Lessee Accounting Flashcards
What are leases?
they are used by public and private entities as a means of gaining access to asstes and reducing their exposure to the full risks of asset ownership; a lease is defined as a contractual agreement between a lessor who conveys the right to use real or personal property (an asset) and a lessee who agrees to pay consideration for this right over a specific period of time; in order for a contract to be a lease or contain a lease, both of the criteria below must be met
the contract must depend on an identifiable asset in which the lessor does not have a substantive substitution right
the contract must convey the right to control the use of the asset over the lease term to the lessee; the lessee will have the right to obtain substantially all of the economic benefits from using the asset and have the right to direct its use
consideration associated with a contract is calculated as: all components of lease payments + other required payments in contract - incentives owed/provided to lessee not accounted for in lease payments
leases transfer substantially all of the benefits and risks inherent in ownership of property to the lessee; this is an accounting transaction, which is in substance an installment purchase in the form of a leasing arrangement; the lessee accounts for a lease as either an operating or a finance lease, reflective of the acquisition of both an asset and a related liability
When to classify a lease as operating or financing
at the onset of a lease, the lessee 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 finance lease by the lessee; if none of the above criteria are met, or if the lease is considered short-term (less than 12 months), it should be treated as an operating lease by the lessee
ownership transfers to the lessee at the end of the lease term
written purchase option which lessee is reasonably certain to exercise
net present value equals or exceeds substantially all of the fair value of the asset (90% or more of the fair value of the underlying asset would reasonably be considered substantial)
economic life is a major part of the underlying asset within the lease term (75% or more of the remaining economic life of the underlying asset would reasonably be considered major part)
specialized asset such that it will not have an expected, alternative use to the lessor
Lease term
the commencement date for a lease is the date for which the lessor makes the underlying asset available to the lessee for use; the lease term begins on this date and extends to the end of the noncancelable period (the period in which the lessee’s right is enforceable) for which the lessee has the right to use the underlying asset; a lease that can be terminated by both parties with only minor penalties results in a non-enforceable lease
an option to terminate exists when one or the other (but not both) has the right to terminate; the lease term will also need to account for any options to extend or terminate the lease as follows:
periods covered by an option to extend the lease are included if the lessee is reasonably certain to exercise that option
periods covered by an option to terminate the lease are included if the lessee is reasonably certain not to exercise that option
periods covered by an option to either extend or terminate the lease are included if the exercise is controlled by the lessor
Lease payments
in the calculation of the lease payments, the lessee will include all of the following:
required contractual fixed payments, exercise option reasonably assured, purchase price at the end of the lease, only indexed or rate variable payments, residual guarantees likely to be owed, termination penalties reasonably assured
lessee lease payments may or may not include the following (at the lessee’s option):
nonlease components
lessee lease payments will specifically exclude the following:
guarantees of lessor debt by lessee and other variable lease payments
when calculating the present value of the minimum lease payments, the lessor will use the rate implicit in the lease; the lessee uses either the rate implicit in the lease (if known) or if this rate is not readily determinable, the incremental borrowing rate of the lessee (the rate the lessee would be charged for a collateralized loan with equal payments and a similar lease term to the lease)
initial direct costs will be included in the valuation of the ROU asset; these costs are only incurred as a result of the execution of the lease; any costs incurred prior to signing the lease, which can include lease term negotiations, document preparation, credit checks, etc., are not included in the accounting for direct costs
Operating leases
if the lease is an operating lease, the balance sheet will reflect a right-of-use (ROU) asset and lease liability and both will be amortized over the life of the lase using the effective interest method; the ROU asset and lease liability amounts are calculated using the present value of the lease payments, using the appropriate discount rate; on the income statement, lease expense will be recognized each year over the lease term using the straight-line method for expense measurement; instead of reporting interest expense on the income statement, the lessee will report the interest as part of lease expense
Finance leases
if the lease is a finance lease, the lessee will recognize both an ROU asset and a corresponding liability on its balance sheet; the liability will equal the present value of lease payments owed; the ROU asset will include initial direct costs (such as commissions paid, legal and consulting fees, etc.) that were incurred as a result of the lease execution, as well as any lease payments made by the lessee to the lessor at or before lease commencement; any incentives received by the lessee from the lessor will reduce the value of the asset
unlike with operating (capital) leases, the amortization of the ROU asset for a finance lease will be expensed based on how the entity recognizes amortization expense on similar assets
in the early years of a finance lease, expense recognition is front-loaded as interest expense, plus asset amortization expense will create a higher total expense than under an operating (capital) lease; in later years, a finance lease will reflect a lower total expense than an operating lease; the overall expense total across the entire lease will be the same under both lease types
Financial statement presentation of leases
balance sheet - ROU assets and associated lease liabilities may either be recognized as separate line items on the balance sheet (in their respective sections) or included with other assets/liabilities and disclosed separately in the notes to the financial statements (indicating which line items in the balance sheet include them); the portion of lease liabilities due within a year or the operating cycle, whichever is longer, should be reported in the current section and the remainder in the long-term section; finance and operating lease ROU assets and lease liabilities cannot be presented together; the ROU asset will be amortized, and the lease liability will e paid down over the life of the lease
income statement - for operating leases, lease expense will be included in income from continuing operations on the lessee’s income statement; for finance leases, the income statement will include the amortization of the ROU asset and the portion of the lease expense related to interest on the lease liability
statement of cash flows - for operating leases, lease payments (which include all variable lease payments) are classified as cash flow from operations; payments for short-term leases are also included in cash flow form operations; any payments needed to bring the asset to a condition and location in preparation for its intended use are considered investing activities; for finance leases, the principal portion of the lease payment is a cash flow from financing, the interest portion of the lease payment is a cash flow from operations, and any variable lease payments and short-term lease payments not included in the lease liability are classified as cash flows from operations
