Chapter 21: Leases Flashcards
Lease
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
Executory Contract
Contract requiring continuing performance by both parties
Present Value of lease payments
Have to consider if payments are at the end of a period (ordinary annuity) or beginning (annuity due) when calculating present value of periodic rental payments
Determining annual payment amount
Fair value of leased equipment
Less: present value of residual value
= amount to be recovered by lessor via lease payment
divided by PVF for annuity (end of year) or annuity due (beginning of year)
for periods, implicit rate of return
Accounting for finance-type leases (sales-type)
Lessor: receivable and asset leases
- records lease receivable
- eliminates leased asset from books
Lease Receivable amount = present value of rental payments (PV Annuity/due)
+ present value of guaranteed and unguaranteed residual value
(potentially may separate out unguaranteed residual value as net investment)
Sale-type lease lease receivable amount
Present value of rental payment (payment x PVF annuity or annuity due)
+ Present value of guaranteed residual value (residual x PVF dollar)
Accounting for a guaranteed residual value
1 - if it is probable that the expected residual value is equal to or greater than the guaranteed residual value the lessee should not include the residual value in the computation of lease liability
2- If it is probable that the expected residual value is less than the guaranteed residual value, the difference between the expected and guaranteed residual values should be included in the computation of lease liability.
Computing lease liability/ right-of-use asset with guaranteed residual value (lessee)
When expected residual value < guaranteed residual value
Present value of annual rent payments (PVF annuity or AD)
+ Present value of probable residual value payment (difference expected vs guaranteed rs when due (PVF $1 periods after commencement, implicit rate))
= lease liability
Lesee Lease amortization schedule with guaranteed residual value
Expected residual value payment included in schedule as additional payment at end of lease term (still split between interest on liability and reduction of lease liability)
Different liability amount will create different interest on liability amounts and different straight line amortization of right-of-use asset expense
Guaranteed Residual value payment (Lesee)
Dr Lease Liability
Cr. Cash
If actual fair value of asset is less than expected residual value at end of lease with guarantee
Record as loss
Dr lease liability (expected amount)
Dr loss on lease liability (additional amount)
Cr Cash (total paid)
Operating lease: lessee: recording lease expense
Dr Lease Expense (payment amount)
Cr Right-of-use asset
Cr Lease Liability
creates a single lease expense (operating expense) on income statement
Record end of year adjusting entry
use lease amortization schedule and lease expense schedule to determine amounts
final entry is just
Dr lease expense
Cr Right-of-use asset (down to $0)
Operating lease: lessee: commencement of lease
Dr. Right-of-use asset (at PV of payments)
Cr lease liability
to calculate (if implicit rate is known): Payment x PVF-AD (periods, rate)
Unguaranteed residual value treatment: lessor
Revenue recognition: only recognize revenue and COGS for portion of asset where recovery is assured
So sales revenue and cogs are REDUCED by the unguaranteed residual value
gross profit is the same either way but may have to record loss on lease on return of inventory
Guaranteed Residual Value - Lessor Perspective
Computation of amount to be recovered by the lessor through lease payments is the same whether the residual value is guaranteed or not.
For sale type lease guaranteed residual value included in sales revenue (amount will be received in cash or value when the leased asset is returned)
Operating lease: Lessee: recording lease payments
Dr Lease Liability
Cr Cash
1st payment is just the lease payment amount
later payment same amount but noted that split between lease liability (reduction and amortization expense)
Expenses recorded separately from payment
Operating Lease amortization schedule
Effective interest table computing interest on liability balance at implicit interest rate
Operating lease: lease expense schedule: lessee
Splits the straight line lease expense (amount of annual payments) to be recognized at the end of each period into interest on liability (calculated in lease amortization schedule) and amortization of right-of-use asset
shows that carrying value for ROU asset is $0 at end of lease period
Transfer of ownership test
Does the lease transfer ownership of the underlying asset by the end of the lease term?
Yes= finance lease
Purchase Option test
Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonable certain to exercise?
(option to purchase property for price lower than underlying asset’s expected fair value at the date the option becomes exercisable.)
Yes = finance lease
Lease term test
Is the lease term for a major part of the remaining economic life of the underlying asset?
yes = finance lease
Major part of remaining life = 75% or more of economic life of leased asset (guideline, not concrete)
Include in lease term any bargain renewal periods
Bargain Renewal Option
Option for lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option can be exercised.
Difference between renewal rental and expected fair rental must be enough to make exercise of option reasonably certain
Accounting for changes to variable lease payments lined to index/rate
Base lease liability on index/ rate at commencement of lease. Difference in payments should be expensed in period incurred.
If variation amount is not known it is not recorded and simply expensed
Residual value
Expected value of leased asset at the end of the lease term
Guaranteed Residual value
Obliges the lessee to not only return the asset at the end of the lease but also to guarantee that the residual value will be a certain amount
Lease payment components considered for Present value calculation
- fixed payments per agreement
- Variable payments based on an index or a rate (for PV use index/rate at commencement date and do not assume changes in rate)
- amounts guaranteed by a lessee under a residual value test (include full amount of guarantee for PV test, do not include unguaranteed amounts)
- payments related to purchase or termination option the lessee is reasonably certain to exercise
Incremental borrowing rate
Rate of interest the lessee would have to pay on a similar lease or the rate that, at commencement of the lease, the lessee would incur to borrow over a similar term the funds necessary to purchase the asset.
Implicit interest rate
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
Bargain Purchase Option
Lease purchase option that allows the lessee to 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
Price so favorable that exercise appears reasonably certain
Alternative use test
Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
yes = finance lease
Assumption lessee uses all the benefits from the lease
Assets built to suit
Advantages of leasing for the lessee
- 100% financing at fixed rates (generally do not require money down, vs loan interest rates which may float)
- protection against obsolescence (risk of residual value to lessor)
- Flexibility (less restrictive provisions than other debt agreements)
- less costly financing (offers potential tax savings)
Categories of lessors
- Banks
- Captive leasing companies (generally focus on their parent company’s products vs general lease financing)
- independents (often good at developing innovative leasing contracts. may act as captive finance companies for companies without leasing subsidiaries.)
Captive leasing companies
Subsidiaries whose primary business is to perform leasing operations for parent company
Advantages of leasing for the lessor
- profitable interest margins
- stimulates product sales
- potential tax benefits
- high residual value of the return property at the end of the lease term (though can also lead to losses for less valuable assets)
Operating leases: Lessor recognition of revenue
Collection (beginning of period)
Dr Cash
Cr Unearned Lease revenue
Revenue Recognition (end of period)
Dr Unearned lease revenue
Cr lease revenue
+ need to record normal depreciation expense and any other costs of the least arrangement
Operating Leases: Lessor Balance Sheet
Lease assets on balance sheet with accumulated depreciation
listed as “leased asset”
Sale type lease: Lessor: selling profit on transfer of leased asset
Sales revenue and COGS are recorded at the commencement of the lease
Dr. Lease Receivable
Dr. COGS
Cr. Sales revenue (= lease receivable)
Cr. Inventory
Sales type lease: Lessor: interest revenue
Recognized over life of lease using effective-interest method using lease amortization schedule
Dr Cash
Cr lease receivable (reduction + interest)
Dr Lease Receivable
Cr Interest Revenue
Sales-type lease: Lessor balance sheet
Current Assets: Lease receivable (interest + reduction)
Non current assets:
Lease receivable
Current = part due within one year/ one operating cycle, whichever is longer
Sales-type lease: lessor income statement
Sales:
Sales Revenue
Less: Cogs
(recognized at commencement of lease)
Other revenue:
Interest revenue
End of sale type lease: Lessor side
Accrue interest up to end so that lease receivable = guaranteed residual value
Dr Inventory (returned to books)
Cr Lease receivable (take down to $0)
Last interest accrual:
Dr Lease receivable
Cr. Lease revenue (to bring up to residual value)
Present value test
Does the present value of the sum of (1) the lease payments and (2) any lessee residual value guarantee not reflected in the lease payments equal or exceed substantially all of the underlying assets’ fair value?
If yes = finance lease
Present value of lease payments >= 90% Fair Value of asset
Discount rate is either the implicit interest rate (more accurate but can only use if known) or the incremental borrowing rate (easy to determine)
Calculate using full amount of any residual value guarantee
Short term leases
Lease with a term of 12 months or less at commencement date
If includes a renewal option lessee is reasonably certain to exercise it should be included in the lease term (may make not short term)
Lessees may elect to expense short term lease payments as incurred
Executory Costs
Normal expenses associated with owning a leased asset (property insurance, property taxes)
Accounting depends on whether it is a gross or net lease
Gross vs Net lease
Gross: payments made to lessor are fixed in the contract
Net: Lessee makes variable payment to lessor or third party for executory costs
Accounting for executory costs
Gross Lease: costs included in fixed payment to lessor - include costs in computation of lease liability
Net lease: executory costs paid separately = variable payment expensed in period incurred (not included in lease liablity)
Adjustments to right-of-use asset value
Chart with lease liability amount ADD lease prepayments SUBTRACT lease incentives received by lessee ADD initial direct costs = Right of use asset value
Initial direct costs
Incremental costs of a lease that would not have been incurred had the lease not been executed
Does not include:
- costs directly/ indirectly attributable to lease negotiations
May include: legal fees from lease execution and fees incurred after restitution, commissions
Initial direct cost accounting: Lessee
Costs included in right-of-use asset value but NOT in lease liability
Initial direct cost accounting: Lessor
Operating leases: initial direct costs deferred and amortized as expenses over lease term
Sale-type leases: lessor expenses initial direct costs at lease commencement (when records profits from sale) unless there is no profit/ is a loss then expenses deferred over lease term
Internal costs are not include in the initial direct costs
Accounting for bargain purchase option: Lessee
Affects accounting same as guaranteed residual value: additional amount owed at end of lease add present value of option price to present value of lease payments
Amortized over full economic life of underlying asset (vs. guaranteed residual value amortized over lease term)
Lessee presentation of leases on financial reports
Balance sheet:
- Finance and operating leases
- Right-of-use asset
- Lease liability
Income statement:
- Finance lease: amortization expense & interest expense
- Operating lease: lease expense
Lessor financial statement presentation: operating lease
Balance sheet:
- no effect
Income statement:
- Revenue generally recognized on straight line basis
- depreciation expense on leased asset
Lessor financial statement presentation: sale-type lease
Balance sheet:
- lease receivable (separate from other assets)
- de-recognize leased asset
Income statement
- interest revenue
- selling profit or loss
Disclosures: both lessee and lessor
- Nature of leases and general description
- how variable payments determined
- terms and conditions for options to extend/ terminate + residual value guarantees
- significant assumptions + judgements (discount rates)
Lessee specific disclosures
- Total lease cost
- Financing lease cost (separated between amortization and interest)
- operating and short-term lease cost
- Weighted average remaining lease term and weighted-average discount rate (for financing vs operating)
- maturity analysis of lease liability
- on an annual basis
- for each of the next 5 years + undiscounted cash flows of all years after
Lessor-specific disclosures for leases
- lease related income (P&L at least commencement for sales-type and direct financing leases + interest income)
- income from variable lease payments not in lease receivable
- components of net investment in sales-type and direct financing leases
- maturity analysis for operating lease payments
- separate analysis for operating lease receivable - management approaches for risk associated with residual value
“Firm” leases
non-cancellable rights and obligations
unlikely to avoid performance under contract without a penalty
FASB approach to capitalization of leases
Companies capitalize all long-term leases
leases with a term covering less than a year do not have to be capitalized
Right to use property = asset
commencement to make payments = liability
Finance lease on income statement
- Lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method
- amortization of expense on right-to-use asset is generally straight line
both amortization and interest expense on income statement= total expense higher in earlier years of the arrangement
Operating lease on income statement
- interest expense measured with effective-interest method
- amortization calculated such that lease expense is the same from period to period
Accounting for financial leases: lessee recording asset and liability
Lease liability = capitalized amount right-of-use asset = payments @ PV + EXPECTED residual value guarantee payment @ PV
Lease payments x PV factor of annuity (periods, implicit rate or incremental borrowing rate)
Dr Right-of-use Asset
Cr. Lease liability
Financial leases: recording payments: lessee side
Dr. Payment
Dr. Lease liability (decreases laibility)
Cr. Cash
then use amortization schedule to determine amortization of interest
Dr. Interest expense
Cr lease liability (increases liability/ decreases amount liability reduced by payment)
Financial leases: amortizing of asset: Lessee side
Use normal company depreciation policy
Dr Amortization expense
Cr Right-of-use asset
Finance leases: Lessee Income statement
Expenses:
- interest expense (lease liability)
- Amortization expense (right-of-use assets)
Finance leases on balance sheet: lessee side
Noncurrent assets:
- Right of use assets (carrying amount)
Current liability:
- lease liability (reduction of liability + expense due in next year)
Non-current liability
- lease liability (balance)
Can either report separately on balance sheet or disclose right-of-use asset and lease liability in notes
Finance lease expiration: lessee side
When fully discharged: lease liability and right-of-use asset should have $0 balances
if asset is purchased
Dr Asset
Cr Cash
Collectability considerations for lessor
Lessor may determine if collectability of lease payments is probable
if NOT probable:
- no receivable recorded
- lessor does not derecognize leased asset
- receipt of payments is recorded as deposit liability
Operating lease
Lessee obtains right to use underlying asset but not effectively ownership of asset
Transfer only right-of-use
Finance lease
Lease effectively transfers control/ ownership of underlying asset to the lessee
Lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term
Transfer of control or ownership non-cancellable and meets at least one of the five lease classification tests
Lease classification tests
Determines if a lease is a finance or operating lease:
- transfer of ownership test
- purchase option test
- lease term test
- present-value test
- alternative use test
if lease is non-cancellable and meets one of these tests then it is a finance lease
Otherwise it is an operating lease
same tests for lessee and lessor
Lease - generic definition
Contractual agreement between a lessor and a lessee giving the lessee the right to use specific property owned by the lessor, for a specified period of time in return for rental payments over that period
Transfers use without transferring ownership
