ACC4305 Michel Leseure Accounting for Leases ACC4305.

ACC4305Michel Leseure

Accounting for Leases

ACC4305


Leases

• The lease is a contractual agreement between the lessor and the lessee.

• The lease gives the lessee the right to use specific property.

• The lease specifies the duration of the lease and rental payments.

• The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee.


Advantages of Leases

• Leases may not require any money down.• Lease payments are often fixed.• Leases reduce the risk of obsolescence to the

lessee.• Leases may contain less restrictive covenants

than other types of lending arrangements.• Leases may be a less costly means of financing.• Certain leases may not add to existing debt on

the balance sheet. Off Balance SheetFinancing


Tax Advantages

• The lessee can write off the full cost of the asset, including the part that relates to land.

• The deduction may be accelerated since it is often spread over the period of the lease rather than the actual economic life of the property.


Defining Leases

• According to the FASB:– a lease transferring substantially all of the

benefits and risks of ownership should be capitalized.

– Transfer of ownership can be assumed only if there is a high degree of performance to the transfer, that is, the lease is non-cancelable.

– Leases that do not substantially transfers benefits and risks are operating leases.


Accounting by Lessee

• Leases that meet any of the following four criteria are capital leases for the lessee:– Leases, transferring ownership– Leases with bargain purchase options– Leases with lease terms equal to 75% or

more of the economic life (75% rule)– Leases where the present value of lease

payments is equal to 90% or more of the fair market value (90% rule)



Lease Agreement

Is there transferof ownership?

Yes

Is there a bargainpurchase option?

Yes No

Is lease term equalto or greater than75% of economic

life ?

Yes

No

CapitalLease

OperatingLease

Is present valueof payments

equal to or morethan 90% FMV?

Yes

No



• In a capital lease transaction, the lessee records an asset and a liability.– The asset is depreciated by the lessee over

the economic life of the asset.– The effective interest method is used to

allocate the rental payments between principal and interest.

– Depreciation of the asset and discharge of the lease obligation are independent accounting procedures.


Illustration


An introductory example

• To illustrate accounting for lease transactions, we will use a simple case involving three parties:

• 1. Meknes Farms SA» Needs a Combine Model SX

» Expected useful life of six years with no salvage value


An introductory example

• 2. Meknes First Bank» Currently charging 12% interest on long-term

equipment loans

• 3. Said Tractors, SA» Manufactures the Model SX combine at a cost of dh

400,000.

» Selling price is dh 500,000

» It also has a few units for trial use which rent for dh 5000 per week


Operating Lease

• If Meknes Farms rents a combine for one week from Said Tractors, the journal entries would follow the usual pattern for a rental:

Meknes Farms

Equipment rent expense 5,000

Cash5,000


Operating Lease

• Said Tractors– Cash 5,000– Rental Revenue 5,000

• Since Said Tractors is the owner of the combine, it would record depreciation:– Depreciation expense 1,282– Acc’d depreciation 1,282

[400,000/6 years/52 weeks]


Operating leases- Summary

• Assign rent expense or revenue to period benefited– Subject to accruals

• No liability on lessee’s balance sheet • Lessor depreciates the asset• Lessor is probably responsible for

insurance, property taxes and maintenance


Purchase with LT loan

• Assume Meknes Farms decides to purchase the combine and borrows the full purchase price of Dh 500,000 from Meknes First Bank at 12% interest on the unpaid balance of the loan.

• Meknes Farms agrees to make annual payments of Dh 100,000 for five years.

• Again, the journal entries follow the normal pattern.


Securing the Loan

• Meknes FarmsCash 500,000

Note Payable 500,000 • Meknes First Bank • Loan receivable 500,000

Cash 500,000


Purchasing the Equipment

• Said Tractors SA. Cash 500,000

Sales 500,000• COGS 400,000

Inventory 400,000

• Meknes FarmsCombine 500,000

Cash 500,000


End of the Year

• Meknes FarmDepreciation Expense 83,333

Acc'd Depreciation 83,333• Interest Expense 60,000

Interest Payable 60,000[500,000 * 12%]

• Meknes First BankInterest Receivable 60,000

Interest Revenue 60,000

500,000/6 years


First Installment Payment

• Meknes First Bank• Cash 160,000

Loan Receivable 100,000Interest Receivable 60,000

• Meknes FarmsInterest Payable 60,000Notes Payable 100,000

Cash 160,000


Capital Lease

• For various reasons either (or both) Meknes Farms and Meknes First Bank might prefer a lease arrangement to an outright purchase & long-term loan – Assume that the bank agrees to purchase

the combine from Said Tractors for MAD 500,000 and lease it to Meknes Farms for five years.

– Meknes Farms gets to keep the combine at the end of the lease.


Capital Lease

• The bank must determine how much to charge to earn its desired rate of 12% interest.– Assuming the first annual payment comes

at the end of the first year (after harvest). – PV = 500,000, n = 5, i = 12%

• Payment must be 138,710


Direct Financing Lease

• The lessor calls this a “direct financing lease” because it is essentially an installment sale.

• The only money the lessor makes from the lease is interest revenue.


Bank buys combine:

• Meknes First Bank• Asset to be leased 500,000

Cash 500,000 • Said Tractors SA.

Cash 500,000Sales 500,000

COGS 400,000Inventory 400,000


Asset is transferred to lessee:

• Meknes Farms

Leased Asset 500,000Lease Payable 500,000

• Meknes First Bank Investment in lease 500,000

Asset to be leased 500,000


End of the Year

• Meknes FarmsDepreciation Expense 83,333

Acc'd Depreciation 83,333

500,000/6 years

Acc. Dep to be applied against Leased Asset account


First Lease Payment

• Meknes First Bank• Cash 138,710

Investment in Lease 78,710Interest Revenue 60,000

• Meknes FarmsInterest Expense 60,000Lease Payable 78,710

Cash 138,710


Is Said Tractor missing out on a business opportunity?

– By offering a lease option, Troy Tractor gains the following advantages:

• 1. a way of indirectly making a sale,and

• 2. an alternative means of obtaining a profit opportunity.


Sales Type Lease

• Accordingly, Meknes Farms may be able to arrange a similar or better lease arrangement with the manufacturer

of the Model SX combine. – This is called a “sales-type lease” for the lessor because

Said Tractors will make a profit from “selling” the combine and it will earn interest revenue over the lease term.

– We will assume that the lease terms are the same for purposes of illustration.


Sales Type Lease

• NOTE: The first step in doing lease accounting involves finding the present value of the cash flows which will be transferred between the lessee and lessor. – This "present value of the minimum lease payments"

[PVMLP] will give you the SALES amount for the lessor (assuming a sales-type lease) and the ASSET amount for the lessee.

– COMPUTE PVMLP: [n = 5, i = 12%, pymt = 138,710]– PV = MAD 500,000


Sales Type Lease

• Meknes Farms• Leased Asset (PV of MLP) 500,000

Lease Liability 500,000

• Depreciation Expense 83,333Acc'd Depreciation 83,333

• Interest Expense 60,000Lease Liability 78,710 Cash 138,710


Sales Type Lease

• Said Tractors• Lease Receivable 500,000

Sales 500,000


Cash 138,710Interest Revenue 60,000Lease Receivable 78,710


Accounting by Lessor

• Lessor classifies leases as one of the following:– Operating lease– Direct financing lease– Sales-type lease


Classification of Lease for Lessor

• To be classified as an operating lease:– The lease doesn’t meet any group 1 criteria

(same as lessee’s), OR– Collectibility of payments isn’t reasonably

assured, OR– Lessor’s performance isn’t substantially

complete.


Classification of Lease for Lessor

• To be classified as a direct financing lease the lease must meet group 1 criteria (same as lessee’s), and the following, group 2 criteria:– Collectibility of payments must be

reasonably assured, and– Lessor’s performance must be

substantially complete, and– Asset’s fair value must be equal to lessor’s

book value


SummaryLease Agreement

Does lease meet Group 1 criteria?

No

Is collectibility ofpayments assured?

No yes

Is lessor’s performancesubstantiallycomplete ?

No

yes

OperatingLease

Directfinancing

Does asset FMVequal lessor’sbook value?

No

yes

yes

Sales type


Accounting Issues

• Residual values• Sales-type leases• Bargain purchase options• Initial direct costs• Disclosure


Bargain purchase options (BPO)

• Many leases are equivalent to a purchase financed with a long-term loan. We have assumed, so far, that Meknes Farm got to keep the tractor at the end of the lease (TITLE TRANSFER).

• Another way a lease is equivalent to a purchase is if the lessee can purchase the asset for a bargain price at the end of the lease. Consider the following lease terms:


BPO - Lease

• Inception date: 1/1/02• Lessor: Said Tractors Inc.• Fair value of combine at

1/1/02: MAD 500,000• Cost to manufacture

combine: 400,000• Estimated fair value at end

of lease is 100,000• Fixed non-cancelable

lease term: 5 years.

• First payment due on 12/31/02

• Lessee: Meknes Farms• Incremental borrowing

rate (lessee): 12%• Implicit interest rate

(known to lessee): 12%• Option to buy at end of

lease term for 50,000• Estimated useful life of

combine: 8 years


Bargain Purchase Option

• What amount should Said Tractors charge?

• Amount to be recovered (PV) = MAD 500,000

• n=5, i=12%, FV (BPO) = 50,000• What is PV of 50,000?• .5674 * 50,000 = 28,370• Amount to be recovered with annual

payments = 500,000 – 28,370 =471,630



Therefore, PV-OA = 471,630

PMT * PVIF-OA = PV-OA

PMT * 3.6048 = $471,630

471630/3.6048 = 130,830



MEKNES FARMSCombine (at PVMLP) 500,000

Lease Liability 500,000

Interest Expense 60,000Lease Liability. 70,830Cash 130,830

Depreciation Expense 62,500Acc'd Depreciation 62,500

Useful life = 8 years



SAID TRACTORS SA.Lease Receivable 500,000

Sales 500,000


Cash 130,830Lease Receivable 70,830Interest Revenue 60,000

Note: Last Payment includes BPO payment


Leasing in Moroccan Accounting

• A lease is a rental contract, and thus is always off balance sheet financing!

• Growing use– Medical equipment– Royal Air Maroc– Ship operators– Individuals

• Limited use for real estate• No interest charges presents an interest for

Islamic banking– New IAS standards with implicit interest rates!

Dossier de l’EconomisteNumber 2208


Leasing in Moroccan Accounting

• www.chaabileasing.co.ma• Salafin• Credit du Maroc Leasing


• Royal Air Maroc has filed for and obtained an exemption from Moroccan regulations to capitalise its aircraft leases

• Motivations?

Leases in Moroccan Accounting


Lease Backs

• An agreement whereby a company sells its asset to a lessor and rents it back under the form of a lease

• Motivations:– Cash infusion (at market value rather than

book value!)• Risk: use the cash to a productive investment purpose!

– Off balance sheet balancing• Down to the nature of the contract!• Systematic with MA/FR accounting


Lease Backs

• Can be used, legally, to “window dress” accounts

• Example:– Company in financial difficulty– Fully amortized asset on the books (or not)– Lease back

• Liquidity increases, solvency increases!• COMANAV in 2003• Not possible with IFRS

ACC4305 Michel Leseure Accounting for Leases ACC4305.

Documents

lessee leases

leases acc4305 slide

ownership leases

capital leases

lessee lease agreement

capital lease operating

rule leases

operating leases