CAPITAL OR OPERATING LEASE? LEASE CAPITAL OR OPERATING LEASE? LESSEE CRITERIA #1

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1 LEASE Contractual agreement between a lessor and a lessee that conveys to the lessee the right to use specific property owned by the lessor for a specified period of time. CAPITAL OR OPERATING LEASE? Substance over form: leases that transfer substantially all benefits and risks of property ownership should be capitalized. CAPITAL OR OPERATING LEASE? iteria for lessee: 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. LESSEE CRITERIA #1 The lease transfers ownership of the property to the lessee. ACC 301, Spring 2001 Chapter 22 Lecture Notes, Page 1

2 LESSEE CRITERIA #2 LESSEE CRITERIA #3 The lease contains a bargain purchase option.» The lessee can purchase the leased property for a price that is significantly lower than the property s expected fair value at the date the option becomes exercisable.» Difference must be large enough to make exercise of the option reasonably assured. The lease term is equal to 75% or more of the estimated economic life of the leased property.» Note: Economic life test is not applicable if the inception of the lease occurs during the last 25% of the life of the asset. LEASE TERM The fixed, noncancelable term of the lease. Can be extended beyond the original lease term for leases which have:» Bargain renewal option» Substantial penalties for nonrenewal» Periods for which the lessor has the option to renew or extend the lease» Periods where any lessee guarantees of the lessors debt are expected to be in effect or in which there will be a loan outstanding from the lessee to the lessor LESSEE CRITERIA #4 The present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property. ACC 301, Spring 2001 Chapter 22 Lecture Notes, Page 2

3 MINIMUM LEASE PAYMENTS EXECUTORY COSTS Includes:» Minimum Rental Payments» Guaranteed Residual Value» Penalty for Failure to Renew or Extend the Lease» Bargain Purchase Option Insurance, maintenance, taxes If the lessor retains responsibility for these a portion of each lease payment that represents executory costs should be excluded in computing the PV of minimum lease payments. DISCOUNT RATE DISCOUNT RATE Lessee:» Lessee s incremental borrowing rate OR» If lessee knows lessor s implicit rate and it is less than the lessee s incremental borrowing rate, use lessor s implicit rate. Lessor s implicit rate:» The rate at which the PV of minimum lease payments and any unguaranteed residual value equals the fair value of the leased property. ACC 301, Spring 2001 Chapter 22 Lecture Notes, Page 3

4 Record leased asset and a liability at the lower of:» PV of minimum lease payments OR» FMV of the leased asset at the inception of the lease. Leased Asset Under Capital Lease Obligation Under Capital Lease To record leased asset. Obligation Under Capital Lease Interest Expense Cash To record lease payments. Depreciation Expense Accumulated Depreciation To record depreciation on leased asset. Depreciation» Estimated Useful Life (EUL) Does lease transfer ownership of asset to the lessee or contain a bargain purchase option? Yes, depreciate using economic life of asset. No, depreciate using lease term.» Residual Value Use estimated residual value if guaranteed. Calculation of Interest Expense:» Use effective interest method Lease Obligation X interest rate» Interest rate If FMV PV of the minimum lease payments, use interest rate used to compute PV If FMV < PV of the minimum lease payments, compute new rate to use in interest computations ACC 301, Spring 2001 Chapter 22 Lecture Notes, Page 4

5 CAPITAL OR OPERATING LEASE? iteria for Lessor 1 of 4 criteria (same as lessee criteria) and both of the following:» Collectibility of the payments from the lessee is reasonably predictable.» No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. CAPITAL LEASE: LESSOR Gross Investment (Lease Payments Receivable) Minimum Lease Payments + URV Unearned Interest Revenue Gross Investment - FMV of the Asset CAPITAL LEASES: LESSOR LESSOR: SALES-TYPE LEASE Direct Financing Lease FMV of Asset = Cost (Carrying Value) Sales-Type Lease FMV of Asset Cost (Carrying Value) Sales Price» PV of minimum lease payments Cost of Goods Sold» Cost of asset to lessor (or carrying value) MINUS PV of any unguaranteed residual value ACC 301, Spring 2001 Chapter 22 Lecture Notes, Page 5

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