1 / 59

Financial Reporting for Leases

Financial Reporting for Leases. Revsine/Collins/Johnson: Chapter 12. Learning objectives. The difference between capital leases and operating leases. Lessee’s incentives to keep leases off the balance sheet. The criteria used to classify leases on the lessee’s books.

drake-jacobson
Download Presentation

Financial Reporting for Leases

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Financial Reportingfor Leases Revsine/Collins/Johnson: Chapter 12

  2. Learning objectives • The difference between capital leases and operating leases. • Lessee’s incentives to keep leases off the balance sheet. • The criteria used to classify leases on the lessee’s books. • The treatment of executory costs, residual values, and other aspects of lease contracts. • The effects of capital lease versus operating lease treatment on the lessee’s financial statements. • How analysts can adjust for ratio distortions from off-balance sheet leases when comparing firms.

  3. Learning objectives:Continued • Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees. • The difference between sales-type, direct financing, and operating lease treatment by lessors. • How different lease accounting treatments can affect income and net asset balances. • Sale/leaseback arrangements and other special leasing situations. • How to use lease footnote disclosures.

  4. 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. Right to use Owns the asset Lessor Lessee Wants to use the asset Lease payment

  5. 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 Month 2 5 – year term of lease Lease signed and Iris moves in $2,000 payment $2,000 payment

  6. 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 DRRent expense $2,000 CR Lease liability $2,000 To accrue a liability for that portion of the contract that has been performed. DRLease liability $2,000 CR Cash $2,000 To record the payment of the stipulated rental fee at the end of the month.

  7. Evolution of lease accounting:Entries for Crest Company (lessor) • At inception, when the lease contract is signed: • At the end of each month: No Entry: Executory contract DRCash $2,000 CR Rental revenue $2,000 To record the rental payment received each month. DRDepreciation expense –leased building $2,000 CR Accumulated depreciation –leased building $2,000 The building remains an asset on the books, periodic depreciation is recorded.

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

  9. 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: DRLeased 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

  10. Evolution of lease accounting:Overview of the two approaches

  11. 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.

  12. 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:

  13. 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. PV of MLP $300,000 PV of MLP $300,000 Payments and interest Amortization $0 $0 Inception End of Lease Inception End of Lease Lease Asset Lease liability

  14. Lessee accounting:Effective interest method = $79,139.18-$19,680.77 = $250,860.82 x 10%

  15. Lessee accounting:Annual cost of leased asset = $300,000 ÷ 5 years

  16. At the end of 2005: DRObligation under capital lease$49,139.18 DR Interest expense 30,000.00 CR Cash $79,139.18 DRDepreciation expense –capital lease$60,000.00 CR Accumulated depreciation –capital lease $60,000.00 • Interest expense at the end of 2006: DRObligation under capital lease$54,053.10 DR Interest expense 25,086.08 CR Cash $79,139.18 Lessee accounting:Capital lease journal entries • At inception, when the lease contract is signed: DRLeased asset –capital lease $300,000 CR Obligation under capital lease $300,000 PV of MLP

  17. Lessee accounting:Capital lease summary

  18. 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: DRObligation under capital lease $49,139.18 DR Interest expense 30,000.00 DR Miscellaneous lease expense 2,000.00 CR Cash $81,139.18 Executory costs

  19. Lessee accounting:Residual value guarantees • Suppose Lessee Corp. guarantees that the asset will be worth no lessthan $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

  20. Lessee accounting:Residual value guarantee details = ($312,418.40 - $20,000) ÷ 5 years = $79,139.18 -26,452.11 $264,521.06 x 10% =

  21. When Lessee returns the asset worth only $15,000 and pays cash as required by the guarantee: DRObligation under capital lease$20,000.00 DRLoss on residual value guarantee 5,000.00 CR Leased asset –capital lease $20,000.00 CR Cash 5,000.00 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: DRLeased asset –capital lease $312,418.40 CR Obligation under capital lease $312,418.40 DRObligation under capital lease$20,000.00 CR Leased asset –capital lease $20,000.00

  22. Many lease contracts require payments to be made at the beginning of each period: Inception Year 1 Year 2 Term of lease $XX $XX $XX Present values • If Lessee Corporation’s lease had this form, the lessor would require a smaller payment each period: Lessee accounting:Payments in advance • The lease contracts described thus far all involve payments that occur at the end of each period. Inception Year 1 Year 2 Term of lease $XX $XX Present values

  23. 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 =

  24. Lessee accounting:Financial statement effects Lessee Company Pattern of Expense Recognition: Capital Versus Operating Rental payment Interest plus depreciation

  25. Lessee accounting:Use of operating and capital leases

  26. Lessee accounting:Footnote disclosure Off-balance sheet obligation Balance sheet liabilities

  27. Lessee accounting:Adjusting income

  28. Cash flow effects also occur: $79,139 $30,000 Operating (amortization) Operating (rent) $49,139 Financing (interest) Capital lease Operating lease 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): Capital lease Operating lease Current assets Current liabilities Current assets Current liabilities Increased by $49,139 Unchanged

  29. 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 amountand 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 Capital Operating Sales-type Direct-financing Operating

  30. Lessor accounting:Decision tree • Asset removed from books. • Financing profit only • Asset removed from books. • Two profit streams: Manufacturer’s/dealer’s profit Financing profit over time • Asset remains on books. • Rental income over time

  31. Lessor accounting:Sales-type lease example Recognized over time as earned Recognized at inception

  32. Lessor accounting:Direct-financing lease example Recognized over time as earned

  33. 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. Lessor accounting:SFAS No. 13 criteria for capital lease treatment Type 1 characteristics (at least one of these is met…) Type 2 characteristics (…and both of these are met) Measurability Critical event

  34. Lessor accounting:Expanded decision tree

  35. Lessor accounting:Direct-financing lease treatment illustrated Also equals the present value of MLP plus GRV

  36. Lessor accounting:Implied rate of return on direct-financing lease PV of MLP PV of GRV

  37. Lessor accounting:Amortization schedule for direct-financing lease $258,699.85 x 11% = = $79,189.18 - $22,881.94

  38. At the end of the first year (2005): DRCash $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 lease when the asset is returned: DREquipment $20,000.00 CR Gross investment in leased asset $20,000.00 Lessor accounting:Journal entries for direct-financing lease • At inception, when the lease contract is signed: DRGross investment in leased asset $415,695.90 CR Equipment $304,359.49 CR Unearned financing income –leases 111,336.41

  39. At the end of the first year (2005): DRCash $79,139.18 CR Rental revenue $79,139.18 DR Depreciation expense $56,871.90 CR Accumulated depreciation $56,871.90 • At the end of the lease when the asset is returned: No Entry Lessor accounting:Journal entries for an operating lease • At inception, when the lease contract is signed: No Entry: Asset remains on lessor’s books

  40. Lessor accounting:Comparison of operating and direct-financing $79,139.18 - $56,871.90 =

  41. At the end of the first year (2005): DRCash $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 lease when the asset is returned: DREquipment $20,000.00 CR Gross investment in leased asset $20,000.00 Lessor accounting:Journal entries for sales-type lease • At inception, when the lease contract is signed: Manufacturer’s profit recognized at inception DRGross investment in leased asset $415,695.90 DR 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

  42. The following entry is made at year-end 2005 when the first payment is received: DRCash $81,139.18 CR Gross investment in leased asset $79,139.18 CR Maintenance revenue 20,000.00 DR Unearned financing income –leases $33,479.54 CR Financing income –leases $33,479.54 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:

  43. 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. “Sale” transaction transfers title to asset First Company Second Company “Lease back” allows use to be retained

  44. 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: • Amortized using the some rate and life used for leased asset $200,000 deferred gain $200,000 deferred gain • Amortized in proportion to rental payments Capital lease Operating lease DRCash (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

  45. 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). Non-recourse financing Lessor Bank 1 Standard lease contract 2 Lessee

  46. 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: Financial reporting Income tax Lessee Operating Capital Lessor Capital Operating Accelerates expense recognition Delays revenue recognition

  47. Additional leasing aspects:Lessors’ disclosures

  48. Additional leasing aspects:Lessors’ disclosures (concluded) Expected cash flow

  49. 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.

  50. 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.

More Related