ACC 302 Class Prep QuestionsChapter 21 ” Accounting for LeasesAssignment: Please begin your preparation by reading the Learning Objectives (LOs), discussion of the chapter topic, and Preview at the front of the chapter. These will give you a bird’s eye view of the content we will cover. Next, casually read the pages covering those LOs. Then you will have a better idea of what you’re going to learn. After that, I want you to read the chapter again, outlining and taking notes on the concepts and looking up definitions for any words you are not familiar with.
Review the summary of the LOs assigned at the back of the chapter. Then you’ll be in a good position to double back to the start and answer the questions in the attached sheet and the Brief Exercises (BEs) that help you learn the basics of the LOs assigned. Show your work. When we meet in class I’ll choose students at random to present their answer these questions and show and discuss their work on the BEs to the class.
The goal will be to be able to discuss and explain your answers rather than read them. Then we will work together in groups to complete more challenging exercises and problems. After class you will be expected to regularly review this work in order to master it, add it to your long-term memory and be prepared for comprehensive quizzes and exams. (LO 1) Discuss the prevalence of the leasing in global and U.S. businesses. What is being leased? How prevalent is leasing in consumer transactions from your point of view? Leasing is everywhere in the U.S. Leasing of Assets is heavily involved. Assets such as machinery, real estate, automobiles, distribution. It is very prevalent.Discuss the advantages of leasing for the lessee. Flexible in that the lease agreement may contain less restrictive provisionsPermits 100% financing of assets (No money down)Favorable tax benefitsWhat are the categories of lessors? Briefly describe each.Bonds: largest player, low-cost fundsCaptive leasing company: subsidiaries primary business is to perform leasing operations for the parent company. Independents: innovative contracts for lessees What does it mean to capitalize a lease (Google)? What is the FASB’s recently adopted approach to capitalization of leases? Briefly explain.When it is recorded as an asset rather than an expense. New Approach, which requires companies to capitalize all long-term leases. Only exception is short-term (less than 1 year) Explain the accounting for finance vs. operating leases including the balance sheet and income statement effects.Finance: recognizes interest expense on lease liability over the life of the lease using effective interest and records amortization expense on the right-of-use asset as straight-line. Lessee then reports both interest expense and amortization ROV asset on income statement, higher in earlier years. Operating: uses effective interest. However, the lessee amortizes the ROV asset such as the total lease expense is the same from period to period. Only single lease expense comprised of interest on liability and ROV asset is recognized on the income statement. **Both balance sheets will be the same **(LO 2) A lease is classified as a capital lease by the lessee when the contract is non-cancelable and any one of five other criteria are met. Discuss the first three criteria.Transfer of ownership: when the asset is transferred to the lesseeBargain ” Purchase Option: Lessee to purchase the leased property for a price that is significantly values then the property and fair value at exercisable date. Economic life 75%: lease period = 75% of assets life, the lessor transfers most of the risk /reward to lessee. Capitalization is appropriate. Explain the present value test including an explanation of the elements generally included in lease payments. (BE 3-5)If PV of lease payments is reasonably close to the Fair value of the asset, a company is effectively purchasing the asset and should use finance method. Included are fixed payments, variable payments, based on index or rate, amounts guaranteed by the lessee under residual value guarantee, payments related to purchase or termination options that the lessee is reasonably certain to exercise. BE3)lease payments:Fixed $800,000*6$4,800,000Bargain Purchase 11,000,000Lease Agreement Total$15,800,000BE4)YearAnnual RentLess: IncentiveTotal1$2,0003001,70022,0003001,70032,00002,000Total:5,400BE5) 4% net sales, variable, not included in value determining **Record right-of-use asset at zero and record lease expense when payments are made. Explain the selection of the discount rate used, including your explanation of the difference between implicit and incremental interest rates.Implicit (Realistic): discount rate that, at commencement of the lease causes the aggregate present value of the lease payments and unguaranteed residual value to be equal to the FV of the leased asset. Incremental (Easier): rate similar to a similar lease or the rate at commencement of the lease, the lessee would incur to borrow over a similar term the funds necessary to purchase the asset.Describe the alternative use test.If at the end of the lease term, the lessor does not have an alternative use for the asset, the lessee classifies the lease as a finance lease, lessee uses all benefits from asset and has essentially purchased it.Discuss examples of lessee lease classification using BEs 1 and 2.The lease does not meet any of the lease classification tests for finance lease. BE1) Does not meet any tests, except the Present Value Test; the PV of the lease payments ($150,000) is greater than 90% of the FV of the asset ($135,000). Therefore, Callaway should classify the lease as a finance lease. BE2) does not meet transfer of ownership, bargain purchase, or specialized asset tests. While initial 5 year lease term and rental payment would may the lease fail the economic life test and PV test, the renewal option must also be considered. When computing the lease term and PV of the lease payments, the exercise of the renewal option is reasonably certain. When accounting for the bargain renewal option, the lease will in fact meet both the economic and PV tests. The lease should be classified as a finance lease for Jelly Co. Economic Life Test:6 Years (5 initial + 1 year renewal option) /7 years = 85.7% > 75%PV Test:PV of initial rental payments (4.54595*$15,000)$69,189PV of bargain renewal option (.78353*$10,000)7,835PV of lease payments$76,024FV of the Equipment/76,024PV of lease Payments at %100%What is a right-to use asset? A lease liability? How is the amount of the liability computed? Right to control the use of an asset, lease liability future rent payments. First recorded at PV of lease payments includes periodic rental payments, bargain purchase option and amounts probable to be owed under residual value guarantee, reported as lease liabilityDiscuss the accounting for the asset and liability in a lessee’s finance lease. What is recorded at inception and periodically thereafter? What are the effects of these on the balance sheet and income statement? How do these differ from similar accrual and payment transactions you have learned in the past?Lessee records the right-of-use asset and liability at commencement of the lease. The lessee then recognizes interest expense on the lease liability over the life of the lease using the effective interest method and records amortization expense on the right-of-use asset generally on a straight line basis. Then reports both interest expense and amortization of ROV asset on income statement, total expense is higher in earlier years. Amortization of ROV asset continues and decreases the principal of liability until it hits zero. Amortized for life of lease unless a bargain purchase option or ownership of asset transfers to lessee at the end of the lease. If Criteria met, amortize over life of economic life. Explain the subsequent measurement of the right-of-use asset and lease liability. Give an example of amortization of the right-of-use asset and lease liability. Explain the subsequent measurement of the lease liability. Give an example of amortization of the lease liability using the amortization of the first two payments of a lessee’s finance lease highlighting the special treatment of the first payment and why that treatment is used. How will you remember this? Using BE 6 discuss the journal entries for periodic recognition of amortization of the lease liability and right-to-use asset. Take care to note how the cookie jar (interest payable) is not used in the adjusting entry as you should expect. Demonstrate how the entries would change if the lease was dated January 1, 2018 and payments were due on January 1st. (BE 7)(LO 3) A lease should be classified an operating lease when?The lease does not meet any of the lease classification tests for a finance leaseUse BE 16 to demonstrate the accounting for an operating lease by the lessee through the second payment. (BE 18)BE16)1/1Right-of-use asset (2.83339*$35,000)99,169Lease Liability99,169Lease Liability35,000Cash35,000Schedule AKingston CorpLease Amotization ScheduleAnnuity-Due basisDateAnnual PaymentInt. (6%) on Liab. Reduc.of lease LiabLease Liability1/1/17$99,1691/1/17$35,000$0$35,00064,1691/1/1835,0003,85031,15033,0191/1/1935,0001,98133,0190Schedule BLease Expense ScheduleDate Straight-LineInterest (6%)Amortization of ROU AssetCarry Value1/1/17$99,16912/31/17$35,000$3,850$31,15068,01912/31/1835,000BE18)Make a side-by-side comparison of accounting for finance leases vs. operating leases. Discuss the similarities and differences. Create a concept map including references to the questions and BEs above.