Chapter 21- Leases

Question 1

What is a Lease? (Common Features)

Answer 1

• A contract
• Conveys use of property
• By the legal owner (Lessor)
• To another party (Lessee)
• For a period of time (Lease Term)
• In exchange for valuable consideration

Question 2

Optional Features of a Lease (1 circumstance qualifies)

Answer 2

• Lessee may extend or reduce the Lease Term
• Lessee may guarantee asset value at return
• Lessee may purchase property

Question 3

Short term lease (1 circumstance applies)

Answer 3

Lease term of 12 months or less AND lease does not include an option to purchase the property or if it does include a purchase option, exercise of the option is not considered likely.
(To qualify as a short term lease it must be probable that the property will be used for 12 months or less and not purchased by the Lessee

Question 4

Long term lease- 2 circumstances qualify

Answer 4

Lease term of more than 12 months with or without a purchase option

Lease term- of 12 months or less and the lease includes a purchase option that is probable of exercise

Question 5

Lease Term

Answer 5

Period of time we are reasonably certain the lease will run

Question 6

Advantages of leasing?

Answer 6

1. 100% financing at fixed rates
2. Protection against obsolescence
3. Flexibility
4. Less costly financing

Question 7

A lease is defined as..?

Answer 7

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 8

How to report leases?

Answer 8

1. Do not capitalize any leased assets
2. Capitalize leases that are similar to installment purchases
3. Capitalize all long-term leases
4. Capitalize firm leases where the penalty for non performance is substantial
   (Do not capitalize short term leases (< 1 year)

Question 9

Income statement for finance lease

Answer 9

For a finance lease, the Lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right to use of asset on a straight line basis. A Lessee therefore reports both on the income statement, so the expense for the lease transaction is generally higher in the earlier years of the lease arrangement under a finance lease arrangement

Question 10

Income statement for operating lease

Answer 10

The Lessee measures interest expense using effective interest method however the Lessee amortizes the right of use asset such that the total lease expense is the same from period to period typically on a straight line basis

Question 11

Classifying a finance lease the 5 tests??

If yes, it is a finance lease also must be non cancelable

Answer 11

If lease transfers ownership or control of the underlying asset to a Lessee, then the lease is classified as a finance lease.

1. Transfer of ownership test
2. Purchase option test
3. Lease term test (Is the lease term for a major part of the remaining economic life of underlying asset? Equal to OR greater than 75% or a bargain renewal option, Home Depot Dell example)
4. 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 substantially exceed all of the underlying asset’s fair value?)(90% test, if the present value of lease payments is Equal to or greater than 90% of the Fair value then its a finance lease)
5. Alternative use test (Is the underlying asset of such specialized nature that it is expected to have no significant use to the lessor at the end of the lease term?)

Question 12

Classifying a operating lease

Answer 12

A Lessee obtains the right to use the underlying asset but not owner ship of the asset itself

Question 13

Types of lease payments

Answer 13

1. Fixed payments (rent payments that are specified in the lease agreement and fixed over the lease term
2. Variable payments that are based on an index or a rate (Any difference if payments due to changes in index or rate is expensed in the period incurred and include variable lease payments in the value of the lease liability at the level of index/rate at commencement date)

Question 14

Guaranteed residual value vs Unguaranteed residual value

Answer 14

A guaranteed residual value means that the Lessee must return the leased asset at the end of the lease term but also must guarantee the asset residual Value will be a certain amount as opposed to not guaranteed. (For classification purposes the Lessee includes the full amount of the residual value guarantee at the end of the lease term in the present value test as opposed to the non guaranteed one

Question 15

Analyzing a termination option?

Answer 15

If certain a company will terminate by end of lease then include in present value

Question 16

Implicit interest rate

Answer 16

The discount rate that at commencement of the lease l, 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 17

Incremental borrowing rate

Answer 17

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 18

True or false: If the lease is in substance a sale, it is classified as a finance lease?

Answer 18

True

Question 19

Commencement date

Answer 19

Date which lessor makes the asset available for use by the Lessee , date the lease begins not usually when the lease is signed

Question 20

Executory Costs

Answer 20

Normal costs associated with the leased property including insurance on leased property and property taxes on leased property
(Don’t include maintenance services on lease payments)

Question 21

Regarding likelihood of an event

Answer 21

> 50% = Probable

100%> Reasonably Certain> Probable

Question 22

Deficiency Payments

Answer 22

Payment Lessee is expected to make to fulfill an obligation related to the guaranteed residual value

Question 23

Variable payments

Answer 23

Payments that vary under the lease contract and are excluded from lease payments

1. Payments based on a future price index
2. Payments based on a future interest rate
3. Payments based on a future Lessee sales
4. Payments based on Lessee asset usage, such as miles an auto is driven
5. Repair services for the leased asset

Question 24

Record right to use asset

Answer 24

Right-to-use-asset. (Debit)
Lease liability (credit)

Question 25

Record first lease payment

Answer 25

Lease liability (debit)
Cash (Credit)

Question 26

Effective Interest setup for a lease

Answer 26

Date, Annual Lease Payment, Interest on liability, Reduction of lease liability, Lease liability

Question 27

Balance sheet (show right to use asset)

Answer 27

Under Non current assets it’s capitalization amount - amortization amount

Question 28

On balance sheet show (lease liability)

Answer 28

Under Current liabilities, it is interest on liability plus Interest expense = annual lease payment

Question 29

On balance sheet show lease liability (not current liabilities)

Answer 29

Under non current liabilities it’s the lease liability from earlier minus interest expense :)

Question 30

What is listed on the income statement?

Answer 30

Interest expense(lease liabilities) and amortization expense (right-of-use-asset)

Question 31

Sales type lease

Answer 31

A lease is classified as a sales-type lease by the lessor when the fair value of the leased property at the start of a lease varies from its carrying amount, and there is a transfer of ownership to the lessee by the end of the lease term

Question 32

Lease Receivable =

Answer 32

Present value of rental payments + Present value of guaranteed and un guaranteed residual values

Question 33

Record Straight line annual lease expense

Answer 33

Divide lease payment total by 3 to get annual lease term payments