Lease related problems

 (a) ASC 840, requires the party that bears substantially all the risks and rewards of ownership of the leased property, to recognize a lease asset and corresponding obligation and it specifies criteria to make this determination, i.e whether a lease is capital or operating. The objective is to determine whether the lessor has transferred substantially all the risks and rewards of ownership to the lessee or not.

(b) Determining whether an entity has transferred substantially all the risks and rewards of ownership will often be readily apparent from the terms and conditions of the transfer. Situations where “substantially all the risks and rewards of ownership” are being transferred as are follows:

  • Transfer of ownership to the lessee by the end of the lease term.
  • The lessee has the option to purchase the asset at a price that is expected to be lower than its fair value such that the option is likely to be exercised.
  • The lease term is for a major part of the economic life of the asset, even if title to the asset is not transferred.
  • The present value of the minimum lease payments is equal to substantially all of the fair value of the asset.
  • The leased assets are of a specialized nature such that only the lessee can use them without significant modification.

The entity needs to compute and compare its exposure to the variability in the timing and amounts of the net cash flows before and after the transfer. If the entity’s exposure to the variability does not change significantly as a result of the transfer, it is concluded that there is retention of substantially all the risks and rewards of ownership.

(c) Factors that could affect the term of a lease can broadly be characterized as follows:

Contractual factors that could effect the extension or termination of the lease, such as:

  • Level of rentals in any secondary period (bargain, discounted, market ,or fixed rate)
  • Residual value guarantees – existence and amounts
  • Any termination penalties – existence and amounts
  • Costs associated with returning the leased item in a contractually specified condition or to a contractually specified location

Non-contractual financial factors, such as:

  • The existence of significant leasehold improvements that would be lost if the lease were terminated or not extended
  • Non-contractual relocation costs
  • Costs of lost production
  • Tax consequences
  • Costs associated with sourcing an alternative item

Business factors, such as:

  • Nature of the asset (Core vs. non-core, specialized vs. non-specialized)
  • Willingness to allow a competitor to use the leased property
  • Industry practice

Lessee specific factors, such as:

  • Lessee intent
  • Past practice

 (d) Guaranteed residual value is the amount that the lessee or any third party agrees the leased asset will be worth at the end of the lease. If the asset is less than the guaranteed residual value, the lessee must pay the difference between the guaranteed residual value and the actual value of the asset at the end of the lease.

It protects the lessor against any loss is estimated residual value and is included in minimum lease payments to satisfy the 90% of fair market value criterion.

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