Question

Carey Company is considering the acquisition of additional equipment for the business and is analyzing the opportunity to purchase versus lease the equipment. The staff at Carey Co. fully understands the accounting for a purchase of equipment but is not familiar with the new rules related to lease accounting (ASC 842). Prepare a memo presenting information to Carey Company specifically addressing the following at a minimum. Responses should be incorporated as a part of the memo discussion rather than as separate answers. -Under what conditions is an exchange regarded as a lease? -How is “substantially all risks and rewards of ownership transferred” defined? -If Carey Company decides to pursue a lease, how would the lease term affect the transaction? -If Carey Company engages in the lease, the agreement would require that they make up a residual value deficiency at the end of the lease term that is attributable to damage or extraordinary wear and tear. Would this requirement constitute a guarantee of the estimated residual value and be included in the minimum lease payments?

Answer 1

"Under what conditions is an exchange regarded as a lease?

As per ASC 842 :

A lease conveys the right to use an underlying asset for a period of time in exchange for consideration. At the inception of an arrangement, the parties should determine whether the contract contains a lease by assessing both of the following:

1. Whether there is an identified asset

2. Whether the contract conveys the right to control the use of the identified asset in exchange for consideration for a period of time

ASC 842-10-15-3 Define Lease as:

A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce)."

"How is “substantially all risks and rewards of ownership transferred” defined?

The second criterion in the control assessment is the right to the economic benefits derived from the asset. To be a lease, the arrangement must convey the right to obtain substantially all of the potential economic benefits that can be obtained from directing the use of the asset throughout the period of use.

The period of use could be consecutive or nonconsecutive periods of time. A customer would not control an asset if another party has the right to more than an insignificant portion of the potential economic benefits. This is not a probability analysis as to who is likely to receive the benefits; the assessment should focus on the contractual rights of the respective parties. Specifically, the rights to the output and other economics derived from use of the asset should be considered. For example, if an electronic billboard is used by multiple advertisers it is likely that control rests with the billboard owner because none of the advertisers obtain substantially all of the economic benefits. If a customer does not have contractual rights to all of the existing capacity of the asset, and the arrangement does not grant the customer an option to acquire any additional capacity, the arrangement is unlikely to be a lease. However, if the customer has the option to increase the volume of the output it consumes before it is given to additional customers (right of first refusal), the arrangement likely meets this criterion.

If the asset produces more than one type of output or benefit, this assessment should be made based on the fair value of the contractual rights. In other words, the assessment should be performed based on the likely economic returns associated with these contractual rights. The assessment should be based on the asset as it exists at the time of entering into the arrangement by considering the capacity level at which the asset is expected to operate, maintenance schedules, and type of physical asset when arriving at the likely economic benefits. The standard does not define “economic benefits” but it does provide examples of ways the benefits can be obtained."

-If Carey Company decides to pursue a lease, how would the lease term affect the transaction?

For lessees, the recognition of lease related assets and liabilities and changes to the pattern and timing of lease expense recognition could have significant financial reporting and business implications, such as:

• Key balance sheet metrics may change

• Changes to lease revenue and expenses may affect other key metrics, such as earnings before interest, taxes, depreciation and amortization (EBITDA)

• Debt covenants and borrowing capacity may be affected

• Decisions of whether to lease or buy significant assets may be affected

Measuring the lease liability

On the lease commencement date, a lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments, discounted using the rate implicit in the lease (or if that rate cannot be readily determined, the lessee’s incremental borrowing rate). Lease payments used in measuring the lease liability are amounts due to the lessor excluding any payments that a lessee makes before lease commencement. There are six components that should be factored into measuring lease payments. Lease arrangements should be thoroughly reviewed to ensure that all applicable payments are being considered. With some exceptions, the lease payments used to measure the lease liability should be the same as those used to determine lease classification. Two of these exceptions are:

To classify a lease, a lessee should use all lease payments (i.e., including payments made before the commencement date), whereas only the remaining payments due should be used to measure the lease liability

For lease classification purposes, the entire potential payment under a residual value guarantee should be included in the lease payments. The lease liability Accounting for leases recorded at lease commencement should only include amounts probable of being owed by the lessee under residual value guarantees