chapter 18 self test questions

what is the difference between an operating lease and a financial (Capital) lease?

Operating Lease- A lease whose term is much shorter than the expected useful life of the asset being leased. Generally, provide both financing and maintenance. Operating leases typically require the lessor to maintain and service the leased equipment, with the cost of maintenance built into the lease payments. Operating leases are not fully amortized, meaning the payments required under the lease contract are not sufficient for the lessor to recover the full cost of the equipment. A final feature of operating leases is that they frequently contain a cancellation clause that gives the lessee the right to cancel the lease and return the equipment to the lessor prior to the expiration of the lease. Financial Lease- A lease agreement that has a term (life) approximately equal to the expected useful life of the leased asset. They differ from operating leases in that they (1) typically do not provide for maintenance, (2) are typically not cancelable, (3) are generally for a period that approximates the useful life of the asset, and (4) are fully amortized.

what is a sale and leaseback?

Special type of financial lease, often used with real estate, which can be arranged by a user who currently owns some asset. The user sells the asset to another party and simultaneously executes an agreement to lease the property for a stated period under specific terms. In a sale and leaseback, the lessee receives an immediate cash payment in exchange for a future series of lease payments that must be made to rent the use of the asset sold.

what is tax exempt lease?

A special type of financial transaction created for not-for-profit businesses. The major difference between a tax-exempt lease and a conventional lease is that the implied interest portion of the lease payment is not classified as taxable income to the lessor, so it is exempt from federal income taxes. The rational for this tax treatment is that the interest paid on most debt financing used by not-for-profit organizations is tax exempt to the lender, and a lessor is, in actuality a lender.

how are leases accounted for on a business's balance sheet? on income statement?

Balance Sheet- capital (long-term) leases, the leased property is reported as an asset and the present value of lease payments is reported as a liability. Income Statement- expense item, depreciation expense

how do per procedure payment term differ from conventional terms?

Conventional terms- fixed payments are made to the lessor periodically, usually monthly. With this type of payment, the costs to the lessee (and the return to the lessor) is known (more or less) with certainty. Per procedure payment terms- a fixed amount is paid each time the equipment is used. In this case, the cost to the lessee and the return to the lessor are not known with certainty—rather, they depend on volume.

what is the difference between a tax-oriented (guideline) lease and a non-tax-oriented lease?

Guideline lease (tax-oriented lease)- A lease the complies with all of the IRS requirements for taxable businesses. In a guideline lease, ownership (depreciation) tax benefits accrue to the lessor, and the lessee's lease payments are fully tax deductible. Non-tax-orientated lease- a lease that does not meet the tax guidelines of the IRS. For this type of lease, a for-profit lessee can deduct only the implied interest portion of each lease payment. However, in this situation the IRS considers the lessee the owner of the leased equipment, so the lessee, rather than the lessor, obtains the tax depreciation benefits.

what is the primary effect of the new lease accounting rule?

Leases would no longer be classified by accountants as operating or capital. Rather, all leases greater than one year in length would be accounted for in the same way on the balance sheet—there would be no difference between short-term and long-term leases. All leased property would be listed on the asset side as "right to use assets" and on the liabilities side as "lease liabilities". Over the term of the lease, leased assets would be depreciated by the straight-line method and lease liabilities would be decreased by the rental payments made. The ultimate purpose is to eliminate operating leases as a source of off-balance-sheet financing and hence report all leases directly on the balance sheet.

why is leasing financing sometimes called off-balance-sheet financing?

Under certain conditions, neither the leased asset nor the contract liabilities (present value of lease payments) appear on the lessee's balance sheet.