📈Financial Accounting II Unit 9 – Lease Accounting: Lessee and Lessor
Lease accounting is a critical area of financial reporting that governs how companies record and report lease transactions. It covers both lessee and lessor perspectives, addressing the recognition, measurement, and disclosure of lease agreements on financial statements.
Recent changes in accounting standards have significantly impacted lease accounting practices. These changes aim to provide greater transparency by requiring most leases to be recorded on the balance sheet, affecting key financial metrics and decision-making processes for businesses across various industries.
Lease a contractual agreement where the lessor grants the lessee the right to use an asset for a specified period in exchange for consideration (rent payments)
Lease term the non-cancellable period for which a lessee has the right to use an underlying asset, including optional periods when reasonably certain to be exercised
Right-of-use asset represents the lessee's right to use the underlying asset over the lease term
Lease liability the lessee's obligation to make lease payments arising from a lease, measured on a discounted basis
Calculated as the present value of remaining lease payments using the discount rate for the lease
Short-term lease a lease with a lease term of 12 months or less that does not include a purchase option
Lease payments include fixed payments, variable lease payments that depend on an index or rate, residual value guarantees, and penalties for terminating the lease if reasonably certain to be exercised
Discount rate for the lease the rate implicit in the lease unless not readily determinable, in which case the lessee's incremental borrowing rate is used
Types of Leases
Finance lease (capital lease under previous GAAP) transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee
Lessee recognizes a right-of-use asset and lease liability on the balance sheet
Lease payments are allocated between interest expense and reduction of the lease liability
Operating lease all leases that do not meet the criteria for classification as a finance lease
Lessee recognizes a right-of-use asset and lease liability on the balance sheet
Lease expense is recognized on a straight-line basis over the lease term
Sales-type lease lessor transfers control of the underlying asset and recognizes a net investment in the lease and profit or loss at lease commencement
Direct financing lease lessor transfers substantially all the risks and rewards of ownership but does not transfer control, recognizing a net investment in the lease at commencement
Leveraged lease a lease that involves a lessor, lessee, and long-term creditor providing financing; not covered under the new lease accounting standards (ASC 842 and IFRS 16)
Lessee Accounting
At lease commencement, the lessee recognizes a right-of-use asset and lease liability for all leases with a term greater than 12 months, unless the underlying asset is of low value
Initial measurement of the right-of-use asset includes the lease liability, initial direct costs, prepaid lease payments, and estimated costs to dismantle or remove the asset, less any lease incentives received
Lease liability is initially measured at the present value of remaining lease payments using the discount rate for the lease
Subsequent measurement of the right-of-use asset depends on the lease classification (finance or operating)
Finance leases the asset is depreciated over the shorter of the lease term or useful life, and interest expense is recognized on the lease liability using the effective interest method
Operating leases the asset is depreciated on a straight-line basis over the lease term, and a single lease expense is recognized on a straight-line basis
Remeasurement of the lease liability is required when there is a change in future lease payments (due to a change in index or rate) or a change in the assessment of options to extend or terminate the lease
Lessor Accounting
Lessor classifies leases as sales-type, direct financing, or operating at lease commencement
Sales-type lease lessor derecognizes the underlying asset, recognizes a net investment in the lease (lease receivable and unguaranteed residual asset), and recognizes selling profit or loss
Selling profit or loss is the difference between the fair value of the underlying asset (or lease payments if lower) and its carrying amount
Direct financing lease lessor derecognizes the underlying asset and recognizes a net investment in the lease, but does not recognize selling profit or loss at commencement
Interest income is recognized over the lease term using the effective interest method
Operating lease lessor continues to recognize the underlying asset and recognizes lease income on a straight-line basis over the lease term
Collectability assessment lessor must assess whether it is probable that it will collect the lease payments and any residual value guarantee
If collectability is not probable, the lease is classified as an operating lease and lease income is recognized only when cash is received
Financial Statement Impact
Lessee balance sheet right-of-use assets are presented separately or combined with property, plant, and equipment; lease liabilities are presented separately or combined with other financial liabilities
Finance lease assets and liabilities may be presented separately from operating lease assets and liabilities
Lessee income statement finance leases result in interest expense and depreciation expense, while operating leases result in a single lease expense on a straight-line basis
Lessee cash flow statement cash payments for the principal portion of finance lease liabilities are classified as financing activities, while interest payments and operating lease payments are classified as operating activities
Lessor balance sheet sales-type and direct financing leases result in a net investment in the lease (lease receivable and unguaranteed residual asset), while operating leases continue to present the underlying asset
Lessor income statement sales-type leases may result in selling profit or loss at commencement, while direct financing and operating leases result in interest income and lease income, respectively
Disclosure Requirements
Lessee disclosures include a description of leases, basis and terms of variable lease payments, existence and terms of options to extend or terminate leases, and restrictions or covenants imposed by leases
Quantitative disclosures include lease costs, weighted-average remaining lease term, and weighted-average discount rate for finance and operating leases
Maturity analysis of lease liabilities, separately for finance and operating leases
Lessor disclosures include a description of leases, basis and terms of variable lease payments, and lease income recognized
For sales-type and direct financing leases, the components of the net investment in the lease and a maturity analysis of lease receivables
For operating leases, the maturity analysis of lease payments and disclosure of the underlying assets subject to operating leases
Sale and leaseback transactions require disclosure of the main terms and conditions, any gains or losses arising from the transaction, and the cash flows between the seller-lessee and buyer-lessor
Sublease disclosures include the income from subleasing right-of-use assets and a maturity analysis of sublease receivables
Practical Examples and Calculations
Example 1 Lessee enters into a 5-year lease for equipment with annual lease payments of $10,000, payable at the beginning of each year. The implicit rate is not readily determinable, so the lessee uses its incremental borrowing rate of 6%.
Lease liability at commencement: 43,553(presentvalueof5paymentsof10,000 at 6%)
Right-of-use asset at commencement: $43,553 (equal to the lease liability)
Annual interest expense: 2,613inYear1(643,553), decreasing each year as the lease liability is reduced
Example 2 Lessor leases a machine with a fair value of 100,000andacarryingamountof80,000 for 5 years. The lease payments are 20,000peryear,payableatthebeginningofeachyear.Themachinehasanestimatedusefullifeof7yearsandaresidualvalueof20,000.
The lease is classified as a sales-type lease because the present value of the lease payments ($86,563 at an implicit rate of 5%) exceeds substantially all of the fair value of the machine.
At commencement, the lessor recognizes a lease receivable of 86,563,anunguaranteedresidualassetof13,437 (20,000discountedat520,000 (100,000−80,000).
Interest income is recognized each year using the effective interest method, and the lease receivable is reduced by the lease payments received.
Recent Changes and IFRS vs. GAAP Differences
ASC 842 (US GAAP) and IFRS 16 (IFRS) became effective for public companies in 2019 and 2020, respectively, replacing the previous lease accounting standards (ASC 840 and IAS 17)
The new standards require lessees to recognize right-of-use assets and lease liabilities for most leases, eliminating the previous classification of operating leases as off-balance sheet
Key differences between ASC 842 and IFRS 16 include:
Low-value asset exemption IFRS 16 allows lessees to elect not to recognize assets and liabilities for leases of low-value assets, while ASC 842 does not provide this exemption
Sublease classification ASC 842 requires sublessors to classify subleases with reference to the underlying asset, while IFRS 16 requires classification with reference to the right-of-use asset
Lessor accounting ASC 842 provides a practical expedient allowing lessors to not separate non-lease components from the associated lease component, while IFRS 16 does not include this practical expedient
Sale and leaseback transactions both standards include new guidance on determining whether a sale has occurred in a sale and leaseback transaction, based on the transfer of control
If a sale has occurred, the seller-lessee recognizes the transaction price and a lease liability, while the buyer-lessor recognizes the underlying asset and a lease receivable
If a sale has not occurred, the transaction is accounted for as a financing arrangement by both parties