Intermediate Accounting

Transcription

1 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

2 Chapter 19 Accounting For Leases By Lessors

3 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. 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, after-tax analysis and recording of capital leases, and leveraged leasing.

4 Operating Leases Operating lease [paras and ]: 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.

5 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.

6 Basic Example 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.

7 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.

8 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, segregated between current and long-term portions [CICA , 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.

9 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.

10 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 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

11 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 ]. 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.

12 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, 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.

13 Direct Financing Leases Gross Method 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.

14 Principal Characteristics Of The Gross Method 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.

15 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, not of reporting.

16 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. 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).

17 Disclosure For Lessors The disclosure requirements for lessors are quite simple. The CICA Handbook recommends only the following disclosures [CICA ]: 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.

18 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.

19 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.

20 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.

21 Leveraged Leases 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.