1 1.Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2.Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction. 3. Outline the types of contractual provisions typically included in lease agreements. Leases - Learning Objectives

2 4.Apply the lease classification criteria in order to distinguish between capital and operating leases. 5.Properly account for both capital and operating leases from the standpoint of the lessee (asset user). 6. Properly account for both capital and operating leases from the standpoint of the lessor (asset owner). 7. Prepare and interpret the lease disclosures required of both lessors and lessees. Learning Objectives

3Lease A lease is a contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party. Parties: –Lessee - he party granted the right to use the property under the terms of a lease. –Lessor- The owner of the property that is rented (leased) to another party.

4 Advantages of Leasing No down payment Avoid risks of ownership Flexibility No down payment Avoid risks of ownership Flexibility Increased sales Ongoing business relationship with lessee Residual valued retained Increased sales Ongoing business relationship with lessee Residual valued retained To the LesseeTo the Lessor

5 Simple Example Owner Company owns a piece of equipment with a market value of $10,000. User Company wishes to acquire the equipment for use in its operations. ContinuedContinued

6 Simple Example One option for User Company is to purchase the equipment from Owner by borrowing $10,000 from a bank at an interest rate of 10%. Owner would repay the principal and interest by making five annual payments of $2,638. ContinuedContinued

7 Simple Example Alternatively, User Company can lease the asset from Owner Company for five years, making annual “rental” payments of $2,638. Buy $2,638 annually Lease $2,638 annually ContinuedContinued

8 Simple Example  Has effective ownership passed?  Does Owner Company have any significant responsibility remaining?  Is Owner Company reasonable certain that they five annual payments can be collected? ContinuedContinued

9 Simple Example Scenario 1 The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease. Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase. ContinuedContinued

10 Simple Example Scenario 2 The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1. Offering the equipment to User Company for a bargain price at the end of the lease indicates that this arrangement is in substance a purchase. ContinuedContinued

11 Simple Example Scenario 3 The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else. Because the life of the asset and the term of the lease are identical, this arrangement is in substance a purchase. ContinuedContinued

12 Simple Example Scenario 4 The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date. When the present value of the lease payments is close to the market value of the leased item, the arrangement is in substance a purchase. The exact rules will be discussed later in this chapter.

13 Simple Example Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee. Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease.

14 Nature of Leases Cancellation Provision Specifies under what circumstances the lease may be canceled. Lease Term Delineates the time period the lease is to be in force. Bargain Purchase Option Grants lessee the right to purchase the asset at the end of the lease term for less than the residual value.ContinuedContinued

15 Residual Value Market value of leased asset at end of lease term. Rental payment required over lease term plus any payment for residual value as well as any bargain purchase option. Minimum Lease Payment Nature of Leases Payments for insurance, maintenance and taxes incurred for the leased property Executory Costs

16 Minimum Lease Payment Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed a residual value of $10,000 by the lessee. Minimum lease payments: Rental payments ($3,000 – $500) x 36$ 90,000 Guaranteed residual value 10,000 Total minimum lease payment$100,000ContinuedContinued Nature of Leases

17 Minimum Lease Payment Computation Present value of 36 monthly payments of $2,500 at 1% interest paid at the end of the month: PMT = $2,500, N = 36, I = 1%$75,269 Present value of $10,000 guaranteed residual value at the end of 10 years at 12% compounded monthly: FV = $10,000, N = 36, I = 1% 6,989 Present value of minimum lease payment$82,258 Assuming an implicit rate of 1% per month:

18 Lease Classification Criteria A lease is classified as a capital lease by the lessee if it is noncancelable and meets any one of the following criteria:

19 1)The lease transfers ownership of the leased asset to the lessee by the end of the lease term. 2)The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price. 3)The lease term is equal to 75 percent or more of the estimated economic life of the asset. 4)The present value of the lease payments at the beginning of the lease is 90 percent or more of the fair market value of the leased asset. Lease Classification CriteriaContinuedContinued

20 Transfer of Ownership? Yes Bargain Purchase Option? Option? No Term >75% of Useful Life? Term >75% of Useful Life? No PV Payment >90% of FMV? PV Payment >90% of FMV? No Lease Classification—Lessee Capital Lease Capital Lease Operating Lease Operating Lease No

21 Lease Classification—Lessor Additional revenue recognition criteria applicable to lessors. 1.Collectibility of the minimum lease payments is reasonably predictable. 2.No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.

22 Exhibit 15-2 Exhibit 15-2 in the textbook provides four lease provision situations. We will go through Lease 1 together. Understanding the lease classification criteria is important. We strongly urge you to analyze Lease 2 through Lease 4. ContinuedContinued

23 Lease 1 Lessee This is a test to see if the lease qualifies as a capital lease. If it doesn’t, then it is an operating lease. Does the lease transfer ownership at the end of the lease term? No! So, we move to Criteria 2. ContinuedContinued

24 Lease 1 Lessee Does the lease contain a bargain purchase option? No! So, we move to Criteria 3. ContinuedContinued

25 Lease 1 Lessee Is the lease term equal to 75 percent or more of the estimated economic life of the asset? No! The 10-year lease covers approximately 72 percent of the economic life of the asset. So, we move to Criteria 4. ContinuedContinued

26 Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? Before we answer this question, let’s pause and review two terms related to interest on a lease. ContinuedContinued

27 Implicit Interest Rate: Rate that would be used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease. Incremental Borrowing Rate: Rate at which lessee could borrow the amount of money necessary to purchase the leased asset. Lease 1ContinuedContinued

28 Lessor always uses the implicit rate to discount rental payments. Lessee uses the lesser of the implicit rate (if known) and the incremental borrowing rate. Lease 1ContinuedContinued

29 Lease 1 Lessee Does the present value of the lease payments equal 90 percent or more of the fair market value of the leased asset? No, the lessee only knows the incremental borrowing rate, which provides a present value of less than 90 percent. ContinuedContinued

30 The lessor answered negatively to the first three criteria, so let’s analyze the fourth criteria. ContinuedContinued Lease 1 Lessor

31 Lease 1 Lessor In addition to meeting at least one of the four criteria, the lessor must meet both of a second set of criteria. ContinuedContinued

32 Lease 1 Lessor Is the collectibility of the minimum lease payment reasonably predictable? ContinuedContinued AND Are there important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor?

33 Lease 1 Lessor Collectibility is predictable and there are no important uncertainties about reimburseable cost… …so this is a capital lease to the lessor and an operating lease to the lessee.

34 Accounting for Operating Leases—Lessee Bob Jones signs a two-year lease which requires a monthly payment of $1,000. When the lease expires, Bob will either move out or negotiate a new lease. Rent Expense 1,000 Cash 1,000

35 Operating Leases With Varying Lease Payments The terms of a lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years and $250,000 for each of the next three years. ContinuedContinued

36 Entry Each Year for Years 1 and 2: Rent Expense210,000 Cash150,000 Rent Payable60,000 Entry Each Year for Years 3-5: Rent Expense210,000 Rent Payable40,000 Cash250,000 Operating Leases With Varying Lease Payments

37 Accounting for Capital Leases

38 Minimum payment (in advance) including $5,000 executory costs$65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 5 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Accounting for Capital Leases Lessee ContinuedContinued

39 Leased Equipment250,192 Obligations under Capital Leases250,192 Accounting for Capital Leases Entries on January 1, 2005 Lease Expense 5,000 Obligations under Capital Leases60,000 Cash65,000 PMT = $60,000; N = 5; I = 10% PMT = $60,000; N = 5; I = 10% ContinuedContinued

40 Accounting for Capital Leases Entries on December 31, 2005 Amortization Expense on Leased Equipment50,038 Accumulated Amortization on Leased Equipment50,038 Prepaid Executory Costs 5,000 Obligations under Capital Leases40,981 Interest Expense19,019 Cash65,000 ($250,192 – $60,000) x 10%

41 Accounting for Leases With a Bargain Purchase Option Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price. The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability. BARGAIN DEAL

42 Accounting for Leases With a Bargain Purchase Option Minimum payment (in advance) including $5,000 executory costs$65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 10 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Bargain purchase option$75,000 Lessee ContinuedContinued

43 Accounting for Leases With a Bargain Purchase Option Minimum Lease Payment Present value of five payments at the beginning of each year for five years: PMT = $60,000, N = 5, I = 10%$250,192 Present value of the bargain purchase option of $75,000 at the end of 5 years: FV = $75,000, N = 5, I = 10% 46,569 Present value of minimum lease payment$296,761 ContinuedContinued

44 Accounting for Leases With a Bargain Purchase Option Entries on December 31, 2009 Obligations under Capital Leases68,182 Interest Expense6,818 Cash75,000 Equipment148,381 Accumulated Amortization on Leased Equipment148,380 Leased Equipment296,761 $ 68,182 x 10% ($296,761 ÷ 10) x 5 years

45 Treatment of Leases on Lessee’s Statement of Cash Flows Operating Activities (indirect) Net income (includes reduction for Lease interest expense) + Amortization of leased asset Investing Activities No impact Financing Activities Principal portion of lease payment ContinuedContinued

46 Operating Activities (direct) - Lease interest expense Investing Activities No impact Financing Activities - Principal portion of lease payment Treatment of Leases on Lessee’s Statement of Cash Flows

47 Accounting for Leases The Lessor

48 Type of Lease Accounting Treatment of Costs OperatingCapitalize and amortize over lease term. Capital (Direct Capitalize and amortize, financing)with unearned interest, over lease term. Capital (SalesImmediately recognize cost – -type)as reduction in profits. Accounting for Leases— Lessor

49 Accounting for Operating Leases—Lessor Minimum payment (in advance) including $5,000 executory costs$65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 10 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost to lessor$400,000 Direct costs incurred$15,000 ContinuedContinued

50 Deferred Initial Direct Costs15,000 Cash15,000 At Inception of Lease (1/01/05): Cash65,000 Rent Revenue60,000 Executory Costs (contra effect)5,000 At Receipt of First Payment (1/01/05: Accounting for Operating Leases—LessorContinuedContinued

51 Amortization of Initial Direct Costs3,000 Deferred Initial Direct Costs3,000 At End of the First Year (12/31/05): Depreciation Expense on Leased Equipment40,000 Accumulated Depreciation on Leased Equipment40,000 Accounting for Operating Leases—LessorContinuedContinued $400,000 ÷ 10

52 Direct Financing Lease Accounting for a direct financing lease for lessors is similar to that used for capital leases by the lessee—only in reverse.

53 Minimum payment (in advance) including $5,000 executory costs$65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 5 years Estimated residual value at end of lease$0 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment$250,192 ContinuedContinued Direct Financing Lease

54 Direct Financing Lease Lease Payments Receivable 250,192 (net) Equipment Purchased for Lease250,192 At Inception of Lease (1/01/05): Cash65,000 Lease Payment Receivable60,000 Executory Costs5,000 At Receipt of First Payment (1/01/05): ContinuedContinued

55 Direct Financing Lease Cash65,000 Lease Payment Receivable40,981 Interest Revenue19,019 Deferred Executory Costs5,000 At End of First Year (12/31/05): A liability

56 Direct Financing Lease With Residual Value Minimum payment (in advance) including $5,000 executory costs$65,000/year Lease period (beginning 01/01/05) 5 years Economic life of asset 5 years Estimated residual value (end of lease)$75,000 Implicit Rate 10% Incremental Borrowing Rate 10% Cost and fair market value of equipment$296,761 ContinuedContinued

57 Direct Financing Lease With Residual Value Lease Payments Receivable296,761 Equipment Purchased for Lease296,761 At Inception of Lease (1/01/05): Cash65,000 Lease Payment Receivable60,000 Executory Costs5,000 At Receipt of First Payment (1/01/05): ContinuedContinued

58 Direct Financing Lease With Residual Value Cash65,000 Lease Payment Receivable36,324 Deferred Executory Costs5,000 Interest Revenue23,676 At End of First Year (12/31/05): Equipment75,000 Lease Payment Receivable68,182 Interest Revenue6,818 At End of Lease Term (12/31/09):

59 Sales-Type Lease Transaction Components Minimum Lease Payments Fair Market Value of Leased Asset Cost of Leased Asset to Lessor Manufacturer’s or Dealer’s Profit Financing Revenue (Interest)

60 Sales-Type Lease Transaction Components Minimum Lease Payments Fair Market Value of Leased Asset Cost of Leased Asset to Lessor Manufacturer’s or Dealer’s Profit Financing Revenue (Interest) ($65,000 – $5,000) x 5 = $300,000 $250,192 $49,808 $175,000 $75,192

61 Sales-Type Lease Transaction Components Lease Payment Receivable250,192 Sales250,192 At Beginning of First Year (1/01/05): Cost of Goods Sold175,000 Finished Goods Inventory160,000 Deferred Initial Direct Costs15,000 Cash65,000 Lease Payment Receivable60,000 Executory Costs5,000

62 Sales-Type Lease With BPO or Guaranteed Residual Value Reminder - If the agreement provides for the lessor to receive a lump sum (from a bargain purchase option) at the end of the lease term or a guaranteed residual value, the minimum lease payments include these amounts. Also, the receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

63 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Financing Method Method Activities Activities Lessee: Operating lease payments Capital lease: Lease payments-- interest Lease payments-- principal Amortization of asset NI- Cash - Cash + NINo impact

64 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Method Method Activities Lessor: Operating lease: Initial direct costs (IDC) Amortization of IDC Lease receipts Direct financing lease: Initial direct costs Amortization of IDC Lease receipts--interest Lease receipts--principal - Cash +NINo impact NI+ Cash - Cash + NINo impact NI+ Cash + Cash

65 Summary of Lease Impact on Statement of Cash Flows Indirect Direct Investing Method Method Activities Lessor: Sales-type lease: Initial direct costs Manufacturer’s or dealer’s profit (net of IDC) Lease receipts--interest Lease receipts--principal - Cash - NINo impact NI+ Cash + NI+ Cash

66 Other issues: For Lessee, see page For Lessor, see page 951 Disclosure Requirements for Leases Sale-Leaseback Transactions An arrangement whereby one party sells property to a second party, and then the first party leases the property back is a sale-leaseback transaction.