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Lease by Sir Waseem Ahmad



Important points. While attempting the question on lease one must keep following points in mind Rental payments and lease payments are two different concepts. Lease payments are total amounts received by lessor including rental payments and residual value whether guaranteed or unguaranteed. Rental payments are those amounts which are paid by lessor on periodic bases. ? Lessor subtracts residual value (guaranteed or unguaranteed) at time of calculating rental payments. ? At end of lease term either asset will be returned back to lessor or retained by lessee. ? f asset reverts back to lessor the market value of asset may either be more than residual value or less than residual value. (!) f residual value is guaranteed by lessee he has to pay deficiency in case market value of asset is less than guaranteed residual value. (") f residual value is guaranteed by lessee and market value is more than residual value profit belongs to lessor. Lessee does not have to pay any amount. (#) f residual value is unguaranteed both loss and profit belongs to lessor. ? n case of finance lease lessee recogni$e asset at lower of cost or present value of minimum lease payments. (At %& level' case where cost is lower than present value of minimum lease payment is not tested). n lessee(s point of view minimum lease payments include rental payments and residual value guaranteed by lessee or party related to lessee. ? f both bargain purchase option and guaranteed residual value are available in question one should consider bargain purchase option for calculating minimum lease payments of lessee. t is so because bargain purchase option is normally lower than guaranteed residual value and lessee will definitely opt bargain purchase option to avoid any e)tra payment. ? *inimum lease payments in lessor(s point of view also include residual value guaranteed by third party. (+hird party should not be party related to lessor). t is important to remember that third party will only guarantee residual value on payment of fee. ,o lessor will always try to get guarantee from lessee. f lessee guarantees residual value there is no need to get guarantee from third party. ,o *L- (lessor) . *L- calculated by lessee / residual value guaranteed by independent third party. ? Lessor recogni$e receivables at gross investment' derecogni$e asset and difference is unearned finance income. 0ross investment includes rental payments and residual value whether guaranteed or not. ? Any e)ecutary costs' insurance' or ta)es paid by lessee are not part of *L-. ? nitial direct costs may be treated in three different ways i) f it is direct finance lease lessor will debit receivables and credit cash at time of payment and reverse above entry when reali$ed from lessee. ii) f it is operating lease lessor will amorti$e them over lease term if not reimbursed by lessee. iii) f it is dealer(s or manufacturer(s leases it will be debited directly to profit and loss account. ? n case of sale1type (Lessor is manufacturer or dealer) lessor will debit receivables (0ross investment) and credit sales account and unearned finance income. ,ales account will be credited by lower of fair market value of asset or present value of minimum lease payment. f offers lower interest rate one should use market rate to calculate present value of *L-. Lecturer lessor at CPE Islamabad ?


Lease by Sir Waseem Ahmad 03216873333 2013 Lessor will also debit cost of goods sold and credit inventory account (manufacturer) or asset account (dealer). Lecturer at CPE Islamabad " .

7 !":'# :8 7!#!'?8? Lecturer at CPE Islamabad The present value of an ordinary annuity of 71 for three periods at 10% is 2. . . rrespective of the 7!4'444 residual value guarantee' the leased asset is e)pected to have only a 7!'444 salvage value on 9ecember #!' "4!". <. +he present value of the lease obligation is as follows2 . ". #. (lessor(s implicit rate is unknown). At the end of lease term if market value is more than expected residual value !"""# lessee only have to pay deficiency.486 . While calculating rental payments lessor always subtracts residual value whether guaranteed or unguaranteed. +he equipment reverts back to the lessor on e)piration of the lease agreement. &. An additional sum of 7!'444 is to be paid annually by the lessee for insurance. +hree payments are due to the lessor in the amount of 784'444 per year beginning 9ecember #!' "4!4. # . The present value of an amount of 71 due in three periods at 10% is 0.Lease by Sir Waseem Ahmad 03216873333 ? 2013 n sale1type lease lessor earns two profits' gross profit (difference between cost value and sales value) and unearned finance income (difference between receivables and sales value) Example of accounting for a finance lease—asset returned to lessor at termination Assume the following2 !. Explanation: lessee guaranteed residual value which is more than expected value to save rental payments.:?&@ .<8!# >> 784'444 = ". +he 5*6 of the equipment is 7!#8'444. +he lessee(s incremental borrowing rate is !4. 8. +he lease is initiated on 3anuary !' "4!4' for equipment with an e)pected useful life of three years. :. -6 of guaranteed residual value -6 of annual payments * ** > 7!4'444 = 4. Lessee guarantees a 7!4'444 residual value on 9ecember #!' "4!"' to the lessor.7513.

n this case' the lease term is for three years' which is equal to !44. Aotice that the test of fair value versus present value is also fulfilled' as the -6 of the minimum lease Lecturer at CPE Islamabad : . of the e)pected useful life of the asset.Lease by Sir Waseem Ahmad 03216873333 2013 +he first step in accounting for any lease transaction is to classify the lease.

<. +he lessee is also required to pay 7!'444 for insurance on an annual basis. n assumption < above the present value of the lease obligation is computed.ation /alan%e of lease o'li.pense ! " # 784'444 84'444 84'444 -edu%tion in lease o'li. of the 5*6. f the present value of the minimum lease payments had e)ceeded the fair value' the lease would be recorded at fair value' as defined under A. +hus' this lease should be accounted for as a finance lease.ation 7!#!'?8? 7!#'!?& 7#&'?!: @8'4: : @'84: :4':@& 8:'8: ? 8':8" ::'8:? !4'44 4 +he interest is calculated at !4. +his is done using the effective interest method as illus1 trated below. Aote that the e)ecutor costs (insurance) are not included in the minimum lease payments and that the incremental borrowing rate of the lessee was used to determine the present value. !"T#$ To have used the impli%it rate it &ould have to have 'een (no&n to the lessee.(Aot checked at %& level) +he ne)t step is to determine the proper allocation between interest and a reduction in the lease obligation for each lease payment. )ear *ash payment +nterest e. . +he entry necessary to record the lease on 3anuary !' "4!4' is Leased equipment !#!'?8? Lease obligation !#!'?8? Aote that the lease is recorded at the present value of the minimum lease payments' which in this case is less than the fair value. (the incremental borrowing rate) of the balance of the lease obligation for each period' and the remainder of the 784'444 payment is allocated to a reduction in the lease obligation.payments (7!#!'?8?) could easily be considered as being equal to substantially all the 5*6 (7!#8'444)' being equal to @<. #&' dealing with impairment of long1lived assets. +his rate was used because the implicit rate was not determinable. +he entries necessary to record all payments relative to the lease for each of the three years are shown below.

+he bal1 .nsurance e)pense nterest e)pense Lease obligation %ash 0e%em'er 311 2010 !'444 !#'!?& #&'!?: 8!'444 0e%em'er 311 2011 !'444 @'84: :4':@& 8!'444 0e%em'er 311 !'444 2012 8':8" ::'8:? 8!'444 +he leased equipment recorded as an asset must also be amorti$ed (depreciated).

+his three1year period represents the lease term' not the life of the asset' because the asset reverts back to the lessor at the end of the lease term. +he lessee made a guarantee that the residual value would be 7!4'444 on 9ecember #!' "4!"B as a result' the lessee must make up the difference between the guaranteed residual value and the actual residual value with a cash payment to the lessor. At the end of the lease' the balance of the lease obli1 gation should equal the guaranteed residual value' the bargain purchase option price' or a termination penalty. n such a circumstance' the lease liability will not be amorti$ed completely as of the termination date' in many cases. n this case' the straight1line depreciation method is applied over a period of three years.ance of this account is 7!#!'?8?B however' as with any other asset' it cannot be depreciated below the estimated residual value of 7!'444 (note that it is depreciated down to the actual estimated re1 sidual value' not the guaranteed residual value). +he following entry illustrates the removal of the leased asset and obligation from the books of the les1 see2 Lease obligation Accumulated depreciation %ash Leased equipment !4'444 !#4'?8? @'44 4 !#!'?8 ? +he foregoing e)ample illustrated a situation where the asset was to be returned to the lessor. !<' leased assets are amorti$ed over their useful life when title transfers or a bargain purchase option e)ists. Example of accounting for a finance lease—asset ownership transferred to lessee and fair market value of leased asset lower than present value of minimum lease payments Assume the following2 . +herefore' the following entry will be made at the end of each year2 9epreciation e)pense Accumulated depreciation :#'&!@ :#'&!@ C(7!#!'?8? D 7!'444) E #F 5inally' on 9ecember #!' "4!"' we must recogni$e the fact that ownership of the property has reverted back to the owner (lessor). Another situation e)ists (where there is a bargain purchase option or automatic trans1 fer of title) where the asset is e)pected to remain with the lessee. Recall that' under A.

+he lessor pays 7"'444 per year for insurance on the equipment. Aote that in this case' the -6 versus 5*6 test is also clearly fulfilled.!. n conclusion' since the -6 is greater than the fair . Gnce again' the classification of the lease must take place prior to the accounting for it. +his lease is classified as a finance lease because it contains a bargain purchase option (H-G). ** The present value of an annuity due of 71 for three periods at 10% is 2. +he e)pected residual value at 9ecember #!' "4!:' is 7!'444. . +he -6 of the lease obligation is computed as follows2 -6 of bargain purchase option -6 of annual payments * . 7!4'444 (78"'444 D 7"'444) = 4. #. +he lessee can e)ercise a bargain purchase option on 9ecember #!' "4!"' for 7!4'444. +he fair market value of the property leased is 7!:4'444. (lessor(s implicit rate is unknown). A three1year lease is initiated on 3anuary !' "4!4' for equipment with an e)pected useful life of five years.7355.7513.<8!# = >> ". +hree annual lease payments of 78"'444 are required beginning on 3anuary !' "4!4' (note that the payment at the beginning of the year changes the -6 computation).<#88 > . 8. Also notice that since the lessor pays 7"'444 a year for insurance' this payment is treated as e)ecutory costs and hence e)cluded from calculation of the present value of annual payments. 7 <'8!# !#&'<8 8 7!::'"? Aotice that in the e)ample above' the present value of the lease obligation is greater than the fair value of the asset. +he lessee(s incremental borrowing rate is !4. The present value of an amount of 71 due in three periods at 10% is 0. . :. ".

value' the lease obligation (as well as the leased asset) must be recorded at the fair value of the asset leased (being the lower of the two). +he entry on 3anuary !' "4!4' is as follows2 Leased equipment !:4'444 Gbligation under finance lease !:4'444 .

n this e)ample' the interest rate was determined to be !#. +he amorti$ation of the lease takes place as follows2 )ear % nception of lease 3anuary !' "4!4 3anuary !' "4!! 3anuary !' "4!" 9ecember #!' "4!" %ash payment 784'444 84'444 84'444 !4'444 +nterest e.ation 7 11 !!'@#@ &'? @4 !'! <! 784'444 #?'4&! :#'!!4 ?'? "@ 7!:4'4 @4'4 44 44 8!'@# @ ?'?" @ 11 +he following entries are required in years "4!4 through "4!" to recogni$e the payment and depreciation (amorti$ation).e.pense -edu%tion in lease o'li.e.' the liability) and thus would not alter the initially determined interest rate. #&' and this would not affect the recorded amount of the lease obligation (i. (Aote' however' that an impairment after the inception date would be recogni$ed as e)pense in the period of the impairment' following the procedures set forth in A. 3anuary ! Gperating e)pense Gbligation under finance lease Accrued interest payable %ash nterest e)pense Accrued interest payable Gbligation under finance lease 9epreciation e)pense Accumulated depreciation (7!#@'444' five years) Gbligation under finance lease %ash 20 "'444 10 84'444 8"'44 4 !!'@#@ !!'@#@ "<'?44 "<'?44 2 "'444 01 #?'4&! !!'@#@ &'? @4 "<'?44 "<'?44 !4'444 !4'444 8"'44 4 &'?@4 2 "'444 0 :#'!!4 &'?@4 !'! <! "<'?44 "<'?44 8"'4 44 !'!<! 9ecember #! 9ecember #! 9ecember #! . As noted above' a special rule applies under I.' when the asset is impaired) at lease inception. 0AA.(which are illu1 strated here) when the present value of the minimum lease payments e)ceeds the fair value of the leased asset (i."&8.According to A. !<' the apportionment between interest and principal is to be such that in1 terest recogni$ed reflects the use of a constant periodic rate of interest applied to the remaining balance of the obligation. When the -6 e)ceeds the fair value of the leased asset' a new' effective rate must be computed through a series of trial1and1error calculations.ation /alan%e of lease o'li..

+he noncancelable fi)ed portion of the lease term is five years. +he first step is to calculate the annual payment due to the lessor. is a manufacturer of speciali$ed equipment.@&<&: 7"@'#?". +he lessor is to receive equal annual payments over the term of the lease. +he estimated useful life of the asset is ten years. -6 of minimum lease payment Gr' in this case' 7!84'444 7!:8'@&!. n this case' the implicit rate is given as !". +he lease is initiated on 3anuary !' "4!4. +hus' the structure of the computation would be as follows2 Aormal selling price D -6 of residual value . :. Hecause of this' JKL offers a leas1 ing alternative.@&<&: = *inimum *inimum lease payment *inimum lease payment >> lease 0. +he lessor incurs cost associated with the inception of the lease in the amount of 7"'844. &. periods at a . 8.Example of accounting for a sales$type lease JKL nc. +he equipment is e)pected to have a residual value of 7!8'444 at the end of five years and 7!4'444 at the end of eight years. +he present value is to be computed using the implicit interest rate and the lease term. *any of its customers do not have the necessary funds or financing available for outright purchase. +he lessor has the op1 tion to renew the lease for an additional three years at the same rental. . is 7!44'444. (the implicit rate). <. -ayments are due on 9ecember #! for the duration of the lease term. +he data relative to a typical lease are as follows2 !. and the lease term is ? years (which in1 cludes the fi)ed noncancelable portion plus the renewal period' since the lessee guarantee terms make renewal virtually inevitable).40388 is the present value of an amount of 71 due in ei. Recall that the present value (-6) of the minimum lease payments is equal to the selling price adMusted for the present value of the residual amount. . ".:4#?? = :. +he cost of the equipment to JKL nc. Lessee guarantees a residual value of 7:4'444 at the end of five years' but the guarantee lapses if the full three renewal periods are e)ercised. +he leased property reverts back to the lessor on termination of the lease. #. +he lessor desires a return of !". +he selling price of the equipment for an outright purchase is 7!84'444.:4 > ."4 * D E (4.

12% interest rate. .

"4 (7!44'444 / 7"'844 D 7:'4#?. of the 5*6 C7!84'444F' could be considered to be equal to substantially all of the fair value of the leased asset. +he inventory account is credited for the carrying value of the asset' in this case 7!44'444. +o do this' e)amine the 5*6 or selling price of the as1 set and compare it to the cost. +hus' the cost of goods sold amount is 7@?':&!.?4). +he adMusted selling price is equal to the -6 of the minimum payments' or . Ae)t' obtain the figures necessary to record the entry on the books of the lessor."4 +he cost of goods sold is the historical cost of the inventory (7!44'444) plus any initial direct costs (7"'844) less the -6 of the unguaranteed residual value (7!4'444 = 4. Hecause the two are not equal' we can determine this to be a sales1 type lease."4' which is @<.** 4. -rior to e)amining the accounting implications of a lease' we must determine the lease classification. n this e)ample' the lease term is eight years (discussed above) while the estimated useful life of the asset is !4 yearsB thus this lease qualifies as something other than an operating lease. Aote that the initial direct costs will require a credit entry to some account' usually accounts payable or cash. 6764 is the present value of an annuity of 71 for ei.) Aow it must be determined if this is a sales1 type' direct financing' or leveraged lease. (Aote that it also meets the 5*6 versus -6 criterion because the -6 of the minimum lease payments of 7!:8'@&!. 7":8'48@. +he gross investment is the total minimum lease payments plus the unguaranteed residual value' or (7"@'#?".ht periods at a 12% interest rate.:4#??).:4 = ?) / 7!4'444 .

@&<&:) / (7!4'444 = 4. Lease receivable %ost of goods sold nventory .ales +herefore' the entry necessary to re1 cord the lease is ":8'48@. "4 @8'48@.:4 = :.:4 and the unguaranteed residual of 7!4'444).7!:8'@&!."4 !44'444. 44 !:8'@&!.44 Inearned finance income Accounts payable (initial direct costs) +he ne)t step in accounting for a sales1type lease is to determine proper handling of the pay1 ment. Hoth principal and interest are included in each payment. According to A."4 "'844.' lease receivable) less the present value of the components making up the gross investment (the minimum lease payment of 7"@'#?". 5inally' the unearned finance income is equal to the gross investment (i."4 @?':&!.e. !<' interest is ."4. +he present value of these items is 7!84'444 C(7"@'#?".:4#??)F.

+he entries below illustrate the proper treatment to record the receipt of the lease payment and the amorti$ation of the unearned finance income in the year ended 9ecember #!' "4!4. "# @8'8@@.:4 "@'#?".:4 !?'444. #! !!!'8@!.<" &'@!8. !#?'&!<.recogni$ed on a basis such that a constant periodic rate of return is earned over the term of the lease.4? !8'@@!. 0ate or year ended *ash payment 3anuary !' "4!4 9ecember #!' "4!4 9ecember #!' "4!! 9ecember #!' "4!" 9ecember #!' "4!# 9ecember #!' "4!: 9ecember #!' "4!8 9ecember #!' "4!& 9ecember #!' "4!< 7 "@'#?". (im1 plicit rate) of the net investment."4 +nterest 7!?'444.:4 "@'#?".@8 !!':<!.:4 7"#8'48@. 5irst' the net investment is the gross investment (lease receivable) less the unearned finance income.8& :'"!@.#" !#'#@4.44 "@'#?".?# 7!:4'444.:4 "@'#?". Asset Leased receivable !4'444 !4'4 44 At the end of the lease term' 9ecember #!' "4!<' the asset is returned to the lessor and the following entry is required2 Lecturer at CPE Islamabad 9 .?: "8'!&".:4 !"'<:?. <? <<'&?@. +his will require setting up an amorti$ation schedule as illustrated below.: 4 !?'444.:4 and the unearned finance income account by only 7!?'444. 44 A few of the columns need to be elaborated on. Also note that the total interest earned over the lease term is equal to the unearned interest (unearned finance income) at the beginning of the lease term.:4 "@'#?".:4 "@'#?".44 /alan%e of net investment 7!84'444. +his is done automatically when the net investment is reduced by decreasing the lease receivable (gross investment) by 7"@'#?".@< @'#"". Aotice that at the end of the lease term' the net investment is equal to the estimated residual value.!! !8'!4:."@ !:'"<?. +hese entries are to be made over the life of the lease. +he 7!?'444 is !".:4 "@'#?". ?# !4'444. %ash Lease receivable Inearned finance income nterest revenue "@'#?".44 !&'&#:.:4 "@'#?".:# "4'48@."4 -edu%tion in prin%ipal 7 !!'#?".8< 7@8'48@.&? ""':&&.:8 !<'@!4.4 4 Aotice that there is no e)plicit entry to recogni$e the principal reduction. #8 8<'&"@. 44 !"8'?&@. &< #8'!&".

Lecturer at CPE Islamabad 9 .f the estimated residual value has changed during the lease term' the accounting computations would have also changed to reflect this.