RCMA 1: LEASES | Phoenixnotebook

LEASES

Overview:

Organizations will occasionally lease assets from the rightful owner rather than purchasing them completely. A lease is a formal agreement wherein the right to use an asset for a predetermined amount of time in exchange for a predetermined series of payments is granted to the lessee by the legal owner, or lessor. Lease categorization dictates the accounting approach; leases can be classified as operating or financial depending on the parameters of the contract. In this session, we'll identify the two distinct kinds of leases and go over how each should be recorded.

In a LEASE, the counterparty to the contract (the lessee) is legally granted the right to use an asset (leased item) for a specific period (the lease term) in exchange for a certain number of payments (the minimum lease payments) from the lessor, the legal owner of the asset. Renting out assets allows organizations to obtain their utilization without owning them outright.

The accounting for leases is dependent upon the classification of the lease as finance

or operating. Lessees will classify leases as one of two types:

Finance Lease—The lessor assigns certain privileges and advantages of the lessee's ownership.

For Example: A lease for a specialized piece of machinery where the lessee is responsible for repairs, insurance, or other activities traditionally considered part of ownership.

I. Finance Lease in treating the arrangement as a borrowing and purchasing.

A. Borrowing: Similar to amortizing a typical mortgage loan with equal installments, the lessee registers a liability for the present value of the minimum lease payments and amortizes the obligation as payments are made.

B. Purchase: The property is listed by the lessee as an asset with a right-of-use (ROU), also records depreciation expense on its income statement.

II. The Financial Accounting Standards Board (FASB) has documented five criteria to determine if a lease should be recorded as a finance lease:

1. Upon the expiration of the lease, ownership is transferred to the lessee.

2. At the end of the lease term, there is a "bargain purchase option" to acquire the asset for a sum that is markedly less than its estimated market worth.

3. The lease covers the majority of the underlying asset's remaining economic life. The FASB has provided a guideline of 75% of the asset's projected useful life when considering whether the lease term is for a "major" part of the asset's life, even if there isn't a clear cut answer in this case.

4. The minimum lease payments' present value is significantly greater than the underlying asset's fair value. Although there isn't a clear-cut answer in this case, the FASB has provided a guideline of 90% of the asset's fair market value when considering whether the item's value is "substantially all" covered by the minimum lease payments.

5.The underlying asset is so specialized for the lessee that it is expected to have no alternative future use to the lessor at the end of the lease term.

Note: Only one of the preceding five criteria must be met to record the lease as a finance Lease.

Operating Lease—The lessor simply gives the lessee permission to utilize the property. The majority of the risks and rewards of ownership remain with the lessee and the lessor/owner.

For example: An apartment lease is an operating lease, as the landlord pays for all repairs and other costs of ownership. In addition, the

apartment lease is generally for a relatively short period of time when compared to the life of the asset.

I. Recording of Operating Lease Transactions:

The minimum lease payments' current value is recorded by the lessee as a liability, which is then amortized as payments are received. To enable the lessee to recognize the entire lease expense (interest plus ROU asset amortization) on a straight-line basis during the lease's term, an ROU asset is recorded at the time of lease signing and is then amortized by the lessee.

Illustration 1: Illustration 1: Company B (lessee) leases a car from Company A (lessor) for five years beginning on January 1 and paying $2,000 a year beginning on December 31. The car has a ten-year useful life, and at the end of the lease, Company B will not automatically receive the title or have a bargain purchase option. At the time of lease signing, the car's market value was $9,000. Company B does not know the implicit rate of the lease and has an 8% incremental borrowing rate.

A. Lease Classification: Finance lease, determined by the fourth criterion below.

Bargain purchase option? NO
Title transfer? NO
75% test? NO [Lease term 5/Useful life 10 = 50% < 75%]
90% test? YES [Present value of lease payments ÷ Fair value of asset = 96% > 90%]
Specialization? NO [car]

4. Interest will decline for each of the next three payments as the amount of the liability decreases with each payment, similar to a level-payment mortgage loan.

Practice Question:

On January 2, 20X8, A Company intends to begin leasing construction equipment from C Company. For a period of seven years, the lease requires $43,000 in annual payments. 11% is the implicit interest rate. The initial payment is required on the first day of the lease, and starting in 20X8, future installments are due on December 31 of each year. The lease does not contain a bargain buy option, the equipment has a nine-year useful life, and at the conclusion of the lease term, ownership will not pass from C Company to A Company. At the time of signing the lease, the equipment had a market value of $275,000.

a. Which of the five FASB lease classification criteria cause the lease to be classified as finance?

b. What is the amount of the ROU asset balance at the end of the 2nd year of the lease (after lease amortization is recorded)?

c. What is the amount of the lease liability immediately following the 3rd payment?

Answer

1. The lease would be classified as finance because it meets the 3rd

criterion below:

• Bargain purchase option? NO

• Title transfer? NO

• 75% test? YES [7-year lease term divided by the 9-year life of the equipment = 78% > 75%]

• 90% test? NO [Divide the present value of the minimum lease payments by the fair value of the equipment. The present value of the minimum lease payments is $224,913. $224,913 ÷

$275,000 = 82% < 90%. To find the present value of the minimum lease payments, use the following values: Years (N): 7, Interest Rate (I): 11, Payment (P): $43,000,

Solve forPresent Value (PV). Make sure that your calculator is in Begin

mode because the first payment is due at the beginning of the

lease term.]

• Specialization? NO [construction equipment]

2. ROU Asset balance at the end of the 2nd year = $160,653. Annual Amortization Expense = Present Value of the leased equipment ÷ term of lease = $224,913 ÷ 7 = $32,130.

3. The remaining amount for the lease liability following the 3rd

payment is $133,405. The beginning of the amortization schedule is

shown below.

Screen Shot 0006-05-09 at 3.25.07 AM.png

PRACTICE QUESTIONS:

At the end of the lease, the machine's owner keeps ownership of the machine, and Lease A covers 60% of a standardized machine's projected useful life. The machine's fair market value is equal to the present value of the minimum lease payments, which is 81%. Lease B provides for the following: the lessee has the opportunity to purchase the asset for $1 at the end of the lease; the machine's fair market value is equal to the present value of the minimum lease payments, which equals 85% of the machine's projected useful life. How should Lease A and Lease B be categorized by the lessee?

a. Lease A is a finance lease and Lease B is a finance lease.

b. Lease A is a finance lease and Lease B is an operating lease.

c. Lease A is an operating lease and Lease B is an operating lease.

d. Lease A is an operating lease and Lease B is a finance lease

2. All of the following are criteria for a lease to be classified as a finance lease except:

a. The lease agreement indicates that ownership of the asset transfers to the lessee at the end of the lease term.

b. The lease term is for a minor part of the remaining economic life of the asset.

c. The lease contains a bargain purchase option.

d. The present value of the minimum lease payments exceeds substantially all of the fair value of the underlying asset.

3. The CDH Company incorrectly accounts for a finance lease as an operating lease. Which of the following statements about CDH’s financial statements is correct?

a. CDH will record less expense than it should in each year.

b. CDH will correctly record a lease liability at the inception of the lease even though it classifies the lease incorrectly.

c. Total lease expenses will increase each year of the lease even though it should not.

d. CDH will not record an ROU asset at the inception of the lease even though it should.

4. A firm has just signed a 6-year lease on a new standardized machine, after which the machine will be returned to the lessor.

• Fair value of the machine is $450,000.

• Lease payments are $75,000 per year, payable at the end of the year.

• The machine has a 10-year useful life.

• The firm’s incremental borrowing cost is 8%.

• The PV of an ordinary annuity having 6 payments of $1 at 8% is $4.6229.

The lease should be classified as:

a. operating lease.

b. finance lease.

c. Rental lease.

d.long-term lease

5. The entry to record the initial recognition of a finance lease would include which of the following:

a. Dr. Lease Expense, Cr. Lease Liability, Cr. ROU Asset

b. Dr. Amortization Expense, Cr. ROU Asset

c. Dr. Lease Liability, Cr. Cash.

d. Dr. ROU Asset, Cr. Lease Liability

6. On January 1, 20X0, a corporation signs a 4-year lease for a piece of machinery. The first payment of $75,000 is due on December 31, 20X0, and the lease is renewed every December 31 after that. The implicit rate in the lease is unknown, while the company's incremental borrowing cost is 8%. The minimum lease payments have a present value of $248,410. It is accurate to classify the lease as a financing lease. What is the total expense related to the 20X0 lease?

a. $62,103

b. $19,873

c. $75,000

d. $81,976

7. On January 1, 20X0, a corporation signs a 4-year lease for a piece of machinery. The first payment of $68,000 is due on December 31, 20X0, and the lease is renewed every December 31 after that. The implicit rate in the lease is unknown, while the company's incremental borrowing rate is 9%. The minimum lease payments have a present value of $220,301. It is accurate to classify the lease as an operating lease. What is the total expense related to the 20X0 lease??

a. $55,075

b. $19,827

c. $68,000

d. $74,902

8. On December 30, Year 5, Howard Co., leased a typical new machine from Gavin Corp. The following data relate to the lease transaction at the inception of the lease.

Lease term: 11 years

Annual lease payment at the end of each lease year $120,000

Useful life of the machine 13 years

Implicit interest rate 11%

Present value of an annuity due of $1 for 11 periods at 11% 6.8892

Present value of an ordinary annuity of $1 for 11 periods at 11% 6.2065

Fair value of the machine $1,000,000

The lease has no purchase option, and the possession of the machine reverts to Gavin when the lease terminates. At the inception of the lease, Howard should record a lease liability of:

a. $0.

b. $1,320,000.

c. $826,704.

d. $744,780

Answer Key:

The Answer is D

To be an operating lease, a lease must not satisfy any of the five criteria for classifying a lease as a finance lease established by the FASB. In this case, only Lease A fails to satisfy any of the criteria. One criterion is that if the lease term is more than “a major part” of the remaining economic life of the asset, the lease is a finance lease.

The Answer is B

The correct criterion is if the lease term is for a major part of the remaining economic life of the underlying asset, not a minor part. While no bright line exists here, the FASB has given a guideline of 75% of the expected useful life of the asset when determining whether the lease term is for a “major” part of the asset's life.

The Answer is B

Leases are classified as either finance leases or operating leases. A finance lease is treated like the lessee is borrowing money and purchasing an asset, while an operating lease is where the lessee is receiving the right to use an asset for a period of time. In both cases, the lessee records an ROU asset since it is obtaining the right to use an asset regardless of lease classification. This asset must be offset by a corresponding liability.

The Answer is A

To be an operating lease, a lease must not satisfy any of the five criteria for classifying a lease as a finance lease established by the FASB. In this case, the lease fails all five criteria.

The Answer is D

This entry records an asset and a liability consistent with a finance lease.

The Answer is D

The annual expense of a finance lease consists of the amortization of the right-of-use asset created when the lease was signed and interest expense on the lease liability. The right-of-use asset is amortized annually on a straight-line basis.

For this lease, the annual amortization expense is $62,103 ($248,410 ÷ 4). The annual interest expense is calculated using the effective-interest method. The interest expense on the lease liability in 20X0 is $19,873 (8% × $248,410). The total expense is $81,976 ($62,103 + $19,873).

The Answer is C

Under an operating lease, the lease expense recognized each year is equal to the annual lease payment made.

The Answer is D

The lease is a finance lease since the lease term is for a major part of the remaining economic life of the underlying asset (greater than 75% of the expected useful life of the asset). Since the lease payments are made at the end of the period, the present value factor for an ordinary annuity is used: 6.2065 × $120,000 = $744,780

Reference:

Wiley (2023). Wiley CMA Exam Review 2023 Study Guide Part 1: Financial Planning, Performance and Analytics. Wiley.