Far 3-Accounting for Leases

a lease is a contract, which conveys the right to possess and use the lessor's property for a specified period in time in return for periodic cash payments by the lessee to the lessor. Our goal is to recognize the true substance over form of the lease. It may be a true rental(operating lease) or it could be a purchase and sale, which transfers all the rights and risks of ownership(Capital/Non-operating lease).

Operating lease is a lease where the rights and risks of ownership don't transfer, considered a true rental.

So we have a Lessor and Lessee and under operating simply record the following:

• Lessor
• Cash x
•     Rent Revenue x

• Lessee
• Rent Expense x
•     Cash x

• On the lessor's side:
• -Depreciates the asset because he still owns it.
• -Direct lease costs(commissions, legal fees) are amortized S/L over the lease term.
• -Executory cost(taxes, insurance, maintenance) are recognized as incurred.
• -Lease bonus is deferred(unearned revenue) and amortized over the life of lease)
• -Rent received in advance is considered unearned(deferred revenue)
• -Security Deposits-nonrefundable(unearned revenue until earned). refundable(liability until returned).
• -Uneven rental payments are recognized uniformily(evenly) over the lease term(free rent for example).
• -Termination costs should be measured and recognized at the fair value at the date the agreement is terminated.

• On the Lessee side:
• -Lease rent expense is recognized uniformly
• -Lease bonus is considered an asset and amortized S/L over the lease term.
• -Leasehold improvements are reported with PP&E and amortized over the shorter of legal life or useful life.
• -Refundable security deposits are assets(receivable)
• -Per FASB 146 early termination costs must be recognized immediately at the fair value of the lessee.

• Capital Lease looks at the lessee perspective- a lease where the right and risks of ownership of the asset does change. Treat the lease as a purchase because of substance over form. So to see if its a Capital Lease it has to meet 1 to 4 criteria. The 4 criteria:
• 1. TT-Title Transfer at the end of the lease.
• 2. BPO-Bargain Purchase Option
• 3. 75-Lease term greater than 75% useful life.
• 4. 90-MLP greater than 90% of FMV of Assets.

The lessee records the lease at the lower of FV or PVMLP. PVMLP(includes annual payments+BPO+Guaranteed Residual Value)

*the rate used for PVMLP should be the incremental borrowing rate or the implicit rate if its known and lower.

so here are the journal entries for a Capital Lease:

• Day 1
• Lease Asset 428415
•     Lease Liability 428415

• First payment(day 1)
• Lease Liability 75000
•     Cash 75000

• Second payment(year later)
• Lease Liability 36124(plug)
• Interest Exp 38876(below)
•     Cash 75000
• *(428415-75000=353415 x 11% = 38876 interest)

• Depreciation(lessee owns asset now)- if criteria 1 or 2 are met then depreciate the asset over the useful life and take out salvage value. if criteria 3 or 4 are met then depreciate over the useful life and lease term and ignore salvage value. Entry is:
• Depreciate x
•     Accumulated Dep. x

in this perspective we are looking at the lessor and if the lease meets the 4 criteria(TT,BPO,75,90) so that the asset is essentially purchased we have 2 types of non-operating leases.

1. Sales-Type Lease- this is a lease where the seller is manufacturer or dealer of the asset, and uses the lease as a way of selling the asset. Includes both Profit and Interest. So lets look at sample example:

• Lease Receivable 600000(75 x 8yrs)
•     Deferred Interest 171585(rec down to pv)
•     Asset 400000(CV)
•     G/L 28415

*The interest payment collected will be calculated by multiplying the PV of the Receivable. Remember the interest exp should match the interest receivable.

2. Direct financing lease- a lease where the equipment is not acquired by purchasing it, but, instead, by entering into a lease agreement with lease company. They are no manufacturer of product so no profit recognized. Journal entry is simplier as g/l is put into unearned interest.

• Lease Receivable x(MLP-Residual)
•     Asset x(CV)
•     Unearned Interest Revenue x(plug)

The property owner sells the property, then immediately leases all or part of it back from the new owner. It is considered two separate and distinct economic transactions. The leaseback may either be an operating lease or a capital lease depending on the criteria ect. So here is how we account for these:

1. If PVMLP is greater than 90% of the FV of the asset being leased, this implies the seller-lessee retains substantially all the rights to use of the property and is accounted for as a Capital Leaseback. In this defer all gain and offset against depreciation exp.

2. If PVMLP is greater than 10% but less than 90% of the FV could be either Operating or Capital Leaseback based on the 4 criteria(TT,BPO,75,90). In this scenario we defer the gain up to the PVMLP, and recognize the rest immediately. If capital defer gain against depreciation exp. If operating defer gain against rent exp.

3. If PVMLP is less than 10% of the FV of the asset then its an operating leaseback and the entire gain is recognized, because they don't own property.

• Initial sale entry
• Cash x
•     Asset x(cv)
•     Defer gain x(plug)

• Operating Leaseback
• Defer Gain x
•     Rent exp x

• Capital Leaseback
• Defer Gain x
•     Depreciation x

Under IFRS, a lease is classified as either an operating lease or a finance lease(known as a capital lease under GAAP) for both the lessee and the lessor.

Operating Lease- lease payments are recognized as expense on a straight-line basis over the lease term. The lessee must disclose the in the footnotes the total future minimum payments for the next 12 months.

• Finance Lease- to be a finance lease has to meet 1 of 4 criteria.
• 1. TT
• 2. BPO
• 3. PVMLP equal substantially all the FV of asset.
• 4. The asset is leased for substantially all of its useful life.
• *under IFRS no thresholds but what matters is that its substantially all which infers professional judgement.