GAAP Review Series - Part 2

• Chapter 1 - Accounting for Leases
  • Learning Objectives
  • Introduction
  • Applicability of the FASB Pronouncements
  • Module 1A – Lessee's Classification of Leases of Personal Property
    • Criterion (c): Comparing the Lease Term to the Economic Life of the Property
    • Criterion (d): Comparing the Present Value of the Minimum Lease Payments to the Fair Value of the Leased Property
    • Minimum Lease Payments
    • Discount Rate
    • Implementation Guidelines
    • Fair Value of Leased Property
  • Module 1B – Lessor's Classification of Leases of Personal Property
    • Sales-Type Leases
    • Direct Financing Leases
    • Leveraged Leases
  • Module 2A – Lessee's Classification of Real Estate Leases
    • Leases of Land
    • Leases of Land and Buildings
    • Solution Explanation
    • Leases of Real Estate and Personal Property
    • Leases of a Part of a Building
  • Module 2B – Lessor's Classification of Real Estate Leases
    • Leases of Land
    • Leases of Land and Buildings
    • Leases of Both Real Estate and Equipment
    • Leases of Part of a Building
  • Module 3A – Lessee's Accounting for Leases
    • Operating Leases
    • Capital Leases
    • Accounting for Residual Values and Penalties at the End of a Capital Lease
    • Changes in Lease Agreements
  • Module 3B – Lessor's Accounting for Leases
    • Operating Leases
    • Sales-Type Leases
    • Direct Financing Leases
    • Leveraged Leases
  • Module 4 – Sale-Leaseback Transactions
    • Transactions Involving Only Personal Property
    • Sale-Leaseback Transactions Involving Real Estate
    • Criteria for Sale-Leaseback Accounting
  • Module 5 – Subleases
    • Subleases That Relieve the Original Lessee of Its Obligation
    • Subleases in Which the Original Lessee Retains Its Obligation
  • Module 6A – Lessee's Disclosure Requirements
    • Operating Lease Disclosures
    • Capital Lease Disclosures
    • Sale-Leaseback Disclosures
    • Implementation Guidelines
    • Financial Statement Illustrations
  • Module 6B – Lessor's Disclosure Requirements
    • Operating Lease Disclosures
    • Sales-Type and Direct Financing Lease Disclosures
    • Sale-Leaseback Disclosures
    • Financial Statement Illustrations
  • Module 7 – Case Studies
    • Case 1-1 – Lessee’s Classification of a Lease
    • Case 1-2 – Accounting for a Sale-Leaseback Transaction
    • Case 1-3 – Lessor’s Classification of Leases
    • Case 1-4 – Lessor’s Classification of Leases
• Chapter 2 - Contingencies and Other Uncertainties
  • Learning Objectives
  • Introduction
  • Applicability of the Authoritative Guidance
  • Module 1 – Contingency Defined
    • Definition of a Contingency
    • Examples of Contingencies
  • Module 2 – Accounting for Gain Contingencies
    • Financial Statement Illustration
  • Module 3 – Accounting for Loss Contingencies
    • Loss Contingencies That Must Be Recognized
    • Environmental Contingencies and Remediation Liabilities
    • Measurement of Liability
    • Financial Statement Illustrations
    • Loss Contingencies That Must Be Disclosed but Are Not Recognized
    • Unasserted Claims
    • Financial Statement Illustrations
    • Loss Contingencies for Which No Disclosure Is Required
  • Module 4 – Disclosure of Significant Risks and Uncertainties
    • Financial Statement Illustrations
  • Module 5 – Accounting for Preacquisition Contingencies
  • Module 6 –Accounting for Costs Associated with Exit or Disposal Activities
    • Reporting and Disclosure Issues
  • Module 7 – Case Studies
    • Case 2-1 – Contingencies
    • Case 2-2 – Recognition of Contingencies
• Chapter 3 - Accounting for Debt
  • Learning Objectives
  • Introduction
  • Module 1 – The Balance Sheet Classification of Debt
    • Classification of Short-Term Debt Expected to Be Refinanced on a Long-Term Basis
    • Implementation Guidelines
    • Disclosure Requirements
    • Financial Statement Illustration
    • Classification of Debt That Is Callable
    • Financial Statement Illustration
  • Module 2 – Disclosure of Long-Term Obligations
    • Unconditional Purchase Obligations
    • Recorded Long-Term Debt
    • Redeemable Stock
    • Financial Statement Illustrations
  • Module 3 – Direct Extinguishment of Debt
    • Debt Extinguishment Defined
    • Gains or Losses on Debt Extinguishment
    • Disclosure Requirements for Direct Debt Extinguishments
    • Financial Statement Illustrations
  • Module 4 – Troubled Debt Restructuring – Debtor and Creditor
    • Accounting for Troubled Debt Restructuring
    • Transfer of Assets in Full Settlement – Debtor
    • Receipt of Assets in Full Settlement – Creditor
    • Transfer of Equity Interest in Full Settlement – Debtor
    • Receipt of Equity Interest in Full Settlement – Creditor
    • Modification of Terms – Debtor
    • Modification of Terms – Creditor [FASB ASC 310 (SFAS No. 114)]
    • Disclosure of Troubled Debt Restructuring – Debtor
    • Financial Statement Illustrations
  • Module 5 – Conversion of Convertible Debt
    • Characteristics of Convertible Debt
    • Conversion Pursuant to the Original Conversion Terms
    • Conversion Pursuant to an Inducement Modifying the Original Conversion Terms
    • Disclosure of Debt Conversion
    • Financial Statement Illustrations
  • Module 6 – Case Studies
    • Case 3-1 – Debt Extinguishments
    • Case 3-2 – Troubled Debt Restructuring
    • Case 3-3 – Troubled Debt Restructuring
    • Case 3-4 – Balance Sheet Classification of Debt
• Chapter 4 - Other Liabilities
  • Learning Objectives
  • Introduction
  • Module 1 – Convertible Debt and Debt with Stock Warrants
    • Convertible Debt
    • Debt with Stock Purchase Warrants
    • Financial Statement Illustrations
  • Module 2 – Accounting for Notes with Unrealistic Interest Rates
    • Notes Exchanged for Cash
    • Notes Exchanged for Goods or Services
    • Disclosure Requirements
    • Financial Statement Illustration
  • Module 3 – Accounting for Compensated Absences
    • Criteria for Accrual of Compensated Absence Expense
    • Exception to Accrual Criteria
    • The Amount of Accrued Compensation Expense
    • Implementation Guidelines
    • Disclosure Requirements
    • Financial Statement Illustrations
  • Module 4 – Case Studies
  • Case 4-1 – Debt with Detachable Warrants
  • Case 4-2 – Notes with Unrealistic Interest Rates
  • Case 4-3 – Imputing an Interest Rate
  • Case 4-4 – Note with Unrealistic Interest Rate
  • Case 4-5 – Compensated Absences
  • Case 4-6 – Sick Leave
  • Case 4-7 – Compensated Absences
• Chapter 5 - Accounting for Income Taxes
  • Learning Objectives
  • Introduction
  • Accounting for Uncertainty in Income Taxes
  • Module 1 – Book-Tax Differences
    • Temporary Differences
    • Permanent Differences
  • Module 2 – Measuring Deferred Tax Assets and Liabilities
    • Balance Sheet Classification of Deferred Tax Assets and Liabilities
    • Steps to Compute Deferred Tax Assets, Liabilities, and Tax Expense
    • Applicable Tax Rate
    • Valuation Allowance for Deferred Tax Assets
    • Scheduling of Reversals of Temporary Differences
    • Tax Planning Strategies
  • Module 3 – Intraperiod Tax Allocation
  • Module 4 – Other Considerations
    • Issues Related to Business Combinations
    • Reporting NOL Carryforwards and Carrybacks
    • Tax Effects of Transactions among or with Shareholders
    • Changes in Tax Status
  • Module 5 – Disclosure Requirements
    • Financial Statement Illustrations
  • Module 6 – Accounting for Uncertainty in Income Taxes
    • Required Disclosures
    • FASB Staff Positions Concerning Uncertain Tax Positions
  • Module 7 – Case Studies
    • Case 5-1 – Temporary Differences
    • Case 5-2 – Computation of Valuation Allowance
    • Case 5-3 – Measurement of Tax Expense
    • Case 5-4 – Classification of Deferred Tax Liabilities, Assets, and Valuation Allowance
• Chapter 6 - Latest Developments

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Chapter 1 - Accounting for Leases

Learning Objectives

After completing this chapter you will be able to

• Classify leases as operating or capital for the lessee.

• Classify leases as operating, sales-type, direct financing, or leveraged for the lessor.

Recommend lease provisions that will result in operating lease classification if a lessee desires off-balance-sheet financing.

• Prepare the lessee's journal entries for operating and capital leases of personal property.

• Prepare the lessee's journal entries for operating and capital leases of real estate.

• Prepare the lessee's journal entries for sale-leaseback transactions and calculate the amortization of any deferred profit or loss.

• Prepare the lessee's journal entries for subleases of leased assets.

• Describe the accounting by lessors for operating, sales-type, and direct financing leases.

• Identify the required financial statement disclosures for lease transactions by both lessees and lessors.

Introduction

This chapter emphasizes accounting by lessees: however, there are many parallels between lessee and lessor accounting. Where appropriate, the modules are organized into A and B parts that describe the lessee's accounting and the lessor's accounting, respectively. In all of the twopart modules, the description of the lessor's accounting in part B is abbreviated and relies on the more complete description of the lessee's accounting presented in part A.

A lease contract gives the lessee (leaseholder) certain rights related to the leased property and imposes an obligation to pay for these rights. The rights of the lessee are less than those obtained from the purchase of the property. Generally accepted accounting principles establish criteria for determining whether a lease agreement transfers sufficient rights to give the transaction the substance of an outright purchase. If the accounting criteria are met, the lease is described as a capital lease, and the leased asset and the lease obligation are reported in the lessee's balance sheet. If effect, the lease is reported in the same manner as an installment purchase of the leased asset. If the accounting criteria are not met, the lease is described as an operating lease and is reported as an executory contract in the periods that performance occurs.

The flexibility that lease agreements provide with respect to property rights and financial obligations results in continued growth in the volume of lease transactions. Consider the following:

• Leases may provide financing of 100% of the asset's cost.

• Leases may limit the lessee's exposure to losses due to obsolescence.

• A company that is not able to benefit from the tax depreciation of a new asset because of net operating loss carryforwards can indirectly obtain this benefit via reduced lease payments to a lessor that can benefit from the depreciation of the asset.

• Sale-leaseback transactions are a source of financing that can provide off-balance-sheet leverage as well as significant tax advantages.

• Leases can provide a means of reducing the alternative minimum tax (AMT).

• There is almost infinite flexibility in the assignment of the risks and rewards of ownership and in structuring the financing obligation.

In addition, many companies prefer the off-balance-sheet financing aspect of operating leases. To the extent that a company's balance sheet appears to have too much debt or it is close to defaulting on existing debt covenants, operating leases may provide a financing mechanism that does not cause further deterioration in critical debt-equity ratios. Although one may question the real benefits of off-balance-sheet financing, many lessees carefully structure lease agreements to avoid meeting the accounting requirements for capital lease treatment. In fact, the strong desire of companies to maintain the ability to obtain the off-balance-sheet treatment has influenced standard setters to issue accounting standards that are lenient with respect to requiring capital lease accounting.

Accounting for lease agreements often is complicated by differences between their legal form and their economic substance. If sufficient property rights are transferred, the economic substance of a lease is the same as a legal purchase. But how is the determination made that a lease agreement transfers sufficient property rights to the lessee to justify reporting the lease as if a purchase has occurred? U.S. GAAP provides specific criteria to identify the critical point at which a lease must be reported as a capital lease. Nonetheless, U.S. GAAP does not assure that companies with substantially identical lease agreements will report these lease agreements identically. In fact, the criteria are such that companies wishing to avoid capital lease accounting while obtaining most of the benefits of ownership generally are able to do so. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 840, Leases (SFAS No. 13) provides the authoritative guidance for all lease transactions. As previously noted, the FASB and the IASB are continuing work on a joint project on leases. The objective of the accounting for leases project is to comprehensively reconsider the guidance in FASB ASC 840 (SFAS No. 13) and IAS 17, Leases, along with subsequent amendments and interpretations, to ensure that financial statements provide useful, transparent, and complete information about leasing transactions to investors and other users of financial statements. The Boards began deliberations of lease accounting issues in 2007. They published a Discussion Paper for public comment in March, 2009 that explores these issues and describes both Boards' preliminary views.

Applicability of the FASB Pronouncements

FASB ASC 840 (SFAS No. 13) applies to financial reporting of leases by both lessors and lessees.

A lease is an agreement that conveys the right to use property, plant, or equipment usually for a stated period of time. Significantly, this definition does not include agreements that convey the right to use only intangible assets or services. However, agreements that include substantial services or intangibles in addition to plant, property, or equipment are considered leases for the purposes of financial reporting.

The standards do not apply to

• Lease agreements that convey rights to explore for or to extract natural resources, including oil, gas, minerals, and timber.

• Licensing agreements for motion pictures, plays, manuscripts, patents, copyrights, and other intangibles.

Module 1A – Lessee's Classification of Leases of Personal Property

Lessees must classify leases as either operating or capital. Operating leases are accounted for as rental agreements in a manner similar to that of other executory contracts. Capital leases are accounted essentially as if an installment purchase of the leased asset has occurred.

FASB ASC 840, Leases (SFAS No. 13), identifies four criteria for classifying leases. If one or more of these criteria are satisfied by a lease agreement at its inception, it is classified as a capital lease. All other leases are classified as operating leases. Once classified, there are no further changes in classification unless the terms of the lease are modified. A lease of personal property meeting any of the following criteria at its inception is a capital lease:

(a) Ownership is transferred to the lessee by the end of the lease term.

(b) A bargain purchase option for the leased property is available to the lessee. A bargain purchase option is defined as an option to purchase the property at a price low enough relative to its fair value to provide reasonable assurance that the lessee will exercise its option.

(c) The term of the lease equals or exceeds 75% of the remaining estimated economic life of the leased property, except that this criterion is not applicable if the beginning of the lease term falls within the last 25% of the total estimated economic life.

(d) The present value of the minimum lease payments, excluding any portion representing executory costs, equals or exceeds 90% of the fair value of the leased property to the lessor. Like the second criterion, this criterion is not applicable if the beginning of the lease term falls within the last 25% of the total estimated economic life.

The (a) and (b) criteria are straightforward and do not cause significant problems in practice, even though judgment is required to determine whether a purchase option qualifies as a bargain. The (c) and (d) criteria are difficult to apply, and they will be discussed in detail.

Criterion (c): Comparing the Lease Term to the Economic Life of the Property

Two measurements are required to determine whether the lease term exceeds 75% of the economic life of the leased property:

1. The economic life of the leased asset

2. The term of the lease

Once the measurements are made, a simple comparison is required to determine whether the term of the lease exceeds 75% of the remaining estimated economic life of the asset. Note that this criterion is not applied if the leased property is in the last 25% of its total economic life at the inception of the lease.

The economic life of a leased asset is defined as the remaining period during which the asset will be economically useful for the purpose for which was intended at the inception of the lease. The economic life is not limited by the lease term, and it includes use by parties other than the lessee. The estimate of economic life assumes that normal repairs and maintenance will be performed.

The term of the lease includes all of the following:

• The fixed noncancelable term of the lease.

• Periods for which bargain renewal options apply. A bargain renewal option allows the lessee to extend the lease at a rental sufficiently less than a fair rental amount to provide reasonable assurance of renewal.

• Periods for which failure to renew results in a penalty high enough that renewal is reasonably assured.

• Periods for which ordinary renewal options apply and for which it is expected that either (1) a guarantee by the lessee of the lessor's debt related to the property will be in effect, or (2) a loan by the lessee to the lessor related to the property will exist.

• Periods for which ordinary renewal options apply preceding the exercise date of a bargain purchase option.

• Periods for which the lessor may force renewal or extension of the lease term, but not beyond the date that a bargain purchase option is exercisable. The implicit assumption is that a lessee will agree to let the lessor force extension of the lease term only if it wants to lease the property for the longer period.

A noncancelable lease is one that is not cancelable by the lessee. In addition, a lease is considered noncancelable even when the following conditions are present:

• The lease is cancelable upon the occurrence of some remote contingency.

• The lease is cancelable with the permission of the lessor.

• The lease is cancelable if the lessee enters into a new lease with the lessor.

• The lease is cancelable but the lessee is subject to such a large penalty that continuation of the lease is reasonably assured.

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