Chp. 15 Notes

Lessors

..........are not permitted to reassess the initial determination of the lease term or discount rate.

Residual Value

Affects several aspects of lease accounting including: •Size of the periodic lease payments •Classification of the lease •Amounts recorded by the lessee and lessor

1. Implicit rate 2. Incremental borrowing rate

Two types of Discount Rates

incremental borrowing rate

When the lessor's implicit rate is not known, the lessee should use its own?

Leasehold Improvements

•Improvements made to a leased property by the lessee •Recorded in asset accounts descriptive of their nature •Cost of a leasehold improvement is amortized or depreciated over its useful life to the lessee

What if the Lease Term is Uncertain?

•The contractual lease term is adjusted for any periods covered by options to extend or terminate the lease for which exercise is deemed to be "reasonably certain" after considering the relevant economic factors •Factors that might create an economic incentive for the lessee include bargain renewal rates, penalty payments for cancellation or non-renewal and economic penalties such as significant customization or installment costs.

Finance/sales type Leases with Selling Profit for Lessees

•The lessee's accounting is not impacted by whether or not the lessor recognizes a profit. The journal entries made by the lessee are precisely the same with or without a selling profit for the lessor.

Implicit rate

•This is the desired rate of return that the lessor has in mind when deciding the size of the lease payments. Rate of return the lease payments provide the lessor under the lease.

Guaranteed Residual Value

•This provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value.

lessees

•When there is a change in the lease term,.................are required to reassess the classification of the lease.

Finance/sales type Leases with Selling Profit for Lessors

•When there is a selling profit, all lessor entries, other than the entry at the beginning of the lease to include the selling profit, are precisely the same as the entries for a sales-type lease without a selling profit.

General accounting for uncertainty of lease payment amounts

1) Because the amounts of future lease payments are uncertain and often avoidable, we don't consider them as part of the lease payments used to calculate the lessee's lease liability and the lessor's lease receivable. 2) If and when lease payments increase, the change in the lease payments has no effect on balance sheet accounts and simply is reported as a separate lease expense (lessee) and lease revenue (lessor).

Five criteria for finance / sales-type leases

1. Does the agreement specify that ownership of the asset transfers to the lessee? 2. Does this agreement contain a purchase option that is reasonably certain to be exercised? 3. Is the lease term the major part of the expected economic life of the asset? 4. Is the present value of the minimum lease payments equal to or greater than substantially all of the fair value? 5. Does the asset have no alternative future use?

Criteria for Leases

1. There must be an identified asset. -The asset must be property, plant, or equipment and, -The asset must be specified in the contract, either explicitly or implicitly 2. Lessee must have the right to control the use of the identified asset. -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

Criteria for Short-Term Leases

1.Has a lease term (including any options to renew or extend) of twelve months or less, and 2.Does not contain a purchase option that that the lessee is reasonably certain to exercise, which would extend the term beyond twelve months.

Advantages of leasing

1.Leasing reduces the upfront cash needed to use an asset. 2.Lease payments often are 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.

Amortization for Finance lease

Amortization reflects the right to use the asset and the financing of that right (interest expense).

True

Both the lessee and lessor use the same amortization schedule for recording interest. The lessee amortizes its lease payable and records interest expense. Similarly, the lessor amortizes its lease receivable and records interest revenue, reflecting the opposite side of the same transaction. TorF?

No, only non-movable assets can be recognized as a leasehold improvement

Can a movable asset be a leasehold improvement?

Non-debt liability.

For Operating Leases lease payable is considered a.............on the lesse's balance sheet.

operating

In an.........lease, it's the total lease expense, not the amortization component, that's a straight-line amount.

Bargain Purchase Option (BPO)

In practice, a purchase option whose exercise is reasonably certain is often referred to as a?

Lease

Is a contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset for a specified period of time. In return for this right, the lessee agrees to make stipulated, periodic cash payments during the term of the lease.

Purchase Option

Is a provision of some lease contracts that gives the lessee the option to purchase the lease asset during, or at the end of, the lease term at a specified exercise price.

Residual value

Is an estimate of what a leased asset's commercial value will be at the end of the lease term.

Selling profit

Is the difference between sales revenue and cost of goods sold.

Incremental borrowing rate

Is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

Operating lease

It is considered to be more in the nature of a rental agreement for a period of time.

1. Financing lease 2. Operating lease

Lease Classifications for lessee

1. Sales-type lease -without selling profit -with selling profit 2. Operating lease

Lease Classifications for lessor

Amortization for Operating lease

Lease expense is recorded in a manner designed to mirror straight-line rental of the asset during the lease term.

Effect of Residual Value on Lease Classification

Leases are classified as a finance/sales-type lease if, in substance, the lessor is selling the asset to the lessee. •Payments from the lessee are the periodic lease payments plus any portion of the residual value the lessee has guaranteed. •If the present value of the lease payments, including any lessee-guaranteed residual value constitutes "substantially all" of the fair value of the asset, it's a finance lease from the lessee's perspective and a sales-type lease from the lessor's perspective

Accounting for Short-term leases-Lessee

Lessee: •Can elect to not recognize a right-of-use asset or a lease liability. •Can recognize lease payments as expense over the lease term.

Reassessing the classification of the lease.

Lessees must apply the five criteria to determine whether the lease now meets the criteria for classification as a finance lease. If the classification has changed from an operating lease to a finance lease, then the lessee must account for the lease as a finance lease for the remainder of the lease term.

Implicit rate

Rate is used to consider the time value of money while calculating the present value.

Advance Payments

Represent prepaid rent (lease costs). •In a finance lease, any advance payments are included with other payments when the lessee determines the present value of lease payments to determine the right-of-use asset and lease liability and when the lessor calculates its lease receivable. •In an operating lease, advance payments are recorded as deferred rent revenue and allocated (normally on a straight-line basis) to rent revenue over the lease term.

Effect of Residual Value on Lease Payments

Residual value and lease payments have an inverse relationship If residual value increases the size of the lease payment decreases.

Uncertainty of Lease Payments

Sometimes lease payments are scheduled to be increased (or decreased) at some future date during the lease term, depending on whether or not some specified event occurs. Usually the contingency is related to: •Revenues •Profitability •Asset usage

Lease Expense

Stays the same each period-straight-line Impacts income statement • Reduce net income Operating lease- for Lessee

Discount rate used for Reassessment of a Lease Term

The discount rate for the new term is the incremental borrowing rate of the lessee using market interest rates at the time of the reassessment, rather than the rate used at the beginning of the lease

Amortization process for finance leases

The lessee normally should amortize a leased asset over the term of the lease. However, if ownership transfers, or exercise of a purchase option is reasonably certain (i.e., either of the first two classification criteria is met), the asset should be amortized over its useful life. The amortization process usually is on a straight-line basis unless the lessee's pattern of using the asset is different. That amortization results in an expense for the lessee.

Accounting for Short-term leases (Short-cut approach)

The shortcut approach for short-term leases permits the lessee to choose not to record an asset and related liability associated with the lease at the beginning of the lease term. Instead, the lessee can simply record lease payments as rent expense over the lease term. This is the approach used by the lessor for lease revenue on the flip side of the transaction.

Operating leases vs. Finance leases

Unlike Finance leases, Operating leases avoid front loading. As you can imagine, lessees tend to prefer the operating lease classification. It defers expense recognition, making net income higher in the early years of the lease.

1.There must be an identified asset. 2. Lessee must have the right to control the use of the identified asset

What are the two key criteria to determine if a contract is a lease?

Short-Term Lease - Shortcut Method

•A lease that has a maximum possible lease term (including any options to renew) of 12 months or less is a "short-term lease." •Lease-by-lease option to choose a shortcut approach.

Guaranteed 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. •The lessee promises to return not only the property but possibly also sufficient cash to meet the guaranteed amount promised in the lease agreement.

Accounting for Operating Leases

•A sale is not recorded by the lessor; the lessor records lease revenue on a straight-line basis. •Lessee records the right-of-use asset and lease payable at commencement based on present value of lease payments. Lessor does not record lease receivable.

Termination penalty

•Additional cash payment if the lessee is "reasonably certain" to terminate the lease. •If termination is predicted, we consider the lease term to be from the beginning of the lease to the expected termination date.

Initial Direct Costs

•Costs associated directly with consummating a lease•Essential to execute the lease•would not have been incurred had the lease agreement not occurred Ex: 1. Preparing and processing lease documents 2. Commission 3. Legal fees

Operating Leases

•Doesn't meet any of the criteria for a finance lease •Fundamental rights and responsibilities of ownership are retained by the lessor •Lessee merely uses the asset temporarily

Sales-Type Leases with Selling Profit

•Occurs when the fair value of the asset exceeds the cost or carrying value. •Lessor recognizes a selling profit at the beginning of the lease term. •Lessor also recognizes interest revenue over the lease term.

Reassessment of the Lease Term •Circumstances can change that require reassessment of a lease term.

•Reassessment requires a "triggering event" such that the lessee now has an economic incentive to exercise an option that extends or terminates the lease. • •The 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.