I would like to record about the key points of the US CPA exam content.
<Create and note the points based on mainly Becker’s workbook>
the definition of lease
- A lease is defined as a contractual agreement between a lessor and a lessee. The lessor conveys the right to use an asset (real or personal property) and a lessee agrees to pay consideration to the lessor for this right. When a lessee enters into a contract with another lessee for a specific property, this is called a sublease.
- The lessee should begin the recognition of lease expenses at the commencement date. The commencement date is the date the underlying asset is made available to the lessee for use. Lease expense is recorded over the lease term.
- The lessee calculates lease payments at commencement of the lease based on the present value of the following items: fixed payments, variable payments, exercise price of purchase option, termination penalties, and the probable amount owed of the guaranteed residual.
- lease expense as operating lease: The lessor is offering 8 months of free rent, resulting in a total lease expense of $1,680,000 over 112 months ($15,000 per month). According to the revenue recognition and expense recognition principles, this expense must be evenly allocated over the entire 120-month lease period.
OWNES Criteria (US GAAP ASC 842)
- “OWNES” criteria are used to classify a lease as a finance lease. The OWNES criteria consist of the following five conditions:
- O – Ownership Transfer: Whether the ownership of the asset transfers to the lessee by the end of the lease term.
- W – Written Option: Whether there is a purchase option, and it is reasonably certain that the option will be exercised.
- N – Net Present Value (NPV): Whether the present value of the minimum lease payments equals or exceeds 90% of the fair value of the asset.
- E – Economic Life: Whether the lease term is for the major part (75% or more) of the economic life of the asset.
- S – Specialized Asset: Whether the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.
Timing of Payments
- Annuity Due: Payments are made at the beginning of each period. The present value of an annuity due is the present value of an ordinary annuity multiplied by (1 + interest rate).
- When lease payments are made in advance, at initial recognition, the right-of-use asset and the lease liability are recorded at the same amount. However, the lease liability is immediately reduced at the time of initial recognition.
- Ordinary Annuity: Payments are made at the end of each period. The present value of an ordinary annuity is the sum of the future payments discounted to the present value at the time of each payment.
- (Example) Required payments: $100,000 × 4.4651 (the factor for an annuity due for five years of lease team at 6%) = $446,510. Expected residual: $20,000 × 0.7473 (the present value of $1 at 6%) = $14,946.
Finance lease
- The equipment will be recorded at a cost (the present value of minimum lease payments and bargain purchase option). As this lease contains a bargain purchase option, regarding the depreciation, the useful life of the asset rather than the lease period will be used to calculate depreciation.
- Variable lease payments not included in the lease liability are treated as cash outflows operations and will have a negative impact of bottom-line cash flow from operations.
- Initial direct costs must be added to the finance lease assets at lease inception.
- (Example) (DR) ROU asset 1100 / (CR) Cash 100, Lease Liability 1000. 100 is Initial direct cost.
- (Example) (DR) Intest expense 3, Lease Liability 100, (CR) Cash 103. Interest expense is calculated based on Lease Liability of 1000, excluding direct cost.
The primary difference between IFRS and US GAAP
- the expense recognition method for right-of-use assets. Under IFRS, the expense is recognized as depreciation expense, whereas under US GAAP, for operating leases, it is recognized evenly as lease expense, including grace period. This distinction characterizes the lease accounting practices of IFRS and US GAAP.
- Determination of Depreciation Period: IFRS: If there is a transfer of ownership or a purchase option, the asset is depreciated over its economic useful life. If not, it is depreciated over the lease term.US GAAP: Similar to IFRS, if there is a transfer of ownership or a purchase option, the asset is depreciated over its economic useful life. If not, it is depreciated over the lease term. However, for operating leases, the lease expense is recognized evenly over the lease term.
- Expense Recognition Method: IFRS: Depreciation expense and interest expense are recognized separately. US GAAP: For finance leases, depreciation expense and interest expense are recognized separately. For operating leases, the lease expense is recognized evenly over the lease term. This means that the Lease Expense amount is equal to the cash paid amount, including interest amount, and the decrease in Lease Liability, calculated using the effective interest method, is equal to the decrease in the Right-of-Use (ROU) asset.
- (Example) (DR) Lease Expense 300, Liase Liability 250 / (CR) Cash 300, ROU 250. Total interest paid can be calculated by comparing summation of the payments to the original lease liability.
- Under IFRS 16, all leases (excluding short-term leases and leases of low-value assets) are recognized as right-of-use assets on the balance sheet along with corresponding lease liabilities. The depreciation period for right-of-use assets is determined by the terms of the lease agreement.
Classification of Lease Liabilities
- Short-Term Lease Liability: Definition: Short-term lease liability refers to the portion of lease payments that are due within 12 months from the end of the reporting period. Recognition: It is recorded as a current liability on the balance sheet.
- Long-Term Lease Liability: Definition: Long-term lease liability refers to the portion of lease payments that are due beyond 12 months from the end of the reporting period. Recognition: It is recorded as a non-current liability on the balance sheet.
Operating lease
- In the case of an operating lease, the monthly lease payments must be fixed, but if there is a rent-free period, the lease payments must be reduced precisely for the duration of the rent-free period.
