Download Accounting for Leases - UCSB Department of Economics

Basics
Basics of
of Leasing
Leasing
Accounting
Accounting for
for Leases
Leases
AALease
Leaseisisaacontractual
contractualagreement
agreementbetween
betweenaalessor
lessorand
andaalessee
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
Chapter
Chapter
Lease
Contract
21
21
Executory
ExecutoryCosts
Costs
Restrictions
Restrictions
Noncancelable
Noncancelable
Early
Earlytermination
termination
Default
Default
Slide
21-1
Slide
21-2
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Advantages
Advantages of
of Leasing
Leasing
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.
100% Financing at Fixed Rates
Protection against Obsolescence
Capital Lease
Operating Lease
Flexibility
Journal Entry:
Rent expense
Cash
Less Costly Financing
Alternative Minimum Tax Problems
xxx
xxx
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).
OffOff-Balance SheetSheet-Financing
Statement of Financial Accounting Standard No. 13,
“Accounting for Leases,”
Leases,” 1980
Slide
21-3
Slide
21-4
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Compare
Compare capital
capital vs.
vs. operating
operating lease
lease
Mechanics
Mechanics
The
The expense
expense recorded
recorded on
on aa 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 aa 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, itit all
all goes
goes into
into rent
rent expense.
expense.
In
In aa capital
capital lease,
lease, think
think of
of itit as
as aa sale.
sale. The
The
commitment
commitment to
to the
the lessor
lessor is
is aa 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.
Slide
21-5
FACTS
Lease a computer worth
Lease term
Annual payment
Estimated life of a computer
Effective borrowing rate
3,000
3 yrs
1,143
4 yrs
7%
PRESENT VALUE OF PAYMENTS
ANNUAL DEPRECIATION
CAPITAL LEASE
Equipment
Cap lease obligation
Cash
Interest expense
Capital lease obligation
Depreciation expense
Accumulated depreciation
$3,000
$750
OPENING
3,000
3,000
YEAR ONE
YEAR TWO
1,143
210
933
750
YEAR THREE
1,143
145
998
750
750
1,143
75
1,068
750
NO OPENING ENTRY!
1,143
750
1,143
750
1,143
1,143
1,143
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
Bob AndersonAnderson- UCSB
Capitalization
Capitalization Criteria
Criteria
Leases that DO NOT meet any
of the four criteria are
accounted for as Operating
Leases
No
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
The lease transfers ownership
of the property to the
lessee.
Lease Agreement
No
Transfer
of
Ownership
Capital Lease
750
1,143
COMPARE EXPENSE OF THE TWO:
Capitalization
Capitalization Criteria
Criteria
No
0
(0)
750
OPERATING LEASE
Rent expense
Cash
Bob AndersonAnderson- UCSB
Lease Agreement
YEAR FOUR
No
O
p
e
r
a
t
i
n
g
No
No
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
L
e
a
s
e
Slide
21-7
No
Transfer
of
Ownership
Capital Lease
No
O
p
e
r
a
t
i
n
g
L
e
a
s
e
Slide
21-8
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Capitalization
Capitalization Criteria
Criteria
Capitalization
Capitalization Criteria
Criteria
Lease Agreement
No
Lease term can be extended by
a bargain renewal option.
option.
Lease Agreement
No
No
Transfer
of
Ownership
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
No
O
p
e
r
a
t
i
n
g
No
Slide
21-9
No
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
L
e
a
s
e
Capital Lease
No
Transfer
of
Ownership
No
O
p
e
r
a
t
i
n
g
L
e
a
s
e
Capital Lease
Slide
21-10
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Capitalization
Capitalization Criteria
Criteria
Three important concepts:
Lease Agreement


No
No
Transfer
of
Ownership
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
Capital Lease
Minimum lease payments:
Lease Agreement
Minimum lease payments
Executory costs
Discount rate

No
Capitalization
Capitalization Criteria
Criteria
No
O
p
e
r
a
t
i
n
g


No
No
No
Transfer
of
Ownership
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
L
e
a
s
e
Slide
21-11
Guaranteed residual value
Penalty for failure to renew
Bargain purchase option

Capital Lease
No
O
p
e
r
a
t
i
n
g
L
e
a
s
e
Slide
21-12
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Capitalization
Capitalization Criteria
Criteria
Executory Costs:
Lease Agreement


No
No
Transfer
of
Ownership
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
Capital Lease
Discount Rate:
Lease Agreement
Insurance
Maintenance
Taxes

No
Capitalization
Capitalization Criteria
Criteria
No
O
p
e
r
a
t
i
n
g
No
No
No
Transfer
of
Ownership
Bargain
Purchase
Lease Term
>= 75%
PV of
Payments
>= 90%
Yes
Yes
Yes
Yes
L
e
a
s
e
Slide
21-13
Lessee computes the PV of the minimum
lease payments using the lessee’s
incremental borrowing rate. (one
exception)
No
O
p
e
r
a
t
i
n
g
L
e
a
s
e
Capital Lease
Slide
21-14
Bob AndersonAnderson- UCSB
REAL
REAL WORLD
WORLD
Bob AndersonAnderson- UCSB
TEXT
TEXT example
example from
from p.1097
p.1097
The
The leasing
leasing companies
companies are
are hip
hip to
to these
these criteria
criteria and
and go
go
out
out with
with aa 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 itit works
works as
as an
an
operating
operating lease,
lease, doesn’t
doesn’t make
make itit so!!
so!!
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.
Slide
21-15
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
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
RESIDUAL
- LESSEE
VALUE
RESIDUAL VALUEVALUELESSEE
OPENING ENTRY:
Equipment
100,000
Capital lease obligation
1/1/05 ENTRY:
Lease liability
Property tax expense
Cash
100,000
23,982
2,000
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.
25,982
-
* smaller of lessee borrowing rate or lessor implicit rate
20,000
7,602
-
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 aa 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)
25,982
-
Slide
21-17
Slide
21-18
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
BARGAIN
BARGAIN PURCHASE
PURCHASE OPTION
OPTION
Illustration
Illustration
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 aa 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- 33 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 it’s
it’s 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
$250
$250
$$ 56
56
$306
$306
Slide
21-19
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 Company’s incremental borrowing rate is 12% a year (1% a
month). Simon’s implicit rate is unknown.
Instructions
Prepare the journal entries on the books of Delaney Company for the
first month of the lease.
Slide
21-20
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Solution
-2
E21
Solution E21E21-2
FACTS
Term of lease
Monthly rent
Rate
Guaranteed res. Value
Life of asset
Benefits
Benefits Available
Available To
To The
The Lessor
Lessor
50 months
200
12%
1,180
60 months
Interest Revenue
Tax Incentives
This is a capital lease because two of the criteria are met (only need one met)
Lease term
Life of asset
High Residual Value
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
Slide
21-21
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
Slide
21-22
$ 200.00
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Capitalization
Lessor))
((Lessor)
Capitalization Criteria
Criteria (Lessor
LESSOR:
LESSOR: DIRECT
DIRECT FINANCING
FINANCING VS.
VS. SALES
SALES TYPE
TYPE LEASES
LEASES
Group
Group II





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
IF
IF ALL
ALL THE
THE CRITERIA
CRITERIA ARE
ARE MET,
MET, THEN
THEN IT
IT IS
IS EITHER
EITHER AA
DIRECT
DIRECT FINANCING
FINANCING OR
OR SALES-TYPE
SALES-TYPE LEASE
LEASE TO
TO THE
THE
LESSOR:
LESSOR:

Group
Group II
II


Collectibility
Collectibilityof
ofthe
thepayments
paymentsrequired
requiredfrom
fromthe
thelessee
lesseeisisreasonably
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(lessor’s
(lessor’sperformance
performanceisis
substantially
substantiallycomplete
completeor
orfuture
futurecosts
costsare
arereasonably
reasonablypredictable).
predictable).

Why Group II Requirements?
Slide
21-23
Direct
Direct Financing:
Financing: Lessor
Lessor isis not
not making
making money
money from
from selling
selling the
the
product,
product, they
they are
are inin itit for
for the
the financing
financing aspect
aspect (more
(more like
like aa
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 isis getting
getting aa financing
financing fee,
fee, but
but ALSO
ALSO isis
making
making money
money from
from the
the product
product itself
itself as
as well
well (they
(they may
may be
be aa
manufacturer
manufacturer or
or retailer).
retailer). More
More complicatedcomplicated- need
need to
to deal
deal
with
with any
any profit
profit the
the lessor
lessor isis making
making from
from selling
selling the
the asset.
asset.
Slide
21-24
Bob AndersonAnderson- UCSB
Bob AndersonAnderson- UCSB
Payment
period
rate
PV
FV
Cost
Capitalization
Lessor))
((Lessor)
Capitalization Criteria
Criteria (Lessor
Group 1 criteria are the four criteria
that must be considered for
capitalization of a lease by a lessee.
Lease Agreement
Yes
Any Group 1
Criteria Met?
Collectibility
of Payments
Reasonably
Certain?
Yes
Lessor’s
Performance
Substantially
Complete?
UPON "SALE"
Cap lease receivable
Asset
YR 1
Cash
Interest income
Cap lease receivable
Yes
Is Asset
FMV >
Bookvalue?
Yes
Both
No
No
No
YR 2
Cash
SalesSales-Type
Lease
No
Slide
21-25
LESSOR- DIRECT FINANCING
258
258
100
21
79
100
Interest income
Cap lease receivable
Direct Financing
Lease
Operating Lease
100
3
8%
258
258
258
YR 3
Cash
Slide
21-26
14
86
100
Interest income
Interest income
Bob AndersonAnderson- UCSB
Payment
period
rate
PV
FV
Cost
100
3
8%
258
258
200
UPON "SALE"
Cap lease receivable
Asset
Gain
YR 1
Cash
Interest income
Cap lease receivable
YR 2
Cash
Bob AndersonAnderson- UCSB
LESSOR: SALES TYPE
Capitalization
Lessor))
((Lessor)
Capitalization Criteria
Criteria (Lessor
Is
Isititpossible
possiblethat
thataalessor
lessorhaving
havingnot
notmet
metboth
bothcriteria
criteriawill
willclassify
classifyaa
lease
leaseas
asan
anoperating
operatinglease
leasebut
butthe
thelessee
lesseewill
willclassify
classifythe
thesame
same
lease
leaseas
asaacapital
capitallease?
lease?
In
Insuch
suchan
anevent,
event,who
whowill
willhave
havethe
theasset
asseton
ontheir
theirbooks?
books?
258
200
58
100
21
79
100
Interest income
Cap lease receivable
YR 3
Cash
Slide
21-27
7
93
14
86
100
Interest income
Interest income
7
93
Bob AndersonAnderson- UCSB
Slide
21-28
Bob AndersonAnderson- UCSB
Capitalization
Capitalization Criteria
Criteria
Discount Rate:
Lease Agreement
No
Lesse e comput es th e PV of th e minimum
lease payments using the lessee’s
increme ntal borrowing rate. (one
exce ption)
No
No
Transfer
of
Ow nership
Bargain
Purchase
Lease Term
>= 75%
PV of
Pay ments
>= 9 0%
Yes
Yes
Yes
Yes
Capital Lease
No
O
p
e
r
a
t
i
n
g
L
e
a
s
e
Sl ide
22-13
Copyright
© 2000 by
Coby Harmon
Slide
21-29
Bob AndersonAnderson- UCSB