Chapter 20: Leases Source: http://two.leasingnews.org/ Questions We Need to Answer 1. How to distinguish capital leases from operating leases? 2. What are the accounting and disclosure requirements for operating leases and capital leases? Skills We Will Learn 1. Understand accounting criteria for capitalizing leases. 2. Prepare journal entries to record operating leases and capital leases for lessees. 3. Prepare journal entries to record operating leases, direct financing leases, and sales-type leases for lessors. 4. Identify the effect of residual values and bargain purchase options on lease accounting. Leasing: Basics • The lease is a contractual agreement between the lessor and the lessee • The lease gives the lessee the right to use specific property (owned by the lessor) • The lease specifies the duration of the lease and rental payments • The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee or divided Advantages of Leasing • Protection from obsolescence – Property can be upgraded • Flexibility – Lease may be structured to meet different needs (e.g., cash flow) • Less costly financing (lessee); tax incentives (lessor) • Off-balance sheet financing – To avoid negative impact on ratios Current Accounting Standard • CICA standard is consistent with approach similar to instalment purchases • A lease that transfers substantially all the benefits and risks of property ownership should be capitalized Lease Classification • Capital Lease – Where the benefits and risks of ownership have effectively been transferred to the lessee • Accounted for as a purchase by the lessee – Journal Entries: Lessee Lessor Leased Equipment XXX Lease Receivable (net) XXX Lease Obligation XXX Equipment XXX Lease Classification • Operating Lease – Where the rights and risks of ownership have not been transferred • A rental-only has occured – Journal Entries: Lessee Lessor Lease Expense XXX Cash XXX Cash XXX Rental Revenue XXX Capital vs. Operating Lease Lease Agreement Is there a Is Lease Term No No Is Present No Transfer of 75% of Value of Ownership Economic Life Payments or Bargain 90% of Fair Purchase Value Option? Yes Yes Yes Capital Lease Operating Lease Capital Lease Criteria • Transfer of ownership test • Economic life test • Recovery of Investment test – If the PV of minimum lease payments is 90% of the fair value of the asset – minimum lease payments (lessee) defined as: • Minimum rental payments + • Guaranteed residual value + • Bargain purchase option+ • Penalty for not renewing or extending lease Minimum Lease Payments (MLP) • Minimum rental payments – Regular payment made to lessor, excluding executory costs • Executory costs include insurance, maintenance and tax expenses. They should be excluded from the minimum rental payment calculation • Guaranteed residual value – The amount at which the lessor has the right to require the lessee to purchase the asset; or – The amount the lessee (or 3rd party guarantor) guarantees that the lessor will realize • Bargain Purchase Option Discount rate used to calculate PV of MLP • The lessee’s incremental borrowing rate • This rate is not used when – The lessee knows the implicit rate lessor used to calculate the lease payment, and it is less than the lessee’s incremental borrowing rate – In this case, use the lessor’s implicit rate Accounting for a Capital Lease • Asset and liability recorded at the lower of: – PV of the minimum lease payments (as defined above) or – Fair value of the asset at the inception of the lease • Depreciation of the asset is amortized over: – The economic life of the asset if ownership transfers to lessee at the end of the lease or there is a bargain purchase option – The term of the lease if title does not transfer or there is no bargain purchase option Accounting for a Capital Lease • Interest expense resulting from the lease transaction is recorded following the effective interest method – The discount rate used to establish the initial PV is used to calculate the interest expenses Journal entries for a capital lease At the inception of the lease Dr. Asset under capital leases Cr. Obligations under capital leases To record interest expenses Using the Effective Dr. Interest Expense Interest Method Cr. Interest Payable To record asset amortization Using method Dr. Amortization Expense appropriate to Cr. Accumulated Amortization the asset To record the lease payment Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under capital lease Cr. Cash Capital Lease – Example Lease Terms Given, Jan 1/2005: • Term of 5 years, non-cancellable • Annual payments $25,981.62 (due at the beginning of each year) • Fair value of lease asset is $100,000 • Economic life = 5 years; No residual value of the asset • Lease payments include $2,000 property taxes (executory cost) • Lease has no renewal option, and asset reverts to Lessor at termination of lease • Lessee’s incremental borrowing rate = 11% • Lessor’s implicit rate =10% (known to lessee) Capital Lease: Determining Capitalization • Does this qualify as a capital lease? • Only one of the tests must be met Is there a Is Lease Term Is Present Value Transfer of 75% of of Payments Ownership No Economic Life? 90% of Fair or Bargain Value? Purchase Option? Yes Yes PV of payments (n=5, i=10%) Capital Lease =(25,981.62 - 2000.00) x 4.16986 =$100,000.00 Use Financial Calculator Make sure you press BGN button before doing any calculation on annuity due PV $? Yields $100,000 10% I 5 N ($23,981) PMT $0 FV Capital Lease – Journal Entries (1) • Entry to record initial lease transaction The lower Lease Assets 100,000 of PV of MLP or FV Lease Liability 100,000 of the asset. • Entry to record initial payment (Jan 1/05) No Property Tax Expense 2,000.00 interest. Lease Liability 23,981.62 All Cash 25,981.62 payment reduce Executory obligation costs are excluded Capital Lease – Amortization Schedule Capital Lease – Journal Entries (2) • Interest expenses (December 31, 2005) Interest Expense 7,601.84 Interest Payable 7,601.84 (100,000-23,981.62)*10% = 7,601.84 (Interest Payable is debited in all subsequent lease payment entries) • Asset amortization (December 31, 2005) Amortization expense 20,000 Accumulated amortization 20,000 20,000=100,000 / 5 years There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset Capital Lease – Journal Entries (3) • Entry to record the second payment (Jan 1/06) Property Tax Expense 2,000.00 Interest Payable 7601.84 Lease Liability 16,329.78 Cash 25,981.62 Capital vs Operating Comparing Charges to Operations Capital Lease Operating Lease Year Amortization Executory costs Interest Total Charges Lease Charge Difference 2005 $20,000.00 $2,000.00 $7,601.84 $29,601.84 $25,981.62 $3,620.22 2006 $20,000.00 $2,000.00 $5,963.86 $27,963.86 $25,981.62 $1,982.24 2007 $20,000.00 $2,000.00 $4,162.08 $26,162.08 $25,981.62 $180.46 2008 $20,000.00 $2,000.00 $2,180.32 $24,180.32 $25,981.62 -$1,801.30 2009 $20,000.00 $2,000.00 $0.00 $22,000.00 $25,981.62 -$3,981.62 Total $100,000.00 $10,000.00 $19,908.10 $129,908.10 $129,908.10 $0.00 Disclosure Requirements – Capital Lease • Gross amount of assets and related accumulated amortization • Amortization Current Portion=Interest accrued since expense may be disclosed, methods and last payment rate should be disclosed date + Lease obligation that will separately from yr. • Lease obligations reported be paid within 1 other liabilities • Current portion of lease obligation=current liability • Minimum lease payments in total and for the next five fiscal years; executory costs and imputed interest disclosed separately • Interest expense from the lease may be separately disclosed; or included with other interest expense • May disclose any related contingencies Accounting by the Lessor • Leases are classified as either: – Operating Lease – Direct financing Lease These are – Sales-type Lease capital leases • The determination of a capital or operating lease depends on answering a series of questions Lease Classification - Lessor Lease Are the Agreement remaining Is the risk unreim- Yes Does Asset associated Yes burseable Fair Value = with collection costs to Lessor’s normal? Lessor Does Lease Book Value? estimatible? meet any of Lessee’s No Yes Yes Capital No Direct Lease No Financing criteria? Lease No Operating Sales-Type Lease Lease Direct financing vs Sale-type • Both the direct financing lease and the sales-type lease are capital leases • The difference is whether or not there exists a manufacturer’s or dealer’s profit • The sales-type lease incorporates a profit Direct Financing Lease - Lessor • Lessor replaces investment in asset to be leased with a lease receivable • Over lease term, the receivable is collected, and interest is earned • Net investment in the lease = lease payments receivable – unearned interest revenue Direct Financing-Example Lease Terms Given, Jan 1/2005: • Term of 5 years, non-cancellable • Annual payments $25,981.62 (due at the beginning of each year) • Fair value of lease asset is $100,000, equal to the lessor’s acquisition cost • Economic life = 5 years; No residual value of the asset • Lease payments include $2,000 property taxes (executory cost) • Lease has no renewal option, and asset reverts to Lessor at termination of lease • Lessee’s incremental borrowing rate = 11% • Lessor’s implicit rate =10% (known to lessee) Calculation of Lease Payment by the Lessor Step 1: Calculate the payment required to provide lessor with required rate of return Discounted amount of Cost/FMV of asset to be recovered $100,000 total receivables Less: PV of expected residue value -0- PV of amount to be recovered Undiscounted amount through lease payments $100,000 of total receivables Number of payment=5, Implicit Rate=10% PV of an annuity due = 4.16986 Lease payment required= $100,000 / 4.16986 = 23,981.62 Step 2: Total lease payment receivable = 23,981.62*5+0=119,908.10 Step 3: Unearned interest revenue= 119,908.10-100,000=19,908.10 Use Financial Calculator Make sure you press BGN button before doing any calculation on annuity due PMT $? Yields ($23,981) 10% I 5 N $100,000 PV $0 FV Direct Financing Lease (Lessor) • The lease payments receivable are equal to: Lease payments (net of executory costs) + salvage (residual) value / BPO • The unearned interest revenue is the difference between the lease payment receivable and the asset cost (FMV) • The journal entries are then: Direct Financing Lease (Lessor) January 1, 2005 Lease Payments Receivable 119,908.10 Equipment for Lease 100,000.00 Unearned Interest Revenue 19,908.10 January 1, 2005 (first payment) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable 23,981.62 Direct Financing Lease (Lessor) At Dec. 31/05 year end, Lessor recognizes interest earned: Amount originally financed $100,000.00 Paid on principal Jan. 1/05 (23,981.62) Balance outstanding $ 76,018.38 Interest : 10% x 76,018.38 x 12/12 = $7,601.84 Unearned Interest Revenue 7,601.84 Interest Revenue 7,601.84 Sales-Type Lease - Lessor • Entries are the same as for the direct financing lease, except for: – Entry at the inception of the lease must record the sale and cost of goods sold • Lessor earns a gross profit on sale + interest as the sale is financed Sales-Type Lease – Example • Take the same data as in direct financing example, except the asset has been recorded in the Lessor’s inventory at a cost of $85,000 (FMV=$100,000) • All previous lessor entries remain the same except for the entry at the lease inception – Sales and Gross Profit are recorded Sales-Type Lease – Example January 1, 2005 Lease Payments Receivable 119,908.10 Sales 100,000.00 Unearned Interest Revenue 19,908.10 Cost of Goods Sold 85,000.00 Inventory 85,000.00 The journal entries in subsequent dates are exactly the same as direct-financing lease. Disclosure Requirements - Lessor • Disclose the net investment in the lease (classified as current and non-current) • How the investment is calculated for purposes of income recognition • Finance income amount • Operating Leases – Separate disclosure of the cost and accumulated amortization of the property – Amount of rental (lease) income earned Lessor’s Journal Entries for Operating Leases • To record cash rental receipt: Dr. Cash xx Cr. Rental Revenue xx • To record asset amortization: Dr. Amortization Expense xx —Lease Equipment Cr. Accumulated Amortization xx —Lease Equipment Residual Value for Lessee • If guaranteed by lessee, PV of residual is included in leased asset and lease obligation recognized (i.e. is included in definition of minimum lease payments) • If not guaranteed by lessee, residual value is not included in definition of minimum lease payments – not in asset or liability amounts recognized Residual Value for Lessor • Direct Financing Lease: whether guaranteed or unguaranteed, the residual is included in the lessor calculations • Sales-Type Lease (see textbook example in page 1261): – PV of guaranteed residual value is part of Sales Revenue and COGS – PV of unguaranteed residual value is excluded from Sales Revenue and COGS – No difference on total payment receivable and unearned interest revenue Bargain Purchase Option • For Lessee: – Lessee accounting assumes bargain option price will be paid: PV of BPO amount included in asset cost and obligation recognized; – Amortization period is the economic life of the asset. • For Lessor: – The accounting for BPO is similar to guaranteed residual value. Case for next week • CA20-1, on page 1304 of the textbook • Team #2 of each tutorial section will present the case solution next week (Nov. 13). • The 2-page report is due at the beginning of the tutorial on Nov. 20.
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