878 SECTION 3 Financial Instruments and Liabilities The lessor is unaffected by executory costs paid by the lessee. Sometimes, as an expediency, a lease contract will specify that the lessor is to pay executory costs, but that the lessee will reimburse the lessor through higher periodic rental payments. When rental payments are inflated for this reason, these executory costs are excluded in determining the present value of the minimum lease payments. They still are expensed by the lessee, even though paid through the lessor. For demonstration, let’s modify Illustration 15–6 to assume the periodic rental payments were increased to $102,000 with the provision the lessor (First LeaseCorp) pays the maintenance fee. We do this in Illustration 15–14 . Any portion of rental payments that represents maintenance, insurance, taxes, or other executory costs is not considered when calculating the PV of lease payments. Executory costs that are included in periodic rental payments to be paid by the lessor are, in effect, indirectly paid by the lessee—and expensed by the lessee. The lessee uses the lower of the interest rate implicit in the lease or the lessee’s own incremental borrowing rate. Maintenance expense ......................................................................... 2,000 Cash (annual fee) ............................................................................. 2,000 On January 1, 2016, Sans Serif Publishers, Inc., leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation at a cost of $479,079. Additional information: • Six annual payments of $102,000 beginning January 1, 2016. • Payments include $2,000 which First LeaseCorp will use to pay an annual maintenance fee. • The interest rate in these financing arrangements is 10%. • Capital lease to Sans Serif. • Direct financing lease to First LeaseCorp. First Payment (January 1, 2016) Sans Serif Publishers, Inc. (Lessee) Maintenance expense (2013 fee) ............................................. 2,000 Lease payable .......................................................................... 100,000 Cash (lease payment) ........................................................... 102,000 First LeaseCorp (Lessor) Cash (rental payment) ............................................................... 102,000 Lease receivable ................................................................. 100,000 Maintenance fee payable* ................................................. 2,000 *This assumes the $2,000 maintenance fee has not yet been paid to the outside maintenance service. Illustration 15–14 Rental Payments Including Executory Costs Paid by the Lessor Discount Rate An important factor in the overall lease equation that we’ve glossed over until now is the discount rate used in present value calculations. Because lease payments occur in future periods, we must consider the time value of money when evaluating their present value. The rate is important because it influences virtually every amount reported by both the lessor and the lessee in connection with the lease. One rate is implicit in the lease agreement. This is the effective interest rate the lease payments provide the lessor over and above the price at which the asset is sold under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. (Refer to our earlier calculations of the periodic rental payments.) Usually the lessee is aware of the lessor’s implicit rate or can infer it from the asset’s fair value. 25 When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset. When the lessor’s implicit rate is known, the lessee should use the lower of the two rates. 26 25 The corporation laws of some states, Florida for instance, actually require the interest rate to be expressly stated in the lease agreement. 26 Incremental borrowing rate refers to the fact that lending institutions tend to view debt as being increasingly risky as the level of debt increases. Thus, additional (i.e., incremental) debt is likely to be loaned at a higher interest rate than existing debt, other things being equal. The lessee simply expenses executory costs as incurred.
Spiceland_Inter_Accounting8e_Ch15
To see the actual publication please follow the link above