McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. LEASES Chapter 15.

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

LEASESLEASES

Chapter 15

Slide 2

15-2

Accounting by the Lessor and LesseeAccounting by the Lessor and Lessee

A lease is an agreement where the A lease is an agreement where the lessorlessor conveys the right to use property, plant, conveys the right to use property, plant, or equipment, usually for a stated period or equipment, usually for a stated period

of time, to the of time, to the lesseelessee..

Lessor = Owner of propertyLessor = Owner of propertyLessor = Owner of propertyLessor = Owner of propertyLessee = RenterLessee = RenterLessee = RenterLessee = Renter

Lessee Lessor

Operating lease Operating lease

Capital lease Direct financing lease

Sales-type lease

Lessee Lessor

Operating lease Operating lease

Capital lease Direct financing lease

Sales-type lease

Slide 3

15-3

Capital Leases and Installment Notes ComparedCapital Leases and Installment Notes Compared

Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 every six months for the next three years. The interest

rate associated with the agreement is 9%. Let’s look at the arrangement as an installment note payable and as a capital

lease agreement. First, let’s prepare an amortization schedule for the payments.

Effective Decrease OutstandingDate Payment Interest in Balance Balance

Initial value . . . . . . . . . . . . . . . . . . . 1,000,000$ 1 193,878$ 45,000$ 148,878$ 851,122 2 193,878 38,300 155,578 695,544 3 193,878 31,300 162,578 532,966 4 193,878 23,983 169,895 363,071 5 193,878 16,338 177,540 185,532 6 193,878 8,346 185,532 -

Slide 4

15-4

Inception of the AgreementInception of the AgreementJanuary 1

Installment Note

Description Debit Credit

Equipment 1,000,000 Notes payable 1,000,000

Capital Lease


Equipment 1,000,000 Lease payable 1,000,000

Slide 5

15-5

First Semi-Annual Payment DateFirst Semi-Annual Payment DateJune 30

Installment Note


Interest expense 45,000Notes payable 148,878 Cash 193,878

Capital Lease


Interest expense 45,000Lease payable 148,878 Cash 193,878

Slide 6

15-6

Lease ClassificationLease Classification

OwnershipOwnership transferstransfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase optionbargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The non-cancelable lease term is equal to The non-cancelable lease term is equal to 75% or more75% or more of the expected economic life of of the expected economic life of the asset, or . . .the asset, or . . .

The PV of the minimum lease payments (MLP) The PV of the minimum lease payments (MLP) is is 90% or more of the fair value90% or more of the fair value of the asset.of the asset.

OwnershipOwnership transferstransfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase optionbargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The non-cancelable lease term is equal to The non-cancelable lease term is equal to 75% or more75% or more of the expected economic life of of the expected economic life of the asset, or . . .the asset, or . . .

The PV of the minimum lease payments (MLP) The PV of the minimum lease payments (MLP) is is 90% or more of the fair value90% or more of the fair value of the asset.of the asset.

A capital leasecapital lease must meet oneone of four criteria:

Operating Lease

Capital Lease

Slide 7

15-7

Classification CriteriaClassification Criteria

A A bargain purchase option (BPO)bargain purchase option (BPO) gives the lessee the gives the lessee the right to purchase the leased asset at a price significantly right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the lower than the expected fair value of the property and the exercise of the option appears reasonably assured.exercise of the option appears reasonably assured.

The The lease termlease term is normally considered to be the non- is normally considered to be the non-cancelable term of the lease plus any periods covered by cancelable term of the lease plus any periods covered by bargain renewal optionsbargain renewal options. If the inception of the lease . If the inception of the lease occurs during the last 25% of an asset’s economic life, occurs during the last 25% of an asset’s economic life, this criterion does not apply.this criterion does not apply.

For the lessee, a capital lease is treated as the purchase For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an asset and of an asset – the lessee records both an asset and

liability at inception of the lease.liability at inception of the lease.

Slide 8

15-8

Additional Lessor ConditionsAdditional Lessor Conditions

Lessor = Owner of the property subject to the lease.Lessor = Owner of the property subject to the lease.Lessor = Owner of the property subject to the lease.Lessor = Owner of the property subject to the lease.

The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease:

1. The collectibility of the lease payments must be reasonably predictable.

2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the lessor is substantially complete.

Slide 9

15-9

Operating LeasesOperating Leases

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Lease Lease agreement agreement

exists.exists.

Lease Lease agreement agreement

exists.exists.

Record lease as Record lease as an Operating an Operating

Lease.Lease.

Record lease as Record lease as an Operating an Operating

Lease.Lease. CapitalLease

Slide 10

15-10

Nonoperating Leases - LesseeNonoperating Leases - Lessee

The amount recorded (capitalized) is the The amount recorded (capitalized) is the present value of the minimum lease payments. present value of the minimum lease payments. However, the amount recorded cannot exceed However, the amount recorded cannot exceed

the fair value of the leased asset.the fair value of the leased asset.

The amount recorded (capitalized) is the The amount recorded (capitalized) is the present value of the minimum lease payments. present value of the minimum lease payments. However, the amount recorded cannot exceed However, the amount recorded cannot exceed

the fair value of the leased asset.the fair value of the leased asset.

In calculating the present value of the minimum In calculating the present value of the minimum lease payments, the interest rate used by the lease payments, the interest rate used by the

lessee is the lower of:lessee is the lower of:

1.1. Its incremental borrowing rate, Its incremental borrowing rate, oror

2.2. The implicit interest rate used by the lessor.The implicit interest rate used by the lessor.

In calculating the present value of the minimum In calculating the present value of the minimum lease payments, the interest rate used by the lease payments, the interest rate used by the

lessee is the lower of:lessee is the lower of:

1.1. Its incremental borrowing rate, Its incremental borrowing rate, oror

2.2. The implicit interest rate used by the lessor.The implicit interest rate used by the lessor.

Slide 11

15-11

Nonoperating Leases - LessorNonoperating Leases - Lessor

When the lessor is a manufacturer or When the lessor is a manufacturer or dealer, the fair value of the property at the dealer, the fair value of the property at the

inception of the lease is likely to be its inception of the lease is likely to be its normal selling price.normal selling price.

When the lessor is a manufacturer or When the lessor is a manufacturer or dealer, the fair value of the property at the dealer, the fair value of the property at the

inception of the lease is likely to be its inception of the lease is likely to be its normal selling price.normal selling price.

If the lessor is not a manufacturer or If the lessor is not a manufacturer or dealer, the fair value of the leased dealer, the fair value of the leased asset is typically the lessor’s cost.asset is typically the lessor’s cost.

If the lessor is not a manufacturer or If the lessor is not a manufacturer or dealer, the fair value of the leased dealer, the fair value of the leased asset is typically the lessor’s cost.asset is typically the lessor’s cost.

Slide 12

15-12

Nonoperating LeasesNonoperating Leases

On January 1, 2009, Matrix, Inc. signed a On January 1, 2009, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for 5-year lease with RentPro, Inc. for

equipment. The lease specifies annual equipment. The lease specifies annual payments of $6,000 beginning 1/1/09 and payments of $6,000 beginning 1/1/09 and

at each December 31at each December 31stst through 2012. through 2012.

The equipment has an economic life of 5 The equipment has an economic life of 5 years and a fair value of $25,873. The years and a fair value of $25,873. The

equipment reverts to RentPro at the end equipment reverts to RentPro at the end of the lease. Matrix has an incremental of the lease. Matrix has an incremental borrowing rate of 8%, which is the same borrowing rate of 8%, which is the same as the implicit rate used by RentPro to as the implicit rate used by RentPro to

calculate the annual payment.calculate the annual payment.

Slide 13

15-13


The lease term meets the “The lease term meets the “75% of the 75% of the economic lifeeconomic life” test.” test.

YearsEconomic life 575% of economic life 3.75

Lease Term 5

Lease Term (5 years) is more than 75% of the economiclife of the equipment (3.75 years). This test is met.

YearsEconomic life 575% of economic life 3.75

Lease Term 5

Lease Term (5 years) is more than 75% of the economiclife of the equipment (3.75 years). This test is met.

Slide 14

15-14

Minimum Lease Payments per Year 6,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.31213

Present Value of the payments 25,872.78$

Fair value of the equipment at lease inception 25,873$ 90% of the fair value of the equipment at lease inception 23,286$

The present value of the payments > 90% of the fair value of theequipment. This test is met.

Minimum Lease Payments per Year 6,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.31213

Present Value of the payments 25,872.78$

Fair value of the equipment at lease inception 25,873$ 90% of the fair value of the equipment at lease inception 23,286$

The present value of the payments > 90% of the fair value of theequipment. This test is met.


The PV of the The PV of the payments payments 90% 90% of the of the equipment’s fair valueequipment’s fair value

Slide 15

15-15


Matrix makes the following entries at Matrix makes the following entries at inception of the lease.inception of the lease.

GENERAL JOURNAL

Date Description Debit Credit

Jan 1 Leased equipment 25,873 Lease payable 25,873

Lease payable 6,000 Cash 6,000

Slide 16

15-16


In addition to the information given earlier, the In addition to the information given earlier, the lessor (RentPro) knows that the collectibility lessor (RentPro) knows that the collectibility

of the lease payments is reasonably of the lease payments is reasonably predictable, and there are no future costs to predictable, and there are no future costs to

be incurred. RentPro’s performance is be incurred. RentPro’s performance is substantially complete as far as the lease is substantially complete as far as the lease is concerned. RentPro is not a manufacturer concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is or dealer and its cost of the equipment is

$25,873 (rounded). $25,873 (rounded).

Slide 17

15-17


Because the cost of the asset is equal to its Because the cost of the asset is equal to its fair value, the lease is classified as a fair value, the lease is classified as a Direct Direct

Financing LeaseFinancing Lease..

Because the cost of the asset is equal to its Because the cost of the asset is equal to its fair value, the lease is classified as a fair value, the lease is classified as a Direct Direct

Financing LeaseFinancing Lease..

GENERAL JOURNAL


Jan 1 Lease receivable 25,873 Inventory of equipment 25,873

Cash 6,000 Lease receivable 6,000

Slide 18

15-18

Period PaymentsEffective Interest

Decrease in Balance

Outstanding Balance

1/1/09 25,873$ 1/1/09 6,000$ -$ 6,000$ 19,873

12/31/09 6,000 1,590 4,410 15,463 12/31/10 6,000 1,237 4,763 10,700 12/31/11 6,000 856 5,144 5,556 12/31/12 6,000 444 5,556 0

Lease Amortization Schedule

Period PaymentsEffective Interest

Decrease in Balance

Outstanding Balance

1/1/09 25,873$ 1/1/09 6,000$ -$ 6,000$ 19,873

12/31/09 6,000 1,590 4,410 15,463 12/31/10 6,000 1,237 4,763 10,700 12/31/11 6,000 856 5,144 5,556 12/31/12 6,000 444 5,556 0

Lease Amortization Schedule

Lease Amortization ScheduleLease Amortization Schedule

$19,873 × 8% = $1,590$19,873 × 8% = $1,590

$6,000 - $1,590 = $4,410$6,000 - $1,590 = $4,410

$19,873 - $4,410 = $15,463$19,873 - $4,410 = $15,463

Slide 19

15-19

Nonoperating LeasesNonoperating Leases

December 31, 2009, entry by Matrix.December 31, 2009, entry by Matrix.GENERAL JOURNAL


Dec 31 Interest expense 1,590Lease obligation 4,410 Cash 6,000

December 31, 2009, entry by RentPro.December 31, 2009, entry by RentPro.GENERAL JOURNAL


Dec 31 Cash 6,000 Interest revenue 1,590 Lease receivable 4,410

Slide 20

15-20

Depreciation by LesseeDepreciation by Lessee

Depreciation expense is recorded in a manner Depreciation expense is recorded in a manner consistent with the company’s usual policy consistent with the company’s usual policy

concerning depreciation of other operational concerning depreciation of other operational assets.assets.

Depreciation expense is recorded in a manner Depreciation expense is recorded in a manner consistent with the company’s usual policy consistent with the company’s usual policy

concerning depreciation of other operational concerning depreciation of other operational assets.assets.

If title passes to the lessee at the end of the lease If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase term, or the lease contains a bargain purchase option, the asset is depreciated over theoption, the asset is depreciated over the asset’sasset’s

economic lifeeconomic life; otherwise, it is depreciated over the; otherwise, it is depreciated over the lease termlease term..

If title passes to the lessee at the end of the lease If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase term, or the lease contains a bargain purchase option, the asset is depreciated over theoption, the asset is depreciated over the asset’sasset’s

economic lifeeconomic life; otherwise, it is depreciated over the; otherwise, it is depreciated over the lease termlease term..

Slide 21

15-21

Depreciation by LesseeDepreciation by Lessee

At December 31, 2009, Matrix prepares the At December 31, 2009, Matrix prepares the following entry to recognize depreciation following entry to recognize depreciation

expense for the year.expense for the year.

GENERAL JOURNAL


Dec 31 Depreciation expense 5,175 Accumulated depreciation 5,175

$25,87$25,8733

5 years5 years

= = $5,175$5,175

Slide 22

15-22

Sales-Type LeasesSales-Type Leases

If the lessor is a manufacturer or dealer, If the lessor is a manufacturer or dealer, the fair value of the leased asset generally the fair value of the leased asset generally

is higher than the cost of the asset.is higher than the cost of the asset.

At inception of the lease, the lessor will At inception of the lease, the lessor will record therecord the Cost of Goods SoldCost of Goods Sold as well as as well as

the the Sales RevenueSales Revenue (PV of payments).(PV of payments).

At inception of the lease, the lessor will At inception of the lease, the lessor will record therecord the Cost of Goods SoldCost of Goods Sold as well as as well as

the the Sales RevenueSales Revenue (PV of payments).(PV of payments).

Slide 23

15-23

Sales-Type LeasesSales-Type LeasesOn January 1, 2009, Matrix, Inc. signed a 5-year On January 1, 2009, Matrix, Inc. signed a 5-year

lease with RentPro, Inc. for equipment. The lease with RentPro, Inc. for equipment. The lease specifies annual payments of $6,000 lease specifies annual payments of $6,000

beginning 1/1/09 and at each December 31beginning 1/1/09 and at each December 31stst through 2012.through 2012.

The equipment has an economic life of 5 years The equipment has an economic life of 5 years and a fair value of $25,873. The equipment and a fair value of $25,873. The equipment has a cost basis in the hands of RentPro of has a cost basis in the hands of RentPro of

$19,873. Title to the leased equipment passes $19,873. Title to the leased equipment passes to Matrix at the end of the lease. Matrix has an to Matrix at the end of the lease. Matrix has an incremental borrowing rate of 8%, which is the incremental borrowing rate of 8%, which is the same as the implicit rate used by RentPro to same as the implicit rate used by RentPro to

calculate the annual payment.calculate the annual payment.

Slide 24

15-24

Sales-Type Leases: LesseeSales-Type Leases: Lessee

Matrix makes the following entries at Matrix makes the following entries at inception of the lease.inception of the lease.

GENERAL JOURNAL


Jan 1 Leased equipment 25,873 Lease payable 25,873

Lease payable 6,000 Cash 6,000

Slide 25

15-25

Sales-Type Leases: LessorSales-Type Leases: Lessor

Because the cost of the asset is not equal to Because the cost of the asset is not equal to its fair value, the lease is classified as a its fair value, the lease is classified as a

Sales-Type LeaseSales-Type Lease..

Because the cost of the asset is not equal to Because the cost of the asset is not equal to its fair value, the lease is classified as a its fair value, the lease is classified as a

Sales-Type LeaseSales-Type Lease..

GENERAL JOURNAL


Jan 1 Lease receivable 25,873Cost of goods sold 19,873 Sales revenue 25,873 Inventory of equipment 19,873

Cash 6,000 Lease receivable 6,000

Slide 26

15-26

Residual ValueResidual Value

The residual value of a leased asset is The residual value of a leased asset is an estimate of what its an estimate of what its commercial commercial valuevalue will be at the end of the lease will be at the end of the lease

term. We need to determine the proper term. We need to determine the proper accounting for residual value by both accounting for residual value by both

the lessee and lessor.the lessee and lessor.

Slide 27

15-27


The only impact on the lessee is the The only impact on the lessee is the determination of determination of depreciationdepreciation expense. expense. The cost of the asset will be reduced by The cost of the asset will be reduced by

the the estimated residual value estimated residual value and and depreciated over the economic life of depreciated over the economic life of

the asset.the asset.

Lessee Obtains Title to Leased AssetLessee Obtains Title to Leased Asset

Slide 28

15-28


In determining the lease payment In determining the lease payment amount, the lessor will reduce the fair amount, the lessor will reduce the fair

value of the asset by the value of the asset by the present value present value of the residual valueof the residual value. The reduced fair . The reduced fair

value becomes the value used to value becomes the value used to calculate the lease payments.calculate the lease payments.

Lessor Retains Title to Leased AssetLessor Retains Title to Leased Asset

Slide 29

15-29

Executory CostsExecutory Costs

Executory costs include costs of ownership like Executory costs include costs of ownership like maintenance, insurance, taxes, and other costs. If maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible the lease agreement makes the lessee responsible

for the executory costs, they are treated as for the executory costs, they are treated as expenses by the lessee.expenses by the lessee.

In some cases, the lessor pays executory costs, In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through and the lessee will reimburse the lessor through higher periodic lease payments. These costs are higher periodic lease payments. These costs are

excluded in determining the minimum lease excluded in determining the minimum lease payment.payment.

Slide 30

15-30

Initial Direct CostsInitial Direct Costs

Incremental costs incurred by the lessor in Incremental costs incurred by the lessor in negotiating and consummating a lease negotiating and consummating a lease

agreement.agreement.Operating LeasesOperating Leases −− Capitalize and amortize Capitalize and amortize

over the lease term by the lessor.over the lease term by the lessor.Direct Financing LeasesDirect Financing Leases −− Include as part of Include as part of

investment balance.investment balance.

Incremental costs incurred by the lessor in Incremental costs incurred by the lessor in negotiating and consummating a lease negotiating and consummating a lease

agreement.agreement.Operating LeasesOperating Leases −− Capitalize and amortize Capitalize and amortize

over the lease term by the lessor.over the lease term by the lessor.Direct Financing LeasesDirect Financing Leases −− Include as part of Include as part of

investment balance.investment balance.

Slide 31

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Special Leasing ArrangementsSpecial Leasing Arrangements

1.1. Sale-Leaseback Arrangements Sale-Leaseback Arrangements – the owner of an asset – the owner of an asset sells it and immediately leases it back from the new sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is and amortized. A real loss on the sale of the property is recognized immediately.recognized immediately.

2.2. Real Estate LeasesReal Estate Leases::• Leases of Land OnlyLeases of Land Only• Leases of Land and BuildingLeases of Land and Building• Leases of Only Part of a BuildingLeases of Only Part of a Building

3.3. Leveraged Leases Leveraged Leases – a third-party, long-term creditor – a third-party, long-term creditor provides nonrecourse financing for a lease agreement provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the to the asset after borrowing a large part of the investment.investment.

1.1. Sale-Leaseback Arrangements Sale-Leaseback Arrangements – the owner of an asset – the owner of an asset sells it and immediately leases it back from the new sells it and immediately leases it back from the new owner. Any gain on the sale of the asset is deferred owner. Any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the property is and amortized. A real loss on the sale of the property is recognized immediately.recognized immediately.

2.2. Real Estate LeasesReal Estate Leases::• Leases of Land OnlyLeases of Land Only• Leases of Land and BuildingLeases of Land and Building• Leases of Only Part of a BuildingLeases of Only Part of a Building

3.3. Leveraged Leases Leveraged Leases – a third-party, long-term creditor – a third-party, long-term creditor provides nonrecourse financing for a lease agreement provides nonrecourse financing for a lease agreement between a lessor and lessee. The lessor acquires title between a lessor and lessee. The lessor acquires title to the asset after borrowing a large part of the to the asset after borrowing a large part of the investment.investment.

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. LEASES Chapter 15.

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