Leases Learning Objectives. Overview of Leasing. Advantages of Leasing

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1 Leases Learning Objectives 1. Describe the characteristics and advantages of leases 2. Operating leases vs Captial leases 3. Determine rental payments 4. Account for operating leases - lessee 5. Account for capital leases lessee 6. Cash flow effects lessee 7. Types of leases for lessors: Direct financing, Sales type and operating 1 Overview of Leasing Lessee acquires the right to use the property Lease An agreement that secures the right to use property, plant, or equipment for a stated period of time in exchange for rent or some other form of compensation Lessor conveys the right to use the property 2 Advantages of Leasing Flexibility Financing Benefits Reduction of Risk Lease can be structured to meet the needs of the lessor and the lessee May allow for 100% financing, financing at a fixed rate, financing at a lower rate than loans Lessee can reduce the risk of obsolete equipment Financial Statements Lessee can avoid presentation of lease on balance sheet in certain situations 3 1

2 Provisions of a Lease A lease agreement typically includes: Term of the lease Asset disposition at end of lease (asset may revert to lessor or may transfer to lessee) Bargain purchase option (allows lessor the right to purchase asset at end of term) Residual value of the asset (estimated FMV may be guaranteed or unguaranteed) Executory costs (identifies who is responsible for insurance, maintenance, taxes, etc. on the asset) Timing of payments (ordinary annuity or annuity due) 4 Two Types of Leases for the Lessee Operating Lease: The lessee does not assume the risks and rewards of ownership. Thus, the asset and the related obligation are not recorded on the lessee s balance sheet. Capital Lease: The lessee does assume most of the risks and rewards of ownership and records the asset and related liability on the balance sheet. Interest and depreciation are reflected on the income statement. 5 Capital Leases To be considered a capital lease, the lease must be noncancelable and must meet one or more of the following criteria: 1. Lease transfers ownership of property to lessee at the end of lease term 2. Lease contains a bargain purchase option 3. Lease term is equal to 75 percent or more of the estimated economic life of the leased asset 4. Present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the FMV of the leased asset 6 2

3 Calculate the Present Value of the Minimum Lease Payments First, choose an appropriate interest rate: The incremental borrowing rate should be used unless (a) the lessee knows the implicit rate of the lease, and (b) the implicit rate is less than the incremental borrowing rate. 7 Calculate the Present Value of the Minimum Lease Payments Incremental borrowing rate the rate that, at the inception of the lease, the lessee would have incurred to borrow a similar amount of money to purchase the leased asset Implicit borrowing rate the rate that, when applied to the minimum lease payments, causes the total present value at the inception of the lease to be equal to the FMV of the asset at that time 8 Minimum Lease Payments Minimum lease payments are the payments that the lessee is obligated to make or can be required to make in connection with the leased asset. They include: Rental payments annual rental payments defined in the lease contract Bargain purchase option If the lessee is allowed to purchase the asset at the end of the lease term, the bargain purchase option amount is included as a minimum rental payment. Guaranteed residual value Any guarantee of resididual value by the lessee is include as a minimum rental payment 9 3

4 Characteristics of Operating and Capital Leases Risks and rewards of ownership Lease criteria Balance sheet impact Income statement impact Operating Lease Retained by lessor Does not meet any of the four lease criteria Leased asset and obligation do not appear on lessee s balance sheet Lease payments treated as expense Capital Lease Transferred to the lessee Meets one or more of the four lease criteria Leased asset and obligation appear on the lessee s balance sheet Lessee incurs interest and depreciation expense 10 Calculation of Lease Payments Rutowski Co. leases an asset from Gable Co. for five years, making annual payments at the end of each lease year. The asset has a FMV at lease inception of $500,000 and will have a residual value of $40,000 at the end of the lease. Gable Co. wishes to achieve a 10 percent return on the leased asset. Calculate annual rental payments 11 Accounting for an Operating Lease as the Lessee Lessee does not obtain substantially all of the rights of ownership of an asset Lessee treats the lease payments as rental payments as follows: Lease Expense (or Rent Expense) Cash xxx xxx 12 4

5 Capital or Operating Lease term 10 yrs Useful life of asset 15 yrs Annual rental payment, due at beg. $100,000 FMV of asset at beg. of lease $800,000 Incremental borrowing rate 12% Implicit borrowing rate 10% Asset reverts to lessor at lease end Residual value of asset, not guaranteed $321, Capital or Operating Criterion 1: Does title pass? No Criterion 2: Is there a bargain purchase option? No Criterion 3: Is the lease term equal to or greater than 75 percent of the asset s life? 10 years 15 years = 66.67% No Criterion 4: Is the present value of the minimum lease payments equal to or greater than 90 percent of the asset s FMV? $675,900 $800,000 = 84.5% No This lease does not meet any of the four criteria; thus it should be classified as an operating lease. 14 Operating Lease Disclosures Though the leased asset and related obligation do not appear on the lessee s balance sheet, the following must be disclosed if the operating lease initial term exceeds one year. 1. Future minimum rental payments at balance sheet date, in total and for five following years 2. Total of minimum rental payments to be received in the future under subleases at balance sheet date 3. Rent expense, with minimum rentals, contingent rentals, and sublease rentals detailed 4. General description of lease arrangements 15 5

6 Leasehold Improvements A lessee may add to or improve a leased asset in its possession Are these improvements considered an asset to the lessee even if the lease is an operating lease? Yes, leasehold improvements are considered assets and are reported in the property, plant, and equipment category of the balance sheet, less accumulated depreciation or amortization. Leasehold improvements should be depreciated over the term of the lease or life of the improvement, whichever is shorter. 16 Accounting for a Capital Lease - Lessee If lease meets at least one of the four lease criteria, the lessee treats it as a capital lease. Leased Asset* xxx Lease Obligation xxx *Asset is capitalized at the total present value of the minimum lease payments, not to exceed the FMV of the asset at lease inception. To depreciate the asset: If asset reverts to the lessor at end of lease, depreciate the asset over the term of the lease. If the lessee keeps the asset, depreciate over the useful life of the asset. 17 Capital Lease Presentation on the Balance Sheet An asset under a capital lease is presented in the lessee s balance sheet in the property, plant, and equipment category, net of accumulated depreciation. The associated lease obligation is presented as a liability, allocated between its current and long-term portions. 18 6

7 Capital Lease Verde Co. will lease equipment from Huskie Leasing. The lease begins on 1/1/05 and lasts 10 years. The useful life of the equipment is 15 years. Verde will pay annual payments at the beginning of each year, including $5,000 for executory costs, of $105,000. The FMV of the equipment was $675,902. The incremental borrowing rate is 12% and the implicit borrowing rate is 10%. Title passes to Verde at the end of the lease. Capital or Operating Lease? Record the lease 19 Capital Lease To record the first lease payment: 1/1/05 Executory Expense 5,000 Lease Obligation 100,000 Cash 105,000 To record depreciation on the leased asset: 12/31/05 Depreciation Expense 45,060 Accumulated Depr. Leased Equip. 45,060 $675, years To accrue interest: 12/31/05 Interest Expense 57,590 Interest Payable 57,590 Based on amortization schedule 20 Cash Flow: Operating Leases Versus Capital Leases Operating Leases Cash outflows are reported as operating activities on the statement of cash flows Capital Leases Depreciation is added back to net income in the operating activities section. The principal amount of rental payment is disclosed as a financing activity. Significant noncash transactions (like a capital lease agreement) must be presented as a supplemental disclosure in the statement of cash flows. 21 7

8 FedEx Off-Balance-Sheet Leases A summary of future minimum lease payments under capital leases and noncancelable operating leases (principally aircraft, retail locations, and facilities) with an initial or remaining term in excess of one year at May 31, 2004, is as follows (in millions): Capital Operating Leases Leases 2005 $ 160 $ 1, , , , ,169 Thereafter 225 7,820 $ 639 $15,016 Less amount representing interest 105 Present value of net minimum lease payments $ 534 Do not appear on balance sheet 22 Accounting for Leases as a Lessor Operating Lease: Leased assets appear on the lessor s balance sheet like any other asset Direct Financing Lease: Form of capital lease in which the lessor transfers the risk and rewards of ownership to the lessee and serves as the financing agent Sales-Type Lease: Form of capital lease in which the lessor is considered to be both selling an asset to the lessee and serving as the financing agent 23 Capital Lease Criteria - Lessors Type 1 Criteria: Lease transfers ownership of property to lessee at lease end Lease contains a bargain purchase option Lease term is equal to 75 percent or more of the estimated economic life of the leased asset Present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the FMV of the leased asset Type 2 Criteria: Collectibility of minimum lease payments is reasonably predictable No important uncertainties surrounding the unreimbursable costs yet to be incurred by the lessor 24 8

9 Characteristics of the Operating Lease for the Lessor Risks and rewards of ownership Lease criteria Retained by the lessor Does not meet any of Type 1 criteria and/or Type 2 criteria Balance sheet impact Income statement impact Leased asset appears on lessor s balance sheet Lease payments are treated as income 25 Characteristics of the Direct Financing Lease for the Lessor Risks and rewards of ownership Lease criteria Balance sheet impact Income statement impact Transferred to the lessee Meets one or more of Type 1 criteria and both of Type 2 criteria Lease Receivable and Unearned Interest Income appear on lessor s balance sheet Interest portion of payments treated as income 26 Characteristics of the Sales-Type Lease for the Lessor Risks and rewards of ownership Lease criteria Balance sheet impact Income statement impact Transferred to the lessee Meets one or more of Type 1 criteria and both of Type 2 criteria Lease Receivable and Unearned Interest Income appear on lessor s balance sheet Gross profit is recorded in the year of sale. Interest income is recorded over life of lease. 27 9

10 Accounting for an Operating Lease as the Lessor Lessor treats the lease payments as rental payments, considered income per the accrual basis of accounting Cash Rent Revenue (or Lease Revenue) xxx xxx Initial direct costs are directly associated with negotiating and signing the lease. For an operating lease, these costs are deferred and amortized over the life of the lease in proportion to recognition of income. 28 Accounting for a Direct Financing Lease as the Lessor When the lessor is a bank, leasing company, or financial firm that is operating only as a financing agent, the lease is a direct financing lease. The lessor will use the effective interest method to recognize a portion of each payment as income over the life of the lease. 29 Direct Financing Lease Binkert Co. has leased an asset to Kearney Co. The lease begins on 1/1/05 and lasts 5 years. The useful life of the asset is 6 years. Kearney will pay annual payments at the end of each year of $140,046. The FMV of the asset at lease inception is $600,000. The implicit rate of interest is 8%. Title passes to Binkert at the end of the lease and there is a guaranteed residual value of $60,000. Collectibility of the lease payments is reasonably predictable, and there are no important uncertainties about the agreement. Because Binkert is not a manufacturer, and at least one Type 1 criteria and both of the Type 2 criteria have been met, the lease is classified as a direct financing lease

11 Direct Financing Lease Binkert will remove the asset from its books and recognize a Lease Receivable for the gross investment (sum of the minimum lease payments, excluding executory costs, plus any unguaranteed residual value). Lease Receivable [($140,046 x 5) + $60,000] 760,230 Asset 600,000 Unearned Interest Income 160,230 Continue 31 Direct Financing Lease At the time of the first payment (12/31/05), Binkert will also record the lease s unearned interest income the difference between the gross investment and the PV of the minimum lease payments plus the PV of the unguaranteed residual value of the asset. Cash 140,046 Lease Receivable 140,046 Unearned Interest Income 48,000 Interest Income 48, Direct Financing Lease on the Balance Sheet Binkert will report the net investment, which is the balance of the Lease Receivable account less the balance of the Unearned Interest Income account, on the balance sheet. The portion that is a current amount is presented in the current asset category, and the remainder is presented in the long-term asset category

12 Direct Financing Lease At the end of the lease, the asset reverts to Binkert Co. with a guaranteed residual value. If the asset has a value of $60,000, as guaranteed, Binkert records the following: Asset 60,000 Lease Receivable 60, Direct Financing Lease If the asset has a value of only $45,000, Kearney Co. must pay the difference in cash and Binkert will record the following: Asset 45,000 Cash 15,000 Lease Receivable 60, Accounting for a Sales-Type Lease as the Lessor When the lessor of a capital lease is a manufacturer or dealer in the asset, the lease is considered a sales-type lease. The lessor of a sales-type lease must recognize two distinct forms of income: a) gross profit on the sale of the asset b) interest on the financing of the transaction 36 12

13 Sales-Type Lease Tooltime Co. is a dealer in heavy construction equipment. Urso agrees to lease equipment from Tooltime with a start date of 1/1/05 and a term of 5 years. The useful life of the asset is 6 years. Urso will pay annual payments at the end of each year of $140,046. The FMV of the asset at lease inception is $600,000. The cost of the asset to Tooltime was $500,000. The implicit rate of interest is 8%. Title reverts to Tooltime at the end of the lease and there is a guaranteed residual value of $60,000. Collectibility of the lease payments is reasonably predictable, and there are no important uncertainties about the agreement. 37 Sales-Type Lease Tooltime is a dealer and will realize gross profit on the transaction ($600,000 - $500,000) as well as the cost of the equipment from its inventory. Lease Receivable [($140,046 x 5) + $60,000] 760,230 Sales 600,000 Unearned Interest Income 160,230 Cost of Goods Sold 500,000 Inventory 500,000 Continue 38 Sales-Type Lease Tooltime would develop an amortization schedule for the lease using the effective interest method. At the time of the first payment, the company would record the following entries: Cash 140,046 Lease Receivable 140,046 Unearned Interest Income 48,000 Interest Income 48,