Intermediate Accounting II
Intermediate Accounting II ACC 3033
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This 6 page Class Notes was uploaded by Rocio West on Thursday October 29, 2015. The Class Notes belongs to ACC 3033 at University of Texas at San Antonio taught by Jeffery Boone in Fall. Since its upload, it has received 19 views. For similar materials see /class/231440/acc-3033-university-of-texas-at-san-antonio in Accounting at University of Texas at San Antonio.
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Date Created: 10/29/15
Leasing The Basic Idea 0 239 Everyone has heard how Enron structured various transactions to keep debt off of their balance sheet and thus make the company appear less risky than it really was 0 Chapter 21 discusses how GAAP attempts to bring onto the balance sheet debt off balance sheet debt that arises from leasing transactions v The purpose of lease accounting is to prevent companies from structuring leases in ways that would allow them to do what Enron did 7 ie to keep debt off the balance sheet Economics of Leasing 0 239 Leasing is a transaction in which the owner of property called a lessor allows another party called the lessee to use the property for some speci ed duration of time the lease term in exchange for periodic payments lease payments v Some leasing agreements are economically indistinguishable from an outright sale of the property to the lessee nanced by the issuance of a note payable by the lessor to the lessee example leasing an auto v Other leasing agreements are more akin to shortterm rental arrangements example renting a UHaul truck v Common sense would dictate that if we want to prevent companies from structuring transactions as leases merely to keep debt off their balance sheet then leases that are economically indistinguishable from a debt nanced purchase should be accounted for in accordance with their economic substance ie a debt nanced purchase transaction rather than their legal form ie a lease 39 The accounting challenge is to develop a workable set of rules that allow us to identify such leases o I A Identifying Leases that are In Debt Financed Purchases v GAAP has four very mechanical tests that are used to identify lease that in substance are debtfinanced purchasesales transactions 39239 Answering yes to any of the four questions means that the lease is indistinguishable from a debt nanced purchasesales transaction and thus in accounting for the transaction we will ignore the form of the transaction and instead account for the transaction as a purchase by the lessee and a sale by the lessor Note lessors have 2 additional tests that almost always are met 39239 This sort of lease is called a capital lease 39239 4 Mechanical Tests applicable to both lessors and lessees Does the lease transfer ownership of the property to the lessee Does the lease contain a bargain purchase option Does the lease term span at least 75 ofthe economic life of the lease Is the present value of the minimum lease payments at least 90 of the fair market value of the leased asset bE NH 39239 2 Additional Tests that are Applicable to Lessors Only 1 Collectibility reasonably assured 2 No important uncertainties about future costs to be incurred by lessor under the lease 39239 Any lease for which you answer no to all four questions is accounted for in accordance with its form ie a shortterm equipment usage agreement that is similar to renting a UHaul truck and is called an operating lease gt Answering yes to any of the 4 questions means the lease is a capital lease for the lessee gt Answering yes to any of the 4 questions yes to both of the 2 additional lessor only questions means the lease is a capital lease for the lessor Important Terms 39239 Minimum lease payments The agreedupon recurring lease payment any bargain purchase option any guaranteed residual value The recurring lease payment excludes any socalled executory costs things like taxes insurance repair costs etc that the lessee is required to pay even ifpaid to the lessor 39239 Guaranteed residual value A minimum value for the leased asset that the lessee guarantees at the expiration of the lease term If the value of the asset is less than the guaranteed minimum the lessee must pay the lessor the difference o v Unguaranteeal residual value Any residual value that is not guaranteed 39239 Lessor s implicit rate The discount rate that the lessor uses in determining the amount of the lease payments 39239 Lessee s incremental borrowing rate The interest rate the lessee would have to pay if the lessee had borrowed money at the bank and bought the asset outright rather than leasing the asset gt Note the importance of lessor s implicit rate and lessee s incremental borrowing rate is this In preparing the required present value calculations the lessee uses as a discount rate the smaller of its incremental borrowing rate or the lessor s implicit rate gt Note the lessor always uses its implicit rate in its present value calculations Operating Leases 39239 Lessee accounts for an operating lease by debiting rental expense and crediting cash or whatever asset was used to make payment 39239 Lessor accounts for an operating lease by debiting cash or whatever asset was received as payment and crediting rental revenue Capital Leases 7 Accounting by Lessees 39239 Lessee accounts for a capital lease by debiting an asset account called leased equipment and crediting a liability account called lease payable for the present value of the minimum lease payments Entry Made by Lessee at Inception of Capital Lease Leased Equipment XX Capital Lease Obligation XX 39239 The xx denotes the present value of the minimum lease payments 39239 See Exhibit 215 and Real Report 211 text pages 1083 and 1084 for examples of the detailed footnote disclosures that lessees must make for operating and capital leases Depreciating the leased asset applies to lessees only 39239 If the lease transfers ownership of the leased asset to the lessee at the termination of the lease OR the lease contains a bargain purchase option the leased asset is depreciated down to its estimated salvage value over the remaining economic life of the asset ie the normal depreciation approach 39239 Otherwise the leased asset is depreciated down to its guaranteed residual value over the term of the lease Capital Leases 7 Accounting by Lessors 39239 The Lessor accounts for a capital lease by debiting an asset account called lease receivable for the gross amount of the minimum lease payments plus any unguaranteed residual value discussed below and crediting a contra asset account called unearned interest revenue for the difference between the amount debited to the lease receivable account and the present value of the lease receivable o 0 The remainder of the entry depends upon whether the lessor is using leasing as a means of selling its inventory ie Boeing Co leasing itsjets to American Airlines OR whether the lessor is simply serving as a nancing intermediary between the manufacturer of the product and the end user gt Leases in which the manufacturer is using leasing as a means of selling its inventory are known as sales type leases V Leases in which the lessor is serving as a financing intermediary are known as direct nancing leases V You distinguish between the two types of leases by comparing the lessor s cost of the leased asset to its fair market value I If COSTFMV the lease is called a direct financing capital lease and the remaining part of the entry entails a credit to the asset account that contains the historical cost of the leased asset If COSTltFMV the lease is called a salestype capital lease and thus the remaining portion of the entry entails l a credit to remove the historical cost of the leased asset same entry as made under direct financing lease except the credit is usually to inventory 2 a debit to cost of goods sold for the cost of the leased asset less the present value of any unguaranteed residual value and 3 a credit to sales revenue for the present value of the minimum lease payments Entry Made by Lessor at Inception of Direct Financing Type Capital Lease Lease Receivable aa Unearned Interest Revenue bb Equipment 00 39239 aa denotes the undiscounted minimum lease payments plus the unguaranteed residual value 39239 cc denotes the ca1rying amount of the equipment in the lessor s accounting records which by definition of a direct financing lease also equals the fair market value of the asset at the inception of the lease gt Since the asset being leased by the lessor is NOT an item of inventory for the lessor the account that contains the cost of the leased asset will be some account other than inventory examples in the text assume the cost of the leased asset is carried in an asset account called Equipment 39239 Mechanically bb is a plug ie the difference between aa and cc Conceptually bb undiscounted minimum lease payments plus undiscounted unguaranteed residual value present value of the minimum lease payments plus present value of unguaranteed residual value 39239 The account Unearned Interest Revenue is a contra asset account that is netted against Lease Receivable with the net amount reported on the lessor s balance sheet Entry Made by Lessor at Inception of Sales Type Capital Lease Lease receivable aa Unearned interest revenue bb Sales revenue 0 Cost of goods sold dd Inventory ee v aa denotes the undiscounted minimum lease payments plus the unguaranteed residual value ie same as in a direct nancing lease v cc denotes the present value of the minimum lease payments v bb is not a plug as contrasted with bb as described above for direct nancing leases It must be calculated as bb undiscounted minimum lease payments plus undiscounted unguaranteed residual value present value of the minimum lease payments plus present value of unguaranteed residual value v ee denotes the carrying amount of the inventory in the lessor s accounting records which by de nition of a sales type lease does NOT equal the fair market value of the leased asset at the inception of the lease Also note that the inventory account is being credited and not the equipment account this is because the item being sold via a capital lease is an item of inventory for the lessor v dd equals the carrying amount of the inventory in the lessor s accounting records minus the present value of any unguaranteed residual value Initial Direct Costs applies to lessor onlv 39239 Initial direct costs IDC are upfront costs the lessor incurs from originating the lease e g legal fees These costs are matched with the resulting income from the lease as follows gt In operating leases IDC are capitalized and amortized over the lease period in proportion to rental receipts as a fraction of total rental receipts V In direct nancing leases IDC are capitalized and the lessor determines a new implicit interest rate text page 1093 says that the new implicit interest rate will be provided as part of the problem gt In salestype leases IDC are immediately expensed See Exhibit 216 text page 1096 for information on the footnote disclosures that lessors must make Special Cases Appendix Material 0 39 In leases of land only the rst two of the capital lease criteria apply 0 O In leases of buildings the land component of the lease is ignored and lease accounting applied as if the land and building were a single unit if the FMV of the land is less than 25 of the total value of the leased asset Otherwise lease accounting is applied to each component separately 0 0 In salesleasebacks company A sells an asset to company B and then immediately enters into a lease agreement in order to retain the use of the asset Result lease accounting applied to the lease portion of the transaction any gain on the sales part of the transaction is deferred and recognized over the lease term loss is immediately recognized