15-1 Intermediate Accounting,17E Stice | Stice | Skousen © 2010 Cengage Learning PowerPoint...

15-1

Intermediate Accounting,17E

Stice | Stice | Skousen

© 2010 Cengage Learning

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Leases

15-2

Economic Advantages to Leasing Over Purchasing

1. No down payment2. Avoid risks of ownership3. Flexibility

For the LesseeFor the LesseeFor the LesseeFor the Lessee

1. Increased sales2. Ongoing business relationship with lessee3. Residual value retained

For the LessorFor the LessorFor the LessorFor the Lessor

15-3

Simple Example

• Owner Company owns a piece of equipment with a market value of $10,000.

• User Company wishes to acquire the equipment.

• User Company can borrow $10,000 from the bank at 10% interest. Payments would be $2,638 each year for five years.

(continues)

15-4

Simple Example

• User Company can lease the equipment from Owner Company for five years and make five annual “rental” payments of $2,638. Owner maintains title throughout. At the end of the lease, the equipment is no longer useful.

• Should Owner Company recognize an equipment sale when the lease is signed?

(continues)

15-5

Simple Example

• Has effective ownership of the equipment been passed from Owner to User?

• Is the transaction complete?

• Is Owner Company reasonably certain the five annual payments can be collected from User Company?

(continues)

Key accounting issues for Owner Company

15-6

Simple Example

• On the date the lease is signed, should User recognize the lease equipment as an asset and the obligation to make the lease payment as a liability?

• The answer hinges on whether effective ownership, as opposed to legal ownership, of the equipment changes hands when Owner and User sign the lease agreement.(continues)

Key accounting issues for User Company.

15-7

The economic substance of this lease is that the lease signing is equivalent to the transfer of effective ownership, and the fact that Owner retains legal title of the equipment during the lease period is a mere technicality.

Simple Example

The arrangement should be treated as a sale by Owner and a purchase by User.

15-8

Scenario OneScenario OneScenario OneScenario One

The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but title is to pass to User at the end of the lease.

Even though this is a leasing arrangement, the transfer of title at the end indicates that this is in substance a purchase.

Simple Example

15-9

Scenario TwoScenario TwoScenario TwoScenario Two

The lease agreement stipulates that Owner Company is to maintain legal title to the equipment for the 5-year lease period, but at the end of the lease period User has the option to buy the equipment for $1.Offering the equipment to User Company for a bargain price at the end of the lease indicates that this is in substance a purchase.

Simple Example

15-10

Scenario ThreeScenario ThreeScenario ThreeScenario Three

The useful life of the equipment is just five years. Accordingly, when the lease term is over, the equipment can no longer be used by anyone else.

Because the life of this asset and the lease term are the same, this arrangement is in substance a purchase.

Simple Example

15-11

Scenario FourScenario FourScenario FourScenario Four

The present value of the lease payments equals the $10,000 market value of the equipment on the lease signing date.When the present value of the lease payments equals the lease item’s market value, it is in substance a purchase.

Simple Example

15-12

Capital vs. Operating Lease

• Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to lessee.

• Operating leases are accounted for as rental agreements.

15-13

Cancellation Provisions

Some leases are noncancelable, meaning that these lease contracts are cancelable only on the outcome of some remote contingency or that the cancellation provisions and penalties of these leases are so costly to the lessee that cancellation will not occur.

15-14

Bargain Purchase Option

If a lease includes a provision giving the lessee the right to purchase the leased property at a price that is expected to be considerably less than the fair value, the option is called a bargain purchase option.

15-15

Lease Term

• The lease term is the time period from the beginning to the end of the lease.

• The beginning of the lease term occurs when the leased property is transferred to the lessee.

• The end of the lease term is at the end of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised.

15-16

Residual Value

• The market value of the leased property at the end of the lease term is referred to as its residual value.

• Some lease contracts require the lessee to guarantee a minimum residual value. If the market value falls below the guaranteed residual value, the lessee must pay the difference.

15-17

Minimum Lease Payments

• The rental payments required over the lease term plus any amount to be paid for the residual value are referred to as the minimum lease payments.

• Lease payments sometimes include charges for insurance, maintenance, and taxes on the leased property. These are referred to as executory costs.

15-18

Lease 1

• The implicit interest rate is used to discount the minimum lease payments to the fair market value of the leased asset at the inception of the lease.

• The lessor always uses the implicit rate to discount rental payments.

• The interest rate that the lessee could use to borrow the amount of money necessary to purchase the leased asset is the incremental borrowing rate.

(continues)

15-19

Lease 1

• The lessee uses the lower of the implicit interest rate or the incremental borrowing rate to compute present value of minimum lease payments.

15-20

Lease Classification Criteria

1. The lease transfers ownership of the leased asset to the lessee by the end of the lease term.

2. The lease contains an option allowing the lessee to purchase the asset at the end of the lease term at a bargain price.

3. The lease term is equal to 75% or more of the estimated economic life of the asset.

4. The present value of the lease payments at the beginning of the lease is 90% or more of the fair market value of the leased asset.

A lease is classified as a capital lease by the lessee if it is noncancelable and meets any one of the following criteria:

15-21

IASB Approach

IAS 17, “Accounting for Leases,” states simply:

“A lease is classified as a finance (i.e., capital) lease if it transfers substantially all the risks and rewards incident to ownership.”

This places the responsibility of distinguishing the type of lease on the accountant.

15-22

General Classification Criteria—

Lessee and LessorThe four general criteria that apply to all leases for both the lessee and lessor relate to—• transfer of ownership

• bargain purchase option

• economic life

• fair value of the leased asset

15-23

Lease Classification―Lessor

Additional revenue recognition criteria applicable to lessors:1. Collectibility of the minimum

lease payments must be reasonably predictable.

2. Any unreimbursable costs yet to be incurred by the lessor can be reasonably estimated at the lease inception date.

15-24

Accounting for Operating Lease—Lessee

The lease terms for manufacturing equipment are $40,000 a year on a year-to-year basis. The entry to record the lease payment for the year would be:Rent Expense 40,000

Cash 40,000

15-25

The terms of the lease for an aircraft by International Airlines provide for payments of $150,000 a year for the first two years of the lease and $250,000 for each of the next three years. The total lease payments would be $1,050,000, or $210,000 a year on a straight-line basis.

(continues)

Operating Leases with Varying Lease Payments

15-26

Operating Leases with Varying Lease Payments

The required entries in the first two years would be as follows:

Rent Expense 210,000Cash 150,000Rent Payable 60,000current liabilitycurrent liability

The entries for each of the last three years are as follows:

Rent Expense 210,000Rent Payable 40,000

Cash 250,000

15-27

• Lease period: 5 years, beginning January 1, 2011, noncancelable

• Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs

• Estimated economic life of equipment: 5 years

• Expected residual value of equipment at end of lease period: None

Marshall Corporation—LesseeMarshall Corporation—LesseeMarshall Corporation—LesseeMarshall Corporation—Lessee

(continues)

Accounting for Capital Leases—Lessee

15-28

Leased Equipment 250,192

Obligations under Capital Leases 250,192

Marshall Corp. Entries on January 1, 2011Marshall Corp. Entries on January 1, 2011Marshall Corp. Entries on January 1, 2011Marshall Corp. Entries on January 1, 2011

Lease Expense 5,000Obligations under Capital Leases 60,000

Cash65,000

((PMTPMT = $60,000; = $60,000; NN = 5; = 5; II = 10%) = 10%)

((PMTPMT = $60,000; = $60,000; NN = 5; = 5; II = 10%) = 10%)


(continues)

15-29

(continues)

15-30

Marshall Corp. Entries on December 31, 2011Marshall Corp. Entries on December 31, 2011Marshall Corp. Entries on December 31, 2011Marshall Corp. Entries on December 31, 2011


Amortization Expense on Leased Equipment 50,038

Accumulated Amortization on Leased Equipment

50,038 $250,192 $250,192 ÷ ÷ 55

If normal company depreciation policy for this type of equipment is used, the amortization entry for 2011 is shown below:

(continues)

15-31

Prepaid Executory Costs 5,000Obligations under Capital Leases 40,981Interest Expense 19,019

Cash65,000


Entries on December 31, 2011Entries on December 31, 2011Entries on December 31, 2011Entries on December 31, 2011

($250,192 ($250,192 –– $60,000) $60,000) ×× 0.10 0.10

15-32

Accounting for Leases with a Bargain Purchase Option

• Frequently, the lessee is given the option of purchasing the property in the future at what appears to be a bargain price.

• The present value of the bargain purchase option would be added to the present value of the minimum lease payments to establish the initial asset and liability.

15-33

• There is a bargain purchase option of $75,000 exercisable after five years

LesseeLesseeLesseeLessee


• Lease period: 5 years, beginning January 1, 2011, noncancelable

• Rent amount: $65,000 per year payable annually in advance; includes $5,000 to cover executory costs

• Estimated economic life of equipment: 5 years• Expected residual value of equipment at end

of lease period: None

These are the same facts as These are the same facts as before, but with one new item.before, but with one new item.

15-34

Minimum Lease PaymentMinimum Lease PaymentMinimum Lease PaymentMinimum Lease Payment

Present value of five payments at the beginning of each year for five years:

PMT = $60,000, N = 5, I = 10% $250,192

Present value of the bargain purchaseoption of $75,000 at the end of 5 years:

FV = $75,000, N = 5, I = 10% 46,569 Present value of minimum lease payment $296,761


15-36

Entries on December 31, 2015Entries on December 31, 2015Entries on December 31, 2015Entries on December 31, 2015

Obligations under Capital Leases 68,182Interest Expense 6,818

Cash75,000

To record exercise of bargain purchase option.

Equipment 148,381Accumulated Amortization on

Leased Equipment 148,380Leased Equipment296,761

To transfer remaining balance inleased asset account to Equipment.

$68,182 $68,182 ×× 10%10%

($296,761 ($296,761 ÷ ÷ 10) 10) ×× 5 years5 years


15-37


If the equipment is not purchased and the lease is permitted to lapse, the following entry is required on December 31, 2015:

Loss from Failure to Exercise Bargain Purchase Option 73,381Obligation under Capital Leases 68,182Interest Expense 6,818Accumulated Amortization on

Leased Equipment 148,380Leased Equipment296,761

.

15-38

Accounting for Purchase of Asset During Lease Term

On December 31, 2013, the lessee purchased the leased property in the Marshall Corporation example for $120,000. At that date, the remaining liability recorded on the lessee’s books is $114,545 and the net book value of the recorded leased asset is $100,078 [capitalized value of $250,192 less $150,114 amortization ($50,038 × 3)].

(continues)

15-39

Given the facts in Slide 15-38, the entry to record the purchase on the lessee’s books would be as follows:Interest Expense 10,413Obligation under Capital Leases 104,132Equipment 105,533Accumulated Amortization on

Leased Equipment 150,114Leased Equipment250,192Cash120,000

[$100,078 + ($120,000 – $114,545)]

Accounting for Purchase of Asset During Lease Term

15-40

In 2011, Marshall Corporation’s income before any lease-related expenses is $200,000. Net income for the year is computed as follows:Income before lease-related expenses $200,000Lease-related interest expense (19,019)Lease-related amortization expense (50,038) Net income $130,943

Treatment of Leases on Lessee’s Statement of Cash

Flows

15-41

Accounting for Leases—Lessor

Direct financing leases involve a lessor who is primarily engaged in financing activities, such as a bank or finance company.

Sales-type leases involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products.

15-42

Revenue Generated by a Sales-Type Lease

A sales-type lease generates two different types of revenue:

1. An immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease

2. Interest revenue earned over time as the lessee makes the lease payments

15-43

Accounting for Operating Leases—Lessor

Minimum payment (in advance) including $5,000 executory cost $65,000/year

Lease period (beginning Jan. 1, 2011) 5 yearsEconomic life of asset 10 yearsEstimated residual value at end of lease $0Implicit rate 10%Incremental borrowing rate 10%Cost to lessor $400,000Direct costs incurred $15,000

Universal Leasing Co. (Lessor)Universal Leasing Co. (Lessor)Universal Leasing Co. (Lessor)Universal Leasing Co. (Lessor)

(continues)

15-44



To record the payment of the initial direct costs and the receipt of the lease payment on January 1, 2011:

Deferred Initial Direct Costs 15,000Cash 15,000

Cash 65,000Rent Revenue 60,000Executory Costs 5,000

(continues)

15-45



To record the amortization of direct costs over five years and the depreciation of equipment over ten years using the straight-line basis:Amortization of Initial Direct Costs 3,000

Deferred Initial Direct Costs 3,000

Depreciation Expense on Leased Equipment 40,000

Accumulated Depreciation on Leased Equipment 40,000

15-46

Accounting for Direct Financing Leases

Refer to Slides 15-27 and 15-28 for details concerning Marshall Corporation’s leasing arrangement with Universal Leasing Company. The cost of the equipment to Universal was the same as the fair value, $250,192 and Equipment Purchased for Lease was charged when the equipment was acquired.

Left click on the button to go to Slide 15-27, then type “46” and press the “Enter” key to return to this slide.

(continues)

15-47

To record initial lease on January 1, 2011:

Lease Payments Receivable 300,000Equipment Purchased for Lease 250,192Unearned Interest Revenue 49,808


(continues)

Receivable Recorded at Gross AmountReceivable Recorded at Gross AmountReceivable Recorded at Gross AmountReceivable Recorded at Gross Amount

To record first payment on January 1, 2011:

Cash 65,000Lease Payment Receivable 60,000Executory Costs 5,000

15-48


To record receipt of payment on December 31, 2011:Cash 65,000

Lease Payment Receivable 60,000Deferred Executory Costs (a liability) 5,000

Unearned Interest Revenue 19,019Interest Revenue 19,019

(continues)

15-49

Lessor Accounting for Direct Financing Leases with Residual Value

Assuming the same facts as the last illustration, except that the asset has a residual value at the end of the 5-year lease of $75,000. Assume the cost to Universal Leasing Company was $296,761 (which is also its fair value).

15-50


To record initial lease on January 1, 2011:

Lease Payments Receivable 296,761Equipment Purchased for Lease 296,761

(continues)

Receivable Recorded at Net AmountReceivable Recorded at Net AmountReceivable Recorded at Net AmountReceivable Recorded at Net Amount

To record first payment on January 1, 2011:

Cash 65,000Lease Payment Receivable 60,000Executory Costs 5,000

15-51


To record payment on December 31, 2011:

Cash 65,000Lease Payments Receivable 36,324Deferred Executory Cost 5,000Interest Revenue 23,676

To record recovery of the leased asset on December 31, 2015:

Equipment 75,000Lease Payment Receivable 68,182Interest Revenue 6,818

15-52

Accounting for Sales-Type Leases—Lessor

• If there is no difference between the sales price and the lessor’s cost, the lease is not a sales-type lease.

• The lessor will also recognize interest revenue over the lease term for the difference between the sales price and the gross amount of the minimum lease payments.

15-53


(3) Cost or carrying value of leased asset to lessor

Manufacturer’s or Dealer’s

Profit (Loss)

(1) Minimum lease payments

(2) Fair value of leased asset

Financial Revenue (Interest)

15-54


Fair value of equipment $250,192

Lease period (beginning Jan. 1, 2011) 5 years

Economic life of asset 10 years

Estimated residual value at end of lease $0

Implicit rate 10%

PV of future lease payments $250,192

Cost to lessor $160,000

Direct costs incurred $15,000

American Manufacturing Co. (Lessor)American Manufacturing Co. (Lessor)American Manufacturing Co. (Lessor)American Manufacturing Co. (Lessor)

(continues)

15-55


(1) Minimum lease payments: ($65,000 – $5,000) × 5

$300,000(2) Fair value of equipment

$250,192

$49,808 (Interest Revenue)

(3) Cost of leased equipmentto lessor, plus initial directcosts

$175,000

$75,192 (Mfr.’s Profit)

(continues)

15-56



Lease Payments Receivable 250,192Sales 250,192

Cost of Goods Sold 175,000Finished Goods Inventory 160,000Deferred Initial Direct Costs 15,000

Cash 65,000Lease Payments Receivable 60,000Executory Costs 5,000

To record entries on January 1, 2011:

15-57

• The minimum lease payments will include the following if they are part of the agreement:• A lump sum (from a bargain purchase

option) at the end of the lease term OR• A guaranteed residual value

• The receivable is increased by the gross amount of the bargain purchase option or the guaranteed residual value.

Accounting for Sales-Type Leases—BPO or Guaranteed R/V

15-58


Using the data from Exhibit 15-5, American Manufacturing offers a bargain purchase option of $75,000 at the end of five years.

(continues)

15-59



Cost of Goods Sold 175,000Finished Goods Inventory 160,000Deferred Initial Direct Costs 15,000

Cash 65,000Lease Payments Receivable 60,000Executory Costs 5,000



15-60

Accounting for Sales-Type Leases—Unguaranteed R/V

When a sales-type lease does not contain a bargain purchase option or a guaranteed residual value, but the economic life of the leased asset exceeds the lease term, the residual value will remain with the lessor. This is called an unguaranteed residual value.

15-61

Accounting for Sales-Type Leases—Unguaranteed R/V


Cost of Goods Sold ($175,000 – $46,569) 128,431Finished Goods Inventory ($160,000 –

$46,569) 160,000Deferred Initial Direct Costs 15,000

Lease Payments Receivable 46,569Finished Goods Inventory 46,569


Compare the entries below with the ones on Slide15-56.

Left click on the button to go to Slide 15-56, then type “61” and press the “Enter” key to return to this slide.

15-62

Sale of Asset During Lease Term

If the leased asset in Exhibit 15-8 below is sold on December 31, 2013, for $140,000 before the rental payment is made (the Lease Payments Receivable balance is $104,132),…

(continues)

15-63

Sale of Asset During Lease Term

…the following journal entry would be recorded on December 31, 2013, to record the sale:Cash 140,000

Interest Revenue 10,413Lease Payments Receivable 104,132Gain on Sale of Leased Asset 25,455

15-64

Treatment of Leases on Lessor’s Statement of Cash

FlowsIn 2011, American Manufacturing’s income before any lease-related items is $200,000. Net income for the year can be computed as follows:Income before lease-related items $200,000Lease-related sales 250,192Lease-related cost of goods sold (175,000)Leased-related interest revenue 19,019 Net income $294,211

15-65

Disclosure Requirements for Leases

• For an operating lease, the lease-related asset and liability are off-balance-sheet items.

• It is important for the financial statement user to be able to interpret the associated note.

• Lessee is required to provide enough note disclosure to allow the users to quantify the magnitude of the operating leases.

• Lessor is required to provide enough disclosure to allow the financial statement user to figure out the extent to which lease-related sales and rentals have impacted the lessor’s financial statements.

15-66

International Accounting

of Leases• IAS 17 relies on the exercise of

accounting judgment to distinguish between operating and capital leases.

• A proposal, titled “Accounting for Leases: A New Approach,” suggests that all lease contracts longer than one year be accounted for as capital leases.

• This proposal is still under discussion.

15-67

Sale-Leaseback Transactions

On January 1, 2011, Hopkins Inc. sells equipment having a carrying value of $750,000 to Ashcroft Co. for $950,000 and immediately leases back the equipment. Terms of the lease are:1. The term of the lease is 10 years,

noncancelable. A down payment of $200,000 is required plus equal lease payments of $107,107 at the beginning of each year. The implicit rate is 10%. (continues)

15-68


2. The equipment has a fair value of $950,000 and an expected life of 20 years. Straight-line depreciation is used.

3. Hopkins has an option to renew the lease for $10,000 per year for 10 years, the rest of its economic life. Title passes at the end of the lease.

(continues)

15-69


(continues)

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15-1 Intermediate Accounting,17E Stice | Stice | Skousen © 2010 Cengage Learning PowerPoint...

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