Question 15-8

Yes. The minimum lease payments for the lessee exclude any residual value not guaranteed by the lessee. On the other hand, the lessor includes any residual value not guaranteed by the lessee but guaranteed by a third-party guarantor. Even when minimum lease payments are the same, their present values will differ if the lessee uses a discount rate different from the lessor’s implicit rate. This would occur if the lessee is unaware of the implicit rate or if the implicit rate exceeds the lessee’s incremental borrowing rate.

Question 15-9

The way a bargain purchase option is included in determining minimum lease payments is precisely the same way that a lessee-guaranteed residual value is included. The expectation that the option price will be paid effectively adds an additional cash flow to the lease. That additional payment is included as a component of minimum lease payments. It therefore is included in the computation of the amount to be capitalized (as an asset and liability) by thelessee. But, a residual value not guaranteed by the lessee is ignored.

Question 15-10

Executory costs are costs usually associated with ownership of an asset such as maintenance, insurance, and taxes. These are responsibilities of ownership that we assume are transferred to the lessee in a capital lease. When paid by the lessee, these expenditures are expensed by the lessee as incurred. When paid by the lessor, lease payments usually are inflated for this reason. These executory costs, including any lessor profit thereon, are excluded in determining the minimum lease payments and still are expensed by the lessee, even though paid by the lessor.

Question 15-11

Thelessor’sdiscount rate is the effective interest rate the lease payments provide the lessor over and above the “price” at which the asset is “sold” under the lease. It is the desired rate of return the lessor has in mind when deciding the size of the lease payments. When the lessor’s implicit rate is unknown, the lessee should use its own incremental borrowing rate. When the lessor’s implicit rate is known, thelesseeshould use the lower of the two rates. This is the rate the lessee would be expected to pay a bank if funds were borrowed to buy the asset.

Answers to Questions (continued)

Question 15-12

Contingent rentals arenotincluded in minimum lease payments but are reported in disclosure notes by both the lessor and lessee. This is because they are not determinable at the inception of the lease. They are included as components of income when (and if) the payments occur. However, increases or decreases in lease payments that are dependent only upon the passage of time arenotcontingent rentals; these are part of minimum lease payments.

Question 15-13

The costs of negotiating and consummating a completed lease transaction incurred by the lessor that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs. They include legal fees, evaluating the prospective lessee's financial condition, commissions, and preparing and processing lease documents.

Question 15-14

In an operating lease initial direct costs are recorded as prepaid expenses (assets) and amortized as an operating expense (usually straight-line) over the lease term. This approach is due to the nature of operating leases in which rental revenue is earned over the lease term. Initial direct costs are matched, along with depreciation and other associated costs, with the rent revenues they help generate.

In a direct financinglease initial direct costs are amortized over the lease term. This is accomplished by offsettinglease receivableby the initial direct costs. This recognizes the initial direct costs at the same rate (that is, proportionally), as the interest revenue to which it is related. The nature of the lease motivates this treatment. The only revenue a direct financing lease generates for the lessor is interest revenue, which is earned over the lease term. So, initial direct costs are matched proportionally over the term of the lease.

In a sales-type lease, GAAP requires that initial direct costs be expensed in the period of “sale” – that is, at the inception of the lease. This treatment implicitly assumes that in a sales-type lease the primary reason for incurring these costs is to facilitate the sale of the leased asset.