A Review of the Accounting Cycle

1
Leases
2
Learning Objectives

• Describe the circumstances in which leasing makes
  more business sense than does an outright sale
  and purchase.
• Understand the accounting issues faced by the
  asset owner (lessor) and the asset user (lessee)
  in recording a lease transaction.
• Outline the types of contractual provisions
  typically included in lease agreements.

3
Learning Objectives

• Apply the lease classification criteria in order
  to distinguish between capital and operating
  leases.
• Properly account for both capital and operating
  leases from the standpoint of the lessee (asset
  user).
• Properly account for both capital and operating
  leases from the standpoint of the lessor (asset
  owner).

4
Learning Objectives

• Prepare and interpret the lease disclosures
  required of both lessors and lessees.
• Compare the treatment of accounting for leases in
  the United States with the requirements of
  international accounting standards.

5
Learning Objectives
EXPANDED MATERIAL

• Record a sale-leaseback transaction for both a
  seller-lessee and a purchaser-lessor.
• Recognize the special characteristics of real
  estate leases.

6
Lease

• A contract specifying the terms under which the
  owner of an asset agrees to transfer the right to
  use the asset to another party.

7
Assets Acquired by Leasing

• Lessee The party granted the right to use the
  property under the terms of a lease.
• Lessor The owner of the property that is rented
  (leased) to another party.
• Operating Lease A simple rental agreement.
• Capital Lease A leasing transaction that is
  recorded as a purchase by the lessee.

8
Economic Advantages of Leasing

• No down payment.
• Avoid risks of ownership.
• Flexibility.

9
Advantages to Lessor

• Increased sales.
• Ongoing business relationship with lessee.
• Residual valued retained.

10
Lease Provisions
11
Lease Provisions
12
Lease Classification Criteria
A lease is classified as a capital lease by the
lessee if it is noncancelable and meets any one
of the following criteria
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Lease Classification Criteria

• The lease transfers ownership of the leased asset
  to the lessee by the end of the lease term.
• The lease contains an option allowing the lessee
  to purchase the asset at the end of the lease
  term at a bargain price.
• The lease term is equal to 75 percent or more of
  the estimated economic life of the asset.
• The present value of the lease payments at the
  beginning of the lease is 90 percent or more of
  the fair market value of the leased asset.

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Lease Classification--Lessee
Transfer of Ownership?
Yes
15
Lease Classification--Lessor
Additional revenue recognition criteria
applicable to lessors.

• Collectibility of the minimum lease payments is
  reasonably predictable.
• No important uncertainties surround the amount of
  unreimbursable costs yet to be incurred by lessor.

16
Example Operating Lease
Bob Jones signs a two-year lease which requires a
monthly payment of 1,000. When the lease
expires, Bob will either move out or negotiate a
new lease.
Lessee
Rent (or Lease) Expense 1,000 Cash
1,000 To record monthly rent on
office building.
17
Example Operating Lease
Bob Jones signs a two-year lease which requires a
monthly payment of 1,000. When the lease
expires, Bob will either move out or negotiate a
new lease.
Lessor
Cash 1,000 Rent Revenue
1,000 To record monthly rent on office
building.
18
Operating Leases With Varying Lease Payments
The terms of a lease for an aircraft by
International Airlines provide for payments of
150,000 a year for the first two years and
250,000 for each of the next three years.
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Operating Leases With Varying Lease Payments
Entry Each Year for Years 1 and 2
Rent Expense 210,000 Cash 150,000 Rent
Payable 60,000
Entry Each Year for Years 3-5
Rent Expense 210,000 Rent Payable 40,000 Cash 25
0,000
20
Interest Rates for DiscountingLease Payments

• Implicit Interest Rate Rate that would be used
  to discount the minimum lease payments to the
  fair market value of the leased asset at the
  inception of the lease.
• Incremental Borrowing Rate Rate at which lessee
  could borrow the amount of money necessary to
  purchase the leased asset.

21
Interest Rates for DiscountingLease Payments
Lessor always uses the implicit rate to discount
rental payments.
Lessee uses the lesser of the implicit rate and
the incremental borrowing rate.
22
Accounting for Capital Leases
The Lessee
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Example Leases

• Minimum Payment 1,000/year
• Executory Costs 100
• Term 10 years
• Useful Life of Asset 10 years
• Implicit Rate 10
• Incremental Borrowing Rate 12

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Example Inception of the Lease

• Leased Equipment 6,759
• Obligations under Capital
• Leases 6,759
• (PV of 1,000 in arrears for 10 years at 10.)
• Lease Expense 100
• Obligations under Capital
• Leases 1,000
• Cash 1,100

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Example End of Year 1

• Prepaid Executory Costs 100
• Obligations under Capital
• Leases 424
• Interest Expense 576
• Cash 1,100
• Amortization Expense 615
• Acc. Amortization 615
• (Straight-line amortization of leased asset.)

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Choosing an AmortizationPeriod for Leased Assets
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Bargain Purchase Option
Frequently, the lessee is given the option of
purchasing the property in the future at what
appears to be a bargain price.
28
Bargain Purchase Option
The present value of the bargain purchase option
would be added to the present value of the
minimum lease payments to establish the initial
asset and liability.
29
Impact of a Capital Lease on Lessees Statement
of Cash Flows
Operating Activities (indirect)
Net income (includes reduction for Lease
interest expense Lease amortization expense)
Amortization of leased asset
30
Impact of a Capital Lease on Lessees Statement
of Cash Flows
31
Accounting for Capital Leases
The Lessor
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Treatment of InitialDirect Costs
Type of Lease
Accounting Treatment of Costs
Operating Capitalize and amortize over lease
term.
Direct Capitalize and amortize, Financing with
unearned interest, over lease term.
Sales-Type Immediately recognize cost as
reduction in profits.
33
Accounting for DirectFinancing Leases

• Minimum Payment 1,000/year
• Executory Costs 100
• Term 10 years
• Useful Life of Asset 10 years
• Implicit Rate 10
• Incremental Borrowing Rate 12

34
Example Direct Financing Lease
At Inception of Lease

• Lease Payments Receivable 10,000
• Equipment Purchased for Lease 6,759
• Unearned Interest Revenue 3,241

At Receipt of First Payment
Cash 1,100 Lease Payments Receivable 1,000 Ex
ecutory Costs 100
35
Example Direct Financing Lease
At End of the First Year
Cash 1,100 Lease Payments Receivable 1,000 De
ferred Executory Costs 100
Unearned Interest Revenue 576 Interest
Revenue 576
36
Direct Financing Lease
If the lessor incurs any initial direct costs,
those costs are recorded as a separate asset.
37
Accounting forSales-Type Leases
(Continues example introduced in lessee section)

• Minimum Payment 1,000/year
• Executory Costs 100
• Term 10 years
• Useful Life of Asset 10 years
• Implicit Rate 10
• Incremental Borrowing Rate 12
• Cost of Equipment 5,000

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Sales-Type LeaseTransaction Components
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Sales-Type LeaseTransaction Components
Minimum Lease Payments
3,421 Financing Revenue (Interest)
10,000
Fair Market Value of Leased Asset
6,759
40
Sales-Type Lease
To Record the Sale

• Lease Payments Receivable 10,000
• Unearned Interest Revenue 3,431
• Sales 6,569

To Remove the Inventory and Record Cost
Cost of Goods Sold 5,000 Finished Goods
Inventory 5,000
41
Sales-Type Lease With BPO or Guaranteed Residual
Value
If the agreement provides for the lessor to
receive a lump sum (from a bargain purchase
option) at the end of the lease term or a
guaranteed residual value, the minimum lease
payments include these amounts.
42
Sales-Type Lease With BPO or Guaranteed Residual
Value
The receivable is increased by the gross amount
of the bargain purchase option or the guaranteed
residual value.
43
Summary of Lease Impact on Statement of Cash Flows
Indirect Direct Investing Financing Method
Method Activities Activities
Lessee Operating lease payments Capital
lease Lease payments-- interest Lease
payments-- principal Amortization of asset
NI - Cash NI - Cash - Cash NI No
impact
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Summary of Lease Impact on Statement of Cash Flows
Indirect Direct Investing
Method Method Activities
Lessor Operating lease Initial direct costs
(IDC) Amortization of IDC Lease receipts Direct
financing lease Initial direct
costs Amortization of IDC Lease
receipts--interest Lease receipts--principal
- Cash NI No impact NI Cash - Cash
NI No impact NI Cash Cash
45
Summary of Lease Impact on Statement of Cash Flows
Indirect Direct Investing
Method Method Activities
Lessor Sales-type lease Initial direct
costs Manufacturers or dealers profit (net
of IDC) Lease receipts--interest Lease
receipts--principal
- Cash - NI No impact NI Cash NI
Cash
46
Sale-Leaseback Transactions
An arrangement whereby one party sells property
to a second party, and then the first party
leases the property back is a sale-leaseback
transaction.
47
Real Estate Leases
Does lease meet criterion 1 and 2?
Is lease for land only or building only?
48
Real Estate Leases
Does lease meet criterion 1 and 2?
Is lease for land only or building only?
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Real Estate Leases
Allocate rent to land and building
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Real Estate Leases
Does lease meet criterion 1 and 2?
51
Real Estate Leases
Allocate rent to land and building
52
Real Estate Leases
53
Real Estate Leases
Does lease meet criterion 1 and 2?
54
Real Estate Leases
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The End