INT 2 Ch 15
A Residual Value affects several aspects of Lease Accounting, including:
(a) The size of the periodic Lease payments (b) The classification of a Lease (c) The amounts recorded by both the Lessee and Lessor
Finance Lease Criteria
1. Agreement specifies that ownership of the asset transfers to the lessee 2. The agreement contains a purchase option that the lessee is reasonably certain to exercise 3. The lease term is for the "major part" of the remaining economic life of the underlying asset 4. The present value of the total of the lease payments equals or exceeds "substantially all" of the fair value of the underlying asset 5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the term.
If it is "reasonably certain" that the Lessee will exercise a purchase option, accounting for the Lease is effected in three ways:
1. Lease is classified as a Finance/Sales-Type 2. Both the Lessee and Lessor consider the exercise price of the Option to be an additional cash payment 3. We assume the Lease Term ends on the date that the Option is expected to be exercised.
Why Lease?
1. Reduces the upfront cash required. 2. Lease payments are often lower than installments. 3. Offers flexibility and a lower cost when disposing of the Asset. 4. Might offer protection against the risk of declining asset values. 5. Can be advantageous for tax purposes
Typically, uncertain increases or decreases in future lease payments are driven by
1. Revenues 2. Profitability 3. Asset Usage above an arbitrary threshold
What if Lease Terms are Modified?
1. The modification might grant the Lessee and additional right of use. -Terminate original Lease -Account for modified arrangement in new Lease 2. The modification might alter the Lessee's right to use the asset. -Adjust/add to/reduce what has been recorded in order to conform to the new terms of the contract
Two key criteria must be met at the inception of the contract for an arrangement to constitute a Lease for purposes of ASC 842
1. There must be an identified asset -Asset must be PP&E, not inventory, intangibles, or natural resources, etc. -Asset must be specified in the contract, either explicitly or implicitly 2. Lessee must have the right to control the use of the asset
There are two exceptions to not including variable payments in the calculation of the Lease Liability recorded at the beginning of the lease.
1. When variable lease payments are in-substance fixed payments -'Fixed payments in disguise' -Ex: Rent will increase next year by greater of 250/month or .5% monthly revenue: You can include 250 2. When variable lease payments depend on an Index or Rate -Use current rate to discount to Present Value for right-of-use Asset, Lease Liability, and Lease Receivable
Operating Lease
A lease that does not involve any common attributes of ownership. (Transfer of Title, "major part" of useful life consumed in lease, PV of all payments exceeds the fair value of the asset, etc.)
Finance/Sales-Type Lease
A lease that more resembles a loan/purchase agreement. Conversely, an Operating Lease more closely resemble a rental. Finance- Lessees classification Sales-Type- Lessors classification -Either: 1. Without Selling Profit 2. With Selling Profit
Both the ___________ _____________ ____________ and the ____________ ____________ ____________ as a result of a Purchase Option impact the calculation of the Lessee's Right-of-Use Asset and Lease Liability, as well as the Lessor's Lease Receivable
Additional cash payment, shortened Lease Term **Remember, one of the few reasons a Lessee should Amortize their Right-of-Use Asset over the term of its economic life (rather than the term of the lease) is because of a Purchase Option
The _______________ Expense is uniform in a Finance Lease, while the _____________ Expense is uniform in an Operating Lease
Amortization, Total
Leasehold Improvements
Capitalize cost and amortize as 'depreciation/amortization expense' over the SOONER of lease expiration or useful life.
When there is a change in the lease term, lessees are required to reassess the _____________________ of a lease as well.
Classification
Initial Direct Costs
Costs that: 1. Are associated directly with consummating a Lease. 2. Are Essential to acquire the Lease 3. Would not have been incurred had the Lease Agreement not occurred
When accounting for a Sales-Type Lease, the Lessor must _______________ the Asset in question from its books.
Derecognize
If a cash payment is expected at lease end to supplement insufficient Residual Value, the Lesse should:
Discount the expected cash payment to PV and add it to the PV of the periodic lease payments that Lessee records as both a right-of-use Asset and Lease Liability
What is the determining factor in whether gray area Costs (maintenance, hazard insurance, property taxes, etc) should be separated from the Lease Payments and expensed, or included in the Lease Payments and capitalized?
Does the charge represent a transfer of a good or service to the lessee? (Apart from the Leased Asset) If so, it is a "Non-Lease Component" of the payment and is separated from Lease Payments
Finance Leases - Lessee (SOCF)
Each lease payment from the Lessee consists of two parts (interest expense, reduction in principal. (**Except for 1st payment) The Interest Expense is treated as an operational cash expenditure Reduction in principal portion is an investing cash expenditure
The Lessee uses the ___________ interest rate implicit in the lease. This is the desired rate of return the lessor had in mind when deciding on periodic payment amounts.
Effective or "Rate of Return the Lease Payments Provide the Lessor" *IF KNOWN If not, Lessee uses its own incremental borrowing rate*
When does a Selling Profit occur under Sales-Type Leases?
Fair Value of the Asset EXCEEDS the Cost/Carrying Value of the asset sold. REMEMBER: Fair value of the asset = PV of all lease payments
The Lessor's ___________________ is the total periodic lease payments and any residual value
Gross Investment in the Lease
Under what circumstances should a Lessee Amortize their right-of-use Asset over its useful life rather than the duration of the lease?
If ownership will transfer from Lessor to Lessee, or a Purchase Option is expected to be exercised.
BPO Exercisable B4 the End of the Term, treatment?
If the option is reasonably certain to be exercised, the lease term ends for accounting purposes when the option becomes exercisable.
Advance Payments
In a Finance/Sale-Type Lease, such payments are included with other payments used to determine PV of Right-of-Use Asset and Lease Liability, as well as Lessor determination of Lease Receivable. *Remember, Lessor's in operating leases do not account for Lease Receivable, therefore advance payments are recorded as deferred rent revenue and allocated (straight line) to rent revenue over the lease term.
Finance Lease Entry Example- INT PMT 3 Year Lease Machine BV- 666,633 Semi-Annual PMT- 139,857 Interest Rate- 14% (Remember ^ semi-annual PMT)
Interest Expense (7% x 666,633) 46,664 Lease Payable (plug) 93,193 Cash 139,857
A lessor _________ (is/is not) permitted to reassess its initial determination of the lease term or discount rate
Is not
Sales-Type Leases - Lessor (SOCF)
Just as if the Lessor were selling a product, cash receipts from ST Leases treated as cash inflow from operations.
Short-Term Lease Expense Entry
Lease Expense x Cash X Does NOT require a right-of-use asset or lease liability to be recorded.
For a Lessor, the distinction of recording an Operating Lease means NOT recording a __________ ___________, or 'derecognizing' the leased Asset, such is the case under a ___________ _________ Lease
Lease Receivable, Sales-Type *** It ALSO means reporting Lease Revenue as an equal amount each month, as opposed to the declining amount of interest revenue each period with a Lease Receivable
A lease is considered Short-Term if:
Lease Term (including options for renewal) of twelve months or less Does not contain a purchase option that the Lessee is reasonably certain to exercise, which would extend the term.
As the lease term and risk of obsolescence increase, residual value becomes _________ (more/less) of an issue.
Less Longer Lease Term -> Less remaining useful life -> Less of a chance the Residual Value is material.
Nonlease Components INCLUDED in periodic Lease Payments are paid by the _____________ (Lessee/Lessor)
Lessee Even if the contract conveys the Lessor will cover that component, by definition, anything included in the Lease Payments is paid by the Lessee
Because Contingent Payment Provisions do not carry any certainty with them, we do not consider them as part of the lease payments used to calculate what?
Lessee's Right-of-Use Asset/Lease Liability and the Lessor's Lease Receivable **If and when lease payments increase, the change in the lease payments has no effect on Balance Sheet accounts. Reported as separate Lease Expense (Lessee) or Revenue (Lessor)
In a Finance Lease, a Lessee records _________ (more/less) expense and the Lessor records __________ (more/less) revenue early in its life.
More, More "Front Loading"
While legal and processing fees for executing the lease document ARE included as IDC, legal fees for _______________ and ______________ are not Initial Direct Costs. (Expensed as incurred)
Negotiations, Drafting Documents
The Lessor _______________ (Must consistently/Never) reassess(es) its Lease Receivable for Variable Lease Payments
Never
Although an operating lease liability is reported in the balance sheet of the lessee, it is designated as a _________ __________ __________ in order to distinguish it from traditional liabilities.
Non-Debt Liability
Recall that the Lessor records both Sales Revenue and COGS to account for profit. The Sales Revenue is the present value of only the ____________________, not including the __________________
Periodic Lease Payments, Residual Value Doesn't include residual value b/c the revenue to be recovered form the lessee is lease payments only
Residual Asset
Present Value of the residual value of a lease asset
ONLY if and when the Lessee remeasures the Lease Liability for ___________________________________ should the Lessee adjust the Right-of-Use Asset and Lease Liability for changes in the amount of payments.
Reasons OTHER than a change in the Index or Rate Ex: Reassessment of the Lease Term, Modification of the Lease -In such cases, the Leased Asset and Lease Liability are recalculated by determining the PV of future lease payments using: (a) New lease payments as adjusted for changes in the index or rate (b) The discount rate that applies as of the date of reassessment
Substance-Over-Form
Refers to a concept of financial accounting whereby transactions are not necessarily classified/accounted for based upon their legal form. Rather, the economic substance of the transaction is the deciding factor. (A lease that is identical to an installment plan is accounted for as an installment plan, even though legal ownership never changes hands)
Bargain Purchase Option
Required to classify a lease as 'Finance' IF it is the only criteria met. A BPO is a decision the Lessee is entitled to upon completion of the Primary Lease Term. The Lessee's decision is effectively assured because the price at which purchase can be made is a "Bargain"
A lessee is required to extend one of their leases. Assuming the present value of the remaining five lease payments totaled 400,000, while the current balance of the lease liability before RE measurement is 250,000. What adjustment must the Lessee make?
Right-of-Use Asset 150,000 Lease Payable 150,000 **In situations when the lease term is shortened (termination option) the journal entry would be reversed to REDUCE the account balances.
Finance Lease Entry Example- EXECUTION 3 Year Lease Machine BV- 666,633 Semi-Annual PMT- 139,857 Interest Rate- 14% (Remember ^ semi-annual PMT)
Right-of-use-Asset 666,633 Lease Payable 666,633
A Lessor needs to include supplemental cash (to cover residual value) in the Lease Receivable account for _______________________ (Operating/Sale-Type) Leases
Sale-Type **Remember, in an Operating Lease the Lessor does not record Lease Receivable or remove the Asset from its books.**
Lessor Accounting for Initial Direct Costs
Sales-Type WITH Profit - IDC are expensed in the period of sale. Treated as COGS Sales-Type WITHOUT Profit - IDC are deferred and expensed over the lease term. Operating Lease - IDC are deferred and expensed over the lease term, generally on a straight-line basis.
Contingent Payment Provisions place the risk associated with an Asset's Profitability on ______________ (Lessee/Lessor/Both)
Shared Risk Ex: Gap, Inc may be willing to pay significantly higher rents to a certain mall operator if the mall meets a certain threshold of foot traffic.
We can think of Lease Expenses in a Finance Lease as reflecting (a) the right to use the asset (Amortization) plus (b) the financing of that right. (interest) On the other hand, in an Operating Lease, lease expense is reported in a manner that is designed to mirror _________ ___________ ____________
Straight Line Rental (Calculate Interest Expense via CV table then plug whatever Amortization figure keeps the payment uniform. Combine the Interest and Amortization such that your uniform figure is reported annually)
Operating Leases (SOCF)
The Lessee treats an operating lease as a rent expense and a common operational cash flow expenditure. The Lessor treats an operating lease as rent revenue, operational cash flow
Lease Uncertainties Include:
The Term Variable Lease Payments Unguaranteed Residual Value Lessee Guaranteed Residual Value Excess of Guaranteed Residual Value over Expected Residual Value Purchase Options Termination Penalties Modification of a Lease
Upon Reassessment of a Lease, how is the new Discount Rate Determined?
The discount rate for the new term is the incremental borrowing rate of the Lessee using market interest rates at the time of the reassessment.
Net Investment in the Lease
The gross investment in a lease discounted at the interest rate implicit in the lease.