ch20(1)

Prepared by:Dragan Stojanovic, CA

Rotman School of Management, University of Toronto

Chapter Chapter 2020

LeasesLeases

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LeasesLeases

Leasing Leasing BasicsBasics•The leasing environment•Conceptual nature of a lease•Current standards

Classification Classification Approach – Approach – Lessors Lessors •Classification criteria•Accounting for financing and sales-type leases•Accounting for an operating lease•Initial direct cost•Lessor disclosures•Time for change

Classification Classification Approach – Approach – Lessees Lessees •Classification criteria•How the lessor determines the rental payment•Accounting for a capital lease•Accounting for an operating lease•Capital and operating leases compared•Presentation and disclosure

Contract-Based Contract-Based ApproachApproach•Scope and definition•Recognition and measurement – lessee •Illustration•Recognition and measurement basics – lessor •New lease accounting standard

IFRS / IFRS / Private Private Enterprise Enterprise GAAP GAAP ComparisonComparison•Comparison of IFRS and private enterprise GAAP•Looking ahead

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LeasesLeases






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Leasing: BasicsLeasing: Basics

• The lease is a contractual agreement between the lessor and the lessee

• The lease gives the lessee the right to use specific property (owned by the lessor)

• The lease specifies also the duration of the lease and rental payments

• The obligations for taxes, insurance, and maintenance (executory costs) may be assumed by the lessor or the lessee or divided

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Advantages of LeasingAdvantages of Leasing• 100 percent financing at a fixed rate

– No down payment required– Rate charged is fixed for the term of the lease

• Protection from obsolescence– Property can be upgraded

• Flexibility– Lease may be structured to meet different needs

(e.g., cash flow)• Less costly financing (lessee); tax incentives (lessor)• Off-balance sheet financing

– Impact on ratios

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Conceptual Nature of LeaseConceptual Nature of Lease1. Do not capitalize any leased assets – an executory contract

approach– Since lessee does not own the property, capitalization is

considered inappropriate– Since executory contracts are not capitalized, leases

should not be either2. Capitalize leases that are similar to instalment purchases – a

classification approach– if instalment purchases are capitalized, so should leases

with similar characteristics3. Capitalize all long-term leases – a contract-based approach

– The long-term right to use property justifies its capitalization

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Current Accounting StandardCurrent Accounting Standard• Current IFRS, PE GAAP, and FASB standards

are consistent with classification approach – A lease that transfers substantially all the benefits

and risks of property ownership should be capitalized (classified as capital lease)

– A lease where benefits and risks of ownership are not transferred is classified as operating lease

• Proposed IASB and FASB converged lease accounting standard is based on the contract-based approach

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LeasesLeases






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Lease ClassificationLease ClassificationCapital Lease• Where the benefits and risks of ownership haveeffectively been transferred to the lessee• Accounted for as a purchase by the lessee• Under IFRS, capital leases is called finance leasesJournal Entries:

Lessee LessorLeased Equipment XXX Lease Receivable (net) XXX Lease Obligation XXX Equipment XXX

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Lease ClassificationLease ClassificationOperating Lease• Where the rights and risks of ownership have not

been transferred • A rental-only has occurred

Journal Entries:

Lessee LessorRent Expense XXX Cash XXX Cash XXX Rental Income XXX

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• Most important factor in determining whether a lease is capital is whether risks and rewards have transferred from lessor to lessee.

• Both IFRS and PE GAAP provide specific guidelines to help determine whether risks and rewards have transferred.

Capital Lease CriteriaCapital Lease Criteria

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Under IFRS any one of the following normally indicates a finance lease:

1. Reasonable assurance that ownership will transfer to lessee at end of lease term– It is assumed that bargain purchase option (BPO) will be

exercised by lessee if available 2. Lease term allows lessee to get substantially all economic

benefits that could be expected from using the leased asset over its entire life

3. Lease terms allow lessor to recover substantially all investment in leased asset, and also earn a rate of return – If PV of minimum lease payments (MLP) is close the fair

value of the leased asset4. Leased asset is specialized and can only be used by lessee

(without major modifications)

Capital Lease Criteria: IFRSCapital Lease Criteria: IFRS

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Under PE GAAP any one of the three requirements normally indicates a capital lease:

1. [as #1 under IFRS] 2. [as #2 under IFRS]

– Additional threshold: assumed if lease term is 75% of lease asset’s economic life

3. [as #3 under IFRS] – Additional threshold: assumed if PV of

minimum lease payments (excluding executory costs) is 90% of the fair value of the leased asset

Capital Lease Criteria: PE Capital Lease Criteria: PE GAAPGAAP

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Minimum lease payments (lessee) defined:• Minimum rental payments +• Amounts guaranteed +• Bargain purchase option

Minimum rental payments• Regular payment made to lessor, excluding executory

costs• Executory costs include insurance, maintenance and tax

expenses. If these payments made by the lessor, they are estimated and excluded from the PV of minimum rental payment calculation

Minimum Lease PaymentsMinimum Lease Payments

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Minimum Lease PaymentsMinimum Lease PaymentsGuaranteed amounts• Guaranteed residual value (GRV): guaranteed value

of the leased asset at the end of the lease term • For lessee, maximum amount lessor can require

lessee to pay at end of the leaseBargain Purchase Option (BPO)• An option to purchase the leased asset at the end of

the lease at a price below expected fair value• If included as part of lease, only minimum lease

payments and bargain purchase option included in definition of minimum payments

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• Incremental borrowing rate: the rate the lessee would have incurred if they had borrowed the funds to purchase the asset– Under similar term (length) and similar security

(same type of asset)• Rate implicit in the lease: rate that makes

PV of MLP + unguaranteed residual values = FV of leased asset

• Under IFRS, use rate implicit in the lease if it is reasonably determinable

• Under PE GAAP, use lower of two rates

Discount RateDiscount Rate

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• Lessor sets rental payments to have specific rate of return (i.e. the implicit rate) on leasing the asset

• If the lease has BPO or residual value, then those components do not need to be recovered through rental payments

Determining Rental Determining Rental PaymentsPayments

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Calculate the payment required to provide lessor with required rate of return

Cost/FMV of asset to be recovered $100,000Less: PV of expected residual value -0-

Amount to be recovered through lease payments $100,000

Calculation of Lease Payment Calculation of Lease Payment by Lessorby Lessor

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Amount to be recovered $100,000

Payments: (n=5, i=10) $100,000 4.16986

= $23,981.62

Total lease payments: 5 x $23,981.62 = $119,908.10

Calculation of Lease Payment Calculation of Lease Payment (Cont’d)(Cont’d)

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• Asset and liability recorded at the lower of:1. PV of the minimum lease payments (as defined

above) and2. Fair value of the asset at the inception of the

lease• Depreciation of the asset is amortized over:

– The economic life of the asset if ownership transfers to lessee at the end of the lease or there is a bargain purchase option

– The term of the lease if title does not transfer to the lessee or there is no bargain purchase option

Accounting for aAccounting for a Capital Lease Capital Lease

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• Interest expense resulting from the lease transaction is recorded following the effective interest method– The discount rate used to establish the initial PV

is used to amortize the lease– Each lease payment is allocated between

principal and interest• Journal entries required to record a capital lease

transaction are as follows:


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At the inception of the leaseDr. Asset under Capital Lease

Cr. Obligations under Capital Lease

To record interestDr. Interest Expense

Cr. Interest Payable

Using the EffectiveInterest Method

To record asset amortizationDr. Amortization Expense

Cr. Accumulated Amortization

Using methodappropriate to the asset

To record the lease paymentDr. Related Executory Expense (if any)Dr. Interest PayableDr. Obligations under Capital Lease

Cr. Cash

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Capital Lease - ExampleCapital Lease - ExampleLease Terms Given:• Term of 5 years, non-cancellable• Annual payments $25,981.62 (due at beginning of each

year, starting January 1, 2010)• Fair value of asset $100,000• Economic life = 5 years Residual value = Zero• Lease payments include $2,000 property taxes (executory

cost)• Lease has no renewal option, and asset reverts to Lessor

at termination of lease• Lessee’s incremental borrowing rate = 11%• Lessor’s implicit rate =10% (known to lessee)• Similar assets are depreciated using straight-line method

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Capital Lease - ExampleCapital Lease - Example• Does this qualify as a capital lease?

– Yes, under both IFRS and PE GAAP• Only one of the tests must be met (PE GAAP thresholds

illustrated)

Is there a Transfer of Ownership or Bargain Purchase Option?

Is Lease Term 75% of Economic Life?

Is Present Value of Payments 90% of Fair Value?

No

Capital Lease

Yes

PV of payments (n=5, i=10%)25,981.62 - 2000.00 =23,981.62 x 4.16986 =$100,000.00

Yes

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• Entry to record initial lease transaction Equipment under Capital Lease 100,000

Obligations under Capital lease 100,000

• Entry to record initial payment (Jan 1/10)Property Tax Expense 2,000.00Obligations under Capital Lease 23,981.62

Cash 25,981.62• As this is a capital lease the following must also be

recorded (at year end or in each reporting period)– Interest expense– Asset amortization

Capital Lease - ExampleCapital Lease - Example

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• Record Interest (December 31, 2010)Interest Expense 7,601.84

Interest Payable 7,601.84(100,000-23,981.62)*10% = 7,601.84(Interest Payable is debited in all subsequent lease payment entries)

• Asset amortization (December 31, 2010)Amortization expense20,000

Accumulated amortization 20,000(100,000 / 5 years = 20,000)(There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset)


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Capital Lease - ExampleCapital Lease - Example• Financial Statement Presentation (as at

December 31, 2010):Balance SheetCurrent liabilitiesInterest payable $7,601.84Obligations under capital leases 16,379.78

(as per amortization schedule)Non-current liabilitiesObligations under capital leases $59,638.60

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• Lease payment on January 1, 2011Property Tax Expense 2,000.00Interest Payable 7,601.84Obligations under Capital Leases 16,379.78

Cash 25,981.61

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Other Lease Accounting Other Lease Accounting IssuesIssues

• Residual Value – Lessee– If guaranteed by lessee, PV of residual is

included in asset’s cost and lease obligation recognized (i.e. is included in definition of minimum lease payments)

– If not guaranteed by lessee, residual value is not included in definition of minimum lease payments – i.e. not in asset or liability amounts recognized

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Bargain Purchase Option• Lessee:

– Lessee accounting assumes bargain option will be exercised

– PV of option price included in asset cost and obligation recognized

– Asset is amortized over economic life (not lease term), as it is assumed that BPO will be exercised and so asset will be purchased and continue to be used


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Operating Leases - LesseeOperating Leases - Lessee• Risks and benefits of ownership of leased

assets are not transferred to lessee• Lease payments are treated as rent expense

– Dr. Rent Expense• Cr. Cash / Accounts Payable

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Operating vs. Capital LeasesOperating vs. Capital Leases• Total expenses over lease term are same

regardless of accounting method (i.e. operating vs. capital)

• Timing of expenses over lease term is different – Operating leases result in lower expenses in

earlier years, and higher expenses in later years compared to capital leases

• Operating leases result in lower debt-to-equity ratio and improved return on total assets

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Current and Noncurrent Current and Noncurrent

• Current portion = principal amount to be received/paid within 12 months from balance sheet date + interest accrued to the balance sheet date

• Long-term = principal amount not recoverable/payable within 12 months from balance sheet date

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• Given that capital/finance leases give rise to a leased asset and long-term liability, most disclosures are covered by standards for– PP&E– Intangible assets– Financial instruments– Long-term liabilities

• IFRS requires additional disclosures, including:– Net carrying amount of each class of leased asset– Reconciliations of future MLP and their PV– Various lease terms (e.g. conditions relating to

subleases and contingent rents)

Disclosure Requirements –Disclosure Requirements –Capital/Finance LeasesCapital/Finance Leases

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Operating LeasesOperating Leases• Lessees must disclose:

– Future minimum lease payments extending into the future

– IFRS requires additional disclosures relating to various lease terms (e.g. conditions relating to subleases and contingent rents)

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LeasesLeases






Classification Approach - Classification Approach - LessorsLessors

Type PE GAAP IFRSOperating Operating lease Operating lease

Financing lease:Sales-type Sales-type lease Manufacturer or

dealer leaseOr Or

Financing-type Direct financing lease Other finance lease

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• How does the lessor determine whether the lease is a capital/finance lease?

• IFRS: lessor uses same criteria as lessee• PE GAAP: lessor uses same criteria as lessee as

well as additional two revenue recognition-based considerations that must be passed:1. Credit risk associated with collection is normal2. Remaining unreimbursable costs to lessor can

be estimated• If required criteria are not met, the lease is

accounted for as an operating lease

Classification Criteria - Classification Criteria - LessorLessor

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• Both sales-type and financing-type leases are capital/finance leases

• The difference is whether or not there exists a manufacturer’s or dealer’s profit

• The sales-type lease incorporates a this profit• A lease may qualify as a capital lease by the

lessee and as an operating lease by the lessor

Lease Classification - LessorLease Classification - Lessor

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• Lessor replaces investment in asset to be leased with a lease receivable

• Over lease term, the receivable is collected, and interest is earned

• Net investment in the lease = lease payments receivable – unearned interest income

Financing-Type Lease - Financing-Type Lease - LessorLessor

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• The lease payments receivable are equal to:Lease payments (net of executory costs) + salvage (residual) value

• The unearned interest revenue is the difference between the lease payment receivable and the asset cost (FMV)

Financing-Type Lease - Financing-Type Lease - LessorLessor

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Financing-Type Lease - Financing-Type Lease - ExampleExample

Lease Terms Given:• Term of 5 years, non-cancellable• Annual payments $25,981.62 (receivable at beginning of

each year, starting January 1, 2010)• Fair value of asset $100,000• Economic life = 5 years Residual value = Zero• Lease payments include $2,000 property taxes (executory

cost)• Lease has no renewal option, and asset reverts to Lessor

at termination of lease• Lessor’s implicit rate (required return) =10%• Collectibillity is reasonably assured• No additional costs expected to be incurred by Lessor

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January 1, 2010Lease Payments Receivable 119,908.10

Unearned Interest Income 19,908.10Equipment for Lease 100,000.00

Lease payment receivable (gross investment in lease): (25,981.62 – 2,000) x 5 = 119,908.10

Net investment in lease:23,981.62 x 4.16986 (n=5, i=10%) = 100,000


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January 1, 2010 (first payment)Cash ($23,981.62+$2,000) 25,981.62

Property Tax Expense 2,000.00Lease Payments Receivable 23,981.62

December 31, 2010Unearned Interest Income 7,601.84

Interest Income 7,601.84


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At Dec. 31/10 year end, Lessor recognizes interest earned:

Amount originally financed $100,000.00Paid on principal Jan. 1/10 (23,981.62)Balance outstanding $ 76,018.38

Interest : 10% x 76,018.38 x 12/12 = $7,601.84Unearned Interest Income 7,601.84 Interest Income 7,601.84


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• Entries are the same as for financing-type lease, except for:– Entry at the inception of the lease must

record the sale and cost of goods sold– Recall that the sales-type lease includes a

manufacturer’s/dealer’s profit margin• Lessor earns a gross profit on sale +

interest as the sale is financed

Sales-Type Lease - LessorSales-Type Lease - Lessor

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Sales-Type Lease – ExampleSales-Type Lease – Example

• Take the same data as in our example, except the asset has been recorded in the Lessor’s inventory at a cost of $85,000 (FMV=$100,000)

• All previous lessor entries remain the same except for the entry at the lease inception– Sales and Cost of Goods Sold are recorded

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Sales-Type Lease – ExampleSales-Type Lease – Example

January 1, 2010Lease Payments Receivable 119,908.10 Unearned Interest Income 19,908.10Sales 100,000.00

Cost of Goods Sold 85,000.00Inventory 85,000.00

January 1, 2010 (first payment-remains the same)Cash ($23,981.62+$2,000) 25,981.62Property Tax Expense 2,000.00Lease Payments Receivable 23,981.62

December 31, 2010 (remains the same)Unearned Interest Income 7,601.84Interest Income 7,601.84

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• Residual Value – Lessor Financing-Type Lease: whether guaranteed or

unguaranteed, the residual is included in the lessor calculations

Sales-Type Lease: Residual value is part of Sales Revenue (and COGS) if guaranteed

• With unguaranteed residual value, the Sales Revenue and COGS are reduced by the PV of that unguaranteed residual value

• The gross profit amount on the sale is the same regardless if residual value is guaranteed or not


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Bargain Purchase Option• Lessor:

– With financing-type and sales-type leases, the bargain purchase price is included in the lease payments receivable and the PV of the bargain purchase option is included in net investment calculations


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Operating Leases - LessorOperating Leases - Lessor• Risks and benefits of ownership of leased

assets are not transferred to lessee• Lease payments are treated as rental

incomeDr. Cash

Cr. Rental Income• Lease asset remains on lessor’s books and

continues to be depreciatedDr. Depreciation expense

Cr. Accumulated depreciation

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Initial Direct Costs of LessorInitial Direct Costs of Lessor

• Costs incurred by lessor that can be directly attributable to negotiating and arranging a specific lease (e.g. legal fees, commissions, etc)

• General approach– Operating lease – allocated over lease term– Financing-type lease – allocated over lease term– Sales-type lease – expensed in the year costs are

incurred i.e. in same period as gross profit on sale recognized

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Financing and Sales-Type Leases• Under PE GAAP, disclose:

– Net investment in the lease, and implicit rate– Carrying amount of impaired leases (and

impairment allowance)• Under IFRS, disclose more, including:

– Reconciliation between PV of MLP and gross investment and amounts due over time

– Unearned finance income– Unguaranteed residual values– Other

Disclosure Requirements - Disclosure Requirements - LessorLessor

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Disclosure Requirements - Disclosure Requirements - LessorLessor

Operating Leases• Under PE GAAP, disclose:

– Separate disclosure of the cost and accumulated amortization of the property

• Under IFRS, disclosures similar to those for financing leases

Remember, disclosure requirements imposed by other (related) standards also apply (e.g. PP&E, financial instruments, impairment, etc)

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LeasesLeases






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Contract-Based ApproachContract-Based Approach• IASB and FASB have been working on a

new lease standard for years• Final standard is expected in 2011• There are many significant differences

between the new standard (contract-based approach) and the current requirements (classification approach)

• Under contract-based approach, asset taken on by lessee is the right to use the leased asset

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Contract-Based ApproachContract-Based Approach• Lease definition under contract-based

approach: – “a contract in which the right to use a

specified asset is conveyed, for a period of time, in exchange for consideration”

• Contracts that actually do transfer control or substantially all risks and benefits of ownership are excluded from new standard– These contracts relating to in-substance

purchases would be accounted for in a way similar to current capital/finance leases

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Recognition and Recognition and Measurement - LesseeMeasurement - Lessee

Initial Recognition and Measurement• Assets/liabilities recognized immediately upon signing of

lease contract (before asset delivered or beginning of lease)– Reported net on balance sheet

• Contractual lease obligation measurement considerations: – Include contingent rental payments and amounts

expected to be paid under residual value guarantees– Lease term is calculated as longest possible lease

term that is “more likely than not” to happen– Lessee uses incremental borrowing rate, or rate

implicit in the lease (if readily determinable)– Lessee’s direct costs also capitalized

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Recognition and Recognition and Measurement - LesseeMeasurement - Lessee

Measurement after acquisition• Once lease starts (and asset delivered),

contractual rights and obligations no longer reported net on balance sheet

• Contractual lease obligation: – Accounted for at amortized cost– Estimates reassessed at every reporting date

• Contractual right-of-use asset:– Accounting requirements similar to those for

intangible assets (including amortization, revaluation, and impairment)

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Contract-Based Approach Contract-Based Approach ExampleExample

Lease terms and expectations:• Economic life: 7 years• Lease term: Sep 1/11 to Aug 31/15• Lease payments: $5,000 per year (in advance)• Renewal option: 2 additional years at $4,500/yr

(option most likely to be taken by lessee)

• FV of leased asset at start: $24,000• Lessor’s initial direct costs: $365• Expected values of asset:

– $6,000 Aug 31/15 or $1,000 on Aug 31/17• Rate implicit in lease and incremental borrowing rate

are same at 9%• Title retained by lessor

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Lessee Accounting: • Present value of amounts payable under lease

contract

PV rents for 4 years (Aug 31/11 to Aug 31/15)5,000 x 3.53130 (n=4, i=9%) = 17,656

PV of rents for 2 year extensions most likely takenfor 2016: 4,500 x 0.70843 (n=4, i=9%) = 3,188for 2017: 4,500 x 0.64993 (n=5, i=9%) = 2,925

23,769

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Lessee Accounting – journal entries:

September 1, 2011Contractual Lease Rights 23,769

Contractual Lease Obligations 23,769

Contractual Lease Obligation 5,000Cash 5,000

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Lessee Accounting – journal entries:

December 31, 2011Amortization Expense 1,320

Contractual Lease Rights 1,320[(23,769 / 6 years) x 4/12]

Interest Expense 563Interest Payable 563

[(23,769 – 5,000) x .09 x 4/12]

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Recognition and Recognition and Measurement - LessorMeasurement - Lessor

Initial Recognition and Measurement• Rights and obligations are recognized

immediately and reported net on balance sheet

• Lease receivable– Initially measured at PV of rental payments,

discounted at rate charged by lessor • Initial direct costs also capitalized

– Accounted for at amortized cost using effective interest method

• Lessor may have different expectations about lease outcomes compared to lessee (e.g. renewal options taken, etc)

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LeasesLeases






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Looking AheadLooking Ahead• Major changes are expected with the new

IFRS leasing standard expected in 2011

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