CPA FAR F4

Employee-Related Liabilities

Payroll taxes → Expense for the employer

Payroll deductions → Not an expense for the employer

• Unemployment taxes and the employer’s share of payroll taxes

  • Accrued by the employer as an expense

  • Liability is liquidated when amounts are remitted to the appropriate taxing authority

• Payroll deductions

  • Treated similar to sales taxes payable

  • Deductions for Social Security, Medicare, and income taxes withheld from employees out of the gross pay from paychecks

  • Expense to the employee, not the employer

  • Credited to a payable account until remitted

Accrued Vacation

• Vacation accruals are recorded in the year earned if all of the following conditions are met:

  • S - Services have been rendered by employees

  • O - Obligation relates to rights that vest or accumulate

  • C - Payment of the compensation is probable

  • R - Amount can be reasonably estimated

Exit or Disposal Costs

• Involuntary employee termination benefits (severance pay)

• Costs to terminate a contract that is not a lease (breach of contract)

• Consolidating facilities

• Relocating employees

• Moving PP&E

Criteria for Liability Recognition

A liability associated with an exit or disposal activity should be recognized only when a transaction or event occurs that creates a present obligation of an entity to transfer an economic benefit

Liability Measurement

• Liability should be measured at fair value

• Liability may be adjusted in future periods because of:

  • Revisions to the timing of, or estimated cash flows from, the exit or disposal activity

• Revisions are accounted for prospectively (change in estimate)

  • Do not restate prior years

Income Statement Presentation

• There may be a major strategic shift related to discontinued operations:

• Costs associated with an exit or disposal activity related to a discontinued operation should be:

  • Reported in discontinued operations (net of tax)

• There may be an exit or disposal activity not related to discontinued operations:

• Costs associated with an exit or disposal activity not related to discontinued operations should be:

  • Reported in income from continuing operations (Non-operating expense)

• Estimated future operating losses:

  • Not recorded until they actually occur

Disclosures of Liabilities

Should be made in the notes to the financial statements

• In the period that the exit or disposal activity was initiated; and

• All subsequent periods until the activity is completed

Required Disclosures Related to Liabilities

• A description of the exit or disposal activity

• For each major cost associated with an activity

  • Disclose the total amount expected to be incurred in connection with the activity

  • Reconcile the beginning and ending liability balances showing the changes during the period

• Disclose the line item(s) in the income statement in which the costs are aggregated

• For each reportable segment disclose

  • The total amount of costs expected to be incurred

  • The amount incurred in the period and incurred to date net of any adjustments with an explanation for the reasons

• If a liability for a cost associated with the activity is not recognized because fair value cannot be reasonably estimated, the reasons for that should be disclosed

Asset Retirement Obligations (ARO) Overview

• Matching principle is applied

• Future obligation payment expensed during periods of benefit

• Closure costs or removal costs

• An ARO is a legal obligation associated with the retirement of a tangible long-lived asset that results from its:

  • Acquisition

  • Construction or development

  • Normal operation

Recording ARO

• Recorded as a liability for future payment required to clean up, close down, or restore the condition of the asset

  • Liability = Amount to be paid in future x Present value factor

  • Recorded at the present value of future cash flow or discounted cash flow (DCF)

When Does an ARO Qualify for Recognition

When it meets the definition of a liability

• Duty of responsibility

• Obligating event

• Little or no discretion to avoid

A law or a private contract with the owner of the land requires the entity to spend money in the future to properly clean or close the property

Performance of the ARO

• Performance may not be required

• Entities may spend money on lobbyists to change laws

  • Future spending on cleaning or closing the asset may be reduced

  • Future value of the liability will be reduced

  • Entity does not have the right to defer the ARO

Initial Measurement of ARO (Balance Sheet Approach)

When an ARO exists and qualifies for recognition, entity records the fair value of the ARO on the B/S

• A liability → ARO (liability associated with the retirement of a tangible long-lived asset)

• An asset → Asset retirement cost, ARC (amount capitalized that increases the carrying amount of the asset)

Subsequent Measurement

Accretion and Depreciation

• ARC is spread over the remaining years to be benefited

• Depreciation expense decreases the ARC asset reported on the B/S

• When there is a liability on the books at a discounted amount, an expense needs to be accrued

• Accretion expense is the increase in the ARO liability due to the passage of time calculated using the appropriate accretion rate

  • Beginning carrying value x Discount rate → Debit the expense

Accretion of ARO (Increase in ARO)

• # of payments x Payment amount = Amount to be paid in future (undiscounted future cash outflow)

• If the present value of the future cash flow is not given

  • Amount to be paid in the future x Present value factor

• If the present value of the future cash flow is given

  • Undiscounted future cash flow - Present value of the future cash flow = Future accretion expenses reported over time

• Accretion expense is added to the ARO liability each period

• At the end of the accretion period, the ARO liability reported on the B/S should be (approximately) equal to the ARO to be paid

Depreciation (Decrease in ARC)

• Depreciation expense decreases the ARC asset reported on the B/S\

• Annual depreciation expense (ARC)

• At the end of the accretion period, the asset retirement cost (asset) should be fully depreciated

• Cumulative accretion expense (interest) + Cumulative depreciation expenses (Principal) = Total future payment (Undiscounted cost)

Revision to Cash Flow Estimates

• Estimated cash flows are used to calculate the discounted ARO liability reported on the B/S

• Under US GAAP, these cash flow estimates may be revised over time:

  • Upward revision → Costs more

    • Liability ⬆

    • Additional amount to be paid will be discounted back using the current/new discount rate

  • Downward revision → Costs less

    • Liability ⬇

    • Historical rate used as the discount rate

• Exit or disposal activities

  • Record a loss

• ARO

  • Record the discounted amount that is an asset and a liability

  • Spread that cost over the # of years by booking accretion and depreciation

Examples of Loss Contingencies

• Collectability of receivables

• Product warranties

• Unredeemed coupons

• Threat of expropriation of assets

• Pending or threatened litigation

Gain Contingencies

• Apply the rule of conservatism → No accrual → No journal entry

• Can be disclosed in the notes of financial statements

Examples of Gain Contingencies

• Expected favorable settlement from a pending court case

• Possible refunds from tax disputes

• Possible insurance reimbursement

Range of Probable Losses

• For a range of probable losses → GAAP requires that the loss be accrued with the highest probability occurring → The best estimate

• If every outcome has an equal probability, and there’s a range of losses, the minimum amount in the range should be accrued

• A note disclosing the possibility of the range should be disclosed in the footnotes

Reasonably possible = more than remote; less than likely

Disclose the amount in the footnotes. The disclosure should include:

• Nature of the contingency (e.g., lawsuit)

• Estimate of the possible loss

• Range of loss

• Reason an estimate cannot be made

Loss is Remote

• It is a loss contingency

• It’s remote

DOG Guarantee

• D - Debt of others guaranteed (officers, related party, another company)

• O - Obligations of commercial banks under standby letters of credit

• G - Guarantees of repurchase receivables (or related property) that have been sold or assigned

Potential Loss Contingencies

Loss is probable → unasserted claim will be filed → Treat it like any other loss contingency

• Probable

  • Can be reasonably estimated → Book journal entry

• Not Probable

  • Cannot be reasonably estimated → Disclose in footnotes

  • More than remote

If it’s remote and doesn’t relate to a DOG guarantee, simply ignore it

General of unspecified business risks (such as fire, flood, strikes, and war) do not meet the conditions for accrual, and no loss accrual shall be made (nor is disclosure required)

Appropriation of Retained Earnings

• Set aside for specific purpose or use

• Are not available to pay dividends to stockholders

• Set aside for acquisition, expansion, or lawsuit

• Not a substitute for booking a loss accrual

• Shown within the stockholder’s equity section

• Costs of losses shall not be charged to an appropriation of retained earnings

• Restore to retained earnings as soon as its purpose is no longer deemed necessary

Present Value Concepts are Divided into 6 Types

• Present value of $1 (Single Lump Sum)

• Future value of $ 1 (Single Lump Sum)

• Present value to an ordinary annuity (Multiple Equal Cash Flows)

• Future value to an ordinary annuity (Multiple Equal Cash Flows)

• Present value to an annuity due (Multiple Equal Cash Flows)

• Future value to an annuity due (Multiple Equal Cash Flows)

Annuities

• A large number of business transactions involve multiple payments or receipts. Bond interest payments and lease rental payments are two examples

• Annuities are transactions that result in identical periodic payments or receipts at regular intervals

• Ordinary annuity (also called “annuity in arrears”) payments are made at the end of each period

• Annuity due payments occur at the beginning of each period

• The timing of payments is the only difference between an ordinary annuity and an annuity due. This applies to both present value and future value annuities

Present Value of an Ordinary Annuity

Payment happens at the end of each period

Present Value of an Annuity Due

• Only difference in the calculations of an annuity due and an ordinary annuity is the timing of the payments

• For an annuity due, the payment occurs at the beginning of each period

• When calculating the PV of an annuity due, it is calculated on the day of the first payment

• To adjust the PV factor for an ordinary annuity to the PV factor for an annuity due

• Add 1.00 to the PV of an ordinary annuity of 1 for n periods

Future Value of an Ordinary Annuity

• Deposit an equal amount into a savings account every period for a:

  • Certain number of periods

  • Earning a certain rate of interest

• If saving at end of each period, use future value factors for an ordinary annuity

• If saving at the beginning of each period, use future value factor for an annuity due

Distinguishing Liabilities from Equity

Liability

• Maturity date/due date

• Obligation to repay the capital

Equity

• No maturity date

• No obligation to repay anything

Financial Instruments Classified as Liabilities

• Financial instruments in the form of shares that are mandatorily redeemable

  • Representing an unconditional obligation to the issuer to redeem the instrument

  • Involving transferring assets at a specified date or upon a future event

• Financial instruments, other than outstanding shares, that represent an obligation to repurchase the issuer’s equity shares by transferring assets

• Financial instruments that represent an obligation to issue a variable number of shares

Notes Payable

Are contractual rights to pay money at a fixed or determinable rate

• The general rule is that the discount must be calculated so that it can be recorded at PV

• Notes payable must be recorded at PV at the date of issuance

• If a note is noninterest-bearing or the interest rate is unreasonable (usually below market), the value of the note must be determined by imputing the market rate of the note and by using the effective interest method

• Many of these rules apply when notes are exchanged for goods and services and the interest rate varies from the prevailing interest rates

• Notes must be recorded at PV so that expense for the period is not distorted

Stated Interest Factors

A note issued solely for cash equal to its face amount is presumed to earn the interest stated

• There is a general presumption that the interest stated on a note resulting from a business transaction entered into at arm’s length, where the parties are not related, is fair and adequate

• However, if rights or privileges are attached to the note, they must be evaluated separately

• If no rights or privileges are attached and the interest rate on the note effects prevailing interest rates, record the note at face value without any present value considerations

Imputing Interest

• With the accrual basis, we must record interest expense over the life of the security, whether or not the interest is paid

• Imputed interest is recorded on an accrual basis

• Interest expense must be recorded whether or not the coupon payments are made

• When a note contains either no interest or an unreasonable rate of interest, the substance rather than the form of the transaction must be recorded. This involves determining the present value of the obligation at the appropriate market interest rate, and:

  • Recording the payable at its face amount (gross note payable)

  • Recording the item received in exchange for the note at the PV of the obligation

  • Recording any difference between the face amount of the note and its present value as a discount that must be amortized over the life of the note

Imputing Interest Not Required

Imputing Interest Not Required

The PV calculation at the market rate of interest is not required for certain payables with low or no interest rate when those payables:

• Arise in the ordinary course of business, the terms of which do not exceed approximately one year (short-term notes)

• Are paid in property or services (not in cash)

• Represent security deposits

• Bear an interest rate determined by a government agency

• Arise from transactions between a parent company and its subsidiaries

Amortization of the Discount

Any discount resulting from imputing interest on a note payable must be amortized over the life of the note payable using the effective interest method

Step 1: Beginning carrying value x Effective market rate = Interest expense

Step 2: Periodic payment - Interest expense = Principal reduction of note

Presentation & Disclosure of Notes Payable Discount

• The discount is inseparable from the related note payable and is added to the note payable to determine the carrying value of the N/P to be reported on the B/S

• The discount on the N/P account is a contra-liability account, which means that by adding the balances in this account to the N/P account, the net carrying value of the N/P will be reduced on the B/S

• A full description of the payable, the effective interest rate, and the face amount of the note should be disclosed in the financial statement or notes thereto

Types of Bonds

• Debentures - unsecured bonds, with high risk and high yield

• Mortgage bonds - Secured by real property

• Collateral trust bonds - secured bonds, with less risk and low yield

• Convertible bonds

• Participating Bonds

• Term bonds

• Serial bonds - Prenumbered bonds that the issuer may call and redeem a portion by serial number

• Income bonds - Only pay interest if certain income objectives are met

• Zero coupon bonds entry to begin: Also known as “deep discount bonds”; bonds sold with no stated interest but rather at a discount and redeemed at the face value without periodic interest payments

• Commodity-Backed Bonds - Also known as “asset-linked bonds”; bonds that are redeemable either in cash or a stated volume of a commodity, whichever is greater

Bonds Payable vs Notes Payable

Bonds

• Terms are more standardized which allows them to be publicly traded

• Interest payments are made over the life of the bond

• All of the principal is paid at maturity

Notes

• Customized and privately placed

• Every monthly payment can be principal and interest

• Payments are negotiated. There is an agreement between the borrower and the lender

Bond Selling Price

• Discount is a deferred loss, but cannot be recorded as a loss on the income statement immediately

• Amortize - record that discount over the life of the bond by making the interest expense greater than the coupon

• What’s needed to determine the proceeds on sale of a bond

  • Present value factor using the market rate

  • Number of periods using the periodic market rate

  • Present value of 1, to find the present value of the principal

  • Present value of an ordinary annuity, to find the present value of the coupon payments

• Discount on bonds is amortized over the life of the bond

Bond Interest Rates

• Market rate determines present value factors to be used to get the selling price of the bond

• Market is dictated by the bondholders’ required rate of return

• Bondholders’ required rate of return is dictated by the issuer’s credit rating at the time of the issuance

Discounts on Bonds Payable

• If the market rate is higher than the coupon rate, the bonds will sell at a discount (Selling price < FV → Deferred loss)

• As discount is amortized over the life of the bond, interest expense will be greater than the interest paid in cash to the bondholders

• FV, coupon rate, and coupon payment do not change over the life of the bond regardless of the market rate

Unamortized Discount and its Amortization for Bonds Payable

• The unamortized discount on bonds payable is a contra-account to bonds payable (contra liability)

• It is present on the B/S as a direct reduction from the face (par) value of the bonds to arrive at the bond’s CV at any particular point in time

• As a discount is recorded, interest expense > coupon paid

• Difference between the interest expense and the coupon paid (i.e., the additional interest to be paid at the bond maturity) is amortized over the life of the bond

• As the CV ⬆; interest expense ⬆

• The interest expense must be greater than the coupon paid when a bond is issued at a discount

Premiums for Bonds Payable

• If the market rate is lower than the coupon rate, the bonds will sell at a premium (selling price > FV → Deferred gain)

• As the premium is recorded, interest expense < coupon paid

• Interest expense for each period will decrease with the decrease in the CV

Unamortized Premium and its Amortization

• It is presented on the B/S as a direct additional to the face (par) value of the bonds to arrive at the bond’s CV at any particular point in time (additional liability)

• As the CV ⬇, Interest expense ⬇

• Difference between the interest expense and the coupon paid (i.e., the premium) is amortized over the life of the bond

• The interest expense must be lower than the coupon paid when a bond is issued at a premium

Bond Issuance Costs

• Subtracted from the face value to arrive at a reduced initial carrying value 

• Amortized as interest expense over the life of the bond (matching principle)

• Bond issuance costs are transaction costs incurred when the bonds are issued. Example = legal fees.

Deferred Bond Issuance Costs

• Bond issuance costs incurred before the issuance of the bonds are deferred on the balance sheet until the bond liability is recorded

  • DR: Deferred bond issuance costs

  • CR: Cash

• When bonds are eventually issued, credit deferred bond issuance costs

Bond Premium Amortization: Effective Interest Method

• Selling price > PAR

• Interest expense < Coupon paid

• Effect interest method is a constant rate method required by US GAAP

• As carrying value of the liability goes down, interest expense goes down

• Market rate and # of periods is used to get present value factor and sales proceeds

Bond Issued Between Interest Dates

• Bond dated January 1 might sell on Feb 1 or another miscellaneous date

• Irrespective of the period for which bondholder hold the bond, the issuer pays them a six-month coupon payment on the interest payment date

• The accrued interest is added to the price of the bond. The bondholder pays such interest and is reimbursed at the next payment date on the receipt of a full period’s interest

Year-End Bond Interest Accrual

• The matching principle states that a publicly traded company must match its expense by quarter

• If the company is release quarterly financial, then they record period-end accruals

• When the date of a scheduled interest payment and the issuer’s year-end do not agree, it is necessary to accrue interest by an adjusting entry on the issuer’s books at year-end

• The accrual must take into account a prorated share of discount or premium amortization

Disclosure Requirements for Notes

• Companies with many debt issues often report only on B/S total, which is supported by comments and schedules in the accompanying notes

• Notes often show details regarding the 

  • Liability maturity dates

  • Interest rates

  • Call and conversion privileges

  • Assets pledged as security

  • Borrower-imposed restrictions

Troubled Debt Restructuring

The creditor allows the debtor certain concessions to improve the likelihood of collection that would not be considered under normal circumstances

• Concessions include items such as:

  • Reduced interest rates

  • Extensions of maturity dates

  • Reduction of the face amount of the debt;

• The concessions must be made in light of the debtor’s financial difficulty

• Troubled debt restructuring are often the result of:

  • Legal proceedings; or

  • Negotiation between parties

Transfer of Equity Interest

• The difference between the carrying amount of the payable and the fair value of the equity interest is recognized as a gain (gain on restructuring of debt) under US GAAP

• Recognize a gain

Combination of Type

• All gains on debt restructuring are:

  • Aggregated; and

  • Included in net income for the period

• They are treated and classified along with other gains of the company typically in the continuing operations section of the income statement

Recognition of Impairment

• A loan is considered to impaired if it is probable that the creditor will be unable to collect all amounts due under the original contract when due

• Normal loan procedures should be used to judge whether a loan is impaired

• A loan restructured in a troubled debt restructuring is an impaired loan

Measurement of Impairment

• Receipt of assets or equity

  • When the creditor receives either assets or equity as a full settlement of a receivable, these are accounted for at their fair value at the time of the restructuring

  • The fair value of the receivable satisfied can be used if it is more clearly determinable than the fair value of the asset or equity acquired

  • In a partial payment, the creditor must use the fair value of the asset or equity received

  • The excess of the recorded receivable over the fair value of the asset received is recognized as a loss

  • The creditor accounts for these assets as if they were acquired for cash

Modification of Terms (Impairment)

• Impairment should be captured as part of an entity’s overall assessment of credit losses

• Any losses with troubled debt restructuring should be incorporated into a creditor’s estimate of its allowance for credit losses

• Entities may employ a variety of methods to estimate credit losses

• If a discounted cash flow approach is used, the post-restructuring effective interest rate must be used as the discount rate

• Impairment should be measured based on the loan’s present value of the expected future cash flows discounted at the loan’s historical effective interest rate

• The impairment is recorded by creating a valuation allowance with a corresponding charge to bad debt expense

Extinguishment of Debt

Debtor perspective

• Corporations issuing bonds may call or retire them prior to maturity

  • Callable bonds can be retired after a certain date at a stated price

    • Issuer has the right to refinance the debt at a lower rate if the interest rates go down

• Refundable bonds allow an existing issue to be retired and replaced with anew issue at a lower interest rate

Definition of Extinguishment

• Debt is considered extinguished if

  • Debtor pays it off

  • Debtor is legally released

Debtor Legally Released

• A liability is considered extinguished if the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor

• A troubled debt restructuring would result in the extinguishment of debt only if the debt were forgiven by the creditor as a result of

  • Transfer of assets; or

  • Transfer of equity interest

• Modification of terms isn’t extinguishment

Debtor Pays Liability

A liability is considered extinguished if the debtor pays the creditor and is relieved of its obligation for the liability

• Bond Extinguishment at Maturity

  • If a bond is paid at maturity, the carrying value of the bond is equal to the face amount of the bond and no gain or loss is recorded

• Bond Extinguished Before Maturity

  • If a bond is extinguished before maturity, a gain or loss is generally recorded

  • Gain or loss is the difference between

    • Carrying value of the bond (Face value less unamortized discount or plus unamortized premium

    • The cash paid to extinguish the bond

In-Substance Defeasance Not Extinguishment of Debt

• It is an arrangement in which a company places purchased securities into an irrevocable trust

• The company pledges them for the future principal and interest payments on its long-term debt

• Because the company remains the primary obligor while there is outstanding debt, the liability is not considered extinguished by an in-substance defeasance

Lease

• Used by public and private entities as means of gaining access to assets and reducing their exposure to the full risks of asset ownership

• Defined as a contractual agreement between

  • A lessor who conveys the right to use real of personal property (an asset); and

  • A lessee who agrees to pay consideration for this right over a specific period of time

Lease Criteria

Both are required to be met

1. Contract must depend on an identifiable asset in which the lessor doesn’t have a substantive substitution right

2. Contract must convey the right to control the use of the asset over the lease term to the lessee

Lease vs Nonlease Components

Decision as to whether a contract is a lease or contains a lease

• Must be made at contract inception

• Only may be reassessed if the terms and conditions of the contract change

Once the determination is made that the contact is or contains a lease, the lessee must:

• Assess whether multiple contracts should be combined;

• Identify the separate lease components within a given contract (or combined contracts); and

• If applicable, determine whether separate lease components within the contract should be combined or separated from any related nonlease components

Combining Contracts

For accounting purposes, contracts should be combined if they meet all of the following criteria

1. One or more contracts contains or is a lease

2. Contracts are entered into at approximately the same time

3. Parties to the contract are the same, or are related parties

4. One of more of the following

   1. Performance or price of one contract affects the consideration paid in the other contract(s)

   2. Contracts have the same commercial objectives and were negotiated as part of a package

   3. Regarding the use of underlying assets, the rights to use them do not meet the accounting criteria for separate lease components

OWNES Criteria

Lease is classified as Finance if any of the criteria are met

1. Ownership transfers to the lessee at the end of the lease term

2. Written purchase option which lessee is reasonably certain to exercise

3. Net present value equals or exceeds substantially all of the FV of asset

4. Economic life (major part) of the underlying asset within lease term

5. Specialized asset such that it will not have an expected, alternative use to lessor

No to all OWNES criteria = Operating Lease

Quantitative Approach

• OWNES criteria doesn’t provide specific, quantitative thresholds for assessing “substantially exceeds” and “major part” determinations

• Previous FASB guidance can serve as a reasonable approach to determining whether these thresholds are met

  • N criteria, 90% of more of the fair value of the underlying asset would reasonably considered “substantial”

  • E criteria, “major part” of the remaining economic life of the asset would reasonably considered 75% or more

• To determine whether a lease commences at or near the end of the underlying asset’s economic life, use a threshold of 25% of less of the underlying asset’s total economic life

Lease Payments

• R - Required contractual fixed payments less any lease incentives paid or payable to the lessee

• E - Exercise option reasonably assured: The exercise price of an option, which gives the  lessee the right to purchase the underlying asset (if it is “reasonably certain” that the lessee will exercise this option)

• P - Purchase price at the end of the lease: the state purchase price of the underlying asset at the end of the lease term

• O - Only indexed or rate variable payments: No increase or decrease to future lease payments should be assumed based on increases or decreases in the index or rate. Instead, any differences in payments due to changes in the index or rate are expensed in the period incurred

• R - Residual guarantees likely to be owned: The lessee includes the full amount of the residual value guarantee at the end of the lease term in the present value test. The lessee doesn’t consider unguaranteed residual value as part of the present value test

• T - Termination penalties reasonably assured: Any penalty due from the lessee upon lease termination

Lease Payments

Lease payments may or may not include the following (at the lessee’s option)

• Nonlease components

Lessee lease payments will specifically exclude

• Guarantees of lessor debt by lessee

• Other variable lease payments: other than those noted above

Initial Direct Costs

• Included in valuation of the ROU asset

• Only incurred as a result of the execution of the lease

• Any costs incurred prior to signing the lease, which can include lease term negotiation, document preparation, credit checks, etc., are not included in the accounting for direct costs

Operating Leases (No OWNES)

• Operating lease is a lease that has failed the OWNES tests

• Balance sheet

  • Will reflect a ROU asset and lease liability

  • Both will be amortized over the life of the lease using the effective interest method

  • ROU asset and lease liability amounts are calculated using the present value of the lease payments, using the appropriate discount rate

Operating Lease Income Statement

• Lease expense will be recognized each year over the lease term using the straight line method for expense measurement

• Instead of reporting interest expense on the income statement, the lessee will report the interest as part of lease expense

Finance Leases (OWNES)

• Lessee will recognize both an ROU asset and a corresponding liability on its balance sheet

  • Liability will equal the PV of lease payments owed

  • ROU asset will include direct costs that were incurred as a result of the lease execution, as well as any lease payments made by the lessee to the lessor at or before lease commencement

• Any incentives received by the lessee from the lessor will reduce the value of the asset

• In the early years of a finance lease, expense recognition is front-loaded as interest expense, plus asset amortization expense will create a higher total expense than under an operating (capital) lease

• In later years, a finance lease will reflect a lower total expense than an operating lease

• The overall expense total across the entire lease will be the same under both lease types

Accounting Policy Election (ROU)

• Lessees can make an accounting policy election and choose to not recognize ROU assets and lease liabilities for leases with terms of 12 months or less

• If this election is made, it:

  • Must be done by the class of the underlying asset; and

  • Cannot include purchase options for the asset the lessee is reasonably certain to exercise

Balance Sheet (ROU)

• ROU assets and associated lease liabilities may either be:

  • Recognized as separate line items on the B/S; or

  • Included with other assets/liabilities and disclosed separately in the notes to the financial statements

• The portion of lease liabilities due within a year or the operating cycle, whichever is longer, should be reported in the current section and the remained in the long-term section

• Finance and operating lease ROU assets and lease liabilities cannot be presented together

  • The ROU asset will be amortized

  • The lease liability will be paid down over the life of the lease

Income Statement

• For operating leases, lease expense will be included in income from continuing operations on the lessee’s I/S

• For finance leases, the I/S will include:

  • The amortization of the ROU asset; and

  • The portion of the lease expense related to interest on the lease liability

Finance Lease (Cash Flow Statement)

• Principal portion of the lease payment is a cash flow from financing

• Interest portion of the lease payment is a cash flow from operations

• Any variable lease payments and short-term lease payments not included in the lease liability are classified as cash flows from operations

Operating Leases (Cash Flow Statement)

• Lease payments are classified as cash flow from operations

• Payments from short-term leases are included in cash flow from operations

• Any payments needed to bring the asset to a condition and location in preparation for its intended use are considered investing activities

Lease Qualitative Disclosures

• information about the nature of the leases, including any                                                     

• restrictions or covenants;

• basis for determination of variable lease payments;

• options to extend or terminate (existence, terms, conditions);

• residual value guarantees (existence, terms, conditions);

• information on leases that have not commenced but create                                                      

• significant obligations and/or rights for the lessee;

• significant assumptions and judgments made in application

Lease Quantitative Disclosures

• finance lease costs (separated between the amortization of ROU assets and 

• interest on lease liabilities);

• operating lease costs;

• short-term lease costs;

• variable lease costs;

• cash payments for lease liabilities segregated between                                     

• operating and financing cash flows;

• supplemental noncash information on lease liabilities due to obtaining ROU assets;

• the weighted average remaining lease term and discount rate; and

• separate maturity analyses for operating and finance lease liabilities for five years