Question

1. Explain the potential benefits of leasing an asset rather than buying.  Explain how the classification of a lease (operating or capital) may alter the transparency of information on the financial statements.

2. Explain and identify the application of the different contract modification techniques.

3. Explain the extent and timing of revenue recognition based on identified performance obligations.

Answer 1

Answer 1:

Potential benefit of leasing an asset rather than buying

This method is good for equipment that needs to be updated often because you can acquire updated technology easier and quicker. If you will need to update your equipment on an annual basis to remain competitive, leasing allows you to avoid being stuck with outdated equipment.

There is less expense up-front with leasing because you have easy, predictable payments. You don’t have to deal with one large lump sum to purchase what you need, making it easier to budget for the equipment over a longer period of time.

Leasing is often 100% tax-deductible as an operational expense under the 179 IRS Tax Code.

Leasing is flexible and offers more options when it comes to the type of equipment you get. You aren’t as restricted by high up-front costs or other hesitations to try something new that may help your business.

With leasing, you don’t pay for maintenance. If something breaks or has issues due to normal wear and tear, the leasing company is in charge of fixing the equipment.

How classification of asset may alter the transparency of information on financial statements

Operating Leases: Many companies choose operating leases because of their legitimate advantages. Under operating leases the lessee generally does not bear the risks of ownership. The lessor often bears the risk of over estimating residual value, since the lessor is the owner of the asset.

Arguably the most attractive advantage of operating leases is that they can be used as a form of off-balance sheet financing. However, this causes much confusion. When a company acquires an asset with debt financing, a liability shows up in its financial statements alerting investors of the claims against future income. When an asset is leased, however, no liability is created even though the company has entered into a lease contract and is legally obligated to make lease payments in the future. It is no surprise then that many experts think operating leases should be classified as a liability.

Synthetic Leases: Much more dangerous than operating leases are their cousins, synthetic leases. Under a synthetic lease, a company creates a special purpose entity (SPE). The SPE exists solely to provide the parent company with an operating lease. Synthetic leases keep debt off the parent company's books under current accounting rules.

Capital Leases: The other classification of a lease in the business world today is a capital lease, sometimes referred to as a finance lease. Capital leases make the company’s balance sheet have more liability as opposed to an operating lease

Answer 2.

Contract modifications are of the following types:

(a) Bilateral. A bilateral modification (supplemental agreement) is a contract modification that is signed by the contractor and the contracting officer. Bilateral modifications are used to --

(1) Make negotiated equitable adjustments resulting from the issuance of a change order;

(2) Definitize letter contracts; and

(3) Reflect other agreements of the parties modifying the terms of contracts.

(b) Unilateral. A unilateral modification is a contract modification that is signed only by the contracting officer. Unilateral modifications are used, for example, to -

(1) Make administrative changes;

(2) Issue change orders;

(3) Make changes authorized by clauses other than a changes clause (e.g., Property clause, Options clause, or Suspension of Work clause); and

(4) Issue termination notices.

Answer 3.

Extent and timing of revenue recognition based on identified performance obligation

For recognizing revenue, first step identify the contract with the customer.

The second step is to identify the performance obligations.

A performance obligation is defined as a promise to transfer a good or service. A performance obligation can be explicitly stated in the contract or it can be implied. Activities undertaken to fulfil a contract are not considered a performance obligation unless those activities transfer a good or service to a customer.

The transaction price will be allocated to the different performance obligations. So identifying performance obligations is important because it will have a significant impact on when and how much revenue will be recognized.

A performance obligation shall be allocated a portion of the transaction price if either of the following is true:

a. The good or service (or a bundle of goods or services) is distinct; or

b. The good or service is part of a series of distinct goods or services that are substantially the same, and have the same pattern of transfer to the customer.

Revenue allocated to a performance obligation should be recognized when the goods or services are transferred to the customer, which occurs when the customer has control of the asset or use of the service.

Performance obligations can be satisfied, and thus revenue recognized over time or at a point in time.