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Title: Financial Accounting and Accounting Standards


1
PART III Decision Tools
Lecture 29
Special Accounting Problems Related to Leases
Instructor Adnan Shoaib
2
Learning Objectives
  1. Identify special features of lease arrangements
    that cause unique accounting problems.
  2. Describe the effect of residual values,
    guaranteed and unguaranteed, on lease accounting.
  3. Describe the lessors accounting for sales-type
    leases.
  4. List the disclosure requirements for leases.

3
Accounting for Leases
Leasing Environment
Accounting by Lessee
Accounting by Lessor
Special Accounting Problems
  • Who are players?
  • Advantages of leasing
  • Conceptual nature of a lease
  • Capitalization criteria
  • Accounting differences
  • Capital lease method
  • Operating method
  • Comparison
  • Residual values
  • Sales-type leases
  • Bargain-purchase option
  • Initial direct costs
  • Current versus noncurrent
  • Disclosure
  • Unresolved problems
  • Economics of leasing
  • Classification
  • Direct-financing method
  • Operating method

4
Special Accounting Problems
  1. Residual values.
  2. Sales-type leases (lessor).
  3. Bargain-purchase options.
  4. Initial direct costs.
  5. Current versus non-current classification.
  6. Disclosure.

LO 1 Identify special features of lease
arrangements that cause unique accounting
problems.
5
Special Accounting Problems
Residual Values
Meaning of Residual Value - Estimated fair value
of the leased asset at the end of the lease
term. Guaranteed Residual Value Lessee agrees
to make up any deficiency below a stated amount
that the lessor realizes in residual value at the
end of the lease term.
LO 1 Identify special features of lease
arrangements that cause unique accounting
problems.
6
Special Accounting Problems
Residual Values
Lease Payments - Lessor may adjust lease payments
because of the increased certainty of recovery of
a guaranteed residual value. Lessee Accounting
for Residual Value - The minimum lease payments,
include the guaranteed residual value but
excludes the unguaranteed residual value.
LO 1 Identify special features of lease
arrangements that cause unique accounting
problems.
7
Special Accounting Problems
  • Illustration (Guaranteed Residual Value Lessee
    Accounting) Caterpillar Financial Services
    Corp. (a subsidiary of Caterpillar) and Sterling
    Construction Corp. sign a lease agreement dated
    January 1, 2012, that calls for Caterpillar to
    lease a front-end loader to Sterling beginning
    January 1, 2012. The terms and provisions of the
    lease agreement, and other pertinent data, are as
    follows.
  • The term of the lease is five years. The lease
    agreement is noncancelable, requiring equal
    rental payments at the beginning of each year
    (annuity-due basis).
  • The loader has a fair value at the inception of
    the lease of 100,000, an estimated economic life
    of five years, and estimated residual value of
    5,000 at the end of the lease.

LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
8
Special Accounting Problems
  • Illustration (Guaranteed Residual Value Lessee
    Accounting)
  • Sterling pays all of the executory costs directly
    to third parties except for the property taxes of
    2,000 per year, which is included as part of its
    annual payments to Caterpillar.
  • The lease contains no renewal options. The loader
    reverts to Caterpillar at the termination of the
    lease.
  • Sterlings incremental borrowing rate is 11
    percent per year.
  • Sterling depreciates on a straight-line basis.
  • Caterpillar sets the annual rental to earn a rate
    of return on its investment of 10 percent per
    year Sterling knows this fact.

LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
9
Special Accounting Problems
Illustration (Guaranteed Residual Value Lessee
Accounting)
Caterpillar computation of the lease payments
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
10
Special Accounting Problems
Illustration (Guaranteed Residual Value Lessee
Accounting)
Computation of Lessees capitalized amount
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
11
Special Accounting Problems
Illustration (Guaranteed Residual Value Lessee
Accounting)
LO 7
12
Special Accounting Problems
Illustration (Guaranteed Residual Value Lessee
Accounting)
At the end of the lease term, before the lessee
transfers the asset to Caterpillar, the lease
asset and liability accounts have the following
balances.
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
13
Special Accounting Problems
Illustration (Guaranteed Residual Value Lessee
Accounting)
Assume that Sterling depreciated the leased asset
down to its residual value of 5,000 but that the
fair market value of the residual value at
December 31, 2016, was 3,000. Sterling would
make the following journal entry.
Loss on Capital Lease 2,000.00 Interest Expense
(or Interest Payable) 454.76 Lease Liability
4,545.24 Accumulated Depreciation 95,000.00 Leas
ed Equipment (under capital leases)
100,000.00 Cash 2,000.00
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
14
Special Accounting Problems
Illustration (Unguaranteed Residual Value
Lessee Accounting)
Assume the same facts as those above except that
the 5,000 residual value is unguaranteed instead
of guaranteed. Caterpillar would compute the
amount of the lease payments as follows
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
15
Special Accounting Problems
Illustration (Unguaranteed Residual Value
Lessee Accounting)
Computation of Lease Amortization Schedule
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
16
Special Accounting Problems
Illustration (Unguaranteed Residual Value
Lessee Accounting)
At the end of the lease term, before Sterling
transfers the asset to Caterpillar, the lease
asset and liability accounts have the following
balances.
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
17
Special Accounting Problems
Comparative Entries, Lessee Company
18
Special Accounting Problems
Lessor Accounting for Residual Value
The lessor works on the assumption that it will
realize the residual value at the end of the
lease term whether guaranteed or unguaranteed.
Illustration Assume a direct-financing lease
with a residual value (either guaranteed or
unguaranteed) of 5,000. Caterpillar determines
the payments as follows.
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
19
Special Accounting Problems
Lessor Accounting for Residual Value
Illustration Lease Amortization Schedule, for
Lessor.
LO 7
20
Special Accounting Problems
Lessor Accounting for Residual Value
Illustration Caterpillar would make the
following entries for this direct-financing lease
in the first year.
LO 2 Describe the effect of residual values,
guaranteed and unguaranteed, on lease accounting.
21
Special Accounting Problems
Sales-Type Leases (Lessor)
  • Primary difference between a direct-financing
    lease and a sales-type lease is the
    manufacturers or dealers gross profit (or
    loss).
  • Lessor records the sale price of the asset, the
    cost of goods sold and related inventory
    reduction, and the lease receivable.
  • Difference in accounting for guaranteed and
    unguaranteed residual values.

LO 3 Describe the lessors accounting for
sales-type leases.
22
Special Accounting Problems
Sales-Type Leases (Lessor)
LO 3 Describe the lessors accounting for
sales-type leases.
23
Special Accounting Problems
Sales-Type Leases (Lessor)
LO 3 Describe the lessors accounting for
sales-type leases.
24
Special Accounting Problems
Sales-Type Leases (Lessor)
Illustration To illustrate a sales-type lease
with a guaranteed residual value and with an
unguaranteed residual value, assume the same
facts as in the preceding direct-financing lease
situation. The estimated residual value is 5,000
(the present value of which is 3,104.60), and
the leased equipment has an 85,000 cost to the
dealer, Caterpillar. Assume that the fair market
value of the residual value is 3,000 at the end
of the lease term.
LO 3 Describe the lessors accounting for
sales-type leases.
25
Special Accounting Problems
Sales-Type Leases (Lessor)
Illustration Computation of Lease Amounts by
Caterpillar FinancialSales-Type Lease
LO 3 Describe the lessors accounting for
sales-type leases.
26
Special Accounting Problems
Sales-Type Leases (Lessor)
Illustration Caterpillar makes the following
entries.
LO 3 Describe the lessors accounting for
sales-type leases.
27
Special Accounting Problems
Sales-Type Leases (Lessor)
Illustration Caterpillar makes the following
entries.
LO 3 Describe the lessors accounting for
sales-type leases.
28
Special Accounting Problems
Bargain Purchase Option (Lessee)
  • Present value of the minimum lease payments must
    include the present value of the option.
  • Only difference between the accounting treatment
    for a bargain-purchase option and a guaranteed
    residual value of identical amounts is in the
    computation of the annual depreciation.

LO 3 Describe the lessors accounting for
sales-type leases.
29
Bargain Purchase Optionsand Residual Value
A bargain purchase option (BPO) is a provision of
some lease contracts that gives the lessee the
option of purchasing the leased property at a
bargain price. The expectation that the option
price will be paid effectively adds an additional
cash flow to the lease for both the lessee and
the lessor. As a result
LESSEE adds the present value of the BPO price to
the present value of periodic rental payments
when computing the amount to be recorded a leased
asset and a lease liability. LESSOR, when
computing periodic rental payments, subtracts the
present value of the BPO price from the amount to
be recovered (fair value) to determine the amount
that must be recovered from the lessee through
the periodic rental payments.
30
Bargain Purchase Option (BPO)
On January 1, 2011, Sans Serif Publishers, Inc.,
leased a color copier from CompuDec Corporation
at a price of 479,079. The lease agreement
specifies annual payments beginning January 1,
2011, the inception of the lease, and at each
December 31 there after through 2015. The
estimated useful life of the copier is seven
years. On December 31, 2016, at the end of the
six year lease term, the copier is expected to be
worth 75,000, and Sans Serif has the option to
purchase it for 60,000 on that date. The
residual value after seven years is zero.
CompuDec manufactured the copier at a cost of
300,000 and its interest rate for financing the
transaction is10.
31
Bargain Purchase Option (BPO)
Exercise of BPO at the end of the lease
term 54,542 10 5,458 60,000 BPO payment
- 5,458 54,542
32
Bargain Purchase Option (BPO)
End of Lease December 31, 2016 Sans Serif
Publishers, Inc. (Lessee) Depreciation expense
(479,079 7) 68,440 Accumulated
depreciation 68,440 Interest expense
5,458 Lease payable 54,542 Cash (BPO
payment) 60,000 CompDec Corporation(Lessor) Ca
sh 60,000 Lease receivable
54,582 Interest revenue 5,458
Refer the amortization schedule and computations
on the previous screen
33
Special Accounting Problems
Initial Direct Costs (Lessor)
  • Accounting for initial direct costs
  • Operating leases, the lessor should defer initial
    direct costs.
  • Sales-type leases, the lessor expenses the
    initial direct costs.
  • Direct-financing lease, the lessor adds initial
    direct costs to the net investment.

LO 3 Describe the lessors accounting for
sales-type leases.
34
Special Accounting Problems
Current versus Noncurrent
GAAP does not indicate how to measure the current
and noncurrent amounts. For both the annuity-due
and the ordinary-annuity situations report the
reduction of principal for the next period as a
current liability/current asset.
LO 3 Describe the lessors accounting for
sales-type leases.
35
Special Accounting Problems
Disclosing Lease Data
  • For lessees
  • General description of material leasing
    arrangements.
  • Reconciliation between the total of future
    minimum lease payments at the end of the
    reporting period and their present value.
  • Total of future minimum lease payments at the end
    of the reporting period, and their present value
    for periods (1) not later than one year, (2)
    later than one year and not later than five
    years, and (3) later than five years.

LO 4 List the disclosure requirements for leases.
36
Special Accounting Problems
Disclosing Lease Data
  1. General description of the nature of leasing
    arrangements.
  2. The nature, timing, and amount of cash inflows
    and outflows associated with leases, including
    payments to be paid or received for each of the
    five succeeding years.
  3. The amount of lease revenues and expenses
    reported in the income statement each period.
  4. Description and amounts of leased assets by major
    balance sheet classification and related
    liabilities.
  5. Amounts receivable and unearned revenues under
    lease agreements.

LO 4 List the disclosure requirements for leases.
37
EXAMPLES OF LEASE ARRANGEMENTS
38
EXAMPLES OF LEASE ARRANGEMENTS
39
EXAMPLES OF LEASE ARRANGEMENTS
40
EXAMPLES OF LEASE ARRANGEMENTS
41
EXAMPLES OF LEASE ARRANGEMENTS
42
EXAMPLES OF LEASE ARRANGEMENTS
43
EXAMPLES OF LEASE ARRANGEMENTS
44
EXAMPLES OF LEASE ARRANGEMENTS
45
SALE-LEASEBACKS
The term sale-leaseback describes a transaction
in which the owner of the property
(seller-lessee) sells the property to another and
simultaneously leases it back from the new owner.
  • Advantages
  • Financing
  • Taxes

46
SALE-LEASEBACKS
Determining Asset Use
  • To the extent the seller-lessee continues to use
    the asset after the sale, the sale-leaseback is
    really a form of financing.
  • Lessor should not recognize a gain or loss on the
    transaction.
  • If the seller-lessee gives up the right to the
    use of the asset, the transaction is in substance
    a sale.
  • Gain or loss recognition is appropriate.

47
SALE-LEASEBACKS
Lessee
  • If the lease meets one of the four criteria for
    treatment as a capital lease, the seller-lessee
    should
  • Account for the transaction as a sale and the
    lease as a capital lease.
  • Defer any profit or loss it experiences from the
    sale of the assets that are leased back under a
    capital lease.
  • Amortize profit over the lease term .

48
SALE-LEASEBACKS
Lessee
  • If none of the capital lease criteria are
    satisfied, the seller-lessee accounts for the
    transaction as a sale and the lease as an
    operating lease.
  • Lessee defers such profit or loss and amortizes
    it in proportion to the rental payments over the
    period when it expects to use the assets.

49
SALE-LEASEBACKS
Lessor
If the lease meets one of the lease
capitalization criteria, the purchaser-lessor
records the transaction as a purchase and a
direct-financing lease. If the lease does not
meet the criteria, the purchaser-lessor records
the transaction as a purchase and an operating
lease.
50
SALE-LEASEBACKS
Sale-Leaseback Example
  • American Airlines on January 1, 2011, sells a
    used Boeing 757 having a carrying amount on its
    books of 75,500,000 to CitiCapital for
    80,000,000. American immediately leases the
    aircraft back under the following conditions
  • The term of the lease is 15 years, noncancelable,
    and requires equal rental payments of 10,487,443
    at the beginning of each year.
  • The aircraft has a fair value of 80,000,000 on
    January 1, 2012, and an estimated economic life
    of 15 years.
  • American pays all executory costs.
  • American depreciates similar aircraft that it
    owns on a straight-line basis over 15 years.
  • The annual payments assure the lessor a 12
    percent return.
  • Americans incremental borrowing rate is 12
    percent.

51
SALE-LEASEBACKS
Sale-Leaseback Example
This lease is a finance lease to American because
the lease term is equal to the estimated life of
the aircraft and because the present value of the
lease payments is equal to the fair value of the
aircraft to CitiCapital. CitiCapital should
classify this lease as a direct financing lease.
52
SALE-LEASEBACKS
53
RELEVANT FACTS
  • Both GAAP and IFRS share the same objective of
    recording leases by lessees and lessors according
    to their economic substancethat is, according to
    the definitions of assets and liabilities.
  • GAAP for leases uses bright-line criteria to
    determine if a lease arrangement transfers the
    risks and rewards of ownership IFRS is more
    general in its provisions.
  • One difference in IFRS and GAAP is that finance
    leases are referred to as capital leases in GAAP.
  • Under IFRS, lessees and lessors use the same
    general lease capitalization criteria. GAAP has
    additional lessor criteria that payments are
    collectible and there are no additional costs
    associated with a lease.

54
RELEVANT FACTS
  • IFRS requires that lessees use the implicit rate
    to record a lease, unless it is impractical to
    determine the lessors implicit rate. GAAP
    requires use of the incremental rate, unless the
    implicit rate is known by the lessee and the
    implicit rate is lower than the incremental rate.
  • Under GAAP, extensive disclosure of future
    noncancelable lease payments is required for each
    of the next five years and the years thereafter.
    Although some international companies (e.g.,
    Nokia) provide a year-by-year breakout of
    payments due in years 1 through 5, IFRS does not
    require it.

55
End of Lecture 29
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