ACCOUNTING FOR LEASES

IFRS 16
ACCT 320
Samia Ali
Spring 2022
LO1 :Explain the nature, economic substance, and
advantages of lease transactions

LO 2: Lessee accounting

LO 3: Lessee disclosures

LO 4: Lessor accounting

LO 5: Lessor disclosures

LO 6: Special Issues

LO 7: Sale and leaseback

 LO 4
LESSOR ACCOUNTING
Lessor Accounting- Economics of leasing

Lessor determines the amount of the rental payment, not the

lessee.
 Determines payment using rate of return (implicit rate).
 Considers credit standing of lessee.
 Length of the lease.
 Status of the residual value (guaranteed versus
unguaranteed).
Lessor Accounting

Economics of Leasing
In Examples 1 and 2, CNH determined the implicit rate to be 4
percent, the fair value of the equipment to be €100,000, and the
residual value to be $5,000. CNH then computes the lease
payment as shown.

Fair value of leased equipment €100,000.00

Less: Present value of the residual value
(€5,000 × .82193 (PVF 5,4%)) 4,109.65
Amount to be recovered by lessor through
lease payments € 95,890.35
Five beginning-of-year lease payments to earn a
4% return (€95,890.35 ÷ 4.62990) (PVF-AD 5,4%)) €
20,711.11
Classification of Leases by the Lessor
 A Finance lease is a lease where substantially all of the risks
and rewards of the underlying asset transfer to the lessee.
Asset taken off the books of the lessor and a receivable is created
 An Operating lease is a lease that does not meet the definition
of a finance lease.

For a finance lease,

• must be non-cancelable and
• meet at least one of the five tests.
Purchase at Less than
expected FV

75% of more

90% of more
 Additional tests

1. The lessee will compensate the lessor for their losses if the
lease is cancelled
2. Gains or losses from fluctuations in the fair value of the
residual fall to the lessee
3. The lessee can continue the lease for a secondary period in
exchange for substantially lower than market rent payments.

Note: Not given in the book

Classification of Leases by the Lessor

Finance Lease Payments

Generally include:

1. Fixed payments.

2. Variable payments.

3. Residual values (guaranteed or not).

4. Payments the lessee is reasonably certain to exercise.

(Termination penalties, purchase options)
 Classification of Leases by the Lessor

Finance leases discount Rate

 Implicit rate or
 Rate that makes

PV of (lease payments + unguaranteed residual value)

= FV of leased asset
 Classification of Leases by the Lessor

Finance leases Initial measurement

Lease Receivable

Sales-type leases : used to market products (equipment on lease)

Direct finance leases : financing mechanism (banks, insurance)

 Finance (Sales-Type) Lease Example

Illustration: CNH Financial Services Corp. (a subsidiary of CNH) and Ivanhoe

Construction sign a lease agreement dated January 1, 2019, that calls for CNH
to lease a backhoe to Ivanhoe beginning January 1, 2019. The terms and
provisions of the lease agreement, and other pertinent data, are as follows.
• The term of the lease is five years. The lease agreement is non-cancelable,
requiring equal rental payments at the beginning of each year (annuity-due
basis).
• The backhoe has a fair value at the commencement of the lease of €100,000,
an estimated economic life of five years, and a guaranteed residual value of
€5,000 (which is less than the expected residual value of the backhoe at the
end of the lease). Further, assume the underlying asset (the backhoe) has an
€85,000 cost to the dealer, CNH.
• The lease contains no renewal options. The backhoe reverts to CNH at the
termination of the lease.
• Collectibility of payments by CNH is probable.
LO 3
 Finance (Sales-Type) Lease Example

Lessor sets the annual rental payment to earn a rate of return of 4 percent per
year (implicit rate) on its investment

NOTE: Payments due at beginning of

period
Purchase at Less than
expected FV

75% of greater

Lease
term test –
Yes

PV value
test - Yes
Finance (Sales-Type) Lease Example

The journal entries on January 1, 2019, are as follows.

Lease Receivable 100,000

Sales Revenue 100,000
Cost of Goods Sold 85,000
Inventory 85,000
On January 1, 2019, CNH records receipt of the first year’s lease
payment as follows.
Cash 20,711.11
Lease Receivable 20,711.11
 ILLUSTRATION 21.23

+ -

On December 31, 2019, CNH recognizes the interest revenue on the

lease receivable during the first year through the following entry.

Lease Receivable 3,171.56

Interest Revenue 3,171.56
 Finance (Sales-Type) Lease Example

The balance sheet as it relates to lease transactions at December

31, 2019.

ILLUSTRATION 21.24
Balance Sheet
Presentation

On its December 31, 2019, income statement, CNH reports,

ILLUSTRATION 21.25
Income Statement
presentation
 ILLUSTRATION 21.23

The following entries record receipt of the second year’s lease

payment and recognition of the interest revenue in 2020.

Jan. 1 Cash 20,711.11

Lease Receivable 20,711.11
Ivanhoe records accrued interest on December 31, 2019
Dec. 31 Lease Receivable 2,469.97
Interest Revenue 2,469.97
* rounding
 ILLUSTRATION 21.23

FINAL YEAR
CNH makes the following entry on December 31, 2023.

Ivanhoe records accrued

Lease Receivable interest on December 31, 2019
192.19
Lease Revenue 192.19

* rounding
 ILLUSTRATION 21.23

At January 1, 2024, when the leased asset is returned to CNH.

Inventory 5,000
Lease Receivable 5,000

* rounding
Lessor—Unguaranteed Residual Value

In this case, there is less certainty that the unguaranteed residual

portion of the asset has been “sold.”
 The lessor recognizes sales revenue and cost of goods sold
only for the portion of the asset for which recovery is assured.
 Both sales revenue and cost of goods sold are reduced by the
present value of the unguaranteed residual value.
 The gross profit computed will still be the same amount as
when a guaranteed residual value exists.
Lessor—Unguaranteed Residual Value

To compare a sales-type lease with a guaranteed residual value

to one with an unguaranteed residual value, assume the same
facts as in the CNH/Ivanhoe lease situation. That is:

1. The sales price is €100,000.

2. The expected residual value is €5,000 (the present value of

which is €4,109.65).

3. The leased equipment has an €85,000 cost to the dealer,

CNH.
 Lessor—Unguaranteed Residual Value

Computation of Lease Amounts by CNH

Financial—Sales-Type Lease

ILLUSTRATION 21.27
Computation of Lease Amounts by CNH—Sales-Type Lease
ILLUSTRATION 21.28
Entries for Guaranteed and Unguaranteed Residual Values — Sales-Type Lease
Lessor Accounting for Operating Leases

The following data relates to a lease agreement between Hathaway Disposal

Ltd. and M&S for the use of one of Hathaway’s standard cardboard
compactors. Information relevant to the lease is as follows.
• The term of the lease is three years. The lease agreement is non-
cancelable, requiring three annual rental payments of £17,620.08, with the
first payment on January 1, 2019 (annuity-due basis).
• The compactor has a cost and fair value at commencement of the lease of
£60,000, an estimated economic life of five years, and a residual value at
the end of the lease of £12,000 (unguaranteed).
• The lease contains no renewal options. The compactor reverts to
Hathaway at the termination of the lease.
• The implicit rate of the lessor is known by M&S. Traylor’s incremental
borrowing rate is 6 percent. Hathaway sets the annual rental rate to earn a
rate of return of 6 percent per year (implicit rate) on its investment.
Lessor Accounting for Operating Leases

Hathaway classifies the lease as an operating lease because none of

the finance lease tests are met.

ILLUSTRATION 21.30
Lease Classification Tests
Lessor Accounting for Operating Leases

Under the operating method, Hathawary (the lessor)

 continues to recognize the asset on its statement of
financial position and recognizes lease revenue (generally
on a straight-line basis) in each period.
 continues to depreciate the leased asset.
Lessor Accounting for Operating Leases

To illustrate the operating method for the Hathaway/M&S lease,

Hathaway records the lease payment on a straight-line basis on
January 1, 2019, 2020, and 2021, as follows.

Cash 17,620.08
Unearned Lease Revenue 17,620.08

On December 31, 2019, 2020, and 2021, Hathaway records the

recognition of the revenue each period as follows.

Unearned Lease Revenue 17,620.08

Lease Revenue 17,620.08

Performance
obligation
Lessor Accounting for Operating Leases

Hathaway also records depreciation expense on the leased

equipment (assuming double-declining-balance, given a cost basis
of £60,000, and a five-year economic life), as follows.

Depreciation Expense (£60,000 × 40%) 24,000.00

Accumulated Depreciation—Equipment
24,000.00

Hathaway records other costs related to the lease arrangement,

such as insurance, maintenance, and taxes in the period incurred.
 LO 5
LESSOR DISCLOSURES
 Presentation, Disclosure, and Analysis

Presentation
Summary of how the lessor reports the information related to
sales-type and operating leases in the financial statements.

ILLUSTRATION 21.36
Presentation in Financial Statements—Lessor
 Presentation, Disclosure, and Analysis

Disclosure
This illustration presents the type of quantitative information that
should be disclosed for the lessor.

ILLUSTRATION 21.40
Lessor Quantitative Disclosures

LO 4
Analysis

Assets and liabilities changes lead to profitability and solvency

changes.
• ROA will decrease.
• Earnings before interest, taxes, and depreciation and
amortization (EBIDTA)
• Debt to equity ratio will increase, and the interest coverage ratio
will decrease.
 LO 6
SPECIAL ISSUES
Special Lease Accounting Problems

Other Lease Adjustments

Executory Costs expenses associated with owning a leased
asset, such as property insurance and property taxes.
 Executory costs included in the fixed payments required by
the lessor should be included in lease payments for purposes
of measuring the lease liability.
 Payments by the lessee made directly to the taxing authority
or insurance provider are considered variable payments and
are expensed as incurred.
Special Lease Accounting Problems

Other Lease Adjustments

Lease Prepayment Increase right of use asset

Lease incentive Decrease right of use asset

Indirect costs by lessee Increase right of use asset

Note: Initial direct costs are incremental costs of a lease that would
not have been incurred had the lease not been executed.
Special Lease Accounting Problems – Initial Indirect Costs

LESSEE LESSOR

Right of Asset – Increase Operating leases, Defer and amortize as

Liability – No change expense over the term of the lease.

Finance leases expense initial direct

costs at lease commencement (same
period as sale)
 LO 7
Sale - Leaseback
APPENDIX 21A Sale-Leasebacks

A company (the seller-lessee) transfers an asset to another company

(the buyer-lessor) and then leases that asset back from the buyer-lessor.
APPENDIX 21A Sale-Leasebacks

Why sale-leaseback seller/lessee?

1. Use the cash that otherwise would be tied up in property to
expand its operations. At the same time, it continues to use the
property through the lease term.

2. Structure the lease arrangement so issues such as repurchase

provisions, refinancing issues, and conventional financing costs
are minimized.

3. May receive a tax advantage in that entire rental payments are

tax-deductible, whereas under a conventional financing, only
interest and depreciation can be deducted.
APPENDIX 21A Sale-Leasebacks

Why sale-leaseback buy/lessor?

 It generally can earn a higher rate of return under a sale-

leaseback than under traditional financing.
 During the lease term, lessor protected from a downturn in the
real estate market and may have an inflation hedge, provided
the property appreciates in value.
APPENDIX 21A Sale-Leasebacks- ACCOUNTING

Transactions is a SALE or a FINANCING DEAL.

 If control has passed from seller to buyer, then a sale has
occurred.
 If control has not passed from seller to buyer, the transaction
is recorded as a financing (often referred to as a failed sale).

Apply IFRS 15 Revenue from Contracts with

Customers
 SALE NOT A SALE

Seller-lessee Seller-lessee

• Increases cash and reduces the • Continue to recognise the

carrying value of the asset to zero. transferred asset
• Recognizes a gain or loss as • Recognise a financial liability
appropriate. equal to the transfer proceeds.
• Accounts for the leaseback in
accordance with lease accounting Transfer proceeds are treated as a
loan
Buyer-lessor
• Asset purchase using the most Buyer-lessor
applicable accounting standard • Not recognise the transferred
• The lease is accounted for by asset
applying lessor accounting • Recognise a financial asset equal
requirements. to the transfer proceeds.
LEASES IN FINANCIAL STATEMENTS