Accounting for Leases by Lessees

2. Accounting for Leases by Lessees Chapter 18

3. Definition of a Lease • 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

4. 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 Operating lease:a short-term lease that provides the lessee with temporary use of an asset Why Lease? The Leasing Continuum

5. 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 and is called a capital lease Why Lease? The Leasing Continuum(cont.)

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 that are accounted for as normal expense items by the lessee

7. Operating Leases (cont.) • The lessor credits the payments to an income account such as leasing revenue • A short-term is a relative phrase when it comes to asset leasing; a 10-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

8. Guidelines for Defining Capital Leases • The CICA Handbook states that, normally, a lease should be assumed to transfer substantially all of the risks and benefits of ownership to the lessee when at least one of the following conditions is present at the inception of the lease: • there is reasonable assurance that the lessee will obtain ownership of the leased property at the end of the lease term • this would occur if the lease provides for automatic transfer of title to the lessee at the end of the lease, or if the lessee is entitled to exercise a bargain purchase option

9. Guidelines for Defining Capital Leases(cont.) • the lessee will receive substantially all of the economic benefits expected to be derived through use of the leased property • since assets are most productive in the earlier years of their lives, this condition is presumed to be satisfied if the lease term is at least 75% of the asset’s economic life

10. Guidelines for Defining Capital Leases(cont.) • the lessor will be assured of recovering the investment in the leased property, plus a return on the investment, over the lease term • this condition is presumed to be satisfied if the 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

11. Definitions • A bargain purchase option exists when there is a stated or determinable price given in the lease that is sufficiently lower than the expected fair value of the leased asset at the option’s exercise date to make it likely that the lessee will exercise the option • The lease term includes: • all terms prior to the exercise date of a bargain purchase option • all bargain renewal terms • all renewal terms at the lessor’s option

12. Definitions • Bargain renewal terms:periods for which the lessee has the option of extending the lease at lease payments that are substantially less than would normally be expected for an asset of that age and type • Minimum net lease payments:all payments over the lease term, as described above, net of operating or executory costs that are implicitly included in the lease payments, plus any guaranteed residual value • Guaranteed residual value:the amount that the lessee agrees to assure that the lessor can get for the asset by selling it to a third party at the end of the lease term

13. Definitions (cont.) • Incremental borrowing rate (IBR):the interest rate that the lessee would have to pay if they obtained financing through the bank (or other credit sources) to buy the asset • Implicit lease interest rate:the interest rate that discounts the minimum net lease payments to equal the fair market value of the leased property at the beginning of the lease

14. 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 and the expected useful economic life of the equipment is 20 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

15. Example of a Capital Lease (cont.) • 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

16. Example of a Capital Lease (cont.) • these payments include property taxes and insurance costs that are estimated to be $5,000 per year • if Rosie Inc. does not exercise the renewal options, the asset reverts to the lessor and will be physically removed from Rosie’s premises • following the second renewal term (that is, after 16 years), the asset will automatically revert to the lessor, although the lessor may elect not to physically remove the asset

17. Example of a Capital Lease (cont.) • all lease payments are due at the beginning of each lease year • if Rosie went to the company’s friendly local bank manager, the company would be able to borrow the money to buy the equipment at an interest rate of 10% • Rosie Inc. does not know the lessor’s interest rate implicit in the lease

18. Example of a Capital Lease (cont.) • The terms of the lease can be compared to the three guidelines for determining whether substantially all of the risks and rewards of ownership have been transferred to the lessee: • there is no bargain purchase option and no automatic reversion of the asset to the lessee at the end of the lease • therefore, there appears not to be reasonable assurance that the lessee will obtain ownership of the asset at the end of the lease term

19. Example of a Capital Lease (cont.) • the lease term, including bargain renewal terms, is 16 years. This lease term constitutes 80% of the asset’s estimated 20-year useful life • therefore, it appears that Rosie Inc. will have the use of the asset over 80% of its useful life.

20. Example of a Capital Lease (cont.) • the discounted present value of the minimum net lease payments over the 16-year lease term at Rosie Inc.’s IBR of 10% is $656,056: • PV = $95,000 (P/A due, 10%, 8) + $36,000 (P/A due, 10%, 8) (P/F, 10%, 8) • PV = $557,500 + $98,556 • PV = $656,056

21. 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

22. Informal Criterion For Capital Leases(cont.) • 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

23. 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.”

24. Accounting Approach for Capital Leases • If a long-term lease qualifies as a capital lease for accounting purposes, the general approach is to record the asset on the books of the lessee as though it had been purchased and financed by instalment debt • The accounting is as follows: • the present value of the lease payments is determined by using • The lower of the lessee’s IBR or the lessor’s implicit rate, if known, and • Net lease payments for the initial term, plus net lease payments for any bargain renewal terms, plus any renewal terms at the lessor’s option, plus any guaranteed residual value or any bargain purchase price

25. Capital Lease Illustration--Basic Example • Lessee Ltd. wishes to acquire equipment that has an expected economic life of five years and a fair value of $55,000. Instead of buying the asset outright, the company enters into a lease with a bank’s leasing subsidiary • The terms of the lease are as follows: • the initial lease term is three years. • the lease begins on 2 January 20X2 • payments over the initial lease term are $22,000 per year, payable at the end of each lease year (that is, on 31 December)

26. Capital Lease Illustration--Basic Example(cont.) • lease payments include insurance costs that are estimated to be $2,000 per year for the three years of the initial lease term • at the end of the initial lease term, the lease is renewable for another two years at Lessee Ltd.’s option for $6,000 per year, including insurance. The cost of insurance in Year 4 and thereafter is estimated to be $1,000 per year. The normal rental cost of three-year old equipment of this type is almost $10,000 per year

27. Capital Lease Illustration--Basic Example(cont.) • there is no guaranteed residual value, and the asset reverts to the lessor at the end of the lease • if Lessee Ltd. had purchased the asset, the company would have drawn on its bank line of credit, which bears interest at 12% per annum

28. Capital Lease Illustration--Basic Example(cont.) • In this example, the important elements for analysis are as follows: • the lease term is five years: the initial lease term of three years plus the bargain renewal term of two years • the minimum net lease payments are $20,000 for each of the first three years and $5,000 per year for the fourth and fifth years (that is, the estimated insurance cost must be subtracted or netted out to determine the net lease payments) • Lessee Ltd.’s incremental borrowing rate is 12% per annum)

29. Capital Lease Illustration--Basic Example(cont.) • Under the guidelines provided by the CICA Handbook,this lease is a capital lease for the following reasons: • the lease term is five years, which exceeds 75% of the equipment’s estimated five year economic life

30. Capital Lease Illustration--Basic Example(cont.) • the present value of the minimum net lease payments at the lessee’s IBR is $54,051, which exceeds 90% of the $55,000 fair value of the equipment: • PV = $20,000 (P/A, 12%, 3) + $5,000 (P/A, 12%, 2) (P/F, 12%, 3) • PV = $48,037 + $6,014 • PV = $54,051 • To clinch matters, the lessor is a financial intermediary whose business is the financing of assets through direct financing leases

31. Accounting for the Lease • The principal amount outstanding during the year 20X2 is the full present value of $54,051. In general journal form, the lease would be recorded on the books on 2 January 20X2 as follows: • Asset under capital lease $54,051 • Lease liability $54,051 • The entry to record the accrued interest is: • Interest expense $6,486 • Lease liability $6,486

32. Accounting for the Lease (cont.) • When the cash payment is made, the entry is: • Insurance expense $2,000 • Lease liability $20,000 • Cash $22,000 • Since the cash payment includes an implicit amount for insurance, the estimated insurance amount must be debited separately to an expense account

33. Exhibit 18-1

34. If a lessee enters into a lease contract, Canada Customs and Revenue Agency 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 Canada Customs and Revenue Agency as instalment sales contracts in substance, and will be taxed as a purchase Future Income Taxes

35. 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 Future Income Taxes (cont.)

36. 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 Future Income Taxes (cont.)

37. Capital Lease Illustration– Extended Example • Assume that Lessee Ltd. needs to acquire equipment that has a fair value purchase price of $55,000 • The company elects to acquire this equipment through a lease from their bank’s leasing subsidiary. The terms of the lease are as follows: • the initial lease term is three years and the lease begins on 1 April 20x2 • payments over the initial lease term are $20,500 per year, payable at the beginning of each lease year (that is, on 1 April)

38. Capital Lease Illustration– Extended Example (cont.) • lease payments include insurance costs that are estimated to be $2,000 per year for the three years of the initial lease term • at the end of the initial lease term, the lease is renewable for another two years at Lessee Ltd.’s option for $4,200 per year, including insurance • the cost of insurance in Year 4 and thereafter is estimated to be $1,000 per year • the normal rental cost of three-year old equipment of this type is almost $10,000 per year

39. Capital Lease Illustration– Extended Example (cont.) • the asset reverts to the lessor at the end of the lease; there is no guaranteed residual value • if Lessee Ltd. had purchased the asset, the company would have drawn on its bank line of credit, which bears interest at 12% per annum • Lessee Ltd.’s fiscal year ends on 31 December

40. Capital Lease Illustration– Extended Example (cont.) • 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.

41. Capital Lease Illustration– Extended Example (cont.) • 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

42. On 1 April 20X2, Lessee Ltd. will record its acquisition of the asset and the related obligation as follows: Asset under capital lease $54,077 Lease liability $54,077 Simultaneously, a cheque for $20,500 will be issued to the lessor: Insurance expense $2,000 Lease liability $18,500 Cash $20,500 Accounting for the Lease

43. Since the first payment is made at the inception of the lease, the principal balance outstanding during the first lease year is only $35,577: $54,077  $18,500 The interest expense over the life of the lease clearly will be less than in the earlier example because the outstanding balance is alwaysless Accounting for the Lease (cont.)

44. At the end of Lessee Ltd.’s fiscal year, the accounts must be adjusted to record accrued interest, as well as to record asset amortization and (if material) to allocate the insurance expense The adjusting entries on 31 December 20X2 will appear as follows, assuming that the company follows a policy of allocating depreciation on a monthly basis: Accounting for the Lease (cont.)

45. Accounting for the Lease (cont.) Interest expense $3,202 Lease liability $3,202 [$35,577  12%  9/12 year = $3,201.93] Amortization expense $8,112 Accumulated amortization $8,112 [$54,077  5 years  9/12 year = $8,111.55] Prepaid expenses $500 Insurance expense $500 [$2,000  3/12 year]

46. 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 simultaneously sold and 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

47. Sale and Leaseback (cont.) • 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

48. 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

49. Example of Sale and Leaseback (cont.) • 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

50. Example of Sale and Leaseback (cont.) • The building has a net book value, after accumulated depreciation, of $4,000,000 • Since the selling price is $8,500,000, Vendeur realizes a gain of $4,500,000 on the transaction • However, this gain is not recognized in income but instead is deferred • The journal entry to record this sale on 1 January 20X1is: