Trying to appreciate new lease depreciation decision

 

I am getting ready to teach the leasing module in my MAcc class.  I was going over the decisions to date on the FASB web, and I found the following:

“Lease payments should include amounts expected to be payable under residual value guarantees… The Boards discussed the subsequent measurement of residual value guarantees by lessees … and tentatively decided that:

The amounts expected to be payable under residual value guarantees included in the measurement of the lessee’s right-of-use asset should be amortized consistently with how other lease payments that are included in the measurement of a right-of-use asset are amortized. That is, amortization should be on a systematic basis from the date of commencement of the lease to the end of the lease term…”

So let’s suppose the guaranteed residual = expected residual = $10,000.  At the end of the lease, the lease liability will be $10,000.  The expected cash payment to the lessor is zero, and it will be zero if the asset is worth at least $10,000.  But the asset’s carrying value is zero.  This means a gain when the asset is returned.

Under current accounting for capital leases with guaranteed residual value, the residual value is used as salvage value when calculating depreciation for the leased asset.  If I am reading this tentative decision correctly, all future leases will have to use zero as the salvage value.  That will generally produce overstated depreciation expenses over the lease term followed by a gain at the end of the lease.  Why would the Boards do this?  Do they mistrust the accuracy of residual values?  Or am I misreading the words?

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Straight Line Depreciation: the most common of accounting depreciation methods

Straight line depreciation is the simplest and most frequently used depreciation method for financial reporting purposes.

Straight line depreciation is based on the assumption that the assets usefulness declines evenly over time. Increased activity or use of the asset has no bearing on the amount of depreciation each year since it is the same every period.

To calculate asset depreciation under the straight line method, simply divide the depreciation basis (cost – salvage value) by the estimated useful life.

Calculate Depreciation: Straight Line Depreciation Method

(Acquisition cost – Estimated salvage value)
Estimated Useful Life

If Sunny places a vehicle he purchased for $12,800 in service as of the beginning of 2010 with an estimated life of five years, and a $1,000 salvage value, Sunny would calculate straight line depreciation as $2,360 per year:

The straight line depreciation method can also be expressed as a depreciation rate:

In this case, the depreciation rate = 20% (1/5). The depreciation rate is then multiplied by the cost less any salvage value, to arrive at the same amount: $2,360.

Graphically, straight line depreciation is a straight line spread over the course of 5 years, with a $2,360 depreciation expense taken each year on the income statement.

Straight Line Depreciation Method

When viewed graphically, it is easy to see where the straight line depreciation method gets its name. The depreciation expense holds steady during the time period, resulting in a linear graph.

Straight Line Depreciation Book Value

Similarly, the book value of the asset declines steadily over the course of the asset depreciation period, since an even amount of depreciation is taken each period. Notice that the depreciation is taken from the total acquisition cost of $12,800, not the depreciation base of $11,800.

The accounting journal entry at the end of each year is entered as:

To record annual depreciation expense of company vehicle.

At the end of year five, the book value equals the salvage value of $1,000. The company vehicle is listed on the balance sheet at the original acquisition or historical cost, less the accumulated depreciation amount:

Accumulated depreciation is a contra account to the property plant and equipment account that reduces the asset balance to the carrying value of the asset, or its historical cost less the total accumulated depreciation.