CH 21

CHAPTER
21
ACCOUNTING FOR LEASES
Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Chapter 21-1
Learning Objectives
1. 2. 3. 4. 5. 6. 7. 8. 9.
Chapter 21-2
Explain the nature, economic substance, and advantages of lease transactions. Describe the accounting criteria and procedures for capitalizing leases by the lessee. Contrast the operating and capitalization methods of recording leases. Identify the classifications of leases for the lessor. Describe the lessors accounting for direct-financing leases. Identify special features of lease arrangements that cause unique accounting problems. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Describe the lessors accounting for sales-type leases. List the disclosure requirements for leases.
Accounting for Leases

Special Accounting Problems Residual values SalesSales-type leases Bargain purchase option Initial direct costs Current versus noncurrent Disclosure Unsolved problems
Leasing Environment Who are players? Advantages of leasing Conceptual nature of a lease
Accounting by Lessee Capitalization criteria Accounting differences Capital lease method Operating method Comparison
Accounting by Lessor Economics of leasing Classification DirectDirect-financing method Operating method
Chapter 21-3
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, Transportation (trucks, aircraft, rail), Construction and Agriculture.
Chapter 21-4
LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Who Are the Players?
Three general categories: Banks. Captive leasing companies. Independents.
Chapter 21-5

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.
Chapter 21-6

Conceptual Nature of a Lease
Capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases.
Chapter 21-7

The issue of how to report leases is the case of substance versus form. Although technically legal title may not pass, the benefits from the use of the property do.
Operating Lease
Journal Entry: Rent expense Cash xxx xxx
Capital Lease
Journal Entry: Leased equipment Lease liability xxx xxx
A lease that transfers substantially all of the benefits and risks of property ownership should be capitalized (only noncancellable leases may be capitalized).
Chapter 21-8
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.
Typical Journal Entries for Capitalized Lease
Illustration 21-2 21-
Chapter 21-9
LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee.

To record a lease as a capital lease, the lease must be noncancelable. One or more of four criteria must be met:
1.
Transfers ownership to the lessee.
2. Contains a bargain purchase option. 3. Lease term is equal to or greater than 75 percent of
the estimated economic life of the leased property.

4. The present value of the minimum lease payments
(excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.
Chapter 21-10

Lease Agreement
Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases.
Chapter 21-11

Capitalization Criteria
Transfer of Ownership Test
Not controversial and easily implemented.
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.
Chapter 21-12

Economic Life Test (75% Test)
Lease term is generally considered to be the fixed, noncancelable 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.
Chapter 21-13

Recovery of Investment Test (90% Test) Minimum lease payments:

Minimum rental payment Guaranteed residual value Penalty for failure to renew Bargain purchase option Insurance Maintenance Taxes
Exclude from PV of Minimum Lease Payment Calculation
LO 2
Executory Costs:

Chapter 21-14

Recovery of Investment Test (90% Test) Discount Rate
Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception.
If the lessee knows the implicit interest rate
computed by the lessor and it is less than the lessees incremental borrowing rate, then lessee must use the lessors rate.
Chapter 21-15
LO 2

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.
Chapter 21-16

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.
Chapter 21-17

Effective-Interest Method The effective-interest method is used to allocate each lease payment between principal and interest. Depreciation Concept Depreciation and the discharge of the obligation are independent accounting processes.
Chapter 21-18

E21-1 (Capital Lease with Unguaranteed Residual Value): On January 1, 2011, Adams Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9,968 at the beginning of each year, starting January 1, 2011. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adamss incremental borrowing rate is 10%, and the Lessors implicit rate is unknown. Instructions (a) What type of lease is this? Explain. (b) Compute the present value of the minimum lease payments. (c) Prepare all necessary journal entries for Adams for this lease through January 1, 2012. Chapter
21-19
LO 2

E21-1: What type of lease is this? Explain. Capitalization Criteria:
1. Transfer of ownership 2. Bargain purchase option 3. Lease term => 75% of
Capital Lease, #3
NO NO
Lease term Economic life 5 yrs. 6 yrs. 83.3%
economic life of leased property

4. Present value of minimum
YES
lease payments => 90% of FMV of property

Chapter 21-20
FMV of leased property is unknown.

E21-1: Compute present value of the minimum lease payments. Payment Present value factor (i=10%,n=5) PV of minimum lease payments
1/1/11 Journal Entries: Leased Machine Under Capital Leases Lease Liability Lease Liability Cash
Chapter 21-21
$ 9,968 4.16986 $41,565

41,565 41,565 9,968 9,968

E21-1: Lease Amortization Schedule
ate / / / / / / / /
Chapter 21-22
Lease a ment
nterest ense
eduction in Lia ilit
Lease Lia ilit
/ / / /

E21-1: Journal entries for Adams through Jan. 1, 2012.
12/31/11 Depreciation Expense
($41,565 5 = $8,313)
8,313 8,313
Accumulated DepreciationCapital Leases
Interest Expense Interest Payable

($41,565 $9,968) X .10]
3,160 3,160
Chapter 21-23

E21-1: Journal entries for Adams through Jan. 1, 2012.
1/1/12 Lease Liability Interest Payable Cash 6,808 3,160 9,968
Chapter 21-24

Operating Method
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 Adams accounts for it as an operating lease. Adams records this payment on January 1, 2011, as follows. Rent Expense Cash
Chapter 21-25
9,968 9,968
LO 3 Contrast the operating and capitalization methods of recording leases.

E21-1: Comparison of Capital Lease with Operating Lease
Capital Lease nterest pense otal Operating Lease pense
ate
epre iation pense
iff
Chapter 21-26
LO 3 Contrast the operating and capitalization methods of recording leases.
Accounting by the Lessor

Benefits to the Lessor
1.
Interest Revenue.
2. Tax Incentives. 3. High Residual Value.
Chapter 21-27
LO 4 Identify the classifications of leases for the lessor.

Economics of Leasing
A lessor determines the amount of the rental, based on the rate of return 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
Chapter 21-28

E21-10 (Computation of Rental): Fieval Leasing Company signs an agreement on January 1, 2010, to lease equipment to Reid Company. The following information relates to this agreement.
1. 2. 3. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. The cost of the asset to the lessor is $343,000. The fair value of the asset at January 1, 2010, is $343,000. The asset will revert to the lessor at the end of the lease term at which time the asset is expected to have a residual value of $61,071, none of which is guaranteed. The agreement requires annual rental payments, beg. Jan. 1, 2010. Collectibility of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.
4. 5.
Chapter 21-29

E21-10 (Computation of Rental): Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required.
Residual value PV of single sum (i=10%, n=6) PV of residual value Fair market value of leased equipment Present value of residual value Amount to be recovered through lease payment PV factor of annunity due (i=10%, n=6) Annual payment required
Chapter 21-30
$
x
61,071 0.56447 34,473
$ 343,000
-
(34,473) 308,527 4.79079 $ 64,400

Classification of Leases by the Lessor
a. Operating leases. b. Direct-financing leases. c. Sales-type leases.
Chapter 21-31

A sales-type lease involves a manufacturers or dealers profit, and a direct-financing lease does not.
Chapter 21-32

A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.
Chapter 21-33

irect-Financing Method (Lessor)
In substance the financing of an asset purchase by the lessee.
Chapter 21-34
LO 5 Describe the lessors accounting for direct-financing leases.

E21-10: Prepare an amortization schedule that would be suitable for the lessor.
Chapter 21-35

E21-10: Prepare all of the journal entries for the lessor for 2010 and 2011. 1 1 10 Lease Receivable Equipment 1 1 10 Cash Lease Receivable 12 31 10 Interest Receivable Interest Revenue 27,860 27,860 64,400 64,400 343,000 343,000
Chapter 21-36

E21-10: Prepare all of the journal entries for the lessor for 2010 and 2011. 1 1 11 Cash Lease Receivable Interest Receivable 12 31 11 Interest Receivable Interest Revenue 24,206 24,206 64,400 36,540 27,860
Chapter 21-37

Operating Method (Lessor)
Records each rental receipt as rental revenue. Depreciates the leased asset in the normal manner.
Chapter 21-38

Operating Method (Lessor)
Illustration: Assume Fieval accounts for the lease as an operating lease. It records the cash rental receipt as follows: Cash Rental Revenue Depreciation is recorded as follows: Depreciation Expense Accumulated Depreciation
$343,000
Chapter 21-39
64,400 64,400
57,167 57,167
6 years = 57,167 LO 5 Describe the lessors accounting for direct-financing leases.
Special Accounting Problems

1. Residual values. 2. Sales-type leases (lessor). 3. Bargain purchase options. 4. Initial direct costs. 5. Current versus noncurrent classification. 6. Disclosure.
Chapter 21-40
LO 6 Identify special features of lease arrangements that cause unique accounting problems.

Residual Values
Meaning of Residual Value - Estimated fair value of
the leased asset at the end of the lease term.
Guaranteed Residual Value 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.
Chapter 21-41
LO 7 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.

Residual Values
Lessee Accounting for Residual Value The accounting consequence is that the minimum lease payments, include the guaranteed residual value but excludes the unguaranteed residual value.
Chapter 21-42

Illustration (Guaranteed Residual Value Lessee Accounting):
Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2011, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2011. 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 noncancelable, requiring equal rental payments 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.
Chapter 21-43

Illustration (Guaranteed Residual Value Lessee Accounting):
Sterling 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 Caterpillar. The lease contains no renewal options. The loader reverts to Caterpillar at the termination of the lease. Sterlings incremental borrowing rate is 11 percent per year. Sterling depreciates on a straight-line basis. Caterpillar sets the annual rental to earn a rate of return on its investment of 10 percent per year; Sterling knows this fact. Caterpillar estimates a residual value of $5,000 a the end of the lease.
Chapter 21-44

Illustration (Guaranteed Residual Value Lessee Accounting): Caterpillar would compute the amount of the lease payments as follows:
NOTE: For the Lessee, the minimum lease payment includes the guaranteed residual value but excludes the unguaranteed residual value.
Chapter 21-45 Solution on notes page

Illustration (Guaranteed Residual Value Lessee Accounting): Computation of Lessees capitalized amount
Chapter 21-46
Solution on notes page

Illustration (Guaranteed Residual Value Lessee Accounting): Computation of Lease Amortization Schedule
Chapter 21-47
LO 7

Illustration (Guaranteed Residual Value Lessee Accounting): At the end of the lease term, before the lessee transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances.
Chapter 21-48

Illustration (Guaranteed Residual Value Lessee Accounting): Assume that Sterling 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, 2015, was $3,000. Sterling would make the following journal entry. Loss on Capital Lease Interest Expense (or Interest Payable) Lease Liability Accumulated DepreciationCapital Leases Leased Equipment under Capital Leases Cash
Chapter 21-49
2,000.00 454.76 4,545.24 95,000.00 100,000.00 2,000.00

Illustration (Unguaranteed Residual Value Lessee Accounting): Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. Caterpillar would compute the amount of the lease payments as follows:
Chapter 21-50

Illustration (Unguaranteed Residual Value Lessee Accounting): Computation of Lease Amortization Schedule
Chapter 21-51

Illustration (Unguaranteed Residual Value Lessee Accounting): At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances.
Chapter 21-52

Comparative Entries, Lessee Company
Chapter 21-53

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. Caterpillar determines the payments as follows.
Chapter 21-54

Illustration: Lease Amortization Schedule, for Lessor Guaranteed or Unguaranteed Residual Value
Chapter 21-55

Illustration: Caterpillar would make the following entries for this direct-financing lease in the first year.
Chapter 21-56

Sales-Type Leases (Lessor)
Primary difference between a direct-financing lease and a sales-type lease is the manufacturers or dealers 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. Difference in accounting for guaranteed and unguaranteed residual values.
Chapter 21-57
LO 8 Describe the lessors accounting for sales-type leases.

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 directfinancing 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, Caterpillar. Assume that the fair market value of the residual value is $3,000 at the end of the lease term.
Chapter 21-58

Illustration: Computation of Lease Amounts by Caterpillar FinancialSales-Type Lease
Chapter 21-59

Illustration: Caterpillar makes the following entries to record this transaction on January 1, 2011, and the receipt of the residual value at the end of the lease term.
Chapter 21-60

Chapter 21-61

Chapter 21-62

Bargain Purchase Option (Lessee)
Present value of the minimum lease payments must include 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.
Chapter 21-63

Initial Direct Costs (Lessor)
The accounting for initial direct costs: For operating leases, the lessor should defer initial direct costs. For sales-type leases, the lessor expenses the initial direct costs. For a direct-financing lease, the lessor adds initial direct costs to the net investment.
Chapter 21-64

Current versus Noncurrent
FASB Statement No. 13 does not indicate how to measure the current and noncurrent amounts. It requires that for the lessee the obligations shall be separately identified on the balance sheet as obligations under capital leases and shall be subject to the same considerations as other obligations in classifying them with current and noncurrent liabilities in classified balance sheets.
Chapter 21-65

isclosing Lease Data
1.
General description of the nature of the lease. associated with leases, including payments for each of the five succeeding years.
2. Nature, timing and amount of cash inflows and outflows
3. Amount of lease revenues and expenses reported in the
income statement each period.

4. Description and amounts of leased assets by major
balance sheet classification and related liabilities.

5. Amounts receivable and unearned revenues under lease.
Chapter 21-66
LO 9 List the disclosure requirements for leases.
Leasing was on the FASBs initial agenda in 1973 and SFAS No. 13 was issued in 1976 (before the conceptual framework was developed). SFAS No. 13 has been the subject of more than 30 interpretations since its issuance. The iGAAP leasing standard is IAS 17, first issued in 1982. This standard is the subject of only three interpretations. One reason for this small number of interpretations is that iGAAP does not specifically address a number of leasing transactions that are covered by U.S. GAAP. Examples include lease agreements for natural resources, sale-leasebacks, real estate leases, and leveraged leases.
Chapter 21-67
Both U.S. GAAP and iGAAP share the same objective of recording leases by lessees and lessors according to their economic substancethat is, according to the definitions of assets and liabilities. U.S. GAAP for leases in much more rule-based with specific bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; iGAAP is more general in its provisions.
Chapter 21-68
Chapter 21-69
LO 10
Illustration 21A-2 21A-
Chapter 21-70
LO 10 Understand and apply lease accounting concepts to various lease arrangements.
Chapter 21-71
Chapter 21-72
Chapter 21-73
Chapter 21-74
Chapter 21-75
Chapter 21-76
The term sale-leaseback describes a transaction in which the owner of the property (seller-lessee) sells the property to another and simultaneously leases it back from the new owner. Advantages:
1. May allow seller to refinance at lower rates. particularly when liquidity is tight. 3. By selling the property, the seller-lessee may deduct the entire lease payment, which is not subject to alternative minimum tax considerations.
Chapter 21-77
2. May provide another source of working capital,
LO 11 Describe the lessees accounting for sale-leaseback transactions. sale-
Determining Asset Use

To the extent the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing. Lessor should not recognize a gain or loss on the transaction. If the seller-lessee gives up the right to the use of the asset, the transaction is in substance a sale. Gain or loss recognition is appropriate.
Chapter 21-78
Lessee
If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee should Account for the transaction as a sale and the lease as a capital lease. Defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease. Amortize profit over the lease term .
Chapter 21-79
Lessee
If none of the capital lease criteria are satisfied, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Lessee defers such profit or loss and amortizes it in proportion to the rental payments over the period when it expects to use the assets. Exceptions: Losses Recognized and Minor Leaseback
Chapter 21-80
Lessor
If the lease meets one of the criteria in Group I and both of the criteria in Group II, the purchaser-lessor records the transaction as a purchase and a directfinancing lease. If the lease does not meet the criteria, the purchaserlessor records the transaction as a purchase and an operating lease.
Chapter 21-81
Sale-Leaseback Example
American Airlines on January 1, 2011, sells a used Boeing 757 having a carrying amount on its books of $75,500,000 to CitiCapital for $80,000,000. American immediately leases the aircraft back under the following conditions: 1. 2. 3. 4. 5. 6.
Chapter 21-82
The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year. The aircraft has a fair value of $80,000,000 on January 1, 2011, and an estimated economic life of 15 years. American pays all executory costs. American depreciates similar aircraft that it owns on a straight-line basis over 15 years. The annual payments assure the lessor a 12 percent return. Americans incremental borrowing rate is 12 percent.
This lease is a capital lease to American because
lease term exceeds 75 percent of the estimated life
of the aircraft and

present value of the lease payments exceeds 90
percent of the fair value of the aircraft to CitiCapital.

Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist in relation to unreimbursable costs yet to be incurred by CitiCapital, it should classify this lease as a direct-financing lease.
Chapter 21-83
Chapter 21-84
Chapter 21-85
Copyright
Copyright 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
Chapter 21-86

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CHAPTER

ACCOUNTING FOR LEASES

Intermediate Accounting 13th Edition Kieso, Weygandt, and Warfield

Accounting for Leases

Accounting by Lessor Economics of leasing Classification DirectDirect-financing method Operating method

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

The Leasing Environment

LO 1 Explain the nature, economic substance, and advantages of lease transactions.

Accounting by the Lessee

Accounting by the Lessee

Transfers ownership to the lessee.

the estimated economic life of the leased property.

Accounting by the Lessee

Accounting by the Lessee

Bargain-Purchase Option Test

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

Accounting by the Lessee

economic life of leased property

lease payments => 90% of FMV of property

FMV of leased property is unknown.

Accounting by the Lessee

$ 9,968 4.16986 $41,565

Accounting by the Lessee

eduction in Lia ilit

Lease Lia ilit

Accounting by the Lessee

Accumulated DepreciationCapital Leases

Interest Expense Interest Payable

Accounting by the Lessee

Accounting by the Lessee

LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessee

epre iation pense

LO 3 Contrast the operating and capitalization methods of recording leases.

Accounting by the Lessor

2. Tax Incentives. 3. High Residual Value.

LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor

LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor

Accounting by the Lessor

61,071 0.56447 34,473

(34,473) 308,527 4.79079 $ 64,400

LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor

LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor

LO 4 Identify the classifications of leases for the lessor.

Accounting by the Lessor