1. Accounting For Leases hapter 21 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. C Intermediate Accounting 10th edition Nikolai Bazley Jones

2. 2 A lease is an agreement between a lessor and a lessee that conveys to the lessee the right to use specific property, real or personal, owned by the lessor, for a stated period of time. In return for this right, the lessee agrees to make periodic cash payments to the lessor. Definition of Lease

3. 3 Financial benefits Risk benefit Tax benefit Financial reporting benefit-no liability recorded Billing benefit-pass through on contracts, including interest Advantages of Leasing from Lessee’s Viewpoint

4. 4  The lease provides 100% financing, so that the lessee acquires the asset without having to make a down payment.  The lease contract contains fewer restrictive provisions and is more flexible than other debt agreements.  The leasing arrangement creates a claim that is against only the leased equipment and not against all assets. Financial Benefits Advantages of Leasing from Lessee’s Viewpoint

5. 5 Financial Reporting Benefit Companies A and B have identical financial data: Current assets$2,100,000 Noncurrent assets2,900,000 Current liabilities1,000,000 Noncurrent liabilities1,600,000 Stockholders’ equity2,400,000 Companies A and B have identical financial data: Current assets$2,100,000 Noncurrent assets2,900,000 Current liabilities1,000,000 Noncurrent liabilities1,600,000 Stockholders’ equity2,400,000 ContinuedContinued Advantages of Leasing from Lessee’s Viewpoint

6. 6 On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 Advantages of Leasing from Lessee’s Viewpoint

7. 7 On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. After Acquisition Current Ratio: $2,100,000 $1,446,429 = 1.45 ContinuedContinued Advantages of Leasing from Lessee’s Viewpoint

8. 8 On December 31, 2007, B Company leases similar equipment to that leased by A Company, agreeing to pay $500,000 rent each year for the next 10 years. Assuming 12% interest, the present value of the lease is $2,825,112 ($500,000 x 5.650223). Before Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 After Acquisition Current Ratio: $2,100,000 $1,000,000 = 2.10 The ratio of debt to stockholders’ equity would remain at 1.08-to-1. Advantages of Leasing from Lessee’s Viewpoint

9. 9 The ratio of debt to stockholders’ equity would increase from 1.08 before acquisition to 2.26 after acquisition. On December 31, 2007, A Company purchases equipment with a 10-year life, at a cost of $2,825,112, by signing a 10-year, 12% note requiring $500,000 to be paid at the end of each year beginning December 31, 2008. ContinuedContinued Advantages of Leasing from Lessee’s Viewpoint $2,600,000$5,425,112$2,400,000 $2,400,000 = 1.08 = 2.26

10. 10 Current liabilities-LEASE$1,000,000 Plus: Noncurrent liabilities1,600,000 Equals:$2,600,000 Divided by: Stockholders’ equity2,400,000 Equals: Debt to Equity ratio1.08 Current liabilities-LEASE$1,000,000 Plus: Noncurrent liabilities1,600,000 Equals:$2,600,000 Divided by: Stockholders’ equity2,400,000 Equals: Debt to Equity ratio1.08 Current liabilities-PURCHASE$1,500,000 Plus: Noncurrent liabilities3,925,112 Equals:$5,425,112 Divided by: Stockholders’ equity2,400,000 Equals: Debt to Equity ratio2.26 Current liabilities-PURCHASE$1,500,000 Plus: Noncurrent liabilities3,925,112 Equals:$5,425,112 Divided by: Stockholders’ equity2,400,000 Equals: Debt to Equity ratio2.26 Advantages of Leasing from Lessee’s Viewpoint

11. 11  Bargain purchase option  Bargain renewal option  Estimated economic life of leased property  Estimated residual value of leased property  Executory costs  Fair value of leased property  Guaranteed residual value  Inception of the lease  Initial direct costs There’s more. FASB Statement No. 13 as Amended and interpreted defines a number of lease terms. Key Terms Related to Leasing

12. 12  Interest rate implicit in the lease  Lease term  Lessee’s incremental borrowing rate  Manufacturer’s or dealer’s profit or loss  Minimum lease payments- present value  Minimum lease payments receivable- gross  Unguaranteed residual value  Unreimbursable cost Key Terms Related to Leasing

13. 13 A capital lease meets one or more of Column A criteria. An operating lease does not meet any of the Column A criteria. Classification by the Lessee Classification of Leases Involving Personal Property

14. 14 A sales-type lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. Classification by the Lessor Sale-type lease Classification by the Lessor Sale-type lease It must involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor. Classification of Leases Involving Personal Property

15. 15 It must not involve a transaction giving rise to a manufacturer’s or dealer’s profit or loss to the lessor. A direct financing lease must meet one or more of the criteria listed in Column A and both criteria listed in Column B. Classification by the Lessor Direct financing lease Classification by the Lessor Direct financing lease Classification of Leases Involving Personal Property

16. 16 Classification by the Lessor Operating lease Classification by the Lessor Operating lease An operating lease meets none of the criteria in Column A or does not meet both criteria in Column B. Classification of Leases Involving Personal Property

17. 17 As an operating lease, User Company simply records the annual payment as a rent. Rent Expense50,000 Cash50,000 If User Company prepares quarterly interim statements, it reports the unexpired portion of the expense as an asset. Operating Lease (Lessee)

18. 18 The term “minimum lease payments” includes the present value of 1.Minimum rental payments. 2.Guaranteed residual value. 3.Amount payable for failure to renew. 4. Any bargain purchase option. Ignore residual, if there is a bargain purchase option. The term “minimum lease payments” includes the present value of 1.Minimum rental payments. 2.Guaranteed residual value. 3.Amount payable for failure to renew. 4. Any bargain purchase option. Ignore residual, if there is a bargain purchase option. Minimum Lease Payments

19. 19 The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2007, that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2007. Capital Lease (Lessee)

20. 20 The Martin Company (lessee) and the Gardner Company (lessor) sign a lease agreement dated January 1, 2007, that provides for the Martin Company to lease a piece of equipment beginning on January 1, 2007. Is this a capital lease? To check your response, click the button in the corner. Capital Lease (Lessee) Wait

21. 21 Initial Recording of Capital Lease on January 1, 2007 Leased Equipment100,000.00 Capital Lease Obligation 100,000.00 December 31, 2007 Interest Expense12,000.00 Capital Lease Obligation 20,923.45 Cash32,923.45 12% x $100,000 $32,923.45 - $12,000.00 ContinuedContinued Capital Lease (Lessee)

22. 22 Recognition of Depreciation, December 31, 2007 Depreciation Expense: Leased Equipment25,000.00 Accumulated Depreciation: Leased Equipment25,000.00 Second Annual Payment, December 31, 2008 Interest Expense9,489.19 Capital Lease Obligation 23,434.26 Cash32,923.45 $100,000 ÷ 4 $32,923.45 - $9,489.19 The depreciation entry on Dec. 31, 2008, again would be for $25,000. Capital Lease (Lessee) $79,076.55x.12$79,076.55x.12

23. 23 Assume that Martin Company is required to make lease payments in advance on January 1 of each year,... …and that the cost and fair value of the equipment is $112,000. Present value of four payments of $32,923.45 in advance at 12% = $32,923.45 x 3.401831 = $112,000 Capital Lease (Lessee)

24. 24 Initial Recording of Capital Lease on Jan. 1, 2007 Leased Equipment112,000.00 Capital Lease Obligation 112,000.00 First Payment in Advance, January 1, 2007 Capital Lease Obligation 32,923.45 Cash32,923.45 ContinuedContinued Capital Lease (Lessee)

25. 25 Recognition of Depreciation, December 31, 2007 Depreciation Expense: Leased Equipment28,000.00 Accumulated Depreciation: Leased Equipment28,000.00 Recognition of Interest Expense, December 31, 2007 Interest Expense9,489.19 Accrued Interest on Capital Lease Obligation9,489.19 $112,000 ÷ 4 $79,076.55 x 0.12 ContinuedContinued Capital Lease (Lessee)

26. 26 Recognition of Depreciation, December 31, 2008 Depreciation Expense: Leased Equipment28,000.00 Accumulated Depreciation: Leased Equipment28,000.00 Second Annual Payment in Advance, January 1, 2008 Accrued Interest on Capital Lease Obligation 9,489.19 Capital Lease Obligation23,434.26 Cash32,923.45 Capital Lease (Lessee)

27. 27 Redd Company leases equipment for 4 years and agrees to pay $2,000 at the end of the fourth year to purchase the asset. Redd is reasonably assured that it will exercise the option. Redd’s incremental borrowing rate is 11% and the lessor’s implicit interest rate is 10%. The cost and fair value of the equipment is $128,160.63. Does this qualify as a capital lease? Yes…because of the bargain purchase option. Bargain Purchase Option

28. 28 The minimum lease payments, based on the lower 10% rate, is calculated as follows: Present value of the annual payments discounted at 10% ($40,000 x 3.169865)$126,794.60 Add: Present value of the single sum of $2,000 (the bargain purchase option) discounted at 10% ($2,000 x 0.683013) 1,366.03 Present value of the minimum lease payments$128,160.63 Present value of the annual payments discounted at 10% ($40,000 x 3.169865)$126,794.60 Add: Present value of the single sum of $2,000 (the bargain purchase option) discounted at 10% ($2,000 x 0.683013) 1,366.03 Present value of the minimum lease payments$128,160.63 Leased Equipment128,160.63 Capital Lease Obligation 128,160.63 Leased Equipment128,160.63 Capital Lease Obligation 128,160.63 Bargain Purchase Option

29. 29 Karpas Company leases equipment for 4 years that cost the lessor $147,284.99 (its fair value) and agrees to pay an annual rent of $40,000 at the end of each year. Karpas Company agrees to guarantee the estimated residual value of $30,000 at the end of the fourth year. Assume a 10% interest rate. Guaranteed Residual Value

30. 30 Leased Equipment Under Capital Leases 147,284.99 Accumulated Depreciation: Leased Equipment 117,284.99 Obligation Under Capital Leases 30,000.00 At the end of the lease, both parties agree that the equipment is worth only $20,000, but the guaranteed residual was $30,000. Accumulated Depreciation: Leased Equip.117,284.99 Capital Lease Obligation 30,000.00 Loss on Disposal of Leased Equipment10,000.00 Leased Equipment147,284.99 Cash10,000.00 Guaranteed Residual Value 117,284.99

31. 31 If the fair value is more than $30,000, the lessee pays the liability in full by returning the asset to the lessor. Guaranteed Residual Value

32. 32 On January 1, 2007, Brahms Inc. leases equipment with a fair value of $100,000, an economic life of four years and a lease term of three years. Brahms incremental borrowing rate is 10%. There is a bargain purchase option at that time of $10,000. The first payment is due immediately. Find the payment and the amount to be capitalized. Cost Given-Find Rental Payments

33. 33 Cost or fair value of leased asset (amount capitalized if residual guaranteed) Less:Present value of residual or bargain purchase Yields:Present value to be recovered through rental payments (amount capitalized if residual unguaranteed) Find:Lease payment for principal and interest Plus:Executory costs (not present valued) Equals:Minimum rental payment (regardless of whether residual guaranteed) Cost Given- Find Rental Payments

34. 34 Cost or fair value of leased asset $100,000 (amount capitalized if residual guaranteed) Less:Present value of residual or bargain purchase 7,513 Yields:Present value of rental payments $92,487 (amount capitalized if residual unguaranteed) Find:Lease payment for principal and interest 33,809 Plus:Executory costs (not present valued) 0 Equals:Minimum rental payment (regardless of whether residual guaranteed) $33,809 Cost Given- Find Rental Payments

35. 35 AnnualInterestReduction ofLease PaymentExpenseObligationObligation 1/1/07$100,000 1/1/07$33,8090$33,80966,191 1/1/0833,8096,61927,19039,001 1/1/0833,8093,90029,9099,092 12/31/0810,0009089,0920 Lessor’s Receivable$111,427 Lessor’s unearned interest$11,427 AnnualInterestReduction ofLease PaymentExpenseObligationObligation 1/1/07$100,000 1/1/07$33,8090$33,80966,191 1/1/0833,8096,61927,19039,001 1/1/0833,8093,90029,9099,092 12/31/0810,0009089,0920 Lessor’s Receivable$111,427 Lessor’s unearned interest$11,427 The lessor’s schedule will have the same numbers as the lessee’s schedule with a guaranteed residual. Lessee Schedule-Lessee

36. 36 On January 1, 2007, Rutter Inc. enters into a lease agreement, which qualifies as a capital lease. Their borrowing rate is 10%, the lease term is three years, the residual value is $5,000, and executory costs are $2,000 per year. The first payment of $37,182.62 is due immediately. How much should Rutter capitalize if (1)the residual value is not guaranteed, and (2) the residual value is guaranteed? On January 1, 2007, Rutter Inc. enters into a lease agreement, which qualifies as a capital lease. Their borrowing rate is 10%, the lease term is three years, the residual value is $5,000, and executory costs are $2,000 per year. The first payment of $37,182.62 is due immediately. How much should Rutter capitalize if (1)the residual value is not guaranteed, and (2) the residual value is guaranteed? Payments Given- Find Amount to be Capitalized

37. 37 Minimum rental payment Less:Executory costs (not present valued) Yields:Lease payment for principal and interest Gives:Present value to be recovered through rental payments (amount capitalized if residual unguaranteed) Plus:Present value of residual or bargain purchase Equals:Amount to be capitalized if residual is guaranteed Minimum rental payment Less:Executory costs (not present valued) Yields:Lease payment for principal and interest Gives:Present value to be recovered through rental payments (amount capitalized if residual unguaranteed) Plus:Present value of residual or bargain purchase Equals:Amount to be capitalized if residual is guaranteed Payments Given- Find Amount to be Capitalized

38. 38 Minimum rental payment$37,182.62 Less:Executory costs (not present valued)2,000 Yields:Lease payment for principal and interest$35,182.62 Gives:Present value to be recovered through rental payments (3 years)$96,243.46 (amount capitalized if residual unguaranteed) Plus:Present value of residual or bargain purchase3,756.55 Equals: Amount to be capitalized if residual is guaranteed$100,000 Minimum rental payment$37,182.62 Less:Executory costs (not present valued)2,000 Yields:Lease payment for principal and interest$35,182.62 Gives:Present value to be recovered through rental payments (3 years)$96,243.46 (amount capitalized if residual unguaranteed) Plus:Present value of residual or bargain purchase3,756.55 Equals: Amount to be capitalized if residual is guaranteed$100,000 Payments Given- Find Amount to be Capitalized

39. 39 1.With a capital lease, the lessee records depreciation using the firm’s normal depreciation method. 2.Over the economic life if title is transferred or the is a bargain purchase option. 3.Over the term of the lease if the lease term is equal to 75% or more of the economic life, or the present value of the minimum lease payments is at least 90% of the fair value. 4.Any residual (salvage) is ignored if the residual is not guaranteed. 5.Any residual is not discounted (present valued) if the residual is guaranteed. 1.With a capital lease, the lessee records depreciation using the firm’s normal depreciation method. 2.Over the economic life if title is transferred or the is a bargain purchase option. 3.Over the term of the lease if the lease term is equal to 75% or more of the economic life, or the present value of the minimum lease payments is at least 90% of the fair value. 4.Any residual (salvage) is ignored if the residual is not guaranteed. 5.Any residual is not discounted (present valued) if the residual is guaranteed. Depreciation

40. 40 In the Brahms example above the lease term was three years, the economic life was four years and there was a bargain purchase option. Amount capitalized less salvage = depreciation Economic life Amount capitalized less salvage = depreciation Economic life $100,000 - $10,000 = $22,500 per year Four years $100,000 - $10,000 = $22,500 per year Four years Depreciation

41. 41 Assume that there was no bargain purchase option and the residual was not guaranteed. Amount capitalized = depreciation Lease term Amount capitalized = depreciation Lease term $92,487 = $30,829 per year 3 years $92,487 = $30,829 per year 3 years Depreciation

42. 42 Operating lease Sales-type lease Direct financing lease Leveraged lease Lessor’s Classifications A leveraged lease is a special three- party lease that is always considered to be a direct financing lease.

43. 43 Owner Company leases a piece of equipment to User Company for 5 years. User Company agrees to pay $50,000 at the beginning of each year. Owner Company purchased the equipment for $300,000. The equipment has an estimated life of 10 years and Owner Company uses straight-line depreciation. Owner pays the annual insurance premium of $2,000, and on December 15, 2007, it pays for repairs of $1,500. Why is this an operating lease? None of the criteria in Column A (Example 21-2) were met; therefore, this lease should be treated as an operating lease. Operating Lease (Lessor)

44. 44 Purchase of Equipment to Be Leased on Jan. 1, 2007 Equipment Leased to Others 300,000 Cash (or Accounts Payable)300,000 Collection of Annual Payment on January 1, 2007 Cash50,000 Rental Revenue50,000 ContinuedContinued Payment of Annual Insurance Premium, Jan. 10, 2007 Insurance Expense2,000 Cash2,000 Operating Lease (Lessor)

45. 45 Payment of Repairs on December 15, 2007 Repair Expense 1,500 Cash 1,500 Recognition of Annual Depreciation, Dec. 31, 2007 Depreciation Expense: Equipment Leased to Others30,000 Accumulated Depreciation: Equipment Leased to Others30,000 Operating Lease (Lessor)

46. 46 Under a direct financing lease, the lessor “sells” the asset at no gain or loss. The net amount at which the lessor records the receivable must be equal to the carrying value of the property. 1. The undiscounted minimum lease payments to be received by the lessor (net of executory costs paid by the lessor) plus 2. The unguaranteed residual value accruing to the benefit of the lessor. The gross receivable of the lessor includes the sum of-- Direct Financing Leases (Lessor)

47. 47 Gardner Company leases equipment to the Martin Company for 4 years. The lease is noncancelable and requires equal payments of $32,923.45. This equipment cost Gardner $100,000. There is no guaranteed residual value. Martin agrees to pay all executory costs. The equipment reverts back to Gardner at the end of 4 years. Martin’s incremental borrowing rate is 12.5%, while Gardner’s is 12%. Martin Company uses straight- line depreciation. All requirements for Column B are met. $100,000 ÷ 3.037349 Why is this a direct financing lease? Direct Financing Leases (Lessor)

48. 48 It is a direct financing lease because it meets the three requirements: (1) one or more of the items listed in Column A (Exhibit 21-2)— Items 3 and 4. …(2) both of the criteria listed in Column B (Example 21-2), and (3) there is no manufacturer’s or dealer’s profit. See Example 21-7 for more detail. Direct Financing Leases (Lessor)

49. 49 Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 131,693.80 Equipment100,000.00 Unearned Interest: Leases31,693.80 Collection of Annual Payment on December 31, 2007 Cash32,923.45 Lease Payments Receivable32,923.45 ContinuedContinued $32,923.45 x 4 Direct Financing Leases (Lessor)

50. 50 Recognition of Interest Revenue on Dec. 31, 2007 Unearned Interest: Leases12,000.00 Interest Revenue: Leases12,000.00 Collection of Annual Payment on Dec. 31, 2008 Cash32,923.45 Lease Payments Receivable32,923.45 $100,000 x 0.12 Recognition of Interest Revenue on December 31, 2008 Unearned Interest: Leases9,489.19 Interest Revenue: Leases9,489.19 ($100,000 - $20,923.45) x 0.12 Direct Financing Leases (Lessor)

51. 51 Let’s look at a direct financing lease where the payments will be received in advance. Direct Financing Leases (Lessor)

52. 52 On January 1, 2007, the Watkins Finance Company leases equipment that cost $391,371.20 (which is also the fair value) to the Hutton Company. The term of the lease is 5 years, with annual payments of $100,000 received in advance. The economic useful life is 5 years. There is no BPO or guaranteed residual value. The lease receipts will yield Watkins a 14% return. The collectibility is reasonably assured, and there are no uncertainties involved in the lease. Direct Financing Leases (Lessor) $100,000 X 3.913712

53. 53 Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 500,000.00 Equipment391,371.20 Unearned Interest: Leases108,628.80 Collection of Annual Payment on January 1, 2007 Cash100,000.00 Lease Payments Receivable100,000.00 ContinuedContinued $100,000 x 5 Direct Financing Leases (Lessor)

54. 54 Recognition of Interest Revenue on Dec. 31, 2007 Unearned Interest: Leases 40,791.97 Interest Revenue: Leases40,791.97 $291,371.20 x 0.14 Direct Financing Leases (Lessor)

55. 55 Take a moment to examine the data in the next slide. Why is this a sales-type lease? Click on the button to check your response. Sales Type Leases (Lessor)

56. 56 Initial Recording of the Lease on January 1, 2007 Lease Payments Receivable 300,500.00 Unearned Interest: Leases (plug)110,491.51 Sales Revenue190,008.49 Cost of Goods Sold120,000.00 Merchandise Inventory (or Equipment)120,000.00 ContinuedContinued $30,000 x 6.328250 =$189,847.50 $500 x 0.321973 = 160.99 $190,008.49 $30,000 x 6.328250 =$189,847.50 $500 x 0.321973 = 160.99 $190,008.49 Sales Type Leases (Lessor) ($30,000 x 10) + $500

57. 57 Collection of Annual Payment on January 1, 2007 Cash30,000.00 Lease Payments Receivable30,000.00 Recognition of Interest Revenue on December 31, 2007 Unearned Interest: Leases19,201.02 Interest Revenue: Leases19,201.02 12% x [($300,500 - $30,000) - $110,491.51] Sales Type Leases (Lessor)

58. 58 Initial Direct Costs for Lessor Costs that a lessor would not have incurred if it had not entered into the lease contract. Operating leaseExpense in proportion to the receipts from the lease over the term of the lease. Direct financing leaseReduce “Unearned Interest” and calculate a new (lower) implicit interest rate. Sales-type leaseExpense in period of sale.

59. 59 Why would a lessee or lessor want to avoid capitalizing a lease? The motivation usually comes from the lessee who wants to avoid reporting the liability. Conceptual Issues

60. 60 C hapter 21 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

61. 61 The lease meets two of the criteria: (a) The lease term is 75% or more of the asset’s economic life and (b) the present value of the lease payments is 90% or more of the asset’s fair value. Return

62. 62 Three of four criteria from Column A (Example 21-7) are met and both items from Column B, and there is a manufacturer’s or dealer’s profit. Return