module05 leases

Module 5: LeasesOverview

The previous four modules address liability and equity issues. This module introduces another common form of financing — the lease agreement.

In Module 5, lease agreements are analyzed in relation to financial statement elements, and leasing an asset is compared to owning an asset outright. The module explains lease classification from the point of view of the lessee, and looks at lease amortization. The module concludes by analyzing accounting treatments for lease agreements from the point of view of the lessor.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Topic outline and learning objectives

5.1 Leases: Theoretical foundation Explain how property rights are obtained and obligations assumed under lease agreements, and analyze the substance of lease agreements with reference to the criteria for recognition of assets and liabilities in financial statements. (Level 1)

5.2 Leasing versus owning Evaluate the advantages and disadvantages of leasing compared to owning a capital asset. (Level 1)

5.3 Classifying leases Classify leases as operating or financing leases for the lessee, and explain how the classification criteria may relate to the substance of the lease agreement. (Level 1)

5.4 Lease accounting: Lessee Record leases from the perspective of the lessee, and analyze the impact of leasing agreements on lessee financial statements. (Level 1)

5.5 Accounting for a financing lease Calculate lease liability amortization using a worksheet. (Level 1)

5.6 Financial statement disclosure for lessees, and QOE Prepare financial statement disclosure for a lease from the perspective of the lessee (including note disclosure), and assess QOE concerns. (Level 1)

5.7 Lease accounting: Lessor Classify leases as operating or financing for the lessor, and analyze and explain the impact of various categories of leases in lessor financial statements. (Level 1)

Module summary

International accounting standards governing the topics in this module and PEGAAP, along with existing Canadian standards, are converged, with the following exceptions:

1. The terminology is different; leases that transfer the risks and rewards of ownership to the lessee are called capital leases under PEGAAP, and under existing Canadian GAAP, and financing leases under IFRS. These terms have the same meaning.

2. The criteria identified to decide whether a lease is financing or operating are the same, but are applied on a more

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judgmental basis under IFRS and are more of a “line” under PEGAAP and existing Canadian GAAP.

3. IFRS specify that the lessee should use the interest rate implicit in the lease for present value calculations if it is known; the lessee’s incremental borrowing rate is only used if the implicit rate is unknown. Canadian rules require that the lessee use the lower of the incremental borrowing rate or the interest rate in the lease if it can be determined.

4. The terminology is different for leases from the perspective of the lessor. While the accounting is the same, PEGAAP and existing Canadian GAAP refer to sales-type leases and direct-financing type leases, while IFRS does not use these terms.

5. Under IFRS, if there is a sale and leaseback transaction that is covered by an operating lease, profit on the sale is recognized up front; under PEGAAP and existing Canadian GAAP, deferral is required.

6. IFRS disclosure requirements are more extensive than under PEGAAP.

Lease accounting is under active study in the international sphere. The IASB’s research study suggests much broader capitalization than is now the case.

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5.1 Leases: Theoretical foundation

Learning objective

● Explain how property rights are obtained and obligations assumed under lease agreements, and analyze the substance of a lease agreement with reference to the criteria for recognition of assets and liabilities in financial statements. (Level 1)

Required reading

● Chapter 17, pages 1006-1013 up to "Long-term Leases: Pros and Cons". The term “capital lease” in the text is synonymous with “financing lease” under IFRS.

LEVEL 1

A lease is an agreement that conveys the right to use an asset for a certain period of time for an agreed payment or series of payments. If the rights are minor or temporary, a simple rental relationship is recorded in the financial statements of both parties. If the substance of the agreement conveys substantially all of the risks and rewards of ownership to the lessee, an asset and a liability and any related expenses must be recorded in the lessee financial statements. The lessor’s financial statements must then show the lease payments receivable, and measure revenues according to the substance of the lease agreement.

A lease is one way to acquire an asset and assume a liability. When are such assets and liabilities recognized and how does such recognition affect the financial statements?

Substance of a lease

A financial statement element is recognized (recorded) when all of the following criteria are met:

1. The item meets the definition of an element.2. The item has an appropriate basis of measurement.3. A reasonable estimate can be made of the amount involved.4. Economic benefits or sacrifices are probable.

Also recall that an asset is:

● an economic resource controlled by a company● a result of past transactions or events, or● something that will generate future economic benefits.

What is the substance of a lease agreement? Is it a rental contract, allowing the lessee use of a tangible asset for a period of time in exchange for rent paid to a lessor, who has legal title to the asset? Or is it a purchase transaction, transferring both an asset and a liability to the lessee?

Consider a rental contract requiring fixed payments over 10 years — the entire life span of the given tangible leased asset. At the end of the contract, the leased equipment is ready for the scrap heap. The lessee has had all the risks and benefits of ownership, and the lessor has only had a (guaranteed) financial interest in the asset. The asset has, in substance, been the security on a fixed-interest loan made by the lessor to the lessee. The definition of an asset does not require that the lessee has legal title — just that control be established.

Review the recognition criteria for a financial statement element, considering a leased asset. The leased item appears to meet the definition of an asset. The basis of measurement would be the present value of the lease payments, readily estimated because payments are specified in the lease contract. The existence of the contract makes the payments probable.

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Now review the recognition criteria considering a 10-year lease contract obligation. Again, it is important that all four criteria for liability recognition be met. Remember that a 10-year lease contract is little different from a 10-year loan that requires annual blended payments. With a loan, you receive a monetary asset (cash) up front (the principal or loan amount), which you might use to buy a capital asset. In a lease, you get the asset itself — in substance, a minor difference.

Lease capitalization

Throughout the 1950s and 1960s, standard setters tried to mandate lease capitalization for leases that were, in substance, the purchase of an asset. They relied on standards that were judgment oriented, not rule oriented. These standards were systematically avoided by lessees, who were resisting lease capitalization. The current standard, effective since the late 1970s, has had more success in forcing capitalization by lessees.

There are still many leases that are not capitalized. In fact, many lease contracts are written to avoid the capitalization criteria. (This can be accomplished by inserting cancellation clauses in lease arrangements, using third party guarantees, and shifting payments to contingent rent conditions.)

Why try to avoid capitalization? For the lessee, aversion to capitalization has been based on the desire to keep the lease liability off the balance sheet. Leases are big business; most firms are involved in some kind of lease arrangements, and they are frequently material.

Minimum lease payments

Pay special attention to the definition of minimum lease payments (MLPs). MLPs involve anything that the lessee pays to the lessor over the lease term, as illustrated in Exhibit 5.1-1. At the end of the lease, the lessee may have to pay a lump sum to the lessor under the terms of the lease contract: a bargain purchase option (BPO), a guaranteed residual, or perhaps some kind of penalty payment. Only one payment can be present in any lease; they are mutually exclusive. An unguaranteed residual is not a payment made by the lessee to the lessor and is not part of the MLPs.

In a bargain purchase option, the price offered to the lessee is less than the fair value of the leased asset at the end of the lease term. For example, at the end of the lease term, if the leased asset were valued at $20,000 and the lessee has the option to purchase it at $5,000, this would be a bargain purchase option. The lessee will always exercise this option. The lessee can buy the asset at the end of the lease for $5,000 and, if no longer needed, sell the asset for the estimated residual value of $20,000. What a bargain!

Exhibit 5.1-1: Minimum lease payments

Residual value

When evaluating the need to include a residual value in lease calculations, you always use a pessimistic assumption. For



instance, suppose there was an estimated $1,000 residual value. If it was guaranteed by the lessee and the equipment was sold for $750, the lessee would have to pay an extra $250 to the lessor. When capitalizing the lease, assume that the equipment will be sold for nothing and thus you include the whole $1,000 (worst case scenario) in the MLPs. This will increase the lease liability and the recorded value of the leased asset. If the residual is not guaranteed, it has nothing to do with the lessee — it is only important to the lessor and is not part of the MLPs.


5.2 Leasing versus owning

Learning objective

● Evaluate the advantages and disadvantages of leasing compared to owning a capital asset. (Level 1)

Required reading

● Chapter 17, pages 1013-1015 up to “Accounting for Capital Leases”

LEVEL 1

Pay special attention to the pros and cons of lease arrangements in the text. Financing an acquisition with a lease arrangement should always be compared to other alternatives (buy and borrow, for instance).


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5.3 Classifying leases

Learning objective

● Classify leases as operating or financing leases for the lessee, and explain how the classification criteria may reflect the substance of the lease agreement. (Level 1)

Required reading

● Chapter 17, pages 1009-1013, 1015-1020, and 1026-1027 to “Sale and Leaseback"

LEVEL 1

Capitalization criteria

From the perspective of the lessee, a lease can be one of two types, as shown in Exhibit 5.3-1.

Exhibit 5.3-1: Lease classification for the lessee

Financing leases are recorded as assets and liabilities (see pages 1015-1016), while operating leases are simply rental contracts (see pages 1026-1027).

Decision 1 is based on whether substantially all of the benefits and risks of ownership related to the leased property are transferred from the lessor to the lessee. This decision is made judgmentally, based around certain criteria. These criteria for classifying leases are explained and defined on pages 1009-1010:

1. Transfer of title through contract or through the presence of a bargain purchase option.

2. Lease term covers the major economic life of the asset; under IFRS “major” is to be defined judgmentally, but under PEGAAP, the “line” is 75% of economic life.

3. PV of minimum lease payments is substantially all the fair value of the leased asset; under IFRS “substantially all” is defined judgmentally, but under PEGAAP the “line” is 90%.

4. In addition to the criteria listed in the text, IFRS identifies an additional factor to consider: is the leased asset one that is of such a specialized nature that only the lessee can use it without major modifications? If so, the lease is more likely to be a financing lease. If the asset is a general use asset, the lease is




more likely to be an operating lease.

The criteria are guidelines, not rules. They ensure that leases that transfer risks and rewards of ownership are capitalized in the financial statements. Judgment involved includes such questions as:

● When is a purchase option a bargain purchase option? If the lease term covers 73.5% of the economic life, is that sufficient to warrant capitalization? If the present value of the lease is 88% of fair value, is this high enough to warrant capitalization?

● The lessee may not know the economic life of the asset at the inception of the lease. This must be estimated.

● In some circumstances, the fair value of the asset leased may not be ascertainable, if there is no active market for this kind of asset, and if there is a material unguaranteed residual value unknown by the lessee.

Under IFRS, the interest rate to use when determining the present value of the lease is the interest rate implicit in the lease. If the lessee does not know this rate, the lessee would use the lessee’s incremental borrowing rate.

Focus on PEGAAP

Under PEGAAP, lease capitalization criteria are treated less judgmentally, and exclude the nature of the leased asset; refer to the list on page 1009. The criteria 75% of lease term and 90% of fair value are considered “lines.”

Under PEGAAP, a lessee performs present value calculations using the lower of the interest rate implicit in the lease, if known, and the lessee’s incremental borrowing rate.

Present value calculations

Present value calculations are integral to lease accounting. Consider the example in the following activity.

Activity 5.3-1: Present value calculations

Assume Apollo Company’s lease has an initial term of 3 years, with payments of $10,000 per year, starting at the beginning of the lease term. This is followed by 2 additional years with lease payments of $8,000 per year, also at the beginning of the year. Finally, at the end of the 5th year, there is a purchase option that is considered to be a bargain purchase option; it requires a payment of $500. The interest rate implicit in the lease is 10%; the lessee knows this rate. What is the present value of this payment stream?

The lease term is 5 years, as the lease term includes all periods up to the exercise of a bargain purchase option (BPO). (This calculation can be done on most financial calculators.) The payments can be illustrated on a timeline:

Beginning of: End of:

Year 1 |

Year 2 |

Year 3 |

Year 4 |

Year 5 |

Year 5 |

$10,000 $10,000 $10,000 $8,000 $8,000 $500

All these payments must be taken back, through present value calculations, to the beginning of Year 1. The interest rate to be used is the lower of the rates provided: 10%. Calculate the PV now:

PV = __________

Solution

There are a number of alternative calculation methods that can be used to get the correct answer; as long as you are able to consistently get the correct answer, your methodology is correct. (If you need a refresher in calculating present values, refer to the examples and summary of formulas provided in the foundation review.)

Lease classification



For practice, classify the four leases described in Activity 5.3-2.

Activity 5.3-2: Lease classification, lessee

Lease number 1 2 3 4 Title passes no no no noBargain purchase option no no $1,000, end of

Year 6 no

Useful life of equipment 10 years 7 years 9 years 9 yearsLease term 3 years 5 years 6 years 8 yearsMV of equipment $120,000 $55,000 $150,000 $115,000Lessee's IBR 12% 12% 12% 12%Implicit rate in lease unknown to

lessee 10% unknown to

lessee 10%

Annual payments, Jan. 1 (rounded) $17,5471 $13,190 $33,734 $19,199Residual, guaranteed, end of lease term no no no $5,000Residual, unguaranteed, end of lease term unknown unknown unknown noSpecialized asset No No No YesCredit risk normal normal normal normalUnestimable costs none none none noneCarrying value, lessor's books $100,000 $55,000 $106,000 $97,000 Determination: Criteria 1 — Title passes or BPO _______

_______ _______ _______

Criteria 2 — economic life _______ _______ _______ _______Criteria 3 — PV FMV _______ _______ _______ _______ PV _______ _______ _______ _______ % of FMV _______ _______ _______ _______Criteria 4 – Specialized asset Lease classification: _______ _______ _______ _______

1 The lessor based rental on recovery of 40% of the fair market value over the three-year lease term and an interest rate of 10%. The lessee does not know this.

Solution


5.4 Lease accounting: Lessee

Learning objective

● Record leases from the perspective of the lessee, and analyze the impact of leasing agreements on lessee financial statements. (Level 1)

Required reading

● Chapter 17, pages 1015-1026 up to "Non-capital Leases," 1027-1029 ("Sale and Leaseback"), and 1034-1036 (Review Problem and Solution)

LEVEL 1

Calculating lease amortization

As a first step, every lease must be classified as either finance or operating, using the judgment and established criteria. Once the decision has been made as to the type of lease, the lessee accounts for the lease

● as an operating lease: a straightforward rental contract, or● as a financing lease: the purchase of an asset and the assumption of a long-term liability.

Lease liabilities may be analyzed through an amortization table, illustrated below. (You will learn how to prepare this amortization table in Excel later in this module.)

Example 5.4-1: Lease liability schedule

Refer to the information on the Apollo Company lease in Activity 5.3-1. The present value of the payment stream was $39,140. Over the life of the lease, the liability will be reduced to zero as follows:

Schedule of lease liability amortizationLease year

Outstanding balance

Interest @ 10.0% Payment

Incr. / (Decr.) in balance

Ending balance

1 $ 39,140 $ 10,000 ($ 10,000) $ 29,1402 29,140 2,914 10,000 (7,086) 22,0543 22,054 2,205 10,000 (7,795) 14,2594 14,259 1,426 8,000 (6,574) 7,6855 7,685 769 8,000 (7,231) 454

5* 454 46 500 (454) (0)Totals $ 7,360 $ 46,500 ($ 39,140)

* End of year 5 payment of the BPO

The bargain purchase option is included in this table; it is a payment like all other payments. The entry to record the BPO would be as follows:

End of year 5:

Interest expense 46




Lease liability 46The balance in the lease liability account is now $500 ($454 + $46)Lease liability 500 Cash 500

A compound entry could also be made that includes both entries.

What if the bargain purchase option were not exercised? The BPO should be such a bargain that this is not a reasonable suggestion. However, if the irrational decision were made to not exercise the BPO, the asset and its accumulated amortization would be written off, along with the liability. A loss would be recognized.

Fiscal years

The amortization table for the lease payments will not necessarily correspond to the fiscal year. To relate the table to fiscal years, dates must be carefully examined. Return to the data in the Apollo Company example. Assume that the lease was signed on January 1, 20X2. How much interest expense is recorded in 20X2? It is tempting to answer "zero" because there is no interest on the first line of the table. However, this is not correct. Remember, all during 20X2, there was a liability of $29,140 outstanding. Interest must be accrued on this amount. Interest expense is $2,914 for 20X2; it appears on the second line of the table.

Interest is accrued at the end of the year as follows:

Interest expense 2,914

Lease liability 2,914

At the end of 20X2, the balance in the lease liability account will be $32,054 ($29,140 + $2,914). This includes the lease liability and interest payable. While some companies will use a separate interest payable account to keep track of the interest accruals, this practice makes recording the subsequent lease payment less straightforward. However, there is a fair bit of variation in practice. The table identifies the interest portion of each payment; it’s up to you to record it in the correct fiscal year.

What will be the interest expense for 20X4, the year in which the third payment is made? Reason your way through the table again. You should have said $1,426.

The table sorts out the lease payments, but you must be careful when applying it to fiscal years. Preparing the entries often helps establish the proper time frames. See also the text example on pages 1020-1025, which accrues interest in the appropriate fiscal year.

Lessee amortization periods

Over what period should the lessee amortize the leased asset? Common sense should make this decision easy. How long will the lessee use the asset? This dictates the amortization period. To illustrate this, work through the following activity. Choose the amortization period for each of the three cases.

Activity 5.4-1: Examples of financing leases

Lease number 1 2 3

Title passes yes no no

Lease term 5 years 7 years 7 years

Useful life 10 years 10 years 10 years

BPO no yes no

Residual value present: asset reverts to lessor at end of lease term, or is sold no no yes



Solution

What if the lessee plans to use the asset for a period less than the lease term? (for example, it’s a five-year lease, but the useful life is three years). The amortization period would be the (shorter) period of use (three years, in this example). However, this is a very unlikely scenario — what lessor will allow a lessee to pay for an asset over a period that exceeds its useful life? If the lessee stopped paying in Year 4, and the lessor were to repossess the asset, the asset would likely be worthless. The lease term is rarely, if ever, greater than the life of the asset.

Lessee capitalization ceiling

On the books of the lessee, a financing lease will increase capital assets and liabilities. It will result in the recognition of interest and amortization expense on the income statement.

If the lessee uses the incremental borrowing rate instead of the implicit rate when calculating present values, the result may be a number higher than fair value. This situation might arise under IFRS when the lessee did not know the implicit interest rate. It might also arise if the fair value of the asset were to suddenly drop in the period between the time the lease was signed and the time that the lease commenced. The lessee must record the asset at a value no higher than fair value (fair value is the ceiling).

The interest rate must be re-calculated such that the present value of the future outflows of cash (that is, the PV of the MLPs) will equal the fair value of the asset.

This interest rate will be higher than that used in the original calculation. This calculated interest rate is then used by the lessee to create the liability amortization table. Consequently it is also this calculated interest rate that is used by the lessee to record the interest expense on the lease liability. Work through the following activity, which illustrates the capitalization ceiling for the lessee. Determine the present value of the MLPs, and the entry for the lessee.

Activity 5.4-2: Capitalization ceiling, lessee

Lease term 8 years

Economic life of asset 10 years

Fair value of asset at inception $ 114,000

Bargain purchase option no

Transfer of title no

Residual value $ 10,000, unguaranteed

Lessee’s incremental borrowing rate 12%

Interest rate implicit in lease unknown

Payment date January 1

Payment amount $ 20,894

Solution

The following two activities illustrate interest rate calculations.

Activity 5.4-3: Implicit interest rate

Once the fair value is used as a ceiling, the interest rate must be adjusted upward. This interest rate is used in subsequent interest calculations. If the asset is recorded at $114,000 (Activity 5.4-2), what is the correct interest rate?

Solution

Activity 5.4-4: Irregular payment streams



If the payment stream is not regular (that is, involves a lump sum at the end or different annual payments), the look-up tables cannot easily be used; trial and error must be used, and it is tedious. An IRR calculation is the best approach. This can also be done on a financial calculator.

All the minimum lease payments must be included in the list of cash flows. For example, if the lease described in Activity 5.4-2 also required a $10,000 guaranteed residual at the end of the eighth year, what is the correct interest rate?

Solution

Sale and leaseback

Work through the text material on pages 1027-1029.

Under IFRS, if there is a sale and leaseback transaction that is covered by an operating lease, profit on the sale is recognized up front as long as the lease rental rate represents market rental rates; under PEGAAP and existing Canadian GAAP, deferral is required. However, most sale and leasebacks involve capital leases, where there are no differences between IFRS and PEGAAP.

Future income tax

Tax considerations often play a major role in capital asset acquisition. Tax depreciation, called capital cost allowance (CCA), is deductible only by the entity that owns the property. Investment tax credits (ITCs) — reductions to taxes payable based on a percentage of the cost of capital assets acquired during the year — are also provided to owners. What happens with leased assets?

CCA and ITCs are available to the lessee with a financing lease; however, CRA generally considers leases to be financing leases only if title passes. Therefore, any lease that is capitalized because of the second or third classification criteria (length of contract or PV of MLPs) will be considered to be an operating lease for tax purposes, even though it is a financing lease for accounting purposes.

There are many differences between financial accounting standards and tax practice: one does not dictate the other. After all, reporting to owners and creditors on the results of performance is far different from the objectives of a tax collection system. You should be aware of such differences; they affect the calculation of tax expense and give rise to future income tax.

Land leases

If land is subject to a lease, it can only be a financing lease if title passes or there is a BPO (Criterion 1). Otherwise, the land lease is an operating lease. This is because of land's indefinite life. If a lease is signed that is partially for a building and partially for the land on which the building sits, the lease payment is divided on the basis of the relative fair market values of the two assets. Each portion of the lease is then independently classified. Land leases may impact on the amortization terms of assets that are permanently affixed to the land: a building with a 30-year life, situated on a piece of land under a 10-year non-renewable lease, will clearly only be used for 10 years unless there is some way to remove it when the land is returned to the lessor. The amortization period would therefore be 10 years.

Review problem

Lease questions involve some complex numbers and decisions. Practice by working through the review problem on pages 1034-1036.


5.5 Accounting for a financing lease

Learning objective

● Calculate lease liability amortization using a worksheet. (Level 1)

LEVEL 1

The advantage of using a worksheet to calculate a lease liability amortization is that once a generalized lease liability amortization model is built, it is easy to calculate different lease liability amortization schedules for different situations.

Computer activity 5.5-1: Calculating lease liability amortization

In this illustration, you learn how to

● construct a worksheet to calculate a generalized lease liability amortization schedule● calculate the interest rate implicit in the lease, and ● calculate lease liability amortization schedules for different lease terms.

Material provided

FA3M5P1 contains two worksheets:

M5P1 — a partially completed worksheet to calculate lease liability amortization, and M5P1S — the solution for the worksheet M5P1.

Description

This illustration is based on a financing lease with the following details:

● There are five annual January 1 payments, to be made in 20X4, 20X5, 20X6, 20X7, and 20X8.● The annual lease payment is $41,831.● At the end of the lease, on December 31, 20X8, the lessee will purchase the asset by paying a bargain purchase

option price of $1,000.● The fair market value of the leased equipment is $178,000.● The lessor’s implicit interest rate is 10%.

Required

Complete the data table and enter the necessary formulas to calculate the lease liability amortization.

Procedure

1. Open FA3M5P1. Click sheet tab M5P1.

2. Study the layout of the worksheet. Rows 4 to 14 contain the information that forms the data table, rows 16 to 24 contain the information to calculate IRR, and rows 26 to 35 form the lease liability amortization schedule.

3. Enter the information given in the example in cells E7 to E10, and E12, skipping cells E11, E13, and E14 for now.

4. Enter the appropriate (beginning of the year) cash flows in cells B19 to B24. Remember that the lease payments are paid at the beginning of the year and that there is a bargain purchase option paid at the end of the lease, which should be entered under year 20X9.

5. Go to cell C19 and complete the IRR. To do this, select fx from your Excel tool bar, select Financial under Function




Category and IRR under Function Name. Click OK. In the values box, select cells B19 to B24 and click OK. For students using Excel 2007, click the Formulas tab then select Fx from the ribbon. Select financial from the drop-down list then click on IRR under Select a function. Click OK. In the Function Arguments window select cells B19 to B24 in the values box and click ok.

6. Enter in cell E14 the appropriate discount rate to use for the lease liability.

7. Enter in cell E11 the formula to calculate the present value of the bargain purchase option.

8. For cell F7 use the PV formula to verify the fair market value of the asset. Your formula should consider two components: present value of the annuity due and the present value of the BPO: = PV (interest, term, – payment, -BPO, 1)

9. Complete the formulas in cells B29 to F34. Use the table on page 1021 of the text as a reference. The total formulas in row 35 are already entered for you.

10. Save the file.

11. Print a copy of the completed worksheet and compare it to the review solution on the sheet tab M5P1S.

12. If you did not get the same answer, study the formulas given in the M5P1S worksheet and then make the necessary changes to your worksheet M5P1.


5.6 Financial statement disclosure for lessees, and QOE

Learning objective

● Prepare financial statement disclosure for a lease from the perspective of the lessee (including note disclosure), and assess QOE concerns. (Level 1)

Required reading

● Chapter 17, pages 1030-1033

LEVEL 1

Statement of cash flow

The required reading explains statement of cash flow disclosure for the lessee under a financing lease. Notice that the initial entry, recording a financing lease, is a non-cash transaction and thus is not disclosed on the face of the SCF. After that, there are the typical disclosures for add-back of amortization and cash outflows for repayment of loans.

Disclosure

The disclosures for lessees listed on page 1030 should seem like logical disclosures for an interest-bearing debt.

All the disclosure listed in the text is required under IFRS, but, in addition, a lessee must provide a general description of their leasing arrangements, along with conditions in lease arrangements.

The required future minimum lease payments (cash flow) disclosure warrants a careful look, as illustrated in Example 5.6-1.

Example 5.6-1: Minimum lease payments disclosure

Refer back to the data in Activity 5.3-2, lease number 4, a lease for a $115,000 asset that involved annual January 1 payments of $19,199 for 8 years, then a guaranteed residual payment of $5,000.

The entries that the lessee would make in the first year of the lease are as follows:

January 1 Leased asset 115,000 Lease liability 115,000 Lease liability 19,199 Cash 19,199December 31 Interest expense ($115,000 – $19,199) × 0.10 9,580 Lease liability 9,580 Amortization expense ($115,000 – $5,000)* ÷ 8 13,750 Accumulated amortization 13,750

* This assumes the lessee plans to sell the equipment at the end of the lease term and will receive proceeds of $5,000.

At the end of December, the lease liability on the balance sheet would have a balance of $105,381 ($115,000 – $19,199 + $9,580). This would be shown as a $19,199 current liability, the portion due in the next fiscal year (all at the beginning of the




year), and the balance as a long-term liability, $86,182 ($105,381 – $19,199).

That is, on the balance sheet:

Capital assets:

Leased asset $115,000

Accumulated amortization (13,750)

101,250

Short-term liabilities

Lease liability $ 19,199

Long-term liabilities

Lease liability 86,182

The future minimum lease payments disclosures would appear as follows.

The company has the following cash commitments under financing leases:

Year 1 (next year) $ 19,199

Year 2 19,199

Year 3 19,199

Year 4 19,199

Year 5 and thereafter [($19,199 × 3) + $5,000] 62,597

Total cash commitments 139,393

Less: interest ($139,393 – $105,381) (34,012)

Cash commitments less interest 105,381

Less: current portion (19,199)

Long-term lease liability $ 86,182

The company has made one lease payment to date; the other seven, and the guaranteed residual, are listed in the schedule. If payments last longer than five years, remaining payments are lumped on the "Year 5 and after" line. The interest deduction is the sum of interest amounts implicit in the payments, obtained from the liability amortization table (not reproduced here). Finally, the current portion is subtracted to reconcile the minimum lease payments to the long-term lease liability. Since the next lease payment is due January 1 (tomorrow), the entire amount is current. If the payment was due December 31, only the principal portion (obtainable from an amortization table) would be current, since the interest portion would accrue over the next 12 months.

Quality of earnings

Earnings quality can also be used as a substance over form assessment. Earnings, and the financial statements in general, should portray the substance of the company’s activities. Therefore, if lease contracts are in substance a borrowing arrangement and are NOT reflected as such in the financial statements, then the quality of earnings is low.

Many companies in many different industries utilize operating leases as a permanent part of their capital structure. Operating leases are not capitalized. They are accordingly called “off-balance sheet financing.” As a result, quality of earnings



assessment includes assessing the extent of the company’s operating lease commitments. High incidence of operating leases is viewed as a negative factor. This evaluation is done in relation to the commitments of similar companies. In some industries, where operating leases prevail, quality of earnings might be suspect.

Future directions

The topic of lease accounting is under study in the international sphere. Study pages 1032-1033 of the text. The IASB’s research study suggested much broader capitalization than is now the case. That is, all leases with an initial lease term of more than one year would have to be capitalized. If the IASB moves in this direction, this will represent a significant change to Canadian practice.


5.7 Lease accounting: Lessor

Learning objective

● Classify leases as operating or financing for the lessor, and analyze and explain the impact of various categories of leases in lessor financial statements. (Level 1)

Required reading

● Chapter 17, pages 1037-1041, 1044 (Disclosure), 1044-1047 (When you study the disclosure indicated on page 1044, the first item is just the balance of the lease receivable account, recorded at its present value.) The terms “sales-type lease” and “direct financing lease” are not used in IFRS, but the accounting treatment is identical.

LEVEL 1

There are two kinds of companies involved in leases as lessors: finance companies, which are interested in earning interest revenue over the life of a lease contract, and manufacturers or dealers, interested in selling their product and earning a gross profit but also earning interest revenue. The decision to become a lessor is complex and sometimes has significant cash flow implications for an operating company.

For the lessor, you are responsible for the following items:

1. Lease classification2. Description of the financial statement impact of an operating lease, 3. Description of the financial statement impact of a financing lease on the books of a finance company and for a

manufacturer/dealer.

Lease accounting from the lessor’s perspective is a complicated and specialized area. In FA3, your responsibility is to be able to discuss classification and the financial statement impact; you are NOT responsible for journal entries for the lessor. Exhibit 5.7-1 illustrates lease classification for the lessor.

Exhibit 5.7-1: Lease classification for the lessor

Capitalization criteria

Decision 1 is much the same for the lessor and the lessee. The lease is a financing lease for the lessor if the risks and




rewards of ownership have passed to the lessee. This is evaluated judgmentally around the same criteria:

1. Transfer of title through contract or through the presence of a bargain purchase option.

2. Lease term covers the major economic life of the asset; under IFRS “major” is to be defined judgmentally, but under PEGAAP the “line” is 75% of economic life.

3. PV of minimum lease payments is substantially all the fair value of the leased asset; under IFRS “substantially all” is defined judgmentally, but under PEGAAP the “line” is 90%. Use the interest rate implicit in the lease for this calculation.

4. In addition to the criteria listing the text, IFRS identifies an additional factor to consider: is the leased asset one that is of such a specialized nature that only the lessee can use it without major modifications? If so, the lease is more likely to be a financing lease. If the asset is a general use asset, the lease is more likely to be an operating lease.

Two additional criteria are listed on page 1037 for the lessor. To consider the lease a financing lease:

1. Collectability of lease payments is assured.

2. There are no significant unestimable, unreimbursable costs associated with the lease.

Failure to meet either of these last two criteria results in the lease being classified as an operating lease for the lessor, regardless of the accounting treatment adopted by the lessee. These criteria are not explicitly listed in the IFRS lease standard, but are supported by the general revenue recognition criteria as appropriate in a classification decision.

Operating lease

If a lease is an operating lease for the lessor, the impact on the financial statements is as follows:

● The asset under the lease contract will remain on the books of the lessor, as a capital asset. It will be amortized over its period of useful life to the lessor.

● Lease/rent revenue will be recorded on the income statement of the lessor.

Financing lease: Finance company versus manufacturer/dealer

After determining that the lease is a financing lease, the next step is to determine if the lessor is a finance company or a manufacturer/dealer.

● Is the lessor a finance company? In general, if the lessor has apparently bought the asset at fair market value and leased it out immediately, the lease is only a financing mechanism. The lessor typically does not actually take delivery of the asset in these leases, but rather orders the asset to be delivered to the lessee. The lessor reports only finance revenue over the life of the lease.

● Is the lessor in the business of buying or manufacturing the leased asset in order to make a profit by "selling" it in some form? The lessor recognizes an initial gross profit on sales and finance revenue over the life of the lease.

Classification rests on the facts of the question. If you need an objective criterion, look at the cost, or carrying value, of the asset on the lessor’s books. If it is carried at fair value, then the lease only involves finance revenue; the lessor obviously just bought this asset to lease it. If the carrying value is higher or lower than fair value, the lease will trigger an initial profit or loss, followed by regular finance revenue.

Interest rates

At some point in time, the lessor must recover the fair market value of the leased asset from someone. Most of it will come from annual rental payments, but there is the potential for a lump-sum payment at the end of the lease in the form of a bargain purchase option, some kind of a cancellation penalty that the lessee pays, or a salvage value (either guaranteed or unguaranteed). The lessor takes on risk if the residual value is unguaranteed; the lessee takes on risk if the lessee guarantees the residual. Many finance companies will not assume this kind of risk (selling used equipment); they pass this risk on to the lessee or contract it out to a third party insurer. If a third party is the guarantor, then the lessee does not take on the risk.



For example, return to the data in Activity 5.3-2 in Topic 5.3. How does the lessor recoup the fair value of the asset in each case? The figures used for PV are based on the interest rates implicit in the lease:

FMV = PV rent + PV BPO or PV UngR or PV GR

Lease #1 $ 120,000 = $ 48,000 + $ 72,000 (unguaranteed residual*)

Lease #2 $ 55,000 = $ 55,000 + 0

Lease #3 $ 150,000 = $ 149,545 + $ 455 (BPO)

Lease #4 $ 115,000 = $ 112,667 + $ 2,333 (guaranteed residual)

* The unguaranteed residual is unknown to the lessee. The lessor would be planning to recover this amount by sale of the used asset at the end of the lease term or by re-leasing the asset to another party.

The structure of a lease is shown in Exhibit 5.7-2. An unguaranteed residual is included in the calculations made for the lessor.

Exhibit 5.7-2: Structure of a lease

Finance leases; finance revenue only

For a financing lease that involves finance revenue only at inception, the accounting treatment is as follows:

1. Establish the lease receivable at its net present value (set up lease payments receivable).

2. Remove the leased asset from the books (reduce the asset, if already on the books, or reduce cash, if the asset is



only now being bought).

The lessor will show financial assets on the books — the lease receivable. The leased asset is not on the lessor’s books. Annually, for such a lease, note the following steps:

1. Record interest income, increasing the lease receivable.2. Record the lessee’s payments, decreasing the lease receivable.3. The net receivable on the balance sheet will reduce annually, affected both by the cash collected, and the interest

revenue.

When you look at the example of a direct financing lease in your textbook (pages 1039-1041) make sure you understand the basic financial statement elements that change. (Remember: You are not responsible for these entries.)

Financing leases; manufacturer/dealer

When you read the discussion of sales-type leases in the text (pages 1044-1047) look at the entries to understand the changes to financial statement elements. Again, you are not responsible for the numbers in the journal entries, just for their meaning.

If the lessor is a manufacturer/dealer, the lessor has to record the sale of an asset (inventory) at a profit (or perhaps a loss), but also a lease contract on which the lessor will earn finance income over the life of the lease contract.

For these leases at inception, the accounting treatment follows:

1. Establish the lease receivable at its gross (undiscounted) value by debiting lease payments receivable.

2. Record the sales amount (fair market value, unless the lease involves an unguaranteed residual) by crediting sales.

3. Create an unearned interest revenue account for the difference between 1 and 2 by crediting unearned finance revenue.

4. Expense the cost of the asset sold by debiting cost of goods sold.

5. Remove the leased asset from the books by crediting an asset (likely inventory).

The accounting treatment after the initial entry is similar to the treatment of a lease that only involves finance revenue:

1. Record finance income.

2. Record the lessee’s payments.

Two kinds of profit: The judgment issue

For a manufacturer/dealer, there are two kinds of profit:

● gross profit, recognized at the inception of the lease● finance revenue, recognized over the term of the lease

The split between these two kinds of revenue is judgmental, and occasionally problematic. For example, assume that a lessor enters into a five-year financing lease with payments of $100,000 per year, for a total of $500,000. The asset was manufactured for $275,000. A total of $225,000 ($500,000 – $275,000) of profit will be recognized over the life of the lease.

But how much is recognized now (gross profit) versus as time passes (finance revenue)? This split is determined by the fair value of the asset on the day the lease is signed. For example, if the fair value of the asset is $400,000, then there is $125,000 of gross profit and $100,000 of finance revenue. If the fair value is $450,000, then the split becomes $175,000 of gross profit and $50,000 of finance revenue.

Sometimes, fair values are hard to determine. Perhaps the asset is rarely sold outright, only leased. In that circumstance, fair value is not readily ascertainable. This makes the profit split highly judgmental. Of course, the total revenue reported over



time is the same in all circumstances; it’s only the allocation that is problematic.

Financial statement impact

On the books of the lessee, a financing lease will increase capital assets and liabilities. It will result in the recognition of interest and amortization expense on the income statement. On the books of the lessor, a financing lease will result in replacing the leased asset with a new receivable on the balance sheet. Finance revenue will be recognized over the life of the lease.


Module 5 summary

You will find summaries of key points on pages 1033-1034 and 1047.

Explain how property rights are obtained and obligations assumed under lease agreements, and analyze the substance of a lease agreement with reference to the criteria for recognition of assets and liabilities in financial statements

● Lease agreements may represent, in substance, the purchase/sale of an asset, and a corresponding obligation/lease receivable.

● This happens when the risks and rewards of ownership pass to the lessee.● If this is the case, the lessor takes the asset off its books, and replaces it with a loan receivable.● The lessee records both an asset and a liability.

Evaluate the advantages and disadvantages of leasing compared to owning a capital asset

● Leasing is an attractive form of financing, providing flexible access to assets, protection from interest rate changes, 100% financing, off-balance sheet financing for operating leases, and some possible tax advantages.

● A lease may be more expensive than traditional lending arrangements and may lock the lessee into a long-term obligation.

Classify leases as operating or financing leases for the lessee, and explain how the classification criteria may relate to the substance of the lease agreement

● A lease transfers the risks and rewards of ownership based on a qualitative judgment of factors: �❍ Title passes to lessee by end of lease.�❍ There is a bargain purchase option.�❍ The lease covers the major portion of the economic life of the asset (>75%?). �❍ The present value of the lease payments is substantially all of the fair value of the asset at inception of the

lease (>90%?).�❍ The leased asset is a specialized asset, only useful in current form to the lessee.

● Leases that are not financing leases are classified as operating leases.● For operating leases:

�❍ The contract is a simple rental agreement.�❍ The lease does not give rise to property rights.�❍ Payments are expensed as time passes or benefits are received.

● There are three common structures adopted to avoid capitalization: �❍ Contingent rent�❍ Inserting a third party�❍ Shortening the lease term

Record leases from the perspective of the lessee, and analyze the impact of leasing agreements on lessee financial statements

● A leased asset and a lease liability are recognized at the PV of lease payments.● A leased asset is used by the lessee over the lease term and is amortized like any other owned asset.● A lease obligation, like any other interest-bearing obligation, is increased by interest each period and reduced by

payments made.● The lease year will not coincide with the fiscal year, and interest will have to be accrued for a part year.● The leased asset is amortized over the lease term, but if the lessee keeps the asset at the end of the lease term and

uses it, the longer useful life is used for amortization.● If the PV is higher than fair market value of the leased asset, the asset is recorded at fair market value and the

interest rate increases.● If the lessee sells an asset to the lessor and leases it back with a financing lease, any gain on the sale is deferred and

amortized over the lease term.

Calculate lease liability amortization using a worksheet

● With respect to lease liabilities, worksheets can be used to:

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�❍ Construct a generalized lease liability amortization table for different lease terms. �❍ Calculate the interest rate implicit in the lease, if necessary.

Prepare financial statement disclosure for a lease from the perspective of the lessee (including note disclosure), and assess QOE concerns.

● Financial statement disclosure for the lessee includes segregating assets under financing leases from other assets and disclosing accumulated amortization.

● The lease liability is shown for both short- and long-term portions.● Amortization and interest expense are disclosed.● Notes include amortization policy, terms of the liability, five-year cash flow schedule, and an explanation of the

significance of leases.● On the statement of cash flow:

�❍ Initial recognition of a leased asset is a non-cash transaction.�❍ Payment of the liability is a financing outflow.�❍ Amortization is added back in operations if the indirect method is used.

● Quality of earnings assessment is focused on evaluating the extent of use of operating leases.● IFRS may require capitalization of all leases with a term longer than one year in the future.

Classify leases as operating or financing leases for the lessor; analyze and explain the impact of various categories of leases in lessor financial statements

● A lease is a financing lease for the lessor using similar criteria as for the lessee.● If a financing lease is present for a financing company, finance income is recognized over the lease. ● If a financing lease is present for a manufacturer/dealer, gross profit is recognized at the inception of the lease, and

then finance income is recognized over the lease.● The lessor records the net present value of lease payments receivable from the lessee, and removes the leased asset

from its books.● Cash received reduces the receivable, and interest earned on the net balance is recognized as time passes.● For the lessor, the balance sheet reflects net receivables and the income statement, finance revenue and/or gross

profit; extensive disclosure is required.

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Activity 5.3-1 solution

The present value is:

[$10,000 × (P/AD, 10%, 3)] + [$8,000 × (P/AD, 10%, 2)(P/F, 10%, 3)] + ($500 × P/F, 10%, 5) =

$39,140.41

The present value of an annuity due is used, as the annual payments are made at the beginning of the period. The second annuity must be multiplied by two PV factors: the first calculates present value as of the beginning of Year 4 (end of Year 3), the second takes this present value back to the beginning of the lease (the beginning of Year 1).

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Determination: Criteria 1 — Title passes or BPO no no yes1 noCriteria 2 — economic life 3/10 = 30%

short 5/7=71% medium 6/9 = 67%

medium yes; 8/9 = 89% long

Criteria 3 — PV ≥ FMV $120,000 $55,000 $150,000 $115,000 PV $47,2022 $55,0013 $155,8444 $115,0005

% of FMV 39% 100% 103% 100%Criteria 4- specialized asset No No No Yes Lease classification: Operating Finance Finance Finance

1 This $150,000 asset has a nine-year life and a six-year lease term. Acquiring three years of use for $1,000 is assumed to be a bargain in this case.

2 Lease 1 (12%): ($17,547 × P/AD, 12%, 3) = $47,202

3 Lease 2 (10%): ($13,190 × P/AD, 10%, 5) = $55,001

4 Lease 3 (12%): ($33,734 × P/AD, 12%, 6) + ($1,000 × P/F, 12%, 6) = $155,844

5 Lease 4 (10%): ($19,199 × P/AD, 10%, 8) + ($5,000 × P/F, 10%, 8) = $115,000




Lease number 1 2 3Amortization period 10 years 10 years 7 years




For the lessee, the present value of the MLPs is calculated using the incremental borrowing rate, because the implicit rate is unknown. Even if it were known, the lessee would still use the lower IBR in this calculation:

PV of MLPs = $20,894 × (P/AD, 12%, 8) = $116,249

The maximum value to be recorded as an asset is the FMV, $114,000. The lessee would make the following entry:

Asset under financing lease 114,000 Lease liability 114,000




The correct interest rate is obtained as follows:

$114,000 = $20,894 (P/AD, x%, 8)

Calculating correct interest rates

You can obtain the answer by using the IRR function in Excel. You should get approximately 12.75%.

To use IRR in Excel, set up a worksheet with the cash flows in the following cells:

A1 (93,106) that is, $114,000 – $20,894* A2 20,894 A3 20,894 A4 20,894 A5 20,894 A6 20,894 A7 20,894 A8 20,894

* Since the lease payment date is January 1, the initial cash flows must be lumped together. That is, if two payments are made on the same date, include their net amount in the IRR scheme.

The IRR function works as IRR (values, guess); therefore, enter =IRR(A1:A8,12%) in A9.

You should get 0.12758. The interest rate can also be calculated on a financial calculator.

This interest rate is used to calculate the interest expense in subsequent journal entries. (This exact rate needs to be used in doing the interest calculation, or rounding errors will be introduced.)

If you were to use the look-up tables to solve this problem, you would take the fair value of the asset and divide by the payments to get 5.45611 ($114,000 ÷ $20,894). You would then look for this number in the annuity due table on the eight-year line. It falls between 12% and 14%, and you would interpolate to get a more exact interest rate.




The payment stream would be entered as follows:

A1 (93,106) that is, $114,000 – $20,894 A2 20,894 A3 20,894 A4 20,894 A5 20,894 A6 20,894 A7 20,894 A8 20,894 A9 10,000

Notice that the beginning of year lease payment for year 8 is entered in cell A8, but the end of year payment is not lumped with it: it goes on its own in cell A9. In this case, you should get 0.14000 or 14%.



module05 leases

Documents

lease accounting

lease classification

lease amortization

financing leases

substance of lease agreements

lessee record leases

lease liability amortization

different leases