20 LEASES After studying this chapter, you should be able to: Understand the importance of leases from a business perspective. Explain the conceptual nature, economic substance, and advantages of lease transactions. Identify and apply the criteria that are used to determine the type of lease for accounting purposes for a lessee under the classification approach. Calculate the lease payment that is required for a lessor to earn a specific return. Account for a lessee’s basic capital (finance) lease. Determine the effect of, and account for, residual values and bargain purchase options in a lessee’s capital (finance) lease. Account for an operating lease by a lessee and compare the operating and capitalization methods of accounting for leases. Determine the statement of financial position presentation of a capital (finance) lease and identify other disclosures required. Identify and apply the criteria that are used to determine the type of lease for a lessor under the classification approach. Account for and report basic financing and sales-type leases by a lessor. Account for and report financing and sales-type leases with guaranteed residual values or a bargain purchase option by a lessor. Account for and report an operating lease by a lessor. Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

Leases Leasing Basics Classification Approach – Lessees Importance of leases from a business perspective Current standards Classification Approach – Lessees Classification criteria Determination of rental payments Accounting for a finance lease Accounting for residual values and bargain purchase options in a finance lease Accounting for an operating lease Finance and operating leases compared Presentation and disclosure Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for residual values and bargain purchase options in a financing or sales-type lease Accounting for an operating lease Initial direct cost Disclosure IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking ahead

Importance of Leases Leasing is popular because it is a cost-effective way of financing property and equipment This is especially true for items that become obsolete quickly From an accounting standpoint, leases have been controversial because many are “off-balance sheet” Standard setters have been concerned about this lack of transparency for many years LO1

Leasing Environment A 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 LO2

Leasing Environment In Canada, there are three main types of lessors: Manufacturer finance companies Subsidiaries whose main business is leasing (e.g. Honda Canada Finance Inc.) Independent finance companies Financial intermediaries Traditional financial institutions Subsidiaries of domestic and foreign banks LO2

Advantages of Leasing 100% 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) and tax incentives (lessor) Off-balance sheet financing Does not impact ratios LO2

Conceptual Nature of Lease Do not capitalize any leased assets – an executory contract approach Since lessee does not own the property, capitalization is considered inappropriate Since other executory contracts are not capitalized, leases should not be either Capitalize leases that are similar to instalment purchases – a classification approach if installment purchases are capitalized, so should leases with similar characteristics Capitalize all long-term leases – a contract-based approach The long-term right to use property justifies its capitalization LO2

Current Standards Current IFRS, ASPE, and FASB standards are consistent with the classification approach A lease that transfers substantially all the benefits and risks of property ownership should be capitalized (classified as finance/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 Lease contracts create assets and liabilities that should be recognized Finance and operating leases would be capitalized LO2

Leases Leasing Basics Classification Approach – Lessees Importance of leases from a business perspective Current standards Classification Approach – Lessees Classification criteria Determination of rental payments Accounting for a finance lease Accounting for residual values and bargain purchase options in a finance lease Accounting for an operating lease Finance and operating leases compared Presentation and disclosure Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for residual values and bargain purchase options in a financing or sales-type lease Accounting for an operating lease Initial direct cost Disclosure IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking ahead

Classification Criteria Most important factor in determining whether a lease is capital is whether risks and rewards have transferred from lessor to lessee Both IFRS and ASPE provide specific guidelines to help determine whether risks and rewards have transferred LO3

Classification Criteria: IFRS Under IFRS any one of the following normally indicates a finance lease: 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 Lease term allows lessee to get substantially all economic benefits that could be expected from using the leased asset over its entire life 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 asset Leased asset is specialized and can only be used by lessee (without major modifications) LO3

Classification Criteria: ASPE Under ASPE any one of the three requirements normally indicates a capital lease: Same as #1 under IFRS Similar to #2 under IFRS Additional threshold: assumed if lease term is  75% of lease asset’s economic life Similar to #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 LO3

Minimum Lease Payments 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 are made by the lessor, they are estimated and excluded from the PV of minimum rental payment calculation LO3

Minimum Lease Payments Guaranteed 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 lease Bargain Purchase Option (BPO) An option to purchase the leased asset at the end of the lease at a price below expected fair value LO3

Discount Rate Rate implicit in the lease: rate that makes PV of MLP + unguaranteed residual values = FV of leased asset 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) Under IFRS, use the rate implicit in the lease if it is reasonably determinable Under ASPE, use the lower of the two rates LO3

Determining Rental Payments Lessor sets rental payments to earn a specific rate of return (i.e. the implicit rate) If the lease has a BPO or residual value, these components do not need to be recovered through rental payments LO4

Determining Rental Payments - Example Given: Lessor Corporation wants to earn a 10% return on its investment of $100,000 Lessee Corporation is leasing the asset for five years Annual rental payments are due at the beginning of each year There is no BPO or residual value at the end of the lease Calculate the payment required to provide lessor with required rate of return LO4

Determining Rental Payments - Example Cost/FMV of asset to be recovered $100,000 Less: PV of expected residual value -0- Amount to be recovered through lease payments $100,000 PV of Annuity due (n=5, i=10%) 4.16986 Payments: ($100,000/4.16986) $23,981.62 Total lease payments: 5 x $23,981.62 = $119,908.10 LO4

Accounting for a Finance Lease Asset and liability recorded at the lower of: PV of the minimum lease payments and 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 LO5

Accounting for a Finance Lease 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 LO5

Accounting for a Finance Lease – Journal Entries At the inception of the lease: Dr. Asset under Lease Cr. Obligations under Lease To accrue interest: Dr. Interest Expense Cr. Interest Payable Using the Effective Interest Method To record asset depreciation: Dr. Depreciation Expense Cr. Accumulated Depreciation Using method appropriate to the asset LO5 To record the lease payment: Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under Lease Cr. Cash

Finance Lease - Example Given: Lease term of 5 years, non-cancellable Annual payments $25,981.62 (due at beginning of each year, starting January 1, 2014) Fair value of asset $100,000 Economic life = 5 years No residual value Lease payments include $2,000 of maintenance fees (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 LO5

Finance Lease - Example Does this qualify as a finance lease? Yes, under both IFRS and ASPE Only one of the tests must be met (ASPE 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 PV of payments (n=5, i=10%) 25,981.62 - 2000.00 = 23,981.62 x 4.16986 = $100,000.00 Yes Yes LO5 Finance Lease

Finance Lease - Example Entry to record initial lease transaction: Equipment under Lease 100,000 Obligations under Lease 100,000 Entry to record initial payment (Jan 1/14): Maintenance and Repairs Expense 2,000.00 Obligations under Capital Lease 23,981.62 Cash 25,981.62 Since this is a finance lease, the following must also be recorded (at year end or in each reporting period): Interest expense Asset depreciation LO5

Finance Lease - Example Entry to record interest (December 31, 2014): 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 since interest is accrued at year-end Entry to record asset depreciation (December 31, 2014): Depreciation expense 20,000 Accumulated depreciation 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 LO5

Finance Lease - Example Financial Statement Presentation (as at December 31, 2014) Statement of Financial Position Current liabilities Interest payable $ 7,601.84 Obligations under lease, current portion 16,379.78 Non-current liabilities Obligations under lease $59,638.60 LO5

Finance Lease - Example To record lease payment on January 1, 2015: Maintenance and Repairs Expense 2,000.00 Interest Payable 7,601.84 Obligations under Lease 16,379.78 Cash 25,981.61 LO5

Accounting for Residual Values If the residual value is guaranteed by the lessee, its PV is included in the leased asset and lease obligation recognized i.e., is included in definition of minimum lease payments If the residual value is unguaranteed, it is not included in the leased asset and lease obligation recognized i.e., is not included in the definition of minimum lease payments LO6

Accounting for Bargain Purchase Options (BPOs) Lessee accounting assumes bargain option will be exercised PV of BPO is included in asset cost and obligation recognized Asset is amortized over its economic life (not the lease term) It is assumed that BPO will be exercised and therefore that the asset will be purchased and continue to be used LO6

Accounting for an Operating Lease Risks and benefits of ownership of leased assets are not transferred to lessee Lease payments are treated as rent expense: Dr. Rent Expense/Prepaid Rent xx Cr. Cash/Accounts Payable xx Lease expense is recognized on a straight-line basis if lease inducements are offered LO7

Finance vs. Operating 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 Finance leases result in higher expenses in earlier years and lower expenses in later years compared to operating leases Operating leases result in lower debt-to-equity ratio and improved total asset turnover and return on total assets LO7

Current versus Non-Current Classification Current portion = principal amount to be repaid within 12 months from date of the statement of financial position (SFP) + interest accrued to SFP date Long-term = principal amount not payable within 12 months from the SFP date LO8

Disclosure – Finance Leases 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) LO8

Disclosure - Operating 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) LO8

Leases Leasing Basics Classification Approach – Lessees Importance of leases from a business perspective Current standards Classification Approach – Lessees Classification criteria Determination of rental payments Accounting for a finance lease Accounting for residual values and bargain purchase options in a finance lease Accounting for an operating lease Finance and operating leases compared Presentation and disclosure Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for residual values and bargain purchase options in a financing or sales-type lease Accounting for an operating lease Initial direct cost Disclosure IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking ahead

Classification Criteria - Lessor Type ASPE IFRS Operating Operating lease Financing lease: Sales-type Sales-type lease Manufacturer or dealer lease or Financing-type Direct financing lease Finance lease LO9

Classification Criteria - Lessor Under IFRS and ASPE, the lessor uses the same criteria as the lessee However under ASPE there are two additional revenue recognition-based considerations that must be passed: Credit risk associated with collection is normal Remaining unreimbursable costs to lessor can be estimated If required criteria are not met, the lease is accounted for as an operating lease Under ASPE, a lease may qualify as a finance lease by the lessee but be an operating lease for the lessor LO9

Classification Criteria - Lessor Both sales-type and financing-type leases are finance leases The difference is whether or not there exists a manufacturer’s or dealer’s profit The sales-type lease incorporates this profit LO9

Accounting for a Financing-Type Lease 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 LO10

Accounting for a Financing-Type Lease The gross investment in the lease and lease payments receivable are equal to: Lease payments (net of executory costs) + salvage/residual value or bargain purchase option (BPO) The net investment in the lease is equal to: the gross investment in the lease discounted at the implicit rate The unearned interest revenue is the difference between the gross and net investment LO10

Accounting for a Financing-Type Lease - Example Given: Lease term of 5 years, non-cancellable Annual payments $25,981.62 (receivable at beginning of each year, starting January 1, 2014) Fair value of asset $100,000 Economic life = 5 years No residual value Lease payments include $2,000 of maintenance fees (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 LO10

Accounting for a Financing-Type Lease - Example Entries to record the inception of the lease (January 1, 2014): Equipment Acquired for Lessee 100,000 Cash 100,000 Lease Receivable 119,908.10 Equipment Acquired for Lessee 100,000.00 Unearned Interest Income 19,908.10 Lease payments receivable (gross investment in lease): (25,981.62 – 2,000) x 5 = 119,908.10 Net investment in lease: (25,981.62 – 2,000) x 4.16986 (n=5, i=10%) = 100,000 LO10

Accounting for a Financing-Type Lease - Example Entry to record first payment (January 1, 2014): Cash ($23,981.62+$2,000) 25,981.62 Lease Payments Receivable 23,981.62 Maintenance and Repairs Expense 2,000.00 Entry to accrue interest earned (December 31, 2014): Unearned Interest Income 7,601.84 Interest Income 7,601.84 LO10

Accounting for a Financing-Type Lease - Example Calculation of interest earned at December 31, 2014: Amount originally financed $100,000.00 Paid on principal Jan. 1/14 (23,981.62) Balance outstanding $ 76,018.38 Interest: 10% x 76,018.38 x 12/12 = $7,601.84 LO10

Accounting for a Financing-Type Lease - Example Financial Statement Presentation (as at December 31, 2014) Statement of Financial Position Current assets Net investment in finance leases $23,981.62 Non-current assets Net investment in finance leases $59,638.60 LO10

Accounting for a Sales-Type Lease 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 LO10

Accounting for a Sales-Type Lease - Example Given: Take the same data as the finance-type lease 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 LO10

Accounting for a Sales-Type Lease - Example Entries to record inception of lease (January 1, 2014): Lease Receivable 119,908.10 Unearned Interest Income 19,908.10 Sales 100,000.00 Cost of Goods Sold 85,000.00 Inventory 85,000.00 Entry to record the first payment (January 1, 2014) is the same: Cash ($23,981.62+$2,000) 25,981.62 Lease Receivable 23,981.62 Maintenance and Repairs Expense 2,000.00 Entry to accrue interest earned (December 31, 2014) is the same: Unearned Interest Income 7,601.84 Interest Income 7,601.84 LO10

Accounting for Residual Values - Lessor Whether guaranteed or unguaranteed, the residual is included in the lessor calculations for both financing-type leases or sales-type leases However, for sales-type leases unguaranteed residual values changes how it is included for accounting purposes: With unguaranteed residual value, the Sales Revenue and COGS are reduced by the PV of the unguaranteed residual value The gross profit amount on the sale will remain the same LO11

Accounting for Bargain Purchase Options (BPOs) - 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 LO11

Accounting for an Operating Lease - Lessor Risks and benefits of ownership of leased assets are not transferred to lessee Lease payments are treated as rental income Dr. Cash xx Cr. Rental Income xx Lease asset remains on lessor’s books and continues to be depreciated Dr. Depreciation Expense xx Cr. Accumulated Depreciation xx LO12

Initial 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: Financing-type lease – allocated over lease term Sales-type lease – expensed in the year the costs are incurred (i.e., in same period as gross profit on sale recognized) Operating lease – deferred and allocated over lease term LO12

Disclosure - Lessor Financing and Sales-Type Leases Under ASPE, disclose: Net investment in the lease and implicit rate Carrying amount of impaired leases (and impairment allowance) Under IFRS, additional disclosures including: Reconciliation between PV of MLP and gross investment and amounts due over time Unearned finance income Unguaranteed residual values Other LO12

Disclosure - Lessor Operating Leases Under ASPE, 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.) LO12

Leases Leasing Basics Classification Approach – Lessees Importance of leases from a business perspective Current standards Classification Approach – Lessees Classification criteria Determination of rental payments Accounting for a finance lease Accounting for residual values and bargain purchase options in a finance lease Accounting for an operating lease Finance and operating leases compared Presentation and disclosure Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for residual values and bargain purchase options in a financing or sales-type lease Accounting for an operating lease Initial direct cost Disclosure IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking ahead

Looking Ahead Major changes are expected with the new IFRS leasing standard that takes a more contract-based approach (as detailed in Appendix 20B) LO13

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