CHAPTER 15

Leases |||||||||||||||||||||||||||||||||||||||||

 

 /// PREFACE  

    The  FASB  and  the  IASB  are  collaborating  on  several  major  new  standards designed  in  part  to move U.S. GAAP  and  IFRS  closer  together  (convergence).  This reading is based on their joint Exposure Draft of the new leases standard.   

 

    This  is  a  draft  of  only  a  portion  of  the  Leases  chapter  as  it  would  appear assuming  the Exposure Draft  is adopted  intact, which  is not at all a certainty.  This  incomplete draft does not  include many of  the  features  and  assignment materials  that  the new chapter will contain.    It  is  intended only  to give you a basis  for  lease  coverage while we  await  the outcome of  the  standard‐setting process. 

  

 /// OVERVIEW  

   In the previous chapter, we saw how companies account for their long‐term debt. The focus of that discussion was bonds and notes. In this chapter we continue our discussion  of  debt,  but  we  now  turn  our  attention  to  liabilities  arising  in connection with  leases.  Leases produce  liabilities  for  the  lessees’ obligations  to pay  for  the  right  of use  for  the  assets being  leased.   On  the other  side of  the transaction,  lessors  assume  a  performance  obligation  to  allow  the  asset  to  be used,  unless  all  significant  risks  and  benefits  are  transferred  in  which  case derecognition of the asset is appropriate. 

 

 

LEARNING OBJECTIVES  After studying this chapter, you should be able to: 

● LO1  Describe and demonstrate the lessee’s right‐of‐use approach to accounting for a lease. (p. xxx) 

● LO2  Describe and demonstrate how the lessor accounts for a lease by the performance obligation approach and when that approach is appropriate. (p. xxx)  

● LO3  Describe and demonstrate how the lessor accounts for a lease using the derecognition approach and when that approach is appropriate. (p. xxx) 

● LO4  Explain  the circumstance  that  indicates  that  the  lessor should  record a  residual asset and how  the asset should be measured. (p. xxx) 

● LO5  Explain the impact on lease accounting of initial direct costs. (p. xxx) 

● LO6  Describe  and  demonstrate  the  short‐cut method  for  accounting  for  leases  and  explain when  its  use  is appropriate. (p. xxx)  

● LO7  Explain how to determine the lease term when the agreement contains renewal or termination options. (p. xxx) 

● LO8  Describe and demonstrate the expected outcome technique when dealing with uncertain lease payments. (p. xxx) 

● LO9  Explain the impact on lease accounting of a guaranteed residual value. (p. xxx) 

● LO10 Describe the ways leases are reported in financial statements and lease disclosure requirements. (p. xxx) 

● LO11 Explain sale‐leaseback agreements and their accounting treatment. (p. xxx)  

 FINANCIAL REPORTING CASE  It’s a Hit! “Don’t  get  too  comfortable  with  those  big  numbers,”  said  Aaron  Sanchez,  controller  for  your  new 

employer. “It’s likely our revenues will take a hit over the next couple of years as more of our customers lease our machines rather than buy them.” You’ve just finished your first look at Higher Graphics’ third quarter 

earnings  report.  Like most  companies  in your  industry, HG  leases  its labeling machines to some customers and sells them to others. Eager to understand the implications of your new supervisor’s concerns, you search the Internet for guidance. 

By the time you finish this chapter, you should be able to respond appropriately to the questions posed in this case. Compare your response to the solution provided at the end of the chapter. 

QUESTIONS ///How would HG’s revenues “take a hit” as a result of more customers leasing rather than buying labeling machines? (page xxx) Under what lease accounting approach would the “hit” not occur?  (page xxx) 

CHAPTER 15  Leases                  3 

  LEASE FUNDAMENTALS  If  you  ever  have  leased  an  apartment,  you  know  that  a  lease  is  a  contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset  for  a  specified period of  time.  In  return  for  this  right,  the  lessee  agrees  to make stipulated, periodic cash payments during the term of the  lease. Businesses, too,  lease assets under similar arrangements. The right to use the  leased property can be a significant asset.  Likewise, the obligation to make the lease payments can be  a  significant  liability.    Appropriately,  the  lessee  reports  both  the  right‐of‐use asset and the liability in the balance sheet.   

On  the  other  side  of  the  transaction,  the  lessor  reports  a  receivable  for  the lease payments it will receive and, depending on whether it retains or transfers the risks  and  benefits  associated with  the  leased  asset,  either  (a)  a  liability  for  the obligation to allow the lessee to use the asset or (b) sales revenue.  If sales revenue is  recorded,  the  lessor  also  removes  from  its  records  (derecognizes)  the  asset transferred, with an accompanying debit  to  cost of  sales.   Before we  look at  the possibilities in more detail, Graphic 15–1 provides a quick overview.   

Lessee Lessor Right-of-use approach Performance obligation approach

Derecognition approach

Short-cut method Short-cut method

 

We see an expanded overview in Graphic 15–2 indicating when it’s appropriate to  use  each  approach, what  to  record when  the  approach  is  used,  and  how  to measure the amounts recorded.   

Part A      An apartment lease is a common leasing arrangement. 

GRAPHIC 15–1 Basic Lease Accounting Methods 

4  SECTION 3  Financial Instruments and Liabilities    When to Use  What to Record  How to Measure Lessee:       Right of Use Approach 

All leases, unless short‐cut method is allowed. 

Record: • Right‐of‐ use asset representing the right to use the asset  

• Lease liability for obligation to pay for the asset’s use 

• Asset: Recent value of expected payments plus initial direct costs if any 

• Liability: Present value of expected payments  

Short‐Cut Method 

Maximum lease term is 12 Months or less 

 Same as above 

Option to: • Measure asset and liability at total of payments rather than their present value  

Lessor:       Performance Obligation Approach

Lessor retains exposure to significant risks or benefits associated with the asset during or after the lease term. 

Record: • Receivable representing the right to receive payments   

• Performance obligation to permit lessee to use the asset 

 • Asset: Present value of expected payments plus initial direct costs if any 

• Liability: Present value of expected payments

Derecognition Approach

Lessor does not retain exposure to significant risks or benefits associated with the asset. 

• A receivable and sales revenue  

• Derecognize asset and record cost of goods sold. 

• Asset: Present value of expected payments

• COGS: Carrying value of the asset (or portion transferred)

Short‐Cut Method 

Maximum lease term is 12 Months or less 

Option to: Record no entry at commencement of lease 

If option is elected: • Record no receivable or performance obligation 

• Recognize lease payments as income 

 

Note: If the contract transfers: (a) control of the underlying asset and (b) all but a trivial amount of the risks and benefits associated with the asset, the transaction is not a lease and is recorded as a purchase/sale by both parties to the transaction.  

After  looking  at  some  of  the  possible  advantages  of  companies  leasing  assets 

rather  than  buying  them  in  certain  circumstances, we will  explore  differences  in leases further.  

DECISION MAKERS’ PERSPECTIVE—ADVANTAGES OF LEASING  When a young entrepreneur  started a computer  training center a  few years ago, she  had  no  idea  how  fast  her  business  would  grow.  She  knew  she  needed computers, but she didn’t know how many. Just starting out, she also had little cash with which to buy them. The  mutual  funds  department  of  a  large  investment  firm  often  needs  new 

computers and peripherals—fast. The department manager knows he can’t afford to wait up to a year, which  is the time  it sometimes takes to go through company channels to obtain purchase approval. 

GRAPHIC 15–2 Lease Accounting Overview 

• LO1 

CHAPTER 15  Leases                  5  An  established  computer  software  publisher  recently  began  developing  a  new 

line of business software. The senior programmer has to be  certain he’s  testing  the  company’s products on the  latest versions of computer hardware. And yet he views  large  expenditures  on  equipment  subject  to rapid  technological  change  and  obsolescence  as  risky business. Each of these individuals is faced with different predicaments and concerns. The 

entrepreneur  is  faced with  uncertainty  and  cash  flow  problems,  the  department manager with time constraints and bureaucratic control systems, the programmer with  fear of obsolescence. Though  their specific concerns differ,  these  individuals have all met their firms’ information technology needs with the same solution: each has decided to lease the computers rather than buy them. Computers  are  by  no  means  the  only  assets  obtained  through  leasing 

arrangements. To the contrary,  leasing has grown to be the most popular method of external financing of corporate assets in America. The airplane in which you last flew probably was  leased, as was  the gate  from which  it departed. Your  favorite retail  outlet  at  the  local  shopping mall  likely  leases  the  space  it  operates. Many companies actually exist for the sole purpose of acquiring assets and  leasing them to others. And, leasing often is a primary method of “selling” a firm’s products. IBM and Boeing are familiar examples. In  light  of  its  popularity,  you  may  be  surprised  that  leasing  usually  is  more 

expensive than buying. Of course, the higher apparent cost of leasing is because the lessor  usually  shoulders  at  least  some  of  the  financial  and  risk  burdens  that  a purchaser normally would assume. So, why the popularity? The  lease  decisions  described  above  are motivated  by  operational  incentives. 

Lessees are willing  to pay extra  to shift some  financial and risk burden  to  lessors.  But tax and market considerations also motivate firms to lease. Sometimes leasing offers tax saving advantages over outright purchases. For instance, a company with little  or  no  taxable  income—maybe  a  business  just  getting  started,  or  one experiencing  an  economic  downturn—will  get  little  benefit  from  depreciation deductions. But  the  company  can benefit  indirectly by  leasing  assets  rather  than buying.  By  allowing  the  lessor  to  retain  ownership  and  thus  benefit  from depreciation  deductions,  the  lessee  often  can  negotiate  lower  lease  payments. Lessees  with  sufficient  taxable  income  to  take  advantage  of  the  depreciation deductions,  but  still  in  lower  tax  brackets  than  lessors,  also  can  achieve  similar indirect tax benefits. 

 

The U.S. Navy once leased a fleet of tankers to avoid asking Congress for appropriations. 

Leasing can facilitate asset acquisition. 

The number one method of external financing by U.S. businesses is leasing. 

Tax incentives often motivate leasing. 

Operational, tax, and financial market incentives often make leasing an attractive alternative to purchasing. 

6  SECTION 3  Financial Instruments and Liabilities  Leases and Installment Notes Compared  

You  learned  in the previous chapter how to account  for an  installment note. To a great  extent,  then,  you  already  have  learned  how  to  account  for  a  lease.  To illustrate,  let’s recall the situation described  in the previous chapter. We assumed that  Skill  Graphics  purchased  a  package‐labeling  machine  from  Hughes–Barker Corporation by  issuing a  three‐year  installment note  that  required six semiannual installment  payments  of  $139,857  each.  That  arrangement  provided  for  the purchase of the $666,633 machine as well as interest at an annual rate of 14% (7% twice each year). Remember, too, that each installment payment consisted of part interest (7% times the outstanding balance) and part payment for the machine (the remainder of each payment). Now  let’s  suppose  that  Skill  Graphics  instead  acquired  use  of  the  package‐

labeling machine  from Hughes–Barker Corporation under  a  three‐year  lease  that required  six  semiannual  lease  payments  of  $139,857  each.  Obviously,  the fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. So, it would be inconsistent to account  for  this  lease  in  a  fundamentally  different way  than  for  an  installment purchase:   

At Commencement (January 1) Installment Note Machinery  ...................................................................  666,633     Note payable  ...........................................................    666,633  

Lease Right‐of‐use asset  .......................................................  666,633     Lease liability  ...........................................................    666,633 

 Skill Graphics did not acquire ownership of the asset in this lease but did acquire 

the right to use the asset for the duration of the lease, which in this case also is the useful  life of the asset.   The fact that the  lease term  is the same as the useful  life does  not  affect  the  way  we  account  for  the  lease.    By  entering  this  lease arrangement Skill Graphics has acquired something of value, an asset, which is the right  to use  the  asset.   We  call  this  a Right‐of‐use  asset.   At  the  same  time,  the company  has  assumed  an  obligation  to  pay  for  the  asset’s  use  and  accordingly records a liability for the present value of the payments it’s obligated to make. 

Comparison of a Note and Lease  As in an installment purchase, the right to use an asset is acquired in exchange for the obligation to pay for that right. 

CHAPTER 15  Leases                  7  Consistent with  the  nature  of  the  transaction,  interest  expense  accrues  each 

period at the effective rate times the outstanding balance:  

At the First Semiannual Payment Date (June 30) Installment Note Interest expense (7% × $666,633) .................................  46,664 Note payable (difference) .............................................  93,193     Cash (installment payment) ........................................    139,857  Lease Interest expense (7% × $666,633) .................................  46,664 Lease liability (difference) .............................................  93,193     Cash (lease payment) .................................................    139,857 

 Because  the  lease  liability balance declines with each payment,  the amount of 

interest declines each period. An amortization schedule provides a convenient way to track the changing amounts as shown in Graphic 15–3.  

    Decrease  OutstandingDate  Payments Effective Interest in Balance  Balance

    (7% × Outstanding balance) 

   

    666,6331  139,857 .07(666,633) = 46,664 93,193  573,4402  139,857 .07(573,440) = 40,141 99,716  473,7243  139,857 .07(473,724) = 33,161 106,696  367,0284  139,857 .07(367,028) = 25,692 114,165  252,8635  139,857 .07(252,863) = 17,700 122,157  130,7066  139,857 .07(130,706) =    9,151* 130,706  0  839,142 172,509 666,633 

 *Adjusted for rounding of other numbers in schedule 

You should recognize this as essentially the same amortization schedule we used

in the previous chapter in connection with our installment note example. The reason for the similarity is that we view a lease as being, in substance, equivalent to an installment purchase of the right to use an asset for a specified period of time. In this illustration the lease covers the entire life of the asset, so it is purchasing the right to use the asset for its whole life. So naturally the accounting treatment of the two essentially identical transactions should be consistent.

Interest Compared for a Note and Lease  Each payment includes both an amount that represents interest and an amount that represents a reduction of principal. 

GRAPHIC 15–3 Lease Amortization Schedule  Each lease payment includes interest on the outstanding balance at the effective rate. The remainder of each payment reduces the outstanding balance. 

8  SECTION 3  Financial Instruments and Liabilities 

Lessee’s Right‐of‐Use Approach and  Lessor’s Performance Obligation Approach 

Let’s look at an example that illustrates and compares the accounting for leases by both the lessee and lessor. The lessee uses the same right‐of‐use approach we saw in  the  previous  section.    For  the  lessor,  the  method  we  used  is  called  the performance  obligation  approach.    The  name  refers  to  the  lessor  recording  a liability we’ll call a “performance obligation” for  its obligation to permit the  lessee to use  the asset during  the  lease  term.   This  is  the most  commonly used of  two approaches available to the lessor.  It is used when the lessor “retains exposure to risks or benefits” associated with the  leased asset.   For  instance, the  lessor would be exposed to risks or benefits during the lease term if the agreement includes (a) additional  payments  based  on  a  percentage  of,  say,  net  sales,  (b)  payments contingent on meeting a specified performance target, or (c) options to extend or terminate the lease.    Even more likely, if the asset will be returned to the lessor at the end of the lease term but before the end of the asset’s useful life, the lessor has the benefit of possibly re‐leasing, using, or selling the asset.1 

Later,  we’ll  discuss  a  second  method  of  lessor  accounting  called  the derecognition approach that’s used when the lessor does not retain such exposure.  The lessee’s accounting is the same regardless of which approach the lessor uses. 

The  earlier  example  comparing  a  lease  to  an  installment  purchase  assumed lease  payments  at  the  end  of  each  period.  A more  typical  leasing  arrangement requires  lease  payments  at  the  beginning  of  each  period.  This  more  realistic payment schedule is assumed in Illustration 15–1. 

1 Leases (Exposure Draft)–Lessor–Recognition, para. 28-29

  Based on whether it retains significant risks or benefits, the lessor uses either a performance obligation approach or a derecognition approach to accounting for a lease. 

The lessee’s accounting is the same regardless of which approach the lessor uses. 

• LO2   

CHAPTER 15  Leases                  9  On January 1, 2011, Sans Serif Publishers, a computer services and printing firm, leased printing equipment from First LeaseCorp. The previous week, First LeaseCorp purchased the equipment from CompuDec Corporation at its fair value of $479,079.

The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2013. The useful life of the equipment is estimated to be six years.

First LeaseCorp calculated the lease payments at an amount that would provide a 10% rate of return for financing the asset for the lessee.2

$100,000 × 3.48685* = $348,685 Lease Present payments value

* Present value of an annuity due of $1: n = 4, i = 10%. Recall from Chapter 6 that we refer to periodic payments at the beginning of each period as an annuity due.

Commencement of the Lease (January 1, 2011)*

Sans Serif Publishers, Inc. (Lessee) Right-of-use asset ........................................................ 348,685 Lease liability (present value of lease payments) ......... 348,685

First LeaseCorp (Lessor) Lease receivable (present value of lease payments) ......... 348,685 Performance obligation ............................................ 348,685

First Lease Payment (January 1, 2011)*

Sans Serif Publishers, Inc. (Lessee) Lease liability ............................................................... 100,000 Cash.......................................................................... 100,000

First LeaseCorp (Lessor) Cash.............................................................................. 100,000 Lease receivable ....................................................... 100,000 * Of course, the entries to record the lease and the first payment could be combined into a

single entry since they occur at the same time. Notice that as the  lessee acquires the right to use the asset (right‐of‐use asset), 

the  lessor  assumes  the  obligation  to  allow  that  use  (lessor’s  performance obligation).     Similarly, as the  lessee assumes the obligation to pay  for the asset’s 

2 Wanting to recoup $348,685 from the lessee in four payments while earning a rate of return of 10%, First LeaseCorp calculated the lease payments as follows:

$348,685 ÷ 3.48685* = $100,000 Present Lease value payments

* Present value of an annuity due of $1: n = 4, i = 10%.

Illustration 15–1 Lessee and Lessor (Performance Obligation Approach by the Lessor)  

 Using Excel, enter: =PV (.10,4,100000, 1) Output: 348685.2  

 Using a calculator: enter: BEG mode N 4 I 10 PMT −100000 FV Output: PV 348685

The lessee acquires an asset – the right to use the equipment.  The lessor has a liability – the obligation to allow the equipment to be used. 

10  SECTION 3  Financial Instruments and Liabilities  use (lessee’s lease liability), the lessor acquires the right to receive those payments (lease receivable).  Recording the first payment above emphasizes that relationship; the  $100,000  reduces  both  the  lessee’s  lease  liability  and  the  lessor’s  lease receivable. The  amount  recorded by  the  lessee  at  the  commencement of  the  lease  is  the 

present value of the lease payments. However, if the fair value of the asset is lower than this amount, the recorded amount of the asset should be limited to fair value. Unless  the  lessor  is  a manufacturer or dealer,  the  fair  value  typically will be  the lessor’s  cost  ($479,079  in  this  case).  However,  if  considerable  time  has  elapsed between the purchase of the property by the lessor and the commencement of the lease,  the  fair  value might  be  different. When  the  lessor  is  a manufacturer  or dealer, the fair value of the property at the commencement of the lease ordinarily will be its normal selling price (reduced by any volume or trade discounts). Be  sure  to  note  that  the  entire  $100,000  first  lease  payment  is  applied  to 

principal  (lease  payable  /  lease  receivable)  reduction.3    Because  the  payment occurred  at  the  commencement  of  the  lease,  no  interest  had  yet  accrued. Subsequent lease payments, though, include interest on the outstanding balance as well as a portion  that  reduces  that outstanding balance.   As of  the  second  lease payment  date,  one  year’s  interest  has  accrued  on  the  $248,685  ($348,685  – 100,000) balance outstanding during 2012, and is recorded as in Illustration 15–1A. Notice  that  the  outstanding  balance  is  reduced  by  $75,131—the  portion  of  the $100,000 payment remaining after interest is covered. 

Second Lease Payment (December 31, 2011) Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] .............. 24,869 Lease liability (difference) ........................................... 75,131 Cash (lease payment) ................................................. 100,000

First LeaseCorp (Lessor) Cash (lease payment) ................................................... 100,000 Lease receivable ....................................................... 75,131 Interest revenue [10% × ($348,685 – 100,000)] .......... 24,869

3 Another way to view this is to think of the first $100,000 as a down payment with the remaining $249,685 financed by 3 (i.e., 4 – 1) year-end lease payments.

  A right‐of‐use asset is recorded by the lessee at the present value of the lease payments or the asset’s fair value, whichever is lower. 

Interest is a function of time. It accrues at the effective rate on the balance outstanding during the period. 

ILLUSTRATION 15–1A Journal Entries for the Second Lease Payment    LESSEE   Lease liability   $348,685    (100,000)   $248,685      (75,131)   $173,554      LESSOR  Lease Receivable   $348,685    (100,000)   $248,685      (75,131)   $173,554 

CHAPTER 15  Leases                  11 

 The amortization schedule in Graphic 15–4 shows how the lease balance and the 

effective  interest change over  the  four‐year  lease  term. Each  lease payment after the  first  includes  both  an  amount  that  represents  interest  and  an  amount  that represents  a  reduction  of  the  outstanding  balance.  The  periodic  reduction  is sufficient that, at the end of the lease term, the outstanding balance is zero.  

  Payments  Effective Interest Decrease in Balance 

Outstanding Balance 

  (10% × Outstanding balance)   1/1/11        348,685 1/1/11  100,000    100,000  248,685 

12/31/11  100,000  .10 (248,685) =   24,869 75,131  173,554 12/31/12  100,000  .10 (173,554) =   17,355 82,645  90,909 12/31/13  100,000  .10 (  90,909) =     9,091   90,909  0 

  400,000    51,315 348,685             

 

 Amortization  The lessee amortizes its right‐of‐use asset over lease term (or the useful life of the asset if it’s shorter).  Similarly, the lessor amortizes its performance obligation in a systematic way  that measures  the  remaining obligation  to provide  the use of  the asset to the lessee.  This usually is on a straight‐line basis unless the lessee’s pattern of using the asset is different.4  Using the asset results in an expense for the lessee.  Providing the use of the asset represents lease income for the lessor.  

4 Output measures such as units produced or input measures such as hours used might provide a better indication of the reduction in the remaining liability.

GRAPHIC 15–4 Lease Amortization Schedule  

The first lease payment includes no interest.  

The total of the cash payments ($400,000) provides for: 1. Payment for the equipment’s use ($348,685). 

2. Interest ($51,315) at an effective rate of 10%. 

FINANCIAL Reporting Case 

Q1, p. xxx 

12  SECTION 3  Financial Instruments and Liabilities 

December 31, 2011 and End of Next Three Years  

Sans Serif Publishers, Inc. (Lessee) Amortization expense ($348,685 ÷ 4 years) ...................  87,171      Right‐of‐use asset ....................................................    87,171  

First LeaseCorp (Lessor)5 Performance obligation ...............................................  87,171      Lease income ($348,685 ÷ 4 years) ............................    87,171  

 In the  journal entries above and throughout the chapter, we  look at the entries 

of  the  lessee  and  the  lessor  together.  This  way,  we  can  be  reminded  that  the entries  for  the  lessor  usually  are  essentially  the mirror  image  of  those  for  the lessee, the other side of the same coin. Notice that the lessor has two assets now.  It has lease receivable recorded at the 

commencement of  the  lease, and  it  still has  the equipment underlying  the  lease.  Separate from the  lease, at the end of each of the four years of the  lease term as well  as  the  two  additional  years  of  the  six‐year  estimated  life  of  the  equipment being  leased  to  Sans  Serif,  First  LeaseCorp  will  record  depreciation  on  the equipment:  

First LeaseCorp (Lessor  

Depreciation expense–equip. for lease ($479,079 ÷ 6 years)   79,847          Accumulated depreciation  ..................................                             79,847   Discount Rate  An important factor in the overall lease equation that we’ve glossed over until now is  the  discount  rate  used  in  present  value  calculations.  Because  lease  payments occur in future periods, we must consider the time value of money when evaluating their  present  value.  The  rate  is  important  because  it  influences  virtually  every amount reported by both the lessor and the lessee in connection with the lease. 

One rate is implicit in the lease agreement. This is the desired rate of return the lessor has in mind when deciding the size of the lease payments.  In other words, it is the rate the lessor charges the lessee, because it is the rate that causes the sum of (a) the present value of lease payments and (b) the present value of any residual 

5 Even when the two sides are not mirror images there are many similarities, so the comparison still is helpful.

   The lessee incurs an expense as it uses the asset; the lessor earns income as it satisfies its obligation to provide the asset’s use. 

  The lessor uses the rate it charges the lessee. 

LO4  

CHAPTER 15  Leases                  13  value of the leased asset at the end of the lease to equal the fair value of the asset at the commencement of the lease.  For instance, we said the fair value of the printing equipment in our illustration is $479,079.  But, First LeaseCorp decided that at the end of the four‐year lease term the asset would have a residual value of $190,911.  How much must the lessor recover from the lessee just through the four lease payments?   The $479,079 is the fair value now, so to determine the amount that needs to be recovered from the four lease payments, we need to subtract from fair value the present value of the four‐years‐away residual value: 

  

  Amount to be recovered (fair value)     $479,079   Less: Present value of the residual value ($190,911 x .68301*)    (130,394)   To be recovered through periodic lease payments (present value)  $348,685 

        ÷ 3.48685**   Lease payments at the beginning of each of the next 4 years  $100,000   *   present value of $1: n=4, i=10%   ** present value of an annuity due of $1: n=4, i=10% 

 In its calculations, the lessee can use this same rate charged by the lessor if it is 

known.  Or, the lessee can use its own incremental borrowing rate.  This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.6  

In practice the lessor’s implicit rate usually is known. Even if the lessor chooses not  to  explicitly  disclose  the  rate,  the  lessee  usually  can  deduce  the  rate  using information  known  about  the  value of  the  leased  asset  and  the  lease payments. After  all,  in  making  the  decision  to  lease  rather  than  buy,  the  lessee  typically becomes quite knowledgeable about the asset. 7 

 Accrued Interest  If  a  company’s  reporting  period  ends  at  any  time  between  payment  dates,  it’s necessary  to  record  (as  an  adjusting  entry)  any  interest  that  has  accrued  since interest  was  last  recorded.  We  purposely  avoided  this  step  in  the  previous illustration  by  assuming  that  the  lease  agreement  specified  lease  payments  on December 31—the end of each  reporting period. But  if payments were made on another date, or if the company’s fiscal year ended on a date other than December 31, accrued interest would be recorded prior to preparing financial statements.  For example, if lease payments in Illustration 15‐1A on page 8 were made on January 1  6 Incremental borrowing rate refers to the fact that lending institutions tend to view debt as being

increasingly risky as the level of debt increases. Thus, additional (i.e., incremental) debt is likely to be loaned at a higher interest rate than existing debt, other things being equal.

7 The corporation laws of some states, Florida for instance, actually require the interest rate to be expressly stated in the lease agreement.

 The lessee uses the rate charged by the lessor if known or, alternatively, its own incremental borrowing rate. 

  At each financial statement date, any interest that has accrued since interest was last recorded must be accrued for all liabilities and receivables, including those relating to leases. 

14  SECTION 3  Financial Instruments and Liabilities  of  each  year,  the  effective  interest  amounts  shown  in  the  lease  amortization schedule  still would be  appropriate but would be  recorded one day prior  to  the actual  lease payment. For  instance,  the  second cash payment of $100,000 would occur on  January 1, 2012, but  the  interest component of  that payment  ($37,908) would be accrued a day earlier as shown in Illustration 15–2.  

December 31, 2011 (to accrue interest) 

 Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] ..............  24,869  Interest payable .......................................................    24,869 

First LeaseCorp (Lessor) Interest receivable .......................................................  24,869  Interest revenue [10% × ($348,685 – 100,000)] ..........    24,869 

Second Lease Payment (January 1, 2012) 

 Sans Serif Publishers, Inc. (Lessee) Interest payable (from adjusting entry above) ...............  24,869 Lease liability (difference) .............................................  75,131  Cash (lease payment) .................................................    100,000 

First LeaseCorp (Lessor) Cash (lease payment) .....................................................  100,000  Lease receivable .......................................................    75,131  Interest receivable (from adjusting entry above) ........    24,869 

Notice that this is consistent with recording accrued interest on any debt, whether

in the form of a note, a bond, or a lease.  

ILLUSTRATION 15–2 Journal Entries When Interest Is Accrued Prior to the Lease Payment 

  We accrue interest at the financial statement date.          The interest is paid early the next year. 

CHAPTER 15  Leases                  15 

 CONCEPT REVIEW EXERCISE 

 United Cellular Systems leased a satellite transmission device from Pinnacle Leasing Services on January 1, 2012. Its fair value is $2 million.  

Terms of the Lease Agreement and Related Information: 

Lease term  3 years (6 semiannual periods) Semiannual rental payments  $120,000 at the beginning of each period Economic life of asset  10 years Interest rate  12% 

 Required: 

1.  Prepare the appropriate entries  for both United Cellular Systems and Pinnacle Leasing Services on January 1, the commencement of the lease. 

2.  Prepare an amortization  schedule  that  shows  the pattern of  interest expense for United Cellular Systems and  interest revenue  for Pinnacle Leasing Services over the lease term. 

3.  Prepare  the  appropriate  entries  to  record  the  second  lease  payment  and amortization on July 1, 2012, and adjusting entries on December 31, 2012 (the end of both companies’ fiscal years). 

 

1. Prepare the appropriate entries for both United Cellular Systems and Pinnacle Leasing Services on January 1, the inception of the lease.

  

Present value of periodic lease payments: ($120,000 × 5.21236*) = $625,483 

*Present value of an annuity due of $1: n = 6, i = 6%.  

January 1, 2012 

United Cellular Systems (Lessee) Right‐of‐use asset  ................................................................ 625,483  Lease payable (calculated above)  ....................................   625,483  Lease payable  .......................................................................

 120,000 

 

Cash (lease payment)  .......................................................   120,000    

Pinnacle Leasing Services (Lessor) Lease receivable (calculated above)  .................................... 625,483    Performance obligation ....................................................   625,483  

Cash (lease payment)  ..........................................................   120,000    Lease receivable    120,000   

Right‐of‐Use and Performance Obligation Approaches 

SOLUTION  

Calculation of the present value of minimum lease payments.  

16  SECTION 3  Financial Instruments and Liabilities   2.  Prepare an amortization  schedule  that  shows  the pattern of  interest expense 

for United Cellular Systems and  interest revenue  for Pinnacle Leasing Services over the lease term. 

 

Date  Payments  Effective Interest Decrease in Balance 

Outstanding Balance 

(6% × Outstanding balance) 1/1/12        625,483 1/1/12  120,000    120,000  505,483 7/1/12  120,000  .06 (505,483) = 30,329  89,671  415,812 1/1/13  120,000  .06 (415,812) = 24,949  95,051  320,761 7/1/13  120,000  .06 (320,761) = 19,246  100,754  220,007 1/1/14  120,000  .06 (220,007) = 13,200  106,800  113,207 7/1/14  120,000   .06 (113,207) =  6,793* 113,207  0 

  720,000  94,517 625,483  *Adjusted for rounding of other numbers in the schedule  3.  Prepare  the  appropriate  entries  to  record  the  second  lease  payment  and 

amortization on July 1, 2012, and adjusting entries on December 31, 2012 (the end of both companies’ fiscal years).  

 July 1, 2012 

 United Cellular Systems (Lessee) Interest expense [6% × ($625,483 − 120,000)]  .........................   30,329   Lease payable (difference)  ........................................................   89,671       Cash (lease payment)  ............................................................     120,000  Amortization expense ($625,483 ÷ 3 years)  .............................   208,494       Right‐of‐use asset  ..................................................................     208,494  Pinnacle Leasing Services (Lessor) Cash (lease payment)  ................................................................   120,000       Lease receivable (difference)  ................................................     89,671     Interest revenue [6% × ($625,483 − 120,000)]  .....................     30,329  Performance obligation .............................................................   208,494       Lease income ($625,483 ÷ 3 years) ...........................................     208,494  

December 31, 2012  United Cellular Systems (Lessee) Interest expense (6% × $415,812: from schedule)  ........................   24,949       Interest payable  .....................................................................     24,949  Amortization expense ($625,483 ÷ 3 years)  ................................   208,494       Right‐of‐use asset  ..................................................................     208,494 

CHAPTER 15  Leases                  17   Pinnacle Leasing Services (Lessor) Interest receivable  ....................................................................   24,949       Interest revenue (6% × $415,812: from schedule)  ....................     24,949  Performance obligation .............................................................   208,494       Lease income ($625,483 ÷ 3 years) ...........................................     208,494  Depreciation expense ($2,000,000 ÷ 10 years)  ............................   200,000       Accumulated depreciation  ....................................................     200,000  

Derecognition Approach 

 Returning  to  our  illustration  if  First  LeaseCorp  and  Sans  Serif  Publishers,  we assumed  in  the  illustration  so  far  that  First  LeaseCorp  bought  the  printing equipment  from  its manufacturer and  then  leased  it  for  four years of  its  six‐year life. Upon getting the asset back at the end of the lease term, First LeaseCorp would have the opportunity to  lease  it again, sell  it, use  it, or otherwise receive benefits during  its remaining  life.   Therefore, we were  looking at a  lease situation  in which First LeaseCorp retained “exposure to significant risks or benefits” associated with the  equipment,  which  required  that  the  lessor  account  for  the  lease  using  the performance obligation approach.   The name comes  from  the  fact  that  the  lease liability the  lessor records  is a “performance obligation” to allow the  lessee to use the asset during the lease term.   

When  assessing  exposure  to  risks  or  benefits,  the  lessor  looks  at  relevant indicators like contingent rentals, options to extend or renew, and the amount and uncertainty of  residual  value.   The  credit worthiness of  the  lessee  should not be considered.    What  constitutes  “significant”  risks  or  benefits  is  a  matter  of professional judgment.   If  the  lessor does not  retain exposure  to significant  risks or benefits associated 

with the leased asset, but instead transfers those risks and benefits of ownership to the lessee, the lessor uses a different approach called the derecognition approach.  The name comes  from the  fact that the  lessor “derecognizes” the asset such that the asset no longer appears on the lessor’s balance sheet.8  One way to view this is to think of it as something very much like a sale of an asset, at which time the lease transfers  the  significant  risks  and  benefits  of  ownership  from  the  lessor  to  the lessee,  so  the  lessor  accounts  for  the  lease  as  if  it  transferred  the  asset  to  the 

8 Later, we see that sometimes only a portion of the asset is deemed transferred and we derecognize only a portion of the carrying amount.

    Depending on whether the lessor retains significant risks or benefits, the company uses either a performance obligation approach or a derecognition approach to accounting for a lease.  The lessor should ignore credit risk associated with the lessee when assessing exposure to risks or benefits during the lease term. 

LO3  

18  SECTION 3  Financial Instruments and Liabilities  lessee.9   The performance obligation  is deemed to be the obligation to deliver the asset to the lessee, satisfied at the commencement of the lease, so no performance obligation is recorded. To see the derecognition approach demonstrated, let’s modify our previous 

illustration. Assume all facts are the same except that Sans Serif Publishers leased the printing equipment directly from CompuDec Corporation, rather than through the financing intermediary and that CompuDec’s cost of producing the printing equipment was $300,000. When we calculate the present value of the six lease payments, we see that the payments provide a “selling price” of $479,079 and that CompuDec earns a gross profit on the transaction of $479,079 − 300,000 = $179,079.   Illustration 15‐3 provides this example.   We don’t revisit  lessee accounting here 

because  lessee  accounting  is  not  affected  by  whether  the  lessor  uses  the performance obligation approach or the derecognition approach. 

 On January 1, 2011, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2015. The six‐year lease term ending December 31, 2016 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec determined that it does not retain exposure to significant risks or benefits associated with the printer. CompuDec manufactured the printing equipment at a cost of $300,000.   The fair value of the printing equipment is $479,079. CompuDec’s interest rate for financing the transaction is 10%. 

   $100,000 × 4.79079* = $479,079 

        Lease   Present      payments   value  

9 If (1) the lessor does not retain exposure to significant risks or benefits associated with the leased asset and (2) the agreement transfers control of the asset to the lessee it meets the criteria for classification as a purchase and sale of the asset. It is not a lease and is accounted for as a sale/purchase. This normally occurs if, for example, (a) the contract transfers legal ownership during or at the end of the lease term or (b) a lessee’s option to purchase has terms that make it likely to occur.

The lessee’s accounting is the right‐of‐use approach regardless of which approach the lessor uses. 

Illustration 15–3 Lessor; Derecognition Approach 

CHAPTER 15  Leases                  19 

*Present value of an annuity due of $1: n = 6, i = 10%. 

 Commencement of the Lease (January 1, 2011) 

Lease receivable (present value of lease payments) .......  479,079     Sales revenue ..........................................................    479,079  Cost of goods sold ............................................................   300,000      Inventory of equipment (lessor’s cost) ......................     300,000  

First Lease Payment (January 1, 2011) Cash ..............................................................................  100,000    Lease receivable .......................................................    100,000  

Second Lease Payment (December 31, 2011) Cash (lease payment) ...................................................  100,000  Lease receivable .......................................................    62,092  Interest revenue [10% × ($479,079 ‐ 100,000)] ..........    37,908  

 

You should recognize the similarity between recording both the revenue and cost components of this “sale” by  lease and recording the same components for other sales  transactions.  As  in  the  sale  of  any  product,  gross  profit  is  the  difference between sales revenue and cost of goods sold. Dell Inc. “sells” some of its products using leases and disclosed the following in a recent annual report:  Note 1 (in part) Dell records revenue from the sale of equipment under …. leases as product revenue at the inception of the lease. … [L]eases also produce financing income, which Dell recognizes at consistent rates of return over the lease term. 

As noted previously, accounting by the  lessee  is not affected by how the  lessor 

classifies  the  lease.  All  lessee  entries  are  precisely  the  same  as  in  the  previous illustrations.  

VARIATIONS IN LEASE SITUATIONS  

Derecognition Approach – Sometimes a Residual Asset Is Retained  

In our previous illustration, we assumed that the lease payments were calculated by  the  lessor  so  that  their present  value would equal  the  fair  value of  the  asset being leased. That is not an improbable assumption; often a manufacturer or dealer will  use  leasing  often  as  a  primary method  of  “selling”  its  products.    Suppose, though,  that  other  factors,  say  competitive  market  conditions,  influence  the amount of the payments  in such a way that their present value  is a  little  less than the  fair value of the asset.    In that case, the entire asset  is not transferred to the lessee; the lessor retains a portion of the asset.  In this situation, the lessor should divide the carrying amount of the asset  into two parts, (1) the portion transferred and  thus derecognized and  (2)  the portion  retained and  thus  reclassified as what 

The derecognition approach is similar to recording a sale of merchandise on account:  A/R ................{price}  Sales rev ....  {price} COGS .............{cost}  Inventory ...  {cost}  

 Remember, no interest has accrued when the first payment is made at the commencement of the lease. 

Real World Financials 

PART B 

  

● LO4    Under the derecognition approach for lessor accounting, a residual asset represents the rights to the leased asset retained by the lessor. 

20  SECTION 3  Financial Instruments and Liabilities  we call a residual asset.  The allocation is based on the ratio of the present value of the  payments  to  the  fair  value  of  the  asset.10    The  residual  asset  is  reported separate  from other assets  in  the balance sheet.    Illustration 15‐2A demonstrates the calculation. 

On January 1, 2011, Sans Serif Publishers leased printing equipment from CompuDec Corporation.  The lease agreement specifies six annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2015. The six‐year lease term ending December 31, 2016 (a year after the final payment),  is equal to the estimated useful life of the printing equipment. CompuDec determined that it does not retain exposure to significant risks or benefits associated with the printer. CompuDec manufactured the printing equipment at a cost of $300,000.   The fair value of the printing equipment is $500,000. CompuDec’s interest rate for financing the transaction is 10%. 

   

$100,000 × 4.79079* = $479,079         Lease   Present      payments   value  

*Present value of an annuity due of $1: n = 6, i = 10%.  

Commencement of the Lease (January 1, 2011) Lease receivable (present value of lease payments) .......  479,079     Sales revenue ..........................................................    479,079  Cost of goods sold ............................................................   287,447      Inventory of equipment ($300,000 x 479,079/500,000)**     287,447  Residual asset ...................................................................   12,553      Inventory of equipment ($300,000 – 287,447)** ......     12,553  

First Lease Payment (January 1, 2011) Cash ..............................................................................  100,000    Lease receivable .......................................................    100,000  

Second Lease Payment (December 31, 2011) Cash (lease payment) .....................................................  100,000  Lease receivable .......................................................    62,092  Interest revenue [10% × ($479,079 – 100,000)] ..........    37,908  

10 It’s unlikely that the fair value will exceed the present value of the cash flows by a large amount and the derecognition approach still be appropriate. That’s because the derecognition approach is appropriate only when the lessor does not retain significant risks and rewards of ownership, and a relatively large residual asset would be inconsistent with that condition.

Illustration 15–2A Lessor; Derecognition Approach – Present Value of Payments Less than Fair Value  

    The portion of the carrying amount the lessor derecognizes is $300,000 times the ratio of the PV of the payments to the FV of the asset.  The remainder is reclassified as a residual asset.  

CHAPTER 15  Leases                  21 

 **  The $287,447 portion of the asset deemed transferred and thus derecognized 

is calculated as its “selling price” divided by its fair value.  The remaining portion ($12,553) of the asset’s carrying amount is reclassified as a residual asset.   

  Initial Direct Costs  The  costs  incurred  that  are  associated  directly with  originating  a  lease  and  are essential  to acquire  that  lease are  referred  to as  initial direct costs. They  include legal fees, commissions, evaluating the prospective financial condition of the other company, and preparing and processing  lease documents. Any such costs paid by the  lessee  simply  add  to  the  lessee’s  right‐of‐use  asset  recorded  at  the commencement  of  the  lease.  This  is  consistent with  the  cost  principal we  apply when recording any asset at its total cost.  Any such costs paid by the lessor add to the lessor’s lease receivable recorded at the commencement of the lease. 

Let’s modify our original example to assume  in Illustration 15‐4 that the  lessee incurred initial direct costs. 

 

    

● LO5 

22  SECTION 3  Financial Instruments and Liabilities  On January 1, 2011, Sans Serif Publishers leased printing equipment from First LeaseCorp. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2013. The useful life of the equipment is estimated to be six years. 

Sans Serif paid $2,000 for professional fees and for preparing and processing lease documents.  First LeaseCorp’s interest rate for financing the transaction is 10%. 

   $100,000 × 3.48685* = $348,685 

        Lease   Present      payments   value  

*Present value of an annuity due of $1: n = 4, i = 10%. 

 Commencement of the Lease (January 1, 2011) 

 Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset (PV of lease payments plus initial direct costs)  350,685    Lease liability (PV of lease payments) .........................    348,685     Cash (initial direct costs) .............................................    2,000 

 First Lease Payment (January 1, 2011) 

 Sans Serif Publishers, Inc. (Lessee) Lease liability ................................................................  100,000    Cash  .........................................................................    100,000  

Second Lease Payment (December 31, 2011)  Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] ..............  24,869 Lease liability (difference) ............................................  75,131  Cash (lease payment) .................................................    100,000  

December 31, 2011 and End of Next Three Years  

Sans Serif Publishers, Inc. (Lessee) Amortization expense ($350,685 ÷ 4 years) ...................  87,671      Right‐of‐use equipment ..........................................    87,671      

Illustration 15–4 Initial Direct Costs 

 Initial direct costs paid by the lessee add to the lessee’s right‐of‐use asset.  

CHAPTER 15  Leases                  23  Short‐Term Leases – A Short‐Cut Method  

It’s not unusual to simplify accounting for situations in which doing so has no material effect on the results.  You might recognize this as the concept of “materiality.”11  One such situation that is permitted a simpler application is a short‐term lease.  A lease that has a maximum possible lease term (including any options to renew or extend) of twelve months or less is considered a “short‐term lease.”  Both the lessee and the lessor have a lease‐by‐lease option to choose a short‐cut approach to accounting for a short‐term lease.  LESSEE.  Conceptually, a lessee’s right‐of‐use asset as well as the liability to make payments for that right to use the asset should be measured as the present value of the future payments.  We make an exception, though, when the payments are not very far in the future.  Specifically, when a lessee has a short‐term lease it’s acceptable to forego using present value and measure the right‐of‐use asset and the lease liability simply as the total of the payments without discounting them to present value.      LESSOR.  The short‐cut approach is even more simplified for the lessor.  When a lessor has a short‐term lease, the company can choose not to record the lease receivable and the performance obligation that are normally recognized for a lease.  The lessor continues to recognize the asset being leased and recognizes lease payments as revenue over the lease term.   Let’s look at an example that illustrates the relatively straightforward accounting 

for  short‐term  leases. To do  this we modify  Illustration 15–1  to assume  the  lease term is twelve months in Illustration 15‐5. 

11 Materiality is a qualitative characteristic in Concepts Statement No. 8: Conceptual Framework

for Financial Reporting—Chapter 3, Qualitative Characteristics of Useful Financial Information, QC11, FASB, September, 2010.

    

● LO6 

  When a lessee has a short‐term lease, it can elect not to use present value and instead can measure the right‐of‐use asset and the lease liability simply as the total of the payments.  

 When a lessor has a short‐term lease, it can elect not to record the lease receivable or the performance obligation.  

24  SECTION 3  Financial Instruments and Liabilities 

On January 1, 2011, Sans Serif Publishers leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment at a cost of $479,079. The lease agreement specifies four quarterly payments of $100,000 beginning 

January 1, 2011, the commencement of the lease, and at the first day of each of the next three quarters. The useful life of the equipment is estimated to be six years. Before  deciding  to  lease,  Sans  Serif  considered  purchasing  the  equipment  for 

$479,079. First LeaseCorp’s interest rate for financing the transaction is 10%.    

Commencement of the Lease (January 1, 2011)    

Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset (undiscounted total of lease payments12)  400,000       Lease liability (undiscounted total of lease payments)    400,000  

First LeaseCorp (Lessor)  No entry  

Lease Payments (January 1, July 1, October 1, 2011)  

Sans Serif Publishers, Inc. (Lessee) Lease liability ...............................................................   100,000       Cash  ......................................................................     100,000  

First LeaseCorp (Lessor) Cash .............................................................................   100,000           Lease income  .......................................................     100,000   

December 31, 2011   

Sans Serif Publishers, Inc. (Lessee) Amortization expense ($400,000 ÷ 1 year) ....................   400,000          Right‐of‐use asset ..................................................     400,000    

First LeaseCorp (Lessor)13  No entry   

 Leasehold Improvements  

Sometimes a lessee will make improvements to leased property that reverts back to the  lessor at  the end of  the  lease.  If a  lessee constructs a new building or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets,  its cost  is allocated as depreciation expense 

12 Also would include initial direct costs paid by lessee if any (discussed previously) 13 At the end of each of the six years of the six-year estimated life of the equipment being leased to

Sans Serif, First LeaseCorp will record depreciation on its equipment:

Depreciation expense–equipment for lease ($479,079 ÷ 6 years) 79,847 Accumulated depreciation 79,847

Illustration 15–5 Short‐Term Lease; Lessee and Lessor 

If the lessor chooses this short‐cut option, it recognizes lease payments as lease income over the lease term. 

If the lessee chooses this short‐cut option, it recognizes lease payments as amortization expense over the lease term. 

  The cost of a leasehold improvement is depreciated over its useful life to the lessee. 

CHAPTER 15  Leases                  25  over its useful life to the lessee, which will be the shorter of the physical life of the asset  or  the  lease  term.    Theoretically,  such  assets  can  be  recorded  in  accounts descriptive of  their nature,  such  as buildings or plant.  In practice,  the  traditional account  title  used  is  leasehold  improvements.14  In  any  case,  the  undepreciated cost usually is reported in the balance sheet under the caption property, plant, and equipment.  Movable  assets  like  office  furniture  and  equipment  that  are  not attached to the leased property are not considered leasehold improvements. 

 

UNCERTAINTY IN LEASE TRANSACTIONS    What if the Lease Term is Uncertain?  

Sometimes  the actual  term of a  lease  is not obvious.   Suppose,  for  instance,  that the lease term is specified as four years, but it can be renewed at the option of the lessee  for  two  additional  years.   Or, maybe either party  can  terminate  the  lease after,  say,  three  years.    In  these  uncertain  situations, we  need  to  estimate  the likelihood of an increase or decrease in the lease term and choose accordingly.  If, for instance, it’s “more likely than not” that the four‐year original lease term will be renewed  for  an  additional  two  years,  the  lease  term  used  in  accounting  for  the lease is six years.  Our objective is that the lease term should reflect the company’s reasonable  expectation  of  what  the  term  will  actually  be,  taking  into  account renewal options and termination options. When more than two terms are possible, we choose the longest possible term for which that length or longer is “more likely than not.”   

Let’s say, for instance, that a 10‐year lease can be renewed for two additional 5‐year periods, but that it also can be terminated after only 5 years.   Management assesses the probability of a 5‐year, 10‐year, 15‐year, and 20‐year lease term to be 25%, 20%, 20%, and 35%, respectively.  The likelihood that the lease term will be at least 5 years is 100%, and 75% (20% +20% +35%) that it will be 10 years or longer.  The chance that it will extend 15 years or longer is 55% (20% +35%), but only 35% that it will be 20 years.  The most likely of the choices is that it will be 10 years or longer (75%).  But is that our choice?  No.  The probability that it will extend 15 years or longer is 55%, which also is more likely than not, but a longer term.  So, we consider the lease term to be 15 years because we use he longest possible lease term that is more likely than not to occur. 

14 Also, traditionally, depreciation sometimes is labeled amortization when in connection with leased

assets and leasehold improvements. This is of little consequence. Remember, both depreciation and amortization refer to the process of allocating an asset’s cost over its useful life.

PART C 

         The lease term for both the lessee and the lessor is the longest possible term that is “more likely than not” to occur taking into account any options to extend or terminate the lease. 

    

● LO7 

26  SECTION 3  Financial Instruments and Liabilities 

You might want to ponder the possibilities if we did not have this requirement to specifically consider renewal options and their likelihood when we determine the lease term.  Management might be tempted to structure leases with artificially short initial terms and numerous renewal options that could be ignored as a scheme to be able to use the short‐cut method or to reduce significantly the amount of the lease liability to be reported (off‐balance‐sheet financing). 

 

What if the Lease Payments are Uncertain?  

Sometimes lease payments are to be increased (or decreased) at some future time during the  lease term, depending on whether or not some specified event occurs. Usually the contingency  is related to revenues, profitability, or usage above some designated  level. For example, a recent annual report of Walmart Stores  included the note re‐created in Graphic 15–5.  

9 Commitments (in part) Certain  of  the  leases  provide  for  the  payment  of  contingent  leases  based  on percentage of sales. Such contingent  leases amounted  to $21 million, $33 million and $41 million in 2009, 2008 and 2007, respectively. 

 

Why would  a  lease  include  a  contingent  payment  provision?    It  is  a way  for lessees and  lessors  to share  the  risk associated with  the asset’s productivity.   For example,  a  shop  owner  who  pays  for  a  premium  mall  location  is  doing  so anticipating higher revenue.  If the mall attracts many shoppers, the lessee pays the lessor  part  of  the  resulting  higher  profits,  but  if  not,  the  lessee makes  only  the normal  minimum  lease  payment.    This  arrangement  also  provides  the  lessor incentive to attract shoppers to the mall, which is in the lessee’s best interest. If  the amounts of  future  lease payments are uncertain due  to contingencies or 

otherwise, we need  to estimate  the expected outcome of  those payments.   The expected outcome  is the present value of the probability‐weighted average of the cash flows for a reasonable number of possible outcomes.    It’s easier to see what that means if we look at an example. Suppose, for instance, that lease payments are $100,000 each for four years as in 

Illustration 15‐1 on page 6, but contingent lease payments also are specified at the end of years 1, 2, and 3 equal to 1% of the lessee’s revenue that year.  Now let’s say that Sans Serif estimates the probabilities for three possible outcomes for revenue as $1 million each year (30%), $1 million  in 2011 plus an  increase of $50,000 each year (45%), and $1 million in 2011 minus a $50,000 reduction each year (25%).  The expected outcome for contingent lease payments is estimated in Illustration 15‐6:  

    

● LO8 

GRAPHIC 15–5 Contingent Lease Payments—Walmart Stores  Real World Financials 

CHAPTER 15  Leases                  27 

Possible Outcomes and Probabilities (%):    

      Jan. 1  Dec. 31  Dec. 31  Dec. 31         2011  2011  2012  2013  Total   1  Revenue (30%)   $1,000,000  $1,000,000  $1,000,000       Contingent payment  0  $10,000  $10,000  $10,000    2  Revenue (45%)    $1,000,000  $1,050,000  $1,100,000       Contingent payment  0  10,000  10,500  $11,000    3  Revenue (25%)    $1,000,000  $  950,000  $  900,000       Contingent payment  0  10,000   9,500  $ 9,000         

  PV of $1, i=10%, n=1, 2, 3  .90909  .82645  .75131  1  Present value of outcome 1    $9,091  $8,265  $7,513  $24,869  

2  Present value of outcome 2    $9,091  $8,678   $8,264  $26,033  

 3  Present value of outcome 3    $9,091  $7,851  $6,762  $23,704  

Expected outcome (probability‐weighted average):                                       $24,869 x 30%  +  $26,033 x 45%  +  $23,704 x 25%  =               $25,102 

  The expected outcome, $25,102,  is  the  amount  the  lessee  should  add  to  the 

$348,685  present  value  of  the  $100,000  annual  lease  payments  to measure  its right‐of‐use  asset  as well  as  its  lease  liability  as  $373,787.    Likewise,  this  is  the amount  the  lessor uses  to  record  its  lease  receivable and performance obligation (or sales revenue when using the derecognition approach).   

Reassessing the Lease Term and the Expected Lease Payments  

When  the  lease  term  or  lease  payments  are  uncertain,  we  need  to  make estimates as described above.   Usually, there’s no assurance that those estimates won’t change.  If circumstances later indicate that a significant change has occurred in  the amounts measured  for  the  lessee’s  liability  to make  lease payments or  the lessor’s right to receive lease payments, we should reevaluate the lease term or the expected  amount  of  lease  payments  and  make  necessary  adjustments.    As  an example,  let’s continue the previous  illustration and assume the actual revenue  in 2011 was $1,100,000, 10% higher than estimated. 

 

Illustration 15–6 Determining the Expected Outcome of Uncertain Lease Payments  

    Contingent lease payments are specified at the end of years 1, 2, and 3 equal to 1% of revenue that year.         When lease payments are uncertain we use the expected outcome, which is the present value of the probability‐weighted average of the possible cash flows. 

28  SECTION 3  Financial Instruments and Liabilities 

       First‐year revenue was estimated to be $1,000,000; actual revenue was $1,100,000.  Estimates of future revenue were unchanged.     Annual lease payments ($100,000 × 3.48685*)  $348,685    Contingent payments (expected outcome**)      25,102        Total right‐of‐use asset/ lease liability  $373,787    

  *  present value of an annuity due of $1: n = 4, i = 10%.  **  from Illustration 15‐6 assuming first‐year revenue of $1,000,000 

 Commencement of the Lease (January 1, 2011)  

Right‐of‐use asset  .......................................................  373,787    Lease liability (PV of lease payments plus         expected contingent payments) ................................    373,787  First Lease Payment (January 1, 2011)  

Lease liability ................................................................  100,000    Cash..... .....................................................................    100,000  Second Lease Payment (December 31, 2011)  

Interest expense [10% × ($373,787 – 100,000)] ..............  27,379 Lease liability (to balance) .............................................  82,621 Lease expense (1% x $100,000 unexpected revenue) ......  1,000  Cash ($100,000 + [1% x $1,100,000]) ...........................    111,000  

A change in actual or expected payments is reflected in earnings if it relates to the current period or prior periods as it does in this situation.  All other changes would be recorded as an adjustment to the right‐of‐use asset instead.  For instance, if contingent payments are based on achieving a performance target in the future, and we revise our estimate of future performance in such a way that the lease liability (present value of expected future payments) is, say,  $12,000 less, we would reduce the right‐of‐use asset and lease liability: 

  Lease liability (change in estimate) ................................  12,000   Right‐of‐use asset  .................................................    12,000    

  

Illustration 15–6A Reassessing Expected Lease Payments 

Changes in the lease liability from reassessing uncertain lease payments that relate to current or prior periods are recognized in earnings (lease expense or lease revenue). 

     Changes in the lease liability from reassessing uncertain lease payments that relate to future periods are recognized as an adjustment to the right‐of‐use asset. 

CHAPTER 15  Leases                  29  Residual Value 

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. The lessee promises to return not only the property but also sufficient cash to provide the lessor with a minimum combined value.  

Essentially, a lessee‐guaranteed residual value is viewed the same way as the contingent lease payments we discussed in the previous section.  If a cash payment under a lessee‐guaranteed residual value is predicted on a probability‐weighted outcome basis, the present value of that payment is added to the present value of the lease payments the lessee records as both a right‐of‐use asset and a lease liability.  Likewise, it also adds to the amount that the lessor records as both a lease receivable and performance obligation (or sales revenue when the derecognition approach is used).   

Let’s return to Illustration 15‐1, but now assume that, at the commencement of the  lease, both the  lessee and  lessor expect the residual value after the  four‐year lease term to be $180,000 with a 50% probability, but also estimate a 25% chance it will  be  $160,000  and  a  25%  chance  it will  be  $244,000. Negotiations  led  to  the lessee guaranteeing a $240,000 residual value.    If the property’s value  is  less than $240,000 at the end of the lease term, the lessee will make a cash payment for the excess of the $240,000 over the actual value. 

The expected excess guaranteed residual value  is viewed as an additional cash flow and its present value is included in the calculation of the present value of lease payments as shown in Illustration 15–7.   

Estimated actual residual values: 1‐ $160,000: 25%;     2‐ $180,000: 50%;     3‐ $244,000: 25%      Possible cash payments (Excess of $240,000 over actual residual value): 1‐ $80,000: 25%;      2‐ $60,000: 50%;      3‐ $0: 25%  Probability weighted outcome: (25% x $80,000) + (50% x $60,000) + (25% x $0) = $50,000  Present value of periodic lease payments ($100,000 × 3.48685*)  $348,685 Plus: Present value of estimated payment under            residual value guarantee ($50,000 × .68301†)  34,151 Present value of expected lease payments   $382,836  *Present value of an annuity due of $1: n = 4, i = 10%. †Present value of $1: n = 4, i = 10%.    

      A cash payment predicted under a lessee‐guaranteed residual value is treated the same as a lease payment.      

● LO9 

ILLUSTRATION 15–7 Guaranteed Residual Value 

30  SECTION 3  Financial Instruments and Liabilities 

Commencement of the Lease (January 1, 2011)  Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset  .......................................................  382,836    Lease liability (present value of lease payments) ........    382,836 

First LeaseCorp (Lessor) Lease receivable (present value of lease payments) .......  382,836    Performance obligation ...........................................    382,836  

Situations in which the lessee‐guaranteed residual value exceeds the probability‐weighted estimate of the actual residual value are rare in practice. It makes little economic sense for a lessee to agree to guarantee an amount greater than the estimated residual value, virtually ensuring an additional cash payment at the conclusion of the lease.  The requirement to account for it in this way, though, serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lessee‐guaranteed residual value to compensate for the reduced lease payments.   ADDITIONAL CONSIDERATION 

If a residual value  is not guaranteed,  is guaranteed by a third party (insurance companies  sometimes assume  this  role), or  is guaranteed by  the  lessee but does not differ from the estimate of the actual fair value at the end of the lease term, it does not affect the calculations by either the lessee or lessor of the present value of the  lease  payments.    Obviously,  though,  even  if  the  residual  value  is  not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. That amount would contribute  to  the  total amount  to be  recovered by  the lessor  and  would  reduce  the  amount  needed  to  be  recovered  from  the  lessee through  periodic  lease  payments.  A  residual  value  likely  will  affect  the  lessor’s calculation of periodic lease payments.  For instance, whether the residual value in the  illustration  is  guaranteed  or  not,  its  existence  affected  the  lessor’s  lease payment calculation:   

     The lessor subtracts the PV of the residual value to determine lease payments. 

CHAPTER 15  Leases                  31     Amount to be recovered (fair value)  $479,079   Less: Present value of the Residual value ($191,00015 × .68301*)     (130,455)   Amount to be recovered through periodic lease payments  $348,624    Lease payments at the beginning of each of the next six years:        

÷   3.48685** $100,000 † 

 

 

* Present value of $1: n = 4, i = 10%. **Present value of an annuity due of $1: n = 4, i = 10%. †  rounded for simplicity; actually $99,982

If an additional cash payment  is expected due to a  lessee‐guaranteed residual value,  the  amount  to  be  recovered  through  periodic  lease  payments  would  be reduced still further.   

 Purchase Options  

A purchase option  is a provision of some  lease contracts that gives the  lessee the option of purchasing the leased property during, or at the end of, the lease term at a specified exercise price.  We don’t consider the exercise price to be an additional cash payment within  the  lease agreement.    Instead,  it will be viewed as  the cash payment  to generate a  sale/purchase of  the asset  if and when  it  is exercised.   A lease  is considered terminated when an option to purchase the asset  is exercised by the lessee. 

That  said,  the  existence  of  a  purchase  option might  affect whether  or  not  a lease  even  exists  for  accounting  purposes.    If,  for  instance,  the  exercise  price  is sufficiently below the property’s expected fair value that the exercise of the option appears more  likely  than  not  (sometimes  called  a  bargain  purchase  option), we ordinarily would  consider  “control” of  the  asset  to have been  transferred  to  the lessee.16    When  (a)  control  is  transferred  and  (b)  the  lessor  does  not  retain exposure to significant risks or benefits associated with the leased asset, then there is no lease and the agreement is accounted for as a sale/purchase.  

 CONCEPT REVIEW EXERCISE 

 (This is a variation of the previous Concept Review Exercise.) United  Cellular  Systems  leased  a  satellite  transmission  device  from  Satellite  Technology Corporation on  January 1, 2011. Satellite Technology paid $500,000  for  the  transmission device. Its retail value is $653,681.  

15 For the previous illustration, the expected residual value given the three possibilities and their

probabilities was $160,000 x 25% + $180.000 x 50% + $244,000 x 25% = $191,000. 16 Control of the asset also is ordinarily assumed to have been transferred to the lessee if actual

ownership is transferred under the terms of the lease agreement.

A purchase option affects lease accounting only when it is exercised. 

32  SECTION 3  Financial Instruments and Liabilities  Terms of the Lease Agreement and Related Information: 

Lease term  3 years (6 semiannual periods) Semiannual lease payments  $120,000 at the beginning of each period Economic life of asset  3 years Interest rate lessor charges (known by lessee)  12% Risks and benefits associated with asset   Retained by lessor Lessee’s initial direct costs  $4,500 Contingent lease payment  Additional $100,000 at the end of 2013 if 

revenues exceed a specified base (40% estimated probability) 

Required: 1.  Prepare  an  amortization  schedule  that  describes  the  pattern  of  interest 

expense/interest revenue over the lease term. 2.  Prepare  the  appropriate  entries  for  both  United  Cellular  Systems  and  Satellite 

Technology on January 1, 2011. 3.  Prepare  the  appropriate  entries  for  both  United  Cellular  Systems  and  Satellite 

Technology  on  June  30,  2011,  assuming  that  each  company  revised  its  estimated probability for the contingent payment from 40% to 60%. 

4.  Prepare  the  appropriate  entries  for  both  United  Cellular  Systems  and  Satellite Technology on January 1, 2011, assuming that the agreement contained no contingent payment  clause  and  Satellite  Technology  did  not  retain  significant  risks  or  benefits associated with the leased asset. 

 

 1.  Prepare an amortization schedule that describes the pattern of interest 

expense/interest revenue over the lease term.      

  Present value of payments ($120,000 × 5.21236*)  $625,483   Plus: Expected outcome of the contingent lease payment                   ([$100,000 × .70496† × 40%] +   [ $0 × .70496† × 60%])     28,198   Lease’s lessee liability / lessor’s lease receivable  $653,681    *Present value of an annuity due of $1: n = 6, i = 6%.   †Present value of $1: n = 6, i = 6%.  

Date  Payments  Effective Interest Decrease in Balance 

Outstanding Balance 

(6% × Outstanding balance) 1/1/11        653,681 1/1/11  120,000    120,000  533,681 6/30/11  120,000  .06 (533,681) =  32,021  87,979  445,702 1/1/12  120,000  .06 (445,702) =  26,742  93,258  352,444 6/30/12  120,000  .06 (352,444) =  21,147  98,853  253,591 1/1/13  120,000  .06 (253,591) =  15,215  104,785  148,806 6/30/13  120,000  .06 (148,806) =    8,928  111,072  37,734 

12/31/13  40,000  .06 (37,734) =      2,266* 37,734  0   760,000      106,319  653,681    *Adjusted for rounding of other numbers in the schedule.

SOLUTION  

CHAPTER 15  Leases                  33  2.  Prepare  the appropriate entries  for both United Cellular Systems and Satellite 

Technology on January 1, 2011.  

January 1, 2011  United Cellular Systems (Lessee)       Right‐of‐use asset (PV of payments plus initial direct costs)    658,181       Lease payable (calculated above)      653,681   Cash (initial direct costs)      4,500        

Lease payable    120,000       Cash (lease payment)     120,000  Satellite Technology (Lessor) Lease receivable (calculated above)   653,681     Performance obligation    653,681  

Cash (lease payment)    120,000     Lease receivable      120,000    

 3.  Prepare  the appropriate entries  for both United Cellular Systems and Satellite 

Technology  on  June  30,  2011,  assuming  that  each  company  revised  its estimated probability for the contingent payment from 40% to 60%. 

 June 30, 2011 

 

United Cellular Systems (Lessee) 

Interest expense (6% × [$653,681 – 120,000])     32,021   Lease payable (difference)     87,979     Cash (lease payment)       120,000  Amortization expense ($653,681 ÷ 3 years x ½)  108,947     Right‐of‐use asset    108,947  Satellite Technology (Lessor) Cash (lease payment)   120,000   Lease receivable (difference)    87,979   Interest revenue (6% × [$653,681 – 120,000])    32,021  Performance obligation  108,947     Lease income ($653,681 ÷ 3 years x ½)    108,947     

34  SECTION 3  Financial Instruments and Liabilities     PV of remaining 4 payments ($120,000 × 3.46511*)  $415,813   Plus: Expected outcome of the contingent lease payment                   ([$100,000 × .79209† × 60%] +   [ $0 × .79209† × 40%])      47,525   Lease’s lessee liability / lessor’s lease receivable  $463,338    *Present value of an ordinary annuity of $1: n = 4, i = 6%.   †Present value of $1: n = 4, i = 6%.    Note: At this point we have an ordinary annuity since the next payment won’t occur until 

the end of the next six month period.  

  Revised balance needed  $463,338   Carrying amount (from schedule: $653,681 – 120,000 – 87,979)    445,702         Increase in balance  $  17,636  

United Cellular Systems (Lessee) 

Right‐of‐use asset    17,636       Lease payable (calculated above)      17,636  Interest expense (6% × $463,339)     27,800   Lease payable (difference)     92,200     Cash (lease payment)       120,000  Satellite Technology (Lessor) Lease receivable (calculated above)   17,636     Performance obligation    17,636  Cash (lease payment)   120,000   Lease receivable (difference)    92,200   Interest revenue (6% × $463,339)    27,800   4.  Prepare  the  appropriate  entries  for  Satellite  Technology  on  January  1,  2011, 

assuming  that  the  agreement  contained  no  contingent  payment  clause  and Satellite Technology did not  retain significant  risks or benefits associated with the leased asset. 

    Present value of payments:  $120,000 × 5.21236* =  $625,483   *Present value of an annuity due of $1: n = 6, i = 6%. 

 Satellite Technology (Lessor) Lease receivable (calculated above)   625,483     Sales revenue    625,483  

Cost of goods sold    500,000     Inventory of equipment (lessor’s cost)       500,000  

CHAPTER 15  Leases                  35 

FINANCIAL STATEMENT REPORTING AND DISCLOLSURES     

 

Leases in Financial Statements    

Income Statement.    In general,  lease  items within the  income statement, balance sheet,  and  statement  of  cash  flows  should  be  reported  separate  from  non‐lease components.  Lessees,  for  instance,  report  amortization  expense  and  interest expense  related  to  right‐to‐use  assets  separately  in  the  income  statement  from their  non‐lease  counterparts.    Likewise,  lessors  report  lease  income,  interest income, and depreciation expense separately  in the  income statement so decision makers are informed about income and expenses that relate to leases.  Balance  Sheet.    Balance  sheets,  too,  should  separate  lease  assets  and  liabilities from non‐lease assets and  liabilities.   Right‐of‐use assets are  reported within  the property,  plant,  and  equipment  classification,  but  separate  from  other  assets  in that  category.    The  lessee’s  lease  liability,  too,  is  reported  separate  from  other liabilities.   A  lessor using the performance obligation approach, not only separates its  lease  and non‐lease balance  sheet  components, but  also  links  them  together.  Using  the  amounts  from  Illustration  15‐1  at  the  end  of  the  first  year,  Sans  Serif would report the following:      Equipment for lease (net of depreciation)  $399,232   Lease receivable  173,554   Performance obligation  (261,514)        Net lease asset  $311,272  

A lessor using the derecognition approach reports its lease receivable separate from other receivables and any residual asset separate from other property, plant, and equipment.  Statement of Cash Flows.    In a statement of cash  flows, we separate  inflows and outflows of cash  into operating,  investing, and financing activities.   When a  lessee acquires a  right‐of‐use asset and  related  liability,  there  is no  inflow or outflow of cash.   However, because a primary purpose of  the  statement of  cash  flows  is  to report  significant  operating,  investing,  and  financing  activities,  the  initial transaction  is  reported  in  the  disclosure  notes  as  a  significant  noncash  investing activity (investing  in the right‐of‐use asset) and financing activity (financing  it with debt). Then  the  lessee’s cash payments  for  leases are  then classified as  financing activities  in  its  statement  of  cash  flows  and  presented  separately  from  other financing cash flows.   

The lessor classifies its cash receipts from lease payments as operating activities in  its  statement  of  cash  flows  after  initially  reporting  its  acquisition  of  a  lease 

Part D 

  

● LO10 

36  SECTION 3  Financial Instruments and Liabilities  receivable  and  performance  obligation  as  a  significant  noncash  investing  and financing activity in its cash flow disclosure note.    We  have  discussed  the  ways  leases  are  reported  in  the  financial  statements.  Graphic 15‐5 summarizes the effects on the balance sheet, income statement, and statement of cash flows.   

  Lessee  Lessor-

Performance Obligation Approach 

Lessor- Derecognition Approach

Income Statement 

• Interest expense • Amortization

expense

• Interest revenue • Lease income • Depreciation

expense

• Interest revenue • Sales revenue • Cost of goods sold

Balance Sheet 

• Right-of-use asset • Lease liability

• Underlying asset

• Lease receivable • Performance

obligation • = net leased asset

or liability

• Derecognize underlying asset

• Residual asset

• Lease receivable

Statement of Cash Flows 

• Cash outflows from financing activities 

• Cash inflows from operating activities

• Cash inflows from operating activities

 

 Disclosure  

Lease disclosure  requirements are quite extensive  for both  the  lessor and  lessee. Virtually all aspects of  the  lease agreement must be disclosed. For all  leases  (a) a general description of the  leasing arrangement  is required as well as (b) minimum future payments,  in the aggregate and for each of the five succeeding fiscal years, distinguishing   those attributable to the minimum   amounts   specified rather than from  contingent  rentals,  term  option  penalties  and    residual  value  guarantees.  Companies also describe the amounts recognized in the financial statements arising from  leases and how  leases may affect the amount, timing and uncertainty of the company’s future cash flows.  

Each company reports a schedule reconciling opening and closing balances of, for lessees, the (a) right‐of‐use assets and (b) lease liabilities and, for lessors, the (a)  lease receivables, (b)  performance obligations, and (c)  residual assets  arising from the derecognition approach.   

Other required disclosures include:  • contingent  rentals,  renewal  and  termination  options,  including  whether 

GRAPHIC 15–5 Leases in Financial  Statements 

CHAPTER 15  Leases                  37 

they affected assets and liabilities recognized  • purchase options    • residual value guarantees  • initial direct costs   • significant subleases  • recognized amount of short‐term leases  • discount rate used    • sale and leaseback arrangements • significant service obligations related to its leases  • impairment losses    

 The lessor also must disclose its exposure to the risks or benefits that it used in 

determining  whether  to  apply  the  performance  obligation  approach  or  the derecognition approach.     

SALE‐LEASEBACK ARRANGEMENTS  In  a  sale‐leaseback  transaction,  the  owner  of  an  asset  sells  it  and  immediately leases it back from the new owner. Sound strange? Maybe, but this arrangement is common. In a sale‐leaseback transaction two things happen: 

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

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

What motivates this kind of arrangement? The two most common reasons 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 a sale‐leaseback transaction is to generate cash. 

Illustration 15–8  demonstrates  a  sale‐leaseback  involving  a  lease  for warehouses.  The  sale  and  simultaneous  leaseback  of  the warehouses  should  be viewed  as  a  single  borrowing  transaction.  Although  there  appear  to  be  two separate transactions, look closer at the substance of the agreement. Teledyne still retains the use of the warehouses that it had prior to the sale and leaseback. What is  different?  Teledyne  has  $900,000  cash  and  an  obligation  to  make  annual payments of $133,155. In substance, Teledyne simply has borrowed $900,000 to be repaid over 10 years along with 10% interest.  

Part E 

  

● LO11 

  Recording a sale‐leaseback transaction follows the basic accounting concept of substance over form. 

38  SECTION 3  Financial Instruments and Liabilities   Teledyne Distribution Center was in need of cash. Its solution: sell its four warehouses for $900,000, then lease back the warehouses to obtain their continued use. The warehouses had a carrying value on Teledyne’s books of $600,000 (original cost $950,000). Other information:  1. The sale date is December 31, 2011. 2. The noncancelable lease term is 10 years and requires annual payments of 

$133,155 beginning December 31, 2011. The estimated remaining useful life of the warehouses is 10 years. 

3. Teledyne depreciates its warehouses on a straight‐line basis. 4. The annual lease payments (present value $900,000) provides the lessor with a 

10% rate of return on the financing arrangement. Teledyne’s incremental borrowing rate is 10%. 

     

  $133,155      ×      6.75902* =    $900,000 ($899,997.31 rounded)   Lease            Present    payments     value 

                                         * present value of an annuity due of $1:  n = 10, i = 10%  

December 31, 2011 

Cash      900,000   Accumulated depreciation ($950,000 − 600,000)      350,000       Warehouses (cost)        950,000     Gain on sale‐leaseback (difference)        300,000 

Right‐of‐use asset     900,000       Lease liability (present value of lease payments)        900,000 

Lease liability      133,155       Cash        133,155 

December 31, 2012  

Interest expense [10% × ($900,000 − 133,155)]      76,685   Lease liability (difference)      56,470       Cash (lease payment)        133,155 

Amortization expense ($900,000 ÷ 10 years)      90,000       Right‐of‐use asset       90,000  

 There  typically  is  interdependency  between  the  lease  terms  and  the  price  at 

which  the  asset  is  sold.  Little  imagination  is  needed  to  envision  an  agreement between the seller‐lessee and the buyer‐lessor designed to manipulate the amount of cash effectively borrowed under the sale‐leaseback and thus the reported gain.  Suppose, for instance, that the two companies agreed that Teledyne would receive $1,000,000 from the sale of the warehouses in return for agreeing to increase lease payments from $133,155 (PV: $900,000) to $147,950 (PV: $1,000,000).   When the sales price is materially different from the fair value of the asset sold, we adjust the 

ILLUSTRATION 15–8 Sale‐Leaseback             Through the sale‐leaseback Teledyne obtains $900,000 cash in exchange for the promise to repay that amount plus interest over the lease term. 

CHAPTER 15  Leases                  39  gain on  the  sale  and  the  right‐of‐use  asset by  the difference  to  avoid  those  two amounts being misstated.  Illustration 15‐8A demonstrates this situation.           

  $147,950      ×      6.75902*   =    $1,000,000    Lease            Present    payments     value                                          * present value of an annuity due of $1:  n = 10, i = 10%  

December 31, 2011 

Cash    1,000,000   Accumulated depreciation ($950,000 − 600,000)   350,000    Warehouses (cost)        950,000  Gain on sale‐leaseback (difference)        400,000 

Right‐of‐use asset   1,000,000    Lease liability (present value of lease payments)        1,000,000  Gain on sale‐leaseback ($1,000,000 − 900,000)  100,000     Right‐of‐use asset (PV of payments less fair value of asset)    100,000 

Lease liability      147,950    Cash        147,950 

December 31, 2012 

Interest expense [10% × ($1,000,000 − 147,950)]      85,205   Lease liability (difference)      62,745    Cash (lease payment)        147,950 

Amortization expense [$1,000,000  − 100,000) ÷ 10 years]      90,000     Right‐of‐use asset       90,000  

 FINANCIAL REPORTING CASE SOLUTION 

 1.  How would HG’s revenues “take a hit” as a result of more customers leasing 

than buying labeling machines? (p. xxx) When HG leases machines, it reports lease income as it amortizes its performance obligation over the lease term in addition to interest revenue for financing the arrangement. When HG sells machines, on the other hand, it recognizes revenue “up front” in the year of sales. Actually, total revenues are not necessarily less with a lease, but are spread out over the several years of the lease term. This delays the recognition of revenues, creating the “hit” in the reporting periods in which a shift to leasing occurs.  This is partially offset by delaying the associated expense by depreciating the asset over its life rather than expensing its cost all at once as cost of goods sold. 

ILLUSTRATION 15–8A Sale‐Leaseback; sales price different from the fair value of the asset sold     We adjust the gain on the sale and the right‐of‐use asset to avoid those two amounts being misstated. 

40  SECTION 3  Financial Instruments and Liabilities  2.  Under what lease accounting approach would the “hit” not occur?  (p. xxx)

The hit will not occur when HG uses the derecognition approach (and there is no residual asset). This is appropriate when HG does not retain risks and benefits associated with the leased assets.  In those cases, despite the fact that the contract specifies a lease, in effect, HG actually sells its machines under the arrangement. Consequently, HG will recognize sales revenue (and cost of goods sold) at the commencement of the lease. The amount recognized is roughly the same as if customers actually buy the machines. As a result, the income statement will not receive the hit created by the substitution of operating leases for outright sales.  

 THE BOTTOM LINE    LO1  A  right‐of‐use asset and  lease  liability  is  recorded by  the  lessee at  the 

present value of the  lease payments. The asset  is amortized to expense over the life of the lease. (p. xxx) 

  LO2  The  lessor  records both a  lease  receivable and performance obligation for the present value of the lease payments.  The obligation is amortized to income over the life of the lease.  (p. xxx) 

  LO3  If  the  lessor  does  not  retain  exposure  to  significant  risks  or  benefits associated  with  the  leased  asset,  the  lessor  uses  the  derecognition approach.  This means recording sales revenue and cost of goods sold by the lessor at the inception of the lease. (p. xxx) 

  LO4  If  the present value of  lease payments  is  less than the  fair value of the asset, the lessor divides the carrying amount of the asset into two parts, (1)  the portion  transferred  and  thus derecognized  and  (2)  the portion retained  and  thus  reclassified  as what we  call  a  residual  asset.    The allocation is based on the ratio of the present value of the payments to the fair value of the asset. (p. xxx) 

  LO5  Initial  direct  costs  paid  by  the  lessee  add  to  the  lessee’s  right‐of‐use asset.    Any  such  costs  paid  by  the  lessor  add  to  the  lessor’s  lease receivable recorded at the commencement of the lease. (p. xxx) 

  LO6  A short‐term lease is twelve months or less.  When a lessee has a short‐term lease, it can elect not to use present value and measure the right‐of‐use asset and the  lease  liability simply as the total of the payments.  When a lessor has a short‐term lease, it can elect not to record the lease receivable or the performance obligation. (p. xxx) 

  LO7  The lease term for both the lessee and the lessor is the longest possible term  that  is  “more  likely  than  not”  to  occur  taking  into  account  any options to extend or terminate the lease. (p. xxx)  

 ●  LO8  When  lease  payments  are  uncertain  we  use  the  expected  outcome, 

which  is  the present  value of  the probability‐weighted  average of  the 

CHAPTER 15  Leases                  41 

possible cash flows. (p. xxx)  ●  LO9  If a cash payment under a lessee‐guaranteed residual value is predicted 

on  a  probability‐weighted  outcome  basis,  the  present  value  of  that payment is added to the present value of the lease payments. (p. xxx) 

 ●  LO10  Lease  disclosure  requirements  are  quite  extensive  for  both  the  lessor 

and  lessee.  Virtually  all  aspects  of  the  lease  agreement  must  be disclosed including a general description of the leasing arrangement and minimum  future  payments,  in  the  aggregate  and  for  each  of  the  five succeeding fiscal years. (p. xxx) 

 ●  LO11  In  a  sale‐leaseback  transaction,  the  owner  of  an  asset  sells  it  and 

immediately leases it back from the new owner. When the sales price is materially different  from the  fair value of the asset sold, we adjust the gain  on  the  sale  and  the  right‐of‐use  asset  by  the  difference  to  avoid those two amounts being misstated. (p. xxx) 

 QUESTIONS FOR REVIEW OF KEY TOPICS  

Q 15–1  Briefly  describe  conceptual  basis  for  the  right‐of‐use  approach  used  by the lessee in a lease transaction. 

Q 15–2  What are the two approaches a lessor uses in a lease transaction?  What determines the choice between the two approaches? 

Q 15–3  How  is  interest  determined  in  a  lease  transaction?  How  does  the approach compare to other forms of debt (say, bonds payable or notes payable)? 

Q 15–4  How are leases and installment notes the same? How do they differ? 

Q 15–5  A lessee’s earnings are affected by what two amounts (ignoring taxes) in a lease transaction?  On the flip side, what two corresponding amounts affect the lessor’s earnings? 

Q 15–6  What  discount  rate  does  the  lessor  use  in  determining  its  lease receivable and performance obligation using the performance obligation approach?  How is the rate determined? 

Q 15–7  What discount  rate does  the  lessee use  in determining  its  right‐of‐use asset and lease liability? 

Q 15–8  What  is  the  similarity between  recording a  lease by  the derecognition approach and recording the sale of merchandise on account?  

Q 15–9  What is a residual asset, and when should it be recorded? 

Q 15–10  Initial direct costs often are substantial. What are initial direct costs? 

Q 15–11  How do the lessee and lessor record initial direct costs? 

Q 15–12  A  lease that has a maximum possible  lease term (including any options 

42  SECTION 3  Financial Instruments and Liabilities 

to renew) of  twelve months or  less  is considered a “short‐term  lease.”  Both the lessee and the lessor have a lease‐by‐lease option to choose a short‐cut  approach  to  accounting  for  a  short‐term  lease.   How does  a lessee record a lease using the short‐cut approach?  

Q 15–13  How does a lessor record a lease using the short‐cut approach?  

Q 15–14  A 6‐year lease can be renewed for two additional 3‐year periods, and it also can be  terminated after only 3 years.     Management assesses  the probability of a 3‐year, 6‐year, 9‐year, and 12‐year lease term to be 20%, 20%, 25%,  and 35%,  respectively.   What  lease  term  should  the  lessee and lessor use in accounting for the lease? 

Q 15–15  A  lease  might  specify  that  lease  payments  may  be  increased  (or decreased)  at  some  future  time  during  the  lease  term  depending  on whether or not some specified event occurs such as revenues or profits exceeding some designated level. In such situations, what is the amount a lessee should use to measure its right‐of‐use asset and lease liability? 

Q 15–16  Occasionally, a lease agreement includes a guarantee by the lessee that the  lessor will  recover  a  specified  residual  value when  custody  of  the asset  reverts  back  to  the  lessor  at  the  end  of  the  lease  term.   Under what  circumstance  can  the  guaranteed  residual  value  influence  the amounts recorded by the  lessee and  lessor?   In that circumstance, how are the amounts affected? 

Q 15–17  What is a purchase option? How is a lease potentially affected by a purchase option? 

Q 15–18  In a statement of cash flows, we separate  inflows and outflows of cash into operating,  investing, and  financing activities.   How do  lessees and lessors  report  their  cash  flows  from  lease  transactions  in  their statements of cash flows? 

Q 15–19  What are the required lease disclosures for the lessor and lessee?  

Q 15–20  In  a  sale‐leaseback  transaction  the  owner  of  an  asset  sells  it  and immediately  leases  it back  from  the new owner. What discourages an agreement between  the  seller‐lessee and  the buyer‐lessor designed  to artificially increase the gain reported under the sale‐leaseback? 

 

BRIEF EXERCISES  

At the beginning of its fiscal year, Café Med leased restaurant space from Crescent Corporation under a nine‐year lease agreement. The contract calls for annual lease payments of $25,000 each at  the end of each year. The building was acquired by Crescent at a cost of $300,000 and was expected to have a useful  life of 25 years with no residual value.  The company seeks a 10% return on its lease investments.  What will be the effect of the lease on Café Med’s earnings for the first year (ignore taxes)? 

BE 15–1 Lessee; effect on earnings  ●  LO1  

CHAPTER 15  Leases                  43   In the situation described in BE 15‐1, what will be the balances in accounts related to the lease at the end of the first year for Café Med (ignore taxes)?   A lease agreement calls for annual lease payments of $26,269 over a six‐year lease term,  with  the  first  payment  at  January  1,  the  lease’s  commencement,  and subsequent payments at January 1 of the following five years. The  interest rate  is 5%. If the lessee’s fiscal year is the calendar year, what would be the amount of the lease liability that the lessee would report in its balance sheet at the end of the first year? What would be the interest payable?  

In the situation described in BE 15–3, what would be the pretax amounts related to the  lease that the  lessee would report  in  its  income statement for the year ended December 31?  In  the  situation  described  in  BE  15‐1,  what  will  be  the  effect  of  the  lease  on Crescent’s earnings for the first year (ignore taxes)?  In the situation described in BE 15‐1, what will be the balances in accounts related to the lease at the end of the first year for Crescent (ignore taxes)? 

 A lease agreement calls for quarterly lease payments of $5,376 over a 10‐year lease term, with the first payment at July 1, the lease’s inception. The interest rate is 8%. Both  the  fair  value  and  the  cost  of  the  asset  to  the  lessor  are  $150,000. What would be  the amount of  interest expense  the  lessee would record  in conjunction with  the  second quarterly payment at October 1? What would be  the amount of interest revenue the  lessor would record  in conjunction with the second quarterly payment at October 1?  

Manning Imports is contemplating an agreement to lease equipment to a customer for five years, the asset’s estimated useful life. Manning normally sells the asset for a cash price of $100,000. Assuming that 8%  is a reasonable rate of  interest, what must be the amount of quarterly lease payments (beginning at the commencement of the  lease)  in order for Manning to recover  its normal selling price as well as be compensated for financing the asset over the lease term?  In the situation described in BE 15–3, assume the asset being leased cost the lessor $125,000  to produce  and  that  the  company does not  retain  significant  risks  and benefits associated with the leased asset. Determine the price at which the lessor is “selling” the asset (present value of the lease payments). What would be the pretax amounts related to the  lease that the  lessor would report  in  its  income statement for the year ended December 31?  

BE 15–2 Lessee; effect on balance sheet ●  LO1  BE 15–3 Lessee; accrued interest; balance sheet effects ●  LO1 

BE 15–4 Lessee; accrued interest; income statement effects ●  LO1 

BE 15–5 Lessor; effect on earnings ●  LO2 

BE 15–6 Lessor; effect on balance sheet ●  LO2 

BE 15–7 Calculate interest ●  LO2 

BE 15–8 Lessor; calculate lease payments ●  LO2 

BE 15–9 Derecognition; income statement effects ●  LO3 

44  SECTION 3  Financial Instruments and Liabilities  Corinth Co.  leased equipment  to Athens Corporation  for an eight‐year period, at which  time  possession  of  the  leased  asset  will  revert  back  to  Corinth.  The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal  sales  price  is  $22.4 million.  The  present  value  of  the  lease  payments  for both  the  lessor  and  lessee  is $21 million. Corinth believes  it does not  retain  any significant risks or benefits associated with the equipment.   The first payment was made  at  the  commencement of  the  lease. What will be  the  amount Corinth will record as a residual asset at the commencement of the lease? Why?  King  Cones  leased  ice  cream  making  equipment  from  Ace  Leasing.  Ace  earns interest  under  such  arrangements  at  a  6%  annual  rate.    The  lease  term  is  eight months  with  monthly  payments  of  $10,000  at  the  end  of  each  month.  Ace purchased  the equipment having  an estimated useful  life of 4  years  at  a  cost of $300,000.    Both  the  lessee  and  the  lessor  elected  the  short‐term  lease  option.  Amortization  is  recorded at  the end of each month on a  straight‐line basis.   Ace depreciates assets monthly on a straight‐line basis. What  is the effect of the  lease on King Cones’ earnings during the eight‐month term, ignoring taxes?  In  the  situation  described  in  BE  15–11,  what  is  the  effect  of  the  lease  on  Ace Leasing’s earnings during the eight‐month term, ignoring taxes?  

 Culinary Creations leased kitchen equipment under a 5‐year  lease with  an option to renew for 3 years at the end of 5 years and an option to renew for an additional 3 years at the end of 8 years.  Culinary Creations determines the probability for the three possible  lease terms as: 40% for a 5‐year term, 25% for an 8‐year term, and 35%  for  an  11‐year  term.  What  is  the  length  of  the  lease  term  that  Culinary Creations should assume in recording the transactions related to the lease? 

 On  January 1, Garcia  Supply  leased a  truck  for a  four‐year period, at which  time possession of  the  truck will  revert back  to  the  lessor. Annual  lease payments are $10,000  due  on December  31  of  each  year,  calculated  by  the  lessor  using  a  5% discount  rate.    If Garcia’s  revenues  exceed  a  specified  amount  during  the  lease term,  James will pay an additional $4,000  lease payment at  the end of  the  lease.  James estimates a 25% probability of meeting the target revenue amount.  What is the  amount  to  be  added  to  the  right‐of‐use  asset  and  lease  liability  under  the contingent rent agreement?  On  January 1, Garcia  Supply  leased a  truck  for a  four‐year period, at which  time possession of  the  truck will  revert back  to  the  lessor. Annual  lease payments are $10,000  due  on December  31  of  each  year,  calculated  by  the  lessor  using  a  5% discount rate.  Negotiations led to Garcia guaranteeing a $36,000 residual value at the end of the lease term.  James estimates that the residual value after four years has a 25% probability of being $32,000, a 50% probability of being $36,000 and a 25% probability of being $40,000.  What is the amount to be added to the right‐of‐use asset and lease liability under the residual value guarantee? 

BE 15–10 Residual asset ●  LO4 

BE 15–11 Short‐term lease; lessee ●  LO6 

BE 15–12 Short‐term lease; lessor ●  LO6 

BE 15–13 Renewal options ●  LO7 

BE 15–14 Uncertain lease payments ●  LO8 

BE 15–15 Guaranteed residual value ●  LO9 

CHAPTER 15  Leases                  45   As  a way  to  obtain  cash  for  its  operations,  Parsons  Paints  sold  equipment  to  a finance  company  for  $154,000  and  immediately  leased  the  equipment  back  for payments whose  present  value  is  $154,000.    The  equipment  has  a  fair  value  of $130,000.  Its  cost  and  its  carrying  amount  were  $124,000.  Its  useful  life  is estimated to be 15 years. What is the amount of the gain that Parsons will include in its income statement in the year of the sale‐leaseback?   EXERCISES  (Note: Exercises 15-1 through 15-3 and 15-12 through 15-16 are variations of the same basic lease situation.) Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term.

Related Information: 

Lease term   2 years (8 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required: Prepare a lease amortization schedule and appropriate entries for Manufacturers Southern from the commencement of the lease through January 1, 2012. Amortization is recorded at the end of each quarter on a straight-line basis. December 31 is the fiscal year end for each company.

BE 15–16 Sale‐leaseback ●  LO11  

E 15–1 Lessee ● LO1 

46  SECTION 3  Financial Instruments and Liabilities  Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term. Amortization is recorded at the end of each quarter on a straight-line basis. Edison depreciates assets annually on a straight-line basis.

Related Information: 

Lease term   2 years (8 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required: Prepare a lease amortization schedule and appropriate entries for Edison Leasing from the commencement of the lease through January 1, 2012. Edison’s fiscal year ends December 31. Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. International Machines determined that it will not retain exposure to significant risks or benefits associated with the equipment during or after the five-year lease term. International Machines manufactured the equipment at a cost of $200,000 and lists a cash selling price of 250,177. International Machines depreciates assets annually on a straight-line basis.

Related Information:

Lease term 5 years (20 quarterly periods) Quarterly lease payments $15,000 at the beginning of each

period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)

Required: 1. Show how International Machines determined the $15,000 quarterly lease

payments.

2. Prepare appropriate entries for International Machines to record the lease at its commencement, January 1, 2011, and the second lease payment on April 1, 2011.

E 15–2 Lessor; retains exposure to significant risks or benefits ● LO2 

E 15–3 Lessor; no exposure to significant risks or benefits ● LO3 

CHAPTER 15  Leases                  47 

Each of the four independent situations below describes a lease in which annual lease payments are payable at the beginning of each year. Determine the annual lease payments for each:

Situation 1 2 3 4

Lease term (years) 4 7 5 8 Lessor’s rate of return 10% 11% 9% 12% Fair value of leased asset $50,000 $350,000 $75,000 $465,000 Residual value 0 $ 50,000 $ 7,000 $ 45,000

For each of the three independent situations below determine the amount of the annual lease payments. Each describes a lease in which annual lease payments are payable at the beginning of each year.

Situation 1 2 3

Lease term (years) 5 5 3 Lessor’s rate of return 12% 11% 9% Fair value of leased asset $60,000 $420,000 $185,000 Lessor’s cost of leased asset $50,000 $420,000 $145,000 Residual value at end of lease term $10,000 $ 50,000 $ 22,000

At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments.   Required: 1. What pretax amounts related to the lease would LTT report in its balance sheet at

December 31, 2011? 2. What pretax amounts related to the lease would LTT report in its income

statement for the year ended December 31, 2011? At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments.  Required: 1. What pretax amounts related to the lease would Lakeside report in its balance

sheet at December 31, 2011? 2. What pretax amounts related to the lease would Lakeside report in its income

statement for the year ended December 31, 2011?

E 15–4 Calculation of annual lease payments; residual value ● LO2 

E 15–5 Calculation of annual lease payments; residual value ● LO2 

E 15–6 Lessee; effect on financial statements ● LO1 

E 15–7 Lessor; effect on financial statements ● LO2 

48  SECTION 3  Financial Instruments and Liabilities  American Food Services, Inc. leased a packaging machine from Barton and Barton Corporation. Barton and Barton completed construction of the machine on January 1, 2011. The lease agreement for the $4 million (fair value and present value of the lease payments) machine specified four equal payments at the end of each year. The useful life of the machine was expected to be four years with no residual value. Barton and Barton’s implicit interest rate was 10% (also American Food Services’ incremental borrowing rate).

Required: 1. Prepare the journal entry for American Food Services at the commencement of the

lease on January 1, 2011.

2. Prepare an amortization schedule for the four-year term of the lease.

3. Prepare the journal entry for the first lease payment on December 31, 2011.

4. Prepare the appropriate journal entry(s) on December 31, 2013. (Note: Exercises 15-9 through 15-11 are variations of the same lease situation.) On June 30, 2011, Papa Phil, Inc. leased a pizza maker from IC Leasing Corporation. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate IC used to calculate lease payment amounts. Amortization is recorded on a straight-line basis at the end of each fiscal year. The fair value of the warehouse is $3 million.

Required: 1. Determine the present value of the lease payments at June 30, 2011 (to the nearest

$000) that Papa Phil uses to record the right-of-use asset and lease liability. 2. What pretax amounts related to the lease would Papa Phil report in its balance

sheet at December 31, 2011? 3. What pretax amounts related to the lease would Papa Phil report in its income

statement for the year ended December 31, 2011? On June 30, 2011, Papa Phil, Inc. leased a pizza maker from IC Leasing Corporation. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate IC used to calculate lease payment amounts. IC purchased the machine from Pizza, Inc. at a cost of $3 million. IC determined that it will retain exposure to significant risks or benefits associated with the machine after the expected lease term. Amortization and depreciation are recorded on a straight-line basis at the end of each fiscal year. Required: 1. What pretax amounts related to the lease would IC report in its balance sheet at

December 31, 2011?

2. What pretax amounts related to the lease would IC report in its income statement for the year ended December 31, 2011?

E 15–8 Lessee ● LO1 

E 15–9 Lessee; balance sheet and income statement effects ● LO1 

E 15–10 Lessor; balance sheet and income statement effects; retains exposure to significant risks or benefits ● LO2 

CHAPTER 15  Leases                  49  On June 30, 2011, Papa Phil, Inc. leased a pizza maker from Pizza, Inc. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate Pizza, Inc. used to calculate lease payment amounts. Pizza, Inc. manufactured the machine at a cost of $2.5 million. Its fair value is $3,000,000. Pizza, Inc. determined that it will not retain exposure to significant risks or benefits associated with the equipment after the expected lease term. Required: 1. Determine the price at which Pizza, Inc. is “selling” the warehouse (present value

of the lease payments) at June 30, 2011 (to the nearest $000).

2. What pretax amounts related to the lease would Pizza, Inc. report in its balance sheet at December 31, 2011?

3. What pretax amounts related to the lease would Pizza, Inc. report in its income statement for the year ended December 31, 2011?

(Note: Exercises 15-1 through 15-3 and 15-12 through 15-16 are variations of the same basic lease situation.) Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. International Machines determined that it will not retain exposure to significant risks or benefits associated with the equipment during or after the five-year lease term. International Machines manufactured the equipment at a cost of $200,000. It has a fair value of 260,000. International Machines depreciates assets annually on a straight-line basis.

Related Information: 

Lease term   5 years (20 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required:  Prepare appropriate entries for International Machines to record the lease at its

commencement, January 1, 2011, and the second lease payment on April 1, 2011.

E 15–11 Lessor; balance sheet and income statement effects; retains no exposure to significant risks or benefits ● LO3 

E 15–12 Lessor; no exposure to significant risks or benefits; partial transfer ● LO4 

50  SECTION 3  Financial Instruments and Liabilities  Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. Title to the asset transfers to Manufacturers Southern at the end of the lease term causing International Machines to determine that control of the asset and risks and returns of ownership will be transferred. International Machines manufactured the equipment at a cost of $200,000 and lists a cash selling price of 250,177. Both companies depreciate assets annually.

Related Information: 

Lease term   5 years (20 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

 Required: 1. Prepare appropriate entries for Manufacturers Southern to record the arrangement

at its commencement, January 1, 2011, and the second payment on April 1, 2011. 2. Prepare appropriate entries for International Machines to record the arrangement

at its commencement, January 1, 2011, and the second payment on April 1, 2011. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $2,000. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term.

Related Information: 

Lease term   2 years (8 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through April 1, 2011. Amortization is recorded at the end of each quarter on a straight-line basis. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $2,000. Edison purchased the equipment from International Machines at a cost of $250,177. Both the lessee and the lessor elected the short-term lease option. Amortization is recorded at the end of each quarter on a straight-line basis. Edison depreciates assets annually on a straight-line basis.

E 15–13 Lessee and lessor; control remains with lessor ● LO3 

E 15–14 Lessee; initial direct costs ● LO5 

E 15–15 Lessee; short-term lease: initial direct costs ● LO6 

CHAPTER 15  Leases                  51 

Related Information: 

Lease term   1 year (4 quarterly periods)  Quarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required: 1. Prepare appropriate entries for Manufacturers Southern from the commencement

of the lease through December 31, 2011. 2. Prepare appropriate entries for Edison Leasing from the commencement of the

lease through December 31, 2011. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Manufacturers Southern has the option to renew the lease at the end of two years for an additional two years and it is more likely than not that the renewal option will be exercised. Edison purchased the equipment from International Machines at a cost of $250,177.

Related Information: Lease term   2 years (8 quarterly periods) Lease renewal option for an additional 2 yearsQuarterly lease payments  $15,000 at the beginning of each period Economic life of asset  5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate) 

Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through April 1, 2011. Amortization is recorded at the end of each quarter on a straight-line basis.

Callahan Distributors leased office space from Grover Developers under a 15-year lease with an option to renew for 5 years at the end of 15 years and an option to renew for an additional 5 years at the end of 20 years. Callahan determines the probability for the three possible lease terms to be: 30% for a 15-year term, 40% for a 20-year term, and 40% for a 25-year term. Annual lease payments are $130,000 payable at the beginning of each year. Callahan is aware that the interest rate Grover charges in the lease agreement is 6%. Required: Show the appropriate entries for both Callahan Distributors and Grover Developers on January 1, 2011, to record the lease.

E 15–16 Lessee; renewal option ● LO7 

E 15–17 Renewal options ● LO7 

52  SECTION 3  Financial Instruments and Liabilities  LCD Financial leased a machine it purchased for $84,000 on December 31, 2010 to Brazzel Flooring. The four-year lease term specified annual payments of $8,000 beginning December 31, 2011 and each December 31 through 2014. The lease commenced on January 1, 2011. The machine’s estimated useful life is 12 years with no estimated residual value. LCD earns interest under the lease at a 10% annual rate.

Brazzel had the option to renew the lease after four years for an additional two years. At the commencement of the lease, both firms estimated that it was more likely than not that the lease term would not be renewed. LCD decided it retained exposure to significant risks or benefits associated with the machine after the lease term. Both firms use straight line amortization and depreciation. Required: 1. Prepare the appropriate entries for both LCD and Brazzel from the

commencement of the lease through the end of 2011. 2. At the beginning of 2012, both firms reassessed the lease term and estimated that

the option will be exercised and the lease will be renewed at the end of four years (five more years remaining). Prepare the appropriate entries for both companies at January 1, 2012, to reflect the change in the lease term.

PH Printers leased a machine from CSW Corporation. The five-year lease term specified annual payments of $5,000 beginning December 31, 2011 and each December 31 through 2015. The lease commenced on January 1, 2011. The machine’s estimated useful life is 16 years with no estimated residual value. The interest rate charged by the lessor is 8%. PH had the option to terminate the lease after three years. At the commencement of the lease, PH estimated that it was more likely than not that the lease term would be terminated after three years. PH uses straight line amortization. Required: 1. Prepare the appropriate entries for both LCD and Brazzel from the

commencement of the lease through the end of 2011. 2. At the beginning of 2012, PH reassessed the lease term and estimated that the

option will not be exercised and the lease will continue for the full five years. Prepare the appropriate entries for PH at January 1, 2012, to reflect the change in the lease term.

3. Prepare the appropriate entries pertaining to the lease for PH at December 31, 2012.

E15–18 Change in lease term; lessee and lessor ● LO7 

E15–19 Change in lease term; lessee and lessor ● LO7 

CHAPTER 15  Leases                  53  Irana Imports leased equipment under a 5-year lease. The following relate to the lease agreement:

a. The lease term commenced January 1, 2011.

b. Annual lease payments at the end of each year were $15,000. If the lessee’s revenues exceed a prespecified amount in the third year, the payments the last two years will be $20,000. Irana considers the likelihood of that possibility to be 25%.

c. The lessor’s interest rate is 8%.

Required: Prepare the appropriate entry for Irana Imports at the commencement of the lease on January 1, 2011. ABC Well Supply leased equipment under a 4-year lease. The following relate to the lease agreement:

a. The lease term commenced January 1, 2011.

b. Annual lease payments at the end of each year were $10,000 plus 1% of ABC’s net sales. ABC estimates its net sales to be $200,000 each year, but with a 30% probability that they will be 10% higher and a 20% probability they will be 10% less.

c. The lessor’s interest rate is 8%.

Required: Prepare the appropriate entry for ABC Well Supply at the commencement of the lease on January 1, 2011. On January 1, 2011, Pastner leased a machine with a useful life of six years for a five-year period ending December 31, 2015, at which time possession of the leased asset will revert back to the lessor. The residual value at December 31, 2015, is expected to be $50,000 with a 75% probability, although there is a 25% probability it will be $60,000, but negotiations led to Pastner guaranteeing a $60,000 residual value. Pastner is aware that the lessor used a 4% interest rate when calculating lease payments of $100,000 each year, with the first payment being made on December 31, 2011. Pastner uses straight-line amortization. Required: 1. Show the appropriate entries for Pastner on January 1, 2011, to record the lease.

2. Show all appropriate entries for Pastner on December 31, 2011, related to the lease.

E 15–20 Uncertain lease payments ● LO8 

E 15–21 Uncertain lease payments ● LO8 

E 15–22 Lessee; lessee-guaranteed residual value ● LO9 

54  SECTION 3  Financial Instruments and Liabilities 

Listed below are several terms and phrases associated with leases. Pair each item from List A with the item from List B (by letter) that is most appropriately associated with it. List A List B ___ 1. Effective rate times balance. a. Shortens the lease term. ___ 2. Residual asset. b. Expected outcome. ___ 3. Guaranteed residual value exceeds c. Disclosure note. estimated residual value. d. As obligation is satisfied. ___ 4. Lease term is twelve months e. Depreciable assets. or less. f. More likely than not criterion.

___ 5. Amount of lease payments is g. Lessor records a liability. uncertain. h. Not a lease. ___ 6. Initial direct costs. i. No interest. ___ 7. Lease income. j. Interest expense. ___ 8. Derecognition approach. k. Present value less than fair value. ___ 9. Leasehold improvements. l. No lessor receivable. ___ 10. Length of lease term is m. Lessor does not retain risks or uncertain. benefits. ___ 11. Performance obligation approach. n. Increases right-of-use asset. ___ 12. A purchase option is more likely o. Increases lease payable and lease than not. receivable. ___ 13. Title transfers to lessee. ___ 14. Lease payment at commencement of lease. ___ 15. Minimum future payments for each of the five succeeding fiscal years. To raise operating funds, Signal Aviation sold an airplane hangar on January 1, 2011, to a finance company for $770,000. Signal immediately leased the hangar back for a 13-year period, at which time ownership of the hangar will transfer to Signal. The hangar has a fair value of $770,000. Its cost and its carrying amount were $620,000. Its useful life is estimated to be 15 years. The lease requires Signal to make payments of $102,771 to the finance company each January 1. Signal amortizes and depreciates assets on a straight-line basis. The lease has an implicit rate of 11%. Required: Prepare the appropriate entries for Signal on:

1. January 1, 2011, to record the sale-leaseback (round present value to nearest thousand).

2. December 31, 2011, to record necessary adjustments. 3. Assume the hangar has a fair value of $650,000 and prepare the appropriate

entries for Signal on January 1, 2011, and December 31.

E 15–23 Concepts; terminology ● LO1 through LO9 

E 15–24 Sale-leaseback ● LO11  

CHAPTER 15  Leases                  55  PROBLEMS  The Antonescu Sporting Goods leased equipment from Chapman Industries on January 1, 2011. Clowers Industries had manufactured the equipment at a cost of $800,000. Its cash selling price and fair value is $1,000,000.

Other information: Lease term 4 years Annual payments $279,556 beginning Jan.1, 2011, and at Dec.

31, 2011, 2012, and 2013 Life of asset 4 years Rate the lessor charges 8%

Required: 1. Prepare the appropriate entries for Antonescu Sporting Goods (Lessee) on January 1,

2011 and December 31, 2011. Round to nearest dollar. 2. Prepare the appropriate entries for Chapman Industries (Lessor) on January 1, 2011 and

December 31, 2011. Assume that Chapman determined that it does retain exposure to significant risks or benefits associated with the equipment. Round to nearest dollar.

3. Prepare the appropriate entries for Chapman Industries (Lessor) on January 1, 2011 and December 31, 2011. Assume that Chapman determined that it does not retain exposure to significant risks or benefits associated with the equipment. Round to nearest dollar.

At the beginning of 2011, VHF Industries acquired the use of a machine with a useful life of four years and a fair value of $6,074,700 by signing a four-year lease. The lease is payable in four annual payments of $2 million at the end of each year. Required: 1. What is the effective rate of interest the lessor is charging the lessee (implicit rate)

in the agreement?

2. Prepare the lessee’s journal entry at the commencement of the lease.

3. Prepare the journal entry to record the first lease payment at December 31, 2011.

4. Prepare the appropriate journal entry(s) at December 31, 2012.

5. Suppose the fair value of the machine and the lessor’s implicit rate were unknown at the time of the lease, but that the lessee’s incremental borrowing rate of interest for notes of similar risk was 11%. Prepare the lessee’s entry at the commencement of the lease.

(Note: You may wish to compare your solution to Problem 15–2 with that of Problem 14–12, which deals with a parallel situation in which the machine was acquired with an installment note.)

P 15–1 Lessee and lessor; lessor does/does not retain risks and benefits associated with the leased asset ● LO1  LO2 

P 15–2 Lessee; interest rate charged by lessor ● LO1

56  SECTION 3  Financial Instruments and Liabilities  Terms of a lease agreement and related facts were:

a. Leased asset had a retail cash selling price of $100,000. Its useful life was six years with no residual value (straight-line depreciation).

b. Annual lease payments at the beginning of each year were $20,873, beginning January 1. The lease term is six years.

c. Lessor’s interest rate when calculating annual lease payments was 9%. d. Costs of negotiating and consummating the completed lease transaction incurred

by the lessor were $2,062. Required: Prepare the appropriate entries for the lessor to record the lease, the initial payment at its commencement, and at the December 31 fiscal year-end under each of the following two independent assumptions:

1. The lessor recently paid $100,000 to acquire the asset. Also assume the lessor retains significant risks and benefits associated with the leased asset.

2. The lessor recently paid $85,000 to acquire the asset. Also assume the lessor does not retain significant risks and benefits associated with the leased asset.

Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians’ Leasing purchased a lithotripter from Rand for $3,000,000 and leased it to Mid-South Urologists Group on January 1, 2011.

Lease Description:  

Quarterly lease payments   $130,516—beginning of each period  Lease term   5 years (20 quarters), renewable for 

another 5 years  Economic life of lithotripter  10 years  Implicit interest rate and lessee’s incremental borrowing 

rate  12% 

Fair value of asset   $3,000,000  

Physicians’ Leasing will retain ownership of the lithotripter at the end of the lease. .

Required: 1. Prepare appropriate entries for Mid-South Urologists Group from the

commencement of the lease through the second lease payment on April 1, 2011. Depreciation or amortization is recorded at the end of each quarter. The company considers it more likely than not that the lease will not be renewed.

2. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011. Depreciation or amortization is recorded at the end of each quarter. The company considers it more likely than not that the lease will not be renewed.

3. Assume that Physicians’ Leasing (a) considers it more likely than not that the lease will be renewed, and (b) believes the company will retain significant risks or benefits associated with the lithotripter during the expected lease term. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011.

4. Assume that Physicians’ Leasing (a) considers it extremely likely that the lease will be renewed, and (b) the company will not retain significant risks or benefits

P 15–3 Lessor’s initial direct costs; performance obligation and derecognition approaches ●  LO2  LO3

P 15–4 Lessee and lessor; renewal option ●  LO7

CHAPTER 15  Leases                  57 

associated with the lithotripter during or after the expected lease term. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011.

Universal Leasing leases electronic equipment to a variety of businesses. The company’s primary service is providing alternate financing by acquiring equipment and leasing it to customers under long-term direct financing leases. Universal earns interest under these arrangements at a 10% annual rate.

The company leased an electronic typesetting machine it purchased on December 31, 2010 for $90,000 to a local publisher, Desktop Inc. The six-year lease term commenced January 1, 2011, and the lease contract specified annual payments of $8,000 beginning December 31, 2011 and each December 31 through 2016. The machine’s estimated useful life is 15 years with no estimated residual value.

The publisher had the option to terminate the lease after four years. At the commencement of the lease, Universal estimated that it was more likely than not that the lease term would not be terminated and that it retains exposure to significant risks or benefits associated with the machine after the expected lease term. Universal uses straight line amortization and depreciation.

Required: 1. Prepare the appropriate entries for Universal Leasing from the commencement of

the lease through the end of 2011. 2. At the beginning of 2012, Universal reassessed the lease term and estimated that

the option will be exercised and the lease will terminate at the end of four years (three years remaining). Prepare the appropriate entries for Universal Leasing at January 1, 2012, to reflect the change in the lease term.

3. Prepare the appropriate entries pertaining to the lease for Universal Leasing at December 31, 2012.

4. Determine the balances in the following accounts pertaining to the lease at December 31, 2011: Lease receivable, performance obligation, asset for lease, accumulated depreciation.

5. Determine the amounts reported in income pertaining to the lease during 2011 and during 2012 (ignore taxes).

The following relate to a lease agreement:

a. The lease term is 5 years, beginning January 1, 2011. b. The leased asset cost the lessor $800,000 and had an estimated useful life of seven

years with no residual value. c. Annual lease payments at the end of each year were $150,000. If the lessee’s

revenues exceed a prespecified amount in the third year, the payments the last two years will be $200,000. The lessee considers the likelihood of that possibility to be 70%.

d. The lessor’s interest rate is 8%.  Required: Prepare the appropriate entries for the lessee from the commencement of the lease through the end of the lease term assuming the target revenues are achieved in the third year.

P 15–5 Change in lease term; lessor ●  LO7

P 15–6 Uncertain lease payments ●  LO8

58  SECTION 3  Financial Instruments and Liabilities  On January 1, 2011, Allied Industries leased a high-performance conveyer to Karrier Company for a four-year period ending December 31, 2014, at which time possession of the leased asset will revert back to Allied. The equipment cost Allied $1,072,000 and has an expected useful life of six years. Allied feels there is a 40% chance that the residual value at December 31, 2014, will be $330,000 but that there is a 30% chance it will be $220,000 and a 30% chance it will be $440,000. Negotiations led to the lessee guaranteeing a $340,000 residual value.

Equal payments under the lease are $200,000 and are due on December 31 of each year with the first payment being made on December 31, 2011. Karrier is aware that Allied used a 5% interest rate when calculating lease payments. Both companies use straight-line amortization and depreciation. Required: 1. Show the appropriate entries for both Karrier and Allied on January 1, 2011, to

record the lease. 2. Show all appropriate entries for both Karrier and Allied on December 31, 2011,

related to the lease and the leased asset. On December 31, 2011, Rhone-Metro Industries leased equipment to Western Soya Co. for a four-year period ending December 31, 2015, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost Rhone-Metro $403,326 and has an expected useful life of six years. Its normal sales price is $403,326. The residual value at December 31, 2015, is estimated to be with a 50% probability $50,000 although there is a 25% chance it will be $40,000 and a 25% chance it will be $80,000. Negotiations led to the lessee guaranteeing an $80,000 residual value.

Equal payments under the lease are $100,000 and are due on December 31 of each year. The first payment was made on December 31, 2011. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line amortization/depreciation. Required: 1. Show how Rhone-Metro calculated the $100,000 annual lease payments. 2. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on

December 31, 2011. 3. Prepare an amortization schedule(s) describing the pattern of interest over the

lease term for the lessee and the lessor. 4. Prepare all appropriate entries for both Western Soya and Rhone-Metro on

December 31, 2012 (the second lease payment and depreciation). 5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on

December 31, 2015 assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $70,000.

P 15–7 Lessee and lessor; lessee guaranteed residual value ●  LO9

P 15–8 Lessee and lessor; lessee guaranteed residual value ●  LO9 

CHAPTER 15  Leases                  59  BioGen Pharmaceuticals leased equipment under a 4-year lease. The following relate to the lease agreement:

a. The lease term commenced January 1, 2011.

b. Annual lease payments at the end of each year were $30,000 plus 1% of BioGen’s revenues. BioGen estimates its revenues to be $600,000 each year, but with a 30% probability that they will be $660,000 and a 20% probability they will be $540,000.

c. The lessor’s interest rate is 8%.

Required: 1. Show the appropriate entries for BioGen on January 1, 2011, to record the lease.

2. Show all appropriate entries for BioGen on December 31, 2011, related to the lease assuming revenues during 2011 are $630,000 and that Bio Gen does not revise its projection of future revenues.

3. Show all appropriate entries for BioGen on December 31, 2011, related to the lease assuming revenues during 2011 are $630,000 prompting Bio Gen to revise its projection of future revenues to $600,000 each year with a 50% probability, and $660,000 with a 50% probability.

On January 1, 2011, Shirt Barn leased a new store location. The lease specified a three-year term with three optional renewal periods of two years each. At the lease’s inception, Shirt Barn estimated that the probabilities for the four possible lease terms were: 40% for a 3-year term, 20% for a 5-year term, 20% for a 7-year term, and 20% for a 9-year term.

Annual year-end base lease payments are $100,000 for the first three years and $120,000 during any optional renewal periods. In addition, Shirt Barn will make contingent payments equal to 2% of net sales each year. The company estimates that net sales will be $1,000,000 the first year of the lease with (A) a 50% likelihood of constant net sales, (B) a 30% likelihood of a 5% increase each year, and (C) a 20% chance that net sales will decline by 5% a year.

Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $12,000. Shirt Barn’s incremental borrowing rate is 8% and is unaware of the rate the lessor charges in its lease agreements.  Required: 1. Determine the appropriate lease term.

2. Determine the amount Shirt Barn should record as its lease liability.

3. Prepare all appropriate entries for Shirt Barn for 2011 assuming net sales that year were $1,000,000 as projected.

4. Prepare all appropriate entries for Shirt Barn for 2011 assuming net sales that year were $1,100,000 and estimates for future years were unchanged.

P 15–9 Uncertain lease payments ●  LO8

P 15–10 Uncertain lease term; contingent lease payments; initial direct costs ●  LO5  LO7  LO8 

60  SECTION 3  Financial Instruments and Liabilities  BROADEN YOUR PERSPECTIVE  Apply your critical‐thinking ability to the knowledge you’ve gained. These cases will provide you an opportunity to develop your research, analysis, judgment, and communication skills. You also will work with other students, integrate what you’ve learned, apply it in real world situations, and consider  its  global  and  ethical  ramifications.  This  practice  will  broaden  your  knowledge  and further develop your decision‐making abilities.  “I don’t see that in my intermediate accounting text I saved from college,” you explain to another member of the accounting division of Dowell Chemical Corporation. “This will take some research.” Your comments pertain to the appropriate accounting treatment of a proposed sublease of warehouses Dowell has used for product storage.

Dowell leased the warehouses one year ago on December 31. The five-year lease agreement called for Dowell to make quarterly lease payments of $2,398,303, payable each December 31, March 31, June 30, and September 30, with the first payment at the lease’s inception. Dowell had recorded the right-of-use asset and liability at $40 million, the present value of the lease payments at 8%. Dowell records amortization on a straight-line basis at the end of each fiscal year.

Today, James Williams, Dowell’s controller, explained a proposal to sublease the underused warehouses to American Tankers, Inc. for the remaining four years of the lease term. “So now we will be both a lessor and a lessee,” he had said. “Check on how we would need to account for this and get back to me.” Required: 

1. After the first full year under the warehouse lease, what is the balance in Dowell’s lease liability? An amortization schedule will be helpful in determining this amount.

2. After the first full year under the warehouse lease, what is the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses?

3. Obtain the relevant authoritative literature on reporting a sublease by lessees using the FASB’s Codification Research System. You might gain access from the FASB website (www.fasb.org), from your school library, or some other source. Determine the appropriate reporting treatment for the proposed sublease. What is the specific Codification citation that Dowell would rely on for the appropriate reporting?

4. Assuming the sublease is commenced after one full year, how would Dowell report the right-of-use asset, lease liability, lease receivable, and performance obligation in connection with the sublease?

Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year lease on January 1, 2011. Information concerning the lease and the vans follows:

a. Equal annual lease payments of $300,000 are due on January 1, 2011, and thereafter on December 31 each year. The first payment was made January 1, 2011. Interstate’s implicit interest rate is 10% and known by VIP.

b. VIP estimates the fair value of the vans to be $1,100,000. Interstate’s cost was $850,000.

c. VIP’s incremental borrowing rate is 11%. d. Interstate will not retain significant risks or benefits of ownership.

Your instructor will divide the class into two to six groups depending on the size of the

class. The mission of your group is to assess the proper recording and reporting of the lease described.

Research Case 15‐1 FASB codification; locate and extract relevant information and authoritative support for a financial reporting issue; sublease of a leased asset  ● LO1  LO10  (insert codification icon)

Communication Case 15‐2 Lessee accounting; partial transfer  ● LO1 LO3 LO4  

CHAPTER 15  Leases                  61  Required: 1. Each group member should deliberate the situation independently and draft a tentative

argument prior to the class session for which the case is assigned. 2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom.

During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.

3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group’s solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation. Specifically, you should address: a. Identify potential advantages to VIP of leasing the vans rather than purchasing them. b. How should the lease be recorded by VIP? by Interstate? c. Regardless of your response to previous requirements, suppose VIP recorded the

lease on January 1, 2011, in the amount of $1,100,000. What would be the appropriate journal entries related to the lease for the second lease payment on December 31, 2011?

American Movieplex, a large movie theater chain, leases most of its theater facilities. Each lease has multiple renewal options. The question being discussed over breakfast on Wednesday morning was the length of lease term for new lease agreements. The company controller, Sarah Keene, was surprised by the suggestion of Larry Person, her new assistant.

Keene: Why 8 years? We’ve almost always renewed leases for total lease terms of much longer.

Person: I noticed that in my review of back records. But during our expansion to the Midwest, we don’t need lease liabilities and expenses to be any higher than necessary.

Keene: But isn’t that a pretty conservative estimate of these leases; actual lives? Trade publications show an average lease term more in keeping with our historical average of 12 years.

Required: 

1. How would decreasing the lease term affect American Movieplex’s income and liabilities?

2. Does reducing the estimate pose an ethical dilemma? 3. Who would be affected if Person’s suggestion is followed?

Ethics Case 15‐3 Renewal options  ● LO 7 

62  SECTION 3  Financial Instruments and Liabilities  Wal-Mart Stores, Inc., is the world’s largest retailer. A large portion of the premises that the company occupies are leased. Its financial statements and disclosure notes revealed the following information: Balance Sheet 

($ in millions)  

2009 2008 

Assets Property: Property under lease $5,341 $5,736 Less: Accumulated amortization (2,544) (2,594)

Liabilities Current liabilities: Obligations under leases due within one year 315 316 Long-term debt: Long-term obligations under leases 3,200 3,603

Required: 

1. Discuss some possible reasons why Wal-Mart leases rather than purchases most of its premises.

2. The net asset “property under lease” has a 2009 balance of $2,797 million ($5,341 − 2,544). Liabilities for leases total $3,515 ($315 + 3,200). Why do the asset and liability amounts differ?

3. Prepare a 2009 summary entry to record Wal-Mart’s lease payments, which were $603 million.

4. What is the approximate average interest rate on Wal-Mart’s leases? (Hint: See Req. 3) Note: This case is modified to assume that Wal-Mart’s leases in 2008-2009 were recorded

under the right-of-use model with came into being at a later time. Concepts involved are not affected.

General Tools is seeking ways to maintain and improve cash balances. As company controller, you have proposed the sale and leaseback of much of the company’s equipment. As seller-lessee, General Tools would retain the right to essentially all of the remaining use of the equipment. The term of the lease would be six years. A gain would result on the sale portion of the transaction.

You previously convinced your CFO of the cash flow benefits of the arrangement, but now he doesn’t understand the way you will account for the transaction. “I really am counting on that gain to bolster this period’s earnings. Why can’t we simply sell for more than it’s worth and compensate the other guy with higher lease payments?” he wondered. “Put it in a memo, will you? I’m having trouble following what you’re saying to me.” Required: 

Write a memo to your CFO. Include discussion of each of these points: 1. The motivation for sale-leasebacks. 2. Why the scheme to bolster the reported gain will not work.

Real Word Case 15‐4 Lease concepts; Wal‐Mart  ● LO1       

Communication Case 15‐5 Grow the gain?  ● LO 11