1. The Principal Advantages To A Lessee In Leasing Rather Than Purchasing Property Are As Follows:

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CHAPTER 15

QUESTIONS

1

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1. The principal advantages to a lessee in leasing rather than purchasing property are as follows:

(a) Frequently, no down payment is
required to attain access to property when it is leased. This frees company capital to be used for purposes such as expanding production, reducing long-term debt, or providing for future
pension benefits.

(b) A lease avoids the risks of ownership when a company has many uncertainties as to the length of benefit from various assets. If a company purchases assets, any obsolescence or reduction in usefulness of the asset would result in a loss. A lease leaves these risks of ownership with the lessor rather than shifting them to the lessee.

(c) Leases give the lessee flexibility to get a different asset if market conditions or technological changes require it.

2. The principal advantages to a lessor in leasing property rather than selling it are as follows:

(a) Lease contracts provide another alternative to those businesses needing property for customers to acquire their services. This can increase the volume of sales and thus improve the operating position of the manufacturer.

(b) Because a lease arrangement results in an ongoing business relationship, there may be other business dealings that could develop between the lessee and lessor.

(c) The lease arrangement may be negotiated so that any residual value remains with the lessor. Although expected
residual values are usually considered in arriving at the financial terms of a lease, these estimates usually are
conservative. Thus, lessors may benefit from a higher residual value at the end of the lease term than expected when the lease was negotiated.

3. A capital lease is accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee. Capital leases are generally long term, covering most of the economic life of the leased
asset, and the lease payments are large enough that they effectively pay for the
asset by the end of the lease term. An
operating lease, on the other hand, is
accounted for as rental agreement, with no transfer of effective ownership associated with the lease.

4. Leases frequently give the lessee the option to purchase the leased asset at some
future date. If the price specified in the
purchase option is so low that it is almost certain that the lessee will end up buying the leased asset, the option is called a
bargain purchase option. Because leases with bargain purchase options are likely to lead to transfer of ownership from the
lessor to the lessee, they are accounted for as capital leases.

5. The lease term begins when leased property is transferred to the lessee and extends to the end of period for which the lessee is expected to use the property, including any periods covered by bargain renewal
options. If a bargain purchase option is
included in the lease agreement, the term ends on the date this option is available.

6. ( a) A lessee will use the lower of its incremental borrowing rate and the implicit rate in the lease agreement (if known by the lessee). If the rate used results in a capitalized value for the lease that is greater than the fair market value of the lease property at the beginning of the lease term, the fair market value should be used as the asset value.

( b) A lessor will use the interest rate
implicit in the terms of the lease. This is the rate that will discount the minimum lease payments plus any unguaranteed residual value to the fair market value of the leased asset.

7. For a lease to be properly accounted for as a capital lease by the lessee, at least one of the following criteria must be met:

(a) Title transfer. The lease transfers ownership of the property to the lessee by the end of the lease term.

(b) Bargain purchase option. The lease contains a bargain purchase option.

(c) Economic life. The lease term is equal to 75% or more of the estimated economic life of the leased property.

(d) Investment recovery. The present value of the minimum lease payments, excluding the portion that represents executory costs to be paid by the lessor, equals or exceeds 90% of the fair market value of the leased property.

8. The two additional criteria for lessors are as follows:

(a) Collectibility. Collectibility of the minimum lease payments required from the lessee is reasonably predictable.

(b) Substantial completion. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease.

When a greater-than-normal credit risk is involved and the collectibility of lease payments is questionable, the lease would be accounted for as an operating lease. Revenue would then be recognized as it is collected.

The second criterion has to do with the question of whether or not the lessee has assumed substantially all the risks of ownership or if these have been retained by the lessor. Thus, if the lessor had made some unusual guarantees concerning the performance of a leased asset, ownership essentially rests with the lessor, and the lease should be accounted for as an operating lease.

9. Operating leases are viewed as simple rental contracts. All rental payments are debited to expense when paid or incurred. If rent is prepaid, the expense is recognized as the prepayment expires. No asset or liability value is recognized on the balance sheet.

Capital leases are viewed as a purchase of an asset and the incurrence of a liability. The present value of the future minimum
lease payments is recorded as an asset and a liability. The asset is amortized as though it had been purchased by the lessee. The liability is accounted for in the same manner as if a mortgage had been placed on the property. Amortization expense and interest expense are recognized each year.

10. If rental payments are uneven, the debit to Rental Expense by the lessee should be made on a straight-line basis (i.e., total expense over the lease term should be allocated equally to each period) unless another systematic and rational basis better shows the time pattern in which use benefit is derived from the leased asset.

11. The amount to be recorded as an asset and a liability for capital leases on the books of the lessee should be the present value of future minimum lease payments, including total rental payments and any bargain purchase option or other guarantee of the residual value made by the lessee. Executory costs would be excluded from the minimum rental payments. If the fair market value of the leased asset is less than the present value, the lower value is recorded.

12. The asset balance is amortized over the lease term according to the lessee’s normal depreciation policy for similar owned assets. The liability balance is reduced as payments are made after recognizing the accrual of interest expense on the liability balance. Only if the depreciation method and the interest computation produced the same reduction would the asset and liability balances remain the same.

13. The time period used for amortization of a capitalized lease depends on which criterion was used to qualify the lease as a capital lease. If the lease qualified under the transfer of ownership or bargain purchase option criteria, the asset life should be used for amortizing the capitalized value. If the lease qualified under the economic life or 90% of fair value criteria, the lease term should be used for amortizing the capitalized value.

14. Total charges over the term of a lease are the same whether the lease is accounted for as an operating or a capital lease. Periodic charges vary, however, because
the operating lease usually provides for a constant expense each period, while the capital lease method charge varies according to the following:

(a) The amortization method used to write off the cost of the leased assets, and

(b) The particular lease period involved.

A greater charge for interest expense is recognized in the earlier periods, and there is either a greater charge for amortization in the early years or a constant amount over all years. Therefore, it is more likely that the capital lease method will produce a lower net income than the operating lease method in the early years of the lease, with the reverse being true in the later years of the lease.

15. (a) The interest portion of the lease payments is recorded as an expense and is included in the computation of net income. The principal portion of the lease payments is recorded as a financing cash outflow. The amortization of the leased asset is added back to net income under the indirect method.

( b) The immediate cash outflow from a purchase would be reported as an investing outflow of cash. The payments on the note would be handled exactly as the lease: the interest portion included in the computation of net income and the principal portion as a financing cash outflow.

16. If a lease meets the classification criteria for a capital lease, the lessor records it as either a sales-type lease or a direct financing lease.

Sales-type leases involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products. There are two types of revenue generated by this type of lease. These are as follows:

(a) An immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease, and

(b) The interest revenue to compensate for the deferred payment provisions.

Direct financing leases involve a lessor who primarily is engaged in financial activities, such as a bank or finance company. The lessor views the lease as an investment, and the revenue generated by this type of lease is interest revenue.

17. The present value of the unguaranteed residual value is deducted from both Sales and Cost of Goods Sold because the leased asset reverts to the lessor at the end of the lease term, and the residual value amount represents the portion that was not “sold.”

18. Minimum lease payments include the rental payments over the lease term plus any amount to be paid for the residual value through either a bargain purchase option or a guarantee of the residual value. If the lessee is making all of these payments, the minimum lease payments for the lessee and lessor will be the same. However, if the guarantee of residual value is made by a third party, the guarantee will be included in the minimum lease payments of the lessor but not of the lessee. This condition could result in the lease qualifying as a capital lease to the lessor under the 90% of market value criterion but failing to qualify under this criterion for the lessee.

19. The lessor treats a lease as an investing or an operating activity. If it is a direct financing lease, the lessor is using the lease as a way of investing its resources and earning a return on its investment. If it is a sales-type lease, the lessor is using the lease as an alternative way of selling merchandise. On the other hand, the lessee is using the lease as an alternative way of financing a purchase of an asset. Principal payments made on the lease by the lessee are thus financing cash outflows.

20. Lessees are required to disclose information as to asset and liability accounts as follows:

(a) The gross amount of assets recorded as capital leases and related accumulated amortization.

(b) Future minimum lease payments at the date of the latest balance sheet, both in the aggregate and for each of the five succeeding fiscal years. These payments should be separated between operating and capital leases. For capital leases, executory costs should be excluded.

(c) Rental expense for each period for which an income statement is presented. Additional information concerning minimum rentals, contingent rentals, and sublease rentals is required for the same periods.

(d) A general description of the lease contracts, including information about restrictions on such items as dividends, additional debt, and further leasing.

(e) For capital leases, the amount of imputed interest necessary to reduce the lease payments to present value.

21. The following components of the net investment in sales-type and direct financing leases are required disclosures by lessors as of the date of each balance sheet presented:

(a) Future minimum lease payments receivable with separate deductions for amounts representing executory costs and the accumulated allowance for uncollectible minimum lease payments receivable.

(b) Unguaranteed residual values accruing to the benefit of the lessor.

(c) Unearned revenue.

(d) For direct financing leases only, initial direct costs.

22. The lease classification standard in IAS 17 is that a lease should be accounted for as a capital lease if it transfers substantially all of the risk and rewards of ownership. This broad standard differs significantly from the four specific lease classification criteria contained in Statement No. 13.

23. The international proposal suggests that the lease accounting rules be simplified as follows: All lease contracts for longer than one year are to be accounted for as capital leases. Individual national standard setters (including the FASB) have circulated this proposal in their countries.

24.? The FASB has recommended that if the initial sale results in a profit, it should be deferred and amortized in proportion to the amortization of the leased asset if it is a sales-type or direct financing lease or in proportion to the rental payments if it is an operating lease.

If the transaction produces a loss because the fair market value of the asset is less than its undepreciated cost, an immediate loss should be recognized.