Talk:Intermediate Accounting/Liabilities

Leases A lease is a contractual arrangement by which a lessor/owner provides a lessee/user the right to use an asset for a specified period of time. In return, the lessee agrees to make periodic cash payments during the term of the lease. An apartment lease is a typical rental agreement referred to as an operating lease in which the fundamental rights and responsibilities of ownership are retained by the lessor. Capital leases(Direct financing or sales-type leases to the lessor) are contracts that are formulated outwardly as leases, but in reality are installment purchases/sales. Typically, Lessee : 1.Operating Lease 2.Capital Lessor : 1.Operating Lease 2.Direct Financing Lease or Sales-type lease Leasing sometimes is used as a means of off-balance-sheet financing. Operational, tax, and financial market incentives often make leasing an attractive alternative to purchasing.

Lease Classification Capital Leases: A lessee should classify a lease transaction as a capital lease if it includes a noncancelable lease term and one or more of the four criteria listed are met. Otherwise, it is an operating lease. 1. The agreement specifies that ownership of the asset transfers to the lessee. 2. The agreement contains a bargain purchase option. 3. The noncancelable lease term is equal to 75% or more of the expected economic life of the asset. 4. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset.

A Bargain purchase option (BPO) is a provision in the lease contract that gives the lessee the option of purchasing the leased property at a bargain price. This is defined as a price sufficiently lower than the expected fair value of the property that the exercise of the option appears reasonably assured at the inception of the lease.

Expected economic life: If an asset is leased for most of its useful life, then most of the benefits and responsibilities of ownership are transferred to the lessee. 75% or more of the expected economic life of the asset is threshold point for this purpose.

Bargain renewal options gives the lessee the option to renew the lease at a bargain rate. That is, the rental payment is sufficiently lower than the expected fair rental of the property at the date the option becomes exercisable that exercise of the option appears reasonably assured.

Minimum lease payments: If the lease payments required by a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease equivalent to an installment purchase. It is considered to exist when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease. Additional Lessor Conditions 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. (Performance by the lessor is substantially complete.)

Operating Lease If a lease does not met any of the criteria for a capital lease it is considered to be more in the nature of a rental agreement and is referred to as an operating lease. In an operating lease, rent is recognized on a straight-line basis unless another systematic method more clearly reflects the benefits of the asset's use. So, if rental payments are uneven-for instance, if rent increases are scheduled-the total scheduled payments ordinarily would be expensed equally over the lease term. Advance Payments Often lease agreements call for advance payments to be made at the inception of the lease that represent prepaid rent. For instance, it is common for a lessee to pay a bonus in return for negotiating more favorable lease terms. Such payments are recorded as prepaid rent and allocated( normally on a straight-line basis ) to rent expense/rent revenue over the lease term. Sometimes advance payments include security deposits that are refundable at the expiration of the lease or prepayments of the last period's rent. Rent payments may be scheduled to increase periodically over the lease term. The total rent over the term of the lease is allocated to individual periods on a straight-line basis. As a result, the temporarily unpaid portion of rent expense must be credited to deferred rent expense payable until later in the lease term when rent payments exceed rent expense.

On January 1, 2010, Doogin Wagon, Inc., a computer services firm, leased a printer from ElernZac Corporation. The lease agreement specifies four annual payments of $100,000 beginning January 1, 2010, the inception of the lease, and at each January 1 thereafter through 2013. The useful life of the printer is estimated to be eight years. Before deciding to lease, Doogin Wagon considered purchasing the printer for its cash price of $625,000. If funds were borrowed to buy the copier, the interest rate would have been 10%. 1. Does the agreement specify a ownership transfer? 2. Does the agreement contain a bargain purchase option? 3. Is the lease term equal to 75% or more of the expected economic life of the asset? 4. Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the printer? 5. How should this lease be classified?

ANSWER: 1. Does the agreement specify a ownership transfer? NO

2. Does the agreement contain a bargain purchase option? NO

3. Is the lease term equal to 75% or more of the expected economic life of the asset? 4 years < 75% of 8 years 4 years < 6 years NO

4. Is the present value of the minimum lease payments equal to or greater than 90% of the fair value of the printer? $100,000 x 3.48685 (Table 6, n=4, i=10%)= $348,685 $348,685 < 90% of $625,000=$348,685 < $562,500

5. How should this lease be classified? Since none of the four classification criteria is met, this is an operating lease.