1Leases. 2 Describe the circumstances in which leasing makes more business sense than does an...

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LeasesLeases

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Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase.

Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction.

Outline the types of contractual provisions typically included in lease agreements.

Learning Objectives

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Apply the lease classification criteria in order to distinguish between capital and operating leases.

Properly account for both capital and operating leases from the standpoint of the lessee (asset user).

Properly account for both capital and operating leases from the standpoint of the lessor (asset owner).

Learning Objectives

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Learning Objectives

Prepare and interpret the lease disclosures required of both lessors and lessees.

Compare the treatment of accounting for leases in the United States with the requirements of international accounting standards.

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Learning Objectives

Record a sale-leaseback transaction for both a seller-lessee and a purchaser-lessor.

Recognize the special characteristics of real estate leases.

EXPANDED MATERIAL

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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.

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Assets Acquired by Leasing

• Lessee: 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.

• Operating Lease: A simple rental agreement.

• Capital Lease: A leasing transaction that is recorded as a purchase by the lessee.

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Economic Advantages of Leasing

• No down payment.

• Avoid risks of ownership.

• Flexibility.

• No down payment.

• Avoid risks of ownership.

• Flexibility.

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Advantages to Lessor

• Increased sales.

• Ongoing business relationship with lessee.

• Residual valued retained.

• Increased sales.

• Ongoing business relationship with lessee.

• Residual valued retained.

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Lease Provisions

Cancellation Cancellation ProvisionProvision

Cancellation Cancellation ProvisionProvision

Specifies under whatcircumstances the leasemay be canceled.

Lease TermLease TermLease TermLease Term Delineates the time period the lease is to be in force.

Bargain Purchase Bargain Purchase OptionOption

Bargain Purchase Bargain Purchase OptionOption

Grants lessee the right topurchase the asset at the end of the lease term for less than the residual value.

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Lease Provisions

Residual ValueResidual ValueResidual ValueResidual Value Market value of leasedasset at end of lease term.

Rental payment requiredover lease term plus anypayment for residual value.

Minimum Lease Minimum Lease PaymentPayment

Minimum Lease Minimum Lease PaymentPayment

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Lease Classification Criteria

A lease is classified as a capital lease by the lessee if

it is noncancelable and meets any one of the following

criteria:

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The lease transfers ownership of the leased asset to the lessee by the end of the lease term.

The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.

The lease term is equal to 75 percent or more of the estimated economic life of the asset.

The present value of the lease payments at the beginning of the lease is 90 percent or more of the fair market value of the leased asset.

Lease Classification Criteria

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Transfer of Ownership?Transfer of Ownership?Transfer of Ownership?Transfer of Ownership?Yes

Yes

Yes

Yes

Bargain PurchaseBargain PurchaseOption?Option?

Bargain PurchaseBargain PurchaseOption?Option?

No

Term Term >>75% of75% ofUseful Life?Useful Life?

Term Term >>75% of75% ofUseful Life?Useful Life?

No

PV Payment PV Payment >>90%90%of FMV?of FMV?

PV Payment PV Payment >>90%90%of FMV?of FMV?

No

Lease Classification--Lessee

CapitalLease

CapitalLease No

OperatingLease

OperatingLease

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Lease Classification--Lessor

Additional revenue recognition criteria applicable to lessors.

Additional revenue recognition criteria applicable to lessors.

Collectibility of the minimum lease payments is reasonably predictable.

No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.

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Example: 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 (or Lease) Expense 1,000 Cash 1,000To record monthly rent on office building.

Lessee

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Example: 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.

Cash 1,000 Rent Revenue 1,000To record monthly rent on office building.

Lessor

18Operating 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.

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.

19Operating Leases With Varying Lease Payments

Entry Each Year for Years 1 and 2:Rent Expense 210,000

Cash 150,000Rent Payable 60,000

Entry Each Year for Years 3-5:

Rent Expense 210,000Rent Payable 40,000

Cash 250,000

20Interest Rates for DiscountingLease Payments

Implicit Interest Rate: Rate that would be used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease.

Incremental Borrowing Rate: Rate at which lessee could borrow the amount of money necessary to purchase the leased asset.

21Interest Rates for DiscountingLease Payments

Lessor always uses the implicit rate to discount rental payments.

Lessor always uses the implicit rate to discount rental payments.Lessee uses the

lesser of the implicit rate and the incremental borrowing rate.

Lessee uses the lesser of the

implicit rate and the incremental borrowing rate.

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Accounting for Capital Leases

The Lessee

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Example: Leases

• Minimum Payment $1,000/year• Executory Costs $100• Term 10 years• Useful Life of Asset 10 years• Implicit Rate 10%• Incremental Borrowing Rate 12%

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Example: Inception of the Lease

Leased Equipment 6,759Obligations under Capital Leases 6,759

(PV of $1,000 in arrears for 10 years at 10%.)

Lease Expense 100Obligations under Capital Leases 1,000

Cash 1,100

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Example: End of Year 1

Prepaid Executory Costs 100Obligations under Capital Leases 424Interest Expense 576

Cash 1,100

Amortization Expense 615Acc. Amortization 615

(Straight-line amortization of leased asset.)

26Choosing an AmortizationPeriod for Leased Assets

FASB 13 Criterion MetAmortize OverUseful

LifeLeaseTerm

Title passes at end of lease term XLease contains bargain purchase option X

Term of life 75% of asset’s useful life

X

Present value of payments 90% of asset’s fair market value X

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Bargain Purchase Option

Frequently, the lessee is given the option of

purchasing the property in the future at what appears to be

a bargain price.

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Bargain Purchase Option

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.

29Impact of a Capital Lease on Lessee’s Statement of Cash Flows

Operating Activities (indirect)Net income

(includes reduction for Lease interest expenseLease amortization expense)

+ Amortization of leased asset

Investing Activities No impact

Financing Activities Principal portion of lease payment

30Impact of a Capital Lease on Lessee’s Statement of Cash Flows

Operating Activities (direct)

- Lease interest expense

Investing Activities

No impact

Financing Activities

- Principal portion of lease payment

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Accounting for Capital Leases

The Lessor

32Treatment of InitialDirect Costs

Type of Lease Accounting Treatment of Costs

Operating Capitalize and amortize over lease term.

Direct Capitalize and amortize, Financing with unearned interest, over

lease term.Sales-Type Immediately recognize cost as reduction in profits.

33Accounting for DirectFinancing Leases

• Minimum Payment $1,000/year

• Executory Costs $100

• Term 10 years

• Useful Life of Asset 10 years

• Implicit Rate 10%

• Incremental Borrowing Rate 12%

34Example: Direct Financing Lease

Lease Payments Receivable 10,000Equipment Purchased for Lease 6,759Unearned Interest Revenue 3,241

At Inception of Lease:

Cash1,100Lease Payments Receivable1,000Executory Costs100

At Receipt of First Payment:

35Example: Direct Financing Lease

Cash1,100Lease Payments Receivable1,000Deferred Executory Costs100

At End of the First Year:

Unearned Interest Revenue 576Interest Revenue576

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Direct Financing Lease

If the lessor incurs any initial direct costs, those costs are recorded as a

separate asset.

If the lessor incurs any initial direct costs, those costs are recorded as a

separate asset.

37Accounting forSales-Type Leases

• Minimum Payment $1,000/year

• Executory Costs $100

• Term 10 years

• Useful Life of Asset 10 years

• Implicit Rate 10%

• Incremental Borrowing Rate 12%

• Cost of Equipment $5,000

(Continues example introduced in lessee section)

38Sales-Type LeaseTransaction Components

Minimum Lease Payments

Fair Market Value of Leased Asset

$10,000

$ 6,759

$ 3,421Financing Revenue (Interest)

39Sales-Type LeaseTransaction Components

Minimum Lease Payments

Fair Market Value of Leased Asset

$10,000

$ 6,759

Cost of Leased Asset to Lessor$ 5,000

$ 3,421Financing Revenue (Interest)

$ 1,759Manufacturer’s

or Dealer’sProfit

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Sales-Type Lease

Lease Payments Receivable 10,000Unearned Interest Revenue 3,431Sales 6,569

Cost of Goods Sold 5,000Finished Goods Inventory 5,000

To Record the Sale:

To Remove the Inventory and Record Cost:

41Sales-Type Lease With BPO or Guaranteed Residual Value

If the agreement provides for the lessor to receive a lump sum (from a bargain purchase option) at the

end of the lease term or a guaranteed residual value, the

minimum lease payments include these amounts.

If the agreement provides for the lessor to receive a lump sum (from a bargain purchase option) at the

end of the lease term or a guaranteed residual value, the

minimum lease payments include these amounts.

42Sales-Type Lease With BPO or Guaranteed Residual Value

The receivable is increased by the gross amount of the

bargain purchase option or the guaranteed residual value.

The receivable is increased by the gross amount of the

bargain purchase option or the guaranteed residual value.

43Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing Financing Method Method Activities ActivitiesLessee:

Operating lease payments

Capital lease:Lease payments--

interestLease payments--

principalAmortization of

asset

NI - Cash

NI - Cash

- Cash

+ NI No impact

44Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing Method Method ActivitiesLessor:

Operating lease: Initial direct costs (IDC)Amortization of IDCLease receipts

Direct financing lease:Initial direct costsAmortization of IDCLease receipts--interestLease receipts--principal

- Cash+NI No impact

NI + Cash

- Cash+ NI No impact

NI + Cash+ Cash

45Summary of Lease Impact on Statement of Cash Flows

Indirect Direct Investing Method Method ActivitiesLessor:

Sales-type lease:Initial direct costsManufacturer’s or dealer’s profit (net of

IDC)Lease receipts--interestLease receipts--principal

- Cash

- NI No impactNI + Cash

+ NI + Cash

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Sale-Leaseback Transactions

An arrangement whereby one party sells property to a second party, and then the first

party leases the property back is a sale-leaseback transaction.

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Real Estate Leases

Does lease meet criterion

1 and 2?

Does lease meet criterion

1 and 2?

Yes

Is lease for land only or building

only?

Is lease for land only or building

only?

Yes

Capitalize lease if lessee. Report as a

sales-type or a direct financing lease if lessor and supple-

mentary criteria met.

Capitalize lease if lessee. Report as a

sales-type or a direct financing lease if lessor and supple-

mentary criteria met.

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Real Estate Leases

Does lease meet criterion

1 and 2?

Does lease meet criterion

1 and 2?

Yes

Is lease for land only or building

only?

Is lease for land only or building

only?

No Allocate rents to land and building

Allocate rents to land and building

Next slide

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Real Estate Leases

Allocate rent to land and building

Allocate rent to land and building

LandLand BuildingBuilding

Capitalize lease if lessee. Lessor reports a sales-type or a direct financing lease if

supplementary criteria met.

Capitalize lease if lessee. Lessor reports a sales-type or a direct financing lease if

supplementary criteria met.

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Allocate rents to land and building

Allocate rents to land and building

Yes

Real Estate Leases

Does lease meet criterion

1 and 2?

Does lease meet criterion

1 and 2?

Is land more than 25% of total value?

Is land more than 25% of total value?

No

Next slide

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Real Estate Leases

Allocate rent to land and building

Allocate rent to land and building

BuildingBuilding LandLand

Does lease meet criterion

3 or 4?

Does lease meet criterion

3 or 4?

Yes

Capitalize lease (lessor must

meet supplementary

criteria).

Capitalize lease (lessor must

meet supplementary

criteria).

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Real Estate Leases

Allocate rent to land and building

Allocate rent to land and building

BuildingBuilding LandLand

Does lease meet criterion

3 or 4?

Does lease meet criterion

3 or 4?

NoOperating leaseOperating lease

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Real Estate Leases

Does lease meet criterion

1 and 2?

Does lease meet criterion

1 and 2?

Is land more than 25% of total value?

Is land more than 25% of total value?

No

NoDoes lease

meet criterion 3

or 4?

Does lease meet

criterion 3 or 4?

No

Operating leaseOperating lease

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Real Estate Leases

Does lease meet criterion

1 and 2?

Does lease meet criterion

1 and 2?

Is land more than 25% of total value?

Is land more than 25% of total value?

No

NoDoes lease

meet criterion 3

or 4?

Does lease meet

criterion 3 or 4?

Yes

Capitalize lease (lessor must meet supplementary criteria).

Capitalize lease (lessor must meet supplementary criteria).

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The EndThe End