Intermediate Accounting V2 - Chapter 20

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Kieso 9CE - Intermediate Accounting V2

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<p>Change in Flight Path for Lease ReportingWITH A FLEET of more than 80 aircraft, about40% of which is leased, WestJet has significant lease obligations. The reason the Calgary-based airline leases a good portion of its fleet is simple: airplanes are expensive. Its a big capital commitment when you purchase an aircraft, says Robert Palmer, WestJets Vice-President, Controller. Leasing allows us to be more flexible with our fleet planning. After the term of the lease, the company can return the plane or extend the lease. Another advantage is offbalance sheet reporting. When WestJet signs a lease, it tests the lease to determine if its an operating lease or a capital lease. All of WestJets current aircraft leases do not qualify as capital leases and therefore are considered operating leases: the airline will not own the aircraft at the end of the leases term; the leases range from 8 to 14 years, just a portion of the aircrafts economic lives; and the lease payments are only a portion of the aircrafts fair value. WestJet does not include the future operating lease payments on the balance sheet, but instead includes them in the notes to the financial statements as a commitment. The aircraft rental expensei.e., the lease paymentis included in the statement of earnings. This may change, however, with WestJets move to IFRS as of January 2011. The IASB and FASB have put out a discussion paper on removing the concept of operating leases, explains Palmer. Every lease would become a capital lease, so therefore, the asset and corresponding liability would be on your balance sheet. This will affect WestJets reporting of its liabilities since, as of September 2009, it had approximately $1.6 billion in lease commitments that were not included in liabilities. The big concern, says Palmer, is what it will do to your covenants and ratios, such as the debt-to-equity ratio. But WestJet isnt too worried since it considers offbalance sheet obligations relating to aircraft operating leases when doing these calculations. WestJet will have to make changes to its balance sheet and educate users about those changes. But nothing has really changed in the business, Palmer stresses. Its just the way its being presented. </p> <p>CHAPTER 20</p> <p>Leases</p> <p>Learning ObjectivesAfter studying this chapter, you should be able to: 1. Explain the conceptual nature, economic substance, and advantages of lease transactions. 2. Identify and apply the criteria that are used to determine the type of lease for accounting purposes for a lessee under the classification approach. 3. Calculate the lease payment that is required for a lessor to earn a specific return. 4. Account for a lessees basic capital (finance) lease. 5. Determine the effect of, and account for, residual values and bargain purchase options in a lessees capital (finance) lease. 6. Account for an operating lease by a lessee and compare the operating and capitalization methods of accounting for leases. 7. Determine the balance sheet presentation of a capital (finance) lease and identify other disclosures required. 8. Identify and apply the criteria that are used to determine the type of lease for a lessor under the classification approach. 9. Account for and report basic financing and sales-type leases by a lessor. 10. Account for and report financing and sales-type leases with guaranteed values or a bargain purchase option by a lessor. 11. Account for and report an operating lease by a lessor. 12. Explain and apply the contract-based approach to a basic lease for a lessee and lessor. 13. Identify differences in accounting between accounting standards for private enterprises and IFRS, and what changes are expected in the near future. After studying Appendix 20A, you should be able to: 14. Describe and apply the lessees accounting for sale-leaseback transactions.</p> <p>Preview of Chapter 20Leasing continues to grow in popularity as a form of asset-based financing.1 Instead of borrowing money to buy an airplane, a computer, a nuclear core, or a satellite, a company leases the item. Railroads lease huge amounts of equipment, many hotel and motel chains lease their facilities, most retail chains lease the bulk of their retail premises and warehouses, and, as indicated in the opening vignette, most airlines lease their airplanes! The popularity of leasing is shown by the fact that 189 of 200 companies surveyed in Financial Reporting in Canada2008 disclosed lease data.2 Small and medium-sized enterprises also use leases as an important form of debt financing. Because of the significance and popularity of lease arrangements, consistent accounting and complete reporting of these transactions are crucial. In this chapter, we look at these important issues related to leasing. The chapter is organized as follows:</p> <p>LEASES</p> <p>Leasing BasicsThe leasing environment Conceptual nature of a lease Current standards</p> <p>Classification Approach LesseesClassification criteria How the lessor determines the rental payments Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure</p> <p>Classification Approach LessorsClassification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change</p> <p>Contract-Based ApproachScope and definition Recognition and measurement lessee Illustration Recognition and measurement basicslessor New lease accounting standard</p> <p>IFRS and Private Enterprise GAAP ComparisonComparison of IFRS and private enterprise GAAP Looking ahead</p> <p>Appendix 20A Other Lease IssuesSale and leaseback transactions Real estate leases</p> <p>1 Asset-based financing is the financing of equipment through a secured loan, conditional sales contract, or lease. 2</p> <p>CICA, Financial Reporting in Canada2008, p. 301.</p> <p>LEASING BASICSThe Leasing EnvironmentAristotle once said, Wealth does not lie in ownership but in the use of things! Many Canadian companies have clearly come to agree with Aristotle as, rather than owning assets, they now are heavily involved in leasing them. A lease is a contractual agreement between a lessor and a lessee that gives the lessee, for a specified period of time, the right to use specific property owned by the lessor in return for specified, and generally periodic, cash payments (rents). An essential element of the lease agreement is that the lessor transfers less than the total interest in the property. Because of the financial, operating, and risk advantages that the lease arrangement provides, many businesses and other types of organizations lease substantial amounts of property as an alternative to ownership. Any type of equipment or property can be leased, such as rail cars, helicopters, bulldozers, schools, golf club facilities, barges, medical scanners, computers, and so on. The largest class of leased equipment is information technology equipment. Next are assets in the transportation area, such as trucks, aircraft, and rail cars.EXAMPLE The lessee company gains the right to use the asset over the lease term in exchange for promising to make periodic rent or lease payments. The asset might be an automobile, a building, or any of a broad range of possible assets.Lessee</p> <p>1 ObjectiveExplain the conceptual nature, economic substance, and advantages of lease transactions.</p> <p>Leased asset</p> <p>Obligation to make payments</p> <p>Lessor</p> <p>Because a lease is a contract, the provisions that the lessor and lessee agree to can vary widely from lease to lease. Indeed, they are limited only by the ingenuity of the two parties to the contract and their advisors. The leases durationlease termmay be anything from a short period of time to the entire expected economic life of the asset. The rental payments may be the same amount from year to year, or they may increase or decrease; further, they may be predetermined or may vary with sales, the prime interest rate, the consumer price index, or some other factor. In many cases, the rent is set at an amount that enables the lessor to recover the assets cost plus a fair return over the life of the lease. The obligations for taxes, insurance, and maintenance (executory costs) may be the responsibility of either the lessor or the lessee, or they may be divided. In order to protect the lessor from default on the rents, the lease may include restrictionscomparable to those in bond indenturesthat limit the lessees activities in making dividend payments or incurring further debt. In addition, the lease contract may be non-cancellable or may grant the right to early termination on payment of a set scale of prices plus a penalty. In case of default, the lessee may be liable for all future payments at once, and receive title to the property in exchange; or the lessor may have the right to sell the asset to a third party and collect from the lessee all or a portion of the difference between the sale price and the lessors unrecovered cost. When the lease term ends, several alternatives may be available to the lessee. These may range from simple termination, to the right to renew or buy the asset at a nominal price.</p> <p>Law</p> <p>Who Are the Players?Who are the lessors referred to above? In Canada, lessors are usually one of three types of company: 1. Manufacturer finance companies 2. Independent finance companies 3. Traditional financial institutions Manufacturer finance companies, or captive leasing companies as they are also called, are subsidiaries whose main business is to perform leasing operations for the parent company. General Motors Acceptance Corporation of Canada, Limited is an example of a captive leasing company. As soon as the parent company receives a possible order, its leasing subsidiary can quickly develop a lease-financing arrangement that facilitates the parent companys sale of its product. An independent finance company acts as a financial intermediary by providing financing for transactions for manufacturers, vendors, or distributors. Your dentist, for example, when acquiring specialized equipment for his or her practice, may order the equipment through the manufacturer or distributor, who in turn may outsource the financing to a lessor such as an independent finance company. Subsidiaries of domestic and foreign banks are examples of traditional financial institutions that provide leasing as another form of financing to their customers.</p> <p>Advantages of LeasingAlthough leasing does have disadvantages, the growth in its use suggests that it often has a genuine advantage over owning property. Some of the advantages are as follows:</p> <p>1. 100% Financing at Fixed Rates. Leases are often signed without requiring anymoney down from the lessee, helping to conserve scarce cashan especially desirable feature for new and developing companies. In addition, lease payments often remain fixed (i.e., unchanging), which protects the lessee against inflation and increases in the cost of money. The following comment about a conventional loan is typical: Our local bank finally agreed to finance 80% of the purchase price but wouldnt go any higher, and they wanted a floating interest rate. We just couldnt afford the down payment and we needed to lock in a payment we knew we could live with. Turning to the lessors point of view, financial institutions and leasing companies find leasing profitable because it provides attractive interest margins.</p> <p>2. Protection Against Obsolescence. Leasing equipment reduces the risk of obsolescence to the lessee, and in many cases passes the risk of residual value to the lessor. For example, a company that leases computers may have a lease agreement that permits it to turn in an old computer for a new model at any time, cancelling the old lease and writing a new one. The cost of the new lease is added to the balance due on the old lease, less the old computers trade-in value. As one treasurer remarked, Our instinct is to purchase. But when new computers come along in a short time, then leasing is just a heck of a lot more convenient than purchasing. On the other hand, the lessor can benefit from the property reversion (i.e., the return of the asset) at the end of the lease term. Residual values can produce very large profits. For example, Citicorp at one time assumed that the commercial aircraft it was leasing to the airline industry would have a residual value of 5% of their purchase price. As it turned out, however, the planes were worth 150% of their costa handsome price appreciation. Three years later these same planes slumped to 80% of their cost, but this was still a far greater residual value than the projected 5%.</p> <p>3. Flexibility. Lease agreements may contain less restrictive provisions than other debtagreements. Innovative lessors can tailor a lease agreement to the lessees specific needs. For instance, a ski lift operator using equipment for only six months of the year can arrange rental payments that fit well with the operations revenue streams. In addition, because the lessor retains ownership and the leased property is the collateral, it is usually easier to arrange financing through a lease.</p> <p>4. Less Costly Financing for Lessee, Tax Incentives for Lessor. Some companies findleasing cheaper than other forms of financing. For example, start-up companies in depressed industries or companies in low tax brackets may lease as a way of claiming tax benefits that might otherwise be lost. Investment tax credits and capital cost allowance deductions offer no benefit to companies that have little or no taxable income. Through leasing, these tax benefits are used by the leasing companies or financial institutions. They can then pass some of these tax benefits back to the assets user through lower rental payments.</p> <p>Underlying ConceptSome companies double-dip at the international level. The leasing rules of the lessors and lessees countries may differ, permitting both parties to own the asset. In such cases, both the lessor and lessee can receive the tax benefits related to amortization.</p> <p>5. OffBalance Sheet Financing. Certain leases do not add debt on a balance sheet or affect financial ratios, and may add to borrowing capacity.3 Offbalance sheet financing has been critical to some companies. For example, airlines use lease arrangements extensively and this results in a great deal of offbalance sheet financing. Illustration 20-1 indicates that debt levels are understated by WestJet Airlines Ltd., Air Canada, and Helijet International Inc., a sample of Canadian companies in the transportation industry.WestJet December 31, 2009 ($ thousands) Long-term liabilities, excluding future income taxes and deferred credits Shareholders equity Unrecognized future minimum lease payments under existing operating leases Air Canada December 31, 2009 ($ millions) Helijet August 31, 2009 ($ thousands)</p> <p>Illustration 20-1 Reported Debt and Unrecognized Operating Lease Obligations</p> <p>$1,056,838 1,388,928</p> <p>$...</p>