Topics in Long-Term Liabilities and Equity Flashcards
What is a lease and define the lessee and lessor?
A lease is a contract that conveys the right to use an asset for a period of time in exchange for consideration. The party who uses the asset and pays consideration is the lessee and vice versa. is the lessor.
Leasing is a way to obtain the benefits of the asset without purchasing it outright. From the perspective of a lessee, it is a form of financing that resembles acquiring an asset with a note payable. From the perspective of a lessor, a lease is a form of investment and can also be an effective selling strategy, because customers generally prefer to pay in installments.
What are three requirements for a lease contract to be a lease contract?
- Identify a specific underlying asset
- Give the customer the right to obtain largely all of the economic benefits from the asset over the contract term
- Give the customer the ability to direct how and for what objective the underlying asset is used
What are three advantages of leasing?
- Less cash is needed upfront because leases require very little down payment.
- Cost effectiveness: since leasing is secured borrowing, the lessor can simply repossess the asset, which leads to a relatively lower interest rate.
- Convenience and lower risks than asset ownership
What is the difference between finance and operating lease?
A finance lease resembles a purchase, hence, the lease contract is equal to the useful life.
When the lease contract is shorter, it resembles a rental contract, hence an operating lease.
What are the five requirements for a finance lease? PS: an asset only has to match one requirement to be addressed as a finance lease, otherwise it is an operating lease!
- The lease transfers ownership of the underlying asset to the lessee.
- The lessee has an option to purchase the underlying asset and is reasonably certain it will do so.
- The lease term is for a major part of the asset’s useful life.
- The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the asset.
- The underlying asset has no alternative use to the lessor.
The financial reporting of a lease depends on whether the party is the lessee or lessor, whether the party reports with IFRS or US GAAP, and the classification of the lease as finance or operating.
For lessees, there are lease accounting exemptions for certain lease contracts: If its term is 12 months or less (IFRS and US GAAP) or it is for a “low-value asset,” up to USD5,000 in sales price (IFRS only), then the lessee can elect to simply expense the lease payments on a straight-line basis. These exemptions are not available to lessors.
Describe the lessee accounting under IFRS. (It is the same for finance and operating lease)
At lease inception, the lessee records a lease payable liability and a right-of-use (ROU) asset on its balance sheet, both equal to the present value of future lease payments. The discount rate used in the present value calculation is either the rate implicit in the lease or an estimated secured borrowing rate.
The lease liability is subsequently reduced by each lease payment using the effective interest method. Each lease payment is composed of interest expense, which is the product of the lease liability and the discount rate, and principal repayment, which is the difference between the interest expense and lease payment.
The ROU asset is subsequently amortized, often on a straight-line basis, over the lease term. So, although the lease liability and ROU asset begin with the same carrying value on the balance sheet, they typically diverge in subsequent periods because the principal repayment that reduces the lease liability and the amortization expense that reduces the ROU asset are calculated differently.
Describe the lessee accounting under US GAAP for finance lease.
Identical to lessee accounting under IFRS
Describe the lessee accounting under US GAAP for operating lease.
At operating lease inception, the lessee records a lease payable liability and a corresponding right-of-use asset on its balance sheet that are subsequently reduced by the principal repayment component of the lease payment and amortization, respectively, in the same manner that an IFRS lessee would.
The key difference between an operating lease and a finance lease is how the amortization of the ROU asset is calculated. For an operating lease, the lessee’s ROU asset amortization expense is the lease payment minus the interest expense. The implication is that the total expense reported on the income statement (interest plus amortization) will equal the lease payment and that the lease liability and the ROU asset will always equal each other because the principal repayment and amortization are calculated in an identical manner.
The lease cash outflows are all OPERATING instead of financing!!
Describe lessor accounting which is the same under IFRS and US GAAP?
At finance lease inception, the lessor recognizes a lease receivable asset equal to the present value of future lease payments and de-recognizes the leased asset, simultaneously recognizing any difference as a gain or loss. The discount rate used in the present value calculation is the rate implicit in the lease.
The lease receivable is subsequently reduced by each lease payment using the effective interest method. Each lease payment is composed of interest income, which is the product of the lease receivable and the discount rate, and principal proceeds, which equals the difference between the interest income and cash receipt.
Why do companies issue employee compensation packages?
Satisfying employees’ needs for liquidity, retaining employees, and motivating employees.
What are common components of employee compensation packages?
Salary, bonuses, health and life insurance premiums, defined contribution and benefit pension plans, and share-based compensation.
A company reports compensation expense on the income statement in the period in which compensation vests. Therefore, when the employee has earned the salary or bonus, an expense is recorded for the fair value of the compensation, and a cash outflow or accrued compensation liability (a current liability) is recognized.
What is deferred compensation?
Deferred compensation vests over time and can provide valuable retirement savings and financial upside to employees and often serve as an effective retention and stakeholder alignment tool for employers.
What is a defined-contribution plan?
A company contributes an agreed-upon amount into the plan, which may be structured as a match to employees’ contributions into the plan (e.g., 50 percent of 5 percent of employees’ contribution up to a certain limit).
What is a defined-benefit pension plan?
company makes promises of future benefits to be paid to the employee during retirement. For example, a company could promise an employee annual pension payments equal to 70 percent of her final salary at retirement until death. Measuring the obligation arising from that promise requires the company to make many assumptions, such as the employee’s expected salary at retirement and the number of years the employee is expected to live beyond retirement. The company estimates the future amounts to be paid and discounts the future estimated amounts to a present value (using a discount rate equal to the yield on a high-quality corporate bond) to determine the pension obligation today. The discount rate and other assumptions used to determine the pension obligation significantly affects the size of the pension obligation.
Most defined-benefit pension plans are funded through assets held in a separate legal entity, typically a pension trust fund. A company makes payments into the pension fund and retirees are paid from the fund. The payments that a company makes into the fund are invested until they are needed to pay the retirees. If the fair value of the plan’s assets is higher than the present value of the estimated pension obligation, the plan has a surplus and the company will report a net pension asset on its balance sheet. Conversely, if the present value of the estimated pension obligation exceeds the fair value of the fund’s assets, the plan has a deficit and the company will report a net pension liability on its balance sheet.
How to account for defined benefit plans under IFRS?
