Memorandum

To: Sable Inc.

From: Accounting Research Team

Date: 03/13/2018

Re: Treatment of Bulldozer Lease

Facts

Sable is leasing a bulldozer and needs to record the lease in accordance with generally accepted accounting standards. This requires that we determine if the lease is a capital lease where we would record it as if we were selling it (versus renting it) and record a long-term receivable. If the lease is determined not been a capital lease, we would just record rent revenue each year and show a rented bulldozer as an asset with no lease receivable. Sable sells a bulldozer for a list price of $135,000 however the competition has lowered their price for the same bulldozer and we have recently sold it for an average price of $125,000. Sable has no added costs on the bulldozer and believes Buildit will pay the amounts when due. The lease payment if $16,000 and this does not include executory costs that are paid by the lessee.

Issues

  1. What fair value should be used in determining the classification of the lease?
  2. Is the lease a capital lease for financial accounting purchases?
  3. How should the lease be recorded and how does it impact the financial statements in Year 1?

Analysis—Issue 1: What fair value should be used in determining the classification of the lease?

The list price of the bulldozer seems at first the fair value but fair value is not what the bulldozer “should” sell for under the pricing policy. According to the FASB Codification, fair value is “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (FASB ASC)

Conclusion-Issue 1

Here, the average recent selling prices are more reflective of transactions between market participants – that is, actual sales. So, the fair value for the purposes of the lease should be the $125,000 average selling price.

Analysis—Issue 2: Is the lease a capital lease for financial accounting purchases?

There are four criteria used to determine the classification of a lease (ASC 840-10-25-1). Further, since the lessor is leasing inventory, it is a sales-type lease and so two added criteria must be met to record a markup (sale) of the leased item (if a capital lease) (ASC840-10-25-42). These six criteria are listed in the Appendix and summarized here:

Conclusion—Issue 2

In accordance with the FASB codification, the present value of the minimum lease payments is more than 90% of the fair value and so it is a capital lease. That means the lessor will show it as a sale. Further, since the two added requirements are met (collectability and costs known), they can record the sale. The entries at signing and the first payment are shown below:

Analysis—Issue 3:How should the lease be recorded and how does it impact the financial statements in Year 1?

The lease is a capital lease so it is recorded as a sale (using journal entries above). The lease receivable is reported as a long term receivable (with the current portion reflecting the upcoming year’s payment) and the inventory does not show the bulldozer. The amortization schedule below shows the balance of the receivable over the life of the lease and uses the implicit rate of 6.93% based on the fair value of $125,000:

Conclusion-Issue 3

The lease is treated as a sale and so the only financial statement impact is a long-term receivable that will amortize over the 10 years down to zero and the income statement will show rent revenue equal to the amount shown above.

Appendix

Source: asc.fasb.org

Lease Classification Criteria

840-10-25-1A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception under the guidance in the Lessees Subsection of this Section (for the lessee) and the Lessors Subsection of this Section (for the lessor):

a.[Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term. [FAS 013,paragraph7,sequence121] ][ This criterion is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term in exchange for the payment of a nominal fee, for example, the minimum required by statutory regulation to transfer title. [FAS 013,paragraph7,sequence122] ]

b.[Bargain purchase option. The lease contains a bargain purchase option. [FAS 013,paragraph7,sequence123] ]

c.[Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. [FAS 013,paragraph7,sequence124] ]

d.[Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. [FAS 013,paragraph7,sequence125.1.1] ][If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease. [FAS 013,paragraph7,sequence125.1.2.1] ]

840-10-25-42

A lessor shall consider all four lease classification criteria in paragraph 840-10-25-1 and both of the following incremental criteria:

  • a.Collectibility of the minimum lease payments is reasonably predictable. A lessor shall not be precluded from classifying a lease as a sales-type lease, a direct financing lease, or a leveraged lease simply because the receivable is subject to an estimate of uncollectibility based on experience with groups of similar receivables.
  • b.No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. Important uncertainties might include commitments by the lessor to guarantee performance of the leased property in a manner more extensive than the typical product warranty or to effectively protect the lessee from obsolescence of the leased property. However, the necessity of estimating executory costs such as insurance, maintenance, and taxes to be paid by the lessor (see paragraph 840-30-30-6(a)) shall not by itself constitute an important uncertainty as referred to herein. If the property covered by the lease is yet to be constructed or has not been acquired by the lessor at lease inception, the classification criterion in this paragraph shall be applied by the lessor at the date that construction of the property is completed or the property is acquired by the lessor.