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858 SECTION 3 Financial Instruments and Liabilities Another implementation issue is estimating the economic life of the leased property. This is the estimated remaining time the property is expected to be economically usable for its intended purpose, with normal maintenance and repairs, at the inception of the lease. Estimates of the economic life of leased property are subject to the same uncertainty limitations of most estimates. This uncertainty presents the opportunity to arrive at estimates that cause this third criterion not to be met. Finally, if the inception of the lease occurs during the last 25% of an asset’s economic life, this third criterion does not apply. This is consistent with the basic premise of this criterion that most of the risks and rewards of ownership occur during the first 75% of an asset’s life. If the lease payments required by a lease contract substantially pay for a leased asset, it is logical to identify the arrangement as a lease equivalent to an installment purchase. This situation is considered to exist when the present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset at the inception of the lease. In general, minimum lease payments are payments the lessee is required to make in connection with the lease and consist of: • the total of periodic rental payments • any guaranteed residual value • any bargain purchase option price We look closer at the make-up of minimum lease payments later in the chapter when we discuss residual values and bargain purchase options in more detail. The 90% of fair value criterion often is the decisive one in identifying a capital lease. As mentioned earlier, lessees often try to avoid writing a lease agreement that will require recording an asset and liability. When this is an objective, it usually is relatively easy to avoid meeting the first three criteria. However, when the underlying motive for the lease agreement is that the lessee substantively acquire the asset, it is more difficult to avoid meeting the 90% recovery criterion without defeating that motive. New ways, though, continually are being devised to structure leases to avoid meeting this criterion. Later we will look at some popular devices that are used. Again consistent with the basic premise that most of the risks and rewards of ownership occur during the first 75% of an asset’s life, this fourth criterion does not apply if the inception of the lease occurs during the last 25% of an asset’s economic life. Additional Lessor Conditions As we saw in the previous section, the lessee accounts for a capital lease as if an asset were purchased; that is, the lessee records both an asset and a liability at the inception of the lease. Consistency would suggest that the lessor in the same lease transaction should record the sale of an asset. Indeed, consistency is a goal of the FASB’s lease accounting standards. The four classification criteria discussed in the previous section apply to both parties to the transaction, lessees and lessors. However, a fundamental difference is that for a lessor to record the sale side of the transaction, it is necessary also to satisfy the conditions of revenue recognition we discussed in Chapter 5. In particular, the FASB specifies that for the lessor to record a lease as a direct financing lease or a sales-type lease, two conditions must be met in addition to one of the four classification criteria. These are listed in Illustration 15–4 . Criterion 4: Present value of payments is 90% of fair value. Illustration 15–4 Additional Conditions for Classification as a Capital Lease by the Lessor 1. The collectibility of the lease payments must be reasonably predictable. 2. If any costs to the lessor have yet to be incurred, they are reasonably predictable. (Performance by the lessor is substantially complete.) Although uniformity of classification is a goal of lease accounting standards, it is obvious that the additional conditions allow inconsistencies. 8 Indeed, in lease negotiations an 8 “FASB ASC 840–10–25–42: Leases–Overall–Recognition (previously “Accounting for Leases,” Statement of Financial Accounting Standards No. 13 (Stamford, Conn.: FASB, 1980)).


Spiceland_Inter_Accounting8e_Ch15
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