Exam 2

Question 1

Lease

Answer 1

An agreement conveying the right to use the property, plant, or equipment usually for a stated period of time

Question 2

Lessee

Answer 2

The party paying for the right to use the asset for a specified period of time

Question 3

Lessor

Answer 3

The party that legally owns the asset and is receiving payment from the lessee for use of that asset for a specified period of time

Question 4

Why would you lease rather than buy? (Lessee)

Answer 4

• Fixed rate with no down payment
• Only want part of an asset
• Protection against obsolescence
• Flexibility
• Tax benefits
• Off-sheet financing for operating leases

Question 5

Why would you lease rather than buy? (Lessor)

Answer 5

• Generate proceeds from an asset not in use

- Financing income

Question 6

Operating leases

Answer 6

• Recognizes lease payments as an expense

- Risks and rewards of ownership NOT transferred

Question 7

Capital Leases

Answer 7

Leases transfer to the lessee the risks and rewards of ownership

• Recognizes leased item and payment obligation on the balance sheet
• Depreciates the leased item
• Lease payments are allocated between reduction of the outstanding liability and finance charge
• More like the sale of property with periodic payments (financing or economically like a bank loan)

Question 8

4 Criteria

Answer 8

If lease meets ANY 1 of the criteria, it is capital:

1) Transfer ownership at the end of the lease? (strong)
2) BPO? (strong)
3) Lease term >= 75% of useful life? (weak)
4) Present value of minimum lease payments >= 90% of fair value? (weak)

Question 9

BRO

Answer 9

Bargain Renewal Option: allows lessee to renew the lease for a period of time at a rent lower than the market rental price

Question 10

BPO

Answer 10

Bargain Purchase Option: lessee has the option to purchase the asset at a specified time for a price substantially below the asset’s fair market value at that point in time

Question 11

Residual Value

Answer 11

Estimated fair market value of the leasaed asset at the end of the lease term

Question 12

GRV

Answer 12

Guaranteed Residual Value: amount lessee is obligated to pay for the asset at the end of the lease term

• amount lessee guarantees the lessor will receive for the asset
• To prevent lessee from abusing the asset and returning it with very low or even 0 residual value
• Unguaranteed part is a risk the lessor takes

Question 13

Lease term

Answer 13

Fixed, non-cancelable term of the lease

-lease term does not extend beyond date a BPO becomes exercisable, is extended for renewal periods

Question 14

Minimum Lease Payments Include:

Answer 14

• Rent payments the lessee is obligated to make under terms of lease (excluding any executory costs paid by the lessor)
• Amount of BPO
• Guaranteed residual value

Question 15

Minimum Lease Payments do NOT include:

Answer 15

• Executory costs (if lessee pays these, expensed in the period incurred)
• Payments contigent on future performance (expensed if conditions are met)

Question 16

Discount rate

Answer 16

The rate used to find the present value of the future minimum lease payments . Rate for LESSEE is the lesser of:

• Lessee’s incremental borrowing rate (if lessee went to bank, the rate they would get)
• Lessor’s implicit interest rate (if it is known)

Question 17

Amortization Strong v Weak form

Answer 17

Strong form:
-Useful life
-Net salvage value
Weak form:
-Lease term (depreciated to 0 if no GRV)
-Expected value to lessee

Question 18

Inception of lease

Answer 18

asset and liability both are recorded at lower of:
-fair market value of leased asset
-present value of minimum lease payments
Asset and liability starts out the same

Question 19

Termination of Capital Lease

Answer 19

Strong:

• Transfer leased equipment and accumulated depreciation accounts to “owned” equipment
• Liability will already be at 0 or will be 0 after BPO

Weak:

• Leased equip, accum, and liability are zeroed out
• Cash paid to lessor if FMV is less than GRV
• Gain/loss recognized if actual FMV different from original expected FMV

Question 20

Capital lease - Lessor

Answer 20

• Either direct financing (lessor’s only income is interest revenue) or sales type (lessor has profit on trasnfer as well as interest revenue)
• Must meet BOTH group 2 criteria
  1) Collectibility of lease payments is reasonably assured
  2) No important uncertanties about unreimburseable costs

Question 21

Discount rate for lessor

Answer 21

• Lessors implicit interest rate

- The discount rate could differ from rate used by lessee

Question 22

BPO effects

Answer 22

• BPO is considered part of the minimum lease payments (last payment)
• Asset depreciated over life of the asset rather than lease term
• Salvage value subtracted at the end to calc depreciation
• changes the term of depreciation
• potetially changes the term of lease and final payment amt
• must reclassify asset at “owned”

Question 23

Operating v Capital Effects

Answer 23

• The total expense over the life of the lease is the SAME for both methods
• No cash flow implications
• Operating leases = lower assets and liabilities (lower annual expense) early in the life of the lease

Question 24

Off-balance sheet financing

Answer 24

• 1/3 of all capital expenditures are done through leasing

- For many companies, off balance sheet lease obligations (operating) are many times higher than reported debt

Question 25

GRV effects on Lessee

Answer 25

- ONLY the GRV is considered part of minimum lease payments (considered last payment made) - Depreciation schedule based on PV of minimum lease payments - GRV and depreciated over the life of the lease

Question 26

GRV effects on Lessor

Answer 26

- End of lease, if true residual value is < GRV, the lessee returns the asset and pays cash to make up the difference, Lessee records a loss - Entire residual value (guaranteed and unguaranteed) is considered part of the lease receivable - May record a loss for unguaranteed, but if the true value is greater than GRV, does NOT record a gain

Question 27

Sales type lease - lessor

Answer 27

- FMV > seller's cost | - Recognize 2 types of revenue; Profit on sale (selling price or FMV - seller's cost) and interest revenue

Question 28

Taxes Payable

Answer 28

- Tax term (based on IRC) - Taxable revenue - deductions * tax rate - Usually not the same as tax expense

Question 29

Tax expense

Answer 29

US GAAP revenue - US GAAP expenses = net income | Depends on timing differences of revenue and expenses

Question 30

Income taxes for businesses

Answer 30

- Proprietorships, Partnerships & S-corporations: Net income of business is divided among the owners, the taxes are paid and income is included on the owners' individual tax return - Corporations: separate taxable entity, corporation must file tax return and pay taxes on income, pay taxes on dividends

Question 31

Taxable income

Answer 31

- Used to calculate taxes payable - Tax rules set by Congress and enforced by the IRS - Goals include: raising revenue for gov't and encouraging social goals - Often closer to modified cash basis

Question 32

Accounting income

Answer 32

- Used to calculate tax expense - Rules set by FASB and enforced by SEC - Goals include transparent reporting of the financial position of the company - Accrual basis

Question 33

Comprehensive Interperiod tax allocation

Answer 33

The full tax consequence of an event is recognized in the period in which event is recognized

Question 34

Permanent differences

Answer 34

Pretax accounting items that will never be included for taxable income or vice versa (NEVER will have to pay or deduct) - Interest gained on municipal debt - Fines/ expenses associated with violation of the law - Amounts paid for key officer life insurance

Question 35

Temporary differences

Answer 35

- Items that are recorded in taxable income in a difference year than pretax income (will eventually be recorded in both, so the difference is temporary) - Bad debt expense, warranty expense, advances from customers, accelerated depreciation

Question 36

Deferred tax asset

Answer 36

- Taxable income > accounting income - Assets: book value is less than tax basis - Liabilities: book value is greater than tax basis - Carryforwards

Question 37

Deferred tax liability

Answer 37

- Accounting income > taxable income - Assets: book value is greater than tax basis - Liabilities: book value is less than tax basis

Question 38

Net operating loss

Answer 38

- Occurs for tax purposes when tax deductions exceed tax revenues - Loss carryback - a corporation may carry a loss back and receive a refund for taxes previously paid - Loss carryforward - use NOL to offset future taxable income

Question 39

Tax expense calculation

Answer 39

Taxes payable + change in DTL - change in DTA

Question 40

Tax rate changes

Answer 40

- Valuation of deferred tax assets and liabilities are based on new tax rates - Tax expense in year of enacted rate change is affects - Example: Net asset position in DTA, then increase in tax rates will cause greater tax expense to decrease, so the benefit of the future deduction is greater