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what if the lease term is uncertain?
what if the lease term is uncertain?
Reassessment of lease term
Reassessment of lease term
Example of how accounting changes when lease term is extended
what if lease payments are uncertain?
what if lease payments are uncertain?
In this scenario, because the amounts of future lease payments are uncertain and often unavoidable, we don't consider them as part of lease payments used to calculate the lessee's lease liability and the lessor's lease receivable. If and when lease payments increase, the change in the lease payments has no effect on the balance sheet accounts and simply is reported as a separate lease expense (lessee) and lease revenue (lessor).
However, there are two exceptions: (1) When variable lease payments are in substance fixed payments and (2) when variable lease payments depend on an index or rate.
When variable lease payments are in substance fixed payments
When variable lease payments are in substance fixed payments
When variable lease payments depend on an index or rate
When variable lease payments depend on an index or rate
what if the lease terms are modified?
what if the lease terms are modified?
Sometimes a lessor and lessee agree to modify the terms of a lease before the lease term ends. The modification results in either:
An additional right of use being given to the lessee: First lease is canceled and replaced with a new lease, or
An alteration to the lessee's right of use: A modification of the original lease.
Residual value
Residual value
The residual value is an estimate of what a leased asset's commercial value will be at the end of the lease term. Residual values most often affect operating leases, rather than sales-type/finance leases, because the lease term of an operating lease ends before the end of an asset's useful life (remember criteria number 3 for determining whether a lease is a sales-type/finance lease?).
The lessor's accounting is affected by residual value. Conversely, the lessee's accounting is not.
Guarantee of the residual value
Guarantee of the residual value
A lessee sometimes will guarantee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor. Why? If the lessor knows it will get an asset back at the end of the lease that has some value, it can afford to charge the lessee smaller lease payments.
Effect of a residual value on the size of the lease payments
Effect of a residual value on the size of the lease payments
Effect of a residual value on amounts recorded by the lessor
Effect of a residual value on amounts recorded by the lessor
For the lessor, the journal entry recorded at the beginning of the lease, is unaffected by the presence of the residual value. The lessor's lease receivable simply includes the value of the asset at the end of the lease term (see below). At the end of the lease term, the lessor needs to record the receipt of the asset from the lessee. This end of lease entry is the only significant change to the accounting for the lessor when a residual value is present.
Effect of a residual value on lease classification
Effect of a residual value on lease classification
Residual value must be incorporated into the evaluation of whether a lease is an operating lease or a finance/sales-type lease. Recall that, if the present value of lease payments is greater than or equal to 90% of the leased asset's fair value, the lease would be classified as a finance/sales-type lease. Well, GAAP says that any residual value should be incorporated into the calculation of "present value of lease payments" referred to in the previous sentence. Therefore, it is possible that residual value will change whether a lease is classified as operating or finance/sales-type.
Purchase option
Purchase option
A purchase option is a provision of some lease contracts that gives the lessee the option to purchase the lease asset during, or at the end of the lease term at a specified exercise price.
If it is "reasonably certain" that the lessee will exercise the purchase option, the accounting for the lease is affected in 3 ways:
The lease is classified as a finance/sales-type lease,
both the lessee and lessor consider the exercise price of the option to be an additional cash payment, and
we assume the lease term ends on the date that the option is expected to be exercised.
What is reasonably certain? In practice, accountants assume that it is reasonably certain the option will be exercised if the price of the purchase option is too good to pass up (i.e., the lessee is getting a good deal on the price of the asset). This "good deal" is referred to in practice as a bargain purchase option (BPO).
Purchase option exercisable before the end of the lease term
Purchase option exercisable before the end of the lease term
When a BPO is present, the length of the lease term is limited to the time up to when the purchase option becomes exercisable.
Termination penalties
Termination penalties
Some leases have a termination option where the lessee can terminate the lease early by paying a termination penalty. Like a BPO, if it is reasonably certain a termination option will be exercised, the accounting must be modified for this option.
Summary of the lease uncertainties
Summary of the lease uncertainties
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