessee)
Lease payable 92,931
Cash 92,931
CompDec Corporation (Lessor)
Cash
Lease receivable
92,931
92,931

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December 31, 2015
San Serif Publishers, Inc. (Lessee)
Depreciation expense 68,847
Accumulation depreciation 68,847
Recorded cost of leased asset
Guarantted residual value
Basis for depreciation
Useful life in years
Annual depreciation
÷
$ 479,079
(60,000)
419,079
6
$ 69,847
Interest expense
Lease payable
Cash
13,407
79,524
92,931
CompDec Corporation (Lessor)
Cash
Interest revenue
Lease receivable
92,931
13,407
79,524
See amortization schedule

Lessor
Computation of Minimum Lease
Lease Payment Payment Residual value in leased asset?
Lessee gets the residual value (by transfer of title or a BPO)
Lessor get the residual value (title does not
No transfer; no BPO)
Residual value is not guaranteed.
Yes
Residual value is guaranteed by lessee.
Yes
Residual value is guaranteed by a third party.
Yes
No
No
Yes
Yes
No
No
Yes
No
Lessee
Minimum Lease
Payment
15 - 34

15 - 35
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:
Sans Serif Publishers, Inc. (Lessee)
Maintenance expense 2,000
Cash 2,000

15 - 36
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.

15 - 37
Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.
• Operating Leases − Capitalize and amortize over the lease term by the lessor.
• Direct Financing Leases − Include as part of investment balance.
• Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.

15 - 38
Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs.
Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

15 - 39
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.

15 - 40
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.

15 - 41
Lease transactions impact several financial ratios
1.
Debt to equity ratio – Lease liabilities are recorded.
2.
Rate of return on assets – Lease assets are recorded.
Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

15 - 42
1.
Sale-Leaseback Arrangements – 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.
2.
Real Estate Leases :
• Leases of Land Only
• Leases of Land and Building
• Leases of Only Part of a Building
3.
Leveraged Leases – a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment.