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Chapter 21 Texbook Outline

by: Lauren95

Chapter 21 Texbook Outline Acc 302

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This document highlights all the important terms and information in chapter 21.This chapter is about leases. After reading this you should be able to: (1) Describe the accounting criteria and pro...
Intermediate Accounting II
Class Notes
Intermediate Accounting, Kieso, Weygandt, Warfield, reisig, Leases, Lease, Chapter 21, Wiley
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This 7 page Class Notes was uploaded by Lauren95 on Thursday March 31, 2016. The Class Notes belongs to Acc 302 at Pace University taught by Reisig in Spring 2016. Since its upload, it has received 23 views. For similar materials see Intermediate Accounting II in Accounting at Pace University.


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Date Created: 03/31/16
Chapter 21 – Accounting for Leases  A lease is a contractual agreement between a lessor and a lessee.  This arrangement gives the lessee the right to use specific property, owned by the lessor, for a specified period of time.  In return for the use of the property, the lessee makes rental payments over the lease term to the lessor.  Who are the lessors that own this property? o They generally fall into one of three categories:  1. Banks.  They have low-cost funds, which give them the advantage of being able to purchase assets at less cost than their competitors.  Banks have been more aggressive in the leasing markets.  Deciding that there is money to be made in leasing, banks have expanded their product lines in this area.  Leasing transactions are now more standardized, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements.  2. Captive leasing companies.  Captive leasing companies are subsidiaries whose primary business is to perform leasing operations for the parent company.  Captive leasing companies have the point-of-sale advantage in finding leasing customers.  3. Independents.  Independents do not have point-of-sale access, nor do they have a low cost of funds advantage.  What they are often good at is developing innovative contracts for lessees.  Advantages of Leasing: o 1. 100% financing at fixed rates.  Leases are often signed without requiring any money down from the lessee. This helps the lessee conserve scarce cash—an especially desirable feature for new and developing companies.  Lease payments often remain fixed, which protects the lessee against inflation and increases in the cost of money. o 2. Protection against obsolescence.  Leasing equipment reduces risk of obsolescence to the lessee and in many cases passes the risk of residual value to the lessor. o 3. Flexibility.  Lease agreements may contain less restrictive provisions than other debt agreements.  Innovative lessors can tailor a lease agreement to the lessee’s special needs.  The duration of the lease—the lease term —may be anything from a short period of time to the entire expected economic life of the asset. o 4. Less costly financing.  Some companies find leasing cheaper than other forms of financing.  Through leasing, the leasing companies or financial institutions use these tax benefits.  They can then pass some of these tax benefits back to the user of the asset in the form of lower rental payments. o 5. Tax advantages.  For financial reporting purposes, companies do not report an asset or a liability for the lease arrangement.  For tax purposes, however, companies can capitalize and depreciate the leased asset.  As a result, a company takes deductions earlier rather than later and also reduces its taxes. o 6. Off-balance-sheet financing.  Certain leases do not add debt on a balance sheet or affect financial ratios.  Conceptual Nature of a Lease: o The various views on capitalization of leases are as follows:  1. Do not capitalize any leased assets.  A lease is an “executory” contract requiring continuing performance by both parties. Because companies do not currently capitalize other executory contracts (such as purchase commitments and employment contracts), they should not capitalize leases either.  2. Capitalize leases that are similar to installment purchases.  This view holds that companies should report transactions in accordance with their economic substance.  If companies capitalize installment purchases, they should also capitalize leases that have similar characteristics.  3. Capitalize all long-term leases.  This approach requires only the long-term right to use the property in order to capitalize.  This property-rights approach capitalizes all long-term leases.  4. Capitalize firm leases where the penalty for nonperformance is substantial.  A final approach advocates capitalizing only “firm” (noncancelable) contractual rights and obligations.  “Firm” means that it is unlikely to avoid performance under the lease without a severe penalty.  Noncancelable means that a company can cancel the lease contract only upon the outcome of some remote contingency, or that the cancellation provisions and penalties of the contract are so costly to the company that cancellation probably will not occur. o Three basic conclusions:  (1) Companies must identify the characteristics that indicate the transfer of substantially all of the benefits and risks of ownership.  (2) The same characteristics should apply consistently to the lessee and the lessor.  (3) Those leases that do not transfer substantially all the benefits and risks of ownership are operating leases.  Companies should not capitalize operating leases.  Capitalizes a lease, it records an asset and a liability generally equal to the present value of the rental payments.  In order to record a lease as a capital lease, the lease must be noncancelable.  Three of the four capitalization criteria that apply to lessees are controversial and can be difficult to apply in practice. o Transfer of Ownership Test  If the lease transfers ownership of the asset to the lessee, it is a capital lease. o Bargain-Purchase Option Test  A bargain-purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s expected fair value at the date the option becomes exercisable.  At the inception of the lease, the difference between the option price and the expected fair value must be large enough to make exercise of the option reasonably assured. o Economic Life Test (75% Test)  If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee.  Capitalization is therefore appropriate. Determining the lease term and the economic life of the asset can be troublesome.  The lease term is generally considered to be the fixed, noncancelable term of the lease.  A bargain-renewal option, if provided in the lease agreement, can extend this period.  A bargain-renewal option allows the lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable.  At the inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. o Recovery of Investment Test (90% Test)  If the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the asset, then a lessee should capitalize the leased asset.  Determining the present value of the minimum lease payments involves three important concepts: o (1) minimum lease payments, o (2) executory costs, and o (3) discount rate.  Minimum Lease Payments:  1. Minimum rental payments o Minimum rental payments are those that Company A must make to Company B under the lease agreement. o In some cases, the minimum rental payments may equal the minimum lease payments. o The minimum lease payments may also include a guaranteed residual value (if any), penalty for failure to renew, or a bargain-purchase option.  2. Guaranteed residual value. o The residual value is the estimated fair (market) value of the leased property at the end of the lease term. ILFC may transfer the risk of loss to Delta or to a third party by obtaining a guarantee of the estimated residual value. The guaranteed residual value is either (1) the certain or determinable amount that Delta will pay ILFC at the end of the lease to purchase the aircraft at the end of the lease, or (2) the amount Delta or the third party guarantees that ILFC will realize if the aircraft is returned. ( Third-party guarantors are, in essence, insurers who for a fee assume the risk of deficiencies in leased asset residual value.) If not guaranteed in full, the unguaranteed residual value is the estimated residual value exclusive of any portion guaranteed.  3. Penalty for failure to renew or extend the lease. o The amount Company A must pay if the agreement specifies that it must extend or renew the lease, and it fails to do so.  4. Bargain-purchase option. o An option given to Company A to purchase an asset at the end of the lease term at a price that is fixed sufficiently below the expected fair value, so that, at the inception of the lease, purchase is reasonably assured.  Like most assets, leased tangible assets incur insurance, maintenance, and tax expenses—called executory costs —during their economic life.  A company computes the present value of the mini-mum lease payments using its incremental borrowing rate. o This rate is defined as: “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.”  Asset and Liability Recorded o Under the capital lease method, Company A treats the lease transaction as if it purchases an asset (aircraft) in a financing transaction. That is, Company A acquires the asset and creates an obligation. I  It records a capital lease as an asset and a liability at the lower of (1) the present value of the minimum lease payments (excluding executory costs) or (2) the fair value of the leased asset at the inception of the lease.  The rationale for this approach is that companies should not record a leased asset for more than its fair value.  Depreciation Period o If the lease agreement transfers ownership of the asset to Company A (criterion 1) or contains a bargain- purchase option (criterion 2), Company A depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset . o On the other hand, if the lease does not transfer ownership or does not contain a bargain-purchase option, then Company A depreciates it over the term of the lease .  In this case, the aircraft reverts to Company B after a certain period of time.  Effective-Interest Method o Throughout the term of the lease, Company a uses the effective-interest method to allocate each lease payment between principal and interest. o This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. o When applying the effective-interest method to capital leases, Company A must use the same discount rate that determines the present value of the minimum lease payments.  Depreciation Concept o Although Company A computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. o It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum- of-the-years’-digits, declining-balance, units of production, etc.  Capital Lease Method for the lessee  Operating Method for the lessee: o Under the operating method , rent expense (and the associated liability) accrues day by day to the lessee as it uses the property. o The lessee assigns rent to the periods benefiting from the use of the asset and ignores, in the accounting, any commitments to make future payments. o The lessee makes appropriate accruals or deferrals if the ac-counting period ends between cash payment dates.  The following differences occur if using a capital lease instead of an operating lease: o 1. An increase in the amount of reported debt (both short-term and long-term). o 2. An increase in the amount of total assets (specifically long-lived assets). o 3. A lower income early in the life of the lease and, therefore, lower retained earnings.  Accounting by the Lessor: o 1. Interest revenue.  Leasing is a form of financing.  Banks, captives, and independent leasing companies find leasing attractive because it provides competitive interest margins. o 2. Tax incentives.  In many cases, companies that lease cannot use the tax benefit of the asset, but leasing allows them to transfer such tax benefits to another party (the lessor) in return for a lower rental rate on the leased asset. o 3. High residual value.  Another advantage to the lessor is the return of the property at the end of the lease term.  Residual values can produce very large profits.  For accounting purposes, the lessor may classify leases as one of the following: o 1. Operating leases. o 2. Direct-financing leases. o 3. Sales-type leases.  Direct- Financing Method – Lessor: o Direct-financing leases are in substance the financing of an asset purchase by the lessee.  In this type of lease, the lessor records a lease receivable instead of a leased asset.  The lease receivable is the present value of the minimum lease payments.  Remember that “minimum lease payments” include:  1. Rental payments (excluding executory costs).  2. Bargain-purchase option (if any).  3. Guaranteed residual value (if any). 4  . Penalty for failure to renew (if any).  The lessor records the residual value, whether guaranteed or not.  Operating Method – Lessor o The operating method , the lessor records each rental receipt as rental revenue.  It depreciates the leased asset in the normal manner , with the depreciation expense of the period matched against the rental revenue.  The amount of revenue recognized in each accounting period is a level amount (straight-line basis) regardless of the lease provisions, unless another systematic and rational basis better represents the time pat-tern in which the lessor derives benefit from the leased asset.  The lessor amortizes over the life of the lease any costs paid to independent third parties, such as appraisal fees, finder’s fees, and costs of credit checks, usually on a straight-line basis.  The features of lease arrangements that cause unique accounting problems are: o 1. Residual values.  The residual value is the estimated fair value of the leased asset at the end of the lease term.  Stated amount is the guaranteed residual value .  Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee.  We saw the economic consequence—lower lease payments—in the preceding example.  The accounting consequence is that the minimum lease payments , the basis for capitalization, include the guaranteed residual value but exclude the unguaranteed residual value.  The guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term.  From the lessee’s viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability.  The lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. o 2. Sales-type leases (lessor).  Sales-type lease is the manufacturer’s or dealer’s gross profit (or loss). o 3. Bargain-purchase options.  A bargain-purchase option allows the lessee to purchase the leased property for a future price that is substantially lower than the property’s expected future fair value.  The price is so favorable at the lease’s inception that the future exercise of the option appears to be reasonably assured.  If a bargain-purchase option exists, the lessee must increase the present value of the minimum lease payments by the present value of the option price. o 4. Initial direct costs.  Initial direct costs are of two types: incremental and internal.  Incremental direct costs are paid to independent third parties for originating a lease arrangement.  Internal direct costs are directly related to specified activities performed by the lessor on a given lease.  The accounting for initial direct costs depends on the type of lease:  • For operating leases , the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental revenue.  • For sales-type leases , the lessor expenses the initial direct costs in the period in which it recognizes the profit on the sale.  • For a direct-financing lease , the lessor adds initial direct costs to the net investment in the lease and amortizes them over the life of the lease as a yield adjustment. o 5. Current versus noncurrent classification.  The most common method of measuring the current liability portion in ordinary annuity leases is the change-in-the-present-value method.  A current asset arises for the receivable reduction and for the interest that was recognized in the preceding period. o 6. Disclosure.  These disclosure requirements provide investors with the following information:  General description of the nature of leasing arrangements  The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years.  The amount of lease revenues and expenses reported in the income statement each period.  Description and amounts of leased assets by major balance sheet classification and related liabilities.  Amounts receivable and unearned revenues under lease agreements.  Unresolved Lease Accounting Problems: o Companies can easily devise lease agreements in such a way, by meeting the following specifications:  1. Ensure that the lease does not specify the transfer of title of the property to the lessee.  2. Do not write in a bargain-purchase option.  3. Set the lease term at something less than 75 percent of the estimated economic life of the leased property.  4. Arrange for the present value of the minimum lease payments to be less than 90 percent of the fair value of the leased property. o The lessee’s use of the higher interest rate is probably the more popular subterfuge. o The residual value guarantee is the other unique, yet popular, device used by lessees and lessors.


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