Exam 2 Flashcards
Lease
An agreement conveying the right to use the property, plant, or equipment usually for a stated period of time
Lessee
The party paying for the right to use the asset for a specified period of time
Lessor
The party that legally owns the asset and is receiving payment from the lessee for use of that asset for a specified period of time
Why would you lease rather than buy? (Lessee)
- Fixed rate with no down payment
- Only want part of an asset
- Protection against obsolescence
- Flexibility
- Tax benefits
- Off-sheet financing for operating leases
Why would you lease rather than buy? (Lessor)
- Generate proceeds from an asset not in use
- Financing income
Operating leases
- Recognizes lease payments as an expense
- Risks and rewards of ownership NOT transferred
Capital Leases
Leases transfer to the lessee the risks and rewards of ownership
- Recognizes leased item and payment obligation on the balance sheet
- Depreciates the leased item
- Lease payments are allocated between reduction of the outstanding liability and finance charge
- More like the sale of property with periodic payments (financing or economically like a bank loan)
4 Criteria
If lease meets ANY 1 of the criteria, it is capital:
1) Transfer ownership at the end of the lease? (strong)
2) BPO? (strong)
3) Lease term >= 75% of useful life? (weak)
4) Present value of minimum lease payments >= 90% of fair value? (weak)
BRO
Bargain Renewal Option: allows lessee to renew the lease for a period of time at a rent lower than the market rental price
BPO
Bargain Purchase Option: lessee has the option to purchase the asset at a specified time for a price substantially below the asset’s fair market value at that point in time
Residual Value
Estimated fair market value of the leasaed asset at the end of the lease term
GRV
Guaranteed Residual Value: amount lessee is obligated to pay for the asset at the end of the lease term
- amount lessee guarantees the lessor will receive for the asset
- To prevent lessee from abusing the asset and returning it with very low or even 0 residual value
- Unguaranteed part is a risk the lessor takes
Lease term
Fixed, non-cancelable term of the lease
-lease term does not extend beyond date a BPO becomes exercisable, is extended for renewal periods
Minimum Lease Payments Include:
- Rent payments the lessee is obligated to make under terms of lease (excluding any executory costs paid by the lessor)
- Amount of BPO
- Guaranteed residual value
Minimum Lease Payments do NOT include:
- Executory costs (if lessee pays these, expensed in the period incurred)
- Payments contigent on future performance (expensed if conditions are met)
Discount rate
The rate used to find the present value of the future minimum lease payments . Rate for LESSEE is the lesser of:
- Lessee’s incremental borrowing rate (if lessee went to bank, the rate they would get)
- Lessor’s implicit interest rate (if it is known)
Amortization Strong v Weak form
Strong form: -Useful life -Net salvage value Weak form: -Lease term (depreciated to 0 if no GRV) -Expected value to lessee
Inception of lease
asset and liability both are recorded at lower of:
-fair market value of leased asset
-present value of minimum lease payments
Asset and liability starts out the same
Termination of Capital Lease
Strong:
- Transfer leased equipment and accumulated depreciation accounts to “owned” equipment
- Liability will already be at 0 or will be 0 after BPO
Weak:
- Leased equip, accum, and liability are zeroed out
- Cash paid to lessor if FMV is less than GRV
- Gain/loss recognized if actual FMV different from original expected FMV
Capital lease - Lessor
- Either direct financing (lessor’s only income is interest revenue) or sales type (lessor has profit on trasnfer as well as interest revenue)
- Must meet BOTH group 2 criteria
1) Collectibility of lease payments is reasonably assured
2) No important uncertanties about unreimburseable costs
Discount rate for lessor
- Lessors implicit interest rate
- The discount rate could differ from rate used by lessee
BPO effects
- BPO is considered part of the minimum lease payments (last payment)
- Asset depreciated over life of the asset rather than lease term
- Salvage value subtracted at the end to calc depreciation
- changes the term of depreciation
- potetially changes the term of lease and final payment amt
- must reclassify asset at “owned”
Operating v Capital Effects
- The total expense over the life of the lease is the SAME for both methods
- No cash flow implications
- Operating leases = lower assets and liabilities (lower annual expense) early in the life of the lease
Off-balance sheet financing
- 1/3 of all capital expenditures are done through leasing
- For many companies, off balance sheet lease obligations (operating) are many times higher than reported debt
GRV effects on Lessee
- ONLY the GRV is considered part of minimum lease payments (considered last payment made)
- Depreciation schedule based on PV of minimum lease payments - GRV and depreciated over the life of the lease
GRV effects on Lessor
- End of lease, if true residual value is < GRV, the lessee returns the asset and pays cash to make up the difference, Lessee records a loss
- Entire residual value (guaranteed and unguaranteed) is considered part of the lease receivable
- May record a loss for unguaranteed, but if the true value is greater than GRV, does NOT record a gain
Sales type lease - lessor
- FMV > seller’s cost
- Recognize 2 types of revenue; Profit on sale (selling price or FMV - seller’s cost) and interest revenue
Taxes Payable
- Tax term (based on IRC)
- Taxable revenue - deductions * tax rate
- Usually not the same as tax expense
Tax expense
US GAAP revenue - US GAAP expenses = net income
Depends on timing differences of revenue and expenses
Income taxes for businesses
- Proprietorships, Partnerships & S-corporations: Net income of business is divided among the owners, the taxes are paid and income is included on the owners’ individual tax return
- Corporations: separate taxable entity, corporation must file tax return and pay taxes on income, pay taxes on dividends
Taxable income
- Used to calculate taxes payable
- Tax rules set by Congress and enforced by the IRS
- Goals include: raising revenue for gov’t and encouraging social goals
- Often closer to modified cash basis
Accounting income
- Used to calculate tax expense
- Rules set by FASB and enforced by SEC
- Goals include transparent reporting of the financial position of the company
- Accrual basis
Comprehensive Interperiod tax allocation
The full tax consequence of an event is recognized in the period in which event is recognized
Permanent differences
Pretax accounting items that will never be included for taxable income or vice versa (NEVER will have to pay or deduct)
- Interest gained on municipal debt
- Fines/ expenses associated with violation of the law
- Amounts paid for key officer life insurance
Temporary differences
- Items that are recorded in taxable income in a difference year than pretax income (will eventually be recorded in both, so the difference is temporary)
- Bad debt expense, warranty expense, advances from customers, accelerated depreciation
Deferred tax asset
- Taxable income > accounting income
- Assets: book value is less than tax basis
- Liabilities: book value is greater than tax basis
- Carryforwards
Deferred tax liability
- Accounting income > taxable income
- Assets: book value is greater than tax basis
- Liabilities: book value is less than tax basis
Net operating loss
- Occurs for tax purposes when tax deductions exceed tax revenues
- Loss carryback - a corporation may carry a loss back and receive a refund for taxes previously paid
- Loss carryforward - use NOL to offset future taxable income
Tax expense calculation
Taxes payable + change in DTL - change in DTA
Tax rate changes
- Valuation of deferred tax assets and liabilities are based on new tax rates
- Tax expense in year of enacted rate change is affects
- Example: Net asset position in DTA, then increase in tax rates will cause greater tax expense to decrease, so the benefit of the future deduction is greater
