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Response to Client Request I

Subject: Research leases and lease structure issues on the FASB website, in particular

related to sales types, direct financing, and operating leases.

On the FASB website, the SFAS N0.13 discusses the Accounting for Leases that relate

to two objectives on the lease: lessee and lessor. According to this statement, the lessee classifies

the leases as operating leases and capital leases. The FASB also indicates the lease must meet at

least one or more of four criteria so that it is treatedas capital lease. Otherwise, it is categorized

as an operating lease. Four criteria are listedas following:

- There is a transfer of ownership to the lessee at the end of the lease term- There is an option to purchase the asset at a "bargain price" at the end of the lease term- The lease life exceeds 75% of the life of the asset- The present value of the lease payments, discounted at an appropriate discount rate,

exceeds 90% of the fair market value of the asset.

On the other hand, leases are categorizedas direct financing, sales types, leverage, and operating

leases from the lessors point of view. Both direct financing and sales type leases must satisfy

one or more of the four above criteria. In addition, they also need to satisfy two additional

criteria

Collectibility of the minimum lease payments is reasonably predictable.

No important uncertainties surround the amount of unreimbursable costs yet to beincurred by the lessor under the lease (Schroeder, Clark, & Cathey, 2005, p. 420.

The general examination of direct financing, sales-type and operating leases will help the

regional truck company choose the suitable lease for its operation.

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Direct Financing Leases

The direct financing lease occurs when there is no manufacturers or dealers profits (or

losses) are recorded. The lessor only purchases the property for the purpose of leasing it, and the

lessor does not make profit at the time of sale. The lessor is viewed as a lending institution for

revenue recognition purposes. At the leases origination, the FASB requires the lessor record the

minimum lease payment as a receivable on the transactions date. Unearned interest revenue is

the difference between gross investment and the cost of the leased property; andit is amortized

to income during the lease. The net investment equals gross investment less the unearned

income. Furthermore, the lessor needs to review the residual value annually. If the estimated

value declines, accountants should revise the changing, and the decrease is recordedat a loss in

the period that the estimate is changed.

Sales type leases

A sales type lease is a lease when there are profits or losses of the manufacturers or

dealers. The lessor sets a selling price above the asset cost, therefore, there is a recognizing a

profit at the inception of the lease. The assets fair market value is greater than the cost of the

lease asset. The initial direct costs should associate with obtaining the lease agreements are

written off when the sale is recoded. The lessor will debit lease receivables and cost of goods

sold and credit sales, unearned income andinventory. When sale is recorded, the initial cost is

associated with getting the lease agreement is written off.

Regarding the types of sales-type and direct financing lease, the FASB has established

some disclosure requirements for them. Some of disclosure requirements are the future minimum

lease payment, the unguaranteed residual value, contingent rentals, and general description of the

leasing arrangement.

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Operating Leases

An operating lease is a lease that does not meet the criteria for categorization as direct

financing or sales-type lease. Operating lease is cancelable leases that mean the equipments can

be returnedif they become obsolete or too old. The leased equipment is reported on the balance

sheet and the accumulated depreciation is deductedfrom the book value of the lease equipment.

The rent is reportedas income over the lease term when it becomes receivable. The lessor will

debit cash and credit rental revenue to record receiving rental payments from the lessee. With

operating lease, the lessor also can claim depreciation expenses and tax benefits.

Recommendation

After researching each type of lease on the FASB website to determine which lease is the

best choice for the truck company, the recommendation is the company should go with the

operating lease. Developing more clients, the truck companys business will expand its business

in the rental truck market. In addition, the truck company has capacity to meets customers

requirements and builds good relationships with its customers. Additionally, the truck company

can obtainseveral benefits from tax deduction and depreciation expenses. The best choice for the

truck company is to choose operating lease that helps the company meets customers

requirement and the company has the opportunities to do business with this customers for long.

Based on the research of the direct financing, sales-type and operating lease on the FASB

website, the above memo gives brief information about each type of lease. The consultants

recommendation isto choose the operating lease. Please do not hesitate to contact our team

consultant if the client has any questions regarding the leases.

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