21.1 (The Leasing Environment)

Question 1

Lease

Answer 1

A contractual agreement between a lessor and lessee.

A “contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration.

Conveys the use of an asset from one party (the lessor) to another (the lessee) without transferring ownership.

Question 2

Equipment Leasing Association

Answer 2

Its numbers show how leasing is more prevalent

Question 3

What are several major companies leasing?

Answer 3

Equipment, transportation assets, construction, and agriculture.

Question 4

Advantages of leasing (Lessees perspective)

Answer 4

• 100% financing at fixed rates
• Protection against obsolescence
• Flexibility
• Lost costly financing

Question 5

Who are the Lessors?

Answer 5

Generally fall into one of the three following categories

• Banks
• Captive Leasing Companies
• Independents

Question 6

Subsidiary

Answer 6

A company controlled by a holding company

Question 7

Advantages of leasing (Lessors perspective)

Answer 7

• Profitable interest margins
• Stimulate sales of lessors product
• Tax benefits
• High residual value (residual value loss)

Question 8

Tax benefits (leasing)

Answer 8

Opportunity to reduce your tax bill

Question 9

Residual value (leasing)

Answer 9

Estimated value of a fixed asset at the end of its lease term or useful life

Question 10

Different views on capitalization of leases

Answer 10

1. Do not capitalize any leased assets
2. Capitalize leases that are similar to installment purchases
3. Capitalize all long-term leases
4. Capitalize firm leases where the penalty for nonperformance is substantial

FASB adopted the 3rd approach

Question 11

Finance lease

Answer 11

Lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis.

Total expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement.

Question 12

Operating lease

Answer 12

Lessee also measures interest expense using the effective-interest method. Lessee amortizes the right-of-use asset such that the total reported lease expense is the same from period to period.

Question 13

Lease Classification

Answer 13

If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease.

All leases that do not meet any of the finance lease tests are classified as operating leases. In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself.

Question 14

Lease classification tests

Answer 14

• Finance lease: It must be non-cancelable and meet at least one of the five tests

Otherwise, the lease is an operating lease.

Question 15

Transfer of ownership test

Answer 15

Lease transfers ownership of the asset to the lessee.

Question 16

Purchase option test

Answer 16

Reasonable certainty that the lessee will purchase the property for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable.

Question 17

Lease term test (75% test)

Answer 17

When the lease term is a major part of the remaining economic life of the leased asset, companies should use the finance method in accounting for the lease transaction.

Question 18

Present value test

Answer 18

If the present value of the lease payments is reasonably close to the fair value of the asset, a company is effectively purchasing the asset and should therefore use the finance method to account for the lease.

If the present value of the lease payments equals or exceeds 90 percent of the fair value of the asset, then a lessee should use the finance method to record the lease.

Question 19

Alternative use test

Answer 19

If at the end of the lease term the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease.

“build-to-suit” arrangement

Question 20

Lease payments (Present Value Test)

Answer 20

To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate.

1. Fixed payments
2. Variable payments that are based on an index or a rate
3. Amounts guaranteed by a lessee under a residual value guarantee
4. Payments related to purchase or termination options that the lessee is reasonably certain to exercise.

Question 21

Discount rate (Present value test)

Answer 21

To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate.

Implicit interest rate - rate is defined as the discount rate that, at commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset.