Leases

Question 1

How is a Capital Lease recorded?

Answer 1

Capitalize at cost: Asset & Liability Recorded at Present Value of Future Lease Payments

Question 2

What footnote disclosures are required for a Capital Lease?

Answer 2

Future minimum rental commitments by year - for 5 years

And the total in aggregate

Question 3

What are the requirements for a lease to be a Capital Lease?

Answer 3

Same for Lessee and Lessor:
(TT, BPO 75 of life or a 90% FMV- Substance) PLUS:
Collectability of lease payments is predictable
No uncertainties about the lessor reimbursing the lessee for costs incurred

Question 4

What are the characteristics of an Operating Lease for a lessee?

Answer 4

Risk of ownership does NOT pass
No asset or liability is recorded on the financial statements
Leasehold improvements - capitalized and depreciated over the lesser of lease life or leasehold improvement’s life.
If payments fluctuate over the term of the lease - rent expense recognized on a straight line basis

Question 5

What are the characteristics of an Operating Lease for a LESSOR?

Answer 5

Rent revenue recorded
Leased property remains an asset and depreciated by lessor
If payments fluctuate over the term of the lease- rent revenue recognized on a straight line basis

Question 6

What are the characteristics of a Direct Financing Lease?

Answer 6

Interest Revenue (or expense for lessor) decreases with passage of time

Principal amount increases with each payment

Carrying amount of Lease decreases

Question 7

How is a sale-leaseback recorded?

Answer 7

Any profit on the sale is deferred and amortized
Exception: If PV of lease payments is 10% or less of the asset’s FMV- the gain is recognizedIf PV of lease payments is greater than 10% of FMV and the lease is operating- all of the gain is recognized except the amount of the PV of the lease payments

Question 8

What are the characteristics of lease payments under an annuity due situation?

Answer 8

Payments begin at the start of the lease period

Think: Rent/Mortgage payments are Due at the first of the month

Question 9

What are the characteristics of lease payments under an ordinary annuity situation?

Answer 9

Payments begin after the end of the first year

Think: An annuity that pays you at the end of each year

Question 10

What are the characteristics of a Capital Lease for a lessee?

Answer 10

Risk of ownership passes to lessee by:
TT, BPO, 75% of leased property’s life, or PV of MLP is 90% or more of the FMV of the property at inception

“TT ,BPO,75 or a 90”

Question 11

In a capital lease, what are the journal entries to be recorded by Lessee?

Answer 11

1) Record Lease at the PV of Minimum Lease Payments:
Leased Asset XX
Leased Liability XX

2) Record the 1st payment (day 1)
Lease Liability XX
Cash XX

3) Record the 2nd payment (year 2)
Lease Liability XX
Interest Expense XX
Cash XX

4) Depreciation:
Depreciation Expense XX
A/D XX

Question 12

How is the value of the leased asset calculated by a Lessee?

Answer 12

Lower of:
FMV (a new implicit interest rate must be calculated)
PV of Minimum Lease Payments

Question 13

How does a Lessee PV the Lease Payments?

Answer 13

Use “Incremental Borrowing Rate” - Discount rate the lessee would pay in the lending market to purchase the leased asset
UNLESS BOTH:
1) Lessee knows the lessor’s implicit rate AND
2) Implicit Rate is lower than the incremental borrowing rt

Question 14

How does a Lessor PV the Lease Payments

Answer 14

Always uses the implicit rate in the lease

Question 15

How are Capital Leases amortized?

Answer 15

Effect Interest Method

Lease Liability (unamortized) x Implicit or Incremental rate = Interest Expense
- Lease Payment (fixed)
=Amortization of Lease Liability

Same way you amortize Discounts/Premiums in Bonds

Question 16

What is included in calculating the PV of a Lease Payment?

Answer 16

• Annual Payment
• BPO as a Lump Sum
• Guaranteed Residual Value as a Lump Sum

Question 17

How are the executory costs of leases recorded?

Answer 17

Expensed as incurred

Question 18

In a Capital Lease, what are the two criteria that must be met for a Lessor to record a Sales-Type Lease or Direct Financing Lease?

Answer 18

1) Collectabilty of the lease payments is reasonably assured

2) No significant uncertainties regarding reimbursable costs to be incurred by Lessor

Question 19

What is a sales-type lease?

Answer 19

A lease where the seller is a manufacturer or dealer of the asset, and uses the lease as a way of selling the asset on an installment basis.

The FV of the leased property differs from the cost, which creates a dealer’s profit or loss

Includes: Profit/Loss in period of sales AND Interest Revenue to be earned

Question 20

What is a Direct Financing Lease?

Answer 20

A lease where equipment is not acquired by purchasing it but instead by entering into a lease agreement with the leasing company

Differs from a Sales-Type Lease in that only Interest Income arises - no profit or loss

Question 21

What is a Sale-Leaseback?

Answer 21

The property owner sells the property, then immediately leases all or part of it back from the new owner.

Considered 2 separate and distinct economic transactions.

Either an operating lease or a Capital Lease

Question 22

When is a Sale-Leaseback considered an Operating Lease or a Capital Lease?

Answer 22

If PV of Rental Payments:
>90% of FV of property = Capital Lease
>10% and <90% of FV of property = Operating Lease

Question 23

Capital Sales Leaseback:

Answer 23

Gain or Loss is deferred and amortized over the period as a reduction to depreciation expense

Depreciation Expense 50
A/D 50
Deferred Gain 20
Depreciation Expense 20

Question 24

Operating Sales Leaseback

Answer 24

Gain or Loss is deferred and amortized over the lease term as a reduction to rent expense

Rent Expense 50
Cash 50
Deferred Gain 20
Rent Expense 20

Question 25

If there is a change in the provisions of a capital lease that gives rise to a new agreement classified as an operating lease - how should this lease now be classified?

Answer 25

Sale Leaseback Requirements

Question 26

When do you use the lease life vs the lease’s useful life in recording depreciation under a capital lease?

Answer 26

When the criteria of 75/90 is met - lease life
When the criteria of BPO/TT is met - asset’s useful life

If both met - lessor of the 2

Question 27

Under an operating lease, what does the lessee record as a liability at the time the lease is initiated?

What does the lessee record on the income statement on an annual basis?

Answer 27

No liability is recorded

Rent expense is recorded annually throughout the lease life

Question 28

Under a capital lease, what does the lessee record as a liability at the time the lease is initiated?

What does the lessee record on the income statement on an annual basis?

Answer 28

The liability is the present value of the minimum lease payments

Depreciation and interest expense are recorded on an annual basis. Once the lease expires, if the lessee takes over ownership (TT/BPO) the asset continues to be depreciated.