Ch 15

what are the characteristics of a finance lease?

(a) 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 (b) creates obligations for the lessee that are similar to those that financing the asset would impose

sales-type leases - lessor

- cash receipts from a sales-type lease are cash flows from operating activities

lease

-a contract that gives the lessee (user) the right to control the use of an 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 -when a company reports a lease, the right to use the asset for a period of time is recorded as a "right-of-use" asset in the balance sheet, while the obligation to make payments of the lease period is recorded as a lease liability

qualitative disclosures

-a general description of the leasing arrangement is required, including information about variable lease payments, options, nonlease payments, and residual values

guarantee of the residual value

-a lessee sometimes will guarantee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor -reduces the lessor's risk and provides an incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value -lessee promises to return not only the property but also sufficient cash to meet the guaranteed amount promised in the lease agreement -residual value affects the size of the periodic lease payments, the classification of a lease, and the amounts recorded by both the lessee and the lessor

lease disclosures

-guiding objective is that lessees and lessors provide disclosures and enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases -info disclosed is both qualitative and quantitative

why lease?

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

when is a lease considered a short term lease

a lease is considered a short-term lease if it: 1. has a lease term (including any options to renew or extend of twelves months or less, and 2. does not contain a purchase option that the lease is reasonably certain to exercise, which would extend the term beyond 12 months

initial direct costs

costs that (a) are associated directly with consummating a lease, (b) are essential to acquire the lease, and (c) would not have been incurred had the agreement not occured -include legal fees, commissions, and preparing and processing lease documents -for the lessee: initial direct costs incurred are added to the right-of-use asset -for the lessor, accounting for initial direct costs depends on the classification of the lease: *in a sales type lease that includes selling profit: intital direct costs are expensed in the period of "sale"- that is, at the beginning of the lease. this treatment assumes that in a sales type lease the primary reason for incurring these costs is to facilitate the sale of the leased asset *in a sales-type lease with no selling profit: initial direct costs are deferred and expense of the lease term which is done by including it in the lease receivable. increasing the receivable causes the implicit rate (the interest rate that causes the present value of the lease payments *in an operating lease: initial direct costs are deferred and expensed over the lease term, generally on a straight line basis

operating leases

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

lessor

owner

residual asset

the present value of the residual value of a lease asset -as the expected residual value increases, the size of lease payments decreases -the residual, whether guaranteed or unguaranteed, affects the size of the lease payments

lessee

user

purchase option exercisable before the end of the lease term

when we have BPO, the length of the lease term is limited to the time up to when the purchase option becomes excercisable

operating leases - statement of cash flow impact

-both the lessee and lessor report cash payments for operating leases as operating activities

how does a lessee report interest and amortization expense in an operating lease

-combines them to report a single lease expense in the income statement

what can a lessee do in short term leases

-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

quantitative disclosures - lessee

-finance lease costs, with separate disclosure of interest expense and amortization expense -operating lease expense, with separate disclosure of interest and amortization -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 a total of payments for the remaining years, and (for finance leases) reconciled with the balance sheet liabilities

composition of lease payments

-fixed payments -PLUS: exercise price for purchase option if excercise is "reasonably certain" -PLUS: termination penalty for termination option if exercise is "reasonably certain" -PLUS: variable lease payments only if (a) deemed in-substance fixed payments or (b) based on index or rate (with any changes in payments included only if and when the lessee remeasures the lease liability for another reason

operating lease

-if a lease does not meet the five criteria for a finance/sales type lease, then its considered to be more in the nature of a rental agreement for a period of time

termination penalties

-if a lease includes a penalty payment if the lessee chooses to terminate the lease at a time specified in the contract, we consider the termination penalty to be an additional cash payment if the lessee is reasonably certain to terminate the lease

comparison of lessee's expense recognition between finance and operating leases

-in an operating lease, it's the total lease expense, not the amortization component, that's a straight-line amount -lessee records more expense and the lessor records more revenue early in the life of a finance lease -"front-loading" of lease expense/revenue in finance leases occurs due to the fact that interest is higher initially than it is in the later stages of lease, while amortization expense for the lessee's right of use asset stays the same each period -operating leases avoid front-loading -companies tend to prefer the operating lease classification because it defers expense recognition, making net income higher in the early years of the lease

quantitative disclosures - lessor

-information about lease contracts and significant contracts and significant assumptions and judgements -table of lease revenues received -lease sales disclosed seperately 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 (for sales-type leases) reconciled with balance sheet receivables -information about asses 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

why would a lease include a contingent payment provision?

-its a way for lessees and lessors to share the risk associated with the assets productivity -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

reassessment of lease term

-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 -when there is a change in the lease term, the lessees are required to reassess the classification of the lease -only lessee does this

finance lease/sales type lease

-lessee has, in substance, purchased the lease asset; assumed when one of the five classification criteria is met

what if lease terms are modified?

-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 -modification might alter the lessee's right to use the asset rather than grant an additional right of use. This would mean adjusting, adding to, or deleting what has been recorded in order to conform to the new terms of the contract (say, a change in lease terms or payments) and maybe reclassifying the operating leases to sales type leases and visa versa

composition of lease terms

-non cancelable period -PLUS: periods covered by renewal options if excercise is reasonably certain -MINUS: periods following the date of purchase option if excercise is reasonably certain -PLUS: periods covered by renewal options if under control of lessor -PLUS: periods following date of termination option if its "reasonably certain" the option will not be exercised

nonlease components of lease payments

-nonlease 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

discount rate

-one discount rate is implicit in the lease agreement, called the effective interest rate of return the lease payments provide the lessor under the lease -the lessee uses the interest rate implicit in the lease if known; otherwise the lessee uses its own incremental borrowing rate

advance payments

-represent prepaid rent in lease agreements -recorded as deferred rent revenue and allocated (normally on a straight-line basis) to rent revenue over the lease term

residual value

-residual value of leased property is an estimate of what its commercial value will be at the end of a lease term -typically will have this in an operating lease because the lease term usually ends before the lease asset's value has been depleted -a residual value is less likely, but certainly not unusual, when the lease qualifies as a sales type lease, because the lease term is for most, if not all, of the assets life -typically the lessee promises to return the leased asset to the lessor at the end of a lease. An asset being returned will likely have some value

leasehold improvements

-the cost is depreciated over its useful life to the lessee -if lessee constructs a new building or makes modifications to existing structures, that cost represents an asset just like any other capital expenditure -reported in balance sheet under property plant and equipment

purchase option

-the exercise price of a purchase option is considered to be an additional cash payment if exercise of the option is "reasonably certain" -this will affect the accounting for the lease in three ways: (1) the lease is classified as a finance/sales-type lease, (2) both the lessee and the lessor consider the exercise price of the option to be an additional cash payment, (3) we assume the lease terms end on the date that the option is expected to be exercised -both the additional cash payment and the shortened lease term impact the calculation of the lessee's right-of-use asset and lease liability and the lessor's lease receivable -since the lessee is predicted to own the asset after the lease term, the right-of-use asset recognized by the lessee should be amortized over the economic life of the asset, rather than over the lease term -usually a purchase option whose exercise is reasonably certain is referred to as a "bargain" purchase option (BPO)

finance leases - lessee: statement of cash flow impact

-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

what if lease term is uncertain?

-the lease term is the contractual lease term modified by any renewal or termination options that are reasonably certain to be exercised -in other words, if the benefits of excercising an option are sufficently high that we think the lessee will excercise it, we adjust the contractual term by adding the additional period of renewal, or by subtracting the period that follows a termination option

when does selling profit exist

-when the fair value of the asset (usually the present value of the lease payments, or "selling price") exceeds the cost of the carrying value of the asset sold. -in addition to the interest revenue earned over the lease term, the lessor recognizes profit on the "sale of the asset" -accounting is the same for a sales-type lease without a selling profit except that profit is disclosed in the beginning

what are the five criteria for classification as a finance lease?

1. the agreement specifies that ownership of the asset transfers to the lessee (transfer of ownership) 2. the agreement contains a purchase option that the lessee is reasonably certain to exercise (purchase option: a provision in the lease contract that gives the lessee the option to purchase the leased property at a specified price 3. the lease term is for the "major part" of the remaining economic life of the underlying asset (say 75% or more of the remaining economic life of the underlying asset constitutes a "major part" of the remaining useful life 4. the present value of the total lease payments equals or exceeds substantially all of the fair value of the underlying asset (payments with present value of 90% or more of the fair value of the underlying asset represent "substantially all" of the fair value 5. the underlying asset is of such a specialized nature that is expected to have no alternative use to the lessor at the end of the lease term

when is it allowed to elect not to seperate nonlease components and instead to account for the entire arrangement as a lease?

1. the timing pattern of transfer for the lease and nonlease components are identical (like when lease payments and payments for maintenance contract both equal straight-line amounts paid monthly), and 2. the lease would qualify as an operating lease if the lease payments alone (without the nonlease payments) are considered

what are the two exceptions to not including variable payment in the initial recording of the lease?

1. when variable lease payments are in-substance fixed payments (fixed payments in disguise) (we include these in present value calculations) 2. when variable lease payments depend on an index or rate (here we use the initial lease payment amount, based on the current index (or rate) to discount to present value when determining the right of use asset, lease liability, and lease receivable. when lease payments do change in the future (because index rate changes), we don't remeasure the lease liaibility or leased asset at that time, but simply report the additional amount as a seperate lease payment that produces expense for the lessee and revenue for the lessor. only if and when the lessee remeasures the lease liability for reasons other than a change in index or rate shoulld the lessee adjust the right-of-usee asset and lease liability for changes in the amount of payments.)

when does a contract meet the definition of a lease?

two key criteria must be met at the inception of the contract for an arrangement to constitute a lease: 1. there must be an identified asset. this means: -the asset must be property, plant, or equipment (not inventory, intangibles or natural resources), and -the asset must be specified in the contract as either (a) explicity with a identification or serial number or (b) implicitly with enough information to recognize the physically distinct asset that is the subject of the lease 2. the lessee must have the right to control the use of the identified asset, which requires that: -the customer can derive substantially all of the potential economic benefits from using the asset -the customer can direct the use of the asset throughout the contract term, and -the lessor cannot have the right to substitute an alternative asset anytime during the period of use and possibly benefit economically from such a substitution