Chapter 3.4

Lease liability

At lease commencement date, this is measured at the present value of the lease payments to be made over the lease term. 1. Lease payments are discounted using discount rate for the lease. a. It is the rate implicit in the lease, if known to lessee b. If not known, it is the lessee's incremental borrowing rate 2. Lease payments used to calculate lease liability depend on specifics of each lease contract. a. If lease includes purchase option that lessee is certain to exercise, lease payments consist of rental payments and exercise price of purchase option b. If no purchase option exists, lease payments consist of rental payments, any penalties for terminating the lease, and amounts probable of being owed by the lessee under residual value guarantees. 3. In the balance sheet, total lease liability is allocated between current and noncurrent portions. Current portion is the reduction of lease liability in forthcoming year.

Lease classification test

At lease commencement, at least one of the following five criteria are met: 1. Lease transfers ownership of the leased asset to the lessee by the end of the lease term 2. Lease includes an option to purchase the leased asset that the lessee is reasonably certain to exercise 3. Lease term is for the major part of the remaining economic life of the leased asset a. Lease term of 75% or more of the remaining economic life of the leased asset generally is considered to be a major part of its remaining economic life b. This criterion is inapplicable if the beginning of the lease term is at or near the end of the economic life of the leased asset 1. This period generally is considered to be the last 25% of the leased asset's total economic life. 4. Present value of the sum of (a) the lease payments and (b) any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the leased asset a. Present value of 90% or more of the fair value of the leased asset generally is considered to be substantially all of it's fair value 5. Leased asset is so specialized that it is expected to have no alternative use to the lessor at the end of lease term.

Classification of leases by lessor - IFRS

Classified as either a finance lease (similar to sales type lease under GAAP) or an operating lease. Does not distinguish between sales type and direct financing leases. Selling profit that is deferred at lease commencement in direct financing lease under GAAP will be recognized when lease is classified as a finance lease.

Reporting of leases - IFRS

Lessee accounts for all leases, except for short term and low value leases, similarly to a finance lease under GAAP. Operating lease is not an option. Lessee may elect to account for low value lease (assets with value of $5,000 or less) the same way as short term lease. Lease payments are recognized as an expense on a straight line basis over the lease term.

Lease

Long term contract in which the owner of property (lessor) allows another party (lessee) to use the property for a stated period in exchange for a stated payment

Lease accounting for operating leases - subsequent measurement

a. Finance vs. operating leases 1. Differences in accounting a. Subsequent accounting for amortization of right-of-use asset b. Income statement presentation of interest expense and amortization of right-of-use asset c. Statement of cash flow classification of cash lease payments b. Single (lease) expense for operating lease is recognized in each period. Total undiscounted lease payments are allocated over lease term on straight line basis. 1. Initial direct costs incurred by lessee are included in total undiscounted lease payments. 2. Single periodic lease expense has two components, (1) interest expense on lease liability and (2) amortization of right-of-use asset 3. Single amount for total lease expense for the period is reported in income from continuing operations. Interest expense for the lease liability and amortization expense for right-of-use asset are not reported separately. c. Finance lease and operating lease liabilities must not be presented together in the same line item of balance sheet. Disclosed in the notes or presented in balance sheet separately from each other and separately from other liabilities. d. Repayment of lease liability and interest expense on lease liability for operating leases are cash outflows from operating activities. 1. Payments for short term leases are cash outflows from operating activities.

Lessee accounting for finance leases - subsequent measurement

a. Interest expense and lease liability amortization Each periodic lease payment made by lessee has two components 1. Interest expense 2. Reduction of lease liability If first periodic lease payment is made at commencement date of the lease, it's only component is the reduction of lease liability. No interest expense is recognized for first payment because no time elapsed between lease commencement date and payment. Interest expense is calculated using effective interest method (also known as effective-rate method or interest method). It is calculated as carrying amount of lease liability at beginning of period times discount rate of the lease. Reduction of lease liability is the excess of the periodic lease payment over the interest expense recognized during the period. b. Amortization of the right-of-use asset Lessee amortizes right-of-use asset on straight line basis. It is amortized over the shorter of (a) it's useful life or (b) the lease term. However, if at end of lease term, (1) ownership of leased asset is transferred to lessee, or (2) lessee is reasonably certain to exercise purchase option, amortization period is useful life of leased asset.

Lessor accounting for operating and direct financing leases

a. Lease payments from operating leases are recognized as lease (rental) income by lessor over full lease term on straight line basis even if rental payments vary 1. Journal entry for lessor to record for operating lease payments: Debit: Cash or lease receivable Credit: Rental (lease) income 2. Leased asset continues to be reported on lessor's balance sheet. No net investment recognized. a. Lessor depreciates leased asset according to it's normal depreciation policy for owned assets 3. Initial direct costs, such as realtor fees, are initially deferred by lessor b. At lease commencement date for direct financing leases, lessor derecognizes carrying amount of leased asset and recognizes net investment in lease 1. Selling loss but not a selling profit is recognized. Any selling profit is deferred and reduces initial amount of net investment in the lease. 2. If lease does not result in a selling loss and no initial direct costs are incurred, net investment in lease equals the carrying amount of leased asset Debit: Net investment in lease Credit: Leased asset 3. Subsequent to lease commencement date, each periodic cash payment received includes (a) interest income and (b) reduction of net investment in lease a. Interest income equals beginning balance of net investment in lease times a new discount rate that is used only for subsequent accounting 1. New discount rate is derived on lease commencement date from following equation: Net investment in lease recognized = PV of cash and other assets the lessor expects to receive over lease term

Lessor accounting for sales-type leases

a. Lease receivable is (1) present value of lease payments plus (2) present value of residual value guaranteed by lessee or any other third party 1. Present value is calculated using discount rate implicit in the lease 2. Lease receivable is revenue recognized at lease commencement date b. Unguaranteed residual value is the amount that lessor expects to derive from leased asset at the end of lease term that is not guaranteed by any other party c. Net investment in lease is the total of cash and other assets that lessor expects to receive over lease term 1. It consists of (a) lease receivable plus (b) present value of unguaranteed residual value 2. Because present value is calculated using implicit rate in the lease, net investment in lease is fair value of leased asset d. Selling profit or loss is determined on lease commencement date. Assuming no initial direct costs, selling profit or loss (gross profit) is calculated as follows: Fair value of leased asset (PV of lease payments + PV of guaranteed residual value + PV of unguaranteed residual value) - Carrying amount of leased asset 1. Lease can be classified as sales type lease even if it does not result in recognition of selling profit or loss e. For initial measurement on lease commencement date, lessor must derecognize leased asset and recognize (1) net investment in lease and (2) selling profit or loss 1. Selling profit or loss can also be calculated as: Revenue (lease receivable) - COGS (carrying amount of leased asset minus present value of unguaranteed residual value) 2. Journal entry recorded at lease commencement date: Debit: Net investment in lease Debit: COGS Credit: Revenue Credit: Leased asset a. Leased asset (property held for lease) is derecognized (credit) at its carrying amount at lease commencement date f. For subsequent measurement, a periodic lease payment consists of interest income and the reduction of net investment in lease 1. Interest income is calculated using effective interest method as carrying amount of net investment in the lease at beginning of period times discount rate implicit in the lease a. Reduction of net investment in lease equals the difference between lease payments received minus interest income recognized g. Net investments in lease assets from sales type and direct financing leases are aggregated and presented together in balance sheet. Although presented together, they are presented separately from other assets and they should be allocated between current and noncurrent portions. h. Cash receipts from all leases (sales type, direct financing, and operating) are cash inflows from operating activities

Short term lease

At commencement date, has a lease term of 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise. As an accounting policy, a lessee may elect not to recognize the right-of-use asset and lease liability. Under this lease exception, the lessee recognizes lease payments as rent expense on the straight-line basis over the full lease term. Form of off-balance sheet financing. The lessee has the right to use the leased asset, but neither the asset nor a liability for future lease payments is recorded in the financial statements.

Reasons to account for lease as short term lease instead of finance lease

Avoid recognition in the financial statements of 1. Liability for future lease payments 2. Interest expense 3. Depreciation of the leased asset

Journal entry for short term lease payments

Debit: Rent expense Credit: Cash or Rent Payable

Journal entry to record right-of-use asset

Debit: Right-of-use asset Credit: Lease liabilty

Finance lease by the lessee/sales type lease by the lessor - GAAP

When at least one of the five classification criteria are met

Operating lease by the lessee/operating lease (direct financing lease) by the lessor - GAAP

When none of the five classification criteria are met

Right-of-use asset

At lease commencement date, this is measured at the amount at which the lease liability was recognized plus initial direct costs incurred by the lessee. If no initial direct costs were incurred by lessee, this equals the lease liability recognized. Subsequent to initial recognition, this is reported in the balance sheet at cost minus accumulated amortization and any impairment losses.

Initial measurement for lessee accounting

For finance and operating leases, lessee must recognize a lease liability and right-of-use asset at the lease commencement date.

Reporting of a direct financing lease by lessor

Only when: 1. Present value of the sum of (a) the lease payments and (b) any residual value guaranteed by the lessee or any other third party equals or exceeds substantially all of the fair value of the leased asset, and 2. It is probable that the lease payments and any residual value guarantee will be collected