Economic

Memorandum5 7Example

MemorandumTo: Tech Startup Inc. Controller’s Group FilesFrom: [Student Name], Controller’s Group AnalystRe: Lease of 15 Tech DriveDate: X/X/XXXXFactsSee facts as given in case study.Issues/ QuestionShould the lease arrangement be classified as an operating lease or as a capital lease?AnalysisLessee must determine whether to account for its lease as a capital or operating lease. ASC 840-10-25-1 provides the following lease classification criteria: 25-1A 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 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…. 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 leased property… 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 at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor…In addition to these four criteria, ASC 840 provides the following guidance regarding lessees’ application of lease classification criteria:25-29If at its inception a lease meets any of the four lease classification criteria in paragraph 840-10-25-1, the lease shall be classified by the lessee as a capital lease. Accordingly, Lessee has analyzed each criterion individually to determine whether it is met for this lease.Analysis—Transfer of OwnershipThe lease does not call for transfer of ownership at the end of the lease term. This condition for capital lease treatment is therefore not met.Analysis—Bargain Purchase OptionLessee is given the option to purchase the leased property at the end of the lease term for a price ($16.25M) that is below the estimated lease-end fair value of the property ($17M). This contractual provision bears further consideration.The glossary of ASC 840-10 defines a bargain purchase option as:A provision allowing the lessee, at his option, to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured.Little other guidance is provided within the Codification to assist a lessee in determining whether a purchase option is, in fact, a bargain. However EY’s guide book, Lease Accounting (2014), Section 2.4 (page 2), offers additional guidance for applying this condition. In particular, EY notes that—when determining whether exercise of a purchase option meets the threshold of being reasonably assured—entities should consider factors such as (1) how far into the future the purchase option is being offered, where a longer term could decrease the likelihood of exercise, and (2) the stability of the property’s value. An excerpt of this guidance follows:The further into the future a lessee is required to consider, the less precise will be the estimates of future needs for the leased asset. Also, the fair value of certain types of assets is more likely to change over time than will the value of other types of assets (e.g., the future value of a technology asset, such as a computer, is more difficult to predict than the future value of a relatively stable asset, such as a fully-leased commercial office building located in a prime area). Accordingly, the further into the future the option date, the lower the option price must be in relation to the estimated future fair value to reasonably assure exercise. Also, the relationship at a future point in time between the option price and the estimated future fair value should be lower for an asset subject to significant changes in value than would be the case for an asset having a relatively stable value.In this case, the determination is judgmental. Although the option is fairly far into the future (10 years is somewhat long given that the company is a tech startup whose needs could change), the building is supposedly in a prime area and thus a $750K discount off of its purchase price could be compelling.In Section 2.4.3 of its Lease Accounting guide, EY goes on to emphasize (in Illustration 2-2) that external factors should be considered when determining whether exercise of a purchase option is reasonably assured:Illustration 2-2: Determining whether a bargain purchase option existsAssume a company leases equipment from a lessor under a 5-year lease that includes an option for the lessee to purchase the equipment at the end of the lease term for $900,000. The lessee estimates that the equipment will have a fair value at the end of the lease term of $1,000,000. The equipment is expected to be readily available in the market at the end of the lease term. The lessee determined that the purchase option would not be considered reasonably assured of exercise and therefore a bargain because while it is priced below estimated fair value, the discount is not so significant that exercise rises to the level of reasonably assured. Therefore, the option does not qualify as a bargain purchase option.Again, consistent with this guidance, the purchase option in this case is close enough to the estimated future fair value of the building that its exercise likely does not rise to the level of being reasonably assured. This is especially true in this case when you consider the company’s specific situation as a tech startup. Accordingly, a bargain purchase option is not deemed to exist.Analysis—Lease TermThis lease is for a 10-year term, which is 25% of the estimated useful life of the leased property. As this is below the 75% threshold for capital lease classification, this condition is not met.Considering also the definition of lease term, any bargain renewal options should also be included in the lease term. In this case, no such renewal options are present.Analysis—Minimum Lease PaymentsLessee will pay $50,000 monthly plus a contingent amount determined as 1% of its sales. Lessee must evaluate whether these rental payments exceed 90% of the fair value of the leased property and, accordingly, would result in capital lease treatment. ASC 840-10-25-4 provides the following guidance indicating that lease payments based on sales volume should not be considered when calculating the minimum lease payments payable under the lease:

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