CHAPTER 15
Leases |||||||||||||||||||||||||||||||||||||||||
/// PREFACE
The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This reading is based on their joint Exposure Draft of the new leases standard.
This is a draft of only a portion of the Leases chapter as it would appear assuming the Exposure Draft is adopted intact, which is not at all a certainty. This incomplete draft does not include many of the features and assignment materials that the new chapter will contain. It is intended only to give you a basis for lease coverage while we await the outcome of the standard‐setting process.
/// OVERVIEW
In the previous chapter, we saw how companies account for their long‐term debt. The focus of that discussion was bonds and notes. In this chapter we continue our discussion of debt, but we now turn our attention to liabilities arising in connection with leases. Leases produce liabilities for the lessees’ obligations to pay for the right of use for the assets being leased. On the other side of the transaction, lessors assume a performance obligation to allow the asset to be used, unless all significant risks and benefits are transferred in which case derecognition of the asset is appropriate.
LEARNING OBJECTIVES After studying this chapter, you should be able to:
● LO1 Describe and demonstrate the lessee’s right‐of‐use approach to accounting for a lease. (p. xxx)
● LO2 Describe and demonstrate how the lessor accounts for a lease by the performance obligation approach and when that approach is appropriate. (p. xxx)
● LO3 Describe and demonstrate how the lessor accounts for a lease using the derecognition approach and when that approach is appropriate. (p. xxx)
● LO4 Explain the circumstance that indicates that the lessor should record a residual asset and how the asset should be measured. (p. xxx)
● LO5 Explain the impact on lease accounting of initial direct costs. (p. xxx)
● LO6 Describe and demonstrate the short‐cut method for accounting for leases and explain when its use is appropriate. (p. xxx)
● LO7 Explain how to determine the lease term when the agreement contains renewal or termination options. (p. xxx)
● LO8 Describe and demonstrate the expected outcome technique when dealing with uncertain lease payments. (p. xxx)
● LO9 Explain the impact on lease accounting of a guaranteed residual value. (p. xxx)
● LO10 Describe the ways leases are reported in financial statements and lease disclosure requirements. (p. xxx)
● LO11 Explain sale‐leaseback agreements and their accounting treatment. (p. xxx)
FINANCIAL REPORTING CASE It’s a Hit! “Don’t get too comfortable with those big numbers,” said Aaron Sanchez, controller for your new
employer. “It’s likely our revenues will take a hit over the next couple of years as more of our customers lease our machines rather than buy them.” You’ve just finished your first look at Higher Graphics’ third quarter
earnings report. Like most companies in your industry, HG leases its labeling machines to some customers and sells them to others. Eager to understand the implications of your new supervisor’s concerns, you search the Internet for guidance.
By the time you finish this chapter, you should be able to respond appropriately to the questions posed in this case. Compare your response to the solution provided at the end of the chapter.
QUESTIONS ///How would HG’s revenues “take a hit” as a result of more customers leasing rather than buying labeling machines? (page xxx) Under what lease accounting approach would the “hit” not occur? (page xxx)
CHAPTER 15 Leases 3
LEASE FUNDAMENTALS If you ever have leased an apartment, you know that a lease is a contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset for a specified period of time. In return for this right, the lessee agrees to make stipulated, periodic cash payments during the term of the lease. Businesses, too, lease assets under similar arrangements. The right to use the leased property can be a significant asset. Likewise, the obligation to make the lease payments can be a significant liability. Appropriately, the lessee reports both the right‐of‐use asset and the liability in the balance sheet.
On the other side of the transaction, the lessor reports a receivable for the lease payments it will receive and, depending on whether it retains or transfers the risks and benefits associated with the leased asset, either (a) a liability for the obligation to allow the lessee to use the asset or (b) sales revenue. If sales revenue is recorded, the lessor also removes from its records (derecognizes) the asset transferred, with an accompanying debit to cost of sales. Before we look at the possibilities in more detail, Graphic 15–1 provides a quick overview.
Lessee Lessor Right-of-use approach Performance obligation approach
Derecognition approach
Short-cut method Short-cut method
We see an expanded overview in Graphic 15–2 indicating when it’s appropriate to use each approach, what to record when the approach is used, and how to measure the amounts recorded.
Part A An apartment lease is a common leasing arrangement.
GRAPHIC 15–1 Basic Lease Accounting Methods
4 SECTION 3 Financial Instruments and Liabilities When to Use What to Record How to Measure Lessee: Right of Use Approach
All leases, unless short‐cut method is allowed.
Record: • Right‐of‐ use asset representing the right to use the asset
• Lease liability for obligation to pay for the asset’s use
• Asset: Recent value of expected payments plus initial direct costs if any
• Liability: Present value of expected payments
Short‐Cut Method
Maximum lease term is 12 Months or less
Same as above
Option to: • Measure asset and liability at total of payments rather than their present value
Lessor: Performance Obligation Approach
Lessor retains exposure to significant risks or benefits associated with the asset during or after the lease term.
Record: • Receivable representing the right to receive payments
• Performance obligation to permit lessee to use the asset
• Asset: Present value of expected payments plus initial direct costs if any
• Liability: Present value of expected payments
Derecognition Approach
Lessor does not retain exposure to significant risks or benefits associated with the asset.
• A receivable and sales revenue
• Derecognize asset and record cost of goods sold.
• Asset: Present value of expected payments
• COGS: Carrying value of the asset (or portion transferred)
Short‐Cut Method
Maximum lease term is 12 Months or less
Option to: Record no entry at commencement of lease
If option is elected: • Record no receivable or performance obligation
• Recognize lease payments as income
Note: If the contract transfers: (a) control of the underlying asset and (b) all but a trivial amount of the risks and benefits associated with the asset, the transaction is not a lease and is recorded as a purchase/sale by both parties to the transaction.
After looking at some of the possible advantages of companies leasing assets
rather than buying them in certain circumstances, we will explore differences in leases further.
DECISION MAKERS’ PERSPECTIVE—ADVANTAGES OF LEASING When a young entrepreneur started a computer training center a few years ago, she had no idea how fast her business would grow. She knew she needed computers, but she didn’t know how many. Just starting out, she also had little cash with which to buy them. The mutual funds department of a large investment firm often needs new
computers and peripherals—fast. The department manager knows he can’t afford to wait up to a year, which is the time it sometimes takes to go through company channels to obtain purchase approval.
GRAPHIC 15–2 Lease Accounting Overview
• LO1
CHAPTER 15 Leases 5 An established computer software publisher recently began developing a new
line of business software. The senior programmer has to be certain he’s testing the company’s products on the latest versions of computer hardware. And yet he views large expenditures on equipment subject to rapid technological change and obsolescence as risky business. Each of these individuals is faced with different predicaments and concerns. The
entrepreneur is faced with uncertainty and cash flow problems, the department manager with time constraints and bureaucratic control systems, the programmer with fear of obsolescence. Though their specific concerns differ, these individuals have all met their firms’ information technology needs with the same solution: each has decided to lease the computers rather than buy them. Computers are by no means the only assets obtained through leasing
arrangements. To the contrary, leasing has grown to be the most popular method of external financing of corporate assets in America. The airplane in which you last flew probably was leased, as was the gate from which it departed. Your favorite retail outlet at the local shopping mall likely leases the space it operates. Many companies actually exist for the sole purpose of acquiring assets and leasing them to others. And, leasing often is a primary method of “selling” a firm’s products. IBM and Boeing are familiar examples. In light of its popularity, you may be surprised that leasing usually is more
expensive than buying. Of course, the higher apparent cost of leasing is because the lessor usually shoulders at least some of the financial and risk burdens that a purchaser normally would assume. So, why the popularity? The lease decisions described above are motivated by operational incentives.
Lessees are willing to pay extra to shift some financial and risk burden to lessors. But tax and market considerations also motivate firms to lease. Sometimes leasing offers tax saving advantages over outright purchases. For instance, a company with little or no taxable income—maybe a business just getting started, or one experiencing an economic downturn—will get little benefit from depreciation deductions. But the company can benefit indirectly by leasing assets rather than buying. By allowing the lessor to retain ownership and thus benefit from depreciation deductions, the lessee often can negotiate lower lease payments. Lessees with sufficient taxable income to take advantage of the depreciation deductions, but still in lower tax brackets than lessors, also can achieve similar indirect tax benefits.
The U.S. Navy once leased a fleet of tankers to avoid asking Congress for appropriations.
Leasing can facilitate asset acquisition.
The number one method of external financing by U.S. businesses is leasing.
Tax incentives often motivate leasing.
Operational, tax, and financial market incentives often make leasing an attractive alternative to purchasing.
6 SECTION 3 Financial Instruments and Liabilities Leases and Installment Notes Compared
You learned in the previous chapter how to account for an installment note. To a great extent, then, you already have learned how to account for a lease. To illustrate, let’s recall the situation described in the previous chapter. We assumed that Skill Graphics purchased a package‐labeling machine from Hughes–Barker Corporation by issuing a three‐year installment note that required six semiannual installment payments of $139,857 each. That arrangement provided for the purchase of the $666,633 machine as well as interest at an annual rate of 14% (7% twice each year). Remember, too, that each installment payment consisted of part interest (7% times the outstanding balance) and part payment for the machine (the remainder of each payment). Now let’s suppose that Skill Graphics instead acquired use of the package‐
labeling machine from Hughes–Barker Corporation under a three‐year lease that required six semiannual lease payments of $139,857 each. Obviously, the fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. So, it would be inconsistent to account for this lease in a fundamentally different way than for an installment purchase:
At Commencement (January 1) Installment Note Machinery ................................................................... 666,633 Note payable ........................................................... 666,633
Lease Right‐of‐use asset ....................................................... 666,633 Lease liability ........................................................... 666,633
Skill Graphics did not acquire ownership of the asset in this lease but did acquire
the right to use the asset for the duration of the lease, which in this case also is the useful life of the asset. The fact that the lease term is the same as the useful life does not affect the way we account for the lease. By entering this lease arrangement Skill Graphics has acquired something of value, an asset, which is the right to use the asset. We call this a Right‐of‐use asset. At the same time, the company has assumed an obligation to pay for the asset’s use and accordingly records a liability for the present value of the payments it’s obligated to make.
Comparison of a Note and Lease As in an installment purchase, the right to use an asset is acquired in exchange for the obligation to pay for that right.
CHAPTER 15 Leases 7 Consistent with the nature of the transaction, interest expense accrues each
period at the effective rate times the outstanding balance:
At the First Semiannual Payment Date (June 30) Installment Note Interest expense (7% × $666,633) ................................. 46,664 Note payable (difference) ............................................. 93,193 Cash (installment payment) ........................................ 139,857 Lease Interest expense (7% × $666,633) ................................. 46,664 Lease liability (difference) ............................................. 93,193 Cash (lease payment) ................................................. 139,857
Because the lease liability balance declines with each payment, the amount of
interest declines each period. An amortization schedule provides a convenient way to track the changing amounts as shown in Graphic 15–3.
Decrease OutstandingDate Payments Effective Interest in Balance Balance
(7% × Outstanding balance)
666,6331 139,857 .07(666,633) = 46,664 93,193 573,4402 139,857 .07(573,440) = 40,141 99,716 473,7243 139,857 .07(473,724) = 33,161 106,696 367,0284 139,857 .07(367,028) = 25,692 114,165 252,8635 139,857 .07(252,863) = 17,700 122,157 130,7066 139,857 .07(130,706) = 9,151* 130,706 0 839,142 172,509 666,633
*Adjusted for rounding of other numbers in schedule
You should recognize this as essentially the same amortization schedule we used
in the previous chapter in connection with our installment note example. The reason for the similarity is that we view a lease as being, in substance, equivalent to an installment purchase of the right to use an asset for a specified period of time. In this illustration the lease covers the entire life of the asset, so it is purchasing the right to use the asset for its whole life. So naturally the accounting treatment of the two essentially identical transactions should be consistent.
Interest Compared for a Note and Lease Each payment includes both an amount that represents interest and an amount that represents a reduction of principal.
GRAPHIC 15–3 Lease Amortization Schedule Each lease payment includes interest on the outstanding balance at the effective rate. The remainder of each payment reduces the outstanding balance.
8 SECTION 3 Financial Instruments and Liabilities
Lessee’s Right‐of‐Use Approach and Lessor’s Performance Obligation Approach
Let’s look at an example that illustrates and compares the accounting for leases by both the lessee and lessor. The lessee uses the same right‐of‐use approach we saw in the previous section. For the lessor, the method we used is called the performance obligation approach. The name refers to the lessor recording a liability we’ll call a “performance obligation” for its obligation to permit the lessee to use the asset during the lease term. This is the most commonly used of two approaches available to the lessor. It is used when the lessor “retains exposure to risks or benefits” associated with the leased asset. For instance, the lessor would be exposed to risks or benefits during the lease term if the agreement includes (a) additional payments based on a percentage of, say, net sales, (b) payments contingent on meeting a specified performance target, or (c) options to extend or terminate the lease. Even more likely, if the asset will be returned to the lessor at the end of the lease term but before the end of the asset’s useful life, the lessor has the benefit of possibly re‐leasing, using, or selling the asset.1
Later, we’ll discuss a second method of lessor accounting called the derecognition approach that’s used when the lessor does not retain such exposure. The lessee’s accounting is the same regardless of which approach the lessor uses.
The earlier example comparing a lease to an installment purchase assumed lease payments at the end of each period. A more typical leasing arrangement requires lease payments at the beginning of each period. This more realistic payment schedule is assumed in Illustration 15–1.
1 Leases (Exposure Draft)–Lessor–Recognition, para. 28-29
Based on whether it retains significant risks or benefits, the lessor uses either a performance obligation approach or a derecognition approach to accounting for a lease.
The lessee’s accounting is the same regardless of which approach the lessor uses.
• LO2
CHAPTER 15 Leases 9 On January 1, 2011, Sans Serif Publishers, a computer services and printing firm, leased printing equipment from First LeaseCorp. The previous week, First LeaseCorp purchased the equipment from CompuDec Corporation at its fair value of $479,079.
The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2013. The useful life of the equipment is estimated to be six years.
First LeaseCorp calculated the lease payments at an amount that would provide a 10% rate of return for financing the asset for the lessee.2
$100,000 × 3.48685* = $348,685 Lease Present payments value
* Present value of an annuity due of $1: n = 4, i = 10%. Recall from Chapter 6 that we refer to periodic payments at the beginning of each period as an annuity due.
Commencement of the Lease (January 1, 2011)*
Sans Serif Publishers, Inc. (Lessee) Right-of-use asset ........................................................ 348,685 Lease liability (present value of lease payments) ......... 348,685
First LeaseCorp (Lessor) Lease receivable (present value of lease payments) ......... 348,685 Performance obligation ............................................ 348,685
First Lease Payment (January 1, 2011)*
Sans Serif Publishers, Inc. (Lessee) Lease liability ............................................................... 100,000 Cash.......................................................................... 100,000
First LeaseCorp (Lessor) Cash.............................................................................. 100,000 Lease receivable ....................................................... 100,000 * Of course, the entries to record the lease and the first payment could be combined into a
single entry since they occur at the same time. Notice that as the lessee acquires the right to use the asset (right‐of‐use asset),
the lessor assumes the obligation to allow that use (lessor’s performance obligation). Similarly, as the lessee assumes the obligation to pay for the asset’s
2 Wanting to recoup $348,685 from the lessee in four payments while earning a rate of return of 10%, First LeaseCorp calculated the lease payments as follows:
$348,685 ÷ 3.48685* = $100,000 Present Lease value payments
* Present value of an annuity due of $1: n = 4, i = 10%.
Illustration 15–1 Lessee and Lessor (Performance Obligation Approach by the Lessor)
Using Excel, enter: =PV (.10,4,100000, 1) Output: 348685.2
Using a calculator: enter: BEG mode N 4 I 10 PMT −100000 FV Output: PV 348685
The lessee acquires an asset – the right to use the equipment. The lessor has a liability – the obligation to allow the equipment to be used.
10 SECTION 3 Financial Instruments and Liabilities use (lessee’s lease liability), the lessor acquires the right to receive those payments (lease receivable). Recording the first payment above emphasizes that relationship; the $100,000 reduces both the lessee’s lease liability and the lessor’s lease receivable. The amount recorded by the lessee at the commencement of the lease is the
present value of the lease payments. However, if the fair value of the asset is lower than this amount, the recorded amount of the asset should be limited to fair value. Unless the lessor is a manufacturer or dealer, the fair value typically will be the lessor’s cost ($479,079 in this case). However, if considerable time has elapsed between the purchase of the property by the lessor and the commencement of the lease, the fair value might be different. When the lessor is a manufacturer or dealer, the fair value of the property at the commencement of the lease ordinarily will be its normal selling price (reduced by any volume or trade discounts). Be sure to note that the entire $100,000 first lease payment is applied to
principal (lease payable / lease receivable) reduction.3 Because the payment occurred at the commencement of the lease, no interest had yet accrued. Subsequent lease payments, though, include interest on the outstanding balance as well as a portion that reduces that outstanding balance. As of the second lease payment date, one year’s interest has accrued on the $248,685 ($348,685 – 100,000) balance outstanding during 2012, and is recorded as in Illustration 15–1A. Notice that the outstanding balance is reduced by $75,131—the portion of the $100,000 payment remaining after interest is covered.
Second Lease Payment (December 31, 2011) Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] .............. 24,869 Lease liability (difference) ........................................... 75,131 Cash (lease payment) ................................................. 100,000
First LeaseCorp (Lessor) Cash (lease payment) ................................................... 100,000 Lease receivable ....................................................... 75,131 Interest revenue [10% × ($348,685 – 100,000)] .......... 24,869
3 Another way to view this is to think of the first $100,000 as a down payment with the remaining $249,685 financed by 3 (i.e., 4 – 1) year-end lease payments.
A right‐of‐use asset is recorded by the lessee at the present value of the lease payments or the asset’s fair value, whichever is lower.
Interest is a function of time. It accrues at the effective rate on the balance outstanding during the period.
ILLUSTRATION 15–1A Journal Entries for the Second Lease Payment LESSEE Lease liability $348,685 (100,000) $248,685 (75,131) $173,554 LESSOR Lease Receivable $348,685 (100,000) $248,685 (75,131) $173,554
CHAPTER 15 Leases 11
The amortization schedule in Graphic 15–4 shows how the lease balance and the
effective interest change over the four‐year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance. The periodic reduction is sufficient that, at the end of the lease term, the outstanding balance is zero.
Payments Effective Interest Decrease in Balance
Outstanding Balance
(10% × Outstanding balance) 1/1/11 348,685 1/1/11 100,000 100,000 248,685
12/31/11 100,000 .10 (248,685) = 24,869 75,131 173,554 12/31/12 100,000 .10 (173,554) = 17,355 82,645 90,909 12/31/13 100,000 .10 ( 90,909) = 9,091 90,909 0
400,000 51,315 348,685
Amortization The lessee amortizes its right‐of‐use asset over lease term (or the useful life of the asset if it’s shorter). Similarly, the lessor amortizes its performance obligation in a systematic way that measures the remaining obligation to provide the use of the asset to the lessee. This usually is on a straight‐line basis unless the lessee’s pattern of using the asset is different.4 Using the asset results in an expense for the lessee. Providing the use of the asset represents lease income for the lessor.
4 Output measures such as units produced or input measures such as hours used might provide a better indication of the reduction in the remaining liability.
GRAPHIC 15–4 Lease Amortization Schedule
The first lease payment includes no interest.
The total of the cash payments ($400,000) provides for: 1. Payment for the equipment’s use ($348,685).
2. Interest ($51,315) at an effective rate of 10%.
FINANCIAL Reporting Case
Q1, p. xxx
12 SECTION 3 Financial Instruments and Liabilities
December 31, 2011 and End of Next Three Years
Sans Serif Publishers, Inc. (Lessee) Amortization expense ($348,685 ÷ 4 years) ................... 87,171 Right‐of‐use asset .................................................... 87,171
First LeaseCorp (Lessor)5 Performance obligation ............................................... 87,171 Lease income ($348,685 ÷ 4 years) ............................ 87,171
In the journal entries above and throughout the chapter, we look at the entries
of the lessee and the lessor together. This way, we can be reminded that the entries for the lessor usually are essentially the mirror image of those for the lessee, the other side of the same coin. Notice that the lessor has two assets now. It has lease receivable recorded at the
commencement of the lease, and it still has the equipment underlying the lease. Separate from the lease, at the end of each of the four years of the lease term as well as the two additional years of the six‐year estimated life of the equipment being leased to Sans Serif, First LeaseCorp will record depreciation on the equipment:
First LeaseCorp (Lessor
Depreciation expense–equip. for lease ($479,079 ÷ 6 years) 79,847 Accumulated depreciation .................................. 79,847 Discount Rate An important factor in the overall lease equation that we’ve glossed over until now is the discount rate used in present value calculations. Because lease payments occur in future periods, we must consider the time value of money when evaluating their present value. The rate is important because it influences virtually every amount reported by both the lessor and the lessee in connection with the lease.
One rate is implicit in the lease agreement. This is the desired rate of return the lessor has in mind when deciding the size of the lease payments. In other words, it is the rate the lessor charges the lessee, because it is the rate that causes the sum of (a) the present value of lease payments and (b) the present value of any residual
5 Even when the two sides are not mirror images there are many similarities, so the comparison still is helpful.
The lessee incurs an expense as it uses the asset; the lessor earns income as it satisfies its obligation to provide the asset’s use.
The lessor uses the rate it charges the lessee.
LO4
CHAPTER 15 Leases 13 value of the leased asset at the end of the lease to equal the fair value of the asset at the commencement of the lease. For instance, we said the fair value of the printing equipment in our illustration is $479,079. But, First LeaseCorp decided that at the end of the four‐year lease term the asset would have a residual value of $190,911. How much must the lessor recover from the lessee just through the four lease payments? The $479,079 is the fair value now, so to determine the amount that needs to be recovered from the four lease payments, we need to subtract from fair value the present value of the four‐years‐away residual value:
Amount to be recovered (fair value) $479,079 Less: Present value of the residual value ($190,911 x .68301*) (130,394) To be recovered through periodic lease payments (present value) $348,685
÷ 3.48685** Lease payments at the beginning of each of the next 4 years $100,000 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10%
In its calculations, the lessee can use this same rate charged by the lessor if it is
known. Or, the lessee can use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.6
In practice the lessor’s implicit rate usually is known. Even if the lessor chooses not to explicitly disclose the rate, the lessee usually can deduce the rate using information known about the value of the leased asset and the lease payments. After all, in making the decision to lease rather than buy, the lessee typically becomes quite knowledgeable about the asset. 7
Accrued Interest If a company’s reporting period ends at any time between payment dates, it’s necessary to record (as an adjusting entry) any interest that has accrued since interest was last recorded. We purposely avoided this step in the previous illustration by assuming that the lease agreement specified lease payments on December 31—the end of each reporting period. But if payments were made on another date, or if the company’s fiscal year ended on a date other than December 31, accrued interest would be recorded prior to preparing financial statements. For example, if lease payments in Illustration 15‐1A on page 8 were made on January 1 6 Incremental borrowing rate refers to the fact that lending institutions tend to view debt as being
increasingly risky as the level of debt increases. Thus, additional (i.e., incremental) debt is likely to be loaned at a higher interest rate than existing debt, other things being equal.
7 The corporation laws of some states, Florida for instance, actually require the interest rate to be expressly stated in the lease agreement.
The lessee uses the rate charged by the lessor if known or, alternatively, its own incremental borrowing rate.
At each financial statement date, any interest that has accrued since interest was last recorded must be accrued for all liabilities and receivables, including those relating to leases.
14 SECTION 3 Financial Instruments and Liabilities of each year, the effective interest amounts shown in the lease amortization schedule still would be appropriate but would be recorded one day prior to the actual lease payment. For instance, the second cash payment of $100,000 would occur on January 1, 2012, but the interest component of that payment ($37,908) would be accrued a day earlier as shown in Illustration 15–2.
December 31, 2011 (to accrue interest)
Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] .............. 24,869 Interest payable ....................................................... 24,869
First LeaseCorp (Lessor) Interest receivable ....................................................... 24,869 Interest revenue [10% × ($348,685 – 100,000)] .......... 24,869
Second Lease Payment (January 1, 2012)
Sans Serif Publishers, Inc. (Lessee) Interest payable (from adjusting entry above) ............... 24,869 Lease liability (difference) ............................................. 75,131 Cash (lease payment) ................................................. 100,000
First LeaseCorp (Lessor) Cash (lease payment) ..................................................... 100,000 Lease receivable ....................................................... 75,131 Interest receivable (from adjusting entry above) ........ 24,869
Notice that this is consistent with recording accrued interest on any debt, whether
in the form of a note, a bond, or a lease.
ILLUSTRATION 15–2 Journal Entries When Interest Is Accrued Prior to the Lease Payment
We accrue interest at the financial statement date. The interest is paid early the next year.
CHAPTER 15 Leases 15
CONCEPT REVIEW EXERCISE
United Cellular Systems leased a satellite transmission device from Pinnacle Leasing Services on January 1, 2012. Its fair value is $2 million.
Terms of the Lease Agreement and Related Information:
Lease term 3 years (6 semiannual periods) Semiannual rental payments $120,000 at the beginning of each period Economic life of asset 10 years Interest rate 12%
Required:
1. Prepare the appropriate entries for both United Cellular Systems and Pinnacle Leasing Services on January 1, the commencement of the lease.
2. Prepare an amortization schedule that shows the pattern of interest expense for United Cellular Systems and interest revenue for Pinnacle Leasing Services over the lease term.
3. Prepare the appropriate entries to record the second lease payment and amortization on July 1, 2012, and adjusting entries on December 31, 2012 (the end of both companies’ fiscal years).
1. Prepare the appropriate entries for both United Cellular Systems and Pinnacle Leasing Services on January 1, the inception of the lease.
Present value of periodic lease payments: ($120,000 × 5.21236*) = $625,483
*Present value of an annuity due of $1: n = 6, i = 6%.
January 1, 2012
United Cellular Systems (Lessee) Right‐of‐use asset ................................................................ 625,483 Lease payable (calculated above) .................................... 625,483 Lease payable .......................................................................
120,000
Cash (lease payment) ....................................................... 120,000
Pinnacle Leasing Services (Lessor) Lease receivable (calculated above) .................................... 625,483 Performance obligation .................................................... 625,483
Cash (lease payment) .......................................................... 120,000 Lease receivable 120,000
Right‐of‐Use and Performance Obligation Approaches
SOLUTION
Calculation of the present value of minimum lease payments.
16 SECTION 3 Financial Instruments and Liabilities 2. Prepare an amortization schedule that shows the pattern of interest expense
for United Cellular Systems and interest revenue for Pinnacle Leasing Services over the lease term.
Date Payments Effective Interest Decrease in Balance
Outstanding Balance
(6% × Outstanding balance) 1/1/12 625,483 1/1/12 120,000 120,000 505,483 7/1/12 120,000 .06 (505,483) = 30,329 89,671 415,812 1/1/13 120,000 .06 (415,812) = 24,949 95,051 320,761 7/1/13 120,000 .06 (320,761) = 19,246 100,754 220,007 1/1/14 120,000 .06 (220,007) = 13,200 106,800 113,207 7/1/14 120,000 .06 (113,207) = 6,793* 113,207 0
720,000 94,517 625,483 *Adjusted for rounding of other numbers in the schedule 3. Prepare the appropriate entries to record the second lease payment and
amortization on July 1, 2012, and adjusting entries on December 31, 2012 (the end of both companies’ fiscal years).
July 1, 2012
United Cellular Systems (Lessee) Interest expense [6% × ($625,483 − 120,000)] ......................... 30,329 Lease payable (difference) ........................................................ 89,671 Cash (lease payment) ............................................................ 120,000 Amortization expense ($625,483 ÷ 3 years) ............................. 208,494 Right‐of‐use asset .................................................................. 208,494 Pinnacle Leasing Services (Lessor) Cash (lease payment) ................................................................ 120,000 Lease receivable (difference) ................................................ 89,671 Interest revenue [6% × ($625,483 − 120,000)] ..................... 30,329 Performance obligation ............................................................. 208,494 Lease income ($625,483 ÷ 3 years) ........................................... 208,494
December 31, 2012 United Cellular Systems (Lessee) Interest expense (6% × $415,812: from schedule) ........................ 24,949 Interest payable ..................................................................... 24,949 Amortization expense ($625,483 ÷ 3 years) ................................ 208,494 Right‐of‐use asset .................................................................. 208,494
CHAPTER 15 Leases 17 Pinnacle Leasing Services (Lessor) Interest receivable .................................................................... 24,949 Interest revenue (6% × $415,812: from schedule) .................... 24,949 Performance obligation ............................................................. 208,494 Lease income ($625,483 ÷ 3 years) ........................................... 208,494 Depreciation expense ($2,000,000 ÷ 10 years) ............................ 200,000 Accumulated depreciation .................................................... 200,000
Derecognition Approach
Returning to our illustration if First LeaseCorp and Sans Serif Publishers, we assumed in the illustration so far that First LeaseCorp bought the printing equipment from its manufacturer and then leased it for four years of its six‐year life. Upon getting the asset back at the end of the lease term, First LeaseCorp would have the opportunity to lease it again, sell it, use it, or otherwise receive benefits during its remaining life. Therefore, we were looking at a lease situation in which First LeaseCorp retained “exposure to significant risks or benefits” associated with the equipment, which required that the lessor account for the lease using the performance obligation approach. The name comes from the fact that the lease liability the lessor records is a “performance obligation” to allow the lessee to use the asset during the lease term.
When assessing exposure to risks or benefits, the lessor looks at relevant indicators like contingent rentals, options to extend or renew, and the amount and uncertainty of residual value. The credit worthiness of the lessee should not be considered. What constitutes “significant” risks or benefits is a matter of professional judgment. If the lessor does not retain exposure to significant risks or benefits associated
with the leased asset, but instead transfers those risks and benefits of ownership to the lessee, the lessor uses a different approach called the derecognition approach. The name comes from the fact that the lessor “derecognizes” the asset such that the asset no longer appears on the lessor’s balance sheet.8 One way to view this is to think of it as something very much like a sale of an asset, at which time the lease transfers the significant risks and benefits of ownership from the lessor to the lessee, so the lessor accounts for the lease as if it transferred the asset to the
8 Later, we see that sometimes only a portion of the asset is deemed transferred and we derecognize only a portion of the carrying amount.
Depending on whether the lessor retains significant risks or benefits, the company uses either a performance obligation approach or a derecognition approach to accounting for a lease. The lessor should ignore credit risk associated with the lessee when assessing exposure to risks or benefits during the lease term.
LO3
18 SECTION 3 Financial Instruments and Liabilities lessee.9 The performance obligation is deemed to be the obligation to deliver the asset to the lessee, satisfied at the commencement of the lease, so no performance obligation is recorded. To see the derecognition approach demonstrated, let’s modify our previous
illustration. Assume all facts are the same except that Sans Serif Publishers leased the printing equipment directly from CompuDec Corporation, rather than through the financing intermediary and that CompuDec’s cost of producing the printing equipment was $300,000. When we calculate the present value of the six lease payments, we see that the payments provide a “selling price” of $479,079 and that CompuDec earns a gross profit on the transaction of $479,079 − 300,000 = $179,079. Illustration 15‐3 provides this example. We don’t revisit lessee accounting here
because lessee accounting is not affected by whether the lessor uses the performance obligation approach or the derecognition approach.
On January 1, 2011, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2015. The six‐year lease term ending December 31, 2016 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec determined that it does not retain exposure to significant risks or benefits associated with the printer. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the printing equipment is $479,079. CompuDec’s interest rate for financing the transaction is 10%.
$100,000 × 4.79079* = $479,079
Lease Present payments value
9 If (1) the lessor does not retain exposure to significant risks or benefits associated with the leased asset and (2) the agreement transfers control of the asset to the lessee it meets the criteria for classification as a purchase and sale of the asset. It is not a lease and is accounted for as a sale/purchase. This normally occurs if, for example, (a) the contract transfers legal ownership during or at the end of the lease term or (b) a lessee’s option to purchase has terms that make it likely to occur.
The lessee’s accounting is the right‐of‐use approach regardless of which approach the lessor uses.
Illustration 15–3 Lessor; Derecognition Approach
CHAPTER 15 Leases 19
*Present value of an annuity due of $1: n = 6, i = 10%.
Commencement of the Lease (January 1, 2011)
Lease receivable (present value of lease payments) ....... 479,079 Sales revenue .......................................................... 479,079 Cost of goods sold ............................................................ 300,000 Inventory of equipment (lessor’s cost) ...................... 300,000
First Lease Payment (January 1, 2011) Cash .............................................................................. 100,000 Lease receivable ....................................................... 100,000
Second Lease Payment (December 31, 2011) Cash (lease payment) ................................................... 100,000 Lease receivable ....................................................... 62,092 Interest revenue [10% × ($479,079 ‐ 100,000)] .......... 37,908
You should recognize the similarity between recording both the revenue and cost components of this “sale” by lease and recording the same components for other sales transactions. As in the sale of any product, gross profit is the difference between sales revenue and cost of goods sold. Dell Inc. “sells” some of its products using leases and disclosed the following in a recent annual report: Note 1 (in part) Dell records revenue from the sale of equipment under …. leases as product revenue at the inception of the lease. … [L]eases also produce financing income, which Dell recognizes at consistent rates of return over the lease term.
As noted previously, accounting by the lessee is not affected by how the lessor
classifies the lease. All lessee entries are precisely the same as in the previous illustrations.
VARIATIONS IN LEASE SITUATIONS
Derecognition Approach – Sometimes a Residual Asset Is Retained
In our previous illustration, we assumed that the lease payments were calculated by the lessor so that their present value would equal the fair value of the asset being leased. That is not an improbable assumption; often a manufacturer or dealer will use leasing often as a primary method of “selling” its products. Suppose, though, that other factors, say competitive market conditions, influence the amount of the payments in such a way that their present value is a little less than the fair value of the asset. In that case, the entire asset is not transferred to the lessee; the lessor retains a portion of the asset. In this situation, the lessor should divide the carrying amount of the asset into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as what
The derecognition approach is similar to recording a sale of merchandise on account: A/R ................{price} Sales rev .... {price} COGS .............{cost} Inventory ... {cost}
Remember, no interest has accrued when the first payment is made at the commencement of the lease.
Real World Financials
PART B
● LO4 Under the derecognition approach for lessor accounting, a residual asset represents the rights to the leased asset retained by the lessor.
20 SECTION 3 Financial Instruments and Liabilities we call a residual asset. The allocation is based on the ratio of the present value of the payments to the fair value of the asset.10 The residual asset is reported separate from other assets in the balance sheet. Illustration 15‐2A demonstrates the calculation.
On January 1, 2011, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2015. The six‐year lease term ending December 31, 2016 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec determined that it does not retain exposure to significant risks or benefits associated with the printer. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the printing equipment is $500,000. CompuDec’s interest rate for financing the transaction is 10%.
$100,000 × 4.79079* = $479,079 Lease Present payments value
*Present value of an annuity due of $1: n = 6, i = 10%.
Commencement of the Lease (January 1, 2011) Lease receivable (present value of lease payments) ....... 479,079 Sales revenue .......................................................... 479,079 Cost of goods sold ............................................................ 287,447 Inventory of equipment ($300,000 x 479,079/500,000)** 287,447 Residual asset ................................................................... 12,553 Inventory of equipment ($300,000 – 287,447)** ...... 12,553
First Lease Payment (January 1, 2011) Cash .............................................................................. 100,000 Lease receivable ....................................................... 100,000
Second Lease Payment (December 31, 2011) Cash (lease payment) ..................................................... 100,000 Lease receivable ....................................................... 62,092 Interest revenue [10% × ($479,079 – 100,000)] .......... 37,908
10 It’s unlikely that the fair value will exceed the present value of the cash flows by a large amount and the derecognition approach still be appropriate. That’s because the derecognition approach is appropriate only when the lessor does not retain significant risks and rewards of ownership, and a relatively large residual asset would be inconsistent with that condition.
Illustration 15–2A Lessor; Derecognition Approach – Present Value of Payments Less than Fair Value
The portion of the carrying amount the lessor derecognizes is $300,000 times the ratio of the PV of the payments to the FV of the asset. The remainder is reclassified as a residual asset.
CHAPTER 15 Leases 21
** The $287,447 portion of the asset deemed transferred and thus derecognized
is calculated as its “selling price” divided by its fair value. The remaining portion ($12,553) of the asset’s carrying amount is reclassified as a residual asset.
Initial Direct Costs The costs incurred that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs. They include legal fees, commissions, evaluating the prospective financial condition of the other company, and preparing and processing lease documents. Any such costs paid by the lessee simply add to the lessee’s right‐of‐use asset recorded at the commencement of the lease. This is consistent with the cost principal we apply when recording any asset at its total cost. Any such costs paid by the lessor add to the lessor’s lease receivable recorded at the commencement of the lease.
Let’s modify our original example to assume in Illustration 15‐4 that the lessee incurred initial direct costs.
● LO5
22 SECTION 3 Financial Instruments and Liabilities On January 1, 2011, Sans Serif Publishers leased printing equipment from First LeaseCorp. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2011, the commencement of the lease, and at each December 31 thereafter through 2013. The useful life of the equipment is estimated to be six years.
Sans Serif paid $2,000 for professional fees and for preparing and processing lease documents. First LeaseCorp’s interest rate for financing the transaction is 10%.
$100,000 × 3.48685* = $348,685
Lease Present payments value
*Present value of an annuity due of $1: n = 4, i = 10%.
Commencement of the Lease (January 1, 2011)
Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset (PV of lease payments plus initial direct costs) 350,685 Lease liability (PV of lease payments) ......................... 348,685 Cash (initial direct costs) ............................................. 2,000
First Lease Payment (January 1, 2011)
Sans Serif Publishers, Inc. (Lessee) Lease liability ................................................................ 100,000 Cash ......................................................................... 100,000
Second Lease Payment (December 31, 2011) Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] .............. 24,869 Lease liability (difference) ............................................ 75,131 Cash (lease payment) ................................................. 100,000
December 31, 2011 and End of Next Three Years
Sans Serif Publishers, Inc. (Lessee) Amortization expense ($350,685 ÷ 4 years) ................... 87,671 Right‐of‐use equipment .......................................... 87,671
Illustration 15–4 Initial Direct Costs
Initial direct costs paid by the lessee add to the lessee’s right‐of‐use asset.
CHAPTER 15 Leases 23 Short‐Term Leases – A Short‐Cut Method
It’s not unusual to simplify accounting for situations in which doing so has no material effect on the results. You might recognize this as the concept of “materiality.”11 One such situation that is permitted a simpler application is a short‐term lease. A lease that has a maximum possible lease term (including any options to renew or extend) of twelve months or less is considered a “short‐term lease.” Both the lessee and the lessor have a lease‐by‐lease option to choose a short‐cut approach to accounting for a short‐term lease. LESSEE. Conceptually, a lessee’s right‐of‐use asset as well as the liability to make payments for that right to use the asset should be measured as the present value of the future payments. We make an exception, though, when the payments are not very far in the future. Specifically, when a lessee has a short‐term lease it’s acceptable to forego using present value and measure the right‐of‐use asset and the lease liability simply as the total of the payments without discounting them to present value. LESSOR. The short‐cut approach is even more simplified for the lessor. When a lessor has a short‐term lease, the company can choose not to record the lease receivable and the performance obligation that are normally recognized for a lease. The lessor continues to recognize the asset being leased and recognizes lease payments as revenue over the lease term. Let’s look at an example that illustrates the relatively straightforward accounting
for short‐term leases. To do this we modify Illustration 15–1 to assume the lease term is twelve months in Illustration 15‐5.
11 Materiality is a qualitative characteristic in Concepts Statement No. 8: Conceptual Framework
for Financial Reporting—Chapter 3, Qualitative Characteristics of Useful Financial Information, QC11, FASB, September, 2010.
● LO6
When a lessee has a short‐term lease, it can elect not to use present value and instead can measure the right‐of‐use asset and the lease liability simply as the total of the payments.
When a lessor has a short‐term lease, it can elect not to record the lease receivable or the performance obligation.
24 SECTION 3 Financial Instruments and Liabilities
On January 1, 2011, Sans Serif Publishers leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment at a cost of $479,079. The lease agreement specifies four quarterly payments of $100,000 beginning
January 1, 2011, the commencement of the lease, and at the first day of each of the next three quarters. The useful life of the equipment is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the equipment for
$479,079. First LeaseCorp’s interest rate for financing the transaction is 10%.
Commencement of the Lease (January 1, 2011)
Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset (undiscounted total of lease payments12) 400,000 Lease liability (undiscounted total of lease payments) 400,000
First LeaseCorp (Lessor) No entry
Lease Payments (January 1, July 1, October 1, 2011)
Sans Serif Publishers, Inc. (Lessee) Lease liability ............................................................... 100,000 Cash ...................................................................... 100,000
First LeaseCorp (Lessor) Cash ............................................................................. 100,000 Lease income ....................................................... 100,000
December 31, 2011
Sans Serif Publishers, Inc. (Lessee) Amortization expense ($400,000 ÷ 1 year) .................... 400,000 Right‐of‐use asset .................................................. 400,000
First LeaseCorp (Lessor)13 No entry
Leasehold Improvements
Sometimes a lessee will make improvements to leased property that reverts back to the lessor at the end of the lease. If a lessee constructs a new building or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure. Like other assets, its cost is allocated as depreciation expense
12 Also would include initial direct costs paid by lessee if any (discussed previously) 13 At the end of each of the six years of the six-year estimated life of the equipment being leased to
Sans Serif, First LeaseCorp will record depreciation on its equipment:
Depreciation expense–equipment for lease ($479,079 ÷ 6 years) 79,847 Accumulated depreciation 79,847
Illustration 15–5 Short‐Term Lease; Lessee and Lessor
If the lessor chooses this short‐cut option, it recognizes lease payments as lease income over the lease term.
If the lessee chooses this short‐cut option, it recognizes lease payments as amortization expense over the lease term.
The cost of a leasehold improvement is depreciated over its useful life to the lessee.
CHAPTER 15 Leases 25 over its useful life to the lessee, which will be the shorter of the physical life of the asset or the lease term. Theoretically, such assets can be recorded in accounts descriptive of their nature, such as buildings or plant. In practice, the traditional account title used is leasehold improvements.14 In any case, the undepreciated cost usually is reported in the balance sheet under the caption property, plant, and equipment. Movable assets like office furniture and equipment that are not attached to the leased property are not considered leasehold improvements.
UNCERTAINTY IN LEASE TRANSACTIONS What if the Lease Term is Uncertain?
Sometimes the actual term of a lease is not obvious. Suppose, for instance, that the lease term is specified as four years, but it can be renewed at the option of the lessee for two additional years. Or, maybe either party can terminate the lease after, say, three years. In these uncertain situations, we need to estimate the likelihood of an increase or decrease in the lease term and choose accordingly. If, for instance, it’s “more likely than not” that the four‐year original lease term will be renewed for an additional two years, the lease term used in accounting for the lease is six years. Our objective is that the lease term should reflect the company’s reasonable expectation of what the term will actually be, taking into account renewal options and termination options. When more than two terms are possible, we choose the longest possible term for which that length or longer is “more likely than not.”
Let’s say, for instance, that a 10‐year lease can be renewed for two additional 5‐year periods, but that it also can be terminated after only 5 years. Management assesses the probability of a 5‐year, 10‐year, 15‐year, and 20‐year lease term to be 25%, 20%, 20%, and 35%, respectively. The likelihood that the lease term will be at least 5 years is 100%, and 75% (20% +20% +35%) that it will be 10 years or longer. The chance that it will extend 15 years or longer is 55% (20% +35%), but only 35% that it will be 20 years. The most likely of the choices is that it will be 10 years or longer (75%). But is that our choice? No. The probability that it will extend 15 years or longer is 55%, which also is more likely than not, but a longer term. So, we consider the lease term to be 15 years because we use he longest possible lease term that is more likely than not to occur.
14 Also, traditionally, depreciation sometimes is labeled amortization when in connection with leased
assets and leasehold improvements. This is of little consequence. Remember, both depreciation and amortization refer to the process of allocating an asset’s cost over its useful life.
PART C
The lease term for both the lessee and the lessor is the longest possible term that is “more likely than not” to occur taking into account any options to extend or terminate the lease.
● LO7
26 SECTION 3 Financial Instruments and Liabilities
You might want to ponder the possibilities if we did not have this requirement to specifically consider renewal options and their likelihood when we determine the lease term. Management might be tempted to structure leases with artificially short initial terms and numerous renewal options that could be ignored as a scheme to be able to use the short‐cut method or to reduce significantly the amount of the lease liability to be reported (off‐balance‐sheet financing).
What if the Lease Payments are Uncertain?
Sometimes lease payments are to be increased (or decreased) at some future time during the lease term, depending on whether or not some specified event occurs. Usually the contingency is related to revenues, profitability, or usage above some designated level. For example, a recent annual report of Walmart Stores included the note re‐created in Graphic 15–5.
9 Commitments (in part) Certain of the leases provide for the payment of contingent leases based on percentage of sales. Such contingent leases amounted to $21 million, $33 million and $41 million in 2009, 2008 and 2007, respectively.
Why would a lease include a contingent payment provision? It is a way for lessees and lessors to share the risk associated with the asset’s productivity. For example, a shop owner who pays for a premium mall location is doing so anticipating higher revenue. If the mall attracts many shoppers, the lessee pays the lessor part of the resulting higher profits, but if not, the lessee makes only the normal minimum lease payment. This arrangement also provides the lessor incentive to attract shoppers to the mall, which is in the lessee’s best interest. If the amounts of future lease payments are uncertain due to contingencies or
otherwise, we need to estimate the expected outcome of those payments. The expected outcome is the present value of the probability‐weighted average of the cash flows for a reasonable number of possible outcomes. It’s easier to see what that means if we look at an example. Suppose, for instance, that lease payments are $100,000 each for four years as in
Illustration 15‐1 on page 6, but contingent lease payments also are specified at the end of years 1, 2, and 3 equal to 1% of the lessee’s revenue that year. Now let’s say that Sans Serif estimates the probabilities for three possible outcomes for revenue as $1 million each year (30%), $1 million in 2011 plus an increase of $50,000 each year (45%), and $1 million in 2011 minus a $50,000 reduction each year (25%). The expected outcome for contingent lease payments is estimated in Illustration 15‐6:
● LO8
GRAPHIC 15–5 Contingent Lease Payments—Walmart Stores Real World Financials
CHAPTER 15 Leases 27
Possible Outcomes and Probabilities (%):
Jan. 1 Dec. 31 Dec. 31 Dec. 31 2011 2011 2012 2013 Total 1 Revenue (30%) $1,000,000 $1,000,000 $1,000,000 Contingent payment 0 $10,000 $10,000 $10,000 2 Revenue (45%) $1,000,000 $1,050,000 $1,100,000 Contingent payment 0 10,000 10,500 $11,000 3 Revenue (25%) $1,000,000 $ 950,000 $ 900,000 Contingent payment 0 10,000 9,500 $ 9,000
PV of $1, i=10%, n=1, 2, 3 .90909 .82645 .75131 1 Present value of outcome 1 $9,091 $8,265 $7,513 $24,869
2 Present value of outcome 2 $9,091 $8,678 $8,264 $26,033
3 Present value of outcome 3 $9,091 $7,851 $6,762 $23,704
Expected outcome (probability‐weighted average): $24,869 x 30% + $26,033 x 45% + $23,704 x 25% = $25,102
The expected outcome, $25,102, is the amount the lessee should add to the
$348,685 present value of the $100,000 annual lease payments to measure its right‐of‐use asset as well as its lease liability as $373,787. Likewise, this is the amount the lessor uses to record its lease receivable and performance obligation (or sales revenue when using the derecognition approach).
Reassessing the Lease Term and the Expected Lease Payments
When the lease term or lease payments are uncertain, we need to make estimates as described above. Usually, there’s no assurance that those estimates won’t change. If circumstances later indicate that a significant change has occurred in the amounts measured for the lessee’s liability to make lease payments or the lessor’s right to receive lease payments, we should reevaluate the lease term or the expected amount of lease payments and make necessary adjustments. As an example, let’s continue the previous illustration and assume the actual revenue in 2011 was $1,100,000, 10% higher than estimated.
Illustration 15–6 Determining the Expected Outcome of Uncertain Lease Payments
Contingent lease payments are specified at the end of years 1, 2, and 3 equal to 1% of revenue that year. When lease payments are uncertain we use the expected outcome, which is the present value of the probability‐weighted average of the possible cash flows.
28 SECTION 3 Financial Instruments and Liabilities
First‐year revenue was estimated to be $1,000,000; actual revenue was $1,100,000. Estimates of future revenue were unchanged. Annual lease payments ($100,000 × 3.48685*) $348,685 Contingent payments (expected outcome**) 25,102 Total right‐of‐use asset/ lease liability $373,787
* present value of an annuity due of $1: n = 4, i = 10%. ** from Illustration 15‐6 assuming first‐year revenue of $1,000,000
Commencement of the Lease (January 1, 2011)
Right‐of‐use asset ....................................................... 373,787 Lease liability (PV of lease payments plus expected contingent payments) ................................ 373,787 First Lease Payment (January 1, 2011)
Lease liability ................................................................ 100,000 Cash..... ..................................................................... 100,000 Second Lease Payment (December 31, 2011)
Interest expense [10% × ($373,787 – 100,000)] .............. 27,379 Lease liability (to balance) ............................................. 82,621 Lease expense (1% x $100,000 unexpected revenue) ...... 1,000 Cash ($100,000 + [1% x $1,100,000]) ........................... 111,000
A change in actual or expected payments is reflected in earnings if it relates to the current period or prior periods as it does in this situation. All other changes would be recorded as an adjustment to the right‐of‐use asset instead. For instance, if contingent payments are based on achieving a performance target in the future, and we revise our estimate of future performance in such a way that the lease liability (present value of expected future payments) is, say, $12,000 less, we would reduce the right‐of‐use asset and lease liability:
Lease liability (change in estimate) ................................ 12,000 Right‐of‐use asset ................................................. 12,000
Illustration 15–6A Reassessing Expected Lease Payments
Changes in the lease liability from reassessing uncertain lease payments that relate to current or prior periods are recognized in earnings (lease expense or lease revenue).
Changes in the lease liability from reassessing uncertain lease payments that relate to future periods are recognized as an adjustment to the right‐of‐use asset.
CHAPTER 15 Leases 29 Residual Value
The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor’s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. The lessee promises to return not only the property but also sufficient cash to provide the lessor with a minimum combined value.
Essentially, a lessee‐guaranteed residual value is viewed the same way as the contingent lease payments we discussed in the previous section. If a cash payment under a lessee‐guaranteed residual value is predicted on a probability‐weighted outcome basis, the present value of that payment is added to the present value of the lease payments the lessee records as both a right‐of‐use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as both a lease receivable and performance obligation (or sales revenue when the derecognition approach is used).
Let’s return to Illustration 15‐1, but now assume that, at the commencement of the lease, both the lessee and lessor expect the residual value after the four‐year lease term to be $180,000 with a 50% probability, but also estimate a 25% chance it will be $160,000 and a 25% chance it will be $244,000. Negotiations led to the lessee guaranteeing a $240,000 residual value. If the property’s value is less than $240,000 at the end of the lease term, the lessee will make a cash payment for the excess of the $240,000 over the actual value.
The expected excess guaranteed residual value is viewed as an additional cash flow and its present value is included in the calculation of the present value of lease payments as shown in Illustration 15–7.
Estimated actual residual values: 1‐ $160,000: 25%; 2‐ $180,000: 50%; 3‐ $244,000: 25% Possible cash payments (Excess of $240,000 over actual residual value): 1‐ $80,000: 25%; 2‐ $60,000: 50%; 3‐ $0: 25% Probability weighted outcome: (25% x $80,000) + (50% x $60,000) + (25% x $0) = $50,000 Present value of periodic lease payments ($100,000 × 3.48685*) $348,685 Plus: Present value of estimated payment under residual value guarantee ($50,000 × .68301†) 34,151 Present value of expected lease payments $382,836 *Present value of an annuity due of $1: n = 4, i = 10%. †Present value of $1: n = 4, i = 10%.
A cash payment predicted under a lessee‐guaranteed residual value is treated the same as a lease payment.
● LO9
ILLUSTRATION 15–7 Guaranteed Residual Value
30 SECTION 3 Financial Instruments and Liabilities
Commencement of the Lease (January 1, 2011) Sans Serif Publishers, Inc. (Lessee) Right‐of‐use asset ....................................................... 382,836 Lease liability (present value of lease payments) ........ 382,836
First LeaseCorp (Lessor) Lease receivable (present value of lease payments) ....... 382,836 Performance obligation ........................................... 382,836
Situations in which the lessee‐guaranteed residual value exceeds the probability‐weighted estimate of the actual residual value are rare in practice. It makes little economic sense for a lessee to agree to guarantee an amount greater than the estimated residual value, virtually ensuring an additional cash payment at the conclusion of the lease. The requirement to account for it in this way, though, serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lessee‐guaranteed residual value to compensate for the reduced lease payments. ADDITIONAL CONSIDERATION
If a residual value is not guaranteed, is guaranteed by a third party (insurance companies sometimes assume this role), or is guaranteed by the lessee but does not differ from the estimate of the actual fair value at the end of the lease term, it does not affect the calculations by either the lessee or lessor of the present value of the lease payments. Obviously, though, even if the residual value is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. That amount would contribute to the total amount to be recovered by the lessor and would reduce the amount needed to be recovered from the lessee through periodic lease payments. A residual value likely will affect the lessor’s calculation of periodic lease payments. For instance, whether the residual value in the illustration is guaranteed or not, its existence affected the lessor’s lease payment calculation:
The lessor subtracts the PV of the residual value to determine lease payments.
CHAPTER 15 Leases 31 Amount to be recovered (fair value) $479,079 Less: Present value of the Residual value ($191,00015 × .68301*) (130,455) Amount to be recovered through periodic lease payments $348,624 Lease payments at the beginning of each of the next six years:
÷ 3.48685** $100,000 †
* Present value of $1: n = 4, i = 10%. **Present value of an annuity due of $1: n = 4, i = 10%. † rounded for simplicity; actually $99,982
If an additional cash payment is expected due to a lessee‐guaranteed residual value, the amount to be recovered through periodic lease payments would be reduced still further.
Purchase Options
A purchase option is a provision of some lease contracts that gives the lessee the option of purchasing the leased property during, or at the end of, the lease term at a specified exercise price. We don’t consider the exercise price to be an additional cash payment within the lease agreement. Instead, it will be viewed as the cash payment to generate a sale/purchase of the asset if and when it is exercised. A lease is considered terminated when an option to purchase the asset is exercised by the lessee.
That said, the existence of a purchase option might affect whether or not a lease even exists for accounting purposes. If, for instance, the exercise price is sufficiently below the property’s expected fair value that the exercise of the option appears more likely than not (sometimes called a bargain purchase option), we ordinarily would consider “control” of the asset to have been transferred to the lessee.16 When (a) control is transferred and (b) the lessor does not retain exposure to significant risks or benefits associated with the leased asset, then there is no lease and the agreement is accounted for as a sale/purchase.
CONCEPT REVIEW EXERCISE
(This is a variation of the previous Concept Review Exercise.) United Cellular Systems leased a satellite transmission device from Satellite Technology Corporation on January 1, 2011. Satellite Technology paid $500,000 for the transmission device. Its retail value is $653,681.
15 For the previous illustration, the expected residual value given the three possibilities and their
probabilities was $160,000 x 25% + $180.000 x 50% + $244,000 x 25% = $191,000. 16 Control of the asset also is ordinarily assumed to have been transferred to the lessee if actual
ownership is transferred under the terms of the lease agreement.
A purchase option affects lease accounting only when it is exercised.
32 SECTION 3 Financial Instruments and Liabilities Terms of the Lease Agreement and Related Information:
Lease term 3 years (6 semiannual periods) Semiannual lease payments $120,000 at the beginning of each period Economic life of asset 3 years Interest rate lessor charges (known by lessee) 12% Risks and benefits associated with asset Retained by lessor Lessee’s initial direct costs $4,500 Contingent lease payment Additional $100,000 at the end of 2013 if
revenues exceed a specified base (40% estimated probability)
Required: 1. Prepare an amortization schedule that describes the pattern of interest
expense/interest revenue over the lease term. 2. Prepare the appropriate entries for both United Cellular Systems and Satellite
Technology on January 1, 2011. 3. Prepare the appropriate entries for both United Cellular Systems and Satellite
Technology on June 30, 2011, assuming that each company revised its estimated probability for the contingent payment from 40% to 60%.
4. Prepare the appropriate entries for both United Cellular Systems and Satellite Technology on January 1, 2011, assuming that the agreement contained no contingent payment clause and Satellite Technology did not retain significant risks or benefits associated with the leased asset.
1. Prepare an amortization schedule that describes the pattern of interest
expense/interest revenue over the lease term.
Present value of payments ($120,000 × 5.21236*) $625,483 Plus: Expected outcome of the contingent lease payment ([$100,000 × .70496† × 40%] + [ $0 × .70496† × 60%]) 28,198 Lease’s lessee liability / lessor’s lease receivable $653,681 *Present value of an annuity due of $1: n = 6, i = 6%. †Present value of $1: n = 6, i = 6%.
Date Payments Effective Interest Decrease in Balance
Outstanding Balance
(6% × Outstanding balance) 1/1/11 653,681 1/1/11 120,000 120,000 533,681 6/30/11 120,000 .06 (533,681) = 32,021 87,979 445,702 1/1/12 120,000 .06 (445,702) = 26,742 93,258 352,444 6/30/12 120,000 .06 (352,444) = 21,147 98,853 253,591 1/1/13 120,000 .06 (253,591) = 15,215 104,785 148,806 6/30/13 120,000 .06 (148,806) = 8,928 111,072 37,734
12/31/13 40,000 .06 (37,734) = 2,266* 37,734 0 760,000 106,319 653,681 *Adjusted for rounding of other numbers in the schedule.
SOLUTION
CHAPTER 15 Leases 33 2. Prepare the appropriate entries for both United Cellular Systems and Satellite
Technology on January 1, 2011.
January 1, 2011 United Cellular Systems (Lessee) Right‐of‐use asset (PV of payments plus initial direct costs) 658,181 Lease payable (calculated above) 653,681 Cash (initial direct costs) 4,500
Lease payable 120,000 Cash (lease payment) 120,000 Satellite Technology (Lessor) Lease receivable (calculated above) 653,681 Performance obligation 653,681
Cash (lease payment) 120,000 Lease receivable 120,000
3. Prepare the appropriate entries for both United Cellular Systems and Satellite
Technology on June 30, 2011, assuming that each company revised its estimated probability for the contingent payment from 40% to 60%.
June 30, 2011
United Cellular Systems (Lessee)
Interest expense (6% × [$653,681 – 120,000]) 32,021 Lease payable (difference) 87,979 Cash (lease payment) 120,000 Amortization expense ($653,681 ÷ 3 years x ½) 108,947 Right‐of‐use asset 108,947 Satellite Technology (Lessor) Cash (lease payment) 120,000 Lease receivable (difference) 87,979 Interest revenue (6% × [$653,681 – 120,000]) 32,021 Performance obligation 108,947 Lease income ($653,681 ÷ 3 years x ½) 108,947
34 SECTION 3 Financial Instruments and Liabilities PV of remaining 4 payments ($120,000 × 3.46511*) $415,813 Plus: Expected outcome of the contingent lease payment ([$100,000 × .79209† × 60%] + [ $0 × .79209† × 40%]) 47,525 Lease’s lessee liability / lessor’s lease receivable $463,338 *Present value of an ordinary annuity of $1: n = 4, i = 6%. †Present value of $1: n = 4, i = 6%. Note: At this point we have an ordinary annuity since the next payment won’t occur until
the end of the next six month period.
Revised balance needed $463,338 Carrying amount (from schedule: $653,681 – 120,000 – 87,979) 445,702 Increase in balance $ 17,636
United Cellular Systems (Lessee)
Right‐of‐use asset 17,636 Lease payable (calculated above) 17,636 Interest expense (6% × $463,339) 27,800 Lease payable (difference) 92,200 Cash (lease payment) 120,000 Satellite Technology (Lessor) Lease receivable (calculated above) 17,636 Performance obligation 17,636 Cash (lease payment) 120,000 Lease receivable (difference) 92,200 Interest revenue (6% × $463,339) 27,800 4. Prepare the appropriate entries for Satellite Technology on January 1, 2011,
assuming that the agreement contained no contingent payment clause and Satellite Technology did not retain significant risks or benefits associated with the leased asset.
Present value of payments: $120,000 × 5.21236* = $625,483 *Present value of an annuity due of $1: n = 6, i = 6%.
Satellite Technology (Lessor) Lease receivable (calculated above) 625,483 Sales revenue 625,483
Cost of goods sold 500,000 Inventory of equipment (lessor’s cost) 500,000
CHAPTER 15 Leases 35
FINANCIAL STATEMENT REPORTING AND DISCLOLSURES
Leases in Financial Statements
Income Statement. In general, lease items within the income statement, balance sheet, and statement of cash flows should be reported separate from non‐lease components. Lessees, for instance, report amortization expense and interest expense related to right‐to‐use assets separately in the income statement from their non‐lease counterparts. Likewise, lessors report lease income, interest income, and depreciation expense separately in the income statement so decision makers are informed about income and expenses that relate to leases. Balance Sheet. Balance sheets, too, should separate lease assets and liabilities from non‐lease assets and liabilities. Right‐of‐use assets are reported within the property, plant, and equipment classification, but separate from other assets in that category. The lessee’s lease liability, too, is reported separate from other liabilities. A lessor using the performance obligation approach, not only separates its lease and non‐lease balance sheet components, but also links them together. Using the amounts from Illustration 15‐1 at the end of the first year, Sans Serif would report the following: Equipment for lease (net of depreciation) $399,232 Lease receivable 173,554 Performance obligation (261,514) Net lease asset $311,272
A lessor using the derecognition approach reports its lease receivable separate from other receivables and any residual asset separate from other property, plant, and equipment. Statement of Cash Flows. In a statement of cash flows, we separate inflows and outflows of cash into operating, investing, and financing activities. When a lessee acquires a right‐of‐use asset and related liability, there is no inflow or outflow of cash. However, because a primary purpose of the statement of cash flows is to report significant operating, investing, and financing activities, the initial transaction is reported in the disclosure notes as a significant noncash investing activity (investing in the right‐of‐use asset) and financing activity (financing it with debt). Then the lessee’s cash payments for leases are then classified as financing activities in its statement of cash flows and presented separately from other financing cash flows.
The lessor classifies its cash receipts from lease payments as operating activities in its statement of cash flows after initially reporting its acquisition of a lease
Part D
● LO10
36 SECTION 3 Financial Instruments and Liabilities receivable and performance obligation as a significant noncash investing and financing activity in its cash flow disclosure note. We have discussed the ways leases are reported in the financial statements. Graphic 15‐5 summarizes the effects on the balance sheet, income statement, and statement of cash flows.
Lessee Lessor-
Performance Obligation Approach
Lessor- Derecognition Approach
Income Statement
• Interest expense • Amortization
expense
• Interest revenue • Lease income • Depreciation
expense
• Interest revenue • Sales revenue • Cost of goods sold
Balance Sheet
• Right-of-use asset • Lease liability
• Underlying asset
• Lease receivable • Performance
obligation • = net leased asset
or liability
• Derecognize underlying asset
• Residual asset
• Lease receivable
Statement of Cash Flows
• Cash outflows from financing activities
• Cash inflows from operating activities
• Cash inflows from operating activities
Disclosure
Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the five succeeding fiscal years, distinguishing those attributable to the minimum amounts specified rather than from contingent rentals, term option penalties and residual value guarantees. Companies also describe the amounts recognized in the financial statements arising from leases and how leases may affect the amount, timing and uncertainty of the company’s future cash flows.
Each company reports a schedule reconciling opening and closing balances of, for lessees, the (a) right‐of‐use assets and (b) lease liabilities and, for lessors, the (a) lease receivables, (b) performance obligations, and (c) residual assets arising from the derecognition approach.
Other required disclosures include: • contingent rentals, renewal and termination options, including whether
GRAPHIC 15–5 Leases in Financial Statements
CHAPTER 15 Leases 37
they affected assets and liabilities recognized • purchase options • residual value guarantees • initial direct costs • significant subleases • recognized amount of short‐term leases • discount rate used • sale and leaseback arrangements • significant service obligations related to its leases • impairment losses
The lessor also must disclose its exposure to the risks or benefits that it used in
determining whether to apply the performance obligation approach or the derecognition approach.
SALE‐LEASEBACK ARRANGEMENTS In a sale‐leaseback transaction, the owner of an asset sells it and immediately leases it back from the new owner. Sound strange? Maybe, but this arrangement is common. In a sale‐leaseback transaction two things happen:
1. The seller‐lessee receives cash from the sale of the asset.
2. The seller‐lessee pays periodic lease payments to the buyer‐lessor to retain the use of the asset.
What motivates this kind of arrangement? The two most common reasons are: (1) If the asset had been financed originally with debt and interest rates have fallen, the sale‐leaseback transaction can be used to effectively refinance at a lower rate. (2) The most likely motivation for a sale‐leaseback transaction is to generate cash.
Illustration 15–8 demonstrates a sale‐leaseback involving a lease for warehouses. The sale and simultaneous leaseback of the warehouses should be viewed as a single borrowing transaction. Although there appear to be two separate transactions, look closer at the substance of the agreement. Teledyne still retains the use of the warehouses that it had prior to the sale and leaseback. What is different? Teledyne has $900,000 cash and an obligation to make annual payments of $133,155. In substance, Teledyne simply has borrowed $900,000 to be repaid over 10 years along with 10% interest.
Part E
● LO11
Recording a sale‐leaseback transaction follows the basic accounting concept of substance over form.
38 SECTION 3 Financial Instruments and Liabilities Teledyne Distribution Center was in need of cash. Its solution: sell its four warehouses for $900,000, then lease back the warehouses to obtain their continued use. The warehouses had a carrying value on Teledyne’s books of $600,000 (original cost $950,000). Other information: 1. The sale date is December 31, 2011. 2. The noncancelable lease term is 10 years and requires annual payments of
$133,155 beginning December 31, 2011. The estimated remaining useful life of the warehouses is 10 years.
3. Teledyne depreciates its warehouses on a straight‐line basis. 4. The annual lease payments (present value $900,000) provides the lessor with a
10% rate of return on the financing arrangement. Teledyne’s incremental borrowing rate is 10%.
$133,155 × 6.75902* = $900,000 ($899,997.31 rounded) Lease Present payments value
* present value of an annuity due of $1: n = 10, i = 10%
December 31, 2011
Cash 900,000 Accumulated depreciation ($950,000 − 600,000) 350,000 Warehouses (cost) 950,000 Gain on sale‐leaseback (difference) 300,000
Right‐of‐use asset 900,000 Lease liability (present value of lease payments) 900,000
Lease liability 133,155 Cash 133,155
December 31, 2012
Interest expense [10% × ($900,000 − 133,155)] 76,685 Lease liability (difference) 56,470 Cash (lease payment) 133,155
Amortization expense ($900,000 ÷ 10 years) 90,000 Right‐of‐use asset 90,000
There typically is interdependency between the lease terms and the price at
which the asset is sold. Little imagination is needed to envision an agreement between the seller‐lessee and the buyer‐lessor designed to manipulate the amount of cash effectively borrowed under the sale‐leaseback and thus the reported gain. Suppose, for instance, that the two companies agreed that Teledyne would receive $1,000,000 from the sale of the warehouses in return for agreeing to increase lease payments from $133,155 (PV: $900,000) to $147,950 (PV: $1,000,000). When the sales price is materially different from the fair value of the asset sold, we adjust the
ILLUSTRATION 15–8 Sale‐Leaseback Through the sale‐leaseback Teledyne obtains $900,000 cash in exchange for the promise to repay that amount plus interest over the lease term.
CHAPTER 15 Leases 39 gain on the sale and the right‐of‐use asset by the difference to avoid those two amounts being misstated. Illustration 15‐8A demonstrates this situation.
$147,950 × 6.75902* = $1,000,000 Lease Present payments value * present value of an annuity due of $1: n = 10, i = 10%
December 31, 2011
Cash 1,000,000 Accumulated depreciation ($950,000 − 600,000) 350,000 Warehouses (cost) 950,000 Gain on sale‐leaseback (difference) 400,000
Right‐of‐use asset 1,000,000 Lease liability (present value of lease payments) 1,000,000 Gain on sale‐leaseback ($1,000,000 − 900,000) 100,000 Right‐of‐use asset (PV of payments less fair value of asset) 100,000
Lease liability 147,950 Cash 147,950
December 31, 2012
Interest expense [10% × ($1,000,000 − 147,950)] 85,205 Lease liability (difference) 62,745 Cash (lease payment) 147,950
Amortization expense [$1,000,000 − 100,000) ÷ 10 years] 90,000 Right‐of‐use asset 90,000
FINANCIAL REPORTING CASE SOLUTION
1. How would HG’s revenues “take a hit” as a result of more customers leasing
than buying labeling machines? (p. xxx) When HG leases machines, it reports lease income as it amortizes its performance obligation over the lease term in addition to interest revenue for financing the arrangement. When HG sells machines, on the other hand, it recognizes revenue “up front” in the year of sales. Actually, total revenues are not necessarily less with a lease, but are spread out over the several years of the lease term. This delays the recognition of revenues, creating the “hit” in the reporting periods in which a shift to leasing occurs. This is partially offset by delaying the associated expense by depreciating the asset over its life rather than expensing its cost all at once as cost of goods sold.
ILLUSTRATION 15–8A Sale‐Leaseback; sales price different from the fair value of the asset sold We adjust the gain on the sale and the right‐of‐use asset to avoid those two amounts being misstated.
40 SECTION 3 Financial Instruments and Liabilities 2. Under what lease accounting approach would the “hit” not occur? (p. xxx)
The hit will not occur when HG uses the derecognition approach (and there is no residual asset). This is appropriate when HG does not retain risks and benefits associated with the leased assets. In those cases, despite the fact that the contract specifies a lease, in effect, HG actually sells its machines under the arrangement. Consequently, HG will recognize sales revenue (and cost of goods sold) at the commencement of the lease. The amount recognized is roughly the same as if customers actually buy the machines. As a result, the income statement will not receive the hit created by the substitution of operating leases for outright sales.
THE BOTTOM LINE LO1 A right‐of‐use asset and lease liability is recorded by the lessee at the
present value of the lease payments. The asset is amortized to expense over the life of the lease. (p. xxx)
LO2 The lessor records both a lease receivable and performance obligation for the present value of the lease payments. The obligation is amortized to income over the life of the lease. (p. xxx)
LO3 If the lessor does not retain exposure to significant risks or benefits associated with the leased asset, the lessor uses the derecognition approach. This means recording sales revenue and cost of goods sold by the lessor at the inception of the lease. (p. xxx)
LO4 If the present value of lease payments is less than the fair value of the asset, the lessor divides the carrying amount of the asset into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as what we call a residual asset. The allocation is based on the ratio of the present value of the payments to the fair value of the asset. (p. xxx)
LO5 Initial direct costs paid by the lessee add to the lessee’s right‐of‐use asset. Any such costs paid by the lessor add to the lessor’s lease receivable recorded at the commencement of the lease. (p. xxx)
LO6 A short‐term lease is twelve months or less. When a lessee has a short‐term lease, it can elect not to use present value and measure the right‐of‐use asset and the lease liability simply as the total of the payments. When a lessor has a short‐term lease, it can elect not to record the lease receivable or the performance obligation. (p. xxx)
LO7 The lease term for both the lessee and the lessor is the longest possible term that is “more likely than not” to occur taking into account any options to extend or terminate the lease. (p. xxx)
● LO8 When lease payments are uncertain we use the expected outcome,
which is the present value of the probability‐weighted average of the
CHAPTER 15 Leases 41
possible cash flows. (p. xxx) ● LO9 If a cash payment under a lessee‐guaranteed residual value is predicted
on a probability‐weighted outcome basis, the present value of that payment is added to the present value of the lease payments. (p. xxx)
● LO10 Lease disclosure requirements are quite extensive for both the lessor
and lessee. Virtually all aspects of the lease agreement must be disclosed including a general description of the leasing arrangement and minimum future payments, in the aggregate and for each of the five succeeding fiscal years. (p. xxx)
● LO11 In a sale‐leaseback transaction, the owner of an asset sells it and
immediately leases it back from the new owner. When the sales price is materially different from the fair value of the asset sold, we adjust the gain on the sale and the right‐of‐use asset by the difference to avoid those two amounts being misstated. (p. xxx)
QUESTIONS FOR REVIEW OF KEY TOPICS
Q 15–1 Briefly describe conceptual basis for the right‐of‐use approach used by the lessee in a lease transaction.
Q 15–2 What are the two approaches a lessor uses in a lease transaction? What determines the choice between the two approaches?
Q 15–3 How is interest determined in a lease transaction? How does the approach compare to other forms of debt (say, bonds payable or notes payable)?
Q 15–4 How are leases and installment notes the same? How do they differ?
Q 15–5 A lessee’s earnings are affected by what two amounts (ignoring taxes) in a lease transaction? On the flip side, what two corresponding amounts affect the lessor’s earnings?
Q 15–6 What discount rate does the lessor use in determining its lease receivable and performance obligation using the performance obligation approach? How is the rate determined?
Q 15–7 What discount rate does the lessee use in determining its right‐of‐use asset and lease liability?
Q 15–8 What is the similarity between recording a lease by the derecognition approach and recording the sale of merchandise on account?
Q 15–9 What is a residual asset, and when should it be recorded?
Q 15–10 Initial direct costs often are substantial. What are initial direct costs?
Q 15–11 How do the lessee and lessor record initial direct costs?
Q 15–12 A lease that has a maximum possible lease term (including any options
42 SECTION 3 Financial Instruments and Liabilities
to renew) of twelve months or less is considered a “short‐term lease.” Both the lessee and the lessor have a lease‐by‐lease option to choose a short‐cut approach to accounting for a short‐term lease. How does a lessee record a lease using the short‐cut approach?
Q 15–13 How does a lessor record a lease using the short‐cut approach?
Q 15–14 A 6‐year lease can be renewed for two additional 3‐year periods, and it also can be terminated after only 3 years. Management assesses the probability of a 3‐year, 6‐year, 9‐year, and 12‐year lease term to be 20%, 20%, 25%, and 35%, respectively. What lease term should the lessee and lessor use in accounting for the lease?
Q 15–15 A lease might specify that lease payments may be increased (or decreased) at some future time during the lease term depending on whether or not some specified event occurs such as revenues or profits exceeding some designated level. In such situations, what is the amount a lessee should use to measure its right‐of‐use asset and lease liability?
Q 15–16 Occasionally, a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. Under what circumstance can the guaranteed residual value influence the amounts recorded by the lessee and lessor? In that circumstance, how are the amounts affected?
Q 15–17 What is a purchase option? How is a lease potentially affected by a purchase option?
Q 15–18 In a statement of cash flows, we separate inflows and outflows of cash into operating, investing, and financing activities. How do lessees and lessors report their cash flows from lease transactions in their statements of cash flows?
Q 15–19 What are the required lease disclosures for the lessor and lessee?
Q 15–20 In a sale‐leaseback transaction the owner of an asset sells it and immediately leases it back from the new owner. What discourages an agreement between the seller‐lessee and the buyer‐lessor designed to artificially increase the gain reported under the sale‐leaseback?
BRIEF EXERCISES
At the beginning of its fiscal year, Café Med leased restaurant space from Crescent Corporation under a nine‐year lease agreement. The contract calls for annual lease payments of $25,000 each at the end of each year. The building was acquired by Crescent at a cost of $300,000 and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments. What will be the effect of the lease on Café Med’s earnings for the first year (ignore taxes)?
BE 15–1 Lessee; effect on earnings ● LO1
CHAPTER 15 Leases 43 In the situation described in BE 15‐1, what will be the balances in accounts related to the lease at the end of the first year for Café Med (ignore taxes)? A lease agreement calls for annual lease payments of $26,269 over a six‐year lease term, with the first payment at January 1, the lease’s commencement, and subsequent payments at January 1 of the following five years. The interest rate is 5%. If the lessee’s fiscal year is the calendar year, what would be the amount of the lease liability that the lessee would report in its balance sheet at the end of the first year? What would be the interest payable?
In the situation described in BE 15–3, what would be the pretax amounts related to the lease that the lessee would report in its income statement for the year ended December 31? In the situation described in BE 15‐1, what will be the effect of the lease on Crescent’s earnings for the first year (ignore taxes)? In the situation described in BE 15‐1, what will be the balances in accounts related to the lease at the end of the first year for Crescent (ignore taxes)?
A lease agreement calls for quarterly lease payments of $5,376 over a 10‐year lease term, with the first payment at July 1, the lease’s inception. The interest rate is 8%. Both the fair value and the cost of the asset to the lessor are $150,000. What would be the amount of interest expense the lessee would record in conjunction with the second quarterly payment at October 1? What would be the amount of interest revenue the lessor would record in conjunction with the second quarterly payment at October 1?
Manning Imports is contemplating an agreement to lease equipment to a customer for five years, the asset’s estimated useful life. Manning normally sells the asset for a cash price of $100,000. Assuming that 8% is a reasonable rate of interest, what must be the amount of quarterly lease payments (beginning at the commencement of the lease) in order for Manning to recover its normal selling price as well as be compensated for financing the asset over the lease term? In the situation described in BE 15–3, assume the asset being leased cost the lessor $125,000 to produce and that the company does not retain significant risks and benefits associated with the leased asset. Determine the price at which the lessor is “selling” the asset (present value of the lease payments). What would be the pretax amounts related to the lease that the lessor would report in its income statement for the year ended December 31?
BE 15–2 Lessee; effect on balance sheet ● LO1 BE 15–3 Lessee; accrued interest; balance sheet effects ● LO1
BE 15–4 Lessee; accrued interest; income statement effects ● LO1
BE 15–5 Lessor; effect on earnings ● LO2
BE 15–6 Lessor; effect on balance sheet ● LO2
BE 15–7 Calculate interest ● LO2
BE 15–8 Lessor; calculate lease payments ● LO2
BE 15–9 Derecognition; income statement effects ● LO3
44 SECTION 3 Financial Instruments and Liabilities Corinth Co. leased equipment to Athens Corporation for an eight‐year period, at which time possession of the leased asset will revert back to Corinth. The equipment cost Corinth $16 million and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the lease payments for both the lessor and lessee is $21 million. Corinth believes it does not retain any significant risks or benefits associated with the equipment. The first payment was made at the commencement of the lease. What will be the amount Corinth will record as a residual asset at the commencement of the lease? Why? King Cones leased ice cream making equipment from Ace Leasing. Ace earns interest under such arrangements at a 6% annual rate. The lease term is eight months with monthly payments of $10,000 at the end of each month. Ace purchased the equipment having an estimated useful life of 4 years at a cost of $300,000. Both the lessee and the lessor elected the short‐term lease option. Amortization is recorded at the end of each month on a straight‐line basis. Ace depreciates assets monthly on a straight‐line basis. What is the effect of the lease on King Cones’ earnings during the eight‐month term, ignoring taxes? In the situation described in BE 15–11, what is the effect of the lease on Ace Leasing’s earnings during the eight‐month term, ignoring taxes?
Culinary Creations leased kitchen equipment under a 5‐year lease with an option to renew for 3 years at the end of 5 years and an option to renew for an additional 3 years at the end of 8 years. Culinary Creations determines the probability for the three possible lease terms as: 40% for a 5‐year term, 25% for an 8‐year term, and 35% for an 11‐year term. What is the length of the lease term that Culinary Creations should assume in recording the transactions related to the lease?
On January 1, Garcia Supply leased a truck for a four‐year period, at which time possession of the truck will revert back to the lessor. Annual lease payments are $10,000 due on December 31 of each year, calculated by the lessor using a 5% discount rate. If Garcia’s revenues exceed a specified amount during the lease term, James will pay an additional $4,000 lease payment at the end of the lease. James estimates a 25% probability of meeting the target revenue amount. What is the amount to be added to the right‐of‐use asset and lease liability under the contingent rent agreement? On January 1, Garcia Supply leased a truck for a four‐year period, at which time possession of the truck will revert back to the lessor. Annual lease payments are $10,000 due on December 31 of each year, calculated by the lessor using a 5% discount rate. Negotiations led to Garcia guaranteeing a $36,000 residual value at the end of the lease term. James estimates that the residual value after four years has a 25% probability of being $32,000, a 50% probability of being $36,000 and a 25% probability of being $40,000. What is the amount to be added to the right‐of‐use asset and lease liability under the residual value guarantee?
BE 15–10 Residual asset ● LO4
BE 15–11 Short‐term lease; lessee ● LO6
BE 15–12 Short‐term lease; lessor ● LO6
BE 15–13 Renewal options ● LO7
BE 15–14 Uncertain lease payments ● LO8
BE 15–15 Guaranteed residual value ● LO9
CHAPTER 15 Leases 45 As a way to obtain cash for its operations, Parsons Paints sold equipment to a finance company for $154,000 and immediately leased the equipment back for payments whose present value is $154,000. The equipment has a fair value of $130,000. Its cost and its carrying amount were $124,000. Its useful life is estimated to be 15 years. What is the amount of the gain that Parsons will include in its income statement in the year of the sale‐leaseback? EXERCISES (Note: Exercises 15-1 through 15-3 and 15-12 through 15-16 are variations of the same basic lease situation.) Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term.
Related Information:
Lease term 2 years (8 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: Prepare a lease amortization schedule and appropriate entries for Manufacturers Southern from the commencement of the lease through January 1, 2012. Amortization is recorded at the end of each quarter on a straight-line basis. December 31 is the fiscal year end for each company.
BE 15–16 Sale‐leaseback ● LO11
E 15–1 Lessee ● LO1
46 SECTION 3 Financial Instruments and Liabilities Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term. Amortization is recorded at the end of each quarter on a straight-line basis. Edison depreciates assets annually on a straight-line basis.
Related Information:
Lease term 2 years (8 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: Prepare a lease amortization schedule and appropriate entries for Edison Leasing from the commencement of the lease through January 1, 2012. Edison’s fiscal year ends December 31. Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. International Machines determined that it will not retain exposure to significant risks or benefits associated with the equipment during or after the five-year lease term. International Machines manufactured the equipment at a cost of $200,000 and lists a cash selling price of 250,177. International Machines depreciates assets annually on a straight-line basis.
Related Information:
Lease term 5 years (20 quarterly periods) Quarterly lease payments $15,000 at the beginning of each
period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: 1. Show how International Machines determined the $15,000 quarterly lease
payments.
2. Prepare appropriate entries for International Machines to record the lease at its commencement, January 1, 2011, and the second lease payment on April 1, 2011.
E 15–2 Lessor; retains exposure to significant risks or benefits ● LO2
E 15–3 Lessor; no exposure to significant risks or benefits ● LO3
CHAPTER 15 Leases 47
Each of the four independent situations below describes a lease in which annual lease payments are payable at the beginning of each year. Determine the annual lease payments for each:
Situation 1 2 3 4
Lease term (years) 4 7 5 8 Lessor’s rate of return 10% 11% 9% 12% Fair value of leased asset $50,000 $350,000 $75,000 $465,000 Residual value 0 $ 50,000 $ 7,000 $ 45,000
For each of the three independent situations below determine the amount of the annual lease payments. Each describes a lease in which annual lease payments are payable at the beginning of each year.
Situation 1 2 3
Lease term (years) 5 5 3 Lessor’s rate of return 12% 11% 9% Fair value of leased asset $60,000 $420,000 $185,000 Lessor’s cost of leased asset $50,000 $420,000 $145,000 Residual value at end of lease term $10,000 $ 50,000 $ 22,000
At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments. Required: 1. What pretax amounts related to the lease would LTT report in its balance sheet at
December 31, 2011? 2. What pretax amounts related to the lease would LTT report in its income
statement for the year ended December 31, 2011? At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments. Required: 1. What pretax amounts related to the lease would Lakeside report in its balance
sheet at December 31, 2011? 2. What pretax amounts related to the lease would Lakeside report in its income
statement for the year ended December 31, 2011?
E 15–4 Calculation of annual lease payments; residual value ● LO2
E 15–5 Calculation of annual lease payments; residual value ● LO2
E 15–6 Lessee; effect on financial statements ● LO1
E 15–7 Lessor; effect on financial statements ● LO2
48 SECTION 3 Financial Instruments and Liabilities American Food Services, Inc. leased a packaging machine from Barton and Barton Corporation. Barton and Barton completed construction of the machine on January 1, 2011. The lease agreement for the $4 million (fair value and present value of the lease payments) machine specified four equal payments at the end of each year. The useful life of the machine was expected to be four years with no residual value. Barton and Barton’s implicit interest rate was 10% (also American Food Services’ incremental borrowing rate).
Required: 1. Prepare the journal entry for American Food Services at the commencement of the
lease on January 1, 2011.
2. Prepare an amortization schedule for the four-year term of the lease.
3. Prepare the journal entry for the first lease payment on December 31, 2011.
4. Prepare the appropriate journal entry(s) on December 31, 2013. (Note: Exercises 15-9 through 15-11 are variations of the same lease situation.) On June 30, 2011, Papa Phil, Inc. leased a pizza maker from IC Leasing Corporation. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate IC used to calculate lease payment amounts. Amortization is recorded on a straight-line basis at the end of each fiscal year. The fair value of the warehouse is $3 million.
Required: 1. Determine the present value of the lease payments at June 30, 2011 (to the nearest
$000) that Papa Phil uses to record the right-of-use asset and lease liability. 2. What pretax amounts related to the lease would Papa Phil report in its balance
sheet at December 31, 2011? 3. What pretax amounts related to the lease would Papa Phil report in its income
statement for the year ended December 31, 2011? On June 30, 2011, Papa Phil, Inc. leased a pizza maker from IC Leasing Corporation. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate IC used to calculate lease payment amounts. IC purchased the machine from Pizza, Inc. at a cost of $3 million. IC determined that it will retain exposure to significant risks or benefits associated with the machine after the expected lease term. Amortization and depreciation are recorded on a straight-line basis at the end of each fiscal year. Required: 1. What pretax amounts related to the lease would IC report in its balance sheet at
December 31, 2011?
2. What pretax amounts related to the lease would IC report in its income statement for the year ended December 31, 2011?
E 15–8 Lessee ● LO1
E 15–9 Lessee; balance sheet and income statement effects ● LO1
E 15–10 Lessor; balance sheet and income statement effects; retains exposure to significant risks or benefits ● LO2
CHAPTER 15 Leases 49 On June 30, 2011, Papa Phil, Inc. leased a pizza maker from Pizza, Inc. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2011. Papa Phil’s incremental borrowing rate is 10%, the same rate Pizza, Inc. used to calculate lease payment amounts. Pizza, Inc. manufactured the machine at a cost of $2.5 million. Its fair value is $3,000,000. Pizza, Inc. determined that it will not retain exposure to significant risks or benefits associated with the equipment after the expected lease term. Required: 1. Determine the price at which Pizza, Inc. is “selling” the warehouse (present value
of the lease payments) at June 30, 2011 (to the nearest $000).
2. What pretax amounts related to the lease would Pizza, Inc. report in its balance sheet at December 31, 2011?
3. What pretax amounts related to the lease would Pizza, Inc. report in its income statement for the year ended December 31, 2011?
(Note: Exercises 15-1 through 15-3 and 15-12 through 15-16 are variations of the same basic lease situation.) Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. International Machines determined that it will not retain exposure to significant risks or benefits associated with the equipment during or after the five-year lease term. International Machines manufactured the equipment at a cost of $200,000. It has a fair value of 260,000. International Machines depreciates assets annually on a straight-line basis.
Related Information:
Lease term 5 years (20 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: Prepare appropriate entries for International Machines to record the lease at its
commencement, January 1, 2011, and the second lease payment on April 1, 2011.
E 15–11 Lessor; balance sheet and income statement effects; retains no exposure to significant risks or benefits ● LO3
E 15–12 Lessor; no exposure to significant risks or benefits; partial transfer ● LO4
50 SECTION 3 Financial Instruments and Liabilities Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2011. Title to the asset transfers to Manufacturers Southern at the end of the lease term causing International Machines to determine that control of the asset and risks and returns of ownership will be transferred. International Machines manufactured the equipment at a cost of $200,000 and lists a cash selling price of 250,177. Both companies depreciate assets annually.
Related Information:
Lease term 5 years (20 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: 1. Prepare appropriate entries for Manufacturers Southern to record the arrangement
at its commencement, January 1, 2011, and the second payment on April 1, 2011. 2. Prepare appropriate entries for International Machines to record the arrangement
at its commencement, January 1, 2011, and the second payment on April 1, 2011. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $2,000. Edison purchased the equipment from International Machines at a cost of $250,177. Edison determined that it will retain exposure to significant risks or benefits associated with the equipment after the expected lease term.
Related Information:
Lease term 2 years (8 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through April 1, 2011. Amortization is recorded at the end of each quarter on a straight-line basis. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $2,000. Edison purchased the equipment from International Machines at a cost of $250,177. Both the lessee and the lessor elected the short-term lease option. Amortization is recorded at the end of each quarter on a straight-line basis. Edison depreciates assets annually on a straight-line basis.
E 15–13 Lessee and lessor; control remains with lessor ● LO3
E 15–14 Lessee; initial direct costs ● LO5
E 15–15 Lessee; short-term lease: initial direct costs ● LO6
CHAPTER 15 Leases 51
Related Information:
Lease term 1 year (4 quarterly periods) Quarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: 1. Prepare appropriate entries for Manufacturers Southern from the commencement
of the lease through December 31, 2011. 2. Prepare appropriate entries for Edison Leasing from the commencement of the
lease through December 31, 2011. Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2011. Manufacturers Southern has the option to renew the lease at the end of two years for an additional two years and it is more likely than not that the renewal option will be exercised. Edison purchased the equipment from International Machines at a cost of $250,177.
Related Information: Lease term 2 years (8 quarterly periods) Lease renewal option for an additional 2 yearsQuarterly lease payments $15,000 at the beginning of each period Economic life of asset 5 years Interest rate charged by the lessor 8% (Also lessee’s incremental borrowing rate)
Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through April 1, 2011. Amortization is recorded at the end of each quarter on a straight-line basis.
Callahan Distributors leased office space from Grover Developers under a 15-year lease with an option to renew for 5 years at the end of 15 years and an option to renew for an additional 5 years at the end of 20 years. Callahan determines the probability for the three possible lease terms to be: 30% for a 15-year term, 40% for a 20-year term, and 40% for a 25-year term. Annual lease payments are $130,000 payable at the beginning of each year. Callahan is aware that the interest rate Grover charges in the lease agreement is 6%. Required: Show the appropriate entries for both Callahan Distributors and Grover Developers on January 1, 2011, to record the lease.
E 15–16 Lessee; renewal option ● LO7
E 15–17 Renewal options ● LO7
52 SECTION 3 Financial Instruments and Liabilities LCD Financial leased a machine it purchased for $84,000 on December 31, 2010 to Brazzel Flooring. The four-year lease term specified annual payments of $8,000 beginning December 31, 2011 and each December 31 through 2014. The lease commenced on January 1, 2011. The machine’s estimated useful life is 12 years with no estimated residual value. LCD earns interest under the lease at a 10% annual rate.
Brazzel had the option to renew the lease after four years for an additional two years. At the commencement of the lease, both firms estimated that it was more likely than not that the lease term would not be renewed. LCD decided it retained exposure to significant risks or benefits associated with the machine after the lease term. Both firms use straight line amortization and depreciation. Required: 1. Prepare the appropriate entries for both LCD and Brazzel from the
commencement of the lease through the end of 2011. 2. At the beginning of 2012, both firms reassessed the lease term and estimated that
the option will be exercised and the lease will be renewed at the end of four years (five more years remaining). Prepare the appropriate entries for both companies at January 1, 2012, to reflect the change in the lease term.
PH Printers leased a machine from CSW Corporation. The five-year lease term specified annual payments of $5,000 beginning December 31, 2011 and each December 31 through 2015. The lease commenced on January 1, 2011. The machine’s estimated useful life is 16 years with no estimated residual value. The interest rate charged by the lessor is 8%. PH had the option to terminate the lease after three years. At the commencement of the lease, PH estimated that it was more likely than not that the lease term would be terminated after three years. PH uses straight line amortization. Required: 1. Prepare the appropriate entries for both LCD and Brazzel from the
commencement of the lease through the end of 2011. 2. At the beginning of 2012, PH reassessed the lease term and estimated that the
option will not be exercised and the lease will continue for the full five years. Prepare the appropriate entries for PH at January 1, 2012, to reflect the change in the lease term.
3. Prepare the appropriate entries pertaining to the lease for PH at December 31, 2012.
E15–18 Change in lease term; lessee and lessor ● LO7
E15–19 Change in lease term; lessee and lessor ● LO7
CHAPTER 15 Leases 53 Irana Imports leased equipment under a 5-year lease. The following relate to the lease agreement:
a. The lease term commenced January 1, 2011.
b. Annual lease payments at the end of each year were $15,000. If the lessee’s revenues exceed a prespecified amount in the third year, the payments the last two years will be $20,000. Irana considers the likelihood of that possibility to be 25%.
c. The lessor’s interest rate is 8%.
Required: Prepare the appropriate entry for Irana Imports at the commencement of the lease on January 1, 2011. ABC Well Supply leased equipment under a 4-year lease. The following relate to the lease agreement:
a. The lease term commenced January 1, 2011.
b. Annual lease payments at the end of each year were $10,000 plus 1% of ABC’s net sales. ABC estimates its net sales to be $200,000 each year, but with a 30% probability that they will be 10% higher and a 20% probability they will be 10% less.
c. The lessor’s interest rate is 8%.
Required: Prepare the appropriate entry for ABC Well Supply at the commencement of the lease on January 1, 2011. On January 1, 2011, Pastner leased a machine with a useful life of six years for a five-year period ending December 31, 2015, at which time possession of the leased asset will revert back to the lessor. The residual value at December 31, 2015, is expected to be $50,000 with a 75% probability, although there is a 25% probability it will be $60,000, but negotiations led to Pastner guaranteeing a $60,000 residual value. Pastner is aware that the lessor used a 4% interest rate when calculating lease payments of $100,000 each year, with the first payment being made on December 31, 2011. Pastner uses straight-line amortization. Required: 1. Show the appropriate entries for Pastner on January 1, 2011, to record the lease.
2. Show all appropriate entries for Pastner on December 31, 2011, related to the lease.
E 15–20 Uncertain lease payments ● LO8
E 15–21 Uncertain lease payments ● LO8
E 15–22 Lessee; lessee-guaranteed residual value ● LO9
54 SECTION 3 Financial Instruments and Liabilities
Listed below are several terms and phrases associated with leases. Pair each item from List A with the item from List B (by letter) that is most appropriately associated with it. List A List B ___ 1. Effective rate times balance. a. Shortens the lease term. ___ 2. Residual asset. b. Expected outcome. ___ 3. Guaranteed residual value exceeds c. Disclosure note. estimated residual value. d. As obligation is satisfied. ___ 4. Lease term is twelve months e. Depreciable assets. or less. f. More likely than not criterion.
___ 5. Amount of lease payments is g. Lessor records a liability. uncertain. h. Not a lease. ___ 6. Initial direct costs. i. No interest. ___ 7. Lease income. j. Interest expense. ___ 8. Derecognition approach. k. Present value less than fair value. ___ 9. Leasehold improvements. l. No lessor receivable. ___ 10. Length of lease term is m. Lessor does not retain risks or uncertain. benefits. ___ 11. Performance obligation approach. n. Increases right-of-use asset. ___ 12. A purchase option is more likely o. Increases lease payable and lease than not. receivable. ___ 13. Title transfers to lessee. ___ 14. Lease payment at commencement of lease. ___ 15. Minimum future payments for each of the five succeeding fiscal years. To raise operating funds, Signal Aviation sold an airplane hangar on January 1, 2011, to a finance company for $770,000. Signal immediately leased the hangar back for a 13-year period, at which time ownership of the hangar will transfer to Signal. The hangar has a fair value of $770,000. Its cost and its carrying amount were $620,000. Its useful life is estimated to be 15 years. The lease requires Signal to make payments of $102,771 to the finance company each January 1. Signal amortizes and depreciates assets on a straight-line basis. The lease has an implicit rate of 11%. Required: Prepare the appropriate entries for Signal on:
1. January 1, 2011, to record the sale-leaseback (round present value to nearest thousand).
2. December 31, 2011, to record necessary adjustments. 3. Assume the hangar has a fair value of $650,000 and prepare the appropriate
entries for Signal on January 1, 2011, and December 31.
E 15–23 Concepts; terminology ● LO1 through LO9
E 15–24 Sale-leaseback ● LO11
CHAPTER 15 Leases 55 PROBLEMS The Antonescu Sporting Goods leased equipment from Chapman Industries on January 1, 2011. Clowers Industries had manufactured the equipment at a cost of $800,000. Its cash selling price and fair value is $1,000,000.
Other information: Lease term 4 years Annual payments $279,556 beginning Jan.1, 2011, and at Dec.
31, 2011, 2012, and 2013 Life of asset 4 years Rate the lessor charges 8%
Required: 1. Prepare the appropriate entries for Antonescu Sporting Goods (Lessee) on January 1,
2011 and December 31, 2011. Round to nearest dollar. 2. Prepare the appropriate entries for Chapman Industries (Lessor) on January 1, 2011 and
December 31, 2011. Assume that Chapman determined that it does retain exposure to significant risks or benefits associated with the equipment. Round to nearest dollar.
3. Prepare the appropriate entries for Chapman Industries (Lessor) on January 1, 2011 and December 31, 2011. Assume that Chapman determined that it does not retain exposure to significant risks or benefits associated with the equipment. Round to nearest dollar.
At the beginning of 2011, VHF Industries acquired the use of a machine with a useful life of four years and a fair value of $6,074,700 by signing a four-year lease. The lease is payable in four annual payments of $2 million at the end of each year. Required: 1. What is the effective rate of interest the lessor is charging the lessee (implicit rate)
in the agreement?
2. Prepare the lessee’s journal entry at the commencement of the lease.
3. Prepare the journal entry to record the first lease payment at December 31, 2011.
4. Prepare the appropriate journal entry(s) at December 31, 2012.
5. Suppose the fair value of the machine and the lessor’s implicit rate were unknown at the time of the lease, but that the lessee’s incremental borrowing rate of interest for notes of similar risk was 11%. Prepare the lessee’s entry at the commencement of the lease.
(Note: You may wish to compare your solution to Problem 15–2 with that of Problem 14–12, which deals with a parallel situation in which the machine was acquired with an installment note.)
P 15–1 Lessee and lessor; lessor does/does not retain risks and benefits associated with the leased asset ● LO1 LO2
P 15–2 Lessee; interest rate charged by lessor ● LO1
56 SECTION 3 Financial Instruments and Liabilities Terms of a lease agreement and related facts were:
a. Leased asset had a retail cash selling price of $100,000. Its useful life was six years with no residual value (straight-line depreciation).
b. Annual lease payments at the beginning of each year were $20,873, beginning January 1. The lease term is six years.
c. Lessor’s interest rate when calculating annual lease payments was 9%. d. Costs of negotiating and consummating the completed lease transaction incurred
by the lessor were $2,062. Required: Prepare the appropriate entries for the lessor to record the lease, the initial payment at its commencement, and at the December 31 fiscal year-end under each of the following two independent assumptions:
1. The lessor recently paid $100,000 to acquire the asset. Also assume the lessor retains significant risks and benefits associated with the leased asset.
2. The lessor recently paid $85,000 to acquire the asset. Also assume the lessor does not retain significant risks and benefits associated with the leased asset.
Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians’ Leasing purchased a lithotripter from Rand for $3,000,000 and leased it to Mid-South Urologists Group on January 1, 2011.
Lease Description:
Quarterly lease payments $130,516—beginning of each period Lease term 5 years (20 quarters), renewable for
another 5 years Economic life of lithotripter 10 years Implicit interest rate and lessee’s incremental borrowing
rate 12%
Fair value of asset $3,000,000
Physicians’ Leasing will retain ownership of the lithotripter at the end of the lease. .
Required: 1. Prepare appropriate entries for Mid-South Urologists Group from the
commencement of the lease through the second lease payment on April 1, 2011. Depreciation or amortization is recorded at the end of each quarter. The company considers it more likely than not that the lease will not be renewed.
2. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011. Depreciation or amortization is recorded at the end of each quarter. The company considers it more likely than not that the lease will not be renewed.
3. Assume that Physicians’ Leasing (a) considers it more likely than not that the lease will be renewed, and (b) believes the company will retain significant risks or benefits associated with the lithotripter during the expected lease term. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011.
4. Assume that Physicians’ Leasing (a) considers it extremely likely that the lease will be renewed, and (b) the company will not retain significant risks or benefits
P 15–3 Lessor’s initial direct costs; performance obligation and derecognition approaches ● LO2 LO3
P 15–4 Lessee and lessor; renewal option ● LO7
CHAPTER 15 Leases 57
associated with the lithotripter during or after the expected lease term. Prepare appropriate entries for Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2011.
Universal Leasing leases electronic equipment to a variety of businesses. The company’s primary service is providing alternate financing by acquiring equipment and leasing it to customers under long-term direct financing leases. Universal earns interest under these arrangements at a 10% annual rate.
The company leased an electronic typesetting machine it purchased on December 31, 2010 for $90,000 to a local publisher, Desktop Inc. The six-year lease term commenced January 1, 2011, and the lease contract specified annual payments of $8,000 beginning December 31, 2011 and each December 31 through 2016. The machine’s estimated useful life is 15 years with no estimated residual value.
The publisher had the option to terminate the lease after four years. At the commencement of the lease, Universal estimated that it was more likely than not that the lease term would not be terminated and that it retains exposure to significant risks or benefits associated with the machine after the expected lease term. Universal uses straight line amortization and depreciation.
Required: 1. Prepare the appropriate entries for Universal Leasing from the commencement of
the lease through the end of 2011. 2. At the beginning of 2012, Universal reassessed the lease term and estimated that
the option will be exercised and the lease will terminate at the end of four years (three years remaining). Prepare the appropriate entries for Universal Leasing at January 1, 2012, to reflect the change in the lease term.
3. Prepare the appropriate entries pertaining to the lease for Universal Leasing at December 31, 2012.
4. Determine the balances in the following accounts pertaining to the lease at December 31, 2011: Lease receivable, performance obligation, asset for lease, accumulated depreciation.
5. Determine the amounts reported in income pertaining to the lease during 2011 and during 2012 (ignore taxes).
The following relate to a lease agreement:
a. The lease term is 5 years, beginning January 1, 2011. b. The leased asset cost the lessor $800,000 and had an estimated useful life of seven
years with no residual value. c. Annual lease payments at the end of each year were $150,000. If the lessee’s
revenues exceed a prespecified amount in the third year, the payments the last two years will be $200,000. The lessee considers the likelihood of that possibility to be 70%.
d. The lessor’s interest rate is 8%. Required: Prepare the appropriate entries for the lessee from the commencement of the lease through the end of the lease term assuming the target revenues are achieved in the third year.
P 15–5 Change in lease term; lessor ● LO7
P 15–6 Uncertain lease payments ● LO8
58 SECTION 3 Financial Instruments and Liabilities On January 1, 2011, Allied Industries leased a high-performance conveyer to Karrier Company for a four-year period ending December 31, 2014, at which time possession of the leased asset will revert back to Allied. The equipment cost Allied $1,072,000 and has an expected useful life of six years. Allied feels there is a 40% chance that the residual value at December 31, 2014, will be $330,000 but that there is a 30% chance it will be $220,000 and a 30% chance it will be $440,000. Negotiations led to the lessee guaranteeing a $340,000 residual value.
Equal payments under the lease are $200,000 and are due on December 31 of each year with the first payment being made on December 31, 2011. Karrier is aware that Allied used a 5% interest rate when calculating lease payments. Both companies use straight-line amortization and depreciation. Required: 1. Show the appropriate entries for both Karrier and Allied on January 1, 2011, to
record the lease. 2. Show all appropriate entries for both Karrier and Allied on December 31, 2011,
related to the lease and the leased asset. On December 31, 2011, Rhone-Metro Industries leased equipment to Western Soya Co. for a four-year period ending December 31, 2015, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost Rhone-Metro $403,326 and has an expected useful life of six years. Its normal sales price is $403,326. The residual value at December 31, 2015, is estimated to be with a 50% probability $50,000 although there is a 25% chance it will be $40,000 and a 25% chance it will be $80,000. Negotiations led to the lessee guaranteeing an $80,000 residual value.
Equal payments under the lease are $100,000 and are due on December 31 of each year. The first payment was made on December 31, 2011. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line amortization/depreciation. Required: 1. Show how Rhone-Metro calculated the $100,000 annual lease payments. 2. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on
December 31, 2011. 3. Prepare an amortization schedule(s) describing the pattern of interest over the
lease term for the lessee and the lessor. 4. Prepare all appropriate entries for both Western Soya and Rhone-Metro on
December 31, 2012 (the second lease payment and depreciation). 5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on
December 31, 2015 assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $70,000.
P 15–7 Lessee and lessor; lessee guaranteed residual value ● LO9
P 15–8 Lessee and lessor; lessee guaranteed residual value ● LO9
CHAPTER 15 Leases 59 BioGen Pharmaceuticals leased equipment under a 4-year lease. The following relate to the lease agreement:
a. The lease term commenced January 1, 2011.
b. Annual lease payments at the end of each year were $30,000 plus 1% of BioGen’s revenues. BioGen estimates its revenues to be $600,000 each year, but with a 30% probability that they will be $660,000 and a 20% probability they will be $540,000.
c. The lessor’s interest rate is 8%.
Required: 1. Show the appropriate entries for BioGen on January 1, 2011, to record the lease.
2. Show all appropriate entries for BioGen on December 31, 2011, related to the lease assuming revenues during 2011 are $630,000 and that Bio Gen does not revise its projection of future revenues.
3. Show all appropriate entries for BioGen on December 31, 2011, related to the lease assuming revenues during 2011 are $630,000 prompting Bio Gen to revise its projection of future revenues to $600,000 each year with a 50% probability, and $660,000 with a 50% probability.
On January 1, 2011, Shirt Barn leased a new store location. The lease specified a three-year term with three optional renewal periods of two years each. At the lease’s inception, Shirt Barn estimated that the probabilities for the four possible lease terms were: 40% for a 3-year term, 20% for a 5-year term, 20% for a 7-year term, and 20% for a 9-year term.
Annual year-end base lease payments are $100,000 for the first three years and $120,000 during any optional renewal periods. In addition, Shirt Barn will make contingent payments equal to 2% of net sales each year. The company estimates that net sales will be $1,000,000 the first year of the lease with (A) a 50% likelihood of constant net sales, (B) a 30% likelihood of a 5% increase each year, and (C) a 20% chance that net sales will decline by 5% a year.
Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $12,000. Shirt Barn’s incremental borrowing rate is 8% and is unaware of the rate the lessor charges in its lease agreements. Required: 1. Determine the appropriate lease term.
2. Determine the amount Shirt Barn should record as its lease liability.
3. Prepare all appropriate entries for Shirt Barn for 2011 assuming net sales that year were $1,000,000 as projected.
4. Prepare all appropriate entries for Shirt Barn for 2011 assuming net sales that year were $1,100,000 and estimates for future years were unchanged.
P 15–9 Uncertain lease payments ● LO8
P 15–10 Uncertain lease term; contingent lease payments; initial direct costs ● LO5 LO7 LO8
60 SECTION 3 Financial Instruments and Liabilities BROADEN YOUR PERSPECTIVE Apply your critical‐thinking ability to the knowledge you’ve gained. These cases will provide you an opportunity to develop your research, analysis, judgment, and communication skills. You also will work with other students, integrate what you’ve learned, apply it in real world situations, and consider its global and ethical ramifications. This practice will broaden your knowledge and further develop your decision‐making abilities. “I don’t see that in my intermediate accounting text I saved from college,” you explain to another member of the accounting division of Dowell Chemical Corporation. “This will take some research.” Your comments pertain to the appropriate accounting treatment of a proposed sublease of warehouses Dowell has used for product storage.
Dowell leased the warehouses one year ago on December 31. The five-year lease agreement called for Dowell to make quarterly lease payments of $2,398,303, payable each December 31, March 31, June 30, and September 30, with the first payment at the lease’s inception. Dowell had recorded the right-of-use asset and liability at $40 million, the present value of the lease payments at 8%. Dowell records amortization on a straight-line basis at the end of each fiscal year.
Today, James Williams, Dowell’s controller, explained a proposal to sublease the underused warehouses to American Tankers, Inc. for the remaining four years of the lease term. “So now we will be both a lessor and a lessee,” he had said. “Check on how we would need to account for this and get back to me.” Required:
1. After the first full year under the warehouse lease, what is the balance in Dowell’s lease liability? An amortization schedule will be helpful in determining this amount.
2. After the first full year under the warehouse lease, what is the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses?
3. Obtain the relevant authoritative literature on reporting a sublease by lessees using the FASB’s Codification Research System. You might gain access from the FASB website (www.fasb.org), from your school library, or some other source. Determine the appropriate reporting treatment for the proposed sublease. What is the specific Codification citation that Dowell would rely on for the appropriate reporting?
4. Assuming the sublease is commenced after one full year, how would Dowell report the right-of-use asset, lease liability, lease receivable, and performance obligation in connection with the sublease?
Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year lease on January 1, 2011. Information concerning the lease and the vans follows:
a. Equal annual lease payments of $300,000 are due on January 1, 2011, and thereafter on December 31 each year. The first payment was made January 1, 2011. Interstate’s implicit interest rate is 10% and known by VIP.
b. VIP estimates the fair value of the vans to be $1,100,000. Interstate’s cost was $850,000.
c. VIP’s incremental borrowing rate is 11%. d. Interstate will not retain significant risks or benefits of ownership.
Your instructor will divide the class into two to six groups depending on the size of the
class. The mission of your group is to assess the proper recording and reporting of the lease described.
Research Case 15‐1 FASB codification; locate and extract relevant information and authoritative support for a financial reporting issue; sublease of a leased asset ● LO1 LO10 (insert codification icon)
Communication Case 15‐2 Lessee accounting; partial transfer ● LO1 LO3 LO4
CHAPTER 15 Leases 61 Required: 1. Each group member should deliberate the situation independently and draft a tentative
argument prior to the class session for which the case is assigned. 2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom.
During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.
3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group’s solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation. Specifically, you should address: a. Identify potential advantages to VIP of leasing the vans rather than purchasing them. b. How should the lease be recorded by VIP? by Interstate? c. Regardless of your response to previous requirements, suppose VIP recorded the
lease on January 1, 2011, in the amount of $1,100,000. What would be the appropriate journal entries related to the lease for the second lease payment on December 31, 2011?
American Movieplex, a large movie theater chain, leases most of its theater facilities. Each lease has multiple renewal options. The question being discussed over breakfast on Wednesday morning was the length of lease term for new lease agreements. The company controller, Sarah Keene, was surprised by the suggestion of Larry Person, her new assistant.
Keene: Why 8 years? We’ve almost always renewed leases for total lease terms of much longer.
Person: I noticed that in my review of back records. But during our expansion to the Midwest, we don’t need lease liabilities and expenses to be any higher than necessary.
Keene: But isn’t that a pretty conservative estimate of these leases; actual lives? Trade publications show an average lease term more in keeping with our historical average of 12 years.
Required:
1. How would decreasing the lease term affect American Movieplex’s income and liabilities?
2. Does reducing the estimate pose an ethical dilemma? 3. Who would be affected if Person’s suggestion is followed?
Ethics Case 15‐3 Renewal options ● LO 7
62 SECTION 3 Financial Instruments and Liabilities Wal-Mart Stores, Inc., is the world’s largest retailer. A large portion of the premises that the company occupies are leased. Its financial statements and disclosure notes revealed the following information: Balance Sheet
($ in millions)
2009 2008
Assets Property: Property under lease $5,341 $5,736 Less: Accumulated amortization (2,544) (2,594)
Liabilities Current liabilities: Obligations under leases due within one year 315 316 Long-term debt: Long-term obligations under leases 3,200 3,603
Required:
1. Discuss some possible reasons why Wal-Mart leases rather than purchases most of its premises.
2. The net asset “property under lease” has a 2009 balance of $2,797 million ($5,341 − 2,544). Liabilities for leases total $3,515 ($315 + 3,200). Why do the asset and liability amounts differ?
3. Prepare a 2009 summary entry to record Wal-Mart’s lease payments, which were $603 million.
4. What is the approximate average interest rate on Wal-Mart’s leases? (Hint: See Req. 3) Note: This case is modified to assume that Wal-Mart’s leases in 2008-2009 were recorded
under the right-of-use model with came into being at a later time. Concepts involved are not affected.
General Tools is seeking ways to maintain and improve cash balances. As company controller, you have proposed the sale and leaseback of much of the company’s equipment. As seller-lessee, General Tools would retain the right to essentially all of the remaining use of the equipment. The term of the lease would be six years. A gain would result on the sale portion of the transaction.
You previously convinced your CFO of the cash flow benefits of the arrangement, but now he doesn’t understand the way you will account for the transaction. “I really am counting on that gain to bolster this period’s earnings. Why can’t we simply sell for more than it’s worth and compensate the other guy with higher lease payments?” he wondered. “Put it in a memo, will you? I’m having trouble following what you’re saying to me.” Required:
Write a memo to your CFO. Include discussion of each of these points: 1. The motivation for sale-leasebacks. 2. Why the scheme to bolster the reported gain will not work.
Real Word Case 15‐4 Lease concepts; Wal‐Mart ● LO1
Communication Case 15‐5 Grow the gain? ● LO 11