Intermediate Accounting

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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 18 Accounting for Leases by Lessees

3 Introduction A lease is an arrangement whereby the person or company that owns an asset agrees to let another person or company use the asset for a period of time at a stated (or determinable) amount of rent. The owner is called the lessor, while the renter is the lessee. In accounting, a basic principle is that we should attempt to report transactions in accordance with their economic substance rather than their legal form. Often, the economic substance of a lease is that the lessor is really providing the lessee with use of the asset over the bulk of the asset s useful life in return for a full repayment of the cost of the asset, plus interest

4 Definition Of A Lease the conveyance, by a lessor to a lessee, of the rights to use a tangible asset usually for a specified period of time in return for rent. The lease specifies the terms under which the lessee has the right to use the owner's property and the compensation to be paid to the lessor in exchange. CICA Handbook Section 3065, paragraph.03(n). This definition does not include (a) agreements that are contracts for services that do not transfer the right to use property, plant, or equipment from one contracting party to the other, (b) lease agreements concerning the rights to explore for or to exploit natural resources such as oil, gas, minerals, and timber, or (c) licensing agreements for items such as motion picture films, plays, manuscripts, patents, and copyrights.

5 Why Lease? The Leasing Continuum Why do companies lease assets instead of buying them? A short-term lease is used to obtain temporary use of an asset without having to buy it. This is appropriate when there is no long-term need for an asset, or when the lessee s business is volatile and there is not a constant need for a certain type of asset. A short-term lease that provides the lessee with temporary use of an asset is called an operating lease. The longer the lease term, the lower the daily rental cost. A lease that conveys substantially all of the risks and rewards of ownership from the lessor to the lessee is, in substance, a means of financing acquisition of the asset which is called a capital lease.

6 Operating Leases An operating lease is one that gives the lessee the right to use the asset for only a relatively short period of its useful life, such as renting a car or truck for a day, a month or a year. The lessee makes periodic payments to the lessor, which are accounted for as normal expense items by the lessee. Meanwhile, the lessor credits the payments to an income account such as leasing revenue. It is important to remember that short-term is a relative phrase when it comes to asset leasing; a ten-year lease is short term when it applies to leasing a building or a part of a building whose useful life may be 60 or 80 years.

7 Example Of A Capital Lease Assume that Rosie Inc. enters into a lease for equipment. The terms of the lease and the characteristics of the equipment are as follows: The current purchase price of the equipment is $700,000. The expected useful economic life of the equipment is twenty years. The initial lease term is eight years; Rosie cannot cancel the lease during this period. Lease payments during the initial lease term are $100,000 per year. These payments include property taxes and insurance costs that are estimated to be $5,000 per year. At the end of the initial lease term, Rosie can elect to renew the lease for two successive four-year terms at an annual rental of $40,000 per year, including estimated property taxes and insurance of $4,000 per year. Eight-year-old equipment of this type has a fair value of approximately $350,000, and can be leased for about $54,000 per year, net.

8 Informal Criterion For Capital Leases In order to fully realize the tax advantages that often are the driving force behind capital leases, a lessor must qualify as a lessor under the income tax regulations. Lessor must derive at least 90% of its revenues from lease transactions. Any company that meets this criterion is not an operating company; it is a financial intermediary. A capital lease is assumed if the lease term is for 70% of the asset s useful life and the present value of the minimum net lease payments is 85% of the fair value of the asset. If the tax advantages of the lease are substantial, the reduced lease payments could result in a lease contract that easily fails to meet the capital lease criteria. Thus the emphasis of the CICA Handbook on the substance of the transaction must remain paramount, regardless of whether any of the three capital lease criteria are present.

9 Advantages Of Long Term Leases Off-Balance Sheet Financing the acquisition of assets through capital leases permitted lessees to obtain the full and unfettered use of assets without having to report the assets on their balance sheets 100% Financing Flexibility Protection from Interest Rate Changes Transfer of Income Tax Benefits...the driving force behind the bulk of direct financing leases.

10 Future Income Taxes If a lessee enters into a lease contract, Revenue Canada normally will view the appropriate deduction for tax purposes to be the amount of lease payments made during the tax year. The fact that a lease may be accounted for as a capital lease is of no interest to the tax people. Leases that transfer title to the lessee at the end of the lease term will be viewed by Revenue Canada as installment sales contracts in substance, and will be taxed as a purchase. If a lease is taxed as a purchase, then the lessee will deduct imputed interest expense and will be eligible to deduct CCA. Therefore, leases are seldom structured in a way that invites taxation as a purchase. In most instances, a lease that is reported by the lessee as a capital lease will be taxed as an operating lease. This difference in treatment will give rise to a temporary difference. The future tax impact of the temporary difference relating to a capital lease is credited to the long-term future income tax balance.

11 Capital Lease Illustration Extended Example In this extended example, the important elements for analysis are as follows: The lease term is still five years: the initial lease term of three years plus the bargain renewal term of two years. The minimum net lease payments are now $18,500 for each of the first three years and $3,200 per year for the fourth and fifth years (as in the earlier example, the estimated insurance cost must be subtracted or netted out to determine the net lease payments). Lessee Ltd. s incremental borrowing rate is 12% p.a. The present value of the minimum net lease payments, at 12%, is $54,077: PV = $18,500 (P/A due, 12%, 3) + $3,200 (P/A due, 12%, 2) (P/F, 12%, 3) PV = $49,766 + $4,311 PV = $54,077 The annual lease payments are less than in the earlier example, but the present value is almost the same because the payments now are at the beginning of each lease year instead of at the end.

12 Sale And Leaseback It is not unusual for a company to take an asset that it owns and enter into a transaction with another party in which the asset is sold and simultaneously leased back. The asset is thereby converted from an owned asset to a leased asset. The transaction results in an immediate cash flow to the seller, which can be used to retire debt (particularly any outstanding debt on the asset, such as a mortgage or a collateral loan) or used for operating purposes, or a combination of both. The lease part of the transaction must be evaluated and judged to be either a capital lease or an operating lease. The sale portion of the deal is initially recorded just like any other sale, with a gain or loss recorded for the difference between the net proceeds from the sale and the asset s net book value.

13 Example Of Sale And Leaseback Assume that Vendeur Ltd. owns a building in central Montreal. Vendeur enters into an agreement with Bailleur Inc. whereby Vendeur sells the building to Bailleur and simultaneously leases it back. The historical cost of the building is $10,000,000; it is 60% depreciated on Vendeur s books. Bailleur agrees to pay Vendeur $8,500,000 for the building. Bailleur agrees to lease the building to Vendeur for 20 years. The annual lease payment is $850,000, payable at the end of each lease year. There is no guaranteed residual value. Vendeur will pay all of the building s operating and maintenance costs, including property taxes and insurance. The effective date of the agreement is 1 January 20x1. Vendeur s incremental borrowing rate is 9%. Bailleur s interest rate implicit in the lease is computed after tax, and is not disclosed to Vendeur.

14 Example Of Sale And Leaseback At the end of 20x1, Vendeur: records the interest expense pays the $850,000 annual lease payment to Bailleur, amortizes the asset, and amortizes the deferred gain. The interest expense and the lease payment will be recorded as follows: Interest expense 698,334 Lease liability 698,334 Lease liability 850,000 Cash 850,000

15 Disclosure Of Leases Operating Leases The CICA Handbook recommends that lessees disclose, in the notes to the financial statements, the company s obligation for operating lease payments for each of the next five years and for the five-year period in total [CICA ]. Operating leases that are on a year-byyear basis, with no obligation beyond the forthcoming year, are usually not included in the disclosure because there is no obligation beyond the current year. Capital Leases A company s rights to leased assets are different from its rights to owned assets. A company can sell, modify, or otherwise dispose of owned assets without restriction. Owned assets can also be used as collateral for a loan. Leased assets, on the other hand, belong to the lessor. The lessee does not have the same rights of ownership, even though the lessee bears substantially all of the risks and rewards of ownership.

16 Exhibit 18-8 Example of Operating Lease Disclosure Tesma International Inc. Notes to Consolidated Financial Statements 9. DEBT AND COMMITMENTS [f] The Company had commitments under operating leases requiring minimum annual rental payments for the years ending July 31 as follows: 000s Canadian Dollars 1998 $4, , , , ,959 Thereafter 1,259 $17,907 Approximately 27% of these lease commitments represent the Company s share of commitments of its proportionately consolidated joint ventures. For the year ended July 31, 1997, payments under operating leases amounted to approximately $4.0 million [1996 $3.4 million; 1995 $3.0 million].

17 International Perspective Capitalization of long-term leases has become a widely accepted practice world-wide. International Accounting Standard 17 recommends that leases that transfer substantially all of the risks and benefits of ownership to the lessee should be capitalized. As well, most developed countries have their own lease accounting standards that are generally similar to Canadian practice. Differences in the criteria: limit capital lease accounting Several countries (e.g., Spain and Sweden) purchase option at the end of the lease. France forbids capitalization of the lease payments until the purchase option has been exercised. Denmark and Austria have no standard that requires lease capitalization.

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