Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

C H A P T E R 21 LeasesLeases

1. Explain the nature, economic substance, and advantages of lease transactions. 2. Identify and explain the accounting criteria and procedures for capitalizing leases by the lessee. 3. Identify the lessee’s disclosure requirements for capital leases. 4. Identify the lessee’s accounting and disclosure requirements for an operating lease. Learning Objectives

5. Contrast the operating and capitalization methods of recording leases. 6. Calculate the lease payment required for the lessor to earn a given return. 7. Identify the classifications of leases for the lessor. 8. Describe the lessor’s accounting for direct financing leases. 9. Describe the lessor’s accounting for sales-type leases. Learning Objectives

10. Describe the lessor’s accounting for operating leases. 11. Identify the lessor’s disclosure requirements. 12. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. 13. Describe the effect of bargain purchase options on lease accounting. 14. Describe the lessor’s accounting treatment for initial direct costs. Learning Objectives

15. Describe the lessee’s accounting for sale- leaseback transactions (Appendix 21A). 16. Explain the classification and accounting treatment accorded leases that involve land as well as buildings and equipment (Appendix 21A).

Leases Basics of Leasing Advantages of leasing Conceptual nature of a lease Illustrations of Lease Arrange- ments Harmon, Inc. Arden’s Oven Corp. Mendotta Truck Corp. Appleland Computer Accounting by Lessees Capitalization criteria Accounting for a capital lease Capital lease method illustrated Reporting and disclosure-capital leases Accounting for an operating lease Reporting and disclosure-operating leases Perspectives Illustration of disclosures Accounting by Lessors Economics of leasing Classification Capitalization criteria Direct financing lease Sales-type lease Operating leases Reporting and disclosure Illustration of lessor disclosures Special Accounting Issues Residual values Bargain purchase options Initial direct costs Current versus noncurrent Unsolved problems

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

Advantages of Leasing 100 percent financing at a fixed rate100 percent financing at a fixed rate –No down payment required –Rate charged is fixed for the term of the lease Protection from obsolescenceProtection from obsolescence –Property can be upgraded FlexibilityFlexibility –Lease may be structured to meet different needs (e.g., cash flow) Less costly financing (lessee); tax incentives (lessor)Less costly financing (lessee); tax incentives (lessor) Off-balance sheet financingOff-balance sheet financing –Impact on ratios

Differing Views on Capitalization of Leases Do not capitalize any leased assets –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 –If instalment purchases are capitalized, so should leases with similar characteristics

Differing Views on Capitalization of Leases Capitalize all long-term leases –The long-term right to use property justifies its capitalization (property rights approach) Capitalize firm leases where the penalty for nonperformance is substantial –Capitalize only “firm” or non-cancellable contractual rights and obligations

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

Current Accounting Standard Basic Conclusions: 1.Characteristics indicating transfer of risks and benefits of ownership must be identified 2.Same characteristics should apply to the lessee and lessor 3.Leases that do not transfer substantially all benefits and risks of ownership should not be capitalized

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

Lease Classification Operating LeaseOperating Lease –Where the rights and risks of ownership have not been transferred A rental-only has occuredA rental-only has occured –Journal Entries: LesseeLessor Lease ExpenseXXXCashXXX Cash XXX Rental Revenue XXX Cash XXX Rental Revenue XXX

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 Capital Lease Operating Lease Yes Yes Yes NoNoNo Lease Agreement Capital vs. Operating Lease

Transfer of ownershipTransfer of ownership Economic lifeEconomic life PV of paymentsPV of payments –If the PV of minimum lease payments is  90% of the fair value of the asset –minimum lease payments (lessee) defined: Minimum rental payments +Minimum rental payments + Guaranteed residual value +Guaranteed residual value + Penalty for not renewing or extending lease +Penalty for not renewing or extending lease + Bargain purchase optionBargain purchase option Capital Lease Criteria

Minimum rental paymentsMinimum 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 minimum rental payment calculationExecutory costs include insurance, maintenance and tax expenses. If these payments made by the lessor, they are estimated and excluded from the minimum rental payment calculation Guaranteed residual valueGuaranteed 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 3 rd party guarantor) guarantees that the lessor will realize Minimum Lease Payments

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

Asset and liability recorded at the lower of:Asset and liability recorded at the lower of: –PV of the minimum lease payments (as defined above) or –Fair value of the asset at the inception of the lease Depreciation of the asset is amortized over: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 or there is no bargain purchase option –Otherwise over the term of the lease Accounting for a Capital Lease

Interest expense resulting from the lease transaction is recorded following the effective interest methodInterest 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 Journal entries required to record a capital lease transaction are as follows:Journal entries required to record a capital lease transaction are as follows: Accounting for a Capital Lease

At the inception of the lease Dr. Asset Cr.Obligations under capital lease To record interest amortization 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

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

Capital Lease - Example Does this qualify as a capital lease?Does this qualify as a capital lease? Only one of the tests must be metOnly 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 Capital Lease Yes PV of payments (n=5, i=10%) 25, = 23, x = $100, Yes

Entry to record initial lease transaction Leased Equipment100,000 Lease Liability 100,000Entry to record initial lease transaction Leased Equipment100,000 Lease Liability 100,000 Entry to record initial payment (Jan 1/05) Property Tax Expense 2, Lease Liability23, Cash25,981.62Entry to record initial payment (Jan 1/05) Property Tax Expense 2, Lease Liability23, Cash25, As this is a capital lease the following must also be recorded (at year end or in each reporting period)As this is a capital lease the following must also be recorded (at year end or in each reporting period) –Interest expense –Asset amortization Capital Lease - Example

Interest amortization (December 31, 2005) Interest Expense7, Interest Payable 7, (100,000-23,981.62)*10% = 7, (Interest Payable is debited in all subsequent lease payment entries)Interest amortization (December 31, 2005) Interest Expense7, Interest Payable 7, (100,000-23,981.62)*10% = 7, (Interest Payable is debited in all subsequent lease payment entries) Asset amortization (December 31, 2005) Amortization expense20,000 Accumulated amortization20,000 (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)Asset amortization (December 31, 2005) Amortization expense20,000 Accumulated amortization20,000 (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) Capital Lease - Example

Gross amount of assets and related accumulated amortizationGross amount of assets and related accumulated amortization Amortization expense may be disclosed, methods and rate should be disclosedAmortization expense may be disclosed, methods and rate should be disclosed Lease obligations reported separately from other liabilitiesLease obligations reported separately from other liabilities Current portion of lease obligation=current liabilityCurrent portion of lease obligation=current liability Minimum lease payments in total and for the next five fiscal years; executory costs and imputed interest disclosed separatelyMinimum 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 expenseInterest expense from the lease may be separately disclosed; or included with other interest expense May disclose any related contingenciesMay disclose any related contingencies Disclosure Requirements – Capital Lease

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

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

Both the direct financing lease and the sales- type lease are capital leasesBoth 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 profitThe 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 mapThe 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 lessorA lease may qualify as a capital lease by the lessee and as an operating lease by the lessor Lease Classification - Lessor

Lessor replaces investment in asset to be leased with a lease receivableLessor replaces investment in asset to be leased with a lease receivable Over lease term, the receivable is collected, and interest is earnedOver lease term, the receivable is collected, and interest is earned Net investment in the lease = lease payments receivable – unearned interest revenueNet investment in the lease = lease payments receivable – unearned interest revenue Direct Financing Lease - 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 residue value -0- Amount to be recovered through lease payments $100,000 lease payments $100,000 Calculation of Lease Payment by Lessor

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

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

January 1, 2005 Lease Payments Receivable 119, Equipment for Lease100, Unearned Interest Revenue 19, January 1, 2005 (first payment) Cash ($23, $2,000) 25, Property Tax Expense 2, Lease Payments Receivable23, December 31, 2005 Unearned Interest Revenue 7, Interest Revenue 7, Direct Financing Lease (Lessor)

At Dec. 31/05 year end, Lessor recognizes interest earned: Amount originally financed $100, Paid on principal Jan. 1/05 (23,981.62) Balance outstanding $ 76, Interest : 10% x 76, x 12/12 = $7, = $7, Unearned Interest Revenue 7, Interest Revenue 7, Interest Revenue 7, Direct Financing Lease (Lessor)

Entries are the same as for the direct financing lease, except for: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 financedLessor earns a gross profit on sale + interest as the sale is financed Sales-Type Lease - Lessor

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)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 inceptionAll previous lessor entries remain the same except for the entry at the lease inception –Sales and Gross Profit are recorded

Sales-Type Lease – Example January 1, 2005 Lease Payments Receivable 119, Sales100, Unearned Interest Revenue 19, Cost of Goods Sold 85, Inventory 85, January 1, 2005 (first payment-remains the same) Cash ($23, $2,000) 25, Property Tax Expense 2, Lease Payments Receivable 23, December 31, 2005 (remains the same) Unearned Interest Revenue 7, Interest Revenue 7,601.84

Disclose the net investment in the lease (classified as current and non-current)Disclose the net investment in the lease (classified as current and non-current) How the investment is calculated for purposes of income recognitionHow the investment is calculated for purposes of income recognition Finance income amountFinance income amount Operating LeasesOperating Leases –Separate disclosure of the cost and accumulated amortization of the property –Amount of rental (lease) income earned Disclosure Requirements - Lessor

Residual Value – LessorResidual Value – Lessor –Direct Financing Lease: whether guaranteed or unguaranteed, the residual is included in the lessor calculations –Sales-Type Lease: with unguaranteed residual value the Sales Revenue and COGS are reduced by the PV of that unguaranteed residual value –Residual value is part of Sales Revenue (and COGS) if guaranteed Other Lease Accounting Issues

Residual Value – LesseeResidual Value – Lessee –If guaranteed by lessee, p.v. of residual is included in asset 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 – not in asset or liability amounts recognized

Bargain Purchase OptionBargain Purchase Option –With direct financing and sales-type leases, the bargain purchase price is included in the net investment calculations by Lessor –Lessee accounting assumes bargain option price will be paid: p.v. of amount included in asset cost and obligation recognized Other Lease Accounting Issues

Initial Direct Costs of Lessor Application of Matching PrincipleApplication of Matching Principle –Operating lease – over term of lease –Direct financing lease – over term of lease –Sales-type lease – in same period as gross profit on sale recognized

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

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