Auditing PP&E, Including Leases

Auditing PP&E, Including Leases Learning Objectives Discuss typical audit risks and special considerations. Tailor an audit plan to assessed audit risk. Explain key controls related to PP&E. Describe lease accounting requirements: Apply current accounting principles. Explain the impact of potential accounting standard changes. 2 1

PP&E Defined Assets used in operations. Estimated useful life > one year. Includes capitalizable leased property. 3 Primary Assertions Existence -- Sold and obsolete removed. Completeness -- Constructed assets added. Rights -- Full rights to recorded assets. Valuation -- Depreciation adequate. Accuracy/classification -- Liens. Cut-off. 4 2

Exhibit 1: Typical Property, Plant, and Equipment Audit Procedures Capitalization Policy Capitalization limit. Estimated useful lives: Period useful for acquired purpose. Preferred depreciation method. 6 3

Cost Considerations Initially stated at purchase price plus additional costs to obtain and prepare for intended use. Capitalizable costs: Direct (freight, sales tax, installation). Indirect (construction labor, interest). 7 Typical Capitalizable Costs Land: Purchase price plus commissions, legal fees, escrow fees, surveying fees, clearing and grading, assessments for water and sewer lines, etc. Land improvements: Cost plus materials, labor, and overhead Buildings: Purchase price plus commissions, reconditioning costs, etc. Equipment: Purchase price plus taxes, freight, insurance, installation, reconditioning and testing, etc. 8 4

Post-Acquisition Costs Maintenance and repairs to keep in working order: Expense as incurred. Renewals and replacements No extension of useful life or increase in future cash flows: Expense as incurred, as no new component acquired. Renewals and replacements Extends useful life or increases future cash flows: Capitalize costs as a new component. Remaining book value of replaced component added to current period depreciation expense. Additions and betterments: Capitalize as a separate new component with own useful life. 9 Basket Purchases Acquired for one lump sum, requiring allocation: May portion allocation to specific assets if clearly identifiable. May require appraisal values or similar evidence: Proportionate allocation based in relative market value. 10 5

Cost Segregation Costs of real estate used in operating activities. Composite life option. Refine to smaller components with appropriate engineering expertise. Cost segregation study required for tax purposes. 11 Salvage Value If minor, not necessary to consider. Depreciate up to salvage value. Changes in salvage value considered changes in estimates. If continual large gains/losses on disposal, challenge estimation process. 12 6

Capitalized Interest Construction for own use. Stop when substantially complete and ready for use. Weight based on when expenditures actually incurred. First use rate incurred for any debt specifically incurred for construction project: Weighted average of rates applicable all other debt as alternative. Cannot exceed actual interest costs accrued. 13 Exhibit 2: Capitalized Interest Example 7

Exchange of Nonmonetary Assets Generally, new asset valued at its FV, or the FV of the asset given up, whichever is more clearly determinable: FV is based on market participants, not simply list price. If cash was an option for either party, then the amount of cash reflects FV of the exchanged assets. For example: New car sticker price $50,000. Trade-in offer for used car is $5,000, but really worth $3,000. Cash only offer for new car would likely be $48,000. FV is the better reflected at the true cash price. In exchange, use of FV results in a gain or loss on disposal. 15 Red Flags of Possible Impairment of Long-Lived Assets Significant decline in FMV. Significant decline in extent of use. Significant negative physical change. Adverse action by regulators. Asset rendered obsolete. Significant cost overruns. Significant cash flow losses with operation. Known retirement before est. useful life. 16 8

General Process Accounting for Impairment Why? Whenever a material change in asset use or business environment. Information suggests FMV has declined. When? Recognize impairment loss only when undiscounted sum of estimated future cash inflows is less than book value. How? Difference between book value and FV of asset. FV may be PV of estimated future cash flows of asset (discounted). What? Disclose reasons, assumptions, and impact. Impairment loss part of income from continuing operations. 17 Exhibit 3: Key Controls Related to PP&E 9

Topic 840, Leases Arrangement conveys right to control the use of PP&E. Capital lease: Treated as an acquisition that is financed over the lease term. Operating lease: Treated as operating expense in current year results of operations. Evaluation made at inception of arrangement. 19 Operating Lease -- Lessee Debit rent expense and credit cash/rent payable. Scheduled rent changes generally expensed on straight-line basis over lease term. Prepaid rent/rent payable for difference with actual cash outlay. Contingent rentals: Variable payments based on future events, such as sales volume, inflation, property taxes, etc., are accruable at time of occurrence. 20 10

Operating Lease -- Lessor Credit rent revenue and debit cash/rent receivable. Asset remains on books with depreciation recorded. Initial direct costs to consummate lease agreement (e.g., legal fees, credit report fees, accounting fees, commissions) are debited as intangible asset and amortized to match revenue. 21 Key Terms Defined Noncancellable: Cancellable only on remote contingencies. Cancellation provisions/penalties so costly that remote. All cancellable leases are operating leases. Lease term: Begins with leased property transferred to lessee. Ends with fixed noncancellable period, plus all renewal option periods likely to be exercised. Residual value: FV at end of lease term. Lease term may extend over entire economic life of leased asset, so $0. 22 11

Key Terms Defined Bargain renewal period: Attractive lease rate or other favorable provision. At lease inception, likely that renewal will occur. Not extend beyond date of bargain purchase option. Bargain purchase option: Right to purchase leased asset at some future date. Option price is considerably < FV at option date. Expected to be exercised, as to economic advantage. 23 Key Terms Defined Guaranteed residual value (GRV): If FV at end of lease < GRV, lessee pays difference. Protects lessor from unexpected declines in asset FV. Minimum lease payments (MLP): Required lease payments over term of lease. Plus amount paid for bargain purchase option or GRV. Excludes executory charges for insurance, maintenance, taxes, etc. Excludes payments contingent on future events. 24 12

Incremental Borrowing Rate Rate the lessee could borrow money at inception at the lease. Considers lessee s financial condition and economy. Lessee s use this rate to calculate the PV of minimum lease payments if: Lessor s implicit rate not known OR Incremental rate is higher than the implicit rate (which would result in a lower PV of MLP amount). 25 Implicit Interest Rate Rate used by the lessor to calculate desired payment. Always used by lessor to calculate the PV of MLP. Lessee may not be able to calculate if leased asset does not have a readily determinable FV or if reliable residual value not known. Implicit rate example: 48 month lease for $1,166.67 monthly. Selling price = $52,308. 3.4 percent implied interest rate if plugged as the variable in PV calculation. 26 13

Which to Use -- Incremental or Implicit Rate? Lessee: Use incremental borrowing rate in computing PV of lease payments to compare to FV for lease classification purposes. Lessor: Unless it is practicable to compute implicit rate, and implicit rate is less than incremental borrowing rate. Use implicit rate in the lease for computing PV of lease payments for comparison to FV. 27 Capital Lease Accounting Lessee: Rent reclassified as interest and principle obligation payments. Asset is depreciated: If transfer-of-ownership or bargain-purchase, use asset s economic life. If otherwise, use lease term. Lessor: Credit owned assets and debit lease receivable for PV of rents. With each payment, debit cash and credit receivable and unearned interest income. Differentiate between current and long-term. 28 14

Criteria for Capital Lease Treatment 1. Title passes to the lessee by the end of the lease term. 2. Lease contains a bargain purchase option. 3. Lease term at least 75% of estimated economic useful life: Land has unlimited life, so does not apply to land lease. 4. Present value of the minimum lease payments (MLP) at the beginning of the lease term is at least 90% of the asset s fair value. Note: If the lease term begins within the last 25% of the leased asset s total estimated economic life, the 75% and 90% tests are irrelevant. 29 Lessor -- Additional Revenue Recognition Criteria 1. Collectibility of MLP reasonably predictable. 2. No important uncertainties surround amount of unreimbursed costs yet to be incurred by lessor: I.e., any unreimbursable costs yet to be incurred by lessor are known or reasonably estimated at lease inception date. If leased asset constructed by lessor, criterion is applied at the later of the lease inception date or construction completion date. Note: Capital lease if any one of the general criteria are met AND both revenue recognition criteria met. 30 15

Recording Lease Transactions -- Lessee 1. Calculate the minimum lease payments. 2. Calculate the PV of the minimum lease payments: Computed using lower of incremental borrowing rate and known implicit rate. 3. Determine fair value of the asset: Generally, known or estimated selling price of asset. 4. Use the lower of PV or FV to record transaction. 5. Generally, depreciate the leased asset over estimated economic life. 6. Account for the lease obligation using the interest method. 31 Estimated Economic Life Period asset useable for intended purpose at the inception of the lease, with maintenance and repair. Cannot exceed the original lease term if rapid obsolescence. Depreciate capitalized asset over the lease term if title does not pass or not a bargain purchase option: Amortize to expected value, if any, at end of lease. If bargain purchase option, use estimated useful life for depreciation. If land only, do not amortize asset if title transfers or bargainpurchase-option. 32 16

Lease Term Generally, the noncancellable portion of the lease: Add all renewal options reasonably assured or at option of lessor. If bargain purchase option, lease term cannot extend beyond the date option is exercisable. Includes all periods in which a lessee has access to and control over lease space: Even if those periods precede or exceed the fixed noncancellable term stated in the lease agreement (leasehold improvement period). 33 Minimum Lease Payments All payments called for under the lease term. Add any guaranteed residual value by the lessee: E.g., lessor has the right to require the lessee to purchase the property at lease termination for a certain or determinable amount. Includes guarantees made by third parties for lessor. Add penalty payments for not renewing/extending lease: Unless lease extended because of the provision at inception. Add payments made before the beginning of the lease term: Use future value, accreting using same interest rate applied for PV. 34 17

Minimum Lease Payments Add fees paid by the lessee to owners of a special-purpose entity for structuring the lease transaction: Do not consider these fees in the 90 percent test. Generally include payments dependent on existing index or rate (e.g., consumer price index): While subsequent changes in rate are contingent rentals. Generally exclude: Executory costs (insurance, maintenance, taxes) and related profit. Guarantees of lessor s debt. Penalties for which the lease term has been extended. Contingent rentals (payments based on machine hours or sales volume). 35 Bargain Purchase Option -- Lessee PV of BPO included in capitalized lease value: Use date of option to determine the PV of the BPO. Total asset balance amortized over asset life. No gain or loss should be recognized when leased asset purchased: FV of the equipment on the purchase date is ignored unless evidence of significant impairment exists. At option exercise, net balance of leased asset and related accumulated amortization transferred to PP&E. 36 18

Bargain Purchase Option -- Lapse If capitalized asset is ultimately not purchased and the is option allowed to lapse: Loss recognized as difference between remaining leased asset and remaining lease liability (including accrued interest) accounts. 37 Guaranteed Residual Value -- Lessee Residual value similar to salvage value concept: Include guarantee as part of the capitalized lease value. At lease expiration, amount of guarantee reported as liability: Remaining NBV of leased asset will be equal to GRV. If FV of leased asset < GRV, then loss reported for difference: Lessee makes up for difference as cash payment. 38 19

Accounting for Purchase -- Lessee Lessee may acquire leased asset during lease term: Without transfer of ownership of bargain purchase option terms. Purchase price generally different from lease obligation remaining: No gain or loss should be recorded at purchase date. Difference charged/credited to acquired asset s carrying value recorded in regular PP&E. Note: Lessor does recognize a gain/loss on sale of leased asset, which is the difference between the selling price of the asset and the remaining receivable balance (including accrued interest income). 39 Accounting for Purchase -- Lessee Example Assume the following at leased asset purchase date: Remaining lease obligation = $104,132 Interest payable = $10,413 Net book value of leased asset = $100,078 (250,192 less 150,114 accumulated amortization) Purchase price = $120,000 Equipment = $100,078 + (120,000 104,132 10,413) = $105,533 Journal Entry: Dr. Capital lease obligation $104,132 Dr. Accumulated amortization 150,114 Dr. Interest payable 10,413 Dr. Equipment 105,533 Cr. Cash $120,000 Cr. Leased equipment 250,192 40 20

Capital Lease Example -- Lessee Lessors cost of equipment = $50,000. FV of equipment = $50,000. Fixed noncancellable lease term = 5 years. Lessee guaranteed residual value = $2,500. No initial direct costs of negotiating and closing transaction for lessor to capitalize as an intangible asset. 41 Capital Lease Example -- Lessee Annual payment = $14,618.54 due beginning of each year: There will be an annuity due, with unearned income recorded, upon initial recording of payments. Annual payment includes $3,000 of property tax paid by lessee. Total payment associated only with leased asset obligation is $11,618.54. Implicit interest rate = 10%. Assume both known and less than incremental borrowing rate. 42 21

Accounting for Capital Lease -- Lessee Minimum lease payments = $60,592.70: Rental payments $11,618.54 x 5 = $58,092.70. Note: $3,000 x 5 years of executory costs treated as a current period expense, and excluded from MLP calculation. Residual value guarantee (RVG) = $2,500. PV of $60,592.70 @ 10% = $50,000. Record asset and liability at $50,000. PV of MLP > FV provided by lessor. 43 Example Lease Amortization Table Pymt. Date Lease Amount Interest at 10% Lease Liability Relief Lease Liability 50,000 1/1/15 11,618.54 0 11,618.54 38,381.46 1/1/16 11,618.54 3,838.14 7,780.40 30,601.06 1/1/17 11,618.54 3,060.10 8,558.44 22,042.62 1/1/18 11,618.54 2,204.26 9,414.28 12,628.34 1/1/19 11,618.54 1.262.83 10,355.71 2,272.63 GRV 2,500 227.37 2,272.63 0 60,592.70 10,592.70 50,000.00 44 22

Accounting for Capital Lease -- Lessee Depreciate $50,000 asset over 5 year lease term to salvage value of $2,500. Dr. Equipment under capital lease $50,000 Cr. Capital Lease payable $50,000 To record capital lease asset and obligation Dr. Depreciation expense $9,500 Cr. Accumulated depreciation $9,500 To record related annual depreciation: ($50,000 - $2,500 = $47,500 / 5 = $9,500) 45 Exhibit 4: Capital Lease -- Case Study 23

Lessee Accounting Issues Leasehold improvements made by lessee: Revert back to lessor at termination. Depreciated over lesser of lease term or life of asset. Consider option period in lease term. Lease bonus: Periodic payment in addition to rent. Prepayment for future expenses, so prepaid rent. Amortize asset using straight-line method over lease. 47 Lessee Accounting Issues Rent kicker or percentage rent: Premium rent payment that lessor requires. E.g., if sales are over $1 million, excess over amount will have 2% taken out as a rent kicker. Treated as period expense. Not considered in capital vs. operating test. 48 24

Leases Involving Real Estate -- Impact on Estimates and Calculations If both real estate and equipment: Estimate payments applicable to equipment. Segregate for applying lease classification. If both land and buildings: If residual value guarantee, and FV of land is >25 percent of total property, how treat for performing 90 percent test? Multiply FV of the land by the lessee s incremental borrowing rate. Remaining minimum lease payments, including full amount of residual value guarantee, are attributed to the building. 49 Leases Involving Real Estate -- Impact on Estimates and Calculations If only part of a building: Reasonable estimates of the leased property s fair value might be objectively determined by independent appraisal or replacement cost. If FV not objectively determinable, classify using lease-term criterion only. Apply economic life of entire building. 50 25

Leases Involving Real Estate -- Lessee Classification If land only: Account for as operating lease. Unless transfer-of-ownership or bargain-purchaseoption criterion met. If both land and building: If meets either transfer-of-ownership or bargainpurchase-option criterion, capitalize separately. Allocate based on FV proportion at lease inception. Include any escalations for construction or acquisition costs in FV. 51 Leases Involving Real Estate -- Lessee Classification If FV of land is < 25% of total leased property value, consider as a single unit using estimated economic life of building: If lease-term or minimum-lease-payment criterion met, capitalize as a single unit. If FV of land > 25% of total, consider separately for capitalization. 52 26

Exposure Draft: Leases Existing models may fail to provide a faithful representation of transactions: They may omit relevant information about rights and obligations. Lead to lack comparability and undue complexity because of bright line distinction between capital and operating lease types. Many F/S users adjust the statement of financial position to reflect assets and liabilities arising from long-term operating leases. Very common for lessors to record a capital lease an lessees to record an operating lease. 53 Leases of Assets Other Than Property -- Lessee Leases of assets other than property use right to use method, unless: The lease term is an insignificant portion of the economic life of the underlying asset; or The PV of the fixed lease payments is insignificant relative to the FV of the underlying asset. Front-loaded expense recognition pattern. Referred to as Type A leases. 54 27

Leases of Property -- Lessee Leases of property (land/building) straight-line method, unless: Lease term is for the major part of the economic life of the underlying asset; or The PV of fixed lease payments accounts for substantially all the FV of the underlying asset. Referred to as Type B leases. 55 Right to Use Model -- Lessee Right to Use Model: Initially recognize a liability to make lease payments and a right-of-use asset. Both measured at PV of lease payments. Subsequently measure liability to make lease payments using effective interest method. Amortize the asset on a systematic basis that reflects the pattern of consumption of the expected future economic benefits. Recognize interest expense and amortization separately on income statement. 56 28

Straight-Line Lease Model -- Lessee Straight-Line Lease Model: Initially recognize a liability to make lease payments and a right-of-use asset. Both measured at PV of lease payments. Subsequently measure liability to make lease payments using effective interest method. Measure the asset each period as a balancing figure such that the total lease expense would be recognized on a straight-line basis. Regardless of timing of lease payments. Recognize lease expense as one amount in income statement. 57 Thank You! CONNECT WITH US Surgent Professional Education 29