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theory of financial accounting ii > Chapter 21: Leases > Flashcards

Chapter 21: Leases Flashcards

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1
Q

Lease

A

A contract or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration

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2
Q

Executory Contract

A

Contract requiring continuing performance by both parties

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3
Q

Present Value of lease payments

A

Have to consider if payments are at the end of a period (ordinary annuity) or beginning (annuity due) when calculating present value of periodic rental payments

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4
Q

Determining annual payment amount

A

Fair value of leased equipment
Less: present value of residual value
= amount to be recovered by lessor via lease payment
divided by PVF for annuity (end of year) or annuity due (beginning of year)
for periods, implicit rate of return

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5
Q

Accounting for finance-type leases (sales-type)

Lessor: receivable and asset leases

A
  • records lease receivable
  • eliminates leased asset from books

Lease Receivable amount = present value of rental payments (PV Annuity/due)
+ present value of guaranteed and unguaranteed residual value

(potentially may separate out unguaranteed residual value as net investment)

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6
Q

Sale-type lease lease receivable amount

A

Present value of rental payment (payment x PVF annuity or annuity due)
+ Present value of guaranteed residual value (residual x PVF dollar)

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7
Q

Accounting for a guaranteed residual value

A

1 - if it is probable that the expected residual value is equal to or greater than the guaranteed residual value the lessee should not include the residual value in the computation of lease liability
2- 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 lease liability.

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8
Q

Computing lease liability/ right-of-use asset with guaranteed residual value (lessee)

A

When expected residual value < guaranteed residual value

Present value of annual rent payments (PVF annuity or AD)
+ Present value of probable residual value payment (difference expected vs guaranteed rs when due (PVF $1 periods after commencement, implicit rate))
= lease liability

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9
Q

Lesee Lease amortization schedule with guaranteed residual value

A

Expected residual value payment included in schedule as additional payment at end of lease term (still split between interest on liability and reduction of lease liability)

Different liability amount will create different interest on liability amounts and different straight line amortization of right-of-use asset expense

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10
Q

Guaranteed Residual value payment (Lesee)

A

Dr Lease Liability

Cr. Cash

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11
Q

If actual fair value of asset is less than expected residual value at end of lease with guarantee

A

Record as loss

Dr lease liability (expected amount)
Dr loss on lease liability (additional amount)
Cr Cash (total paid)

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12
Q

Operating lease: lessee: recording lease expense

A

Dr Lease Expense (payment amount)
Cr Right-of-use asset
Cr Lease Liability
creates a single lease expense (operating expense) on income statement

Record end of year adjusting entry
use lease amortization schedule and lease expense schedule to determine amounts

final entry is just
Dr lease expense
Cr Right-of-use asset (down to $0)

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13
Q

Operating lease: lessee: commencement of lease

A

Dr. Right-of-use asset (at PV of payments)
Cr lease liability

to calculate (if implicit rate is known): Payment x PVF-AD (periods, rate)

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14
Q

Unguaranteed residual value treatment: lessor

A

Revenue recognition: only recognize revenue and COGS for portion of asset where recovery is assured

So sales revenue and cogs are REDUCED by the unguaranteed residual value

gross profit is the same either way but may have to record loss on lease on return of inventory

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15
Q

Guaranteed Residual Value - Lessor Perspective

A

Computation of amount to be recovered by the lessor through lease payments is the same whether the residual value is guaranteed or not.

For sale type lease guaranteed residual value included in sales revenue (amount will be received in cash or value when the leased asset is returned)

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16
Q

Operating lease: Lessee: recording lease payments

A

Dr Lease Liability
Cr Cash

1st payment is just the lease payment amount

later payment same amount but noted that split between lease liability (reduction and amortization expense)

Expenses recorded separately from payment

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17
Q

Operating Lease amortization schedule

A

Effective interest table computing interest on liability balance at implicit interest rate

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18
Q

Operating lease: lease expense schedule: lessee

A

Splits the straight line lease expense (amount of annual payments) to be recognized at the end of each period into interest on liability (calculated in lease amortization schedule) and amortization of right-of-use asset

shows that carrying value for ROU asset is $0 at end of lease period

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19
Q

Transfer of ownership test

A

Does the lease transfer ownership of the underlying asset by the end of the lease term?

Yes= finance lease

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20
Q

Purchase Option test

A

Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonable certain to exercise?

(option to purchase property for price lower than underlying asset’s expected fair value at the date the option becomes exercisable.)

Yes = finance lease

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21
Q

Lease term test

A

Is the lease term for a major part of the remaining economic life of the underlying asset?

yes = finance lease

Major part of remaining life = 75% or more of economic life of leased asset (guideline, not concrete)

Include in lease term any bargain renewal periods

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22
Q

Bargain Renewal Option

A

Option for lessee to renew the lease for a rental that is lower than the expected fair rental at the time the option can be exercised.

Difference between renewal rental and expected fair rental must be enough to make exercise of option reasonably certain

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23
Q

Accounting for changes to variable lease payments lined to index/rate

A

Base lease liability on index/ rate at commencement of lease. Difference in payments should be expensed in period incurred.

If variation amount is not known it is not recorded and simply expensed

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24
Q

Residual value

A

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

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25
Q

Guaranteed Residual value

A

Obliges the lessee to not only return the asset at the end of the lease but also to guarantee that the residual value will be a certain amount

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26
Q

Lease payment components considered for Present value calculation

A
  • fixed payments per agreement
  • Variable payments based on an index or a rate (for PV use index/rate at commencement date and do not assume changes in rate)
  • amounts guaranteed by a lessee under a residual value test (include full amount of guarantee for PV test, do not include unguaranteed amounts)
  • payments related to purchase or termination option the lessee is reasonably certain to exercise
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27
Q

Incremental borrowing rate

A

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

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28
Q

Implicit interest rate

A

The discount rate that, at 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

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29
Q

Bargain Purchase Option

A

Lease purchase option that allows the lessee to purchase the property for a price that is significantly lower than the underlying asset’s expected fair value at the date the option becomes exercisable

Price so favorable that exercise appears reasonably certain

30
Q

Alternative use test

A

Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

yes = finance lease

Assumption lessee uses all the benefits from the lease

Assets built to suit

31
Q

Advantages of leasing for the lessee

A
  • 100% financing at fixed rates (generally do not require money down, vs loan interest rates which may float)
  • protection against obsolescence (risk of residual value to lessor)
  • Flexibility (less restrictive provisions than other debt agreements)
  • less costly financing (offers potential tax savings)
32
Q

Categories of lessors

A
  • Banks
  • Captive leasing companies (generally focus on their parent company’s products vs general lease financing)
  • independents (often good at developing innovative leasing contracts. may act as captive finance companies for companies without leasing subsidiaries.)
33
Q

Captive leasing companies

A

Subsidiaries whose primary business is to perform leasing operations for parent company

34
Q

Advantages of leasing for the lessor

A
  • profitable interest margins
  • stimulates product sales
  • potential tax benefits
  • high residual value of the return property at the end of the lease term (though can also lead to losses for less valuable assets)
35
Q

Operating leases: Lessor recognition of revenue

A

Collection (beginning of period)
Dr Cash
Cr Unearned Lease revenue

Revenue Recognition (end of period)
Dr Unearned lease revenue
Cr lease revenue

+ need to record normal depreciation expense and any other costs of the least arrangement

36
Q

Operating Leases: Lessor Balance Sheet

A

Lease assets on balance sheet with accumulated depreciation

listed as “leased asset”

37
Q

Sale type lease: Lessor: selling profit on transfer of leased asset

A

Sales revenue and COGS are recorded at the commencement of the lease

Dr. Lease Receivable
Dr. COGS
Cr. Sales revenue (= lease receivable)
Cr. Inventory

38
Q

Sales type lease: Lessor: interest revenue

A

Recognized over life of lease using effective-interest method using lease amortization schedule

Dr Cash
Cr lease receivable (reduction + interest)

Dr Lease Receivable
Cr Interest Revenue

39
Q

Sales-type lease: Lessor balance sheet

A 
Current Assets:
Lease receivable (interest + reduction)

Non current assets:
Lease receivable

Current = part due within one year/ one operating cycle, whichever is longer

40
Q

Sales-type lease: lessor income statement

A

Sales:
Sales Revenue
Less: Cogs
(recognized at commencement of lease)

Other revenue:
Interest revenue

41
Q

End of sale type lease: Lessor side

A

Accrue interest up to end so that lease receivable = guaranteed residual value

Dr Inventory (returned to books)
       Cr Lease receivable (take down to $0)

Last interest accrual:
Dr Lease receivable
Cr. Lease revenue (to bring up to residual value)

42
Q

Present value test

A

Does the present value of the sum of (1) the lease payments and (2) any lessee residual value guarantee not reflected in the lease payments equal or exceed substantially all of the underlying assets’ fair value?

If yes = finance lease

Present value of lease payments >= 90% Fair Value of asset

Discount rate is either the implicit interest rate (more accurate but can only use if known) or the incremental borrowing rate (easy to determine)

Calculate using full amount of any residual value guarantee

43
Q

Short term leases

A

Lease with a term of 12 months or less at commencement date

If includes a renewal option lessee is reasonably certain to exercise it should be included in the lease term (may make not short term)

Lessees may elect to expense short term lease payments as incurred

44
Q

Executory Costs

A

Normal expenses associated with owning a leased asset (property insurance, property taxes)

Accounting depends on whether it is a gross or net lease

45
Q

Gross vs Net lease

A

Gross: payments made to lessor are fixed in the contract

Net: Lessee makes variable payment to lessor or third party for executory costs

46
Q

Accounting for executory costs

A

Gross Lease: costs included in fixed payment to lessor - include costs in computation of lease liability

Net lease: executory costs paid separately = variable payment expensed in period incurred (not included in lease liablity)

47
Q

Adjustments to right-of-use asset value

A 
Chart with lease liability amount 
ADD lease prepayments
SUBTRACT lease incentives received by lessee
ADD initial direct costs
= Right of use asset value
48
Q

Initial direct costs

A

Incremental costs of a lease that would not have been incurred had the lease not been executed

Does not include:
- costs directly/ indirectly attributable to lease negotiations

May include: legal fees from lease execution and fees incurred after restitution, commissions

49
Q

Initial direct cost accounting: Lessee

A

Costs included in right-of-use asset value but NOT in lease liability

50
Q

Initial direct cost accounting: Lessor

A

Operating leases: initial direct costs deferred and amortized as expenses over lease term

Sale-type leases: lessor expenses initial direct costs at lease commencement (when records profits from sale) unless there is no profit/ is a loss then expenses deferred over lease term

Internal costs are not include in the initial direct costs

51
Q

Accounting for bargain purchase option: Lessee

A

Affects accounting same as guaranteed residual value: additional amount owed at end of lease add present value of option price to present value of lease payments

Amortized over full economic life of underlying asset (vs. guaranteed residual value amortized over lease term)

52
Q

Lessee presentation of leases on financial reports

A

Balance sheet:

  • Finance and operating leases
  • Right-of-use asset
  • Lease liability

Income statement:

  • Finance lease: amortization expense & interest expense
  • Operating lease: lease expense
53
Q

Lessor financial statement presentation: operating lease

A

Balance sheet:
- no effect

Income statement:

  • Revenue generally recognized on straight line basis
  • depreciation expense on leased asset
54
Q

Lessor financial statement presentation: sale-type lease

A

Balance sheet:

  • lease receivable (separate from other assets)
  • de-recognize leased asset

Income statement

  • interest revenue
  • selling profit or loss
55
Q

Disclosures: both lessee and lessor

A
  • Nature of leases and general description
  • how variable payments determined
  • terms and conditions for options to extend/ terminate + residual value guarantees
  • significant assumptions + judgements (discount rates)
56
Q

Lessee specific disclosures

A
  • Total lease cost
  • Financing lease cost (separated between amortization and interest)
  • operating and short-term lease cost
  • Weighted average remaining lease term and weighted-average discount rate (for financing vs operating)
  • maturity analysis of lease liability
    - on an annual basis
    - for each of the next 5 years + undiscounted cash flows of all years after
57
Q

Lessor-specific disclosures for leases

A
  • lease related income (P&L at least commencement for sales-type and direct financing leases + interest income)
  • income from variable lease payments not in lease receivable
  • components of net investment in sales-type and direct financing leases
  • maturity analysis for operating lease payments
    - separate analysis for operating lease receivable
  • management approaches for risk associated with residual value
58
Q

“Firm” leases

A

non-cancellable rights and obligations

unlikely to avoid performance under contract without a penalty

59
Q

FASB approach to capitalization of leases

A

Companies capitalize all long-term leases

leases with a term covering less than a year do not have to be capitalized

Right to use property = asset
commencement to make payments = liability

60
Q

Finance lease on income statement

A
  • Lessee recognizes interest expense on the lease liability over the life of the lease using the effective interest method
  • amortization of expense on right-to-use asset is generally straight line

both amortization and interest expense on income statement= total expense higher in earlier years of the arrangement

61
Q

Operating lease on income statement

A
  • interest expense measured with effective-interest method

- amortization calculated such that lease expense is the same from period to period

62
Q

Accounting for financial leases: lessee recording asset and liability

A

Lease liability = capitalized amount right-of-use asset = payments @ PV + EXPECTED residual value guarantee payment @ PV

Lease payments x PV factor of annuity (periods, implicit rate or incremental borrowing rate)

Dr Right-of-use Asset
Cr. Lease liability

63
Q

Financial leases: recording payments: lessee side

A

Dr. Payment
Dr. Lease liability (decreases laibility)
Cr. Cash

then use amortization schedule to determine amortization of interest

Dr. Interest expense
Cr lease liability (increases liability/ decreases amount liability reduced by payment)

64
Q

Financial leases: amortizing of asset: Lessee side

A

Use normal company depreciation policy

Dr Amortization expense
Cr Right-of-use asset

65
Q

Finance leases: Lessee Income statement

A

Expenses:

  • interest expense (lease liability)
  • Amortization expense (right-of-use assets)
66
Q

Finance leases on balance sheet: lessee side

A

Noncurrent assets:
- Right of use assets (carrying amount)

Current liability:
- lease liability (reduction of liability + expense due in next year)
Non-current liability
- lease liability (balance)

Can either report separately on balance sheet or disclose right-of-use asset and lease liability in notes

67
Q

Finance lease expiration: lessee side

A

When fully discharged: lease liability and right-of-use asset should have $0 balances

if asset is purchased
Dr Asset
Cr Cash

68
Q

Collectability considerations for lessor

A

Lessor may determine if collectability of lease payments is probable

if NOT probable:

  • no receivable recorded
  • lessor does not derecognize leased asset
  • receipt of payments is recorded as deposit liability
69
Q

Operating lease

A

Lessee obtains right to use underlying asset but not effectively ownership of asset

Transfer only right-of-use

70
Q

Finance lease

A

Lease effectively transfers control/ ownership of underlying asset to the lessee

Lessee takes ownership or consumes the substantial portion of the underlying asset over the lease term

Transfer of control or ownership non-cancellable and meets at least one of the five lease classification tests

71
Q

Lease classification tests

A

Determines if a lease is a finance or operating lease:

  • transfer of ownership test
  • purchase option test
  • lease term test
  • present-value test
  • alternative use test

if lease is non-cancellable and meets one of these tests then it is a finance lease

Otherwise it is an operating lease

same tests for lessee and lessor

72
Q

Lease - generic definition

A

Contractual agreement between a lessor and a lessee giving the lessee the right to use specific property owned by the lessor, for a specified period of time in return for rental payments over that period

Transfers use without transferring ownership

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