This chapter list three major long-term liability categories and identify key financial ratios relied upon to assess the importance of these liabilities as a form of financing; list three basic contractual forms that underlie long-term liabilities, and in each case show how the effective interest rate is computed.
PART III: Decision Tools Lecture 29 Special Accounting Problems Related to Leases Learning Learning Objectives Objectives Identify special features of lease arrangements that cause unique accounting problems Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting Describe the lessor’s accounting for sales-type leases List the disclosure requirements for leases Accounting Accounting for for Leases Leases Leasing Environment Special Accounting Problems Accounting by Lessee Accounting by Lessor Who are players? Capitalization criteria Economics of leasing Advantages of leasing Accounting differences Classification Sales-type leases Conceptual nature of a lease Capital lease method Direct-financing method Bargainpurchase option Operating method Initial direct costs Operating method Comparison Residual values Current versus noncurrent Disclosure Unresolved problems Special Special Accounting Accounting Problems Problems Residual values Sales-type leases (lessor) Bargain-purchase options Initial direct costs Current versus non-current classification Disclosure LO Identify special features of lease arrangements that cause unique accounting problems Special Special Accounting Accounting Problems Problems Residual Values Meaning of Residual Value - Estimated fair value of the leased asset at the end of the lease term Guaranteed Residual Value – Lessee agrees to make up any deficiency below a stated amount that the lessor realizes in residual value at the end of the lease term LO Identify special features of lease arrangements that cause unique accounting problems Special Special Accounting Accounting Problems Problems Residual Values Lease Payments - Lessor may adjust lease payments because of the increased certainty of recovery of a guaranteed residual value Lessee Accounting for Residual Value - The minimum lease payments, include the guaranteed residual value but excludes the unguaranteed residual value LO Identify special features of lease arrangements that cause unique accounting problems Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Caterpillar Financial Services Corp (a subsidiary of Caterpillar) and Sterling Construction Corp sign a lease agreement dated January 1, 2012, that calls for Caterpillar to lease a front-end loader to Sterling beginning January 1, 2012 The terms and provisions of the lease agreement, and other pertinent data, are as follows The term of the lease is five years The lease agreement is noncancelable, requiring equal rental payments at the beginning of each year (annuity-due basis) The loader has a fair value at the inception of the lease of $100,000, an estimated economic life of five years, and estimated residual value of $5,000 at the end of the lease LO Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Sterling pays all of the executory costs directly to third parties except for the property taxes of $2,000 per year, which is included as part of its annual payments to Caterpillar The lease contains no renewal options The loader reverts to Caterpillar at the termination of the lease Sterling’s incremental borrowing rate is 11 percent per year Sterling depreciates on a straight-line basis Caterpillar sets the annual rental to earn a rate of return on its investment of 10 percent per year; Sterling knows this fact LO Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Caterpillar computation of the lease payments: LO Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting): Computation of Lessee’s capitalized amount 10 LO Describe the effect of residual values, guaranteed and unguaranteed, on lease accounting EXAMPLES OF LEASE ARRANGEMENTS 40 EXAMPLES OF LEASE ARRANGEMENTS 41 EXAMPLES OF LEASE ARRANGEMENTS 42 EXAMPLES OF LEASE ARRANGEMENTS 43 EXAMPLES OF LEASE ARRANGEMENTS 44 SALE-LEASEBACKS The term sale-leaseback describes a transaction in which the owner of the property (seller-lessee) sells the property to another and simultaneously leases it back from the new owner Advantages: Financing Taxes 45 SALE-LEASEBACKS Determining Asset Use To the extent the seller-lessee continues to use the asset after the sale, the sale-leaseback is really a form of financing Lessor should not recognize a gain or loss on the transaction If the seller-lessee gives up the right to the use of the asset, the transaction is in substance a sale 46 Gain or loss recognition is appropriate SALE-LEASEBACKS Lessee If the lease meets one of the four criteria for treatment as a capital lease, the seller-lessee should 47 Account for the transaction as a sale and the lease as a capital lease Defer any profit or loss it experiences from the sale of the assets that are leased back under a capital lease Amortize profit over the lease term SALE-LEASEBACKS Lessee If none of the capital lease criteria are satisfied, the sellerlessee accounts for the transaction as a sale and the lease as an operating lease 48 Lessee defers such profit or loss and amortizes it in proportion to the rental payments over the period when it expects to use the assets SALE-LEASEBACKS Lessor If the lease meets one of the lease capitalization criteria, the purchaser-lessor records the transaction as a purchase and a direct-financing lease If the lease does not meet the criteria, the purchaser-lessor records the transaction as a purchase and an operating lease 49 SALE-LEASEBACKS Sale-Leaseback Example American Airlines on January 1, 2011, sells a used Boeing 757 having a carrying amount on its books of $75,500,000 to CitiCapital for $80,000,000 American immediately leases the aircraft back under the following conditions: The term of the lease is 15 years, noncancelable, and requires equal rental payments of $10,487,443 at the beginning of each year The aircraft has a fair value of $80,000,000 on January 1, 2012, and an estimated economic life of 15 years American pays all executory costs American depreciates similar aircraft that it owns on a straight-line basis over 15 years 50 The annual payments assure the lessor a 12 percent return American’s incremental borrowing rate is 12 percent SALE-LEASEBACKS Sale-Leaseback Example This lease is a finance lease to American because the lease term is equal to the estimated life of the aircraft and because the present value of the lease payments is equal to the fair value of the aircraft to CitiCapital CitiCapital should classify this lease as a direct financing lease 51 SALE-LEASEBACKS 52 RELEVANT FACTS 53 Both GAAP and IFRS share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities GAAP for leases uses bright-line criteria to determine if a lease arrangement transfers the risks and rewards of ownership; IFRS is more general in its provisions One difference in IFRS and GAAP is that finance leases are referred to as capital leases in GAAP Under IFRS, lessees and lessors use the same general lease capitalization criteria GAAP has additional lessor criteria that payments are collectible and there are no additional costs associated with a lease RELEVANT FACTS 54 IFRS requires that lessees use the implicit rate to record a lease, unless it is impractical to determine the lessor’s implicit rate GAAP requires use of the incremental rate, unless the implicit rate is known by the lessee and the implicit rate is lower than the incremental rate Under GAAP, extensive disclosure of future noncancelable lease payments is required for each of the next five years and the years thereafter Although some international companies (e.g., Nokia) provide a year-by-year breakout of payments due in years through 5, IFRS does not require it ... lease accounting Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting) : 11 LO Special Special Accounting Accounting Problems Problems... Special Special Accounting Accounting Problems Problems Sales-Type Leases (Lessor) 22 LO Describe the lessor’s accounting for sales-type leases Special Special Accounting Accounting Problems Problems... lease accounting Special Special Accounting Accounting Problems Problems Illustration (Guaranteed Residual Value – Lessee Accounting) : Sterling pays all of the executory costs directly to third