Intermediate Accounting
Thomas H. Beechy
Schulich School of
Business,
York University
Joan E. D. Conrod
Faculty of Management
Dalhousie University
Powerpoint slides by:
Michael L. Hockenstein  Commerce Department • Vanier College
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Accounting for Leases by Lessors
Chapter 19
19-2
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Classification as a Capital Lease
 A capital lease: a lease that, from the point

of view of the lessee, transfers substantially all
the benefits and risks incident to ownership of
property to the lessee [CICA 3065.03(a)]
The three guidelines that apply to both
lessees and lessors are:
 lessee will obtain ownership at the end of the
lease term; automatic transfer of title--bargain purchase option
19-3
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Classification as a Capital Lease (cont.)
 lessee obtains substantially all of the
economic benefits - lease term is at least
75% of the asset’s economic life
 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 including guaranteed residual
19-4
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Classification as a Capital Lease (cont.)
 The two that, in addition, apply only to lessors
are:
 the credit risk associated with the lease is
normal
 the amounts of any unreimbursable costs can
be reasonably estimated [CICA 3065.07]
19-5
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Classification as a Capital Lease (cont.)
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

Minimum lease term includes bargain renewal
terms, terms prior to the exercisability of a bargain
purchase option, and renewal terms at the lessor’s
option
Minimum net lease payments includes lease
payments during bargain renewal terms, any bargain
purchase option price, and any guaranteed residual
value
The interest rate used for discounting the net
lease payments by the lessor is the rate implicit in
the lease
19-6
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Classification as a Capital Lease (cont.)



In a direct financing lease, the lessor is acting
purely as a financial intermediary
A sales-type lease is used by a manufacturer or a
dealer as a means of selling a product
There are two profit components in a sales-type
lease:
 the profit (or loss) on the sale
 interest revenue from the lease
19-7
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Operating Leases

The characteristics of accounting for an
operating lease are as follows [CICA 3065.55
and 3065.56]:
 the assets that are available for leasing are
shown (at cost) on the lessor’s balance sheet
 the assets are amortized in accordance with
whatever policy management chooses
 lease revenue is recognized as the lease
payments become due (or are accrued, if the
payment dates do not coincide with the
reporting periods)
19-8
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Operating Leases (cont.)
 lump sum payments (e.g., at the inception
of the lease) are amortized over the initial
lease term
 initial direct costs (that is, the direct costs
of negotiating and setting up the lease)
are deferred and amortized over the initial
lease term proportionate to the lease
revenue
19-9
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Direct Financing Leases---Net Basis


A direct financing lease arises when a lessor acts
purely as a financial intermediary
The lessor in a direct financing lease recognizes
revenue as finance revenue or interest revenue on a
compound interest basis over the minimum lease
term
19-10
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Current vs. Long Term Balances


If the lessor uses a current/long-term
classification: the current portion is the amount
by which the principal will be reduced during the
next fiscal year, plus any interest accrued to date
The CICA Handbook recommends that the lease
receivable “should be disclosed and, in a
classified balance sheet, segregated between
current and long-term portions” [CICA 3065.54,
italics added]
19-11
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Change in Residual Value


The CICA Handbook recommends that any
estimated residual value “be reviewed annually to
determine whether a decline in its value has
occurred” [CICA 3065.41]
If there has been a decline in value, and if the
reduction in the estimated residual value “is other
than temporary,” the original salvage value used in
the amortization schedule should be replaced by
the new estimate
19-12
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Change in Residual Value (cont.)



Changing a component of the cash flows will change
the remaining present value of the receivable, of
course, and the AcSB recommends that the resulting
reduction be charged to income (that is, as a loss)
Reducing the present value will also reduce the
amount of future finance revenue, due to the
reduction of the present value base on which the
revenue is calculated
Increases in residual value are not accounted for;
they are recognized as a gain at disposal
19-13
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Future Income Taxes



When the lessor accounts for a lease as a capital
lease, net income will include imputed interest as
finance revenue
On the tax return the lessor will report the full
amount of the lease payments as rental revenue
and will claim CCA on the leased asset as a tax
deduction
Each year there will be a difference between the
revenue reported on the income statement and the
revenue and expense reported on the tax return
19-14
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Future Income Taxes (cont.)


This is a temporary difference that gives rise to
future income tax liability
Over the life of the lease, the finance revenue (for
accounting purposes) will equal the net difference
between the rental revenue and the accumulated
CCA
19-15
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Principal Characteristics
of the Gross Method
 The crucial aspect of reporting a lease is that the


balance sheet must show the net present value of
the remaining lease payments at all times
The income statement will show the accrued
finance revenue (or interest income) earned
during the reporting period
Lessors normally use the gross method of
recording capital leases, to facilitate control
19-16
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Principal Characteristics
of the Gross Method (cont.)
 Gross method of recording capital
leases: the lessor records the gross amount of


the net lease payments (that is, undiscounted) and
offsets that gross amount with the portion that
represents unearned revenue for reporting
purposes
The gross method yields exactly the same results
as the net method
The difference is only one of bookkeeping, not of
financial reporting
19-17
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Disclosure for Lessors
 The CICA Handbook recommends only the
following disclosures [CICA 3065.54]:
the lessor’s net investment (i.e., the lease
payments receivable, less unearned finance
revenue)
the amount of finance income
the lease revenue recognition policy
19-18
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Disclosure For Lessors (cont.)
 The CICA Handbook also suggests that “it
may be desirable” to disclose the following
information:
 the aggregate future minimum lease payments
receivable (that is, the gross amount)
 the amount of unearned finance income
 the estimated amount of unguaranteed residual
values
 executory costs included in minimum lease
payments
19-19
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Sales-Type Leases
 A sales-type lease is a capital lease that,

from the lessor’s point of view, represents
the sale of an item of inventory
Lessors in sales-type leases are
manufacturers or dealers, they are not
financial institutions and are not acting as
financial intermediaries
19-20
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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Sales-Type Leases (cont.)
 For the lessor’s financial reporting the
distinction matters because a sales-type
lease is viewed as two distinct but related
transactions:
 the sale of the product, with recognition of a
profit or loss on the sale
 the financing of the sale through a capital
lease, with finance income recognized over
the lease term
19-21
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Example: Sales-Type Lease
 Assume that on 31 December 20X1, Binary



Corporation, a computer manufacturer, leases a large
computer to a local university for five years at
$200,000 per year, payable at the beginning of each
lease year
The normal cash sales price of the computer is
$820,000
The computer cost Binary Corporation (BC) $500,000
to build
The lease states that the computer will revert to BC at
the end of the lease term, but a side letter from BC to
the university states BC’s intention not to actually
reclaim the computer at the end of the lease
19-22
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Example: Sales-Type Lease (cont.)



The implicit interest rate that discounts the lease
payments to the $820,000 fair value of the
computer is 11.04%
Unless the cost of financing is well in excess of this
rate, the lease can be assumed to be a capital
lease
Because the lessor is the manufacturer of the
product, and because the computer is carried on
BC’s books at a value that is less than fair value,
the lease clearly is a sales-type lease
19-23
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Example: Sales-Type Lease (cont.)
The sale component of the transaction will be recorded as follows (using the gross method):
31 December 20X1:
Lease payments receivable
1,000,000
Unearned finance revenue
180,000
Sales revenue
820,000
Cost of goods sold
500,000
Computer inventory
500,000
The first payment will recorded:
31 December 20X1:
Cash
200,000
Lease payments receivable
200,000
19-24
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The Interest Rate Question
 The interest rate used in accounting for a capital lease




is the rate implicit in the lease
The fair value or “cash price” may not be so obvious
The problem arises because many products that are
sold via sales-type leases are subject to discounts or
special “deals” wherein the actual price is less than
the stated list price
In theory, the lease payments should be discounted to
equal the actual price rather than the list price
In practice, this is harder to do because the actual
price is often hidden in the transaction
19-25
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The Interest Rate Question (cont.)
 The interest rate does not matter in the long run,


because total revenue (the sales price plus finance
revenue) will work out the same regardless of the
interest rate used in the calculations
However, decreasing the interest rate will have the
effect of increasing the reported selling price and
thereby shifting revenue (and profit) from the finance
period to the period of the sale
Increasing the interest rate would have the opposite
effect
19-26
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Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
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The Interest Rate Question (cont.)
 The CICA Handbook offers no real assistance.
The explanation offered for reporting a salestype lease is as follows:
 the sales revenue recorded at the inception of a
sales-type lease is the present value of the
minimum lease payments . . . computed at the
interest rate implicit in the lease [CICA 3065.43]
19-27
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Incidence of Sales-Type Leases
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
The incidence of sales-type leases in Canada is,
technically, rather rare
There are a lot of manufacturers and/or dealers
who do appear to sell their products through
sales-type leases; e.g., computers and
automobiles
A lessor will not be able to claim the full amount
of CCA on leased assets if the CCA exceeds the
lease payments received, unless the lessor
qualifies as a lessor under the income tax
regulations
19-28
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Incidence of Sales-Type Leases (cont.)


To qualify, a lessor must obtain at least 90% of its
revenue from leasing
In order for the leases to receive full tax advantage,
companies that use leasing as a sales technique
almost inevitably form a separate subsidiary
corporation to carry out the leasing activity
19-29
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After-Tax Accounting for Leases
by Lessors


Leases normally are taxed as operating leases,
regardless of the accounting treatment; the lessor
reports taxable rental receipts and deducts CCA
Leases that are taxed as operating leases but
accounted for as capital leases will give rise to
temporary differences for income tax accounting
 Tax shield: an amount that is deductible when
calculating income taxes and therefore shields that
taxpayer from some amount of income tax, most
frequently used to refer to capital cost allowance
19-30
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Leveraged Leases
 A leveraged lease: one wherein the lessor
obtains direct financing for a lease from a third
party; the lessor is an intermediary
 A non-recourse lease: the third party cannot

go to the lessor for repayment if the lessee defaults
and the cash stops flowing
 the third party can seek redress only from the
lessee directly
In non-recourse leases, the lessor does not report
the liability to the third party on its balance sheet
because the lessor is not liable to the third party
except as an intermediary
19-31
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Leveraged Leases (cont.)
 Lease with recourse: the lessor is liable to third


parties even if the lessee stops making payments
If the lease is with recourse to the lessor, then the
lessor is obligated to the third party and the full
liability will be reported on the lessor’s balance
sheet
Leases that do not qualify for capital lease treatment
are reported as operating leases; the physical asset
remains on the lessor’s balance sheet and is
depreciated, while the lease payments are reported
as rental revenue
19-32
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