Lease

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CHAPTER FOUR

Accounting for Leases


THE LEASING ENVIRONMENT

A lease is a contractual agreement between a lessor and a lessee,


that gives the lessee the right to use specific property, owned by the
lessor, for a specified period of time.

Largest group of leased equipment involves:


 Information technology equipment
 Transportation (trucks, aircraft, rail)
 Construction
 Agriculture
THE LEASING ENVIRONMENT

Advantages of Leasing
1. 100% financing at fixed rates.
2. Protection against obsolescence.
3. Flexibility.
4. Less costly financing.
5. Tax advantages.
6. Off-balance-sheet
financing.
THE LEASING ENVIRONMENT

Conceptual Nature of a Lease


Capitalize a lease that transfers substantially all of the benefits
and risks of property ownership, provided the lease is non-
cancelable.

Leases that do not transfer substantially all the benefits


and risks of ownership are operating leases.
ACCOUNTING BY THE LESSEE

If the lessee capitalizes a lease, the lessee records an asset and a


liability generally equal to the present value of the rental payments.
 Records depreciation on the leased asset.
 Treats the lease payments as consisting of interest and
principal.
ACCOUNTING BY THE LESSEE

For a finance lease, the IASB has identified four criteria.


1. Lease transfers ownership of the property to the lessee.
2. Lease contains a bargain-purchase option.
3. Lease term is for major part of the economic life of the asset.

4. Present value of the minimum lease One or more


must be met for
payments amounts to substantially finance lease
all of the fair value of the leased accounting.
asset.
ACCOUNTING BY THE LESSEE

Leases that DO NOT meet any of the four criteria are accounted for
as operating leases.
ACCOUNTING BY THE LESSEE

Capitalization Criteria
Transfer of Ownership Test
 If the lease transfers ownership of the asset to the lessee, it is a
finance lease.

Bargain-Purchase Option Test


 At the inception of the lease, the difference between the option
price and the expected fair market value must be large enough to
make exercise of the option reasonably assured.
ACCOUNTING BY THE LESSEE

Capitalization Criteria
Economic Life Test
 Lease term is generally considered to be the fixed, non-
cancelable term of the lease.
 Bargain-renewal option can extend this period.
 At the inception of the lease, the difference between the
renewal rental and the expected fair rental must be great
enough to make exercise of the option to renew reasonably
assured.
ACCOUNTING BY THE LESSEE

Illustration: Carrefour (FRA) leases Lenovo (CHN) PCs for two


years at a rental of €100 per month per computer and subsequently
can lease them for €10 per month per computer for another two
years. The lease clearly offers a bargain-renewal option; the lease
term is considered to be four years.
ACCOUNTING BY THE LESSEE

Capitalization Criteria
Recovery of Investment Test
Minimum Lease Payments:
 Minimum rental payments
 Guaranteed residual value
 Penalty for failure to renew or extend the lease
 Bargain-purchase option
Executory Costs:
 Insurance Exclude from PV of
 Maintenance Minimum Lease
 Taxes Payment Calculation
ACCOUNTING BY THE LESSEE

Capitalization Criteria
Recovery of Investment Test

Discount Rate
 Lessee computes the present value of the minimum lease
payments using the implicit interest rate.
 In the event it is impracticable to determine the implicit rate, the
lessee should use its incremental borrowing rate.
ACCOUNTING BY THE LESSEE

Asset and Liability Accounted for Differently


Asset and Liability Recorded at the lower of:
1. present value of the minimum lease payments (excluding
executory costs) or

2. fair market value of the leased asset at the inception of the


lease.
ACCOUNTING BY THE LESSEE

Asset and Liability Accounted for Differently


Depreciation Period
 If lease transfers ownership, depreciate asset over the
economic life of the asset.
 If lease does not transfer ownership, depreciate over the
term of the lease.
ACCOUNTING BY THE LESSEE

Asset and Liability Accounted for Differently


Effective-Interest Method
 Used to allocate each lease payment between principal and
interest.

Depreciation Concept
 Depreciation and the discharge of the obligation are independent
accounting processes.
ACCOUNTING BY THE LESSEE
Illustration: CNH Capital (NLD) (a subsidiary of CNH Global) and Ivanhoe Mines Ltd.
(CAN) sign a lease agreement dated January 1, 2015, that calls for CNH to lease a front-
end loader to Ivanhoe beginning January 1, 2015. The terms and provisions of the lease
agreement and other pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due
basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years, and no residual value.
• Ivanhoe pays all of the executory costs directly to third parties except for the
property taxes of $2,000 per year, which is included as part of its annual payments to
CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination
of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent per
year; Ivanhoe knows this fact.
ACCOUNTING BY THE LESSEE

What type of lease is this? Explain.


Capitalization Criteria: Finance Lease, #3
1. Transfer of ownership NO
2. Bargain purchase option NO
3. Lease term for major part of
economic life of leased Lease term = 5 yrs.
YES
property Economic life = 5 yrs.

4. Present value of minimum


lease payments substantially PV = $100,000 FMV
all of FMV of property YES
= $100,000.
ACCOUNTING BY THE LESSEE

Computation of Capitalized Lease Payments

Payment $ 25,981.62
Property taxes (executory cost) - 2,000.00
Minimum lease payment 23,981.62
Present value factor (i=10%,n=5) x 4.16986 *

PV of minimum lease payments $100.000.00

Ivanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental
borrowing rate of 11 percent because (1) it is lower and (2) it knows about it.

* Present value of an annuity due of 1 for 5 periods at 10% (Table 6-5)


ACCOUNTING BY THE LESSEE

Ivanhoe records the finance lease on its books on January 1, 2015, as:

Leased Equipment 100,000.00


Lease Liability 100,000.00

Ivanhoe records the first lease payment on January 1, 2015, as follows.

Property Tax Expense 2,000.00


Lease Liability 23,981.62
Cash 25,981.62
ACCOUNTING BY THE LESSEE
ACCOUNTING BY THE LESSEE

Prepare the entry to record accrued interest at December 31, 2015.


Ivanhoe records accrued interest on December 31, 2014
Interest Expense 7,601.84
Interest Payable 7,601.84
ACCOUNTING BY THE LESSEE

Prepare the required on December 31, 2015, to record depreciation for the
year using the straight-line method ($100,000 ÷ 5 years).

Depreciation Expense 20,000


Accumulated Depreciation—Leased Equipment 20,000

The liabilities section as it relates to lease transactions at December 31,


2015.
ACCOUNTING BY THE LESSEE

Ivanhoe records
the lease
payment of
January 1,
2015, as
follows.

Property Tax Expense 2,000.00


Interest Payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.62
ACCOUNTING BY THE LESSEE

Operating Method (Lessee)


The lessee assigns rent to the periods benefiting from the use of the
asset and ignores, in the accounting, any commitments to make future
payments.

Illustration: Assume Ivanhoe accounts for the lease as an operating


lease. Ivanhoe records the payment on January 1, 2015, as follows.

Rent Expense 25,981.62


Cash 25,981.62
ACCOUNTING BY THE LESSEE

Differences using a finance lease instead of an operating lease.


1. Increase in amount of reported debt (both short-term and long-term).
2. Increase in amount of total assets (specifically long-lived assets).
3. Lower income early in the life of the lease, therefore lower retained earnings.
ACCOUNTING BY THE LESSOR

Benefits to the Lessor


1. Interest revenue.
2. Tax incentives.
3. Residual value profits.
ACCOUNTING BY THE LESSOR

Economics of Leasing
A lessor determines the amount of the rental, basing it on the rate of
return—the implicit rate—needed to justify leasing the asset.

If a residual value is involved (whether guaranteed or not), the company


would not have to recover as much from the lease payments.
ACCOUNTING BY THE LESSOR

Classification of Leases by the Lessor


a. Operating leases.

b. Finance leases
 Direct-financing leases
 Sales-type leases
ACCOUNTING BY THE LESSOR

Classification of Leases by the Lessor


ACCOUNTING BY THE LESSOR

Direct-Financing Method (Lessor)


In substance the financing of an asset purchase by the lessee.
Lessor records:
 A lease receivable instead of a leased asset.
 Receivable is the present value of the minimum lease payments
plus the present value of the unguaranteed residual value.
ACCOUNTING BY THE LESSOR

Illustration: Using the data from the preceding CNH/Ivanhoe example we


illustrate the accounting treatment for a direct-financing lease. We repeat here
the information relevant to CNH in accounting for this lease transaction.
1. The term of the lease is five years beginning January 1, 2015, non-
cancelable, and requires equal rental payments of $25,981.62 at the
beginning of each year. Payments include $2,000 of executory costs
(property taxes).
2. The equipment (front-end loader) has a cost of $100,000 to CNH, a fair
value at the inception of the lease of $100,000, an estimated economic
life of five years, and no residual value.
3. CNH incurred no initial direct costs in negotiating and closing the lease
transaction.
ACCOUNTING BY THE LESSOR

We repeat here the information relevant to CNH in accounting for this lease
transaction.
4. The lease contains no renewal options. The equipment reverts to CNH at
the termination of the lease.
5. CNH sets the annual lease payments to ensure a rate of return of 10
percent (implicit rate) on its investment as shown.

Fair market value of leased equipment $ 100,000.00


Present value of residual value (calculation below) -
Amount to be recovered through lease payment 100,000.00
PV factor of annunity due (i=10%, n=5) 4.16986
Annual payment required $ 23,981.62
ACCOUNTING BY THE LESSOR

The lease meets the criteria for classification as a direct-financing


lease for two reasons:
1. the lease term equals the equipment’s estimated economic life, and

2. the present value of the minimum lease payments equals the


equipment's fair value.

It is not a sales-type lease because there is no difference between the


fair value ($100,000) of the loader and CNH’s cost ($100,000).
ACCOUNTING BY THE LESSOR

CNH records the lease of the asset and the resulting receivable on
January 1, 2015 (the inception of the lease), as follows.

Lease Receivable 100,000


Equipment 100,000

Companies often report the lease receivable in the statement of financial


position as “Net investment in finance leases.
ACCOUNTING BY THE LESSOR
ACCOUNTING BY THE LESSOR

On January 1, 2015, CNH records receipt of the first year’s lease payment as
follows.

Cash 25,981.62
Ivanhoe records accrued interest on December 31, 2014
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00
ACCOUNTING BY THE LESSOR

On December 31, 2015, CNH recognizes the interest revenue earned during
the first year through the following entry.

Interest Receivable 7,601.84


Ivanhoe records accrued interest on December 31, 2014
Interest Revenue 7,601.84
ACCOUNTING BY THE LESSOR

At December 31, 2015, CNH reports the lease receivable in its statement of
financial position among current assets or non-current assets, or both. It
classifies the portion due within one year or the operating cycle, whichever is
longer, as a current asset, and the rest with non-current assets.
ACCOUNTING BY THE LESSOR

The following entry records the receipt of the second year's lease payment on
January 1, 2016.
Cash 25,981.62
Ivanhoe records accrued interest on16,379.78
Lease Receivable
December 31, 2014
Interest Receivable 7,601.84
Property Tax Expense/Property Taxes Payable 2,000.00
ACCOUNTING BY THE LESSOR

The following entry records the recognition of interest earned on December


31, 2016.

Interest Receivable
Ivanhoe 5,963.86
records accrued interest on December 31, 2014
Interest Revenue 5,963.86
ACCOUNTING BY THE LESSOR

Operating Method (Lessor)


 Records each rental receipt as rental revenue.
 Depreciates leased asset in the normal manner.
ACCOUNTING BY THE LESSOR

Assuming that the direct-financing lease illustrated for CNH does not
qualify as a finance lease, CNH accounts for it as an operating lease and
records the cash rental receipt as follows.

Cash 25,981.62
Rental Revenue 25,981.62

Depreciation is recorded as follows: ($100,000 ÷ 5 years = $20,000)

Depreciation Expense 20,000


Accumulated Depreciation 20,000
SPECIAL ACCOUNTING PROBLEMS

1. Residual values.
2. Sales-type leases (lessor).
3. Bargain-purchase options.
4. Initial direct costs.
5. Current versus non-current classification.
6. Disclosure.
SPECIAL ACCOUNTING PROBLEMS

Residual Values
Meaning of Residual Value - Estimated fair value of the leased asset
at the end of the lease term.

Guaranteed versus Unguaranteed – A guaranteed residual value is


when the lessee agrees to make up any deficiency below a stated
amount that the lessor realizes in residual value at the end of the lease
term.
SPECIAL ACCOUNTING PROBLEMS

Residual Values
Lease Payments - Lessor may adjust lease payments because of the
increased certainty of recovery of a guaranteed residual value.

Lessee Accounting for Residual Value - The minimum lease


payment includes a guaranteed residual value but excludes an
unguaranteed residual value.
Lease Payments
Illustration: Assume the same data as in the CNH/Ivanhoe illustrations except that CNH
estimates a residual value of $5,000 at the end of the five-year lease term. In addition,
CNH assumes a 10 percent return on investment (ROI), whether the residual value is
guaranteed or unguaranteed. The terms and provisions of the lease agreement and other
pertinent data are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable, requiring
equal rental payments of $25,981.62 at the beginning of each year (annuity-due
basis).
• The loader has a fair value at the inception of the lease of $100,000, an estimated
economic life of five years.
• Ivanhoe pays all of the executory costs directly to third parties except for the
property taxes of $2,000 per year, which is included as part of its annual payments to
CNH.
• The lease contains no renewal options. The loader reverts to CNH at the termination
of the lease.
• Ivanhoe’s incremental borrowing rate is 11 percent per year.
• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.
• CNH sets the annual rental to earn a rate of return on its investment of 10 percent per
year; Ivanhoe knows this fact.
Lease Payments

CNH assumes a 10 percent return on investment (ROI), whether the


residual value is guaranteed or unguaranteed. CNH would compute the
amount of the lease payments as follows.
Lease Accounting for Residual Value

Guaranteed Residual Value (Lessee Accounting)


An additional lease payment that the lessee will pay in property or cash,
or both, at the end of the lease term.
Guaranteed Residual Value (Lessee)
Guaranteed Residual Value (Lessee)

At the end of the lease term, before the lessee transfers the asset to CNH,
the lease asset and liability accounts have the following balances.

Assume that Ivanhoe depreciated the leased asset down to its residual
value of $5,000 but that the fair market value of the residual value at
December 31, 2019, was $3,000. Ivanhoe would make the following
journal entry.
Guaranteed Residual Value (Lessee)

Loss on Disposal of Equipment 2,000.00


Interest Expense (or Interest Payable) 454.76
Lease Liability 4,545.24
Accumulated Depreciation—Leased Equipment 95,000.00
Leased Equipment 100,000.00
Cash 2,000.00
Lease Accounting for Residual Value

Unguaranteed Residual Value (Lessee Accounting)


Assume the same facts as those above except that the $5,000 residual
value is unguaranteed instead of guaranteed. CNH will recover the same
amount through lease rentals—that is, $96,895.40. Ivanhoe would
capitalize the amount as follows:
Unguaranteed Residual Value (Lessee)

ILLUSTRATION 21-20
Lease Amortization Schedule for Lessee
—Unguaranteed Residual Value
Unguaranteed Residual Value (Lessee)

At the end of the lease term, before Ivanhoe transfers the asset to CNH,
the lease asset and liability accounts have the following balances.
Lessee Entries Involving Residual Values
SPECIAL ACCOUNTING PROBLEMS

Lessor Accounting for Residual Value


The lessor works on the assumption that it will realize the residual value at
the end of the lease term whether guaranteed or unguaranteed.

Illustration: Assume a direct-financing lease with a residual value (either


guaranteed or unguaranteed) of $5,000. CNH determines the payments as
follows.
Lessor Accounting for Residual Value
Lessor Accounting for Residual Value

CNH would
make the
following
entry for this
direct-
financing
lease on
1/1/15.

Lease Receivable 100,000.00


Equipment 100,000.00
Lessor Accounting for Residual Value

CNH would
make the
following
entry for this
direct-
financing
lease on
1/1/15.

Cash 25,237.09
Lease Receivable 23,237.09
Property Tax Expense/Property Taxes Payable
2,000.00
Lessor Accounting for Residual Value

CNH would
make the
following
entry for this
direct-
financing
lease on
12/31/15.

Interest Receivable 7,676.29


Interest Revenue 7,676.29
SPECIAL ACCOUNTING PROBLEMS

Sales-Type Leases (Lessor)


 Primary difference between a direct-financing lease and a sales-
type lease is the manufacturer’s or dealer’s gross profit (or loss).
 Lessor records the sale price of the asset, the cost of goods sold and
related inventory reduction, and the lease receivable.
 There is a difference in accounting for guaranteed and
unguaranteed residual values.
Sales-Type Leases (Lessor)

Direct-Financing versus Sales-Type Leases


Sales-Type Leases (Lessor)

LEASE RECEIVABLE (also referred to as NET INVESTMENT). The present


value of the minimum lease payments plus the present value of any unguaranteed
residual value. The lease receivable therefore includes the present value of the
residual value, whether guaranteed or not.

SALES PRICE OF THE ASSET. The present value of the minimum lease
payments.

COST OF GOODS SOLD. The cost of the asset to the lessor, less the present
value of any unguaranteed residual value.
Sales-Type Leases (Lessor)

Illustration: To illustrate a sales-type lease with a guaranteed residual


value and with an unguaranteed residual value, assume the same facts
as in the preceding direct-financing lease situation. The estimated
residual value is $5,000 (the present value of which is $3,104.60), and
the leased equipment has an $85,000 cost to the dealer, CNH. Assume
that the fair market value of the residual value is $3,000 at the end of
the lease term.
Sales-Type Leases (Lessor)

Computation of Lease Amounts by CNH Financial—Sales-Type Lease


Comparative
Sales-Type Leases (Lessor) Entries
SPECIAL ACCOUNTING PROBLEMS

Bargain Purchase Option (Lessee)


 Lessee must increase the present value of the minimum lease
payments by the present value of the option.
 Only difference between the accounting treatment for a
bargain-purchase option and a guaranteed residual value of
identical amounts is in the computation of the annual
depreciation.
SPECIAL ACCOUNTING PROBLEMS

Initial Direct Costs (Lessor)


Accounting for initial direct costs:
 Operating leases, the lessor should defer initial direct costs.
 Sales-type leases, the lessor expenses the initial direct costs.
 Direct-financing lease, the lessor adds initial direct costs to
the net investment.
SPECIAL ACCOUNTING PROBLEMS

Current versus Noncurrent


Both the annuity-due and the ordinary-annuity situations report the
reduction of principal for the next period as a current liability/current
asset.
Current versus Noncurrent

The current portion of the lease liability/receivable as of December 31,


2015, would be $18,017.70.
SPECIAL ACCOUNTING PROBLEMS

Disclosing Lease Data


For lessees:
 A general description of material leasing arrangements.

 A reconciliation between the total of future minimum lease payments


at the end of the reporting period and their present value.

 The total of future minimum lease payments at the end of the reporting
period, and their present value for periods (1) not later than one year,
(2) later than one year and not later than five years, and (3) later than
five years.
SPECIAL ACCOUNTING PROBLEMS

Disclosing Lease Data


For lessors:
 A general description of material leasing arrangements.

 A reconciliation between the gross investment in the lease at the end of


the reporting period, and the present value of minimum lease payments
receivable at the end of the reporting period.

 Unearned finance income.

 The gross investment in the lease and the present value of minimum
lease payments receivable at the end of the reporting period for periods
(1) not later than one year, (2) later than one year and not later than
five years, and (3) later than five years.
Unresolved Lease Accounting Problems

To avoid leased asset capitalization, companies design, write, and


interpret lease agreements to prevent satisfying any of the four finance
lease criteria.

The real challenge lies in disqualifying the lease as a finance lease to


the lessee, while having the same lease qualify as a finance (sales or
financing) lease to the lessor.

Unlike lessees, lessors try to avoid having lease arrangements


classified as operating leases.

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