Forensic accounting questions and answers pdf

Forensic Accounting: Case Study

Memorandum

To: Tech Startup Inc. Controller's Group Files

From: [Student Name], Controller's Group Analyst

Re: Lease of 15 Tech Drive

Date: X/X/XXXX

Facts

See facts as given in case study.

Issues/ Question

Should the lease arrangement be classified as an operating lease or as a capital lease?

Analysis

Lessee must determine whether to account for its lease as a capital or operating lease. ASC 840-10-25-1 provides the following lease classification criteria:

25-1 A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception under the guidance in the Lessees Subsection of this Section (for the lessee) and the Lessors Subsection of this Section (for the lessor):

a. Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term....

b. Bargain purchase option. The lease contains a bargain purchase option.

c. Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property...

d. Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor...

In addition to these four criteria, ASC 840 provides the following guidance regarding lessees' application of lease classification criteria:

25-29 If at its inception a lease meets any of the four lease classification criteria in paragraph 840-10-25-1, the lease shall be classified by the lessee as a capital lease.

Accordingly, Lessee has analyzed each criterion individually to determine whether it is met for this lease.

Analysis—Transfer of Ownership

The lease does not call for transfer of ownership at the end of the lease term. This condition for capital lease treatment is therefore not met.

Analysis—Bargain Purchase Option

Lessee is given the option to purchase the leased property at the end of the lease term for a price ($16.25M) that is below the estimated lease-end fair value of the property ($17M). This contractual provision bears further consideration.

The glossary of ASC 840-10 defines a bargain purchase option as:

A provision allowing the lessee, at his option, to purchase the leased property for a price that is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at lease inception, to be reasonably assured.

Little other guidance is provided within the Codification to assist a lessee in determining whether a purchase option is, in fact, a bargain. However EY’s guide book, Lease Accounting (2014), Section 2.4 (page 2), offers additional guidance for applying this condition. In particular, EY notes that—when determining whether exercise of a purchase option meets the threshold of being reasonably assured—entities should consider factors such as (1) how far into the future the purchase option is being offered, where a longer term could decrease the likelihood of exercise, and (2) the stability of the property’s value. An excerpt of this guidance follows:

The further into the future a lessee is required to consider, the less precise will be the estimates of future needs for the leased asset. Also, the fair value of certain types of assets is more likely to change over time than will the value of other types of assets (e.g., the future value of a technology asset, such as a computer, is more difficult to predict than the future value of a relatively stable asset, such as a fully-leased commercial office building located in a prime area).

Accordingly, the further into the future the option date, the lower the option price must be in relation to the estimated future fair value to reasonably assure exercise. Also, the relationship at a future point in time between the option price and the estimated future fair value should be lower for an asset subject to significant changes in value than would be the case for an asset having a relatively stable value.

In this case, the determination is judgmental. Although the option is fairly far into the future (10 years is somewhat long given that the company is a tech startup whose needs could change), the building is supposedly in a prime area and thus a $750K discount off of its purchase price could be compelling.

In Section 2.4.3 of its Lease Accounting guide, EY goes on to emphasize (in Illustration 2-2) that external factors should be considered when determining whether exercise of a purchase option is reasonably assured:

Illustration 2-2: Determining whether a bargain purchase option exists

Assume a company leases equipment from a lessor under a 5-year lease that includes an option for the lessee to purchase the equipment at the end of the lease term for $900,000. The lessee estimates that the equipment will have a fair value at the end of the lease term of $1,000,000. The equipment is expected to be readily available in the market at the end of the lease term.

The lessee determined that the purchase option would not be considered reasonably assured of exercise and therefore a bargain because while it is priced below estimated fair value, the discount is not so significant that exercise rises to the level of reasonably assured. Therefore, the option does not qualify as a bargain purchase option.

Again, consistent with this guidance, the purchase option in this case is close enough to the estimated future fair value of the building that its exercise likely does not rise to the level of being reasonably assured. This is especially true in this case when you consider the company’s specific situation as a tech startup. Accordingly, a bargain purchase option is not deemed to exist.

Analysis—Lease Term

This lease is for a 10-year term, which is 25% of the estimated useful life of the leased property. As this is below the 75% threshold for capital lease classification, this condition is not met.

Considering also the definition of lease term, any bargain renewal options should also be included in the lease term. In this case, no such renewal options are present.

Analysis—Minimum Lease Payments

Lessee will pay $50,000 monthly plus a contingent amount determined as 1% of its sales. Lessee must evaluate whether these rental payments exceed 90% of the fair value of the leased property and, accordingly, would result in capital lease treatment.

ASC 840-10-25-4 provides the following guidance indicating that lease payments based on sales volume should not be considered when calculating the minimum lease payments payable under the lease:

> Minimum-Lease-Payments Criterion

25-4 This guidance addresses what constitutes minimum lease payments under the minimum-lease-payments criterion in paragraph 840-10-25-1(d) from the perspective of the lessee and the lessor. Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. (Example 6 [see paragraph 840-10-55-38] illustrates this guidance.) [Emphasis added]

Example 6 of Topic 840-10's implementation guidance further illustrates this point, stating that rental payments based on sales are contingent, and should not be counted in determining minimum lease payments. The guidance states that: "the future sales for the lease term do not exist at lease inception..."

> > Example 6: Applying the Definition of Contingent Rentals—Rentals Contingent on Factor Related to Future Use

55-38 This Example illustrates paragraph 840-10-25-4, which states that lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours or use of sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. Assume that a lease agreement for retail store space stipulates a monthly base rental of $200 and a monthly supplemental rental of one-fourth of one percent of monthly sales volume during the lease term. Even if the lease agreement is a renewal for store space that had averaged monthly sales of $25,000 for the past 2 years, minimum lease payments would include only the $200 monthly base rental; the supplemental rental is a contingent rental that is excluded from minimum lease payments. The future sales for the lease term do not exist at lease inception, and future rentals would be limited to $200 per month if the store were subsequently closed and no sales were made thereafter. [Emphasis added]

Therefore, the 1% of sales (an estimated $20,000 per month) shall be excluded when determining the minimum lease payments for purposes of the 90% test.

Therefore, the fixed monthly rental payment shall be used to evaluate whether the minimum lease payments condition is met. These payments amount to: $50,000 per month, times 12 months, times 10 years, equals a total lease payment of $6 million (ignoring discounting). This is less than 90% of the fair value of the leased property.

Notably, had Lessee concluded that the lease contained a bargain purchase option, this option would also need to be included when determining minimum lease payments, per par. 25-6:

25-6 If the lease contains a bargain purchase option, only the minimum rental payments over the lease term and the payment called for by the bargain purchase option shall be included in the minimum lease payments.

However, given our conclusion that no bargain purchase option is present, this amount shall be excluded from the calculation, and the 90% condition for capital lease treatment is not met.

Conclusion

This lease shall be classified as an operating lease. None of the four conditions for capital lease accounting was met. Namely, (1) the lease does not transfer ownership at the end of the lease term, (2) the lease does not contain a bargain purchase option that is reasonably assured of being exercised, (3) the lease term is less than 75% of the economic life of the leased asset, and (4) the minimum lease payments are less than 90% of the fair value of the leased asset.

Judgment was involved in determining that the end-of-lease term purchase option is not considered a bargain. In this case, the Lessee’s business circumstances (of being a tech startup) were considered, in addition to the length into the future (10 years) at which this option is offered, and the amount of discount versus the expected fair value of the leased asset, which was not deemed significant enough to cause the purchase option to rise to the level of being reasonably assured.