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.

Indicators of a finance lease

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).
WHEN TO CLASSIFY? Inception and Commencement of lease
Lease classification is made at the inception date and is reassessed only if there is a lease
modification.
Inception date Commencement date
the earlier of (a) the date of the lease agreement the date on which a lessor makes an underlying
and (b) the date of commitment by the parties to asset available for use by a lessee. It is on this
the principal provisions of the lease. As at this date that the lessee is entitled to exercise its right
date: to use the leased asset.
a. a lease is classified as either an operating or a The commencement date is the date of
finance lease; and initial recognition for the lease, i.e., it is on this
b. in the case of a finance lease, the amounts to date that journal entries are recorded. However,
be recognized at the commencement date are the amounts in the journal entries are determined
determined. at the inception date.

ACCOUNTING for Finance Lease by LESSOR

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.
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)
= Lease payments + Unguaranteed residual value

 Net investment in the lease (net lease receivable)

= PV of Gross Investment ; or
= PV of lease Payments + PV of Unguaranteed residual value

 Unearned finance income (unearned interest income)

= Gross Investment – Net Investment

Lease payments & 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

are included in the initial measurement of the net investment in the lease and reduce the
amount of income recognized over the lease term. HOWEVER, 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.
 Net investment = Present value of Gross investment or (PV of lease payments + PV of
Unguaranteed residual value)
 Unearned interest income = Gross investment — Net investment
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.
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 Sales Type Lease

 Lessor recognizes: Lessor recognizes:

I. Interest income over the lease term 1. Interest income over the lease term.
2. Sales revenue*
 The fair value of the leased asset is often 3. Cost of sale*
equal to the cost or carrying amount of the 4. Selling profit or loss*
leased asset.
 Net investment is often equal to the -The fair value of the leased asset is often greater
cost/carrying amount of the leased asset than the cost or carrying amount of the leased
plus initial direct costs. asset, i.e., often equal to the cash selling price of
the leased asset.
-Net investment is often equal to the cash selling
price of the cash selling price or 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.
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.
Residual value is guaranteed if guaranteed by:
As to the lessee As to the lessor
a. Guaranteed by the lessee; a. The lessee
b. Guaranteed by a party related to 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.
 If the residual value is guaranteed, If the residual value is
unguaranteed,

the present value of the guaranteed the present value of the

residual value is added to sales. unguaranteed residual value is
deducted from cost of sales.

 Gross profit is the same whether the residual value is

guaranteed or unguaranteed.

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 Not a separate lease
 if both the scope and consideration in the  not accounted for as a separate lease is
lease are increased due to the: accounted for as follows:
o addition of a right to use one or more
underlying assets and a. If the lease would have been classified as an
o the increase in the consideration operating lease had the modification been in
reflects the stand-alone price for the effect at the inception date, the lessor shall:
increase in scope. i. account for the lease modification as a new
lease from the effective date of the modification;
 No adjustment is made to the existing net and
investment from the original contract. 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.
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 Operating Lease
Statement of financial position Statement of financial position
-Derecognize leased asset and net Continue to recognize leased asset (and
investment in recognize the lease / its depreciation).
Statement of P/L & OCI -Does not recognize net investment in the
-Recognize interest income and, in the lease
case of a sales type lease, a manufacturer Statement Of P/L & OCI
or at the dealer profit commencement date -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.
 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.
  a lessor allocates the lease payments to the elements based on their relative fair values at
the inception date.

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."
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.

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

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
and for the lease applying the lessor accounting.

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:
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

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.