ACC 319 Chapter 21

Independents (14% Market Share)

- International Lease Finance Corp.

A Look at the Lessor: Banks (55% Market Share)

- Wells Fargo - Chase - Citigroup - PNC

Purchase Option Test Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise?

- Yes - Finance Lease - No - Operating Lease

Transfer of Ownership Test: Does the lease transfer ownership of the underlying asset to the lessee by the end of the lease term?

- Yes - Finance Lease - No - Operating Lease

For a Finance Lease, it must-

- be non-cancelable and - meet at least one of the five tests

Largest Group of Leased Equipment Involves:

-Information technology equipment - Transportation (trucks, aircraft, rail) - Construction - Agriculture

Advantages of Leasing—Lessees

1. 100% financing at fixed rates. 2. Protection against obsolescence. 3. Flexibility. 4. Less costly financing.

Various Views on Capitalization of Leases

1. Do not capitalize any leased assets. 2. Capitalize leases that are similar to installment purchases. 3. Capitalize all long-term leases. 4. Capitalize firm leases where the penalty for nonperformance is substantial.

Advantages of Leasing—Lessor

1. Often provides profitable interest margins. 2. It can stimulate sales of a lessor's product. 3. It often provides tax benefits to various parties in the lease. 4. It can provide a high residual value to the lessor.

Special Lease Accounting Problems

1. Residual values. 2. Other lease adjustments. 3. Bargain purchase options. 4. Short-term leases. 5. Presentation, disclosure, and analysis.

SPECIAL LEASE ACCOUNTING PROBLEMS Other Lease Adjustments: Executory Costs

Executory Costs are normal expenses associated with owning a leased asset, such as property insurance and property taxes.

Lessor—Unguaranteed Residual Value

In this case, there is less certainty that the unguaranteed residual portion of the asset has been "sold." - The lessor recognizes sales revenue and cost of goods sold only for the portion of the asset for which recovery is assured. - Both sales revenue and cost of goods sold are reduced by the present value of the unguaranteed residual value. - The gross profit computed will still be the same amount as when a guaranteed residual value exists.

Lease Receivable Formula:

Present Value of Rental Payments + Present Value of Guaranteed and Unguaranteed Residual Values

Special Lease Accounting Problems: Residual values: Lessee Perspective - Guaranteed Residual Value

The guidelines for accounting for a guaranteed residual value are, if it is probable that the expected residual value is 1. equal to or greater than the guaranteed residual value, the lessee should not include the guaranteed residual value in the computation of the lease liability. 2. less than the guaranteed residual value, the difference between the expected and guaranteed residual values should be included in computation of the lease liability.

Analysis

With the increase in the assets and liabilities, a number of financial metrics used to measure the profitability and solvency of companies will change: - Return on assets will decrease. - Earnings before interest, taxes, and depreciation and amortization (EBIDTA), which likely will require some adjustments as companies amortize right-of-use assets. - Debt to equity ratio will increase, and the interest coverage ratio will decrease.

SPECIAL LEASE ACCOUNTING PROBLEMS Short-Term Leases

- A lease that, at the commencement date, has a lease term of 12 months or less. - Rather than recording a right-of-use asset and lease liability, lessees may elect to expense the lease payments as incurred. - Renewal or termination options that are reasonably certain of exercise by the lessee are included in the lease term.

Lessee—Unguaranteed Residual Value

- A lessee does not include an unguaranteed residual value in the computation of the lease liability, whether it is a finance lease or an operating lease. - At the end of the lease, the lessee simply returns the leased asset to the lessor without any other payment.

SPECIAL LEASE ACCOUNTING PROBLEMS Bargain Purchase Option

- Allows the lessee to purchase the leased property for a future price that is substantially lower than the asset's expected future fair value. - If a bargain purchase option exists, the lessee must increase the present value of the lease payments by the present value of the option price.

Captive Leasing Companies (31% Market Share)

- Caterpillar Financial Services Corp. - Ford Motor Credit (Ford) - IBM Global Financing

SPECIAL LEASE ACCOUNTING PROBLEMS Lease Prepayments and Incentives

- Companies adjust the right-of-use asset for any lease prepayments, lease incentives, and initial direct costs made prior to or at the commencement date. 1. Lease prepayments made by the lessee increase the right-of-use asset. 2. Lease incentive payments made by the lessor to the lessee reduce the right-of-use asset. 3. Initial direct costs incurred by the lessee (discussed in the next section) increase the right-of-use asset.

Finance and Operating Leases (Lessee)

- Companies classify lease arrangements as either finance or operating. In either case, companies capitalize all leased assets and liabilities.

SPECIAL LEASE ACCOUNTING PROBLEMS Executory Costs

- Executory costs included in the fixed payments required by the lessor should be included in lease payments for purposes of measuring the lease liability. - Payments by the lessee made directly to the taxing authority or insurance provider are considered variable payments and are expensed as incurred.

Present Value Test Lease Payments:

- Fixed payments. - Variable payments that are based on an index or a rate. - Guaranteed residual value. - Payments related to purchase or termination options that the lessee is reasonably certain to exercise.

Lessor Accounting for Sales-Type Leases: Accounting Measurement and Presentation

- For a sales-type lease, the lessor accounts for the lease in a manner similar to the sale of an asset. - the lessor generally records a Lease Receivable and eliminates the leased asset. - the lease receivable for Sterling is computed as shown

Lease Classification: Lessee's Perspective

- From the lessee's perspective, a lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset. - If the lease transfers control (or ownership) of the underlying asset to a lessee, then the lease is classified as a finance lease. - The lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term. - All leases that do not meet any of the finance lease tests are classified as operating leases.

Alternative Use Test

- If at the end of the lease term the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease. - The assumption is that the lessee uses all the benefits from the leased asset and therefore the lessee has essentially purchased the asset.

Lease Term Test

- If the lease term is 75 percent or greater of the economic life of the leased asset, the lease meets the lease term test and finance lease treatment is appropriate (75% test). - Lease term is generally considered to be the fixed, non-cancelable term of the lease. - Bargain-renewal option can extend this period. - At the commencement of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain.

Transfer of Ownership Test

- If the lease transfers ownership of the asset to the lessee, it is a finance lease.

SPECIAL LEASE ACCOUNTING PROBLEMS Initial Direct Costs

- Initial Direct Costs are incremental costs of a lease that would not have been incurred had the lease not been executed. - Examples of costs included and excluded from initial direct costs from the lessee and lessor side.

SPECIAL LEASE ACCOUNTING PROBLEMS Initial Direct Costs

- Initial direct costs incurred by the lessee are included in the cost of the right-of-use asset but are not recorded as part of the lease liability. - Lessor accounting for initial direct costs depends on the type of lease: - For operating leases, a lessor defers the initial direct costs and amortizes them as expenses over the term of the lease. - For sales-type leases, the lessor expenses initial direct costs at lease commencement (in the period in which it recognizes the profit on the sale).

Present Value Test Discount Rate:

- Lessee should compute the present value of the lease payments using the implicit interest rate: This rate, at commencement of the lease, which causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset. - In the event that it is impracticable to determine the implicit rate, Delta uses its incremental borrowing rate.

Lessor Accounting for Sales-Type Leases

- The lease classification tests for the lessor are identical to the tests used by the lessee to determine classification of a lease as a financing or operating lease, as shown in Illustration 21-6. - The lessor has, in substance, transferred control of the right-of-use asset and therefore has a sales-type lease if the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term. - On the other hand, if the lease does not transfer control of the asset over the lease term, the lessor will generally use the operating approach in accounting for the lease.

Sales-Type Lease

- The lease meets the criteria for classification as a finance (sales-type) lease because: 1. the present value of the lease payments is equal to the fair value of the asset, and 2. the lease term is equal to the economic life of the asset. That is, Sterling will consume substantially the entire underlying asset over the lease term.

Purchase Option Test

- The lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset's expected fair value at the date the option becomes exercisable (bargain purchase option).

Operating Lease

- The lessee also measures interest expense using the effective-interest method. However, the lessee amortizes the right-of-use asset such that the total lease expense is the same from period to period. - Only a single lease expense (comprised of interest on the liability and amortization of the right-of-use asset) is recognized on the income statement.

Finance Lease

- The lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and - records amortization expense on the right-of-use asset generally on a straight-line basis.

Alternative Use Test Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term?

- Yes - Finance Lease - No - Operating Lease

Lease Term Test Is the lease term for a major part of the remaining economic life of the underlying asset?

- Yes - Finance Lease - No - Operating Lease

Present Value Test Does the present value of the sum of (1) the lease payments and (2) any lessee residual value guarantee not reflected in the lease payments equal or exceed substantially all of the underlying asset's fair value?

- Yes - Finance Lease - No - Operating Lease

The Leasing Environment: Lease

-A lease is a contractual agreement between a lessor and a lessee, that gives the lessee the right to use specific property, owned by the lessor, for a specified period of time.

Presentation

-Summary of how the lessee reports the information related to finance and operating leases in the financial statements: BALANCE SHEET: - Finance Lease: Right of use Asset Lease Liability - Operating Lease: Right of Use Asset Lease Liability INCOME STATEMENT: -Finance Lease: Amortization expense Interest expense -Operating Lease Lease Expense

Conceptual Nature of a Lease

- A lease conveys the use of an asset from one party (the lessor) to another (the lessee) without transferring ownership.

Lessee Accounting for Operating Leases

- If a lease does not meet any of the lease classification tests for a finance lease, a lessee should classify it as an operating lease. For leases classified as operating, the lessee records: - a right-of-use asset and lease liability at commencement of the lease, similar to the finance lease approach. - However, unlike a finance lease, the lessee records the same amount for lease expense each period over the lease term.