DEFINITION: Agreement conveying the right to use property, plant or equipment for stated periods of time. Is the OWNER of the property. Is the RENTER of the property.

Capital vs. Operating Leases. Capital Lease Transfers essentially ALL risk/rewards of ownership to the lessee: Lessee gets property on B/S as asset Debt is recorded as a liability. The asset is even depreciated. Operating Lease Does not essentially transfer all risks/rewards to lessee. Do not report on B/S. Rents are charged as they become due. This is OFF-BALANCE SHEET FINANCING. THIS IS WHAT FIRMS WANT!!

Grafix Inc. (LESSEE) leases a computer from Comfast Inc. (LESSOR) for 2-years beginning January 1, Grafix will pay Comfast $4,800/ yr, payable in advance on January 1 of each year. Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance). Lessee incurs only one risk (payment of rents) and one benefit (temporary use of asset). Lessor’s cost was $30,000, 10 year life and st line depreciation with no salvage) : Receipt of first payment Cash…………….. $4,800 Unearned Revenue……… $4,800 12/31/08 EOY ADJS Unearned Rev… $4,800 Rent Revenue…. $4,800 Depreciation Expense.. $3,000 Accumulated Dep… $3,000 LessOR depreciates the asset because they didn’t relinquish ownership.

Grafix Inc. (LESSEE) leases a computer from Comfast Inc. (LESSOR) for 2-years beginning January 1, Grafix will pay Comfast $4,800/ yr, payable in advance on January 1 of each year. Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance). Lessee incurs only one risk (payment of rents) and one benefit (temporary use of asset). Lessor’s cost was $30,000, 10 year life and st line depreciation with no salvage) : First payment Prepaid rent………… $4,800 Cash……………..$4,800 12/31/08 EOY ADJS Rent Expense………. $4,800 Prepaid………………$4,800

If a lease meets ANY ONE of the following 4 criteria at the inception of the lease, the lease is a CAPITAL LEASE. *TRANSFER OF OWNERSHIP. Explicitly states a transfer of ownership at EOL without payment of additional compensation. *BARGAIN PURCHASE OPTION (BPO). LEASE TERM EQUAL TO 75% OR MORE OF THE ASSETS REMAINING USEFUL SERVICE LIFE. MINIMUM LEASE PAYMENTS (pv) ARE AT LEAST 90% OF THE ASSETS MARKET VALUE.

CAPTIAL LEASE IS RECORDED AT: The LOWER of: VS.

Example: January 1, 2008 LESSOR CO. and LESSEE CO. sign a 3-year, non-cancelable lease for an asset with an estimated economic life of 3 years. There are no collection uncertainties and the lessor’s performance is complete. There are (3) lease payments worth $36,556 each. They are payable on January 1 of 2008, 2009 and The fair value of the asset at inception of the lease is $100,000 (which is also the carrying value on the lessor’s books). The lease DOES NOT contain a renewal or Bargain Purchase Option (BPO) and the asset reverts to the lessor at the end of the three year period. Lessee and Lessor depreciation on a ST LINE basis for book purposes. Residual value (salvage) is –0-. * The lessee’s incremental borrowing rate is 10%

*The accounting year ends on December 31 for each party. *The Lessor’s IMPLICIT interest rate is 10%. YES Lease term is equal to 75% or > of the assets remaining useful life. 3/3 = 100% Minimum lease payments (PV) are at least 90% of the assets market value. $36,556 x = $100,000 FMV = $100,000 $100,000/$100,000 = 100%

TO RECORD THE LEASELeased Asset………….. $100,000 Lease Liability………$100,000 TO RECORD THE FIRST PAYMENT ON THE FIRST DAY Lease Liability……… $36,556 Cash………………..$36,556 DatePaymentInterest 10%LL adjLL Bal. 1/1/08$100,000 1/1/08$36,556$0$36,556$63,444 1/1/09$36,556$6,344$30,212$33,232 1/1/10$36,556 $3,323$33,233$0

TO RECOGNIZE INTEREST EXPENSE FOR 1/1/09 Interest Expense………… $6,344 Lease Liability………….$6,344 TO RECORD DEPRECIATION EXPENSE ($100,000 - $0 SALVAGE) / 3 YEARS = $33,333 Depreciation Expense……….. $33,333 Accumulated Depreciation……… $33,333

THE LESSOR MUST NOT ONLY MEET (1) OF THE FOUR PREVIOUSLY MENTIONED CAPITAL LEASE CRITERIA BUT ALSO BOTH OF THE CRITERIA LISTED BELOW: COLLECTIBILITY OF THE MINIMUM LEASE PAYMENTS IS REASONABLY ASSURED. NO IMPORTANT UNCERTAINTIES SURROUND THE AMOUNT OF ANY REIMBURSEABLE COSTS YET TO BE INCURRED BY THE LESSOR UNDER THE LEASE. The Lessor classifies capital leases in one of two ways:

Does NOT provide a gross profit to the lessor at the time the lease is signed. Value of the leased asset equals its MARKET VALUE at the inception date. The lessor uses this to compute rent payments. Example from above: Now continued for the LESSOR. *This is a DIRECT FINANCING lease. FMV = $100,000 which equals the cost on the lessor’s books. Lessor earns profits from interest revenue during lease We know the rent payments are $36,556, but how was this established? FMV OR PV OF MIN LEASE PAYMENTS = RENT X FACTOR

FMV OR PV OF MIN LEASE PAYMENTS = RENT X FACTOR $100, (10%, 3 YRS ANN DUE; T 6-5) $36,556 TO RECORD The RECEIVABLE at 1/1/08 Lease Receivable… $100,000 Asset…………… $100,000 RECORD The FIRST PAYMENT ON The DAY The LEASE IS SIGNED at 1/1/08 Cash……….. $36,556 Lease Receivable…….. $36,556

RECORD The SECOND RECEIPT OF CASH at 1/1/09 Cash…….. $36,556 Lease Receivable….. $30,212 Earned Interest Rev $6,344

Provides a GROSS PROFIT to the lessor at the inception of the lease. Value of leased asset is greater (or less than) the lessor’s cost (or carrying). Lessor wants to earn a profit on the sale of the leased asset and interest during the period. Example continued: Assume that the FMV of the asset at inception of this lease is $100,000 and that the carrying value on the lessor’s books is $80,000. DEALER’S PROFIT  $100,000 FMV - $80,000 carrying = $20,000 profit

RECORD The LEASE INCEPTION Lease Receivable… $100,000 Sales Revenue………. $100,000 same as before FMV of asset Inventory $80,000 COGs…………. $80,000 From here other entries are the same..

In Sales Type leases there is a DIFFERENCE in accounting for Guaranteed THE WAY PROFIT IS RECORDED vs. Unguaranteed Residual Values. THE WAY PROFIT IS RECORDED GUARANTEED RV is considered part of the sale. UNGUARANTEED RV is not considered part of the sale. inserting any residual value into the previous example would change too many things so we’ll use the book example to illustrate this.

Basically since an UN-guaranteed salvage value can’t be considered part of a sale its PRESENT VALUE needs to be subtracted from the SALES and the COG. But that actually leaves the GP unchanged. Assume estimated RV is $5,000 with a PV of $3, Assume leased equipment has an $85,000 cost to the dealer. Rent payments are $23, FMV of asset at time of leasing $100,000 PV of minimum lease payments = (R x f) + (RV x f) $100,000 = ($23, x ) + ($5,000 x.62092)

Basically since an UN-guaranteed salvage value can’t be considered part of a sale its PRESENT VALUE needs to be subtracted from the SALES and the COG. But that actually leaves the GP unchanged. Assume estimated RV is $5,000 with a PV of $3, Assume leased equipment has an $85,000 cost to the dealer. Rent payments are $23, FMV of asset at time of leasing $100,000 Guaranteed Residual Value Unguaranteed Residual Value Lease Receivable.. $100,000 Sales Rev $100,000 COG $ 85,000 Inventory $85,000 Sales $100,000 - COG $ 85, GP $15,000 Lease Receivable.... $100,000 Sales Rev $96, (100K – 3, PV of RV) COG $81, (85K – 3,104.60) Inventory $85,000 Sales $96, COG $ 81, GP $15,000

Assume the BPO is $10,000, exerciseable at the end of the three year lease. (BACK TO OUR ORIGINAL EXAMPLE) The residual value is now $15,000, at the BPO date. At the end of the 4 th year its –0-. Assume we are dealing with the DIRECT FINANCING type lease. annual rent is now FMV = RENT (FACTOR) + BPO (FACTOR) $100,000= Rent ( )+ $10,000 (.75131) $33,809

DEPRECIATION TIMETABLES ALSO CHANGE WITH BPOS The lease depreciates over the EXPECTED USEFUL LIFE not the life of the lease, since they are expected to own it at the EOL.

When the lessee agrees to makeup any deficiency in the stated amount realized for an asset at the end of the lease. A RESIDUAL VALUE IMPACTS The AMOUNT OF The ANNUAL RENT WHETHER ITS GUARANTEED OR NOT Originally we calculated the rent as follows: $100,000 = Rent x (10%, 3yrs)RENT = $36,556 Now if we assume there is also a $10,000 residual value $100,000 = (rent x ) + ($10,000 x.75132) RENT = $33,809

What the guaranteed or unguaranteed status of the salvage does impact is the amount of the MINIMUM LEASE PAYMENTS in terms of finding an amount for the capitalized asset. is capitalized. is not capitalized.

Returning to the original example, now consider the following changes: The actual residual value at the EOL is $9,000 (rather than the $10K expected earlier). The salvage value is FULLY guaranteed (lessee must pay $10,000 cash if necessary). The $10,000 estimated salvage value has resulted in annual payments of $33,809. What amount does the lessee capitalize? ($33,809 x ) + ($10,000 x.75131) = $100,000

ENTRY TO RECORD The LEASE Leased asset…… $100,000 Lease liability……. $100,000 DateLease payInterest 10%LL adjLL bal 1/1/08$100,000 1/1/08$33,809$0$33,809$ 66,191 1/1/09$33,809$6,619$27,190$ 39,001 1/1/10$33,809$3,900$29,909$9,092 12/31/10$909$10,001 The last year builds interest and then the residual value remains in the lease liability. ENTRY FOR FIRST RENT PAYMENT Lease liability……. $33,809 Cash…………..$33,809 SECOND PAYMENT Interest expense.. $6,619 Lease Liability… $27,190 Cash…………..$33,809

ENTRY FOR 1 ST DEPRECIATION ($100,000 - $10,000)/3 = $30,000 Life of LEASE, asset reverts to lessor Depreciation expense…… $30,000 Accumulated Depreciation…..$30,000 TERMINATION OF The LEASEActual residual is $9,000 Lease liability… $10,000 (remove) Leased asset… $100,000 (remove) Accum Dep….. $90,000 (remove) Cash……….. $1,000 (pay) LOSS on lease.. $1,000

The LESSOR’s accounting is the same, with a guaranteed or an unguaranteed residual value. The INCEPTION OF The LEASE Lease receivable: Lease Receivable…… $100,000 Asset……… $100,000 $100,000 = (rent x ) + ($10,000 x.75132)

RECEIPT OF The FIRST RENT (DAY LEASE IS SIGNED) Cash…….. $33,809 Lease Receivable……. $33,809 RECEIPT OF SECOND RENT (ONE YEAR LATER) Cash……. $33,809 Lease Receivable….. $27,190 Interest Revenue…. $6,619 TERMINATION OF The LEASE Asset…….. $9,000 (get it back) Cash………. $1000 (receive guaranteed payment) Lease receivable……. $10,000

Lessee capitalizes ONLY the lease payments (NOT the salvage) Assume there is now a $10,000 un-guaranteed salvage value at the EOL. Note:The rent payment will STILL be $33,809 because the salvage reduces it whether its guaranteed or not. $100,000 = (RENT x ) + $10,000 (.75131) The AMOUNT CAPITALIZED FOR The LEASED ASSET IS: $33,809 ( ) = $92,487DON’T capitalize salvage Leased asset… $92,487 Lease liability……$92,487

Remember, whether the salvage value is guaranteed or not, it is ALWAYS deducted in order to compute the AMOUNT of the rent payment. Recall, however, that the lessee will not capitalize the amount of the salvage because they do not promise to pay it. The LESSOR HOWEVER WILL CAPITALIZE The SALVAGE VALUE AS IT COMES TO HIM/HER AT The EOL REGARDLESS OF WHETHER ITS GUARANTEED OR NOT (AT LEAST IN THEORY IT DOES). LEASE RECEIVABLE RECORDED Lease Receivable.. $100,000 Asset……. $100,000 $100,000 = (rent x ) + ($10,000 x.75132)