1. Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto Chapter 20 Leases Chapter 20 Leases

2. 2 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

3. 3 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

4. 4 Leasing: Basics The lease is a contractual agreement between the lessor and the lessee The lease gives the lessee the right to use specific property (owned by the lessor) The lease specifies also the duration of the lease and rental payments The obligations for taxes, insurance, and maintenance (executory costs) may be assumed by the lessor or the lessee or divided

5. 5 Advantages of Leasing 100 percent financing at a fixed rate –No down payment required –Rate charged is fixed for the term of the lease Protection from obsolescence –Property can be upgraded Flexibility –Lease may be structured to meet different needs (e.g., cash flow) Less costly financing (lessee); tax incentives (lessor) Off-balance sheet financing –Impact on ratios

6. 6 Conceptual Nature of Lease 1.Do not capitalize any leased assets – an executory contract approach –Since lessee does not own the property, capitalization is considered inappropriate –Since executory contracts are not capitalized, leases should not be either 2.Capitalize leases that are similar to instalment purchases – a classification approach –if instalment purchases are capitalized, so should leases with similar characteristics 3.Capitalize all long-term leases – a contract-based approach –The long-term right to use property justifies its capitalization

7. 7 Current Accounting Standard Current IFRS, PE GAAP, and FASB standards are consistent with classification approach –A lease that transfers substantially all the benefits and risks of property ownership should be capitalized (classified as capital lease) –A lease where benefits and risks of ownership are not transferred is classified as operating lease Proposed IASB and FASB converged lease accounting standard is based on the contract- based approach

8. 8 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

9. 9 Lease Classification Capital Lease Where the benefits and risks of ownership have effectively been transferred to the lessee Accounted for as a purchase by the lessee Under IFRS, capital leases is called finance leases Journal Entries: LesseeLessor Leased EquipmentXXX Lease Receivable (net)XXX Lease Obligation XXX Equipment XXX

10. 10 Lease Classification Operating Lease Where the rights and risks of ownership have not been transferred A rental-only has occurred Journal Entries: LesseeLessor Rent ExpenseXXXCashXXX Cash XXX Rental Income XXX

11. 11 Most important factor in determining whether a lease is capital is whether risks and rewards have transferred from lessor to lessee. Both IFRS and PE GAAP provide specific guidelines to help determine whether risks and rewards have transferred. Capital Lease Criteria

12. 12 Under IFRS any one of the following normally indicates a finance lease: 1.Reasonable assurance that ownership will transfer to lessee at end of lease term –It is assumed that bargain purchase option (BPO) will be exercised by lessee if available 2.Lease term allows lessee to get substantially all economic benefits that could be expected from using the leased asset over its entire life 3.Lease terms allow lessor to recover substantially all investment in leased asset, and also earn a rate of return –If PV of minimum lease payments (MLP) is close the fair value of the leased asset 4.Leased asset is specialized and can only be used by lessee (without major modifications) Capital Lease Criteria: IFRS

13. 13 Under PE GAAP any one of the three requirements normally indicates a capital lease: 1.[as #1 under IFRS] 2.[as #2 under IFRS] –Additional threshold: assumed if lease term is  75% of lease asset’s economic life 3.[as #3 under IFRS] –Additional threshold: assumed if PV of minimum lease payments (excluding executory costs) is  90% of the fair value of the leased asset Capital Lease Criteria: PE GAAP

14. 14 Minimum lease payments (lessee) defined: Minimum rental payments + Amounts guaranteed + Bargain purchase option Minimum rental payments Regular payment made to lessor, excluding executory costs Executory costs include insurance, maintenance and tax expenses. If these payments made by the lessor, they are estimated and excluded from the PV of minimum rental payment calculation Minimum Lease Payments

15. 15 Minimum Lease Payments Guaranteed amounts Guaranteed residual value (GRV): guaranteed value of the leased asset at the end of the lease term For lessee, maximum amount lessor can require lessee to pay at end of the lease Bargain Purchase Option (BPO) An option to purchase the leased asset at the end of the lease at a price below expected fair value If included as part of lease, only minimum lease payments and bargain purchase option included in definition of minimum payments

16. 16 Incremental borrowing rate: the rate the lessee would have incurred if they had borrowed the funds to purchase the asset –Under similar term (length) and similar security (same type of asset) Rate implicit in the lease: rate that makes PV of MLP + unguaranteed residual values = FV of leased asset Under IFRS, use rate implicit in the lease if it is reasonably determinable Under PE GAAP, use lower of two rates Discount Rate

17. 17 Lessor sets rental payments to have specific rate of return (i.e. the implicit rate) on leasing the asset If the lease has BPO or residual value, then those components do not need to be recovered through rental payments Determining Rental Payments

18. 18 Calculate the payment required to provide lessor with required rate of return Cost/FMV of asset to be recovered $100,000 Less: PV of expected residual value -0- Amount to be recovered through lease payments $100,000 Calculation of Lease Payment by Lessor

19. 19 Amount to be recovered $100,000 Payments: (n=5, i=10) $100,000 4.16986 = $23,981.62 Total lease payments: 5 x $23,981.62 = $119,908.10 Calculation of Lease Payment (Cont’d)

20. 20 Asset and liability recorded at the lower of: 1.PV of the minimum lease payments (as defined above) and 2.Fair value of the asset at the inception of the lease Depreciation of the asset is amortized over: –The economic life of the asset if ownership transfers to lessee at the end of the lease or there is a bargain purchase option –The term of the lease if title does not transfer to the lessee or there is no bargain purchase option Accounting for a Capital Lease

21. 21 Interest expense resulting from the lease transaction is recorded following the effective interest method –The discount rate used to establish the initial PV is used to amortize the lease –Each lease payment is allocated between principal and interest Journal entries required to record a capital lease transaction are as follows: Accounting for a Capital Lease

22. 22 Accounting for a Capital Lease At the inception of the lease Dr. Asset under Capital Lease Cr.Obligations under Capital Lease To record interest Dr. Interest Expense Cr.Interest Payable Using the Effective Interest Method To record asset amortization Dr. Amortization Expense Cr.Accumulated Amortization Using method appropriate to the asset To record the lease payment Dr. Related Executory Expense (if any) Dr. Interest Payable Dr. Obligations under Capital Lease Cr.Cash

23. 23 Capital Lease - Example Lease Terms Given: Term of 5 years, non-cancellable Annual payments $25,981.62 (due at beginning of each year, starting January 1, 2010) Fair value of asset $100,000 Economic life = 5 years Residual value = Zero Lease payments include $2,000 property taxes (executory cost) Lease has no renewal option, and asset reverts to Lessor at termination of lease Lessee’s incremental borrowing rate = 11% Lessor’s implicit rate =10% (known to lessee) Similar assets are depreciated using straight-line method

24. 24 Capital Lease - Example Does this qualify as a capital lease? –Yes, under both IFRS and PE GAAP Only one of the tests must be met (PE GAAP thresholds illustrated) Is there a Transfer of Ownership or Bargain Purchase Option? Is Lease Term  75% of Economic Life? Is Present Value of Payments  90% of Fair Value? No Capital Lease Yes PV of payments (n=5, i=10%) 25,981.62 - 2000.00 = 23,981.62 x 4.16986 = $100,000.00 Yes

25. 25 Entry to record initial lease transaction Equipment under Capital Lease100,000 Obligations under Capital lease 100,000 Entry to record initial payment (Jan 1/10) Property Tax Expense 2,000.00 Obligations under Capital Lease 23,981.62 Cash 25,981.62 As this is a capital lease the following must also be recorded (at year end or in each reporting period) –Interest expense –Asset amortization Capital Lease - Example

26. 26 Record Interest (December 31, 2010) Interest Expense7,601.84 Interest Payable 7,601.84 (100,000-23,981.62)*10% = 7,601.84 (Interest Payable is debited in all subsequent lease payment entries) Asset amortization (December 31, 2010) Amortization expense20,000 Accumulated amortization20,000 (100,000 / 5 years = 20,000) (There is no transfer of ownership or bargain purchase option, so the term of the lease is used to amortize the asset) Capital Lease - Example

27. 27 Capital Lease - Example Financial Statement Presentation (as at December 31, 2010): Balance Sheet Current liabilities Interest payable$7,601.84 Obligations under capital leases16,379.78 (as per amortization schedule) Non-current liabilities Obligations under capital leases $59,638.60

28. 28 Capital Lease - Example Lease payment on January 1, 2011 Property Tax Expense 2,000.00 Interest Payable 7,601.84 Obligations under Capital Leases16,379.78 Cash 25,981.61

29. 29 Other Lease Accounting Issues Residual Value – Lessee –If guaranteed by lessee, PV of residual is included in asset’s cost and lease obligation recognized (i.e. is included in definition of minimum lease payments) –If not guaranteed by lessee, residual value is not included in definition of minimum lease payments – i.e. not in asset or liability amounts recognized

30. 30 Bargain Purchase Option Lessee: –Lessee accounting assumes bargain option will be exercised –PV of option price included in asset cost and obligation recognized –Asset is amortized over economic life (not lease term), as it is assumed that BPO will be exercised and so asset will be purchased and continue to be used Other Lease Accounting Issues

31. 31 Operating Leases - Lessee Risks and benefits of ownership of leased assets are not transferred to lessee Lease payments are treated as rent expense –Dr. Rent Expense Cr. Cash / Accounts Payable

32. 32 Operating vs. Capital Leases Total expenses over lease term are same regardless of accounting method (i.e. operating vs. capital) Timing of expenses over lease term is different –Operating leases result in lower expenses in earlier years, and higher expenses in later years compared to capital leases Operating leases result in lower debt-to-equity ratio and improved return on total assets

33. 33 Current and Noncurrent Current portion = principal amount to be received/paid within 12 months from balance sheet date + interest accrued to the balance sheet date Long-term = principal amount not recoverable/payable within 12 months from balance sheet date

34. 34 Given that capital/finance leases give rise to a leased asset and long-term liability, most disclosures are covered by standards for –PP&E –Intangible assets –Financial instruments –Long-term liabilities IFRS requires additional disclosures, including: –Net carrying amount of each class of leased asset –Reconciliations of future MLP and their PV –Various lease terms (e.g. conditions relating to subleases and contingent rents) Disclosure Requirements – Capital/Finance Leases

35. 35 Operating Leases Lessees must disclose: –Future minimum lease payments extending into the future –IFRS requires additional disclosures relating to various lease terms (e.g. conditions relating to subleases and contingent rents)

36. 36 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

37. Classification Approach - Lessors TypePE GAAPIFRS OperatingOperating lease Financing lease: Sales-typeSales-type leaseManufacturer or dealer lease Or Financing-typeDirect financing leaseOther finance lease 37

38. 38 How does the lessor determine whether the lease is a capital/finance lease? IFRS: lessor uses same criteria as lessee PE GAAP: lessor uses same criteria as lessee as well as additional two revenue recognition-based considerations that must be passed: 1.Credit risk associated with collection is normal 2.Remaining unreimbursable costs to lessor can be estimated If required criteria are not met, the lease is accounted for as an operating lease Classification Criteria - Lessor

39. 39 Both sales-type and financing-type leases are capital/finance leases The difference is whether or not there exists a manufacturer’s or dealer’s profit The sales-type lease incorporates a this profit A lease may qualify as a capital lease by the lessee and as an operating lease by the lessor Lease Classification - Lessor

40. 40 Lessor replaces investment in asset to be leased with a lease receivable Over lease term, the receivable is collected, and interest is earned Net investment in the lease = lease payments receivable – unearned interest income Financing-Type Lease - Lessor

41. 41 The lease payments receivable are equal to: Lease payments (net of executory costs) + salvage (residual) value The unearned interest revenue is the difference between the lease payment receivable and the asset cost (FMV) Financing-Type Lease - Lessor

42. 42 Financing-Type Lease - Example Lease Terms Given: Term of 5 years, non-cancellable Annual payments $25,981.62 (receivable at beginning of each year, starting January 1, 2010) Fair value of asset $100,000 Economic life = 5 years Residual value = Zero Lease payments include $2,000 property taxes (executory cost) Lease has no renewal option, and asset reverts to Lessor at termination of lease Lessor’s implicit rate (required return) =10% Collectibillity is reasonably assured No additional costs expected to be incurred by Lessor

43. 43 January 1, 2010 Lease Payments Receivable 119,908.10 Unearned Interest Income 19,908.10 Equipment for Lease100,000.00 Lease payment receivable (gross investment in lease): (25,981.62 – 2,000) x 5 = 119,908.10 Net investment in lease: 23,981.62 x 4.16986 (n=5, i=10%) = 100,000 Financing-Type Lease - Example

44. 44 January 1, 2010 (first payment) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable23,981.62 December 31, 2010 Unearned Interest Income 7,601.84 Interest Income 7,601.84 Financing-Type Lease - Example

45. 45 At Dec. 31/10 year end, Lessor recognizes interest earned: Amount originally financed $100,000.00 Paid on principal Jan. 1/10 (23,981.62) Balance outstanding $ 76,018.38 Interest : 10% x 76,018.38 x 12/12 = $7,601.84 Unearned Interest Income 7,601.84 Interest Income 7,601.84 Financing-Type Lease - Example

46. 46 Entries are the same as for financing-type lease, except for: –Entry at the inception of the lease must record the sale and cost of goods sold –Recall that the sales-type lease includes a manufacturer’s/dealer’s profit margin Lessor earns a gross profit on sale + interest as the sale is financed Sales-Type Lease - Lessor

47. 47 Sales-Type Lease – Example Take the same data as in our example, except the asset has been recorded in the Lessor’s inventory at a cost of $85,000 (FMV=$100,000) All previous lessor entries remain the same except for the entry at the lease inception –Sales and Cost of Goods Sold are recorded

48. 48 Sales-Type Lease – Example January 1, 2010 Lease Payments Receivable 119,908.10 Unearned Interest Income 19,908.10 Sales100,000.00 Cost of Goods Sold 85,000.00 Inventory 85,000.00 January 1, 2010 (first payment-remains the same) Cash ($23,981.62+$2,000) 25,981.62 Property Tax Expense 2,000.00 Lease Payments Receivable 23,981.62 December 31, 2010 (remains the same) Unearned Interest Income 7,601.84 Interest Income 7,601.84

49. 49 Residual Value – Lessor Financing-Type Lease: whether guaranteed or unguaranteed, the residual is included in the lessor calculations Sales-Type Lease: Residual value is part of Sales Revenue (and COGS) if guaranteed With unguaranteed residual value, the Sales Revenue and COGS are reduced by the PV of that unguaranteed residual value The gross profit amount on the sale is the same regardless if residual value is guaranteed or not Other Lease Accounting Issues

50. 50 Bargain Purchase Option Lessor: –With financing-type and sales-type leases, the bargain purchase price is included in the lease payments receivable and the PV of the bargain purchase option is included in net investment calculations Other Lease Accounting Issues

51. 51 Operating Leases - Lessor Risks and benefits of ownership of leased assets are not transferred to lessee Lease payments are treated as rental income Dr. Cash Cr. Rental Income Lease asset remains on lessor’s books and continues to be depreciated Dr. Depreciation expense Cr. Accumulated depreciation

52. 52 Initial Direct Costs of Lessor Costs incurred by lessor that can be directly attributable to negotiating and arranging a specific lease (e.g. legal fees, commissions, etc) General approach –Operating lease – allocated over lease term –Financing-type lease – allocated over lease term –Sales-type lease – expensed in the year costs are incurred i.e. in same period as gross profit on sale recognized

53. 53 Financing and Sales-Type Leases Under PE GAAP, disclose: –Net investment in the lease, and implicit rate –Carrying amount of impaired leases (and impairment allowance) Under IFRS, disclose more, including: –Reconciliation between PV of MLP and gross investment and amounts due over time –Unearned finance income –Unguaranteed residual values –Other Disclosure Requirements - Lessor

54. 54 Disclosure Requirements - Lessor Operating Leases Under PE GAAP, disclose: –Separate disclosure of the cost and accumulated amortization of the property Under IFRS, disclosures similar to those for financing leases Remember, disclosure requirements imposed by other (related) standards also apply (e.g. PP&E, financial instruments, impairment, etc)

55. 55 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

56. 56 Contract-Based Approach IASB and FASB have been working on a new lease standard for years Final standard is expected in 2011 There are many significant differences between the new standard (contract-based approach) and the current requirements (classification approach) Under contract-based approach, asset taken on by lessee is the right to use the leased asset

57. 57 Contract-Based Approach Lease definition under contract-based approach: –“a contract in which the right to use a specified asset is conveyed, for a period of time, in exchange for consideration” Contracts that actually do transfer control or substantially all risks and benefits of ownership are excluded from new standard –These contracts relating to in-substance purchases would be accounted for in a way similar to current capital/finance leases

58. 58 Recognition and Measurement - Lessee Initial Recognition and Measurement Assets/liabilities recognized immediately upon signing of lease contract (before asset delivered or beginning of lease) –Reported net on balance sheet Contractual lease obligation measurement considerations: –Include contingent rental payments and amounts expected to be paid under residual value guarantees –Lease term is calculated as longest possible lease term that is “more likely than not” to happen –Lessee uses incremental borrowing rate, or rate implicit in the lease (if readily determinable) –Lessee’s direct costs also capitalized

59. 59 Recognition and Measurement - Lessee Measurement after acquisition Once lease starts (and asset delivered), contractual rights and obligations no longer reported net on balance sheet Contractual lease obligation: –Accounted for at amortized cost –Estimates reassessed at every reporting date Contractual right-of-use asset: –Accounting requirements similar to those for intangible assets (including amortization, revaluation, and impairment)

60. 60 Contract-Based Approach Example Lease terms and expectations: Economic life: 7 years Lease term: Sep 1/11 to Aug 31/15 Lease payments: $5,000 per year (in advance) Renewal option: 2 additional years at $4,500/yr (option most likely to be taken by lessee) FV of leased asset at start:$24,000 Lessor’s initial direct costs:$365 Expected values of asset: –$6,000 Aug 31/15 or $1,000 on Aug 31/17 Rate implicit in lease and incremental borrowing rate are same at 9% Title retained by lessor

61. 61 Contract-Based Approach Example Lessee Accounting: Present value of amounts payable under lease contract PV rents for 4 years (Aug 31/11 to Aug 31/15) 5,000 x 3.53130 (n=4, i=9%) = 17,656 PV of rents for 2 year extensions most likely taken for 2016:4,500 x 0.70843 (n=4, i=9%) = 3,188 for 2017: 4,500 x 0.64993 (n=5, i=9%) = 2,925 23,769

62. 62 Contract-Based Approach Example Lessee Accounting – journal entries: September 1, 2011 Contractual Lease Rights23,769 Contractual Lease Obligations23,769 Contractual Lease Obligation5,000 Cash 5,000

63. 63 Contract-Based Approach Example Lessee Accounting – journal entries: December 31, 2011 Amortization Expense1,320 Contractual Lease Rights1,320 [(23,769 / 6 years) x 4/12] Interest Expense563 Interest Payable563 [(23,769 – 5,000) x.09 x 4/12]

64. 64 Recognition and Measurement - Lessor Initial Recognition and Measurement Rights and obligations are recognized immediately and reported net on balance sheet Lease receivable –Initially measured at PV of rental payments, discounted at rate charged by lessor Initial direct costs also capitalized –Accounted for at amortized cost using effective interest method Lessor may have different expectations about lease outcomes compared to lessee (e.g. renewal options taken, etc)

65. 65 Leases Leasing Basics The leasing environment Conceptual nature of a lease Current standards Classification Approach – Lessors Classification criteria Accounting for financing and sales-type leases Accounting for an operating lease Initial direct cost Lessor disclosures Time for change Classification Approach – Lessees Classification criteria How the lessor determines the rental payment Accounting for a capital lease Accounting for an operating lease Capital and operating leases compared Presentation and disclosure Contract-Based Approach Scope and definition Recognition and measurement – lessee Illustration Recognition and measurement basics – lessor New lease accounting standard IFRS / Private Enterprise GAAP Comparison Comparison of IFRS and private enterprise GAAP Looking ahead

66. 66 Looking Ahead Major changes are expected with the new IFRS leasing standard expected in 2011

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