1 accounting for leases acctg 5120 david plumlee
TRANSCRIPT
page2
What is a Lease?
“ A lease is a contractual agreement between a lessor (owner) and a lessee (renter) that gives the lessee the right to use property owned by the lessor for a specific period of time in return for rental payments.”
page3
Accounting for Leases
Before 1976 most leases accounted for leases as rental agreements. Why was this accounting found lacking ?
Over time lease agreements began to resemble installment purchases where Companies were in effect borrowing money to buy an asset
page4
Classification of Leases
What is the economic nature of a capital lease?
What is the economic nature of an operating lease?
One that transfers substantially all the risks and benefits of ownership to the lessee.
One that does not transfer the risks and benefits of ownership to the lessee;a rental agreement
page5
Accounting for Capital Leases
Accounting reflects economic substance, not legal form
Make it appear as though company purchased an asset with borrowed funds an asset and an obligation interest expense on obligation depreciation on asset
page6
Is this a Capital Lease?Does it meet ANY ONE of the four criteria?
•Lease transfers ownership of asset •automatically by end of lease term or•through a bargain purchase option
•Lease term is at least 75% of asset’s estimated economic life•PV of minimum lease payments is at least 90% of asset’s fair market value at beginning of lease term
page7
Minimum Lease Payments
Minimum rental payments plus Any guaranteed residual value plus
amount the lessee guarantees lessor will realize on the asset at the end of the lease term
Penalties for failure to renew lease if at the beginning of lease term renewal does not appear to be reasonably assured
Leases without a BPO
page8
MLP continued
What are executory costs?
Are they included in MLP?
NO!
Payments to the lessor to reimburse him/her for operating costs like repairs and maintenance or insurance
page9
Minimum Lease Payments
What is the MLP for leases with a BPO?
What is a bargain purchase option?
An option to purchase asset at end of lease term at a price sufficiently below expected market value that exercise of option appears reasonably assured
PV of rental payments and the BPO at the end of the lease term.
page10
Capital Lease Example
6-year lease Annual payment due at year end =
$18,287 No BPO and legal title does not pass at the
end of lease term FMV of leased asset = $75,185 Economic life of asset = 10 years Appropriate interest rate = 12% Est. salvage value = $3,185
page11
Present Value of MLP
1 2 3 4 5 6
$18,287 $18,287 $18,287 $18,287 $18,287 $18,287
= $18,287 x 4.11141 = $75,185
PV = $18,287 x PVIFA(n=6, r=12%)
page12
Lessee Journal Entries
Inception of lease: record leased asset and lease obligation at present value of MLP
Record payments At period end accrue:
depreciate asset record interest expense
page13
Inception of Lease Term
JE to record leased asset and lease obligation at present value of MLP?
leased asset $75,185lease obligation
$75, 185
page14
Depreciation Expense
On what does the depreciation period used depend?
If bargain purchase option exists or title passes during lease term, use economic life
Otherwise use lease term
page15
Basis for Depreciation
What ending values are used for depreciation?Salvage value if depreciating over economic life
Guaranteed residual value if depreciating over lease term
page16
Record Depreciation Expense
What is the depreciable basis of this asset?
$75,185 (Salvage value is irrelevant because the asset reverts to the lessor.)
$75,185/6yrs = $12,531
depreciation expense $12,531accum. depreciation
$12,531
page18
Lease Amortization Table
Date Payment Interest Reduction BalanceIn Obligation
0 75,1851 18,2872 18,2873 18,2874 18,2875 18,2876 18,287
PV of the min. lease payments
page19
Lease Amortization TableDate Payment (a) Interest (b) Reduction Balance
In Obligation (a-c)
0 75,1851 18,287 9,022 9,265 65,9202 18,287 7,910 10,377 55,5443 18,287 6,665 11,622 43,9224 18,287 5,271 13,016 30,9055 18,287 3,709 14,578 16,3276 18,287 1,959 16,328 -1
page20
Record First Lease Payment
interest expense ($75,185 x 12%) $9,022lease obligation 9,265
cash $18,287
Interest rate implicit in the lease unless the lessee’s incremental borrowing rate is both known by the lessor and is lower.
page21
Lessor Capital Lease Types Direct financing leases
PV of minimum lease payments equals the FMV of the leased asset
No “profit” is recorded; considered to be a financing arrangement.
Sales-type leases PV of minimum lease payments less the
FMV of the leased asset equals the “dealer profit”
Profit is recognized as revenue at the inception of the lease
page22
Initial Direct Costs Includes costs directly associated with
negotiating a particular lease amounts paid to third parties (e.g.
lawyer’s fees, appraisal fees, finders fees) amounts incurred internally (e.g. time
spent negotiating lease terms, preparing and processing documents)
Excludes indirect costs (e.g. allocated portion of general advertising, administration costs or overhead)
page23
Accounting forInitial Direct Costs
Operating -
Sales-type -
Direct financing-
defer and allocate over lease term in proportion to rental incomeexpense in same period as profit on sale recognized
add to gross investment in the leaseamortize over lease as a yield adjustment
page24
Example - Direct Financing
3 year lease $20,000 payments due at end of
year implicit interest rate = 10% FMV (lessor’s cost of asset) =
$49,737 initial direct costs = $1,000
page25
Net Investment in Lease
20,000 x PVIFA(n=3,r=10%)=$49,737 = cost (this is a direct financing lease)(this is a direct financing lease)
What is the PV of the MLP (without initial direct costs)?
Do initial direct costs affect this calculation?Yes, they are added and a new interest rate is found.
page26
Impute New Effective Yield
$50,737 = $20,000 x PVa (n=3,r=?)2.53685 = PVa (n=3,r=?)
by trial and error: : r=8.89%
Why add to the initial direct costs?We want the interest rate the equates the net investment to the cash flows$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)
page27
Ignoring Initial Direct Costs
payment interest principal balanceopening (10%) 49,737 yr. 1 20,000 4,974 15,026 34,711 yr. 2 20,000 3,471 16,529 18,182 yr. 3 20,000 1,818 18,182 (0) total interest income 10,263
page28
Including Initial Direct Costs
payment interest principal balanceopening (8.89%) 50,737 yr. 1 20,000 4,511 15,489 35,248 yr. 2 20,000 3,134 16,866 18,381 yr. 3 20,000 1,619 18,381 0 total interest income 9,263
Reduction in income = 10,263 - 9,263 = 1,000 = initial direct costs
page29
Amort. of Initial Direct Costs
interest interestat 10% at 8.89% amortization
yr. 1 4,974 4,511 463 yr. 2 3,471 3,134 337 yr. 3 1,818 1,618 200 total 10,263 9,263 1,000
page30
Journal Entry
Entries to record lease:
deferred initial direct costs 1,000cash (etc.)
1,000lease receivable 60,000
unearned interest income 10,263
leased asset49,737
page31
Journal Entries
Entries to record first payment and amortization of income and costscash 20,000
lease receivable20,000unearned interest income 4,974
interest income 4,974
initial direct expense amortization 463deferred initial direct costs 463
page32
Sale/leaseback
Seller/lessee
Buyer/lessor
Sale:Legal titleTransfers
Leaseback: seller retains use of the assetAccount for lease according to classification tests.
Should the gain or loss on sale be recognized
when asset “sold” to lessor?
page33
Sale/leaseback- operating lease
Lessee Retains Right To Use Asset defer gains only (losses are recognized
immediately) amortize to rent expense over lease term in
proportion to rental payments
Why do you think we defer any gains?Owners would strike deals where they “sold” the asset for an inflated price and booked a huge gain on sale and in return they promised to make unreasonably large lease payments in the future
page34
Sale/leaseback -- capital lease
defer gains only (losses are recognized immediately)
amortize to depreciation expense over lease term in proportion to amortization of leased asset
Lessee Retains Right To Use Asset