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1 Chapter 15 Leases Part 2: Capital Leases Intermediate Accounting II Dr. Chula King Student Learning Outcomes Explain and use the criteria for determining whether a lease is capital or not Describe and demonstrate how both the lessee and lessor account for a capital lease Describe and demonstrate how a bargain purchase option, guaranteed residual value and unguaranteed residual value impact the accounting for a capital lease by the lessee and the lessor Explain the impact of executory costs, discount rate, and initial direct costs on lease accounting Classification Criteria Lessee Agreement specifies that ownership of the asset transfers to the lessee Agreement contains bargain purchase option The noncancelable lbl lease term is at least 75% of the asset s expected economic life The present value of minimum lease payments is at least 90% of the asset s fair market value The meeting of only one criterion is required 1

2 Classification Criteria Lessor At least one criterion applying to lessee, AND, both of the following: Collectibility of lease payments is reasonably predictable If any costs to the lessor have yet to be incurred, they are reasonably predictable Capital Lease - Lessee Leased asset and lease liability recorded at present value of minimum lease payments Present value of minimum lease payments Payments in advance: Annuity due use Table 6 Payments not in advance: Ordinary annuity use Table 4 Bargain purchase option or guaranteed residual value: Single sum Use Table 2 Discount rate Implicit rate, if known Otherwise, incremental borrowing rate Capital Lease - Lessee Leased asset straight-line depreciation Depreciation period Asset s economic life if title transfer or bargain purchase option Lease term, otherwise Salvage value Expected value at end of asset s useful life if title transfer or bargain purchase option Guaranteed residual value if present, otherwise 2

3 Capital Lease Lessor Lease receivable recorded at present value of minimum lease payments Payments in advance: Annuity due use Table 6 Payments not in advance: Ordinary annuity use Table 4 Bargain purchase option, guaranteed residual value or unguaranteed residual value: Single sum Use Table 2 Discount rate: Implicit rate Same as installment note receivable Capital Lease Lessor Direct Financing Lease: Cost of the asset is equal to the asset s fair market value (PVMLP) Debit Lease Receivable, and credit the asset being leased to remove it from the books of the lessor Sales-Type Lease: Cost of the asset is not equal to the assets fair market value (PVMLP) Debit Lease Receivable, and credit Sales for the PVMLP Debit Cost of Goods Sold, and credit the asset being leased For Example Applying the Criteria Apex, Inc., leases equipment from Xavier Leasing Company. In each of the following cases, assuming none of the other criteria for capitalizing leases is met, determine whether the lease would be a capital lease or an operating lease for Apex. If it is a capital lease, would the asset be depreciated over its economic life or the lease term? 3

4 For Example Applying the Criteria 1. At the end of the lease term, the market value of the equipment is expected to be $20,000. Apex has the option of purchasing it for $5,000. This is a bargain purchase option capital lease with depreciation over the economic life 2. The fair market value of the equipment is $75,000; the PVMLP is $60,000. Operating lease; PVMLP is 80% of FMV (60,000 75,000) For Example Applying the Criteria 1. At the end of the lease term, the market value of the equipment is expected to be $20,000. Apex has the option of purchasing it for $5,000. Capital lease - Bargain purchase option; depreciation over the economic life 2. The fair market value of the equipment is $75,000; the PVMLP is $60,000. Operating lease; PVMLP is 80% of FMV (60,000 75,000) For Example Applying the Criteria 3. Ownership of the equipment automatically reverts to Apex. Capital lease Title transfer; depreciation over the economic life 4. The economic life of the equipment is 15 years; the lease term is 12 years Capital lease Lease term is 80% of economic life (12 15); depreciation over lease term 4

5 For Example Apex leased a machine from Xavier with a fair market value of $128,872 on January 1, 2013, for a three-year period ending December 31, The machine cost Xavier $95,000. The lease agreement specifies annual payments of $36,000 beginning with the first payment at the inception of the lease, and each December 31 through Apex has the option of purchasing the machine on December 30, 2015, for $45,000 when its fair value was expected to be $90,000. The machine s estimated useful life was six years with no salvage value. Apex depreciates assets by the straight-line method. Apex is aware of Xavier s implicit rate of return of 12%. Collectibility of the lease payments by Xavier is reasonably predictable and there are no costs to Xavier that are yet to be incurred. Calculation of PVMLP 1/1/13 12/31/13 12/31/14 12/31/15 36,000 36,000 36,000 45,000 (BPO) Table 6, 3 12% $96,842 = x $36,000 Table 2, 3 12% 32,030 = x $45,000 $128,872 Applying Criteria 1. Title transfer to the lessee? No 2. Bargain purchase option? Yes 3. Lease term 75% of asset economic life? No, it is 50% (3 6) 4. PVMLP 90% of FMV? Yes, it is 100% ($128,872 $128,872) The two additional lessor criteria are satisfied. This is a capital lease to Apex because the 2 nd and 4 th criteria are satisfied, and to Xavier because in addition to the 2 nd and 4 th criteria being satisfied, the two additional lessor criteria are satisfied. For Xavier, this is a sales type lease because the cost of $95,000 is not equal to the FMV of $128,872. 5

6 Amortization Schedule for Both Lessee and Lessor Interest Date 12% Principal Balance 1/1/ ,872 1/1/ ,000-36,000 92,872 12/31/ ,000 11,145 24,855 68,017 12/31/ ,000 8,162 27,838 40,179 12/30/ ,000 4,821 40,179 0 Entries by Lessee 1/1/13 Leased asset 128,872 Lease payable 128,872 1/1/13 Lease payable 36,000 Cash 36,000 12/31/13 Lease py payable 24,855 Interest expense 11,145 Cash 36,000 12/31/13 Depreciation expense 21,479 Accumulated depreciation 21,479 (128,872 6) The asset is depreciated over its estimated useful life rather than the lease term because of the bargain purchase option. Entries by Lessee 12/31/14 Lease payable 27,838 Interest expense 8,162 Cash 36,000 12/31/14 Depreciation expense 21,479 Accumulated depreciation 21,479 12/30/15 Lease payable 40,179 Interest expense 4,821 Cash 45,000 12/31/15 Depreciation expense 21,479 Accumulated depreciation 21,479 6

7 Entries by Lessor 1/1/13 Lease receivable 128,872 Sales 128,872 Cost of goods sold 95,000 Machine inventory 95,000 1/1/13 Cash 36,000 Lease receivable 36,000 12/31/13 Cash 36,000 Lease receivable 24,855 Interest revenue 11,145 Entries by Lessor 12/31/14 Cash 36,000 Lease receivable 27,838 Interest revenue 8,162 12/30/15 Cash 45,000 Lease receivable 40,179 Interest revenue 4,821 Nuances Residual Value If title transfer or BPO Value of the asset at the end of its economic life; included in depreciation by lessee Guaranteed Treated as additional minimum lease payment by lessee and lessor Treated as salvage value by lessee in computing depreciation Unguaranteed Treated as additional minimum lease payment by lessor Ignored by lessee 7

8 Nuances Executory Costs Payments for maintenance, insurances, taxes, etc. Excluded from minimum lease payments and present value computations If paid by lessee expense If paid by lessor and reimbursed by lessee Recorded as payable by lessor Expensed by lessee Nuances Discount Rate Lessor always uses the implicit rate Lessee If the implicit rate is known, the lessee uses the lower of the implicit rate or the incremental borrowing rate, unless the result produces a present value of minimum lease payments in excess of fair market value; in this case, use the implicit rate If the implicit rate is not known, use the incremental borrowing rate Nuances - Initial Direct Costs Costs incurred by lessor that are directly associated with originating a lease. Operating lease: Record as asset and amortize over lease term Direct financing: Defer and recognize over lease term by increasing lessor s lease receivable by the total of the initial direct costs, and proportionally recognize at a constant effective rate. Sales-type: Expense at inception of lease 8

9 The Next Step Exercises 15-1, 15-6, 15-7, 15-15, 15-17, 15-18, 15-19, 15-21, Problems 15-2, 15-3, 15-8, 15-9, 15-11, 15-15,

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