San Diego State University Chapter 15 SDI Reporting Objective Questions Chapter 15 discussion After reading Chapter 15, post your answers to the following

San Diego State University Chapter 15 SDI Reporting Objective Questions Chapter 15 discussion

After reading Chapter 15, post your answers to the following questions pertaining to IFRS Case 15-6 in the Chapter 15 discussion forum. Be sure to support and explain your answers.

QUESTIONS:

1. Which lease classification would management prefer? Explain.

2. Would meeting SDI’s reporting objective be more or less difficult under IFRS? Explain.

3. Does SDI’s reporting objective pose an ethical dilemma? Why?

4. Who may be affected by SDI’s reporting objective? Why?

lectuer chapter 15

If you’ve ever leased an apartment, you know that a lease is a contract, pursuant to which a lessor (the owner) provides a lessee (the tenant) the right to use an asset for a specified period of time. In return for this right, the lessee agrees to make stipulated, periodic cash payments during the term of the lease. An apartment lease is a typical rental agreement in which the fundamental rights and responsibilities of ownership are retained by the lessor, and the lessee merely uses the asset temporarily. Businesses also lease assets under similar arrangements. These are referred to as operating leases. However, many contracts are formulated outwardly as leases, but in reality are installment purchases and sales. These are called finance leases by the lessee and sales-type leases by the lessor.

When the term of a lease begins, the lessee records a “right-of-use” asset along with a lease liability. Subsequent accounting treatment depends on the classification of the lease as either (a) an operating lease or (b) a finance lease. Leasing has grown to be the most popular method of external financing of corporate assets in the U.S. Because the lessor usually takes on at least some of the financial burdens and risks that a purchaser normally would assume, leasing usually is more expensive than buying.

Lease decisions are motivated by operational incentives, as well as tax and market considerations. Sometimes leasing offers tax savings over outright purchases. For example, a company with little or no taxable income will get little benefit from depreciation deductions for an owned asset. However, the company can benefit indirectly by leasing assets, rather than buying them. By allowing the lessor to retain ownership and thus benefit from depreciation deductions, the lessee often can negotiate lower lease payments. Lessees with sufficient taxable income to take advantage of the depreciation deductions, but still in lower tax brackets than lessors, can also realize similar indirect tax benefits.

Before recent lease accounting guidance, another reason to lease rather than buy was to obtain “off-balance-sheet financing.” When funds are borrowed to purchase an asset, the liability has a detrimental effect on the company’s debt-to-equity ratio and other quantifiable indicators of financial risk. Similarly, purchased assets increase total assets and correspondingly lower calculations of the rate of return on assets. To avoid looking more risky and less profitable, managers previously were able to keep assets and liabilities “off balance sheet” by leasing them, rather than buying them. That way, managers could avoid surpassing contractual limits on designated financial ratios (e.g., debt-to-equity ratio). Also, some managers might have thought they were fooling the financial markets into thinking their strategies were less risky and more profitable than actually was the case. However, U.S. GAAP now requires lessees to record assets and liabilities for all but very short term leases. In fact, the primary motivation for the new guidance was to curtail off-balance-sheet financing. Still, even without the incentive of off-balance-sheet financing, when the operational, tax, and financial advantages are considered, the net cost of leasing is often less than the cost of purchasing, so leasing arrangements remain very popular.

A lease is accounted for in one of two ways. It is viewed as either (a) a finance/sales-type lease (a purchase and sale accompanied by debt financing), or (b) an operating lease (a true rental). The choice of accounting method depends on the nature of the leasing contract.

Professional judgment is needed to differentiate between leases that are, in essence, installment purchases and sales and those that are not. From an accounting perspective, legal ownership is irrelevant in this decision. A finance lease is not the same thing as the purchase of an asset. The rights a lease grants a lessee under any lease, whether classified as a finance lease or an operating lease, are different from the rights transferred in the outright purchase and sale of an asset. For example, the lessee can’t sell the leased asset.

Nevertheless, a finance lease is economically similar to a purchase of the asset because (a) the terms of a finance lease normally allow the lessee to direct the use of the asset in a way that the lessee receives substantially all of the remaining benefits from the asset, and (b) it creates obligations for the lessee that are similar to those that financing the purchase of an asset would impose. The essential question is whether the lease is economically similar to the purchase of an asset because the lessee obtains control of the underlying asset (i.e., the lessee has the ability to direct the use of the asset and to obtain substantially all of its remaining benefits). This is in contrast to merely controlling the use of the asset for a certain period of time.

The desire to encourage consistency in practice motivated the FASB to provide guidance for distinguishing between the two fundamental types of leases because determining lease classification based on judgment alone is likely to lead to inconsistencies in practice. Some leases clearly fit the classifications we give them. However, others fall in a gray area somewhere between the two extremes, in which case we classify according to the best evidence available.

Because the objective is to determine whether the lessor has, in substance, sold the asset to the lessee, the first criterion is self-evident. Ownership attributes are obviously transferred if legal title passes to the lessee during, or at the end of, the lease term.

A purchase option is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a specified exercise price. This criterion is met if the exercise price is sufficiently lower than the expected fair value the leased property when the option becomes exercisable.

The third criterion considers whether the asset is leased for the “major part” of its useful life. If so, then most of the risks and rewards of ownership are transferred to the lessee. A reasonable approach to assessing this criterion would be to conclude that 75 percent or more of the remaining economic life of the underlying asset constitutes a major part of the remaining economic life of that underlying asset. However, this is only one approach and not a precise indication.

The fourth criterion indicates that, if the lease payments required by a lease contract substantially pay for the leased asset, it’s logical to classify the contract as equivalent to a sale. A reasonable approach to assessing this criterion would be to conclude that 90 percent or more of the fair value of the underlying asset amounts to “substantially all” its fair value. In general, lease payments for the purpose of classifying a lease are payments the lessee is required to make in connection with the lease.

An amortization schedule shows how the lease balance and the effective interest change over the lease term, using the effective interest rate. Each lease payment after the first one includes both (a) an amount that represents interest and (b) an amount that represents a reduction of the outstanding balance. At the end of the lease term, the periodic reduction is sufficient for the outstanding balance to be zero. The schedule is used to track the changing amounts. Both the lessee and lessor use this same amortization schedule. The lessee amortizes its lease payable and records interest expense. Similarly, the lessor amortizes its lease receivable and records interest revenue, reflecting the opposite side of the same transaction.

Normally, the lessee should amortize a leased asset over the term of the lease. However, if (a) ownership transfers or (b) exercise of a purchase option is reasonably certain (i.e., either of the first two classification criteria is met), the asset should be amortized over its useful life. Meeting either of those first two criteria means the lessee will have the asset beyond the lease term, and thus the asset is amortized over the useful life of the asset to the lessee, whether or not that useful life is limited by the term of the lease.

Selling profit for the lessor exists when the fair value of the asset (e.g., the present value of the lease payments or “selling price”) exceeds the cost or carrying value of the asset sold. In addition to interest revenue earned over the lease term, the lessor recognizes a selling profit on the “sale” of the asset. Like the sale of any product, gross profit is the difference between sales revenue and cost of goods sold. The accounting is the same as for a sales-type lease without a selling profit, except that profit is recognized at the beginning.

When there is a selling profit, all lessor entries, other than the entry at the beginning of the lease to include the selling profit, are precisely the same as the entries for a sales-type lease without a selling profit. On the other side of the transaction, accounting by the lessee is not affected by whether the lessor recognizes a profit or not.

Recognizing the similarity between recording both the revenue and cost components of this “sale by lease” and recording the same components of other sales transactions, when a company sells a product on account, two entries are recorded: (a) one to record the receivable and sales revenue and (b) another to record the cost of goods sold and corresponding reduction in inventory. Economically, leases are just one of the arrangements that sellers can use to help customers buy their products. Sales-type leases must be separated from non-lease sales in the financial statements.

Although an operating lease liability is reported in the lessee’s balance sheet, it is designated as a “non-debt liability” in order to distinguish it from traditional liabilities, including finance lease liabilities. This separate classification is intended to prevent operating lease liabilities from causing companies to violate debt covenants, (e.g., restriction that the debt-to-equity ratio not exceed a certain limit). The lessor does not record a lease receivable. Instead, the lessor views an operating lease as simply renting the asset to the lessee and records rent revenue on a straight-line basis over the lease term.

How do we account for an operating lease? The lessee still records an asset and a liability at the beginning of the lease. The reason is that the lessee, although not having effectively purchased the asset via the lease agreement, still has acquired the right to use the asset for part of the asset’s useful life. Just like a finance lease, the right to use the leased asset can be a significant benefit, even if for a shorter period of time, and the promise to make the lease payments can be a significant obligation. So, just like the case in which the asset was leased for its entire life, the lessee still recognizes (a) a right-of-use asset and (b) a lease liability.

Each year, the lessee records interest the normal way and then “plugs” the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment. In a finance lease, we can think of lease expenses as reflecting (a) the right to use the asset (amortization) plus (b) the financing of that right (interest). The way the lessee does that is to (a) determine interest expense and then (b) determine amortization of the right-of-use asset as the amount needed to cause the total lease expense (interest plus amortization) to be an equal, straight-line amount over the lease term. In other words, the lessee records interest the normal way and then “plugs” the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment.

On the other hand, in an operating lease, lease expense is recorded in a manner that is designed to mirror straight-line rental of the asset during the lease term.

The lessee records more expense and the lessor records more revenue early in the life of a finance lease. This “front loading” of lease expense and revenue occurs because interest is higher initially than it is in the later stages of a lease. Operating leases avoid this front loading. Therefore, lessees tend to prefer the operating lease classification because it defers expense recognition, making net income higher in the early years of the lease.

Leasing can allow a company to (a) conserve assets, (b) avoid some risks of owning assets, and (c) obtain favorable tax benefits. These advantages are desirable. Accounting guidelines are designed to limit the ability of firms to obscure the realities of their financial position through off-balance-sheet financing, thereby avoiding violating terms of contracts that limit the amount of debt a company can have. Disclosure requirements include reporting finance lease liabilities and operating lease liabilities separately.

Because lease payments occur in future periods, we must consider the time value of money when evaluating their present value. Thus, an important factor in lease calculations is the discount (interest) rate used in present value calculations. This rate is important because it influences virtually every amount reported by both the lessor and the lessee in connection with the lease.

One discount rate is implicit in the lease agreement. This is the effective interest rate of return that the lease payments provide the lessor under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. (Refer to our earlier calculations of the periodic lease payments.) If known by the lessee, this is the lessor’s rate implicit in the lease agreement.

However, frequently the lessee is unaware of the lessor’s implicit rate. This might happen if, for example, the leased asset has a relatively high residual value. If there’s a residual value (guaranteed or not), it is an ingredient in the lessor’s calculation of the lease payments. Sometimes it may be hard for the lessee to identify the residual value estimated by the lessor if the lessor chooses not to reveal it. However, as the lease term and risk of obsolescence increase, the residual value is typically less of a factor.

When the lessor’s implicit rate is not known, the lessee should use its own incremental borrowing rate. This is the rate the lessee would expect to pay a bank if funds were borrowed to buy the asset.

A short-term lease permits the lessee to choose not to record an asset and related liability associated with the lease at the beginning of the lease term. Instead, the lessee can simply record lease payments as rent expense over the lease term. This is also the same approach used by the lessor for lease revenue. A lease is considered short-term if it:

1. Has a lease term (including any options to renew or extend) of twelve months or less and

2. Does not contain a purchase option that (a) would extend the term beyond twelve months and (b) the lessee is reasonably certain to exercise.

Sometimes the actual term of a lease is not obvious. For example, a lease term may be specified as four years, but it can be renewed at the option of the lessee for two additional years. Another example is where either party has the option after three years to terminate the four-year lease. In such situations, we adjust the contractual lease term for any periods covered by options to extend or terminate the lease where there is a significant economic incentive to exercise the options. A company adjusts the lease term for an option only if it is “reasonably certain” that the lessee will exercise the option, after considering the relevant economic factors. In other words, we adjust the contractual lease term if the benefits of exercising an option are sufficiently high that we think it will be exercised.

Circumstances can change, which may require a reassessment of how long the lease term will be. Reassessment requires a “triggering event” where the lessee now has an economic incentive to exercise an option that extends or terminates the lease. When there is a change in the lease term, lessees are also required to reassess the classification of a lease. For example, the lease may have been classified initially as an operating lease, but with the increase in the lease term, it meets the criteria for a finance lease, rather than an operating lease.

Note: This discussion pertains to a lessee; a lessor is not permitted to reassess its initial determination of the lease term or discount rate.

Sometimes, lease payments are scheduled to increase (or decrease) at some future date during the lease term, depending on whether or not some specified event occurs. Usually the contingency is related to revenues, profitability, or asset usage above some designated level. A contingent payment provision is a way for lessees and lessors to share the risk associated with the asset’s productivity. Because the amounts of future lease payments are uncertain and often avoidable, we don’t consider them as part of the lease payments used to calculate the lessee’s lease liability and the lessor’s lease receivable. If and when lease payments increase, the change in the lease payments has no effect on balance sheet accounts and simply is reported as a separate lease expense (for the lessee) and lease revenue (for the lessor).

However, we include “fixed payments in disguise” as part of the lessee’s lease payments. For example, a retail store’s monthly lease payments will increase next year by the higher of $250 or 0.5% of monthly store revenue. In that case, we know that the lease payment will increase by at least $250, so those payments are deemed to be in-substance fixed payments and are included in the lease payments used in present value calculations.

Another exception to not including certain payments when initially recording the lease liability is where the amount of the lease payments depends on an index or a rate (e.g., the Consumer Price Index). Even though we know that lease payments will vary in the future, we use the initial lease payment amount, based on the current index, to discount to present value when determining the right-of-use asset lease liability and lease receivable. When lease payments do change in the future (e.g., when the index or rate change), we don’t re-measure the lease liability or leased asset at that time, but simply report the additional amount as a separate lease payment that produces expense (for the lessee) and revenue (for the lessor).

The lessee should adjust the right-of-use asset and lease liability for changes in the amount of the payments only if and when the lessee re-measures the lease liability for reasons other than a change in the index or rate. For example, this might happen due to a reassessment of the lease term (described above) or a modification of the lease (described below). In that case, the leased asset and lease liability are recalculated by determining the present value of future lease payments using (a) the new lease payments as adjusted for changes in in the index or rate and (b) the discount rate that applies as of the date of the reassessment.

Note: The lessor never reassesses its lease receivable for variable lease payments.

Sometimes the lessee and lessor will agree to modify the terms of a lease before the lease term ends. This creates two possibilities:

1. The modification might grant the lessee an additional right of use, which would mean terminating the original lease and accounting for the modified arrangement as a new lease, or

2. Rather than grant an additional right of use, the modification might (a) alter the lessee’s right to use the asset, which would mean adjusting, adding to, or deleting what has been recorded in order to conform to the new terms of the contract (e.g., a change in the lease term or lease payments) and (b) perhaps reclassifying the lease from one type to another.

For example, there is a four-year operating lease of equipment with a useful life of six years, and after two years, the lessee and lessor agree to extend the lease term by two years and to alter the amount of the lease payments. The additional two years were not originally an option. In this case, the modification alters the lessee’s right to use the equipment; it doesn’t grant the lessee an additional right to use another asset. In addition, the modified lease term of two additional years (six years total) is now for a “major part” of the asset’s economic life, so classification changes from an operating lease to a finance/sales-type lease.

The lessee-guaranteed residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Typically, we will have a residual value in an operating lease because the lease term usually ends before the lease asset’s value has been depleted. A residual value is less likely, but still may happen, when the lease qualifies as a sales-type lease, because the lease term is for most, if not all, of the asset’s life.

Sometimes a lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the leased asset reverts back to the lessor at the end of the lease term. This both (a) reduces the lessor’s risk and (b) gives the lessee an incentive to exercise a higher degree of care in maintaining the leased asset in order to preserve its value. The lessee promises to return both (a) the leased asset and (b) any cash necessary to provide the lessor with a minimum combined value. A residual value affects several aspects of lease accounting, including: (a) the size of the periodic lease payments, (b) the classification of a lease, and (b) the amounts recorded by both the lessee and lessor.

However, if the lessor gets the leased asset back at the end of the lease and the leased asset has commercial value, this residual value (the value of the leased asset itself) will provide another source of recovery of the lessor’s investment. The present value of the residual value of a lease asset also is called a residual asset. It reduces the amount needed from periodic lessee payments for the lessor to generate its expected return.

The lessee doesn’t view the residual asset as its asset because the leased asset will revert to the lessor. However, from the lessor’s perspective, even if a residual value is not guaranteed, the lessor still expects to receive something. Therefore, the lessor will view the residual asset as contributing to the amount needed to recover its investment, causing the lessee’s lease payments to be lower than would otherwise be the case. As the expected residual value increases, the size of the lease payments decreases.

The total amount of lease receipts is collected is referred to as the lessor’s gross investment in the lease and is included in the lessor’s lease disclosure note. The present value of those same payments is referred to as the net investment in the lease and is the amount recorded as the lease receivable in the journal entry at the beginning of the lease. If there is a residual value, in the final year of the lease, the cash payment is received and the equipment is reinstated on the lessor’s books at its fair value, which we assume to be the amount predicted when the lease began.

When a sales-type lease that includes a residual value also has a selling profit, we need to take that into consideration when the lease is recorded initially. Recall that the lessor records both sales revenue and cost of goods sold to account for the selling profit. The sales revenue is the present value of only the periodic lease payments, not including the residual value. Sales revenue does not include the residual value because the revenue to be recovered from the lessee is lease payments only. The remainder of the lessor’s investment is to be recovered – not from payment by the lessee, but by selling, releasing, or otherwise obtaining value from the asset when it reverts back to the lessor. Think of it this way: The portion of the asset sold is the portion not represented by the residual value. Therefore, both the asset’s cost of goods sold and its selling price are reduced by the present value of the portion not sold.

Other than this reduction of lease payments, should a lessee be concerned with the residual value of the leased asset? Maybe; it depends on:

1. Whether the lessee has arranged to guarantee a specific value of the residual asset at the conclusion of the lease and

2. How that value compares to the prediction of its actual value.

As discussed earlier, a lease agreement sometimes includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. The lessee promises to return not only (a) the leased asset, but also (b) sufficient cash to provide the lessor with a minimum combined value. However, that doesn’t necessarily mean that the lessee will be required to make any cash payment. A cash payment would be expected as of the beginning of a lease only if the guaranteed amount exceeds the estimated residual value of the leased asset.

If a cash payment under a lessee-guaranteed residual value is predicted, the present value of that payment is added to the present value of the periodic lease payments that the lessee records as both (a) a right-of-use asset and (b) a lease liability. For example, if the leases asset’s value is less than the lessee-guaranteed residual value at the end of the term, the lessee will pay cash for the difference. Therefore, the lessee views any expected excess guaranteed residual value as an additional cash flow to be paid to the lessor (i.e., addition to lease payments), and the lessee would add the present value of the expected excess guaranteed residual to the present value of the periodic lease payments when recording the right-of-use asset and lease liability at the beginning of the lease.

Looking at it from the other side of the transaction, the lessor would also view the expected excess guaranteed residual value as an additional amount to be collected. In a sales-type lease, the lessor would include this guaranteed residual value in the lease receivable.

It makes little economic sense for a lessee to agree to guarantee an amount greater than the estimated residual value, virtually ensuring an additional cash payment at the conclusion of the lease. Therefore, situations in which the lessee-guaranteed residual value exceeds the estimate of the actual residual value are rare in practice. The requirement to account for it in this way, though, serves as a deterrent to lessees and lessors who might be inclined to manipulate reported numbers by reducing lease payments while creating an excess lessee-guaranteed residual value to compensate for the reduced lease payments.

We classify a lease as a finance/sales-type lease if, in substance, the lessor is selling the asset to the lessee. Recall that one of the classification criteria is a comparison of the fair value of an asset with the present value of the payments coming from the lessee. Payments from the lessee are the periodic lease payments plus any portion of the residual value the lessee has guaranteed. That’s the basis for classification criterion 4: If the present value of the lease payments, including any lessee-guaranteed residual value constitutes “substantially all” of the fair value of the asset, it’s a finance lease from the lessee’s perspective and a sales-type lease from the lessor’s perspective.

A purchase option is a provision in some lease contracts that gives the lessee the option to purchase the lease asset during, or at the end of, the lease term at a specified exercise price. If it is “reasonably certain” that the lessee will exercise the purchase option, the accounting for the lease is affected in three ways:

1. The lease is classified as a finance/sales-type lease,

2. Both the lessee and the lessor consider the exercise price of the option to be an additional cash payment, and

3. We assume the lease term ends on the date that the option is expected to be exercised.

Both the additional cash payment and the shortened lease term impact the calculation of the lessee’s right-of-use asset and lease liability and the lessor’s lease receivable. Also, because the lessee is predicted to own the asset after the lease term, the right-of-use asset recognized by the lessee should be amortized over the economic life of the asset, rather than over the lease term. In practice, where the exercise of a purchase option is reasonably certain, it is often referred to as a “bargain” purchase option (BPO) because the exercise price of the purchase option is a good deal (or a bargain) to the lessee, making it reasonably certain that the lessee will exercise the option. Therefore, the exercise price is a component of the lease payments for both the lessor and the lessee.

When we have a bargain purchase option, we ignore the residual value because the option is expected to be exercised. When it is exercised, title to the leased asset passes to the lessee and, with title, any residual value also passes. When that happens, the residual value cannot be considered an additional lease payment to the lessor.

Amortization of the leased asset is also affected by the BPO. As mentioned earlier, the lessee normally amortizes its right-of-use asset over the term of the lease, but if ownership transfers (a) by contract or (b) by the expected exercise of a purchase option, the lessee will have the asset beyond the lease term, and will amortize it over the longer useful life. This reflects the fact that the lessee anticipates using the leased equipment for its full useful life.

Sometimes the lease contract specifies that an option becomes exercisable before the designated lease term ends. If the option is reasonably certain to be exercised, the lease term ends for accounting purposes when the option becomes exercisable. Lease payments include only the periodic cash payments specified in the agreement that occur prior to the date a BPO becomes exercisable. We assume the option is exercised at that time and the lease ends.

Similar to a lease with a purchase option, if a lease contract includes a penalty payment if the lessee chooses to terminate the lease at a time specified in the contract, we consider the termination penalty to be an additional cash payment if the lessee is “reasonably certain” to terminate the lease. Again, if termination is predicted, we consider the lease term to be from the beginning of the lease to the expected termination date.

When considering the various uncertainties surrounding leases discussed above, we’ve encountered several situations that cause us to re-measure a lease liability (and right-of-use asset). In each case, we compare the re-measured liability with its current balance to see the adjustment needed, calculating the new amount as the present value of the remaining lease payments.

Service contracts, maintenance, hazard insurance, and property taxes are costs often associated with owning and operating an asset. Frequently, for convenience, a lease contract will specify that the lessor is to pay some or all of these costs, but in reality these additional costs are embedded in the periodic payments made by the lessee. Here is the accounting question:

1. Include these additional costs as separate components of the lease contract (to be expensed by the lessee) or

2. Include these additional costs as amounts to be capitalized as part of the right-of-use asset.

For example, if the non-lease component has a fixed payment for hazard insurance or property taxes, that payment does not transfer to the lessee a separate good or service. Instead, payments for hazard insurance and property taxes are specifically identified in the lease accounting guidance as part of the