Chapter 21: Leases

Question 1

Lease

Answer 1

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

Question 2

Executory Contract

Answer 2

Contract requiring continuing performance by both parties

Question 3

Present Value of lease payments

Answer 3

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

Question 4

Determining annual payment amount

Answer 4

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

Question 5

Accounting for finance-type leases (sales-type)

Lessor: receivable and asset leases

Answer 5

• 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)

Question 6

Sale-type lease lease receivable amount

Answer 6

Present value of rental payment (payment x PVF annuity or annuity due)
+ Present value of guaranteed residual value (residual x PVF dollar)

Question 7

Accounting for a guaranteed residual value

Answer 7

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.

Question 8

Computing lease liability/ right-of-use asset with guaranteed residual value (lessee)

Answer 8

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

Question 9

Lesee Lease amortization schedule with guaranteed residual value

Answer 9

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

Question 10

Guaranteed Residual value payment (Lesee)

Answer 10

Dr Lease Liability

Cr. Cash

Question 11

If actual fair value of asset is less than expected residual value at end of lease with guarantee

Answer 11

Record as loss

Dr lease liability (expected amount)
Dr loss on lease liability (additional amount)
Cr Cash (total paid)

Question 12

Operating lease: lessee: recording lease expense

Answer 12

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)

Question 13

Operating lease: lessee: commencement of lease

Answer 13

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)

Question 14

Unguaranteed residual value treatment: lessor

Answer 14

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

Question 15

Guaranteed Residual Value - Lessor Perspective

Answer 15

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)

Question 16

Operating lease: Lessee: recording lease payments

Answer 16

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

Question 17

Operating Lease amortization schedule

Answer 17

Effective interest table computing interest on liability balance at implicit interest rate

Question 18

Operating lease: lease expense schedule: lessee

Answer 18

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

Question 19

Transfer of ownership test

Answer 19

Does the lease transfer ownership of the underlying asset by the end of the lease term?

Yes= finance lease

Question 20

Purchase Option test

Answer 20

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

Question 21

Lease term test

Answer 21

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

Question 22

Bargain Renewal Option

Answer 22

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

Question 23

Accounting for changes to variable lease payments lined to index/rate

Answer 23

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

Question 24

Residual value

Answer 24

Expected value of leased asset at the end of the lease term

Question 25

Guaranteed Residual value

Answer 25

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

Question 26

Lease payment components considered for Present value calculation

Answer 26

- 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

Question 27

Incremental borrowing rate

Answer 27

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.

Question 28

Implicit interest rate

Answer 28

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

Question 29

Bargain Purchase Option

Answer 29

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

Question 30

Alternative use test

Answer 30

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

Question 31

Advantages of leasing for the lessee

Answer 31

- 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)

Question 32

Categories of lessors

Answer 32

- 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.)

Question 33

Captive leasing companies

Answer 33

Subsidiaries whose primary business is to perform leasing operations for parent company

Question 34

Advantages of leasing for the lessor

Answer 34

- 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)

Question 35

Operating leases: Lessor recognition of revenue

Answer 35

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

Question 36

Operating Leases: Lessor Balance Sheet

Answer 36

Lease assets on balance sheet with accumulated depreciation listed as "leased asset"

Question 37

Sale type lease: Lessor: selling profit on transfer of leased asset

Answer 37

Sales revenue and COGS are recorded at the commencement of the lease Dr. Lease Receivable Dr. COGS Cr. Sales revenue (= lease receivable) Cr. Inventory

Question 38

Sales type lease: Lessor: interest revenue

Answer 38

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

Question 39

Sales-type lease: Lessor balance sheet

Answer 39

``` Current Assets: Lease receivable (interest + reduction) ``` Non current assets: Lease receivable Current = part due within one year/ one operating cycle, whichever is longer

Question 40

Sales-type lease: lessor income statement

Answer 40

Sales: Sales Revenue Less: Cogs (recognized at commencement of lease) Other revenue: Interest revenue

Question 41

End of sale type lease: Lessor side

Answer 41

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)

Question 42

Present value test

Answer 42

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

Question 43

Short term leases

Answer 43

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

Question 44

Executory Costs

Answer 44

Normal expenses associated with owning a leased asset (property insurance, property taxes) Accounting depends on whether it is a gross or net lease

Question 45

Gross vs Net lease

Answer 45

Gross: payments made to lessor are fixed in the contract Net: Lessee makes variable payment to lessor or third party for executory costs

Question 46

Accounting for executory costs

Answer 46

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)

Question 47

Adjustments to right-of-use asset value

Answer 47

``` Chart with lease liability amount ADD lease prepayments SUBTRACT lease incentives received by lessee ADD initial direct costs = Right of use asset value ```

Question 48

Initial direct costs

Answer 48

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

Question 49

Initial direct cost accounting: Lessee

Answer 49

Costs included in right-of-use asset value but NOT in lease liability

Question 50

Initial direct cost accounting: Lessor

Answer 50

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

Question 51

Accounting for bargain purchase option: Lessee

Answer 51

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)

Question 52

Lessee presentation of leases on financial reports

Answer 52

Balance sheet: - Finance and operating leases - Right-of-use asset - Lease liability Income statement: - Finance lease: amortization expense & interest expense - Operating lease: lease expense

Question 53

Lessor financial statement presentation: operating lease

Answer 53

Balance sheet: - no effect Income statement: - Revenue generally recognized on straight line basis - depreciation expense on leased asset

Question 54

Lessor financial statement presentation: sale-type lease

Answer 54

Balance sheet: - lease receivable (separate from other assets) - de-recognize leased asset Income statement - interest revenue - selling profit or loss

Question 55

Disclosures: both lessee and lessor

Answer 55

- 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)

Question 56

Lessee specific disclosures

Answer 56

- 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

Question 57

Lessor-specific disclosures for leases

Answer 57

- 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

Question 58

"Firm" leases

Answer 58

non-cancellable rights and obligations unlikely to avoid performance under contract without a penalty

Question 59

FASB approach to capitalization of leases

Answer 59

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

Question 60

Finance lease on income statement

Answer 60

- 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

Question 61

Operating lease on income statement

Answer 61

- interest expense measured with effective-interest method | - amortization calculated such that lease expense is the same from period to period

Question 62

Accounting for financial leases: lessee recording asset and liability

Answer 62

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

Question 63

Financial leases: recording payments: lessee side

Answer 63

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)

Question 64

Financial leases: amortizing of asset: Lessee side

Answer 64

Use normal company depreciation policy Dr Amortization expense Cr Right-of-use asset

Question 65

Finance leases: Lessee Income statement

Answer 65

Expenses: - interest expense (lease liability) - Amortization expense (right-of-use assets)

Question 66

Finance leases on balance sheet: lessee side

Answer 66

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

Question 67

Finance lease expiration: lessee side

Answer 67

When fully discharged: lease liability and right-of-use asset should have $0 balances if asset is purchased Dr Asset Cr Cash

Question 68

Collectability considerations for lessor

Answer 68

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

Question 69

Operating lease

Answer 69

Lessee obtains right to use underlying asset but not effectively ownership of asset Transfer only right-of-use

Question 70

Finance lease

Answer 70

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

Question 71

Lease classification tests

Answer 71

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

Question 72

Lease - generic definition

Answer 72

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