ACCT - Ch 21A Accounting for Leases

What are the advantages of leasing from the LESSEE'S perspective?

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

What are the three categories of lessors?

1. Banks 2. Captive leasing companies 3. Independents

4 Types of Lease Payments

1. Fixed payments 2. Variable payments that are based on an index rate 3. Amounts guaranteed by a lessee under a residual value guarantee 4. Payments related to purchase or termination options that the lessee is reasonably certain to exercise

Advantages of Leasing - LESSORS

1. Provides profitable interest margins 2. It can stimulate sales of a lessor's product - whether from dealer or manufacturer. 3. Provides tax benefits to various parties in the lease, enhancing the return to all the parties involved, including the lessor. 4. It can provide a high residual value to the lessor upon the return of the property at the end of the lease term.

What are the 5 tests used to determine whether a company should use the finance lease approach or operating lease approach?

1. Transfer of ownership test 2. Purchase option test 3. Lease term test 4. Present value test 5. Alternative use test

What is a lease defined as?

A "contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration." This is done WITHOUT transferring ownership

What is a lease?

A contractual agreement between a lessor and a lessee. Gives the lessee the right to use specific property, which is owned by the lessor, for a specific period of time. In return for the use of property, the lessee makes rental payments over the lease term to the lessor.

How do companies (from the lessee's perspective) determine whether to use the finance method or the operating method?

A lessee should classify a lease based on whether the arrangement is effectively a purchase of the underlying asset.

Operating Lease Classification

All leases that do not meet any of the finance lease tests are classified as operating leases. - A lessee obtains the right to use the underlying asset but not ownership of the asset itself.

Protection against obsolescence

Also passes the risk of residual value to the lessor. This is good if it is likely that a new technology will come out, making the current asset obsolete.

100% financing at fixed rates...

Because leases are often signed without requiring any money down from the lessee, it is a great way for the lessee to preserve scarce cash, an especially desirable feature for new developing companies. Lease payments are also often at fixed payments, which protects the lessee against inflation and increase in the cost of money.

Implicit Interest Rate

Defined as the discount rate that, at the commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset.

What are the two ways that companies classify lease arrangements and how do they affect the financials? - LESSEE

Financing or operating lease. In either case, companies capitalize all leases assets and liabilities. Therefore, the balance sheet for a company that uses either a finance lease or an operating lease will be the same. However, for INCOME statement purposes, the reporting of financial information depends on whether the lease is classified as a finance or operating lease.

5. Alternative Use Test

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

Present Value Test

IF the present value of the lease payments is reasonably close to the fair value of the asset, a company is effectively purchasing the asset and should, therefore, use the finance method to account for the lease. 90% test - if the present value of the lease payments equals or exceeds 90 percent of the fair value of the asset, then a lessee should use the finance method to record the lease.

4. Payments related to purchase or termination options that the lessee is reasonably certain to exercise

If the lease contains a bargain purchase option, the cost of that option should be considered part of the lease payments.

Financial Lease Classification

If the lease transfers control (or ownership) of the underlying asset to a lessee, they the lease is classified as a finance lease. In this situation, the lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term.

Transfer of ownership test

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

What does the FASB require for all long-term leases?

It requires companies to capitalize all long-term leases. The right to use property under the terms of the lease is an asset, and the lessee's commitment to making payments under the lease is a liability. The FASB believes that the reporting of an asset and liability for a lease arrangement is consistent with its conceptual framework definition of assets and liabilities. (Exception - Leases covering a term of less than over year.)

Banks

Largest players in the leasing business. Because they have low-cost funds, they are able to purchase assets at less cost than their competitors.

Flexibility

Lease agreements often contain less restrictive provisions than other debt agreements. Lessors can also tailor lease agreements to the lessee's special needs.

Asset

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liability

Probable future sacrifices of economic benefits arising from present obligations or a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

3. Amounts guaranteed by a lessee under a residual value guarantee

Residual value is the expected value of the leased asset at the end of the lease term. Residual value can be guaranteed or unguaranteed. - The lessee includes the full amount of the residual value guarantee at the end of the lease term in the present value test. - The lessee does not consider unguaranteed residual value as part of the present value test.

How should the lessee determine whether the present value of the payments equals or exceeds 90% of fair value?

Should compute the present value of the lease payments using the implicit interest rate.

Sales-type lease

Sold the asset to the lessee and provided him or her with credit to finance the purchase. - Earn a profit on the differences between the cost of the asset and its selling price and the interest on the loan. Use the same criteria for the lessee, except now we also determine whether collectability of payments is reasonably assured. Do not want to record profit or a receivable if we don't know we're going to get the cash or we might end up incurring mroe in costs than we get in payments.

Captive Leasing Companies

Subsidiaries whose primary business is to perform leasing operations for the parent company. The company selling the product has their own financial services corporation that provides the financing rather than an outside financial institution. These companies have the point-of-sale advantage in finding leasing customers. Has product knowledge that gives it an advantage when financing the parent's product.

What is the issue on how to report for leases?

The classic case of substance over form. - Although legal title does not technically pass in lease transactions, the benefits from the use of the property do transfer.

Operating Lease

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

Un-guaranteed Residual Value

The lessee does not have any obligation to the lessor at the end of the lease, except to return the leased asset to the lessor.

Guaranteed Residual Value

The lessee has an obligation to not only return the leased asset at the end of the lease term but also to guarantee that the residual value will be a certain amount.

Financial Lease

The lessee recognized interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. Therefore, lessee reports both interest expense and amortization of the right-of-use asset on the income statement. This results in the total expense for the lease transaction being generally higher in the early years of the lease arrangement under financial lease arrangements.

2. Variable payments that are based on an index rate

The lessee should include variable lease payments in the value of the lease liability at the level of the index/rate at the commencement date. When valuing the lease liability, no increase or decrease to future lease payments should be assumed based on increases or decreases in the index or rate. Instead, any differences in the payments due to changes in the index or rate is expensed in the PERIOD INCURRED.

What does the profitability of equipment leasing hinge on?

The lessor's ability to accurately estimate the residual value of the leased asset at the end of the lease so as to resell the asset at a profit when returned by the lessee.

1. Fixed payments

The rental payments that are specified in the lease agreement and are fixed over the lease term

Independents

They are good at developing innovative contacts for lesses. They also are starting to act as captive finance companies for some companies that do not have leasing subsidiaries.

What does a company do if it is impractical to determine the implicit rate of the lessor?

They should use the incremental borrowing rate.

Purchase option test

This test is met if it is reasonably certain that the lessee with exercise the purchase option. - The lease purchase option allows the lessee to purchase the property for a price that is significantly lower than the underlying asset's expected fair value at the date the option becomes exercisable.

Lease Term Test

When the lease term is a major part of the remaining economic life of the leased asset, companies should use the finance method in accounting for the lease transaction. If the lease term is 75% or greater fo the economic life of the leased asset, the lease meets the lease term test and finance lease treatment is appropriate.

Incremental borrowing rate

the rate of interest the lessee would have to pay on a similar lease or the rate that, at the commencement of the lease, the lessee would incur to borrow over a similar term the funds necessary to purchase the asset.