Materials requirements in process costing

Materials can be required at any moment of production process. In general, some direct material  should be introduced at the beginning of a production process or there would be no requirement for labor or overhead to be incurred. 

 

For example, to make its various products, XYX Co. dispenses wax at the beginning of a process. Any material added at the beginning of production is 100 percent complete throughout the process regardless of the percentage of completion of labor and overhead.

Most production processes require multiple direct materials. Additional materials may be added at any point or even continuously during processing. A material, such as a box, may even be added at the end of processing. During the production process, the product is 0 percent complete as to the box although other materials may be complete and some labor and overhead may have been incurred.

Factors taken into consideration in determining lease rent

Five things are taken into consideration when determining the amount of rent:
1. The value of the equipment today and what it will be worth at the end of the lease.
2. The likelihood the lessee may stop paying the rent.

3. The value of being able to take depreciation on the equipment.
4. The cost to the lessor of borrowing the money to buy the equipment.
5. The amount the lessor needs to charge, and keep in reserve, to cover the risk of getting the preceding four estimates wrong.

 

Four distinct advantages make a lease attractive to a lessor:
1. Regular cash flow from the rent payments.
2. The prospect of making a profit on selling the equipment when the lease is over.
3. Tax benefits of depreciation on the equipment.
4. Ability to further enhance the value of a lease with a creative financial structuring.

Why a lease is different from other means of financing?

Leasing is unique in three fundamental ways:

1. The lessor owns the equipment and is not simply financing it. In most cases, a lessor buys a piece of equipment only when it has a customer who wants to use it. In the case of airplanes and rail cars, however, there are leasing companies that order planes and rail cars without specific customer orders in the hope they will be able to lease the equipment when it is delivered.

2. Leases are long. Though a computer lease probably lasts no more than three years, the lease on a rail car may last up to 25 years, and the lease on a power plant for 30 years. This means that at the start of the lease it is not easy to take into account everything that can happen to the equipment or to the lessee for the next 3 to 30 years. 

3. There is no organized market for buying and selling leases. Leases are not traded like bonds or stocks because there are not enough common characteristics among them. Lease prices do not show up on Bloomberg or Reuters. There is a reasonably active private market for syndicating leases when they are originated. 

Sales of seasoned leases (2 to 10 years old), however, are not common, so if a lessor is unhappy with the risk or return on a lease it has in portfolio, it may take a while to fix the problem. This lack of a ready market means that the lessor must be careful when deciding what leases it wants in portfolio and have the tools for tracking what is happening with the lessee, the equipment, and tax rates and regulations.

How a Lease Works

The way a lease works can be described in five steps:

1. A company needs new equipment. It specifies the make, model, and features, and negotiates the price with the manufacturer.

2. The company then negotiates an agreement with a lessor—how much rent, for how long, and what the equipment will be worth at the end of the lease.

3. The equipment is delivered. The company and the lessor make sure it is what was ordered. The lessor pays for it.

4. Rent payments are made by the company, now a lessee, to the lessor.

5. At the end of the lease the lessee may have an option to renew the lease or to buy the equipment.

Is lease better than buy things?

Yes! In several ways leases are beneficial than buying things.

 

According to a recent survey three of the main reasons a company leases equipment rather than buying it are:
 

1. Leasing equipment protects companies against owning equipment that may become technologically obsolete—that risk is shifted to the lessor.
 

2. Often the company does not have to show the equipment and the debt financing it on its balance sheet. On their face, the financials of the company leasing the equipment look better than they otherwise would.

3. The company leasing the equipment cannot make use of the depreciation benefits.

A lease is a contract that lets a company (lessee) rent equipment for a specified period of time. The rent is paid periodically throughout the term of the lease—every month, or every 3, 6, or 12 months. The leasing company (lessor) owns the equipment. Lessors deduct the depreciation charges for the equipment from their income before calculating their taxes. Lessees receive part of the tax benefit of depreciation in the form of lower rent.

Types of Leases contemplated in Accounting Standards

Accounting Standard 19 has divided the lease into two types viz. (i) Finance Lease and (ii) Operating Lease.

Finance Lease : A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. title may or may not eventually be transferred. At the inception of a finance lease, the lessee should recognize the lease as an asset and a liability. Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and liability should be the present value of the minimum lease payments from the standpoint of the lessee.

Operating Lease : A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incident to ownership. Lease payments under an operating lease should be recognized as an expense in the statement of profit and loss on a straight line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.

Sales Lease Back Transactions as per Accounting Standards

Sale and leaseback transactions: As per AS 19 on ‘Leases’, a sale and leaseback transaction involves the sale of an asset by the vendor and the leasing of the asset back to the vendor. The lease payments and the sale price are usually interdependent, as they are negotiated as a package. The accounting treatment of a sale and lease back transaction depends upon the type of lease involved.

If a sale and leaseback transaction results in a finance lease, any excess or deficiency of sale proceeds over the carrying amount should be deferred and amortized over the lease term in proportion to the depreciation of the leased asset.

If sale and leaseback transaction results in a operating lease, and it is clear that the transaction is established at fair value, any profit or loss should be recognized immediately. If the sale price is below fair value any profit or loss should be recognized immediately except that, if the loss is compensated by future lease payments at below market price, it should be deferred and amortized in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value should be deferred and amortized over the period for which the asset is expected to be used.

What is the nature of a sale-leaseback transaction?

The term “sale-leaseback” describes a transaction in which the owner of property sells such property to another and immediately leases it back from the new owner. The property is sold generally at a price equal to or less than current market value and leased back for a term approximating the property’s useful life for lease payments sufficient to repay the buyer for the cash invested plus a reasonable return on the buyer’s investment. The purpose of the transaction is to raise money with certain property given as security. 

For accounting purposes the salelease back should be accounted for by the lessee as a capital lease if the criteria are satisfied and by the lessor as a purchase and a direct-financing lease if the criteria are satisfied. Any income or loss experienced by the seller-lessee from the sale of the assets that are leased back should be deferred and amortized over the lease term (or the economic life if either criteria (1) a bargain purchase option or (2) a transfer of ownership occurs at the end of the lease is satisfied) in proportion to the amortization of the leased assets. Losses should be recognized immediately. Furthermore, minor leasebacks (present value of rentals less than 10% of fair value) should be reported as a sale with related gain recognition.

Lessor’s accounting for sales-type leases.

A sales-type lease recognizes interest revenue like a direct-financing lease. It also recognizes a manufacturer’s or dealer’s profit. In a sales-type lease, the lessor records at the inception of the lease the sales price of the asset, the cost of goods sold and related inventory reduction, and the lease receivable. Sales-type leases differ from direct-financing leases in terms of the cost and fair value of the leased asset, which results in gross profit. 

Lease receivable and interest revenue are the same whether a guaranteed or an unguaranteed residual value is involved. The accounting for guaranteed and for unguaranteed residual values requires recording sales revenue and cost of goods sold differently. The guaranteed residual value can be considered part of sales revenue because the lessor knows that the entire asset has been sold. There is less certainty that the unguaranteed residual portion of the asset has been “sold”; therefore, lessors recognize sales and cost of goods sold only for the portion of the asset for which realization is assured. However, the gross profit amount on the sale of the asset is the same whether a guaranteed or unguaranteed residual value is involved.

Disclosure requirements in lease accounting

The FASB requires lessees and lessors to disclose certain information about leases in their financial statements or in the notes. These requirements vary based upon the type of lease (capital or operating) and whether the issuer is the lessor or lessee. These disclosure requirements provide investors with the following
information:
• General description of the nature of leasing arrangements.
• The nature, timing, and amount of cash inflows and outflows associated with leases, including payments to be paid or received for each of the five succeeding years.
• The amount of lease revenues and expenses reported in the income statement each period.
• Description and amounts of leased assets by major balance sheet classification and related liabilities.
• Amounts receivable and unearned revenues under lease agreements.

Murali Company
(dollar amounts in thousands)
Current Liabilities                                                     2007                    2006
Current obligations under capital leases                    $ 431                     $327
Noncurrent Liabilities
Long-term obligations under capital leases,
less current portion                                                 $1,003                    $208
 

Note 8: Commitments and Contingencies
The Company leases certain facilities, machinery, automotive and computer equipment under noncancelable lease agreements. The Company expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Property, plant and equipment relating to capital leases were $1,618 at December 29, 2007, and $2,234 at December 30, 2006, with accumulated amortization of $116 and $1,881, respectively. Depreciation and amortization of assets recorded under capital leases was $468 in 2007 and $719 in 2006.
 

The following is a schedule of future minimum lease payments as of December 29, 2007:
                                                                                             Noncancelable
                                                                   Capital Leases                  Operating Leases
          2008                                                    $ 565                                $1,119
          2009                                                       503                                     947
          2010                                                       395                                     645
          2011                                                       193                                     467
          2012                                                        —                                      180
Later years                                                         —                                      396
Total minimum lease payments                          $1,656                                 $3,754
Less interest portion of payments                           221
Present value of future minimum lease payments $1,435

Rental expense was approximately $2,634 in 2007 and $2,732 in 2006.

What are Initial direct costs in a lease?

Initial direct costs are of two types: incremental and internal. Incremental direct costs are paid to independent third parties for originating a lease arrangement. Examples include the cost of independent appraisal of collateral used to secure a lease, the cost of an outside credit check of the lessee, or a broker’s fee for finding the lessee. Internal direct costs are directly related to specified activities performed by the lessor on a given lease. Examples are evaluating the prospective lessee’s financial condition; evaluating and recording guarantees, collateral, and other security arrangements; negotiating lease terms and preparing and processing lease documents; and closing the transaction. The costs directly related to an employee’s time spent on a specific lease transaction are also considered initial direct costs.

However, initial direct costs should not include internal indirect costs. Such costs are related to activities the lessor performs for advertising, servicing existing leases, and establishing and monitoring credit policies. Nor should the lessor include the costs for supervision and administration or for expenses such as rent and depreciation. 

The accounting for initial direct costs depends on the type of lease:
• For operating leases, the lessor should defer initial direct costs and allocate them over the lease term in proportion to the recognition of rental revenue.
• For sales-type leases, the lessor expenses the initial direct costs in the period in which it recognizes the profit on the sale.
• For a direct-financing lease, the lessor adds initial direct costs to the net investment in the lease and amortizes them over the life of the lease as a yield adjustment. In a direct-financing lease, the lessor must disclose the unamortized deferred initial direct costs that are part of its investment in the direct-financing lease.

Lessor and Lessee Accounting for Residual Value

Lessee Accounting for Residual Value
Whether the estimated residual value is guaranteed or unguaranteed has both economic and accounting consequence to the lessee. The accounting consequence is that the minimum lease payments, the basis for capitalization, include the guaranteed residual value but excludes the unguaranteed residual value.
 

Guaranteed Residual Value (Lessee Accounting). A guaranteed residual value affects the lessee’s computation of minimum lease payments. Therefore it also affects the amounts capitalized as a leased asset and a lease obligation. In effect, the guaranteed residual value is an additional lease payment that the lessee will pay in property or cash, or both, at the end of the lease term.

Lessee records the leased asset (front-end loader) and liability, depreciation, interest,property tax, and lease payments on the basis of a guaranteed residual value.If the fair market value exceeds residual value, a gain may be recognized. When there is a guaranteed residual value, the lessee must be careful not to depreciate
the total cost of the asset.

Unguaranteed Residual Value (Lessee Accounting). From the lessee’s viewpoint, an unguaranteed residual value is the same as no residual value in terms of its effect upon the lessee’s method of computing the minimum lease payments and the capitalization of the leased asset and the lease liability.

Lessor Accounting for Residual Value

The lessor will recover the same net investment whether the residual value is guaranteed or unguaranteed. That is, the lessor works on the assumption that it will realize the residual value at the end of the lease term whether guaranteed or unguaranteed. The lease payments required in order for the company to earn a certain return on investment are the same whether the residual value is guaranteed or unguaranteed.

Types of Leases by Lessor

The lessor may classify leases as one of the following:
1. Operating leases.
2. Direct-financing leases.
3. Sales-type leases.

 Capitalization Criteria (Lessor)

Group I
1. The lease transfers ownership of the property to the lessee.
2. The lease contains a bargain-purchase option.
3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.
 

Group II
1. Collectibility of the payments required from the lessee is reasonably predictable.
2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease (lessor’s performance is substantially complete or future costs are reasonably predictable).

Two groups of capitalization criteria for the lessor. If at the date of inception, the lessor agrees to a lease that meets one or more of the Group I criteria (1, 2, 3, and 4) and both of the Group II criteria (1 and 2), the lessor shall classify and account for the arrangement as a direct-financing lease or as a sales-type lease.

(Note that the Group I criteria are identical to the criteria that must be met in order for a lessee to classify a lease as a capital lease). Why the Group II requirements? The profession wants to ensure that the lessor has
really transferred the risks and benefits of ownership. If collectibility of payments is not predictable or if performance by the lessor is incomplete, then the criteria for revenue recognition have not been met. The lessor should therefore account for the lease as an operating lease.

Difference between direct-financing leases and salestype leases

The distinction for the lessor between a direct-financing lease and a salestype lease is the presence or absence of a manufacturer’s or dealer’s profit (or loss): 

A sales-type lease involves a manufacturer’s or dealer’s profit, and a direct-financing lease does not. The profit (or loss) to the lessor is evidenced by the difference between the fair value of the leased property at the inception of the lease and the lessor’s cost or carrying amount (book value).

Normally, sales-type leases arise when manufacturers or dealers use leasing as a means of marketing their products. For example, a computer manufacturer will lease its computer equipment (possibly through a captive) to businesses and institutions. 

Direct-financing leases generally result from arrangements with lessors that are primarily engaged in financing operations (e.g., banks). However, a lessor need not be a manufacturer or dealer to recognize a profit (or loss) at the inception of a lease that requires application of sales-type lease accounting.

What are the lease benefits available to the lessor?

Three important benefits are available to the lessor:

1. Interest Revenue. Leasing is a form of financing. Banks, captives, and independent leasing companies find leasing attractive because it provides competitive interest margins.

2. Tax Incentives. In many cases, companies that lease cannot use the tax benefit of the asset, but leasing allows them to transfer such tax benefits to another party (the lessor) in return for a lower rental rate on the leased asset.

3. High Residual Value. Another advantage to the lessor is the return of the property at the end of the lease term. Residual values can produce very large profits. At the same time, if residual values decline, lessors can suffer losses when less-valuable leased assets are returned at the conclusion of the lease.

How a leasee records Asset and Liability in a lease?

In a capital lease transaction, Lessee uses the lease as a source of financing. Lessor finances the transaction (provides the investment capital) through the leased asset. Lessee makes rent payments, which actually are installment payments. Therefore, over the life of the aircraft rented, the rental payments to Lessor constitute a payment of principal plus interest.

Asset and Liability Recorded
Under the capital lease method, Lessee treats the lease transaction as if it purchases the aircraft in a financing transaction. That is, Lessee acquires the aircraft and creates an obligation. Therefore, it records a capital lease as an asset and a liability at the lower of  

(1) the present value of the minimum lease payments (excluding executory costs) or
(2) the fair value of the leased asset at the inception of the lease. 

 The rationale for this approach is that companies should not record a leased asset for more than its fair value.
 

 Depreciation Period
One troublesome aspect of accounting for the depreciation of the capitalized leased asset relates to the period of depreciation. If the lease agreement transfers ownership of the asset to Lessee (criterion 1) or contains a bargain-purchase option (criterion 2), Lessee depreciates the aircraft consistent with its normal depreciation policy for other aircraft, using the economic life of the asset. On the other hand, if the lease does not transfer ownership or does not contain a bargain purchase option, then Lessee depreciates it over the term of the lease. In this case, the aircraft reverts to Lessor after a certain period of time.
 

Effective-Interest Method
Throughout the term of the lease, Lessee uses the effective-interest method to allocate each lease payment between principal and interest. This method produces a periodic interest expense equal to a constant percentage of the carrying value of the lease obligation. When applying the effective-interest method to capital leases, Lessee must use the same discount rate that determines the present value of the minimum lease
payments.



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Depreciation Concept
Although Lessee computes the amounts initially capitalized as an asset and recorded as an obligation at the same present value, the depreciation of the aircraft and the discharge of the obligation are independent accounting processes during the term of the lease. It should depreciate the leased asset by applying conventional depreciation methods: straight-line, sum-of-the-years’-digits, declining-balance, units of production, etc.  

The FASB uses the term “amortization” more frequently than “depreciation” to recognize intangible leased property rights. We prefer “depreciation” to describe the writeoff of a tangible asset’s expired services.

What are incremental borrowing and implicit interest rates in a lease?

A lessee, generally computes the present value of the minimum lease payments using its incremental borrowing rate. This rate is defined as: “The rate that, at the inception of the lease, the lessee would have incurred to borrow the funds necessary to buy the leased asset on a secured loan with repayment terms similar to the payment schedule called for in the lease.”  

To determine whether the present value of these payments is less than 90 percent of the fair market value of the property, Delta discounts the payments using its incremental borrowing rate. Determining the incremental borrowing rate often requires judgment because the lessee bases it on a hypothetical purchase of the property.

However, there is one exception to this rule. If (1) Lessee knows the implicit interest rate computed by Lessor and (2) it is less than Lessee ’s incremental borrowing rate, then Lessee must use Lessor ’s implicit rate. 

What is the interest rate implicit in the lease? It is the discount rate that, when applied to the minimum lease payments and any unguaranteed residual value accruing to the lessor, causes the aggregate present value to equal the fair value of the leased property to the lessor.

 
The purpose of this exception is two fold. First, the implicit rate of Lessor is generally a more realistic rate to use in determining the amount (if any) to report as the asset and related liability for Lessee. Second, the guideline ensures that Lessee does not use an artificially high incremental borrowing rate that would cause the present value of the minimum lease payments to be less than 90 percent of the fair market value of the aircraft. Use of such a rate would thus make it possible to avoid capitalization of the asset and related liability.

How to determine the present value of the minimum lease payments?

 Determining the present value of the minimum lease payments involves three important concepts: (1) minimum lease payments, (2) executory costs, and (3) discount rate.

Minimum Lease Payments. Lessee is obligated to make, or expected to make, minimum lease payments in connection with the leased property. These payments include the following.

1. Minimum Rental Payments—Minimum rental payments are those that lessee must make to lessor under the lease agreement. In some cases, the minimum rental payments may equal the minimum lease payments. However, the minimum lease payments may also include a guaranteed residual value (if any), penalty for failure to renew, or a bargain-purchase option (if any).

2. Guaranteed Residual Value—The residual value is the estimated fair (market) value of the leased property at the end of the lease term. Lessor may transfer the risk of loss to Lessee or to a third party by obtaining a guarantee of the estimated residual value. The guaranteed residual value is either 

(1) the certain or determinable amount that Lessee will pay to lessor at the end of the lease to purchase the aircraft at the end of the lease, or 

(2) the amount Lessee or the third party guarantees that  lessor will realize if the aircraft is returned. (Third-party guarantors are, in essence, insurers who for a fee assume the risk of deficiencies in leased asset residual value.) If not guaranteed in full, the unguaranteed residual value is the estimated residual value exclusive of any portion guaranteed.

3. Penalty for Failure to Renew or Extend the Lease—The amount Lessee must pay if the agreement specifies that it must extend or renew the lease, and it fails to do so.

4. Bargain-Purchase Option—An option given to Lessee to purchase the aircraft at the end of the lease term at a price that is fixed sufficiently below the expected fair value, so that, at the inception of the lease, purchase is reasonably assured.

How a lease is classified as Capital lease?

In order to record a lease as a capital lease, the lease must be non-cancelable. Further, it must meet one or more of the four criteria listed as below:

• The lease transfers ownership of the property to the lessee. If the lease transfers ownership of the asset to the lessee, it is a capital lease. This criterion is not controversial and easily implemented in practice. 

• The lease contains a bargain-purchase option. A bargain-purchase option allows the lessee to purchase the leased property for a price that is significantly lower than the property’s 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 market value must be large enough to make exercise of the option reasonably assured.

• If the lease period equals or exceeds 75 percent of the asset’s economic life, the lessor transfers most of the risks and rewards of ownership to the lessee. Capitalization is therefore appropriate. However, determining the lease term and the economic life of the asset can be troublesome. The lease term is generally considered to be the fixed, noncancelable term of the lease. However, a bargain-renewal option, if provided in the lease agreement, can extend this period. A bargain-renewal option allows the 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 inception of the lease, the difference between the renewal rental and the expected fair rental must be great enough to make exercise of the option to renew reasonably assured. 

• If the present value of the minimum lease payments equals or exceeds 90 percent of the fair market value of the asset, then a lessee should capitalize the leased asset. If the present value of the minimum lease payments is reasonably close to the market price of the aircraft, lessee is effectively purchasing the asset.

Who are lessors?

Lessors generally fall into one of three categories:

1. Banks: Banks are the largest players in the leasing business. They have low-cost funds, which give them the advantage of being able to purchase assets at less cost than their competitors. Banks also have been more aggressive in the leasing markets. They have decided that there is money to be made in leasing, and as a result they have expanded their product lines in this area. Finally, leasing transactions are now more standardized, which gives banks an advantage because they do not have to be as innovative in structuring lease arrangements.

 
2. Captive leasing companies.Captive leasing companies have the point-of-sale advantage in finding leasing customers. That is, as soon as Caterpillar receives a possible order, its leasing subsidiary can quickly develop a lease-financing arrangement. Furthermore, the captive lessor has product knowledge that gives it an advantage when financing the parent’s product. The current trend is for captives to focus primarily on their companies’ products rather than do general lease financing. 

3. Independents: Independents are the final category of lessors. Independents have not done well over the last few years. Their market share has dropped fairly dramatically as banks and captive leasing companies have become more aggressive in the lease-financing area. Independents do not have point-of-sale access, nor do they have a low cost of funds advantage. What they are often good at is developing innovative contracts for lessees. In addition, they are starting to act as captive finance companies for some companies that do not have a leasing subsidiary.