head: Running Response to Client Request I
Response to Client Request I
ACC/541
May 19, 2012
Mark Taylor, C.P.A.
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Running head: Response to Client Request I
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Response to Client Request I
Memo
To: Regional Trucking Company
From:
In Re: Leases and Lease Structures
When looking at leases and lease structures there needs to be some knowledge on the
impacts on the financial for the company. In dealing with leases there are codifications from
the Financial Accounting Standards Boards that give substance to different lease structures
which comes with terms and conditions for lease transactions. The statement of financial
accounting standards (SFAS) has different lease structures. In SFAS Number 13 which
discusses the categorization of various principles about lease structures for capital leases and
operating leases. A simple definition of a capital leases are leases in which the benefits and the
risks pass to the lessee. To be more accurate, the lessor should report a lease as a sales-type
lease when at least one of the capital lease criteria is met, both lessor certainty criteria are met,
and there is a manufacturers or dealers profit (or loss). This implies that the leased asset is an
item of inventory and that the seller is earning a gross profi t on the sale (Schroeder, Clark &
Cathey, p.439, 2011). For a sales type lease, the fair value and the price of the property are
different which means the manufacturer or dealer can market their product in a sales type lease.
When this happens the lessor receives a net gain or loss from the manufacturer or dealer when
it is a sales type lease. When a profit or loss is recorder for a dealer or manufacturer the fair
value is not equivalent to the carrying amount of the rental property. For a sales type lease, the
risks and benefits move to the lessee.
For a manufacturer who is the lessor uses sales-type leasing and reports the gross profit
directly because o the rental fees that are collected throughout the lease in excess of the
Running head: Response to Client Request I
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manufacturing cost of the equipment leases. When the company receives income on the terms
of the lease it needs to acknowledge the interest income on a lease receivable. According to
Shcroeder, Clark & Cathey (p.439 2011) the amount to be recorded as gross investment (a) is
the total amount of the minimum lease payments over the life of the lease, plus any
unguaranteed residual value accruing to the benefit of the lessor. Once the gross investment has
been determined, it is to be discounted to its present value (b) using an interest rate that causes
the aggregate present value at the beginning of the lease term to be equal to the fair value of the
leased property. For a sales type lease, the direct cost in relation to acquiring the lease is
written off and is recorded at the sale when the lease started.
In a direct financing lease, the dealer or manufacturer does not record a profit and is a
type of a sub-lease. According to the FASB a direct financing lease needs to meet the following
criteria as set forth by SFAS No.13, (1) collectability of the minimum lease payments is
reasonably predictable; (2) the lessors performance must be substantially complete; (3) and
assets fair value must be equal to the lessors value, book (FASB, 2008). In a direct financing
lease the banking organization and the lessor are seen as the same for detecting revenue. The
leverage lease criterion is not meet by a direct financing lease. The financial report impact of a
direct financing lease is that when rental payments are received gross receivables decrease by
the full amount of that payment. When that payment is received a percentage of unearned
income transfers to earned income.
The next type of a lease is an operating lease which gives the use of an asset but does
not carry rights relation to ownership of the asset.
Financially operating leases are not
capitalized but they are recorded as a rent expense. Normally operating leases are short-term as
the equipment is normally only used for a short period of time. For the lessee the only
Running head: Response to Client Request I
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requirement is recording the operating expense of the asset which does not affect the balance
sheet.
With an operating lease the lessee takes some risk of ownership. Because of
depreciation of the asset and the interest paid on the lease the lessee appreciates the tax
deductions. This then needs to be documented in the statements as an asset and a liability. For
the lease to be classified as an operating lease and enter it into the financial records as a
operating lease a criteria needs to be met. When one of the criterions is met, the company
records the lease as operating and enters the financial records as an operating lease. According
to Shcroeder, Clark & Cathey (p.432-433, 2011) one of the criteria is when the lease term is
equal to 75 percent or more of the estimated remaining economic life of the leased property,
unless the beginning of the lease term falls within the last 25 percent of the total estimated
economic life of the leased property. When the lease is completed ownership shifts. At the
end of a lease an option there is a bargain price if the asset is purchased. For the lease payment
it is valued at the appropriate discount rate, which is more than 90% of the fair market price.
By knowing what the standards that have been set forth by the Financial Accounting
Standards Board it will help in effectively operating the business. By knowing what leases are
and which ones that will work for the company it will help in determining to purchase an asset
or to lease an asset. As stated previously a leas can be good for the short term and the long
term. With the different kinds of leases of capital and operating leases there needs to be a look
at the criteria to distinguish the two. For a operating lease gives use of an asset but does not
carry rights relating to ownership of the asset. As for a direct financing lease it is a lease in
which the dealer or lessor does not record the profit. The lessor will receive a profit or loss
from the manufacturer or dealer in a sales type lease.
Running head: Response to Client Request I
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References
Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2011) Financial Accounting Theory and
Analysis: Text readings and cases (10th ed.). Hoboken, NJ: Wiley
Financial Accounting Standards Board (2008) Statements of Financial Accounting Standards
Number 13, Accounting for Leases. Retrieved from: http://www.fasb.org/pdf/fas13.pdf