The Theoretical Basis for the Accounting Standard - Essay Example

RUNNING HEAD: SFAS No. 13 SFAS No. 13 in APA Style Case 13-4 Application of SFAS No. 13 What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? The requirement to capitalize long-term leases is based on the concept of substance over form. This means that in its legal form (as supported by a lease contract), a transaction may be deemed a lease. However, in substance (and therefore in the accounting point of view), the lessee is actually purchasing the leased asset from the lessor because the risks and rewards of using the leased asset are actually transferred by the lessor to the lessee. 2. How should Lani account for this lease at its inception and determine the amount to be recorded? Paragraph number 7 of SFAS No. 13, Accounting for Leases, laid down the criteria to be used by a lessee in classifying a lease as either capital or operating. One such criterion is “the lease transfers ownership of the property to the lessee by the end of the lease term” with the phrase “lease term” defined by paragraph 5(f) of SFAS No. 13 as a “fixed noncancelable term of the lease”. Since the lease is not cancelable and will transfer ownership of the machine after the lease term to Lani, this lease qualifies as a capital lease. For capital leases, Lani, who is the lessee, is required to book both an asset and a liability in her books. According to Paragraph 10 of SFAS No. 13, the amount recorded should be the higher of the fair value of the leased property and the “present value at the beginning of the lease term of minimum lease payments during the year”. The minimum lease payments (and therefore the present value) should exclude the costs to execute the lease contract. 3. What expenses related to this lease will Lani incur during the first year of the lease, and how will they be determined? The expenses that Lani may incur during the first year of the lease are the “executory costs” that Lani may reimburse to her lessor. These costs may include insurance costs, maintenance costs and transfer taxes that will be initially paid by the lessors but will later be reimbursed by the lessee. Such costs are clearly laid down in the lease contract and should be properly excluded from the minimum lease payments used to calculate the present value. 4. How should Lani report the lease transaction on its December 31, 2006, balance sheet? According to Paragraph 13 of SFAS No. 13, the capitalized asset should not be offset against the liability recognized for the capital lease. The asset capitalized should be shown separately in the balance sheet of the lessee or in the notes to financial statements, net of the related accumulated amortization. Likewise, the related liability should also be shown separately in the liability section of the balance sheet or in the notes to financial statements. Case 13-5 Lease Classifications 1. What criteria must be met by the lease in order the Doherty Company classify it as a capital lease? From the point of view of Doherty Company, which is the lessee in this case, the criterion or criteria that should be met prior to classifying the lease as a capital lease may be one or more of the four criteria discussed in Paragraph 10 of SFAS No. 13. The first criterion is that the lease contract provides for the transfer of the ownership of the leased property by the lessor to the lessee upon the termination of the lease. This assumes that the lease contract is fixed and is not cancelable during the lease term. The second criterion is that there is a “bargain purchase option” provided for in the lease contract. That is (according to paragraph 5d of SFAS No. 13), the lessee is allowed under the lease contract to buy the leased asset from the lessor at a “price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable”. The third criterion is that the term of the lease is “equal to 75% or more of the estimated economic life of the leased property”. The last criterion is that the “present value…of the minimum lease payments…” is almost equal (90% or more) to the fair value of the property being leased less any “related investment tax credit retained by the lessor” which the lessor expects to realize in the future. Paragraph 10 also stated that if the lease term begins within the last 25% of the “total estimated economic life of the leased property”, the last two criteria should not be utilized to determine if the lease is a capital lease or an operating lease. 2. What criteria must be met by the lease meet in order the Lambert Company classify it as a sales-type or direct financing lease? In the point of view of Lambert Company as the lessor, the company should classify the lease as a sales-type lease if Lambert will transfer the ownership of the leased property to Doherty at the end of the lease term and Lambert realizes a manufacturer’s or dealer’s profit or a loss from the lease. On the other hand, for Lambert to be able to classify the lease as a direct financing lease, the lease should meet any one of the criteria in Paragraph 10 (i.e., transfer of ownership at end of lease, provision for bargain purchase option, present value of minimum lease payments equals or exceeds 90% of the fair value and lease term equals or exceeds 75% of the economic life of the leased asset). In addition, the lease should meet two other criteria discussed in Paragraph 8 of SFAS No. 13 for it to be classified as a direct financing lease. The first criterion is that the “collectibility of the minimum lease payments should be reasonably predictable”. The second criterion is that there are no significant doubts surrounding the “amount of the unreimbursable costs yet to be incurred by the lessor under the lease”. 3. Contrast a sales-type lease with a direct financing lease. For a lease to be classified as a sales-type lease, it only requires the specific provision for the transfer of the leased property from the lessor to the lessee at the end of the lease term. In addition, the lease will enable the lessor to realize a manufacturer’s or dealer’s profit or loss from the lease agreement. A direct financing lease may also result to the transfer of ownership of the lease to the lessee, however, the lessor does not realize any manufacturer’s or dealer’s profit or loss from entering into the lease. For the accounting under these two types, there are also similarities and differences. In terms of recording the gross investment, according to Paragraphs 17a and 18a, they both use the total of the “minimum lease payments…and the unguaranteed residual value accruing to the benefit of the lessor” to come up with the amount to be recorded as gross investment. The difference between the gross investment and the carrying value of the leased asset shall be recorded as unearned income and amortized over the lease term. What’s different between the two types is that, under the sales-type lease and according to Paragraph 17c, the lessor will record a sales price equivalent to the “present value of the minimum lease payments” and a charge to income comprising “the cost or carrying amount of the leased property…plus any initial direct cost…, less the present value of the unguaranteed residual value”. This is because the lessor realized a profit or loss from the said lease. This accounting is not found in the direct financing lease since there is no profit or loss on the side of the lessor under this type of lease arrangement. Reference Financial Accounting Standards Board (2008). Statement of Financial Accounting Standards No. 13: Accounting for Leases. Retrieved May 12, 2009 from http://www.fasb.org/ pdf/aop_FAS13.pdf. Read More