Chapter 10

Question 1

What is a Lease

Answer 1

A contract between the owner of an asset (the lessor) and the party desiring to use that asset (the lessee)

It is a private contract only governed by applicable commercial law

Question 2

What are the benefits of a lease

Answer 2

1. Lower equity investment means the ability to finance a higher proportion of the asset’s cost
2. Flexibility that a leasing contract provides

Question 3

Explain the New Lease Reporting Standard set forth by FASB

Answer 3

Requires all companies classify all leases as either a finance lease or an operating lease

• Finance leases transfer control of the lease asset to the lessee. (Finance leases are effectively like purchasing the asset and financing the purchase with a collateralized loan)
• Operating leases transfer control of the use of the lease asset, but not the asset itself. (Any lease of 12 months or more not classified as a finance lease is classified as an operating lease)

Question 4

Describe the two transition options for adopting the new lease options

Answer 4

1. Retroactive adoption: implement the new standard in the current year and restate all prior periods represented in the financial statements.
2. Prospective adoption: implement the new standard without restatement of the prior periods, which means to different accounting methods on the books.

Question 5

Finance leases must meet one or more of what criteria

Answer 5

• Transfer of ownership: Ownership of asset transfers to lessee by end of lease term
• Purchase option: Lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
• Lease term: Lease term is for a major part of the remaining economic life of the asset
• Present value: The present vale of the sum of the lease payments and any residual value guaranteed by the lessee that is not already included in the lease payments equals or exceeds all of the fair value of the asset
• Specialized asset: Asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

Question 6

Review Lease Accounting and the Balance Sheet

Answer 6

A lease liability is recognized at the present value of the remaining lease payments

A right-of-use asset is recognized at an amount calculated as follows (see image)

(This means the right-of-use asset will often be greater than the related lease liability at the inception of the lease)

Question 7

How are lease liabilities presented on the BS

Answer 7

BS presents lease liabilities and right-of-use assets separately (not the net amount)

Finance lease assets are typically included in PPE and lease liabilities are included with debt

Operating lease assets and liabilities are each reported in a separate line item if material

Question 8

Review Lease Accounting and the IS

Answer 8

Total expense over the lifetime of the lease is recognized in the income statement in an amount equal to the total remaining lease payments plus total amortization of any up-front costs.

Question 9

How are leases reflected on the IS

Answer 9

Operating lease. Lease expense is recognized each period as rent expense in arriving at income from operating activities

Finance lease. Lease expense includes interest on the lease liability plus straight-line amortization of the right-of-use asset

• Amortization of the right-of-use asset will be included in income from operations
• Interest expense will be reported after operating income
• Operating profit will be higher by the amount of interest expense recognized as non operating

Question 10

Describe the impact of leases on the Statement of Cash Flows

Answer 10

Operating lease. Cash flow from operating activities includes the entire lease payment

Finance lease.

• The lease payments include payment of accrued interest and reduction to the principal balance of the lease liability.
• The interest portion is included in net income and, therefore, in net cash flows from operating activities
• The portion representing the payment of the principal balance of the lease liability is considered a financing activity.
• Net cash flows from operating activities will therefore be higher for finance leases by the amount of the payment allocated to reduction of the lease liability

Question 11

Summary of Lease Accounting and Reporting

Answer 11

For both operating and financing leases, the BS treatment is identical. The income statement and statement of cash flows depend on the lease classification

• Income Statement
  
  • Operating leases: level rent expense recorded each period (an operating item)
  • Finance lease: Amortization expense recorded each period (an operating item) and interest expense accrued on the lease liability (a non operating item)
• Statement of Cash Flows
  
  • Operating lease: Rent expense is reported in net income and, thus, is included in net cash from operating activities. The amortization of direct costs (non-cash portion of rent expense) is added back as a reconciling item
  • Finance lease: Amortization expense is an add-back in net cash from operating activities. Interest expense is reported in net income and, thus is included in net cash from operating activities. Repayment of the lease obligation is classified as a financing activity

Question 12

What are the Analysis Issues Relating to Leases

Answer 12

1. Treatment of operating leases prior to adoption of the 2019 accounting standard
2. Different accounting treatments for operating and finance leases

Question 13

What are the 2 Types of Pensions

Answer 13

1. Defined contribution plan: e.g., 401k
2. Defined benefit plan: Third party administered after retirement

Question 14

Define Funded Status

Answer 14

The difference b/t the Projected Benefit Obligation (PBO) less the Pension Plan Assets.

It is reported on the BS

If the plan assets exceed the projected benefit obligation, it is overfunded and is a net asset

If the plan assets are underfunded, then it is a liability for the underfunded amount

Question 15

Define Pension Plan Assets

Answer 15

The investment vehicle(s) in which a company contributes. These can also generate gains (losses) based on the market

Question 16

Define Projected Benefit Obligations (PBO)

Answer 16

A liability which represents the present value of the company’s estimated future payments to retirees.

Question 17

What are some of the difficulties in projecting future payments for PBOs

Answer 17

• Payments often do not occur form many decades in the future
• Number of eligible employees is uncertain
• Employees’ longevity with the company is unknown
• Payments depend on employees’ final salary levels, which must be estimated

Question 18

Review Items impacting the Funded Status on the IS

Answer 18

• Service cost: Increase in liability when a person adds another year of service
• Interest cost: Interest accrued on the PBO liability, computed using the discount rate
• Investment returns: Gains or losses generated by the investment
• Actuarial adjustments: Estimates about the future that can change
  
  • Wage inflation
  • Years of benefit payments
  • Discount rate
  • Investment returns

Question 19

Define Pension Expense Smoothing

Answer 19

As long as the total deferred gains or losses are not excessive, they remain on the balance sheet in AOCI and are, therefore, not included in the IS

1. Companies recognize expected returns over the long term rather than actual returns
2. Only the amortization of excess deferred gains or losses is recognized in current income

Question 20

Review how PPA and PBO are updated

Answer 20

Question 21

Review the Impact of Various rates on Pension Expense

Answer 21