DEFINITION:

Agreement conveying the right to use property,plant or equipment for stated periods of time.

Is the OWNER of the property.

Is the RENTER of the property.

Capital vs. Operating Leases.Capital Lease

Transfers essentially ALL risk/rewards of ownership tothe lessee:

•Lessee gets property on B/S as asset•Debt is recorded as a liability.•The asset is even depreciated.

Operating Lease

Does not essentially transfer all risks/rewards to lessee.

•Do not report on B/S.•Rents are charged as they become due.•This is OFF-BALANCE SHEET FINANCING.

THIS ISWHAT FIRMSWANT!!

Grafix Inc. (LESSEE) leases a computer fromComfast Inc. (LESSOR) for 2-years beginningJanuary 1, 2008. Grafix will pay Comfast $4,800/yr, payable in advance on January 1 of each year.Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance).Lessee incurs only one risk (payment of rents)and one benefit (temporary use of asset). Lessor’scost was $30,000, 10 year life and st line depreciation with no salvage).

1-1-08: Receipt of first payment

Cash…………….. $4,800Unearned Revenue……… $4,800

12/31/08 EOY ADJS

Unearned Rev… $4,800 Rent Revenue…. $4,800

Depreciation Expense.. $3,000Accumulated Dep… $3,000

LessOR depreciates the asset becausethey didn’t relinquish ownership.

Grafix Inc. (LESSEE) leases a computer fromComfast Inc. (LESSOR) for 2-years beginningJanuary 1, 2008. Grafix will pay Comfast $4,800/yr, payable in advance on January 1 of each year.Comfast is responsible for ownership costs, (i.e., maintenance, property tax & insurance).Lessee incurs only one risk (payment of rents)and one benefit (temporary use of asset). Lessor’scost was $30,000, 10 year life and st line depreciation with no salvage).

1-1-08: First payment

Prepaid rent………… $4,800Cash……………..$4,800

12/31/08 EOY ADJS

Rent Expense………. $4,800Prepaid………………$4,800

If a lease meets ANY ONE of the following 4 criteria at the inception of the lease, the lease is a CAPITAL LEASE.

* TRANSFER OF OWNERSHIP.

Explicitly states a transfer of ownership at EOL withoutpayment of additional compensation.

* BARGAIN PURCHASE OPTION (BPO).

• LEASE TERM EQUAL TO 75% OR MORE OF THEASSETS REMAINING USEFUL SERVICE LIFE.

• MINIMUM LEASE PAYMENTS (pv) ARE AT LEAST 90% OF THE ASSETS MARKET VALUE.

CAPTIAL LEASE IS RECORDED AT:

The LOWER of:

VS.

Example:

•January 1, 2008 LESSOR CO. and LESSEE CO. sign a 3-year, non-cancelablelease for an asset with an estimated economic life of 3 years.

•There are no collection uncertainties and the lessor’s performance iscomplete.

•There are (3) lease payments worth $36,556 each. They are payable onJanuary 1 of 2008, 2009 and 2010.

•The fair value of the asset at inception of the lease is $100,000 (which isalso the carrying value on the lessor’s books).

•The lease DOES NOT contain a renewal or Bargain Purchase Option (BPO)and the asset reverts to the lessor at the end of the three year period.

•Lessee and Lessor depreciation on a ST LINE basis for book purposes.Residual value (salvage) is –0-.

* The lessee’s incremental borrowing rate is 10%

* The accounting year ends on December 31 for each party.

* The Lessor’s IMPLICIT interest rate is 10%.

YES

•Lease term is equal to 75% or > of the assets remaininguseful life.

3/3 = 100%

•Minimum lease payments (PV) are at least 90% of the assetsmarket value.

$36,556 x 2.73554 = $100,000

FMV = $100,000

$100,000/$100,000 = 100%

TO RECORD THE LEASE Leased Asset………….. $100,000

Lease Liability………$100,000

TO RECORD THE FIRST PAYMENT ON THE FIRST DAY

Lease Liability……… $36,556Cash………………..$36,556

Date Payment Interest 10% LL adj LL Bal.

1/1/08 $100,000

1/1/08 $36,556 $0 $36,556 $63,444

1/1/09 $36,556 $6,344 $30,212 $33,232

1/1/10 $36,556 $3,323 $33,233 $0

TO RECOGNIZE INTEREST EXPENSE FOR 1/1/09

Interest Expense………… $6,344

Lease Liability………….$6,344

TO RECORD DEPRECIATION EXPENSE

($100,000 - $0 SALVAGE) / 3 YEARS = $33,333

Depreciation Expense……….. $33,333Accumulated Depreciation……… $33,333

THE LESSOR MUST NOT ONLY MEET (1) OF THE FOUR PREVIOUSLYMENTIONED CAPITAL LEASE CRITERIA BUT ALSO BOTH OF THE CRITERIA LISTED BELOW:

COLLECTIBILITY OF THE MINIMUM LEASE PAYMENTS ISREASONABLY ASSURED.

NO IMPORTANT UNCERTAINTIES SURROUND THE AMOUNTOF ANY REIMBURSEABLE COSTS YET TO BE INCURRED BY THE LESSOR UNDER THE LEASE.

The Lessor classifies capital leases in one of two ways:

Does NOT provide a gross profit to the lessorat the time the lease is signed.

Value of the leased asset equals its MARKET VALUEat the inception date.

•The lessor uses this to compute rentpayments.

Example from above: Now continued for the LESSOR.

* This is a DIRECT FINANCING lease.

FMV = $100,000 which equals the cost on the lessor’s books.

Lessor earns profits from interest revenue during lease

We know the rent payments are $36,556, but how was this established?

FMV OR PVOF MIN LEASE PAYMENTS = RENT X FACTOR

FMV OR PVOF MIN LEASE PAYMENTS = RENT X FACTOR$100,000 2.7354

(10%, 3 YRS ANN DUE;T 6-5)

$36,556

TO RECORD The RECEIVABLE at 1/1/08

Lease Receivable… $100,000Asset…………… $100,000

RECORD The FIRST PAYMENT ON The DAY The LEASE IS SIGNED at 1/1/08

Cash……….. $36,556Lease Receivable…….. $36,556

RECORD The SECOND RECEIPT OF CASH at 1/1/09

Cash…….. $36,556

Lease Receivable….. $30,212

Earned Interest Rev $6,344

Provides a GROSS PROFIT to the lessor at theinception of the lease.

Value of leased asset is greater (or less than) thelessor’s cost (or carrying).

Lessor wants to earn a profit on the sale of the leased asset and interestduring the period.

Example continued:

Assume that the FMV of the asset at inception of this lease is $100,000and that the carrying value on the lessor’s books is $80,000.

DEALER’S PROFIT $100,000 FMV - $80,000 carrying = $20,000 profit

RECORD The LEASE INCEPTION

Lease Receivable… $100,000

Sales Revenue………. $100,000

same as before

FMV of asset

Inventory....................... $80,000COGs…………. $80,000

From here other entries are the same..

In Sales Type leases there is a DIFFERENCE in accounting for Guaranteed

vs. Unguaranteed Residual Values. THE WAY PROFIT IS RECORDEDTHE WAY PROFIT IS RECORDED

GUARANTEED RV is considered part of the sale.

UNGUARANTEED RV is not considered part of the sale.

•inserting any residual value into the previous example would change too many things so we’ll use the book example to illustrate this.

Basically since an UN-guaranteed salvage value can’t be considered part of a saleits PRESENT VALUE needs to be subtracted from the SALES and the COG. Butthat actually leaves the GP unchanged.

Assume estimated RV is $5,000 with a PV of $3,104.60

Assume leased equipment has an $85,000 cost to the dealer.

Rent payments are $23,237.09

FMV of asset at time of leasing $100,000

PV of minimum lease payments = (R x f) + (RV x f)

$100,000 = ($23,237.09 x 4.16986) + ($5,000 x .62092)

Basically since an UN-guaranteed salvage value can’t be considered part of a saleits PRESENT VALUE needs to be subtracted from the SALES and the COG. Butthat actually leaves the GP unchanged.

Assume estimated RV is $5,000 with a PV of $3,104.60

Assume leased equipment has an $85,000 cost to the dealer.

Rent payments are $23,237.09 FMV of asset at time of leasing $100,000

Guaranteed Residual Value Unguaranteed Residual Value

Lease Receivable.. $100,000

Sales Rev.......... $100,000

COG...................... $ 85,000

Inventory.......... $85,000

Sales...........$100,000-COG...........$ 85,000--------------------------GP.............. $15,000

Lease Receivable.... $100,000

Sales Rev............. $96,895.40(100K – 3,104.60 PV of RV)

COG........................ $81,895.40(85K – 3,104.60)

Inventory............ $85,000

Sales...........$96,895.40-COG...........$ 81,895.40--------------------------GP.............. $15,000

Assume the BPO is $10,000, exerciseable at the end of the three year lease.(BACK TO OUR ORIGINAL EXAMPLE)

The residual value is now $15,000, at the BPO date. At the end of the 4th yearits –0-.

Assume we are dealing with the DIRECT FINANCING type lease.

annual rent is now

FMV = RENT (FACTOR) + BPO (FACTOR)

$100,000 = Rent (2.73554) + $10,000 (.75131)

$33,809

DEPRECIATION TIMETABLES ALSO CHANGE WITH BPOS

•The lease depreciates over the EXPECTED USEFUL LIFE notthe life of the lease, since they are expected to own it at the EOL.

When the lessee agrees to makeup any deficiency in the stated amount realized foran asset at the end of the lease.

A RESIDUAL VALUE IMPACTS The AMOUNT OF The ANNUALRENT WHETHER ITS GUARANTEED OR NOT

Originally we calculated the rent as follows:

$100,000 = Rent x 2.7354 (10%, 3yrs) RENT = $36,556

Now if we assume there is also a $10,000 residual value

$100,000 = (rent x 2.7354) + ($10,000 x .75132)

RENT = $33,809

What the guaranteed or unguaranteed status of the salvage does impact is theamount of the MINIMUM LEASE PAYMENTS in terms of finding anamount for the capitalized asset.

is capitalized.

is not capitalized.

Returning to the original example, now consider the following changes:

•The actual residual value at the EOL is $9,000 (rather than the $10Kexpected earlier).

•The salvage value is FULLY guaranteed (lessee must pay $10,000cash if necessary).

•The $10,000 estimated salvage value has resulted in annualpayments of $33,809.

What amount does the lessee capitalize?

($33,809 x 2.73554) + ($10,000 x .75131) = $100,000

ENTRY TO RECORD The LEASE

Leased asset…… $100,000Lease liability……. $100,000

Date Lease pay Interest 10% LL adj LL bal1/1/08 $100,0001/1/08 $33,809 $0 $33,809 $ 66,1911/1/09 $33,809 $6,619 $27,190 $ 39,0011/1/10 $33,809 $3,900 $29,909 $9,09212/31/10 $909 $10,001

•The last year builds interest and then the residual value remains in the lease liability.

ENTRY FOR FIRST RENT PAYMENT

Lease liability……. $33,809Cash…………..$33,809

SECOND PAYMENT

Interest expense.. $6,619Lease Liability… $27,190

Cash…………..$33,809

ENTRY FOR 1ST DEPRECIATION($100,000 - $10,000)/3 = $30,000

Life of LEASE, asset reverts to lessor

Depreciation expense…… $30,000Accumulated Depreciation…..$30,000

TERMINATION OF The LEASE Actual residual is $9,000

Lease liability… $10,000 (remove)

Leased asset… $100,000 (remove)

Accum Dep….. $90,000 (remove)

Cash……….. $1,000 (pay)

LOSS on lease.. $1,000

The LESSOR’s accounting is the same, with a guaranteed or an unguaranteedresidual value.

The INCEPTION OF The LEASE

Lease receivable:

Lease Receivable…… $100,000

Asset……… $100,000

$100,000 = (rent x 2.7354) + ($10,000 x .75132)

RECEIPT OF The FIRST RENT (DAY LEASE IS SIGNED)

Cash…….. $33,809Lease Receivable……. $33,809

RECEIPT OF SECOND RENT (ONE YEAR LATER)

Cash……. $33,809

Lease Receivable….. $27,190

Interest Revenue…. $6,619

TERMINATION OF The LEASE

Asset…….. $9,000 (get it back)

Cash………. $1000 (receive guaranteed payment)

Lease receivable……. $10,000

Lessee capitalizes ONLY the lease payments (NOT the salvage)

Assume there is now a $10,000 un-guaranteed salvage value at the EOL.

Note: The rent payment will STILL be $33,809 because the salvagereduces it whether its guaranteed or not.

$100,000 = (RENT x 2.73554) + $10,000 (.75131)

The AMOUNT CAPITALIZED FOR The LEASED ASSET IS:

$33,809 (2.73554) = $92,487 DON’T capitalize salvage

Leased asset… $92,487Lease liability……$92,487

Remember, whether the salvage value is guaranteed or not, it is ALWAYSdeducted in order to compute the AMOUNT of the rent payment.

Recall, however, that the lessee will not capitalize the amount of thesalvage because they do not promise to pay it.

The LESSOR HOWEVER WILL CAPITALIZE The SALVAGE VALUEAS IT COMES TO HIM/HER AT The EOL REGARDLESS OF WHETHERITS GUARANTEED OR NOT (AT LEAST IN THEORY IT DOES).

LEASE RECEIVABLE RECORDEDLease Receivable.. $100,000

Asset……. $100,000$100,000 = (rent x 2.7354) + ($10,000 x .75132)