Intermediate Accounting - McGraw-Hill Education Canada · h o m e b a c k n e x t 19 Copyright 1998...

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


19


Chapter 19

Accounting For Leases ByLessors


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Introduction

■ In 1976 CICA Section 3065 hadvery little impact on accounting bylessors.

■ Lessors who provided assetfinancing through capital leaseshad always treated the leases ascapital leases, reporting as theirassets the financial receivablesfinancial receivablesrather than the physical assetsbeing leased.

■■ CICA Handbook CICA Handbook simply codifiedthe accounting and reportingpractices that the financialintermediary sector of the leasingindustry had always been using.

Chapter Topics:Chapter Topics:

• the criteriacriteria that should exist inorder for a lease to be reportedas a capital lease by the lessor

•• lessor recording lessor recording of operatingoperatingleases,leases,

• the two types of capital leasescapital leasesfrom the lessor�s point of view,

• the two methods of recordingrecordingcapital leasescapital leases,

•• after-tax analysis after-tax analysis and recordingof capital leases, and

•• leveraged leasingleveraged leasing.


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Operating Leases

■ Operating lease [[parasparas. 3065.55 and 3065.56]:. 3065.55 and 3065.56]:• the assets that are available for leasing assets that are available for leasing are shown

(at cost) on the lessor�s balance sheet;

• the assets are depreciated depreciated in accordance withwhatever policy management chooses;

•• lease revenue is recognized lease revenue is recognized as the lease paymentsbecome due (or are accrued, if the payment dates donot coincide with the reporting periods);

•• lump sum payments lump sum payments (e.g., at the inception of thelease) are amortizedamortized over the initial lease term; and

•• initial direct costs initial direct costs (that is, the direct costs ofnegotiating and setting up the lease) are deferred andamortizedamortized over the initial lease term proportionate tothe lease revenue.


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Direct Financing Leases � Net Basis

■ A direct financing lease arises when a lessor actspurely as a financial intermediaryfinancial intermediary.

■ The lessor in a direct financing lease recognizesrevenue as finance revenue or interest revenue finance revenue or interest revenue ona compound interest basis over the minimum leaseterm.


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Basic Example

■ The minimum lease term includes bargain renewalterms and all terms prior to exercisability of a bargainpurchase option.

■ The minimum net lease payments includes allpayments during the lease term (as defined above),less initial direct costs, executory costs and operatingcosts, plus the estimated residual value (whetherguaranteed or unguaranteed).

■ A capital lease results in the physical asset beingremoved from the lessor�s books; the reported asset isthe present value of the minimum net lease payments.


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Residual Value At Renewal Option Time

■ For example, at 12%, the PV of two rental payments of $10,000 at the end ofeach of two years is $16,901, without even taking into consideration anyadditional rental value or salvage value after two years. Rental value isrelated to fair value, and since the PV of the probable rent is much higherthan $10,740, the lessor is not bearing any significant risk if the lesseedecides not to renew after the three-year initial lease term.

■ Even if Lessee Ltd. is not constrained by the terms of the lease, it would beeconomically unsound for the lessee not to renew the lease. If Lessee isable to assign the lease to another company (i.e., enter into a sub-lease),then Lessee would be better off to continue leasing the asset for two yearsat $5,000 and simultaneously rent it out at $10,000, even if Lessee itself hasno further use for the asset. Many leases prohibit the lessee from doing this,however. If the lessee is not going to use the asset, then it reverts to thelessor at renewal time so that the lessor can enjoy the added benefits of theasset by selling or re-leasing it.


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Current Versus Long Term Balances

■■ IfIf the lessor uses a current/long-term classification, the same principle willapply: the current portion is the amount by which the principle will bereduced during the next fiscal year, plus any interest accrued to date.

■ The CICA Handbook CICA Handbook recommends that the lease receivable �should bedisclosed and, in a classified balance sheetin a classified balance sheet, segregated betweencurrent and long-term portions� [CICA 3065.54, italics added].

■ This recommendation recognizes that a lessor may not use a balancesheet format that classifies items as current or long term. Companies whoengage in direct-financing leases are financial institutions (e.g., banksubsidiaries, finance companies, or specialized leasing companies), andfinancial institutions do not classify their assets and liabilities on the basisof current vs. non-current.

■ Therefore, the classification of the current portion of the receivablebalance is generally not an issue for lessors.


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Extended Example

■ The basic example was somewhat unrealistic because:� it assumed that lease payments were made at the end of the year, and

� there were no costs borne by the lessor.

■ Lease payments normally are made at the beginningbeginning of eachlease period, just like rent on an apartment. Also, it is commonfor the lessor to pay some costs for the asset while it is underlease.

■ For example, a lessor may carry the insurance on leasedassets in order to be certain that the assets are properlyinsured. The lessor then increases the lease payments in orderto recover the estimated cost from the lessee. We will modifythe basic example to remove these two simplifications. Theanalytical technique will be the same, however.


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Extended Example

■ At the inception of the lease, the journal entries to record the assetacquisition and receipt of the first lease payment will appear asfollows:� 2 January 20x2:

Lease receivable 55,000

Initial lease expense 2,500

Insurance expense 2,000

Cash 59,500

Cash 20,000

Initial lease expense 2,500

Insurance expense 2,000

Lease receivable 15,500


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Change In Residual Value

■ The CICA Handbook CICA Handbook recommends that any estimated residual value �bebereviewed annually to determine whether a decline in its value hasreviewed annually to determine whether a decline in its value hasoccurredoccurred� [CICA 3065.41].[CICA 3065.41].

■ If there has been a decline in value, and if the reduction in the estimatedresidual value �is other than temporary�, �is other than temporary�, the original salvage valueused in the amortization schedule should be replaced by the newestimate.

■ Changing a component of the cash flows will change the remainingpresent value of the receivable, of course, and the AcSB recommendsthat the resulting reduction be charged to income (that is, as a loss).

■ Reducing the present value will also reduce the amount of future financerevenue, due to the reduction of the present value base on which therevenue is calculated.

■ Increases in residual value are not accounted for; they are recognized asa gain at disposala gain at disposal.


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Future Income Taxes

■ When the lessor accounts for a lease as a capital lease, netincome will include imputed interest as finance revenue.

■ On the tax return, however, the lessor will report the full amount ofthe lease payments as rental revenue and will claim CCA on theleased asset as a tax deduction.

■ Each year there will be a difference between the revenue reportedon the income statement and the revenue and expense reportedon the tax return.

■ This is a temporary difference that gives rise to future income taxliability.

■ Over the life of the lease, the finance revenue (for accountingpurposes) will equal the net difference between the rental revenueand the accumulated CCA.


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Direct Financing Leases � Gross Method

■ Lessors normally use the gross method ofrecording capital leases, to facilitate control.

■ The net method and the gross method give thesame results in the financial statements.


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Principal Characteristics Of The GrossMethod

■ The crucial aspect of reporting a lease is that the balance sheet show the netpresent value of the remaining lease payments at all times. The incomestatement will show the accrued finance revenue (or interest income) earnedduring the reporting period.

■ In practice, lessors are unlikely to use the net method. Instead, an alternativeapproach is used wherein the lessor records the gross amount of the net leasepayments (that is, undiscounted) and offsets that gross amount with the portionthat represents unearned revenue for reporting purposes. Because this mostcommon lessor method of recording uses the undiscounted lease payments, themethod is called the gross method gross method of recording leases. The CICA HandbookCICA Handbookimplicitly assumes that lessors will use the gross method (whereas the netmethod is assumed for lessees). The reasons for using the gross method will bediscussed following the example below.

■ It should be emphasized at the outset that the gross and net methods result inthe same amounts in the financial statements. The difference is only one ofbookkeepingbookkeeping, not of financial reportingfinancial reporting.


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Extended Example � Gross Method

■ The gross method yields exactly the sameresults as the net method. The gross methodlooks more complex, and probably is not sointuitively obvious, but it is a matter ofindifference for financial reporting whichmethod is used. They are only differentmethods of recordingrecording, not of reportingreporting.


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Why Use The Gross Method?

■ Like almost all of the accounts shown on any company�s balance sheet, theLease Receivables account is a control accountcontrol account.

■ The Lease Receivables is much like Accounts Receivable. The balance sheetamount is a total; underlying that total is a large number of individual leases.For good internal control, an important characteristic of a control account is thatit be easily reconcilable to the underlying subsidiary records. For LeaseReceivables, that means that the receivables for the individual leases can besummed to verify the balance in the control account.

■ The gross method makes that reconciliation easier. Since the amounts in theLease Payments Receivable account are gross amounts, the balance can beverified by adding the remaining gross payments shown on all of the individualleases. Under the net method, by contrast, it is necessary to compute thepresent value of each lease at a particular point of time in order to perform thereconciliation. The gross method has the advantage of separating the controlaccount function (via the Lease Payments Receivable) from the revenuerecognition function (via the Unearned Finance Revenue).


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Disclosure For Lessors

■ The disclosure requirements for lessors are quite simple. TheCICA Handbook CICA Handbook recommends only the following disclosures[CICA 3065.54]:[CICA 3065.54]:� the lessor�s net investment (i.e., the lease payments receivable, less

unearned finance revenue);

� the amount of finance income; and

� the lease revenue recognition policy.

■ The CICA Handbook CICA Handbook also suggests that �it may be desirable� �it may be desirable� todisclose the following information:� the aggregate future minimum lease payments receivable (that is, the

gross amount);

� the amount of unearned finance income;

� the estimated amount of unguaranteed residual values; and

� executory costs included in minimum lease payments.


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Sales-Type Leases

■ Basic Nature� A sales-type lease is a capital lease that, from the lessor�s point

of view, represents the sale of an item of inventory. Lessors insales-type leases are manufacturers or dealers, they are notfinancial institutions and are not acting as financialintermediaries.

� For the lessor�s financial reporting, however, the distinctionmatters because a sales-type lease is viewed as two distinct(albeit related) transactions:

✜ the sale of the product, with recognition of a profit or loss on thesale; and

✜ the financing of the sale through a capital lease, with financeincome recognized over the lease term.


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Incidence Of Sales-Type Leases

■ The incidence of sales-type leases in Canada is, technically, rather rare.

■ There are a lot of manufacturers and/or dealers who do appear to sell theirproducts through sales-type leases. Common examples are computersand automobiles. But a lessor will not be able to claim the full amount ofCCA on leased assets if the CCA exceeds the lease payments received,unlessunless the lessor qualifies as a lessor under the income tax regulations.

■ To qualify, a lessor must obtain at least 90% of its revenue from leasing.

■ In order for the leases to receive full tax advantage, companies that useleasing as a sales technique almost inevitably form a separate subsidiarycorporation to carry out the leasing activity.

■ The leasing subsidiary may not be a �real� �real� company in the sense that it isautonomous and has separate management; the subsidiary may be nomore than a filing cabinet full of lease agreements.


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After-Tax Accounting For Leases ByLessors

■ Leases normally are taxed as operating leases, regardless of theaccounting treatment; the lessor reports taxable rental receipts anddeducts CCA.Leases that are taxed as operating leases but accounted for as capitalleases will give rise to temporary differences for income tax accounting.

■ If a lessor classifies its assets between current and long term, the currentportion is the amount of the total receivable at the balance sheet date(including accrued interest receivable) that will be received within thenext year.

■ Lessors often account for leases on an after-tax basis, wherein the cashflows and the interest rate used in the present value and compoundingcalculations are computed after taking income tax effects into account.


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Leveraged Leases

■ A leveraged lease is one wherein the lessor obtains directfinancing for a lease from a third party; the lessor is anintermediary. Usually, the third party cannot go to the lessor forrepayment if the lessee defaults and the cash stops flowing; this isknown as a non-recourse lease. The third party can seek redressonly from the lessee directly. In non-recourse leases, the lessordoes not report the liability to the third party on its balance sheetbecause the lessor is not liable to the third party except as anintermediary.

■ Leases that do not qualify for capital lease treatment are reportedas operating leases; the physical asset remains on the lessor�sbalance sheet and is depreciated, while the lease payments arereported as rental revenue.

Intermediate Accounting - McGraw-Hill Education Canada · h o m e b a c k n e x t 19 Copyright 1998...

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