Basics Basics of of Leasing Leasing

Accounting Accounting for for Leases Leases

Chapter Chapter

A ALease Leaseis isa acontractual contractualagreement agreementbetween betweena alessor lessorand anda alessee lessee that thatgives givesthe thelessee lesseethe theright rightto touse usespecific specificproperty, property,owned ownedby by the lessor, for a specified period of time in return for stipulated, the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payments (rents).. and generally periodic, cash payments (rents)..
Lease Leaseterm term Rental Rentalpayments payments Lease Contract Executory ExecutoryCosts Costs Restrictions Restrictions Noncancelable Noncancelable Early Earlytermination termination Default Default

21 21

Slide 21-1

Slide 21-2

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Advantages Advantages of of Leasing Leasing

100% Financing at Fixed Rates Protection against Obsolescence Flexibility Less Costly Financing Alternative Minimum Tax Problems OffOff-Balance SheetSheet-Financing

Accounting Accounting by by Lessee Lessee

The issue of how to report leases is the case of substance versus versus form. Although technically legal title does not pass in lease transactions, the benefits from the use of the property do. Operating Lease
Journal Entry: Rent expense Cash xxx xxx

Capital Lease
Journal Entry: Leased equipment Lease obligation xxx xxx

A lease that transfers substantially all of the benefits and risks risks of property ownership should be capitalized (only noncancellable leases may be capitalized). Statement of Financial Accounting Standard No. 13, Accounting for Leases, Leases, 1980

Slide 21-3

Slide 21-4

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Mechanics Mechanics
The The expense expense recorded recorded on on a a capital capital lease lease and and an an operating operating lease lease are are THE THE SAME SAME over over the the life life of of the the asset. asset. In In a a capital capital lease lease it it hits hits the the P&L P&L via via interest interest expense expense and and depreciation depreciation expense expense VS VS operating, operating, it it all all goes goes into into rent rent expense. expense. In In a a capital capital lease, lease, think think of of it it as as a a sale. sale. The The commitment commitment to to the the lessor lessor is is a a debt debt and and should should be be treated treated like like any any other other debt debt (current (current vs. vs. noncurrent, noncurrent, accrue accrue interest interest etc.) etc.) The The asset asset gets gets depreciated depreciated just just like like if if it it were were owned/purchased. owned/purchased.

Compare Compare capital capital vs. vs. operating operating lease lease
FACTS Lease a computer worth Lease term Annual payment Estimated life of a computer Effective borrowing rate PRESENT VALUE OF PAYMENTS ANNUAL DEPRECIATION 3,000 3 yrs 1,143 4 yrs 7% $3,000 $750 YEAR ONE YEAR TWO YEAR THREE YEAR FOUR

CAPITAL LEASE
Equipment Cap lease obligation Cash Interest expense Capital lease obligation Depreciation expense Accumulated depreciation

OPENING 3,000 3,000

1,143 210 933 750 750 NO OPENING ENTRY! 1,143 1,143 1,143 145 998 750

1,143 75 1,068 750 750 1,143 1,143

1,143 0 (0) 750 750 750

OPERATING LEASE
Rent expense Cash 1,143

COMPARE EXPENSE OF THE TWO:

CAPITAL LEASE Interest expense Depreciation expense OPERATING LEASE 429 Rent expense 3,000 3,429 DIFFERENCE BETWEEN THE TWO OVERALL: NONE!!!! Slide 21-6 3,429

Slide 21-5

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Capitalization Criteria Criteria

Lease Agreement

Capitalization Capitalization Criteria Criteria

Lease Agreement

Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

The lease transfers ownership of the property to the lessee.

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Capital Lease
Slide 21-7

Capital Lease
Slide 21-8

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Capitalization Criteria Criteria

Lease Agreement

Capitalization Capitalization Criteria Criteria

Lease Agreement

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Lease term can be extended by a bargain renewal option. option.

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Capital Lease
Slide 21-9

Capital Lease
Slide 21-10

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Capitalization Criteria Criteria

Lease Agreement

Capitalization Capitalization Criteria Criteria

Lease Agreement

Three important concepts:

Minimum lease payments Executory costs Discount rate

Minimum lease payments:

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Guaranteed residual value Penalty for failure to renew Bargain purchase option

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Capital Lease
Slide 21-11

Capital Lease
Slide 21-12

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Capitalization Criteria Criteria

Lease Agreement

Capitalization Capitalization Criteria Criteria

Lease Agreement

Executory Costs:

Insurance Maintenance Taxes

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Lessee computes the PV of the minimum lease payments using the lessees incremental borrowing rate. (one exception)

Discount Rate:

No
Transfer of Ownership Bargain Purchase

No
Lease Term >= 75%

No
PV of Payments >= 90%

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Capital Lease
Slide 21-13

Capital Lease
Slide 21-14

Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

REAL REAL WORLD WORLD

The The leasing leasing companies companies are are hip hip to to these these criteria criteria and and go go out out with with a a lease lease that that they they believe believe satisfies satisfies the the requirements. requirements. They They usually usually run run really really tight tight (i.e (i.e PV PV of of payments payments is is 89.9% 89.9% of of the the fair fair value value of of the the asset). asset). Just Just because because the the leasing leasing company company says says it it works works as as an an operating operating lease, lease, doesnt doesnt make make it it so!! so!!

TEXT TEXT example example from from p.1097 p.1097

Lessor and Lessee sign a lease agreement dated January 1, 2005 which requires Lessor to lease equipment to lessee beginning January 1, 2005. Terms are: 5 year, noncancelable lease term, equal annual payments at beginning of year of $25,981.62 Fair value of equipment is $100,000 at inception and has 5 yr. Life and no residual value Lessee pays all executory costs directly, except property tax which is $2,000 per year and part of the annual payment of $25,981.62 No renewal options and equipment reverts to Lessor at termination Lessee borrowing rate is 11%, Lessor implicit rate is 10% and known to Lessor Lessee depreciates on a straight line basis. Instructions Prepare the journal entries on the books of the Lessee that relate Slide 21-16 to the lease agreement through December 31, 2009.
Bob AndersonAnderson- UCSB Bob AndersonAnderson- UCSB

Slide 21-15

p. p. 1097 1097 SOLUTION SOLUTION

Payment Property tax Lease portion Rate Period PV Life of asset 25,981.62 (2,000.00) 23,981.62 10% * 5 100,000 5 OPENING ENTRY: Equipment 100,000 Capital lease obligation 1/1/05 ENTRY: Lease liability Property tax expense Cash 100,000

RESIDUAL - LESSEE VALUE RESIDUAL VALUEVALUELESSEE

Accounting Accounting depends depends on on whether whether the the residual residual is is guaranteed guaranteed or or not: not: Not Not Guaranteed: Guaranteed: As As if if it it did did not not exist exist Guaranteed: Guaranteed: As As if if the the guaranteed guaranteed amount amount is is a a final final payment payment (gain/ (gain/ loss loss results results on on final final payment payment depending depending on on what what the the value value of of the the property property is) is)

23,982 2,000 25,982 -

12/31/05 ENTRY: Interest expense 7,602 20,000 IS THIS A CAPITAL LEASE? YES- 100% OF LIFE IS>75% AND Pv of Payments>90% Depreciation expense accum dep LEASE AMORTIZATION SCHEDULE Accrued interest LEASE LEASE LEASE PMT INTEREST REDUX LIABILITY 1/1/06 PAYMNT: 1/1/05- OPENING 100,000.00 Property tax expense 2,000 1/1/05 PAYMENT 23,981.62 23,981.62 76,018.38 Lease liability 16,380 1/1/06 PAYMENT 23,981.62 7,601.84 16,379.78 59,638.60 Interest payable 7,602 1/1/07 PAYMENT 23,981.62 5,963.86 18,017.76 41,620.84 Cash 1/1/08 PAYMENT 23,981.62 4,162.08 19,819.54 21,801.30 1/1/09 PAYMENT 23,981.62 2,180.13 21,801.49 ETC.

* smaller of lessee borrowing rate or lessor implicit rate

20,000 7,602 -

25,982 -

Slide 21-17

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Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

BARGAIN BARGAIN PURCHASE PURCHASE OPTION OPTION

DISCOUNT DISCOUNT THE THE BARGAIN! BARGAIN! (if (if get get 10 10 for for 2, 2, then then what what is is the the PV PV of of the the cost cost of of the the $8 $8 bargain?? bargain?? The The cost= cost= PV PV of of the the $2 $2 payment)) payment)) If If there there is is a a bargain bargain purchase purchase option, option, then then you you assume assume it it will will be be paid paid and and the the asset asset transferred transferred at at the the end end of the term. Think of it as a final lease payment. of the term. Think of it as a final lease payment. For For instanceinstance- 3 3 year year lease lease at at $100 $100 per per year, year, 10% 10% implicit implicit rate. rate. Can Can buy buy the the item item for for $75 $75 at at the the end end of of the the term term when when its its fair fair value value would would be be $150. $150. Then Then the the PV PV of of the the payments payments is: is: PV PV of of lease lease payment payment PLUS PLUS PV PV of of $75 $75 in in the the future future PV PV of of the the lease lease
Slide 21-19

Illustration Illustration
E21E21-2 Pat Delaney Company leases an automobile with a fair value of $8,725 from John Simon Motors, Inc., on the following terms: 1. Noncancelable term of 50 months 2. Rental of $200 per month (at end of each month; present value at 1% per month is $7,840). 3. Estimated residual value after 50 months is $1,180 (the present value at 1% per month is $715). Delaney Company guarantees the residual value of $1,180. 4. Estimated economic life of the automobile is 60 months. 5. Delaney Companys incremental borrowing rate is 12% a year (1% a month). Simons implicit rate is unknown. Instructions Prepare the journal entries on the books of Delaney Company for the first month of the lease.

$250 $250 $ $ 56 56 $306 $306

Bob AndersonAnderson- UCSB

Slide 21-20

Bob AndersonAnderson- UCSB

Solution -2 E21 Solution E21E21-2

FACTS Term of lease Monthly rent Rate Guaranteed res. Value Life of asset 50 months 200 12% 1,180 60 months

Benefits Benefits Available Available To To The The Lessor Lessor

Interest Revenue Tax Incentives High Residual Value

This is a capital lease because two of the criteria are met (only need one met) Lease term Life of asset 50 60 83% > 75% requirement

PV of payments (since residual is guaranteed, it is included) PV of payments $7,839.22 PV of residual $717 $8,556.71 ENTRY TO RECORD: Leased equip under cap lease Lease liability 1st Month Entry: Depreciation expense Accum. Dep Lease liability Interest expense Cash

$ 8,556.71 $ 8,556.71

$ 147.53 $ 147.53 $ 114.43 $ 85.57 $ 200.00

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Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Lessor) ) ((Lessor) Capitalization Criteria Criteria (Lessor

Group Group I I

LESSOR: LESSOR: DIRECT DIRECT FINANCING FINANCING VS. VS. SALES SALES TYPE TYPE LEASES LEASES IF IF ALL ALL THE THE CRITERIA CRITERIA ARE ARE MET, MET, THEN THEN IT IT IS IS EITHER EITHER A A DIRECT DIRECT FINANCING FINANCING OR OR SALES-TYPE SALES-TYPE LEASE LEASE TO TO THE THE LESSOR: LESSOR:

Transfer Transferof ofownership ownership Bargain Bargainpurchase purchaseoption option Lease Leaseterm term=> =>75% 75%of ofeconomic economiclife lifeof ofleased leasedproperty property Present Presentvalue valueof ofminimum minimumlease leasepayments payments=> =>90% 90%of ofFMV FMVof ofproperty property

Group Group II II

Collectibility Collectibilityof ofthe thepayments paymentsrequired requiredfrom fromthe thelessee lesseeis isreasonably reasonably predictable. predictable. No important uncertainties surround the amount of unreimbursable No important uncertainties surround the amount of unreimbursablecosts costs yet yetto tobe beincurred incurredby bythe thelessor lessorunder underthe thelease lease(lessors (lessorsperformance performanceis is substantially substantiallycomplete completeor orfuture futurecosts costsare arereasonably reasonablypredictable). predictable).

Why Group II Requirements?

Direct Direct Financing: Financing: Lessor Lessor is is not not making making money money from from selling selling the the product, product, they they are are in in it it for for the the financing financing aspect aspect (more (more like like a a lender). lender). It It works works just just like like the the capital capital lease lease we we just just spoke spoke of of for for lessee, lessee, but but in in reverse reverse (interest (interest income, income, lease lease receivable receivable VS VS interest interest expense expense ,, interest interest receivable receivable )) Sales-Type: Sales-Type: Lessor Lessor is is getting getting a a financing financing fee, fee, but but ALSO ALSO is is making making money money from from the the product product itself itself as as well well (they (they may may be be a a manufacturer or retailer). More complicatedneed to deal manufacturer or retailer). More complicated- need to deal with any profit the lessor is making from selling the asset. with any profit the lessor is making from selling the asset.

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Bob AndersonAnderson- UCSB

Bob AndersonAnderson- UCSB

Capitalization Lessor) ) ((Lessor) Capitalization Criteria Criteria (Lessor

Lease Agreement

Group 1 criteria are the four criteria that must be considered for capitalization of a lease by a lessee.

Payment period rate PV FV Cost

100 3 8% 258 258 258

LESSOR- DIRECT FINANCING

Yes
Any Group 1 Criteria Met?

Collectibility of Payments Reasonably Certain?

Yes

Lessors Performance Substantially Complete?

Yes
Is Asset FMV > Bookvalue?

Yes

Both No No No No
SalesSales-Type Lease

UPON "SALE" Cap lease receivable Asset YR 1 Cash Interest income Cap lease receivable YR 2 Cash Interest income Cap lease receivable YR 3 Cash
Slide 21-26

258 258 100 21 79

100 14 86 100 Interest income Interest income 7 93

Bob AndersonAnderson- UCSB

Operating Lease
Slide 21-25

Direct Financing Lease

Bob AndersonAnderson- UCSB

Payment period rate PV FV Cost

100 3 8% 258 258 200

LESSOR: SALES TYPE

Capitalization Lessor) ) ((Lessor) Capitalization Criteria Criteria (Lessor

Is Isit itpossible possiblethat thata alessor lessorhaving havingnot notmet metboth bothcriteria criteriawill willclassify classifya a lease leaseas asan anoperating operatinglease leasebut butthe thelessee lesseewill willclassify classifythe thesame same lease leaseas asa acapital capitallease? lease? In Insuch suchan anevent, event,who whowill willhave havethe theasset asseton ontheir theirbooks? books?

UPON "SALE" Cap lease receivable Asset Gain YR 1 Cash Interest income Cap lease receivable YR 2 Cash Interest income Cap lease receivable YR 3 Cash
Slide 21-27

258 200 58 100 21 79

100 14 86 100 Interest income Interest income 7 93

Bob AndersonAnderson- UCSB
Slide 21-28

Bob AndersonAnderson- UCSB

Capitalization Capitalization Criteria Criteria

Lease Agreement

Discount Rate:
Lesse e comput es th e PV of th e minimum lease payments using the lessees increme ntal borrowing rate. (one exce ption)

No
Transfer of Ow nership Bargain Purchase

No
Lease Term >= 75%

No
PV of Pay ments >= 9 0%

No

O p e r a t i n g L e a s e

Yes

Yes

Yes

Yes

Capital Lease
Sl ide 22-13

Copyright

2000 by

Coby Harmon

Slide 21-29

Bob AndersonAnderson- UCSB