2What is a Lease?“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”let’s start by just defining a leasea lease is ....so the lessor is the owner of the property and the lessee is the renter that will be entitled to use the property for some period of time in return for rental payments
3Accounting for LeasesBefore 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?before 1976 most companies accounted for leases as straight rental agreementswhich means that as the rental costs were incurred they debited rent expense and credited cashbut over time lease agreements became more and more elaborate and in some cases began to resemble installment purchases of assets as opposed to just straight rental agreementseventually the problem became widespread enough that the FASB decided some action needed to be taken because the above accounting approach was lacking when the rental agreement really was more like and installment purchase than a straight rentalwhy was it viewed as lacking?because under an installment purchase the company is in effect borrowing money to buy an assetbut the above accounting does not reflect the acquisition of an asset or the assumption of a liabilityin other words, simply by structuring a purchase of an asset as a lease agreement a company could finance an asset purchase off-balance sheeti.e. the company would not have to report the obligation or the asseteventually it was decided that leases can be categorized as either straight rental agreements - we call these operating leases or something more similar to a purchase on credit - we call these capital leasesOver time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset
4Classification of Leases What is the economic nature of a capital lease?One that transfers substantially all the risks and benefits of ownership to the lessee.What is the economic nature of an operating lease?more formally however, a capital lease is a lease that transfers substantially all of the risks and benefits of ownership to the lesseein form we have a lease - legal title to the asset has not passed and so some might argue that the lessee should not record an asset or an obligation for the present value of the future lease paymentshowever, in substance the terms of a capital lease provide the lessee with virtually the same risks and benefits that would come with ownershipin addition, the lease commits the lessee to a noncancellable payment for the term of the lease very similar to the commitment the company would face if it had borrowed the money to purchase the assetunder capital lease accounting we treat the lease transaction as though the lessee purchased the asset and borrowed the money to do sowhich means that the lessee is going to record an asset and an obligation at the beginning of the lease termduring the lease term the lessee will recognize interest expense on the lease obligationand will record depreciation expense on the leased assetso capital lease accounting is really an attempt to account for the lease transaction is such a way that the economic substance of the transaction is emphasized over the legal formOne that does not transfer the risks and benefits of ownership to the lessee;a rental agreement
5Accounting for Capital Leases Accounting reflects economic substance, not legal formMake it appear as though company purchased an asset with borrowed fundsan asset and an obligationinterest expense on obligationdepreciation on assetbefore we get into the actual computations let’s just summarize what it is that we will want our capital lease accounting to do for uswe want a capital lease to be accounted for such that it appears that the company purchased an asset and borrowed the funds to do soso at the inception of the lease term we will record an asset and an obligationover the lease term we will record the payments made just like they were loan payments and record interest expense on the obligationfinally the asset acquired will have to be depreciatedremember that the primary objective of capital lease accounting is not to reflect the legal form of the transaction but the economic substance of the transaction
6Is this a Capital Lease? Does it meet ANY ONE of the four criteria? Lease transfers ownership of assetautomatically by end of lease term orthrough a bargain purchase optionLease term is at least 75% of asset’s estimated economic lifePV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease termthe first question we need to ask ourselves is, is this a capital leasedoes it meet any of our four criteria?it meets none of them until we hit the last onethe present value of the minimum lease payments is greater than 90% of fair valuein fact in this case it’s equal to 100% of fair valuehow do we calculate fair value???PV of the annuity...
7Minimum Lease Payments Leases without a BPOMinimum rental payments plusAny guaranteed residual value plusamount the lessee guarantees lessor will realize on the asset at the end of the lease termPenalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assuredif the lease agreement does not include a BPO then it might include a guaranteed residual value or penalties for failure to renew the leasea guaranteed residual value is the amount that the lessee guarantees the asset will be worth at the end of the lease termso the lessee must either return an asset worth that amount to the lessee or make a cash payment for the shortfallby including the full amount of the guarantee in the computation we are taking the conservative stance and assuming that the asset will not be worth anything at the end of the lease term and the full guarantee will have to be paid in cashpenalties for failure to renew the lease must also be included in the minimum lease payments if at the beginning of the lease term renewal does not appear reasonably assured
8MLP continued What are executory costs? Are they included in MLP? Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insuranceone thing that the minimum lease payment does not include are executory costssometimes under the lease agreement the lessee will be required to make payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurancethese are not payments made towards the “purchase price” of the assetthey are operating costs and so such payments should be charged to operating expenses as incurred and not included in the the minimum lease payment computationany questions so far?Are they included in MLP?NO!
9Minimum Lease Payments What is a bargain purchase option?An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assuredthe last criteria refers to something called the minimum lease paymentssince this may not be a term you’ve confronted before it may be worth while discussing how it is computedminimum lease payments is a measure of the amount that we reasonably expect the the lessee to have to pay over the lease termyou can sort of view these as the amounts that the lessee is paying on behalf of the assetif the lease agreement includes a bargain purchase option then the lessee is going to make two kinds of payments over the lease termrental payments as specified by the agreement and the BPO at the end of the lease termwhere a BPO is defined as an option to purchase the asset at the end...What is the MLP for leases with a BPO?PV of rental payments and the BPO at the end of the lease term.
10Capital Lease Example 6-year lease Annual payment due at year end = $18,287No BPO and legal title does not pass at the end of lease termFMV of leased asset = $75,185Economic life of asset = 10 yearsAppropriate interest rate = 12%Est. salvage value = $3,185to illustrate capital lease accounting consider the following datasay we are the lessee and we have just signed a six year leasewe have agreed to 6 annual lease payments in the amount of $18,287 which are due at the end of each yearthe fair value of the leased asset is 75,185and the economic life is 10 yearsalso assume that the appropriate interest rate that the lessee should be using in his/her computations is 12%why do we need to include and interest rate?Because part of the lease payments will be considered interest if it is a capital lease...
11Present Value of MLP PV = $18,287 x PVIFA(n=6, r=12%) $18,287$18,287 $18,287 $18,287 $18,287this is computed on the next slidesince the lease does not contain a BPO minimum lease payments consists of the minimum rental payments plus penalties for failure to renew plus guaranteed residual valueswell we will have to assume that the latter two are not applicable in this lease since we have no information to the contraryso the MLP is equal to the minimum rental paymentthe present value of the MLP is computed by discounting the six payments at the “appropriate” rate of 12%in this case it works out to be equal to fair valuethis is not always going to be the case but often will bePV = $18,287 x PVIFA(n=6, r=12%)= $18,287 x= $75,185
12Lessee Journal Entries Inception of lease: record leased asset and lease obligation at present value of MLPRecord paymentsAt period end accrue:depreciate assetrecord interest expensenow that we know we have a capital lease all that remains is to start accounting for it consistent with how we would account for the purchase of an asset on creditthe present value of the obligation is the present value of all of the payments that we have agreed to make on behalf of the asset i.e. the MLP’sthis amount is debited to the leased asset account and credited to the lease obligation for the present value of the lease paymentswith this entry and from here on in you need to put yourself in the mind set of an asset purchaseand if you can do that everything we do should make perfect sense because when you hit the end of the year you have an asset now that needs to be depreciated and an obligation on which you need to record interest expense
13Inception of Lease Term JE to record leased asset and lease obligation at present value of MLP?leased asset $75,185lease obligation $75, 185now that we know we have a capital lease all that remains is to start accounting for it consistent with how we would account for the purchase of an asset on creditthe present value of the obligation is the present value of all of the payments that we have agreed to make on behalf of the asset i.e. the MLP’sthis amount is debited to the leased asset account and credited to the lease obligation for the present value of the lease paymentswith this entry and from here on in you need to put yourself in the mind set of an asset purchaseand if you can do that everything we do should make perfect sense because when you hit the end of the year you have an asset now that needs to be depreciated and an obligation on which you need to record interest expense
14Depreciation Expense On what does the depreciation period used depend? If bargain purchase option exists or title passes during lease term, use economic lifeOtherwise use lease termwell whenever you compute depreciation expense you should ask yourself three questionsfirst what depreciation method should I useany one of the typical methods is finesecond what period should I depreciate the asset overwell that should be the period of the usein the case of a leased asset the period of use will be the economic life if we are going to end up owning the assetotherwise the period of use will be the lease term
15Basis for Depreciation What ending values are used for depreciation?Salvage value if depreciating over economic lifeGuaranteed residual value if depreciating over lease termand finally what is the cost basis that needs to be depreciatedwell generally we depreciate cost minus salvage value at the end of the economic life and it stands to reason that this is what we want to do if we are going to end up owning the assetbut if we are not going to end up owning the asset and we have guaranteed a residual value then we would not want to depreciate more than the cost minus the guaranteed residual value since we have promised that we won’t consume that portion of the asset
16Record Depreciation Expense What is the depreciable basis of this asset?$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)$75,185/6yrs = $12,531depreciation expense $12,531accum. depreciation $12,531in this case we are not going to end up owning the asset so we will depreciate over the lease term of 6 yearsand since there is no guaranteed residual value we will depreciate the full costthe second entry I’m making is to record interest expense on the obligation for the year and the first lease payment i.e. payment on our “loan”note that in this example I have used an annuity in arrearsmore typically leases call for payments at the beginning of the period and so the text generally uses examples with payments made up front
20Record First Lease Payment interest expense ($75,185 x 12%) $9,022lease obligation ,265cash $18,287Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.
21Lessor Capital Lease Types Direct financing leasesPV of minimum lease payments equals the FMV of the leased assetNo “profit” is recorded; considered to be a financing arrangement.Sales-type leasesPV of minimum lease payments less the FMV of the leased asset equals the “dealer profit”Profit is recognized as revenue at the inception of the lease
22Initial Direct CostsIncludes costs directly associated with negotiating a particular leaseamounts paid to third parties (e.g. lawyer’s fees, appraisal fees, finders fees)amounts incurred internally (e.g. time spent negotiating lease terms, preparing and processing documents)Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)often the lessor incurs costs related to negotiating and signing the lease with the lesseesome of these costs are directly related to a particular lease agreementthese would include both amounts paid to parties external to the firm like lawyer’s fees, appraisals and the likeand amounts incurred internally but still directly related to a particular lease like the time spent preparing and processing the lease documentsthe matching principle would suggest that these direct costs should be charged to expense in the same period as the related revenuehowever, the lessor will also incur some costs that are not directly related to a particular lease agreement but are incurred regardless of whether the lessor is currently working on a new lease agreement or notthings like overhead, rent and administrative expensesthese are period expenses and should be charged to income in the period they are incurredthey are not directly related to the generation of a specific revenue stream and so the matching principle does not apply in this caseso initial direct costs include only costs that can be traced directly back to a specific lease transaction
23Accounting for Initial Direct Costs Operating -Sales-type -Direct financing-defer and allocate over lease term in proportion to rental incomeexpense in same period as profit on sale recognizedsince we want to match these costs to the related lease revenue we have to consider when that lease revenue will get recognizedif the lessor classifies the associated lease as an operating lease then the lessor will recognize rental income over the term of the leasein this case we would want to defer the initial direct costs and recognize them as a deduction from income over the lease term in proportion to the rental income recordedif the lessor classifies the lease as a sales-type lease then profit is recognized on signing the lease (i.e. the manufacturers or dealers profit) and over the lease termsince there is some income recognition up front we simply expense all of the initial direct costs immediately thereby matching it against the manufacturers’ profitfinally if the lessee classifies the lease as a direct financing lease then once again the income will be realized over the lease term as interest incomein this case we would want to defer the initial direct costs and amortize it over the lease term in proportion to the interest income recordedthis is done by adjusting the yield on the leaseadd to gross investment in the leaseamortize over lease as a yield adjustment
24Example - Direct Financing 3 year lease$20,000 payments due at end of yearimplicit interest rate = 10%FMV (lessor’s cost of asset) = $49,737initial direct costs = $1,000to illustrate this we’ll do an examplesay we have a three year lease with the lease payments due at the end of the yearthe interest rate implicit in the lease is 10%the cost of the asset to the lessor is 49,737and we’ll assume that 1,000 of direct costs were incurred in negotiating the lease
25Net Investment in Lease What is the PV of the MLP (without initial direct costs)?20,000 x PVIFA(n=3,r=10%)$49,737 = cost (this is a direct financing lease)we saw last day that we compute the net investment in the lease by taking the present value of the minimum lease payments plus the unguaranteed residual valuethis works out to 49,737 which is the same as the lessor’s cost so this is a direct financing leaseto figure out the yield adjustment we start by adding the initial direct costs to the net investment in the leasewhy do we add this to the net investmentbecause what is happening is that we are giving up an asset which in today’s dollars is worth 49737in return we are receiving 3 payments of 20,000 and we are paying out 1,000 up front in direct costsif we ignore the 1,000 the interest rate that would bring this into balance would be 10%but if we consider the impact of the 1,000, we know that the interest rate will no longer be 10% but something elseto figure out what that something else is we take the 1,000 over to the other side (i.e. add the indirect costs to the net investment in the lease and then solve the resulting equation for the PVIFADo initial direct costs affect this calculation?Yes, they are added and a new interest rate is found.
26Impute New Effective Yield Why add to the initial direct costs?We want the interest rate the equates the net investment to the cash flows$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)$50,737 = $20,000 x PVa (n=3,r=?)= PVa (n=3,r=?)like thisso I know that the PVIFA,n=3,r=appropriate rate isby trial and error just fiddling with the amortization table I figured out the new effective yield, taking the indirect costs into consideration to be 8.89%by trial and error: r=8.89%
27Ignoring Initial Direct Costs well now let’s compare what the amortization looks like if we ignore the indirect costswe start off with a net balance of 49,737we compute interest at a rate of 10%total interest income recorded over the term of the lease would be 10,263
28Including Initial Direct Costs if we include the initial indirect costs in the computation the opening balance increases by 1,000 to 50,737the interest rate is our new effective yield of 8.89%under this scenario the total income recorded over the lease term is only 9,263 or $1,000 lessthe 1,000 difference is the initial direct costsso the difference between the interest income on this table and the interest income on the previous table is the initial direct cost amortizationReduction in income = 10, ,263= 1,000= initial direct costs
29Amort. of Initial Direct Costs so to get the initial direct cost amortization for each year just take the difference in the interest income amounts reported on these two amortization tablesany questions so far?
30Journal Entry Entries to record lease: deferred initial direct costs ,000cash (etc.) ,000the lessor’s journal entry to record this direct financing lease would look like thisthe first entry is identical to the one we did last daydebit lease receivable for the gross investment in the leasecredit unearned interest income for the interest to be generated over the lease term based on the interest rate implicit in the leasethen debit the amounts expended for initial direct costs to a deferred charge accountcould be reported as an asset or perhaps netted against the unearned interest income accountlease receivable ,000unearned interest income ,263leased asset 49,737
31Journal EntriesEntries to record first payment and amortization of income and costscash ,000lease receivable 20,000unearned interest income ,974interest income ,974finally here are the entries to record the first payment (received at the end of the year) and the first year’s amortization of the unearned interest income and the deferred initial direct expensesany questions on this?this is not covered very well in the textso don’t be surprised if you haven’t read the chapter yetwhen you do they basically just say do a yield adjustment and leave it at thatinitial direct expense amortization 463deferred initial direct costs
32Sale/leasebackShould the gain or loss on sale be recognized when asset “sold” to lessor?Seller/lesseeLeaseback: seller retains use of the assetSale:Legal titleTransferswith a sale-leaseback the owner loses title to the property but still ends up getting to the use the propertyso the accounting issue is whether or not the owner should be allowed to record the gain or loss on sale of the asset when the asset is “sold” to the lessorthe answer to that question depends on how extensively the original owners gets to use the asset after the saleif the owner (now lessee) retains the right to use the asset then the transaction is viewed not as a sale but as a financing transactionas a result, gains from the “sale” are not recognized in income immediately but are deferred and amortized to income over the lease termlosses on the other hand are recognized immediatelywhy? due to the conservatism principleif the lessee loses most of the rights to use the asset then the transaction is viewed as a sale and gains and losses both must be recognized immediatelyin a moment we will see that we call the situations where most of the right to use the asset has been lost a minor leasebackBuyer/lessorAccount for lease according to classification tests.
33Sale/leaseback- operating lease Lessee Retains Right To Use Assetdefer gains only (losses are recognized immediately)amortize to rent expense over lease term in proportion to rental paymentsWhy do you think we defer any gains?but first lets look at the case where the lessee retains the right to use the assetif the lessee classifies the lease as an operating lease then he/she would defer the gain on sale and amortize it to rent expense over the lease term in proportion to the rental paymentsany idea how company’s might abuse the system if they didn’t have to defer the gain?before this rule owners would strike deals where they “sold” the asset for an inflated price upfront and book a huge gain on sale and in return they promised to make unreasonably large lease payments in the futurethe net effect was that they successfully shifted income through time and got to recognize it earlierif the lessee classifies the lease as a capital lease then once again they must defer any gains (losses are recognized immediately) and amortize the gain to depreciation expense at the same rate that they are depreciating the leased assetany questions on thisOwners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future
34Sale/leaseback -- capital lease Lessee Retains Right To Use Assetdefer gains only (losses are recognized immediately)amortize to depreciation expense over lease term in proportion to amortization of leased assetbut first lets look at the case where the lessee retains the right to use the assetif the lessee classifies the lease as an operating lease then he/she would defer the gain on sale and amortize it to rent expense over the lease term in proportion to the rental paymentswhy do you think we do this? any idea how company’s might abuse the system if they didn’t have to defer the gain?before this rule owners would strike deals where they “sold” the asset for an inflated price upfront and book a huge gain on sale and in return they promised to make unreasonably large lease payments in the futurethe net effect was that they successfully shifted income through time and got to recognize it earlierif the lessee classifies the lease as a capital lease then once again they must defer any gains (losses are recognized immediately) and amortize the gain to depreciation expense at the same rate that they are depreciating the leased assetany questions on this
35“Minor leaseback” Lessee Loses Most Rights To Use Asset Defined as PV of rental payments is 10% or less of asset’s fair valueRecognize gain or loss on sale immediatelythat is what we do when the owner now lessee retains the right to use the assetthe situation where they lose most of the rights to use the asset is called a minor leasebackso minor that it does not interfere with the sellers right to recognize the gain or loss on sale when the asset is sold to the lessora minor leaseback is defined as one in which the present value of the rental payments is 10% or less of the asset’s fair valuedo E22-15