accounting assighment

Accounting for Leases

Unit-III

Leasing Environment:

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 a specified period of time. Lessee makes the payment to the lessor in return over the lease term for the use of the property.

The largest group of leased equipment involves Information technology, Transportation (trucks, motor cars), Construction and Agriculture.

Who are the Lessors? The lessors that own this property generally fall into one of following three categories:

1. Banks.

2. Captive leasing companies.

3. Independents.

Advantages of Leasing:

1. 100% financing at Fixed Rates: Leases are often signed without initial amount from the lessee. In addition, lease payments often remain fixed which protects the lessee against inflation and increases in the cost of money.

2. Protection against Obsolescence: Leasing equipment reduces risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor.

3. Flexibility: Lease agreements may contain less restrictive provisions than other debt agreements. For example, the duration of the lease may be anything from short period of time to the entire expected economic life of the asset. The payment of rent in most cases is set to enable the lessor to recover the cost of the asset plus a fair return over the life of the lease.

4. Less Costly Financing: Some companies find leasing cheaper than other forms of financing. This may reduce the tax burden of the companies. Through leasing, the leasing companies or financial institutions use these tax benefits. They can pass some of these tax benefits back to the user of the asset in the form of lower rental payments.

5. Tax Advantages: For financial reporting purposes companies do not report an asset or a liability for the lease arrangement. For tax purposes, however, companies can capitalize and depreciate the leased assets.

6. Off-Balance-Sheet Financing: Some leases do not add debt on a balance sheet or affect financial ratios. But they may be added to borrowing capacity.

Accounting by the Lessee: Lessee capitalizes a lease; it records an asset and a liability generally equal to the present value of the rental payments. Lessor having transferred substantially all the benefits and risks of ownership recognizes a sale by removing the asset from the balance sheet and replacing it with a receivable.

Capitalization Criteria (Lessee): In order to record a lease as a capital lease, the lease must be non cancelable. In addition, it must meet one or more of the following four criteria.

1. Transfers ownership to the lessee.

2. Contains a bargain purchase option.

3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

4. The present value of the minimum lease payments (excluding executor costs) equals or exceeds 90 percent of the fair value of the leased property.

Accounting Methods of Lease in the books of Lessee:

There are two methods of treating lease in the books of lessee.

1. Capital Lease Method: In this, assets and liabilities are recorded at the present value of the rental payments. It should also fulfill at least one of the capitalization criteria.

2. Operating Method: Under this method, rent expense accrues day by day to the lessee as it uses the property. There is no need to fulfill any of the capitalization criteria.

Accounting by the Lessor:

A lessor determines the amount of rental on the basis of rate of return or the implicit rate. In establishing the rate of return, lessor considers the credit standing of the lessee, the length of the lease, and the status of the residual value.

Advantages of Lessor: Following three benefits are available to the lessor.

1. Interest Revenue: Leasing is a form of financing. Banks and independent leasing companies find leasing attractive because it provides competitive interest margin.

2. Tax Incentives: The lessee cannot use the tax benefit of the assets but allows such tax benefits to lessor in return for a lower rental rate on the leased asset.

3. High Residual Value: Return of the property at the end of the lease term is another advantage to the lessor. Residual values can produce very large profits

Classification of Leases by the Lessor:

For accounting purposes, the lessor may classify leases as follows:

1. Direct financing leases

2. Sales type leases

3. Operating leases

Capitalization Criteria for Lessor: If the lessor agrees to a lease that meets one or more criteria of group-I and both the criteria of group-II, he will classify and account for the arrangement as a direct financing lease or as a sales type lease.

Group-I

1. Transfers ownership to the lessee.

2. Contains a bargain purchase option.

3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

4. The present value of the minimum lease payments (excluding executor costs) equals or exceeds 90 percent of the fair value of the leased property.

Group-II

1. Collectability of the payments required from the lessee is reasonably predictable.

2. No important uncertainties surround the amount of reimbursable costs yet to be incurred by the lessor under the lease (lessor's performance is substantially complete or future costs are reasonably predictable.

A sales type lease involves a manufacturer's or dealer's profit, and a direct financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor's cost or carrying amount (book value).

Lessors classify and account for all leases that do not qualify as direct financing or sales type leases as operating leases. In other words, if lessor does not meet both the capitalization criteria of group-II the lease will be an operating lease.

Direct Financing Method (Lessor):

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. Minimum lease payments include rental payments (excluding executor costs), bargain purchase option, guaranteed residual value, penalty for failure to renew (if any). Thus, the lessor records the residual value, whether guaranteed or not. Also, if the lessor pays any executor costs, then it should reduce the rental payment by that amount in computing minimum lease payments.

Operating Method (Lessor):

Under this method, the lessor records each rental receipt as rental revenue. It depreciates the leased asset in the normal manner. 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, finder's fees, and costs of credit checks, usually on a straight line basis.

Workout Problems:

Q.1. On January 1, 2007, Hall crow Corporation signed a 5-year non-cancelable lease for a machine. The terms of the lease called for Hall crow to make annual payments of SR8,668 at the beginning of each year, starting January 1, 2007. The machine has an estimated useful life of 6 years and a SR 5,000 unguaranteed residual value. Hall crow uses the straight-line method of depreciation for all of its plant assets. Hall crow incremental borrowing rate is 10%, and the Lessor’s implicit rate is unknown. The lease meets the criteria for classification as a capital lease. (Present value of one riyal at 10% for 5 years is 4.16986)

Instructions

(a) Compute the present value of the minimum lease payments.

(b) Calculate Amortization Schedule.

( c ) Prepare journal entries for Burke for two years.

Q2 Caterpillar financial services corporation and sterling construction corporation sign a lease agreement dated January 1, 2008, that calls for caterpillar to lease a front-end loader to sterling beginning January1, 2008. The terms and provisions of the lease agreement are as follows:

a. The term of the lease is five years. The lease agreement is non-cacheable, requiring equal rental payments of SR25, 981.62 at the beginning of each year (annuity due basis)

b. The loader has a fair value at the inception of the lease of SR100, 000, an estimated economic life of five years, and no residual value.

c. Sterling pays all of the executory costs directly to third parties except for the property taxes of SR2000 per year, which it includes as part of its annual payment to caterpillar

d. Starlings' incremental borrowing rate is 11% per year

e. Starlings depreciates on straight- line basis, similar equipment that it owes

P.V.of 1 Riyal at 10% for 5 years is 4.16986. Compute present value and Amortization schedule and pass journal entries.

25,981.62-2,000=23,981.62x4.16986= SR 100,000

Q3. Based on the question number 2 pass journal entries in the books of Lesser under capitalization method.

Q4. Assume that the capital lease method adopted in question 2 did not apply. Record the journal entry for the year 2008 under operating lease method.

Q5. Based on the question number 2 pass journal entries in the books of Lesser under operating lease method.

Q.6. (Computation of Rental) Morgan Leasing Company signs an agreement on January 1, 2009, to lease equipment to Cole Company. The following information relates to this agreement.

1. The term of the non-cancelable lease is 6 years with no renewal option. The equipment has an estimated economic life of 6 years.

2. The cost of the asset to the lessor is SR 245,000. The fair value of the asset at January 1, 2007, is SR 245,000.

3. The asset will revert to the lessor at the end of the lease term at which time the asset is expected to have a residual value of SR 43,622, none of which is guaranteed.

4. The agreement requires annual rental payments, beg. Jan. 1, 2007.

5. Collectability of the lease payments is reasonably predictable. There are no important uncertainties surrounding the amount of costs yet to be incurred by the lessor.

Compute annual rental of the lease.

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Q.1. A-1 Solution: Compute present value of the minimum lease payments.

Payment SR 8,668

Present value factor (i=10%, n=5) 4.16986

PV of minimum lease payments SR 36,144

Calculation of Amortization Schedule

Date	Lease Payment	Interest Expenses	Reduction in Liability	Lease Liability
1-1-7	--	--	--	36,144
1-1-7	8,668	---	8,668	27,476
1-1-8	8,668	2,748	5,920	21,556
1-1-9	8,668	2,156	6,512	15,044
1-1-10	8,668	1,504	7,164	7,880
1-1-11	8,668	788	7,880	0

Journal Entries in the Books of Hall Crow (Lessee)

Date	Particulars	L.F.	Amounts (dr)	Amounts (cr)
1-1-7	Lease Machine dr Lease Liability		36,144	36,144
1-1-7	Lease Liability dr Cash		8,668	8,668
31-12-7	Depreciation Expenses dr Accumulated Depreciation		6,229	6,229
31-12-7	Interest expenses dr Interest payable		2,748	2,748
1-1-8	Lease liability dr Cash		8,668	8,668
31-12-8	Depreciation Expenses dr Accumulated Depreciation		6,229	6,229
31-12-8	Interest expenses dr Interest payable		2,156	2,156

Q.2. Capitalized amount= (SR 25,981.62-$2000)*present value of an annuity due of 1 for 5 periods at 10%

=SR 23,981.62x4.16986

=SR 100,000

Calculation of Amortization Schedule

Date	Lease Payment	Property Tax	Interest Expenses	Reduction in Liability	Lease Liability
1-1-8	--	-----	--	--	100,000
1-1-8	25,981.62	2,000	---	23,981.62	76,018.36
1-1-9	25,981.62	2,000	7,602	16,379.62	59,638.76
1-1-10	25,981.62	2,000	5,964	18,017.62	41,621.14
1-1-11	25,981.62	2,000	4,162	19,819.62	21,801.52
1-1-12	25,981.62	2,000	2,180	21,801.62	0

Journal Entries in the Books of Sterling (Lessee)

Date	Particulars	L.F.	Amounts (dr)	Amounts (cr)
1-1-8	Lease Equipment dr Lease Liability		100,000	100,000
1-1-8	Property tax Lease Liability dr Cash		2,000 23,981.62	25,981.62
31-12-8	Interest Expenses dr Interest Payable		7,601.84	7,601.84
31-12-8	Depreciation expenses dr Accumulated Depreciation		20,000	20,000
1-1-9	Property tax dr Interest payable dr Lease Liability dr Cash		2,000 7,601.84 16,379.62	25,981.62
31-12-9	Interest expenses dr Interest payable		5,964	5,964
31-12-9	Depreciation expenses dr Accumulated Depreciation		20,000	20,000
31-12-10	Property tax dr Interest payable dr Lease Liability dr Cash		2,000 5,964 18,017.62	25,981.62

Q.3.

Journal Entries in the Books of Caterpillar (Lesser)

Date	Particulars	L.F.	Amounts (dr)	Amounts (cr)
1-1-8	Lease Receivable dr Lease Equipment		100,000	100,000
1-1-8	Cash dr Property tax expenses Lease receivable		25,981.62	2,000 23,981.62
31-12-8	Interest receivable dr Interest revenue		7,601.84	7,601.84
1-1-9	Cash dr Property tax expenses Interest receivable Lease receivable		25,981.62	2,000 7,601.84 16,379.78
31-12-9	Interest receivable dr Interest revenue		5,964	5,964
1-1-10	Cash dr Property tax expenses Interest receivable Lease receivable		25,981.62	2,000 5,964 18,017.62

Q.4. Journal Entries in the Books of Sterling (Lessee) under operating Lease

Date	Particulars	L.F.	Amounts (dr)	Amounts (cr)
1-1-8	Rent Expenses dr Cash		25,981.62	25,981.62
1-1-9	Rent Expenses dr Cash		25,981.62	25,981.62

Q.5. Journal Entries in the books of Lessor under Operating lease method

Date	Particulars	L.F.	Amounts (dr)	Amounts (cr)
1-1-8	Cash dr Rental revenue		25,981.62	25,981.62
31-12-8	Depreciation expenses dr Accumulated Depreciation		20,000	20,000
1-1-9	Cash dr Rental revenue		25,981.62	25,981.62
31-12-9	Depreciation expenses dr Accumulated Depreciation		20,000	20,000

Ans-6 Residual Value SR 43,622

P.V. of single sum (i=10%, N=6) x 0.56447 , 43,622 x0.56445 = SR 24,623

P.V. of residual value = SR 24,623

Fair Market Value of Leased Equipment SR 245, 000

Less Present Value of Residual Value 24,623 = 220,377

Amount to be recovered through lease payment SR 220,377 /4.79079

PV factor of Annuity due (i=10%, n=6) 4.79079

Annual Payment Required SR 46,000

245,000 – 43,622 = 201,378 / 6= 33,563 (Depreciation expenses)

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