Intermediate Accounting - McGraw-Hill Education Canada · Intermediate Accounting. ... In accounting, a basic principle is that we should attempt to report transactions in accordance

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


18


Chapter 18

■ Accounting for Leases byLessees


18


Introduction

■ A lease is an arrangement whereby the person or company that ownsan asset agrees to let another person or company use the asset for aperiod of time at a stated (or determinable) amount of rent. The owneris called the lessorlessor, while the renter is the lesseelessee.

■ In accounting, a basic principle is that we should attempt to reporttransactions in accordance with their economic substance economic substance rather thantheir legal form.legal form.

■ Often, the economic substance of a lease is that the lessor is reallyproviding the lessee with use of the asset over the bulk of theuse of the asset over the bulk of theasset�s useful life in return for a full repayment of the cost of theasset�s useful life in return for a full repayment of the cost of theasset, plus interest.asset, plus interest.

500500

500 500


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Definition Of A Lease

■ �the conveyance, by a lessor to a lessee, of the rights to use atangible asset usually for a specified period of time in return forrent.�

■ The lease specifies the terms under which the lessee has the rightto use the owner's property and the compensation to be paid to thelessor in exchange.

CICA Handbook Section 3065, paragraph .03(n). CICA Handbook Section 3065, paragraph .03(n). This definition does notnotinclude (a) agreements that are contracts for services contracts for services that do not transfer theright to use property, plant, or equipment from one contracting party to the

other, (b) lease agreements concerning the rights to explore rights to explore for or to exploitnatural resources such as oil, gas, minerals, and timber, or (c) licensinglicensing

agreements for items such as motion picture films, plays, manuscripts, patents,and copyrights.


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Why Lease? The Leasing Continuum

■■ Why do companies leaseWhy do companies leaseassets instead of buying them?assets instead of buying them?

■ A short-term lease is used toobtain temporary use of antemporary use of anasset asset without having to buy it.This is appropriate when there isno long-term need for an asset,or when the lessee�s business isvolatile and there is not aconstant need for a certain typeof asset.

■ A short-term lease that providesthe lessee with temporary use ofan asset is called an operatingoperatinglease.lease.

■ The longer the lease term, thelower the daily rental cost.

■ A lease that conveys substantiallyall of the risks and rewards ofownership from the lessor to thelessee is, in substance, a meansof financing acquisition of thefinancing acquisition of theasset asset which is called a capitalcapitalleaselease.


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Operating Leases

■ An operating lease is one that gives the lesseethe right to use the asset for only a relativelyrelativelyshort period of its useful lifeshort period of its useful life, such as rentinga car or truck for a day, a month or a year.

■ The lessee makes periodic payments to thelessor, which are accounted for as normalnormalexpense items expense items by the lessee. Meanwhile, thelessor credits the payments to an incomeaccount such as leasing revenue.leasing revenue.

■ It is important to remember that short-term is ashort-term is arelative phrase relative phrase when it comes to asset leasing;a ten-year lease is short term when it applies toleasing a building or a part of a building whoseuseful life may be 60 or 80 years.

Example Of A Capital Lease

■ Assume that Rosie Inc. enters into a lease for equipment. Theterms of the lease and the characteristics of the equipmentare as follows:

• The current purchase price of the equipment is $700,000purchase price of the equipment is $700,000. Theexpected useful economic life of the equipment is twenty years.twenty years.

• The initial lease term is eight yearsinitial lease term is eight years; Rosie cannot cancel thelease during this period.

• Lease payments during the initial lease term are $100,000 per$100,000 peryearyear. These payments include property taxes and insuranceinclude property taxes and insurancecosts that are estimated to be $5,000 per year.

• At the end of the initial lease term, Rosie can elect to renew elect to renew thelease for two successive four-year terms at an annual rental of$40,000 per year, including estimated property taxes and insuranceof $4,000 per year.

• Eight-year-old equipment of this type has a fair value fair value ofapproximately $350,000, and can be leased for about $54,000 peryear, net.


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Informal Criterion For Capital Leases

■ In order to fully realize the tax advantages that often are the driving forcebehind capital leases, a lessor must qualify as a lessor under the incometax regulations.

■ Lessor must derive at least 90% of its revenues from lease90% of its revenues from leasetransactions. transactions. Any company that meets this criterion is not an operatingcompany; it is a financial intermediaryfinancial intermediary. A capital lease capital lease is assumed ifthe lease term is for 70% 70% of the asset�s useful life useful life and the presentpresentvalue value of the minimum net lease payments is 85% 85% of the fair value fair value of theasset.

■ If the tax advantages of the lease are substantial, the reduced leasepayments could result in a lease contract that easily fails to meet thecapital lease criteria.

■ Thus the emphasis of the CICA Handbook CICA Handbook on the substance of thesubstance of thetransaction transaction must remain paramount, regardless of whether any of thethree capital lease criteria are present.


18


Advantages Of Long Term Leases

■■ Off-Balance Sheet FinancingOff-Balance Sheet Financing

� the acquisition of assets through capital leasespermitted lessees to obtain the full and unfettered useof assets without having to report the assets on theirbalance sheets

■ 100% Financing

■ Flexibility

■ Protection from Interest Rate Changes

■ Transfer of Income Tax Benefits

�� ...the driving force behind the�...the driving force behind thebulk of direct financing leases.�bulk of direct financing leases.�


18


Future Income Taxes

■ If a lessee enters into a lease contract, Revenue Canada normally will view theappropriate deduction for tax purposes to be the amount of lease paymentsmade during the tax year. The fact that a lease may be accounted for as acapital lease is of no interest to the tax people.

■ Leases that transfer title to the lessee at the end of the lease term will beviewed by Revenue Canada as installment sales contracts in substance, andwill be taxed as a purchase. If a lease is taxed as a purchase, then the lesseewill deduct imputed interest expense and will be eligible to deduct CCA.Therefore, leases are seldom structured in a way that invites taxation as apurchase.

■ In most instances, a lease that is reported by the lessee as a capital lease will betaxed as an operating lease. This difference in treatment will give rise to atemporary difference.temporary difference.

■ The future tax impact of the temporary difference relating to a capital lease iscredited to the long-term long-term future income tax balance.


18


Capital Lease Illustration � Extended Example

■ In this extended example, the important elements for analysis are as follows:• The lease term 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 minimum net lease payments are now $18,500 for each of the first three yearsand $3,200 per year for the fourth and fifth years (as in the earlier example, theestimated insurance cost must be subtracted or netted out to determine the net leasepayments).

• Lessee Ltd.�s incremental borrowing rate incremental borrowing rate is 12% p.a.

■ 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 = $18,500 (P/A due, 12%, 3) + $3,200 (P/A due, 12%, 2) (P/F, 12%, 3)

�� PV = $49,766 + $4,311PV = $49,766 + $4,311

�� PV = $54,077PV = $54,077

■ The annual lease payments are less than in the earlier example, but the presentvalue is almost the same because the payments now are at the beginning of eachlease year instead of at the end.


18


Sale And Leaseback

■ It is not unusual for a company to take an asset that it owns and enterinto a transaction with another party in which the asset is sold andsimultaneously leased back. The asset is thereby converted from anowned asset to a leased asset. The transaction results in animmediate cash flow to the seller, which can be used to retire debt(particularly any outstanding debt on the asset, such as a mortgage ora collateral loan) or used for operating purposes, or a combination ofboth.

� The lease part of the transaction must be evaluated and judged tobe either a capital lease or an operating lease.

� The sale portion of the deal is initially recorded just like any othersale, with a gain or loss recorded for the difference between thenet proceeds from the sale and the asset�s net book value.


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Example Of Sale And Leaseback

■ Assume that Vendeur Ltd. owns a building in central Montreal. Vendeurenters into an agreement with Bailleur Inc. whereby Vendeur sells thebuilding to Bailleur and simultaneously leases it back.

■ The historical cost of the building is $10,000,000; it is 60% depreciated onVendeur�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 annuallease payment is $850,000, payable at the end of each lease year.

• 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 notdisclosed to Vendeur.


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Example Of Sale And Leaseback

■ At the end of 20x1, Vendeur:• records the interest expense (@9%),

• pays the $850,000 annual lease payment to Bailleur,

• amortizes the asset, and

• amortizes the deferred gain.

■ The interest expense and the lease payment will berecorded as follows:

Interest expenseInterest expense 698,334698,334

Lease liability Lease liability 698,334698,334

Lease liabilityLease liability 850,000850,000

CashCash 850,000850,000


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Disclosure Of Leases

■■ Operating LeasesOperating Leases� The CICA Handbook CICA Handbook recommends that lessees disclose, in the notes

to the financial statements, the company�s obligation for operatinglease payments for each of the next five years and for the five-yearperiod in total [CICA 3065.32].[CICA 3065.32]. Operating leases that are on a year-by-year basis, with no obligation beyond the forthcoming year, are usuallynot included in the disclosure because there is no obligation beyondthe current year.

■■ Capital LeasesCapital Leases� A company�s rights to leased assets are different from its rights to

owned assets. A company can sell, modify, or otherwise dispose ofowned assets without restriction. Owned assets can also be used ascollateral for a loan. Leased assets, on the other hand, belong to thelessor. The lessee does not have the same rights of ownership, eventhough the lessee bears substantially all of the risks and rewards ofownership.


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Exhibit 18-8

000s Canadian Dollars1998 $4,5491999 6,5162000 4,2642001 2,6602002 1,959

Thereafter 1,259$17,907

Example of Operating Lease DisclosureTesma International Inc. −−−− Notes to Consolidated Financial Statements9. DEBT AND COMMITMENTS

[f] The Company had commitments under operating leases requiring minimumannual rental payments for the years ending July 31 as follows:

Approximately 27% of these leaseApproximately 27% of these leasecommitments represent thecommitments represent theCompany�s share ofCompany�s share ofcommitments of itscommitments of itsproportionately consolidated jointproportionately consolidated jointventures. For the year ended Julyventures. For the year ended July31, 1997, payments under31, 1997, payments underoperating leases amounted tooperating leases amounted toapproximately $4.0 million [1996 �approximately $4.0 million [1996 �$3.4 million; 1995 $3.4 million; 1995 −−−−−−−− $3.0 million]. $3.0 million].


18


International Perspective

■ Capitalization of long-term leases has become a widely acceptedpractice world-wide. International Accounting Standard 17International Accounting Standard 17recommends that leases that transfer substantially all of the risks andbenefits of ownership to the lessee should be capitalized.

■ As well, most developed countries have their own lease accountingstandards that are generally similar to Canadian practice.

■ Differences in the criteria: limit capital lease accounting

■ Several countries (e.g., Spain and Sweden)� purchase option at the end of the lease.

■ France � forbids capitalization of the leasepayments until the purchase option has beenexercised.

■ Denmark and Austria have no standard thatrequires lease capitalization.

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Intermediate Accounting - McGraw-Hill Education Canada · Intermediate Accounting. ... In accounting, a basic principle is that we should attempt to report transactions in accordance