Lecture 13 Leases

Question 1

What is a lease?

Answer 1

A lease is a contractual agreement by which the owner of an asset (the lessor) permits a counterparty (the lessee) to use the asset for a specified period in exchange for specified payments.

The lessor retains title to the asset and typically takes possession of the asset again at the end of the lease term.

Question 2

Leasing tend to make companies appear more profitable and have a lower leverage, how do we deal with this problem?

Answer 2

Leaving leased assets off the balance sheet means that firms that lease, rather than own, show higher profitability ratios and lower financial leverage (both of which are generally desirable).

To address the problem, both the IASB and the FASB have created rules that require lessees to capitalize leases, i.e., to account for their leases as if they were purchases.

Question 3

How do we treat a lease at its inception?

Answer 3

At the inception of the lease, the lessee recognizes on its balance sheet:

• the lease asset (or right-of-use asset), valued at the present value of the future lease payments; and
• a lease obligation liability equal to the lease asset value.
  (The only exception is leases of low value or short duration, whose costs may be expensed as incurred, without balance sheet recognition.)

How a lessee accounts for the lease asset and obligation subsequently, over the course of the lease term, depends on whether the lease is classified as a finance lease or an operating lease.

Question 4

How do we determine if a lease is operating or finance?

Answer 4

Under US GAAP, a lease is considered a finance lease if at least one of the following criteria is met (and is considered an operating lease otherwise):

• title to the asset transfers to the lessee at the end of the lease term;

or

• the lessee may purchase the asset at a low price at the end of the lease (bargain purchase option);

or

• the lease term covers the major part of the lease asset’s useful life;

or

• the present value of the minimum lease payments is close to the fair value of the lease asset;

or

• the lease asset is so specific that only the lessee can use it without major modifications.

Under IFRS, all leases are, for lessees, considered finance leases.

Question 5

What are the specifics of finance lease accounting?

Answer 5

In a finance lease, the lessee recognizes, in each period of the lease term,

• depreciation (or amortization) expense on the lease asset; and
• interest expense on the lease obligation.

The difference between interest expense and lease payments reduces the lease obligation.

The interest (discount) rate is either

• the implicit rate, i.e., the one that equates the present value of lease payments plus residual value to the fair value of the asset; or
• the lessee’s marginal borrowing rate (if no implicit rate can be found)

Question 6

What are the specifics of operating lease accounting?

Answer 6

In an operating lease, the lessee

• periodically reduces both the lease asset and obligation by an amount such that the obligation equals the present value of the remaining lease payments at the end of each period; and
• records periodic lease expense according to a straight-line allocation of the total lease payments over the lease term.

Temporary differences between lease payments and expenses are debited or credited to the lease asset.

Question 7

How are operating leases treated from the lessor’s side?

Answer 7

In operating leases (see earlier discussion for the criteria), the lessor

• keeps the leased asset on its own balance sheet and depreciates it over time; and
• recognizes lease income according to a straight-line allocation (or some other appropriate allocation) of total lease payments over the course of the lease term.

Both IFRS and US GAAP apply this rule.

Question 8

How are finance leases treated from the lessor’s side under IFRS?

Answer 8

Under IFRS, lessors treat finance leases like a sale of the lease asset, as long as the lessor’s costs and the collectability of the payments from the lessee are reasonably certain.

The lessor recognizes
* the difference between the cost of the asset and the present value of the future lease payments as profit at the beginning of the lease term;
* the future lease payments at their present value as a long-term receivable; and
* in each period, interest income on the outstanding lease payments receivable.

Question 9

How are finance leases treated under US GAAP?

Answer 9

Under US GAAP, two outcomes are possible for the lessor.
If the lease qualifies as a finance lease outright, the accounting is as under IFRS. (US GAAP uses the term sales-type lease for the lessor in this case.)

If the lease does not meet any of the finance lease criteria but meets a weaker criterion (that the present value of the lease payments plus any residual value guarantees by the lessee and other parties exceeds most of the lease asset’s fair value), the lessor treats the lease as a direct financing lease rather than an operating lease.

In a direct financing lease, profit is not recognized at the inception of the lease but initially subtracted from the lease receivable and then gradually recognized as financing income by the effective interest method.