Leases Flashcards
What are leases?
they transfer substantially all of the benefits and risks inherent in ownership of property from the lessor to the lessee; the lessor accounts for the lease as either an operating lease or a finance lease (which has two types: sales-type lease and direct financing lease)
at the onset of a lease, the lessor must determine whether the lease will be classified as an operating lease or a finance lease; the assessment, based on a defined set of criteria, will focus on whether the lessee will in effect assume control of the underlying asset
the criteria below (OWNES) are applicable to lessors and lessees; if any one of the five criteria is met, the lease will be classified as a sales-type lease by the lessor
ownership of the underlying asset transfers from the lessor to the lessee by the end of the lease term
the lessee has the written option to purchase the underlying asset; the option is one that the lessee is “reasonably certain” to exercise
the net present value of all lease payments and any guaranteed residual value equals or exceeds substantially all of the underlying asset’s fair value (around 90%)
the term of the lease represents the major part of the economic life remaining for the underlying asset (at least 75%)
the asset is specialized such that it will not have an expected, alternative use to the lessor when the lease term ends
for the lessor, if none of the criteria above are met, the classification will depend on whether both of the following criteria are met:
present value of the sum of the lease payments, lessee guaranteed residual value not included in the lease payments, and any third-party guaranteed residual value is equal to or substantially exceeds the underlying asset’s fair value
collection of the lease payments and any amounts necessary to satisfy residual value guarantees is probable
when both of the criteria above are met, the lessor will classify the lease as a direct financing lease; if only one or neither are met, the lessor will classify the lease as an operating lease
when calculating the present value of the minimum lease payments, the lessor will use the rate implicit in the lease
T/F: on the commencement date of the lease, lessors will classify a lease as a sales-type lease, a direct financing lease, or an operating lease
True
in a sales-type lease, the lessee gains control of the underlying asset; the lessor will derecognize the asset and recognize a net investment in the lease, as well as a profit/loss, assuming that the collectability of any residual value guarantee and the lease payments themselves are probable on the date the lease commences; if collectability is not probable, the lease payments received will be treated as deposit liabilities
for any initial direct costs incurred as part of the lease, if there is a profit/loss, expense the direct costs at commencement date; if there is no profit/loss, defer and recognize the direct costs over the lease term; each period, the lessor will recognize interest income equal to the implicit interest rate applied to the beginning lease receivable balance
in a direct financing lease, the lessee does not gain control of the underlying asset; the lessor will derecognize the asset and recognize a net investment in the lease; the net investment in lease includes a lease receivable and a residual asset; any gain will be deferred and amortized over the life of the lease, and any loss will be recognized immediately
for any initial direct costs incurred as part of the lease, they will be deferred and amortized over the lease term; interest income will be recognized using the interest method over the lease term; each period, the lessor will recognize interest income equal to the discount rate applied to the net investment in lease
in an operating lease, the lessor will keep the asset on its balance sheet, which will include depreciating it and recognizing any impairment charges if applicable; lease income will be recognized on a straight-line basis, and initial direct costs will be deferred and amortized over the lease term
What is a sale-leaseback transaction?
it occurs when one party that has control of the asset (the seller) transfers it to another party (the buyer), with a subsequent lease of the same asset where the seller becomes the lessee and the buyer becomes the lessor; having control of an asset means being able to direct its use and obtaining substantially all of its remaining benefits
to qualify as a sale, revenue recognition requirements must be met - in particular, when 1) a contract exists and 2) control has transferred from the seller to the buyer; if the asset transfer does not meet these requirements, this will be treated as a financing transaction
if an asset transfer involves either of the two key situations below, the transfer may or may not be considered a sale, depending on the circumstances
repurchase option - to meet the criteria to be a sale, both of the following must be met: the option’s exercise price already is or will be the same as the underlying asset’s fair value at the time of exercise & alternative assets that are substantially equivalent to the underlying asset are readily available in the marketplace; if both of these criteria are not met, the existence of the repurchase option will result in a “failed sale” and this will be treated as a financing transaction
residual value guarantee - a sale cannot take place if control of the asset has not transferred to the buyer; it is a qualitative judgment, but the more significant the guarantee, the more unlikely it is that control has transferred
Sale-leaseback: sale criteria met
if the criteria are met for a sale, each party must determine whether the transaction is at fair value (transactions between related parties do not require this process); to make this determination, two steps are needed:
step 1 - determine which of the two sets of information below are more readily determinable:
set 1: asset sale price and fair value
set 2: PV of lease payments and PV of market rental payments
step 2 - of the one that is more determinable, identify any difference between the two data points
if a difference exists, this will require an adjustment to either the sale price or the purchase price; any increases in sales or purchase prices will be treated as prepaid rent via an adjustment to the ROU asset in the leaseback, and any decreases in sales or purchase price will be treated as additional financing provided by the buyer-lessor to the seller-lessee
upon the execution of the sale-leaseback, two transactions will take place:
1) the sale, along with recognition of profit/loss, would be recorded; note that in order to record a profit/loss, the leaseback will have to be an operating lease; if the lease were to meet the OWNES criteria it would be treated as a finance lease - essentially the equivalent of a repurchase and therefore a “failed sale”
2) the lease would be recorded, based on the same accounting rules as other leases
Sale-leaseback: sale criteria are not met
both the seller (lessee) and the buyer (lessor) will treat a “failed sale” as a financing transaction, which will involve the seller (lessee) recording a financing liability and the buyer (lessor) recording a financing receivable for amounts received from the other party; in regard to the asset, the seller will continue to recognize the asset and the buyer will not recognize it on its books
