Sporon Corp. is a fast-growing Canadian private company in the manufacturing, distribution, and retail of specially designed yoga and leisure wear

Sporon Corp. is a fast-growing Canadian private company in the manufacturing, distribution, and retail of specially designed yoga and leisure wear. Sporon has recently signed 10 new leases for new retail locations and is looking to sign about 30 more over the next year as the company grows and expands its retail outlets. All of these leases are for five years with a renewal option for five more years. All of the leases also have a contingent rent that is based on a percentage of the excess of annual sales in each location over a certain amount. The threshold and the percentage vary between locations. The contingent rent is payable annually on the anniversary date of the lease. The company has currently assessed these to be operating, as they have no conditions that meet the capitalization criteria under accounting standards for private enterprises. All of these payments on these leases are expensed as incurred.

The company has also moved into a new state-of-the-art manufacturing and office facility designed specifically for its needs, and signed a 20-year lease with PPS Pension Inc., the owner. As this building lease also does not meet any of the criteria for a capital lease under accounting standards for private enterprises, Sporon accounts for this lease as an operating lease. As a result, it expenses both the monthly rental and the annual payment that it agreed on with PPS to cover property tax increases above the 2010 base property tax cost. The tax increase amount is determined by PPS and is payable by September 30 each year.

The small group of individuals who own the company are very interested in the company’s annual financial statements as they expect, if all goes well, to take the company public by 2012. For this and other reasons, Sporon’s chief financial officer, Louise Bren, has been debating whether or not to adopt IFRS or ASPE for the 2011 year end. Louise has also been following the new changes that are being proposed by the IASB to adopt the contract-based approach.

Instructions

(a) Explain to Louise Bren to what extent, if any, adjustments will be needed to Sporon’s financial statements for the leases described above, based on existing private enterprise accounting standards and international accounting standards.

(b) Assume that the joint IASB-FASB study group supports the contract-based approach for leases. Prepare a short report for the CFO that explains the conceptual basis for this approach and that identifies how Sporon Corp.’s statement of financial position, statement of comprehensive income, and cash flow statement will likely differ under revised leasing standards based on this approach.

(c) Prepare a short, but informative, appendix to your report in (b) that addresses how applying such a revised standard might affect a financial analyst’s basic ratio analysis of Sporon Corp.’s profitability (profit margin, return on assets, return on equity); risk (debt-to-equity, times interest earned); and solvency (operating cash flows to total debt).

(a)  The retail outlet leases:  Based on the lease terms and conditions for the retail outlets noted in the question, these leases represent operating leases.   Leases that are operating leases are recognized and reported in the same manner under both ASPE and IFRS:  the monthly lease payments and contingent rental payments are all expensed as incurred.

Building Lease:  The information notes that the building lease has been assessed against the capitalization criteria under private enterprise accounting standards, and found to qualify as an operating lease.

   

    However, there are a few differences in these criteria under IFRS that might change the final conclusion as noted below:  

1. Transfer of benefits and risks: In assessing the transfer of risks and rewards, IFRS also requires an assessment of the degree to which an asset is specialized and of use only to the lessee without major expense to the lessor.  If it is found on review, that the new facility is so specialized that the lessor would have difficulty leasing to another tenant without a lot of extra costs, then the lease contract transfers substantially all of the benefits and risks of property ownership, and should be capitalized. Considering that the building was designed specifically for Sporon’s needs, substantial amounts of benefits may be transferred to Sporon. Thus, careful review of the lease contract is required to identify any substantial transfer of risks, including the requirement to pay property tax increases.

2.   Depending on which interest rate was used to test the minimum lease payment criterion, Sporon may need to account for the lease as a finance lease under IFRS. While CICA Handbook Part II, Section 3065 specifies the use of the lower of the interest rate implicit in the lease and the lessee's incremental borrowing rate, IAS 17 specifies use of the interest rate implicit in the lease when it is practicably determinable; otherwise, the lessee's incremental borrowing rate is used.

(b)  To Louise Bren,

Subject: Accounting Treatment for Leases under the approach of the FASB-IASB joint project.

The IASB and FASB, through a Joint International Working Group, are currently looking at a variety of topics related to financial reporting. As for leases, the contract based approach is being considered as they intend to choose a model that will rely on asset and liability definitions in the conceptual framework. This approach is based on the idea that all arrangements that provide one party the right to use an item of another party should be accounted for similarly. The contract based approach is expected to be more useful to users as some entities are not recognizing a substantial amount of lease obligations that meet the definition of liabilities under the conceptual framework. Under the contract based approach, the capital (or finance) and operating lease distinction would disappear and most leases would qualify for recognition as assets and liabilities by the lessee.

Retail outlet leases: 

If this approach is adopted, these leases will be shown on the statement of financial position.  An intangible asset for the contractual lease rights will be recognized, and amortized over a systematic period, likely a straight-line basis over the lease term. A liability for the contractual lease obligation will be recognized and amortized using the appropriate discount rate over the lease term.  As payments are made, the obligation will be reduced and interest expense will be recognized.  There are three issues with respect to these leases that would have to be assessed: 

1.  What is the lease term? The lease term should be the “longest lease term that is more likely than not” to occur.  This would be 10 years for the current retail leases – the initial term and the renewal period.

2. What are the payments to be included in the contractual obligations?  In this case, the monthly payments and the contingent payments would be included in determining the value of the obligation.   The value for the contingent rental payments would be determined using probability weighted expected values over the term of the lease.  The value of these contingent payments would have to be reassessed at each reporting period, with any changes related to the current and past period contingencies being reported immediately into income and any impact on future periods would change the amount of the obligation.

3.  What discount rate should be used in determining the amount of the obligation and asset?  Sporon’s incremental borrowing rate would be used to discount the payments to determine the contractual obligation.

Building lease:  For the building lease, the first assessment that needs to be made is whether substantially all of the risks and rewards have been transferred since the building is unique to Sporon’s purposes and the lease, by design, perhaps earns the lessor a fixed return.  If this is the case, then the lease would be seen to be a purchase in substance, and the value of the contractual obligation and the building as an asset would be recognised.  The building would be depreciated over its useful life, and the obligation would be reduced as payments are made, and interest is expensed.    If it is found that the lease does not substantially transfer the risks and rewards, then an intangible asset is recognized instead and amortized over some systematic basis – likely straight-line over the 20 year term of the lease.  The amount of the obligation would be the same in either case.  For this assessment, the lease term would be 20 years, and the discount rate would be Sporon’s incremental borrowing rate.

The impact on the cash flow statement would remove the lease payments    from operating cash flows, and instead, the portion of the payment that represents interest would be shown as either operating or financing (depending on the company’s policy) and the reduction in the obligation would be recorded as a financing activity.  This would cause the operating cash flow to be higher under the contract based approach.

(c)  Appendix: The impact of the revised standard on basic ratios.

Profitability
	Profit margin	The ratio will be lower in the earlier years and higher in the later years under the contract-based lease treatment because 1) operating leases recognize lease expenses evenly during the lease term; and 2) interest expense and amortization expenses, which are recorded under a capital lease, are higher in the earlier years.
	Return on assets	Lower: Assets, the denominator, would increase by the value of the intangible assets. The net income will be lower in the earlier years due to the higher interest and amortization expenses.  As a result, the return on assets will be lower.  Over time, this will increase as the asset is reduced and net income is higher with the lower amounts charged for interest and amortization expenses.
	Return on equity	Lower: The return would decrease in the earlier years and so would retained earnings in equity for the same reasons noted above
Risk
	Debt-to-equity	Higher: Debt would increase by the contractual lease obligation amount while equity (retained earnings) would decrease (in the earlier years).
	Times interest earned	EBIT would increase because although there is an amortization expense this may be lower than the rent expense disappears. However, the denominator, interest expense, would increase as well.
Solvency
	Operating cash flows to total debt	As cash outflows for the principal balance of the lease obligation would be reported under ”financing activities”, the cash flow from operating activities would be higher. At the same time, the amount of total debt, which is the denominator of this ratio, would increase by the lease obligation and later get smaller as the obligation gets repaid.