ACCOUNTING FOR LEASES 1.

Leasing: Meaning and Advantages Lease is an arrangement whereby one party (Lessor) transfers the rights to use its property to another party (Lessee), in return for cash payments over a specified period of time. Advantages of leasing include greater financing, larger tax deductions, reduction in the risk of property obsolescence and off-balance-sheet-financing. 2. Major Conceptual Issue: Rental or Acquisition? This issue is alternatively known as "legal liability vs. economic substance", or "operating lease vs. capital lease". If the rights, risks, and rewards of ownership are borne by the lessee, it is in substance an acquisition by financing. If they are not, it is a rental arrangement. Once the substantive decision of rental vs. acquisition is made, the accounting thereafter is fairly straightforward. For operating lease, each lease rental is recorded as an expense in the books of the lessee. For capital lease (also known as finance lease), an asset and liability is recorded at the inception, and interest expenses and depreciation expenses are recorded thereafter. Lessors accounting can be more involved, which we will discuss later. Incorrectly recording a capital lease as operating one (or vice versa) has significant effects on the income statement and balance sheet. Because of the impact on debtequity ratio, return on assets, profits in the initial periods, and current ratio, lessees generally prefer a lease agreement to be classified as an operating rather than capital lease. On the contrary, the lessor would prefer to record it as a capital lease. A capital lease will help the lessor to recognize income sooner, report higher profits and ROA in initial years, and have a higher current ratio. 3. Financial Statement Effects of Operating and Capital Leases: Whether the lease arrangement is recorded as capital lease or operating lease has significant effects on the income statement, balance sheet, and statement of cash flows. Please note, however, that the two methods result in identical total cash flows and total income over the lifetime of the lease.

The reporting (i.e. classification) of cash flow effects would be different, however. For a capital lease, the interest expense is classified as an operating cash flow whereas the principal repayment component is classified as a financing cash flow. For an operating lease, the entire lease payment is classified as an operating cash flow. As a result, cash flow from operations for a lessee is lower for operating leases. 4. Types of Leases: Lessee: Operating and Capital Lessor: Operating, Direct-Financing and Sales-type 5. Criteria for Classification of Lease as Capital Lease: Per the U.S. GAAP, In addition to lease being non-cancelable, the lessee has to meet one of the following four conditions: a. b. c. d. Transfer of title Bargain Purchase Option Lease term = 75% of remaining economic life PV of Minimum Lease Payments = 90% of FMV at inception

Lessor has to meet one of the above four conditions and BOTH of the following conditions (a) Collectibility and (b) No uncertainty about unreimbursable costs. Indian GAAP and IFRS do not contain very specific conditions. Both simply state that if the rights, risks, and rewards of ownership are borne by the lessee, it is a capital (i.e., finance) lease in the books for the lessee. 6. Meaning of Certain Terms: a) Bargain Purchase Option: An option to purchase the property at a price that is substantially below the expected fair value at the date the option may be exercised.

b) Lease Term: Normally includes only the fixed, non-cancelable term of the lease. Bargain renewal options or penalty for non-renewal could extend the lease term in certain circumstances. c) Minimum Lease Payments: If the lease agreement contains a bargain purchase option, the minimum lease payments include (1) the periodic lease payments up to the date that the bargain purchase option becomes exercisable, and (2) the amount of the bargain purchase option. (Remember that the lessee depreciates the asset over its economic life rather than the lease term in the presence of a bargain purchase option). If the lease agreement does not contain a bargain purchase option, the minimum lease payments include (1) the periodic lease payments over the lease term, (2) the amount of any guaranteed residual value at the end of the lease term, and (3) any payment required by the lessee for non-renewal of lease. In either case, contingent rentals are not included in MLP. Also, executory costs such as insurance, maintenance, and taxes on the leased property, are excluded from MLP. These are period costs rather than acquisition costs of the property. d) Discount Rate to be used by the lessee: To calculate the present value of MLP, the lessee should use his or her incremental borrowing rate unless (1) it is practicable for the lessee to know the implicit rate in the lease, and (2) the implicit rate is less than the lessee's incremental borrowing rate. For the purpose of our course, we will typically assume that the implicit rate of the lessor is known to the lessee and that it is the same as the incremental borrowing rate of the lessee.

7. Lessor Accounting: Following are the important accounting issues: Computing of lease rentals to be charged Recording the investment in the lease (Note that it includes both the guaranteed and unguaranteed residual value) Additional entry (for COGS) for the sale-type of leases Recording interest revenue Recording return of equipment Balance sheet disclosures 8. Lessee Accounting for Capital Leases: The important accounting issues are: What amount to capitalize at inception Lower of the (a) PV of MLP, and (b) FMV Amortization of lease liability Use effective interest method Amortization of leased asset Use the depreciation method for similar assets Return of equipment Remember to reduce to zero both the equipment and accumulated depreciation account Balance sheet disclosures. 9. Additional Leasing Issues: a) Residual Values: In rational economic terms, the lessor will require a lower rate of return if the residual value is guaranteed by the lessee than if it is not guaranteed. However, given the lease rentals,

In the books of the lessor, There is no impact because MLPR include MLP and Unguaranteed residual value. In other words, it includes both the guaranteed and unguaranteed residual values. A slight difference, however, needs to be made for recording the journal entry at inception. Remember to subtract the present value of the unguaranteed residual value from both sales and cost of goods sold (principle of realization). In the books of the lessee, There is an impact because MLP include guaranteed residual value only. Accordingly, it has an impact on initial capitalization, interest amortization, asset amortization (reduce the guaranteed residual value to determine depreciable base, but not the unguaranteed residual value), and equipment return. b) Lessor's Initial Direct Costs: Initial direct costs include commissions, credit investigations, legal fees, and other costs incurred by the lessor. Whether these costs are expenses of the period in which the lease is signed, or need to be spread over the lease term, depends on the type of the lease. If it is an operating lease, initial direct costs should be recorded as an asset and amortized over the lease term in proportion to rental income. c) Sale-Leaseback Transactions: Depending on time availability, we will cover or skip this topic in class.

HANDOUT PROBLEMS - LEASES For each of the following situations, make the journal entries for the lessee and the lessor for the first year of the lease. Be sure you know the type of lease described, and which criteria are fulfilled.

Present value of ordinary annuity for 6 periods at 14% is 3.8887 Present value of a single sum for 6 periods at 14% is 0.4556

Situation I (No residual value, direct financing) Superware Corporation, the lessor, agrees to lease equipment to Toughware Corporation, the lessee, beginning January 1, 2010. The lease terms, provisions, and related events are as follows: 1. The lease term is 6 years; the lease is non-cancelable and requires annual rental payments of $37,000 to be made at the end of each year. The fair market value of the equipment is $136,103. The cost of the equipment to Superware is $136,103. The estimated life of the equipment is 6 years. Toughware agrees to pay all executory costs, except for the property taxes of $2,000 per year which is included as a part of the annual lease payments. The interest rate implicit in the lease is 14%. This is known to Toughware. The initial direct costs are insignificant and assumed to be zero. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

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Situation II (Guaranteed residual value, sale-type) Superware Corporation, the lessor, agrees to lease equipment to Toughware Corporation, the lessee, beginning January 1, 2010. The lease terms, provisions, and related events are as follows: 1. The lease term is 6 years; the lease is non-cancelable and requires annual payments of $37,000 to be made at the end of each year. The cost of the equipment is $105,000; the equipment has an estimated life of 7 years and at the end of the lease term has a guaranteed residual value of $20,000 accruing to the benefit of the Superware Corporation. Assume FMV at inception to be $145,215. Toughware agrees to pay all executory costs, except for the property taxes of $2,000 per year which is included as a part of the annual lease payments. The interest rate implicit in the lease is 14%. This is known to Toughware. The initial direct costs are insignificant and assumed to be zero. The collectibility of the rentals is reasonably assured, and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

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Situation III (Bargain purchase option, sale-type) Superware Corporation, the lessor, agrees to lease equipment to Toughware Corporation, the lessee, beginning January 1, 2010. The lease terms, provisions, and related events are as follows: 1. The lease term is 6 years; the lease is non-cancelable and requires annual rental payments of $37,000 to be made at the end of each year. The cost of the equipment is $105,000; the equipment has an estimated life of 7 years and at the end of the lease term has an expected but unguaranteed residual value of $20,000 accruing to the benefit of the Superware Corporation. Toughware has an option to buy the equipment at the end of the lease term for $1,000. FMV at inception = $136,560. Toughware agrees to pay all executory costs, except for the property taxes of $2,000 per year which is included as a part of the annual lease payments. The interest rate implicit in the lease is 14%. This is known to Toughware. The initial direct costs are insignificant and assumed to be zero. The collectibility of the rentals is reasonably assured and there are no important uncertainties surrounding the amount of unreimbursable costs yet to be incurred by the lessor.

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