accounting for a lease

FASB Accounting Case New Standards for Capital Leases Case Overview and Key Issues Sable., a company located in San Fransico, CA, specializes in the manufacturing of heavy equipment and have different financing options for clients to own or lease the heavy equipment that they produce. The first option is to purchase the machinery in a traditional standard sale for a lump sum price of $135,000 in which the customers purchases the equipment outright.

Another option is for a client to lease the equipment for a period of ten years and pay the lease payment on an annual basis. Sable has been charging $16,000 annually each year to lease the equipment during the ten-year period. However, both options are being effected by the economic conditions that loom in the external environment and some of the company's competitors are reducing their fees for similar equipment options and charging an average of $125,000.

Once of its customers, Buildit, is a construction company in San Francisco that has recently entered into a lease for the regular price before the economic downtown took effect. The primary consideration in this case is how to deal with the accounting aspects of this transaction because the financial evaluation has changed due to the economic conditions in the external environment. Recent Changes on FASB Lease Accounting The Financial Accounting Standards Board (FASB) instituted new guidelines for lease accounting in early 2016.

The new standards have been enacted to attempt to improve the needs of financial statements in improving the representation of leased assets in reporting requirements. Under the current accounting model, an organization applies a classification test to determine the accounting for the lease arrangement (FASB, 2016): • Some leases are classified as capital leases (for example, a lease of equipment for nearly all of its useful life) whereby the lessee would recognize lease assets and liabilities on the balance sheet.

• Other leases are classified as operating leases (for example, a lease of office space for 10 years) whereby the lessee would not recognize lease assets or liabilities on the balance sheet. The SEC and a number of other studies have all concluded that much of the reporting conducted with leased items occurs off-balance sheet in a way that is detrimental to the transparency and the representation of assets to investors.

To improve transparency, the FASB has rewritten much of the reporting requirements about leases and breaks down the previous category into to sub-categories, capital leases and operating leases. The section, 840 Leases, 30 Capital Leases, 05 Overview and Background, deals with the classification of capital leases as per the guidance give in subtopic 840-10 (FASB, N.d.).

There are now four different criteria that can classify a lease which are as follows: 1) Explicit transfer of ownership at the end of the lease term 2) Bargain purchase option 3) The lease term is equal to seventy-five percent of the estimated economic life of the leased item or property 4) Minimum lease payments at the present value equals, or exceeds, ninety percent of the fair value at the lease inception When applied to Sable Inc. and their bulldozers, the fair valuation in the external environment changes some of the accounting implications.

First of all, the lease contract does not explicitly transfer the ownership to the client and therefore does not qualify as a capital asset in terms of the first criteria. Furthermore, the bulldozer also does not qualify for the bargain purchase option under the second criteria. The third criteria also do not apply since the lease deal is roughly equal to two-thirds of the estimated economic life of the bulldozer (which is less than the three-fourths cutoff).

Therefore, it is the last of the criteria that can alone qualify this lease as a capital lease and not an operating lease. However, since the evaluation of the equipment is dependent upon the estimate of a fair market price, and the fair market value has decreased due to the economic downturn, then this has the potential of changing the lease classification from a capital lease to an operating lease.

However, even with the decrease in the fair market value, the equipment does not exceed the threshold of being ninety percent of the fair market value (it's slightly over eighty percent) and therefore, for accounting purposes, the asset can be classified as an operating leased item. The initial journal entry will have to use what is referred to as a "lease liability" account which is equal to the present value of the lease payments due over the lease term.

On the other side of the balance sheet, the ROU asset is initially recorded at an amount equal to (DHG, 2016): • The initial lease liability; plus • Any lease payments made at or before lease commencement; plus • Any initial direct costs incurred by the lessee; less • Any lease incentives received from the lessor. Figure 1 - calculating the ROU of an asset (DHG,.