Crown
Inc. (CI) is a private company that manufactures a special type of cap that
fits on a bottle. At present, it is the only manufacturer of this cap and
therefore enjoys market security. The machinery that makes the cap has been in use
for 20 years and is due for replacement. CI has the option of buying the
machine or leasing it. Currently, CI is leaning toward leasing the machine
since it is expensive to buy and funds would have to be borrowed from the bank.
The company’s debt-to-equity ratio is currently marginal, and if the funds were
borrowed, the debt-to-equity ratio would surely worsen. CI’s top management is
anxious to maintain the ratio at its present level.
The
dilemma for CI is that if it leases the machine, it may have to set up a
long-term obligation under the lease and this would also affect the
debt-to-equity ratio. Since this is clearly unacceptable, CI decided to see if
the leasing company, Anchor Limited, could do anything to help with the
situation. After much negotiation, the following terms were agreed upon and
written into the lease agreement:
1.
Anchor Limited would manufacture and lease to CI a unique machine for making
caps.
2.
The lease would be for a period of 12 years.
3.
The lease payments of $150,000 would be paid at the end of each year.
4.
CI would have the option to purchase the machine for $850,000 at the end of the
lease term, which is equal to the expected fair market value at that time;
otherwise, the machine would be returned to the lessor.
5.
CI also has the option to lease the machine for another eight years at $150,000
per year.
6.
The rate that is implicit in the lease is 9%.
The
new machine is expected to last 20 years. Since it is a unique machine, Anchor
Limited has no other use for it if CI
does not either purchase it at the end of the lease or renew the lease. If CI
had purchased the asset, it would have cost $1.9 million. Although it was
purposefully omitted from the written lease agreement, there was a tacit
understanding that CI would either renew the lease or exercise the purchase
option.
Instructions
Assume
the role of CI’s auditors and discuss the nature of the lease, noting how it
should be accounted for. The company controller has confided in you that the
machine will likely be purchased at the end of the lease. Assume that you are
aware of top management’s position on adding debt to the balance sheet.
Management has also asked you to compare the accounting under ASPE and IFRS.
Overview
-
CI’s management has a financial reporting
bias; that is, they do not want to increase the debt that is presently on the
balance sheet.
-
IFRS is a
constraint since CI is public. Note that the company also wants to know the
differences between IFRS and ASPE.
-
Since the company appears to have other
debt, the creditors will be key users. They will want objective information and
will be concerned with the debt-to-equity ratio to assess how leveraged the
company is, and thereby assess the company's ability to repay debt.
-
As the auditor you will want conservative
and transparent financial statements.
Analysis and
Recommendations
Issue: Whether the lease is a capital/finance lease or an
operating lease
-
There is no evidence that legal title
passes to CI at the end of the lease.
-
There is no BPO
since the purchase option allows CI to purchase at the FV.
-
The term of the lease is only 12 years,
which is less than 75% of the economic life of 20 years.
-
The PVMLP is as follows:
§ $150,000
X 7.16073 = $1,074,110
§ $1,074,110/$1,900,000
= 56.5% which is
less than 90%
Therefore, it would appear, on the surface that the lease was an
operating lease.
On the other hand, given that the asset is manufactured
specifically for CI, there is no other possible use for the machine, and AL
likely does not want the machine back, it would appear to be common sense that
the lease is indeed a capital lease that represents a purchase in substance by
CI. The written agreement should not be reviewed in isolation but rather within
the context of the reporting environment (management bias) and the additional
unwritten agreement to purchase.
The principle hinges on the transfer of the risk and rewards of
ownership. In this case, both the auditor and the client know that the
substance is such that the lease has been used as alternative financing in
order to obtain off-balance-sheet financing; however, the client will argue
that it is not a capital/finance lease since it does not meet the criteria if
numerical thresholds are used as a benchmark. Note that under ASPE the numerical
thresholds are often used but under IFRS
the analysis does not hinge upon this. The key is on assessing the substance of
the arrangement.
Minor differences from the perspective of the lessee include:
-
Terminology – IFRS
refers to capital leases as finance leases
-
Discount rates – ASPE requires the use of
the lower of the IR and IBR if IR known whereas IFRS
requires the use of IR if known (otherwise IBR).
Recommendation: As an auditor, there is an overriding concern that
the financial statements are fairly presented, the implication being that the
substance of all transactions is appropriately reflected in the financial
statements. In this case, the evidence is too strong that this is a
capital/finance lease and, therefore, the auditor should argue to capitalize
the lease, especially if the amounts are material.
