Chapter 15

Entries for Sales-type leases with selling profit

-Lessor-Entry at beginning of lease includes selling profit; other entries not affected. -Lessee-Entries not affected

Assume that a lessee had no significant economic incentive as of the beginning of a 10-year lease for a storefront to exercise an option to terminate the lease after 5 years. However, by the end of the fourth year, the lessee has decided to close the store within the next year, making termination of the lease "reasonably certain." At the end of the fourth year, the lessee would

-Remeasure the lease liability -Record an entry to decrease the lease payable account balance. (Since the triggering event was at the end of the fourth year and it is reasonably certain that the lease will be terminated at the end of the fifth year, the lessee would determine the full term of the lease to be a total of five years with one year remaining. the lessee would calculate the PV of the remaining one lease payments using the market interest rates at the end of year four, the time of the reassessment. In situations when a lease term is lengthened (extension option), the journal entry would increase the right-of-use asset and lease payable account balances. On the other hand, when a lease term is shortened (such as in this option), the journal entry would decrease the Right-of-use asset and lease payable account balances.

If the option is reasonably certain to be exercised, how does the inclusion of a provision that gives the lessee the option to purchase the lease asset during the lease term at a specified exercise price impact that accounting for that lease?

-The lessor must classify the lease as a sales-type lease -The lease term is assumed to end on the date that the option is expected to be exercised -In the PV calculations, lessor adds the PV of the exercise price to the PV of the periodic lease payments to determine the amount recorded as the lease receivable. (If a purchase option is reasonably certain to be exercised, the lessor must classify the lese as a sales-type lease and the lessee must classify it as a finance lease. Both the lessee and lessor consider the exercise price of the option to be an additional cash payment. This means that the PV of the exercise price is added to the PV of the periodic leaae payments to determine the lease liability or receivable.

Impact of Purchase option on Accounting for Lease (Assuming Payment is Reasonably Certain)

1) Lease classified as a finance/sales-type lease 2) Lessee and Lessor both consider the exercise price of the option to be an additional cash payment

Companies choose to lease rather than purchase for a variety of reasons:

1) Leasing reduces the upfront cash needed to use an asset. 2) Lease payments often are lower than installment payments. 3) Leasing offers flexibility and a lower cost when disposing of an asset. 4) Leasing might offer protection against the risk of declining asset values.

The lessor's receipt of payment on an operating lease is

All recorded as lease revenue

Assume that Sans Serif Publishers leased the equipment directly from CompuDec and that CompuDec's cost of the equipment was $300,000. The equipment will be returned to CompuDec and is expected to have a residual value of $60,000. The PV of the estimated residual value of $33,868 is computed by multiplying the estimated residual value of $60,000 by the PV factor for a single payment (when n=6 and i=10%)

As a lessor CompuDec will make an entry at the beginning of the lease that includes a debit to Lease Receivable for $479,079 and a Debit to COGS for $266,132 (computed as the cost of the equipment of $300,000 - the PV of the estimated residual value of $33,868 and a Credit to Sales Revenue for $445,211 (computed as the PV of the periodic lease payments of $479,079 - PV of the estimated residual value of $33,868 and a Credit to Equipment for $300,000 (which is its cost)

Nonlease components: Property taxes

Capitalize in right of use asset ((Specifically identified in lease accounting guidance as part or lease payments)

Nonlease component: Hazard insurance

Capitalize in right of use asset (Specifically identified in lease accounting guidance as part of lease payments)

How we account for sales-type leases with selling profit: Assume all facts are the same except that Sans Serif Publishers leased the equipment directly from CompuDec Corporation rather than through First LeaseCorp, the financing intermediary. Also, assume that Compudec's cost of the equipment was $300,000. Recall that when we applied the fourth classification criterion, we determined that the PV of the lease payments was $479,079 (the selling price.) Since the lease now includes a selling profit, the entry recorded at the beginning of the lease is expanded so that it also includes a

Debit to COGS for $300,000 and Credit to Sales Revenue for $479,079. CompuDec Corporations (lessor) Debit Lease Receivable $479,000 Debit COGS $300,000 Credit Sales Revenue (PV of lease payments) $479,079 Credit to Equipment (Lessor's cost) $300,000

Lessee accounting for embedded costs-Recognize as expense-Maintenance or service contract

Debit to Maintenace expense $2000 Debit to Lease payable $100,000 Credit to Cash $102,000

From an accounting standpoint, legal ownership of a leased asset is ______ to the accounting method used.

From an accounting standpoint, legal ownership of a leased asset is irrelevant to the accounting method used.

Selling profits exists when the fair value of the asset (usually the PV of the lease payments pr "selling price") Exceeds the cost or carrying value of the asset sold.

In addition to interest revenue earned over the lease term the lessor also recognizes a selling profit on the "sale" of the asset.

In a _________ lease, recording lease expense should reflect straight line rental of the asset during the lease term.

In an operating lease, recording lease expense should reflect straight line rental of the asset during the lease term.

In an operating lease, the lessee reports lease _____ and the lessor reports lease ______, both on a straight line basis.

In an operating lease, the lessee reports lease expense and the lessor reports lease revenue, both on a straight line basis.

In an operating lease, the _____ records no asset or liability at the inception of the lease and the ______ records both.

In an operating lease, the lessor records no asset or liability at the inception of the lease and the lessee records both.

On the other hand payments for hazard insurance and property taxes are specifically identified in the lease accounting guidance as part of the lease payments.

In other words, those payments are capitalized, not expensed. As such these costs are included in the lease payment amount used in the PV calculations

A lease is a contractual arrangement by which a lessor (that is, the owner of an asset) provides a lessee (the user of an asset) the right to use the asset for a specified period of time.

In return for this right, the lessee agrees to make periodic cash payments during the term of the lease.

On January 1, Year 1, Savor Corporation leased equipment to Spree Company. The lease term is 9 years. The first payment of $698,000 was made on January 1, 2018. The PV of the lease payments is $4,561,300. The lease is appropriately classified as an operating lease. Assuming the interest rate for this lease is 9%, how much interest revenue will Savor record in Year 1 on this lease?

Interest revenue Savor will record in year 1 on this lease is $0. (when a lease is classified as an operating lease, the lessor will report lease revenue rather than interest revenue (which it would have reported if this had been a sales-type lease). In other words, the lessor does not report any interest revenue for an operating lease.

On January 1, Warren Corporation leases equipment from best Lease Co. Best lease Co. purchased the equipment from Electronic Plus at a cost of $500,000. The lease agreement specifies three annual payments of $100,000 beginning at the inception of the lease. The useful life of the asset is estimated to be five years, but Warren will lease the asset for a total of three years. The PV of the three lease payments is $273,554. At the inception of the lease Best Lease Co. should

No entry to remove the asset from the balance sheet.

Basing our assessment on the economic substance of the transaction, even if the conflicts with its legal form, is referred to as

Substance over form.

The amortization of a right-of-use asset over the lease term is computed by:

Subtracting the amount needed for interest from the straight-line lease payment

However, if the asset reverts to the lessor at the end of the lease and the asset has commercial value at that time the lessor has another source of return.

The PV of that residual value reduces the amount that otherwise needs to be recovered through periodic lease payments. Although a residual value will cause the lease payments to be lower the lessee's accounting is otherwise unaffected by the residual value.

Sometimes the lessee and lessor will agree to modify the terms of a lease before the lease term ends. This creates two possibilities

The first possibility relates to modification that grants the lessee an additional right of use.

Reporting operating lease expense and lease revenue in the income statement for a Lessee

The lessee will have two lease related expenses-interest expense and Amortization expense. The Lessee combines these two accounts into a single Lease Expense account and reports a single amount each year in its income statement. In an operating lease its the total lease expense not the amortization component that's a straight-line amount

The remeasurement must be recorded in a journal entry. Assume the PV of the remaining five payments totaled $400,000 while the current balance of the lease liability before remeasurement is $250,000. The Lease Payable must be increased by $150,000 the difference between the two amounts

The lessee would DEBIT right-of-use asset $150,000 Credit to Lease Payable $150,000

What interest rate is used to compute the present value of the remaining lease payments when a lease term is reassessed and changed?

The lessee's incremental borrowing rate at the time of the reassessment.

Reporting operating lease expense and Lease revenue in the Income Statement for the LESSOR

The lessor has only a single lease revenue account in an operating lease and reports that straight-line amount each year in its Income Statement. The Lessor also reports Depreciation Expense related to the asset leased in its Income Statement.

What represents the COGS in a sales-type lease?

The lessor's cost of the leased asset

The right-of-use asset is amortized straight-line, unless the lessee's ______ of using the asset is different.

The right-of-use asset is amortized straight-line, unless the lessee's pattern of using the asset is different

The rights granted to a lessee under a finance lease ______ the same as those granted to a company that purchased an asset.

The rights granted to a lessee under a finance lease are not the same as those granted to a company that purchased an asset.

The rights granted to a lessee under a finance lease ______ the same as those granted to a company that purchases an asset.

The rights granted to a lessee under a finance lease are not the same as those granted to a company that purchases an asset.

When there is a change in the lease term, the _____ is required to reassess the classification of the lease. A ______ is not permitted to reassess its initial determination of the lease term.

When there is a change in the lease term, the lessee is required to reassess the classification of the lease. A lessor is NOT permitted to reassess its initial determination of the lease term.

Ludwig Corporation leases a machine to Kluge Corporation under a three-year lease agreement determined to be a finance/sales-type lease. At the inception of the lease, Ludwig Corporation should record

a lease receivable

Munchin manufacturing Company leases an asset to Peter Inc in a sales type lease. The present value of the lease payments is $400,000 and the cost of the asset is $330,000. At the beginning of the five year lease term, Munchin should recognize a profit of:

$70,000

In which ways can a lease be accounted for?

-As a rental agreement -As a purchase/sales agreement with debt financing

possible reasons for leasing an asset rather than purchasing an asset?

-Avoiding the risk of decreasing selling prices -No additional fees -Lower periodic payments on the asset -Tax benefits

What are possible reasons for leasing an asset rather than purchasing an asset?

-Avoiding the risk of decreasing selling prices -No additional fees -Tax benefits -Lower periodic payments on the asset

However, there are two exceptions to this rule

-First exception relates to apparent "variable" payments that are in-substance fixed payments. We include these "fixed payments in disguise" as part of the lessee's lease payments

Sometimes, a lease will include a provision in which the lessee guarantees a specific value of the residual asset when it reverts to the lessor at the end of the lease.

-If the fair value of the asset equals or is greater than the guaranteed residual value, a cash payment is not required. -On the other hand, a cash payment would need to be made to the lessor if the guaranteed amount exceeds the estimated residual value of the asset.

Lease payments often are lower than installment payments

-Installment payment to buy an asset are based on the asset's full fair value. -Lease payments often are tied only to the portion of the asset's fair value expected to decline over the lease period. -Because the lease period can be less than the asset's full life, the monthly payments associated with leasing often are lower.

PV calculation included PV of exercise price to determine:

-Lease liability (recorded by the Lessee) -Lease Receivable (recorded by the lessor)

In a short-term lease, periodic rental payments are

-Recorded as rent expense by the lessee -Recorded as rent revenue by the lessor

The lessee's payment in an operating lease is

-Reported as a single lease expense. -allocated between interest expense and amortization for the right-of-use asset.

Leasing offers flexibility and a lower cost when disposing of an asset.

-Returning a leased asset at the end of the lease term requires little effort or cost. -Selling an asset you've previously purchased usually isn't that easy. -Selling an asset also can require significant costs.

The lessee amortizes the right-of-use asset over the asset's useful life, when

-ownership transfers at the end of the lease term. -Exercise of a purchase option is reasonably certain.

Recall that five classification criteria determine whether we have a finance or sale-type lease. A lease transaction is classified as a finance lease (sales-type lease form the lessors perspective) IF ONE OR MORE of the five criteria are met

1) Does the agreement specify that ownership of the asset transfers to the lessee? 2) Does the agreement contain a purchase option reasonably certain to be exercised? 3) Is the lease term for the "Major Part" (75%) of the estimated economic life of the asset? 4) Is the PV of the lease payments equal to or greater than "substantially all" (90%) of the fair value of the asset? 5) Is the asset of such a specialized nature that it is expected to have NOT alternative use to the lessor at the end of the lease term?

Companies choose to lease rather than purchase an asset for a variety of reasons:

1) Leasing reduces the upfront cash needed to use an asset. 2) Lease payments often are lower than installment payments.

First Lease Corp. leases equipment to Taylor. The interest rate implicit in the loan is 8% and is known to both parties. Taylor's incremental borrowing rate is 10%. market rate on similar leases is averaging 9%. What interest rate should Taylor use to compute the present value of lease payments?

8% The lessee uses the interest rate implicit in the lease when known.

A lease structured as an installment purchase is called a ______ lease by the lessee.

A lease structured as an installment purchase is called a finance lease by the lessee

A lease that is more true to the nature of a rental agreement is called a ______ lease.

A lease that is more true to the nature of a rental agreement is called an operating lease

For an operating lease, the lessee will report

A single lease expense

Sans Serif records the amortization expense for Year 1 in a quite different way.

Amortization is a plug figure. Since interest expense is $24,869, amortization must be $75,131 in order for the total of the two to be $100,000. This is recorded with a Debit to Amortization Expense $75,131 Credit to Right-of-use Asset $75,131

Periods covered by renewal options

Are NOT included in the lease term if a bargain purchase option is present.

Determining lease classifications based on judgement alone is likely to lead to inconsistencies in practice.

As a result, leases are classified as a finance lease (sales-type lease from the lessor's perspective) based on classification criteria set by the FASB

How is amortization expense computed on the right-of-use asset by the lessee in an operating lease?

As the payment less the interest expense

how is amortization expense computed on the right-of-use asset by the lessee in an operating lease?

As the payment less the interest expense

Recall that the PV of the residual value was included in the lease receivable when it was first recorded. So, the residual value will be left in the lease receivable account before the final entry is made

As, such to balance it the final entry will include a Debit to Equipment -if actual residual value is less (or more) than the estimated residual value, a loss (or gain) will also be recorded.

Lesse Accounting for embedded costs: Recognize as expense in Income statement

Cost represents a transfer of a good or service to lessee

On January 1, 20X1, Mitchell Company leases equipment from Donelson Corp. for the equipment's entire useful life of six years. Donelson acquired the asset for @239,826 and normally utilizes an 5% interest rate for these types of transactions. the annual lease payment is $45,000. On January 1, 20X1, Donelson should recognize the receipt of the first lease payment by

Crediting lease receivable for $45,000

Glueck Inc. leases an asset with a cost of $200,000 to Perl Company. the PV of the annual lease payments is $320,000 and control of the asset is transferred to Perl Company. At the commencement of the lease, Glueck should debit:

DR Lease receivable for $320,000

At the inception of a finance lease for computer equipment, the lessee should

Debit right-of-use asset Credit Lease Payable

The related entry recorded by Sans Serif at the end of each year will include

Debit to Amortization Expense $79,847 Credit to Right-of-use asset $79,847

First LeaseCorp would record?

Debit to Lease receivable for the present value of the lease payments received of $479,079 and Credit to Equipment for the carrying amount of the equipment of $479,079 to remove the equipment being leased from its balance sheet.

The journal entry by Sans Serif to record the finance lease includes

Debit to Right-of-use Asset; Credit to Lease Payable for the present value of the lease payments of $479,079.

Recall that San Serif Publishers leased printing equipment from First LeaseCorp. The lease specifies Six annual payments of $100,000 beginning January 1, Year 1. The interest rate in these financing arrangements is 10%. When we applied the fourth classification criteria, we determined that the present value of the lease payments was $479,079. The entry by Sans Serif to record the first lease payment includes a

Debit to lease Payable and Credit to Cash for $100,000 Because this first lease payment occurred at the beginning of the lease, no interest expense has yet accrued.

on January 1, 20X1, Tucker Company leases equipment from Franz Inc. over the equipment's entire estimated useful life of five years. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for these types of transactions. The annual lease payment is $100,000. Franz should recognize receipt of the first lease payment on January 1, 20X1 by

Debiting Cash for $100,000 Crediting lease Receivable for $100,000

Assume that a lessor incurs initial direct costs. Operating lease

Deferred and expensed over the lease term (generally on a straight-line basis)

CompuDec, the lessor,

Does NOT record a lease receivable and does NOT remove the equipment from its books.

On January 1, 20X1, Tucker Company leases equipment from Franz Inc. over the equipment's entire estimated useful life of five years. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for those types of transactions. The annual rental payment is $100,000; the first payment is due on January 1, 20X1. at the commencement of the lease, Franz should credit:

Equipment $431,213

If a triggering event occurs, a lessor must reassess the lease term and the initial lease classification. T/F

False (A lessor is NOT permitted to reassess its initial determination of the lease term or discount rate)

The incremental borrowing rate is the rate of return that the lessor desires to earn and is used to calculate the lease payments T/F

False (The implicit rate is the desired rate of return of the lessor)

Which type of lease follows the same accounting method as that of an installment purchase?

Finance leaase

Corr Inc. leases equipment from LM leasing Corp. The lease requires rental payments of $20,000 per year for 5 years. The title of the property transfers at the end of the lease term. The equipment has a useful life of 10 years. How should the lease by classified by Corr?

Finance lease

Lessee has, in substance, purchased the lease asset

Finance lease

What type of lease involves a "front loading" of lease expense and revenue due to higher interest in the earlier stages of the lease?

Finance/sales-type

If a leased asset is specialized and has no alternative use to the lessor, then the lessee accounts for it as a______ lease

If a leased asste is specialized nad has not alternative use to the lessor, then the lessee accounts for it as a finance lease.

If the lease payments have a total value that represents "substantially all" of the asset's fair value, it is logical to identify the contract as _______

If the lease payments have a total value that represents "substantially all" of the asset's fair value, it is logical to identify the contract as equivalent to a sale.

What is included in the lease payments used in present value calculations

In-substance fixed lease payments

When the second lease payment is made a year later, interest of 10% on the outstanding balance has accrued and is recorded by the LESSEE as

Interest expense. The remaining portion of the $100,000 cash payment reduces the outstanding balance

On the other hand the obligation to make payments over the lease period is reported as a

Lease Liability in the balance sheet.

Lease payments are often ______ than installment payments.

Lease payments are often lower than installment payments

Glueck Inc. leases an asset with a cost of $200,000 to Perl Company. the present value of the annual lease payments is $320,000 and control of the asset is transferred to Perl Company. At the commencement of the lease, Glueck should debit

Lease receivable for $320,000

The short-cut method may be applied only if the maximum possible lease term is

Less than or equal to 12 months

Who is allowed to reassess initial calculation of the lease term or discount rate?

Lessee only

When the lessor's implicit rate is unknown, which rate should be used to calculate the present value of the lease payments for the lessee?

Lessee's incremental borrowing rate.

The lessee records an asset and liability for operating leases under

New GAAP only.

How is lease expense recorded by the lessee in an operating lease?

On a straight-line basis

it's not unusual to simplify accounting for situations in which doing so has no material effect on the financial statements.

One such situation that permits a simpler application is a short-term lease.

The two basic lease classifications by a lessee are

Operating and Finance

The two basic lease classifications by a lessor are

Operating and sales-type

Lessee: Amount recorded as Right-of-use asset and lease liability =

PV of periodic lease payments + PV of additional cash payment expected

Selling profit exists in a sales-type lease when the

Present value of the lease payments is greater than the cost of the asset.

Purchase option=

Provision that gives lessee the option to purchase the lease asset

Nonlease Componnets: Maintenance

Record as Expense (This charge represents a transfer of a good or service to the lessee)

Nonlease component: Service contract

Record as Expense (This charge represents a transfer of a good or service to the lessee)

In a typical finance lease, the first lease payment at the beginning of the lease consists of

Reduction in principle only

Lease accounting guidance suggests that a "major part" of the leased asset's life is 75% of more of the

Remaining economic life

The lessee reports the right to use the asset for a period of time as a

Right-to-use asset in the balance sheet.

Leasing offers tax savings over outright purchases.

SOMETIMES leasing offers tax savings over outright purchases. For instance, a company with little to no taxable income (maybe a business just started, or one experiencing an economic downturn) will get little benefit from deducting depreciation on its tax return. Normally, depreciation reduces taxable income and thus reduces taxes, but if there's little to no taxable income to reduces, there's little or no tax savings.

Lessor transfers control of lease asset to lessee, with or without a selling profit on the sale of the asset

Sales-type lease

in which type of lease does the lessor record a lease receivable at the inception of the lease?

Sales-type lease

The accounting for finance leases is similar to the purchase of an asset using an _______ note.

The accounting for finance leases is similar to the purchase of an asset using an installment note.

The desired rate of return for the lessor when determining the lease payments is referred to as the ______ interest rate.

The desired rate of return for the lessor when determining the lease payments is referred to as the implicit interest rate.

The accounting question is whether to include these costs as separate components of the lease contract (to be expensed by the lessee) or instead, as amounts to be capitalized as part of the right of use asset.

The determining factor is whether the charge represents a transfer of a good or service to the lessee. If it does represent a transfer of a good or service to the lessee it qualifies as a "nonlease component" of the payment which is separated from the lease payments and expensed as incurred.

On the other hand when the fundamental rights and responsibilities of ownership are retained by the lessor and the lessee merely is using the asset temporarily

The lease is classified as an operating lease by both the lessee and the lessor.

Leasing reduces the upfront cash needed to use an asset.

The purchase of an asset can include several additional fees. Many leases, though, begin with the first lease payment including nothing more than the agreed-upon monthly amount.

The rate of interest incurred by the lessee if funds were borrowed to purchase the leased asset is known as the _______ rate.

The rate incurred by the lessee if funds were borrowed to purchase the leased asset is known as the incremental borrrowing rate

The rate of interest incurred by the lessee if funds were borrowed to purchase the lease asset is known as the _____ rate.

The rate of interest incurred by the lessee if funds were borrowed to purchase the lease asset is known as the incremental borrowing rate.

The incremental borrowing rate is

The rate the lessee would pay a bank to borrow funds.

When the rights and responsibilities of ownership are retained by the lessor, the lese is classified as a _______ lease.

When the rights and responsibilities of ownership are retained by the lessor, the lease is classified as an OPERATING lease.

The periodic lease payment in an operating lease reduces the outstanding lease balance so that at the end of the lease term the outstanding balance is equal to the

Zero

If a lease doesn't meet ANY of the five criteria or a finance or sales-type lease, then it is classified as

an operating lease.

The lessee amortizes its lease payable

and records it as interest expense

The primary motivation for the new accounting guidance on leases was to

deter the use of off-balance-sheet financing

Agatha Corp. leases store space from Christie Company. Agatha agrees to pay $10,000 per month. In addition, if Agatha exceeds specified sales targets, it will pay additional monthly rent based on a percentage of those excess sales. The additional rent payments

have no effect on the lessee's lease liability and the lessor's lease receivable.

A lease is considered a "short-term lease"

if it has a lease term (including any options to renew or extend) of 12 months or less and -does not contain a purchase option that the lessee is reasonably certain to exercise, which would extend the term beyond 12 months.

At the beginning of the lease the entry by First LeaseCorp

includes a debit to Lease Receivable $479,079 and a Credit to Equipment for the same amount to remove the equipment being leased from its balance sheet.

After the first lease payment, each lease payment in a finance lease consists of an amount representing

interest and a reduction in the principle

The lessor amortizes its lease receivable and records

interest revenue

At the beginning of the lease: If a cash payment under a lessee-guaranteed residual value is predicted that amount is viewed as one more payment

is added to the PV of the periodic lease payments that the lessee records as both a right-of-use asset and a lease liability.

Amortization of the right-of-use asset for an operating lease

is calculated as the lease payment minus interest expense

An operating lease

is similar to a typical rental agreement

What would justify reassessment of a lease term?

leasehold improvements

In which type of lease does the lessee report a single straight-line lease expense amount in its income statement?

operating

In which type of lease does the lessor report a single lease revenue account with a straight line amount?

operating

Fundamental rights and responsibilities of ownership are retained by the lessor and the lessee merely is using the asset temporarily

operating lease

Under the shortcut method, the lessee recognizes

rent expense over the lease term.

Here the modified lease term of two additional years (six years total) is now for a "major part" of the asset's six-year economic life

so our classification changes from operating lease to finance or sale-type lease.

If and when lease payments do change in the future (because the index or rate changes) we simply report the additional amount as a separate lease payment

that produces expense for the lessee and revenue for the lessor.

To record the lease Receivable at the beginning of a sale-type lease

the Lessor combines a) the PV of the lease payments b) the PV of the expected residual value and c) the PV of the cash payment expected at the end of the lease

When the last lease payment is made

the balance in the lease payable account on the lessee's books and the related balance in the Lease Receivable account on the lessor's books will be reduced to zero.

Leasing might offer tax advantages

-Leasing might offer tax savings over outright purchases. Normally depreciation reduces taxable income and thus reduces taxes, but if there is little or no taxable income to reduce, there's little or tax savings. -The company can benefit indirectly by leasing assets rather than buying. By allowing the lessor to retain ownership and thus benefit from depreciation deductions, the lessee often can negotiate lower lease payments.

What occurs in a lease?

-Lessee pays the lessor periodic cash payments. -Lessee has the right to use an asset for a specified period of time. -Contractual agreement.

If a leased asset is of a very specialized nature and has no alternative use to the lessor at the end of the lease term than

-Only the lessee receives the risks and rewards of ownership -it is accounted for as a finance lease

If a leased asset is of a very specialized nature and has no alternative use to the lessor at the end of the lease term than

-Only the lessee receives the risks and rewards of ownership. -It is accounted for as a finance lease.

The lessee amortizes the right-of-use asset over the asset's useful life, when

-Ownership transfers at the end of the lease term -Exercise of a purchase option is reasonably certain.

When a lessee makes an entry at the beginning of a lease, what is included in the amount that will be recorded as both a right-of-use asset and a lease liability?

-PV of a cash payment expected to be made at the end of the lease term because of a guaranteed residual value -PV of periodic lease payments

The lease term includes

-The contractual term of the lease. -Any periods covered by options to extend with significant incentive.

Leasing reduces the upfront cash needed to use an asset

-The purchase of an asset can include several additional fees. -Many leases begin with the first lease payment including nothing more than the agreed-upon monthly amount. -Some companies might not have enough cash to pay the full purchase cost for an asset. But they likely have enough cash to begin monthly payments. -Companies that have high credit risk may not be able to obtain financing to purchase an asset. Leasing might be these companies' only option to acquire an asset.

Leasing might offer protection against the risk of declining asset values.

-When a company buys an asset, the price it might eventually sell the asset for at the end of its productive life. -When a company leases an asset, it avoids the risk of declining values but also misses out on any increase in fair value.

On January 1, Leveler Corporation leased equipment to Messy Company. the PV of the lease payments is $200,000 and Leveler's cost of the equipment was $125,000. The lease is properly classified as a sales-type lease. In comparison to the entries that would have been made if this lease did not include a selling profit, how are the entries affected because this lease includes a selling profit?

-the entries made by Messy are NOT affected -The entry by Leveler to record the receipt of the first lease payment also will include the sales revenue and COGS. Lessor- DEBIT Lease Receivable $200,000 DEBIT to COGS $300,000 Credit to Sales Revenue $200,000 Credit Equipment $300,000.

Companies choose to lease rather than purchase assets for a variety of reasons:

1) Leasing reduces the upfront cash needed to use an asset.

Companies choose to lease rather than purchase for a variety of reasons:

1) Leasing reduces the upfront cash needed to use an asset. 2) Lease payments often are lower than installment payments. 3) Leasing offers flexibility and a lower cost when disposing of the asset.

Companies choose to lease rather than purchase an asset for a variety of reasons:

1) Leasing reduces the upfront cash needed to use an asset. 2) Lease payments often are lower than installment payments. 3) Leasing offers flexibility and lower costs when disposing of the asset. 4) Leasing might offer protection against the risk of declining asset values. 5) Leasing might offer tax advantages

A lease is accounted for in one of two ways. The classification depends on the nature of the lease agreement.

A lease is viewed as either a finance or sales-type lease (a purchase or sale accompanied by debt financing) OR as and Operating Lease (a rental)

Lessee accounting for embedded costs: Capitalize in right of use asset reported in balance sheet

Cost does NOT represent a transfer of a good or service to lessee.

Glueck Inc. leases an asset with a cost of $200,000 to Perl Company. The PV of the annual lease payments id $320,000 and control of the asset is transferred to Perl Company. At the commencement of the lease, Glueck should Credit:

Credit Equipment $200,000 Credit Sales revenue $320,000

As lessor, First LeaseCorp records the flip side of the transaction. The $37,908 that is interest expense for the lessee, is Interest revenue to the lessor which is recorded as a credit balance in the books.

Debit to Cash $100,000 Credit to Lease Revue $37,908 Credit to Lease Receivable $62,092 (difference)

The entry by First LeaseCorp includes

Debit to Cash $100,000; Credit to Lease Receivable $100,000. Because the first lease payment occurred at the beginning of the lease, no interest revenue has accrued.

Assume that a lessor applies the five criteria to a lease involving equipment and determines that a lease should be classified as a sales-type lease. The entry the lessor will record at the beginning of the lease will include:

Debit to Lease receivable for the present value of the lease payments.

On January 1, 20X1, Tucker Company leases equipment from Franz Inc. over three years of the equipment's five year estimated useful life. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for these types of transactions. The present value of the lease payments is $357,710. The annual lease payment is $100,000; the first payment is due on January 1, 20X1. Franz should recognize the first lease payment by

Debiting cash $100,000 Crediting deferred lease revenue

On January 1, 20X1, Tucker Company leases equipment from Franz Inc. over the equipment's entire estimated useful life of the five years. Franz acquired the asset for $431,213 and normally utilizes an 8% interest rate for these types of transactions. the annual lease payment is $100,000. Tucker should recognize the first lease payment on January 1, 20X1 by

Debiting lease payable $100,000 Crediting Cash $100,000

Recall that Sans Serif Publishers leased printing equipment from First LeaseCorp for $479,079. Assume that at the end of the six-year lease term, the equipment is expected to have a residual value of $60,000. The lease is accounted for as a sales-type lease.

First LeaseCorp (lessor) includes the $60,000 residual value in its amortization schedule along with the lease payments.

Leasing offers flexibility when disposing of an asset

First, returning a leased asset at the end of the lease term requires little to no effort or cost. On the other hand, selling an asset that you've previously purchased usually isn't that easy.

Accounting for leases attempts to see through the legal form of the agreements to determine their economic substance. Professional judgment is needed to differentiate between leases that in essence are installment purchase/sales and those that are not.

From an accounting perspective, legal ownership is irrelevant in the decision.

The lessee normally should amortize a lease asset over the term of the lease,

However, if a) ownership transfers OR b) exercise of a purchase option is reasonably certain, the asset should be amortized instead over its useful life.

If a leased asset is specialized and has no alternative use to the lessor, then the lessee accounts for it as a _______ lease

If a leased asset is specialized and has no alternative use to the lessor, then the lessee accounts for it as a finance lease

Lease specifies annual lease payments of $75,000 per year plus the Consumer Price Index (CPI) as of the beginning of the year. The CPI at the beginning of the lease was 3% higher than the previous year.

Increase the initial annual leas payment by 3% in the PV calculation performed at the beginning of lease. (Any increase in payments later (becasue the index or rate changes), will be reported as a seperate lease payment that produces expense for the lessee and revenue for the lessor.

The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. With regards to the periodic lease payments as the expected residual value increases, the size of the lease payments decreases. Why?

Lessors need to recover the purchase price of an asset through the leasing contract along with interest revenue sufficient to achieve its business objectives. Thus, the lessor will determine the amount of the periodic lease payments as the amount needed to generate its return. In other words, the PV of the lease payments will equal the value of the asset that needs to be recovered.

Lessor

Owner of property

When recording a finance lease, the amount initially recognized for the right-of-use asset is the

PV of the lease payments

Assume that the five classification criteria are applied to a lease involving equipment and, because none of the criteria is met, it is determined that a lease should be classified as an operating lease. At the beginning of the lease, the lessee:

Records an entry that includes a debit to Right-of-use Asset for the PV of the lease payments. (The entry by the lessee to record an operating lease includes a debit to Right-of-use asset and a credit to Lease payble for the PV of the lease payments. The lessor does NOT record a lease receivable and does NOT remove the equipment from its books.

Later payments, though, occur after time has passed and, therefore, interest has accrued.

So the entries for these subsequent lease payments will include an interest of 10% on the outstanding balance. The portion of the payments that exceed the interest reduces the outstanding balance.

Recall that one of the classification criteria is a comparison of the fair value of an asset with the PV of the payments coming from the lessee

So, if a residual value reduces the payments but is not guaranteed the amount we compare with the fair value in the applying of criterion 4 will be different

Which method should normally be used to amortize the right-of-use asset?

Strait-line

Off-balance-sheet financing refers to the practice of

Structuring transactions to keep assets and liabilities off the balance sheet by leasing rather than buying them.

Suppose that a lease term is specified as four years, but it can be renewed at the option of the lessee, for two additional years. OR maybe either party can terminate the lease after say, three years. What is the lease term in this situation?

The lease term is a contractual lease term, adjusted (+/-) for any periods covered by options to extend (terminate) the lease, for which there is significant economic incentive to exercise the options.

What is true regarding accounting for an operating lease?

The lessee records both an asset and a liability even when the risks and rewards of ownership do not transfer

In an operating lease, we amortize the right-of-use asset quite differently from the way we amortize it in a finance lease.

The lessee records interest the normal way (as it would under a finance lease) and then "plugs" the right-of-use asset amortization at whatever amount is needed for interest plus amortization at whatever amount is needed for interest + amortization to equal the straight-line lease payment.

In an operating lease, who reports the leased asset on their balance sheet?

The lessor

Lessee accounting for embedded costs: Capitalize in right of use asset-Hazard insurance -Property taxes

These costs are included in lease payment amount used in PV calculations

Frequently for convenience a lease contract will specify that the lessor is to pay additional costs often associated with owning and operating an asset.

Those additional costs might include service contracts, maintenance, hazard insurance, and property taxes.

As noted above, the lease payment, made on December 31, Year 1 of $100,000 minus the Year 1 interest expense of $24,869 equals the amortization of $75,131.

Total lease expense (amortization + interest) for Sans Serif will equal $100,000

A lessee and a lessor will use the same amortization schedules for recording interest. T/F

True

When a bargain purchase option exists, a renewal option is considered irrelevant because it is assumed that the purchase option will be exercised. T/F

True

Sometimes lease payments change during the term of the lease. Lease specifies annual lease payments of $25,000 per year plus 3% of sale over $100,000. Sales exceed $100,000 this year.

Use stated amount of the lease payment in the PV calculation performed at the beginning of the lease. (Use the stated lease payment of $25,000 per year in the PV calculation performed as of the beginning of the lease)

Lessee

User of property

When there is a change in lease term,

a lease initially classified as an operating lease may need to be reclassified as a finance lease.

A reasonable conclusion is that the "major part" of the leased asset's life is included in the lease, if ______ of the remaining economic life of the asset is covered by the lease term.

a reasonable conclusion is that the "major part" of the leased asset's life is included in the lease, if 75% or more of the remaining economic life of the asset is covered by the lease term.

Depending on the nature of the leasing arrangement, a lease is accounted for

as a rental or purchase/sale

In a sort-term lease the LESSEE can elect not to record a right-of-use asset and lease payable at the beginning of the lease term,

but instead to simply record lease payments as expense as they occur.

In a short-term lease the LESSOR can elect NOT to remove the leased asset from its books and record the lease receivable at the beginning of the lese term,

but instead to simply record lease payments as revenue as they are received

Amortization of the right-of-use asset for an operating lease

is calculated as the lease payment minus the interest payment

If PV of the lease payments including any lessee-guaranteed residual value constitutes "substantially all" of the fair value of the asset

it's a finance lease from the lessee's perspective and a sales-type lease from the lessor's perspective

The short-cut method of accounting for leases

may be used if the lease has a lease term (including any options to renew or extend) of 12 months or less.

The lease term is typically considered to be

the contractual term of the lease plus any periods covered by options to extend if extension is reasonably certain to occur.

The selling profit is

the difference between sales revenue and COGS

When the lessee has, in substance, purchased the leased asset and the lessor transfers control of the lease asset to the lessee, with or without a selling profit on the sale of the asset

the lease is classified as a finance lease by the lessee and a sale-type lease by the lessor.

When a lease is classified as an operating lease

the lessee will report a single expense composed of 1) Interest expense on the lease liability and 2) The amortization of the right-of-use asset. The Lessor will report: Lease Revenue over the lease term and must Depreciate the asset being leased.

However, the lessor's accounting is affected. Assume that we have a sales-type lease with a residual value and the asset leased returns to the lessor at the end of the lease. To record the Lease Receivable at the beginning of the lease

the lessor combines a) the PV of the lease payments and b) the PV of the residual value. At the end of the last year of the lease the equipment is returned to the lessor.

The lease records the right-of-use asset as

the present value of lease payments

What represents the selling price in a sales-type lease?

the present value of the lease payments

Under an operating lease:

-The Lessee reports a single amount of lease expense, which is equal to interest expense plus Amortization Expense, In its Income Statement. -The lessee reports lease expense on a straight line basis and the Lessor reports Lease Revenue on a straight-line basis Over the lease term. (under an operating lease, the lessee reports a single amount of lease expense, which is composed of interest expense plus Amortization expense, in its Income Statemnet. This is in keeping with the key objective of reporting a straight-line lease expense for an operating lease. On the other hand, in keeping with the presumption that an operating lease is, in effect, a rental agreement, the LESSOR reports Lease Revenue on a straight-line basis over the lease term.

Criteria used for classification as a finance lease

-The lease includes a purchase option the lessee is reasonably certain to exercise. -The PV of the total lease payments is greater than substantially all of the fair value of the asst -Ownership of the asset transfers to the lessee

The criteria that must be met for a company to treat a lease as a short-term lease?

-The lease term (including any options to renew or extend) is 12 months or less. -The lease does not contain a purchase option that the lessee is reasonably certain to exercise, which would extend the term beyond 12 months.

On January 1, 20X1, Mitchell Company leases equipment from Donelson Corp. for the equipment's entire useful life of six years. Donelson acquired the asset for $239,826 and normally utilizes an 5% interest rate for these types of transactions. The annual lease payment is $45,000. For the year ended 20X1, Mitchell should allocate the cost of the right-of-use asset by

Debiting amortization expense for $39,971 $239,826/6 years

Lease specifies annual lease payments of $50,000 per year plus the higher of $10,000 or 3% of sales over $150,000.

Include the minimum amount of lease payment increase in the present value calculation performed at beginning of lease. (Include the minimum scheduled lease payment of $60,000 (calculated as $50,000 + Minimum increase of $10,000) in the PV calculation performed as of the beginning of lease

For example, a 10-year noncancelable lease of a computer with a 10-year useful life, by which title passes to the lessee at the end of the lease term.

Obviously more nearly represents a purchase than a rental agreement. This type of lease is classified as a finance lease by the lessee, and a sales-type lease by the lessor.

An amortization schedule is convenient to track the changing amounts. As each payment is made, interest is calculated by multiplying 10% by the outstanding balance.

Bothe the lessee and the lessor would use the same amortization schedule.

On January 1, 2018, Savor Corporation leased equipment to Spree Company. The lease term is 9 years. The first payment of $698,000 was made on January 1, 2018. The PV of the lease payments is $4,561,300. The lease is appropriately classified as a sales-types lease. Assuming the interest rate for this lease is 9%, how much interest revenue will Savor record in 2018 on the lease?

Interest Revue =$347,697 Interest= outstanding balance x 9% Interest = (4,561,300-698,000) x 9% = $347,697

A purchase option whose exercise price is reasonably certain often is referred to as a "bargain" purchase option (BPO).

It is "reasonably certain" that the lessee will exercise a purchase option the accounting for the lease is affected in three ways. 1) Lease is classified as a finance lease or sales-type lease 2) Both the lessee and the lessor consider the exercise price of the option to be additional cash payment. (IN other words, the PV of the exercise price is added to the PV calculation used to determine the lease liability (recorded by the lessee) or lease receivable (recorded by the lessor) 3) We assume that the lease term ends on the date that the option is expected to be exercised.

Lessees prefer the ______ lease classification because it defers expense recognition, as compared to the _______ lease classification, which "front loads" lease expense due to high interest expense in early years and straight line amortization expense.

Lessees prefer the operating lease classification because it defers expense recognition, as compared to the finance lease classification, which "front loads" lease expense due to high interest expense in early years and straight line amortization expense.

Selma leases equipment from ABC Corp. The 4-year lease requires payments of $10,000 per year, beginning at the inception of the lease. The fair value of the equipment at the inception of the lease is $100,000. The equipment has a 6-year life. Selma's incremental borrowing rate is 6%. The lease does not transfer title and does not have a bargain purchase option. How should the lease be classified by Selma?

Operating (Not a financing because the PV of the minimum lease payments is less than substantially all of the fair value of the leases asset. Also, there is no transfer of title, and no purchase options)

Circumstances might change later that require reassessment of how long the lease term will be.

Reassessment requires a "triggering event" such that the lessee now has economic incentive to exercise an option that extends or terminates the lease.

What is one of the classifications of a lease transaction as a finance lease?

The asset is of a very specialized nature and will have not alternative use to the lessor

Assume that the equipment has fair value equal to the estimated residual value of $60,000 at the end of the lease.

The related entry by First LeaseCorp includes a debit to Equipment for $60,000 (to add the equipment that was leased to its balance sheet) and a Credit to Lease Receivable for $54,542 and a Credit to Interest revenue for $5,458

For example: assume a four-year operating lease of equipment (specified as "asset ABC") with a useful life of four years. Let's say after one year the lessee and lessor agree to include additional equipment (specified as "Asset XYZ") in the lease with a 10% increase in lease payments. Since an additional right of use (that is, the use of another asset) is granted, the original lease is terminated and

a new lease is created based on the modified arrangement.

Assume that an asset being leased is expected to have a residual value at the end of the lease term. What will be the impact of the residual value?

-It will affect the lessor's accounting for the lease -At the beginning of the lease, the lessor will add the PV of the residual value to the amount of the lease receivable that would otherwise be recorded under the lease. -A gain or loss will be recorded at the end of the lease if the actual residual value is different than that estimated.

A reasonable conclusion is that ______ of the fair value of the asset amounts to "substantially all" of the fair value.

A reasonable conclusion is that 90% or more of the fair value of the asset amounts to "substantially all" of the fair value.

As of the second lease payment on December 31, Year 1 one year's interest has accrued. The balance outstanding during year 1 equals the PV of the payments of $479,079 minus the first payment of $100,000 made at the beginning of the lease. Multiplying the amount outstanding of $379,079 by the interest rate of 10% gives us the interest amount of $37,908. As lessee, Sans Serif incurs interest expense

Debit to Interest expense $37,908 Debit to reduce Lease payable for $62,092 (difference) Credit to Cash for $100,000

Leasing provides protection against the risk of declining asset values

Leasing MIGHT offer protection against the risk of declining asset values. When a company buys an asset, the price it might eventually sell the asset for at the end at the end of its productive life is uncertain. On the other hand, when a company leases an asset it avoids the risk of declining fair values (that is =, selling price) but also misses out on any increase in fair value.

The amortization table for an operating lease allows the lessee to allocate each lease payment to ______ and _______.

The amortization table for an operating lease allows the lessee to allocate each lease payment to interest expense and reduction of the lease liability.

Because the lessee's right-of-use asset provides an economic benefit (the right to use a productive asset) over the period covered by the lease term, the lessee must amortize its right-of-use asset generally over the use term.

The amortization usually is on a straight-line basis.

both the lessee and lessor use the same amortization schedule for a finance/sales-type lease. The lessee records interest ______ and the lessor records interest ______.

Both the lessee and lessor use the same amortization schedule for a finance/sales-type lease. The lessee records interest expense and the lessor records interest revenue.

As Lessor, First LeaseCorp records three entries: First LeaseCorp recognizes its Year 1 lease revenue with a

Debit to Deferred Lease revenue of $100,000 and a Credit to Lease Revenue of $100,000; Next First LaseCorp records the receipt of the Year 2 lease payment on December 31, Year 1. Debit Cash $100,000 Credit Deferred Lease revenue of $100,000. Finally since this is an operating lease: First LeaseCorp records the Year 1 depreciation for the equipment. Debit to Depreciation Expense $79, 847 ($479,079 / 6 years) Credit to accumulated Depreciation $79,847.

On January 1, 20X1, Kilian Inc. leases equipment with a fair value of $140,000 and a useful life of four years to Marion Company for one year. Under the lease term, Marion makes four quarterly payments of $20,000 beginning on January 1. Assuming that Marion chooses the short-cut method, at the commencement of the lease before the first lease payment is made, Marion should

Not make any journal entry

Recall that Sans Serif Publishers leased printing equipment from First LeaseCorp. The lease specifies six annual payments of $100,000 over a six-year period. The PV of the lease payments is $479,079.

The annual amortization expense, then is $479,079 divided by six years, or $79,847.

Xavier Corp. lease equipment with a useful life of ten years to Zero Inc. The operating lease requires annual payments of $1500 over a three-year period without a renewal option. After two years, the two companies agree to extend a lease term by two years and increase annual payments to $1750. What should happen because of this lease modification?

What has been recorded by both companies must be adjusted to conform to the new terms of the contract. (This modification alters Zero's right to use the equipment; it doesnt grant Zero an additional right to use another asset. What has been recorded by both companies must be adjusted to conform to the new terms of the contract. Although the modified lease term added two additional years, the new total lease term of five years is not a "major part" of the asset's ten-year economic life; as such, this modification does not necessarily change the classification from an operating lease to a finance/sales type lease.

On January 1, Year 1, manlier Inc. leased equipment costing $45,000 to one of its customers. the sales-type lease agreement specifies six annual payments of $15,000 beginning on that date. The PV of the annual lease payments is $73,619. At the end of the lease, the equipment will be returned to Manlier and is expected to have a residual value of $5,000. The PV of that residual value is $2,822. Complete the appropriate journal entry recorded by Manlier (lessor) at the beginning of the lease.

Debit to Lease receivable $76,441 ( PV of annual lease payments of $73,619 + PV of residual value of $2,822) Debit to COGS $42,178 (Cost of $45,000 - PV of residual value of $2,822) Credit to sales Revenue $73,619 (PV of annual lease payments $73,619 or Lease receivable $76,441 - PV of residual value of $2,822) Credit to Equipment $45000 (cost of equipment)

Ludwig Corporation lease a machine to Kluge Corporation under a three-year lease agreement determined to be a finance/sales-type lease. At inception of the lease,

-Kluge records a right-of-use asset Kluge records a lease payable

On January 1, Year 1 Sans Serif Publishers leased printing equipment from First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation a cost of $479,079. The lease agreement specifies six annual payments of $100,000 beginning January 1, Year 1, the beginning of the lease, and at each December 31 from Year 1 through Year 5. The six-year lease term ending December 31, Year 6, is equal to the estimated useful life of the equipment. First LeaseCorp routinely acquires electronic equipment for lease to other firms. The interest rate in these financing arrangements is 10%. Let's apply the five classification criteria to determine how Sans Serif, the lessee, should classify this lease. We will use the same criteria for First LeaseCorp, the lessor.

1) Does the agreement specify that ownership of the asset transfers to the lessee? No 2) Does this agreement contain a purchase option reasonably certain to be exercised? No option is mentioned. 3) Is the lease term for the "major part" of the estimated economic life of the asset? Since the lase term is for six years and is equal to the useful life of the equipment the answer is "YES". 4) Is the present value of the lease payments equal to or greater than "substantially all" of the fair value of the asset? PV of the lease payments of $479,079 equals the fair value of the equipment, so the answer is "YES". 5) Is the 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? Since First LeaseCorp routinely lease this type of equipment, the answer is "NO". Decision: Since atleast one of the five classification criteria is met, this is a finance lease to the lessee and a sales-type lease to the lessor. Sans Serif, the lessee, would classify the lease as finance lease and First LeaseCorp. the lessor, would classify the lease as a sales-type lease.

How we account for an operating lease at the beginning of the lease: On January 1, Year 1, Sans Serif Publishers leased printing equipment form First LeaseCorp. First LeaseCorp purchased the equipment from CompuDec Corporation at a cost of $479,079. Sans Serif's borrowing rate for similar transactions is 10%. The lease agreement specifies four annual payments of $100,000 beginning January 1, Year 1, the beginning of the lease, and at each December 31 from year 1 through Year 3. The useful life of the equipment is estimated to be six years. The PV of the four payments at a discount rate of 10% is $348,685. The price Sans Serif pays for the right to control the use of the equipment is the PV of the lease payments. The lease doesn't meet any of the five classification criteria, so it is accounted for as an operating lease. The journal entry by Sans Serif to record the operating lease includes

Debit to Right-of-use Asset $348,685 Credit to Lease Payable $348,685 (PV of the lease payments) Just as it would in a finance lease. Sans Serif reports the operating lese liability in its BALANCE SHEET. it si designated as a "non-debt liability" to distinguish it from traditional liabilitties.

For example, a store owner might sign a lease that provides for rent based on a percentage of sales that are more than a predetermined level. If the mall attracts a sufficiently higher number of shoppers the lessee pays the lessor part of the resulting higher sales, but if not, the lessee makes only the normal lease payments. Lets say the lease payments are $20,000 per year plus 5% of sales over $100,000.

In this case, if the specified event occurs (in this exp, sales exceed $100,000) and lease payments increase (in this exp, by 5% of the sales over $100,000) and the additional payment that results is simply reported as a separate lease expense (by the lessee) and lease revenue (by the lessor). In addition the Balance Sheet accounts are not affected.

To illustrate the second type, let's assume a four-year operating lease equipment with a useful life of six years. Now say that after two years the lessee and lessor agree to extend the lease term by two years and to alter the amount of the lease payments. The additional two years were not originally an option.

In this case, the modification alters the lessee's right to use the asset rather than grant an additional right of use. -This means adjusting, adding to, or deleting what has been recorded to conform to the new terms in the contract. -it's also possible that we need to reclassify the lease from one type to another (operating or finance or sales-type or vice versa)

Amortization of a right-of-use asset over the lease term is recorded by the:

Lessee with a debit to Amortization Expense (Like other noncurrent assets, the lessee's right-of-use asset provides an economic benefit (the right to use a productive asset) over the period covered by the lease term. So, the lessee amortizes its right-of-use asset over the lease term with a debit to Amortization Expense and a Credit to Right-of-use asset.

Recall that San Serif Publishers leased printing equipment form First LeaseCorp. The lease specifies four annual payments of $100,000 beginning January 1, Year 1. The interest rate in these financing arrangements is 10%. The PV of the lease payments at a discount of 10% is $348,685. The lease doesn't meet any of the five criteria, so it's accounted for as an operating lease. When Sans Serif makes the first lease payment

Lessee: It reduces Lease Payable with a Debit of $100,000 and a Credit of $100,000. Why no interest? Because the first lease payment occurred at the BEGINNING of the lease, no interest expense has accrued. Lessor: When First LeaseCorp receives the first payment it records a Debit to Cash $100,000 and a credit to Deferred Lease Revenue. Why no lease revenue? Because the first payment occurred at the beginning of the lease and as such, the related revenue has not yet been earned. So, the liability account, Deferred Lease revenue is credited here instead.

As of the second lease payment on December 31, Year1, one year's interest has accrued. The balnce outstanding during Year 1 equals the PV of the payments of $348,685 minus the first payment of $100,000 made on January 1, Year 1. Interest = Outstanding balance x 10% (348,685 -$100,000) x 10% =$248,685 x 10% = $24,869 The entry recorded by Sans Serif includes

Lessee: Debit to Interest Expense for $24,869 Debit to Lease Payable $75,131 Credit to Cash $100,000 (Lease payable is the difference between the lease payment and the interest) Sans Serif can use an amortization schedule to track the changing amounts. As lessee, Sans Serif amortizes its lease payable and records interest expense. When the last payment is made, the balance in the Lease Payable account on the lessee's books and the related balance in the lessor's Lease Receivable account will be reduced to zero.

Let's assume that Mansfield Inc., as a lessee, had no significant economic incentive as of the beginning of a 6-year lease to exercise a 2-year extension option. At this point, the lease term is six years. However, by the end of the third year, let's say the lessee has made significant improvements to the asset whose cost could be recovered only if the lessee exercises the extension option making an extension of the lease "reasonably certain."

Now the lease term is 8-years with five years remaining. At the end of the third year, the lessee would remeasure the lease liability as the PV of the remaining five lease payments. The discount rate used should equal the incremental borrowing rate of the lessee using the market interest rates at the time of the reassessment.

Company enters into a 10-day rental of a computer with a 10-year useful life with no passage of title to the lessee.

Obviously represents a rental and not a sale. These types of rental arrangements are referred to as operating leases.

Accounting for a short-term lease: On January 1, Year 1, Sans Serif Publishers leased printing equipment from First LeaseCorp. The lease agreement specifies four quarterly payments of $25,000 beginning January 1, Year 1, the beginning of the lease, and at the first day of each of the next three quarters. The useful life of the equipment is estimated to be six years. The lease meets the short-term lease criteria because the lease term is 12 months and it does not contain a purchase option.

On January 1, Year 1, which is the beginning of the lese Sans Serif does NOT record any journal entry to show a right-of-use asset and liability. Instead, as the company makes each of the four lease payments on January 1, April 1, July 1, and October 1, Year 1, Sans Serif will record an entry with a DEBIT to Lease Expense and a CREDIT to Cash

For example, assume that a retail store's monthly lease payments will increase next year by the higher of $250 or 0.5% of monthly store revenue. In that case, we know the lease payment will increase by at least $250.

So these payments are deemed to be in-substance fixed payments and are included in the lease payments used in PV calculations. -The second exception relates to variable payments that depend on an index or rate (like the Consumer Price Index or current prime rate of interest). Even though lease payments will vary in the future, we use the initial lease payment amount based on the current index (or rate) to calculate the PV of the lease payments at the beginning of the lease.

Let's say that a lessor increases annual lease payments from $100,000 to $102,000 with the provision that the lessor will pay an annual maintenance fee of $2,000 to a third-party maintenance firm.(The same thinking would apply here if it was for a service contract)

The $2000 would be excluded from the lease payment amount as a nonlease component when the PV calculation is performed, (That is, the cost is not capitalized) When each lease payment is made the related entry would include a Debit to Maintenance expense for $2,000

What best describes the period over which the right-of-use asset is amortized when ownership transfers at the end of the lease?

The asset's estimated useful life

Recall that Sans Serif publishers leased printing equipment from First LeaseCorp. The lease specifies four annual payments of $100,000 over a four-year period. The PV of those four lease payments at a discount rate of 10% is $348,685. The lease is accounted for as an operating lease. Lets consider the second lease payment on December 31, Year1.

The balance outstanding = the PV of the payments of $348,685 - the first payment of $100,000 made on January 1, Year 1. Multiplying the amount outstanding of $248,685 by the interest rate of 10% gives us the revenue amount of $24,869. That is the same amount of interest we would have, if this had been a finance lease. As LESSEE, when Sans Serif makes the second lease payment, it records: Debit to Interest Expense of $24,869 Debit to Lease Payable $75,131 and a Credit to Cash for $100,000; this would be the same entry we would have if it had been a finance lease. That's where the similarity to a finance lease ends.

Now. let's consider a sales-type lease that includes a residual value as well as a selling profit. Recall that the lessor records both sales revenue and COGS to represent the selling profit

The sales revenue = PV of the periodic lease payments it does not include the residual value (since that part of the asset was not sold) Since the asset will revert to the lessor the COGS = the cost of the asset being leased - PV of its residual value (the part not sold)

In an operating lease, interest expense plus amortization expense is equal to

The straight line lease payment