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CHAPTER 20 OUTLINE A. Leasing basics A1) The leasing environment A 2 ) Advantages of leasing A 3 ) Conceptual nature of leases – 3 different perspectives A4) Current accounting standards for leases i) Classification approach under ASPE (for Lessee and Lessors) ii) Right-of-use or contract-based approach under IFRS (for Lessee only) B. IFRS vs ASPE approach to leases – Lessee B 1 ) Common lease terminology under IFRS and ASPE B 2 ) Accounting for right-of-use (“RoU”) approach under IFRS B3) Comprehensive illustration #1 – Comparison between RoU and Classification approaches B 4 ) Accounting for capital leases under ASPE B5) Illustration #2 – Classification approach under ASPE B 6 ) Sale and leaseback for Lessee along with illustration #3 (Appendix 20A) B 7 ) Disclosure requirements under IFRS and ASPE C. Classification approach – Lessor (same for both IFRS and ASPE) C1) Capital lease criteria C2) Two types of capital leases along with illustration # i) Finance-type capital lease ii) Sales-type capital lease C3) Other lease accounting issues D4) Disclosure requirements D. IFRS vs ASPE comparison
A. LEASING BASICS
A1) The Leasing Environment
Source of off-BS financing for companies over many years to avoid increasing D/E ratio and decreasing ROOA…..quite controversial due to lack of transparency, comparability and disclosure. o Prior to new IFRS 16 standard, most lease transactions were ‘off-balance sheet’ Treated as rental expense with no separate recording of related asset/liability o Controversy overcome by IFRS 16 introduced Jan 1 16 for implementation by Jan 1 19 with early adoption encouraged. Lease is a contractual agreement giving Lessee right-to-use specific property owned by the Lessor for specific time period in return for lease payments. o In substance, most leases are a borrowing of funds to acquire leased assets o Less than total interest in property transferred to Lessee since Lessor still the owner o Largest class of leased equipment today is ‘information technology’
A 2 ) Advantages of Leasing
Cost-effective financing for Lessee
o 100% financing, ie. no money down, and fixed payments for specific
term with interest rate dependent on credit rating:
Strong credit rating _____
Average credit rating _____
Poor credit rating _____
o Normally, less costly than bank borrowing
o Easier to obtain with equipment as collateral
Protection against obsolescence for Lessee
o Legal title not transferred but benefits from use are
o Property more easily upgraded without ownership….Lessor risk
More flexibility for Lessee
o Less restrictive provisions than other debt arrangements
o Can be structured to meet cash flow needs of lessee
Tax incentives for Lessor
A3) Conceptual Nature of Leases – Three Different Perspectives
1) Executory contract approach – not GAAP
Requires continuing performance by both parties but no
capitalization involved.
2) Classification approach
Formerly used by IFRS and ASPE for both Lessees and Lessors
but now used for IFRS Lessors and for ASPE Lessees and
Lessors
Leased assets capitalized when lease contract has Bargain
Purchase Option (“BPO”) similar to installment purchase
3) Right-of-use (“RoU”) or Contract-based approach
Used for IFRS Lessees only
Leased contract considered ‘right-to-use’ leased asset in
return for lease liability payments
Substantially all leases capitalized.
A4) i) Cont’d
JE symmetry for Finance-Type Capital Lease under ASPE at
inception
Lessee: Leased asset (@ PV of MLPs = FMV) xxx
Lease liability xxx
Lessor: Lease receivable (@ AV of MLPs) xxx
Unearned interest revenue xxx
Cash or AP or Equipment Inventory xxx
JE symmetry for Operating lease under ASPE at inception when
benefits and risks of ownership not transferred to Lessee……no
asset/liability recognized
Lessee: Rental expense xxx
Cash xxx
Lessor: Cash xxx
Rental income xxx
A4) ii) RoU/Contract-Based Approach Under IFRS (for Lessee only)
After years of study, new IFRS 16 standard adopted right-of-use
approach on Jan 1 16 with implementation deadline Jan 1 19.
Lease contract considered right to use and control specific asset for
period of time in exchange for consideration
o Primary objective to faithfully represent effect of leases on FS
o Not considered ownership transfer over time as with ASPE standard
o Substantially all captured as capital leases under IFRS, some of which
would be treated as Operating Leases under ASPE
Executory costs excluded from PV of MLPs, same as Classification
Approach. Leases not capitalized under IFRS are considered to be
operating leases since:
i) Short term < 12 months and/or
ii) Leased asset has relatively low value
Can also be used by ASPE instead of Classification Approach
B. IFRS VS ASPE APPROACH TO LEASES – LESSEE
B 1 ) Common Lease Terminology under both IFRS and ASPE i) Bargain Purchase Option (BPO). Purchase price at end of lease set below expected FMV to encourage lessee to exercise option since Lessor prefers not to take asset back for resale. PV of BPO included in capitalized value of lease. ii) Lease Term normally includes fixed non-cancellable term + bargain renewal option(s). iii) Bargain Renewal Option (“BRO”) set sufficiently below expected FMV of asset at end of initial lease period to encourage exercise by lessee. BPO often re-financed over extended term. iv) Guaranteed Residual Value (“GRV”). Value of leased asset guaranteed by Lessee at end of lease and therefore included in capitalized lease value. When asset returned to lessor and FMV less than GRV, lessee must pay cash deficiency. v) Unguaranteed Residual Value (“UGRV”). Lessor responsible for RV or 3 rd party related to lessor at end of lease (but not lessee). Therefore not included by Lessee in capitalized value of leased asset/liability but included by Lessor. Lessee has no responsibility/obligation for asset’s condition when returned to Lessor….part of negotiations in competitive market place.
B1) Cont’d vi) Minimum lease payments (“MLPs”). Stream of ‘blended’ payments of interest and principal over initial lease term + any BROs using effective interest method….similar to mortgage amortization. Also includes any lessee guaranteed payments at end of lease (BPO/GRV) but excludes UGRV (lessor responsibility), contingent rental and executory costs. vii) Executory costs (“ECs”) or Service Components. Offered by lessor as “pass through” operating costs associated with ownership (maintenance, insurance, property taxes). Possibility of passing on bulk-buy or fleet discounts negotiated by Lessor on behalf of Lessee group to serve as incentive to help “seal the deal”. If included in lease payment, must be excluded from PV of MLP calculation re. 6 above then recorded as Prepaid for expensing on annual basis. viii) Lessee’s incremental borrowing rate (“IBR”). Interest rate reflecting lessee’s credit risk assuming equivalent funds borrowed from Bank for similar term, asset type and security. ix) Lessor’s implicit interest rate (“IIR”). Internal rate of return priced into lease by Lessor making PV of MLPs + PV of BPO or GRV but not UGRV = FMV of leased asset at lease inception. x) Interest rate used by Lessee for discounting MLPs. o Under IFRS, use Lessor’s IIR (if known by lessee) or lessee’s IBR. o Under ASPE, use lower of Lessor’s IIR, if known by lessee, or Lessee’s IBR. o Under both, can’t capitalize more than FMV of leased asset which would be very poor Lessee negotiations if this happened.
B2) Cont’d
Basic JEs for Right-of-Use asset
i) Lease inception (PV of MLPs primarily using ‘annuity due’)
RoU asset xxx
Lease liability (“LL”) xxx
ii) Annual Lease payment (in this course)
Prepaid executory expense xxx
Lease liability ** xxx
Cash xxx
iii) YE Interest accrual using effective interest method
(if lease anniversary date differs from YE date)
Interest expense xxx
Lease liability ** xxx
iv) Annual Depreciation (in this course)
Depreciation expense xxx
Accumulated deprec’n – RofU asset xxx
** Easier to use LL for both lease payments and interest accruals,
ie. ignore ‘interest payable’ contrary to text illustrations.
B3) Comprehensive Illustration # 1 – Comparison Between RoU and
Classification Approaches (for Lessee)
Lease terms and expectations:
Right-of-use or leased asset Equipment
Economic life 5 years SL with no residual value
Lease term Jan 1, 20 23 to Dec 3 1, 202 7
Lease payments $25,982 per year in advance including $2,
of executory costs for mtce
Renewal option Not applicable
FV of leased asset $100,000 at Jan. 1, 20 23
Lessor’s initial direct costs $
Contingent rental payments Not applicable
No BRO and no BPO/GRV when asset reverts back to lessor at end of lease
Lessee’s IBR 11%; lessor’s IIR 10% and known to lessee
Lessee has Dec 31 YE
Required
Determine lease type under both IFRS and ASPE, then do JEs for parts a) to d)
a) Basic lease JEs with no GRV/BPO nor UGRV for Jan 1 23 , Dec 31 2 3 , Jan 1
24 , Dec 31 2 7 and supporting amortization table.
b) JEs assuming both $5,000 and $3,000 GRV/BPO.
c) JEs assuming $5,000 UGRV.
d) JEs assuming $5,000 BPO only.
B3) a) Cont’d) IFRS ASPE Dec 31, 20 23 - Year end (cont’d) Depreciation expense $________ A/D - RoU – equipment $________ Mtce expense $________ Prepaid mtce expense $________ Jan 1, 20 24 – 2 nd^ lease payment Prepaid mtce expense $________ Lease liability $________ Cash $________ Dec 3 1 20 27 - End of lease (fully depreciated) A/D – RoU asset – equip. $________ Right-of-Use asset – equip. $________
B3(a) Cont’d Basic Lessee Amortization Table with no GRV/BPO nor UGRV (Annuity Due = Beginning of Period Payment) Lease Beginning Interest 1 January Principal Ending Year Balance at 10% Payment Decrease Balance 1 $100,000 $ - $23,982 $ (23,982) $76, 2 76,018 7,602 23,982 (16,380) 59, 3 59,638 5,964 23,982 (18,018) 41, 4 41,620 4,162 23,982 (19,820) 21, 5 21,800 2,180 23,982 (21,802) (2) rounding $19,908 $119,910 $100,00 2 Instead of reverting back to lessor, assume lessee makes ‘new deal’ to buy equipment at end of lease for $5,000 expecting to use for 2 more years (not a BPO). IFRS ASPE Dec 31 202 7 , End of lease A/D – Right-of-Use asset – equip. $________ Right-of-Use asset – equip. $________ Used equipment $________ Cash $________
B3(b) Cont’d Jan 1, 2023 - Lease inception Right-of-use asset – equipment $________ Lease liability $________ Prepaid mtce expense $________ Lease liability $________ Cash $________ Dec 31, 20 23 – Year end Interest expense $________ Lease Liability $________ Depreciation expense $________ A/D - Right-of-use asset – equip. $________ Mtce expense $________ Prepaid mtce expense $________ Jan 1, 20 24 – 2 nd lease payment Prepaid mtce expense $________ Lease liability $________ Cash $________
B3(b) Cont’d If FMV of equipment at end of lease only $3,000 vs GRV of $5,000 (BPO excluded here) Dec 31 202 7 - End of lease Interest expense $________ Lease Liability $________ A/D – Right-of-Use asset $________ Lease liability $________ Right-of-Use asset $________ Loss on right-of-use asset $________ Cash $________ B3(c) JEs Assuming UGRV - Lessee Lessee’s capitalized amount if UGRV part of lease PV of annual lease pymts per above $__________ PV of UGRV (not included in MLPs) $__________ Capitalized amount $__________ Lessee Amortization Table with UGRV (Annuity Due = Beginning of Period Payment) Lease Beginning Interest 1 January Principal Ending Year Balance at 10% Payment Decrease Balance 1 $96,895 $ - $23,237 $(23,237) $73,658 NOTE – Lessor amort. table would 2 73,658 7,366 23,237 (15,871) 57,787 include $100,000 as beginning 3 57,787 5,779 23,237 (17,458) 40,329 balance and $5,000 UGRV at end. 4 40,329 4,033 23,237 (19,204) 21, 5 21,125 2,113 23,237 (21,124) (1) rounding $19,291 $116,185 ($96,894)
