Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter 15 Leases AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions AACSB Tags Brief Exercises (cont.) AACSB Tags 15–1 15–2 15–3 15–4 15–5 15–6 15–7 15–8 15–9 15–10 15–11 15–12 15–13 15–14 15–15 15–16 15–17 15–18 15–19 15–20 15–21 15–22 Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Reflective thinking Analytic Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking, Communications Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking 15–3 15–4 15–5 15–6 15–7 15–8 15–9 15–10 15–11 15–12 15–13 15–14 15–15 15–16 15–17 15–18 15–19 15–20 15–21 15–22 15–23 15–24 Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Diversity, Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic 15–25 15–26 15–27 15–28 15–29 15–30 15–31 Analytic Analytic Analytic Analytic Analytic Analytic Analytic 15–23 15–24 15–25 15–26 15–27 15–28 15–29 15–30 15–31 15–32 15–33 15–34 15–35 Brief Exercises 15–1 15–1 15–2 Solutions Manual, Vol.2, Chapter 15 Analytic Analytic Analytic Exercises 15–1 15–2 15–3 15–4 15–5 15–6 15–7 15–8 15–9 Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic © The McGraw-Hill Companies, Inc., 2013 15–1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Exercises (cont) AACSB Tags CPA/CMA 15–10 15–11 15–12 15–13 15–14 15–15 15–16 15–17 15–18 15–19 15–20 15–21 15–22 15–23 15–24 15–25 15–26 15–27 15–28 15–29 15–30 Analytic Diversity, Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Reflective thinking Analytic Diversity, Analytic Analytic Diversity, Analytic Reflective thinking, Communications Analytic Reflective thinking, Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic 10 11 15–31 15–32 15–33 15–34 15–35 15–36 15–37 15–38 15–39 15–40 15–41 15–42 15–43 15–44 15–45 15–46 15–47 © The McGraw-Hill Companies, Inc., 2013 15–2 Analytic Analytic Analytic Analytic Analytic Reflective thinking Analytic Analytic Diversity, Reflective thinking Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Reflective thinking Reflective thinking Problems 15–1 15–2 15–3 15–4 15–5 15–6 Analytic Analytic Analytic Analytic Analytic Analytic 15–7 15–8 Analytic Analytic 15–9 15–10 15–11 15–12 15–13 15–14 15–15 15–16 15–17 15–18 15–19 15–20 15–21 15–22 15–23 15–24 15–25 15–26 15–27 15–28 Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Diversity, Analytic Analytic Analytic Analytic Analytic Analytic Analytic Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com QUESTIONS FOR REVIEW OF KEY TOPICS Question 15–1 Regardless of the legal form of the agreement, a lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing depending on the substance of the leasing arrangement Capital leases are agreements that are formulated outwardly as leases, but that are in reality installment purchases Professional judgment is needed to differentiate between leases that represent “rental agreements” and those that in reality are “installment purchases/sales.” The FASB provides guidance for distinguishing between the two fundamental types of leases Question 15–2 Periodic interest expense is calculated by the lessee as the effective interest rate times the amount of the outstanding lease liability during the period This same principle applies to the flip side of the transaction, that is, the lessor’s lease receivable (net investment) The approach is the same regardless of the specific form of the debt, that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments Question 15–3 Leases and installment notes are very similar The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease In return for providing financing, the borrower (lessee) pays interest over the maturity (lease term) Conceptually, leases and installment notes are accounted for in precisely the same way Question 15–4 Current GAAP does allow airlines' balance sheets to appear as if the companies don't have airplanes That’s because most airlines extensively use operating leases to “acquire” airplanes Under current rules, under operating leases, unlike capital leases, neither the leased asset nor the lease liability is reported in the balance sheet Question 15–5 The criteria are: (1) the agreement specifies that ownership of the asset transfers to the lessee, (2) the agreement contains a bargain purchase option, (3) the lease term is equal to 75% or more of the expected economic life of the asset, or (4) the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the leased asset Question 15–6 A bargain purchase option is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a “bargain” price—defined as a price sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears reasonably assured at the inception of the lease Because exercise of the option appears reasonably assured, transfer of ownership is expected Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 15–7 The lease is a capital lease to Seminole because the present value of the minimum lease payments ($5.2 million) is greater than 90% of the fair value of the asset (90% x $5.6 million = $5.04 million) Since the additional lessor conditions also are met, it is a capital lease to Lukawitz Furthermore, it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost Question 15–8 Yes The minimum lease payments for the lessee exclude any residual value not guaranteed by the lessee On the other hand, the lessor includes any residual value not guaranteed by the lessee but guaranteed by a third-party guarantor Even when minimum lease payments are the same, their present values will differ if the lessee uses a discount rate different from the lessor’s implicit rate This would occur if the lessee is unaware of the implicit rate or if the implicit rate exceeds the lessee’s incremental borrowing rate Question 15–9 The way a bargain purchase option is included in determining minimum lease payments is precisely the same way that a lessee-guaranteed residual value is included The expectation that the option price will be paid effectively adds an additional cash flow to the lease That additional payment is included as a component of minimum lease payments Therefore, it is included in the computation of the amount to be capitalized (as an asset and liability) by the lessee But, a residual value not guaranteed by the lessee is ignored Question 15–10 Executory costs are costs usually associated with ownership of an asset such as maintenance, insurance, and taxes These are responsibilities of ownership that we assume are transferred to the lessee in a capital lease When paid by the lessee, these expenditures are expensed by the lessee as incurred When paid by the lessor, lease payments usually are inflated for this reason These executory costs, including any lessor profit thereon, are excluded in determining the minimum lease payments and still are expensed by the lessee, even though paid by the lessor Question 15–11 The lessor’s discount rate is the effective interest rate the lease payments provide the lessor over and above the “price” at which the asset is “sold” under the lease It is the desired rate of return the lessor has in mind when deciding the size of the lease payments When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate When the lessor’s implicit rate is known, the lessee should use the lower of the two rates This is the rate the lessee would be expected to pay a bank if funds were borrowed to buy the asset © The McGraw-Hill Companies, Inc., 2013 15–4 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 15–12 Contingent rentals are not included in minimum lease payments but are reported in disclosure notes by both the lessor and lessee This is because they are not determinable at the inception of the lease They are included as components of income when (and if) the payments occur However, increases or decreases in lease payments that are dependent only upon the passage of time are not contingent rentals; these are part of minimum lease payments Question 15–13 The costs of negotiating and consummating a completed lease transaction incurred by the lessor that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs They include legal fees, evaluating the prospective lessee's financial condition, commissions, and preparing and processing lease documents Question 15–14 In an operating lease, initial direct costs are recorded as prepaid expenses (assets) and amortized as an operating expense (usually straight line) over the lease term This approach is due to the nature of operating leases in which rental revenue is earned over the lease term Initial direct costs are matched, along with depreciation and other associated costs, with the rent revenues they help generate In a direct financing lease initial direct costs are amortized over the lease term This is accomplished by offsetting lease receivable by the initial direct costs This recognizes the initial direct costs at the same rate (that is, proportionally) as the interest revenue to which it is related The nature of the lease motivates this treatment The only revenue a direct financing lease generates for the lessor is interest revenue, which is earned over the lease term So, initial direct costs are matched proportionally over the term of the lease In a sales-type lease, GAAP requires that initial direct costs be expensed in the period of “sale,” that is, at the inception of the lease This treatment implicitly assumes that in a sales-type lease the primary reason for incurring these costs is to facilitate the sale of the leased asset Question 15–15 Lease disclosure requirements are quite extensive for both the lessor and lessee Virtually all aspects of the lease agreement must be disclosed For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years Other required disclosures are specific to the type of lease and include residual values, contingent rentals, sublease rentals, and executory costs Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 15–16 On the surface there are two separate transactions But the seller/lessee still retains the use of the asset that it had prior to the sale-leaseback In reality, the seller/lessee has cash from the sale and a noncancelable obligation to repay a debt In substance, the seller/lessee simply has borrowed cash to be repaid with interest over the lease term So, “substance over form” dictates that the gain on the sale of the asset not be immediately recognized but deferred and recognized over the term of the lease There typically is interdependency between the lease terms and the price at which the asset is sold So, the earnings process is not complete at the time of sale but is completed over the term of the lease Viewing the sale and the leaseback as a single transaction is consistent with the revenue realization principle Question 15–17 The FASB specified exceptions to the general classification criteria for leases that involve land because of the unlimited useful life of land and the inexhaustibility of its inherent value through use When title passes to the lessee—through automatic title passage or bargain purchase—these leases clearly are capital in nature and should be classified as such by the lessee However, the Board felt that there would be difficulty in applying the other two criteria Because land has essentially an infinite life, no lease term could possibly exceed 75 percent of its useful life, and the criterion was not applicable The fourth criterion calls for comparing the present value of the lease payments with 90 percent of the property's fair value to determine if the lessor will recover its investment through the payments When land is involved, the Board felt that the lease was not intended to recover the lessor's investment Further, the lessor would have the land at the end of the lease term in essentially the same condition Accordingly, the FASB concluded that leases involving material amounts of land should be classified as operating leases unless title passes automatically or as the result of a bargain purchase option Question 15–18 The guidelines for determining when a material amount of land is involved in a lease indicate that leases involving property where land constitutes 25 percent or more of the total value should be treated as if they are two leases The portion of the lease attributable to the land should be treated as an operating lease while the portion attributable to the other property should be judged on its own characteristics and accounted for accordingly If the land value is less than 25 percent of the total value of the property, no allocation needs to be made © The McGraw-Hill Companies, Inc., 2013 15–6 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 15–19 A leveraged lease involves significant long-term, nonrecourse financing by a third-party creditor The lessor serves the role of a mortgage broker and earns income by serving as an agent between a company needing to acquire property and a lender looking for an investment The lender provides enough cash to the lessor to acquire the property The leased property is then leased to the lessee under a capital lease with lease payments applied to the note held by the lender A lessee accounts for a leveraged lease the same way as a nonleveraged lease A lessor records its investment (receivable) net of the nonrecourse debt and reports income from the lease only in those years when the receivable exceeds the liability Question 15–20 We can find authoritative guidance for accounting for leases under IFRS in “Leases,” International Accounting Standard No 17, IASCF Question 15–21 Yes A finance lease under IFRS might be classified as an operating lease under U.S GAAP U.S GAAP has precise guidelines while IFRS are more “principles-based.” For instance, if the present value of minimum lease payments is 89% of the leased asset’s fair value, the lease would be classified as an operating lease under U.S GAAP because lease payments are less than 90% of the asset’s fair value, but 89% might be a “major portion” of the asset’s fair value and the lease classified as a finance lease under IAS No 17 Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 15–22 In general, IFRS is considered to be more principles-based while U.S GAAP is more rules-based For example, under IFRS one situation that normally indicates a finance lease is if the noncancelable lease term is for a major portion of the expected economic life of the asset Another is if the present value of the minimum lease payments is equal to or greater than substantially all of the fair value of the asset With regard to lease classification, U.S GAAP provides more precise guidelines The lines are brighter between a capital lease and an operating lease Meeting any one of four criteria qualify a lease as a capital lease under U.S GAAP Also, the specification of what constitutes a “major portion” of the useful life of an asset is much more precise We presume, quite arbitrarily, that 75% or more of the expected economic life of the asset is an appropriate threshold point for this purpose Often, we might consider a “major portion” to be less than 75% and classify a lease as a finance lease under IFRS that would be an operating lease under U.S GAAP Similarly, what constitutes “substantially all” of the fair value of the leased asset also is more precise under U.S GAAP The lessee is considered to have in substance purchased the asset when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease IFRS does not provide a specific percentage for determining what constitutes “substantially all” of the leased asset’s fair value Also, IFRS provides (a) a fifth indicator of a finance lease that normally leads to a finance lease and (b) three indicators that might lead to a finance lease Question 15–23 The IASB and FASB are collaborating on a joint project with the intent of revising accounting standards for leases As of 2011, the Boards have agreed on a “right of use” model Under this approach, the lessee recognizes an asset representing the right to use the leased asset for the lease term and also recognizes a corresponding liability for the lease rentals, whatever the term of the lease The new standard might result in most, if not all, leases being recorded as an intangible asset for the right of use and a liability for the present value of the lease payments It may eliminate operating leases The impact of any changes will be significant; U.S companies alone have over $1.25 trillion in operating lease obligations © The McGraw-Hill Companies, Inc., 2013 15–8 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com SUPPLEMENT QUESTIONS FOR REVIEW OF KEY TOPICS Question 15–24 The right to use a leased asset can provide the lessee with a significant benefit The lessee reports this benefit as a right-of-use asset in the balance sheet Similarly, the obligation to make the lease payments can be a significant liability, which the lessee reports in the balance sheet Question 15–25 The lessor records a receivable for the present value of the lease payments If that amount is less than the fair value of the asset being leased, the entire asset is not transferred to the lessee Instead, the lessor retains a portion of the asset In that case, the lessor divides the carrying amount of the asset into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as a residual asset The allocation is based on the ratio of the present value of the payments to the fair value of the asset That ratio is multiplied by the asset’s carrying value (the amount derecognized) to determine the portion of the carrying value transferred The remainder is the carrying value retained and recorded as a residual asset The residual asset is reported separate from other assets in the balance sheet Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 15–26 A lessee amortizes its right-of-use asset over lease term (or the useful life of the asset if it’s shorter) Using the asset results in an expense for the lessee In addition to amortization expense, the lessee also reports interest expense on its lease liability at the effective rate times the outstanding balance On the other side of the transaction, the lessor reports interest revenue on its lease receivable at the effective rate times the outstanding balance If it records a residual asset at the commencement of the lease, the lessor also reports accretion revenue from accreting the gross residual asset at the effective rate times the outstanding balance Question 15–27 When recording its lease receivable, the lessor uses the discount rate it charges the lessee This is the rate implicit in the lease agreement In other words, it is the desired rate of return the lessor has in mind when deciding the size of the lease payments It is the rate that causes the sum of (a) the present value of lease payments and (b) the present value of any residual value of the leased asset at the end of the lease to equal the fair value of the asset today Question 15–28 In its calculations, the lessee uses same rate the lessor uses if it is known to the lessee This is the rate implicit in the lease agreement In other words, it is the desired rate of return the lessor has in mind when deciding the size of the lease payments, the rate the lessor charges the lessee If that rate is unknown to the lessee, the lessee uses its own incremental borrowing rate, which is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset © The McGraw-Hill Companies, Inc., 2013 15–10 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 15–2 Requirement After the first full year under the warehouse lease, the balance in Dowell’s lease liability is $30,816,422 This is the balance after reductions from the first five quarterly lease payments as shown in this amortization schedule (The first payment was at December 31 of the previous year, the inception of the lease.) Lease Amortization Schedule Effective Interest 2% x Outstanding Balance Payments 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 2,398,303 02 (37,601,697) = 02 02 02 02 02 02 02 02 02 02 02 02 02 02 02 02 02 02 (35,955,428) (34,276,234) (32,563,456) (30,816,422) (29,034,448) (27,216,835) (25,362,869) (23,471,823) (21,542,957) (19,575,514) (17,568,722) (15,521,794) (13,433,927) (11,304,303) (9,132,086) (6,916,425) (4,656,450) (2,351,276) = = = = = = = = = = = = = = = = = = 752,034 719,109 685,525 651,269 616,328 580,689 544,337 507,257 469,436 430,859 391,510 351,374 310,436 268,679 226,086 182,642 138,328 93,129 47,027* Decrease in Balance 2,398,303 1,646,269 1,679,194 1,712,778 1,747,034 1,781,975 1,817,614 1,853,966 1,891,046 1,928,867 1,967,444 2,006,793 2,046,929 2,087,867 2,129,624 2,172,217 2,215,661 2,259,975 2,305,174 2,351,276 Outstanding Balance 40,000,000 37,601,697 35,955,428 34,276,234 32,563,456 30,816,422 29,034,448 27,216,835 25,362,869 23,471,823 21,542,957 19,575,514 17,568,722 15,521,794 13,433,927 11,304,303 9,132,086 6,916,425 4,656,450 2,351,276 * Rounded Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–193 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 15–2 (continued) Requirement After the first full year under the warehouse lease, the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses is 32,000,000: $40,000,000 ÷ years $ 8,000,000 Leased warehouses, PV of lease payments Life of lease Accumulated depreciation after one year $40,000,000 (8,000,000) $32,000,000 Leased warehouses, PV of lease payments Accumulated depreciation after one year Carrying amount after one year Requirement The specific citation that specifies the guidelines for derecognition of capital leases is FASB ACS 840–30–40: “Leases–Capital Leases–Derecognition.” Accounting for lessees is described in paragraphs 40–1 and 2; “Lease Modifications.” (a) if the proposal to sublease will qualify as a termination of a capital lease: 840–10–40–2: "Leases–Overall–Derecognition–Lessees" If the nature of a sublease is such that the original lessee is relieved of the primary obligation under the original lease, the transaction should be considered a termination of the original lease agreement (b) the appropriate accounting treatment for the sublease: Because Dowell’s proposed sublease is a termination of a capital lease before the expiration of the lease term, it falls under Par 40–1: 40–1 A termination of a capital lease before the expiration of the lease term is accounted for by the lessee by removing the asset and obligation, with gain or loss recognized for the difference © The McGraw-Hill Companies, Inc., 2013 15–194 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 15–2 (concluded) Requirement In accordance with FASB ACS 840–30–40–1, the asset and obligation representing the original lease would be removed from the accounts and a loss would be recognized for the difference The journal entry Dowell would record in connection with the sublease is: Lease payable (balance after quarters; from req 1) 30,816,422 Loss on sublease (to balance) 1,183,578 8,000,000 Accumulated depreciation (balance: from req 2) 40,000,000 Leased warehouses (balance: PV of lease payments) Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–195 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 15–3 First, this case has no single right answer The process of developing the proposed solutions will likely be more beneficial than the solutions themselves Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole It is important that each student actively participate in the process Domination by one or two individuals should be discouraged Discussion likely will include the following: a Possible advantages of leasing include: Leasing can preserve the ability to borrow under lines of credit Leasing can provide an interest rate lower than the incremental borrowing rate Leasing may avoid violating restrictive loan agreements that prohibit the issuance of additional debt securities Leasing can lessen the risk of obsolescence Leasing allows 100% financing at fixed interest rates as compared with 70% to 90% financing when assets are purchased b The lessee views a noncancelable lease as a capital lease if it meets at least one of the following criteria The lease transfers ownership of the property to the lessee at the end of the lease term The lease contains a bargain purchase option The lease term is equal to 75% or more of the estimated economic life of the leased property The present value of the minimum lease payments, excluding executory costs, equals or exceeds 90% of the fair value of the leased property and are not met and are met—if the purchase option is viewed as a bargain purchase option Is $290,000 enough less than $300,000 that exercise of the option is expected to occur? If so: The right to purchase the vans at the end of the lease term for $290,000, when the estimated fair value is $300,000, is a bargain purchase option The present value of the minimum lease payments, not including the executory costs, is greater than 90% of the fair value of the vans, calculated as follows: © The McGraw-Hill Companies, Inc., 2013 15–196 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 15–3 (continued) Present value of minimum lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 In this case, it is a capital lease Otherwise: Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Fair value of vans 90% of the fair value of the vans $1,240,000 x 90% $1,116,000 In this case, it is an operating lease to the lessee Either way, it is a capital lease to the lessor: Present value of minimum lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Residual value ($300,000 x 0.68301) 204,903 Total $1,250,958 Since Interstate’s cost, $1,050,000, was less than its “selling price,” this is a sales-type lease to Interstate Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–197 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 15–3 (concluded) c VIP would record the following at December 31, 2013: Interest expense ([$1,100,000 – 300,000] x 10%) 80,000 Lease liability 220,000 Cash Operating expenses Cash 300,000 1,000 1,000 If a BPO is assumed, VIP would have the vans for seven years: Depreciation expense ([$1,100,000 – 50,000] ÷ yrs.) Accumulated depreciation 150,000 150,000 If a BPO is not assumed, VIP would have the vans for four years: Depreciation expense ([$1,100,000 – 300,000] ÷ yrs.) Accumulated depreciation © The McGraw-Hill Companies, Inc., 2013 15–198 200,000 200,000 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 15–4 Discussion should include these elements: Leasehold improvement depreciation period There may be some degree of latitude associated with uncertainty concerning the life of the leasehold improvements However, trade publications indicate 25 years probably is out of range The suggestion to use 25 years clearly is motivated by the desire to “window dress” performance Ethical Dilemma: How does a doubtful justification for the estimated life of leasehold improvements compare with the perceived need to increase reported profits? Who is affected? Person Keene Other managers Shareholders Potential shareholders Employees Creditors The company’s auditors Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–199 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com IFRS Case 15–5 Requirement Dell’s operating lease commitments at January 30, 2011, are: Lease Commitments Dell leases property and equipment, manufacturing facilities, and office space under noncancelable leases Certain of these leases obligate Dell to pay taxes, maintenance, and repair costs At January 28, 2011, future minimum lease payments under these noncancelable leases are as follows: $106 million in Fiscal 2012; $71 million in Fiscal 2013; $53 million in Fiscal 2014; $44 million in Fiscal 2015; $33 million in Fiscal 2016; and $68 million thereafter Requirement There is no single way to estimate the effect of capitalizing Dell’s operating leases The objective is to find the present value of the series of lease payments required by the operating lease obligations Information, though, is insufficient to make exact calculations We can use the amount of payments after 2016 to estimate the number of years those payments are due $68 ÷ $33 = about two years We can then use the midpoint of two years, one year, in the calculation: ($ in millions) Fiscal years 2012 2013 2014 2015 2016 2016 and subsequent Total minimum rentals Operating leases $ 106 71 53 44 33 68 $458 PV factor 6% 943 890 840 792 747 705* Present value $ 100 63 45 35 25 48 $316 * This is the PV factor for i = 6%, n = 6, which treats payments after 2016 as occurring in 2017, one year after 2016, the midpoint of the two years after 2016 © The McGraw-Hill Companies, Inc., 2013 15–200 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 15–5 (concluded) or: An alternative (more accurate, but more difficult) way to estimate the present value of the payments beyond 2016 is to view them as a deferred annuity: $34 ($68 ÷ 2) x 1.84** = $63 $63 x 747*** = $ 47 ** Present value of an ordinary annuity of $1, i = 6%, n = *** Present value of $1, i = 6%, n = (2012–2016) Requirement If capitalized, these operating lease commitments would add $316 million to Dell’s liabilities The impact of this on the percentage of Dell’s debt to equity would be to increase the ratio slightly from 3.97% to 4.01: Without capitalization: With capitalization: $ 30,833 ÷ $ 7,766 = 3.97 ($30,833 + 316) ÷ $7,766 = 4.01 Note two indications from this analysis First, Dell’s debt to equity ratio is quite high Often it is less than one, but Dell’s is about to Second, note that capitalizing operating leases had a negligible impact on the ratio for two reasons—the ratio is high to begin with and Dell has relatively small (and declining) operating lease commitments For many companies, airlines and grocery chains for instance, capitalizing operating leases can greatly increase, often double, the ratio We made reasonable assumptions about the timing of payments and estimated the present value of all future payments to be made on the operating leases as we did in the “Decision Makers’ Perspective” section at the end of the chapter Other reasonable assumptions should yield comparable results In any case, we have a rough estimate Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–201 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 15–6 Requirement Leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and obtain favorable tax benefits Also, leasing sometimes is used as a means of “offbalance-sheet financing.” When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other mechanical indicators of riskiness Also, the purchased asset increases total assets and thus reduces calculations of the rate of return on assets In spite of research that indicates the market is not fooled, managers continue to avoid reporting of assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required Whether or not there is any real effect on security prices, off-balance-sheet financing can help a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance) In fact, in its annual report, Wal-Mart Stores, Inc., indicates that it has several restrictive covenants, one of which relates to the debt to equity ratio Requirement When capital leases are first recorded, both assets and liabilities increase by the present value of minimum lease payments In later years, though, the amounts differ Leased assets are reduced by depreciation Lease liabilities are reduced by the principal portion of lease payments Requirement ($ in millions) Interest expense (difference) Lease liability (current obligation: given) Cash (lease payment: given) 254 346 600 Requirement $ 254 ÷ 3,516 7.2% 2011 interest (from requirement 3) Beginning balance in lease liability–given: $346 + 3,170 Approximate average interest rate = 7.2% © The McGraw-Hill Companies, Inc., 2013 15–202 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 15–7 Requirement In a sale-leaseback transaction, the owner of an asset sells the asset and immediately leases it back from the new owner We view the sale and simultaneous leaseback of the asset as a single borrowing transaction On the surface there appear to be two separate transactions, but the substance of the agreement indicates otherwise The seller-lessee (FedEx in our case) still retains the use of the asset owned prior to the sale-leaseback, but in the process acquires (a) cash from the sale and (b) an obligation to make lease payments over the term of the lease In substance, the seller-lessee has borrowed cash to be repaid over the lease term (along with interest) So, from this perspective of “substance over form,” we not immediately recognize any gains that result from sale-leaseback transactions, but defer the gains to be recognized over the term of the lease There typically is interdependency between the lease terms and the price at which the asset is sold As a result, the earnings process is not complete at the time of sale but is completed over the term of the lease So, viewing the sale and the leaseback as a single transaction is consistent with the realization principle Requirement When amortizing the deferred gain over the lease term, if the lease meets the criteria to be viewed as a capital lease, we reduce depreciation expense each period by the amortized portion of the gain If the leaseback portion of a sale-leaseback transaction is classified as an operating lease, the gain still is deferred, but is recognized as a reduction of rent expense rather than depreciation Because FedEx amortizes its deferred gains “ratably over the life of the lease as a reduction of rent expense” it apparently considers the leases to be operating leases Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–203 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 15–8 Suggested Grading Concepts and Grading Scheme: Content (80%) 30 Sale portion of the sale-leaseback (10 each) Record cash for the sale price Decrease equipment at its undepreciated cost Establish a deferred gain for the excess of the sale price of the equipment over its undepreciated cost 15 Gain on the sale portion (5 each; maximum 15) Amortized over the lease term As a reduction of depreciation expense Results in essentially the same depreciation and interest as if the asset were not sold and leased back, but a note is issued for cash instead Because the sale and the leaseback are two components of a single transaction rather than two independent transactions Consistent with the realization principle 15 Leaseback portion of the sale-leaseback transaction (5 each; maximum 15) Both an asset And a liability At the present value of minimum lease payments Excluding any executory costs Asset amount cannot exceed fair value 20 Conceptual basis (10 each) Economic effect of a long-term capital lease on the lessee is similar to that of an installment purchase Transfers substantially all of the benefits and risks incident to the ownership of property to the lessee 80 points Writing (20%) Terminology and tone appropriate to the audience (CFO) Organization permits ease of understanding Introduction that states purpose Paragraphs separate main points English Word selection Spelling Grammar 20 points © The McGraw-Hill Companies, Inc., 2013 15–204 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Trueblood Case 15–9 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series These are available to instructors at: www.deloitte.com/ us/truebloodcases Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–205 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com IFRS Case 15–10 Requirement The desire to obtain “off-balance-sheet financing” sometimes is a leasing stimulus When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other quantifiable indicators of riskiness Similarly, the purchased asset increases total assets and correspondingly lowers calculations of the rate of return on assets As a result, managers often try to avoid reporting assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required Requirement Whether or not there is any real effect on security prices, sometimes off-balance-sheet financing helps a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance) For these reasons, SCI would prefer an operating lease SCI should not specify a bargain purchase option or the transfer of ownership to the lessee SCI could structure the lease so that the lease term is less than 75% of its useful life of the leased asset and the present value of lease payments is less than 90% of the asset’s fair value Requirement It would be more difficult for SCI to obtain “off-balance-sheet financing” through an operating lease under IFRS, because IAS No 17 stresses substance over form IFRS does not provide a specific percentage for determining what constitutes a “major portion” of the asset’s economic life or “substantially all” of the leased asset’s fair value IFRS also provides a fifth indicator of a lease that normally leads to a finance lease as well as three more indicators that might lead to a finance lease Professional judgment rather than specific rules determine whether the risks and rewards of ownership have been transferred to the lessee © The McGraw-Hill Companies, Inc., 2013 15–206 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Air France–KLM Case Requirement In general—yes More specifically—no Both sets of standards attempt to identify leases under which substantially all the risks and rewards of ownership are transferred to the lessee and treat the assets as if they had been purchased outright However, to distinguish between a capital lease and an operating lease, U.S GAAP uses four specific classification criteria, whereas IFRS uses a variety of “indicators” of a capital (finance) lease In this regard, IFRS is considered to be more principles-based while U.S GAAP is more rules-based Requirement At March 31, 2011, AF’s operating lease commitments for aircraft totaled €4,650 million Its capital lease commitments for aircraft had a present value that totaled €3,427 million (Note 30.4) While we don’t know the present value of the operating leases, likely it would be more than €3,427 Under both U.S GAAP and IFRS, lessees report operating and finance lease commitments for the upcoming five years However, under U.S GAAP, lessees report commitments in each of the next five years and then in total for beyond five years This is not required by IFRS under which most companies report commitments in the upcoming year, years 2–5, and five years or more AF, given this latitude, chose to report future payments in the way used by U.S GAAP companies Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–207 ... Diversity, Analytic Analytic Analytic Analytic Analytic Analytic Analytic Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com QUESTIONS FOR REVIEW... assured, transfer of ownership is expected Solutions Manual, Vol.2, Chapter 15 © The McGraw-Hill Companies, Inc., 2013 15–3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... borrowed to buy the asset © The McGraw-Hill Companies, Inc., 2013 15–4 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions