Deal for a Dozer Case Analysis

Case 6: Deal for a Dozer
2014 Audit Case Competition
University of Iowa
Chen Chen
Yanzhi Gong
Yue Li
Jia Liu
Nicholas 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
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 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.

8
Minimum Lease Payment Test
Minimum Lease Payment:
Fair Value = $125,000
N = 10
I/Y = 6.93%
PMT = $16,000
PV = ? $112,724
≥ 90% of Fair Value Test
$112,724
$125,000
Pass Test
90.2% > 90%

9
What if $135,000?
Minimum Lease Payment:
N = 10
I/Y = 5.94%
PMT = $16,000
PV = ? $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
Criteria
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 Both
of 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
Sales Revenue 112,724
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

14
Amortization Schedule (Interest Rate: 6.93%)
Year
Payment
Ending of
Period
Interest
Income for
Period
Ending
Gross
Investment
Ending
Unamortized
Unearned
Income
Net
Investment at
End of Period
Beginning
Balance:
$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 Credit
Cash $16,000
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 Sheet
Assets
Current assets:
Cash $16,000
Gross 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
Liabilities
Current liabilities:
Unearned income $8,158
Noncurrent 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
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
Liabilities
Total Liabilities
D/E
(Unearned Income)
No Liabilities Recorded

18
Income Statement Impact
Item
Sales-Type Lease
(FMV = $125,000)
Operating Lease
(FMV = $135,000)
Revenue Year 1
Year 2- 10
Gross Profit
Interest Revenue
(Declining)
Rental Revenue
Expense No Depreciation Expense Depreciation Expense

19
Operating vs. Capital Lease
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
$40,000
1 2 3 4 5 6 7 8 9 10
Year
Profit Comparison
Operating Lease Capital Lease

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
Sales $112,724
Cash $16,000
Residual Asset 851
Lease Receivable $8,184
Interest Revenue 8,667

22
Effect on the Accounting Information System
System
Determin
e Lease
Type
Automated Application
Control
ApproveSystem
Data
Report
Agent
Approves
Agent
Reviews
IT Dependent
Manual Control
Input
Lease
Data
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

23
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
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)
Operating Lease
(FMV = $135,000)
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
5 Step Process
Customer
Identify Separate
Determine the
Transaction Price
Price
Recognize Revenue
Provide Bulldozer to
be used for a 10-
year period

31
5 Step Process
Customer
Identify Separate
Determine the
Transaction Price
Price
Recognize Revenue
Based on the Fair
Market Value of the
Asset
Transaction Price is
$125,000

32
5 Step Process
Customer
Identify Separate
Determine the
Transaction Price
Price
Recognize Revenue
Only One
Performance
Obligation for Sable:
Delivery of the Asset

33
5 Step Process
Customer
Identify Separate
Determine the
Transaction Price
Price
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 value
b. 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 payments
ii. The accumulated allowance for uncollectible minimum lease
payments receivable.
2. The unguaranteed residual values accruing to the benefit of the lessor
3. For direct financing leases only, initial direct costs
4. 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 presented
c. 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 Lease
A 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
Lessee
For 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.
Lessor
For 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 term
3. 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
Lessee
For 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 payments
2. 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.
Lessor
For 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 asset
2. Recognize lease income over the lease term typically on a straight -line basis.

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