Intermediate Accounting _ Seventh Canadian Edition by pengxuezhi


									Chapter 20: Leases   Source:
    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
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
• 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

      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
            Yes                   Yes          Yes

                         Capital Lease               Operating
           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
• 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
• 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
• 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
• 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?
Option?                   Yes

                                 Yes   PV of payments (n=5, i=10%)
              Capital Lease            =(25,981.62 - 2000.00) x 4.16986
Use Financial Calculator

     Make sure you press BGN
     button before doing any
     calculation on annuity
     PV                  $?     Yields $100,000
   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

• 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
      Executory                                obligation
      costs are
Capital Lease – Amortization
    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 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
• 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
         Lease Classification - Lessor
                                     Are the
               Is the risk           unreim-
                                                    Yes   Does Asset
               associated        Yes burseable            Fair Value =
               with collection       costs to
               normal?               Lessor
 Does Lease                                               Book Value?
 meet any of
 Lessee’s                                             No             Yes
                                        No                   Direct
                         No                                  Financing
                           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
   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
• 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
                                                    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
     PMT                 $?    Yields ($23,981)
   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
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
• 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
       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
  – 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

• 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.
• The 2-page report is due at the beginning of
  the tutorial on Nov. 20.

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