Leases (In Class Journal Entry Examples)

Acct. 414 – Journal Entry Examples: Leases Prof. Teresa Gordon

Introduction

ACCOUNTING FOR LEASESFASB 13 (as amended)

Synopsis:

A lease that transfers substantially all of the benefits and risks of ownership should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee and as a sale or financing by the lessor.

The chart below includes the BASIC criteria you must learn to classify leases. We will also do more complicated examples that will require FARS research.

U.S. GAAPCRITERIA FOR CAPITALIZATION:

FOR LESSEE AND LESSOR: (must meet at least one)

A1 - TITLE TRANSFERS. The lease transfers ownership of the property to the lessee by the end of the lease term.

A2 - BARGAIN PURCHASE OPTION. The lease contains an option to purchase the leased property at a bargain price.

A3 – ECONOMIC LIFE. The lease term is equal to or greater than 75% of the estimated economic life of the leased property.

A4 – RECOVERY OF INVESTMENT. The present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property less any investment tax credit retained by the lessor.

FOR LESSOR ONLY: (must meet both)

B1 - COLLECTIBILITY. Collectibility of the minimum lease payments is reasonably predictable.

B2 - NO UNCERTAINTIES. No important uncertainties surround the amount of unreimburseable costs yet to be incurred by the lessor under the lease.

We will work through a variety of examples. In some cases, we will classify the lease and do journal entries. Those examples are contained in this file. In other cases, we will just classify the lease. These classification examples are generally in the PowerPoint lecture slides and not included in this file. We will not necessarily work examples in numeric order but you can find all the solutions on the course web page.

Introductory Examples – Lease 1A – Operating Lease

To illustrate accounting for lease transactions, we will use a simple case involving three parties:

1. Farview Farms needs a small tractor (Model SX). These tractors have an expected useful life of six years with no salvage value.

2. Idaho First Bank & Trust which is currently charging 12% interest on long-term equipment loans.

3. Troy Tractors, Inc., which manufactures the Model SX tractor at a cost of $40,000 and then sells them for $50,000. It also has a few units for trial use which rent for $500 per week.

If Farview Farms rents a tractor for one week from Troy Tractors, the journal entries would follow the usual pattern for a rental:

Comments --An operating lease is, in essence, a rental agreement. The lessor retains the risks and benefits of ownership.

Installment Purchase Arrangement

SITUATION 1B: PURCHASE WITH LONG-TERM BANK FINANCING

Assume Farview Farms decides to purchase the tractor and borrows the full purchase price of $50,000 from Idaho First Bank & Trust at 12% interest on the unpaid balance of the loan. The borrower agrees to make annual payments of $10,000 for five years. Again, the journal entries follow the normal pattern:

SITUATION 1C - DIRECT FINANCING LEASE

For various reasons either (or both) Farview Farms and Idaho First Bank & Trust might prefer a lease arrangement to an outright purchase/long-term loan. Assume that the bank agrees to purchase the tractor from Troy Tractors for $50,000. It then computes the payment on the lease required for it to earn its desired rate of 12% interest if the lease is written for five years with the first payment coming at the end of the first year (after harvest). [PVA = 50,000, n = 5, i = 12%, pymt = 13,871]. The lease agreement specifies that Farview Farms gets to keep the tractor at the end of the lease.

------
DATE LEASE INTEREST REDUCTION LEASE
PAYMENT LEASE RECBL/LIAB
50,001.85 RECBL/LIAB BALANCE
------
0 01/01/12 0.00 0.00 0.00 50,000.00
1 12/31/12 13,871.00 6,000.00 7,871.00 42,129.00
2 12/31/13 13,871.00 5,055.48 8,815.52 33,313.48
3 12/31/14 13,871.00 3,997.62 9,873.38 23,440.10
4 12/31/15 13,871.00 2,812.81 11,058.19 12,381.91
5 12/31/16 13,871.00 1,489.09 12,381.91 0.00

SITUATION 1D - SALES TYPE LEASE

Farview Farms may also be able to arrange a similar or better lease arrangement with the manufacturer of the Model SX tractor. We will assume that the lease terms are the same for purposes of illustration.

NOTE: The first step in doing lease accounting involves finding the present value of the cash flows that are transferred between the lessee and lessor. This "present value of the minimum lease payments" [PVMLP] will give you the SALES amount for the lessor (assuming a sales-type lease) and the ASSET amount for the lessee.

COMPUTE PVMLP: [n = 5, i = 12%, pymt = 13,871]

Introductory Example – Lease 1E - BARGAIN PURCHASE OPTION

To earn its desired return of 12%, at what amount should Troy Tractors set the annual payments?

Construct an amortization table and prepare the journal entries for both parties:

Introductory Example – Lease 1F - ANNUITY DUE

Assume that Troy Tractors and Farview Farms sign a lease agreement on a SX Tractor with the following terms:

With these lease terms, how much should Troy Tractors ask for the annual payments?

Construct an amortization table and prepare the journal entries for both parties:

International Financial Reporting Standards (IFRS)Leases (IAS17)

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

Classification depends on the substance of the transaction rather than the form of the contract. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

a)  the lease transfers ownership of the asset to the lessee by the end of the lease term.

b)  the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised.

c)  the lease term is for the major part of the economic life of the asset even if title is not transferred.

d)  at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

e)  the leased assets are of such a specialized nature that only the lessee can use them without major modifications.

Other indications that it is a finance lease include:

a)  if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee.

b)  gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease)

c)  the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.

The examples and indicators (above) are not always conclusive. Ifit is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease.

Lease Example #3

On January 1, 2012, Andrewson Consulting and Sun Computers sign a lease with the following terms:

FIND PRESENT VALUE OF MINIMUM LEASE PAYMENTS:

Type of lease for

Lease Example #5

On March 30, 2012, Genessee Engineering, Inc. and Idaho First Bank sign a lease with the following terms:

FIND THE PAYMENT WHICH IDAHO FIRST BANK SHOULD ASK TO EARN THE IMPLICIT INTEREST RATE LISTED ABOVE:

PVMLP for Lessee:

PVMLP for Lessor:

Type of lease for

Explain:

Example 5 – Lessee Accounting (Capital Lease with BPO)

On March 30, 2012, Genessee Engineering, Inc. and Idaho First Bank sign a lease with the following terms:

Example 5 – Lessor Accounting (Direct Financing Lease with BPO)