1 Leases Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso.
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1
Leases
Sid Glandon, DBA, CPAAssociate Professor of AccountingUniversity of Texas at El Paso
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Basics of Leasing
Lease– Contractual agreement between lessor and
lessee– Gives lessee right to use specific property – Specifies duration and rental payments– Executory costs
• Taxes, insurance and maintenance• May be assumed by either party
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Advantages
100% financing at fixed rates Protection against obsolescence Flexibility Less costly financing AMT problems avoided Off-balance-sheet financing
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Classification of Leases
Capital leases– If lease transfers substantially all of the
benefits and risks of ownership– Must be noncancelable
Operating leases– Do not substantially transfer benefits and
risks of ownership
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Accounting by Lessee
Capitalize if noncancelable, and– Transfers ownership to lessee, or– Contains bargain purchase option, or– Lease term equal to 75% or more of
estimated economic life of property, or– PV of minimum lease payments equals or
exceeds 90% of fair value of property
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Accounting by LesseeDoes lease agreement transfer ownership? Yes
No
Is there a bargain purchase option?
Is the lease term ≥ 75% of economic
Is PV of payments ≥ 90%
No
No
No
Yes
Yes
Yes
Capital Lease
Operating Lease
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Bargain Purchase Option
Allows lessee to buy leased asset Price significantly lower that expected
fair value at date of option Determined at inception of lease Must render option reasonably assured
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Economic Life Test
Lease period equals or exceeds 75% of asset’s economic life
Lease term is considered the fixed noncancelable term of lease
Bargain renewal options are included If lease starts during last 25% of life of
asset, test cannot be used
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Recovery of Investment
PV of minimum lease payments equals or exceeds 90% of fair value
Minimum lease payments– Payments– Guaranteed residual value– Penalty for failure to renew or extend – Bargain purchase option
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Discount Rate
The lesser of – Lessee’s incremental borrowing rate, or– The implicit interest rate
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Executory Cost
Insurance, maintenance and taxes Should be excluded from minimum
lease payments
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Residual Values
Estimated fair value at end of lease Guaranteed residual value
– An additional lease payment Unguaranteed residual value
– Same as no residual value to lessee Lessor assumes residual value will be
realized whether guaranteed or not
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Capitalized LeasesAccounting by Lessee
Asset and Liability– Recorded at the lesser of the PV of
minimum lease payments or FMV Depreciation Period
– Economic life• Lease transfers ownership• Lease has bargain purchase option
– Term of lease
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Fact Pattern
Date: January 1, 2006 Lease term: 10 years Discount rate: 8% Annual lease payments: $12,000 Executory costs: $1,000 Title transfers at end of lease term Economic life of asset: 12 years Residual value: $0
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Date
Annual Lease
PaymentExecutory
Costs Net Lease Interest PrincipalLease
Oblication1/1/06 $79,7161/1/06 $12,000 $1,000 $11,000 $11,000 68,7161/1/07 12,000 1,000 11,000 $5,497 5,503 63,2131/1/08 12,000 1,000 11,000 5,057 5,943 57,2701/1/09 12,000 1,000 11,000 4,582 6,418 50,8521/1/10 12,000 1,000 11,000 4,068 6,932 43,9201/1/11 12,000 1,000 11,000 3,514 7,486 36,4331/1/12 12,000 1,000 11,000 2,915 8,085 28,3481/1/13 12,000 1,000 11,000 2,268 8,732 19,6161/1/14 12,000 1,000 11,000 1,569 9,431 10,1851/1/15 12,000 1,000 11,000 815 10,185 0
$120,000 $10,000 $110,000 $30,284 $79,716
Lease Amortization Schedule
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Date Account Debit Credit1/1/06 Equipment under capital lease $79,716
Obligations under capital lease $79,716
Date Account Debit Credit1/1/06 Obligations under capital lease $11,000
Executory costs, insurance and taxes 1,000 Cash $12,000
To record the signing of a lease classified as a capital lease.
To record the initial lease payment at the signing of a lease classified as a capital lease.
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Date Account Debit Credit12/31/06 Depreciation expense $6,643
Accumulated depreciation $6,643
Analysis of depreciation expense:Capitalized cost of equipment $79,716Salvage (residual) value 0Depreciable base 79,716Economic (service) life 12 Annual depreciation $6,643
To record depreciation expense on equipment under capital lease.
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Date Account Debit Credit1/1/07 Obligations under capital lease $5,503
Executory costs, insurance and taxes 1,000Interest expense 5,497 Cash $12,000
To record the payment of principal, executory costs and interest on capital lease.
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Operating Leases Accounting by Lessee
Lessee assigns rent to periods benefiting
Ignores any commitments for future payments
Note disclosure– For all operating leases that have
noncancelable lease terms in excess of one year
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Classification of Leases Accounting by Lessor
Direct financing leases Sales type leases Operating leases
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Direct Financing Lease
Must meet group I capitalization criteria and– Collectibility of payments must be
reasonably assured– Lessor’s performance must be
substantially complete FV of asset equal to lessor’s book value
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Sales Type Lease
Must meet group I capitalization criteria and– Collectibility of payments must be reasonably
assured– Lessor’s performance must be substantially
complete
FV of asset should not be equal to lessor’s book value– Lease contains a dealer’s gross profit
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Operating LeaseAccounting by Lessor
Does not meet criteria for capitalized lease
Rental receipts recorded as rental receipts
Leased asset depreciated Leased equipment and accumulated
depreciation separately classified
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Accounting by LessorDoes lease four criteria in Group I? No
Yes
Is collectability of payments assured?
Is performance substantially complete?
Yes
Yes
No
No
No
Operating Lease
Direct FinancingDoes asset FMV = lessor's book Yes
Sales Type
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Direct Financing Lease
Debit, Lease receivable– Gross sum of lease payments
Credit, Unearned interest revenue– Lease receivable less FMV of asset
Credit, Inventory of equipment– Lessor’s cost of the asset
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Fact Pattern
Date: January 1, 2005 Inventory of equipment: $103,500 Lease term: 6 years Implicit interest rate: 8% Payments: $20,000 Residual value: $5,786
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Date Payment InterestAmortization of Principal Balance
1/1/05 $103,500 1/1/05 $20,000 $20,000 83,5001/1/06 20,000 $6,680 13,320 70,1801/1/07 20,000 5,614 14,386 55,7941/1/08 20,000 4,464 15,536 40,2581/1/09 20,000 3,221 16,779 23,4791/1/10 20,000 1,878 18,122 5,357
12/31/10 5,786 429 5,357 0$125,786 $22,286 $103,500
Lease Amortization Schedule
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Date Account Debit Credit1/1/05 Lease receivable $125,786
Unearned interest revenue $22,286 Inventory 103,500To record the signing of a direct financing lease.
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Sales Type Leases
Debit, Lease Receivable – Lease payments plus residual
Debit, Cost of Goods Sold– Lessor’s cost
Credit, Sales Price of Asset– PV of minimum lease payments
Credit, Unearned Interest Revenue– Lease Receivable less FMV of asset
Credit, Inventory– Lessor’s cost
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Fact Pattern
Date: January 1, 2005 Inventory of equipment: $60,000 FMV of equipment: $103,500 Lease term: 6 years Implicit interest rate: 8% Payments: $20,000 Residual value: $5,786
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Date Payment InterestAmortization of Principal Balance
1/1/05 $103,500 1/1/05 $20,000 $20,000 83,5001/1/06 20,000 $6,680 13,320 70,1801/1/07 20,000 5,614 14,386 55,7941/1/08 20,000 4,464 15,536 40,2581/1/09 20,000 3,221 16,779 23,4791/1/10 20,000 1,878 18,122 5,357
12/31/10 5,786 429 5,357 0$125,786 $22,286 $103,500
Lease Amortization Schedule
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Date Account Debit Credit1/1/05 Lease receivable $125,786
Cost of goods sold $60,000 Sales revenue $103,500 Unearned interest revenue $22,286 Inventory 60,000To record the signing of a sales type lease.
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