Chapter 15 PowerPoint Notes: Accounting for Leases - Exhaustive Study Guide

Overview and Definitions of Leases

  • Definition of a Lease: A contract that gives a lessee (the user) the right to control the use of an asset for a specific period of time. In exchange for this right, the lessee makes a series of payments to the lessor (the owner).
  • Initial Recognition: At the start of a lease, the lessee records a "right-of-use" (ROUROU) asset and a lease liability on the balance sheet.
  • Right of Control: To have the right to control an asset, the lessee must satisfy two requirements:
    • 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.
  • Asset Identity: A lease must involve an identified asset that is property, plant, or equipment (PP&E). The asset must be explicitly specified (e.g., via a serial number) or implicitly specified (enough info to recognize the physically distinct asset).
  • Lessor Substitution Rights: An arrangement is not a lease if the lessor has the right to substitute an alternative asset at any time and could benefit economically from doing so.

Incentives for Leasing

  • Upfront Cash Savings: Purchasing an asset often requires origination fees, closing costs, brokerage fees, and taxes. Many leases allow a user to begin using an asset with nothing more than the first monthly payment.
  • Lower Periodic Payments: Buy-and-finance installment payments are based on the full fair value. Lease payments are often tied only to the portion of the fair value expected to decline over the specific lease term.
  • Disposal Flexibility: Returning a leased asset is simpler and cheaper than selling a used asset. Certain unique assets may not have an active used-item market, and sales commissions (e.g., 6%6\% for real estate) can be significant.
  • Protection against Declining Value: The lessee avoids the risk of the asset's fair value dropping significantly, though they also forfeit any potential increase in value.
  • Tax Advantages:
    • Companies with little taxable income cannot benefit directly from depreciation tax deductions. By allowing the lessor to retain ownership and claim the depreciation, the lessee can negotiate lower lease payments.
    • Lessees in lower tax brackets than lessors can achieve similar indirect benefits.

Lease Classification Criteria

  • Finance Lease (Lessee) / Sales-Type Lease (Lessor): These are leases that essentially represent the sale of an asset. A lease is classified as such if it meets one or more of the following five criteria:
    1. Ownership Transfer: The agreement specifies that the legal title of the asset transfers to the lessee by the end of the term.
    2. Purchase Option: The agreement contains a purchase option that the lessee is "reasonably certain" to exercise (often called a bargain purchase option or BPOBPO).
    3. Lease Term: The lease term covers a "major part" of the remaining economic life of the asset. ASC Topic 842ASC\,Topic\,842 suggests that 75%75\% or more usually constitutes a "major part."
    4. Present Value: The present value (PVPV) of the lease payments equals or exceeds "substantially all" of the fair value (FVFV) of the asset. ASC Topic 842ASC\,Topic\,842 suggests that 90%90\% or more constitutes "substantially all."
    5. Specialized Nature: The asset is so specialized it has no alternative use to the lessor at the end of the term.
  • Operating Lease: If none of the five criteria are met, the lease is classified as an operating lease, which is treated more like a temporary rental agreement.

Accounting for Finance and Sales-Type Leases

  • Lessee Perspective:
    • Records a right-of-use asset and a lease liability at the beginning of the lease at the present value of lease payments.
    • Amortizes the ROUROU asset over the lease term (unless ownership transfers or a BPOBPO is certain, then use the asset's full useful life).
    • Calculates interest expense on the outstanding lease liability using the effective interest method.
  • Lessor Perspective (No Selling Profit):
    • Removes the asset from the books and records a lease receivable at the present value of the payments.
    • Records interest revenue over the term based on the effective interest rate.
  • Lessor Perspective (With Selling Profit):
    • Selling profit occurs when the FVFV of the asset (selling price) exceeds the cost/carrying value.
    • Initial Entry: Debit Lease Receivable (PVPV of payments), Debit Cost of Goods Sold (Lessor cost), Credit Sales Revenue (PVPV of payments), Credit Equipment (Lessor cost).
    • Selling Profit = Sales Revenue−COGS\text{Sales Revenue} - \text{COGS}.
    • Subsequent entries for interest revenue are identical to those without selling profit.

Accounting for Operating Leases

  • Commonality: Both lessor and lessee report straight-line amounts in their income statements to reflect the nature of a rental.
  • Lessee Treatment:
    • Records an ROUROU asset and lease liability (designated as a "non-debt liability").
    • The total Lease Expense is a single straight-line amount equal to the annual payment.
    • Interest expense is calculated normally (Rate×Balance\text{Rate} \times \text{Balance}).
    • The Amortization of the ROUROU asset is a "plug" figure: Amortization=Total Straight-line Payment−Interest Expense\text{Amortization} = \text{Total Straight-line Payment} - \text{Interest Expense}.
  • Lessor Treatment:
    • The lessor does NOT record a receivable or derecognize the asset. The asset remains on the lessor's balance sheet (PP&E).
    • The lessor records straight-line Lease Revenue.
    • The lessor continues to record Depreciation Expense on the asset over its useful life.

Short-Term Leases and the Shortcut Method

  • Definition: A short-term lease has a maximum possible term of 1212 months or less (including renewal options) and does not contain a purchase option the lessee is reasonably certain to exercise.
  • Shortcut Method: Lessees can elect by asset class to not recognize an ROUROU asset or lease liability. Instead, payments are recognized as Lease Expense over the term.
  • IFRS Difference: Under IFRSIFRS, the shortcut method is also allowed for "small ticket leases" (the underlying asset is worth $5,000\$5,000 or less). U.S. GAAPU.S.\,GAAP does not have a small ticket exception.

Uncertainties and Special Considerations in Lease Accounting

  • Uncertain Lease Term: The term is adjusted for options to extend or terminate if exercise is "reasonably certain." Factors include bargain renewal rates, economic penalties, or significant customization.
  • Discount Rate:
    • The lessor uses the internal rate of return, known as the implicit rate.
    • The lessee uses the implicit rate if known; if not known, the lessee uses its own incremental borrowing rate.
  • Residual Value: The estimated value of the asset at the end of the term.
    • It affects the size of lease payments (higher residual value results in lower lease payments).
    • Guaranteed Residual Value: The lessee promises the lessor will recover a specific value. If the predicted cash payment under guarantee is significant, it is added to the lessee's ROUROU asset and liability.
    • Lessor Gross Investment = Total Lease Payments+Unguaranteed Residual Value\text{Total Lease Payments} + \text{Unguaranteed Residual Value}.
    • Lessor Net Investment (Lease Receivable\text{Lease Receivable}) = PVPV of the gross investment.
  • Purchase Options: If exercise is certain, the exercise price is treated as an additional cash payment. The lease term ends on the option date, and the asset is amortized over its full useful life.
  • Termination Penalties: Treated as an additional payment if termination is reasonably certain.
  • Lease Modifications:
    1. If the modification grants an additional right-of-use, it is treated as a new lease.
    2. If it alters existing rights, accounts must be adjusted to conform to new terms, potentially reclassifying the lease.

Identifying Nonlease Components and Improvements

  • Nonlease Components: Items like maintenance, service contracts, or hazard insurance should be separated from lease payments if they transfer a separate good or service to the lessee.
    • The lessee records the ROUROU asset based on the PVPV of the lease component only.
    • Property taxes and insurance are usually considered part of the lease payments as they do not transfer a separate service.
    • Practical Expedient: Lessees can elect to combine lease and nonlease components, though this increases the lease liability.
  • Initial Direct Costs: Costs like legal fees (for executing, not negotiating), commissions, and document processing.
    • Lessee: Added to the ROUROU asset.
    • Lessor: Depends on lease type - expensed immediately in sales-type leases with profit; deferred and amortized in others.
  • Leasehold Improvements: Costs incurred by the lessee to improve the property (e.g., constructing a building). These are amortized over the shorter of the lease term or their physical useful life.

Presentation and Disclosure Requirements

  • Statement of Cash Flows:
    • Operating Leases: Lessee and Lessor both report as Operating Activities.
    • Finance Leases (Lessee): Interest portion is Operating; Principal portion is Financing.
    • Sales-Type Leases (Lessor): Recorded as Operating Activities (considered the sale of a product).
  • Disclosures: Must enable users to assess the amount, timing, and uncertainty of cash flows.
    • Qualitative: Descriptions of arrangements, variable payments, and options.
    • Quantitative: Weighted average lease term, weighted average discount rate, reconciliation of opening/closing ROUROU balances, and a table of future payments for the next five years plus a total for thereafter.

Questions & Discussion

  • Question: Knottworth Gedding Consulting leased machinery on July 1, 2021. Finance lease. PVPV of payments at 10%10\% was $40.5\$40.5 million. Ten annual payments of $6\$6 million due July 1, 2021. What is interest expense for Dec 31, 2021?
    • Response: The balance after the first payment is $40,500,000−$6,000,000=$34,500,000\$40,500,000 - \$6,000,000 = \$34,500,000. Interest for 6 months (July to Dec) is 0.10 \times \34,500,000 \times \frac{6}{12} = \1,725,0001,725,000.
  • Question: Harry Potter Barn (HPBHPB) leased equipment in a sales-type lease on July 1, 2021. PVPV of payments at 10%10\% was $80,000\$80,000. Ten payments of $12,000\$12,000 due each July 1. What is the decrease in earnings (pretax) at Dec 31, 2021?
    • Response: Interest expense is 12×0.10×($80,000−$12,000)=$3,400\frac{1}{2} \times 0.10 \times (\$80,000 - \$12,000) = \$3,400. Amortization expense (straight-line) is \80,000 \div 10 \times \frac{1}{2} = \4,0004,000. Total decrease = $3,400+$4,000=$7,400\$3,400 + \$4,000 = \$7,400.
  • Question: LeaseCo Industries leased equipment (sales-type with profit) on July 1, 2021. PVPV was $810,000\$810,000. Ten payments of $120,000\$120,000 due July 1. Cost was $750,000\$750,000. Interest is 10%10\%. What is the pretax increase in earnings at Dec 31, 2021?
    • Response: Selling profit is $810,000−$750,000=$60,000\$810,000 - \$750,000 = \$60,000. Interest revenue for half a year is 0.10×($810,000−$120,000)×612=$34,5000.10 \times (\$810,000 - \$120,000) \times \frac{6}{12} = \$34,500. Total increase = $60,000+$34,500=$94,500\$60,000 + \$34,500 = \$94,500.
  • Question: Karla Salons leased equipment in an operating lease on Jan 1, 2021. PVPV at 10%10\% was $80,000\$80,000. Ten payments of $12,000\$12,000 due Jan 1. What is the ROUROU asset amortization for 2021?
    • Response: Total straight-line lease expense is $12,000\$12,000. Interest expense is 0.10×($80,000−$12,000)=$6,8000.10 \times (\$80,000 - \$12,000) = \$6,800. Amortization = $12,000−$6,800=$5,200\$12,000 - \$6,800 = \$5,200.