SEC comment letter. In the comment letter, the SEC asked the company to clarify
ID: 2335141 • Letter: S
Question
SEC comment letter. In the comment letter, the SEC asked the company to clarify its application of AsC &4 Locate this comment letter (see comment #2, Rent Expense), and describe: 840-20 What is the SEC's concern? . What is the company's response? Carefully read, then summarize the company's position and rationale. What information can you gather from this correspondence that may go above and beyond the compan . nual filing disclosure? Finally, notice how readily the company was able to refer to SEC staff guidance that supported their accounting Dos tion. It's like they already had a thoughtful accounting memo on hand, ready to go! Lease Classification, Considering Firm Guidance (Issues Memo) Facts: Tech Startup Inc. ("Lessee") is entering into a contract with Developer Inc. ("Landlord") to rent Landlordt newly constructed office building located at 15 Tech Drive in San Francisco, CA. The lease term is 10 years, and the estimated life of the building is 40 years. Lessee will occupy all 12 floors of the building. At the end of the lease term, Lessee has the option to purchase the property for $16.25 million. The fair value of the building at that time is expected to be $17 million. 5.7 Monthly, Lessee will be required to pay $50,000 to occupy the building, plus a monthly supplemental remtal cost based on Lessee's sales (1% of sales). From experience, Lessee estimates that 1% of its sales should approxi. mate an additional $20,000 per month. For simplicity, please ignore discounting (use of present value calculations rates implicit in the lease, etc.) for purposes of this example. There are no residual value guarantees present in this example. Required: You are a corporate accountant for Lessee and have been asked to prepare an accounting issues memo address the following issue: Should the lease arrangement be classified as an operating lease or as a capital lease Assume that this arrangement is within the scope of lease accounting guidance. As needed to clarify areas ing guide book. Case Studies Involving Energy Works (5.8-5.10) judgment, support your response with guidance from both the Codification and from EY's most recent Lease account Understanding Joint Ventures, using Nonauthoritative Guidance The term joint ventures has a very spec finition and application in U.S. GAAP, as you saw illustrated in the previous chapter's Energy Works example 5.8 ific First, locate Codification guidance defining a corporate joint venture, and explain the requirements to meet this definition. l. anExplanation / Answer
Memorandum
To: Tech Startup Inc. - Accounting Files
From:
Date:
Re: Accounting for Lease Arrangement
Facts
Tech Startup Inc. (“Lessee”) is entering into a contract with Developer Inc (“Landlord”) to rent Landlord’s newly constructed office building. The lease term is 10 years, and the estimated life of the building is 40 years. Lessee will occupy all 12 floors of the building. At the end of the lease term, Lessee has to option to purchase the property for $16.25 million, at which time the fair value of the building at that time is expected to be $17 million. Monthly, Lessee will be required to pay $50,000 to occupy the building, plus a monthly supplemental rental cost based on Lessee’s sales (1% of sales) which Lessee estimates to be approximately $20,000 per month.
Issues
1.Should the lease arrangement be classified as an operating lease or as a capital lease?
Analysis – Issue 1: Should the lease arrangement be classified as an operating lease or as a capital lease?
To determine the appropriate classification of the lease entered into by Tech Startup, Inc., FASB Accounting Standards Codification (ASC) 840-10 (Leases - Overall) was consulted for guidance. To determine the type of lease, ASC 840-10-25-1 (Lease Classification Criteria) reads, in pertinent part
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. This criterion is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term in exchange for the payment of a nominal fee, for example, the minimum required by statutory regulation to transfer title.
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. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.
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. If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.
The application of subsections a, c, and d are found to be not applicable to this lease. There is not a transfer of ownership, but rather the option of Tech Startup Inc to purchase the building. The lease term is less than 75 percent of the estimated economic life of the building making subsection c not applicable. The lease payments do not constitute more than 90 percent of the fair value of the leased property less related investment tax credits, as per the facts presented there aren’t any credits held by the lessor. However a bargain purchase option is 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.
Arguably the discount of nearly three-quarters of a million dollars would incentivize the purchase, especially when taking into consideration the added expense and inconvenience of moving at the end of the lease term. The discount equates to over three years of anticipated lease payments, which is further assurance that the purchase will be pursued.
Furthermore, ASC 840-10-20 (Glossary) defines a Capital Lease as “From the perspective of a lessee, a lease that meets any of the four lease classification criteria in paragraph 840-10-25-1”. Due to the lease meeting the criteria as defined therein, specifically subsection b, this lease constitutes as a capital lease.
Under ASC 840-10-20, an operating lease is defined from the perspective of the lessee, any lease that is not a capital lease. Therefore, given the assertion that this lease is in fact, a capital lease, it cannot be an operating lease.
Conclusion
Given the guidance found in the ASC,
The lessee shall recognize a capital lease as an asset and an obligation. This recognition would include would include an entry to measure the capital lease as an asset and obligation in the amount of the present value at the beginning of the lease term of the minimum lease payments during the lease term excluding that portion which would present executory costs.
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