Question

TopNotch Medical, 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 arrangement if they can classify the lease as an operating lease. The new equipment will replace equipment that TopNotch has been selling in the past. Leasing the new equipment will result in a loss of an estimated 25% in equipment sales.

Some members of management want to structure the leases so that TopNotch 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 statements 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 the accountant for TopNotch, explain how TopNotch should record the leases. Be sure to support your rationale and explain the advantages and disadvantages of your approach as compared to other approaches.

Answer 1

In an operating lease, the lessor (or owner) transfers only the right to use the property to the lessee. At the end of the lease period, the lessee returns the property to the lessor. Since the lessee does not assume the risk of ownership, the lease expense is treated as an operating expense in the income statement and the lease does not affect the balance sheet.

A sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.

As an accountant for TopNotch, i recommend to go for operating lease as lease does not affect the balance sheet.

Following are the advantages and disadvantages of this approach as compared to other approaches:

Operating lease:

1. Asset is kept on the balance sheet and depreciated.
2. Lease payments are recognized as rental income.
3. Full lease payments is classified as cash flow from operating activities

Sales-type lease:

1. Asset is removed from the balance sheet and a lease receivable is created (present value of payments)
2. Sale equal to the present value of the asset is recognized on the income statement and cost of goods sold equal to the carrying value. Therefore a gross profit is recognized (sales – COGS)
3. Interest portion of lease payments is recognized as income and the principal portion reduces the lease receivable.
4. Interest portion is cash inflow from operating activities while the principal is inflow from investing.