1 1. Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2. Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction. 3. Outline the types of contractual provisions typically included in lease agreements. Leases - Learning Objectives
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1 1.Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase. 2.Understand the accounting issues faced.
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1
1. Describe the circumstances in which leasing makes more business sense than does an outright sale and purchase.
2. Understand the accounting issues faced by the asset owner (lessor) and the asset user (lessee) in recording a lease transaction.
3. Outline the types of contractual provisions typically included in lease agreements.
Leases - Learning Objectives
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4. Apply the lease classification criteria in order to distinguish between capital and operating leases.
5. Properly account for both capital and operating leases from the standpoint of the lessee (asset user).
6. Properly account for both capital and operating leases from the standpoint of the lessor (asset owner).
7. Prepare and interpret the lease disclosures required of both lessors and lessees.
Learning Objectives
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LeaseLease
A lease is a contract specifying the terms under which the owner of an asset agrees to transfer the right to use the asset to another party.
Parties:– Lessee - he party granted the right to use the
property under the terms of a lease.– Lessor- The owner of the property that is
rented (leased) to another party.
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Advantages of Leasing
• No down payment
• Avoid risks of ownership
• Flexibility
• No down payment
• Avoid risks of ownership
• Flexibility
• Increased sales
• Ongoing business relationship with lessee
• Residual valued retained
• Increased sales
• Ongoing business relationship with lessee
• Residual valued retained
To the Lessee To the Lessor
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Simple Example
Owner Company owns a piece of equipment with a market value of $10,000.
User Company wishes to acquire the equipment for use in its operations.
ContinuedContinuedContinuedContinued
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Simple Example
One option for User Company is to purchase the equipment from Owner by borrowing
$10,000 from a bank at an interest rate of 10%.
Owner would repay the principal and interest by making five annual payments of $2,638.
ContinuedContinuedContinuedContinued
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Simple Example
Alternatively, User Company can lease the asset from Owner Company for five years,
making annual “rental” payments of $2,638.
Buy$2,638
annually
Lease$2,638
annually
ContinuedContinuedContinuedContinued
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Simple Example
Has effective ownership passed?
Does Owner Company have any significant responsibility remaining?
Is Owner Company reasonable certain that they five annual payments can be collected?
ContinuedContinuedContinuedContinued
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Simple Example
Scenario 1Scenario 1
The lease agreement stipulates that Owner Company is to maintain legal title to the
equipment for the 5-year lease period, but title is to pass to User at the end of the lease.
Even though this is a leasing arrangement, the transfer of title at
the end indicates that this is in substance a purchase.
Even though this is a leasing arrangement, the transfer of title at
the end indicates that this is in substance a purchase.
ContinuedContinuedContinuedContinued
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Simple Example
Scenario 2Scenario 2
The lease agreement stipulates that Owner Company is to maintain legal title to the
equipment for the 5-year lease period, but at the end of the lease period User has the option to buy
the equipment for $1.
Offering the equipment to User Company for a bargain price at the end of the lease indicates that
this arrangement is in substance a purchase.
Offering the equipment to User Company for a bargain price at the end of the lease indicates that
this arrangement is in substance a purchase.ContinuedContinuedContinuedContinued
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Simple Example
Scenario 3Scenario 3
The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used
by anyone else.
Because the life of the asset and the term of the lease are identical, this arrangement
is in substance a purchase.
Because the life of the asset and the term of the lease are identical, this arrangement
is in substance a purchase.
ContinuedContinuedContinuedContinued
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Simple Example
Scenario 4Scenario 4
The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date.
When the present value of the lease payments is close to the market value of the leased item, the arrangement is
in substance a purchase.
When the present value of the lease payments is close to the market value of the leased item, the arrangement is
in substance a purchase.
The exact rules will be discussed later in this chapter.
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Simple Example
Capital leases are accounted for as if the lease agreement
transfers ownership of the asset from the lessor to the lessee.
Capital leases are accounted for as if the lease agreement
transfers ownership of the asset from the lessor to the lessee.
Operating leases are accounted for as rental
agreements, with no transfer of effective ownership
associated with the lease.
Operating leases are accounted for as rental
agreements, with no transfer of effective ownership
associated with the lease.
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Nature of Leases
Cancellation Cancellation ProvisionProvision
Cancellation Cancellation ProvisionProvision
Specifies under whatcircumstances the leasemay be canceled.
Lease TermLease TermLease TermLease Term Delineates the time period the lease is to be in force.
Bargain Purchase Bargain Purchase OptionOption
Bargain Purchase Bargain Purchase OptionOption
Grants lessee the right topurchase the asset at the end of the lease term for less than the residual value.
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Residual ValueResidual ValueResidual ValueResidual Value Market value of leasedasset at end of lease term.
Rental payment requiredover lease term plus anypayment for residual value as well as any bargain purchase option.
Minimum Lease Minimum Lease PaymentPayment
Minimum Lease Minimum Lease PaymentPayment
Nature of Leases
Payments for insurance, maintenance and taxes incurred for the leased property
Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed
a residual value of $10,000 by the lessee.
Dorney Leasing Co. owns and leases road equipment for three years at $3,000 per month. Included in the lease payment is $500 per month of executory costs. At the end of the 3-year period, Dorney is guaranteed
a residual value of $10,000 by the lessee.
Minimum lease payments:Rental payments ($3,000 – $500) x 36
$ 90,000Guaranteed residual value
10,000Total minimum lease payment
$100,000
ContinuedContinuedContinuedContinued
Nature of Leases
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Minimum Lease Payment Computation
Present value of 36 monthly paymentsof $2,500 at 1% interest paid at theend of the month:PMT = $2,500, N = 36, I = 1%
$75,269Present value of $10,000 guaranteed
residual value at the end of 10 years
at 12% compounded monthly:FV = $10,000, N = 36, I = 1%
6,989
Present value of minimum lease payment $82,258
Assuming an implicit rate of 1% per month:
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Lease Classification Criteria
A lease is classified as a capital lease by the lessee if
it is noncancelable and meets any one of the
following criteria:
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1) The lease transfers ownership of the leased asset to the lessee by the end of the lease term.
2) The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.
3) The lease term is equal to 75 percent or more of the estimated economic life of the asset.
4) The present value of the lease payments at the beginning of the lease is 90 percent or more of the fair market value of the leased asset.
Lease Classification Criteria
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Transfer of Ownership?Transfer of Ownership?Transfer of Ownership?Transfer of Ownership?Yes
Yes
Yes
Yes
Bargain PurchaseBargain PurchaseOption?Option?
Bargain PurchaseBargain PurchaseOption?Option?
No
Term Term >>75% of75% ofUseful Life?Useful Life?
Term Term >>75% of75% ofUseful Life?Useful Life?
No
PV Payment PV Payment >>90%90%of FMV?of FMV?
PV Payment PV Payment >>90%90%of FMV?of FMV?
No
Lease Classification—Lessee
CapitalLease
CapitalLease
OperatingLease
OperatingLeaseNo
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Lease Classification—Lessor
Additional revenue recognition criteria applicable to lessors.
Additional revenue recognition criteria applicable to lessors.
1. Collectibility of the minimum lease payments is reasonably predictable.
2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by lessor.
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Exhibit 15-2
Exhibit 15-2 in the textbook provides four lease provision
situations. We will go through Lease 1 together.
Exhibit 15-2 in the textbook provides four lease provision
situations. We will go through Lease 1 together.
Understanding the lease classification criteria is
important. We strongly urge you to analyze Lease 2
through Lease 4.
Understanding the lease classification criteria is
important. We strongly urge you to analyze Lease 2
through Lease 4.
ContinuedContinuedContinuedContinued
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Lease 1
LesseeLessee
This is a test to see if the lease qualifies as a capital lease. If it doesn’t, then it is an operating lease.
Does the lease transfer ownership at Does the lease transfer ownership at the end of the lease term?the end of the lease term?
Does the lease transfer ownership at Does the lease transfer ownership at the end of the lease term?the end of the lease term?
No! So, we move to Criteria 2.
ContinuedContinuedContinuedContinued
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Lease 1
LesseeLessee
Does the lease contain a bargain Does the lease contain a bargain purchase option?purchase option?
Does the lease contain a bargain Does the lease contain a bargain purchase option?purchase option?
No! So, we move to Criteria 3.
ContinuedContinuedContinuedContinued
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Lease 1
LesseeLessee
Is the lease term equal to 75 percent or more Is the lease term equal to 75 percent or more of the estimated economic life of the asset?of the estimated economic life of the asset?Is the lease term equal to 75 percent or more Is the lease term equal to 75 percent or more of the estimated economic life of the asset?of the estimated economic life of the asset?
No! The 10-year lease covers approximately 72 percent of the economic life of the asset. So, we move to Criteria 4.
ContinuedContinuedContinuedContinued
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Lease 1
LesseeLessee
Does the present value of the lease Does the present value of the lease payments equal 90 percent or more of the payments equal 90 percent or more of the
fair market value of the leased asset?fair market value of the leased asset?
Does the present value of the lease Does the present value of the lease payments equal 90 percent or more of the payments equal 90 percent or more of the
fair market value of the leased asset?fair market value of the leased asset?
Before we answer this question, let’s pause and review two terms related to interest on a lease.
ContinuedContinuedContinuedContinued
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• Implicit Interest Rate: Rate that would be used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease.
• Incremental Borrowing Rate: Rate at which lessee could borrow the amount of money necessary to purchase the leased asset.
Lease 1
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Lessor always uses the implicit rate to discount rental payments.
Lessor always uses the implicit rate to discount rental payments. Lessee uses the lesser
of the implicit rate (if known) and the
incremental borrowing rate.
Lessee uses the lesser of the implicit rate (if
known) and the incremental
borrowing rate.
Lease 1
ContinuedContinuedContinuedContinued
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Lease 1
LesseeLessee
Does the present value of the lease Does the present value of the lease payments equal 90 percent or more of the payments equal 90 percent or more of the
fair market value of the leased asset?fair market value of the leased asset?
Does the present value of the lease Does the present value of the lease payments equal 90 percent or more of the payments equal 90 percent or more of the
fair market value of the leased asset?fair market value of the leased asset?
No, the lessee only knows the incremental borrowing rate, which provides a present value
of less than 90 percent.
ContinuedContinuedContinuedContinued
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The lessor answered negatively to the first three
criteria, so let’s analyze the fourth criteria.
The lessor answered negatively to the first three
criteria, so let’s analyze the fourth criteria.
ContinuedContinuedContinuedContinued
Lease 1
LessorLessor
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Lease 1
LessorLessor
In addition to meeting at least one of the four
criteria, the lessor must meet both of a second set of
criteria.
In addition to meeting at least one of the four
criteria, the lessor must meet both of a second set of
criteria.
ContinuedContinuedContinuedContinued
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Lease 1
LessorLessor
Is the collectibility of the minimum lease Is the collectibility of the minimum lease payment reasonably predictable?payment reasonably predictable?
Is the collectibility of the minimum lease Is the collectibility of the minimum lease payment reasonably predictable?payment reasonably predictable?
ContinuedContinuedContinuedContinued
AND
Are there important uncertainties Are there important uncertainties surrounding the amount of surrounding the amount of
unreimbursable costs yet to be incurred unreimbursable costs yet to be incurred by the lessor?by the lessor?
Are there important uncertainties Are there important uncertainties surrounding the amount of surrounding the amount of
unreimbursable costs yet to be incurred unreimbursable costs yet to be incurred by the lessor?by the lessor?
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Lease 1
LessorLessor
Collectibility is predictable and there are no important
uncertainties about reimburseable cost…
Collectibility is predictable and there are no important
uncertainties about reimburseable cost…
…so this is a capital lease to the lessor and an
operating lease to the lessee.
…so this is a capital lease to the lessor and an
operating lease to the lessee.
34Accounting for Operating LeasesAccounting for Operating Leases—Lessee—Lessee
Bob Jones signs a two-year lease which requires a monthly payment of $1,000. When the lease expires, Bob will either move out or negotiate a new lease.
Rent Expense 1,000 Cash 1,000
35Operating Leases With Varying Operating Leases With Varying Lease PaymentsLease Payments
The terms of a lease for an aircraft by International Airlines
provide for payments of $150,000 a year for the first two years and $250,000 for each of
the next three years.
The terms of a lease for an aircraft by International Airlines
provide for payments of $150,000 a year for the first two years and $250,000 for each of
the next three years.
ContinuedContinuedContinuedContinued
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Entry Each Year for Years 1 and 2:Rent Expense 210,000
Cash 150,000Rent Payable 60,000
Entry Each Year for Years 3-5:
Rent Expense 210,000Rent Payable 40,000
Cash 250,000
Operating Leases With Varying Operating Leases With Varying Lease PaymentsLease Payments
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Accounting for Capital Leases
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Minimum payment (in advance)including $5,000 executory costs $65,000/year
Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%
Accounting for Capital Leases
LesseeLessee
ContinuedContinuedContinuedContinued
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Leased Equipment 250,192 Obligations under Capital Leases 250,192
Accounting for Capital Leases
Entries on January 1, 2005Entries on January 1, 2005
Lease Expense 5,000Obligations under Capital Leases 60,000
Cash65,000
PMT = PMT = $60,000;
$60,000; N = 5; N = 5;
I = 10%I = 10%
PMT = PMT = $60,000;
$60,000; N = 5; N = 5;
I = 10%I = 10%
ContinuedContinuedContinuedContinued
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Accounting for Capital Leases
Entries on December 31, 2005Entries on December 31, 2005
Amortization Expense on LeasedEquipment 50,038
Accumulated Amortization on Leased Equipment50,038
Prepaid Executory Costs 5,000Obligations under Capital Leases 40,981Interest Expense 19,019
Cash65,000
($250,192 ($250,192 – $60,000) x 10%– $60,000) x 10%
41Accounting for Leases With a Bargain Purchase Option
Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price.
The present value of the bargain purchase option would be added
to the present value of the minimum lease payments to establish the initial asset and
liability.
BARGAIN DEAL
42Accounting for Leases With a Bargain Purchase Option
Minimum payment (in advance)including $5,000 executory costs $65,000/year
Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 10 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Bargain purchase option $75,000
LesseeLessee
ContinuedContinuedContinuedContinued
43Accounting for Leases With a Bargain Purchase Option
Minimum payment (in advance)including $5,000 executory costs $65,000/year
Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 10 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Cost to lessor $400,000Direct costs incurred $15,000
Accounting for a direct financing lease for lessors is
similar to that used for capital leases by the lessee—
only in reverse.
Accounting for a direct financing lease for lessors is
similar to that used for capital leases by the lessee—
only in reverse.
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Minimum payment (in advance)including $5,000 executory costs $65,000/year
Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value at end of lease $0Implicit Rate 10%Incremental Borrowing Rate 10%Cost and fair market value of equipment $250,192
ContinuedContinuedContinuedContinued
Direct Financing Lease
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Direct Financing Lease
Lease Payments Receivable 250,192 (net)Equipment Purchased for Lease 250,192
Minimum payment (in advance)including $5,000 executory costs $65,000/year
Lease period (beginning 01/01/05) 5 yearsEconomic life of asset 5 yearsEstimated residual value (end of lease) $75,000Implicit Rate 10%Incremental Borrowing Rate 10%Cost and fair market value of equipment $296,761
ContinuedContinuedContinuedContinued
57Direct Financing Lease With Residual Value
Lease Payments Receivable 296,761Equipment Purchased for Lease 296,761