DIRECT-FINANCING TERMS

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1 CHAPTER 21 ALTERNATIVE LESSOR ACCOUNTING GROSS PRESENTATION This alternate discussion describes the accounting by lessors, using a gross presentation. These pages can be substituted for the discussion beginning on page 1307 and continuing to the middle of page 1319 in Intermediate Accounting, 14th Edition. Selected alternative exercises and problems are provided at the end of the following discussion. Direct-Financing Method (Lessor) Direct-financing leases are in substance the financing of an asset purchase by the lessee. In this type of lease, the lessor records a lease receivable instead of a leased asset. The information necessary to record a direct financing lease is as follows. 5 LEARNING OBJECTIVE Describe the lessor s accounting for direct-financing leases. DIRECT-FINANCING TERMS 1 GROSS INVESTMENT ( LEASE PAYMENTS RECEIVABLE ). The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term. 2 UNEARNED INTEREST REVENUE. The difference between the gross investment (the receivable) and the fair value of the property NET INVESTMENT. The gross investment (the receivable) less the unearned interest revenue included therein. When lease payments receivable is defined as minimum lease payments plus unguaranteed residual value, it means that residual value, both guaranteed (because it is included as part of minimum lease payments ) and unguaranteed (because it is added back in to compute the gross investment), is included as part of lease payments receivable if it is relevant to the lessor (that is, if the lessor expects to get the asset back). In addition, if the lessor pays any executory costs, then the rental payment should be reduced by that amount for purposes of computing minimum lease payments. In other words, lease payments receivable includes: 1. Rental payments (less executory costs paid by the lessor). 2. Bargain-purchase option (if any). 3. Guaranteed or unguaranteed residual value (if any). 4. Penalty for failure to renew (if any). At inception, the lessor records unearned interest revenue. The unearned interest revenue is amortized to revenue over the lease term by applying the effective-interest method. Thus, a constant rate of return is produced on the net investment in the lease. 12 In a direct-financing lease, the cost or carrying amount of the asset should be used instead of fair value. In most cases, however, cost or carrying amount is equal to fair value, so fair value is used here. The use of fair value will simplify subsequent discussion in this area. Significant differences between cost or carrying amount and fair value exist for sales-type leases. 1

2 2 Chapter 21 Alternative Lessor Accounting Gross Presentation The following presentation, using the data from the preceding Caterpillar/Sterling example on pages , illustrates the accounting treatment for a direct-financing lease. We repeat here the information relevant to Caterpillar in accounting for this lease transaction. 1. The term of the lease is five years beginning January 1, 2012, noncancelable, and requires equal rental payments of $25, at the beginning of each year. Payments include $2,000 of executory costs (property taxes). 2. The equipment (front-end loader) has a cost of $100,000 to Caterpillar, a fair value at the inception of the lease of $100,000, an estimated economic life of five years, and no residual value. 3. Caterpillar incurred no initial direct costs in negotiating and closing the lease transaction. 4. The lease contains no renewal options. The equipment reverts to Caterpillar at the termination of the lease. 5. Collectibility is reasonably assured and Caterpillar incurs no additional costs (with the exception of the property taxes being collected from Sterling). 6. Caterpillar sets the annual lease payments to ensure a rate of return of 10 percent (implicit rate) on its investment as shown in Illustration ILLUSTRATION Computation of Lease Payments Fair value of leased equipment $100, Less: Present value of residual value 0 Amount to be recovered by lessor through lease payments $100, Five beginning-of-the-year lease payments to yield a 10% return ($100, a ) $ 23, a PV of an annuity due of 1 for 5 years at 10% (Table 6-5). The lease meets the criteria for classification as a direct-financing lease for several reasons: (1) The lease term exceeds 75 percent of the equipment s estimated economic life. (2) The present value of the minimum lease payments exceeds 90 percent of the equipment s fair value. (3) Collectibility of the payments is reasonably assured. And (4) Caterpillar incurs no further costs. It is not a sales-type lease because there is no difference between the fair value ($100,000) of the loader and Caterpillar s cost ($100,000). The lease payments receivable (gross investment) and the unearned interest revenue (computed as the difference between the lease payments receivable and the lessor s fair value of the leased asset) are shown in Illustration ILLUSTRATION Computation of Lease Payments Receivable and the Unearned Interest Revenue Lease payments receivable 5 Minimum lease payments minus executory costs paid by lessor plus unguaranteed residual value 5 [($25, $2,000) 3 5] 1 $0 5 $119, Unearned interest revenue 5 Lease payments receivable minus asset s fair value 5 $119, $100,000 5 $19, The net investment in direct-financing leases is $100,000; that is, the gross investment of $119, minus the unearned interest revenue of $19, The lease of the asset, the resulting receivable, and the unearned interest revenue are recorded January 1, 2012 (the inception of the lease), as follows. Lease Payments Receivable 119, Equipment 100, Unearned Interest Revenue Leases 19, The leased equipment with a cost of $100,000, which represents Caterpillar investment, is replaced with a net lease receivable. In a manner similar to the lease treatment

3 Accounting by the Lessor 3 of interest, Caterpillar applies the effective-interest method and recognizes interest revenue as a function of the unrecovered net investment, as shown in Illustration CATERPILLAR FINANCIAL LEASE AMORTIZATION SCHEDULE (ANNUITY DUE BASIS) Annual Interest Net Lease Executory (10%) on Net Investment Net Date Payment Costs Investment Recovery Investment (a) (b) (c) (d) (e) 1/1/12 $100, /1/12 $ 25, $ 2, $ 0 $ 23, , /1/13 25, , , , , /1/14 25, , , , , /1/15 25, , , , , /1/16 25, , ,180.32* 21, $129, $10, $19, $100, ILLUSTRATION Lease Amortization Schedule for Lessor Annuity Due Basis (a) Annual rental that provides a 10% return on net investment. (b) Executory costs included in rental payment. (c) Ten percent of the preceding balance of (e), except for 1/1/15. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. On January 1, 2012, the journal entry to record receipt of the first year s lease payment is as follows. Cash 25, Lease Payments Receivable 23, Property Tax Expense/Property Taxes Payable 2, On 12/31/12, the interest revenue earned during the first year is recognized through the following entry: Unearned Interest Revenue Leases 7, Interest Revenue Leases 7, At December 31, 2012, the net investment under capital leases is reported in the lessor s balance sheet among current assets or noncurrent assets, or both. The portion due within one year or the operating cycle, whichever is longer, is classified as a current asset and the rest with noncurrent assets. The total net investment at 12/31/12 is equal to $83, (the balance at 1/1/12, $76, plus interest receivable for 2012 of $7,601.84). The current portion is the net investment to be received in 2012, $16,379.78, plus the interest of $7, The remainder, $59, (Lease Payments Receivable of $71, [$23, ] minus Unearned Interest Revenue of $12, [$5, $4, $2,180.32]) should be reported in the noncurrent assets section. The unearned interest revenue is classified on the balance sheet as a deduction from the lease payments receivable if the receivable is reported gross. Generally, the lease payments receivable, although recorded at the gross investment amount, is reported in the balance sheet at the net investment amount (gross investment less unearned interest revenue) and entitled Net investment in capital leases. It is classified either as current or noncurrent, depending on when the net investment is to be recovered. The asset sections as it relates to lease transactions at 12/31/12 would appear as follows for Caterpillar. Current assets Net investment in capital leases $23, Noncurrent assets (investments) Net investment in capital leases $59, ILLUSTRATION Reporting Lease Transactions by Caterpillar

4 4 Chapter 21 Alternative Lessor Accounting Gross Presentation The following entries record receipt of the second year s lease payment and recognition of the interest earned. January 1, 2013 Cash 25, Lease Payments Receivable 23, Property Tax Expense/Property Taxes Payable 2, December 31, 2013 Unearned Interest Revenue Leases 5, Interest Revenue Leases 5, Journal entries through 2016 would follow the same pattern except that no entry would be recorded in 2016 (the last year) for earned interest. Because the receivable is fully collected by 1/1/16, no balance (investment) is outstanding during 2016 to which Caterpillar could attribute any interest. Upon expiration of the lease (whether an ordinary annuity or an annuity due), the gross receivable and the unearned interest revenue would be fully written off. Caterpillar recorded no depreciation. If Sterling buys the loader for $5,000 upon expiration of the lease, Caterpillar would recognize disposition of the equipment as follows. Cash 5,000 Gain on Sale of Leased Equipment 5,000 Operating Method (Lessor) Under the operating method, the lessor records each rental receipt as rental revenue. It depreciates the leased asset in the normal manner, with the depreciation expense of the period matched against the rental revenue. The amount of revenue recognized in each accounting period is a level amount (straight-line basis) regardless of the lease provisions, unless another systematic and rational basis better represents the time pattern in which the lessor derives benefit from the leased asset. In addition to the depreciation charge, the lessor expenses maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period. The lessor amortizes over the life of the lease any costs paid to independent third parties, such as appraisal fees, finder s fees, and costs of credit checks, usually on a straight-line basis. To illustrate the operating method, assume that the direct-financing lease illustrated in the previous section does not qualify as a capital lease. Therefore, Caterpillar accounts for it as an operating lease. It records the cash rental receipt, assuming the $2,000 was for property tax expense, as follows. Cash 25, Rental Revenue 25, Caterpillar records depreciation as follows (assuming a straight-line method, a cost basis of $100,000, and a five-year life). Depreciation Expense Leased Equipment 20,000 Accumulated Depreciation Leased Equipment 20,000 If Caterpillar pays property taxes, insurance, maintenance, and other operating costs during the year, it records them as expenses chargeable against the gross rental revenues. If Caterpillar owns plant assets that it uses in addition to those leased to others, the company separately classifies the leased equipment and accompanying accumulated depreciation as Equipment Leased to Others or Investment in Leased Property. If significant in amount or in terms of activity, Caterpillar separates the rental revenues and accompanying expenses in the income statement from sales revenue and cost of goods sold.

5 Special Accounting Problems 5 SPECIAL ACCOUNTING PROBLEMS The features of lease arrangements that cause unique accounting problems are: 1. Residual values. 2. Sales-type leases (lessor). 3. Bargain-purchase options. 4. Initial direct costs. 5. Current versus noncurrent classification. 6. Disclosure. 6 LEARNING OBJECTIVE Identify special features of lease arrangements that cause unique accounting problems. We discuss each of these features on the following pages. Residual Values Up to this point, in order to develop the basic accounting issues related to lessee and lessor accounting, we have generally ignored residual values. Accounting for residual values is complex and will probably provide you with the greatest challenge in understanding lease accounting. Meaning of Residual Value The residual value is the estimated fair value of the leased asset at the end of the lease term. Frequently, a significant residual value exists at the end of the lease term, especially when the economic life of the leased asset exceeds the lease term. If title does not pass automatically to the lessee (criterion 1) and a bargain-purchase option does not exist (criterion 2), the lessee returns physical custody of the asset to the lessor at the end of the lease term. 13 Guaranteed versus Unguaranteed The residual value may be unguaranteed or guaranteed by the lessee. Sometimes the lessee agrees to make up any deficiency below a stated amount that the lessor realizes in residual value at the end of the lease term. In such a case, that stated amount is the guaranteed residual value. The parties to a lease use guaranteed residual value in lease arrangements for two reasons. The first is a business reason: It protects the lessor against any loss in estimated residual value, thereby ensuring the lessor of the desired rate of return on investment. The second reason is an accounting benefit that you will learn from the discussion at the end of this chapter. Lease Payments A guaranteed residual value by definition has more assurance of realization than does an unguaranteed residual value. As a result, the lessor may adjust lease payments because of the increased certainty of recovery. After the lessor establishes this rate, it makes no difference from an accounting point of view whether the residual value is guaranteed or unguaranteed. The net investment that the lessor records (once the rate is set) will be the same. Assume the same data as in the Caterpillar/Sterling illustrations except that Caterpillar estimates a residual value of $5,000 at the end of the five-year lease term. In addition, 13 When the lease term and the economic life are not the same, the residual value and the salvage value of the asset will probably differ. For simplicity, we will assume that residual value and salvage value are the same, even when the economic life and lease term vary.

6 6 Chapter 21 Alternative Lessor Accounting Gross Presentation Caterpillar assumes a 10 percent return on investment (ROI), 14 whether the residual value is guaranteed or unguaranteed. Caterpillar would compute the amount of the lease payments as follows. ILLUSTRATION Lessor s Computation of Lease Payments CATERPILLAR S COMPUTATION OF LEASE PAYMENTS (10% ROI) GUARANTEED OR UNGUARANTEED RESIDUAL VALUE ANNUITY-DUE BASIS, INCLUDING RESIDUAL VALUE Fair value of leased asset to lessor $100, Less: Present value of residual value ($5, , Table 6-2) 3, Amount to be recovered by lessor through lease payments $ 96, Five periodic lease payments ($96, , Table 6-5) $ 23, Contrast the foregoing lease payment amount to the lease payments of $23, as computed in Illustration 21-9 (on page 1305), where no residual value existed. In the second example, the payments are less, because the present value of the residual value reduces Caterpillar s total recoverable amount from $100,000 to $96, Lessee Accounting for Residual Value Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. We saw the economic consequence lower lease payments in the preceding example. The accounting consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but excludes the unguaranteed residual value. Guaranteed Residual Value (Lessee Accounting). A guaranteed residual value LEARNING OBJECTIVE 7 affects the lessee s computation of minimum lease payments. Therefore it also Describe the effect of residual values, affects the amounts capitalized as a leased asset and a lease obligation. In effect, guaranteed and unguaranteed, on lease accounting. the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. Using the rental payments as computed by the lessor in Illustration 21-16, the minimum lease payments are $121, ([$23, ] 1 $5,000). Illustration shows the capitalized present value of the minimum lease payments (excluding executory costs) for Sterling Construction. ILLUSTRATION Computation of Lessee s Capitalized Amount Guaranteed Residual Value STERLING S CAPITALIZED AMOUNT (10% RATE) ANNUITY-DUE BASIS, INCLUDING GUARANTEED RESIDUAL VALUE Present value of five annual rental payments ($23, , Table 6-5) $ 96, Present value of guaranteed residual value of $5,000 due five years after date of inception: ($5, , Table 6-2) 3, Lessee s capitalized amount $100, Sterling prepares a schedule of interest expense and amortization of the $100,000 lease liability. That schedule, shown in Illustration 21-18, is based on a $5,000 final guaranteed residual value payment at the end of five years. 14 Technically, the rate of return Caterpillar demands would differ depending upon whether the residual value was guaranteed or unguaranteed. To simplify the illustrations, we are ignoring this difference in subsequent sections.

7 Special Accounting Problems 7 STERLING CONSTRUCTION LEASE AMORTIZATION SCHEDULE ANNUITY-DUE BASIS, GUARANTEED RESIDUAL VALUE GRV Lease Reduction Payment Executory Interest (10%) of Lease Lease Date Plus GRV Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/12 $100, /1/12 $ 25, $ 2,000 0 $ 23, , /1/13 25, ,000 $ 7, , , /1/14 25, ,000 6, , , /1/15 25, ,000 4, , , /1/16 25, ,000 2, , , /31/16 5,000.00* ** 4, $131, $10,000 $21, $100, ILLUSTRATION Lease Amortization Schedule for Lessee Guaranteed Residual Value (a) Annual lease payment as required by lease. *Represents the guaranteed residual value. (b) Executory costs included in rental payment. **Rounded by 24 cents. (c) Preceding balance of (e) 3 10%, except for 12/31/16. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). Sterling records the leased asset (front-end loader) and liability, depreciation, interest, property tax, and lease payments on the basis of a guaranteed residual value. (These journal entries are shown in Illustration 21-23, on page 9.) The format of these entries is the same as illustrated earlier, although the amounts are different because of the guaranteed residual value. Sterling records the loader at $100,000 and depreciates it over five years. To compute depreciation, it subtracts the guaranteed residual value from the cost of the loader. Assuming that Sterling uses the straight-line method, the depreciation expense each year is $19,000 ([$100,000 2 $5,000] 4 5 years). At the end of the lease term, before the lessee transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. Leased equipment under capital leases $100, Interest payable $ Less: Accumulated depreciation Lease liability 4, capital leases 95, $ 5, $5, ILLUSTRATION Account Balances on Sterling s Books at End of Lease Term Guaranteed Residual Value If, at the end of the lease, the fair value of the residual value is less than $5,000, Sterling will have to record a loss. Assume that Sterling depreciated the leased asset down to its residual value of $5,000 but that the fair value of the residual value at December 31, 2016, was $3,000. In this case, Sterling would have to report a loss of $2,000. Assuming that it pays cash to make up the residual value deficiency, Sterling would make the following journal entry. Loss on Capital Lease 2, Interest Expense (or Interest Payable) Lease Liability 4, Accumulated Depreciation Capital Leases 95, Leased Equipment under Capital Leases 100, Cash 2, If the fair value exceeds $5,000, a gain may be recognized. Caterpillar and Sterling may apportion gains on guaranteed residual values in whatever ratio the parties initially agree.

8 8 Chapter 21 Alternative Lessor Accounting Gross Presentation When there is a guaranteed residual value, the lessee must be careful not to depreciate the total cost of the asset. For example, if Sterling mistakenly depreciated the total cost of the loader ($100,000), a misstatement would occur. That is, the carrying amount of the asset at the end of the lease term would be zero, but Sterling would show the liability under the capital lease at $5,000. In that case, if the asset was worth $5,000, Sterling would end up reporting a gain of $5,000 when it transferred the asset back to Caterpillar. As a result, Sterling would overstate depreciation and would understate net income in ; in the last year (2016) net income would be overstated. Unguaranteed Residual Value (Lessee Accounting). From the lessee s viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessee s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. Assume the same facts as those above except that the $5,000 residual value is unguaranteed instead of guaranteed. The amount of the annual lease payments would be the same $23, Whether the residual value is guaranteed or unguaranteed, Caterpillar will recover the same amount through lease rentals that is, $96, The minimum lease payments are $116, ($23, ). Lessee Company would capitalize the amount shown in Illustration ILLUSTRATION Computation of Lessee s Capitalized Amount Unguaranteed Residual Value STERLING S CAPITALIZED AMOUNT (10% RATE) ANNUITY-DUE BASIS, INCLUDING UNGUARANTEED RESIDUAL VALUE Present value of 5 annual rental payments of $23, (Table 6-5) $96, Unguaranteed residual value of $5,000 (not capitalized by lessee) 0 Lessee s capitalized amount $96, Illustration shows Sterling s schedule of interest expense and amortization of the lease liability of $96,895.40, assuming an unguaranteed residual value of $5,000 at the end of five years. ILLUSTRATION Lease Amortization Schedule for Lessee Unguaranteed Residual Value STERLING CONSTRUCTION LEASE AMORTIZATION SCHEDULE (10%) ANNUITY-DUE BASIS, UNGUARANTEED RESIDUAL VALUE Annual Reduction Lease Executory Interest (10%) of Lease Lease Date Payments Costs on Liability Liability Liability (a) (b) (c) (d) (e) 1/1/12 $96, /1/12 $ 25, $ 2,000 0 $23, , /1/13 25, ,000 $ 7, , , /1/14 25, ,000 5, , , /1/15 25, ,000 4, , , /1/16 25, ,000 2,112.64* 21, $126, $10,000 $19, $96, (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 3 10%, except for 1/1/16. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 19 cents. Sterling records the leased asset and liability, depreciation, interest, property tax, and lease payments on the basis of an unguaranteed residual value. (These journal

9 entries are shown below in Illustration ) The format of these capital lease entries is the same as illustrated earlier. Note that Sterling records the leased asset at $96, and depreciates it over five years. Assuming that it uses the straight-line method, the depreciation expense each year is $19, ($96, years). At the end of the lease term, before Sterling transfers the asset to Caterpillar, the lease asset and liability accounts have the following balances. Special Accounting Problems 9 Leased equipment under capital Lease liability $ 0 leases $96,895 Less: Accumulated depreciation capital leases 96,895 $ 0 ILLUSTRATION Account Balances on Sterling s Books at End of Lease Term Unguaranteed Residual Value Assuming that Sterling has fully depreciated the leased asset and has fully amortized the lease liability, no entry is required at the end of the lease term, except to remove the asset from the books. If Sterling depreciated the asset down to its unguaranteed residual value, a misstatement would occur. That is, the carrying amount of the leased asset would be $5,000 at the end of the lease, but the liability under the capital lease would be stated at zero before the transfer of the asset. Thus, Sterling would end up reporting a loss of $5,000 when it transferred the asset back to Caterpillar. Sterling would understate depreciation and would overstate net income in ; in the last year (2016) net income would be understated because of the recorded loss. Lessee Entries Involving Residual Values. Illustration shows, in comparative form, Sterling s entries for both a guaranteed and an unguaranteed residual value. ILLUSTRATION Comparative Entries for Guaranteed and Unguaranteed Residual Values, Sterling Guaranteed Residual Value Unguaranteed Residual Value Capitalization of lease (January 1, 2012): Leased Equipment under Leased Equipment under Capital Leases 100, Capital Leases 96, Lease Liability 100, Lease Liability 96, First payment (January 1, 2012): Property Tax Expense 2, Property Tax Expense 2, Lease Liability 23, Lease Liability 23, Cash 25, Cash 25, Adjusting entry for accrued interest (December 31, 2012): Interest Expense 7, Interest Expense 7, Interest Payable 7, Interest Payable 7, Entry to record depreciation (December 31, 2012): Depreciation Expense Depreciation Expense Capital Leases 19, Capital Leases 19, Accumulated Depreciation Accumulated Depreciation Capital Leases 19, Capital Leases 19, ([$100,000 2 $5,000] 4 5 years) ($96, years) Second payment (January 1, 2013): Property Tax Expense 2, Property Tax Expense 2, Lease Liability 15, Lease Liability 15, Interest Expense Interest Expense (or Interest Payable) 7, (or Interest Payable) 7, Cash 25, Cash 25,237.09

10 10 Chapter 21 Alternative Lessor Accounting Gross Presentation Lessor Accounting for Residual Value As indicated earlier, the net investment to be recovered by the lessor is the same whether the residual value is guaranteed or unguaranteed. The lessor works on the assumption that the residual value will be realized at the end of the lease term whether guaranteed or unguaranteed. The lease payments required by the lessor to earn a certain return on investment are the same ($23,237.09) whether the residual value is guaranteed or unguaranteed. Using the Sterling/Caterpillar data and assuming a residual value (either guaranteed or unguaranteed) of $5,000 and classification of the lease as a direct-financing lease, the following necessary amounts are computed: ILLUSTRATION Computation of Direct-Financing Lease Amounts by Caterpillar Gross investment 5 ($23, ) 1 $5,000 5 $121, Unearned interest revenue 5 $121, $100,000 5 $21, Net investment 5 $121, $21, $100,000 The schedule for amortization with guaranteed or unguaranteed residual value is the same: ILLUSTRATION Lease Amortization Schedule, for Lessor Guaranteed or Unguaranteed Residual Value CATERPILLAR FINANCIAL LEASE AMORTIZATION SCHEDULE (ANNUITY DUE BASIS, GUARANTEED OR UNGUARANTEED RESIDUAL VALUE) Annual Lease Interest Payment Plus (10%) on Net Residual Executory Net Investment Net Date Value Costs Investment Recovery Investment (a) (b) (c) (d) (e) 1/1/12 $100, /1/12 $ 25, $ 2, $ 0 $ 23, , /1/13 25, , , , , /1/14 25, , , , , /1/15 25, , , , , /1/16 25, , , , , /31/16 5, * 4, $131, $10, $21, $100, (a) Annual lease payment as required by lease. (b) Executory costs included in rental payment. (c) Preceding balance of (e) 3 10%, except for 12/31/16. (d) (a) minus (b) and (c). (e) Preceding balance minus (d). *Rounded by 24 cents. Using the amounts computed above, the following entries would be made by Caterpillar during the first year for this direct financing lease. Note the similarity to the lessee s entries in Illustration ILLUSTRATION Entries for Either Guaranteed or Unguaranteed Residual Value, Caterpillar Inception of Lease (January 1, 2012): Lease Payments Receivable 121, Equipment 100, Unearned Interest Revenue Leases 21, First Payment Received (January 1, 2012): Cash 25, Lease Payments Receivable 23, Property Tax Expense/Property Taxes Payable 2, Adjusting Entry for Accrued Interest (December 31, 2012): Unearned Interest Revenue Leases 7, Interest Revenue Leases 7,676.29

11 Sales-Type Leases (Lessor) As already indicated, the primary difference between a direct-financing lease and a sales-type lease is the manufacturer s or dealer s gross profit (or loss). A diagram illustrating these relationships is shown in Illustration Special Accounting Problems 11 Equals Fair Value Direct-Financing Lease Cost of Asset Gross Investment Unearned Interest Revenue Does Not Equal Fair Value Sales-Type Lease Cost of Asset Sale Price of Asset Gross Investment Gross Profit Unearned Interest Revenue The information necessary to record the sales-type lease is as follows: SALES-TYPE LEASE TERMS ILLUSTRATION Direct-Financing versus Sales-Type Leases 1 GROSS INVESTMENT (also LEASE PAYMENTS RECEIVABLE ). The minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term. 2 UNEARNED INTEREST REVENUE. The gross investment less the fair value of the asset. 3 SALES PRICE OF THE ASSET. The present value of the minimum lease payments. 4 COST OF GOODS SOLD. The cost of the asset to the lessor, less the present value of any unguaranteed residual value. The gross investment and the unearned interest revenue are the same whether a guaranteed or an unguaranteed residual value is involved. 8 LEARNING OBJECTIVE When recording sales revenue and cost of goods sold, there is a difference in Describe the lessor s accounting for the accounting for guaranteed versus unguaranteed residual values. The guaranteed residual value can be considered part of sales revenue because the lessor sales-type leases. knows that the entire asset has been sold. There is less certainty that the unguaranteed residual portion of the asset has been sold (i.e., will be realized); therefore, sales and cost of goods sold are recognized only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guaranteed or unguaranteed residual value is involved. To illustrate a sales-type lease with a guaranteed residual value and a sales-type lease with an unguaranteed residual value, assume the same facts as in the preceding direct-financing lease situation (page 2). The estimated residual value is $5,000 (the present value of which is $3,104.60), and the leased equipment has an $85,000 cost to the

12 12 Chapter 21 Alternative Lessor Accounting Gross Presentation dealer, Caterpillar. Assume that the fair value of the residual value is $3,000 at the end of the lease term. The amounts relevant to a sales-type lease are computed as follows. ILLUSTRATION Computation of Lease Amounts by Caterpillar Sales-Type Lease Sales-Type Lease Guaranteed Unguaranteed Residual Value Residual Value Gross investment $121, $121, ([$23, ] 1 $5,000) Unearned interest revenue $21, $21, ($121, $100,000) Sales price of the asset $100,000 $96, ($96, $3,104.60) Cost of goods sold $85,000 $81, ($85,000 2 $3,104.60) Gross profit $15,000 $15,000 ($100,000 2 $85,000) ($96, $81,895.40) ILLUSTRATION Entries for Guaranteed and Unguaranteed Residual Values, Caterpillar Sales-Type Lease The profit recorded by Caterpillar at the point of sale is the same, $15,000, whether the residual value is guaranteed or unguaranteed, but the sales revenue and cost of goods sold amounts are different. The present value of the unguaranteed residual value is deducted from sales revenue and cost of goods sold for two reasons: (1) the criteria for revenue recognition have not been met, and (2) matching expense against revenue not yet recognized is improper. The revenue recognition criteria have not been met because of the uncertainty surrounding the realization of the unguaranteed residual value. The entries to record this transaction on January 1, 2012, and the receipt of the residual value at the end of the lease term are presented below. Guaranteed Residual Value Unguaranteed Residual Value To record sales-type lease at inception (January 1, 2012): Cost of Goods Sold 85, Cost of Goods Sold 81, Lease Payments Lease Payments Receivable 121, Receivable 121, Sales Revenue 100, Sales Revenue 96, Unearned Interest Revenue 21, Unearned Interest Revenue 21, Inventory 85, Inventory 85, To record receipt of the first lease payment (January 1, 2012): Cash 25, Cash 25, Lease Payments Receivable 23, Lease Payments Receivable 23, Prop. Tax Exp./Prop. Tax. Pay. 2, Prop. Tax Exp./Prop. Tax Pay. 2, To recognize interest revenue earned during the first year (December 31, 2012): Unearned Interest Revenue 7, Unearned Interest Revenue 7, Interest Revenue 7, Interest Revenue 7, (See lease amortization schedule, Illustration on page 10.) To record receipt of the second lease payment (January 1, 2013): Cash 25, Cash 25, Lease Payments Receivable 23, Lease Payments Receivable 23, Prop. Tax Exp./Prop. Tax Pay. 2, Prop. Tax Exp./Prop. Tax Pay. 2, To recognize interest revenue earned during the second year (December 31, 2013): Unearned Interest Revenue 6, Unearned Interest Revenue 6, Interest Revenue 6, Interest Revenue 6, To record receipt of residual value at end of lease term (December 31, 2016): Inventory 3,000 Inventory 3,000 Cash 2,000 Loss on Capital Lease 2,000 Lease Payments Receivable 5,000 Lease Payments Receivable 5,000

13 Companies must periodically review the estimated unguaranteed residual value in a sales-type lease. If the estimate of the unguaranteed residual value declines, the company must revise the accounting for the transaction using the changed estimate. The decline represents a reduction in the lessor s lease receivable (net investment). The lessor recognizes the decline as a loss in the period in which it reduces the residual estimate. Companies do not recognize upward adjustments in estimated residual value. XEROX TAKES ON THE SEC Exercises and Problems 13 Xerox derives much of its income from leasing equipment. Reporting such leases as sales leases, Xerox records a lease contract as a sale, therefore recognizing income immediately. One problem is that each lease receipt consists of payments for items such as supplies, services, financing, and equipment. The SEC accused Xerox of inappropriately allocating lease receipts, which affects the timing of income that it reports. If Xerox applied SEC guidelines, it would report income in different time periods. Xerox contended that its methods were correct. It also noted that when the lease term is up, the bottom line is the same using either the SEC s recommended allocation method or its current method. Although Xerox can refuse to change its method, the SEC has the right to prevent a company from selling stock or bonds to the public if the agency rejects filings of the company. Apparently, being able to access public markets is very valuable to Xerox. The company agreed to change its accounting according to SEC wishes, and Xerox will pay $670 million to settle a shareholder lawsuit related to its lease transactions. Its former auditor, KPMG LLP, will pay $80 million. What do the numbers mean? Source: Adapted from Xerox Takes on the SEC, Accounting Web (January 9, 2002) (www. account-ingweb.com); and K. Shwiff and M. Maremont, Xerox, KPMG Settle Shareholder Lawsuit, Wall Street Journal Online (March 28, 2008), p. B3. EXERCISES AND PROBLEMS BE21-9 Indiana Jones Corporation enters into a 6-year lease of equipment on January 1, 2011, which requires 6 annual payments of $30,000 each, beginning January 1, In addition, Indiana Jones guarantees the lessor a residual value of $20,000 at lease-end. The equipment has a useful life of 6 years. Prepare Indiana Jones January 1, 2011, journal entries, assuming an interest rate of 10%. BE21-10 Use the information for Indiana Jones Corporation from BE21-9. Assume that for Lost Ark Company, the lessor, collectibility is reasonably predictable, there are no important uncertainties concerning costs, and the carrying amount of the machinery is $155,013. Prepare Lost Ark s January 1, 2011, journal entries. BE21-11 Starfleet Corporation manufactures replicators. On January 1, 2011, it leased to Ferengi Company a replicator that had cost $110,000 to manufacture. The lease agreement covers the 5-year useful life of the replicator and requires 5 equal annual rentals of $45,400 each. An interest rate of 12% is implicit in the lease agreement. Collectibility of the rentals is reasonably assured, and there are no important uncertainties concerning costs. Prepare Starfleet s January 1, 2011, journal entries. E21-6 (Lessor Entries, Sales-Type Lease) Wadkins Company, a machinery dealer, leased a machine to Romero Corporation on January 1, The lease is for an 8-year period and requires equal annual payments of $35,013 at the beginning of each year. The first payment is received on January 1, Wadkins had purchased the machine during 2010 for $160,000. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by Wadkins. Wadkins set the annual rental to ensure an 11% rate of return. The machine has an economic life of 10 years with no residual value and reverts to Wadkins at the termination of the lease. Instructions (a) Compute the amount of each of the following. (1) Gross investment. (2) Unearned interest revenue. (b) Prepare all necessary journal entries for Wadkins for 2011.

14 14 Chapter 21 Alternative Lessor Accounting Gross Presentation E21-7 (Lessee-Lessor Entries, Sales-Type Lease) On January 1, 2011, Palmer Company leased equipment to Woods Corporation. The following information pertains to this lease. 1. The term of the noncancelable lease is 6 years, with no renewal option. The equipment reverts to the lessor at the termination of the lease. 2. Equal rental payments are due on January 1 of each year, beginning in The fair value of the equipment on January 1, 2011, is $150,000, and its cost is $120, The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Woods depreciates all of its equipment on a straight-line basis. 5. Palmer sets the annual rental to ensure an 11% rate of return. Woods incremental borrowing rate is 12%, and the implicit rate of the lessor is unknown. 6. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor. Instructions (Both the lessor and the lessee s accounting period ends on December 31.) (a) Discuss the nature of this lease to Palmer and Woods. (b) Calculate the amount of the annual rental payment. (c) Prepare all the necessary journal entries for Woods for (d) Prepare all the necessary journal entries for Palmer for E21-8 (Lessee Entries with Bargain-Purchase Option) The following facts pertain to a noncancelable lease agreement between Lennox Leasing Company and Gill Company, a lessee. Inception date: May 1, 2010 Annual lease payment due at the beginning of each year, beginning with May 1, 2010 $21, Bargain-purchase option price at end of lease term $ 4, Lease term 5 years Economic life of leased equipment 10 years Lessor s cost $65, Fair value of asset at May 1, 2010 $91, Lessor s implicit rate 10% Lessee s incremental borrowing rate 10% The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. The lessee assumes responsibility for all executory costs. Instructions (Round all numbers to the nearest cent.) (a) Discuss the nature of this lease to Gill Company. (b) Discuss the nature of this lease to Lennox Leasing Company. (c) Prepare a lease amortization schedule for Gill Company for the 5-year lease term. (d) Prepare the journal entries on the lessee s books to reflect the signing of the lease agreement and to record the payments and expenses related to this lease for the years 2010 and Gill s annual accounting period ends on December 31. Reversing entries are used by Gill. E21-9 (Lessor Entries with Bargain-Purchase Option) A lease agreement between Lennox Leasing Company and Gill Company is described in E21-8. Instructions (Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor. (a) Compute the amount of the gross investment at the inception of the lease. (b) Compute the amount of the net investment at the inception of the lease. (c) Prepare a lease amortization schedule for Lennox Leasing Company for the 5-year lease term. (d) Prepare the journal entries to reflect the signing of the lease agreement and to record the receipts and income related to this lease for the years 2010, 2011, and The lessor s accounting period ends on December 31. Reversing entries are not used by Lennox. P21-3 (Lessee-Lessor Entries, Balance Sheet Presentation, Sales-Type Lease) Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston s specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2011, and requires annual rental payments of $620,956 each January 1, starting January 1, 2011.

15 Exercises and Problems 15 Winston s incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is $3,900,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease transaction from the viewpoints of both the lessee and lessor. (b) Prepare the journal entry or entries to record the transaction on January 1, 2011, on the books of Winston Industries. (c) Prepare the journal entry or entries to record the transaction on January 1, 2011, on the books of Ewing Inc. (d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, (e) Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, (Prepare a lease amortization schedule for 2 years.) (f) Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2011, for both the lessee and the lessor P21-13 (Lessor Computations and Entries, Sales-Type Lease with Guaranteed Residual Value) Amirante Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Chambers Medical Center for a period of 10 years. The normal selling price of the machine is $343,734, and its guaranteed residual value at the end of the noncancelable lease term is estimated to be $15,000. The hospital will pay rents of $50,000 at the beginning of each year and all maintenance, insurance, and taxes. Amirante Inc. incurred costs of $210,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Amirante Inc. has determined that the collectibility of the lease payments is reasonably predictable, that there will be no additional costs incurred, and that the implicit interest rate is 10%. Instructions (Round all numbers to the nearest dollar.) (a) Discuss the nature of this lease in relation to the lessor and compute the amount of each of the following items. (1) Gross investment. (2) Unearned interest revenue. (3) Sales price. (4) Cost of sales. (b) Prepare a 10-year lease amortization schedule. (c) Prepare all of the lessor s journal entries for the first year.