Accounting for Leases Flashcards
Operating Leases
A lease where the rights and risks of ownership don’t transfer, considered a “true rental”
- Lessor
- depreciates the asset
- direct lease costs (commissions, legal fees) are amortized S/L over lease term
- executory costs (taxes, insurance and maintenance) are recognized as incurred
- lease bonus is deferred (deferred revenue) and amortized over the life of the lease
- rent received in advance is considered unearned (deferred revenue)
- security deposits
- nonrefundable - unearned revenue until earned
- refundable - liablity until returned
- uneven rental payments are recognized uniformly over the lease term(free rent for example)
- termination costs should be measured and recognized at FV at the date the agreement is terminated.
- Lessee
- lease rent expense is recognized uniformly (free rent)
- lease bonus is considered an asset and amoritzied s/l over the lease term
- leashold improvments are reproted with PP&E and amortized over the shorter of lease term or useful life
- refundable security deposits are assets (receivable)
- early termination costs must be recognized immediately at FV by lessee
Disclosure
- General description of the leasing arrangements
- minimum lease payments for each of the next 5 years and the aggregate
Capital Leases
A lease where the rights and risks of ownership have transferred from the lessor to the lessee. In substance its a purchase, although in form it’s a lease. The lessee therefore recognizes both an asset and a liablity at the PV of minimum lease payments (MLP) not to exceed FMV, while the lessor will account for such a lease as either an operating, sales-type or a direct financing lease.
Capital Lease Criteria
If the lease meets ONE of the following four criteria, the lessee accounts for the lease as a captial lease, as if he owns it. if not, it is considred an operating lease.
- The lease transfers OWNERSHIP of the property to the lessee by the end of the lease term. (Transfers Title - TT)
- The WRITTEN lease contains a bargain purchase option (BPO)
- the noncancellable lease term is > 75% of the estimated economic life of the property at inception
- the PV of the minimum lease payments is > 90% FMV of the property at inception
If the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property, criterion #3 & #4 shall not be used for purposes of classifying the lease.
Noncancellable Lease Term
The noncancellable lease term is the minmum priod of time during which the lease is expected to be in force. It includes:
- Intital lease term - this is the original term of the lease that does not include any renewal periods
- Bargain renewal periods - these are periods for which the lessee has the option to renew the lease at a rate that is expected, as of the date of the inception of the lease, to be lower than the market rate making it likely that hte lease will be renewed.
- Penalty for nonrenewal - when a lease contains a provision that requires the lessee to pay a signifcant penalty to the lessor for not renewing the lease, it is assumed that the lease will be renewed to avoid the penalty and the renewal period is included in the noncancellable lease term.
- Leases containing a BPO - when a lease contains a BPO, it is assumed that the lessee will exercise it. As a result, it is assumed that the noncancellable lease term will include the intial lease term and any renewal periods up to the point that the BOP can be exercised. Since it is assumed that the lessee will exercise a BPO, the noncancellable lase term would not exend beyond the point at which it could be exercised.
Minimum Lease Payments (MLP)
Minimum lease payments represent the minimum amount that the lesee will pay, or that the lessor will receive, under the terms of the lease during the noncancellable lease term.
The lessee records the lease at the lower of:
- FMV (a new implicit interest rate must be calculated)
- PV of the MLP
- Periodic payments (annual payment)
- BPO as a lump sum
- guaranteed residual value as a lump sum
- penalty for failure to renew (if any)
- dont’ include exectory costs since they are expensed as incurred
The minimum lease payments include:
- Base Rent - this is the amount of rent the lessee is required to pay to the lessor over the noncancellable term of the lease. It may be in the form of a periodic payment for the entire duration of the lease, or may be in an amount that increases over time.
- BPO - as indicated, when a lease contains a BPO, it is assumed that the lessee will exercise it. As a result, the amoutn of the BPO will be included in the MLP. For purposes of calculated PV, it will be treated as a lump sum paid at the end of the noncancellable lease term.
- Penalties - when a lease contains penalties for non-renewal that are not so severe as to make it likely that the lessee will renew the lease to avoid the penalty, it is assumed tht the lease will not be renewed and the penalty will be paid, making it part of them MLP.
- Residual Value - when a lease does not contain a BPO and when title does not transfer to the lessee at the end of the lease term, the property subject to the lease will be returned to the lessor at the termination of the lease. In some cases, the lessee guarantees that the property will be worth at least a certain amount, referred to as a residual value guarantee. In other cases, the residual value is guaranteed by a 3rd party, separate from the lessee such as the asset’s manufacturer. When neither of the lessee nor a 3rd party provide such a guarantee, the lessor has an unguaranteed residual value.
MLP EXCLUDE the following:
- Contingent Rents - these are rents that are subject to the occurence of some event in the future
- Executory Costs - costs for taxes, insurance, and maintenance.
Lease Payments
If the first payment is made on day 1, it is all principal, if the payment is made at year end the amount of principal and interest needs to be calculated. The effective interest method is used in amortizing the lease payments.
Day One - Record asset and pmt made on day 1
Leased Asset 428,415
Lease Liability 428,415
Lease Liability 75,000
Cash 75,000
Second pmt - 1 year later & record depreciation
Lease Liablity 36,124
Interest Expense 38,876
Cash 75,000
Depeciation Exp 42,841
Acc Depreciation 42,841
Non-Operating Leases - Lessor
If the lease meets one of the four critersa, and BOTH of the following criteria, the lease is accounted for by the lessor as either a sales-type or direct-financing lease. If both criteria are not met, the lease is an operating lease by the lessor but still a capital lease by the lessee. The two criteria are:
- Collectablity of the lease payments are reasonably assured
- there are no signficant uncertanities regarding unreimbursable costs to be incurred by the lessor (Measurability)
Sales Type Lease
A lease where the seller is usally a manufacturer or dealerof the asset, and used the lease as a way of selling the asset on an installment basis. The FV of the leased property differs from the cost, which creates a dealer’s profit or loss. Includes both:
- Profit/Loss in the period of sale, and
- Interest revenue to be earned over the lease term using the effective interest method.
Direct Financing Lease
A lease where the lessor is finacning the acquisition of an asset by the lessee but is not earning a manufacturer’s or dealer’s profit. The PV of MLPs will be equal to the FV of the property and the lessor will earn only interest income.
Lease payment receivables x (MLP + residual value)
Equipment x
Unearned Int Revenue x
Disclosures
- Future MLP
- Unguaranteed residual value
- Earned income
- Future payments to be received over the next 5 years
Leases Involving Land only: Lessee & Lessor
Leases involving real estate create special problems due to the fact that land has an indefinate useful life.
When leases involve land only:
- The lessee will consider only the first two criteria in classifying the lease (TTO, BPO) as a capital lease.
- If TTO is met, assuming the lessor’s two sperarate criteria are also met, the lessor:
- will report the lease as a sales-type lease if thre is a manufacturer/dealer’s profit or loss
- will report the lease as a direct financing lease if there is no profit or loss
- If the BPO criterion is met, the lessor will account for the lease as a sales-type lease or a direct financing lease as appropriate.
Leases Involving both Land and Building (Lessee)
When leases involve land and building and either of the first two criteria are met (TTO/BPO, the lessee will capitalize the land and building separately. If neither of the first two criteria are met, the lessee will determine if the land is signficant.
- If the FV of the land is < 25% of the total FV, it is ignored and the lease is treated as a bulding lease only. It is capitalized if either of the latter two criteria are met.
- If the FV of the land > 25% of the land and building are considered separately.
- If the portion attributed to the building meets either of the latter two criteria, the building will be capitalized and the land portion will be an operating lease.
- If neither of the latter two criteria are met, the entire lease will be accounted for as a single operating lease
Leases Involving both Land and Building (Lessor)
When leases involve land and building and the first criterion is met (TTO), the lessor will evaluate if there is a manufacturer’s or dealer’s profit or loss.
- If so, the lease will be accounted for as a sales-type lease with the land and building accounted for as a single unit.
- if not:
- if the lease meets both of the seller’s criteria, it will be accounted for as a direct financing lease
- if it does not meet both of the seller’s criteria, it will be accounted for as an operating lease.
When leases involve land and building and the 2nd criterion is met (BPO), the lessor will evaluate if there is a manufacturer’s or dealer’s profit or loss.
- If so, the lease will be accounted for as an operating lease.
- if not:
- if the lease meets both of the seller’s criteria, it will be accounted for as a direct financing lease
- if it does not meet both of the seller’s criteria, it will be accounted for as an operating lease.
When leases involve land and building and neither two criterion are met, the lessor will determine if the land is signficant.
- If the FV of the land is < 25% of the FV of the leased property, the land and building will be treated as a single item.
- If either of the latter criteria are met and both of the lessor’s criteria are met, the lease will be classified as a direct financing or sales-type lease, as appropriate
- If neither of the latter criteria are met or either of the lessor’s criteria are not met, the lease will be accounted fro as an operating lease.
- If the FV of the land > 25% of the total FV of the leased property, the land and building will be treated as separate leases.
Sales Leaseback
The property owner sells the property, then immediately leases all or part of it back from the new owner. It is considered two separate and distinct economic transactions. The leaseback may either be an operating lease or a capital lease (if 1 of the 4 criteria are met), but we also need to see what portion of the rights to the leaseback propety are retained.
- If PV of rental payments is > 90% of FV of the property at inception, this implies that the seller-lessee retains substanitally all the rights to the use of the proerty and leaseback is accounted for as a capital lease
- defer all gain and offset against depreciation expense
- Cash 200
- Equipment 120
- Deferred Gain 80 (amortize over 4yrs)
- Leased Asset 200 (depreciate over 4 yrs)
- obligation under CL 200
- If PV of rental payments is > 10% but < 90% of FV, leaseback could be either Operating or Capital lease based on 1 of 4 criteria
- defer gain up to PV of leaseback payments, recognize rest immediately
- if capital lease, offset against depreciation expense
- if operating lease, offset against rent expense
- if PV of rental payments is < 10% of FV, this implies that the sller only retains a minor portion of the rights to use the property, the sale, and leaseback are considered seperate transactions. The sale is recognized and the leaseback is considred an Operating Lease.
- Recognize all gain immediately
- Cash 200
- Equipment 120
- Deferred Gain 80 (amortize over 4 yrs)
- Prepaid Rent 50 (pmt at beg of period)
- Cash 50
- Cash 200
- Recognize all gain immediately
Capital Leaseback
Gain or loss is deferred and amortized over the periodused for depreciating the asset as a reduction of depreciation expense.
- The deferred gain is reported as an asset valuation allowance to the leased asset account
- a loss is deferred and amortized as prepaid rent if the carrying amount (BV) of the asset sold is greater than the sales price, but the FV exceeds the CV.
- a loss is recognized immeditely if the CV is greater than the FV
Operating Leaseback
Gain or loss is also generally deferred when the leaseback is an operating lease.
- gain or loss is deferred and amortized over the term of the lease as a reduction of rent expense. The deferred gain is considered a deferred credit.
- If Sale-leaseback occurs in the last 25% of an asset’s economic life, classify as an operating lease.
IFRS vs GAAP
