In this chapter we continue our discussion of debt, but we now turn our attention to liabilities arising in connection with leases. Leases that produce such debtor/creditor relationships are referred to as finance leases by the lessee and as either direct financing or sales type leases by the lessor. We also will see that some leases do not produce debtor/creditor relationships, but instead are accounted for as rental agreements. These are designated as operating leases.
Chapter 15 LEASES © 2013 The McGraw-Hill Companies, Inc Accounting by the Lessor and Lessee A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee Lessee Lessee == Renter Renter Lessee Operating lease Capital lease 15 - Lessor Lessor == Owner Owner of of property property Lessor Operating lease Finance lease Direct finance lease Sales-type lease Finance Leases and Installment Notes Compared Matrix acquires equipment from Apex by paying $193,878 every six months for the next three years The interest rate associated with the agreement is 9% Let’s look at the arrangement as an installment note payable and as a finance lease agreement First, let’s prepare an amortization schedule for the payments Date Payment Initial value $ 193,878 193,878 193,878 193,878 193,878 193,878 15 - Effective Decrease Outstanding Interest in Balance Balance $ 1,000,000 $ 45,000 $ 148,878 851,122 38,300 155,578 695,544 31,300 162,578 532,966 23,983 169,895 363,071 16,338 177,540 185,532 8,346 185,532 - Inception of the Agreement At inception January 15 - Installment Note Equipment Notes payable 1,000,000 Finance Lease Leased Equipment Lease payable 1,000,000 1,000,000 1,000,000 Classification Criteria Operating Lease Finance Lease “transfers substantially all the risks and rewards of ownership of an asset to the lessee”: 15 - For example: 1.The agreement transfers ownership of the asset to the lessee by the end of the lease term 2.The agreement contains a bargain purchase option 3.The non-cancelable lease term forms a major part of the economic life of the asset Classification Criteria Operating Lease Finance Lease “transfers substantially all the risks and rewards of ownership of an asset to the lessee”: The present value of the “minimum lease payments” at the start of the lease is equal to or greater than a substantial proportion the fair value of the asset The leased asset is of a specialized nature such that only the lessee is able to use the asset without major modifications 15 - Professional Judgment The examples given earlier are by no means comprehensive We should record a lease as a finance lease if indicators indicate that “substantially all the risks and rewards of ownership” is transferred to the lessee The indicators include the following: In a cancelable lease, the lessee bears the losses suffered by the lessor as a result : The lessee enjoys the gains and absorbs the losses arising from the fluctuations of the fair value of the residual of the leased asset The lessee is able to continue the lease for a secondary period at a rent that is substantially lower than market rent Lessor = Owner of the property subject to the lease 15 - Classification Criteria A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured The lease term is normally considered to be the noncancelable term of the lease plus any periods covered by bargain renewal options Periods covered by bargain renewal options are not included in the lease term if a BPO is present For the lessee, a finance lease is treated as an effective purchase of an asset – the lessee records both an asset and liability at inception of the lease 15 - IFRS versus U.S GAAP Lease accounting under IFRS and U.S GAAP provides a good general comparison of “principles-based accounting” as IFRS often is described and “rules-based accounting” which often is the description assigned to U.S.GAAP • Situations that normally would lead to classification as a finance lease are: Transfer of title Contains a BPO Term is “major portion” of asset’s life PV of MLP greater than “substantially all” of the fair value of the asset Specialized asset 15 - • Lease classification rules Transfer of title Contains a BPO 75% or more of assets life 90% or more of fair value Operating Leases Lease Lease agreement agreement exists exists Record Record lease lease as as an an Operating Operating Lease Lease 15 - 10 Criteria Criteria for for aa finance finance lease lease not not met met Finance Lease Residual Value Guaranteed Let’s use our previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value The guarantee is provided by the lessee Sales-Type Lease – January 1, 2011 San Serif Publishers (Lessee) Leased equipment Lease payable CompDec Corporation (Lessor) Lease receivable Cost of goods sold Sales revenue Inventory of equipment 15 - 32 479,079 479,079 479,079 300,000 479,079 300,000 Residual Value Guaranteed First Lease Payment – January 1, 2011 15 - 33 San Serif Publishers (Lessee) Lease payable Cash 92,931 CompDec Corporation (Lessor) Cash Lease receivable 92,931 92,931 92,931 Residual Value Guaranteed December 31, 2015 San Serif Publishers (Lessee) Depreciation expense 68,847 Accumulation depreciation 68,847 Interest expense Lease payable Cash CompDec Corporation (Lessor) Cash Interest revenue Lease receivable 15 - 34 Recorded cost of leased asset $ 479,079 Guaranteed residual value (60,000) Basis for depreciation 419,079 Useful life in years ÷ Annual depreciation $ 69,847 13,407 79,524 92,931 92,931 13,407 79,524 See amortization schedule Treatment of Residual Value Residual value in leased asset? Lessee gets the residual value (by transfer of title or a BPO) Lessor get the residual value (title does not transfer; no BPO) Residual value is not guaranteed Residual value is guaranteed by lessee or lessee's related party Residual value is guaranteed by a third party 15 - 35 Lessor Computation of Minimum Lease Lease Payment Payment Lessee Minimum Lease Payment No No No Yes No No Yes Yes Yes Yes Yes No Executory Costs One of the responsibilities of ownership that is transferred to the lessee in a finance lease is the responsibility to pay for maintenance, insurance, taxes, and any other costs associated with ownership These are referred to as executory costs costs The lessee records executory costs as incurred: Sans Serif Publishers (Lessee) Maintenance expense 2,000 Cash 2,000 15 - 36 Discount Rate One rate is implicit in the lease agreement This 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 Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset 15 - 37 Lessor’s Initial Direct Costs Incremental costs incurred by the lessor in negotiating and consummating a lease agreement • Operating Leases − Capitalize and amortize over the lease term by the lessor • Direct Finance Leases − Include as part of investment balance • Sales-Type Leases – The initial direct costs are expensed at the inception of the lease 15 - 38 Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs Contingent rentals are not included in the minimum lease payments However, they are disclosed in the notes to the financial statements 15 - 39 Lease Disclosures Lease disclosure requirements are quite extensive for both the lessor and lessee Virtually all aspects of the lease agreement must be disclosed For finance and noncancelable operating leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and in three bands comprising of payments (i) within one year (ii) after one year and less than five years and (iii) after five years 15 - 40 Lease Disclosures The lessor must disclose its net investment in the lease This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value) Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs 15 - 41 Statement of Financial Position and Income Statement Lease Lease transactions transactions impact impact several several financial financial ratios ratios 1 Debt Debt to to equity equity ratio ratio –– Lease Lease liabilities liabilities are are recorded recorded 2 Rate Rate of of return return on on assets assets –– Lease Lease assets assets are are recorded recorded Whether Whether leases leases are are capitalized capitalized or or treated treated as as an an operating operating lease lease affects affects the the income income statement statement and and statement statement of of financial financial position position The The greater greater impact impact is is on on the the statement statement of of financial financial position position 15 - 42 Special Leasing Arrangements Sale-Leaseback Sale-Leaseback Arrangements Arrangements –– the the owner owner of of an an asset asset sells sells itit and and immediately immediately leases leases itit back back from from the the new new owner owner The The lessee lessee is is the the seller seller and and the the lessor lessor is is the the buyer buyer of of the the asset asset Can the sellerlessee recognize the profit or loss on sale immediately? 15 - 43 Special Leasing Arrangements Sale-Leaseback Sale-Leaseback Arrangements Arrangements Can Can the the seller-lessee seller-lessee recognize recognize the the profit profit on on sale? sale? It all depends! • If the lease is a finance lease, risks and rewards are still with the lessee, there is no “sale” as such Any gain on the sale of the asset is deferred and amortized over the lease term However, a loss is recognized immediately if the asset is impaired • If the lease is an operating lease and the terms are at arms’ length pricing (fair values), the real profit or loss on the sale of the asset is recognized immediately “Artificial” profit or loss are deferred and recognized as adjustments to future rent expense 15 - 44 Special Leasing Arrangements Real Real estate estate lease lease –– finance finance or or operating operating lease? lease? • Lease of land – is a finance lease only if there is a transfer of title or a bargain purchase option (the first two situations) • Lease of land and buildings – the minimum lease payments have to be separated for land and buildings (using proportion of fair values) and tested for the lease classification If it is not possible to separate the two, the entire asset is to be accounted for as finance lease • Lease of part of a building – usual lease accounting process applies but requires extra effort to determine the fair value and cost of part of the building 15 - 45 End of Chapter 15 ... lease 15 - IFRS versus U.S GAAP Lease accounting under IFRS and U.S GAAP provides a good general comparison of “principles-based accounting as IFRS often is described and “rules-based accounting ... $300,000 CompuDec’s interest rate for financing the transaction is10% 15 - 21 Sales-Type Leases Lease Classification The lease term (6-years) is equal to 100% of the useful life of the copier, and Fair... is classified as a Sales-Type lease from the viewpoint of CompuDec (lessor) and a finance lease from the viewpoint of Sans Serif Publishers (lessee) 15 - 22 Sales-Type Leases: Lessee At inception