IF THE LEASE MEETS ONE OR MORE OF THE FOLLOWING FOUR CRITERIA, THE LESSEE MUST CLASSIFY AND ACCOUNT FOR THE ARRANGEMENT AS A CAPITAL LEASE:

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1 ILLUSTRATION 22-1 LESSEE'S CAPITALIZATION CRITERIA IF THE LEASE MEETS ONE OR MORE OF THE FOLLOWING FOUR CRITERIA, THE LESSEE MUST CLASSIFY AND ACCOUNT FOR THE ARRANGEMENT AS A CAPITAL LEASE: 1. THE LEASE TRANSFERS OWNERSHIP OF THE PROPERTY TO THE LESSEE. 2. THE LEASE CONTAINS A BARGAIN PURCHASE OPTION. 3. THE LEASE TERM IS EQUAL TO 75% OR MORE OF THE ESTIMATED ECONOMIC LIFE OF THE LEASE PROPERTY. 4. THE PRESENT VALUE OF THE MINIMUM LEASE PAYMENTS (EXCLUDING EXECUTORY COSTS) EQUALS OR EXCEEDS 90% OF THE FAIR VALUE OF THE LEASED PROPERTY. 152

2 ILLUSTRATION 22-2 FLOWCHART FOR LESSEES Start 1 Ownership Transferred at End of Lease? Capital Lease 2 Lease Contain Bargain Purchase Option? 3 Lease Term 75% or More of Asset Life? Calculate Minimum Lease Payment (MLP) 5 Lessor's Implicit Interest Rate Known? 6 Rate Less Than Incremental Borrowing Rate? Discount Rate = Lessor's Implicit Interest Rate Discount Rate = Lessee's Incremental Borrowing Rate 4 Discounted MLP 90% or More of Fair Value of Asset? Operating Lease 7 Lease Contain Bargain Purchase Option? MLP = MRP + Bargain Purchase Option Payment MLP = MRP + Guarantee of Residual + Penalty for nrenewal Capitalization Charged to Current Income Lease Obligation Reduced Using Interest Method Upon Payment 8 Present Value of MLP < Fair Value of Property? Present Value of MLP Recorded as Asset and Liability Fair Value of Property Recorded as Asset and Liability Source: Bill K. Jarnegin and Jon A Booker, "Flowchart of Accounting for Lease Lessee." The CPA Journal, June Ownership Transferred at End of Lease Term? Amortize Asset Over Economic Life of Property Amortize Asset Over Term of the Lease 10 Lease Contain Bargain Purchase Option? 153

3 ILLUSTRATION 22-3 LESSEE CAPITAL LEASE LESSOR DIRECT FINANCING LEASE EXAMPLE On January 1, 1998, Velde Company (lessee) entered into a four-year, noncancellable contract to lease a computer from Exceptional Computer Company (lessor). Annual rentals of $17,208 are to be paid each January 1, Velde will assume responsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $60,000 and it had an estimated useful life of four years and no residual value. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor. Capitalization Criteria Lessee Lessor Group 1: Criteria #1 Criteria #1 Criteria #2 Criteria #2 Criteria #3 Criteria #3 Criteria #4 Criteria #4 Group II: Criteria #1 Criteria #2 Direct financing lease because cost of computer = fair value. Annual rental $17, = $60,000 F.V. $ 60,000 = $17,208 (Table 6-5) $68,832 January 1, 1998 Leased Computer 60,000 Receivable 68,832 Capital Leases 60,000 Unearned Interest Income 8,832 Computer 60,

4 ILLUSTRATION 22-3 (continued) Cash 17,208 Capital Leases 17,208 Cash 17,208 Receivable 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 1998 Interest Expense 4,279 Unearned Interest Interest Payable 4,279 Income 4,279 Interest Income 4,279 January 1, 1999 Interest Payable 4,279 Cash 17,208 Capital Leases 12,929 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 1999 Interest Expense 2,986 Unearned Interest Interest Payable 2,986 Income 2,986 Interest Income 2,986 January 1, 2000 Interest Payable 2,986 Cash 17,208 Capital Leases 14,222 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 2000 Interest Expense 1,567 Unearned Interest Interest Payable 1,567 Income 1,567 Interest Income 1,

5 ILLUSTRATION 22-3 (concluded) January 1, 2001 Interest Payable 1,567 Cash 17,208 Capital Leases 15,641 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 Depreciation 60,000 Leased Computer 60,000 December 31, 2001 Lease Amortization Schedules Annual (10%) Reduction of Lease Date Lease Payment Interest Obligation Obligation Jan. 1, 1998 $60,000 Jan. 1, 1998 $17,208 $ 0 $17,208 42,792 Jan. 1, ,208 4,279 12,929 29,863 Jan. 1, ,208 2,986 14,222 15,641 Jan. 1, ,208 1,567* 15,641 0 Annual (10%) Investment Net Date Lease Payment Interest Recovery Investment Jan. 1, 1998 $60,000 Jan. 1, 1998 $17,208 $ 0 $17,208 42,792 Jan. 1, ,208 4,279 12,929 29,863 Jan. 1, ,208 2,986 14,222 15,641 Jan. 1, ,208 1,567* 15,641 0 *Adjusted for rounding. 156

6 ILLUSTRATION 22-4 LESSOR'S CAPITALIZATION CRITERIA FOR DIRECT FINANCING AND SALES-TYPE LEASES GROUP I THE LEASE AGREEMENT MUST MEET ONE OR MORE OF THE FOLLOWING CRITERIA: 1. THE LEASE TRANSFERS OWNERSHIP OF THE PROPERTY TO THE LESSEE. 2. THE LEASE CONTAINS A BARGAIN PURCHASE OPTION. 3. THE LEASE TERM IS EQUAL TO 75% OR MORE OF THE ESTIMATED ECONOMIC LIFE OF THE LEASED PROPERTY. 4. THE PRESENT VALUE OF THE MINIMUM LEASE PAYMENTS (EXCLUDING EXCUTORY COSTS) EQUALS OR EXCEEDS 90% OF THE FAIR VALUE OF THE LEASED PROPERTY. GROUP II THE LEASE AGREEMENT MUST MEET BOTH OF THE FOLLOWING CRITERIA: 1. COLLECTIBILITY OF THE PAYMENTS REQUIRED FROM THE LESSEE IS REASONABLY PREDICTABLE. 2. NO IMPORTANT UNCERTAINTIES SURROUND THE AMOUNT OF UNREIMBURSABLE COSTS YET TO BE INCURRED BY THE LESSOR UNDER THE LEASE AND THE LESSOR'S PERFORMANCE IS SUBSTANTIALLY COMPLETE OR FUTURE COSTS ARE REASONABLY PREDICTABLE. 157

7 ILLUSTRATION 22-5 LESSOR SALES-TYPE LEASE LESSEE CAPITAL LEASE EXAMPLE On January 1, 1998, Velde Company (lessee) entered into a four-year, noncancellable contract to lease a computer from Exceptional Computer Company (lessor). Annual rentals of $17,208 are to be paid each January 1, Velde will assume responsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $40,000 and had an estimated fair value of $60,000, a useful life of four years and no residual value. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor. Capitalization Criteria Lessee Lessor Group 1: Criteria #1 Criteria #1 Criteria #2 Criteria #2 Criteria #3 Criteria #3 Criteria #4 Criteria #4 Present value Group II: Criteria #1 Criteria #2 Sales-type lease because cost of computer is less than fair value. Dealer profit of $20,000. Annual rental $17, = $60,000 F.V. $ 60,000 = $17,208 (Table 6-5) $68,

8 ILLUSTRATION 22-5 (continued) January 1, 1998 Leased Computer 60,000 Receivable 68,832 Capital Leases 60,000 Cost of goods sold 40,000 Inventory 40,000 Unearned Interest Income 8,832 Sales Revenue 60,000 Capital Leases 17,208 Cash 17,208 Cash 17,208 Receivable 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 1998 Interest Expense 4,279 Unearned Interest Interest Payable 4,279 Income 4,279 Interest Income 4,279 January 1, 1999 Interest Payable 4,279 Cash 17,208 Capital Leases 12,929 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 1999 Interest Expense 2,986 Unearned Interest Interest Payable 2,986 Income 2,986 Interest Income 2,

9 ILLUSTRATION 22-5 (concluded) January 1, 2000 Interest Payable 2,986 Cash 17,208 Capital Leases 14,222 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 December 31, 2000 Interest Expense 1,567 Unearned Interest Interest Payable 1,567 Income 1,567 Interest Income 1,567 January 1, 2001 Interest Payable 1,567 Cash 17,208 Capital Leases 15,641 Receivable 17,208 Cash 17,208 Depreciation Expense 15,000 Depreciation 15,000 Depreciation 60,000 Leased Computer 60,000 December 31,

10 ILLUSTRATION 22-6 FLOWCHART FOR LESSORS Is real estate involved? Are C1, C2, C3 or C4 and C5 met?* Is equipment involved? Allocate lease payments to: real estate equipment Are only part of the facilities involved? Are both cost and fair value determinable? Are C1 or C2 and C5 met? Is land fair value <25% of total? Allocate lease payments to: buildings land Are C3 or C4 and C5 met? Operating lease Is there a manufacturer's or Sales-type dealer's profit?** lease *C1: Transfer of ownership C2: Bargain purchase option C3: 75% of economic life C4: 90% of fair value Direct financing C5: Collectibility predictable lease **Sales-leaseback transactions may and no important uncertainties not be classified as sales-type leases Source: William A. Collins, "Accounting for Leases Flowcharts," Journal of Accountancy, September

11 ILLUSTRATION 22-7 RESIDUAL VALUE GUARANTEED LESSEE CAPITAL LEASE LESSOR DIRECT FINANCING LEASE EXAMPLE On January 1, 1998, Velde Company (lessee) entered into a four-year, noncancellable contract to lease a computer from Exceptional Computer Company (lessor). Annual rentals of $16,228 are to be paid each January 1, Velde will assume responsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $60,000 and had an estimated useful life of four years and a $5,000 residual value. Velde has guaranteed the lessor a residual value of $5,000. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setling annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor. Capitalization Criteria Lessee Lessor Group 1: Criteria #1 Criteria #1 Criteria #2 Criteria #2 Criteria #3 Criteria #3 Criteria #4 Criteria #4 Group II: Criteria #1 Criteria #2 Direct financing lease because cost of computer = fair value. Annual rental Cost $60,000 Present value T6-2 3,415 (Present value/residual) $16, = $56,585 $56,585 = $16,228 (Rent) (Table 6-5) T $5, = 3,415 64,912 (Table 6-2) $60,000 Residual value 5,000 $69,

12 ILLUSTRATION 22-7 (continued) January 1, 1998 Leased Computer 60,000 Receivable 69,912 Capital Leases 60,000 Unearned Interest Income 9,912 Computer 60,000 Cash 16,228 Capital Leases 16,228 Cash 16,228 Receivable 16,228 Depreciation Expense 13,750 Depreciation 13,750 December 31, 1998 Interest Expense 4,377 Unearned Interest Interest Payable 4,377 Income 4,377 Interest Income 4,377 January 1, 1999 Interest Payable 4,377 Cash 16,228 Capital Leases 11,851 Receivable 16,228 Cash 16,228 Depreciation Expense 13,750 Depreciation 13,750 December 31, 1999 Interest Expense 3,192 Unearned Interest Interest Payable 3,192 Income 3,192 Interest Income 3,192 January 1, 2000 Interest Payable 3,192 Cash 16,228 Capital Leases 13,036 Receivable 16,228 Cash 16,

13 ILLUSTRATION 22-7 (continued) Depreciation Expense 13,750 Depreciation 13,750 December 31, 2000 Interest Expense 1,889 Unearned Interest Interest Payable 1,889 Income 1,889 Interest Income 1,889 January 1, 2001 Interest Payable 1,889 Cash 16,228 Capital Leases 14,339 Receivable 16,228 Cash 16,228 Depreciation Expense 13,750 Depreciation 13,750 December 31, 2001 Interest Expense 454 Unearned Interest Obligations Income 454 Capital Lease 4,546 Interest Income 454 Depreciation 55,000 Computer 5,000 Leased Computer 60,000 Receivable 5,

14 ILLUSTRATION 22-7 (concluded) Lease Amortization Schedules Annual (10%) Reduction of Lease Date Lease Payment Interest Obligation Obligation Jan. 1, 1998 $60,000 Jan. 1, 1998 $16,228 $ 0 $16,228 43,772 Jan. 1, ,228 4,377 11,851 31,921 Jan. 1, ,228 3,192 13,036 18,885 Jan. 1, ,228 1,889 14,339 4,546 Dec. 31, , * 4,546 0 Annual (10%) Investment Net Date Lease Payment Interest Recovery Investment Jan. 1, 1998 $60,000 Jan. 1, 1998 $16,228 $ 0 $16,228 43,772 Jan. 1, ,228 4,377 11,851 31,921 Jan. 1, ,228 3,192 13,036 18,885 Jan. 1, ,228 1,889 14,339 4,546 Dec. 31, , * 4,546 0 *Adjusted for rounding. 165

15 ILLUSTRATION 22-8 RESIDUAL VALUE UNGUARANTEED LESSEE CAPITAL LEASE LESSOR DIRECT FINANCING LEASE EXAMPLE On January 1, 1998, Velde Company (lessee) entered into a four-year, noncancellable contract to lease a computer from Exceptional Computer Company (lessor). Annual rentals of $16,228 are to be paid each January 1, Velde will assume responsibility for all normal ownership costs, and at the end of the lease period the computer will be returned to Exceptional Computer Company. The cost of the computer to Exceptional Computer Company was $60,000 and had an estimated useful life of four years and a $5,000 residual value. Velde has an incremental borrowing rate of 12% but has knowledge that Exceptional Computer Company used a rate 10% in setting annual rentals. Collection of the rentals is reasonably predictable and there are no important uncertainties regarding future unreimbursable costs to be incurred by the lessor. Capitalization Criteria Lessee Lessor Group 1: Criteria #1 Criteria #1 Criteria #2 Criteria #2 Criteria #3 Criteria #3 Criteria #4 Criteria #4 Group II: Criteria #1 Criteria #2 Direct financing lease because cost of computer = fair value. Annual rental $16, = $56,585 Cost $60,000 (Table 6-5) T6-2 3,415 (Present value/residual) $56,595 = $16,228 (Rent) T ,912 Residual value 5,000 $69,

16 ILLUSTRATION 22-8 (continued) January 1, 1998 Leased Computer 56,585 Receivable 69,912 Capital Leases 56,585 Unearned Interest Income 9,912 Computer 60,000 Cash 16,228 Capital Leases 16,228 Cash 16,228 Receivable 16,228 Depreciation Expense 14,146 Depreciation 14,146 December 31, 1998 Interest Expense 4,036 Unearned Interest Interest Payable 4,036 Income 4,377 Interest Income 4,377 January 1, 1999 Interest Payable 4,036 Cash 16,228 Capital Leases 12,192 Receivable 16,228 Cash 16,228 Depreciation Expense 14,146 Depreciation 14,146 December 31, 1999 Interest Expense 2,817 Unearned Interest Interest Payable 2,817 Income 3,192 Interest Income 3,192 January 1, 2000 Interest Payable 2,817 Cash 16,228 Capital Leases 13,411 Receivable 16,228 Cash 16,

17 ILLUSTRATION 22-8 (continued) January 1, 1998 Leased Computer 56,585 Receivable 69,912 Capital Leases 56,585 Unearned Interest Income 9,912 Computer 60,000 Cash 16,228 Capital Leases 16,228 Cash 16,228 Receivable 16,228 Depreciation Expense 14,146 Depreciation 14,146 December 31, 1998 Interest Expense 4,036 Unearned Interest Interest Payable 4,036 Income 4,377 Interest Income 4,377 January 1, 1999 Interest Payable 4,036 Cash 16,228 Capital Leases 12,192 Receivable 16,228 Cash 16,228 Depreciation Expense 14,146 Depreciation 14,146 December 31, 1999 Interest Expense 2,817 Unearned Interest Interest Payable 2,817 Income 3,192 Interest Income 3,192 January 1, 2000 Interest Payable 2,817 Cash 16,228 Capital Leases 13,411 Receivable 16,228 Cash 16,

18 ILLUSTRATION 22-8 (continued) Depreciation Expense 14,146 Depreciation 14,146 December 31, 2000 Interest Expense 1,474 Unearned Interest Interest Payable 1,474 Income 1,889 Interest Income 1,889 January 1, 2001 Interest Payable 1,474 Cash 16,228 Capital Leases 14,754 Receivable 16,228 Cash 16,228 December 31, 2001 Depreciation Expense 14,147 Unearned Interest Income 454 Depreciation 14,147 Interest Income 454 Computer 5,000 Depreciation 56,585 Leased Computer 56,585 Receivable 5,

19 ILLUSTRATION 22-8 (concluded) Lease Amortization Schedules Annual (10%) Reduction of Lease Date Lease Payment Interest Obligation Obligation Jan. 1, 1998 $56,585 Jan. 1, 1998 $16,228 $ 0 $16,228 40,357 Jan. 1, ,228 4,036 12,192 28,165 Jan. 1, ,228 2,817 13,411 14,754 Jan. 1, ,228 1,474* 14,754 0 Annual (10%) Investment Net Date Lease Payment Interest Recovery Investment Jan. 1, 1998 $60,000 Jan. 1, 1998 $16,228 $ 0 $16,228 43,772 Jan. 1, ,228 4,377 11,851 31,921 Jan. 1, ,228 3,192 13,036 18,885 Jan. 1, ,228 1,889 14,339 4,546 Dec. 31, , * 4,546 0 *Adjusted for rounding. 169

20 ILLUSTRATION 22-9 TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES Lessor Lessee Operating Direct financing and Sales Type Operating Capital Initial Direct Costs Capitalize and amortize Direct financing: N/A N/A over lease term in Record in separate account proportion to rent Add to net investment in lease revenue recognized Compute new effective rate that equates (normally S.L. basis) gross amt. of min. lease payments and unguar. residual value with net invest. Amortize so as to produce constant rate of return over lease term Sales-type: Expense in period incurred Bargain Purchases N/A Include in: N/A Include in: Option Minimum lease payments Minimum lease payments 90% test 90% test Guaranteed N/A Include in: N/A Include in: Residual value Minimum lease payments Minimum lease payments 90% test 90% test Sales-type: Include PV in sales revenues Unguaranteed N/A Include in: N/A t included in: Residual value "Gross Investment in Lease" Minimum lease payments t included in: 90% test 90% test Sales-type: Exclude from sales revenue Deduct PV from cost of sales Contingent Rentals Revenue in period t a part of minimum lease payments, revenue Expense is period t part of minimum lease payments: in period earned incurred expense in period incurred Deprec. (Amort.) Amortize down to N/A N/A b Amortize down to estimated residual value Period estimated residual over lease term or estimated economic value over estimated life economic life of asset a Revenue Rent revenue (normally Direct financing: c Rent expense Interest Expense and Depreciation (Expense) S.L. basis) Interest revenue on net investment in lease (normally S.L. (Amortization) Expense (gross investment less unearned interest basis) income) Depreciation expense Sales-type: Dealer profit in period of sale (sales revenue less cost of leased asset) Interest revenue on net investment in lease a Elements of revenue (expense) listed for the above items are not repeated here (e.g., treatment of initial direct costs) b If lease has automatic passage of title or bargain purchase option, use estimated economic life; otherwise, use the lease term. c If payments are not on a S.L. basis, recognize rent expense on a S.L. basis unless another systematic and rational method is more representative of use benefit obtained from the property, in which case, the other method should be used. Source: Adapted from Delaney, CPA Examination Review,

21 ILLUSTRATION DISCLOSURES FOR LESSEES (a) For capital leases: (b) For operating leases having initial or i. The gross amount of assets at each remaining noncancellable lease terms in balance sheet date categorized by excess of one year: nature or function. This information i. Future minimum rental payments may be combined with comparable required as of the latest balance sheet information for owned assets. date, in the aggregate and for each of ii. Future minimum lease payments as the five succeeding fiscal years. of the latest balance sheet date, in ii. Total minimum rentals to be received in the aggregate and for each of five the future under noncancellable subleases succeeding fiscal years. Separate as of the latest balance sheet date. deductions for executory costs (c) For all operating leases, rental expense for included in the minimum lease each period with separate amounts for payments and for the amount of minimum rentals, contingent rentals, and imputed interest necessary to reduce sublease rentals. Rental payments under net minimum lease payments to leases with terms of a month or less that present value. were not renewed need not be included. iii. Total noncancellable minimum sublease (d) A general description of the lessee's rentals to be received in the future, as arrangements including, but not limited to: of the latest balance sheet date. i. The basis on which contingent rental iv. Total contingent rentals. payments are determined. v. Assets recorded under capital leases ii. The existence and terms of renewal or and the accumulated amortization purchase options and escalation thereon shall be separately identified in clauses. the lessee's balance sheet or notes. iii. Restrictions imposed by lease Likewise, related obligations shall be agreements, such as those concerning separately identified as obligations dividends, additional debt, and further under capital leases. Depreciation on leasing. capitalized leased assets should be separately disclosed. 171

22 ILLUSTRATION DISCLOSURES FOR LESSORS (a) For Sales-type and direct financing leases: (b) For operating leases: i. The components of the net investment i. The cost and carrying amount, if in sales-type and direct financing leases different, of leased property according as of each balance sheet date: to nature or function, and total amount a. Future minimum lease payments to of accumulated depreciation. be received, with separate deductions ii. Minimum future rentals on noncancellable for (i) executory costs and (ii) the leases as of the latest balance sheet accumulated allowance for date, in aggregate and for each of five uncollectible minimum lease succeeding fiscal years. payments receivable. iii. Total contingent rentals included in b. The unguaranteed residual values income for each period for which an accruing to the lessor. income statement is presented. c. Unearned revenue. (c) A general description of the lessor's ii. Future minimum lease payments to be leasing arrangements. received for each of the five succeeding fiscal years. iii. The amount of unearned revenue included in income to offset initial direct costs charged against income for each period for which an income statement is presented. (For direct financing leases only.) iv. Total contingent rentals included in income for each period for which an income statement is presented. 172

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