Chapter 21 Flashcards
What is a lease?
contractual agreement between the lessor and lessee
What right does the lease give to the lessee?
the right to use specific property
What does the lease specify?
the duration of the lease and rental payments
Who assumes the obligations for taxes, insurance, and maintenance?
The lessor or lessee
Who is the lessee?
the temporary user of an asset
Who is the lessor?
the titleholder and true owner of the property
What are the advantages of leasing?
1) Leases may not require any money down, 2) Lease payments are often fixed, 3) Leases reduce the risk of obsolescence to the lessee (don’t want to be stick with older model), 4) Leases may contain less restrictive covenants than other types of lending arrangements, 5) Leases may be a less costly means of financing, 6) Certain leases may not add to existing debt on the balance sheet
What kind of balance sheet item are leases?
off-balance sheet items
According to the FASB, when should a lease be capitalized?
when a lease transfers substantially all of the benefits and risks of ownership
According to the FASB, when can transfer of ownership be assumed?
only if there is a high degree of performance to the transfer, that is, the lease is non-cancelable
According to the FASB, what are operating leases?
leases that do not substantially transfer benefits and risks and can be cancelled
Which standard applies to leases?
SFAS 13
What is the effect on assets and liabilities when a lease is capitalized?
debit asset and credit liability
What is the effect is a lease is classified as operating?
debit rent expense
What are the four criteria for classifying a lease as a capital lease?
1) Leases transferring ownership, 2) Leases with bargain purchase options, 3) Leases with lease terms equal to 75% or more of the economic life (75% rule), 4) Leases where the present value of lease payments is equal to 90% or more of the fair market value (90% rule)
How many criteria must a lease meet in order to be capitalized?
One
What type of accounting bases does the lease standard follow?
Bright-line accounting
In what order does the evidence for capitalization of leases go?
Strongest to weakest, with 1 being the strongest and 4 being the weakest
Which two principles of lease accounting are non-controversial and are similar between IFRS and GAAP?
the first two principles
Why are the first two principles of lease accounting non-controversial?
1) If it says anywhere that there will be a transfer of title, is a transfer of ownership, no matter when the transfer occurs, 2) If option is to purchase for less than FV, then will probably be exercised
How do you determine the value of a bargain purchase option?
Compare purchase prices at end to FV (10% less than FV)
Which two principles of lease accounting are controversial?
the last two principles
Why are the last two principles controversial?
1) no rounding, calculations must be exact, 2) life of the asset can change, 3) what discount rate to use, 4) what really is fair value, 5) where do percentages come from
What does the GAAP method of accounting for leases allow companies to do?
manipulate around standards so don’t have to capitalize leases
How does IFRS differ from GAAP?
IFRS does not specify percentages that must be used for last two principles and uses judgement and principles-based accounting
What is the lessee entry in a capital lease transaction?
records asset and liability
What is the lessee required to do with the with the asset?
depreciate it over the economic life of the asset
What is the lessee required to do with the rental payments?
allocate them between principal and interest
What method is used to allocate rental payments?
the effective interest method
Are depreciation of the asset and discharge of the lease similar accounting procedures?
no, independent accounting procesudures
What are the 3 levels of lessor lease classification?
1) Operating lease, 2) Direct financing lease, 3) Sales-type lease
How does IFRS say lessors must classify leases?
Operating or direct financing
What is the lessee process for recording a lease
1) Debit asset and credit liability, 2) Depreciate asset, 3) Set up to determine interest, 4) Determine what it’s really worth compared to what discharge is
What criteria must be met in order for a lessor to classify a lease as an operating lease?
1) The lease does not meet any group 1 criteria (same as lessee’s) OR 2) Collectibility of payments isn’t reasonably assured OR 3) Lessor’s performance isn’t substantially complete
What is used to determine the collectibility of payments
the revenue recognition principle and the lessor will check the party’s ability to pay
When is a lessor’s performance not complete?
if the lessor is still responsible for maintenance
What criteria must be met in order for a lessor to classify a lease as a direct financing lease?
Lease must meet group 1 criteria (same as lessee’s), and the following group 2 criteria: 1) Collectibility of payments must be reasonably assured, AND 2) Lessor’s performance must be substantially complete, AND 3) Asset’s fair value must be equal to lessor’s book value
Can a lessee and lessor classify leases differently?
Yes
What biases are present amongst lessors and lessees?
Lessor biased toward operating leases while lessee is biased toward capitalized leases
What information is needed by the lessor to record a direct financing lease?
lease investment (lease receivable), consisting of the minimum lease payments and any residual value at the end of the lease term
What determines the residual value?
the nature of the asset
What information is needed by the lessor to record a sales lease?
Lease receivable plus sales (equal to lease receivable) and COGS (equal to asset book value)
What statements do sales and lease receivable appear on?
Sales - Income Statement, Lease Receivable - Balance Sheet
Why are sales leases most beneficial for the lessor?
Because they make a profit on sale and ongoing profits through interest revenue
What is a residual value?
the estimated fair value of an asset at the end of the lease term
What are the two types of residual values?
Guaranteed or Unguaranteed
Does a lessor care is a residual value is guaranteed or not?
do not care after the lease rate is determined
Do lessee’s care if a residual value is guaranteed or not?
Yes, guaranteed residual values affect the minimum lease payment calculations and unguaranteed residual values do not
What is the difference between a guaranteed and unguaranteed residual value?
Guaranteed: what part you are staking, Unguaranteed: kind of nebulous
What are executory costs?
Maintenance and extra costs
What is an annuity due?
When interest payments are made at the beginning of the year
How is residual value treated in regards to depreciation?
residual value is seen as the salvage value but is not subtracted when it is not included within the asset value and only depreciate for term of lease
How does strong vs. weak criteria effect depreciation?
When strong evidence is used, use the entire asset life and strong vs. weak only changes years of depreciation
What indicates if the collection of payments is reasonably uncertain?
If says have liquidity concerns or payment problems
What is the main difference between sales type and direct financing leases?
Sales type leases are presented on the income statement in the form of COGS and sales, while direct financing leases are not
What journal entry occurs if the equipment leased out is taken back and not purchased?
Debit equipment and credit lease receivable
