1 1.Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2.Understand the accounting issues faced

1

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.

Leases - Learning Objectives

2

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).

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

Learning Objectives

3

LeaseLease

A lease is 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:– Lessee - he 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.

4

Advantages of Leasing

• No down payment

• Avoid risks of ownership

• Flexibility

• No down payment

• Avoid risks of ownership

• Flexibility

• Increased sales

• Ongoing business relationship with lessee

• Residual valued retained

• Increased sales

• Ongoing business relationship with lessee

• Residual valued retained

To the Lessee To the Lessor

5

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.

ContinuedContinuedContinuedContinued

6

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.


7

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


8

Simple Example

Has effective ownership passed?

Does Owner Company have any significant responsibility remaining?

Is Owner Company reasonable certain that they five annual payments can be collected?


9

Simple Example

Scenario 1Scenario 1

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.

Even though this is a leasing arrangement, the transfer of title at

the end indicates that this is in substance a purchase.


10

Simple Example


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 arrangement is in substance a purchase.

Offering the equipment to User Company for a bargain price at the end of the lease indicates that

this arrangement is in substance a purchase.ContinuedContinuedContinuedContinued

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Simple Example


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 the asset and the term of the lease are identical, this arrangement

is in substance a purchase.

Because the life of the asset and the term of the lease are identical, this arrangement

is in substance a purchase.


12

Simple Example


The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date.

When the present value of the lease payments is close to the market value of the leased item, the arrangement is

in substance a purchase.

When the present value of the lease payments is close to the market value of the leased item, the arrangement is

in substance a purchase.

The exact rules will be discussed later in this chapter.

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Simple Example

Capital leases are accounted for as if the lease agreement

transfers ownership of the asset from the lessor to the lessee.

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.

Operating leases are accounted for as rental

agreements, with no transfer of effective ownership

associated with the lease.

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Nature of Leases

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

Rental payment requiredover lease term plus anypayment for residual value as well as any bargain purchase option.

Minimum Lease Minimum Lease PaymentPayment

Minimum Lease Minimum Lease PaymentPayment

Nature of Leases

Payments for insurance, maintenance and taxes incurred for the leased property

Executory CostsExecutory CostsExecutory CostsExecutory Costs

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Minimum Lease PaymentMinimum Lease PaymentMinimum Lease PaymentMinimum Lease Payment

Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed

a residual value of $10,000 by the lessee.

Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed

a residual value of $10,000 by the lessee.

Minimum lease payments:Rental payments ($3,000 – $500) x 36

$ 90,000Guaranteed residual value

10,000Total minimum lease payment

$100,000


Nature of Leases

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Minimum Lease Payment Computation

Present value of 36 monthly paymentsof $2,500 at 1% interest paid at theend of the month:PMT = $2,500, N = 36, I = 1%

$75,269Present value of $10,000 guaranteed

residual value at the end of 10 years

at 12% compounded monthly:FV = $10,000, N = 36, I = 1%

6,989

Present value of minimum lease payment $82,258

Assuming an implicit rate of 1% per month:

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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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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 percent 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 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

OperatingLease

OperatingLeaseNo

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Lease Classification—Lessor

Additional revenue recognition criteria applicable to lessors.

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.

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Exhibit 15-2

Exhibit 15-2 in the textbook provides four lease provision

situations. We will go through Lease 1 together.

Exhibit 15-2 in the textbook provides four lease provision

situations. We will go through Lease 1 together.

Understanding the lease classification criteria is

important. We strongly urge you to analyze Lease 2

through Lease 4.

Understanding the lease classification criteria is

important. We strongly urge you to analyze Lease 2

through Lease 4.


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Lease 1

LesseeLessee

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 Does the lease transfer ownership at the end of the lease term?the end of the lease term?

Does the lease transfer ownership at Does the lease transfer ownership at the end of the lease term?the end of the lease term?

No! So, we move to Criteria 2.


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Lease 1

LesseeLessee

Does the lease contain a bargain Does the lease contain a bargain purchase option?purchase option?

Does the lease contain a bargain Does the lease contain a bargain purchase option?purchase option?

No! So, we move to Criteria 3.


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Lease 1

LesseeLessee

Is the lease term equal to 75 percent or more Is the lease term equal to 75 percent or more of the estimated economic life of the asset?of the estimated economic life of the asset?Is the lease term equal to 75 percent or more Is the lease term equal to 75 percent or more of the estimated economic life of the asset?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.


26

Lease 1

LesseeLessee

Does the present value of the lease Does the present value of the lease payments equal 90 percent or more of the payments equal 90 percent or more of the

fair market value of the leased asset?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.


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• 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.

Lease 1


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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 (if known) and the

incremental borrowing rate.

Lessee uses the lesser of the implicit rate (if

known) and the incremental

borrowing rate.

Lease 1


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Lease 1

LesseeLessee





No, the lessee only knows the incremental borrowing rate, which provides a present value

of less than 90 percent.


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The lessor answered negatively to the first three

criteria, so let’s analyze the fourth criteria.

The lessor answered negatively to the first three

criteria, so let’s analyze the fourth criteria.


Lease 1

LessorLessor

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Lease 1

LessorLessor

In addition to meeting at least one of the four

criteria, the lessor must meet both of a second set of

criteria.

In addition to meeting at least one of the four

criteria, the lessor must meet both of a second set of

criteria.


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Lease 1

LessorLessor

Is the collectibility of the minimum lease Is the collectibility of the minimum lease payment reasonably predictable?payment reasonably predictable?

Is the collectibility of the minimum lease Is the collectibility of the minimum lease payment reasonably predictable?payment reasonably predictable?


AND

Are there important uncertainties Are there important uncertainties surrounding the amount of surrounding the amount of

unreimbursable costs yet to be incurred unreimbursable costs yet to be incurred by the lessor?by the lessor?

Are there important uncertainties Are there important uncertainties surrounding the amount of surrounding the amount of

unreimbursable costs yet to be incurred unreimbursable costs yet to be incurred by the lessor?by the lessor?

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Lease 1

LessorLessor

Collectibility is predictable and there are no important

uncertainties about reimburseable cost…

Collectibility is predictable and there are no important

uncertainties about reimburseable cost…

…so this is a capital lease to the lessor and an

operating lease to the lessee.

…so this is a capital lease to the lessor and an

operating lease to the lessee.

34Accounting for Operating LeasesAccounting for Operating Leases—Lessee—Lessee

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 1,000 Cash 1,000

35Operating Leases With Varying Operating Leases With Varying Lease PaymentsLease 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.


36

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

Operating Leases With Varying Operating Leases With Varying Lease PaymentsLease Payments

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Accounting for Capital Leases

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Minimum payment (in advance)including $5,000 executory costs $65,000/year

Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%


LesseeLessee


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Leased Equipment 250,192 Obligations under Capital Leases 250,192


Entries on January 1, 2005Entries on January 1, 2005

Lease Expense 5,000Obligations under Capital Leases 60,000

Cash65,000

PMT = PMT = $60,000;

$60,000; N = 5; N = 5;

I = 10%I = 10%

PMT = PMT = $60,000;

$60,000; N = 5; N = 5;

I = 10%I = 10%


40


Entries on December 31, 2005Entries on December 31, 2005

Amortization Expense on LeasedEquipment 50,038

Accumulated Amortization on Leased Equipment50,038

Prepaid Executory Costs 5,000Obligations under Capital Leases 40,981Interest Expense 19,019

Cash65,000

($250,192 ($250,192 – $60,000) x 10%– $60,000) x 10%

41Accounting for Leases With a 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.

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.

BARGAIN DEAL



Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 10 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Bargain purchase option $75,000

LesseeLessee



Minimum Lease PaymentMinimum Lease PaymentMinimum Lease PaymentMinimum Lease Payment

Present value of five payments at the beginning of each year for five years:PMT = $60,000, N = 5, I = 10%

$250,192Present value of the bargain purchaseoption 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



Entries on December 31, 2009Entries on December 31, 2009

Obligations under Capital Leases 68,182Interest Expense 6,818

Cash75,000Equipment 148,381

Accumulated Amortization onLeased Equipment 148,380

Leased Equipment296,761

$$68,18

2 x 10

%

68,18

2 x 10

%

$$68,18

2 x 10

%

68,18

2 x 10

%($296,761

($296,761 ÷ 10) x 5

÷ 10) x 5

yearsyears

45Treatment of Leases on Lessee’s Statement of Cash Flows

Operating Activities (indirect)Net income

(includes reduction for Lease interest expense)

+ Amortization of leased asset

Investing Activities No impact

Financing Activities Principal portion of lease payment


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Operating Activities (direct)

- Lease interest expense

Investing Activities

No impact

Financing Activities

- Principal portion of lease payment

Treatment of Leases on Lessee’s Statement of Cash Flows

47

Accounting for Leases

The Lessor

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Type of Lease Accounting Treatment of Costs

Operating Capitalize and amortize over lease term.

Capital (Direct Capitalize and amortize, financing) with unearned interest, over

lease term.Capital (Sales Immediately recognize cost

– -type) as reduction in profits.

Accounting for Leases—Lessor

49Accounting for Operating Leases—Lessor


Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 10 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Cost to lessor $400,000Direct costs incurred $15,000


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Deferred Initial Direct Costs 15,000Cash 15,000

At Inception of Lease (1/01/05):

Cash 65,000Rent Revenue 60,000Executory Costs (contra effect) 5,000

At Receipt of First Payment (1/01/05:

Accounting for Operating Leases—Lessor


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Amortization of Initial Direct Costs 3,000Deferred Initial Direct Costs 3,000

At End of the First Year (12/31/05):

Depreciation Expense on Leased Equipment 40,000

Accumulated Depreciation on Leased Equipment 40,000

Accounting for Operating Leases—Lessor

ContinuedContinuedContinuedContinued$400,000 ÷ 10$400,000 ÷ 10

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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.

Accounting for a direct financing lease for lessors is

similar to that used for capital leases by the lessee—

only in reverse.

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Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Cost and fair market value of equipment $250,192



54


Lease Payments Receivable 250,192 (net)Equipment Purchased for Lease 250,192


Cash 65,000Lease Payment Receivable 60,000Executory Costs 5,000

At Receipt of First Payment (1/01/05):


55


Cash 65,000Lease Payment Receivable 40,981Interest Revenue 19,019Deferred Executory Costs 5,000

At End of First Year (12/31/05):

A liability

56Direct Financing Lease With Residual Value


Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value (end of lease) $75,000Implicit Rate 10%Incremental Borrowing Rate 10%Cost and fair market value of equipment $296,761



Lease Payments Receivable 296,761Equipment Purchased for Lease 296,761



At Receipt of First Payment (1/01/05):



Cash 65,000Lease Payment Receivable 36,324Deferred Executory Costs 5,000Interest Revenue 23,676

At End of First Year (12/31/05):

Equipment 75,000Lease Payment Receivable 68,182Interest Revenue 6,818

At End of Lease Term (12/31/09):

59Sales-Type LeaseTransaction Components

Minimum Lease Payments

Fair Market Value of Leased Asset

Cost of Leased Asset to Lessor

Manufacturer’s or Dealer’s

Profit

Financing Revenue (Interest)


Minimum Lease Payments

Fair Market Value of Leased Asset

Cost of Leased Asset to Lessor

Manufacturer’s or Dealer’s

Profit

Financing Revenue (Interest)

($65,000 – $5,000) x 5 = $300,000

$250,192

$49,808

$175,000$75,192


Lease Payment Receivable 250,192Sales 250,192

At Beginning of First Year (1/01/05):

Cost of Goods Sold 175,000Finished Goods Inventory 160,000Deferred Initial Direct Costs 15,000


62Sales-Type Lease With BPO or Guaranteed Residual Value

Reminder - 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. Also, the receivable is increased by the gross amount of the bargain purchase option

or the guaranteed residual value.

Reminder - 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. Also, the receivable is increased by the gross amount of the bargain purchase option

or the guaranteed residual value.

63Summary 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


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


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

66

Other issues:

• For Lessee, see page 949-950

• For Lessor, see page 951

Disclosure Requirements for Leases

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.

Documents

1 1.Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2.Understand the accounting issues faced