Leases

OPERATING LEASE

Lessee JE:
Rent Expense 8,000
Rent payable 8,000

Note: Uneven rental payments are expensed evenly over lease term
Ex: Payments of $10K due for 10 years, first 2 years free
*Yearly expense is ($80K/10 yrs) = $8K/year rent expense

Lessor JE:
Rent receivable 8,000
Rent Revenue 8,000

“Non-Returnable Deposit” or “Initial direct cost” paid by Lessee or Lessor

• AMORTIZE to rent expense over lease term

Leasehold Improvement
• Capitalized and AMORTIZED over useful life to lessee

Returnable Deposit
• Do NOT amortize, treat as asset because ownership will revert @ end of lease

CAPITAL LEASES
Lessee Side:
• If, in substance, if “purchasing an asset”. Must meet ONE OF FOUR CRITERIA
1. Transfer of ownership (during or subsequent to the lease term)
2. Bargain purchase option (during or after lease)
3. Term of lease >= 75% of remaining useful life of asset
4. PV of lease payments >= 90% of FMV of the asset

Signing the lease

Lease Property 37,900 [PVA factor(10%,5yrs) * 10K Min annual
lease pmt]
Lease Liability 37,900

12/31/x1
Interest expense 3,790 [CV lease liability * 10% interest rate]
Lease Liability 6,210 [PLUG]
Cash 10,000 [annual lease payment]

12/31/x2
Interest expense 3,169 [31,690 CV lease liab * 10%]
Lease Liability 6,831 [PLUG]
Cash 10,000 [annual payment]
Annual Executory Costs
• Expense as incurred (e.g. “annual maitenence”)

12/31/x1 Depreciation Entry

Rule: If transfer of ownership or bargain purchase option is met à Depreciate over useful life
• If only the 75% or 90% test is met à Depreciate over the lease term
Depreciation Expense 4,737 [$37,900 / 8 years SL]
A.D. 4,737

Interest Rate Rules:

• Use lessor’s implicit rate if it is both…
• Lower than lesee’s incremental rate
• Known to lessee

Bargain Purchase Option- capitalize!!!

• Assume that lessee will take advantage of this option, so must discount this CF too &
CAPITALIZE
• Discount at PV$1 over # years in lease term

If FMV (cash price) of lease is given and less than PV of lease payments…
• Must record lease at cash price, not discounted PV

Lessor Side:
• To be considered a sale: Must meet all of the following….
• Must meet ALL 4 CRITERIA for a capital lease
• Collectability of MLP’s must be reasonable assured
• There are no material uncertainties regarding any future costs

Gross Investment in Lessee = MLP’s (undiscounted) + unguaranteed residual value

Net Investment in Lessee = PV of MLP’s – Principal pmts made by lessee over lease term

Sales Type Lease

Gross Lease Receivable 50K [10K annual pmt * 5 years]
Sales 37,900 [discounted PV of payments or cash
selling price]
Unearned interest income 12,100 [PLUG]

COGS 30K [PV of MLP – cost – PV unguaranteed

residual]
Asset (inventory) 30K [cost]

Profit on Sale = (Sales – COGS) = 7,900

• Profit = (PV of MLP’s) – (BV of equipment sold)
• List price is irrelevant
• Only use “normal sales price” as FMV if the PV of MLP’s are not attainable/determinable

Interest Income = (Net receivable * interest rate) = (50K – 12,100)*10% = 3,790

Discount 3,790 [amortization of discount to interest income]
Interest Income 3,790

Direct Financing Type Lease

• No gain/loss from sale of the asset
• All profit comes from financing by amortizing the discount to interest income over the lease
term
• (FMV of equipment) / (PVA) = annual payment

Gross Lease Receivable 50K [10K annual pmt * 5 years]

Asset 37,900 [cost]
Discount 12,100 [PLUG]

Interest Income = Use net receivable * interest rate

Discount 3,790 [amortization of discount to interest income]
Interest Income 3,790

Sale-Leaseback Transaction
• Company sells the asset to buyer, and subsequently leases the same asset back from the buyer
• Can be operating (amortize in proportion to rental expense) or capital (amortize in proportion
to leased asset)

Sale
Cash 100K [sell price]
Asset 80K [cost]
Deferred Gain 20K [PLUG]

• Must defer gain if seller retains “substantial economic interest in property sold”
• Lease term is LARGE percentage of useful life (arguably 60%+)
• PV of MLP’s is > 90%
• Amortize against rent expense if operating lease, against depreciation if capital lease
• If criteria to defer are not met, recognize all of the gain in current year I/S

Deferring the Gain if maintaining (more than a minor interest, 10%, but < a major, 90% interest)
• Defer the gain up to the PV of the lease payments

Deferred Gain Classification

• Capital = Asset valuation allowance
• Operating = Deferred credit in liabilities section of B/S

Cash 600K
Airplane 100K [cost]
Deferred Gain 190K [PV of operating lease payments]
Gain 310K [500K gain – 190K deferred gain]

Deferred Losses
 • If sales price for leaseback transaction is < Carrying Value, a loss is deferred & amortized
over lease term
• In essence à Amortized as prepaid rent
Disclosure by Lessee – Capital Lease
• Disclose MLP for 5 succeeding years, and the total aggregate MLP payable over the term of
the lease

Guaranteed Residual Value by Lessee

• Include in MLP @ discounted PV