Leases

ASPE: 3065

Leases

ASPE: 3065

Level Tested on CPA PEP

ExamLevel TestedImportance (low, medium, or high)
Core 1 Module Level AHigh 
Assurance ElectiveLevel AHigh 
Scope

The following items are not covered under this section:

  • licensing agreements for items such as motion pictures, videotapes, plays, manuscripts, patents and copyrights
Definitions
  • Capital lease is a lease that transfers substantially all the benefits and risks incident to ownership of property to the lessee
  • Operating lease is a lease in which the lessor does not transfer substantially all the benefits and risks incident to ownership of property
  • interest rate implicit in the lease is such that the FV of leased asset = PV of (Minimum Lease Payments + unguaranteed Residual value)
  • executory costs = costs related to operating leased asset (insurance, maintenance, property tax)
Classification
  • A lease is classified as:
    • from the point of view of the lessee — capital or operating leases; and
    • from the point of view of the lessor — sales-type, direct financing or operating leases
Lessee’s criteria
  • From the point of view of a lessee, a lease is a capital lease when one of the following is met:
    1. There is reasonable assurance that the lessee will obtain ownership of the leased asset by the end of the lease term
      1. ownership is transferred to the lessee by the end of the lease term or
      2. when the lease provides for a bargain purchase option (BPO)
    2. the lease term is equal to a major portion (usually 75 percent or more) of the economic life of the leased property
    3. present value, at the beginning of the lease term, of the minimum lease payments, excluding any portion relating to executory costs, is equal to substantially all (usually 90 percent or more) of the fair value of the leased property,
      1. the discount rate used by the lessee is the lower of the
        1. lessee’s rate for incremental borrowing and
        2. the interest rate implicit in the lease, if known
Accounting treatment by a lessee
Accounting for capital lease by lessee

A capital lease is accounted for as an asset and a liability at the lower of:

  1. The fair value of the leased property; or
  2. The present value of the minimum lease payments (MLP)
    • The discount rate to use in the present value = lower of incremental borrowing rate and the rate implicit in the lease
Minimum lease payments (MLP) for the lessee
  • The minimum lease payments = rental payments + residual value guaranteed (partial or full) by the lessee or a third party related to the lessee + bargain purchase option
  • Contingent rent is excluded from MLP
Subsequent measurement
  • The capitalized value of a PPE is to be amortized
    • If there is a BPO or ownership transfer at the end of the lease, amortize over the useful life of the asset
    • Otherwise, amortize over the lease term
  • The lease liability is just like a loan; therefore, lease payments are allocated between:
    • interest
    • principal (reduction to liability); and
    • executory costs
Accounting for operating lease by the lessee
  • operating leases are recognized in expense over a straight-line basis over the lease term (even if not payable in a straight line manner)
  • lease expense per term = net lease payments over lease ÷ lease terms
    • any difference between lease expense and cash payment is recognized as an asset or liability
    • net lease payments = total lease payments – lease inducements
  • lease inducements are inseparable from the lease; and are treated as a reduction to the expense recognized per term
Accounting treatment by a lessor
  • the lessor recognizes
    • gross receivable = the minimum lease payments (excluding executory costs) + any unguaranteed residual value
    • deferred financing income = gross receivable – book value of asset leased
  • initial direct costs = costs to arrange/negotiate lease (commission, legal fees)
  • for direct finance leases, the initial direct costs are expensed when incurred; and a portion of deferred finance income is brought into income at the same time (no effect on P&L)
Dr. Initial legal expense$500
Cr. Cash(500)
Dr. Deferred finance income$500
Cr. Income(500)
Accounting for Sales Type Lease by Lessor
  • the lessor recognizes
    • gross receivable = the minimum lease payments (excluding executory costs) + any unguaranteed residual value
    • the lessor will have a deferred financing income = gross receivable – PV of the gross receivable
    • Sales revenue = PV of MLP (excluding executory costs) @ rate implicit in the lease
    • Cost of goods sold = book value of the leased asset less PV of unguaranteed residual value
  • Initial direct costs are expensed at the inception of the lease
Sample journal entries for lessor
  • Direct Finance Lease vs. Sales Type Lease
    • Annual payment = 10,000 per year for 10 yrs.
    • RV=5,000
    • PV (annual PMT) = 80,000
    • PV (RV) =1,000
    • BV of leased PPE = 50,000
    • FV of the leased asset = 81,000
Case 1: If residual value is unguaranteed
Direct Financing LeaseSales Type Lease
Gross receivable (dr.)10,000*10 + 5,000=105,00010,000*10 + 5,000=105,000
Deferred Finance Income (cr.)= 105,000-81,000=24,000= 105,000-81,000=24,000
Credit entry FV of Asset Leased = PV (annual pmt, RV) = 81,000Sales = PV (MLP) = 80,000
Debit entryCOGS=BV of leased asset – PV(ungur. RV)= 50,000-1,000=49,000
Direct Financing LeaseSales Type Lease
Dr. Gross investment……….….105K

Cr. Deferred finance income……………..24K

Cr. Leased asset……………………………81K

Dr. Gross investment……….105KDr. Cost of goods sold……..…49K

Cr. Deferred finance income…………….24K

Cr. Inventory………………………………..50K

Cr. Sales……………………..…..….…….…80K

Case 2: If residual value is guaranteed
 Direct Financing LeaseSales Type Lease
Gross receivable (dr.)10,000*10 + 5,000=105,00010,000*10 + 5,000=105,000
Deferred Finance Income (cr.)= 105,000-81,000=24,000= 105,000-81,000=24,000
Credit entryFV of Asset Leased = PV (annual pmt, RV) = 81,000

Sales = lower of:

  • PV (MLP)= 81,000
  • FV of leased Asset = 81,000
Debit entry COGS=BV of leased asset – PV(Ungur. RV)= 50,000-0=50,000
Direct Financing LeaseSales Type Lease
Dr. Gross investment……….105KCr. Deferred finance income…………24KCr. Leased asset……………………….81KDr. Gross investment……….105KDr. Cost of goods sold……..…50KCr. Deferred finance income………………24KCr. Inventory………………………………….50KCr. Sales……………………..…………….…81K
Accounting for Operating Lease by Lessor
  • operating leases are recognized in income over a straight-line basis over the lease term (even if not payable in a straight line manner)
  • lease income per term = net lease receipts over lease ÷ lease terms
    • any difference between lease income and cash receipts is recognized as an asset or liability
    • net lease receipts = total lease receipts – lease inducements
  • initial direct costs are capitalized as a separate asset and amortized over the lease term to income
Subleases
  • subleases have no effect on the accounting for the original lease
  • if a sublease transfers all the benefits/risks of ownership related to the sub-leased asset (see criteria above) – then it is accounted for as a sales-type or direct financing lease; otherwise, it is accounted for as an operating lease
Sale-leaseback transaction
  • A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset
  • The general theory under ASPE is that a sale and a lease are inseparable, and as a result, the profit or loss from sale-leaseback transactions are deferred and amortized to income over the lease term
  • However, when the leaseback is a “portion” of the property sold, ASPE says that the sale and leaseback become separable; as a result, a portion of the profit or loss can be recognized immediately
    • A portion can be the following:
      • Part of a property (i.e. sold office building and leased back 1 floor)
      • A portion of the asset’s remaining useful life
Sale-Leaseback: Operating Leases
  • When a seller-lessee leases back only a minor portion of the asset sold, the entire gain or loss from the sale is recognized in income at the date of sale
    • Use judgement in determining what constitutes “minor portion” (i.e. 1 floor leased back of a 20-floor building)
    • In addition, ASPE says that, if the PV of the MLP is ≤ 10% of the FV of the asset sold; the lessee is deemed to have only leased back a minor portion and the full profit on the sale is recognized immediately
  • When the seller-lessee leases back more than a minor portion but less than substantially all of the asset; the gain from the sale recognized in income = gain from the sale less the PV of the MLP
    • Again use judgement
    • This usually occurs when the PV MLP is between 11% to 89% of the FV of the asset
  • When the seller-lessee lease back substantially all of the asset; the gain or loss from the sale is deferred and amortized to income over the lease term
  • When at the time of sale-leaseback of the FV of the asset < book value of the asset; the difference is recognized as a loss immediately
Sale-Leaseback: Capital Leases
  • When a seller-lessee leases back only a minor portion of the asset sold, the entire gain or loss from the sale is recognized in income at the date of sale
    • Use judgement in determining what constitutes “minor portion” (i.e. 1 floor leased back of a 20-floor building)
    • In addition, ASPE says that, if the PV of the MLP is ≤ 10% of the FV of the asset sold; the lessee is deemed to have only leased back a minor portion and the full profit on the sale is recognized immediately
  • When the seller-lessee leases back more than a minor portion but less than substantially all of the asset; the gain from the sale recognized in income = gain from sale less the recorded amount of the leased back asset (usually the PV of MLP)
    • Again use judgement
    • This usually occurs when the PV MLP is between 11% to 89% of the FV of the asset
  • When the seller-lessee lease back substantially all of the asset; the gain or loss from the sale is deferred and amortized to income over the useful life of the asset (if land amortize over lease term)
  • When at the time of sale-leaseback of the FV of the asset < book value of the asset; the difference is recognized as a loss immediately
Leases involving land and buildings
  • For a capital lease involving both a land and building component, only capitalize the land separately from the building if there will be a change in ownership or a bargain purchase option @ the end of the lease
    • Allocate the minimum lease payments to the land and building component with respect to the relative fair values of the land and building
  • When no change in ownership or BPO, and when the FV of the land is minor compared to the FV of the total property, treat the land and building as a single unit for classification
  • When no change in ownership or BPO, and when the FV of the land is significant compared to the FV of the total property, you need to separately capitalize the land and building
Comparison to IFRS
  • Leases are covered under IAS 17
  • The terminology is different; a finance lease is called the capital lease
  • Under IFRS, the criteria to classify a lease as a finance lease is less defined (for instance it doesn’t say the present value of the minimum lease payments must be ≥90% of the fair market value)
  • Under IFRS, secondary conditions are mentioned for classifying a lease as a finance lease
  • Under IFRS, for a lease with a land and building
    • you do always need to split the land and the building unless the FV of the land is minor
    • the minimum lease payments are allocated based on the relative fair values of the leasehold interest attributable to land/building as opposed to the relative fair values of the physical land and building
  • under IFRS, the minimum lease payments are discounted at the rate implicit in the lease (only when this is not known, we use the borrowing rate)
  • under IFRS, initial direct costs are only mentioned for both lessees and lessors; initial direct costs are handled differently (please see notes)
  • under IFRS, executor costs are called costs for services and taxes to be paid by and reimbursed to the lessor and are also excluded from the MLP
  • under IFRS, manufacturer/dealer leases are called the sales-type lease
  • under IFRS, accounting sales and leaseback transactions is different

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