On October 30, 2011, Truttman Corp. sold a five-year-old building

On October 30, 2011, Truttman Corp. sold a five-year-old building with a carrying value of $10 million at its fair value of $13 million and leased it back. There was a gain on the sale. Truttman pays all insurance, maintenance, and taxes on the building. The lease provides for 20 equal annual payments, beginning October 30, 2011, with a present value

equal to 85% of the building’s fair value and sales price. The lease’s term is equal to 73% of the building’s useful life. There is no provision for Truttman to reacquire ownership of the building at the end of the lease term. Truttman has a December 31 year end.

Instructions

(a) Why would Truttman have entered into such an agreement?

(b) In reaching a decision on how to classify a lease, why is it important to compare the equipment’s fair value with the present value of the lease payments, and its useful life to the lease term? What does this information tell you under ASPE and IFRS?

(c) Assuming that Truttman would classify this as an operating lease, determine how the initial sale and the saleleaseback transaction would be reported under ASPE and IFRS for the 2011 year. What would be the implications  if the selling price had been $14 million, $1 million greater than the fair value of the building?

(d) Assuming that Truttman would classify this as a finance lease, determine how the initial sale and the sale-leaseback transaction would be reported under ASPE and IFRS for the 2011 year.

(a) In addition to triggering a gain, most likely Truttman was motivated to sell and leaseback equipment to generate some much needed cash flow.  The interest rate offered by the leasing company was most likely favourable from the point of view of Truttman, in comparison to other sources of financing.

(b) 1.  A lease is categorized as a finance lease if, at the date of the lease agreement, it meets any one of three criteria under ASPE or four criteria under IFRS. As the lease has no provision for Truttman to reacquire ownership of the equipment, it fails the criteria of transfer of ownership at the end of the lease under both IFRS and ASPE; there is no bargain purchase option. Truttman’s lease payments, with a present value equalling 75% of the equipment’s fair value, fails the criterion for a present value equalling or exceeding 90% of the equipment’s fair value for ASPE. However, under IFRS, since there are no “bright lines” one would have to judgementally determine if the present value of the payments allows the lessor to recover substantially all of its investment in the property with an appropriate rate of return. This criteria is likely not to be met under IFRS either. Under ASPE, the final criterion is whether its term allows the lessee to substantially use the building for its economic useful life.  In this case, 73% is below the 75% threshold and therefore the criteria would not be met. In this case, under ASPE the lease would be classified as an operating lease.  However, under IFRS, since there are again no bright lies, one could conclude that 73% of the economic life is long enough to receive substantially all of the economic benefits.  In this case, the lease might be recorded as a finance lease.  The final criteria under IFRS would look at whether or not the asset is specialized for the lessee’s use, which in this case, does not seem to be the case.

    2.  Comparisons of equipment’s fair value to its lease payments’ present value, and of its useful life to the lease term, are used to determine whether the lease is equivalent to an instalment sale and is therefore a finance lease. If the fair value test or the useful life test is met, there is an indication that the lessee is obtaining most of the benefits that the asset has to offer.

(a)        Operating lease treatment under ASPE: Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the equipment’s carrying amount over its sale price.  The deferred gain will be recognized over the term of the lease.   If the sale price is greater than the fair value, the total gain deferred would be $4 million.  All of the gain over the carrying value is deferred and amortized over the operating lease term.  The operating lease payments are then recorded as an expense as made.

    Operating lease treatment under IFRS:  IFRS recognizes that if an operating lease is taken back, then the asset has been technically sold, and therefore all of the gain of $3 million, representing the difference between fair value ($13 million) and the carrying value ($10 million) is fully recognized into income at the time of the sale on October 31, 2011.  If, as proposed in the question, the selling price was actually greater than its fair value, then the portion of the selling price greater than fair value of $1 million would be recognized as a deferred gain and amortized over the term of the lease, and the $3 million gain would be recognized immediately.  The operating lease payments are then recorded as an expense as made during November and December, 2011.

(d) Capital lease treatment under ASPE:  Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the equipment’s carrying amount over its sale price.  The deferred gain will be recognized on the same basis as depreciation of the leased asset.   At the same time, a capital leased asset and an offsetting capital lease obligation will be recognized and will equal the present value of the lease payments.  At the end of the year, December 31, 2011, Truttman would recognize interest expense on the obligation at the effective interest rate, principal reduction in the obligation, and depreciation expense on the building (depreciated over the term of the lease). 

    Accrued interest on the obligation for the period from November 1, to December 31, 2011, will appear in the current liabilities section of the statement of financial position along with the principal portion of the first lease payment due October 30, 2012. 

The remaining portion of the principal to be repaid beyond 2012 will be reported as a non-current liability. The cash flow statement for the year ended December 31, 2011, will show proceeds from the sale of the equipment as a source of cash in the investing section of the cash flow statement. For the operating activities section, prepared using the indirect format, the gain on the sale of the equipment and the depreciation expense will be added back to income as well as the increase in the interest payable for the accrual recorded on the lease at the end of the year. 

Finally the capital lease and the related obligation under capital lease from the leaseback transaction are a non-cash financing and investing transaction that will not appear on the face of the cash flow statement but will be reported in the notes to the financial statements.

    Capital lease treatment under IFRS:  Truttman should account for the sale portion of the sale-leaseback transaction at October 31, 2011, by increasing cash for the sale price for $13 million, decreasing building (and related accumulated depreciation) by the carrying amount of $10 million, and recognizing a deferred gain on sale of $3 million for the excess of the equipment’s carrying amount over its sale price.  The deferred gain will be recognized over the term of the lease (which differs from ASPE).   At the same time, a capital leased asset and an offsetting capital lease obligation will be recognized and equal to the present value of the lease payments.  At the end of the year, December 31, 2011, Truttman would recognize interest expense on the obligation at the effective interest rate, principal reduction in the obligation, and depreciation expense on the building (depreciated over the term of the lease). 

    Accrued interest on the obligation for the period from November 1, to December 31, 2011, will appear in the current liabilities section of the statement of financial position along with the principal portion of the first lease payment due October 30, 2012. 

The remaining portion of the principal to be repaid beyond 2012 will be reported as a non-current liability. The cash flow statement for the year ended December 31, 2011, will show proceeds from the sale of the equipment as a source of cash in the investing section of the cash flow statement. For the operating activities section, prepared using the indirect format, the gain on the sale of the equipment and the depreciation expense will be added back to income as well as the increase in the interest payable for the accrual recorded on the lease at the end of the year. 

Finally the capital lease and the related obligation under capital lease from the leaseback transaction are a non-cash financing and investing transaction that will not appear on the face of the cash flow statement but will be reported in the notes to the financial statements.