Chapter 21- Leases Flashcards
What is a Lease? (Common Features)
- 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
Optional Features of a Lease (1 circumstance qualifies)
- Lessee may extend or reduce the Lease Term
- Lessee may guarantee asset value at return
- Lessee may purchase property
Short term lease (1 circumstance applies)
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
Long term lease- 2 circumstances qualify
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
Lease Term
Period of time we are reasonably certain the lease will run
Advantages of leasing?
- 100% financing at fixed rates
- Protection against obsolescence
- Flexibility
- Less costly financing
A lease is defined as..?
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
How to report leases?
- Do not capitalize any leased assets
- Capitalize leases that are similar to installment purchases
- Capitalize all long-term leases
- Capitalize firm leases where the penalty for non performance is substantial
(Do not capitalize short term leases (< 1 year)
Income statement for finance lease
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
Income statement for operating lease
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
Classifying a finance lease the 5 tests??
If yes, it is a finance lease also must be non cancelable
If lease transfers ownership or control of the underlying asset to a Lessee, then the lease is classified as a finance lease.
- Transfer of ownership test
- Purchase option test
- 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)
- 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)
- 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?)
Classifying a operating lease
A Lessee obtains the right to use the underlying asset but not owner ship of the asset itself
Types of lease payments
- Fixed payments (rent payments that are specified in the lease agreement and fixed over the lease term
- 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)
Guaranteed residual value vs Unguaranteed residual value
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
Analyzing a termination option?
If certain a company will terminate by end of lease then include in present value
Implicit interest rate
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.
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
True or false: If the lease is in substance a sale, it is classified as a finance lease?
True
Commencement date
Date which lessor makes the asset available for use by the Lessee , date the lease begins not usually when the lease is signed
Executory Costs
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)
Regarding likelihood of an event
> 50% = Probable
100%> Reasonably Certain> Probable
Deficiency Payments
Payment Lessee is expected to make to fulfill an obligation related to the guaranteed residual value
Variable payments
Payments that vary under the lease contract and are excluded from lease payments
- Payments based on a future price index
- Payments based on a future interest rate
- Payments based on a future Lessee sales
- Payments based on Lessee asset usage, such as miles an auto is driven
- Repair services for the leased asset
Record right to use asset
Right-to-use-asset. (Debit) Lease liability (credit)
Record first lease payment
Lease liability (debit) Cash (Credit)
Effective Interest setup for a lease
Date, Annual Lease Payment, Interest on liability, Reduction of lease liability, Lease liability
Balance sheet (show right to use asset)
Under Non current assets it’s capitalization amount - amortization amount
On balance sheet show (lease liability)
Under Current liabilities, it is interest on liability plus Interest expense = annual lease payment
On balance sheet show lease liability (not current liabilities)
Under non current liabilities it’s the lease liability from earlier minus interest expense :)
What is listed on the income statement?
Interest expense(lease liabilities) and amortization expense (right-of-use-asset)
Sales type lease
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
Lease Receivable =
Present value of rental payments + Present value of guaranteed and un guaranteed residual values
Record Straight line annual lease expense
Divide lease payment total by 3 to get annual lease term payments
