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1 LEASE ACCOUNTING -LESSEE POLICY PERSPECTIVE A Lease is defined as an agreement conveying the right to use property, plant, or equipment (land and/or depreciable assets) for a stated period of time. This document describes the two classifications (Capitalized and Operating) and the accounting treatment required for leases where the company is the lessee, plus sale/leaseback and subleases. POLICY If at its inception a lease meets one or more of the following four criteria, the lease shall be classified as a capital lease: A. The lease transfers ownership of the property to the company by the end of the lease term. B. The lease contains a bargain purchase option. C. The lease term is equal to 75% or more of the estimated asset life of the leased property. This criterion does not apply if the beginning of the lease term falls within the last 25% of the asset life. D. The present value (PV) of the minimum lease payments at the lease inception date equals or exceeds 90% of the fair value of the leased property at the lease inception less any related investment tax credit retained by the lessor. Minimum lease payments exclude executory costs such as insurance, maintenance, and taxes to be paid by the lessor and 1

2 profit thereon. This criterion does not apply if the beginning of the lease term falls within the last 25% of the asset life. The company should have a preferred provider for all lease arrangements by its business units. The preferred provider should be contacted whenever a business unit is considering leasing arrangements. The preferred provider should be utilized whenever they provide competitive contract terms, interest rates, etc., to the company. POLICY STATEMENTS 1. Upon expiration of the lease term, any renewal/extension/change in provision of the lease is to be treated as a new lease. 2. A lease agreement which meets the capitalization criteria and whose annual rental payment is less than $2,500 (U.S.) should not be capitalized but rather treated as an operating lease. Leases covering multiple-like assets (e.g., auto and fleet leases) are subject to the dollar limitation in the aggregate. 3. International organizations with nonaffiliated rental expense less than $250,000 and that meet the conditions set forth in the Alternative Accounting Criteria Policy are to account for the lease agreements under the operating lease method. Accounting Treatment for Capitalized Leases 4. The lessee (the company) is to compute the present value of the minimum lease payments using his incremental borrowing rate, unless (i) the implicit rate can be readily obtained from the lessor and (ii) the implicit rate obtained from the lessor is less than the lessee's incremental borrowing rate. If both of 2

3 these conditions are met, the lessee is to use the lessor's implicit rate for the present value computation. 5. The lessee (the company) is to record a capital lease as an asset and a liability. The amount should equal the lower of the PV of the minimum lease payments at the lease inception date excluding executory costs and profit thereon or the fair value of the leased property at the lease inception date. If executory costs including profit are indeterminate, they are to be estimated where practical. 6. When fair value is the amount to be capitalized, the interest rate implicit in the minimum lease payments should be used to determine the portion of each lease payment which is principal and which is interest. When present value is the amount to be capitalized, the interest rate determined in Policy Statement 5 should be used to allocate the portion of each lease payment which is principal and which is interest. 7. If either the first or second criterion of a capitalized lease is met, the depreciation period is to be the estimated asset life of the leased property. If the lease does not meet either the first or second criterion, the asset is to be depreciated over the lease term. 8. Prior to the expiration of the lease term, termination of a capital lease is to be accounted for by removing the asset and liability and recognizing a gain or loss for the difference. 9. If at its inception a lease does not meet at least one of the four criteria of a capitalized lease, the lease is to be classified as an operating lease. Rental on an operating lease is to be charged to expense over the lease term on a straight-iine basis. 3

4 Leases Involving Real Estate 10. If land is the sole item of property leased and either the first or second criterion of a capitalized lease is met, the lease is to be accounted for as a capital lease. The asset recorded will not be depreciated. Criteria Three and Four of a capital lease are not applicable to land only leases. 11. For lease agreements that meet either the first or second criterion of a capitalized lease, the land and buildings are to be separately capitalized by the lessee. The present value of the minimum lease payments, less executory costs and profits thereon, are to be allocated between the two elements in proportion of their fair values at the inception of the lease. The building is to be depreciated on a straight-iine basis over its asset life. Land capitalized under a lease that meets the first or second criterion of a capitalized lease will not be depreciated. 12. For a lease that meets neither the first nor second criterion but meets either the third or fourth criterion of a capitalized lease then the land and building elements are to be capitalized as a single unit (building capital lease) and depreciated over the length of the lease term. 13. For real estate leases whose term is less than or equal to ten years, criteria "C" and "D" need not be applied. 14. For lease agreements involving equipment as well as real estate, the portion of the minimum lease payments applicable to the equipment of the lease is to be estimated and the equipment is to be considered separately for purposes of applying the criteria of a capitalized lease and the equipment and real estate shall be accounted for separately. 15. If the cost and fair value of the leased property involving only part of a building are objectively determinable, the lease is to be classified and 4

5 accounted for according to the provisions of Policy Statement 12. If both the cost and the fair value are not objectively determinable, the lease is classified and accounted for as follows: - If the fair value of a leased property is objectively determinable, the lessee should classify and account for the lease according to the provisions of Policy Statement If the fair value of the leased property is not objectively determinable, the lessee should classify the lease according to the third criterion of a capitalized lease only, using the estimated asset life of the building in which the leased premises are located. If the lease term is equal to 75% or more of the estimated asset life of the leased property, the leased property should be capitalized as a unit and depreciated over the lease term. Otherwise, the lease should be treated as an operating lease. Sale and Leaseback 16. A sale-leaseback transaction occurs when the company sells owned property to an outside party and concurrently enters into an agreement to leaseback that property (such as buildings). If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee (the company) should account for the lease as a capital lease--otherwise as an operating lease. Additionally, any profit on the sale shall be deferred and amortized in proportion to the depreciation of the leased asset, if a capital lease, or in proportion to rental payments over the period of time the asset is expected to be used, if an operating lease. Any loss on the sale is to be recognized immediately. Sublease and Similar Transactions 17. If the company is relieved of the primary obligation under the original lease (by substitution of a new lessee through a new agreement), the termination of the original lease agreement is accounted for as follows: 5

6 - If the original lease was a capital lease, the asset and liability representing the original lease should be removed from the accounts and gain or loss should be recognized for the difference. If the original lessee (the company) is secondarily liable, the loss contingency should be treated as per the policy regarding "Contingencies." Any consideration paid or received upon termination is included in the determination of gain or loss to be recognized. - If the original lease was an operating lease and the original lessee (the company) is secondarily liable, the loss contingency should be treated as provided by Corporate Finance and Accounting Policy regarding "Contingencies." - If the original lessee (the company) is not relieved of the primary liability under the original lease, the original lessee (the company), as sublessor, should continue to account for the original lease as previously established. - When a leased property is no longer useful to the original lessee, causing either a sublease or abandonment, a provision for any losses, which can be reasonably estimated, should be recorded by the sublessor or original lessee. The loss should include all costs directly related to the decision to abandon or sublease the facility including rental payments (net of rental income) and capitalized leasehold improvements to the extent any improvements have no substantive future use or benefit to the company. Inter-company Leases 18. Inter-company rentals should be structured and accounted for as operating leases. Disclosure Requirements 19. Extensive public disclosure rules are currently in force for leases. The company must comply with these rules; therefore, division/group records must be maintained on file at the local level supporting capital/operating 6

7 lease classification decisions. In addition, sufficient documentation must also be available to permit the following disclosures: - For Capital Leases: - The gross amount of assets recorded under capital leases. These amounts must be segregated by balance sheet date and by land, buildings, and machinery and equipment. - The aggregate total of future net minimum lease payments as of the latest balance sheet date and for each of the five succeeding fiscal years plus the balance applicable to later years. Separate deductions must be shown for the imputed interest necessary to reduce the net minimum payments to present value. - The total minimum sublease rentals to be received in the future under non-cancelable subleases as of the date of the latest balance sheet presented. - For operating leases having initial or remaining non-cancelable lease terms in excess of one year: - The aggregate total of future minimum rental payments for leases in force as of the latest balance sheet date and for each of the five succeeding fiscal years plus the balance applicable to later years. - The total minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. - For all operating leases, the following information is to be separately maintained for rental expense for each period for which an income statement is presented with separate amounts for: - Minimum rentals - Contingent rentals -Rentals on which the amounts are dependent on some factor other than the passage of time. If a minimum rental is 7

8 established, the contingent rental is the amount in excess of the minimum rental. - Sublease rentals - Rental payments under leases with terms of a month or less that were not renewed need not be included. - For Capital and Operating Leases, a general description of the lessee's leasing arrangements including, but not limited to, the following is to be maintained: - The basis on which contingent rental payments are determined. - The existence and terms of renewal or purchase options and escalation clauses. - Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing. POLICY SUPPLEMENT 1. The following terms/definitions apply to this policy: - Asset Life -Refers to the company s financial depreciation lives for fixed assets. - Bargain Purchase Option -A provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable so that exercise of the option appears, at the lease inception, to be reasonably assured. - Bargain Renewal Option -A provision allowing the lessee at his option to renew the lease for a rental sufficiently lower than the fair rental of the property at the date the option becomes exercisable so that exercise of the option appears, at the inception of the lease, to be reasonably assured. 8

9 - Capital Lease -An agreement whereby the lessee acquires substantial, long term rights to the use of property under lease. Specific criteria for a capital lease are described in the policy. - Executory Costs -Insurance, maintenance, and taxes to be paid by the lessor, including profit thereon. - Fair Value of the Leased Property -The price for which the property could be sold in an arm's length transaction between unrelated parties. Fair value of leased property should be obtained from the lessor wherever possible. However, in those limited situations where fair value is unavailable to the company, a special appraisal is not required. For land and buildings, the fair value should be reasonably estimated after contact with Corporate Real Estate Division. - Imputed Interest to the company -Difference between the Total Net Minimum Lease Payments and the lesser of the present value of the Net Minimum Lease Payments or the Fair Value of the leased property. - Inception of the Lease -The date of the lease agreement or commitment if earlier. An agreement or commitment shall be in writing, signed by the parties in interest to the transaction, and shall specifically set forth the principal provisions of the transaction. - Lease Term -Initial Term of Lease (the fixed non-cancelable term of the lease) plus Extended Term Options: [a) all periods covered by bargain renewal options, b) all periods for which failure to renew the lease imposes a penalty on the lessee such that the renewal appears at the inception of the lease to be reasonably assured, c) all periods covered by ordinary renewal options during which a guarantee by the lessee of the lessor's debt related to the leased property is expected to be in effect, d) all periods covered by ordinary renewal options preceding the date when a bargain purchase option is exercisable, and e) all periods covering renewals 9

10 or extensions of the lease at the lessor's option up to the date when a bargain purchase option is exercisable. - Lessee -Company or individual granted a lease. - Lessee's Incremental Borrowing Rate -The rate that the company would have incurred to borrow over a similar term the funds necessary to purchase the leased asset. - Lessor- Company or individual granting a lease. - Lessor's Implicit Rate -That rate which, when used to discount the minimum lease payments and residual value of leased property to the lessor, to their aggregate present value at lease inception, will provide a result equal to the fair value of the leased property less any investment tax credit retained by the lessor. - Minimum Lease Payments -The payments that the lessee is obligated to make or can be required to make in connection with the leased property. This includes: o Minimum Rental Payments -The rental payments called for by the lease over the lease term. o Guarantees -Any residual value at the expiration of the lease term guaranteed by the lessee. This requirement is in effect whether or not payment of the residual constitutes a purchase of the leased property. o Bargain Purchase Options -Any bargain purchase amount (an option allowing the lessee to purchase the leased property for a price which is sufficiently lower than the expected fair value of the Property at the date the option becomes exercisable so that exercise of the option appears, at the lease inception, to be reasonably assured). o Penalty -Any payment that the lessee (the company) must make or can be required to make upon failure to renew or extend the lease at the expiration of the lease term. This requirement is in 10

11 effect whether or not the payment would constitute a purchase of the leased property. - Minimum Sublease Rentals -When property is subleased by the Company to another party, the minimum rental amount per the agreement. - Net Minimum Lease Payments -Minimum Rental Payments plus Bargain Purchase Options, plus Guarantee and Penalty amounts, less Executory Costs. - Operating Lease -A temporary or cancelable agreement whereby the lessee agrees to make periodic payments to the lessor for use of property. True ownership interest is retained by the lessor. - Present Value of Net Minimum Lease Payments -Total net minimum lease payments for each period discounted at the appropriate discount rate. - Residual Value of Leased Property to Lessor -The estimated remaining value of the lease property, at the end of the lease term, exclusive of any portion guaranteed by the lessee which is deemed to be recoverable by the lessor based on price levels existing at the lease inception date. 11

12 Policy Statement 5 Illustration of a Capitalized Lease -Machinery and Equipment Example Data -Minimum rental payments over the lease term $231,905 -Fair value of the property at the inception of the lease $205,000 -Estimated asset life of the property 5 years -Non-cancelable lease term 5 years -Rent payable annually at the beginning of the year $ 46,381 -Lessee's incremental borrowing rate 8% -Lessor's implicit rate (residual value of leased property to lessor: 8 1/2% $9,250) -Maintenance, property taxes, and insurance are paid by the lessee. Amortization Schedule: Jan. 1, 20X1 Jan. 1, 20X2 Jan. 1, 20X2 Jan. 1, 20X3 Jan. 1, 20X4 Jan. 1, 20X5 Annual Rental Interest On Unpaid Principal Payment On Principal $ 46,381 0 $ 46,381 $ 46,381 $12,290 (8% x $153,619) $ 34,091 $ 46,381 $ 9,562 (8% x $119,528) $ 36,819 $ 46,381 $ 6,617 (8% x $82,709) $ 39,764 $ 46,381 $ (8% x $42,945) $ 42,945 $ $ $200,000 Unpaid Balance $200,000 $153,619 $119,528 $ 82,709 $ 42,945 $ 0 Computation of Present Value of Rent Payments: $46,381 rent payable annually at the beginning of the year for five years at 8% interest. When rent is payable at the beginning of the year, there is no discount back from the first rent payment, so there is one less discount period than the 12

13 number of rent payments. Therefore, the discount periods used in this example are (5 1) or 4. Using an ordinary annuity table below, the present value of rent payments is computed as follows. PV = (Discount rate x annual rent payment) + first rent payment PV = (3.312 x $46,381) + $46,381 PV = $153,614 + $46,381 PV = $200,000 rounded Present Value of Annuity of $1 (Ordinary) Received annually at the end of each period for n periods. Years Discount Rates n 2% 4% 6% 8% 10% , NOTE: If the rent is payable annually at the end of the year, the discount periods will equal the number of rent payments on the Present Value Table for an Ordinary Annuity of $1. 13

14 Classification of the Lease Agreement as a Capital Lease: - Criterion One not met. The lease does not transfer ownership of the property to the lessee by the end of the lease term. - Criterion Two not met. The lease does not contain a bargain purchase option. - Criterion Three met. The lease term of five years is more than 75% of the asset life of the property which is also five years. - Criterion Four met. The present value ($200,000) of the minimum lease payments ($231,905) using the lessee's incremental borrowing rate of 8% exceeds 90% of the fair value of the property at the inception of the lease (90% of $205,000 or $184,500). Accounting Entries. Jan. 1, 20X1: Machinery and Equipment Capital Leases $200,000 Non-current Installment on Capital Lease Obligations $ 46,381 Non-current Installment on Capital Lease Obligations $200,000 Cash $46,381 To record capital lease and first annual payment Jan. 31, 20X1: Depreciation Machinery -Machinery and Equipment Capital Leases $ 3,333 Machinery and Equipment Capital Leases -Allowance for Depreciation $ 3,333 To record monthly depreciation ($200,000 divided by 5 divided by 12) Non-current Installment on Capital Lease Obligations $ 34,091 14

15 Current Installment on Capital Lease Obligations $ 34,091 To transfer current portion of capital lease obligations out of non-current portion of capital lease obligations. Interest Expense -Capital Leases $ 1,024 Current Liability -Capital Lease Interest Payable $ 1,024 To accrue interest expense ($12,290 divided by 12) Jan. 1, 20X2: Current Installment on Capital Lease Obligations $ 34,091 Customer Focused Current Liability -Capital Lease Interest Payable $ 12,290 Cash $ 46,381 To record annual payment Jan. 31, 20X2: Depreciation -Machinery and Equipment Capital Leases $ 3,333 Machinery and Equipment Capital Leases -Allowance for Depreciation $ 3,333 To record monthly depreciation ($200,000 divided by 5 divided by 12) Non-current Installment on Capital Lease Obligations $ 36,819 Current Installment on Capital Lease Obligations $ 36,819 To transfer current portion of capital lease obligations out of noncurrent portion of capital lease obligations. Interest Expense -Capital Leases $

16 Current Liability -Capital Lease Interest Payable $ 797 To accrue interest expense ($9,562 divided by 12) 16

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