Accounting for Leases by Lessors

Accounting for Leases by Lessors Chapter 19

A capital lease:a lease that, from the point of view of the lessee, transfers substantially all the benefits and risks incident to ownership of property to the lessee [CICA 3065.03(a)] The three guidelines that apply to both lessees and lessors are: lessee will obtain ownership at the end of the lease term; automatic transfer of title---bargain purchase option Classification as a Capital Lease

lessee obtains substantially all of the economic benefits - lease term is at least 75% of the asset’s economic life present value of the minimum net lease payments is equal to at least 90% of the fair value of the asset at the inception of the lease including guaranteed residual Classification as a Capital Lease (cont.)

The two that, in addition, apply only to lessors are: the credit risk associated with the lease is normal the amounts of any unreimbursable costs can be reasonably estimated [CICA 3065.07] Classification as a Capital Lease (cont.)

Classification as a Capital Lease (cont.) • Minimum lease term includes bargain renewal terms, terms prior to the exercisability of a bargain purchase option, and renewal terms at the lessor’s option • Minimum net lease payments includes lease payments during bargain renewal terms, any bargain purchase option price, and any guaranteed residual value • The interest rate used for discounting the net lease payments by the lessor is the rate implicit in the lease

Classification as a Capital Lease (cont.) • In a direct financing lease, the lessor is acting purely as a financial intermediary • A sales-type lease is used by a manufacturer or a dealer as a means of selling a product • There are two profit components in a sales-type lease: • the profit (or loss) on the sale • interest revenue from the lease

Operating Leases • The characteristics of accounting for an operating lease are as follows [CICA 3065.55 and 3065.56]: • the assets that are available for leasing are shown (at cost) on the lessor’s balance sheet • the assets are amortized in accordance with whatever policy management chooses • lease revenue is recognized as the lease payments become due (or are accrued, if the payment dates do not coincide with the reporting periods)

Operating Leases(cont.) • lump sum payments (e.g., at the inception of the lease) are amortized over the initial lease term • initial direct costs (that is, the direct costs of negotiating and setting up the lease) are deferred and amortized over the initial lease term proportionate to the lease revenue

Direct Financing Leases---Net Basis • A direct financing lease arises when a lessor acts purely as a financial intermediary • The lessor in a direct financing lease recognizes revenue as finance revenue or interest revenue on a compound interest basis over the minimum lease term

Current vs. Long Term Balances • If the lessor uses a current/long-term classification: the current portion is the amount by which the principal will be reduced during the next fiscal year, plus any interest accrued to date • The CICA Handbook recommends that the lease receivable “should be disclosed and, in a classified balance sheet, segregated between current and long-term portions” [CICA 3065.54, italics added]

Change in Residual Value • The CICA Handbook recommends that any estimated residual value “be reviewed annually to determine whether a decline in its value has occurred” [CICA 3065.41] • If there has been a decline in value, and if the reduction in the estimated residual value “is other than temporary,” the original salvage value used in the amortization schedule should be replaced by the new estimate

Change in Residual Value (cont.) • Changing a component of the cash flows will change the remaining present value of the receivable, of course, and the AcSB recommends that the resulting reduction be charged to income (that is, as a loss) • Reducing the present value will also reduce the amount of future finance revenue, due to the reduction of the present value base on which the revenue is calculated • Increases in residual value are not accounted for; they are recognized as a gain at disposal

Future Income Taxes • When the lessor accounts for a lease as a capital lease, net income will include imputed interest as finance revenue • On the tax return the lessor will report the full amount of the lease payments as rental revenue and will claim CCA on the leased asset as a tax deduction • Each year there will be a difference between the revenue reported on the income statement and the revenue and expense reported on the tax return

Future Income Taxes (cont.) • This is a temporary difference that gives rise to future income tax liability • Over the life of the lease, the finance revenue (for accounting purposes) will equal the net difference between the rental revenue and the accumulated CCA

Principal Characteristics of the Gross Method • The crucial aspect of reporting a lease is that the balance sheet must show the net present value of the remaining lease payments at all times • The income statement will show the accrued finance revenue (or interest income) earned during the reporting period • Lessors normally use the gross method of recording capital leases, to facilitate control

Principal Characteristics of the Gross Method(cont.) • Gross method of recording capital leases:the lessor records the gross amount of the net lease payments (that is, undiscounted) and offsets that gross amount with the portion that represents unearned revenue for reporting purposes • The gross method yields exactly the same results as the net method • The difference is only one of bookkeeping, not of financial reporting

Disclosure for Lessors • The CICA Handbook recommends only the following disclosures [CICA 3065.54]: • the lessor’s net investment (i.e., the lease payments receivable, less unearned finance revenue) • the amount of finance income • the lease revenue recognition policy

Disclosure For Lessors (cont.) • The CICA Handbook also suggests that “it may be desirable” to disclose 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 • executory costs included in minimum lease payments

Sales-Type Leases • 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 in sales-type leases are manufacturers or dealers, they are not financial institutions and are not acting as financial intermediaries

Sales-Type Leases (cont.) • For the lessor’s financial reporting the distinction matters because a sales-type lease is viewed as two distinct but related transactions: • the sale of the product, with recognition of a profit or loss on the sale • the financing of the sale through a capital lease, with finance income recognized over the lease term

Example: Sales-Type Lease • Assume that on 31 December 20X1, Binary Corporation, a computer manufacturer, leases a large computer to a local university for five years at $200,000 per year, payable at the beginning of each lease year • The normal cash sales price of the computer is $820,000 • The computer cost Binary Corporation (BC) $500,000 to build • The lease states that the computer will revert to BC at the end of the lease term, but a sideletter from BC to the university states BC’s intention not to actually reclaim the computer at the end of the lease

Example: Sales-Type Lease (cont.) • The implicit interest rate that discounts the lease payments to the $820,000 fair value of the computer is 11.04% • Unless the cost of financing is well in excess of this rate, the lease can be assumed to be a capital lease • Because the lessor is the manufacturer of the product, and because the computer is carried on BC’s books at a value that is less than fair value, the lease clearly is a sales-type lease

Example: Sales-Type Lease(cont.) The sale component of the transaction will be recorded as follows (using the gross method): 31 December 20X1: Lease payments receivable 1,000,000 Unearned finance revenue 180,000 Sales revenue 820,000 Cost of goods sold 500,000 Computer inventory 500,000 The first payment will recorded: 31 December 20X1: Cash 200,000 Lease payments receivable 200,000

The Interest Rate Question • The interest rate used in accounting for a capital lease is the rate implicit in the lease • The fair value or “cash price” may not be so obvious • The problem arises because many products that are sold via sales-type leases are subject to discounts or special “deals” wherein the actual price is less than the stated list price • In theory, the lease payments should be discounted to equal the actual price rather than the list price • In practice, this is harder to do because the actual price is often hidden in the transaction

The Interest Rate Question (cont.) • The interest rate does not matter in the long run, because total revenue (the sales price plus finance revenue) will work out the same regardless of the interest rate used in the calculations • However, decreasing the interest rate will have the effect of increasing the reported selling price and thereby shifting revenue (and profit) from the finance period to the period of the sale • Increasing the interest rate would have the opposite effect

The Interest Rate Question (cont.) • The CICA Handbook offers no real assistance. The explanation offered for reporting a sales-type lease is as follows: • the sales revenue recorded at the inception of a sales-type lease is the present value of the minimum lease payments . . . computed at the interest rate implicit in the lease [CICA 3065.43]

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 their products through sales-type leases; e.g., computers and automobiles • A lessor will not be able to claim the full amount of CCA on leased assets if the CCA exceeds the lease payments received, unless the lessor qualifies as a lessor under the income tax regulations

Incidence of Sales-Type Leases (cont.) • 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 use leasing as a sales technique almost inevitably form a separate subsidiary corporation to carry out the leasing activity

After-Tax Accounting for Leases by Lessors • Leases normally are taxed as operating leases, regardless of the accounting treatment; the lessor reports taxable rental receipts and deducts CCA • Leases that are taxed as operating leases but accounted for as capital leases will give rise to temporary differences for income tax accounting • Tax shield: an amount that is deductiblewhen calculating income taxes and therefore shields that taxpayer from some amount of income tax, most frequently used to refer to capital cost allowance

Leveraged Leases • A leveraged lease:one wherein the lessor obtains direct financing for a lease from a third party; the lessor is an intermediary • A non-recourse lease:the third party cannot go to the lessor for repayment if the lessee defaults and the cash stops flowing • the third party can seek redress only from the lessee directly • In non-recourse leases, the lessor does not report the liability to the third party on its balance sheet because the lessor is not liable to the third party except as an intermediary

Leveraged Leases (cont.) • Lease with recourse:the lessor is liable to third parties even if the lessee stops making payments • If the lease is with recourse to the lessor, then the lessor is obligated to the third party and the full liability will be reported on the lessor’s balance sheet • Leases that do not qualify for capital lease treatment are reported as operating leases; the physical asset remains on the lessor’s balance sheet and is depreciated, while the lease payments are reported as rental revenue

Accounting for Leases by Lessors