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Patricia Zima, CA Mohawk College of Applied Arts and Technology

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1 Patricia Zima, CA Mohawk College of Applied Arts and Technology
Chapter Leases Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology

2 Leases Leasing Basics The leasing environment
Conceptual nature of a lease Lessee accounting for a capital lease Lessee accounting and reporting for an operating lease Capital and operating leases compared Introduction to lessor accounting Lessor accounting for a direct financing lease Lessor accounting for a sales-type lease Lessor accounting and reporting for an operating lease Lease Complexities Residual values Bargain purchase options Lessor’s initial direct costs Current versus non-current classification Unsolved problems Illustrations of Lease Arrangements Harmon, Inc. Arden’s Oven Corp. Mendotta Truck Corp. Appleland Computer Perspectives Reporting and disclosures: lessee Reporting and disclosures: lessor International Appendix 20A- Other Lease Issues Sale and leaseback transactions Real estate leases

3 Leasing: Basics The lease is a contractual agreement between the lessor and the lessee The lease gives the lessee the right to use specific property (owned by the lessor) The lease specifies also the duration of the lease and rental payments The obligations for taxes, insurance, and maintenance (executory costs) may be assumed by the lessor or the lessee or divided

4 Advantages of Leasing 100 percent financing at a fixed rate
No down payment required Rate charged is fixed for the term of the lease Protection from obsolescence Property can be upgraded Flexibility Lease may be structured to meet different needs (e.g., cash flow) Less costly financing (lessee); tax incentives (lessor) Off-balance sheet financing Impact on ratios

5 Conceptual Nature of Lease
Do not capitalize any leased assets – an executory contract approach Since lessee does not own the property, capitalization is considered inappropriate Since executory contracts are not capitalized, leases should not be either Capitalize leases that are similar to instalment purchases – a whole asset approach if instalment purchases are capitalized, so should leases with similar characteristics Capitalize all long-term leases – a right of use approach The long-term right to use property justifies its capitalization

6 Current Accounting Standard
CICA standard is consistent with approach similar to instalment purchases A lease that transfers substantially all the benefits and risks of property ownership should be capitalized

7 Current Accounting Standard
Basic Conclusions: Characteristics indicating transfer of substantially all risks and benefits of ownership must be identified Same characteristics should apply to the lessee and lessor Leases that do not transfer substantially all benefits and risks of ownership should not be capitalized

8 Lease Classification Capital Lease
Where the benefits and risks of ownership have effectively been transferred to the lessee Accounted for as a purchase by the lessee Journal Entries: Lessee Lessor Leased Equipment XXX Lease Receivable (net) XXX Lease Obligation XXX Equipment XXX

9 Lease Classification Operating Lease
Where the rights and risks of ownership have not been transferred A rental-only has occurred Journal Entries: Lessee Lessor Rent Expense XXX Cash XXX Cash XXX Rental Income XXX

10 Capital vs. Operating Lease
Lease Agreement Is there a Transfer of Ownership or Bargain Purchase Option? Is Present Value of Payments  90% of Fair Value Is Lease Term  75% of Economic Life No No No Yes Yes Yes Operating Lease Capital Lease

11 Capital Lease Criteria
Handbook section 3065, specifies that if any one of the following criteria met, considered a capital lease: Transfer of ownership or bargain purchase option If lease term is  75% of economic life of leased asset If PV of minimum lease payments (excluding executory costs) is  90% of the fair value of the leased asset

12 Minimum Lease Payments
Minimum lease payments (lessee) defined: Minimum rental payments + Guaranteed residual value + Penalty for not renewing or extending lease + Bargain purchase option Minimum rental payments Regular payment made to lessor, excluding executory costs Executory costs include insurance, maintenance and tax expenses. If these payments made by the lessor, they are estimated and excluded from the PV of minimum rental payment calculation

13 Minimum Lease Payments
Guaranteed residual value The amount at which the lessor has the right to require the lessee to purchase the asset; or The amount the lessee (or 3rd party guarantor) guarantees that the lessor will realize Bargain Purchase Option An option to purchase the leased asset at the end of the lease at a price below expected fair value If included as part of lease, only minimum lease payments and bargain purchase option included in definition of minimum payments

14 Discount Rate The rate the lessee would have incurred if they had borrowed the funds to purchase the asset (incremental borrowing rate) Under similar term (length) and similar security (same type of asset) This rate is not used when The lessee knows the implicit rate that the lessor used to calculate the lease payment, and it is less than the lessee’s incremental borrowing rate In this case, use implicit rate

15 Accounting for a Capital Lease
Asset and liability recorded at the lower of: PV of the minimum lease payments (as defined above) and Fair value of the asset at the inception of the lease Depreciation of the asset is amortized over: The economic life of the asset if ownership transfers to lessee at the end of the lease or there is a bargain purchase option The term of the lease if title does not transfer to the lessee or there is no bargain purchase option

16 Accounting for a Capital Lease
Interest expense resulting from the lease transaction is recorded following the effective interest method The discount rate used to establish the initial PV is used to amortize the lease Each lease payment is allocated between principal and interest Journal entries required to record a capital lease transaction are as follows:

17 Accounting for a Capital Lease
At the inception of the lease Dr. Asset under Capital Lease Cr. Obligations under Capital Lease To record interest Dr. Interest Expense Cr. Interest Payable Using the Effective Interest Method To record asset amortization Dr. Amortization Expense Cr. Accumulated Amortization Using method appropriate to the asset To record the lease payment Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under Capital Lease Cr. Cash

18 Capital Lease - Example
Lease Terms Given: Term of 5 years, non-cancellable Annual payments $25, (due at beginning of each year) Fair value of asset $100,000 Economic life = 5 years Residual value = Zero Lease payments include $2,000 property taxes (executory cost) Lease has no renewal option, and asset reverts to Lessor at termination of lease Lessee’s incremental borrowing rate = 11% Lessor’s implicit rate =10% (known to lessee)

19 Capital Lease - Example
Does this qualify as a capital lease? Only one of the tests must be met Is there a Transfer of Ownership or Bargain Purchase Option? Is Lease Term  75% of Economic Life? Is Present Value of Payments  90% of Fair Value? No PV of payments (n=5, i=10%) 25, = 23, x = $100,000.00 Yes Yes Capital Lease

20 Capital Lease - Example
Entry to record initial lease transaction Equipment under Capital Lease 100,000 Obligations under Capital lease ,000 Entry to record initial payment (Jan 1/08) Property Tax Expense , Obligations under Capital Lease 23, Cash ,981.62 As this is a capital lease the following must also be recorded (at year end or in each reporting period) Interest expense Asset amortization

21 Capital Lease - Example
Record Interest (December 31, 2008) Interest Expense 7, Interest Payable , (100,000-23,981.62)*10% = 7, (Interest Payable is debited in all subsequent lease payment entries) Asset amortization (December 31, 2008) Amortization expense 20,000 Accumulated amortization 20,000 (100,000 / 5 years = 20,000) (There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset)

22 Capital Lease - Example
Financial Statement Presentation (as at December 31, 2008): Balance Sheet Current liabilities Interest payable $7,601.84 Obligations under capital leases 16,379.78 (as per amortization schedule) Non-current liabilities Obligations under capital leases $59,638.60

23 Capital Lease - Example
Lease payment on January 1, 2009 Property Tax Expense 2,000.00 Interest Payable ,601.84 Obligations under Capital Leases 16,379.78 Cash ,981.61

24 Disclosure Requirements – Capital Lease
Gross amount of assets and related accumulated amortization Amortization expense may be disclosed, methods and rate should be disclosed Lease obligations reported separately from other liabilities; also interest rates, expiry dates and any restrictions imposed by lease Current portion of lease obligation=current liability Minimum lease payments in total and for the next five fiscal years; executory costs and imputed interest disclosed separately Interest expense from the lease may be separately disclosed; or included with other interest expense May disclose any related contingencies

25 Operating Leases This is the non-capitalization method used where risks and benefits of ownership of leased assets are not transferred to lessee Lease payments are treated as rent expense Lessees must disclose: Future minimum lease payments, in total and for each of the next five years A description of the nature of any commitments under the lease

26 Accounting by the Lessor
Leases are classified as either: Operating Lease Direct financing Lease Sales-type Lease These are capital leases The determination of a capital or operating lease depends on answering a series of questions

27 Lease Classification - Lessor
Lease Agreement Remaining unreim- burseable costs to Lessor estimatible? Yes Risk associated with collection normal? Yes Does Asset Fair Value = Lessor’s Book Value? Yes Does Lease meet any of Lessee’s Capital Lease criteria? No No No No Yes Operating Lease Sales-Type Lease Direct Financing Lease

28 Lease Classification - Lessor
Both the direct financing lease and the sales-type lease are capital leases The difference is whether or not there exists a manufacturer’s or dealer’s profit The sales-type lease incorporates a profit – hence the final question on the previous map A lease may qualify as a capital lease by the lessee and as an operating lease by the lessor

29 Direct Financing Lease - Lessor
Lessor replaces investment in asset to be leased with a lease receivable Over lease term, the receivable is collected, and interest is earned Net investment in the lease = lease payments receivable – unearned interest income

30 Calculation of Lease Payment by Lessor
Step 1: Calculate the payment required to provide lessor with required rate of return Cost/FMV of asset to be recovered $100,000 Less: PV of expected residual value Amount to be recovered through lease payments $100,000

31 Calculation of Lease Payment (Cont’d)
Amount to be recovered $100,000 Payments: (n=5, i=10) $100,000 = $23,981.62 Lease payments receivable: 5 x $23, = $119,908.10

32 Direct Financing Lease (Lessor)
The lease payments receivable are equal to: Lease payments (net of executory costs) + salvage (residual) value The unearned interest revenue is the difference between the lease payment receivable and the asset cost (FMV) The journal entries are then:

33 Direct Financing Lease (Lessor)
January 1, 2008 Lease Payments Receivable 119, Equipment for Lease 100, Unearned Interest Income 19,908.10 January 1, 2008 (first payment) Cash ($23, $2,000) 25, Property Tax Expense 2, Lease Payments Receivable 23,981.62 December 31, 2008 Unearned Interest Income 7, Interest Income ,601.84

34 Direct Financing Lease (Lessor)
At Dec. 31/08 year end, Lessor recognizes interest earned: Amount originally financed $100,000.00 Paid on principal Jan. 1/ (23,981.62) Balance outstanding $ 76,018.38 Interest : 10% x 76, x 12/12 = $7,601.84 Unearned Interest Income 7,601.84 Interest Income ,601.84

35 Sales-Type Lease - Lessor
Entries are the same as for the direct financing lease, except for: Entry at the inception of the lease must record the sale and cost of goods sold Recall that the sales-type lease includes a manufacturer’s/dealer’s profit margin Lessor earns a gross profit on sale + interest as the sale is financed

36 Sales-Type Lease – Example
Take the same data as in our example, except the asset has been recorded in the Lessor’s inventory at a cost of $85,000 (FMV=$100,000) All previous lessor entries remain the same except for the entry at the lease inception Sales and Cost of Goods Sold are recorded

37 Sales-Type Lease – Example
January 1, 2008 Lease Payments Receivable 119, Sales , Unearned Interest Income , Cost of Goods Sold , Inventory ,000.00 January 1, 2008 (first payment-remains the same) Cash ($23, $2,000) 25, Property Tax Expense , Lease Payments Receivable ,981.62 December 31, 2008 (remains the same) Unearned Interest Income , Interest Income ,601.84

38 Disclosure Requirements - Lessor
Capital Leases Disclose the net investment in the lease (Lease Payments Receivable less Unearned Interest Income), classified as current and non-current on the Balance Sheet How the investment is calculated for purposes of income recognition Finance income amount

39 Disclosure Requirements - Lessor
Operating Leases Separate disclosure of the cost and accumulated amortization of the property Amount of rental (lease) income earned If property taxes, insurance, maintenance and other operating expenses are lessor’s obligation, they are recorded as expenses

40 Other Lease Accounting Issues
Residual Value – Lessor Direct Financing Lease: whether guaranteed or unguaranteed, the residual is included in the lessor calculations Sales-Type Lease: Residual value is part of Sales Revenue (and COGS) if guaranteed with unguaranteed residual value, the Sales Revenue and COGS are reduced by the PV of that unguaranteed residual value The gross profit amount on the sale is the same regardless if residual value is gauranteed or not

41 Other Lease Accounting Issues
Residual Value – Lessee If guaranteed by lessee, PV of residual is included in asset’s cost and lease obligation recognized (i.e. is included in definition of minimum lease payments) If not guaranteed by lessee, residual value is not included in definition of minimum lease payments – i.e. not in asset or liability amounts recognized

42 Other Lease Accounting Issues
Bargain Purchase Option Lessor: With direct financing and sales-type leases, the bargain purchase price is included in the lease payments receivable and the PV of the bargain purchase option is included in net investment calculations Lessee: Lessee accounting assumes bargain option will be exercised PV of option price included in asset cost and obligation recognized

43 Initial Direct Costs of Lessor
Application of Matching Concept Operating lease – over term of lease Direct financing lease – over term of lease Sales-type lease – expensed in the year costs are incurred i.e. in same period as gross profit on sale recognized

44 Current and Noncurrent
Current portion = principal amount to be received/paid within 12 months from balance sheet date + interest accrued to the balance sheet date Long-term = principal amount not recoverable/payable within 12 months from balance sheet date

45 Current and Noncurrent
Example of Lease: Balance of lease on Sept 1, $ 100,000.00 Lease payment on Sept 1, (26,379.73) Interest (at 10%) ,000.00 Balance outstanding on Sept 1, $ 83,620.27 On December 31, 2008 (year end): Reported in Current Liabilities: Principal repaid within 12 months $ 16,379.73 Interest accrued (100,000 x 10% x 4/12) ,333.00 Reported in Long-term Liabilities: Principal not repaid in 12 months $ 83,620.27

46 International No substantial differences between Canadian standards and international standards Some differences follow: No sales-type classification in international standards International standard more principles-based IAS requires lessor to report gross investment and the unearned income reported for finance leases, and additional details about its investment in operating lease assets

47 COPYRIGHT Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

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