Exam 1 ACT 311

What is a Lease?

-A lease is a contract that gives a lessee (user) the right to control the use of an asset for a period of time. The lessee pays the lessor (owner) for that right, typically with a series of payments made over the lease term. -Lease agreements are common in our daily lives, as well as in business...

Lease Classification Criteria

1. Ownership of the asset transfers to the lessee at the end of the lease term. 2. A purchase option exists that the lessee is reasonably certain to exercise 3. A purchase option exists that the lessee is reasonably certain to exercise 4. The present value of total lease payments equals or exceeds "substantially all" (90%) of the fair value of the leased asset 5. The present value of total lease payments equals or exceeds "substantially all" (90%) of the fair value of the leased asset

A deferred tax asset is best described as:

A future tax benefit resulting from a future deductible amount

Chapter 15: Accounting for Leases Out:

Comparison to installment notes, Statement of cash flow impact, Lease disclosures, Sale leaseback arrangements.

A lease might specify that lease payments may be increased (decreased) at some future time during the lease term depending on whether or not some specified event occurs such as revenues or profits exceeding some designated level. Under what circumstances are contingent rentals included or excluded from "lease payments"? If excluded, how are they recognized in income determination?

Contingent rentals are not included in lease payments but are reported in disclosure notes by both the lessor and lessee. This is because they are not determinable at the beginning of the lease. They are included as components of income when (and if) the payments occur. An exception is when apparent "variable" payments actually are fixed payments in disguise, these in-substance fixed payments are considered as part of the lease payments.

For financial reporting, income tax expense includes the following two components:

Current income tax & deferred income tax

Matt Co. is the lessor in connection with an operating lease. In connection with this lease agreement Matt Co. would record:

Depreciation expense

What is intra-period tax allocation?

Intra-period tax allocation means the total income tax obligation for a reporting period is allocated among the income statement items that gave rise to the income tax. The following items should be reported net of their respective income tax effects: • Income (or loss) from continuing operations • Discontinued operations • Amounts included in other comprehensive income

Lessor, sales-type lease w/o profit:

deferred & expensed over the lease-term

Lessor, operating lease

deferred and expensed over the lease-term.

Lessor, sales-type lease w/ profit:

expensed at commencement with "sale"

One of the five criteria for a finance lease specifies that the lease term be equal to or greater than:

the major part of the remaining economic life of the leased asset

a commitment to compensate the lessor for a shortfall in the value of the underlying asset at the end of the lease term.

a commitment to compensate the lessor for a shortfall in the value of the underlying asset at the end of the lease term.

What is an "Uncertain Tax Position"?

-Tax returns are prepared & filed by the taxpayer, and subject to subsequent audit by taxing authorities of each jurisdiction... -Positions taken by the taxpayer on its filed returns can be inherently "uncertain" as to outcome because... +Income tax laws are subject to different interpretations between taxpayer & taxing authorities +Some tax positions are subject to estimates & judgments, which could differ between taxpayer & taxing authority

Temporary Differences

-Amounts that are reported in different periods for financial reporting (GAAP) vs. income tax returns (IRS) are referred to as "temporary differences"... -Because financial statements are prepared on an accrual basis, income tax expense will include both... +A current expense reflecting amounts due on income tax return filings for the current period; and +A deferred expense, reflecting amounts expected to be paid in the future for taxable/deductible amounts arising from current period activities that will be reported on future tax returns

plus lease payments

-Any exercise price for a purchase option, if exercise is reasonably certain -Any payment for a termination penalty, if termination is reasonably certain -any payment for a guaranteed residual value*... -Certain variable payments, only if based on an index or rate, with no increase / decrease included for changes in the index / rate after commencement of the lease

Balance Sheet Disclosure: Deferred Taxes

-Deferred taxes (assets and liabilities) are presented as non-current in the balance sheet -Total of deferred tax assets and liabilities -Tax effect of each type of temporary difference -Total valuation allowance and reconciliation of changes in the valuation allowance

Plus lease term

-Periods covered by renewal options if the option is under the control of the lessor. -Periods covered by renewal options under the control of the lessee, if exercise of the option is "reasonably certain" -Periods following a termination option if it's "reasonably certain" the option will not be exercised

When Tax Rates Change, How Does That Impact Deferred Tax Amounts?

-To measure deferred tax assets and liabilities we multiply temporary differences by the enacted tax rate that will be effective in the year(s) the temporary differences reverse -The rate used would reflect all jurisdictions (i.e.: federal, state, etc.) where those differences are deductible / taxable -Deferred tax rates are not based on anticipated legislation; the impact of changes in tax rates is accounted for in the year the tax rate change is enacted into law...

The income tax rate for Hudson Refinery has been 35% for each of its 12 years of operation. Company forecasters expect a much-debated tax reform bill to be passed by Congress early next year. The new tax measure would increase Hudson's tax rate to 42%. When measuring this year's deferred tax balances, which rate should Hudson use?

A deferred tax liability (or asset) is based on enacted tax rates and laws. Hudson should use the 35% rate, the currently enacted tax rate that will be effective in the year(s) the temporary difference reverses. Calculations are not based on anticipated legislation that would alter the company's tax rate.

King Cones leased ice cream-making equipment from Ace Leasing. Ace earns interest under such arrangements at a 6% annual rate. The lease term is eight months with monthly payments of $10,000 due at the end of each month. King Cones elected the short-cut lease option. What journal entries would King Cone make at the inception of the lease? What is the effect of the lease on King Cones' earnings during the eight-month term?

A lessee that has a short-term lease has the option to not record the right-of-use asset and the liability to make lease payments and instead to simply record lease expense for the amount of each lease payment. No amounts would be recorded at commencement of the lease. Lease expense would be recorded as monthly payments are made ($80,000 in total).

Lease term includes:

All periods that are not cancellable at the option of the lessee...

On January 1, 2018, Wellburn Corporation (lessee) leased an asset from Tabitha Company (lessor). The lease agreement is an operating lease that calls for four annual payments beginning on January 1, 2018, in the amount of $36,000, with remaining payments due on January 1 of each subsequent year. On January 1, 2018, Tabitha would record a debit to cash for $36,000 and a credit for the same amount to which account?

Deferred rent revenue

Chapter 16: Accounting for Income Taxes In:

Deferred tax assets (future deductible amounts), Deferred tax liabilities (future taxable amounts), Temporary differences, Taxable income and current taxes, Deferred tax valuation allowances, Permanent differences, Changes in tax rates, Net operating losses, Uncertainty in income taxes, Intra-period tax allocation.

The benefit of future deductible amounts can be achieved only if future taxable income is sufficient to take advantage of the deferred deductions. For that reason, not all deferred tax assets will ultimately be realized. How is this possibility reflected in the way we recognize deferred tax assets?

Deferred tax assets are recognized for all deductible temporary differences and operating loss carry-forwards. However, a deferred tax asset is then reduced by a valuation allowance if it is "more likely than not" that some portion or the entire deferred tax asset will not be realized. The decision as to whether a valuation allowance is needed should be based on the weight of all available evidence.

At the beginning of an operating lease, the lessor will record what asset(s), if any?

In an operating lease, the lessor records no lease receivable and does not remove from its balance sheet the asset being leased. So, it records no new asset, but records depreciation on the asset that remains on it's balance sheet. The lessor would also record lease revenue as lease payments are received

From the perspective of the lessee, leases may be classified as either:

Finance or operating

Sometimes a temporary difference will produce future deductible amounts. Explain what is meant by future deductible amounts. Describe two general situations that have this effect. How are such situations recognized in the financial statements?

Future deductible amounts mean that taxable income will be decreased relative to pretax accounting income in one or more future years. These situations have favorable tax consequences that are recognized as deferred tax assets. Examples include...

At the beginning of a sales-type lease, the lessor will record what asset(s), if any?

In a sales-type lease, the lessor removes from its balance sheet the asset being leased, and records a lease receivable equal to the present value of lease payments over the term of the lease. As lease payments are made the lessor records interest revenue. Because the lessor removes the asset from its books it would not have depreciation to record.

Chapter 16: Accounting for Income Taxes Out:

Income tax disclosures, Financial statement presentation.

A member of the board of directors is concerned that the company's income statement reports income tax expense of $12.3 million, but the income tax obligation (payable) at year-end is only $7.9 million (and there were no estimated taxes paid during the year). How might this difference be explained?

Income tax expense is comprised of both the current and the deferred tax consequences of events and transactions already recognized. The difference between amounts reported as income tax expense, and amounts currently payable, would be due to deferred tax consequences.

Chapter 15: Accounting for Leases In:

Lease classification, Accounting for leases by lessee, Accounting for leases by lessor, Short-term leases, Uncertainty in lease transactions, Initial direct costs, Leasehold improvements, Non-lease components.

The "valuation allowance" that is sometimes used in conjunction with deferred taxes relates:

Only to deferred tax assets

Minus lease term

Periods following date of purchase option if exercise is "reasonably certain"

The lessee normally measures the lease liability to be recorded as the:

Present value of lease payments over the term of the lease

What non-lease costs [components] might be included as part of lease payments? How are they accounted for by the lessee in a finance lease when paid by the lessee? When paid by the lessor?

Repairs, maintenance, insurance, and property taxes are costs often associated with owning and operating an asset. Payments for property insurance & taxes are always considered to be "lease payments" (i.e.: a component of the lease), and therefore included in the measurement of the right-of-use asset. Payments for repairs and maintenance (and utilities) are considered "non-lease components" and therefore may be expensed as a separate cost when incurred (i.e.: not included in the measurement of the right-of-use asset). A lessee may, however, elect to include non-lease components in its measurement of the ROU asset.

When a finance lease is first recorded at the beginning of the lease, the lessee debits:

Right-of-use asset

From the perspective of the lessor, leases may be classified as either:

Sales-type without selling profit or sales-type with selling profit or operating

Temporary differences result in future taxable or deductible amounts. Some financial statement vs. tax return differences do not result in future tax consequences. What are these differences called? What are examples? What effect do these differences have on current taxes payable? Deferred taxes? Tax expense?

Some provisions of the tax laws exempt certain revenues from taxation and prohibit the deduction of certain expenses. These are referred to as "permanent" differences. Permanent differences result in an increase / decrease to current taxes payable and income tax expense, but have no impact on deferred taxes.

A six-year lease can be renewed for two additional three-year periods, and it also can be terminated after only three years. How do the lessee and lessor decide the lease term to be used in accounting for this lease?

Sometimes the actual term of a lease is not obvious. In these situations, we need to decide whether the lessee is "reasonably certain" to exercise any renewal, purchase, or termination options. If so, both the lessee and lessor adjust the lease term accordingly. Otherwise, they use the contractual lease term.

Taco King leases retail space from Fogleman Properties. The 10-year finance lease requires quarterly variable lease payments equal to 3% of Taco King's sales revenue, with a quarterly sales minimum of $400,000. During the previous 5-year period Taco King generated sales revenue in excess of $650,000 each quarter (20 consecutive quarters). What should Taco King use as total lease payments for classification of / accounting for this lease?

Taco King made an initial lease payment at the commencement of the lease (January 1), and will make quarterly payments thereafter based on the previous quarter's sales. Assuming a 4% annual implicit interest rate and a present value factor of 33.16303, what journal entry would Taco King make to record its April 1 lease payment if first quarter sales were $660,000?

What are initial direct costs? How are initial direct costs accounted for by the lessee?

The incremental costs (those that would not have been incurred had the lease agreement not occurred) of consummating a lease transaction that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs. They include legal fees, commissions, and preparing and processing lease documents.

How Do I Determine the Lease Term?

The lease term is based on the non-cancellable period for which a lessee has the right to use the asset. Periods subject to lessee renewal or termination options would not be included in the lease term unless economic factors indicate that continuation of the lease appears to be reasonably certain at lease commencement. The lease term includes periods covered by renewal or early termination options if their exercise is controlled by the lessor.

A lease agreement contains no purchase option or transfer of ownership. The lease would be classified as a "short-term" lease if:

The lease term is less than 12 months

At the beginning of a finance lease, the lessee will record what asset and liability, if any?

The lessee acquires the right to use the asset and will record a right-of-use asset and lease liability for the present value of lease payments.

At the beginning of an operating lease, the lessee will record what asset and liability, if any?

The lessee acquires the right to use the asset and will record a right-of-use asset and lease liability for the present value of lease payments.

To address "uncertainty" in accounting for income taxes, a company is allowed to recognize a tax benefit in its financial statements only if:

The tax position resulting in the tax benefit will "more likely than not" be sustained

A lease that has a lease term (including any options to terminate or renew that are reasonably certain) of 12 months of less is considered a "short-term lease". How does a lessee record a lease using the short-cut approach available as an option for short-term leases?

When a lessee has a short-term lease it's acceptable to use a short-cut approach and forego recording the right-of-use asset and the lease payable. The lessee simply recognizes lease payments as expense over the lease term.

A residual value guarantee

a commitment to compensate the lessor for a shortfall in the value of the underlying asset at the end of the lease term.

Lessee

added to ROU asset

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 lease agreement not occurred, are referred to as "initial direct costs". Initial direct costs incurred by the lessee are:

added to the right-of-use asset and expensed over an amortization period