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Copyright 2003 McGraw-Hill Ryerson Limited, Canada

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Accounting for Leases by Lessors

Chapter 19

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19-3

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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19-4

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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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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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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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

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