Chapter 15 Outline Leases A PDF

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Intermediate Accounting–Accounting 3020 Chapter 15–Leases Our coverage of Chapter 15 will focus only on lessee accounting. While we will want to understand what a lessor is, we will not do the accounting for the lessor, only for the lessee. GAAP for leases is in flux. We will learn the new GAAP. Existing GAAP is in the chapter supplement, which we will not cover. Part A–Accounting by the Lessor and Lessee (a lease is a contractual arrangement by which a lessor (owner) provides a lessee (user) the right to use an asset for a period of time in exchange for making periodic cash payments; a typical rental/lease agreement in which the lessor retains the fundamental rights and responsibilities of ownership with the lessee just using the asset temporarily is called an operating lease; however, some lease contracts are more like installment purchases/sales agreements; these leases are called finance leases by the lessee) Lease Classification (while some leases are obviously operating leases and some are obviously finance leases, others are not so clearly judged, so the FASB has given some guidance for distinguishing which leases the lessee will record as operating leases and which leases the lessee will record as finance leases) Classification Criteria (if one or more of the following five criteria is met, the lease is treated by the lessee as a finance lease; if none of the criteria is met, the lease is treated by the lessee as an operating lease) Criterion 1 (contract includes transfer of ownership to the lessee) Criterion 2 (contract includes a purchase option that the lessee is reasonably certain to exercise [bargain purchase option–BPO]) Criterion 3 (the lease term is for the “major part” of the remaining economic life of the asset [rule of thumb: $75%]) Criterion 4 (the present value of the total lease payments equals or exceeds “substantially all” of the fair value of the asset [rule of thumb: $90%]) Criterion 5 (the asset is so specialized as to have no alternative use to the lessor at the end of the lease term) Finance Leases and Installment Notes Compared (Skip) Finance/Sales-Type Leases (usually, but not always, lease payments come at the beginning of each lease period, not at the end; if the lease qualifies as a finance lease for the lessee, the lessee will record a Rightof-Use Asset and a Lease Payable for the present value of the appropriate lease payments; since the first payment usually comes in conjunction with the signing of the lease, the first cash payment will directly reduce the Lease Payable as no interest expense has yet been incurred) Recording Interest Expense/Interest Revenue (succeeding cash payments will be split between Interest Expense and a reduction of the Lease Payable, with interest calculated at the appropriate interest rate multiplied by the book value of the loan outstanding during the prior period) Recording Amortization of the Right-of-Use Asset (since the Right-of-Use Asset provides benefits over the lease period, the lessee will amortize this asset; our authors illustrate this with Amortization Expense and a direct reduction to the Right-of-Use Asset; a typical method for amortization would be the straight-line basis, but other methods could be used) Amortization Period (the usual life for amortization purposes would be the lease life, but if the lease is a finance lease because of a passage of title or a bargain purchase option, the life of the asset, if longer than the lease life, should be used as the useful life) Sales-Type Leases with Selling Profit (Skip) Operating Leases (if none of the criteria are met for the lessee to record the lease as a finance lease, it will be an operating lease, which is more like a rental agreement than a purchase; the lessee still records a rightof-use asset and a liability at the beginning of the lease; however, an operating lease liability is designated as a “non-debt liability” to distinguish it from a traditional liability) Recording Interest Expense/Lease Revenue (the lessee will report a single lease expense on a straight-line basis, but the expense includes two components which are calculated and recorded separately; the interest expense is calculated the same as it would be for a finance lease)

1 Recording Amortization of the Right-of-Use Asset (once the interest expense is recorded, the amortization expense is a plug figure which makes the interest expense plus the amortization expense equal to a straight-line amount over the lease term; this is NOT the way we normally record amortization) Reporting Lease Expense and Lease Revenue (after recording both interest expense and amortization expense in separate entries, the lessee combines these amounts into a single lease expense which reflects a straight-line expense over the life of the lease) Discount Rate (the discount rate usually used for lease calculations is the rate implicit in the lease agreement; this is the rate of return the lease payments provide the lessor under the lease; if this rate is not known by the lessee, the lessee will use its own incremental borrowing rate, the rate the lessee would expect to pay the bank if funds were borrowed (on an incremental basis) to buy the asset) Short-Term Leases–A Shortcut Method (if the lease term (including renewal or extension options) is 12 months or less and the lease does not contain a purchase option which the lessee is reasonably certain to exercise, which would extend the term beyond 12 months, the lessee can use a short-cut method; under this method, no Right-of-Use Asset or Lease Payable is recorded; instead, Lease expense is debited as the asset is used, and Cash is credited as payments are made) Part B–Uncertainty in Lease Transactions What if the Lease Term is Uncertain? (Skip) What if the Lease Payments are Uncertain (Skip) What if Lease Terms are Modified (Skip) Residual Value (an estimate of the leased asset’s commercial value at the end of the lease term when the asset is returned to the lessor; a lease agreement may require the lessee to guarantee a certain amount of residual value; this reduces the lessor’s risk and may also motivate the lessee to take better care of the asset) Effect of a Residual Value on the Size of Lease Payments (the higher the expected residual value of the asset when it is returned to the lessor, the lower the regular lease payments will need to be to allow the lessor to recover the value of the asset) Effect of a Residual Value on Amounts Recorded by the Lessor (Skip) Effect of a Residual Value on Lease Classification (when determining if a lease is a finance lease for the lessee, one of the criteria relates to the present value of the total lease payments (Criterion 4 above); if the lessee has guaranteed some residual value, this amount would be included in the total lease payments for which the present value would be calculated and compared to the fair value of the underlying asset) Purchase Option (if the lease contract contains a BPO, (1) the lessee would classify the lease as a finance lease, (2) the lessee would consider the option price an additional cash payment for the lease, and (3) the lease would be assumed to end on the day the option is expected to be exercised) Purchase Option Exercisable Before the End of the Lease Term (if the BPO becomes exercisable before the end of the designated lease term, we assume the option is exercised at that time and that the lease ends at that time) Termination Penalties (if the lease contains a penalty payment for lessee termination at a time specified in the contract and it is reasonably certain that the lessee will terminate the lease, the termination penalty would be considered an additional lease payment) Summary of the Lease Uncertainties (Skip except summary of portions covered)

Part C–Other Lease Accounting Issues and Reporting Requirements (Skip entire section) Appendix 15–Sale-Leaseback Arrangements (Skip)

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