Intermediate Accounting

Thomas H. Beechy
Schulich School of
Business,
York University

Joan E. D. Conrod
Faculty of Management
Dalhousie University

Powerpoint slides by:

Michael L. Hockenstein Commerce Department Vanier College
Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Accounting for Leases by Lessors

Chapter 19
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Classification as a Capital Lease

A capital lease: a lease that, from the point

of view of the lessee, transfers substantially all

the benefits and risks incident to ownership of
property to the lessee [CICA 3065.03(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 purchase option

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Classification as a Capital Lease (cont.)

lessee obtains substantially all of the
economic benefits - lease term is at least
75% of the assets economic life
present value of the minimum net lease
payments is equal to at least 90% of the fair
value of the asset at the inception of the
lease including guaranteed residual

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Classification as a Capital Lease (cont.)

The two that, in addition, apply only to lessors

are:
the credit risk associated with the lease is
normal
the amounts of any unreimbursable costs can
be reasonably estimated [CICA 3065.07]

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Classification as a Capital Lease (cont.)

Minimum lease term includes bargain renewal

terms, terms prior to the exercisability of a bargain
purchase option, and renewal terms at the lessors
option
Minimum net lease payments includes lease
payments during bargain renewal terms, any bargain
purchase option price, and any guaranteed residual
value
The interest rate used for discounting the net
lease payments by the lessor is the rate implicit in
the lease

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Classification as a Capital Lease (cont.)

In a direct financing lease, the lessor is acting

purely as a financial intermediary
A sales-type lease is used by a manufacturer or a
dealer as a means of selling a product
There are two profit components in a sales-type
lease:
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 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)

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Operating Leases (cont.)

lump sum payments (e.g., at the inception
of the lease) are amortized over the initial
lease term
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

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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

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Current vs. Long Term Balances

If the lessor uses a current/long-term

classification: the current portion is the amount
by which the principal 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 3065.54,
italics added]

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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 3065.41]
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

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Change in Residual Value (cont.)

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

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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 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

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Future Income Taxes (cont.)

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

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Copyright 2003 McGraw-Hill Ryerson Limited, Canada

Principal Characteristics
of the Gross Method

The crucial aspect of reporting a lease is that the

balance sheet must 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
Lessors normally use the gross method of
recording 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 of

the net lease payments (that is, undiscounted) and

offsets that gross amount with the portion that
represents 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 Handbook recommends only the

following disclosures [CICA 3065.54]:
the lessors net investment (i.e., the lease
payments receivable, less unearned finance
revenue)
the amount of finance income
the lease revenue recognition policy

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Disclosure For Lessors (cont.)

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
executory costs included in minimum lease
payments

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Copyright 2003 McGraw-Hill Ryerson Limited, Canada

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 not
financial institutions and are not acting as
financial intermediaries

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Sales-Type Leases (cont.)

For the lessors financial reporting the

distinction matters because a sales-type
lease is viewed as two distinct but related
transactions:
the sale of the product, with recognition of a
profit or loss on the sale
the financing of the sale through a capital
lease, with finance income recognized over
the lease term
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Example: Sales-Type Lease

Assume that on 31 December 20X1, Binary

Corporation, a computer manufacturer, leases a large

computer to a local university for five years at
$200,000 per year, payable at the beginning of each
lease year
The normal cash sales price of the computer is
$820,000
The computer cost Binary Corporation (BC) $500,000
to build
The lease states that the computer will revert to BC at
the end of the lease term, but a side letter from BC to
the university states BCs intention not to actually
reclaim the computer at the end of the lease

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Example: Sales-Type Lease (cont.)

The implicit interest rate that discounts the lease

payments to the $820,000 fair value of the
computer is 11.04%
Unless the cost of financing is well in excess of this
rate, the lease can be assumed to be a capital
lease
Because the lessor is the manufacturer of the
product, and because the computer is carried on
BCs 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 lease

is 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 or
special deals wherein the actual price is less than
the 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 finance

revenue) will work out the same regardless of the
interest rate used in the calculations
However, decreasing the interest rate will have the
effect of increasing the reported selling price and
thereby shifting revenue (and profit) from the finance
period to the period of the sale
Increasing the interest rate would have the opposite
effect

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The Interest Rate Question (cont.)

The CICA Handbook offers no real assistance.

The explanation offered for reporting a salestype lease is as follows:
the sales revenue recorded at the inception of a
sales-type lease is the present value of the
minimum lease payments . . . computed at the
interest rate implicit in the lease [CICA 3065.43]

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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 dealers
who do appear to sell their products through
sales-type leases; e.g., computers and
automobiles
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

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Incidence of Sales-Type Leases (cont.)

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

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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

Tax shield: an amount that is deductible when

calculating income taxes and therefore shields that

taxpayer 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 lessor

obtains direct financing for a lease from a third
party; the lessor is an intermediary

A non-recourse lease: the third party cannot

go to the lessor for repayment if the lessee defaults

and the cash stops flowing
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

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Leveraged Leases (cont.)

Lease with recourse: the lessor is liable to third

parties 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 balance
sheet
Leases that do not qualify for capital lease treatment
are reported as operating leases; the physical asset
remains on the lessors balance sheet and is
depreciated, while the lease payments are reported
as rental revenue

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