1 Leases Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso.

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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.