Financial Reporting for 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 The structure of a lease. Lessee’s incentives to keep leases off the balance sheet. The criteria used to classify leases on the lessee’s books. The financial statement effects of executory costs, residual values, purchase options and other aspects of lease contracts. The effects of capital lease versus operating lease treatment on the lessee’s financial statements. Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees. 12-2

Learning objectives: Continued 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. The key differences between current GAAP and IFRS requirements for lease accounting and the changes proposed by the FASB and the IASB. How to use financial statement disclosure to estimate the financial statement effects of treating operating leases as capital leases. 12-3

Lease contracts Right to use Owns the asset Lessor Lessee Wants to use the asset Lease payment 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. 12-4

Evolution of lease accounting: Differences between Operating and Capital Leases 12-5

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. 12-6

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. 12-7

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: 12-8

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 12-9

Lessee accounting: Effective interest method = $250,860.82 x 10% = $300,000/5 years = $79,139.18-$19,680.77 12-10

Lessee accounting: Capital lease journal entries At inception, when the lease contract is signed: PV of MLP At the end of 2014: Interest expense at the end of 2015: 12-11

Lessee accounting: Capital lease summary Lessees’ Accounting for Capital Leases 12-12

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 12-13

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 12-14

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: 12-15

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 2 Term of lease Inception Present values Many lease contracts require payments to be made at the beginning of each period: Year 1 $XX Year 2 Term of lease Inception Present values If Lessee Corporation’s lease had this form, the lessor would require a smaller payment each period: 12-16

Lessee accounting: Financial statement effects Lessee Company Pattern of Expense Recognition: Capital Versus Operating Rental payment Interest plus depreciation 12-17

Lessee accounting: Lessee disclosure, Whole Foods Market, Inc. 12-18

Lessor accounting: Capital and operating leases Sales-type Direct-financing Operating 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. For terms of bankrupcty: Capital Lease = Operating Lease 12-19

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 12-20

Lessor accounting: FASB ASC 840 Criteria for Capital Lease Treatment Type I characteristics (at least one of these is met…) Type II characteristics (…and both of these are met) 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. Remember: Revenue is recognized when both conditions exist: Critical event has taken place The amount of revenue earned is measurable 12-21

Lessor accounting: Expanded decision tree 12-22

Lessor accounting: Implied rate of return on direct-financing lease 12-23

Lessor accounting: Amortization schedule for direct-financing lease 12-24

Lessor accounting: Journal entries for direct-financing lease At inception, when the lease contract is signed: At the end of the first year (2014): 12-25

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: 12-26

Additional leasing aspects: Sale and leaseback Second Company First “Sale” transaction transfers title to asset “Lease back” allows use to be retained 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. 12-27

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: $200,000 deferred gain Amortized using the same rate and life used for leased asset Capital lease $200,000 deferred gain Amortized in proportion to rental payments Operating lease 12-28

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). Non-recourse financing Lessor Bank 1 Standard lease contract 2 Lessee 12-29

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: Operating Capital Financial reporting Lessee Lessor Capital Operating Income tax Accelerates expense recognition Delays revenue recognition 12-30

Global Vantage Point Comparison 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: 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 12-31

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. 12-32

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. 12-33