Chapter 13
Net investment continue
-Sales revenue (price) is credited for the present value of the minimum lease payments (PV of periodic lease payments + PV of guaranteed residual value). -The asset is credited for its cost or carrying amount. -Cost of goods sold is debited for the cost or carrying amount, plus any initial direct costs, minus the present value of any unguaranteed residual value.
Gross investment
-The gross investment is the amount of lease payments receivable recognized by the lessor at the inception of the lease. It equals the minimum lease payments plus the unguaranteed residual value. Essentially, it is the total of cash and other assets that the lessor expects to receive over the lease term. Gross investment = Minimum lease payment + unguarenteed residual value
Types of contingencys
A contingency may be -Probable. Future events are likely to occur. -Reasonably possible. The chance of occurrence is more than remote but less than probable. -Remote. The chance of occurrence is slight.
Calculating profit or loss
Assuming no initial direct costs, the manufacturer's or dealer's profit or loss on sales-type leases (gross profit) is calculated as follows: -PV of minimum lease payments (Asset's cost or carrying amount) -PV of unguaranteed residual value -Gross profit on sales-type lease
able to recognize immediatly under the "Another exception" for operating
The portion of gain on the sale that may be immediately recognized equals the difference between the total gain on the sale and the present value of the minimum lease payments. Asset's sale price (Asset's carrying amount) =Total gain on the sale (PV of minimum lease payments) -Gain recognized immediately
Summary of how to depreciate Capitalization critera
Capitalization Depreciation Criterion Satisfied Period 1 Economic Life 2 Economic Life 3 Lease Term 4 Lease Term
The lessor records the following journal entry:
Cash or rent receivable DR Rent income CR
estimate
The estimate of residual value is reviewed at least annually. A nontemporary decrease results in revision of the accounting for the transaction and recognition of an irreversible loss because of the reduction in the net investment.
Final exception
The third exception applies when the carrying amount of the asset exceeds its fair value. In this case, a loss must be immediately recognized.
Gain Contingencies
-Gain contingencies are recognized only when realized. For example, an award of damages in a lawsuit is not realized if it is being appealed. -A gain contingency must be adequately disclosed in the notes to the financial statements.
Other remote loss contingencies No accrual is permitted
-Other remote loss contingencies that should be disclosed are obligations of commercial banks under standby letters of credit and guarantees to repurchase receivables (or the related property) that were sold or assigned. -No accrual is permitted for general or unspecified business risks, for example, those related to national and international economic conditions. No disclosure is required.
Operating leasee acounting
-Rent is reported as an expense by the lessee in accordance with the lease agreement. -If rental payments vary from a straight-line basis (e.g., if the first month is free), rent expense is recognized over the full lease term on the straight-line basis. Thus, an equal amount of rent expense will be recognized each period over the lease term. The lessee records the following journal entry:
13.8 CONTINGENCIES -- RECOGNITION AND REPORTING
13.8 CONTINGENCIES -- RECOGNITION AND REPORTING
Another Exception
Another exception applies when the seller-lessee retains more than a minor part (more than 10%) but less than substantially all (less than 90%) of the rights to the remaining use of the property. 10% of the property's fair value < PV of lease payments < 90% of the propertys fair value In this case, the amount of gain on sale that should be deferred and the amount of gain on sale that should be recognized immediately depend on whether the leaseback is classified as a capital or an operating lease. If the leaseback is classified as an operating lease, the gain on the sale up to the present value of the lease payments must be deferred and subsequently amortized.
Gleim tip
Historically, the AICPA has asked conceptual questions involving contingencies. Successful candidates will know how to ascertain if situations are probable or remote loss contingencies.
Reasonable loss
If one or both conditions are not met but the probability of the loss is at least reasonably possible, the nature of the contingency must be described. -Also, an estimate of the amount or the range of loss must be disclosed, or a statement must be included indicating that an estimate cannot be made.
For captial lease for the another exception
If the leaseback is classified as a capital lease, the gain on sale up to the recorded amount of the leased asset (the present value of minimum lease payments or, if lower, the fair value of the asset) must be deferred and subsequently amortized. Asset's sale price (Asset's carrying amount) =Total gain on the sale (Recorded amount of the leased asset) =Gain immediately recognized
Sales-type lease
In a sales-type lease, the lessor recognizes a manufacturer's or dealer's profit or loss. The fair value (selling price) of the leased property at the lease's inception differs from its cost or carrying amount.
Gross investment -sales type
The gross investment is the amount of lease payments receivable recognized by the lessor at the inception of the lease. It equals the minimum lease payments plus the unguaranteed residual value. This amount is the same for sales-type and direct-financing leases. Gross investment= Minimum lease payment + unguranteed residual value
Capital lease
The lessee may capitalize the lease based on the third criterion (lease term) or the fourth criterion (PV of minimum lease payments). In these cases, the asset is depreciated over the lease term to its expected value to the lessee, if any, at the end of that term.
Recording a capital lease
The lessee records a capital lease as an asset and an obligation at an amount equal to the present value of the minimum lease payments. Leased property DR Lease obligation CR
Unearned interest income
Unearned interest income is the difference between the gross investment and the present value of the gross investment using the interest rate implicit in the lease. -Gross investment -(PV of minimum lease payments) -(PV of unguaranteed residual value) Unearned interest income The unearned interest income must be amortized to income over the lease term using the interest method.
Capital Leases
-A lease is classified as a capital lease by the lessee if, at its inception, one or more of four criteria is satisfied. The presence of any of the following indicates that substantially all of the benefits and risks of ownership have been transferred: 1.The lease provides for the transfer of ownership. 2.The lease contains a bargain purchase option (BPO). 3.The lease term is 75% or more of the estimated economic life of the leased property. -This criterion is inapplicable if the beginning of the lease term falls within the last 25% of the property's total estimated economic life. 4.The present value of the minimum lease payments is at least 90% of the fair value of the leased property to the lessor at the inception of the lease. -This criterion is inapplicable if the beginning of the lease term falls within the last 25% of the property's total estimated economic life. Memory aid: Owners bargain for life and fair value. If a lease covers only land and provides for either a transfer of ownership at the end of its term or a BPO, the lessee capitalizes the lease. Otherwise, it is accounted for as an operating lease.
Operating lease
-A lessee does not recognize depreciation for an operating lease. -However, general improvements to leased property should be capitalized as leasehold improvements and amortized in accordance with the lessee's normal depreciation policy over the shorter of their expected useful life or the lease term.
Probable Loss Contingencies
-A material contingent loss must be accrued (debit loss, credit liability or asset valuation allowance) when two conditions are met. Based on information available prior to the issuance (or availability for issuance) of the financial statements, accrual is required if 1.It is probable that, at a balance sheet date, an asset has been impaired or a liability has been incurred, and 2.The amount of the loss can be reasonably estimated. -The amount that appears to be a better estimate than any other within a range of loss must be accrued. 1.If no amount within that range appears to be a better estimate than any other, the minimum should be accrued. -Disclosure of the nature of the accrual and, in some cases, the amount or the range of loss may be required to prevent the financial statements from being misleading.
Sales leaseback Classification
-A sale-leaseback involves the sale of property by the owner and a lease of the property back to the seller. -If the lease qualifies as a capital lease, the gain or loss on the sale is normally deferred and amortized by the seller-lessee in proportion to the amortization of the leased asset, that is, at the same rate at which the leased asset is depreciated. -The gain deferred may be reported as an asset valuation allowance (a contra asset with a credit balance). -A loss occurs when the carrying amount is greater than the fair value. In this instance, the full loss is recognized immediately. -However, if the carrying amount is greater than the sale price but the fair value exceeds the carrying amount, the loss is deferred and amortized as prepaid rent.
13.4 LESSEE ACCOUNTING FOR CAPITAL LEASES -- OTHER CONSIDERATIONS
-An asset recorded under a capital lease by the lessee must be depreciated in a manner consistent with the lessee's normal depreciation policy. -Thus, the lease obligation is accounted for under lease accounting. However, the depreciation of the asset is the same as if the lessee owned the asset. If the lease is capitalized because the lease either transfers ownership to the lessee by the end of the lease term (criterion 1) or contains a bargain purchase option (BPO) (criterion 2), -the depreciation of the asset is over its entire estimated economic life.
If sales leaseback qualifies as an operating lease
-If the lease qualifies as an operating lease, a gain or loss on the sale normally should be deferred and amortized in proportion to the gross rental payments expensed over the lease term. -When the seller-lessee classifies the lease as an operating lease, no asset is reported on the balance sheet. Thus, the deferral cannot be presented as a contra asset. Accordingly, the usual practice is to report the gain or loss as a deferred credit or debit.
Direct Financing Leases
-In a direct financing lease, the lessor's economic interest is in financing the purchase, not promoting the sale of its product. -The lessor recognizes no manufacturer's or dealer's profit or loss in connection with the lease. The fair value of the leased property and its cost or carrying amount are the same at the inception of the lease.
Classification
-Lease classification is slightly more complex for the lessor. A lessor can capitalize a lease if it meets one of the four criteria described in item 2.b. of Subunit 13.1 and two additional criteria: -Collectibility of the remaining payments is reasonably predictable, and -No material uncertainties exist regarding unreimbursable costs to be incurred by the lessor. -If the lease is to be capitalized, the lessor also must determine whether it is a direct financing or sales-type lease.
Exceptions
-One exception applies when the seller-lessee retains only a minor portion (less than 10%) of the rights to the remaining use of the property. -The test for determining the portion of the rights retained is based on the ratio of the present value of the lease payments to the fair value of the leased property. -The seller-lessee retains only a minor portion of the rights to the remaining use of the property when the present value of the lease payments is less than 10% of the fair value of the leased property. PV of lease payments < 10% of FV of the leased property -In this case, no gain or loss is deferred. The seller-lessee must account for the sale and the leaseback as separate transactions based upon their respective terms. Accordingly, the gain or loss on the sale must be recognized immediately.
Lessor Accounting
-Operating leases do not meet the criteria for capitalization. -They are transactions in which lessees rent the right to use lessor assets without acquiring a substantial portion of the benefits and risks of ownership. -Thus, the lessor does not record a sale or financing. -Rent is reported as revenue by the lessor in accordance with the lease agreement. -If rental payments vary from a straight-line basis (e.g., if the first month is free), rental revenue should be recognized over the full lease term on the straight-line basis. Thus, an equal amount of rental revenue will be recognized each period over the lease term
Remote Loss Contingencies
-These loss contingencies ordinarily are not disclosed. -However, a guarantee (e.g., of the indebtedness of another or to repurchase receivables) must be disclosed even if the probability of loss is remote. -The disclosure should include the nature and amount of the guarantee. 1.This disclosure is required whether the guarantee is direct or indirect. 2.A guarantee is a noncontingent obligation to perform after the occurrence of a triggering event or condition. It is coupled with a contingent obligation to make payments if such an event or condition occurs. Thus, recognition of a liability at the inception of a guarantee is required even when it is not probable that payments will be made. 3.The initial measurement of a noncontingent obligation ordinarily is at fair value. If a contingent loss and liability also are required to be recognized, the liability recognized by the guarantor is the greater of the fair value measurement or the contingent liability amount.
Unearned interest income
-Unearned interest income recognized by the lessor at the inception of the lease equals the difference between the gross investment and the cost (carrying amount) of the leased property. Unearned interest income = Minimum lease payment - carrying amount of lease projects. -Unearned interest income also equals the difference between the gross investment and the present value of the gross investment.
Components of Lessee's Minimum Lease Payments -Minimum rental payments -Bargain purchase option -
1.Minimum rental payments are the periodic amounts owed by the lessee, minus any executory costs (such as insurance, maintenance, or taxes) to be paid by the lessor. 2. A bargain purchase option (BPO) gives the lessee the right to purchase the leased property for a price lower than its expected fair value at the date the BPO becomes exercisable. To qualify as a BPO, the option price must be sufficiently low that exercise "appears, at the inception of the lease, to be reasonably assured." 3.Guaranteed residual value. The residual value is generally the estimated fair value of the leased property upon expiration of the lease. All or part of this amount may be guaranteed by the lessee. Any amount guaranteed by the lessee is, in effect, a final payment to the lessor. -The amount of guaranteed residual value to be included in the lessee's minimum lease payments is the maximum amount the lessee is obligated to pay. -A guarantee of residual value may be obtained by the lessee from an unrelated third party for the benefit of the lessor. This third-party guarantee is specifically excluded from the lessee's minimum lease payments if the lessor explicitly releases the lessee from liability on a residual value deficiency. 4.A nonrenewal penalty is a required payment by the lessee upon failure to renew or extend the lease at the end of the lease term. -Minimum lease payments do not include contingent rentals.
If the lessors implicit rate is unknown to the lessee
3.If the lessor's implicit rate is unknown to the lessee, the lessor and the lessee may use different rates. -The higher the rate used, the lower the present value of the minimum lease payments and the less likely that the fourth capitalization criterion will be met. -Thus, if the lessee and lessor use different rates, one might recognize an operating lease and the other might recognize a capital lease. -Given a BPO, the minimum lease payments have two components: (1) minimum rental payments and (2) the amount of the BPO. If no BPO exists, the minimum lease payments may have three components: (1) the minimum rental payments, (2) the amount of residual value guaranteed by the lessee, and (3) any nonrenewal penalty imposed.
Contingency
A contingency is "an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (a gain contingency) or loss (a loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." A contingency should not be confused with an estimate. Thus, the estimated depreciation for the period is not consistent with the definition of a contingency because it is certain that the utility of a depreciable asset will expire.
IFRS difference
A lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. Whether the lease is a finance lease (a capital lease under U.S. GAAP) or an operating lease depends on the substance of the transaction. IFRS provide examples and indicators of situations that individually or together can result in classification as a finance lease but are not always conclusive. Thus, a lease is classified at its inception as a finance lease if, for example, (1) it provides for the transfer of ownership of the leased asset by the end of the lease term, (2) it contains a bargain purchase option, (3) the lease term is for the major part of the economic life of the leased asset, (4) the present value of the minimum lease payments is at least substantially all of the fair value of the leased asset at the inception of the lease, and (5) the leased asset is such that it can be used only by the lessee without major modification. Other factors also may indicate classification as a finance lease: (1) lessor losses from cancelation of the lease are borne by the lessee, (2) the lessee bears the risk of fluctuations in the fair value of the residual value, and (3) the lessee may renew the lease at a rent substantially below the market rent. Essentially, a lease that is classified as a capital lease under U.S. GAAP also is classified as a finance lease under IFRS.
LESSEE ACCOUNTING FOR CAPITAL LEASES -- SUBSEQUENT MEASUREMENT Amortization
Amortization of Lease Obligation and Balance Sheet Presentation -Each periodic lease payment made by the lessee has two components: interest and the reduction of the lease obligation. -If the first periodic lease payment is made at the inception of the lease, its only component is the reduction of the lease obligation. No interest expense is recognized for the first payment because no time has elapsed between the inception of the lease and the payment. -The effective-interest method (also known as the effective-rate method or the interest method) is required. It applies the appropriate interest rate to the carrying amount of the lease obligation at the beginning of each period to calculate interest expense. - The portion of the minimum lease payment in excess of interest expense reduces the lease liability. -In a classified balance sheet, the lease liability must be allocated between current and noncurrent portions. The current portion at a balance sheet date is the reduction of the lease liability in the forthcoming year.
Examples of Noncontingent obligations
Examples of a noncontingent obligation are 1.A standalone guarantee given for a premium (debit cash or a receivable), 2.A standalone guarantee to an unrelated party without consideration (debit expense), or 3.An operating lessee's guarantee of residual value (debit prepaid rent).
Disclosures
Future minimum lease payments as of the latest balance sheet presented must be disclosed in the aggregate and for each of the 5 succeeding fiscal years. This disclosure is required whether the lease is a capital or an operating lease.
Initial direct costs Net investments
Initial direct costs include the lessor's costs to originate a lease incurred in dealings with independent third parties that directly result from, and are essential to, the acquisition of the lease. -Net investment equals the present value of gross investment (assuming no initial direct costs were recognized). The gross investment is discounted by using the interest rate implicit in the lease. 1.In a direct financing lease, the net investment equals gross investment plus any unamortized initial direct costs minus the unearned income. 2. The unearned interest income and the initial direct costs must be amortized to income over the lease term using the interest method. 3. In a direct financing lease, the net investment recognized at the inception of the lease (PV of the gross investment) equals the carrying amount (the fair value) of the leased property. The following journal entry is recorded by the lessor at the inception of a direct financing lease: Lease receivables (gross investment) DR Asset (FV = carrying amount) CR Unearned interest income CR
Leases over view
Leases are classified in one of two ways. -Substantially all of the benefits and risks of ownership remain with the lessor under an operating lease. Such a lease is a simple rental arrangement. -Substantially all of the benefits and risks of ownership are transferred to the lessee under a capital lease. Such a lease is a purchase-and-financing arrangement.
Lessor accounting continued
Nonrefundable lease bonuses also should be recognized as rental revenue on a straight-line basis over the lease term. The lessor must report the leased property near property, plant, and equipment in the balance sheet. It must depreciate the property according to its normal depreciation policy for owned assets. Initial direct costs, such as realtor fees, must be deferred and amortized by the lessor over the lease term in proportion to the recognition of rental income.
IFRS Difference
Provisions are liabilities of uncertain timing or amount except (1) those resulting from unperformed contracts (unless their unavoidable costs exceed their expected benefits) or (2) those covered by other IFRS. Examples are liabilities for violations of environmental law, nuclear plant decommissioning costs, warranties, and restructurings. Recognition of provisions is appropriate when (a) the entity has a legal or constructive present obligation resulting from a past event (called an obligating event), (b) it is probable that an outflow of economic benefits will be necessary to settle the obligation, and (c) its amount can be reliably estimated. If the estimate of a provision is stated within a continuous range of possible outcomes, and each point in the range is as likely as any other, the midpoint is used. A contingent liability is a possible obligation arising from past events. Its existence will be confirmed only by uncertain future events not wholly within the entity's control. A liability also is contingent if it is a present obligation that arises from past events but does not meet the recognition criteria (i.e., either a transfer of economic benefits is not probable or no reliable estimate can be made). A contingent liability must not be recognized. However, it should be disclosed unless the possibility of resource outflows is remote. A contingent asset must not be recognized, but it is disclosed if an inflow of economic benefits is probable (similar to accounting for gain contingencies under U.S. GAAP).
The lessee records the following journal entry:
Rent expense DR Cash or rent payable CR
Minimum lease payment
The minimum lease payments calculated by the lessor are the same as those for the lessee except that they include any residual value or rental payments beyond the lease term guaranteed by a financially capable third party unrelated to the lessor or the lessee. Lessor's PV of minimum lease payments= Lessee's PV of minimum lease payments+Amounts guaranteed by independent third party The effect of this difference may be that the fourth capitalization criterion is met by the lessor bu
Net investment journal entry - Sales type
The net investment equals the gross investment minus the unearned interest income. The following journal entry is recorded by the lessor at the inception of a sales-type lease: Lease payments receivable DR Cost of goods sold DR Unearned interest income CR Sales revenue CR Asset CR
Purchaser-Lessor Accounting
The purchaser-lessor accounts for a sale-leaseback transaction as a purchase and a direct financing lease if the capitalization criteria are satisfied. If these criteria are not met, the lessor records a purchase and an operating lease.
