Chapter 21
Accounting For Leases
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation
by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under license.
2
Definition of Lease
A lease is an agreement between a
lessor and a lessee that conveys to the
lessee the right to use specific
property, real or personal, owned by
the lessor, for a stated period of time.
In return for this right, the lessee
agrees to make periodic cash
payments to the lessor.
3
Advantages of Leasing from
Lessee’s Viewpoint
 Financial benefits
 Risk benefit
 Tax benefit
 Financial reporting
benefit-no liability
recorded
 Billing benefit-pass
through on contracts,
including interest
4
Advantages of Leasing from
Lessee’s Viewpoint
Financial Benefits
 The lease provides 100% financing, so that the
lessee acquires the asset without having to make a
down payment.
 The lease contract contains fewer restrictive
provisions and is more flexible than other debt
agreements.
 The leasing arrangement creates a claim that is
against only the leased equipment and not against
all assets.
5
Advantages of Leasing from
Lessee’s Viewpoint
Financial Reporting Benefit
Companies A and B have identical financial
data:
Current assets
$2,100,000
Noncurrent assets
2,900,000
Current liabilities
1,000,000
Noncurrent liabilities
1,600,000
Stockholders’ equity
2,400,000
Continued
6
Advantages of Leasing from
Lessee’s Viewpoint
On December 31, 2007, A Company
purchases equipment with a 10-year life, at a
cost of $2,825,112, by signing a 10-year, 12%
note requiring $500,000 to be paid at the end
of each year beginning December 31, 2008.
Before Acquisition Current Ratio:
$2,100,000
= 2.10
$1,000,000
7
Advantages of Leasing from
Lessee’s Viewpoint
On December 31, 2007, A Company
purchases equipment with a 10-year life, at a
cost of $2,825,112, by signing a 10-year, 12%
note requiring $500,000 to be paid at the end
of each year beginning December 31, 2008.
After Acquisition Current Ratio:
$2,100,000
= 1.45
$1,446,429
Continued
8
Advantages of Leasing from
Lessee’s Viewpoint
On December 31, 2007, B Company leases
similar equipment to that leased by A
Company, agreeing to pay $500,000 rent each
year for the next 10 years. Assuming 12%
interest, the present value of the lease is
$2,825,112 ($500,000 x 5.650223).
Before
AfterAcquisition
Acquisition Current
Current Ratio:
Ratio:
The ratio$2,100,000
of
debt to stockholders’
$2,100,000
equity would remain =
at=2.10
1.08-to-1.
2.10
$1,000,000
$1,000,000
9
Advantages of Leasing from
Lessee’s Viewpoint
On December 31, 2007, A Company
purchases equipment with a 10-year life, at a
cost of $2,825,112, by signing a 10-year, 12%
note requiring $500,000 to be paid at the end
of each year beginning December 31, 2008.
The ratio of debt to stockholders’ equity
$2,600,000
$5,425,112
would increase
from 1.08
before acquisition
= 2.26
= 1.08
$2,400,000 to 2.26 after acquisition.
$2,400,000
Continued
10
Advantages of Leasing from
Lessee’s Viewpoint
Current liabilities-LEASE
$1,000,000
Plus: Noncurrent liabilities
1,600,000
Equals:
$2,600,000
Divided by: Stockholders’ equity 2,400,000
Equals: Debt to Equity ratio
1.08
Current liabilities-PURCHASE $1,500,000
Plus: Noncurrent liabilities
3,925,112
Equals:
$5,425,112
Divided by: Stockholders’ equity 2,400,000
Equals: Debt to Equity ratio
2.26
11
Key Terms Related to Leasing
Bargain purchase option
Bargain renewal option
Estimated economic life
of leased property
Estimated residual value
of leased property
Executory costs
Fair value of leased
property
Guaranteed residual
value
Inception of the lease
Initial direct costs
FASB Statement No. 13
as Amended and
interpreted defines a
number of lease terms.
There’s more.
12
Key Terms Related to Leasing
Interest rate implicit in the lease
Lease term
Lessee’s incremental borrowing rate
Manufacturer’s or dealer’s profit or loss
Minimum lease payments- present value
Minimum lease payments receivablegross
Unguaranteed residual value
Unreimbursable cost
13
Classification of Leases
Involving Personal Property
A capital lease
meets one or
more of Column An operating lease
does not meet any of
A criteria.
the Column A
criteria.
Classification by
the Lessee
14
Classification of Leases
Involving Personal Property
A sales-type lease must meet
It must involve a transaction giving
one or more of the criteria
rise to a manufacturer’s or dealer’s
listed in Column A and both
profit or loss to the lessor.
criteria listed in Column B.
Classification by
the Lessor
Sale-type lease
15
Classification of Leases
Involving Personal Property
A direct financing lease must
or moreaoftransaction
the
It meet
must one
not involve
criteria
listed
Column A and or
giving rise
toin
a manufacturer’s
both
criteria
in Column
dealer’s
profitlisted
or loss
to the lessor.
B.
Classification by
the Lessor
Direct financing
lease
16
Classification of Leases
Involving Personal Property
An operating lease meets none of the
criteria in Column A or does not
meet both criteria in Column B.
Classification by
the Lessor
Operating lease
17
Operating Lease (Lessee)
As an operating lease, User Company simply
records the annual payment as a rent.
Rent Expense
Cash
50,000
50,000
If User Company prepares quarterly interim
statements, it reports the unexpired portion of
the expense as an asset.
18
Minimum Lease Payments
The term “minimum lease
payments” includes the
present value of
1. Minimum rental payments.
2. Guaranteed residual value.
3. Amount payable for failure to
renew.
4. Any bargain purchase option.
Ignore residual, if there is a
bargain purchase option.
19
Capital Lease (Lessee)
The Martin Company (lessee) and the
Gardner Company (lessor) sign a
lease agreement dated January 1,
2007, that provides for the Martin
Company to lease a piece of
equipment beginning on January 1,
2007.
20
Capital Lease (Lessee)
Is this a capital lease? To
check your response, click
Martin
(lessee) and the
theThe
button
in the Company
corner.
Gardner Company (lessor) sign a
lease agreement dated January 1,
2007, that provides for the Martin
Company to lease a piece of
equipment beginning on January 1,
2007.
Wait
21
Capital Lease (Lessee)
Initial Recording of Capital Lease on January 1, 2007
Leased Equipment
Capital Lease Obligation
100,000.00
100,000.00
12% x $100,000
December 31, 2007
Interest Expense
Capital Lease Obligation
Cash
12,000.00
20,923.45
Continued
$32,923.45 - $12,000.00
32,923.45
22
Capital Lease (Lessee)
$100,000 ÷ 4
Recognition of Depreciation, December 31, 2007
Depreciation Expense: Leased
Equipment
25,000.00
Accumulated Depreciation:
Leased Equipment
25,000.00
Second Annual Payment, December 31, 2008
$79,076.55
x
Interest Expense
9,489.19
.12
Capital Lease Obligation
23,434.26
Cash
32,923.45
$32,923.45 - $9,489.19
The depreciation entry on Dec. 31, 2008, again would be for $25,000.
23
Capital Lease (Lessee)
Assume that Martin
Company
required
…and thatisthe
cost to
make
lease
payments
and
fair
value
of the in
advance on
equipment
is January
$112,000.1 of
each year,...
Present value of
four payments of
$32,923.45 in
advance at 12% = $32,923.45 x
3.401831
= $112,000
24
Capital Lease (Lessee)
Initial Recording of Capital Lease on Jan. 1, 2007
Leased Equipment
112,000.00
Capital Lease Obligation
112,000.00
First Payment in Advance, January 1, 2007
Capital Lease Obligation
32,923.45
Cash
32,923.45
Continued
25
Capital Lease (Lessee)
Recognition of Depreciation, December 31, 2007
Depreciation Expense: Leased
Equipment
28,000.00
Accumulated Depreciation:
Leased Equipment
28,000.00
Recognition of Interest Expense, $112,000
December
÷ 31,
4 2007
Interest Expense
9,489.19
Accrued Interest on Capital
Lease Obligation
9,489.19
$79,076.55 x 0.12
Continued
26
Capital Lease (Lessee)
Second Annual Payment in Advance, January 1, 2008
Accrued Interest on Capital
Lease Obligation
Capital Lease Obligation
Cash
9,489.19
23,434.26
32,923.45
Recognition of Depreciation, December 31, 2008
Depreciation Expense: Leased
Equipment
28,000.00
Accumulated Depreciation:
Leased Equipment
28,000.00
27
Bargain Purchase Option
Redd Company leases equipment for 4
years and agrees to pay $2,000 at the end
of the fourth year to purchase the asset.
Yes…because
of as
thea
Does
Redd is reasonably assured that
it this
will qualify
purchase
capital
lease?option.
exercise the option. Redd’s bargain
incremental
borrowing rate is 11% and the lessor’s
implicit interest rate is 10%. The cost and
fair value of the equipment is $128,160.63.
28
Bargain Purchase Option
The minimum lease payments, based on the
lower 10% rate, is calculated as follows:
Present value of the annual payments discounted
at 10% ($40,000 x 3.169865)
$126,794.60
Add: Present value of the single sum of $2,000
(the bargain purchase option) discounted at
10% ($2,000 x 0.683013)
Present value of the minimum lease payments
Leased Equipment
Capital Lease Obligation
1,366.03
$128,160.63
128,160.63
128,160.63
29
Guaranteed Residual Value
Karpas Company leases
equipment for 4 years that cost
the lessor $147,284.99 (its fair
value) and agrees to pay an
annual rent of $40,000 at the end
of each year. Karpas Company
agrees to guarantee the
estimated residual value of
$30,000 at the end of the fourth
year. Assume a 10% interest
rate.
30
Guaranteed Residual Value
Leased Equipment Under
Capital Leases
147,284.99
At the end of the lease, both
parties agree that the
equipment is worth only
$20,000, but the guaranteed
residual was $30,000.
Accumulated Depreciation:
Leased Equipment
117,284.99
117,284.99
Obligation Under
Capital Leases
30,000.00
Accumulated Depreciation: Leased Equip. 117,284.99
Capital Lease Obligation
30,000.00
Loss on Disposal of Leased Equipment
10,000.00
Leased Equipment
147,284.99
Cash
10,000.00
31
Guaranteed Residual Value
If the fair value is more than
$30,000, the lessee pays the
liability in full by returning the
asset to the lessor.
32
Cost Given-Find Rental
Payments
On January 1, 2007, Brahms Inc. leases
equipment with a fair value of $100,000, an
economic life of four years and a lease term of
three years. Brahms incremental borrowing rate
is 10%. There is a bargain purchase option at that
time of $10,000. The first payment is due
immediately. Find the payment and the amount
to be capitalized.
33
Cost GivenFind Rental Payments
Cost or fair value of leased asset
(amount capitalized if residual guaranteed)
Less: Present value of residual or bargain purchase
Yields: Present value to be recovered through rental
payments
(amount capitalized if residual unguaranteed)
Find: Lease payment for principal and interest
Plus: Executory costs (not present valued)
Equals: Minimum rental payment
(regardless of whether residual guaranteed)
34
Cost GivenFind Rental Payments
Cost or fair value of leased asset
$100,000
(amount capitalized if residual guaranteed)
Less:
Present value of residual or bargain purchase 7,513
Yields: Present value of rental payments
$92,487
(amount capitalized if residual unguaranteed)
Find: Lease payment for principal and interest
33,809
Plus:
Executory costs (not present valued)
0
Equals: Minimum rental payment
(regardless of whether residual guaranteed) $33,809
35
Lessee Schedule-Lessee
Annual
Payment
Interest
Expense
1/1/07
1/1/07
$33,809
0
1/1/08
33,809
6,619
1/1/08
33,809
3,900
12/31/08
10,000
908
Lessor’s
Receivable $111,427
Lessor’s unearned interest $11,427
Reduction of
Lease
Obligation Obligation
$100,000
$33,809
66,191
27,190
39,001
29,909
9,092
9,092
0
The lessor’s schedule will have the same numbers as
the lessee’s schedule with a guaranteed residual.
36
Payments GivenFind Amount to be Capitalized
On January 1, 2007, Rutter Inc. enters into a
lease agreement, which qualifies as a capital
lease. Their borrowing rate is 10%, the lease
term is three years, the residual value is
$5,000, and executory costs are $2,000 per
year. The first payment of $37,182.62 is due
immediately. How much should Rutter
capitalize if
(1) the residual value is not guaranteed, and
(2) the residual value is guaranteed?
37
Payments GivenFind Amount to be Capitalized
Minimum rental payment
Less: Executory costs (not present valued)
Yields: Lease payment for principal and interest
Gives: Present value to be recovered through rental payments
(amount capitalized if residual unguaranteed)
Plus: Present value of residual or bargain purchase
Equals:Amount to be capitalized if residual is guaranteed
38
Payments GivenFind Amount to be Capitalized
Minimum rental payment
$37,182.62
Less: Executory costs (not present valued)
2,000
Yields: Lease payment for principal and interest
$35,182.62
Gives: Present value to be recovered through
rental payments (3 years)
$96,243.46
(amount capitalized if residual unguaranteed)
Plus: Present value of residual or bargain purchase 3,756.55
Equals: Amount to be capitalized if residual
is guaranteed
$100,000
39
Depreciation
1. With a capital lease, the lessee records depreciation using
the firm’s normal depreciation method.
2. Over the economic life if title is transferred or the is a
bargain purchase option.
3. Over the term of the lease if the lease term is equal to 75%
or more of the economic life, or the present value of the
minimum lease payments is at least 90% of the fair value.
4. Any residual (salvage) is ignored if the residual is not
guaranteed.
5. Any residual is not discounted (present valued) if the
residual is guaranteed.
40
Depreciation
In the Brahms example above the lease term was three
years, the economic life was four years and there
was a bargain purchase option.
Amount capitalized less salvage = depreciation
Economic life
$100,000 - $10,000 = $22,500 per year
Four years
41
Depreciation
Assume that there was no bargain purchase option
and the residual was not guaranteed.
Amount capitalized = depreciation
Lease term
$92,487 = $30,829 per year
3 years
42
A leveraged lease is
Lessor’s Classifications
Operating lease
Sales-type lease
Direct financing
lease
Leveraged lease
a special threeparty lease that is
always considered
to be a direct
financing lease.
43
Operating Lease (Lessor)
Owner Company leases a piece of equipment to User
Company for 5 years. User Company agrees to pay
$50,000 at the beginning of each year. Owner
Company purchased the equipment for $300,000.
The equipment has an estimated life of 10 years and
Owner Company uses straight-line depreciation.
Owner pays the annual insurance premium of
$2,000, and on December 15, 2007, it pays for
repairs of $1,500.
None of the criteria in Column A (Example 21-2)
Why
is this this
an operating
lease?
were met;
therefore,
lease should
be treated as
an operating lease.
44
Operating Lease (Lessor)
Purchase of Equipment to Be Leased on Jan. 1, 2007
Equipment Leased to Others
300,000
Cash (or Accounts Payable)
300,000
Collection of Annual Payment on January 1, 2007
Cash
50,000
Rental Revenue
50,000
Payment of Annual Insurance Premium, Jan. 10, 2007
Insurance Expense
2,000
Cash
2,000
Continued
45
Operating Lease (Lessor)
Payment of Repairs on December 15, 2007
Repair Expense
1,500
Cash
1,500
Recognition of Annual Depreciation, Dec. 31, 2007
Depreciation Expense: Equipment
Leased to Others
30,000
Accumulated Depreciation:
Equipment Leased to Others
30,000
46
Direct Financing Leases (Lessor)
Under a direct financing
lease, the lessor “sells”
the asset at no gain or
loss. The net amount at
which the lessor records
the receivable must be
equal to the carrying
value of the property.
The gross receivable of the
lessor includes the sum of-1. The undiscounted
minimum lease payments
to be received by the
lessor (net of executory
costs paid by the lessor)
plus
2. The unguaranteed
residual value accruing to
the benefit of the lessor.
47
Direct Financing Leases (Lessor)
Gardner Company leases equipment to the Martin
Why is
thislease
a is noncancelable
Company for 4 years.
The
direct
financing
and requires equal
payments
of $32,923.45. This
lease?$100,000. There is no
equipment cost Gardner
guaranteed residual value. Martin agrees to pay all
$100,000 ÷ 3.037349
executory costs. The equipment reverts back to
Gardner at the end of 4 years. Martin’s
incremental borrowing rate is 12.5%, while
Gardner’s is 12%. Martin Company uses straightline depreciation. All requirements for Column B
are met.
48
Direct Financing Leases (Lessor)
…(2)
It is aboth
direct
of financing
the criterialease
listed
inbecause
Columnit B
meets
(Example
the three
21-2),
requirements:
and (3) there
(1)isone
no or
more
manufacturer’s
of the itemsorlisted
dealer’s
in
profit.
ColumnSee
A (Exhibit
Example21-2)—
21-7 for
Items
more3 detail.
and 4.
49
Direct Financing Leases (Lessor)
Initial Recording of the Lease on January 1, 2007
Lease Payments Receivable
131,693.80
Equipment
100,000.00
Unearned Interest: Leases
31,693.80
$32,923.45 x 4
Collection of Annual Payment on December 31, 2007
Cash
32,923.45
Lease Payments Receivable
32,923.45
Continued
50
Direct Financing Leases (Lessor)
Recognition of Interest Revenue on Dec. 31, 2007
Unearned Interest: Leases
12,000.00
Interest Revenue: Leases
12,000.00
$100,000 x 0.12
Collection of Annual Payment on Dec. 31, 2008
Cash
32,923.45
Lease Payments Receivable
32,923.45
Recognition of Interest Revenue on December 31, 2008
Unearned Interest: Leases
9,489.19
Interest Revenue: Leases
9,489.19
($100,000 - $20,923.45) x 0.12
51
Direct Financing Leases (Lessor)
Let’s look at a direct
financing lease where the
payments will be received
in advance.
52
Direct Financing Leases (Lessor)
$100,000 X 3.913712
On January 1, 2007, the Watkins Finance
Company leases equipment that cost $391,371.20
(which is also the fair value) to the Hutton
Company. The term of the lease is 5 years, with
annual payments of $100,000 received in advance.
The economic useful life is 5 years. There is no
BPO or guaranteed residual value. The lease
receipts will yield Watkins a 14% return. The
collectibility is reasonably assured, and there are
no uncertainties involved in the lease.
53
Direct Financing Leases (Lessor)
Initial Recording of the Lease on January 1, 2007
Lease Payments Receivable
500,000.00
Equipment
391,371.20
Unearned Interest: Leases
108,628.80
$100,000 x 5
Collection of Annual Payment on January 1, 2007
Cash
100,000.00
Lease Payments Receivable
100,000.00
Continued
54
Direct Financing Leases (Lessor)
Recognition of Interest Revenue on Dec. 31, 2007
Unearned Interest: Leases
40,791.97
Interest Revenue: Leases
40,791.97
$291,371.20 x 0.14
55
Sales Type Leases (Lessor)
Take a moment to examine
the data in the next slide.
Why is this a sales-type
lease? Click on the button to
check your response.
56
Sales Type Leases (Lessor)
($30,000 x 10) + $500
Initial Recording of the Lease on January 1, 2007
Lease Payments Receivable 300,500.00
Unearned Interest: Leases (plug)
110,491.51
Sales Revenue
190,008.49
$30,000 x 6.328250 =$189,847.50
$500 x 0.321973 =
160.99
$190,008.49
Cost of Goods Sold
120,000.00
Merchandise Inventory (or Equipment) 120,000.00
Continued
57
Sales Type Leases (Lessor)
Collection of Annual Payment on January 1, 2007
Cash
30,000.00
Lease Payments Receivable
30,000.00
Recognition of Interest Revenue on December 31, 2007
Unearned Interest: Leases
19,201.02
Interest Revenue: Leases
19,201.02
12% x [($300,500 - $30,000) - $110,491.51]
58
Initial Direct Costs for Lessor
Costs that a lessor would not have incurred if
it had not entered into the lease contract.
Operating lease
Expense in proportion to the
receipts from the lease over
the term of the lease.
Direct financing lease Reduce “Unearned Interest”
and calculate a new (lower)
implicit interest rate.
Sales-type lease
Expense in period of sale.
59
Conceptual Issues
Why would a lessee
or lessor want to
avoid capitalizing a
lease?
The motivation usually
comes from the lessee
who wants to avoid
reporting the liability.
60
Chapter21
Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.
61
The lease meets two of the criteria:
(a) The lease term is 75% or more of
the asset’s economic life and (b) the
present value of the lease payments is
90% or more of the asset’s fair value.
Return
62
Three of four criteria from
Column A (Example 21-7) are met
and both items from Column B,
and there is a manufacturer’s or
dealer’s profit.
Return