Accounting for Leases

1
Chapter 15

• Accounting for Leases

2
Accounting for Leases

• According to to FASB statement No. 13 , a lease
  is defined as an agreement conveying the right
  to use property, plant, or equipment for a stated
  period of time.

3
Accounting for Leases (contd.)

• A lease involves a lessee and a lessor.
• A lessee acquires the right to use the property,
  plant and equipment and a lessor gives up the
  right.
• A lease is a contractual agreement and therefore
  the parties involved can incorporate any
  provision in the contract. All kinds of assets
  can be leased.
• Among the most popular are photocopies, computer,
  airplanes, and warehouses.

4
Accounting for Leases (contd.)

• This chapter emphasizes the long-term
  non-cancelable leases involving depreciable
  personal property such as equipment, machinery,
  trucks and other movable assets.
• The lease of real property (land, building and
  other items firmly attached to the land) and
  certain other specialized lease issues are also
  discussed.

5
Advantages of Leasing from Lessees viewpoint
1. Financing benefits a. The lease provides 100
financing (no down payment is needed). For
companies with cash shortage, lease is a
good alternative to purchase b. The lease
contract may contain fewer restrictive
provisions than other debt agreement and c. The
lease agreement creates a claim that is against
only the leased asset , not against all assets.
6
Advantages of Leasing from Lessees viewpoint
(contd.)
2. Risk benefit Reduce the risk of
obsolescence. 3. Tax benefit Tax deduction
may be accelerated since it is often spread over
the lease term (rather than the economic life
of the property). The full cost of the leased
asset can be written off including the part
that relates to land.
7
Advantages of Leasing from Lessees viewpoint
(contd.)
4.Financial reporting benefit For an
operating lease, the lease does not add a
liability or an asset to the balance sheet,
and therefore does not affect financial ratios.
5.By maintaining these ratios, the company's
borrowing capacity can also be
maintained. (See a numerical example later. In
general,when an asset and a liability are
added to the balance sheet, the current ratio
will be reduced, and the debt to equity ratio
will be increase)
8
Advantages of Leasing from Lessees viewpoint
(contd.)
5. Billing benefit Leasing permits higher
charges because the interest element contained
in the rental payments is treated as an
expense. 6.Less Costly Financing The
income tax savings on depreciation expenses for
the leasing company(the lessor) may pass on to
the lessee in the form of a reduced rental
payment.
9
Advantages of Leasing from Lessees viewpoint
(contd.)

• An example of using leasing to achieve off
  balance sheet financing assuming that in 20X1,
  two identical companies, A and B, have the
  following data prior to any new acquisitions
• current assets 3,000,000 noncurrent
  assets 5,000,000 current liabilities 2,000,000
  noncurrent liabilities 2,500,000 stockholders
  equity 3,500,000

10
Advantages of Leasing from Lessees viewpoint
(contd.)

• On December 31, 20X1, a company purchases an
  equipment with a 5-year life costing 3,018,400
  by signing a 5-year, 8 note requiring 755,923
  to be paid at the end of each year staring
  December 31,20X2. The payments include interests
  at 8 on the beginning-of-year principal
  balance.The remainder of each annual payment
  reduces principal.
• A company records the asset purchased and the
  note payable. As financial data show the
  following changes

11
Advantages of Leasing from Lessees viewpoint
(contd.)

• noncurrent assets 5,000,000 3,018,400
  8,018,400
• current liabilities 200,000 755,923
  0.926 2,699,985
• noncurrent liabilities 2,500,000
  (3,018,400 - 699,985)
  4,818,415
• The rest remains unchanged.

12
Advantages of Leasing from Lessees viewpoint
(contd.)
Therefore Before
Acquisition After acquisition current ratio
3,000,000/2,000,000 3,000,000/2,699,985
1.5 1.11 debt to
stockholder equity 4,500,000/3,500,000
(2,699,9854,818,415) 3,500,000
1.29 2.15
13
Advantages of Leasing from Lessees viewpoint
(contd.)

• The current ratio falls significantly (from 1.5
  to 1.11) while the debt to stockholders equity
  ratio increases 67 after the acquisition.
• The rate of return on investment in 20X2 could
  also be impaired (due to the increase of
  noncurrent assets).
• These adverse impact on financial ratios will
  damage the borrowing capacity of A company and
  may also affect its ability to sell stock.

14
Advantages of Leasing from Lessees viewpoint
(contd.)

• On the other hand, assume that B company leases
  identical equipment by the use of a lease and
  agrees to pay 755,923 rent each year for the
  next 5 years. If interest rate is 8, the present
  Value (P.V.) of the equipment is 3,018,400.
• If the lease is classified as a capital lease,
  than, B records an asset and a liability and the
  effects on its B/S are the same as the effects
  of purchase on As B/S.

15
Advantages of Leasing from Lessees viewpoint
(contd.)

• However, if the lease is classified as an
  operating lease, B does not have to record an
  asset or a liability.
• Therefore, the financial ratios (i.e, the current
  ratio) will be same as before the acquisition.
• In sum, two identical economic events (both
  acquiring the right to use the equipment.) can
  have very different impact on key ratios of
  financial statement(F/S).

16
Advantages of Leasing from Lessors viewpoint
(contd.)
1. A way of indirectly making a sale. 2. An
alternative means of engaging in a profit
opportunity. The lease agreement enables the
lessor to earn a normal rate of return (in a form
of interest) on the cost of leased asset.
17
Classification of Personal property Leases

• FASB statement No. 13 requires that a lease that
  transfers substantially all the risks and
  benefits of ownership to the lessee represents a
  purchase by the lessee and a sale by the lessor
  (i.e., a capital lease).
• This statement provides criteria for determining
  the classification of leases by both lessees and
  lessors.

18
Classification of Leases
Involving Personal PropertyGeneral Criteria for
classifying leasesExhibit 1

• Column B Criteria Applicable to
  Lessor Only
• a.The collectibility of the minimum lease
  payments is reasonably assured (i.e.,
  predictable).
• b.No important uncertainties surround the amount
  of unreimbursable cost yet to be incurred by
  the lessor under the lease.

• Column A Criteria Applicable
  to Both Lessee and Lessor
• a.The lease transfers ownership of the property
  to the lessee by the end of the lease term.
• b.The lease contains a bargain purchase option
• c.The lease term is equal to or greater than 75
  of the estimated economic life of the leased
  property.
• d.The present value of the minimum lease
  payments (MPV) is equal to 90 or more of the
  fair value of the leased property to the lessor.

19
Classification by the lessee

• Capital lease. Lease that meets one or more of
  the criteria in column A.
• Lessee should treat capital lease as a purchase
  of asset recognize leased asset and obligation
  under capital lease.
• Operating lease. Lease that does not meet any of
  the criteria in Column A.

20
Classification by the Lessor

• Sales-Type lease Lease that meets these
  three criteria
• 1. One of more of the four criteria listed in
  column A 2. Both criteria in column B
  and 3. Transaction giving rise to a
  manufacturer or dealers profit (or loss) to
  the lessor. A profit exists when the fair
  market value of the leased property (at the
  inception of the lease) is greater than its cost
  or carrying value.

21
Classification by the Lessor (contd.)

• Direct Financing lease Lease that meets
  these three criteria
• 1. One or more of the four criteria in column
  A 2. Both criteria in column B and 3. No
  manufactures or dealers profit.
• Operating lease Lease that meets none of the
  criteria in column A, or does not meet
  both criteria in column B.
• Items c and d do not apply if the beginning of
  the lease term falls within the last 25 of the
  total estimated economic life.

22
Key Terms Related to Leases

• Bargain Purchase Option A provision allowing
  the lessee to purchase the leased property at the
  end of the life of the lease at a price so
  favorable that the exercise of the option
  appears, at the inception of the lease, to be
  reasonably assured.
• Estimated Economic Life The estimated
  remaining period during which the property is
  expected to be useable for the purpose that was
  intended at the inception of the lease, with
  normal repair and maintenance.

23
Key Terms Related to Leases (contd.)

• Fair Value of Leased Property Price for which
  the property can be sold in an arms length
  transaction between unrelated parties.
  For manufacturers and dealers, the fair value is
  the selling price (adjusted for trade discount
  and other unusual market condition).
  For others, the fair value is the cost of the
  asset to the lessor.

24
Key Terms Related to Leases (contd.)

• Minimum Lease Payments(MLP) Payments that are
  required to be paid by the lessee to the lessor
  over the life of the lease.
• For a lease with a bargain purchase option (BPO),
  the MLP include
• 1.The minimum periodic payments required by the
  lease over the lease term and
• 2. The payment required by the BPO.

25
Key Terms Related to Leases (contd.)

• Otherwise, the MLP include
• 1.The minimum periodic payments, plus 2.Any
  guaranteed residual value, and 3.Any payments
  or failure to renew or extend the lease.

26
Key Terms Related to Leases (contd.)

• Executory costs are not included in MLP.
• Executory costs are ownerhip-type costs (such
  as insurance, maintenance and property taxes).
  
• The cost may be paid by either the lessor or
  the lessee (depends on the provision).
• Normally, it is expected to be paid by the
  party with the ownership.

27
Example and Accounting Treatment of operating
lease Exhibit 3

• Terms and provisions of lease agreement
  between landlord company (lessor) and tenant
  company (lessee) dated January 1,1995
• 1.The lease term is 5 years. The lease
  is noncancelable and requires equal rental
  payments of 50,000 at the beginning of each
  year.
• 2.The cost, and also fair value, of the equipment
  to the Landlord Company at the inception of the
  lease is400,000. The equipment has an estimated
  economic life of 10 years and has a zero
  estimated residual value at the end of this
  time.

28
Example and Accounting Treatment of operating
lease Exhibit 3 (contd.)

• 3.There is no guarantee of the residual value by
  the Tenant Company.
• 4.The Landlord Company agrees to pay all
  executory costs.
• 5.The equipment reverts to the Landlord Company
  at the end of the 5 years that is, the lease
  contains no bargain purchase option and no
  agreement to transfer ownership at the end of
  the lease.
• 6.The Tenant Companys incremental borrowing rate
  is 12.5 per year.
• 7.For the Landlord Company, the interest rate
  implicit in the lease is 12.
• 8.The present value of an annuity due (in
  advance) of 5 payments of 50,000 each at 12
  is 4.037349 50,000 201,867.45

29
APPLICATION OF CRITERIA FOR DETERMINATION OF
LEASE CLASSIFICATION BY TENANT (LESSEE)

• Classification Criteria Criteria Met?
  Remarks
• 1. Transfer of ownership at end of lease No
• 2. Bargain purchase option No
• 3. Lease term is 75 of economic life
  No It is 50
• 4. Present value of lease payments is 90
• of fair value
  No The present value is
  201,867.45, or 67
  of fair value
• Decision A capital lease must meet one or more
  of the classification criteria otherwise
  the lease is an operating lease.
• Conclusion the lease is an operating lease. It
  meets none of the criteria.

30
APPLICATION OF CRITERIA FOR DETERMINATION OF
LEASE CLASSIFICATION BY TENANT (LESSEE) (contd.)

• The only journal entry recorded by the lessee
  is 1-1-95 Rent Expense 50,000 Cash
  50,000
• Similar entry will be recorded at the beginning
  of 1996 through 1999. If interim statements are
  prepared, adjusting entry is needed to account
  for the unexpired portion of the prepaid rent.
• Under the operating lease, neither an asset nor a
  liability is recognized.

31
Capital Lessee (for lessee)

• Lessee records an asset (i.e., leased
  equipment) and a liability (i.e., obligation
  under capital lease) equals to the sum of
  present value (at the beginning of the lease
  term) of the minimum lease payments (MLP) during
  the lease term.
• In a capital lease, the lessee is usually
  responsible for the executory costs. If these
  costs are paid by the lessor, these costs
  should be deducted from the lease payments in
  computing the MLP. (Because, portion of the
  lease payments are reimbursement to the lessor
  for the executory costs paid by the lessor).

32
Discount Rate (used in computing the present
value of the MLP)

• The lessee should use the lower of
• a.The lessees incremental borrowing rate
  (borrowing additional cash for the purchase of
  identical property).
• b.The lessors interest rate implicit in the
  lease if known by the lessee. (If unknown, the
  lessee can use available information (i.e., BPO
  price, guaranteed residual value) to calculate
  the implicit rate.
• If b cannot be obtained, use a.

33
Depreciation or Amortization of Criteria for
Leased AssetsExhibit 4
34
Depreciation or Amortization of Criteria for
Leased AssetsExhibit 4 (contd.)
a.Depreciates to the estimated residual
value. b.Depreciates or amortizes to the
guaranteed residual value (if there is any)
If not, depreciate to zero. Both
Amortization and depreciation term can be
used. FASB uses Amortization more often due
to leased asset is an intangible.
35
Examples and Accounting Treatments for Capital
Leases (Lessee)

• Example I Equipment is leased under an
  agreement without a purchase or bargain purchase
  option.
• Exhibit 5
• Terms and provisions of lease agreement
  between Gardner company (lessor) and Martin
  company (lessee) dated January 1,1995
• 1.The lease term is 4 years. The lease is
  noncancelable and requires equal payments of
  32,923.45 at the end of each year.

36
Examples and Accounting Treatments for Capital
Leases (Lessee) (contd.)
2.The cost, and also fair value, of the equipment
to the Gardner Company at the inception of the
lease is 100,000. The equipment has an
estimated economic life of 4 years and has a
zero estimated residual value at the end of
lease term. 3.There is no guarantee of the
residual value by the Martin Company. 4.The
Martin Company agrees to pay all executory
costs. 5.The equipment reverts to the Gardner
Company at the end of the 4 years that is, the
lease contains no purchase provisions.
37
Examples and Accounting Treatments for Capital
Leases (Lessee) (contd.)
6.The Martin Companys incremental borrowing rate
is 12.5 per year. 7.The Martin Company uses the
straight-line method to record depreciation on
similar equipments. 8.For the Gardner Company,
the interest rate implicit in the lease is 12.
The Martin Company knows this rate. 9.The
present value of an ordinary annuity of 4
payments of 32,923.45 each at 12 is 100,000,
calculated as follows 3.037349 32,923.45
100,000. (this is the only present value
calculation necessary, since there is no
guaranteed residual value or bargain purchase
option.)
38
Application of criteria to determine the lease
classification by Lessee

• Classification Criteria Criteria Met?
  Remarks
• 1. Transfer of ownership at end of lease No
  Title reverts to lessor
• 2. Bargain purchase option No
• 3. Leas term is 75 or more of economic life
  Yes 100 of
  estimated life
• 4. Present value of MLP is 90 or more
• of fair value Yes The
  Present value is
  100,000, or 100 of
  fair value
• Decision A capital lease must meet one or more
  of the classification criteria otherwise,
  the lease is an operating lease.
• Conclusion The lease is a capital lease. It
  meets two of the four criteria.

39
Journal Entries for Capital Lease (Lessee)

• The journal entries to record the acquisition of
  the leased asset, the amortization
  (depreciation) for 4 years by Martin Company
  (the lessee) are as follows
• 1. Initial Recording of capital lease on 1/1/95
• Leased Equipment under Capital Lease (C.L.)
  100,000
• Obligation under Capital Lease 100,000
• (or Lease Payable)
• (MLP 32,923.45 3.037349 100,000)
• P.V. of ordinary annuity, 12, 4-period

40
Journal Entries for Capital Lease (Lessee)
(contd.)

• 2. First payment (on 12/31/95)
• Interest Expense 12,000 Obligation under
  C.L. 20,923 Cash 32,923
• 100,000 12 12,000 Interest Expense
  under effective interest method Interest
  Expense P.V. of liability. effective
  interest. rate.

41
Journal Entries for Capital Lease (Lessee)
(contd.)

• 3.Recognition of Annual Depreciation (or
  amortization)of leased equipment on
  12/31/95 Depreciation Expense Leased Equipment
  25,000 Acc. Depreciation Leased Equipment
  25,000
• The asset is amortized over the lease term
  because the lease does not include a transfer of
  ownership or a BPO. Depreciate to zero due to
  no guaranteed residual value.

42
Journal Entries for Capital Lease
(Lessee) (contd.) ReportingBalance Sheet
(12/31/95)

• Assets Liabilities
• PPE Current Liability
• Leased Equipment 100,000 Obligation
  under capital lease 23,434a
• Acc. Depr.Leased Equip (25,000) Long-Term
  Liability
• Obligation Under C.L
  55,643b

a. 32,923.45-(100,000-20,923)0.1223,434 b.
100,000 - 20,923 - 23,434 55,643
43
Journal Entries for Capital Lease (Lessee)
(contd.)

• 4. Payment on 12/31/96 Interest
  Expense 9,489.19a Obligation Under Cap.
  Lease 23,434.26b Cash 32,923.45
• a. P.V. of liability ar the beginning of 1996
  12 (100,000-20,923.45) 12
  9,489.12
• b. 32,923.45 -9489.19 23,434.26
• 5. Depreciation Expense of 96 Depreciation
  Expense Leased Equip. 25,000 Acc.
  Depreciation Leased Equip 25,000

44
Journal Entries for Capital Lease (Lessee)
(contd.)

• 1997Interest Expense 6,677.17
• Obligation 26,246.38
• Cash 32,923.45
• Depreciation Expense Leased Equip 25,000
• Acc Depreciation L.E 25,000

• 1998Interest Expense 3,527.54
• Obligation 29,395.91
• Cash 32,923.45
• Depreciation Expense Lend Equip 25,000
• Acc Depreciation LE 25,000

45
Summary of lease payments and interest expense of
Martin company (Lessee)

• Payments at End of Year

46
Summary of lease payments and interest expense of
Martin company (Lessee) (contd.)

• a. Column 5 at beginning of year 12
• b. Column 2 - Column 3
• c. Column 5 at beginning of year - Column 4
• d. adjusted for rounded error of 0.03.

• Executory costs paid by the lessee are recorded
  as operating expenses. If these costs are paid
  by the lessor, they should be deducted from the
  computation of MLP.

47
Examples and Accounting Treatments for Capital
Leases (Lessee) (contd.)

• Example II Lease Payments are required to be
  made at the beginning of the year. Assume all the
  lease provisions are the same as in example I
  except that the lease payments are made at the
  beginning of each year. The cost also the fair
  value of the equipment is 112,000.
• P.V. of MLP 32,923.42 3,401831
• 112,000.

48
Journal Entries for Capital Leases (Lessee)
(contd.)

• 1. Initial Recording
• Leased Equip under C.L. 112,000
• Obligation under C.L. 112,000

2. Payment on 1-1-95 (the inception of the
lease) Obligation under C.L. 32,923.45 Cas
h 32,923.45
3. Recording of Depreciation on 12-31-95
Depreciation Expense Leased
Equipment 28,000 Acc. Depreciation Leased
Equipment 28,000
49
Journal Entries for Capital Leases (Lessee)
(contd.)

• 4. Recording accrued Interest Expense
• 12-31-95 Interest Expense 9,489.19a
• Accrued Interest on 9489.19
• Obligation under Capital Lease
• a. (112,000 -32,923,45) 12

5.Second annual payment in advance on
1/1/96 Accrued Interest on Obligation
9,489.19 Obligation under C.L.
23,9434.26 Cash 32,923.45
Similar Entries will be recorded for 12/31/96,
1/1/97, 12/31/98, 1-1-98 (no accrued interest on
12/31/98).
50
Summary of lease payments and interest expense of
Martin company (Lessee)Payment in Advance
51
Example and Accounting Treatments for Capital
Leases with BPO (Lessee) (contd.)

• Example III Capital Lease with Bargain Purchase
  Option. Terms and Provisions of Lease
  Agreement Dated 1-1-95
• 1.The lease term is 4 years. The lease is
  noncancelable and requires equal payments of
  40,000 at the end of each year.
• 2.The lease includes an option to pay 2,000 at
  the end of the fourth year to purchase the asset.
  (Consider as a BPO because the amount is much
  lower than the expected value of the asset at the
  end of 4the year).
• 3.The incremental borrowing rate of the lessee is
  10 (lower than the implicit interest rate of the
  lessor).
• 4.The cost (and also the fair value) of the
  equipment is 128,160.63.

52
Journal Entries for Capital Leases with BPO
(Lessee) (contd.)

• The lease qualities as a capital lease because it
  includes a BPO. MLP of the lease is P.V.
  of annual payments discounted at 10 40,000
  3.169865 126,794.60
• P.V. of the BPO price
  2,000 0.683013
  1,366.03 128,160.63
• Initial recording (by Lessee)
• 1/1/95 Leased Equipment under C.L.
  128,160.63 Obligation under C.L.
  128,160.63

53
Journal Entries for Capital Leases with BPO
(Lessee) (contd.)

• 12/31/95 Interest expense 12,816
  a Obligation under C.L. 27,184 Cash 40,00
  0
• a. 128,160.63 10 12/31/95 Depreciati
  on Expense Leased Equipment 10,000 Acc.
  Depreciation LE 10,000 (128,160.63 -
  estimated residual value of 28,160.13)/ estimated
  economic life of 10 10,000

54
Journal Entries for Capital Leases with BPO
(Lessee) (contd.)

• By the end of 4th year, the obligation account
  will have a balance of 2,000. When the lessee
  exercises the BPO, the following J.E. will be
  recorded Obligation under
  C.L 2,000 Cash 2,000
• By the end of the 4th year, the Acc. Depr LE
  will have a balance less than the balance of
  leased equipment (128,160.63) if the estimated
  economic life is greater than 4 years and
  Estimated R.V not equal to zero.

55
Journal Entries for Capital Leases with BPO
(Lessee) (contd.) Example IIICapital Lease
for Lessee(with BPO)
56
IIICapital Lease for Lessee(with guaranteed
Residual Value)

• Guaranteed Residual value Lease provision
  will include guaranteed residual value only if
  no ownership transfer and no BPO
• The Provision (or all) if the estimated residual
  value of the leased property that is guaranteed
  by the lessee (or by a third party not related to
  the lessor) If the residual value is guaranteed
  in case when the fair market value of the leased
  property at the end of the lease term is less
  than the guaranteed amount, the lessee has to pay
  (in cash) the difference to the lessor.

57
Example IV Capital Lease with Guaranteed
Residual value

• Terms and provisions of the lease agreement dated
  1/1/95
• 1. Lease Term 4 years
• 2. Cost Fair market value 147,284.99
• 3. Annual lease payment by lessee is 40,000 at
  the end of each year
• 4. Estimated residual value at the end of 4th
  year 30,000
• 5. The lessee agrees to guarantee the entire
  amount of residual value
• 6. Discount Rate 10.
• The lease qualifies as a capital lease because
  MLP is 100 of the fair market value.

58
Example IV (Contd.)

• MLP
• P.V. of annual lease payment
• 40,000 3.16985 126,794.60
• P.V. of guaranteed R.V.
• 30,000 0.683013 20,490.39
• 147,284.99
• 1/1/95 Recording of Lessee
• Leased Equipment under CL 147,284.99
• Obligation under C.L. 147,284.99

59
Example IV (Contd.)

• The asset will be amortized over the lease term
  (4 years) to the guaranteed R.V. of 30,000. The
  liability is reduced by using the effective
  interest method. At the end of the 4th year, the
  obligation account will have a balance of
  30,000. The balance of Acc. Depreciation account
  will be 147,284.99 - 30,000 117,284.99 by the
  end of the 4th year. At the end of the 4th year,
  the lessee will have the following balance
• Account Balance
• Leased Equipment under Capital Lease
  147,284.99 (Dr.)
• Acc. Depreciation Lease Equipment 117,284.99
  (Cr.)
• Obligation under C.L 30,000
  (Cr.)

60
Example IV (Contd.)

• If the fair market value of the leased equipment
  at the end of 4th year is 10,000 less than the
  guaranteed R.V., the following entry will be
  recorded for the disposal
• Obligation under C.L 30,000
• Acc Depr Leased Equip 117,284.99
• Loss on Disposal of Leased Equipment 10,000
• Leased Equipment 147,284.99
• Cash 10,000

61
Example IV (Contd.)
62
Accounting and Reporting by Lessor

• Types of leases classified by lessor
• 1.Operating lease. A lease that meets none
  of the criteria in column A or does not meet
  both criteria in column B of Exhibit 1 .
• 2.Sale-type lease. A sale-type lease
  involves the recognition of a manufacturers or
  dealers profit (or loss) and meets one or more
  of the criteria in column A and both criteria in
  column B of Exhibit 1.

63
Accounting and Reporting by Lessor(Contd.)

• 3.Direct-financing lease. A direct-financing
  lease involves no manufacturers or dealers
  profit and meets one or more of the criteria in
  column A and both criteria in column B of
  Exhibit 1.
• 4.Leveraged lease. A special three-party lease
  which is considered to be a direct-financing
  lease.

64
Operating Lease (Lessor)

• Under an operating lease, lessor retains
  substantially all the risk and benefit of
  ownership. The leased equipment is reported
  on the balance sheet in Property,Plant and
  Equipment subsection entitled Equipment
  leased to others and record depreciation.
  The lessor usually pays the executory fees and
  records them as operating expenses.

65
Operating Lease (Lessor)(Contd.)

• The accounting treatment of an operating lease
  (for lessor)
• Example assume that landlord Company (lessor)
  Leases a piece of equipment to Tenant Co.
  (lessee) for 5 years under the term described
  on page 26. Tenant agrees to pay 50,000 at the
  beginning of each year. The equipment was
  purchased by Landlord at a cost of 300,000. It
  has an estimated life of 10 years.

66
Operating Lease (Lessor) (contd.)

• Landlord uses straight-line depreciation
  method. On 1/10/95, the lessor pays the annual
  insurance premium of 2,000 and on12/15/95,it
  pays for repair expense of 1,500. Assuming no
  initial direct costs, the preceding information
  is recorded in the following journal entries
• 1. Purchase of equipment to be leased on
  1/1/95 Equipment leased to others 300,000 Cas
  h (or Equipment if equipment was
  already owned) 300,000
• 2.Collection of annual payment on operating
  lease on 1/1/95 Cash 50,000 Rental
  Revenue (or Unearned rent) 50,000

67
Operating Lease (contd.)

• 3. Payments of annual insurance premium on
  1/10/95 (an executory cost) Insurance
  expense 2,000 Cash 2,000
• 4.12/15/95 Payment for Repair expense
  1,500 Cash
  1,500
• 5. Recognition of Annual depreciation
  expense Depreciation Expense Equipment leased
  to others 30,000 Acc. Depreciation
  Equipment leased to others 30,000
  (300,000/10 30,000)

68
Initial Direct Costs (involving in an operating
lease)

• Initial Direct Costs are costs that result
  directly from acquiring a lease and would not
  have been incurred had that lease transaction
  not occurred. For an operating lease, these
  costs are recorded as a prepaid asset and are
  allocated to an operating expense in proportion
  to the rental received over the lease term
  (exercise the matching principle).

69
The Accounting Treatment for Capital Lease
(Lessor)

• Example 1 Direct financing with no unguaranteed
  residual value and payments made at the end of
  year.
• Use the example of Gardner and Martin Company
  in exhibit 5, and
• 1.The collectiblity of rental is reasonably
  assured and no uncertainties involved in the
  lease.
• 2.No initial direct costs.
  The cost of the equipment (and
  the fair value) is 100,000. The implicit
  interest rate of the lease is 12 on the net
  investment (minimum lease payments receivable
  - unearned interest leases). The annual rental
  payments charged by the lessor can be calculated
  as follows 100,000 / 3.037349 32,923.45
• P.V. of an annuity for 4 periods at 12.

70
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• The lease is a direct, not a sale-type lease
  because the fair market value of the property is
  equal to the cost.
• The minimum lease payments receivable (MLPR)
  for the lessor is The undiscounted annual
  payments Undiscounted Unguaranteed Residual
  value to be collected from the lessee less any
  executory costs paid X by the lessor.
  
• In the previous example, the MLPR is equal to
• 4(32,923.45 - 0) 0 131,693.80

71
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• 1. Initial recording of the lessor on 1/1/95
• Minimum Lease Payments Receivable 131,693.80
• (or Lease Receivable)
• Equipment 100,000
• Unearned Interestleases 1,693.80
• The unearned interest is a contra to MLPR.
  Net investment MLPR- unearned interest. The
  equipment has not transfer to the lessee
  because from an economic-substance-over-legal
  point of view, a direct - financing lease is
  treated as a disposal of an asset.

72
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• 2.Collection of annual payment at the end of
  first year on 12/31/95
• Cash 32,923.45
• MLPR(or Lease Receivable) 32,923.45
• 3.Recognized of Interest Revenue on 12/31/95
• Unearned Ineterst Leases 12,000
• Interest revenue Leases 12,000
• The unearned interest is amortized using
  effective interest method. The amount of
  interest revenue recognized is 12 (the
  discount rate) times the net investment at the
  beginning of the period .
• gt12 100,000(Net Inv at 1/1/95)

73
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• Therefore, the net investment on 12/31/95 is
  equal to 98,770.55 - 19,693.80 79,076.55
• Reporting MLPR is divided into current and
  noncurrent portions for B/S reporting purposes.
• Current Noncurrent
  Total MLPR
• 32,923.45 a 65,840.90 b
  98,770.35
• (9,489.19) c (10,204.60) (19,693.80)
• Net Investment 23,434.26 55,636.30
  79,076.55
• a. The lessees annual payment of 1996
• b. 98,770.35 -32,923.45
• c. 79,076.55 (Net Investment) 12

74
The Accounting Treatment for Capital Lease
(Lessor) (contd.)

• 4.Collection of Annual Payment for second year
  on 12/31/96
• Cash 32,923.45
• MLPR 32,923.45
• 5.Recognized of Interest Revenue on 12/31/96
• Unearned InterestLeases 9,489.19
• Interest Revenue 9,489.19

75
Summary of lease payments received and interest
revenue earned by Gardner company (Lessor)

• Receipts at End of Year

a. column 7 at beginning of year 12 b. Column
2 - Column 3 c. Annual lease payment Number of
years remaining on lease d. Previous
balance - Column 3 e Column 5 - Column 6
76
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• Example 2 Direct Financing with no unguaranteed
  residual value and payments received in advance
  on 1/1/95, Watkins leases equipment to the
  Hutton company, with the terms and provisions of
  the lease as indicted in Exhibit 9.
• Terms and provisions of lease agreement
  between Watkins company (Lessor) and Hutton
  company (Lessee) dated January 1, 1995
• 1.The cost, and fair value, of the equipment is
  391,371.20
• 2.The initial direct costs incurred by Watkins
  Company are assumed to be zero.

77
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• 3.The term of the lease is 5 years, with annual
  payments of 100,000 received in advance at the
  beginning of each year.
• 4.The economic useful life of the equipment is 5
  years, there is no estimated unguaranteed
  residual value and the lessee is not required to
  guarantee any estimated residual value.
• 5.The lease receipts are determined at an amount
  that will yield to the Watkins Company a 14
  annual rate of return on net investment.
• 6.The Hutton Company pays all the executory
  costs.

78
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• 7.The equipment reverts to the Watkins Company at
  the end of the fifth year the lease contains no
  bargain purchase option.
• 8.The present value of he minimum lease payments
  receivable for the lessor is 391,371.20,
  calculated as follows
• Present value of 5 rents of 1000,000 in advance
  at 14
• 3.913712 100,000
• 391,371.20
• 9.The collectibility of the payments is
  reasonably assured, and there are no
  uncertainties involved in the lease.

79
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• This is a direct financing lease because the
  provision of the lease agreement meet one or
  more of the Group I and both of Group II
  classification criteria, do not include any
  manufacturers or dealers profit, and the fair
  market value of the property is equal to the
  cost. The Watkins (the lessor) records the
  information for the lease in 1995 as follows
• 1.1/1/95
• Minimum Lease Payment Receivable 500,000
• Equipment 391,371.20
• Unearned Interest Leases 108,628.80

80
The Accounting Treatment for Capital Lease
(Lessor)(contd.)

• 2.1/1/95 Collection of Cash
• Cash 100,000
• MLPR 100,000
• 3.12/31/95 Unearned Interest 40,791.97
• Interest revenue 40,791.97
• (net Investment 14 Net Investment MLPR -
  unearned Interest (500,000 - 100,000) -
  108,628.80
• The lessor would use the information as shown in
  Exhibit 10 to record the journal entries for the
  remaining years to the lease.

81
Exhibit 10Summary of lease payments received and
interest revenue earned by Watkins company
(Lessor)

• Receipts in Advance

82
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance

• Assume that on 1/1/95, the Carlson Company
  Leases equipment to the Johnson Company, with
  the terms and provisions of the lease as
  indicated in Exhibit 11. This lease is direct -
  Financing lease (Because the provisions of the
  lease in exhibit 1 meet one or more of Group
  I and both of Group II lease classification
  criteria, and do not include any manufactures
  or dealers profit).

83
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• 1.The cost, and fair value, of the equipment is
  11,149.06.
• 2.The initial direct costs incurred by Carlson
  Company are assumed to be zero.
• 3.The term of the lease is 4 years, with annual
  payments of 3,000 received at the beginning of
  each year. The Johnson Company does not
  guarantee any of the estimated residual value.

84
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• 4.The estimated economic life of the equipment is
  6 years, the lease is for 4 years, there is an
  estimated unguaranteed residual value of 2,000
  at the end of the lease, and it accrues to the
  benefit of the Carlson Company.
• 5.The lease payments are determined at an amount
  that will yield to the Carlson Company at 14
  annual rate of return on its net investment.
• 6.The Johnson Company pays all the executory
  costs.
• 7.The equipment reverts to the Carlson Company at
  the end of the sixth year.

85
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• 8.The present value of the minimum lease payments
  receivable for the lessor, plus the unguaranteed
  residual value, is 11,149.06, calculated as
  follows
• Present value of 4 rents of 3,000
• in advance at 14 (3.321632 3,000)
  9,964.90
• Add present value of a single sum of
• 2,000 (the unguaranteed residual value)
• at 14 for 4 period (0.592080 2,000)
  1,184.16
• Total present value 11,149.06
• 9.The collectibility of the payments is
  reasonably assured, and there are no
  uncertainties involved in the lease.

86
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• The Carlson Company (the lessor) records the
  information relevant to the lease as follow
• 1. 1/1/95
• Minimum Lease Payment Receivable 14,000
• Equipment 11,149.06
• Unearned Interest Lease 2,850.94
• The transaction is considered as a disposal of
  an asset, the equipment is removed (at cost)
  from books. The undiscounted residual value is
  included in the MLPR in determining the net
  investment and the return (14) on net
  investment The initial net investment is equal
  to the cost of the equipment. (14,000 -2,850.94
  11,149.06)

87
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• 2.Collection of Annual payment for For first year
  on 1/1/95
• Cash 3,000
• MLPR 3,000
• payments are collected in advance (at the
  beginning of the year)
• 3.Recognition of interest revenue for the first
  year on 12/31/95
• Unearned Interest Lease 1,140.87
• Interest revenue 1,140.87
• (Net Investment at beginning of the year)
  14
• (14,000 - 3,000) - 2,850.94 14
• Carlson Company (the lessor) will use the
  information in Exhibit 12 to record the entries
  for the remaining years.

88
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• Rents Payable in Advance

89
Example 3 Direct Financing with an Unguaranteed
Residual Value at the End of Lease and Payments
Made in Advance (Contd.)

• At the end of the lease, the MLPR will have a
  balance of 2,000. Assume that the lowest of the
  cost, carrying value, or the fair market value
  of the leased asset at the end of the lease is
  1,400. When the asset is received by the
  lessor, the entry is
• Equipment 1,400
• Loss 600
• MLPR 2,000

90
Initial Direct Costs Involved in a Direct
Financing Lease

• Initial direct costs of a lease transaction
  include direct costs. Incremental direct costs
  include costs that result directly from and are
  essential to the leasing transaction and would
  not have been incurred by the lessor if the
  transaction had not occurred.
• For example, costs related to evaluating the
  lessee financial condition, negotiating
  terms,preparing and processing lease
  documents, and closing the transaction.

91
Initial Direct Costs Involved in a Direct
Financing Lease(contd.)

• In addition, employeecompensation and
  benefits associated with the time spent
  performing those activities should also be
  included in as part of the direct costs. All
  other lease related costs (i.e., advertising,
  serving existing leases, unsuccessful lease
  origination, supervision and administration)
  are exposure as incurred. In order to comply
  with the matching principle, the initial direct
  costs are deferred due to there is no revenue
  recognized at the time of signing a direct
  financing lease.

92
Initial Direct Costs Involved in a Direct
Financing Lease(contd.)

• The lessor needs to determine a new (lower)
  implicit rate that will discount the remaining
  future minimum lease payments to the net
  investments as of the inceptions of the lease.
• Assuming the lessor incurred 5,000 of initial
  direct costs on a direct financing lease, it
  will records the costs as follows
• Unearned interest Lease 5,000
• Cash (or A/P) 5,000

93
Initial Direct Costs Involved in a Direct
Financing Lease(contd.)

• Consequence
• The debiting of unearned interest for the
  direct costs will increase net investment and
  decrease the implicit rate (due to future cash
  flows remain unchanged). The lower rate
  result in less interest revenue recognition
  each period and achieve the goal of
  determining direct costs and including them
  as a reduction of income over the life of the
  lease.

94
Sales-Types Lease (lessor)

• The major differences between a sales- type
  lease and a direct financing lease are the
  presence of a manufacturers or dealers profit
  or loss in a sales-type lease and the
  accounting for initial direct costs. The
  manufacturers or dealers profit (or loss) is
  measured as the difference between
• (1) the present value of MLP (net of
  executory costs) computed at interest rate
  implicit in the lease (i.e, the sales price)

95
Sales-Types Lease (lessor)(contd.)

• (2) the cost or carrying value of the asset plus
  the initial direct costs less the present
  value of the unguaranteed residual value
  accruing to the benefit of lessor.
• The accounting treatment for a sales-type
  lease is the same as for a direct financing
  lease except for recognizing the profit at the
  inception of the lease.
• Example on 1/1/95, the York Company leases
  an equipment to the Lake Company with the terms
  and provisions as indicated in Exhibit 13. The
  test in Exhibit 14 shows that this lease
  qualities as a sales-type lease

96
Exhibit 13TERMS AND PROVISIONS OF LEASE
AGREEMENT BETWEEN YORK COMPANY (LESSOR) AND LAKE
COMPANY (LESSEE) DATED January 1, 1995

• 1.The cost of the equipment is 120,000. The fair
  market value is 190,008.49.
• 2.No initial direct costs are incurred by the
  York Company.
• 3.The term of the lease is 10 Years, with annual
  payments of 30,000 received at the beginning
  of each year. The estimated economic life of
  the equipment is also 10 years.
• 4.The Lake Company agrees to absorb all executory
  costs.
• 5.The Lake Company is given an option to buy the
  equipment is also 10 years.

97
Exhibit 13TERMS AND PROVISIONS OF LEASE
AGREEMENT BETWEEN YORK COMPANY (LESSOR) AND LAKE
COMPANY (LESSEE) DATED January 1, 1995

• 6.The interest rate implicit in the lease is 12.
• 7.The present value of 10 payments of 30,000 at
  12 on an annuity basis plus the present value
  of the bargain purchase option is 190,008.49,
  calculated as follows
• Present value of 10 rents in
• advance at 12 (6.328250 30,000) 189,847.50
• Plus Present value of 500
• discounted at 12 (0.321973 500)
  160.99
• Total present value 190,008.49
• 8.The collectibility of the payment is reasonably
  assured, and there are no uncertainties
  involved in the lease.

98
Exhibit 14APPLICATION OF CRITERIA FOR
DETERMINATION OF LEASE CLASSIFICATION BY YORK
COMPANY (LESSOR)
99
Exhibit 14APPLICATION OF CRITERIA FOR
DETERMINATION OF LEASE CLASSIFICATION BY YORK
COMPANY (LESSOR)(contd.)

• Decision If the lease meets one or more of the
  Group I criteria and both of Group II criteria,
  it is either a direct financing or a sales-type
  lease. In addition, if there is a
  manufacturers or dealers profit or loss, it is
  a sales-type lease. If it meets the criteria and
  does not contain a profit or loss element, it is
  a direct financing leases.
• Conclusion The lease is a sales-type lease ,
  since appropriate criteria are met and there is
  a manufacturers or dealers profit, because
  the amount used as the selling price
  (190,008.49) exceeds the cost (120,000) that
  is, the present (fair) value of the lease
  payments is greater than the cost of the
  property.

100
Exhibit 14APPLICATION OF CRITERIA FOR
DETERMINATION OF LEASE CLASSIFICATION BY YORK
COMPANY (LESSOR)(contd.)

• Assuming that the York Company (the lessor) uses
  the perpetual Inventory system and is a
  manufacturer in the specially equipment being
  leased, it records the information relevant to
  the lease as follows
• 1.Initial Recording of the sales-Type lease on
  1/1/95
• Minimum lease Payment Receivable 300,500
• Cost of Goods Sold 120,000
• Sales Revenue 190,008.49
• Equipment Held for Lease 120,000
• Unearned Interest Leases 110,491.51
• Sales revenue P.V. of MLP P.V. of BPO price

101
Exhibit 14APPLICATION OF CRITERIA FOR
DETERMINATION OF LEASE CLASSIFICATION BY YORK
COMPANY (LESSOR)(contd.)

• 2.Collection of first annual lease payment on
  1/1/95
• Cash 30,000
• MLPR 30,000
• 3. Recognition of interest revenue on 12/31/95
• Unearned Interest Lease 19,201.02 Interest
  Revenue 19,201.02
• (300,500 - 30,000) - 110,491.51 12
• The journal entries for the next 9 years for the
  lessor will follow similar pattern as to the
  entries of 1995. After the entries for the 10th
  year are made, the net investment on 12/31/2004
  will be 500 (see exhibit
  15).

102
Exhibit 14APPLICATION OF CRITERIA FOR
DETERMINATION OF LEASE CLASSIFICATION BY YORK
COMPANY (LESSOR)(contd.)

• Also, the lessor does not record any depreciation
  on the leased asset since a sale is deemed to
  have taken place (due to BPO price is so low).
  The lessee will depreciate the leased asset and
  pay for the executory costs.
• Initial Direct Costs (IRD) Involved in a
  Sales-Type Lease
  The IRD
  under the sales-Type lease should be expensed
  at time occurrence in order to match with the
  revenue recognition at the inception of the
  lease. This can be done by including these costs
  in the cost of goods sold or as a selling
  expense.

103
Exhibit 15