Financial Reporting and Analysis III
Reading 28. Non-current (Long-term) Liabilities
Learning Outcome Statements
h. determine the initial recognition, initial measurement, and subsequent measurement of finance leases;
i. compare the disclosures relating to finance and operating leases;
CFA Curriculum, 2020, Volume 3
Subject 9. Accounting and Reporting by the Lessor
Under IFRS, leases are classified as finance leases when substantially all the risks and rewards of legal ownership are transferred to the lessee.
Under U.S. GAAP, for a lessor, the lease must be capitalized if it meets any one of the four criteria specified for capitalization by the lessee and both of the following revenue recognition criteria:
- Collectability of the minimum lease payments is reasonably predictable.
- There are no uncertainties regarding the amount of unreimbursable cost yet to be incurred by the lessor.
Leases not meeting these criteria must be reported as operating leases.
Under U.S. GAAP there are two alternative types of capital leases when dealing with lessors: a sales-type lease and a direct financing lease. IFRS does not distinguish between them. The accounting is the same for IFRS and U.S. GAAP.
1. Sales-Type Lease
Sale-leaseback (S-L) transactions are sales of property by the owner, who then leases the property back from the buyer-lessee. The seller (lessor) leases its own property, rather than selling it outright. Such leases involve two transactions:
- Selling the property at the time the lease is initiated.
- Providing financing to the lessee.
At the inception of the lease, a manufacturer treats the transaction as if it sold the asset in exchange for an investment in a capital lease. It recognizes a gross profit from the sale of the asset.
- Sales = the lower of the present value of minimum lease payments or the fair value of the asset. The total lease payments (un-discounted) are known as the lessor's Gross Investment in Lease.
- Cost of goods sold = cost of leased asset - present value of residual value
- Gross profit (manufacturer's profit) = sales - cost of goods sold.
- The balance sheet also records an asset: net investment in lease = present value of lease payment + present value of residual value. The difference between gross investment in a lease and net investment in a lease is the unearned interest income, which is the financing income component of the manufacturer's total profit.
- Each year over the life of the lease, interest income is recognized using the following formula: interest income = the year's beginning value of net investment in lease x implicit interest rate of the lease. It is a cash flow from operations under U.S. GAAP and either an operating or investing cash flow under IFRS.
- The difference between lease payment and interest income represents the portion of Net Investment in Lease recovered during the year. Recovery in Net Investment in Lease is an investment cash flow.
- The Net Investment in Lease at the end of the year is: the year's beginning value of Net Investment in Lease - Net Investment Recovery.
2. Direct Financing Lease
In a direct financing lease, a leasing company purchases a property from a manufacturer and then leases the equipment to the lessee. The distinction between a sales-type lease and a direct financing lease is the presence/absence of a manufacturer's or dealer's profit. In a direct financing lease, the cost of the leased asset equals its market value, so only financing income is involved. In a sales-type lease, the cost of the leased asset is less than its market value (the present market value of lease payments), creating a manufacturer's or dealer's profit in addition to financing income.
As in a direct financing lease, the lessor's original cost or the carrying value (prior to the lease) of the asset approximates the market value of the leased asset (the present value of the MLPs); such leases are pure financing transactions and financial reporting for direct financing leases reflects this fact. No sale is recognized at the inception of the lease and there is no manufacturing or dealer profit. Only financing income is reported.
Effects of Operating and Capital (Finance) Leases on a Lessor's Financial Statements
- Operating Lease: The book value of the asset is reported on the balance sheet as a long-term asset, net of accumulated depreciation.
- Capital Lease: Lease receivable, instead of the asset, is reported on the balance sheet, and is amortized over the life of the lease.
- For a sales-type lease, the gain from the sale of the asset recognized at the inception of the lease increases shareholders' equity. Therefore, a sales-type lease results in higher total assets and higher shareholders' equity.
- Operating Lease: At the inception of the lease, no income is recognized. Over the life of the lease, income tends to be constant if straight-line depreciation is used.
- Capital Lease: Over the life of the lease, interest income tends to decline over time.
- At the inception of the lease, the gain from the sale of the lease asset is recognized for a sales-type lease. The sales-type lease reports substantially higher income at the inception of the lease, thus recognizing income earlier than an operating lease. However, total income over the life of the lease is the same for both. Although IFRS does not have a provision for sales-type leases, the accounting treatment is the same if there's a profit at the inception of the lease.
Cash Flow Statement:
- Operating Lease: At the inception of the lease, no cash flow occurs. Over the term of the lease, the entire lease payment is reported as an operating cash inflow.
- Capital Lease: Over the term of the lease, the lease payment from the lessee is allocated to interest income (an operating cash inflow under U.S. GAAP, and either an operating or an investing cash flow under IFRS) and net investment recovery (investing inflow).
- Sales-type leases report higher operating cash flow at the inception of the lease, but lower operating cash flow over the lease term.
The lessor has an asset on the books with a cost of $1,000. The lessor leases the asset out as a sales-type lease with the present value of the minimum lease payments equal to $1,300. The total minimum lease payments are $2,000 over the lease term.
The lessor recognizes a sale of $1,300 and cost of sales of $1,000, which results in a gross profit of $300 ($1,300 - $1,000).
The corresponding entry is the recognition of a net investment in leases of $1300. The net investment in leases is made up of a gross investment - unearned finance income. Gross investment is equal to the remaining minimum lease payments (not discounted) and the unearned finance income is the interest income that will be earned over the remainder of the lease. In this instance these are as follows:
Gross investment in lease: $2,000
Unearned finance income: ($700)
Net investment: $1,300
As you can see, the unearned finance income is the difference between the minimum lease payments and the present value of the minimum lease payments. This amount amortizes on the income statement as interest income as the lease is repaid.
User Contributed Comments 10You need to log in first to add your comment.
why does the expected rate of return increase with more debt? doesn't the wacc equation imply lower wacc with more debt versus equity, as debt normally costs less?
the more debt, the more financial leverage.The more financial leverage,the more financial risk.The more financial risk, the more return will be expected from shareholders.
Yes WACC will decrease as you use more debt because the decreasing proportion of equity within WACC will offset the rising cost of equity.
They must mean use of more debt increases return on equity.
Can someone explain to me a sale-type lease?
What the notes say is that the owner (lessor) sell the property to the buyer (lessee) and then lease it back.
But how can he be the lessor if he's leasing it back?
Doesn't make sense to me...
I was happy until I got to this section
Changed my mind --- its easy --- just do the questions then the notes make sense....
All the notes should say is that the difference between sales type and direct type is the there is a profit recognized intitially and then everything is the same between two
In case anyone needs... IFRS vs GAAP can be found in this pdf
Does it means they are loosing money and then paying for it? so loosing two times!?!