Accounting Chapter 15 Addendum

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CHAPTER 15 Leases 1 Leases Where We’re Headed Preview A Chapter Addendum The FASB and the IASB are collaborating on several major new standards designed in part to move…

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CHAPTER 15 Leases 1 Leases Where We’re Headed Preview A Chapter Addendum The FASB and the IASB are collaborating on several major new standards designed in part to move U.S. GAAP and IFRS closer together (convergence). This Addendum is based on their joint Exposure Draft of the new leases standard update and “tentative decisions” of the Boards after receiving feedback from the Exposure Draft as of the date this text went to press. 1 Even after the new Accounting Standard Update is issued, previous GAAP will be relevant until the new ASU becomes effective (likely not mandatory before 2016) and students taking the CPA or CMA exams will be responsible for the previous GAAP until six months after that effective date. Conversely, prior to the effective date of the new Accounting Standard Update it is useful for soon-to-be graduates to have an understanding of the new guidance on the horizon. RIGHT-OF-USE MODEL Because the ASU had not been finalized as of the date this text went to press, it is possible that some aspects of the ASU are different from what we show in this Addendum. Check the FASB Updates page (http://lsb.scu.edu/jsepe/fasb-update7e.htm) to see if any changes have occurred. 1 2 SECTION 3 Financial Instruments and Liabilities GAAP Change The new guidance for lease accounting eliminates the concept of operating leases. From your own experience of leasing an apartment or a car or knowing someone who has, you know that a lease is a contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset for a specified period of time. In return for this right, the lessee agrees to make stipulated, periodic cash payments during the term of the lease. In the right-of-use model introduced in the new standards update, all leases are recorded as an asset and liability (with the exception of short term leases as described later), and the concept of operating leases is eliminated. The right to use the leased property can be a significant asset. Likewise, the obligation to make the lease payments can be a significant liability. Appropriately, the lessee reports both the right-of-use asset and the corresponding liability in the balance sheet: Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ... xxx xxx The lessee records both a right-of-use asset and a liability to pay for that right. GAAP Change The new ASU eliminates the concept of direct financing and sales-type leases. The lessor records a receivable for the lease payments it will receive and derecognizes the asset being leased. If only a portion of the right of use is leased, the lessor also records a residual asset. On the other side of the transaction, the lessor reports a receivable for the lease payments it will receive and removes from its records (derecognizes) the asset (or portion thereof) for which it has given up the right of use. We no longer employ the concept of direct financing and sales-type leases. If the lease receivable represents only a portion of the total fair value of the asset, the lessor also records a “residual asset” for the portion related to the right of use not transferred to the lessee: Lease receivable (present value of lease payments) ...... Asset (carrying amount of asset being leased) ........ OR Lease receivable (present value of lease payments)....... Residual asset (carrying amount of portion retained) ..... Asset (carrying amount of asset being leased) ......... xxx xxx xxx xxx xxx When the Lessor is a Financial Intermediary Either of these two scenarios is typical for most leases in which the lessor’s primary role is to acquire an asset and then finance it for a lessee during all or a portion of the asset’s useful life. The lessor, in this case, is a financial intermediary that earns interest revenue for providing financing of the asset for the lessee. Look, for example, at Illustration 15- 24: CHAPTER 15 ILLUSTRATION 15–24 Right of Use Model Leases 3 LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and leases it to UserCorp for lease payments whose present value is $100,000. UserCorp Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ... LeaseCo Lease receivable (present value of lease payments) ..... Asset (carrying amount of asset being leased) ........ 100,000 100,000 100,000 100,000 Two potential characteristics of a lease arrangement can complicate the lessor’s accounting: (1) retaining a residual asset and (2) earning a profit on the lease. We first discuss each individually and then discuss them in combination. When the Lessor Retains a Residual Asset Sometimes the lessee obtains the right to use the asset for only a portion of its useful life or to use only a portion of the asset. In that case, the lessor retains a “residual asset” that represents the carrying amount of the asset not transferred to the lessee. ILLUSTRATION 15–25 Residual Asset LeaseCo buys a machine from its manufacturer at its fair value of $100,000 and leases it to UserCorp for lease payments whose present value is $40,000. UserCorp Right-of-use asset (present value of lease payments) .... Lease liability (present value of lease payments) ... 40,000 40,000 Only a portion of the right to use the asset is being transferred. Accordingly, a portion is being retained. The portion transferred is: $40,000 / $100,000 x $100,000 = $40,000. So, the portion retained (residual asset) is the remainder: $100,000 – 40,000 = $60,000. The lessor “derecognizes” the asset under lease and replaces it with two assets – a lease receivable and a residual asset. LeaseCo Lease receivable (present value of lease payments) ..... Residual asset (carrying amount of portion retained) ... Asset (carrying amount of asset being leased) ........ 40,000 60,000 100,000 4 SECTION 3 Financial Instruments and Liabilities When the Lessor Earns a Profit from the Lease In some scenarios, the lessor earns an immediate profit from the lease transaction in addition to the interest revenue earned over the term of the lease. Often, the lessor in this type of transaction is a manufacturer or a merchandiser that is using the lease as a means of “selling” its product. We account for these situations similar to the way we account for sales-type leases in earlier GAAP. See Illustration 15-26 for an example. ILLUSTRATION 15–26 Profit from the Lease ManuCom manufactures a machine at a cost of $80,000 with a retail selling price (fair value) $100,000. Rather than selling the machine, it leases the machine to UserCorp under an agreement in which the present value of the lease payments is $100,000. Either way, ManuCom generates a gross profit of $20,000: Lease receivable (PV of lease payments) ..................... Asset (carrying amount of asset being leased) ........ Profit (difference2 between the PV of lease payments and the carrying amount of asset) ...................... 100,000 80,000 20,000 If the PV of the lease payments exceeds the carrying amount of the asset transferred, the lessor has a profit from the lease. We can think of (a) the present value of the lease payments to be received as being the “selling price” of the right to use the asset and (b) the carrying amount of the portion related to that right of use, and thus transferred, as the “cost of goods sold,” with the difference being the profit on the “sale.” When the Lessor Earns a Profit and Retains a Residual Asset As we saw earlier, the lessee sometimes obtains the right to use the asset for only a portion of its useful life or to use only a portion of the asset and retains a “residual asset.” This can happen also in a situation in which the lessor earns a profit on the lease: Lease receivable (PV of lease payments) ....................... Residual asset (carrying amount of portion retained, if any) Asset (carrying amount of asset being leased) ........ xxx xxx xxx CHAPTER 15 Leases 5 Profit (difference, if any, between the PV of lease payments and the carrying amount of portion transferred) ... xxx In Illustration 15-27 we modify our previous example to include a residual asset in a lease involving a profit. In the rare instance that this is a debit difference, we would have a loss rather than profit. Companies might choose to separate this profit into its two components: Sales revenue and cost of goods sold, which is the gross method demonstrated for “sales-type” leases in the main chapter. 2 6 SECTION 3 Financial Instruments and Liabilities ILLUSTRATION 15–27 Profit from the Lease and Residual Asset The fraction of the $80,000 carrying amount deemed transferred is: PV of payments ManuCom manufactures a machine at a cost of $80,000 with a retail selling price (fair value) of $100,000. Rather than selling the machine, it leases the machine to UserCorp under an agreement in which the present value of the lease payments is $90,000. Because the lessor is not receiving the full value of the machine, only a portion of the right to use the asset is being transferred. Accordingly, a portion is being retained. The portion transferred is: $90,000 / FV of asset / $100,000 x $80,000 = $72,000. So, the portion retained (residual asset) is the remainder: $80,000 – 72,000 = $8,000. Lease receivable (PV of lease payments) ....................... Residual asset (carrying amount of portion retained) ........ Asset (carrying amount of asset being leased) ........ Profit ($90,000 – 72,000)..................................... 90,000 8,000 80,000 18,0003 APPLICATION TO CHAPTER ILLUSTRATIONS Let’s look back to the situations we discussed in the main chapter in which we applied current GAAP, but instead now see how the new guidance would compare. We start with a rather straightforward situation and then look at the three variations we just discussed: (1) the lessor retains a residual interest, (2) the lessor recognizes some immediate profit, and (3) the lessor both retains a residual interest and recognizes some immediate profit. In Illustration 15–28 we have the same straightforward lease agreement we saw earlier in Illustration 15-6. Accounting under the new lease guidance is quite similar to what would appear under current GAAP. Conceptually, though, we view the situation differently than we would under current GAAP. Rather than thinking of Sans Serif as having “purchased” the asset from First LeaseCorp, we think of the company as having acquired the right to use the asset, in this case, for its entire useful life. That’s why Sans Serif records a right-of-use asset instead of an asset to be depreciated as if it were owned. Otherwise, though, the accounting is much the same. On the other side of the transaction, First LeaseCorp again derecognizes the asset (removes it from the 3 GAAP Change Companies might choose to separate this profit into its two components: Sales revenue ($90,000) and cost of goods sold ($72,000), which is the gross method demonstrated for “sales-type” leases in the main chapter. CHAPTER 15 Leases 7 books) as it records a receivable for the lease payments to be received. ILLUSTRATION 15–28 Right-of-Use Model Using Excel, enter: =PMT(.10,6,479079,, 1) Output: 100000 Using a calculator: enter: BEG mode N 6 I 10 PV −479079 FV Output: PMT 100000 On January 1, 2013, Sans Serif Publishers, Inc., leased a copier from First Lease Corp. First Lease Corp purchased the equipment from CompuDec Corporation at a cost of $479,079. The lease agreement specifies annual payments beginning January 1, 2013, the inception of the lease, and at each December 31 thereafter through 2017. The sixyear lease term ending December 31, 2018, is equal to the estimated useful life of the copier. First Lease Corp routinely acquires electronic equipment for lease to other firms. The interest rate in these financing arrangements is 10%. To achieve its objectives, First LeaseCorp must (a) recover its $479,079 investment as well as (b) earn interest revenue at a rate of 10%. So, the lessor determined that annual rental payments would be $100,000: $479,079 ÷ 4.79079* = $100,000 Lessor’s cost Rental payments *Present value of an annuity due of $1: n = 6, i = 10%. Of course, Sans Serif Publishers, Inc., views the transaction from the other side. The price the lessee pays for the copier is the present value of the rental payments: $100,000 × 4.79079* = $479,079 Rental payments Lessee’s cost *Present value of an annuity due of $1: n = 6, i = 10%. Commencement of the Lease (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Right-of-use asset (present value of lease payments) ................... 479,079 Lease payable (present value of lease payments) ................. 479,079 First LeaseCorp (Lessor) Lease receivable (present value of lease payments) ..................... 479,079 Inventory of equipment (carrying amount of asset being leased) 479,079 First Lease Payment (January 1, 2013)* Sans Serif Publishers, Inc. (Lessee) Lease payable ............................................................................. 100,000 Cash ..... .................................................................................. 100,000 First LeaseCorp (Lessor) Cash ............................................................................................ 100,000 Lease receivable ..................................................................... 100,000 * Of course, the entries to record the lease and the first payment could be combined into a single Notice that the lessor’s entries are the flip side or mirror image of the lessee’s entries. The first lease payment reduces the balances in the lease payable and the lease receivable by $100,000 to $379,079. 8 SECTION 3 Financial Instruments and Liabilities entry since they occur at the same time. A leased asset is recorded by the lessee at the present value of the lease payments. Interest is a function of time. It accrues at the effective rate on the balance outstanding during the period. Notice that as the lessee assumes the obligation to pay for the asset’s use (lessee’s lease liability), the lessor acquires the right to receive those payments (lease receivable). Recording the first payment above emphasizes that relationship; the $100,000 reduces both the lessee’s lease liability and the lessor’s lease receivable. Unless the lessor is a manufacturer or dealer, the fair value typically will be the lessor’s cost ($479,079 in this case). However, if considerable time has elapsed between the purchase of the property by the lessor and the inception of the lease, the fair value might be different. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease ordinarily will be its normal selling price. More on that later. In unusual cases, market conditions may cause fair value to be less than the normal selling price.4 Be sure to note that the entire $100,000 first lease payment is applied to principal reduction.5 Because it occurred at the commencement of the lease, no interest had yet accrued. Subsequent lease payments include interest on the outstanding balance as well as a portion that reduces that outstanding balance. As of the second rental payment date, one year’s interest has accrued on the $379,079 balance outstanding during 2013, recorded as in Illustration 15–28A. Notice that the outstanding balance is reduced by $62,092—the portion of the $100,000 payment remaining after interest is covered. If you compare each of these entries after the lessee’s initial recording of the right-of-use asset with the entries we recorded in Illustrations 15-6 and 15-6A, you will notice that they are precisely the same as under prior GAAP. FASB ASC 840–10: Leases–Overall (previously “Accounting for Leases,” Statement of Financial Accounting Standards No. 13 (Stamford, Conn.: FASB, 1980)). 5 Another way to view this is to think of the first $100,000 as a down payment with the remaining $379,079 financed by 5 (i.e., 6 – 1) year-end lease payments. 4 CHAPTER 15 ILLUSTRATION 15–28A Journal Entries for the Second Lease Payment LESSEE Lease Payable $479,079 (100,000) $379,079 (62,092) $316,987 LESSOR Lease Receivable $479,079 (100,000) $379,079 (62,092) $316,987 Leases 9 Second Lease Payment (December 31, 2013) Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($479,079 – 100,000)] .............. Lease payable (difference) ............................................ Cash (lease payment) ............................................... 37,908 62,092 100,000 First LeaseCorp (Lessor) Cash (lease payment) ..................................................... Lease receivable ....................................................... Interest revenue [10% × ($479,079 – 100,000)] .......... 100,000 62,092 37,908 Amortization of the Lease Receivable / Lease Payable The amortization schedule (Illustration 15-28B), too, is no different from what we would use under current GAAP (Illustration 15–6B). It shows how the lease balance and the effective interest change over the six-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of principal. The periodic reduction of principal is sufficient that, at the end of the lease term, the outstanding balance is zero. ILLUSTRATION 15–28B Lease Amortization Schedule The first rental payment includes no interest. The total of the cash payments ($600,000) provides for: 1. Payment for the copier ($479,079). 2. Interest ($120,921) at an effective rate of 10%. Payments 1/1/13 1/1/13 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 Effective Interest Decrease in Balance Outstanding Balance 479,079 379,079 316,987 248,686 173,555 90,910 0 (10% × Outstanding balance) 100,000 100,000 100,000 100,000 100,000 100,000 600,000 100,000 62,092 68,301 75,131 82,645 90,910 479,079 .10 (379,079) = 37,908 .10 (316,987) = 31,699 .10 (248,686) = 24,869 .10 (173,555) = 17,355 .10 (90,910 )= 9,090* 120,921* *Adjusted for rounding of other numbers in the schedule. Amortization of the Right-of-Use Asset (Lessee) Like other noncurrent assets, the lessee’s right-of-use asset provides benefits, the right to use a productive asset, over the period covered by the lease term. Consistent with that, the lessee amortizes its right-of-use asset over lease term (or 10 SECTION 3 Financial Instruments and Liabilities the useful life of the asset if it’s shorter). This usually is on a straight-line basis unless the lessee’s pattern of using the asset is different.6 Using the asset results in an expense for the lessee. December 31, 2013 and End of Next Five Years The lessee incurs an expense as it uses the asset. Sans Serif Publishers, Inc. (Lessee) Amortization expense ($479,079 ÷ 6 years) ................... Right-of-use asset .................................................... 79,847 79,847 GAAP Change This is similar to the lessee depreciating a leased asset in a capital lease under prior GAAP but, since we no longer have operating leases, amortizing right-of-use assets is much more pervasive. When the Lessor Retains a Residual Asset In the situation above, the lessor transferred the right of use for the entire life of the asset and retained no residual asset. Now, in Illustration 15-29, we apply the right-of-use model to the situation in the previous Illustration 15–5 in which the lease term is only four years of the asset’s six-year life. Illustration 15–29 Lessee and Lessor (Residual Asset for the Lessor) On January 1, 2013, Sans Serif Publishers, a computer services and printing firm, leased printing equipment from First LeaseCorp. The previous week, First LeaseCorp purchased the equipment from CompuDec Corporation at its fair value of $479,079. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2015. . As in Illustration 15-5, the present value of those four payments at a discount rate of 10% is $348,685. The useful life of the equipment is estimated to be six years. 6 Output measures such as units produced or input measures such as hours used might provide a better indication of the reduction in the remaining liability. CHAPTER 15 Leases 11 Commencement of the Lease (January 1, 2013) The lessee acquires an asset – the right to use the equipment. The fraction of the $479,079 carrying amount deemed transferred is the: PV of payments Sans Serif Publishers, Inc. (Lessee) Right-of-use asset ....................................................... Lease liability (present value of lease payments) ......... 348,685 348,685 First LeaseCorp (Lessor) Only a portion of the right to use the asset is being transferred. Accordingly, a portion is being retained. The portion transferred is: $348,685 / FV of asset / $479,079 x $479,079 = $348,685. So, the portion retained (residual asset) is the remainder: GAAP Change The lessor derecognizes the asset being leased but records a “residual asset” for the portion retained. $479,079 – 348,685 = $130,394. Lease receivable (present value of lease payments) ....... Residual asset (carrying amount of portion retained)...... Inventory of equipment (carrying amount of asset being leased) First Lease Payment (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Lease liability ................................................................ Cash..... ..................................................................... First LeaseCorp (Lessor) Cash .............................................................................. Lease receivable ....................................................... 100,000 100,000 100,000 100,000 348,685 130,394 479,079 . The amount recorded as a lease receivable by the lessor at the commencement of the lease is the present value of the lease payments. If that amount is less than the fair value of the asset, then the entire asset is not transferred to the lessee; the lessor retains a portion of the asset. In this situation, the lessor divides the carrying amount of the asset into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as what we call a residual asset. The allocation is based on the ratio of the present value of the payments to the fair value of the asset. That ratio is multiplied by the asset’s carrying value (the amount derecognized) to determine the portion of the carrying value transferred. The remainder is the carrying value retained and recorded as a residual asset. You might have deduced that when the carrying amount of the asset is equal to its fair value, the residual asset is simply the difference between the carrying amount (fair value) and the lease receivable. 12 SECTION 3 Financial Instruments and Liabilities Interest accrues at the effective rate on the balance outstanding during the period. Be sure to note that the entire $100,000 first lease payment is applied to principal (lease payable / lease receivable) reduction.7 Because the payment occurred at the commencement of the lease, no interest had yet accrued. Subsequent lease payments, though, include interest on the outstanding balance as well as a portion that reduces that outstanding balance. As of the second lease payment date, one year’s interest has accrued on the $248,685 ($348,685 – 100,000) balance outstanding during 2013, and is recorded as in Illustration 15– 29A. Notice that the outstanding balance is reduced by $75,131—the portion of the $100,000 payment remaining after interest is covered. ILLUSTRATION 15–29A Journal Entries for the Second Lease Payment LESSEE Lease liability $348,685 (100,000) $248,685 (75,131) $173,554 LESSOR Lease Receivable $348,685 (100,000) $248,685 (75,131) $173,554 Second Lease Payment (December 31, 2013) Sans Serif Publishers, Inc. (Lessee) Interest expense [10% × ($348,685 – 100,000)] .............. Lease liability (difference) ........................................... Cash (lease payment) ................................................. 24,869 75,131 100,000 First LeaseCorp (Lessor) Cash (lease payment) ................................................... Lease receivable ....................................................... Interest revenue [10% × ($348,685 – 100,000)] .......... 100,000 75,131 24,869 Amortization of the Lease Receivable / Lease Payable The amortization schedule in Illustration 15–29B shows how the lease balance and the effective interest change over the four-year lease term. Each lease payment after the first includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance. The periodic reduction is sufficient that, at the end of the lease term, the outstanding balance is zero. Another way to view this is to think of the first $100,000 as a down payment with the remaining $249,685 financed by 3 (i.e., 4 – 1) year-end lease payments. 7 CHAPTER 15 Illustration 15–29B Lease Amortization Schedule The first lease payment includes no interest. The total of the cash payments ($400,000) provides for: 1. Payment for the equipment’s use ($348,685). 2. Interest ($51,315) at an effective rate of 10%. Leases 13 Payments 1/1/13 1/1/13 12/31/13 12/31/14 12/31/15 Effective Interest Decrease in Balance Outstanding Balance 348,685 248,685 173,554 90,909 0 (10% × Outstanding balance) 100,000 100,000 100,000 100,000 400,000 100,000 75,131 82,645 90,909 348,685 .10 (248,685) = 24,869 .10 (173,554) = 17,355 .10 ( 90,909) = 9,091 51,315 Amortization of the Right-of-Use Asset (Lessee) In this situation, the lessee amortizes its right-of-use asset over a four-year lease term. December 31, 2013 and End of Next Three Years The lessee incurs an expense as it uses the asset. Sans Serif Publishers, Inc. (Lessee) Amortization expense ($348,685 ÷ 4 years) ................... Right-of-use asset .................................................... 87,171 87,171 Accretion of the Residual Asset (Lessor) Notice that the lessor has two assets now. It has a lease receivable recorded at the commencement of the lease, and it also has a residual asset representing the portion of the underlying asset not transferred to the lessee. To understand why we “accrete” the residual asset, let’s consider what the residual asset means to the lessor. Recall that we said that the fair value of the printing equipment in our illustrations is $479,079. In Illustration 15-5, First LeaseCorp decided that, at the end of the four-year lease term, the asset would have a residual value of $190,911. That amount was instrumental in determining the $100,000 lease payments. How much must the lessor recover from the lessee just through the four lease payments if it intends to earn a 10% rate of return on the transaction? The $479,079 is the fair value now, so to determine the amount that needs to be recovered from the four lease payments, First LeaseCorp subtracted from fair value the present value of the four-years-away residual value: 14 SECTION 3 Financial Instruments and Liabilities To determine the lease payments, the lessor subtracts from fair value the present value of the four-years-away residual value. Amount to be recovered (fair value) Less: Present value of the residual value ($190,911 x .68301*) To be recovered through periodic lease payments (present value) Lease payments at the beginning of each of the next 4 years * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% $479,079 (130,394) $348,685 ÷ 3.48685** $100,000 So, First LeaseCorp expects to recover its $479,079 investment as follows: Present value of periodic lease payments ($100,000 x 3.48685**) Plus: Present value of the residual value ($190,911 x .68301*) Amount to be recovered (fair value) * present value of $1: n=4, i=10% ** present value of an annuity due of $1: n=4, i=10% $348,685 130,394 $479,079 Our focus here is on the residual asset. Notice that it has a present value of $130,394 but is anticipated to have a value of $190,911 in four years, at the end of the lease term. At the commencement of the lease, First LeaseCorp recorded its residual asset at $130,394 (Illustration 15-29). At the end of the lease term, that amount will have risen to $190,911. The process of increasing the asset’s balance is called accretion. At the end of each of the four years of the lease term, First LeaseCorp will record accretion of the residual asset using the interest rate implicit in the agreement (10%). Because the asset increases with the passage of time, First LeaseCorp records revenue from accretion. The first year, the entry is: First LeaseCorp (Lessor Residual asset............................................................... Revenue from asset accretion ($130,394 x 10%) . 13,039 13,039 The increase in the residual asset’s balance through accretion is shown in Illustration 15-30. Illustration 15–30 Residual Asset Accretion Effective Interest Increase in (Revenue from Asset Accretion) Balance (10% × Outstanding balance) 1/1/13 12/31/13 12/31/14 12/31/15 12/31/16 *rounded Outstanding Balance 130,394 143,078 157,776 173,554 190,911 The balance in the residual asset accretes at the 10% discount rate to its anticipated value at the end of the lease term. .10 (130,394) = .10 (143,078) = .10 (157,386) = .10 (173,125) = 13,039 14,343 15,778 17,355 13,039 14,343 15,778 17,357* CHAPTER 15 Leases 15 The lessor’s investment is recovered from two sources: (a) payments for the portion of the carrying value transferred and (b) obtaining the residual asset at the end of the lease term, much like a loan with a balloon payment at the end. Its revenue is (a) the interest revenue from financing the portion transferred and (b) the revenue from accretion of its residual asset not transferred, both at the 10% interest rate implicit in the lease. Thus, First LeaseCorp earns a 10% rate of return on both the portion of its asset transferred and the portion retained as a residual asset. Ignoring tax effects, the lease’s effect on the earnings of the lessee and lessor are depicted in Illustration 15-31: Illustration 15–31 Earnings Effects of Lease with Residual Asset Lessee Interest Amortization Expense Expense 2013 2014 2015 2016 24,869 17,355 9,091 0* 87,171 87,171 87,171 87,171 Lessor Interest Accretion Revenue Revenue 24,869 17,355 9,091 0* 13,039 14,343 15,788 17,357 . *Recall that since the payments are at the beginning of each period, there is no interest during the last year of the lease. In keeping with the lessor recovering its investment from two sources, you should note that the total of the lessor’s interest revenue and accretion revenue each year is 10% (the interest rate) of the total of the lease receivable and residual asset balances at the beginning of that year. For instance, in 2015 the lessor’s revenue is 9,091 + 15,788 = $24,869. This is 10% of $248,686 ($157,776, the 2014 ending balance of the residual asset [Illustration 15-30] plus $90,909, the 2014 ending balance of the lease receivable [Illustration 15-29B]). When the Lessor Earns a Profit from the Lease In some situations, the lessor earns an immediate profit from the lease transaction in addition to the interest revenue earned over the term of the lease.8 Usually, the lessor in this type of agreement is a manufacturer or a merchandiser that is using the lease as a means of “selling” its product. In addition to interest revenue earned over the lease term, the lessor receives a manufacturer’s or dealer’s profit on the “sale” of the asset. This additional profit exists when the present value of the lease payments, or “selling price,” exceeds the 8 If profit on the right-of-use asset is not “reasonably assured,” the lessor would recognize that profit over the lease term. 16 SECTION 3 Financial Instruments and Liabilities cost or carrying value of the asset transferred to the lessee. Accounting for this type of lease is the same as for others except for recognizing the profit at the commencement of the lease. To illustrate, let’s modify our earlier Illustration 15-28. Assume all facts are the same except Sans Serif Publishers leased the copier directly from CompuDec Corporation, rather than through the financing intermediary. Also assume CompuDec’s cost of the copier was $300,000. If you recall that the lease payments (their present value) provide a “selling price” of $479,079, you see that CompuDec earns a gross profit of $479,079 − 300,000 = $179,079. This is demonstrated in Illustration 15–32. We don’t revisit lessee accounting here because lessee accounting is not affected by whether the lessor has a profit in the lease or not. Illustration 15–32 Lessor; Profit on Lease On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $100,000 beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDec’s interest rate for financing the transaction is 10%. $100,000 × 4.79079* = $479,079 Lease payments Present value *Present value of an annuity due of $1: n = 6, i = 10%. Commencement of the Lease (January 1, 2013) CompuDec (Lessor) Lease receivable (present value of lease payments) ....... 479,079 Inventory of equipment (lessor’s cost: carrying amount) 300,000 Profit (difference) ................................................................. 179.0799 All entries other than the entry at the commencement of the lease, which now includes the profit, are precisely the same as in Illustrations 15-28 and 15-28A on pages xxx-xxx. Accounting by the lessee is not affected by how the lessor records the lease. All lessee entries are exactly the same as in Illustrations 15-28 and 15-28A. You might recognize this process as similar to the way sales type leases are accounted for under prior GAAP. 9 Companies might choose to separate this profit into its two components: Sales revenue ($479,079) and cost of goods sold ($300,000), which is the gross method demonstrated for “sales-type” leases in the main chapter. CHAPTER 15 Leases 17 When the Lessor Earns a Profit and Retains a Residual Asset Now let’s combine our two previous illustrations to consider a circumstance in which the lessor both earns a profit and retains a residual asset. In our last illustration, we assumed that the lease payments were calculated by the lessor so that their present value would equal the fair value of the asset being leased. That is not an improbable assumption; often a manufacturer or dealer will use leasing as a primary method of “selling” its products. Suppose, though, that other factors, say competitive market conditions, influence the amount of the payments in such a way that their present value is less than the fair value of the asset. In that case, the entire asset is not transferred to the lessee; the lessor retains a portion of the asset. In this situation, the lessor should divide the carrying amount of the asset into two parts, (1) the portion transferred and thus derecognized and (2) the portion retained and thus reclassified as a residual asset. The allocation is based on the ratio of the present value of the payments to the fair value of the asset. The residual asset is reported separate from other assets in the balance sheet. Let’s assume we have a situation like the one in the previous Illustration in which a profit is indicated, but the present value of the lease payments (“selling price”) is less than the fair value of the asset being leased. Illustration 15-33 provides a demonstration by having us assume that the six annual payments are $90,000 each rather than $100,000. Illustration 15–33 Lessor; Profit on Lease; Residual Asset On January 1, 2013, Sans Serif Publishers leased printing equipment from CompuDec Corporation. The lease agreement specifies six annual payments of $90,000 beginning January 1, 2013, the commencement of the lease, and at each December 31 thereafter through 2017. The six-year lease term ending December 31, 2018 (a year after the final payment), is equal to the estimated useful life of the printing equipment. CompuDec manufactured the printing equipment at a cost of $300,000. The fair value of the equipment is $479,079. CompuDec’s interest rate for financing the transaction is 10%. $90,000 × 4.79079* = $431,117 Lease payments Present value *Present value of an annuity due of $1: n = 6, i = 10%. The fraction of the $300,000 carrying amount deemed transferred is the: PV of payments Commencement of the Lease (January 1, 2013) CompuDec (Lessor) The portion transferred is: $431,117 / FV of asset / $479,079 x $300,000 = $269,966. So, the portion retained (residual asset) is the remainder: $300,000 – 269,966 = $30,034. 18 SECTION 3 Financial Instruments and Liabilities A residual asset represents the rights to the leased asset retained by the lessor. Lease receivable (present value of lease payments) ....... Residual asset (carrying amount of portion retained) .......... Inventory of equipment (lessor’s cost: carrying amount) Profit ($431,117 – 269,966) .................................................. 431,117 30,034 300,000 161,151 All entries other than the entry at the commencement of the lease, except perhaps for the amounts involved, are the same whether we have a residual asset and/or profit. Accounting by the lessee is not affected by how the lessor records the lease. Initial Direct Costs The costs that are associated directly with originating a lease and that would not have been incurred had the lease agreement not occurred are referred to as initial direct costs. They include legal fees, commissions, evaluating the prospective lessee’s financial condition, and preparing and processing lease documents. Under the ASU, accounting for initial indirect costs is simple. Initial direct costs are added to the carrying amount of the right-of-use asset if incurred by the lessee or to the lease receivable if incurred by the lessor. Under current GAAP, the method of accounting for initial direct costs depends on the nature of the lease. Accounting differs depending on whether the lease is (1) an operating lease, (2) a direct financing lease, or (3) a sales-type lease. GAAP Change UNCERTAINTY IN LEASE TRANSACTIONS What if the Lease Term is Uncertain? Sometimes the actual term of a lease is not obvious. Suppose, for instance, that the lease term is specified as four years, but it can be renewed at the option of the lessee for two additional years. Or, maybe either party can terminate the lease after, say, three years. In such situations, we consider the lease term to be the contractual lease term adjusted for any periods covered by options to extend or terminate the lease for which there is a “significant economic incentive” to exercise the options. Factors that might create an economic incentive for the lessee to exercise an option include bargain renewal rates, penalty payments for cancellation or non-renewal and economic penalties such as significant customization or installment costs. This is similar to current GAAP’s treatment of renewal options.. You might want to ponder the possibilities if we did not have this requirement to specifically consider renewal options and the economic incentive for exercising them when we determine the lease term. Management might be tempted to structure leases with artificially short initial terms and numerous renewal options as The lease term for both the lessee and the lessor is the contractual lease term modified by any renewal or termination options for which there is a clear economic incentive to exercise the options. CHAPTER 15 Leases 19 a scheme to be able to use the short-cut method (that we discuss later) or to reduce significantly the amount of the lease liability to be reported (off-balancesheet financing). The lease term should be reassessed only when there is a significant indication that the lessee’s economic incentive to exercise any options to extend or terminate the lease has changed. What if the Lease Payments are Uncertain? Sometimes lease payments are to be increased (or decreased) at some future time during the lease term, depending on whether or not some specified event occurs. Usually the contingency is related to revenues, profitability, or usage above some designated level. For example, a recent annual report of Walmart included the note shown in Illustration 15–34. Illustration 15–34 Contingent Lease Payments—Walmart Real World Financials 13 Commitments (in part) Certain of the Company's leases provide for the payment of contingent rentals based on a percentage of sales. Such contingent rentals were immaterial for fiscal years 2011, 2010 and 2009. Why would a lease include a contingent payment provision? It is a way for lessees and lessors to share the risk associated with the asset’s productivity. For example, a shop owner who pays for a premium mall location is doing so anticipating higher revenue. If the mall attracts many shoppers, the lessee pays the lessor part of the resulting higher profits, but if not, the lessee makes only the normal minimum lease payment. This arrangement also provides the lessor incentive to attract shoppers to the mall, which is in the lessee’s best interest. If the amounts of future lease payments are uncertain due to contingencies or otherwise, we consider them as part of the lease payments only if they are “reasonably assured.” Under current GAAP, contingent payments are included only when they are considered “probable.” While there is considerable overlap, fewer contingent payments will be included in lease payments under the new guidance. If the amounts of future lease payments vary solely when an index or rate changes, the payments are estimated and included as part of the lease payments. Those payments should be reassessed using the index or rate that exists at the end of each reporting period. If future lease payments are uncertain, we consider them as part of the lease payments only if they are “reasonably assured.” GAAP Change 20 SECTION 3 Financial Instruments and Liabilities Guaranteed Residual Value The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Sometimes a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when A cash payment predicted custody of the asset reverts back to the lessor at the end of the lease term. This under a lesseenot only reduces the lessor’s risk but also provides incentive for the lessee to guaranteed residual value exercise a higher degree of care in maintaining the leased asset to preserve the is treated the same as a lease payment. residual value. The lessee promises to return not only the property but also sufficient cash to provide the lessor with a minimum combined value. If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the lease payments the lessee records as both a right-of-use asset and a lease liability. Likewise, it also adds to the amount that the lessor records as a lease receivable. Let’s return to Illustration 15-29, when both the lessee and lessor expect the residual value after the four-year lease term to be $190,911. Now assume that negotiations led to the lessee guaranteeing a $210,000 residual value. If the property’s value is less than $210,000 at the end of the lease term, the lessee will make a cash payment for the excess of the $210,000 over the actual value. The expected excess guaranteed residual value is viewed as an additional cash flow and its present value is included in the calculation of the present value of lease payments as shown in Illustration 15–35. CHAPTER 15 ILLUSTRATION 15–35 Guaranteed Residual Value Any expected excess guaranteed residual value is viewed as an additional cash flow and its present value is included in the lessor’s lease receivable. Leases 21 Present value of periodic lease payments ($100,000 × 3.48685*) Plus: Present value of estimated payment under residual value guarantee ($19,089† × .68301**) Present value of expected lease payments $348,685 13,038 $361,723 *Present value of an annuity due of $1: n = 4, i = 10%. ** Present value of $1: n = 4, i = 10%. † $210,000 guaranteed residual value minus $191,911 expected residual value Commencement of the Lease (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) Right-of-use asset ....................................................... Lease liability (present value of lease payments) ........ 361,723 361,723 First LeaseCorp (Lessor) The expected excess guaranteed residual value is viewed as an additional cash flow and its present value is included in the lessor’s lease receivable and influences the portion of the right to use the asset being transferred. The portion transferred is: $361,723 / $479,079 x $479,079 = $361,723. So, the portion retained (residual asset) is the remainder: $479,079 – 361,723 = $117,356. Lease receivable (present value of lease payments) ....... Residual asset (carrying amount of portion retained)...... Inventory of equipment (carrying amount of asset being leased) 361,723 117,356 479,079 22 SECTION 3 Financial Instruments and Liabilities GAAP Change Situations in which the lessee-guaranteed residual value exceeds the estimate of the actual residual value are rare in practice. It makes little economic sense for a lessee to agree to guarantee an amount greater than the estimated residual value, virtually ensuring an additional cash payment at the conclusion of the lease. The requirement to account for it in this way, though, serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lessee-guaranteed residual value to compensate for the reduced lease payments. Notice that this treatment of a guaranteed residual values is quite different from current GAAP. Prior to the new ASU, we included the present value of the entire guaranteed residual value, not just its excess over estimated residual value, as an additional cash flow. We also included residual values guaranteed by third parties. ADDITIONAL CONSIDERATION If a residual value is not guaranteed, is guaranteed by a third party (insurance companies sometimes assume this role), or is guaranteed by the lessee but does not differ from the estimate of the actual fair value at the end of the lease term, it does not affect the calculations by either the lessee or lessor of the present value of the lease payments. Obviously, though, even if the residual value is not guaranteed, the lessor still expects to receive it in the form of property, or cash, or both. That amount would contribute to the total amount to be recovered by the lessor and would reduce the amount needed to be recovered from the lessee through periodic lease payments. A residual value likely will affect the lessor’s calculation of periodic lease payments. For instance, whether the residual value in the illustration is guaranteed or not, its existence affected the lessor’s lease payment calculation as we discussed and demonstrated earlier: Amount to be recovered (fair value) Less: Present value of the residual value ($190,911 × .68301*) Amount to be recovered through periodic lease payments Lease payments at the beginning of each of the next six years: * Present value of $1: n = 4, i = 10%. ** Present value of an annuity due of $1: n = 4, i = 10%. The lessor subtracts the PV of the residual value to determine lease payments. $479,079 (130,394) $348,685 ÷ 3.48685** $100,000 If an additional cash payment is expected due to a lessee-guaranteed residual value, the amount to be recovered through periodic lease payments would be reduced still further. CHAPTER 15 Leases 23 Purchase Options The exercise price of a purchase option is considered to be an additional cash payment if the lessee has a "significant economic incentive" to exercise the option. A purchase option is a provision of some lease contracts that gives the lessee the option of purchasing the leased property during, or at the end of, the lease term at a specified exercise price. We consider the exercise price to be an additional cash payment, which will increase both the lessee’s lease payable and the lessor’s lease receivable, if the lessee has a "significant economic incentive" to exercise the purchase option. In that case, the right-of-use asset recognized by the lessee should be amortized over the economic life of the underlying asset, rather than over the lease term. This is similar to accounting for a “bargain purchase option” under prior GAAP. Because we defined a BPO as a purchase option we expected to be exercised, the condition of inclusion in the lease payments resembles the “significant economic incentive” condition under the new ASU. SHORT-TERM LEASES – A SHORT-CUT METHOD It’s not unusual to simplify accounting for situations in which doing so has no material effect on the results. You might recognize this as the concept of “materiality.”10 One such situation that permits a simpler application is a short-term lease. A lease that has a maximum possible lease term (including any options to renew or extend) of twelve months or less is considered a “short-term lease.” Both the lessee and the lessor have a lease-by-lease option to choose a short-cut approach to accounting for a short-term lease. The short-cut approach permits the lessee and lessor to choose not to In a short-term lease, the record the lease at its commencement. Instead, the lessee can simply record lessee and lessor can elect not to record the lease at lease payments as rent expense over the lease term, and the lessor can record its commencement and lease payments as rent revenue over the lease term. Yes, this is the approach instead simply recording used under current GAAP for operating leases. lease payments as expense and revenue. Let’s look at an example that illustrates the relatively straightforward accounting for short-term leases. To do this we modify Illustration 15–29 to assume the lease term is twelve months in Illustration 15-36. 10 Materiality is a qualitative characteristic in Concepts Statement No. 8: Conceptual Framework for Financial Reporting—Chapter 3, Qualitative Characteristics of Useful Financial Information, QC11, FASB, September, 2010. 24 Illustration 15–36 Short-Term Lease; Lessee and Lessor SECTION 3 Financial Instruments and Liabilities On January 1, 2013, Sans Serif Publishers leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment at a cost of $479,079. The lease agreement specifies four quarterly payments of $100,000 beginning January 1, 2013, the commencement of the lease, and at the first day of each of the next three quarters. The useful life of the equipment is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the equipment for $479,079. First LeaseCorp’s interest rate for financing the transaction is 10%. Commencement of the Lease (January 1, 2013) Sans Serif Publishers, Inc. (Lessee) No entry First LeaseCorp (Lessor) No entry Lease Payments (January 1, April 1, July 1, October 1, 2013) If the short-cut option is chosen, the lessee and lessor recognize lease payments as lease expense and lease revenue over the lease term. Sans Serif Publishers, Inc. (Lessee) Lease expense .............................................................. Cash ...................................................................... First LeaseCorp (Lessor) Cash ............................................................................. Lease revenue ...................................................... 100,000 100,000 100,000 100,000 Respond to the questions, brief exercises, exercises, and problems in this Addendum with the presumption that the guidance provided by the new Accounting Standards Update is being applied. QUESTIONS FOR REVIEW OF KEY TOPICS Q 15–24 Briefly describe the conceptual basis for asset and liability recognition under the right-of-use approach used by the lessee in a lease transaction. Q 15–25 Q 15–26 Why does a lessor sometimes record a residual asset in a lease transaction? What determines the amount recorded as a residual asset? A lessee’s earnings are affected by what two amounts (ignoring taxes) in a lease transaction? On the flip side, what amount or amounts affect the lessor’s earnings? What discount rate does the lessor use in determining its lease receivable? How is the rate determined? What discount rate does the lessee use in determining its right-of-use asset and lease liability? Q 15–27 Q 15–28 CHAPTER 15 Leases 25 Q 15–29 Q 15–30 When does a lessor record an immediate profit at the commencement of a lease? A six-year lease can be renewed for two additional three-year periods, and it also can be terminated after only three years. How do the lessee and lessor decide the lease term to be used in accounting for the lease? A lease might specify that lease payments may be increased (or decreased) at some future time during the lease term depending on whether or not some specified event occurs such as revenues or profits exceeding some designated level. In such situations, what is the amount a lessee should use to measure its right-of-use asset and lease liability? Occasionally, a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. Under what circumstance can the guaranteed residual value influence the amounts recorded by the lessee and lessor? In that circumstance, how are the amounts affected? What is a purchase option? How is a lease potentially affected by a purchase option? A lease that has a maximum possible lease term (including any options to renew) of twelve months or less is considered a “short-term lease.” Both the lessee and the lessor have a lease-by-lease option to choose a short-cut approach to accounting for a short-term lease. How does a lessee record a lease using the short-cut approach? How does a lessor record a lease using the short-cut approach? Q 15–31 Q 15–32 Q 15–33 Q 15–34 Q 15–35 BRIEF EXERCISES BE 15–15 Lessee; effect on earnings At the beginning of its fiscal year, Café Med leased restaurant space from Crescent Corporation under a nine-year lease agreement. The contract calls for annual lease payments of $25,000 each at the end of each year. The building was acquired recently by Crescent at a cost of $300,000 (its fair value) and was expected to have a useful life of 25 years with no residual value. The company seeks a 10% return on its lease investments. What will be the effect of the lease on Café Med’s earnings for the first year (ignore taxes)? In the situation described in BE 15-15, what will be the balances in the balance sheet accounts related to the lease at the end of the first year for Café Med (ignore taxes)? BE 15–16 Lessee; effect on balance sheet 26 SECTION 3 Financial Instruments and Liabilities BE 15–17 Lessee; accrued interest; balance sheet effects A lease agreement calls for annual lease payments of $26,269 over a six-year lease term, with the first payment at January 1, the lease’s commencement, and subsequent payments at January 1 of the following five years. The interest rate is 5%. If the lessee’s fiscal year is the calendar year, what would be the amount of the lease liability that the lessee would report in its balance sheet at the end of the first year? What would be the interest payable? In the situation described in BE 15–17, what would be the pretax amounts related to the lease that the lessee would report in its income statement for the first year ended December 31? In the situation described in BE 15-15, what will be the effect of the lease on Crescent’s earnings for the first year (ignore taxes)? In the situation described in BE 15-15, what will be the balances in the balance sheet accounts related to the lease at the end of the first year for Crescent (ignore taxes)? A lease agreement calls for quarterly lease payments of $5,376 over a 10-year lease term, with the first payment at July 1, the lease’s inception. The interest rate is 8%. Both the fair value and the cost of the asset to the lessor are $150,000. What would be the amount of interest expense the lessee would record in conjunction with the second quarterly payment at October 1? What would be the amount of interest revenue the lessor would record in conjunction with the second quarterly payment at October 1? Manning Imports is contemplating an agreement to lease equipment to a customer for five years, the asset’s estimated useful life. Manning normally sells the asset for a cash price of $100,000. Assuming that 8% is a reasonable rate of interest, what must be the amount of quarterly lease payments (beginning at the commencement of the lease) in order for Manning to recover its normal selling price as well as be compensated for financing the asset over the lease term? In the situation described in BE 15–17, assume the asset being leased cost the lessor $125,000 to produce. Determine the price at which the lessor is “selling” the right to use the asset (present value of the lease payments). What would be the pretax amounts related to the lease that the lessor would report in its income statement for the year ended December 31? In the situation described in BE 15–17, assume the asset being leased cost the lessor $125,000 to produce and its fair value is $150,000. Determine the price at which the lessor is “selling” the right to use the asset (present value of the lease payments). What would be the pretax amounts related to the lease that the lessor would report in its income statement for the year ended December 31? BE 15–18 Lessee; accrued interest; income statement effects BE 15–19 Lessor; effect on earnings BE 15–20 Lessor; effect on balance sheet BE 15–21 Calculate interest BE 15–22 Lessor; calculate lease payments BE 15–23 Lessor profit; income statement effects BE 15–24 Lessor profit; residual asset; income statement effects CHAPTER 15 BE 15–25 Lessor profit; residual asset; balance sheet effects Leases 27 In the situation described in BE 15–17, assume the asset being leased cost the lessor $125,000 to produce and its fair value is $150,000. Determine the price at which the lessor is “selling” the right to use the asset (present value of the lease payments). What will be the balances in the balance sheet accounts related to the lease at the end of the first year (ignore taxes)? Corinth Co. leased equipment to Athens Corporation for an eight-year period, at which time possession of the leased asset will revert back to Corinth. The equipment cost Corinth $16 million to manufacture and has an expected useful life of 12 years. Its normal sales price is $22.4 million. The present value of the lease payments for both the lessor and lessee is $21 million. The first payment was made at the commencement of the lease. What will be the amount Corinth will record as a residual asset at the commencement of the lease? Why? Culinary Creations leased kitchen equipment under a five-year lease with an option to renew for three years at the end of five years and an option to renew for an additional three years at the end of eight years. The first three-year renewal option can be exercised for one-half the original and usual rate. What is the length of the lease term that Culinary Creations should assume in recording the transactions related to the lease? On January 1, Garcia Supply leased a truck for a four-year period, at which time possession of the truck will revert back to the lessor. Annual lease payments are $10,000 due on December 31 of each year, calculated by the lessor using a 5% discount rate. If Garcia’s revenues exceed a specified amount during the lease term, Garcia will pay an additional $4,000 lease payment at the end of the lease. Garcia estimates a 10% probability of meeting the target revenue amount. What amount, if any, should be added to the right-of-use asset and lease liability under the contingent rent agreement? On January 1, Garcia Supply leased a truck for a four-year period, at which time possession of the truck will revert back to the lessor. Annual lease payments are $10,000 due on December 31 of each year, calculated by the lessor using a 5% discount rate. Negotiations led to Garcia guaranteeing a $36,000 residual value at the end of the lease term. Garcia estimates that the residual value after four years will be $35,000. What is the amount to be added to the right-of-use asset and lease liability under the residual value guarantee? King Cones leased ice cream-making equipment from Ace Leasing. Ace earns interest under such arrangements at a 6% annual rate. The lease term is eight months with monthly payments of $10,000 at the end of each month. Ace purchased the equipment having an estimated useful life of four years at a cost of $300,000. Both the lessee and the lessor elected the short-term lease option. Amortization is recorded at the end of each month on a straight-line basis. Ace depreciates assets monthly on a straight-line basis. What is the effect of the lease on King Cones’ earnings during the eight-month term, ignoring taxes? BE 15–26 Residual asset BE 15–27 Renewal options BE 15–28 Uncertain lease payments BE 15–29 Guaranteed residual value BE 15–30 Short-term lease; lessee 28 SECTION 3 Financial Instruments and Liabilities BE 15–31 Short-term lease; lessor In the situation described in BE 15–30, what is the effect of the lease on Ace Leasing’s earnings during the eight-month term, ignoring taxes? EXERCISES E 15–33 Lessee (Note: Exercises 15-33 through 15-41 are variations of the same basic lease situation.) Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Edison purchased the equipment from International Machines at a cost of $112,080. Related Information: Lease term Quarterly lease payments Economic life of asset Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% Required: Prepare a lease amortization schedule and appropriate entries for Manufacturers Southern from the commencement of the lease through December 31, 2013. December 31 is the fiscal year end for each company. Appropriate adjusting entries are recorded at the end of each quarter. E 15–34 Lessor Refer to the situation described in E15-33. Required: Prepare a lease amortization schedule and appropriate entries for Edison Leasing from the commencement of the lease through December 31, 2013. Edison’s fiscal year ends December 31. E 15–35 Residual asset Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Edison purchased the equipment from International Machines at a cost of $250,177. Appropriate adjusting entries are recorded at the end of each quarter. Related Information: Lease term Quarterly lease payments Economic life of asset Residual value of asset at end of lease term Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years $161,803 8% CHAPTER 15 Leases 29 Required: 1. Show how Edison determined the $15,000 quarterly lease payments. 2. Prepare appropriate entries for Edison to record the lease at its commencement, January 1, 2013, and on April 1, 2013. E 15–36 Lessor profit; calculate payments Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2013. International Machines manufactured the equipment at a cost of $80,000 and lists a cash selling price of $112,080. Related Information: Lease term Quarterly lease payments Economic life of asset Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% Required: 1. Show how International Machines determined the $15,000 quarterly lease payments. 2. Prepare appropriate entries for International Machines to record the lease at its commencement, January 1, 2013, and on March 31, 2013. E 15–37 Lessee and lessor; lessor profit Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2013. International Machines manufactured the equipment at a cost of $200,000 and lists a cash selling price of $250,177. Appropriate adjusting entries are made quarterly. Related Information: Lease term Quarterly lease payments Economic life of asset Interest rate charged by the lessor 5 years (20 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% Required: 1. Prepare appropriate entries for Manufacturers Southern to record the arrangement at its commencement, January 1, 2013, and on March 31, 2013. 2. Prepare appropriate entries for International Machines to record the arrangement at its commencement, January 1, 2013, and on March 31, 2013. E 15–38 Lessee and lessor; lessor profit; residual asset Manufacturers Southern leased high-tech electronic equipment from International Machines on January 1, 2013. International Machines manufactured the equipment at a cost of $200,000. The equipment has a fair value of $260,000. Appropriate adjusting entries are made quarterly. 30 SECTION 3 Financial Instruments and Liabilities Related Information: Lease term Quarterly lease payments Economic life of asset Residual value of asset at end of lease term Interest rate charged by the lessor 5 years (20 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years $11,228 8% Required: 1. Prepare appropriate entries for Manufacturers Southern to record the arrangement at its commencement, January 1, 2013, and on March 31, 2013. 2. Prepare appropriate entries for International Machines to record the arrangement at its commencement, January 1, 2013, and on March 31, 2013. E 15–39 Lessee; initial direct costs Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Costs of negotiating and consummating the completed lease transaction incurred by Manufacturers Southern were $2,000. Edison purchased the equipment from International Machines at a cost of $250,177. Related Information: Lease term Quarterly lease payments Economic life of asset Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through March 31, 2013. Appropriate adjusting entries are made quarterly. E 15–40 Lessee; renewal option Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Manufacturers Southern has the option to renew the lease at the end of two years for an additional three years. Manufacturers Southern is subject to a $45,000 penalty after two years if it fails to renew the lease. Edison purchased the equipment from International Machines at a cost of $250,177. Related Information: Lease term Lease renewal option for an additional 3 years Quarterly lease payments Economic life of asset Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% CHAPTER 15 Leases 31 Required: Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through March 31, 2013. Appropriate adjusting entries are made quarterly. E 15–41 Lessee and lessor; shortterm lease Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Edison purchased the equipment from International Machines at a cost of $250,177. Both the lessee and the lessor elected the shortterm lease option. Appropriate adjusting entries are made annually. Related Information: Lease term Quarterly lease payments Economic life of asset Interest rate charged by the lessor 1 year (4 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, and Sept. 30. 5 years 8% Required: 1. Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through December 31, 2013. 2. Prepare appropriate entries for Edison Leasing from the commencement of the lease through December 31, 2013. E 15–42 Lessee; effect on financial statements At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. Lakeside seeks a 10% return on its lease investments. Appropriate adjusting entries are made quarterly. Required: 1. What pretax amounts related to the lease would LTT report in its balance sheet at December 31, 2013? 2. What pretax amounts related to the lease would LTT report in its income statement for the year ended December 31, 2013? E 15–43 Lessor; effect on financial statements At the beginning of its fiscal year, Lakeside Inc. leased office space to LTT Corporation under a ten-year lease agreement. The contract calls for quarterly lease payments of $25,000 each at the end of each quarter. The office building was acquired by Lakeside at a cost of $1 million and was expected to have a useful life of 25 years with no residual value. Lakeside seeks a 10% return on its lease investments. Appropriate adjusting entries are made quarterly. Required: 1. What pretax amounts related to the lease would Lakeside report in its balance 32 SECTION 3 Financial Instruments and Liabilities sheet at December 31, 2013? 2. What pretax amounts related to the lease would Lakeside report in its income statement for the year ended December 31, 2013? E 15–44 Lessee American Food Services, Inc. leased a packaging machine from Barton and Barton Corporation. Barton and Barton completed construction of the machine on January 1, 2013. The lease agreement for the $4 million (fair value and present value of the lease payments) machine specified four equal payments at the end of each year. The useful life of the machine was expected to be four years with no residual value. Barton and Barton’s implicit interest rate was 10%. Required: 1. Prepare the journal entry for American Food Services at the commencement of the lease on January 1, 2013. 2. Prepare an amortization schedule for the four-year term of the lease. 3. Prepare the appropriate journal entry(s) on December 31, 2013. 4. Prepare the appropriate journal entry(s) on December 31, 2015. E 15–45 Lessee; balance sheet and income statement effects (Note: Exercises 15-45 through 15-47 are variations of the same lease situation.) On June 30, 2013, Papa Phil, Inc. leased 200 pizza ovens for its chain of restaurants from IC Leasing Corporation. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2013. IC calculated lease payment amounts using a 10% interest rate. IC purchased thepizza ovens from Pizza Inc. at their retail price of $3 million. Required: 1. Determine the present value of the lease payments at June 30, 2013 (to the nearest $000) that Papa Phil uses to record the right-of-use asset and lease liability. 2. What pretax amounts related to the lease would Papa Phil report in its balance sheet at December 31, 2013? 3. What pretax amounts related to the lease would Papa Phil report in its income statement for the year ended December 31, 2013? E 15–46 Lessor; balance sheet and income statement effects Refer to the situation described in E15-45. Required: 1. What pretax amounts related to the lease would IC report in its balance sheet at December 31, 2013? 2. What pretax amounts related to the lease would IC report in its income statement for the year ended December 31, 2013? On June 30, 2013, Papa Phil, Inc. leased 200 pizza ovens for its chain of restaurants from Pizza, Inc. The lease agreement calls for Papa Phil to make semiannual lease payments of $562,907 over a three-year lease term, payable each June 30 and December 31, with the first payment at June 30, 2013. Pizza, Inc. calculated lease E 15–47 Lessor; balance sheet and income statement effects; lessor profit CHAPTER 15 Leases 33 payment amounts using an interest rate of 10%. Pizza, Inc. manufactured the ovens at a cost of $2.5 million. Their fair value is $3,000,000. Required: 1. Determine the price at which Pizza, Inc. is “selling” the warehouse (present value of the lease payments) at June 30, 2013 (to the nearest $000). 2. What pretax amounts related to the lease would Pizza, Inc. report in its balance sheet at December 31, 2013? 3. What pretax amounts related to the lease would Pizza, Inc. report in its income statement for the year ended December 31, 2013? PROBLEMS P 15–23 Lessee and lessor The Antonescu Sporting Goods leased equipment from Chapman Industries on January 1, 2013. Chapman Industries had manufactured the equipment at a cost of $800,000. Its cash selling price and fair value is $1,000,000. Other information: Lease term Annual payments Life of asset Rate the lessor charges 4 years $279,556 beginning Jan.1, 2013, and at Dec. 31, 2013, 2014, and 2015 4 years 8% Required: 1. Prepare the appropriate entries for Antonescu Sporting Goods (Lessee) on January 1, 2013 and December 31, 2013. Round to nearest dollar. 2. Prepare the appropriate entries for Chapman Industries (Lessor) on January 1, 2013 and December 31, 2013. Round to nearest dollar. P 15–24 Lessor’s initial direct costs; lessor profit Terms of a lease agreement and related facts were: a. Leased asset has a retail cash selling price of $100,000. Its useful life is six years. b. Annual lease payments at the beginning of each year are $20,873, beginning January 1. The lease term is six years. c. Lessor’s interest rate when calculating annual lease payments was 9%. d. Costs of negotiating and consummating the completed lease transaction incurred by the lessor are $2,062. Required: Prepare the appropriate entries for the lessor to record the lease, the initial payment at its commencement, and at the December 31 fiscal year-end under each of the following two independent assumptions: 1. The lessor recently paid $100,000 to acquire the asset. 2. The lessor recently paid $85,000 to acquire the asset. 34 SECTION 3 Financial Instruments and Liabilities P 15–25 Lessee and lessor; renewal option; residual asset; lessor profit Rand Medical manufactures lithotripters. Lithotripsy uses shock waves instead of surgery to eliminate kidney stones. Physicians’ Leasing purchased a lithotripter for $3,000,000 and leased it to Mid-South Urologists Group on January 1, 2013. Both companies record appropriate adjusting entries quarterly. Lease Description: Quarterly lease payments Lease term Economic life of lithotripter Implicit interest rate Fair value of asset $130,516—beginning of each period 5 years (20 quarters), renewable for another 5 years 10 years 12% $3,000,000 Required: The following two situations are independent of each other. 1. Mid-South Urologists Group considers it unlikely that the lease will be renewed. Prepare appropriate entries for Mid-South Urologists Group and Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2013. 2. Because of extensive and costly leasehold improvements related to making the lithotripter available to patients, Mid-South Urologists Group feels it will have significant economic incentive to renew the lease. Prepare appropriate entries for Mid-South Urologists Group and Physicians’ Leasing from the commencement of the lease through the second lease payment on April 1, 2013. P 15–26 Change in lease term; lessor Universal Leasing leases electronic equipment to a variety of businesses. The company’s primary service is providing alternate financing by acquiring equipment and leasing it to customers under long-term leases. Universal earns interest under these arrangements at a 10% annual rate. The company leased an electronic typesetting machine it purchased on December 31, 2012 for $90,000 to a local publisher, Desktop Inc. The six-year lease term commenced January 1, 2013, and the lease contract specified annual payments of $8,000 beginning December 31, 2013 and each December 31 through 2018. The machine’s estimated useful life is 15 years with no estimated residual value. The publisher had the option to terminate the lease after four years. At the commencement of the lease, there was no reason to believe the lease would be terminated. Required: 1. Prepare the appropriate entries for Universal Leasing from the commencement of the lease through the end of 2013. 2. At the beginning of 2014, there was a significant indication that Desktop’s economic incentive to terminate the lease had changed causing both companies to believe the lease will terminate at the end of four years (three years CHAPTER 15 Leases 35 remaining). Prepare the appropriate entries for Universal Leasing at January 1, 2014, to reflect the change in the lease term. 3. Prepare the appropriate entries pertaining to the lease for Universal Leasing at December 31, 2014. 4. Determine the balances in the following accounts pertaining to the lease at December 31, 2013: Lease receivable, residual asset, and asset for lease. 5. Determine the amounts reported in earnings pertaining to the lease during 2013 and during 2014 (ignore taxes). P 15–27 Lessee; renewal option Manufacturers Southern leased high-tech electronic equipment from Edison Leasing on January 1, 2013. Manufacturers Southern has the option to renew the lease at the end of two years for an additional three years for $8,000 per quarter. Edison purchased the equipment from International Machines at a cost of $198,375. Related Information: Lease term Lease renewal option for an additional 3 years at $8,000 per quarter Quarterly lease payments Economic life of asset Interest rate charged by the lessor 2 years (8 quarterly periods) $15,000 at Jan. 1, 2013, and at Mar. 31, June 30, Sept. 30, and Dec. 31 thereafter. 5 years 8% Required: 1. Prepare appropriate entries for Manufacturers Southern from the commencement of the lease through March 31, 2013. Appropriate adjusting entries are made quarterly. 2. Prepare an amortization schedule for the term of the lease. P 15–28 Lessee and lessor; lessee guaranteed residual value On January 1, 2013, Allied Industries leased a high-performance conveyer to Karrier Company for a four-year period ending December 31, 2016, at which time possession of the leased asset will revert back to Allied. The equipment cost Allied $966,000 and has an expected useful life of six years. Allied expects the residual value at December 31, 2016, will be $300,000. Negotiations led to the lessee guaranteeing a $340,000 residual value. Equal payments under the lease are $200,000 and are due on December 31 of each year with the first payment being made on December 31, 2013. Karrier is aware that Allied used a 5% interest rate when calculating lease payments. Required: 1. Show the appropriate entries for both Karrier and Allied on January 1, 2013, to record the lease. 2. Show all appropriate entries for both Karrier and Allied on December 31, 2013, related to the lease and the leased asset.

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