Leases Flashcards
What is the difference between a capital lease and an operating lease?
Capital lease = transfers some ownership, and therefore requires disclosure on balance sheet
Operating lease = only transfers the right to use the property, can simply be reported as an operating expense
How is a capital lease recorded?
Capitalize at cost:
Asset & liability recorded at PV of future lease payments
Discount rate = lesser of implicit rate in the lease or market rate
What footnote disclosures are required for a capital lease?
Future minimum rental commitments
By year – for 5 years
All remaining years as a group
What are the characteristics of an operating lease for a lessee?
Risk of ownership does NOT pass
No asset or liability is recorded on the financial statements
What are the characteristics of an operating lease for a lessor?
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
What are the characteristics of lease payments under an annuity due situation?
Payments begin at the start of the lease period
Think: Rent/Mortgage payments are Due at the first of the month
What are the characteristics of lease payments under an ordinary annuity situation?
Payments begin after the end of the first year
Think: An annuity that pays you at the end of each year
Besides the noncancelable term, what is included in the lease term?
All periods covered by bargain renewal options
The lease term should never extend beyond the date at which a bargain purchase option can be exercised
What is the purpose of calculating minimum lease payments (MLPs)?
To calculate a present value for the lease as a whole
What is a bargain purchase option?
An option for the lessee to buy the leased asset at the end of the lease for a reduced price
What are the MLPs if a lease contains a bargain purchase option?
Only (1) the minimum rental payments over the term up to the date when the option is exercisable and (2) the payment in the option
For leases without bargain purchasing options, what is included in minimum lease payments (MLPs)?
Minimum rental payments over the lease term
Any guarantee of a leased asset’s residual value (i.e. its FV at the end of the lease)
Penalty for failure to renew the lease (unless renewal is assumed to occur)
How can a leased asset’s residual value be guaranteed?
By the lessee
By a third party related to the lessee
By a third party unrelated to both lessee and lessor, if it is financially capable to do so (but this adds to MLPs only for the LESSOR)
What are not included in minimum lease payments (MLPs)?
Executory costs
Contingent rentals (i.e. changes in rental payments based on future events that may or may not occur)
What are executory costs?
Expenditures such as insurance, maintenance, taxes, etc. paid on the leased asset
Should be treated as period costs
How are executory costs accounted for?
If the lessor pays them, and if they are implied in the MLP, then that portion should be estimated (if necessary) and removed
If the lessee pays them, they should be charged to an expense account
What is the incremental borrowing rate?
The interest rate the lessee would pay if he borrowed money to purchase the leased asset
The lessee uses this rate to calculate PV for MLPs, unless the lessor’s implicit interest rate can be determined and the implicit rate < the borrowing rate
What is the lessor’s implicit interest rate?
The rate that will discount the (MLP + unguaranteed residual value) to the asset’s FV at the beginning of the lease
Remember that guaranteed residual value is already included in MLP
What is the purpose of determining the residual value for a leased asset?
For the lessee to purchase it
For the lessee to make up for any gap between the FV and a “stated amount” that the lessee guaranteed to the lessor
How do you calculate the lessor’s gross investment?
Sum of MLP and asset’s unguaranteed residual value (undiscounted)
Thus, the gross investment decreases as lease payments are made
What are the four conditions, any one of which would make a lease into a capital lease for the lessee?
TO - transfers ownership at end of lease
BPO - includes a bargain purchase option
75 - 75% of the asset’s economic life is committed in the lease term
90 - 90% of the asset’s FMV <= PV of future lease payments
If a lease is not classified as a capital lease, what should it be classified as?
Operating lease
Under what circumstances will the lessor classify a lease as a capital lease?
All are necessary:
- The lease is a capital lease for the lessee
- Collectibility of lease payments is predictable
- No uncertainties exist regarding unreimbursable costs yet to be incurred by the lessor
What are the two kinds of capital leases for lessors?
Sales-type leases
Direct financing leases
All other leases are operating
What are sales-type leases?
Sales of assets in installments
Recognizes both manufactuer’s or dealer’s profit/loss and interest income
How should income be recognized on a sale-type lease?
Manufacturer’s or dealer’s profit/loss (difference b/w asset’s cost and FV) recognized at beginning of lease
Interest income recognized over lease term (using interest method)
How do direct financing leases differ from sales-type leases?
DF leases only recognize interest income
This is because the lessor purchases the item only to lease it
How is income recognized for direct financing leases?
Any difference between the lessor’s gross investment and the leased asset’s BV is recorded as unearned interest income, which is then amortized over the lease term
How should the lessee report rent expenses for operating leases?
As they become payable
If the rent payments are not uniform, rent expense should still be recognized on a SL basis, unless a better method fits the way in which the asset’s benefits are used up
Note: the key is connecting the asset’s benefits to the rent expense, not necessarily the rental payment to the period
For lessees, what should be included in rental expense besides the actual rental payments?
The amortization of any lease bonus
How should the lessor report rent revenue for operating leases?
The same way the lessee reports expenses
E.g. if rent payments are not uniform, revenue should still be recognized on a SL basis unless another method better fits the way the asset is used up
What composes rental income for the lessor?
Rental payments (on a SL basis if not uniform)
Amortization of any lease bonus
Depreciation of asset
Amortization of any initial direct costs (straight-line)
Executory costs (expensed as incurred)
What amount should lessees record as a capital lease?
Whichever is lower:
(a) the FV of the leased property at the beginning of the lease
(b) the PV of minimum lease payments
How should lessees record a capital lease?
Record the amount as both an asset, “Leased Asset Under Capital Leases,” and as a liability, “Obligations Under Capital Leases”
Should be divided into current and noncurrent portions and amortized over the lease term
How should the lessee’s leased asset be amortized in a capital lease?
The same way the lessee depreciates such assets
If there is a title transfer or bargain purchase option, amortization should be to the asset’s residual value
How long should a lessee’s leased asset be amortized in a capital lease?
If the lease is a capital lease due to the FIRST two of the four criteria, then it should be amortized over its estimated life
If the SECOND, then amortized over the lease term
How should the lessee’s lease liability be amortized in a capital lease?
Effective interest method
How should lease payments on a capital lease be recorded?
Part interest expense (not rent expense) and part reduction of the lease liability
Over time, equal lease payments will be less interest expense and more liability-reduction
For a capital lease, does the lessee amortize the leased asset and the lease liability at the same rate?
No – despite that they begin at the same value
Under a capital lease, should lessees check their leased assets for impairment?
Yes, whenever the asset seems impaired
If undiscounted future net cash flows (interest charges excluded) < carrying amount, write down the asset
What is the lessee required to disclose for a capital lease?
Gross amount of assets under capital leases
PV of future minimum lease payments for next 5 years and in aggregate
-Format can either be “aggregate” or “aggregate for periods after 5 years”
How do you calculate the lessor’s net investment for a capital lease?
PV of gross investment
For a capital lease, what is the lessor’s unearned interest income?
Difference between gross and net investment
Recorded as a contra-asset to gross investment
Amortized by the interest method over the lease term
For a capital lease, what is the lessor’s sales price in the lease?
PV of the lessor’s MLPs (calculate PV with lessor’s implicit rate)
Should equal the FV of the leased asset minus the PV of unguaranteed residual value
For a capital lease, what is the lessor’s cost of sales?
(Book value of leased asset) - (PV of unguaranteed residual value)
What are initial direct costs for the lessor?
Costs directly associated with negotiating and consummating COMPLETED leasing transactions
E.g., commissions, legal fees, costs of preparing relevant documents, compensating employees for completing the transactions
Excludes executory costs
For a capital lease, what is the manufacturer’s or dealer’s profit?
Asset FV
- BV
= Profit
FV will be PV of MLPs or cash value, whichever is lower
For a capital lease, what is the lessor required to disclose?
Future MLP (for each of the next 5 years)
Unguaranteed residual value
Unearned interest income
What is the unearned interest income for a direct financing lease?
(Gross investment in lease) - (BV of leased property)
What is a sale-leaseback transaction?
An asset is sold and the buyer then leases the asset back to the seller
How does the seller-lessee record a sale-leaseback?
Any gain or loss on the sale is deferred and amortized
Exception: If PV of lease payments is 10% or less of the asset’s FV, the gain is recognized at the point of sale
If PV of lease payments is greater than 10% of FV and the lease is operating, all of the gain is recognized except the amount of the PV of the lease payments
How should the lessee amortize deferred gains/losses on sale-leasebacks?
For capital leases, the same method by which the leased asset is amortized
For operating leases, amortized in proportion to the gross rental expense for the period (usually SL)
When does the lessee not defer and amortize a gain in a sale-leaseback?
When the lessee retains a “minor portion” of the use of the asset – generally, if the PV of rental payments < 10% of the asset’s FV
Any gain is recognized at the point of sale
What gain is recognized if the lessee has more than a minor portion of the asset, but less than substantially all of it?
Operating lease: any gain over the PV of MLPs is recognized at date of sale; the rest is deferred and amortizd
Capital lease: any gain over the recorded amount of the asset is recognized at date of sale; the rest is deferred and amortized
Only applies to gains, not losses
How should a lessee recognize any losses on a sale-leaseback?
Loss between FV of asset and undepreciated cost should be recognized immediately
The rest is deferred and amortized
How does a buyer-lessor account for a sale-leaseback transaction?
As if it were bought from and leased to two separate parties
How do you calculate the interest expense as part of an annual lease payment?
(Unamortized lease obligation) x (interest rate) = interest portion of MLP
If the first lease payment is due immediately, then it will have no interest
If there is no evidence that a lease is a capital lease for the first two of the four listed reasons (i.e. transfer of ownership or a BPO), then how long is the leased asset amortized?
Over the lease term
If the seller-lessee in a sale-leaseback records a gain, how is it reported?
If capital lease = asset valuation allowance
If operating lease = deferred credit
notes for writing cards
the following six principles are definitely right – whatever is unclear or contradicts this in the older cards should go
1st principle
- PV of MLPs at lease-beginning = the FV of the asset, i.e. the “selling price” or “sales price” – but note that this differs from “list price” or “market price”
2nd principle
- lessor’s PV of MLPs (plus unguaranteed residual value) just is the net investment in the lease at any point in time
3rd principle
- undiscounted MLPs (plus unguaranteed residual value) is gross investment
4th principle
- difference between gross and net investment is “unearned interest income” – and thus the unearned interest income at the beginning is the gross investment minus the FV
5th principle
- Interest revenue = interest rate x net investment
6th principle
- manufacturer’s/dealer’s profit = FV of asset minus BV of asset
See 1st principle for clarification on FV
