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Accounting for Leases
ACC4305
ACC4305
Michel Leseure
Leases
• The lease is a contractual agreement
between the lessor and the lessee.
• The lease gives the lessee the right to use
specific property.
• The lease specifies the duration of the
lease and rental payments.
• The obligations for taxes, insurance, and
maintenance may be assumed by the
lessor or the lessee.
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Michel Leseure
Advantages of Leases
• Leases may not require any money down.
• Lease payments are often fixed.
• Leases reduce the risk of obsolescence to the
lessee.
• Leases may contain less restrictive covenants
than other types of lending arrangements.
• Leases may be a less costly means of financing.
• Certain leases may not add to existing debt on
the balance sheet.
Off Balance Sheet
Financing
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Michel Leseure
Tax Advantages
• The lessee can write off the full cost of
the asset, including the part that relates to
land.
• The deduction may be accelerated since it
is often spread over the period of the
lease rather than the actual economic life
of the property.
ACC4305
Michel Leseure
Defining Leases
• According to the FASB:
– a lease transferring substantially all of the
benefits and risks of ownership should be
capitalized.
– Transfer of ownership can be assumed
only if there is a high degree of
performance to the transfer, that is, the
lease is non-cancelable.
– Leases that do not substantially transfers
benefits and risks are operating leases.
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Michel Leseure
Accounting by Lessee
• Leases that meet any of the following four
criteria are capital leases for the lessee:
– Leases, transferring ownership
– Leases with bargain purchase options
– Leases with lease terms equal to 75% or
more of the economic life (75% rule)
– Leases where the present value of lease
payments is equal to 90% or more of the
fair market value (90% rule)
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Michel Leseure
Accounting by Lessee
Lease Agreement
Is there transfer
of ownership?
No
Capital
Lease
Yes
Yes
Is there a bargain
purchase option?
No
Yes
Is lease term equal
to or greater than
75% of economic
life ?
Yes
No
Operating
Lease
Is present value
of payments
equal to or more
than 90% FMV?
ACC4305
Michel Leseure
Accounting by Lessee
• In a capital lease transaction, the lessee
records an asset and a liability.
– The asset is depreciated by the lessee over
the economic life of the asset.
– The effective interest method is used to
allocate the rental payments between
principal and interest.
– Depreciation of the asset and discharge of
the lease obligation are independent
accounting procedures.
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Michel Leseure
Illustration
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Michel Leseure
An introductory example
• To illustrate accounting for lease
transactions, we will use a simple case
involving three parties:
• 1.
Meknes Farms SA
» Needs a Combine Model SX
» Expected useful life of six years with no salvage value
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Michel Leseure
An introductory example
• 2.
Meknes First Bank
» Currently charging 12% interest on long-term
equipment loans
• 3.
Said Tractors, SA
» Manufactures the Model SX combine at a cost of dh
400,000.
» Selling price is dh 500,000
» It also has a few units for trial use which rent for dh
5000 per week
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Michel Leseure
Operating Lease
• If Meknes Farms rents a combine for one
week from Said Tractors, the journal
entries would follow the usual pattern for a
rental:
Meknes Farms
Equipment rent expense
Cash
5,000
5,000
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Michel Leseure
Operating Lease
• Said Tractors
– Cash
– Rental Revenue
5,000
5,000
• Since Said Tractors is the owner of the
combine, it would record depreciation:
– Depreciation expense
1,282
–
Acc’d depreciation
1,282
[400,000/6 years/52 weeks]
ACC4305
Michel Leseure
Operating leases- Summary
• Assign rent expense or revenue to period
benefited
– Subject to accruals
• No liability on lessee’s balance sheet
• Lessor depreciates the asset
• Lessor is probably responsible for
insurance, property taxes and
maintenance
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Michel Leseure
Purchase with LT loan
• Assume Meknes Farms decides to
purchase the combine and borrows the
full purchase price of Dh 500,000 from
Meknes First Bank at 12% interest on the
unpaid balance of the loan.
• Meknes Farms agrees to make annual
payments of Dh 100,000 for five years.
• Again, the journal entries follow the
normal pattern.
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Michel Leseure
Securing the Loan
• Meknes Farms
Cash
500,000
Note Payable
500,000
• Meknes First Bank
• Loan receivable
500,000
Cash
500,000
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Michel Leseure
Purchasing the Equipment
• Said Tractors SA.
Cash
Sales
• COGS
Inventory
500,000
500,000
400,000
400,000
• Meknes Farms
Combine
Cash
500,000
500,000
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Michel Leseure
End of the Year
500,000/6 years
• Meknes Farm
Depreciation Expense
83,333
Acc'd Depreciation
83,333
• Interest Expense
60,000
Interest Payable
60,000
[500,000 * 12%]
• Meknes First Bank
Interest Receivable 60,000
Interest Revenue
60,000
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Michel Leseure
First Installment Payment
• Meknes First Bank
• Cash
160,000
Loan Receivable
100,000
Interest Receivable
60,000
• Meknes Farms
Interest Payable
Notes Payable
Cash
60,000
100,000
160,000
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Michel Leseure
Capital Lease
• For various reasons either (or both)
Meknes Farms and Meknes First Bank
might prefer a lease arrangement to an
outright purchase & long-term loan
– Assume that the bank agrees to purchase
the combine from Said Tractors for MAD
500,000 and lease it to Meknes Farms for
five years.
– Meknes Farms gets to keep the combine at
the end of the lease.
ACC4305
Michel Leseure
Capital Lease
• The bank must determine how much to
charge to earn its desired rate of 12%
interest.
– Assuming the first annual payment comes
at the end of the first year (after harvest).
– PV = 500,000, n = 5, i = 12%
• Payment must be 138,710
ACC4305
Michel Leseure
Direct Financing Lease
• The lessor calls this a “direct financing
lease” because it is essentially an
installment sale.
• The only money the lessor makes from
the lease is interest revenue.
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Michel Leseure
Bank buys combine:
• Meknes First Bank
• Asset to be leased 500,000
Cash
500,000
• Said Tractors SA.
Cash
500,000
Sales
500,000
COGS
400,000
Inventory
400,000
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Michel Leseure
Asset is transferred to lessee:
• Meknes Farms
Leased Asset
Lease Payable
500,000
500,000
• Meknes First Bank
Investment in lease
500,000
Asset to be leased
500,000
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Michel Leseure
End of the Year
• Meknes Farms
Depreciation Expense
Acc'd Depreciation
500,000/6 years
83,333
83,333
Acc. Dep to be applied against Leased Asset account
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Michel Leseure
First Lease Payment
• Meknes First Bank
• Cash
Investment in Lease
Interest Revenue
• Meknes Farms
Interest Expense
Lease Payable
Cash
138,710
78,710
60,000
60,000
78,710
138,710
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Michel Leseure
Is Said Tractor missing out on a
business opportunity?
– By offering a lease option, Troy Tractor
gains the following advantages:
• 1. a way of indirectly making
a sale,and
• 2. an alternative means of
obtaining a profit opportunity.
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Michel Leseure
Sales Type Lease
• Accordingly, Meknes Farms may be able to arrange a
similar or better lease arrangement with the manufacturer
of the Model SX combine.
– This is called a “sales-type lease” for the lessor because
Said Tractors will make a profit from “selling” the
combine and it will earn interest revenue over the lease
term.
– We will assume that the lease terms are the same for
purposes of illustration.
ACC4305
Michel Leseure
Sales Type Lease
• NOTE: The first step in doing lease
accounting involves finding the present value
of the cash flows which will be transferred
between the lessee and lessor.
– This "present value of the minimum lease payments"
[PVMLP] will give you the SALES amount for the lessor
(assuming a sales-type lease) and the ASSET amount
for the lessee.
– COMPUTE PVMLP: [n = 5, i = 12%, pymt = 138,710]
– PV = MAD 500,000
ACC4305
Michel Leseure
Sales Type Lease
• Meknes Farms
• Leased Asset (PV of MLP)
Lease Liability
500,000
500,000
• Depreciation Expense
Acc'd Depreciation
83,333
• Interest Expense
Lease Liability
Cash
60,000
78,710
138,710
83,333
ACC4305
Michel Leseure
Sales Type Lease
• Said Tractors
• Lease Receivable
Sales
500,000
500,000
COGS
Inventory
400,000
400,000
Cash
Interest Revenue
Lease Receivable
138,710
60,000
78,710
ACC4305
Michel Leseure
Accounting by Lessor
• Lessor classifies leases as one of the
following:
– Operating lease
– Direct financing lease
– Sales-type lease
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Michel Leseure
Classification of Lease for Lessor
• To be classified as an operating lease:
– The lease doesn’t meet any group 1 criteria
(same as lessee’s), OR
– Collectibility of payments isn’t reasonably
assured, OR
– Lessor’s performance isn’t substantially
complete.
ACC4305
Michel Leseure
Classification of Lease for Lessor
• To be classified as a direct financing
lease the lease must meet group 1 criteria
(same as lessee’s), and the following,
group 2 criteria:
– Collectibility of payments must be
reasonably assured, and
– Lessor’s performance must be
substantially complete, and
– Asset’s fair value must be equal to lessor’s
book value
ACC4305
Michel Leseure
Summary
Lease Agreement
Does lease meet
Group 1 criteria?
yes
No
Sales type
No
Is collectibility of
payments assured?
yes
No
Is lessor’s
performance
substantially
complete ?
No
yes
Operating
Lease
Direct
financing
Does asset FMV
equal lessor’s
book value?
yes
ACC4305
Michel Leseure
Accounting Issues
•
•
•
•
•
Residual values
Sales-type leases
Bargain purchase options
Initial direct costs
Disclosure
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Michel Leseure
Bargain purchase options (BPO)
• Many leases are equivalent to a purchase
financed with a long-term loan. We have
assumed, so far, that Meknes Farm got to
keep the tractor at the end of the lease
(TITLE TRANSFER).
• Another way a lease is equivalent to a
purchase is if the lessee can purchase the
asset for a bargain price at the end of the
lease. Consider the following lease terms:
ACC4305
Michel Leseure
BPO - Lease
• Inception date: 1/1/02
• Lessor: Said Tractors Inc.
• Fair value of combine at
1/1/02: MAD 500,000
• Cost to manufacture
combine: 400,000
• Estimated fair value at end
of lease is 100,000
• Fixed non-cancelable
lease term: 5 years.
• First payment due on
12/31/02
• Lessee: Meknes Farms
• Incremental borrowing
rate (lessee): 12%
• Implicit interest rate
(known to lessee): 12%
• Option to buy at end of
lease term for 50,000
• Estimated useful life of
combine: 8 years
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Michel Leseure
Bargain Purchase Option
• What amount should Said Tractors
charge?
• Amount to be recovered (PV) = MAD
500,000
• n=5, i=12%, FV (BPO) = 50,000
• What is PV of 50,000?
• .5674 * 50,000 = 28,370
• Amount to be recovered with annual
payments = 500,000 – 28,370 =471,630
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Michel Leseure
Bargain Purchase Option
Therefore, PV-OA = 471,630
PMT * PVIF-OA = PV-OA
PMT * 3.6048 = $471,630
471630/3.6048 = 130,830
ACC4305
Michel Leseure
Bargain Purchase Option
MEKNES FARMS
Combine (at PVMLP)
Lease Liability
Interest Expense
Lease Liability.
Cash
Depreciation Expense
Acc'd Depreciation
Useful life
= 8 years
500,000
500,000
60,000
70,830
130,830
62,500
62,500
ACC4305
Michel Leseure
Bargain Purchase Option
SAID TRACTORS SA.
Lease Receivable
Sales
COGS
Inventory
Cash
Lease Receivable
Interest Revenue
500,000
500,000
400,000
400,000
130,830
70,830
60,000
Note: Last Payment includes BPO payment
ACC4305
Michel Leseure
Leasing in Moroccan Accounting
• A lease is a rental contract, and thus is always off
balance sheet financing!
• Growing use
–
–
–
–
Medical equipment
Royal Air Maroc
Ship operators
Individuals
• Limited use for real estate
• No interest charges presents an interest for
Islamic banking
– New IAS standards with implicit interest rates!
Dossier de l’Economiste
Number 2208
ACC4305
Michel Leseure
Leasing in Moroccan Accounting
• www.chaabileasing.co.ma
• Salafin
• Credit du Maroc Leasing
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Michel Leseure
Leases in Moroccan Accounting
• Royal Air Maroc has filed for and obtained
an exemption from Moroccan regulations
to capitalise its aircraft leases
• Motivations?
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Michel Leseure
Lease Backs
• An agreement whereby a company sells
its asset to a lessor and rents it back
under the form of a lease
• Motivations:
– Cash infusion (at market value rather than
book value!)
• Risk: use the cash to a productive investment purpose!
– Off balance sheet balancing
• Down to the nature of the contract!
• Systematic with MA/FR accounting
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Michel Leseure
Lease Backs
• Can be used, legally, to “window dress”
accounts
• Example:
– Company in financial difficulty
– Fully amortized asset on the books (or not)
– Lease back
• Liquidity increases, solvency increases!
• COMANAV in 2003
• Not possible with IFRS
ACC4305
Michel Leseure