302412 Lease - Finance Lease 3F Flashcards
Grant Services leases a machine from Jacobson Leasing. Ownership of the machine returns to Jacobson after the 15-year lease expires. Jacobson intends to seek another lessee after the lease with Grant is over. The machine is expected to have an economic life of 17 years. The present value of the minimum lease payments is substantially all of the fair value of the machine. What is the appropriate classification of this lease for Grant?
Finance lease
Leveraged lease
Operating lease
Sale-leaseback lease
Question #302412
Finance lease
The lessee must classify a lease as a finance lease instead of an operating lease if any one of the following five criteria is met: the lease transfers ownership to the lessee by the end of the lease term (not met in this lease); the lease contains a purchase option (not indicated for this lease); the leased asset has an alternative use; the noncancelable lease term is the majority of the remaining economic useful life of the leased asset (true for this lease); or the present value of the minimum lease payments is substantially all of the fair value of the leased asset (less any investment tax credit retained by and expected to be realized by the lessor) at the inception of the lease (true for this lease).
Grant’s lease meets two of these criteria (only one is necessary). For the lessee, no other criteria have to be met. Grant is the lessee; therefore, the lease is a finance lease for Grant.
Criteria
Criteria are the benchmarks used to measure or evaluate the subject matter.
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
FASB ASC 842-10-25-2
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
Sale and Leaseback
A sale/leaseback is a lease transaction in which the owner of the asset sells it and immediately leases it back from the buyer. It is subject to the same capitalization criteria as any lease agreement. Any profit (or loss) is deferred and amortized (by the lessee-seller) in proportion to the amortization of the leased asset (under a finance lease) or in proportion to the related gross rental to expense over the lease term (under an operating lease).
2361.01
The following flowchart (from FASB ASC 842-10-55-1) depicts the decision process to follow in identifying whether a contract is a lease or contains a lease.
2361.02
The FASB defines a lease in ASU 2016-02 to be “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.” (Emphasis added)
2361.03
Although typically explicitly specified, an identified asset can be implicitly specified in the contract.
a. A physically distinct portion of an asset (floor of a building) can be an identified asset. However, a capacity portion of an asset (e.g., a capacity portion of a fiber-optic cable that is less than substantially all of the capacity of the cable) cannot be an identified asset because it is not physically distinct from the remaining capacity of the asset.
b. A contract would not involve the use of an identified asset if a supplier has the substantive right to substitute the asset used to fulfill the contract (e.g., the supplier can substitute an asset and it can benefit from exercising that right of substitution). If it is not readily determinable whether or not the supplier has a substantive substitution right, it shall be assumed the substitution right is not substantive.
2361.04
An entity will determine whether a contract contains a lease by assessing whether the use of an identified asset is either explicitly or implicitly specified and whether the customer controls the use of the identified asset.
a. A contract conveys the right to control the use of an identified asset if the customer has the right to direct the use of the identified asset and obtains substantially all of the economic benefits from directing the use of the identified asset.
b. The right to direct the use of the identified asset is determined by the customer having the right to direct (or make relevant decisions about) how and for what purpose the asset is used or if either the customer has the right to operate the asset without supplier interference or the customer designed the asset. Only rights during the period of use (not before the use) of the asset should be assessed unless the customer designed the asset.
c. A supplier’s protective rights (e.g., a contract may specify the maximum amount of use of an asset to protect the supplier‘s interest in the asset) over the identified asset does not prevent the customer from having the right to direct the use of the asset.
2361.05
Lease Example 1: Contract for Shipping Containers
Scenario 1 (based on FASB ASC 842-10-55-42 through 55-47)
A contract between Customer and a freight carrier (Carrier) provides Customer with the use of 10 shipping containers owned by Carrier for 5 years. The contract specifies the type of container. Customer determines when, where, and which goods are to be transported using the containers. When the containers are not in use, they are kept at Customer‘s premises. Customer can use the containers for another purpose (e.g., storage) if it so chooses. If a particular container needs to be serviced or repaired, Carrier is required to substitute an equivalent container of the same type. Otherwise, and other than on default by Customer, Carrier cannot retrieve the containers during the 5-year period.
The contract also requires Carrier to provide a ship (barge) and a captain when requested by Customer and stipulates that, if Carrier is unable to do so, Customer has the right to hire a ship and a captain from other suppliers. Carrier keeps the ships at its premises and provides instructions to the captain detailing Customer‘s requests to transport goods. Carrier can choose to use any one of a number of ships to fulfill each of Customer‘s requests, and one ship could be used to transport not only Customer‘s goods but also the goods of other customers, if other customers require the transportation of goods to destinations close to the destination requested by Customer and within a similar time frame. Carrier can choose to load up to 100 shipping containers on the ship.
Does the contract contain a lease?
Yes. The contract contains a lease of shipping containers. Customer has the right to use 10 shipping containers for 5 years. Fulfillment of the contract depends on the use of 10 identified containers. Once delivered to Customer, Carrier can substitute the containers only when they are not operating properly.
Customer has the right to control the use of the containers because of both of the following:
a. Customer has the ability to direct the use of the containers. Customer determines how, when, and for what purpose the containers are used, not only when they are being used to transport Customer‘s goods but throughout the term of the contract.
b. Customer has the ability to derive the benefits from use of the containers. The containers are available for Customer‘s use throughout the term of the contract, including when they are not being used to transport Customer‘s goods.
The contract also contains a nonlease (service) component that relates to the use of a ship and a captain but does not convey the right to use an identified ship and captain.
2361.05
Scenario 2 (based on FASB ASC 842-10-55-48 through 55-51)
The contract between Customer and Carrier requires Carrier to transport a specified quantity of goods in accordance with a stated timetable for a period of 5 years. The timetable and quantity of goods specified is equivalent to Customer having the use of 10 shipping containers for 5 years. Carrier provides the shipping containers, ship (barge), and captain as part of the contract. The contract states the nature and quantity of the goods to be transported but does not include specific details about the containers, ship, or captain to be used to transport Customer‘s goods.
Although transporting the goods identified in the contract requires containers similar to those identified in Scenario 1 above, Carrier has a large pool of similar containers that can be used to transport Customer‘s goods. Similarly, Carrier can choose to use any one of a number of ships and captains to fulfill each of Customer‘s requests, and one ship could be used to transport not only Customer‘s goods but also the goods of other customers. The containers and ships are stored in Carrier‘s premises when not being used to transport goods.
Does the contract contain a lease?
No. The contract does not contain a lease. Fulfillment of the contract does not depend on the use of 10 identified shipping containers or an identified ship and captain because Carrier has substantive substitution rights. Carrier can choose the containers, ship, and captain without Customer‘s consent. There also are no economic barriers that prevent Carrier from using any container within the pool of containers of a particular specification, and any one of a number of ships and captains, for each delivery of Customer‘s goods.
2361.06
There are two sets of lease criteria for both lessees and lessors.
