Leases PV Computations Classification of Leases Under US GAAP & IFRS Acct 414 – Fall 2008 – Prof. Teresa Gordon

BPO - Lease 1E 1. Inception date: 1/1/12 2. Lessor: Troy Tractors Inc. 3. Fair value of combine at 1/1/02: $50, Cost to manufacture combine: $40, Estimated fair value at end of lease is $10, Fixed non-cancelable lease term: 5 years. 7. First payment due on 12/31/12 8. Lessee: Farview Farms 9. Incremental borrowing rate (lessee): 12% 10. Implicit interest rate (known to lessee): 12% 11. Option to buy at end of lease term for $5, Estimated useful life of combine: 8 years 1e

Bargain Purchase Option PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE 0 50, $13,083$6,000.00$7, , ,083 5, , , ,083 4, , , ,083 3, , , ,083 1, , Note that the last payment will include the $5,000 BPO 1e

Bargain Purchase Option PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE 0 50, $13,083$6,000.00$7, , ,083 5, , , ,083 4, , , ,083 3, , , ,083 1, , $50,000 * 12% $13,083 - $6,000 $50,000 - $7,083 1e An ordinary annuity situation – the first line includes interest

Bargain Purchase Option PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE 0 50, $13,083$6,000.00$7, , ,083 5, , , ,083 4, , , ,083 3, , , ,083 1, , Now, prepare the journal entries 1e

Bargain Purchase Option PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE 0 50, $13,083$6,000.00$7, , ,083 5, , , FARVIEW FARMS Combine (at PVMLP)50,000 Lease Liability. 50,000 Interest Expense 6,000 Lease Liability. 7,083 Cash 13,083 Depreciation Expense 6,250 Acc'd Depreciation 6,250 Depreciation Expense 6,250 Acc'd Depreciation 6,250 1/1/02 12/31/02 Useful life = 8 years 1e

Bargain Purchase Option PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE 0 50, $13,083$6,000.00$7, , ,083 5, , , TROY TRACTORS INC. Lease Receivable50,000 Sales50,000 COGS40,000 Inventory40,000 Cash13,083 Lease Receivable 7,083 Interest Revenue 6,000 1/1/02 12/31/02 1e

Example 1F 1.Inception date: 1/1/12 2.Lessor: Troy Tractors Inc. 3.Fair value of combine at 1/1/12: $50,000 4.Estimated fair value at end of lease is $10,000 5.First payment due on 1/1/12 6.Lessee: Farview Farms 7.Fixed non-cancelable lease term: 6 years. 8.Option to buy at end of lease term for $2,000 9.Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40,000. 1f What amount should the payment be given that the lessor requires a 12% return?

Example 1F 1.Inception date: 1/1/12 2.Lessor: Troy Tractors Inc. 3.Fair value of combine at 1/1/12: $50,000 4.Estimated fair value at end of lease is $10, First payment due on 1/1/12 6.Lessee: Farview Farms 7.Fixed non-cancelable lease term: 6 years 8.Option to buy at end of lease term for $2,000 9.Estimated useful life of combine: 8 years 10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12% 11. The cost to manufacture the tractor is $40, Payment = 10,638 1f Now, classify the lease

Example 1f PAYMENTINTEREST"PRINCIPAL" BALANCE PAYMENTINTEREST"PRINCIPAL" BALANCE $50, $50, $10,638$ 0.00$10, , ,638 4, , , ,638 4, , , ,638 3, , , ,638 2, , , ,638 1,331,33 9, , , , f Note that the first payment is ALL principal since no interest has yet been incurred 39,362 * 12% 10, ,723 39, ,915 Note that there is interest on the BPO This is an annuity due situation – the first payment is 100% principal.

A quick comparison IFRS vs. US GAAP IAS 17 vs. FAS 13 as amended many times

IFRS uses “indicators” that are considered as a whole Indications that a contract is a FINANCE lease –Title transfer –Bargain purchase option –Term of lease covers a majority of leased asset’s economic life –Present value of minimum lease payments is equivalent to nearly all of the leased asset’s fair value But there’s more! Note that IFRS has no “bright line” rules

Indications that a contract is a FINANCE lease (continued) –Leased assets are of a specialized nature and are only usable by the lessee unless substantial costs are incurred to modify (nothing comparable in US GAAP) –Upon early termination of lease, lessee is responsible for lessor’s losses –Any gains & losses due to fluctuations in fair value of leased asset are attributed to the lessee –Lessee has option to renew for below market cost

Terminology Differences IFRSUS GAAP For LessorOperating lease Finance leaseDirect Financing Lease Finance leaseSales-type lease Finance leaseLeveraged lease For LesseeOperating lease Finance leaseCapital lease

Example 2 1.Inception of the lease: January 1, Inception of the lease: January 1, Term: 3 years 2.Term: 3 years 3.Implicit interest rate (known to lessee) 10% 3.Implicit interest rate (known to lessee) 10% 4.Fair value of asset $100,000 4.Fair value of asset $100,000 5.Incremental borrowing rate: 12% 5.Incremental borrowing rate: 12% 6.No collection or cost uncertainties for lessor 6.No collection or cost uncertainties for lessor 7.First payment due 1/1/12 7.First payment due 1/1/12 8.Estimated useful life of asset: 5 years 8.Estimated useful life of asset: 5 years 9.Lessor retains ownership of asset at end of lease 9.Lessor retains ownership of asset at end of lease 10. Cost of asset $100, Payments of $36,556 per year 2

What to use for “i” To do present value computations, we need an interest rate. Lessors always use the interest rate implicit in the lease The lessee uses the LOWER of the implicit interest rate and their own incremental borrowing rate Under IFRS: “The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall be used.

Example 2a 1.Inception of the lease: January 1, Inception of the lease: January 1, Term: 3 years 2.Term: 3 years 3.Implicit interest rate ( known to lessee) 10% 3.Implicit interest rate (NOT known to lessee) 10% 4.Fair value of asset $100,000 4.Fair value of asset $100,000 5.Incremental borrowing rate: 12% 5.Incremental borrowing rate: 12% 6.No collection or cost uncertainties for lessor 6.No collection or cost uncertainties for lessor 7.First payment due 1/1/12 7.First payment due 1/1/12 8.Estimated useful life of asset: 5 years 8.Estimated useful life of asset: 5 years 9.Lessor retains ownership of asset at end of lease 9.Lessor retains ownership of asset at end of lease 10. Cost of asset $100, Payments of $36,556 per year 2a What if the lessor’s rate were NOT known to lessee? What would be the PVMLP?

On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 1.Term: 3 years 1.Term: 3 years 3.Implicit interest rate (known to lessee) 10% 3.Implicit interest rate (known to lessee) 10% 5.Fair value of asset $130,000 5.Fair value of asset $130,000 7.Incremental borrowing rate: 12% 7.Incremental borrowing rate: 12% 9.Estimated useful life of asset: 5 years 9.Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2.Payments of $46,836 2.Payments of $46,836 4.Est. fair value of asset at end of lease $2,500 4.Est. fair value of asset at end of lease $2,500 6.Cost of asset $100,000 6.Cost of asset $100,000 8.First payment due 1/1/12 (at inception) 8.First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4a Classify lease under US GAAP and IFRS

On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 1.Term: 3 years 1.Term: 3 years 3.Implicit interest rate (NOT known to lessee) 10% 3.Implicit interest rate (NOT known to lessee) 10% 5.Fair value of asset $130,000 5.Fair value of asset $130,000 7.Incremental borrowing rate: 12% 7.Incremental borrowing rate: 12% 9.Estimated useful life of asset: 5 years 9.Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2.Payments of $46,836 2.Payments of $46,836 4.Est. fair value of asset at end of lease $5,000 4.Est. fair value of asset at end of lease $5,000 6.Cost of asset $100,000 6.Cost of asset $100,000 8.First payment due 1/1/12 (at inception) 8.First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4b What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.

On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the following terms: 1.Term: 3 years 1.Term: 3 years 3.Implicit interest rate (NOT known to lessee) 10% 3.Implicit interest rate (NOT known to lessee) 10% 5.Fair value of asset $130,000 5.Fair value of asset $130,000 7.Incremental borrowing rate: 12% 7.Incremental borrowing rate: 12% 9.Estimated useful life of asset: 5 years 9.Estimated useful life of asset: 5 years 11.Purchase option at end of lease: $2,500 2.Payments of $46,836 2.Payments of $46,836 4.Est. fair value of asset at end of lease $5,000 4.Est. fair value of asset at end of lease $5,000 6.Cost of asset $100,000 6.Cost of asset $100,000 8.First payment due 1/1/12 (at inception) 8.First payment due 1/1/12 (at inception) 10.No collection or cost uncertainties for lessor 4c What if the fair value of the asset is $5,000 at end of the lease? Find the PVMLP.

Complications Initial Direct Costs Residual Values

Initial Direct Costs Type of Lease Accounting Treatment for Initial Direct Costs Operating Recorded as an asset and amortized over the lease term* Direct Financing (US) Finance (IFRS) Recorded as part of investment in lease and amortized over lease term by reducing interest revenue (find new implicit rate)* Sales-type Lease (US) Finance if lessor is manufacturer or dealer (IFRS) Immediately recognized as cost of goods sold (reduces profit or increases loss on sale of leased asset)

Residual Value and MLP Include guaranteed residual value of property when computing PVMLP –If guaranteed by lessee –If guaranteed by third party, only lessor includes as part of minimum lease payments –Unguaranteed residual value is NOT included in MLP Remember that the UnGRV is part of lessor’s receivable and therefore is included in the amortization table!

On 1/1/12, Micronomics Inc. and Ozark Oscillators entered into a lease with the following terms: 1. Term: 4 years 2. Payments of $83, Implicit interest rate (known to lessee) 10% 4. Lessor retains ownership of asset at end of lease 5. Fair value of asset $300, Cost of asset $250, Incremental borrowing rate: 12% 8. First payment due 1/1/02 9. Estimated useful life of asset: 5 years 10. No collection or cost uncertainties for lessor 11. Est. fair value of asset at end of lease: $15, The residual value is guaranteed by a third party at a cost of $500 (initial direct cost) 6

Two different tables needed! 6

On October 1, 2002, Seiler Systems and Computer Leasing of America sign a lease with the following terms: 1.Term: 3 years 1.Term: 3 years 3.Implicit interest rate (NOT known to lessee) 10% 3.Implicit interest rate (NOT known to lessee) 10% 5.Fair value of asset $100,000 5.Fair value of asset $100,000 7.Incremental borrowing rate: 14% 7.Incremental borrowing rate: 14% 9.Estimated useful life of asset: 5 years 9.Estimated useful life of asset: 5 years 11. Est. fair value of asset at end of lease: $10, Payments of $33, Payments of $33, Lessor retains ownership of asset at end of lease 4. Lessor retains ownership of asset at end of lease 6. Cost of asset $100, Cost of asset $100, First payment due 10/1/02 8. First payment due 10/1/ No collection or cost uncertainties for lessor 12. The residual value is NOT guaranteed by lessee 8

Example 7 - Lessor Now we’re ready for the HARDEST type of journal entries: a sales-type lease with unguaranteed residual value –If there is an UnGRV, the lessor has not “sold” the entire asset –This means we need to reduce sales and cost of goods sold for the present value of the unGRV 7

More complications... Lease Term Renewal Periods Executory Costs

Determining the Lease Term Always ends at a bargain purchase option (including ordinary renewal periods up to BPO). Includes renewal periods covered by –bargain renewal options –penalty large enough to assure renewal –renewal or extensions at option of lessor –guarantees by lessee of lessor's debt related to property

Excluded from MLP Exclude contingent rentals Exclude all rental payments past date of bargain purchase option Exclude renewal penalty big enough to assure renewal Exclude executory costs paid by lessor: –maintenance –property taxes –insurance

On June 1, 2012, Fantasia Funnels, Inc. and Idaho First Bank sign a lease with the following terms: 1.Term: 4 years 1.Term: 4 years 3.Interest rate used to compute payments = 12% 3.Interest rate used to compute payments = 12% 5.Fair value of asset $200,000 5.Fair value of asset $200,000 7.Incremental borrowing rate: 14% 7.Incremental borrowing rate: 14% 9.Estimated useful life of asset: 6 years 9.Estimated useful life of asset: 6 years 11. Est. fair value of asset at end of lease: $10, Initial direct costs to arrange lease: $3,000 2.Payments of $61,924 2.Payments of $61,924 4.Cost of asset $200,000 4.Cost of asset $200,000 6.First payment due 6/1/12 6.First payment due 6/1/12 8.No collection or cost uncertainties for lessor 8.No collection or cost uncertainties for lessor 10. The payments include $5,000 for insurance. 12. The lessee can purchase asset for $10,000 at end of lease, otherwise, asset is returned to lessor. 11

Finding the Effective Interest Rate for Direct Financing Lease with IDC 11

Lessor Amortization Table 11

On January 1, 2012, Hells Gate Jet Boats and Washington Leasing Co. sign a lease with the following terms: Term: 4 years with possible renewal (see #12) Implicit interest rate (NOT known to lessee) 10% Fair value of asset $200, Incremental borrowing rate: 14% Estimated useful life of asset: 6 years The residual value is NOT guaranteed by lessee, asset is expected to be worth $25,000 at end of 4 years, and $15,000 at end of 5 years Payments of $49, Lessor retains ownership of asset at end of lease Cost of asset $200, First payment due 1/1/ No collection or cost uncertainties for lessor At the end of the lease, HGJB can renew for one more year at same annual amount of $49,523. This is certainly no bargain. There is a $15,000 penalty for non-renewal of the lease. However, this amount is probably not large enough to assure that HGJB will renew. 12

Inception = 1/1/12 1. Term: 4 years, with possible renewal (see #11) 1. Term: 4 years, with possible renewal (see #11) 3.Implicit interest rate (NOT known to lessee) 10% 3.Implicit interest rate (NOT known to lessee) 10% 5.Fair value of asset $260,000 5.Fair value of asset $260,000 7.Incremental borrowing rate: 12% 7.Incremental borrowing rate: 12% 9.Estimated useful life of asset: 6 years 9.Estimated useful life of asset: 6 years 11. Lease can be renewed for one more year at $17,000. The actual value is probably $25, There are no guarantees of residual value 2.Payments of $68,565 2.Payments of $68, Lessor retains title to the asset at end of lease 4. Lessor retains title to the asset at end of lease 6.Cost of asset $200,000 6.Cost of asset $200,000 8.First payment due 1/1/12 8.First payment due 1/1/ No collection or cost uncertainties for lessor 12. Est. fair value of asset at end of original lease term is $35,000. It should be worth $15,000 at the end of 5 years. 13