Accounting For Lease

ACCOUNTING FOR LEASES

Accounting by the Lessor/Lessee A lease is a contractual agreement: - lessor (Owner of Property) conveys the right to use property to - lessee (User/Renter) in return for periodic cash payments - For stated period of time

Classification of leases>>>

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CLASSIFICATION OF LEASE LEASES LESSOR

LESSEE CAPITAL LEASE

OPERATING LEASE

transfers ownership

rental agreements

OPERATING LEASE

DIRECT FINANCING

CAPITAL LEASE

SALES TYPE

Classification Criteria:…> 3

CLASSIFICATION OF LEASE LEASES PART I

PART II LESSOR

LESSEE CAPITAL LEASE

OPERATING LEASE

transfers ownership

rental agreements

Classification Criteria:…> 4

Operating Lease (Rental Approach) - Lessee Lease payment

Rent Expense

Lease bonus - additional to periodic rental

Prepaid rent expense – subject to amortization over the lease term

Leasehold improvement

Depreciated over the life of improvement or lease term whichever is shorter

Residual value of leasehold improvement

Ignore in computations of depreciations

Security deposit

Accounted as asset

Incentives given by lessor

Includes rent free periods or contributions by the lessor to the lessee’s relocation – is amortized over the life of the lease. 5

Illustration - Lessee On January 1, 2015, Easy Company lease equipment from another entity for P300,000 annually for three years.

Rent Expense Cash

300,000 300,000

Made a security deposit P300,000 refundable upon the lease expiration

Rent Deposit Cash

300,000 300,000

In addition to the annual rental, the company on paid P60,000 to the lessor as a lease bonus on January 1, 201.5

Prepaid Rent Cash

60,000 60,000

Amortization of lease bonus

Rent Expense Prepaid Rent

20,000 20,000

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Operating Lease - Lessor Rental receive

Rent Income

Lease property

Remain an asset by lessor / record the depreciation

Initial direct cost

Added to the carrying amount of the leased asset and recognized as expense over the lease term - Maybe spread over the life of the lease or charged when incurred.

Security deposits

Accounted as liability

Lease bonus

Treated as unearned rent income to be amortized over the lease term

Difference Realized amount and Amounts Received

Adjusted to lease receivables or deferred income 7

Illustration - Lessor On. Jan. 1, 2015 – Simple company purchased machinery for P3,000,000 cash for the purpose of leasing it. Useful life of 10-year with no residual value

Machinery Cash

3,000,000 3,000,000

Leased the machine to another entity at a monthly rental of P50,000, payable at the beginning of every month

Cash (50,000x9) Rent Income

450,000 450,000

Security Deposit P600,000

Cash 600,000 Liability for rent deposit 600,000

Lease bonus P 120,000

Cash 120,000 Unearned Rent Income 120,000

Paid initial direct cost P300,000

Deferred initial direct cost Cash

300,000 300,000

Paid repair and maintenance cost P20,000

Repair and Maintenance Cash

20,000 20,000

Amortization of lease bonus (40,000 x 9/12)

Unearned Rent Income Rent Income

30,000 30,000

Depreciation of machinery

Depreciation Expense Accu. Depreciation

300,000 300,000

Amortization of initial direct cost

Amortization of Initial Direct Cost Deferred Initial Direct Cost

75,000 75,000 8

Unequal Rental Payments - Simply means that where the operating lease requires unequal lease payments, the total cash payment for the lease term shall be amortized uniformly on the straight line basis.

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Illustration Aye Company leased office space to Bee Company for a 3 year period beginning January 1, 2015. Under the terms of the operating lease, rent for the 1st year is P1,000,000, and rent for the next 2 years, P1,250,000 annually. However, as an inducement to enter the lease, Aye granted Bee the first six month of the lease rent free. 10

Entries Terms

Lessor

Lessee

2015

Cash 500,000 Rent Receivable 500,000 Rent Income 1,000,000

Rent Expense Cash Rent Payable

1,000,000 500,000 500,000

2016

Cash 1,250,000 Rent Income 1,000,000 Rent Receivable 250,000

Rent Expense Rent Payable Cash

1,000,000 250,000 1,250,000

2017

Cash 1,250,000 Rent Income 1,000,000 Rent Receivable 250,000

Rent Expense Rent Payable Cash

1,000,000 250,000 1,250,000

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CRITERIA 1. Transfer of Ownership The lease contract includes a provision that the title to the leased asset passes to the lessee by the end of the lease term

2. Bargain Purchase Option (BPO) Makes it reasonably assured that the lessee will acquire asset

allows the lessee to buy the leased asset at a price significantly lower than the asset’s fair value when the option is exercisable (BARGAIN PRICE)

3. Term: 75% of economic Life – Lease term is equal to 75% or more of the economic life of the leased asset

4.

Asset Value: Present value of the minimum lease payments is greater than or equal to 90% of the FMV of the leased asset on the lease signing - what is included in Lease payments12

CLASSIFICATION CLASSIFICATION OF OF LEASE:LESSEE LEASE:LESSEE MUST MEET JUST ONE CRITERIA

Lease Agreement Non-Cancellable

No

No

O p e r a t i n g

No

Transfer of Ownership

Bargain Purchase

Lease Term >= 75%

PV of Payments >= 90%

Yes

Yes

Yes

Yes

No

L e a s e

Capital Lease 13

ACCOUNTING FOR CAPITAL LEASE: LESSEE LESSEE Asset user Asset & Liability are recognized -Amount: PV of Lease payments -Including any BPO or Guarantee Residual Value (GRV) Lease payments reduction in Lease Liability & Increases to interest expense (relates to liability) Asset is subsequently Depreciated *

Let’s Illustrate… 14

ACCOUNTING FOR CAPITAL LEASE PURCHASE/OWNERSHIP LESSEE (books)

• • • •

Determine the criteria: 1. Ownership transfer 2. Bargain purchase option 3. PV of MLP (minimum lease payment) is equal to 90% of more • 4. Lease term 75% or more of estimated economic life 15

Calculation of CAPITAL LEASE LESSEE (books) • Determine the criteria: (any one…) • Lease is classified as: CAPITAL LEASE LESSEE’S BOOKS

DR. ASSET: LEASE PROPERTY CR. LEASE OBLIGATION (PAYABLE)

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CAPITALIZED AMOUNT Lessee • The Lessee records the lease an asset/liability: LESSER OF: 1. FAIR VALUE of the asset at the inception of lease or 2. PV of MLP (PVMLP) whichever is lower Question: what should be included in the PVMLP 17

Residual Value (RV) Guaranteed or Unguaranteed • Estimated Value at the end of the lease term! • GUARANTEED RV is additional payment at the end of the lease term • If Bargain Purchase Option: –GRV becomes

irrelevant

• UNGUARANTEED: not required to make additional payment at the end of the lease term 18

Accounting Accounting by by the the Lessee Lessee PV OF MINIMUM LEASE PAYMENTS (PVMLP) Minimum lease payments: 

PV rental payment (usually beginning of the period)

Plus: PV Guaranteed residual value  (unguaranteed : NOT included in PVMLP)

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Illustration On January 1, 2015, an entity leased a machinery for 4 years which is the same as the useful life of the machinery at annual rental of P100,000 payable at the end of each year. The lessee provides for a transfer of ownership of the leased asset to the lessee at the end of the lease term. The implicit interest rate is 12%. Entry:

Machinery 303,730 Lease liability

303,730

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Depreciation of Asset: Rules*: • Transfer of Ownership: Depreciate over asset life • Bargain purchase option: Depreciate over the asset life • Term (75%) : Depreciate between the life of asset or lease term whichever is shorter • Asset Value (90% FV): Depreciate between the life of asset or lease term whichever is shorter 21

Accounting for rental payment Interest Expense = Face Value – Present Value = P100,000 – 303,730 = P96,270 Date

Payment

Interest

Principal

Jan. 1, 2015

Present Value 303,730

Dec. 31, 2015

100,000

36,448

63,552

240,178

Dec. 31, 2016

100,000

28,821

71,179

168,999

Dec. 31, 2017

100,000

20,280

79,720

89,279

Dec. 31, 2018

100,000

10,721

89,279

Entries Dec. 31, 2015 Interest Expense Lease liability Cash

36,448 63,552 100,000

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Executory Costs • Ownership of the asset is responsible for Insurance, maintenance, etc Capital Lease: Lessee gets the benefit of using the asset (LESSEE’s expense) Dr. Maintenance expense (executory costs) Cr Cash • (if included in lease payment – deduct to calculate PV MLP) • If lessor makes the payment, these costs are reimbursed by lessee by recording the expense

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CAPITAL Leases - Lessee The amount recorded (capitalized) is the PVMLP. However, the amount recorded cannot exceed the fair value of the leased asset. the interest rate used by the lessee is the lower of: 1. Its incremental borrowing rate, or 2. The implicit interest rate used by the lessor.

Bargain Purchase Option Lessee Company leased a machine on January 1, 2015 with the following pertinent information: Annual rental payable at the end of each year 1,000,000 Lease term 10-years Useful life of machine 12-years Incremental borrowing rate of lessee 14% Implicit interest rate of lessor known to lessee 12% Present value of ordinary annuity of 1 for 10 periods at 14% 5.216 12% 5.650 Present value of 1 for 10 periods at 14% 0.270 12% 0.322 Lessee Company has the option to purchase the machine upon the lease expiration on January 1, 2025 by paying P500,000 which is sufficiently lower than the expected fair value of the machine on January 1, 2025. At the inception of the lease, the bargain purchase option is reasonably certain to be exercised. The estimated residual value of the machine at the end of the 12-year life is P600,000.

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Capitalist cost of the machine Present value of rentals (1,000,000 x 5.65 Present value of bargain purchase option (500,000 x .322) Total lease liability

6,650,000 161,000 5,811,000

Schedule of payments: Page 403 Acquisition of machinery

Machinery 5,811,000 Lease liability 5,811,000

First rental payment

Interest Expense Lease liability Cash

Annual depreciation

Depreciation 434,250 Accu. Depreciation 434,250

697,320 302,680 1,000,000 26

Exercise the bargain purchase option

Lease liability Cash

Not exercise the bargain purchase option

Machinery 500,000 Acc. Depreciation 500,000 (434,250 x 10) Carrying Amount 1/1/25 Lease liability 1/1/25 Loss on finance lease

5,811,000 4,342,500 1,468,500 500,000 968,500

Entry: Accu. Depreciation 4,342,500 Lease liability 500,000 Loss on finance lease 968,500 Machinery 5,811,000

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Guaranteed residual value Easy Company leased an equipment on January 1, 2015 with the following information: Annual rental payable at the end of each lease year 1,000,000 Lease term 4 years Useful life of equipment 5 years Implicit interest rate 10% Present value of an ordinary annuity of 1 for 4 periods at 10% 3.16987 Present value of 1 for 4 periods at 10% 0.683 Easy Company has guaranteed a P200,000 residual value on December 31, 2018 to the lessor. Note: As long as there is a guaranteed residual value, there is no more bargain purchase option because the equipment will revert back to the lessor upon the expiration of the lease on December 31, 2018. 28

Computations Present Value of rental payments (1,000,000 x 3.16987) 3,169,970 Present value of guaranteed residual value (200,000 x .683) 136,600 Date lease liability Payment Interest Principal Present value Total 3,306,470 1/1/2015 3,306,470 12/31/2015

1,000,000

330,647

669,353

2,637,117

12/31/2016

1,000,000

263,711

736,289

1,900,828

12/31/2017

1,000,000

190,082

809,918

1,090,910

12/31/2018

1,000,000

109,090

890,910

200,000

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Entry Acquisition Equipment Lease liability

3,306,470 3,306,470

Payment of rent Interest Expense Lease liability Cash

330,647 669,353 1,000,000

Depreciation Depreciation = 3,306,470 -200,000/5 = 776,617

Depreciation Expense 776,617 Accu. Depreciation 776,617

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Return of equipment to lessor Final payment Interest expense Lease liability Cash

109,090 890,910 1,000,000

Return of equipment to the lessor Loss on finance lease = Fair Value < Guaranteed residual value

Accu. Depreciation Lease liability Equipment

3,106,470 200,000 3,306,470

And Fair value > guaranteed residual value = no gain because no payment the asset revert back to lessor 31

Illustration 2 – Guaranteed residual value Simple Company leased an equipment on January 1, 2015 with the following information: Annual rental payable in advance at the beginning of each year lease year 1,000,000 Initial direct cost paid on January 1, 2015 100,000 Lease term 5 years Useful life of equipment 6 years Implicit interest rate 8% Present value of an annuity of I in advance at 8% for 5 years 4.3121 Present value of 1 at 8% for 5 periods .6806 The equipment has guaranteed a P300,000 residual value on January 1, 2020 to the lessor. The equipment will revert to the lessor upon the lease expiration on January 1, 2020. Present value of rentals (1,000,000 x 4.3121) PV of guaranteed residual value (300,000 x .6806) Lease liability Initial direct cost Total cost of equipment

4,312,100 204,180 4,516,280 100,000 4,616,280 32

Computation Date

Payment

Interest

Principal

1/1/15

Present Value 4,516,280

1/1/15

1,000,000

-

1,000,000

3,516,280

1/1/16

1,000,000

281,302

718,698

2,797,582

1/1/17

1,000,000

223,807

776,193

2,021,389

1/1/18

1,000,000

161,711

838,289

1,183,100

1/1/19

1,000,000

94,648

905,352

277,748

1/1/20

300,000

22,252

277,748

-

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Entries 2015 Acquisition

Equipment Lease liability Cash

4,616,280 4,516,280 100,000

First payment

Lease liability Cash

Accrual of interest

Interest Expense 281,302 Accrued Interest Payable 281,302

Depreciation (4,616,280 – 300,000 / 5)

Depreciation expense Accu. Depreciation

2016 Second payment

Accrued interest payable 281,302 Lease liability 718,698 Cash 1,000,000

Accrual of interest

Interest expense 223,807 Accrued interest payable 223,807

Depreciation

Depreciation expense Accu. Depreciation

1,000,000 1,000,000

863,256 863,256

863,256 863,256

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Return of asset to lessor Assume that on January 1, 2020 the fair market value is P400,000. Entry: Accumulated depreciation 4,316,280 Lease liability 277,748 Accrued interest payable 22,252 Equipment 4,616,280 35

Unguaranteed Residual Value Ezzy Company leased an equipment on January 1,2015 with the following information: Annual rental payable at the end of each year Lease term Useful life of equipment Implicit interest rate Present value of an ordinary annuity of 1 at 10% Present value of 1 at 10% for 6 periods

600,000 6 years 8 years 10% 4.36 0.56

The lease provides for neither a transfer of title nor a bargain purchase option. Thus, the equipment will revert back to lessor upon the expiration of lease on January 1, 2021. The equipment has an estimated residual value of P200,000 but the amount is unguaranteed by the lessee.

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Entries Acquisition

Equipment Lease liability

2,616,000 2,616,000

First payment of rental

Interest Expense Lease liability Cash

Depreciation = 2,616,000/6 = 436,000

Depreciation expense 436,000 Accu. Depreciation 436,000

Return of equipment

Accu. Depreciation Equipment

261,600 338,400 600,000

2,616,000 2,616,000

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Actual purchase of lease asset Cost = Carrying amount of lease asset + Cash payment Balance of lease liability

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Illustration

An entity purchased an equipment that it had been leasing under finance lease for P4,000,000. The balances of certain accounts on the date of actual purchase are as follows: Equipment under finance lease Accumulated depreciation Lease liability Cost of equipment Accu. Depreciation Carrying amount Cash payment Total consideration Lease liability Cost of equipment

5,000,000 1,500,000 3,500,000 4,000,000 7,500,000 3,800,000 3,700,000

5,000,000 1,500,000 3,800,000 Entry Equipment 3,700,000 Acc. Depreciation 1,500,000 Lease Liability 3,800,000 Equipment 5,000,000 Cash 4,000,000

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Problem 1 On December 1, 2014, Iliad Company leased office space for 5 years at a monthly rental of P60,000. On the same date, the company paid the lessor the following: First month rent 60,000 Last month’s rent 60,000 Security deposit(refundable at lease expiration) 80,000 Installation of new walls and offices 360,000 How much is the total expense that Iliad should report in its December 31, 2014 profit or loss relating to the utilization of office space?

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Problem 2 On January 1, 2014, Nickel Co. signed a 10-year operating lease for office space at P576,000 per year. The lease included a provision for additional rent of 5% annual company sales in excess of P3,000,000. Nickel’s sales for the year ended December 31, 2014 were P3,600,000. Upon the execution of the lease, Nickel paid P144,000 as a bonus for the lease. How much should Nickel’s rent expense for the year ended December 31, 2014?

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Problem 3 On July 1, 2014, Radium Inc. leased a delivery truck from Titanium Corp. Under a 3-year operating lease. Total rent for the term of the lease will be P360,000 payable as follows: 12 months at P5,000 per month 12 months at P7,500 per month 12 months at P17,500 per month

= P60,000 = 90,000 = 210,000

All expenses were made when due. In Radium’s June 30, 2016 balance sheet, what amount should be reported as accrued rent payable?

42

Problem 4 As an inducement to enter a lease, Athena, a lessor, grants Zeus Corp. a lessee, months of free rent under a 5-year operating lease. The lease is effective July 1, 2014 and provides for a monthly rental of P20,000 to begin April 1, 2015. In Zeus’ income statement for the year ended June 30, 2015, how much should be reported as rent expense?

43

Problem 5 Wall Co. leased office premises to Fox, Inc. for a 5-year term beginning January 1, 2014.Under the terms of the operating lease, rent for the first year is P80,000 and rent for 2 years to 5 is P125,000 per annum. However, as an inducement to enter the lease, Wall granted Fox the first 6 months of the lease rent-free. In its December 31, 2014 profit or loss, what amount should Fox as rental expense?

44

Problem 6 Christian Company, a lessor of office machines, purchased a new machine for P600,000 on January 1, 2014 which was leased the same day to Dior. The machine will be depreciated at P55,000 per year. The lease is for four-year period expiring January 1, 2018 and provides for annual rental payments of P100,000 beginning January 1, 2014. In addition, Dior paid P64,000 to Christian as lease bonus. In its 2014 profit and loss, what amount of revenue and expense should Christian report on this leased asset?

45

Problem 7 Dream Company, a lessor of office machines, purchased a new machine for P500,000 on January 1, 2014, which was leased the same day to Girl Company. The machine is expected to have a ten-year life and will be depreciated P50,000 per year. The lease is for three-year period expiring January 1, 2017 and provides for annual rental payments of P100,000 beginning January 1, 2014.In Addition, Girl paid P60,000 as a lease bonus to obtain a three-year lease. In its 2014 profit or loss, what amount should Dream report as operating profit on this leased asset?

46

Problem 8 On December 31, 2014, Soap Corporation signed an operating lease for a warehouse with Opera Company for ten years at P30,000 per year. Upon the execution of the lease, Opera paid Soap P60,000, covering rent reported P60,000 as gross income in its 2014 income tax return. How much should shown in Soap’s 2014 profit or loss as gross rental income?

47

Problem 9 On January 1, 2014, Bauman Company leased a warehouse to Cuban under an operating lease for ten years at P100,000 per year, payable the first day of each lease year. Bauman paid P45,000 to real estate broker as finder’s fee. The warehouse is depreciated P25,000 per year. During 2014, Bauman incurred insurance and property tax expense of P18,750, How much should Bauman’s net rental income for 2014?

48

Problem 10 On January 2, 2014, Sunrise Company leased a warehouse to Sunshine Corporation under operating lease for ten years at P80,000 per year payable on the first day of each lease year. Sunrise Company agrees to pay the lessee’s relocation/moving cost as an incentive to Sunshine Corporation for entering into the new lease. The moving cost is P6,000. What amount of rent income should Sunrise Company recognize in its 2014 profit or loss?

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LEASE PART II Accounting for Leases- Lessor

• Classification of Lease: LESSOR’S BOOK

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CLASSIFICATION OF LEASE: LESSOR LEASES LESSOR

LESSEE CAPITAL LEASE

OPERATING LEASE

OPERATING LEASE

DIRECT FINANCING

CAPITAL LEASE

SALES TYPE

Classification Criteria:…> 51

Accounting Accounting by by the the Lessor Lessor Classification of Leases by the Lessor

52

Accounting Accounting by by the the Lessor Lessor Classification of Leases by the Lessor

If any costs to the lessor to be incurred, are reasonably predictable A lessor may classify a lease as an operating lease but the lessee may classify the same lease as a capital lease. 53

Nonoperating Leases: - Lessor If the lessor is not a manufacturer or dealer, the fair value of the leased asset is typically the lessor’s costDIRECT FINANCING LEASE

When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease is likely to be its normal selling price – SALES TYPE LEASE

Direct-Financing Lease: Lessor

Depreciation: NOT RECORDED BY LESSOR • Asset is removed from the Lessor’s books

Illustration: DIRECT FINANCING…. LESSOR-

56

Direct Financing Lease Source of Income – interest income -Is actually engaged in financing business. -No dealer profit is recognized because the Fair Value = Cost of the Asset 57

Accounting Considerations Gross Investment

= Gross rentals + absolute amount of Residual value (whether guaranteed or unguaranteed)

Net Investment in lease

= Cost of the asset + Initial direct cost paid by the lessor

Unearned Interest Income

= Gross Investment – Net investment in lease

Initial direct cost

= added to the cost of the asset = subject for amortization

58

Illustration On January 1, 2015, Lessor Company leased a machinery to another entity with the following details: Cost of machinery 1,518,650 Annual rental payable at the end of each year 500,000 Lease term 4 years Useful life of machinery 4 years Implicit interest rate 12% Present value of annuity of 1 for 4 years at 12% 3.0373 The initial problem is the determination of annual rental which will give the lessor fair rate of return on the net investment in the lease. Assume desired rate of return is 12% 59

Computation Gross rentals or lease receivables (500,000 x 4) 2,000,000 Less: PV of the gross rentals (equal to the net investments in the lease or cost of machinery) 1,518,650 Unearned Interest Income 481,350 Entry: Lease receivable 2,000,000 Machinery 1,518,650 Unearned Interest Income 481,350 Collection: Cash 500,000 Lease Receivable 500,000 Amortization of Interest Unearned Interest Income 182,238 Interest Income 182,238 Amortization Table: See page 454

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Direct Financing – with initial direct cost On January 1, 2015, Lessor Company leased a machinery to another entity with the following details: Cost of machinery 1,518,650 Annual rental payable at the end of each yea 500,000 Lease term 4 years Useful life of machinery 4 years Implicit interest rate 12% Present value of annuity of 1 for 4 years at 12% 3.0373 On January 1, 2015, The lessor Company paid initial direct cost of P66,300. Computations: Cost of machinery 1,518,650 Initial direct cost 66,300 Net investment in the lease 1,584,950 Determine the reduced implicit interest rate?

Direct Financing – with residual value On January 1, 2015, Lessor Company leased a machinery to another entity with the following details: Cost of machinery 3,194,410 Residual Value 500,000 Lease term 4 years Implicit Interest Rate 10% Present value of 10% for 4 periods .6830 PV of an ordinary annuity of 1 at 10% for 4 years 3.1699 The machinery will revert to the lessor at the end of the lease term because there is neither a transfer of title nor a bargain purchase option. Determine the annual payment? Cost of machinery 3,194,410 Less: Present value of Residual Value 341,500 Net investment to be recovered from rental 2,852,910 Divide by PV of an ordinary annuity of 1 3.1699 Annual rental payment 900,000

Amortization Table Gross Rentals (900,000 x 4) Residual Value Gross Investment Less: Cost of machinery Unearned Interest Income Date

Payment

Interest

3,600,000 500,000 4,100,000 3,194,410 905,590 Principal

1-1-2015

Present Value 3,194,410

12-31-2015

900,000

319,441

580,559

2,613,851

12-31-2016

900,000

261,385

638,615

1,975,236

12-31-2017

900,000

197,524

702,476

1,272,760

12-31-2018

900,000

127,240

772,760

500,000

63

Entry To record the lease - 2015

Lease Receivable Machinery Unearned interest income

4,100,000 3,194,410 905,590

Annul collection

Cash Lease receivable

900,000 900,000

Interest Income

Unearned interest income Interest income

319,441 319,441

Expiration – Guaranteed or not Revert back to lessor

Machinery Lease receivable

FMV < Residual Value Guaranteed – Lessee will pay

Cash Machinery Lease receivable

Unguaranteed

Loss on finance lease Machinery Lease receivable

500,000 500,000 100,000 400,000 500,000 100,000 400,000 500,000 64

Direct Financing – wl R/V – advance payment On January 1, 2015, Lessor Company leased a machinery to another entity with the following details: Cost of machinery 3,760,100 Residual Value - guaranteed 400,000 Lease term 4 years Implicit interest rate 10% Present value of 10% for 4 periods .6830 PV of an ordinary annuity of 1 in advance 3.4869 The annual rental is payable in advance on January 1 of each year starting January 1, 2015. Computation: Cost of machinery 3,760,100 Less: PV of R/V (400,000 x. 6830) 283,200 Net investment to be recovered from rental 3,486,900 Divide : PV of annuity in advance 3.4869 Annual rental payment 1,000,000

Initial Direct Costs

•• •• ••

costs costs incurred incurred by by the the lessor lessor in in negotiating/preparing negotiating/preparing aa lease lease agreement. agreement. e.g. e.g. Legal Legal fees, fees, commissions commissions Operating Operating Leases Leases −− Capitalize Capitalize and and amortize amortize over over the the lease lease term term by by the the lessor. lessor. Direct Direct Financing Financing Leases Leases −− not not expensed expensed ;; deferred deferred and and recognized recognized over over the the lease lease term term Sales Sales type type leases leases:: expensed expensed at at the the inception inception of of the the lease lease (selling (selling expense) expense)

How should the lease be classified by LESSOR • Since the fair value equals the lessor’s carrying value, there is no dealer’s profit, making this a direct financing lease. • Prepare appropriate entries for Canfor (lessor)

67

Sales-Type Lease: LESSOR

Total payments – sale price = interest

Accounting for Sales-Type Lease LESSOR Record: 1. Receivable (PV) & Sales 2. Cost of goods sold / reducing the inventory 3. Any Initial Direct Costs recognized as an expense immediately 4. Reimbursement of executory costs – same as direct financing 69

Sales Type Lease with Guaranteed Residual Value • Guaranteed Residual Value: Both Lessee and Lessor include Guaranteed Residual Value in calculating MLP • If RV is not guaranteed by Lessee (Lessee exclude in MLP) • LESSOR: – Lessor : even if it is not guaranteed by lessee, lessor expects to receive from 3rd party – Includes residual value in their receivable – But the sales revenue and COGS are reduced by the same amounts

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Lessee Disclosures • For capital leases, disclose – Gross amount of assets recorded under capital leases. – Future MLP in the aggregate and for each of the five succeeding years. – Total minimum sublease rentals to be received in the future under noncancelable subleases.

(continued)

International Accounting of Leases • IAS 17 relies on the exercise of accounting judgment to distinguish between operating and capital leases.