Lease accounting

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Lease accounting

  1. 1. 1 Leases Sid Glandon, DBA, CPA Associate Professor of Accounting University of Texas at El Paso
  2. 2. 2 Basics of Leasing  Lease – Contractual agreement between lessor and lessee – Gives lessee right to use specific property – Specifies duration and rental payments – Executory costs • Taxes, insurance and maintenance • May be assumed by either party
  3. 3. 3 Advantages  100% financing at fixed rates  Protection against obsolescence  Flexibility  Less costly financing  AMT problems avoided  Off-balance-sheet financing
  4. 4. 4 Classification of Leases  Capital leases – If lease transfers substantially all of the benefits and risks of ownership – Must be noncancelable  Operating leases – Do not substantially transfer benefits and risks of ownership
  5. 5. 5 Accounting by Lessee  Capitalize if noncancelable, and – Transfers ownership to lessee, or – Contains bargain purchase option, or – Lease term equal to 75% or more of estimated economic life of property, or – PV of minimum lease payments equals or exceeds 90% of fair value of property
  6. 6. 6 Accounting by Lessee Does lease agreement transfer ownership? Yes No Is there a bargain purchase option? Is the lease term ≥ 75% of economic Is PV of payments ≥ 90% No No No Yes Yes Yes Capital Lease Operating Lease
  7. 7. 7 Bargain Purchase Option  Allows lessee to buy leased asset  Price significantly lower that expected fair value at date of option  Determined at inception of lease  Must render option reasonably assured
  8. 8. 8 Economic Life Test  Lease period equals or exceeds 75% of asset’s economic life  Lease term is considered the fixed noncancelable term of lease  Bargain renewal options are included  If lease starts during last 25% of life of asset, test cannot be used
  9. 9. 9 Recovery of Investment  PV of minimum lease payments equals or exceeds 90% of fair value  Minimum lease payments – Payments – Guaranteed residual value – Penalty for failure to renew or extend – Bargain purchase option
  10. 10. 10 Discount Rate  The lesser of – Lessee’s incremental borrowing rate, or – The implicit interest rate
  11. 11. 11 Executory Cost  Insurance, maintenance and taxes  Should be excluded from minimum lease payments
  12. 12. 12 Residual Values  Estimated fair value at end of lease  Guaranteed residual value – An additional lease payment  Unguaranteed residual value – Same as no residual value to lessee  Lessor assumes residual value will be realized whether guaranteed or not
  13. 13. 13 Capitalized Leases Accounting by Lessee  Asset and Liability – Recorded at the lesser of the PV of minimum lease payments or FMV  Depreciation Period – Economic life • Lease transfers ownership • Lease has bargain purchase option – Term of lease
  14. 14. 14 Fact Pattern  Date: January 1, 2006  Lease term: 10 years  Discount rate: 8%  Annual lease payments: $12,000  Executory costs: $1,000  Title transfers at end of lease term  Economic life of asset: 12 years  Residual value: $0
  15. 15. 15 Date Annual Lease Payment Executory Costs Net Lease Interest Principal Lease Oblication 1/1/06 $79,716 1/1/06 $12,000 $1,000 $11,000 $11,000 68,716 1/1/07 12,000 1,000 11,000 $5,497 5,503 63,213 1/1/08 12,000 1,000 11,000 5,057 5,943 57,270 1/1/09 12,000 1,000 11,000 4,582 6,418 50,852 1/1/10 12,000 1,000 11,000 4,068 6,932 43,920 1/1/11 12,000 1,000 11,000 3,514 7,486 36,433 1/1/12 12,000 1,000 11,000 2,915 8,085 28,348 1/1/13 12,000 1,000 11,000 2,268 8,732 19,616 1/1/14 12,000 1,000 11,000 1,569 9,431 10,185 1/1/15 12,000 1,000 11,000 815 10,185 0 $120,000 $10,000 $110,000 $30,284 $79,716 Lease Amortization Schedule
  16. 16. 16 Date Account Debit Credit 1/1/06 Equipment under capital lease $79,716 Obligations under capital lease $79,716 Date Account Debit Credit 1/1/06 Obligations under capital lease $11,000 Executory costs, insurance and taxes 1,000 Cash $12,000 To record the signing of a lease classified as a capital lease. To record the initial lease payment at the signing of a lease classified as a capital lease.
  17. 17. 17 Date Account Debit Credit 12/31/06 Depreciation expense $6,643 Accumulated depreciation $6,643 Analysis of depreciation expense: Capitalized cost of equipment $79,716 Salvage (residual) value 0 Depreciable base 79,716 Economic (service) life 12 Annual depreciation $6,643 To record depreciation expense on equipment under capital lease.
  18. 18. 18 Date Account Debit Credit 1/1/07 Obligations under capital lease $5,503 Executory costs, insurance and taxes 1,000 Interest expense 5,497 Cash $12,000 To record the payment of principal, executory costs and interest on capital lease.
  19. 19. 19 Operating Leases Accounting by Lessee  Lessee assigns rent to periods benefiting  Ignores any commitments for future payments  Note disclosure – For all operating leases that have noncancelable lease terms in excess of one year
  20. 20. 20 Classification of Leases Accounting by Lessor  Direct financing leases  Sales type leases  Operating leases
  21. 21. 21 Direct Financing Lease  Must meet group I capitalization criteria and – Collectibility of payments must be reasonably assured – Lessor’s performance must be substantially complete  FV of asset equal to lessor’s book value
  22. 22. 22 Sales Type Lease  Must meet group I capitalization criteria and – Collectibility of payments must be reasonably assured – Lessor’s performance must be substantially complete  FV of asset should not be equal to lessor’s book value – Lease contains a dealer’s gross profit
  23. 23. 23 Operating Lease Accounting by Lessor  Does not meet criteria for capitalized lease  Rental receipts recorded as rental receipts  Leased asset depreciated  Leased equipment and accumulated depreciation separately classified
  24. 24. 24 Accounting by Lessor Does lease four criteria in Group I? No Yes Is collectability of payments assured? Is performance substantially complete? Yes Yes No No No Operating Lease Direct FinancingDoes asset FMV = lessor's book Yes Sales Type
  25. 25. 25 Direct Financing Lease  Debit, Lease receivable – Gross sum of lease payments  Credit, Unearned interest revenue – Lease receivable less FMV of asset  Credit, Inventory of equipment – Lessor’s cost of the asset
  26. 26. 26 Fact Pattern  Date: January 1, 2005  Inventory of equipment: $103,500  Lease term: 6 years  Implicit interest rate: 8%  Payments: $20,000  Residual value: $5,786
  27. 27. 27 Date Payment Interest Amortization of Principal Balance 1/1/05 $103,500 1/1/05 $20,000 $20,000 83,500 1/1/06 20,000 $6,680 13,320 70,180 1/1/07 20,000 5,614 14,386 55,794 1/1/08 20,000 4,464 15,536 40,258 1/1/09 20,000 3,221 16,779 23,479 1/1/10 20,000 1,878 18,122 5,357 12/31/10 5,786 429 5,357 0 $125,786 $22,286 $103,500 Lease Amortization Schedule
  28. 28. 28 Date Account Debit Credit 1/1/05 Lease receivable $125,786 Unearned interest revenue $22,286 Inventory 103,500 To record the signing of a direct financing lease.
  29. 29. 29 Sales Type Leases  Debit, Lease Receivable – Lease payments plus residual  Debit, Cost of Goods Sold – Lessor’s cost  Credit, Sales Price of Asset – PV of minimum lease payments  Credit, Unearned Interest Revenue – Lease Receivable less FMV of asset  Credit, Inventory – Lessor’s cost
  30. 30. 30 Fact Pattern  Date: January 1, 2005  Inventory of equipment: $60,000  FMV of equipment: $103,500  Lease term: 6 years  Implicit interest rate: 8%  Payments: $20,000  Residual value: $5,786
  31. 31. 31 Date Payment Interest Amortization of Principal Balance 1/1/05 $103,500 1/1/05 $20,000 $20,000 83,500 1/1/06 20,000 $6,680 13,320 70,180 1/1/07 20,000 5,614 14,386 55,794 1/1/08 20,000 4,464 15,536 40,258 1/1/09 20,000 3,221 16,779 23,479 1/1/10 20,000 1,878 18,122 5,357 12/31/10 5,786 429 5,357 0 $125,786 $22,286 $103,500 Lease Amortization Schedule
  32. 32. 32 Date Account Debit Credit 1/1/05 Lease receivable $125,786 Cost of goods sold $60,000 Sales revenue $103,500 Unearned interest revenue $22,286 Inventory 60,000 To record the signing of a sales type lease.

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