Chapter 5 Intercompany Transactions: Topic 2, Leases Dr. Chula King Advanced Accounting The University of West Florida 1 Student Learning Outcomes Eliminate intercompany leases on the consolidated worksheet. Direct financing Sales type 2 Back to Intermediate II: Accounting for Leases On January 1, 2015, Lessor Company leased a piece of equipment to Lessee Company. The usual selling price of the equipment is $35,000; it has a cost to Lessor of $25,000. The lease provides for payments of $9,096 at the beginning of each year for five years. The payments include $1,000 in executory costs. There is a $2,000 bargain purchase option at the end of the fifth year. The implicit interest rate in the lease is 10%. The equipment is being depreciated straight line over 8 years. 3 1
The Facts Lease inception: 1/1/15 Fair market value of equipment: $35,000 Cost of equipment: $25,000 Minimum lease payment (MLP): $8,096 Executory costs: $1,000 Lease term: 5 years Bargain purchase option: $2,000 Implicit rate in lease: 10% Asset s economic life: 8 years 4 Present Value of MLP 1/1/15 1/1/16 1/1/17 1/1/18 1/1/19 12/31/19 8,096 8,096 8,096 8,096 8,096 2,000 33,759 + 1,241 PV annuity due, 5 payments @ 10% 8,096 x 4.16986 PV single sum, 5 periods @ 10% 2,000 x.62091 35,000 5 Criteria for Capital Lease Must meet at least one of the following: Title transfer Bargain purchase option Lease term 75% of economic life Present value (PV) of minimum lease payments (MLP) 90% of fair market value Lessor has two additional criteria (ignore) Sales type lease: PV of MLP Cost Direct financing lease: PV of MLP = Cost 6 2
Significance of Capital Lease Lessor Records the total amount to be received and related unearned interest; writes the asset off its books; and recognizes sales profit, if any. Year end adjusting entry: recognition of earned portion of unearned interest. Does not record depreciation Lessee Records the asset and related liability at the present value of the minimum lease payments. Each payment is interest and principal. Year end adjusting entries: accrual of interest, if any; depreciation 7 From the Example: Is there title transfer? No Is there a bargain purchase option? Yes! Is the lease term 75% of the asset s economic life? No, the percentage is 62.5% (5 8) Is the PV of MLP 90% of fair market value? Yes, they are equal Type of lease for lessor: Sales type PV of MLP = $35,000 $10,000 sales profit Cost = 25,000 8 1/1/15 Lessor and Lessee Entries Lessor MLP Rec* 42,480 Unearned Int.** 7,480 Asset 25,000 Sales Profit*** 10,000 *(5 x 8,096) + 2,000 **42,480 35,000 ***35,000 25,000 Lessee Asset C/L 35,000 Oblig. under C/L 35,000 9 3
Interest Amortization Interest Date Payment @ 10% Principal Balance 1/1/2015 35,000 1/1/2015 8,096 8,096 26,904 1/1/2016 8,096 2,690 5,406 21,498 1/1/2017 8,096 2,150 5,946 15,552 1/1/2018 8,096 1,555 6,541 9,011 1/1/2019 8,096 901 7,195 1,816 12/31/2019 2,000 184 1,816 Transaction Date MLP Receivable Date Specific Int Rev/Exp Int/P Unearned Int. 12/31 Equivalent Obligation under C/L Date Specific 10 Lessor and Lessee Entries 1/1/15 Lessor Cash 9,096 MLP Rec 8,096 Maint. Rev. 1,000 Lessee Oblig. under C/L 8,096 Maint. Exp. 1,000 Cash 9,096 12/31/15 Unearned Int. 2,691 Interest Rev. 2,691 If not leased, Depreciation 25,000 8=3,125 Interest Exp. 2,691 Interest/P 2,691 Dep n Exp LA 4,375 Acc Dep n LA 4,375 35,000 8 11 Back to Advanced Lessor MLP Rec 42,480 Unearned Int. 7,480 Asset 25,000 Sales Profit 10,000 Lessee Leased Asset 35,000 Oblig. under C/L 35,000 Just like an intercompany sale of depreciable asset, except that the account titles are different: Lessor depreciation 25,000 8= 3,125 Lessee depreciation 35,000 8= 4,372 $1,250 excess dep n; $10,000 8=$1,250 Just like intercompany payables and receivables 12 4
Back to Advanced (continued) Lessor Cash 9,096 MLP Rec 8,096 Maint. Rev. 1,000 Unearned Int. 2,691 Interest Rev. 2,691 If not leased, Depreciation 25,000 8=3,125 Lessee Oblig. under C/L 8,096 Maint. Exp. 1,000 Cash 9,096 Interest Exp. 2,691 Interest/P 2,691 Dep n Exp LA 4,375 Acc Dep n LA 4,375 35,000 8 13 The Rules The Lessor is charged with ALL income effects from the eliminations Eliminate interest revenue against interest expense Interest Revenue Lessor Interest Expense Lessor If executory costs are present, eliminate maintenance revenue against maintenance expense Maintenance Revenue Lessor Maintenance Expense Lessor 14 The Rules (continued) Eliminate end of year balances in the payable (obligation under capital lease and possibly interest payable) against the receivable (MLP receivable and unearned interest) Obligation Under Capital Lease Interest Payable Unearned Interest MLP Receivable If a sales type lease, eliminate the original sales profit against the leased asset Sales Profit Lessor (or R/E Lessor) Leased Asset 15 5
The Rules (continued) Eliminate current and past years depreciation on the leased asset Accumulated Depreciation Leased Asset Dep n Exp Leased Asset Lessor (current) R/E Lessor (prior) Record current and past year s depreciation as though the asset had not been leased Dep n Exp PPE Lessor (current) R/E Lessor (prior) Accumulated Depreciation PPE Recategorize the asset PPE Leased Asset 16 That sounds hard! Almost all of the information that is needed for the eliminations is in the interest amortization table! 17 Back to the Example Lessor owns 80% of Lessee. On January 1, 2015, Lessor Company leased a piece of equipment to Lessee Company. The usual selling price of the equipment is $35,000; it has a cost to Lessor of $25,000. The lease provides for payments of $9,096 at the beginning of each year for five years. The payments include $1,000 in executory costs. There is a $2,000 bargain purchase option at the end of the fifth year. The implicit interest rate in the lease is 10%. The equipment is being depreciated straight line over 8 years. PVMLP = $35,000 Capital Lease; Sales type for Lessor 18 6
Lessor and Lessee Entries 1/1/15 Lessor (parent) MLP Rec* 42,480 Unearned Int.** 7,480 Asset 25,000 Sales Profit*** 10,000 *(5 x 8,096) + 2,000 **42,480 35,000 ***35,000 25,000 Dep n = 25,000 8=3,125 Lessee Asset C/L 35,000 Oblig. under C/L 35,000 Dep n = 35,000 8=4,375 19 Eliminations, 12/31/15 Interest Principal Date Payment @ 10% Principal Balance 1/1/2015 35,000 1/1/2015 8,096-8,096 26,904 1/1/2016 8,096 2,690 5,406 21,498 1/1/2017 8,096 2,150 5,946 15,552 1/1/2018 8,096 1,555 6,541 9,011 1/1/2019 8,096 901 7,195 1,816 12/31/2019 2,000 184 1,816-20 Eliminations, 12/31/15 (1) Interest Revenue Parent 2,690 Interest Expense Parent 2,690 (2) Maintenance Revenue Parent 1,000 Maintenance Expense Parent 1,000 21 7
Interest Principal Date Payment @ 10% Principal Balance 1/1/2015 35,000 1/1/2015 8,096-8,096 26,904 1/1/2016 8,096 2,690 5,406 21,498 1/1/2017 8,096 2,150 5,946 15,552 1/1/2018 8,096 1,555 6,541 9,011 1/1/2019 8,096 901 7,195 1,816 12/31/2019 2,000 184 1,816 - Obligation Under Capital Lease 26,904 Interest Payable 2,690 Unearned Interest 4,790 MLP Receivable 34,384 Eliminations, 12/31/15 (3) Obligation Under Capital Lease 26,904 Interest Payable 2,690 Unearned Interest 4,790 MLP Receivable 34,384 (4) Sales Profit Parent 10,000 Leased Asset 10,000 (5) Acc Dep n, L/A 4,375 Dep n Expense, L/A Parent 4,375 (6) Dep n Expense, Machine Parent 3,125 Acc Dep n, Machine 3,125 (7) Machine 25,000 Leased Asset 25,000 23 Eliminations, 12/31/16 Interest Principal Date Payment @ 10% Principal Balance 1/1/2015 35,000 1/1/2015 8,096-8,096 26,904 1/1/2016 8,096 2,690 5,406 21,498 1/1/2017 8,096 2,150 5,946 15,552 1/1/2018 8,096 1,555 6,541 9,011 1/1/2019 8,096 901 7,195 1,816 12/31/2019 2,000 184 1,816-24 8
Eliminations, 12/31/16 (1) Interest Revenue Parent 2,150 Interest Expense Parent 2,150 (2) Maintenance Revenue Parent 1,000 Maintenance Expense Parent 1,000 25 Interest Principal Date Payment @ 10% Principal Balance 1/1/2015 35,000 1/1/2015 8,096-8,096 26,904 1/1/2016 8,096 2,690 5,406 21,498 1/1/2017 8,096 2,150 5,946 15,552 1/1/2018 8,096 1,555 6,541 9,011 1/1/2019 8,096 901 7,195 1,816 12/31/2019 2,000 184 1,816 - Obligation Under Capital Lease 21,498 Interest Payable 2,150 Unearned Interest 2,640 MLP Receivable 26,288 26 Eliminations, 12/31/16 (3) Obligation Under Capital Lease 21,498 Interest Payable 2,150 Unearned Interest 2,640 MLP Receivable 26,288 (4) R/E Parent 10,000 Leased Asset 10,000 (5) Acc Dep n, L/A ( 15, 16) 8,750 Dep n Expense, L/A Parent ( 16) 4,375 R/E Parent ( 15) 4,375 (6) Dep n Expense, Machine Parent( 16) 3,125 R/E Parent ( 15) 3,125 Acc Dep n, Machine( 15, 16) 6,250 (7) Machine 25,000 Leased Asset 25,000 27 9
Subsidiary is the Lessor All income effects would be charged to the subsidiary. Any retained earnings effects would be split between the parent and subsidiary according to ownership percentages. 28 Concluding Comments The Rules The Lessor is charged with ALL income effects from the eliminations Eliminate interest revenue against interest expense If executory costs are present, eliminate maintenance revenue against maintenance expense Eliminate end of year balances in the payable (obligation under capital lease and possibly interest payable) against the receivable (MLP receivable and unearned interest) 29 Concluding Comments The Rules (continued) If a sales type lease, eliminate the original sales profit against the leased asset; retained earnings in later years Eliminate current and past year s depreciation on the leased asset Record current and past year s depreciation as though the asset had not been leased Re categorize the asset 30 10
The Next Step Work Exercises 8, 9 Work Problems 12, 14 and 15 Intercompany leases 31 11