Question

Need memo

Format: Facts, Issue, Analysis, Conclusion

Background

You are an audit senior for Burns & Allen, LLP. One of the audit partners received a call from Brenda Parker, CFO of a publicly traded client, Toys For U (“Toys”). Toys is a retailer with 25 locations and is expanding each year. Toys leases retail space on long-term leases ranging from 10 to 15 years. Most of the leases have multiple renewal options. Under current rules, the arrangements are reported as operating leases. Brenda read that changes are coming to reporting for leases and wants to prepare for the changes that will be required. The audit partner at your firm, Erica Dalton, has asked you to prepare a memo to the Toys for U audit file explaining the proposed changes to accounting for leases. She asked that you include an example in the memo.

Required

Write a memo to the “Toys R U Audit File.” Be sure to include the following:

Brief description of current reporting rules for leases

Description of proposed reporting rules for leases

Example of application of proposed rules for a lesseeAssume the following lease terms:

Identifiable Asset: Facility (building) lease

Term 10 years – assume no renewal option

Monthly lease payments beginning at $125,000 per month over the ten year lease term

The risk free rate is 2%, Toys R U borrows at an incremental rate of 6%, and the lessor rate is unavailable

Assume the lease commences on January 1, 2021 and the first payment is due February 1, 2021

Include the following journal entries:

Recording of lease related asset and liability at lease inception – use “Capitalized Lease Asset” and “Capitalized Lease Liability” as account titles

Recording of the monthly expense for the first two months – do each month separately

Attach an Excel worksheet to your memo with the following:

Calculation of the amount of the capitalized lease asset and related lease liability

An amortization schedule for the lease term

Answer 1

Brief description of current reporting rules for leases

     Most of the leases have multiple renewal options. Under current rules, the arrangements are reported as operating leases. Brenda read that changes are coming to reporting for leases and wants to prepare for the changes that will be required. Record and manage critical dates notifications, options, expirations, straight-lining, CAM, contractual rent steps, and more. The Financial Accounting Standards Board (FASB) has issued a new standard for the financial reporting of leases that has been ten years in the making. The financial reporting obligations of companies that engage in leasing for assets such as fixed assets, vehicles, and equipment. The new standard is intended to make it easier for users of financial statements to compare different companies, but it will also likely have a range of additional repercussions for the companies themselves.

Description of proposed reporting rules for leases

Leasing is an vital activity for many enterprise—whether a public sector private sector, or a not-for-profit organization. It is a means of gaining access to assets, obtaining financing, and reducing an organization’s exposure to the risks of asset ownership. Many organizations lease assets such as fixed asset, airplanes, trucks, ships, and construction and manufacturing equipment. Because of the prevalence of leasing, it is important for users of financial statements to have a complete and understandable picture of an organization’s leasing activities.
The Propsed accounting models for leases require lessees and lessors to classify their leases as either capital leases or operating leases and to account for those leases differently. Those models have been criticized for failing to meet the needs of users of financial statements because they do not always provide a faithful representation of leasing transactions.
As a result, there has been a widespread request from users of financial statements and other stakeholders to change the accounting guidance so that lessees would be required to recognize assets and liabilities arising from leases. The Proposed method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property).

Example of application of proposed rules for a lessee Assume the following lease terms:

Arrangements containing a lease and non-lease element is whether all products and services provided by the lessor are considered executory costs as that term is used in ASC 840 and therefore, should be deducted from total consideration that the lessee is obligated to pay, or can be required to pay, in connection with the leased property when determining minimum lease payments. We believe that substantial services provided by the lessor (e.g., significant operating services) are not executory costs within the scope of ASC 840. The payments and other consideration called for by the arrangement should be separated at the inception of the arrangement or on a reassessment of the arrangement (as described in ASC 840-10-35-2 — see Section 1.1.4). A key feature of ASC 840-10-15-19 is that separating the lease elements from the non-lease elements in an arrangement is not elective. That is, regardless of whether objective evidence of relative standalone selling price exists, the lease elements still must be separated from the non-lease elements and accounted for under ASC 840. Once the lease elements have been separated from the non-lease elements, the executory costs that will be paid to the lessor, if any, must be estimated (including a reasonable profit thereon) and excluded from the minimum lease payments for purposes of assessing lease classification. Allocating the arrangement consideration between lease and non-lease elements when the leaseinception date is on or after the effective date of ASC 606.

Excerpt from Accounting Standards Codification

Pending Content:

If you’re a landlord or property owner, your lease agreement is probably one of the most important documents you use. it is the legal agreement between you and each tenant that occupies the space you own, and therefore, it acts as the rules by which they live in that space as well as defining the repercussions should the rules be broken.

The lease agreement provides renters and landlords with a legally enforceable contract and it’s important that this document have the necessary elements to provide security to both renter and landlord. A good lease agreement protects your interests and prevents misunderstandings that could potentially lead to litigation.

1. Parties to the lease – the lease agreement should be the name of landlords and tenants who are bound by the agreement.
2. Description of the property – the lease agreement should have a description of the property controlled by the lease agreement.
3. Terms of rent – the amount should be in the agreement as well as the day of the month rent is due, where the rent is to be sent, and how it will be accepted (by check, by automatic draft, etc.).
4. Lease dates and termination – the start and end of the lease should be in the agreement as well as the description of how and when the landlord and tenant can end the lease. For example, an apartment lease may be terminated with one month’s notice and a final month’s rent.
5. Security deposit details – the amount of the security deposit, how it is to be paid, and the terms of its future release should be specified in detailed the lease agreement.
6. Occupants of the property – the lease agreement should list the names of every person who will   occupy the property
7. Pet details – the lease agreement should specify whether or not a tenant is allowed to have a pet.
8. Repairs and damages- the condition of the property should be noted as well as the tenant’s and landlord’s responsibilities for repairs and problems with the property. The lease agreement should also describe whether the landlord or tenant is responsible for damages to the property.
9. Alterations to the property – the lease agreement should describe what, if any, alterations the tenant may make to the property.
10. Right of entry – the lease should include a clause that allows the landlord to enter and inspect the property with reasonable notice. The terms should define reasonable notice and explain the rights of the tenant.

Term 10 years – assume no renewal option

A renewal option provides the leaseholder the option, but not the obligation, to renew or extend a lease agreement beyond its initial terms. A start-up business may, for example, rent an office space for five years. A renewal option would allow the business to renew or extend the lease to remain in the office space beyond the five-year lease term. This can be beneficial to the business: if it is doing well in the location, it can remain for an additional term; if it is doing poorly, it can close shop at the end of the initial term without defaulting on the lease and without pressure to renew or extend it.

Monthly lease payments beginning at $125,000 per month over the ten year lease term

The risk free rate is 2%, Toys R U borrows at an incremental rate of 6%, and the lessor rate is unavailable

If we assume that the lease does not call for any advance payments, then calculating the regular monthly payment is straightforward. The lease cash flows are an annuity (the monthly payment) and a lump sum (the residual value) at the end of the lease.

Recording of lease related asset and liability at lease inception – use “Capitalized Lease Asset” and “Capitalized Lease Liability” as account titles

A capital lease is a lease in which the lessee records the underlying asset as though it owns the asset. This means that the lessor is treated as a party that happens to be financing an asset that the lessee owns. The lessor should record a lease as a capital lease if any of the following criteria are met: The lease period minimum cover at 75% of the useful life of the asset; or There is an option to buy the leased asset following the lease expiration at a below-market rate; or Ownership of the leased asset shifts to the lessee following the lease expiration;The PV of the minimum lease payments totals at least 90% of the fair value of the asset at the beginning of the lease.The lessor and lessee typically agree upon lease conditions in advance that will designate a lease as an operating or capital lease; the outcome of the lease analysis is rarely accidental. If an examination of these criteria indicate that a leased asset is a capital lease, the accounting for the lease is comprised of the following activities: Initial recordation. Calculate the present value of all lease payments; this will be the recorded cost of the asset. Record the amount as a debit to the appropriate fixed asset account, and a credit to the capital lease liability account. For example, if the present value of all lease payments for a production machine is $200,000, record it as a debit of $200,000 to the production equipment account and a credit of $200,000 to the capital lease liability account.