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Chapter 20

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Department
Business
Course
BU397
Professor
Allan Foerster
Semester
Fall

Description
Leases Basics - A lease is an agreement whereby the lessor conveys to the lessee, in return for a payment or a series of payments, the right to use an asset for an agreed period of time - A finance lease is a lease that transfers substantially all the risk and rewards incidental to ownership of an asset o Title may not eventually be transferred - Operating leases are any leases other than finance leases - Perceived ads to leasing o For 100 percent financing at a fixed rate  No down payment required  Rate charged is fixed for the term of the lease o Protection form obsolescence  Residual value lays with the lessor  Property can be upgraded o Flexibility  Lease may be structured to meet different needs o Less costly financing for the lessee  Tax incentives for the lessor o Off-balance sheet financing  Some leases do not add debt on the balance sheet or affect financial ratios Conceptual Nature of Lease - 3 approaches to accounting for leases - 1: Do not capitalize any leased assets- Executory Contract Approach o Since the lessee doesn’t own the property capitalization is considered inappropriate o Since executor contracts aren’t capitalized, leases shouldn’t be either - 2: Capitalize all long-term leases- A Contract Based Approach o The long-term right to use of property justifies its capitalization o The contractual obligation is to make lease payments - 3: Capitalize leases that are similar to installment purchases- A Classification Approach o Transaction should be classified and accounted for according to their economic substance o Because installment purchases are capitalized as PPE, leases that have similar characteristics to installment purchases should be treated the same o Transactions not recognized as in-substance acquisitions of assets are classified as operating leases and accounted for differently Current Accounting Standards - A lease that transfers substantially all the benefits and risks of property ownership should be capitalized o Capital/financing lease - Characteristics indicating transfer of substantially all risks and benefits of ownership must be identified - Same characteristics should apply to the lessee and lessor o If its an asset on the lessee’s books should come off the lessors books as an asset - Leases that do not transfer substantially all benefits and risks of ownership should not be capitalized o Operating lease to Net Income - Finance Lease o Where the benefits and risks of ownership have effectively been transferred to the lessee o Accounted for as a purchase by the lessee o JE’s  Lessee  DR Leased Equipment  CR Lease Obligation  DR Depreciation Expense  CR Accumulated Depreciation  DR Lease obligation  DR Interest Expense  CR Cash  Lessor  DR Lease Receivable (net)  CR Equipment  DR Cash  CR Interest Income  CR Lease Receivable - Operating Lease o Where the rights and risks of ownership have not been transferred o Rental-only has occurred o JE’s  Lessee  DR Rent Expense  CR Cash  Lessor  DR Cash  CR Rental Income Lease Accounting- Lessor - The criteria for classification is the same between the lessor and the lessee - The lessor records the net investment in the lease at inception o Net investment = gross investment  Lease payments plus initial direct costs – residual value  Discounted at rate implicit in the lease o Rate implicit in the lease is the discount rate that equates the PV of the MLP and the residual value to the sum of the FV of the asset and the initial direct costs of the lessor Finance vs. Operating Lease - When the risks and benefits of ownership are transferred from the lessor to the lessee it’s a finance lease - Benefits o Ability to use the assets to generate profits over its useful life o Benefit from any appreciation in the assets value o Realize its residual value at the end of its economic life - Risks o Exposure to uncertain returns o Risk of loss from use or idle capacity and from technological obsolescence - Finance Lease o If any of these are met, it’s a finance lease, if none are its operating: o There is a transfer of ownership at the end of the term or a bargain purchase option it’s a finance lease  Bargain purchase option is a provision that allows the lessee to purchase the leased asset for a price that is significantly lower than the assets expected FV when the lessee can exercise the option  At the beginning of the lease, the difference between the option price and the expected FV in the future must be large enough to make it reasonably sure that the option will be exercised o The lease term a major part of the assets economic life  Is the term long enough that the lessee will receive substantially all of economic benefits  For PE the lease term is 75% or more of the leased property’s economic life  Lease term is considered the fixed, non-cancellable term of the lease  Can be extended through a bargain renewal option o Allows the lessee to renew the lease for a rental amount that is lower than the expected fair rental at the date when the option becomes exercisable o The PV of MLP is substantially all of the assets FV o The lease allows the lessor to recover substantially all of its investment in the leased property and to earn a return on investment  For PE the PV of the MLP is equal to 90% or more of the fair value of the leased asset o The leased assets are so specialized that without major modification they are of use to only the lessee Minimum Lease pa
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