GlossaryChapter 21

bargain-purchase option An option that allows a lessee to purchase the leased property for a price that is significantly lower than the propertys expected fair value at the date the option becomes exercisable. At the inception of the lease, the difference between the option price and the expected fair value must be large enough to make exercise of the option reasonably assured. A bargain-purchase option is one of the criteria for determining if a lease is a capital lease. (p. 1295). bargain-renewal option An option that allows a lessee to renew the lease for a rental that is lower than the expected fair rental at the date the option becomes exercisable. At the start of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option reasonably assured. A bargain-renewal option extends the life of the lease, when determining the lease term. (p. 1296). capital lease Agreement that allows one party (the lessee) to use the asset of another party (the lessor) and to account for the transaction as a purchase. The lease must be noncancelable and must meet one or more of four capitalization criteria. (p. 1295). capitalization criteria Four criteria for deciding if a lease qualifies as a capital lease. In addition to being noncancelable, the lease must meet one or more of the four criteria: (1) transfers ownership of the property to the lessee; (2) contains a bargain-purchase option; (3) its lease term equals or exceeds 75 percent of the assets economic life; or (4) the present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased asset. If a lease does not meet any of the four criteria, then it is classified and accounted for as an operating lease. (p. 1295). capitalization of leases The process of accounting for leases in the same way a company would account for installment purchases. The FASB prescribes a capitalization approach when the lease is similar to an installment purchase, as determined by being noncancelable and by meeting one or more of four capitalization criteria. (p. 1293). direct-financing lease Agreement that is in substance the financing of an asset purchase by the lessee. The lessor records a lease receivable (the present value of the minimum lease payments plus the present value of the unguaranteed residual value) instead of a leased asset. Companies often report the lease receivable in the balance sheet as Net investment in capital leases and classify it either as current or noncurrent, depending on when they recover the net investment. (p. 1307). effective-interest method (leases) Method used by the lessee to allocate each payment under a capital lease between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. The lessee must use the same discount rate that determines the present value of the minimum lease payments. (p. 1298). executory costs Costs for insurance, maintenance, and tax expenses during the economic life of a leased asset. Executory costs do not represent payment on or reduction of the lease obligation. Many lease agreements specify that the lessee directly pays executory costs to the appropriate third parties. (p. 1297). guaranteed residual value Either the certain or determinable amount that the lessee will pay the lessor at the end of a lease to purchase the leased asset or the amount the lessee or third-party guarantees the lessor will realize if the asset is returned. The amount of guaranteed residual value is included in determining the amount of minimum lease payments. (pp. 1297, 1311). implicit interest rate The interest rate used by the lessor in determining the lease payments; it ensures a desired rate of return for the lessor in the leasing arrangement. (p. 1297). incremental borrowing rate Discount rate that the lessee would have incurred to borrow the funds necessary to buy a leased asset on a secured loan with repayment terms similar to the payments called for in the lease. This rate is used to determine whether a lease meets the 90 percent (recovery of investment) test if the lessors implicit rate is not known or if the incremental borrowing rate is higher than the implicit rate of the lessor. (p. 1297). initial direct costs The lessors incremental and internal costs; incremental direct costs are paid to independent third parties for originating a lease agreement, and internal direct costs are directly related to specified activities performed by the lessor on a given lease, such as evaluating the prospective lessees financial condition. (p. 1320). lease A contractual agreement that gives a lessee the right to use specific property, owned by the lessor, for a specified period of time in exchange for rental payments over the life of the lease. For accounting purposes, leases are classified as either capital leases or operating leases. (p. 1290).

lease receivable The present value of the minimum lease payments plus the present value of the unguaranteed residual value of a direct-financing lease. Direct-financing leases require the lessor to substitute a lease receivable for the leased asset. (p. 1307). lease term The duration of a lease, generally considered to be the fixed, noncancelable term of a lease. A lease term equal to 75 percent or more of the estimate life of leased property is one of the criteria for determining if a lease is a capital lease. (pp. 1292, 1296). lessee A party that has made a contractual arrangement to use another partys asset for a specific period of time by making periodic payments. (p. 1290). lessor A party that has made a contractual arrangement to let another party use an asset for a specific period of time in exchange for periodic payments. (p. 1290). manufacturers or dealers profit (or loss) Distinguishing feature of a sales-type lease. The lessor recognizes a sale of the asset and a gross profit (or loss) on the sale, a measure based on the difference between the selling price of the leased asset and its cost. (p. 1306). minimum lease payments A measure, the present value of which is determined and used as part of the recovery of investment (90 percent) test. Minimum lease payments include minimum rental payments, a guaranteed residual value, a penalty for failure to renew the lease, and a bargain-purchase option. The lessee does not include executory costs in computing the present value of the minimum lease payments. (p. 1296). noncancelable Terms of a lease agreement by which the lessee can cancel the lease contract only upon the outcome of some remote contingency or that involve cancellation provisions and penalties that are so costly to the lessee that cancellation probably will not occur. (p. 1294). offbalance-sheet financing Borrowing funds in a way that avoids recording the obligations. Examples of such arrangements are nonconsolidated subsidiaries, special-purpose entities, and operating leases. Companies engage in offbalance-sheet financing as a way to remove debt from the balance sheet or bypass loan covenants. In response to offbalance-sheet financing gone bad (e.g., Enron), the FASB has increased disclosure (note) requirements related to this type of financing. (p. 1292). operating lease Lease that does not meet any of the criteria for a capital lease. An operating lease essentially allows the lessee to account for the use of the lessors asset as a rental, with payments recorded as rent expense. (p. 1295). residual value The estimated fair value of leased property at the end of the lease term. This value is included by the lessor in the computation of lease payments. The residual value is included in the minimum lease payments, if it is guaranteed. (p. 1310). sales-type lease Lease that recognizes interest revenue like a direct-financing lease but that also recognizes a manufacturers or dealers profit. In a sales-type lease, the lessor records the sale price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable. (p. 1316). third-party guarantors Insurers who for a fee assume the risk of deficiencies in leased asset residual values. (p. 1297). unguaranteed residual value The estimated residual value of a leased asset, exclusive of any portion guaranteed by the lessee or a third-party guarantor. (p. 1313). Appendix 21B: minor leaseback Leasebacks in which the present value of the rental payments are 10 percent or less of the fair value of the asset. (p. 1332). sale-leaseback A transaction in which the owner of the property (seller-lessee) sells the property to another and simultaneously leases it back from the new owner. (p. 1331).