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Intermediate Accounting II(ACC310)Chapter 21“Accounting for Leases”Prepared By :Hussain Ahmed & S. Mujtaba HashimIntermediate Accounting II Acc3101 | P a g e A _ A C A D E M YACCOUNTING BY THE LESSEEIf the lessee capitalizes a lease, the lessee records an asset and a liability generally equal tothe present value of the rental payments. Records depreciation on the leased asset. Treats the lease payments as consisting of interest and principal.Journal Entries for Capitalized Lease– Air France (Lessee) Leased EquipmentxxLease Liabilityxx – ILFC (Lessor) Lease ReceivablexxEquipmentxx For a finance lease, the IASB has identified four criteria.1. Lease transfers ownership of the property to the lessee.2. Lease contains a bargain-purchase option.3. Lease term is for major part of the economic life of the asset.4. Present value of the minimum lease payments amounts to substantially all of the fairvalue of the leased asset.One or more must bemet for finance leaseaccounting.Intermediate Accounting II Acc3102 | P a g e A _ A C A D E M YCapitalization Criteria– Transfer of Ownership Test If the lease transfers ownership of the asset to the lessee, it is a finance lease.– Bargain-Purchase Option Test At the inception of the lease, the difference between the option price and the expectedfair market value must be large enough to make exercise of the option reasonablyassured.– Economic Life Test Lease term is generally considered to be the fixed, non-cancelable term of the lease. Bargain-renewal option can extend this period. At the inception of the lease, the difference between the renewal rental and theexpected fair rental must be great enough to make exercise of the option to renewreasonably assured.Intermediate Accounting II Acc3103 | P a g e A _ A C A D E M YIllustration: Carrefour (FRA) leases Lenovo (CHN) PCs for two years at a rental of €100per month per computer and subsequently can lease them for €10 per month per computerfor another two years. The lease clearly offers a bargain-renewal option; the lease term isconsidered to be four years.Capitalization CriteriaRecovery of Investment Test 😮 Minimum rental paymentso Guaranteed residual valueo Penalty for failure to renew or extend the leaseo Bargain-purchase optionExecutory Costs 😮 Insuranceo Maintenanceo TaxesDiscount Rateo Lessee computes the present value of the minimum lease payments using the implicitinterest rate.o In the event it is impracticable to determine the implicit rate, the lessee should use itsincremental borrowing rate.Exclude from PV ofMinimum LeasePayment CalculationIntermediate Accounting II Acc3104 | P a g e A _ A C A D E M YAsset and Liability Accounted for DifferentlyAsset and Liability Recorded at the lower of:1. present value of the minimum lease payments (excluding executory costs) or2. fair market value of the leased asset at the inception of the lease.Effective-Interest MethodUsed to allocate each lease payment between principal and interest.Depreciation ConceptDepreciation and the discharge of the obligation are independent accounting processes.Computation of Minimum Lease Payments Paymentxxx– Property taxes (executory cost)xxx= Minimum lease paymentxxxx Present value factor (Annuity table)xxx= PV of minimum lease paymentsxxx Intermediate Accounting II Acc3105 | P a g e A _ A C A D E M YIllustration: CNH Capital (NLD) (a subsidiary of CNH Global) and Ivanhoe Mines Ltd.(CAN) sign a lease agreement dated January 1, 2015, that calls for CNH to lease a front-endloader to Ivanhoe beginning January 1, 2015. The terms and provisions of the lease agreementand other pertinent data are as follows.• The term of the lease is five years. The lease agreement is non-cancelable, requiringequal rental payments of $25,981.62 at the beginning of each year (annuity-due basis).• The loader has a fair value at the inception of the lease of $100,000, an estimatedeconomic life of five years, and no residual value.• Ivanhoe pays all of the executory costs directly to third parties except for the propertytaxes of $2,000 per year, which is included as part of its annual payments to CNH.• The lease contains no renewal options. The loader reverts to CNH at the termination ofthe lease.• Ivanhoe’s incremental borrowing rate is 11 percent per year.• Ivanhoe depreciates similar equipment that it owns on a straight-line basis.• CNH sets the annual rental to earn a rate of return on its investment of 10 percent peryear; Ivanhoe knows this fact.Capitalization Criteria:1. Transfer of ownership. No2. Bargain purchase option. No3. Lease term for major part of economic life of leased property. Yes(Lease term = 5 yrs | Economic life = 5 yrs)4. Present value of minimum lease payments substantially all of FMV of property. Yes(PV = $100,000 | FMV = $100,000.)Intermediate Accounting II Acc3106 | P a g e A _ A C A D E M Y– Computation of Capitalized Lease PaymentsIvanhoe uses CNH’s implicit interest rate of 10 percent instead of its incremental borrowingrate of 11 percent because (1) it is lower and (2) it knows about it.Ivanhoe records the finance lease on its books on January 1, 2015, as: DateDebitCreditJan 1st ,2015Leased Equipment100,000Lease Liability100,000 Ivanhoe records the first lease payment on January 1, 2015, as follows. DateDebitCreditJan 1st ,2015Property Tax Expense2,000Lease Liability23,981.62Cash25,981.62 PaymentProperty taxes (executory cost)Minimum lease paymentPresent value factor (i=10%,n=5)PV of minimum lease payments$ 25,981.62– 2,000.0023,981.62x 4.16986$100,000 Intermediate Accounting II Acc3107 | P a g e A _ A C A D E M YILLUSTRATION 21-6 : Lease Amortization Schedule for Lessee—Annuity-Due Basis DateAnnual LeasePaymentExecutoryCostsInterest 10%on LiabilityReduction ofLease LiabilityLeaseLiability1/1/2015–––$100,0001/1/2015$25,981.62$2,000$ -0-$23,981.6276,018.381/1/2016$25,981.622,0007,601.8416,379.7859,638.601/1/2017$25,981.622,0005,963.8618,017.7641,620.841/1/2018$25,981.622,0004,162.0819,819.5421,801.301/1/2019$25,981.622,0002,180.32*21,801.30-0-$129,908.10$10,000$19,908.10$100,000 * RoundedPrepare the entry to record accrued interest at December 31, 2015. DateDebitCreditDec 31st ,2015Interest Expense7,601.84Interest Payable7,601.84 Prepare the required on December 31, 2015, to record depreciation for the year using thestraight-line method($100,000 ÷ 5 years). DateDebitCreditDec 31st ,2015Depreciation expense20,000Accumulated depreciation – Leased Liability20,000 The liabilities section as it relates to lease transactions at December 31, 2015. Statement of Financial Position (31/12)Non-current liabilities :Lease Liability ($76,018.38 – $16,379.78 )$59,638.60Current liabilities :Interest Payable$7,601.84Lease Liability16,379.78 Intermediate Accounting II Acc3108 | P a g e A _ A C A D E M YIvanhoe records the lease payment of January 1, 2016, as follows. DateDebitCreditJan 1st ,2016Property Tax Expense2,000Interest Payable7,601.84Lease Liability16,379.78Cash25,981.82 Intermediate Accounting II Acc3109 | P a g e A _ A C A D E M YEx1 : (Lessee Computations and Entries, Finance Lease with Guaranteed ResidualValue) : Brecker Company leases an automobile with a fair value of €10,906 fromEmporia Motors, Inc., on the following terms :1. Non-cancelable term of 50 months.2. Rental of €250 per month (at end of each month). (The present value at 1% permonth is €9,800.)3. Estimated residual value after 50 months is €1,180. (The present value at 1% permonth is €715.) Brecker Company guarantees the residual value of €1,180.4. Estimated economic life of the automobile is 60 months.5. Brecker Company’s incremental borrowing rate is 12% a year (1% a month). It isimpracticable to determine Emporia’s implicit rate.Instructions(a) What is the nature of this lease to Brecker Company?(b)What is the present value of the minimum lease payments?(c) Record the lease on Brecker Company’s books at the date of inception.(d)Record the first month’s depreciation on Brecker Company’s books (assumestraight-line).(e) Record the first month’s lease payment.(a)(b)Intermediate Accounting II Acc31010 | P a g e A _ A C A D E M Y(c) DateDebitCredit (d) DateDebitCredit (e) DateDebitCredit Intermediate Accounting II Acc31011 | P a g e A _ A C A D E M YEx2 : (Lessee Entries, Finance Lease with Executory Costs and UnguaranteedResidual Value) : Assume that on January 1, 2015, Stora Enso (FIN) signs a 10-year,non-cancelable lease agreement to lease a storage building from Balesteros StorageCompany. The following information pertains to this lease agreement.1. The agreement requires equal rental payments of €90,000 beginning on January1, 2015.2. The fair value of the building on January 1, 2015, is €550,000.3. The building has an estimated economic life of 12 years, with an unguaranteedresidual value of €10,000. Stora Enso depreciates similar buildings on thestraight-line method.4. The lease is non-renewable. At the termination of the lease, the building revertsto the lessor.5. Stora Enso’s incremental borrowing rate is 12% per year. It is impracticable todetermine the lessor’s implicit rate.6. The yearly rental payment includes €3,088.14 of executory costs related to taxeson the property.InstructionsPrepare the journal entries on the lessee’s books to reflect the signing of the leaseagreement and to record the payments and expenses related to this lease for the years2015 and 2016. Stora Enso’s corporate yearend is December 31.Intermediate Accounting II Acc31012 | P a g e A _ A C A D E M Y2015 : DateDebitCredit DateLess ExecutoryCostsInterest onLiabilityReduction oflease liabilityLease Liability Intermediate Accounting II Acc31013 | P a g e A _ A C A D E M Y2016 : DateDebitCredit Intermediate Accounting II Acc31014 | P a g e A _ A C A D E M YEx3 : (Amortization Schedule and Journal Entries for Lessee) : Demir LeasingCompany signs an agreement on January 1, 2015, to lease equipment to AzureCompany. The following information relates to this agreement.1. The term of the non-cancelable lease is 5 years with no renewal option. Theequipment has an estimated economic life of 5 years.2. The fair value of the asset at January 1, 2015, is 90,000.3. The asset will revert to the lessor at the end of the lease term, at which time the assetis expected to have a residual value of 7,000, none of which is guaranteed.4. Azure Company assumes direct responsibility for all executory costs, which includethe following annual amounts: (1) 900 to Frontier Insurance Company for insuranceand (2) 1,600 for property taxes.5. The agreement requires equal annual rental payments of 20,541.11 to the lessor,beginning on January 1, 2015.6. The lessee’s incremental borrowing rate is 12%. The lessor’s implicit rate is 10% andis known to the lessee.7. Azure Company uses the straight-line depreciation method for all equipment.8. Azure uses reversing entries when appropriate.Instructions(Round all numbers to two decimal places.)(a) Prepare an amortization schedule that would be suitable for the lessee for the leaseterm.(b)Prepare all of the journal entries for the lessee for 2015 and 2016 to record the leaseagreement, the lease payments, and all expenses related to this lease. Assume thelessee’s annual accounting period ends on December 31.Intermediate Accounting II Acc31015 | P a g e A _ A C A D E M Y(a) DateAnnual leasePaymentInterest inlease liabilityReduction oflease liabilityLease Liability (b)2015 DateDebitCredit Intermediate Accounting II Acc31016 | P a g e A _ A C A D E M Y2016 DateDebitCredit Intermediate Accounting II Acc31017 | P a g e A _ A C A D E M YACCOUNTING BY THE LESSORBenefits to the Lessor1. Interest revenue.2. Tax incentives.3. Residual value profits.Economics of Leasing– A lessor determines the amount of the rental, basing it on the rate of return—the implicitrate—needed to justify leasing the asset.– If a residual value is involved (whether guaranteed or not), the company would not haveto recover as much from the lease payments.Classification of Leases by the Lessor :a. Operating leases.b. Finance leaseso Direct-financing leases.o Sales-type leases.Direct-Financing Method (Lessor)In substance the financing of an asset purchase by the lessee.Lessor records:o A lease receivable instead of a leased asset.o Receivable is the present value of the minimum lease payments plus the present valueof the unguaranteed residual value.Intermediate Accounting II Acc31018 | P a g e A _ A C A D E M Y1. Types of lease :– Direct-financing leases : If cost = Fair value– Sales-type leases : If cost # Fair value2. Computation of Minimum Lease Payments Cost / Fair valuexxx– Pv to Residual valuexxx= Amount to be recoveredxxx÷ Present value factor (Annuity table)xxx= Rental Payment paymentsxxx 3. Record journal entry to start lease : Lease ReceivablexxEquipmentxx 4. Prepare Amortization table5. Prepare journal entry to recover first payment , secondIntermediate Accounting II Acc31019 | P a g e A _ A C A D E M YIllustration: Using the data from the preceding CNH/Ivanhoe example we illustrate theaccounting treatment for a direct-financing lease. We repeat here the information relevantto CNH in accounting for this lease transaction.1. The term of the lease is five years beginning January 1, 2015, non-cancelable, andrequires equal rental payments of $25,981.62 at the beginning of each year. Paymentsinclude $2,000 of executory costs (property taxes).2. The equipment (front-end loader) has a cost of $100,000 to CNH, a fair value at theinception of the lease of $100,000, an estimated economic life of five years, and noresidual value.3. CNH incurred no initial direct costs in negotiating and closing the lease transaction.We repeat here the information relevant to CNH in accounting for this lease transaction :4. The lease contains no renewal options. The equipment reverts to CNH at thetermination of the lease.5. CNH sets the annual lease payments to ensure a rate of return of 10 percent (implicitrate) on its investment as shown. Fair market value of leased equipment$100,000Present value of residual value (calculation below)–Amount to be recovered$100,000Present value factor (Annuity table)4.16986Annual payment required$23,981.62 * Residual value $ 43,622 x PV of single sum (i=10%, n=6) 0.56447 = $24,623The lease meets the criteria for classification as a direct-financing lease for two reasons:1. the lease term equals the equipment’s estimated economic life, and2. the present value of the minimum lease payments equals the equipment’s fair value.It is not a sales-type lease because there is no difference between the fair value ($100,000)of the loader and CNH’s cost ($100,000).Intermediate Accounting II Acc31020 | P a g e A _ A C A D E M Y– CNH records the lease of the asset and the resulting receivable on January 1, 2015 (theinception of the lease), as follows. DateDebitCreditJan1st ,2015Lease Receivable100,000Equipment100,000 Companies often report the lease receivable in the statement of financial position as “Netinvestment in finance leases”.ILLUSTRATION 21-13 : Lease Amortization Schedule for Lessor— Annuity-Due Basis DateAnnual LeasePaymentExecutoryCostsInterest 10%on LeaseReceivableReduction ofReceivableRecoveryLeaseReceivable1/1/2015–––$100,0001/1/2015$25,981.62$2,000$ -0-$23,981.6276,018.381/1/2016$25,981.622,0007,601.8416,379.7859,638.601/1/2017$25,981.622,0005,963.8618,017.7641,620.841/1/2018$25,981.622,0004,162.0819,819.5421,801.301/1/2019$25,981.622,0002,180.32*21,801.30-0-$129,908.10$10,000$19,908.10$100,000 * Rounded– On January 1, 2015, CNH records receipt of the first year’s lease payment as follows. DateDebitCreditJan 1st ,2015Cash25,981.62Lease Receivable23,981.62Property Tax Expense/Property Taxes Payable2,000 – On December 31, 2015, CNH recognizes the interest revenue earned during the first yearthrough the following entry. DateDebitCreditDec 31st ,2015Interest Receivable7,601.84Interest Revenue7,601.84 Intermediate Accounting II Acc31021 | P a g e A _ A C A D E M Y– At December 31, 2015, CNH reports the lease receivable in its statement of financialposition among current assets or non-current assets, or both. It classifies the portion duewithin one year or the operating cycle, whichever is longer, as a current asset, and the restwith non-current assets. Statement of Financial Position (31/12)Non-current assets (investments) :Lease Liability ($76,018.38 – $16,379.78 )$59,638.60Current Assets :Interest Receivable$7,601.84Lease Receivable16,379.78 – The following entry records the receipt of the second year’s lease payment on January 1,2016. DateDebitCreditJan 1st ,2016Cash25,981.82Lease Receivable16,379.78Interest Receivable7,601.84Property Tax Expense / Property Tax Payable2,000 – The following entry records the recognition of interest earned on December 31, 2016. DateDebitCreditDec 31st ,2016Interest Receivable5,963.86Interest Revenue5,963.86 Note : No Depreciation expense (Assets with lessee)Intermediate Accounting II Acc31022 | P a g e A _ A C A D E M YEx4 : (Lessor Entries, Direct-Financing Lease with Option to Purchase) : KraussLeasing Company signs a lease agreement on January 1, 2015, to lease electronicequipment to Stewart Company. The term of the non-cancelable lease is 2 years, andpayments are required at the end of each year. The following information relates tothis agreement.1. Stewart has the option to purchase the equipment for £16,000 upon termination ofthe lease.2. The equipment has a cost and fair value of £240,000 to Krauss Leasing Company.The useful economic life is 2 years, with a residual value of £16,000.3. Stewart Company is required to pay £7,000 each year to the lessor for executorycosts.4. Krauss Leasing Company desires to earn a return of 10% on its investment.Instructions(a) Prepare the journal entries on the books of Krauss Leasing to reflect the paymentsreceived under the lease and to recognize income for the years 2015 and 2016.(b)Assuming that Stewart Company exercises its option to purchase the equipment onDecember 31, 2016, prepare the journal entry to reflect the sale on Krauss’s books. DateAnnual paymentless ExecutoryCostsInterest 10%on ReceivableRecovery oflease ReceivableLeaseReceivable Intermediate Accounting II Acc31023 | P a g e A _ A C A D E M Y(a) DateDebitCredit (b) DateDebitCredit Intermediate Accounting II Acc31024 | P a g e A _ A C A D E M YANSWERSAnswer of Ex 1 :(Lessee Computations and Entries, Finance Lease with Guaranteed Residual Value)a)Lease TermEconomic Life =50 Months60 Months = 83.33% 83.33% > 75%𝑃𝑉 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡Fair Value =$10,515∗$10,906 = 96% 96% > 90%∗ $9,800 + $715 = $10,515b) $10,515c) DateDebitCreditLease Equipment10,515Lease Liability10,515 d)$10,515-1,18050 Months = $186.7 per month DateDebitCreditDepreciation expense186.7Accumulated depreciation186.7 e) DateDebitCreditInterest Expense ($10,515 x 1%)105.15Lease Liability144.85Cash250 Intermediate Accounting II Acc31025 | P a g e A _ A C A D E M YAnswer of Ex 2 : (Lessee Entries, Finance Lease with Executory Costs andUnguaranteed Residual Value)Minimum Lease Payment = Yearly Payment 9,000 – Executory cost 3,088.14 = $86,911.86PV of minimum lease Payment = $86,911.86 x 6.32825 = $550,000 DateDebitCredit1 Jan ,2015Leased Equipment550,000Lease Liability550,0001 Jan ,2015Property Tax Expense3,088.14Lease Liability86,911.86Cash90,00031 Dec ,2015Depreciation Expense (550,000 / 10)55,000Accumulated Depreciation55,000Interest Expense {(550,000 – 86,911.86) x 12%}55,570.58Interest Payable55,570.58 DateLess ExecutoryCostInterest 12% onLiabilityReduction ofLease LiabilityLease Liability1/1/2015–––$550,0001/1/201586,911.86-0-86,911.86463,088.141/1/201686,911.8655,570.5831,3412.28431,746.861/1/201786,911.8651,809.6235,102.24396,644.62 Intermediate Accounting II Acc31026 | P a g e A _ A C A D E M Y DateDebitCredit1 Jan ,2016Property Tax Expense3,088.14Interest expense55,570.58Lease Liability31,341.28Cash90,00031 Dec ,2016Depreciation Expense (550,000 / 10y)55,000Accumulated Depreciation55,000Interest Expense {(463,088.14 – 86,911.86) x 12%}51,809.62Interest Payable51,809.62 Answer of Ex 3 : (Lessor Entries, Direct-Financing Lease with Option to Purchase)Amount to be recovered : 240,000 – 13,233.20 = $226,776.80Two Payments = $226,776.80 / 1.73554 = $130,666.42 DateAnnual PaymentLess ExecutoryCostInterest 10% onReceivableRecovery ofLeaseReceivableLeaseReceivable1/1/2015–––$240,0001/1/2015130,666.4224,000106,666.42133,333.581/1/2016130,666.4213,332.84*117,333.5816,000 * Rounded Residual ValueIntermediate Accounting II Acc31027 | P a g e A _ A C A D E M Y(a) DateDebitCredit1 Jan ,2015Lease Receivable240,000Equipment240,00031 Dec ,2015Cash (130,666.42 + 7,000)137,666.42Property Tax Payable7,000Interest Revenue24,000Lease Receivable106,666.4231 Dec ,2016Cash137,666.42Property Tax Payable7,000Interest Revenue13,333.84Lease Receivable117,333.58 (b) DateDebitCredit31 Dec ,2016Cash16,000Lease Receivable16,000 Answer of Ex 4 : (Amortization Schedule and Journal Entries for Lessee)Lease TermEconomic Life =5 years5 years= 100% 100% > 75%𝑃𝑉 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝐿𝑒𝑎𝑠𝑒 𝑃𝑎𝑦𝑚𝑒𝑛𝑡Fair Value =$85,653.55$90,000 = 95% 95% > 90%Intermediate Accounting II Acc31028 | P a g e A _ A C A D E M Y(a) DateAnnual leasePaymentInterest 10% inlease liabilityReduction ofLease LiabilityLease Liability1/1/2015–––$85,653.551/1/2015$20,541.11-0-($20,541.11)65,112.441/1/201620,541.116,511.24(14,029.87)51,082.571/1/201720,541.115,108.26(15,432.85)35,649.721/1/201820,541.113,564.97(16,976.14)18,673.581/1/201920,541.111,867.53*(18,673.58)0$102,705.55$17,052.00$85,653.55 * Rounded(b)– 2015 DateDebitCredit1 Jan ,2015Leased Equipment85,653.55Lease Liability85,653.551 Jan ,2015Lease Liability20,541.11Cash20,541.11During2015Insurance Expense900Cash900Property Tax Expense1,600Cash1,60031 Dec ,2015Interest expense6,511.24Interest Payable6,511.24Depreciation Expense (85,653.55 / 5y)17,130.71Accumulated Depreciation17,130.71 Intermediate Accounting II Acc31029 | P a g e A _ A C A D E M Y– 2016 : DateDebitCredit1 Jan ,2016Interest Payable6,511.24Interest expense6,511.241 Jan ,2016Interest expense6,511.24Lease Liability14,029.87Cash20,541.11During2016Insurance Expense900Cash900Property Tax Expense1,600Cash1,60031 Dec ,2016Interest expense5,108.26Interest Payable5,108.26Depreciation Expense (85,653.55 / 5y)17,130.71Accumulated Depreciation17,130.71


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