Question

This question has been posted before but the answers vary greatly.  

Questions:

1. Should Medic-Tech (Lessor) classify the leases as sales-type leases and avoid further reduction of income? If so, how will this impact the financial statements?

2. Should Medic-Tech (Lessor) classify the leases as operating leases and minimize the income tax liability in the short-term? If so, how will this impact the financial statements?

3. Can Medic-Tech (Lessor) classify the leases as sales-type leases while the lessees classify the leases as operating leases? If so, how will this impact the financial statements?

FACTS:

Medic-Tech, Inc. is a supplier of medical equipment. It recently introduced a new line of equipment that may revolutionize the medical profession. Because of the new technology, potential users of the equipment are reluctant to purchase the equipment, but they are willing to enter into a lease agreement if they can classify the lease as an operating lease. The new equipment will replace equipment that Medic-Tech has been selling in the past. Leasing the new equipment will result in the loss of an estimated 25% in equipment sales.

Some members of management want to structure the leases so that, Medic-Tech as the lessor, can classify the lease as a sales-type lease and thus avoid further reduction of income. Others believe that they should treat the leases as operating leases and minimize the income tax liability in the short-term. They are uncertain, however, as to how the financial statement would be affected under these two different approaches. They also are uncertain as to how leases could be structured to permit the lessee to treat the lease as an operating lease and the lessor to treat it as a sales-type lease.

As teams of accountants for Medic-Tech, explain how Medic-Tech should record the leases. Be sure to support your rationale and explain the advantages and disadvantages of the method or approach your team chose.  

Answer 1

Answer: 1

The type of lease that is beneficial to the company at the time of introducing a new product line into the market is a sales-type lease. This method of the lease is generally used by the manufacturers and dealers. Therefore, Medic-Tech will make use of sales-type lease to introduce its new product. For sales-type leases, both fair value and carrying value of the leased property at the time of inception of lease should be different. Moreover, the ownership of the leased property should be transferred to lessee at the end of lease period. As the ownership is to be transferred, it is assumed that the item is sold in the same year the lease begins and during the entire period of lease, the interest will accrue to the lessor. It is possible for lessor to recognize more revenue and gross profit immediately at the beginning of lease. It is assumed by the management, this method of lease will control the reduction of income.

Answer: 2

One of the requirements of sales-type lease is that the fair value of leased asset should be equal to book value of the lessor or the amount of lease receivable by the lessor should be more than the carrying value of the leased asset, so the lease arrangement proves to be profitable for the lessor. In sales-type lease, the asset is depreciated by the lessee, not the lessor. The lease payments are reported as the unearned income by the lessor. The value of the asset during the commencement of the lease is shown by the lessor as an inventory cost and this cost is deducted from the lease income. In this way, the sales-type lease contributes in reducing the income and therefore the income tax in the short term. Therefore, Medic-Tech (Lessor) should not classify the leases as operating leases and minimize the income tax liability in the short-term.

Answer: 3

Medic-Tech (Lessor) is the supplier and thus sales-type lease will be beneficial as it helps in controlling income reduction and minimizing the income tax liability. The lessees should also classify the leases as sales-type lease to have ownership rights at the end of lease term.