Financial Reporting for Leases Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 12 Copyright © 2015 McGraw-Hill Education. All rights reserved. No.

Financial Reportingfor Leases

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 12

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives

1. The structure of a lease.

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 financial statement effects of executory costs, residual values, purchase options and other aspects of lease contracts.

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

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

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Learning objectives:Continued

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

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

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

10.The key differences between current GAAP and IFRS requirements for lease accounting and the changes proposed by the FASB and the IASB.

11.How to use financial statement disclosure to estimate the financial statement effects of treating operating leases as capital leases.

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Lease contracts

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

The lessor typically retains legal title to the asset which reverts to the lessor at the end of the lease term. The asset’s expected fair value at the end of the lease is the residual value.

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

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Evolution of lease accounting:Differences between Operating and Capital Leases

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Lessee accounting:ASC 840 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.

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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 the total asset turnover ratio

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

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Lessee accounting:Capital lease treatment illustrated

ASC 840 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:

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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

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Lessee accounting:Effective interest method

= $250,860.82 x 10%= $79,139.18-$19,680.77

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= $300,000/5 years

Lessee accounting:Capital lease journal entries

At inception, when the lease contract is signed:

At the end of 2014:

Interest expense at the end of 2015:

PV of MLP

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Lessee accounting:Capital lease summary

Lessees’ Accounting for Capital Leases

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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:

Executory costs

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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

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Lessee accounting:Residual value guarantee journal entries

At inception, when the lease contract is signed:

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

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

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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:

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Lessee accounting:Financial statement effects

Lessee Company Pattern of Expense Recognition: Capital Versus Operating

Interest plus depreciation

Rental payment

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Lessee accounting:Lessee disclosure, Whole Foods Market, Inc.

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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

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For terms of bankrupcty:Capital Lease = Operating Lease

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

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Lessor accounting:FASB ASC 840 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.

Collectibility 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 I characteristics(at least one of these is met…)

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

• Critical event has taken place • The amount of revenue earned is measurable

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Remember: Revenue is recognized when both conditions exist:

Lessor accounting:Expanded decision tree

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

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Lessor accounting:Amortization schedule for direct-financing lease

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Lessor accounting:Journal entries for direct-financing lease

At inception, when the lease contract is signed:

At the end of the first year (2014):

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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 2014 when the first payment is received:

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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 ASC 840 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

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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 same rate and life used for leased asset

Capital lease

$200,000deferred

gain

• Amortized in proportion to rental payments

Operating lease

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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 (ASC 840).

Lessor Bank

Lessee

Non-recourse financing

Standardlease

contract

1

2

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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 the GAAP criteria.

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

Capital

Operating

Income tax

Operating

Capital

Financial reporting

Lessee

Lessor

Accelerates expense

recognition

Delays revenue recognition

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Global Vantage PointComparison of IFRS and GAAP Lease Accounting

IFRS and U.S. GAAP are similar – differences include: Differences between the concepts of operating leases and capital

leases (called finance leases in IFRS). Classification depends on which party has the risks and rewards of ownership.

Difference in the ability to classify some assets held under leases as investment property. Lessors have the choice between fair value and historical cost for investment property provided to lessees under operating leases.

Differences in classifying leases on the balance sheet:

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Essentially the same as the current accounting for a capital lease

Type A lease – Equipment lease

Type B lease – Property lease

Depreciation is equal to the difference between the lease payment and interest expense for the period. Called interest-based amortization and is not allowed under U.S. GAAP

Summary

The treatment of leases in ASC 840 represents a compromise between the “unperformed contracts” and “property-rights” approaches.

FASB ASC 840 adopts a middle-of-the-road approach and specifies precise intermediate circumstances under which leases are capitalized.

Several of the lease capitalization criteria rely on bright-line rules, 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.

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Summary concluded

Lessors’ use of the capital lease approach accelerates income recognition in contrast to the timing of income recognition under the operating lease approach.

IFRS also distinguishes between operating and capital (finance) leases.

The FASB and IASB have issued a jointly developed exposure draft on lease accounting. The proposed accounting adopts a “right-of-use” approach and would require lessees to treat most leases as capital leases.

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