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FAR > Leases > Flashcards

Leases Flashcards

1
Q

What is the difference between a capital lease and an operating lease?

A

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

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2
Q

How is a capital lease recorded?

A

Capitalize at cost:

Asset & liability recorded at PV of future lease payments

Discount rate = lesser of implicit rate in the lease or market rate

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3
Q

What footnote disclosures are required for a capital lease?

A

Future minimum rental commitments

By year – for 5 years

All remaining years as a group

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4
Q

What are the characteristics of an operating lease for a lessee?

A

Risk of ownership does NOT pass

No asset or liability is recorded on the financial statements

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5
Q

What are the characteristics of an operating lease for a lessor?

A

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

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6
Q

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

A

Payments begin at the start of the lease period

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

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7
Q

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

A

Payments begin after the end of the first year

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

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8
Q

Besides the noncancelable term, what is included in the lease term?

A

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

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9
Q

What is the purpose of calculating minimum lease payments (MLPs)?

A

To calculate a present value for the lease as a whole

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10
Q

What is a bargain purchase option?

A

An option for the lessee to buy the leased asset at the end of the lease for a reduced price

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11
Q

What are the MLPs if a lease contains a bargain purchase option?

A

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

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12
Q

For leases without bargain purchasing options, what is included in minimum lease payments (MLPs)?

A

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)

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13
Q

How can a leased asset’s residual value be guaranteed?

A

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)

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14
Q

What are not included in minimum lease payments (MLPs)?

A

Executory costs

Contingent rentals (i.e. changes in rental payments based on future events that may or may not occur)

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15
Q

What are executory costs?

A

Expenditures such as insurance, maintenance, taxes, etc. paid on the leased asset

Should be treated as period costs

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16
Q

How are executory costs accounted for?

A

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

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17
Q

What is the incremental borrowing rate?

A

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

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18
Q

What is the lessor’s implicit interest rate?

A

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

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19
Q

What is the purpose of determining the residual value for a leased asset?

A

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

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20
Q

How do you calculate the lessor’s gross investment?

A

Sum of MLP and asset’s unguaranteed residual value (undiscounted)

Thus, the gross investment decreases as lease payments are made

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21
Q

What are the four conditions, any one of which would make a lease into a capital lease for the lessee?

A

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

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22
Q

If a lease is not classified as a capital lease, what should it be classified as?

A

Operating lease

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23
Q

Under what circumstances will the lessor classify a lease as a capital lease?

A

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
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24
Q

What are the two kinds of capital leases for lessors?

A

Sales-type leases

Direct financing leases

All other leases are operating

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25
Q

What are sales-type leases?

A

Sales of assets in installments

Recognizes both manufactuer’s or dealer’s profit/loss and interest income

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26
Q

How should income be recognized on a sale-type lease?

A

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)

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27
Q

How do direct financing leases differ from sales-type leases?

A

DF leases only recognize interest income

This is because the lessor purchases the item only to lease it

28
Q

How is income recognized for direct financing leases?

A

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

29
Q

How should the lessee report rent expenses for operating leases?

A

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

30
Q

For lessees, what should be included in rental expense besides the actual rental payments?

A

The amortization of any lease bonus

31
Q

How should the lessor report rent revenue for operating leases?

A

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

32
Q

What composes rental income for the lessor?

A

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)

33
Q

What amount should lessees record as a capital lease?

A

Whichever is lower:

(a) the FV of the leased property at the beginning of the lease
(b) the PV of minimum lease payments

34
Q

How should lessees record a capital lease?

A

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

35
Q

How should the lessee’s leased asset be amortized in a capital lease?

A

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

36
Q

How long should a lessee’s leased asset be amortized in a capital lease?

A

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

37
Q

How should the lessee’s lease liability be amortized in a capital lease?

A

Effective interest method

38
Q

How should lease payments on a capital lease be recorded?

A

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

39
Q

For a capital lease, does the lessee amortize the leased asset and the lease liability at the same rate?

A

No – despite that they begin at the same value

40
Q

Under a capital lease, should lessees check their leased assets for impairment?

A

Yes, whenever the asset seems impaired

If undiscounted future net cash flows (interest charges excluded) < carrying amount, write down the asset

41
Q

What is the lessee required to disclose for a capital lease?

A

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”

42
Q

How do you calculate the lessor’s net investment for a capital lease?

A

PV of gross investment

43
Q

For a capital lease, what is the lessor’s unearned interest income?

A

Difference between gross and net investment

Recorded as a contra-asset to gross investment

Amortized by the interest method over the lease term

44
Q

For a capital lease, what is the lessor’s sales price in the lease?

A

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

45
Q

For a capital lease, what is the lessor’s cost of sales?

A

(Book value of leased asset) - (PV of unguaranteed residual value)

46
Q

What are initial direct costs for the lessor?

A

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

47
Q

For a capital lease, what is the manufacturer’s or dealer’s profit?

A

Asset FV
- BV
= Profit

FV will be PV of MLPs or cash value, whichever is lower

48
Q

For a capital lease, what is the lessor required to disclose?

A

Future MLP (for each of the next 5 years)

Unguaranteed residual value

Unearned interest income

49
Q

What is the unearned interest income for a direct financing lease?

A

(Gross investment in lease) - (BV of leased property)

50
Q

What is a sale-leaseback transaction?

A

An asset is sold and the buyer then leases the asset back to the seller

51
Q

How does the seller-lessee record a sale-leaseback?

A

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

52
Q

How should the lessee amortize deferred gains/losses on sale-leasebacks?

A

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)

53
Q

When does the lessee not defer and amortize a gain in a sale-leaseback?

A

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

54
Q

What gain is recognized if the lessee has more than a minor portion of the asset, but less than substantially all of it?

A

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

55
Q

How should a lessee recognize any losses on a sale-leaseback?

A

Loss between FV of asset and undepreciated cost should be recognized immediately

The rest is deferred and amortized

56
Q

How does a buyer-lessor account for a sale-leaseback transaction?

A

As if it were bought from and leased to two separate parties

57
Q

How do you calculate the interest expense as part of an annual lease payment?

A

(Unamortized lease obligation) x (interest rate) = interest portion of MLP

If the first lease payment is due immediately, then it will have no interest

58
Q

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?

A

Over the lease term

59
Q

If the seller-lessee in a sale-leaseback records a gain, how is it reported?

A

If capital lease = asset valuation allowance

If operating lease = deferred credit

60
Q

notes for writing cards

A

the following six principles are definitely right – whatever is unclear or contradicts this in the older cards should go

61
Q

1st principle

A
  1. 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”
62
Q

2nd principle

A
  1. lessor’s PV of MLPs (plus unguaranteed residual value) just is the net investment in the lease at any point in time
63
Q

3rd principle

A
  1. undiscounted MLPs (plus unguaranteed residual value) is gross investment
64
Q

4th principle

A
  1. 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
65
Q

5th principle

A
  1. Interest revenue = interest rate x net investment
66
Q

6th principle

A
  1. manufacturer’s/dealer’s profit = FV of asset minus BV of asset

See 1st principle for clarification on FV

FAR (26 decks)

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