Chapter 8 Leases (Part 2)

Accounting for leases by Lessor

A lessor classifies each of its leases as either a finance lease or an operating lease.
Classification of lease by a lessor
1. Finance lease (capital lease) is a lease that transfers substantially
all the risks and rewards incidental to ownership -of an underlying asset.
2. Operating lease is a lease that does not transfer substantially all the risks and
rewards incidental to ownership of an underlying asset.  
• Risks include the possibilities of losses from idle capacity or technological
obsolescence and of variations in return because of changing economic conditions.
• Rewards may be represented by the expectation of profitable operation over the
asset's economic life and of gain from appreciation in value or realization of a residual
value.
Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than the form of the contract.  
Indicators of a finance lease
The following are situations that individually or in combination would normally lead to a
finance lease classification:
a. The lease transfers ownership of the asset to the lessee by the end of the lease term.
b. The lessee has the option to purchase the underlying asset at a price that is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable for
it to be reasonably certain, at the inception date, that the option will be exercised (i.e.,
'bargain purchase option').
c. The lease term is for the major part of the economic life of the asset even if title is not
transferred.  
PFRS 16 does not provide specific guidance in determining what constitutes a
"major part" of the economic life of a leased asset. However, under Financial
Accounting Series (FAS), Statement of Financial Accounting Standards (SFAS) No.13
of US GAAP, if the lease term is at least 75% of the economic life of the leased asset, it
is generally held that the lease term constitutes a major part of the economic life of the
asset.  
Economic life is "either:
i. The period over which an asset is expected to be economically usable by one or more
users; or
ii. The number of production or similar units expected to be obtained. from the asset by
one or more users." (PFRS 16. Appendix A)
 d. The present value of the lease payments amounts to at least substantially all of the
fair value of the leased asset at the inception 'date.
  Again, PFRS 16 does not provide specific guidance in determining what
constitutes "substantially all" Of the fair value of the asset at inception date. Under
SFAS 13 Of US GAAP, if the present value of the lease payments amounts to at least
90% of the fair value of the leased asset at inception date, it is generally held that the
present value of the lease payments amounts to at least substantially all of the fair value
of the leased asset at the inception of the lease.
 e. The leased asset is of such a specialized nature that only the lessee can use it
without major modifications. (PFRS 1663)
 In practice, the accountant identifies the indicators listed above by examining
the lease contract (including any attachments or addendum thereto).
Remember the following.
Any of the following will lead to a finance lease classification.
1. Transfer of ownership
2. Bargain purchase option (BPO)
3. Lease term is at least 75% of the useful life of the leased asset
4. Present value of lease payments is at least 90% of the fair value of the leased asset
at the inception date
5. Leased asset is of specialized nature  
Other indicators of finance lease
Any of the following could also lead to a lease being classified as a finance lease:
a. If the lessee can cancel the lease, the lessor's losses associated with the cancellation
are borne by the lessee (transfer of risk);
b. Gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee (transfer of risks and rewards); and
c. The lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent (transfer of reward).
(PFRS 16.64)
 
 The above indicators are not always conclusive. If it is clear that the lease does
not transfer substantially all the risks and rewards incidental to ownership, the lease is
classified as an operating lease. For example, this may be the case if the purchase
option is not bargain, i.e., the exercise price is equal to the fair value of the asset.  
Inception and Commencement of lease
Lease classification is made at the inception date and is reassessed only if there
is a lease modification. Changes in estimates (e.g. changes in economic life or residual
value), or changes in circumstances (e.g., default by the lessee), do not give rise to new
classification of a lease for accounting purposes.
1. Inception date is the earlier of (a) the date of the lease agreement and (b) the date
of commitment by the parties to the principal provisions of the lease. As at this date:
a. a lease is classified as either an operating or a finance lease; and
b. in the case of a finance lease, the amounts to be recognized at the commencement
date are determined.  
2. Commencement date is the date on which a lessor makes an underlying asset
available for use by a lessee. It is on this date that the lessee is entitled to exercise its
right to use the leased asset.
The commencement date is the date of initial recognition for the lease, i.e., it is
on this date that journal entries are recorded. However, the amounts in the journal
entries are determined at the inception date.  
Finance Lease
Initial measurement
A lessor recognizes an asset from a finance lease as receivable measured at an
amount equal to the net investment in the lease.
Under a finance lease, the lessor transfers substantially all the risks and rewards
incidental to ownership over the leased asset to the lessee. Thus, the lessor
derecognizes the leased asset and recognizes a finance lease receivable. The
receivable is treated as repayment of principal and finance income to reimburse and
reward the lessor for its investment and services.
 Gross investment in the lease (gross lease receivable) — "the sum of:
a. the lease payments receivable by the lessor under a finance lease, and
b. any unguaranteed residual value accruing to the lessor."
 
  Net investment in the lease (net lease receivable) — "the gross investment in
the lease discounted at the interest rate implicit in the lease."
 Unearned finance income (unearned interest income) — "the difference
between:
a. the gross investment in the lease, and
b. the net investment in the lease."
(PFRS 16.Appendix A)  
Lease payments
Lease payments include the following:
a. Fixed payments, including in-substance fixed payments, less any lease incentives
payable;
b. Variable lease payments that depend on an index or a rate initially measured using
the index or rate as at the commencement date;
c. Guaranteed residual value;
d. The exercise price of a purchase option if the lessee is reasonably certain to exercise
that option; and
e. Payments of penalties for terminating the lease, if the lease term reflects the lessee
exercising an option to terminate the lease.
(PFRS 16.70)  
Discount rate
The net investment is measured using the interest rate implicit in the lease.
In the case of a sublease, if the interest rate implicit in the sublease cannot be readily
determined, an intermediate lessor may use the discount rate used for the head lease
(adjusted for any initial direct costs associated with the sublease) to measure the net
investment in the sublease.  
Subsequent measurement
The net investment in the lease (net lease receivable) is subsequently
measured similar to an amortized cost financial asset.
Accordingly:
• Finance income (interest income) is computed using the effective interest method and
recognized in profit or loss. Interest in each period reflects a constant periodic rate ff
return on the lessor’s net investment in the lease.
• Lease payments are applied against the gross investment in the lease to reduce both
the principal and the unearned finance income.  
Recall the following.
 Gross investment = Lease payments + Unguaranteed residual value
 Lease payments comprise the following:
1. Fixed lease payments, including in-substance, less lease incentives payable
2. Variable lease payments based on index or rate
3. Guaranteed residual value
4. Exercise price of purchase option, if reasonably certain
5. Termination penalty, if reasonably certain  
 Net investment = Present value of Gross investment or (PV of lease payments +
PV of Unguaranteed residual value)
 Unearned interest income = Gross investment — Net investment
 
Initial direct costs
Initial direct costs, other than those incurred by manufacturer or dealer lessors,
are included in the initial measurement of the net investment in the lease and reduce
the amount of income recognized over the lease term.
Initial direct costs include commissions, legal fees and internal costs that are
incremental and directly attributable to negotiating and arranging a lease. They exclude
general overheads (sales and marketing team).
  The interest rate implicit in the lease is defined in such a way that the initial direct
costs are included automatically in the net investment in the lease; there is no need to
add them separately.
 Interest rate implicit in the lease — the rate of interest that causes the present
value of (a) the lease payments and (b) the unguaranteed residual value to equal
the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs
of the lessor.
 Initial direct costs — incremental costs of obtaining a lease that would not have
been incurred if the lease had not been obtained, except for such costs incurred
by a manufacturer or dealer lessor in connection with a finance lease.
  Direct costs incurred by a manufacturer or dealer lessor are excluded from the
definition of initial direct costs and therefore, are expensed immediately.
 
Classification of finance lease by the lessor
A lessor classifies a finance lease as either:
a. Direct financing lease; or
b. Sales type lease  
Direct financing lease
Under a direct financing lease, a lessor acquires assets and leases them with
the intention of generating income through interest. The lessor is neither the
manufacturer nor a dealer of the asset being leased. The previous illustrations pertain to
direct financing lease.
 Sales type lease
Under a sales type lease, the lessor is the manufacturer or a dealer of the asset
being leased and uses leasing as a means of marketing its products. The lessor often
provides its customers a choice of either buying or leasing an asset.
A sales type lease is accounted for like a direct financing lease, except that the
manufacturer or dealer lessor recognizes the following at the commencement date:  
a. Sales revenue — measured at the lower of the (a) present value of lease
payments, discounted using a market rate of interest, and the (b) fair value of the
asset;
b. Cost of sale — equal to the cost, or carrying amount if different, of the
underlying asset less the present value of the unguaranteed residual value; and
c. Gross profit — the difference between revenue and cost of sale
  Costs incurred in connection with obtaining a sales type finance lease are
recognized immediately as expense. Such costs are excluded from the definition of
initial direct costs, and therefore are excluded from investment in the lease.
 
Direct financing lease
 Lessor recognizes:
I. Interest income over the lease term
Sales Type Lease
Lessor recognizes:
1. Interest income over the lease term.
2. Sales revenue*
3. Cost of sale*
4. Selling profit or loss*
*Recognized at the commencement date.
 The fair value of the leased asset is often equal to the cost or carrying amount of
the leased asset.
Sales Type Lease
-The fair value of the leased asset is often greater than the cost or carrying amount of
the leased asset, i.e., often equal to the cash selling price of the leased asset.
 Net investment is often equal to the cost/carrying amount of the leased asset
plus initial direct costs.
Sales Type Lease
-Net investment is often equal to the cash selling price of the
leased asset.   
Residual value
Unlike for lessees who account for guaranteed residual value only, lessors
account for both guaranteed and unguaranteed residual values, provided the leased
asset reverts back to the lessor at the end of the lease term. The reason is that, when
the leased reverts back to the lessor, any residual value (whether guaranteed or not)
inures to the benefit of the lessor, i.e., the lessor is the one who will sell the asset at the
end of its useful.  
If the leased asset does not revert back to the lessor, such as when ownership is
transferred to the lessee at the end of the lease term, the lessor does not account for
any residual value because it inures to the benefit of the lessee, i.e., the lessee is the
one who will sell the asset at the end of its useful life.
  Residual value guarantee is a guarantee made to a lessor by a party unrelated
to the lessor that the value (or part of the value) of an underlying asset at the end of a
lease will be at least a specified amount.
As to the lessor, a residual value is guaranteed if it is:
a. Guaranteed by the lessee;
b. Guaranteed by a party related to the lessee; or
c. Guaranteed by a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.  
Residual value is guaranteed if guaranteed by:
 a. The lessee
b. A party related to lessee.
c. A third party unrelated to the lessor that is financially capable of the obligations
under the guarantee.
  Actually, the amounts of gross investment, net investment, and unearned interest
income are the same whether the residual value is guaranteed or not.
The only difference between the accounting for guaranteed and unguaranteed
residual value lies in the computations of sales and cost of sales under a sales type
lease.
 If the residual value is guaranteed, the present value of the guaranteed residual
value is added to sales.
 If the residual value is unguaranteed, the present value of the unguaranteed
residual value is deducted from cost of sales.
 Gross profit is the same whether the residual value is guaranteed or
unguaranteed.  
Guaranteed residual value is added to sales under a sales type lease because, in
effect, this portion is sold. If the actual residual value of the leased asset at the end of
lease term falls below the guaranteed amount, the purchaser/lessee will be held liable
to make good the deficiency.  
Unguaranteed residual value is deducted from cost of sales because, in effect, this
portion is unsold. Any deficiency on the actual residual value of the leased asset at the
end of lease term is borne by the seller/lessor.  
Summary Concepts:
-A lessor accounts for a residual value, whether guaranteed or unguaranteed, for as
long as the leased asset reverts back to the lessor.
-Gross investment, Net investment, Unearned interest income, and Gross profit are the
same whether residual value is guaranteed or unguaranteed.
-Under a sales type lease, the PV of a guaranteed residual value is included in sales
while the PV of an unguaranteed residual value is deducted from cost of sales.
-Under direct financing lease, initial direct costs automatically form part of the lease
receivable. The accounting for initial direct costs affects only the computation of implicit
interest rate. Net investment equals the cost of the leased asset plus initial direct costs.
-Under sales type lease, direct costs are expensed immediately. Net investment equals
sales (if residual value is guaranteed), except when the fair value of the leased asset is
lower.
 
Lease modifications
Depending on its nature, a lease modification is accounted for as a:
a. Separate lease; or
b. Remeasurement or derecognition of the net investment in the lease  
Separate lease
A lease modification is accounted for as a separate lease if both the scope and
consideration in the lease are increased due to the addition of a right to use one or
more underlying assets and the increase in the consideration reflects the stand-alone
price for the increase in scope.  
No adjustment is made to the existing net investment from the original contract.  
Not a separate lease
A modification of a finance lease that is not accounted for as a separate lease is
accounted for as follows:
a. If the lease would have been classified as an operating lease had the modification
been in effect at the inception date, the lessor shall:
i. account for the lease modification as a new lease from the effective date of the
modification; and
Ii. measure the carrying amount of the underlying asset as the net investment in the
lease immediately before the effective date of the lease modification.  
b. Otherwise, the lessor shall apply the requirements of PFRS 9 Financial Instruments.  
Operating Lease
An operating lease is a lease that does not transfer substantially all the risks
and rewards incidental to ownership of an underlying asset.  
The accounting for operating leases is straight-forward. The lessor recognizes
the lease payments as income on a straight-line basis over the lease term, unless
another systematic basis is more representative of the pattern in which benefit from the
use of the underlying asset is diminished.  
The accounting for operating leases by a lessor is the same as the recognition
exemption available to a lessee for "Short-term" and "low value" leases.
A manufacturer or dealer lessor does not recognize any selling profit on entering
into an operating lease because it is not the equivalent of a sale.  
Initial direct costs
The lessor capitalizes the initial direct costs to the carrying amount of the
underlying asset and recognize those costs as expense over the lease term on the
same basis as the lease income (i.e., if lease income is recognized under the straight-
line basis, the initial direct costs are also recognized as expense using the straight-line
basis). This is irrespective of the depreciation method used on the underlying asset.  
Other costs incurred in earning the lease income, including depreciation, are
recognized as expense in the period incurred. These are not offset from the lease
income.  
Depreciation
The leased asset remains the asset of the lessor. Therefore, the lessor continues
to depreciate it.
Under an operating lease, the lessor does not recognize any finance lease
receivable.
Lease bonus
The lessor accounts for a lease bonus as unearned income and recognize it as
income over the lease term, on the same basis as the lease income.  
Advance rentals
Advance rentals are accounted for as unearned income and recognize it as
income only when earned.  
Security deposits
A lessor recognizes a security deposit received from the lessee as payable,
measured as an amortized cost financial liability.  
Lease modifications
A modification to an operating lease is accounted for as a new lease from the
modification date. Prepaid or accrued lease payments relating to the original lease are
treated as payments for the new lease.  
Recall the following concepts:
Accounting for leases by a lessor:
Finance lease
Statement of financial position
-Derecognize leased asset and net investment in recognize the lease /
Statement of P/L & OCI
-Recognize interest income and, in the case of a sales type lease, a manufacturer or at
the dealer profit commencement date
Operating Lease
Statement of financial position
Continue to recognize leased asset (and its depreciation).
-Does not recognize net investment in the lease
Statement Of P/L & OCI
-Recognize lease payments income using straight line basis (or another more
appropriate basis) over the lease term
Lease of land and building
When a lease includes both land and buildings elements, a lessor assesses the
classification of each element as a finance lease or an operating lease separately. 
In determining whether the land element is an operating or a finance lease, an
important consideration is that land normally has an indefinite economic life, and
therefore the "useful life or 75%" criterion does not apply.
However, even if the lease does not transfer title over the land, a lessor may
nonetheless classify the land element as a finance lease if the lease extends to a
relatively very long period of time. "In reaching this conclusion the IASB had considered
the example of a 999-year lease of land and buildings. It had noted that, for such a
lease, significant risks and rewards associated with the land during the lease term
would have been transferred by the lessor despite there being no transfer of title."
(PFRS 16.BCZ242)
  To account for the land and building components of a lease separately, a lessor
allocates the lease payments to the elements based on their relative fair values at the
inception date.
 If no reliable allocation basis exists, the entire lease is classified as a finance lease,
unless it is clear that both elements are operating leases, in which case the entire lease
is classified as an operating lease.  
If the land element is immaterial to the lease, both components may be treated
as a single unit for purposes of lease classification. In such case, a lessor regards the
economic life of the building as the economic life of the entire underlying asset.  
Subleases
 Sublease is "a transaction for which an underlying asset is re-leased by a lessee
('intermediate lessor') to a third party, and the lease ('head lease') between the head
lessor and lessee remains in effect." (PFRS 16. Appendix A)  
An intermediate lessor classifies a sublease as a finance lease or an operating lease
as follows:
a. If the head lease is a short-term lease that the entity, as a lessee, has accounted
for applying the recognition exemption, the sublease is classified as an operating
lease.
b. Otherwise, the sublease is classified by reference to the right- of-use asset
arising from the head lease, rather than by reference to the underlying asset (for
example, the item of property, plant or equipment that is the subject of the lease).
If the leased asset is subleased, the head lease does not qualify as a lease of a
low-value asset.  
Presentation
Underlying assets subject to operating leases are presented in the statement of
financial position according to their nature.  
Sale and leaseback transactions
A sale and leaseback transaction occurs when a party sells an asset and
immediately leases it back from the buyer. The seller becomes the lessee while the
buyer becomes the lessor.
  To account for a sale and leaseback transaction, both the seller/lessee and the
buyer/lessor determine whether the transfer qualifies as a sale based on the
requirements for satisfying a performance obligation in PFRS 15.
Transfer of asset is a sale
If the transfer qualifies as a sale under PFRS 15:
a. The seller/lessee shall:
i. measure the right-of-use asset arising from the leaseback at the proportion of the
previous carrying amount of the asset that relates to the right of use retained by the
seller- lessee; and
ii. recognize only the amount of any gain or loss that relates to the rights transferred to
the buyer-lessor.
b. The buyer-lessor shall account for the purchase of the asset applying applicable
Standards (e.g., PAS 16 if the asset is an item of PPE), and for the lease applying the
lessor accounting under PFRS 16. 
Adjustments 
If (a) the sale price is not equal to the fair value of the asset, or if
(b) the lease payments are not at market rates; the following adjustments shall be made
to measure the sale proceeds at fair value:
a. any below-market terms shall be accounted for as a prepayment of lease payments;
and
b. any above-market terms shall be accounted for as addition financing provided by the
buyer-lessor to the seller-lessee.  
The adjustment is measured based on the more readily determinable of:
a. the difference between the fair value of the consideration for the sale and the fair
value of the asset; and
b. the difference between the present value of the contractual payments for the lease
and the present value of payments for the lease at market rates.
 
Transfer of the asset is not a sale
If the transfer does not qualify as a sale, the parties shall account for it as a
financing transaction. Accordingly,
a. the seller/lessee continues to recognize the asset and accounts for the amounts
received as a financial liability under PFRS 9.
b. the buyer/lessor does not recognize the transferred asset and accounts for the
amounts paid as a financial asset under PFRS 9.
 

Chapter 8: Summary
-A lessor classifies a lease as either a finance lease or an operating lease. A finance
lease transfers substantially all the risks and rewards incidental to ownership of an
underlying asset; an
-Indicators of a finance lease: (1) Transfer of ownership; (2) Bargain purchase option
'BPO'; (3) Major part of useful life '75%'; (4) PV of LP is substantially all of fair value
'90%'• (5) Specialized in nature.
-Finance lease: Initial accounting: Lessor derecognizes leased asset (and hence,
discontinues depreciating it) and recognizes net investment in the lease. Subsequent
accounting: net investment in the lease is subsequently measured at amortized cost.
-Net investment = PV of lease payments + PV of Unguaranteed residual value
-Lease payments consist of: (a) Fixed payments (less lease incentives receivable); (b)
Variable payments based on index/rate; (c) Guaranteed residual value; (d) Purchase
option, if reasonably certain; (e) Termination penalties and Payments in optional
extension periods, if reasonably certain.
-Initial direct costs are included automatically in the net investment; no need to add
them separately.
-A manufacturer or dealer lessor recognizes profit from a sales type lease at the
commencement date, in addition to interest income over the lease term. Direct costs are
expensed outright.
-A lessor accounts for both guaranteed and unguaranteed residual value. PV of residual
value is added to sales while PV Of unguaranteed residual value. is deducted from cost
of sales. Profit is the same whether residual value is guaranteed or not.