Response_to_Client_Request-Mamo

MEMO To: Supervisor From: Your Name Date: February 1, 2010 RE: Response to Client Request – FASB Codification Summarized The purpose of this memo is to clarify leasing issues in accordance with the Financial Accounting Standards Board (FASB) Codification and recommend an approach to dealing with the situation with your client. Specifically, I will outline current practices relating to direct financing, sales-type, and operating leases. A 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 Accounting Financial Standards Board (FASB Codifications Website under 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 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. • b. Bargain purchase option - The lease contains a bargain purchase option. • c. Lease term - The lease term is equal to 75 percent or more of the estimated economic life of the lease 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. • 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 a lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. 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. Essentially, if a lease is defined as a capital lease (one in which the lessor transfers much of the liabilities to the lessee), it will either be considered a direct financing or sales-type lease. The main distinction between a direct financing lease and a sales-type lease is the presence or absence of a manufacturer’s or dealer’s profit. A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct financing lease does not. The profit is the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying value. A direct financing lease does not record a profit or loss on the inventory, whereas they do with a sales-type lease indicating that they are earning a gross profit (Schroeder, 2005). If it is not a capital lease, it is referred to as an operating lease (one that serves principally as a rental agreement). The current practice involving direct financing leases requires the recording of minimum total lease payments as a receivable on the date of the transaction and treating the difference between that amount and the asset cost as unearned income. Subsequently, as each rental payment is received, the receivable is reduced by the full amount of the payment, and a portion of the unearned income is transferred to earned income statement (Schroeder, 2005). In the end, interest revenue is the only revenue recorded by the lessor. On the other hand, a sales-type lease is treated more like an up-front sales transaction rather than the direct financing lease’s gradual method. For sales-type leases, because the critical event is the sale, the initial direct costs associated with obtaining the lease agreement are written off when the sale is recorded at the inception of the lease. These costs are disclosed as selling expenses on the income statement (Schroeder, 2005). If your client chooses to enter into an operating lease, than the client will essentially be signing a rental agreement for use of the trailers for a set amount of time. This looks to be your clients’ best option considering the clients’ uncertainness of how long the relationship will last between your client and their new customer. Not to mention, operating lease will relieve your clients’ company from baring many ownership responsibilities. References Schroeder, Richard G., Myrtle W. Clark & Jack M. Cathey (2005). Financial Accounting Theory and Analysis. New Jersey: John Wiley & Sons, Inc.