Chapter 21 - Leasing

8/4/2019 Chapter 21 - Leasing

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Chapter21-1


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Chapter21-2

C H A P T E R 21

ACCOUNTING FOR LEASES

Intermediate Accounting13th Edition

Kieso, Weygandt, and Warfield


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Chapter21-3

1. Explain the nature, economic substance, and advantages of leasetransactions.

2. Describe the accounting criteria and procedures for capitalizing leasesby the lessee.

3. Contrast the operating and capitalization methods of recording leases.

4. Identify the classifications of leases for the lessor.

5. Describe the lessors accounting for direct-financing leases.

6. Identify special features of lease arrangements that cause uniqueaccounting problems.

7. Describe the effect of residual values, guaranteed and unguaranteed, onlease accounting.

8. Describe the lessors accounting for sales-type leases.

9. List the disclosure requirements for leases.

Learning Objectives


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Chapter21-4

Leasing

Environment

Who are

players?

Advantages ofleasing

Conceptualnature of a lease

Accounting by

Lessee

Accounting by

Lessor

Special

Accounting

Problems

Capitalization

criteria

Accountingdifferences

Capital leasemethod

Operatingmethod

Comparison

Residual values

Sales-typeleases

Bargain-purchase option

Initial direct costs

Current versusnoncurrent

Disclosure

Unresolvedproblems

Economics of

leasing

Classification

Direct-financingmethod

Operatingmethod

Accounting for Leases


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Chapter21-5

Largest group of leased equipment involves:

Information technology

Transportation (trucks, aircraft, rail)

Construction

Agriculture

LO 1 Explain the nature, economic substance,and advantages of lease transactions.

A leaseis a contractual agreement between a lessorand a lessee, that gives the lesseethe right to usespecific property, owned by the lessor, for aspecified period of time.

The Leasing Environment


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Chapter21-6

Three general categories:

Banks.Captive leasing companies.

Independents.


Who Are the Players?



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Chapter21-7

1. 100% Financing at Fixed Rates.

2. Protection Against Obsolescence.

3. Flexibility.

4. Less Costly Financing.

5. Tax Advantages.

6. Off-Balance-Sheet Financing.



Advantages of Leasing


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Chapter21-8

Capitalize a lease that transfers substantially all

of the benefits and risks of property ownership,

provided the lease is noncancelable.

Leases that do not transfer

substantially all the benefits

and risks of ownershipare operating leases.



Conceptual Nature of a Lease


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Chapter21-9

Operating Lease Capital Lease

Journal Entry:Rent expense xxx

Cash xxx

Journal Entry:Leased equipment xxx

Lease liability xxx

The issue of how to report leases is the case of substance versusform. Although technically legal title may not pass, the benefitsfrom the use of the property do.

A lease that transfers substantially all of the benefits and risks of

property ownership should be capitalized (only noncancellable leasesmay be capitalized).




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Chapter21-10

If the lessee capitalizesa lease, the lessee recordsan asset and a liability generally equal to the present

value of the rental payments.

Records depreciation on the leased asset.

Treats the lease payments as consisting of interest and

principal.

Accounting by the Lessee

LO 2 Describe the accounting criteria and proceduresfor capitalizing leases by the lessee.

Typical Journal Entries for Capitalized Lease Illustration 21-2


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Chapter21-11

To record a lease as a capital lease, the lease must benoncancelable.

One or more of four criteria must be met:

1. Transfers ownership to the lessee.2. Contains a bargain-purchase option.

3. Lease term is equal to or greater than 75 percent ofthe estimated economic life of the leased property.

4. The present value of the minimum lease payments(excluding executory costs) equals or exceeds 90percent of the fair value of the leased property.




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Chapter21-12 LO 2 Describe the accounting criteria and proceduresfor capitalizing leases by the lessee.

Lease Agreement Leases that DO NOTmeet any of the fourcriteria are accounted foras Operating Leases.


Illustration 21-4


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Chapter21-13

Capitalization Criteria



Transfer of Ownership Test

Not controversial and easily implemented.

Bargain-Purchase Option Test

At the inception of the lease, the difference

between the option price and the expected fairmarket value must be large enough to make

exercise of the option reasonably assured.


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Chapter21-14




Economic Life Test (75% Test)

Lease term is generally considered to be the

fixed, noncancelable term of the lease.

Bargain-renewal option can extend this period.

At the inception of the lease, the difference

between the renewal rental and the expected fairrental must be great enough to make exercise of

the option to renew reasonably assured.


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Chapter21-15

Recovery of Investment Test (90% Test)

LO 2


Minimum Lease Payments: Minimum rental payment Guaranteed residual value

Penalty for failure to renew

Bargain-purchase option

Executory Costs: Insurance

Maintenance

Taxes

Exclude from PV ofMinimum Lease

Payment Calculation



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Chapter21-16


Discount Rate

Lessee computes the present value of the minimum

lease payments using its incremental borrowing rate,

with one exception.

If the lessee knows the implicit interest rate

computed by the lessorand it is less than the lessees

incremental borrowing rate, then lessee must use the

lessors rate.

Recovery of Investment Test (90% Test)


LO 2


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Chapter21-17

Asset and Liability Recorded at the lower of:

1. present value of the minimum lease payments(excluding executory costs) or

2. fair-market value of the leased asset.

Asset and Liability Accounted for Differently




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Depreciation Period

If lease transfers ownership, depreciate assetover the economic life of the asset.

If lease does not transfer ownership,

depreciate over the term of the lease.



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Effective-Interest Method

The effective-interest method is used toallocate each lease payment between principal

and interest.


Depreciation ConceptDepreciation and the discharge of the obligation

are independent accounting processes.


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Chapter21-20

E21-1 (Capital Lease with Unguaranteed Residual Value): OnJanuary 1, 2011, Adams Corporation signed a 5-year noncancelablelease for a machine. The terms of the lease called for Adams tomake annual payments of $9,968 at the beginning of each year,starting January 1, 2011. The machine has an estimated useful life

of 6 years and a $5,000 unguaranteed residual value. Adams usesthe straight-line method of depreciation for all of its plant assets.Adamss incremental borrowing rate is 10%, and the Lessors

implicit rate is unknown.

LO 2


Instructions(a) What type of lease is this? Explain.

(b) Compute the present value of the minimum lease payments.

(c) Prepare all necessary journal entries for Adams for this leasethrough January 1, 2012.


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Chapter21-21

E21-1: What type of lease is this? Explain.



Capitalization Criteria:

1. Transfer of ownership

2. Bargain purchase option3. Lease term => 75% of

economic life of leasedproperty

4. Present value of minimumlease payments => 90% ofFMV of property

NO

NOLease term 5 yrs.Economic life 6 yrs.

YES 83.3%

FMV of leasedproperty is unknown.

Capital Lease, #3


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Chapter21-22

E21-1: Compute present value of the minimum leasepayments.



Payment $ 9,968

Present value factor (i=10%,n=5) 4.16986

PV of minimum lease payments $41,565

Leased Machine Under Capital Leases 41,565

Lease Liability 41,565


Cash 9,968

1/1/11 Journal Entries:


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Chapter21-23

E21-1: Lease Amortization Schedule



10%Lease Interest Reduction Lease

Date Payment Expense in Liability Liability

1/1/11 41,565$

1/1/11 9,968$ 9,968$ 31,597

12/31/11 9,968 3,160 6,808 24,789

12/31/12 9,968 2,479 7,489 17,30012/31/13 9,968 1,730 8,238 9,062

12/31/14 9,968 906 9,062 0


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Chapter21-24

E21-1: Journal entries for Adams through Jan. 1, 2012.



Depreciation Expense 8,313

Accumulated DepreciationCapital Leases 8,313($41,565 5 = $8,313)

Interest Expense 3,160

Interest Payable 3,160($41,565 $9,968) X .10]

12/31/11


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Chapter21-25

E21-1: Journal entries for Adams through Jan. 1, 2012.




Interest Payable 3,160Cash 9,968

1/1/12


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Chapter21-26 LO 3 Contrast the operating and capitalization methods of recording leases.


Operating MethodThe lessee assigns rent to the periods benefiting from

the use of the asset and ignores, in the accounting, any

commitments to make future payments.Illustration: Assume Adams accounts for it as an

operating lease. Adams records this payment on January

1, 2011, as follows.

Rent Expense 9,968

Cash 9,968


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Chapter21-27

E21-1: Comparison of Capital Lease with Operating Lease

LO 3 Contrast the operating and capitalization methods of recording leases.


E21-1 Capital Lease OperatingDepreciation Interest Lease

Date Expense Expense Total Expense Diff.

2011 8,313$ 3,160$ 11,473$ 9,968$ 1,505$

2012 8,313 2,479 10,792 9,968 824

2013 8,313 1,730 10,043 9,968 75

2014 8,313 906 9,219 9,968 (749)2015 8,313 8,313 9,968 (1,655)

41,565$ 8,275$ 49,840$ 49,840$ 0


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Chapter21-28

1. Interest Revenue.

2. Tax Incentives.

3. High Residual Value.

Accounting by the Lessor

Benefits to the Lessor

LO 4 Identify the classifications of leases for the lessor.


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Chapter21-29

A lessor determines the amount of the rental, based

on the rate of return needed to justify leasing the

asset.If a residual value is involved (whether guaranteed or

not), the company would not have to recover as much

from the lease payments

Economics of Leasing




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Chapter21-30

E21-10 (Computation of Rental):Fieval Leasing Company signs anagreement on January 1, 2010, to lease equipment to ReidCompany. The following information relates to this agreement.

1. The term of the noncancelable lease is 6 years with no renewal option.The equipment has an estimated economic life of 6 years.

2. The cost of the asset to the lessor is $343,000. The fair value of theasset at January 1, 2010, is $343,000.

3. The asset will revert to the lessor at the end of the lease term atwhich time the asset is expected to have a residual value of $61,071,none of which is guaranteed.

4. The agreement requires annual rental payments, beg. Jan. 1, 2010.

5. Collectibility of the lease payments is reasonably predictable. Thereare no important uncertainties surrounding the amount of costs yet tobe incurred by the lessor.




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Chapter21-31



Residual value 61,071$

PV of single sum (i=10%, n=6) 0.56447PV of residual value 34,473$

Fair market value of leased equipment 343,000$

Present value of residual value (34,473)Amount to be recovered through lease payment 308,527

PV factor of annunity due (i=10%, n=6) 4.79079

Annual payment required 64,400$

E21-10 (Computation of Rental): Assuming the lessor desires a10% rate of return on its investment, calculate the amount of theannual rental payment required.

x

-


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Chapter21-32

a. Operating leases.

b. Direct-financing leases.

c. Sales-type leases.

Classification of Leases by the Lessor




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Chapter21-33




A sales-type lease involves a manufacturers or dealers profit, and adirect-financing lease does not.

Illustration 21-10


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Chapter21-34




A lessor may classify a lease as an operatinglease but the lesseemay classify the same lease as a capitallease.

Illustration 21-11


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Chapter21-35

In substance the financing of an asset purchase by

the lessee.

Direct-Financing Method (Lessor)


LO 5 Describe the lessors accounting for direct-financing leases.


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Chapter21-36


E21-10: Prepare an amortization schedule that would besuitable for the lessor.



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Chapter21-37


E21-10:Prepare all of the journal entries for the lessorfor 2010 and 2011.


1/1/10 Lease Receivable 343,000

Equipment 343,0001/1/10 Cash 64,400

Lease Receivable 64,400

12/31/10 Interest Receivable 27,860Interest Revenue 27,860


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Chapter21-38


E21-10:Prepare all of the journal entries for the lessorfor 2010 and 2011.


1/1/11 Cash 64,400

Lease Receivable 36,540Interest Receivable 27,860

12/31/11 Interest Receivable 24,206

Interest Revenue 24,206


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Chapter21-39

Records each rental receipt as rental revenue.

Depreciates the leased asset in the normal manner.

Operating Method (Lessor)




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Chapter21-40

Illustration: Assume Fieval accounts for the lease as an

operating lease. It records the cash rental receipt as

follows:

Operating Method (Lessor)



Cash 64,400

Rental Revenue 64,400

Depreciation is recorded as follows:Depreciation Expense 57,167

Accumulated Depreciation 57,167$343,000 / 6 years = 57,167


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Chapter21-41

1. Residual values.

2. Sales-type leases (lessor).

3. Bargain-purchase options.

4. Initial direct costs.

5. Current versus noncurrent classification.

6. Disclosure.

Special Accounting Problems

LO 6 Identify special features of lease arrangementsthat cause unique accounting problems.


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Chapter21-42

Meaning of Residual Value - Estimated fair value of

the leased asset at the end of the lease term.

Guaranteed Residual Value Lessee agrees to make

up any deficiency below a stated amount that the lessor

realizes in residual value at the end of the lease term.

Residual Values


LO 7 Describe the effect of residual values, guaranteedand unguaranteed, on lease accounting.


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Chapter21-43

Lessee Accounting for Residual Value

The accounting consequence is that the minimum

lease payments, include the guaranteed residualvalue but excludes the unguaranteed residual value.

Residual Values




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Chapter21-44

Illustration (Guaranteed Residual Value

Lessee Accounting):Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) andSterling Construction Corp. sign a lease agreement dated January 1,

2011, that calls for Caterpillar to lease a front-end loader to Sterling

beginning January 1, 2011. The terms and provisions of the lease

agreement, and other pertinent data, are as follows.

The term of the lease is five years. The lease agreement is

noncancelable, requiring equal rental payments at the beginning of

each year (annuity due basis).

The loader has a fair value at the inception of the lease of$100,000, an estimated economic life of five years, and no residual

value.




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Chapter21-45


Lessee Accounting):Sterling pays all of the executory costs directly to third parties

except for the property taxes of $2,000 per year, which is included

as part of its annual payments to Caterpillar.

The lease contains no renewal options. The loader reverts toCaterpillar at the termination of the lease.

Sterlings incremental borrowing rate is 11 percent per year.

Sterling depreciates on a straight-line basis.

Caterpillar sets the annual rental to earn a rate of return on itsinvestment of 10 percent per year; Sterling knows this fact.

Caterpillar estimates a residual value of $5,000 a the end of the

lease.




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Chapter21-46


Lessee Accounting):

Caterpillar would compute the amount of the lease payments as

follows:



Illustration 21-16

NOTE: For the Lessee, the minimum lease payment includes the guaranteedresidual value but excludes the unguaranteed residual value.

Solution on

notes page


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Chapter21-47

Illustration 21-17


Lessee Accounting):

Computation of Lessees capitalized amount



Solution on

notes page


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Chapter21-48


Lessee Accounting):Computation of Lease Amortization Schedule

Illustration 21-18


LO 7


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Chapter

21-49


Lessee Accounting):At the end of the lease term, before the lessee transfers the

asset to Caterpillar, the lease asset and liability accounts have the

following balances.

Illustration 21-19




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Chapter

21-50


Lessee Accounting):Assume that Sterling depreciated the leased asset down to its

residual value of $5,000 but that the fair market value of the

residual value at December 31, 2015, was $3,000. Sterling would

make the following journal entry.



Loss on Capital Lease 2,000.00

Interest Expense (or Interest Payable) 454.76

Lease Liability 4,545.24

Accumulated DepreciationCapital Leases 95,000.00

Leased Equipment under Capital Leases 100,000.00

Cash 2,000.00


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Chapter

21-51

Illustration (Unguaranteed Residual Value

Lessee Accounting):Assume the same facts as those above except that the $5,000

residual value is unguaranteed instead of guaranteed. Caterpillar

would compute the amount of the lease payments as follows:



Illustration 21-20

Solution on

notes page


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Chapter

21-52


Lessee Accounting):Computation of Lease Amortization Schedule

Illustration 21-21




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Chapter

21-53


Lessee Accounting):At the end of the lease term, before Sterling transfers the asset

to Caterpillar, the lease asset and liability accounts have the

following balances.

Illustration 21-22



S i l A i P bl


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Chapter

21-54


Illustration 21-23Comparative Entries, Lessee Company


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Chapter

21-55


Illustration: Assume a direct-financing lease with a residual value

(either guaranteed or unguaranteed) of $5,000. Caterpillar

determines the payments as follows.


Lessor Accounting for Residual ValueThe lessor works on the assumption that it will realize the residualvalue at the end of the lease term whether guaranteed orunguaranteed.

Illustration 21-24


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Chapter

21-56


Lessor Accounting for Residual ValueIllustration: Lease Amortization Schedule, for LessorGuaranteed or Unguaranteed Residual Value

Illustration 21-25


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Chapter

21-57 LO 7 Describe the effect of residual values, guaranteedand unguaranteed, on lease accounting.


Lessor Accounting for Residual ValueIllustration: Caterpillar would make the following entries for thisdirect-financing lease in the first year.

Illustration 21-26

Solution on

notes page


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Chapter

21-58

Primary difference between a direct-financing

lease and a sales-type leaseis the

manufacturers or dealers gross profit (or loss).Lessor records the sale price of the asset, the

cost of goods sold and related inventory

reduction, and the lease receivable.

Difference in accounting for guaranteed and

unguaranteed residual values.

Sales-Type Leases (Lessor)


LO 8 Describe the lessors accounting for sales-type leases.


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Chapter

21-59




Illustration: To illustrate a sales-type lease with a

guaranteed residual value and with an unguaranteed residual

value, assume the same facts as in the preceding direct-financing lease situation. The estimated residual value is

$5,000 (the present value of which is $3,104.60), and the

leased equipment has an $85,000 cost to the dealer,

Caterpillar. Assume that the fair market value of theresidual value is $3,000 at the end of the lease term.


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21-60




Illustration: Computation of Lease Amounts by Caterpillar

FinancialSales-Type LeaseIllustration 21-28


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Chapter

21-61




Illustration: Caterpillar makes the following entries to

record this transaction on January 1, 2011, and the receipt of

the residual value at the end of the lease term.Illustration 21-29


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Chapter

21-62







(January 1, 2012)


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Chapter

21-63








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Chapter

21-64

Present value of the minimum lease payments

must include the present value of the option.

Only difference between the accounting

treatment for a bargain-purchase option and a

guaranteed residual value of identical amounts

is in the computation of the annualdepreciation.

Bargain Purchase Option (Lessee)




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Chapter

21-65

The accounting for initial direct costs:

For operating leases, the lessor should defer

initial direct costs.

For sales-type leases, the lessor expenses the

initial direct costs.

For a direct-financing lease, the lessor addsinitial direct costs to the net investment.

Initial Direct Costs (Lessor)




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Chapter

21-66

FASB Statement No. 13does not indicate how tomeasure the current and noncurrent amounts.

It requires that for the lessee the obligations shallbe separately identified on the balance sheet as

obligations under capital leases and shall be subject

to the same considerations as other obligations inclassifying them with current and noncurrent

liabilities in classified balance sheets.

Current versus Noncurrent




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Chapter

21-67

1. General description of the nature of the lease.

2. Nature, timing and amount of cash inflows and outflows

associated with leases, including payments for each of

the five succeeding years.

3. Amount of lease revenues and expenses reported in the

income statement each period.

4. Description and amounts of leased assets by majorbalance sheet classification and related liabilities.

5. Amounts receivable and unearned revenues under lease.

Disclosing Lease Data


LO 9 List the disclosure requirements for leases.


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Chapter

21-68

Leasing was on the FASBs initial agenda in 1973 and SFAS No. 13

was issued in 1976 (before the conceptual framework wasdeveloped). SFAS No. 13 has been the subject of more than 30

interpretations since its issuance.

The iGAAP leasing standard is IAS 17, first issued in 1982. This

standard is the subject of only three interpretations. One reasonfor this small number of interpretations is that iGAAP does not

specifically address a number of leasing transactions that are

covered by U.S. GAAP. Examples include lease agreements for

natural resources, sale-leasebacks, real estate leases, and

leveraged leases.


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Chapter

21-69

Both U.S. GAAP and iGAAP share the same objective of recording

leases by lessees and lessors according to their economicsubstancethat is, according to the definitions of assets and

liabilities.

U.S. GAAP for leases in much more rule-based with specific

bright-line criteria to determine if a lease arrangement transfers

the risks and rewards of ownership; iGAAP is more general in its

provisions.


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Chapter

21-70 LO 10


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Chapter

21-71 LO 10 Understand and apply lease accounting concepts to various lease arrangements.

Solution on

notes page

Illustration 21A-2


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Chapter

21-72

Solution onnotes page


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21-73

Illustration 21A-3

LO 10 Understand and apply lease accounting concepts to various lease arrangements.


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21-75

Illustration 21A-4



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21-77

Illustration 21A-5



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Chapter

21-78 LO 11 Describe the lessees accounting for sale-leaseback transactions.

The term sale-leasebackdescribes a transaction inwhich the owner of the property (seller-lessee) sells the

property to another and simultaneously leases it back

from the new owner.

Advantages:

1. May allow seller to refinance at lower rates.

2. May provide another source of working capital,

particularly when liquidity is tight.3. By selling the property, the seller-lessee may deduct

the entire lease payment, which is not subject to

alternative minimum tax considerations.


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Chapter


Determining Asset Use

To the extent the seller-lessee continues to use the asset

after the sale, the sale-leaseback is really a form of financing.

Lessor should not recognize a gain or loss on thetransaction.

If the seller-lessee gives up the right to the use of the

asset, the transaction is in substance a sale. Gain or loss recognition is appropriate.


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Chapter


Lessee

If the lease meets one of the four criteria for treatment

as a capital lease, the seller-lessee should

Account for the transaction as a sale and the lease asa capital lease.

Defer any profit or loss it experiences from the sale

of the assets that are leased back under a capital

lease.

Amortize profit over the lease term .


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Chapter


Lessee

If none of the capital lease criteria are satisfied, the

seller-lessee accounts for the transaction as a sale and the

lease as an operating lease. Lessee defers such profit or loss and amortizes it in

proportion to the rental payments over the period

when it expects to use the assets.

Exceptions:

Losses Recognized and Minor Leaseback


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Chapter


Lessor

If the lease meets one of the criteria in Group I and

both of the criteria in Group II, the purchaser-lessor

records the transaction as a purchase and a direct-financing lease.

If the lease does not meet the criteria, the purchaser-

lessor records the transaction as a purchase and anoperating lease.


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Chapter


Sale-Leaseback ExampleAmerican Airlines on January 1, 2011, sells a used Boeing 757 having a carrying

amount on its books of $75,500,000 to CitiCapital for $80,000,000. American

immediately leases the aircraft back under the following conditions:

1. The term of the lease is 15 years, noncancelable, and requires equal

rental payments of $10,487,443 at the beginning of each year.

2. The aircraft has a fair value of $80,000,000 on January 1, 2011, and an

estimated economic life of 15 years.

3. American pays all executory costs.

4. American depreciates similar aircraft that it owns on a straight-linebasis over 15 years.

5. The annual payments assure the lessor a 12 percent return.

6. Americans incremental borrowing rate is 12 percent.


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Chapter


Sale-Leaseback ExampleThis lease is a capital lease to American because

lease term exceeds 75 percent of the estimated life

of the aircraft and present value of the lease payments exceeds 90

percent of the fair value of the aircraft to CitiCapital.

Assuming that collectibility of the lease payments is reasonablypredictable and that no important uncertainties exist in relation

to unreimbursable costs yet to be incurred by CitiCapital, it

should classify this lease as a direct-financing lease.


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Chapter


Sale-Leaseback Example Illustration 21B-1


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Chapter


Sale-Leaseback Example

Copyright


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Chapter 21 - Leasing

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