Intermediate Accounting
Thomas H. Beechy
Schulich School of Business,
York University
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Chapter 19
Accounting For Leases By
Lessors
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Introduction
In 1976 CICA Section 3065 had
very little impact on accounting by
lessors.
Lessors who provided asset
financing through capital leases
had always treated the leases as
capital leases, reporting as their
assets the financial receivables
rather than the physical assets
being leased.
CICA Handbook simply codified
the accounting and reporting
practices that the financial
intermediary sector of the leasing
industry had always been using.
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
Chapter Topics:
•
the criteria that should exist in
order for a lease to be reported
as a capital lease by the lessor
•
lessor recording of operating
leases,
•
the two types of capital leases
from the lessor’s point of view,
•
the two methods of recording
capital leases,
leases
•
after-tax analysis and recording
of capital leases, and
•
leveraged leasing.
leasing
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Operating Leases
Operating lease [paras. 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 depreciated 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);
• lump sum payments (e.g., at the inception of the
lease) are amortized over the initial lease term; and
• 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.
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Direct Financing Leases – Net Basis
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A direct financing lease arises when a lessor acts
purely as a financial intermediary.
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.
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Basic Example
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The minimum lease term includes bargain renewal
terms and all terms prior to exercisability of a bargain
purchase option.
The minimum net lease payments includes all
payments during the lease term (as defined above),
less initial direct costs, executory costs and operating
costs, plus the estimated residual value (whether
guaranteed or unguaranteed).
A capital lease results in the physical asset being
removed from the lessor’s books; the reported asset is
the 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 of
each of two years is $16,901, without even taking into consideration any
additional rental value or salvage value after two years. Rental value is
related to fair value, and since the PV of the probable rent is much higher
than $10,740, the lessor is not bearing any significant risk if the lessee
decides 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 be
economically unsound for the lessee not to renew the lease. If Lessee is
able 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 years
at $5,000 and simultaneously rent it out at $10,000, even if Lessee itself has
no 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 the
lessor at renewal time so that the lessor can enjoy the added benefits of the
asset by selling or re-leasing it.
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Current Versus Long Term Balances
If the lessor uses a current/long-term classification, the same principle will
apply: the current portion is the amount by which the principle 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,
sheet segregated between
current and long-term portions” [CICA 3065.54, italics added].
This recommendation recognizes that a lessor may not use a balance
sheet format that classifies items as current or long term. Companies who
engage in direct-financing leases are financial institutions (e.g., bank
subsidiaries, finance companies, or specialized leasing companies), and
financial institutions do not classify their assets and liabilities on the basis
of current vs. non-current.
Therefore, the classification of the current portion of the receivable
balance 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 beginning of each
lease period, just like rent on an apartment. Also, it is common
for the lessor to pay some costs for the asset while it is under
lease.
For example, a lessor may carry the insurance on leased
assets in order to be certain that the assets are properly
insured. The lessor then increases the lease payments in order
to recover the estimated cost from the lessee. We will modify
the basic example to remove these two simplifications. The
analytical technique will be the same, however.
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Extended Example
■
At the inception of the lease, the journal entries to record the asset
acquisition and receipt of the first lease payment will appear as
follows:
– 2 January 20x2:
Lease receivable
Initial lease expense
Insurance expense
Cash
Cash
55,000
2,500
2,000
20,000
Initial lease expense
Insurance expense
Lease receivable
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59,500
2,500
2,000
15,500
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Change In Residual Value
The CICA Handbook recommends that any estimated residual value “be
be
reviewed annually to determine whether a decline in its value has
occurred” [CICA 3065.41].
occurred
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.
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.
disposal
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Future Income Taxes
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When the lessor accounts for a lease as a capital lease, net
income will include imputed interest as finance revenue.
On the tax return, however, 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.
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.
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Direct Financing Leases – Gross Method
■
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Lessors normally use the gross method of
recording capital leases, to facilitate control.
The net method and the gross method give the
same results in the financial statements.
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Principal Characteristics Of The Gross
Method
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The crucial aspect of reporting a lease is that the balance sheet 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.
In practice, lessors are unlikely to use the net method. Instead, an alternative
approach is used wherein 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. Because this most
common lessor method of recording uses the undiscounted lease payments, the
method is called the gross method of recording leases. The CICA Handbook
implicitly assumes that lessors will use the gross method (whereas the net
method is assumed for lessees). The reasons for using the gross method will be
discussed following the example below.
It should be emphasized at the outset that the gross and net methods result in
the same amounts in the financial statements. The difference is only one of
bookkeeping, not of financial reporting.
bookkeeping
reporting
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Extended Example – Gross Method
■
The gross method yields exactly the same
results as the net method. The gross method
looks more complex, and probably is not so
intuitively obvious, but it is a matter of
indifference for financial reporting which
method is used. They are only different
methods of recording,
recording not of reporting.
reporting
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Why Use The Gross Method?
Like almost all of the accounts shown on any company’s balance sheet, the
Lease Receivables account is a control account.
account
The Lease Receivables is much like Accounts Receivable. The balance sheet
amount 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 that
it be easily reconcilable to the underlying subsidiary records. For Lease
Receivables, that means that the receivables for the individual leases can be
summed to verify the balance in the control account.
The gross method makes that reconciliation easier. Since the amounts in the
Lease Payments Receivable account are gross amounts, the balance can be
verified by adding the remaining gross payments shown on all of the individual
leases. Under the net method, by contrast, it is necessary to compute the
present value of each lease at a particular point of time in order to perform the
reconciliation. The gross method has the advantage of separating the control
account function (via the Lease Payments Receivable) from the revenue
recognition function (via the Unearned Finance Revenue).
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Disclosure For Lessors
■
The disclosure requirements for lessors are quite simple. 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; and
– the lease revenue recognition policy.
■
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; 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 in
sales-type leases are manufacturers or dealers, they are not
financial institutions and are not acting as financial
intermediaries.
– For the lessor’s financial reporting, however, the distinction
matters 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 the
sale; and
the financing of the sale through a capital lease, with finance
income 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 their
products through sales-type leases. Common examples are computers
and automobiles. But 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.
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.
The leasing subsidiary may not be a ‘real’ company in the sense that it is
autonomous and has separate management; the subsidiary may be no
more than a filing cabinet full of lease agreements.
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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.
If a lessor classifies its assets between current and long term, the current
portion is the amount of the total receivable at the balance sheet date
(including accrued interest receivable) that will be received within the
next year.
Lessors often account for leases on an after-tax basis, wherein the cash
flows and the interest rate used in the present value and compounding
calculations are computed after taking income tax effects into account.
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Leveraged Leases
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A leveraged lease is one wherein the lessor obtains direct
financing for a lease from a third party; the lessor is an
intermediary. Usually, the third party cannot go to the lessor for
repayment if the lessee defaults and the cash stops flowing; this is
known as a non-recourse lease. 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.
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.
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