Transcript Document

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