Leases

1
Leases

• Intermediate Accounting II
• Chapter 15

2
Leases

• Lease contractual agreement where the lessor
  provides the lessee the right to use an asset for
  a specified period of time in return for periodic
  cash payments
• Lessor party who owns the asset
• Lessee party using the asset

3
Basic Lease Classifications

• A lease is accounted for as either a lease
  agreement (operating lease) or a purchase/sale
  accompanied by debt financing. The choice of
  accounting method hinges on the nature of the
  leasing arrangement. Capital leases are
  agreements that we identify as being formulated
  outwardly as leases, but which are in reality
  installment purchases.

4
Capital Lease Criteria
A lessee should classify a lease transaction as a
capital lease if it is noncancellable and if one
or more of four classification criteria are met
1. The agreement specifies that asset ownership
transfers to the lessee. 2. The agreement
contains a bargain purchase option. 3. The
noncancellable lease term is equal to 75 or more
of the expected economic life of the asset. 4.
The present value of the minimum lease payments
is equal to or greater than 90 of the fair value
of the asset.
Otherwise, the lease is accounted for as an
operating lease.
5
Capital Lease or Operating Lease?
On January 1, 2016, Sans Serif Publishers, Inc.,
a computer services and printing firm, leased a
color copier from CompuDec Corporation. The
lease agreement specifies four annual payments of
100,000 beginning January 1, 2016, the inception
of the lease, and at each January 1 through 2019.
The useful life of the copier is estimated to be
six years. Before deciding to lease, Sans Serif
considered purchasing the copier for its cash
price of 479,079. If funds were borrowed to buy
the copier the interest rate would have been
10. How should this lease be classified?
Account for this lease as an Operating Lease
Does the agreement specify that ownership of the
asset transfers to the lessee?
No
Does the agreement contain a bargain purchase
option?
No
Is the lease term equal to 75 or more of the
expected economic life of the asset?
No
4/6 years 67
Is the present value of the minimum lease
payments at least 90 of the fair value of the
asset?
Present Value MLP 100,000 X 3.48685
348,68590 FV 479,079 X.9 431,171
No
6
Capital Lease or Operating Lease?
Brief Exercise 15-4 Corinth Co. leased to
Athens Corporation for an eight-year period, at
which time possession of the leased asset will
revert to Corinth. The equipment cost Corinth
16 million and has an expected useful life of 12
years. Its normal sales price is 22.4 million.
The present value of the minimum lease payments
of both the lessor and lessee is 20.4 million.
The first payment was made at the inception of
the lease. How should Athens classify this lease?
Account for this lease as a Capital Lease
Does the agreement specify that ownership of the
asset transfers to the lessee?
No
Does the agreement contain a bargain purchase
option?
No
Is the lease term equal to 75 or more of the
expected economic life of the asset?
No
8/12 years 67
Is the present value of the minimum lease
payments at least 90 of the fair value of the
asset?
Present Value MLP 20.4 million 90 FV 22.4
20.16 million
Yes
7
Accounting for Operating Leases

• The fundamental rights and responsibilities of
  ownership are retained by the lessor and that the
  lessee merely is using the asset temporarily.
• A sale is not recorded by the lessor.
• A purchase is not recorded by the lessee.
• The periodic lease payments are accounted for as
  rent
• Rent revenue by the lessor,
• Rent expense by the lessee.
• Advance payments are considered prepayments of
  rent. They are deferred and allocated to rent
  over the lease term.
• Any refundable security deposit is recorded as a
  long-term receivable (by the lessee) and
  liability (by the lessor) unless it is not
  expected to be returned.
• A prepayment of the last periods rent is
  recorded as prepaid rent and allocated to rent
  expense/rent revenue during the last period of
  the lease term.
• The cost of a leasehold improvement is
  depreciated over its useful life by the lessee.

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Exercise 151, page 902
(a) Nath-Langstrom Services, Inc. (Lessee) June
30, 2013 Rent expense 10,000 Cash
10,000 December 31, 2013 Rent
expense 10,000 Cash 10,000   (b)
ComputerWorld Corporation (Lessor) June 30,
2013 Cash 10,000 Rent revenue 10,000 December
31, 2013 Cash 10,000 Rent revenue 10,000   Dep
reciation exp 15,000 (90,000 6
years) Accumulated depreciation 15,000
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Accounting for Capital Leases - Lessee

• In a capital lease, the lessee records a leased
  asset at the present value of the minimum lease
  payments.
• Interest accrues at the effective rate on the
  balance outstanding during the period. Lease
  payments (except the first) include interest on
  the outstanding balance as well as a residual
  portion that reduces that outstanding balance.
• An amortization schedule is helpful to keep up
  with changing interest and lease obligation
  amounts.
• Depreciation is recorded for leased assets in a
  manner consistent with the lessees usual policy
  for depreciating its operational assets
• Normally over the term of the lease.
• Over the asset's useful life, if
• Ownership transfers or
• A bargain purchase option is present

10
Accounting for Capital Leases - Lessor
Two additional criteria must be met for a capital
lease to be recorded by the lessor.

• The collectibility of the lease payments must be
  reasonably predictable.
• If any costs to the lessor have yet to be
  incurred, they are reasonably predictable.
  (Performance by the lessor is substantially
  complete.)

11
Capital Lease or Operating Lease?
On January 1, 2016, Sans Serif Publishers, Inc.,
leased printing equipment from First LeaseCorp.
First LeaseCorp purchased the equipment from
ComuDec Corporation at a cost of 479,079. The
lease agreement specifies annual payments
beginning January 1, 2016, the inception of the
lease, and at each December 31 thereafter through
2020. The six year lease term ending December
31, 2021, is equal to the estimated useful life
of the equipment. First LeaseCorp routinely
acquires electronic equipment for lease to other
firms. The interest rate in these financing
arrangements is 10.
Account for this lease as an Capital Lease
Does the agreement specify that ownership of the
asset transfers to the lessee?
No
Does the agreement contain a bargain purchase
option?
No
Is the lease term equal to 75 or more of the
expected economic life of the asset?
No
6/6 years 100
Is the present value of the minimum lease
payments at least 90 of the fair value of the
asset?
Present Value MLP 100,000 X 3.48685
348,68590 FV 479,079 X.9 431,171
No
12
Capital Lease LesseeExample (continued)
Date Account Debit Credit
2016 Jan 1 Leased Equipment 479,079
Lease Payable 479,079
(to record lease obligation)
Jan 1 Lease Payable 100,000
Cash 100,000
(to record 1st lease payment)
2016 Dec 31 Lease Payable 62,092
Interest Expense (479,079-100,000 X 10) 37,908
Cash 100,000
(to record 2nd lease payment)

13
Accounting for Capital LeasesLease Amortization
Schedule

• Interest accrues at the effective rate on the
  balance outstanding during the period. Lease
  payments (except the first) include interest on
  the outstanding balance as well as a residual
  portion that reduces that outstanding balance.
• An amortization schedule is helpful to keep up
  with changing interest and lease obligation
  amounts.
• This process is very similar to that followed to
  amortize bond interest or installment loans.

14
Amortization Schedule Example
American Food Services, Inc, leased a packaging
machine from Barton and Barton Corporation on
January 1, 2016. The lease agreement for the 4
million (fair value and present value of the
lease payments) machine specified four equal
payments of 1,147,167 beginning January 1, 2016
and each December 31 thereafter. The useful life
of the machine was expected to be four years with
no residual value. American Food Servicess
incremental borrowing rate is 10. Prepare an
amortization schedule for the four-year term of
the lease.
Payment Date Lease Payments Interest Expense Decrease in Balance Lease Balance
        4,000,000
Jan 1 2016 1,147,167   1,147,167 2,852,833
Dec 31 2017 1,147,167 285,283 861,884 1,990,949
Dec 31 2018 1,147,167 199,095 948,072 1,042,877
Dec 31 2019 1,147,167 104,290 1,042,877 (0)
Totals 4,588,668 588,668 4,000,000  
Interest was adjusted in the last year to
account for rounding differences.
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Accounting for Capital Leases - Lessor
A capital lease is recorded by the lessor as a
sales-type lease or direct financing lease,
depending on whether the lease provides the
lessor a dealers profit.
Direct-Financing LeaseA direct-financing lease
is basically the coupling of a sale and financing
transaction (credit sale). In a direct-financing
lease, the lessor removes the leased asset from
its books and replaces it with a receivable from
the lessee. The only income recognized by the
lessor is the interest received. Interest is
calculated using the effective interest rate. Use
an amortization schedule to assist with
allocating payments between the lease obligation
and interest. Sales-Type LeaseA sales-type
lease is accounted for like a direct-financing
lease, except that a profit on the sale is
recognized in the period of the lease inception
in addition to the interest income recognized
during the lease term. The gross profit
recognized at the inception of the lease is the
PV of all lease payments minus the cost (or
carrying value) of the leased asset. Upon
inception of the lease, the lessor records sales
revenue and cost of goods sold and removes the
leased asset from its books.
Regardless of the lease type, no expenses, such
as depreciation or executory costs, are recorded
by the lessor for capital leases.
Source Investopedia, http//www.investopedia.com/
exam-guide/cfa-level-1/liabilities/accounting-for-
leases.asp
16
Accounting for Capital Leases Lessor Direct
Financing Lease
Exercise 155, page 896-897
Date
Account
Debit
Credit
(to record lease receivable)
Jan 1
17
Accounting for Capital Leases Lessor
Sales-type Lease
Exercise 15, page 897
Present Value MLP 112,080 Cost of Asset
85,000Profit 27,080
Date
Account
Debit
Credit
2016
Jan 1
112,080
(present value of minimum lease pmts)
Cost of Goods Sold
85,000
Sales Revenue
112,080
85,000
(to record lease receivable sale)
Jan 1
Cash
15,000
Lease Receivable
15,000
(to record 1st lease payment)
15,000
Cash
1,942
Lease Receivable
13,058
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Bargain Purchase Option

• A bargain purchase option (BPO) is a provision of
  some lease contracts that gives the lessee the
  option of purchasing the leased property at a
  bargain price. When a BPO is present, both the
  lessor and the lessee view the option price as an
  additional lease payment. The expectation that
  the option price will be paid effectively adds an
  additional cash flow to the lease for both the
  lessee and the lessor. That additional payment
  is included as a component of minimum lease
  payments for both the lessor and the lessee.
• The lessor, when computing periodic lease
  payments, subtracts the present value of the BPO
  price from the amount to be recovered (fair
  market value) to determine the amount that must
  be recovered from the lessee through the periodic
  rent payments.
• The lessee adds the present value of the BPO
  price to the present value of periodic payments
  when computing the amount to be recorded as a
  leased asset and a lease liability
• The lease term effectively ends when the BPO is
  exercisable.
• Thus, if a BPO in a six-year lease could be
  exercised at the end of the fifth year, the
  effect will be to change the lease term to five
  years, from six.

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Residual Value
Amount an asset is worth at the end of the lease
agreement. The lease agreement may include a
guarantee by the lessee for residual
value. Guaranteed residual value is considered
an additional lease payment that is to be paid in
property, cash, or both. When calculating
minimum lease payments, deduct the present value
of the residual value from the fair value of the
leased asset. If the lessee obtains title to the
leased asset, the lessors computation of lease
payments is unaffected by any residual value.
20
Executory Costs
Executory costs are maintenance, insurance,
taxes, and any other costs usually associated
with asset ownership.

• In a capital lease, the lessee is responsible for
  executory costs.
• Sometimes, as an expediency, a lease contract
  will specify that the lessor is to pay executory
  costs, but that the lessee will reimburse the
  lessor through higher lease payments.
• Any portion of lease payments that represents
  executory costs is not considered part of minimum
  lease payments and interest is not incurred for
  executory costs.
• The lessee expenses executory costs as incurred.

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Executory Costs Example Problem

• Branif Leasing leases mechanical equipment to
  Branson Construction. The lease agreement
  specified 20 annual payments of 100,000
  beginning December 31, 2014, the inception of the
  lease. The estimated useful life of the leased
  equipment is 20 years with no residual value.
  Its cost to Branif was 936,500. The lease
  qualifies as a capital lease to Branson.
  Maintenance of the equipment was contracted for
  through a 20-year service agreement with Midway
  service Company requiring 20 annual payments of
  3,000 beginning December 31, 2014. Both
  companies use straight-line depreciation.
• Prepare journal entries for the second lease
  payments, depreciation, and executory costs for
  the lessee and lessor under each of the following
  assumptions
• The lessee pays executory costs as incurred.
• The lease agreement specifies that the lessor
  pays executory costs as incurred. The lessees
  lease payments were increased to 103,000 to
  include reimbursement for these costs.

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Executory Costs Example Item a Solution
Lessee (Branson)
Lessor (Branif)
Date Account Account Debit Credit
2015 Dec 31 Lease Payable 16,350
Interest Expense Interest Expense 83,650
Cash Cash 100,000

Maintenance Expense Maintenance Expense 3,000
Cash Cash 3,000

Depreciation Exp (936,500/10 yrs) Depreciation Exp (936,500/10 yrs) 46,825
Accumulated Depreciation Accumulated Depreciation 46,825
Date Account Debit Credit
2015 Dec 31 Cash 100,000
Interest Revenue 83,650
Lease Receivable 16,350






Interest Expense (936,500 - 100,000) X 10
83,650
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Executory Costs Example Item b Solution
Lessee (Branson)
Lessor (Branif)
Date Account Debit Credit
2015 Dec 31 Cash 103,000
Lease Receivable 16,350
Interest Revenue 83,650
Maintenance Fee Payable 3,000



Date Account Debit Credit
2015 Dec 31 Lease Payable (to balance) 16,350
Interest Expense (836,500 X 10) 83,650
Maintenance Expense 3,000
Cash 103,000

Depreciation Exp (936,500/10 yrs) 46,825
Accumulated Depreciation 46,825
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Leases

• Intermediate accounting ii - Chapter 15
• End of presentation