CHAPTER 15 Leases 1 Leases Where We’re Headed A Chapter Addendum Preview The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This Addendum is based on their joint Exposure Draft of the new leases standard update and “tentative decisions” of the Boards after receiving feedback from the Exposure Draft as of the date this text went to press. 1 Even after the new Accounting Standard Update is issued, previous GAAP will be relevant until the new ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the new Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon. RIGHT-OF-USE MODEL 1 Because the ASU had not been finalized as of the date this text went to press, it is possible that some aspects of the ASU are different from what we show in this Addendum. Check the FASB Updates page (http://lsb.scu.edu/jsepe/fasb-update- 7e.htm ) to see if any changes have occurred.
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CHAPTER 15 Leases 1
Leases
Where We’re Headed A Chapter Addendum
Preview The FASB and the IASB are collaborating on several major new standards designed
in part to move U.S. GAAP and IFRS closer together (convergence). This Addendum
is based on their joint Exposure Draft of the new leases standard update and
“tentative decisions” of the Boards after receiving feedback from the Exposure
Draft as of the date this text went to press. 1
Even after the new Accounting Standard Update is issued, previous GAAP will be
relevant until the new ASU becomes effective (likely not mandatory before 2016)
and students taking the CPA or CMA exams will be responsible for the previous
GAAP until six months after that effective date. Conversely, prior to the effective
date of the new Accounting Standard Update it is useful for soon-to-be graduates to
have an understanding of the new guidance on the horizon.
RIGHT-OF-USE MODEL
1 Because the ASU had not been finalized as of the date this text went to press, it is possible that some aspects of the ASU are different from what we show in this Addendum. Check the FASB Updates page (http://lsb.scu.edu/jsepe/fasb-update-7e.htm) to see if any changes have occurred.
2 SECTION 3 Financial Instruments and Liabilities
From your own experience of leasing an apartment or a car or knowing someone
who has, you know that a lease is a contractual arrangement by which a lessor
(owner) provides a lessee (user) the right to use an asset for a specified period of
time. In return for this right, the lessee agrees to make stipulated, periodic cash
payments during the term of the lease. In the right-of-use model introduced in the
new standards update, all leases are recorded as an asset and liability (with the
exception of short term leases as described later), and the concept of operating
leases is eliminated.
The right to use the leased property can be a significant asset. Likewise, the
obligation to make the lease payments can be a significant liability. Appropriately,
the lessee reports both the right-of-use asset and the corresponding liability in the
balance sheet:
Right-of-use asset (present value of lease payments) .... xxx
Lease liability (present value of lease payments) ... xxx
On the other side of the transaction, the lessor reports a receivable for the lease
payments it will receive and removes from its records (derecognizes) the asset (or
portion thereof) for which it has given up the right of use. We no longer employ the
concept of direct financing and sales-type leases. If the lease receivable represents
only a portion of the total fair value of the asset, the lessor also records a “residual
asset” for the portion related to the right of use not transferred to the lessee:
Lease receivable (present value of lease payments) ...... xxx
Asset (carrying amount of asset being leased) ........ xxx
OR
Lease receivable (present value of lease payments) ....... xxx
Residual asset (carrying amount of portion retained) ..... xxx
Asset (carrying amount of asset being leased) ......... xxx
When the Lessor is a Financial Intermediary
Either of these two scenarios is typical for most leases in which the lessor’s primary
role is to acquire an asset and then finance it for a lessee during all or a portion of
the asset’s useful life. The lessor, in this case, is a financial intermediary that earns
interest revenue for providing financing of the asset for the lessee. Look, for
example, at Illustration 15- 24:
GAAP Change
The new guidance for
lease accounting
eliminates the concept of
operating leases.
The lessee records both a
right-of-use asset and a
liability to pay for that
right.
GAAP Change
The new ASU eliminates
the concept of direct
financing and sales-type
leases.
The lessor records a
receivable for the lease
payments it will receive
and derecognizes the
asset being leased.
If only a portion of the
right of use is leased, the
lessor also records a
residual asset.
CHAPTER 15 Leases 3
LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and
leases it to UserCorp for lease payments whose present value is $100,000.
UserCorp
Right-of-use asset (present value of lease payments) .... 100,000
Lease liability (present value of lease payments) ... 100,000
LeaseCo
Lease receivable (present value of lease payments) ..... 100,000
Asset (carrying amount of asset being leased) ........ 100,000
Two potential characteristics of a lease arrangement can complicate the lessor’s
accounting: (1) retaining a residual asset and (2) earning a profit on the lease. We
first discuss each individually and then discuss them in combination.
When the Lessor Retains a Residual Asset
Sometimes the lessee obtains the right to use the asset for only a portion of its
useful life or to use only a portion of the asset. In that case, the lessor retains a
“residual asset” that represents the carrying amount of the asset not transferred to
the lessee.
LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and
leases it to UserCorp for lease payments whose present value is $40,000.
UserCorp
Right-of-use asset (present value of lease payments) .... 40,000
Lease liability (present value of lease payments) ... 40,000
Only a portion of the right to use the asset is being transferred. Accordingly, a
portion is being retained. The portion transferred is:
$40,000 / $100,000 x $100,000 = $40,000.
So, the portion retained (residual asset) is the remainder:
$100,000 – 40,000 = $60,000.
LeaseCo
Lease receivable (present value of lease payments) ..... 40,000
Residual asset (carrying amount of portion retained) ... 60,000
Asset (carrying amount of asset being leased) ........ 100,000
ILLUSTRATION 15–24
Right of Use Model
ILLUSTRATION 15–25
Residual Asset
The lessor “derecognizes”
the asset under lease and
replaces it with two assets
– a lease receivable and a
residual asset.
4 SECTION 3 Financial Instruments and Liabilities
When the Lessor Earns a Profit from the Lease
In some scenarios, the lessor earns an immediate profit from the lease transaction
in addition to the interest revenue earned over the term of the lease. Often, the
lessor in this type of transaction is a manufacturer or a merchandiser that is using
the lease as a means of “selling” its product. We account for these situations
similar to the way we account for sales-type leases in earlier GAAP. See Illustration
15-26 for an example.
ManuCom manufactures a machine at a cost of $80,000 with a retail selling
price (fair value) $100,000. Rather than selling the machine, it leases the machine
to UserCorp under an agreement in which the present value of the lease payments
is $100,000. Either way, ManuCom generates a gross profit of $20,000:
Lease receivable (PV of lease payments) ..................... 100,000
Asset (carrying amount of asset being leased) ........ 80,000
Profit (difference2 between the PV of lease payments
and the carrying amount of asset) ...................... 20,000
We can think of (a) the present value of the lease payments to be received as
being the “selling price” of the right to use the asset and (b) the carrying amount of
the portion related to that right of use, and thus transferred, as the “cost of goods
sold,” with the difference being the profit on the “sale.”
When the Lessor Earns a Profit and Retains a Residual Asset
As we saw earlier, the lessee sometimes obtains the right to use the asset for only a
portion of its useful life or to use only a portion of the asset and retains a “residual
asset.” This can happen also in a situation in which the lessor earns a profit on the
lease:
Lease receivable (PV of lease payments) ....................... xxx
Residual asset (carrying amount of portion retained, if any) xxx
Asset (carrying amount of asset being leased) ........ xxx
ILLUSTRATION 15–26
Profit from the Lease
If the PV of the lease
payments exceeds the
carrying amount of the
asset transferred, the
lessor has a profit from
the lease.
CHAPTER 15 Leases 5
Profit (difference, if any, between the PV of lease payments
and the carrying amount of portion transferred) ... xxx
In Illustration 15-27 we modify our previous example to include a residual asset
in a lease involving a profit.
2 In the rare instance that this is a debit difference, we would have a loss rather than profit. Companies might choose to separate this profit into its two components: Sales revenue and cost of goods sold, which is the gross method demonstrated for “sales-type” leases in the main chapter.
6 SECTION 3 Financial Instruments and Liabilities
ManuCom manufactures a machine at a cost of $80,000 with a retail selling
price (fair value) of $100,000. Rather than selling the machine, it leases the
machine to UserCorp under an agreement in which the present value of the lease
payments is $90,000. Because the lessor is not receiving the full value of the
machine, only a portion of the right to use the asset is being transferred.
Accordingly, a portion is being retained. The portion transferred is:
$90,000
/ $100,000 x $80,000 = $72,000.
So, the portion retained (residual asset) is the remainder:
$80,000 – 72,000 = $8,000.
Lease receivable (PV of lease payments) ....................... 90,000
Residual asset (carrying amount of portion retained) ........ 8,000
Asset (carrying amount of asset being leased) ........ 80,000
APPLICATION TO CHAPTER ILLUSTRATIONS Let’s look back to the situations we discussed in the main chapter in which we applied current GAAP, but instead now see how the new guidance would compare. We start with a rather straightforward situation and then look at the three variations we just discussed: (1) the lessor retains a residual interest, (2) the lessor recognizes some immediate profit, and (3) the lessor both retains a residual interest and recognizes some immediate profit. In Illustration 15–28 we have the same straightforward lease agreement we saw earlier in Illustration 15-6. Accounting under the new lease guidance is quite similar to what would appear under current GAAP. Conceptually, though, we view the situation differently than we would under current GAAP. Rather than thinking of Sans Serif as having “purchased” the asset from First LeaseCorp, we think of the company as having acquired the right to use the asset, in this case, for its entire useful life. That’s why Sans Serif records a right-of-use asset instead of an asset to be depreciated as if it were owned. Otherwise, though, the accounting is much the same. On the other side of the transaction, First LeaseCorp again derecognizes the asset (removes it from the 3 Companies might choose to separate this profit into its two components: Sales revenue ($90,000) and cost of goods sold ($72,000), which is the gross method demonstrated for “sales-type” leases in the main chapter.
The fraction of the
$80,000 carrying amount
deemed transferred is:
PV of payments
/ FV of asset
ILLUSTRATION 15–27
Profit from the Lease and
Residual Asset
GAAP Change
CHAPTER 15 Leases 7
books) as it records a receivable for the lease payments to be received.
On January 1, 2013, Sans Serif Publishers, Inc., leased a copier from First Lease
Corp. First Lease Corp purchased the equipment from CompuDec Corporation at a
cost of $479,079.
The lease agreement specifies annual payments beginning January 1, 2013, the
inception of the lease, and at each December 31 thereafter through 2017. The six-
year lease term ending December 31, 2018, is equal to the estimated useful life of
the copier.
First Lease Corp routinely acquires electronic equipment for lease to other firms.
The interest rate in these financing arrangements is 10%.
To achieve its objectives, First LeaseCorp 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:
$479,079 ÷ 4.79079* = $100,000
Lessor’s Rental
cost payments *Present value of an annuity due of $1: n = 6, i = 10%.
Of course, Sans Serif Publishers, Inc., views the transaction from the other side.
The price the lessee pays for the copier is the present value of the rental payments:
$100,000 × 4.79079* = $479,079
Rental Lessee’s
payments cost *Present value of an annuity due of $1: n = 6, i = 10%.
Commencement of the Lease (January 1, 2013)
Sans Serif Publishers, Inc. (Lessee)
Right-of-use asset (present value of lease payments) ................... 479,079
Lease payable (present value of lease payments) ................. 479,079
First LeaseCorp (Lessor)
Lease receivable (present value of lease payments) ..................... 479,079
Inventory of equipment (carrying amount of asset being leased) 479,079
* Of course, the entries to record the lease and the first payment could be combined into a single
ILLUSTRATION 15–28
Right-of-Use Model
Using Excel, enter:
=PMT(.10,6,479079,, 1)
Output: 100000
Using a calculator:
enter: BEG mode N 6 I 10
PV −479079 FV
Output: PMT 100000
Notice that the lessor’s
entries are the flip side or
mirror image of the
lessee’s entries.
The first lease payment
reduces the balances in
the lease payable and the
lease receivable by
$100,000 to $379,079.
8 SECTION 3 Financial Instruments and Liabilities
entry since they occur at the same time.
Notice that as the lessee assumes the obligation to pay for the asset’s use
(lessee’s lease liability), the lessor acquires the right to receive those payments
(lease receivable). Recording the first payment above emphasizes that relationship;
the $100,000 reduces both the lessee’s lease liability and the lessor’s lease
receivable.
Unless the lessor is a manufacturer or dealer, the fair value typically will be the
lessor’s cost ($479,079 in this case). However, if considerable time has elapsed
between the purchase of the property by the lessor and the inception of the lease,
the fair value might be different. When the lessor is a manufacturer or dealer, the
fair value of the property at the inception of the lease ordinarily will be its normal
selling price. More on that later. In unusual cases, market conditions may cause fair
value to be less than the normal selling price.4
Be sure to note that the entire $100,000 first lease payment is applied to
principal reduction.5 Because it occurred at the commencement of the lease, no
interest had yet accrued. Subsequent lease payments include interest on the
outstanding balance as well as a portion that reduces that outstanding balance. As
of the second rental payment date, one year’s interest has accrued on the $379,079
balance outstanding during 2013, recorded as in Illustration 15–28A. Notice that the
outstanding balance is reduced by $62,092—the portion of the $100,000 payment
remaining after interest is covered. If you compare each of these entries after the
lessee’s initial recording of the right-of-use asset with the entries we recorded in
Illustrations 15-6 and 15-6A, you will notice that they are precisely the same as
under prior GAAP.
4 FASB ASC 840–10: Leases–Overall (previously “Accounting for Leases,” Statement of Financial
Accounting Standards No. 13 (Stamford, Conn.: FASB, 1980)). 5 Another way to view this is to think of the first $100,000 as a down payment with the remaining $379,079 financed by 5 (i.e., 6 – 1) year-end lease payments.
This is similar to the lessee depreciating a leased asset in a capital lease under
prior GAAP but, since we no longer have operating leases, amortizing right-of-use
assets is much more pervasive.
When the Lessor Retains a Residual Asset
In the situation above, the lessor transferred the right of use for the entire life of
the asset and retained no residual asset. Now, in Illustration 15-29, we apply the
right-of-use model to the situation in the previous Illustration 15–5 in which the
lease term is only four years of the asset’s six-year life.
On January 1, 2013, Sans Serif Publishers, a computer services and printing firm,
leased printing equipment from First LeaseCorp. The previous week, First
LeaseCorp purchased the equipment from CompuDec Corporation at its fair value
of $479,079.
The lease agreement specifies four annual payments of $100,000 beginning
January 1, 2013, the commencement of the lease, and at each December 31
thereafter through 2015. . As in Illustration 15-5, the present value of those four
payments at a discount rate of 10% is $348,685. The useful life of the equipment is
estimated to be six years.
6 Output measures such as units produced or input measures such as hours used might provide a better indication of the reduction in the remaining liability.
Amortization of the Lease Receivable / Lease Payable
The amortization schedule in Illustration 15–29B shows how the lease balance
and the effective interest change over the four-year lease term. Each lease payment
after the first includes both an amount that represents interest and an amount that
represents a reduction of the outstanding balance. The periodic reduction is
sufficient that, at the end of the lease term, the outstanding balance is zero.
7 Another way to view this is to think of the first $100,000 as a down payment with the remaining $249,685 financed by 3 (i.e., 4 – 1) year-end lease payments.
All entries other than the entry at the commencement of the lease, which now
includes the profit, are precisely the same as in Illustrations 15-28 and 15-28A on
pages xxx-xxx.
Accounting by the lessee is not affected by how the lessor records the lease. All
lessee entries are exactly the same as in Illustrations 15-28 and 15-28A.
You might recognize this process as similar to the way sales type leases are
accounted for under prior GAAP. 9 Companies might choose to separate this profit into its two components: Sales revenue ($479,079) and cost of goods sold ($300,000), which is the gross method demonstrated for “sales-type” leases in the main chapter.
Illustration 15–32
Lessor; Profit on Lease
CHAPTER 15 Leases 17
When the Lessor Earns a Profit and Retains a Residual Asset
Now let’s combine our two previous illustrations to consider a circumstance in
which the lessor both earns a profit and retains a residual asset. In our last
illustration, we assumed that the lease payments were calculated by the lessor so
that their present value would equal the fair value of the asset being leased. That is
not an improbable assumption; often a manufacturer or dealer will use leasing as a
primary method of “selling” its products. Suppose, though, that other factors, say
competitive market conditions, influence the amount of the payments in such a
way that their present value is less than the fair value of the asset. In that case, the
entire asset is not transferred to the lessee; the lessor retains a portion of the asset.
In this situation, the lessor should divide the carrying amount of the asset into two
parts, (1) the portion transferred and thus derecognized and (2) the portion
retained and thus reclassified as a residual asset. The allocation is based on the
ratio of the present value of the payments to the fair value of the asset. The
residual asset is reported separate from other assets in the balance sheet.
Let’s assume we have a situation like the one in the previous Illustration in
which a profit is indicated, but the present value of the lease payments (“selling
price”) is less than the fair value of the asset being leased. Illustration 15-33
provides a demonstration by having us assume that the six annual payments are
$90,000 each rather than $100,000.
On January 1, 2013, Sans Serif Publishers leased printing equipment from
CompuDec Corporation. The lease agreement specifies six annual payments of
$90,000 beginning January 1, 2013, the commencement of the lease, and at each
December 31 thereafter through 2017. The six-year lease term ending December
31, 2018 (a year after the final payment), is equal to the estimated useful life of the
printing equipment.
CompuDec manufactured the printing equipment at a cost of $300,000. The fair
value of the equipment is $479,079. CompuDec’s interest rate for financing the
transaction is 10%. $90,000 × 4.79079* = $431,117
Lease Present
payments value
*Present value of an annuity due of $1: n = 6, i = 10%.
Commencement of the Lease (January 1, 2013)
CompuDec (Lessor)
The portion transferred is: $431,117
/ $479,079 x $300,000 = $269,966.
So, the portion retained (residual asset) is the remainder:
$300,000 – 269,966 = $30,034.
Illustration 15–33
Lessor; Profit on Lease;
Residual Asset
The fraction of the
$300,000 carrying amount
deemed transferred is
the:
PV of payments
/ FV of asset
18 SECTION 3 Financial Instruments and Liabilities
Lease receivable (present value of lease payments) ....... 431,117
Residual asset (carrying amount of portion retained) .......... 30,034
Inventory of equipment (lessor’s cost: carrying amount) 300,000
All entries other than the entry at the commencement of the lease, except perhaps for the amounts involved, are the same whether we have a residual asset and/or profit. Accounting by the lessee is not affected by how the lessor records the lease.
Initial Direct Costs
The costs that are associated directly with originating a lease and that would not have been incurred had the lease agreement not occurred are referred to as initial direct costs. They include legal fees, commissions, evaluating the prospective lessee’s financial condition, and preparing and processing lease documents.
Under the ASU, accounting for initial indirect costs is simple. Initial direct costs are added to the carrying amount of the right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the lessor.
Under current GAAP, the method of accounting for initial direct costs depends on the nature of the lease. Accounting differs depending on whether the lease is (1) an operating lease, (2) a direct financing lease, or (3) a sales-type lease.
UNCERTAINTY IN LEASE TRANSACTIONS
What if the Lease Term is Uncertain?
Sometimes the actual term of a lease is not obvious. Suppose, for instance, that the
lease term is specified as four years, but it can be renewed at the option of the
lessee for two additional years. Or, maybe either party can terminate the lease
after, say, three years. In such situations, we consider the lease term to be the
contractual lease term adjusted for any periods covered by options to extend or
terminate the lease for which there is a “significant economic incentive” to exercise
the options. Factors that might create an economic incentive for the lessee to
exercise an option include bargain renewal rates, penalty payments for cancellation
or non-renewal and economic penalties such as significant customization or
installment costs. This is similar to current GAAP’s treatment of renewal options..
You might want to ponder the possibilities if we did not have this requirement
to specifically consider renewal options and the economic incentive for exercising
them when we determine the lease term. Management might be tempted to
structure leases with artificially short initial terms and numerous renewal options as
A residual asset
represents the rights to
the leased asset retained
by the lessor.
GAAP Change
The lease term for both
the lessee and the
lessor is the contractual
lease term modified by
any renewal or
termination options for
which there is a clear
economic incentive to
exercise the options.
CHAPTER 15 Leases 19
a scheme to be able to use the short-cut method (that we discuss later) or to
reduce significantly the amount of the lease liability to be reported (off-balance-
sheet financing).
The lease term should be reassessed only when there is a significant indication
that the lessee’s economic incentive to exercise any options to extend or terminate
the lease has changed.
What if the Lease Payments are Uncertain?
Sometimes lease payments are to be increased (or decreased) at some future time
during the lease term, depending on whether or not some specified event occurs.
Usually the contingency is related to revenues, profitability, or usage above some
designated level. For example, a recent annual report of Walmart included the note
shown in Illustration 15–34.
13 Commitments (in part)
Certain of the Company's leases provide for the payment of contingent rentals
based on a percentage of sales. Such contingent rentals were immaterial for fiscal
years 2011, 2010 and 2009.
Why would a lease include a contingent payment provision? It is a way for
lessees and lessors to share the risk associated with the asset’s productivity. For
example, a shop owner who pays for a premium mall location is doing so
anticipating higher revenue. If the mall attracts many shoppers, the lessee pays the
lessor part of the resulting higher profits, but if not, the lessee makes only the
normal minimum lease payment. This arrangement also provides the lessor
incentive to attract shoppers to the mall, which is in the lessee’s best interest. If
the amounts of future lease payments are uncertain due to contingencies or
otherwise, we consider them as part of the lease payments only if they are
“reasonably assured.”
Under current GAAP, contingent payments are included only when they are
considered “probable.” While there is considerable overlap, fewer contingent
payments will be included in lease payments under the new guidance.
If the amounts of future lease payments vary solely when an index or rate
changes, the payments are estimated and included as part of the lease payments.
Those payments should be reassessed using the index or rate that exists at the end of
each reporting period.
Illustration 15–34
Contingent Lease
Payments—Walmart
Real World Financials
If future lease payments
are uncertain, we
consider them as part of
the lease payments only if
they are “reasonably
assured.”
GAAP Change
20 SECTION 3 Financial Instruments and Liabilities
Guaranteed 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. Sometimes a 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 lessor’s 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. The lessee promises to return not only the property but also
sufficient cash to provide the lessor with a minimum combined value.
If a cash payment under a lessee-guaranteed residual value is predicted, the
present value of that payment is added to the present value of the lease payments
the lessee records as both a right-of-use asset and a lease liability. Likewise, it also
adds to the amount that the lessor records as a lease receivable.
Let’s return to Illustration 15-29, when both the lessee and lessor expect the
residual value after the four-year lease term to be $190,911. Now assume that
negotiations led to the lessee guaranteeing a $210,000 residual value. If the
property’s value is less than $210,000 at the end of the lease term, the lessee will
make a cash payment for the excess of the $210,000 over the actual value.
The expected excess guaranteed residual value is viewed as an additional cash
flow and its present value is included in the calculation of the present value of lease
payments as shown in Illustration 15–35.
A cash payment predicted
under a lessee-
guaranteed residual value
is treated the same as a
lease payment.
CHAPTER 15 Leases 21
Present value of periodic lease payments ($100,000 × 3.48685*) $348,685
Plus: Present value of estimated payment under
residual value guarantee ($19,089† × .68301**) 13,038
Present value of expected lease payments $361,723
*Present value of an annuity due of $1: n = 4, i = 10%. **
Present value of $1: n = 4, i = 10%. †$210,000 guaranteed residual value minus $191,911 expected residual value
Lease liability (present value of lease payments) ........ 361,723
First LeaseCorp (Lessor)
The expected excess guaranteed residual value is viewed as an additional cash
flow and its present value is included in the lessor’s lease receivable and influences
the portion of the right to use the asset being transferred. The portion transferred
is: $361,723
/ $479,079 x $479,079 = $361,723.
So, the portion retained (residual asset) is the remainder:
$479,079 – 361,723 = $117,356.
Lease receivable (present value of lease payments) ....... 361,723
Residual asset (carrying amount of portion retained) ...... 117,356
Inventory of equipment (carrying amount of asset being leased) 479,079
ILLUSTRATION 15–35
Guaranteed Residual
Value
Any expected excess
guaranteed residual value
is viewed as an additional
cash flow and its present
value is included in the
lessor’s lease receivable.
22 SECTION 3 Financial Instruments and Liabilities
Situations in which the lessee-guaranteed residual value exceeds the estimate
of the actual residual value are rare in practice. It makes little economic sense for
a lessee to agree to guarantee an amount greater than the estimated residual
value, virtually ensuring an additional cash payment at the conclusion of the lease.
The requirement to account for it in this way, though, serves as a deterrent to
lessees and lessors who might be inclined to manipulate reported numbers by
reducing lease payments while creating an excess lessee-guaranteed residual value
to compensate for the reduced lease payments.
Notice that this treatment of a guaranteed residual values is quite different
from current GAAP. Prior to the new ASU, we included the present value of the
entire guaranteed residual value, not just its excess over estimated residual value,
as an additional cash flow. We also included residual values guaranteed by third
parties.
ADDITIONAL CONSIDERATION If a residual value is not guaranteed, is guaranteed by a third party (insurance
companies sometimes assume this role), or is guaranteed by the lessee but does
not differ from the estimate of the actual fair value at the end of the lease term, it
does not affect the calculations by either the lessee or lessor of the present value of
the lease payments. Obviously, though, even if the residual value is not
guaranteed, the lessor still expects to receive it in the form of property, or cash, or
both. That amount would contribute to the total amount to be recovered by the
lessor and would reduce the amount needed to be recovered from the lessee
through periodic lease payments. A residual value likely will affect the lessor’s
calculation of periodic lease payments. For instance, whether the residual value in
the illustration is guaranteed or not, its existence affected the lessor’s lease
payment calculation as we discussed and demonstrated earlier:
Amount to be recovered (fair value) $479,079
Less: Present value of the residual value ($190,911 × .68301*) (130,394)
Amount to be recovered through periodic lease payments $348,685
Lease payments at the beginning of each of the next six years:
÷ 3.48685**
$100,000
* Present value of $1: n = 4, i = 10%. **
Present value of an annuity due of $1: n = 4, i = 10%.
If an additional cash payment is expected due to a lessee-guaranteed residual
value, the amount to be recovered through periodic lease payments would be
reduced still further.
GAAP Change
The lessor subtracts the
PV of the residual value
to determine lease
payments.
CHAPTER 15 Leases 23
Purchase Options
A purchase option is a provision of some lease contracts that gives the lessee the
option of purchasing the leased property during, or at the end of, the lease term at
a specified exercise price. We consider the exercise price to be an additional cash
payment, which will increase both the lessee’s lease payable and the lessor’s lease
receivable, if the lessee has a "significant economic incentive" to exercise the
purchase option. In that case, the right-of-use asset recognized by the lessee
should be amortized over the economic life of the underlying asset, rather than
over the lease term.
This is similar to accounting for a “bargain purchase option” under prior GAAP.
Because we defined a BPO as a purchase option we expected to be exercised, the
condition of inclusion in the lease payments resembles the “significant economic
incentive” condition under the new ASU.
SHORT-TERM LEASES – A SHORT-CUT METHOD
It’s not unusual to simplify accounting for situations in which doing so has no
material effect on the results. You might recognize this as the concept of
“materiality.”10 One such situation that permits a simpler application is a
short-term lease. A lease that has a maximum possible lease term (including
any options to renew or extend) of twelve months or less is considered a
“short-term lease.” Both the lessee and the lessor have a lease-by-lease option
to choose a short-cut approach to accounting for a short-term lease.
The short-cut approach permits the lessee and lessor to choose not to
record the lease at its commencement. Instead, the lessee can simply record
lease payments as rent expense over the lease term, and the lessor can record
lease payments as rent revenue over the lease term. Yes, this is the approach
used under current GAAP for operating leases.
Let’s look at an example that illustrates the relatively straightforward accounting
for short-term leases. To do this we modify Illustration 15–29 to assume the lease
term is twelve months in Illustration 15-36.
10 Materiality is a qualitative characteristic in Concepts Statement No. 8: Conceptual Framework for Financial Reporting—Chapter 3, Qualitative Characteristics of Useful Financial Information,
QC11, FASB, September, 2010.
The exercise price of a
purchase option is
considered to be an
additional cash payment
if the lessee has a
"significant economic
incentive" to exercise the
option.
In a short-term lease, the
lessee and lessor can elect
not to record the lease at
its commencement and
instead simply recording
lease payments as
expense and revenue.
24 SECTION 3 Financial Instruments and Liabilities
On January 1, 2013, Sans Serif Publishers leased printing equipment from First
LeaseCorp. First LeaseCorp purchased the equipment at a cost of $479,079.
The lease agreement specifies four quarterly payments of $100,000 beginning
January 1, 2013, the commencement of the lease, and at the first day of each of the
next three quarters. The useful life of the equipment is estimated to be six years.
Before deciding to lease, Sans Serif considered purchasing the equipment for
$479,079. First LeaseCorp’s interest rate for financing the transaction is 10%.
Commencement of the Lease (January 1, 2013)
Sans Serif Publishers, Inc. (Lessee)
No entry
First LeaseCorp (Lessor)
No entry
Lease Payments (January 1, April 1, July 1, October 1, 2013)