Unit 5

What describes current practice in accounting for leases?

All long-term leases are capitalized. Capitalize all long-term leases. This approach requires the long-term right to use the property in order to capitalize.

Which of the following does a lessee record in a finance lease? a. depreciation expense. b. a right of use asset. c. lease expense. d. interest revenue.

Ans b: the lessee records a right-of-use asset and lease liability initially and then interest expense and amortization expense over the lease term

Residual Value

The expected value of the leased asset at the end of the lease term *guaranteed residual value:* a guarantee made by the lessee to the lessor that the value of the leased asset returned at the end of a lease will be at least a specified amount; any amounts guaranteed under a residual value guarantee should be included in the present value test by both the lessee and lessor *unguaranteed residual value:* the lessee does not have any obligation to the lessor at the end of the lease, except to return the leased asset to the lessor; excluded in the present value test by both the lessee and lessor

Transfer of Ownership Test (finance lease criteria)-title transfer

The lease transfers control (or ownership) of the asset to the lessee by the end of the lease term -the noncancelable lease transfers title (ownership) of the asset to the lessee during or at the end of the lease term

Company A (lessee) enters into a lease agreement with Company B (lessor). The term of the lease is five years with monthly payments of $1,500. Prior to the beginning of the lease, Company A paid $9,000 in advance. What is the journal entry the lessee makes to record the advance payment of rent? a. debit rent expense $9,000, credit cash $9,000. b. debit rent expense $9,000, credit lease liability $9,000. c. debit right of use asset $9,000, credit cash $9,000. d. debit right of use asset $9,000, credit lease liability $9,000.

c. the lessee increases the right of use asset by $9,000 and credits cash for the same amount. Advance payments are added to the right of use asset.

The appropriate right to use asset value reported in the balance sheet by the lessee for an operating lease is: a. present value of the lease payments. b. sum of the lease payments. c. the lessor's book value of the asset at the beginning of the lease. d. zero, unless a prepayment or accrual is involved.

present value of the lease payments

Advantages of leasing- perspective of the lessor

*1. Provides profitable interest margins* *2. Stimulate sales* *3. Provide tax benefits* enhances the return to all parties involved *4. Provide a high residual value to the lessor* upon the return of the property at the end of the lease term-residual value profits

Accounting for Sales-Type Lease-Lessor

*To record initial sales-type lease:* D- Lease Receivable C- Sales Revenue D- Cost of Goods Sold C- Inventory [cost of the leased asset] -The lease receivable is recorded at the present value of the lease payments plus the present value of the guaranteed and unguaranteed residual value. -a lease receivable is recognized because the asset left the lessor's books -when lessors account for residual values related to leased assets, they include the residual value in the receivable measurement because it is assumed the residual value will be realized *To record receipt of first lease payment:* D- Cash C- Lease Receivable *To record accrued interest revenue:* D- Lease Receivable C- Interest Revenue

Income Statement Presentation

-differs between the operating and finance lease methods of accounting for the lessee Finance Lease: amortization expense, interest expense Operating Lease: lease expense, revenue, depreciation expense Sales-type Lease: interest revenue

Advantages of Leases to the Lessee

1. *100% financing at fixed rates.* leasing usually requires a no down payment and the payments are often fixed, which protects the lessee against inflation and increases in the cost of money 2. *Protection against obsolescence*. Leasing equipment reduces risk of obsolescence (no longer useful) to the lessee and in many cases passes the risk of residual value to the lessor 3. *Flexibility.* · Lease agreements may contain less restrictive provisions than other debt agreements; leasing agreements can be tailor to the special needs of the lessee e.g. lease term, rental payments 4.*Less costly financing.* Leasing may be cheaper than other forms of financing and provide tax benefits; can provide the lessor with tax benefits that can then be passed onto the lessee in the form of lower rental payments

Short-term Leases (lessee)

A lease that, at the commencement date, has a term of 12 months or less -the lease payments are expensed when incurred -If the lease contains a renewal option or termination option that is reasonably certain of exercise by the lessee, the additional months are added to the initial lease term. *Accounting for lease expense (lessee)* -no asset or liability recorded on the balance sheet D- Lease Expense C- Cash or Payable *Accounting for lease revenue (lessor)* D- Cash or Receivable C- Lease Revenue

Operating Lease Accounting- Lessee

A lessee obtains control of only the use of the underlying asset but not ownership of the underlying asset itself *To record initial operating lease:* D- Right-of-Use Asset [PV of lease payments] C- Lease Liability Right of Use Asset = PV of Lease Pymts + initial direct costs + Prepaid Lease Pymts - Lessor Provided Lease Incentive -in calculating the present value of lease payments, the lessee uses the implicit interest rate if known and < incremental borrowing rate, otherwise, the incremental borrowing rate is used *To record first lease payment:* D- Lease Liability C- Cash *To record lease expense:* -the total lease expense is composed of essentially two different components and only one expense account is used on the income statement to recognize those two components -the interest and right-of-use asset amortization related to the lease is presented as a single lease (operating) expense in the income statement each year D-Lease Expense [same annual lease payment amounts each period/straight-line] C-Right-of-Use Asset [amortization: plug amount] C-Lease Liability [interest component]

Which single lease expense is recognized on the income statement?

An operating lease

For an asset lease with a four-year term, where should a Lease Liability be classified on the balance sheet?

As with all liabilities, the portion that is payable within the operating cycle or one year, whichever is less, is reported as a current liability. The remaining lease liability is shown as a non-current liability on the balance sheet.

A lessee leased an asset at the beginning of the year and classified it as a finance lease. Which journal entry should the lessee record at the end of the year?

D- Interest Expense D- Amortization Expense C- Lease Liability C- Right-of-Use Asset

A lessee made a cash rental payment to a lessor at the end of the current period. The asset was leased at the beginning of the current period and was properly recorded as a finance lease. Which journal entry should the lessee use to record the payment?

D- Interest Expense D- Lease Liability C- Cash

Company A leases a piece of machinery to Company B on January 1, Year 1. Information pertaining to the lease is as follows: • The lease is noncancellable with a term of three years. • The machinery has a cost and fair value at the start of the lease of $60,000; an estimated economic life of five years; and a residual value at the end of the lease of $12,000 (unguaranteed). • The lease contains no renewal options, and the machinery reverts to Company A at the end of the lease. • The present value of the residual value has been calculated as $10,075.44. · The annual lease payments are $17,620.08. What is the journal entry Company B makes to record the first payment on January 1, Year 1 a. debit rent expense $17,620.08, credit cash $17,620.08. b. debit rent expense $17,620.08, debit lease liability $17,620.08. c. debit lease liability $17,620.08, credit cash $17,620.08. d. debit right of use asset $17,620.08, credit lease liability $17,620.08.

D- Lease Liability- 17,620.08 C- Cash-17,620.08

Computation of lease payments

Fair value of leased equipment - present value of the residual value

Balance Sheet Presentation

Finance Lease and Operating Lease: Right-of-use asset and lease liability Sales-type Lease: Lease Receivable

When you're thinking about the lessee (the one who leases it), remember that they have short-term leases, operating leases, and finance leases.

From the lessors perspective (the one who owns it), we are going to see operating leases, sales-type leases, and direct financing leases.

Which of the following would be included in the lease receivable account in a sales-type lease? I. Guaranteed residual value. II. Unguaranteed residual value. III. Executory costs IV. Lease payments.

I, II, & IV

The lessee continues to amortize the right-of-use asset and decrease the principal of the lease liability until both are reduced to zero at the end of the lease. The right-of-use asset should be amortized over the lease term, unless there is a bargain-purchase option or ownership of the asset transfers to the lessee at the end of the lease.

If either of these criteria are met, then the lessee amortizes the right-of-use asset over the economic life of the asset.

Initial Direct Costs

Incremental costs of a lease that would not have been incurred had the lease not been executed -Initial direct costs incurred by the lessee are included in the cost of the right-of-use asset e.g., commissions, legal fees from the execution of the lease, lease documentation preparation costs incurred after execution, consideration paid for a guarantee of residual value

Measurement of the right-of-use asset:

Initial measurement of the lease liability - cash incentives + initial direct costs + prepayments

a look at the lessee (the one who leases it)

Leasing allows an entity to use an asset without owning it -several major companies are leasing -the types of assets that are being leased include equipment such as railcars, helicopters, bulldozers, barges, CT scanners, computers and there is also real estate leasing

a look at the lessor (the one who owns it)

Lessors that own property generally fall into these categories: *1. Banks* -largest players in leasing business -have access to low-cost funds allowing them to purchase assets at lower cost than their competitors *2. Captive Leasing Companies* -subsidiaries whose primary business is to perform leasing operations for the parent company -have the point of sale advantage in finding leasing customers for the parent company -have the product knowledge which gives it an advantage when financing the parent's product *3. Independents* -good at developing innovative contracts that help avoid accounting problems and, in some occasions, act as captive industries for parent companies that do not have leasing subsidiaries

In computing amortization of a leased asset where there is no bargain purchase option, what should the lessee subtract?

No residual value and depreciation over the term of the lease

What is a major reason why a company may become involved in leasing to other companies?

Stimulate sales

A lessee had a ten-year finance lease requiring equal annual payments. What should the reduction of the lease liability in year 2 be equal to?

The current liability shown for the lease at the end of year 1

Company A agrees to lease a robotic welding unit from Company B on January 1, Year 1. The following conditions apply to the lease · The term of the lease is five years, is noncancellable, and requires payments of $101,350 at the beginning of each year. · The robotic welding unit will have a fair value of $50,000 at the end of the lease; an estimated useful life of five years; and $45,000 guaranteed residual value. · There are no renewal options, so the unit will revert to Company B at the termination of the lease. · Company A can borrow at a 5% interest rate. · Company A uses straight-line depreciation on its assets. · Company B set its annual rate of return at 4%, and Company A is aware of this rate. · Present values are as follows: § Present value of lease payments at 4%: $469,240. § Present value of lease payments at 5%: $460,737. § Present value of residual at 4%: $38,457. § Present value of residual at 5%: $37,021. Which amount should be used to record the lease on January 1, Year 1?

The implicit rate is known and it is less than the incremental borrowing rate; therefore, present value is calculated using a discount rate of 4%. The amount that should be used to record the lease on January 1, Year 1 is $469,240.

Under operating and financing methods, the lessee records a right of use asset and a related lease liability on the balance sheet.

The right of use asset is initially measured as the same amount as the lease liability (i.e. present value of lease payments) adjusted for initial direct costs, prepayments, and lease incentives. Initial direct costs paid by the lessee will increase the initial value of the right of use asset. Similarly, prepaid rent paid by the lessee will increase the amount of the right of use asset recorded. Lease incentives granted to the lessee by the lessor will decrease the initial value of the right-of-use asset.

A sales-type lease has an unguaranteed residual value at the end of the lease term. At which amount would the lessor report sales revenue in the period of the inception of the lease?

The sales price less the present value of the residual value

The various views on capitalization of leases are as follows

The viewpoints range from no capitalization to capitalization of all long-term leases The FASB has recently adopted the third approach, which requires *companies to capitalize all long-term leases*. The only exception to capitalization is that leases covering a term of less than one year do not have to be capitalized. The FASB indicates that the right to use property under the terms of the lease is an asset, and the lessee's commitment to make payments under the lease is a liability and should be reflected on the balance sheet.

Companies classify lease arrangements as either finance or operating. In either case, companies capitalize all leased assets and liabilities in these leasing arrangements. Capitalize means to record an expense on the balance sheet.

Therefore, the balance sheet for a company that uses either a finance lease or an operating lease will be the same. However, for income statement purposes, the reporting of financial information depends on whether the lease is classified as a finance lease or operating lease.

What is an advantage of captive leasing companies over the other players in the leasing market?

They have the point-of-sale advantage in finding leasing customers.

lease

a contractual agreement between a lessor and lessee; a contract or part of a contract that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration *Lessee:* given the right to use specific property while making rental payments over the lease term to the lessor; the user or the borrower of an asset in a leasing arrangement *lessor*: the owner of the property; receives consideration from the lessee

Operating Lease (transfer of right-of-use but not ownership)

a lessee obtains the right to use the underlying asset but not ownership of the asset itself; lease is greater than 12 months but does not meet finance lease testing criteria (there are 5 criteria) -for the lessee, only a single lease expense (comprised of interest on the lease liability and amortization of the right-of-use asset) is recognized on the income statement; the total reported lease expense is the same from period to period -for the lessee, the right-of-use asset and the lease liability is recorded on the balance sheet e.g., a lease may convey use of one floor of an office building for five years; at the end of the lease the lessee vacates the floor

Which two finance lease elements are a part of a lease at year end?

an increase in the lease liability and the financing cost (interest expense) D- Interest Expense C- Lease Liability

Which of the following does a lessee record as part of an operating lease? a. amortization expense. b. interest expense. c. depreciation expense. d. lease expense.

lease expense

executory costs

normal expenses associated with owning a leased asset e.g., property insurance, property taxes gross: included in computation of lease liability net: variable payments are made to lessor or third party and expensed as incurred

annuity due

payment made at the beginning of the lease period

ordinary annuity

payments due at the end of the lease period

lease term

the duration of the lease

sales-type lease (the lessor)

when the lessor has, in substance, transferred control of the right-of-use asset if the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term -uses the criteria used to classify a lease as a finance lease for the lessee -the lessor accounts for the lease in a manner similar to the sale of an asset -the lessor generally records a Lease Receivable and eliminates the leased asset lease receivable = present value of rental payment + present value of guaranteed/unguaranteed residual value -the gross profit will be the same whether the residual value is guaranteed or unguaranteed

Company A leases computers from Company B with annual payments of $6,469. The leases are for two years, and the computers have an economic life of three years. At the end of the lease, the computers are expected to have a residual value of $5,000. Company A has an option to purchase the computers for $2,000 at the end of the lease agreement, which it expects to do. The fair value of the lease is $15,000, and the present value of the lease is $12,689. The present value of the option to purchase the computers is $1,849. How does Company A account for the amortization of the computers due to the bargain purchase option? a. it will amortize $15,000 using the lease term of the computers. b. it will amortize $14,538 using the lease term of the computers. c. it will amortize $15,000 using the economic life of the computers. d. it will amortize $14,538 using the economic life of the computers.

12,689 + 1,849 = 14,538 There is a bargain purchase option so the computers are amortized using the economic life.

Company A leases a piece of machinery to Company B on January 1, Year 1. Information pertaining to the lease is as follows: • The lease is noncancellable with a term of three years. • The machinery has a cost and fair value at the start of the lease of $60,000; an estimated economic life of five years; and a residual value at the end of the lease of $12,000 (unguaranteed). • The lease contains no renewal options, and the machinery reverts to Company A at the end of the lease. • The present value of the residual value has been calculated as $10,075.44. · The annual lease payments has been calculated as $17,620.08. How much should Company B record as the right of use asset on January 1, Year 1 a. $60,000.00 b. $49,924.56 c. $48,000.00 d. $42,379.92

60,000 - 10,075.44= 49,924.56

Company A leases a piece of machinery to Company B on January 1, Year 1. Information pertaining to the lease is as follows: • The lease is noncancellable with a term of three years. • The machinery has a cost and fair value at the start of the lease of $60,000; an estimated economic life of five years; and a residual value at the end of the lease of $10,000 (unguaranteed). • The lease contains no renewal options, and the machinery reverts to Company A at the end of the lease. • The present value of the residual value is $8,396. How much should Company B record as the right of use asset on January 1, Year 1 a. $50,000 b. $51,604 c. $60,000 d. $68,396

60,000 - 8,396 = 51,604

Bargain Purchase Options

Allows the lessee to purchase the leased property for a future price that is substantially lower than the asset's expected future fair value -If a bargain purchase option exists, the lessee must increase the present value of the lease payments by the present value of the option price -In the case of a bargain purchase option, a company uses the economic life of the underlying asset in the computation of the annual amortization , given that the lessee takes ownership of the asset

Alternative Use Test (finance lease criteria)

At the end of the lease term the lessor does not have an alternative use for the asset -the noncancelable lease is specialized in nature and has no alternative use to the lessor at the end of the lease term -the assumption here is that the lessee uses up all of the benefits from the leased asset, and, therefore, has essentially purchased the asset e.g., Company A determines that the racks have no alternative use.

Lessees generally have two possible lease accounting methods: (a) the operating method and (b) the finance method. To determine which method to apply, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset (i.e. if control transfers to the lessee).

If the lease meets one of five classification tests to determine whether the arrangement is effectively a purchase of the underlying asset, the lease is treated as a finance lease. Otherwise, if none of the tests are met, the lessee is deemed to only obtain the right to use the asset (not ownership of the asset itself), and accounts for the lease as an operating lease.

In computing the present value of the lease payments, which rate should the lessee use?

The implicit rate of the lessor, assuming that the implicit rate is known to the lessee.

Purchase Option Test (finance lease criteria)

The lease grants the lessee an option to purchase the asset that the lessee is reasonably certain to exercise bargain purchase option: a lease purchase option that allows the lessee to purchase the property for a price significantly lower than the asset's expected fair value; the cost of that option should be considered part of the lease payments e.g., The purchase option test is met because Company B is reasonably certain it will exercise the right to purchase the scanner at the end of the lease

Accounting for Finance Lease-Lessee

The lease is in substance a sale; lease transfers control of asset to the lessee *To record initial finance lease at inception:* -computed as the present value of the lease payments using the implicit rate (if known) -in measuring the right-of-use asset, initial direct costs and prepayments are added and incentives are deducted D- Right-of-Use Asset C- Lease Liability *To record first lease payment:* D- Lease Liability C- Cash *To record interest expense accrued:* D- Interest Expense C- Lease Liability *To record amortization expense of the right-of-use asset (straight line method): D- Amortization Expense C- Right-of-Use Asset -lessee records interest expense and amortization of the right-of-use asset separately on the income statement

Lease Term Test (finance lease criteria)

The lease term is a major part (75%) of the remaining economic life of the underlying asset bargain renewal option: allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option becomes exercisable; additional months are included in the lease term e.g., Company A agrees to lease racks to Company B for five years. The expected economic life of the racks are five years. The lease term is for 100% of the expected economic life of the racks.

Unguaranteed Residual Value

The lessor has less certainty that the unguaranteed residual portion of the asset has been sold *Classification Test:* ignore *Measurement of Lease Liability (lessee):* ignore *Measurement of Lease Receivable (lessor):* include -sales revenue and cost of goods sold are reduced by the present value of the unguaranteed residual values

Guaranteed Residual Value

The lessor knows that it will receive the full amount of the guarantee at the end of the lease *Classification Test:* include full amount of residual value in PV test (90% test) *Measurement of Lease Liability (lessee):* -if expected value of residual value >= to guaranteed residual value, ignore because the lessee expects to owe nothing at the end of the lease term -if expected value of residual value =< to guaranteed residual value, the difference between the two is included in the measurement of the lease lability; lessee will record a loss on the final payment *Measurement of Lease Receivable (lessor):* include -sales revenue and cost of goods are affected and are higher with a sales-type lease having a guaranteed residual value

Operating Lease Accounting- Lessor

The lessor records depreciation expense and lease revenue as a part of an operating lease. *To record advance lease payment received:* D- Cash C- Unearned Lease Revenue *To record recognition of lease revenue at year end:* D-Unearned Lease Revenue C-Lease Revenue -Lease revenue: recognized as time passes and the lease performance obligation is fulfilled *To record lease payment received (no advance)*: D- Cash C- Lease Revenue *To record depreciation of the asset:* D- Depreciation Expense C- Accumulated Depreciation -Continue to record depreciation expense on the asset (straight-line), so take the cost of the asset and divide by economic life In addition to depreciation expense, the lessor records other costs related to the lease arrangement, such as insurance, maintenance, and taxes in the period incurred

Present Value Test (finance lease criteria)

The present value of the lease payments (plus guaranteed residual value) equals or exceeds substantially all (90%) of the underlying asset's fair value PV of payments > 90% To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate *Lease Payments* The following items are included in calculating the present value test: the *fixed payments* specified in the lease plus *future variable payments* that are based on an index or a rate plus *guaranteed residual value* plus *purchase or termination options* reasonably certain to be exercised *Discount Rate/Interest Rate* Interest rate is used to determine present value factor implicit rate: the rate earned by the lessor on the lease In computing the present value of the lease payments, the lessee should use the implicit rate assuming that it is known unless the incremental borrowing rate is < the implicit rate; in that case, the lessee uses the incremental rate incremental borrowing rate: the borrowing rate that the lessee would have to pay if they went through a bank or through a lending institution in order to finance the lease

Finance Lease (transfer of control or ownership)

a lease that transfers control (or ownership) of the underlying asset to a lessee; the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term; has a term greater than 12 months and meets at least one of the finance lease criteria (lease classification tests) -the lease is in substance a sale of the asset -the lessee recognizes interest expense on the lease liability over the life of the lease (effective interested method) AND records amortization expense for the right-of-use asset (straight line basis) -A lessee therefore reports both interest expense and amortization expense of the right-of-use asset separately on the income statement -Upon expiration of the lease, a company has fully amortized the amount capitalized as a right-of-use asset

lease classification tests

tests that are used to determine whether a company should use the finance (sales-type) lease approach or the operating lease approach -For a lease to be a finance lease, it must be non-cancelable and meet at least one of the five tests: transfer of ownership test, purchase option test, lease term test, present value test, alternative use test; otherwise, the lease is an operating lease -we assume that the lease is non-cancelable unless explicitly stated otherwise -if none of the criteria are met, the lessor has an operating lease -if none of the criteria are met, the lessee has an operating lease (>12 mo) or short-term lease (<12 mo) -if one ore more of the criteria are met, the lessor has a sales-type lease