© 2004 McGraw-Hill Ryerson. McGraw-Hill Ryerson CHAPTER 15 Leases

© 2004 McGraw-Hill Ryerson.McGraw-Hill Ryerson

CHAPTER 15

LeasesLeases


Slide15-2

Basic Lease Terms

A lease is an agreement where the A lease is an agreement where the lessorlessor conveys the right to use property, plant, conveys the right to use property, plant, or equipment, usually for a stated period or equipment, usually for a stated period

of time, to the of time, to the lesseelessee..

Lessor = Owner of propertyLessor = Owner of propertyLessor = Owner of propertyLessor = Owner of property

Lessee = RenterLessee = RenterLessee = RenterLessee = Renter


Slide15-3

Lease Classifications

Lessee Lessor

Operating lease Operating lease

Capital lease Direct financing lease

Sales-type lease

Lessee Lessor

Operating lease Operating lease

Capital lease Direct financing lease

Sales-type lease


Slide15-4

Capital Lease Classification

1.1. OwnershipOwnership transferstransfers to the lessee at the end of the to the lessee at the end of the lease term, or the agreement contains a lease term, or the agreement contains a bargain bargain purchase optionpurchase option (BPO).(BPO).

2.2. The noncancellable lease term is equal to The noncancellable lease term is equal to 75% or 75% or moremore of the expected economic life of the asset.of the expected economic life of the asset.

3.3. The PV of the minimum lease payments (MLP) is The PV of the minimum lease payments (MLP) is 90% or more of the fair value90% or more of the fair value of the asset.of the asset.

Must include a noncancellable lease term.Must include a noncancellable lease term.

1.1. OwnershipOwnership transferstransfers to the lessee at the end of the to the lessee at the end of the lease term, or the agreement contains a lease term, or the agreement contains a bargain bargain purchase optionpurchase option (BPO).(BPO).

2.2. The noncancellable lease term is equal to The noncancellable lease term is equal to 75% or 75% or moremore of the expected economic life of the asset.of the expected economic life of the asset.

3.3. The PV of the minimum lease payments (MLP) is The PV of the minimum lease payments (MLP) is 90% or more of the fair value90% or more of the fair value of the asset.of the asset.

Must include a noncancellable lease term.Must include a noncancellable lease term.

A capital leasecapital lease must meet one of three criteria:


Slide15-5


A A bargain purchase option (BPO)bargain purchase option (BPO) gives the lessee gives the lessee the right to purchase the leased asset at a price the right to purchase the leased asset at a price sufficiently lower than the expected fair value of sufficiently lower than the expected fair value of the property and the exercise of the option appears the property and the exercise of the option appears reasonably assured.reasonably assured.


Slide15-6


The The lease termlease term is normally considered to be the is normally considered to be the noncancelable term of the lease plus any periods noncancelable term of the lease plus any periods covered by covered by bargain renewal optionsbargain renewal options. If the . If the inception of the lease occurs during the last 25% inception of the lease occurs during the last 25% of an asset’s economic life, this criterion does not of an asset’s economic life, this criterion does not apply.apply.

For the lessee, a capital lease is treated For the lessee, a capital lease is treated as the purchase of an asset – the lessee as the purchase of an asset – the lessee records both an asset and liability at records both an asset and liability at inception of the lease.inception of the lease.


Slide15-7

Additional Lessor Conditions

The three conditions discussed apply to both The three conditions discussed apply to both the lessee and lessor. However, the lessor must the lessee and lessor. However, the lessor must meet two additional conditions for the lease to meet two additional conditions for the lease to

be classified as either a direct financing or sales-be classified as either a direct financing or sales-type lease:type lease:

1.1. The collectibility of the lease payments must be The collectibility of the lease payments must be reasonably predictable.reasonably predictable.

2.2. If any costs to the lessor have yet to be incurred If any costs to the lessor have yet to be incurred they are reasonably predictable. Performance they are reasonably predictable. Performance by the lessor is substantially complete.by the lessor is substantially complete.

The three conditions discussed apply to both The three conditions discussed apply to both the lessee and lessor. However, the lessor must the lessee and lessor. However, the lessor must meet two additional conditions for the lease to meet two additional conditions for the lease to

be classified as either a direct financing or sales-be classified as either a direct financing or sales-type lease:type lease:

1.1. The collectibility of the lease payments must be The collectibility of the lease payments must be reasonably predictable.reasonably predictable.

2.2. If any costs to the lessor have yet to be incurred If any costs to the lessor have yet to be incurred they are reasonably predictable. Performance they are reasonably predictable. Performance by the lessor is substantially complete.by the lessor is substantially complete.


Slide15-8

Operating Leases

Criteria for a capital Criteria for a capital lease not met.lease not met.

Criteria for a capital Criteria for a capital lease not met.lease not met.

Lease agreement Lease agreement exists.exists.

Lease agreement Lease agreement exists.exists.

Record lease as an Record lease as an Operating LeaseOperating Lease

Record lease as an Record lease as an Operating LeaseOperating Lease


Slide15-9

Operating Leases

On January 1, 2005, Sans Serif On January 1, 2005, Sans Serif leased a colour copier from leased a colour copier from

CompuDec. The lease specified CompuDec. The lease specified four $100,000 payments four $100,000 payments

commencing January 1, 2005. The commencing January 1, 2005. The useful life of the copier is estimated useful life of the copier is estimated at six years. The cash price of the at six years. The cash price of the

copier is $479,079 and if Sans Serif copier is $479,079 and if Sans Serif were to use borrowed funds the were to use borrowed funds the

cost would have been 10%. cost would have been 10%.

On January 1, 2005, Sans Serif On January 1, 2005, Sans Serif leased a colour copier from leased a colour copier from

CompuDec. The lease specified CompuDec. The lease specified four $100,000 payments four $100,000 payments

commencing January 1, 2005. The commencing January 1, 2005. The useful life of the copier is estimated useful life of the copier is estimated at six years. The cash price of the at six years. The cash price of the

copier is $479,079 and if Sans Serif copier is $479,079 and if Sans Serif were to use borrowed funds the were to use borrowed funds the

cost would have been 10%. cost would have been 10%.


Slide15-10

Operating Leases

Prepare the entry on the books of Sans Serif on Prepare the entry on the books of Sans Serif on January 1.January 1.

GENERAL JOURNAL

Date Description Debit Credit

Jan 1 Prepaid rent 100,000 Cash 100,000


Slide15-11

Operating Leases

Prepare the entry the CompuDec would make to Prepare the entry the CompuDec would make to record receipt of the January 1 payment. record receipt of the January 1 payment.

GENERAL JOURNAL


Jan 1 Cash 100,000 Unearned Rent Revenue 100,000


Slide15-12

Operating LeasesThe December 31 adjustment by Sans Serif.The December 31 adjustment by Sans Serif.

GENERAL JOURNAL


Dec 31 Rent expense 100,000 Prepaid rent 100,000

The December 31 adjustment by CompuDec.The December 31 adjustment by CompuDec.

GENERAL JOURNAL


Dec 31 Unearned rent revenue 100,000 Rent revenue 100,000


Slide15-13

Operating Leases - Amortization

Lessee does not record amortization

Lessor retains title and therefore records amortization


Slide15-14

We’ll look at We’ll look at non-operating non-operating

leases for leases for Lessee and Lessee and

Lessor in some Lessor in some detail.detail.


Slide15-15

Nonoperating Leases - Lessee

The amount recorded (capitalized) is the present The amount recorded (capitalized) is the present value of the minimum lease payment. However, the value of the minimum lease payment. However, the amount recorded cannot exceed the fair value of the amount recorded cannot exceed the fair value of the

leased asset.leased asset.

The amount recorded (capitalized) is the present The amount recorded (capitalized) is the present value of the minimum lease payment. However, the value of the minimum lease payment. However, the amount recorded cannot exceed the fair value of the amount recorded cannot exceed the fair value of the

leased asset.leased asset.

In calculating the present value of the minimum In calculating the present value of the minimum lease payment, the interest rate used by the lessee lease payment, the interest rate used by the lessee

is the lower of:is the lower of:

1.1. Its incremental borrowing rate, orIts incremental borrowing rate, or

2.2. The implicit interest rate used by the lessor.The implicit interest rate used by the lessor.

In calculating the present value of the minimum In calculating the present value of the minimum lease payment, the interest rate used by the lessee lease payment, the interest rate used by the lessee

is the lower of:is the lower of:

1.1. Its incremental borrowing rate, orIts incremental borrowing rate, or

2.2. The implicit interest rate used by the lessor.The implicit interest rate used by the lessor.


Slide15-16

Nonoperating Leases - Lessor

When the lessor is a manufacturer or dealer, the fair When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is value of the property at the inception of the lease is

likely to be its normal selling price.likely to be its normal selling price.

When the lessor is a manufacturer or dealer, the fair When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is value of the property at the inception of the lease is

likely to be its normal selling price.likely to be its normal selling price.

If the lessor is not a manufacturer or dealer, the fair If the lessor is not a manufacturer or dealer, the fair value of the leased assets is typically the lessor’s value of the leased assets is typically the lessor’s

cost.cost.

If the lessor is not a manufacturer or dealer, the fair If the lessor is not a manufacturer or dealer, the fair value of the leased assets is typically the lessor’s value of the leased assets is typically the lessor’s

cost.cost.


Slide15-17

Nonoperating Leases

On December 31, 2004, Sans Serif, Inc. signed a On December 31, 2004, Sans Serif, Inc. signed a 6-year lease with First LeaseCorp who 6-year lease with First LeaseCorp who

acquired the copier from CompuDec for acquired the copier from CompuDec for $479,079. $479,079.

The equipment has a economic life of 6 years.The equipment has a economic life of 6 years.

First LeaseCorp routinely leases equipment and First LeaseCorp routinely leases equipment and the financing rate is 10%.the financing rate is 10%.

On December 31, 2004, Sans Serif, Inc. signed a On December 31, 2004, Sans Serif, Inc. signed a 6-year lease with First LeaseCorp who 6-year lease with First LeaseCorp who

acquired the copier from CompuDec for acquired the copier from CompuDec for $479,079. $479,079.

The equipment has a economic life of 6 years.The equipment has a economic life of 6 years.

First LeaseCorp routinely leases equipment and First LeaseCorp routinely leases equipment and the financing rate is 10%.the financing rate is 10%.


Slide15-18


The lease term does meet the “75% of the The lease term does meet the “75% of the economic life” test.economic life” test.

YearsEconomic life 675% of economic life 4.5

Lease Term 6

Lease Term (6 years) is equal to the economiclife of the equipment (6 years). This test is met.

YearsEconomic life 675% of economic life 4.5

Lease Term 6

Lease Term (6 years) is equal to the economiclife of the equipment (6 years). This test is met.


Slide15-19

Minimum Lease Payments per Year 100,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.79079

Present Value of the MLP $479,079

FMV of the equipment at lease inception 479,079$ 90% of the FMV of the equipment at lease inception 431,171$

The present value of the MLP > 90% of the FMV of theequipment. This test is met.

Minimum Lease Payments per Year 100,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.79079

Present Value of the MLP $479,079

FMV of the equipment at lease inception 479,079$ 90% of the FMV of the equipment at lease inception 431,171$

The present value of the MLP > 90% of the FMV of theequipment. This test is met.


Is the PV of the minimum lease payments (MLP) Is the PV of the minimum lease payments (MLP) 90% of the equipment’s fair value? 90% of the equipment’s fair value?


Slide15-20


Sans Serif makes the following entries at Sans Serif makes the following entries at inception of the lease.inception of the lease.

GENERAL JOURNAL


Dec 31 Leased equipment 479,079 Lease payable 479,079

Lease payable 100,000 Cash 100,000


Slide15-21


In addition to the information given earlier, the In addition to the information given earlier, the lessor (First LeaseCorp) knows that the lessor (First LeaseCorp) knows that the collectibility of the lease payments is collectibility of the lease payments is

reasonably predictable, and there are no reasonably predictable, and there are no future cost to be incurred. First LeaseCorp’s future cost to be incurred. First LeaseCorp’s performance is substantially complete as far performance is substantially complete as far as the lease is concerned. First LeaseCorp is as the lease is concerned. First LeaseCorp is not a manufacturer or dealer and its cost of not a manufacturer or dealer and its cost of

the equipment is $479,079. the equipment is $479,079.

In addition to the information given earlier, the In addition to the information given earlier, the lessor (First LeaseCorp) knows that the lessor (First LeaseCorp) knows that the collectibility of the lease payments is collectibility of the lease payments is

reasonably predictable, and there are no reasonably predictable, and there are no future cost to be incurred. First LeaseCorp’s future cost to be incurred. First LeaseCorp’s performance is substantially complete as far performance is substantially complete as far as the lease is concerned. First LeaseCorp is as the lease is concerned. First LeaseCorp is not a manufacturer or dealer and its cost of not a manufacturer or dealer and its cost of

the equipment is $479,079. the equipment is $479,079.


Slide15-22


Because the cost of the asset in the hands of the Because the cost of the asset in the hands of the lessor is equal fair market value, the lease is lessor is equal fair market value, the lease is

classified as a classified as a Direct Financing LeaseDirect Financing Lease..



GENERAL JOURNAL


Dec 31 Lease receivable 600,000 Inventory of equipment 479,079 Unearned interest revenue 120,921

$100,000 $100,000 × 6 = × 6 = $600,000$600,000

$100,000 $100,000 × 6 = × 6 = $600,000$600,000


Slide15-23






GENERAL JOURNAL


Dec 31 Cash 100,000 Lease receivable 100,000


Slide15-24

Dec 31 PaymentEffective Interest

Decrease in balance

Outstanding Balance

2004 479,079$ 2004 100,000$ -$ 100,000$ 379,079 2005 100,000 37,908 62,092 316,987 2006 100,000 31,699 68,301 248,686 2007 100,000 24,869 75,131 173,554 2008 100,000 17,355 82,645 90,910 2009 100,000 9,090 90,910 0

600,000$ 120,921$ 479,079$

Lease Amortization Schedule


Decrease in balance

Outstanding Balance

2004 479,079$ 2004 100,000$ -$ 100,000$ 379,079 2005 100,000 37,908 62,092 316,987 2006 100,000 31,699 68,301 248,686 2007 100,000 24,869 75,131 173,554 2008 100,000 17,355 82,645 90,910 2009 100,000 9,090 90,910 0

600,000$ 120,921$ 479,079$




Slide15-25

Nonoperating LeasesDecember 31, 2005, adjustment by Sans Serif.December 31, 2005, adjustment by Sans Serif.

GENERAL JOURNAL


Dec 31 Interest expense 37,908 Interest payable 37,908

December 31, 2005, adjustment by CompuDec.December 31, 2005, adjustment by CompuDec.

GENERAL JOURNAL


Dec 31 Unearned interest revenue 37,908 Interest revenue 37,908


Slide15-26

Amortization by Lessee

Amortization expense is recorded in a manner Amortization expense is recorded in a manner consistent with the company’s usual policy concerning consistent with the company’s usual policy concerning

Amortization of other operational assets.Amortization of other operational assets.

Amortization expense is recorded in a manner Amortization expense is recorded in a manner consistent with the company’s usual policy concerning consistent with the company’s usual policy concerning

Amortization of other operational assets.Amortization of other operational assets.

If title passes to the lessee at the end of the If title passes to the lessee at the end of the lease term, or the lease contains a bargain lease term, or the lease contains a bargain

purchase option, the asset is amortized purchase option, the asset is amortized over the over the asset’s economic lifeasset’s economic life; otherwise, it ; otherwise, it

is amortized over the is amortized over the lease termlease term..

If title passes to the lessee at the end of the If title passes to the lessee at the end of the lease term, or the lease contains a bargain lease term, or the lease contains a bargain

purchase option, the asset is amortized purchase option, the asset is amortized over the over the asset’s economic lifeasset’s economic life; otherwise, it ; otherwise, it

is amortized over the is amortized over the lease termlease term..


Slide15-27

Amortization by Lessee

At December 31, 2005, Sans Serif At December 31, 2005, Sans Serif prepares the following entry to prepares the following entry to

recognize amortization expense for recognize amortization expense for the year.the year.

GENERAL JOURNAL


Dec 31 Amortization expense 79,847 Accumulated amortization 79,847

$479,07$479,0799

6 years6 years

= = $79,847$79,847


Slide15-28


Sans Serif records the second payment on Sans Serif records the second payment on January 1, 2006.January 1, 2006.

GENERAL JOURNAL


Jan 1 Interest payable 37,908Lease payable 62,098 Cash 100,000

From the December 31, 2005, accrual.From the December 31, 2005, accrual.


Slide15-29


GENERAL JOURNAL


Jan 1 Cash 100,000 Lease receivable 100,000

CompuDec records the receipt of $100,000 CompuDec records the receipt of $100,000 on January 1, 2006 as follows: on January 1, 2006 as follows:


Slide15-30

Now let’s Now let’s look at look at

sales-type sales-type leases.leases.

Nonoperating Leases


Slide15-31

Sales-Type Lease

Because the lessor is a manufacturer or Because the lessor is a manufacturer or dealer, the FMV of the leased asset dealer, the FMV of the leased asset is not is not

equal to theequal to the Cost of the asset. Cost of the asset.

At inception of the lease, the lessor will At inception of the lease, the lessor will record the record the Cost of Goods SoldCost of Goods Sold as well as as well as

the the Sales RevenueSales Revenue (PV of MLP). (PV of MLP).

At inception of the lease, the lessor will At inception of the lease, the lessor will record the record the Cost of Goods SoldCost of Goods Sold as well as as well as

the the Sales RevenueSales Revenue (PV of MLP). (PV of MLP).


Slide15-32

Sales-Type Lease

On 31/1/04, Sans Serif leased a copier from On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.CompuDec at a price of $479,079.

Other relevant information:Other relevant information:

Six annual payments of $100,000 commencing Six annual payments of $100,000 commencing December 31, 2004.December 31, 2004.

6-year term is equal to useful life of copier.6-year term is equal to useful life of copier.

CompuDec’s manufactured cost is $300,000.CompuDec’s manufactured cost is $300,000.

CompuDec’s interest rate for financing is 10%.CompuDec’s interest rate for financing is 10%.

On 31/1/04, Sans Serif leased a copier from On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.CompuDec at a price of $479,079.



6-year term is equal to useful life of copier.6-year term is equal to useful life of copier.




Slide15-33

Sales-Type Lease

This is a This is a sales-type leasesales-type lease. It differs from . It differs from a direct financing lease since the a direct financing lease since the

lessor (CompuDec) earns a profit on lessor (CompuDec) earns a profit on selling the item in addition to interest.selling the item in addition to interest.

Sans Serif treats this as a Sans Serif treats this as a capital leasecapital lease. .


Slide15-34

Sales-Type Lease - Lessor

Entry at inception of the leaseEntry at inception of the lease

GENERAL JOURNAL


Dec 31 Lease receivable 600,000Cost of goods sold 300,000 Sales revenue 479,079 Unearned interest revenue 120,921 Inventory of equipment 300,000

($100,000 ($100,000 × 6) = $600,000× 6) = $600,000($100,000 ($100,000 × 6) = $600,000× 6) = $600,000


Slide15-35

Sales-Type Lease - LessorFirst receiptFirst receipt

GENERAL JOURNAL


Dec 31 Lease receivable 100,000 Cash 100,000


Slide15-36

Let’s look at Let’s look at how we how we handle handle residual residual value.value.


Slide15-37

Residual Value

The residual value of a leased asset is an The residual value of a leased asset is an estimate of what its estimate of what its commercial valuecommercial value will will be at the end of the lease term. Let’s see be at the end of the lease term. Let’s see

how residual value impacts the accounting how residual value impacts the accounting for leases by both the lessee and lessor.for leases by both the lessee and lessor.


Slide15-38

Residual Value

The only impact on the lessee is The only impact on the lessee is the determination of the determination of amortizationamortization expense. The cost of the asset will expense. The cost of the asset will

be reduced by the estimated be reduced by the estimated residual value and amortized over residual value and amortized over

the economic life of the asset.the economic life of the asset.

Lessee Obtains Title to Leased Lessee Obtains Title to Leased Asset.Asset.


Slide15-39

Residual Value

In determining the lease payment, In determining the lease payment, the lessor will reduce the fair value the lessor will reduce the fair value of the asset by the of the asset by the present value present value of the residual valueof the residual value. The reduced . The reduced fair value becomes the value used fair value becomes the value used

to calculate the lease payment.to calculate the lease payment.

Lessor Retains Title to Leased Lessor Retains Title to Leased Asset.Asset.


Slide15-40

Residual Value

On 31/1/04, Sans Serif leased a copier from CompuDec On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.at a price of $479,079.



Lease term is 6 years. Estimated useful life is 7 years.Lease term is 6 years. Estimated useful life is 7 years.



Let’s calculate the lease payment!Let’s calculate the lease payment!

On 31/1/04, Sans Serif leased a copier from CompuDec On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.at a price of $479,079.








Slide15-41

Residual Value

Calculation of the lease payment.Calculation of the lease payment.

Fair value of asset 479,079$

Residual value 60,000$

PV $1 factor, n=10, i=8% 0.56447 (33,868)

Recovered through lease payments 445,211

PV annuity $1, n=10, i=8% ÷ 4.79079

Lease payment 92,931$


Residual value 60,000$

PV $1 factor, n=10, i=8% 0.56447 (33,868)


PV annuity $1, n=10, i=8% ÷ 4.79079



Slide15-42

Residual Value Guaranteed by Lessee

Lessee pays any difference between guaranteed Lessee pays any difference between guaranteed residual value and the appraised value.residual value and the appraised value.

Let’s use the previous information, except that Sans Let’s use the previous information, except that Sans Serif (Lessee) guarantees to pay the residual value Serif (Lessee) guarantees to pay the residual value and the custody of copier reverts to lessor at end of and the custody of copier reverts to lessor at end of

lease.lease.

In this case, the annual lease payments are unchanged.In this case, the annual lease payments are unchanged.

However, there will be a payment of $60,000 at the end However, there will be a payment of $60,000 at the end of the lease.of the lease.

Let’s use the previous information, except that Sans Let’s use the previous information, except that Sans Serif (Lessee) guarantees to pay the residual value Serif (Lessee) guarantees to pay the residual value and the custody of copier reverts to lessor at end of and the custody of copier reverts to lessor at end of

lease.lease.

In this case, the annual lease payments are unchanged.In this case, the annual lease payments are unchanged.

However, there will be a payment of $60,000 at the end However, there will be a payment of $60,000 at the end of the lease.of the lease.


Slide15-43



Balance Reduction

Outstanding Balance

2004 479,079$ 2004 92,931$ -$ 92,931$ 386,148 2005 92,931 38,615 54,316 331,832 2006 92,931 33,183 59,748 272,084 2007 92,931 27,208 65,723 206,361 2008 92,931 20,636 72,295 134,067 2009 92,931 13,407 79,524 54,542 2010 60,000 5,458 54,542 0

$617,586 $138,507 $479,079



Slide15-44


GENERAL JOURNAL



Sans Serif records the asset at the present Sans Serif records the asset at the present value of the payments.value of the payments.


Slide15-45


GENERAL JOURNAL


Dec 31 Lease receivable 617,586Cost of Goods Sold 300,000 Sales revenue 479,079 Unearned interest revenue 138,507 Inventory of equipment 300,000

CompuDec records the sale as follows:CompuDec records the sale as follows:


Slide15-46


First lease payment by Sans Serif.First lease payment by Sans Serif.GENERAL JOURNAL


Dec 31 Lease payable 92,931 Cash 92,931

Receipt of first payment by CompuDec.Receipt of first payment by CompuDec.

GENERAL JOURNAL




Slide15-47


Amortization recorded by Sans Serif.Amortization recorded by Sans Serif.GENERAL JOURNAL


Dec 31 Amortization expense 69,847 Accumulated Amrt. 69,847

Final periodic payment made by Sans Serif.Final periodic payment made by Sans Serif.GENERAL JOURNAL


Dec 31 Interest expense 13,407Lease payable 79,524 Cash 92,931


Slide15-48


Receipt of final payment by CompuDec.Receipt of final payment by CompuDec.GENERAL JOURNAL



Recording of revenue on final periodic payment.Recording of revenue on final periodic payment.GENERAL JOURNAL


Dec 31 Unearned interest revenue 13,407 Interest revenue 13,407


Slide15-49


At the end of the lease term the lessee must remove the At the end of the lease term the lessee must remove the asset and related amortization in addition to recording asset and related amortization in addition to recording

the interest. the interest.

GENERAL JOURNAL


Dec 31 Interest Expense 5,458Lease payable 54,542Accumulated amortization 419,079 Leased Equipment 479,079


Slide15-50


Lessor records receiving copier at end of lease.Lessor records receiving copier at end of lease.GENERAL JOURNAL


Dec 31 Inventory of equipment 60,000 Lease receivable 60,000

Also records final amount of interest revenue.Also records final amount of interest revenue.

GENERAL JOURNAL


Dec 31 Unearned rent revenue 5,458 Rent revenue 5,458


Slide15-51

Residual Value Not Guaranteed by Lessee

Lessee is only obligated to make periodic rental Lessee is only obligated to make periodic rental payments.payments.

Present value of lease payments is recorded as Present value of lease payments is recorded as leased asset and lease liability.leased asset and lease liability.

Same method applied if residual value is Same method applied if residual value is guaranteed by a third party.guaranteed by a third party.

Lessee is only obligated to make periodic rental Lessee is only obligated to make periodic rental payments.payments.

Present value of lease payments is recorded as Present value of lease payments is recorded as leased asset and lease liability.leased asset and lease liability.

Same method applied if residual value is Same method applied if residual value is guaranteed by a third party.guaranteed by a third party.


Slide15-52



Decrease in Balance

Outstanding Balance

2004 445,211$ 2004 92,931$ -$ 92,931$ 352,280 2005 92,931 35,228 57,703 294,577 2006 92,931 29,458 63,473 231,104 2007 92,931 23,110 69,821 161,283 2008 92,931 16,128 76,803 84,480 2009 92,931 8,451 84,480 0

557,586$ 112,375$ 445,211$



Slide15-53


Recording the asset and liability by Sans Serif.Recording the asset and liability by Sans Serif.GENERAL JOURNAL



First lease payment by Sans Serif.First lease payment by Sans Serif.

GENERAL JOURNAL




Slide15-54


CompuDec makes the following entry at the CompuDec makes the following entry at the start of the lease.start of the lease.

GENERAL JOURNAL


Dec 31 Lease receivable 617,586Cost of Goods Sold 266,132 Sales revenues 445,211 Unearned interest rev. 138,507 Inventory of equipment 300,000


Slide15-55

Let’s look at Let’s look at how we how we handle handle Bargain Bargain

Purchase Purchase OptionsOptions


Slide15-56

Bargain Purchase Options

This is a provision in a lease that gives the This is a provision in a lease that gives the lessee the option of purchasing the asset at a lessee the option of purchasing the asset at a price below fair market value at the end of price below fair market value at the end of

the lease.the lease.

The accounting and calculations are similar The accounting and calculations are similar to residual values.to residual values.


Slide15-57

Bargain Purchase OptionsOn 31/1/04, Sans Serif leased a copier from CompuDec at a On 31/1/04, Sans Serif leased a copier from CompuDec at a

price of $479,079.price of $479,079.


Six annual payments commencing December 31, 2004.Six annual payments commencing December 31, 2004.


Copier is expected to be worth $75,000 at end of lease.Copier is expected to be worth $75,000 at end of lease.

Sans Serif has option to buy at end of lease for $60,000. Sans Serif has option to buy at end of lease for $60,000.

Residual value at end of lease is zero.Residual value at end of lease is zero.



On 31/1/04, Sans Serif leased a copier from CompuDec at a On 31/1/04, Sans Serif leased a copier from CompuDec at a price of $479,079.price of $479,079.


Six annual payments commencing December 31, 2004.Six annual payments commencing December 31, 2004.


Copier is expected to be worth $75,000 at end of lease.Copier is expected to be worth $75,000 at end of lease.

Sans Serif has option to buy at end of lease for $60,000. Sans Serif has option to buy at end of lease for $60,000.

Residual value at end of lease is zero.Residual value at end of lease is zero.




Slide15-58


Calculation of the lease payment.Calculation of the lease payment.


Bargain purchase price 60,000$

PV $1 factor, n=10, i=8% 0.56447 (33,868)


PV annuity $1, n=10, i=8% ÷ 4.79079



Bargain purchase price 60,000$

PV $1 factor, n=10, i=8% 0.56447 (33,868)


PV annuity $1, n=10, i=8% ÷ 4.79079



Slide15-59


Calculation of the PV of lease payments by lesseeCalculation of the PV of lease payments by lessee

..

PV of rental payments 445,211$

($92,931 x 4.79079)

Plus PV of BPO

($60,000 x .56447) 33,868

PV of minumum lease payments 479,079$

(recorded as leased asset and lease liability)

PV of rental payments 445,211$

($92,931 x 4.79079)

Plus PV of BPO

($60,000 x .56447) 33,868

PV of minumum lease payments 479,079$

(recorded as leased asset and lease liability)


Slide15-60



Balance Reduction

Outstanding Balance

2004 479,079$ 2004 92,931$ -$ 92,931$ 386,148 2005 92,931 38,615 54,316 331,832 2006 92,931 33,183 59,748 272,084 2007 92,931 27,208 65,723 206,361 2008 92,931 20,636 72,295 134,067 2009 92,931 13,407 79,524 54,542 2010 60,000 5,458 54,542 0

617,586$ 138,507$ 479,079$



Slide15-61

Bargain Purchase OptionsRecording amortization by Lessee.Recording amortization by Lessee.

GENERAL JOURNAL


Dec 31 Amortization expense 68,440 Accumulated Amort. 68,440(479,079/7years)

Entry to record payment of BPO at end of lease.Entry to record payment of BPO at end of lease.GENERAL JOURNAL


Dec 31 Interest expense 5,458Lease payable 54,542 Cash 60,000


Slide15-62


What happens if BPO is exercisable What happens if BPO is exercisable before end of lease?before end of lease?

Lease term ends when option Lease term ends when option becomes exercisable.becomes exercisable.

All calculations modified to consider All calculations modified to consider shorter lease term.shorter lease term.

What happens if BPO is exercisable What happens if BPO is exercisable before end of lease?before end of lease?

Lease term ends when option Lease term ends when option becomes exercisable.becomes exercisable.

All calculations modified to consider All calculations modified to consider shorter lease term.shorter lease term.


Slide15-63

Executory Costs

Executory costs include cost of ownership like Executory costs include cost of ownership like maintenance, insurance, taxes, and other costs. If maintenance, insurance, taxes, and other costs. If the lease agreement makes the lessee responsible the lease agreement makes the lessee responsible

for the executory costs, they are treated as for the executory costs, they are treated as expenses by the lessee.expenses by the lessee.

In some cases, the lessor pays executory costs, In some cases, the lessor pays executory costs, and the lessee will reimburse the lessor through and the lessee will reimburse the lessor through higher periodic lease payments. These costs are higher periodic lease payments. These costs are

excluded in determining the minimum lease excluded in determining the minimum lease payment.payment.


Slide15-64

Discount Rate

Implicit rate is the effective interest rate the lease Implicit rate is the effective interest rate the lease payments provide the lessor over and above the payments provide the lessor over and above the

price that the asset is sold under the lease.price that the asset is sold under the lease.

If this rate is not known by lessee, the lessee should If this rate is not known by lessee, the lessee should use its own incremental borrowing rate, which is use its own incremental borrowing rate, which is

the rate the lessee would expect to pay if the the rate the lessee would expect to pay if the funds were borrowed from the bank.funds were borrowed from the bank.

Implicit rate is the effective interest rate the lease Implicit rate is the effective interest rate the lease payments provide the lessor over and above the payments provide the lessor over and above the

price that the asset is sold under the lease.price that the asset is sold under the lease.

If this rate is not known by lessee, the lessee should If this rate is not known by lessee, the lessee should use its own incremental borrowing rate, which is use its own incremental borrowing rate, which is

the rate the lessee would expect to pay if the the rate the lessee would expect to pay if the funds were borrowed from the bank.funds were borrowed from the bank.


Slide15-65

Initial Direct Costs

Incremental costs incurred by the lessor in negotiating and Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.consummating a lease agreement.

Operating LeasesOperating Leases −− Capitalize and amortize over the Capitalize and amortize over the lease term by the lessor.lease term by the lessor.

Direct Financing LeasesDirect Financing Leases −− Expense as incurred and a Expense as incurred and a portion of unearned income equal to costs should be portion of unearned income equal to costs should be recognized as income in same period. Remainder recognized as income in same period. Remainder deferred and taken to income over lease term.deferred and taken to income over lease term.

Sales-Type Leases Sales-Type Leases – expense at inception of lease.– expense at inception of lease.

Incremental costs incurred by the lessor in negotiating and Incremental costs incurred by the lessor in negotiating and consummating a lease agreement.consummating a lease agreement.

Operating LeasesOperating Leases −− Capitalize and amortize over the Capitalize and amortize over the lease term by the lessor.lease term by the lessor.

Direct Financing LeasesDirect Financing Leases −− Expense as incurred and a Expense as incurred and a portion of unearned income equal to costs should be portion of unearned income equal to costs should be recognized as income in same period. Remainder recognized as income in same period. Remainder deferred and taken to income over lease term.deferred and taken to income over lease term.

Sales-Type Leases Sales-Type Leases – expense at inception of lease.– expense at inception of lease.


Slide15-66

Contingent Rentals

Sometimes rental payment may be increased (or Sometimes rental payment may be increased (or decreased) at some future time during the lease decreased) at some future time during the lease

term, depending on whether or not some specified term, depending on whether or not some specified event occurs.event occurs.

Contingent rentals are not included in the minimum Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the lease payments. However, they are disclosed in the

notes to the financial statements.notes to the financial statements.

Sometimes rental payment may be increased (or Sometimes rental payment may be increased (or decreased) at some future time during the lease decreased) at some future time during the lease

term, depending on whether or not some specified term, depending on whether or not some specified event occurs.event occurs.

Contingent rentals are not included in the minimum Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the lease payments. However, they are disclosed in the

notes to the financial statements.notes to the financial statements.


Slide15-67

Lessee Disclosures

For capital leases, discloseFor capital leases, disclose Gross amount of assets recorded under Gross amount of assets recorded under

capital leases and related accumulated capital leases and related accumulated amortization.amortization.

Separately from other long-term obligations.Separately from other long-term obligations. Amounts due within one year of balance Amounts due within one year of balance

sheet date are disclosed as current liabilities.sheet date are disclosed as current liabilities. Future MLP in the aggregate and for each of Future MLP in the aggregate and for each of

the five succeeding years.the five succeeding years.


Slide15-68

Lessee Disclosures

For capital leases, discloseFor capital leases, disclose Amortization expense disclosed separately Amortization expense disclosed separately

or part of amortization of capital assets.or part of amortization of capital assets. Interest expense related to leases Interest expense related to leases

disclosed separately or as part of interest disclosed separately or as part of interest on long-term debt.on long-term debt.

Total minimum sublease rentals to be Total minimum sublease rentals to be received in the future under noncancelable received in the future under noncancelable subleases. (Desirable)subleases. (Desirable)

Total contingent rentals. (Desirable)Total contingent rentals. (Desirable)


Slide15-69

Lessee Disclosures

For operating leases in excess of one year, For operating leases in excess of one year, disclosedisclose Future minimum rental payments required in the Future minimum rental payments required in the

aggregate and for each of the five succeeding aggregate and for each of the five succeeding fiscal years and other commitments.fiscal years and other commitments.

Total of minimum rentals to be received in the Total of minimum rentals to be received in the future under noncancellable subleases. (Desirable)future under noncancellable subleases. (Desirable)

For all operating leases, disclose rental expense, For all operating leases, disclose rental expense, with separate amounts for minimum rentals, with separate amounts for minimum rentals, contingent rentals, and sublease rentals. contingent rentals, and sublease rentals. (Desirable) (Desirable)


Slide15-70

Lessee Disclosures

Provide a description of the lessee’s leasing Provide a description of the lessee’s leasing arrangements including, but not limited to arrangements including, but not limited to The basis on which contingent rental payments The basis on which contingent rental payments

are determined.are determined. The existence and terms of renewal or purchase The existence and terms of renewal or purchase

options and escalation clauses.options and escalation clauses. Restrictions imposed by lease agreements, such Restrictions imposed by lease agreements, such

as those concerning dividends, additional debt, as those concerning dividends, additional debt, and further leasing.and further leasing.


Slide15-71

Lessor Disclosures

For sales-type and direct financing leases, For sales-type and direct financing leases, disclosedisclose

Lessor’s net investment, segregated between Lessor’s net investment, segregated between current and long-term portions.current and long-term portions.

Finance Income.Finance Income. Computation of investment in leases for Computation of investment in leases for

purposes of recognizing income.purposes of recognizing income.


Slide15-72

Lessor Disclosures

For sales-type and direct financing leases, For sales-type and direct financing leases, disclose (Desirable)disclose (Desirable)

Components of the net investment in sales-Components of the net investment in sales-type and direct financing leasestype and direct financing leases

1.1. Future MLP to be received.Future MLP to be received.

2.2. Unguaranteed residual values.Unguaranteed residual values.

3.3. Unearned Interest Revenue.Unearned Interest Revenue. Future MLP to be received for each of the five Future MLP to be received for each of the five

succeeding fiscal years.succeeding fiscal years. Total contingent rentals included in income.Total contingent rentals included in income.


Slide15-73

Lessor Disclosures

For operating leases, discloseFor operating leases, disclose Cost of property held for leasing and the related Cost of property held for leasing and the related

accumulated amortization. accumulated amortization. Rental income from operating leases.Rental income from operating leases. Minimum future rentals on noncancellable leases Minimum future rentals on noncancellable leases

in the aggregate and for each of the five in the aggregate and for each of the five succeeding years. (Desirable)succeeding years. (Desirable)

Total contingent rentals included in income. Total contingent rentals included in income. (Desirable)(Desirable)


Slide15-74

Balance Sheet & Income Statement

Lease transactions impact several financial Lease transactions impact several financial ratios:ratios:

1.1. Debt to equity ratio – Lease liabilities are Debt to equity ratio – Lease liabilities are recorded.recorded.

2.2. Rate of return on assets – Lease assets Rate of return on assets – Lease assets are recorded.are recorded.

Whether leases are capitalized or treated as Whether leases are capitalized or treated as an operating lease affects the income an operating lease affects the income statement and balance sheet. The most statement and balance sheet. The most impact is on the balance sheet.impact is on the balance sheet.

Lease transactions impact several financial Lease transactions impact several financial ratios:ratios:

1.1. Debt to equity ratio – Lease liabilities are Debt to equity ratio – Lease liabilities are recorded.recorded.

2.2. Rate of return on assets – Lease assets Rate of return on assets – Lease assets are recorded.are recorded.

Whether leases are capitalized or treated as Whether leases are capitalized or treated as an operating lease affects the income an operating lease affects the income statement and balance sheet. The most statement and balance sheet. The most impact is on the balance sheet.impact is on the balance sheet.


Slide15-75

Statement of Cash Flows

Operating leasesOperating leases - Rent expense is a cash - Rent expense is a cash outflow to the lessee and a cash inflow to outflow to the lessee and a cash inflow to the lessor.the lessor.

Capital & Direct Financing LeasesCapital & Direct Financing Leases – Lessee – Lessee reports interest expense as an outflow reports interest expense as an outflow from operating activities and principal from operating activities and principal payment as an outflow from financing payment as an outflow from financing activities. The lessor has a cash inflow activities. The lessor has a cash inflow from operating activities and investing from operating activities and investing activities.activities.

Operating leasesOperating leases - Rent expense is a cash - Rent expense is a cash outflow to the lessee and a cash inflow to outflow to the lessee and a cash inflow to the lessor.the lessor.

Capital & Direct Financing LeasesCapital & Direct Financing Leases – Lessee – Lessee reports interest expense as an outflow reports interest expense as an outflow from operating activities and principal from operating activities and principal payment as an outflow from financing payment as an outflow from financing activities. The lessor has a cash inflow activities. The lessor has a cash inflow from operating activities and investing from operating activities and investing activities.activities.


Slide15-76

Statement of Cash Flows

Sales-type leasesSales-type leases – The lessor recognizes – The lessor recognizes the interest revenue in the operating the interest revenue in the operating activities section of the statement and the activities section of the statement and the principal reduction in the investing principal reduction in the investing section. In addition, the lessor has sales section. In addition, the lessor has sales revenue and cost of goods sold revenue and cost of goods sold recognized in the operating activities recognized in the operating activities section.section.

Sales-type leasesSales-type leases – The lessor recognizes – The lessor recognizes the interest revenue in the operating the interest revenue in the operating activities section of the statement and the activities section of the statement and the principal reduction in the investing principal reduction in the investing section. In addition, the lessor has sales section. In addition, the lessor has sales revenue and cost of goods sold revenue and cost of goods sold recognized in the operating activities recognized in the operating activities section.section.


Slide15-77

Sale-Leaseback – Capital Lease

Owner of asset sells it and Owner of asset sells it and immediately leases it back from immediately leases it back from

new owner.new owner.

Very common form of financing.Very common form of financing.

Seller-lessee receives cash from sale Seller-lessee receives cash from sale of asset.of asset.

Seller-lessee pays periodic rents to Seller-lessee pays periodic rents to buyer-lessor to retain use of asset.buyer-lessor to retain use of asset.

Owner of asset sells it and Owner of asset sells it and immediately leases it back from immediately leases it back from

new owner.new owner.

Very common form of financing.Very common form of financing.

Seller-lessee receives cash from sale Seller-lessee receives cash from sale of asset.of asset.

Seller-lessee pays periodic rents to Seller-lessee pays periodic rents to buyer-lessor to retain use of asset.buyer-lessor to retain use of asset.


Slide15-78


Teledyne sells its four warehouses for $900,000.Teledyne sells its four warehouses for $900,000.

Original cost $950,000; book value $600,000.Original cost $950,000; book value $600,000.

Sale date Dec 31, 2005.Sale date Dec 31, 2005.

Noncancellable lease term is 10 years.Noncancellable lease term is 10 years.

Annual payments $133,155 starting Dec 31, 2005.Annual payments $133,155 starting Dec 31, 2005.

Rental payments provide 10% return, which is Rental payments provide 10% return, which is equal to incremental borrowing rate.equal to incremental borrowing rate.

Straight-line amortization used.Straight-line amortization used.

Teledyne sells its four warehouses for $900,000.Teledyne sells its four warehouses for $900,000.

Original cost $950,000; book value $600,000.Original cost $950,000; book value $600,000.

Sale date Dec 31, 2005.Sale date Dec 31, 2005.

Noncancellable lease term is 10 years.Noncancellable lease term is 10 years.

Annual payments $133,155 starting Dec 31, 2005.Annual payments $133,155 starting Dec 31, 2005.

Rental payments provide 10% return, which is Rental payments provide 10% return, which is equal to incremental borrowing rate.equal to incremental borrowing rate.

Straight-line amortization used.Straight-line amortization used.


Slide15-79


Prepare the entry to record the sale on Prepare the entry to record the sale on December 31, 2005.December 31, 2005.

GENERAL JOURNAL


Dec 31 Cash 900,000Accumulated Amortization 350,000 Warehouses 950,000 Deferred gain on sale-lease- 300,000 back


Slide15-80

Sale-Leaseback – Capital LeaseRecord asset and liability on Dec 31, 2005.Record asset and liability on Dec 31, 2005.

GENERAL JOURNAL


Dec 31 Leased warehouses 900,000 Lease payable 900,000

Record payment on Dec 31, 2005.Record payment on Dec 31, 2005.

GENERAL JOURNAL




Slide15-81


Prepare the entry on Dec 31, 2006, to record Prepare the entry on Dec 31, 2006, to record the payment.the payment.

GENERAL JOURNAL


Dec 31 Interest expense * 76,684Lease payable 56,471 Cash 133,155

* (10% x [900,000-133,155])


Slide15-82

Sale-Leaseback – Capital LeaseAmortization on December 31, 2006.Amortization on December 31, 2006.

GENERAL JOURNAL


Dec 31 Amortization expense 90,000 Accumulated Amort. 90,000

Reduction of deferred gain on Dec 31, 2006.Reduction of deferred gain on Dec 31, 2006.

GENERAL JOURNAL


Dec 31 Deferred gain on sale/ls. bk. 30,000 Amortization expense 30,000


Slide15-83

Sale-Leaseback – Operating Lease

In this case, the gain is deferred and In this case, the gain is deferred and recognized as a reduction in rent recognized as a reduction in rent expense instead of amortization.expense instead of amortization.

There is no lease to amortize. There is no lease to amortize.

In this case, the gain is deferred and In this case, the gain is deferred and recognized as a reduction in rent recognized as a reduction in rent expense instead of amortization.expense instead of amortization.

There is no lease to amortize. There is no lease to amortize.


Slide15-84

Sale-Leaseback – Losses

In accordance with the conservatism In accordance with the conservatism principle a real loss on the sale of the principle a real loss on the sale of the property is recognized immediately.property is recognized immediately.

A real loss results when the fair value is A real loss results when the fair value is less than the carrying value.less than the carrying value.

An artificial loss results when fair value An artificial loss results when fair value exceeds carrying amount and asset is exceeds carrying amount and asset is

sold for less than carrying amount.sold for less than carrying amount.

Defer and amortize artificial loss if it is a Defer and amortize artificial loss if it is a prepayment of rent in substance.prepayment of rent in substance.

In accordance with the conservatism In accordance with the conservatism principle a real loss on the sale of the principle a real loss on the sale of the property is recognized immediately.property is recognized immediately.

A real loss results when the fair value is A real loss results when the fair value is less than the carrying value.less than the carrying value.

An artificial loss results when fair value An artificial loss results when fair value exceeds carrying amount and asset is exceeds carrying amount and asset is

sold for less than carrying amount.sold for less than carrying amount.

Defer and amortize artificial loss if it is a Defer and amortize artificial loss if it is a prepayment of rent in substance.prepayment of rent in substance.


Slide15-85

Real Estate Leases

Land is never amortized.Land is never amortized.

If land and building are leased you If land and building are leased you must account for separately, based must account for separately, based

on market value proportions.on market value proportions.

However if fair value of land is < However if fair value of land is < 25%, it is ignored and lessee and 25%, it is ignored and lessee and lessor treat land as a single unit.lessor treat land as a single unit.

Land is never amortized.Land is never amortized.

If land and building are leased you If land and building are leased you must account for separately, based must account for separately, based

on market value proportions.on market value proportions.

However if fair value of land is < However if fair value of land is < 25%, it is ignored and lessee and 25%, it is ignored and lessee and lessor treat land as a single unit.lessor treat land as a single unit.


Slide15-86

Leveraged Leases

Occurs when a third party provides Occurs when a third party provides nonrecourse financing for lease nonrecourse financing for lease

between lessor and lessee.between lessor and lessee.

Accounting is similar to non Accounting is similar to non leveraged leases.leveraged leases.

Lessor records lease receivable net Lessor records lease receivable net of nonrecourse debt and reports of nonrecourse debt and reports income in years when receivable income in years when receivable

exceeds liability.exceeds liability.

Occurs when a third party provides Occurs when a third party provides nonrecourse financing for lease nonrecourse financing for lease

between lessor and lessee.between lessor and lessee.

Accounting is similar to non Accounting is similar to non leveraged leases.leveraged leases.

Lessor records lease receivable net Lessor records lease receivable net of nonrecourse debt and reports of nonrecourse debt and reports income in years when receivable income in years when receivable

exceeds liability.exceeds liability.


Slide15-87

End of Chapter 15

Documents

© 2004 McGraw-Hill Ryerson. McGraw-Hill Ryerson CHAPTER 15 Leases