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August 1992 Illustrations of leases involving land and buildings. (Statement of Financial Accounting Standards No. 13) (Accounting)by Aldrige, Richard
One of the more technical aspects of SFAS 13 concerns accounting for leases that involve both land and buildings as one unit without distinction. The Fundamentals Leases that involve land have certain characteristics that distinguish them from other leases involving buildings or personal property. Paragraph seven of SFAS 13 identifies four criteria, any one of which would make a lease a capital lease: 1. Transfer of title; 2. Bargain purchase option; 3. Lease term at least 75% of the economic life of the property; or 4. Present value of minimum lease payments at least 90% of the fair value of the leased property at the inception of the lease. In leases of land only, however, only a transfer of title or the existence of a bargain purchase option (criteria (1) or (2) above) would qualify the lease as a capital lease, because, in these cases, ownership of the land is expected to pass to the lessee. This is an important concept in accounting for leases involving both land and buildings. Transfer of Title or Bargain Purchase Option In leases involving both land and buildings, the initial test is whether the lease meets criterion (1) or (2). if so, then the land and building components must be separated and capitalized individually on the books of the lessee. To accomplish this, the lessee must determine present value of the minimum lease payments and prorate the present value between the land and building components on the basis of their relative fair value at the inception of the lease. Case A below illustrates this procedure. Case A. Lessee Company enters into a lease involving land and building on January 1, 19XX. The fair values of the land and building, respectively, are $40,000 and $60,000. The lease calls for $26,380 payments at the end of each year for the next five years. The implicit interest rate is 12%, which is known by the Lessee Company and is lower than its incremental borrowing rate. The lease transfers title to the lessee at the end of the lease term. Since the lease transfers title, criterion (1) is met, meaning that the land and building must be capitalized separately by Lessee Company. The present value of the minimum lease payments is calculated as follows: $26,380 x factor for PV of annuity, 5 payments @ 12% $26,380 x 3.604776 = $95,094 The present value of the minimum lease payments is then prorated between the land and building components on the basis of their relative fair values, as follows: Land = $95,094 ($40,000/$100,000) = $38,038 Building = $95,094 ($60,000/$100,000) = $57,056 The building component will be amortized over its estimated useful life, using the lessee's usual depreciation methods. The land component will not be amortized. Fair Value of Land Less Than 25% of Total Fair Value If criterion (1) or (2) is not met, then the next decision concerns the fair value of the land relative to the combined fair value of the land and building. If the fair value of the land is less than 25% of the total fair value, then the two components will be considered together for purposes of applying criterion (3) and (4) (lease term 75% or more of economic life or present value of minimum lease payments 90% or more of fair value of property at inception of lease). The accounting for this situation is illustrated with Case B below. Case B: The facts are the same as for Case A, except the lease does not transfer title or contain a bargain purchase option and the land and building have fair values of $20,000 and $80,000, respectively. Since the fair value of the land is less than 25% of the total fair value, the land and building will be considered together for the purpose of applying criteria (3) and (4). As the lease term is five years and the economic life of the building is 10 years, criterion (3) is not met. The present value of the minimum lease payments is $95,094 (same as Case A), which is 95% of the fair value of the land and building ($100,000). Therefore, the lease meets criterion (4), and the land and building will be capitalized as one unit, with the resulting asset being amortized over the term of the lease. If neither criterion (3) nor (4) had been met, then the lease would not have been capitalized but rather would have been accounted for as an operating lease. Case C: If, in Case B, the implicit interest rate/incremental borrowing rate had been 15% instead of 12%, then the present value of the minimum lease payments would have been calculated as follows: $26,380 x factor for PV of annuity, 5 years @ 15% $26,380 x 3.352155 = $88,430 The present value of the minimum lease payments amounts to only 88% of the fair value of the land and building; therefore, criterion (4) is not met, and the lease will be treated as an operating lease. Fair Value of Land Least 25% of Total Fair Value If criteria (1) and (2) are not met and if the fair value of the land component of the lease is at least 25% of the total fair value, then land and building components must be considered separately. The land component will be accounted for as an operating lease, as criterion (3) or (4) are not operable for leases involving land. The building component of the lease will be separately determined and only this portion of the lease will be subjected to criterion (3) or (4). The mechanics of accomplishing this are illustrated in Case D below. Case D: The facts are the same as for Case B except that land and building have fair values of $30,000 and $70,000, respectively. Since criterion (1) or (2) is not met, and the land's fair value exceeds 25% of the total fair value, the land and building must be considered separately for the purpose of applying criterion (3) or (4). Since the lease term is five years and the economic life of the building is 10 years, criterion (3) is not met. To determine whether criterion (4) is met, several steps must be taken. The first step is to compute a payment amount that would equate to the fair value of the land component ($30,000). The formula for this payment would be as follows: $30,000 = factor for PV of annuity, 5 payments @ 12% $30,000 = 3.604776 x unknown Solving for the unknown = $8,322 Thus, the $8,322 represents that portion of the total lease payment ($26,380) that would presumably be for the land only. In the second step, the portion of the lease payment attributable to the land is subtracted from the total payment to determine the portion of the payment attributable to the building. Determining the portion of the lease payment for the land based on the land's full fair market value results in a conservative estimate of the lease payment attributable to the building for purposes of applying the 90% test. In this case, the difference of $18,058 ($26,380  $8,322) represents the portion of the lease payments attributable to the building. In the third step, the present value of the building portion of the lease payment, i.e., $18,058, is calculated as follows: $18,058 x factor for PV annuity, 5 payments @ 12% $18,058 x 3.604776 = $65,095 The $65,095 is approximately 93% of the fair value of the building ($70,000). Therefore, criterion (4) is met and the building component of the lease should be capitalized and amortized over the lease term of five years. Flow Chart The accompanying flowchart summarizes the accounting for leases involving land and buildings. Using the flowchart with the illustration discussed in this article should help implementation of SFAS 13 regarding leases involving land and buildings.
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