15

Leases

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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

Lessee Operating lease Capital lease

Lessor Operating lease Capital lease Direct financing lease Sales-type lease

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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%. Lets look at the arrangement as an installment note payable and as a capital lease agreement. First, lets prepare an amortization schedule for the payments.
Effective Decrease Outstanding Interest in Balance Balance ......... $ 1,000,000 $ 45,000 $ 148,878 851,122 38,300 155,578 695,544 31,300 162,578 532,966 23,983 169,895 363,071 16,338 177,540 185,532 8,346 185,532 -

Date Payment Initial value . . . . . . . . . . 1 $ 193,878 2 193,878 3 193,878 4 193,878 5 193,878 6 193,878
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Inception of the Agreement

At inception January 1
Installment Note Equipment Notes payable Capital Lease Leased Equipment Lease payable Installment Note Interest expense Notes payable Cash Capital Lease Interest expense Lease payable Cash
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1,000,000 1,000,000

1,000,000
1,000,000

First payment, June 30

45,000 148,878 193,878

45,000 148,878

193,878

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 . . .
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The PV of the minimum lease payments (MLP) is 90% or more of the fair value of the asset.

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 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 assets 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.
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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: 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.

Lessor = Owner of the property subject to the lease.

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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.

Lease classification rules.

1. Same as IFRS.

2. 3.

4.

75% or more of assets life. Substantially all means 90% or more. Title transfers.

Situations that normally would lead to classification as a finance lease are:

1. Contains a BPO 2. Term is major portion of assets life. 3. PV of MLP greater than substantially all of the fair value of the asset. 4. Other circumstances impact classification.

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Operating Leases Lease agreement exists.

Criteria for a capital lease not met.

Record lease as an Operating Lease.

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Capital Lease

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 San Serif Publishers, Inc. (Lessee) Prepaid rent 100,000 Cash 100,000 CompuDec Corporation (Lessor) Cash 100,000 Unearned rent revenue
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100,000

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.

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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:

1. Its incremental borrowing rate, or

2. The implicit interest rate used by the lessor.
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Capital Leases Lessee and Lessee

If the lessor is not a manufacturer or dealer, the fair value of the leased asset typically is the lessors 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.

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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 life4.79079* = $100,000 rental payments. $479,079 of the copier. First *PV of an annuityacquires electronic equipment for lease to other firms. Lease routinely due of $1: n = 6, I = 10% The interest rate In these financing arrangements is10%. $100,000 4,79079* the expected lessees the copier (>75%), Since the lease term is equal to= $479,079useful life ofcost 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.

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Capital Leases Lessee and Lessor

Direct Financing Lease (January 1, 2011)
San Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) Lease payable (PV of payments)

479,079
479,079

First Lease Corp. (Lessor) Lease receivable (PV of payments) 479,079 Inventory of equipment (Lessors cost) 479,079

First Lease Payment (January 1, 2011)

San Serif Publishers, Inc. (Lessee) Lease payable Cash First Lease Corp. (Lessor) Cash Lease receivable
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100,000
100,000

100,000

100,000

Capital Leases Lessee and Lessor

Amortization Schedule for the Lease
Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15
*Rounded.

Payment $ 100,000 100,000 100,000 100,000 100,000 100,000 $ 600,000

Effective Interest $

Decrease in Balance

$ 100,000 37,908 62,092 31,699 68,301 24,869 75,131 17,355 82,645 9,090 * 90,910 $ 120,921 $ 479,079

Outstanding Balance $ 479,079 379,079 316,987 248,686 173,554 90,910 -

$379,079 10% = $37,908 $100,000 - $37,908 = $62,092

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$379,079 - $62,092 = $316,987

Capital Leases Lessee and Lessor

Second Lease Payment (December 31, 2011)
San Serif Publishers, Inc. (Lessee) Interest expense Lease payable Cash First Lease Corp. (Lessor) Cash Lease receivable Interest revenue 37,908 62,092 100,000

100,000 62,092 37,908

Depreciation Recorded at (December 31, 2011)

San Serif Publishers, Inc. (Lessee) Depreciation expense Accumulated depreciation
79,847 79,847

($479,079 6 = $79,847 Assuming straight-line method.)

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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.

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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).

In addition to interest revenue earned over the lease term, the lessor receives a manufacturers or dealers profit on the sale of the asset.
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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 2015. 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. CompuDecs interest rate for financing the transaction is10%.

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Sales-Type Leases
Lease Classification
1. The lease term (6-years) is equal to 100% of the useful life of the copier, and 2. Fair market value is difference from cost of the leased asset. 3. CompuDec is certain about the collectibility of the lease payments, and 4. 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).
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Sales-Type Leases: Lessee

At inception of the Lease January 1, 2011
CompDec Corp. (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment
479,079 300,000 479,079 300,000

Receipt of the First Lease Payment January 1, 2011

CompDec Corp.(Lessor) Cash Lease receivable

100,000
100,000

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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.
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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 2015. 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%.
Lessee's calculation of PV of MLP: PV of periodic payments $ 92,931 Plus: PV of BPO 60,000 PV of MLP Lessor's calculation of rental payments: Fair market value of asset Less: PV of BPO $ 60,000 Amount recoverd through payments PV annuity due factor, n = 6, I = 10% Rental payments at beginning of period
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4.79079 = $ 445,211 0.56447 = 33,868 $ 479,079 $ 479,079 0.56477 = (33,886) $ 445,193 4.79079 $ 92,927

Bargain Purchase Option (BPO)

Date 1/1/11 1/1/11 12/31/11 12/31/12 12/31/13 12/31/14 12/31/15 Payment $ 92,931 92,931 92,931 92,931 92,931 92,931 $ 557,586 Effective Interest 38,615 33,183 27,208 20,636 13,407 $ 133,049 $ Decrease in Balance $ 92,931 54,316 59,748 65,723 72,295 79,524 $ 424,537 Outstanding Balance $ 479,079 386,148 331,832 272,084 206,361 134,067 54,542

Exercise of BPO at the end of the lease term: $54,542 10% = $5,458* $60,000 BPO payment - $5,458 = $54,542
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Bargain Purchase Option (BPO)

End of Lease December 31, 2016
Sans Serif Publishers, Inc. (Lessee) Depreciation expense ($479,079 7) Accumulated depreciation
Interest expense Lease payable Cash (BPO payment) 68,440 68,440 5,458 54,542 60,000

CompDec Corporation(Lessor) Cash Lease receivable Interest revenue

60,000

54,582 5,458

Refer the amortization schedule and computations on the previous screen

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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%.

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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 lessors 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.

Lessee's calculation of PV of MLP: PV of periodic payments $ 92,931 Plus: PV of residual value 60,000 PV of MLP
PV factor of an annuity due of $1: n=6, i=10%

4.79079 = $ 445,211 0.56447 = 33,868 $ 479,079

PV factor of $1: n=6, i=10%

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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.

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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.
Lessor's calculation of rental payments: Fair market value of asset $ 479,079 Less: PV of residual value $ 60,000 0.56447 = (33,868) Amount recoverd through payments $ 445,211 PV annuity due factor, n = 6, I = 10% 4.79079 Rental payments $ 92,931

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Residual Value Guaranteed

Lets 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

479,079

CompDec Corporation (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment

479,079 300,000

479,079 300,000

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Residual Value Guaranteed

First Lease Payment January 1, 2011
San Serif Publishers, Inc. (Lessee) Lease payable 92,931 Cash 92,931

CompDec Corporation (Lessor) Cash Lease receivable

92,931 92,931

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Residual Value Guaranteed

December 31, 2015
San Serif Publishers, Inc. (Lessee) Depreciation expense 68,847 Accumulation depreciation 68,847
Interest expense Lease payable Cash 13,407 79,524 92,931
Recorded cost of leased asset $ 479,079 Guarantted residual value (60,000) Basis for depreciation 419,079 Useful life in years 6 Annual depreciation $ 69,847

CompDec Corporation (Lessor) Cash Interest revenue Lease receivable

92,931

13,407 79,524

See amortization schedule

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Treatment of Residual Value

Residual value in leased asset? Lessee gets the residual value (by transfer of title or a BPO) Lessor get the residual value (title does not transfer; no BPO) Residual value is not guaranteed. Residual value is guaranteed by lessee. Residual value is guaranteed by a third party. Lessor Computation of Minimum Lease Lease Payment Payment No No Lessee Minimum Lease Payment No

Yes Yes Yes

No Yes Yes

No Yes No

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Executory Costs
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
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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 lessors implicit rate or can infer it from the assets fair value. When the lessors 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.

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Lessors 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.

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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.
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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.

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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.

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Balance Sheet and 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.
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Special Leasing Arrangements

1. 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. 2. Real Estate Leases:
Leases of Land Only Leases of Land and Building Leases of Only Part of a Building

3. 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.
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End of Chapter 15