Part 1: Leases. Introduction. Financial Accounting 3 Lesson summary 1 1. Financial Accounting: Liabilities & Equities. Module 5

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1 Financial Accounting: Liabilities & Equities Module 5 Audio lecture presented by: Barbara M. Wyntjes, B.Sc., CGA FA3 Module 5 1 Part 1: Leases FA3 Module 5 2 Introduction Substance of contract Classification of capital or operating lease Accounting Advantages and disadvantages Disclosure FA3 Module 5 3 Financial Accounting 3 Lesson summary 1 1

2 Lease The conveyance, by a lessor to a lessee, of the rights to use a tangible asset usually for a specified period of time in return for rent The lease specifies the terms under which the lessee has the right to use the owner's property and the compensation to be paid to the lessor in exchange FA3 Module 5 4 Why Lease A short-term lease is used to obtain temporary use of an asset without having to buy it Examples - car lease or office rental FA3 Module 5 5 Operating Lease A short-term lease that provides the lessee with temporary use of an asset A simple rental agreement. Accounting: Lessee records a rent expense Lessor records rent revenue (or other income if not usual business) FA3 Module 5 6 Financial Accounting 3 Lesson summary 1 2

3 Operating Lease Initial direct costs are deferred and amortized over the initial lease term in proportion to the lease revenue. Uneven payments initial lump sum Demand > Supply Amortize over the life of the term FA3 Module 5 7 Operating Lease Example: PMT= $80,000/yr, 5 years. Down $100,000/5 = $20,000/yr. Rent expense = $100,000/yr Rent expense 100,000 Deferred charge 20,000 Cash 80,000 FA3 Module 5 8 Operating Lease Uneven payments Supply > Demand Deferred credit amortize over tern Forgiven payments = 1 st year. FA3 Module 5 9 Financial Accounting 3 Lesson summary 1 3

4 Operating Lease Example: Page 1031 in text: PMT= $100,000/yr, 5 years. Total $400,000 (100,000x4) / 5 = $80,000/yr. Rent expense = $80,000/yr and deferred credit until start to pay. Rent expense 80,000 Deferred rent liab. 20,000 Cash 100,000 FA3 Module 5 10 Operating Lease Balance Sheet: Lessee nothing Lessor Asset with accumulated amortization Income Statement: Lessee expense Lessor revenue, maintenance, insurance and amortization expense FA3 Module 5 11 Operating Lease - Disclosure Lessee: disclose in the notes to the financial statements Company s obligation for operating lease payment for each of the next five years. If no obligation after one year, do not need to disclosure Cash flow statement under operating activates FA3 Module 5 12 Financial Accounting 3 Lesson summary 1 4

5 Capital Lease The risks and rewards of ownership pass to the lessee. Lease agreements in substance, is a purchase/sale of an asset and a corresponding obligation/lease receivable. FA3 Module 5 13 Capital Lease The lessor takes the asset off its books and replaces it with a loan receivable. The lessee records both an asset and a liability and records amortization (as if own). FA3 Module 5 14 Capital Lease Criteria A lease should be assumed to transfer substantially all of the risks and benefits of ownership to the lessee when at least one of the following is present at the inception: 1. Lessee will obtain ownership of the leased property at the end of lease term FA3 Module 5 15 Financial Accounting 3 Lesson summary 1 5

6 Capital Lease Criteria 1. Lessee will obtain ownership of the leased property at the end of lease term automatic transfer of title to the lessee at the end of the lease if the lessee is entitled to exercise a bargain purchase option FA3 Module 5 16 Capital Lease Criteria 2. The lessee will receive substantially all of the economic benefits through use of the leased property since assets are most productive in the earlier years of their lives, this condition is presumed to be satisfied if the lease term is at least 75% of the asset s economic life FA3 Module 5 17 Capital Lease Criteria 3. The lessor will be assured of recovering the investment in the leased property, plus a return on the investment, over the lease term this condition is presumed to be satisfied if the present value of the minimum net lease payments is equal to at least 90% of the fair value of the asset at the inception of the lease FA3 Module 5 18 Financial Accounting 3 Lesson summary 1 6

7 Capital Lease Criteria for Lessee A lease is a capital lease if it meets one of the following conditions: 1. Title passes to lessee by end of lease or there is a bargain purchase option. 2. The lease covers 75% or more of the life of the asset. 3. The present value of the lease payments is 90% or more of the fair value of the asset at inception of the lease. FA3 Module 5 19 Capital Lease Criteria for Lessor One of the three previous criteria has been met, plus: there must be an acceptable/normal credit risk associated with the lease payments AND no unreimbursable or unestimatable costs. FA3 Module 5 20 Capital Lease Criteria for Lessor It is a direct financing lease if the lessor is a financing company It is a sales type lease if the lessor is a manufacturer/trader. FA3 Module 5 21 Financial Accounting 3 Lesson summary 1 7

8 Bargain Purchase Option There is a stated or determinable price given in the lease Sufficiently lower than the expected fair value of leased asset at the option s exercise date Likely that the lessee will exercise the option FA3 Module 5 22 Lease Term All terms prior to the exercise date of the bargain purchase option All bargain renewal terms All renewal terms at the option of the lessor FA3 Module 5 23 Bargain Renewal term Periods for which the lessee has the option of extending the lease at lease payments that are substantially less than would normally be expected for an asset of that age and type FA3 Module 5 24 Financial Accounting 3 Lesson summary 1 8

9 Minimum Lease Term Minimum lease term includes bargain renewal terms, terms prior to the exercisability of a bargain purchase option, and renewal terms at the lessor s option FA3 Module 5 25 Minimum Net Lease Payments MLPs = all payments that the lessee pays to the lessor over the lease term: Total periodic rental payments plus only one of the following: bargain purchase option or a guaranteed residual (FMV at end) or penalty payment It does NOT include executory costs (insurance or maintenance costs) FA3 Module 5 26 Terms Incremental borrowing rate (IBR): the interest rate that the lessee would have to pay if they obtained financing through the bank (or other sources) to buy the asset Implicit lease interest rate: the interest rate that discounts the minimum net lease payments to equal the fair market value of the leased property at the beginning of the lease (IRR) FA3 Module 5 27 Financial Accounting 3 Lesson summary 1 9

10 Discounting rate Lessee The lower of the incremental borrowing rate and the implicit lease interest rate (if known by the lessee), is used in the present value calculations FA3 Module 5 28 Discounting rate Lessee Lower rate, higher present value, higher capitalization Leased asset should never be recorded higher than its fair value FA3 Module 5 29 Discounting rate Lessor Always use the interest rate implicit in the lease for discounting the net lease payments Lessor determines the amount of the lease payment to cover their costs. FA3 Module 5 30 Financial Accounting 3 Lesson summary 1 10

11 Accounting - Lessee A leased asset and a long-term lease liability are recognized at the PV of MLPs Amortize (as if owned) asset over lease term (includes bargain renewal terms) and subtract any guaranteed residual Exception if BPO or title transfers (over useful life and subtract any salvage) Over useful life if shorter than lease term FA3 Module 5 31 Accounting - Lessee Straight-line: cost guaranteed residual value that is the responsibility of the lessee over the lease term Straight-line: cost salvage over useful life Amortization schedule 5 years (include BPO) FA3 Module 5 32 Accounting - Lessee Blended payments = equal payment include both interest and principal A lease obligation is increased by interest each period and reduced by payments made If the lease year does not equal the fiscal year, interest will have to be accrued for a part year (Dr interest expense and Cr lease liability). FA3 Module 5 33 Financial Accounting 3 Lesson summary 1 11

12 Accounting - Lessee If lease payments are paid at the end of the fiscal year, the current portion of the liability is only the principal portion of the next rent payment. If payments are made at the beginning of the period, the current portion is the entire next payment, both principal and interest. FA3 Module 5 34 Financial Statement - Lessee Balance Sheet: A leased asset (less accumulated amortization) and a lease liability Current portion (principal and/or any accrued interest) Income Statement: Amortization expense Interest expense FA3 Module 5 35 Disclosure Capital: Lessee The lessee does not have the same rights of ownership (sell, modify, use as collateral) Any major restriction on the leased asset Financial statement disclosure for the lessee includes segregating assets under capital lease from other assets and disclosing accumulated amortization. FA3 Module 5 36 Financial Accounting 3 Lesson summary 1 12

13 Disclosure Capital: Lessee Notes include amortization policy, terms of the liability, interest rate and expiry dates and a five-year cash flow schedule (Minimum lease payments for the next five years). FA3 Module 5 37 Disclosure Capital Lease Cash Flow Statement: Initial recognition of a leased asset is a non-cash transaction Financing outflow: payment of the liability Operating outflow: interest expense If the indirect method is used, amortization is added back to net income FA3 Module 5 38 Part 2: Assignment A17-1 Req d 1 See Chapter 17, page 1080 And handout 1, page 1 FA3 Module 5 39 Financial Accounting 3 Lesson summary 1 13

14 Assignment A17-1 Req d 2 See Chapter 17, page 1080 And handout 1, page 1 FA3 Module 5 40 Assignment A17-1 Req d 3 See Chapter 17, page 1080 And handout 1, page 1 FA3 Module 5 41 Assignment A17-1 Req d 4 See Chapter 17, page 1080 And handout 1, page 1 FA3 Module 5 42 Financial Accounting 3 Lesson summary 1 14

15 Part 3: Assignment A17-3 Lease 1 See Chapter 17, pages And handout 1, page 2 FA3 Module 5 43 Assignment A17-3 Lease 2 See Chapter 17, pages And handout 1, page 2 FA3 Module 5 44 Assignment A17-3 Lease 3 See Chapter 17, pages And handout 1, page 2 FA3 Module 5 45 Financial Accounting 3 Lesson summary 1 15

16 Part 4: Assignment A17-7 Req d 1 See Chapter 17, pages And handout 1, page 3 FA3 Module 5 46 Assignment A17-7 Req d 2 See Chapter 17, pages And handout 1, page 3 FA3 Module 5 47 Assignment A17-7 Req d 3 See Chapter 17, pages And handout 1, page 3 FA3 Module 5 48 Financial Accounting 3 Lesson summary 1 16

17 Assignment A17-7 Req d 4 See Chapter 17, pages And handout 1, page 3 FA3 Module 5 49 Assignment A17-7 Req d 5 See Chapter 17, pages And handout 1, page 3 FA3 Module 5 50 Part 5: FA3 Module 5 51 Financial Accounting 3 Lesson summary 1 17

18 Accounting - Lessor FA3 (as stated in module notes) not responsible for journal entries for the lessor but responsible to be able to discuss classification and impact on financial statements Group 1 criteria FA3 Module 5 52 Accounting - Lessor If capital lease: direct financing or sales-type lease? FMV = PV of annual rental payments plus PV of one of the followings: BPO or residual value (guaranteed or unguaranteed) or failure to renew penalty FA3 Module 5 53 Direct Financing Lessor purchase asset at fair market value and leased out immediately. At inception: Record lease receivable = gross or net Remove leased asset off books Create unearned financial revenue account contra to lease rec. (gross) Initial direct costs (commission) are netted with unearned finance revenue FA3 Module 5 54 Financial Accounting 3 Lesson summary 1 18

19 Direct Financing Annual recording: Record finance income and DR unearned finance revenue (Gross method) Record finance income and DR lease receivable (net method) Lessee s payment, CR lease rec. Executory costs as period costs Only 1 source of income: interest revenue FA3 Module 5 55 Sales-Type Sales-Type lessor buys or manufacture in order to make a profit by selling it At inception record: Lease receivable = gross value Sales amount (FMV) Unearned interest revenue (liability) Cost of goods sold = cost of asset Remove lease asset from books (inventory) Expense direct costs FA3 Module 5 56 Sales-Type Annual recording: Record finance income and DR unearned finance revenue Lessee s payment, CR lease rec. Executory costs as period costs 2 sources of income: at inception - gross profit (FMV CGS) and interest/finance revenue over lease term FA3 Module 5 57 Financial Accounting 3 Lesson summary 1 19

20 Financial Statement - Lessor Balance Sheet: Net receivable = gross lease receivable less unearned interest revenue Income Statement: Finance revenue Executory costs (maintenance, insurance) For a sales-type lease, cost of sales and sales revenue Disclosure (company policy for recognizing the revenue) FA3 Module 5 58 Advantages of long-term Leases Off-Balance Sheet Financing: no reporting of lease obligation or assets (favorable ratios) FA3 Module 5 59 Advantages of long-term Leases 100% Financing Flexibility upgrade Protection from interest rate fluctuations (fixed rate) FA3 Module 5 60 Financial Accounting 3 Lesson summary 1 20

21 Tax Advantages - Lessor Tax advantages: must qualify as a lessor under the income tax regulations Nature of lessor Derive at least 90% of its revenues from lease transactions 3 criteria do not have to be met FA3 Module 5 61 Disadvantages Higher costs Shorter lease term Accelerated lease payments Flexibility Interest rates decrease FA3 Module 5 62 Sale and Leaseback A company simultaneously sells and leases back their asset The asset is thereby converted from an owned asset to a leased asset Immediate cash flow to the seller, which can be used to retire debt or used for operating purposes FA3 Module 5 63 Financial Accounting 3 Lesson summary 1 21

22 Sale and Leaseback The sale portion of the deal is initially recorded just like any other sale, with a gain (deferred) or loss (immediately) recorded for the difference between the net proceeds from the sale and the asset s net book value FA3 Module 5 64 Sale and Leaseback If capital lease, recognize the deferred gain by CR amortization expense Exception: Land CR revenue FA3 Module 5 65 Text Example See pages 1050 to 1052 FA3 Module 5 66 Financial Accounting 3 Lesson summary 1 22

23 Part 6: Assignment A17-13 Req d 1 See Chapter 17, pages And handout 1, page 4 FA3 Module 5 67 Assignment A17-13 Req d 2 See Chapter 17, pages And handout 1, page 4 FA3 Module 5 68 Class example 1 And handout 1, page 5 FA3 Module 5 69 Financial Accounting 3 Lesson summary 1 23

24 Part 7: Past Exam Questions: See Module 5 Handout 2 FA3 Module 5 70 A Blueprint: 8-12% Multiple Choice and long answer (journal entries) FA3 Module 5 71 Question 5a See Module 5 Handout 2 FA3 Module 5 72 Financial Accounting 3 Lesson summary 1 24

25 Question 5b See Module 5 Handout 2 FA3 Module 5 73 Question 5c See Module 5 Handout 2 FA3 Module 5 74 Question 7a See Module 5 Handout 2 FA3 Module 5 75 Financial Accounting 3 Lesson summary 1 25

26 Question 7b See Module 5 Handout 2 FA3 Module 5 76 Multiple Choice i See Module 5 Handout 2 FA3 Module 5 77 Multiple Choice j See Module 5 Handout 2 FA3 Module 5 78 Financial Accounting 3 Lesson summary 1 26

27 Try the questions Journal entries Calculations FA3 Module 5 79 End of presentation FA3 Module 5 80 Financial Accounting 3 Lesson summary 1 27