Question

Question: Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Daniel is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases.

The staff is aware of some lease rules related to a “90 percent of fair value,” “75 percent of useful life,” and “residual value deficiencies,” but they are unsure about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research on these items related to lease capitalization criteria.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

1. What is the objective of lease classification criteria?
2. An important element of evaluating leases is determining whether substantially all of the risks and rewards of ownership are transferred in the lease. How is “substantially all” defined in the authoritative literature?
3. Besides the noncancelable term of the lease, name at least three other considerations in determining the “lease term.”
4. A common issue in the accounting for leases concerns lease requirements that the lessee make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage (e.g., excessive mileage on a leased vehicle). Do these features constitute a lessee guarantee of the residual value such that the estimated residual value of the leased property at the end of the lease term should be included in minimum lease payments? Explain.

Short answer

Answer

1. Classification of leases based on risks and benefits incidental to ownership of a leased asset belongs to the lessor.
2. IAS 17 does not define “substantially all.”
3. A leasing term is defined as a non-cancelable period.
4. The lessee is required to meet the residual value loss due to the damage.

Step-by-step solution

Meaning of Lease

A lease is a contract that transfers land, equipment, or facilities for a specified period of time and for a set/fixed rate. The two parties involved in a lease agreement are the lessor and the lessee.

(a) Explaining the objective of the lease

The classification of leases chosen in this Standard is based on the extent to which risks and benefits incidental to ownership of a leased asset belong to the lessor or the lessee," according to IAS 17, paragraph 7. Losses from idle capacity or technical obsolescence, as well as changes in return due to changing economic conditions, are all risks. The anticipation of successful operation during the asset's economic life, as well as benefit from value appreciation or realization of residual value, may be expressed by rewards.

“A lease is defined as a finance lease if it transfers virtually all of the risks and benefits associated with ownership," says paragraph 8. If a lease does not transfer virtually all of the risks and benefits associated with ownership, it is defined as an operational lease.

(b) Explaining the “substantially all” which is defined in the authoritative literature

IAS 17 does not define “substantially all.”

Leases are divided into two categories under IAS 17:

A financing lease transfers practically all of the risks and benefits associated with ownership; an operational lease does not.

Lessee and lessor accounting rules, as well as to disclosures, are prescribed by IAS 17 for the two forms of leases.

(c) Explaining the three considerations in determining the “lease term.”

Other factors aren't mentioned in IAS 17, but paragraph 4 defines "lease term" as "the non-cancellable period for which the lessee has contracted to lease the asset, together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when it is reasonably certain that the lessee will exercise the option at the inception of the lease."

 Step 5: (d) Explaining the situation for the accounting for leases concerns

A leasing term requires the lessee to make up a residual value deficit due to damage, exceptional wear, and tear, or excessive usage does not constitute a lessee guarantee of the residual value for the purposes of paragraph 840-10-25-6, according to FASB ASC 840-10-25-9. (b).