Accounting for Leases Part 1

Chapter 15 Leases QUESTIONS FOR REVIEW OF KEY TOPICS Regardless of the legal form of the agreement, a lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing depending on the substance of the leasing arrangement. Capital leases are agreements that are formulated outwardly as leases, but that are in reality installment purchases. Professional judgment is needed to differentiate between leases that represent “rental agreements” and those that in reality are “installment purchases/sales.” The FASB provides guidance for distinguishing between the two fundamental types of leases. Periodic interest expense is calculated by the lessee as the effective interest rate Question 15-2 times the amount of the outstanding lease liability during the period. This same principle applies to the flip side of the transaction, i.e., the lessor’s lease receivable (net investment). The approach is the same regardless of the specific form of the debt – that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments. Leases and installment notes are very similar. The fundamental nature of the Question 15-3 transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. In return for providing financing, the borrower (lessee) pays interest over the maturity (lease term). Conceptually, leases and installment notes are accounted for in precisely the same way. Current GAAP does allow airlines' balance sheets to appear as if the companies Question 15-4 don't have airplanes. That’s because most airlines extensively use operating leases to “acquire” airplanes. Under current rules, under operating leases, unlike capital leases, neither the leased asset nor the lease liability is reported in the balance sheet. The criteria are: (1) the agreement specifies that ownership of the asset Question 15-5 transfers to the lessee, (2) the agreement contains a bargain purchase option, (3) the lease term is equal to 75% or more of the expected economic life of the asset, or (4) the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the leased asset. A bargain purchase option is a provision in the lease contract that gives the Question 15-6 lessee the option of purchasing the leased property at a “bargain” price – defined as a price sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears reasonably assured at the inception of the lease. Because exercise of the option appears reasonably assured, transfer of ownership is expected. Question 15-1 Answers to Questions (continued) Question 15-7 The lease is a capital lease to Seminole because the present value of the minimum lease payments ($5.2 million) is greater than 90% of the fair value of the asset (90% x $5.6 million = $5.04 million). Since the additional lessor conditions also are met, it is a capital lease to Lukawitz. Furthermore it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost. Yes. The minimum lease payments for the lessee exclude any residual value Question 15-8 not guaranteed by the lessee. On the other hand, the lessor includes any residual value not guaranteed by the lessee but guaranteed by a third-party guarantor. Even when minimum lease payments are the same, their present values will differ if the lessee uses a discount rate different from the lessor’s implicit rate. This would occur if the lessee is unaware of the implicit rate or if the implicit rate exceeds the lessee’s incremental borrowing rate. The way a bargain purchase option is included in determining minimum lease Question 15-9 payments is precisely the same way that a lessee-guaranteed residual value is included. The expectation that the option price will be paid effectively adds an additional cash flow to the lease. That additional payment is included as a component of minimum lease payments. It therefore is included in the computation of the amount to be capitalized (as an asset and liability) by the lessee. But, a residual value not guaranteed by the lessee is ignored. Executory costs are costs usually associated with ownership of an asset such Question 15-10 as maintenance, insurance, and taxes. These are responsibilities of ownership that we assume are transferred to the lessee in a capital lease. When paid by the lessee, these expenditures are expensed by the lessee as incurred. When paid by the lessor, lease payments usually are inflated for this reason. These executory costs, including any lessor profit thereon, are excluded in determining the minimum lease payments and still are expensed by the lessee, even though paid by the lessor. The lessor’s discount rate is the effective interest rate the lease payments Question 15-11 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. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. When the lessor’s implicit rate is known, the lessee should use the lower of the two rates. This is the rate the lessee would be expected to pay a bank if funds were borrowed to buy the asset. Answers to Questions (continued) Question 15-12 Contingent rentals are not included in minimum lease payments but are reported in disclosure notes by both the lessor and lessee. This is because they are not determinable at the inception of the lease. They are included as components of income when (and if) the payments occur. However, increases or decreases in lease payments that are dependent only upon the passage of time are not contingent rentals; these are part of minimum lease payments. The costs of negotiating and consummating a completed lease transaction Question 15-13 incurred by the lessor that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs. They include legal fees, evaluating the prospective lessee's financial condition, commissions, and preparing and processing lease documents. In an operating lease initial direct costs are recorded as prepaid expenses Question 15-14 (assets) and amortized as an operating expense (usually straight-line) over the lease term. This approach is due to the nature of operating leases in which rental revenue is earned over the lease term. Initial direct costs are matched, along with depreciation and other associated costs, with the rent revenues they help generate. In a direct financing lease initial direct costs are amortized over the lease term. This is accomplished by offsetting lease receivable by the initial direct costs. This recognizes the initial direct costs at the same rate (that is, proportionally), as the interest revenue to which it is related. The nature of the lease motivates this treatment. The only revenue a direct financing lease generates for the lessor is interest revenue, which is earned over the lease term. So, initial direct costs are matched proportionally over the term of the lease. In a sales-type lease, GAAP requires that initial direct costs be expensed in the period of “sale” – that is, at the inception of the lease. This treatment implicitly assumes that in a sales-type lease the primary reason for incurring these costs is to facilitate the sale of the leased asset. Lease disclosure requirements are quite extensive for both the lessor and Question 15-15 lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years. Other required disclosures are specific to the type of lease and include: residual values, contingent rentals, sublease rentals, and executory costs. Answers to Questions (continued) Question 15-16 On the surface there are two separate transactions. But the seller/lessee still retains the use of the asset that it had prior to the sale-leaseback. In reality the seller/lessee has cash from the sale and a noncancelable obligation to repay a debt. In substance, the seller/lessee simply has borrowed cash to be repaid with interest over the lease term. So “substance over form” dictates that the gain on the sale of the asset not be immediately recognized, but deferred and recognized over the term of the lease. There typically is interdependency between the lease terms and the price at which the asset is sold. So the earnings process is not complete at the time of sale but is completed over the term of the lease. Viewing the sale and the leaseback as a single transaction is consistent with the revenue realization principle. The FASB specified exceptions to the general classification criteria for leases Question 15-17 that involve land because of the unlimited useful life of land and the inexhaustibility of its inherent value through use. When title passes to the lessee – through automatic title passage or bargain purchase – these leases clearly are capital in nature and should be classified as such by the lessee. However, the Board felt that there would be difficulty in applying the other two criteria. Because land has essentially an infinite life, no lease term could possibly exceed 75 percent of its useful life, and the criterion was not applicable. The fourth criterion calls for comparing the present value of the lease payments with 90 percent of the property's fair value to determine if the lessor will recover its investment through the payments. When land is involved, the Board felt that the lease was not intended to recover the lessor's investment. Further, the lessor would have the land at the end of the lease term in essentially the same condition. Accordingly, the FASB concluded that leases involving material amounts of land should be classified as operating leases unless title passes automatically or as the result of a bargain purchase option. Question 15-18 The guidelines for determining when a material amount of land is involved in a lease indicate that leases involving property where land constitutes 25 percent or more of the total value should be treated as if they are two leases. The portion of the lease attributable to the land should be treated as an operating lease while the portion attributable to the other property should be judged on its own characteristics and accounted for accordingly. If the land value is less than 25 percent of the total value of the property, no allocation needs to be made. Answers to Questions (continued) Question 15-19 A leveraged lease involves significant long-term, nonrecourse financing by a third-party creditor. The lessor serves the role of a mortgage broker and earns income by serving as an agent between a company needing to acquire property and a lender looking for an investment. The lender provides enough cash to the lessor to acquire the property. The leased property is then leased to the lessee under a capital lease with lease payments applied to the note held by the lender. A lessee accounts for a leveraged lease the same way as a nonleveraged lease. A lessor records its investment (receivable) net of the nonrecourse debt and reports income from the lease only in those years when the receivable exceeds the liability. We can find authoritative guidance for accounting for leases under IFRS in Question 15-20 “Leases,” International Accounting Standard No. 17, IASCF. Question 15-21 Yes. A finance lease under IFRS might be classified as an operating lease under U.S. GAAP. U.S. GAAP has precise guidelines while IFRS are more “principles-based.” For instance, if the present value of minimum lease payments is 89% of the leased asset’s fair value, the lease would be classified as an operating under U.S. GAAP because lease payments are less than 90% of the asset’s fair value, but 89% might be a “major portion” of the asset’s fair value and the lease classified as a finance lease under IAS No. 17. Answers to Questions (concluded) Question 15-22 In general, IFRS is considered to be more principles-based while U.S. GAAP is more rules-based. For example, under IFRS one situation that normally indicates a finance lease is if the noncancelable lease term is for a major portion of the expected economic life of the asset. Another is if the present value of the minimum lease payments is equal to or greater than substantially all of the fair value of the asset. With regard to lease classification, U.S. GAAP provides more precise guidelines. The lines are brighter between a capital lease and an operating lease. Meeting any one of four criteria qualify a lease as a capital lease under U.S. GAAP. Also, the specification of what constitutes a “major portion” of the useful life of an asset is much more precise. We presume, quite arbitrarily, that 75% or more of the expected economic life of the asset is an appropriate threshold point for this purpose. Often, we might consider a “major portion” to be less than 75% and classify a lease as a finance lease under IFRS that would be an operating lease under U.S. GAAP. Similarly, what constitutes “substantially all” of the fair value of the leased asset also is more precise under U.S. GAAP. The lessee is considered to have in substance purchased the asset when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease. IFRS does not provide a specific percentage for determining what constitutes “substantially all” of the leased asset’s fair value. Also, IFRS provides (a) a fifth indicator of a finance lease that normally leads to a finance lease and (b) three indicators that might lead to a finance lease. Question 15-23 The IASB and FASB are collaborating on a joint project with the intent of revising accounting standards for leases. As of 2009, the Boards have agreed on a “right of use” model. Under this approach, the lessee recognizes an asset representing the right to use the leased asset for the lease term and also recognizes a corresponding liability for the lease rentals, whatever the term of the lease. The new standard might result in most, if not all, leases being recorded as an intangible asset for the right of use and a liability for the present value of the lease payments. It may eliminate operating leases. The impact of any changes will be significant; U.S. companies alone have over $1.25 trillion in operating lease obligations. BRIEF EXERCISES Brief Exercise 15-1 Because none of the four classification criteria is met, this is an operating lease. Accordingly, LTT will record rent expense for each of the four $25,000 payments, reducing its earnings by $100,000 each year. Brief Exercise 15-2 Because none of the four classification criteria is met, this is an operating lease. Accordingly, Lakeside will record rent revenue for each of the four $25,000 payments, increasing its earnings by $100,000 each year. In addition Lakeside, as owner of the asset, will record depreciation. Assuming straight-line depreciation of the $2 million cost over the 25-year life, that’s $80,000 depreciation expense each year. So, earnings are increased by a net $20,000 ($100,000 – 80,000). Brief Exercise 15-3 Because this is an operating lease, Ward will record rent expense for each of the $5,000 payments. The advance payment also represents rent, recorded initially as prepaid rent and allocated equally over the ten years of the lease. As a result, Ward’s rent expense for the year reduces its earnings by $70,000 each year. $5,000 x 12 = $60,000 $100,000 / 10 = 10,000 $70,000 Brief Exercise 15-4 The lease is a capital lease to Athens because the present value of the minimum lease payments ($20.4 million) is greater than 90% of the fair value of the asset (90% x $22.4 million = $20.16 million). None of the other three classification criteria is met. Brief Exercise 15-5 The present value of the minimum lease payments ($20.4 million) is greater than 90% of the fair value of the asset (90% x $22.4 million = $20.16 million). Since the additional lessor conditions also are met, it is a capital lease to Corinth. Furthermore, it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost ($16 million). Brief Exercise 15-6 In direct financing leases, the lessor records a receivable for the present value of the lease payments to be received ($2,500,000 for Sonic). The difference between the total of the lease payments ($3,292,000 for Sonic) and the present value of the lease payments to be received over the term of the lease represents interest. Over the term of the leases, Sonic will report this amount ($3,292,000 minus $2,500,000 = $792,000) as interest revenue, determined as the effective interest rate times the outstanding balance (net investment) each period. Brief Exercise 15-7 The amount of interest expense the lessee would record in conjunction with the second quarterly payment at October 1 is $2,892: Initial balance, July 1 (given).................................... Reduction for first payment, January 1.................... Balance..................................................................... $150,000 (5,376) $144,624 Interest expense October 1: 2% x $144,624 = $2,892 Journal entries (not required): July 1 Leased asset (given).............................................. Lease payable.................................................. 150,000 Lease payable ..................................................... Cash (lease payment).......................................... Oct. 1 Interest expense (2% x [$150,000 – 5,376])............... Lease payable (difference)..................................... Cash (lease payment).......................................... 150,000 5,376 5,376 2,892 2,484 5,376 The amount of interest revenue the lessor would record in conjunction with the second quarterly payment at October 1 also is $2,892, determined in the same manner. Brief Exercise 15-8 The lease liability in the balance sheet will be $113,731: Initial balance, January 1 (calculated below)............. Reduction for first payment, January 1.................... December 31, net liability........................................ $140,000 (26,269) $113,731 $26,269 x 5.32948 = $140,000 (rounded)  present value of an annuity due of $1: n=6, i=5% The liability for interest on the lease liability in the balance sheet will be $5,687: Interest expense (5% x [$140,000 – 26,269])................ Interest payable..................................................... 5,687 5,687 Brief Exercise 15-9 Pretax earnings will be reduced by $29,020 as calculated below: January 1 interest expense........................................ Dec. 31, interest expense (5% x [$140,000* – 26,269]) Interest expense for the year..................................... $ Depreciation expense ($140,000* / 6 years).............. Total expenses........................................................ 23,333 $29,020 *$26,269 x 5.32948 = 0 5,687 $ 5,687 $140,000 (rounded)  present value of an annuity due of $1: n=6, i=5% Brief Exercise 15-10 The price at which the lessor is “selling” the asset being leased is the present value of the lease payments: *$26,269 x 5.32948 = $140,000 (rounded)  present value of an annuity due of $1: n=6, i=5% Pretax earnings will be increased by $20,687 as calculated below: January 1, interest revenue....................................... Dec. 31, interest revenue (5% x [$140,000* – 26,269]) Interest revenue for the year..................................... $ Sales revenue*............................................................ Cost of goods sold...................................................... Income effect........................................................... 140,000 (125,000) $ 20,687 Journal entry (not required): Lease receivable (present value)....................................... Cost of goods sold (lessor’s cost)..................................... Sales revenue (present value)....................................... Inventory of equipment (lessor’s cost)......................... Brief Exercise 15-11 $100,000 fair value ÷ 16.67846** = $5,996 lease payments ** present value of an annuity due of $1: n=20, i=2% 0 5,687 $ 5,687 140,000 125,000 140,000 125,000