Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Leases 15

15-2 Learning Objectives Identify and describe the operational, financial, and tax objectives that motivate leasing.

15-3 Basic Lease Terms A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessor = Owner of property Lessee = Renter

15-4 Lease Classifications

15-5 Learning Objectives Explain why some leases constitute rental agreements and some represent purchase/sales accompanied by debt financing.

15-6 Capital Leases and Installment Notes Compared Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 (rounded) every six months for the next three years. The interest rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital lease agreement. First, let’s prepare an amortization schedule for the payments.

15-7 Inception of the Agreement January 1

15-8 First Semi-Annual Payment Date June 30

15-9 Learning Objectives Explain the basis for each of the criteria and conditions used to classify leases.

15-10 Capital Lease Classification  Ownership transfers to the lessee at the end of the lease term, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or...  The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.  Ownership transfers to the lessee at the end of the lease term, or...  A bargain purchase option (BPO) exists, or...  The noncancelable lease term is equal to 75% or more of the expected economic life of the asset, or...  The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset. capital leaseone A capital lease must meet one of four criteria:

15-11 Capital Lease Classification A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured. The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not apply. For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease.

15-12 Additional Lessor Conditions The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: 1.The collectibility of the lease payments must be reasonably predictable. 2.If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete. The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease: 1.The collectibility of the lease payments must be reasonably predictable. 2.If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete. Lessor = Owner of the property subject to the lease agreement.

15-13 Learning Objectives Record all transactions associated with operating leases by both the lessor and lessee.

15-14 Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease. Capital Lease

15-15 Operating Leases On December 1, 2006, Matrix, Inc. signed a two-year operating lease with RentPro, Inc. for office equipment. The lease called for $500 per month, payable at the beginning of each month. The first payment was due on December 1, Matrix paid three months of rent in advance on December 1, On December 1, 2006, Matrix, Inc. signed a two-year operating lease with RentPro, Inc. for office equipment. The lease called for $500 per month, payable at the beginning of each month. The first payment was due on December 1, Matrix paid three months of rent in advance on December 1, 2006.

15-16 Operating Leases Prepare the entry on the books of Matrix on December 1, 2006.

15-17 Operating Leases Prepare the entry the RentPro would make to record receipt of the December 1, 2006.

15-18 Operating Leases The December 31 st adjustment by Matrix. The December 31 st adjustment by RentPro.

15-19 Learning Objectives Describe and demonstrate how both the lessee and lessor account for a nonoperating lease.

15-20 We’ll look at non-operating leases for both the lessee and lessor as we move through our examples.

15-21 Nonoperating Leases - Lessee The amount recorded (capitalized) is the present value of the minimum lease payments. However, the amount recorded cannot exceed the fair value of the leased asset. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor.

15-22 Nonoperating Leases - Lessor When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price. If the lessor is not a manufacturer or dealer, the fair value of the leased asset is typically the lessor’s cost.

15-23 Nonoperating Leases On January 1, 2006, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease calls for $6,000 per year, payable at the beginning of each year starting on 1/1/06. The equipment has an economic life of 5 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment. On January 1, 2006, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease calls for $6,000 per year, payable at the beginning of each year starting on 1/1/06. The equipment has an economic life of 5 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to calculate the annual payment.

15-24 Nonoperating Leases - Lessee The lease term meets the “75% of the economic life” test. The lease term meets the “75% of the economic life” test.

15-25 Nonoperating Leases - Lessee The PV of the MLP  90% of the equipment’s fair value

15-26 Nonoperating Leases - Lessee Matrix makes the following entries at inception of the lease.

15-27 Nonoperating Leases - Lessor In addition to the information given earlier, the lessor (RentPro) knows that the collectibility of the lease payments is reasonably predictable, and there are no future costs to be incurred. RentPro’s performance is substantially complete as far as the lease is concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is $25,873 (rounded).

15-28 Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair market value, the lease is classified as a Direct Financing Lease. $6,000 × 5 = $30,000

15-29 Nonoperating Leases - Lessor Because the cost of the asset is equal to its fair market value, the lease is classified as a Direct Financing Lease. Receipt of the first lease payment.

15-30 Lease Amortization Schedule

15-31 Nonoperating Leases December 31, 2006, adjustment by Matrix. December 31, 2006, adjustment by RentPro.

15-32 Depreciation by Lessee Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets. If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase option, the asset is depreciated over the asset’s economic life; otherwise, it is depreciated over the lease term.

15-33 Depreciation by Lessee At December 31, 2006, Matrix prepares the following entry to recognize depreciation expense for the year. $25,873 5 years = $5,175

15-34 Nonoperating Leases - Lessee Matrix records the second payment on January 1, From the December 31, 2006, accrual.

15-35 Nonoperating Leases - Lessor RentPro records the second receipt on January 1, 2007.

15-36 Learning Objectives Describe and demonstrate how the lessor accounts for a sales-type lease.

15-37 Sales-Type Lease Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to the cost of the asset. Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to the cost of the asset. At inception of the lease, the lessor will record the Cost of Goods Sold as well as the Sales Revenue (PV of MLP).

15-38 Sales-Type Lease On 1/1/06, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The lease calls for payments of $118,516 at the end of each of the next three years. The equipment has a 3-year economic life, a fair value of $300,000 and cost to RentPro of $222,500. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection with the lease. On 1/1/06, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The lease calls for payments of $118,516 at the end of each of the next three years. The equipment has a 3-year economic life, a fair value of $300,000 and cost to RentPro of $222,500. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection with the lease.

15-39 Sales-Type Lease This is a sales-type lease because the lease term is 100% of the economic life of the asset (3 years), the MLP will be collected, no further costs will be incurred by RentPro, and the cost of the asset to RentPro is not equal to its fair value. Matrix treats this as a capital lease because the lease term is 100% of the economic life of the asset.

15-40 Sales-Type Lease Calculation of the lease payment. Lease Amortization Table

15-41 Sales-Type Lease - Lessor Entry at inception of the lease ($118,517 × 3) = $355,551

15-42 Capital Lease - Lessee Entry at inception of the lease

15-43 Sales-Type Lease - Lessee First payment

15-44 Sales-Type Lease - Lessee Record first year depreciation $300,000 ÷ 3 (lease term) = $100,000

15-45 Sales-Type Lease - Lessor First receipt

15-46 Learning Objectives Explain how lease accounting is affected by the residual value of a leased asset.

15-47 Residual Value The residual value of a leased asset is an estimate of what its commercial value will be at the end of the lease term. Let’s see how residual value impacts the accounting for leases by both the lessee and lessor.

15-48 Residual Value The only impact on the lessee is the determination of depreciation expense. The cost of the asset will be reduced by the estimated residual value and depreciated over the economic life of the asset. Lessee Obtains Title to Leased Asset.

15-49 Residual Value In determining the lease payment, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payment. Lessor Retains Title to Leased Asset.

15-50 Residual Value On January 1, 2006, RentPro, Inc. signed a 10- year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the equipment is retained by RentPro and it is estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro requires an 8% return on leased equipment. Let’s calculate the lease payment! On January 1, 2006, RentPro, Inc. signed a 10- year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the equipment is retained by RentPro and it is estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro requires an 8% return on leased equipment. Let’s calculate the lease payment!

15-51 Residual Value Calculation of the lease payment.

15-52 Residual Value Guaranteed by Lessee Lessee pays any difference between guaranteed residual value and the appraised value. On 1/1/06, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by RentPro. The lease payment is based on a 8% return. Let’s calculate the lease payment! On 1/1/06, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by RentPro. The lease payment is based on a 8% return. Let’s calculate the lease payment!

15-53 Residual Value Guaranteed by Lessee Calculation of the lease payment.

15-54 Residual Value Guaranteed by Lessee Residual value

15-55 Residual Value Guaranteed by Lessee The accounting for this direct financing lease will be the same as previously discussed, with two exceptions: 1.The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, and 2.If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must pay the difference between appraised value and guaranteed residual value to the lessor. The accounting for this direct financing lease will be the same as previously discussed, with two exceptions: 1.The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, and 2.If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must pay the difference between appraised value and guaranteed residual value to the lessor.

15-56 Learning Objectives Describe the way a bargain purchase option affects lease accounting.

15-57 Bargain Purchase Option A provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. On 1/1/06, Matrix, Inc. signed a 5-year lease with Apex Leasing for equipment that requires semi-annual, beginning of period payments. For Apex there are no unreimbursable costs and the collection of the MLP is assured.

15-58 Lease Classification This is a capital lease to Matrix (lessee) because it contains a bargain purchase option. This is a direct-financing lease to Apex (lessor) because it contains a bargain purchase option, there are no unreimbursable costs and the MLP is fully collectible.

15-59 Lease Computations Lease payment (pmt) = $60,377 (rounded). Lease payment – determined by Apex (lessor) PV of MLP – determined by Matrix (lessee) PV of MLP (pv) = $485,000.00

15-60 Bargain Purchase Option Effective Interest Amortization

15-61 Inception of the Lease Lessee Lessor

15-62 Second Lease Payment Lessee Lessor

15-63 Year-End Accrual Lessee Lessor

15-64 End of the Lease Term At the end of the lease term, Matrix exercises the BPO and pays Apex $25,000.

15-65 Learning Objectives Explain the impact on lease accounting of executory costs, the discount rate, initial direct costs, and contingent rentals.

15-66 Executory Costs Executory costs include costs of ownership like maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible for the executory costs, they are treated as expenses by the lessee. In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

15-67 Discount Rate In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor. In calculating the present value of the minimum lease payments, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor.

15-68 Initial Direct Costs Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.  Operating Leases − Capitalize and amortize over the lease term by the lessor.  Direct Financing Leases − Include as part of investment balance. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement. Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.  Operating Leases − Capitalize and amortize over the lease term by the lessor.  Direct Financing Leases − Include as part of investment balance.

15-69 Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements. Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

15-70 Lessee Disclosures  For capital leases, disclose Gross amount of assets recorded under capital leases. Future MLP in the aggregate and for each of the five succeeding years. Total minimum sublease rentals to be received in the future under noncancelable subleases. Total contingent rentals.

15-71 Lessee Disclosures  For operating leases in excess of one year, disclose Future minimum rental payments required in the aggregate and for each of the five succeeding fiscal years. Total of minimum rentals to be received in the future under noncancelable subleases.  For all operating leases, disclose rental expense, with separate amounts for minimum rentals, contingent rentals, and sublease rentals.

15-72 Lessee Disclosures  Provide a description of the lessee’s leasing arrangements including, but not limited to The basis on which contingent rental payments are determined. The existence and terms of renewal or purchase options and escalation clauses. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing.

15-73 Lessor Disclosures  For sales-type and direct financing leases, disclose Components of the net investment in sales- type and direct financing leases Future MLP to be received. Unguaranteed residual values. Unearned Interest Revenue. Future MLP to be received for each of the five succeeding fiscal years. Total contingent rentals included in income.

15-74 Lessor Disclosures  For operating leases, disclose Cost and carrying amount of property on lease or held for leasing. Minimum future rentals on noncancelable leases in the aggregate and for each of the five succeeding years. Total contingent rentals included in income.  Provide a general description of the lessor’s leasing arrangements.

15-75 Balance Sheet & Income Statement Lease transactions impact several financial ratios: 1.Debt to equity ratio – Lease liabilities are recorded. 2.Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet. Lease transactions impact several financial ratios: 1.Debt to equity ratio – Lease liabilities are recorded. 2.Rate of return on assets – Lease assets are recorded. Whether leases are capitalized or treated as an operating lease affects the income statement and balance sheet. The greater impact is on the balance sheet.

15-76 Statement of Cash Flows Operating leases - Rent expense is a cash outflow to the lessee and a cash inflow to the lessor. Capital & Direct Financing Leases – Lessee reports interest expense as an outflow from operating activities and principal payment as an outflow from financing activities. The lessor has a cash inflow from operating activities and investing activities. Operating leases - Rent expense is a cash outflow to the lessee and a cash inflow to the lessor. Capital & Direct Financing Leases – Lessee reports interest expense as an outflow from operating activities and principal payment as an outflow from financing activities. The lessor has a cash inflow from operating activities and investing activities.

15-77 Statement of Cash Flows Sales-type leases – The lessor recognizes the interest revenue in the operating activities section of the statement and the principal reduction in the investing section. In addition, the lessor has sales revenue and cost of goods sold recognized in the operating activities section.

15-78 Learning Objectives Explain sale-leaseback agreements and other special leasing arrangements and their accounting treatment.

15-79 Special Leasing Arrangements Sale-Leaseback Arrangements The owner of an asset sells it and immediately leases it back from the new owner. The reasons for this include: 1.The seller-lessee receives cash from the sale of the asset. 2.The seller-lessee pays periodic rent payments to the buyer-lessor to retain the use of the asset.

15-80 Special Leasing Arrangements Sale-Leaseback Arrangements The two most common reasons for this type of transaction are: 1.If the asset had been financed originally with debt, and interest rates have fallen, the sale-leaseback transaction can be used to effectively refinance at a lower rate. 2.The most likely motivation for this transaction is to increase general cash for the seller-lessee

15-81 Treatment of Gains and Losses In a sales-leaseback, any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately.

15-82 Real Estate Leases There are special accounting procedures that must be followed for: 1.Leases of land only. 2.Leases of land and building. 3.Leases of only part of a building. There are special accounting procedures that must be followed for: 1.Leases of land only. 2.Leases of land and building. 3.Leases of only part of a building.

15-83 End of Chapter 15