Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Leases 15

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Leases

15

15-2

Learning Objectives

Identify and describe the operational, financial, and tax objectives that motivate leasing.

15-3

Basic Lease Terms

A lease is an agreement where the A lease is an agreement where the lessorlessor conveys the right to use conveys the right to use property, plant, or equipment, property, plant, or equipment,

usually for a stated period of time, usually for a stated period of time, to the to the lesseelessee..

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

Lessee = RenterLessee = RenterLessee = RenterLessee = Renter

15-4

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

15-5

Learning Objectives

Explain why some leases constitute rental agreements and some represent

purchase/sales accompanied by debt financing.

15-6

Capital Leases and Installment Notes Compared

Matrix, Inc. acquires equipment from Apex, Inc. by paying $193,878 (rounded) 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 capital lease agreement. First, let’s prepare an amortization

schedule for the payments.

Effective Decrease OutstandingDate Payment Interest in Balance Balance

Initial value . . . . . . . . . . . . . . . . . . . 1,000,000$ 1 193,878$ 45,000$ 148,878$ 851,122 2 193,878 38,300 155,578 695,544 3 193,878 31,300 162,578 532,966 4 193,878 23,983 169,895 363,071 5 193,878 16,338 177,540 185,532 6 193,878 8,346 185,532 -

15-7

Inception of the Agreement

January 1Installment Note

Description Debit Credit

Equipment 1,000,000 Notes payable 1,000,000

Capital Lease


Equipment 1,000,000 Lease payable 1,000,000

15-8

First Semi-Annual Payment Date

June 30Installment Note


Interest expense 45,000Notes payable 148,878 Cash 193,878

Capital Lease


Interest expense 45,000Lease payable 148,878 Cash 193,878

15-9

Learning Objectives

Explain the basis for each of the criteria and conditions used to classify leases.

15-10

Capital Lease Classification

OwnershipOwnership transferstransfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase optionbargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The noncancelable lease term is equal to The noncancelable 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, or . . .or . . .

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.

OwnershipOwnership transferstransfers to the lessee at the end of to the lessee at the end of the lease term, or . . . the lease term, or . . .

A A bargain purchase optionbargain purchase option (BPO) exists, or . . .(BPO) exists, or . . .

The noncancelable lease term is equal to The noncancelable 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, or . . .or . . .

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.

A capital leasecapital lease must meet oneone of four criteria:

15-11

Capital Lease Classification

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

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

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

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

For the lessee, a capital lease is treated as the For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an purchase of an asset – the lessee records both an

asset and liability at inception of the lease.asset and liability at inception of the lease.

For the lessee, a capital lease is treated as the For the lessee, a capital lease is treated as the purchase of an asset – the lessee records both an purchase of an asset – the lessee records both an

asset and liability at inception of the lease.asset and liability at inception of the lease.

15-12

Additional Lessor Conditions

The four conditions discussed apply to both the The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet lessee and lessor. However, the lessor must meet

two additional conditions for the lease to be classified two additional conditions for the lease to be classified as either a direct financing or sales-type lease:as either a direct financing or sales-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, they If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the are reasonably predictable. Performance by the lessor is substantially complete.lessor is substantially complete.

The four conditions discussed apply to both the The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet lessee and lessor. However, the lessor must meet

two additional conditions for the lease to be classified two additional conditions for the lease to be classified as either a direct financing or sales-type lease:as either a direct financing or sales-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, they If any costs to the lessor have yet to be incurred, they are reasonably predictable. Performance by the are reasonably predictable. Performance by the lessor is substantially complete.lessor is substantially complete.

Lessor = Owner of the property subject to the lease agreement.Lessor = Owner of the property subject to the lease agreement.Lessor = Owner of the property subject to the lease agreement.Lessor = Owner of the property subject to the lease agreement.

15-13

Learning Objectives

Record all transactions associated with operating leases by both the lessor and lessee.

15-14

Operating Leases

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Lease Lease agreement agreement

exists.exists.

Lease Lease agreement agreement

exists.exists.

Record lease as Record lease as an Operating an Operating

Lease.Lease.

Record lease as Record lease as an Operating an Operating

Lease.Lease. CapitalLease

15-15

Operating Leases

On December 1, 2006, Matrix, Inc. signed a On December 1, 2006, Matrix, Inc. signed a two-year operating lease with RentPro, two-year operating lease with RentPro,

Inc. for office equipment. The lease called Inc. for office equipment. The lease called for $500 per month, payable at the for $500 per month, payable at the

beginningbeginning of each month. of each month.

The first payment was due on December 1, The first payment was due on December 1, 2006. Matrix paid three months of rent in 2006. Matrix paid three months of rent in

advance on December 1, 2006.advance on December 1, 2006.

On December 1, 2006, Matrix, Inc. signed a On December 1, 2006, Matrix, Inc. signed a two-year operating lease with RentPro, two-year operating lease with RentPro,

Inc. for office equipment. The lease called Inc. for office equipment. The lease called for $500 per month, payable at the for $500 per month, payable at the

beginningbeginning of each month. of each month.

The first payment was due on December 1, The first payment was due on December 1, 2006. Matrix paid three months of rent in 2006. Matrix paid three months of rent in

advance on December 1, 2006.advance on December 1, 2006.

15-16

Operating Leases

Prepare the entry on the books of Matrix on Prepare the entry on the books of Matrix on December 1, 2006.December 1, 2006.

GENERAL JOURNAL

Date Description Debit Credit

Dec 1 Prepaid rent 1,500 Cash 1,500

15-17

Operating Leases

Prepare the entry the RentPro would make to record Prepare the entry the RentPro would make to record receipt of the December 1, 2006. receipt of the December 1, 2006.

GENERAL JOURNAL


Dec 1 Cash 1,500 Unearned Rent Revenue 1,500

15-18

Operating Leases

The December 31The December 31stst adjustment by Matrix. adjustment by Matrix.

GENERAL JOURNAL


Dec 31 Rent expense 500 Prepaid rent 500

The December 31The December 31stst adjustment by RentPro. adjustment by RentPro.

GENERAL JOURNAL


Dec 31 Unearned rent revenue 500 Rent revenue 500

15-19

Learning Objectives

Describe and demonstrate how both the lessee and lessor account for a nonoperating lease.

15-20

We’ll look at We’ll look at non-operating non-operating leases for both leases for both the lessee and the lessee and lessor as we lessor as we

move through move through our examples.our examples.

15-21

Nonoperating Leases - Lessee

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

the fair value of the leased asset.the fair value of the leased asset.

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

the fair value of the leased asset.the fair value of the leased asset.

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

lessee is the lower of:lessee is the lower of:

1.1. Its incremental borrowing rate, Its incremental borrowing rate, oror

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





15-22

Nonoperating Leases - Lessor

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

inception of the lease is likely to be its inception of the lease is likely to be its normal selling price.normal selling price.

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

inception of the lease is likely to be its inception of the lease is likely to be its normal selling price.normal selling price.

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

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

15-23

Nonoperating Leases

On January 1, 2006, Matrix, Inc. signed a 5-year On January 1, 2006, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease with RentPro, Inc. for equipment. The

lease calls for $6,000 per year, payable at the lease calls for $6,000 per year, payable at the beginning of each year starting on 1/1/06.beginning of each year starting on 1/1/06.

The equipment has an economic life of 5 years The equipment has an economic life of 5 years and a fair value of $25,873. The equipment and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. reverts to RentPro at the end of the lease.

Matrix has an incremental borrowing rate of 8%, Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by which is the same as the implicit rate used by

RentPro to calculate the annual payment.RentPro to calculate the annual payment.

On January 1, 2006, Matrix, Inc. signed a 5-year On January 1, 2006, Matrix, Inc. signed a 5-year lease with RentPro, Inc. for equipment. The lease with RentPro, Inc. for equipment. The

lease calls for $6,000 per year, payable at the lease calls for $6,000 per year, payable at the beginning of each year starting on 1/1/06.beginning of each year starting on 1/1/06.

The equipment has an economic life of 5 years The equipment has an economic life of 5 years and a fair value of $25,873. The equipment and a fair value of $25,873. The equipment reverts to RentPro at the end of the lease. reverts to RentPro at the end of the lease.

Matrix has an incremental borrowing rate of 8%, Matrix has an incremental borrowing rate of 8%, which is the same as the implicit rate used by which is the same as the implicit rate used by

RentPro to calculate the annual payment.RentPro to calculate the annual payment.

15-24


The lease term meets the “The lease term meets the “75% of the 75% of the economic lifeeconomic life” test.” test.

YearsEconomic life 575% of economic life 3.75

Lease Term 5

Lease Term (5 years) is more than 75% of the economiclife of the equipment (3.75 years). This test is met.

YearsEconomic life 575% of economic life 3.75

Lease Term 5

Lease Term (5 years) is more than 75% of the economiclife of the equipment (3.75 years). This test is met.

15-25

Minimum Lease Payments per Year 6,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.31213

Present Value of the MLP 25,872.78$

FMV of the equipment at lease inception 25,873$ 90% of the FMV of the equipment at lease inception 23,286$

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

Minimum Lease Payments per Year 6,000$ Present Value of Annuity Due factor (5 periods @ 8%) × 4.31213

Present Value of the MLP 25,872.78$

FMV of the equipment at lease inception 25,873$ 90% of the FMV of the equipment at lease inception 23,286$

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


The PV of the MLP The PV of the MLP 90% of the 90% of the equipment’s fair valueequipment’s fair value

15-26


Matrix makes the following entries at Matrix makes the following entries at inception of the lease.inception of the lease.

GENERAL JOURNAL


Jan 1 Leased equipment 25,873 Lease payable 25,873

Lease payable 6,000 Cash 6,000

15-27


In addition to the information given earlier, the In addition to the information given earlier, the lessor (RentPro) knows that the collectibility lessor (RentPro) knows that the collectibility

of the lease payments is reasonably of the lease payments is reasonably predictable, and there are no future costs to predictable, and there are no future costs to

be incurred. RentPro’s performance is be incurred. RentPro’s performance is substantially complete as far as the lease is substantially complete as far as the lease is concerned. RentPro is not a manufacturer concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is or dealer and its cost of the equipment is

$25,873 (rounded). $25,873 (rounded).

In addition to the information given earlier, the In addition to the information given earlier, the lessor (RentPro) knows that the collectibility lessor (RentPro) knows that the collectibility

of the lease payments is reasonably of the lease payments is reasonably predictable, and there are no future costs to predictable, and there are no future costs to

be incurred. RentPro’s performance is be incurred. RentPro’s performance is substantially complete as far as the lease is substantially complete as far as the lease is concerned. RentPro is not a manufacturer concerned. RentPro is not a manufacturer or dealer and its cost of the equipment is or dealer and its cost of the equipment is

$25,873 (rounded). $25,873 (rounded).

15-28


Because the cost of the asset is equal to its Because the cost of the asset is equal to its fair market value, the lease is classified as a fair market value, the lease is classified as a

Direct Financing LeaseDirect Financing Lease..



GENERAL JOURNAL


Jan 1 Lease receivable 30,000 Inventory of equipment 25,873 Unearned interest revenue 4,127

$6,000 $6,000 × 5 = × 5 = $30,000$30,000

$6,000 $6,000 × 5 = × 5 = $30,000$30,000

15-29


GENERAL JOURNAL


Jan 1 Cash 6,000 Lease receivable 6,000





Receipt of the first lease payment.

15-30

Period PaymentsEffective Interest

Decrease in Balance

Outstanding Balance

1/1/06 25,873$ 1/1/06 6,000$ -$ 6,000$ 19,873 1/1/07 6,000 1,590 4,410 15,463 1/1/08 6,000 1,237 4,763 10,700 1/1/09 6,000 856 5,144 5,556 1/1/10 6,000 444 5,556 0

Lease Amortization Schedule

Period PaymentsEffective Interest

Decrease in Balance

Outstanding Balance

1/1/06 25,873$ 1/1/06 6,000$ -$ 6,000$ 19,873 1/1/07 6,000 1,590 4,410 15,463 1/1/08 6,000 1,237 4,763 10,700 1/1/09 6,000 856 5,144 5,556 1/1/10 6,000 444 5,556 0



15-31

Nonoperating Leases

December 31, 2006, adjustment by Matrix.December 31, 2006, adjustment by Matrix.

GENERAL JOURNAL


Dec 31 Interest expense 1,590 Interest payable 1,590

December 31, 2006, adjustment by RentPro.December 31, 2006, adjustment by RentPro.

GENERAL JOURNAL


Dec 31 Unearned interest revenue 1,590 Interest revenue 1,590

15-32

Depreciation by Lessee

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

concerning depreciation of other operational concerning depreciation of other operational assets.assets.

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

concerning depreciation of other operational concerning depreciation of other operational assets.assets.

If title passes to the lessee at the end of the lease If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase term, or the lease contains a bargain purchase option, the asset is depreciated over theoption, the asset is depreciated over the asset’s asset’s

economic lifeeconomic life; otherwise, it is depreciated over the; otherwise, it is depreciated over the lease termlease term..

If title passes to the lessee at the end of the lease If title passes to the lessee at the end of the lease term, or the lease contains a bargain purchase term, or the lease contains a bargain purchase option, the asset is depreciated over theoption, the asset is depreciated over the asset’s asset’s

economic lifeeconomic life; otherwise, it is depreciated over the; otherwise, it is depreciated over the lease termlease term..

15-33

Depreciation by Lessee

At December 31, 2006, Matrix prepares the At December 31, 2006, Matrix prepares the following entry to recognize depreciation following entry to recognize depreciation

expense for the year.expense for the year.

GENERAL JOURNAL


Dec 31 Depreciation expense 5,175 Accumulated depreciation 5,175

$25,87$25,8733

5 years5 years

= = $5,175$5,175

15-34


Matrix records the second payment on Matrix records the second payment on January 1, 2007.January 1, 2007.

GENERAL JOURNAL


Jan 1 Interest payable 1,590Lease payable 4,410 Cash 6,000

From the December 31, 2006, accrual.From the December 31, 2006, accrual.

15-35


GENERAL JOURNAL


Jan 1 Cash 6,000 Lease receivable 6,000

RentPro records the second receipt on RentPro records the second receipt on January 1, 2007.January 1, 2007.

15-36

Learning Objectives

Describe and demonstrate how the lessor accounts for a sales-type lease.

15-37

Sales-Type Lease

Because the lessor is a manufacturer or dealer, Because the lessor is a manufacturer or dealer, the FMV of the leased asset the FMV of the leased asset is not equal to theis not equal 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).

15-38

Sales-Type Lease

On 1/1/06, RentPro, Inc. signed a 3-year lease On 1/1/06, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The agreement with Matrix, Inc. for equipment. The

lease calls for payments of $118,516 at the end of lease calls for payments of $118,516 at the end of each of the next three years.each of the next three years.

The equipment has a 3-year economic life, a fair The equipment has a 3-year economic life, a fair value of $300,000 and cost to RentPro of value of $300,000 and cost to RentPro of

$222,500. RentPro requires a 9% return on leased $222,500. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing equipment. Matrix has an incremental borrowing

rate of 11%, but knows RentPro’s implicit rate. The rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection costs yet to be incurred by RentPro in connection

with the lease.with the lease.

On 1/1/06, RentPro, Inc. signed a 3-year lease On 1/1/06, RentPro, Inc. signed a 3-year lease agreement with Matrix, Inc. for equipment. The agreement with Matrix, Inc. for equipment. The

lease calls for payments of $118,516 at the end of lease calls for payments of $118,516 at the end of each of the next three years.each of the next three years.

The equipment has a 3-year economic life, a fair The equipment has a 3-year economic life, a fair value of $300,000 and cost to RentPro of value of $300,000 and cost to RentPro of

$222,500. RentPro requires a 9% return on leased $222,500. RentPro requires a 9% return on leased equipment. Matrix has an incremental borrowing equipment. Matrix has an incremental borrowing

rate of 11%, but knows RentPro’s implicit rate. The rate of 11%, but knows RentPro’s implicit rate. The collectability of the MLP is certain and there are no collectability of the MLP is certain and there are no costs yet to be incurred by RentPro in connection costs yet to be incurred by RentPro in connection

with the lease.with the lease.

15-39

Sales-Type Lease

This is a This is a sales-type leasesales-type lease because the lease term because the lease term is 100% of the economic life of the asset (3 is 100% of the economic life of the asset (3 years), the MLP will be collected, no further years), the MLP will be collected, no further

costs will be incurred by RentPro, and the cost costs will be incurred by RentPro, and the cost of the asset to RentPro is not equal to its fair of the asset to RentPro is not equal to its fair

value.value.Matrix treats this as a Matrix treats this as a capital leasecapital lease because the because the

lease term is 100% of the economic life of the lease term is 100% of the economic life of the asset.asset.

15-40

Sales-Type Lease

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

Recovered through lease payments 300,000

PV annuity $1, n=3, i=9% ÷ 2.53129

Lease payment 118,517$


PV annuity $1, n=3, i=9% ÷ 2.53129


Lease Amortization TableLease Amortization Table

Effective Decrease in OutstandingDate Payments Interest Balance Balance1/1/06 300,000$

12/31/06 118,517$ 27,000$ 91,517$ 208,483 12/31/07 118,517 18,764 99,753 108,730 12/31/08 118,517 9,787 108,730 -

Totals 355,551$ 55,551$ 300,000$

Effective Decrease in OutstandingDate Payments Interest Balance Balance1/1/06 300,000$

12/31/06 118,517$ 27,000$ 91,517$ 208,483 12/31/07 118,517 18,764 99,753 108,730 12/31/08 118,517 9,787 108,730 -

Totals 355,551$ 55,551$ 300,000$

15-41

Sales-Type Lease - Lessor

Entry at inception of the leaseEntry at inception of the lease

GENERAL JOURNAL


Jan 1 Lease receivable 355,551Cost of goods sold 222,500 Sales revenue 300,000 Unearned interest revenue 55,551 Inventory of equipment 222,500

($118,517 ($118,517 × 3) = $355,551× 3) = $355,551($118,517 ($118,517 × 3) = $355,551× 3) = $355,551

15-42

Capital Lease - Lessee

Entry at inception of the leaseEntry at inception of the lease

GENERAL JOURNAL


Jan 1 Leased equipment 300,000 Lease payable 300,000

15-43

Sales-Type Lease - Lessee

First payment First payment

GENERAL JOURNAL


Dec 31 Lease payable 91,517Interest expense 27,000 Cash 118,517

15-44

Sales-Type Lease - Lessee

Record first year depreciationRecord first year depreciation

GENERAL JOURNAL


Dec 31 Depreciation expense 100,000 Accumulated depreciation 100,000

$300,000 $300,000 ÷ 3 (lease term) = $100,000÷ 3 (lease term) = $100,000$300,000 $300,000 ÷ 3 (lease term) = $100,000÷ 3 (lease term) = $100,000

15-45

Sales-Type Lease - Lessor

First receiptFirst receipt

GENERAL JOURNAL


Dec 31 Lease receivable 118,517 Cash 118,517

Unearned interest revenue 27,000 Interest revenue 27,000

15-46

Learning Objectives

Explain how lease accounting is affected by the residual value of a leased asset.

15-47

Residual Value

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

impacts the accounting for leases by impacts the accounting for leases by both the lessee and lessor.both the lessee and lessor.

15-48

Residual Value

The only impact on the lessee is the The only impact on the lessee is the determination of determination of depreciationdepreciation expense. expense. The cost of the asset will be reduced by The cost of the asset will be reduced by

the estimated residual value and the estimated residual value and depreciated over the economic life of depreciated over the economic life of

the asset.the asset.

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

15-49

Residual Value

In determining the lease payment, the In determining the lease payment, the lessor will reduce the fair value of the lessor will reduce the fair value of the

asset by the asset by the present value of the present value of the residual valueresidual value. The reduced fair value . The reduced fair value becomes the value used to calculate becomes the value used to calculate

the lease payment.the lease payment.

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

15-50

Residual Value

On January 1, 2006, RentPro, Inc. signed a 10-On January 1, 2006, RentPro, Inc. signed a 10-year direct financing lease with Matrix, Inc. for year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period equipment. The lease requires end-of-period

payments. The equipment has a fair value and payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the cost to RentPro of $500,000. Title to the

equipment is retained by RentPro and it is equipment is retained by RentPro and it is estimated that at the end of the lease the asset estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro will have a residual value of $35,000. RentPro requires an 8% return on leased equipment.requires an 8% return on leased equipment.

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

On January 1, 2006, RentPro, Inc. signed a 10-On January 1, 2006, RentPro, Inc. signed a 10-year direct financing lease with Matrix, Inc. for year direct financing lease with Matrix, Inc. for equipment. The lease requires end-of-period equipment. The lease requires end-of-period

payments. The equipment has a fair value and payments. The equipment has a fair value and cost to RentPro of $500,000. Title to the cost to RentPro of $500,000. Title to the

equipment is retained by RentPro and it is equipment is retained by RentPro and it is estimated that at the end of the lease the asset estimated that at the end of the lease the asset will have a residual value of $35,000. RentPro will have a residual value of $35,000. RentPro requires an 8% return on leased equipment.requires an 8% return on leased equipment.


15-51

Residual Value


Fair value of asset 500,000$

Residual value 35,000$

PV $1 factor, n=10, i=8% 0.46319 (16,212)


PV annuity $1, n=10, i=8% ÷ 6.71008



Residual value 35,000$

PV $1 factor, n=10, i=8% 0.46319 (16,212)


PV annuity $1, n=10, i=8% ÷ 6.71008


15-52

Residual Value Guaranteed by Lessee

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

appraised value.appraised value.

On 1/1/06, RentPro, Inc. signed a 5-year direct financing On 1/1/06, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix lease with Matrix, Inc. for equipment. Matrix

guarantees a residual value of $3,500. The lease guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The requires beginning-of-period payments. The

equipment has a fair value and cost to RentPro of equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by $100,000. Title to the equipment is retained by

RentPro. The lease payment is based on a 8% return.RentPro. The lease payment is based on a 8% return.


On 1/1/06, RentPro, Inc. signed a 5-year direct financing On 1/1/06, RentPro, Inc. signed a 5-year direct financing lease with Matrix, Inc. for equipment. Matrix lease with Matrix, Inc. for equipment. Matrix

guarantees a residual value of $3,500. The lease guarantees a residual value of $3,500. The lease requires beginning-of-period payments. The requires beginning-of-period payments. The

equipment has a fair value and cost to RentPro of equipment has a fair value and cost to RentPro of $100,000. Title to the equipment is retained by $100,000. Title to the equipment is retained by

RentPro. The lease payment is based on a 8% return.RentPro. The lease payment is based on a 8% return.


15-53




Guaranteed residual value 3,500$

PV $1 factor, n=5, i=8% 0.68058 (2,382)


PV annuity due $1, n=5, i=8% ÷ 4.31213



Guaranteed residual value 3,500$

PV $1 factor, n=5, i=8% 0.68058 (2,382)


PV annuity due $1, n=5, i=8% ÷ 4.31213


15-54


Year PaymentInterest Income

Decrease in Balance

Outstanding Balance

100,000$ 1 22,638$ -$ (22,638)$ 77,362 2 22,638 6,189 (16,449) 60,913 3 22,638 4,873 (17,765) 43,148 4 22,638 3,452 (19,186) 23,962 5 22,638 1,917 (20,721) 3,241

259 259 3,500


Residual valueResidual valueResidual valueResidual value

15-55


The accounting for this direct financing lease will be The accounting for this direct financing lease will be the same as previously discussed, with two the same as previously discussed, with two

exceptions:exceptions:

1.1. The lessee reduces the cost basis of the asset by The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, $3,500 to calculate depreciation expense, andand

2.2. If at the end of the lease term the appraised value If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must of the asset is less than $3,500, the lessee must pay the difference between appraised value and pay the difference between appraised value and guaranteed residual value to the lessor.guaranteed residual value to the lessor.

The accounting for this direct financing lease will be The accounting for this direct financing lease will be the same as previously discussed, with two the same as previously discussed, with two

exceptions:exceptions:

1.1. The lessee reduces the cost basis of the asset by The lessee reduces the cost basis of the asset by $3,500 to calculate depreciation expense, $3,500 to calculate depreciation expense, andand

2.2. If at the end of the lease term the appraised value If at the end of the lease term the appraised value of the asset is less than $3,500, the lessee must of the asset is less than $3,500, the lessee must pay the difference between appraised value and pay the difference between appraised value and guaranteed residual value to the lessor.guaranteed residual value to the lessor.

15-56

Learning Objectives

Describe the way a bargain purchase option affects lease accounting.

15-57

Bargain Purchase Option

A provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price.

On 1/1/06, Matrix, Inc. signed a 5-year lease with Apex Leasing for equipment that requires semi-annual,

beginning of period payments.

On 1/1/06, Matrix, Inc. signed a 5-year lease with Apex Leasing for equipment that requires semi-annual,

beginning of period payments.

Minimum lease payment 60,377 Bargain purchase option 25,000 Lessor's implicit rate 12%Lessee's incremental rate 12%Fair value of leased asset 485,000 Cost in the hands of Apex 485,000 Economic life of asset 8

Minimum lease payment 60,377 Bargain purchase option 25,000 Lessor's implicit rate 12%Lessee's incremental rate 12%Fair value of leased asset 485,000 Cost in the hands of Apex 485,000 Economic life of asset 8

For Apex there are no unreimbursable costs and the collection of the MLP is assured.

For Apex there are no unreimbursable costs and the collection of the MLP is assured.

15-58

Lease Classification

This is a capital lease to Matrix (lessee) because it contains a bargain purchase option.

This is a direct-financing lease to Apex (lessor) because it contains a bargain purchase option, there are no unreimbursable costs and the MLP

is fully collectible.

15-59

Lease Computations

Fair value of asset (pv) 485,000$ Bargin purchase option (fv) 25,000 Number of periods (n) 10 Interest rate (i) 6%

Lease payment (pmt) = $60,377 (rounded).Lease payment (pmt) = $60,377 (rounded).Lease payment (pmt) = $60,377 (rounded).Lease payment (pmt) = $60,377 (rounded).

Lease payment – determined by Apex (lessor)Lease payment – determined by Apex (lessor)Lease payment – determined by Apex (lessor)Lease payment – determined by Apex (lessor)

PV of MLP – determined by Matrix (lessee)PV of MLP – determined by Matrix (lessee)PV of MLP – determined by Matrix (lessee)PV of MLP – determined by Matrix (lessee)

Lease payment (pmt) 60,377$ Bargin purchase option (fv) 25,000 Number of periods (n) 10 Interest rate (i) 6%

PV of MLP (pv) = $485,000.00PV of MLP (pv) = $485,000.00PV of MLP (pv) = $485,000.00PV of MLP (pv) = $485,000.00

15-60

Bargain Purchase Option

Effective Interest AmortizationEffective Interest Amortization

Period MLPInterest

ExpenseObligation Reduction

Obligation Balance

Present Value of MLP $485,0001 60,377$ -$ 60,377$ 424,6232 60,377 25,477 34,900 389,7233 60,377 23,383 36,994 352,7304 60,377 21,164 39,213 313,5175 60,377 18,811 41,566 271,9516 60,377 16,317 44,060 227,8917 60,377 13,673 46,704 181,1878 60,377 10,871 49,506 131,6819 60,377 7,901 52,476 79,205

10 60,377 4,752 55,625 23,5801,420 (1,420) 25,000

15-61

Inception of the Lease

LesseeLesseeLessorLessor

15-62

Second Lease Payment


15-63

Year-End Accrual


15-64

End of the Lease Term

At the end of the lease term, Matrix exercises At the end of the lease term, Matrix exercises the BPO and pays Apex $25,000.the BPO and pays Apex $25,000.

At the end of the lease term, Matrix exercises At the end of the lease term, Matrix exercises the BPO and pays Apex $25,000.the BPO and pays Apex $25,000.

15-65

Learning Objectives

Explain the impact on lease accounting of executory costs, the discount rate, initial direct

costs, and contingent rentals.

15-66

Executory Costs

Executory costs include costs of ownership like Executory costs include costs 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.

15-67

Discount Rate









15-68

Initial Direct Costs

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

agreement.agreement. Operating LeasesOperating Leases −− Capitalize and amortize over Capitalize and amortize over

the lease term by the lessor.the lease term by the lessor. Direct Financing LeasesDirect Financing Leases −− Include as part of Include as part of

investment balance.investment balance.

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

agreement.agreement. Operating LeasesOperating Leases −− Capitalize and amortize over Capitalize and amortize over

the lease term by the lessor.the lease term by the lessor. Direct Financing LeasesDirect Financing Leases −− Include as part of Include as part of

investment balance.investment balance.

15-69

Contingent Rentals

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

term, depending on whether some specified event term, depending on whether some specified event occurs.occurs.

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

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

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

term, depending on whether some specified event term, depending on whether some specified event occurs.occurs.

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

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

15-70

Lessee Disclosures

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

capital leases.capital leases.

Future MLP in the aggregate and for Future MLP in the aggregate and for each of the five succeeding years.each of the five succeeding years.

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

Total contingent rentals.Total contingent rentals.

15-71

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 Future minimum rental payments required in the aggregate and for each of the five the aggregate and for each of the five succeeding fiscal years.succeeding fiscal years.

Total of minimum rentals to be received in the Total of minimum rentals to be received in the future under noncancelable subleases.future under noncancelable subleases.

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

15-72

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 The existence and terms of renewal or purchase options and escalation clauses.purchase options and escalation clauses.

Restrictions imposed by lease agreements, Restrictions imposed by lease agreements, such as those concerning dividends, such as those concerning dividends, additional debt, and further leasing.additional debt, and further leasing.

15-73

Lessor Disclosures

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

Components of the net investment in sales-Components of the net investment in sales-type and direct financing leasestype and direct financing leasesFuture MLP to be received.Future MLP to be received.

Unguaranteed residual values.Unguaranteed residual values.

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.

15-74

Lessor Disclosures

For operating leases, discloseFor operating leases, discloseCost and carrying amount of property on lease Cost and carrying amount of property on lease

or held for leasing. or held for leasing. Minimum future rentals on noncancelable Minimum future rentals on noncancelable

leases in the aggregate and for each of the leases in the aggregate and for each of the five succeeding years.five succeeding years.

Total contingent rentals included in income.Total contingent rentals included in income. Provide a general description of the lessor’s Provide a general description of the lessor’s

leasing arrangements.leasing arrangements.

15-75

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 greater statement and balance sheet. The greater 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 greater statement and balance sheet. The greater impact is on the balance sheet.impact is on the balance sheet.

15-76

Statement of Cash Flows

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

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

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

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

15-77

Statement of Cash Flows

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

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

15-78

Learning Objectives

Explain sale-leaseback agreements and other special leasing arrangements and their

accounting treatment.

15-79

Special Leasing Arrangements

Sale-Leaseback Arrangements

The owner of an asset sells it and immediately leases it back from the new owner. The reasons for this include:

1. The seller-lessee receives cash from the sale of the asset.

2. The seller-lessee pays periodic rent payments to the buyer-lessor to retain the use of the asset.

15-80

Special Leasing Arrangements

Sale-Leaseback Arrangements

The two most common reasons for this type of transaction are:

1. If the asset had been financed originally with debt, and interest rates have fallen, the sale-leaseback transaction can be used to effectively refinance at a lower rate.

2. The most likely motivation for this transaction is to increase general cash for the seller-lessee

15-81

Treatment of Gains and Losses

In a sales-leaseback, any gain on the sale of the asset is deferred and amortized. A real loss on the sale of the

property is recognized immediately.

15-82

Real Estate Leases

There are special accounting procedures that There are special accounting procedures that must be followed for:must be followed for:

1.1. Leases of land only.Leases of land only.

2.2. Leases of land and building.Leases of land and building.

3.3. Leases of only part of a building.Leases of only part of a building.

There are special accounting procedures that There are special accounting procedures that must be followed for:must be followed for:

1.1. Leases of land only.Leases of land only.

2.2. Leases of land and building.Leases of land and building.

3.3. Leases of only part of a building.Leases of only part of a building.

15-83

End of Chapter 15

Documents

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Leases 15