Chapter 15 Leases 1 Chapter 15 Leases QUESTIONS FOR REVIEW OF KEY TOPICS Question 15-1 Regardless of the legal form of the agreement, a lease is accounted for as either a rental agreement or a purchase/sale accompanied by debt financing depending on the substance of the leasing arrangement. Capital leases are agreements that are formulated outwardly as leases, but that are in reality installment purchases. Professional judgment is needed to differentiate between leases that represent “rental agreements” and those that in reality are “installment purchases/sales.” The FASB provides guidance for distinguishing between the two fundamental types of leases. Question 15-2 Periodic interest expense is calculated by the lessee as the effective interest rate times the amount of the outstanding lease liability during the period. This same principle applies to the flip side of the transaction, i.e., the lessor’s lease receivable (net investment). The approach is the same regardless of the specific form of the debt – that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments. Question 15-3 Leases and installment notes are very similar. The fundamental nature of the transaction remains the same regardless of whether it is negotiated as an installment purchase or as a lease. In return for providing financing, the borrower (lessee) pays interest over the maturity (lease term). Conceptually, leases and installment notes are accounted for in precisely the same way. Question 15-4 The criteria are: (1) the agreement specifies that ownership of the asset transfers to the lessee, (2) the agreement contains a bargain purchase option, (3) the lease term is equal to 75% or more of the expected economic life of the asset, or (4) the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the leased asset. Question 15-5 A bargain purchase option is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a “bargain” price – defined as price sufficiently lower than the expected fair value of the property when the option becomes exercisable that the exercise of the option appears reasonably assured at the inception of the lease. Because exercise of the option appears reasonably assured, transfer of ownership is expected. 2 Answers to Questions (continued) Question 15-6 The lease is a capital lease to Seminole because the present value of the minimum lease payments ($5.2 million) is greater than 90% of the fair value of the asset (90% x $5.6 million = $5.04 million). Since the additional lessor conditions also are met, it is a nonoperating lease to Lukawitz. Furthermore it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost. Question 15-7 Yes. The minimum lease payments for the lessee exclude any residual value not guaranteed by the lessee. On the other hand, the lessor includes any residual value not guaranteed by the lessee but guaranteed by a third-party guarantor. Even when minimum lease payments are the same, their present values will differ if the lessee uses a discount rate different from the lessor’s implicit rate. This would occur if the lessee is unaware of the implicit rate or if the implicit rate exceeds the lessee’s incremental borrowing rate. Question 15-8 The way a BPO is included in determining minimum lease payments is precisely the same way that a lessee-guaranteed residual value is included. The expectation that the option price will be paid effectively adds an additional cash flow to the lease. That additional payment is included as a component of minimum lease payments. It therefore is included in the computation of the amount to be capitalized (as an asset and liability) by the lessee. But, a residual value not guaranteed by the lessee is ignored. Question 15-9 Executory costs are costs usually associated with ownership of an asset such as maintenance, insurance, and taxes. These are responsibilities of ownership that we assume are transferred to the lessee in a capital lease. When paid by the lessee, these expenditures are expensed by the lessee as incurred. When paid by the lessor, rental payments usually are inflated for this reason. These executory costs, including any lessor profit thereon, are excluded in determining the minimum lease payments and still are expensed by the lessee, even though paid by the lessor. Question 15-10 The lessor’s discount rate is the effective interest rate the lease payments provide the lessor over and above the “price” at which the asset is “sold” under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the rental payments. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. When the lessor’s implicit rate is known, the lessee should use the lower of the two rates. This is the rate the lessee would be expected to pay a bank if funds were borrowed to buy the asset. 3 Answers to Questions (continued) Question 15-11 Contingent rentals are not included in minimum lease payments but are reported in disclosure notes by both the lessor and lessee. This is because they are not determinable at the inception of the lease. They are included as components of income when (and if) the payments occur. However, increases or decreases in rental payments that are dependent only upon the passage of time are not contingent rentals; these are part of minimum lease payments. Question 15-12 The costs of negotiating and consummating a completed lease transaction incurred by the lessor 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, evaluating the prospective lessee's financial condition, commissions, and preparing and processing lease documents. Question 15-13 In an operating lease initial direct costs are recorded as prepaid expenses (assets) and amortized as an operating expense (usually straight-line) over the lease term. This approach is due to the nature of operating leases in which rental revenue is earned over the lease term. Initial direct costs are matched, along with depreciation and other associated costs, with the rent revenues they help generate. In a direct financing lease initial direct costs are amortized over the lease term. This is accomplished by offsetting unearned revenue by the initial direct costs. This recognizes the initial direct costs at the same rate (that is, proportionally), as the interest revenue to which it is related. The nature of the lease motivates this treatment. The only revenue a direct financing lease generates for the lessor is interest revenue, which is earned over the lease term. So initial direct costs are matched proportionally over the term of the lease. In a sales-type lease, GAAP requires that initial direct costs be expensed in the period of “sale” – that is, at the inception of the lease. This treatment implicitly assumes that in a sales- type lease the primary reason for incurring these costs is to facilitate the sale of the leased asset. Question 15-14 On the surface there are two separate transactions. But the seller/lessee still retains the use of the asset that it had prior to the sale-leaseback. In reality the seller/lessee has cash from the sale and a noncancelable obligation to repay a debt. In substance, the seller/lessee simply has borrowed cash to be repaid with interest over the lease term. So “substance over form” dictates that the gain on the sale of the asset not be immediately recognized, but deferred and recognized over the term of the lease. There typically is an interdependency between the lease terms and the price at which the asset is sold. So the earnings process is not complete at the time of sale but is completed over the term of the lease. Viewing the sale and the leaseback as a single transaction is consistent with the revenue realization principle. 4 Answers to Questions (concluded) Question 15-15 The FASB specified exceptions to the general classification criteria for leases that involve land because of the unlimited useful life of land and the inexhaustibility of its inherent value through use. When title passes to the lessee – through automatic title passage or bargain purchase – these leases are clearly capital in nature and should be classified as such by the lessee. However, the Board felt that there would be difficulty in applying the other two criteria. Because land has essentially an infinite life, no lease term could possibly exceed 75 percent of its useful life, and the criterion was not applicable. The fourth criterion calls for comparing the present value of the lease payments with 90 percent of the property's fair value to determine if the lessor will recover its investment through the payments. When land is involved, the Board felt that the lease was not intended to recover the lessor's investment. Further, the lessor would have the land at the end of the lease term in essentially the same condition. Accordingly, the FASB concluded that leases involving material amounts of land should be classified as operating leases unless title passes automatically or as the result of a bargain purchase option. Question 15-16 The guidelines for determining when a material amount of land is involved in a lease indicate that leases involving property where land constitutes 25 percent or more of the total value should be treated as if they are two leases. The portion of the lease attributable to the land should be treated as an operating lease while the portion attributable to the other property should be judged on its own characteristics and accounted for accordingly. If the land value is less than 25 percent of the total value of the property, no allocation needs to be made. Question 15-17 A leveraged lease involves significant long-term, nonrecourse financing by a third-party creditor. The lessor serves the role of a mortgage broker and earns income by serving as an agent between a company needing to acquire property and a lender looking for an investment. The lender provides enough cash to the lessor to acquire the property. The leased property is then leased to the lessee under a capital lease with lease payments applied to the note held by the lender. A lessee accounts for a leveraged lease the same way as a nonleveraged lease. A lessor records its investment (receivable) net of the nonrecourse debt and reports income from the lease only in those years when the receivable exceeds the liability. 5 BRIEF EXERCISES Brief Exercise 15-1 Because none of the four classification criteria is met, this is an operating lease. Accordingly, LTT will record rent expense for each of the four $25,000 payments, reducing its earnings by $100,000 each year. Brief Exercise 15-2 Because none of the four classification criteria is met, this is an operating lease. Accordingly, Lakeside will record rent revenue for each of the four $25,000 payments, increasing its earnings by $100,000 each year. In addition Lakeside, as owner of the asset, will record depreciation. Assuming straight-line depreciation of the $2 million cost over the 25-year life, that’s $80,000 depreciation expense each year. So, earnings are increased by a net $20,000 ($100,000 – 80,000). Brief Exercise 15-3 Because this is an operating lease, Ward will record rent expense for each of the $5,000 payments. The advance payment also represents rent, recorded initially as prepaid rent and allocated equally over the ten years of the lease. As a result, Ward’s rent expense for the year reduces its earnings by $70,000 each year. $5,000 x 12 = $60,000 $100,000 / 10 = 10,000 $70,000 6 Brief Exercise 15-4 The lease is a capital lease to Athens because the present value of the minimum lease payments ($20.4 million) is greater than 90% of the fair value of the asset (90% x $22.4 million = $20.16 million). None of the other three classification criteria is met. Brief Exercise 15-5 The present value of the minimum lease payments ($20.4 million) is greater than 90% of the fair value of the asset (90% x $22.4 million = $20.16 million). Since the additional lessor conditions also are met, it is a nonoperating lease to Corinth. Furthermore it is a sales-type lease because the present value of the minimum lease payments exceeds the lessor’s cost ($16 million). Brief Exercise 15-6 In direct financing leases, the lessor records a receivable for the total payments to be received ($10,313,000 for Sonic). The difference between the total of the lease payments and the present value of the lease payments to be received over the term of the lease ($7,161,000 for Sonic) represents unearned interest revenue. Over the term of the leases, Sonic will report this amount ($10,313,000 minus $7,161,000 = $3,152,000) as interest revenue, determined as the effective interest rate times the outstanding balance (net investment) each period. 7 Brief Exercise 15-7 The amount of interest expense the lessee would record in conjunction with the second quarterly payment at October 1 is $2,892: Initial balance, July 1 (given) ................................... $150,000 Reduction for first payment, January 1 ................... (5,376) Balance ..................................................................... $144,624 Interest expense October 1: 2% x $144,624 = $2,892 Journal entries (not required): July 1 Leased asset (given) ............................................. 150,000 Lease payable .................................................. 150,000 Lease payable ..................................................... 5,376 Cash (rental payment) ......................................... 5,376 Oct. 1 Interest expense (2% x [$150,000 – 5,376]) ............... 2,892 Lease payable (difference) .................................... 2,484 Cash (lease payment) .......................................... 5,376 The amount of interest revenue the lessor would record in conjunction with the second quarterly payment at October 1 also is $2,892, determined in the same manner. 8 Brief Exercise 15-8 The lease liability in the balance sheet will be $113,731: Initial balance, January 1 (calculated below) ............ $140,000 Reduction for first payment, January 1 ................... (26,269) December 31, net liability ........................................ $113,731 $26,269 x 5.32948 Φ = $140,000 (rounded) Φ present value of an annuity due of $1: n=6, i=5% The liability for interest on the lease liability in the balance sheet will be $5,687: Interest expense (5% x [$140,000 – 26,269]) ................ 5,687 Interest payable ..................................................... 5,687 Brief Exercise 15-9 Pretax earnings will be reduced by $29,020 as calculated below: January 1 interest expense ....................................... $ 0 Dec. 31, interest expense (5% x [$140,000* – 26,269]) 5,687 Interest expense for the year .................................... $ 5,687 Depreciation expense ($140,000* / 6 years) .............. 23,333 Total expenses ....................................................... $29,020 *$26,269 x 5.32948 Φ = $140,000 (rounded) Φ present value of an annuity due of $1: n=6, i=5% 9 Brief Exercise 15-10 The price at which the lessor is “selling” the asset being leased is the present value of the lease payments: *$26,269 x 5.32948 Φ = $140,000 (rounded) Φ present value of an annuity due of $1: n=6, i=5% Pretax earnings will be increased by $20,687 as calculated below: January 1 interest revenue ....................................... $ 0 Dec. 31, interest revenue (5% x [$140,000* – 26,269]) 5,687 Interest revenue for the year .................................... $ 5,687 Sales revenue* ............................................................ 140,000 Cost of goods sold ...................................................... (125,000) Income effect ........................................................... $ 20,687 Journal entry (not required): Lease receivable ($26,269 x 6)........................................ 157,614 Cost of goods sold (lessor’s cost) ................................... 125,000 Sales revenue (present value) ..................................... 140,000 Unearned interest revenue ($157,614 – 140,000) ....... 17,614 Inventory of equipment (lessor’s cost) ....................... 125,000 Brief Exercise 15-11 $100,000 ÷ 16.67846** = $5,996 fair market lease value payments ** present value of an annuity due of $1: n=20, i=2% 10 Brief Exercise 15-12 Amount to be recovered (fair market value) $700,000 Less: Present value of the residual value ($100,000 x .82270*) (82,270) Amount to be recovered through periodic rental payments $617,730 _______________________↓ Rental payments at the beginning ↓ of each of the next 4 years: ($617,730 ÷ 3.54595**) $174,207 * present value of $1: n=4, i=5% ** present value of an ordinary annuity of $1: n=4, i=5% Brief Exercise 15-13 Amount to be recovered (fair market value) $600,000 Less: Present value of the BPO price ($100,000 x .74726*) (74,726) Amount to be recovered through periodic rental payments $525,274 _____________________↓ Rental payments at the beginning ↓ of each of the next 5 years: ($525,274 ÷ 4.46511**) $117,640 * present value of $1: n=5, i=6% ** present value of an annuity due of $1: n=5, i=6% 11 EXERCISES Exercise 15-1 (a) Nath-Langstrom Services, Inc. (Lessee) June 30, 2006 Rent expense .................................. 10,000 Cash ........................................... 10,000 December 31, 2006 Rent expense .................................. 10,000 Cash ........................................... 10,000 (b) ComputerWorld Corporation (Lessor) June 30, 2006 Cash ............................................... 10,000 Rent revenue .............................. 10,000 December 31, 2006 Cash ............................................... 10,000 Rent revenue .............................. 10,000 Depreciation expense ($90,000 ÷ 6 years) 15,000 Accumulated depreciation ......... 15,000 12 Exercise 15-2 January 1, 2006 Prepaid rent (advance payment) ........................ 96,000 Cash .......................................................... 96,000 Prepaid rent (annual rent payment) ................... 80,000 Cash .......................................................... 80,000 Leasehold improvements .............................. 180,000 Cash .......................................................... 180,000 December 31, 2006 Rent expense (annual rent) .............................. 80,000 Prepaid rent .............................................. 80,000 Rent expense (advance payment allocation) ....... 32,000 Prepaid rent ($96,000 ÷ 3) ........................... 32,000 Depreciation expense ($180,000 ÷ 3 years) ....... 60,000 Accumulated depreciation ........................ 60,000 Exercise 15-3 1. d 2. d 13 Exercise 15-4 Present Value of Minimum Lease Payments: ($15,000 x 7.47199*) = $112,080 rental present payments value * present value of an annuity due of $1: n=8, i=2% [i = 2% (8% ÷ 4) because the lease calls for quarterly payments] Lease Amortization Schedule Rental Effective Decrease Outstanding Payments Interest in Balance Balance 2% x Outstanding Balance 112,080 1 15,000 15,000 97,080 2 15,000 .02 (97,080) = 1,942 13,058 84,022 3 15,000 .02 (84,022) = 1,680 13,320 70,702 4 15,000 .02 (70,702) = 1,414 13,586 57,116 5 15,000 .02 (57,116) = 1,142 13,858 43,258 6 15,000 .02 (43,258) = 865 14,135 29,123 7 15,000 .02 (29,123) = 582 14,418 14,705 8 15,000 .02 (14,705) = 295* 14,705 0 120,000 7,920 112,080 * adjusted for rounding of other numbers in the schedule January 1, 2006 Leased equipment (calculated above) ..................... 112,080 Lease payable (calculated above) ....................... 112,080 Lease payable ..................................................... 15,000 Cash (rental payment) ......................................... 15,000 14 Exercise 15-4 (concluded) April 1, 2006 Interest expense (2% x [$112,080 – 15,000]) ............. 1,942 Lease payable (difference) .................................... 13,058 Cash (rental payment) ......................................... 15,000 July 1, 2006 Interest expense (2% x $84,022: from schedule) ........ 1,680 Lease payable (difference) .................................... 13,320 Cash (rental payment) ......................................... 15,000 October 1, 2006 Interest expense (2% x $70,702: from schedule) ........ 1,414 Lease payable (difference) .................................... 13,586 Cash (rental payment) ......................................... 15,000 December 31, 2006 Interest expense (2% x $57,116: from schedule) ........ 1,142 Interest payable .............................................. 1,142 Depreciation expense ($112,080 ÷ 2 years) ............... 56,040 Accumulated depreciation .............................. 56,040 January 1, 2007 Interest payable (from adjusting entry) ....................... 1,142 Lease payable (difference) .................................... 13,858 Cash (rental payment) ......................................... 15,000 15 Exercise 15-5 Lease Amortization Schedule Rental Effective Decrease Outstanding Payments Interest in Balance Balance 2% x Outstanding Balance 112,080 1 15,000 15,000 97,080 2 15,000 .02 (97,080) = 1,942 13,058 84,022 3 15,000 .02 (84,022) = 1,680 13,320 70,702 4 15,000 .02 (70,702) = 1,414 13,586 57,116 5 15,000 .02 (57,116) = 1,142 13,858 43,258 6 15,000 .02 (43,258) = 865 14,135 29,123 7 15,000 .02 (29,123) = 582 14,418 14,705 8 15,000 .02 (14,705) = 295* 14,705 0 120,000 7,920 112,080 * adjusted for rounding of other numbers in the schedule January 1, 2006 Lease receivable ($15,000 x 8) .............................. 120,000 Unearned interest revenue ($120,000 - 112,080) 7,920 Inventory of equipment (lessor’s cost) .............. 112,080 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 April 1, 2006 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 Unearned interest revenue ................................. 1,942 Interest revenue (2% x [$112,080 – 15,000]) ........ 1,942 July 1, 2006 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 Unearned interest revenue ................................. 1,680 Interest revenue (2% x $84,022: from schedule) ... 1,680 16 Exercise 15-5 (concluded) October 1, 2006 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 Unearned interest revenue ................................. 1,414 Interest revenue (2% x $70,702: from schedule) ... 1,414 December 31, 2006 Unearned interest revenue ................................. 1,142 Interest revenue (2% x $57,116: from schedule) ... 1,142 January 1, 2007 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 17 Exercise 15-6 Requirement 1 Lessor’s Calculation of Rental Payments Amount to be recovered (fair market value) $112,080 __________________↓ Rent payments at the beginning ↓ of each of eight quarters: ($112,080 ÷ 7.47199**) $15,000 ** present value of an annuity due of $1: n=8, i=2% Requirement 2 January 1, 2006 Lease receivable ($15,000 x 8) .............................. 120,000 Cost of goods sold (lessor’s cost) .......................... 85,000 Sales revenue (fair market value) ....................... 112,080 Unearned interest revenue ($120,000 - 112,080) 7,920 Inventory of equipment (lessor’s cost) .............. 85,000 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 April 1, 2006 Cash (rental payment) ............................................. 15,000 Lease receivable ............................................. 15,000 Unearned interest revenue ................................. 1,942 Interest revenue (2% x [$112,080 – 15,000]) ........ 1,942 18 Exercise 15-7 Requirement 1 January 1, 2006 Leased assets ....................................................... 4,000,000 Lease payable .................................................. 4,000,000 Requirement 2 $4,000,000 ÷ 3.16987** = $1,261,881 present lease value payment ** present value of an ordinary annuity of $1: n=4, i=10% Lease Amortization Schedule Rental Effective Decrease Outstanding Payments Interest in Balance Balance 10% x Outstanding Balance 4,000,000 2006 1,261,881 .10 (4,000,000) = 400,000 861,881 3,138,119 2007 1,261,881 .10 (3,138,119) = 313,812 948,069 2,190,050 2008 1,261,881 .10 (2,190,050) = 219,005 1,042,876 1,147,174 2009 1,261,881 .10 (1,147,174) = 114,707* 1,147,174 0 5,047,524 1,047,524 4,000,000 * adjusted for rounding of other numbers in the schedule Requirement 3 December 31, 2006 Interest expense (10% x outstanding balance) .......... 400,000 Lease payable (difference) .................................... 861,881 Cash (payment determined above) ........................ 1,261,881 Requirement 4 December 31, 2008 Interest expense (10% x outstanding balance) .......... 219,005 Lease payable (difference) .................................... 1,042,876 Cash (payment determined above) ........................ 1,261,881 19 Exercise 15-8 1. Calculation of the present value of lease payments $562,907 x 5.32948 Φ = $3,000,000 (rounded) Φ present value of an annuity due of $1: n=6, i=5% 2. Liability at December 31, 2006 Initial balance, June 30, 2006 .................................. $3,000,000 June 30, 2006 reduction ........................................... (562,907)* Dec. 31, 2006 reduction ........................................... (441,052)** December 31, 2006 net liability .............................. $1,996,041 Asset at December 31, 2006 Initial balance, June 30, 2006 .................................. $3,000,000 Accumulated depreciation at Dec. 31, 2006 ............ (500,000)** December 31, 2006 ............................................ $2,500,000 3. Expenses for year ended December 31, 2006 June 30, 2006 interest expense ................................ $ 0* Dec. 31, 2006 interest expense ................................ 121,855** Interest expense for 2006 ......................................... $121,855 Depreciation expense for 2006 ................................ 500,000 Total expenses ....................................................... $621,855 Calculations: June 30, 2006* Leased equipment (calculated in req. 1) ........................... 3,000,000 Lease payable (calculated in req. 1) .............................. 3,000,000 Lease payable ................................................................. 562,907 Cash (rental payment) ................................................... 562,907 December 31, 2006** Interest expense (5% x [$3 million – 562,907]) ................ 121,855 Lease payable (difference) ............................................... 441,052 Cash (rental payment) ................................................... 562,907 Depreciation expense ($3 million / 3 years x ½ year) .... 500,000 Accumulated depreciation .......................................... 500,000 20 Exercise 15-9 1. Receivable at December 31, 2006 Receivable – Unearned = Net Rec. Interest Initial balance, June 30, 2006 ............ $3,377,442 377,442 $3,000,000 June 30, 2006 reduction ..................... (562,907)* 0 (562,907) Dec. 31, 2006 reduction ..................... (562,907)** (121,855) (441,052) December 31, 2006 net receivable .... $2,251,628 255,587 $1,996,041 The receivable is reported as: Lease receivable ................................. $2,251,628 Less: unearned interest revenue ......... (255,587) $1,996,041 The receivable replaces the $3,000,000 machine on the balance sheet. 2. Interest revenue for year ended December 31, 2006 June 30, 2006 interest revenue ................................ $ 0* Dec. 31, 2006 interest revenue ................................ 121,855** Interest revenue for 2006 ......................................... $121,855 Calculations: June 30, 2006* Lease receivable ($562,907 x 6) ...................................... 3,377,442 Unearned interest revenue ($3,377,442 – 3,000,000) ... 377,442 Inventory of equipment (lessor’s cost) ......................... 3,000,000 Cash (rental payment) ..................................................... 562,907 Lease receivable .......................................................... 562,907 December 31, 2006** Cash (rental payment) ....................................................... 562,907 Lease receivable .......................................................... 562,907 Unearned interest revenue ............................................. 121,855 Interest revenue (5% x [$3,000,000 – 562,907]) .......... 121,855 21 Exercise 15-10 1. Calculation of the present value of lease payments (“selling price”) $562,907 x 5.32948 Φ = $3,000,000 (rounded) Φ present value of an annuity due of $1: n=6, i=5% 2. Receivable at December 31, 2006 Receivable – Unearned = Net Rec. Interest Initial balance, June 30, 2006 ............ $3,377,442 377,442 $3,000,000 June 30, 2006 reduction ..................... (562,907)* 0 (562,907) Dec. 31, 2006 reduction ..................... (562,907)** (121,855) (441,052) December 31, 2006 net receivable .... $2,251,628 255,587 $1,996,041 The receivable is reported as: Lease receivable ................................. $2,251,628 Less: unearned interest revenue ......... (255,587) $1,996,041 The receivable replaces the $2,500,000 machine on the balance sheet. 3. Income effect for year ended December 31, 2006 June 30, 2006 interest revenue ................................ $ 0* Dec. 31, 2006 interest revenue ................................ 121,855** Interest revenue for 2006 ......................................... $ 121,855 Sales revenue* ............................................................ 3,000,000 Cost of goods sold* .................................................... (2,500,000) Income effect ........................................................... $ 621,855 22 Exercise 15-10 (concluded) Calculations: June 30, 2006* Lease receivable ($562,907 x 6) ...................................... 3,377,442 Cost of goods sold (lessor’s cost) ................................... 2,500,000 Sales revenue (present value) ..................................... 3,000,000 Unearned interest revenue ($3,377,442 – 3,000,000) ... 377,442 Inventory of equipment (lessor’s cost) ....................... 2,500,000 Cash (rental payment) ..................................................... 562,907 Lease receivable .......................................................... 562,907 December 31, 2006** Cash (rental payment) ....................................................... 562,907 Lease receivable .......................................................... 562,907 Unearned interest revenue ............................................. 121,855 Interest revenue (5% x [$3,000,000 – 562,907]) .......... 121,855 23 Exercise 15-11 Situation 1 (a) $600,000 ÷ 6.53705** = $91,785 fair market lease value payments ** present value of an annuity due of $1: n=10, i=11% (b) $91,785 x 6.53705** = $600,000 (rounded) lease leased asset/ payments lease liability ** present value of an annuity due of $1: n=10, i=11% Situation 2 (a) $980,000 ÷ 9.95011** = $98,491 fair market lease value payments ** present value of an annuity due of $1: n=20, i=9% (b) $98,491 x 9.95011** = $980,000 (rounded) lease leased asset/ payments lease liability ** present value of an annuity due of $1: n=20, i=9% Situation 3 (a) $185,000 ÷ 3.40183** = $54,382 fair market lease value payments ** present value of an annuity due of $1: n=4, i=12% (b) $54,382 x 3.44371** = $187,276 lease leased asset/ payments lease liability ** present value of an annuity due of $1: n=4, i=11% 24 But since this amount exceeds the asset’s fair value, the lessee must capitalize the $185,000 fair value instead. 25 Exercise 15-12 Situation 1 (a) $600,000 ÷ 5.88923** = $101,881 fair market lease value payments ** present value of an ordinary annuity of $1: n=10, i=11% (b) $101,881 x 5.88923** = $600,000* lease leased asset/ payments lease liability * rounded ** present value of an ordinary annuity of $1: n=10, i=11% Situation 2 (a) $980,000 ÷ 9.12855** = $107,355 fair market lease value payments ** present value of an ordinary annuity of $1: n=20, i=9% (b) $107,355 x 9.12855** = $980,000‡ lease leased asset/ payments lease liability ** present value of an ordinary annuity of $1: n=20, i=9% ‡ rounded for convenience Situation 3 (a) $185,000 ÷ 3.03735** = $60,908 fair market lease value payments ** present value of an ordinary annuity of $1: n=4, i=12% (b) $60,908 x 3.10245** = $188,964 lease leased asset/ payments lease liability ** present value of an ordinary annuity of $1: n=4, i=11% 26 But since this amount exceeds the asset’s fair value, the lessee must capitalize the $185,000 fair value instead. 27 Exercise 15-13 Situation 1 Amount to be recovered (fair market value) $50,000 ___________________↓ Rental payments at the beginning ↓ of each of the next 4 years: ($50,000 ÷ 3.48685**) $ 14,340 ** present value of an annuity due of $1: n=4, i=10% Situation 2 Amount to be recovered (fair market value) $350,000 Less: Present value of the residual value ($50,000 x .48166*) (24,083) Amount to be recovered through periodic rental payments $325,917 _______________________↓ Rental payments at the beginning ↓ of each of the next 7 years: ($325,917 ÷ 5.23054**) $ 62,310 * present value of $1: n=7, i=11% ** present value of an annuity due of $1: n=7, i=11% 28 Exercise 15-13 (concluded) Situation 3 Amount to be recovered (fair market value) $75,000 Less: Present value of the residual value ($7,000 x .64993*) (4,550) Amount to be recovered through periodic rental payments $70,450 ______________________↓ Rental payments at the beginning ↓ of each of the next 5 years: ($70,450 ÷ 4.23972**) $ 16,617 * present value of $1: n=5, i=9% ** present value of an annuity due of $1: n=5, i=9% Situation 4 Amount to be recovered (fair market value) $465,000 Less: Present value of the residual value ($45,000 x .40388*) (18,175) Amount to be recovered through periodic rental payments $446,825 ______________________↓ Rental payments at the beginning ↓ of each of the next 8 years: ($446,825 ÷ 5.56376**) $ 80,310 * present value of $1: n=8, i=12% ** present value of an annuity due of $1: n=8, i=12% 29 Exercise 15-14 Situation 1 2 3 4 A. The lessor’s: 1. Minimum lease payments1 $700,000 $750,000 $800,000 $840,000 2. Gross investment in the lease2 700,000 750,000 850,000 900,000 3. Net investment in the lease3 548,592 547,137 610,168 596,764 4. Unearned interest revenue4 151,408 202,863 239,832 303,236 B. The lessee’s: 5. Minimum lease payments5 700,000 750,000 800,000 840,000 6. Leased asset6 548,592 547,137 586,842 572,531 7. Lease liability7 548,592 547,137 586,842 572,531 1 ($100,000 x number of payments) + residual value guaranteed by lessee and/or by third party; for situation 4: ($100,000 x 8) + ($40,000). 2 Minimum lease payments plus unguaranteed residual value; for situation 4: ($840,000 + $60,000). 3 Present value of gross investment (discounted at lessor’s rate); for situation 4: ($100,000 x 5.56376) + ($100,000 x .40388). 4 Gross investment - net investment; for situation 4: ($900,000 - 596,764). 5 ($100,000 x number of payments) + residual value guaranteed by lessee; for situation 4: ($100,000 x 8) + $40,000. 6 Present value of minimum lease payments (discounted at lower of lessor’s rate and lessee’s incremental borrowing rate); should not exceed fair market value; for situation 4: ($100,000 x 5.56376) + ($40,000 x .40388). 7 Present value of minimum lease payments (discounted at lower of lessor’s rate and lessee’s incremental borrowing rate); should not exceed fair market value; for situation 4: ($100,000 x 5.56376) + ($40,000 x .40388). 30 Exercise 15-15 Situation 1 Amount to be recovered (fair market value) $60,000 Less: Present value of the BPO price ($10,000 x .56743*) (5,674) Amount to be recovered through periodic rental payments $54,326 _____________________↓ Rental payments at the beginning ↓ of each of the next 5 years: ($54,326 ÷ 4.03735**) $13,456 * present value of $1: n=5, i=12% ** present value of an annuity due of $1: n=5, i=12% Situation 2 Amount to be recovered (fair market value) $420,000 Less: Present value of the BPO price ($50,000 x .59345*) (29,673) Amount to be recovered through periodic rental payments $390,327 _____________________↓ Rental payments at the beginning ↓ of each of the next 5 years: ($390,327 ÷ 4.10245**) $95,145 * present value of $1: n=5, i=11% ** present value of an annuity due of $1: n=5, i=11% Note: Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. 31 Exercise 15-15 (concluded) Situation 3 Amount to be recovered (fair market value) $185,000 Less: Present value of the BPO price ($22,000 x .77218*) (16,988) Amount to be recovered through periodic rental payments $168,012 _____________________↓ Rental payments at the beginning ↓ of each of the next 3 years: ($168,012 ÷ 2.75911**) $60,894 * present value of $1: n=3, i=9% ** present value of an annuity due of $1: n=3, i=9% Note: Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. 32 Exercise 15-16 Requirement 1 Note: Because exercise of the option appears at the inception of the lease to be reasonably assured, payment of the option price ($45,000) is expected to occur when the option becomes exercisable (at the end of the third year). Present value of annual rental payments ($36,000 x 2.69005**) $ 96,842 Plus: Present value of the BPO price ($45,000 x .71178*) 32,030 Present value of minimum lease payments $128,872 * present value of $1: n=3, i=12% ** present value of an annuity due of $1: n=3, i=12% Requirement 2 Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 12% x Outstanding Balance 128,872 2005 36,000 36,000 92,872 2006 36,000 .12 (92,872) = 11,145 24,855 68,017 2007 36,000 .12 (68,017) = 8,162 27,838 40,179 2008 45,000 .12 (40,179) = 4,821 40,179 0 153,000 24,128 128,872 33 Exercise 15-16 (concluded) Requirement 3 December 31, 2005 Leased equipment (calculated above) ....................... 128,872 Lease payable (calculated above) ......................... 128,872 Lease payable ....................................................... 36,000 Cash (annual payment) ......................................... 36,000 December 31, 2006 Depreciation expense ($128,872 ÷ 6 years*) .............. 21,479 Accumulated depreciation ................................ 21,479 Interest expense (12% x [$128,872 - 36,000]) .............. 11,145 Lease payable (difference : from schedule) ................ 24,855 Cash (annual payment) ......................................... 36,000 December 31, 2007 Depreciation expense ($128,872 ÷ 6 years*) .............. 21,479 Accumulated depreciation ................................ 21,479 Interest expense (12% x $68,017 : from schedule) ....... 8,162 Lease payable (difference : from schedule) ................ 27,838 Cash (annual payment) ......................................... 36,000 December 31, 2008 Depreciation expense ($128,872 ÷ 6 years*) .............. 21,479 Accumulated depreciation ................................ 21,479 Interest expense (12% x $40,179: from schedule) ........ 4,821 Lease payable (difference : from schedule) ................ 40,179 Cash (BPO price) ................................................. 45,000 * Because title passes with the expected exercise of the BPO, depreciation is for the entire six-year useful life of the asset. The depreciation entry will be recorded for three years after the completion of the lease term. 34 Exercise 15-17 Requirement 1 Amount to be recovered (fair market value) $30,900 Less: Present value of the BPO price ($12,000 x .75131*) (9,016) Amount to be recovered through periodic rental payments $21,884 _____________________↓ Rental payments at the beginning ↓ each of three years: ($21,884 ÷ 2.73554**) $8,000 * present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10% Requirement 2 Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 30,900 2005 8,000 8,000 22,900 2006 8,000 .10 (22,900) = 2,290 5,710 17,190 2007 8,000 .10 (17,190) = 1,719 6,281 10,909 2008 12,000 .10 (10,909) = 1,091 10,909 0 36,000 5,100 30,900 35 Exercise 15-17 (concluded) Requirement 3 December 31, 2005 Lease receivable ([$8,000 x 3] + $12,000) ........................... 36,000 Unearned interest revenue ($36,000 - 30,900) ............... 5,100 Inventory of equipment (lessor’s cost) .......................... 30,900 Cash (lease payment) .......................................................... 8,000 Lease receivable .......................................................... 8,000 December 31, 2006 Cash (lease payment) .......................................................... 8,000 Lease receivable .......................................................... 8,000 Unearned interest revenue ............................................. 2,290 Interest revenue (10% x [$30,900 - 8,000]) .......................... 2,290 December 31, 2007 Cash (lease payment) .......................................................... 8,000 Lease receivable .......................................................... 8,000 Unearned interest revenue ............................................. 1,719 Interest revenue (10% x $17,190 : from schedule) ............... 1,719 December 30, 2008 Unearned interest revenue (account balance) ......................... 1,091 Interest revenue (10% x $10,909 : from schedule) ............... 1,091 Cash (BPO price) ............................................................... 12,000 Lease receivable (account balance) ................................ 12,000 36 Exercise 15-18 December 31, 2005 Brand Services (Lessee) Leased equipment (present value of lease payments) ............ 316,412 Lease payable (present value of lease payments) .............. 316,412 Lease payable (payment less executory costs) ...................... 50,000 Prepaid maintenance (2006 fee)............................................... 5,000 Cash (annual payment) ................................................... 55,000 NRC Credit (Lessor) Lease receivable ($50,000 x 10) ........................................ 500,000 Unearned interest revenue ($500,000 - 316,412) ............ 183,588 Inventory of equipment (lessor’s cost) .......................... 316,412 Cash (annual payment) ....................................................... 55,000 Maintenance fee payable [or cash] ............................. 5,000 Lease receivable ......................................................... 50,000 December 31, 2006 Brand Services (Lessee) Maintenance expense (2006 fee) ............................................. 5,000 Prepaid maintenance (paid in 2005) .................................... 5,000 Interest expense (12% x [$316,412 – 50,000]) ......................... 31,969 Lease payable (difference) ................................................ 18,031 Prepaid maintenance (2007 fee)............................................... 5,000 Cash (lease payment) ...................................................... 55,000 Depreciation expense ($316,412 ÷ 10 years) .......................... 31,641 Accumulated depreciation .......................................... 31,641 NRC Credit (Lessor) Cash (lease payment) .......................................................... 55,000 Lease receivable (payment less executory costs) .............. 50,000 Maintenance fee payable [or cash] ............................. 5,000 Unearned interest revenue ............................................. 31,969 Interest revenue (12% x [$316,412 – 50,000]) ..................... 31,969 37 Exercise 15-19 December 31, 2006 Brand Services (Lessee) Maintenance expense (2006 fees plus lessor profit) ................ 5,950 Prepaid maintenance (paid in 2005) .................................... 5,950 Interest expense (12% x [$316,412 – 50,000]) ......................... 31,969 Lease payable (difference) ................................................ 18,031 Prepaid maintenance (2007 fees plus lessor profit) ................. 5,950 Cash (lease payment) ...................................................... 55,950 Depreciation expense ($316,412 ÷ 10 years) .......................... 31,641 Accumulated depreciation .......................................... 31,641 NRC Credit (Lessor) Unearned miscellaneous revenue (received in 2005) ......... 250 Miscellaneous revenue (2006 fee) ................................ 250 Cash (lease payment) .......................................................... 55,950 Lease receivable (payment less executory costs) .............. 50,000 Maintenance fee payable ........................................... 5,000 Insurance premium payable ....................................... 700 Unearned miscellaneous revenue (2007 fee) ................ 250 Unearned interest revenue ............................................. 31,969 Interest revenue (12% x [$316,412 – 50,000]) ..................... 31,969 Exercise 15-20 1. d 2. a 3. a 38 Exercise 15-21 Requirement 1 January 1 Cash ................................................................................ 20,873 Unearned rent revenue* .............................................. 20,873 Deferred initial direct cost .............................................. 2,062 Cash ............................................................................ 2,062 December 31 Unearned rent revenue .................................................... 20,873 Rent revenue* ............................................................. 20,873 Lease expense ($2,062 ÷ 3 years) ....................................... 687 Deferred initial direct cost .......................................... 687 Depreciation expense ($100,000 ÷ 6 years) ........................ 16,667 Accumulated depreciation .......................................... 16,667 * Alternatively, Rent revenue. Either way, an adjusting entry is needed at the end of the reporting period to assure that the earned portion of the payment is recorded in Rent revenue and the unearned portion in Unearned rent revenue Requirement 2 January 1 Proof that new effective rate is 9% (not required): $102,062 ÷ 4.88965** = $20,873 lessor’s lease net investment payments ** present value of an annuity due of $1: n=6, i=9% 39 Exercise 15-21 (concluded) January 1 Lease receivable ($20,873 x 6) .......................................... 125,238 Unearned interest revenue ($125,238 - 100,000) ............ 25,238 Inventory of equipment (lessor’s cost) .......................... 100,000 Unearned interest revenue .............................................. 2,062 Cash (initial direct costs) ................................................. 2,062 Cash (lease payment) .......................................................... 20,873 Lease receivable .......................................................... 20,873 December 31 Unearned interest revenue .............................................. 7,307 Interest revenue (9% x [$100,000 + 2,062 - 20,873]) ........ 7,307 Requirement 3 January 1 Lease receivable ($20,873 x 6) .......................................... 125,238 Cost of goods sold (lessor’s cost) ...................................... 85,000 Sales revenue (fair market value) ................................... 100,000 Unearned interest revenue ($125,238 - 100,000) ............ 25,238 Inventory of equipment (lessor’s cost) .......................... 85,000 Selling expense ............................................................... 2,062 Cash (initial direct costs) ................................................. 2,062 Cash (lease payment) .......................................................... 20,873 Lease receivable .......................................................... 20,873 December 31 Unearned interest revenue .............................................. 7,913 Interest revenue (10% x [$100,000 - 20,873]) .................. 7,913 40 Exercise 15-22 January 1, 2006, 2007, 2008 Cash ................................................................................ 137,000 Rent revenue* ............................................................. 137,000 Deferred initial direct cost .............................................. 2,400 Cash ............................................................................ 2,400 December 31, 2006, 2007, 2008 Lease expense ($2,400 ÷ 3 years) ....................................... 800 Deferred initial direct cost .......................................... 800 Depreciation expense ($800,000 ÷ 8 years) ........................ 100,000 Accumulated depreciation .......................................... 100,000 * Alternatively, Unearned rent revenue. If so, an adjusting entry is needed at the end of the reporting period to transfer the $137,000, now earned, from Unearned rent revenue to Rent revenue. 41 Exercise 15-23 1. January 1, 2006 Lease receivable ($184,330 x 3) ........................................ 552,990 Unearned interest revenue ($552,990 - 500,000) ............ 52,990 Inventory of equipment (lessor’s cost) .......................... 500,000 Unearned interest revenue .............................................. 4,242 Cash (initial direct costs) ................................................. 4,242 Cash (lease payment) .......................................................... 184,330 Lease receivable .......................................................... 184,330 2. Effective rate of interest revenue: Since the unearned interest is reduced by the initial direct costs, the net investment is higher: $500,000 + $4,242. The new effective rate is the discount rate that equates the net investment and the future lease payments: $504,242 ÷ ? ** = $184,330 lessor’s lease net investment payments ** present value of an annuity due of $1: n=3, i=?% Rearranging algebraically: $504,242 ÷ $184,330= 2.73554. When you consult the present value table for an annuity due, you search row 3 (n=3) for this value and find it in the 10% column. So the effective interest rate is 10%. The net investment is amortized at the new rate. 3. December 31, 2006 Unearned interest revenue .............................................. 31,991 Interest revenue (10% x [$500,000 + 4,242 - 184,330]) ..... 31,991 42 Exercise 15-24 Inception of the Lease Lease receivable ($69,571 x 5) .......................................... 347,855 Cost of goods sold (lessor’s cost) ...................................... 265,000 Sales revenue (fair market value) ................................... 300,000 Unearned interest revenue ($347,855 - 300,000) ............ 47,855 Inventory of equipment (lessor’s cost) .......................... 265,000 Selling expense ............................................................... 7,500 Cash (initial direct costs) ................................................. 7,500 Cash (lease payment) .......................................................... 69,571 Lease receivable .......................................................... 69,571 December 31 Unearned interest revenue .............................................. 18,434 Interest revenue (8% x [$300,000 - 69,571) ..................... 18,434 43 Exercise 15-25 Present value of periodic rental payments* ($102,771 x 7.49236**) $770,000* * rounded ** present value of an annuity due of $1: n=13, i=11% The lease meets at least one (actually 3 of 4 in this case) criteria for classification as a capital lease. January 1, 2006 Cash (given) ...................................................................... 770,000 Airplanes (carrying value) .............................................. 620,000 Deferred gain on sale-leaseback (difference) ................ 150,000 Leased airplane (present value of lease payments) ................... 770,000 Lease payable (present value of lease payments) .............. 770,000 Lease payable ................................................................. 102,771 Cash ............................................................................ 102,771 December 31, 2006 Interest expense (11% x [$770,000 - 102,771]) ........................ 73,395 Interest payable .......................................................... 73,395 Depreciation expense ($770,000 ÷ 15 years*) ..................... 51,333 Accumulated depreciation .......................................... 51,333 Deferred gain on sale-leaseback ($150,000 ÷ 15 years) ....... 10,000 Depreciation expense ................................................. 10,000 * The airplane is depreciated over its remaining useful life rather than the lease term because title transfers to the lessee. 44 Exercise 15-26 January 1, 2006 Cash (given) ...................................................................... 800,000 Accumulated depreciation (cost - carrying amount) ............ 350,000 Building (original cost) .................................................. 1,000,000 Deferred gain on sale-leaseback (difference) ................ 150,000 December 31, 2006 Rent expense .............................................................................. 100,000 Cash (rental payment) ..................................................... 100,000 Deferred gain on sale-leaseback ($150,000 ÷ 12 years) ....... 12,500 Rent expense .............................................................. 12,500 Exercise 15-27 1. d 2. a 45 Exercise 15-28 List A List B j_ 1. Effective rate times balance. a. PV of BPO price. k_ 2. Realization principle. b. Lessor’s net investment. c_ 3. Minimum lease payments plus c. Lessor’s gross investment. unguaranteed residual value. d. Operating lease. l_ 4. Periodic rent payments plus e. Depreciable assets. lessee-guaranteed residual value. f. Loss to lessee. b_ 5. PV of minimum lease payments plus g. Executory costs. PV of unguaranteed residual value. h. Depreciation longer than lease term. n_ 6. Initial direct costs. i. Disclosure only. d_ 7. Rent revenue. j. Interest expense. m_8. Bargain purchase option. k. Additional lessor conditions. e_ 9. Leasehold improvements. l. Lessee’s minimum lease payments f_10. Cash to satisfy residual value m. Purchase price less than fair guarantee. market value. g_11. Capital lease expense. n. Sales-type lease selling expense. a_12. Deducted in lessor’s computation o. Lessor’s minimum lease payments. of rental payments. h_13. Title transfers to lessee. i_14. Contingent rentals. o_15. Rent payments plus lessee-guaranteed and 3rd-party-guaranteed residual value. 46 Exercise 15-29 Note: Because exercise of the option appears at the inception of the lease to be reasonably assured, payment of the option price ($100,000) is expected to occur when the option becomes exercisable (at the end of the 10th year). When the leased property includes both land and a building and the lease is expected to transfer ownership by exercise of a BPO, the lessee should record each leased asset separately. The present value of the minimum lease payments is allocated between the leased land and leased building accounts on the basis of their relative market values. Present value of lease payments ($200,000 x 6.75902**) $1,351,804 Plus: Present value of the BPO price ($100,000 x .38554*) 38,554 Present value of minimum lease payments $1,390,358 * present value of $1: n=10, i=10% ** present value of an annuity due of $1: n=10, i=10% January 1, 2006 Leased land (fair value) ..................................................... 400,000 Leased building ($1,390,358 - 400,000) .............................. 990,358 Lease liability (calculated above) ................................... 1,390,358 Lease liability .................................................................. 200,000 Cash (annual rental) ....................................................... 200,000 December 31, 2006 Depreciation expense ([$990,358 - 150,000] ÷ 20 years) ....... 42,018 Accumulated depreciation – leased building .............. 42,018 Interest expense ([$1,390,358 - 200,000] x 10%) ..................... 119,036 Interest payable .......................................................... 119,036 47 Exercise 15-30 1. d. For both sales-type and direct-financing leases, the lessor should record as the gross investment in the lease the amount of the minimum lease payments (which include periodic payments plus guaranteed residual value) plus any amounts of unguaranteed residual value. The net investment in the lease is equal to the gross investment, plus any unamortized initial direct costs, minus unearned income. The unguaranteed residual value is the expected value of the leased asset in excess of the guaranteed residual value at the end of the lease term (SFAS 13). 2. b. SFAS 91 defines initial direct costs as having two components: (1) the lessor’s external costs to originate a lease incurred in dealings with independent third parties and (2) the internal costs directly related to specified activities performed by the lessor for that lease. According to SFAS 13, in a sales-type lease, the cost, or carrying amount if different, plus any initial direct costs, minus the present value of any unguaranteed residual value, is charged against income in the same period that the present value of the minimum lease payments is credited to sales. The result is the recognition of a net profit or loss on the sales-type lease. 3. d. A lessee records a lease as a capital lease if it meets any one of four criteria. Existence of a bargain purchase option is one of these criteria. If a lease involving land and a building contains a bargain purchase option or if the lease transfers ownership to the lessee at the end of its term, the lessee separately capitalizes the land and the building. 48 PROBLEMS Problem 15-1 December 31, 2010 Rent expense ($10,000 + [$500 x 20 ÷ 2])* .......................... 15,000 Deferred rent expense payable (difference) .................. 3,000 Cash ($10,000 + [$500 x 4]) ........................................... 12,000 December 31, 2020 Rent expense ($10,000 + [$500 x 20 ÷ 2])* .......................... 15,000 Deferred rent expense payable (difference) ...................... 2,000 Cash ($10,000 + [$500 x 14]) ......................................... 17,000 * This is the average rent over the 20-year period. Also: ($10,000 + $20,000) ÷ 2 Beg. Rent Ending Rent 49 Problem 15-2 1. NIC’s lease liability at the inception of the lease $172,501: [$192,501 – 20,000] (present value of minimum lease payments or initial lease balance minus first payment) 2. Leased asset $192,501 (present value of minimum lease payments; initial lease balance) 3. Lease term in years 20 years 4. Asset’s residual value expected at the end of the lease term $35,000 5. Residual value guaranteed by the lessee $35,000 (would not be part of lessee’s minimum lease payments unless lessee-guaranteed) 6. Effective annual interest rate 10%: ($17,250 ÷ $172,501) 7. Total of minimum lease payments $435,000: [$20,000 x 20 years] + $35,000 8. Total effective interest expense over the term of the lease $242,499: [$435,000 - 192,501] 50 Problem 15-3 Requirement 1 Capital lease to lessee; Direct financing lease to lessor. Since the present value of minimum lease payments (same for both the lessor and the lessee) is equal to (>90%) the fair value of the asset, the 90% recovery criterion is met. Calculation of the Present Value of Minimum Lease Payments Present value of periodic rental payments $130,516 x 15.32380** = $2,000,000 (rounded) ** present value of an annuity due of $1: n=20, i=3% The 75% of useful life criterion is met also. Both additional lessor conditions are met for a nonoperating lease. There is no dealer’s profit because the fair value equals the lessor’s cost. Requirement 2 Mid-South Urologists Group (Lessee) January 1, 2006 Leased equipment (calculated above) ................................. 2,000,000 Lease payable (calculated above) ................................... 2,000,000 Lease payable ................................................................. 130,516 Cash (rental payment) ..................................................... 130,516 April 1, 2006 Interest expense (3% x [$2 million – 130,516]) ........................ 56,085 Lease payable (difference) ................................................ 74,431 Cash (rental payment) ..................................................... 130,516 51 Problem 15-3 (concluded) Physicians’ Leasing (Lessor) January 1, 2006 Lease receivable ($130,516 x 20) ...................................... 2,610,320 Unearned interest revenue ($2,610,320 - 2,000,000) ....... 610,320 Inventory of equipment (lessor’s cost) .......................... 2,000,000 Cash (rental payment) ......................................................... 130,516 Lease receivable ......................................................... 130,516 April 1, 2006 Cash (rental payment) ......................................................... 130,516 Lease receivable ......................................................... 130,516 Unearned interest revenue ............................................. 56,085 Interest revenue (3% x [$2 million – 130,516]) .................. 56,085 Requirement 3 Rand Medical (Lessor) January 1, 2006 Lease receivable ($130,516 x 20) ...................................... 2,610,320 Cost of goods sold (lessor’s cost) ...................................... 1,700,000 Sales revenue (fair market value) ................................... 2,000,000 Unearned interest revenue ($2,610,320 - 2,000,000) ....... 610,320 Inventory of equipment (lessor’s cost) .......................... 1,700,000 Cash (rental payment) ......................................................... 130,516 Lease receivable ......................................................... 130,516 April 1, 2006 Cash (rental payment) ......................................................... 130,516 Lease receivable ......................................................... 130,516 Unearned interest revenue ............................................. 56,085 Interest revenue (3% x [$2 million – 130,516]) .................. 56,085 52 Problem 15-4 [Note: This problem is the lease equivalent of Problem 14-11, which deals with a parallel situation in which the machine was acquired with an installment note. 1. Effective rate of interest implicit in the agreement $6,074,700 ÷ $2,000,000 = 3.03735 present lease present value value payment table amount This is the ordinary annuity present value table amount for n = 4, i = ? In row 4 of the present value table, the number 3.03735 is in the 12% column. So, 12% is the implicit interest rate. 2. Inception of the lease Leased asset (fair market value ) ......................................... 6,074,700 Leases payable (present value ) ..................................... 6,074,700 3. December 31, 2006 Interest expense (12% x $6,074,700) ........................................ 728,964 Leases payable (difference) ............................................... 1,271,036 Cash (rental payment) ..................................................... 2,000,000 4. December 31, 2007 Interest expense (12% x [$6,074,700 – 1,271,036]) ................. 576,440 Lease payable (difference) ................................................ 1,423,560 Cash (rental payment) ..................................................... 2,000,000 5. Inception of the lease $2,000,000 x 3.10245** = $6,204,900 rental present payment value ** present value of an ordinary annuity of $1: n=4, i=11% Leased asset ................................................................... 6,204,900 Lease payable .............................................................. 6,204,900 53 Problem 15-5 1. Calculation of the present value of lease payments $391,548 x 15.32380Φ = $6,000,000 (rounded) Φ present value of an annuity due of $1: n=20, i=3% 2. Liability at December 31, 2006 Initial balance, September 30, 2006 ........................ $6,000,000 Sept. 30, 2006 reduction .......................................... (391,548)* Dec. 31, 2006 reduction ........................................... (223,294)** December 31, 2006 net liability .............................. $5,385,158 The current and noncurrent portions of the liability would be reported separately. Asset at December 31, 2006 Initial balance, September 30, 2006 ........................ $6,000,000 Accumulated depreciation at Dec. 31, 2006 ............ (300,000)** December 31, 2006 ............................................ $5,700,000 3. Expenses for year ended December 31, 2006 Sept. 30, 2006 interest expense ............................... $ 0* Dec. 31, 2006 interest expense ................................ 168,254** Interest expense for 2006 ......................................... $168,254 Depreciation expense for 2006 ................................ 300,000 Total expenses ....................................................... $468,254 54 Problem 15-5 (concluded) 4. Statement of cash flows for year ended December 31, 2006 Werner would report the $6,000,000* investment in the protein analyzer and its financing with a capital lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are divided into the interest portion and the principal portion. The interest portion, $168,254, is reported as cash outflows from operating activities. The principal portion, $391,548 + $223,294, is reported as cash outflows from financing activities. Note: By the indirect method of reporting cash flows from operating activities, we would add back to net income the $300,000 depreciation expense since it didn’t actually reduce cash. The $168,254 interest expense that reduced net income actually did reduce cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2006* Leased equipment (calculated in req. 1) ........................... 6,000,000 Lease payable (calculated in req. 1) .............................. 6,000,000 Lease payable ................................................................. 391,548 Cash (rental payment) ................................................... 391,548 December 31, 2006** Interest expense (3% x [$6 million – 391,548]) ................ 168,254 Lease payable (difference) ............................................... 223,294 Cash (rental payment) ................................................... 391,548 Depreciation expense ($6 million / 5 years x ¼ year) ....... 300,000 Accumulated depreciation .......................................... 300,000 55 Problem 15-6 1. Receivable at December 31, 2006 Receivable – Unearned = Net Rec. Interest Initial balance, September 30, 2006 .. $7,830,960 1,830,960 $6,000,000 Sept. 30, 2006 reduction .................... (391,548)* 0 (391,548) Dec. 31, 2006 reduction ..................... (391,548)** (168,254) (223,294) December 31, 2006 net receivable .... $7,047,864 1,662,706 $5,385,158 The receivable is reported as: Lease receivable ................................. $7,047,864 Less: unearned interest revenue ......... (1,662,706) $5,385,158 The receivable replaces the $6,000,000 machine on the balance sheet. 2. Interest revenue for year ended December 31, 2006 Sept. 30, 2006 interest revenue ................................ $ 0* Dec. 31, 2006 interest revenue ................................ 168,254** Interest revenue for 2006 ......................................... $168,254 3. Statement of cash flows for year ended December 31, 2006 Abbott would report the $6,000,000* direct financing lease of the protein analyzer as a significant noncash investing activity (acquiring one asset and disposing of another) in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are divided into the interest portion and the principal portion. The interest portion, $168,254, is reported as cash inflows from operating activities. The principal portion, $391,548 + $223,294, is reported as cash inflows from investing activities. Note: By the indirect method of reporting cash flows from operating activities, the $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so no adjustment to net income is necessary. 56 Problem 15-6 (concluded) Calculations: September 30, 2006* Lease receivable ($391,548 x 20) ..................................... 7,830,960 Unearned interest revenue ($7,830,960 – 6,000,000) ... 1,830,960 Inventory of equipment (lessor’s cost) ......................... 6,000,000 Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 December 31, 2006** Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 Unearned interest revenue ............................................. 168,254 Interest revenue (3% x [$6,000,000 – 391,548]) ........... 168,254 57 Problem 15-7 1. Calculation of the present value of lease payments (“selling price”) $391,548 x 15.32380Φ = $6,000,000 (rounded) Φ present value of an annuity due of $1: n=20, i=3% 2. Receivable at December 31, 2006 Receivable – Unearned = Net Rec. Interest Initial balance, September 30, 2006 .. $7,830,960 1,830,960 $6,000,000 Sept. 30, 2006 reduction .................... (391,548)* 0 (391,548) Dec. 31, 2006 reduction ..................... (391,548)** (168,254) (223,294) December 31, 2006 net liability ........ $7,047,864 1,662,706 $5,385,158 The receivable is reported as: Lease receivable ................................. $7,047,864 Less: unearned interest revenue ......... (1,662,706) $5,385,158 The receivable replaces the $5,000,000 machine in inventory in the balance sheet. 3. Income effect for year ended December 31, 2006 Sept. 30, 2006 interest revenue ................................ $ 0* Dec. 31, 2006 interest revenue ................................ 168,254** Interest revenue for 2006 ......................................... $ 168,254 Sales revenue* ............................................................ 6,000,000 Cost of goods sold* .................................................... (5,000,000) Income effect ........................................................... $1,168,254 58 Problem 15-7 (continued) 4. Statement of cash flows for year ended December 31, 2006 NutraLabs would report the $6,000,000* sales-type lease of the protein analyzer as a significant noncash activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are considered to be cash flows from operating activities. A sales-type lease differs from a direct financing lease in that we assume the lessor is actually selling its product, an operating activity. Thus, both the interest portion, $168,254, and the principal portion, $391,548 + $223,294, are reported as cash inflows from operating activities. Note: By the indirect method of reporting cash flows from operating activities, the $1,000,000 (Sales revenue: $6,000,000 – Cost of goods sold: $5,000,000) dealer’s profit must be deducted from net income because it is included in net income but won’t increase cash flows until the lease payments are collected over the next five years. This addition, however, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers) and for the change in inventory (to adjust cost of goods sold to cash paid to suppliers). The $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. The principal portion, $391,548 + $223,294, must be added because it is not otherwise included in net income. This, too, though, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers). Noncash adjustments to convert net income to cash flows from operating activities: Increase in lease receivable ........................................ ($7,830,960) Increase in unearned interest (contra lease receivable) 1,830,960 Decrease in inventory of equipment .......................... 5,000,000 Decrease in lease receivable, Sept. 30 ....................... 391,548 Decrease in lease receivable, Dec. 31 ........................ 391,548 Decrease in unearned interest (contra lease receivable), Dec. 31 (168,254) 59 Problem 15-7 (concluded) Calculations: September 30, 2006* Lease receivable ($391,548 x 20) ..................................... 7,830,960 Cost of goods sold (lessor’s cost) ..................................... 5,000,000 Sales revenue (present value) ....................................... 6,000,000 Unearned interest revenue ($7,830,960 – 6,000,000) ... 1,830,960 Inventory of equipment (lessor’s cost) ......................... 5,000,000 Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 December 31, 2006** Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 Unearned interest revenue ............................................. 168,254 Interest revenue (3% x [$6,000,000 – 391,548]) ........... 168,254 60 Problem 15-8 Requirement 1 Lessor’s Calculation of Rental Payments Amount to be recovered (fair market value) $365,760 Less: Present value of the guaranteed residual value ($25,000 x .68301*) (17,075) Amount to be recovered through periodic rental payments $348,685 _____________________↓ Rental payments at the beginning ↓ of each of four years: ($348,685 ÷ 3.48685**) $100,000 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% Requirement 2 The lessee’s incremental borrowing rate (12%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate: 61 Problem 15-8 (continued) Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected NO economic life of the asset? {4 yrs 90% of $365,760} b See calculation below. Present Value of Minimum Lease Payments Present value of periodic rental payments ($100,000 x 3.48685**) $348,685 Plus: Present value of the lessee-guaranteed residual value ($25,000 x .68301*) 17,075 Present value of minimum lease payments $365,760 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% 62 Problem 15-8 (continued) (a) By Western Soya Co. (the lessee) Since at least one criterion is met, this is a capital lease to the lessee. Western Soya records the present value of minimum lease payments as a leased asset and a lease liability. (b) By Rhone-Metro (the lessor) Since the fair market value equals the lessor’s carrying value, there is no dealer’s profit, making this a direct financing lease. Requirement 3 December 31, 2006 Western Soya Co. (Lessee) Leased equipment (calculated above) ................................. 365,760 Lease payable (calculated above) ................................... 365,760 Lease payable .................................................................. 100,000 Cash (rental payment) ..................................................... 100,000 Rhone-Metro (Lessor) Lease receivable ([$100,000 x 4] + $25,000) ....................... 425,000 Unearned interest revenue ($425,000 - 365,760) ............ 59,240 Inventory of equipment (lessor’s cost) .......................... 365,760 Cash (rental payment) ......................................................... 100,000 Lease receivable .......................................................... 100,000 63 Problem 15-8 (continued) Requirement 4 Since both use the same discount rate and since the residual value is lessee- guaranteed, the same amortization schedule applies to both the lessee and lessor: Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 2006 365,760 2006 100,000 100,000 265,760 2007 100,000 .10 (265,760) = 26,576 73,424 192,336 2008 100,000 .10 (192,336) = 19,234 80,766 111,570 2009 100,000 .10 (111,570) = 11,157 88,843 22,727 2010 25,000 .10 (22,727) = 2,273 22,727 0 425,000 59,240 365,760 Requirement 5 December 31, 2007 Western Soya Co. (Lessee) Interest expense (10% x [$365,760 - 100,000]) ........................ 26,576 Lease payable (difference) ................................................ 73,424 Cash (rental payment) ..................................................... 100,000 Depreciation expense ([$365,760 - 25,000] ÷ 4 years) ........... 85,190 Accumulated depreciation .......................................... 85,190 Rhone-Metro (Lessor) Cash (rental payment) ......................................................... 100,000 Lease receivable .......................................................... 100,000 Unearned interest revenue ............................................. 26,576 Interest revenue (10% x [$365,760 - 100,000]) ................... 26,576 64 Problem 15-8 (concluded) Requirement 6 December 31, 2010 Western Soya Club (Lessee) Depreciation expense ([$365,760 - 25,000] ÷ 4 years) ......... 85,190 Accumulated depreciation .......................................... 85,190 Interest expense (10% x 22,727: from schedule) ...................... 2,273 Lease payable (difference : from schedule) .......................... 22,727 Accumulated depreciation ($365,760 - 25,000) .................. 340,760 Loss on residual value guarantee ($25,000 - 1,500) ............. 23,500 Leased equipment (account balance) .............................. 365,760 Cash ($25,000 - 1,500) ................................................... 23,500 Rhone-Metro (Lessor) Inventory of equipment (actual residual value) ................... 1,500 Cash ($25,000 - 1,500) ....................................................... 23,500 Lease receivable (account balance) ................................ 25,000 Unearned interest revenue (account balance) ..................... 2,273 Interest revenue (10% x 22,727: from schedule) .................. 2,273 65 Problem 15-9 Requirement 1 Lessor’s Calculation of Rental Payments Amount to be recovered (fair market value) $365,760 Less: Present value of the unguaranteed residual value ($25,000 x .68301*) (17,075) Amount to be recovered through periodic rental payments $348,685 _____________________↓ Rental payments at the beginning ↓ of each of four years: ($348,685 ÷ 3.48685**) $100,000 Plus: Executory costs 4,000 Rental payments including executory costs $104,000 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% 66 Problem 15-9 (continued) Requirement 2 The lessee’s incremental borrowing rate (12%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate: Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected NO economic life of the asset? {4 yrs 90% of $365,760} a See calculation below. 67 Present Value of Minimum Lease Payments Present value of periodic rental payments excluding executory costs of $4,000 ($100,000* x 3.48685**) $348,685 ** present value of an annuity due of $1: n=4, i=10% * Since the residual value is not guaranteed, it is excluded from both the lessor’s and the lessee’s minimum lease payments and therefore does not affect the 90% of fair value test. 68 Problem 15-9 (continued) (a) by Western Soya Co. (the lessee) Since at least one criterion is met, this is a capital lease to the lessee. Western Soya records the present value of minimum lease payments as a leased asset and a lease liability. (b) by Rhone-Metro (the lessor) Since the fair market value exceeds the lessor’s carrying value, the equipment is being “sold” at a profit, making this a sales-type lease: Fair market value $365,760 minus Carrying value (300,000) equals Dealer’s profit $ 65,760 Requirement 3 December 31, 2006 Western Soya Co. (Lessee) Leased equipment (calculated above) ................................. 348,685 Lease payable (calculated above) ................................... 348,685 Lease payable .................................................................. 100,000 Prepaid operating expense (2007 expenses) ....................... 4,000 Cash (rental payment) ..................................................... 104,000 Rhone-Metro (Lessor) Lease receivable ([$100,000 x 4] + $25,000) ....................... 425,000 Cost of goods sold ($300,000 - [$25,000 x .68301]) ............... 282,925 Sales revenue ($365,760 - [$25,000 x .68301]) ................. 348,685 Unearned interest revenue ($425,000 - 365,760) ............ 59,240 Inventory of equipment (lessor’s cost) .......................... 300,000 Cash (rental payment) ......................................................... 104,000 Payable (maintenance, insurance, etc.) ....................... 4,000 Lease receivable .......................................................... 100,000 69 Problem 15-9 (continued) Requirement 4 Lessee (unguaranteed residual value excluded): Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 2006 348,685 2006 100,000 100,000 248,685 2007 100,000 .10 (248,685) = 24,869 75,131 173,554 2008 100,000 .10 (173,554) = 17,355 82,645 90,909 2009 100,000 .10 (90,909) = 9,091 90,909 0 400,000 51,315 348,685 Lessor (unguaranteed residual value included): Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 2006 365,760 2006 100,000 100,000 265,760 2007 100,000 .10 (265,760) = 26,576 73,424 192,336 2008 100,000 .10 (192,336) = 19,234 80,766 111,570 2009 100,000 .10 (111,570) = 11,157 88,843 22,727 2010 25,000 .10 (22,727) = 2,273 22,727 0 425,000 59,240 365,760 70 Problem 15-9 (continued) Requirement 5 December 31, 2007 Western Soya Co. (Lessee) Depreciation expense ([$348,685] ÷ 4 years) .......................... 87,171 Accumulated depreciation .......................................... 87,171 Operating expense (2007 expenses) ................................... 4,000 Prepaid operating expense (paid in 2006) ...................... 4,000 Interest expense (10% x [$348,685– 100,000]) ........................ 24,869 Lease payable (difference) ................................................ 75,131 Prepaid operating expense (2008 expenses) ....................... 4,000 Cash (rental payment) ..................................................... 104,000 Rhone-Metro (Lessor) Cash (rental payment) ......................................................... 104,000 Payable (maintenance, insurance, etc.) ....................... 4,000 Lease receivable .......................................................... 100,000 Unearned interest revenue ............................................. 26,576 Interest revenue (10% x [$365,760– 100,000]) ................... 26,576 71 Problem 15-9 (concluded) Requirement 6 December 31, 2010 Western Soya Co. (Lessee) Operating expense (2010 expenses) ................................... 4,000 Prepaid operating expense (paid in 2009) ...................... 4,000 Depreciation expense ([$348,685] ÷ 4 years) .......................... 87,171 Accumulated depreciation .......................................... 87,171 Accumulated depreciation (account balance) ..................... 348,685 Leased equipment (account balance) .............................. 348,685 Rhone-Metro (Lessor) Inventory of equipment (actual residual value) ................... 1,500 Loss on leased assets ($25,000 - 1,500) ............................. 23,500 Lease receivable (account balance) ................................ 25,000 Unearned interest revenue (account balance) ..................... 2,273 Interest revenue (10% x 22,727: from schedule) .................. 2,273 72 Problem 15-10 Requirement 1 Lessor’s Calculation of Rental Payments Amount to be recovered (fair market value) $365,760 Less: Present value of the BPO price ($10,000 x .75131*) (7,513) Amount to be recovered through periodic rental payments $358,247 _____________________↓ Rental payments at the beginning ↓ of each of three years: ($358,247 ÷ 2.73554**) $130,960 Plus: Executory costs 4,000 Rental payments including executory costs $134,960 * present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10% Requirement 2 The lessee’s incremental borrowing rate (12%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate: 73 Problem 15-10 (continued) Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? YES 3 Is the lease term equal to 75% or more of the expected NO economic life of the asset? {3 yrsa 90% of $365,760} a The lease term is considered to end at the date a BPO becomes exercisable. b See calculation below. 74 Present Value of Minimum Lease Payments Present value of periodic rental payments excluding executory costs of $4,000 ($130,960 x 2.73554**) $358,247*** Plus: Present value of the BPO price ($10,000 x .75131*) 7,513 Present value of minimum lease payments $365,760 * present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10% *** rounded Note: The BPO price is included in both the lessor’s and the lessee’s minimum lease payments. Also the lease term ends for accounting purposes after 3 years, when the BPO becomes exercisable. 75 Problem 15-10 (continued) (a) by Western Soya Co. (the lessee) Since at least one (two in this case) classification criterion is met, this is a capital lease to the lessee. Western Soya records the present value of minimum lease payments as a leased asset and a lease liability. (b) by Rhone-Metro (the lessor) Since the fair market value exceeds the lessor’s carrying value, the equipment is being “sold” at a profit, making this a sales-type lease: Fair market value $365,760 minus Carrying value (300,000) equals Dealer’s profit $ 65,760 Requirement 3 December 31, 2006 Western Soya Co. (Lessee) Leased equipment (calculated above) ................................. 365,760 Lease payable (calculated above) ................................... 365,760 Lease payable .................................................................. 130,960 Prepaid operating expense (2007 executory costs) .............. 4,000 Cash (rental payment) ..................................................... 134,960 Rhone-Metro (Lessor) Lease receivable ([$130,960 x 3] + $10,000) ....................... 402,880 Cost of goods sold (lessor’s cost) ...................................... 300,000 Sales revenue (present value of minimum lease payments) . 365,760 Unearned interest revenue ($402,880 - 365,760) ............ 37,120 Inventory of equipment (lessor’s cost) .......................... 300,000 Cash (rental payment) ......................................................... 134,960 Payable (maintenance, insurance, etc.) ....................... 4,000 Lease receivable .......................................................... 130,960 76 Problem 15-10 (continued) Requirement 4 Lessee and lessor (BPO included): Since both use the same discount rate and since the bargain purchase option is included as an additional payment for both, the same amortization schedule applies to both the lessee and lessor. The lease term ends for accounting purposes after 3 rental payments, because the BPO becomes exercisable before the fourth: Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 2006 365,760 2006 130,960 130,960 234,800 2007 130,960 .10 (234,800) = 23,480 107,480 127,320 2008 130,960 .10 (127,320) = 12,732 118,228 9,092 2009 10,000 .10 (9,092) = 908* 9,092 0 402,880 37,120 365,760 * adjusted for rounding of other numbers in the schedule 77 Problem 15-10 (continued) Requirement 5 December 31, 2007 Western Soya Co. (Lessee) Depreciation expense ($365,760 ÷ 6 years*) .......................... 60,960 Accumulated depreciation .......................................... 60,960 Operating expense (2007 executory costs) .......................... 4,000 Prepaid operating expense (paid in 2006) ..................... 4,000 Interest expense (10% x [$365,760 – 130,960]) ....................... 23,480 Lease payable (difference) ................................................ 107,480 Prepaid operating expense (2008 executory costs) .............. 4,000 Cash (rental payment) ..................................................... 134,960 Rhone-Metro (Lessor) Cash (rental payment) ......................................................... 134,960 Payable (maintenance, insurance, etc.) ....................... 4,000 Lease receivable .......................................................... 130,960 Unearned interest revenue ............................................. 23,480 Interest revenue (10% x [$365,760 – 130,960]) .................. 23,480 * If ownership transfers (a) by contract or (b) by the expected exercise of a bargain purchase option, the asset should be depreciated over the asset's useful life. This reflects the fact that the lessee anticipates using the leased asset for its full useful life. In this case, the equipment is expected to be useful for 6 years. 78 Problem 15-10 (concluded) Requirement 6 December 31, 2009 Western Soya Club (Lessee) Depreciation expense ($365,760 ÷ 6 years) ............................ 60,960 Accumulated depreciation .......................................... 60,960 Interest expense (10% x $9,092: from schedule[rounded]) ..... 908 Lease payable (from schedule) ........................................... 9,092 Cash (BPO price) ........................................................... 10,000 Operating expense (2009 executory costs) .......................... 4,000 Prepaid operating expense (paid in 2008) ..................... 4,000 Prepaid operating expense (2010 executory costs)* ............ 4,000 Cash (paid to lessor or supplier of services) ....................... 4,000 Equipment ...................................................................... 365,760 Leased equipment ...................................................... 365,760 Rhone-Metro (Lessor) Cash (BPO price) ............................................................... 10,000 Lease receivable .......................................................... 10,000 Unearned interest revenue ............................................. 908 Interest revenue (10% x $9,092: from schedule[rounded]) . 908 Cash (if executory costs continue to be paid by lessor) ............ 4,000 Payable (maintenance, insurance, etc.) ....................... 4,000 * If paid to suppliers of services, the payments and this entry may occur in 2010. 79 Problem 15-11 Requirement 1 Lessor’s Calculation of Rental Payments Amount to be recovered (fair market value) $659,805 Less: Present value of the third-party-guaranteed residual value* ($150,000 x .75131*) (112,697) Amount to be recovered through periodic rental payments $547,108 _____________________↓ Rental payments at the beginning ↓ of each of three years: ($547,108 ÷ 2.73554**) $200,000 * present value of $1: n=3, i=10% ** present value of an annuity due of $1: n=3, i=10% Note: Since the residual value is guaranteed to the lessor, it is included in the lessor’s minimum lease payments and therefore affects the 90% of fair value test. Requirement 2 Since [1] title to the conveyer does not transfer to the lessee, [2] there is no BPO, and [3] the lease term (3 years) is less than 75% of the estimated useful life (6 years), the critical classification criterion is [4] whether the present value of minimum lease payments exceeds 90% of the fair value of the conveyer ($659,805). The present value is influenced by the fact that the residual value is (a) relatively large and (b) guaranteed, but by a third-party, not the lessee. The residual value, if guaranteed (by the lessee or by a third party guarantor), is included in the minimum lease payments by the lessor when applying the 90% of fair value criterion and thus increases the likelihood that it is met. However, when the residual value is guaranteed by a third-party guarantor and not by the lessee, it is not included in the lessee’s minimum lease payments. So, if a residual value is sufficiently large and guaranteed by a third-party guarantor, it may cause the 90% of fair value criterion to be met by the lessor, but not by the lessee. 80 Problem 15-11 (continued) For the lessor, the criterion is met: The present value of minimum lease payments ($659,805) is more than 90% of the fair value ($659,805 x 90% = $593,825). Also, since the fair market value exceeds the lessor’s carrying value, the conveyer is being “sold” at a profit, making this a sales-type lease: Fair market value $659,805 minus Carrying value (450,000) equals Dealer’s profit $209,805 Lessee’s Calculation of the Present Value of Minimum Lease Payments Present value of periodic rental payments* ($200,000 x 2.73554**) $547,108 ** present value of an annuity due of $1: n=3, i=10% * Since the residual value is not guaranteed by the lessee, it is excluded from the lessee’s minimum lease payments and therefore does not affect the 90% of fair value test. For the lessee, the criterion is not met: The present value of minimum lease payments ($547,108) is less than 90% of the fair value ($659,805 x 90% = $593,825). So, this is an operating lease to the lessee. 81 Problem 15-11 (continued) Requirement 3 December 31, 2006 Poole (Lessee) Prepaid rent (2006 payment; 2007 expense) ......................... 200,000 Cash (rental payment) ..................................................... 200,000 Allied (Lessor) Lease receivable ([$200,000 x 3] + $150,000) ..................... 750,000 Cost of goods sold (lessor’s cost) ...................................... 450,000 Sales revenue (present value of minimum lease payments) . 659,805 Unearned interest revenue ($750,000 - 659,805 ) ........... 90,195 Inventory of equipment (lessor’s cost) .......................... 450,000 Cash (rental payment) ......................................................... 200,000 Lease receivable .......................................................... 200,000 Requirement 4 Since the lessee records the lease as an operating lease, interest expense is not recorded and an amortization schedule is not applicable. Lessor (third-party-guaranteed residual value included): Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 2006 659,805 2006 200,000 200,000 459,805 2007 200,000 .10 (459,805) = 45,981 154,019 305,786 2008 200,000 .10 (305,786) = 30,579 169,421 136,365 2009 150,000 .10 (136,365) = 13,635* 136,365 0 750,000 90,195 659,805 * rounded 82 Problem 15-11 (continued) Requirement 5 December 31, 2007 Poole (Lessee) Rent expense ................................................................... 200,000 Prepaid rent (2006 payment; 2007 expense) ..................... 200,000 Prepaid rent ..................................................................... 200,000 Cash (2007 payment; 2008 expense) ................................. 200,000 Allied (Lessor) Cash (rental payment) ......................................................... 200,000 Lease receivable .......................................................... 200,000 Unearned interest revenue ............................................. 45,981 Interest revenue (10% x [$659,805 – 200,000]) .................. 45,981 December 31, 2008 Poole (Lessee) Rent expense ................................................................... 200,000 Prepaid rent (2007 payment; 2008 expense) ..................... 200,000 Prepaid rent ..................................................................... 200,000 Cash (2008 payment; 2009 expense) ................................. 200,000 Allied (Lessor) Cash (rental payment) ......................................................... 200,000 Lease receivable .......................................................... 200,000 Unearned interest revenue .............................................. 30,579 Interest revenue (10% x 305,786: from schedule) ................ 30,579 83 Problem 15-11 (concluded) December 31, 2009 Poole (Lessee) Rent expense ................................................................... 200,000 Prepaid rent (2008 payment; 2009 expense) ..................... 200,000 Allied (Lessor) Inventory of equipment (actual residual value) ................... 105,000 Cash ($150,000 - 105,000: from 3rd party guarantor) .............. 45,000 Lease receivable (account balance) ................................ 150,000 Unearned interest revenue (account balance) ..................... 13,635 Interest revenue (10% x 136,365: from schedule) ................ 13,635 Problem 15-12 Situation 1 2 3 4 A. The lessor’s: 1. Minimum lease payments1 $40,000 $44,000 $44,000 $40,000 2. Gross investment in the lease2 40,000 44,000 44,000 44,000 3. Net investment in the lease3 34,437 37,072 37,072 37,072 4. Unearned interest revenue4 5,563 6,928 6,928 6,928 B. The lessee’s: 5. Minimum lease payments5 40,000 44,000 40,000 40,000 6. Leased asset6 34,437 37,072 34,437 34,437 7. Lease liability7 34,437 37,072 34,437 34,437 1 ($10,000 x number of payments) + Residual value guaranteed by lessee and/or by third party. 2 Minimum lease payments plus unguaranteed residual value. 3 Present value of gross investment. 4 Gross investment - Net investment. 5 ($10,000 x number of payments) + Residual value guaranteed by lessee. 6 Present value of minimum lease payments; should not exceed fair market value. 7 Present value of minimum lease payments; should not exceed fair market value. 84 Problem 15-13 Situation 1 2 3 4 A. The lessor’s: 1. Minimum lease payments1 $400,000 $553,000 $640,000 $510,000 2. Gross investment in the lease2 $430,000 553,000 675,000 550,000 3. Net investment in the lease3 369,175 433,809 533,685 451,137 4. Unearned interest revenue4 60,825 119,191 141,315 98,863 5. Sales revenue5 N/A N/A 512,816 423,817 6. Cost of goods sold6 N/A N/A 479,131 372,680 7. Dealer’s profit7 N/A N/A 33,685 51,137 B. The lessee’s: 8. Minimum lease payments8 $400,000 553,000 640,000 460,000 9. Leased asset9 353,129 449,896 512,816 389,666 10. Lease liability10 353,129 449,896 512,816 389,666 Note: Since executory costs are excluded from minimum lease payments, they have no effect on any of the calculated amounts. 1 ($100,000 x Number of payments) + Residual value guaranteed by lessee and/or by third party; for situation 4: ($100,000 x 4) + ($60,000 + 50,000) 2 Minimum lease payments plus unguaranteed residual value; for situation 4: ($510,000 + $40,000) 3 Present value of gross investment (discounted at lessor’s rate); for situation 4: ($100,000 x 3.48685) + ($150,000 x .68301) 4 Gross investment - Net investment; for situation 4: ($550,000 - 451,137) 5 Present value of minimum lease payments; also, Net investment - Present value of unguaranteed residual value; for situation 4: ($100,000 x 3.48685) + ($110,000 x .68301); also, $451,137 - 27,320 ($40,000 x .68301) 6 Lessor’s cost - Present value of unguaranteed residual value; for situation 4: ($400,000 - ($40,000 x .68301) 7 Sales revenue - cost of goods sold; also, Net investment - Lessor’s cost ; for situation 4: ($423,817 - 372,680); also, ($451,137 - 400,000) 8 ($100,000 x number of payments) + Residual value guaranteed by lessee; for situation 4: ($100,000 x 4) + $60,000 9 Present value of minimum lease payments (discounted at lower of lessor’s rate and lessee’s incremental borrowing rate); should not exceed fair market value; for situation 4: ($100,000 x 3.48685) + ($60,000 x .68301) 10 Present value of minimum lease payments (discounted at lower of lessor’s rate and lessee’s incremental borrowing rate); should not exceed fair market value; for situation 4: ($100,000 x 3.48685) + ($60,000 x .68301) 85 Problem 15-14 Requirement 1 Branson Construction (Lessee) Interest expense (10% x [$936,500 – 100,000]) ....................... 83,650 Lease payable (difference) ................................................ 16,350 Cash (lease payment) ...................................................... 100,000 Maintenance expense ............................................................... 3,000 Cash (2006 expenses as incurred) ..................................... 3,000 Depreciation expense ($936,500 ÷ 20 years) .......................... 46,825 Accumulated depreciation .......................................... 46,825 Branif Leasing (Lessor) Cash (lease payment) .......................................................... 100,000 Lease receivable .......................................................... 100,000 Unearned interest revenue ............................................. 83,650 Interest revenue (10% x [$936,500 – 100,000]) ................... 83,650 Requirement 2 Branson Construction (Lessee) Interest expense (10% x [$936,500 – 100,000]) ....................... 83,650 Lease payable (difference) ................................................ 16,350 Maintenance expense (annual fee)* ......................................... 3,000 Cash (lease payment) ...................................................... 103,000 Depreciation expense ($936,500 ÷ 20 years) .......................... 46,825 Accumulated depreciation .......................................... 46,825 * This debit to maintenance expense is the net effect of (a) expensing the current year’s costs that were prepaid with the first lease payment the last day of 2005 and (b) prepaying next year’s expense with the 2006 payment: Maintenance expense (2006 costs) ................................................ 3,000 Prepaid maintenance expense (paid in 2005) ........................... 3,000 Interest expense (10% x [$936,500 – 100,000]) ............................ 83,650 Lease payable (difference) ............................................................ 16,350 Prepaid maintenance expense (2007 costs) ................................... 3,000 Cash (lease payment) ................................................................ 103,000 86 Problem 15-14 (concluded) Branif Leasing (Lessor) Cash (lease payment) .......................................................... 103,000 Lease receivable (payment less executory costs) .............. 100,000 Maintenance fee payable [or cash] ............................. 3,000 Unearned interest revenue ............................................. 83,650 Interest revenue (10% x [$936,500 – 100,000]) ................... 83,650 Requirement 3 Branson Construction (Lessee) Interest expense (10% x [$936,500 – 100,000]) ....................... 83,650 Lease payable (difference) ................................................ 16,350 Maintenance expense (annual fee)* ......................................... 3,300 Cash (lease payment) ...................................................... 103,300 Depreciation expense ($936,500 ÷ 20 years) .......................... 46,825 Accumulated depreciation .......................................... 46,825 * This debit to maintenance expense is the net effect of (a) expensing the current year’s costs that were prepaid with the first lease payment the last day of 2005 and (b) prepaying next year’s expense with the 2006 payment: Maintenance expense (2006 costs) ................................................ 3,300 Prepaid maintenance expense (paid in 2005) ........................... 3,300 Interest expense (10% x [$936,500 – 100,000]) ............................ 83,650 Lease payable (difference) ............................................................ 16,350 Prepaid maintenance expense (2007 costs) ................................... 3,300 Cash (lease payment) ................................................................ 103,300 Branif Leasing (Lessor) Cash (lease payment) .......................................................... 103,300 Maintenance fee payable [or cash] ............................. 3,000 Miscellaneous revenue ................................................ 300 Lease receivable (payment less executory costs) .............. 100,000 Unearned interest revenue ............................................. 83,650 Interest revenue (10% x [$936,500 – 100,000]) ................... 83,650 87 Problem 15-15 Requirement 1 Note: Because exercise of the option appears at the inception of the lease to be reasonably assured, payment of the option price ($6,000) is expected to occur when the option becomes exercisable (at the end of the eighth quarter). Also, the lease contract specifies that the BPO becomes exercisable before the designated lease term ends. Since a BPO is expected to be exercised, the lease term ends for accounting purposes when the option becomes exercisable (after two years of the three-year lease term). Present value of quarterly rental payments ($3,000 x 7.23028**) $21,691 Plus: Present value of the BPO price ($6,000 x .78941*) 4,736 Present value of minimum lease payments $26,427 * present value of $1: n=8, i=3% ** present value of an annuity due of $1: n=8, i=3% “Selling price” $26,427 minus Truck’s cost (25,000) equals Dealer’s profit $ 1,427 88 Problem 15-15 (continued) Not required in the problem, but helpful to see that the present value calculation is precisely the reverse of the lessor’s calculation of quarterly payments: Amount to be recovered (fair market value) $26,427 Less: Present value of the BPO price ($6,000 x .78941*) (4,736) Amount to be recovered through quarterly rental payments $21,691 _____________________↓ Rental payments at the beginning ↓ each of the next eight quarters: ($21,691 ÷ 7.23028**) $3,000 * present value of $1: n=8, i=3% ** present value of an annuity due of $1: n=8, i=3% Requirement 2 September 30, 2006 Anything Grows (Lessee) Leased equipment .......................................................... 26,427 Lease payable (present value of minimum lease payments) 26,427 Lease payable ................................................................. 3,000 Cash (lease payment) ...................................................... 3,000 Mid-South Auto Leasing (Lessor) Lease receivable ([$3,000 x 8] + $6,000) ............................ 30,000 Cost of goods sold (lessor’s cost) ...................................... 25,000 Sales revenue (calculated above) .................................... 26,427 Unearned interest revenue ($30,000 - 26,427) ............... 3,573 Inventory of equipment (lessor’s cost) .......................... 25,000 Cash (lease payment) .......................................................... 3,000 Lease receivable .......................................................... 3,000 89 Problem 15-15 (continued) Requirement 3 Since both use the same discount rate, the amortization schedule for the lessee and lessor is the same: Lease Amortization Schedule Effective Decrease Outstanding Date Payments Interest in Balance Balance 3% x Outstanding Balance 9/30/06 26,427 9/30/06 3,000 3,000 23,427 12/31/06 3,000 .03 (23,427) = 703 2,297 21,130 3/31/07 3,000 .03 (21,130) = 634 2,366 18,764 6/30/07 3,000 .03 (18,764) = 563 2,437 16,327 9/30/07 3,000 .03 (16,327) = 490 2,510 13,817 12/31/07 3,000 .03 (13,817) = 415 2,585 11,232 3/31/08 3,000 .03 (11,232) = 337 2,663 8,569 6/30/08 3,000 .03 (8,569) = 257 2,743 5,826 9/29/08 6,000 .03 (5,826) = 174* 5,826 0 30,000 3,573 26,427 * adjusted for rounding of other numbers in the schedule 90 Problem 15-15 (concluded) Requirement 4 Anything Grows (Lessee) Depreciation expense ([$26,427 ÷ 4 years*] x 1/4 year) .......... 1,652 Accumulated depreciation .......................................... 1,652 Interest expense (3% x [$26,427 - 3,000]: from schedule) ...... 703 Lease payable (difference : from schedule) .......................... 2,297 Cash (lease payment) ...................................................... 3,000 Mid-South Auto Leasing (Lessor) Cash (lease payment) .......................................................... 3,000 Lease receivable .......................................................... 3,000 Unearned interest revenue ............................................. 703 Interest revenue (3% x [$26,427 - 3,000]) ............................ 703 * Because title passes with the expected exercise of the BPO, depreciation is over the full 4-year useful life. Requirement 5 Anything Grows (Lessee) Depreciation expense ([$26,427 ÷ 4 years*] x 3/4 year) ......... 4,955 Accumulated depreciation .......................................... 4,955 Interest expense (3% x $5,826 : from schedule) ....................... 174 Lease payable (difference : from schedule) .......................... 5,826 Cash (BPO price) ........................................................... 6,000 Mid-South Auto Leasing (Lessor) Cash (BPO price) ............................................................... 6,000 Lease receivable (account balance) ................................ 6,000 Unearned interest revenue (account balance) ..................... 174 Interest revenue (3% x $5,826 : from schedule) ................... 174 * Because title passes with the expected exercise of the BPO, depreciation is over the full 4-year useful life. 91 Problem 15-16 Requirement 1 Since at least one (exactly one in this case) criterion is met, this is a capital lease to the lessee: Lessee’s Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected YES economic life of the asset? {4 yrs > 75% of 5 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% of the NO fair value of the asset? {$39,564a 75% of 5 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% of the YES fair value of the asset? {$42,382a > 90% of $45,114=$40,603} a See schedule 2 below. Schedule 2: Lessor’s Calculation of the Present Value of Minimum Lease Payments Present value of periodic rent payments ($10,000 x 3.48685**) $34,869 Plus: Present value of the guaranteed residual value ($11,000*** x .68301*) 7,513 Present value of lessor’s minimum lease payments $42,382 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% *** includes $6,000 guaranteed by the lessee and $5,000 guaranteed by a third-party guarantor 94 Problem 15-16 (continued) Since the fair market value exceeds the lessor’s carrying value, the asset is being “sold” at a profit, making this a sales-type lease: Fair market value $45,114 minus Carrying value (40,000) equals Dealer’s profit $ 5,114 also: Sales revenue $42,382 (Lessor’s PV of minimum lease Minus payments per sch.2) Cost of goods sold (37,268) ($40,000 – [$4,000* x .68301]) equals Dealer’s profit $ 5,114 * This is the unguaranteed residual value: $15,000 – 11,000. Requirement 4 Lessor’s Calculation of Lease Payments Amount to be recovered (fair market value) $45,114 Less: Present value of the residual value ($15,000 x .68301*) (10,245) Amount to be recovered through periodic rental payments $34,869 ______________________⏐ Rent payments at the beginning ⏐ of each of the next four years: ($34,869 ÷ 3.48685**) $10,000 Plus: Executory costs 1,000 Rental payments including executory costs $ 11,000 * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% 95 Problem 15-16 (continued) Requirement 5 Present value of lessor’s minimum lease payments, calculated in Schedule 2 above: $42,382 Requirement 6 December 31, 2005 Yard Art Landscaping (Lessee) Leased equipment (calculated in requirement 1) .................. 39,564 Lease payable (calculated requirement 1) ........................ 39,564 Lease payable (payment less executory costs) ...................... 10,000 Prepaid maintenance expense (2006 fee) .............................. 1,000 Cash (lease payment) ...................................................... 11,000 Branch Motors (Lessor) Lease receivable ([$10,000 x 4] + $15,000) ......................... 55,000 Cost of goods sold ($40,000 - [$4,000a x .68301]) ............... 37,268 Sales revenue (calculated in Schedule 2) ......................... 42,382 Unearned interest revenue ($55,000 - 45,114) ............... 9,886 Inventory of equipment (lessor’s cost) .......................... 40,000 Cash (lease payment) .......................................................... 11,000 Maintenance fee payable [or prepaid maintenance*] . 1,000 Lease receivable (payment less executory costs) .............. 10,000 a This is the unguaranteed residual value: $15,000 - 11,000. * If paid previously. 96 Problem 15-16 (continued) Requirement 7 Lessee’s Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 9% x Outstanding Balance 39,564 2005 10,000 10,000 29,564 2006 10,000 .09 (29,564) = 2,661 7,339 22,225 2007 10,000 .09 (22,225) = 2,000 8,000 14,225 2008 10,000 .09 (14,225) = 1,280 8,720 5,505 2009 6,000 .09 (5,505) = 495 5,505 0 46,000 6,436 39,564 Requirement 8 Lessor’s Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 45,114 2005 10,000 10,000 35,114 2006 10,000 .10 (35,114) = 3,511 6,489 28,625 2007 10,000 .10 (28,625) = 2,863 7,137 21,488 2008 10,000 .10 (21,488) = 2,149 7,851 13,637 2009 15,000 .10 (13,637) = 1,363* 13,637 0 55,000 9,886 45,114 * adjusted for rounding of other numbers in the schedule 97 Problem 15-16 (continued) Requirement 9 December 31, 2006 Yard Art Landscaping (Lessee) Maintenance expense (2006 fee) ............................................. 1,000 Prepaid maintenance expense (paid in 2005) .................... 1,000 Interest expense (9% x [$39,564 – 10,000]) ............................. 2,661 Lease payable (difference) ................................................ 7,339 Prepaid maintenance expense (2007 fee) .............................. 1,000 Cash (lease payment) ...................................................... 11,000 Depreciation expense ([$39,564 - 6,000] ÷ 4 years) ............. 8,391 Accumulated depreciation .......................................... 8,391 Branch Motors (Lessor) Cash (lease payment) .......................................................... 11,000 Maintenance fee payable [or prepaid maintenance*] . 1,000 Lease receivable (payment less executory costs) .............. 10,000 Unearned interest revenue ............................................. 3,511 Interest revenue (10% x [$45,114 - 10,000]) ........................ 3,511 * If paid previously. 98 Problem 15-16 (continued) Requirement 10 December 31, 2008 Yard Art Landscaping (Lessee) Maintenance expense (2008 fee) ............................................. 1,000 Prepaid maintenance expense (paid in 2007) .................... 1,000 Interest expense (9% x $14,225 – from schedule) .................... 1,280 Lease payable (difference – from schedule) ......................... 8,720 Prepaid maintenance expense (2009 fee) .............................. 1,000 Cash (lease payment) ...................................................... 11,000 Depreciation expense ([$39,564 - 6,000] ÷ 4 years) ............. 8,391 Accumulated depreciation .......................................... 8,391 Branch Motors (Lessor) Cash (lease payment) .......................................................... 11,000 Maintenance fee payable [or prepaid maintenance*] . 1,000 Lease receivable (payment less executory costs) .............. 10,000 Unearned interest revenue ............................................. 2,149 Interest revenue (10% x $21,488 – from schedule) .............. 2,149 * If paid previously. 99 Problem 15-16 (concluded) Requirement 11 December 31, 2009 Yard Art Landscaping (Lessee) Maintenance expense (2009 fee) ............................................. 1,000 Prepaid maintenance expense (paid in 2008) .................... 1,000 Depreciation expense ([$39,564 - 6,000] ÷ 4 years) ............. 8,391 Accumulated depreciation .......................................... 8,391 Interest expense (9% x $5,505 : from schedule) ....................... 495 Lease payable (difference : from schedule) .......................... 5,505 Accumulated depreciation (account balance) ..................... 33,564 Loss on residual value guarantee ($6,000 - 4,000) ............ 2,000 Leased equipment (account balance) .............................. 39,564 Cash ($6,000 - 4,000) ..................................................... 2,000 Branch Motors (Lessor) Inventory of equipment (actual residual value) ................... 4,000 Cash ($11,000 - $4,000) ...................................................... 7,000* Loss on leased assets ($15,000 - $11,000) .......................... 4,000 Lease receivable (account balance) ................................ 15,000 Unearned interest revenue (account balance) ..................... 1,363 Interest revenue (10% x $13,637 : from schedule) ............... 1,363 * $2,000 from lessee and $5,000 from third-party guarantor 100 Problem 15-17 Requirement 1 Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected YES economic life of the asset? {8 yrs > 75% of 8 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% of the YES fair value of the asset? {$645,526a > 90% of $645,526} a See calculation below. The lessee’s incremental borrowing rate (11%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate: Present value of minimum lease payments ($110,000 x 5.86842**) $645,526 ** present value of an annuity due of $1: n=8, i=10% 101 Problem 15-17 (continued) (a) Since at least one (two in this case) classification criterion and both additional lessor conditions are met, this is a nonoperating lease to the lessor (Bidwell Leasing). Since the fair market value is the lessor’s cost, there is no dealer’s profit, making this a direct financing lease: (b) Since at least one (two in this case) criterion is met, this is a capital lease to the lessee. Red Baron records the present value of minimum lease payments as a leased asset and a lease liability. Requirement 2 December 31, 2005 Red Baron Flying Club (Lessee) Leased equipment (calculated above) ................................. 645,526 Lease payable (calculated above) ................................... 645,526 Lease payable .................................................................. 110,000 Cash (lease payment) ...................................................... 110,000 Bidwell Leasing (Lessor) Lease receivable ($110,000 x 8) ........................................ 880,000 Unearned interest revenue ($880,000 - 645,526) ............ 234,474 Inventory of equipment (lessor’s cost) .......................... 645,526 Unearned interest revenue .............................................. 18,099 Cash (initial direct costs) ................................................. 18,099 Cash (lease payment) .......................................................... 110,000 Lease receivable .......................................................... 110,000 102 Problem 15-17 (continued) Requirement 3 Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 645,526 2005 110,000 110,000 535,526 2006 110,000 .10 (535,526) = 53,553 56,447 479,079 2007 110,000 .10 (479,079) = 47,908 62,092 416,987 2008 110,000 .10 (416,987) = 41,699 68,301 348,686 2009 110,000 .10 (348,686) = 34,869 75,131 273,555 2010 110,000 .10 (273,555 = 27,356 82,644 190,911 2011 110,000 .10 (190,911) = 19,089* 90,911 100,000 2012 110,000 .10 (100,000) = 10,000 100,000 0 880,000 234,474 645,526 * adjusted for rounding of other numbers in the schedule Requirement 4 With the initial direct costs, the rental payments are the same, but the net investment is higher: $645,526 + 18,099 = $663,625. The new effective rate is the discount rate that equates the net investment and the future lease payments: $663,625 ÷ ?** = $110,000 lessor’s lease investment payments ** present value of an annuity due of $1: n=8, i=? Rearranging algebraically we find that the present value table value is $663,625 ÷ $110,000 = 6.03295. When you consult the present value table, you search row 8 (n=8) for this value and find it in the 9% column. So the effective interest rate has declined from 10% to 9%. The net investment is amortized at the 9% rate. 103 Problem 15-17 (continued) Requirement 5 Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 9% x Outstanding Balance 663,625 2005 110,000 110,000 553,625 2006 110,000 .09 (553,625) = 49,826 60,174 493,451 2007 110,000 .09 (493,451) = 44,411 65,589 427,862 2008 110,000 .09 (427,862) = 38,508 71,492 356,370 2009 110,000 .09 (356,370) = 32,073 77,927 278,443 2010 110,000 .09 (278,443) = 25,060 84,940 193,503 2011 110,000 .09 (193,503) = 17,415 92,585 100,918 2012 110,000 .09 (100,918) = 9,082* 100,918 0 880,000 216,375 663,625 * adjusted for rounding of other numbers in the schedule 104 Problem 15-17 (concluded) Requirement 6 December 31, 2006 Red Baron Flying Club (Lessee) Interest expense (10% x [$645,526 – 110,000]) ....................... 53,553 Lease payable (difference) ................................................ 56,447 Cash (lease payment) ...................................................... 110,000 Depreciation expense ($645,526 ÷ 8 years) ........................ 80,691 Accumulated depreciation .......................................... 80,691 Bidwell Leasing (Lessor) Cash (lease payment) .......................................................... 110,000 Lease receivable ......................................................... 110,000 Unearned interest revenue ............................................. 49,826 Interest revenue (9% x [$663,625 - 110,000]) ...................... 49,826 Requirement 7 December 31, 2012 Red Baron Flying Club (Lessee) Interest expense (10% x $100,000 : from schedule) ................. 10,000 Lease payable (difference) ................................................ 100,000 Cash (lease payment) ...................................................... 110,000 Depreciation expense ($645,526 ÷ 8 years) ........................ 80,691 Accumulated depreciation .......................................... 80,691 Bidwell Leasing (Lessor) Cash (lease payment) .......................................................... 110,000 Lease receivable ......................................................... 110,000 Unearned interest revenue ............................................. 9,082 Interest revenue (9% x $100,918 : from schedule) ............... 9,082 105 Problem 15-18 Requirement 1 Application of Classification Criteria 1 Does the agreement specify that ownership of the asset transfers to the lessee? NO 2 Does the agreement contain a bargain purchase option? NO 3 Is the lease term equal to 75% or more of the expected YES economic life of the asset? {8 yrs > 75% of 8 yrs} 4 Is the present value of the minimum lease payments equal to or greater than 90% of the YES fair value of the asset? {$645,526a > 90% of $645,526} a See calculation below. The lessee’s incremental borrowing rate (11%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate: Present value of minimum lease payments ($110,000 x 5.86842**) $645,526 ** present value of an annuity due of $1: n=8, i=10% 106 Problem 15-18 (continued) (a) Since at least one (two in this case) classification criterion and both additional lessor conditions are met, this is a nonoperating lease to the lessor (Bidwell Leasing). Since the fair market value exceeds the lessor’s carrying value, the plane was “sold” at a profit, making this a sales-type lease: Fair market value $645,526 minus Carrying value (400,000) equals Dealer’s profit $ 245,526 (b) Since at least one (two in this case) criterion is met, this is a capital lease to the lessee. Red Baron records the present value of minimum lease payments as a leased asset and a lease liability. Requirement 2 December 31, 2005 Red Baron Flying Club (Lessee) Leased equipment (calculated above) ................................. 645,526 Lease payable (calculated above) ................................... 645,526 Lease payable .................................................................. 110,000 Cash (lease payment) ...................................................... 110,000 Bidwell Leasing (Lessor) Lease receivable ($110,000 x 8) ........................................ 880,000 Cost of goods sold .......................................................... 400,000 Sales revenue (calculated above) .................................... 645,526 Unearned interest revenue ($880,000 - 645,526) ............ 234,474 Inventory of equipment (lessor’s cost) .......................... 400,000 Selling expense ............................................................... 18,099 Cash (initial direct costs) ................................................. 18,099 Cash (lease payment) .......................................................... 110,000 Lease receivable .......................................................... 110,000 107 Problem 15-18 (continued) Requirement 3 Lease Amortization Schedule Effective Decrease Outstanding Dec. Payments Interest in Balance Balance 31 10% x Outstanding Balance 645,526 2005 110,000 110,000 535,526 2006 110,000 .10 (535,526) = 53,553 56,447 479,079 2007 110,000 .10 (479,079) = 47,908 62,092 416,987 2008 110,000 .10 (416,987) = 41,699 68,301 348,686 2009 110,000 .10 (348,686) = 34,869 75,131 273,555 2010 110,000 .10 (273,555) = 27,356 82,644 190,911 2011 110,000 .10 (190,911) = 19,089* 90,911 100,000 2012 110,000 .10 (100,000) = 10,000 100,000 0 880,000 234,474 645,526 * adjusted for rounding of other numbers in the schedule Requirement 4 December 31, 2006 Red Baron Flying Club (Lessee) Interest expense (10% x [$645,526 – 110,000]) ....................... 53,553 Lease payable (difference) ................................................ 56,447 Cash (lease payment) ...................................................... 110,000 Depreciation expense ($645,526 ÷ 8 years) ........................ 80,691 Accumulated depreciation .......................................... 80,691 Bidwell Leasing (Lessor) Cash (lease payment) .......................................................... 110,000 Lease receivable ......................................................... 110,000 Unearned interest revenue ............................................. 53,553 Interest revenue (10% x [$645,526 – 110,000]) ................... 53,553 108 Problem 15-18 (concluded) Requirement 5 December 31, 2012 Red Baron Flying Club (Lessee) Interest expense (10% x $100,000 : from schedule) ................. 10,000 Lease payable (difference) ................................................ 100,000 Cash (lease payment) ...................................................... 110,000 Depreciation expense ($645,526 ÷ 8 years) ........................ 80,691 Accumulated depreciation .......................................... 80,691 Bidwell Leasing (Lessor) Cash (lease payment) .......................................................... 110,000 Lease receivable ......................................................... 110,000 Unearned interest revenue ............................................. 10,000 Interest revenue (10% x $100,000 : from schedule) ............. 10,000 109 Problem 15-19 Requirement 1 Present value of periodic rental payments ($88,492 x 5.65022**) $500,000* * rounded ** present value of an ordinary annuity of $1: n=10, i=12% January 1, 2006 Cash ................................................................................ 500,000 Accumulated depreciation (cost - carrying amount) ............ 600,000 Buildings (original cost) ................................................ 1,000,000 Deferred gain on sale-leaseback (difference) ................ 100,000 Leased building (present value of lease payments) ................... 500,000 Lease payable (present value of lease payments) .............. 500,000 Note: Because the title transfers to the lessee, this is a capital lease. December 31, 2006 Interest expense (12% x $500,000) ........................................... 60,000 Lease payable (difference) ................................................ 28,492 Cash (rental payment) ..................................................... 88,492 Depreciation expense ($500,000 ÷ 12 years*) ..................... 41,667 Accumulated depreciation .......................................... 41,667 Deferred gain on sale-leaseback ($100,000 ÷ 12 years*) ..... 8,333 Depreciation expense ................................................. 8,333 * The building is depreciated over its remaining useful life rather than the lease term because title transfers to the lessee. The remaining useful life can be calculated as: total life x carrying amount/cost = 30 years x $400,000/$1,000,000 = 12 years 110 Problem 15-19 (continued) Requirement 2 BALANCE SHEET Assets: Leased asset .......................................................... $500,000 less: accumulated depreciation ........................... (41,667) less: deferred gain ($100,000 - 8,333) .................... (91,667) $366,666 Liabilities: Current: Lease payable ($88,492 - {12% x [$500,000 - 28,492]}) $31,911 Noncurrent: Lease payable ($500,000 - 28,492 - 31,911) ............... $439,597 INCOME STATEMENT Interest expense .................................................... $60,000 Depreciation expense ($41,667 - 8,333) ................... 33,334 $93,334 Portion of Amortization Schedule – not required, but verifies several amounts: Lease Amortization Schedule Effective Decrease Outstanding Date Payments Interest in Balance Balance 12% x Outstanding Balance 1/1/06 500,000 12/31/06 88,492 .12 (500,000) = 60,000 28,492 471,508 12/31/07 88,492 .12 (471,508) = 56,581 31,911 439,597 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 111 Problem 15-20 Requirement 1 Since the fair value of the land ($400,000) is more than 25% of the combined fair value ($1,450,000), both the lessee and the lessor treat the land and building as two separate leases. The land lease is an operating lease, and the building lease is, in this case, a capital lease. Since land could be rented without the building for $59,000, the portion of the annual rental attributable to the building is $200,000 - 59,000 = $141,000. Present value of lease payments ($141,000 x 6.75902**) $953,022 ** present value of an annuity due of $1: n=10, i=10% January 1, 2006 Leased building (calculated above) .................................... 953,022 Lease liability (calculated above) ................................... 953,022 Rent expense (given) ....................................................... 59,000 Lease liability (difference) ................................................ 141,000 Cash (annual rental) ....................................................... 200,000 December 31, 2006 Depreciation expense ($953,022 ÷ 10 years) .......................... 95,302 Accumulated depreciation – leased building .............. 95,302 Interest expense ([$953,022 - 141,000] x 10%) ........................ 81,202 Interest payable .......................................................... 81,202 112 Problem 15-20 (continued) Requirement 2 Since the fair value of the land ($200,000) is less than 25% of the combined fair value ($1,450,000), it is in effect ignored and the land and building are treated as a single unit. The “single” leased asset is depreciated as if land were not involved. Present value of lease payments ($200,000 x 6.75902**) $1,351,804 ** present value of an annuity due of $1: n=10, i=10% January 1, 2006 Leased property (calculated above) .................................... 1,351,804 Lease liability (calculated above) ................................... 1,351,804 Lease liability .................................................................. 200,000 Cash (annual rental) ....................................................... 200,000 December 31, 2006 Depreciation expense ($1,351,804 ÷ 10 years) ....................... 135,180 Accumulated depreciation – leased property ............. 135,180 Interest expense ([$1,351,804 - 200,000] x 10%) ..................... 115,180 Interest payable .......................................................... 115,180 113 CASES Analysis Case 15-1 1. When FedEx’s management says some leases “qualify as off-balance-sheet” financing, it is referring to the fact that when assets are acquired under operating leases, accounting standards do not require the lessee to record a liability as would be the case under a capital lease. Thus the financing escapes the balance sheet. Most of FedEx’s leases do not meet any of the four classification criteria that would cause the lease to be capitalized. 2. Note 7: “Lease Commitments“ indicates that: At May 31, 2004, the present value of net minimum lease payments for capital lease obligations was $534,000,000. 3. If the operating leases were capitalized, the capital lease liability would increase by approximately a multiple of 23. Note 7 below indicates that future minimum lease payments under non-cancelable operating leases are about 23 times higher than for capital leases (15,016 / 639). Assuming comparable discount rates and timing of payments, the present value of future minimum lease payments for operating leases would be about: $534,000,000 x 23 = $12,282 million. Of course, we could also make some reasonable assumptions about discount rates and the timing of payments and estimate the present value of all future payments to be made on the operating leases as we did in the “Decision- Makers’ Perspective” section at the end of the chapter. Results should be comparable. In either case, we have a rough estimate. Note 7: Lease Commitments (in part) A summary of future minimum lease payments under capital leases and non- cancelable operating leases (principally aircraft, retail locations, and facilities) with an initial or remaining term in excess of one year at May 31, 2004, is as follows ($ in millions): Capital Leases Operating Leases 2005 $ 160 $1,707 2006 122 1,555 2007 22 1,436 2008 99 1,329 2009 11 1,169 Thereafter 225 7,820 $639 $15,016 Less amount representing interest 105 Present value of net minimum lease payments $534 114 Case 15-1 (concluded) 4. In general, debt increases risk. Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. Also, debt requires payment, usually on specific dates, and failure to pay interest and principal may result in default and perhaps even bankruptcy. The debt-to-equity ratio, total liabilities/shareholders’ equity, frequently is calculated to measure the degree of risk. Other things being equal, the higher the ratio, the higher the risk. The debt-equity ratio for FedEx is: [$19,134 – 8,036] ÷ $8,036 = 1.38 If debt is increased by $12,282 million from capitalizing operating leases, the debt to equity ratio more than doubles: ([$19,134 – 8,036] + 12,282) ÷ $8,036 = 2.91 As shown in the chapter, adding the assets from capitalizing operating leases also causes the return on assets to decline. Analysts and management should be alert to the off-balance-sheet effect of operating leases. Remember, though, debt also can be an advantage. Debt can be used to enhance the return to shareholders. If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. This desirable situation is called “favorable financial leverage.” 115 Research Case 15-2 Requirement 1 After the first full year under the warehouse lease, the balance in Dowell’s lease liability is $30,816,422. This is the balance after reductions from the first five quarterly lease payments as shown in this amortization schedule. (The first payment was at December 31 of the previous year, the inception of the lease.) Lease Amortization Schedule Effective Decrease Outstanding Payments Interest in Balance Balance 10% x Outstanding Balance 40,000,000 2,398,303 2,398,303 37,601,697 2,398,303 .02 (37,601,697) = 752,034 1,646,269 35,955,428 2,398,303 .02 (35,955,428) = 719,109 1,679,194 34,276,234 2,398,303 .02 (34,276,234) = 685,525 1,712,778 32,563,456 2,398,303 .02 (32,563,456) = 651,269 1,747,034 30,816,422 2,398,303 .02 (30,816,422) = 616,328 1,781,975 29,034,448 2,398,303 .02 (29,034,448) = 580,689 1,817,614 27,216,835 2,398,303 .02 (27,216,835) = 544,337 1,853,966 25,362,869 2,398,303 .02 (25,362,869) = 507,257 1,891,046 23,471,823 2,398,303 .02 (23,471,823) = 469,436 1,928,867 21,542,957 2,398,303 .02 (21,542,957) = 430,859 1,967,444 19,575,514 2,398,303 .02 (19,575,514) = 391,510 2,006,793 17,568,722 2,398,303 .02 (17,568,722) = 351,374 2,046,929 15,521,794 2,398,303 .02 (15,521,794) = 310,436 2,087,867 13,433,927 2,398,303 .02 (13,433,927) = 268,679 2,129,624 11,304,303 2,398,303 .02 (11,304,303) = 226,086 2,172,217 9,132,086 2,398,303 .02 (9,132,086) = 182,642 2,215,661 6,916,425 2,398,303 .02 (6,916,425) = 138,328 2,259,975 4,656,450 2,398,303 .02 (4,656,450) = 93,129 2,305,174 2,351,276 2,398,303 .02 (2,351,276) = 47,027* 2,351,276 0 * rounded 116 Case 15-2 (continued) Requirement 2 After the first full year under the warehouse lease, the carrying amount (after accumulated depreciation) of Dowell’s leased warehouses is 32,000,000: $40,000,000 Leased warehouses, PV of lease payments ÷ 5 years Life of lease $ 8,000,000 Accumulated depreciation after one year $40,000,000 Leased warehouses, PV of lease payments (8,000,000) Accumulated depreciation after one year $32,000,000 Carrying amount after one year Requirement 3 The appropriate accounting treatment for the proposed sublease is specified in SFAS 13 “Accounting for Leases.” Accounting and Reporting for Subleases and Similar Transactions is described in paragraphs 35-40. Dowell’s proposed sublease fits the description of Par. 35(b): 35. This section deals with the following types of leasing transactions: a. The leased property is re-leased by the original lessee to a third party, and the lease agreement between the two original parties remains in effect (a sublease). b. A new lessee is substituted under the original lease agreement. The new lessee becomes the primary obligor under the agreement, and the original lessee may or may not be secondarily liable. c. A new lessee is substituted through a new agreement, with cancellation of the original lease agreement. 117 Case 15-2 (continued) Because Dowell’s proposed sublease fits the description of 35.b, accounting for it is described in Par. 38(a): 38. If the nature of the transaction is such that the original lessee is relieved of the primary obligation under the original lease, as would be the case in transactions of the type described in paragraphs 35(b) and 35(c), the termination of the original lease agreement shall be accounted for as follows: a. If the original lease was a capital lease, the asset and obligation representing the original lease shall be removed from the accounts, gain or loss shall be recognized for the difference, and, if the original lessee is secondarily liable, the loss contingency shall be treated as provided by FASB Statement No. 5, "Accounting for Contingencies." Any consideration paid or received upon termination shall be included in the determination of gain or loss to be recognized. b. If the original lease was an operating lease and the original lessee is secondarily liable, the loss contingency shall be treated as provided by FASB Statement No. 5. Requirement 4 In accordance with 38(a), the asset and obligation representing the original lease would be removed from the accounts and a loss would be recognized for the difference. The journal entry would Dowell record in connection with the sublease is: Lease payable (balance after 4 quarters; from req. 1) ... 30,816,422 Loss on sublease (to balance) .................................. 1,183,578 Accumulated depreciation (balance: from req. 2) ..... 8,000,000 Leased warehouses (balance: PV of lease payments) 40,000,000 118 Case 15-2 (concluded) Requirement 5 In accordance with 38(a), because Dowell, the original lessee, is secondarily liable, the loss contingency would be treated as provided by FASB Statement No. 5, "Accounting for Contingencies." Recall from Chapter 13 that a loss contingency is accrued as a liability only if (a) it is probable a loss will occur and (b) the amount can be reasonably estimated. Because it would not be probable, no accrual is required, but because it would be reasonably possible that American Tankers would default and Dowell would be required to fulfill those obligations, disclosure of the contingency would be required in the notes to the financial statements throughout the term of the sublease. 119 Communication Case 15-3 First, this case has no single right answer. The process of developing the proposed solutions will likely be more beneficial than the solutions themselves. Students should benefit from participating in the process, interacting first with other group members, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Discussion likely will include the following: a. Possible advantages of leasing include: 1. Leasing can preserve the ability to borrow under lines of credit. 2. Leasing can provide an interest rate lower than the incremental borrowing rate. 3. Leasing may avoid violating restrictive loan agreements that prohibit the issuance of additional debt securities. 4. Leasing can lessen the risk of obsolescence. 5. Leasing allows 100% financing at fixed interest rates as compared with 70% to 90% financing when assets are purchased. b. The lessee views a noncancelable lease as a capital lease if it meets at least one of the following criteria. 1. The lease transfers ownership of the property to the lessee at the end of the lease term. 2. The lease contains a bargain purchase option. 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments, excluding executory costs, equals or exceeds 90% of the fair value of the leased property. 1. and 3. are not met. 2. and 4. are met – if the purchase option is viewed as a bargain purchase option. Is $290,000 enough less than $300,000 that exercise of the option is expected to occur? If so: 2. The right to purchase the vans at the end of the lease term for $290,000, when the estimated fair market value is $300,000, is a bargain purchase option. 4. The present value of the minimum lease payments, not including the executory costs, is greater than 90% of the fair market value of the vans, calculated as follows: 120 Case 15-3 (continued) Present value of minimum lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 In this case, it is a capital lease. Otherwise: Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Fair value of vans $1,240,000 x 90% 90% of the fair value of the vans $1,116,000 In this case, it is an operating lease to the lessee. Either way, it is a nonoperating lease to the lessor: Present value of minimum lease payments, assuming a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Bargain purchase price ($290,000 x 0.68301) 198,073 Total $1,244,128 Present value of minimum lease payments, assuming the purchase option is not a BPO: Lease payments ($300,000 x 3.48685) $1,046,055 Residual value ($300,000 x 0.68301) 204,903 Total $1,250,958 Since Interstate’s cost, $1,050,000, was less than its “selling price,” this is a sales-type lease to Interstate. 121 Case 15-3 (concluded) c. VIP would record the following at December 31, 2006: Interest expense ([$1,100,000 - 300,000] x 10%) ..................... 80,000 Lease liability .................................................................. 220,000 Cash ............................................................................ 300,000 Operating expenses ......................................................... 1,000 Cash ............................................................................ 1,000 If a BPO is assumed, VIP would have the vans for 7 years: Depreciation expense ([$1,100,000 - 50,000]÷ 7 yrs.) 150,000 Accumulated depreciation ......................................... 150,000 If a BPO is not assumed, VIP would have the vans for 4 years: Depreciation expense ([$1,100,000 - 300,000]÷ 4 yrs.) 200,000 Accumulated depreciation ......................................... 200,000 122 International Case 15-4 The basic objective of accounting for leases is the same in both countries. Leases that transfer to the lessee substantially all risks and rewards of ownership are distinguished from operating leases. In the U.K. these are referred to as finance leases; in the U.S.A., these are termed capital leases. By either name, the present value of underlying lease payments is recorded as both an asset and a liability. Rental expense under operating leases is charged against income as incurred. Although the fundamental accounting approach is the same, disclosures differ, particularly the extensiveness of disclosures. In the U.S.A., virtually all aspects of leases must be disclosed. Required disclosures are specific to the type of lease and include: FOR CAPITAL LEASES: A. Gross amount of leased property under capital leases as of the date of each balance sheet (by major classes according to nature or function). B. Future minimum lease payments as of the date of the latest balance sheet presented – in the aggregate and for each of the 5 succeeding fiscal years, with separate deductions for the: 1. amount representing executory costs (including any profit), 2. amount representing interest (called finance charges by BP). C. Minimum sublease rentals to be received under noncancelable subleases. D. Contingent rentals actually incurred. FOR OPERATING LEASES A. Rental expense with separate amounts for minimum rentals, contingent rentals, and sublease rentals. B. Future minimum rental payments as of the date of the latest balance sheet presented – in the aggregate and for each of the 5 succeeding fiscal years. C. Minimum sublease rentals to be received under noncancelable subleases. Some of this information is provided by BP’s disclosures, but a U.S. company’s disclosures typically would be more extensive. 123 Judgment Case 15-5 Requirement 1 ($ in millions) Fiscal Operating PV factor Present years leases 12% value 2005 $ 1,066 .893 $ 952 2006 999 .797 796 2007 982 .712 699 2008 931 .636 592 2009 838 .567 475 2010 and subsequent 7,525 .322* 2,423 Total minimum rentals $12,341 $5,937 * This is the PV factor for i=12%, n=10, which treats payments after 2009 as occurring in 2014, 5 years after 2009, the midpoint of the 9 years after 2009. or: An alternative (more accurate, but more difficult) way to estimate the present value of the payments beyond 2009 is: to view them as a deferred annuity: $836 ($7,525/9) x 5.328** = $4,454 $4,454 x .567*** = $2,525 ** present value of an ordinary annuity of $1, i=12%, n=9 *** present value of $1, i=12%, n=5 (2005-2009) Requirement 2 If capitalized, these operating lease commitments would add $5,937 million to American’s liabilities. The impact this on the percentage of the company's debt comprising lease liabilities would be to increase the percentage from 4.6% to 22.5%: Without capitalization: $1,165 / $25,567 = 4.6% With capitalization: ($1,165 + $5,937) / ($25,567 + $5,937) = 22.5% 124 Real World Case 15-6 Requirement 1 Leasing can allow a firm to conserve assets, to avoid some risks of owning assets, and obtain favorable tax benefits. Also, leasing sometimes is used as a means of “off-balance-sheet financing.” When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-equity ratio and other mechanical indicators of riskiness. Also, the purchased asset increases total assets and thus reduces calculations of the rate of return on assets. In spite of research that indicates the market is not fooled, managers continue to avoid reporting of assets and liabilities by leasing rather than buying and by constructing lease agreements in such a way that capitalizing the assets and liabilities is not required. Whether or not there is any real effect on security prices, off-balance- sheet financing can help a firm avoid exceeding contractual limits on designated financial ratios (like the debt to equity ratio, for instance). In fact, in its annual report, Safeway indicates that they have several restrictive covenants, one of which relates to the debt to equity ratio. Requirement 2 When capital leases are first recorded, both assets and liabilities increase by the present value of minimum lease payments. In later years, though, the amounts differ. Leased assets are reduced by depreciation. Lease liabilities are reduced by the principal portion of lease payments. Requirement 3 ($ in millions) Interest expense (difference) ........................ 69.2 Lease payable (current obligation - given) .. 42.8 Cash (rental payment - given) ................. 112.0 Requirement 4 $758.1 Property under capital lease, beg. of 2004 ÷ $ 49.3 2004 amortization (230.9 – 181.6) 15.4 Approximate average life of capital leases = 15.4 years 125 Case 15-6 (concluded) Requirement 5 $ 69.2 2005 interest (from requirement 3) ÷ 718.8 Beginning balance in lease liability – given: $50.5 + 668.3 9.6 % Approximate average interest rate = 9.6% Ethics Case 15-7 Discussion should include these elements: Leasehold improvement depreciation period There may be some degree of latitude associated with uncertainty concerning the life of the leasehold improvements. However, trade publications indicate 25 years probably is out of range. The suggestion to use 25 years clearly is motivated by the desire to “window dress” performance. Ethical Dilemma: How does a doubtful justification for the estimated life of leasehold improvements compare with the perceived need to increase reported profits? Who is affected?: Person Keene Other managers Shareholders Potential shareholders Employees Creditors The company’s auditors 126 Research Case 15-8 Results will vary depending on companies chosen. Kroger provided the following disclosures in its annual report for the year ending December 31, 2003: LIABILITIES Current liabilities Current portion of long-term debt including obligations under capital leases $ 248 $ 352 Accounts payable 3,058 3,269 Accrued salaries and wages 547 571 Deferred income taxes 138 39 Other current liabilities 1,595 1,377 Total current liabilities 5,586 5,608 Long-term debt Face value long-term debt including obligations under capital leases 8,116 8,222 Deferred income taxes 990 709 Other long-term liabilities 1,481 1,713 Total Liabilities 16,173 16,252 11. LEASES The Company operates primarily in leased facilities. Lease terms generally range from 10 to 20 years with options to renew for varying terms. Terms of certain leases include escalation clauses, percentage rents based on sales, or payment of executory costs such as property taxes, utilities, or insurance and maintenance. Rent expense for leases with escalation clauses, capital improvement funding and other lease concessions is accounted for on a straight-line basis over the minimum lease term. Portions of certain properties are subleased to others for periods generally ranging from one to 20 years. Rent expense (under operating leases) consists of: 2003 2002 2001 Minimum rentals $ 740 $ 739 $ 718 Contingent payments 9 10 14 Sublease income (96) (93) (82) $ 653 $ 656 $ 650 127 Case 15-8 (concluded) Minimum annual rentals for the five years subsequent to 2003 and in the aggregate are: Capital Operating Leases Leases 2004 $ 66 $ 784 2005 64 746 2006 61 691 2007 57 644 2008 54 595 Thereafter 439 4,201 741 $ 7,661 Less estimated executory costs included in capital leases (6) Net minimum lease payments under capital leases 735 Less amount representing interest (348) Present value of net minimum lease payments $ 387 Total future minimum rentals under noncancellable subleases at January 31, 2004, were $354. Requirements 3 & 4 The $387 million capital lease liability represents 2.4 % of the $16,173 million total liabilities. However, the obligations under operating leases are roughly 10 times those for capital leases, so the lease liability also would be roughly ten times higher if the operating leases were capitalized (treated as capital leases). 128 Real World Case 15-9 Requirement 1 In a sale-leaseback transaction the owner of an asset sells the asset and immediately leases it back from the new owner. We view the sale and simultaneous leaseback of the asset as a single borrowing transaction. On the surface there appear to be two separate transactions, but the substance of the agreement indicates otherwise. The seller-lessee (FedEx in our case) still retains the use of the asset owned prior to the sale-leaseback, but in the process acquires (a) cash from the sale and (b) an obligation to make lease payments over the term of the lease. In substance, the seller-lessee has borrowed cash to be repaid over the lease term (along with interest). So, from this perspective of “substance over form,” we do not immediately recognize any gains that result from sale-leaseback transactions, but defer the gains to be recognized over the term of the lease. There typically is an interdependency between the lease terms and the price at which the asset is sold. As a result, the earnings process is not complete at the time of sale but is completed over the term of the lease. So, viewing the sale and the leaseback as a single transaction is consistent with the realization principle. Requirement 2 When amortizing the deferred gain over the lease term, if the lease meets the criteria to be viewed as a capital lease, we reduce depreciation expense each period by the amortized portion of the gain. If the leaseback portion of a sale-leaseback transaction is classified as an operating lease, the gain still is deferred, but is recognized as a reduction of rent expense rather than depreciation. Because FedEx amortizes its deferred gains “ratably over the life of the lease as a reduction of rent expense” it apparently considers the leases to be operating leases. 129 Communication Case 15-10 Suggested Grading Concepts and Grading Scheme: Content (80% ) 30 Sale portion of the sale-leaseback (10 each). Record cash for the sale price. Decrease equipment at its undepreciated cost. Establish a deferred gain for the excess of the sale price of the equipment over its undepreciated cost. 15 Gain on the sale portion (5 each; maximum 15). Amortized over the lease term. As a reduction of depreciation expense. Results in essentially same depreciation and interest as if the asset were not sold and leased back, but a note issued for cash instead. Because the sale and the leaseback are two components of a single transaction rather than two independent transactions. Consistent with the realization principle. 15 Leaseback portion of the sale-leaseback transaction (5 each; maximum 15). Both an asset. And a liability. At the present value of minimum lease payments. Excluding any executory costs. Asset amount cannot exceed fair value. 20 Conceptual basis (10 each). Economic effect of a long-term capital lease on the lessee is similar to that of an installment purchase. Transfers substantially all of the benefits and risks incident to the ownership of property to the lessee. 80 points Writing (20%) 5 Terminology and tone appropriate to the audience (CFO). 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points 130 Trueblood Accounting Case 15-11 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. These are available to instructors at: https://secure.deloitte.com/rmtbcs00/casesolutions.asp Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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