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FA3 Lesson 5: Leases

FA3 Lesson 5: Leases. Capitalization criteria Lessee: Basic lease accounting Lessee: Fiscal year and capitalization cap Lessee: Sale and leaseback Lessor: Lease accounting Cash flow statement review. 1. Capitalization criteria.

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FA3 Lesson 5: Leases

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  1. FA3 Lesson 5: Leases • Capitalization criteria • Lessee: Basic lease accounting • Lessee: Fiscal year and capitalization cap • Lessee: Sale and leaseback • Lessor: Lease accounting • Cash flow statement review

  2. 1. Capitalization criteria Central objective: Accounting should capture the economic essence of the lease transaction. Is the transaction essentially a rental or a sale? Capitalization guidelines • Lessee owns asset at end of lease term • Lease term > 75% of asset useful life • PV of min. lease payments at least 90% of FMV of asset If not a capital lease, then operating lease.

  3. Lease vocabulary Min. lease payments: total periodic rental payments (less executory costs) plus bargain purchase option (BPO) or guaranteed residual or failure to renew penalty Interest rate: lessee incremental borrowing rate or rate implicit in lease, whichever is lower Residual value: value of leased asset at end of lease Lease term: all terms prior to exercise date of BPO, all bargain renewal terms, all renewal terms at lessor’s option

  4. 2. Lessee: Basic lease accounting • For an operating lease, lessee records only rent expense (plus any prepaid rent/rent payable) • For a capital lease, lessee must record an asset and liability equal to PV of min. lease payments • For a capital lease, lease payments represent interest and capital repayment; asset must be amortized over period lessee will use the asset EXAMPLE: A18-1

  5. 3. Lessee: Fiscal year and capitalization cap • The amortization table for lease payments will not necessarily correspond to the fiscal year; interest expense could be a combination of interest from two different lease payments • Lessee cannot record the leased asset at a value higher than its market value; if the lessee incremental borrowing rate is too low, must use rate implicit in the lease (the one that sets PV of min. lease payments equal to FMV of asset) Example: A18-7

  6. 4. Lessee: Sale and leaseback • Sale and leaseback: The former owner (now lessee) sells the asset and leases it back immediately from lessor • Any gain on sale to the lessee is amortized over the lifetime of the lease, proportionately to amortization of leased asset; any loss on sale is recognized immediately EXAMPLE: A18-27

  7. 5. Lessor: Lease accounting Lessor capitalization guidelines • Does lessee own asset at end of lease term, either through contract provision or bargain purchase option? • Is lease term ≥ 75% of asset useful life? • Is present value of min. lease payments ≥ 90% of fair market value of asset? + 4. Is risk associated with collection normal? + 5. Can remaining lessor costs be estimated? ---- 1 or 2 or 3; + 4 + 5 = Capital lease ---- Otherwise, operating lease.

  8. 5. Lessor: Lease accounting From lessor point of view, two types of capital leases: • Direct financing lease: lessor is a finance company that purchased the asset at fair market value and leased it immediately to lessee; lessor reports only financing revenue, recognized over lifetime of lease • Sales-type lease: lessor is a manufacturer or retailer who earns (1) gross profit on sale of asset, recognized at time of sale; and (2) financing revenue, recognized over lifetime of lease

  9. 5. Lessor: Lease accounting (cont’d) Accounting for direct financing leases: • Establish lease receivable at gross value • Remove leased asset from books • Create unearned finance revenue account for difference between (1) and (2), a contra account to lease receivable; any initial direct costs charged to unearned finance revenue • Annually, record finance income, lessee payment, and any other lease-related costs. EXAMPLE: A19-14

  10. 5. Lessor: Lease accounting (cont’d) Accounting for sales-type leases: • Establish lease receivable at gross value • Record sales revenue = fmv of asset • Remove asset from books and record COGS • Create unearned finance revenue account for difference between (1) and (2) • Initial direct costs expensed as incurred • Annually, record finance income, lessee payment, and any other lease-related costs. EXAMPLE: A19-14

  11. 6. Cash flow statement review EXAMPLE: A19-27

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