Unit 12 - Leases and contingencies Flashcards
Lease Classification
What is the criteria for a finance lease
A lease is classified as a finance lease by the lessee and as a sales-type lease by the lessor if, at lease commencement, at least one of the following five criteria is met:
(1) The ownership of the leased asset is transferred to the lessee by the end of the lease term,
(2) the lease includes an option to purchase the leased asset that the lessee is reasonably certain to exercise,
(3) the lease term is for the major part (generally considered as 75%) of the remaining economic life of the leased asset,
(4) the present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value (generally considered as 90%) of the leased asset, and
(5) the leased asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.
When no classification criterion is met, the lease is classified as an operating lease by the lessee.
Lease Classification
What % rate do you use to calculate on a lease?
The discount rate for the lease is the rate implicit in the lease.
If the lessee cannot determine the rate implicit in the lease, the lessee uses its incremental borrowing rate.
Because the implicit rate of 10% is known to Beal, it is used as the discount rate of the lease.
Lessee Accounting - Initial Measurement
How do you record a lease liability at the beginning of the lease term?
For a finance or an operating lease, a lessee initially must recognize a lease liability and a right-of-use asset.
At the lease commencement date, a lease liability is measured at the present value of the lease payments to be made over the lease term.
When the lease includes a purchase option that the lessee is reasonably certain to exercise, the lease is a finance lease.
The lease payments therefore consist of rental payments and the exercise price of the purchase option.
eg. The discount rate for the lease is the rate implicit in the lease of 12% because it is known by Robbin. Thus, the lease liability is equal to $66,500 [($10,000 × 6.328) + ($10,000 × .322)].
Lessee Accounting - Initial Measurement
How do you record/recognize a lease asset (right of use)?
For finance and operating leases, a lessee must recognize a lease liability and a right-of-use asset at the lease commencement date.
A right-of-use asset initially is measured at the amount at which the lease liability was recognized (i.e., present value of lease payments) plus initial direct costs incurred by the lessee. These payments include the initial payment at the inception of the lease. Thus, the annual payments constitute an annuity due.
Eg. In the absence of a purchase option, guaranteed residual value, or nonrenewal penalty, the amount recognized as leased asset (right-of-use asset) is $2,675,000 ($500,000 annual payment × 5.35 present value of an annuity due for 7 years).
Lessee Accounting for Finance Leases - Subsequent Measurement
How do you recognize/record amortization expense on the right-of-use asset in the current year?
Under a finance lease when
(1) the ownership of the leased asset is not transferred to the lessee, and
(2) the lease does not include a purchase option that the lessee is reasonably certain to exercise, the right-of-use asset is amortized on a straight-line basis over the SHORTER of its USEFUL LIFE or LEASE TERM.
Initial Direct Costs and Sale and Leaseback Transactions
If the leaseback is classified as an operating lease, the initial transfer of the asset to the buyer-lessor can be accounted for as a sale of an asset if all the criteria for revenue recognition are met.
When the sale and leaseback transaction is not at fair value or based on market terms, off-market adjustments are needed to recognize the sale at fair value.
When the selling price of an asset (or leaseback payment) is greater than fair value (or market value), the difference is essentially additional financing received from the buyer-lessor.
This additional financing should be accounted for separately from the lease liability. A financial liability is recognized by the seller-lessee for the off-market adjustment (e.g., the excess of the selling price of an asset over its fair value).
Contingencies:
How are they accounted?
A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to the impairment of an asset’s value or the incurrence of a liability as of the balance sheet date. Resolution of the uncertainty depends on the occurrence or nonoccurence of one or more future events.
A loss should be debited and either an asset valuation allowance or a liability credited when the loss contingency is both probable and reasonably estimable. Thus, the company should accrue a loss and a liability.
