FAR-F6-M2/M3-Leases Part 1 and 2

Question 1

What are the three types of leases?

Answer 1

1. Short term leases
2. Operating leases
3. Finance leases

Question 2

What is a short term lease?

Answer 2

A short term lease is a lease of less than 12 months with no transfer of ownership of the asset.

Question 3

What is an operating lease?

Answer 3

An operating lease is a lease of 12 months or longer but doesn’t qualify as a finance lease. There is NO TRANSFER of ownership of the asset. However, the lessee recognizes the leased asset on the balance sheet.

Question 4

What is a finance lease?

Answer 4

A finance lease is a lease that is treated as if it were a sale. Ownership of the asset IS TRANSFERED and the lessee is recognizes the asset on their balance sheet and the lessor removes the asset from their balance sheet.

Question 5

With a short term lease, does the lessee report the asset on its balance sheet? Does the lessor remove the asset from its balance sheet?

Answer 5

A short term lease is essentially renting an asset for less than 12 months. The lessee doesn’t list the asset being rented on their balance sheet, nor does the lessor remove the asset from their balance sheet, like they would with a finance lease.

Question 6

What are the journal entries that a lessee should record for a short term lease? What are the journal entries that a lessor should record for a short term lease?

Answer 6

JE recorded by lessee on a monthly basis:
Dr. Lease Expense XXX
Cr. Cash or AP (XXX)

JE recorded by lessor on a monthly basis:
Dr. Cash XXX
Cr. Lease Revenue (XXX)

Question 7

What is the criteria to determine whether a lease should be treated as a finance lease or an operating lease?

Answer 7

If ANY of the 5 criteria are met, then the lease should be classified as a finance lease by the lessee and a sales-type lease by the lessor.
Acronym - OWNES

1. OWNERSHIP transfers to the lessee at the end of the lease term.
2. The lease contains a WRITTEN purchase option that the lessee is reasonably certain to exercise.
3. The NET PRESENT VALUE at the beginning of the lease term of the minimum lease payments AND any guaranteed residual value (by lessee) equals or exceeds the fair value of the leased property (generally 90% of the Fair value is the minimum threshold).
4. The lease term is the major part (75% of more) of the estimated ECONOMIC LIFE of the leased property.
5. The asset is SPECIALIZED that there is no alternative use to the lessor.

Question 8

If none of the OWNES criteria are met or the lease is short term, then is the lease considered an operating lease by the lessee?

Answer 8

Yes, if NONE of the OWNES criteria are met or lease is short term then it is considered an operating lease by the lessee.

For the lessor, classification depends on whether BOTH criteria are met: acronym PC. If BOTH are met then it is considered a direct financing lease by the lessor. If 1 or none are met, then it is considered an operating lease by the lessor.

1. PRESENT VALUE of the sum of the lease payments PLUS third party guaranteed residual value (not by the lessee) is equal to or exceeds underlying asset fair value.
2. COLLECTION of the lease payments and any amounts necessary to collect residual value guarantees is probable.

Question 9

When should the lessee begin the recognition of lease expenses?

Answer 9

The lessee should begin the recognition of lease expenses as of the commencement date.

Question 10

In the calculation of lease payments, the lessee must include what?

Answer 10

Acronym REPORT.
In the calculation of lease payments, the lessee will include:
1. REQUIRED contractual fixed payments, less any lease incentives paid or payable to the lessee.
2. EXERCISE price of an option, if reasonably certain to be exercised by the lessee.
3. PURCHASE price at the end of the lease, if the LESSOR has the option to require the lessee to purchase the underlying asset.
4. ONLY indexed or rate variable payments.
5. RESIDUAL guarantees likely to be owed. The Lessee includes the full amount of the residual value guarantee at the end of the lease term in the present value test. Does not consider UNGUARANTEED residual value.
6. TERMINATION penalty. Any penalty due from the lessee upon lease termination.

Lessee lease payments MAY OR MAY NOT include the following based on the lessee’s option:
Acronym NGO:
1. NONLEASE components.
2.GUARANTEES of lessor debt by lessee.
3. OTHER variable lease payments.

Question 11

What is a sale-lease back transaction?

Answer 11

A sale-leaseback transaction occurs when the seller that has control of an asset transfers it to another party (the buyer), (the buyer now has control of the asset), with a subsequent lease of the same asset where the seller becomes the lessee and the buyer becomes the lessor.

Question 12

In a sale-leaseback transaction, can the seller of the asset account for the transaction as a sale?

Answer 12

The seller of the asset can only account for the transaction as a sale if the subsequent lease is considered an OPERATING LEASE.

Question 13

In a sale leaseback transaction, if the subsequent lease is considered a finance lease, can the original seller of the asset still account for the transaction as a sale?

Answer 13

No. If the underlying lease in a sale-leaseback transactoin is a FINANCE LEASE, it is considered equivalent to a repurchase and will therefore be considered a FAILED SALE.

Question 14

In a sale-leaseback transaction, if the criteria are met for a sale, each party must determine whether the transaction is at FAIR VALUE. How is this determined?

Answer 14

If the criteria are met for a sale, each party must determine whether the transaction is at fair value.
Step 1. Determine which of the 2 sets of info is more readily available.
Set 1: asset sale price and fair value (purchase price)
Set 2: PV of lease payments and PV of market rental payments.
**USUALLY, Set 1 is used for MCQs.

Step 2: Of the set that is more readily determinable, identify any difference between the 2 data points.

If a difference exists, this will require an adjustment to either the sales price or the purchase price. Any increases in the sales price or purchase price will be treated as prepaid rent via an adjustment to the ROU asset in the lease back, and any decreases in the sales or purchase price will be treated as additional financing provided by the buyer/lessor to the seller/lessee.

Ex. if Sales Price is LARGER than fair value, then seller/lessor is obtaining more cash than the asset is worth, which will need to be paid back to the buyer/lessor once the leaseback begins.

JE to record the sale by the sellor/lessee
Dr. Cash $208,000
Dr. Accumulated Depreciation $130,000
Cr. Equipment ($325,000)
Cr. Financing Liability ($6,000)
Cr. Gain on sale of equipment ($2,000)

Question 15

If the sale-lease back criteria are not met, how will the seller/lessee and the buyer/lessor treat this transaction and record it on their books?

Answer 15

Both the seller/lessee and the buyer/lessor will treat this as FAILED SALE. This financing transaction will involve the seller/lessee recording a financing liability and the buyer/lessor recording a financing receivable. In regard to the asset, the seller/lessee will continue to recognize the asset and the buyer will NOT recognize the asset on its books.

Because essentially, the seller/lessee is repurchasing the asset back, therefore they’re not really sellling the asset in the first place.

Question 16

When calculating the present value of the lease payments for the purpose of calculating the ROU asset and liability (regardless if operating or financing), what Present value factor should be used for the periodic payments and purchase option or guaranteed residual?

Answer 16

When calculating the present value of the lease payments for the purpose of calculating the ROU asset and liability (regardless if operating or financing), the periodic payment will use the PVF of Annuity due if the payments are at the beginning of the period, or the PVF of an ordinary annuity if the payments are at the end of the period.

For the purchase option or guaranteed residual (does not include third party guarantees), the lessee will use the PVF of $1.

Question 17

Lessee accounting of operating leases:
1. What asset and liability will be recorded?
2. What method will be used to amortize the asset and liability by the lessee?
3.How will lease expense be recognized?

Answer 17

If the lease is an operating lease, the balance sheet will reflect a RIGHT OF USE asset and a lease liability and BOTH will be amortized over the LIFE OF THE LEASE using the EFFECTIVE INTEREST METHOD. Important to remember that the ROU asset and lease liability are always reduced by the same amount.

On the income statement, LEASE EXPENSE will be recognized each year over the lease term using the straight line method.

Example of JE to record the initial measurement:
Dr. ROU Asset XXX
Cr. Lease Liability (XXX)

Example of JE to record annual lease expense:
Dr. Lease Expense (straight line) $18,000
Dr. Lease Liability $15,221
Cr. Cash ($18,000)
Cr. Accumulated Amortization ROU asset ($15,221)

Question 18

Lessor accounting of operating leases, what is the JE to record the first payment received from the lessee?

Answer 18

Dr. Cash 12,000
Cr. Unearned Lease Revenue ($12,000)

Unearned until obligation is fulfilled (until year ends)

At the end of the year, the lessor would reverse the entry to record lease revenue and record depreciation expense on the asset using the straight line basis :

Dr. Unearned Lease Revenue 12,000
Cr. Lease Revenue ($12,000)

Dr. Depreciation Expense $5,000
Cr. Accumulated Depreciation ($5,000)

Question 19

Is the following statement true or false? if the lease is a finance lease, the lessee will recognize both an ROU asset and a corresponding lease liability on its balance sheet. The liability will be equal to the Present value of the lease payments owed. The ROU asset will include initial direct costs as well as any lease payments made by the lessee to the lessor at commencement date. Any incentives by lessor to lessee will REDUCE the value of the asset.

Answer 19

True. Is the following statement true or false? if the lease is a finance lease, the lessee will recognize both an ROU asset and a corresponding lease liability on its balance sheet. The liability will be equal to the Present value of the lease payments owed. The ROU asset will include initial direct costs as well as any lease payments made by the lessee to the lessor at commencement date. Any incentives by lessor to lessee will REDUCE the value of the asset.

Question 20

For lessee accounting of an operating lease. What is the general format of the effective interest amortization table to calculate the carrying values of the lease liability and ROU asset?

Answer 20

Date / Lease liability Balance / Lease Expense (straight line) / Interest Expense / Reduction in ROU asset (lease expense-interest expense) / carrying value of ROU asset

Question 21

For lessee accounting of an operating lease, how is interest expense calculated?

Answer 21

Interest expense = remaining lease liability balance * implicit interest rate

Question 22

For lessee accounting of an operating lease, how is lease expense calculated?

Answer 22

Straight Line Lease expense = total payments / total periods

Question 23

For lessee accounting of a financing lease, how is interest expense calculated?

Answer 23

Interest expense = remaining lease liability * implicit interest rate

Question 24

For lessee accounting of a finance lease, what is the journal entry to record the initial measurement of the lease?

Answer 24

The journal entry is the same as for an operating lease. A right of use asset and a Lease liability is recorded by the lease. Calculated at the present value of the lease payments plus any guaranteed residual value. The ROU asset will include initial direct costs at commencement date. Any incentives by the lessor to lessee will reduce the value of the ROU asset.

Question 25

Is the following statement true or false? The present value rate used to value a finance lease is the lessee’s IMPLICIT RATE if known by the lessee, NOT the Incremental Borrowing Rate.

Answer 25

True. The present value rate used to value a finance lease is the lessee’s IMPLICIT RATE if known by the lessee, NOT the incremental borrowing rate.

Question 26

For lessee accounting of a finance lease, what are the journal entries to record a lease payment right at the onset of the lease and the subsequent payment when interest expense is incurred?

Answer 26

Journal Entry to Record the 1st payment without interest expense incurred, assuming annual payments are $50,000
Dr. Lease liability $50,000
Cr. Cash ($50,000)

JE to record 2nd lease payment with interest incurred:
Dr. Interest Expense $26,650
Dr. Lease Liability (plug) $23,350
Cr. Cash ($50,000)

Where the reduction in lease liability account is the portion of the $50,000 payment that does not go to interest expense .

Question 27

For lessee accounting of a finance lease, what is the general format of the effective interest amortization table that is normally used to solve the calculations?

Answer 27

Date / Payment / Interest Expense / Decline in liability (principal portion) / Liability Balance

Question 28

For a finance lease, the minimum lease payment is allocated between principal and interest using the interest rate inherent in the lease or the IBR?

Answer 28

For a finance lease, the minimum lease payment is allocated between portion and interest using the interest rate inherent in the lease, NOT THE IBR.

Question 29

Should the lease liability in the balance sheet be recognized between current (due within 12 months) and noncurrent (due beyond 1 year)?

Answer 29

Yes, the lease liability in the balance sheet should be recognized between current (due within 12 months) and noncurrent (due beyond 1 year). Therefore the reduction in the lease liability each year is equal to the current liability at the end of the previous year.

Question 30

In lessee accounting for a finance lease, what is the JE to record the amortization of the ROU asset?

Answer 30

The lessee will amortize the ROU asset using the straight line method.

(Capitalized ROU asset - Salvage value or fair value) / Depreciation period = annual amortization expense.

Dr. Amortization Expense XXX
Cr. Accumulated Amortization ROU Asset (XXX)

Question 31

Is the following statement true or false? With a finance lease, the lessee should amortize the leased property over the ECONOMIC LIFE of the ASSET when there is a written purchase option OR when the lessee takes ownership of the asset at the end of the lease term. OTHERWISE, amortize over the lease term.

Answer 31

TRUE. With a finance lease, the lessee should amortize the leased property over the ECONOMIC LIFE of the ASSET when there is a written purchase option OR when the lessee takes ownership of the asset at the end of the lease term. OTHERWISE, amortize over the lease term. q

Question 32

A finance lease for a lessee is considered a sales type lease for the lessor. For lessor accounting of a sales type lease, will the lessor derocognize the asset and recognize a net investment in the lease as well as a profit or loss?

Answer 32

For a lessor accounting of a sales type lease, the lessor WILL DERECOGNIZE the asset and recognize a net investment in the lease as well as profit or loss.

Question 33

For lessor accounting of a sales type lease, how are initial direct costs treated?

Answer 33

For lessor accounting of a sales type lease, initial direct costs incurred as part of the lease are expensed at commencement date. If there is no profit or loss then defer and recognize the direct costs over the lease term.

Question 34

What is the JE the lessor will record to recognize the sales type lease?

Answer 34

Lessor JE at commencement date:
Dr. Lease Expense (initial direct costs) $450
Dr. Residual Asset (PV of residual value guarantee at implicit rate) $6,891
Dr. Lease Receivable (PV of lease payments at implicit rate) $17,325
Cr. Cash ($450)
Cr. Truck (carrying value) ($22,000)
Cr. Gain (Fair value of leased asset - carrying value) ($2,216)

How is gain recognized with a sales type lease? In a finance lease / sales type lease, the different between the fair value of the leased asset (PV of lease payments + PV of residual asset) and its cost (carrying value) is recorded as profit.

Question 35

In a finance lease / sales type lease, how is profit calculated by the lessor?

Answer 35

In a finance lease / sales type lease, the difference between the fair value of the leased asset (PV of lease payments plus PV of residual asset ) and its cost (carrying value) is recorded as profit.

Question 36

An operating lease for a lessee can either be an operating lease for a lessor or a direct financing lease, depending on whether 2 criteria are met. Assuming that the criteria have been met to qualify for a direct financing lease, will the lessor keep the asset on its books or recognize the asset?

Answer 36

In a direct financing lease, the lessee does not gain control of the underlying asset. The lessor will derecognize the asset and recognize a net investment in the lease. The net investment in the lease includes a lease receivable and a residual asset. Any gain will be deferred and amortized over the life of the lease and any loss wll be recognized immediately.

Question 37

Lessor accounting of a direct financing lease, what is the JE to record the transaction of a sales type lease?

Answer 37

Dr. Net investment in Lease $24,217
Cr. Truck ($23,767)
Cr. Cash ($450)

Where net investment in lease is equal to the sum of the lease receivable (PV of lease payments and the residual asset (PV of residual asset). The $450 in cash paid is for initial direct costs.

1st payment JE
Cash $5,000
Cr. Interest Income ($1453)
Cr. Net Investment in lease ($3547)

Where interest income = net investment in lease * rate implicit in lease.

Question 38

For lessor accounting of an operating lease (when OWNES is not met), will the lessor keep the asset on its books or remove it?

Answer 38

For lessor accounting of an operating lease, the lessor will keep the asset on its books and recognize lease income on a straight line basis.

Dr. Cash XXX
Cr. Rental Income (XXX)

Dr. Depreciation Expense XXX
Cr. Accumulated Depreciation (XXX)

Question 39

How should leasehold improvements be amortized?

Answer 39

Leasehold improvements should be amortized over the LESSER of the remaining life of the lease or the life of the improvements.