Chapter 10: Appendix 3

Accounting for Leases Leases are agreements where a lessee (tenant) pays a lessor (owner) to use an asset for a specified time. Lease accounting classifies leases as finance leases or operating leases, each with different accounting treatments. 1. Finance Leases: • • Definition: A lease is classified as a finance lease if it meets at least one of five criteria: 1. Ownership is transferred to the lessee by the end of the lease term. 2. The lease includes a purchase option that the lessee is likely to exercise. 3. The lease term covers the majority of the asset's economic life. 4. The present value of lease payments equals or exceeds the asset's fair value. 5. The leased asset is specialized, with no alternative use to the lessor after the lease ends. Accounting Treatment: The lessee records a "Right-of-Use Asset" and a "Lease Liability" at the start of the lease, both equal to the present value of the lease payments. The lease liability is reduced by lease payments, while the asset is amortized, typically on a straight-line basis. Interest expense is recognized on the liability over time. 2. Operating Leases: • • Definition: Operating leases do not meet any of the criteria for finance leases. Accounting Treatment: The lessee still records a "Right-of-Use Asset" and a "Lease Liability" for long-term leases, but the periodic expense is recognized as "Lease Expense," which combines both interest and amortization. The lease payments are spread over the lease term. 3. Short-Term Leases: • Leases with terms of 12 months or less, without purchase options, are not recorded as assets or liabilities. Lease payments are treated as regular expenses. Accounting for Pensions Pensions are employer-sponsored retirement plans that promise future benefits to employees. There are two primary types of pension plans: 1. Defined Benefit Plan: • • Definition: In a defined benefit plan, the employer guarantees a specified retirement benefit. Contributions vary based on estimated future needs to meet the pension obligations. Accounting Treatment: A pension liability is recorded if the present value of the promised pension benefits (accumulated benefit obligation) exceeds the pension plan assets (market value of assets). If plan assets exceed the obligation, a pension asset is reported. Employers accrue pension expenses as employees earn their benefits, often decades before actual payment. 2. Defined Contribution Plan: • • Definition: In a defined contribution plan, the employer specifies the amount to contribute, often matched by the employee. The retirement benefits depend on the contributions and investment returns. Accounting Treatment: The employer records contributions as an expense when made. No future liability is reported because the employer's obligation is limited to the defined contributions. Other Postretirement Benefits These include non-pension benefits such as healthcare and life insurance. The costs of these benefits are estimated and accrued as liabilities when employees earn them, even if many of these plans are unfunded. Key Points: • • Lease Accounting: Requires recording of lease assets and liabilities for long-term leases, with differences in expense recognition based on lease classification (finance or operating). Pension Accounting: Involves estimating future obligations and matching them with plan assets, differentiating between defined benefit and defined contribution plans. These standards aim to provide a clearer view of a company's financial obligations related to leases and pension plans.