Basics of LeasingBasics of Leasing

1 Slide 21-1 Bob AndersonBob Anderson--UCSBUCSBA ccounting for LeasesAccounting for LeasesAccounting for LeasesChapter 21 Chapter Chapter 2121 Slide 21-2 Bob AndersonBob Anderson--UCSBUCSBA lease is a contractual agreement between a lessor and a lesseethat gives the lessee the right to use specific property, owned by the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payments (rents)..A lease lease is a contractual agreement between a lessorlessorand a lesseelesseethat gives the lessee the right to use specific property, owned by the lessor, for a specified period of time in return for stipulated, and generally periodic, cash payments (rents).. Basics of LeasingBasics of LeasingBasics of LeasingLease termLease termLease ContractRental paymentsRental paymentsExecutory CostsExecutory CostsRestrictionsRestrictionsNoncancelab leNoncancelableEarly terminationEarly terminationDefaultDefaultSlide 21-3 Bob AndersonBob Anderson--UCSBUCSBA dvantages of LeasingAdvantages of LeasingAdvantages of Leasing100% Financing at Fixed Rates100% Financing at Fixed RatesProtection against ObsolescenceProtection against ObsolescenceFlexibilityFlexibilityLess Costly FinancingLess Costly FinancingAlternative Minimum Tax ProblemsAlternative Minimum Tax ProblemsOffOff--Balance SheetBalance Sheet--FinancingFinancingSlide 21-4 Bob AndersonBob Anderson--UCSBUCSBA ccounting by LesseeAccounting by LesseeAccounting by LesseeOperating LeaseOperating LeaseCapital LeaseJournal Entry: Journal Entry.

2 Rent expenseRent expensexxxxxxCashCashxxxxxxJournal Entry: Journal Entry: Leased equipment xxxLeased equipment xxxLease obligation xxxLease obligation xxxThe issue of how to report leases is the case of substance versuThe issue of how to report leases is the case of substance versus s form. Although technically legal title does not pass in lease form. Although technically legal title does not pass in lease transactions, the benefits from the use of the property , the benefits from the use of the property of Financial Accounting Standard No. 13, Statement of Financial Accounting Standard No. 13, Accounting for Leases,Accounting for Leases, 19801980A lease that transfers substantially all of the benefits and risA lease that transfers substantially all of the benefits and risks of ks of property ownership should be capitalized (only property ownership should be capitalized (only noncancellablenoncancellableleases may be capitalized).)

3 Leases may be capitalized).Slide 21-5 Bob AndersonBob Anderson--UCSBUCSBM echanicsMechanicsMechanicsThe expense recorded on a capital lease and an operating lease are THE SAME over the life of the asset. In a capital lease it hits the P&L via interest expense and depreciation expense VS operating, it all goes into rent a capital lease , think of it as a sale. The commitment to the lessor is a debt and should be treated like any other debt (current vs. noncurrent, accrue interest etc.) The asset gets depreciated just like if it were expense recorded on a capital lease and an operating lease are THE SAME over the life of the asset. In a capital lease it hits the P&L via interest expense and depreciation expense VS operating, it all goes into rent a capital lease , think of it as a sale. The commitment to the lessor is a debt and should be treated like any other debt (current vs.

4 Noncurrent, accrue interest etc.) The asset gets depreciated just like if it were 21-6 Bob AndersonBob Anderson--UCSBUCSBC ompare capital vs. operating leaseCompare capital vs. operating leaseCompare capital vs. operating leaseFACTSL ease a computer worth3,000 lease term3 yrsAnnual payment1,143 Estimated life of a computer4 yrsEffective borrowing rate7%PRESENT VALUE OF PAYMENTS$3,000 ANNUAL DEPRECIATION$750 CAPITAL LEASEE quipment3,000 Cap lease obligation3,000 Cash1,143 1,143 1,143 Interest expense210 145 75 0 Capital lease obligation933 998 1,068 (0) Depreciation expense750 750 750 750 Accumulated depreciation750 750 750 750 OPERATING LEASERent expenseNO OPENING ENTRY!

5 1,143 1,143 1,143 Cash1,143 1,143 1,143 COMPARE EXPENSE OF THE TWO:CAPITAL LEASEOPERATING lease Interest expense429 Rent expense3,429 Depreciation expense3,000 3,429 DIFFERENCE BETWEEN THE TWO OVERALL:NONE!!!!OPENINGYEAR ONEYEAR TWOYEAR THREEYEAR FOURS lide 21-7 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesLeases that DO NOT meet any Leases that DO NOT meet any of the four criteria are of the four criteria are accounted for as Operating accounted for as Operating LeasesLeasesSlide 21-8 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferTransferofofOwnershipOwnershipBa rgain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesThe lease transfers ownership The lease transfers ownership of the property to the of

6 The property to the 21-9 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferTransferofofOwnershipOwnershipBa rgain Bargain PurchasePurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesSlide 21-10 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesLease term can be extended by lease term can be extended by a a bargain renewal optionbargain renewal 21-11 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesThree important concepts:Three important concepts: Minimum lease paymentsMinimum lease payments ExecutoryExecutorycostscosts Discount rateDiscount rateSlide 21-12 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesMinimum lease payments:Minimum lease payments.

7 Guaranteed residual valueGuaranteed residual value Penalty for failure to renewPenalty for failure to renew Bargain purchase optionBargain purchase optionSlide 21-13 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesExecutoryExecutoryCost s:Costs: InsuranceInsurance MaintenanceMaintenance TaxesTaxesSlide 21-14 Bob AndersonBob Anderson--UCSBUCSBC apitalization Criteria Capitalization Criteria Capitalization Criteria TransferofOwnershipBargain PurchaseLease Term>= 75%PV of Payments>= 90%OperatingLeaseNoNoNoNoNoNoNoNoYesCapi tal LeaseLease AgreementYesYesYesDiscount Rate:Discount Rate:Lessee computes the PV of the minimum lease payments using the lessee s incremental borrowing rate.

8 (one (one exception)exception)Slide 21-15 Bob AndersonBob Anderson--UCSBUCSBREAL WORLDREAL WORLDREAL WORLDThe Leasing companies are hip to these criteria and go out with a lease that they believe satisfies the requirements. They usually run really tight ( PV of payments is of the fair value of the asset).Just because the Leasing company says it works as an operating lease , doesn t make it so!!The Leasing companies are hip to these criteria and go out with a lease that they believe satisfies the requirements. They usually run really tight ( PV of payments is of the fair value of the asset).Just because the Leasing company says it works as an operating lease , doesn t make it so!!Slide 21-16 Bob AndersonBob Anderson--UCSBUCSBTEXT example from example from example from and Lessee sign a lease agreement dated January 1, 2005 which requires Lessor to lease equipment to lessee beginning January 1, 2005.

9 Terms are: 5 year, noncancelable lease term, equal annual payments at beginning of year of $25, Fair value of equipment is $100,000 at inception and has 5 yr. Life and no residual value Lessee pays all executory costs directly, except property tax which is $2,000 per year and part of the annual payment of $25, No renewal options and equipment reverts to Lessor at termination Lessee borrowing rate is 11%, Lessorimplicit rate is 10% and known to Lessor Lessee depreciates on a straight line the journal entries on the books of the Lessee that relate to the lease agreement through December 31, 2009. Slide 21-17 Bob AndersonBob Anderson--UCSBUCSBp. 1097 SOLUTIONp. 1097 SOLUTIONp. 1097 SOLUTIONP ayment25, OPENING ENTRY:Property tax(2, ) Equipment100,000 lease portion23, Capital lease obligation100,000 Rate10% *1/1/05 ENTRY:Period5 lease liability23,982 PV100,000 Property tax expense2,000 Life of asset5 Cash25,982 - * smaller of lessee borrowing rate or lessor implicit rate12/31/05 ENTRY:Interest expense7,602 IS THIS A CAPITAL lease ?

10 YES- 100% OF LIFE IS>75% AND Pv of Payments>90%Depreciation expense20,000 accum dep20,000 lease AMORTIZATION SCHEDULEA ccrued interest7,602 LEASELEASE- lease PMTINTERESTREDUXLIABILITY1/1/06 PAYMNT:1/1/05- OPENING100, Property tax expense2,000 1/1/05 PAYMENT23, - 23, 76, lease liability16,380 1/1/06 PAYMENT23, 7, 16, 59, Interest payable7,602 1/1/07 PAYMENT23, 5, 18, 41, Cash25,982 1/1/08 PAYMENT23, 4, 19, 21, - 1/1/09 PAYMENT23, 2, 21, - 21-18 Bob AndersonBob Anderson--UCSBUCSBRESIDUAL VALUE- LESSEERESIDUAL VALUERESIDUAL VALUE--LESSEELESSEEA ccounting depends on whether the residual is guaranteed or not: Not Guaranteed: As if it did not exist Guaranteed.