COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Leases Chapter 15 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 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.

Learning Objectives 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).

Learning Objectives 7.Prepare and interpret the lease disclosures required of both lessors and lessees. 8.Compare the treatment of accounting for leases in the United States with the requirements of International Accounting Standards. 9.Record a sale-leaseback transaction for both a seller-lessee and a purchaser-lessor.

Lease 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.

Parties Involved in a Lease Lesse- 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.

Economic Advantages to Leasing 1.No down payment. 2.Avoid risks of ownership. 3.Flexibility.

Advantages to the Lessor Increased sales. Ongoing business relationship with lessee. Residual value retained.

Different Lease Types 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

Lease Classification Criteria 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% 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% or more of the fair market value of the leased asset. A lease is classified as a capital lease by the lessee if it is non-cancelable and meets any one of the following criteria:

Lease Classification-Lessor 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.

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 Expense 1,000 Cash 1,000

Accounting for Capital Leases Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 01/01/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10%

Accounting for Capital Lease Leased Equipment250,192 Obligations under Capital Leases250,192 Entries on January 1, 2007 Lease Expense 5,000 Obligations under Capital Leases60,000 Cash65,000 PMT = $60,000; N = 5; I = 10%

Accounting for Capital Leases Entries on December 31, 2007 Amortization Expense on Leased Equipment50,038 Accumulated Amortization on Leased Equipment50,038 $250,192 ÷ 5 Prepaid Executory Costs 5,000 Obligations under Capital Leases40,981 Interest Expense19,019 Cash65,000 ($250,192 – $60,000) x 10%

Bargain Purchase Option (BPO) 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

Accounting for Capital Leases with a BPO Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 01/01/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Bargain purchasing option $75,000 Lessee

Accounting for Capital Leases with a BPO Minimum Lease Payment Present value of five payments at the beginning of each year for five years: PMT = $60,000, N = 5, I = 10% $250,192 Present value of the bargain purchase option 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

Accounting for Capital Leases with a BPO Entries on December 31, 2012 Obligations under Capital Leases68,182 Interest Expense6,818 Cash75,000 Equipment148,381 Accumulated Amortization on Leased Equipment148,380 Leased Equipment296,761 $68,182 x 10% ($296,761 ÷ 10) x 5 years

Accounting for Operating Leases Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 10 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost to lessor$400,000 Direct costs incurred $15,000 Lessor

Accounting for Operating Leases- Lessor At Inception of 1/ 1/07 Deferred initial Direct Costs 15,000 Cash15,000 Cash65,000 Rent Revenue60,000 Executory Costs5,000 At Receipt of First Payment 1/1/07

Accounting for Operating Leases- Lessor At End of the First Year 12/31/2007 Amortization of Initial Direct Costs 3,000 Deferred Initial Direct Costs3,000 Depreciation Expense on Leased Equipment 40,000 Accumulated Depreciation on Leased Equipment 40,000 $400,000 ÷ 10

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. Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment$250,192

Accounting for Direct Financing Leases- Lessor At Inception of 1/1/07 Lease Payment Receivable 250,192 Equipment Purchased for Lease 250,192 Cash65,000 Lease Payment Recievable60,000 Executory Costs5,000 At Receipt of First Payment 1/1/07

Direct Financing Lease At End of the First Year 12/31/2007 Cash 65,000 Lease Payment Receivable40,981 Interest Revenue 19,019 Deferred Executory Costs 5,000 A Liability

Accounting for Direct Financing Leases with Residual Value Minimum payment (in advance) including $5,000 executory cost $65,000/year Lease period (beginning 1/1/07) 5 years Economic life of asset 5 years Estimated residual value at end of lease $75,000 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment$296,761 Lessor

Direct Financing Leases with Residual Value- Lessor At Inception of 1/1/07 Lease Payment Receivable 296,761 Equipment Purchased for Lease 296,761 Cash65,000 Lease Payment Recievable60,000 Executory Costs5,000 At Receipt of First Payment 1/1/07

Direct Financing Lease with Residual Value At End of the First Year 12/31/2007 Cash 65,000 Lease Payment Receivable36,324 Interest Revenue 23,676 Deferred Executory Costs 5,000 At End of the Lease Term 12/31/2012 Equipment 75,000 Lease Payment Receivable68,182 Interest Revenue 6,818

Sales-Type Lease Transaction Components Lease Payment Receivable250,192 Sales250,192 Cost of Goods Sold175,000 Finished Goods Inventory160,000 Deferred Initial Direct Costs15,000 Cash65,000 Lease Payment Receivable60,000 Executory Costs5,000 At Inception of 1/1/07

Sales-Type Lease With BPO or Guaranteed Residual Value The minimum lease payments (to the lessor) will include the following if they are included in the agreement: –A lump sum (from a bargain purchase option) at the end of the lease term OR –A guaranteed residual value The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

Disclosure Requirements for Leases For and operating lease, the lease-related asset and liability are off the balance sheet items. It is important for the financial statement user to be able to interpret the associated note. Lessee is required to provide enough note disclosure to allow the users to quantify the magnitude of the operating leases. Lessor is required to provide enough disclosure to allow the financial statement user to figure out the extent to which lease- related sales and rentals have impacted the lessor’s financial statements.

International Accounting of Leases IFRS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases. A proposal, titled “Accounting for Leases: A New Approach,” suggests that all lease contracts longer than one year be accounted for as capital leases. This proposal is still under discussion.