Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Leases

Chapter 15

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Accounting by the Lessor and Lessee A lease is an agreement in which the A lease is an agreement in which the

lessorlessor conveys the right to use property, conveys the right to use property, plant, or equipment, usually for a stated plant, or equipment, usually for a stated

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

Lessor = Owner of propertyLessee = Renter

Lessee LessorOperating lease Operating leaseCapital lease Capital lease

Direct financing lease Sales-type lease

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Classification Criteria

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

A A bargain purchase option (BPO) exists, or . . .(BPO) exists, or . . . The noncancelable lease term is equal to The noncancelable lease term is equal to 75%

or more of the expected economic life of the of the expected economic life of the asset, asset, or or

The PV of the minimum lease payments is The PV of the minimum lease payments is 90% or more of the fair value of the asset.of the asset.

A capital leasecapital lease must meet oneone of four criteria:

Operating Lease

Capital Lease

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Classification Criteria

Ownership transfers to the lessee at the end to the lessee at the end of the lease term, or . . . of the lease term, or . . .

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

The noncancelable lease term is equal to The noncancelable lease term is equal to 75% or more of the expected economic lifeof the expected economic life of of the asset, the asset, or or

The PV of the minimum lease payments is The PV of the minimum lease payments is 90% or more of the fair value of the asset.of the asset.

A capital leasecapital lease must meet oneone of four criteria:

Operating Lease

Capital Lease

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

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

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

liability at inception of the lease.liability at inception of the lease.

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Additional Lessor Conditions

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

The four conditions discussed apply to both the lessee and lessor. However, the lessor must meet two additional conditions for the lease to be classified as either a direct financing or sales-type lease:

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

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

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U. S. GAAP vs. IFRS

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Operating Leases

Criteria for a Criteria for a capital lease capital lease

not met.not met.

Lease Lease agreement agreement

exists.exists.

Record lease as Record lease as an Operating an Operating

Lease.Lease. CapitalLease

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Leasehold ImprovementsSometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. Like other assets, leasehold improvement costs are allocated as depreciation expense over its useful life to the lessee, which is to be the shorter of the physical life of the asset or the lease term.

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Capital Leases – Lessee and LessorThe amount recorded (capitalized) is the The amount recorded (capitalized) is the

present value of the minimum lease payments. present value of the minimum lease payments. However, the amount recorded cannot exceed However, the amount recorded cannot exceed

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

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

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

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

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

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Capital Leases – Lessee and Lessor

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

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

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

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Capital Leases – Lessee and Lessor

Depreciation PeriodDepreciation PeriodThe lessee normally should depreciate a The lessee normally should depreciate a

leased asset over the leased asset over the term of the leaseterm of the lease. . However, if However, if ownership transfers or a ownership transfers or a bargain purchase option is presentbargain purchase option is present (i.e., (i.e., either of the first two classification criteria is either of the first two classification criteria is met), the asset should be met), the asset should be depreciated over depreciated over its useful lifeits useful life..

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Sales-Type Leases If the lessor is a manufacturer or dealer, the If the lessor is a manufacturer or dealer, the fair value of the leased asset generally is fair value of the leased asset generally is higher than the cost of the asset.higher than the cost of the asset.

At inception of the lease, the lessor will At inception of the lease, the lessor will record therecord the cost of goods soldcost of goods sold as well as as well as

the the sales revenuesales revenue (PV of payments).(PV of payments).

In addition to interest revenue earned over the In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset.or dealer’s profit on the “sale” of the asset.

15-14Bargain Purchase Optionsand Residual Value

A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result:

LESSEE adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability.

LESSOR, when computing periodic rental payments, subtracts the present value of the BPO price from the amount to be recovered (fair value) to determine the amount that must be recovered from the lessee through the periodic rental payments.

15-15Effect on the Lessee of a Residual Value

Unguaranteed Residual ValueUnguaranteed Residual ValueA lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments — recorded as a leased asset and a lease liability — is simply the present value of periodic rental payments ($445,211). The same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

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Discount RateOne rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

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Lessor’s Initial Direct Costs

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

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

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

investment balance.investment balance. Sales-Type Leases Sales-Type Leases – The initial direct costs are – The initial direct costs are

expensed at the inception of the lease.expensed at the inception of the lease.

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Special Leasing Arrangements

1.1. Sale-Leaseback Arrangements Sale-Leaseback Arrangements – the owner of – the owner of an asset sells it and immediately leases it back an asset sells it and immediately leases it back from the new owner. Any gain on the sale of from the new owner. Any gain on the sale of the asset is deferred and amortized. A real loss the asset is deferred and amortized. A real loss on the sale of the property is recognized on the sale of the property is recognized immediately.immediately.

2.2. Real Estate LeasesReal Estate Leases::• Leases of Land OnlyLeases of Land Only• Leases of Land and BuildingLeases of Land and Building• Leases of Only Part of a BuildingLeases of Only Part of a Building

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Leases: Where We’re HeadedThe FASB and the IASB are collaborating on a joint Exposure Draft of the new leases standard update. Even after the proposed Accounting Standard Update (proposed ASU) is issued, previous GAAP will be relevant until the proposed ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the proposed Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon.

In the right-of-use model introduced in the proposed standards update, all leases are recorded as an asset and liability (with the exception of short term leases as described later), and the concept of operating leases is eliminated.

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End of Chapter 15