Financial Accounting and Accounting Standards

Financial Accounting and Accounting Standards

21-1 PREVIEW OF CHAPTER 21 21-2 Intermediate Accounting 16th Edition Kieso Weygandt Warfield 21 Accounting for Leases LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain the nature, economic substance, and advantages of

lease transactions. 2 Describe the accounting for leases by lessees. 21-3 3 Describe the accounting for leases by lessors. 4 Describe the accounting and reporting for special features of lease arrangements. LO 1 THE LEASING ENVIRONMENT A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time. Largest group of leased equipment involves:

21-4 Information technology equipment Transportation (trucks, aircraft, rail) Construction Agriculture

LO 1 21-5 ILLUSTRATION 21-2 What Do Companies Lease? LO 1 THE LEASING ENVIRONMENT Who Are the Players? Banks Wells Fargo Chase Citigroup Independents International

Lease Finance Corp. Financial Services Corp. Credit (Ford) 14% 21-6 Caterpillar Ford Motor PNC 55%

Captive Leasing Companies Market Share IBM Global Financing 31% LO 1 THE LEASING ENVIRONMENT Advantages of Leasing 1. 100% financing at fixed rates. 2. Protection against obsolescence. 3. Flexibility. 4. Less costly financing.

5. Tax advantages. 6. Off-balance-sheet financing. 21-7 LO 1 WHAT DO THE NUMBERS MEAN? OFF-BALANCE-CHEET WHATS YOUR PRINCIPLE FINANCING As shown in our opening story, airlines use lease arrangements extensively. This results in a great deal of off-balance-sheet nancing. The following chart indicates that many airlines that lease aircraft understate debt levels by a substantial amount. Airlines are not the only ones playing the off-balance-sheet game. A recent study estimates that for S&P 500 companies, off-balance-sheet lease obligations total more than one-half trillion dollars, or roughly three percent of market value. 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). 21-8 Source: D. Zion and A. Varshney, Leases Landing on Balance Sheets, Credit Suisse Equity Research (August 17, 2010). LO 1 THE LEASING ENVIRONMENT Conceptual Nature of a Lease Capitalize a lease that transfers substantially all of the benefits

and risks of property ownership, provided the lease is noncancelable. Leases that do not transfer substantially all the benefits and risks of ownership are operating leases. 21-9 LO 1 21 Accounting for Leases LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain the nature, economic

substance, and advantages of lease transactions. 2 Describe the accounting for leases by lessees. 21-10 3 Describe the accounting for leases by lessors. 4 Describe the accounting and reporting for special features of lease arrangements. LO 2 ACCOUNTING BY THE LESSEE If the lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the present value of the rental payments.

Records depreciation on the leased asset. Treats the lease payments as consisting of interest and principal. Journal Entries for Capitalized Lease 21-11 ILLUSTRATION 21-2 LO 2 ACCOUNTING BY THE LESSEE For a capital lease, the FASB has identified four criteria.

1. Lease transfers ownership of the property to the lessee. 2. Lease contains a bargain-purchase option. 3. 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. 21-12 One or more must be met for capital lease accounting. LO 2

ACCOUNTING BY THE LESSEE Lease Agreement Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. ILLUSTRATION 21-4 Diagram of Lessees Criteria for Lease Classication 21-13 LO 2 ACCOUNTING BY THE LESSEE Capitalization Criteria Transfer of Ownership Test

If the lease transfers ownership of the asset to the lessee, it is a capital lease. Bargain-Purchase Option Test 21-14 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. LO 2 ACCOUNTING BY THE LESSEE Capitalization Criteria Economic Life Test (75% Test) 21-15

Lease term is generally considered to be the fixed, noncancelable term of the lease. Bargain-renewal option can extend this period. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. LO 2 ACCOUNTING BY THE LESSEE

Illustration: 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. 21-16 LO 2 ACCOUNTING BY THE LESSEE Capitalization Criteria Recovery of Investment Test (90% Test) Minimum Lease Payments: Minimum rental payment

Guaranteed residual value Penalty for failure to renew or extend the lease Bargain-purchase option Executory Costs: 21-17 Insurance

Maintenance Taxes Exclude from present value of Minimum Lease Payment Calculation LO 2 ACCOUNTING BY THE LESSEE Capitalization Criteria Discount Rate Lessee computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception.

If the lessee knows the implicit interest rate computed by the lessor and it is less than the lessees incremental borrowing rate, then lessee must use the lessors rate. 21-18 LO 2 ACCOUNTING BY THE LESSEE Asset and Liability Accounted for Differently Asset and Liability Recorded at the lower of: 1. present value of the minimum lease payments (excluding executory costs) or 2. fair-market value of the leased asset at the inception of the lease. 21-19

LO 2 ACCOUNTING BY THE LESSEE Asset and Liability Accounted for Differently Depreciation Period 21-20 If lease transfers ownership, depreciate asset over the economic life of the asset. If lease does not transfer ownership, depreciate over the term of the lease.

LO 2 ACCOUNTING BY THE LESSEE Asset and Liability Accounted for Differently Effective-Interest Method Used to allocate each lease payment between principal and interest. Depreciation Concept Depreciation and the discharge of the obligation are independent accounting processes. 21-21 LO 2

ACCOUNTING BY THE LESSEE Illustration: Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2017, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2017. 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 is included as part of its annual payments to Caterpillar. The lease contains no renewal options. The loader reverts to Caterpillar at the termination of the lease. Sterlings incremental borrowing rate is 11 percent per year. Sterling depreciates, on a straight-line basis, 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. 21-22

LO 2 ACCOUNTING BY THE LESSEE What type of lease is this? Capital Lease? Capitalization Criteria: 1. Transfer of ownership 2. Bargain purchase option 21-23 NO NO 3. Lease term = 75% of economic life of leased

property Lease term = 5 yrs. Economic life = 5 yrs. YES 4. Present value of minimum lease payments => 90% of FMV of property PV = $100,000 FMV = $100,000. YES LO 2

ACCOUNTING BY THE LESSEE Compute present value of the minimum lease payments. Payment $ 25,981.62 Property taxes (executory cost) - Minimum lease payment 2,000.00 23,981.62 Present value factor (i=10%,n=5) x

4.16986 PV of minimum lease payments $100.000.00 * Sterling uses Caterpillars 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. * Present value of an annuity due of 1 for 5 periods at 10% (Table 6-5) 21-24 LO 2 ACCOUNTING BY THE LESSEE Sterling records the capital lease on its books on January 1, 2017, as:

Leased Equipment (under capital leases) Lease Liability 100,000 100,000 Sterling records the first lease payment on January 1, 2017, as follows. Property Tax Expense 2,000.00 Lease Liability 23,981.62 Cash 21-25 25,981.62

LO 2 ILLUSTRATION 21-6 Lease Amortization Schedule for LesseeAnnuity-Due Basis 21-26 LO 2 ILLUSTRATION 21-6 Prepare the entry to record accrued interest at Dec. 31, 2017. Interest Expense 7,601.84 Interest Payable 7,601.84 Sterling

records accrued interest on December 31, 2017 21-27 * rounding LO 2 ACCOUNTING BY THE LESSEE Prepare the required on December 31, 2017, to record depreciation for the year using the straight-line method ($100,000 5 years). Depreciation Expense (capital leases) 20,000 Accumulated DepreciationCapital Leases

20,000 The liabilities section as it relates to lease transactions at December 31, 2017. ILLUSTRATION 21-7 Reporting Current and Noncurrent Lease Liabilities 21-28 LO 2 ILLUSTRATION 21-6 Sterling records the lease payment of January 1, 2018, as follows. Property Tax Expense Interest Payable

2,000.00 7,601.84 Lease Liability 16,379.78 21-29 Cash 25,981.62 LO 2 ACCOUNTING BY THE LESSEE Operating Method (Lessee) The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. Illustration: Assume Sterling accounts for the lease as an

operating lease. Sterling records the payment on January 1, 2017, as follows. Rent Expense 25,981.62 Cash 21-30 25,981.62 LO 2 WHAT DO THE NUMBERS MEAN? RESTATEMENTS ON THE MENU WHATS YOUR PRINCIPLE Accounting for operating leases would appear routine, so it is unusual for a

bevy of companies in a single industryrestaurantsto 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 specic 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 Hardees and Carls 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 21-31 (continued) LO 2

WHAT DO THE NUMBERS MEAN? RESTATEMENTS ON THE MENU WHATS YOUR PRINCIPLE share in scal 2002, nine cents a share in scal 2003, and 10 cents a share in scal 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 Chilis; 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. These lease restatements spurred a renewed focus on restatementsboth their causes and their

consequences and have led the SEC to modify its review practices to root out accounting errors that lead to restatements. Sources: Steven D. Jones and Richard Gibson, Wall Street Journal (January 26, 2005), p. C3; and O. Usvyatsky, Restatements: Where They Come From, http://www.auditanalytics.com/blog/ (August 2, 2013). 21-32 LO 2 ACCOUNTING BY THE LESSEE ILLUSTRATION 21-8 Comparison of Charges to OperationsCapital vs. Operating Leases Differences using a capital lease instead of an operating lease. 21-33

1. Increase in amount of reported debt. 2. Increase in amount of total assets (specifically long-lived assets). 3. Lower income early in the life of the lease. LO 2 EVOLVING ISSUE AREPRINCIPLE YOU LIABLE? WHATS YOUR

Under current accounting rules, companies can keep the obligations associated with operating leases off the balance sheet. (For example, see the What Do the Numbers Mean? box on page 1199 for the effects of this approach for airlines.) This approach may change depending on the FASBs new lease accounting rule. The current plans for a new rule in this area should result in many more operating leases on balance sheets. Analysts have estimated the expected impact of a new rule. As shown in the table to the right, if the FASB (and IASB) issue a new rule on operating leases, a company like Walgreen could see its liabilities jump a whopping 216 percent. 21-34 (continued)

LO 2 EVOLVING ISSUE AREPRINCIPLE YOU LIABLE? WHATS YOUR And it is not just retailers who would be impacted. A J.P. Morgan study estimates the following impacts for several industries. 21-35 (continued) LO 2 EVOLVING ISSUE

AREPRINCIPLE YOU LIABLE? WHATS YOUR As indicated, the expected effects are signicant, with all industries expecting an increase in their debt levels and some (retail and travel and leisure) seeing a more than 10 percent increase in leverage ratios. This is not a pretty picture, but investors need to see it if they are to fully understand a companys lease obligations. Sources: Nanette Byrnes, You May Be Liable for That Lease, BusinessWeek (June 5, 2006), p. 76; J. E. Ketz, Operating Lease Obligations to Be Capitalized, Smartpros (August 2010), http://accounting.smartpros.com/x70304.xml; and P. Elwin and S. C. Fernandes, Leases on B/S from 2017? Retailers and Transport Will Be Hit Hard in Leverage Terms, Global Equity Research, J.P. Morgan Securities (May 17, 2013). 21-36 LO 2

21 Accounting for Leases LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain the nature, economic substance, and advantages of lease transactions. 2 Describe the accounting for leases by lessees. 21-37 3 Describe the accounting for leases by lessors. 4 Describe the accounting and

reporting for special features of lease arrangements. LO 3 ACCOUNTING BY THE LESSOR Benefits to the Lessor 1. Interest revenue. 2. Tax incentives. 3. High residual value. 21-38 LO 3 ACCOUNTING BY THE LESSOR Economics of Leasing A lessor determines the amount of the rental, basing it on the rate of returnthe implicit rateneeded to justify leasing the asset.

If a residual value is involved (whether guaranteed or not), the company would not have to recover as much from the lease payments. 21-39 LO 3 ACCOUNTING BY THE LESSOR Classification of Leases by the Lessor a. Operating leases. b. Direct-financing leases. c. Sales-type leases. 21-40 LO 3 ACCOUNTING BY THE LESSOR

Classification of Leases by the Lessor ILLUSTRATION 21-10 A sales-type lease involves a manufacturers or dealers profit, and a direct-financing lease does not. 21-41 LO 3 ACCOUNTING BY THE LESSOR Classification of Leases by the Lessor ILLUSTRATION 21-11 Diagram of Lessors Criteria for Lease Classication A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease.

21-42 LO 3 ACCOUNTING BY THE LESSOR Direct-Financing Method (Lessor) In substance the financing of an asset purchase by the lessee. Lessor records: 21-43 A lease receivable instead of a leased asset. Receivable is the present value of the minimum lease

payments. LO 3 Direct-Financing Method (Lessor) Illustration: Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2017, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2017. The terms and provisions of the lease agreement, and other pertinent data, are as follows. The term of the lease is five years beginning January 1, 2017, 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). 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 Caterpillar 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. 21-44 LO 3 Direct-Financing Method (Lessor) Computation of Lease Payments ILLUSTRATION 21-12 21-45 LO 3 Direct-Financing Method (Lessor) The lease meets the criteria for classification as a directfinancing lease for several reasons. 1. The lease term exceeds 75 percent of the equipments

estimated economic life. 2. The present value of the minimum lease payments exceeds 90 percent of the equipments fair value. 3. Collectibility of the payments is reasonably assured. 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 Caterpillars cost ($100,000). 21-46 LO 3 Direct-Financing Method (Lessor) Computation of Lease Receivable Total payment $ 25,981.62 Property taxes (executory cost)

- Payment net of executory cost 2,000.00 23,981.62 Present value factor (i=10%,n=5) x 4.16986 Lease receivable $100.000.00 Caterpillar records the lease of the asset and resulting

receivable on January 1, 2017, as follows: Leased Receivable 100,000 Equipment 21-47 100,000 LO 3 ILLUSTRATION 21-14 Lease Amortization Schedule for LessorAnnuity-Due Basis 21-48 LO 3 ILLUSTRATION 21-14 On January 1, 2017, Caterpillar records receipt of the first years lease payment as follows.

Cash 25,981.62 Lease Receivable 23,981.62 Property Tax Expense/Property Taxes Payable 21-49 2,000.00 LO 3 ILLUSTRATION 21-14 On December 31, 2017, Caterpillar recognizes the interest revenue during the first year through the following entry. Interest Receivable 7,601.84

Interest Revenue (leases) 21-50 7,601.84 LO 3 Direct-Financing Method (Lessor) Illustration 21-15 shows the assets section as it relates to lease transactions at December 31, 2017. ILLUSTRATION 21-15 Reporting Lease Transactions by Lessor 21-51 LO 3 ILLUSTRATION 21-14

On January 1, 2018, Caterpillar records the following. Cash 25,981.62 Lease Receivable Interest Receivable 21-52 16,379.78 7,601.84 Property Tax Expense/Property Taxes Payable 2,000.00 LO 3 ILLUSTRATION 21-14

On December 31, 2018, Caterpillar accrues interest as follows. Interest Receivable 5,963.86 Interest Revenue (leases) 21-53 5,963.86 LO 3 ACCOUNTING BY THE LESSOR Operating Method (Lessor) 21-54 Records each rental receipt as rental revenue.

Depreciates leased asset in the normal manner. LO 3 ACCOUNTING BY THE LESSOR Illustration: Assume Caterpillar accounts for the lease as an operating lease. It records the cash rental receipt as follows: Cash 25,981.62 Rental Revenue 25,981.62 Depreciation is recorded as follows: $100,000 5 years = $20,000

Depreciation Expense 20,000 Accumulated Depreciation 21-55 20,000 LO 3 21 Accounting for Leases LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain the nature, economic substance, and advantages of

lease transactions. 2 Describe the accounting for leases by lessees. 21-56 3 Describe the accounting for leases by lessors. 4 Describe the accounting and reporting for special features of lease arrangements. LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS 1. Residual values. 2. Sales-type leases (lessor). 3. Bargain-purchase options.

4. Initial direct costs. 5. Current versus noncurrent classification. 6. Disclosure. 21-57 LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Residual Values Meaning of Residual Value - Estimated fair value of the leased asset at the end of the lease term. Guaranteed versus Unguaranteed A guaranteed residual value is when 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. 21-58

LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Residual Values Lease Payments - Lessor may adjust lease payments because of the increased certainty of recovery of a guaranteed residual value. Lessee Accounting for Residual Value - The minimum lease payment includes a guaranteed residual value but excludes an unguaranteed residual value. 21-59 LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS

Illustration: Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2017, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2017. 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 an estimated residual value of $5,000. Sterling pays all of the executory costs directly to third parties except for the property taxes of $2,000 per year, which is included as part of its annual payments to Caterpillar.

The lease contains no renewal options. The loader reverts to Caterpillar at the termination of the lease. Sterlings incremental borrowing rate is 11 percent per year. Sterling depreciates, on a straight-line basis, 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. 21-60

LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Illustration: Caterpillar assumes a 10 percent return on investment (ROI), whether the residual value is guaranteed or unguaranteed. Caterpillar would compute the amount of the lease payments as follows. ILLUSTRATION 21-16 Lessors Computation of Lease Payments 21-61 LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Guaranteed Residual Value (Lessee Accounting)

Computation of Lessees capitalized amount assuming a guaranteed residual value. ILLUSTRATION 21-17 Computation of Lessees Capitalized Amount Guaranteed Residual Value 21-62 LO 4 Guaranteed Residual Value (Lessee) 21-63 ILLUSTRATION 21-18 Lease Amortization Schedule for Lessee Guaranteed Residual Value

LO 4 Guaranteed Residual Value (Lessee) 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 21-19 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, 2021, was $3,000. Sterling would make the following journal entry. 21-64 LO 4 Guaranteed Residual Value (Lessee) ILLUSTRATION 21-19

Loss on Capital Lease 2,000.00 Interest Expense (or Interest Payable) 454.76 Lease Liability 4,545.24 Accumulated DepreciationCapital Leases 95,000.00 Leased Equipment (under capital leases) Cash 21-65 100,000.00 2,000.00 LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Unguaranteed Residual Value (Lessee Accounting)

Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. Caterpillar will recover the same amount through lease rentalsthat is, $96,895.40. Sterling would capitalize the amount as follows: ILLUSTRATION 21-20 Computation of Lessees Capitalized Amount Unguaranteed Residual Value 21-66 LO 4 Unguaranteed Residual Value (Lessee) 21-67 ILLUSTRATION 21-21 Lease Amortization Schedule for Lessee Unguaranteed Residual Value

LO 4 Unguaranteed Residual Value (Lessee) At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. ILLUSTRATION 21-22 Account Balances on Lessees Books at End of Lease Term Unguaranteed Residual Value 21-68 LO 4 Comparative Entries 21-69

ILLUSTRATION 21-23 Comparative Entries for Guaranteed and Unguaranteed Residual Values, Lessee Company LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Lessor Accounting for Residual Value The lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. Illustration: Assume a direct-financing lease with a residual value (either guaranteed or unguaranteed) of $5,000. Caterpillar determines the payments as follows. 21-70

ILLUSTRATION 21-24 Computation of Direct-Financing Lease Payments LO 4 Lessor Accounting for Residual Value ILLUSTRATION 21-25 Lease Amortization Schedule, for Lessor Guaranteed or Unguaranteed Residual Value 21-71 LO 4 ILLUSTRATION 21-25 Caterpillar would make the following entry on January 1, 2017.

21-72 Lease Receivable 100,000.00 Equipment 100,000.00 LO 4 ILLUSTRATION 21-25 Caterpillar would make the following entry on January 1, 2017. Cash 25,237.09 Lease Receivable

23,237.09 Property Tax Expense/Property Taxes Payable 21-73 2,000.00 LO 4 ILLUSTRATION 21-25 Caterpillar would make the following entry on December 31, 2017. Lease Receivable 7,676.29 Interest Revenue 21-74

7,676.29 LO 4 WHAT DO THE NUMBERS MEAN? RESIDUAL REGRET WHATS YOURVALUE PRINCIPLE As you have learned, residual value prots are an important driver for the popularity of leasing for lessors, especially for leases of equipment and vehicles. However, the protability of equipment leasing hinges on the lessors ability to accurately estimate the residual value of the leased asset at the end of the lease so as to resell the asset at a prot when returned by the lessee. However, General Motors (GM) has learned that residual value prots are not guaranteed. Here is what happened.

GM took advantage of a government subsidy for electric vehicles of $7,500 to help drive down the cost of a lease for its electric car, the Chevy Volt. The taxpayer subsidies along with other GM incentives provided for low monthly lease payments, given the estimated residual value, and led to a full two-thirds of all Volt sales being attributed to leases. Thats about three times the lease rate for the overall industry. 21-75 (continued) LO 4 WHAT DO THE NUMBERS MEAN? RESIDUAL REGRET WHATS YOURVALUE PRINCIPLE

The problems for GM started when the Volts came back at the end of the lease. Unfortunately for GM and other electric car enthusiasts, demand for electric cars without the incentives (which expired) has not been sustained, and resale values for Volts have plummeted. As a result, rather than reaping residual value prots, GM sustained losses for the Volt lease returns that sold for less than the original expected residual values. Its a double whammy for GM as the already low sales numbers for new Volts will be further hurt by the supply of low-priced Volts on the used car lot. Although it appears that GM made a bad bet on residual value prots on the Volt, there may be beneciaries as those looking for a good deal on a Volt now have a supply of low-priced, used models to choose from. Source: M. Modica, Chevy Volt Resale Values Plunge as Lease Returns Hit Market, http://nlpc.org/stories/2014/08/07/chevy-volt-resale-valuesplunge-lease-returns-hit-market. 21-76 LO 4

SPECIAL LEASE ACCOUNTING PROBLEMS Sales-Type Leases (Lessor) 21-77 Primary difference between a direct-financing lease and a sales-type lease is the manufacturers or dealers gross profit (or loss). Lessor records the sale price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable.

There is a difference in accounting for guaranteed and unguaranteed residual values. LO 4 Sales-Type Leases (Lessor) Direct-Financing versus Sales-Type Leases 21-78 ILLUSTRATION 21-27 LO 4 Sales-Type Leases (Lessor) 21-79

LO 4 Sales-Type Leases (Lessor) Illustration: To illustrate a sales-type lease with a guaranteed residual value and with an unguaranteed residual value, assume the same facts as in the preceding direct-financing lease situation. The estimated residual value is $5,000 (the present value of which is $3,104.60), and the leased equipment has an $85,000 cost to the dealer, Caterpillar. Assume that the fair market value of the residual value is $3,000 at the end of the lease term. 21-80 LO 4 Sales-Type Leases (Lessor) Computation of Lease Amounts by Caterpillar

FinancialSales-Type Lease 21-81 ILLUSTRATION 21-28 LO 4 21-82 ILLUSTRATION 21-29 Entries for Guaranteed and Unguaranteed Residual Values, Lessor Company Sales-Type Lease LO 4 WHAT DO THE NUMBERS MEAN? XEROX TAKES

ON THE SEC WHATS YOUR PRINCIPLE Xerox derives much of its income from leasing equipment. Reporting such leases as sales leases, Xerox records a lease contract as a sale, thereby recognizing income immediately. One problem is that each lease receipt consists of payments for items such as supplies, services, nancing, 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 SECs 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 nancial lings 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 Xerox paid $670 million to settle a shareholder lawsuit related to its lease transactions. Its

former auditor, KPMG LLP, paid $80 million. Sources: Adapted from Xerox Takes on the SEC, Accounting Web (January 9, 2002), www.account-ingweb.com; and K. Shwiff and M. Maremont, Xerox, KPMG Settle Shareholder Lawsuit, Wall Street Journal Online (March 28, 2008), p. B3 21-83 LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Bargain Purchase Option (Lessee) 21-84 Lessee must increase the present value of the minimum lease payments by the present value of the option.

Only difference between the accounting treatment for a bargain-purchase option and a guaranteed residual value of identical amounts is in the computation of the annual depreciation. LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Initial Direct Costs (Lessor) Accounting for initial direct costs: 21-85

Operating leases, the lessor should defer initial direct costs. Sales-type leases, the lessor expenses the initial direct costs. Direct-financing lease, the lessor adds initial direct costs to the net investment. LO 4 SPECIAL LEASE ACCOUNTING PROBLEMS Current versus Noncurrent Both the annuity-due and the ordinary-annuity situations report

the reduction of principal for the next period as a current liability/current asset. 21-86 LO 4 Current versus Noncurrent ILLUSTRATION 21-30 Lease Amortization Schedule Ordinary-Annuity Basis The current portion of the lease liability/receivable as of December 31, 2017, would be $18,017.70. 21-87 LO 4

SPECIAL LEASE ACCOUNTING PROBLEMS Disclosing Lease Data 21-88 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. Description and amounts of leased assets by major balance sheet classification and related liabilities. Amounts receivable and unearned revenues under lease agreements. LO 4 Unresolved Lease Accounting Problems To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. 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. 21-89 LO 4 APPENDIX 21A 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. Advantages: 1. Financing 2. Taxes

21-90 LO 5 Describe the lessees accounting for sale-leaseback transactions. APPENDIX 21A SALE-LEASEBACKS DETERMINING ASSET USE To the extent the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing. Lessor should not recognize a gain or loss on the transaction. If the seller-lessee gives up the right to the use of the asset, the transaction is in substance a sale.

21-91 Gain or loss recognition is appropriate. LO 5 APPENDIX 21A SALE-LEASEBACKS Lessee If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee should 21-92

Account for the transaction as a sale and the lease as a capital lease. Defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease. Amortize profit over the lease term . LO 5 APPENDIX 21A SALE-LEASEBACKS

Lessee If none of the capital lease criteria are satisfied, the sellerlessee accounts for the transaction as a sale and the lease as an operating lease. 21-93 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. LO 5 APPENDIX 21A SALE-LEASEBACKS Lessor If the lease meets one of the lease capitalization criteria in

Group I and both in Group II, 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. 21-94 LO 5 APPENDIX 21A SALE-LEASEBACKS SALE-LEASEBACK EXAMPLE American Airlines on January 1, 2017, 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, 2017, 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. 21-95

5. The annual payments assure the lessor a 12 percent return. 6. Americans incremental borrowing rate is 12 percent. LO 5 APPENDIX 21A SALE-LEASEBACKS SALE-LEASEBACK EXAMPLE 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. CitiCapital should classify this lease as a direct-financing lease.

21-96 LO 5 ILLUSTRATION 21A-1 Comparative Entries for Sale-Leaseback for Lessee and Lessor 21-97 LO 5 RELEVANT FACTS - Similarities 21-98 Both GAAP and IFRS share the same objective of recording leases by lessees and lessors according to their economic substancethat is,

according to the definitions of assets and liabilities. Much of the terminology for lease accounting in IFRS and GAAP is the same. Under IFRS, lessees and lessors use the same general lease capitalization criteria to determine if the risks and rewards of ownership have been transferred in the lease. LO 6 Compare the accounting for leases under GAAP and IFRS. LO 5 RELEVANT FACTS - Differences 21-99

One difference in lease terminology is that finance leases are referred to as capital leases in GAAP. GAAP for leases uses bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more general in its provisions. GAAP has additional lessor criteria: payments are collectible and there are no additional costs associated with a lease.

IFRS requires that lessees use the implicit rate to record a lease unless it is impractical to determine the lessors implicit rate. GAAP requires use of the incremental rate unless the implicit rate is known by the lessee and the implicit rate is lower than the incremental rate. LO 6 RELEVANT FACTS - Differences 21-100 Under GAAP, extensive disclosure of future non-cancelable lease payments is required for each of the next five years and the years thereafter. Although some international companies (e.g., Nokia) provide a year-by-year breakout of payments due in years 1 through 5. IFRS does not require it.

The FASB standard for leases was originally issued in 1976. The standard (SFAS No. 13) has been the subject of more than 30 interpretations since its issuance. The IFRS leasing standard is IAS 17, first issued in 1982. This standard is the subject of only three interpretations. One reason for this small number of interpretations is that IFRS does not specifically address a number of leasing transactions that are covered by GAAP. Examples include lease agreements for natural resources, sale-leasebacks, real estate leases, and leveraged leases. LO 6 ON THE HORIZON Lease accounting is one of the areas identified in the IASB/FASB Memorandum of Understanding. The Boards have developed rules based on right-of-use (ROU) which require that all leases with terms longer than one year be recorded on the balance sheet. The IASB has decided on a single

approach for lessee accounting. Under that approach, a lessee would account for all leases similar to the current approach for capital leases, recognizing amortization of the ROU asset separately from interest on the lease liability. The FASB reached a different conclusion on the expense recognition for operating-type leases. Under the FASB model, the income effects will reflect a straight-line expense pattern, reported as a single total lease expense. The Boards are generally converged with respect to lessor accounting. A final standard is expected in 2016. You can follow the lease project at either the FASB (http://www.fasb.org) or IASB (http://www.iasb.org) websites. 21-101 LO 6 IFRS SELF-TEST QUESTION Which of the following is not a criterion for a lease to be recorded as a finance lease? a. There is transfer of ownership. b. The lease is cancelable. c.

The lease term is for the major part of the economic life of the asset. d. There is a bargain-purchase option. 21-102 LO 6 IFRS SELF-TEST QUESTION Under IFRS, in computing the present value of the minimum lease payments, the lessee should: a. use its incremental borrowing rate in all cases. b. use either its incremental borrowing rate or the implicit rate of the lessor, whichever is higher, assuming that the implicit rate is known to the lessee. c.

21-103 use either its incremental borrowing rate or the implicit rate of the lessor, whichever is lower, assuming that the implicit rate is known to the lessee. d. use the implicit rate of the lessor, unless it is impracticable to determine the implicit rate. LO 6 IFRS SELF-TEST QUESTION A lease that involves a manufacturers or dealers profit is a (an): a. direct financing lease. b. finance lease. c. operating lease.

d. sales-type lease. 21-104 LO 6 COPYRIGHT Copyright 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 21-105

Recently Viewed Presentations

  • Visual Basic.Net - neilveliz.com

    Visual Basic.Net - neilveliz.com

    Visual Basic.NET Daniel A. Seara Director Regional MSDN Buenos Aires - ARGENTINA NDSoft Objetivos Introducción a Microsoft Visual Basic .NET Nuevos conceptos Cambios Integración con .NET Herramientas Contenido Sección 1: Conceptos generales Sección 2: Características del lenguaje Sección 3: Integración...
  • Product Safety, Legal Dimensions, and Consumer Conduct

    Product Safety, Legal Dimensions, and Consumer Conduct

    Anderson School of Management. ... (such as the former CFO of Francesca Holdings) or infringe on others privacy (waiter of Payton Manning). Legal violations on the company's part could include firing an employee unjustly due to his or her social...
  • ILC Global Control System John Carwardine, ANL Fermilab

    ILC Global Control System John Carwardine, ANL Fermilab

    SAF provides many other capabilities like checkpointing and failover. ... Tier Technical Systems Interfaces Control-point level 668 Two racks per station for signal processing and motor/piezo drives LLRF Station 753 Standard rack populated with one to three controls shelves Controls...
  • Sustainable Property Investment (SPI):

    Sustainable Property Investment (SPI):

    RMIT, Melbourne, Australia By better understanding each actor's decision-making process, including which criteria are used and why they are weighted in a certain way relative to other criteria, the market place will become more transparent - thus enabling a more...
  • Chapter 29: Fallacies of Relevance

    Chapter 29: Fallacies of Relevance

    Irrelevant Conclusion (p.341) Also known as ignoratio elenchi or non sequitur The conclusion doesn't follow. Typically, this is a case in which the premises suggest that a certain conclusion should be accepted, and the conclusion given is different from that...
  • USES of Minerals

    USES of Minerals

    USES of Minerals. See "Rocks and Minerals: What's Their Use?" sheet
  • 6th Grade - lee.k12.nc.us

    6th Grade - lee.k12.nc.us

    Practicing wellness. Practicing good health habits, such as getting plenty of exercise and eating good foods. 9. Being a wise consumer. Comparing different products and services for value and quality. Using the Life Skills. ... 6th Grade Last modified by:
  • CH 4: Chemical Reactions - Valencia College

    CH 4: Chemical Reactions - Valencia College

    (until CHM 1046) * Example 15: Balancing Redox Reactions Balance the following in an acidic sol'n NO3-(aq) + Cu(s) NO(g) + Cu2+ (aq) * Types of Reactions A single-replacement reaction is a a reaction where a more active metal displaces...