Lease_Structure_and_Lease_Issues

Memorandum To: supervisor From: Oksana Panarina Date: April 5, 2010 Subject: Lease Structure and Lease Issues Our client’s company currently owns 100 trailers, customer requires 120 trailers for its project, which is 20 more trailers than the company owned. The relationship with the customer is uncertain but at the same time it has potential for significant growth of client’s company. On the other hand, future relationship with the customer may affect the financial position of client’s company. The additional trailers can be obtained through the capital lease or operating lease. But in considering type of lease for the trailers client’s company should understand lease structure and lease structure issues in the FASB. In order to get the benefits of lease the lease transaction should be structured according to the SFAS No. 13, No. 13,“Accounting for Leases.” There are different types of lease structures, which can be used by client’s company and the customer in making a lease agreement. In SFAS No. 13, the FASB outlined specific criteria to help classify leases as either capital or operating leases. We need to define if this lease will meet one of following four criteria. If so, the lease should be classified as a capital lease. If it will not meet any of listed criteria, then lease should be classified as an operating lease. 1. The lease transfers ownership of the property to the lessee by the end of the lease term. This includes the fixed noncancelable term of the lease plus various specified renewal options and periods. 2. The lease contains a bargain purchase option. This means that the stated purchase price is sufficiently lower than the expected fair market value of the property at the date the option becomes exercisable and that exercise of the option appears, at the inception of the lease, to be reasonably assured. 3. The lease term is equal to 75 % or more of the estimated remaining economic life of the leased property, unless the beginning of the lease term falls within the last 25 % of the total estimated economic life of the leased property. 4. At the beginning of the lease term, the present value of the minimum lease payments (the amounts of the payments the lessee is required to make excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessee) equals or exceeds 90 % of the fair value of the leased property less any related investment tax credit retained by the lessor (Schroeder, Clark, & Cathey, 2005, p. 419). Operating lease structure can be defined as the lease in which risk of the ownership is not transferred to the lessee or federal entity. In other words, it can be defined as the lease agreement in which lessee has the right to use the property in a particular pre-determined time in exchange for periodic rental or lease payments (Federal accounting standards advisory board, 2003). The rent payments made on an operating lease are normally charged to expense as they become payable over the life of the lease. According to Schroeder, Clark, and Cathey (2005) ”In SFAS No. 13, the FASB based its conclusion on the concept that a lease that ”Transfers substantially all of the benefits and risks of the ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee, and as a sale or financing by the lessor” (Schroeder, Clark, & Cathey, 2005, p. 421). Capital lease assets and liabilities have to be separately identified in our balance sheet or in the accompanying footnotes. Depends on when obligations for capital lease must be paid we can classify liability as current and long-term. There are various issues involved in the lease structure, which may affect the interest of client’s company. The first issue is related to the improvement cost of leased asset. It is difficult to determine that this cost should be capitalized or should be treated as expenses for the particular year. There are different types of lease structure, which has significant impact on the financial reporting as capital lease is recognized as asset and liability in balance sheet; while in operating lease the rent payment is recognized as expenses (Williams, Carcello & Neal, 2009). These issues might affect the profitability of client’s company. The regional trucking company should get involved in the capital lease for to fulfill the requirement of 120 trailers. The difference between fair value and carrying value would be profit for the company, which help to maintain its financial position. The risk of uncertainty in relationship with the customer also can be eliminated through this lease structure. At the same time it would also help to maintain long time relationship with the customer. References:  Federal accounting standards advisory board. (2003). Federal accounting standards advisory board. Retrieved from http://www.fasab.gov/index.html Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2005). Financial accounting theory and analysis (8th ed.). Hoboken, NJ: John Wiley & Sons, Inc.. Williams, J.R., Carcello, J.V. & Neal, T.L. (2009). GAAP Guide Level A. CCH.