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Accounting for Leases by Lessors
Chapter 19
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Classification as a Capital Lease
A capital lease:a lease that, from the pointof view of the lessee, transfers substantially all
the benefits and risks incident to ownership of
property to the lessee [CICA3065.03(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 pu rchase opt ion
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Classification as a Capital Lease (cont.)
lessee obtains substantially all of theeconomic benefits - lease term is at least
75% of the assets economic lifepresent value of the minimum net leasepayments is equal to at least 90% of the fairvalue of the asset at the inception of thelease including guaranteed residual
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Classification as a Capital Lease (cont.)
The two that, in addition, apply only to lessorsare:
the credi t r isk associated with the lease isnormal
the amounts of any un reimbursable cos ts canbe reasonably estimated [CICA 3065.07]
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Classification as a Capital Lease (cont.)
Minimum lease term includes bargain renewalterms, terms prior to the exercisability of a bargainpurchase option, and renewal terms at the lessorsoption
Minimum net lease payments includes leasepayments during bargain renewal terms, any bargainpurchase option price, and any guaranteed residualvalue
The in terest rate used fo r discoun t ing the netlease paymentsby the lessor is the rate impl ic i t inthe lease
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Classification as a Capital Lease (cont.)
In a direct financing lease, the lessor is actingpurely as a financial intermediary
A sales-type lease is used by a manufacturer or adealer as a means of selling a product
There are two profit components in a sales-typelease:
the profit (or loss) on the sale
interest revenue from the lease
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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 lessors balance sheet
the assets are amortized in accordance withwhatever policy management chooses
lease revenue is recognized as the lease
payments become due (or are accrued, if thepayment dates do not coincide with thereporting periods)
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Operating Leases(cont.)
lump sum payments (e.g., at the inceptionof the lease) are amortized over the initiallease term
initial direct costs (that is, the direct costsof negotiating and setting up the lease)are deferred and amortized over the initiallease term proportionate to the lease
revenue
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Direct Financing Leases---Net Basis
A direct financing lease arises when a lessor actspurely as a financial intermediary
The lessor in a direct financing lease recognizesrevenue as finance revenue or interest revenue on acompound interest basis over the minimum leaseterm
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Current vs. Long Term Balances
If the lessor uses a current/long-termclassification: the current portion is the amountby which the principal will be reduced during the
next fiscal year, plus any interest accrued to date The CICA Handbookrecommends that the lease
receivable should be disclosed and, in a
classified balance sheet, segregated betweencurrent and long-term portions [CICA3065.54,italics added]
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Change in Residual Value
The CICA Handbookrecommends that anyestimated 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 thereduction in the estimated residual value is other
than temporary, the original salvage value used in
the amortization schedule should be replaced bythe new estimate
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Change in Residual Value (cont.)
Changing a component of the cash flows will changethe remaining present value of the receivable, ofcourse, 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 thereduction 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
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Future Income Taxes
When the lessor accounts for a lease as a capitallease, net income will include imputed interest asfinance revenue
On the tax return the lessor will report the fullamount of the lease payments as rental revenueand will claim CCA on the leased asset as a taxdeduction
Each year there will be a difference between therevenue reported on the income statement and therevenue and expense reported on the tax return
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Future Income Taxes (cont.)
This is a temporary difference that gives rise tofuture income tax liability
Over the life of the lease, the finance revenue (foraccounting purposes) will equal the net differencebetween the rental revenue and the accumulated
CCA
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Principal Characteristics
of the Gross Method
The crucial aspect of reporting a lease is that thebalance sheet must show the net present value ofthe remaining lease payments at all times
The income statement will show the accruedfinance revenue (or interest income) earnedduring the reporting period
Lessors normally use the gross method ofrecording capital leases, to facilitate control
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Principal Characteristics
of the Gross Method(cont.)
Gross method of recording capital
leases:the lessor records the gross amount ofthe net lease payments (that is, undiscounted) and
offsets that gross amount with the portion thatrepresents 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
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Disclosure for Lessors
The CICA Handbookrecommends only thefollowing disclosures [CICA3065.54]:
the lessors net investment (i.e., the lease
payments receivable, less unearned financerevenue)
the amount of finance income
the lease revenue recognition policy
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Disclosure For Lessors (cont.)
The CICA Handbookalso suggests that itmay be desirable to disclose the followinginformation:
the aggregate future minimum lease paymentsreceivable (that is, the gross amount)
the amount of unearned finance income
the estimated amount of unguaranteed residualvalues
executory costs included in minimum leasepayments
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Sales-Type Leases
A sales-type lease is a capital lease that,from the lessors point of view, represents
the sale of an item of inventory Lessors in sales-type leases are
manufacturers or dealers, they are notfinancial institutions and are not acting asfinancial intermediaries
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Sales-Type Leases (cont.)
For the lessors financial reporting the
distinction matters because a sales-typelease is viewed as two distinct but relatedtransactions:
the sale of the product, with recognition of aprofit or loss on the sale
the financing of the sale through a capitallease, with finance income recognized overthe lease term
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Example: Sales-Type Lease
Assume that on 31 December 20X1, BinaryCorporation, a computer manufacturer, leases a largecomputer to a local university for five years at$200,000 per year, payable at the beginning of eachlease year
The normal cash sales price of the computer is$820,000
The computer cost Binary Corporation (BC) $500,000to build
The lease states that the computer will revert to BC atthe end of the lease term, but a sideletterfrom BC tothe university states BCs intention not to actuallyreclaim the computer at the end of the lease
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Example: Sales-Type Lease (cont.)
The implicit interest rate that discounts the leasepayments to the $820,000 fair value of thecomputer is 11.04%
Unless the cost of financing is well in excess of thisrate, the lease can be assumed to be a capitallease
Because the lessor is the manufacturer of the
product, and because the computer is carried onBCs books at a value that is less than fair value,
the lease clearly is a sales-type lease
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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
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The Interest Rate Question
The interest rate used in accounting for a capital leaseis 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 orspecial deals wherein the actual price is less thanthe 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
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The Interest Rate Question (cont.)
The interest rate does not matter in the long run,because total revenue (the sales price plus financerevenue) will work out the same regardless of theinterest rate used in the calculations
However, decreasing the interest rate will have theeffect of increasing the reported selling price andthereby shifting revenue (and profit) from the financeperiod to the period of the sale
Increasing the interest rate would have the oppositeeffect
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The Interest Rate Question (cont.)
The CICA Handbookoffers no real assistance.The explanation offered for reporting a sales-type lease is as follows:
the sales revenue recorded at the inception of asales-type lease is the present value of theminimum lease payments . . . computed at theinterest rate implicit in the lease [CICA3065.43]
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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 dealerswho do appear to sell their products through
sales-type leases; e.g., computers andautomobiles
A lessor will not be able to claim the full amountof CCA on leased assets if the CCA exceeds thelease payments received, unlessthe lessorqualifies as a lessor under the income taxregulations
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Incidence of Sales-Type Leases (cont.)
To qualify, a lessor must obtain at least 90% of itsrevenue from leasing
In order for the leases to receive full tax advantage,
companies that use leasing as a sales techniquealmost inevitably form a separate subsidiarycorporation to carry out the leasing activity
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After-Tax Accounting for Leases
by Lessors
Leases normally are taxed as operating leases,regardless of the accounting treatment; the lessorreports taxable rental receipts and deducts CCA
Leases that are taxed as operating leases butaccounted for as capital leases will give rise totemporary differences for income tax accounting
Tax shield: an amount that is deductiblewhen
calculating income taxes and therefore shields thattaxpayer from some amount of income tax, most
frequently used to refer to capital cost allowance
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Leveraged Leases
A leveraged lease:one wherein the lessorobtains direct financing for a lease from a thirdparty;the lessor is an intermediary
A non-recou rse lease:the third party cannot
go to the lessor for repayment if the lessee defaultsand the cash stops flowing
the third party can seek redress only from thelessee directly
In non-recourse leases, the lessor does not reportthe liability to the third party on its balance sheetbecause the lessor is not liable to the third partyexcept as an intermediary
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Leveraged Leases (cont.)
Lease with recourse:the lessor is liable to thirdparties 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 lessors balancesheet
Leases that do not qualify for capital lease treatmentare reported as operating leases; the physical asset
remains on the lessors balance sheet and isdepreciated, while the lease payments are reportedas rental revenue