Question

Please explain the impact on financial reporting if a lessor grossly inflates the residual value of a capital lease

Answer 1

Capital lease :

Capital lease is a type of lease in which lessor transfers the ownership of the asset to the lesser after the end of the lease period. It is also popularly known as Finance lease. Here the legal ownership rests with the lessor but the accounting ownership rests with the lessee as lessor is only providing the finance in substance. And all risks and rewards related to the asset are transfered.

Residual value impact on Financial reporting:

Lessor should recognize the lease receivable in his books @ Net Investment in lease, which is equal to discounted value of minimum lease payments at interest rate implicit in lease. Here two factors influence the financial reporting of lease in lessor books

1. Minimum lease payments

2. Interest rate implicit in lease,

Where minimum lease payments is the payments receivable from the lessee for the finance lease.

And Interest rate implicit in lease is the rate where the minimum lease payments and unguarnateed residual value if discounted equals to the fair value of asset leased.

Finance income is recorded at every receipt of lease payment by applying this discount rate on the payment. Hence the discount will be inflated if the residual value is inflated. This leads to increase in the Finance income inappropriately and showing less value of the lease receivable.

Conclusion:

If lessor grossly inflates the residual value of a capital lease the finance income will increase inappropriately deviating from the rules as prescribed in the standards. And in the balance sheet the Lease receivable is shown at the lesser value due to recognition of higher finance income through interest rate implicit in lease.