Interest Expense Principal

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1 ACCOUNTING BY THE LESSOR AND LESSEE A lease is a contract between a lessor (the owner of the property) and a lessee (the user of the property). Normally the lessee makes periodic payments in exchange for the use of the property. The lease term can be for any period of time that is acceptable to both parties. The periodic payments are called rental payments. The obligation for taxes, insurance and maintenance is specified in the lease contract. Capital Leases vs. Installment Notes In the previous chapter we discussed installment notes which are used to purchase equipment and real property. In the example, Spencer Company purchase real estate by paying $50,000 down and arranging a 15-year, 8% mortgage (installment note) for the remaining $200,000. A capitalized lease operates in similar manner. Example: Spencer Company leases a piece of equipment for five years. The lease meets the criteria for capitalization. The minimum lease payments are $2,107 per month for five years. The implicit interest rate is 10% per annum. The following is an amortization schedule for the first calendar year. Date Cash Paid Interest Expense Principal Carrying Value 4/1/03 100,000 4/1/03 2, ,107 97,893 5/1/03 2, ,291 96,602 6/1/03 2, ,302 95,300 7/1/03 2, ,313 93,987 8/1/03 2, ,324 92,663 9/1/03 2, ,335 91,328 10/1/03 2, ,346 89,982 11/1/03 2, ,357 88,625 12/1/03 2, ,368 87,257 Note that the first payment and the origination of the lease are on the same day. Normally a lease requires that the lessee make one or more lease payments on the signing of the lease and transfer of the property. Because this is a capitalized lease instead of an installment purchase the journal entry to record the transaction would be as follows: Leased equipment 100,000 Lease payable 100,000 To record the acquisition of equipment under a capitalized lease. The payment made at the signing of the lease would be recorded as follows: F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 1

2 Lease payable 2,107 Cash 2,107 To record the first payment on April 1, 2003 The payment made on May 1, 2003 would be recorded in the same manner as a payment on an installment note. Lease payable 1,291 Interest expense 816 Cash 2,107 To record the second payment on May 1, 2003 Conceptual Nature of a Lease There are a variety of arguments for expensing lease payments as they are made. There are also good arguments for capitalizing leased property as if it were purchased and recording a corresponding debt obligation. The FASB has developed a set of standards that specify if and when a lease transaction must be capitalized. If the lease transfers substantially all of the benefits and risks of ownership of the property the FASB requires that the lease be capitalized. Capital Leases Leases are accounted for in one of two ways. If the lease contract is noncancelable and transfers substantially all of the benefits and risks of ownership to the lessee the lease is capitalized. If the lease does not meet these criteria it is accounted for as an operating lease. In a capitalized lease the lessee records the leased property as an asset and the lease obligation as a liability. The amounts are measured based on the present value of the future rental payments. The lessor records the lease as a sale recording the present value of the future rental payments as the selling price and recognizing the costs of the property in the income statement. There are very specific criteria that must be met for a lease to qualify as a capital lease. The lease must be noncancelable and 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 executory costs) equals or exceeds 90% of the fair value of the leased property Minimum lease payments include the following: 1. Rental payments (excluding executory costs) 2. Bargain purchase option (if any) 3. Guaranteed residual value (if any) 4. Penalty for failure to renew (if any) F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 2

3 In calculating 90% of the fair value the lessee uses the lesser of: 1. The lessee s incremental borrowing rate, or 2. If known the implicit interest rated computed by the lessor EXERCISE: Spencer Company leased equipment from Capital Leasing Company. The lease term is 5 years and requires equal rental payments of $30,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, and estimated useful life of 8 years, and no residual value. Spencer Company pays all executory costs directly to third parties. Capital Leasing Company set the annual rental to earn a rate of return of 10%, and this fact is known to Spencer Company. The lease does not transfer title or contain a bargain purchase option. Review the criteria for capitalization and determine if Spencer Company should capitalize this lease. Respond to each of the criteria listed below: 1. Does the lease transfer ownership of the property to the lessee? Response: Solution: No, there is no provision for the transfer of ownership. 2. Does the lease contain a bargain purchase option? Response: Solution: No, there is no bargain purchase option. 3. Is the term of the lease equal to 75% or more of the economic life of the leased property? Response: Solution: No, the term of the lease is not equal to or greater than 75% of the economic life of the property. 5 Years 8 Years = 62.5% < 75% F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 3

4 4. Does the present value of the minimum lease payments (excluding executory costs) equal or exceed 90% of the fair value of the leased property? Response: Solution: Yes, the present value of the minimum lease payments exceeds 90% of the fair value of the property. PV of minimum lease payments Annuity Factor PV 30,000 * = 125,096 Analysis of factor: PVOA, n=5, i=10% plus 10% PVAD, n=5, i=10% % of the FV FV 90% Amount 138,000 * 90% = 124,200 PV 90% FV 125,096 > 124,200 Additional Lessor Conditions for Classification as a Capitalized Lease From the lessor s perspective there are two additional conditions that must be met in order for the lessor to classify the lease as a capital lease. 1. Collectibility of the payments required from the lessee is reasonably predictable 2. No important uncertainties surround the amount of unreimbursed costs yet to be incurred by the lessor under the lease Asset and Liability Accounts If the lease qualifies as a capital lease the lessee records an asset and liability at the lower of: 1. the present value of the minimum lease payments (excluding executory costs) or 2. the fair market value of the leased asset at the inception of the lease Depreciation Depreciation is recorded on the leased property based on the depreciation policies of the lessee company. If the lease transfers ownership or contains a bargain purchase option the depreciation is allocated over the useful economic life of the leased asset. If the lease does not contain one of these two provisions depreciation is allocated over the term of the lease. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 4

5 The effective interest method is used to allocate between the interest and principal. OPERATING LEASES From the lessee s perspective If the above lease did not meet the criteria for capitalization it would be considered an operating lease. Operating leases are recorded as current expenses as the lease obligation is incurred. The following would be the journal entry for the initial lease payment under operating lease accounting. Property tax expense 1,000 Rent expense 24,000 To record the signing and initial payment on the lease on January 1, 2000 From the lessor s perspective If the lease is classified as an operating lease, the rental payments are record as rental revenue in the periods earned and the underlying property is depreciated in the normal manner based on the lessor s accounting policies. The leased property and accumulated depreciation are reported separately on the lessor s balance sheet. Example: Using the information provided above, if the lease does not qualify as a capitalized lease then Spencer Leasing Company will treat the lease as an operating lease. Under these circumstances the journal entries to record the receipt of rental payments and the annual depreciation on the leased equipment would be recorded as follows. Rental revenue 25,000 To record receipt of rental payment Depreciation expense-leased equipment 10,000 Accumulated depreciation-leased equipment 10,000 To record depreciation expense on leased equipment CAPITALIZED LEASES From the Lessee s Perspective Spencer Company entered into a lease agreement on January 1, 2000, to lease equipment for 10 years. The lease terms require that Spencer Company pay the lessor $25,000 per year including executory costs of $1,000. The first payment is due at the signing of the lease. The useful economic life of the asset is 10 years and there will be no residual value at the end of the lease. Spencer Company can borrow money at the rate of 14% per annum. The lease is designed to F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 5

6 give the lessor a 12% return, which is known to the lessee. The first step is to calculate the present value of the future minimum lease payments. Present value of minimum lease payments: Minimum lease payment 24,000 PVAD, n=10, i=12% Present value 151,878 The executory costs are removed to give us the net lease payment. Using Excel we can calculate the present value of the 10 lease payments. Remember this is an annuity due so the first payment does not include any interest. Using a 12% discount rate, which is the lesser of the lessee s incremental borrowing rate or the implicit interest rate computed by the lessor is know by the lessee, the present value of the minimum lease payments is $151,878. This is the amount that we will capitalize as an asset and liability at the inception of the lease. The journal entry to capitalize this lease is presented below: Leased equipment under capital lease 151,878 Obligations under capital lease 151,878 To record the capital lease of equipment The next step is to prepare a lease amortization schedule so that we will have the appropriate information to record each of the annual payments. LEASE EXECUTORY NET LEASE DATE PAYMENT COSTS LEASE INTEREST PRINCIPLE OBLIGATION 1/1/00 151,878 1/1/00 25,000 1,000 24, , ,878 1/1/01 25,000 1,000 24,000 15,345 8, ,223 1/1/02 25,000 1,000 24,000 14,307 9, ,530 1/1/03 25,000 1,000 24,000 13,144 10,856 98,674 1/1/04 25,000 1,000 24,000 11,841 12,159 86,515 1/1/05 25,000 1,000 24,000 10,382 13,618 72,896 1/1/06 25,000 1,000 24,000 8,748 15,252 57,644 1/1/07 25,000 1,000 24,000 6,917 17,083 40,561 1/1/08 25,000 1,000 24,000 4,867 19,133 21,429 1/1/09 25,000 1,000 24,000 2,571 21,429 0 If we assume that the executory costs are for property taxes then the first journal entry to record the signing of the lease and the payment made on January 1, 2000 is as follows. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 6

7 Property tax expense 1,000 Obligations under capital lease 24,000 To record the signing and initial payment on the lease On December 31, 2000 a journal entry need to be prepared to record the depreciation expense for the first year of use, and the accrued interest on the obligation that will be paid on the first day to the next year. This journal entry is as follows: Interest expense 15,345 Depreciation expense-capital leases 15,188 Interest payable 15,345 Accumulated depreciation-capital leases 15,188 To accrue interest on the lease obligation and record depreciation expense for the first year On January 1, 2001 we record the actual second payment as follows: Property tax expense 1,000 Interest payable 15,345 Obligations under capital leases 8,655 To record the second payment on January 1, 2001 Again, on December 31, 2001 we will need to record depreciation for the second year and accrue the interest associated with the payment that will be made on the following January. The December 31, 2001 journal entry is as follows: Interest expense 14,307 Depreciation expense-capital leases 15,188 Interest payable 14,307 Accumulated depreciation-capital leases 15,188 To accrue interest on the lease obligation and record depreciation expense for the second year At the end of the lease we will assume that Spencer Company returns the used equipment to the lessor. The journal entry to record this final transaction is as follows: Accumulated depreciation-capital leases 151,878 Leased equipment under capital leases 151,878 To record the return of leased equipment on expiration of the lease From the Lessor s Perspective Leasing is another form of financing. Many manufactures provide leases for high ticket items in order to stimulate the sale of their products. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 7

8 Economics of Leasing In order to lease as opposed to selling products manufacturers must earn a return on the lease above and beyond the profit on the sale of the product. The rate of return that the lessor must earn is called the implicit rate. CLASSIFICATION OF LEASES BY THE LESSOR Depending on the circumstances, from the lessor s perspective a capital lease may be accounted for in one of two ways. 1. Direct financing lease 2. Sales-type lease If at the inception of the lease the lease meets one or more of Group I criteria and both of the Group II criteria the lease will be classified as either a direct financing lease or a sales-type lease. The capitalization criteria for a lessor are as follows: Group I 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 executory costs) equals or exceeds 90% of the fair value of the leased property Group II 3. Collectibility of the payments required from the lessee is reasonably predictable 4. No important uncertainties surround the amount of unreimbursed costs yet to be incurred by the lessor under the lease Direct Financing Method Direct financing leases are those that are arranged through banks or other financial institutions. The lessor is a financing organization and not the manufacturer. The financial institution is providing the resources so that the lessee can acquire the property. The form of financing is a lease as opposed to a debt instrument secured by the property. There are three pieces of information necessary to record a direct financing lease. 1. Lease Payments Receivable (Gross Investment) The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term is recorded as an asset in the general ledger. The lease payments receivable include: 1. Rental payments (less executory costs paid by the lessor) 2. Bargain purchase options, if any 3. Guaranteed or unguaranteed residual value, if any 4. Penalty for failure to renew, if any 2. Unearned Interest Revenue F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 8

9 The fair market value of the property (normally the cost of the item to the lessor) less the lease payments receivable. 3. Cost of the Inventory of Equipment to the Lessor (Net Investment) The lessor s cost of the item is credited to the inventory account at the time the direct financing lease is executed. Example: Spencer Leasing Company enters into a contract to lease equipment to Alexander Company. The equipment is purchased from Sophie Company for $151,878. Assume that the lease meets the criteria for capitalization. As the lessor Spencer Leasing Company is providing the financing for Alexander Company and therefore this will be accounted for as a direct financing lease. The same facts and circumstances will be used to demonstrate the recording of the lease transactions. The first transaction that must be recorded is the purchase of the equipment by Spencer Leasing Company. The company will purchase and lease (sell) the equipment in simultaneous transactions. Equipment 151,878 Cash 151,878 To record the purchase of equipement to be leased The present value of the minimum lease payments should equal the fair market value at the inception of the lease (the cost to the lessor). Annual lease payment $25,000 Executory costs 1,000 Net lease payment 24,000 Interest rate 12% Present value $151,878 FV of equipment $151,878 To analyze the information that we will need to book this lease transaction and the periodic payment the following amortization schedule is provided. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/2006 9

10 ANNUAL LEASE EXECUTORY NET LEASE DATE PAYMENT COSTS LEASE INTEREST PRINCIPLE OBLIGATION 1/1/00 151,878 1/1/00 25,000 1,000 24, , ,878 1/1/01 25,000 1,000 24,000 15,345 8, ,223 1/1/02 25,000 1,000 24,000 14,307 9, ,530 1/1/03 25,000 1,000 24,000 13,144 10,856 98,674 1/1/04 25,000 1,000 24,000 11,841 12,159 86,515 1/1/05 25,000 1,000 24,000 10,382 13,618 72,896 1/1/06 25,000 1,000 24,000 8,748 15,252 57,644 1/1/07 25,000 1,000 24,000 6,917 17,083 40,561 1/1/08 25,000 1,000 24,000 4,867 19,133 21,429 1/1/09 25,000 1,000 24,000 2,571 21, ,000 10, ,000 88, ,878 The lease payments receivable include all payments less executory costs for the duration of the lease. In this example, the lease payments receivable will be $240,000. The unearned interest revenue is the difference between the lease payments receivable and the fair market value of the property at the inception of the lease. In this example, the unearned interest is $88,122 ($240,000 - $151,878). At the signing of the lease, on January 1, 2000, we will need to book the lease payments receivable, remove the equipment from the lessor s books and record the unearned interest revenue. The following journal reflects this transaction for this example. Lease payments receivable 240,000 Equipment 151,878 Unearned interest revenue 88,122 To record the capitalization of a financing lease with Alexander Company The first lease payment is recorded at the signing of the lease so there is no interest associated with this payment. The following is the journal entry to record the signing of the lease and receipt of the payment on January 1, Lease payments receivable 24,000 Property tax payable 1,000 To record the signing and initial payment on the lease At December 31, 2000 the company will accrue the interest earned on the lease contract as follows: F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/

11 Unearned interest revenue 15,345 Interest revenue 15,345 To accrue interest earned through December 31, 2000 To record the second payment we will need to record the receipt of the payment. The amortization of unearned interest was already recorded in the above journal entry on December 31, The journal entry would be recorded as follows: Lease payments receivable 24,000 Property tax payable 1,000 To record the payment received on January 1, 2001 At December 31, 2001 the company will again accrue the interest earned during the year on the lease contract as follows: Unearned interest revenue 14,307 Interest revenue 14,307 To accrue interest earned through December 31, 2001 Sales-Type Leases In a sales-type lease there is a manufacturer s or dealer s gross profit or loss. There are four pieces of information necessary to record a sales-type lease. 1. Lease Payments Receivable (Gross Investment) The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term are recorded as an asset at the inception of the lease. 2. Unearned Interest Revenue The gross investment less the fair market value of the asset. 3. Sales Price of the Asset The present value of the minimum lease payments. 4. Cost of Goods Sold The cost of the asset to the lessor, less the present value of any unguaranteed residual value. Example: Spencer Manufacturing Company sells and leases equipment to pet supply distributors. Assume the same facts and circumstances as in the above two examples except that it cost Spencer Manufacturing Company $110,000 to manufacture the equipment that is going to be leased to Alexander Company. We will assume that Alexander Company has guaranteed a residual value at the end of the lease is $5,000. Under this scenario the selling price of the equipment has changed. The following provides a calculation of the selling price of the equipment. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/

12 Annual lease payment 25,000 Executory costs 1,000 Net lease payment 24,000 Interest rate 12% Present value 151,878 Guaranteed residual 5,000 Interest rate 12% Present value 1,610 Selling price 153,488 With the guaranteed residual the net present value of the entire package is now $153,488. We can now calculate the rest of the components of the sale-type lease agreement. The following provides this analysis. The gross investment includes the ten annual payments and the guaranteed residual. Lease Payments Receivable Minimum lease payments 24,000 Number of periods 10 Lease payments receivable 240,000 Guaranteed residual 5,000 Lease payments receivable 245,000 The unearned interest revenue is equal to the gross investment less the present value of the minimum lease payments and the present value of the guaranteed residual. Unearned Interest Revenue Gross investment 245,000 Present value of minimum lease payments (151,878) Present value of guaranteed residual (1,610) Unearned interest revenue 91,512 The sales price is the present value of the minimum lease payments plus the present value of the guaranteed residual. Sales Price of Equipment Present value of minimum lease payments 151,878 Present value of guaranteed residual 1,610 Sales price 153,488 The cost of goods sold was given in the question. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/

13 Cost of Goods Sold 110,000 The gross profit is the sales price less the cost of goods sold. Gross Profit Sales price 153,488 Cost of goods sold 110,000 Gross profit 43,488 To better visualize the transactions in this sales-type of lease the following is an amortization schedule prepared for Spencer Leasing Company. ANNUAL LEASE EXECUTORY NET LEASE DATE PAYMENT COSTS LEASE INTEREST PRINCIPAL OBLIGATION 1/1/00 153,488 1/1/00 25,000 1,000 24, , ,488 1/1/01 25,000 1,000 24,000 15,539 8, ,027 1/1/02 25,000 1,000 24,000 14,523 9, ,550 1/1/03 25,000 1,000 24,000 13,386 10, ,936 1/1/04 25,000 1,000 24,000 12,112 11,888 89,048 1/1/05 25,000 1,000 24,000 10,686 13,314 75,734 1/1/06 25,000 1,000 24,000 9,088 14,912 60,822 1/1/07 25,000 1,000 24,000 7,299 16,701 44,120 1/1/08 25,000 1,000 24,000 5,294 18,706 25,415 1/1/09 25,000 1,000 24,000 3,050 20,950 4,465 12/31/09 5,000 5, , ,000 10, ,000 91, ,488 With the above computations complete we can now prepare the journal entries to record the lease transactions. The first journal entry is to record the sales-type lease at inception. Cost of goods sold 110,000 Lease payments receivable 245,000 Sales revenue 153,488 Unearned interest revenue 91,512 Inventory 110,000 To record the signing of a sales-type lease on January 1, 2000 Along with the signing of the lease the lessee makes the first payment. The following journal records the receipt of the first lease payment. F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/

14 Lease payments receivable 24,000 Property tax payable 1,000 To record the payment received on January 1, 2001 On December 31, 2000 the company will prepare the following journal entry to record the interest earned in 2000 on the lease contract. Unearned interest revenue 15,539 Interest revenue 15,539 To accrue interest earned through December 31, 2000 On January 1, 2001 Spencer Leasing Company will receive the second lease payment. This transaction should be recorded as follows. Lease payments receivable 1,000 Property tax payable 24,000 To record the payment received on January 1, 2001 At the end of the term of the lease, on December 31, 2009, Alexander Company will return the equipment and pay the amount necessary to honor the guarantee. If we assume that on December 31, 2009 the fair market value of the equipment is $1,000 then Alexander Company will return the equipment and pay Spencer Leasing Company the difference between the fair market value of the equipment and the guarantee of $5,000. In this case the cash payment will be $4,000. Inventory 25,000 Cash 1,000 Lease payments receivable 24,000 To record the return of the equipment and payment of the guarantee F:\course\ACCT3322\200720\module2\c15\tnotes\c15a.doc 12/11/

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