FRF for SMEs--Lessor Accounting for Leases
The FRF permits three methods for lease accounting:
- Direct financing lease
- Sales-type lease
- Operating lease
Direct Financing Lease
Direct financing leases normally provide financing between a manufacturer or dealer and a lessee and generate financing income. Income from such leases is comprised of the difference between total net minimum lease payments and the carrying amount of the leased asset.
The lessor’s investment in the lease is comprised of the net amount of:
- Minimum lease payments receivable, net of any executory costs (insurance, maintenance and taxes) and any profit on the sale.
- The unguaranteed residual value of the leased asset.
- Unearned finance income, net of any initial direct costs to be allocated over the lease term.
- Any investment tax credits to be allocated over the lease term.
Initial direct costs should be expensed as incurred with an equal portion of unearned income recognized in the same period. Unearned finance income should be deferred and recognized in income so that a constant rate of return on the investment is included in the statement of revenues and expenses.
The estimated residual value of the asset should be reviewed annually to determine if its value has declined. For permanent declines, the accounting for the transactions should be revised. Any reduction in the investment should be recorded as a loss in the period of decline.
Sales-type leases are used by manufacturers and dealers to sell products. Income from these leases consists of a profit or loss on the sale and finance income over the lease term. Sales revenue is determined by discounting the minimum lease payments, net of any executory costs and included profit, using the interest rate implicit in the lease. The cost of sale is the carrying amount of the leased asset reduced by the present value of the unguaranteed residual, also calculated using the interest rate implicit in the lease.
Finance income is calculated as the difference between total net minimum less payments plus any unguaranteed residual and the aggregate of the present value of minimum lease payments determined using the interest rate implicit in the lease.
Initial direct costs are recognized as an expense at the inception of the lease. Profit or loss is recognized at the date of the transaction. Unearned finance income is deferred and recognized in income to produce a constant rate of return over the term of the lease. The estimated residual value will be reviewed annually and adjusted for a permanent decline in value.
All leases should be reviewed annually for collectability and/or recoverability issues. When a significant adverse change has occurred the carrying amount of the asset should be reduced to the highest of the discounted value of expected cash flows (discounted at a current market rate) from holding the asset or the net amount of sales proceeds that could be realized at the reporting date.
Rental revenue from an operating lease should be recognized on a straight-line basis over the term of the lease unless another method more appropriately reflects income earned. Initial direct costs should also be deferred and amortized in the same manner.
The lessor’s net investment in a capital lease is a long-term receivable that should be presented separately from other assets. The net investment in the lease includes:
- The net minimum lease payments receivable.
- Any unguaranteed residual value.
- Unearned finance income
The lessor’s net investment should be presented as both current and long-term amounts in the statement of financial position. Footnote disclosure should include the net investment in direct-financing and sales-type leases along with interest rates implicit in the leases.
More information about the FRF for SMEs can be obtained from four webcasts I will present later this fall. The webcasts can be accessed by clicking on the “Live Webcasts” box on the left side of my home page, www.cpafirmsupport.com.
by Larry Perry, CPA, CPA Firm Support Services, LLC - Larry has over 40 years experience as a CPA practitioner, author of accounting and auditing manuals, author and presenter of live staff training seminars and author of webcast and self-study CPE programs. He is co-founder of CPA Firm Support Services, LLC (www.cpafirmsupport.com), an organization providing resources, training and consulting to smaller CPA firms. Larry writes a weekly blog on AccountingWEB.com focusing on small audits, reviews and compilations. He is currently developing documentation manuals and handbooks for small audits, reviews and compilations and related electronic practice aids.