PV ComputationsClassification of Leases

Acct 414 – Fall 2008 – Prof. Teresa Gordon

1. Inception date: 1/1/122. Lessor: Troy Tractors

Inc.3. Fair value of combine

at 1/1/02: $50,0004. Cost to manufacture

combine: $40,0005. Estimated fair value at

end of lease is $10,0006. Fixed non-cancelable

lease term: 5 years.

7. First payment due on 12/31/12

8. Lessee: Farview Farms9. Incremental borrowing

rate (lessee): 12%10.Implicit interest rate

(lessor’s desired rate of return): 12%

11.Option to buy at end of lease term for $5,000

12.Estimated useful life of combine: 8 years

1e

Note that the last payment willinclude the $5,000 BPO

1e

$50,000 * 12%

$13,083 - $6,000

$50,000 - $7,083

1e

An ordinary annuity situation – the first line includes interest

1e

1. Inception date: 1/1/12

2. Lessor: Troy Tractors Inc.

3. Fair value of combine at 1/1/12: $50,000

4. Estimated fair value at end of lease is $10,000

5. First payment due on 1/1/12

6. Lessee: Farview Farms

7. Fixed non-cancelable lease term: 6 years.

8. Option to buy at end of lease term for $2,000

9. Estimated useful life of combine: 8 years

10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12%

11. The cost to manufacture the tractor is $40,000.

1f

What amount should the payment be given that the lessor requires a 12% return?

1. Inception date: 1/1/122. Lessor: Troy Tractors

Inc.3. Fair value of combine at

1/1/12: $50,0004. Estimated fair value at

end of lease is $10,0005. First payment due on

1/1/126. Lessee: Farview Farms7. Fixed non-cancelable

lease term: 6 years

8. Option to buy at end of lease term for $2,000

9. Estimated useful life of combine: 8 years

10. Desired rate of return for lessor and incremental borrowing rate for lessee: 12%

11. The cost to manufacture the tractor is $40,000.

12. Payment = 10,638

Now, classify the lease

1f

Note that the first payment is ALL principalsince no interest has yet been incurred

39,362 * 12%

10,638 - 4,723

39,362 - 5,915

This is an annuity due situation – the first payment is 100% principal.

1f

Note that there is interest on the BPO

This is an annuity due situation – the first payment is 100% principal.

1f

IFRS vs. US GAAPIAS 17 vs. FAS 13 as amended many times

But there’s more!

Note that IFRS has no “bright

line” rules

Leased assets are of a specialized nature and are only usable by the lessee unless substantial costs are incurred to modify (nothing comparable in US GAAP)

Upon early termination of lease, lessee is responsible for lessor’s losses

Any gains & losses due to fluctuations in fair value of leased asset are attributed to the lessee

Lessee has option to renew for below market cost

IFRS US GAAP

For Lessor Operating lease Operating lease

Finance lease Direct Financing Lease

Finance lease Sales-type leaseFinance lease Leveraged lease

For Lessee Operating lease Operating lease

Finance lease Capital lease

1. Inception of the lease: January 1, 2012

2. Term: 3 years 3. Implicit interest rate

(known to lessee) 10% 4. Fair value of asset

$100,000 5. Incremental

borrowing rate: 12% 6. No collection or cost

uncertainties for lessor

7. First payment due 1/1/12

8. Estimated useful life of asset: 5 years

9. Lessor retains ownership of asset at end of lease

10. Cost of asset $100,000

11. Payments of $36,556 per year

2

1. Inception of the lease: January 1, 2012

2. Term: 3 years 3. Implicit interest rate

10% (NOT known to lessee but could be estimated)

4. Fair value of asset $100,000

5. Incremental borrowing rate: 12%

6. No collection or cost uncertainties for lessor

7. First payment due 1/1/12

8. Estimated useful life of asset: 5 years

9. Lessor retains ownership of asset at end of lease

10. Cost of asset $100,000

11. Payments of $36,556 per year

2a

What if the lessor’s rate were NOT known to lessee? What would be the PVMLP?

What if we follow IFRS?

1. Term: 3 years 3. Implicit interest rate

(known to lessee) 10% 5. Fair value of asset

$130,000 7. Incremental

borrowing rate: 12% 9. Estimated useful life

of asset: 5 years11.Purchase option at

end of lease: $2,500

2. Payments of $________________

4. Est. fair value of asset at end of lease $2,500

6. Cost of asset $100,000

8. First payment due 1/1/12 (at inception)

10.No collection or cost uncertainties for lessor

4a

1. Term: 3 years 3. Implicit interest rate

=10% (known to lessee)

5. Fair value of asset $130,000

7. Incremental borrowing rate: 12%

9. Estimated useful life of asset: 5 years

11.Purchase option at end of lease: $2,500

2. Payments of $46,836 4. Est. fair value of asset

at end of lease $2,500 6. Cost of asset

$100,000 8. First payment due

1/1/12 (at inception)10.No collection or cost

uncertainties for lessor

4A

Classify lease under US GAAP and IFRS

1. Term: 3 years 3. Implicit interest rate

=10% (NOT known to lessee but could be estimated)

5. Fair value of asset $130,000

7. Incremental borrowing rate: 12%

9. Estimated useful life of asset: 5 years

11.Purchase option at end of lease: $2,500

2. Payments of $46,836

4. Est. fair value of asset at end of lease $2,500

6. Cost of asset $100,000

8. First payment due 1/1/12 (at inception)

10.No collection or cost uncertainties for lessor

4B

What if the lessor’s implicit rate is NOT known to lessee? Find the PVMLP.

1. Term: 3 years 3. mplicit interest rate

(NOT known to lessee) 10%

5. Fair value of asset $130,000

7. Incremental borrowing rate: 12%

9. Estimated useful life of asset: 5 years

11.Purchase option at end of lease: $2,500

2. Payments of $46,836 4. Est. fair value of asset

at end of lease $5,000 6. Cost of asset

$100,000 8. First payment due

1/1/12 (at inception)10.No collection or cost

uncertainties for lessor

4c

What if the fair value of the asset is $5,000 at end of the lease? Find the PVMLP.

Initial Direct CostsResidual Values

Type of LeaseAccounting Treatment for Initial Direct Costs

OperatingRecorded as an asset and amortized over the lease term*

Direct Financing (US)Finance (IFRS)

Recorded as part of investment in lease and amortized over lease term by reducing interest revenue (find new implicit rate)*

Sales-type Lease (US)Finance if lessor is manufacturer or dealer (IFRS)

Immediately recognized as cost of goods sold (reduces profit or increases loss on sale of leased asset)

Remember that the UnGRV is part of lessor’s receivable and therefore is included in the amortization table!

1. Term: 4 years2. Payments of

$83,0993. Implicit interest

rate (known to lessee) 10%

4. Lessor retains ownership of asset at end of lease

5. Fair value of asset $300,000

6. Cost of asset $250,000

7. Incremental borrowing rate: 12%

8. First payment due 1/1/129. Estimated useful life of

asset: 5 years10.No collection or cost

uncertainties for lessor11.Est. fair value of asset at

end of lease: $15,00012.The residual value is

guaranteed by a third party at a cost of $500 (initial direct cost)

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Lessor Date Lease Payment Interest Principal Balance 01/01/12 300,000 0 01/01/12 83,099 0 83,099 216,901 1 01/01/13 83,099 21,690 61,409 155,492 2 01/01/14 83,099 15,549 67,550 87,942 3 01/01/15 83,099 8,794 74,305 13,638

01/01/16 15,000 1,362 13,638 0

6Lessee

DateLease

PaymentInterest Principal Balance

01/01/12 289,754 0 01/01/12 83,099 0 83,099 206,655 1 01/01/13 83,099 20,665 62,434 144,221 2 01/01/14 83,099 14,422 68,677 75,545 3 01/01/15 83,099 7,554 75,545 0

1. Term: 3 years 3. Implicit interest rate

(NOT known to lessee) 10%

5. Fair value of asset $100,000

7. Incremental borrowing rate: 14%

9. Estimated useful life of asset: 5 years

11. Est. fair value of asset at end of lease: $10,000

2. Payments of $33,809 4. Lessor retains

ownership of asset at end of lease

6. Cost of asset $100,000

8. First payment due 10/1/12

10. No collection or cost uncertainties for lessor

12. The residual value is NOT guaranteed by lessee

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Lease TermRenewal PeriodsExecutory Costs

IFRS has the same “rule” about the end of the lease term

1. Term: 4 years 3. Interest rate used to

compute payments = 12% 5. Fair value of asset $200,000 7. Incremental borrowing rate:

14% 9. Estimated useful life of asset:

6 years11. Est. fair value of asset at

end of lease: $10,00013. Initial direct costs to arrange

lease: $3,000

2. Payments of $61,924 4. Cost of asset $200,000 6. First payment due 6/1/12 8. No collection or cost

uncertainties for lessor10. The payments include

$5,000 for insurance.12. The lessee can

purchase asset for $10,000 at end of lease, otherwise, asset is returned to lessor.

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11

DateLease

PaymentInterest Principal Balance

6/01/02 203,000

0 6/01/02 56,924

1 6/01/03 56,924

2 6/01/04 56,924

3 6/01/05 56,924

4 6/01/06 10,000

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DateLease

Payment Interest Principal Balance

10/1/2002 10.86% 203,000

0 10/1/2002 56,924 0 56,924 146,076

1 10/1/2003 56,924 15,858 41,066 105,010

2 10/1/2004 56,924 11,400 45,524 59,486

3 10/1/2005 56,924 6,458 50,466 9,020

4 10/1/2006 10,000 980 9,020 0

1. Term: 4 years with possible renewal (see #12)

2. Implicit interest rate (NOT known to lessee) 10%

3. Fair value of asset $200,000

4. Incremental borrowing rate: 14%

5. Estimated useful life of asset: 6 years

6. The residual value is NOT guaranteed by lessee, asset is expected to be worth $25,000 at end of 4 years, and $15,000 at end of 5 years.

7. Payments of $49,523 8. Lessor retains ownership of

asset at end of lease 9. Cost of asset $200,000 10.First payment due 1/1/1211.No collection or cost

uncertainties for lessor12.At the end of the lease, HGJB

can renew for one more year at same annual amount of $49,523. This is certainly no bargain. There is a $15,000 penalty for non-renewal of the lease. However, this amount is probably not large enough to assure that HGJB will renew.

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1.Term: 4 years, with possible renewal (see #11)

3. Implicit interest rate (NOT known to lessee) 10%

5. Fair value of asset $260,000

7. Incremental borrowing rate: 12%

9. Estimated useful life of asset: 6 years

11. Lease can be renewed for one more year at $17,000. The actual value is probably $25,000.

13. There are no guarantees of residual value

2. Payments of $68,565 4 . Lessor retains title to

the asset at end of lease 6. Cost of asset $200,000 8. First payment due

1/1/1210. No collection or cost

uncertainties for lessor12. Est. fair value of asset

at end of original lease term is $35,000. It should be worth $15,000 at the end of 5 years.

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