Lease_accounting Chapter 15 Notes

1Leases I. Background Information A. Parties to Lease Contract 1. Lessee Party using the property and paying the lease payments 2. Lessor Legal owner of property who receives the lease payments B. Business Purpose for Lessee 1. Minimize capital resources needed 2. Tax advantages 3. Protection against obsolescence 4. Secure off-balance sheet financing 5. Avoid violating debt covenants 2I. C. Types of Leases 1. Operating Lease a. Involves mere use of property b. Short-term in duration relative to useful life c. Example - Lease storage space on a year-to-year contract d. Lessee Accounting i. Record asset if prepay rent ii. Record rent expense as incurred iii. Asset not recorded on balance sheet e. Lessor Accounting i. Record liability if collect rent in advance ii. Record rent income as earned iii. Record depreciation on asset

3I. C. Types of Leases (continued) 2. Capital Lease a. Transfers substantially all of the benefits andrisks of ownership to Lessee b. Is in substance similar to an installment purchase by Lessee c. Duration is often all (or nearly all) of assets economic life d. Lessee Accounting (installment purchase) - i. Record leased asset as PPE ii.Record depreciation expense on leased asset iii. Record liability for present value of lease payments iv.Record interest expense related to liability 4I. C. Types of Leases (continued) 2. Capital Lease (continued) e.Lessor Accounting (installment sale) - i. Remove asset from balance sheet ii.Record receivable for leasepayments iii. Record interest income earned on outstanding receivable iv.If fair value of asset exceeds cost of assetat lease inception then record gross profiton sale of asset 5I. D. Terminology 1. Executory Costs Costs associated with the leased property including a. Maintenance b. Taxes c. Insurance Note: The lease contract will usually specify The party responsible (bears expense) for these costs. The party who pays (disburses) cash for these costs. 2. Asset Economic Life a. Total Economic life of asset when new b. Remaining Economic life of asset at start of the lease Note: If lease involves a new asset then Total Life = Remaining Life6I.D. 3. Lease Payments a. Payments that areset forth in the lease contract i. Required ii.Optional iii. Contingent b. Possible Components Always Present in Contract i. Rental Payment Payment for use of property Sometimes Present in Contract

ii. Executory costs Payment to reimburse lessor for executory costs that are lessees responsibility under the lease contract iii. Penalty Amount Payment required by the lease contract if the lessee does not extend or renew the lease iv. Purchase Option Payment lessee can make to purchase the property7I.D.3.b. Possible Components (of lease payments) v. Residual Value Deficiency Lease contract may require the lessee to make up (pay cash) any difference between the actual value of the property at the end of the lease and a guaranteed value specified in the lease contract 2 types of deficiencies Due to normal use (treated as part of lease cost) Due to damage, extraordinary wear and tear, or excessive use (treated as period cost when paid) Note: The guaranteed value specified in the contract may not be the full expected residual value at the end of the lease. In this case, part of the expected residual value is Guaranteed and part is Unguaranteed.

8II. Classification of Lease for Lessee A. General Issues Regarding Lessee Classification 1. To qualify as a Capital Lease some portion of the Lease Term must be Noncancelable 2. GAAP specifies 4 tests that are designed to indicate if a Noncancelable lease is really an installment purchase (a capital lease) 3. Tests are applied as of lease inception (date of lease contract) 4. If at least 1 test is met Lease is treated as a Capital Lease 5. If none of the tests are met Lease is treated as an Operating Lease 6. Tests 1 and 2 a. Are always reliable b. Apply to all types of property i. Land ii.Buildings and Equipment 9II.A. General Issues Regarding Lessee Classification 7. Tests 3 and 4 Not always useful a. Land i. Tests 3 and 4 are not useful for evaluating a lease where land is a Material component of the leased property Material = More than 25% of value ofleased property ii. So before tests 3 and 4 are used we always check to see if the lease involves land, and if so we calculate the value of the land relative to the total value of the leased property b. Buildings and Equipment i. Tests 3 and 4 are considered unreliable if the lease begins in the last 25% of the assetstotal economic life ii. So before tests 3 and 4 are used we alwayscheck to be sure lease does not begin in last 25% of assets total economic life 10II.A.7.b. Buildings and Equipment iii. Example ABC Co. leases a building with a life of 100 yrs 17576 100

25 years Lease Begins at Start of Year Does Lease Begin in Last 25% of Assets Total Life? 1No 75No Last 26% 76Yes Exactly Last 25% 100Yes 11II. B.Lessee Classification Tests 1. Test 1: Does lease transfer ownership to lesseeby the end of the Lease Term ? a. Yes = Capital Lease b. Nominal fee may be required to cover legal fees and taxes 2. Test 2: Does the lease contain aBargain Purchase Option? a. Yes = Capital Lease b. Bargain Purchase Option Lease contract contains an option that permits purchase of the property at a bargain price (below expected fair value) and at lease inception Lessee exercise of this option appears reasonably assured. Note: This test really asks the following Does the lease contain a purchase option that seems reasonably assured of exercise?12II. B.Lessee Classification Tests 3. Test 3:Is the following condition met? Lease Term 75% of asset remaining economic life at lease inception a. Yes = Capital Lease 4. Test 4:Is the following condition met? PresentMinimum .90 xFMV -ITCValue Lease Payments Fair Market ValueInvestment Tax at lease inceptionCredit Retained by Lessor a. Yes = Capital Lease 13II. B.Lessee Classification Tests Question:Why are tests 3 and 4 not appropriate for land? Answer:To be considered a purchase in substance the lessee must secure substantially all of the benefits of ownership. Since land has an unlimited life,the Lessee must assume ownership of the land to secure substantially all of the benefits of ownership (e.g. meets test 1 or test 2). Question:Why are tests 3 and 4 not appropriate for buildings and equipment when the lease begins in the last 25% of the assets total economic life? Answer:To be considered a purchase in substance the lessee must secure substantially all of the benefits of ownership. But if the asset is in its last 25% of useful life, the lessee does not securesubstantially all of the benefits ofownership even though test 3 or test 4are met.14II. C.Lease Term 1. Sum of the following periods a. Fixed Noncancelable term b. Periods covered by bargain renewal options (bargain = renewal is reasonably assured) c. Periods covered by a penalty for nonrenewal where penalty appears sufficient to concludethatrenewal is reasonably assured d. Periods covered by ordinary renewal optionsduring which the Lessee has guaranteed thedebt of the Lessor which is related to the leased property e. Periods covered by ordinary renewal options preceding the date at which aBargain Purchase Option can be exercised Note: The idea is to estimate the length of time that we can be reasonably sure thatthe lease will be in effect. 15II.C. Lease Term (continued) 2. Noncancelable means a. Can be canceled only upon the occurrence of some remote contingency, or b. Can be canceled with permission of Lessor, or c. Can be canceled if the Lessee enters into a new lease with the Lessor, or d. Can be canceled if a penalty is paid, but thepenalty is of sufficient magnitude thatcontinuation of lease appears reasonably assured. 3. Limit on Lease Term Estimated Lease Term cannot exceed the length of time from lease inception to the date that a Bargain Purchase Option (if any) can be exercised. 16II.C. Lease Term (continued) 4. Example a. Facts Jones Co. leases equipment under a contract with the following terms Initial noncancelable term of 2 years @ $100 each year Lease can be renewed for 1 additional year @ $60 If lease is not renewed lessee must pay a penalty of $50 b. Lease Term If penalty for nonrenewal is sufficient to ensure renewal then Lease Term = 3 years (2 + 1) If penalty for nonrenewal is not sufficient to ensure renewal then Lease Term = 2 years (2 + 0) 17II.D. Present Value of Minimum Lease Payments 1. Concept Present value of the minimum consideration the Lessor will receiveduring the course of the lease [ abbreviated as: PV(MLP) ] Note:Consideration can be: o Cash payments made, and o Guaranteed value of property returned to Lessor 2. Components - a. Consideration required under contract i.Rent (but exclude executory costs, if any)

b. Consideration contingent on future events and/or Lessee decisions but reasonably assured at lease inception i. Purchase option ii.Penalty for nonrenewal iii. Guaranteed residual value

18II.D. Present Value of Minimum Lease Payments 3. Discount Rate used by Lessee a. General Rule Use Lessee Incrementalborrowing rate Note:Incremental Rate is the rate that Lessee could actually secure if money were borrowed and the asset was purchased for cash

b. Exception Use Lessor implicit rate if i.Known to Lessee and ii. Lessor implicit rate < Lessee incremental rate

Note: Implicit Rate is the Lessors rate of return earned on the leased asset. It is also the rate that results in: PV(MLP) + PV(UGR) = Asset Fair Value MLP= Minimum Lease Payments UGR= Unguaranteed Residual Valueto Lessor 19II.D. Present Value of Minimum Lease Payments 4. Calculation Details (sum of following components) a. PV (Net Rental Payments for Lease Term ) Net Rental =Gross Rental Executory Costsincluded in Gross Rental b. PV (Bargain Purchase Option)(if payment is reasonably assured) c. PV (Penalty for Nonrenewal)(if payment is reasonably assured) d. PV (Guaranteed Residual Value to Lessor) (if property expected to be returned to Lessor)

Note:Including a Bargain Purchase Option precludes both the Penalty for Nonrenewal and the Guaranteed Residual Value Reason If Lessee buys the property there is no need to renew the lease or guarantee a residual to the Lessor So can have: {a}, {a,b}, {a,c}, {a,d}, {a,c,d} Cannot have: {a,b,c}, {a,b,d}, {a,b,c,d} 20II.D. Present Value of Minimum Lease Payments 5. Example a. Facts Lease begins Jan. 1, 19X1 Initial noncancelable term of 2 years

Rent =$120 each year made on Jan. 1

Rental payment includes $20 that is reimbursement of insurance paid by Lessor on behalf of Lessee Lease can be renewed for 1 additional year @ $60 If lease is not renewed lessee must pay a penalty of $50 at end of year 2 (Dec. 31) At lease inception Lessee does not expect to extend lease to year 3 (so Lessee expects to pay penalty) Lessee Incremental Rate is 10% and Lessors Implicit Rate is unknown No guaranteed residual value or purchase option 21II.D. 5. Example (continued) b. Lease Term = 2 years c. Expected Lease consideration = 1 2 $100 $100$50 Rent RentPenalty d. Formula to calculate present value of amount Present Value =Amount ( 1 + i ) n Amount = Amount to be paid i = Interest rate per compounding period n = Number of compounding periods e. Numeric Calculation Payment DateCalculationAmount 1-1-X1$100 / (1.1)0$100.001-1-X2$100 / (1.1)190.9112-31-X2 $50 /(1.1)241.32Total $232.2322II.D. Present Value of Minimum Lease Payments 5. Example (continued) f. Amortization Schedule Payment DatePmt. Interest @10% Principal ReductionRemainingPrincipal 232.231-1-X1$1000 100.00 132.231-1-X2$10013.22 86.78 45.4512-31-X2$504.55 45.45 0Totals$25017.77 232.23 g. Comments i.Calculation of Lease Term affects calculation of PV(MLP) ii.Lease Term is based on estimates and judgments iii. Calculation of Lease Term and calculation of PV(MLP) must be internally consistent (based on same facts and assumptions) iv. So we always calculate the Lease Termbefore we calculate PV(MLP) 23III. Journal Entries for Lessee Operating Lease A. Pay Rent in Advance Prepaid Rent XX CashXX B.Adjusting Journal Entry Rent Expense XX Prepaid Rent XX 24IV. Journal Entries for Lessee Capital Lease A. Set-up entry at lease inception Leased Assets Under Capital Leases XX Lease Obligation [Liability] XX [PPE][Liability] Lower of: PV(MLP) or Fair value at lease inception Note: If asset is recorded at a lower fair value amount, the discount rate used in the amortization schedule is adjusted to force the ending liability balance to 0. Question: Does the discount rate go up or down? Answer: With less principal to pay, but total payments remaining the same, this means that the total of interest paid must increase. Hence, the discount rate must be increased to a higher number. 25IV. Journal Entries for Lessee Capital Lease

B. First rental payment 1. Made at start of lease period (Annuity Due), so no interest included in the payment Lease Obligation XX [Executory Costs]XX [if any] CashXX [Gross rental] Debit could be to a prepaid account or expense account depending on the facts 26IV. Journal Entries for Lessee Capital Lease

B. First rental payment (continued) 2. Made at end of lease period (Ordinary Annuity) (passage of time results in interest on liability) Lease Obligation XX [Executory Costs ]XX [if any] Interest Expense XX [from amor. sch.] CashXX [Gross rental] Entry could be to Interest Payable if interest expense has already been accrued (see textbook) Debit could be to a prepaid account or expense account depending on the facts (pay in advance or after incurred 27IV. Journal Entries for Lessee Capital Lease C. Rental payments 2, 3, ... Lease Obligation XX [Executory Costs ]XX [if any] Interest Expense XX [from amor. sch.] CashXX [Gross rental] Entry could be to Interest Payable if interest expense has already been accrued (see textbook) Debit could be to a prepaid account or expense account depending on the facts (pay in advance or after incurred 28IV. Journal Entries for Lessee Capital Lease D. AJE for accrued interest Interest Expense XX Interest PayableXX Outstanding Lease Months Int. Balance of xDiscountxAccrued Lease Obligation Rate12 Note: The amount of interest can also becalculated by allocating the interest component of the next payment as detailedin the amortization schedule. 29IV. Journal Entries for Lessee Capital Lease E. Year end AJE for depreciation expense Depreciation ExpenseXX Accumulated Depreciation Leased Assets XX Note: The calculation uses the same methods (SL, DDB, SYD) as for regular PPE. 1. Depreciation Period a. Lessee expects to keep asset(lease meets tests 1 or 2) Depreciation period = Life of asset b. Lessee expects to return asset(lease meets only test 3 or 4) Depreciation period = Lease Term

30IV. Journal Entries for Lessee Capital Lease E. Year end AJE for depreciation expense (continued) 2. Residual Value for Depreciation Calculation a. Lessee expects to keep asset(lease meets tests 1 or 2) Residual = Expected value to Lessee and end of assets useful life Expected Value = Est. salvage at end of life 31IV. Journal Entries for Lessee Capital Lease E. Year end AJE for depreciation expense 2. Residual Value for Depreciation Calculation(continued) b. Lessee expects to return asset(lease meets only test 3 or 4) Residual = Expected value to Lessee at end of Lease Term i.No Guaranteed Residual: Expected Value = 0 ii. Guaranteed Residual: Expected Value = Estimated Fair Valuebut limited to the Guaranteed Amount Why? If there is a guaranteed residual the Lessee avoids a cash payment to the Lessor for the amount of fair value up tothe amount of the guarantee. 32IV. Journal Entries for Lessee Capital Lease F. Exercise purchase option 1. Strategy - Remove Leased Asset accounts Cost Accumulated Depreciation Set up regular Accumulated Dep. at amount of Acc. Dep. on leasedassets Record cash paid Record cost of asset as plug figure 2. Example Journal Entry At date of exercise the following GL balances exist Leased Assets under Capital Leases100 dr Acc. Depreciation - Lease Assets 80 cr Lease Obligation (Liability) 0 cr Exercise price of purchase option is $15 Acc. Dep. - Leased Assets80 Leased Assets - Capital Leases 100 Acc. Dep. - Equipment80 Cash 15 Equipment 115[plug]33IV. Journal Entries for Lessee Capital Lease G. Return asset to Lessor 1. Residual value guaranteed a. Strategy: Clean off balance sheet Leased Asset Acc. Dep. - Lease Asset Lease Obligation Record interest on Lease Obligation Record any unexpected cashpayment as a period loss b. JE: Asset value Guarantee amount (no deficiency cash payment required) Interest Expense [Payable] XX Lease ObligationXX Acc. Dep. - Leased AssetsXX Leased Assets - Capital LeasesXX 34IV. Journal Entries for Lessee Capital Lease G. Return asset to Lessor 1. Residual value guaranteed (continued) c. JE: Asset value < Guarantee amount (deficiency cash payment required) (record cash payment as period loss) Interest Expense [Payable] XX Lease ObligationXX Acc. Dep. - Leased AssetsXX Leased Assets - Capital LeasesXX Loss on Capital LeaseXX CashXX 35IV. Journal Entries for Lessee Capital Lease G. Return asset to Lessor 2. Residual value not guaranteed a. With no guarantee, at end of lease : Leased asset cost = Acc. dep. - leased asset Accumulated Dep. - Lease AssetsXX Lease Assets - Capital LeasesXX Note: With no guaranteed residual value, the Lease Obligation balance should be 0 after the last rental payment.36V.Lessee Capital Lease FS Presentation A. Balance Sheet 1. Assets a. Current - Prepaid [executory costs]XX b. Noncurrent - Lease Assets - Capital LeasesXX Acc. Dep. - Leased Assets(XX) XX 37V.Lessee Capital Lease FS Presentation A. Balance Sheet 2. Liabilities a. Current - Interest PayableXX Lease Obligation XX Amount that will be retired within next year (from amor. schedule) b. Noncurrent - Lease Obligation XX Amount that will be retired beyond one year from BS date(from amor. schedule) 38V.Lessee Capital Lease FS Presentation B. Income Statement Sheet [Executory cost] Expense XX [if any] Depreciation Expense XX Interest ExpenseXX Loss on Capital Lease XX [if any] 39VI. Classification of Lease for Lessor A. Tests 1. Same basic rules and definitions as for Lessee a. Transfer of ownership test b. Bargain purchase test c. Lease term test d. PV(MLP) to Fair value test Note: Lessor discount rate is always implicit rate 2. Add two additional Lessor tests related tocertainty of cash flow measurement(both must be met) a. Test 5: Collectibility of lease payments must be reasonably predictable b. Test 6:There must be no importantuncertainties regarding the amount of unreimbursable costs yet to be incurred by the Lessor under the lease contract 3. Lease is a capital lease for Lessor if a. Meets at least 1 of 4 tests used by Lessees b. Meets both tests added for Lessors 40VI. Classification of Lease for Lessor B. Types of capital leases (for Lessor) 1. Direct Financing - a. Lessor essentially serves as financing agent(bank). b. Sole earnings are interestincome. c. Indicated when: Lessor asset cost = Asset fair value 2. Sales-Type- a. Lessor is a dealer/manufacturer and also serves as financing agent(bank). b. Earnings include: i.Gross Profit on sale, and ii. Interestincome. c. Indicated when: Lessor asset cost Asset Cost b. Strategy - Remove asset cost from G/L Record receivable using netmethod (gross method also permitted) Record revenue and CGS c. Entry -

Lease ReceivableX1[ asset fair value ] [Asset Account] X2 [ cost ] Cost of Goods SoldX3[ cost - PV(UGR) ] Sales RevenueX4 [ PV(MLP) ] 45VIII. Journal Entries for Lessor Capital Lease

B. Receive first rental payment 1. Receive at start of lease period (Annuity Due) (no interest earned yet) CashXX Lease ReceivableXX [Executory costs]XX

Account credited depends on JE Lessor made when the executory cost was paid (expense or payable) 2. Receive at end of lease period (Ord. Annuity) (with passage of time interest has been earned) CashXX Lease ReceivableXX [Executory costs]XX Interest ReceivableXX Could be income if interest has not yet been accrued

46VIII. Journal Entries for Lessor Capital Lease C. Accrual of Interest Receivable and Income Interest Receivable XX Interest IncomeXX Outstanding LessorMonths Int. Balance of xImplicitxAccrued Lease ReceivableRate12 Note: This entry can be made at any time (monthly, quarterly, year end) 47VIII. Journal Entries for Lessor Capital Lease D. Sell asset to Lessee at end of lease 1. Strategy -Remove any remaining Lease Rec. Record Interest (if any) Record receipt of Cash Balancing amount(if any) is gain/loss 2. Comment regarding Lease Receivable After last rental payment the balance will be:Lessor Expectation at Lease Inception About Leased Asset Lease ReceivableBalance Property expected to be returned to Lessor and estimated residual value=0 0 Property expected to be returned to Lessor and estimated residual value=XX (guaranteed or unguaranteed) PV(XX) at start of last year Property not expected to be returned to Lessor and no payment to be made by Lessee (automatic title transfer) 0 Property not expected to be returned to Lessor and payment to be made by Lessee=YY (cash purchase option) PV(YY) at start of last year 48VIII. D. Sell asset (continued) 3. Example #1 a. Facts Lease begins Jan. 1, 19X1 Initial noncancelable term of 2 years

Rent =$120 each year made on Jan. 1

Rental payment includes $20 that is reimbursement of insurance paid by Lessor on behalf of Lessee Lessee can purchase asset at end of year 2 for $50 At lease inception Lessor expects Lessee to exercise the purchase option Lessors implicit rate is 10%(asset fair value=$232.23) Expected residual value to Lessor is 0 because Lessor expects Lessee to purchase the asset (asset is expected to have a fair value of $60 at end of lease) 49VIII. D. 3. Example JE (continued) b. Lessor Amortization Schedule Date Net Pmt. Interest @10% Receivable Recovered RemainingReceivable232.231-1-X1$1000 100.00132.231-1-X2$10013.22 86.7845.4512-31-X2$50 purchase price 4.55 45.450 c. Sale journal entry at 12-31-X2 (as expected) Cash 50.00 Lease Receivable45.45 Interest Income 4.55 50VIII. D. Sell Asset (continued) 4. Example #2 a. Facts Lease begins Jan. 1, 19X1 Initial noncancelable term of 2 years

Rent =$120 each year made on Jan. 1

Rental payment includes $20 that is reimbursement of insurance paid by Lessor on behalf of Lessee Lessee can purchase asset at end of year 2 for $50 At lease inception Lessor does not expect Lessee to exercise the purchase option Lessors implicit rate is 10%(asset fair value =$240.49) Expected residual value to Lessor is $60and this is not guaranteed by Lessee 51VIII. D. 3. Example Sale JE (continued) b. Lessor Amortization Schedule Date Net Pmt. Interest @10% Receivable Recovered RemainingReceivable240.491-1-X1$1000 100.00140.491-1-X2$10014.05 85.9554.5412-31-X2$60 expected residual 5.46 54.540 c. Sale journal entry at 12-31-X2 (not expected) Cash50.00 Lease Receivable54.54 Interest Income5.46 Loss on Sale of Leased Asset 10.0052VIII. E. Lessee returns asset at end of lease 1. Strategy -Remove any remaining Lease Rec. Record Interest (if any) Record receipt of returned assetBalancing debit(if any) is loss (nogain recorded) 2. Comment regarding: Lease Receivable After last rental payment the balance will be:Lessor Expectation at Lease Inception About Leased Asset Lease ReceivableBalance Property expected to be returned to Lessor and estimated residual value=0 0 Property expected to be returned to Lessor and estimated residual value=XX (guaranteed or unguaranteed) PV(XX) at start of last year Property not expected to be returned to Lessor and no payment to be made by Lessee (automatic title transfer) 0 Property not expected to be returned to Lessor and payment to be made by Lessee=YY (cash purchase option) PV(YY) at start of last year 53VIII.E. JE for return of assed (continued) 3. Example #1 (return expected) a. Facts Lease begins Jan. 1, 19X1 Initial noncancelable term of 2 years

Rent =$120 each year made on Jan. 1

Rental payment includes $20 that is reimbursement of insurance paid by Lessor on behalf of Lessee Lessee can purchase asset at end of year 2 for $50 At lease inception Lessor does not expect Lessee to exercise the purchase option Lessors implicit rate is 10% (asset fair value =$240.49) Expected residual value to Lessor is $60and this is not guaranteed by Lessee 54VIII. E. 3. Example Return JE (continued) b. Lessor Amortization Schedule Date Net Pmt. Interest @10% Receivable Recovered RemainingReceivable240.491-1-X1$1000 100.00140.491-1-X2$10014.05 85.9554.5412-31-X2$60 expected residual 5.46 54.540 c. Return journal entry at 12-31-X2 (Asset returned as expected) (Asset fair value $60 as expected) Inventory 60.00 Lease Receivable54.54 Interest Income5.46

55VIII. E.Example Return JE (continued) 4. Example #2: Use same facts as example #1 but assume fair value = $40 (Asset returned as expected) (Asset fair value less than expected and residual value not guaranteed by Lessee) Inventory 40.00 Lease Receivable54.54 Interest Income 5.46 Loss on Capital Lease20.00 56VIII. E.Example Return JE (continued) 5. Example #3: Use same facts as example #1 but assume asset fair value = $40 and residual of $60 is guaranteed by Lessee (Asset returned as expected) (Asset fair value less than expected and residual value is guaranteed by Lessee) (Lessee makes $20 residual deficiency payment) Inventory 40.00 Lease Receivable54.54 Interest Income 5.46 Cash 20.00 57VIII.E. Example Return JE (continued) 6. Example #4 (return not expected) a. Facts Lease begins Jan. 1, 19X1 Initial noncancelable term of 2 years

Rent =$120 each year made on Jan. 1

Rental payment includes $20 that is reimbursement of insurance paid by Lessor on behalf of Lessee Lessee can purchase asset at end of year 2 for $50 At lease inception Lessor expects Lessee to exercise the purchase option Lessors implicit rate is 10% (asset fair value =$232.23) Expected residual value to Lessor is 0 because Lessor expects Lessee to purchase the asset (asset is expected to have a fair value of $60 at end of lease) 58VIII. E. 6. Example JE (continued) b. Lessor Amortization Schedule Date Net Pmt. Interest @10% Receivable Recovered RemainingReceivable232.231-1-X1$1000 100.00132.231-1-X2$10013.22 86.7845.4512-31-X2$50 purchase price 4.55 45.450 c. Return journal entry at 12-31-X2 (Return not expected) ( Asset fair value = $60 as expected) Inventory 50.00 Lease Receivable45.45 Interest Income 4.55 Note: Recognition of any apparent gain is deferred until confirmed by an arms-lengthtransaction

59VIII. E. 7. Example #5 (return not expected) a. Use same facts as Example #4 but now assume the leased asset has a fair value of $40 b. Return journal entry at 12-31-X2

(Return not expected) ( Asset fair value = $40 not as expected) (Residual not guaranteed) Inventory 40.00 Lease Receivable 45.45 Interest Income 4.55 Loss on Capital Lease10.00

60IX. Lessor Capital Lease FS Presentation A. Balance Sheet 1. Assets a. Current - Interest ReceivableXX Lease ReceivableXX Amount that will be collected within next year per amor. schedule b. Noncurrent - Lease ReceivableXX Amount that will be collected beyond one year from BS date per amor. schedule 2. Liabilities - None61IX.Lessor Capital Lease FS Presentation B. Income Statement Sheet Sales RevenueXXSales-Type Cost of Goods Sold (XX)Lease Interest Income (Revenue) XX Loss on Capital LeaseXX [if any] 62X. Leases Involving Land A. General Concepts 1. If Land is immaterial part of leased asset we ignore the fact that land is present Material 25% of leased property value at lease inception 2. If Land is material, we separate land from other part of property, then account for each part of leased property separately Lease of land can be a capital lease only if Test 1 or Test 2 is met So Lessee must be expected to become legal owner of the land 63X. Leases Involving Land B. Land only 1. Lessee a. Capital lease if:Test 1 or Test 2 is met (Lessee expected to get land) b. Otherwise an operating lease 2. Lessor a. Capital lease if: Test 1 or Test 2 is met, and both Tests 5 and 6 are met b. Otherwise and operating lease 64X. Leases Involving Land C. Land and Buildings 1. Land value < 25% of value of leased property Ignore fact that lease involves land anduse normal tests (1-4 for lessee; 1-6 for lessor) and normal journal entries 2. Land value 25% of value of leased property a. Allocate lease payment betweenland component and building component b. Land component must meet either Test 1 or Test 2 to qualify as a capital lease c. Apply normal tests to building component (tests 1-4 for lessee; tests 1-6 for lessor) Note: This means that in some leases the land component is an operating lease and the building component is a capital lease 65XI. Lessor Treatment of Initial Direct Costs A. Definition - Direct costs incurred in securing a specific lease. Examples:Brokers fees Appraisal costs Credit check costs Labor cost of negotiating lease B. Accounting Treatment 1. Operating Lease - a. Defer and allocate to expense over the lease term b. Basis of allocation is proportion of rentalincome recorded (to get proper matching) 2. Sales-Type Lease - Expense in year lease starts (to match with profit on sale) 3. Direct Financing Lease - Add cost to net investment (LR) and amortize as a yield (interest income) adjustment 66Remember Old exams before Spring 2004 use the Gross Method to report the Lessors lease receivable. The current edition of the book uses the Net Method to report the Lessors lease receivable. Your exam will assume use of the Net Method to be consistent with the textbook.