Fall 2010 Class 10

Fall 2010 Class 10 - Chapter 20 Leases Chapter 20 Leases...

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Unformatted text preview: Chapter 20: Leases Chapter 20: Leases Source: http://two. eas ngnews.org/ Source: http://two.lleasiingnews.org/ Questions We Need to Answer 1. How to distinguish capital / finance leases from operating leases? 2. What are the accounting and disclosure requirements for operating leases and capital / finance leases? Skills We Will Learn Skills We Will Learn 1. Understand accounting criteria for capitalizing leases. 2. Prepare journal entries to record operating leases and capital leases for lessees. 3. Prepare journal entries to record operating leases, direct financing leases, and sales-type leases for lessors. 4. Identify the effect of residual values and bargain purchase options on lease accounting. Definition of A Lease Definition of A Lease • IAS 17.4 defines a lease as: – “An agreement whereby the lessor conveys to An the lessee, in return for a payment or series of payments, the right to use an asset for an agreed period of time.” • IAS 17 classify a lease as either a finance IAS lease or an operating lease, based on the lease operating based extent to which the risks and rewards of ownership are transferred to the lessee. Leasing: Basics Leasing: Basics • The lease is a contractual agreement The lease between the lessor and the lessee lessor lessee • The lease gives the lessee the right to use The specific property (owned by the lessor) specific • The lease specifies the duration of the lease The and rental payments and • The obligations for taxes, insurance, and The maintenance may be assumed by the lessor or the lessee or divided or Advantages of Leasing Advantages of Leasing • Protection from obsolescence – Property can be upgraded • Flexibility – Lease may be structured to meet different needs Lease (e.g., cash flow) (e.g., • Less costly financing (lessee); tax incentives Less (lessor) (lessor) • Off-balance sheet financing – To avoid negative impact on ratios Current Accounting Standard Current Accounting Standard • IFRS and Canadian PE GAAP is consistent IFRS with “Classification Approach”: • A llease that transfers substantially all the ease benefits and risks of property ownership benefits should be capitalized capitalized Lease Classification Lease Classification • Capital Lease – Where the benefits and risks of ownership Where have effectively been transferred to the lessee have • Accounted for as a purchase by the lessee – Journal Entries: Lessee Leased Equipment XXX Lease Obligation XXX Lease Lessor Lease Receivable (net) XXX Equipment XXX Lease Classification Lease Classification • Operating Lease – Where the rights and risks of ownership have Where not been transferred not • A rental-only has occured – Journal Entries: Lessee Lease Expense XXX Cash XXX Cash Lessor Cash XXX Rental Revenue XXX Capital vs. Operating Lease Lease Lease Agreement Agreement Is Present Value of Is Payments ≥ 90% of Fair Value Fair Is there a Transfer of Ownership or Bargain Purchase Option? Option? Yes No No Is Lease Term Is ≥ 75% of Economic Life Economic Yes Capital Lease Yes No Is the asset Is highly specialized (IFRS) (IFRS) Yes Operating Operating Lease Lease No Capital Lease Criteria • Transfer of ownership test (PE GAAP&IFRS) • Economic life test (PE GAAP&IFRS) • Recovery of Investment test (PE GAAP&IFRS) – If the PV of minimum lease payments is ≥ 90% If minimum of the fair value of the asset of – minimum lease payments (lessee) defined as: defined • • • • Minimum rental payments + Guaranteed residual value + Bargain purchase option+ Penalty for not renewing or extending lease Minimum Lease Payments (MLP) • Minimum rental payments – Regular payment made to lessor, excluding Regular excluding executory costs executory • Executory costs include insurance, maintenance and Executory tax expenses. They should be excluded from the tax They minimum rental payment calculation minimum • Guaranteed residual value – The amount at which the lessor has the right to The require the lessee to purchase the asset; or require – The amount the lessee (or 3rd party guarantor) guarantees that the lessor will realize guarantees • Bargain Purchase Option Discount rate used to calculate PV of Discount rate MLP • The lessee’s incremental borrowing rate The incremental • Under PE GAAP, this rate is not used when – The lessee knows the implicit rate lessor used The implicit to calculate the lease payment, and it is less than the lessee’s incremental borrowing rate than – In this case, use the lessor’s implicit rate • Under IFRS, this rate is not used when Under – llessor’s implicit rate is reasonably essor’s determinable. Accounting for a Capital Lease • Asset and liability recorded at the lower of: – PV of the minimum lease payments (as defined PV above) or above) – Fair value of the asset at the inception of the Fair lease lease • Depreciation of the asset is amortized over: – The economic life of the asset if ownership The economic transfers to lessee at the end of the lease or there is a bargain purchase option is – The term of the lease if title does not transfer or The term there is no bargain purchase option there Accounting for a Capital Lease • Interest expense resulting from the lease transaction is recorded following the effective interest method interest – The discount rate used to establish the initial PV The is used to calculate the interest expenses is Journal entries for a Journal entries for a capital lease At the inception of the lease Dr. Asset under capital leases Cr. Obligations under capital leases To record interest expenses Dr. Interest Expense Cr. Interest Payable Using the Effective Interest Method Using method To record asset amortization appropriate to appropriate Dr. Amortization Expense the Cr. Accumulated Amortization the asset To record the lease payment Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under capital lease Cr. Cash Capital Lease – Example Capital Lease – Example Lease Terms Given, Jan 1/2005: • Term of 5 years, non-cancellable • Annual payments $25,981.62 (due at the beginning of each year) each • Fair value of lease asset is $100,000 • Economic life = 5 years; No residual value of the asset • Lease payments include $2,000 property taxes (executory Lease cost) cost) • Lease has no renewal option, and asset reverts to Lessor Lease at termination of lease at • Lessee’s incremental borrowing rate = 11% • Lessor’s implicit rate =10% (known to lessee) Capital Lease: Determining Capital Lease: Determining Capitalization • Does this qualify as a capital lease? • Only one of the tests must be met Only one Is there a Is Transfer of Ownership or Bargain Purchase Option? Option? No Is Lease Term Is ≥ 75% of Economic Life? Economic Is Present Value Is of Payments ≥ 90% of Fair Value? Value? Yes Capital Lease Yes PV of payments (n=5, i=10%) =(25,981.62 - 2000.00) x 4.16986 =(25,981.62 4.16986 =$100,000.00 Use Financial Calculator Use Financial Calculator Make sure you press BGN button before doing any calculation on annuity due PV I N PMT FV $? 10% 5 ($23,981) $0 Yields $100,000 Capital Lease – Journal Entries (1) • Entry to record initial lease transaction Lease Assets 100,000 Lease Liability 100,000 Lease 100,000 The lower of PV of MLP or FV of the asset. • Entry to record initial payment (Jan 1/05) Property Tax Expense Property Lease Liability Cash Executory costs are excluded No 2,000.00 interest. All 23,981.62 payment 25,981.62 reduce obligation Capital Lease – Amortization Schedule Capital Lease – Amortization Schedule Total Lease Obligation = $100,000 Discount Rate = 10% Lease Term= 5 years Payment made at the beginning of each year Year Jan 1, 05 Jan 1, 05 Jan 1, 06 Jan 1, 07 Jan 1, 08 Jan 1, 09 Annual Lease Payment A $23,981.62 $23,981.62 $23,981.62 $23,981.62 $23,981.62 Reduction of Balance of Interest on Lease Lease Unpaid Obligation Obligation Obligation B C D $100,000.00 $0.00 $23,981.62 $76,018.38 $7,601.84 $16,379.78 $59,638.60 $5,963.86 $18,017.76 $41,620.84 $4,162.08 $19,819.54 $21,801.30 $2,180.32 $21,801.30 $0.00 Capital Lease – Journal Entries (2) • Interest expenses (December 31, 2005) Interest Expense Interest Payable 7,601.84 7,601.84 (100,000-23,981.62)*10% = 7,601.84 (Interest Payable is debited in all subsequent lease payment entries) • Asset amortization (December 31, 2005) Amortization expense 20,000 Accumulated amortization 20,000 20,000=100,000 / 5 years There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset Capital Lease – Journal Entries (3) • Entry to record the second payment (Jan 1/06) Property Tax Expense Property Interest Payable Lease Liability Cash 2,000.00 7601.84 16,329.78 25,981.62 Capital vs Operating Capital vs Operating Comparing Charges to Operations Capital Lease Year Amortization Executory costs Interest Total Charges 2005 $20,000.00 $2,000.00 $7,601.84 $29,601.84 2006 $20,000.00 $2,000.00 $5,963.86 $27,963.86 2007 $20,000.00 $2,000.00 $4,162.08 $26,162.08 2008 $20,000.00 $2,000.00 $2,180.32 $24,180.32 2009 $20,000.00 $2,000.00 $0.00 $22,000.00 Total $100,000.00 $10,000.00 $19,908.10 $129,908.10 Operating Lease Lease Charge Difference $25,981.62 $3,620.22 $25,981.62 $1,982.24 $25,981.62 $180.46 $25,981.62 -$1,801.30 $25,981.62 -$3,981.62 $129,908.10 $0.00 Disclosure Requirements – Capital Lease • Gross amount of assets and related accumulated Gross amortization amortization • Amortization Current Portion=Interest accrued since Amortization expense may be disclosed, methods and may rate should be disclosed should last payment date + Lease obligation • Lease obligations reported separately from other that will be paid within 1 yr. Lease liabilities liabilities • Current portion of lease obligation=current liability • Minimum lease payments in total and for the next five Minimum fiscal years; executory costs and imputed interest disclosed separately disclosed • Interest expense from the lease may be separately Interest may disclosed; or included with other interest expense disclosed; • May disclose any related contingencies Accounting by the Lessor • Leases are classified as either: – – – Operating Lease Direct financing Lease Sales-type Lease These are These capital leases capital • The determination of a capital or operating The lease depends on answering a series of questions questions Lease Classification ­ Lessor Lease Lease Agreement Agreement Does Lease Does meet any of Lessee’s Capital Lease criteria? criteria? Are the Are Is the risk Is remaining associated unreimwith collection Yes burseable normal? (PE costs to GAAP) GAAP) Lessor estimatible? estimatible? (PE GAAP) Yes No Does Yes Does Asset Fair Value = Lessor’s Book Value? Book No Direct Direct Financing Lease Lease No No Operating Lease Lease Yes Sales-Type Sales-Type Lease Lease Direct financing vs Sale­type • Both the direct financing lease and the Both direct sales-type lease are capital leases sales-type • The difference is whether or not there The exists a manufacturer’s or dealer’s profit manufacturer’s • The sales-type lease incorporates a The sales-type profit profit Direct Financing Lease ­ Lessor • Lessor replaces investment in asset to be leased Lessor with a lease receivable with • Over lease term, the receivable is collected, and Over interest is earned interest • Net investment in the lease = lease payments receivable – unearned interest revenue receivable unearned Direct Financing­Example Direct Financing­Example Lease Terms Given, Jan 1/2005: • Term of 5 years, non-cancellable • Annual payments $25,981.62 (due at the beginning of each year) each • Fair value of lease asset is $100,000, equal to the lessor’s Fair acquisition cost acquisition • Economic life = 5 years; No residual value of the asset • Lease payments include $2,000 property taxes (executory Lease cost) cost) • Lease has no renewal option, and asset reverts to Lessor Lease at termination of lease at • Lessee’s incremental borrowing rate = 11% • Lessor’s implicit rate =10% (known to lessee) Calculation of Lease Payment by the Lessor Step 1: Step Calculate the payment required to provide lessor with required rate of return return Cost/FMV of asset to be recovered $100,000 Less: PV of expected residue value -0Less: PV PV of amount to be recovered PV through lease payments $100,000 $100,000 Discounted amount of total receivables Undiscounted amount of total receivables Number of payment=5, Implicit Rate=10% PV of an annuity due = 4.16986 PV 4.16986 Lease payment required= $100,000 / 4.16986 = 23,981.62 4.16986 Step 2: Total lease payment receivable = 23,981.62*5+0=119,908.10 Step 23,981.62*5 Step 3: Unearned interest revenue= 119,908.10-100,000=19,908.10 119,908.10-100,000 Use Financial Calculator Use Financial Calculator Make sure you press BGN button before doing any calculation on annuity due PMT I N PV FV $? 10% 5 $100,000 $0 Yields ($23,981) Direct Financing Lease (Lessor) • The lease payments receivable are equal to: Lease payments (net of executory costs) + Lease salvage (residual) value / BPO salvage • The unearned interest revenue is the difference The between the lease payment receivable and the asset cost (FMV) asset • The journal entries are then: Direct Financing Lease (Lessor) January 1, 2005 January Lease Payments Receivable 119,908.10 Equipment for Lease 100,000.00 Equipment Unearned Interest Revenue 19,908.10 January 1, 2005 (first payment) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable 23,981.62 Direct Financing Lease (Lessor) At Dec. 31/05 year end, Lessor recognizes interest At Lessor earned: earned: Amount originally financed $100,000.00 Paid on principal Jan. 1/05 (23,981.62) Paid Balance outstanding $ 76,018.38 Balance 76,018.38 Interest : 10% x 76,018.38 x 12/12 Interest 12/12 = $7,601.84 $7,601.84 Unearned Interest Revenue Interest Revenue Interest 7,601.84 7,601.84 Sales­Type Lease ­ Lessor • Entries are the same as for the direct Entries financing lease, except for: financing – Entry at the inception of the lease must Entry record the sale and cost of goods sold sale • Lessor earns a gross profit on sale + Lessor interest as the sale is financed interest Sales­Type Lease – Example Sales­Type Lease – Example • Take the same data as in direct financing Take example, except the asset has been recorded in the Lessor’s inventory at a cost of $85,000 Lessor’s (FMV=$100,000) (FMV=$100,000) • All previous lessor entries remain the same All except for the entry at the lease inception except – Sales and Gross Profit are recorded Sales­Type Lease – Example Sales­Type Lease – Example January 1, 2005 Lease Payments Receivable Sales Sales Unearned Interest Revenue Cost of Goods Sold Inventory 119,908.10 85,000.00 100,000.00 19,908.10 85,000.00 The journal entries in subsequent dates are exactly the same as The direct-financing lease. direct-financing Disclosure Requirements ­ Lessor • Disclose the net investment in the lease Disclose (classified as current and non-current) current • How the investment is calculated for How purposes of income recognition purposes • Finance income amount • Operating Leases – Separate disclosure of the cost and Separate accumulated amortization of the property accumulated – Amount of rental (lease) income earned Lessor’s Journal Entries for Operating Lessor’s Journal Entries for Operating Leases • To record cash rental receipt: To Dr. Cash xx Dr. Cr. Rental Revenue xx • To record asset amortization: Dr. Amortization Expense —Lease Equipment Cr. Accumulated Amortization —Lease Equipment xx xx Residual Value for Lessee Residual Value for • If guaranteed by lessee, PV of residual is If included in leased asset and lease obligation recognized (i.e. is included in definition of minimum lease payments) minimum • If not guaranteed by lessee, residual value is If not included in definition of minimum lease not payments – not in asset or liability amounts recognized recognized Residual Value for Lessor • Direct Financing Lease: whether guaranteed or unguaranteed, the residual is included in the residual lessor calculations lessor • Sales-Type Lease (see textbook example in page Sales-Type 1341): 1341 – PV of guaranteed residual value is part of Sales PV guaranteed Revenue and COGS Revenue – PV of unguaranteed residual value is excluded PV unguaranteed from Sales Revenue and COGS Sales – No difference on total payment receivable and No unearned interest revenue unearned Bargain Purchase Option • For Lessee: For Lessee – Lessee accounting assumes bargain option price Lessee will be paid: PV of BPO amount included in asset cost and obligation recognized; – Amortization period is the economic life of the asset. asset. • For Lessor: For Lessor – The accounting for BPO is similar to guaranteed The residual value. residual ...
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