Leasing - Fakoor 2013

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Chapter 15

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Accounting for Leases:

Accounting for Leases Farima Fakoor, MBA Acctg 200B

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Largest group of leased equipment involves: Information technology equipment Transportation (trucks, aircraft, rail) Construction Agriculture 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. The Leasing Environment

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The Leasing Environment

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Banks Who Are the Players? Captive Leasing Companies Independents Wells Fargo Chase Citigroup PNC Caterpillar Financial Services Corp. Ford Motor Credit (Ford) IBM Global Financing Market Share 47% 23% 26% The Leasing Environment International Lease Finance Corp.

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100% financing at fixed rates. Protection against obsolescence. Flexibility. Less costly financing. Tax advantages. Off-balance-sheet financing. Advantages of Leasing The Leasing Environment

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

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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. Accounting by the Lessee Journal Entries for Capitalized Lease

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For a capital lease , the FASB has identified four criteria. Lease transfers ownership of the property to the lessee. Lease contains a bargain-purchase option. Lease term is equal to 75 percent or more of the estimated economic life of the leased property. One or more must be met for capital lease accounting. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property. Accounting by the Lessee

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Lease Agreement Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases . Accounting by the Lessee

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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 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. Accounting by the Lessee

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Economic Life Test (75% Test) Lease term is generally considered to be the fixed, noncancelable term of the lease. Bargain-renewal option can extend this period. At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. Capitalization Criteria Accounting by the Lessee

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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: Insurance Maintenance Taxes Exclude from present value of Minimum Lease Payment Calculation Capitalization Criteria Accounting by the Lessee

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Discount Rate Capitalization Criteria 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 lessee’s incremental borrowing rate, then lessee must use the lessor’s rate. Accounting by the Lessee

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Asset and Liability Recorded at the lower of: present value of the minimum lease payments (excluding executory costs) or fair-market value of the leased asset. Asset and Liability Accounted for Differently Accounting by the Lessee

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Depreciation Period If lease transfers ownership , depreciate asset over the economic life of the asset. If lease does not transfer ownership , depreciate over the term of the lease . Asset and Liability Accounted for Differently Accounting by the Lessee

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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. Asset and Liability Accounted for Differently Accounting by the Lessee

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Illustration: Caterpillar Financial Services Corp. (a subsidiary of Caterpillar) and Sterling Construction Corp. sign a lease agreement dated January 1, 2014, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2014. 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. 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. Accounting by the Lessee

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What type of lease is this? Capitalization Criteria: Transfer of ownership Bargain purchase option Lease term = 75% of economic life of leased property Present value of minimum lease payments => 90% of FMV of property NO NO Lease term = 5 yrs. Economic life = 5 yrs. PV = $100,000 FMV = $100,000. Capital Lease? Accounting by the Lessee YES YES

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Payment $ 25,981.62 Property taxes (executory cost) - 2,000.00 Minimum lease payment 23,981.62 Present value factor (i=10%,n=5) x 4.16986 PV of minimum lease payments $100.000.00 Compute present value of the minimum lease payments. Accounting by the Lessee * * Present value of an annuity due of 1 for 5 periods at 10% 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.

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Leased Equipment (under capital leases) 100,000 Lease Liability 100,000 Accounting by the Lessee Sterling records the capital lease on its books on January 1, 2014, as: Property Tax Expense 2,000.00 Lease Liability 23,981.62 Cash 25,981.62 Sterling records the first lease payment on January 1, 2014 , as follows.

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Accounting by the Lessee Sterling records accrued interest on December 31, 2014

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Accounting by the Lessee Sterling records accrued interest on December 31, 2014 Interest Expense 7,601.84 Interest Payable 7,601.84 Prepare the entry to record accrued interest at Dec. 31, 2014.

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Depreciation Expense (capital leases) 20,000 Accumulated Depreciation—Capital Leases 20,000 Accounting by the Lessee Prepare the required on December 31, 2014, to record depreciation for the year using the straight-line method ($100,000 ÷ 5 years). The liabilities section as it relates to lease transactions at December 31, 2014.

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Accounting by the Lessee Property Tax Expense 2,000.00 Interest Payable 7,601.84 Lease Liability 16,379.78 Cash 25,981.62 Sterling records the lease payment of January 1, 2015, as follows.

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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, 2014, as follows. Accounting by the Lessee Rent Expense 25,981.62 Cash 25,981.62

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Accounting by the Lessee Differences using a capital lease instead of an operating lease. Increase in amount of reported debt. Increase in amount of total assets (specifically long-lived assets). Lower income early in the life of the lease.

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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. Unresolved Lease Accounting Problems

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