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Leases I N T ERMEDIATE ACCOU N T I NG I I CHA PT ER 1 5 Leases Lease – contractual agreement where the lessor provides the lessee the right to use an asset for a specified period of time in return for periodic cash payments Lessor – party who owns the asset Lessee – party leasing the asset Basic Lease Classifications A lease is accounted for as either a lease agreement (operating lease) or a purchase/sale accompanied by debt financing. The choice of accounting method hinges on the nature of the leasing arrangement. Capital leases are agreements that we identify as being formulated outwardly as leases, but which are in reality installment purchases. Capital Lease Criteria A lessee should classify a lease transaction as a capital lease if it is noncancellable and if one or more of four classification criteria are met: 1. The agreement specifies that asset ownership transfers to the lessee. 2. The agreement contains a bargain purchase option. 3. The noncancellable lease term is equal to 75% or more of the expected economic life of the asset. 4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset. Otherwise, the lease is accounted for as an operating lease. Capital Lease or Operating Lease? On January 1, 2013, Sans Serif Publishers, Inc., a computer services and printing firm, leased a color copier from CompuDec Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2013, the inception of the lease, and at each January 1 through 2013. The useful life of the copier is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the copier for its cash price of $479,079. If funds were borrowed to buy the copier the interest rate would have been 10%. How should this lease be classified? Does the agreement specify that ownership of the asset transfers to the lessee? No Does the agreement contain a bargain purchase option? No Account for this lease as an Operating Lease Is the lease term equal to 75% or more of the expected economic life of the asset? 4/6 years = 67% Is the present value of the minimum lease payments at least 90% of the fair value of the asset? Present Value MLP = $100,000 X 3.48685 = $348,685 90% FV = $479,079 X.9 = $431,171 No No Capital Lease or Operating Lease? Brief Exercise 15-4 Corinth Co. leased to Athens Corporation for an eight-year period, at which time possession of the leased asset will revert to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the minimum lease payments of both the lessor and lessee is $20.4 million. The first payment was made at the inception of the lease. How should Athens classify this lease? Does the agreement specify that ownership of the asset transfers to the lessee? No Does the agreement contain a bargain purchase option? No Account for this lease as a Capital Lease Is the lease term equal to 75% or more of the expected economic life of the asset? 8/12 years = 67% Is the present value of the minimum lease payments at least 90% of the fair value of the asset? Present Value MLP = $20.4 million 90% FV = $22.4 = $20.16 million No Yes Accounting for Operating Leases The fundamental rights and responsibilities of ownership are retained by the lessor and that the lessee merely is using the asset temporarily. A “sale” is not recorded by the lessor. A “purchase” is not recorded by the lessee. The periodic lease payments are accounted for as rent: • Rent revenue by the lessor, • Rent expense by the lessee. Advance payments are considered prepayments of rent. They are deferred and allocated to rent over the lease term. • Any refundable security deposit is recorded as a long-term receivable (by the lessee) and liability (by the lessor) unless it is not expected to be returned. • A prepayment of the last period’s rent is recorded as prepaid rent and allocated to rent expense/rent revenue during the last period of the lease term. The cost of a leasehold improvement is depreciated over its useful life by the lessee. Exercise 15–1, page 902 (a) Nath-Langstrom Services, Inc. (Lessee) June 30, 2013 Rent expense Cash 10,000 December 31, 2013 Rent expense Cash 10,000 10,000 10,000 (b) ComputerWorld Corporation (Lessor) June 30, 2013 Cash Rent revenue 10,000 December 31, 2013 Cash Rent revenue 10,000 10,000 10,000 Depreciation exp 15,000 ($90,000 ÷ 6 years) Accumulated depreciation 15,000 Accounting for Capital Leases - Lessee In a capital lease the lessee records a leased asset at the present value of the minimum lease payments. Interest accrues at the effective rate on the balance outstanding during the period. Lease payments (except the first) include interest on the outstanding balance as well as a residual portion that reduces that outstanding balance. An amortization schedule is helpful to keep up with changing interest and lease obligation amounts. Depreciation is recorded for leased assets in a manner consistent with the lessee’s usual policy for depreciating its operational assets Normally over the term of the lease. Over the asset's useful life, if: • Ownership transfers or • A bargain purchase option is present Accounting for Capital Leases - Lessor Two additional criteria must be met for a capital lease to be recorded by the lessor. The collectibility of the lease payments must be reasonably predictable. If any costs to the lessor have yet to be incurred, they are reasonably predictable. (Performance by the lessor is substantially complete.) Accounting for Capital Leases - Lessor A capital lease is recorded by the lessor as a sales-type lease or direct financing lease, depending on whether the lease provides the lessor a dealer’s profit. Direct-Financing Lease A direct-financing lease is basically the coupling of a sale and financing transaction (credit sale). In a direct-financing lease, the lessor removes the leased asset from its books and replaces it with a receivable from the lessee. The only income recognized by the lessor is the interest received. Interest is calculated using the effective interest rate. Use an amortization schedule to assist with allocating payments between the lease obligation and interest. Sales-Type Lease A sales-type lease is accounted for like a direct-financing lease, except that a profit on the sale is recognized in the period of the lease inception in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost (or carrying value) of the leased asset. Upon inception of the lease, the lessor records sales revenue and cost of goods sold and removes the leased asset from its books. Regardless of the lease type, no expenses, such as depreciation or executory costs, are recorded by the lessor for capital leases. Source: Investopedia, http://www.investopedia.com/exam-guide/cfa-level-1/liabilities/accounting-for-leases.asp Accounting for Capital Leases - Example See example provided by instructor. Bargain Purchase Option A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a “bargain” price. When a BPO is present, both the lessor and the lessee view the option price as an additional lease payment. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. That additional payment is included as a component of minimum lease payments for both the lessor and the lessee. • The lessor, when computing periodic lease payments, subtracts the present value of the BPO price from the amount to be recovered (fair market value) to determine the amount that must be recovered from the lessee through the periodic rent payments. • The lessee adds the present value of the BPO price to the present value of periodic payments when computing the amount to be recorded as a leased asset and a lease liability The lease term effectively ends when the BPO is exercisable. • Thus, if a BPO in a six-year lease could be exercised at the end of the fifth year, the effect will be to change the lease term to five years, from six. Residual Value Amount an asset is worth at the end of the lease agreement. The lease agreement may include a guarantee by the lessee for residual value. Guaranteed residual value is considered an additional lease payment that is to be paid in property, cash, or both. When calculating minimum lease payments, deduct the present value of the residual value from the fair value of the leased asset. If the lessee obtains title to the leased asset, the lessor’s computation of lease payments is unaffected by any residual value. Executory Costs Executory costs are maintenance, insurance, taxes, and any other costs usually associated with asset ownership. In a capital lease, the lessee is responsible for executory costs. • Sometimes, as an expediency, a lease contract will specify that the lessor is to pay executory costs, but that the lessee will reimburse the lessor through higher lease payments. Any portion of lease payments that represents executory costs is not considered part of minimum lease payments and interest is not incurred for executory costs. The lessee expenses executory costs as incurred. Executory Costs Example Problem Branif Leasing leases mechanical equipment to Branson Construction. The lease agreement specified 20 annual payments of $100,000 beginning December 31, 2014, the inception of the lease. The estimated useful life of the leased equipment is 20 years with no residual value. Its cost to Branif was $936,500. The lease qualifies as a capital lease to Branson. Maintenance of the equipment was contracted for through a 20-year service agreement with Midway service Company requiring 20 annual payments of $3,000 beginning December 31, 2014. Both companies use straight-line depreciation. Prepare journal entries for the first two payments for the lessee and lessor under each of the following assumptions: a. The lessee pays executory costs as incurred. b. The lease agreement specifies that the lessor pays executory costs as incurred. The lessee’s lease payments were increased to $103,000 to include reimbursement for these costs. Executory Costs Example: Item a – Solution Lessee (Branson) Date Account 2014 Dec 31 Lease Payable Debit 100,000 3,000 Cash 2015 Dec 31 Lease Payable Interest Expense (836,500 X 10%) 3,000 16,350 83,650 Cash Depreciation Exp (936,500/10 yrs) Accumulated Depreciation Account 2014 Dec 31 Cash 100,000 Cash Maintenance Expense Credit Lessor (Branif) Date 100,000 46,825 46,825 Debit 100,000 Lease Receivable 2015 Dec 31 Cash Credit 100,000 100,000 Interest Revenue 83,650 Lease Receivable 16,350 Executory Costs Example: Item b – Solution Lessee (Branson) Date Lessor (Branif) Account 2014 Dec 31 Lease Payable Maintenance Expense Debit Interest Expense (836,500 X 10%) Maintenance Expense 3,000 Accumulated Depreciation Account Debit Credit 103,000 Lease Receivable 100,000 103,000 2015 Dec 31 Cash 103,000 16,350 Lease Receivable 16,350 83,650 Interest Revenue 83,650 3,000 Cash Depreciation Exp (936,500/10 yrs) Date 2014 Dec 31 Cash 100,000 Cash 2015 Dec 31 Lease Payable (to balance) Credit Maintenance Fee Payable 103,000 46,825 46,825 3,000 Leases I N T ERMEDIATE ACCOU N T I NG I I - CHA PT ER 1 5 E N D OF P R ESENTATION