Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-1 Chapter Fifteen Leases

© 2007 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 15 Leases

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-3 Basic Lease Terms A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee. A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, for a stated period of time, to the lessee. Lessor: Owner of property Lessee: User of property

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-4 Lease Classifications

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-5 Capital Lease Classification  Ownership transfers to the lessee during or 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 is 90% or more of the fair value of the asset.  Ownership transfers to the lessee during or 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 is 90% or more of the fair value of the asset. capital lease A capital lease if it meets one of four criteria: A BPO gives the lessee the option to purchase the leased asset at a price sufficiently less than the expected fair value of the asset that 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-6 Capital Lease A capital lease is treated as the purchase of an asset – the lessee records both an asset and liability at inception of the lease. Leased AssetPV Lease liabilityPV

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-7 Additional Lessor Conditions  The four classification apply to both the lessee and lessor. However, for the lessor, the agreement must meet two additional conditions for the lease to be a non-operating lease (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 classification apply to both the lessee and lessor. However, for the lessor, the agreement must meet two additional conditions for the lease to be a non-operating lease (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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-8 Operating Leases None of the criteria for a capital lease is met. Record lease as an Operating Lease Simply record rent over the lease term

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-9 OPERATING LEASES   On January 1, 2006, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation.   The lease agreement specifies four annual payments of $100,000 beginning January 1, 2006, the inception of the lease, and at each January 1 through The useful life of the copier is estimated to be six years. Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier the interest rate would have been 10%. How should this lease be classified?

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide OPERATING LEASES 1Does the agreement specify that ownership of the asset transfers to the lessee?NO 2 Does the agreement contain a bargain purchase option?NO 3 Is the lease term equal to 75% or more of the expected economic life of the asset? NO {4 yrs < 75% of 6 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% NO of the fair value of the asset? {$348,685 < 90% of $479,079} $100,000 x ** = $348,685 lease present payments value ** present value of an annuity due of $1: n=4, i=10% Since none of the four classification criteria is met, this is an operating lease.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Operating Leases At Each of the Four Payment Dates Sans Serif Publishers, Inc. (Lessee) Prepaid rent100,000 Cash 100,000 CompuDec Corporation (Lessor) Cash100,000 Unearned rent revenue100,000 At the End of Each Year Sans Serif Publishers, Inc. (Lessee) Rent expense100,000 Prepaid rent100,000 CompuDec Corporation (Lessor) Unearned rent revenue100,000 Rent revenue100,000 Depreciation expense x,xxx Accumulated depreciation x,xxx

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Operating Leases ADVANCE PAYMENTS  Advance payments are considered prepayments of rent. They are deferred and allocated to rent over the lease term. LEASEHOLD IMPROVEMENTS  Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease.  If a lessee constructs a new building on or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets, its cost is allocated as depreciation expense over its useful life to the lessee, which will be the shorter of the physical life of the asset or the lease term.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Let’s look at non-operating leases now.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Capital Leases - Lessee The amount recorded (as both an asset and liability) 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 PV of the payments, the discount rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor (when calculating lease payments). In calculating the PV of the payments, the discount rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor (when calculating lease payments).

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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, exceeding its cost by its gross profit margin. If the lessor is a leasing company rather than a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Direct Financing Leases – Lessee and Lessor Calculations   On Dec. 31, 2006, Sans Serif leased a copier from First LeaseCorp. which purchased the equipment from CompuDec at a cost of $479,079. Annual payments beginning Dec. 31, 2006, the inception of the lease, and at each Dec. 31 through The 6-year lease term is equal to the estimated life of the copier. The interest rate is 10%. Lessor: $479,079 ÷ ** = $100,000 lessor’s rental cost payments Lessee: $100,000 x ** = $479,079 rental lessee’s payments cost ** present value of an annuity due of $1: n=6, i=10%

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Direct Financing Leases – Lessee and Lessor Entries Inception of Lease [Dec. 31, 2006] Sans Serif Publishers, Inc. (Lessee) Leased equipment (present value of payments) 479,079 Lease payable (present value of payments) 479,079 First LeaseCorp (Lessor) Lease receivable (gross sum of payments) 600,000 Unearned interest revenue (difference) 120,921 Inventory of equipment (lessor’s cost) 479,079 First Lease Payment [Dec. 31, 2006] Sans Serif Publishers, Inc. (Lessee) Lease payable 100,000 Cash100,000 First LeaseCorp (Lessor) Cash100,000 Lease receivable 100,000

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Second Lease Payment [Dec. 31, 2007] Sans Serif Publishers, Inc. (Lessee) Interest expense (10% x [$479,079 – 100,000]) 37,908 Lease payable (difference) 62,092 Cash (rental payment) 100,000 First LeaseCorp (Lessor) Cash (rental payment) 100,000 Lease receivable 100,000 Unearned interest revenue 37,908 Interest revenue (10% x [$600, , ,000]) 37,908 Outstanding BalanceEffective Rate

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide LEASE AMORTIZATION SCHEDULE EffectiveDecrease Outstanding Payments Interest in BalanceBalance Dec % x Outstanding Balance , , ,000379, , (379,079) = 37,90862,092316, , (316,987) = 31,69968,301248, , (248,686) = 24,86975,131173, , (173,555) = 17,35582,645 90, , (90,910) = 9,09090, , , ,079 No interest yet; no time has passed.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide DEPRECIATION End of Each Year Sans Serif Publishers, Inc. (Lessee) Depreciation exp. ($479,079 ÷ 6 years*) 79,847 Accumulated depreciation79,847 * if the lessee depreciates assets by the straight-line method The lessee normally should depreciate a leased asset over the term of the lease. However, if: (a) ownership transfers, or (b) a bargain purchase option is present (i.e., either of the first two classification criteria is met) the asset should be depreciated over the asset's useful life. Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Sales-Type Leases On December 31, 2006, Sans Serif Publishers, Inc. leased a copier from CompuDec at a “price” of $479,079. The lease agreement specifies annual payments of $100,000 beginning Dec. 31, 2006, the inception of the lease, and at each Dec. 31 through The six-year lease term is equal to the estimated useful life of the copier. CompuDec manufactured the copier at a cost of $300,000. CompuDec’s interest rate for financing the transaction is 10%. Lease receivable ($100,000 x 6) 600,000 Cost of goods sold (lessor’s cost) 300,000 Sales revenue (PV of minimum lease payments) 479,079 Unearned interest revenue ($600, ,079) 120,921 Inventory of equipment (lessor’s cost) 300,000 First Lease Payment Cash100,000 Lease receivable 100, ,079 Direct Financing Lease On December 31, 2006, Sans Serif Publishers, Inc. leased a copier from First LeaseCorp at a “price” of $479,079. First LeaseCorp purchased the copier at a cost of $479,079. First LeaseCorp’s interest rate for financing the transaction is 10%. Now, let’s make it a sales-type lease Since the lessor’s cost is $300,000, a dealer’s profit exists.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide What if the asset has a residual value?

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Residual Value  The only impact on the lessee is the effect on calculating depreciation expense.  In determining the amount to capitalize as a leased asset and to record as a lease liability, the lessee ignores the residual value. First Assume the Lessee will Obtain Title to Leased Asset.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Residual Value Now Assume the Lessor will Retain Title to Leased Asset  The amount needed to be recovered by the lessor through periodic lease payments is reduced by the PV of the residual value.  The lessee considers the “purchase” price” to include the PV of the residual value as an additional “payment” if the lessee guarantees the residual value to be a particular amount.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide RESIDUAL VALUE The estimated useful life of the copier is 7 years. At the end of the 6-year lease term the copier is expected to be worth $60,000. Lessor’s Calculation of Lease Payments Amount to be recovered (fair value) $479,079 Less: PV of the residual value ($60,000 x.56447*) (33,868) Amount to be recovered thru lease payments$445,211 Lease payments at the beg. of each of the next 6 yrs: ($445,211 ÷ ** ) $ 92,931 * present value of $1: n=6, i=10% ** present value of an annuity due of $1: n=6, i=10%

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessee’s Calculation When There is a Residual Value  On the other side of the transaction, the lessee considers the “purchase” price of the copier to include, at a minimum, the PV of the periodic rental payments ($445,211): $92,931 x ** = $445,211 rental present payments value ** present value of an annuity due of $1: n=6, i=10%  If Residual Value is Guaranteed: PV of periodic payments $445,211 Plus: PV of the residual value ($60,000 x.56447*) 33,868 PV of minimum lease payments [Recorded as a leased asset and a lease liability] $479,079 * present value of $1: n=6, i=10% ** present value of an annuity due of $1: n=6, i=10%

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide AMORTIZATION SCHEDULE WITH RESIDUAL VALUE EffectiveDecrease Outstanding Payments Interest in BalanceBalance 10% x Outstanding Balance , ,93192,931386, , (386,148) = 38,61554,316331, , (331,832) = 33,18359,748272, , (272,084) = 27,20865,723206, , (206,361) = 20,63672,295134, , (134,066) = 13,40779,52454, , (54,542) = 5,458* 54, , , ,079

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Executory Costs Executory costs include cost 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 pay executory costs, and the lessee will reimburse the lessor through higher periodic lease payments. These costs are excluded in determining the minimum lease payment.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide EFFECT OF A BARGAIN PURCHASE OPTION A BPO gives the lessee the option of purchasing the leased property at a “bargain” price. The expectation that the option price will be paid effectively adds an additional cash flow for both the lessee and the lessor.  The lessor, when computing periodic rental payments, subtracts the PV of the BPO price from the amount to be recovered (fair market value) to determine the amount that must be recovered through the periodic rent payments.  The lessee adds the PV of the BPO price to the PV of periodic payments when computing the amount to be recorded as a leased asset and a lease liability.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Financing Leases − Include as part of investment balance. 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. Operating Leases − Capitalize and amortize over the lease term by the lessor. Direct Financing Leases − Include as part of investment balance. Direct Financing Leases − Include as part of investment balance.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Contingent Rentals Sometimes rental payment may be increased (or decreased) at some future time during the lease term, depending on whether or not 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 payment may be increased (or decreased) at some future time during the lease term, depending on whether or not 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessee Disclosures For capital leases, disclose For capital leases, disclose Gross amount of assets recorded under capital leases. Gross amount of assets recorded under capital leases. Future MLP in the aggregate and for each of the five succeeding years. 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 minimum sublease rentals to be received in the future under noncancelable subleases. Total contingent rentals. Total contingent rentals.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessee Disclosures For operating leases in excess of one year, disclose 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. 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. 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. For all operating leases, disclose rental expense, with separate amounts for minimum rentals, contingent rentals, and sublease rentals.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessee Disclosures Provide a description of the lessee’s leasing arrangements including, but not limited to Provide a description of the lessee’s leasing arrangements including, but not limited to The basis on which contingent rental payments are determined. The basis on which contingent rental payments are determined. The existence and terms of renewal or purchase options and escalation clauses. 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. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessor Disclosures For sales-type and direct financing leases, disclose For sales-type and direct financing leases, disclose Components of the net investment in sales- type and direct financing leases Components of the net investment in sales- type and direct financing leases 1. Future MLP to be received. 2. Unguaranteed residual values. 3. Unearned Interest Revenue. Future MLP to be received for each of the five succeeding fiscal years. Future MLP to be received for each of the five succeeding fiscal years. Total contingent rentals included in income. Total contingent rentals included in income.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lessor Disclosures For operating leases, disclose For operating leases, disclose Cost and carrying amount of property on lease or held for leasing. 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. Minimum future rentals on noncancelable leases in the aggregate and for each of the five succeeding years. Total contingent rentals included in income. Total contingent rentals included in income. Provide a general description of the lessor’s leasing arrangements. Provide a general description of the lessor’s leasing arrangements.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

Copyright © 2007 by The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide End of Chapter 15