1. 15 Leases Chapter 15: Leases.
In this chapter we continue our discussion of debt, but we now turn our attention to liabilities arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as capital leases by the lessee and as either direct financing or sales type leases by the lessor. We also will see that some leases do not produce debtor/creditor relationships, but instead are accounted for as rental agreements. These are designated as operating leases.
McGraw-Hill/Irwin
2011, Royal University of Law and Economics

2. Accounting by the Lessor and Lessee
A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee.
Lessee = Renter
Lessor = Owner of property
The lessee receives the beneficial use of property in the lease. The lessor owns the property, and the lessee is the party who uses the assets and makes lease payments.
From the perspective of the lessee, we have two types of leases. The first lease is referred to as an operating lease, and the second is known as a capital lease. We view a capital lease as an in-substance purchase of an asset.
From the perspective of the lessor, we have three types of leases. We have an operating lease, a direct-financing-type lease, and a sales-type lease.

3. Capital Leases and Installment Notes Compared
Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 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.
At the heart of the rules for lease accounting is a concept of “substance over form.” As accountants and business people, we believe that is the transaction is “in substance” a purchase of property, plant, and equipment, we should recognize it as a purchase no matter how difficult the guidelines are to development for the proper accounting. While the “form” of the transaction may say that it is a lease, we go beyond “form” to look at the “substance” of the transaction.
From the perspective of the lessee there is a direct comparison between a capital lease and an installment note. In this example, Matrix purchases equipment from Apex, agreeing to pay $193,878 (rounded), every six months for the next three years. The interest rate associated with this agreement is 9%. Let’s prepare an effective interest amortization table for this note.
The effective interest is determined by multiplying the carrying value of one million dollars times four and a half percent. Remember that payments are made every six months.

4. Inception of the Agreement
At inception January 1
Installment Note
Equipment 1,000,000
Notes payable ,000,000
Capital Lease
Leased Equipment 1,000,000
Lease payable ,000,000
First payment, June 30
Installment Note
Interest expense ,000
Notes payable ,878
Cash ,878
Capital Lease
Lease payable ,878
Part I
If this transaction is to be treated as an installment note, the entry to record the acquisition of the equipment would be to debit equipment for one million dollars and credit notes payable for the same amount.
If this transaction will be treated as a capital lease, the entry to record the acquisition of the equipment is to debit leased equipment for one million dollars, and credit lease payable for one million.
Part II
Viewing this transaction as an installment note, the first payment is due on June 30. The required journal entry is to debit interest expense for $45,000, debit notes payable for $148,878, and credit cash for $193,878.
If we view this transaction as a capital lease, the first payment would be made on June 30. The required journal entry would be to debit interest expense for $45,000, debit lease payable for $148,878, and credit cash for $193,878.

5. Classification Criteria
Operating Lease
Capital Lease
A capital lease must meet one of four criteria:
Ownership transfers to the lessee at the end of the lease term, or . . .
A bargain purchase option (BPO) exists, or . . .
The non-cancelable 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.
A lease is accounted for as either a rental agreement (known as an operating lease) or a purchase/sale accompanied by debt financing (known as a capital lease). The choice of accounting method hinges on the nature of the leasing arrangement.
From the viewpoint of the lessee, a capital lease must meet one of the four following conditions:
First, ownership to the leased asset must transfer to the lessee at the end of the lease term.
Second, the lease may contain a bargain purchase option payment at the end of the lease term.
Third, the non-cancelable lease term must be equal to 75% or more of the expected economic life of the leased asset.
Finally, the present value of the minimum lease payment is 90% or more of the fair value of the leased asset.
Remember, to be classified as a capital lease the agreement must meet only one of these four conditions.

6. Classification Criteria
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 non-cancelable 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.
A bargain purchase option gives the lessee the right to acquire the leased asset at the end of the lease term at an amount significantly lower than expected fair value.
The lease term is normally considered to be the non-cancelable term of the lease plus any option to renew the term at the end of the original lease term.
When a lease is classified as a capital lease, the lessee records both the asset and liability at inception of the lease. We saw this accounting when we compared accounting for a capital lease to an installment note payable.
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.

7. 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 collectibility of the lease payments must be reasonably predictable.
If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete.
To properly classify the lease from the viewpoint of the lessor, two additional conditions must be met. First, the collectibility of the minimum lease payments must be reasonably predictable. Second, if any costs yet to be incurred by the lessor exist, they must be reasonably predictable.
Remember, the lessor must meet one of the first four conditions that apply to the lessee, plus these two additional conditions. That’s because a capital lease to the lessor means the lessor will account for the agreement as a “sale.” Look closely, the two additional lessor conditions are essentially the usual revenue recognition criteria.
Lessor = Owner of the property subject to the lease.

8. U. S. GAAP vs. IFRS
Lease accounting under U.S. GAAP and IFRS provides a good general comparison of “rules-based accounting” as U.S. GAAP often is described and “principles-based
accounting” which often is the description assigned to IFRS.
Situations that normally would lead to classification as a finance lease are:
Contains a BPO
Term is “major portion” of asset’s life.
PV of MLP greater than “substantially all” of the fair value of the asset.
Other circumstances impact classification.
Lease classification rules.
Same as IFRS.
75% or more of assets life.
“Substantially all means 90% or more.
Title transfers.
Lease accounting under U.S. GAAP and IFRS provides a good general comparison of “rules-based accounting” as U.S. GAAP often is described and “principles-based accounting” which often is the description assigned to IFRS. Where the FASB issued rules to determine the classification, the IFRS permits management to analyze and determine the classification.
From the viewpoint of the IFRS:
Situations that normally would lead to classification as a finance lease are:
Contains a BPO
Term is “major portion” of asset’s life.
PV of MLP greater than “substantially all” of the fair value of the asset.
Other circumstances impact classification.
However, the FASB has the following rules for classification of capital leases:
Contains a BPO,
75% of more of the economic of the asset,
PV of MLP is 90% or more of the fair value of the asset,
Title to the leased asset transfers to the lessee at the end of the lease.

9. Lease agreement exists. Criteria for a capital lease not met.
Operating Leases
Lease agreement exists.
Criteria for a capital lease not met.
Record lease as an Operating Lease.
From the viewpoint of the lessee, when a lease agreement exists and the criteria for classification as a capital lease are not met, we treat the lease as an operating lease.
Capital Lease

10. At End of the Four Payment Dates
Operating Leases
On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation.
The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each January 1 thereafter through 2014.The useful life of the copier is estimated to be six years. Before deciding to lease, 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%.
At End of the Four Payment Dates
On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and a teach January 1 thereafter through 2014.The useful life of the copier is estimated to be six years. Before deciding to lease, 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%.
The lease fails all four of the capital lease tests, and is classified as an operating lease.
At the end of the four payment dates, the lessee, San Serif, will debit prepaid rent and credit cash for $100,000. The lessor will debit cash and credit unearned revenue for $100,000.
Because the lessor keeps the asset on its books, it is the lessor that records depreciation of the asset.
San Serif Publishers, Inc. (Lessee)
Prepaid rent 100,000
Cash ,000
CompuDec Corporation (Lessor)
Cash ,000
Unearned rent revenue ,000

11. Leasehold Improvements
Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.
Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.

12. Capital Leases – Lessee and Lessor
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:
Its incremental borrowing rate, or
The implicit interest rate used by the lessor.
From the viewpoint of the lessee, the amount recorded as the asset will be the present value of the minimum lease payments. However, the amount recorded as the asset can never exceed the fair value of that asset.
In calculating the present value of the minimum lease payment, the interest rate used will be the lower of the lessee’s incremental borrowing rate, or the implicit rate used by the lessor to set the lease payment amount.

13. Capital Leases – Lessee and Lessee
If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessor’s cost.
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 of the asset being leased, the fair value of the leased asset usually will be equal to the lessor’s cost. However, when the lessor is a manufacturer or dealer, the fair value of the leased property at inception of lease will usually be more than the cost of the asset in the hands of the lessor.

14. Capital Leases – Lessee and Lessor
On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079.
The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016,is equal to the estimated useful life of the copier.
First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is10%.
Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease.
We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000.
$479,079 ÷ * = $100,000 rental payments.
*PV of an annuity due of $1: n = 6, I = 10%
$100,000 × 4,79079* = $479,079 lessee’s cost
Part I
On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The six year lease term ending December 31, 2016,is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate In these financing arrangements is 10%. Since the lease term is equal to the expected useful life of the copier (>75%), the transaction must be recorded by the lessee as a capital lease. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing lease to First Lease. To achieve its objectives, First Lease must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000.
Part II
Here are the calculations of the $100,000 rental payments, and the lessee’s cost of the copier. Notice that we found the present value of an annuity due because the payments are made at the beginning of the period.

15. Capital Leases – Lessee and Lessor
Direct Financing Lease (January 1, 2011)
San Serif Publishers, Inc. (Lessee)
Leased equipment (PV of payments) 479,079
Lease payable (PV of payments) ,079
First Lease Corp. (Lessor)
Lease receivable (PV of payments) 479,079
Inventory of equipment (Lessor’s cost) 479,079
First Lease Payment (January 1, 2011)
San Serif Publishers, Inc. (Lessee)
Lease payable ,000
Cash ,000
First Lease Corp. (Lessor)
Cash ,000
Lease receivable ,000
On the date of inception, the lessee will debit leased equipment for $479,079 and credit lease payable for the same amount. In addition, the lessor will debit lease receivable for $479,079, and credit inventory of equipment held for lease for the same amount. On January 1, 2011, the first payment is due. The lessee will lease payable for $100,000, and credit cash for the same amount. The lessor will debit cash for $100,000, and credit lease receivable for the same amount.

16. Capital Leases – Lessee and Lessor
Amortization Schedule for the Lease
The amortization shows all the values that will be needed to record the journal entries in connection with the lease for both the lessee and lessor. Pay particular attention to the calculations shown on your screen.
$379,079 - $62,092 = $316,987
$379,079 × 10% = $37,908
$100,000 - $37,908 = $62,092

17. Capital Leases – Lessee and Lessor
Second Lease Payment (December 31, 2011)
San Serif Publishers, Inc. (Lessee)
Interest expense 37,908
Lease payable 62,092
Cash ,000
First Lease Corp. (Lessor)
Cash ,000
Lease receivable ,092
Interest revenue ,908
Please refer to the amortization schedule on the previous slide. Notice that interest expense and interest revenue have been calculated to be $37,908, with a total payment of $100,000.
At the second lease payment, the lessee will debit interest expense for $37,908, debit lease payable for $62,092 (again refer back to the amortization schedule), and credit cash for the total lease payment of $100,000.
The lessor with debit cash for $100,000, credit lease receivable for $62,092, and credit interest revenue for $37,908.
Assuming the lessee uses the straight-line method of depreciation for similar owned assets, depreciation on the copier will have to be recorded. The journal entry is to debit depreciation expense for $70,847 ($479,079 ÷ 6 years), and credit accumulated depreciation for $79,847.
Depreciation Recorded at (December 31, 2011)
San Serif Publishers, Inc. (Lessee)
Depreciation expense ,847
Accumulated depreciation ,847
($479,079 ÷ 6 = $79,847 Assuming straight-line method.)

18. Capital Leases – Lessee and Lessor
Depreciation Period
The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i.e., either of the first two classification criteria is met), the asset should be depreciated over its useful life.
The lessee normally should depreciate a leased asset over the term of the lease. However, if ownership transfers or a bargain purchase option is present (i.e., either of the first two classification criteria is met), the asset should be depreciated over its useful life. The lessee should use the same depreciation method used for similar owned assets.

19. Sales-Type Leases
If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is higher than 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 payments).
If the lessor is a manufacturer or dealer of the leased assets then the fair market value is generally not equal to the cost of the asset in the hands of the lessor. At the inception of the lease the lessor will recognize sales revenue and cost of goods sold associated with the transaction. In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.
In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.

20. Sales-Type Leases
On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from CompuDec Corp. at a price of $479,079.
The lease agreement specifies annual payments of $100,000 beginning January 1, 2011 (the inception of the lease), and at each December 31 thereafter through The six year lease term ending December 31, 2016, 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 is10%.
On January 1, 2011, Sans Serif Publishers, Inc., leased a copier from CompuDec Corp. at a price of $479,079.
The lease agreement specifies annual payments of $100,000 beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through The six year lease term ending December 31, 2016, 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%.

21. Sales-Type Leases SO Lease Classification
The lease term (6-years) is equal to 100% of the useful life of the copier, and
Fair market value is difference from cost of the leased asset.
CompuDec is certain about the collectibility of the lease payments, and
No costs are to be incurred by CompuDec relating to the lease agreement, SO
The lease agreement is classified as a Sales-Type lease from the viewpoint of CompuDec (lessor) and a capital lease from the viewpoint of Sans Serif Publishers (lessee).
The asset leased by the lessee is a depreciable asset. It should be depreciated in a manner used for similar owned assets. If title to the leased asset passes to the lessee at the end of the lease term, or if the lease contains a bargain purchase option, the asset should be depreciated over the asset’s economic life. If neither of these conditions are met, the asset should be depreciated over the lease term.

22. Sales-Type Leases: Lessee
At inception of the Lease – January 1, 2011
CompDec Corp. (Lessor)
Lease receivable 479,079
Cost of goods sold 300,000
Sales revenue ,079
Inventory of equipment ,000
Receipt of the First Lease Payment – January 1, 2011
CompDec Corp.(Lessor)
Cash ,000
Lease receivable ,000
At inception of the lease agreement, CompDec Corporation (the lessor), will prepare two journal entries. The first entry is to record the lease of the asset. CompDec will debit lease receivable for $479,079, and debit Cost of goods sold for $300,000 (the cost basis to CompDec). The company will complete the entry with a credit to sales revenue for $479,079, and credit inventory of equipment for $300,000. CompDec will recognize a gross profit from the “sale” of the lease asset of $179,079 (revenue of $479,079 less cost of goods sold of $300,000).
Also, on January 1, 2011, CompDec will record the receipt of the first lease payment with a debit to cash for $100,000, and a credit to lease receivable for the same amount.

23. Bargain Purchase Options and Residual Value
A bargain purchase option (BPO) is a provision of some lease contracts that 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 to the lease for both the lessee and the lessor. As a result:
LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability.
LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.
A bargain purchase option (BPO) is a provision of some lease contracts that 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 to the lease for both the lessee and the lessor. As a result:
The LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability.
The LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.

24. Bargain Purchase Option (BPO)
On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 there after through The estimated useful life of the copier is seven years. On December 31, 2016, at the end of the six year lease term, the copier is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.
On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 there after through The estimated useful life of the copier is seven years. On December 31, 2016, at the end of the six year lease term, the copier is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is 10%.
We have developed a table to show the computation of the present value of the minimum lease payments for the lessee, and the determination of the lease payments by the lessor. We need to use the present value of an annuity due of $1, for 6 periods, at 10% interest, and the present value of $1, for 6 periods, at 10% interest. Remember, the lessor determines the periodic lease payment and the lessee may accept or reject the contract.

25. Bargain Purchase Option (BPO)
After the last lease payment, the balance in the obligation balance is $54,542, which represents the amount, that when compounded at 10% to the end of the lease, will equal the amount of the BPO. We will look at the journal entries relating to the payment of the BPO on the next slide.
Exercise of BPO at the end of the lease term:
$54,542 × 10% = $5,458*
$60,000 BPO payment - $5,458 = $54,542

26. Bargain Purchase Option (BPO)
End of Lease – December 31, 2016
Sans Serif Publishers, Inc. (Lessee)
Depreciation expense ($479,079 ÷ 7) 68,440
Accumulated depreciation 68,440
Interest expense ,458
Lease payable ,542 Cash (BPO payment) 60,000
CompDec Corporation(Lessor)
Cash ,000
Lease receivable ,582
Interest revenue ,458
At the end of the lease term Sans Serif exercises the bargain purchase option paying $60,000 cash to CompDec. The interest and obligation reduction were developed on the previous slide.
Sometimes the lease contract specifies that a BPO becomes exercisable before the designated lease term ends. Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. All calculations would be modified accordingly.
Refer the amortization schedule and computations on the previous screen

27. Residual Value
The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term.
On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2016, the copier is expected to be worth $60,000. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.
The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Let’s examine the impact of residual value on accounting for leases.
On January 1, 2011, Sans Serif Publishers, Inc., leased a color copier from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2011, the inception of the lease, and at each December 31 thereafter through 2015.The estimated useful life of the copier is seven years. At the end of the six year lease term, ending December 31, 2016, the copier is expected to be worth $60,000. CompuDec manufactured the copier at a cost of $300,000 and its interest rate for financing the transaction is10%.

28. Effect on the Lessee of a Residual Value
Guaranteed Residual Value
Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value.
A lease agreement may contain a guaranteed residual value. Such a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value.
Examine the calculation of the present value of the minimum lease payments under the lease terms shown on the previous screen.
PV factor of an annuity due of $1: n=6, i=10%
PV factor of $1: n=6, i=10%

29. Effect on the Lessee of a Residual Value
Unguaranteed Residual Value
A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.
A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

30. Effects on the Lessor of a Residual Value
Guaranteed Residual Value
When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both.
When the residual value is guaranteed, the lessor as well as the lessee views it as a component of minimum lease payments. In fact, even if it is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. The lessor will subtract the present value of the residual value from the fair value to determine the amount to be recovered through lease payments. In our example, the lease payments will be $92,931,

31. Residual Value Guaranteed
Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value.
Sales-Type Lease – January 1, 2011
San Serif Publishers, Inc. (Lessee)
Leased equipment 479,079
Lease payable ,079
CompDec Corporation (Lessor)
Lease receivable 479,079
Cost of goods sold 300,000
Sales revenue ,079
Inventory of equipment ,000
Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value.
On January 1, 2011, San Serif Publishers, Inc. will debit leased equipment for $479,079, and credit lease payable for the same amount. On the same date, CompDec Corporation, the lessor, will debit lease receivable for $479,079 and cost of goods sold for $300,000, the finish the entry, the company will credit sales revenue for $479,079, and inventory of equipment for $300,000.

32. Residual Value Guaranteed
First Lease Payment – January 1, 2011
San Serif Publishers, Inc. (Lessee)
Lease payable 92,931
Cash 92,931
CompDec Corporation (Lessor)
Lease receivable ,931
On January 1, 2011, San Serif will debit lease payable and credit cash for $92,931, while CompDec will debit cash and credit lease receivable for $92,931. Now let’s look at the end of the lease term.

33. Residual Value Guaranteed
December 31, 2015
San Serif Publishers, Inc. (Lessee)
Depreciation expense 68,847
Accumulation depreciation 68,847
Interest expense 13,407
Lease payable 79,524
Cash 92,931
CompDec Corporation (Lessor)
Interest revenue 13,407
Lease receivable ,524
On December 31, 2015, San Serif, the lessee, will record depreciation of $68,847. Look at the calculation of this amount in the schedule on the top right of your screen. Both the lessee and lessor will record the final lease payment. Refer back to the lease amortization schedule for the amounts included in the journal entries.
See amortization schedule

34. Treatment of Residual Value
The schedule summarizes the effect of the residual value of a leased asset for each of the various possibilities regarding the nature of the residual value.

35. The lessee records executory costs as incurred:
One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs.
The lessee records executory costs as incurred:
One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership. These are referred to as executory costs. The lessee records executory costs as incurred.
Sans Serif Publishers, Inc. (Lessee)
Maintenance expense 2,000
Cash 2,000

36. Discount Rate
One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.
One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

37. Lessor’s Initial Direct Costs
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.
Sales-Type Leases – The initial direct costs are expensed at the inception of the lease.
Initial direct costs are costs incurred by the lessor to draw-up and consummate the lease agreement. For operating leases, the lessor would capitalize these costs and amortize them, generally using the straight-line method, over the lease term. For a direct-financing type lease, the initial direct costs are included as part of the gross investment in the lease. When we include the initial direct costs in a direct-financing type lease, we must calculate a new implicit interest rate that previously was unknown to the lessor. For a sales-type lease the initial direct costs are expenses at the inception of the lease agreement.

38. 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.
Contingent rentals may increase or decrease the minimum lease payment. However, contingent rentals are not included in the minimum lease payment. Instead, contingent rentals are disclosed in the notes to the financial statements.

39. Lease Disclosures
Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.
Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years.

40. Lease Disclosures The lessor must disclose its net investment in
the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value).
Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs.
The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value).
Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs.

41. Balance Sheet and Income Statement
Lease transactions impact several financial ratios
Debt to equity ratio – Lease liabilities are recorded.
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 have a profound impact on motive ratios.
The first is the debt to equity ratio. The lease liability is included in the denominator of this equation.
The second ratio is the rate of return on assets. The leased asset is included in the numerator of this ratio.

42. Special Leasing Arrangements
Sale-Leaseback Arrangements – the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately.
Real Estate Leases:
Leases of Land Only
Leases of Land and Building
Leases of Only Part of a Building
Leveraged Leases – a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment.
In a sale and leaseback arrangement the owner of an asset sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is recognized immediately.
Many leases involve real estate. The fact that land has an unlimited life causes us to modify how we account for some leases involving real estate.
For a lease of land only the risks and rewards of ownership cannot be presumed transferred from the lessor to the lessee unless title to the land is expected to transfer, either outright or through a bargain purchase option. Depreciation of land is not appropriate in accounting.
When the leased property includes both land and a building and the lease transfers ownership or is expected to by exercise of a bargain purchase option, the lessee should recorded each leased asset separately. The present value of the minimum lease payments is allocated between the leased land and leased building accounts on the basis of relative market values.
Some of the most common leases involve leasing only part of a building. Despite practical difficulties like the determination of the fair value of the portion of the building leased, normal lease accounting treatment applies.
In a leveraged leases a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the investment. From the lessee’s point of view, accounting for a leveraged lease is the same as accounting for a non-leveraged lease. Accounting from the lessor’s point of view is new. The lessor records its investment net of the nonrecourse debt. The lessor’s liability to the lender should be offset against its lease receivable from the lessee because its role is in substance that of a mortgage broker.

43. End of Chapter 15
End of Chapter 15.