Contemporary Accounting Leases

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A lease is a contractual agreement between two parties the lessor and the lessee. The lessor owns the property and agrees to let the lessee use the property for a period of time for periodic payments. Between the two parties there can be two different types of lease agreements. The first is called an operating lease. With an operating lease, the lessee merely uses the asset of the lessor for a period of time while paying a periodic fee (ex. Monthly rent). In an operating lease there is no transfer of ownership. The second type of lease is called a capital lease which transfers substantially all of the benefits and risk inherent in ownership of property to the lessee. Capital leases can be looked at as an accounting transaction which is basically an installment purchase in the form of a lease agreement. For the lessee, in order for a lease to be classified as a capital lease one of the four following criteria must be met: 1) Ownership is transferred at the end of the lease, 2) The lease contains a written option for a bargain purchase, 3) The lease term is equal to 75 percent or more of the estimated economic life of the leased asset, or 4) The present value of the minimum lease payments exceeds or equals 90 percent of the fair value of the leased property. Once classified as a capital lease the lessee should account for this transaction as an acquisition of both the asset (equal to the PV of the payments of the capital lease) and the liability associated with that asset. With regards to the lessor, in order for a lease to be considered a capital lease it must meet all three of the requirements listed: 1) The lessee must “own” the property (this means that any of the lessee requirements must be met), 2) The collectability of the lease payments is reasonably predictable, and 3) Uncertainties do not exist regarding any non-reimbursable costs to be incurred by the lessor. In addition, at inception of the lease, the lessor must then determine if the capital lease should be classified as a sales type or direct financing lease, with the main difference between the two classifications being the profit recognized. The 2010 Exposure Draft proposes many changes to the reporting of leases. On the date of inception of the lease, the lessee must measure the liability to make the lease payments at the present value. The lessee’s incremental borrowing rate is used unless you can determine the rate the lessor charges the lessee. Also, the lessee measures the right-of-use asset by adding the initial direct costs and the amount of the liability to the lessee. To determine the present value of lease payments the lessee includes three criteria. The first criterion is the estimate of contingent rentals payable. If the contingents rely on a rate then the lessee will use a forward rate. If the forward rate cannot be determined, then the lessee will use prevailing rates. The next criterion is the estimate of payables to the lessor using residual value guarantees. If the residual value guarantee is given by a third party, it is not considered a lease payment. The last criterion is the estimate of expected payments under term option penalties. The exposure draft concludes that the lessee should use present value over fair value when computing lease payments. When using the present value of payments along with the discount rate, it is a good estimate to the fair value.

Another proposal from the Exposure Draft deals with the subsequent measurement of the lease payments. Once the lease is commenced, the lessee will measure the liability at amortized cost using the interest method. Also, the lessee will measure the right-of-use asset at amortized cost. If there are circumstances where there would be a significant change in the liability from the previous period, the lessee needs to reassess the carrying amount of the liability. When this happens, the lessee needs to change the length of the lease term and adjust the right-of-use asset. The...
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