Student Learning Outcomes

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Chapter 15 Leases

Part 2: Capital

Intermediate Accounting II Dr. Chula King

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Leases

Student Learning Outcomes

• Explain and use the criteria for determining whether a lease is capital or not

• Describe and demonstrate how both the lessee and lessor account for a capital lease

• Describe and demonstrate how a bargain purchase

• Describe and demonstrate how a bargain purchase option, guaranteed residual value and

unguaranteed residual value impact the accounting for a capital lease by the lessee and the lessor

• Explain the impact of executory costs, discount rate, and initial direct costs on lease accounting

Classification Criteria – Lessee

• Agreement specifies that ownership of the

asset transfers to the lessee

• Agreement contains bargain purchase option

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• The noncancelable lease term is at least 75%

of the asset’s expected economic life

• The present value of minimum lease payments

is at least 90% of the asset’s fair market value

• The meeting of only one criterion is required

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Classification Criteria – Lessor

• At least one criterion applying to lessee,

• AND, both of the following:

• Collectibility of lease payments is reasonably

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predictable

• If any costs to the lessor have yet to be

incurred, they are reasonably predictable

Capital Lease - Lessee

• Leased asset and lease liability recorded at present value of minimum lease payments • Present value of minimum lease payments

 Payments in advance: Annuity due – use Table 6  Payments not in advance: Ordinary annuity use

 Payments not in advance: Ordinary annuity – use Table 4

 Bargain purchase option or guaranteed residual value: Single sum – Use Table 2

• Discount rate

 Implicit rate, if known

 Otherwise, incremental borrowing rate

Capital Lease - Lessee

• Leased asset – straight-line depreciation

 Depreciation period

•Asset’s economic life if title transfer or bargain purchase option

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•Lease term, otherwise

 “Salvage value”

•Expected value at end of asset’s useful life if title transfer or bargain purchase option

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Capital Lease – Lessor

• Lease receivable recorded at present value of

minimum lease payments

 Payments in advance: Annuity due – use Table 6  Payments not in advance: Ordinary annuity – use

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Table 4

 Bargain purchase option, guaranteed residual value or unguaranteed residual value: Single sum – Use Table 2

 Discount rate: Implicit rate

• Same as installment note receivable

Capital Lease – Lessor

• Direct Financing Lease: Cost of the asset is

equal to the asset’s fair market value (PVMLP)

 Debit Lease Receivable, and credit the asset being leased to remove it from the books of the lessor

• Sales-Type Lease: Cost of the asset is not equal

to the assets fair market value (PVMLP)

 Debit Lease Receivable, and credit Sales for the PVMLP

 Debit Cost of Goods Sold, and credit the asset being leased

For Example – Applying the Criteria

• Apex, Inc., leases equipment from Xavier

Leasing Company. In each of the following

cases, assuming none of the other criteria for

capitalizing leases is met determine whether

capitalizing leases is met, determine whether

the lease would be a capital lease or an

operating lease for Apex. If it is a capital

lease, would the asset be depreciated over its

economic life or the lease term?

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For Example – Applying the Criteria

1. At the end of the lease term, the market value of the equipment is expected to be $20,000. Apex has the option of purchasing it for $5,000. This is a bargain purchase option – capital lease

This is a bargain purchase option capital lease with depreciation over the economic life 2. The fair market value of the equipment is

$75,000; the PVMLP is $60,000. Operating lease; PVMLP is 80% of FMV (60,000 ÷ 75,000)

For Example – Applying the Criteria

1. At the end of the lease term, the market value of the equipment is expected to be $20,000. Apex has the option of purchasing it for $5,000. Capital lease - Bargain purchase option;

Capital lease Bargain purchase option; depreciation over the economic life 2. The fair market value of the equipment is

$75,000; the PVMLP is $60,000.

Operating lease; PVMLP is 80% of FMV (60,000 ÷ 75,000)

For Example – Applying the Criteria

3. Ownership of the equipment automatically

reverts to Apex.

Capital lease – Title transfer; depreciation over

the economic life

4. The economic life of the equipment is 15

years; the lease term is 12 years

Capital lease – Lease term is 80% of economic

life (12 ÷ 15); depreciation over lease term

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For Example

• Apex leased a machine from Xavier with a fair market value of $128,872 on January 1, 2013, for a three-year period ending December 31, 2015. The machine cost Xavier $95,000. The lease agreement specifies annual payments of $36,000 beginning with the first payment at the inception of the lease, and each December 31 through 2014. Apex has

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the option of purchasing the machine on December 30, 2015, for $45,000 when its fair value was expected to be $90,000. The machine’s estimated useful life was six years with no salvage value. Apex depreciates assets by the straight-line method. Apex is aware of Xavier’s implicit rate of return of 12%. Collectibility of the lease payments by Xavier is reasonably predictable and there are no costs to Xavier that are yet to be incurred.

Calculation of PVMLP

Table 6, 3 payments @ 12% $96,842 = 2.69005 x $36,000 Table 2, 3 periods @ 12% 32,030 = 0.71178 x $45,000 $128,872

Applying Criteria

1. Title transfer to the lessee? No 2. Bargain purchase option? Yes

3. Lease term ≥ 75% of asset economic life? No, it is 50% (3 ÷ 6)

4. PVMLP ≥ 90% of FMV? Yes, it is 100% ($128,872 ÷ 4. PVMLP ≥ 90% of FMV? Yes, it is 100% ($128,872

$128,872)

• The two additional lessor criteria are satisfied. • This is a capital lease to Apex because the 2nd_{and 4}th

criteria are satisfied, and to Xavier because in addition to the 2nd_{and 4}th_{criteria being satisfied, the two}

additional lessor criteria are satisfied.

• For Xavier, this is a sales type lease because the cost of $95,000 is not equal to the FMV of $128,872.

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Amortization Schedule for Both Lessee

and Lessor

1/1/2013 36,000 - 36,000 92,872 12/31/2013 36,000 11,145 24,855 68,017 12/31/2014 36,000 8,162 27,838 40,179 12/30/2015 45,000 4,821 40,179 0

Entries by Lessee

p y , Interest expense 11,145 Cash 36,000 12/31/13 Depreciation expense 21,479 Accumulated depreciation 21,479 (128,872 ÷ 6)

The asset is depreciated over its estimated useful life rather than the lease term because of the bargain purchase option.

Entries by Lessee

Accumulated depreciation 21,479 12/30/15 Lease payable 40,179 Interest expense 4,821 Cash 45,000 12/31/15 Depreciation expense 21,479 Accumulated depreciation 21,479

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Entries by Lessor

1/1/13 Lease receivable 128,872

Sales 128,872

Cost of goods sold 95,000

Machine inventory 95,000

1/1/13 Cash 36,000 Lease receivable 36,000 12/31/13 Cash 36,000 Lease receivable 24,855 Interest revenue 11,145

Entries by Lessor

12/31/14 Cash

36,000

Lease receivable

27,838

Interest revenue

8,162

12/30/15 Cash

45,000

Lease receivable

40,179

Interest revenue

4,821

Nuances – Residual Value

• If title transfer or BPO – Value of the asset at the end of its economic life; included in depreciation by lessee

• Guaranteed

 Treated as additional minimum lease payment by lessee and lessor

and lessor

 Treated as “salvage” value by lessee in computing depreciation

• Unguaranteed

 Treated as additional minimum lease payment by lessor  Ignored by lessee

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Nuances – Executory Costs

• Payments for maintenance, insurances, taxes,

etc.

• Excluded from minimum lease payments and

present value computations

• If paid by lessee – expense

• If paid by lessor and reimbursed by lessee

 Recorded as payable by lessor  Expensed by lessee

Nuances – Discount Rate

• Lessor – always uses the implicit rate

• Lessee

 If the implicit rate is known, the lessee uses the lower of the implicit rate or the incremental

lower of the implicit rate or the incremental borrowing rate, unless the result produces a present value of minimum lease payments in excess of fair market value; in this case, use the implicit rate  If the implicit rate is not known, use the

incremental borrowing rate

Nuances - Initial Direct Costs

• Costs incurred by lessor that are directly associated with originating a lease.

• Operating lease: Record as asset and amortize over lease term

over lease term

• Direct financing: Defer and recognize over lease term by increasing lessor’s lease receivable by the total of the initial direct costs, and proportionally recognize at a constant effective rate.