Accounting For Leases: Learning Objectives

Session 9&10: Leases
Accounting for
Leases
Sessions 9 & 10
AC2091: Financial Reporting
Learning Objectives
• Describe both operating leases and finance leases
• Demonstrate accounting for both operating and
finance leases, and explain possible implications for
accounts’ users
• Discuss off-balance sheet financing in relation to
operating leases
1
Leases (IAS 17)

• Definition
o An agreement whereby the lessor conveys to the lessee in
return for a payment or series of payments the right to use
an asset for an agreed period of time
o Contract between the lessor (the of the
asset) and a lessee (the of the leased
asset) for the hire of a specific asset
o Lessor retains ownership of the asset but conveys the use
of the asset to the lessee for an agreed period of time in
return for the payment of rental
Leases (IAS 17)

• Advantages of leasing
o Better by redirecting cash to
the business operations rather than purchasing assets
o Optimise credit lines as loans are not taken to finance
purchase of assets
o Flexibility of business expansion as leases are
structured to match companies’ cashflow needs
o Provides where
company has the use of an asset without recognition of
the asset or liability in its statement of financial position
2
Types of Leases
Types of Leases
Operating Lease Finance Lease
Transfers substantially all the

Lease other than a
risks and rewards incidental to
finance lease
ownership of an asset
Title may or may not

eventually be transferred
5
Operating Lease
• Operating lease –accounting for lessee
o A lease other than a finance lease
o Lessee pays periodic amounts to lessor
o Amount is charged to profit or loss as expense
o Incentives may be received by lessee
 Discounts (e.g. rent-free period, cashback) are spread
over lease period in accordance with accrual principle
 Total amount (less cashback) is charged evenly across
lease period
Accounting treatment:
Dr profit/loss
Cr
6
3
Operating Lease
– Accounting Treatment
• Operating lease – disclosure requirements (lessee)
– Amounts of minimum lease payments at balance sheet
date under non-cancellable operating leases for:
a) not later than one year;
b) later than one year and not later than five years;
c) later than five years
– Total future minimum sublease income under non-
cancellable subleases
– Lease and sublease payments recognised in income for
the period
Operating Lease
• Operating lease – disclosure requirements (lessee)
– Contingent rent recognised as an expense
– General description of significant leasing arrangements,
including contingent rent provisions, renewal or purchase
options, and restrictions imposed on dividends,
borrowings, or further leasing
4
Operating Lease
• Operating lease - accounting for lessor
– Assets under operating leases should be presented in the
balance sheet of the lessor
– Lease income recognised over lease term on straight-line
basis
o Unless another basis better represents time pattern
in which benefit is derived from leased asset
Operating Lease
• Operating lease - accounting for lessor
– Incentives for renewed or new operating leases should be
recognised by the lessor as a reduction of the rental
income over the lease term
o Irrespective of the incentive's nature or form, or the
timing of payments
10
10
5
Operating Lease
• Operating lease – disclosure requirements (lessor)
– Amounts of minimum lease payments at balance sheet
date under non-cancellable operating leases for:
o not later than one year;
o later than one year and not later than five years;
o later than five years
– Contingent rent recognised as in income
– General description of significant leasing arrangements
11
11
Finance Lease
• Definition
o A lease that transfers substantially all the
o Classification is made at the inception of the lease

 When a lease includes both land and buildings
elements, classification of each element assessed
as a finance or an operating lease separately
o Akin to hire purchase transaction with the lessee
effectively owning the asset
o Lease has to meet criteria stated in IAS 17 (para. 10) in
order to be classified as a finance lease
12
12
6
Transfer of ownership at end of lease term?

Yes
No
Finance
Bargain purchase option?
No
Yes
Lease:
Lease term form major part of economic life?
No
Yes Criteria
Present value of Minimum Lease Payments
substantially equal to fair value? Yes
No
Asset is of specialized nature Yes

No
Operating Finance
Lease Lease
13
13
Finance Lease: Criteria

• Additional indicators (IAS 17 para. 11)
o Lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the
lessee;
o Gains or losses from the fluctuation in residual fair value
accrue to the lessee (e.g. rent rebate equalling most of
the sales proceeds at the end of the lease);
o Lessee has the ability to continue the lease for a
secondary period at a rent that is substantially lower
than market rent
14
14
7

Yes
No
Finance
No
Yes
Lease:
No
Yes Criteria
No

No
Operating Finance
Lease Lease
15
15

• Lease term
– Non-cancellable period for which the lessee has
contracted to lease the asset together with any further
terms for which the lessee has the option to continue to
lease the asset, with or without further payment, when at
the inception of the lease it is reasonably certain that the
lessee will exercise the option
16
16
8

• Economic life is either:
– Period over which an asset is expected to be
economically usable by one or more users; or
– Number of production or similar units expected to be
obtained from the asset by one or more users
17
17

– Lease term to be major part of economic life
o Not specifically stated in IAS 17
o FASB quantifies “a major part” as “equal or
exceeds ” (FAS 13)
18
18
9

Yes
No
Finance
No
Yes
Lease:
No
Yes Criteria
No

No
Operating Finance
Lease Lease
19
19

– Minimum lease payments
o Payments over the lease term that the lessee is, or can
be, required to make (excluding contingent rent, costs
for services and taxes to be paid by and reimbursed to
the lessor) together with:
 For lessee: any amounts guaranteed by the
lessee or by a party related to the lessee; or
 For lessor: any residual value guaranteed to the
lessor by
a) the lessee;
b) a party related to the lessee; or
c) a third party unrelated to the lessor that is financially
capable of discharging the obligations under the
guarantee
20
20
10

– Minimum lease payments
o If lessee has option to purchase the asset at a
price sufficiently lower than the fair value at the
exercise date of the option, it is reasonably certain
that option will be exercised
o Minimum lease payments comprises of:

 Minimum rental payable over the lease term
 Exercise price of purchase option
 Guaranteed residual value
21
21

– Discount rate to be used in calculating the present
value of the minimum lease payments is either:
i) Interest rate implicit in the lease, if this is practicable; or
ii) Lessee’s incremental borrowing rate shall be used.
 Interest rate implicit in the lease

o discount rate that, at the inception of the lease, causes
the aggregate present value of (a) the minimum lease
payments and (b) the unguaranteed residual value to
be equal to the sum of (i) the fair value of the leased
asset and (ii) any initial direct costs of the lessor
22
22
11

Aggregate
Unguaranteed
present value Initial direct
residual value Fair value of
of minimum cost of the
(assumed to leased asset
lease lessor
be nil)
payments
– Fair value
o the amount for which an asset could be exchanged, or
a liability settled, between knowledgeable, willing
parties in an arm’s length transaction
– Initial direct cost
o Incremental costs that are directly attributable to
negotiating and arranging a lease
23
23

 Lessee’s incremental borrowing rate of interest
a) rate of interest the lessee would have to pay on a
similar lease , if determinable; or
b) rate that, at the inception of the lease, the lessee
would incur to borrow over a similar term, and with
a similar security, the funds necessary to purchase
the asset
24
24
12

– Present value of Minimum Lease Payments
substantially equal to fair value
o Not specified in IAS 17
o FAS 13 quantifies “substantially all” as “equal or

exceeds the fair market value of leased
property” [FASB]

substantially equal to fair value?
25
25
Finance Lease
• Applies the principle of substance over form
• Substance over form
o Transactions and other events should be
accounted for and presented in accordance with
their and not
merely their legal form [Conceptual Framework]
o Accounting based on purely legal form may not
provide faithful representation
o Example: finance lease as asset acquisition vs.
operating lease as off-balance sheet financing
26
26
13
Finance Lease
• Finance lease – accounting for lessee
o Recognise asset in his books as the substance of the
transaction is that a non-current asset was acquired
• Lease is to be classified and amounts to be recognised
under finance lease determined on inception date
o Inception date: earlier of the date of the lease agreement
and the date of commitment by the parties to the principal
provisions of the lease
• Both asset and liability to be recorded at the
commencement of the lease
o Commencement date: date on which a lessor makes an
underlying asset available for use by a lessee.
• Non-current asset is subject to deprecation as
per IAS 16
27
27
Finance Lease
– Finance lease - accounting for lessee
o Recorded as an asset and a liability
Commencement of lease term:
Dr
Cr
o Amount recorded at commencement of lease

Recognition of Asset/Liability
lower of
Fair value of asset Present value of

Minimum Lease Payments
28
28
14
Finance Lease
o Lease payments apportioned between the finance
charge and the reduction of the outstanding liability
o Apportion lease payments into two elements:
 Interest charge on the finance provided by
lessor which increases the interest expense in
profit or loss
 Repayment of part of capital cost of asset so
as to reduce the liability in lessee’s books
Upon payment of each lease payment:
Dr
29
Cr
29
Finance Lease
Methods of Finance Charge Allocation
Method Description
Actuarial method  Constant periodic rate of charge to the
balance of the leasing obligation
 Rate of return calculated by applying
present value tables to annual payment
Sum of digits  Rule of 78
method  Finance charge is apportioned to
accounting period based on reducing scale
Straight line method  Finance charge spread evenly over the
lease period
30
30
15
Finance Lease
o Assets should be depreciated under the policy
consistent with that for owned assets (IAS 16)
Depreciable period
Lower of
Lease term Useful life
Note: Depreciate over useful life if reasonable certainty of eventual

ownership, i.e. following clauses are present in lease agreement:
 Transfer of ownership to lessee at end of lease term
 Bargain purchase option
31
31
Finance Lease
– Finance lease – disclosure requirements (lessee)
o net carrying amount at financial year end for each
major class of asset,
o reconciliation between the total of the minimum
lease payments at the balance sheet date, and
their present value
o the total of minimum lease payments at financial
year end, and their present value, for each of the
following periods:
32
32
16
Finance Lease
– Finance lease - accounting for lessor
o Recorded as a receivable at inception of lease
o Lease income recognised based on pattern
reflecting constant rate of return on net investment
outstanding
Net Gross Unearned

Investment Investment Finance
Outstanding in Lease Income
33
33
Finance Lease
– Finance lease - accounting for lessor
o Gross Investment in Lease
 Minimum lease payments from lessor’s
standpoint + any unguaranteed residual value
accruing to lessor
o Unearned Finance Income
 Difference between:
a) Minimum lease payments from lessor’s standpoint + any
unguaranteed residual value accruing to lessor
b) Present value of (a) at interest rate implicit in the lease
34
34
17
Finance Lease
– Finance lease – disclosure requirements (lessor)
o reconciliation between gross investment in the lease and the
present value of minimum lease payments
o gross investment and present value of minimum lease
payments receivable for:
o unearned finance income
o unguaranteed residual values
o accumulated allowance for uncollectible lease payments
receivable
o contingent rent recognised in income
o general description of significant leasing arrangements
35
35
Off-Balance Sheet Financing

• Funding of a company’s operations whereby
some or all of the finance may
under legal
requirements and accounting conventions
o Involves removal of assets and/or liabilities
o Possible impact on profit or loss
o May lead to users of financial statements not
having a clear or proper view of state of company’s
affairs
 Insufficient disclosure prescribed by national
company laws and accounting standards
36
36
18

Reasons for companies to undertake
off-balance sheet financing
 Keep gearing level low to avoid public perception of over-
reliance on debt and subsequent need to raise funds through
issue of shares
 Keep gearing down so as to comply with loan covenants
imposed by lenders
 Keep interest costs low and reduce financial risk of company
 Exclude subsidiaries from consolidation due to differences in

business nature and characteristics
37
37

Operating
Lease
Common
Forms of Off-
Consignment Balance Sale &
Inventory Sheet Leaseback
Finance
Debt
Factoring
38
38
19

• Consignment inventory
– Arrangement whereby inventory is held by one
party (e.g. dealer) but is owned by another party
(e.g. manufacturer)
– Similar to goods sold on “sale or return” basis
– Need to determine time when benefits are
acquired rather than transfer of legal title
o Can manufacturer require dealer to return
inventory without compensation?
o Does manufacturer bear the risk of
obsolescence and slow-moving goods?
39
39

• Factoring of receivables/debt
– Arrangement whereby original creditor sells the
debts to a factor
– Factor may offer credit facility for seller to draw
upon a proportion of amount owed
– Need to determine if benefits of debt passed to
factor, or is factor is effectively providing a loan on
the security of the receivables balance
o Is seller required to pay interest?
o Does seller bear risk of non-payment by
debtors?
40
40
20

• Sale and leaseback transactions
– Involves sale of an asset and the leasing back of
the same asset concurrently
– Lease payment and sale price usually negotiated
as a package
– Accounting treatment depends on type of lease
involved in the agreement
41
41
Sale and Leaseback

Type of Lease Accounting Treatment
Finance lease  In substance a loan from lessor to lessee
 Leased asset treated as a security
 Excess of proceeds over carrying amount is deferred
and amortised over lease term
Operating Lease a) Selling Price = Fair Value
 Normal sale transaction
 Profit or loss recognised immediately
 Lease installments treated as lease payments and
not return on capital and interest charges
b) Selling Price < Fair Value
 Profit or loss recognised immediately
 If future rentals at below market price, loss to be
amortised over period of use
42
42
21
Sale and Leaseback

Type of Lease Accounting Treatment
Operating Lease c) Selling Price > Fair Value
 Excess over fair value to be deferred and
amortised over period of asset use
 Fair Value < Carrying Amount
 Loss amounting to the difference is
recognised immediately
43
43
Introduction to IFRS 16: Leases

[effective 1 January 2019]
• A lease is defined as a contract that conveys to the
customer (‘lessee’) the right to use an asset for a
period of time in exchange for consideration
– Contract contains a lease if the customer has the right to
control the use of an identified asset for a period of time
– Although leases and services are often combined in a
single contract, amounts related to services are not
required to be reported on the balance sheet
[Source: IFRS 16 Leases: Project Summary & Feedback Statement]
44
44
22
IFRS 16: Lessee Accounting

• A lease exists when the customer controls the use
of the underlying asset throughout the period of use,
meaning that the customer
– obtains substantially all of the economic benefits from the
use of the identified asset throughout the period of use;
and
– directs the use of the asset through the period of use,
which means the customer has the ability to change how,
and for what purpose, the asset is used during the
contractual terms
45
45

• Classification of leases into operating and finance
leases has been eliminated
– All leases are treated in a similar way to finance leases
applying IAS 17 [i.e. purchase asset on financed basis]
– Recognise asset at present value of the lease payments
and showing them either as lease assets (right-of-use
assets) or together with property, plant and equipment
– If lease payments are made over time, recognise financial
liability representing its obligation to make future lease
payments
46
46
23

• Recognition of right-of-use asset
Inflow of
Description of right Control Past event economic Asset?
benefits
Legally enforceable Delivery following

Right to use asset
right established by signing of the Yes Yes
during the lease term
the lease contract lease contract
• Recognition of lease liability

Outflow of
Description of
Present obligation Past event economic Liability?
obligation
benefits
Obligation to pay Legally enforceable Delivery following Yes (cash Yes
rentals obligation signing of the payments)
established by the lease contract
lease contract
47
47

• Lessee shall recognise a right-of-use asset and a
lease liability at the commencement date
– Right-of use asset: right to use underlying asset
– Lease liability: obligation to pay agreed amounts over the
lease term for the right to use the asset
– Commencement date: date on which a lessor makes an
underlying asset available for use by a lessee
48
24

• Right-of-use asset is measured at cost
– Cost comprises the following amounts:
o the initial lease liability
o any lease payments made at or before the
commencement date less any lease incentives
received
o any initial direct costs incurred by the lessee
o an estimate of costs to be incurred by the lessee in
dismantling and removing the underlying asset
49

• Initial lease liability is the present value of unpaid
lease payments discounted by the implicit rate
– Lease payments comprise the following:
o Fixed payments less any lease incentives
o Variable lease payments based on an index or rate
o Expected payable amount under residual value
guarantee
o Exercise price of purchase option that lessee is
reasonably certain to exercise
o Penalty payment for termination that is reflected in
the lease term
50
25

• Exemptions
– IFRS 16 does not require a company to recognise assets
and liabilities for (a) short-term leases (i.e. leases of 12
months or less) and (b) leases of low-value assets (e.g.
value of USD5,000 or less)
– Assets can only be low value if
o the lessee can benefit from the use of the asset
either on its own, or in conjunction with other
assets/resources at the disposal of the lessee
o the use of the leased asset is not highly dependent
on, or interrelated with, other assets
51

• Criticisms of IAS 17
– Many leases and corresponding debt obligations not
presented in financial statements
o Off-balance sheet financing (e.g. sale & leaseback)
– Accounting model failed to meet the needs of users of
financial statements
o Relevant information in a manner that faithfully
represents those transactions
– Requirements for recognition of leases were too
complicated
o Recognition criteria for finance leases
52
52
26

• Impact for operating leases under IAS 17
– Straight-line lease expense replaced with a depreciation
charge for lease assets (included within operating costs)
and an interest expense on lease liabilities (included
within finance costs)
o Depreciation charge evenly spread over period
o Interest expense reduces over lease term
 Total lease expense reduces as lease matures
53
53

• Cash flow impact
– No impact on actual cashflows between lessee and lessor
– Changes in presentation of cash ﬂows related to former
off balance sheet leases
o Reduce operating cash outﬂows
 No lease expense, replaced with depreciation
o Increase financing cash outflows
 Principal repayments on lease liabilities
 Classification of interest paid under financing activities
54
54
27
IFRS 16: Lessor Accounting

• Lessor continues to classify its leases as operating
leases or finance leases as per IAS 17, and to
account for those two types of leases differently
55
55
Q&A
Thank You
56
56
28

Accounting For Leases: Learning Objectives

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Session 9&10: Leases

Leases (IAS 17)

Leases (IAS 17)

Operating Lease Finance Lease

Transfers substantially all the

Title may or may not

o Classification is made at the inception of the lease

Transfer of ownership at end of lease term?

Asset is of specialized nature Yes

Finance Lease: Criteria

Transfer of ownership at end of lease term?

Asset is of specialized nature Yes

Finance Lease: Criteria

Finance Lease: Criteria

Finance Lease: Criteria

Lease term form major part of economic life?

Transfer of ownership at end of lease term?

Asset is of specialized nature Yes

Finance Lease: Criteria

Finance Lease: Criteria

o Minimum lease payments comprises of:

Finance Lease: Criteria

ii) Lessee’s incremental borrowing rate shall be used.

 Interest rate implicit in the lease

Finance Lease: Criteria

Finance Lease: Criteria

Finance Lease: Criteria

o FAS 13 quantifies “substantially all” as “equal or

Present value of Minimum Lease Payments

o Amount recorded at commencement of lease

Fair value of asset Present value of

Lease term Useful life

Note: Depreciate over useful life if reasonable certainty of eventual

Net Gross Unearned

Off-Balance Sheet Financing

Off-Balance Sheet Financing

 Keep interest costs low and reduce financial risk of company

 Exclude subsidiaries from consolidation due to differences in

Off-Balance Sheet Financing

Off-Balance Sheet Financing

Off-Balance Sheet Financing

Off-Balance Sheet Financing

Sale and Leaseback

Sale and Leaseback

Introduction to IFRS 16: Leases

[Source: IFRS 16 Leases: Project Summary & Feedback Statement]

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

Legally enforceable Delivery following

• Recognition of lease liability

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

[Source: IFRS 16 Leases: Project Summary & Feedback Statement]

IFRS 16: Lessee Accounting

IFRS 16: Lessee Accounting

[Source: IFRS 16 Leases: Project Summary & Feedback Statement]

IFRS 16: Lessee Accounting

[Source: IFRS 16 Leases: Project Summary & Feedback Statement]

IFRS 16: Lessor Accounting

[Source: IFRS 16 Leases: Project Summary & Feedback Statement]