Intermediate_Accounting_Chapter21

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Unformatted text preview: 1460T_c21.qxd 1/21/06 03:45 am Page 1087 C H A P T E R T W E N T Y O N E ACCOUNTING FOR LEASES More Companies Ask, “Why Buy?” Leasing has grown tremendously in popularity. Today it is the fastest growing form of capital investment. Instead of borrowing money to buy an airplane, computer, nuclear core, or satellite, a company makes periodic payments to lease these assets. Even gambling casinos lease their slot machines. Of the 600 companies surveyed by the AICPA in 2004, 575 disclosed lease data.1 A classic example is the airline industry. Many travelers on airlines such as United, Delta, and Southwest believe these airlines own the planes on which they are flying. Often, this is not the case. Here are the lease percentages for the major U.S. airlines. The Phantom Fleets: Number of Aircraft and Percent Carried Off the Balance Sheet American Delta Northwest UAL Southwest 0 300 21% 41% 43% Fleet Under Operating Leases Fleet Owned 35% 25% 600 900 1200 Source: Company reports, 2004. As you will learn, airlines lease many of their airplanes due to the favorable accounting treatment they receive if they lease rather than purchase. AICPA, Accounting Trends and Techniques—2004. Eight out of 10 U.S. companies lease all or some of their equipment. Companies that lease tend to be smaller, are high growth, and are in technology-oriented industries (see www.techlease.com). 1 Learning Objectives After studying this chapter, you should be able to: 1 2 3 4 5 6 7 8 9 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 lessor’s 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 lessor’s accounting for sales-type leases. List the disclosure requirements for leases. 1087 1460T_c21.qxd 1/21/06 03:45 am Page 1088 PREVIEW OF CHAPTER 21 Our opening story indicates the increased significance and prevalence of lease arrangements. As a result, the need for uniform accounting and informative reporting of these transactions has intensified. In this chapter we look at the accounting issues related to leasing. The content and organization of this chapter are as follows. ACCOUNTING FOR LEASES LEASING ENVIRONMENT • Who are players? • Advantages of l easing • 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 • Direct-financing method • Operating method SPECIAL ACCOUNTING PROBLEMS • Residual values • Sales-type leases • Bargain purchase option • Initial direct costs • Current versus noncurrent • Disclosure • Unsolved problems THE LEASING ENVIRONMENT OBJECTIVE 1 Explain the nature, economic substance, and advantages of lease transactions. Aristotle once said, “Wealth does not lie in ownership but in the use of things”! Clearly, many U.S. companies have decided that Aristotle is right, as they have become heavily involved in leasing assets rather than owning them. For example, Illustration 21-1 shows the growth in leasing transactions from 1990 to 2003. Equipment Leasing Net Asset Size Growth (in $ billions), Based on a Survey of 100 Largest Lessors 2002 2000 1998 1996 1994 1992 1990 ILLUSTRATION 21-1 Equipment Leasing Growth $0 $100 $200 $300 $400 $500 Source: Monitor 100, June 2004 What types of assets are being leased? As the opening story indicated, any type of equipment can be leased, such as railcars, helicopters, bulldozers, barges, CT scanners, computers, and so on. The largest group of leased equipment involves information technology equipment, followed by assets in the transportation area (trucks, aircraft, rail), and then construction and agriculture. 1088 1460T_c21.qxd 1/21/06 03:45 am Page 1089 The Leasing Environment • 1089 Who Are the Players? A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. In return for the use of the property, the lessee makes rental payments over the lease term to the lessor. Who are the lessors that own this property? They generally fall into one of three categories: 1 2 3 Banks. Captive leasing companies. Independents. Banks Banks are the largest players in the leasing business. They have low-cost funds, which give them the advantage of being able to purchase assets at less cost than their competitors. Banks also have been more aggressive in the leasing markets. They have decided that there is money to be made in leasing, and as a result they have expanded their product lines in this area. Finally, leasing transactions are now more standardized, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements. Thus banks like Wells Fargo, Chase, Citigroup, and PNC have substantial leasing subsidiaries. Captive Leasing Companies Captive leasing companies are subsidiaries whose primary business is to perform leasing operations for the parent company. Companies like Caterpillar Financial Services Corp. (for Caterpillar), Chrysler Financial (for Daimler-Chrysler), and IBM Global Financing (for IBM) facilitate the sale of products to consumers. For example, suppose that Sterling Construction Co. wants to acquire a number of earthmovers from Caterpillar. In this case, Caterpillar Financial Services Corp. will offer to structure the transaction as a lease rather than as a purchase. Thus, Caterpillar Financial provides the financing rather than an outside financial institution. Captive leasing companies have the point-of-sale advantage in finding leasing customers. That is, as soon as Caterpillar receives a possible order, its leasing subsidiary can quickly develop a lease-financing arrangement. Furthermore, the captive lessor has product knowledge that gives it an advantage when financing the parents’ product. The current trend is for captives to focus primarily on their company’s products rather than do general lease financing. For example, Boeing Capital and UPS Capital are two captives that have left the general finance business to focus exclusively on their parent companies’ products. Independents Independents are the final category of lessors. Independents have not done well over the last few years. Their market share has dropped fairly dramatically as banks and captive leasing companies have become more aggressive in the lease-financing area. Independents do not have point-of-sale access, nor do they have a low cost of funds advantage. What they are often good at is developing innovative contracts for lessees. In addition, they are starting to act as captive finance companies for some companies that do not have a leasing subsidiary. Illustration 21-2 (page 1090) shows the new business volume by lessor type in a recent five-year period. As the chart shows, both banks and captives have increased business at the expense of the independents. Advantages of Leasing The growth in leasing indicates that it often has some genuine advantages over owning property, such as: 1460T_c21.qxd 1/21/06 03:45 am Page 1090 1090 • Chapter 21 Accounting for Leases ILLUSTRATION 21-2 Lessor Types Banks and captives are taking market from independents Five-Year Historical New Business Volume by Lessor Type (% of total new business volume) Five-Year % Change 100% 80% 60% 40% 20% 0% 1999 Source: www.ficinc.com 2000 Banks 2001 Captives 2002 2003 Independents 52.7% 37.1% 27.8% 19.5% 24.4% 28.1% 31.6% 30.2% 36.4% 26.6% 29.6% 43.8% 38.5% 42.3% 37.6% 57.6% 43.8% 32.1% 1 2 3 4 International Insight Some companies “double dip” on the international level too. The leasing rules of the lessor’s and lessee’s countries may differ, permitting both parties to own the asset. Thus, both lessor and lessee receive the tax benefits related to depreciation. 5 100% Financing at Fixed Rates. Leases are often signed without requiring any money down from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature for new and developing companies. In addition, lease payments often remain fixed, which protects the lessee against inflation and increases in the cost of money. The following comment explains why companies choose a lease instead of a conventional loan: “Our local bank finally came up to 80 percent of the purchase price but wouldn’t go any higher, and they wanted a floating interest rate. We just couldn’t afford the down payment, and we needed to lock in a final payment rate we knew we could live with.” Protection Against Obsolescence. Leasing equipment reduces risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor. For example, Merck (a pharmaceutical maker) leases computers. Under the lease agreement, Merck may turn in an old computer for a new model at any time, canceling the old lease and writing a new one. The lessor adds the cost of the new lease to the balance due on the old lease, less the old computer’s trade-in value. As one treasurer remarked, “Our instinct is to purchase.” But if a new computer is likely to come along in a short time, “then leasing is just a heck of a lot more convenient than purchasing.” Flexibility. Lease agreements may contain less restrictive provisions than other debt agreements. Innovative lessors can tailor a lease agreement to the lessee’s special needs. For instance, the duration of the lease—the lease term— may be anything from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, or they may increase or decrease in amount. The payment amount may be predetermined or may vary with sales, the prime interest rate, the Consumer Price Index, or some other factor. In most cases the rent is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease. Less Costly Financing. Some companies find leasing cheaper than other forms of financing. For example, start-up companies in depressed industries or companies in low tax brackets may lease to claim tax benefits that they might otherwise lose. Depreciation deductions offer no benefit to companies that have little if any taxable income. Through leasing, the leasing companies or financial institutions use these tax benefits. They can then pass some of these tax benefits back to the user of the asset in the form of lower rental payments. Tax Advantages. In some cases, companies can “have their cake and eat it too” with tax advantages that leases offer. That is, for financial reporting purposes companies do not report an asset or a liability for the lease arrangement. For tax purposes, however, companies can capitalize and depreciate the leased asset. As a result, a 1460T_c21.qxd 1/21/06 03:45 am Page 1091 The Leasing Environment company takes deductions earlier rather than later and also reduces its taxes. A common vehicle for this type of transaction is a “synthetic lease” arrangement. (On page 1101 we discuss a synthetic lease used by Krispy Kreme.) Off-Balance-Sheet Financing. Certain leases do not add debt on a balance sheet or affect financial ratios. In fact, they may add to borrowing capacity.2 Such offbalance-sheet financing is critical to some companies. • 1091 6 Off-balance-sheet financing As shown in our opening story, airlines use lease arrangements extensively. This results in a great deal of off-balance-sheet financing. The following chart indicates that many airlines that lease aircraft understate debt levels by a substantial amount. What do the numbers mean? Net Reported Debt and Additional Debt from Leases 40,000 $ in millions 30,000 20,000 10,000 0 UAL American Southwest Delta Northwest Source: Company reports, 2004. Additional Debt from Capitalizing Leases Reported Debt And airlines are not the only ones playing the off-balance-sheet game. A recent SEC study estimates that for SEC registrants, off-balance-sheet lease obligations total more the $1.3 trillion, or 31 times the amount of on-balance-sheet obligations. (See SEC OffBalance Sheet report at www.sec.gov/news/studies/soxoffbalancerpt.pdf.) Thus, analysts must adjust reported debt levels for the effects of non-capitalized leases. A methodology for making this adjustment is discussed in Eugene A. Imhoff, Jr., Robert C. Lipe, and David W. Wright, “Operating Leases: Impact of Constructive Capitalization,” Accounting Horizons (March 1991). Conceptual Nature of a Lease If Delta borrows $47 million on a 10-year note from Bank of America to purchase a Boeing 737 jet plane, Delta should clearly report an asset and related liability at that amount on its balance sheet. Similarly, if Delta purchases the 737 for $47 million directly from Boeing through an installment purchase over 10 years, it should obviously report an asset and related liability (i.e., it should “capitalize” the installment transaction). However, what if Delta leases the Boeing 737 for 10 years from International Lease Finance Corp. (ILFC)—the world’s largest lessor of airplanes—through a noncancelable lease transaction with payments of the same amount as the installment purchase As demonstrated later in this chapter, certain types of lease arrangements are not capitalized on the balance sheet. The liabilities section is thereby relieved of large future lease commitments that, if recorded, would adversely affect the debt to equity ratio. The reluctance to record lease obligations as liabilities is one of the primary reasons some companies resist capitalized lease accounting. 2 1460T_c21.qxd 1/21/06 03:45 am Page 1092 1092 • Chapter 21 Accounting for Leases transaction? In that case, opinion differs over how to report this transaction. The various views on capitalization of leases are as follows. 1 2 3 Underlying Concepts The issue of how to report leases is the classic case of substance versus form. Although legal title does not technically pass in lease transactions, the benefits from the use of the property do transfer. 4 Do Not Capitalize Any Leased Assets. This view considers capitalization inappropriate, because Delta does not own the property. Furthermore, a lease is an “executory” contract requiring continuing performance by both parties. Because companies do not currently capitalize other executory contracts (such as purchase commitments and employment contracts), they should not capitalize leases either. Capitalize Leases That Are Similar to Installment Purchases. This view holds that companies should report transactions in accordance with their economic substance. Therefore, if companies capitalize installment purchases, they should also capitalize leases that have similar characteristics. For example, Delta Airlines makes the same payments over a 10-year period for either a lease or an installment purchase. Lessees make rental payments, whereas owners make mortgage payments. Why should the financial statements not report these transactions in the same manner? Capitalize All Long-Term Leases. This approach requires only the long-term right to use the property in order to capitalize. This property-rights approach capitalizes all long-term leases.3 Capitalize Firm Leases Where the Penalty for Nonperformance Is Substantial. A final approach advocates capitalizing only “firm” (noncancelable) contractual rights and obligations. “Firm” means that it is unlikely to avoid performance under the lease without a severe penalty.4 In short, the various viewpoints range from no capitalization to capitalization of all leases. The FASB apparently agrees with the capitalization approach when the lease is similar to an installment purchase: It notes that Delta should capitalize a lease that transfers substantially all of the benefits and risks of property ownership, provided the lease is noncancelable. Noncancelable means that Delta can cancel the lease contract only upon the outcome of some remote contingency, or that the cancellation provisions and penalties of the contract are so costly to Delta that cancellation probably will not occur. This viewpoint leads to three basic conclusions: (1) Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership. (2) The same characteristics should apply consistently to the lessee and the lessor. (3) Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases. Companies should not capitalize operating leases. Instead, companies should account for them as rental payments and receipts. ACCOUNTING BY THE LESSEE OBJECTIVE 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee. If Delta Airlines (the lessee) capitalizes a lease, it records an asset and a liability generally equal to the present value of the rental payments. ILFC (the lessor), having transferred substantially all the benefits and risks of ownership, recognizes a sale by removing the asset from the balance sheet and replacing it with a receivable. The typical journal entries 3 The property rights approach was originally recommended in a research study by the AICPA: John H. Myers, “Reporting of Leases in Financial Statements,” Accounting Research Study No. 4 (New York: AICPA, 1964), pp. 10–11. Recently, this view has received additional support. See Peter H. Knutson, “Financial Reporting in the 1990s and Beyond,” Position Paper (Charlottesville, Va.: AIMR, 1993), and Warren McGregor, “Accounting for Leases: A New Approach,” Special Report (Norwalk, Conn.: FASB, 1996). Yuji Ijiri, Recognition of Contractual Rights and Obligations, Research Report (Stamford, Conn.: FASB, 1980). 4 1460T_c21.qxd 1/21/06 03:45 am Page 1093 Accounting by the Lessee for Delta and ILFC, assuming leased and capitalized equipment, appear as shown in Illustration 21-3. • 1093 Delta (Lessee) Leased Equipment Lease Liability XXX XXX Lease Receivable Equipment ILFC (Lessor) XXX XXX ILLUSTRATION 21-3 Journal Entries for Capitalized Lease Having capitalized the asset, Delta records depreciation on the leased asset. Both ILFC and Delta treat the lease rental payments as consisting of interest and principal. If Delta does not capitalize the lease, it does not record an asset, nor does ILFC remove one from its books. When Delta makes a lease payment, it records rental expense; ILFC recognizes rental revenue. In order to record a lease as a capital lease, the lease must be noncancelable. Further, it must meet one or more of the four criteria listed in Illustration 21-4. ILLUSTRATION 21-4 Capitalization Criteria for Lessee Capitalization Criteria (Lessee) • • • • The lease transfers ownership of the property to the lessee. The lease contains a bargain purchase option.5 The lease term is equal to 75 percent or more of the estimated economic life of the leased property. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.6 Delta classifies and accounts for leases that do not meet any of the four criteria as operating leases. Illustration 21-5 shows that a lease meeting any one of the four criteria results in the lessee having a capital lease. ILLUSTRATION 21-5 Diagram of Lessee’s Criteria for Lease Classification Lease Agreement Is There a Transfer of Ownership? Is There a Bargain Purchase Option? Is Lease Term ≥ 75% of Economic Life? Is Present Value of Payments ≥ 90% of Fair Value? No No No No Yes Yes Capital Lease Yes Yes Operating Lease In keeping with the FASB’s reasoning that a company consumes a significant portion of the value of the asset in the first 75 percent of its life, the lessee applies neither the third nor the fourth criterion when the inception of the lease occurs during the last 25 percent of the asset’s life. 5 6 We define a bargain purchase option in the next section. “Accounting for Leases,” FASB Statement No. 13 as amended and interpreted through May 1980 (Stamford, Conn.: FASB, 1980), par. 7. 1460T_c21.qxd 1/21/06 03:45 am Page 1094 1094 • Chapter 21 Accounting for Leases Capitalization Criteria Three of the four capitalization criteria that apply to lessees are controversial and can be difficult to apply in practice. We discuss each of the criteria in detail on the following pages. Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is not controversial and easily implemented in practice. Bargain Purchase Option Test A bargain purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable. 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. For example, assume that Brett’s Delivery Service was to lease a Honda Accord for $599 per month for 40 months, with an option to purchase for $100 at the end of the 40-month period. If the estimated fair value of the Honda Accord is $3,000 at the end of the 40 months, the $100 option to purchase is clearly a bargain. Therefore, Brett must capitalize the lease. In other cases, the criterion may not be as easy to apply, and determining now that a certain future price is a bargain can be difficult. Economic Life Test (75% Test) If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate. However, determining the lease term and the economic life of the asset can be troublesome. The lease term is generally considered to be the fixed, noncancelable term of the lease. However, a bargain renewal option, if provided in the lease agreement, can extend this period. A bargain renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable. 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. For example, assume that Home Depot leases Dell 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. However, with bargain renewal options, as with bargain purchase options, it is sometimes difficult to determine what is a bargain.7 Determining estimated economic life can also pose problems, especially if the leased item is a specialized item or has been used for a significant period of time. For example, determining the economic life of a nuclear core is extremely difficult. It is subject to much more than normal “wear and tear.” As indicated earlier, the FASB takes the position that if the lease starts during the last 25 percent of the life of the asset, companies cannot use the economic life test to classify a lease as a capital lease. International Insight In some countries (e.g., Italy, Japan), accounting principles do not specify criteria for capitalization of leases. In others (e.g., Sweden, Switzerland), such criteria exist, but capitalization of the leases is optional. The original lease term is also extended for leases having the following: substantial penalties for nonrenewal; periods for which the lessor has the option to renew or extend the lease; renewal periods preceding the date a bargain purchase option becomes exercisable; and renewal periods in which any lessee guarantees of the lessor’s debt are expected to be in effect or in which there will be a loan outstanding from the lessee to the lessor. The lease term, however, can never extend beyond the time a bargain purchase option becomes exercisable. “Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases,” Statement of Financial Accounting Standards No. 98 (Stamford, Conn.: FASB, 1988). 7 1460T_c21.qxd 1/21/06 03:45 am Page 1095 Accounting by the Lessee Recovery of Investment Test (90% Test) If the present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the asset, then a lessee like Delta should capitalize the leased asset. Why? If the present value of the minimum lease payments is reasonably close to the market price of the aircraft, Delta is effectively purchasing the asset. Determining the present value of the minimum lease payments involves three important concepts: (1) minimum lease payments, (2) executory costs, and (3) discount rate. Minimum Lease Payments. Delta is obligated to make, or expected to make, minimum lease payments in connection with the leased property. These payments include the following. 1 • 1095 2 3 4 Minimum Rental Payments—Minimum rental payments are those that Delta must make to ILFC under the lease agreement. In some cases, the minimum rental payments may equal the minimum lease payments. However, the minimum lease payments may also include a guaranteed residual value (if any), penalty for failure to renew, or a bargain purchase option (if any), as we note below. Guaranteed Residual Value—The residual value is the estimated fair (market) value of the leased property at the end of the lease term. ILFC may transfer the risk of loss to Delta or to a third party by obtaining a guarantee of the estimated residual value. The guaranteed residual value is either (1) the certain or determinable amount that Delta will pay ILFC at the end of the lease to purchase the aircraft at the end of the lease, or (2) the amount Delta or the third party guarantees that ILFC will realize if the aircraft is returned. (Third-party guarantors are, in essence, insurers who for a fee assume the risk of deficiencies in leased asset residual value.) If not guaranteed in full, the unguaranteed residual value is the estimated residual value exclusive of any portion guaranteed.8 Penalty for Failure to Renew or Extend the Lease—The amount Delta must pay if the agreement specifies that it must extend or renew the lease, and it fails to do so. Bargain Purchase Option—As we indicated earlier (in item 1), an option given to Delta to purchase the aircraft at the end of the lease term at a price that is fixed sufficiently below the expected fair value, so that, at the inception of the lease, purchase is reasonably assured. Delta excludes executory costs (defined below) from its computation of the present value of the minimum lease payments. Executory Costs. Like most assets, leased tangible assets incur insurance, maintenance, and tax expenses—called executory costs—during their economic life. If ILFC retains responsibility for the payment of these “ownership-type costs,” it should exclude, in computing the present value of the minimum lease payments, a portion of each lease payment that represents executory costs. Executory costs do not represent payment on or reduction of the obligation. Many lease agreements specify that the lessee directly pays executory costs to the appropriate third parties. In these cases, the lessor can use the rental payment without adjustment in the present value computation. Discount Rate. A lessee, like Delta computes the present value of the minimum lease payments using its incremental borrowing rate. This rate is defined as: “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.”9 8 A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is not included in the minimum lease payments. Lessees recognize such costs as period costs when incurred. “Lessee Guarantee of the Residual Value of Leased Property,” FASB Interpretation No. 19 (Stamford, Conn.: FASB, 1977), par. 3. 9 FASB Statement No. 13, op. cit., par. 5 (l). 1460T_c21.qxd 1/21/06 03:45 am Page 1096 1096 • Chapter 21 Accounting for Leases To determine whether the present value of these payments is less than 90 percent of the fair market value of the property, Delta discounts the payments using its incremental borrowing rate. Determining the incremental borrowing rate often requires judgment because the lessee bases it on a hypothetical purchase of the property. However, there is one exception to this rule. If (1) Delta knows the implicit interest rate computed by ILFC and (2) it is less than Delta’s incremental borrowing rate, then Delta must use ILFC’s implicit rate. What is the interest rate implicit in the lease? It is the discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate present value to equal the fair value of the leased property to the lessor.10 The purpose of this exception is twofold. First, the implicit rate of ILFC is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for Delta. Second, the guideline ensures that Delta does not use an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be less than 90 percent of the fair market value of the aircraft. Use of such a rate would thus make it possible to avoid capitalization of the asset and related liability. Delta may argue that it cannot determine the implicit rate of the lessor and therefore should use the higher rate. However, in most cases, Delta can approximate the implicit rate used by ILFC. The determination of whether or not a reasonable estimate could be made will require judgment, particularly where the result from using the incremental borrowing rate comes close to meeting the 90 percent test. Because Delta may not capitalize the leased property at more than its fair value (as we discuss later), it cannot use an excessively low discount rate. Asset and Liability Accounted for Differently In a capital lease transaction, Delta uses the lease as a source of financing. ILFC finances the transaction (provides the investment capital) through the leased asset. Delta makes rent payments, which actually are installment payments. Therefore, over the life of the aircraft rented, the rental payments to ILFC constitute a payment of principal plus interest. Asset and Liability Recorded Under the capital lease method, Delta treats the lease transaction as if it purchases the aircraft in a financing transaction. That is, Delta acquires the aircraft and creates an obligation. Therefore, it records a capital lease as an asset and a liability at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair-market value of the leased asset at the inception of the lease. The rationale for this approach is that companies should not record a leased asset for more than its fair market value. Depreciation Period One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Delta (criterion 1) or contains a bargain purchase option (criterion 2), Delta depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain purchase option, then Delta depreciates it over the term of the lease. In this case, the aircraft reverts to ILFC after a certain period of time. Effective-Interest Method Throughout the term of the lease, Delta uses the effective-interest method to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the 10 Ibid., par. 5 (k). 1460T_c21.qxd 1/21/06 03:45 am Page 1097 Accounting by the Lessee lease obligation. When applying the effective-interest method to capital leases, Delta must use the same discount rate that determines the present value of the minimum lease payments. Depreciation Concept Although Delta computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years’-digits, declining-balance, units of production, etc. The FASB uses the term “amortization” more frequently than “depreciation” to recognize intangible leased property rights. We prefer “depreciation” to describe the writeoff of a tangible asset’s expired services. • 1097 Capital Lease Method (Lessee) To illustrate a capital lease, assume that Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2008, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2008. 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 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. • Sterling pays all of the executory costs directly to third parties except for the property taxes of $2,000 per year, which it includes 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. • Sterling’s incremental borrowing rate is 11 percent per year. • Sterling depreciates, on a straight-line basis, similar equipment that it owns. • Caterpillar sets the annual rental to earn a rate of return on its investment of 10 percent per year; Sterling knows this fact.11 The lease meets the criteria for classification as a capital lease for the following reasons: 1 2 The lease term of five years, being equal to the equipment’s estimated economic life of five years, satisfies the 75 percent test. The present value of the minimum lease payments ($100,000 as computed below) exceeds 90 percent of the fair value of the loader ($100,000). The minimum lease payments are $119,908.10 ($23,981.62 5). Sterling computes the amount capitalized as leased assets as the present value of the minimum lease payments (excluding executory costs—property taxes of $2,000) as shown in Illustration 21-6. Capitalized amount ($25,981.62 $23,981.62 $100,000 $2,000) 4.16986 Present value of an annuity due of 1 for 5 periods at 10% (Table 6-5) ILLUSTRATION 21-6 Computation of Capitalized Lease Payments If Sterling has an incremental borrowing rate of, say, 9 percent (lower than the 10 percent rate used by Caterpillar) and it did not know the rate used by Caterpillar, the present value computation would yield a capitalized amount of $101,675.35 ($23,981.62 4.23972). And, because this amount exceeds the $100,000 fair value of the equipment, Sterling would have to capitalize the $100,000 and use 10 percent as its effective rate for amortization of the lease obligation. 11 1460T_c21.qxd 1/21/06 03:45 am Page 1098 1098 • Chapter 21 Accounting for Leases Sterling uses Caterpillar’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. Sterling records the capital lease on its books on January 1, 2008, as: Leased Equipment under Capital Leases Lease Liability 100,000 100,000 Calculator Solution Inputs Answer N I PV PMT FV 5 10 Note that the entry records the obligation at the net amount of $100,000 (the present value of the future rental payments) rather than at the gross amount of $119,908.10 ($23,981.62 5). Sterling records the first lease payment on January 1, 2008, as follows: 100,000 ? –23,981.59 Property Tax Expense Lease Liability Cash 2,000.00 23,981.62 25,981.62 0 Each lease payment of $25,981.62 consists of three elements: (1) a reduction in the lease liability, (2) a financing cost (interest expense), and (3) executory costs (property taxes). The total financing cost (interest expense) over the term of the lease is $19,908.10. This amount is the difference between the present value of the lease payments ($100,000) and the actual cash disbursed, net of executory costs ($119,908.10). Therefore, the annual interest expense, applying the effective-interest method, is a function of the outstanding liability, as Illustration 21-7 shows. ILLUSTRATION 21-7 Lease Amortization Schedule for Lessee— Annuity-Due Basis Date 1/1/08 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 Annual Lease Payment (a) $ 25,981.62 25,981.62 25,981.62 25,981.62 25,981.62 $129,908.10 STERLING CONSTRUCTION LEASE AMORTIZATION SCHEDULE (ANNUITY-DUE BASIS) Executory Costs (b) $ 2,000 2,000 2,000 2,000 2,000 $10,000 $ Interest (10%) on Liability (c) –0– 7,601.84 5,963.86 4,162.08 2,180.32* Reduction of Lease Liability (d) $ 23,981.62 16,379.78 18,017.76 19,819.54 21,801.30 $100,000.00 Lease Liability (e) $100,000.00 76,018.38 59,638.60 41,620.84 21,801.30 –0– $19,908.10 (a) Lease payment as required by lease. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e) except for 1/1/05; since this is an annuity due, no time has elapsed at the date of the first payment and no interest has accrued. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. At the end of its fiscal year, December 31, 2008, Sterling records accrued interest as follows. Interest Expense Interest Payable 7,601.84 7,601.84 Depreciation of the leased equipment over its five-year lease term, applying Sterling’s normal depreciation policy (straight-line method), results in the following entry on December 31, 2008. Depreciation Expense—Capital Leases Accumulated Depreciation—Capital Leases ($100,000 5 years) 20,000 20,000 1460T_c21.qxd 1/21/06 03:45 am Page 1099 Accounting by the Lessee At December 31, 2008, Sterling separately identifies the assets recorded under capital leases on its balance sheet. Similarly, it separately identifies the related obligations. Sterling classifies the portion due within one year or the operating cycle, whichever is longer, with current liabilities, and the rest with noncurrent liabilities. For example, the current portion of the December 31, 2008, total obligation of $76,018.38 in Sterling’s amortization schedule is the amount of the reduction in the obligation in 2009, or $16,379.78. Illustration 21-8 shows the liabilities section as it relates to lease transactions at December 31, 2008. Current liabilities Interest payable Lease liability Noncurrent liabilities Lease liability $59,638.60 $ 7,601.84 16,379.78 • 1099 ILLUSTRATION 21-8 Reporting Current and Noncurrent Lease Liabilities Sterling records the lease payment of January 1, 2009, as follows. Property Tax Expense Interest Payable Lease Liability Cash 2,000.00 7,601.84 16,379.78 25,981.62 Entries through 2012 would follow the pattern above. Sterling records its other executory costs (insurance and maintenance) in a manner similar to how it records any other operating costs incurred on assets it owns. Upon expiration of the lease, Sterling has fully amortized the amount capitalized as leased equipment. It also has fully discharged its lease obligation. If Sterling does not purchase the loader, it returns the equipment to Caterpillar. Sterling then removes the leased equipment and related accumulated depreciation accounts from its books.12 If Sterling purchases the equipment at termination of the lease, at a price of $5,000 and the estimated life of the equipment changes from five to seven years, it makes the following entry. Equipment ($100,000 $5,000) Accumulated Depreciation—Capital Leases Leased Equipment under Capital Leases Accumulated Depreciation—Equipment Cash 105,000 100,000 100,000 100,000 5,000 Operating Method (Lessee) Under the operating method, rent expense (and the associated liability) accrues day by day to the lessee as it uses the property. 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. The lessee makes appropriate accruals or deferrals if the accounting period ends between cash payment dates. For example, assume that the capital lease illustrated in the previous section did not qualify as a capital lease. Sterling therefore accounts for it as an operating lease. The first-year charge to operations is now $25,981.62, the amount of the rental payment. Sterling records this payment on January 1, 2008, as follows. Rent Expense Cash 25,981.62 25,981.62 If Sterling purchases the front-end loader during the term of a “capital lease,” it accounts for it like a renewal or extension of a capital lease. “Any difference between the purchase price and the carrying amount of the lease obligation shall be recorded as an adjustment of the carrying amount of the asset.” See “Accounting for Purchase of a Leased Asset by the Lessee During the Term of the Lease,” FASB Interpretation No. 26 (Stamford, Conn.: FASB, 1978), par. 5. 12 1460T_c21.qxd 1/21/06 03:45 am Page 1100 1100 • Chapter 21 Accounting for Leases Sterling does not report the loader, as well as any long-term liability for future rental payments, on the balance sheet. Sterling reports rent expense on the income statement. And, as discussed later in the chapter, Sterling must disclose all operating leases that have noncancelable lease terms in excess of one year. Restatements on the menu Accounting for operating leases would appear routine, so it is unusual for a bevy of companies in a single industry—restaurants—to get caught up in the accounting rules for operating leases. Getting the accounting right is particularly important for restaurant chains, because they make extensive use of leases for their restaurants and equipment. The problem stems from the way most property (and equipment) leases cover a specific number of years (the so-called primary lease term) as well as renewal periods (sometimes referred to as the option term). In some cases, companies were calculating their lease expense for the primary term but depreciating lease-related assets over both the primary and option terms. This practice resulted in understating the total cost of the lease and thus boosted earnings. For example, the CFO at CKE Restaurants Inc., owner of the Hardee’s and Carl’s Jr. chains, noted that CKE ran into trouble because it was not consistent in calculating the lease and depreciation expense. Correcting the error at CKE reduced earnings by nine cents a share in fiscal 2002, nine cents a share in fiscal 2003, and 10 cents a share in fiscal 2004. The company now uses the shorter, primary lease terms for calculating both lease expense and depreciation. The change increases depreciation annually, which in turn decreases total assets. CKE was not alone in improper operating lease accounting. Notable restaurateurs who ran afoul of the lease rules included Brinker International Inc., operator of Chili’s; Darden Restaurants Inc., which operates Red Lobster and Olive Garden; and Jack in the Box. To correct their operating lease accounting, these restaurants reported restatements that resulted in lower earnings and assets. Source: Steven D. Jones and Richard Gibson, Wall Street Journal (January 26, 2005). p. C3. What do the numbers mean? Comparison of Capital Lease with Operating Lease OBJECTIVE 3 Contrast the operating and capitalization methods of recording leases. As we indicated, if accounting for the lease as an operating lease, the first-year charge to operations is $25,981.62, the amount of the rental payment. Treating the transaction as a capital lease, however, results in a first-year charge of $29,601.84: depreciation of $20,000 (assuming straight-line), interest expense of $7,601.84 (per Illustration 21-7), and executory costs of $2,000. Illustration 21-9 shows that while the total charges to operations are the same over the lease term whether accounting for the lease as a ILLUSTRATION 21-9 Comparison of Charges to Operations—Capital vs. Operating Leases STERLING CONSTRUCTION SCHEDULE OF CHARGES TO OPERATIONS CAPITAL LEASE VERSUS OPERATING LEASE Capital Lease Year 2008 2009 2010 2011 2012 Depreciation $ 20,000 20,000 20,000 20,000 20,000 $100,000 Executory Costs $ 2,000 2,000 2,000 2,000 2,000 $10,000 Interest $ 7,601.84 5,963.86 4,162.08 2,180.32 — $19,908.10 Total Charge $ 29,601.84 27,963.86 26,162.08 24,180.32 22,000.00 $129,908.10 Operating Lease Charge $ 25,981.62 25,981.62 25,981.62 25,981.62 25,981.62 $129,908.10 Difference $3,620.22 1,982.24 180.46 (1,801.30) (3,981.62) $ –0– 1460T_c21.qxd 1/21/06 03:45 am Page 1101 Accounting by the Lessee capital lease or as an operating lease, under the capital lease treatment the charges are higher in the earlier years and lower in the later years.13 If using an accelerated method of depreciation, the differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. In addition, using the capital lease approach results in an asset and related liability of $100,000 initially reported on the balance sheet. The lessee would not report any asset or liability under the operating method. Therefore, the following differences occur if using a capital lease instead of an operating lease: 1 2 3 • 1101 An increase in the amount of reported debt (both short-term and long-term). An increase in the amount of total assets (specifically long-lived assets). A lower income early in the life of the lease and, therefore, lower retained earnings. Thus, many companies believe that capital leases negatively impact their financial position: Their debt to total equity ratio increases, and their rate of return on total assets decreases. As a result, the business community resists capitalizing leases. Whether this resistance is well founded is debatable. From a cash flow point of view, the company is in the same position whether accounting for the lease as an operating or a capital lease. Managers often argue against capitalization for several reasons: First is that capitalization can more easily lead to violation of loan covenants. It also can affect the amount of compensation received by owners (for example, a stock compensation plan tied to earnings). Finally, capitalization can lower rates of return Dollars to doughnuts Krispy Kreme, a chain of 217 doughnut shops, has caught the attention—some good, some bad—of Wall Street. On the good side, investors are impressed by the company’s ability to grow rapidly on a relatively small bit of capital. For the first nine months of fiscal 2002, the company’s capital expenditures fell to $38 million, from $59 million the year before. Yet Krispy Kreme expanded, along with its customers’ waistlines, during the same period: Its earnings rose 73 percent, to $18 million, on sales that were up 27 percent to $277 million. That’s an impressive feat if you care about return on capital. But there’s a hole in this doughnut. Amid much hoopla, the company announced in 2001 that it would spend $30 million on a new 187,000 square foot mixing plant and warehouse in Effingham, Illinois. Yet the financial statements failed to disclose the investments and obligations associated with that $30 million. By financing through a synthetic lease, Krispy Kreme keeps the investment and obligation off the books. In a synthetic lease, a financial institution like Bank of America sets up a special purpose entity (SPE) that borrows money to build the plant and then leases it to Krispy Kreme. For accounting purposes, Krispy Kreme reports an operating lease, but for tax purposes the company is considered the owner of the asset and gets depreciation tax deductions. In response to negative publicity about the use of SPEs to get favorable financial reporting and tax benefits, Krispy Kreme announced it would change its method of financing construction of its dough-making plant. Source: Adapted from Seth Lubore and Elizabeth MacDonald, “Debt? Who, Me?” Forbes (February 18, 2002), p. 56. What do the numbers mean? The higher charges in the early years is one reason lessees are reluctant to adopt the capital lease accounting method. Lessees (especially those of real estate) claim that it is really no more costly to operate the leased asset in the early years than in the later years. Thus, they advocate an even charge similar to that provided by the operating method. 13 1460T_c21.qxd 1/21/06 03:45 am Page 1102 1102 • Chapter 21 Accounting for Leases and increase debt to equity relationships, making the company less attractive to present and potential investors.14 ACCOUNTING BY THE LESSOR Earlier in this chapter we discussed leasing’s advantages to the lessee. Three important benefits are available to the lessor: 1 International Insight Recently, the IASB indicated it plans to reform the rules on accounting for leased assets. 2 3 Interest Revenue. Leasing is a form of financing. Banks, captives, and independent leasing companies find leasing attractive because it provides competitive interest margins. Tax Incentives. In many cases, companies that lease cannot use the tax benefit of the asset, but leasing allows them to transfer such tax benefits to another party (the lessor) in return for a lower rental rate on the leased asset. To illustrate, Boeing Aircraft might sell one of its 737 jet planes to a wealthy investor who needed only the tax benefit. The investor then leased the plane to a foreign airline, for whom the tax benefit was of no use. Everyone gained. Boeing sold its airplane, the investor received the tax benefit, and the foreign airline cheaply acquired a 737.15 High Residual Value. Another advantage to the lessor is the return of the property at the end of the lease term. Residual values can produce very large profits. Citigroup at one time assumed that the commercial aircraft it was leasing to the airline industry would have a residual value of 5 percent of their purchase price. It turned out that they were worth 150 percent of their cost—a handsome profit. However, three years later these same planes slumped to 80 percent of their cost, but still far more than 5 percent. Economics of Leasing A lessor, such as Caterpillar Financial in our earlier example, determines the amount of the rental, basing it on the rate of return—the implicit rate—needed to justify leasing the front-end loader. In establishing the rate of return, Caterpillar considers the credit standing of Sterling Construction, the length of the lease, and the status of the residual value (guaranteed versus unguaranteed). In the Caterpillar/Sterling example on pages 1097–1099, Caterpillar’s implicit rate was 10 percent, the cost of the equipment to Caterpillar was $100,000 (also fair market value), and the estimated residual value was zero. Caterpillar determines the amount of the lease payment as follows. ILLUSTRATION 21-10 Computation of Lease Payments Fair market value of leased equipment Less: Present value of the residual value Amount to be recovered by lessor through lease payments Five beginning-of-the-year lease payments to yield a 10% return ($100,000 4.16986a) a $100,000.00 –0– $100,000.00 $ 23,981.62 PV of an annuity due of 1 for 5 years at 10% (Table 6-5) One study indicates that management’s behavior did change as a result of FASB No. 13. For example, many companies restructure their leases to avoid capitalization. Others increase their purchases of assets instead of leasing. Still others, faced with capitalization, postpone their debt offerings or issue stock instead. However, note that the study found no significant effect on stock or bond prices as a result of capitalization of leases. A. Rashad Abdel-khalik, “The Economic Effects on Lessees of FASB Statement No. 13, Accounting for Leases,” Research Report (Stamford, Conn.: FASB, 1981). Some would argue that there is a loser—the U.S. government. The tax benefits enable the profitable investor to reduce or eliminate taxable income. 15 14 1460T_c21.qxd 1/21/06 03:45 am Page 1103 Accounting by the Lessor If a residual value is involved (whether guaranteed or not), Caterpillar would not have to recover as much from the lease payments. Therefore, the lease payments would be less. (Illustration 21-17, on page 1108, shows this situation.) • 1103 Classification of Leases by the Lessor For accounting purposes, the lessor may classify leases as one of the following: 1 2 3 OBJECTIVE 4 Identify the classifications of leases for the lessor. Operating leases. Direct-financing leases. Sales-type leases. Illustration 21-11 presents two groups of capitalization criteria for the lessor. If at the date of inception, the lessor agrees to a lease that meets one or more of the Group I criteria (1, 2, 3, and 4) and both of the Group II criteria (1 and 2), the lessor shall classify and account for the arrangement as a direct-financing lease or as a sales-type lease.16 (Note that the Group I criteria are identical to the criteria that must be met in order for a lessee to classify a lease as a capital lease, as shown in Illustration 21-4.) ILLUSTRATION 21-11 Capitalization Criteria for Lessor Capitalization Criteria (Lessor) Group I 1. The lease transfers ownership of the property to the lessee. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75 percent or more 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. Group II 1. Collectibility of the payments required from the lessee is reasonably predictable. 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable). Why the Group II requirements? The profession wants to ensure that the lessor has really transferred the risks and benefits of ownership. If collectibility of payments is not predictable or if performance by the lessor is incomplete, then the criteria for revenue recognition have not been met. The lessor should therefore account for the lease as an operating lease. For example, computer leasing companies at one time used to buy IBM equipment, lease the equipment, and remove the leased assets from their balance sheets. In leasing the assets, the computer lessors stated that they would substitute new IBM equipment if obsolescence occurred. However, when IBM introduced a new computer line, IBM refused to sell it to the computer leasing companies. As a result, a number of the lessors could not meet their contracts with their customers and had to take back the old equipment. The computer leasing companies therefore had to reinstate the assets they had taken off the books. Such a case demonstrates one reason for the Group II requirements. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss): A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying amount (book value). Normally, sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products. For example, a computer manufacturer will lease 16 International Insight U.S. GAAP is consistent with International Standard No. 17 (Accounting for Leases). However, the international standard is a relatively simple statement of basic principles, whereas the U.S. rules on leases are more prescriptive and detailed. FASB Statement No. 13, op. cit., pars. 6, 7, and 8. 1460T_c21.qxd 1/21/06 03:45 am Page 1104 1104 • Chapter 21 Accounting for Leases its computer equipment (possibly through a captive) to businesses and institutions. Direct-financing leases generally result from arrangements with lessors that are primarily engaged in financing operations (e.g., banks). However, a lessor need not be a manufacturer or dealer to recognize a profit (or loss) at the inception of a lease that requires application of sales-type lease accounting. Lessors classify and account for all leases that do not qualify as direct-financing or sales-type leases as operating leases. Illustration 21-12 shows the circumstances under which a lessor classifies a lease as operating, direct-financing, or sales-type. ILLUSTRATION 21-12 Diagram of Lessor’s Criteria for Lease Classification Lease Agreement Does Lease Meet Any of Group I Criteria? (Same as Lessee's) Is Collectibility of Lease Payments Reasonably Certain? Is Lessor's Performance Substantially Complete? Does Asset Fair Value Equal Lessor's Book Value? Yes Yes Yes Yes No No No No DirectFinancing Lease Operating Lease Sales-Type Lease As a consequence of the additional Group II criteria for lessors, a lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease. In such an event, both the lessor and lessee will carry the asset on their books, and both will depreciate the capitalized asset. For purposes of comparison with the lessee’s accounting, we will illustrate only the operating and direct-financing leases in the following section. We will discuss the more complex sales-type lease later in the chapter. Direct-Financing Method (Lessor) OBJECTIVE 5 Describe the lessor’s accounting for directfinancing leases. Direct-financing leases are in substance the financing of an asset purchase by the lessee. In this type of lease, the lessor records a lease receivable instead of a leased asset. The lease receivable is the present value of the minimum lease payments. Remember that “minimum lease payments” include: 1 2 3 4 Rental payments (excluding executory costs). Bargain purchase option (if any). Guaranteed residual value (if any). Penalty for failure to renew (if any). Thus, the lessor records the residual value, whether guaranteed or not. Also, recall that if the lessor pays any executory costs, then it should reduce the rental payment by that amount in computing minimum lease payments. The following presentation, using the data from the preceding Caterpillar/Sterling example on pages 1097–1099, illustrates the accounting treatment for a direct-financing lease. We repeat here the information relevant to Caterpillar in accounting for this lease transaction. 1 The term of the lease is five years beginning January 1, 2008, noncancelable, and requires equal rental payments of $25,981.62 at the beginning of each year. Payments include $2,000 of executory costs (property taxes). 1460T_c21.qxd 1/21/06 03:45 am Page 1105 Accounting by the Lessor 2 • 1105 3 4 5 6 The equipment (front-end loader) has a cost of $100,000 to Caterpillar, a fair value at the inception of the lease of $100,000, an estimated economic life of five years, and no residual value. Caterpillar incurred no initial direct costs in negotiating and closing the lease transaction. The lease contains no renewal options. The equipment reverts to Caterpillar at the termination of the lease. Collectibility is reasonably assured and Caterplillar incurs no additional costs (with the exception of the property taxes being collected from Sterling). Caterpillar sets the annual lease payments to ensure a rate of return of 10 percent (implicit rate) on its investment as shown in Illustration 21-13. ILLUSTRATION 21-13 Computation of Lease Payments Fair market value of leased equipment Less: Present value of residual value Amount to be recovered by lessor through lease payments Five beginning-of-the-year lease payments to yield a 10% return ($100,000 4.16986a) a $100,000.00 –0– $100,000.00 $ 23,981.62 PV of an annuity due of 1 for 5 years at 10% (Table 6-5). The lease meets the criteria for classification as a direct-financing lease for several reasons: (1) The lease term exceeds 75 percent of the equipment’s estimated economic life. (2) The present value of the minimum lease payments exceeds 90 percent of the equipment’s fair value. (3) Collectibility of the payments is reasonably assured. And (4) Caterpillar incurs no further costs. It is not a sales-type lease because there is no difference between the fair value ($100,000) of the loader and Caterpillar’s cost ($100,000). The Lease Receivable is the present value of the minimum lease payments (excluding executory costs which are property taxes of $2,000). Caterpillar computes it as follows. ILLUSTRATION 21-14 Computation of Lease Receivable Lease receivable ($25,981.62 $23,981.62 $100,000 $2,000) 4.16986 Present value of an annuity due of 1 for 5 periods at 10% (Table 6-5) Caterpillar records the lease of the asset and the resulting receivable on January 1, 2008 (the inception of the lease), as follows. Lease Receivable Equipment 100,000 100,000 Companies often report the lease receivable in the balance sheet as “Net investment in capital leases.” Companies classify it either as current or noncurrent, depending on when they recover the net investment.17 Caterpillar replaces its investment (the leased front-end loader, a cost of $100,000), with a lease receivable. In a manner similar to Sterling’s treatment of interest, Caterpillar applies the effective-interest method and recognizes interest revenue as a function of the lease receivable balance, as Illustration 21-15 (page 1106) shows. 17 In the notes to the financial statements (see Illustration 21-33), the lease receivable is reported at its gross amount (minimum lease payments plus the unguaranteed residual value). In addition, the lessor also reports total unearned interest related to the lease. As a result, some lessors record lease receivable on a gross basis and record the unearned interest in a separate account. We illustrate the net approach here because it is consistent with the accounting for the lessee. 1460T_c21.qxd 1/21/06 03:45 am Page 1106 1106 • Chapter 21 Accounting for Leases ILLUSTRATION 21-15 Lease Amortization Schedule for Lessor— Annuity-Due Basis Date 1/1/08 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 Annual Lease Payment (a) $ 25,981.62 25,981.62 25,981.62 25,981.62 25,981.62 $129,908.10 CATERPILLAR FINANCIAL LEASE AMORTIZATION SCHEDULE (ANNUITY-DUE BASIS) Executory Costs (b) $ 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 $10,000.00 $ Interest (10%) on Lease Receivable (c) –0– 7,601.84 5,963.86 4,162.08 2,180.32* Lease Receivable Recovery (d) $ 23,981.62 16,379.78 18,017.76 19,819.54 21,801.30 $100,000.00 Lease Receivable (e) $100,000.00 76,018.38 59,638.60 41,620.84 21,801.30 –0– $19,908.10 (a) Annual rental that provides a 10% return on net investment. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e) except for 1/1/08. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. On January 1, 2008, Caterpillar records receipt of the first year’s lease payment as follows. Cash Lease Receivable Property Tax Expense/Property Taxes Payable 25,981.62 23,981.62 2,000.00 On December 31, 2008, Caterpillar recognizes the interest revenue earned during the first year through the following entry. Interest Receivable Interest Revenue—Leases 7,601.84 7,601.84 At December 31, 2008, Caterpillar reports the lease receivable in its balance sheet among current assets or noncurrent 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 noncurrent assets. Illustration 21-16 shows the assets section as it relates to lease transactions at December 31, 2008. ILLUSTRATION 21-16 Reporting Lease Transactions by Lessor Current assets Interest receivable Lease receivable Noncurrent assets (investments) Lease receivable $59,638.60 $ 7,601.84 16,379.78 The following entries record receipt of the second year’s lease payment and recognition of the interest earned. January 1, 2009 Cash Lease Receivable Interest Receivable Property Tax Expense/Property Taxes Payable December 31, 2009 Interest Receivable Interest Revenue—Leases 5,963.86 5,963.86 25,981.62 16,379.78 7,601.84 2,000.00 1460T_c21.qxd 1/21/06 03:45 am Page 1107 Special Accounting Problems Journal entries through 2012 follow the same pattern except that Caterpillar records no entry in 2012 (the last year) for earned interest. Because it fully collects the receivable by January 1, 2012, no balance (investment) is outstanding during 2012. Caterpillar recorded no depreciation. If Sterling buys the loader for $5,000 upon expiration of the lease, Caterpillar recognizes disposition of the equipment as follows. Cash Gain on Sale of Leased Equipment 5,000 5,000 • 1107 Operating Method (Lessor) Under the operating method, the lessor records each rental receipt as rental revenue. It depreciates the leased asset in the normal manner, with the depreciation expense of the period matched against the rental revenue. The amount of revenue recognized in each accounting period is a level amount (straight-line basis) regardless of the lease provisions, unless another systematic and rational basis better represents the time pattern in which the lessor derives benefit from the leased asset. In addition to the depreciation charge, the lessor expenses maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period. The lessor amortizes over the life of the lease any costs paid to independent third parties, such as appraisal fees, finder’s fees, and costs of credit checks, usually on a straight-line basis. To illustrate the operating method, assume that the direct-financing lease illustrated in the previous section does not qualify as a capital lease. Therefore, Caterpillar accounts for it as an operating lease. It records the cash rental receipt, assuming the $2,000 was for property tax expense, as follows. Cash Rental Revenue 25,981.62 25,981.62 Caterpillar records depreciation as follows (assuming a straight-line method, a cost basis of $100,000, and a five-year life). Depreciation Expense—Leased Equipment Accumulated Depreciation—Leased Equipment 20,000 20,000 If Caterpillar pays property taxes, insurance, maintenance, and other operating costs during the year, it records them as expenses chargeable against the gross rental revenues. If Caterpillar owns plant assets that it uses in addition to those leased to others, the company separately classifies the leased equipment and accompanying accumulated depreciation as Equipment Leased to Others or Investment in Leased Property. If significant in amount or in terms of activity, Caterpillar separates the rental revenues and accompanying expenses in the income statement from sales revenue and cost of goods sold. SPECIAL ACCOUNTING PROBLEMS The features of lease arrangements that cause unique accounting problems are: 1 2 3 4 5 6 OBJECTIVE 6 Identify special features of lease arrangements that cause unique accounting problems. Residual values. Sales-type leases (lessor). Bargain purchase options. Initial direct costs. Current versus noncurrent classification. Disclosure. We discuss each of these features on the following pages. 1460T_c21.qxd 1/21/06 03:45 am Page 1108 1108 • Chapter 21 Accounting for Leases Residual Values Up to this point, in order to develop the basic accounting issues related to lessee and lessor accounting, we have generally ignored residual values. Accounting for residual values is complex and will probably provide you with the greatest challenge in understanding lease accounting. Meaning of Residual Value The residual value is the estimated fair value of the leased asset at the end of the lease term. Frequently, a significant residual value exists at the end of the lease term, especially when the economic life of the leased asset exceeds the lease term. If title does not pass automatically to the lessee (criterion 1) and a bargain purchase option does not exist (criterion 2), the lessee returns physical custody of the asset to the lessor at the end of the lease term.18 Guaranteed versus Unguaranteed The residual value may be unguaranteed or guaranteed by the lessee. Sometimes 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. In such a case, that stated amount is the guaranteed residual value. The parties to a lease use guaranteed residual value in lease arrangements for two reasons. The first is a business reason: It protects the lessor against any loss in estimated residual value, thereby ensuring the lessor of the desired rate of return on investment. The second reason is an accounting benefit that you will learn from the discussion at the end of this chapter. Lease Payments A guaranteed residual value—by definition—has more assurance of realization than does an unguaranteed residual value. As a result, the lessor may adjust lease payments because of the increased certainty of recovery. After the lessor establishes this rate, it makes no difference from an accounting point of view whether the residual value is guaranteed or unguaranteed. The net investment that the lessor records (once the rate is set) will be the same. Assume the same data as in the Caterpillar/Sterling illustrations except that Caterpillar estimates a residual value of $5,000 at the end of the five-year lease term. In addition, Caterpillar assumes a 10 percent return on investment (ROI),19 whether the residual value is guaranteed or unguaranteed. Caterpillar would compute the amount of the lease payments as follows. ILLUSTRATION 21-17 Lessor’s Computation of Lease Payments CATERPILLAR’S COMPUTATION OF LEASE PAYMENTS (10% ROI) GUARANTEED OR UNGUARANTEED RESIDUAL VALUE (ANNUITY-DUE BASIS, INCLUDING RESIDUAL VALUE) Fair market value of leased asset to lessor Less: Present value of residual value ($5,000 .62092, Table 6-2) $100,000.00 3,104.60 $ 96,895.40 $ 23,237.09 Amount to be recovered by lessor through lease payments Five periodic lease payments ($96,895.40 4.16986, Table 6-5) When the lease term and the economic life are not the same, the residual value and the salvage value of the asset will probably differ. For simplicity, we will assume that residual value and salvage value are the same, even when the economic life and lease term vary. Technically, the rate of return Caterpillar demands would differ depending upon whether the residual value was guaranteed or unguaranteed. To simplify the illustrations, we are ignoring this difference in subsequent sections. 19 18 1460T_c21.qxd 1/21/06 03:45 am Page 1109 Special Accounting Problems Contrast the foregoing lease payment amount to the lease payments of $23,981.62 as computed in Illustration 21-10, where no residual value existed. In the second example, the payments are less, because the present value of the residual value reduces Caterpillar’s total recoverable amount from $100,000 to $96,895.40. Lessee Accounting for Residual Value Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. We saw the economic consequence— lower lease payments—in the preceding example. The accounting consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but excludes the unguaranteed residual value. Guaranteed Residual Value (Lessee Accounting). A guaranteed residual value affects the lessee’s computation of minimum lease payments. Therefore it also affects the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. Using the rental payments as computed by the lessor in Illustration 21-17, the minimum lease payments are $121,185.45 ([$23,237.09 5] $5,000). Illustration 21-18 shows the capitalized present value of the minimum lease payments (excluding executory costs) for Sterling Construction. OBJECTIVE 7 • 1109 Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. STERLING’S CAPITALIZED AMOUNT (10% RATE) (ANNUITY-DUE Present value of ($23,237.09 Present value of due five years BASIS, INCLUDING GUARANTEED RESIDUAL VALUE) five annual rental payments 4.16986, Table 6-5) guaranteed residual value of $5,000 after date of inception: ($5,000 .62092, Table 6-2) $ 96,895.40 3,104.60 $100,000.00 ILLUSTRATION 21-18 Computation of Lessee’s Capitalized Amount— Guaranteed Residual Value Lessee’s capitalized amount Sterling prepares a schedule of interest expense and amortization of the $100,000 lease liability. That schedule, shown in Illustration 21-19, is based on a $5,000 final guaranteed residual value payment at the end of five years. ILLUSTRATION 21-19 Lease Amortization Schedule for Lessee— Guaranteed Residual Value STERLING CONSTRUCTION LEASE AMORTIZATION SCHEDULE (ANNUITY-DUE BASIS, GUARANTEED RESIDUAL VALUE—GRV) Lease Payment Plus GRV (a) 1/1/08 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 12/31/12 $ 25,237.09 25,237.09 25,237.09 25,237.09 25,237.09 5,000.00* $131,185.45 (a) (b) (c) (d) (e) Date Executory Costs (b) $ 2,000 2,000 2,000 2,000 2,000 $10,000 Interest (10%) on Liability (c) –0– $ 7,676.29 6,120.21 4,408.52 2,525.67 454.76** $21,185.45 Reduction of Lease Liability (d) $ 23,237.09 15,560.80 17,116.88 18,828.57 20,711.42 4,545.24 $100,000.00 Lease Liability (e) $100,000.00 76,762.91 61,202.11 44,085.23 25,256.66 4,545.24 –0– Annual lease payment as required by lease. Executory costs included in rental payment. Preceding balance of (e) 10%, except 1/1/08. (a) minus (b) and (c). Preceding balance minus (d). *Represents the guaranteed residual value. **Rounded by 24 cents. 1460T_c21.qxd 1/21/06 03:45 am Page 1110 1110 • Chapter 21 Accounting for Leases Sterling records the leased asset (front-end loader) and liability, depreciation, interest, property tax, and lease payments on the basis of a guaranteed residual value. (These journal entries are shown in Illustration 21-24, on page 1112.) The format of these entries is the same as illustrated earlier, although the amounts are different because of the guaranteed residual value. Sterling records the loader at $100,000 and depreciates it over five years. To compute depreciation, it subtracts the guaranteed residual value from the cost of the loader. Assuming that Sterling uses the straightline method, the depreciation expense each year is $19,000 ([$100,000 $5,000] 5 years). 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. ILLUSTRATION 21-20 Account Balances on Lessee’s Books at End of Lease Term—Guaranteed Residual Value Leased equipment under capital leases Less: Accumulated depreciation— capital leases $100,000.00 95,000.00 $ 5,000.00 Interest payable Lease liability $ 454.76 4,545.24 $5,000.00 If, at the end of the lease, the fair market value of the residual value is less than $5,000, Sterling will have to record a loss. 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, 2012, was $3,000. In this case, Sterling would have to report a loss of $2,000. Assuming that it pays cash to make up the residual value deficiency, Sterling would make the following journal entry. Loss on Capital Lease Interest Expense (or Interest Payable) Lease Liability Accumulated Depreciation—Capital Leases Leased Equipment under Capital Leases Cash 2,000.00 454.76 4,545.24 95,000.00 100,000.00 2,000.00 If the fair market value exceeds $5,000, a gain may be recognized. Caterpillar and Sterling may apportion gains on guaranteed residual values in whatever ratio the parties initially agree. When there is a guaranteed residual value, the lessee must be careful not to depreciate the total cost of the asset. For example, if Sterling mistakenly depreciated the total cost of the loader ($100,000), a misstatement would occur. That is, the carrying amount of the asset at the end of the lease term would be zero, but Sterling would show the liability under the capital lease at $5,000. In that case, if the asset was worth $5,000, Sterling would end up reporting a gain of $5,000 when it transferred the asset back to Caterpillar. As a result, Sterling would overstate depreciation and would understate net income in 2008–2011; in the last year (2012) net income would be overstated. Unguaranteed Residual Value (Lessee Accounting). From the lessee’s viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. The amount of the annual lease payments would be the same—$23,237.09. Whether the residual value is guaranteed or unguaranteed, Caterpillar will recover the same amount through lease rentals—that is, $96,895.40. The 1460T_c21.qxd 1/21/06 03:45 am Page 1111 Special Accounting Problems minimum lease payments are $116,185.45 ($23,237.09 italize the amount shown in Illustration 21-21. 5). Lessee Company would cap- • 1111 STERLING’S CAPITALIZED AMOUNT (10% RATE) (ANNUITY-DUE BASIS, INCLUDING UNGUARANTEED RESIDUAL VALUE) Present value of 5 annual rental payments of $23,237.09 4.16986 (Table 6-5) Unguaranteed residual value of $5,000 (not capitalized by lessee) Lessee’s capitalized amount $96,895.40 –0– $96,895.40 ILLUSTRATION 21-21 Computation of Lessee’s Capitalized Amount— Unguaranteed Residual Value Illustration 21-22 shows Sterling’s schedule of interest expense and amortization of the lease liability of $96,895.40, assuming an unguaranteed residual value of $5,000 at the end of five years. STERLING CONSTRUCTION LEASE AMORTIZATION SCHEDULE (10%) (ANNUITY-DUE BASIS, UNGUARANTEED RESIDUAL VALUE) Annual Lease Payments (a) 1/1/08 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 $ 25,237.09 25,237.09 25,237.09 25,237.09 25,237.09 $126,185.45 Executory Costs (b) $ 2,000 2,000 2,000 2,000 2,000 $10,000 Interest (10%) on Liability (c) –0– $ 7,365.83 5,778.71 4,032.87 2,112.64* $19,290.05 Reduction of Lease Liability (d) $23,237.09 15,871.26 17,458.38 19,204.22 21,124.45 $96,895.40 Lease Liability (e) $96,895.40 73,658.31 57,787.05 40,328.67 21,124.45 –0– ILLUSTRATION 21-22 Lease Amortization Schedule for Lessee— Unguaranteed Residual Value Date (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 10%. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. Sterling records the leased asset and liability, depreciation, interest, property tax, and lease payments on the basis of an unguaranteed residual value. (These journal entries are shown in Illustration 21-24, on page 1112.) The format of these capital lease entries is the same as illustrated earlier. Note that Sterling records the leased asset at $96,895.40 and depreciates it over five years. Assuming that it uses the straight-line method, the depreciation expense each year is $19,379.08 ($96,895.40 5 years). At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. Leased equipment under capital leases Less: Accumulated depreciation— capital leases Lease liability $96,895 96,895 $ –0– $–0– ILLUSTRATION 21-23 Account Balances on Lessee’s Books at End of Lease Term— Unguaranteed Residual Value 1460T_c21.qxd 1/21/06 03:45 am Page 1112 1112 • Chapter 21 Accounting for Leases Assuming that Sterling has fully depreciated the leased asset and has fully amortized the lease liability, no entry is required at the end of the lease term, except to remove the asset from the books. If Sterling depreciated the asset down to its unguaranteed residual value, a misstatement would occur. That is, the carrying amount of the leased asset would be $5,000 at the end of the lease, but the liability under the capital lease would be stated at zero before the transfer of the asset. Thus, Sterling would end up reporting a loss of $5,000 when it transferred the asset back to Caterpillar. Sterling would understate depreciation and would overstate net income in 2008–2011; in the last year (2012) net income would be understated because of the recorded loss. Lessee Entries Involving Residual Values. Illustration 21-24 shows, in comparative form, Sterling’s entries for both a guaranteed and an unguaranteed residual value. ILLUSTRATION 21-24 Comparative Entries for Guaranteed and Unguaranteed Residual Values, Lessee Company Guaranteed Residual Value Capitalization of Lease 1/1/08: Leased Equipment under Capital Leases Lease Liability 100,000.00 100,000.00 Unguaranteed Residual Value Leased Equipment under Capital Leases Lease Liability 96,895.40 96,895.40 First Payment 1/1/08: Property Tax Expense Lease Liability Cash 2,000.00 23,237.09 25,237.09 Property Tax Expense Lease Liability Cash 2,000.00 23,237.09 25,237.09 Adjusting Entry for Accrued Interest 12/31/08: Interest Expense Interest Payable 7,676.29 7,676.29 Interest Expense Interest Payable 7,365.83 7,365.83 Entry to Record Depreciation 12/31/08: Depreciation Expense— Capital Leases Accumulated Depreciation— Capital Leases ([$100,000 $5,000] 5 years) 19,000.00 19,000.00 Depreciation Expense— Capital Leases Accumulated Depreciation— Capital Leases ($96,895.40 5 years) 19,379.08 19,379.08 Second Payment 1/1/09: Property Tax Expense Lease Liability Interest Expense (or Interest Payable) Cash 2,000.00 15,560.80 7,676.29 25,237.09 Property Tax Expense Lease Liability Interest Expense (or Interest Payable) Cash 2,000.00 15,871.26 7,365.83 25,237.09 Lessor Accounting for Residual Value As we indicated earlier, the lessor will recover the same net investment whether the residual value is guaranteed or unguaranteed. That is, the lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. The lease payments required in order for the company to earn a certain return on investment are the same (e.g., $23,237.09 in our example) whether the residual value is guaranteed or unguaranteed. To illustrate, we again use the Caterpillar/Sterling data and assume classification of the lease as a direct-financing lease. With a residual value (either guaranteed or unguaranteed) of $5,000, Caterpillar determines the payments as follows. 1460T_c21.qxd 1/21/06 03:45 am Page 1113 Special Accounting Problems Fair market value of leased equipment Less: Present value of residual value ($5,000 $100,000.00 3,104.60 $ 96,895.40 $ 23,237.09 • 1113 .62092, Table 6-2) Amount to be recovered by lessor through lease payments Five beginning-of-the-year lease payments to yield a 10% return ($96,895.40 4.16986, Table 6-5) ILLUSTRATION 21-25 Computation of DirectFinancing Lease Payments The amortization schedule is the same for guaranteed or unguaranteed residual value, as Illustration 21-26 shows. ILLUSTRATION 21-26 Lease Amortization Schedule, for Lessor— Guaranteed or Unguaranteed Residual Value (ANNUITY-DUE Annual Lease Payment Plus Residual Value (a) 1/1/08 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 12/31/12 $ 25,237.09 25,237.09 25,237.09 25,237.09 25,237.09 5,000.00 $131,185.45 CATERPILLAR FINANCIAL LEASE AMORTIZATION SCHEDULE BASIS, GUARANTEED OR UNGUARANTEED Interest (10%) on Lease Receivable (c) $ –0– 7,676.29 6,120.21 4,408.52 2,525.67 454.76* RESIDUAL VALUE) Date Executory Costs (b) $ 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00 –0– $10,000.00 Lease Receivable Recovery (d) $ 23,237.09 15,560.80 17,116.88 18,828.57 20,711.42 4,545.24 $100,000.00 Lease Receivable (e) $100,000.00 76,762.91 61,202.11 44,085.23 25,256.66 4,545.24 –0– $21,185.45 (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 10%, except 1/1/08. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 24 cents. Using the amounts computed above, Caterpillar would make the following entries for this direct-financing lease in the first year. Note the similarity to Sterling’s entries in Illustration 21-24. ILLUSTRATION 21-27 Entries for Either Guaranteed or Unguaranteed Residual Value, Lessor Company Inception of Lease 1/1/08: Lease Receivable Equipment Cash Lease Receivable Property Tax Expense/Property Taxes Payable Interest Receivable Interest Revenue 100,000.00 100,000.00 First Payment Received 1/1/08: 25,237.09 23,237.09 2,000.00 7,676.29 7,676.29 Adjusting Entry for Accrued Interest 12/31/08: Sales-Type Leases (Lessor) As already indicated, the primary difference between a direct-financing lease and a salestype lease is the manufacturer’s or dealer’s gross profit (or loss). The diagram in Illustration 21-28 presents the distinctions between direct-financing and sales-type leases. OBJECTIVE 8 Describe the lessor’s accounting for salestype leases. 1460T_c21.qxd 1/21/06 03:45 am Page 1114 1114 • Chapter 21 Accounting for Leases Direct-Financing Lease Equals Fair Market Value Cost of Asset Total Payments (Interest and Principal) Interest Revenue Sales-Type Lease Does Not Equal Fair Market Value Cost of Asset Sale Price of Asset Total Payments (Interest and Principal) Gross Profit Interest Revenue ILLUSTRATION 21-28 Direct-Financing versus Sales-Type Leases In a sales-type lease, the lessor records the sale price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable. The information necessary to record the sales-type lease is as follows. SALES-TYPE LEASE TERMS LEASE RECEIVABLE (also 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. When recording sales revenue and cost of goods sold, there is a difference in the accounting for guaranteed and unguaranteed residual values. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. But there is less certainty that the unguaranteed residual portion of the asset has been “sold” (i.e., will be realized). Therefore, the lessor recognizes sales and cost of goods sold only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guaranteed or unguaranteed residual value is involved. 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 (pages 1104–1107). 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. Illustration 21-29 shows computation of the amounts relevant to a sales-type lease. 1460T_c21.qxd 1/21/06 03:45 am Page 1115 Special Accounting Problems Sales-Type Lease Guaranteed Residual Value Lease receivable [$23,237.09 $5,000 Sales price of the asset Cost of goods sold Gross profit $100,000 4.16986 (Table 6-5) .62092 (Table 6-2)] $100,000 $85,000 $15,000 ($100,000 $85,000) Unguaranteed Residual Value Same $96,895.40 ($100,000 $3,104.60) $81,895.40 ($85,000 $3,104.60) $15,000 ($96,895.40 $81,895.40) • 1115 ILLUSTRATION 21-29 Computation of Lease Amounts by Caterpillar Financial—Sales-Type Lease Caterpillar records the same profit ($15,000) at the point of sale whether the residual value is guaranteed or unguaranteed. The difference between the two is that the sales revenue and cost of goods sold amounts are different. In making this computation, we deduct the present value of the unguaranteed residual value from sales revenue and cost of goods sold for two reasons: (1) The criteria for revenue recognition have not been met. (2) It is improper to match expense against revenue not yet recognized. The revenue recognition criteria have not been met because of the uncertainty surrounding the realization of the unguaranteed residual value. Caterpillar makes the following entries to record this transaction on January 1, 2008, and the receipt of the residual value at the end of the lease term. ILLUSTRATION 21-30 Entries for Guaranteed and Unguaranteed Residual Values, Lessor Company—Sales-Type Lease Guaranteed Residual Value Unguaranteed Residual Value To record sales-type lease at inception (January 1, 2008): Cost of Goods Sold Lease Receivable Sales Revenue Inventory 85,000.00 100,000.00 100,000.00 85,000.00 Cost of Goods Sold Lease Receivable Sales Revenue Inventory 81,895.40 100,000.00 96,895.40 85,000.00 To record receipt of the first lease payment (January 1, 2008): Cash Lease Receivable Property Tax Exp./Pay. 25,237.09 23,237.09 2,000.00 Cash Lease Receivable Property Tax Exp./Pay. 25,237.09 23,237.09 2,000.00 To recognize interest revenue earned during the first year (December 31, 2008): Interest Receivable 7,676.29 Interest Receivable Interest Revenue 7,676.29 Interest Revenue (See lease amortization schedule, Illustration 21-26 on page 1113.) To record receipt of the second lease payment (January 1, 2009): Cash Interest Receivable Lease Receivable Property Tax Exp./Pay. 25,237.09 7,676.29 15,560.80 2,000.00 Cash Interest Receivable Lease Receivable Property Tax Exp./Pay. 25,237.09 7,676.29 15,560.80 2,000.00 7,676.29 7,676.29 To recognize interest revenue earned during the second year (December 31, 2009): Interest Receivable Interest Revenue 6,120.21 6,120.21 Interest Receivable Interest Revenue 6,120.21 6,120.21 To record receipt of residual value at end of lease term (December 31, 2012): Inventory Cash Lease Receivable 3,000 2,000 5,000 Inventory Loss on Capital Lease Lease Receivable 3,000 2,000 5,000 1460T_c21.qxd 1/21/06 03:45 am Page 1116 1116 • Chapter 21 Accounting for Leases Companies must periodically review the estimated unguaranteed residual value in a sales-type lease. If the estimate of the unguaranteed residual value declines, the company must revise the accounting for the transaction using the changed estimate. The decline represents a reduction in the lessor’s lease receivable (net investment). The lessor recognizes the decline as a loss in the period in which it reduces the residual estimate. Companies do not recognize upward adjustments in estimated residual value. Xerox takes on the SEC Xerox derives much of its income from leasing equipment. Reporting such leases as sales leases, Xerox records a lease contract as a sale, therefore recognizing income immediately. One problem is that each lease receipt consists of payments for items such as supplies, services, financing, and equipment. The SEC accused Xerox of inappropriately allocating lease receipts, which affects the timing of income that it reports. If Xerox applied SEC guidelines, it would report income in different time periods. Xerox contended that its methods were correct. It also noted that when the lease term is up, the bottom line is the same using either the SEC’s recommended allocation method or its current method. Although Xerox can refuse to change its method, the SEC has the right to prevent a company from selling stock or bonds to the public if the agency rejects filings of the company. Apparently, being able to access public markets is very valuable to Xerox. The company agreed to change its accounting according to SEC wishes, and paid a fine of $10 million due to its past accounting practices. Source: Adapted from “Xerox Takes on the SEC,” Accounting Web (January 9, 2002) (www.accountingweb.com). What do the numbers mean? Bargain Purchase Option (Lessee) As stated earlier, a bargain purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the property’s expected future fair value. The price is so favorable at the lease’s inception that the future exercise of the option appears to be reasonably assured. If a bargain purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. For example, assume that Sterling Construction in the illustration on page 1109 had an option to buy the leased equipment for $5,000 at the end of the five-year lease term. At that point, Sterling and Caterpillar expect the fair value to be $18,000. The significant difference between the option price and the fair value creates a bargain purchase option, and the exercise of that option is reasonably assured. A bargain purchase option affects the accounting for leases in essentially the same way as a guaranteed residual value. In other words, with a guaranteed residual value, the lessee must pay the residual value at the end of the lease. Similarly, a purchase option which is a bargain will almost certainly be paid by the lessee. Therefore, the computations, amortization schedule, and entries that would be prepared for this $5,000 bargain purchase option are identical to those shown for the $5,000 guaranteed residual value (see Illustrations 21-17, 21-18, and 21-19). The only difference between the accounting treatment for a bargain purchase option and a guaranteed residual value of identical amounts and circumstances is in the computation of the annual depreciation. In the case of a guaranteed residual value, Sterling depreciates the asset over the lease term; in the case of a bargain purchase option, it uses the economic life of the asset. 1460T_c21.qxd 1/21/06 03:45 am Page 1117 Special Accounting Problems • 1117 Initial Direct Costs (Lessor) Initial direct costs are of two types: incremental and internal.20 Incremental direct costs are paid to independent third parties for originating a lease arrangement. Examples include the cost of independent appraisal of collateral used to secure a lease, the cost of an outside credit check of the lessee, or a broker’s fee for finding the lessee. Internal direct costs are directly related to specified activities performed by the lessor on a given lease. Examples are evaluating the prospective lessee’s financial condition; evaluating and recording guarantees, collateral, and other security arrangements; negotiating lease terms and preparing and processing lease documents; and closing the transaction. The costs directly related to an employee’s time spent on a specific lease transaction are also considered initial direct costs. However, initial direct costs should not include internal indirect costs. Such costs are related to activities the lessor performs for advertising, servicing existing leases, and establishing and monitoring credit policies. Nor should the lessor include the costs for supervision and administration or for expenses such as rent and depreciation. The accounting for initial direct costs depends on the type of lease: • For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental revenue. • For sales-type leases, the lessor expenses the initial direct costs in the period in which it recognizes the profit on the sale. • For a direct-financing lease, the lessor adds initial direct costs to the net investment in the lease and amortizes them over the life of the lease as a yield adjustment. In a direct-financing lease, the lessor must disclose the unamortized deferred initial direct costs that are part of its investment in the direct-financing lease. For example, if the carrying value of the asset in the lease is $4,000,000 and the lessor incurs initial direct costs of $35,000, then the lease receivable (net investment in the lease) would be $4,035,000. The yield would be lower than the initial rate of return, and the lessor would adjust the yield to ensure proper amortization of the amount over the life of the lease. Current versus Noncurrent Earlier in the chapter we presented the classification of the lease liability/receivable in an annuity-due situation. Illustration 21-8 indicated that Sterling’s current liability is the payment of $23,981.62 (excluding $2,000 of executory costs) to be made on January 1 of the next year. Similarly, as shown in Illustration 21-16, Caterpillar’s current asset is the $23,981.62 (excluding $2,000 of executory costs) it will collect on January 1 of the next year. In these annuity-due instances, the balance sheet date is December 31 and the due date of the lease payment is January 1 (less than one year), so the present value ($23,981.62) of the payment due the following January 1 is the same as the rental payment ($23,981.62). What happens if the situation is an ordinary annuity rather than an annuity due? For example, assume that the rent is due at the end of the year (December 31) rather than at the beginning (January 1). 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.”21 The most common “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” Statement of Financial Accounting Standards No. 91 (Stamford: Conn.: FASB, 1987). 21 20 “Accounting for Leases,” op. cit., par. 16. 1460T_c21.qxd 1/21/06 03:45 am Page 1118 1118 • Chapter 21 Accounting for Leases method of measuring the current liability portion in ordinary annuity leases is the change-in-the-present-value method.22 To illustrate the change-in-the-present-value method, assume an ordinary-annuity situation with the same facts as the Caterpillar/Sterling case, excluding the $2,000 of executory costs. Because Sterling pays the rents at the end of the period instead of at the beginning, Caterpillar sets the five rents at $26,379.73, to have an effective interest rate of 10 percent. Illustration 21-31 shows the ordinary-annuity amortization schedule. ILLUSTRATION 21-31 Lease Amortization Schedule—OrdinaryAnnuity Basis Date 1/1/08 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 STERLING/CATERPILLAR LEASE AMORTIZATION SCHEDULE (ORDINARY-ANNUITY BASIS) Annual Lease Payment $ 26,379.73 26,379.73 26,379.73 26,379.73 26,379.73 $131,898.65 *Rounded by 12 cents. Interest 10% $10,000.00 8,362.03 6,560.26 4,578.31 2,398.05* $31,898.65 Reduction of Lease Liability/Receivable $ 16,379.73 18,017.70 19,819.47 21,801.42 23,981.68 $100,000.00 Balance of Lease Liability/Receivable $100,000.00 83,620.27 65,602.57 45,783.10 23,981.68 –0– The current portion of the lease liability/receivable under the change-in-thepresent-value method as of December 31, 2008, would be $18,017.70 ($83,620.27 $65,602.57). As of December 31, 2009, the current portion would be $19,819.47 ($65,602.57 $45,783.10). At December 31, 2008, Caterpillar classifies $65,602.57 of the receivable as noncurrent. Thus, both the annuity-due and the ordinary-annuity situations report the reduction of principal for the next period as a current liability/current asset. In the annuitydue situation, Caterpillar accrues interest during the year but is not paid until the next period. As a result, a current asset arises for the receivable reduction and for the interest that was earned in the preceding period. In the ordinary-annuity situation, the interest accrued during the period is also paid in the same period. Consequently, the lessor shows as a current asset only the principal reduction. Disclosing Lease Data OBJECTIVE 9 List the disclosure requirements for leases. The FASB requires lessees and lessors to disclose certain information about leases in their financial statements or in the notes. These requirements vary based upon the type of lease (capital or operating) and whether the issuer is the lessor or lessee. These disclosure requirements provide investors with the following information: • General description of the nature of leasing arrangements. • The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years. • The amount of lease revenues and expenses reported in the income statement each period. For additional discussion on this approach and possible alternatives, see R. J. Swieringa, “When Current Is Noncurrent and Vice Versa!” The Accounting Review (January 1984), pp. 123–30, and A. W. Richardson, “The Measurement of the Current Portion of the Long-Term Lease Obligations—Some Evidence from Practice,” The Accounting Review (October 1985), pp. 744–52. 22 1460T_c21.qxd 1/25/06 05:47 am Page 1119 Special Accounting Problems • Description and amounts of leased assets by major balance sheet classification and related liabilities. • Amounts receivable and unearned revenues under lease agreements.23 Illustration 21-32 presents financial statement excerpts from the 2004 annual report of Tasty Baking Company. These excerpts represent the statement and note disclosures typical of a lessee having both capital leases and operating leases. • 1119 Tasty Baking Company (dollar amounts in thousands) Current Liabilities Current obligations under capital leases Noncurrent Liabilities Long-term obligations under capital leases, less current portion Note 7: Commitments and Contingencies The company leases certain plant and distribution facilities, machinery and automotive equipment under noncancelable lease agreements. The company expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. . . .Property, plant and equipment relating to capital leases was $5,965 at December 25, 2004, and $8,310 at December 27, 2003, with accumulated amortization of $1,019 and $2,303, respectively. Depreciation and amortization of assets recorded under capital leases was $690 in 2004 and $261 in 2003. The following is a schedule of future minimum lease payments as of December 25, 2004: Capital Leases 2005 2006 2007 2008 2009 Later years Total minimum lease payments Less interest portion of payments Present value of future minimum lease payments $1,142 1,142 1,089 581 561 2,525 $7,040 2,168 $4,872 Noncancelable Operating Leases $1,747 1,440 701 487 146 4 $4,525 4,159 4,705 2004 $ 713 2003 $ 634 ILLUSTRATION 21-32 Disclosure of Leases by Lessee Description and amount of lease obligations General description Description and amounts of leased assets Nature, timing, and amounts of cash outflows Rental expense was approximately $2,474 in 2004 and $2,194 in 2003. Amount of lease rental expense Illustration 21-33 presents the lease note disclosure from the 2004 annual report of Hewlett-Packard Company. The disclosure highlights required lessor disclosures. Hewlett-Packard Company Notes to Financial Statements (in millions) Note 1 (in part): Lease Financing Lease financing consists of direct financing leases, leveraged leases and equipment on operating leases. Income on direct financing leases is recognized by a method which produces a constant periodic rate of return on the outstanding investment in the lease. . . . Initial direct costs are deferred and amortized using the interest method over the lease period. Equipment under operating leases is recorded at cost, net of accumulated depreciation. Income from operating leases is recognized ratably over the term of the leases. continued on next page ILLUSTRATION 21-33 Disclosure of Leases by Lessor General description 23 “Accounting for Leases,” FASB Statement No. 13, as amended and interpreted through May 1980 (Stamford, Conn.: FASB, 1980), par. 16; par. 23. 1460T_c21.qxd 1/21/06 03:45 am Page 1120 1120 • Chapter 21 Accounting for Leases Note 9: Financing Receivables and Operating Leases Financing receivables represent sales-type and direct-financing leases resulting from the marketing of HP’s and complementary third-party products. These receivables typically have terms from two to five years and are usually collateralized by a security interest in the underlying assets. Financing receivables also include billed receivables from operating leases. The components of net financing receivables, which are included in financing receivables and long-term financing receivables and other assets, were as follows at October 31: 2004 2003 (In millions) $ 5.328 $ 6,010 (213) (210) 394 446 (396) (475) 5,113 (2,945) $ 2,168 5,771 (3,026) $ 2,745 Amount receivable and unearned revenues Minimum lease payments receivable Allowance for doubtful accounts Unguaranteed residual value Unearned income Financing receivables, net Less current portion Amounts due after one year, net Scheduled maturities of HP’s minimum lease payments receivable are as follows at October 31, 2004: Nature, timing, and amounts of cash inflows 2005 Scheduled maturities of minimum lease payments receivable $3,045 2006 $1,381 2007 2008 2009 (In millions) $612 $194 $67 Thereafter $29 Total $5,328 Description of leased assets Equipment leased to customers under operating leases was $2.3 billion at October 31, 2004, and $2.1 billion at October 31, 2003, and is included in machinery and equipment. Accumulated depreciation on equipment under lease was $0.9 billion at October 31, 2004 and $1.2 billion at October 31, 2003. Minimum future rentals on non-cancelable operating leases related to leased equipment are as follows at October 31, 2004: 2005 2006 $404 Minimum future rentals on noncancelable operating leases 2008 2009 (In millions) $103 $18 $3 2007 Thereafter $11 Total $1,363 Amount of future rentals llege/k $824 co i o es w Additional Lease Disclosures ile y. c o m / LEASE ACCOUNTING—UNSOLVED PROBLEMS As we indicated at the beginning of this chapter, lease accounting is subject to abuse. Companies make strenuous efforts to circumvent Statement No. 13. In practice, the strong desires of lessees to resist capitalization have rendered the accounting rules for capitalizing leases partially ineffective. Leasing generally involves large dollar amounts that, when capitalized, materially increase reported liabilities and adversely affect the debt-to-equity ratio. Lessees also resist lease capitalization because charges to expense made in the early years of the lease term are higher under the capital lease method than under the operating method, frequently without tax benefit. As a consequence, “let’s beat Statement No. 13” is one of the most popular games in town.24 To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. Companies can easily devise lease agreements in such a way, by meeting the following specifications. 1 2 Ensure that the lease does not specify the transfer of title of the property to the lessee. Do not write in a bargain purchase option. Richard Dieter, “Is Lessee Accounting Working?” CPA Journal (August 1979), pp. 13–19. This article provides interesting examples of abuses of Statement No. 13, discusses the circumstances that led to the current situation, and proposes a solution. 24 1460T_c21.qxd 1/21/06 03:45 am Page 1121 Lease Accounting—Unsolved Problems 3 4 • 1121 Set the lease term at something less than 75 percent of the estimated economic life of the leased property. Arrange for the present value of the minimum lease payments to be less than 90 percent of the fair value of the leased property. The real challenge lies in disqualifying the lease as a capital lease to the lessee, while having the same lease qualify as a capital (sales or financing) lease to the lessor. Unlike lessees, lessors try to avoid having lease arrangements classified as operating leases.25 Avoiding the first three criteria is relatively simple, but it takes a little ingenuity to avoid the “90 percent recovery test” for the lessee while satisfying it for the lessor. Two of the factors involved in this effort are: (1) the use of the incremental borrowing rate by the lessee when it is higher than the implicit interest rate of the lessor, by making information about the implicit rate unavailable to the lessee; and (2) residual value guarantees. The lessee’s use of the higher interest rate is probably the more popular subterfuge. Lessees are knowledgeable about the fair value of the leased property and, of course, the rental payments. However, they generally are unaware of the estimated residual value used by the lessor. Therefore, the lessee who does not know exactly the lessor’s implicit interest rate might use a different (higher) incremental borrowing rate. The residual-value guarantee is the other unique, yet popular, device used by lessees and lessors. In fact, a whole new industry has emerged to circumvent symmetry between the lessee and the lessor in accounting for leases. The residual-value guarantee has spawned numerous companies whose principal, or even sole, function is to guarantee the residual value of leased assets. Because the minimum lease payments include the guaranteed residual value for the lessor, this satisfies the 90 percent recovery of fair market value test. The lease is a nonoperating lease to the lessor. But because a third-party guarantees the residual value, the minimum lease payments of the lessee exclude the guarantee. Thus, by merely transferring some of the risk to a third party, lessees can alter substantially the accounting treatment by converting what would otherwise be capital leases to operating leases.26 The nature of the criteria encourages much of this circumvention, stemming from weaknesses in the basic objective of Statement No. 13. Accounting standards-setting bodies continue to have poor experience with arbitrary break points or other size and percentage criteria—such as rules like “90 percent of” and “75 percent of.” Some believe that a more workable solution is to require capitalization of all leases that have noncancelable payment terms in excess of one year. Under this approach, lessee acquires an asset (a property right) and a corresponding liability, rather than on the basis that the lease transfers substantially all the risks and rewards of ownership. Three years after it issued Statement No. 13, a majority of the FASB expressed “the tentative view that, if Statement 13 were to be reconsidered, they would support a property right approach in which all leases are included as ‘rights to use property’ and as International Insight The reason is that most lessors are banks, which are not permitted to hold these assets on their balance sheets except for relatively short periods of time. Furthermore, the capital-lease transaction from the lessor’s standpoint provides higher income flows in the earlier periods of the lease life. As an aside, third-party guarantors have experienced some difficulty. Lloyd’s of London, at one time, insured the fast-growing U.S. computer-leasing industry in the amount of $2 billion against revenue losses, and losses in residual value, for canceled leases. Because of “overnight” technological improvements and the successive introductions of more efficient and less expensive computers, lessees in abundance canceled their leases. As the market for second-hand computers became flooded, residual values plummeted, and third-party guarantor Lloyd’s of London projected a loss of $400 million. The lessees’ and lessors’ desire to circumvent FASB Statement No. 13 stimulated much of the third-party guarantee business. 26 25 Recently the SEC indicated that it might be advisable for the IASB and the FASB to jointly undertake a project to reconsider lease accounting standards. 1460T_c21.qxd 1/21/06 03:45 am Page 1122 1122 • Chapter 21 Accounting for Leases ‘lease obligations’ in the lessee’s balance sheet.”27 The FASB and other international standard setters have issued a report on lease accounting that proposes the capitalization of more leases.28 Swap meet Telecommunication companies have developed one of the more innovative and controversial uses of leases. In order to provide fiber-optic service to their customers in areas where they did not have networks installed, telecommunication companies such as Global Crossing, Qwest Communications International, and Cable and Wireless entered into agreements to swap some of their unused network capacity in exchange for the use of another company’s fiber-optic cables. Here’s how it works: What do the numbers mean? COMPANY A Owned transcontinental fiber-optic cable, but wanted to carry broadband signals across the Atlantic. COMPANY B Owned transatlantic fiber-optic cable, but wanted to carry broadband signals across the United States. COMPANY A CABLE The two companies agreed to swap some of their capacity. In the swap, each company granted the other the right to use some of its fiber-optic cables, usually for a period of 15 to 25 years. COMPANY B CABLE Cable that can be used by Company B Cable that can be used by Company A Such trades seem like a good way to make efficient use of telecommunication assets. What got some telecommunications companies in trouble, though, was how they did the accounting for the swap. The most conservative accounting for the capacity trades is to treat the swap as an exchange of assets, which does not affect the income statement. However, Global Crossing got into trouble with the SEC when it structured some of its capacity swaps as leases—the legal right to use capacity. Global Crossing was recognizing as revenue the payments received for the outgoing transfer of capacity, while payments for the incoming cable capacity were treated as capital expenditures, and therefore not expensed. As a result, Global Crossing was showing strong profits from its capacity swaps. However, the company’s investors got an unpleasant surprise when the market for bandwidth cooled off and there was no longer demand for its broadband capacity or its longterm leasing arrangements. Source: Simon Romero and Seth Schiesel, “The Fiber-Optic Fantasy Slips Away,” New York Times on the Web (February 17, 2002). By permission. 27 28 “Is Lessee Accounting Working?” op. cit., p. 19. H. Nailor and A. Lennard, “Capital Leases: Implementation of a New Approach,” Financial Accounting Series No. 206A (Norwalk, Conn.: FASB, 2000). 1460T_c21.qxd 1/21/06 03:45 am Page 1123 Summary of Learning Objectives KEY TERMS • 1123 SUMMARY OF LEARNING OBJECTIVES 1. Explain the nature, economic substance, and advantages of lease transactions. A lease is a contractual agreement between a lessor and a lessee that conveys to the lessee the right to use specific property (real or personal), owned by the lessor, for a specified period of time. In return, the lessee periodically pays cash (rent) to the lessor. The advantages of lease transactions are: (1) 100 percent financing; (2) protection against obsolescence, (3) flexibility, (4) less costly financing, (5) possible tax advantages, and (6) off-balance-sheet financing. 2. Describe the accounting criteria and procedures for capitalizing leases by the lessee. A lease is a capital lease if it meets one or more of the following (Group I) criteria: (1) The lease transfers ownership of the property to the lessee. (2) The lease contains a bargain purchase option. (3) The lease term is equal to 75 percent or more 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. For a capital lease, the lessee records an asset and a liability at the lower of (1) the present value of the minimum lease payments, or (2) the fair market value of the leased asset at the inception of the lease. 3. Contrast the operating and capitalization methods of recording leases. The total charges to operations are the same over the lease term whether accounting for the lease as a capital lease or as an operating lease. Under the capital lease treatment, the charges are higher in the earlier years and lower in the later years. If using an accelerated method of depreciation, the differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. If using a capital lease instead of an operating lease, the following occurs: (1) an increase in the amount of reported debt (both short-term and long-term), (2) an increase in the amount of total assets (specifically long-lived assets), and (3) lower income early in the life of the lease and, therefore, lower retained earnings. 4. Identify the classifications of leases for the lessor. A lessor may classify leases for accounting purposes as follows: (1) operating leases, (2) direct-financing leases, (3) sales-type leases. The lessor should classify and account for an arrangement as a direct-financing lease or a sales-type lease if, at the date of the lease agreement, the lease meets one or more of the Group I criteria (as shown in learning objective 2 for lessees) and both of the following Group II criteria. Group II: (1) Collectibility of the payments required from the lessee is reasonably predictable; and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. The lessor classifies and accounts for all leases that fail to meet the criteria as operating leases. 5. Describe the lessor’s accounting for direct-financing leases. Leases that are in substance the financing of an asset purchase by a lessee require the lessor to substitute a “lease receivable” for the leased asset. “Lease receivable” is the present value of the minimum lease payments plus the present value of the unguaranteed residual value. Therefore lessors include the residual value, whether guaranteed or unguaranteed, as part of lease receivable. 6. Identify special features of lease arrangements that cause unique accounting problems. The features of lease arrangements that cause unique accounting problems are: (1) residual values; (2) sales-type leases (lessor); (3) bargain purchase options; (4) initial direct costs; (5) current versus noncurrent; and (6) disclosures. 7. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Whether the estimated residual value is guaranteed or unguaranteed is of both economic and accounting consequence to the lessee. The accounting consequence bargain purchase option, 1094 bargain renewal option, 1094 capital lease, 1093 capitalization criteria, 1094 capitalization of leases, 1092 direct-financing lease, 1104 effective-interest method, 1096 executory costs, 1095 guaranteed residual value, 1095, 1108 implicit interest rate, 1096 incremental borrowing rate, 1095 initial direct costs, 1117 lease, 1089 lease receivable, 1104 lease term, 1090, 1094 lessee, 1089 lessor, 1089 manufacturer’s or dealer’s profit (or loss), 1103 minimum lease payments, 1095 noncancelable, 1092 off-balance-sheet financing, 1091 operating lease, 1093 residual value, 1108 sales-type lease, 1113 third-party guarantors, 1095 unguaranteed residual value, 1110 1460T_c21.qxd 1/21/06 03:45 am Page 1124 1124 • Chapter 21 Accounting for Leases is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but exclude the unguaranteed residual value. A guaranteed residual value affects the lessee’s computation of minimum lease payments and the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. An unguaranteed residual value from the lessee’s viewpoint is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. 8. Describe the lessor’s accounting for sales-type leases. A sales-type lease recognizes interest revenue like a direct-financing lease. It also recognizes a manufacturer’s or dealer’s profit. In a sales-type lease, the lessor records at the inception of the lease the sales price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable. Sales-type leases differ from direct-financing leases in terms of the cost and fair value of the leased asset, which results in gross profit. Lease receivable and interest revenue are the same whether a guaranteed or an unguaranteed residual value is involved. The accounting for guaranteed and for unguaranteed residual values requires recording sales revenue and cost of goods sold differently. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. There is less certainty that the unguaranteed residual portion of the asset has been “sold”; therefore, lessors recognize sales and cost of goods sold only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guaranteed or unguaranteed residual value is involved. co llege/k i es o E xpanded Discussion of Real Estate Leases and Leveraged Leases 9. List the disclosure requirements for leases. The disclosure requirements for the lessees and lessors vary based upon the type of lease (capital or operating) and whether the issuer is the lessor or lessee. These disclosure requirements provide investors with the following information: (1) general description of the nature of leasing arrangements, (2) the nature, timing and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years, (3) the 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, and (5) amounts receivable and unearned revenues under lease agreements. w APPENDIX 21A OBJECTIVE 10 Understand and apply lease accounting concepts to various lease arrangements. ile y. c o m / Examples of Lease Arrangements To illustrate concepts discussed in this chapter, assume that Morgan Bakeries is involved in four different lease situations. Each of these leases is noncancelable, and in no case does Morgan receive title to the properties leased during or at the end of the lease term. All leases start on January 1, 2008, with the first rental due at the beginning of the year. The additional information is shown in Illustration 21A-1. 1460T_c21.qxd 1/21/06 03:45 am Page 1125 Lease Example: Harmon, Inc. Harmon, Inc. Type of property Yearly rental Lease term Estimated economic life Purchase option Cabinets $6,000 20 years 30 years None Arden’s Oven Co. Oven $15,000 10 years 25 years $75,000 at end of 10 years $4,000 at end of 15 years 5-year renewal option at $15,000 per year Mendota Truck Co. Truck $5,582.62 3 years 7 years None • 1125 Appleland Computer Computer $3,557.25 3 years 5 years $3,000 at end of 3 years, which approximates fair market value 1 year at $1,500; no penalty for nonrenewal; standard renewal clause Renewal option None None Fair market value at inception of lease Cost of asset to lessor Residual value Guaranteed Unguaranteed Incremental borrowing rate of lessee Executory costs paid by $60,000 $60,000 –0– $5,000 12% Lessee $300 per year $120,000 $120,000 –0– –0– 12% Lessee $1,000 per year $20,000 $15,000 $7,000 –0 12% Lessee $500 per year $10,000 $10,000 –0– $3,000 12% Lessor Estimated to be $500 per year Present value of minimum lease payments Using incremental borrowing rate of lessee Using implicit rate of lessor $50,194.68 Not known $115,153.35 Not known $20,000 Not known $8,224.16 Known by lessee, $8,027.48 Estimated fair market value at end of lease $5,000 $80,000 at end of 10 years $60,000 at end of 15 years Not available $3,000 HARMON, INC. The following is an analysis of the Harmon, Inc. lease. 1 2 3 4 ILLUSTRATION 21A-1 Illustrative Lease Situations, Lessors Transfer of title? No. Bargain purchase option? No. Economic life test (75% test). The lease term is 20 years and the estimated economic life is 30 years. Thus it does not meet the 75 percent test. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $60,000 90% $54,000 Rental payments PV of annuity due for 20 years at 12% PV of rental payments $ 6,000 8.36578 $50,194.68 Because the present value of the minimum lease payments is less than 90 percent of the fair market value, the lease does not meet the 90 percent test. Both Morgan and Harmon should account for this lease as an operating lease, as indicated by the January 1, 2008, entries shown in Illustration 21A-2 (on page 1126). 1460T_c21.qxd 1/21/06 03:45 am Page 1126 1126 • Chapter 21 Accounting for Leases ILLUSTRATION 21A-2 Comparative Entries for Operating Lease Rent Expense Cash Morgan Bakeries (Lessee) 6,000 6,000 Harmon, Inc. (Lessor) Cash Rental Revenue 6,000 6,000 ARDEN’S OVEN CO. The following is an analysis of the Arden’s Oven Co. lease. 1 2 3 4 Transfer of title? No. Bargain purchase option? The $75,000 option at the end of 10 years does not appear to be sufficiently lower than the expected fair value of $80,000 to make it reasonably assured that it will be exercised. However, the $4,000 at the end of 15 years when the fair value is $60,000 does appear to be a bargain. From the information given, criterion 2 is therefore met. Note that both the guaranteed and the unguaranteed residual values are assigned zero values because the lessor does not expect to repossess the leased asset. Economic life test (75% test): Given that a bargain purchase option exists, the lease term is the initial lease period of 10 years plus the five-year renewal option since it precedes a bargain purchase option. Even though the lease term is now considered to be 15 years, this test is still not met because 75 percent of the economic life of 25 years is 18.75 years. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $120,000 90% $108,000 Rental payments PV of annuity due for 15 years at 12% PV of rental payments PV of bargain purchase option: $4,000 (PVF15,12%) $4,000 $ 15,000.00 7.62817 $114,422.55 .18270 $730.80 PV of rental payments PV of bargain purchase option PV of minimum lease payments $114,422.55 730.80 $115,153.35 The present value of the minimum lease payments is greater than 90 percent of the fair market value; therefore, the lease does meet the 90 percent test. Morgan Bakeries should account for this as a capital lease because the lease meets both criteria 2 and 4. Assuming that Arden’s implicit rate is less than Morgan’s incremental borrowing rate, the following entries are made on January 1, 2008. ILLUSTRATION 21A-3 Comparative Entries for Capital Lease—Bargain Purchase Option Morgan Bakeries (Lessee) Leased Asset—Oven 115,153.35 Lease Liability 115,153.35 Arden’s Oven Co. (Lessor) Lease Receivable Asset—Oven 120,000 120,000 Morgan Bakeries would depreciate the leased asset over its economic life of 25 years, given the bargain purchase option. Arden’s Oven Co. does not use sales-type accounting because the fair market value and the cost of the asset are the same at the inception of the lease. MENDOTA TRUCK CO. The following is an analysis of the Mendota Truck Co. lease. 1 2 Transfer of title? No. Bargain purchase option? No. 1460T_c21.qxd 1/21/06 03:45 am Page 1127 Lease Example: Appleland Computer 3 4 • 1127 Economic life test (75% test): The lease term is three years and the estimated economic life is seven years. Thus it does not meet the 75 percent test. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $20,000 90% $18,000 Rental payments PV of annuity due for 3 years at 12% PV of rental payments (Note: Adjusted for $0.01 due to rounding) PV of guaranteed residual value: $7,000 (PVF3,12%) $ 5,582.62 2.69005 $15,017.54 $7,000 .71178 $4,982.46 PV of rental payments PV of guaranteed residual value PV of minimum lease payments $15,017.54 4,982.46 $20,000.00 The present value of the minimum lease payments is greater than 90 percent of the fair market value; therefore, the lease meets the 90 percent test. Assuming that Mendota’s implicit rate is the same as Morgan’s incremental borrowing rate, the following entries are made on January 1, 2008. ILLUSTRATION 21A-4 Comparative Entries for Capital Lease 15,000 20,000 Morgan Bakeries (Lessee) Leased Asset—Truck Lease Liability 20,000 20,000 Mendota Truck Co. (Lessor) Lease Receivable Cost of Goods Sold Inventory—Truck Sales 20,000 15,000 Morgan depreciates the leased asset over three years to its guaranteed residual value. APPLELAND COMPUTER The following is an analysis of the Appleland Computer lease. 1 2 3 4 Transfer of title? No. Bargain purchase option? No. The option to purchase at the end of three years at approximate fair market value is clearly not a bargain. Economic life test (75% test): The lease term is three years, and no bargain renewal period exists. Therefore the 75 percent test is not met. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $10,000 90% $ 9,000 PV of annuity due factor for 3 years at 12% PV of minimum lease payments using incremental borrowing rate Rental payments Less executory costs $3,557.25 500.00 3,057.25 2.69005 $8,224.16 The present value of the minimum lease payments using the incremental borrowing rate is $8,224.16; using the implicit rate, it is $8,027.48 (see Illustration 21A-1). The lessor’s implicit rate is therefore higher than the incremental borrowing rate. Given this situation, the lessee uses the $8,224.16 (lower interest rate when discounting) when comparing with the 90 percent of fair market value. Because the present value of the minimum lease payments is lower than 90 percent of the fair market value, the lease does not meet the recovery of investment test. The following entries are made on January 1, 2008, indicating an operating lease. 1460T_c21.qxd 1/21/06 03:45 am Page 1128 1128 • Chapter 21 Accounting for Leases Morgan Bakeries (Lessee) Rent Expense Cash 3,557.25 3,557.25 Appleland Computer (Lessor) Cash Rental Revenue 3,557.25 3,557.25 ILLUSTRATION 21A-5 Comparative Entries for Operating Lease If the lease payments had been $3,557.25 with no executory costs involved, this lease arrangement would have qualified for capital-lease accounting treatment. SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 21A 10. Understand and apply lease accounting concepts to various lease arrangements. The classification of leases by lessees and lessors is based on criteria that assess whether the lessor has transferred to the lessee substantially all of the risks and benefits of ownership of the asset. In addition, lessors assess two additional criteria to ensure that payment is assured and that there are not uncertainties about lessor’s future costs. Lessees capitalize leases that meet any of the criteria, recording a lease asset and related lease liability. For leases that are in substance a financing of an asset purchase, lessors substitute a lease receivable for the leased asset. In a sales-type lease, the fair value of the leased asset is greater than the cost, and lessors record gross profit. Leases that do not meet capitalization criteria are classified as operating leases, on which rent expense (revenue) is recognized by lessees (lessors) for lease payments. APPENDIX 21B OBJECTIVE 11 Describe the lessee’s accounting for saleleaseback transactions. Sale-Leasebacks 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. The use of the property is generally continued without interruption. Sale-leasebacks are common. Financial institutions (e.g., Bank of America and First Chicago) have used this technique for their administrative offices, public utilities (Ohio Edison and Pinnacle West Corporation) for their generating plants, and airlines (Continental and Alaska Airlines) for their aircraft. The advantages of a sale-leaseback from the seller’s viewpoint usually involve two primary considerations: 1 2 Financing—If the purchase of equipment has already been financed, a sale-leaseback can allow the seller to refinance at lower rates, assuming rates have dropped. In addition, a sale-leaseback can provide another source of working capital, particularly when liquidity is tight. Taxes—At the time a company purchased equipment, it may not have known that it would be subject to an alternative minimum tax and that ownership might increase its minimum tax liability. By selling the property, the seller-lessee may deduct the entire lease payment, which is not subject to alternative minimum tax considerations. 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. Therefore the lessor should not recognize a gain or loss on the transaction. In short, the seller-lessee is simply borrowing funds. 1460T_c21.qxd 1/21/06 03:45 am Page 1129 Determining Asset Use On the other hand, if the seller-lessee gives up the right to the use of the asset, the transaction is in substance a sale. In that case, gain or loss recognition is appropriate. Trying to ascertain when the lessee has given up the use of the asset is difficult, however, and the FASB has formulated complex rules to identify this situation.1 To understand the profession’s position in this area, we discuss the basic accounting for the lessee and lessor below. • 1129 Underlying Concepts A sale-leaseback is similar in substance to the parking of inventories (discussed in Chapter 8). The ultimate economic benefits remain under the control of the “seller,” thus satisfying the definition of an asset. Lessee If the lease meets one of the four criteria for treatment as a capital lease (see Illustration 21-4), the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. The seller-lessee should defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease; it should amortize that profit over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased assets. For example, assume Scott Paper sells equipment having a book value of $580,000 and a fair value of $623,110 to General Electric Credit for $623,110 and leases the equipment back for $50,000 a year for 20 years. Scott should amortize the profit of $43,110 over the 20-year period at the same rate that it depreciates the $623,110.2 It credits the $43,110 ($623,110 $580,000) to Unearned Profit on Sale-Leaseback. 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. Under an operating lease, the 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. There are exceptions to these two general rules. They are: 1 2 Losses Recognized—When the fair value of the asset is less than the book value (carrying amount), the lessee must recognize a loss immediately, up to the amount of the difference between the book value and fair value. For example, if Lessee, Inc. sells equipment having a book value of $650,000 and a fair value of $623,110, it should charge the difference of $26,890 to a loss account.3 Minor Leaseback—Leasebacks in which the present value of the rental payments are 10 percent or less of the fair value of the asset are minor leasebacks. In this case, the seller-lessee gives up most of the rights to the use of the asset sold. Therefore, the transaction is a sale, and full gain or loss recognition is appropriate. It is not a financing transaction because the risks of ownership have been transferred.4 Lessor If the lease meets one of the criteria in Group I and both of the criteria in Group II (see Illustration 21-11), the purchaser-lessor records the transaction as a purchase and a direct-financing lease. If the lease does not meet the criteria, the purchaser-lessor records the transaction as a purchase and an operating lease. Sales and leasebacks of real estate are often accounted for differently. A discussion of the issues related to these transactions is beyond the scope of this textbook. See Statement of Financial Accounting Standards No. 98, op. cit. Statement of Financial Accounting Standards No. 28, “Accounting for Sales with Leasebacks” (Stamford, Conn.: FASB, 1979). There can be two types of losses in sale-leaseback arrangements. One is a real economic loss that results when the carrying amount of the asset is higher than the fair market value of the asset. In this case, the loss should be recognized. An artificial loss results when the sale price is below the carrying amount of the asset but the fair market value is above the carrying amount. In this case the loss is more in the form of prepaid rent, and the lessee should defer the loss and amortize it in the future. 4 In some cases the seller-lessee retains more than a minor part but less than substantially all. The computations to arrive at these values are complex and beyond the scope of this textbook. 3 2 1 1460T_c21.qxd 1/21/06 03:45 am Page 1130 1130 • Chapter 21 Accounting for Leases SALE-LEASEBACK EXAMPLE To illustrate the accounting treatment accorded a sale-leaseback transaction, assume that American Airlines on January 1, 2008, 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 The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year. 2 The aircraft has a fair value of $80,000,000 on January 1, 2008, and an estimated economic life of 15 years. 3 American pays all executory costs. 4 American depreciates similar aircraft that it owns on a straight-line basis over 15 years. 5 The annual payments assure the lessor a 12 percent return. 6 American’s incremental borrowing rate is 12 percent. This lease is a capital lease to American because the lease term exceeds 75 percent of the estimated life of the aircraft and because the 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. Illustration 21B-1 presents the typical journal entries to record the sale-leaseback transactions for American and Citicapital for the first year. Citicapital (Lessor) Aircraft Cash Lease Receivable Aircraft 80,000,000 80,000,000 80,000,000 80,000,000 ILLUSTRATION 21B-1 Comparative Entries for Sale-Leaseback for Lessee and Lessor American Airlines (Lessee) Cash Aircraft Unearned Profit on Sale-Leaseback Leased Aircraft under Capital Leases Lease Liability Lease Liability Cash 80,000,000 75,500,000 4,500,000 80,000,000 80,000,000 First Lease Payment, January 1, 2008: 10,487,443 10,487,443 Sale of Aircraft by American to Citicapital, January 1, 2008: Cash Lease Receivable 10,487,443 10,487,443 Incurrence and Payment of Executory Costs by American Corp. throughout 2008: Insurance, Maintenance, (No entry) Taxes, etc. XXX Cash or Accounts Payable XXX Depreciation Expense Accumulated Depr.— Capital Leases ($80,000,000 15) Depreciation Expense on the Aircraft, December 31, 2008: 5,333,333 (No entry) 5,333,333 Amortization of Profit on Sale-Leaseback by American, December 31, 2008: Unearned Profit on (No entry) Sale-Leaseback 300,000 Depreciation Expense 300,000 ($4,500,000 15) Note: A case might be made for crediting Revenue instead of Depreciation Expense. Interest Expense Interest Payable a Interest for 2008, December 31, 2008: Interest Receivable 8,341,507a 8,341,507 Interest Revenue 8,341,507 8,341,507a Partial Lease Amortization Schedule: Annual Rental Payment $10,487,443 10,487,443 Interest 12% $ –0– 8,341,507 Reduction of Balance $10,487,443 2,145,936 Date 1/1/08 1/1/08 1/1/09 Balance $80,000,000 69,512,557 67,366,621 1460T_c21.qxd 1/21/06 03:45 am Page 1131 Questions • 1131 SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 21B 11. Describe the lessee’s accounting for sale-leaseback transactions. If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. The seller-lessee defers any profit it experiences from the sale of the assets that are leased back under a capital lease. The seller-lessee amortizes any profit over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased assets. If the lease satisfies none of the capital lease criteria, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Under an operating lease, the lessee defers such profit and amortizes it in proportion to the rental payments over the period of time that it expects to use the assets. Note: All asterisked Questions, Brief Exercises, Exercises, and Concepts for Analysis relate to material contained in the appendixes to the chapter. KEY TERMS minor leaseback, 1129 sale-leaseback, 1128 QUESTIONS 1. What are the major lessor groups in the United States? What advantage does a captive have in a leasing arrangement? 2. Jackie Remmers Co. is expanding its operations and is in the process of selecting the method of financing this program. After some investigation, the company determines that it may (1) issue bonds and with the proceeds purchase the needed assets or (2) lease the assets on a long-term basis. Without knowing the comparative costs involved, answer these questions: (a) What might be the advantages of leasing the assets instead of owning them? (b) What might be the disadvantages of leasing the assets instead of owning them? (c) In what way will the balance sheet be differently affected by leasing the assets as opposed to issuing bonds and purchasing the assets? 3. Identify the two recognized lease accounting methods for lessees and distinguish between them. 4. Wayne Higley Company rents a warehouse on a monthto-month basis for the storage of its excess inventory. The company periodically must rent space whenever its production greatly exceeds actual sales. For several years the company officials have discussed building their own storage facility, but this enthusiasm wavers when sales increase sufficiently to absorb the excess inventory. What is the nature of this type of lease arrangement, and what accounting treatment should be accorded it? 5. Distinguish between minimum rental payments and minimum lease payments, and indicate what is included in minimum lease payments. 6. Explain the distinction between a direct-financing lease and a sales-type lease for a lessor. 7. Outline the accounting procedures involved in applying the operating method by a lessee. 8. Outline the accounting procedures involved in applying the capital-lease method by a lessee. 9. Identify the lease classifications for lessors and the criteria that must be met for each classification. 10. Outline the accounting procedures involved in applying the direct-financing method. 11. Outline the accounting procedures involved in applying the operating method by a lessor. 12. Joan Elbert Company is a manufacturer and lessor of computer equipment. What should be the nature of its lease arrangements with lessees if the company wishes to account for its lease transactions as sales-type leases? 13. Gordon Graham Corporation’s lease arrangements qualify as sales-type leases at the time of entering into the transactions. How should the corporation recognize revenues and costs in these situations? 14. Joann Skabo, M.D. (lessee) has a noncancelable 20-year lease with Countryman Realty, Inc. (lessor) for the use of a medical building. Taxes, insurance, and maintenance are paid by the lessee in addition to the fixed annual payments, of which the present value is equal to the fair market value of the leased property. At the end of the lease period, title becomes the lessee’s at a nominal price. Considering the terms of the lease described above, comment on the nature of the lease transaction and the accounting treatment that should be accorded it by the lessee. 15. The residual value is the estimated fair value of the leased property at the end of the lease term. (a) Of what significance is (1) an unguaranteed and (2) a guaranteed residual value in the lessee’s accounting for a capitalized-lease transaction? (b) Of what significance is (1) an unguaranteed and (2) a guaranteed residual value in the lessor’s accounting for a direct-financing lease transaction? 1460T_c21.qxd 1/24/06 04:35 am Page 1132 1132 • Chapter 21 Accounting for Leases 19. What disclosures should be made by lessees and lessors related to future lease payments? 16. How should changes in the estimated unguaranteed residual values be handled by the lessor? 17. Describe the effect of a “bargain purchase option” on accounting for a capital-lease transaction by a lessee. 18. What are “initial direct costs” and how are they accounted for? *20. What is the nature of a “sale-leaseback” transaction? BRIEF EXERCISES (L0 2) BE21-1 Callaway Golf Co. leases telecommunication equipment. Assume the following data for equipment leased from Photon Company. The lease term is 5 years and requires equal rental payments of $30,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, an estimated useful life of 8 years, and no residual value. Callaway pays all executory costs directly to third parties. Photon set the annual rental to earn a rate of return of 10%, and this fact is known to Callaway. The lease does not transfer title or contain a bargain purchase option. How should Callaway classify this lease? BE21-2 Waterworld Company leased equipment from Costner Company. The lease term is 4 years and requires equal rental payments of $37,283 at the beginning of each year. The equipment has a fair value at the inception of the lease of $130,000, an estimated useful life of 4 years, and no salvage value. Waterworld pays all executory costs directly to third parties. The appropriate interest rate is 10%. Prepare Waterworld’s January 1, 2008, journal entries at the inception of the lease. BE21-3 Rick Kleckner Corporation recorded a capital lease at $200,000 on January 1, 2008. The interest rate is 12%. Kleckner Corporation made the first lease payment of $35,947 on January 1, 2008. The lease requires eight annual payments. The equipment has a useful life of 8 years with no salvage value. Prepare Kleckner Corporation’s December 31, 2008, adjusting entries. BE21-4 Use the information for Rick Kleckner Corporation from BE21-3. Assume that at December 31, 2008, Kleckner made an adjusting entry to accrue interest expense of $19,686 on the lease. Prepare Kleckner’s January 1, 2009, journal entry to record the second lease payment of $35,947. BE21-5 Jana Kingston Corporation enters into a lease on January 1, 2008, that does not transfer ownership or contain a bargain purchase option. It covers 3 years of the equipment’s 8-year useful life, and the present value of the minimum lease payments is less than 90% of the fair market value of the asset leased. Prepare Jana Kingstons journal entry to record its January 1, 2008, annual lease payment of $37,500. BE21-6 Assume that IBM leased equipment that was carried at a cost of $150,000 to Sharon Swander Company. The term of the lease is 6 years beginning January 1, 2008, with equal rental payments of $30,677 at the beginning of each year. All executory costs are paid by Swander directly to third parties. The fair value of the equipment at the inception of the lease is $150,000. The equipment has a useful life of 6 years with no salvage value. The lease has an implicit interest rate of 9%, no bargain purchase option, and no transfer of title. Collectibility is reasonably assured with no additional cost to be incurred by IBM. Prepare IBM’s January 1, 2008, journal entries at the inception of the lease. BE21-7 Use the information for IBM from BE21-6. Assume the direct-financing lease was recorded at a present value of $150,000. Prepare IBM’s December 31, 2008, entry to record interest. BE21-8 Jennifer Brent Corporation owns equipment that cost $72,000 and has a useful life of 8 years with no salvage value. On January 1, 2008, Jennifer Brent leases the equipment to Donna Havaci Inc. for one year with one rental payment of $15,000 on January 1. Prepare Jennifer Brent Corporation’s 2008 journal entries. BE21-9 Indiana Jones Corporation enters into a 6-year lease of equipment on January 1, 2008, which requires 6 annual payments of $30,000 each, beginning January 1, 2008. In addition, Indiana Jones guarantees the lessor a residual value of $20,000 at lease-end. The equipment has a useful life of 6 years. Prepare Indiana Jones’ January 1, 2008, journal entries assuming an interest rate of 10%. BE21-10 Use the information for Indiana Jones Corporation from BE21-9. Assume that for Lost Ark Company, the lessor, collectibility is reasonably predictable, there are no important uncertainties concerning costs, and the carrying amount of the machinery is $155,013. Prepare Lost Ark’s January 1, 2008, journal entries. (L0 2) (L0 2) (L0 2) (L0 3) (L0 4, 5) (L0 4, 5) (L0 4) (L0 6, 7) (L0 6, 7) 1460T_c21.qxd 1/24/06 04:35 am Page 1133 Exercises (L0 8) • 1133 BE21-11 Starfleet Corporation manufactures replicators. On January 1, 2008, it leased to Ferengi Company a replicator that had cost $110,000 to manufacture. The lease agreement covers the 5-year useful life of the replicator and requires 5 equal annual rentals of $45,400 each. An interest rate of 12% is implicit in the lease agreement. Collectibility of the rentals is reasonably assured, and there are no important uncertainties concerning costs. Prepare Starfleet’s January 1, 2008, journal entries. (L0 10) *BE21-12 On January 1, 2008, Acme Animation sold a truck to Coyote Finance for $35,000 and immediately leased it back. The truck was carried on Acme’s books at $28,000. The term of the lease is 5 years, and title transfers to Acme at lease-end. The lease requires five equal rental payments of $9,233 at the end of each year. The appropriate rate of interest is 10%, and the truck has a useful life of 5 years with no salvage value. Prepare Acme’s 2008 journal entries. EXERCISES (L0 2) E21-1 (Lessee Entries; Capital Lease with Unguaranteed Residual Value) On January 1, 2007, Burke Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Burke to make annual payments of $8,668 at the beginning of each year, starting January 1, 2007. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. The machine reverts back to the lessor at the end of the lease term. Burke uses the straight-line method of depreciation for all of its plant assets. Burke’s incremental borrowing rate is 10%, and the Lessor’s 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 Burke for this lease through January 1, 2008. (L0 2) E21-2 (Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Pat Delaney Company leases an automobile with a fair value of $8,725 from John Simon Motors, Inc., on the following terms: 1. Noncancelable term of 50 months. 2. Rental of $200 per month (at end of each month). (The present value at 1% per month is $7,840.) 3. Estimated residual value after 50 months is $1,180. (The present value at 1% per month is $715.) Delaney Company guarantees the residual value of $1,180. 4. Estimated economic life of the automobile is 60 months. 5. Delaney Company’s incremental borrowing rate is 12% a year (1% a month). Simon’s implicit rate is unknown. Instructions (a) What is the nature of this lease to Delaney Company? (b) What is the present value of the minimum lease payments? (c) Record the lease on Delaney Company’s books at the date of inception. (d) Record the first month’s depreciation on Delaney Company’s books (assume straight-line). (e) Record the first month’s lease payment. (L0 2, 7) E21-3 (Lessee Entries; Capital Lease with Executory Costs and Unguaranteed Residual Value) Assume that on January 1, 2008, Kimberly-Clark Corp. signs a 10-year noncancelable lease agreement to lease a storage building from Sheffield Storage Company. The following information pertains to this lease agreement. 1. The agreement requires equal rental payments of $72,000 beginning on January 1, 2008. 2. The fair value of the building on January 1, 2008 is $440,000. 3. The building has an estimated economic life of 12 years, with an unguaranteed residual value of $10,000. Kimberly-Clark depreciates similar buildings on the straight-line method. 4. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor. 5. Kimberly-Clark’s incremental borrowing rate is 12% per year. The lessor’s implicit rate is not known by Kimberly-Clark. 6. The yearly rental payment includes $2,470.51 of executory costs related to taxes on the property. Instructions Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2008 and 2009. Kimberly-Clark’s corporate year end is December 31. 1460T_c21.qxd 1/21/06 03:45 am Page 1134 1134 (L0 5) • Chapter 21 Accounting for Leases E21-4 (Lessor Entries; Direct-Financing Lease with Option to Purchase) Castle Leasing Company signs a lease agreement on January 1, 2008, to lease electronic equipment to Jan Way Company. The term of the noncancelable lease is 2 years, and payments are required at the end of each year. The following information relates to this agreement: 1. Jan Way has the option to purchase the equipment for $16,000 upon termination of the lease. 2. The equipment has a cost and fair value of $160,000 to Castle Leasing Company. The useful economic life is 2 years, with a salvage value of $16,000. 3. Jan Way Company is required to pay $5,000 each year to the lessor for executory costs. 4. Castle Leasing Company desires to earn a return of 10% on its investment. 5. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Instructions (a) Prepare the journal entries on the books of Castle Leasing to reflect the payments received under the lease and to recognize income for the years 2008 and 2009. (b) Assuming that Jan Way Company exercises its option to purchase the equipment on December 31, 2009, prepare the journal entry to reflect the sale on Castle’s books. (L0 2, 3) E21-5 (Type of Lease; Amortization Schedule) Mike Macinski Leasing Company leases a new machine that has a cost and fair value of $95,000 to Sharrer Corporation on a 3-year noncancelable contract. Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2008. Mike Macinski Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31. Instructions (a) Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply. (b) Prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved. (L0 8) E21-6 (Lessor Entries; Sales-Type Lease) Crosley Company, a machinery dealer, leased a machine to Dexter Corporation on January 1, 2007. The lease is for an 8-year period and requires equal annual payments of $35,013 at the beginning of each year. The first payment is received on January 1, 2007. Crosley had purchased the machine during 2006 for $160,000. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by Crosley. Crosley set the annual rental to ensure an 11% rate of return. The machine has an economic life of 10 years with no residual value and reverts to Crosley at the termination of the lease. Instructions (a) Compute the amount of the lease receivable. (b) Prepare all necessary journal entries for Crosley for 2007. (L0 8) E21-7 (Lessee-Lessor Entries; Sales-Type Lease) On January 1, 2007, Bensen Company leased equipment to Flynn Corporation. The following information pertains to this lease. 1. The term of the noncancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease. 2. Equal rental payments are due on January 1 of each year, beginning in 2007. 3. The fair value of the equipment on January 1, 2007, is $150,000, and its cost is $120,000. 4. The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Flynn depreciates all of its equipment on a straight-line basis. 5. Bensen set the annual rental to ensure an 11% rate of return. Flynn’s incremental borrowing rate is 12%, and the implicit rate of the lessor is unknown. 6. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor. Instructions (Both the lessor and the lessee’s accounting period ends on December 31.) (a) (b) (c) (d) Discuss the nature of this lease to Bensen and Flynn. Calculate the amount of the annual rental payment. Prepare all the necessary journal entries for Flynn for 2007. Prepare all the necessary journal entries for Bensen for 2007. 1460T_c21.qxd 1/21/06 03:45 am Page 1135 Exercises (L0 6, 7) • 1135 E21-8 (Lessee Entries with Bargain Purchase Option) The following facts pertain to a noncancelable lease agreement between Mooney Leasing Company and Rode Company, a lessee. Inception date: Annual lease payment due at the beginning of each year, beginning with May 1, 2007 Bargain purchase option price at end of lease term Lease term Economic life of leased equipment Lessor’s cost Fair value of asset at May 1, 2007 Lessor’s implicit rate Lessee’s incremental borrowing rate May 1, 2007 $21,227.65 $ 4,000.00 5 years 10 years $65,000.00 $91,000.00 10% 10% The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs. Instructions (Round all numbers to the nearest cent.) (a) (b) (c) (d) Discuss the nature of this lease to Rode Company. Discuss the nature of this lease to Mooney Company. Prepare a lease amortization schedule for Rode Company for the 5-year lease term. Prepare the journal entries on the lessee’s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2007 and 2008. Rode’s annual accounting period ends on December 31. Reversing entries are used by Rode. (L0 8) E21-9 (Lessor Entries with Bargain Purchase Option) A lease agreement between Mooney Leasing Company and Rode Company is described in E21-8. Instructions (Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor. (a) Compute the amount of the lease receivable at the inception of the lease. (b) Prepare a lease amortization schedule for Mooney Leasing Company for the 5-year lease term. (c) Prepare the journal entries to reflect the signing of the lease agreement and to record the receipts and income related to this lease for the years 2007, 2008, and 2009. The lessor’s accounting period ends on December 31. Reversing entries are not used by Mooney. (L0 5) E21-10 (Computation of Rental; Journal Entries for Lessor) Morgan Leasing Company signs an agreement on January 1, 2007, to lease equipment to Cole Company. The following information relates to this agreement. 1. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. 2. The cost of the asset to the lessor is $245,000. The fair value of the asset at January 1, 2007, is $245,000. 3. 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 $43,622, none of which is guaranteed. 4. Cole Company assumes direct responsibility for all executory costs. 5. The agreement requires equal annual rental payments, beginning on January 1, 2007. 6. 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. Instructions (Round all numbers to the nearest cent.) (a) Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. Round to the nearest dollar. (b) Prepare an amortization schedule that would be suitable for the lessor for the lease term. (c) Prepare all of the journal entries for the lessor for 2007 and 2008 to record the lease agreement, the receipt of lease payments, and the recognition of income. Assume the lessor’s annual accounting period ends on December 31. (L0 2) E21-11 (Amortization Schedule and Journal Entries for Lessee) Laura Leasing Company signs an agreement on January 1, 2007, to lease equipment to Plote Company. The information at the top of page 1136 relates to this agreement. 1460T_c21.qxd 1/21/06 03:45 am Page 1136 1136 • Chapter 21 Accounting for Leases 1. 2. 3. 4. The term of the noncancelable lease is 5 years with no renewal option. The equipment has an estimated economic life of 5 years. The fair value of the asset at January 1, 2007, is $80,000. 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 $7,000, none of which is guaranteed. Plote Company assumes direct responsibility for all executory costs, which include the following annual amounts: (1) $900 to Rocky Mountain Insurance Company for insurance and (2) $1,600 to Laclede County for property taxes. The agreement requires equal annual rental payments of $18,142.95 to the lessor, beginning on January 1, 2007. The lessee’s incremental borrowing rate is 12%. The lessor’s implicit rate is 10% and is known to the lessee. Plote Company uses the straight-line depreciation method for all equipment. Plote uses reversing entries when appropriate. 5. 6. 7. 8. Instructions (Round all numbers to the nearest cent.) (a) Prepare an amortization schedule that would be suitable for the lessee for the lease term. (b) Prepare all of the journal entries for the lessee for 2007 and 2008 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee’s annual accounting period ends on December 31. (L0 3, 4) E21-12 (Accounting for an Operating Lease) On January 1, 2007, Doug Nelson Co. leased a building to Patrick Wise Inc. The relevant information related to the lease is as follows. 1. The lease arrangement is for 10 years. 2. The leased building cost $4,500,000 and was purchased for cash on January 1, 2007. 3. The building is depreciated on a straight-line basis. Its estimated economic life is 50 years with no salvage value. 4. Lease payments are $275,000 per year and are made at the end of the year. 5. Property tax expense of $85,000 and insurance expense of $10,000 on the building were incurred by Nelson in the first year. Payment on these two items was made at the end of the year. 6. Both the lessor and the lessee are on a calendar-year basis. Instructions (a) Prepare the journal entries that Nelson Co. should make in 2007. (b) Prepare the journal entries that Wise Inc. should make in 2007. (c) If Nelson paid $30,000 to a real estate broker on January 1, 2007, as a fee for finding the lessee, how much should be reported as an expense for this item in 2007 by Nelson Co.? (L0 3, 4) E21-13 (Accounting for an Operating Lease) On January 1, 2008, a machine was purchased for $900,000 by Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2008, at an annual rental of $210,000. Other relevant information is as follows. 1. 2. 3. 4. The lease term is for 3 years. Young Co. incurred maintenance and other executory costs of $25,000 in 2008 related to this lease. The machine could have been sold by Young Co. for $940,000 instead of leasing it. St. Leger is required to pay a rent security deposit of $35,000 and to prepay the last month’s rent of $17,500. Instructions (a) How much should Young Co. report as income before income tax on this lease for 2008? (b) What amount should St. Leger Inc. report for rent expense for 2008 on this lease? (L0 3, 4) E21-14 (Operating Lease for Lessee and Lessor) On February 20, 2007, Barbara Brent Inc., purchased a machine for $1,500,000 for the purpose of leasing it. The machine is expected to have a 10-year life, no residual value, and will be depreciated on the straight-line basis. The machine was leased to Rudy Company on March 1, 2007, for a 4-year period at a monthly rental of $19,500. There is no provision for the renewal of the lease or purchase of the machine by the lessee at the expiration of the lease term. Brent paid $30,000 of commissions associated with negotiating the lease in February 2007: Instructions (a) What expense should Rudy Company record as a result of the facts above for the year ended December 31, 2007? Show supporting computations in good form. 1460T_c21.qxd 1/21/06 03:45 am Page 1137 Problems (b) What income or loss before income taxes should Brent record as a result of the facts above for the year ended December 31, 2007? (Hint: Amortize commissions over the life of the lease.) (AICPA adapted) (L0 10) • 1137 *E21-15 (Sale and Leaseback) Assume that on January 1, 2007, Elmer’s Restaurants sells a computer system to Liquidity Finance Co. for $680,000 and immediately leases the computer system back. The relevant information is as follows. 1. 2. 3. 4. 5. 6. The computer was carried on Elmer’s books at a value of $600,000. The term of the noncancelable lease is 10 years; title will transfer to Elmer. The lease agreement requires equal rental payments of $110,666.81 at the end of each year. The incremental borrowing rate for Elmer is 12%. Elmer is aware that Liquidity Finance Co. set the annual rental to insure a rate of return of 10%. The computer has a fair value of $680,000 on January 1, 2007, and an estimated economic life of 10 years. Elmer pays executory costs of $9,000 per year. Instructions Prepare the journal entries for both the lessee and the lessor for 2007 to reflect the sale and leaseback agreement. No uncertainties exist, and collectibility is reasonably certain. (L0 10) *E21-16 (Lessee-Lessor, Sale-Leaseback) Presented below are four independent situations. (a) On December 31, 2008, Zarle Inc. sold computer equipment to Daniell Co. and immediately leased it back for 10 years. The sales price of the equipment was $520,000, its carrying amount is $400,000, and its estimated remaining economic life is 12 years. Determine the amount of deferred revenue to be reported from the sale of the computer equipment on December 31, 2008. (b) On December 31, 2008, Wasicsko Co. sold a machine to Cross Co. and simultaneously leased it back for one year. The sale price of the machine was $480,000, the carrying amount is $420,000, and it had an estimated remaining useful life of 14 years. The present value of the rental payments for the one year is $35,000. At December 31, 2008, how much should Wasicsko report as deferred revenue from the sale of the machine? (c) On January 1, 2008, McKane Corp. sold an airplane with an estimated useful life of 10 years. At the same time, McKane leased back the plane for 10 years. The sales price of the airplane was $500,000, the carrying amount $379,000, and the annual rental $73,975.22. McKane Corp. intends to depreciate the leased asset using the sum-of-the-years’-digits depreciation method. Discuss how the gain on the sale should be reported at the end of 2008 in the financial statements. (d) On January 1, 2008, Sondgeroth Co. sold equipment with an estimated useful life of 5 years. At the same time, Sondgeroth leased back the equipment for 2 years under a lease classified as an operating lease. The sales price (fair market value) of the equipment was $212,700, the carrying amount is $300,000, the monthly rental under the lease is $6,000, and the present value of the rental payments is $115,753. For the year ended December 31, 2008, determine which items would be reported on its income statement for the sale-leaseback transaction. See the book’s website, www.wiley.com/college/kieso, for Additional Exercises. co llege/k i es o w PROBLEMS (L0 2, 8) P21-1 (Lessee-Lessor Entries; Sales-Type Lease) Stine Leasing Company agrees to lease machinery to Potter Corporation on January 1, 2007. The following information relates to the lease agreement. 1. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. 2. The cost of the machinery is $420,000, and the fair value of the asset on January 1, 2007, is $560,000. 3. At the end of the lease term the asset reverts to the lessor. At the end of the lease term the asset has a guaranteed residual value of $80,000. Potter depreciates all of its equipment on a straightline basis. ile y. c o m / 1460T_c21.qxd 1/21/06 03:45 am Page 1138 1138 • Chapter 21 Accounting for Leases 4. 5. 6. The lease agreement requires equal annual rental payments, beginning on January 1, 2007. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. Stine desires a 10% rate of return on its investments. Potter’s incremental borrowing rate is 11%, and the lessor’s implicit rate is unknown. Instructions (Assume the accounting period ends on December 31.) (a) (b) (c) (d) (e) (L0 3, 4) Discuss the nature of this lease for both the lessee and the lessor. Calculate the amount of the annual rental payment required. Compute the present value of the minimum lease payments. Prepare the journal entries Potter would make in 2007 and 2008 related to the lease arrangement. Prepare the journal entries Stine would make in 2007 and 2008. P21-2 (Lessee-Lessor Entries; Operating Lease) Synergetics Inc. leased a new crane to M. K. Gumowski Construction under a 5-year noncancelable contract starting January 1, 2008. Terms of the lease require payments of $22,000 each January 1, starting January 1, 2008. Synergetics will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of $160,000, and a cost to Synergetics of $160,000. The estimated fair value of the crane is expected to be $45,000 at the end of the lease term. No bargain purchase or renewal options are included in the contract. Both Synergetics and Gumowski adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Gumowski’s incremental borrowing rate is 10%, and Synergetics’ implicit interest rate of 9% is known to Gumowski. Instructions (a) Identify the type of lease involved and give reasons for your classification. Discuss the accounting treatment that should be applied by both the lessee and the lessor. (b) Prepare all the entries related to the lease contract and leased asset for the year 2008 for the lessee and lessor, assuming the following amounts. (1) Insurance $500. (2) Taxes $2,000. (3) Maintenance $650. (4) Straight-line depreciation and salvage value $10,000. (c) Discuss what should be presented in the balance sheet, the income statement, and the related notes of both the lessee and the lessor at December 31, 2008. (L0 2, 8, 9) P21-3 (Lessee-Lessor Entries, Balance Sheet Presentation; Sales-Type Lease) Cascade Industries and Hardy Inc. enter into an agreement that requires Hardy Inc. to build three diesel-electric engines to Cascade’s specifications. Upon completion of the engines, Cascade has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2008, and requires annual rental payments of $620,956 each January 1, starting January 1, 2008. Cascade’s incremental borrowing rate is 10%. The implicit interest rate used by Hardy Inc. and known to Cascade is 8%. The total cost of building the three engines is $3,900,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Cascade depreciates similar equipment on a straight-line basis. At the end of the lease, Cascade assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor. (b) Prepare the journal entry or entries to record the transaction on January 1, 2008, on the books of Cascade Industries. (c) Prepare the journal entry or entries to record the transaction on January 1, 2008, on the books of Hardy Inc. (d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2008. (e) Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2008. (Prepare a lease amortization schedule for 2 years.) (f) Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2008, for both the lessee and the lessor. (L0 2, 6, 9) P21-4 (Balance Sheet and Income Statement Disclosure—Lessee) The following facts pertain to a noncancelable lease agreement between Alschuler Leasing Company and McKee Electronics, a lessee, for a computer system. 1460T_c21.qxd 1/21/06 03:45 am Page 1139 Problems Inception date Lease term Economic life of leased equipment Fair value of asset at October 1, 2007 Residual value at end of lease term Lessor’s implicit rate Lessee’s incremental borrowing rate Annual lease payment due at the beginning of each year, beginning with October 1, 2007 October 1, 2007 6 years 6 years $200,255 –0– 10% 10% $41,800 • 1139 The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs, which amount to $5,500 per year and are to be paid each October 1, beginning October 1, 2007. (This $5,500 is not included in the rental payment of $41,800.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment. The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor. Annual Lease Payment/ Receipt $ 41,800 41,800 41,800 41,800 41,800 41,800 $250,800 *Rounding error is $1. Date 10/01/07 10/01/07 10/01/08 10/01/09 10/01/10 10/01/11 10/01/12 Interest (10%) on Unpaid Liability/Receivable Reduction of Lease Liability/Receivable $ 41,800 25,954 28,550 31,405 34,545 38,001 $200,255 Balance of Lease Liability/Receivable $200,255 158,455 132,501 103,951 72,546 38,001 –0– $15,846 13,250 10,395 7,255 3,799* $50,545 Instructions (Round all numbers to the nearest cent.) (a) Assuming the lessee’s accounting period ends on September 30, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessee’s income statement for the year ending September 30, 2008? (2) What items and amounts will appear on the lessee’s balance sheet at September 30, 2008? (3) What items and amounts will appear on the lessee’s income statement for the year ending September 30, 2009? (4) What items and amounts will appear on the lessee’s balance sheet at September 30, 2009? (b) Assuming the lessee’s accounting period ends on December 31, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessee’s income statement for the year ending December 31, 2007? (2) What items and amounts will appear on the lessee’s balance sheet at December 31, 2007? (3) What items and amounts will appear on the lessee’s income statement for the year ending December 31, 2008? (4) What items and amounts will appear on the lessee’s balance sheet at December 31, 2008? (L0 5, 9) P21-5 (Balance Sheet and Income Statement Disclosure—Lessor) Assume the same information as in P21-4. Instructions (Round all numbers to the nearest cent.) (a) Assuming the lessor’s accounting period ends on September 30, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessor’s income statement for the year ending September 30, 2008? (2) What items and amounts will appear on the lessor’s balance sheet at September 30, 2008? 1460T_c21.qxd 1/21/06 03:45 am Page 1140 1140 • Chapter 21 Accounting for Leases (3) What items and amounts will appear on the lessor’s income statement for the year ending September 30, 2009? (4) What items and amounts will appear on the lessor’s balance sheet at September 30, 2009? (b) Assuming the lessor’s accounting period ends on December 31, answer the following questions with respect to this lease agreement. (1) What items and amounts will appear on the lessor’s income statement for the year ending December 31, 2007? (2) What items and amounts will appear on the lessor’s balance sheet at December 31, 2007? (3) What items and amounts will appear on the lessor’s income statement for the year ending December 31, 2008? (4) What items and amounts will appear on the lessor’s balance sheet at December 31, 2008? P21-6 (Lessee Entries with Residual Value) The following facts pertain to a noncancelable lease agreement between Voris Leasing Company and Zarle Company, a lessee. Inception date Annual lease payment due at the beginning of each year, beginning with January 1, 2007 Residual value of equipment at end of lease term, guaranteed by the lessee Lease term Economic life of leased equipment Fair value of asset at January 1, 2007 Lessor’s implicit rate Lessee’s incremental borrowing rate January 1, 2007 $81,365 $50,000 6 years 6 years $400,000 12% 12% The lessee assumes responsibility for all executory costs, which are expected to amount to $4,000 per year. The asset will revert to the lessor at the end of the lease term. The lessee has guaranteed the lessor a residual value of $50,000. The lessee uses the straight-line depreciation method for all equipment. Instructions (Round all numbers to the nearest cent.) (a) Prepare an amortization schedule that would be suitable for the lessee for the lease term. (b) Prepare all of the journal entries for the lessee for 2007 and 2008 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee’s annual accounting period ends on December 31 and reversing entries are used when appropriate. (L0 2, 9) P21-7 (Lessee Entries and Balance Sheet Presentation; Capital Lease) Brennan Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2007. Annual rental payments of $32,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 10%; Brennan’s incremental borrowing rate is 12%. Brennan is unaware of the rate being used by the lessor. At the end of the lease, Brennan has the option to buy the equipment for $1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Brennan uses the straight-line method of depreciation on similar owned equipment. Instructions (Round all numbers to the nearest dollar.) (a) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2007, by Brennan. (Assume no residual value.) (b) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2008, by Brennan. (Prepare the lease amortization schedule for all five payments.) (c) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2009, by Brennan. (d) What amounts would appear on Brennan’s December 31, 2009, balance sheet relative to the lease arrangement? (L0 2, 9) P21-8 (Lessee Entries and Balance Sheet Presentation; Capital Lease) On January 1, 2008, Charlie Doss Company contracts to lease equipment for 5 years, agreeing to make a payment of $94,732 (including the executory costs of $6,000) at the beginning of each year, starting January 1, 2008. The taxes, the insurance, and the maintenance, estimated at $6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at $370,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Doss’s incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Doss. Title to the equipment transfers to Doss when the lease expires. The asset has an estimated useful life of 5 years and no residual value. 1460T_c21.qxd 1/21/06 03:45 am Page 1141 Problems Instructions (Round all numbers to the nearest dollar.) (a) Explain the probable relationship of the $370,000 amount to the lease arrangement. (b) Prepare the journal entry or entries that should be recorded on January 1, 2008, by Charlie Doss Company. (c) Prepare the journal entry to record depreciation of the leased asset for the year 2008. (d) Prepare the journal entry to record the interest expense for the year 2008. (e) Prepare the journal entry to record the lease payment of January 1, 2009, assuming reversing entries are not made. (f) What amounts will appear on the lessee’s December 31, 2008, balance sheet relative to the lease contract? (L0 2, 6) • 1141 P21-9 (Lessee Entries, Capital Lease with Monthly Payments) John Roesch Inc. was incorporated in 2006 to operate as a computer software service firm with an accounting fiscal year ending August 31. Roesch’s primary product is a sophisticated online inventory-control system; its customers pay a fixed fee plus a usage charge for using the system. Roesch has leased a large, Alpha-3 computer system from the manufacturer. The lease calls for a monthly rental of $50,000 for the 144 months (12 years) of the lease term. The estimated useful life of the computer is 15 years. Each scheduled monthly rental payment includes $4,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on the first day of the month beginning with August 1, 2007, the date the computer was installed and the lease agreement was signed. The lease is noncancelable for its 12-year term, and it is secured only by the manufacturer’s chattel lien on the Alpha-3 system. This lease is to be accounted for as a capital lease by Roesch, and it will be depreciated by the straightline method with no expected salvage value. Borrowed funds for this type of transaction would cost Roesch 12% per year (1% per month). Following is a schedule of the present value of $1 for selected periods discounted at 1% per period when payments are made at the beginning of each period. Periods (months) 1 2 3 143 144 Present Value of $1 per Period Discounted at 1% per Period 1.000 1.990 2.970 76.658 76.899 Instructions Prepare, in general journal form, all entries Roesch should have made in its accounting records during August 2007 relating to this lease. Give full explanations and show supporting computations for each entry. Remember, August 31, 2007, is the end of Roesch’s fiscal accounting period and it will be preparing financial statements on that date. Do not prepare closing entries. (AICPA adapted) (L0 4, 7, 8) P21-10 (Lessor Computations and Entries; Sales-Type Lease with Unguaranteed RV) Hanson Company manufactures a computer with an estimated economic life of 12 years and leases it to Flypaper Airlines for a period of 10 years. The normal selling price of the equipment is $210,482, and its unguaranteed residual value at the end of the lease term is estimated to be $20,000. Flypaper will pay annual payments of $30,000 at the beginning of each year and all maintenance, insurance, and taxes. Hanson incurred costs of $135,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. Hanson has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be incurred, and that the implicit interest rate is 10%. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items. (1) Lease receivable. (2) Sales price. (3) Cost of sales. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessor’s journal entries for the first year. 1460T_c21.qxd 1/21/06 03:45 am Page 1142 1142 • Chapter 21 Accounting for Leases P21-11 (Lessee Computations and Entries; Capital Lease with Unguaranteed Residual Value) Assume the same data as in P21-10 with Flypaper Airlines Co. having an incremental borrowing rate of 10%. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial obligation under capital leases. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessee’s journal entries for the first year. P21-12 (Basic Lessee Accounting with Difficult PV Calculation) In 2005 Judy Yin Trucking Company negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were erected to the company’s specifications on land owned by the company. On January 1, 2006, Judy Yin Trucking Company took possession of the lease properties. On January 1, 2006 and 2007, the company made cash payments of $1,048,000 that were recorded as rental expenses. Although the terminals have a composite useful life of 40 years, the noncancelable lease runs for 20 years from January 1, 2006, with a bargain purchase option available upon expiration of the lease. The 20-year lease is effective for the period January 1, 2006, through December 31, 2025. Advance rental payments of $900,000 are payable to the lessor on January 1 of each of the first 10 years of the lease term. Advance rental payments of $320,000 are due on January 1 for each of the last 10 years of the lease. The company has an option to purchase all of these leased facilities for $1 on December 31, 2025. It also must make annual payments to the lessor of $125,000 for property taxes and $23,000 for insurance. The lease was negotiated to assure the lessor a 6% rate of return. Instructions (Round all numbers to the nearest dollar.) (a) Prepare a schedule to compute for Judy Yin Trucking Company the discounted present value of the terminal facilities and related obligation at January 1, 2006. (b) Assuming that the discounted present value of terminal facilities and related obligation at January 1, 2006, was $8,400,000, prepare journal entries for Judy Yin Trucking Company to record the: (1) Cash payment to the lessor on January 1, 2008. (2) Amortization of the cost of the leased properties for 2008 using the straight-line method and assuming a zero salvage value. (3) Accrual of interest expense at December 31, 2008. Selected present value factors are as follows: Periods 1 2 8 9 10 19 20 For an Ordinary Annuity of $1 at 6% .943396 1.833393 6.209794 6.801692 7.360087 11.158117 11.469921 For $1 at 6% .943396 .889996 .627412 .591898 .558395 .330513 .311805 (L0 2, 6, 7) (AICPA adapted) (L0 4, 7, 8) P21-13 (Lessor Computations and Entries; Sales-Type Lease with Guaranteed Residual Value) Laura Jennings Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Craig Gocker Medical Center for a period of 10 years. The normal selling price of the machine is $343,734, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be $15,000. The hospital will pay rents of $50,000 at the beginning of each year and all maintenance, insurance, and taxes. Laura Jennings Inc. incurred costs of $210,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Laura Jennings Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items. (1) Lease receivable at inception (2) Sales price. of the lease. (3) Cost of sales. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessor’s journal entries for the first year. 1460T_c21.qxd 1/21/06 03:45 am Page 1143 Problems (L0 2, 7) • 1143 P21-14 (Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Assume the same data as in P21-13 and that Craig Gocker Medical Center has an incremental borrowing rate of 10%. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial obligation under capital leases. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessee’s journal entries for the first year. (L0 2, 3, 7) P21-15 (Operating Lease vs. Capital Lease) You are auditing the December 31, 2006, financial statements of Sarah Shamess, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a 2005 Shirk automobile not listed in the equipment subsidiary ledger is parked in the company garage. You ask Sally Straub, plant manager, about the vehicle, and she tells you that the company did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2006, with Jack Hayes New and Used Cars. You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms. 1. Noncancelable term of 4 years. 2. Rental of $2,160 per year (at the end of each year). (The present value at 8% per year is $7,154.) 3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Shamess guarantees the residual value of $1,100. 4. Estimated economic life of the automobile is 5 years. 5. Shamess’s incremental borrowing rate is 8% per year. Instructions You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client’s books. (It is also necessary to include the fact that you communicated this information to your client.) (L0 2, 4, 7) P21-16 (Lessee-Lessor Accounting for Residual Values) Lanier Dairy leases its milking equipment from Zeff Finance Company under the following lease terms. 1. 2. The lease term is 10 years, noncancelable, and requires equal rental payments of $25,250 due at the beginning of each year starting January 1, 2007. The equipment has a fair value and cost at the inception of the lease (January 1, 2007) of $185,078, an estimated economic life of 10 years, and a residual value (which is guaranteed by Lanier Dairy) of $20,000. The lease contains no renewable options, and the equipment reverts to Zeff Finance Company upon termination of the lease. Lanier Dairy’s incremental borrowing rate is 9% per year. The implicit rate is also 9%. Lanier Dairy depreciates similar equipment that it owns on a straight-line basis. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. 3. 4. 5. 6. Instructions (a) Evaluate the criteria for classification of the lease, and describe the nature of the lease. In general, discuss how the lessee and lessor should account for the lease transaction. (b) Prepare the journal entries for the lessee and lessor at January 1, 2007, and December 31, 2007 (the lessee’s and lessor’s year-end). Assume no reversing entries. (c) What would have been the amount capitalized by the lessee upon the inception of the lease if: (1) The residual value of $20,000 had been guaranteed by a third party, not the lessee? (2) The residual value of $20,000 had not been guaranteed at all? (d) On the lessor’s books, what would be the amount recorded as the Net Investment (Lease Receivable) at the inception of the lease, assuming: (1) The residual value of $20,000 had been guaranteed by a third party? (2) The residual value of $20,000 had not been guaranteed at all? (e) Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee’s annual payments will be appropriately reduced as the residual value increases.) 1460T_c21.qxd 1/21/06 03:45 am Page 1144 1144 • Chapter 21 Accounting for Leases CONCEPTS FOR ANALYSIS CA21-1 (Lessee Accounting and Reporting) On January 1, 2008, Hayes Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Hayes by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Hayes on January 1, 2008, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met. Instructions (a) What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease. (b) How should Hayes account for this lease at its inception and determine the amount to be recorded? (c) What expenses related to this lease will Hayes incur during the first year of the lease, and how will they be determined? (d) How should Hayes report the lease transaction on its December 31, 2008, balance sheet? CA21-2 (Lessor and Lessee Accounting and Disclosure) Laurie Gocker Inc. entered into a noncancelable lease arrangement with Nathan Morgan Leasing Corporation for a certain machine. Morgan’s primary business is leasing; it is not a manufacturer or dealer. Gocker will lease the machine for a period of 3 years, which is 50% of the machine’s economic life. Morgan will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Gocker does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term. Gocker’s incremental borrowing rate is 10%, and the implicit rate in the lease is 9%. Gocker has no way of knowing the implicit rate used by Morgan. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement. Gocker has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Morgan is reasonably certain that Gocker will pay all lease payments, and because Gocker has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Morgan. Assume that no indirect costs are involved. Instructions (a) With respect to Gocker (the lessee), answer the following. (1) What type of lease has been entered into? Explain the reason for your answer. (2) How should Gocker compute the appropriate amount to be recorded for the lease or asset acquired? (3) What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings? (4) What disclosures must Gocker make regarding this leased asset? (b) With respect to Morgan (the lessor), answer the following: (1) What type of leasing arrangement has been entered into? Explain the reason for your answer. (2) How should this lease be recorded by Morgan, and how are the appropriate amounts determined? (3) How should Morgan determine the appropriate amount of earnings to be recognized from each lease payment? (4) What disclosures must Morgan make regarding this lease? (AICPA adapted) CA21-3 (Lessee Capitalization Criteria) On January 1, Shinault Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Shinault at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment. The following information is peculiar to each lease. 1. Lease L does not contain a bargain purchase option. The lease term is equal to 80% of the estimated economic life of the equipment. 2. Lease M contains a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment. 3. Lease N does not contain a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment. 1460T_c21.qxd 1/21/06 03:45 am Page 1145 Concepts for Analysis Instructions (a) How should Shinault Company classify each of the three leases above, and why? Discuss the rationale for your answer. (b) What amount, if any, should Shinault record as a liability at the inception of the lease for each of the three leases above? (c) Assuming that the minimum lease payments are made on a straight-line basis, how should Shinault record each minimum lease payment for each of the three leases above? (AICPA adapted) CA21-4 (Comparison of Different Types of Accounting by Lessee and Lessor) • 1145 Part 1 Capital leases and operating leases are the two classifications of leases described in FASB pronouncements from the standpoint of the lessee. Instructions (a) Describe how a capital lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming the lease transfers ownership of the property to the lessee by the end of the lease. (b) Describe how an operating lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming equal monthly payments are made by the lessee at the beginning of each month of the lease. Describe the change in accounting, if any, when rental payments are not made on a straight-line basis. Do not discuss the criteria for distinguishing between capital leases and operating leases. Part 2 Sales-type leases and direct financing leases are two of the classifications of leases described in FASB pronouncements from the standpoint of the lessor. Instructions Compare and contrast a sales-type lease with a direct financing lease as follows. (a) Lease receivable. (b) Recognition of interest revenue. (c) Manufacturer’s or dealer’s profit. Do not discuss the criteria for distinguishing between the leases described above and operating leases. (AICPA adapted) CA21-5 (Lessee Capitalization of Bargain Purchase Option) Brad Hayes Corporation is a diversified company with nationwide interests in commercial real estate developments, banking, copper mining, and metal fabrication. The company has offices and operating locations in major cities throughout the United States. Corporate headquarters for Brad Hayes Corporation is located in a metropolitan area of a midwestern state, and executives connected with various phases of company operations travel extensively. Corporate management is currently evaluating the feasibility of acquiring a business aircraft that can be used by company executives to expedite business travel to areas not adequately served by commercial airlines. Proposals for either leasing or purchasing a suitable aircraft have been analyzed, and the leasing proposal was considered to be more desirable. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair market value of $1,000,000. This plane would be leased for a period of 10 years beginning January 1, 2008. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2008. Maintenance operations are strictly scheduled by the lessor, and Brad Hayes Corporation will pay for these services as they are performed. Estimated annual maintenance costs are $6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $4,000 annually and are included in the annual lease payment of $141,780. Upon expiration of the 10-year lease, Brad Hayes Corporation can purchase the Viking for $44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be $100,000 after 10 years. The salvage value probably will never be less than $75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2017. Brad Hayes Corporation can borrow $1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor’s implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on ten net rental payments of $137,780 per year and the initial market value of $1,000,000 for the plane. On January 1, 2008, the present value of all net rental payments and the purchase option of $44,440 is $888,890 using the 12% interest rate. The present value of all 1460T_c21.qxd 1/21/06 03:45 am Page 1146 1146 • Chapter 21 Accounting for Leases net rental payments and the $44,440 purchase option on January 1, 2008, is $1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice-president of Brad Hayes Corporation has established that this lease agreement is a capital lease as defined in Statement of Financial Accounting Standards No. 13, “Accounting for Leases.” Instructions (a) What is the appropriate amount that Brad Hayes Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed? (b) Without prejudice to your answer in part (a), assume that the annual lease payment is $141,780 as stated in the question, that the appropriate capitalized amount for the leased aircraft is $1,000,000 on January 1, 2008, and that the interest rate is 9%. How will the lease be reported in the December 31, 2008, balance sheet and related income statement? (Ignore any income tax implications.) (CMA adapted) CA21-6 (Lease Capitalization, Bargain Purchase Option) Cubby Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated market value is $2,500. Glenn Beckert, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain purchase agreement. The controller, Donna Kessinger, disagrees: “Although I don’t know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price. Instructions Answer the following questions. (a) What ethical issue is at stake? (b) Should the controller’s argument be accepted if she does not really know much about copier technology? Would it make a difference if the controller were knowledgeable about the pace of change in copier technology? (c) What should Beckert do? *CA21-7 (Sale-Leaseback) On January 1, 2007, Laura Dwyer Company sold equipment for cash and leased it back. As seller-lessee, Laura Dwyer retained the right to substantially all of the remaining use of the equipment. The term of the lease is 8 years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease. Instructions (a) What is the theoretical basis for requiring lessees to capitalize certain long-term leases? Do not discuss the specific criteria for classifying a lease as a capital lease. (b) (1) How should Laura Dwyer account for the sale portion of the sale-leaseback transaction at January 1, 2007? (2) How should Laura Dwyer account for the leaseback portion of the sale-leaseback transaction at January 1, 2007? (c) How should Laura Dwyer account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease? Why? (AICPA adapted) *CA21-8 (Sale-Leaseback) On December 31, 2007, Laura Truttman Co. sold 6-month old equipment at fair value and leased it back. There was a loss on the sale. Laura Truttman pays all insurance, maintenance, and taxes on the equipment. The lease provides for eight equal annual payments, beginning December 31, 2008, with a present value equal to 85% of the equipment’s fair value and sales price. The lease’s term is equal to 80% of the equipment’s useful life. There is no provision for Laura Truttman to reacquire ownership of the equipment at the end of the lease term. Instructions (a) (1) Why is it important to compare an equipment’s fair value to its lease payments’ present value and its useful life to the lease term? (2) Evaluate Laura Truttman’s leaseback of the equipment in terms of each of the four criteria for determination of a capital lease. (b) How should Laura Truttman account for the sale portion of the sale-leaseback transaction at December 31, 2007? (c) How should Laura Truttman report the leaseback portion of the sale-leaseback transaction on its December 31, 2008, balance sheet? 1460T_c21.qxd 1/24/06 04:35 am Page 1147 Using Your Judgment • 1147 USING YOUR JUDGMENT Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B or can be accessed at the KWW website. llege/k co i e so Instructions Refer to P&G’s financial statements, accompanying notes, and management’s discussion and analysis to answer the following questions. (a) What types of leases are used by P&G? (b) What amount of capital leases was reported by P&G in total and for less than one year? (c) What minimum annual rental commitments under all noncancelable leases at June 30, 2004, did P&G disclose? w co llege/k i es o ile ile y. c o m / y. c o m / Financial Statement Analysis Case Tasty Baking Company Presented in Illustration 21-32 are the financial statement disclosures from the 2004 annual report of Tasty Baking Company. Instructions Answer the following questions related to these disclosures. (a) What is the total obligation under capital leases at December 25, 2004, for Tasty Baking Company? (b) What is the book value of the assets under capital lease at December 25, 2004, for Tasty Baking Company? Explain why there is a difference between the amounts reported for assets and liabilities under capital leases. (c) What is the total rental expense reported for leasing activity for the year ended December 25, 2004, for Tasty Baking Company? (d) Estimate the off-balance-sheet liability due to Tasty Baking’s operating leases at fiscal year-end 2004. Comparative Analysis Case UAL, Inc. and Southwest Airlines Instructions Go to the KWW website or the company websites and use information found there to answer the following questions related to UAL, Inc. and Southwest Airlines. (a) What types of leases are used by Southwest and on what assets are these leases primarily used? (b) How long-term are some of Southwest’s leases? What are some of the characteristics or provisions of Southwest’s (as lessee) leases? (c) What did Southwest report in 2004 as its future minimum annual rental commitments under noncancelable leases? (d) At year-end 2004, what was the present value of the minimum rental payments under Southwest’s capital leases? How much imputed interest was deducted from the future minimum annual rental commitments to arrive at the present value? (e) What were the amounts and details reported by Southwest for rental expense in 2004, 2003, and 2002? (f) How does UAL’s use of leases compare with Southwest’s? w Research Cases Case 1 The accounting for operating leases is a controversial issue. Many contend that firms employing operating leases are utilizing significantly more assets and are more highly leveraged than indicated by the balance sheet alone. As a result, analysts often use footnote disclosures to “constructively capitalize” operating lease obligations. One way to do so is to increase a firm’s assets and liabilities by the present value of all future minimum rental payments. 1460T_c21.qxd 1/21/06 03:45 am Page 1148 1148 • Chapter 21 Accounting for Leases Instructions (a) Obtain the most recent annual report for a firm that relies heavily on operating leases. (Firms in the airline and retail industries are good candidates.) The schedule of future minimum rental payments is usually included in the “Commitments and Contingencies” footnote. Use the schedule to determine the present value of future minimum rental payments, assuming a discount rate of 10%. (b) Calculate the company’s debt-to-total-assets ratio with and without the present value of operating lease payments. Is there a significant difference? Case 2 The January 7, 2002, edition of the Wall Street Journal includes an article by Judith Burns and Michael Schroeder, entitled “Accounting Firms Ask SEC for Post-Enron Guide.” Instructions Read the article and answer the following questions. (a) Why are the Big 5 firms asking the SEC to issue new guidance for disclosure? (b) One of the areas the Big 5 suggest needs improving is reporting of lease obligations. How are offbalance-sheet lease obligations currently reported? (c) One of the suggestions the Big 5 firms make for improving lease reporting is that firms should have to describe why these obligations aren’t reported in the financial statements. Why aren’t these obligations reported in the financial statements as liabilities? International Reporting Case As discussed in the chapter, U.S. GAAP accounting for leases allows companies to use off-balance-sheet financing for the purchase of operating assets. International accounting standards are similar to U.S. GAAP in that under these rules, companies can keep leased assets and obligations off their balance sheets. However, under International Accounting Standard No. 17 (IAS 17), leases are capitalized based on the subjective evaluation of whether the risks and rewards of ownership are transferred in the lease. In Japan, virtually all leases are treated as operating leases. Furthermore, unlike U.S. and IAS standards, the Japanese rules do not require disclosure of future minimum lease payments. Presented below are recent financial data for three major airlines that lease some part of their aircraft fleet. American Airlines prepares its financial statements under U.S. GAAP and leases approximately 27% of its fleet. KLM Royal Dutch Airlines and Japan Airlines (JAL) present their statements in accordance with their home country GAAP (Netherlands and Japan respectively). KLM leases about 22% of its aircraft, and JAL leases approximately 50% of its fleet. Financial Statement Data As-reported Assets Liabilities Income Estimated impact of capitalizing operating leases on:1 Assets Liabilities Income 1 American Airlines (millions of dollars) KLM Royal Dutch Airlines (millions of guilders) Japan Airlines (millions of yen) 20,915 14,699 985 19,205 13,837 606 2,042,761 1,857,800 4,619 5,897 6,886 (143) 1,812 1,776 24 244,063 265,103 (9,598) Based on Apples to Apples: Global Airlines: Flight to Quality (New York: N.Y.: Morgan Stanley Dean Witter, October 1998). Instructions (a) Using the as-reported data for each of the airlines, compute the rate of return on assets and the debt to assets ratio. Compare these companies on the basis of this analysis. (b) Adjust the as-reported numbers of the three companies for the effects of non-capitalization of leases, and then redo the analysis in part (a). (c) The following statement was overheard in the library: “Non-capitalization of operating leases is not that big a deal for profitability analysis based on rate of return on assets, since the operating lease payments (under operating lease accounting) are about the same as the sum of the interest and depreciation expense under capital lease treatment.” Do you agree? Explain. (d) Since the accounting for leases worldwide is similar, does your analysis above suggest there is a need for an improved accounting standard for leases? (Hint: Reflect on comparability of information about these companies’ leasing activities, when leasing is more prevalent in one country than in others.) 1460T_c21.qxd 1/21/06 03:45 am Page 1149 Using Your Judgment • 1149 Professional Research: Financial Accounting and Reporting Henley Hardware Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Henley is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Henley has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases. The staff is aware of some lease rules related to a “90 percent of fair value,” “75 percent of useful life,” and “residual value deficiencies,” but they are unsure about the meanings of these terms in lease accounting. Henley has asked you to conduct some research on these items related to lease capitalization criteria. Instructions Using the Financial Accounting Research System (FARS), respond to the following items. (Provide text strings used in your search.) (a) Define “fair value of the leased property.” What are some examples of the determination of fair value? (b) Besides the noncancelable term of the lease, name at least three other considerations in determining the “lease term.” (c) A common issue in the accounting for leases concerns lease requirements that the lessee make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage (e.g., excessive mileage on a leased vehicle). Do these features constitute a lessee guarantee of the residual value such that the estimated residual value of the leased property at the end of the lease term should be included in minimum lease payments? Professional Simulations Simulation 1 In this simulation you are asked to address questions related to the accounting for leases. Prepare responses to all parts. © KWW_Professional _Simulation Accounting for Leases Directions Situation Measurement Journal Entry Time Remaining 2 hours 00 minutes Resources copy paste calculator sheet standards help ? spliter done Assume that the following facts pertain to a noncancelable lease agreement between Fifth-Third Leasing Company and Bob Evans Farms, a lessee. Inception date Annual lease payment due at the beginning of each year, beginning with January 1, 2007 Residual value of equipment at end of lease term, guaranteed by the lessee Lease term Economic life of leased equipment Fair value of asset at January 1, 2007 Lessor’s implicit rate Lessee’s incremental borrowing rate January 1, 2007 $81,365 $50,000 6 years 6 years $400,000 12% 12% The lessee assumes responsibility for all executory costs, which are expected to amount to $4,000 per year. The asset will revert to the lessor at the end of the lease term. The lessee has guaranteed the lessor a residual value of $50,000. The lessee uses the straight-line depreciation method for all equipment. Directions Situation Measurement Journal Entry Resources Use a computer spreadsheet to prepare an amortization schedule that would be suitable for the lessee for the lease term. Directions Situation Measurement Journal Entry Resources Prepare the journal entries for the lessee for 2007 and 2008 to record the lease agreement and all expenses related to the lease. Assume the lessee’s annual accounting period ends on December 31 and that reversing entries are used when appropriate. 1460T_c21.qxd 1/21/06 03:45 am Page 1150 1150 • Chapter 21 Accounting for Leases Simulation 2 In this simulation you are asked to address questions related to the accounting for leases. Prepare responses to all parts. © KWW_Professional _Simulation Accounting for Leases Directions Situation Explanation Measurement Time Remaining 1 hour 40 minutes Journal Entry Resources copy paste calculator sheet standards help ? spliter done On January 1, 2007, Dexter Labs, Inc. signed a 5-year noncancelable lease for a machine. The terms of the lease called for Dexter to make annual payments of $8,668 at the beginning of each year, starting January 1, 2007. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. The machine reverts back to the lessor at the end of the lease term. Dexter uses the straight-line method of depreciation for all of its plant assets. Dexter’s incremental borrowing rate is 10%, and the Lessor’s implicit rate is unknown. Directions Situation Explanation Measurement Journal Entry Resources What type of lease is this? Explain. Directions Situation Explanation Measurement Journal Entry Resources Compute the present value of the minimum lease payments. Directions Situation Explanation Measurement Journal Entry Resources Prepare all necessary journal entries for Dexter Labs, Inc. for this lease through January 1, 2008. co Remember to check the book’s companion website to find additional resources for this chapter. llege/k i es o w ile y. c o m / ...
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This note was uploaded on 03/06/2011 for the course ACC 545 taught by Professor Cole during the Spring '09 term at University of Phoenix.

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