leases pv computations classification of leases under us gaap & ifrs acct 414 – fall 2008 –...

LeasesLeases

PV ComputationsPV Computations

Classification of LeasesClassification of LeasesUnder US GAAP & IFRSUnder US GAAP & IFRS

Acct 414 – Fall 2008 – Prof. Teresa Gordon

BPO - Lease 1EBPO - Lease 1E

1.1. Inception date: 1/1/12Inception date: 1/1/12

2.2. Lessor: Troy Tractors Inc.Lessor: Troy Tractors Inc.

3.3. Fair value of combine at Fair value of combine at 1/1/02: $50,0001/1/02: $50,000

4.4. Cost to manufacture Cost to manufacture combine: $40,000combine: $40,000

5.5. Estimated fair value at end Estimated fair value at end of lease is $10,000of lease is $10,000

6.6. Fixed non-cancelable Fixed non-cancelable lease term: 5 years.lease term: 5 years.

7.7. First payment due on First payment due on 12/31/1212/31/12

8.8. Lessee: Farview FarmsLessee: Farview Farms9.9. Incremental borrowing Incremental borrowing

rate (lessee): 12%rate (lessee): 12%10.10. Implicit interest rate Implicit interest rate

(known to lessee): 12%(known to lessee): 12%11.11. Option to buy at end of Option to buy at end of

lease term for $5,000lease term for $5,00012.12. Estimated useful life of Estimated useful life of

combine: 8 yearscombine: 8 years

1e

Bargain Purchase Option Bargain Purchase Option

PAYMENTPAYMENT INTERESTINTEREST "PRINCIPAL""PRINCIPAL" BALANCE BALANCE

00 50,000.00 50,000.00

11 $13,083$13,083 $6,000.00$6,000.00 $7,083.00$7,083.00 42,917.0042,917.00

22 13,083 13,083 5,180.04 5,180.04 7,932.96 7,932.96 34,984.0434,984.04

33 13,083 13,083 4,198.08 4,198.08 8,884.92 8,884.92 26,099.1226,099.12

44 13,083 13,083 3,131.89 3,131.89 9,951.11 9,951.11 16,148.0116,148.01

55 18,083 18,083 1,934.99 1,934.99 16,148.0116,148.01 0.00 0.00

Note that the last payment willinclude the $5,000 BPO

1e

Bargain Purchase Option Bargain Purchase Option


00 50,000.00 50,000.00

11 $13,083$13,083 $6,000.00$6,000.00 $7,083.00$7,083.00 42,917.0042,917.00

22 13,083 13,083 5,150.04 5,150.04 7,932.96 7,932.96 34,984.0434,984.04

33 13,083 13,083 4,198.08 4,198.08 8,884.92 8,884.92 26,099.1226,099.12

44 13,083 13,083 3,131.89 3,131.89 9,951.11 9,951.11 16,148.0116,148.01

55 18,083 18,083 1,934.99 1,934.99 16,148.0116,148.01 0.00 0.00

$50,000 * 12%

$13,083 - $6,000

$50,000 - $7,083

1e

An ordinary annuity situation – the first line includes interest

Example 1FExample 1F

1.1. Inception date: 1/1/12Inception date: 1/1/12

2.2. Lessor: Troy Tractors Lessor: Troy Tractors Inc.Inc.

3.3. Fair value of combine at Fair value of combine at 1/1/12: $50,0001/1/12: $50,000

4.4. Estimated fair value at Estimated fair value at end of lease is $10,000end of lease is $10,000

5.5. First payment due on First payment due on

1/1/121/1/12

6.6. Lessee: Farview FarmsLessee: Farview Farms7.7. Fixed non-cancelable Fixed non-cancelable

lease term: 6 years.lease term: 6 years.8.8. Option to buy at end of Option to buy at end of

lease term for $2,000lease term for $2,0009.9. Estimated useful life of Estimated useful life of

combine: 8 yearscombine: 8 years10. Desired rate of return for 10. Desired rate of return for

lessor and incremental lessor and incremental borrowing rate for lessee: borrowing rate for lessee: 12%12%

11. The cost to manufacture 11. The cost to manufacture the tractor is $40,000.the tractor is $40,000.

1f

What amount should the payment be given that the lessor requires a 12% return?

Example 1FExample 1F

1.1. Inception date: 1/1/12Inception date: 1/1/122.2. Lessor: Troy Tractors Lessor: Troy Tractors

Inc.Inc.3.3. Fair value of combine at Fair value of combine at

1/1/12: $50,0001/1/12: $50,0004.4. Estimated fair value at Estimated fair value at

end of lease is $10,000end of lease is $10,0005.5. First payment due on First payment due on

1/1/121/1/126.6. Lessee: Farview FarmsLessee: Farview Farms7.7. Fixed non-cancelable Fixed non-cancelable

lease term: 6 yearslease term: 6 years

8.8. Option to buy at end of Option to buy at end of lease term for $2,000lease term for $2,000

9.9. Estimated useful life of Estimated useful life of combine: 8 yearscombine: 8 years

10. Desired rate of return for 10. Desired rate of return for lessor and incremental lessor and incremental borrowing rate for lessee: borrowing rate for lessee: 12% 12%

11. The cost to manufacture 11. The cost to manufacture the tractor is $40,000.the tractor is $40,000.

12. Payment = 10,63812. Payment = 10,638

1f

Now, classify the lease

Example 1fExample 1f


$50,000.00$50,000.00

00 $10,638$10,638 $ 0.00$ 0.00 $10,638.00$10,638.00 39,362.00 39,362.00

11 10,638 10,638 4,723.44 4,723.44 5,914.56 5,914.56 33,447.44 33,447.44

22 10,638 10,638 4,013.69 4,013.69 6,624.31 6,624.31 26,823.13 26,823.13

33 10,638 10,638 3,218.78 3,218.78 7,419.22 7,419.22 19,403.91 19,403.91

44 10,638 10,638 2,328.47 2,328.47 8,309.53 8,309.53 11,094.38 11,094.38

55 10,638 10,638 1,331,33 1,331,33 9,306.67 9,306.67 1,787.71 1,787.71

66 2,000 2,000 212.29 212.29 1,787.71 1,787.71 0.00 0.00

1f

Note that the first payment is ALL principalsince no interest has yet been incurred

39,362 * 12%

10,638 - 4,723

39,362 - 5,915Note that there is

interest on the BPO

This is an annuity due situation – the first payment is 100% principal.

A quick comparisonA quick comparison

IFRS vs. US GAAPIFRS vs. US GAAP

IAS 17 vs. FAS 13 as IAS 17 vs. FAS 13 as amended many timesamended many times

IFRS uses “indicators” that are IFRS uses “indicators” that are considered as a wholeconsidered as a whole

Indications that a contract is a FINANCE leaseIndications that a contract is a FINANCE lease– Title transferTitle transfer– Bargain purchase optionBargain purchase option– Term of lease covers a majority of leased asset’s Term of lease covers a majority of leased asset’s

economic lifeeconomic life– Present value of minimum lease payments is Present value of minimum lease payments is

equivalent to nearly all of the leased asset’s fair valueequivalent to nearly all of the leased asset’s fair value

But there’s more!

Note that IFRS has no “bright

line” rules

Indications that a contract is a Indications that a contract is a FINANCE lease (continued)FINANCE lease (continued)

– Leased assets are of a specialized nature and Leased assets are of a specialized nature and are only usable by the lessee unless substantial are only usable by the lessee unless substantial costs are incurred to modify (nothing comparable costs are incurred to modify (nothing comparable in US GAAP)in US GAAP)

– Upon early termination of lease, lessee is Upon early termination of lease, lessee is responsible for lessor’s lossesresponsible for lessor’s losses

– Any gains & losses due to fluctuations in fair Any gains & losses due to fluctuations in fair value of leased asset are attributed to the lesseevalue of leased asset are attributed to the lessee

– Lessee has option to renew for below market Lessee has option to renew for below market costcost

Terminology DifferencesTerminology Differences

IFRS US GAAP

For Lessor Operating lease Operating lease

Finance lease Direct Financing Lease

Finance lease Sales-type leaseFinance lease Leveraged lease

For Lessee Operating lease Operating lease

Finance lease Capital lease

Example 2Example 2

1.1.Inception of the lease: Inception of the lease: January 1, 2012January 1, 2012

2.2.Term: 3 yearsTerm: 3 years

3.3.Implicit interest rate Implicit interest rate (known to lessee) 10%(known to lessee) 10%

4.4.Fair value of asset Fair value of asset $100,000$100,000

5.5.Incremental borrowing Incremental borrowing rate: 12%rate: 12%

6.6.No collection or cost No collection or cost uncertainties for lessoruncertainties for lessor

7.7.First payment due 1/1/12First payment due 1/1/12

8.8.Estimated useful life of Estimated useful life of asset: asset: 5 years5 years

9.9.Lessor retains ownership Lessor retains ownership of asset at end of leaseof asset at end of lease

10. Cost of asset $100,00010. Cost of asset $100,000

11. Payments of $36,556 11. Payments of $36,556 per yearper year

2

What to use for What to use for ““ii””To do present value computations, we need an To do present value computations, we need an interest rate.interest rate.Lessors Lessors alwaysalways use the interest rate use the interest rate implicitimplicit in in the leasethe leaseThe lessee uses the The lessee uses the LOWERLOWER of the implicit of the implicit interest rate and their own interest rate and their own incrementalincremental borrowing rateborrowing rate

Under IFRS: Under IFRS: ““The discount rate to be used in calculating The discount rate to be used in calculating the present value of the minimum lease the present value of the minimum lease payments is the interest rate implicit in the payments is the interest rate implicit in the lease, if this is practicable to determine; if not, lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall the lessee’s incremental borrowing rate shall be used. be used.

Example 2aExample 2a

1.1.Inception of the lease: Inception of the lease: January 1, 2012January 1, 2012

2.2.Term: 3 yearsTerm: 3 years 3.3.Implicit interest rate Implicit interest rate

((NOT known to lessee) known to lessee) 10%10%



6.6.No collection or cost No collection or cost uncertainties for lessoruncertainties for lessor

7.7.First payment due 1/1/12First payment due 1/1/12 8.8.Estimated useful life of Estimated useful life of

asset: 5 yearsasset: 5 years 9.9.Lessor retains ownership Lessor retains ownership

of asset at end of leaseof asset at end of lease10. Cost of asset $100,00010. Cost of asset $100,00011. Payments of $36,556 11. Payments of $36,556

per yearper year

2a

What if the lessor’s rate were NOT known to lessee? What would be the PVMLP?

On January 1, 2012, Powell Trucking and On January 1, 2012, Powell Trucking and Cummingham Diesel sign a lease with the Cummingham Diesel sign a lease with the following terms:following terms:


(known to lessee) 10%(known to lessee) 10% 5.5.Fair value of asset Fair value of asset

$130,000$130,000 7.7.Incremental borrowing Incremental borrowing

rate: 12%rate: 12% 9.9.Estimated useful life of Estimated useful life of

asset: 5 yearsasset: 5 years11.Purchase option at end 11.Purchase option at end

of lease: $2,500of lease: $2,500

2.2.Payments of Payments of $46,836$46,836

4.4.Est. fair value of asset at Est. fair value of asset at end of lease $2,500end of lease $2,500

6.6.Cost of asset $100,000Cost of asset $100,000

8.8.First payment due 1/1/12 First payment due 1/1/12 (at inception)(at inception)

10.No collection or cost 10.No collection or cost uncertainties for lessoruncertainties for lessor

4a

Classify lease under US GAAP and IFRS



((NOTNOT known to lessee) known to lessee) 10%10%



9.9.Estimated useful life of Estimated useful life of asset: 5 yearsasset: 5 years

11.Purchase option at end 11.Purchase option at end of lease: $2,500of lease: $2,500

2.2.Payments of Payments of $46,836$46,836

4.4.Est. fair value of asset at Est. fair value of asset at end of lease $5,000end of lease $5,000

6.6.Cost of asset $100,000Cost of asset $100,000

8.8.First payment due 1/1/12 First payment due 1/1/12 (at inception)(at inception)

10.No collection or cost 10.No collection or cost uncertainties for lessoruncertainties for lessor

4b

What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.



((NOTNOT known to lessee) known to lessee) 10%10%



9.9.Estimated useful life of Estimated useful life of asset: 5 yearsasset: 5 years

11.Purchase option at end 11.Purchase option at end of lease: $2,500of lease: $2,500

2.2.Payments of Payments of $46,836$46,836 4.4.Est. fair value of asset at Est. fair value of asset at

end of lease end of lease $5,000$5,000 6.6.Cost of asset $100,000Cost of asset $100,000 8.8.First payment due 1/1/12 First payment due 1/1/12

(at inception)(at inception)10.No collection or cost 10.No collection or cost

uncertainties for lessoruncertainties for lessor

4c

What if the fair value of the asset is $5,000 at end of the lease? Find the PVMLP.

ComplicationsComplications

Initial Direct CostsInitial Direct Costs

Residual ValuesResidual Values

Initial Direct CostsInitial Direct Costs

Type of LeaseAccounting Treatment for Initial Direct Costs

OperatingRecorded as an asset and amortized over the lease term*

Direct Financing (US)Finance (IFRS)

Recorded as part of investment in lease and amortized over lease term by reducing interest revenue (find new implicit rate)*

Sales-type Lease (US)Finance if lessor is manufacturer or dealer (IFRS)

Immediately recognized as cost of goods sold (reduces profit or increases loss on sale of leased asset)

Residual Value and MLPResidual Value and MLP

Include guaranteed residual value of Include guaranteed residual value of property when computing PVMLPproperty when computing PVMLP– If guaranteed by lesseeIf guaranteed by lessee– If guaranteed by third party, only lessor If guaranteed by third party, only lessor

includes as part of minimum lease paymentsincludes as part of minimum lease payments– Unguaranteed residual value is NOT included Unguaranteed residual value is NOT included

in MLP in MLP

Remember that the UnGRV is part of lessor’s receivable and therefore is included in the amortization table!

On 1/1/12, Micronomics Inc. and Ozark On 1/1/12, Micronomics Inc. and Ozark Oscillators entered into a lease with the Oscillators entered into a lease with the following terms:following terms:

1.1. Term: 4 yearsTerm: 4 years2.2. Payments of $83,099Payments of $83,0993.3. Implicit interest rate Implicit interest rate

(known to lessee) 10%(known to lessee) 10%4.4. Lessor retains Lessor retains

ownership of asset at ownership of asset at end of leaseend of lease

5.5. Fair value of asset Fair value of asset $300,000$300,000

6.6. Cost of asset Cost of asset $250,000$250,000

7.7. Incremental borrowing rate: Incremental borrowing rate: 12%12%

8.8. First payment due 1/1/02First payment due 1/1/029.9. Estimated useful life of Estimated useful life of

asset: 5 yearsasset: 5 years10.10. No collection or cost No collection or cost

uncertainties for lessoruncertainties for lessor11.11. Est. fair value of asset at Est. fair value of asset at

end of lease: $15,000end of lease: $15,00012.12. The residual value is The residual value is

guaranteed by a third party guaranteed by a third party at a cost of $500 (initial at a cost of $500 (initial direct cost)direct cost)

6

Two different tables needed!Two different tables needed! Lessee

Date

Lease Payment

Interest Principal Balance

01/01/12 289,754 0 01/01/12 83,099 0 83,099 206,655 1 01/01/13 83,099 20,665 62,434 144,221 2 01/01/14 83,099 14,422 68,677 75,545 3 01/01/15 83,099 7,554 75,545 0

Lessor Date Lease Payment Interest Principal Balance 01/01/12 300,000 0 01/01/12 83,099 0 83,099 216,901 1 01/01/13 83,099 21,690 61,409 155,492 2 01/01/14 83,099 15,549 67,550 87,942 3 01/01/15 83,099 8,794 74,305 13,638

01/01/16 15,000 1,362 13,638 0

6

On October 1, 2002, Seiler Systems and Computer Leasing of America sign a lease with the following terms:

1.1.Term: 3 yearsTerm: 3 years 3.3.Implicit interest rate (NOT Implicit interest rate (NOT

known to lessee) 10%known to lessee) 10% 5.5.Fair value of asset Fair value of asset

$100,000$100,000 7.7.Incremental borrowing rate: Incremental borrowing rate:

14%14% 9.9.Estimated useful life of Estimated useful life of

asset: 5 yearsasset: 5 years11. Est. fair value of asset at 11. Est. fair value of asset at

end of lease: $10,000end of lease: $10,000

2.2. Payments of $33,809 Payments of $33,809

4.4. Lessor retains Lessor retains ownership of asset at ownership of asset at end of leaseend of lease

6.6. Cost of asset $100,000 Cost of asset $100,000

8.8. First payment due First payment due 10/1/0210/1/02

10. No collection or cost 10. No collection or cost uncertainties for lessoruncertainties for lessor

12. The residual value is 12. The residual value is NOT guaranteed by NOT guaranteed by lesseelessee

8

Example 7 - LessorExample 7 - Lessor

Now we’re ready for the HARDEST type of Now we’re ready for the HARDEST type of journal entries: journal entries: a sales-type lease with unguaranteed a sales-type lease with unguaranteed residual valueresidual value– If there is an UnGRV, the lessor has If there is an UnGRV, the lessor has

not “sold” the entire asset not “sold” the entire asset – This means we need to reduce sales and cost This means we need to reduce sales and cost

of goods sold for the present value of the of goods sold for the present value of the unGRVunGRV

7

More complications . . .More complications . . .

Lease TermLease Term

Renewal PeriodsRenewal Periods

Executory CostsExecutory Costs

Determining the Lease TermDetermining the Lease Term

Always ends at a bargain purchase option Always ends at a bargain purchase option (including ordinary renewal periods up to BPO).(including ordinary renewal periods up to BPO).

Includes renewal periods covered byIncludes renewal periods covered by– bargain renewal optionsbargain renewal options– penalty large enough to assure renewalpenalty large enough to assure renewal– renewal or extensions at option of lessorrenewal or extensions at option of lessor– guarantees by lessee of lessor's debt related to guarantees by lessee of lessor's debt related to

propertyproperty

Excluded from MLPExcluded from MLP

Exclude contingent rentalsExclude contingent rentalsExclude all rental payments past date of Exclude all rental payments past date of bargain purchase optionbargain purchase optionExclude renewal penalty big enough to Exclude renewal penalty big enough to assure renewalassure renewalExclude executory costs paid by lessor:Exclude executory costs paid by lessor:– maintenancemaintenance– property taxesproperty taxes– insuranceinsurance

On June 1, 2012, Fantasia Funnels, Inc. and Idaho First Bank sign a lease with the following terms:

1.1. Term: 4 yearsTerm: 4 years 3.3. Interest rate used to Interest rate used to

compute payments = 12%compute payments = 12% 5.5. Fair value of asset $200,000Fair value of asset $200,000 7.7. Incremental borrowing rate: Incremental borrowing rate:

14%14% 9.9. Estimated useful life of Estimated useful life of

asset: 6 yearsasset: 6 years11. Est. fair value of asset at 11. Est. fair value of asset at

end of lease: $10,000end of lease: $10,00013. Initial direct costs to 13. Initial direct costs to

arrange lease: $3,000arrange lease: $3,000

2.2. Payments of $61,924Payments of $61,924 4.4. Cost of asset $200,000Cost of asset $200,000 6.6. First payment due 6/1/12First payment due 6/1/12 8.8. No collection or cost No collection or cost

uncertainties for lessoruncertainties for lessor10. The payments include 10. The payments include

$5,000 for insurance.$5,000 for insurance.12. The lessee can purchase 12. The lessee can purchase

asset for $10,000 at end of asset for $10,000 at end of lease, otherwise, asset is lease, otherwise, asset is returned to lessor.returned to lessor.

11

Finding the Effective Interest Rate for Finding the Effective Interest Rate for Direct Financing Lease with IDCDirect Financing Lease with IDC

Date Lease

Payment Interest Principal Balance

6/01/02 203,000

0 6/01/02 56,924

1 6/01/03 56,924

2 6/01/04 56,924

3 6/01/05 56,924

4 6/01/06 10,000

11

Lessor Amortization TableLessor Amortization Table

DateLease

Payment Interest Principal Balance

10/1/2002 10.86% 203,000

0 10/1/2002 56,924 0 56,924 146,076

1 10/1/2003 56,924 15,858 41,066 105,010

2 10/1/2004 56,924 11,400 45,524 59,486

3 10/1/2005 56,924 6,458 50,466 9,020

4 10/1/2006 10,000 980 9,020 0

11

On January 1, 2012, Hells Gate Jet Boats and Washington Leasing Co. sign a lease with the following terms:

1. Term: 4 years with possible renewal (see #12)

2. Implicit interest rate (NOT known to lessee) 10%

3. Fair value of asset $200,000 4. Incremental borrowing rate:

14% 5. Estimated useful life of asset:

6 years6. The residual value is NOT

guaranteed by lessee, asset is expected to be worth $25,000 at end of 4 years, and $15,000 at end of 5 years.

7. Payments of $49,523 8. Lessor retains ownership of

asset at end of lease 9. Cost of asset $200,000 10.First payment due 1/1/0211.No collection or cost

uncertainties for lessor12.At the end of the lease, HGJB

can renew for one more year at same annual amount of $49,523. This is certainly no bargain. There is a $15,000 penalty for non-renewal of the lease. However, this amount is probably not large enough to assure that HGJB will renew.

12

Inception = 1/1/12Inception = 1/1/12 1.1. Term: 4 years, with possible Term: 4 years, with possible

renewal (see #11)renewal (see #11)

3.3. Implicit interest rate (NOT Implicit interest rate (NOT known to lessee) 10%known to lessee) 10%

5.5. Fair value of asset $260,000Fair value of asset $260,000

7.7. Incremental borrowing rate: Incremental borrowing rate: 12%12%

9.9. Estimated useful life of asset: Estimated useful life of asset: 6 years 6 years

11. Lease can be renewed for 11. Lease can be renewed for one more year at one more year at $17,000. The actual value is $17,000. The actual value is probably $25,000.probably $25,000.

13. There are no guarantees of 13. There are no guarantees of residual valueresidual value

2.2. Payments of Payments of $68,565$68,565 4 . Lessor retains title to4 . Lessor retains title to

the asset at end of leasethe asset at end of lease 6.6. Cost of asset $200,000Cost of asset $200,000 8.8. First payment due 1/1/12First payment due 1/1/1210. No collection or cost 10. No collection or cost

uncertainties for lessoruncertainties for lessor12. Est. fair value of asset at 12. Est. fair value of asset at

end of original lease term is end of original lease term is $35,000. It should be worth $35,000. It should be worth $15,000 at the end of 5 years.$15,000 at the end of 5 years.

13

leases pv computations classification of leases under us gaap & ifrs acct 414 – fall 2008 –...

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