Putra Satria W. Rio Pramudhana F. Rizki Farianto P.

F 0310069 F 0310073 F 0310074

CHAPTER 22 ACCOUNTING FOR LEASE

A. Leasing Environment 1) Who are the players? A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, owned by the lessor, for an agreed period of time. In return for the use of the property, the lessee makes rental payments over the lease term to the lessor. Who are the lessors that own this property? They generally fall into one of three categories : a. Banks Banks are the largest players in the leasing business. They have low-cost funds, which give them the adventage of being able to purchase assets at less cost than their competitors. Banks also have been more aggressive in the leasing markets. b. Captive leasing companies

Captive leasing companies are subsidiaries whose primary business is to perform leasing operations for the parent company. c. Independents Independents are the final category of lessors. Independent have not done well over the last few years. Their market share has dropped fairly dramatically as banks and captive leasing companies have become more aggressive in the lease-financing area.

2) Advantages of leasing The growth in leasing indicates that it often has some genunine advantages over owning property, such as : a. 100 % financing at fixed rates b. Protection against absolesence c. Flexibility d. Less costly financing e. Tax advantages f. Off-ballance-sheet financing

3) Conceptual Nature of a Lease The various views on capitalization of leases are as follows.

a. Do not capitalize any leased assets b. Capitalize leases that are similiar to installment purchase c. Capitalize all long term leases d. Capitalize non cacelable leases where the penalty for non-performance is substantial.

B. Accounting By The Lessee 1. Capitalization Criteria Three of the four capitalization criteria that apply to lessees are contoversional and can be difficult to apply in practice. Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a finance lease. This criterion is not contoversional and easily implemented in practice Bargain purchase option test A bargain purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the propertys expected fair value atbthe date the option becomes exercisable. Economic Life test

In the lease period is for a major part of the assets economic life, the lessor transfers most of the risk and rewards of ownership to the lessee. Recovery of Investment Test If the present value is minimum lease payments equals or exceeds substantially all of the fair value of the assets.

2. Assets and Liability Accounted for Differently In a finance lese transaction, Air France uses the lease as a source of financing. ILFC finances the transaction through the leased assets. Air france makes rent payments, which actually are installment payments. Assets and liability recorded Under the finance lease method, Air France treats the lease transaction as if it purchase the aircraft in a financing transaction. This is, Air France acquires the aircraft and creates an obligation. Depreciation Period One troublesome aspect accounting for the

depreciation of the capitalized leased asset relates to the period of depreciation. Effective-Interset Method

Throughtout the term of the lease, Air France uses the effective-interest method to allocate each lease payments between principal and interest. Depreciation Concept Althought Air France computes the amounts initially capitalized obligation obligation as at are an the assets same and recorded as an the present value,

depreciation of the aircraft and the discharge of the independent accounting process during the term of thr lease.

3. Operating Method Under the operating method, rent expense (and the associated liability) accrues day by day to the lessee as it the property. The lessee assigns rent to the periods benefiting from the use of the assets and ignores, in the accounting, any commitments to make future payments. The lessee makes appropriate accruals or deferrals if the accounting period ends between cash payments dates.

4. Comparison of Finance Lease With Operating Lease If using an accelerated method of depreciation, the

differences between the amounts charged to operations under the two methods would be even larger in the earlier and later years. The following differences occur if using a finance lease instead of an operating lease :

a. An increase in the amount of reported debt b. An increase in the amount of total assets c. A lower incomne early in the life of the lease and, therefore, lower retained earnings.

Direct-Financing Method (Lessor) Direct-financing leases are in substance the financing of an asset purchase by the lessee. 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. Remember that minimum lease payments include: 1. Rental payments (excluding executory costs). 2. Bargain-purchase option (if any). 3. Guaranteed residual value (if any). 4. Penalty for failure to renew (if any). Operating Method (Lessor) Under the operating method, the lessor records each rental receipt as rental revenue. It depreciates the leased asset 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 (straightline basis) regardless of the lease provisions, unless another systematic and rational basis better represents the time pattern in which the lessor derives benefit from the leased asset. In addition to the depreciation charge, the lessor expenses maintenance costs and the cost of any other services rendered under the provisions of the lease that pertain to the current accounting period. The lessor amortizes over the life of the lease

any costs paid to independent third parties, such as appraisal fees, finders fees, and costs of credit checks, usually on a straight-line basis. SPECIAL 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 classification. 6. Disclosure.

Residual Values Up to this point, in order to develop the basic accounting issues related to lessee and lessor accounting, we have generally ignored residual values. 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.

Guaranteed versus Unguaranteed The residual value may be unguaranteed or guaranteed by the lessee. Sometimes 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. In such a case, that stated amount is the guaranteed residual value. The parties to a lease use guaranteed residual value 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. Lease Payments A guaranteed residual valueby definitionhas more assurance of realization than does an unguaranteed residual value. As a result, the lessor may adjust lease payments because of the increased certainty of recovery. After the lessor establishes this rate, it makes no difference from an accounting point of view whether the residual value is guaranteed or unguaranteed. The net investment that the lessor records (once the rate is set) will be the same.

Lessee Accounting for Residual Value Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. We saw the economic consequence lower lease paymentsin the preceding example. The accounting

consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but excludes the unguaranteed residual value. Guaranteed Residual Value (Lessee Accounting). A guaranteed residual value affects the lessees computation of minimum lease payments. Therefore it also affects the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term. Unguaranteed Residual Value (Lessee Accounting). From the lessees viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessees method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability. Lessor Accounting for Residual Value As we indicated earlier, the lessor will recover the same net investment whether the residual value is guaranteed or unguaranteed. That is, the lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. Sales-Type Leases (Lessor) As already indicated, the primary difference between a direct-financing lease and a sales-type lease is the manufacturers or dealers gross profit (or loss). In as a les-type lease, the lessor records the sale price of the asset, the cost of goods sold and related inventory reduction,

and the lease receivable. The information necessary to record the sales-type lease is as follows. 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, the lessor recognizes sales and cost of goods sold 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. Bargain-Purchase Option (Lessee) As stated earlier, a bargain-purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the propertys expected future fair value. The price is so favorable at the leases 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.

Initial Direct Costs (Lessor) Initial direct costs are of two types: incremental and internal. Incremental direct costs are paid to independent third

parties for originating a lease arrangement. Examples 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 brokers fee for finding the lessee. Internal direct costs are directly related to specified activities performed by the lessor on a given lease. Examples are evaluating the prospective lessees 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 employees time spent on a specific lease transaction are also considered initial direct costs. However, initial direct costs should not include internal indirect costs. Such costs are related to activities the lessor performs for advertising, servicing existing leases, and establishing and monitoring credit policies. Nor should the lessor include the costs For supervision and administration or for expenses such as rent and depreciation. The accounting for initial direct costs depends on the type of lease: For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental revenue. For sales-type leases, the lessor expenses the initial direct costs in the period in which it recognizes the profit on the sale. For a direct-financing lease, the lessor adds initial direct costs to the net investment in the lease and amortizes them over the life of the lease as a yield adjustment.

Disclosing Lease Data The FASB requires lessees and lessors to disclose certain information about leases in their financial statements or in the notes. These requirements vary based upon the type of lease (capital or operating) and whether the issuer is the lessor or lessee. These disclosure requirements provide investors with the following information: General description of the nature of leasing arrangements. The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years. The amount of lease revenues and expenses reported in the income statement eachm period. Description and amounts of leased assets by major balance sheet classification and related liabilities. Amounts receivable and unearned revenues under lease agreements. LEASE ACCOUNTINGUNRESOLVED PROBLEMS As we indicated at the beginning of this chapter, lease accounting is subject to abuse. Companies make strenuous efforts to circumvent GAAP in this area. In practice, the strong desires of lessees to resist capitalization have rendered the accounting rules for capitalizing leases partially ineffective. Leasing generally involves large dollar amounts that, when capitalized, materially increase reported liabilities and adversely affect the debt-to-equity ratio. Lessees also resist lease capitalization 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,lets beat the lease standard is one of the most popular games in town. To avoid leased asset capitalization, companies design, write, and interpret lease agreements to prevent satisfying any of the four capitalized lease criteria. Companies can easily devise lease agreements specifications. 1. Ensure that the lease does not specify the transfer of title of the property to the lessee. 2. Do not write in a bargain-purchase option. 3. Set the lease term at something less than 75 percent of the estimated economic life of the leased property. 4. Arrange for the present value of the minimum lease payments to be less than 90 percent of the fair value of the leased property. 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 lessees use of the higher interest rate is probably the more popular subterfuge. Lessees are knowledgeable about the fair value of the leased property and, of course, the rental payments. However, in such a way, by meeting the following

they generally are unaware of the estimated residual value used by the lessor. Therefore, the lessee who does not know exactly the lessors implicit interest rate might use a different (higher) 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 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. Because the minimum lease payments include the guaranteed residual value for the lessor, this satisfies the 90 percent recovery of fair market value test. The lease is a nonoperating lease to the lessor. But because a third-party guarantees the residual value, the minimum lease payments of the lessee exclude 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.