PART 1 – LEASEE ACCOUNTING Accounting for Leases 21 PART 1 – LEASEE ACCOUNTING Kieso, Weygandt, and Warfield

What is a LEASE? A lease is a contract that transfers for a fee the right to exclusive use of an asset for a specified period of time.

Independent Leasing Companies Who Will Lease An Asset to You? Captive Leasing Banks Independent Leasing Companies Caterpillar Financial Services Corp. Ford Motor Credit (Ford) IBM Global Financing These are a FINANCING deals where the bank or leasing company buys the asset from its manufacturer and then leases it to you. The lease is part of a deal to entice you to buy one of their products. This is similar to a SALE but you can pay for the product over time with interest of course. LO 1

Advantages of Leasing 100% financing at fixed rates. (Little or no money down so no large cash outlay.) Protection against obsolescence. (When the asset gets old, exchange it for a new one.) Flexibility and less costly financing especially if credit rating is weak. Tax advantages – lease payments are deductible. Off-balance-sheet financing where the leased asset and corresponding liability do NOT show up on the Balance Sheet.

Conceptual Nature of a Lease Companies would prefer NOT to put the lease on the balance sheet because it would reduce their debt and improve their solvency and efficiency ratios. Substance of transaction most long-term leases are more like purchased assets that are paid (i.e. “financed”) with a loan paid in installments over the life of the lease. Companies are in control of the asset and receive the benefits of ownership and incur liabilities for those benefits. If it looks like an asset and a liability and it functions like an asset and a liability then FASB says it is to be treated as an asset and a liability. A lease meeting the criteria of a CAPITAL lease must be put on the balance sheet as an asset and a liability. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases under current guidance.

CRITERIA FOR CAPITAL LEASES If any ONE of the four criteria is met, you MUST CAPITALIZE the lease 1) Ownership is transferred to lessee at end of the lease 2) Lessee can buy the asset at a bargain price (BPO) 3) Lease term at least 75% of asset’s life 4) Present Value of lease payments is > 90% of FMV of the asset (FINALLY - SOMETHING TO MEMORIZE) Note: Cannot use criteria 3 or 4 if the lease begins in the last 25% of the assets economic life.

ACCOUNTING FOR LEASES BY LESSEE CAPITAL LEASE - A long-term lease capitalized as an asset and a liability OPERATING LEASE - Typically short–term. Treated as an expense similar Rent with NO corresponding asset or liability

The Leasing Environment Substance versus Form Operating Lease Rent expense xxx Cash xxx Although technically legal title may not pass, the benefits from the use of the property do. Capital Lease Leased equipment xxx Lease liability xxx LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Accounting by the Lessee If the lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the present value of the rental payments. Records depreciation on the leased asset. Treats the lease payments as consisting of interest and principal. Journal Entries for Capitalized Lease Illustration 21-2 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Capitalization Criteria Transfer of Ownership Test Easiest to identify. Bargain-Purchase Option Test At the inception of the lease, the difference between the option price and the expected fair market value must be large enough to make exercise of the option reasonably assured, i.e. how can you tell if it is a bargain? THE DISCOUNT HAS TO BE SUFFICIENT TO MAKE THE LESSEE WANT TO USE THE BARGAIN PURCHASE OPTION TO BUY THE ASSET AT THE END OF THE LEASE, i.e. they were getting a “deal”

Capitalization Criteria Economic Life Test (75% Test) Lease term is generally considered to be the fixed, non-cancellable term of the lease. Bargain-renewal option can extend this period. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. THE RENEWAL OPTION MUST BE LOW ENOUGH THAT THE LESSEE WILL PROBABLY RENEW

Accounting by the Lessee Illustration: Home Depot leases Dell PCs for two years at a rental of $100 per month per computer and subsequently can lease them for $10 per month per computer for another two years. The lease clearly offers a bargain-renewal option; the lease term is considered to be four years. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Capitalization Criteria Recovery of Investment Test (90% Test) Minimum Lease Payments - INCLUDE: Minimum rental payment Guaranteed residual value Penalties to be paid for failure to renew or extend the lease Bargain-purchase option amount Executory Costs: Insurance Maintenance Taxes EXCLUDE from PV of Minimum Lease Payment Calculation and EXPENSE as incurred LO 2

Accounting by the Lessee Capitalization Criteria Discount Rate Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception. If the lessee knows the implicit interest rate computed by the lessor and it is LESS than the lessee’s incremental borrowing rate, then lessee must use the lessor’s rate. Use LESSER OF lessee’s incremental rate OR lessor’s implicit rate (if known)

Accounting by the Lessee PV of minimum lease payments OR Asset and Liability Accounted for Differently Asset and Liability Recorded at the lower of: present value of the minimum lease payments (excluding executory costs) or fair-market value of the leased asset. Use LESSER OF PV of minimum lease payments OR FMV of leased asset Depreciation Period If lease transfers ownership, depreciate asset over the economic life of the asset. If lease does not transfer ownership, depreciate over the term of the lease.

Accounting by the Lessee Asset and Liability Accounted for Differently Effective-Interest Method Used to allocate each lease payment between principal and interest. Depreciation Concept Depreciation and the discharge of the obligation are independent accounting processes. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee – EXAMPLE 1 Friar Construction Company has decided to lease a large piece of equipment from Providence Construction Equipment, Inc. beginning January 1, 2013. The lease is non-cancelable and will last for five years at $44,000 per year payable January 1 each year, with no renewal options or bargain purchase options. The equipment has a fair value of $320,000 and an estimated remaining useful life of 8 years, with a $90,000 salvage value at the end of its life (not guaranteed by Friar Construction). The lessor will pay the insurance and taxes on the machine, but Friar Construction will have to pay maintenance and repair costs, which are expected to average $8,000 per year. Friar Construction’s incremental borrowing rate is 10%, and Providence’s implicit interest rate for the lease is 9%, which is known to Friar Construction. What type of lease is this? Explain. Prepare the journal entries to account for the first year of the lease on the books of the leasee, Friar Construction assuming that Friar Construction pays $7,500 of maintenance on the equipment in addition to the lease payment. Show how this lease will appear on Friar Construction’s balance sheet and income statement at the end of 2013. LO 2

LESSEE ACCOUNTING – EXAMPLE 1 1. Does the lease transfer ownership at the end? NO 2. Is there a bargain purchase option? NO 3. Lease term vs. Asset Life? 5 vs 8 yrs is less than 75% 4. PV of lease payments vs FMV of asset? ?

PV OF LEASE PAYMENTS CALCULATION YEAR 1 2 3 4 5 PYMTS $44,000 $44,000 $44,000 $44,000 $44,000 USE 9% IMPLICIT RATE INTEREST RATE FOR PV  10% VS 9% PV OF ANNUITY DUE FACTOR – 5 YR AT 9% = 4.23972 $44,000 x 4.23972 = PV of $186,547 < 90% of $320,000

LESSEE ACCOUNTING – EXAMPLE 1 1. Does the lease transfer ownership at the end? NO 2. Is there a bargain purchase option? NO 3. Lease term vs. Asset Life? 5 vs 12 yrs  under 75% 4. PV of lease payments vs FMV of asset? Under 90% Conclusion: OPERATING LEASE

Accounting by the Lessee – EXAMPLE 1 What type of lease is this? OPERATING LEASE does not meet any of 4 criteria Prepare the journal entries to account for the first year of the lease on the books of the lease, Friar Construction assuming that Friar Construction pays $7,500 on maintenance of the equipment in addition to the lease payment. Show how this lease will appear on Friar Construction’s balance sheet and income statement at the end of 2013. Dr. Equipment Lease Expense 44,000 Equipment Maintenance Expense 8,000 Cr. Cash 52,000 OPERATING LEASE  NO ASSETS OR LIABILITIES

Accounting by the Lessee – EXAMPLE 2 Friar Construction Company has decided to purchase a large piece of equipment from Providence Construction Equipment, Inc. on January 1, 2013 for $464,000. Because the company has a number of construction projects going on at the moment, before going through with the purchase, the CFO wants to check into leasing the machine to see if there are any advantages. Dominican Bankcorp has offered to lease the machine to Friar Construction for an annual lease payment of $55,800 for 16 years with lease payments to be made at the end of the year. At the end of the lease, Friar can purchase the machine from Dominican for $1,000. The estimated useful life of a new machine is 20 years with no residual value. Friar will be responsible for the insurance, maintenance and repair costs on the machine during the lease. Friar Construction’s incremental borrowing rate is 10%, and Dominican’s implicit interest rate for the lease is 9%, which is known to Friar Construction. What type of lease is this? Explain. Prepare the journal entries to account for the first year of the lease on the books of the lease, Friar Construction assuming that Friar Construction pays $9,000 on maintenance of the equipment in addition to the lease payment. Show how this lease will appear on Friar Construction’s balance sheet and income statement at the end of 2013. LO 2

LESSEE ACCOUNTING – EXAMPLE 2 Friar Construction Company has decided to purchase a large piece of equipment from Providence Construction Equipment, Inc. on January 1, 2013 for $464,000. Because the company has a number of construction projects going on at the moment, before going through with the purchase, the CFO want check into leasing the machine to see if there are any advantages. Dominican Bankcorp has offered to lease the machine to Friar Construction for an annual lease payment of $55,800 for 16 years with lease payments to be made at the end of the year. At the end of the lease, Friar can purchase the machine from Dominican for $1,000. The estimated useful life of a new machine is 20 years with no residual value. Friar will be responsible for the insurance, maintenance and repair costs on the machine during the lease. Friar Construction’s incremental borrowing rate is 10%, and Dominican’s implicit interest rate for the lease is 9%, which is known to Friar Construction. 1. Does the lease transfer ownership at the end? NO 2. Is there a bargain purchase option? YES 3. Lease term vs. Asset Life? 16 vs 20 yrs =75% 4. PV of lease payments > 90% FMV of asset? ?

PV OF LEASE PAYMENTS CALCULATION Friar Construction Company has decided to purchase a large piece of equipment from Providence Construction Equipment, Inc. on January 1, 2013 for $464,000. Because the company has a number of construction projects going on at the moment, before going through with the purchase, the CFO want check into leasing the machine to see if there are any advantages. Dominican Bankcorp has offered to lease the machine to Friar Construction for an annual lease payment of $55,800 for 16 years with lease payments to be made at the end of the year. At the end of the lease, Friar can purchase the machine from Dominican for $1000. The estimated useful life of a new machine is 20 years with no residual value. Friar will be responsible for the insurance, maintenance and repair costs on the machine during the lease. Friar Construction’s incremental borrowing rate is 10%, and Dominican’s implicit interest rate for the lease is 9%, which is known to Friar Construction. YEAR 1 2 3 YR 4 to 15 16 PYMTS $55,800 $55,800 $55,800 $55,800 $55,800 USE 9% IMPLICIT RATE INTEREST RATE FOR PV  10% VS 9% PV OF ORDINARY ANNUITY – 16 YR AT 9% = 8.31256 $55,800 x 8.31256 = PV $463,845 + PV of $1,000 BPO = 252 > 90% of $464,000

PV OF LEASE PAYMENTS CALCULATION Friar Construction Company has decided to purchase a large piece of equipment from Providence Construction Equipment, Inc. on January 1, 2013 for $464,000. Because the company has a number of construction projects going on at the moment, before going through with the purchase, the CFO want check into leasing the machine to see if there are any advantages. Dominican Bankcorp has offered to lease the machine to Friar Construction for an annual lease payment of $55,800 for 16 years with lease payments to be made at the end of the year. At the end of the lease, Friar can purchase the machine from Dominican for $1,000. The estimated useful life of a new machine is 20 years with no residual value. Friar will be responsible for the insurance, maintenance and repair costs on the machine during the lease. Friar Construction’s incremental borrowing rate is 10%, and Dominican’s implicit interest rate for the lease is 9%, which is known to Friar Construction. $55,800 x 8.31256 = PV $463,840 + PV of $1,000 = 252 $464,092 > 90% of $464,000 THE LESSORS IMPLICIT INTEREST RATE OF 9% IS EXACTLY THE RATE WHICH WILL CAUSE THE PV OF LEASE PAYMENTS TO EQUAL THE FAIR MARKET VALUE OF THE MACHINE

LESSEE ACCOUNTING – EXAMPLE 2 Friar Construction Company has decided to purchase a large piece of equipment from Providence Construction Equipment, Inc. on January 1, 2013 for $464,000. Because the company has a number of construction projects going on at the moment, before going through with the purchase, the CFO want check into leasing the machine to see if there are any advantages. Dominican Bankcorp has offered to lease the machine to Friar Construction for an annual lease payment of $55,800 for 16 years with lease payments to be made at the end of the year. At the end of the lease, Friar can purchase the machine from Dominican for $1,000. The estimated useful life of a new machine is 20 years with no residual value. Friar will be responsible for the insurance, maintenance and repair costs on the machine during the lease. Friar Construction’s incremental borrowing rate is 10%, and Dominican’s implicit interest rate for the lease is 9%, which is known to Friar Construction. 1. Does the lease transfer ownership at the end? NO 2. Is there a bargain purchase option? YES 3. Lease term vs. Asset Life? YES: 16 vs 20 yrs =75% 4. PV of lease payments >90% FMV of asset? YES Conclusion: CAPITAL LEASE

Accounting by the Lessee – EXAMPLE 2 What type of lease is this? CAPITAL LEASE meets 3 of 4 criteria (ONLY NEED TO MEET ONE) Prepare the journal entries to account for the first year of the lease on the books of the lease, Friar Construction assuming that Friar Construction pays $9,000 on maintenance of the equipment in addition to the lease payment. Dr. Equipment under Capital Lease 464,000 Cr. Lease Liability 464,000 NOTE: CAPITALIZE USE EITHER FMV or PV of Lease Payments – WHICHEVER IS LOWER (i.e. the LESSER OF the two amounts

Accounting by the Lessee – EXAMPLE 2 Record Depreciation on Capital Asset: Dr. Depreciation Expense 23,200 Cr. Accumulated Depreciation 23,200 $464,000/20 yr (due to Bargain Purchase option) = 23,200 / yr REMINDER: Depreciation Period If lease transfers ownership, depreciate asset over the economic life of the asset. If lease does not transfer ownership, depreciate over the term of the lease.

Accounting by the Lessee – EXAMPLE 2 Prepare the journal entries to account for the first year of the lease on the books of the lease, Friar Construction assuming that Friar Construction pays $9,000 on maintenance of the equipment in addition to the lease payment. Show how this lease will appear on Friar Construction’s balance sheet and income statement at the end of 2013. 2013 LEASE PAYMENT Dr. Lease Liability 14,040 Interest Expense 41,760** Cr. Cash 55,800 ** Using Effective Interest Method $464,000 x.09 = $41,760 first-year interest expense

Accounting by the Lessee – EXAMPLE 2 Show how this lease will appear on Friar Construction’s balance sheet and income statement at the end of 2013. BALANCE SHEET INCOME STATEMENT Depreciation 23,200 Repairs Expense 9,000 Interest Expense 41,760 Leased Asset 464,000 Less: (A/D) (23,200) 440,800 Lease Liability 449,960* *(464,000 – 14,040)

Accounting by the Lessee On January 1, 2012, Adams Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9,968 at the beginning of each year, starting January 1, 2012. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adams’s incremental borrowing rate is 10%, and the lessor’s implicit rate is unknown. Instructions What type of lease is this? Explain. Compute the present value of the minimum lease payments. Prepare all necessary journal entries for Adams for this lease through January 1, 2013. NOTE: This exercise is similar to E1 in the Kieso textbook LO 2

Accounting by the Lessee What type of lease is this? Explain. Capitalization Criteria: Transfer of ownership Bargain purchase option Lease term = 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property Capital Lease, #3 NO NO Lease term 5 yrs. Economic life 6 yrs. YES 83.3% FMV of leased property is unknown. LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Compute present value of the minimum lease payments. Payment $ 9,968 Present value factor (i=10%,n=5) 4.16986 PV of minimum lease payments $41,565 1/1/12 Journal Entries: Leased Machine (under capital leases) 41,565 Lease Liability 41,565 Lease Liability 9,968 Cash 9,968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Lease Amortization Schedule LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Journal entries for Adams through Jan. 1, 2013. 12/31/12 Depreciation Expense 8,313 Accumulated Depreciation 8,313 ($41,565 ÷ 5 = $8,313) Interest Expense 3,160 Interest Payable 3,160 ($41,565 – $9,968) X .10] LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Journal entries for Adams through Jan. 1, 2013. 1/1/13 Lease Liability 6,808 Interest Payable 3,160 Cash 9,968 LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

Accounting by the Lessee Operating Method The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. Illustration: Assume Adams accounts for it as an operating lease. Adams records this payment on January 1, 2012, as follows. Rent Expense 9,968 Cash 9,968 LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessee Comparison of Capital Lease with Operating Lease LO 3 Contrast the operating and capitalization methods of recording leases.