Chapter 21: Accounting for Leases

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Chapter 21 Accounting for Leases
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Leasing Basics

• Contractual agreement - lessor lessee
• Gives lessee right to use specific property
• Specifies duration (lease term) payments
• Termination
• Noncancelable
• Early termination
• Default
• Executory costs (taxes, insurance, maintenance)
  may be either
• Essential element
• Lessor conveys less than total interest in asset
• Players
• Banks largest, low cost funds
• Captives subs for parents to facilitate sales
• Independents little market share, good for
  innovative products

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Advantages of Leasing

• May not require any money down
• Payments often fixed
• Reduce risk of obsolescence to lessee
• May contain less restrictive covenants than other
  types of lending
• May be a less costly means of financing
• May capitalize for tax not for FS
• Certain leases may not add to existing debt on BS

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Conceptual Nature of a Lease

• Lease transferring substantially all benefits
  risks of ownership should be capitalized
• Transfer of ownership assumed
• High degree of performance to transfer
• Non-cancelable
• Upon remote contingency
• Costly provisions reduce potential for
  cancellation
• Leases that do not substantially transfer
  benefits and risks operating leases

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Accounting by Lessee

• Capital leases
• Must be noncancelable AND
• Meet any of the following four criteria
• Transfers ownership to lessee
• Bargain purchase option
• Lease term 75 of estimated economic life (of
  leased property)
• 75 rule
• Bargain renewal options reasonable assurance to
  renew
• PV minimum lease payments gt/ 90 FV leased
  property
• 90 rule
• MLP minimum rent, guaranteed residual value,
  penalties, bargain purchase option
• Excludes executory costs

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The Bargain Purchase Option

• Allows lessee to buy the leased asset
• For price significantly lower than the FV when
  option is exercisable
• Difference between option price FV (when the
  option is exercisable)
• Must render option reasonably assured
• Determined at inception

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Discount Rate

• Lessees incremental borrowing rate
• Use lessors implicit interest rate if
• Lessee knows AND
• It is less than lessees incremental rate
• Rationale
• More realistic rate
• Ensures lessee does not use artificially high
  rate to circumvent 90 rule
• Lessors implicit rate produces
• PV of MLP ( unguaranteed residual value) FV of
  asset to lessor

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Accounting by Lessee
Lease Agreement
Capital Lease
Operating Lease
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Accounting by Lessee

• Operating lease transaction
• Periodic lease/rent expense
• Capital lease transaction
• Lessee records
• An asset liability
• Depreciation on leased asset over its economic
  life
• NOT lease term
• Use effective interest method to allocate
  payments between PI
• Depreciation of asset discharge of lease
  obligation independent accounting procedures
• Different periods used

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Advantages of Leasing to Lessor

• Interest revenue
• Tax incentives
• Lessee cant use benefit transfer to lessor for
  reduced payment
• Payment based on ROR needed to justify leasing
  asset
• Lessee credit standing
• Lease length
• Status of residual value (guaranteed or not)
• High residual value

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Classification of Leases Lessor

• Lessor classifies leases as one of the
  following
• Operating lease
• Direct financing lease
• Sales-type lease

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Accounting by Lessor Classification of Leases

• Direct financing or sales type lease
• Must meet 1 group 1 criteria and both group 2
  criteria
• Group 1 criteria same as lessee
• Group 2 criteria
• Collectibility of payments reasonably predictable
  AND
• Lessors performance substantially complete OR
  future costs reasonable predictable
• Distinction manufacturers/dealers profit
• Sales-type dealer profit (FV BV at inception)
• Direct-financing no profit (interest only)

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Accounting by Lessor Classification of Leases

• Operating lease
• The lease doesnt meet any group 1 criteria OR
• Collectibility of payments isnt reasonably
  predictable OR
• Lessors performance isnt substantially complete

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Lessors Criteria for Lease Classification
Lease Agreement
Operating Lease
Direct financing
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Direct Financing Lessor

• Gross investment lease receivable
• PV of MLP PV unguaranteed residual value
• MLP includes guaranteed residual value
• Current or noncurrent based on when net
  investment to be recovered
• Net investment
• Gross investment less unearned interest revenue
• Illustration 21-15, page 1106

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Operating Lease Lessor

• Lessor depreciates according to its depreciation
  policy
• Maintenance costs (payable by lessor) charged to
  expense
• Costs, (finders fees, credit checks, etc.)
  amortized over the lease term
• Leased equipment accumulated depreciation shown
  as Equipment Leased to Others

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Special Accounting Problems

• Residual values
• Sales-type leases (lessor)
• Bargain purchase options
• Initial direct costs
• Current versus noncurrent
• Disclosure

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Residual Values

• Residual value estimated FV of asset at end of
  lease term
• Guaranteed or
• Unguaranteed
• Lessors perspective
• Once lease rate determined, makes no difference
  whether residual value is guaranteed or
  unguaranteed
• Assumes residual value realized at end of lease
  term
• In cash from lessee OR
• Return of asset (resold, re-leased)
• Sales-type lease Illustration 21-29 30, page
  1115
• Review unguaranteed periodically

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Residual Values

• Lessees perspective
• Guaranteed residual affects MLP calculation
• Illustrations page 1109
• Unguaranteed residual does not
• Illustrations page 1111
• Comparison illustration page 1112

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Sales-Type Lease
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Bargain Purchase Option Lessee

• Purchase in future at lower price than expected
  future FV
• Must increase PV of MLP by PV of option price
• Different accounting than GRV
• BPO depreciate over economic life
• GRV depreciate over lease term

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Initial Direct Costs

• Incremental directs costs paid to third parties
  at origination of lease
• Appraisal
• Credit check
• Broker fee
• Internal direct costs directly related to
  services performed by lessor
• Evaluate lessee financial condition
• Evaluate/record guarantees
• Negotiating terms

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Initial Direct Costs

• Operating leases
• Defer allocate over term proportional to rent
  income
• Sales type lease
• Expense in period profit recognized
• Direct financing lease
• Add to net investment amortize over life of
  lease as yield adjustment

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Current vs. Noncurrent

• Ordinary annuity change in PV
• Current noncurrent portions
• Interest accrued paid during period
• Principal reductions only current
• Illustration 21-31 page 1118
• Annuity due
• Interest accrued during period, paid in next
• Principal interest current

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Disclosure Requirements Lessee

• Lessee - capital leases
• Gross amount of assets
• Future minimum lease payments
• Total non-cancelable minimum sublease rentals
• Total contingent rentals
• Identify assets separately
• General description of lessees arrangements
• Illustration 21-32, page 1119

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Disclosure Requirements Lessor

• Lessor - sales-type direct-financing leases
• Components of net investment
• Future minimum lease payments
• Amount of unearned revenue included in revenue
• Total contingent rentals
• General description of lessors leasing
  arrangements
• Illustrations page 1119 1120

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Disclosure Requirements Lessor

• Lessor - operating leases
• Cost and carrying amount
• Minimum future rentals
• Total contingent rentals
• General description of lessors leasing
  arrangements

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Sale-Leasebacks

• Sell immediately lease back
• Advantages to seller
• Refinance at lower rates
• May deduct entire lease payment not subject to
  AMT

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Sale-Leasebacks

• Use continues after sale
• Financing no gain/loss recognized
• Right to use given up
• Sale gain/loss recognized
• Lessee capital lease if meet 1 of 4 criteria
• Gain/loss deferred amortized over lease term
• Exceptions (full gain/loss recognized)
• Loss if BV gt FV
• Minor leaseback PV of payments 10 or less of
  FV
• Lessor direct-financing if meet 1 Group I
  criteria both Group II
• Illustration 21B-1, page 1130

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Class Exercises

• E21-3 E21-4
• E21-11 E21-14
• E21-16