2014 deloitte audit case competition

Case 6: Deal for a Dozer2014 Audit Case Competition

University of IowaChen ChenYanzhi GongYue LiJia LiuNicholas Logan

2

Presentation Agenda

Page

Case Introduction and Answer Key 3

Capitalization Group I Criteria 6

Capitalization Group II Criteria 10

Accounting for Sales-Type Leases 11

Impacts on Financial Statements 16

Implications of New Lease Standards 20

Case Summary 24

3

Case Introduction

• Lessor - Sable Inc.• Lessee - Buildit Inc.

Bulldozer Lease Terms

Lease term 10 years

Estimated economic life 15 years

Fair value (List Price) $125,000 ($135,000)

Lessor’s implicit rate 6.93% (5.45%)

Annual lease payments $16,000

Unguaranteed residual value $24,000

The first lease payment is made at the end of the year 1. Each subsequent payment is made on December 31.

ASC 840-10-55

4

Case Requirements

• 1. How should Sable classify the lease in its accounting records? Sales-Type Lease

• 2. Provide the journal entries that Sable should record to: a. Initially record the lease.

Gross Investment in Lease $184,000

Cost of Sales 87,724

Unearned Income $59,000

Sales Revenue 112,724

Asset (at carrying value) 100,000

5

Case Requirements

b. Account for the first lease payment made to Sable at the end of year 1.

To record receipt of lease payment at the end of year

To record amortization of unearned income for the year

Cash $16,000 Gross Investment in Lease $16,000

Unearned Income $8,667 Interest Income $8,667

6

Capitalization Group I Criteria

Lease Agreement

Capital Lease

Operating Lease

Ownership Transfer?

Lease Term ≥75% Asset Life

PV of Min Lease PMTs ≥90% FMV

No NoNoNo

YesYesYesYes

ASC 840-10-25-1

Bargain Purchase Option?

7

Why $125,000 instead of $135,000?

ASC 840-10-55 Implementation Guidance-Lessor>> Defining Fair Value of the Leased Property55-43 If the lessor is a manufacturer or dealer, the fair value of the property at lease inception ordinarily will be its normal selling price, reflecting any volume or trade discounts that may apply. However, the determination of fair value should be made in light of market conditions prevailing at the time, which may indicate that the fair value of the property is less than the normal selling price and, in some instances, less than the cost of the property.

8

Minimum Lease Payment Test

Minimum Lease Payment:Fair Value = $125,000N = 10I/Y = 6.93%PMT = $16,000PV = ? $112,724

≥ 90% of Fair Value Test

$112,724 $125,000

Pass Test

90.2% > 90%

9

What if $135,000?

Minimum Lease Payment:Fair Value = $135,000N = 10I/Y = 5.94%PMT = $16,000PV = ? $120,885

≥ 90% of Fair Value Test

$120,885 $135,000

Fail Test

89.5% < 90%

10

Capital

Lease for

Lessor

Capitalization Group II Criteria

Pass Group

I Criteri

a

Yes

No

Operating Lease

Yes

No

Payments Assured?

All Costs Complete?

ASC 840-10-25-42

11

Accounting for Sales-Type Leases

Meets Any of Group I Criteria

Yes

No Sales-Type Lease

Does Asset Fair Value Equal Lessor’s

Book Value?Meets Bothof Group II Criteria

Direct-Financing Lease

ASC 840-10-25-43

12

Journal Entries: Beginning of Lease Term

Key Component of the Computation

Gross Investment Net Investment Unearned

Income

Minimum Lease Payments

Lease Payments (10 x $16,000) $160,000 $112,724 $47,276

Unguaranteed Residual 24,000 12,276 11,724

Total $184,000 $125,000 $59,000


Cost of Sales 87,724Unearned Income $59,000 Sales Revenue 112,724Asset (at carrying value) 100,000

ASC 840-30-30

13

Journal Entries: During Year 1

Debit Credit

Cash $16,000


To record receipt of lease payment at the end of year

To record amortization of unearned income for the year

Debit Credit

Unearned Income $8,667

Interest Income $8,667

14

Amortization Schedule (Interest Rate: 6.93%)

YearPayment Ending of

Period

Interest Income

for Period

Ending Gross

Investment

Ending Unamortiz

ed Unearned

Income

Net Investment at End of

Period

BeginningBalance: $184,000 $59,000 $125,000

1 $16,000 $8,667 168,000 50,333 117,667 2 16,000 8,158 152,000 42,175 109,825 3 16,000 7,615 136,000 34,560 101,440 4 16,000 7,033 120,000 27,527 92,473 5 16,000 6,412 104,000 21,115 82,885 6 16,000 5,747 88,000 15,368 72,632 7 16,000 5,036 72,000 10,332 61,668 8 16,000 4,276 56,000 6,056 49,944 9 16,000 3,463 40,000 2,594 37,406 10 16,000 2,594 24,000 0 24,000

Residual Payment 24,000 0 0 0 0

15

Journal Entries: During Year 10

Debit CreditCash $16,000


Unearned Income $2,594 Interest Income $2,594

To record the receipt of the unguaranteed residual value at the end of lease term assuming fair value of the residual value is $24,000

Asset $24,000


To record the receipt of lease payments and the amortization of unearned income

16

Impacts on Financial Statements(End of Year 1)

Balance SheetAssets Current assets:

Cash $16,000Gross investment in sales-type lease 16,000

Noncurrent assets:Gross investment in sales-type lease $152,000 PP&E (100,000)

Total assets $84,000

LiabilitiesCurrent liabilities:

Unearned income $8,158Noncurrent liabilities:

Unearned income $42,175

Total liabilities $50,333

Income Statement

Sales revenue $112,724

Cost of sales 87,724

Gross profit 25,000

Selling and administrative

expenses XXX

Income from operations XXX

Other revenues and gains

Interest income 8,667

Other expenses and losses XXX

Income from continuing

operations before income tax XXX

Changes in net income $33,667

ASC 840-30-50-4

17

Impacts on Financial Statements

Balance Sheet Impact

Item Sales-Type Lease (FMV = $125,000)

Operating Lease(FMV = $135,000)

Assets Total Assets ROA (Net Investment In Lease)

No Assets Recorded

LiabilitiesTotal Liabilities D/E (Unearned Income)

No Liabilities Recorded

18

Impacts on Financial Statements

Income Statement Impact

Item Sales-Type Lease (FMV = $125,000)


Revenue Year 1

Year 2- 10

Gross Profit

Interest Revenue(Declining)

Rental Revenue

Expense No Depreciation Expense Depreciation Expense

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Operating vs. Capital Lease

1 2 3 4 5 6 7 8 9 10$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

Profit Comparison

Operating Lease Capital Lease

Year

20

Proposed New Lease Standards

Lease Contract

≤12 Months?

Type of Asset?

Purchase

Option?

Election?

Simplified Rules

Type A Lease(Other than Property)

Yes

Yes Yes

NoNo

No

Type B Lease(Property)

21

Journal Entries under New Standards

Journal Entries at the Commencement Date

Journal Entries for the First Year

Lease Receivable $112,724

Residual Asset 12,276

Cost of Sales 87,724

Sales $112,724

Asset (at carrying value) 100,000

Cash $16,000

Residual Asset 851

Lease Receivable $8,184

Interest Revenue 8,667

22

Effect on the Accounting Information System

System

Determine

Lease Type

Automated Application Control

ApproveSyste

mData

Report

AgentApprov

es

AgentReview

s

IT Dependent Manual Control

InputLeaseData

NoNo

System is pre-programmed with:• Classification criteria• Company election policy

Agents are trained to look for:• Data input errors• System errors• Contract modifications• Fraud

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Deal for a Dozer

Fair Value $125,000

Sales-Type

Lease

Increase in Assets

and Liabilities

Type A Lease

under New Lease

Standards

Changes in Internal

Control System

Questions?

24

Fair Value ≠ Residual Value

• At the end of the lease– If fair value of residual value < $24,000

– If fair value of residual value > $24,000

Asset (Fair Value) $23,000

Loss on Capital Lease 1,000


Asset (Fair Value) $25,000

Gain on Capital Lease $1,000

Gross Investment in Lease 24,000

25

Fair Value = $135,000

Terms

Lease Term 10 years

Lessor’s implicit rate 5.45%

Lease Type Operating lease

Annual lease payments $16,000

Unguaranteed residual value

$24,000

Fair value of bulldozer $135,000

The first lease payment is made at the end of the year 1. Each subsequent payment is made on Dec 31.

26

Journal Entries

• Beginning of Lease Term

– No Journal Entries

• During Year 1 – Year 10

• Expiration of Lease Term

– No Journal Entries

Cash $16,000

Rent Revenue $16,000

Depreciation Expense $7,600

Accumulated Depreciation – Equipment $7,600

27

Impacts on Financial Statements (Lessee)

Balance Sheet Impact

Item Sale-Type Lease(FMV = $125,000)


Assets Total Assets ROA (Leased Equipment)

No Assets Recorded

Liabilities

Total Liabilities (Leased Liability) D/E (Declining as repayment)

No Liabilities Recorded

28

Impacts on Financial Statements (Lessee)

Income Statement Impact

Item Sale-Type Lease(FMV = $125,000)

Operating Lease

(FMV = $135,000)

Expense

- Depreciation Expense

- Interest Expense (Declining)

Rental Expense

29

New Revenue Recognition Standard

5 Step Process Identify Contract With

Customer

Identify Separate Performance Obligations

Determine the Transaction Price

Allocate the Transaction Price

Recognize Revenue

Contract Signed

Has Commercial Substance

Approved and Committed

Can Identify Each Parties Rights

Identify Payment Term

30



Customer




Recognize Revenue

Provide Bulldozer to be used for a 10-year period

31



Customer




Recognize Revenue

Based on the Fair Market Value of

the Asset

Transaction Price is $125,000

32



Customer




Recognize Revenue

Only One Performance Obligation for

Sable: Delivery of the Asset

33


5 Step Process

Identify Contract With Customer




Recognize Revenue

Recognize when Obligation is

Satisfied

Satisfied Immediately Upon

Transfer

Company Has Right to Payment

Has Customer Gained Control?

Physical Possession is Transferred

Customer Has Accepted Asset

34

ASC 840-10-25-43 Lessor Application of Lease Classification Criteria

25-43 If the lease at inception meets any of the four lease classification criteria in paragraph 840-10-25-1 and both of the criteria in the preceding paragraph, it shall be classified by the lessor as a sales-type lease, a direct financing lease, a leveraged lease, or an operating lease as follows:

a. Sales-type lease. A lease is a sales-type lease if it gives rise to manufacturer’s or dealer’s profit (or loss) to the lessor (that is, the fair value of the leased property at lease inception is greater or less than its cost or carrying amount, if different) and meets either of the following conditions:

1. It involves real estate and meets the criterion in paragraph 840-10-25-1(a) (in which circumstance, neither of the criteria in paragraph 840-10-25-42 applies).

2. It does not involve real estate and meets any of the criteria in paragraph 840-10-25-1 and both of the criteria in paragraph 840-10-25-42.

For implementation guidance on the interaction of lease classification and lessor activities, see paragraph 840-10-55-41.

b. Direct financing lease. A lease is a direct financing lease if it meets all of the following conditions:

1. It meets any of the criteria in paragraph 840-10-25-1 and both of the criteria in the preceding paragraph.

2. It does not give rise to manufacturer's or dealer's profit (or loss) to the lessor.

3. It does not meet the criteria for a leveraged lease in (c).

35

ASC 840-10-55-41 Implementation Guidance

Lease Classification and Lessor Activities

55-41 This guidance discusses the relationship between lease classification criteria and certain lessor activities. Normally, sales-type leases will arise when manufacturers or dealers use leasing as a means of marketing their products. Leases involving lessors that are primarily engaged in financing operations normally will not be sales-type leases if they qualify under paragraphs 840-10-25-1 and 840-10-25-42, but will most often be direct financing leases, described in paragraph 840-10-25-43(b). However, a lessor need not be a dealer to realize dealer's profit (or loss) on a transaction. For example, if a lessor, not a dealer, leases an asset that at lease inception has a fair value that is greater or less than its cost or carrying amount, if different, such a transaction is a sales-type lease, assuming the criteria referred to are met.

36

ASC 840-30-30 Initial Measurement-Lessors

Gross Investment in a Sales-Type Lease or Direct Financing Lease

30-6 The lessor shall measure the gross investment in either a sales-type lease or direct financing lease initially as the sum of the following amounts:

a. The minimum lease payments net of amounts, if any, included therein with respect to executory costs (such as maintenance, taxes, and insurance to be paid by the lessor) including any profit thereon

b. The unguaranteed residual value accruing to the benefit of the lessor. The estimated residual value used to compute this amount shall not exceed the amount estimated at lease inception except as provided in paragraph 840-30-30-7.

Sales-Type Leases

30-8 The lessor's net investment in a sales-type lease shall consist of the gross investment (as measured in paragraph 840-30-30-6) minus the unearned income.

30-9 The lessor shall measure unearned income initially as the difference between the gross investment in the sales-type lease and the sum of the present values of the two components of the gross investment. The discount rate to be used in determining the present values shall be the interest rate implicit in the sales-type lease.

30-10 The present value of the minimum lease payments (net of executory costs, including any profit thereon), computed at the interest rate implicit in the lease, shall be recorded by the lessor as the sales price.

37

ASC 840-30-35 Subsequent Measurement-Lessors

Sales-Type Leases and Direct Financing Leases

35-22 A lessor shall amortize the unearned income on a sales-type lease to income over the lease term to produce a constant periodic rate of return on the net investment in the lease (the interest method). In a sales-type lease containing a residual value guarantee or a termination penalty for failure to renew the lease at the end of the lease term, this method of amortization described will result in a balance of minimum lease payments receivable at the end of the lease term that will equal the amount of the residual value guarantee or termination penalty at that date.35-23 The lessor shall amortize the unearned income and initial direct costs on a direct financing lease to income over the lease term to produce a constant periodic rate of return on the net investment in the lease. A residual value guarantee or termination penalty that serves to extend the lease term is excluded from minimum lease payments and is thus distinguished from those residual value guarantees and termination penalties referred to in this paragraph. In the event that a renewal or other extension of the lease term (including a new lease under which the lessee continues to use the same property) renders the residual value guarantee or termination penalty in a sales-type lease or direct financing lease inoperative, the existing balances of the minimum lease payments receivable and the estimated residual value shall be adjusted for the changes resulting from the revised agreement (subject to the limitation on the residual value imposed by paragraph 840-30-35-25) and the net adjustment shall be charged or credited to unearned income.

38

ASC 840-30-35 (Continued)

35-24 The following guidance applies to a lessor's accounting for both sales-type leases and direct financing leases and is organized as follows:a. Estimated residual valueb. Lease modifications.

Estimated Residual Value

35-25 A lessor shall review the estimated residual value of a leased property at least annually. If the review results in a lower estimate than had been previously established, the lessor shall determine whether the decline in estimated residual value is other than temporary. If the decline in estimated residual value is judged to be other than temporary, the accounting for the transaction shall be revised using the changed estimate and the resulting reduction in the net investment shall be recognized by the lessor as a loss in the period in which the estimate is changed. An upward adjustment of the leased property's estimated residual value (including any guaranteed portion) shall not be made.

39

Deloitte Guidance

840-30-35 (Q&A 08) — Determining the Amount of Any Required Residual Value Write-Down

Question If a residual value write-down is required, how should the amount of the write-down be calculated?

Answer The write-down is calculated by discounting the new estimate of the residual value at the interest rate implicit in the lease and comparing that amount to the carrying amount of the existing residual value (which will reflect accretion of present-value since the beginning of the lease). A write-up of residual value is not permitted, regardless of the strength of the evidence supporting a higher value.

40

ASC 840-10-55 Implementation Guidance-Lessor

Defining Fair Value of the Leased Property

55-43 If the lessor is a manufacturer or dealer, the fair value of the property at lease inception ordinarily will be its normal selling price, reflecting any volume or trade discounts that may apply. However, the determination of fair value should be made in light of market conditions prevailing at the time, which may indicate that the fair value of the property is less than the normal selling price and, in some instances, less than the cost of the property.

41

ASC 840-30-50 Disclosure-Lessors

50-4 If leasing, exclusive of leveraged leasing, is a significant part of the lessor's business activities in terms of revenue, net income, or assets, all of the following information with respect to sales-type and direct financing leases shall be disclosed in the financial statements or footnotes:a. All of the following components of the net investment in sales-type and direct financing leases as of the date of each balance sheet presented:

1. Future minimum lease payments to be received, with separate deductions for both of the following:

i. Amounts representing executory costs (including any profit thereon) included in the minimum lease paymentsii. The accumulated allowance for uncollectible minimum lease

payments receivable.2. The unguaranteed residual values accruing to the benefit of the lessor3. For direct financing leases only, initial direct costs4. Unearned income (see paragraphs 840-30-30-9 and 840-30-30-13).

b. Future minimum lease payments to be received for each of the five succeeding fiscal years as of the date of the latest balance sheet presentedc. Total contingent rentals included in income for each period for which an income statement is presented.

42

Statement of Financial Accounting Concepts No. 5

Revenues and Gains 83. Further guidance for recognition of revenues and gains is intended to provide an

acceptable level of assurance of the existence and amounts of revenues and gains before they are recognized. Revenues and gains of an enterprise during a period are generally measured by the exchange values of the assets (goods or services) or liabilities involved, and recognition involves consideration of two factors (a) being realized or realizable and (b) being earned, with sometimes one and sometimes the other being the more important consideration. a. Realized or realizable. Revenues and gains generally are not recognized until

realized or realizable.50 Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. Readily convertible assets have (i) interchangeable (fungible) units and (ii) quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.

b. Earned. Revenues are not recognized until earned. An entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations,51 and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Gains commonly result from transactions and other events that involve no "earning process," and for recognizing gains, being earned is generally less significant than being realized or realizable.

43

Topic 842 Short-term Lease Definition

Short-Term LeaseA lease that, at the commencement date, has a maximum possible term under the contract, including any options to extend, of 12 months or less. Any lease that contains a purchase option is not a short-term lease.

842-10-25-14 A lessee may elect, as an accounting policy, not to apply the requirements in Subtopic 842-20 to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term. The accounting policy election for short-term leases shall be made by class of underlying asset to which the right of use relates.

842-10-25-15 A lessor may elect, as an accounting policy, not to apply the requirements in Subtopic 842-30, except for the requirements in paragraph 842-30-50-5(d), to short-term leases. Instead, a lessor may recognize the lease payments in profit or loss over the lease term on either a straight-line basis or another systematic basis, if that basis is more representative of the pattern in which income is earned from the underlying asset. The accounting policy election for short-term leases shall be made by class of underlying asset to which the right of use relates.

44

Topic 842 Type A Lease and Type B Lease Classification

842-10-25-6 If the underlying asset is not property, an entity shall classify a lease as a Type A lease unless one of the following two criteria is met:a. The lease term is for an insignificant part of the total economic life of the underlying asset.b. The present value of the lease payments is insignificant relative to the fair value of the underlying asset at the commencement date.

842-10-25-7 If the underlying asset is property, an entity shall classify a lease as a Type B lease unless one of the following two criteria is met:a. The lease term is for the major part of the remaining economic life of the underlying asset.b. The present value of the lease payments accounts for substantially all of the fair value of the underlying asset at the commencement date.

45

Topic 842 Changes on Sale-type Leases Reporting

Leases previously classified as direct finance or sale-type leases

s. For leases that were classified as direct finance or sales-type leases in accordance with Topic 840, the carrying amount of the lease receivable at the beginning of the earliest comparative period presented shall be the carrying amount of the net investment in the lease immediately before that date in accordance with Topic 840.

t. For those leases, a lessor shall do all of the following: 1. Subsequently measure the lease receivable in accordance with paragraphs 842-30-35-1(a), 2(a), and 2(c), 842-30-35-10, and 842-30-35-13.2. Not apply the requirements in paragraphs 842-30-35-1(b) and 2(b), 842-30-35-3 through 35-8, and 842-30-35-11 through 35-12.3. Classify the net investment arising from direct finance or sales-type leases as lease receivables arising from Type A leases for the purposes of presentation and disclosure.

46

Topic 842 Type A Leases Reporting

LesseeFor most leases of assets other than property (for example, equipment, aircraft, cars, trucks), a lessee would classify the lease as a Type A lease and would do the following:1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments 2. Recognize the unwinding of the discount on the lease liability as interest (interest expense) separately from the amortization of the right-of-use asset.

LessorFor most leases of assets other than property, a lessor would classify the lease as a Type A lease and would do the following:1. Derecognize the underlying asset and recognize a right to receive lease payments (the lease receivable) and a residual asset representing the rights the lessor retains relating to the underlying asset) separately listed!2. Recognize the unwinding of the discount on both the lease receivable and the residual asset as interest income over the lease term3. Recognize any profit relating to the lease at the commencement date.

47

Journal Entries for Lessee Under New Lease Standards

Journal Entries at the Commencement Date

Journal Entry at the End of Year 1

Right-of-Use Asset $112,724

Lease Liability $112,724

Interest Expense $7,816

Lease Liability 8,184

Cash $16,000

Amortization Expense $11,272

Right-of-Use Asset $11,272

48

Topic 842 Type B Leases Reporting

LesseeFor most leases of property (that is, land and/or a building or part of a building), a lessee would classify the lease as a Type B lease and would do the following:1. Recognize a right-of-use asset and a lease liability, initially measured at the present value of lease payments2. Recognize a single lease cost, combining the unwinding of the discount on the lease liability with the amortization of the right-of-use asset, on a straight-line basis.

LessorFor most leases of property, a lessor would classify the lease as a Type B lease and would apply an approach similar to existing operating lease accounting in which the lessor would do the following:1. Continue to recognize the underlying asset2. Recognize lease income over the lease term typically on a straight -line basis.

2014 deloitte audit case competition

Documents

lease pmts

lease inception

sales type lease

receipt of lease payment

financing lease asc

annual lease payments

fair value test

lease term key component