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Chapter 21: Q1CRC (page 1255)

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 鈥�90 percent of fair value,鈥� 鈥�75 percent of useful life,鈥� and 鈥渞esidual value deficiencies,鈥� 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 鈥渟ubstantially all鈥� defined in the authoritative literature?
  3. Besides the noncancelable term of the lease, name at least three other considerations in determining the 鈥渓ease term.鈥�
  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

Expert verified

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 鈥渟ubstantially all.鈥�
  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

01

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.

02

(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.

鈥淎 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.

03

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

IAS 17 does not define 鈥渟ubstantially all.鈥�

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.

04

(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."

05

 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).

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Most popular questions from this chapter

What disclosures should be made by lessees and lessors related to future lease payments?

Indiana Jones Corporation enters into a 6-year lease of equipment on January 1, 2017, which requires 6 annual payments of \(40,000 each, beginning January 1, 2017. In addition, Indiana Jones guarantees the lessor a residual value of \)20,000 at lease-end. The equipment has a useful life of 6 years. Prepare Indiana Jones鈥� January 1, 2017, journal entries assuming an interest rate of 10%.

Jennifer Brent Corporation owns equipment that cost \(80,000 and has a useful life of 8 years with no salvage value. On January 1, 2017, Jennifer Brent leases the equipment to Donna Havaci Inc. for 1 year with one rental payment of \)15,000 on January 1. Prepare Jennifer Brent Corporation鈥檚 2017 journal entries.

(Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2017. Annual rental payments of \(40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick鈥檚 incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for \)1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment.

Instructions

(c) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2019, by Ludwick.

A lease agreement between Mooney Leasing Company and Rode Company is described in E21-8.

Inception date

May 1, 2017

Annual lease payment due at the beginning

of each year, beginning with May 1, 2017

\(21,227.65

Bargain-purchase option price at end of lease term

\) 4,000.00

Lease term

5 years

Economic life of leased equipment

10 years

Lessor鈥檚 cost

\(65,000.00

Fair value of asset at May 1, 2017

\)91,000.00

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

Instructions

(Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor.

(a) Compute the amount of the lease receivable at the inception of the lease.
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