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									                          Leases                                                                1




                          Strategic Accounting
                          Leases

                          /// OVERVIEW

                          The FASB and the IASB are collaborating on several major new
                          standards designed in part to move the U.S. GAAP and IFRS closer
                          together (convergence). This reading is based on their joint Exposure
                          Draft of the new leases standard.


        Part A            ACCOUNTING BY THE LESSOR AND LESSEE
                          If you ever have leased an apartment, you know that a lease is a contractual
                          arrangement by which a lessor (owner) provides a lessee (user) the right to use an
                          asset for a specified period of time. In return for this right, the lessee agrees to make
An apartment lease is a   stipulated, periodic cash payments during the term of the lease. Businesses, too, lease
common leasing            assets under similar arrangements. The right to use the leased property can be a
arrangement.
                          significant asset. Likewise, the obligation to make the lease payments can be a
                          significant liability. Both the right-of-use asset and the liability are reported in the
                          lessee’s balance sheet.                                     The U.S. Navy once leased a
                              On the other side of the transaction, the lessor fleet of tankers to avoid
                          reports a receivable for the lease payments it will asking Congress for
                          receive and, depending on whether it retains or appropriations.
                          transfers the risks and benefits associated with the leased asset, either (a) a liability
                          for the obligation to allow the lessee to use the asset or (b) sales revenue. If sales
                          revenue is recorded, the lessor also removes from its records (derecognizes) the asset
                          transferred, with an accompanying debit to cost of sales. Before we look at the
                          possibilities in more detail, Graphic 15–1 provides a summary.
            2




GRAPHIC 15–1                                             When to Use                     What to Record                    How to Measure
Basic Lease Classifications   Lessee:
                                Right of Use      All leases, unless short-     Record:                              Present value of expected
                                 Approach         cut method is used.            Right-of- use asset                 payments plus initial direct
                                                                                  representing the right to use       costs if any
                                                                                  the asset                          Present value of expected
                                                                                 Lease liability for obligation      payments
                                                                                  to pay for the asset’s use
                                 Short-Cut        Maximum lease term is                                              Option to:
                                  Method          12 Months or less                           same                    Measure asset and liability
                                                                                                                       at total of payments rather
                                                                                                                       than their present value
                                                                                                                      Recognize lease payments
                                                                                                                       as expense
                              Lessor:
                                Performance       Lessor retains exposure       Record:
                                 Obligation       to significant risks or        Receivable representing the        Present value of expected
                                 Approach         benefits associated with        right to receive payments           payments plus initial direct
                                                  the asset during or after                                           costs if any
                                                                                 Performance obligation to          Present value of expected
                                                  the lease term.
                                                                                  permit lessee to use the            payments
                                                                                  asset
                               Derecognition      Lessor does not retain         A receivable and sales             Present value of expected
                                 Approach         exposure to significant         revenue                             payments
                                                  risks or benefits              Derecognize asset and record       Carrying value of the asset
                                                  associated with the asset.      cost of goods sold.                 (or portion transferred)
                                 Short-Cut        Maximum lease term is          No entry at commencement of         Option to:
                                  Method          12 Months or less              lease                                Not record receivable or
                                                                                                                       performance obligation
                                                                                                                      Recognize lease payments
                                                                                                                       as income
                              Note: If the contract transfers: (a) control of the underlying asset and (b) all but a trivial amount of the risks and
                                    benefits associated with the asset, the transaction is not a lease and is recorded as a purchase/sale.



                                After looking at some of the possible advantages of leasing assets rather than
                              buying them in certain circumstances, we will explore differences in leases further.

                              DECISION MAKERS’ PERSPECTIVE—ADVANTAGES OF LEASING

                              When a young entrepreneur started a computer training center a few years ago, she
                              had no idea how fast her business would grow. Now, while she knows she needs
                              computers, she doesn’t know how many. Just starting out, she also has little cash
                              with which to buy them.
                                The mutual funds department of a large investment firm often needs new
                              computers and peripherals—fast. The department manager knows he can’t afford to
                              wait up to a year, the time it sometimes takes, to go through company channels to
                              obtain purchase approval.
                                An established computer software publisher recently began developing a new line
                         Leases                                                               3

                            of business software. The senior programmer has to be certain he’s testing the
                            company’s products on the latest versions of computer hardware. And yet he views
                            large expenditures on equipment subject to rapid technological change and
                            obsolescence as risky business.
Leasing can facilitate         Each of these individuals is faced with different predicaments and concerns. The
asset acquisition.          entrepreneur is faced with uncertainty and cash flow problems, the department
                            manager with time constraints and bureaucratic control systems, the programmer
                            with fear of obsolescence. Though their specific concerns differ, these individuals
                            have all met their firms’ information technology needs with the same solution: each
                            has decided to lease the computers rather than buy them.
The number one method          Computers are by no means the only assets obtained through leasing
of external financing by    arrangements. To the contrary, leasing has grown to be the most popular method of
U.S. businesses is leasing.
                            external financing of corporate assets in America. The airplane in which you last
                            flew probably was leased, as was the gate from which it departed. Your favorite
                            retail outlet at the local shopping mall likely leases the space it operates. Many
                            companies actually exist for the sole purpose of acquiring assets and leasing them to
                            others. And, leasing often is a primary method of ―selling‖ a firm’s products. IBM
                            and Boeing are familiar examples.
                               In light of its popularity, you may be surprised that leasing usually is more
                            expensive than buying. Of course, the higher apparent cost of leasing is because the
                            lessor usually shoulders at least some of the financial and risk burdens that a
                            purchaser normally would assume. So, why the popularity?
Tax incentives often           The lease decisions described above are motivated by operational incentives. Tax
motivate leasing.           and market considerations also motivate firms to lease. Sometimes leasing offers tax
                            saving advantages over outright purchases. For instance, a company with little or no
                             taxable income—maybe a business just getting started, or one experiencing an
 Operational, tax, and       economic downturn—will get little benefit from depreciation deductions. But the
 financial market            company can benefit indirectly by leasing assets rather than buying. By allowing the
 incentives often make       lessor to retain ownership and thus benefit from depreciation deductions, the lessee
 leasing an attractive       often can negotiate lower lease payments. Lessees with sufficient taxable income to
 alternative to purchasing.
                             take advantage of the depreciation deductions, but still in lower tax brackets than
                             lessors, also can achieve similar indirect tax benefits.

                         Leases and Installment Notes Compared

                         You learned earlier how to account for an installment note. To a great extent, then,
                         you already have learned how to account for a lease. To illustrate, let’s recall the
                         situation described in a previous module. We assumed that Skill Graphics purchased
                         a package-labeling machine from Hughes–Barker Corporation by issuing a three-
                         year installment note that required six semiannual installment payments of $139,857
                         each. That arrangement provided for the purchase of the $666,633 machine as well
                         as interest at an annual rate of 14% (7% twice each year). Remember, too, that each
           4

                             installment payment consisted of part interest (7% times the outstanding balance)
                             and part payment for the machine (the remainder of each payment).
                                Now let’s suppose that Skill Graphics instead acquired the package-labeling
                             machine from Hughes–Barker Corporation under a three-year lease that required six
                             semiannual lease payments of $139,857 each. Obviously, the fundamental nature of
                             the transaction remains the same regardless of whether it is negotiated as an
                             installment purchase or as a lease. So, it would be inconsistent to account for this
                             lease in a fundamentally different way than for an installment purchase:


Comparison of a Note                                                At Commencement (January 1)
and Lease                    Installment Note
                             Machinery .......................................................................... 666,633
As in an installment           Note payable ..................................................................               666,633
purchase, the right to use
an asset is acquired in
exchange for the             Lease
obligation to pay for that   Right-of-use asset ..............................................................     666,633
right.                         Lease liability .................................................................             666,633

                                Skill Graphics did not acquire ownership of the asset in this lease but did acquire the right
                             to use the asset for the duration of the lease, which in this case also is the useful life of the
                             asset. The fact that the lease term is the same as the useful life does not affect the way we
                             account for the lease. By entering this lease arrangement Skill Graphics has acquired
                             something of value, an asset, which is the right to use the asset. We call this a Right-of-use
                             asset. At the same time, the company has assumed an obligation to pay for the asset’s use
                             and accordingly records a liability for the present value of the payments it’s obligated to
                             make.
                                Consistent with the nature of the transaction, interest expense accrues each period
                             at the effective rate times the outstanding balance:

                                                  At the First Semiannual Payment Date (June 30)
Interest Compared for a      Installment Note
Note and Capital Lease       Interest expense (7%  $666,633) ......................................       46,664
                             Note payable (difference) ................................................... 93,193
Each payment includes
both an amount that             Cash (installment payment) ............................................                      139,857
represents interest and
an amount that               Lease
represents a reduction of    Interest expense (7%  $666,633) ......................................                46,664
principal.
                             Lease liability (difference) ..................................................        93,193
                                Cash (lease payment) ......................................................                  139,857

                                Because the lease liability balance declines with each payment, the interest
                             becomes less each period. An amortization schedule provides a convenient way to
                             track the changing amounts as shown in Graphic 15–2.
                               Leases                                                                5

GRAPHIC 15–2                                                                             Decrease        Outstanding
Lease Amortization                 Date       Payments         Effective Interest       in Balance        Balance
Schedule
                                                           (7%  Outstanding balance)
Each lease payment                                                                                         666,633
includes interest on the
                                        1      139,857      .07(666,633) =    46,664      93,193           573,440
outstanding balance at
the effective rate. The                 2      139,857      .07(573,440) =    40,141      99,716           473,724
remainder of each                       3      139,857      .07(473,724) =    33,161     106,696           367,028
payment reduces the                     4      139,857      .07(367,028) =    25,692     114,165           252,863
outstanding balance.                    5      139,857      .07(252,863) =    17,700     122,157           130,706
                                        6      139,857      .07(130,706) =     9,151*    130,706                 0
                                               839,142                       172,509     666,633

                               *Rounded


                                  You should recognize this as essentially the same amortization schedule we used
                               in the previous module in connection with our installment note example. The reason
                               for the similarity is that we view a lease as being, in substance, equivalent to an
                               installment purchase of the right to use an asset for a specified period of time. So
                               naturally the accounting treatment of the two essentially identical transactions should
                               be consistent.

                               Leases – Accounting by Lessee and Lessor

                           Let’s look at an example that illustrates and compares the accounting for leases by
Based on whether it        both the lessee and lessor. For the lessor, the method shown is called the
retains significant risks or
benefits, the lessor uses  performance obligation approach. The name refers to the lessor recording a
either a performance       liability we’ll call a ―performance obligation‖ for its obligation to permit the lessee
obligation approach or a   to use the asset during the lease term. The lessor uses this approach when it ―retains
derecognition approach
to accounting for a lease.
                           exposure to risks or benefits‖ associated with the leased asset either during the lease
                           term (for instance, due to contingent rentals based on performance or options to
The lessee’s accounting is extend or terminate the lease) or at the end of the lease term (for instance, possibility
the same regardless of
                           of re-leasing or selling the asset). Later, we’ll discuss a second method of lessor
which approach the lessor
uses.                      accounting called the derecognition approach used when the lessor does not retain
                           such exposure. The lessee’s accounting is the same regardless of which approach the
                           lessor uses.
                               The earlier example comparing a capital lease to an installment purchase
                           assumed lease payments at the end of each period. A more typical leasing
                           arrangement requires lease payments at the beginning of each period. This more
                           realistic payment schedule is assumed in Illustration 15–1.
           6

Illustration 15–1           On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm,
Lessee and Lessor           leased printing equipment from First Lease Corp. First Lease Corp purchased the equipment
(Performance Obligation     from CompuDec Corporation at a cost of $479,079.
Approach by the Lessor)        The lease agreement specifies four annual payments of $100,000 beginning January 1,
                            2011, the commencement of the lease, and at each December 31 thereafter through 2013.
                            The useful life of the equipment is estimated to be six years.
                               If funds were borrowed to buy the equipment, the interest rate would have been 10%.
Using Excel, enter:
=PV(.10,4,100000, 1)
Output: 348685.2                                                           $100,000  3.48685* = $348,685
                                                                              Lease                             Present
                                                                            payments                             value

                             * Present value of an annuity due of $1: n = 4, i = 10%. We refer to periodic payments at the beginning of each
Using a calculator:            period as an annuity due.
enter: BEG mode N 4 I 10
PMT 100000 FV
Output: PV 348685                                          Commencement of the Lease (January 1, 2011)*

                            Sans Serif Publishers, Inc. (Lessee)
                            Right-of-use asset ..............................................................             348,685
                              Lease liability (present value of lease payments) ................                                    348,685
                            First LeaseCorp (Lessor)
                            Lease receivable (present value of lease payments) ................                           348,685
                              Performance obligation ...................................................                            348,685

                                                                  First Lease Payment (January 1, 2011)*

                            Sans Serif Publishers, Inc. (Lessee)
                            Lease liability......................................................................         100,000
                              Cash ..... ..........................................................................                 100,000
                            First LeaseCorp (Lessor)
                            Cash ....................................................................................     100,000
                              Lease receivable ..............................................................                       100,000


                            * Of course, the entries to record the lease and the first payment could be combined into a single entry
                            since they occur at the same time.

                               Notice that as the lessee acquires the right to use the asset (right-of-use asset), the
                            lessor assumes the obligation to allow that use (lessor’s performance obligation).
                            Similarly, as the lessee assumes the obligation to pay for the asset’s use (lessee’s
                            lease liability), the lessor acquires the right to receive those payments (lease
                            receivable). Recording the first payment above emphasizes that relationship; the
                            $100,000 reduces both the lessee’s lease liability and the lessor’s performance
                            obligation.
A right-of-use asset is        The amount recorded by the lessee is the present value of the lease payments.
recorded by the lessee at
                            However, if the fair value of the asset is lower than this amount, the recorded value
the present value of the
lease payments or the       of the asset should be limited to fair value. Unless the lessor is a manufacturer or
asset’s fair value,         dealer, the fair value typically will be the lessor’s cost ($479,079 in this case).
whichever is lower.         However, if considerable time has elapsed between the purchase of the property by
                            the lessor and the commencement of the lease, the fair value might be different.
                            Leases                                                                                        7

                            When the lessor is a manufacturer or dealer, the fair value of the property at the
                            commencement of the lease ordinarily will be its normal selling price (reduced by
                            any volume or trade discounts).1
Interest is a function of     Be sure to note that the entire $100,000 first lease payment is applied to principal
time. It accrues at the
                            reduction.2 Because it occurred at the commencement of the lease, no interest had yet
effective rate on the
balance outstanding         accrued. Subsequent lease payments include interest on the outstanding balance as
during the period.          well as a portion that reduces that outstanding balance. As of the second lease
                            payment date, one year’s interest has accrued on the $248,685 balance outstanding
                            during 2012, recorded as in Illustration 15–2A. Notice that the outstanding balance is
                            reduced by $75,131—the portion of the $100,000 payment remaining after interest is
                            covered.

ILLUSTRATION 15–1A
Journal Entries for the                                     Second Lease Payment (December 31, 2011)
Second Lease Payment

         LESSEE
      Lease liability
                            Sans Serif Publishers, Inc. (Lessee)
       $348,685             Interest expense [10%  ($348,685 – 100,000)] .....................                  24,869
        (100,000)           Lease liability (difference) ..................................................      75,131
       $248,685
          (75,131)             Cash (lease payment) ........................................................                  100,000
       $173,554

       LESSOR
    Lease Receivable        First LeaseCorp (Lessor)
       $348,685
       (100,000)
                            Cash (lease payment) ..........................................................     100,000
       $248,685               Lease receivable ..............................................................                  75,131
         (75,131)
       $173,554
                              Interest revenue [10%  ($348,685 – 100,000)]..................                                  24,869




                               The amortization schedule in Graphic 15–3 shows how the lease balance and the
                            effective interest change over the four-year lease term. Each lease payment after the
                            first includes both an amount that represents interest and an amount that represents a
                            reduction of principal. The periodic reduction of principal is sufficient that, at the
                            end of the lease term, the outstanding balance is zero.




                            1
                              FASB ASC 840–10: Leases–Overall (previously ―Accounting for Leases,‖ Statement of Financial
                            Accounting Standards No. 13 (Stamford, Conn.: FASB, 1980)).
                            2
                              Another way to view this is to think of the first $100,000 as a down payment with the remaining
                            $249,685 financed by 3 (i.e., 4 – 1) year-end lease payments.
           8

GRAPHIC 15–3                                                                               Decrease in
Lease Amortization                         Payments           Effective Interest            Balance         Outstanding Balance
Schedule
                                                             (10%  Outstanding balance)
The first lease payment
                                1/1/11                                                                            348,685
includes no interest.
                                1/1/11      100,000                                         100,000               248,685
The total of the cash         12/31/11      100,000          .10 (248,685) = 24,869          75,131               173,554
payments ($400,000)           12/31/12      100,000          .10 (173,554) = 17,355          82,645                90,909
provides for:
                              12/31/13      100,000          .10 ( 90,909) = 9,091           90,909                     0
1. Payment for the
                                            400,000                             51,315       348,685
   equipment’s use
   ($348,685).
2. Interest ($51,315) at an
   effective rate of 10%.
                              *Adjusted for rounding of other numbers in the schedule.


                                 An interesting aspect of the amortization schedule that you may want to note at
                              this point relates to balance sheet disclosure. The lessee and lessor report separately
                              the current and noncurrent portions of the outstanding lease balance. Both amounts
                              are provided by the amortization schedule. For example, if we want the amounts to
                              report on the 2011 balance sheet, refer to the next row of the schedule. The portion
                              of the 2012 payment that represents principal ($82,645) is the current (as of
                              December 31, 2011) balance. The noncurrent amount is the balance outstanding after
                              the 2012 reduction ($90,909). These amounts are the current and noncurrent lease
                              liability for the lessee and the current and noncurrent lease receivable for the lessor.

                              Amortization

                              The lessee amortizes its right-of-use asset over lease term (or the useful life of the
                              asset if it’s shorter). Similarly, the lessor amortizes its performance obligation in a
                              systematic way that measures the remaining obligation to provide the use of the asset
                              to the lessee. This usually is on a straight-line basis unless the lessee’s pattern of
                              using the asset is different.3 Using the asset results in an expense for the lessee.
                              Providing the use of the asset represents lease income for the lessor.




                              3
                                Output measures such as units produced or input measures such as hours used might provide a better
                              indication of the reduction in the remaining liability.
                             Leases                                                                                     9

                                                        December 31, 2011 and End of Next Three Years

                             Sans Serif Publishers, Inc. (Lessee)
The lessee incurs an         Amortization expense ($348,685 ÷ 4 years) ..........................             87,171
expense as it uses the
                               Right-of-use equipment .................................................                     87,181
asset; the lessor earns
income as it satisfies its
obligation to provide the    First LeaseCorp (Lessor)4
asset’s use.
                             Performance obligation .......................................................   87,171
                                Lease income ($348,685÷ 4 years) ...................................                        87,171


                                In the journal entries above and throughout the reading, we look at the entries of
                             the lessee and the lessor together. This way, we can be reminded that the entries for
                             the lessor usually are essentially the mirror image of those for the lessee, the other
                             side of the same coin.5



                             Accrued Interest

                          If a company’s reporting period ends at any time between payment dates, it’s
                          necessary to record (as an adjusting entry) any interest that has accrued since interest
At each financial
statement date, any       was last recorded. We purposely avoided this step in the previous illustration by
interest that has accrued assuming that the lease agreement specified lease payments on December 31—the
since interest was last   end of each reporting period. But if payments were made on another date, or if the
recorded must be accrued
for all liabilities and   company’s fiscal year ended on a date other than December 31, accrued interest
receivables, including    would be recorded prior to preparing financial statements. For example, if lease
those relating to leases. payments were made on January 1 of each year, the effective interest amounts shown
                          in the lease amortization schedule still would be appropriate but would be recorded
                          one day prior to the actual lease payment. For instance, the second cash payment of
                          $100,000 would occur on January 1, 2012, but the interest component of that
                          payment ($37,908) would be accrued a day earlier as shown in Illustration 15–2B.




                             4
                              At the end of each of the four years of the lease term as well as the two additional years of the six-
                             year estimated life of the equipment being leased to Sans Serif, First LeaseCorp will record
                             depreciation on the equipment:
                                  Depreciation expense–equipment for lease ($479,079 ÷ 6 years)               79,847
                                     Accumulated depreciation                                                          79,847
                             5
                              Even when the two sides are not mirror images there are many similarities, so the comparison still is
                             helpful.
            10


ILLUSTRATION 15–1B
Journal Entries When                                                December 31, 2011 (to accrue interest)
Interest Is Accrued Prior to
the Lease Payment              Sans Serif Publishers, Inc. (Lessee)
                               Interest expense [10%  ($348,685 – 100,000)] .....................                    24,869
                                  Interest payable ...............................................................              24,869
We accrue interest at the
financial statement date.      First LeaseCorp (Lessor)
                               Interest receivable ...............................................................    24,869
                                  Interest revenue [10%  ($348,685 – 100,000)]..................                               24,869

                                                                  Second Lease Payment (January 1, 2012)

                               Sans Serif Publishers, Inc. (Lessee)
                               Interest payable (from adjusting entry above) ........................                 24,869
                               Lease liability (difference)....................................................       75,131
The interest is paid early        Cash (lease payment) ........................................................                100,000
the next year.
                               First LeaseCorp (Lessor)
                               Cash (lease payment) ............................................................     100,000
                                 Lease receivable ..............................................................                75,131
                                 Interest receivable (from adjusting entry above) ................                              24,869


                                  Notice that this is consistent with recording accrued interest on any debt, whether
                               in the form of a note, a bond, or a lease.

                               What if the Lease Term is Uncertain?

                               Sometimes the actual term of a lease is not obvious. Suppose, for instance, that the
                               lease term is specified as four years, but it can be renewed at the option of the lessee
                               for two additional years. Or, maybe either party can terminate the lease after, say,
                               three years. In these uncertain situations, we need to estimate the likelihood of an
                               increase or decrease in the lease term and choose accordingly. If, for instance, it’s
                               more likely than not that the four-year original lease term will be renewed for an
                               additional two years, the lease term used in accounting for the lease is six years.
The lease term for both        Purchase options, renewal options, termination options should be evaluated using a
the lessee and the lessor
                               ―more likely than not‖ criterion by both the lessee and lessor when estimating the
is the longest possible
term that is “more likely      lease term. When more than two terms are possible, we use the longest possible term
than not” to occur taking      for which that length or longer is ―more likely than not.‖
into account any options           Let’s say, for instance, that a 10-year lease can be renewed for two additional 5-
to extend or terminate
the lease.                     year periods, but that it also can be terminated after only 5 years. Management
                               assesses the probability of a 5-year, 10-year, 15-year, and 20-year lease term to be
                               25%, 20%, 20%, and 35%, respectively. The likelihood that the lease term will be at
                               least 5 years is 100%, and 75% (20% +20% +35%) that it will be 10 years or longer.
                               The chance that it will extend 15 years or longer is 55% (20% +35%), but only 35%
                               that it will be 20 years. The most likely of the choices is that it will be 10 years or
                              Leases                                                                                  11

                              longer (75%). But is that our choice? No. The probability that it will extend 15
                              years or longer is 55%, which also is more likely than not, but a longer term. So, we
                              consider the lease term to be 15 years.

                              What if the Lease Payments are Uncertain?

                              Sometimes lease payments are to be increased (or decreased) at some future time
                              during the lease term, depending on whether or not some specified event occurs.
                              Usually the contingency is related to revenues, profitability, or usage above some
                              designated level. For example, a recent annual report of Walmart Stores included
                              the note re-created in Graphic 15–4.

GRAPHIC 15–4                  9 Commitments (in part)
Contingent Lease              Certain of the leases provide for the payment of contingent leases based on percentage of sales.
Payments—Walmart              Such contingent leases amounted to $21 million, $33 million and $41 million in 2009, 2008 and 2007,
Stores                        respectively.

Real World Financials
                                 If the amounts of future lease payments are uncertain due to contingencies or
                              otherwise, we need to estimate the expected outcome of those payments. The
                              expected outcome is the present value of the probability-weighted average of the
                              cash flows for a reasonable number of possible outcomes. Suppose, for example,
                              that lease payments are $100,000 each for four years as in Illustration 15-1, but that
                              if the lessee’s net income exceeds a prespecified amount in the second year, the
                              payments the last two years will be $120,000 each. Now let’s say that San Serif
                              estimates a 40% likelihood that the increase will occur. See Illustration 15-X.
Illustration 15–3             Possible Outcomes:
Determining the Expected                                                                              Present
Outcome of Uncertain            Year 1         Year 2               Year 3            Year 4           Value    Probability
Lease Payments                 $100,000       $100,000             $100,000          $100,000        $348,685      60%
                               $100,000       $100,000             $120,000          $120,000        $380,240      40%
                                The company determines the ―expected outcome‖ as the present value of the probability-
                              weighted average of the cash flows:
                              Expected Outcome:                                                                             Probability-
                                                                                                      Present                Weighted
                                 Year 1         Year 2              Year 3            Year 4           Value    Probability Outcome
                                $100,000       $100,000            $100,000          $100,000        $348,685      60%       $209,211
                                          $100,000  3.48685* = $348,685
                                           * PV of an annuity due of $1: n = 4, i = 10%.

When lease payments are         $100,000       $100,000            $120,000          $120,000        $380,240      40%         152,096
uncertain we use the
                                          $100,000  1.90909* =                                 $190,909
expected outcome, which                    * PV of an annuity due of $1: n = 2, i = 10%.
is the present value of the               $120,000  .82645* =                                    99,174
probability-weighted                       * PV of $1: n = 2 note1, i = 10%.
                                          $120,000  .75131* =                                    90,157
average of the possible
                                           * PV of $1: n = 3 note2, i = 10%.
cash flows.
           12

                                                                                               $380,2406
                                 note1: n=2 because beginning of year 3 is the end of year 2
                                 note2: n=3 because beginning of year 4 is the end of year 3                                          ________

                                                                                                         Expected Outcome:            $361,307
                                                                                                     (probability-weighted average)

                             Reassessing the Lease Term and the Expected Lease Payments

                                When the lease term or lease payments are uncertain, we need to make estimates
                             as described above. Usually, there’s no assurance that those estimates won’t change.
                             If circumstances later indicate that a significant change has occurred in the amounts
                             measured for the lessee’s liability to make lease payments or the lessor’s right to
                             receive lease payments, we should reevaluate the lease term and the expected amount
                             of lease payments and make necessary adjustments.
                                Adjustments due to something that happened in the current or prior


                             Short-Term Leases – A Short-Cut Method

                             It’s not unusual to simplify accounting for situations in which doing so has no
                             material effect on the results. You might recognize this as the concept of
                             ―materiality.‖7 One such situation that is permitted a simpler application is a
                             short-term lease. A lease that has a maximum possible lease term (including
                             any options to renew) of twelve months or less is considered a ―short-term
                             lease.‖ Both the lessee and the lessor have a lease-by-lease option to choose a
                             short-cut approach to accounting for a short-term lease.

                             LESSEE. Conceptually, a lessee’s right-of-use asset as well as the liability to
                             make payments for that right to use the asset should be measured as the present
When a lessee has a
short-term lease, it can     value of the future payments. We make an exception, though, when the
elect not to use present     payments are not very far in the future. Specifically, when a lessee has a short-
value and measure the        term lease it’s acceptable to forego using present value and measure the right-
right-of-use asset and the
lease liability simply as    of-use asset and the lease liability simply as the total of the payments without
the total of the payments    discounting them to present value. If the lessee chooses this short-cut option, it
                             recognizes lease payments as amortization expense over the lease term.

                             6
                                 An equivalent way to calculate the present value of these uneven cash flows is:
                                          $100,000  1.90909* =                    $190,909
                                               * PV of an annuity due of $1: n = 2, i = 10%.
                                             $120,000  3.48685* =                              418,422
                                               * PV of an annuity due of $1: n = 4, i = 10%.
                                             $120,000  1.90909* =                             (229,091)
                                               * PV of an annuity due of $1: n = 2, i = 10%.
                                                                                               $380,240
                             7
                                 Materiality and cost are recognized as pervasive constraints in accounting’s Conceptual Framework.
                             Leases                                                                                                13



                             LESSOR. The short-cut approach is even more simplified for the lessor. When a
When a lessor has a
                             lessor has a short-term lease, the company can choose not to record the lease
short-term lease, it can
elect not to record the      receivable or the performance obligation that are normally recognized for a
lease receivable or the      lease. The lessor continues to recognize the asset being leased and recognizes
performance obligation.      lease payments as revenue over the lease term.

                                Let’s look at an example that illustrates the relatively straightforward accounting
                             for short-term leases. To do this we modify Illustration 15–1 to assume the lease
                             term is twelve months in Illustration 15-4.

Illustration 15–4            On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm,
Short-Term Lease;            leased printing equipment from First Lease Corp. First Lease Corp purchased the equipment
Lessee and Lessor            from CompuDec Corporation at a cost of $479,079.
                                The lease agreement specifies four quarterly payments of $100,000 beginning January 1,
                             2011, the commencement of the lease, and at the first day of each of the next three quarters.
                             The useful life of the equipment is estimated to be six years.
                                Before deciding to lease, Sans Serif considered purchasing the equipment for its cash
                             price of $479,079. If funds were borrowed to buy the equipment, the interest rate would
                             have been 10%.

                                                             Commencement of the Lease (January 1, 2011)
                             Sans Serif Publishers, Inc. (Lessee)
                             Right-of-use asset (undiscounted total of lease payments8) .....                            400,000
                                 Lease liability (undiscounted total of lease payments) ......                                          400,000
                             First LeaseCorp (Lessor)
                             No entry
                                                                    First Lease Payment (January 1, 2011)
                             Sans Serif Publishers, Inc. (Lessee)
                             Lease liability......................................................................       100,000
                                 Cash ............................................................................                      100,000
If the lessor chooses this   First LeaseCorp (Lessor)
short-cut option, it         Cash ....................................................................................   100,000
recognizes lease                  Lease income .............................................................                            100,000
payments as lease income
                                                                     Second Lease Payment (April 1, 2011)
over the lease term.
                             Sans Serif Publishers, Inc. (Lessee)
                             Lease liability .....................................................................       100,000
                                 Cash ............................................................................                      100,000




                             8
                                 also would include initial direct costs paid by lessee if any (discussed later)
            14

                             First LeaseCorp (Lessor)
                             Cash ....................................................................................   100,000
                                  Lease income .............................................................                           100,000

If the lessee chooses this                                                          December 31, 2011
short-cut option, it
recognizes lease             Sans Serif Publishers, Inc. (Lessee)
payments as amortization     Amortization expense ($400,000 ÷ 1 year) ...........................                        400,000
expense over the lease          Right-of-use asset ........................................................                            400,000
term.
                             First LeaseCorp (Lessor)9
                             No entry


                             Leasehold Improvements

                             Sometimes a lessee will make improvements to leased property that reverts back to
                             the lessor at the end of the lease. If a lessee constructs a new building or makes
The cost of a leasehold
improvement is               modifications to existing structures, that cost represents an asset just like any other
depreciated over its         capital expenditure. Like other assets, its cost is allocated as depreciation expense
useful life to the lessee.   over its useful life to the lessee, which will be the shorter of the physical life of the
                             asset or the lease term.10 Theoretically, such assets can be recorded in accounts
                             descriptive of their nature, such as buildings or plant. In practice, the traditional
                             account title used is leasehold improvements.11 In any case, the undepreciated cost
                             usually is reported in the balance sheet under the caption property, plant, and
                             equipment. Movable assets like office furniture and equipment that are not attached
                             to the leased property are not considered leasehold improvements.

                             Initial Direct Costs—Lessee and Lessor

                             The costs incurred by either the lessee or the lessor that are associated directly with
                             originating a lease and are essential to acquire that lease are referred to as initial
                             direct costs. They include legal fees, commissions, evaluating the prospective
                             financial condition of the other company, and preparing and processing lease
                             documents. These costs simply add to the asset recorded at the commencement of the
                             lease – the lessee’s right-of-use asset for costs paid by the lessee and the lessor’s

                             9
                              At the end of each of the six years of the six-year estimated life of the equipment being leased to
                             Sans Serif, First LeaseCorp will record depreciation on the equipment:
                                   Depreciation expense–equipment for lease ($479,079 ÷ 6 years)                          79,847
                                      Accumulated depreciation                                                                     79,847

                             10
                                If the agreement contains an option to renew, and the likelihood of renewal is uncertain, the renewal
                             period is ignored.
                             11
                                Also, traditionally, depreciation sometimes is labeled amortization when in connection with leased
                             assets and leasehold improvements. This is of little consequence. Remember, both depreciation and
                             amortization refer to the process of allocating an asset’s cost over its useful life.
                               Leases                                                                                                  15

                               lease receivable for costs paid by the lessor. Let’s modify our original example to
                               assume in Illustration 15-5 that both the lessee and the lessor incur initial direct
                               costs.

Illustration 15–5              On January 1, 2011, Sans Serif Publishers, Inc. leased printing equipment from First Lease
Lessee and Lessor;             Corp. The lease agreement specifies four annual payments of $100,000 beginning January 1,
Initial Direct Costs           2011, the commencement of the lease, and at each December 31 thereafter through 2013.
                               The useful life of the equipment is estimated to be six years.
                                 Sans Serif paid $2,000 for professional fees and for preparing and processing lease
                               documents.
                                   If funds were borrowed to buy the equipment, the interest rate would have been 10%.

                                                                              $100,000  3.48685* = $348,685
                                                                                 Lease                             Present
                                                                               payments                             value

                                                                   *Present value of an annuity due of $1: n = 4, i = 10%.


                                                              Commencement of the Lease (January 1, 2011)*

                               Sans Serif Publishers, Inc. (Lessee)
Initial direct costs paid by   Right-of-use asset (PV of lease payments plus initial direct costs) 350,685
the lessee add to the            Lease liability (PV of lease payments) ...............................                                     348,685
lessee’s right-of-use            Cash (initial direct costs) ...................................................                              2,000
asset.
                               First LeaseCorp (Lessor)
                               Lease receivable (PV of lease payments) ...............................                       348,685
                                  Performance obligation .................................................                                  348,685

                                                                      First Lease Payment (January 1, 2011)

                               Sans Serif Publishers, Inc. (Lessee)
                               Lease liability......................................................................         100,000
                                 Cash ..... ..........................................................................                      100,000
                               First LeaseCorp (Lessor)
                               Cash ....................................................................................     100,000
                                 Lease receivable ..............................................................                            100,000
                                                                  Second Lease Payment (December 31, 2011)

                               Sans Serif Publishers, Inc. (Lessee)
                               Interest expense [10%  ($348,685 – 100,000)] .....................                            24,869
                               Lease liability (difference) ..................................................                75,131
                                  Cash (lease payment) ........................................................                             100,000
                               First LeaseCorp (Lessor)
                               Cash (lease payment) ..........................................................               100,000
                                 Lease receivable ..............................................................                             75,134
                                 Interest revenue [10%  ($348,685 – 100,000)]..................                                             24,866
                                                              December 31, 2011 and End of Next Three Years
                               Sans Serif Publishers, Inc. (Lessee)
                               Amortization expense ($350,685 ÷ 4 years) ..........................                           87,671
                                 Right-of-use equipment .................................................                                    87,671
          16

                          First LeaseCorp (Lessor)12
                          Performance obligation ($348,685 ÷ 4 years) ........................               87,171
                             Lease income ................................................................            87,171


                          Derecognition Approach

                            We assumed in the illustrations so far that First LeaseCorp bought the printing
                            equipment from its manufacturer and then leased it for four or fewer years of its six-
                            year life. Upon getting the asset back at the end of the lease term with the
Depending on whether        opportunity to lease it again, sell it, use it, or otherwise receive benefits during its
the lessor retains          remaining life, we were looking at lease situations in which First LeaseCorp retained
significant risks or
benefits, the company       ―exposure to significant risks or benefits‖ associated with the printer. This is the
uses either a performance requirement for the lessor to account for the lease using what’s called the
obligation approach or a    performance obligation approach. The name comes from the fact that the lease
derecognition approach
to accounting for a lease.
                            liability the lessor records is a ―performance obligation‖ to allow the lessee to use the
                            asset during the lease term.
The lessor should ignore         When assessing exposure to risks or benefits, the lessor looks at relevant
credit risk associates with
                            indicators like contingent rentals, options to extend or renew, and the amount and
the lessee when assessing
exposure to risks or        uncertainty of residual value. The credit worthiness of the lessee should not be
benefits during the lease   considered.
term.                          If the lessor does not retain exposure to significant risks or benefits associated
                            with the leased asset, but instead transfers those risks and benefits of ownership to
                            the lessee, the lessor uses what we call the derecognition approach. The name
                            comes from the fact that we ―derecognize‖ the asset; that is, we remove its carrying
                            amount from the records.13 One way to view this is to think of it as when the lease
                            transfers the significant risks and benefits of ownership, the lessor is, in-substance
                            but not actually, ―selling‖ the asset and should account for it accordingly.14
                               To illustrate, let’s modify our previous illustration. Assume all facts are the same
                            except Sans Serif Publishers leased the printing equipment directly from CompuDec
                            Corporation, rather than through the financing intermediary. Also assume
                            CompuDec’s cost of the printing equipment was $300,000. If you recall that the
                            lease payments (their present value) provide a selling price of $479,079, you see that

                          12
                            At the end of each of the four years of the lease term as well as the two additional years of the six-
                          year estimated life of the equipment being leased to Sans Serif, First LeaseCorp will record
                          depreciation on the equipment:
                               Depreciation expense–equipment for lease ($479,079 ÷ 6 years)          79,847
                                    Accumulated depreciation                                                  79,847
                          13
                             Later, we see that sometimes only a portion of the asset is deemed transferred and we derecognize
                          only a portion of the carrying amount.
                          14
                             We noted earlier that if the agreement transfers control of the asset to the lessee it meets the criteria
                          for classification as a purchase and sale of the asset. It is not a lease and is accounted for as a
                          sale/purchase. This occurs if, for example, the contract transfers ownership during or at the end of the
                          lease term or if a lessee’s option to purchase has terms that make it likely to occur.
                                   Leases                                                                                                 17

                           CompuDec earns a gross profit on the sale of $479,079  300,000 = $179,079.
The lessee’s accounting is   Illustration 15-6 provides this example. We don’t revisit lessee accounting here
the same regardless of     because lessee accounting is not affected by whether the lessor uses the performance
which approach the lessor
uses.                      obligation approach or the derecognition approach.

Illustration 15–6                  On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm,
Lessor; Derecognition              leased printing equipment from CompuDec Corporation.
Approach                               The lease agreement specifies six annual payments of $100,000 beginning January 1,
                                   2011, the commencement of the lease, and at each December 31 thereafter through 2015.
                                   The six-year lease term ending December 31, 2016, is equal to the estimated useful life of
                                   the printing equipment. CompuDec determined that it does not retain exposure to significant
                                   risks or benefits associated with the printer.
                                      CompuDec manufactured the printing equipment at a cost of $300,000.
                                      The fair value of the printing equipment is $479,079.
                                      CompuDec’s interest rate for financing the transaction is 10%.

                                                                                  $100,000  4.79079* = $479,079
                                                                                     Lease                            Present
                                                                                   payments                            value
The derecognition                                                      *Present value of an annuity due of $1: n = 6, i = 10%.
approach is similar to
recording a sale of                                      Commencement of the Lease (January 1, 2011)
merchandise on                     Lease receivable (present value of lease payments) ................               479,079
account:                             Sales revenue .................................................................                           479,079
A/R ................{price}
  Sales rev.....         {price}
                                   Cost of goods sold .....................................................................     300,000
COGS .............{cost}             Inventory of equipment (lessor’s cost) ...............................                                    300,000
  Inventory ...          {cost}
                                                                        First Lease Payment (January 1, 2011)
Remember, no interest              Cash .................................................................................... 100,000
has accrued when the                 Lease receivable ..............................................................                           100,000
first payment is made at
the commencement of                                         Second Lease Payment (December 31, 2011)
the lease.                         Cash (lease payment) ..........................................................   100,000
                                     Lease receivable ..............................................................                            62,092
                                     Interest revenue [10%  ($479,079 - 100,000)] ..................                                           37,908


                                      You should recognize the similarity between recording both the revenue and cost
                                   components of this ―sale‖ by lease and recording the same components of other sales
                                   transactions. As in the sale of any product, gross profit is the difference between
                                   sales revenue and cost of goods sold. Dell Inc. ―sells‖ some of its products using
                                   leases and disclosed the following in a recent annual report:

Real World Financials              Note 1 (in part)
                                   Dell records revenue from the sale of equipment under …. leases as product revenue at the
                                   commencement of the lease. … [L]eases also produce financing income, which Dell recognizes at
                                   consistent rates of return over the lease term.

                                      Accounting by the lessee is not affected by how the lessor classifies the lease. All
                                   lessee entries are precisely the same as in the previous illustrations.
           18



                            Derecognition Approach – If Present Value of Payments Less than the
                            Asset’s Fair Value

                               In our previous illustration, we assumed that the lease payments were calculated
                            by the lessor so that their present value would equal the fair value of the asset being
                            leased. That is not an improbable assumption; often a manufacturer or dealer will use
                            leasing often as a primary method of ―selling‖ its products. Suppose, though, that
A residual asset            other factors, say competitive market conditions, influence the amount of the
represents the rights to    payments in such a way that their present value is a little less than the fair value of
the leased asset retained   the asset. In that case, not all the rights to the asset are transferred to the lessee; the
by the lessor under the     lessor retains a portion of those rights. In this situation, the lessor should divide the
derecognition approach      carrying amount of the asset into two parts, (1) the portion transferred and thus
for lessor accounting.      derecognized and (2) the portion retained and thus reclassified as what we call a
                            residual asset. The allocation is based on the ratio of the present value of the
                            payments to the fair value of the asset.15 Illustration 15-6A demonstrates the
                            calculation.

Illustration 15–6A          On January 1, 2011, Sans Serif Publishers, Inc., a computer services and printing firm,
Lessor; Derecognition       leased printing equipment from CompuDec Corporation.
Approach – Present Value        The lease agreement specifies six annual payments of $100,000 beginning January 1,
of Payments Less than       2011, the commencement of the lease, and at each December 31 thereafter through 2015.
Carrying Amount             The six-year lease term ending December 31, 2016, is equal to the estimated useful life of
                            the printing equipment. CompuDec determined that it does not retain exposure to significant
                            risks or benefits associated with the printer
                               CompuDec manufactured the printing equipment at a cost of $300,000.
                               The fair value of the printing equipment is $500,000.
                               CompuDec’s interest rate for financing the transaction is 10%.

                                                               $100,000  4.79079* = $479,079
                                                                  Lease                      Present
                                                                payments                      value
                                                       *Present value of an annuity due of $1: n = 6, i = 10%.




                            15
                              It’s unlikely that the fair value will exceed the present value of the cash flows by a large amount
                            and the derecognition approach still be appropriate. That’s because the derecognition approach is
                            appropriate only when the lessor does not retain significant risks and rewards of ownership, and a
                            relatively large residual asset would be inconsistent with that condition.
                               Leases                                                                                                  19



                                                     Commencement of the Lease (January 1, 2011)
The portion of the             Lease receivable (present value of lease payments) ................               479,079
carrying amount the
                                 Sales revenue .................................................................                            479,079
lessor derecognizes is
$300,000 times the ratio
                               Cost of goods sold .....................................................................      287,447
of the PV of the payments
                                 Inventory of equipment ($300,000 x 479,079/500,000)*............                                           287,447
to the FV of the asset.

The remainder is               Residual asset.............................................................................    12,553
reclassified as a residual       Inventory of equipment ($300,000 – 287,447)* .................                                              12,553
asset.
                                                                    First Lease Payment (January 1, 2011)
                               Cash .................................................................................... 100,000
                                 Lease receivable ..............................................................                            100,000

                                                        Second Lease Payment (December 31, 2011)
                               Cash (lease payment) ..........................................................   100,000
                                 Lease receivable ..............................................................                             62,092
                                 Interest revenue [10%  ($479,079 – 100,000)]..................                                             37,908


                                      * The $287,447 portion of the asset deemed transferred and thus derecognized is
                                        calculated as its “selling price” divided by its fair value. The remaining portion
                                        ($12,553) of the asset’s carrying amount is reclassified as a residual asset. The
                                        residual asset is reported separate from other assets in the balance sheet.



         PART B                OTHER LEASE ACCOUNTING ISSUES

                               Purchase Options

                               A purchase option is a provision of some lease contracts that gives the lessee the
                               option of purchasing the leased property during, or at the end of, the lease term at a
                               specified exercise price. Although we don’t consider the exercise price to be an
                               additional cash payment, the existence of a purchase option might affect the
                               estimated lease term. If, for instance, (a) the purchase option is exercisable before
 When a purchase option        the designated lease term ends, and (b) the exercise price is sufficiently below the
 is present, both the lessee   property’s expected fair value that the exercise of the option appears more likely than not,
 and the lessor estimate       then we assume the lease term ends for accounting purposes when the option
 whether it’s more likely      becomes exercisable. For example, let’s say Sans Serif has the option in Illustration
 than not to be exercised      15-1 to purchase the leased equipment after three years of the four-year specified
 when determining the
                               lease term. The effect this would have on accounting for the lease is to change the
 expected lease term.
                               lease term from four years to three. All calculations would be modified accordingly.
                               Stated differently, lease payments include only the periodic cash payments specified
                               in the agreement that occur prior to the date a more-likely-than-not purchase option
                               becomes exercisable.
                                   As you might expect, if the lessor expects a purchase option to be exercised prior
                               to the designated lease term, the shorter time period and the expected receipt of the
                               exercise price will likely be considerations when determining the size of the periodic
                               lease payments.
           20




                              Residual Value
If a guaranteed residual      The residual value of leased property is an estimate of what its commercial value
value exceeds the             will be at the end of the lease term. Sometimes the lease agreement includes a
estimate of the actual        guarantee by the lessee that the lessor will recover a specified residual value when
residual value, the PV of
                              custody of the asset reverts back to the lessor at the end of the lease term. This not
that excess is added to
the PV of the lease           only reduces the lessor’s risk but also provides incentive for the lessee to exercise a
payments the lessee           higher degree of care in maintaining the leased asset to preserve the residual value.
records as both a right-of-   The lessee promises to return not only the property but also sufficient cash to provide
use asset and a lease         the lessor with a minimum combined value. In effect, the guaranteed residual value
liability.                    creates an additional lease payment if the guaranteed residual value exceeds the
                              estimate of the actual residual value at the end of the expected lease term. As such,
The PV of the estimated       the present value of an estimate of any amount payable under the guaranteed residual
amount payable also is
added to the lessor’s PV
                              value is added to the present value of the lease payments and affects the amount the
of lease payments for its     lessee records as both a right-of-use asset and a lease liability. It also is added in the
lease receivable.             lessor’s determination of the present value of lease payments for its lease receivable.
                              Let’s return to Illustration 15-1, but now assume that, at the commencement of the
                              lease, both the lessee and lessor expect the residual value after the four-year lease
                              term to be $191,000. Negotiations led to the lessee guaranteeing a $241,000. The
                              excess guaranteed residual value is viewed as an additional cash flow and its present
                              value is included in the calculation of the present value of lease payments as shown
                              in Illustration 15–7.

ILLUSTRATION 15–7             Present value of periodic lease payments ($100,000  3.48685*)                                  $348,685
Calculation of the Present    Plus: Present value of estimated payment under residual value guarantee
Value of Expected Lease       ([$241,000 – 191,000]  .68301†)                                                                  34,151
Payments Including an         Present value of expected lease payments                                                        $382,836
Excess Guaranteed
Residual Value                *Present value of an annuity due of $1: n = 4, i = 10%.
                              †
                                Present value of $1: n = 4, i = 10%.

                                                           Commencement of the Lease (January 1, 2011)

                              Sans Serif Publishers, Inc. (Lessee)
                              Right-of-use asset ..............................................................   382,836
                                Lease liability (present value of lease payments) ................                          382,836
                              First LeaseCorp (Lessor)
                              Lease receivable (present value of lease payments) ................                 382,836
                                Performance obligation ...................................................                  382,836


                              ADDITIONAL CONSIDERATION
                                  If a residual value is not guaranteed, is guaranteed by a third party (Insurance
                              companies sometimes assume this role.), or is guaranteed by the lessee but does not
                              differ from the estimate of the actual fair value at the end of the lease term, it does
The lessor subtracts the      not affect the calculations by either the lessee or lessor of the present value of the
PV of the residual value      lease payments. Obviously, though, even if it is not guaranteed, the lessor still
to determine lease            expects to receive it in the form of property, or cash, or both. That amount would
payments.
                              Leases                                                                               21

                              contribute to the total amount to be recovered by the lessor and would reduce the
                              amount needed to be recovered from the lessee through periodic lease payments. A
                              residual value likely will affect the lessor’s calculation of periodic lease payments.
                              For instance, whether the $191,000 residual value in the previous illustration is
                              guaranteed or not, its existence affected the lessor’s lease payment calculation:

                               Amount to be recovered (fair value)                                         $479,079
                               Less: Present value of the Residual value ($190,91116  .68301*)            (130,394)
                               Amount to be recovered through periodic lease payments                      $348,685
                               Lease payments at the beginning of each of the next six years:              $100,000
                                   ($348,683  3.48685†)


                              *Present value of $1: n = 4, i = 10%.
                              †
                                Present value of an annuity due of $1: n = 4, i = 10%.



                                 We have seen how lease payments are affected by a residual value and by a
                              purchase option. Let’s now consider how maintenance, insurance, taxes, and other
                              costs usually associated with ownership (called service benefits) affect minimum
                              lease payments.

                              Discount Rate

                              An important factor in the overall lease equation that we’ve glossed over until now is
                              the discount rate used in present value calculations. Because lease payments occur in
                              future periods, we must consider the time value of money when evaluating their
                              present value. The rate is important because it influences virtually every amount
                              reported by both the lessor and the lessee in connection with the lease.
The lessor uses the rate it      One rate is implicit in the lease agreement. This is the effective interest rate the
charges the lessee.           lease payments provide the lessor over and above the price at which the right to use
                              the asset is sold under the lease. It is the desired rate of return the lessor has in mind
The lessee uses that rate
                              when deciding the size of the lease payments. Usually the lessee is aware of the rate
if known, otherwise the
lessee’s own incremental      the lessor charges or can infer it from the asset’s fair value.17 When the lessor’s
borrowing rate.               implicit rate is unknown, the lessee should use its own incremental borrowing rate.
                              This is the rate the lessee would expect to pay a bank if funds were borrowed to buy
                              the asset.18 When the lessor’s implicit rate is known, the lessee should use that rate.

                              When the Lessor’s Implicit Rate is Unknown


                              16
                                 For the previous illustration, we rounded the $190,911 residual value to $191,000 to be more
                              representative of a realistic estimate.
                              17
                                 The corporation laws of some states, Florida for instance, actually require the interest rate to be
                              expressly stated in the lease agreement.
                              18
                                 Incremental borrowing rate refers to the fact that lending institutions tend to view debt as being
                              increasingly risky as the level of debt increases. Thus, additional (i.e., incremental) debt is likely to be
                              loaned at a higher interest rate than existing debt, other things being equal.
22

     What if the lessee is unaware of the lessor’s implicit rate? This is a logical question
     in light of the rule that says the lessee should use its own incremental borrowing rate
     when the lessor’s implicit rate is unknown to the lessee. But in practice the lessor’s
     implicit rate usually is known. Even if the lessor chooses not to explicitly disclose
     the rate, the lessee usually can deduce the rate using information he knows about the
     value of the leased asset and the lease payments. After all, in making the decision to
     lease rather than buy, the lessee typically becomes quite knowledgeable about the
     asset.
        Even so, it is possible that a lessee might be unable to derive the lessor’s implicit
     rate. This might happen, for example, if the leased asset has a relatively high residual
     value. Remember, a residual value (guaranteed or not) is an ingredient in the lessor’s
     calculation of the lease payments. Sometimes it may be hard for the lessee to identify
     the residual value estimated by the lessor if the lessor chooses not to make it
     known.19 As the lease term and risk of obsolescence increase, the residual value
     typically is less of a factor.


     Lease Disclosures

     Lease disclosure requirements are quite extensive for both the lessor and lessee.
     Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a
     general description of the leasing arrangement is required as well as (b) minimum
     future payments, in the aggregate and for each of the five succeeding fiscal years,
     distinguishing those attributable to the minimum amounts specified rather than
     from contingent rentals, term option penalties and residual value guarantees.
     Companies also describe the amounts recognized in the financial statements arising
     from leases and how leases may affect the amount, timing and uncertainty of the
     company’s future cash flows.
         Each company reports a schedule reconciling opening and closing balances of,
     for lessees, the (a) right-of-use assets and (b) lease liabilities and, for lessors, the (a)
     lease receivables, (b) performance obligations, and (c) residual assets arising from
     the derecognition approach.
         Other required disclosures include:
          contingent rentals, renewal and termination options, including whether they
             affected assets and liabilities recognized
          purchase options
          residual value guarantees
          initial direct costs
          significant subleases
          recognized amount of short-term leases
          discount rate used
          sale and leaseback arrangements
          significant service obligations related to its leases

     19
       Disclosure requirements provide that the lessor company must disclose the components of its
     investments in leases, which would include any estimated residual values. But the disclosures are
     aggregate amounts, not amounts of individual leased assets.
                        Leases                                                              23

                                impairment losses

                            The lessor also must disclose its exposure to the risks or benefits that it used in
                        determining whether to apply the performance obligation approach or the
                        derecognition approach.


                        Statement of Cash Flow Impact

                            A lessee classifies cash payments for leases as financing activities in its
                        statement of cash flows and presents them separately from other financing cash
                        flows. The lessor classifies the cash receipts from lease payments as operating
                        activities in its statement of cash flows.


        Part C          SALE-LEASEBACK ARRANGEMENTS


                        In a sale-leaseback transaction, the owner of an asset sells it and immediately
                        leases it back from the new owner. Sound strange? Maybe, but this arrangement is
                        common. In a sale-leaseback transaction two things happen:

                          1. The seller-lessee receives cash from the sale of the asset.
                          2. The seller-lessee pays periodic lease payments to the buyer-lessor to retain the
                             use of the asset.

                           What motivates this kind of arrangement? The two most common reasons are: (1)
                        If the asset had been financed originally with debt and interest rates have fallen, the
                        sale-leaseback transaction can be used to effectively refinance at a lower rate. (2)
                        The most likely motivation for a sale-leaseback transaction is to generate cash.
                             Illustration 15–8 demonstrates a sale-leaseback involving a lease for warehouses.
                        The sale and simultaneous leaseback of the warehouses should be viewed as a single
Recording a sale-       borrowing transaction. Although there appear to be two separate transactions, look
leaseback transaction
                        closer at the substance of the agreement. Teledyne still retains the use of the
follows the basic
accounting concept of   warehouses that it had prior to the sale and leaseback. What is different? Teledyne
substance over form.    has $900,000 cash and an obligation to make annual payments of $133,155. In
                        substance, Teledyne simply has borrowed $900,000 to be repaid over 10 years along
                        with 10% interest.
          24

ILLUSTRATION 15–8           Teledyne Distribution Center was in need of cash. Its solution: sell its four warehouses for
Sale-Leaseback              $900,000, then lease back the warehouses to obtain their continued use. The warehouses had
                            a carrying value on Teledyne’s books of $600,000 (original cost $950,000). Other
                            information:

                            1. The sale date is December 31, 2011.
                            2. The noncancelable lease term is 10 years and requires annual payments of $133,155
                               beginning December 31, 2011. The estimated remaining useful life of the warehouses is 10
                               years.
                            3. The annual lease payments (present value $900,000) provides the lessor with a 10% rate of
                               return on the financing arrangement.* Teledyne’s incremental borrowing rate is 10%.
                            4. Teledyne depreciates its warehouses on a straight-line basis.

                                                                    December 31, 2011
Through the sale-
leaseback Teledyne          Cash                                                                   900,000
obtains $900,000 cash in    Accumulated depreciation ($950,000  600,000)                          350,000
exchange for the promise        Warehouses (cost)                                                            950,000
to repay that amount plus       Gain on sale-leaseback (difference)                                          300,000
interest over the lease
term.                       Right-of-use asset                                                     900,000
                                Lease liability (present value of lease payments)                            900,000
                            Lease liability                                                        133,155
                                Cash                                                                         133,155
                                                                    December 31, 2012
                            Interest expense [10%  ($900,000  133,155)]                           76,685
                            Lease liability (difference)                                            56,470
                                 Cash (lease payment)                                                        133,155
                            Interest expense [10%  ($900,000  133,155)]                           79,185
                            Lease liability (difference)                                            53,970
                                 Cash (lease payment)                                                        133,155
                            Amortization expense ($900,000  10 years)                              90,000
                               Right-of-use asset                                                             90,000

                            *$133,155        6.75902           = $900,000 ($899,997.31 rounded)
                               Lease          (from Table 6)      Present value
                              payments        n = 10, i = 10%


                                There typically is interdependency between the lease terms and the price at
                            which the asset is sold. Little imagination is needed to envision an agreement
                            between the seller-lessee and the buyer-lessor designed to manipulate the amount of
                            cash effectively borrowed under the sale-leaseback. Suppose, for instance, that the
                            two companies agreed that Teledyne would receive $1,000,000 from the sale of the
                            warehouses in return for agreeing to increase lease payments from $133,155 (PV:
                            $900,000) to $147,950 (PV: $1,000,000). When the sales price is materially
                            different from the fair value of the asset sold, we adjust the gain on the sale and the
                            right-of-use asset by the difference to avoid those two amounts being misstated.
                            Illustration 15-8A demonstrates this situation.
                              Leases                                                               25

ILLUSTRATION 15–8A                                                     December 31, 2011
Sale-Leaseback; sales price
                              Cash                                                             1,000,000
different from the fair
value of the asset sold
                              Accumulated depreciation ($950,000  600,000)                     350,000
                                Warehouses (cost)                                                            950,000
                                Gain on sale-leaseback (difference)                                          400,000
                              Right-of-use asset                                               1,000,000
                                Lease liability (present value of lease payments)                          1,000,000
We adjust the gain on the
sale and the right-of-use     Gain on sale-leaseback ($1,000,000  900,000)                    100,000
asset to avoid those two        Right-of-use asset (PV of payments less fair value of asset)                100,000
amounts being misstated.
                              Lease liability                                                  147,950
                                Cash                                                                         147,950

                                                                       December 31, 2012
                              Interest expense [10%  ($1,000,000  147,950)]                   85,205
                              Lease liability (difference)                                      62,745
                                 Cash (lease payment)                                                        147,950
                              Amortization expense [$1,000,000  100,000)  10 years]           90,000
                                Right-of-use asset                                                           90,000
                              *$147,950        6.75902           =    $1,000,000
                                  Lease         (from Table 6)        Present value
                                payments        n = 10, i = 10%

								
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