Accounting 302 Chapter 15: Leases

If initial direct costs are incurred by the lessor:

(a) recorded as a selling expense in a sales-type lease that includes selling profit. (b) deferred and expensed over the lease term in a sales-type lease with no selling profit. (c) deferred and expensed over the lease term in an operating lease.

A lease is accounting in two ways:

1. Finance/Sales-type lease 2. Operating Lease

A lease is considered a "short-term lease" if it:

1. Has a lease term of twelve months or less, and 2. Does not contain a purchase option that the lessee is reasonably certain to exercise, which would extend the term beyond twelve months.

A lease is accounted for in one of two ways.

1. It is viewed as either a finance/sales-type lease 2. as an operating lease (a rental).

A lease transaction is a Finance lease if one or more of the five criteria is listed

1. The 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 lease term.

Five criteria must be met to be considered a finance lease

1. The 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 lease term.

A finance lease is economically similar to a purchase of the asset because the terms of a finance lease

1. normally allow the lessee to direct the use of the asset in a way that the lessee receives substantially all of the remaining benefits from the asset and 2. creates obligations for the lessee that are similar to those that financing the purchase of an asset would impose.

LESSEE

Finance lease costs, with separate disclosure of interest and amortization. (The total of these two is reported together in the income statement as lease expense.) Operating lease cost. Short term lease cost. Variable lease cost. Weighted average lease term of operating leases and finance leases. Weighted average discount rate. A reconciliation of opening and closing balances of the right-of-use asset. Contractual obligations (and options that the lessee is "reasonably certain" to exercise) for each of the five succeeding fiscal years, plus a total for the remaining years. Table of future lease payments, segregated by type of lease, for each of the next five years, and total of payments for the remaining years, and (for finance leases) reconciled with the balance sheet liabilities.

LESSOR

Information about lease contracts and significant assumptions and judgments. Table of lease revenues received. Lease sales disclosed separately from regular sales. Table of future lease payments, segregated by type of lease, for each of the next five years, and total of payments thereafter and (for sales-type leases) reconciled with the balance sheet receivables. Information about assets under operating lease. Information about risks associated with residual values. Information about significant changes in unguaranteed residual values. The gross investment and net investment in leases.

The modification might

alter the lessee's right to use the asset rather than grant an additional right of use.

If a modification grants the lessee

an additional right of use, the original lease is terminated and a new lease is created based on the modified arrangement.

By signing a lease, the lessee has an obligation to make payments (a liability),

and in exchange for those payments, the lessee is receiving the right to use a specified asset

Traditionally, leasing was used

as a means of off-balance-sheet financing.

The lessee incurs an expense

as it uses the asset.

Interest accrues

at the effective rate on the balance outstanding during the period

Professional judgment is needed to differentiate

between leases that in essence are installment purchases/sales and those that are not. I

As lease payments are made over the term of the lease,

both the lessee and lessor record interest at the effective interest rate

Cash receipts from a sales-type lease are

cash flows from operating activities.

Finance Lease:

contracts that are formulated outwardly as leases, but in reality, are installment purchases or sales

The cost of a leasehold improvement is

depreciated over its useful life to the lessee

the lessor in an operating lease

determines a single straight-line lease revenue.

The lessor earns the lease revenue

during the year for which payment is received at the beginning of the year

A lessee sometimes will

guarantee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor.

That amortization results

in an expense for the lessee.

Non-lease components that are

included in periodic lease payments to be paid by the lessor are, in effect, indirectly paid by the lessee—and expensed by the lessee.

The interest portion of a finance lease payment

is a cash flow from operating activities and the principal portion is a cash flow from financing activities.

An apartment lease

is a typical rental agreement referred to as an operating lease.

The exercise price of a purchase option

is considered to be an additional cash payment if exercise of the option is "reasonably certain."

The amortization process usually

is on a straight-line basis unless the lessee's pattern of using the asset is different.

Only if the lease asset and lease liability are

later re-measured for another reason, will a change in payments based on the CPI or market interest rates affect the right-of-use asset and liability.

A more typical leasing contract requires

lease payments at the beginning of each period.

GAAP now requires

lessees to record assets and liabilities for all but short-term leases

To avoid looking riskier and less profitable,

managers previously were able to keep assets and liabilities "off balance sheet" by leasing them rather than buying them.

The lease term is the contractual lease term

modified by any renewal or termination options that are reasonably certain to be exercised.

The residual value is an estimate

of what a leased asset's commercial value will be at the end of the lease term.

Operational, tax, and financial incentives

often make leasing an attractive alternative to purchasing.

The first component is the interest expense

on the lease liability and the second component is the amortization of the right-of-use asset.

The lessee uses the interest rate implicit in the lease if known;

otherwise the lessee uses its own incremental borrowing rate.

Both the lessee and lessor

report cash payments for operating leases as operating activities.

Modifying lease terms sometimes

requires reclassifying operating leases to finance/sales-type leases, or vice versa.

The amortization period is

restricted to the lease term unless the lease provides for transfer of title or a BPO.

The lessee amortizes its

right-of-use asset over the lease term.

The lease term is reassessed only when a

significant event or change in circumstances indicates a change in the economic incentive for extension or termination of the lease.

Recording a sales-type lease is

similar to recording a sale of merchandise on account

If known by the lessee,

the lessee also should make its calculations using the lessor's rate implicit in the lease agreement.

The modification might grant

the lessee an additional right of use. This would mean terminating the original lease and accounting for the modified arrangement as a new lease.

In a short-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 an operating lease,

the lessee combines interest expense and amortization expense to report a single lease expense in the income statement

In an operating lease,

the lessee records interest the normal way and then "plugs" the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment.

For an operating lease,

the lessee will report a single lease expense.

Like other noncurrent assets,

the lessee's right-of-use asset provides an economic benefit over the period covered by the lease term.

In addition to interest revenue earned over the lease term,

the lessor recognizes a selling profit on the "sale" of the asset.

If the lessee obtains title,

the lessor's computation of rental payments is unaffected by any residual value.

When funds are borrowed to purchase an asset,

the liability has a detrimental effect on the company's debt to equity ratio and other quantifiable indicators of riskiness.

Managers might have thought

they were fooling the financial markets into thinking their strategies were less risky and more profitable than actually was the case.

If the lease begins at or near the end of the economic life of the asset,

this criterion shouldn't be used for purposes of classifying the lease.

Accounting for leases attempts to see

through the legal form of the agreements to determine their economic substance From an accounting perspective, legal ownership is irrelevant in the decision

The purchased asset increases

total assets and correspondingly lowers calculations of the rate of return on assets

If future lease payments are uncertain,

we consider them as part of the lease payments only if they are "in-substance fixed payments" or if payments vary solely when an index or rate changes.

Most variable lease payments are recognized

when incurred rather than being estimated at lease commencement and included in the lessee's right-of-use asset and lease liability.

Selling profit exists

when the fair value of the asset exceeds the cost or carrying value of the asset sold.

This amount includes two components that the lessee

will calculate and record separately, and then combine for purposes of reporting.

Accounting is the same as for a sales-type lease

without a selling profit except that profit is recognized at the beginning