[koz124]

Just curious to get some opinions on a situation I have at work. The operations manager is trying to get a piece of equipment in 2014 that is not in our budget, so he’s looking for alternatives. One of the options is to lease the equipment for 7-8 months through a financing company and than purchase it. The asset life is approximately 15 years. Total cost of the machine will be about $160,000 with $3,000 payments for the 7-8 months we are “leasing” it. I’m a little torn on how to treat this agreement. We won’t be leasing it for 75% of the life, PV of payments are not 90% (obviously), we will have to make a purchase payment after the lease payments, but it is doubtful that it will be a bargain. Could this be treated as an operating lease even though it appears on the surface to be a financing/capital lease?

Studying with Wiley Review, Wiley Test Bank, Ninja Audio.
Retakes with Ninja MCQ only...awesome!
Far - 1/28 72, 7/22 79
Aud - 2/28 70, 8/14 83
Bec - 4/10 80
Reg - 5/30 64, 7/2 82

[mystical guy]

This is a “substance over form” challenge. Interested to see what answers you get but it seems like FASB still leaves the educated user of the financials to interpret the true economic value vs. legal value, unlike IFRS.

CPA - Since 2015
CISA - Smashed 2012
CIA - Passed 2015

[mystical guy]

This is a “substance over form” challenge. Interested to see what answers you get but it seems like FASB still leaves the educated user of the financials to interpret the true economic value vs. legal value, unlike IFRS.

CPA - Since 2015
CISA - Smashed 2012
CIA - Passed 2015

[koz124]

Was hoping for some input…but not looking like I'll get other opinions?

Studying with Wiley Review, Wiley Test Bank, Ninja Audio.
Retakes with Ninja MCQ only...awesome!
Far - 1/28 72, 7/22 79
Aud - 2/28 70, 8/14 83
Bec - 4/10 80
Reg - 5/30 64, 7/2 82

[koz124]

Was hoping for some input…but not looking like I'll get other opinions?

Studying with Wiley Review, Wiley Test Bank, Ninja Audio.
Retakes with Ninja MCQ only...awesome!
Far - 1/28 72, 7/22 79
Aud - 2/28 70, 8/14 83
Bec - 4/10 80
Reg - 5/30 64, 7/2 82

[Anonymous]

@Kristina –

This is luckily one of those situations where there are very “bright” lines in US GAAP about whether or not something will be classified as an operating or capital lease. Companies OFTEN structure contracts/agreements to come RIGHT under those lines (e.g., lease term is 74.9% of asset's useful life; PV of min lease payments is 89.9% of FV of the asset, etc.).

So evaluate the agreement against the four criteria:

-Is the lease term equal to or greater than 75% of the asset's useful life?

-Is the PV of the minimum lease payments equal to or greater than 90% of the FV of the asset?

-Does ownership of the asset transfer to the lessee upon culmination of the lease term?

-Is there a bargain purchase option? (i.e., at any point during the agreement, can the asset be purchased for a material discount [i.e., bargain purchase] off the value of the equipment)

Under US GAAP, this is luckily one of those areas that does not require a lot of judgment. I do consulting frequently on contracts with embedded leases, so it's an area that I'm familiar with. Good luck.

[Anonymous]

@Kristina –

This is luckily one of those situations where there are very “bright” lines in US GAAP about whether or not something will be classified as an operating or capital lease. Companies OFTEN structure contracts/agreements to come RIGHT under those lines (e.g., lease term is 74.9% of asset's useful life; PV of min lease payments is 89.9% of FV of the asset, etc.).

So evaluate the agreement against the four criteria:

-Is the lease term equal to or greater than 75% of the asset's useful life?

-Is the PV of the minimum lease payments equal to or greater than 90% of the FV of the asset?

-Does ownership of the asset transfer to the lessee upon culmination of the lease term?

-Is there a bargain purchase option? (i.e., at any point during the agreement, can the asset be purchased for a material discount [i.e., bargain purchase] off the value of the equipment)

Under US GAAP, this is luckily one of those areas that does not require a lot of judgment. I do consulting frequently on contracts with embedded leases, so it's an area that I'm familiar with. Good luck.

[StephAV]

I think it will be a bargain purchase because you are putting your lease payments towards the “purchase price.” I really don't know, just trying to give some input, I know this is how real life accounting is for me at work too, not so cut and dry.

What about the time period? So by the end of 2014 would you guys have officially “purchased” the machine/equip? If so what is the financial statement effect of recording the lease as operating vs. capital? If you record it as operating you are going to just dr. 3000 a month rent expense. Capital you are going to book an asset for the PV of the future lease payments which would be ~$24k. I've never dealt with a capital lease IRL. I guess when you purchase it though your are going to

Dr. Equip

Cr. Cash

If you had an asset on the books for the capital lease, it should be zeroed out….

I'm thinking the only difference if this is happening within your fiscal year would be whether the expense goes to rent exp or interest exp?? Hopefully others will weigh in…

FAR - 7/13 - 72, 11/13- 74, 2/14- 82!!! Best score ever (for me)!!!
BEC - 1/14 - 75!!! Perfect score! First Pass! YAY!!!
AUD - 8/14 - 80!!!
REG - 5/14 - 72, 10/14 - 66, 1/15 - 78 - DONE FOREVER!!!
I did 5 of the UNA and CPAExcel classes to earn units.

[StephAV]

I think it will be a bargain purchase because you are putting your lease payments towards the “purchase price.” I really don't know, just trying to give some input, I know this is how real life accounting is for me at work too, not so cut and dry.

What about the time period? So by the end of 2014 would you guys have officially “purchased” the machine/equip? If so what is the financial statement effect of recording the lease as operating vs. capital? If you record it as operating you are going to just dr. 3000 a month rent expense. Capital you are going to book an asset for the PV of the future lease payments which would be ~$24k. I've never dealt with a capital lease IRL. I guess when you purchase it though your are going to

Dr. Equip

Cr. Cash

If you had an asset on the books for the capital lease, it should be zeroed out….

I'm thinking the only difference if this is happening within your fiscal year would be whether the expense goes to rent exp or interest exp?? Hopefully others will weigh in…

FAR - 7/13 - 72, 11/13- 74, 2/14- 82!!! Best score ever (for me)!!!
BEC - 1/14 - 75!!! Perfect score! First Pass! YAY!!!
AUD - 8/14 - 80!!!
REG - 5/14 - 72, 10/14 - 66, 1/15 - 78 - DONE FOREVER!!!
I did 5 of the UNA and CPAExcel classes to earn units.

[Anonymous]

“I think it will be a bargain purchase because you are putting your lease payments towards the “purchase price.””

@StephAV – Respectfully, that is incorrect. The fact that you're putting payments toward the purchase price isn't necessarily a relevant factor in evaluating whether something is a bargain purchase option. A “bargain purchase option” is an option laid out at lease inception to buy the equipment at a price “substantially” lower than the expected FMV of the asset at that time. The only real “judgment” here is how an organization interprets “substantially”.

What this means is this: think of a scenario where you rent a piece of equipment with a fair value of $1,200 for 1 year at $20 per month and the economic life of the asset is 12 years. The agreement has no transfer of ownership, but there is an option to purchase the equipment for $1,100 at the end of the lease term (payments already made applied to purchase price if option taken [i.e., Lessee would only have to fork over an additional $860 if option is exercised]). In this scenario, this is an operating lease:

-75% or > of asset's useful life? (12/144 = 8.3%; NO)

-PV of MLP 90% or > than asset's FV? (not even the MLP straight up [i.e., not PV] are = or > than 90% of the FV of the equipment; NO)

-Ownership transfer (NO)

-Bargain Purchase Option (expected FV of the equipment after one year = $1,100 [$1,200 asset/144 month useful life = $100 depr. per year…expected FV after 12 months is $1,100; option to purchase = $1,100…obviously not a bargain; NO)

Take the same scenario, but say the lessee has the option to purchase the equipment after 12 months for $900. Well now you're slicing roughly 18% off the expected FV of the asset at that time and would probably be considered a bargain purchase, and therefore, a capital lease.

Hopefully that makes sense.

[Anonymous]

“I think it will be a bargain purchase because you are putting your lease payments towards the “purchase price.””

@StephAV – Respectfully, that is incorrect. The fact that you're putting payments toward the purchase price isn't necessarily a relevant factor in evaluating whether something is a bargain purchase option. A “bargain purchase option” is an option laid out at lease inception to buy the equipment at a price “substantially” lower than the expected FMV of the asset at that time. The only real “judgment” here is how an organization interprets “substantially”.

What this means is this: think of a scenario where you rent a piece of equipment with a fair value of $1,200 for 1 year at $20 per month and the economic life of the asset is 12 years. The agreement has no transfer of ownership, but there is an option to purchase the equipment for $1,100 at the end of the lease term (payments already made applied to purchase price if option taken [i.e., Lessee would only have to fork over an additional $860 if option is exercised]). In this scenario, this is an operating lease:

-75% or > of asset's useful life? (12/144 = 8.3%; NO)

-PV of MLP 90% or > than asset's FV? (not even the MLP straight up [i.e., not PV] are = or > than 90% of the FV of the equipment; NO)

-Ownership transfer (NO)

-Bargain Purchase Option (expected FV of the equipment after one year = $1,100 [$1,200 asset/144 month useful life = $100 depr. per year…expected FV after 12 months is $1,100; option to purchase = $1,100…obviously not a bargain; NO)

Take the same scenario, but say the lessee has the option to purchase the equipment after 12 months for $900. Well now you're slicing roughly 18% off the expected FV of the asset at that time and would probably be considered a bargain purchase, and therefore, a capital lease.

Hopefully that makes sense.

[Author]

Replies