1. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 15 Leases

2. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-2 Basic Lease Terms A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. A lease is an agreement where the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessor = Owner of property Lessee = Renter

3. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-3 Lease Classifications

4. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-4 Capital Lease Classification  Ownership transfers to the lessee 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 (MLP) is 90% or more of the fair value of the asset.  Ownership transfers to the lessee 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 (MLP) is 90% or more of the fair value of the asset. capital lease A capital lease must meet one of four criteria:

5. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-5 Capital Lease Classification A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price sufficiently 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 noncancelable 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. 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.

6. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-6 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 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: 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 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 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: 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.

7. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-7 Operating Leases Criteria for a capital lease not met. Lease agreement exists. Record lease as an Operating Lease

8. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-8 Operating Leases On December 26, 2003, Matrix, Inc. signed a two-year operating lease with RentPro, Inc. for office equipment. The lease called for $500 per month, payable at the beginning of each month. The first payment was due on January 1, 2004. Matrix paid three months of rent in advance on December 26. On December 26, 2003, Matrix, Inc. signed a two-year operating lease with RentPro, Inc. for office equipment. The lease called for $500 per month, payable at the beginning of each month. The first payment was due on January 1, 2004. Matrix paid three months of rent in advance on December 26.

9. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-9 Operating Leases Prepare the entry on the books of Matrix on December 26.

10. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-10 Operating Leases Prepare the entry the RentPro would make to record receipt of the December 26.

11. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-11 Operating Leases The January 31 adjustment by Matrix. The January 31 adjustment by RentPro.

12. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-12 We’ll look at non-operating leases for lessee and Lessor in some detail.

13. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-13 Nonoperating Leases - Lessee The amount recorded (capitalized) is the present value of the minimum lease payment. However, the amount recorded cannot exceed the fair value of the leased asset. In calculating the present value of the minimum lease payment, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor. In calculating the present value of the minimum lease payment, the interest rate used by the lessee is the lower of: 1.Its incremental borrowing rate, or 2.The implicit interest rate used by the lessor.

14. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-14 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. If the lessor is not a manufacturer or dealer, the fair value of the leased assets is typically the lessor’s cost.

15. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-15 Nonoperating Leases On January 1, 2002, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease calls for $6,000 per year, payable at the beginning of each year starting on January 1, 2002. The equipment has a economic life of 7 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease, unless Matrix buys the equipment for $4,500, the expected fair value. Matrix has an incremental borrowing rate of 8%, which is the same implicit rate used by RentPro to calculate the annual payment. On January 1, 2002, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease calls for $6,000 per year, payable at the beginning of each year starting on January 1, 2002. The equipment has a economic life of 7 years and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease, unless Matrix buys the equipment for $4,500, the expected fair value. Matrix has an incremental borrowing rate of 8%, which is the same implicit rate used by RentPro to calculate the annual payment.

16. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-16 Nonoperating Leases - Lessee The lease term does not meet the “75% of the economic life” test. The lease term does not meet the “75% of the economic life” test.

17. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-17 Nonoperating Leases - Lessee The PV of the minimum lease payments (MLP)  90% of the equipment’s fair value?

18. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-18 Nonoperating Leases - Lessee Matrix makes the following entries at inception of the lease.

19. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-19 Nonoperating Leases - Lessor In addition to the information given earlier, the lessor (RentPro) knows that the collectibility of the lease payments is reasonably predictable, and there are no future cost to be incurred. RentPro’s performance is substantially complete at far as the lease is concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is $25,872.78.

20. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-20 Nonoperating Leases - Lessor Because the cost of the asset in the hands of the lessor is equal fair market value, the lease is classified as a Direct Financing Lease. $6,000 × 5 = $30,000

21. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-21 Nonoperating Leases - Lessor Because the cost of the asset in the hands of the lessor is equal fair market value, the lease is classified as a Direct Financing Lease.

22. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-22 Lease Amortization Schedule

23. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-23 Nonoperating Leases December 31, 2002, adjustment by Matrix. December 31, 2002, adjustment by RentPro.

24. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-24 Depreciation by Lessee Depreciation expense is recorded in a manner consistent with the company’s usual policy concerning depreciation of other operational assets. If title passes to the lessee at the enter or the lease term, or the lease contains a bargain purchase option, the asset is depreciated over the asset’s economic life; otherwise, it is depreciated over the lease term.

25. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-25 Depreciation by Lessee At December 31, 2002, Matrix prepares the following entry to recognize depreciation expense for the year. $25,873 5 years = $5,175

26. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-26 Nonoperating Leases - Lessee Matrix records the second payment on January 1, 2003. From the December 31, 2002, accrual.

27. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-27 Nonoperating Leases - Lessor RentPro records the second receipt on January 1, 2003.

28. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-28 Now let’s look at sales-type leases. Nonoperating Leases

29. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-29 Sales-Type Lease Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to the Cost of the asset. Because the lessor is a manufacturer or dealer, the FMV of the leased asset is not equal to 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 MLP).

30. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-30 Sales-Type Lease On 1/1/02, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The lease calls for payments of $117,296 at the end of each of the next three years. The equipment has a 5-year economic life, a fair value of $300,000 and cost to RentPro of $222,500. The lease contains a $4,000 bargain purchase option. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection with the lease. On 1/1/02, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The lease calls for payments of $117,296 at the end of each of the next three years. The equipment has a 5-year economic life, a fair value of $300,000 and cost to RentPro of $222,500. The lease contains a $4,000 bargain purchase option. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection with the lease.

31. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-31 Sales-Type Lease This is a sales-type lease because the agreement contains a bargain purchase option, the MLP will be collected, and no further costs will be incurred by RentPro. Matrix treats this as a capital lease because it contains a bargain purchase option.

32. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-32 Sales-Type Lease Calculation of the lease payment.

33. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-33 Sales-Type Lease Lease Amortization Table

34. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-34 Sales-Type Lease - Lessor Entry at inception of the lease ($117,296 × 3) + $4,000 = $355,888

35. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-35 Capital Lease - Lessee Entry at inception of the lease

36. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-36 Sales-Type Lease - Lessee First payment

37. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-37 Sales-Type Lease - Lessee Record first year depreciation $300,000 ÷ 5 (economic life) = $60,000

38. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-38 Sales-Type Lease - Lessor First receipt

39. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-39 Sales-Type Lease On December 31, 2004, the end of the lease term, Matrix exercises the BPO. Matrix, Inc. RentPro, Inc.

40. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-40 Let’s look at how we handle residual value.

41. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-41 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.

42. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-42 Residual Value The only impact on the lessee is the determination of depreciation expense. The cost of the asset will be reduced by the estimated residual value and depreciated over the economic life of the asset. Lessee Obtains Title to Leased Asset.

43. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-43 Residual Value In determining the lease payment, the lessor will reduce the fair value of the asset by the present value of the residual value. The reduced fair value becomes the value used to calculate the lease payment. Lessor Retains Title to Leased Asset.

44. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-44 Residual Value On January 1, 2002, RentPro, Inc. signed a 10- year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the equipment is retained by RentPro and it is estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro requires an 8% return on leased equipment. Let’s calculate the lease payment! On January 1, 2002, RentPro, Inc. signed a 10- year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the equipment is retained by RentPro and it is estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro requires an 8% return on leased equipment. Let’s calculate the lease payment!

45. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-45 Residual Value Calculation of the lease payment.

46. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-46 Residual Value Guaranteed by Lessee Lessee pays any difference between guaranteed residual value and the appraised value. On 1/1/02, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by RentPro. The lease payment is based on a 8% return. Let’s calculate the lease payment! On 1/1/02, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by RentPro. The lease payment is based on a 8% return. Let’s calculate the lease payment!

47. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-47 Residual Value Guaranteed by Lessee Calculation of the lease payment.

48. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-48 Residual Value Guaranteed by Lessee

49. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-49 Residual Value Guaranteed by Lessee The accounting for this direct financing lease will be the same as previously discussed. There are two exceptions: 1.The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, and 2.If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must pay the difference between appraised value and guaranteed residual value to the lessor. The accounting for this direct financing lease will be the same as previously discussed. There are two exceptions: 1.The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, and 2.If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must pay the difference between appraised value and guaranteed residual value to the lessor.

50. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-50 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.

51. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-51 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. 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. Direct Financing Leases − Include as part of investment balance.

52. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-52 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.

53. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-53 Lessee Disclosures 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.

54. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-54 Lessee Disclosures 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.

55. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-55 Lessee Disclosures 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.

56. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-56 Lessor Disclosures 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.

57. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-57 Lessor Disclosures 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.

58. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-58 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 most 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 most impact is on the balance sheet.

59. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-59 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.

60. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-60 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.

61. © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 15-61 End of Chapter 15