IF THE LEASE MEETS ONE OR MORE OF THE ... 22-9 TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES 170 TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES
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On January 1, 1998, Velde Company (lessee) entered into a four-year,noncancellable contract to lease a computer from Exceptional Computer Company(lessor). Annual rentals of $17,208 are to be paid each January 1, Velde will assumeresponsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $60,000 and it had an estimated useful life of four years and no residual value. Velde has an incremental borrowingrate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable andthere are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor.
Capitalization Criteria Lessee Lessor Group 1:Criteria #1 No Criteria #1 NoCriteria #2 No Criteria #2 NoCriteria #3 Yes Criteria #3 YesCriteria #4 Yes Criteria #4 Yes
Group II: Criteria #1 Yes Criteria #2 Yes
Direct financing lease because cost of computer = fair value.
ILLUSTRATION 22-4LESSOR'S CAPITALIZATION CRITERIA FOR DIRECT FINANCINGAND SALES-TYPE LEASES
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GROUP I
THE LEASE AGREEMENT MUST MEET ONE OR MORE OFTHE FOLLOWING CRITERIA:
1. THE LEASE TRANSFERS OWNERSHIP OF THE PROPERTY TO THE LESSEE.
2. THE LEASE CONTAINS A BARGAIN PURCHASE OPTION.
3. THE LEASE TERM IS EQUAL TO 75% OR MORE OF THE ESTIMATED ECONOMIC LIFE OF THE LEASED PROPERTY.
4. THE PRESENT VALUE OF THE MINIMUM LEASE PAYMENTS (EXCLUDING EXCUTORY COSTS) EQUALS OR EXCEEDS 90% OF THE FAIR VALUE OF THE LEASED PROPERTY.
GROUP II
THE LEASE AGREEMENT MUST MEET BOTH OF THEFOLLOWING CRITERIA:
1. COLLECTIBILITY OF THE PAYMENTS REQUIRED FROM THE LESSEE IS REASONABLY PREDICTABLE.
2. NO IMPORTANT UNCERTAINTIES SURROUND THE AMOUNT OF UNREIMBURSABLE COSTS YET TO BE INCURRED BY THE LESSOR UNDER THE LEASE AND THE LESSOR'S PERFORMANCE IS SUBSTANTIALLY COMPLETE OR FUTURE COSTS ARE REASONABLY PREDICTABLE.
On January 1, 1998, Velde Company (lessee) entered into a four-year,noncancellable contract to lease a computer from Exceptional Computer Company(lessor). Annual rentals of $17,208 are to be paid each January 1, Velde will assumeresponsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $40,000 and had an estimated fair value of $60,000, a useful life of four years and no residual value. Velde hasan incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor.
Capitalization Criteria Lessee Lessor Group 1:Criteria #1 No Criteria #1 NoCriteria #2 No Criteria #2 NoCriteria #3 Yes Criteria #3 YesCriteria #4 Yes Criteria #4 Yes
Group II: Criteria #1 Yes Criteria #2 Yes
Sales-type lease because cost of computer is less than fair value. Dealer profit of $20,000.
*C1: Transfer of ownership C2: Bargain purchase option C3: 75% of economic life C4: 90% of fair value C5: Collectibility predictable **Sales-leaseback transactions may and no important uncertainties not be classified as sales-type leases
Source: William A. Collins, "Accounting for Leases Flowcharts," Journal of Accountancy, September 1978
On January 1, 1998, Velde Company (lessee) entered into a four-year,noncancellable contract to lease a computer from Exceptional Computer Company(lessor). Annual rentals of $16,228 are to be paid each January 1, Velde will assumeresponsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of thecomputer to Exceptional Computer Company was $60,000 and had an estimated useful life of four years and a $5,000 residual value. Velde has guaranteed the lessor a residual value of $5,000. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setling annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor.
Capitalization Criteria Lessee Lessor Group 1:Criteria #1 No Criteria #1 NoCriteria #2 No Criteria #2 NoCriteria #3 Yes Criteria #3 YesCriteria #4 Yes Criteria #4 Yes
Group II: Criteria #1 Yes Criteria #2 Yes
Direct financing lease because cost of computer = fair value.
On January 1, 1998, Velde Company (lessee) entered into a four-year,noncancellable contract to lease a computer from Exceptional Computer Company(lessor). Annual rentals of $16,228 are to be paid each January 1, Velde will assumeresponsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of thecomputer to Exceptional Computer Company was $60,000 and had an estimated useful life of four years and a $5,000 residual value. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor.
Capitalization Criteria Lessee Lessor Group 1:Criteria #1 No Criteria #1 NoCriteria #2 No Criteria #2 NoCriteria #3 Yes Criteria #3 YesCriteria #4 Yes Criteria #4 Yes
Group II: Criteria #1 Yes Criteria #2 Yes
Direct financing lease because cost of computer = fair value.
ILLUSTRATION 22-9TREATMENT OF SELECTED ITEMS INACCOUNTING FOR LEASES
170
TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES Lessor Lessee Operating Direct financing and Sales Type Operating Capital
Initial Direct Costs Capitalize and amortize Direct financing: N/A N/A over lease term in Record in separate account proportion to rent Add to net investment in lease revenue recognized Compute new effective rate that equates (normally S.L. basis) gross amt. of min. lease payments and unguar. residual value with net invest. Amortize so as to produce constant rate of return over lease term
Sales-type: Expense in period incurred
Bargain Purchases N/A Include in: N/A Include in:Option Minimum lease payments Minimum lease payments 90% test 90% test
Guaranteed N/A Include in: N/A Include in:Residual value Minimum lease payments Minimum lease payments 90% test 90% test Sales-type: Include PV in sales revenues
Unguaranteed N/A Include in: N/A Not included in:Residual value "Gross Investment in Lease" Minimum lease payments Not included in: 90% test 90% test
Sales-type: Exclude from sales revenue Deduct PV from cost of sales
Contingent Rentals Revenue in period Not a part of minimum lease payments, revenue Expense is period Not part of minimum lease payments: in period earned incurred expense in period incurred
Deprec. (Amort.) Amortize down to N/A N/A b Amortize down to estimated residual valuePeriod estimated residual over lease term or estimated economic value over estimated life economic life of asset
a Revenue Rent revenue (normally Direct financing: c Rent expense Interest Expense and Depreciation(Expense) S.L. basis) Interest revenue on net investment in lease (normally S.L. (Amortization) Expense (gross investment less unearned interest basis) income)
Depreciation expense Sales-type: Dealer profit in period of sale (sales revenue less cost of leased asset) Interest revenue on net investment in lease
a Elements of revenue (expense) listed for the above items are not repeated here (e.g., treatment of initial direct costs)b If lease has automatic passage of title or bargain purchase option, use estimated economic life; otherwise, use the lease term.c If payments are not on a S.L. basis, recognize rent expense on a S.L. basis unless another systematic and rational method is more representative of use benefit obtained from the property, in which case, the other method should be used.
Source: Adapted from Delaney, CPA Examination Review, 1994.
(a) For capital leases: (b) For operating leases having initial or i. The gross amount of assets at each remaining noncancellable lease terms in balance sheet date categorized by excess of one year: nature or function. This information i. Future minimum rental payments may be combined with comparable required as of the latest balance sheet information for owned assets. date, in the aggregate and for each of ii. Future minimum lease payments as the five succeeding fiscal years. of the latest balance sheet date, in ii. Total minimum rentals to be received in the aggregate and for each of five the future under noncancellable subleases succeeding fiscal years. Separate as of the latest balance sheet date. deductions for executory costs (c) For all operating leases, rental expense for included in the minimum lease each period with separate amounts for payments and for the amount of minimum rentals, contingent rentals, and imputed interest necessary to reduce sublease rentals. Rental payments under net minimum lease payments to leases with terms of a month or less that present value. were not renewed need not be included. iii. Total noncancellable minimum sublease (d) A general description of the lessee's rentals to be received in the future, as arrangements including, but not limited to: of the latest balance sheet date. i. The basis on which contingent rental iv. Total contingent rentals. payments are determined. v. Assets recorded under capital leases ii. The existence and terms of renewal or and the accumulated amortization purchase options and escalation thereon shall be separately identified in clauses. the lessee's balance sheet or notes. iii. Restrictions imposed by lease Likewise, related obligations shall be agreements, such as those concerning separately identified as obligations dividends, additional debt, and further under capital leases. Depreciation on leasing. capitalized leased assets should be separately disclosed.
(a) For Sales-type and direct financing leases: (b) For operating leases: i. The components of the net investment i. The cost and carrying amount, if in sales-type and direct financing leases different, of leased property according as of each balance sheet date: to nature or function, and total amount a. Future minimum lease payments to of accumulated depreciation. be received, with separate deductions ii. Minimum future rentals on noncancellable for (i) executory costs and (ii) the leases as of the latest balance sheet accumulated allowance for date, in aggregate and for each of five uncollectible minimum lease succeeding fiscal years. payments receivable. iii. Total contingent rentals included in b. The unguaranteed residual values income for each period for which an accruing to the lessor. income statement is presented. c. Unearned revenue. (c) A general description of the lessor's ii. Future minimum lease payments to be leasing arrangements. received for each of the five succeeding fiscal years. iii. The amount of unearned revenue included in income to offset initial direct costs charged against income for each period for which an income statement is presented. (For direct financing leases only.) iv. Total contingent rentals included in income for each period for which an income statement is presented.