D105 - Intermediate Accounting III OA #2

LESSEES - Advantages of Leasing

• 100% financing at fixed rates

• Protection against obsolescence

  • Passes the risk of residual value to the lessor

• Flexibility

  • May contain less restrictive provisions

• Less costly financing

  • Tax benefits from the lessor go back to the lessee as lower rental payments

LESSOR - Advantages of Leasing

• Profitable interest margin

• Can stimulate sales

• Tax benefits

  • Enhances returns for all parties involved

• High residual value to the lessor

  • Residual values can sometimes provide large profits

Captive Leasing Companies

• They are subsidiaries whose primary business is to perform leasing operations for the parent company

• They have a point-of-sale advantage in finding leasing customers

Capitalization of Leases

• This approach requires only the long-term right to use the property to capitalize. This property-rights approach capitalizes all long-term leases

• The only exception is for leases that are less than a year, as they do not have to be capitalized

Finance (Lessee) / Sales-Type (Lessor) Leases

• Lessees recognize interest expense on the lease liability over the life of the lease

• A lessee reports both interest expense and amortization of the right-of-use asset on the income statement

• When the lessee takes ownership or consumes a substantial portion of the underlying asset over the lease term

Operating Lease

• Lessee amortizes the right-of-use asset such that the total reported lease expense is the same from period to period

  • It “plugs” in an amount that increases the Lease Expense so that it remains equal

• Lessee reports interest on the lease liability as part of Lease Expense

• Only a single lease expense (which is interest on the liability and amortization of the right-of-use asset) is recognized on the income statement

• When lessee obtains the right to use the underlying asset but not ownership of the asset itself

  • Ex.: a lease where the lessee can use one floor of an office building, but not the building itself

Lease Classification Tests

For a lease to be a finance lease, it must be non-cancellable and meet at least one of the five tests. Otherwise, the lease is an operating lease

• Transfer of Ownership

• Purchase Option Test

• Lease Term Test

• Present Value Test

• Alternative Use Test

Transfer of Ownership

If the lease transfers ownership of assets to the lessee, it is a finance lease

Purchase Option Test

• Allows the lessee to purchase the property for a price that’s significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable (bargain purchase option)

• Met if it is reasonably certain the lessee will exercise the option

Lease Term Test (75%)

• If the lease term is 75% or greater of the economic life of the leased asset, the lease meets the lease term, and finance lease treatment is appropriate

• Bargain renewal option: allows the lessee to renew the lease for a rental that’s lower than expected fair rental at the time the option becomes exercisable

• The difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably certain. Thus, companies should include in the lease term any bargain renewal options

Present Value Test (90%)

• If the present value of the lease payments equals or exceeds 90% of the fair value of the asset, then it is a finance lease

• To apply the present value test, a lessee must determine the amount of lease payments and the appropriate discount rate

• Includes the full amount of the guaranteed residual value

Alternative Use Test

• If, at the end of the lease term, the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease

• The assumption is that the lessee uses all the benefits from the leased asset and therefore the lessee essentially purchased the asset

Lease Payments

• Fixed Payments: payments specified in the lease agreement and fixed over the lease term

  • Included in the calculation of the present value of the lease liability

• Variable payments: based on index or a rate

  • Lessee should include them in the value of the lease liability at the level of the index rate at the commencement date

  • Any difference in the payments due to changes in the index or rate is expensed in the period incurred but not included in the calculation of the present value of the lease liability

• Amounts guaranteed by a lessee under a residual value guarantee

  • The lessee includes the full amount of the guaranteed residual value 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

Residual Value

• Expected value of leased asset at the end of the lease term

• Can be guaranteed or unguaranteed

Guaranteed Residual Value

The lessee has an obligation to return the leased asset at the end of the lease term and guarantee the residual value will be a certain amount

Unguaranteed Residual Value

The lessee does not have any obligation to the lessor at the end of the lease, except to return the leased asset to the lessor

Discount Rate

To determine whether the present value of the payments equals or exceeds 90% of the fair value of the leased asset, a lessee should compute the present value of the lease payments using the implicit interest rate

Implicit Interest Rate

• Discount rate that, at the commencement of the lease, causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the fair value of the leased asset

• If it is unknown, the lessee uses the incremental borrowing rate

Incremental Borrowing Rate

Rate of interest the lessee would have to pay on a similar lease or the rate that, at the 0commencement of the lease, the lessee would incur to borrow over a similar term the funds necessary to purchase the asset

Measurement of Lease Liability

Include only the expected residual value probable of being owed by the lessee under the guaranteed residual value

If it is probable that the expected residual value will be greater than the guaranteed residual value, then…

The guaranteed residual value is NOT included in the measurement of the lease liability

Amount Capitalized as Right-of-Use Asset

Amount Capitalized as Right-of-Use Asset = (Annual Payment) x (Present Value of Annual Rental Rate [Implicit Rate])

FINANCE LESSEE Journal Entry - Record Lease

FINANCE LESSEE Journal Entry - Lease Payment

Each lease payment consists of two elements:

• A reduction of the lease liability

• A financing cost (interest expense)

Total Financing Cost (Interest Expense)

Total Financing Cost (Interest Expense) = (Present Value of Lease Payments) - (Actual Cash Disbursed)

FINANCE LESSEE Journal Entry - Record Interest Expense

FINANCE LESSEE Journal Entry - Amortization of the Right-of-Use Asset

FINANCE LESSEE Journal Entry - Purchasing Equipment at End of Lease

Lease Classification Tests - Lessor

• They are identical to the tests used by the lessee

• Although not part of the tests, the lessor must also determine whether the collectability of payments from the lessee is probable

  • If payments are NOT probable, the lessor does not record a receivable. Instead, receipt of any lease payments is recorded as a deposit liability

Sales-Type Lease (Lessor) - Lease Receivable

• Under a sales-type lease, the lessor generally records a lease receivable and eliminates the leased asset

• Lease Receivable = (Present Value of Rental Payments) + (Present Value of Guaranteed AND Unguaranteed Residual Values)

Lessor Profit and Revenue Recognition

• Any selling profit on the transfer of the leased asset is recognized by recording sales revenue and related CoGS at the commencement of the lease

• The lessor recognizes revenue interest on the lease receivable over the life of the lease using the effective-interest method

Amount to be Recovered by Lessor

Amount to be Recovered by Lessor = (Fair value of the leased equipment) - (Present value of the residual value)

FINANCE LESSOR Journal Entry - Lease Receivable/CoGS/Sales Revenue

FINANCE LESSOR Journal Entry - Record Receipt of First Payment

FINANCE LESSOR Journal Entry - Interest Revenue on Lease Receivable

FINANCE LESSOR Journal Entry - Final Lease Payment, but the asset is not returned until a year later

FINANCE LESSOR Journal Entry - Asset is Returned

OPERATING LESSEE Journal Entry - Record Lease

OPERATING LESSEE Journal Entry - Record First Payment

Lease Expense Schedule

OPERATING LESSEE Journal Entry - Record Lease Expense

OPERATING LESSOR Journal Entry - Record Lease Payment

OPERATING LESSOR Journal Entry - Record Recognition of Revenue

OPERATING LESSOR Journal Entry - Record Depreciation Expense on Lease Equipment

Lease arrangements that cause unique accounting problems

• Residual Values

• Bargain Purchase Options

• Short-term Leases

• Presentation, Disclosure, and Analysis

LESSEE - Guaranteed Residual Value

• If it is PROBABLE that the expected residual value is GREATER than or EQUAL to the guaranteed residual value, do NOT include the guaranteed residual value in the computation of lease liability

• If it is PROBABLE that the expected residual value is LESS than the guaranteed residual value, the difference between the expected and guaranteed residual values should be INCLUDED in the computation of the lease liability

• If the fair value of the underlying asset is LESS than the expected residual value, the company will record a loss

LESSEE RESIDUAL VALUE GUARANTEE Journal Entry - Recording a Loss

LESSEE - Unguaranteed Residual Value

• Lessee does NOT include the unguaranteed residual value in the computation of the lease liability, whether it is a finance lease or on an operating lease

LESSOR - Guaranteed Residual Value

• The calculation used to measure the amount to be recovered by the lessor from rental payments is the SAME whether the residual value is guaranteed or unguaranteed

• Lessor accounts for the guaranteed residual value as part of Sales Revenue

• Gross Profit = (Sales Price of the Asset) - (CoGS)

LESSOR - Unguaranteed Residual Value

• Lessor recognizes sales revenue and CoGS only for the portion of the asset for which recovery is assured

• To account for this uncertainty, both sales revenue and CoGS are reduced by the present value of the unguaranteed residual value

  • Gross Profit = (Sales Price of the Asset) - (CoGS)

    • Sales Price of the Asset = (Sales Price) - (Present Value of Expected Residual Value)

    • CoGS = (Cost to the Dealer) - (Present Value of Expected Residual Value)

• It is the same gross profit regardless of whether it is guaranteed or unguaranteed, but the sales revenue and CoGS are reported at different amounts under an unguaranteed residual value situation

Summary of Treatment of Residual Values

Additional lease adjustments that affect the measurement of lease assets and liabilities

• Executory costs

• Lease prepayment and incentives

• Initial direct costs

Executory Costs

• Normal expenses associated with owning a leased asset, such as property insurance and property taxes

  • Gross lease: payments to the lessor are fixed as part of the rental payments in the contract

    • Included in measurement of lease liability

  • Net lease: lessee makes variable payments to a third party or to the lessor directly for the executory costs

    • Not included in measurement of lease liability

    • Expensed as incurred

Lease Repayment and Incentives

• Companies adjust the right-of-use asset for any lease prepayments, lease incentives, and initial direct costs made PRIOR to or AT the commencement date

  • Prepayments made by LESSEE INCREASE the right-of-use asset

  • Incentive payments made by LESSOR REDUCE the right-of-use asset

  • Initial direct costs incurred by LESSEE INCREASE the right-of-use asset

Right-of-Use (ROU) Asset

• It is the value recorded on a lessee’s balance sheet representing the contractual right to use a leased asset over the lease term, measured initially from the present value of future lease payments plus adjustments

• Right-of-Use (ROU) Asset = (Initial measurement of lease liability) + (Prepaid Lease Payments) + (Initial Direct Costs) - (Lease Incentives Received)

Initial Direct Costs

• They are incremental costs of a lease that would not have been incurred had the lease not been executed

  • Costs directly or indirectly attributable to negotiating and arranging the lease (like legal costs, salaries, marketing, depreciation) are NOT considered initial direct costs

• Included in the cost of the right-of-use asset but are NOT recovered as part of the lease liability

Lessor Accounting for Initial Direct Costs

• Operating lease: the lessor defers the initial direct costs and amortizes them as expenses over the term of the lease

• Sales-type lease: the lessor expenses initial direct costs at lease commencement (in the period in which it recognizes the profit on the sale)

  • An exception is when there is no selling profit or loss on the transaction.

  • If there is no selling profit or loss, the initial direct costs are deferred and recognized over the lease term

• Internal direct costs should not be included in initial direct costs

  • Internal costs are costs that would have been incurred regardless of whether a lease was executed and they are expensed as incurred

Bargain Purchase Option

• Allows the lessee to purchase the leased property for a future price that is substantially lower than the asset’s expected future fair value

• If a bargain purchase option exists, the lessee must increase the present value at the lease payments by the present value of the option price

• It uses the economic life of the underlying asset

Short-Term Leases

• A lease that, at the commencement date, has a lease term of 12 months or less

• Lessees may elect to expense the lease payments as incurred

• A one-year lease with a renewal option that the lessee is reasonably certain to exercise is NOT a short-term lease

LESSEE Presentation in Financial Statements

LESSOR Presentation in Financial Statements

Qualitative Lease Disclosures for BOTH Lessor and Lessee

• Nature of its leases, including a general description of those leases

• How variable lease payments are determined

• Existence and terms and conditions for options to extend or terminate the lease and for residual value guarantees

• Information about significant assumptions and judgements (discount rates)

Lessee Quantitative Disclosures

• Total Lease Cost

• Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities

• Operating and short-term lease costs

• Weighted-average remaining lease term and weighted-average discount rate (segregated between finance and operating leases)

• Maturity analysis of finance and operating lease liabilities, on an annual basis for a minimum of each of the next 5 years, and the sum of the undiscounted cash flows for all years thereafter

Lessor Quantitative Disclosures

• Lease-related income, including profit and loss recognized at lease commencement for sales-type and direct financing leases, and interest income

• Income from variable lease payments not included in the lease receivable

• The components of the net investment in sales-type and direct financing leases, including the carrying amount of the lease receivable, the unguaranteed residual asset, and any deferred profit on direct financing leases

• A maturity analysis for operating lease payments and a separate maturity analysis for the lease receivable (sales-type and direct financing lease)

• Management approaches for risk associated with residual value of leased assets (like buyback agreements or third-party insurance)

What is the cost of an asset under a finance lease?

The amount to be recorded as the cost of an asset under a finance lease is equal to the present value of the lease payments

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In computing amortization of a leased asset where there is no bargain purchase option, what should the lessee subtract?

In computing amortization of a leased asset where there is no bargain purchase option, the lessee should subtract no residual value and amortize over the term of the lease.

In an operating lease, what does the lessee record?

In an operating lease, the lessee records the lease expense.

In a finance lease, what does the lessee record?

In a finance lease, the lessee records both amortization and interest expense.

For a lessee with a finance lease containing a bargain purchase option, what is the lease asset depreciated over?

A lessee with a finance lease containing a bargain purchase option should depreciate the leased asset over the asset's remaining economic life

Book Value of Leased Asset

The selling price of the equipment is used when determining the book value of a leased asset

Does the lessor recognize a lease receivable under an operating lease?

Under an operating lease, the lessor does not recognize a lease receivable because the asset never left the books

Prospective Reporting

• Prospective reporting is reporting in future periods

• Companies report changes in accounting estimates prospectively, so they do not adjust previously reported results

Journal Entry - Recording Depreciation

Depreciation Charge Formula

Depreciation Charge = (Book Value of Asset) / (Remaining Service Life)

3 Types of Accounting Changes

• Change in accounting principle

• Change in accounting estimate

• Change in reporting entity

Change in Accounting Principle

• A change from one GAAP to another one

• Ex.: changing an inventory valuation method from LIFO to average-cost

Change in Accounting Estimate

• A change that occurs as a result of new information or additional experience

• Ex.: changing its estimate of the useful lives of depreciable assets

Change in Reporting Entity

• A change from reporting as one type of entity to another type of entity

• Ex.: a company might change the subsidiaries for which it prepares consolidated financial statements

Errors in Financial Statements

Results from mathematical mistakes, mistakes in applying accounting principles, or oversight or misuse of facts that existed when preparing the financial statements

Retrospective Approach

• The company goes back and adjusts prior years’ statements on a basis consistent with the newly adopted principle

Retrospective Accounting Change Approach

• When a company changes an accounting principle, it should report the change using retrospective application

  • It adjusts its financial statements for each period presented on the same basis as the new accounting principle

  • It adjusts the carrying amounts of assets and liabilities as of the beginning of the first year presented

    • By doing so, these accounts reflect the cumulative effect on periods prior to those presented

  • The company also makes an offsetting adjustment to the opening balance of retained earnings or other appropriate component of stockholders’ equity or net assets as of the beginning of the first year presented

How do you report changes in accounting principles?

• Report changes retrospectively

• The application of a different accounting principle to recast previously issued financial statements — as if the new principle had always been used

Reporting a Change in Principle

• Other than using the retrospective approach, one must also include the following information in the financial statements:

  • Nature of the change

  • Why the company made the change

  • The years affected

  • Data on important differences between the amount reported under the old principle and the new one

Retained Earnings Adjustment for Change in Principle

• One of the disclosure requirements is to show the cumulative effect of the change on retained earnings as of the beginning of the earliest period presented

Direct Effects of Changes

• Companies should retrospectively apply the direct effects of a change in accounting principle

• Ex.:

  • An adjustment to an inventory balance as a result of a change in inventory valuation method

• Deferred income tax and the effects of impairment adjustments are also considered direct effects

Indirect Effects of Changes

• Any change to current or future cash flows of a company that results from making a change in accounting principle that is applied retrospectively

• Indirect effects do NOT change prior period amounts

• It is expensed in the current period

• It includes in the financial statements a description of the indirect effects

• Ex.:

  • Change in profit-sharing or royalty payment that’s based on a reported amount such as revenue or net income

Impracticability

• Retrospective application is considered impracticable if a company cannot determine the prior period effects

• Companies should NOT use retrospective application if one of the following conditions exists:

  • The company cannot determine the effects of the retrospective application

  • Retrospective application requires assumptions about management’s intent in a prior period

  • Retrospective application requires significant estimates for a prior period, and the company cannot objectively verify the necessary information to develop these estimates

• If any of the above conditions exist, it is deemed impracticable to apply the retrospective approach

If it is impracticable to apply the retrospective approach, the company then …

prospectively applies the new accounting principle as of the earliest date it is practicable to do so

Changes in Accounting Estimates

• Changes in accounting estimates are reported prospectively

• Companies account for the effects of all changes in estimates in:

  • The period of change if the change affects that period only

  • The period of change and future periods if the change affects both

• It prohibits retrospective treatment

The following items require estimates:

• Uncollectible receivables

• Inventory obsolescence

• Useful lives and salvage values of assets

• Periods benefited by deferred costs

• Liabilities for warranty costs and income taxes

• Recoverable mineral reserves

• Change in depreciation methods

If it is impossible to determine whether a change in principle or a change in estimate has occurred, the rule is:

to consider the change as a change in estimate. This is often referred to do as a change in estimate effected by a change in accounting principle

What is the general rule for issues in differentiating between a change in estimate and a correction of an error?

The general rule is that companies should consider careful estimates that later prove to be incorrect as changes in estimate

For a change in estimate that affects several periods, companies should disclose..

the effect on income from continuing operations and related earnings per share amounts of the current period

When a company has a change in estimate effected by a change in accounting principle, it must indicate why…

the new method is preferable

Changes in Reporting Entity

• Changes that result in different reporting entities have to adjust the financial statements of all prior periods presented (retrospectively)

• The revised statements show the financial information for the new reporting entity for all periods

Retrospective Approach vs Prospective Approach

• Retrospective Approach:

  • Changes in Accounting Principle

  • Changes in Reporting Entity

• Prospective Approach:

  • Changes in Accounting Estimates