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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