301986 LEASE ACCOUNTING 3F Flashcards
Which of the following statements about leases is incorrect?
A lessee classifies a lease as either a finance or a sales-type lease at the commencement date.
One of the criteria for identifying a separate lease component is that the underlying asset is not dependent on the other underlying assets in the lease.
Under FASB Topic 842, there are no “bright lines” for fair value (old 90% test) or asset life (old 75% test).
The ROU asset and the lease liability are initially measured at present value of the lease payments.
A lessee classifies a lease as either a finance or a sales-type lease at the commencement date.
The statement “A lessee classifies a lease as either a finance or a sales-type lease at the commencement date” is incorrect because lessees classify leases as operating or finance, not sales-type.
The other answer choices are correct statements:
Under FASB Topic 842, there are no “bright lines” for fair value (old 90% test) or asset life (old 75% test).
The right-of-use (ROU) asset and the lease liability are initially measured at present value of the lease payments.
One of the criteria for identifying a separate lease component is that the underlying asset is not dependent on the other underlying assets in the lease.
Commencement Date
The commencement date is the date on which a lessor makes an underlying asset available for use by a lessee.
FASB ASC Glossary
Finance Lease
A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
FASB ASC 842-10-25-2
Lessee
A lessee is an entity that enters into a contract to obtain the right to use an underlying asset for a period of time in exchange for consideration.
FASB ASC Glossary
Operating Lease
From the perspective of a lessee, an operating lease is any lease other than a finance lease. From the perspective of a lessor, an operating lease is any lease other than a sales-type lease or a direct financing lease.
FASB ASC Glossary
Present Value
Present value is one of the attributes used to measure assets and liabilities. Present value is the present, or discounted (at the implicit or historical rate), value of future cash flows used for long-term receivables and payables.
Right-of-Use (ROU) Asset
A right-of-use (ROU) asset represents a lessee’s right to use an underlying asset for the lease term.
FASB ASC Glossary
Sales-Type Lease
A lessor shall classify a lease as a sales-type lease and a lessee shall classify a lease as a finance lease when the lease meets any of the following criteria at lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
FASB ASC 842-10-25-2
Underlying Asset
An underlying asset is the subject of a lease for which a right to use that asset has been conveyed to a lessee. The underlying asset could be a physically distinct portion of a single asset.
FASB ASC Glossary
2361.07
The first set of criteria result in a finance lease for a lessee if the lease meets any of the following criteria at commencement:
- Title (ownership) transfers to the lessee by the end of the lease term.
- The lease contains a purchase option that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. This criterion shall not be used if the lease commencement date is near the end of the asset’s economic life.
- The present value of the sum of the lease payments and any lessee guaranteed residual value not already in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is specialized and is not expected to have an alternative use to the lessor at the end of the lease term.
2361.10
Finance leases: For most leases of assets other than property (e.g., cars or trucks, construction or manufacturing equipment), a lessee will classify the lease as a “finance” lease if it meets any of the five criteria listed in section 2361.07, and it will recognize the following:
- At commencement: A lease liability and a right-of-use (ROU) asset. The lease liability is initially measured at the present value of lease payments discounted at the rate implicit in the lease if known; otherwise, the lessee uses its incremental borrowing rate. The ROU asset is initially measured as the lease liability plus any lease payments made to the lessor at or before the commencement date minus any lease incentives received plus any initial direct costs.
- Subsequent to commencement: The unwinding of the discount on the lease liability (i.e., interest expense), using the effective interest method, is accounted for separately from the amortization of the ROU asset. (Note: If a finance lease is due to a transfer of ownership or if the lessee is reasonably certain to exercise a purchase option, the lessee shall amortize over the ROU asset life instead of the shorter of the lease term or ROU asset life.) Impairment, if any, is recorded.
Example: On January 1, Year 1, a finance lease agreement was entered into that requires annual lease payments of $42,500 over a 4-year lease term, which equals the remaining useful life of the asset. There is no residual value. The first payment is due on January 1, Year 1. The interest rate is 7%, resulting in a present value of $154,000 (rounded). Prepare the journal entries for the first year.
To record lease:
ROU Asset 154,000
Lease Liability 154,000
To record payment at commencement:
Lease Liability 42,500
Cash 42,500
To record financing cost:
Interest Expense 7,805
Lease Liability 7,805*
- $154,000 − $42,500 = $111,500; $111,500 × 7%
To record amortization of the ROU asset:
Amortization Expense 38,500
ROU Asset 38,500
2361.11
Operating leases: For most leases of property (e.g., land or building), a lessee would classify the lease as an “operating” lease if none of the five criteria listed in section 2361.07 are met and will recognize the following:
- At commencement: A right-of-use (ROU) asset and a lease liability, initially measured at the present value of lease payments, using the interest rate implicit in the lease if known; otherwise, the lessee uses its incremental borrowing rate.
- Subsequent to commencement: A single lease cost, combining the unwinding of the discount on the lease liability (i.e., interest expense) with the amortization of the ROU asset, on a straight-line basis. In other words, the lease liability is reduced by the amount of the periodic payment less the amount of that payment attributable to interest. The lessee then “plugs” the ROU asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line payment in the lease contract. Impairment, if any, is recorded.
Example: A lessee enters into a 10-year operating lease with yearly payments of $12,000 that start at the commencement of the lease. The present value of the lease payments is $80,000, assuming a known implicit rate in the lease of 10%. The economic life of the asset is 20 years. Prepare the journal entries for the first year of the lease.
To record lease:
ROU Asset 80,000
Lease Liability 80,000
To record lease payment at commencement:
Lease Liability 12,000
Cash 12,000
To record lease expense at end of year:
Lease Expense 12,000
ROU Asset (plug) 5,200
Lease Liability 6,800*
- ($80,000 - $12,000) × 10%
