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AC303Summer 2105
Prof. G. Thomas White
Largest group of leased equipment involves:
Information technology equipment
Transportation (trucks, aircraft, rail)
Construction
Agriculture
A lease is a contractual agreement between a lessor and a
lessee, that gives the lessee the right to use specific
property, owned by the lessor, for a specified period of time.
The Leasing Environment
LO 1
The Leasing Environment
LO 1
Illustration 21-2What Do Companies Lease?
Banks
Who Are the Players? Captive Leasing
CompaniesIndependents
► Wells Fargo
► Chase
► Citigroup
► PNC
► Caterpillar Financial Services Corp.
► Ford Motor Credit (Ford)
► IBM Global Financing
Market Share47%
23%
26%
LO 1
The Leasing Environment
► International Lease Finance Corp.
1. 100% financing at fixed rates.
2. Protection against obsolescence.
3. Flexibility.
4. Less costly financing.
5. Tax advantages.
6. Off-balance-sheet
financing.
Advantages of Leasing
LO 1
The Leasing Environment
LO 1
Capitalize a lease that transfers substantially all of the
benefits and risks of property ownership, provided the
lease is noncancelable.
Conceptual Nature of a Lease
Leases that do not transfer
substantially all the benefits
and risks of
ownership are operating leases.
LO 1
The Leasing Environment
For a capital lease, the FASB has identified four criteria.
1. Lease transfers ownership of the property to the lessee.
2. Lease contains a bargain-purchase option.
3. Lease term is equal to 75 percent or more of the estimated
economic life of the leased property.
One or more must be met for capital
lease accounting.
4. The present value of the minimum lease
payments (excluding executory costs)
equals or exceeds 90 percent of the fair
value of the leased property.
Accounting by the Lessee
LO 2
Capitalization Criteria
Transfer of Ownership Test
If the lease transfers ownership of the asset to the
lessee, it is a capital lease.
Bargain-Purchase Option Test
At the inception of the lease, the difference between
the option price and the expected fair market value
must be large enough to make exercise of the option
reasonably assured.
Accounting by the Lessee
LO 2
Economic Life Test (75% Test)
Lease term is generally considered to be the fixed,
noncancelable term of the lease.
Bargain-renewal option can extend this period.
At the inception of the lease, the difference between the
renewal rental and the expected fair rental must be
great enough to make exercise of the option to renew
reasonably assured.
Capitalization Criteria
Accounting by the Lessee
LO 2
Recovery of Investment Test (90% Test)
Minimum Lease Payments: Minimum rental payment
Guaranteed residual value
Penalty for failure to renew or extend the lease
Bargain-purchase option
Executory Costs: Insurance
Maintenance
Taxes
Exclude from present value of Minimum Lease Payment
Calculation
Capitalization Criteria
Accounting by the Lessee
LO 2
Discount Rate
Capitalization Criteria
Lessee computes the present value of the minimum lease
payments using its incremental borrowing rate, with one
exception.
► If the lessee knows the implicit interest rate computed
by the lessor and it is less than the lessee’s incremental
borrowing rate, then lessee must use the lessor’s rate.
Accounting by the Lessee
LO 2
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.
Asset and Liability Accounted for Differently
Accounting by the Lessee
LO 2
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.
Asset and Liability Accounted for Differently
Accounting by the Lessee
LO 2
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.
Asset and Liability Accounted for Differently
Accounting by the Lessee
LO 2
Operating Method (Lessee)
The lessee assigns rent to the periods
benefiting from the use of the asset and
ignores, in the accounting, any commitments to
make future payments.
Accounting by the Lessee
LO 2
LO 3
1. Interest revenue.
2. Tax incentives.
3. High residual value.
Benefits to the Lessor
LO 4
Accounting by the Lessor
A lessor determines the amount of the rental, basing it on the rate
of return—the implicit rate—needed to justify leasing the asset.
If a residual value is involved (whether guaranteed or not), the
company would not have to recover as much from the lease
payments.
Economics of Leasing
LO 4
Accounting by the Lessor
A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not.
Classification of Leases by the LessorIllustration 21-10
LO 4
Accounting by the Lessor
In substance the financing of an asset purchase by the
lessee.
Lessor records:
A lease receivable instead of a leased asset.
Receivable is the present value of the minimum lease
payments.
Direct-Financing Method (Lessor)
Accounting by the Lessor
LO 5
Records each rental receipt as rental revenue.
Depreciates leased asset in the normal manner.
Operating Method (Lessor)
Accounting by the Lessor
LO 5
a. Operating leases.
b. Direct-financing leases.
c. Sales-type leases.
Classification of Leases by the Lessor
LO 4
Accounting by the Lessor
LO 8
General description of the nature of leasing arrangements.
The nature, timing, and amount of cash inflows and outflows
associated with leases, including payments to be paid or
received for each of the five succeeding years.
The amount of lease revenues and expenses reported in the
income statement each period.
Description and amounts of leased assets by major balance
sheet classification and related liabilities.
Amounts receivable and unearned revenues under lease
agreements.
Disclosing Lease Data
Special Lease Accounting Problems
LO 9
To avoid leased asset capitalization, companies design, write,
and interpret lease agreements to prevent satisfying any of the
four capitalized lease criteria.
The real challenge lies in disqualifying the lease as a capital
lease to the lessee, while having the same lease qualify as a
capital (sales or financing) lease to the lessor.
Unlike lessees, lessors try to avoid having lease arrangements
classified as operating leases.
Unresolved Lease Accounting Problems
LO 9
LO 9
LO 9
LO 9
Allocating costs of long-lived assets:
Fixed assets = Depreciation expense
Intangibles = Amortization expense
Natural resources = Depletion expense
Depreciation is the accounting process of allocating the cost
of tangible assets to expense in a systematic and rational
manner to those periods expected to benefit from the use of
the asset.
LO 1 Explain the concept of depreciation.
LO 2 Identify the factors involved in the depreciation process.
Factors Involved in the Depreciation Process
Three basic questions:
(1)What depreciable base is to be used?
(2)What is the asset’s useful life?
(3)What method of cost apportionment is best?
Some companies try to imply that depreciation is not a cost. For example, in their press releases they will often make a bigger deal over earnings before interest, taxes, depreciation, and amortization (often referred to as EBITDA) than net income under GAAP. They like it because it “dresses up” their earnings numbers. Some on Wall Street buy this hype because they don’t like the allocations that are required to determine net income. Some banks, without batting an eyelash, even let companies base their loan covenants onEBITDA. For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its EBITDA performance. But that number masks a big part of how the company operates—and how it spends its money. Premier argues that analysts should ignore depreciation for big-ticket items like roller coasters because the rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50 percent of its EBITDA just to keep its rides and attractions current. Those expenses are not optional—let the rides get a little rusty, and ticket
WHAT’S YOUR PRINCIPLEWHAT’S YOUR PRINCIPLE
sales start to tail off. That means analysts really should view depreciation associated with the costs of maintaining the rides (or buying new ones) as an everyday expense. It also means investors in those companies should have strong stomachs. What’s the risk of trusting a fad accounting measure? Just look at one year’s bankruptcy numbers. Of the 147 companies tracked by Moody’s that defaulted on their debt, most borrowed money based on EBITDA performance. The bankers in those deals probably wish they had looked at a few other factors. On the other hand, nonfinancial companies in the S&P 500 generated a substantial EBITA margin of 20.9 percent in 2011. Some analysts are concerned that such a high number suggests that companies are reluctant to incur costs and want to stockpile cash. The lesson? Investors will do well to avoid focus on any single accounting measure.
Source: Adapted from Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune (July 10, 2000), p. 240; and V. Monga, “Operating Efficiency Runs High at U.S. Firms,” Wall Street Journal (February 28, 2012), p. B7.
Events leading to an impairment:
a. Significant decrease in the fair value of an asset.
b. Significant change in the manner in which an asset is used.
c. Adverse change in legal factors or in the business climate that
affects the value of an asset.
d. An accumulation of costs in excess of the amount originally
expected to acquire or construct an asset.
e. A projection or forecast that demonstrates continuing losses
associated with an asset.LO 5
When the carrying amount of an asset is not recoverable, a
company records a write-off referred to as an impairment.
1. Review events for possible impairment.
2. If the review indicates impairment, apply the recoverability
test. If the sum of the expected future net cash flows from the
long-lived asset is less than the carrying amount of the asset,
an impairment has occurred.
3. Assuming an impairment, the impairment loss is the amount
by which the carrying amount of the asset exceeds the fair
value of the asset. The fair value is the market value or the
present value of expected future net cash flows.
Measuring Impairments
LO 5 Explain the accounting issues related to asset impairment.
LO 5
Loss reported as part of income from continuing operations, in the “Other expenses and losses” section.