Section 12 Accounting for Leases Accounting by the Lessor and Lessee

Transcription

1 Section 12 Accounting for Leases Accounting by the Lessor and Lessee 15-1 A lease is an agreement in which the lessor conveys the right to use property, plant, or equipment, usually for a stated period of time, to the lessee. Lessee = Renter Lessor = Owner of property Finance lease Lessee Lessor Operating lease Operating lease Capital lease Capital lease (2 add. Criteria) (1 of the 4 criteria) Direct financing lease Sales-type lease

2 Accounting by the Lessee 4 Criteria 15-2 Lease Agreement Leases that presents any of the following 4 criteria are accounted for by the lessee as Capital Leases (Finance Lease). FASB intention: to keep what are in substance purchase from being disguised as rental agreements to keep debt off the B/S.

3 15-3 Leases Are Classified in 2 Ways Depends on the level of transfer of the benefits & risks of ownership remain with the lessor: Substantially all of the benefits & risks of ownership remain with the lessor Operating Lease Substantially all of the benefits & risks of ownership are transferred to the lessee Capital Lease (Finance Lease).

4 4 Classification Criteria 15-4 I: Operating Lease II: Capital Lease A capital lease must meet one of four criteria: 1. Ownership transfers to the lessee at the end of the lease term, or Bargain Purchase Option (BPO) exists, or Noncancelable Lease, term is = or > 75% or more of the expected economic life (useful life) of the asset, or 4. PV of the Minimum Lease Payments is = or > 90% of the fair value of the asset.

5 I: Capital Lease #2 to #4 Classification Criteria 2. A bargain purchase option (BPO) gives the lessee the right to purchase the leased asset at a price significantly lower than the expected fair value of the property and the exercise of the option appears reasonably assured The lease term is = or > 75% or more of the expected economic life (useful life) of the asset. The lease term is normally considered to be the non-cancelable term of the lease plus any periods covered by bargain renewal options. If the inception of the lease occurs during the last 25% of an asset s economic life, this criterion does not apply. Note: For the lessee, a capital lease is treated as the purchase of an asset the lessee records both an asset and liability at inception of the lease.

6 I: Capital Lease #2 to #4 Classification Criteria (cont d) The PV of the minimum lease payments is = or > 90% of the fair value of the asset, AKA Recovery of Investment Test (90% Test): Minimum Lease Payments (is the recognized value for the leased asset & liability): a. Bargain-purchase option (BPO) b. Guaranteed residual value c. Base rent (Minimum rental payment) d. Penalty for failure to renew or extend the lease Contingent rents: Additional rents due based on asset usage or some other criteria (e.g., sales > a base amount) Executory Costs (MIT): a. Maintenance b. Insurance c. Taxes Exclude from PV of Minimum Lease Payment Calculation

7 15-7 Capital Lease - by the Lessee Capitalization Criteria Discount Rate Lessee: computes the present value of the minimum lease payments using its incremental borrowing rate, with one exception. If the lessee knows lessor s implicit interest rate and it is less than the lessee s incremental borrowing rate, then lessee must use the lessor s rate.

8 15-8 Capital Lease - by the Lessee Accounting Asset and Liability Asset and Liability Recorded at the lower of: 1. present value of the minimum lease payments (excluding executory costs) or 2. fair-market value of the leased asset.

9 15-9 Capital Lease - by the Lessee Accounting Asset and Liability Depreciation Period If lease transfers ownership: depreciate asset over the economic life of the asset. If lease does not transfer ownership: depreciate over the term of the lease.

10 15-10 Capital Lease - by the Lessee Accounting Asset and Liability Effective-Interest Method Used to allocate each lease payment between principal and interest. Depreciation Concept Depreciation and the discharge of the obligation are independent accounting processes.

11 15-11 Capital Lease - by the Lessee - Example On January 1, 2012, Adams Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Adams to make annual payments of $9,968 at the beginning of each year, starting January 1, The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. Adams uses the straight-line method of depreciation for all of its plant assets. Adams s incremental borrowing rate is 10%, and the lessor s implicit rate is unknown. Instructions (a) What type of lease is this? Explain. (b) Compute the present value of the minimum lease payments. (c) Prepare all necessary journal entries for Adams for this lease through January 1, 2013.

12 15-12 Capital Lease - by the Lessee Example Cont d a) What type of lease is this? Explain. Capitalization Criteria: 1. Transfer of ownership 2. Bargain purchase option 3. Lease term = or > 75% of economic life of leased property 4. Present Value of minimum lease payments => 90% of FMV of property Capital Lease, #3 NO NO Lease term 5 yrs. Economic life 6 yrs. YES 83.3% FMV of leased property is unknown.

13 15-13 Capital Lease - by the Lessee Example Cont d b). Compute present value of the minimum lease payments. Payment $ 9,968 Present value factor (i=10%,n=5) PV of minimum lease payments $41,565 1/1/12 Journal Entries: Leased Machine (capital leases) 41,565 Lease Liability 41,565 Lease Liability 9,968 Cash 9,968

14 Capital Lease - by the Lessee Example Cont d Note: If Bargain Purchase Option (BPO) exists, PV of BPO must be calculated using PV of $1 factor: Then add it to PV of min. lease payments. The minimum lease payments may have all 4 components (slide 6) if #2 and #4 data (below or slide 6) are available or applicable: 1) BPO 2) Guaranteed residual value by the lessee (calculated using PV of $1 factor:.62092). 3) Base rent (excluding executory costs) & 4) Penalty imposed - nonrenewal (calculated using PV of $1 factor:.62092). If no BPO exits, the minimum lease payments have only 3 (2-4) components. Example: 15-14

15 15-15 Capital Lease - by the Lessee, Example Cont d Lease Amortization Schedule 10% Lease Interest Reduction Lease Date Payment Expense in Liability Liability 1/1/12 $ 41,565 1/1/12 $ 9,968 $ 9,968 31,597 12/31/12 9,968 3,160 6,808 24,789 12/31/13 9,968 2,479 7,489 17,300 12/31/14 9,968 1,730 8,238 9,062 12/31/15 9, , ,565 9,968 = 3,1957 3,160 = 31,597 x 10%

16 15-16 Capital Lease - by the Lessee Example Cont d c) Journal entries for Adams (Lessee) through Jan. 1, /31/12 (1 st year end) Depreciation Expense 8,313 Accumulated Depreciation 8,313 ($41,565 5 = $8,313; no ownership transfer) Interest Expense 3,160 Interest Payable 3,160 ($41,565 $9,968) X.10]

17 Capital Lease - by the Lessee Example Cont d Journal entries for Adams: 1/1/13 Lease Liability (slide 13) 6,808 Interest Payable 3,160 Cash 9,968

18 2 Additional Criteria - by the Lessor for Capital Lease A lessor must capitalize a lease using a) direct financing or b) sales-type lease: if it meets one of the 4 classification criteria discussed earlier and the following 2 additional criteria: Lessor must satisfy the ADDITIONAL conditions of the realization principle, i.e., 1. The collectability of the lease payments must be reasonably predictable. 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. (i.e., performance by the lessor is substantially complete). Note: A sales-type lease involves a manufacturer s or dealer s profit as FV of the leased prop is > cost; a direct-financing lease doesn t Lessor = Owner of the property subject to the lease.

19 Capital Lease (Non-Operating Lease) or Operating Lease If the lease meets 1 of the 4 criteria (slide 4) and the 2 additional criteria (slide 18), Lessor - Capital lease: Sales-type lease or Direct financing lease (if manufacturer/dealer) If both additional criteria are not met, Lessor Operating lease Lessee Capital lease

20 Capital Lease - by the Lessor a. Direct-Financing Method (Lessor) In substance, lessor is financing an asset purchase for the lessee. When the lessor is not a manufacturer or dealer: the fair value of the leased asset typically is the lessor s cost. Lessor records: A lease receivable (present value of the minimum lease payments) instead of a leased asset (for Lessee).

21 Capital Lease - by the Lessor a. Direct Financing Method example Computation of Rental: Fieval Leasing Company signs an agreement on January 1, 2012, to lease equipment to Reid Company. The following information relates to this agreement. 1. The term of the non-cancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. 2. The cost and fair value of the asset at January 1, 2012, is $343, The asset will revert to the lessor at the end of the lease term, at which time the asset is expected to have a residual value of $61,071, none of which is guaranteed. 4. The agreement requires equal annual rental payments, beginning on January 1, Collectability of the lease payments is reasonably predictable. 6. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.

22 Capital Lease - by the Lessor Example Cont d Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. Residual value $ 61,071 PV of single sum (i=10%, n=6) x PV of residual value $ 34,473 Fair market value of leased equipment $ 343,000 Present value of residual value - (34,473) Amount to be recovered through lease payment 308,527 PV factor of annuity due (i=10%, n=6) Annual payment required (308,527 / ) $ 64,400

23 Capital Lease - by the Lessor Example Cont d Amortization schedule for the lessor.

24 Capital Lease - by the Lessor Example Cont d Prepare all of the journal entries for the lessor for 2012 and /1/12 Lease Receivable 343,000 Equipment 343,000 1/1/12 Cash 64,400 Lease Receivable 64,400 12/31/12 Interest Receivable 27,860 Interest Revenue 27,860

25 Capital Lease - by the Lessor Example Cont d Prepare all of the journal entries for the lessor for 2012 and /31/13 Interest Receivable 24,206 Interest Revenue 24,206

26 15-26 Capital Lease by the Lessor b. Sales-Type Leases When the lessor is a manufacturer or dealer: 1. The fair value of the leased asset generally is higher than the cost of the asset; the fair value of the property at the inception of the lease is likely to be its normal selling price. 2. 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.

27 Capital Lease Accounting - by the Lessor b. Sales-Type Leases Cont d Primary difference between a direct-financing lease and a salestype lease: 1. Sales-Type: the manufacturer or dealer has gross profit (or loss). Direct-financing: no gross profit. 2. At inception, Sales-Type Lessor records: the sale price of the asset (sales revenue; PV of payments), the cost of goods sold, related inventory reduction, and the lease receivable. 3. Difference in accounting for guaranteed and unguaranteed residual values.

28 Sales-Type Leases - Lessor 15-28

29 U. S. GAAP vs. IFRS 15-29

30 15-30 Capital Leases More Example - Lessee and Lessor (Direct Financing) On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from First Lease Corp. First Lease 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 6 year lease term ending December 31, 2018, is equal to the estimated useful life of the copier. First Lease routinely acquires electronic equipment for lease to other firms. The interest rate in these financing arrangements is10%. Since the lease term = or > the expected useful life of the equipment (>75%), the transaction must be recorded by the lessee as a capital lease. We believe the collectibility of the lease payments is reasonably certain and any costs to the lessor that are yet incurred are reasonably predictable, this qualifies also as a direct financing lease (not sales lease) to First Lease. To achieve its objectives, First Lease 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, * = $100,000 payments. *PV of an annuity due of $1: n = 6, I = 10% Proof: $100, * = $479,079 lessee s cost

31 15-31 Capital Leases Lessee and Lessor Amortization Schedule for the Lease (Annuity Due) Effective Decrease in Outstanding Date Payment Interest Balance Balance 1/1/13 $ 479,079 1/1/13 $ 100,000 $ - $ 100, ,079 12/31/13 100,000 37,908 62, ,987 12/31/14 100,000 31,699 68, ,686 12/31/15 100,000 24,869 75, ,554 12/31/16 100,000 17,355 82,645 90,910 12/31/17 100,000 9,090 * 90,910 - $ 600,000 $ 120,921 $ 479,079 *Rounded. $379,079 10% = $37,908 $379,079 - $62,092 = $316,987 $100,000 - $37,908 = $62,092

32 I. Capital Leases a. Direct Financing Lessee and Lessor Lease Inception (1/1/13) Sans Serif Publishers, Inc. (Lessee) Leased equipment (PV of payments) 479,079 Lease payable (PV of payments) 479,079 First LeaseCorp. (Lessor) Lease receivable (PV of payments) 479,079 Equipment (Lessor s cost) 479,079 (slide 30) First Lease Payment (1/1/13) Sans Serif Publishers, Inc. (Lessee) Lease payable 100,000 Cash 100,000 First LeaseCorp. (Lessor) Cash 100,000 Lease receivable 100,000

33 Capital Leases Lessee and Lessor Second Lease Payment (12/31/13) Sans Serif Publishers, Inc. (Lessee) Interest expense 37,908 Lease payable 62,092 Cash 100,000 First LeaseCorp. (Lessor) Cash 100,000 Lease receivable 62,092 Interest revenue 37,908 Depreciation Recorded at (12/31/13) Sans Serif Publishers, Inc. (Lessee) Depreciation expense 79,847 Accumulated depreciation 79,847 ($479,079 6 = $79,847 Assuming straight-line method.)

34 15-34 Capital Leases Lessee and Lessor Depreciation Period: 1. The lessee normally should depreciate a leased asset over the term of the lease. 2. If either ownership transfers or a bargain purchase option is present (met), the asset should be depreciated over its useful life.

35 b. Sales-Type Leases (Same Example as Slide 30 Except the Equipment is Manufactured) On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corp. at a price of $479,079. The lease agreement specifies annual payments of $100,000 beginning January 1, 2013 (the inception of the lease), and at each December 31 thereafter through The 6-year lease term ending December 31, 2018, is equal to the estimated useful life of the equipment. CompuDec manufactured the equipment at a cost of $300,000. (different scenario from slide 30) CompuDec s interest rate for financing the transaction is10%.

36 Sales-Type Leases (cont d) Lease Classification 1. The lease term (6-years) is equal to 100% of the useful life of the copier, and 2. Fair market value is different from cost of the leased asset. 3. CompuDec is certain about the collectibility of the lease payments, and 4. No more costs are to be incurred by CompuDec relating to the lease agreement, SO The lease agreement is classified as a sales-type (not Direct Financing) lease from the viewpoint of CompuDec (lessor) and a capital lease from the viewpoint of Sans Serif Publishers (lessee)

37 Sales-Type Leases: Lessee At Inception of the Lease 1/1/13 CompuDec Corp. (Lessor) Lease receivable 600,000 Cost of goods sold (slide 35) 300,000 Sales revenue 479,079 Unearned interest income 120,921 Inventory of equipment 300,000 Receipt of the First Lease Payment 1/1/13 CompuDec Corp. (Lessor) Cash 100,000 Lease receivable 100,000 Unearned interest income 0 Interest income 0 (PPT 31, P12-7))

38 Bargain Purchase Options & Residual Value A bargain purchase option (BPO) is a provision of some lease contracts that gives the lessee the option of purchasing the leased property at a bargain price. The expectation that the option price will be paid effectively adds an additional cash flow to the lease for both the lessee and the lessor. As a result: LESSEE: adds the present value of the BPO price to the present value of periodic rental payments when computing the amount to be recorded a leased asset and a lease liability. LESSOR: amount to be recovered (fair value) - the present value of the BPO price = amount that must be recovered from the lessee through the periodic rental payments.

39 Bargain Purchase Option (BPO) On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price of $479,079. The lease agreement specifies annual payments beginning January 1, 2013, the inception of the lease, and at each December 31 there after through 2017 (6 years). The estimated useful life of the equipment is seven years. On December 31, 2018, at the end of the 6-year lease term, the equipment is expected to be worth $75,000, and Sans Serif has the option to purchase it for $60,000 on that date. The residual value after seven years is zero. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is10%. MLP: Min Lease Payment Lessee's calculation of PV of MLP: PV of periodic payments $ 92, = $ 445,211 Plus: PV of BPO 60, = 33,868 PV of MLP $ 479,079 Lessor's calculation of rental payments: Fair market value of asset $ 479,079 Less: PV of BPO $ 60, = (33,868) Amount recoverd through payments $ 445,211 PV annuity due factor, n = 6, I = 10% Rental payments at beginning of period $ 92, is the PV of Annuity due, I = 10%, n = 6; see slide 22 92,931 = (479,079 33,868) / (also see slide 41 for guaranteed residual value) 15-39

40 Bargain Purchase Option (BPO) Effective Decrease in Outstanding Date Payment Interest Balance Balance 1/1/13 $ 479,079 1/1/13 $ 92,931 $ - $ 92, ,148 12/31/13 92,931 38,615 54, ,832 12/31/14 92,931 33,183 59, ,084 12/31/15 92,931 27,208 65, ,361 12/31/16 92,931 20,636 72, ,067 12/31/17 92,931 13,407 79,524 54,542 $ 557,586 $ 133,049 $ 424,537 Exercise of BPO (ownership transfer) at the end of the lease term: $54,542 10% = $5,458 (interest exp)* for 12/31/17-12/31/18 $60,000 BPO payment - $5,458* = $54,542

41 Bargain Purchase Option (BPO) End of Lease December 31, 2017 (Lease ends at 12/31/18, but the last payment is made on 12/31/17) Sans Serif Publishers, Inc. (Lessee) Depr expense ($479,079 7 useful life) 68,440 Accumulated depreciation 68,440 Interest expense 5,458 Lease payable 54,542 Cash (BPO payment) 60,000 CompuDec Corporation (Lessor) Cash 60,000 Lease receivable 54,542 Interest revenue 5,458 Refer the amortization schedule and computations on the previous slide, 38

42 Residual Value Residual value: an estimate of what its commercial value will be at the end of the lease term. On January 1, 2013, Sans Serif Publishers, Inc., leased printing equipment from CompuDec Corporation at a price 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 estimated useful life of the equipment is 7 years. At the end of the 6-year lease term, ending December 31, 2018, the equipment is expected to be worth $60,000. CompuDec manufactured the equipment at a cost of $300,000 and its interest rate for financing the transaction is10%.

43 Effect on the Lessee of a Residual Value Guaranteed Residual Value Sometimes the 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. 2. It reduces the lessor s risk; also provides incentive for the lessee to maintain the leased asset to preserve the residual value. Lessee's calculation of PV of MLP: PV of periodic payments $ 92, = $ 445,211 Plus: PV of residual value 60, = 33,868 PV of MLP $ 479,079 Slide 39 PV factor of an annuity due of $1: n=6, i=10% PV factor of $1: n=6, i=10%

44 Effect on the Lessee of a Residual Value Unguaranteed Residual Value A lease agreement may be silent as to the question of residual value. This is referred to as an unguaranteed residual value. In the case of unguaranteed residual value, the lessee is not obligated to make any payments other than the periodic rental payments. As a result, the present value of the minimum lease payments is: 1. simply the present value of periodic rental payments ($445,211; slide 39). 2. the same is true when the residual value is guaranteed by a third-party guarantor such as an insurance company.

45 15-45 Effects on the Lessor of a Residual Value Guaranteed Residual Value When the residual value is guaranteed: a component of minimum lease payments for both the lessor and the lessee. When it is not guaranteed: the lessor still expects to receive it in the form of property, or cash, or both. Lessor's calculation of rental payments: Fair market value of asset $ 479,079 Less: PV of residual value $ 60, = (33,868) Amount recoverd through payments $ 445,211 PV annuity due factor, n = 6, I = 10% Rental payments $ 92,931

46 Residual Value Guaranteed Using previous example of a sales-type lease and replace the bargain purchase option with a guaranteed residual value (not depreciable). Sales-Type Lease 1/1/13 Sans Serif Publishers, Inc. (Lessee) Leased equipment 479,079 Lease payable 479,079 CompuDec Corporation (Lessor) Lease receivable 600,000 Cost of goods sold 300,000 Sales revenue 479,079 Unearned interest income 120,921 Inventory of equipment 300,000

47 15-47 Residual Value Guaranteed First Lease Payment 1/1/13 Sans Serif Publishers, Inc. (Lessee) Lease payable 92,931 Cash 92,931 CompuDec Corporation (Lessor) Cash 92,931 Lease receivable 92,931

48 Residual Value Guaranteed /31/17 Sans Serif Publishers, Inc. (Lessee) Depreciation expense 69,847 Accumulation depreciation 69,847 (see slide 41) Interest expense 13,407 Lease payable 79,524 Cash 92,931 Recorded cost of leased asset $ 479,079 Guarantted residual value (60,000) Basis for depreciation 419,079 Useful life in years 6 Annual depreciation $ 69,847 CompuDec Corporation (Lessor) Cash 92,931 Interest revenue 13,407 Lease receivable 79,524 See amortization schedule, slide 40 12/31/16 (or 1/1/17) lease outstanding balance was 134,066. The final period cash payment incurs on 12/31/17 (or) 1/1/18. 13,407 = 10% x 134,066.

49 15-49 Treatment of Residual Value Computation of Lease Payment Lessor Minimum Lease Payment Lessee Minimum Lease Payment Residual value in leased asset? Lessee gets the residual value (by transfer of title or a BPO) (Lease has PBO) No No No Lessor gets the residual value (title does not transfer; no BPO) Residual value is not guaranteed. Yes No No Residual value is guaranteed by lessee. Yes Yes Yes Residual value is guaranteed by a third party. Yes Yes No (See slide 45)

50 Executory Costs One of the responsibilities of ownership that is transferred to the lessee in a capital lease is the responsibility to pay for Executory Costs: maintenance, insurance, taxes, and any other costs associated with ownership. The lessee expense executory costs as incurred: Sans Serif Publishers, Inc. (Lessee) Maintenance expense 2,000 Cash 2,000

51 15-51 II: Operating Leases Lease agreement exists. Capital Lease Criteria for a capital lease not met. Record lease as an Operating Lease. More in the nature of a rental agreement.

52 15-52 Operating Lease Lessor Records each rental receipt as rental revenue. Depreciates leased asset in the normal manner Lessee Records each rental payment as rental expense.

53 Operating Leases - Example On January 1, 2013, Sans Serif Publishers, Inc., a computer services and printing firm, leased printing equipment from First LeaseCorp. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2013, the inception of the lease, and at each January 1 thereafter through 2016.The useful life of the equipment is estimated to be six years. Before deciding to lease, Sans Serif considered purchasing the equipment for its cash price of $479,079. If funds were borrowed to buy the equipment, the interest rate would have been 10%. At Each of Four Payment Dates San Serif Publishers, Inc. (Lessee) Prepaid rent 100,000 Cash 100,000 First LeaseCorp (Lessor) Cash 100,000 Unearned rent revenue 100,000 Note: Lessor also must depreciate the asset according to its normal depreciation policy.

54 15-54 Lessor s Initial Direct Costs Incremental costs (lessor s costs to originate a lease) incurred by the lessor in negotiating and consummating a lease agreement. Direct Financing Leases Include as part of asset investment balance. Sales-Type Leases The initial direct costs are expensed at the inception of the lease.

55 15-55 Contingent Rentals Sometimes rental payments may be increased (or decreased) at some future time during the lease term, depending on whether some specified event occurs. Contingent rentals are not included in the minimum lease payments. However, they are disclosed in the notes to the financial statements.

56 Lease Disclosures Lease disclosure requirements are quite extensive for both the lessor and lessee. Virtually all aspects of the lease agreement must be disclosed. For all leases (a) a general description of the leasing arrangement is required as well as (b) minimum future payments, in the aggregate and for each of the 5 succeeding fiscal years. Other required disclosures: type of lease and include residual values, contingent rentals, sublease rentals, and executory costs.

57 15-57 Lease Disclosures - Lessor The lessor must disclose its net investment in the lease. This amount is the present value of the gross investment in the lease, which is the total of the minimum lease payments (plus any unguaranteed residual value).

58 15-58 SALE-LEASEBACKS The term sale-leaseback describes a transaction in which the owner of the property (seller-lessee) sells the property to another and simultaneously leases it back from the new owner. Advantages: 1. Financing 2. Taxes

59 SALE-LEASEBACKS Seller-Lessee Capital Lease vs Operating Lease Capital Lease If the lease meets one of the 4 criteria: treat as a capital lease, the sellerlessee records: The transaction: as a sale & The lease: as a capital lease. Gain or loss on the sale normally is deferred (as unearned), but the following 3 rules apply: 1. The deferred gain is reported as an asset valuation allowance (a contra asset with a credit balance) 2. If FV>BV>Sales Price, a loss is deferred & amortized as prepaid rent. 3. If BV>FV, a loss is recognized immediately.

60 SALE-LEASEBACKS Seller-Lessee Capital Lease vs Operating Lease Operating Lease If none of the capital lease criteria are met, the sale and leaseback are considered separate transactions: the seller-lessee records: the transaction: as a sale & the lease: as an operating lease. gain or loss deferred form the sale amortize the deferred G or L: in proportion to the rental payments (a reduction of rent) over the term of the lease.

61 15-61 SALE-LEASEBACKS Summary Financing vs Sale If the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing. should defer a gain or loss on the transaction. If the seller-lessee gives up the right to substantially all of the remaining use of the asset sold (10% or less of the FV of the asset sold), the transaction is in substance a sale. Gain or loss recognition is appropriate.

62 15-62 SALE-LEASEBACKS Buyer-Lessor (Direct Financing vs Operating Lease) If the lease meets one of the lease capitalization criteria, the purchaser-lessor records the transaction as a purchase and the lease as a direct-financing lease. If the lease does not meet any criteria, the purchaser-lessor records the transaction as a purchase and an operating lease.

63 SALE-LEASEBACKS Example American Airlines on January 1, 2011, sells a used Boeing 757 having a carrying amount on its books of $75,500,000 to CitiCapital for $80,000,000. American immediately leases the aircraft back under the following conditions: The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year. 2. The aircraft has a fair value of $80,000,000 on January 1, 2012, and an estimated economic life of 15 years. 3. American pays all executory costs. 4. American depreciates similar aircraft that it owns on a straight-line basis over 15 years. 5. The annual payments assure the lessor a 12 percent return. 6. American s incremental borrowing rate is 12 percent.

64 15-64 SALE-LEASEBACKS Example (cont d) This lease is a capital financing lease to American because: 1. the lease term is equal to the estimated life of the aircraft and 2. the present value of the lease payments is equal to the fair value of the aircraft to CitiCapital. CitiCapital should classify this lease as a direct financing lease.

65 SALE-LEASEBACKS ,341,507 = (80,000,000 10,487,443 1 st lease payment) x.12

66 15-66 Contingencies An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. * * Accounting for Contingencies, Statement of Financial Accounting Standards No. 5 (Stamford, Conn.: FASB, 1975), par. 1

67 15-67 Gain Contingencies Typical Gain Contingencies are: 1. Possible receipts of monies from gifts, donations, and bonuses. 2. Possible refunds from the government in tax disputes. 3. Pending court cases with a probable favorable outcome. 4. Tax loss carryforwards. Gain contingencies are not recorded. Disclosed only if probability of receipt is high.

68 15-68 Contingent Liability Loss Contingencies The likelihood that the future event will confirm the incurrence of a liability can range from probable to remote. FASB uses three areas of probability: Probable. Reasonably possible. Remote.

69 15-69 Loss Contingencies Probability Probable Reasonably Possible Remote Accounting Accrue Footnote Ignore

70 15-70 Loss Contingencies - Example Scorcese Inc. is involved in a lawsuit at December 31, (a) Prepare the December 31 entry assuming it is probable that Scorcese will be liable for $900,000 as a result of this suit. (b) Prepare the December 31 entry, if any, assuming it is not probable that Scorcese will be liable for any payment as a result of this suit. (a) Lawsuit loss 900,000 Lawsuit liability 900,000 (b) No entry is necessary. The loss is not accrued because it is not probable that a liability has been incurred at 12/31/10.

71 Loss Contingencies 15-71

72 15-72 Loss Contingencies Common loss contingencies: 1. Litigation, claims, and assessments. 2. Guarantee and warranty costs. 3. Premiums and coupons. 4. Environmental liabilities.