StIce | StIce |Skousen
Leases
Chapter 15
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Describe the circumstances in which
leasing makes more business sense than
does an outright sale and purchase.
2. Understand the accounting issues faced
by the asset owner (lessor) and the asset
user (lessee) in recording a lease
transaction.
3. Outline the types of contractual
provisions typically included in lease
agreements.
Learning Objectives
4. Apply the lease classification criteria
in order to distinguish between
capital and operating leases.
5. Properly account for both capital
and operating leases from the
standpoint of the lessee (asset user).
6. Properly account for both capital
and operating leases from the
standpoint of the lessor (asset
owner).
Learning Objectives
7. Prepare and interpret the lease
disclosures required of both lessors
and lessees.
8. Compare the treatment of
accounting for leases in the United
States with the requirements of
International Accounting Standards.
9. Record a sale-leaseback transaction
for both a seller-lessee and a
purchaser-lessor.
Lease
Lease- a contract
specifying the
terms under
which the owner
of an asset agrees
to transfer the
right to use the
asset to another
party.
Parties Involved in a Lease
• Lesse- the party
granted the right to
use the property
under the terms of
a lease.
• Lessor- The owner
of the property that
is rented (leased) to
another party.
Economic Advantages to
Leasing
1. No down payment.
2. Avoid risks of
ownership.
3. Flexibility.
Advantages to the Lessor
• Increased sales.
• Ongoing business relationship
with lessee.
• Residual value retained.
Simple Example
Owner Company owns a piece of
equipment with a market value of
$10,000.
User Company wishes to acquire the
equipment for use in its operations.
Simple Example
One option for User Company is to
purchase the equipment from Owner by
borrowing $10,000 from a bank at an
interest rate of 10%.
Owner would repay
the principal and
interest by making
five annual
payments of
$2,638.
Simple Example
Alternatively, User Company can lease the
asset from Owner Company for five years,
making annual “rental” payments of $2,638.
Buy
$2,638
annually
Lease
$2,638
annually
Simple Example
•
The key accounting issues for Owner
Company:
1. Has effective ownership passed?
2. Does Owner Company have any
significant responsibility remaining?
3. Is Owner Company reasonable certain
that they five annual payments can be
collected?
• The key accounting issue for User
Company:
• Should User recognize the leased
equipment as an asset and a liability to
make the lease payments?
Simple Example
Scenario One
The lease agreement stipulates that Owner
Company is to maintain legal title to the
equipment for the 5-year lease period, but title
is to pass to User at the end of the lease.
Even though this is a leasing arrangement,
the transfer of title at the end indicates that
this is in substance a purchase.
Simple Example
Scenario Two
The lease agreement stipulates that Owner
Company is to maintain legal title to the
equipment for the 5-year lease period, but at
the end of the lease period User has the option
to buy the equipment for $1.
Offering the equipment to User Company for
a bargain price at the end of the lease
indicates that this is in substance a
purchase.
Simple Example
Scenario Three
The useful life of the equipment is just five
years. Accordingly, when the lease term is
over, the equipment can no longer be used by
anyone else.
Because the life of this asset and the lease
term are the same, this arrangement is in
substance a purchase.
Simple Example
Scenario Four
The present value of the lease payments
equals the $10,000 market value of the
equipment on the lease signing date.
Because the life of this asset and the lease
term are the same, this arrangement is in
substance a purchase.
Different Lease Types
• Capital leases are
accounted for as if
the lease agreement
transfers ownership
of the asset from
the lessor to the
lessee.
• Operating leases
are accounted for
as rental
agreements, with
no transfer of
effective ownership
associated with the
lease
Nature of Leases
Cancellation
Provision
Bargain
Purchase Option
Specifies under what
circumstances the lease may be
canceled.
Grants lessee the right to
purchase the asset at the end of
the lease term for less than the
residual value.
Lease Term
Delineates the time period the
lease is to be in force.
Residual Value
Market value of leased asset at
end of lease term.
Minimum Lease
Payment
Rental payment required over
lease term plus any payment for
residual value.
Lease Classification Criteria
A lease is classified as a capital lease by the lessee
if it is non-cancelable and meets any one of the
following criteria:
1. The lease transfers ownership of the leased asset
to the lessee by the end of the lease term.
2. The lease contains an option allowing the lessee to
purchase the asset at the end of the lease term at
a bargain price.
3. The lease term is equal to 75% or more of the
estimated economic life of the asset.
4. The present value of the lease payments at the
beginning of the lease is 90% or more of the fair
market value of the leased asset.
Lease Classification Criteria
Yes
Transfer of Ownership?
No
Yes
Bargain Purchase
Option?
No
Yes
Yes
Capital
Lease
Term >75% of
Useful Life?
No
PV Payment >90%
of FMV?
No
Operating
Lease
Stop and Think
How exactly does
using a higher
incremental
borrowing rate
reduce the
likelihood that a
lessee will be
required to account
for a lease as a
capital lease?
Lease Classification-Lessor
Additional revenue recognition criteria
applicable to lessors.
1. Collectibility of the minimum lease
payments is reasonably predictable.
2. No important uncertainties surround
the amount of unreimbursable costs
yet to be incurred by lessor.
Lease 1
Lessee
This is a test to see if the lease qualifies
as a capital lease. If it doesn’t, then it is
an operating lease.
Does the lease transfer ownership at
the end of the lease term?
No! So, we move to Criteria 2.
Lease 1
Lessee
Does the lease contain a bargain
purchase option?
No! So, we move to Criteria 3.
Lease 1
Lessee
Is the lease term equal to 75 percent or
more of the estimated economic life of
the asset?
No! The 10-year lease covers
approximately 72 percent of the
economic life of the asset. So, we move
to Criteria 4.
Lease 1
Lessee
Does the present value of the lease
payments equal 90 percent or more of the
fair market value of the leased asset?
Before we answer this question, let’s
pause and review two terms related to
interest on a lease.
Lease 1
• Implicit Interest Rate- used to discount the
minimum lease payments to the fair market
value of the leased asset at the inception of
the lease.
• Lessor always uses the implicit rate to
discount rental payments.
• Incremental Borrowing Rate- rate that the
lessee could borrow the amount of money
necessary to purchase the leased asset.
• Lessee uses the lesser of the implicit rate (if
known) and the incremental borrowing rate.
Lease 1
Lessee
Does the present value of the lease
payments equal 90 percent or more of the
fair market value of the leased asset?
No, the lessee only knows the
incremental borrowing rate, which
provides a present value of less than 90
percent.
Lease 1
Lessor
In addition to meeting at least one of the
four criteria, the lessor must meet both of
Thisset
is aofcapital
a second
criteria.
lease to the lessor
Is the collectibility
of the minimum
and an operating
lease payment lease
reasonably
to the predictable
lessee.
AND
Are there important uncertainties
surrounding the amount of unreimbursable
costs yet to be incurred by the lessor?
Operating Lease
Bob Jones signs a two-year lease which
requires a monthly payment of $1,000.
When the lease expires, Bob will either
move out or negotiate a new lease.
Rent Expense
Cash
1,000
1,000
Operating Leases with Varying
Lease Payments
The terms of a lease for an aircraft
by International Airlines provide
for payments of $150,000 a year
for the first two years and
$250,000 for each of the next
three years.
Operating Leases with Varying
Lease Payments
Entry Each Year for Years 1 and 2:
Rent Expense
210,000
Cash
150,000
Rent Payable
60,000
Entry Each Year for Years 3-5:
Rent Expense
Rent Payable
Cash
210,000
40,000
250,000
Accounting for Capital Leases
Minimum payment (in advance)
including $5,000 executory cost
$65,000/year
Lease period (beginning 01/01/07)
5 years
Economic life of asset
5 years
Estimated residual value at end of lease
$0
Implicit Rate
10%
Incremental Borrowing Rate
10%
Accounting for Capital Lease
Entries on January 1, 2007
Leased Equipment
250,192
Obligations under Capital Leases
250,192
Lease Expense
PMT =5,000
$60,000;
N = 60,000
5; I = 10%
Obligations under Capital Leases
Cash
65,000
Accounting for Capital Leases
Entries on December 31, 2007
Amortization Expense on Leased
Equipment
50,038
Accumulated Amortization
on Leased Equipment
50,038
$250,192 ÷–
($250,192
Prepaid Executory Costs
5,000
5 x 10%
$60,000)
Obligations under Capital
Leases
40,981
Interest Expense
19,019
Cash
65,000
Bargain Purchase Option (BPO)
BARGAIN
DEAL
•Frequently, the lessee is given
the option of purchasing the
property in the future at what
appears to be a bargain price.
•The present value of the bargain
purchase option would be added
to the present value of the
minimum lease payments to
establish the initial asset and
liability.
Accounting for Capital Leases
with a BPO
Lessee
Minimum payment (in advance)
including $5,000 executory cost
$65,000/year
Lease period (beginning 01/01/07)
5 years
Economic life of asset
5 years
Estimated residual value at end of lease
$0
Implicit Rate
10%
Incremental Borrowing Rate
10%
Bargain purchasing option
$75,000
Accounting for Capital Leases
with a BPO
Minimum Lease Payment
Present value of five payments at the
beginning of each year for five years:
PMT = $60,000, N = 5, I = 10% $250,192
Present value of the bargain purchase
option of $75,000 at the end of 5 years:
FV = $75,000, N = 5, I = 10%
46,569
Present value of minimum lease payment
$296,761
Accounting for Capital Leases
with a BPO
Entries on December 31, 2012
Obligations under Capital Leases 68,182
Interest Expense
6,818
Cash
75,000
($296,761 ÷ 10)
$68,182
x 5 yearsx
Equipment
148,381
10%
Accumulated Amortization on
Leased Equipment
148,380
Leased Equipment
296,761
Lessee’s Cash Flow Statement
(Indirect) Impact
Operating Activities
Net income
(includes reduction for
Lease interest expense
Lease amortization expense)
+ Amortization of leased asset
Investing Activities
No impact
Financing Activities
Principal portion of lease payment
Lessee’s Cash Flow Statement
(Direct) Impact
Operating Activities
- Lease Interest Expense
Investing Activities
No impact
Financing Activities
- Principal portion of lease payment
Accounting for Leases- Lessor
• Insert exhibit 15-7
Accounting for
Operating Leases
Lessor
Minimum payment (in advance)
including $5,000 executory cost
$65,000/year
Lease period (beginning 1/1/07)
5 years
Economic life of asset
10 years
Estimated residual value at end of lease
$0
Implicit Rate
10%
Incremental Borrowing Rate
10%
Cost to lessor
$400,000
Direct costs incurred
$15,000
Accounting for
Operating Leases- Lessor
At Inception of 1/ 1/07
Deferred initial Direct Costs
Cash
15,000
15,000
At Receipt of First Payment 1/1/07
Cash
Rent Revenue
Executory Costs
65,000
60,000
5,000
Accounting for Operating
Leases- Lessor
At End of the First Year 12/31/2007
Amortization of Initial Direct Costs 3,000
Deferred Initial Direct Costs
Depreciation Expense on Leased
Equipment
40,000
Accumulated Depreciation on
$400,000 ÷ 10
Leased Equipment
40,000
3,000
Direct Financing Lease
Accounting for a direct financing lease for lessors
is similar to that used for capital leases by the
lessee—only in reverse.
Minimum payment (in advance)
including $5,000 executory cost
$65,000/year
Lease period (beginning 1/1/07)
5 years
Economic life of asset
5 years
Estimated residual value at end of lease
$0
Implicit Rate
10%
Incremental Borrowing Rate
10%
Cost and fair market value of equipment $250,192
Accounting for
Direct Financing Leases- Lessor
At Inception of 1/1/07
Lease Payment Receivable
250,192
Equipment Purchased for Lease
250,192
At Receipt of First Payment 1/1/07
Cash
Lease Payment Recievable
Executory Costs
65,000
60,000
5,000
Direct Financing Lease
At End of the First Year 12/31/2007
Cash
Lease Payment Receivable
Interest Revenue
19,019
Deferred Executory Costs
65,000
40,981
5,000
A Liability
Accounting for Direct Financing
Leases with Residual Value
Lessor
Minimum payment (in advance)
including $5,000 executory cost
$65,000/year
Lease period (beginning 1/1/07)
5 years
Economic life of asset
5 years
Estimated residual value at end of lease $75,000
Implicit Rate
10%
Incremental Borrowing Rate
10%
Cost and fair market value of equipment $296,761
Direct Financing Leases with
Residual Value- Lessor
At Inception of 1/1/07
Lease Payment Receivable
296,761
Equipment Purchased for Lease
296,761
At Receipt of First Payment 1/1/07
Cash
Lease Payment Recievable
Executory Costs
65,000
60,000
5,000
Direct Financing Lease with
Residual Value
At End of the First Year 12/31/2007
Cash
65,000
Lease Payment Receivable
36,324
Interest Revenue
23,676
Deferred Executory Costs
5,000
At End of the Lease Term 12/31/2012
Equipment
75,000
Lease Payment Receivable
Interest Revenue
6,818
68,182
Sales-Type Lease
Transaction Components
Minimum Lease Payments
Financing
Revenue
(Interest)
Fair Market Value of Leased Asset
Manufacturer’s
or Dealer’s
Profit
Cost of Leased Asset to Lessor
Sales-Type Lease
Transaction Components
($65,000 – $5,000) x 5 = $300,000
Minimum Lease Payments
Financing
Revenue
(Interest)
$49,808
Fair Market Value of Leased Asset
$250,192
Manufacturer’s
or Dealer’s
Profit
Cost of Leased Asset to Lessor
$175,000
$75,192
Sales-Type Lease
Transaction Components
At Inception of 1/1/07
Lease Payment Receivable
Sales
250,192
250,192
Cost of Goods Sold
175,000
Finished Goods Inventory
160,000
Deferred Initial Direct Costs
15,000
Cash
65,000
Lease Payment Receivable
60,000
Executory Costs
5,000
Sales-Type Lease With BPO or
Guaranteed Residual Value
• The minimum lease payments (to the lessor)
will include the following if they are
included in the agreement:
– A lump sum (from a bargain purchase option) at
the end of the lease term OR
– A guaranteed residual value
• The receivable is increased by the gross
amount of the bargain purchase option or
the guaranteed residual value.
Summary of Lease Impact on
Statement of Cash Flows
Lessee:
Operating lease
payments
Capital lease:
Lease
payments-interest
Lease
payments-principal
Amortization of
asset
Indirect Direct Investing Financing
Method Method Activities Activities
NI
- Cash
NI
- Cash
- Cash
+ NI
No
impact
Summary of Lease Impact on
Statement of Cash Flows
Indirect
Method
Lessor:
Operating lease:
Initial direct costs (IDC)
+NI
Amortization of IDC
NI
Lease receipts
Direct financing lease:
Initial direct costs
+ NI
Amortization of IDC
NI
Lease receipts--interest
Lease receipts--principal
Direct
Investing
Method Activities
- Cash
No impact
+ Cash
- Cash
No impact
+ Cash
+ Cash
Summary of Lease Impact on
Statement of Cash Flows
Indirect
Method
Lessor:
Sales-type lease:
Initial direct costs
Manufacturer’s or
dealer’s profit (net of
IDC)
Lease receipts--interest
Lease receipts--principal
Direct
Investing
Method Activities
- Cash
- NI
NI
+ NI
No impact
+ Cash
+ Cash
Disclosure Requirements for
Leases
• For and operating lease, the lease-related asset
and liability are off the balance sheet items.
• It is important for the financial statement user
to be able to interpret the associated note.
• Lessee is required to provide enough note
disclosure to allow the users to quantify the
magnitude of the operating leases.
• Lessor is required to provide enough disclosure
to allow the financial statement user to figure
out the extent to which lease- related sales and
rentals have impacted the lessor’s financial
statements.
International Accounting
of Leases
• IFRS 17 relies on the exercise of
accounting judgment to distinguish
between operating and capital leases.
• A proposal, titled “Accounting for Leases:
A New Approach,” suggests that all lease
contracts longer than one year be
accounted for as capital leases.
• This proposal is still under discussion.