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Intermediate Accounting Kieso 11th Edition


Intermediate Accounting
Eleventh Edition

Chapter 21
Accounting for Leases

Donald E. Kieso Jerry J. Weygandt Terry D. Warfield

Intermediate Accounting

by: Donald E. Kieso, Ph.D., C.P.A. KPMG Peat Marwick Emeritus Professor of Accounting Northern Illinois University DeKalb, Illinois Jerry J. Weygandt, Ph.D., C.P.A. Arthur Andersen Alumni Professor of Accounting University of Wisconsin Madison, Wisconsin Terry D. Warfield, Ph.D. Associate Professor University of Wisconsin Madison, Wisconsin

Copyright ? 2004 John Wiley & Sons, Inc. All rights reserved. John Wiley & Sons, Inc. 111 River St., 6th Floor, Hoboken, NJ 07030 0471072087

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Table of Contents
BASICS OF LEASING..................................................................................................................... 3 Advantages of Leasing................................................................................................................ 3 Conceptual Nature of a Lease.................................................................................................... 5 ACCOUNTING BY LESSEE........................................................................................................... 7 Capitalization Criteria................................................................................................................. 8 Asset and Liability Accounted for Differently...................................................................... 11 Capital Lease Method (Lessee)................................................................................................ 12 Operating Method (Lessee)...................................................................................................... 16 Comparison of Capital Lease with Operating Lease............................................................ 16 ACCOUNTING BY LESSOR........................................................................................................ 19 Economics of Leasing................................................................................................................ 19 Classification of Leases by the Lessor..................................................................................... 20 Direct-Financing Method (Lessor)........................................................................................... 22 Operating Method (Lessor)...................................................................................................... 26 SPECIAL ACCOUNTING PROBLEMS..................................................................................... 27 Residual Values.......................................................................................................................... 27 Sales-Type Leases (Lessor)....................................................................................................... 34 Bargain Purchase Option (Lessee)........................................................................................... 37 Initial Direct Costs (Lessor)...................................................................................................... 38 Current versus Noncurrent...................................................................................................... 38 Disclosing Lease Data................................................................................................................ 40 LEASE ACCOUNTING—UNSOLVED PROBLEMS.............................................................. 43 Illustrations of Lease Arrangements........................................................................................... 50 HARMON, INC............................................................................................................................... 51 ARDEN'S OVEN CO...................................................................................................................... 52 MENDOTA TRUCK CO............................................................................................................... 54 APPLELAND COMPUTER........................................................................................................... 55 Sale-Leasebacks............................................................................................................................... 57 DETERMINING ASSET USE....................................................................................................... 58 Lessee........... 58 Lessor........... 59 SALE-LEASEBACK ILLUSTRATION........................................................................................ 60

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More Companies Ask, “Why Buy?” Leasing has grown tremendously in popularity and today is the fastest-growing form of capital investment. Instead of borrowing money to buy an airplane, a computer, a nuclear core, or a satellite, a company makes periodic payments to lease the asset. Even the gambling casinos lease their slot machines. Airlines and railroads lease huge amounts of equipment; many hotel and motel chains lease their facilities; and most retail chains lease the bulk of their retail premises and warehouses. The popularity of leasing is evidenced in the fact that 558 of 600 companies surveyed by the AICPA in 2001 disclosed lease data.1 A classic example is the airline industry. Many travelers on airlines such as United, Delta, and Southwest believe the planes they are flying are owned by these airlines. But in many cases, nothing could be further from the truth. Here are recent lease percentages for the major U.S. airlines.

Why do airline companies lease many of their airplanes? One reason is the favorable accounting treatment that airlines receive if they lease rather than purchase. By not reporting the airplane and related borrowing on their balance sheets, companies lower their debt to equity ratios. In addition, companies that lease often report higher net income in the earlier years of the life of the airplane.

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PREVIEW OF CHAPTER 21 Because of the increased significance and prevalence of lease arrangements indicated in the opening story, the need for uniform accounting and complete informative reporting of these transactions has intensified. In this chapter, we will look at the accounting issues related to leasing. The content and organization of this chapter are as follows.

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BASICS OF LEASING
Study Objective
Explain the nature, economic substance, and advantages of lease transactions. 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 in return for stipulated, and generally periodic, cash payments (rents). An essential element of the lease agreement is that the lessor conveys less than the total interest in the property. Because a lease is a contract, the provisions agreed to by the lessor and lessee may vary widely and may be limited only by their ingenuity. The duration—lease term—of the lease may be anything from a short period of time to the entire expected economic life of the asset. The rental payments may be level from year to year, increasing in amount, or decreasing. They may be predetermined or may vary with sales, the prime interest rate, the consumer price index, or some other factor. In most cases the rent is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease. The obligations for taxes, insurance, and maintenance (executory costs) may be assumed by either the lessor or the lessee, or they may be divided. Restrictions comparable to bond indentures may limit the lessee's activities regarding dividend payments or the incurrence of further debt and lease obligations in order to protect the lessor from default on the rents. The lease contract may be noncancelable, or it may grant the right to early termination on payment of a set scale of prices plus a penalty. In case of default, the lessee may be liable for all future payments at once, receiving title to the property in exchange. Alternatively, in case of default, the lessor may have the right to sell to a third party and collect from the lessee all or a portion of the difference between the sale price and the lessor's unrecovered cost. Different treatments for the lessee at termination of the lease may range from none to the right to purchase the leased asset at the fair market value or the right to renew or buy at a nominal price.

Advantages of Leasing
Although leasing is not without its disadvantages, the growth in its use suggests that it often has a genuine advantage over owning property. Some of the commonly discussed advantages to the lessee of leasing are: 1. 100% Financing at Fixed Rates. Leases are often signed without requiring any money down from the lessee, which helps the lessee to conserve scarce cash—an especially desirable feature for new and developing companies. In addition, lease payments often remain fixed, which protects the lessee against inflation and increases in the cost of
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money. The following comment regarding a conventional loan is typical: “Our local bank finally came up to 80 percent of the purchase price but wouldn't go any higher, and they wanted a floating interest rate. We just couldn't afford the down payment and we needed to lock in a final payment rate we knew we could live with.” 2. Protection against Obsolescence. Leasing equipment reduces the risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor. For example, Merck (a pharmaceutical maker) leases computers. Merck is permitted under the lease agreement to turn in an old computer for a new model at any time, canceling the old lease and writing a new one. The cost of the new lease is added to the balance due on the old lease, less the old computer's trade-in value. As one treasurer remarked, “Our instinct is to purchase.” But if a new computer comes along in a short time, “then leasing is just a heck of a lot more convenient than purchasing.” Flexibility. Lease agreements may contain less restrictive provisions than other debt agreements. Innovative lessors can tailor a lease agreement to the lessee's special needs. For instance, rental payments can be structured to meet the timing of cash revenues generated by the equipment so that payments are made when the equipment is productive. Less Costly Financing. Some companies find leasing cheaper than other forms of financing. For example, start-up companies in depressed industries or companies in low tax brackets may lease as a way of claiming tax benefits that might otherwise be lost. Depreciation deductions offer no benefit to companies that have little, if any, taxable income. Through leasing, these tax benefits are used by the leasing companies or financial institutions, which can pass some of the tax benefits back to the user of the asset in the form of lower rental payments. Some companies “double dip” on the international level too. That is, the leasing rules of the lessor's and lessee's countries may be different, permitting both parties to be an owner of the asset. Thus, both lessor and lessee receive the tax benefits related to depreciation. 5. Tax Advantages. In some cases, companies can “have their cake and eat it too.” That is, companies do not report an asset or a liability for the lease arrangement for financial reporting purposes. However, for tax purposes, the asset is capitalized and depreciated. As a result, the company takes deductions earlier rather than later and also saves on its taxes. A common vehicle for this type transaction is a “synthetic lease” arrangement. An expanded discussion of a synthetic lease used by Krispy Kreme is on page 1098. Off-Balance-Sheet Financing. Certain leases do not add debt on a balance sheet or affect financial ratios, and they may add to borrowing capacity.2 Such off-balance-sheet financing is critical to some companies.

3.

4.

6.

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O FF-BALANCE-SHEET FINANCING As shown in our opening story, the airlines use lease arrangements extensively, which results in a great deal of off-balance-sheet financing. The following chart indicates that debt levels are understated by a substantial amount for many airlines that lease aircraft.

Analysts must adjust reported debt levels for the effects of non-capitalized leases. For example, the estimates for additional debt in the chart above were derived by taking the present value of each airline's future operating lease payments, as disclosed in the lease note in the company's annual report (as shown in Illustration 32). A methodology for making this adjustment is discussed in Eugene A. Imhoff, Jr., Robert C. Lipe, and David W. Wright, “Operating Leases: Impact of Constructive Capitalization,” Accounting Horizons (March 1991).

Conceptual Nature of a Lease
If United Airlines borrows $47 million on a 10-year note from National City Bank to purchase a Boeing 757 jet plane, it is clear that an asset and related liability should be reported on United's balance sheet at that amount. If United purchases the 757 for $47,000,000 directly from Boeing through an installment purchase over 10 years, it is equally clear that an asset and related liability should be reported (i.e., the installment transaction should be “capitalized”). However, if United leases the Boeing 757 for 10 years through a noncancelable lease transaction with payments of the same amount as the installment purchase transaction, differences of opinion start to develop over how this transaction should be reported. The various views on capitalization of leases are as follows. 1. Do Not Capitalize Any Leased Assets. In this view, because the lessee does not have ownership of the property, capitalization is considered inappropriate. Furthermore, a lease is an “executory” contract requiring continuing performance by both parties. Because other executory contracts (such as purchase commitments and employment contracts) are not capitalized at present, leases should not be capitalized either.

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2.

Capitalize Leases That Are Similar to Installment Purchases. In this view, transactions should be reported in accordance with their economic substance. Therefore, if installment purchases are capitalized, so also should leases that have similar characteristics. For example, United Airlines is committed to the same payments over a 10-year period for either a lease or an installment purchase; lessees make rental payments, whereas owners make mortgage payments. Why shouldn't the financial statements report these transactions in the same manner? Capitalize All Long-Term Leases. Under this approach, the only requirement for capitalization is the long-term right to use the property. This property-rights approach capitalizes all long-term leases.3 Capitalize Firm Leases Where the Penalty for Nonperformance Is Substantial. A final approach is to capitalize only “firm” (noncancelable) contractual rights and obligations. “Firm” means that it is unlikely that performance under the lease can be avoided without a severe penalty.4 The issue of how to report leases is the classic case of substance versus form. Although legal title does not technically pass in lease transactions, the benefits from the use of the property do transfer.

3.

4.

In short, the various viewpoints range from no capitalization to capitalization of all leases. The FASB apparently agrees with the capitalization approach when the lease is similar to an installment purchase, noting that a lease that transfers substantially all of the benefits and risks of property ownership should be capitalized. Transfer of ownership can be assumed only if there is a high degree of performance to the transfer—that is, if the lease is noncancelable. Noncancelable means that the lease contract is cancelable only upon the outcome of some remote contingency, or that the cancellation provisions and penalties of the contract are so costly to the lessee that cancellation probably will not occur. Only noncancelable leases may be capitalized. This viewpoint leads to three basic conclusions: (1) The characteristics that indicate that substantially all of the benefits and risks of ownership have been transferred must be identified. (2) The same characteristics should apply consistently to the lessee and the lessor. (3) Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases. They should not be capitalized but rather accounted for as rental payments and receipts.

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ACCOUNTING BY LESSEE
Study Objective
Describe the accounting criteria and procedures for capitalizing leases by the lessee. If a lessee capitalizes a lease, the lessee records an asset and a liability generally equal to the present value of the rental payments. The lessor, having transferred substantially all the benefits and risks of ownership, recognizes a sale by removing the asset from the balance sheet and replacing it with a receivable. The typical journal entries for the lessee and the lessor, assuming equipment is leased and is capitalized, appear as follows.

Journal Entries for Capitalized Lease Having capitalized the asset, the lessee records the depreciation. The lessor and lessee treat the lease rental payments as consisting of interest and principal. If the lease is not capitalized, no asset is recorded by the lessee and no asset is removed from the lessor's books. When a lease payment is made, the lessee records rental expense and the lessor recognizes rental revenue. For a lease to be recorded as a capital lease, the lease must be noncancelable and must meet one or more of the following four criteria.

Capitalization Criteria for Lessee Leases that do not meet any of the four criteria are classified and accounted for by the lessee as operating leases. Illustration 3 shows that a lease meeting any one of the four criteria results in the lessee having a capital lease.

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Diagram of Lessee's Criteria for Lease Classification In keeping with the FASB's reasoning that a significant portion of the value of the asset is consumed in the first 75 percent of its life, neither the third nor the fourth criterion is to be applied when the inception of the lease occurs during the last 25 percent of the life of the asset.

Capitalization Criteria
The four capitalization criteria that apply to lessees are controversial and can be difficult to apply in practice. They are discussed in detail in the following pages.

Transfer of Ownership Test
If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is not controversial and is easily implemented in practice.

Bargain Purchase Option Test
Capitalization of leases illustrates the necessity for good definitions. The lease fits the definition of an asset, as it gives the lessee the economic benefits that flow from the possession or the use of the asset. A bargain purchase option is a provision allowing the lessee to purchase the leased property for a price that is significantly lower than the property's expected fair value at the date the option becomes exercisable. 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. For example, assume that you were to lease a Honda Accord for $599 per month for 40 months with an option to purchase for $100 at the end of the 40-month period. If the estimated fair value of the Honda Accord is $3,000 at the end of the 40 months, the $100 option to purchase is clearly a bargain, and therefore capitalization is required. In other cases, the criterion may not be as easy to apply, and determining now that a certain future price is a bargain can be difficult.

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Economic Life Test (75% Test)
If the lease period equals or exceeds 75 percent of the asset's economic life, most of the risks and rewards of ownership are transferred to the lessee, and capitalization is therefore appropriate. However, determining the lease term and the economic life of the asset can be troublesome. The lease term is generally considered to be the fixed, noncancelable term of the lease. However, this period can be extended if a bargain renewal option is provided in the lease agreement. A bargain renewal option is a provision allowing the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable. 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. In some nations (e.g., Italy, Japan) accounting principles do not specify criteria for capitalization of leases. In others (e.g., Sweden, Switzerland) such criteria exist, but capitalization of the leases is optional. For example, if a Dell PC is leased for 2 years at a rental of $100 per month and subsequently can be leased for $10 per month for another 2 years, it clearly is a bargain renewal option, and the lease term is considered to be 4 years. However, with bargain renewal options, as with bargain purchase options, it is sometimes difficult to determine what is a bargain.7 Determining estimated economic life can also pose problems, especially if the leased item is a specialized item or has been used for a significant period of time. For example, determining the economic life of a nuclear core is extremely difficult because it is subject to much more than normal “wear and tear.” The FASB takes the position that if the lease starts during the last 25 percent of the life of the asset, the economic-life test cannot be used as a basis to classify a lease as a capital lease.

Recovery of Investment Test (90% Test)
If the present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the asset, then the leased asset should be capitalized. The rationale for this test is that if the present value of the minimum lease payments is reasonably close to the market price of the asset, the asset is effectively being purchased. In determining the present value of the minimum lease payments, three important concepts are involved: (1) minimum lease payments, (2) executory costs, and (3) discount rate. Minimum Lease Payments. Minimum lease payments are payments the lessee is obligated to make or can be expected to make in connection with the leased property. They include the following. 1. Minimum Rental Payments—These are minimum payments the lessee is obligated to make to the lessor under the lease agreement. In some cases, the minimum rental

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payments may be equal to the minimum lease payments. However, the minimum lease payments also may include a guaranteed residual value (if any), penalty for failure to renew, or a bargain purchase option (if any), as noted on the next page. 2. Guaranteed Residual Value—The residual value is the estimated fair (market) value of the leased property at the end of the lease term. The lessor often transfers the risk of loss to the lessee or to a third party through a guarantee of the estimated residual value. The guaranteed residual value is (1) the certain or determinable amount at which the lessor has the right to require the lessee to purchase the asset or (2) the amount the lessee or the third-party guarantor guarantees the lessor will realize. If it is not guaranteed in full, the unguaranteed residual value is the estimated residual value exclusive of any portion guaranteed.8 Penalty for Failure to Renew or Extend the Lease—This is the amount payable that is required of the lessee if the agreement specifies that the lease must be extended or renewed and the lessee fails to do so. Bargain Purchase Option—As indicated earlier (on page 1090), this is an option given to the lessee to purchase the equipment at the end of the lease term at a price that is fixed sufficiently below the expected fair value, so that, at the inception of the lease, purchase appears to be reasonably assured.

3.

4.

Executory costs (defined below) are not included in the lessee's computation of the present value of the minimum lease payments. Executory Costs. Like most assets, leased tangible assets require the incurrence of insurance, maintenance, and tax expenses—called executory costs—during their economic life. If the lessor retains responsibility for the payment of these “ownership-type costs,” a portion of each lease payment that represents executory costs should be excluded in computing the present value of the minimum lease payments, because it does not represent payment on or reduction of the obligation. If the portion of the minimum lease payments that represents executory costs is not determinable from the provisions of the lease, an estimate of such amount must be made. Many lease agreements, however, specify that executory costs be paid to the appropriate third parties directly by the lessee. In these cases, the rental payment can be used without adjustment in the present value computation. Discount Rate. The lessee computes the present value of the minimum lease payments using the lessee's incremental borrowing rate. This rate is defined as, “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.”9 Assume, for example, that Mortenson Inc. decides to lease computer equipment for a 5-year period at a cost of $10,000 a year. To determine whether the present value of these payments is less than 90
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percent of the fair market value of the property, the lessee discounts the payments using its incremental borrowing rate. Determining that rate will often require judgment because it is based on a hypothetical purchase of the property. However, there is one exception to this rule: If (1) the lessee knows the implicit interest rate computed by the lessor and (2) it is less than the lessee's incremental borrowing rate, then the lessee must use the lessor's implicit rate. The interest rate implicit in the lease is the discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate present value to be equal to the fair value of the leased property to the lessor.10 The purpose of this exception is twofold: First, the implicit rate of the lessor is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for the lessee. Second, the guideline is provided to ensure that the lessee does not use an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be less than 90 percent of the fair market value of the property—and thus make it possible to avoid capitalization of the asset and related liability. The lessee may argue that it cannot determine the implicit rate of the lessor and therefore the higher rate should be used. However, in many cases, the implicit rate used by the lessor can be approximated. The determination of whether or not a reasonable estimate could be made will require judgment, particularly where the result from using the incremental borrowing rate comes close to meeting the 90 percent test. Because the lessee may not capitalize the leased property at more than its fair value (as discussed later), the lessee is prevented from using an excessively low discount rate.

Asset and Liability Accounted for Differently
In a capital lease transaction, the lessee is using the lease as a source of financing. The lessor finances the transaction (provides the investment capital) through the leased asset, and the lessee makes rent payments, which actually are installment payments. Therefore, over the life of the property rented, the rental payments to the lessor constitute a payment of principal plus interest.

Asset and Liability Recorded
Under the capital lease method, the lessee treats the lease transaction as if an asset were being purchased in a financing transaction in which an asset is acquired and an obligation created. Therefore, the lessee records a capital lease as an asset and a liability at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair market value of the leased asset at the inception of the lease. The rationale for this approach is that the leased asset should not be recorded for more than its fair market value.

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Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to the lessee (criterion 1) or contains a bargain purchase option (criterion 2)—the leased asset is depreciated in a manner consistent with the lessee's normal depreciation policy for owned assets, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain purchase option, then it is depreciated over the term of the lease. In this case, the leased asset reverts to the lessor after a certain period of time.

Effective-Interest Method
Throughout the term of the lease, the effective-interest method is used to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. The discount rate used by the lessee to determine the present value of the minimum lease payments must be used by the lessee when applying the effective-interest method to capital leases.

Depreciation Concept
Although the amounts initially capitalized as an asset and recorded as an obligation are computed at the same present value, the depreciation of the asset and the discharge of the obligation are independent accounting processes during the term of the lease. The lessee should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years'-digits, declining-balance, units- of-production, etc. The FASB uses the term “amortization” more frequently than “depreciation” to recognize intangible leased property rights. The authors prefer “depreciation” to describe the write-off of a tangible asset's expired services.

Capital Lease Method (Lessee)
Assume that Lessor Company and Lessee Company sign a lease agreement dated January 1, 2005, that calls for Lessor Company to lease equipment to Lessee Company beginning January 1, 2005. The terms and provisions of the lease agreement and other pertinent data are as follows. 1. 2. 3. The term of the lease is 5 years, and the lease agreement is noncancelable, requiring equal rental payments of $25,981.62 at the beginning of each year (annuity-due basis). The equipment has a fair value at the inception of the lease of $100,000, an estimated economic life of 5 years, and no residual value. Lessee Company pays all of the executory costs directly to third parties except for the property taxes of $2,000 per year, which are included in the annual payments to the lessor.

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4. 5. 6. 7.

The lease contains no renewal options, and the equipment reverts to Lessor Company at the termination of the lease. Lessee Company's incremental borrowing rate is 11 percent per year. Lessee Company depreciates on a straight-line basis similar equipment that it owns. Lessor Company set the annual rental to earn a rate of return on its investment of 10 percent per year. This fact is known to Lessee Company.11

The lease meets the criteria for classification as a capital lease for the following reasons: (1) The lease term of 5 years, being equal to the equipment's estimated economic life of 5 years, satisfies the 75 percent test. (2) The present value of the minimum lease payments ($100,000 as computed below) exceeds 90 percent of the fair value of the property ($100,000). The minimum lease payments are $119,908.10 ($23,981.62 × 5). The amount capitalized as leased assets is computed as the present value of the minimum lease payments (excluding executory costs—property taxes of $2,000) as follows.

Computation of Capitalized Lease Payments The lessor's implicit interest rate of 10 percent is used instead of the lessee's incremental borrowing rate of 11 percent because (1) it is lower and (2) the lessee has knowledge of it.

The entry to record the capital lease on Lessee Company's books on January 1, 2005, is:

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Leased Equipment under Capital Leases Lease Liability

100,000 100,000

Note that the preceding entry records the obligation at the net amount of $100,000 (the present value of the future rental payments) rather than at the gross amount of $119,908.10 ($23,981.62 × 5). The journal entry to record the first lease payment on January 1, 2005, is: Property Tax Expense Lease Liability Cash 2,000.00 23,981.62 25,981.62

Each lease payment of $25,981.62 consists of three elements: (1) a reduction in the lease liability (obligation), (2) a financing cost (interest expense), and (3) executory costs (property taxes). The total financing cost (interest expense) over the term of the lease is $19,908.10, which is the difference between the present value of the lease payments ($100,000) and the actual cash disbursed, net of executory costs ($119,908.10). Therefore, the annual interest expense, applying the effective-interest method, is a function of the outstanding liability (obligation), as shown in Illustration 5.

Lease Amortization Schedule for Lessee—Annuity-Due Basis At the end of Lessee Company's fiscal year, December 31, 2005, accrued interest is recorded as follows.

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Interest Expense Interest Payable

7,601.84 7,601.84

Depreciation of the leased equipment over its lease term of 5 years, applying Lessee Company's normal depreciation policy (straight-line method), results in the following entry on December 31, 2005. Depreciation Expense—Capital Leases Accumulated Depreciation—Capital Leases ($100,000 ÷ 5 years) 20,000 20,000

At December 31, 2005, the assets recorded under capital leases are separately identified on the lessee's balance sheet. Similarly, the related liabilities are separately identified. The portion due within one year or the operating cycle, whichever is longer, is classified with current liabilities and the rest with noncurrent liabilities. For example, the current portion of the December 31, 2005, total liability of $76,018.38 in the lessee's amortization schedule is the amount of the reduction in the liability in 2006, or $16,379.78. The liabilities section as it relates to lease transactions at December 31, 2005, would appear as shown in Illustration 6.

Reporting Current and Noncurrent Lease Liabilities The journal entry to record the lease payment of January 1, 2006, is as follows. Property Tax Expense Interest Payable Lease Liability Cash 2,000.00 7,601.84 16,379.78 25,981.62

Entries through 2009 would follow the pattern above. Other executory costs (insurance and maintenance) assumed by Lessee Company would be recorded in a manner similar to that used to record any other operating costs incurred on assets owned by Lessee Company. Upon expiration of the lease, the amount capitalized as leased equipment is fully amortized, and the lease obligation is fully discharged. If not purchased, the equipment would be returned to the lessor, and the leased equipment and related accumulated depreciation accounts would be removed from the books.12 If the equipment is purchased at termination of the lease at a price
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of $5,000 and the estimated life of the equipment is changed from 5 to 7 years, the following entry might be made. Equipment ($100,000 + $5,000) Accumulated Depreciation—Capital Leases Leased Equipment under Capital Leases Accumulated Depreciation—Equipment Cash 105,000 100,000 100,000 100,000 5,000

Operating Method (Lessee)
Under the operating method, rent expense (and the associated liability) accrues day by day to the lessee as the property is used. 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. Appropriate accruals or deferrals are made if the accounting period ends between cash payment dates. For example, assume that the capital lease illustrated in the previous section did not qualify as a capital lease and was therefore to be accounted for as an operating lease. The first-year charge to operations would have been $25,981.62, the amount of the rental payment. The journal entry to record this payment on January 1, 2005, would be as follows. Rent Expense Cash 25,981.62 25,981.62

The rented asset, as well as any long-term liability for future rental payments, is not reported on the balance sheet. Rent expense would be reported on the income statement. In addition, note disclosure is required for all operating leases that have noncancelable lease terms in excess of one year. Illustration of the type of note disclosure required for an operating lease (as well as other types of leases) is provided in Illustrations 30 to 33 later in this chapter.

Comparison of Capital Lease with Operating Lease Study Objective
Contrast the operating and capitalization methods of recording leases. As indicated on the previous page, if the lease had been accounted for as an operating lease, the first-year charge to operations would have been $25,981.62, the amount of the rental payment. Treating the transaction as a capital lease, however, resulted in a first-year charge of $29,601.84: depreciation of $20,000 (assuming straight-line), interest expense of $7,601.84 (per Illustration 7),
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and executory costs of $2,000. Illustration 7 shows that while the total charges to operations are the same over the lease term whether the lease is accounted for as a capital lease or as an operating lease, under the capital-lease treatment the charges are higher in the earlier years and lower in the later years.13

Comparison of Charges to Operations—Capital vs. Operating Leases If an accelerated method of depreciation is used, the differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. In addition, using the capital-lease approach would have resulted in an asset and related liability of $100,000 initially reported on the balance sheet. No such asset or liability would be reported under the operating method. Therefore, the following differences occur if a capital lease instead of an operating lease is employed: 1. 2. an increase in the amount of reported debt (both short-term and long-term), an increase in the amount of total assets (specifically long-lived assets), and

3. a lower income early in the life of the lease and, therefore, lower retained earnings. Thus, many companies believe that capital leases have a detrimental impact on their reported financial position: Their debt to total equity ratio increases and their rate of return on total assets decreases. As a result, the business community resists capitalizing leases. Whether this resistance is well founded is a matter of debate. From a cash flow point of view, the company is in the same position whether the lease is accounted for as an operating or a capital lease. The reason why managers often argue against capitalization is that it can more easily lead to violation of loan covenants; it can affect the amount of compensation received by managers (for example, a stock compensation plan tied to earnings); and finally, it can lower rates of return and increase debt to equity relationships, thus making the company less attractive to present and potential investors.14

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DOLLARS TO DONUTS Krispy Kreme, a chain of 217 donut shops, has caught the attention—some good, some bad—of Wall Street. On the good side, investors are impressed by the company's ability to grow rapidly on a relatively small bit of capital. For the first 9 months of fiscal 2002, the company's capital expenditures fell to $38 million, from $59 million the year before. Yet Krispy Kreme expanded along with its customers' waistlines during the same period: Its earnings rose 73 percent, to $18 million, on sales that were up 27 percent to $277 million. That's an impressive feat if you care about return on capital. But there's a hole in this donut. Amid much hoopla, the company announced in 2001 that it would spend $30 million on a new 187,000 square foot mixing plant and warehouse in Effingham, Illinois. Yet the investments and obligations associated with that $30 million are not apparent in the financial statements. By financing through a synthetic lease, Krispy Kreme can keep the investment and obligation off the books. In a synthetic lease, a financial institution like Bank of America sets up a special purpose entity (SPE) that borrows money to build the plant and then leases it to Krispy Kreme. For accounting purposes, Krispy Kreme reports an operating lease, but for tax purposes the company is considered the owner of the asset and gets depreciation tax deductions. In response to negative publicity about the use of SPEs to get favorable financial reporting and tax benefits, Krispy Kreme announced it was going to change its method of financing construction of its dough-making plant.
Source: Adapted from Seth Lubore and Elizabeth MacDonald, “Debt? Who, Me?” Forbes (February 18, 2002), p. 56.

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ACCOUNTING BY LESSOR
In some countries, such as Germany, all leases can be off-balance-sheet. Earlier in this chapter we discussed leasing's advantages to the lessee. Three important benefits are available to the lessor: 1. Interest Revenue. Leasing is a form of financing; therefore, financial institutions and leasing companies find leasing attractive because it provides competitive interest margins. Tax Incentives. In many cases, companies that lease cannot use the tax benefit, but leasing provides them with an opportunity to transfer such tax benefits to another party (the lessor) in return for a lower rental rate on the leased asset. To illustrate, Boeing at one time sold one of its 767 jet planes to a wealthy investor who didn't need the plane but could use the tax benefit. The investor then leased the plane to a foreign airline, for whom the tax benefit was of no use. Everyone gained: Boeing was able to sell its 767, the investor received the tax benefits, and the foreign airline found a cheaper way to acquire a 767.15 High Residual Value. Another advantage to the lessor is the return of the property at the end of the lease term. Residual values can produce very large profits. Citicorp at one time assumed that the commercial aircraft it was leasing to the airline industry would have a residual value of 5 percent of their purchase price. It turned out that they were worth 150 percent of their cost—a handsome profit. However, 3 years later these same planes slumped to 80 percent of their cost, but still far more than 5 percent.

2.

3.

Economics of Leasing
The lessor determines the amount of the rental, basing it on the rate of return—the implicit rate—needed to justify leasing the asset. The key factors considered in establishing the rate of return are the credit standing of the lessee, the length of the lease, and the status of the residual value (guaranteed versus unguaranteed). In the Lessor Company/Lessee Company example on pages 1094–1096, the implicit rate of the lessor was 10 percent, the cost of the equipment to the lessor was $100,000 (also fair market value), and the estimated residual value was zero. Lessor Company determined the amount of the lease payment in the following manner.

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Computation of Lease Payments If a residual value were involved (whether guaranteed or not), the lessor would not have to recover as much from the lease payments. Therefore, the lease payments would be less. (This situation is shown in Illustration 15.)

Classification of Leases by the Lessor
Study Objective
Identify the classifications of leases for the lessor. From the standpoint of the lessor, all leases may be classified for accounting purposes as one of the following: a. b. c. Operating leases. Direct-financing leases. Sales-type leases.

Referring to Illustration 9 (on page 1100), if at the date of the lease agreement (inception) the lessor is party to a lease that meets one or more of the Group I criteria (1, 2, 3, and 4) and both of the Group II criteria (1 and 2), the lessor shall classify and account for the arrangement as a direct-financing lease or as a sales-type lease.16 (Note that the Group I criteria are identical to the criteria that must be met in order for a lease to be classified as a capital lease by a lessee, as shown in Illustration 2.)

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Capitalization Criteria for Lessor

U.S. GAAP is consistent with International Standard No. 17 (Accounting for Leases). However, the international standard is a relatively simple statement of basic principles, whereas the U.S. rules on leases are more prescriptive and detailed. Why the Group II requirements? The answer is that the profession wants to make sure that the lessor has really transferred the risks and benefits of ownership. If collectibility of payments is not predictable or if performance by the lessor is incomplete, then the criteria for revenue recognition have not been met, and the lease should be accounted for as an operating lease. For example, computer leasing companies at one time used to buy IBM equipment, lease it, and remove the leased assets from their balance sheets. In leasing the asset, the computer lessors stated that they would be willing to substitute new IBM equipment if obsolescence occurred. However, when IBM introduced a new computer line, IBM refused to sell it to the computer leasing companies. As a result, a number of the lessors could not meet their contracts with their customers and were forced to take back the old equipment. What the computer leasing companies had taken off the books now had to be reinstated. Such a case demonstrates one reason for the Group II requirements. The distinction for the lessor between a direct-financing lease and a sales-type lease is the presence or absence of a manufacturer's or dealer's profit (or loss) : A sales-type lease involves a manufacturer's or dealer's profit, and a direct-financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor's cost or carrying amount (book value). Normally, sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products. For example, a computer manufacturer will lease its computer equipment to businesses and institutions. Direct-financing leases generally result from arrangements with lessors that are primarily engaged in financing operations, such as lease-finance companies, banks, insurance companies, and pension trusts. However, a lessor need not be a manufacturer or dealer to

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recognize a profit (or loss) at the inception of a lease that requires application of sales-type lease accounting. All leases that do not qualify as direct-financing or sales-type leases are classified and accounted for by the lessors as operating leases. Illustration 10 shows the circumstances under which a lease is classified as operating, direct-financing, or sales-type for the lessor.

Diagram of Lessor's Criteria for Lease Classification As a consequence of the additional Group II criteria for lessors, it may be that a lessor, having not met both criteria, will classify a lease as an operating lease but the lessee will classify the same lease as a capital lease. In such an event, both the lessor and lessee will carry the asset on their books, and both will depreciate the capitalized asset. For purposes of comparison with the lessee's accounting, only the operating and direct-financing leases will be illustrated in the following section. The more complex sales-type lease will be discussed later in the chapter.

Direct-Financing Method (Lessor)
Study Objective
Describe the lessor's accounting for direct-financing leases. Leases that are in substance the financing of an asset purchase by the lessee are called direct-financing leases. In this type of lease, the lessor records a lease receivable instead of a leased asset. The lease receivable is the present value of the minimum lease payments, plus the present value of the unguaranteed residual value. Remember that “minimum lease payments” for the lessee includes: 1. 2. 3. Rental payments (excluding executory costs). Bargain purchase option (if any). Guaranteed residual value (if any).
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4.

Penalty for failure to renew (if any).

Thus, the lessor records the residual value, whether guaranteed or not. Also, recall that if the lessor pays any executory costs, then the rental payment should be reduced by that amount for purposes of computing minimum lease payments. The following presentation, utilizing the data from the preceding Lessor Company/Lessee Company illustration on pages 1094–1096, illustrates the accounting treatment accorded a direct-financing lease. The information relevant to Lessor Company in accounting for this lease transaction is repeated as follows. 1. The term of the lease is 5 years beginning January 1, 2005, is noncancelable, and requires equal rental payments of $25,981.62 at the beginning of each year. Payments include $2,000 of executory costs (property taxes). The equipment has a cost of $100,000 to Lessor Company, a fair value at the inception of the lease of $100,000, an estimated economic life of 5 years, and no residual value. No initial direct costs were incurred in negotiating and closing the lease transaction. The lease contains no renewable options and the equipment reverts to Lessor Company at the termination of the lease. Collectibility is reasonably assured, and no additional costs (with the exception of the property taxes being collected from the lessee) are to be incurred by Lessor Company. Lessor Company set the annual lease payments to ensure a rate of return of 10 percent (implicit rate) on its investment as follows.

2. 3. 4. 5. 6.

Computation of Lease Payments The lease meets the criteria for classification as a direct-financing lease because (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) there are no further costs to be incurred by Lessor Company. It is not a sales-type lease because there is no difference between the fair value ($100,000) of the equipment and the lessor's cost ($100,000). The Lease Receivable is the present value of the minimum lease payments (excluding executory costs minus property taxes of $2,000) and is computed as follows.
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Computation of Lease Receivable The lease of the asset and the resulting receivable are recorded January 1, 2005 (the inception of the lease), as follows. Lease Receivable Equipment 100,000 100,000

The lease receivable is often reported in the balance sheet as “Net investment in capital leases.” It is classified either as current or noncurrent, depending upon when the net investment is to be recovered.17 The leased equipment with a cost of $100,000, which represents Lessor Company's investment, is replaced with a lease receivable. In a manner similar to the lessee's treatment of interest, Lessor Company applies the effective-interest method and recognizes interest revenue as a function of the lease receivable balance, as shown in Illustration 13.

Lease Amortization Schedule for Lessor—Annuity-Due Basis On January 1, 2005, the journal entry to record receipt of the first year's lease payment is shown on page 1103.

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Cash Lease Receivable Property Tax Expense/Property Taxes Payable

25,981.62 23,981.62 2,000.00

On December 31, 2005, the interest revenue earned during the first year is recognized through the following entry. Interest Receivable Interest Revenue 7,601.84 7,601.84

At December 31, 2005, the lease receivable 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 assets section as it relates to lease transactions at December 31, 2005, would appear as follows.

Reporting Lease Transactions by Lessor The following entries record receipt of the second year's lease payment and recognition of the interest earned. January 1, 2006 Cash Lease Receivable Interest Receivable Property Tax Expense/Property Taxes Payable December 31, 2006 Interest Receivable Interest Revenue 25,981.62 16,379.78 7,601.84 2,000.00 5,963.86 5,963.86

Journal entries through 2009 would follow the same pattern except that no entry would be recorded in 2009 (the last year) for earned interest. Because the receivable is fully collected by January 1, 2009, no balance (investment) is outstanding during 2009 to which Lessor Company could attribute any interest. Lessor Company recorded no depreciation. If the equipment is sold to Lessee Company for $5,000 upon expiration of the lease, Lessor Company would recognize disposition of the equipment as follows.
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Cash Gain on Sale of Leased Equipment

5,000 5,000

Operating Method (Lessor)
Under the operating method each rental receipt by the lessor is recorded as rental revenue. The leased asset is depreciated 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 is more representative of the time pattern in which the benefit is derived from the leased asset. In addition to the depreciation charge, maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period are charged to expense. Costs paid to independent third parties, such as appraisal fees, finder's fees, and costs of credit checks, are amortized over the life of the lease. To illustrate the operating method, assume that the direct-financing lease shown on page 1101 did not qualify as a capital lease and was therefore to be accounted for as an operating lease. The entry to record the cash rental receipt, assuming the $2,000 was for property tax expense, would be as follows. Cash Rental Revenue 25,981.62 25,981.62

Depreciation is recorded by the lessor as follows (assuming a straight-line method, a cost basis of $100,000, and a 5-year life). Depreciation Expense—Leased Equipment Accumulated Depreciation—Leased Equipment 20,000 20,000

If property taxes, insurance, maintenance, and other operating costs during the year are the obligation of the lessor, they are recorded as expenses chargeable against the gross rental revenues. If the lessor owned plant assets that it used in addition to those leased to others, the leased equipment and accompanying accumulated depreciation would be separately classified in an account such as “Equipment leased to others” or “Investment in leased property.” If significant in amount or in terms of activity, the rental revenues and accompanying expenses are separated from sales revenue and cost of goods sold in the income statement.

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SPECIAL ACCOUNTING PROBLEMS
Study Objective Identify special features of
lease arrangements that cause unique accounting problems. The features of lease arrangements that cause unique accounting problems are: 1. 2. 3. 4. 5. 6. Residual values. Sales-type leases (lessor). Bargain purchase options. Initial direct costs. Current versus noncurrent. Disclosure.

Residual Values
Up to this point, we have generally ignored discussion of residual values in order that the basic accounting issues related to lessee and lessor accounting could be developed. 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.18

Guaranteed versus Unguaranteed
The residual value may be unguaranteed or guaranteed by the lessee. If 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, that stated amount is the guaranteed residual value. The guaranteed residual value is employed 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.
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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 the certainty of recovery has been increased. After this rate is established, however, it makes no difference from an accounting point of view whether the residual value is guaranteed or unguaranteed. The net investment to be recorded by the lessor (once the rate is set) will be the same. Assume the same data as in the Lessee Company/Lessor Company illustrations except that a residual value of $5,000 is estimated at the end of the 5-year lease term. In addition, a 10 percent return on investment (ROI) is assumed,19 whether the residual value is guaranteed or unguaranteed. Lessor Company would compute the amount of the lease payments as follows.

Lessor's Computation of Lease Payments Contrast the foregoing lease payment amount to the lease payments of $23,981.62 as computed in Illustration 8, where no residual value existed. The payments are less, because the lessor's total recoverable amount of $100,000 is reduced by the present value of the residual value.

Lessee Accounting for Residual Value
Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. The accounting difference is that the minimum lease payments, the basis for capitalization, includes the guaranteed residual value but excludes the unguaranteed residual value. Guaranteed Residual Value (Lessee Accounting).

Study Objective
Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. A guaranteed residual value affects the lessee's computation of minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. In effect, it is an

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additional lease payment that will be paid in property or cash, or both, at the end of the lease term. Using the rental payments as computed by the lessor in Illustration 15, the minimum lease payments are $121,185.45 ([$23,237.09 × 5] + $5,000). The capitalized present value of the minimum lease payments (excluding executory costs) is computed as shown in Illustration 16.

Computation of Lessee's Capitalized Amount—Guaranteed Residual Value Lessee Company's schedule of interest expense and amortization of the $100,000 lease liability that produces a $5,000 final guaranteed residual value payment at the end of 5 years is shown in Illustration 17.

Lease Amortization Schedule for Lessee—Guaranteed Residual Value The journal entries (Illustration 22 on page 1108) to record the leased asset and liability, depreciation, interest, property tax, and lease payments are then made on the basis that the residual value is guaranteed. The format of these entries is the same as illustrated earlier, although the amounts are different because of the guaranteed residual value. The leased asset is recorded at $100,000 and is depreciated over 5 years. To compute depreciation, the guaranteed residual value is subtracted from the cost of the leased asset. Assuming that the straight-line method is used, the depreciation expense each year is $19,000 ([$100,000 ? $5,000] ÷ 5 years).

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At the end of the lease term, before the lessee transfers the asset to the lessor, the lease asset and liability accounts have the following balances.

Account Balances on Lessee's Books at End of Lease Term—Guaranteed Residual Value If, at the end of the lease, the fair market value of the residual value is less than $5,000, Lessee Company will have to record a loss. Assume that Lessee Company depreciated the leased asset down to its residual value of $5,000 but that the fair market value of the residual value at December 31, 2009, was $3,000. In this case, the Lessee Company would have to report a loss of $2,000. The following journal entry would be made, assuming cash was paid to make up the residual value deficiency. Loss on Capital Lease Interest Expense (or Interest Payable) Lease Liability Accumulated Depreciation—Capital Leases Leased Equipment under Capital Leases Cash 2,000.00 454.76 4,545.24 95,000.00 100,000.00 2,000.00

If the fair market value exceeds $5,000, a gain may be recognized. Gains on guaranteed residual values may be apportioned to the lessor and lessee in whatever ratio the parties initially agree. If the lessee depreciated the total cost of the asset ($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 the liability under the capital lease would be stated at $5,000. Thus, if the asset was worth $5,000, the lessee would end up reporting a gain of $5,000 when it transferred the asset to the lessor. As a result, depreciation would be overstated and net income understated in 2005–2008, but in the last year (2009) net income would be overstated. Unguaranteed Residual Value (Lessee Accounting). An unguaranteed residual value from the lessee's viewpoint 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—$23,237.09. Whether the residual value is guaranteed or unguaranteed, Lessor Company's amount to be

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recovered through lease rentals is the same—that is, $96,895.40. The minimum lease payments are $116,185.45 ($23,237.09 × 5). Lessee Company would capitalize the following amount.

Computation of Lessee's Capitalized Amount—Unguaranteed Residual Value The Lessee Company'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 5 years, is shown in Illustration 20.

Lease Amortization Schedule for Lessee—Unguaranteed Residual Value The journal entries (Illustration 22 below) to record the leased asset and liability, depreciation, interest, property tax, and payments on the lease liability are then made on the basis that the residual value is unguaranteed. The format of these entries is the same as illustrated earlier. Note that the leased asset is recorded at $96,895.40 and is depreciated over 5 years. Assuming that the straight-line method is used, the depreciation expense each year is $19,379.08 ($96,895.40 ÷ 5 years). At the end of the lease term, before the lessee transfers the asset to the lessor, the following balances in the accounts result, as illustrated below.

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Account Balances on Lessee's Books at End of Lease Term—Unguaranteed Residual Value Assuming that the leased asset has been fully depreciated and that the lease liability has been fully amortized, no entry is required at the end of the lease term, except to remove the asset from the books. If the lessee 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, the lessee would end up reporting a loss of $5,000 when it transferred the asset to the lessor. Depreciation would be understated and net income overstated in 2005–2008, but in the last year (2009) net income would be understated because of the recorded loss. Lessee Entries Involving Residual Values. The entries by Lessee Company for both a guaranteed and an unguaranteed residual value are shown in Illustration 22, in comparative form.

Comparative Entries for Guaranteed and Unguaranteed Residual Values, Lessee Company

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
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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 (e.g., $23,237.09 in our example) whether the residual value is guaranteed or unguaranteed. Using the Lessee Company/Lessor Company data and assuming a residual value (either guaranteed or unguaranteed) of $5,000 and classification of the lease as a direct financing lease, the lessor determines the payments as follows.

Computation of Direct Financing Lease Payments The schedule for amortization with guaranteed or unguaranteed residual value is the same, as shown in Illustration 24.

Lease Amortization Schedule, for Lessor—Guaranteed or Unguaranteed Residual Value Using the amounts computed above, the following entries would be made by Lessor Company during the first year for this direct financing lease. Note the similarity to the lessee's entries in Illustration 22.

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Entries for Either Guaranteed or Unguaranteed Residual Value, Lessor Company

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 26 below.

Direct-Financing versus Sales-Type Leases The information necessary to record the sales-type lease is as follows. SALES-TYPE LEASE TERMS LEASE RECEIVABLE (also NET INVESTMENT). The present value of the minimum lease payments plus the present value of any unguaranteed residual value. The lease receivable therefore includes the present value of the residual value, whether guaranteed or not. SALES PRICE OF THE ASSET. The present value of the minimum lease payments. COST OF GOODS SOLD. The cost of the asset to the lessor, less the present value of any unguaranteed residual value.

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Study Objective
Describe the lessor's accounting for sales-type leases. When recording sales revenue and cost of goods sold, there is a difference in the accounting for guaranteed and unguaranteed residual values. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. But 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 (pages 1101–1103). 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 dealer, Lessor Company. Assume that the fair market 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 shown in Illustration 27.

Computation of Lease Amounts by Lessor Company—Sales-Type Lease The profit recorded by Lessor Company 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, 2005, and the receipt of the residual value at the end of the lease term are presented below.

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Entries for Guaranteed and Unguaranteed Residual Values, Lessor Company—Sales-Type Lease The estimated unguaranteed residual value in a sales-type lease (and a direct financing-type lease) must be reviewed periodically. If the estimate of the unguaranteed residual value declines, the accounting for the transaction must be revised using the changed estimate. The decline represents a reduction in the lessor's lease receivable (net investment) and is recognized as a loss in the period in which the residual estimate is reduced. Upward adjustments in estimated residual value are not recognized.

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XEROX TAKES ON THE SEC Much of Xerox's income is derived from leasing equipment. Reporting such leases as sales leases, Xerox records a lease contract as a sale, with income therefore being recognized immediately. One problem is that each lease receipt was comprised of payments for various items such as supplies, services, financing, and equipment. The SEC accused Xerox of inappropriately allocating lease receipts, which affects the timing of income that is reported. If SEC guidelines were applied, income would be reported in different time periods. Xerox contended that its methods were correct and also noted that when the lease term is up, the bottom line is the same using either the SEC's recommended allocation method or the method used by Xerox. 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 filings of the company have been rejected by the agency. Apparently, having access to public markets is very valuable to Xerox. The company agreed to change its accounting according to SEC wishes, and paid a fine of $10 million due to its past accounting practices.
Source: Adapted from “Xerox Takes on the SEC,” Accounting Web (January 9, 2002) ( www.accountingweb.com ).

Bargain Purchase Option (Lessee)
A bargain purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the property's expected future fair value. The price is so favorable at the lease's inception that the future exercise of the option appears to be reasonably assured. If a bargain purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. For example, assume that Lessee Company in the illustration on page 1106 had an option to buy the leased equipment for $5,000 at the end of the 5-year lease term when the fair value is expected to be $18,000. The significant difference between the option price and the fair value creates a bargain purchase option, the exercise of which is reasonably assured. Four computations are affected by a bargain purchase option in the same manner that they are by a guaranteed residual value: (1) the amount of the five lease payments necessary for the lessor to earn a 10 percent return on the lease receivable, (2) the amount of the minimum lease payments, (3) the amount capitalized as leased assets and lease liability, and (4) the amortization of the lease liability. Therefore, the computations, amortization schedule, and entries that would be prepared for this $5,000 bargain purchase option are identical to those shown for the $5,000 guaranteed residual value. The only difference between the accounting treatment for a bargain purchase option and a guaranteed residual value of identical amounts and circumstances is in the computation of the annual depreciation. In the case of a guaranteed residual value, the lessee depreciates the asset
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over the lease term, whereas in the case of a bargain purchase option, the lessee uses the economic life of the asset.

Initial Direct Costs (Lessor)
Initial direct costs are of two types.20 The first, incremental direct costs, are costs paid to independent third parties, incurred in originating a lease arrangement. Examples would include the cost of independent appraisal of collateral used to secure a lease, the cost of an outside credit check of the lessee, or a broker's fee for finding the lessee. The second type, internal direct costs, are the costs directly related to specified activities performed by the lessor on a given lease. Examples are evaluating the prospective lessee's financial condition; evaluating and recording guarantees, collateral, and other security arrangements; negotiating lease terms and preparing and processing lease documents; and closing the transaction. The costs directly related to an employee's time spent on a specific lease transaction are also considered initial direct costs. On the other hand, initial direct costs should not include internal indirect costs related to activities performed by the lessor for advertising, servicing existing leases, and establishing and monitoring credit policies. Nor should they include costs for supervision and administration. In addition, expenses such as rent and depreciation are not considered initial direct costs. For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental income. In a sales-type lease transaction, the lessor expenses the initial direct costs in the year of incurrence. That is, they are expensed in the period in which the profit on the sale is recognized. In a direct-financing lease, however, initial direct costs are added to the net investment in the lease and amortized over the life of the lease as a yield adjustment. In addition, the unamortized deferred initial direct costs that are part of the lessor's investment in the direct-financing lease must be disclosed. If the carrying value of the asset in the lease is $4,000,000 and the lessor incurs initial direct costs of $35,000, then the lease receivable (net investment in the lease) would be $4,035,000. The yield would be adjusted to ensure proper amortization of this amount over the life of the lease and would be lower than the initial rate of return.

Current versus Noncurrent
The classification of the lease liability/receivable was presented earlier in an annuity-due situation. As indicated in Illustration 6, the lessee's current liability is the payment of $23,981.62 (excluding $2,000 of executory costs) to be made on January 1 of the next year. Similarly, as shown in Illustration 14, the lessor's current asset is the amount to be collected of $23,981.62 (excluding $2,000 of executory costs) on January 1 of the next year. In both of these annuity-due instances, the balance sheet date is December 31 and the due date of the lease payment is January 1 (less than one year), so the present value ($23,981.62) of the payment due the following January 1 is the same as the rental payment ($23,981.62).
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What happens if the situation is an ordinary-annuity rather than an annuity-due situation? For example, assume that the rent is to be paid at the end of the year (December 31) rather than at the beginning (January 1). FASB Statement No. 13 does not indicate how to measure the current and noncurrent amounts. It requires that for the lessee the “obligations shall be separately identified on the balance sheet as obligations under capital leases and shall be subject to the same considerations as other obligations in classifying them with current and noncurrent liabilities in classified balance sheets.”21 The most common method of measuring the current liability portion in ordinary annuity leases is the change in the present value method. 22 To illustrate the change in the present value method, assume an ordinary-annuity situation with the same facts as the Lessee Company/Lessor Company case, excluding the $2,000 of executory costs. Because the rents are paid at the end of the period instead of at the beginning, the five rents are set at $26,379.73 to have an effective interest rate of 10 percent. The ordinary-annuity amortization schedule is shown in Illustration 29.

Lease Amortization Schedule—Ordinary-Annuity Basis The current portion of the lease liability/receivable under the change in the present value method as of December 31, 2005, would be $18,017.70 ($83,620.27 ? $65,602.57). As of December 31, 2006, it would be $19,819.47 ($65,602.57 ? $45,783.10). The portion of the lease liability/receivable that is not current is classified as such. That is, $65,602.57 is the noncurrent portion at December 31, 2005. Thus, both the annuity-due and the ordinary-annuity situations report the reduction of principal for the next period as a current liability/current asset. In the annuity-due situation, interest is accrued during the year but is not paid until the next period. As a result, a current liability/current asset arises for both the lease liability/receivable reduction and the interest that was incurred/earned in the preceding period. In the ordinary-annuity situation, the interest accrued during the period is also paid in the same period. Consequently, only the principal reduction is shown as a current liability/current asset.

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Disclosing Lease Data
Study Objective
Describe the disclosure requirements for leases.

Disclosures Required of the Lessee
The FASB requires that the following information with respect to leases be disclosed in the lessee's financial statements or in the notes.23

Lessee's Disclosures

Disclosures Required of the Lessor
The FASB requires that lessors disclose in the financial statements or in the notes the following information when leasing “is a significant part of the lessor's business activities in terms of revenue, net income, or assets.”24

Lessor's Disclosures

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Disclosures Illustrated
The financial statement excerpts from the 2001 Annual Report of Penn Traffic Company in Illustration 32 present the statement and note disclosures typical of a lessee having both capital leases and operating leases.

Disclosure of Leases by Lessee

Additional Lease Disclosures The following note from the 2001 Annual Report of Dana Corporation illustrates the disclosures of a lessor.

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Disclosure of Leases by Lessor

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LEASE ACCOUNTING—UNSOLVED PROBLEMS
As indicated at the beginning of this chapter, lease accounting is a much abused area in which strenuous efforts are being made to circumvent Statement No. 13. In practice, the accounting rules for capitalizing leases have been rendered partially ineffective by the strong desires of lessees to resist capitalization. Leasing generally involves large dollar amounts that, when capitalized, materially increase reported liabilities and adversely affect the debt-to-equity ratio. Lease capitalization is also resisted because charges to expense made in the early years of the lease term are higher under the capital-lease method than under the operating method, frequently without tax benefit. As a consequence, “let's beat Statement No. 13” is one of the most popular games in town.25 To avoid leased asset capitalization, lease agreements are designed, written, and interpreted so that none of the four capitalized lease criteria are satisfied from the lessee's viewpoint. Devising lease agreements in such a way has not been too difficult when the following specifications have been met. 1. 2. 3. 4. Make certain that the lease does not specify the transfer of title of the property to the lessee. Do not write in a bargain purchase option. Set the lease term at something less than 75 percent of the estimated economic life of the leased property. Arrange for the present value of the minimum lease payments to be less than 90 percent of the fair value of the leased property.

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.26 Avoiding the first three criteria is relatively simple, but it takes a little ingenuity to avoid the “90 percent recovery test” for the lessee while satisfying it for the lessor. Two of the factors involved in this effort are (1) the use of the incremental borrowing rate by the lessee when it is higher than the implicit interest rate of the lessor, by making information about the implicit rate unavailable to the lessee; and (2) residual-value guarantees. The lessee's use of the higher interest rate is probably the more popular subterfuge. While lessees are knowledgeable about the fair value of the leased property and, of course, the rental payments, they generally are not aware of the estimated residual value used by the lessor. Therefore the lessee who does not know exactly the lessor's implicit interest rate might use a different incremental borrowing rate. The residual-value guarantee is the other unique, yet popular, device used by lessees and lessors. In fact, a whole new industry has emerged to circumvent symmetry between the lessee
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and the lessor in accounting for leases. The residual-value guarantee has spawned numerous companies whose principal, or even sole, function is to guarantee the residual value of leased assets. These third-party guarantors (insurers), for a fee, assume the risk of deficiencies in leased-asset residual value. Because the guaranteed residual value is included in the minimum lease payments for the lessor, the 90 percent recovery of fair market value test is satisfied. The lease is a nonoperating lease to the lessor. But because the residual value is guaranteed by a third party, the minimum lease payments of the lessee do not include the guarantee. Thus, by merely transferring some of the risk to a third party, lessees can alter substantially the accounting treatment by converting what would otherwise be capital leases to operating leases.27

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SWAP MEET Telecommunication companies have developed one of the more innovative and controversial uses of leases. In order to provide fiber-optic service to their customers in areas where they did not have networks installed, telecommunication companies such as Global Crossing, Qwest Communications International, and Cable and Wireless entered into agreements to swap some of their unused network capacity in exchange for the use of another company's fiber-optic cables. Here's how it works:

Such trades seem like a good way to make efficient use of telecommunication assets. What got some telecommunications companies in trouble, though, was how they did the accounting for the swap. The most conservative accounting for the capacity trades is to treat the swap as an exchange of assets, which does not affect the income statement. However, Global Crossing got into trouble with the SEC when it structured some of its capacity swaps as leases—the legal right to use capacity. Global Crossing was recognizing as revenue the payments received for the outgoing transfer of capacity, while payments for the incoming cable capacity were treated as capital expenditures, and therefore not expensed. As a result, Global Crossing was showing strong profits from its capacity swaps. However, the company's investors got an unpleasant surprise when the market for bandwidth cooled off and there was no longer demand for its broadband capacity or its long-term leasing arrangements.
Source: Simon Romero and Seth Schiesel, “The Fiber-Optic Fantasy Slips Away,” New York Times on the Web (February 17, 2002). By permission.

Much of this circumvention is encouraged by the nature of the criteria, which stem from weaknesses in the basic objective of Statement No. 13. Accounting standards-setting bodies continue
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to have poor experience with arbitrary break points or other size and percentage criteria—that is, rules like “90 percent of,” “75 percent of,” etc. Some believe that a more workable solution would be to require capitalization of all leases that extend for some defined period (such as one year). The basis for this treatment is that the lessee has acquired an asset (a property right) and a corresponding liability in contrast to the basis that the lease transfers substantially all the risks and rewards of ownership. Three years after it issued Statement No. 13, a majority of the FASB expressed “the tentative view that, if Statement 13 were to be reconsidered, they would support a property-right approach in which all leases are included as ‘rights to use property’ and as ‘lease obligations’ in the lessee's balance sheet.”28 Recently, the FASB and other international standards setters have issued a report on lease accounting that proposes the capitalization of more leases.29

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Summary of Study Objectives
1. Explain the nature, economic substance, and advantages of lease transactions. A lease is a contractual agreement between a lessor and a lessee that conveys to the lessee the right to use specific property (real or personal), owned by the lessor, for a specified period of time. In return for this right, the lessee agrees to make periodic cash payments (rents) to the lessor. The advantages of lease transactions are: (1) 100 percent financing; (2) protection against obsolescence, (3) flexibility, (4) less costly financing, (5) possible tax advantages, and (6) off-balance-sheet financing. Describe the accounting criteria and procedures for capitalizing leases by the lessee. A lease is a capital lease if one or more of the following criteria (Group I criteria) are met: (1) The lease transfers ownership of the property to the lessee; (2) the lease contains a bargain purchase option; (3) the lease term is equal to 75 percent or more of the estimated economic life of the leased property; (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. For a capital lease, the lessee records an asset and a liability at the lower of (1) the present value of the minimum lease payments or (2) the fair market value of the leased asset at the inception of the lease. Contrast the operating and capitalization methods of recording leases. The total charges to operations are the same over the lease term whether the lease is accounted for as a capital lease or as an operating lease. Under the capital lease treatment, the charges are higher in the earlier years and lower in the later years. If an accelerated method of depreciation is used, the differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. The following occurs if a capital lease instead of an operating lease is employed: (1) an increase in the amount of reported debt (both short-term and long-term), (2) an increase in the amount of total assets (specifically long-lived assets), and (3) lower income early in the life of the lease and, therefore, lower retained earnings. Identify the classifications of leases for the lessor. From the standpoint of the lessor, all leases may be classified for accounting purpose as follows: (1) operating leases, (2) direct-financing leases, (3) sales-type leases. The lessor should classify and account for an arrangement as a direct-financing lease or a sales-type lease if, at the date of the lease agreement, one or more of the Group I criteria (as shown in learning objective 2 for lessees) are met and both of the following Group II criteria are met. Group II: (1) Collectibility of the payments required from the lessee is reasonably predictable; and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. All leases that fail to meet the criteria are classified and accounted for by the lessor as operating leases.

2.

3.

4.

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5.

Describe the lessor's accounting for direct-financing leases. Leases that are in substance the financing of an asset purchase by a lessee require the lessor to substitute a “lease receivable” for the leased asset. “Lease receivable” is defined as the present value of the minimum lease payments plus the present value of the unguaranteed residual value. Therefore the residual value, whether guaranteed or unguaranteed, is included as part of lease receivable. Identify special features of lease arrangements that cause unique 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; and (6) disclosures. Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting. Whether the estimated residual value is guaranteed or unguaranteed is of both economic and accounting consequence to the lessee. The accounting difference is that the minimum lease payments, the basis for capitalization, includes the guaranteed residual value but excludes the unguaranteed residual value. A guaranteed residual value affects the lessee's computation of minimum lease payments and, therefore, the amounts capitalized as a leased asset and a lease obligation. In effect, it is an additional lease payment that will be paid in property or cash, or both, at the end of the lease term. An unguaranteed residual value from the lessee's viewpoint 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. Describe the lessor's accounting for sales-type leases. Sales-type leases are distinguished from direct-financing leases by the difference in the cost and fair value of the leased asset, which results in gross profit. Lease receivable and interest revenue are the same whether a guaranteed or an unguaranteed residual value is involved. When recording sales revenue and cost of goods sold, there is a difference in the accounting for guaranteed and unguaranteed residual values. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. There is less certainty that the unguaranteed residual portion of the asset has been “sold”; 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.

6.

7.

8.

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9.

Describe the disclosure requirements for leases. The disclosure requirements for the lessee are classified as follows: (1) capital leases; (2) operating leases having initial or remaining noncancelable lease terms in excess of one year; (3) all operating leases; and (4) a general description of the lessee's arrangements. The disclosure requirements for the lessor are classified as follows: (1) sales-type and direct-financing leases; (2) operating leases; and (3) a general description of the lessor's leasing arrangements. Expanded Discussion of Real Estate Leases and Leveraged Leases

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Appendix: Illustrations of Lease Arrangements
Study Objective
Understand and apply lease accounting concepts to various lease arrangements. To illustrate concepts discussed in this chapter, assume that Morgan Bakeries is involved in four different lease situations. Each of these leases is noncancelable, and in no case does Morgan receive title to the properties leased during or at the end of the lease term. All leases start on January 1, 2005, with the first rental due at the beginning of the year. The additional information is shown in Illustration 34.

Illustrative Lease Situations, Lessors

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HARMON, INC.
The following is an analysis of the Harmon, Inc. lease. 1. 2. 3. 4. Transfer of title? No. Bargain purchase option? No. Economic life test (75% test). The lease term is 20 years and the estimated economic life is 30 years. Thus it does not meet the 75 percent test. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $60,000 Rental payments 90% PV of annuity due for 20 years at 12% $54,000 PV of rental payments $ 6,000 × 8.36578 $50,194.68

Because the present value of the minimum lease payments is less than 90 percent of the fair market value, the 90 percent test is not met. Both Morgan and Harmon should account for this lease as an operating lease, as indicated by the January 1, 2005, entries shown below.

Comparative Entries for Operating Lease

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ARDEN'S OVEN CO.
The following is an analysis of the Arden's Oven Co. lease. 1. 2. Transfer of title? No. Bargain purchase option? The $75,000 option at the end of 10 years does not appear to be sufficiently lower than the expected fair value of $80,000 to make it reasonably assured that it will be exercised. However, the $4,000 at the end of 15 years when the fair value is $60,000 does appear to be a bargain. From the information given, criterion 2 is therefore met. Note that both the guaranteed and the unguaranteed residual values are assigned zero values because the lessor does not expect to repossess the leased asset. Economic life test (75% test): Given that a bargain purchase option exists, the lease term is the initial lease period of 10 years plus the 5-year renewal option since it precedes a bargain purchase option. Even though the lease term is now considered to be 15 years, this test is still not met because 75 percent of the economic life of 25 years is 18.75 years. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $120,000 Rental payments 90% PV of annuity due for 15 years at 12% $108,000 PV of rental payments $ 15,000.00 × 7.62817 $114,422.55

3.

4.

PV of bargain purchase option: = $4,000 × (PVF15,12%) = $4,000 × .18270 = $730.80 PV of rental payments PV of bargain purchase option PV of minimum lease payments $114,422.55 730.80 $115,153.35

The present value of the minimum lease payments is greater than 90% of the fair market value; therefore, the 90% test is met. Morgan Bakeries should account for this as a capital lease because both criterion 2 and criterion 4 are met. Assuming that Arden's implicit rate is the same as Morgan's incremental borrowing rate, the following entries are made on January 1, 2005.

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Comparative Entries for Capital Lease—Bargain Purchase Option Morgan Bakeries would depreciate the leased asset over its economic life of 25 years, given the bargain purchase option. Arden's Oven Co. does not use sales-type accounting because the fair market value and the cost of the asset are the same at the inception of the lease.

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MENDOTA TRUCK CO.
The following is an analysis of the Mendota Truck Co. lease. 1. 2. 3. 4. Transfer of title? No. Bargain purchase option? No. Economic life test (75% test): The lease term is 3 years and the estimated economic life is 7 years. Thus it does not meet the 75 percent test. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $20,000 Rental payments 90% PV of annuity due for 3 years at 12% $18,000 PV of rental payments (Note: adjusted for $0.01 due to rounding) PV of guaranteed residual value: = $7,000 × (PVF3,12%) = $7,000 × .71178 = $4,982.46 PV of rental payments PV of guaranteed residual value PV of minimum lease payments $15,017.54 4,982.46 $20,000.00 $ 5,582.62 × 2.69005 $15,017.54

The present value of the minimum lease payments is greater than 90 percent of the fair market value; therefore, the 90% test is met. Assuming that Mendota's implicit rate is the same as Morgan's incremental borrowing rate, the following entries are made on January 1, 2005.

Comparative Entries for Capital Lease The leased asset is depreciated by Morgan over 3 years to its guaranteed residual value.
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APPLELAND COMPUTER
The following is an analysis of the Appleland Computer lease. 1. 2. 3. 4. Transfer of title? No. Bargain purchase option? No. The option to purchase at the end of 3 years at approximate fair market value is clearly not a bargain. Economic life test (75% test): The lease term is 3 years, and no bargain renewal period exists. Therefore the 75 percent test is not met. Recovery of investment test (90% test): Fair market value Rate 90% of fair market value $10,000 Rental payments 90% Less executory costs $ 9,000 PV of annuity due factor for 3 years at 12% PV of minimum lease payments using incremental borrowing rate $3,557.25 500.00 3,057.25 × 2.69005 $8,224.16

The present value of the minimum lease payments using the incremental borrowing rate is $8,224.16; using the implicit rate, it is $8,027.48 (see Illustration 34). The implicit rate of the lessor is, therefore, higher than the incremental borrowing rate. Given this situation, the lessee uses the $8,224.16 (lower interest rate when discounting) when comparing with the 90% of fair market value. Because the present value of the minimum lease payments is lower than 90 percent of the fair market value, the recovery of investment test is not met. The following entries are made on January 1, 2005, indicating an operating lease.

Comparative Entries for Operating Lease

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If the lease payments had been $3,557.25 with no executory costs involved, this lease arrangement would have qualified for capital-lease accounting treatment.

Summary of Study Objectives
10 Understand and apply lease accounting concepts to various lease arrangements. The classification of leases by lessees and lessors is based on criteria that assess whether substantially all of the risks and benefits of ownership of the asset have been transferred from the lessor to the lessee. In addition, lessors assess two additional criteria to ensure that payment is assured and that there are not uncertainties about lessor's future costs. Lessees capitalize leases that meet any of the criteria, recording a lease asset and related lease liability. For leases that are in substance a financing of an asset purchase, lessors substitute a lease receivable for the leased asset. In a sales-type lease, the fair value of the leased asset is greater than the cost, and lessors record gross profit. Leases that do not meet capitalization criteria are classified as operating leases, on which rent expense (revenue) is recognized by lessees (lessors) for lease payments.

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Appendix: Sale-Leasebacks
Study Objective
Describe the lessee's accounting for sale-leaseback transactions. 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. The use of the property is generally continued without interruption. Sale-leasebacks are common. Financial institutions (e.g., Bank of America and First Chicago) have used this technique for their administrative offices, public utilities (Ohio Edison and Pinnacle West Corporation) for their generating plants, and airlines (Continental and Alaska Airlines) for their aircraft. The advantages of a sale-leaseback from the seller's viewpoint usually involve two primary considerations: 1. Financing—If the purchase of equipment has already been financed, a sale-leaseback can allow the seller to refinance at lower rates, assuming rates have dropped. In addition, a sale-leaseback can provide another source of working capital, particularly when liquidity is tight. Taxes—At the time a company purchased equipment, it may not have known that it would be subject to a minimum tax and that ownership might increase its minimum tax liability. By selling the property, the seller-lessee may deduct the entire lease payment, which is not subject to minimum tax considerations.

2.

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DETERMINING ASSET USE
A sale-leaseback is similar in substance to the parking of inventories discussed in Chapter 8. The ultimate economic benefits remain under the control of the “seller,” thus satisfying the definition of an asset. To the extent the seller-lessee's use of the asset sold continues after the sale, the sale-leaseback is really a form of financing, and therefore no gain or loss should be recognized on the transaction. In short, the seller-lessee is simply borrowing funds. On the other hand, if the seller-lessee gives up the right to the use of the asset sold, the transaction is in substance a sale, and gain or loss recognition is appropriate. Trying to ascertain when the lessee has given up the use of the asset is difficult, however, and complex rules have been formulated to identify this situation.30 To understand the profession's position in this area, the basic accounting for the lessee and lessor are discussed below.

Lessee
If the lease meets one of the four criteria for treatment as a capital lease (see Illustration 2), the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. Any profit or loss experienced by the seller-lessee from the sale of the assets that are leased back under a capital lease should be deferred and amortized over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased assets. For example, if Lessee, Inc. sells equipment having a book value of $580,000 and a fair value of $623,110 to Lessor, Inc. for $623,110 and leases the equipment back for $50,000 a year for 20 years, the profit of $43,110 should be amortized over the 20-year period at the same rate that the $623,110 is depreciated.31 The $43,110 is credited to “Unearned Profit on Sale-Leaseback.” If none of the capital lease criteria are satisfied, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Under an operating lease, such profit or loss should be deferred and amortized in proportion to the rental payments over the period of time the assets are expected to be used by the lessee. There are exceptions to these two general rules. They are: 1. Losses Recognized—The profession requires that, when the fair value of the asset is less than the book value (carrying amount), a loss must be recognized immediately up to the amount of the difference between the book value and fair value. For example, if Lessee, Inc. sells equipment having a book value of $650,000 and a fair value of $623,110, the difference of $26,890 should be charged to a loss account.32 Minor Leaseback—Leasebacks in which the present value of the rental payments are 10 percent or less of the fair value of the asset are defined as minor leasebacks. In this case, the seller-lessee gives up most of the rights to the use of the asset sold. Therefore,
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the transaction is a sale, and full gain or loss recognition is appropriate. It is not a financing transaction because the risks of ownership have been transferred.33

Lessor
If the lease meets one of the criteria in Group I and both of the criteria in Group II (see Illustration 9), the purchaser-lessor records the transaction as a purchase and a direct-financing lease. If the lease does not meet the criteria, the purchaser-lessor records the transaction as a purchase and an operating lease.

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SALE-LEASEBACK ILLUSTRATION
To illustrate the accounting treatment accorded a sale-leaseback transaction, assume that Lessee Corp. on January 1, 2005, sells a used Boeing 767 having a carrying amount on its books of $75,500,000 to Lessor Corp. for $80,000,000 and immediately leases the aircraft back under the following conditions: 1. 2. 3. 4. 5. 6. The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year. The aircraft has a fair value of $80,000,000 on January 1, 2005, and an estimated economic life of 15 years. Lessee Corp. pays all executory costs. Lessee Corp. depreciates similar aircraft that it owns on a straight-line basis over 15 years. The annual payments assure the lessor a 12 percent return. The incremental borrowing rate of Lessee Corp. is 12 percent.

This lease is a capital lease to Lessee Corp. because the lease term exceeds 75 percent of the estimated life of the aircraft and because the present value of the lease payments exceeds 90 percent of the fair value of the aircraft to the lessor. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist in relation to unreimbursable costs yet to be incurred by the lessor, Lessor Corp. should classify this lease as a direct-financing lease. The typical journal entries to record the transactions relating to this lease for both Lessee Corp. and Lessor Corp. for the first year are presented below.

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Comparative Entries for Sale-Leaseback for Lessee and Lessor

Summary of Study Objectives
11 Describe the lessee's accounting for sale-leaseback transactions. If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee accounts for the transaction as a sale and the lease as a capital lease. Any profit experienced by the seller-lessee from the sale of the assets that are leased back under a capital lease should be deferred and amortized over the lease term (or the economic life if either criterion 1 or 2 is satisfied) in proportion to the amortization of the leased assets. If none of the capital lease criteria are satisfied, the seller-lessee accounts for the transaction as a sale and the lease as an operating lease. Under an operating lease, such profit should be deferred and amortized in proportion to the rental payments over the period of time the assets are expected to be used by the lessee. Note: All asterisked Questions, Brief Exercises, Exercises, and Conceptual Cases relate to material contained in the appendix to the chapter.

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1 2

AICPA, Accounting Trends and Techniques—2001. As demonstrated later in this chapter, certain types of lease arrangements are not capitalized on the balance sheet. The liabilities section is thereby relieved of large future lease commitments that, if recorded, would adversely affect the debt to equity ratio. The reluctance to record lease obligations as liabilities is one of the primary reasons capitalized lease accounting is resisted.

3

The property rights approach was originally recommended in a research study by the AICPA: John H. Myers, “Reporting of Leases in Financial Statements,” Accounting Research Study No. 4 (New York: AICPA, 1964), pp. 10–11. Recently, this view has received additional support. See Peter H. Knutson, “Financial Reporting in the 1990s and Beyond,” Position Paper (Charlottesville, Va.: AIMR, 1993), and Warren McGregor, “Accounting for Leases: A New Approach,” Special Report (Norwalk, Conn.: FASB, 1996).
4

Yuji Ijiri, Recognition of Contractual Rights and Obligations, Research Report (Stamford, Conn.: FASB, 1980).
5 6

A bargain purchase option is defined in the next section. “Accounting for Leases,” FASB Statement No. 13 as amended and interpreted through May 1980 (Stamford, Conn.: FASB, 1980), par. 7. The original lease term is also extended for leases having the following: substantial penalties for nonrenewal; periods for which the lessor has the option to renew or extend the lease; renewal periods preceding the date a bargain purchase option becomes exercisable; and renewal periods in which any lessee guarantees of the lessor's debt are expected to be in effect or in which there will be a loan outstanding from the lessee to the lessor. The lease term, however, can never extend beyond the time a bargain purchase option becomes exercisable. “Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate; Sales-Type Leases of Real Estate; Definition of the Lease Term; Initial Direct Costs of Direct Financing Leases,” Statement of Financial Accounting Standards No. 98 (Stamford, Conn.: FASB, 1988).

7

8

A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is not included in the minimum lease payments. Such costs are recognized as period costs when incurred. “Lessee Guarantee of the Residual Value of Leased Property,” FASB Interpretation No. 19 (Stamford, Conn.: FASB, 1977), par. 3.
9 10 11

FASB Statement No. 13, op. cit., par. 5 (l). Ibid., par. 5 (k). If Lessee Company had an incremental borrowing rate of, say, 9 percent (lower than the 10 percent rate used by Lessor Company) and it did not know the rate used by Lessor Company, the present value computation would have yielded a capitalized amount of $101,675.35 ($23,981.62 × 4.23972). And, because this amount exceeds the $100,000 fair value of the
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equipment, Lessee Company would have had to capitalize the $100,000 and use 10 percent as its effective rate for amortization of the lease obligation.
12

If the lessee purchases a leased asset during the term of a “capital lease,” it is accounted for like a renewal or extension of a capital lease: “Any difference between the purchase price and the carrying amount of the lease obligation shall be recorded as an adjustment of the carrying amount of the asset.” See “Accounting for Purchase of a Leased Asset by the Lessee During the Term of the Lease,” FASB Interpretation No. 26 (Stamford, Conn.: FASB, 1978), par. 5.
13

The higher charges in the early years is one reason lessees are reluctant to adopt the capital-lease accounting method. Lessees (especially those of real estate) claim that it is really no more costly to operate the leased asset in the early years than in the later years. Thus, they advocate an even charge similar to that provided by the operating method.
14

One study indicates that management's behavior did change as a result of FASB No. 13. For example, many companies restructure their leases to avoid capitalization; others increase their purchases of assets instead of leasing; and others, faced with capitalization, postpone their debt offerings or issue stock instead. However, it is interesting to note that the study found no significant effect on stock or bond prices as a result of capitalization of leases. A. Rashad Abdel-khalik, “The Economic Effects on Lessees of FASB Statement No. 13, Accounting for Leases,” Research Report (Stamford, Conn.: FASB, 1981).
15

Some would argue that there is a loser—the U.S. government. The tax benefits enable the profitable investor to reduce or eliminate taxable income.
16 17

FASB Statement No. 13, op. cit., pars. 6, 7, and 8. In the notes to the financial statements (see Illustration 33), the lease receivable is reported at its gross amount (minimum lease payments plus the unguaranteed residual value). In addition, the total unearned interest related to the lease is also reported. As a result, some lessors record lease receivables on a gross basis and record the unearned interest in a separate account. The net approach is illustrated here, which is consistent with the accounting for the lessee.

18

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.
19

Technically, the rate of return demanded by the lessor would be different depending upon whether the residual value was guaranteed or unguaranteed. To simplify the illustrations, we are ignoring this difference in subsequent sections.
20

“Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” Statement of Financial Accounting Standards No. 91 (Stamford: Conn.: FASB, 1987). “Accounting for Leases,” op. cit., par. 16.
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22

For additional discussion on this approach and possible alternatives, see R. J. Swieringa, “When Current Is Noncurrent and Vice Versa!” The Accounting Review (January 1984), pp. 123–30, and A. W. Richardson, “The Measurement of the Current Portion of the Long-Term Lease Obligations—Some Evidence from Practice,” The Accounting Review (October 1985), pp. 744–52. “Accounting for Leases,” FASB Statement No. 13, as amended and interpreted through May 1980 (Stamford, Conn.: FASB, 1980), par. 16. Ibid., par 23. Richard Dieter, “Is Lessee Accounting Working?” The CPA Journal (August 1979), pp. 13–19. This article provides interesting examples of abuses of Statement No. 13, discusses the circumstances that led to the current situation, and proposes a solution.

23

24 25

26

The reason is that most lessors are financial institutions and do not want these types of assets on their balance sheets. In fact, banks and savings and loans are not permitted to report these assets on their balance sheets except for relatively short periods of time. Furthermore, the capital-lease transaction from the lessor's standpoint provides higher income flows in the earlier periods of the lease.
27

As an aside, third-party guarantors have experienced some difficulty. Lloyd's of London, at one time, insured the fast-growing U.S. computer-leasing industry in the amount of $2 billion against revenue losses and losses in residual value if leases were canceled. Because of “overnight” technological improvements and the successive introductions of more efficient and less expensive computers by computer manufacturers, lessees in abundance canceled their leases. As the market for second-hand computers became flooded and residual values plummeted, third-party guarantor Lloyd's of London projected a loss of $400 million. Much of the third-party guarantee business was stimulated by the lessees' and lessors' desire to circumvent FASB Statement No. 13.
28 29

“Is Lessee Accounting Working?” op. cit., p. 19. H. Nailor and A. Lennard, “Capital Leases: Implementation of a New Approach,” Financial Accounting Series No. 206A (Norwalk, Conn.: FASB, 2000). Sales and leasebacks of real estate are often accounted for differently. A discussion of the issues related to these transactions is beyond the scope of this textbook. See Statement of Financial Accounting Standards No. 98, op. cit.

30

31

Statement of Financial Accounting Standards No. 28, “Accounting for Sales with Leasebacks” (Stamford, Conn.: FASB, 1979). There can be two types of losses in sale-leaseback arrangements. One is a real economic loss that results when the carrying amount of the asset is higher than the fair market value of the asset. In this case, the loss should be recognized. An artificial loss results when the sale price is below the carrying amount of the asset but the fair market value is above the

32

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carrying amount. In this case the loss is more in the form of prepaid rent and should be deferred and amortized in the future.
33

In some cases the seller-lessee retains more than a minor part but less than substantially all. The computations to arrive at these values are complex and beyond the scope of this textbook.

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Questions 1. Jackie Remmers Co. is expanding its operations and is in the process of selecting the method of financing this program. After some investigation, the company determines that it may (1) issue bonds and with the proceeds purchase the needed assets or (2) lease the assets on a long-term basis. Without knowing the comparative costs involved, answer these questions: a. b. c. 2. What might be the advantages of leasing the assets instead of owning them? What might be the disadvantages of leasing the assets instead of owning them? In what way will the balance sheet be differently affected by leasing the assets as opposed to issuing bonds and purchasing the assets?

Mildred Natalie Corp. is considering leasing a significant amount of assets. The president, Joan Elaine Robinson, is attending an informal meeting in the afternoon with a potential lessor. Because her legal advisor cannot be reached, she has called on you, the controller, to brief her on the general provisions of lease agreements to which she should give consideration in such preliminary discussions with a possible lessor. Identify the general provisions of the lease agreement that the president should be told to include in her discussion with the potential lessor. Identify the two recognized lease accounting methods for lessees and distinguish between them. Wayne Higley Company rents a warehouse on a month-to-month basis for the storage of its excess inventory. The company periodically must rent space whenever its production greatly exceeds actual sales. For several years the company officials have discussed building their own storage facility, but this enthusiasm wavers when sales increase sufficiently to absorb the excess inventory. What is the nature of this type of lease arrangement, and what accounting treatment should be accorded it? Distinguish between minimum rental payments and minimum lease payments, and indicate what is included in minimum lease payments. Explain the distinction between a direct-financing lease and a sales-type lease for a lessor. Outline the accounting procedures involved in applying the operating method by a lessee. Outline the accounting procedures involved in applying the capital-lease method by a lessee. Identify the lease classifications for lessors and the criteria that must be met for each classification.

3. 4.

5. 6. 7. 8. 9.

10. Outline the accounting procedures involved in applying the direct-financing method.

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11. Outline the accounting procedures involved in applying the operating method by a lessor. 12. Joan Elbert Company is a manufacturer and lessor of computer equipment. What should be the nature of its lease arrangements with lessees if the company wishes to account for its lease transactions as sales-type leases? 13. Gordon Graham Corporation's lease arrangements qualify as sales-type leases at the time of entering into the transactions. How should the corporation recognize revenues and costs in these situations? 14. Joann Skabo, M.D. (lessee) has a noncancelable 20-year lease with Cheryl Countryman Realty, Inc. (lessor) for the use of a medical building. Taxes, insurance, and maintenance are paid by the lessee in addition to the fixed annual payments, of which the present value is equal to the fair market value of the leased property. At the end of the lease period, title becomes the lessee's at a nominal price. Considering the terms of the lease described above, comment on the nature of the lease transaction and the accounting treatment that should be accorded it by the lessee. 15. The residual value is the estimated fair value of the leased property at the end of the lease term. a. b. Of what significance is (1) an unguaranteed and (2) a guaranteed residual value in the lessee's accounting for a capitalized-lease transaction? Of what significance is (1) an unguaranteed and (2) a guaranteed residual value in the lessor's accounting for a direct-financing lease transaction?

16. How should changes in the estimated residual value be handled by the lessor? 17. Describe the effect of a “bargain purchase option” on accounting for a capital-lease transaction by a lessee. 18. What are “initial direct costs” and how are they accounted for? 19. What disclosures should be made by a lessee if the leased assets and the related obligation are not capitalized? 20. What is the nature of a “sale-leaseback” transaction?

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BRIEF EXERCISES
1. Assume that Best Buy leased equipment from Photon Company. The lease term is 5 years and requires equal rental payments of $30,000 at the beginning of each year. The equipment has a fair value at the inception of the lease of $138,000, an estimated useful life of 8 years, and no residual value. Best Buy pays all executory costs directly to third parties. Photon set the annual rental to earn a rate of return of 10%, and this fact is known to Best Buy. The lease does not transfer title or contain a bargain purchase option. How should Best Buy classify this lease? Waterworld Company leased equipment from Costner Company. The lease term is 4 years and requires equal rental payments of $37,283 at the beginning of each year. The equipment has a fair value at the inception of the lease of $130,000, an estimated useful life of 4 years, and no salvage value. Waterworld pays all executory costs directly to third parties. The appropriate interest rate is 10%. Prepare Waterworld's January 1, 2005, journal entries at the inception of the lease. Rick Kleckner Corporation recorded a capital lease at $200,000 on January 1, 2005. The interest rate is 12%. Kleckner Corporation made the first lease payment of $35,947 on January 1, 2005. The lease requires eight annual payments. The equipment has a useful life of 8 years with no salvage value. Prepare Kleckner Corporation's December 31, 2005, adjusting entries. Use the information for Rick Kleckner Corporation from BE21-3. Assume that at December 31, 2005, Kleckner made an adjusting entry to accrue interest expense of $19,686 on the lease. Prepare Kleckner's January 1, 2006, journal entry to record the second lease payment of $35,947. Jana Kingston Corporation enters into a lease on January 1, 2005, that does not transfer ownership or contain a bargain purchase option. It covers 3 years of the equipment's 8-year useful life, and the present value of the minimum lease payments is less than 90% of the fair market value of the asset leased. Prepare Jana Kingston's journal entry to record its January 1, 2005, annual lease payment of $37,500. Assume that IBM leased equipment that was carried at a cost of $150,000 to Sharon Swander Company. The term of the lease is 6 years beginning January 1, 2005, with equal rental payments of $30,677 at the beginning of each year. All executory costs are paid by Swander directly to third parties. The fair value of the equipment at the inception of the lease is $150,000. The equipment has a useful life of 6 years with no salvage value. The lease has an implicit interest rate of 9%, no bargain purchase option, and no transfer of title. Collectibility is reasonably assured with no additional cost to be incurred by Henkel. Prepare IBM's January 1, 2005, journal entries at the inception of the lease.

2.

3.

4.

5.

6.

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7.

Use the information for IBM from BE21-6. Assume the direct-financing lease was recorded at a present value of $150,000. Prepare IBM's December 31, 2005, entry to record interest. Jennifer Brent Corporation owns equipment that cost $72,000 and has a useful life of 8 years with no salvage value. On January 1, 2005, Jennifer Brent leases the equipment to Donna Havaci Inc. for one year with one rental payment of $15,000 on January 1. Prepare Jennifer Brent Corporation's 2005 journal entries. Indiana Jones Corporation enters into a 6-year lease of equipment on January 1, 2005, which requires 6 annual payments of $30,000 each, beginning January 1, 2005. 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, 2005, journal entries assuming an interest rate of 10%.

8.

9.

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, 2005, journal entries. 11. Starfleet Corporation manufactures replicators. On January 1, 2005, 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, 2005, journal entries. 12. On January 1, 2005, Acme Animation sold a truck to Coyote Finance for $35,000 and immediately leased it back. The truck was carried on Acme's books at $28,000. The term of the lease is 5 years, and title transfers to Acme at lease-end. The lease requires five equal rental payments of $9,233 at the end of each year. The appropriate rate of interest is 10%, and the truck has a useful life of 5 years with no salvage value. Prepare Acme's 2005 journal entries.

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EXERCISES
1. (Lessee Entries; Capital Lease with Unguaranteed Residual Value) On January 1, 2004, Burke Corporation signed a 5-year noncancelable lease for a machine. The terms of the lease called for Burke to make annual payments of $8,668 at the beginning of each year, starting January 1, 2004. The machine has an estimated useful life of 6 years and a $5,000 unguaranteed residual value. The machine reverts back to the lessor at the end of the lease term. Burke uses the straight-line method of depreciation for all of its plant assets. Burke's incremental borrowing rate is 10%, and the Lessor's implicit rate is unknown. Instructions a. b. c. 2. What type of lease is this? Explain. Compute the present value of the minimum lease payments. Prepare all necessary journal entries for Burke for this lease through January 1, 2005.

(Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Pat Delaney Company leases an automobile with a fair value of $8,725 from John Simon Motors, Inc., on the following terms: 1. 2. 3. 4. 5. Noncancelable term of 50 months. Rental of $200 per month (at end of each month). (The present value at 1% per month is $7,840.) Estimated residual value after 50 months is $1,180. (The present value at 1% per month is $715.) Delaney Company guarantees the residual value of $1,180. Estimated economic life of the automobile is 60 months. Delaney Company's incremental borrowing rate is 12% a year (1% a month). Simon's implicit rate is unknown. What is the nature of this lease to Delaney Company? What is the present value of the minimum lease payments? Record the lease on Delaney Company's books at the date of inception. Record the first month's depreciation on Delaney Company's books (assume straight-line). Record the first month's lease payment.

Instructions a. b. c. d. e. 3.

(Lessee Entries; Capital Lease with Executory Costs and Unguaranteed Residual Value) Assume that on January 1, 2005, Kimberly-Clark Corp. signs a 10-year

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noncancelable lease agreement to lease a storage building from Sheffield Storage Company. The following information pertains to this lease agreement. 1. 2. 3. The agreement requires equal rental payments of $72,000 beginning on January 1, 2005. The fair value of the building on January 1, 2005 is $440,000. The building has an estimated economic life of 12 years, with an unguaranteed residual value of $10,000. Kimberly-Clark depreciates similar buildings on the straight-line method. The lease is nonrenewable. At the termination of the lease, the building reverts to the lessor. Kimberly-Clark's incremental borrowing rate is 12% per year. The lessor's implicit rate is not known by Kimberly-Clark. The yearly rental payment includes $2,470.51 of executory costs related to taxes on the property.

4. 5. 6.

Instructions 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 2005 and 2006. Kimberly-Clark's corporate year end is December 31. 4. (Lessor Entries; Direct-Financing Lease with Option to Purchase) Castle Leasing Company signs a lease agreement on January 1, 2005, to lease electronic equipment to Jan Way Company. The term of the noncancelable lease is 2 years, and payments are required at the end of each year. The following information relates to this agreement: 1. 2. 3. 4. 5. Jan Way Company has the option to purchase the equipment for $16,000 upon the termination of the lease. The equipment has a cost and fair value of $160,000 to Castle Leasing Company. The useful economic life is 2 years, with a salvage value of $16,000. Jan Way Company is required to pay $5,000 each year to the lessor for executory costs. Castle Leasing Company desires to earn a return of 10% on its investment. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Prepare the journal entries on the books of Castle Leasing to reflect the payments received under the lease and to recognize income for the years 2005 and 2006. Assuming that Jan Way Company exercises its option to purchase the equipment on December 31, 2006, prepare the journal entry to reflect the sale on Castle's books.

Instructions a. b.

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5.

(Type of Lease; Amortization Schedule) Mike Maroscia Leasing Company leases a new machine that has a cost and fair value of $95,000 to Maggie Sharrer Corporation on a 3-year noncancelable contract. Maggie Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2005. Mike Maroscia Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31. Instructions a. b. Discuss the nature of the lease arrangement and the accounting method that each party to the lease should apply. Prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved.

6.

(Lessor Entries; Sales-Type Lease) Crosley Company, a machinery dealer, leased a machine to Dexter Corporation on January 1, 2004. 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, 2004. Crosley had purchased the machine during 2003 for $160,000. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by Crosley. Crosley 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 Crosley at the termination of the lease. Instructions a. b. Compute the amount of the lease receivable. Prepare all necessary journal entries for Crosley for 2004.

7.

(Lessee-Lessor Entries; Sales-Type Lease) On January 1, 2004, Bensen Company leased equipment to Flynn Corporation. The following information pertains to this lease. 1. 2. 3. 4. 5. 6. 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. Equal rental payments are due on January 1 of each year, beginning in 2004. The fair value of the equipment on January 1, 2004, is $150,000, and its cost is $120,000. The equipment has an economic life of 8 years, with an unguaranteed residual value of $10,000. Flynn depreciates all of its equipment on a straight-line basis. Bensen set the annual rental to ensure an 11% rate of return. Flynn's incremental borrowing rate is 12%, and the implicit rate of the lessor is unknown. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by the lessor.

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Instructions a. b. c. Discuss the nature of this lease to Bensen and Flynn. Calculate the amount of the annual rental payment. Prepare all the necessary journal entries for Flynn for 2004. d. Prepare all the necessary journal entries for Bensen for 2004. 8. (Lessee Entries with Bargain Purchase Option) The following facts pertain to a noncancelable lease agreement between Mike Mooney Leasing Company and Denise Rode Company, a lessee. Inception date: Annual lease payment due at the beginning of each year, beginning with May 1, 2004 Bargain purchase option price at end of lease term Lease term Economic life of leased equipment Lessor's cost Fair value of asset at May 1, 2004 Lessor's implicit rate Lessee's incremental borrowing rate May 1, 2004 $21,227.65 $ 4,000.00 5 years 10 years $65,000.00 $91,000.00 10% 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. b. c. d. Discuss the nature of this lease to Rode Company. Discuss the nature of this lease to Mooney Company. Prepare a lease amortization schedule for Rode Company for the 5-year lease term. 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 2004 and 2005. Rode's annual accounting period ends on December 31. Reversing entries are used by Rode.

9.

(Lessor Entries with Bargain Purchase Option) A lease agreement between Mooney Leasing Company and Rode Company is described in E21-8. Instructions
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(Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor. a. b. c. Compute the amount of the lease receivable at the inception of the lease. Prepare a lease amortization schedule for Mooney Leasing Company for the 5-year lease term. 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 2004, 2005, and 2006. The lessor's accounting period ends on December 31. Reversing entries are not used by Mooney.

10. (Computation of Rental; Journal Entries for Lessor) Morgan Marie Leasing Company signs an agreement on January 1, 2004, to lease equipment to Cole William Company. The following information relates to this agreement. 1. 2. 3. 4. 5. 6. The term of the noncancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years. The cost of the asset to the lessor is $245,000. The fair value of the asset at January 1, 2004, is $245,000. 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 $43,622, none of which is guaranteed. Cole William Company assumes direct responsibility for all executory costs. The agreement requires equal annual rental payments, beginning on January 1, 2004. Collectibility of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.

Instructions (Round all numbers to the nearest cent.) a. b. c. Assuming the lessor desires a 10% rate of return on its investment, calculate the amount of the annual rental payment required. Round to the nearest dollar. Prepare an amortization schedule that would be suitable for the lessor for the lease term. Prepare all of the journal entries for the lessor for 2004 and 2005 to record the lease agreement, the receipt of lease payments, and the recognition of income. Assume the lessor's annual accounting period ends on December 31.

11. (Amortization Schedule and Journal Entries for Lessee) Laura Potts Leasing Company signs an agreement on January 1, 2004, to lease equipment to Janet Plote Company. The following information relates to this agreement.
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1.

The term of the noncancelable lease is 5 years with no renewal option. The equipment has an estimated economic life of 5 years. 2. The fair value of the asset at January 1, 2004, is $80,000. 3. 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 $7,000, none of which is guaranteed. 4. Plote Company assumes direct responsibility for all executory costs, which include the following annual amounts: (1) $900 to Rocky Mountain Insurance Company for insurance and (2) $1,600 to Laclede County for property taxes. 5. The agreement requires equal annual rental payments of $18,142.95 to the lessor, beginning on January 1, 2004. 6. The lessee's incremental borrowing rate is 12%. The lessor's implicit rate is 10% and is known to the lessee. 7. Plote Company uses the straight-line depreciation method for all equipment. 8. Plote uses reversing entries when appropriate. Instructions (Round all numbers to the nearest cent.) a. b. Prepare an amortization schedule that would be suitable for the lessee for the lease term. Prepare all of the journal entries for the lessee for 2004 and 2005 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee's annual accounting period ends on December 31.

12. (Accounting for an Operating Lease) On January 1, 2004, Doug Nelson Co. leased a building to Patrick Wise Inc. The relevant information related to the lease is as follows. 1. 2. 3. 4. 5. The lease arrangement is for 10 years. The leased building cost $4,500,000 and was purchased for cash on January 1, 2004. The building is depreciated on a straight-line basis. Its estimated economic life is 50 years. Lease payments are $275,000 per year and are made at the end of the year. Property tax expense of $85,000 and insurance expense of $10,000 on the building were incurred by Nelson in the first year. Payment on these two items was made at the end of the year. Both the lessor and the lessee are on a calendar-year basis. Prepare the journal entries that Nelson Co. should make in 2004. Prepare the journal entries that Wise Inc. should make in 2004.

6. a. b.

Instructions

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c.

If Nelson paid $30,000 to a real estate broker on January 1, 2004, as a fee for finding the lessee, how much should be reported as an expense for this item in 2004 by Nelson Co.?

13. (Accounting for an Operating Lease) On January 1, 2005, a machine was purchased for $900,000 by Tom Young Co. The machine is expected to have an 8-year life with no salvage value. It is to be depreciated on a straight-line basis. The machine was leased to St. Leger Inc. on January 1, 2005, at an annual rental of $210,000. Other relevant information is as follows. 1. 2. 3. 4. The lease term is for 3 years. Tom Young Co. incurred maintenance and other executory costs of $25,000 in 2005 related to this lease. The machine could have been sold by Tom Young Co. for $940,000 instead of leasing it. St. Leger is required to pay a rent security deposit of $35,000 and to prepay the last month's rent of $17,500. How much should Tom Young Co. report as income before income tax on this lease for 2005? What amount should St. Leger Inc. report for rent expense for 2005 on this lease?

Instructions a. b.

14. (Operating Lease for Lessee and Lessor) On February 20, 2004, Barbara Brent Inc., purchased a machine for $1,500,000 for the purpose of leasing it. The machine is expected to have a 10-year life, no residual value, and will be depreciated on the straight-line basis. The machine was leased to Chuck Rudy Company on March 1, 2004, for a 4-year period at a monthly rental of $19,500. There is no provision for the renewal of the lease or purchase of the machine by the lessee at the expiration of the lease term. Brent paid $30,000 of commissions associated with negotiating the lease in February 2004: Instructions a. What expense should Chuck Rudy Company record as a result of the facts above for the year ended December 31, 2004? Show supporting computations in good form. What income or loss before income taxes should Brent record as a result of the facts above for the year ended December 31, 2004? (Hint: Amortize commissions over the life of the lease.)

b.

(AICPA adapted)

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15. (Sale and Leaseback) Assume that on January 1, 2004, Elmer's Restaurants sells a computer system to Liquidity Finance Co. for $680,000 and immediately leases the computer system back. The relevant information is as follows. 1. 2. 3. 4. 5. 6. The computer was carried on Elmer's books at a value of $600,000. The term of the noncancelable lease is 10 years; title will transfer to Elmer. The lease agreement requires equal rental payments of $110,666.81 at the end of each year. The incremental borrowing rate for Elmer is 12%. Elmer is aware that Liquidity Finance Co. set the annual rental to insure a rate of return of 10%. The computer has a fair value of $680,000 on January 1, 2004, and an estimated economic life of 10 years. Elmer pays executory costs of $9,000 per year.

Instructions Prepare the journal entries for both the lessee and the lessor for 2004 to reflect the sale and leaseback agreement. No uncertainties exist, and collectibility is reasonably certain. 16. (Lessee-Lessor, Sale-Leaseback) Presented below are four independent situations. a. On December 31, 2005, Nancy Zarle Inc. sold computer equipment to Erin Daniell Co. and immediately leased it back for 10 years. The sales price of the equipment was $520,000, its carrying amount is $400,000, and its estimated remaining economic life is 12 years. Determine the amount of deferred revenue to be reported from the sale of the computer equipment on December 31, 2005. b. On December 31, 2005, Linda Wasicsko Co. sold a machine to Cross Co. and simultaneously leased it back for one year. The sale price of the machine was $480,000, the carrying amount is $420,000, and it had an estimated remaining useful life of 14 years. The present value of the rental payments for the one year is $35,000. At December 31, 2005, how much should Linda Wasicsko report as deferred revenue from the sale of the machine? c. On January 1, 2005, Joe McKane Corp. sold an airplane with an estimated useful life of 10 years. At the same time, Joe McKane leased back the plane for 10 years. The sales price of the airplane was $500,000, the carrying amount $379,000, and the annual rental $73,975.22. Joe McKane Corp. intends to depreciate the leased asset using the sum-of-the-years'-digits depreciation method. Discuss how the gain on the sale should be reported at the end of 2005 in the financial statements. d. On January 1, 2005, Dick Sondgeroth Co. sold equipment with an estimated useful life of 5 years. At the same time, Dick Sondgeroth leased back the equipment for 2 years under a lease classified as an operating lease. The sales price (fair market value) of the equipment was $212,700, the carrying amount is $300,000, the monthly rental under the lease is $6,000, and the present value of the rental payments is $115,753. For the year ended December 31, 2005, determine which items would be reported on its income statement for the sale-leaseback transaction.
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PROBLEMS
1. (Lessee-Lessor Entries; Sales-Type Lease) Stine Leasing Company agrees to lease machinery to Potter Corporation on January 1, 2004. The following information relates to the lease agreement. 1. 2. 3. The term of the lease is 7 years with no renewal option, and the machinery has an estimated economic life of 9 years. The cost of the machinery is $420,000, and the fair value of the asset on January 1, 2004, is $560,000. At the end of the lease term the asset reverts to the lessor. At the end of the lease term the asset is expected to have a guaranteed residual value of $80,000. Potter depreciates all of its equipment on a straight-line basis. The lease agreement requires equal annual rental payments, beginning on January 1, 2004. The collectibility of the lease payments is reasonably predictable, and there are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor. Stine desires a 10% rate of return on its investments. Potter's incremental borrowing rate is 11%, and the lessor's implicit rate is unknown. Discuss the nature of this lease for both the lessee and the lessor. Calculate the amount of the annual rental payment required. Compute the present value of the minimum lease payments. Prepare the journal entries Potter would make in 2004 and 2005 related to the lease arrangement. Prepare the journal entries Stine would make in 2004 and 2005.

4. 5.

6.

Instructions a. b. c. d. e. 2.

(Lessee-Lessor Entries; Operating Lease) Synergetics Inc. leased a new crane to M. K. Gumowski Construction under a 5-year noncancelable contract starting January 1, 2005. Terms of the lease require payments of $22,000 each January 1, starting January 1, 2005. Synergetics will pay insurance, taxes, and maintenance charges on the crane, which has an estimated life of 12 years, a fair value of $160,000, and a cost to Synergetics of $160,000. The estimated fair value of the crane is expected to be $45,000 at the end of the lease term. No bargain purchase or renewal options are included in the contract. Both Synergetics and Gumowski adjust and close books annually at December 31. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Gumowski's incremental borrowing rate is 10%, and Synergetics' implicit interest rate of 9% is known to Gumowski. Instructions
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a. b.

Identify the type of lease involved and give reasons for your classification. Discuss the accounting treatment that should be applied by both the lessee and the lessor. Prepare all the entries related to the lease contract and leased asset for the year 2005 for the lessee and lessor, assuming the following amounts. 1. 2. 3. 4. Insurance $500. Taxes $2,000. Maintenance $650. Straight-line depreciation and salvage value $10,000.

c. 3.

Discuss what should be presented in the balance sheet, the income statement, and the related notes of both the lessee and the lessor at December 31, 2005.

(Lessee-Lessor Entries, Balance Sheet Presentation; Sales-Type Lease) Cascade Industries and Barbara Hardy Inc. enter into an agreement that requires Barbara Hardy Inc. to build three diesel-electric engines to Cascade's specifications. Upon completion of the engines, Cascade 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, 2005, and requires annual rental payments of $620,956 each January 1, starting January 1, 2005. Cascade's incremental borrowing rate is 10%, and the implicit interest rate used by Barbara Hardy Inc. and known to Cascade 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. Cascade depreciates similar equipment on a straight-line basis. At the end of the lease, Cascade assumes title to the engines. Collectibility of the lease payments is reasonably certain, and no uncertainties exist relative to unreimbursable lessor costs. Instructions (Round all numbers to the nearest dollar.) a. b. c. d. e. Discuss the nature of this lease transaction from the viewpoints of both lessee and lessor. Prepare the journal entry or entries to record the transaction on January 1, 2005, on the books of Cascade Industries. Prepare the journal entry or entries to record the transaction on January 1, 2005, on the books of Barbara Hardy Inc. Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2005. Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2005. (Prepare a lease amortization schedule for 2 years.)
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f. 4.

Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2005, for both the lessee and the lessor.

(Balance Sheet and Income Statement Disclosure—Lessee) The following facts pertain to a noncancelable lease agreement between Ben Alschuler Leasing Company and John McKee Electronics, a lessee, for a computer system. Inception date Lease term Economic life of leased equipment Fair value of asset at October 1, 2004 Residual value at end of lease term Lessor's implicit rate Lessee's incremental borrowing rate Annual lease payment due at the beginning of each year, beginning with October 1, 2004 October 1, 2004 6 years 6 years $200,255 –0– 10% 10% $41,800

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, which amount to $5,500 per year and are to be paid each October 1, beginning October 1, 2004. (This $5,500 is not included in the rental payment of $41,800.) The asset will revert to the lessor at the end of the lease term. The straight-line depreciation method is used for all equipment. The following amortization schedule has been prepared correctly for use by both the lessor and the lessee in accounting for this lease. The lease is to be accounted for properly as a capital lease by the lessee and as a direct-financing lease by the lessor.
Interest (10%) on Unpaid Reduction of Lease Liability/Receivable Liability/Receivable $ 41,800 25,954 28,550 31,405 34,545 38,001 $200,255

Date 10/01/04 10/01/04 10/01/05 10/01/06 10/01/07 10/01/08 10/01/09

Annual Lease Payment/Receipt $ 41,800 41,800 41,800 41,800 41,800 41,800 $250,800

Balance of Lease Liability/Receivable $200,255 158,455 132,501 103,951 72,546 38,001 –0–

$15,846 13,250 10,395 7,255 3,799* $50,545

*

Rounding error is $1.

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Instructions (Round all numbers to the nearest cent.) a. Assuming the lessee's accounting period ends on September 30, answer the following questions with respect to this lease agreement. 1. 2. 3. 4. b. What items and amounts will appear on the lessee's income statement for the year ending September 30, 2005? What items and amounts will appear on the lessee's balance sheet at September 30, 2005? What items and amounts will appear on the lessee's income statement for the year ending September 30, 2006? What items and amounts will appear on the lessee's balance sheet at September 30, 2006?

Assuming the lessee's accounting period ends on December 31, answer the following questions with respect to this lease agreement. 1. 2. 3. 4. What items and amounts will appear on the lessee's income statement for the year ending December 31, 2004? What items and amounts will appear on the lessee's balance sheet at December 31, 2004? What items and amounts will appear on the lessee's income statement for the year ending December 31, 2005? What items and amounts will appear on the lessee's balance sheet at December 31, 2005?

5.

(Balance Sheet and Income Statement Disclosure—Lessor) Assume the same information as in P21-4. Instructions (Round all numbers to the nearest cent.) a. Assuming the lessor's accounting period ends on September 30, answer the following questions with respect to this lease agreement. 1. 2. 3. 4. What items and amounts will appear on the lessor's income statement for the year ending September 30, 2005? What items and amounts will appear on the lessor's balance sheet at September 30, 2005? What items and amounts will appear on the lessor's income statement for the year ending September 30, 2006? What items and amounts will appear on the lessor's balance sheet at September 30, 2006?

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b.

Assuming the lessor's accounting period ends on December 31, answer the following questions with respect to this lease agreement. 1. 2. 3. 4. What items and amounts will appear on the lessor's income statement for the year ending December 31, 2004? What items and amounts will appear on the lessor's balance sheet at December 31, 2004? What items and amounts will appear on the lessor's income statement for the year ending December 31, 2005? What items and amounts will appear on the lessor's balance sheet at December 31, 2005?

6.

(Lessee Entries with Residual Value) The following facts pertain to a noncancelable lease agreement between Frank Voris Leasing Company and Tom Zarle Company, a lessee. Inception date Annual lease payment due at the beginning of each year, beginning with January 1, 2004 Residual value of equipment at end of lease term, guaranteed by the lessee Lease term Economic life of leased equipment Fair value of asset at January 1, 2004 Lessor's implicit rate Lessee's incremental borrowing rate January 1, 2004 $81,365 $50,000 6 years 6 years $400,000 12% 12%

The lessee assumes responsibility for all executory costs, which are expected to amount to $4,000 per year. The asset will revert to the lessor at the end of the lease term. The lessee has guaranteed the lessor a residual value of $50,000. The lessee uses the straight-line depreciation method for all equipment. Instructions (Round all numbers to the nearest cent.) a. b. Prepare an amortization schedule that would be suitable for the lessee for the lease term. Prepare all of the journal entries for the lessee for 2004 and 2005 to record the lease agreement, the lease payments, and all expenses related to this lease. Assume the lessee's annual accounting period ends on December 31 and reversing entries are used when appropriate.

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7.

(Lessee Entries and Balance Sheet Presentation; Capital Lease) Hilary Brennan Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2004. Annual rental payments of $32,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 10%; Brennan's incremental borrowing rate is 12%. Brennan is unaware of the rate being used by the lessor. At the end of the lease, Brennan has the option to buy the equipment for $1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Brennan uses the straight-line method of depreciation on similar owned equipment. Instructions (Round all numbers to the nearest dollar.) a. b. Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2004, by Brennan. (Assume no residual value.) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2005, by Brennan. (Prepare the lease amortization schedule for all five payments.) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2006, by Brennan. What amounts would appear on Brennan's December 31, 2006, balance sheet relative to the lease arrangement?

c. d. 8.

(Lessee Entries and Balance Sheet Presentation; Capital Lease) On January 1, 2005, Charlie Doss Company contracts to lease equipment for 5 years, agreeing to make a payment of $94,732 (including the executory costs of $6,000) at the beginning of each year, starting January 1, 2005. The taxes, the insurance, and the maintenance, estimated at $6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at $370,000. The asset is to be amortized on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Doss's incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Doss. Title to the equipment transfers to Doss when the lease expires. The asset has an estimated useful life of 5 years and no residual value. Instructions (Round all numbers to the nearest dollar.) a. Explain the probable relationship of the $370,000 amount to the lease arrangement. b. Prepare the journal entry or entries that should be recorded on January 1, 2005, by Charlie Doss Company.

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c. d. e. f. 9.

Prepare the journal entry to record depreciation of the leased asset for the year 2005. Prepare the journal entry to record the interest expense for the year 2005. Prepare the journal entry to record the lease payment of January 1, 2006, assuming reversing entries are not made. What amounts will appear on the lessee's December 31, 2005, balance sheet relative to the lease contract?

(Lessee Entries, Capital Lease with Monthly Payments) John Roesch Inc. was incorporated in 2003 to operate as a computer software service firm with an accounting fiscal year ending August 31. Roesch's primary product is a sophisticated online inventory-control system; its customers pay a fixed fee plus a usage charge for using the system. Roesch has leased a large, Alpha-3 computer system from the manufacturer. The lease calls for a monthly rental of $50,000 for the 144 months (12 years) of the lease term. The estimated useful life of the computer is 15 years. Each scheduled monthly rental payment includes $4,000 for full-service maintenance on the computer to be performed by the manufacturer. All rentals are payable on the first day of the month beginning with August 1, 2004, the date the computer was installed and the lease agreement was signed. The lease is noncancelable for its 12-year term, and it is secured only by the manufacturer's chattel lien on the Alpha-3 system. Roesch can purchase the Alpha-3 system from the manufacturer at the end of the 12-year lease term for 75% of the computer's fair value at that time. This lease is to be accounted for as a capital lease by Roesch, and it will be depreciated by the straight-line method with no expected salvage value. Borrowed funds for this type of transaction would cost Roesch 12% per year (1% per month). Following is a schedule of the present value of $1 for selected periods discounted at 1% per period when payments are made at the beginning of each period. Periods (months) 1 2 3 143 144 Instructions Present Value of $1 per Period Discounted at 1% per Period 1.000 1.990 2.970 76.658 76.899

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Prepare, in general journal form, all entries Roesch should have made in its accounting records during August 2004 relating to this lease. Give full explanations and show supporting computations for each entry. Remember, August 31, 2004, is the end of Roesch's fiscal accounting period and it will be preparing financial statements on that date. Do not prepare closing entries. (AICPA adapted) 10. (Lessor Computations and Entries; Sales-Type Lease with Unguaranteed RV) Thomas Hanson Company manufactures a computer with an estimated economic life of 12 years and leases it to Flypaper Airlines for a period of 10 years. The normal selling price of the equipment is $210,482, and its unguaranteed residual value at the end of the lease term is estimated to be $20,000. Flypaper will pay annual payments of $30,000 at the beginning of each year and all maintenance, insurance, and taxes. Hanson incurred costs of $135,000 in manufacturing the equipment and $4,000 in negotiating and closing the lease. Hanson has determined that the collectibility of the lease payments is reasonably predictable, that no additional costs will be 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. 2. 3. b. c. Lease receivable. Sales price. Cost of sales.

Prepare a 10-year lease amortization schedule. Prepare all of the lessor's journal entries for the first year.

11. (Lessee Computations and Entries; Capital Lease with Unguaranteed Residual Value) Assume the same data as in P21-10 with Flypaper Airlines Co. having an incremental borrowing rate of 10%. Instructions (Round all numbers to the nearest dollar.) a. b. c. Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial obligation under capital leases. Prepare a 10-year lease amortization schedule. Prepare all of the lessee's journal entries for the first year.

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12. (Basic Lessee Accounting with Difficult PV Calculation) In 2002 Judy Yin Trucking Company negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were erected to the company's specifications on land owned by the company. On January 1, 2003, Judy Yin Trucking Company took possession of the lease properties. On January 1, 2003 and 2004, the company made cash payments of $1,048,000 that were recorded as rental expenses. Although the terminals have a composite useful life of 40 years, the noncancelable lease runs for 20 years from January 1, 2003, with a bargain purchase option available upon expiration of the lease. The 20-year lease is effective for the period January 1, 2003, through December 31, 2022. Advance rental payments of $900,000 are payable to the lessor on January 1 of each of the first 10 years of the lease term. Advance rental payments of $320,000 are due on January 1 for each of the last 10 years of the lease. The company has an option to purchase all of these leased facilities for $1 on December 31, 2022. It also must make annual payments to the lessor of $125,000 for property taxes and $23,000 for insurance. The lease was negotiated to assure the lessor a 6% rate of return. Instructions (Round all numbers to the nearest dollar.) a. b. Prepare a schedule to compute for Judy Yin Trucking Company the discounted present value of the terminal facilities and related obligation at January 1, 2003. Assuming that the discounted present value of terminal facilities and related obligation at January 1, 2003, was $8,400,000, prepare journal entries for Judy Yin Trucking Company to record the: 1. 2. 3. Cash payment to the lessor on January 1, 2005. Amortization of the cost of the leased properties for 2005 using the straight-line method and assuming a zero salvage value. Accrual of interest expense at December 31, 2005. Selected present value factors are as follows: For an Ordinary Annuity of $1 at 6% .943396 1.833393 6.209794 6.801692 7.360087 11.158117 11.469921

Periods 1 2 8 9 10 19 20

For $1 at 6% .943396 .889996 .627412 .591898 .558395 .330513 .311805

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(AICPA adapted) 13. (Lessor Computations and Entries; Sales-Type Lease with Guaranteed Residual Value) Laura Jennings Inc. manufactures an X-ray machine with an estimated life of 12 years and leases it to Craig Gocker 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 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. Laura Jennings Inc. incurred costs of $210,000 in manufacturing the machine and $14,000 in negotiating and closing the lease. Laura Jennings 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. 2. 3. b. c. Lease receivable at inception of the lease. Sales price. Cost of sales.

Prepare a 10-year lease amortization schedule. Prepare all of the lessor's journal entries for the first year.

14. (Lessee Computations and Entries; Capital Lease with Guaranteed Residual Value) Assume the same data as in P21-13 and that Craig Gocker Medical Center has an incremental borrowing rate of 10%. Instructions (Round all numbers to the nearest dollar.) a. b. c. Discuss the nature of this lease in relation to the lessee, and compute the amount of the initial obligation under capital leases. Prepare a 10-year lease amortization schedule. Prepare all of the lessee's journal entries for the first year.

15. (Operating Lease vs. Capital Lease) You are auditing the December 31, 2003, financial statements of Sarah Shamess, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a 2002 Shirk automobile not listed in the equipment subsidiary ledger is parked in the company garage. You ask Sally Straub, plant manager, about the vehicle, and she tells you that the company

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did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2003, with Jack Hayes New and Used Cars. You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms. 1. 2. 3. 4. 5. Noncancelable term of 50 months. Rental of $180 per month (at the end of each month). (The present value at 1% per month is $7,055.) Estimated residual value after 50 months is $1,100. (The present value at 1% per month is $699.) Shamess guarantees the residual value of $1,100. Estimated economic life of the automobile is 60 months. Shamess's incremental borrowing rate is 12% per year (1% per month).

Instructions You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client's books. (It is also necessary to include the fact that you communicated this information to your client.) 16. (Lessee-Lessor Accounting for Residual Values) Jodie Lanier Dairy leases its milking equipment from Steve Zeff Finance Company under the following lease terms. 1. 2. The lease term is 10 years, noncancelable, and requires equal rental payments of $25,250 due at the beginning of each year starting January 1, 2004. The equipment has a fair value and cost at the inception of the lease (January 1, 2004) of $185,078, an estimated economic life of 10 years, and a residual value (which is guaranteed by Lanier Dairy) of $20,000. The lease contains no renewable options, and the equipment reverts to Steve Zeff Finance Company upon termination of the lease. Lanier Dairy's incremental borrowing rate is 9% per year. The implicit rate is also 9%. Lanier Dairy depreciates similar equipment that it owns on a straight-line basis. Collectibility of the payments is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Evaluate the criteria for classification of the lease, and describe the nature of the lease. In general, discuss how the lessee and lessor should account for the lease transaction.

3. 4. 5. 6.

Instructions a.

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b.

Prepare the journal entries for the lessee and lessor at January 1, 2004, and December 31, 2004 (the lessee's and lessor's year-end). Assume no reversing entries. What would have been the amount capitalized by the lessee upon the inception of the lease if: 1. 2. The residual value of $20,000 had been guaranteed by a third party, not the lessee? The residual value of $20,000 had not been guaranteed at all?

c.

d.

On the lessor's books, what would be the amount recorded as the Net Investment (Lease Receivable) at the inception of the lease, assuming: 1. 2. The residual value of $20,000 had been guaranteed by a third party? The residual value of $20,000 had not been guaranteed at all?

e.

Suppose the useful life of the milking equipment is 20 years. How large would the residual value have to be at the end of 10 years in order for the lessee to qualify for the operating method? (Assume that the residual value would be guaranteed by a third party.) (Hint: The lessee's annual payments will be appropriately reduced as the residual value increases.)

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CONCEPTUAL CASES
1. (Lessee Accounting and Reporting) On January 1, 2005, Sandy Hayes Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Yen Quach by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Yen Quach on January 1, 2005, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met. Instructions a. What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease. How should Hayes account for this lease at its inception and determine the amount to be recorded? What expenses related to this lease will Hayes incur during the first year of the lease, and how will they be determined? How should Hayes report the lease transaction on its December 31, 2005, balance sheet?

b. c. d. 2.

(Lessor and Lessee Accounting and Disclosure) Laurie Gocker Inc. entered into a lease arrangement with Nathan Morgan Leasing Corporation for a certain machine. Morgan's primary business is leasing; it is not a manufacturer or dealer. Gocker will lease the machine for a period of 3 years, which is 50% of the machine's economic life. Morgan will take possession of the machine at the end of the initial 3-year lease and lease it to another, smaller company that does not need the most current version of the machine. Gocker does not guarantee any residual value for the machine and will not purchase the machine at the end of the lease term. Gocker's incremental borrowing rate is 15%, and the implicit rate in the lease is 14%. Gocker has no way of knowing the implicit rate used by Morgan. Using either rate, the present value of the minimum lease payments is between 90% and 100% of the fair value of the machine at the date of the lease agreement. Gocker has agreed to pay all executory costs directly, and no allowance for these costs is included in the lease payments. Morgan is reasonably certain that Gocker will pay all lease payments, and because Gocker has agreed to pay all executory costs, there are no important uncertainties regarding costs to be incurred by Morgan. Assume that no indirect costs are involved. Instructions

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a.

With respect to Gocker (the lessee), answer the following. 1. 2. 3. What type of lease has been entered into? Explain the reason for your answer. How should Gocker compute the appropriate amount to be recorded for the lease or asset acquired? What accounts will be created or affected by this transaction, and how will the lease or asset and other costs related to the transaction be matched with earnings? What disclosures must Gocker make regarding this leased asset? What type of leasing arrangement has been entered into? Explain the reason for your answer. How should this lease be recorded by Morgan, and how are the appropriate amounts determined? How should Morgan determine the appropriate amount of earnings to be recognized from each lease payment? What disclosures must Morgan make regarding this lease?

4. b. 1. 2. 3. 4.

With respect to Morgan (the lessor), answer the following:

(AICPA adapted) 3. (Lessee Capitalization Criteria) On January 1, Melanie Shinault Company, a lessee, entered into three noncancelable leases for brand-new equipment, Lease L, Lease M, and Lease N. None of the three leases transfers ownership of the equipment to Melanie Shinault at the end of the lease term. For each of the three leases, the present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, is 75% of the fair value of the equipment. The following information is peculiar to each lease. 1. 2. 3. Lease L does not contain a bargain purchase option. The lease term is equal to 80% of the estimated economic life of the equipment. Lease M contains a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment. Lease N does not contain a bargain purchase option. The lease term is equal to 50% of the estimated economic life of the equipment. How should Melanie Shinault Company classify each of the three leases above, and why? Discuss the rationale for your answer. What amount, if any, should Melanie Shinault record as a liability at the inception of the lease for each of the three leases above?

Instructions a. b.

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c.

Assuming that the minimum lease payments are made on a straight-line basis, how should Melanie Shinault record each minimum lease payment for each of the three leases above?

(AICPA adapted) 4. (Comparison of Different Types of Accounting by Lessee and Lessor) Part 1 Capital leases and operating leases are the two classifications of leases described in FASB pronouncements from the standpoint of the lessee. Instructions a. Describe how a capital lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming the lease transfers ownership of the property to the lessee by the end of the lease. Describe how an operating lease would be accounted for by the lessee both at the inception of the lease and during the first year of the lease, assuming equal monthly payments are made by the lessee at the beginning of each month of the lease. Describe the change in accounting, if any, when rental payments are not made on a straight-line basis.

b.

Do not discuss the criteria for distinguishing between capital leases and operating leases. Part 2 Sales-type leases and direct financing leases are two of the classifications of leases described in FASB pronouncements from the standpoint of the lessor. Instructions Compare and contrast a sales-type lease with a direct financing lease as follows. a. b. c. Lease receivable. Recognition of interest revenue. Manufacturer's or dealer's profit.

Do not discuss the criteria for distinguishing between the leases described above and operating leases. (AICPA adapted) 5. (Lessee Capitalization of Bargain Purchase Option) Brad Hayes Corporation is a diversified company with nationwide interests in commercial real estate developments, banking, copper mining, and metal fabrication. The company has offices and operating
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locations in major cities throughout the United States. Corporate headquarters for Brad Hayes Corporation is located in a metropolitan area of a midwestern state, and executives connected with various phases of company operations travel extensively. Corporate management is currently evaluating the feasibility of acquiring a business aircraft that can be used by company executives to expedite business travel to areas not adequately served by commercial airlines. Proposals for either leasing or purchasing a suitable aircraft have been analyzed, and the leasing proposal was considered to be more desirable. The proposed lease agreement involves a twin-engine turboprop Viking that has a fair market value of $1,000,000. This plane would be leased for a period of 10 years beginning January 1, 2005. The lease agreement is cancelable only upon accidental destruction of the plane. An annual lease payment of $141,780 is due on January 1 of each year; the first payment is to be made on January 1, 2005. Maintenance operations are strictly scheduled by the lessor, and Brad Hayes Corporation will pay for these services as they are performed. Estimated annual maintenance costs are $6,900. The lessor will pay all insurance premiums and local property taxes, which amount to a combined total of $4,000 annually and are included in the annual lease payment of $141,780. Upon expiration of the 10-year lease, Brad Hayes Corporation can purchase the Viking for $44,440. The estimated useful life of the plane is 15 years, and its salvage value in the used plane market is estimated to be $100,000 after 10 years. The salvage value probably will never be less than $75,000 if the engines are overhauled and maintained as prescribed by the manufacturer. If the purchase option is not exercised, possession of the plane will revert to the lessor, and there is no provision for renewing the lease agreement beyond its termination on December 31, 2014. Brad Hayes Corporation can borrow $1,000,000 under a 10-year term loan agreement at an annual interest rate of 12%. The lessor's implicit interest rate is not expressly stated in the lease agreement, but this rate appears to be approximately 8% based on ten net rental payments of $137,780 per year and the initial market value of $1,000,000 for the plane. On January 1, 2005, the present value of all net rental payments and the purchase option of $44,440 is $888,890 using the 12% interest rate. The present value of all net rental payments and the $44,440 purchase option on January 1, 2005, is $1,022,226 using the 8% interest rate implicit in the lease agreement. The financial vice-president of Brad Hayes Corporation has established that this lease agreement is a capital lease as defined in Statement of Financial Accounting Standards No. 13, “Accounting for Leases.” Instructions a. b. What is the appropriate amount that Brad Hayes Corporation should recognize for the leased aircraft on its balance sheet after the lease is signed? Without prejudice to your answer in part (a), assume that the annual lease payment is $141,780 as stated in the question, that the appropriate capitalized amount for
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the leased aircraft is $1,000,000 on January 1, 2005, and that the interest rate is 9%. How will the lease be reported in the December 31, 2005, balance sheet and related income statement? (Ignore any income tax implications.) (CMA adapted) 6. (Lease Capitalization, Bargain Purchase Option) Cuby Corporation entered into a lease agreement for 10 photocopy machines for its corporate headquarters. The lease agreement qualifies as an operating lease in all terms except there is a bargain purchase option. After the 5-year lease term, the corporation can purchase each copier for $1,000, when the anticipated market value is $2,500. Glenn Beckert, the financial vice president, thinks the financial statements must recognize the lease agreement as a capital lease because of the bargain purchase agreement. The controller, Donna Kessinger, disagrees: “Although I don't know much about the copiers themselves, there is a way to avoid recording the lease liability.” She argues that the corporation might claim that copier technology advances rapidly and that by the end of the lease term the machines will most likely not be worth the $1,000 bargain price. Instructions Answer the following questions. a. b. What ethical issue is at stake? Should the controller's argument be accepted if she does not really know much about copier technology? Would it make a difference if the controller were knowledgeable about the pace of change in copier technology? What should Beckert do?

c. 7.

(Sale-Leaseback) On January 1, 2004, Laura Dwyer Company sold equipment for cash and leased it back. As seller-lessee, Laura Dwyer retained the right to substantially all of the remaining use of the equipment. The term of the lease is 8 years. There is a gain on the sale portion of the transaction. The lease portion of the transaction is classified appropriately as a capital lease. Instructions a. What is the theoretical basis for requiring lessees to capitalize certain long-term leases? Do not discuss the specific criteria for classifying a lease as a capital lease. 1. 2. How should Laura Dwyer account for the sale portion of the sale-leaseback transaction at January 1, 2004? How should Laura Dwyer account for the leaseback portion of the sale-leaseback transaction at January 1, 2004?
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c.

How should Laura Dwyer account for the gain on the sale portion of the sale-leaseback transaction during the first year of the lease? Why?

(AICPA adapted) 8. (Sale-Leaseback) On December 31, 2004, Laura Truttman Co. sold 6-month old equipment at fair value and leased it back. There was a loss on the sale. Laura Truttman pays all insurance, maintenance, and taxes on the equipment. The lease provides for eight equal annual payments, beginning December 31, 2005, with a present value equal to 85% of the equipment's fair value and sales price. The lease's term is equal to 80% of the equipment's useful life. There is no provision for Laura Truttman to reacquire ownership of the equipment at the end of the lease term. Instructions a. 1. 2. b. c. Why is it important to compare an equipment's fair value to its lease payments' present value and its useful life to the lease term? Evaluate Laura Truttman's leaseback of the equipment in terms of each of the four criteria for determination of a capital lease.

How should Laura Truttman account for the sale portion of the sale-leaseback transaction at December 31, 2004? How should Laura Truttman report the leaseback portion of the sale-leaseback transaction on its December 31, 2005, balance sheet?

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FINANCIAL REPORTING PROBLEM
3M Company
The financial statements of 3M are presented in Appendix 5B or can be accessed on the Take Action! CD. Instructions Refer to 3M's financial statements and the accompanying notes to answer the following questions. a. What types of leases are used by 3M? b. c. What amount of rental expense was reported by 3M in 1999, 2000, and 2001? What minimum annual rental commitments under all noncancelable leases at December 31, 2001, did 3M disclose?

FINANCIAL STATEMENT ANALYSIS CASE
Penn Traffic Company
Presented in Illustration 32 are the financial statement disclosures from the 2001 Annual Report of Penn Traffic Company. Instructions Answer the following questions related to these disclosures. a. b. What is the total obligation under capital leases at February 3, 2001, for Penn Traffic? What is the book value of the assets under capital lease at February 3, 2001, for Penn Traffic? Explain why there is a difference between the amounts reported for assets and liabilities under capital leases. What is the total rental expense reported for leasing activity for the year ended February 3, 2001, for Penn Traffic? Estimate the off-balance-sheet liability due to Penn Traffic's operating leases at fiscal year-end 2001.

c. d.

COMPARATIVE ANALYSIS CASE
UAL, Inc. and Southwest Airlines
Instructions Go to the Take Action! CD and use information found there to answer the following questions related to UAL, Inc. and Southwest Airlines.

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a. b. c. d.

What types of leases are used by Southwest and on what assets are these leases primarily used? How long-term are some of Southwest's leases? What are some of the characteristics or provisions of Southwest's (as lessee) leases? What did Southwest report in 2001 as its future minimum annual rental commitments under noncancelable leases? At year-end 2001, what was the present value of the minimum rental payments under Southwest's capital leases? How much imputed interest was deducted from the future minimum annual rental commitments to arrive at the present value? What were the amounts and details reported by Southwest for rental expense in 2001, 2000, and 1999? How does UAL's use of leases compare with Southwest's?

e. f.

RESEARCH CASES
Case 1
The accounting for operating leases is a controversial issue. Many contend that firms employing operating leases are utilizing significantly more assets and are more highly leveraged than indicated by the balance sheet alone. As a result, analysts often use footnote disclosures to “constructively capitalize” operating lease obligations. One way to do so is to increase a firm's assets and liabilities by the present value of all future minimum rental payments. Instructions a. Obtain the most recent annual report for a firm that relies heavily on operating leases. (Firms in the airline and retail industries are good candidates.) The schedule of future minimum rental payments is usually included in the “Commitments and Contingencies” footnote. Use the schedule to determine the present value of future minimum rental payments, assuming a discount rate of 10%. Calculate the company's debt-to-total-assets ratio with and without the present value of operating lease payments. Is there a significant difference?

b.

Case 2
The January 7, 2002, edition of the Wall Street Journal includes an article by Judith Burns and Michael Schroeder, entitled “Accounting Firms Ask SEC for Post-Enron Guide.” (Subscribers to Business Extra can access the article at that site.) Instructions Read the article and answer the following questions.
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a. b. c.

Why are the Big 5 firms asking the SEC to issue new guidance for disclosure? One of the areas the Big 5 suggest needs improving is reporting of lease obligations. How are off-balance-sheet lease obligations currently reported? One of the suggestions the Big 5 firms make for improving lease reporting is that firms should have to describe why these obligations aren't reported in the financial statements. Why aren't these obligations reported in the financial statements as liabilities?

INTERNATIONAL REPORTING CASE
As discussed in the chapter, U.S. GAAP accounting for leases allows companies to use off-balance-sheet financing for the purchase of operating assets. International accounting standards are similar to U.S. GAAP in that under these rules, companies can keep leased assets and obligations off their balance sheets. However, under International Accounting Standard No. 17 (IAS 17), leases are capitalized based on the subjective evaluation of whether the risks and rewards of ownership are transferred in the lease. In Japan, virtually all leases are treated as operating leases. Furthermore, unlike U.S. and IAS standards, the Japanese rules do not require disclosure of future minimum lease payments. Presented below are recent financial data for three major airlines that lease some part of their aircraft fleet. American Airlines prepares its financial statements under U.S. GAAP and leases approximately 27% of its fleet. KLM Royal Dutch Airlines and Japan Airlines (JAL) present their statements in accordance with their home country GAAP (Netherlands and Japan respectively). KLM leases about

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