Special Features of Lease Arrangements and The Effect of Residual Values

Not all leases are alike.  Leases are generally constructed in a manner beneficial to the lessee, lessor, or both.  As a result, most leases have specific features that make them unique and in some cases create accounting problems.  Special features of leases that create accounting issues include, but are not limited to, leasehold improvements and executory costs.  Leasehold improvements occur when the lessee makes improvements to leased property that reverts back to the lessor when the lease ends; Executory costs are maintenance, insurance, taxes, and all other expenses associated with ownership that a lessee is required to pay per the lease agreement. The major problem with leasehold improvements is that some companies allocate the cost incorrectly.  Leasehold improvements should be expensed over the lease term; however, most companies erroneously allocate the cost over leased assets’ estimated useful life.  Allocation of executory costs is generally simple because they are expensed by the lessee as they are incurred.  However, if the lease agreement states that the rental payments are a higher amount because they include executory costs, the lessee must list these cost separate from minimum lease payments.

Residual value is the estimated commercial value of a leased asset at the end of the lease period.  The effect of residual value is dependent on if the lessee guarantees the lessor will recover the value when the asset is reverted at the end of the lease period.  When the residual value is guaranteed, the lessee promises to provide the lessor with an additional lease payment that is included in the minimum lease payments.  When the residual value is not guaranteed, the lessee is only obligated to make periodic lease payments. 

Risk Management

Internal control systems are useful because they identify and correct accounting-related fraud or errors.  However, internal controls are useless if risks associated with an organization’s routine decisions are not monitored.  Enterprise risk management (ERM) focuses on risks to an organization’s operations and ensures controls are in place to eliminate, mitigate, or compensate such risks.  Additionally, ERM identifies and assesses risks related to management’s objectives by evaluating internal control components: control environment, risk assessment, control procedures, monitoring, and information and communication. 

Control Environment

An effective control environment primarily defines organizational structure, commitment to competence, assignment of authority and responsibility, and internal audit functions.  Control environments are important any type of risk approach because it establishes organizational tone, the foundation of organizational internal control, and its response to risk. 

Risk Assessment

Risk assessment is the process used to estimate the likelihood and impact of risks on management’s objectives.  Risk assessment generally includes risk-response.  After potential risks are identified, they become part of an organization’s risk portfolio.  Risk response is then used to evaluate correlations and total impact and make changes to optimize the risk portfolio.

Control Procedure

Control procedures are actions taken by management to eliminate, mitigate, and compensate for risks.  The most frequently used control procedures are performance reviews, segregation of duties, physical controls, and information-processing controls.  Performance reviews gives management the opportunity to perform periodic evaluations of the organization’s objectives and ensure they are being met.   Segregation of duties separates tasks such as authorization to execute transactions, recording transactions, and periodic reconciliation of existing assets to current amounts to reduce the risk of an individual creating and concealing errors, frauds, and misstatements within the organization.  Organizations have physical controls in place to prevent access to documents, inventory, and specific areas by unauthorized individuals.  Information-processing controls create audit trails and are in place to ensure financial statement transactions are processed correctly.

Monitoring

Monitoring is an ongoing assessment of the quality of an organization’s internal controls.  Examples of monitoring controls may include analyzing customer or vendor billing complaints, supervising the accuracy of transaction processing, and comparing recorded amounts to assets and liabilities.  Monitoring activities are similar to control activities.  Unlike control activities, monitoring activities are more in-depth because they include identifying weaknesses in other controls.  Although monitoring includes management related tasks, audit committees are generally assigned these tasks.

Information and Communication

Information and communication are necessary for management to complete an organization’s objectives.  Information systems are effective when they consistently provide timely, current, accurate, and accessible information related to an organization’s external sources.  Communication is the means of relaying information to internal and external sources through report production and distribution.

References

Louwers, L., Ramsay, R., & Sinason, D. (2007). Auditing and Assurance Services.

McCarthy, M. P., Flynn, T. P., & Brownstein, R. (2004). Risk from the CEO and Board Perspective

Depreciation Methods

Depreciation of long term assets involves determining the depreciation base, estimating the useful life and choosing the appropriate depreciation method.  In companies where property, plant, and equipment make up majority of the long term assets, the useful life of these assets is very important.  The period of time an asset is expected to function efficiently is the useful service life.  Determining the useful service life of an asset is associated with the calculation of an asset’s depreciation.  Straight line, accelerated and units of activity are methods often used to calculate depreciation.  Straight line depreciation allocates equal portions of the depreciation cost to each period; the accelerated method uses the sum-of-the-year’s digits and the fixed percentage-of-declining-base; and the units of activity method determines the total expected output obtained from an asset based on its actual use in production.  The type of asset, average useful life, annual maintenance expense and the use of the asset in the production process of the business should be determined prior to determining the appropriate depreciation method. 

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Accounting for Leases

Leases

Components of leases include the lease term, estimated economic life of and estimated residual value of leased assets, minimum lease payments, implicit interest rate, and incremental borrowing rate.  Direct financing, sales-type, and operating leases are generally used to lease property, plant, and equipment.

Direct Financing Leases

With direct financing leases, the lessor leases an asset to the lessee to earn interest revenue.  In other words, the lessor acts as a financial intermediary by acquiring an asset at a favorable rate and later leases it to the lessee.  Suppose Company A leases trailers from Spinner, Inc.  Because this is a direct financing lease, Spinner will first purchase the trailers from a manufacturer or dealer then lease the trailers to Company A at an amount that will recover its initial investment in the trailers plus generate interest revenue during the lease term.  Lessors issuing direct financing leases often lease assets at consistent rates for specific assets.  For example, if Spinner generally leases auto-related assets to other firms at an interest rate of 8%, it will likely lease the trailers to Company A at 8% for a specified term.  Therefore, it would be ideal to research the average rate used by a company for specific assets prior to selecting the direct financing lease option. 

Sales-Type Leases

Sales-type leases are similar to direct financing leases because the lessor generates interest revenue by the leasing assets.  Unlike direct financing leases, the lessor receives a manufacturer’s or dealer’s profit on the sale of the asset.  A lease qualifies as a sales-type lease only if the lessor generates a profit on the sale of the asset.  For example, if a lessor purchases five trailers for $300,000 and later leases the trailers to a lessee with the total minimum lease payments equaling $450,000; the lessor will receive a profit of $150,000 over the term of the lease.  The lease is classified as a direct financing lease if the lessor does not generate profit from the lease payments. Because lessees record direct financing and sales-type leases in the same manner, the classification of either lease does not affect the financial statements of the lessee.  Lessees record the lease at the present value of the lease payments and the first rental payment at the inception of the lease.

Inception of lease (Lessee):

(1) Leased equipment               XXXX

            Lease payable                                      XXXX

(2) Lease payable                                 XXXX

            Cash (lease payment)                            XXXX

All subsequent lease payments are recorded in the same manner as the lease payment (2), but the payments are allocated between the amount paid towards the lease and the interest expense.

Subsequent lease payments (Lessee):

           

Interest expense (Interest rate x (PV of payments – rental payment)                   XXXX

Lease payable  (Rental payment – interest                                                         XXXX

            Cash (lease payment)                                                                                        XXXX

Operating Leases

Operating leases are similar to rental agreements because the lessor retains ownership of an asset while renting it to a lessee.  Accounting for operating leases is relatively straightforward; the lessor records rent revenue and the lessee records a rent expenses.  Although accounting for operating leases is simple, complications can arrive.  For example, the lessee may make improvements to the leased asset.  These improvements are referred to as leasehold improvements.  When leasehold improvements are made the lessee allocates the cost as a depreciation expense over the useful life of the asset.  Additional complications arise when the residual value of an asset is guaranteed by the lessee.  The estimated commercial value of an asset at the end of the lease term is its residual value. The minimum payments are calculated to include an additional lease payment at the end of the lease term if the lessee guarantees the residual value of an asset.  For example, if the periodic rental payments of a lease are $93,000 per year for 6 years and the anticipated residual value of the leased asset is $60,000, the lessee will pay the lessor $93,000 per year for the first six years, and then make the $60,000 guaranteed residual value payment in the seventh year. 

Reference

"Intermediate Accounting", David Spiceland, 2009

Contrast Inventory Valuation Methods: LIFO, FIFO, Specific Identification & Averaging

Inventory consists of finished goods, work in process, and raw materials attained for resale.  Inventory is reported as a current asset on the balance sheet because it should be sold during the fiscal year. Four methods are used to value and measure inventory:  first in first out (FIFO), last in last out (LIFO), specific identification, and the averaging cost method.  The FIFO method assumes the items sold were acquired first; while the LIFO method assumes the items sold were acquired last.  The specific identification method is used to match units sold during a specific period to its actual cost; whereas the average cost method is a combination of FIFO and LIFO.