Intermediate Accounting II Chapter 18: Accounting for Leases

If there is not an observable standalone selling price, the lessor must use an estimate of the standalone selling price and allocate it based on any of the following methods:

1. Adjusted market assessment approach 2. Expected-cost-plus-a-margin approach 3. Residual approach

Consider Mac Sullivan Company from Example 18.6. Assume that Mac Sullivan enters into the same lease agreement except that Mac Sullivan guarantees a residual value of $25,000. 11 The company has determined that none of the Group I criteria have been met, so Mac Sullivan classifies the lease as an operating lease. Provide the journal entries for 2018 and January 1, 2019.

Mac Sullivan determines the initial measurement of the lease liability as the present value of an annuity due to the lease payments that have not been made as of the lease commencement date. The present value of an annuity due for the five lease payments of $20,000 and the guaranteed residual value of $25,000 at a discount rate of 4% is $113,146. N I/Y PV PMT FV Excel Formula Given 5 4.00% -20,000 -25,000 Solve for PV 113,146 =PV(0.04,5,-20000,-25000,1)

Sales Type Lease

Meets any Group 1 Criteria

Direct Financing Lease

Meets both of the Group 2 Criteria and none of the Group 1 criteria

Operating Lease

Neither group 1 or 2 criteria.

After the commencement date, the lessor will record rental revenue composed of the following:

a. Total lease payments, recognized on a straight-line basis b. Variable payments not included in the lease payments

6 elements of a lease payment

1. Fixed payments less any lease incentives paid or payable to the lessee. 7 2. Variable lease payments that depend on a rate or index (such as the consumer price level index or a market rate of interest) using the rate or index in effect at the lease commencement date. 3. The exercise price of an option to purchase the asset if the lessee is reasonably certain to exercise the option. 4. Penalty payments for lease termination if the lessee exercises an option to terminate the lease. 5. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transac-tion. However, these fees are not included in the fair value of the leased asset. 8 6. For a lessee only, the amounts that are probable of being owed by the lessee under residual value guarantees. Note that this component does not include any unguaranteed residual assets or any residual value guarantees made by a third party.

Right of use asset components

1. The lease liability determined as the present value of the remaining lease payments as of the commencement date. 2. Lease payments the lessee makes to the lessor at or before the commencement date. These payments are prepayments made prior to the lease commencement date, often on the lease inception date. The lessee initially reports them as prepaid assets and then reclassifies them to right-of-use assets on the lease commencement date. 3. Any initial direct costs the lessee incurs. Lessees initially report initial direct costs as prepaid assets and then reclassify these costs to increase the right-of-use asset on the lease com-mencement date. 4. A reduction for any lease incentives the lessee receives. Lessees initially report lease incen-tives as liabilities and then reclassify these incentives to reduce the right-of-use asset on the lease commencement date.

The net investment in the lease for a sales-type lease (NIL-ST) reflects the assets related to the lease transaction and is composed of:

1. The lease receivable 2. The present value of any unguaranteed residual asset

To meet the Group I conditions, a transaction needs only to meet one of the five criteria:

1. The lease transfers ownership of the leased asset to the lessee at the end of the lease term. If the lease transfers ownership, the lessee firm has in essence purchased the asset. 2. The lessee is given an option to purchase the asset that the lessee is reasonably certain to exercise. For example, it might be reasonably certain that the lessee would exercise a purchase option if the specified purchase price is well lower than the expected value of the leased asset at the completion of the lease term. 3. The lease term is for a major part of the economic life of the asset. 6 If the lease term provides the lessee the use and control over substantially all of the asset's useful life, the agreement should be considered equivalent to purchasing the asset. The lease term begins at the lease commencement date and includes the noncancellable period for which a lessee has the right to use the leased asset. The lease term also includes periods covered by an option to renew the lease if the lessee is reasonably certain to renew. The lessee is likely to renew if the lease payments over the renewal period are substantially lower than the fair value rental amount. If the lessor controls the option to renew the lease, the renewal period is included in the lease term. If a lease agreement contains an option to terminate and the lessee is reasonably likely to exercise that option, the lease term ends on the earliest date that the lease can be terminated. If the lessor has the option not to terminate the lease then, the lease term is the total lease period and will not terminate early. 4. The present value of the sum of the lease payments and any residual value the lessee guar-antees to pay (that is not otherwise included in the lease payments) is equal to substantially all of the asset's fair value. In this case, the lessor is able to recover the cost of the asset. The present value computation includes lease payments in the renewal periods, if any. Meeting this criterion implies that the lessee is providing the lessor compensation that is equivalent to the purchase of the asset. 5. The leased asset is of a specialized nature. An asset with a specialized nature has no alter-native use to the lessor at the end of the lease term. Because the asset has no alternative use to the lessor, its specialized nature implies that the lessor must have transferred control over the asset to the lessee.

Group II criteria apply to the lessor only. To meet the Group II criteria, a transaction must meet both criteria.

1. The present value of the sum of the lease payments and any residual value the lessee or a third party guarantees to pay (that is not otherwise included in the lease payments) is equal to substantially all of the asset's fair value. 2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.

For a finance lease, the lessee records a lease expense each period of the lease that includes the following:

1. Use of the appropriate discount rate to compute the present value of the liability at the lease commencement date. Interest expense on the lease liability is computed under the effective interest rate method of amortization. 2. Variable lease payments not included in the lease liability in the period in which the obligation for the variable payments is incurred. 3. Changes in variable lease payments that depend on an index or rate.

Lease

A contract granting use or occupation of property during a specified time for a specified payment

Residual Value Guarantee

A guarantee or assurance made to the lessor that he will receive a fixed dollar amount for the leased asset at the end of the lease. The lessee or a third party may provide this guarantee. If the fair value of the asset at the end of the lease is less than the residual value guarantee, the guarantor will make a payment to the lessor for the difference in the residual value guarantee and the fair value of the asset.

Consider Berg Manufacturing from Example 18.11. Assume that the lease agree-ment is the same except that Berg has guaranteed a residual value of $15,000. 14 Berg has determined that the lease meets both Group I Criteria 3 and 4, so Berg classifies the lease as a finance lease. Provide the journal entries for Berg for 2019. Provide the journal entry for 2027, assuming that Berg is required to pay Borko Bank the full $15,000 residual value. Also provide the journal entry for 2027 assuming that Berg is not required to pay Borko Bank any of the residual value. PART 2

AT THE END: Berg amortizes the asset on a straight-line basis over the lease term. Amortization expense is computed as $7,513: the right-of-use asset of $82,617 minus the guaranteed residual value of $15,000 divided by the 9-year lease term. Account December 31, 2019 Amortization Expense—Right-of-Use Asset 7,513 Accumulated Amortization—Right-of-Use Asset 7,513 As shown in the amortization table, Berg allocates the second payment on December 31, 2019, to interest of $7,438 and principal of $4,562. Account December 31, 2019 Lease Liability 4,562 Interest Expense 7,438 Cash 12,000 At December 31, 2027, the lease termination date, the balance of the lease liability is $13,513. Assuming that Berg must pay the $15,000 to cover the guaranteed residual value, Berg will make the following entry: Account December 31, 2027 Lease Liability 13,513 Interest Expense 1,487 Accumulated Amortization—Right-of-Use Asset 67,617 Loss on Lease 15,000 Right-of-Use Asset 82,617 Cash 15,00 If Berg does not have to pay the $15,000, it will make the following entry because it must remove the liability from its balance sheet: Account December 31, 2027 Lease Liability 13,513 Accumulated Amortization—Right-of-Use Asset 67,617 Interest Expense 1,487 Right-of-Use Asset 82,617

Mac Sullivan Company leases nonspecialized medical equipment with a fair value of $195,000 from RehabCo. The lease term is for 5 years and commences on January 1, 2019. The estimated economic life of the equipment is 10 years. Mac Sullivan prepaid the first rental payment of $20,000 on December 15, 2018 (the inception date) and received $28,800 from RehabCo on the inception date to terminate a lease from another lessor. Mac Sullivan must pay five additional rental fees of $20,000 each year beginning on January 1, 2019. The second payment is due on December 31, 2019. Thereafter, each payment is due on December 31. The implicit rate in the lease is 4%. Mac Sullivan incurred initial direct costs prior to the lease commencement of $3,500 that it originally recorded as prepaid initial direct costs. The lease agreement does not contain a transfer of ownership or a purchase option. Mac Sullivan has determined that none of the Group I criteria are met, so the company classifies the lease as an operating lease. How would the lessee measure and record the lease liability and the right-of-use asset?

AT THE END: On the lease commencement date, Mac Sullivan records the right-of-use asset and the lease liability. In addition, it reclassifies the lease incentive and the initial direct costs. It also removes the prepaid lease payment. Mac Sullivan makes the following entry on January 1: Account January 1, 2019 Right-of-Use Asset 87,298 Liability for Lease Incentive 28,800 Prepaid Lease Payment 20,000 Prepaid Initial Direct Costs 3,500 Lease Liability 92,598 In addition to the initial measurement of the lease liability and right-of-use asset, Mac Sullivan also records the first annual lease payment as follows: Account January 1, 2019 Lease Liability 20,000 Cash 20,000

Unguaranteed residual value

An amount the lessor expects to derive from the leased asset at the end of the lease term. This amount is simply the lessor's expectation; the lessee or a third party does not guarantee the residual value.

Right of Use Asset

An asset that represents a lessee's right to use an underlying asset for the lease term

Component

An item or activity of a contract that transfers a good or service.

Bassey Seafood Company leased a warehouse from the Gilli Group for a term of 10 years to store its products. The warehouse includes refrigeration units. The warehouse lease includes the use of forklifts, pallets, and conveyer belts. In addition, Gilli provides mainte-nance of all items of equipment included in the agreement. The maintenance is included in the annual lease payments. What are the lease and nonlease components of the contract? How many lease and non-lease components are included in the contract?

Bassey receives the use of warehouse storage, refrigeration units, and warehouse equipment. It also gets the use of maintenance services. The warehouse and the refrigeration units cannot be separated because they are interdependent. That is, the warehouse cannot be used to store seafood without proper refrigeration. However, the warehouse equipment (fork-lifts, pallets, and conveyer belts) function independently and can be used separately in any warehouse. Therefore, this contract contains two lease components: the warehouse (with refrig-eration) and the equipment. Maintenance is an additional nonlease component of the contract. In total, the contract contains three components: two lease and one nonlease. Lease Components Nonlease Component Warehouse with refrigeration Maintenance Equipment

Lease Commencement

Date on which lessee is allowed to begin using the leased asset

Consider Mac Sullivan Company from the Example 18.6. Provide all necessary journal entries for Mac Sullivan over the lease term. Part 2

Finally, we compute the portion of the annual lease expense that is attributable to the asset amortization. This amount is computed as the annual lease expense (computed in Step 2) less the interest portion that we computed in Step 3.

Finance Lease

Group 1 criteria

Lease Inception

The date the lease agreement is signed

On January 1, 2019, Sturge Manufacturing, an IFRS reporter, leased a piece of machinery for use in its North American operations from Borko Bank. The 9-year, noncan-cellable lease requires lease payments of $14,000 due at the beginning of each year. The machinery built to Sturge's specifications would require significant modifications for another manufacturer to use it. The present value of the lease payments, including payments during the renewal period, is $77,519. The lease agreement does not transfer ownership of the machin-ery, and it does not contain a purchase option. Sturge can renew the lease for $500 a year for 10 additional years and expects these terms to be lower than the market rent on the renewal date. The machinery has a fair value of $95,455 and an estimated life of 20 years. Determine whether Borko Bank should report the lease as an operating or finance lease under IFRS.

IFRS Criteria Met? Explanation Additional IFRS Indicators 1. Does the lessee bear the lessor's losses if the lessee cancels the lease? Uncertain This issue is not addressed. 2. Does the lessee absorb the gains or losses from fluctuations in the fair value of the residual value of the asset? Uncertain This issue is not addressed. 3. May the lessee extend the lease for a secondary period at a rent payment substantially lower than the market rental? Ye s The decrease in rent from $14,000 to $500 implies that rent in the renewal would be substantially lower than the market rental.

Initial Direct Costs

Incremental costs that the lessee would not have incurred if he had not obtained the lease, such as commissions, legal fees resulting from the execution of the lease, costs to prepare documents after the execution of the lease, and payments to existing tenants to move out of a facility.

JPAX Company, a lessor, enters into a 4-year lease transaction with payments due at the beginning of each year. • The lease payments are $48,000 per year. • The fair value of the leased asset is $260,000. • The lessor's deferred initial direct costs are equal to $12,000. • The lessor's estimate of the unguaranteed residual asset is $115,000. What is the implicit rate in the lease for the lessor?

JPAX solves for the implicit rate using the following equality: Present Value of Lease Payments +Present Value of Estimated Residual Value =Fair Value of Asset +Deferred Initial Direct Costs JPAX applies time value of money concepts to identify the terms needed to solve for the implicit rate: the present value, PV; the number of periods, N; the payments per period, PMT; and the future value, FV. Because the payments are due at the beginning of the period, this is a present value of an annuity due problem. The present value, PV, is the present value of the lease payments plus the expected residual value which equals the fair value of the leased asset plus the deferred initial direct costs: Present Value of Lease Payments +Present Value of Estimated Residual Value =$260,000 Fair Value of Leased Asset +$12,000 Initial Direct Costs =$272,000 The number of periods, N, is 4 years. The payments each period, PMT, are $48,000. The future value, FV, is the residual value of $115,000.We use the spreadsheet application from Chapter 7 to determine the implicit rate as 5.22%:

You have been tasked with analyzing the financial statement effects of a lessee accounting for a lease as an operating lease versus finance lease. The lease payments are $600,000 with the first lease payment due on January 1, Year 1, at the commencement of the 5-year lease. The next lease payment is due on December 31, Year 1. The remaining three lease payments are due on December 31 of Years 2 through 4. The lessee's discount rate is 11%, and the present value of the lease payments is $2,461,467. Compare the differences in expenses, operating income, net income, total assets, and cash flows from operating activities of accounting for the lease as an operating lease and finance lease. We assume that the first payment is made at the beginning of Year 1. We ignore the rules that guide the determination of whether a lease is an operating lease or a finance lease so that we can focus on the financial statement effects. The lessee amortizes the right-of-use asset on a straight-line basis under a finance lease. Ignore income taxes. PART 2

Observe that total expenses are higher under a finance lease in the early years of the lease. Therefore, net income will be lower under a finance lease in the early years. Total expenses over the life of the lease are the same. Because the lease cost for the operating lease is reported in operating income whereas only the amortization expense is for the finance lease, operating income is lower for the operating lease.

Consider Mac Sullivan Company from the Example 18.6. Provide all necessary journal entries for Mac Sullivan over the lease term.

Part 1: As noted in Example 18.6, this is an operating lease. Also recall that we initially measured the lease liability at $92,598 and the right-of-use asset at $87,298. Given this infor-mation from the prior example, we now illustrate subsequent measurement using the five steps. Step 1. Total Payments In the first step, we sum all of the payments that Mac Sullivan will make and reduce this by any incentives it receives.

Lease Incentives

Payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of costs of a lessee.

Implicit Rate

Rate of interest that sets the present value of the lease payments plus the present value of the amount that a lessor expects to obtain from the leased asset at the end of the lease term equal to the sum of the fair value of the leased asset and any deferred initial direct costs incurred by the lessor.

key steps in the flow of a lease transaction.

Step 1. Identify a lease contract. Step 2. Identify lease and nonlease components and allocate costs to each component. Step 3. Classify the lease. Step 4. Recognize and initially measure the lease transaction. Step 5. Determine subsequent measurement of the lease transaction.

The practical approach for subsequent measurement for an operating lease involves a five-step methodology:

Step 1: Determine the total payments to be made by the lessee from the lease inception date to the termination date, including prepayments and initial direct costs incurred by the lessee, net of any incentives received. Step 2: Determine the amount of lease expense to be recognized each year by dividing the total payments computed in Step 1 by the lease term. Step 3: Compute the periodic interest expense on the lease liability by using the effective interest rate method. Step 4: Compute the reduction in the lease liability each period as the payment made that period less the interest computed in Step 3. Step 5: Determine the amortization of the right-of-use asset, which is measured as the difference in the straight-line lease expense and the interest expense from Step 3.

Residual Method

Subtracts the other standalone prices from the total contract consideration and assigns the remaining amount as the estimated standalone price of the remaining component.

Hobnob Company leased a piece of machinery to Cutter, Inc. on January 1, 2019. The lease is correctly classified as a sales-type lease. Hobnob will receive three annual lease payments of $19,000 with the first one received on January 1, 2019. There is no guaranteed or unguaranteed residual value. The fair value of the machine is $50,000, and Hobnob incurs initial direct costs of $5,000. Compute the implicit rate and the NIL-ST assuming that the initial direct costs are expensed. Compute the implicit rate and the NIL-ST assuming that the initial direct costs are deferred.

The implicit rate is 3.68% and the NIL-ST is (by construction) $55,000, which is the present value of the lease payments and is equal to the lease receivable in this case. Note that we do not separately add in the initial direct costs; they are included in the lease receivable because they are automatically included in the present value of the lease payments through the computation of the implicit rate.

Lessor

The owner of the asset in a lease.

Lessee

The party acquiring the use of the asset

Lease Receivable

The present value of the payments the lessor will receive plus the present value of any residual value guarantees when the guarantee can be provided by either the lessee or a third party. The lessor earns interest revenue on the lease receivable.

Standalone Price

The price at which it would purchase a component of a contract separately.

Incremental Borrowing Rate

The rate of interest that a lessee would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term to the lease in a similar economic environment.

On January 1, 2019, Carney Brothers Equipment Manufacturers agreed to lease a piece of heavy equipment to Greenbaum Shipping Associates. The equipment is not special-ized and was delivered on January 1, 2019. Carney Brothers paid $800,000 to produce the machine and carries it at this amount in inventory. Carney Brothers incurred initial direct costs of $5,000. The lease terms follow: • Annual rental payments of $188,692 are due on January 1, 2019, and December 31 of every year from 2019 through 2023. • Lease term is 6 years. • There is no transfer of the asset at the end of the lease term and no purchase option. • The economic life of the asset is 6 years. • Carney Brothers' implicit rate is 9%. • Collectability of rental payments is probable. • The fair value (current selling price) of the machine is $922,638. • There is no residual value guarantee, nor does Carney anticipate a residual value for the asset. How does Carney Brothers, the lessor, classify this lease? What journal entries does it make on January 1, 2019?

This lease is a sales type because it meets both Criteria 3 and 4 of the Group I con-ditions. The lease term is 100% of the life of the asset, which is a major part of its economic life. Also, the present value of the lease payments is 100% of the asset's fair value. The present value of an annuity due of the six remaining lease payments of $188,692 at a discount rate of 9% is $922,638 computed as follows: N I/Y PV PMT FV Excel Formula Given 6 9.00% 188,692 0 Solve for PV (922,638) =PV(0.09,6,188692,0,1) The following table presents an analysis of the indicators.

On January 1, 2019, Berg Manufacturing leased a nonspecialized piece of machin-ery for use in its North American operations from Borko Bank. The lease agreement was signed on January 1 and the equipment was provided to Berg on the same day. The 9-year, noncancellable lease requires annual lease payments of $12,000, beginning January 1, 2019, and at each December 31 thereafter through 2026. The lease agreement does not transfer ownership of the machinery, nor does it contain a purchase option. The machinery has a fair value of $75,000 and an estimated life of 10 years. Borko Bank's implicit rate is not known to Berg. Berg's incremental borrowing rate is 11%. Berg incurs initial direct costs of $3,000 on January 1, 2019. Analyze the lease classification criteria to determine whether the lease is an operating or finance lease for Berg. Provide the journal entries for Berg for 2019. (PART 2)

To account for the lease as a finance lease, Berg computes interest on the lease using the effective interest rate method. Interest each period is the beginning lease balance times the interest rate (Column b) as seen in the following table. Berg allocates each lease payment of $12,000 first to interest and any remaining amount then reduces the lease liability (Column c). The amount that reduces the lease liability decreases the lease liability balance (Column d). The amortization table follows. AT THE END: Berg amortizes the leased asset on a straight-line basis over the lease term. Amortization expense is computed as $8,528: the right-of-use asset of $76,753 divided by the 9-year lease term. Account December 31, 2019 Amortization Expense—Right-of-Use Asset 8,528 Accumulated Amortization—Right-of-Use Asset 8,528

On January 1, 2019, Joseph Botti AutoWorld, Inc. leases a SUV that it carries in its inventory to Cava Company. The lease term is 4 years with no renewal options, and the economic life of the SUV is 7 years. The fair value of the automobile is $45,000, and Joseph Botti's cost or carrying value is also $45,000. There are no lease incentives. The lease requires monthly payments of $600 at the end of each month. Botti incurs initial direct costs of $2,400 on January 1, 2019. The implicit rate in the lease is 5%. There is no transfer of ownership at the end of the lease term. Lease payment collection is probable. How should the lessor clas-sify the lease? Provide the journal entries for January 2019 and February 2019 for the lessor.

To determine whether Botti, the lessor, should classify the lease as operating, direct financing, or sales type, we assess both Group I and Group II criteria. We have information to assess all of the criteria except for the fourth criterion of Group I. The present value of an ordinary annuity of the 48 remaining lease payments of $600 at a discount rate of 0.4167% per period (5%/12) is $26,054. N I/Y PV PMT FV Excel Formula Given 48 0.4167% 600 0 Solve for PV (26,054) =PV(0.004167,48,600,0) The following table presents an analysis of the indicators.

On January 1, 2019, Berg Manufacturing leased a nonspecialized piece of machin-ery for use in its North American operations from Borko Bank. The lease agreement was signed on January 1 and the equipment was provided to Berg on the same day. The 9-year, noncancellable lease requires annual lease payments of $12,000, beginning January 1, 2019, and at each December 31 thereafter through 2026. The lease agreement does not transfer ownership of the machinery, nor does it contain a purchase option. The machinery has a fair value of $75,000 and an estimated life of 10 years. Borko Bank's implicit rate is not known to Berg. Berg's incremental borrowing rate is 11%. Berg incurs initial direct costs of $3,000 on January 1, 2019. Analyze the lease classification criteria to determine whether the lease is an operating or finance lease for Berg. Provide the journal entries for Berg for 2019.

We use the Group I criteria to determine whether this lease should be classified as a finance lease for the lessee. We have information to assess all of the Group I criteria except for the fourth criterion on the present value as a substantial part of the fair value. The present value of an annuity due of the nine remaining lease payments of $12,000 at a discount rate of 11% is $73,753.

Consider Carney Brothers Equipment Manufacturers from Example 18.15. Assume that the lease agreement is the same except that Carney now estimates a residual value of $60,000. The lessee guarantees $25,000 of the $60,000, so $35,000 of the residual value is still not guaranteed. What journal entries are required for 2019? 17 Prepare the amortization table for the NIL-ST. PART 2

of the machinery, $800,000, less the present value of the $35,000 unguaranteed residual asset, $18,948, at the implicit rate that is computed next: N I/Y PV PMT FV Excel Formula Given 6 10.76867% 0 35,000 Solve for PV (18,948) =PV(0.1076867,6,0,35000,0) The difference in the $903,690 sales revenue and the $781,052 cost of goods sold results in a gross profit of $122,638. Account January 1, 2019 Net Investment in Lease - Sales Type 922,638 Cost of Goods Sold 781,052 Sales Revenue 903,690 Inventory of Machinery 800,000 Carney expenses the initial direct costs because the fair value is not equal to the carrying value.