Professor Paul Zarowin - NYU Stern School of Business
Professor Paul Zarowin - NYU Stern School of Business
Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
Leases
υ operating vs capital lease
υ lease criteria
υ journal entries
υ comparison of I/S, B/S, SCF
υ inter-temporal effects I/S, B/S
υ footnote disclosure
υ Ahomemade@ capitalization
υ sale and leaseback
υ residual value (guaranteed vs unguaranteed), Bargain Purchase Option
υ Lessor: Direct Financing vs sales Type Leases
Leases
There are two ways to account for leases, operating or capital leases. Accounting for operating leases is like cash basis (Lessee: DR expense, CR cash; Lessor: DR cash , CR revenue) with no B/S recognition of a lease asset or lease liability (called Aoff-B/S financing@). Capital lease accounting by the lessee records a lease asset and a lease liability, equal to the present value of the future lease payments. The 4 conditions that require lessee=s capital lease accounting (Type I criteria) are on page 554. Additional criteria for the lessor (Type II criteria) are on page 568. The essence of these rules is that if the lease transfers the risks and rewards of possession to the lessee, such that the lease is a de facto sale, the lease must be capitalized. In general, both the lessee and lessor handle the lease in the same way (operating or capital). One exception is when the lessee uses a different discount rate than the lessor. The one with the higher rate might fail to meet the 90% PV criteria (if none of the other 3 criteria are met) and not capitalize. The one with the lower rate might capitalize. Another exception is when the lessee=s capitalization criteria are met, but the lessor=s criteria are not; in this case only the lessee capitalizes. Note that if the lessee capitalizes but the lessor does not, the leased asset is on both firms= books, and both amortize (depreciate) it.
The example below shows the accounting for a standard 5 year capital lease, with an interest rate of 10%, with annual payments of $1000 in arrears (ordinary annuity), for both the lessee and the lessor. Note the following points:2
(1) The lessee books the lease at the discounted PV of the payments, whereas
(2) The lessor books the lease at the gross (undiscounted) value of the cash payments. This gross value is divided into the PV and (unearned) interest components.
(3) The lessee=s cash payment includes both interest expense and principal (return of capital).
(4) The lessee=s interest expense equals the interest rate x the net BV of the lease. The net BV declines over time because each payment repays some principal. In this way, a capital lease is the same as a mortgage. This is an example of the effective interest method.
(5) The lessee=s depreciation is (usually) calculated on a SL basis (annual depreciation = PV of lease payments/lease life).
(6) The lessor earns the interest revenue (this is just like an installment sale) each period, using the same calculation as the lessee: interest revenue equals the interest rate x the net BV of the lease. If the lessee and lessor both use the same interest rate (which is usually the case, but is not required), then the lessee=s interest expense equals the lessor=s interest revenue each period.
Capital Lease Example
facts:
5 year lease; $1,000 per year (in arrears); r = 10%; PV = 3.79079 x 1000 = 3791
Lessee Lessor
DR CR DR CR
inception
Leased asset 3791 Lease payments receivable 5000
Lease liability 3791 leased asset 3791 Unearned interest revenue 1209
Note: entries in italics are the same each period.
period 1 Interest expense 379 (10% x 3791) Unearned interest revenue 379
Lease liability 621 (plug) Interest revenue 379
Cash 1000
depreciation exp. 758 (3791)5) Cash 1000
Leased asset 758 Lease payments receivable 1000
period 2 Interest expense 317 (10% x 3170) Unearned interest revenue 317
Lease liability 683 (plug) Interest revenue 317
Cash 1000
depreciation exp. 758 (3791)5) Cash 1000
Leased asset 758 Lease payments receivable 1000
period 3 Interest expense 249 (10% x 2487) Unearned interest revenue 249
Lease liability 751 (plug) Interest revenue 249
Cash 1000
depreciation exp. 758 (3791)5) Cash 1000
Leased asset 758 Lease payments receivable 1000
period 4 Interest expense 174 (10% x 1736) Unearned interest revenue 174
Lease liability 826 (plug) Interest revenue 174
Cash 1000
depreciation exp. 758 (3791)5) Cash 1000
Leased asset 758 Lease payments receivable 1000
period 5 Interest expense 91 (10% x 910) Unearned interest revenue 91
Lease liability 909 (plug) Interest revenue 91
Cash 1000
depreciation exp. 758 (3791)5) Cash 1000
Leased asset 758 Lease payments receivable 1000
Lessor=s asset t-account, net (lease payments Lessor=s lease liability t-account receivable minus unearned interest revenue)
DR CR DR CR
inception 5000 1209
----------------------------------
3791 3791
je per 1 621 379 1000
3170 3170
je per 2 683 317 1000
2487 2487
je per 3 751 249 1000
1736 1736
je per 4 826 174 1000
910 910
je per 5 910 91 1000
0 0
Note: $1 error due to rounding
Major financial reporting and analysis issues for leases are: (1) sale and leaseback, (2) guaranteed versus unguaranteed residual value, (3) bargain purchase options, (4) financial report disclosures, and (5) financial statement effects of operating vs capital leases.
Sale and Leaseback
Sale-Leasebacks are discussed on pgs. 597-598. A sale and leaseback is a transaction where an asset is sold and then leased back. It is a means of financing for the lessee: a way for the lessee to get cash (by selling the asset), while still retaining use of the asset. The journal entries for the lease are shown in the examples we have discussed, and you all know the journal entries for an asset sale: DR CR
Cash
Accum=d Dep=n
Asset-old (at cost)
Loss or Gain
The only new twist for a sale and leaseback is that a gain on sale typically does not hit the I/S in the period of sale. If the lease life is a large fraction of the useful life of the asset, then the gain is CR=d to a liability account unearned profit on sale-leaseback that is amortized into income over the life of the lease; i.e., it is an unrealized gain. The amortization (DR) of the unrealized gain is usually done by a CR to (decrease in) depreciation expense during the lease term, thereby increasing net income. In this way, the gain is amortized into net income over time3.
Guaranteed Residual Value (GRV) versus Unguaranteed Residual Value (URV)
Residual value (RV) is the value of the leased asset at the end of the lease term. Both parties have an expectation of what the asset will be worth (FMV) when the asset is returned to the lessor at this time. The key issue is whether this value is guaranteed or not; i.e., who bears the loss if the asset is worth less than the expected value. If the RV is guaranteed, then the lessee must make up the difference to the lessor, so the lessee bears the loss. If the RV is unguaranteed, then the lessee does not make up the difference to the lessor, so the lessor bears the loss. Thus, the issue of RV, either GRV or URV, is only relevant if the asset reverts to the lessor at the end of the lease term.
The key points of the GRV case are: (1) Both the lessee and the lessor make the inception journal entry for the value of both the periodic payments plus the GRV. As always, the lessee books at PV, whereas the lessor books at gross (undiscounted) value. (2) The lessee=s periodic payment journal entries amortize only the PV of the periodic payments; thus, after the last periodic payment, the PV of the GRV is still left unamortized. This last part gets amortized when the GRV is returned to the lessor. (3) Similarly, the lessee=s periodic depreciation is based on the total PV - the GRV. (4) The lessor=s amortization schedule is also based only on the periodic payments, not the GRV. (5) If the asset=s FMV at he end of the lease term is less than the GRV, the lessee must make up the difference in cash, and records this difference as a loss. Thus, the lessee bears the loss in the URV case, if GRV > FMV.
The key points of the URV case are: (1) The lessor=s journal entries, both the inception entry and the periodic entries, are identical to the GRV case. The lessor=s inception entry includes (the undiscounted value) of both the periodic payments and the RV. This seems to be inconsistent with accounting conservatism; i.e., the lessor includes the (full) value of the RV, even though he might get less. (2) The only accounting difference for the lessor is at the end of the lease term; if the FMV of the asset is worth less than the expected RV, the lessor records thisdifference as a loss.Thus, the lessor bears the loss in the URV case, if URV > FMV. Also note that since the lessor=s periodic entries ignore the RV, there is the additional amount to be amortized when the leased asset is returned (see the amortization schedule at the end of the illustration). (3) The lessee only books the (PV of the) periodic payments, not the RV. The lessee then does all the accounting, both the periodic depreciation and the amortization of the lease liability, based on this amount. Thus, unlike the lessor, the lease is fully amortized after the final payment. In effect, the RV is invisible to the lessee in the URV case.
The following table illustrates the main points of GRV vs URV, for both lessee and lessor.
Lessee Lessor
inception je includes GRV inception je includes GRV
GRV periodic amortization excludes GRV periodic amortization excludes GRV
loss on asset return if FMV ................
................
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