Chapter 20 - Accounting for Leases Flashcards
What is the definition of a lease
a contractual agreement between a lessor and a lessee, that gives lessee the right to use specific, property owned by the lessor
What are the benefits of Leasing for the Lessee
- No (or low) down payment
- Fixed rates
- Avoid risk of ownership
- Flexibility
- Tax advantages
- Less Costly financing
What are the benefits of leasing for the Lessor
- Increased Sales
- Tax advantages
- Residual value retained
What should a lessee classify the lease based on?
If the arrangement is effectively a purchase of the underlying asset
What is a finance lease
a lease where the lease transfers control of the underlying asset to the leasee
When is it determined that a lease is a financing lease
If one of the lease classification tests are triggered
What are the lease classification tests
1. Transfer of ownership
#2 Bargain Purchase Option Test
#3 Lease Term Test
#4 PV Test
#5 No alternative use test
What is the bargain purchase option test
when the lease allows the lessee to purchase the asset for a price that is significantly less than the fair value at the date the option becomes execrable
what is the lease term test
if the lease term is more than or equal to 75% of the assets economic life then it is a finance lease
what is a bargain renewal option
At the commencement of the lease if it is reasonably certain that the lessee will exercise the option to renew… this extends the lease life period
What is the PV Test
If the PV of the lease payment is greater than or equal to 90% of the FV then the test is triggered
What are the lease payments that can contribute to the the PV test
-Fixed payment
-Variable payments (can be known or unknown)
-Guaranteed Residual
-Payments related to purchase or termination options that the lessee is reasonably certain to exercise
what rate should you use first for leases then what should you use if that one is not known
implicit, then incremental borrowing rate
What is the No alternative use test
If there is no alternative use for the asset besides to be used for the lessee than it is a financing lease
- if it is assumed the lessee uses all the benefits from the asset then they essentially have purchased the asset
What is recorded for a finance lease for the lessee
- ROU Asset
- Lease Liability
- Interest Expense
- Amortization Expense
How do you record the J.E at lease inception
Dr. ROU Asset
Cr. Lease Liability (PV of all expected payments)
what method is used to calculated interest expense
effective interest method on the lease liability
What goes into the calculation of the Lease liability
- PV of lease payments
- PV of difference between expected and guaranteed residual if there is one
- PV of probable bargain purchase option
What goes into the calculation of the ROU asset
- lease liability + initial direct costs, prepayments and lease incentives
What is the lease called when it is a financing lease for the lessor
Sale-Type Lease
What does the lessor record for a sales-type lease
Lease inception:
Lease receivable
COGS
Sales Revenue
Inventory
Pmts:
Cash
Lease Receivable
Recognize interest
Lease Receivable
Interest Revenue
How is the lease receivable computed for the lessor
PV of PMTS + PV of Residual (whether guaranteed or not)
*amount they would want to recover
what is different in the lessee accounting for finance vs operating lease
there is a single lease expense that is the same each period. (add up payments and divide by the number of payments to get expense)
what two thing balance lease expense in a journal entry and how are they calc.
the interest expense is calculated based on the effective interest method and amortization is the plug
what does the lessor recognize under the operating method
- Asset continues to be recognized on the balance sheet (doesn’t transfer control of the item)
-recognizes unearned lease revenue at inception
-depreciates over useful life
what is a short term lease?
a lease that at it’s commencement date has a lease term of 12 months or less
How does lessor calculate payments to be recieved
FV of equipment
Less: (PV of residual value)
= amount to be recovered through payments / PV factor
why does a lessor recognize unearned lease revenue in an operating leases
because they have received cash but have not satisfied their performance obligation
what is the journal entry for a short term lease
lease expense
cash
If a lease has an original term for 12 months but has a renewal option that is reasonably certain to exercise then can it be a short term lease?
no
What are executory costs
normal expenses associated with owning a leased asset such as property insurance and property taxes
if a lessor includes executory costs that are fixed payments required by the lessor how should they be accounted for
they should be included in lease payments for purpose of measuring lease liability
- think of zena adding water bill into our lease payments
if the executory costs are payments made directly to the taxing authorities or insurance provider how are they accounted for
they are expensed as incurred
*think of paying monthly energy bill to keep house going
How do lease prepayments, incentives and initial direct costs prior to the lease affect its accounting
- lease prepayments increase the ROU asset (debit ROU)
- Lease incentives decrease the ROU asset (dr. cash cr. ROU)
- Initial direct costs incurred increase the ROU asset
what are initial direct costs?
incremental costs of a lease that would not have been incurred has the lease not been executed
if lessor is paying initial direct costs how would they account for it?
Operating: They would defer the initial direct costs and amortize them as expenses over the term of the lease (capitalize them amortize)
Sales Type: expenses initial direct costs at lease commencement
*Match expense to revenue recognition
What is a bargain purchase option
allows the lessee to purchase the leased property for a future price that is substantially lower than the asset’s expected FV
What changes in the accounting when a bargain purchase option exisits.
- The lessee must increase PV of lease payments by the PV of the option price
- The asset is amortized over economic life not lease term
when are the two scenarios where the lessee benefits from the asset beyond the term of the lease
- Bargain purchase option
- Transfer of ownership
how do you determine how much the amount to be recovered through payments for the lessor will be
FV of asset
less: what they are going to get back from the lessee (could be residual or payment for asset)
For a residual value if the expected residual value is equal to or greater than the guaranteed residual then…
the lessee should not include residual into lease liability
For a residual value if the expected residual value is less than the guaranteed value then…
the difference between the two should be computed in the computation of the lease liability
what does a lessee do with an unguaranteed residual
nothing, they do not compute it into PV test or in lease liability they simply just return the asset without any other payment
If a sales-type lease and there is an unguaranteed residual value how does this affect the accounting
- Sales revenue and COGS is recognized only for the portion of the asset in which recovery is assured
- ## Sales Revenue and COGS are lowered by the present value of the unguaranteed residual
how does Gross profit change when the residual is ungauranteed
it doesn’t change because sales revenue and COGS are decreased by the same amount
If a operating lease and there is an unguaranteed residual value how does this affect the accounting
there are no changes - they often go together
What is a sale lease back
when a company (seller-lessee) transfers an asset to another company (the buyer-lessor) and then leases that asset back from the buyer-lessor
Why do (seller-lessees) engage in sale-leaseback transaction
- can use the cash that would otherwise be tied up in property to expand operations
- Can structure the lease arrangement so issues such as repurchase provisions, refinancing issues, and conventional financing costs are manimized
- May receive a tax advantage in that entire rental payments are tax deductible
Why would (buyer-lessor engage in a sale-leaseback
- A higher rate of return than traditional financing
- Protected from downturn in real estate market and may have an inflation hedge
If control has passed from seller to buyer for a sale-leaseback then…
true sale has occured… operating lease
if control has not passed from seller to buyer in a sale leaseback then…
failed lease… transaction recorded as a financing “note payable”
If there is a sale transaction in a sale-leaseback then what accounting is necessary
Gain or loss is appropriate
- Record sale
Cash
Accum. Depreciation
Inventory
Gain (or loss)
- Account for operating lease
What happens when there is a failed sale-leaseback in the eyes of the seller
-do not reduce the carrying value of the building
-keep depreciating
-recognize sale proceeds as a financial liability
what would be the journal entry for a failed sale-leaseback
Cash
Note Payable
What is a direct financing lease
a part of a sale-leaseback when the lessor relinquishes control of the asset to the lessee but there is a third party involved
-lessors use a third lease classification
what is the main difference between a direct financing lease and a sales-type lease
the profit on the sale…
sale-leaseback: profit immediately recognized
direct financing lease: profit is deferred and recognized over life of lease
what is journal entry for a direct financing lease
lease receivable
deferred gross profit
inventory
How is a finance lease presented on the balance sheet and income statement for lessee
B/S
-ROU Asset
-Lease Liability
I/S
-Ammort Expense
-Interest Expense
How is an operating lease presented on the balance sheet and income statement for lessee
B/S
-ROU Asset
-Lease Liability
I/S
-Lease Expense
How is an operating lease presented on the balance sheet and income statement for lessor
B/S
-continue to recognize assets as PPE
I/S
- revenue on straight line
-depreciation expense
How is a sales-type lease presented on the balance sheet and income statement for lessor
B/S
- Lease receivable
-Derecognize the leased asset
I/S
-interest revenue
-selling profit/loss
What are the disclosures for leases
There are both qualitative and quantitative footnotes that need to be made by lessor and lessee
What are the quantitative disclosures about leases for the lessee
-least cost
-how costs are segregated
-operating and short term lease costs
-weighted average remaining lease term and discount rates
- maturity analysis
What are the qualitative disclosures about leases for the lessee and lessor
- nature of the lease
- how variable pmts are determined
-terms and conditions to extend lease
-info about assumptions or judgements
What are the quantitative disclosures about leases for the lessor
-lease-related income
-income from variable lease payments
- components of the net investments
- maturity analysis
- management approaches for risk with residual value
