Leases

Overview
In the previous chapter, we saw how companies account for their long-term debt. The focus of that discussion
was bonds and notes. In this chapter, we continue our discussion of debt, but we now turn our attention to
liabilities arising in connection with leases. Leases that produce such debtor/creditor relationships are referred
to as either direct finance or sales-type leases by the lessor. We also will see that some leases do not produce
debtor/creditor relationships, but instead are accounted for as lease agreements for lessors. These are designated
operating leases.

Lecture Outline
Part A: Identifying a Lease Arrangement, Lease versus Non-lease Components, and Lease
Term
I. Advantages of Leasing
A. Achieves operational objectives by facilitating asset acquisition to overcome:
1. Uncertainty or cash flow problems.
2. Time constraints and/or bureaucratic control systems.
3. Fear of obsolescence.
B. Achieves tax objectives: A lessee often can negotiate lower lease payments if it allows the lessor to
retain ownership and thus benefit from depreciation deductions when:
1. The lessee has little or no taxable income and will get little benefit from depreciation deductions.
2. The lessee has sufficient taxable income to take advantage of the depreciation deductions but is in
lower tax brackets than lessors.
II. Lease Identification
A contract contains a lease if all the following conditions are satisfied.
A. There is an identified asset, and
1. asset is specified and
2. lessor has no substantial substitution rights.
B. Lessee has right to control the use of asset.
1. obtains substantially all economic benefits from use and
2. has right to direct the use of asset.
III. Lease versus Non-lease Components
A. Lease components must be accounted separately from non-lease components unless election is made to
account for all components as a lease.
B. Each lease component must be accounted for separately unless applying IFRS 16 requirements to
aggregated lease components would not result in a materially different effect than applying IFRS 16
requirements to each separate lease.
C. A lease component is separate if
1. lessee can benefit from it on its own or together with other readily available resources and
2. neither highly dependent on nor highly interrelated with other underlying assets in the contract.
D. The contract fee needs to be allocated to each separate lease component and the aggregated non-lease
components based on their relative stand-alone prices.
IV. Lease Term
A. Lease term refers to the noncancelable period together with
1. the period covered by an extension option that the lessee is reasonably certain to exercise and
2. the period covered by a termination option that the lessee is reasonably certain not to exercise.
B. Assessment of reasonably certain is based on the relevant facts and circumstances that create economic
incentives for the lessee to exercise or not exercise the option.
Part B: Lessee Accounting
I. Lessee Accounting
A. All leases must be recognized as a right-of-use (ROU) asset and a lease liability on commencement of a
lease with two exceptions discussed below.
B. On commencement of a lease, the lessee measures the ROU asset at its cost, comprising
1. The initial amount of the lease liability.
2. Prepaid lease payments, if any.
3. Initial direct costs that are costs to obtain a lease, which would not have been incurred if the lease is
not obtained.
4. Estimated costs to dismantle or remove the leased item at the end of the lease or restore the location
at which the leased asset was used to its previous conditions.
5. Less any lease incentives received (e.g., reimbursement received from the lessor for initial direct
costs incurred by the lessee such as agent’s commission).
C. On commencement of a lease, the lessee measures the lease liability as the present value of unpaid
lease payments, comprising
1. Fixed payments including in-substance fixed payments.
2. Variable lease payments based on an index or rate (e.g., consumer price index).
3. Expected payable amount under residual value guarantees.
4. Exercise price of a purchase option that the lessee is reasonably certain to exercise.
5. Penalty payment for termination that is reflected in the lease term.
6. Less any lease incentives that are receivable.
D. Lessee discounts the unpaid lease payments using the implicit rate of the lease, if known. Otherwise,
lessee uses its incremental borrowing rate for the discounting.
II. Subsequent Measurement of a Lease
A. After commencement date, lessee can measure the ROU asset using
1. cost method (less accumulated depreciation and accumulated impairment),
2. revaluation method for ROU assets qualifying as PPE, or
3. fair value method for ROU asset qualifying as investment property.
B. The ROU asset is depreciated over
1. Lease term if ownership of the leased asset does not transfer to the lessee.
2. Shorter of the lease term and the leased asset’s useful life if ownership of the leased asset is
transferred to the lessee at the end of the lease.
C. After commencement date, lessee measures the lease liability at amortized cost using the effective rate
method.
III. Subsequent Remeasurement of a Lease
A. After commencement date, lessee remeasures its lease liability when there are changes in the terms and
conditions either within or outside the original lease agreement, which result in changes to the lessee’s
(remaining) obligations under the lease.
B. For changes in the terms and conditions that are part of the original lease agreement, lease liability is
remeasured as follows:
1. Changes in lease term or purchase option
a. Remeasure lease liability based on revised lease payments discounted by a revised discount rate.
2. Changes in residual value guarantee or variable lease payments dependent on an index or a rate for
the future
a. Remeasure lease liability based on revised lease payments discounted by the original discount
rate.
3. Changes in variable lease payments (i) dependent on an index or a rate for current period or (ii) not
dependent on an index or a rate.
 a. Lease liability is not remeasured, changes in variable lease payments for current period are
recognized in P/L as a gain/loss.
C. For changes in the terms and conditions that are outside the original lease agreement (i.e., lease
modifications), lease liability is remeasured as follows:
1. For decrease in scope of the lease
a. restate lease liability and ROU asset to reflect the partial/full termination of the lease, and
recognize the restatement difference in P/L as a gain/loss and
b. remeasure lease liability based on revised lease payments discounted using a revised discount
rate and adjust ROU asset correspondingly.
2. For increase in scope of the lease with commensurate increase in lease payments
a. Recognize lease modification as a separate lease and no change in the original lease accounting.
3. All other lease modifications
a. Remeasure lease liability based on revised lease payments discounted by a revised discount rate
and adjust ROU asset correspondingly.
IV. Exceptions in Lease Accounting
A. Lessee can opt to account for leases as rental agreement with the lease payments recognized as rental
expenses as and when the payments are incurred for the following exceptions:
1. Short-term leases with lease term of twelve months or less.
2. Leases with underlying assets of low value (US$5,000 or less).

Part C: Lessor Accounting

I. Lease Classification
A. A lessor need to classify a lease transaction as a finance lease if it transfers substantially all the risks
and rewards of ownership of an asset to the lessee. Some examples of situations that may lead to
classification as a finance lease include:
1. Ownership of the asset is transferred to the lessee by the end of the lease term.
2. The agreement contains a bargain purchase option.
3. The noncancelable lease term forms a major part of the economic life of the asset.
4. The present value of the “minimum lease payments” at the start of the lease is equal to or
greater than a substantial proportion of the fair value of the asset.
5. The leased asset is of a specialized nature such that only the lessee is able to use the asset
without major modifications.
B. Otherwise, it is an operating lease.
C. Record a lease as a finance lease if indicators indicate that “substantially all the risks and rewards of
ownership” is transferred to the lessee. The indicators include the following:
1. In a cancelable lease, the lessee bears the losses suffered by the lessor as a result of the
cancellation.
2. The lessee enjoys the gains and absorbs the losses arising from the fluctuations of the fair
value of the residual of the leased asset.
3. The lessee is able to continue the lease for a secondary period at a rent that is substantially
lower than market rent.
II. Operating Leases
A. We assume that the fundamental rights and responsibilities of ownership are retained by the lessor and
that the lessee merely is using the asset temporarily.
B. A “sale” is not recorded by the lessor.
D. Instead, the periodic lease payments are accounted for merely as rent:
1. Rent revenue by the lessor.
C. Advance payments are considered prepayments of rent. They are deferred and allocated to rent over
the lease term.
 1. A refundable security deposit is recorded as a liability (by the lessor) unless it is not expected to
be returned.
2. A prepayment of the last period’s rent is recorded as prepaid rent and allocated to rent revenue
during the last period of the lease term.
III. Nonoperating Leases
A. A finance lease is recorded by the lessor as a sales-type lease or direct finance lease, depending on
whether the lease provides the lessor a dealer’s profit.
B. Interest accrues at the effective rate on the balance outstanding during the period. Lease payments
(except the first) include interest on the outstanding balance as well as a residual portion that reduces
that outstanding balance.
C. An amortization schedule is convenient to keep up with changing amounts.
D. A sales-type lease requires recording sales revenue and cost of goods sold by the lessor at the
inception of the lease. All other entries are the same as in a direct finance lease.
1. The presence or absence of a manufacturer’s or dealer’s profit distinguishes between a sales-type
lease and a direct finance lease.
2. Additional profit exists when the fair value of the asset (usually the present value of the minimum
lease payments or “selling price”) exceeds the cost or carrying value of the asset “sold.”

Part D: Other Lease Issues

I. Bargain Purchase Option
When a BPO is present, both the lessor and the lessee view the option price as an additional lease payment.
A. The lease term effectively ends when the BPO is exercisable.
B. Thus, if a BPO in a six-year lease could be exercised at the end of the fifth year, the effect will be to
change the lease term to five years, from six.
II. Residual Value
For a lessee-guaranteed residual value (GRV), the expected amount payable under the GRV is included as
a component of minimum lease payments for the lessee, but the entire GRV is included as a component of
minimum lease payments for the lessor. An unguaranteed residual value is not (but is part of the lessor’s
gross investment in the lease).
A. If the lessee obtains title, the lessor’s computation of lease payments is unaffected by any residual
value.
B. If the lessor retains title, the amount to be recovered through periodic lease payments is reduced by the
present value of the residual amount.
C. On the other side of the transaction, the lessee considers the “purchase” price of the copier to include:
1. At a minimum, the present value of the periodic lease payments.
2. An amount expected to be payable due to the residual value viewed as an additional “payment” if
the lessee guarantees the residual value to be a particular amount at the end of the lease term.
III. Executory Costs
A. Executory costs are maintenance, insurance, taxes, and any other costs usually associated with
ownership.
1. Sometimes, as an expediency, a lease contract will specify that the lessor is to pay executory
costs, but that the lessee will reimburse the lessor through higher lease payments.
2. Any portion of lease payments that represents executory costs is not considered part of minimum
lease payments.
3. The lessee simply expenses executory costs as incurred.
B. The lessee uses the lower of the interest rate implicit in the lease or the lessee’s own incremental
borrowing rate.
C. Initial direct costs are the costs incurred by the lessor that are associated directly with originating a
lease and are essential to acquire that lease.
1. They include legal fees, commissions, evaluating the prospective lessee’s financial condition, and
preparing and processing lease documents.
 2. The method of accounting for initial direct costs depends on the nature of the lease:
a. For operating leases, initial direct costs are recorded as assets and amortized over the term of
the lease. Since the only revenue an operating lease produces is lease revenue, and that
revenue is recognized over the lease term, initial direct costs also are automatically
recognized over the lease term to match these costs with the rent revenues they help generate.
b. In direct finance leases, interest revenue is earned over the lease term, so initial direct costs
are matched with the interest revenues they help generate. Therefore, initial direct costs are
not expensed at the outset but are deferred and recognized over the lease term. This can be
accomplished by increasing the lessor’s lease receivable by the total of initial direct costs.
Then, as interest revenue is recognized over the lease term at a constant effective rate, the
initial direct costs are recognized at the same rate (that is, proportionally).
c. For sales-type leases, initial direct costs are expensed at the inception of the lease. Since the
usual reason for a sales-type lease is for a manufacturer or a dealer to sell its product, it’s
reasonable to recognize the costs of creating the transaction as a selling expense in the period
of the sale.
D. Lease disclosure requirements include (a) a “general description” of the leasing arrangement as well as
(b) minimum future payments, in the aggregate, and for each of the five succeeding financial years.
E. Statement of Cash Flow Impact
1. The lessor reports cash payments for operating leases in a statement of cash flows as cash flows
from operating activities.
2. Each lease payment in a finance lease includes both an amount that represents interest and an
amount that represents a reduction of principal. In a statement of cash flows, then, the lessee
reports the interest portion as cash flows from operating activities and the principal portion as cash
flows from financing activities. The lessor in a direct finance lease reports the interest portion as
cash flows from operating activities and the principal portion as cash flows from investing
activities. Both the lessee and the lessor report the lease at its inception as a noncash
investing/financing activity.
3. Consistent with reporting sales of products under installment sales agreements rather than lease
agreements, the lessor reports cash receipts from a sales-type lease as cash flows from operating
activities.

Part E: Special Leasing Arrangements

A. In a sale–leaseback transaction, the owner of an asset sells it and immediately leases it back
from the new owner.
1. If the sale in a sale–leaseback meets the transfer requirements of IFRS 15, it is accounted as a sale
transaction follows by a lease transaction. Otherwise, the sale–leaseback is accounted for as a
financing arrangement.
2. The gain or loss from the sale transaction is computed as [(Fair value − Carrying amount) × (Fair
value − Lease liability)/Lease liability].
3. If the selling price is set at above the asset’s fair value, the excess (i.e., Selling price − Fair value)
is accounted for as an additional loan from the buyer–lessor to the seller–lessee. Conversely, if the
selling price is set below the asset’s fair value, the difference (i.e., Fair value − Selling price) is
accounted for as an upfront prepayment of the lease liability. Effectively, if the selling price
differs from the fair value, the asset is still deemed to be sold at its fair value.
4. For the leaseback, the seller–lessee measures the ROU asset as [Carrying amount of the disposed
asset × (Lease liability/Fair value)].
B. Real estate leases involve land—exclusively, or in part.
1. Only the first (title transfers) and second (BPO) classification criteria apply in a land lease.
2. When (a) the leased property includes both land and a building, (b) neither of the first two criteria
is met, and (c) the fair value of the land is 25 percent or more of the combined fair value, the
lessor treats the land as an operating lease and the building as any other lease.
 3. Usual lease accounting procedures apply to leases that involve only part of a building although
extra effort may be needed to arrive at reasonable estimates of cost and fair value.

U.S. Generally Accepted Accounting Principles

A. It was the original intention of the IASB and FASB to have a common accounting standard for leases
as in the case of the revenue standard. While both the IASB and FASB required lessees to capitalize
leases, the FASB allows for a dual model in terms of profit or loss charges depending on the type of
leases (equipment vs. property), the IASB provides for a single model in which the profit or loss
charges are front loaded.