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Financial Reporting I
Angie Wang
CHAPTER 21
Accounting for Leases
The Leasing Environment
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.
Advantages of Leasing—Lessees
1. 100% financing at fixed rates.
3. Flexibility.
5. Tax advantages.
6. Off-balance-sheet financing.
The Leasing Environment
Advantages of Leasing—Lessor
1. Often provides profitable interest margins.
Only exceptions:
leases covering a term of less than one year or
The lessee
recognizes interest expense on the lease liability using
the effective-interest method and
Lease Term
The fixed, non-cancelable term of the lease.
Lease Payments
Fixed payments.
Discount Rate
Lessee should compute the present value of the lease
payments using the implicit interest rate.
► This rate, at commencement of the lease, which causes
the aggregate present value of the lease payments and
unguaranteed residual value to be equal to the fair value
of the leased asset.
Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments €95,890.35 *
* Rounded by €0.02.
Lessee Accounting: Example 1
* rounding
Lessee Accounting: Example 1
* rounding
If Ivanhoe purchases the equipment from CNH at the termination of the
lease at a price of €5,000 and the estimated remaining life of the
equipment is two years, it makes the following entry.
Equipment 5,000
Cash 5,000
* rounding
Lessee Accounting: Example 2
Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments € 95,890.35 *
Probable residual value € 2,000,00
PV factor (i=4,n=5) x .82193
PV of probable residual value 1,643.86
Lessee’s lease liability/right-of-use asset € 97,534.21
* Rounded by €0.02.
Lessee Accounting: Example 2
Ivanhoe makes the following entries to record the lease and the
first payment on January 1, 2019, as:
The present value of the lease payments for M&S in this situation
is £49,924.56 (£17,620.08 × 2.83339 (PVF = AD 3,6%)).
January 1, 2019
Right-of-Use Asset 49,924.56
Lease Liability 49,924.56
Economics of Leasing
In Examples 1 and 2, CNH determined the implicit rate to be 4
percent, the fair value of the equipment to be €100,000, and the
residual value to be $5,000. CNH then computes the lease
payment as shown.
To meet one of these five tests, the lessor must transfer control of
a substantial portion of the underlying asset to the lessee or
provide ownership of the underlying asset to the lessee.
Lessor
Lessor
ILLUSTRATION 21.218
Lease Classification Tests
Classification of Leases by the Lessor
Lease Payments
Generally include:
1.Fixed payments.
2.Variable payments.
Discount Rate
Implicit rate should be used to determine the present
value of the payments.
The assumption is that the lessee uses all the benefits from
the leased asset and therefore the lessee has essentially
purchased the asset.
Classification of Leases by the Lessor
ILLUSTRATION 21.24
Balance Sheet
Presentation
ILLUSTRATION 21.25
Income Statement
presentation
The following entries record receipt of the second year’s lease
payment and recognition of the interest revenue in 2020.
* rounding
At January 1, 2024, when the leased asset is returned to CNH.
Inventory 5,000
Lease Receivable 5,000
* rounding
Lessor—Guaranteed Residual Value
Both sales revenue and cost of goods sold are reduced by the
present value of the unguaranteed residual value.
ILLUSTRATION 21.30
Lease Classification Tests
Lessor Accounting for Operating Leases
Cash 17,620.08
Unearned Lease Revenue 17,620.08
•For finance leases, the lessor expenses initial direct costs at lease
commencement (in the period in which it recognizes the profit on the
sale).
Special Lease Accounting Problems
Presentation
Summary of how the lessor reports the information related to
sales-type and operating leases in the financial statements.
Presentation, Disclosure, and Analysis
Disclosure
Lessees and lessors must also provide additional qualitative and
quantitative disclosures to help financial statement users assess
the amount, timing, and uncertainty of future cash flows.
Qualitative disclosures to be provided by both lessees and
lessors are summarized as shown.
Presentation, Disclosure, and Analysis
Disclosure
This illustration presents the type of quantitative information that
should be disclosed for the lessee.
Presentation, Disclosure, and Analysis
Disclosure
This illustration presents the type of quantitative information that
should be disclosed for the lessor.
Presentation, Disclosure, and Analysis
Analysis
With the increase in the assets and liabilities, a number of financial
metrics used to measure the profitability and solvency of
companies will change.
•Return on assets will decrease.
•Debt to equity ratio will increase, and the interest coverage ratio will
decrease.
APPENDIX 21A Sale-Leasebacks
Sale Transaction
In a sale, gain or loss recognition is appropriate. Darden
then records the transaction as follows.
1.Increases cash and reduces the carrying value of the asset to
zero (referred to as derecognizing the asset).
Sale Transaction
For example, assume that Stora Enso (FIN) sells one of its
buildings having a carrying value of €580,000 (building
€800,000 less accumulated depreciation €220,000) to
Deutsche Bank (DEU) for €623,110. It then leases the
building back from Deutsche Bank for €50,000 a year, for
eight of the building’s 15 years of remaining economic life.
Assume that the present value of these lease payments is
equal to €310,000, such that the lease is classified as an
operating lease by Deutsche Bank.
APPENDIX 21A Sale-Leasebacks
Sale Transaction
Stora Enso makes the following entries to record the sale-
leaseback.
Cash 623,110
Accumulated Depreciation—Buildings 220,000
Buildings 800,000
Gain on Disposal of Plant Assets 43,110
(€623,110 − €580,000)
APPENDIX 21A Sale-Leasebacks
Sale Transaction
In addition, Stora Enso makes an entry to record the operating
lease from Deutsche Bank as follows.
Sale-Leaseback Example
Japan Airlines (JAL) (JPN) on January 1, 2019, sells a used Boeing 757 having a
carrying amount on its books of $30,000,000 to CitiCapital for $33,000,000. JAL
immediately leases the aircraft back under the following conditions:
• The term of the lease is seven years. The lease agreement is non-
cancelable, requiring equal rental payments of $4,881,448 at the end of
each year (ordinary annuity basis), beginning December 31, 2019.
• The lease contains no renewal or purchase options. The plane reverts to
CitiCapital at the termination of the lease.
• The aircraft has a fair value of $33,000,000 on January 1, 2019, and an
estimated remaining economic life of 10 years. The residual value
(unguaranteed) at the end of the lease is $13,000,000.
• The annual payments assure the lessor an 8 percent return (which is the
same as JAL’s incremental borrowing rate).
Sale-Leaseback Example
Applying the classification tests, the lease-back of the airplane is
classified as an operating lease because none of the sales-type
lease criteria are met, as indicated in Illustration 21A.3.
ILLUSTRATION 21A.3
Lease Classification Tests
Sale-Leaseback Example
ILLUSTRATION 21B.2
Lease Classification Tests
Lease Terms: Scenario 1
Lessee/Lessor Accounting
*Rounded by €0.06.
Scenario 1
Scenario 1
Scenario 1
Lease Terms: Scenario 2
The lease terms are as follows:
• Lease is non-cancelable, term of four years, equal rental payments
of €9,538.39 at the beginning of each year (annuity-due).
• Lift has a fair value of €40,000, economic life of six years, and
residual value of €80,000 (unguaranteed).
• Cost of lift on Stoughton’s books is €30,000.
• No renewal options. Lift reverts to Stoughton. Implicit rate of lessor
is 8 percent and is known by Parker.
Lease Terms: Scenario 2
Stoughton (lessor) evaluates the lease classification tests as
indicated.
ILLUSTRATION 21B.6
Lease Classification Tests
Lease Terms: Scenario 2
Lessee Accounting
Parker makes the following entry to record this lease and the first
payment.
January 1, 2019
Lessee Accounting
*Rounded by €0.02.
Scenario 2
Scenario 2
Scenario 2
Scenario 2
Scenario 2
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