Chapter 21: Accounting for LeasesSlide 2Slide 3Teresa’s Additional ObjectivesSlide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Slide 24Slide 25Initial Direct Costs – TG’s SlideSlide 27Slide 28Slide 29Slide 30Chapter 21: Accounting Chapter 21: Accounting for Leasesfor LeasesIntermediate Accounting, 11th ed.Kieso, Weygandt, and WarfieldPrepared byJep Robertson and Renae ClarkNew Mexico State University1. Explain the nature, economic substance, and advantages of lease transactions.2. Describe the accounting criteria and procedures for capitalizing leases by the lessee.3. Contrast the operating and capitalization methods of recording leases.4. Identify the classifications of leases for the lessor.After studying this chapter, you should be able to:Chapter 21: Accounting Chapter 21: Accounting for Leasesfor Leases5. Describe the lessor’s accounting for direct-financing leases.6. Identify special features of lease arrangements that cause unique accounting problems.7. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting.8. Describe the lessor’s accounting for sales-type leases.9. Describe the disclosure requirements for leases.Chapter 21: Accounting Chapter 21: Accounting for Leasesfor LeasesTeresa’s Additional Objectives•Be able to classify a lease from the perspective of lessor and lessee•Be able to prepare journal entries for lessor and lessee – for both operating and capital-type leases•The lease is a contractual agreement between the lessor and the lessee. •The lease gives the lessee the right to use specific property.•The lease specifies the duration of the lease and rental payments.•The obligations for taxes, insurance, and maintenance may be assumed by the lessor or the lessee.Leasing: BasicsLeasing: Basics1. Leases may not require any money down.2. Lease payments are often fixed.3. Leases reduce the risk of obsolescence to the lessee.4. Leases may contain less restrictive covenants than other types of lending arrangements.5. Leases may be a less costly means of financing.6. Certain leases may not add to existing debt on the balance sheet. Advantages of LeasingAdvantages of LeasingAccording to the FASB:•a lease transferring substantially all of the benefits and risks of ownership should be capitalized.Transfer of ownership can be assumed only if there is a high degree of performance to the transfer, that is, the lease is non-cancelable.Leases that do not substantially transfers benefits and risks are operating leases.Conceptual Nature of a Conceptual Nature of a LeaseLeaseLeases that meet any of the following four criteria are capital leases for the lessee:1. Leases, transferring ownership2. Leases with bargain purchase options3. Leases with lease terms equal to 75% or more of the economic life (75% rule)4. Leases where the present value of lease payments is equal to 90% or more of the fair market value (90% rule) Accounting by LesseeAccounting by LesseeLease AgreementIs there transferof ownership?Yes Is there a bargainpurchase option?Yes NoIs lease term equalto or greater than75% of economiclife ?Yes NoCapitalLeaseOperatingLeaseIs present valueof payments equal to or morethan 90% FMV?Yes NoAccounting by LesseeAccounting by LesseeA bargain purchase option •allows the lessee to buy the leased asset •at a price significantly lower than the asset’s fair value when the option is exercisableThe difference between the option price, and the fair value (when the option is exercisable) as determined at the inception of the lease must render the option reasonably assured.The Bargain Purchase The Bargain Purchase OptionOptionIn determining the present value of the lease payments, three important factors are considered:1) Minimum lease payments the lessee is expected to make under the lease, 2) Executory costs (insurance, taxes, and maintenance), and3) Discount rate (used by the lessee to determine the present value of minimum lease payments) The Recovery of The Recovery of Investment Test (90% Investment Test (90% Test)Test)The minimum lease payments include:1) minimum rental payments (which may or may not be equal to the minimum lease payments)2) guaranteed residual value at the end of the lease term (guaranteed the lessor by the lessee or a third party)3) any penalty required of the lessee for failure to extend or renew the lease4) any bargain purchase option given to lesseeMinimum Lease PaymentsMinimum Lease Payments1. The lessee computes the present value of the lease payments using the lessee’s incremental borrowing rate.2. If the lessee knows the lessor’s implicit interest rate and it is less than the lessee’s incremental rate, then such implicit rate must be used.3. The lessor’s implicit rate produces the following result: present value of (minimum lease payments and unguaranteed residual value) = fair value of the asset to lessorDiscount RateDiscount Rate•In a capital lease transaction, the lessee records an asset and a liability.•The asset is depreciated by the lessee over the economic life of the asset.•The effective interest method is used to allocate the rental payments between principal and interest. •Depreciation of the asset and discharge of the lease obligation are independent accounting procedures. Accounting for Asset and Accounting for Asset and Liability by LesseeLiability by LesseeLessor classifies leases as one of the following:1. Operating lease2. Direct financing lease3. Sales-type leaseClassification of Leases: Classification of Leases: LessorLessorTo be classified as an operating lease:1. The lease doesn’t meet any group 1 criteria (same as lessee’s), OR2. Collectibility of payments isn’t reasonably assured, OR3. Lessor’s performance isn’t substantially complete.Accounting by Lessor: Accounting by Lessor: Classification of LeasesClassification of LeasesTo be classified as a direct financing lease the lease must meet group 1 criteria (same as lessee’s), and the following, group 2 criteria:1. Collectibility of payments must be reasonably assured, and2. Lessor’s performance must be substantially complete, and3. Asset’s fair value must be equal to lessor’s book value Accounting by Lessor: Accounting by Lessor: Classification of LeasesClassification of LeasesLease AgreementDoes lease meet Group 1 criteria?No Is collectibility ofpayments assured?No yesIs lessor’s