financial reporting for leases revsine/collins/johnson: chapter 12
TRANSCRIPT
Financial Reportingfor Leases
Revsine/Collins/Johnson: Chapter 12
2RCJ: Chapter 12 © 2005
Learning objectives
1. The difference between capital leases and operating leases.
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 treatment of executory costs, residual values, and other aspects of lease contracts.
5. The effects of capital lease versus operating lease treatment on the lessee’s financial statements.
6. How analysts can adjust for ratio distortions from off-balance sheet leases when comparing firms.
3RCJ: Chapter 12 © 2005
Learning objectives:Continued
7. Lessor accounting rules and how the financial reporting incentives of lessors are very different from that of lessees.
8. The difference between sales-type, direct financing, and operating lease treatment by lessors.
9. How different lease accounting treatments can affect income and net asset balances.
10.Sale/leaseback arrangements and other special leasing situations.
11.How to use lease footnote disclosures.
4RCJ: Chapter 12 © 2005
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.
LesseeLessorWants to use the asset
Owns the asset
Right to use
Lease payment
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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
$2,000 payment
Lease signed and Iris
moves in
Month 25 – year term of lease
$2,000 payment
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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
DR Rent expense $2,000 CR Lease liability $2,000To accrue a liability for that portion of the contract that has been performed.
DR Lease liability $2,000 CR Cash $2,000To record the payment of the stipulated rental fee at the end of the month.
7RCJ: Chapter 12 © 2005
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
DR Cash $2,000 CR Rental revenue $2,000To record the rental payment received each month.
DR Depreciation expense –leased building $2,000 CR Accumulated depreciation –leased building $2,000The building remains an asset on the books, periodic depreciation is recorded.
8RCJ: Chapter 12 © 2005
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.
NOPATAverage assets
ROA = ROA seems higher when leased assets are not included here.
9RCJ: Chapter 12 © 2005
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:
DR Leased 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
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Evolution of lease accounting:Overview of the two approaches
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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.
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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:
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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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Lessee accounting:Annual cost of leased asset
= $300,000 ÷ 5 years
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Lessee accounting:Capital lease journal entries
At inception, when the lease contract is signed:
DR Leased asset –capital lease $300,000 CR Obligation under capital lease $300,000
At the end of 2005:
DR Obligation under capital lease $49,139.18DR Interest expense 30,000.00 CR Cash $79,139.18
DR Depreciation expense –capital lease $60,000.00 CR Accumulated depreciation –capital lease $60,000.00
Interest expense at the end of 2006:
DR Obligation under capital lease $54,053.10DR Interest expense 25,086.08 CR Cash $79,139.18
PV of MLP
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Lessee accounting:Capital lease summary
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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:
DR Obligation under capital lease $49,139.18DR Interest expense 30,000.00 DR Miscellaneous lease expense 2,000.00 CR Cash $81,139.18
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 details
= ($312,418.40 - $20,000) ÷ 5 years
= $79,139.18 -26,452.11$264,521.06 x 10% =
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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:
DR Leased asset –capital lease $312,418.40 CR Obligation under capital lease $312,418.40
DR Obligation under capital lease $20,000.00 CR Leased asset –capital lease $20,000.00
When Lessee returns the asset worth only $15,000 and pays cash as required by the guarantee:
DR Obligation under capital lease $20,000.00DR Loss on residual value guarantee 5,000.00 CR Leased asset –capital lease $20,000.00 CR Cash 5,000.00
22RCJ: Chapter 12 © 2005
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: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 =
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Lessee accounting:Financial statement effects
Lessee Company Pattern of Expense Recognition: Capital Versus Operating
Rental payment
Interest plus depreciation
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Lessee accounting:Use of operating and capital leases
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Lessee accounting:Footnote disclosure
Off-balance sheet
obligation
Balance sheet
liabilities
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Lessee accounting:Adjusting income
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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):
Current assetsCurrent liabilities
Current assetsCurrent liabilities
Capital lease Operating lease
Increased by $49,139
Unchanged
$30,000
$49,139$79,139
Operating (amortization)
Financing (interest)
Operating (rent)
Capital lease Operating lease
Cash flow effects also occur:
29RCJ: Chapter 12 © 2005
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
30RCJ: Chapter 12 © 2005
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:Sales-type lease example
Recognized at inception
Recognized over time as
earned
32RCJ: Chapter 12 © 2005
Lessor accounting:Direct-financing lease example
Recognized over time as
earned
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Lessor accounting:SFAS No. 13 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.
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.
Type 1 characteristics(at least one of these is met…)
Type 2 characteristics(…and both of these are met)
Critical event Measurability
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Lessor accounting:Expanded decision tree
35RCJ: Chapter 12 © 2005
Lessor accounting:Direct-financing lease treatment illustrated
Also equals the present value of MLP plus GRV
36RCJ: Chapter 12 © 2005
Lessor accounting:Implied rate of return on direct-financing lease
PV of MLP
PV of GRV
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Lessor accounting:Amortization schedule for direct-financing lease
$258,699.85 x 11% == $79,189.18 - $22,881.94
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Lessor accounting:Journal entries for direct-financing lease
At inception, when the lease contract is signed:
DR Gross investment in leased asset $415,695.90 CR Equipment $304,359.49 CR Unearned financing income –leases 111,336.41
DR Cash $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 first year (2005):
DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00
At the end of the lease when the asset is returned:
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Lessor accounting:Journal entries for an operating lease
At inception, when the lease contract is signed:
No Entry: Asset remains on lessor’s books
At the end of the first year (2005):
DR Cash $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
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Lessor accounting:Comparison of operating and direct-financing
$79,139.18 - $56,871.90 =
41RCJ: Chapter 12 © 2005
Lessor accounting:Journal entries for sales-type lease
At inception, when the lease contract is signed:
DR Cash $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 first year (2005):
DR Equipment $20,000.00 CR Gross investment in leased asset $20,000.00
At the end of the lease when the asset is returned:
DR Gross investment in leased asset $415,695.90DR 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
Manufacturer’s profit recognized
at inception
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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 2005 when the first payment is received:
DR Cash $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
43RCJ: Chapter 12 © 2005
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.
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 some rate and life used for leased asset
Capital lease
$200,000deferred
gain
• Amortized in proportion to rental payments
Operating lease
DR Cash (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
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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 (SFAS No. 13).
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 SFAS No. 13.
Firms often favor one treatment for tax purposes and another treatment for financial reporting purposes:
Operating Capital
Capital Operating
Financial reporting Income tax
Lessee
Lessor
Accelerates expense
recognition
Delays revenue recognition
47RCJ: Chapter 12 © 2005
Additional leasing aspects:Lessors’ disclosures
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Additional leasing aspects:Lessors’ disclosures (concluded)
Expected cash flow
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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.
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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.
51RCJ: Chapter 12 © 2005
Appendix:Constructive capitalization
Some companies structure lease contracts to evade capital lease criteria, thereby keeping most of their leases off the balance sheet.
Other companies have a large proportion of capital leases.
The most straightforward method for making balance sheet data comparable is to treat all leases as if they were capital leases. This is called constructive capitalization.
$
Firm 1
$ $
Firm 2
$
Operating leases
Capital leases
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Appendix:Operating lease footnote
To estimate the balance sheet liability that would have been recorded under the capital lease approach, we need to calculate the present value of the MLP.
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Two alternatives for determining the discount rate can be used:
The weighted-average discount rate implicit in capital leases. The weighted-average discount rate on long-term debt.
Here’s how to find the discount rate implicit in capital leases:
A similar approach is used to find the discount rate on long-term debt
Appendix:Determining the discount rate
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Appendix:Estimating payments beyond five years
Panel at bottomPage 664
55RCJ: Chapter 12 © 2005
Appendix:Lease asset & liability (payments at year-end)
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Appendix:Lease asset & liability (payments at start of year)
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Appendix:Albertson’s capitalized leased asset
A footnote reveals that:
Applying this same proportion to the company’s operating leases yields:
$257 million
$321million
Net capital lease assets
Net capital lease obligations
$257$321
≈80%
$1,536 million
$1,920million
Capitalized operating
lease asset
Capitalized operating lease
obligation
80%
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Appendix:Financial statement impact
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Appendix:Financial ratio impact