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What are the 4 criteria for a capital lease?
- 1. Specifies ownership of asset transfers to lessee
- 2. Contains a bargain purchase option
- 3. Lease term is greater than or equal to 75% of the asset's expected economic life.
- 4. Present value of minimum lease payments is greater than or equal to 90% of the asset's fair value
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What are the 2 additional conditions for a lessor's classification of a capital lease?
- 1. The collectibility of the lease payments must be reasonably predictable.
- 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable.
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Effective Rate x Balance
Interest Expense
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Realization Principle
Additional Lessor Conditions
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Minimum lease payments plus unguaranteed residual value
Lessor's gross investment
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Periodic lease payments plus lessee-guaranteed residual value
Lessee's minimum lease payments
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Initial direct costs
Sales-type lease selling expense
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PV of minimum lease payments plus PV of unguaranteed residual value
Lessor's net investment
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Rent Revenue
Operating Lease
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Bargain Purchase Option
- Purchase price less than fair value OR
- Depreciation longer than lease term
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Leasehold Improvements
Depreciable assets
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Cash to satisfy residual value guarantee
Loss to lessee
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Capital lease expense
Executory costs
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Deducted in lessor's computation of lease payments
PV of BPO price
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Title transfers to lessee
Depreciation longer than lease term
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Contingent Rentals
Disclosure Only
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Lease payments plus lessee-guaranteed and third-party-guaranteed residual value
Lessor's minimum lease payments
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What are the three types of leases for the lessor?
Operating, Sales-Type, and Direct Financing
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What are the 2 types of leases for the lessee?
Operating and Capital
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What types of leases are essentially installment purchases?
Capital Leases
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What are the 3 things that generally make up minimum lease payments?
- The total of periodic rental payments
- Any guaranteed residual value
- Any bargain purchase option price
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How do you account for a leasehold improvement?
The lessee depreciates the cost over the useful life of the improvement.
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How does a lessee record a leased asset?
At the present value of the minimum lease payments OR the asset's fair value, whichever is lower.
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How should one account for depreciation of a leased asset?
The lessee should depreciate the leased asset over the term of the lease. However, if ownership transfers or a BPO is present, the asset should be depreciated over its useful life.
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What is a BPO?
A bargain purchase option. The lessee has the option of purchasing an asset at a substantially lower price than fair value.
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How does a lessee account for a direct financing lease?
Simply as a capital lease.
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What types of expenses will the lessee have under a direct financing lease?
Interest and Depreciation.
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How does an operating lease appear on the balance sheet?
It doesn't. However, with a capital lease, an asset and a liability are created.
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At the inception of a capital lease, the guaranteed residual value should be:
Included as part of minimum lease payments at present value.
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For a direct-financing lease, the gross investment of the lessor is equal to the:
Minimum lease payments plus the unguaranteed residual value accruing to the lessor at the end of the lease term.
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Initial direct costs incurred by the lessor under a sales-type lease should be:
Expensed in the period incurred.
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Journal entry for a capital lease purchase of machinery:
- D: Leased Machinery
- C: Lease Payable
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Journal entry for Capital Lease Payment:
- D: Interest Expense (Interest Rate x Outstanding Balance)
- D: Lease Payable
- C: Cash
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What type of lease is more in the nature of a rental agreement?
Operating lease.
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What do we refer to periodic payments made at the beginning of each period as?
Annuity due
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How do you account for advance payments on operating leases?
Classify the payment as prepaid rent and allocate it over the lease term as rent expense/revenue.
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Journal Entry for Operating Lease Payment (Lessor)
- D: Cash
- C: Unearned rent revenue
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Journal Entry for Operating Lease Payment (Lessee)
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Who depreciates the cost of the asset under a capital lease? How long is the depreciation period?
- The lessee.
- The depreciatin period is restricted to the lease term unless the lease provides for transfer of title or a BPO.
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What is a direct financing lease?
A lease in which the lessor finances the asset for the lessee and earns interest revenue over the lease term.
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What is a sales-type lease?
A lease where in addition to interest revenue earned over the lease term, the lessor receives a manufacturer's or dealer's profit on the sale of the asset.
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Journal Entry for Sales-Type Lease (Lessor)
- D: Lease Receivable (PV of lease payments)
- D: COGS (Lessor's cost)
- C: Sales Revenue (PV of lease payments)
- C: Inventory of Equipment (Lessor's Cost)
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What does the difference between the total payments and their present value (selling price of the asset) represent?
Interest.
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Who, if anyone, includes the BPO as an additional payment as a component of minimum lease payments?
Both the lessor and the lessee.
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What does the lessee do with the BPO when computing the amount to be recorded as a leased asset/liability?
They add the PV of the BPO to the PV of payments.
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What does the lessor do with the BPO when computing periodic rental payments?
They subtract the PV of the BPO from the amount that must be recovered from the lessee.
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What does the lessor's gross income consist of?
Total of periodic rental payments and any residual value.
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How is guaranteed residual value?
An additional lease payment that is to be paid in property, or cash, or both.
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What should the lessee do in a scenario where the residual value of the asset is less than the guaranteed residual value?
The lessee is required to pay the difference and records the payment as a loss.
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What are executory costs?
Maintenance, insurance, taxes, and other costs usually associated with ownership.
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What should the lessee do if the lessor's implicit rate is unknown? If the rate is known?
- If the rate is unknown, they should use their own incremental borrowing rate.
- If the rate is known, the lessee should use the lower of the 2 rates.
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What is included in determination of gross investment in the lease?
Total of minimum lease payments plus any unguaranteed residual value.
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What should the lessee do with a real estate lease that is expected to transfer ownership and includes both land and a building?
Record each leased asset separately. The PV of minimum lease payments is allocated based on relative fair values.
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