Chapter 15 19 Edition th Leases Intermediate Accounting James D Stice Earl K Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2014 Cengage Learning 15-1 Introduction • • A lease is a contract specifying the terms under which the owner of property, the lessor, transfers the right to use the property to a lessee A major challenge for the accounting profession has been to establish standards that prevent companies from using the legal form of a lease to avoid recognizing future payment obligations as a liability 15-2 Economic Advantages to Leasing Over Purchasing For Forthe theLessee Lessee No down payment Avoid risks of ownership Flexibility For Forthe theLessor Lessor Increased sales Ongoing business relationship with lessee Residual value retained 15-3 Simple Example • Owner Company owns a piece of equipment with a market value of $10,000 and an estimated useful life of five years • User Company wishes to acquire the equipment • User Company can borrow $10,000 from the bank at 10% interest Payments for principal and interest would be five equal annual installments of $2,638 (continued) 15-4 Simple Example • Alternatively, User Company can lease the equipment from Owner Company for five years and make five annual “rental” payments of $2,638 • User will still use the equipment for five years and will still make payments of $2,638 per year • The primary difference is that now Owner is not just selling the equipment but is also substituting for the bank in providing financing (continued) 15-5 Simple Example On the date the lease is signed, should Owner Company recognize an equipment sale? The key accounting issues for the lessor are: • Has effective ownership of the equipment been passed from Owner to User? • Is the transaction complete, meaning does Owner have any significant responsibilities remaining in regard to the equipment? • Is Owner Company reasonably certain the five annual payments can be collected from User Company? 15-6 (continued) Simple Example • Question: On the date the lease is signed, should User recognize the lease equipment as an asset and the obligation to make the lease payment as a liability? • Answer: The answer hinges on whether effective ownership, as opposed to legal ownership, of the equipment changes hands when Owner and User sign the lease agreement (continued) 15-7 Simple Example • The economic substance of the lease is that the lease signing is equivalent to the transfer of effective ownership, and the fact that Owner retains legal title of the equipment during the lease period is a mere technicality 15-8 Capital vs Operating Lease • Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to lessee • Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease 15-9 Why Leasing Over Purchasing? • Keeping the asset off the balance sheet improves financial ratio measures of efficiency • Keeping the liability off the balance sheet improves measures of leverage • For companies that lease a large portion of the assets they use, the accounting standards associated with leasing are the most critical standards that they apply 15-10 Accounting for Sales-Type Leases—Lessor American AmericanManufacturing Manufacturing Co Co.(Lessor) (Lessor) To record entries on January 1, 2013: Lease Payments Receivable Sales 250,192 Cost of Goods Sold Finished Goods Inventory 160,000 Deferred Initial Direct Costs Cash 15,000 Lease Payments Receivable 60,000 Executory Costs 5,000 250,192 175,000 65,000 15-58 Accounting for Sales-Type Leases—BPO or Guaranteed R/V • • The minimum lease payments will include the following if they are part of the agreement: a lump sum (from a bargain purchase option) at the end of the lease term OR a guaranteed residual value The receivable is increased by the present value of the future payment, and sales are increased by the present value of the additional amount (continued) 15-59 Accounting for Sales-Type Leases—BPO or Guaranteed R/V American AmericanManufacturing Manufacturing Co Co.(Lessor) (Lessor) To record entries on January 1, 2013: Lease Payments Receivable Sales 296,761 Cost of Goods Sold Finished Goods Inventory 160,000 Deferred Initial Direct Costs Cash 15,000 Lease Payments Receivable 60,000 Executory Costs 5,000 296,761 175,000 65,000 15-60 Accounting for Sales-Type Leases— Unguaranteed Residual Value When a sales-type lease does not contain a bargain purchase option or a guaranteed residual value, but the economic life of the leased asset exceeds the lease term, the residual value will remain with the lessor This is called an unguaranteed residual value 15-61 Third-Party Guarantees of Residual Value • • • When a lease is used to increase sales, the seller wants to account for the lease as a sales-type lease On the other hand, the buyer would prefer to account for the lease as an operating lease to keep the obligation off the balance sheet A third-party guarantee of residual value is a clever trick that companies have devised to get around accounting rules How Howdo dothey they doit? it? (continued) 15-62 Third-Party Guarantees of Residual Value • • The lessor includes a guaranteed residual value with the calculation so that present value of the minimum lease payments meet the 90% of fair value criterion This allows the lessor to treat the lease as a sales-type lease The lessee pays an insurance company or investment firm to guarantee the residual value This allows the lessee to remove the guaranteed residual value from the calculation, dropping the amount below 90% This allows the lessee to account for the lease as an operating lease 15-63 Sale of Asset During Lease Term …a gain of $25,455 would be reported The following journal entry would be recorded on December 31, 2015, to record the sale: Cash Interest Revenue 10,413 Lease Payments Receivable 104,132 Gain on Sale of Leased Asset 25,455 140,000 15-64 Treatment of Leases on Lessor’s Statement of Cash Flows In 2013, American Manufacturing’s income before any lease-related items is $200,000 Net income for the year can be computed as follows: Income before lease-related items $200,000 Lease-related sales 250,192 Lease-related cost of goods sold (175,000) Leased-related interest revenue 19,019 (continued) Net income $294,211 15-65 Treatment of Leases on Lessor’s Statement of Cash Flows For 2013, American Manufacturing’s cash flow from operations, using the indirect method, would appear as follows: Operating activities: Net income $294,211 Less: Increase in lease payments receivable ($250,192 – $60,000 – $40,981) (149,211) Plus: Decrease in finished goods inventory 175,000 Net cash flow from operating activities $320,000 15-66 Disclosure Requirements for Leases Lessee Lessee Gross amount of assets recorded as capital leases, along with related accumulated amortization Future minimum rental payments required as of the date of the latest balance sheet presented in aggregate and for each of the five succeeding fiscal years Rental expense for each period for which an income statement is presented (continued) 15-67 Disclosure Requirements for Leases A general description of the lease contracts, including information about restrictions on such items as dividends, additional debt, and further leasing For capital leases, the amount of imputed interest necessary to reduce the lease payments to present value (continued) 15-68 International Accounting of Leases • • IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases A proposal, titled “Accounting for Leases: A New Approach,” notes that current lease accounting standards fail in their objective of requiring companies to recognize significant rights and obligations as assets and liabilities in the balance sheet (continued) 15-69 International Accounting of Leases • This proposal suggests that the lease accounting rule be simplified as follows: All lease contracts are to be accounted for as capital leases 15-70 Chapter 15 ₵ The The End End $ 15-71 15-72 ... incurred by the lessor under the terms of the lease are known or can be reasonably estimated at the lease inception date 15- 25 Accounting for Leases—Lessee • • • All leases as viewed by the lessee... is an operating lease Accounting for operating leases involves the recognition of rent expense over the term of the lease (continued) 15- 26 Accounting for Leases—Lessee • • Accounting for a capital... lessee by the end of the lease term The lease contains a bargain purchase option making it reasonably assured that the property will be purchased by the lessee at a future date (continued) 15- 20