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Flashcards in Ch 21 Deck (73):
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Lease

Contractual agreement between lessor and lessee

1

Lessee

Has right to use specific property for specified period of
Time under lease agreement

Makes rental payments of lease term to lessor

2

Lessor

Owns property being leased

3

3 general categories of lessors that own property?

1 banks

2 captive leasing companies

3 independents

4

What 2 advantages to banks have with leasing?

1 have low cost funds which give them advantage of being
Able to purchase assets at less cost than competitors

2 leasing transactions are standardized, so banks don't need
To innovate to structure lease arrangements

5

Captive leasing companies

Subsidiaries whose primary business is performing leasing
Operations for parent company

Ex. IBM Global Financing, Ford Motor Credit

6

Advantage captive leasing companies have?

Point of sale advantage in finding leasing customers

Can quickly develop lease financing arrangement b/c has
Product knowledge that gives advantage when financing
Parent's product

7

Independents (lessors) what are they good at?

Developing innovative contracts for lessees

8

Independents (lessors), what are they starting to do?

Act as captive finance companies for some companies
That don't have leasing subsidiary

9

Leasing advantage: 100% financing at fixed rates

Signed without requiring any money Down for lessee
Helping lessee conserve scarce cash

Lease payments often remain fixed protecting lessee
Against inflation and increases in cost of money

10

Leasing advantage: protection against obsolescence (lessee)

Risk of obsolescence is reduced by leasing of lessee as
Risk of residual value is passed to lessor

11

Leasing advantage: protection against obsolescence (lessor)

Charges higher rent payments to lessee

12

Leasing advantage: flexibility

Duration of lease can be tailored as short term or span
The entire time for expected economic life of asset

Payment may be fixed or variable (pegged to interest rate
Or inflation), enabling lessor to recover cost of asset with fair
Return

13

Lease term

Duration of lease

14

Leasing advantage: less costly financing

Claim tax benefits if in lower tax bracket (start up companies)

15

Leasing advantage: tax advantages

Synthetic lease arrangement allows companies to capitalize
And depreciate a leased asset for tax purposes

While keeping it off the balance sheet

16

Leasing advantage: off balance sheet financing

Keeping debt off balance sheet to not affect financial ratios
Adds to company's borrowing capacity

17

Executory contract

Requires continuing performance by both parties

18

4 views on capitalizing leases

1 don't capitalize any leased assets
2 capitalize leases that are similar to installment purchases
3 capitalize all long term leases
4 capitalize firm leases where penalty for nonperformance
Is substantial

19

Firm leases

Non cancelable contract, unlikely to avoid without severe
Penalty

20

FASB: preferred lease capitalization approach

Capitalization approach when lease is similar to installment
Purchased and non cancelable

Capitalize a lease that transfers substantially all benefits
And risks of property ownership provided lease is noncancelable

21

Noncancelable

Can only cancel lease contract only upon outcome of some
Remote contingency

22

How does a lessee capitalize a lease

Records asset and liability generally equal to present value
Of rental payments

23

In order to record a lease as a capital lease, the lease must...

Be noncancelable

24

4 capitalization criterial lessee

1 lease transfers ownership of property to lessee
2 lease contains bargain purchase option
3 lease term is equal to 75% or more of estimated economic
Life of property
4 present value of minimum lease payments (excluding
Executory costs) equals or exceeds 90 percent of fair
Value of leased property

25

Operating leases

Leases that do not meet any of the four criteria for
capitalization

26

Bargain purchase option

Allows lessee to purchase leased property for price
significantly lower than property's expected FV at date
Option becomes exercisable

27

Bargain renewal option

Allows lessee to renew lease for rental that is lower than
expected fair rental at date option becomes exercisable

28

What 4 items do minimum lease payments include?

1 minimum rental payments
2 guaranteed residual value
3 penalty for failure to renew or extend lease
4 bargain purchase option

29

Residual value

Estimated fair value of leased property at end of lease term

30

Guaranteed residual value

Either determinable amount company will pay at end of
Lease to purchase asset

Or amount company/or 3rd party guarantees will be realized
When asset is returned

31

Third party guarantors

Insurers who for a fee assume risk of deficiencies in leased
Asset residual value

32

Unguaranteed residual value

Estimated residual value exclusive of any portion guaranteed

33

Executory costs for tangible assets

Incur insurance, maintenance and tax expenses during
Their economic life

34

Incremental borrowing rate

When is it not used?

Discount rate used to compute present value of minimum
lease payments

2) Not used when implicit rate of lessor is known

35

Leases: effective interest method

Used to allocate each lease payment btw/ interest and
Principal

36

For a capitalized asset and recorded obligation at present value, the depreciation of the asset and discharge of the obligation are...

Independent accounting processes

37

Operating method (lessee)

Rent expense (and associated liability) accrues day by day
To lessee as it uses the property

Lessee assigns rent to periods benefitting from use of
Asset and ignores (in accounting) commitments to make
Future payments

38

Disclosure of operating leases

Company must disclose all operating leases that have
Noncancelable lease terms in excess of 1 year

39

Why does the business community look negatively on capitalizing leases? 4 reasons

1 debt to equity increases
2 rate of return on total assets decreases
3 violation of loan covenants
4 affects compensation received by owners (ex. Stock
Compensation plan)

40

3 following differences occur if using capital lease instead of operating lease

1 increase in debt reported

2 increase in total assets (especially long lived assets)

3 lower income early in life of lease (therefore lower retained
Earnings)

41

3 advantages of leasing to the lessor?

1 interest revenue

2 tax incentives

3 high residual value

42

Leasing advantage for lessor: Interest revenue

Provides competitive interest margins

43

Leasing advantage for lessor: Tax incentives

Usually, Companies that lease can't use tax benefit of asset,
But leasing allows them to transfer tax benefits to another
Party (the lessor)

In exchange for a lower rental rate on leased asset

44

Leasing advantage for lessor: high residual value

Return of property at end of lease term, the more value
The higher the profit

45

3 classifications of leases by lessor

1 operating leases
2 direct financing leases
3 sales type leases

46

4 Capitalization criteria for lessor Group 1

1 lease transfers ownership of property to lessee
2 lease contains a bargain purchase option
3 lease term equal to 75% or more of economic life of leased
Property
4 present value of minimum lease payments (excluding
Executory costs) equals or exceeds 90% fair value leased
Property

47

2 Capitalization criteria (lessor) Group II

1 collectibility of payments required from lessee reasonably predictable

2 no key uncertainties surround amount of unreimbursable
Costs yet to be incurred by lessor under the lease

48

How many conditions under Group 1 and Group II or capitalization criteria requirements must be met for lessor to classify arrangement as direct financing lease or sales type lease?

Both criteria for group II and 1 or more criteria for group 1

50

Direct financing lease vs. sales type lease

Sales type lease involves manufacturer's or dealer's profit

Direct financing lease does not

51

Manufacturer's or dealer's profit (or loss)

Evidenced by difference between fair value of leased
Property at inception of lease and lessor's book value

53

The distinction for the lessor between a direct financing lease and a sales type lease is the presence or absence of...

A manufacturer's or dealer's profit (or loss)

54

Lessors classify and account for all leases that do not qualify as direct-financing or sales-type leases as...

Operating leases

55

Direct financing leases

Financing of an asset purchased by the lessee

56

Lease receivable (direct financing leases)

Lessor records "lease receivable" instead of leased asset

57

Operating method: rental receipts recorded by lessor

Recorded as rental revenue

58

6 lease arrangements that cause unique accounting problems

1 residual values
2 sales type leases (lessor)
3 bargain purchase options
4 initial direct costs
5 current vs. Noncurrent classification
6 disclosure

59

Guaranteed residual value

Lessee agrees to make up any deficiency below stated
Amount that lessor realizes in residual value at end of lease
Term

60

3 sales type lease terms

1 lease receivable

2 sales price of the asset

3 cost of goods sold

61

Sales-type lease terms: lease receivable AKA net investment

Present value of minimum lease payments
+ PV of any Unguaranteed residual value

62

Sales-type lease term: Sales price of asset

Present value of minimum lease payment

63

Sales-type lease term: cost of goods sold

Cost of asset to lessor less PV of any Unguaranteed residual
Value

64

Sales type lease: gross profit

Gross profit amount on sale of asset is same whether
Guaranteed or Unguaranteed residual value is involved

65

If the bargain purchase option exists the lessee must...

Increase the PV of minimum lease payments by the PV
Of the option price

66

Accounting treatment of computation of depreciation: bargain purchase option vs. guaranteed residual value

Guaranteed residual value: depreciates asset over lease term

Bargain purchase option: depreciates economic life of asset

67

2 types of initial direct costs (lessor)

1 incremental direct costs

2 internal direct costs

68

Incremental direct costs

Paid to independent third parties for orginating lease
Arrangement

Ex. Cost of independent appraisal of collateral used to secure lease, cost of outside credit check of lessee

69

Internal direct costs

Directly related to specified activities performed by lessor
On a given lease

Ex. Evaluating lessee's prospective financial condition,
Evaluating and recording guarantees and collateral

70

3 internal indirect costs (lessor performs)

1 advertising

2 servicing existing leases

3 establishing and monitoring credit policies

71

The most common method of measuring current liability portion in ordinary annuity leases?

Change in the present value method

72

How do companies get around capitalizing their leases ?

Companies design, write and interpret lease agreements
To prevent satisfying any if the 4 capitalized lease criteria

73

How do lessees and lessors get around the "90% recovery test"?
2 methods

1 use incremental borrowing rate by lessee when it is higher
Than implicit interest rate of lessor (making implicit int. rate
Unavailable to lessee)

2 residual value guarantees,

74

Residual value guarantees to get around 90% recovery test

Have 3rd party guarantee residual value, so minimum
Lease payments of lessee exclude the guarantee