Financial Reporting for Leases Revsine/Collins/Johnson: Chapter 12.

Financial Reportingfor Leases

Revsine/Collins/Johnson: Chapter 12

2RCJ: Chapter 12 © 2005

Learning objectives

1. The difference between capital leases and operating leases.

2. Lessee’s incentives to keep leases off the balance sheet.

3. The criteria used to classify leases on the lessee’s books.

4. The treatment of executory costs, residual values, and other aspects of lease contracts.

5. The effects of capital lease versus operating lease treatment on the lessee’s financial statements.

6. How analysts can adjust for ratio distortions from off-balance sheet leases when comparing firms.


Learning objectives:Continued

7. Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees.

8. The difference between sales-type, direct financing, and operating lease treatment by lessors.

9. How different lease accounting treatments can affect income and net asset balances.

10.Sale/leaseback arrangements and other special leasing situations.

11.How to use lease footnote disclosures.


Lease contracts

A lease contract conveys the right to use an asset in exchange for a fee (the lease payment).

At its inception, a lease is a mutually unperformed contract meaning that neither party has yet performed all of the duties called for in the contract.

The accounting for unperformed contracts is controversial.

LesseeLessorWants to use the asset

Owns the asset

Right to use

Lease payment


Evolution of lease accounting:Operating lease approach

SFAS No 13 spells out GAAP for leases. Before it was issued in 1976, virtually all leases were accounted for using the operating lease approach.

Here’s an example:

Month 1

$2,000 payment

Lease signed and Iris

moves in

Month 25 – year term of lease

$2,000 payment


Evolution of lease accounting:Entries for Iris Company (lessee)

At inception, when the lease contract is signed:

At the end of each month:

No Entry: Executory (unperformed) contract

DR Rent expense $2,000 CR Lease liability $2,000To accrue a liability for that portion of the contract that has been performed.

DR Lease liability $2,000 CR Cash $2,000To record the payment of the stipulated rental fee at the end of the month.


Evolution of lease accounting:Entries for Crest Company (lessor)


At the end of each month:

No Entry: Executory contract

DR Cash $2,000 CR Rental revenue $2,000To record the rental payment received each month.

DR Depreciation expense –leased building $2,000 CR Accumulated depreciation –leased building $2,000The building remains an asset on the books, periodic depreciation is recorded.


Evolution of lease accounting:Why lessees like the operating lease approach

The operating approach does not reflect the cumulative economic liability for all future lease payments on the balance sheet.

Keeping the lease obligation (and asset) off of the balance sheet may:

Reduce the likelihood of debt covenant violation. Improve the ability to obtain additional loans in the future. Improve financial performance ratios like ROA

However, GAAP does require footnote disclosure of this off-balance sheet lease obligation.

NOPATAverage assets

ROA = ROA seems higher when leased assets are not included here.


Evolution of lease accounting:The SEC’s initiative

The SEC issued ASR No. 147 in 1973 to improve financial reporting for leases.

The SEC took a property rights approach to lease accounting: The lease conveys property rights (an asset) to the lessee. The payment stream represents the lessee’s liability.

Under this capital lease approach, the lessee makes the following entry when the lease is signed:

DR Leased asset (to reflect the property right, not ownership of the asset) $XXX CR Lease obligation (to reflect the liability arising from future lease payments) $XXX


Evolution of lease accounting:Overview of the two approaches


Lessee accounting:SFAS No. 13 criteria for capital lease treatment

If, at inception, the lease satisfies any one or more of the following criteria, it must be treated as a capital lease on the books of the lessee:

The lease transfers ownership of the asset to the lessee at the end of the lease term.

The lease contains a bargain purchase option.

The non-cancelable lease term is 75% or more of the estimated economic life of the leased asset.

The present value of the minimum lease payments equals or exceeds 90% of the current fair market value of the leased asset.


Lessee accounting:Capital lease treatment illustrated

SFAS No. 13 requires that the lease asset and liability initially be recorded at a dollar amount equal to the discounted present value of the minimum lease payments:


Lessee accounting:Capital lease accounting overview

The balance sheet amount shown for the lease asset and liability are equal only at the inception and at the end of the lease:

The leased asset is amortized over time using a depreciation schedule for assets of this type.

The lease obligation is reduced in accordance with the payment schedule once interest is accrued using the effective interest method.

$300,000

Inception

$0

End of Lease

Lease Asset

PV of MLP

Amortization

$300,000

Inception

$0

End of Lease

Lease liability

PV of MLP

Payments and interest


Lessee accounting:Effective interest method

= $250,860.82 x 10%

= $79,139.18-$19,680.77


Lessee accounting:Annual cost of leased asset

= $300,000 ÷ 5 years


Lessee accounting:Capital lease journal entries


DR Leased asset –capital lease $300,000 CR Obligation under capital lease $300,000

At the end of 2005:

DR Obligation under capital lease $49,139.18DR Interest expense 30,000.00 CR Cash $79,139.18

DR Depreciation expense –capital lease $60,000.00 CR Accumulated depreciation –capital lease $60,000.00

Interest expense at the end of 2006:

DR Obligation under capital lease $54,053.10DR Interest expense 25,086.08 CR Cash $79,139.18

PV of MLP


Lessee accounting:Capital lease summary


Lessee accounting:Executory costs

These are the costs of using the asset—such as maintenance, taxes, and insurance.

Accordingly, they are omitted when determining minimum lease payments and the capitalized amount shown for the leased asset.

Instead, they are charged to expense when incurred:

DR Obligation under capital lease $49,139.18DR Interest expense 30,000.00 DR Miscellaneous lease expense 2,000.00 CR Cash $81,139.18

Executory costs


Lessee accounting:Residual value guarantees

Suppose Lessee Corp. guarantees that the asset will be worth no less than $20,000 when the lease ends.

Residual value guarantees of this sort protect the lessor against two business risks:

Unforeseen technological or marketplace changes that erode asset value. Possibility that the lessee does not take proper care of the asset.

With this guarantee, the new present value of minimum lease payments becomes:

Without guarantee

With guarantee


Lessee accounting:Residual value guarantee details

= ($312,418.40 - $20,000) ÷ 5 years

= $79,139.18 -26,452.11$264,521.06 x 10% =


Lessee accounting:Residual value guarantee journal entries


When Lessee Corp. returns the asset worth at least $20,000 to the lessor:

DR Leased asset –capital lease $312,418.40 CR Obligation under capital lease $312,418.40

DR Obligation under capital lease $20,000.00 CR Leased asset –capital lease $20,000.00

When Lessee returns the asset worth only $15,000 and pays cash as required by the guarantee:

DR Obligation under capital lease $20,000.00DR Loss on residual value guarantee 5,000.00 CR Leased asset –capital lease $20,000.00 CR Cash 5,000.00


Lessee accounting:Payments in advance

The lease contracts described thus far all involve payments that occur at the end of each period.

Year 1

$XX

Year 2Term of lease

$XX

Inception

Present values

Many lease contracts require payments to be made at the beginning of each period:

Year 1

$XX$XX

Year 2Term of lease

$XX

Inception

Present values

If Lessee Corporation’s lease had this form, the lessor would require a smaller payment each period:


Lessee accounting:Amortization with payments in advance

The payment is smaller than before because it is made at the beginning

of each period.

= $228,055 x 10%$300,00 ÷ 5 years =


Lessee accounting:Financial statement effects

Lessee Company Pattern of Expense Recognition: Capital Versus Operating

Rental payment

Interest plus depreciation


Lessee accounting:Use of operating and capital leases


Lessee accounting:Footnote disclosure

Off-balance sheet

obligation

Balance sheet

liabilities


Lessee accounting:Adjusting income


Lessee accounting:Balance sheet and ratio effects

Capital lease accounting can effect the current ratio. Consider the Lessee Corp. lease at inception (Exhibit 12.1):

Current assetsCurrent liabilities

Current assetsCurrent liabilities

Capital lease Operating lease

Increased by $49,139

Unchanged

$30,000

$49,139$79,139

Operating (amortization)

Financing (interest)

Operating (rent)

Capital lease Operating lease

Cash flow effects also occur:


Lessor accounting:Capital and operating leases

From the lessor’s perspective, a capital lease must both: Transfer property rights in the leased asset to the lessee, and Allow reasonably accurate estimates regarding the amount and

collectibility of the eventual net cash flows to the lessor.

When both conditions are not simultaneously met, the lease must be treated as an operating lease.

Lease

Sales-type Direct-financing Operating

Capital Operating


Lessor accounting:Decision tree

Asset removed from books.Two profit streams: Manufacturer’s/dealer’s profit Financing profit over time

Asset removed from books.

Financing profit only

Asset remains on books.Rental income over time


Lessor accounting:Sales-type lease example

Recognized at inception

Recognized over time as

earned


Lessor accounting:Direct-financing lease example

Recognized over time as

earned


Lessor accounting:SFAS No. 13 criteria for capital lease treatment

Ownership is transferred to lessee by end of lease term.

Lease contains a bargain purchase option.

Noncancelable lease term is 75% or more of estimated economic life.

Present value of minimum lease payments exceeds 90% of the FMV of the leased asset.

Collectability of minimum lease payments is reasonably assured.

There are no important uncertainties surrounding the amount or unreimbursable costs yet to be incurred by the lessor under the lease.

Type 1 characteristics(at least one of these is met…)

Type 2 characteristics(…and both of these are met)

Critical event Measurability


Lessor accounting:Expanded decision tree


Lessor accounting:Direct-financing lease treatment illustrated

Also equals the present value of MLP plus GRV


Lessor accounting:Implied rate of return on direct-financing lease

PV of MLP

PV of GRV


Lessor accounting:Amortization schedule for direct-financing lease

$258,699.85 x 11% == $79,189.18 - $22,881.94


Lessor accounting:Journal entries for direct-financing lease


DR Gross investment in leased asset $415,695.90 CR Equipment $304,359.49 CR Unearned financing income –leases 111,336.41

DR Cash $79,139.18 CR Gross investment leased asset $79,139.18

DR Unearned financing income –leases $33,479.54 CR Financing income –leases $33,479.54

At the end of the first year (2005):

DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00

At the end of the lease when the asset is returned:


Lessor accounting:Journal entries for an operating lease


No Entry: Asset remains on lessor’s books


DR Cash $79,139.18 CR Rental revenue $79,139.18

DR Depreciation expense $56,871.90 CR Accumulated depreciation $56,871.90


No Entry


Lessor accounting:Comparison of operating and direct-financing

$79,139.18 - $56,871.90 =


Lessor accounting:Journal entries for sales-type lease


DR Cash $79,139.18 CR Gross investment leased asset $79,139.18



DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00


DR Gross investment in leased asset $415,695.90DR Cost of goods sold 240,000.00 CR Sales revenue $304,359.49 CR Unearned financing income –leases 111,336.41 CR Inventory 240,000.00

Manufacturer’s profit recognized

at inception


Lessor accounting:Sales-type lease with executory costs

Suppose Lessor Company also promises to provide maintenance services on the leased asset for an additional annual fee of $2,000.

The “gross investment” calculation is now:

The following entry is made at year-end 2005 when the first payment is received:

DR Cash $81,139.18 CR Gross investment in leased asset $79,139.18 CR Maintenance revenue 20,000.00



Additional leasing aspects:Sale and leaseback

First Company gets a $1 million cash infusion and can treat the entire annual rental ($120,000) as a deductible expense for tax purposes.

The same SFAS No. 13 criteria are used to determine if the lease qualifies for capital or operating lease treatment.

SecondCompany

FirstCompany

“Sale” transaction transfers title to asset

“Lease back” allows use to be retained


Additional leasing aspects:Sale and leaseback (continued)

However, First Company’s “gain” cannot be recognized immediately.

If it qualifies as a capital lease, First Company would make the following entries at inception:

$200,000deferred

gain

• Amortized using the some rate and life used for leased asset

Capital lease

$200,000deferred

gain

• Amortized in proportion to rental payments

Operating lease

DR Cash (or receivable) $1,000,000 CR Plant and equipment $800,000 CR Deferred gain 200,000

DR Leased asset –capital leases $1,000,000 CR Obligation under capital leases $1,000,000


Additional leasing aspects:Leveraged lease

Lessor borrows money from a third-party. This non-recourse loan provides the “leverage.”

Lessor then buys an asset and leases it.

A leveraged lease does not affect the lessee’s accounting.

The lessor must use the “direct-financing” approach and special details apply (SFAS No. 13).

Lessor Bank

Lessee

Non-recourse financing

Standardlease

contract

1

2


Additional leasing aspects:Tax accounting

U.S. income tax laws also distinguish between operating leases and capital leases.

However, the tax criteria are not the same as SFAS No. 13.

Firms often favor one treatment for tax purposes and another treatment for financial reporting purposes:

Operating Capital

Capital Operating

Financial reporting Income tax

Lessee

Lessor

Accelerates expense

recognition

Delays revenue recognition


Additional leasing aspects:Lessors’ disclosures


Additional leasing aspects:Lessors’ disclosures (concluded)

Expected cash flow


Summary

The treatment of leases in SFAS No. 13 represents a compromise between the “unperformed contracts” and “property-rights” approaches.

SFAS No. 13 adopts a middle-of-the-road approach and specifies precise intermediate circumstances under which leases are capitalized.

Several of the lease capitalization criteria are arbitrary, which allows lease contracts to be structured in ways that avoid required capitalization.

Because the proportion of operating lease payments to capital lease payments can vary greatly between firms in the same industry, analysts must often constructively capitalize operating leases to make valid comparisons.


Summary concluded

The FASB has issued 10 statements on leases subsequent to SFAS No. 13 and numerous interpretations of the original statement in an effort to close the loopholes for keeping leases off the balance sheet.

New loopholes are likely to be discovered and invented.

When lessors use the capital lease approach, income recognition is accelerated and financial statement ratios are improved. It is not surprising that capital leases appear frequently on lessor’s financial statements.


Appendix:Constructive capitalization

Some companies structure lease contracts to evade capital lease criteria, thereby keeping most of their leases off the balance sheet.

Other companies have a large proportion of capital leases.

The most straightforward method for making balance sheet data comparable is to treat all leases as if they were capital leases. This is called constructive capitalization.

$

Firm 1

$ $

Firm 2

$

Operating leases

Capital leases


Appendix:Operating lease footnote

To estimate the balance sheet liability that would have been recorded under the capital lease approach, we need to calculate the present value of the MLP.


Two alternatives for determining the discount rate can be used:

The weighted-average discount rate implicit in capital leases. The weighted-average discount rate on long-term debt.

Here’s how to find the discount rate implicit in capital leases:

A similar approach is used to find the discount rate on long-term debt

Appendix:Determining the discount rate


Appendix:Estimating payments beyond five years

Panel at bottomPage 664


Appendix:Lease asset & liability (payments at year-end)


Appendix:Lease asset & liability (payments at start of year)


Appendix:Albertson’s capitalized leased asset

A footnote reveals that:

Applying this same proportion to the company’s operating leases yields:

$257 million

$321million

Net capital lease assets

Net capital lease obligations

$257$321

≈80%

$1,536 million

$1,920million

Capitalized operating

lease asset

Capitalized operating lease

obligation

80%


Appendix:Financial statement impact


Appendix:Financial ratio impact

Financial Reporting for Leases Revsine/Collins/Johnson: Chapter 12.

Documents

payment lease

lease obligation

lease payment slide

evolution of lease accounting

operating lease treatment

cr lease liability

dr lease liability

aspects of lease contracts