Intermediate Accounting, Seventh Canadian Edition

1
Chapter 20 Leases
Source http//two.leasingnews.org/
2
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?

3
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.
4
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

5
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

6
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

7
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
8
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
9
Capital vs. Operating Lease
Is there a Transfer of Ownership or Bargain
Purchase Option?
Is Lease Term ? 75 of Economic Life
Is Present Value of Payments ? 90 of Fair Value
No
No
No
Yes
Yes
Yes
Operating Lease
Capital Lease
10
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

11
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

12
Discount rate used to calculate PV of MLP

• The lessees 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 lessees incremental borrowing rate
• In this case, use the lessors implicit rate

13
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

14
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

15
Journal entries for a capital lease
At the inception of the lease Dr. Asset under
capital leases Cr. Obligations under capital
leases
To record the lease payment Dr. Related
Executory Expense (if any)Dr. Interest
PayableDr. Obligations under capital
lease Cr. Cash
16
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
• Lessees incremental borrowing rate 11
• Lessors implicit rate 10 (known to lessee)

17
Capital Lease Determining Capitalization

• Does this qualify as a capital lease?
• Only one of the tests must be met

Capital Lease
18
Use Financial Calculator
Make sure you press BGN button before doing any calculation on annuity due Make sure you press BGN button before doing any calculation on annuity due
PV ?  Yields 100,000  
I 10  
N 5  
PMT (23,981)  
FV 0  
19
Capital Lease Journal Entries (1)

• Entry to record initial lease transaction Lease
  Assets 100,000 Lease Liability
  100,000
• Entry to record initial payment (Jan
  1/05)Property Tax Expense 2,000.00Lease
  Liability 23,981.62 Cash 25,981.62

The lower of PV of MLP or FV of the asset.
No interest. All payment reduce obligation
Executory costs are excluded
20
Capital Lease Amortization Schedule
21
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

20,000100,000 / 5 yearsThere is no transfer of
ownership or bargain purchase option, so the term
of the lease is used to amortize the asset
22
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

23
Capital vs Operating
24
Disclosure Requirements Capital Lease

• Gross amount of assets and related accumulated
  amortization
• Amortization expense may be disclosed, methods
  and rate should be disclosed
• Lease obligations reported separately from other
  liabilities
• Current portion of lease obligationcurrent
  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

Current PortionInterest accrued since last
payment date Lease obligation that will be paid
within 1 yr.
25
Accounting by the Lessor

• Leases are classified as either
• Operating Lease
• Direct financing Lease
• Sales-type Lease

• The determination of a capital or operating lease
  depends on answering a series of questions

26
Lease Classification - Lessor
No
27
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
  manufacturers or dealers profit
• The sales-type lease incorporates a profit

28
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

29
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 lessors 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
• Lessees incremental borrowing rate 11
• Lessors implicit rate 10 (known to lessee)

30
Calculation of Lease Payment by the Lessor

• Step 1
• Calculate the payment required to provide lessor
  with required rate of return
• Cost/FMV of asset to be recovered 100,000
• Less PV of expected residue value
  -0-
• PV of amount to be recovered
• through lease payments
  100,000
• Number of payment5, Implicit Rate10
• PV of an annuity due 4.16986
• Lease payment required 100,000 / 4.16986
  23,981.62
• Step 2 Total lease payment receivable
  23,981.6250119,908.10
• Step 3 Unearned interest revenue
  119,908.10-100,00019,908.10

Discounted amount of total receivables
Undiscounted amount of total receivables
31
Use Financial Calculator
Make sure you press BGN button before doing any calculation on annuity due Make sure you press BGN button before doing any calculation on annuity due
PMT ?  Yields (23,981)  
I 10  
N 5  
PV 100,000  
FV 0  
32
Direct Financing Lease (Lessor)

• The lease payments receivable are equal toLease
  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

33
Direct Financing Lease (Lessor)

• January 1, 2005Lease Payments Receivable
  119,908.10 Equipment for Lease 100,000.00 Une
  arned Interest Revenue 19,908.10
• January 1, 2005 (first payment)Cash
  (23,981.622,000) 25,981.62 Property Tax
  Expense 2,000.00 Lease Payments
  Receivable 23,981.62

34
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

35
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

36
Sales-Type Lease Example

• Take the same data as in direct financing
  example, except the asset has been recorded in
  the Lessors inventory at a cost of 85,000
  (FMV100,000)
• All previous lessor entries remain the same
  except for the entry at the lease inception
• Sales and Gross Profit are recorded

37
Sales-Type Lease Example

• January 1, 2005Lease 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.

38
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

39
Lessors 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

40
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

41
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

42
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.

43
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.