💰Intermediate Financial Accounting II Unit 3 – Lease Accounting Fundamentals

What's This Unit All About?

• Focuses on the accounting treatment for leases from both the lessee and lessor perspectives
• Covers the classification of leases as either operating or finance leases
• Explores the initial recognition, measurement, and subsequent accounting for lease transactions
• Discusses the presentation and disclosure requirements for leases in financial statements
• Introduces the concept of lease modifications and reassessments and their impact on accounting
• Highlights the differences between the accounting for operating and finance leases
• Emphasizes the importance of understanding lease accounting for real-world applications

Key Concepts and Definitions

• Lease: a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration
• Lessee: the party that obtains the right to use an underlying asset for a period of time in exchange for consideration
• Lessor: the party that provides the right to use an underlying asset for a period of time in exchange for consideration
• Lease term: the non-cancellable period of the lease, together with optional renewal periods and termination options
• Lease payments: the payments made by the lessee to the lessor for the right to use the underlying asset
  • Includes fixed payments, variable payments based on an index or rate, and residual value guarantees
• Discount rate: the rate used to calculate the present value of lease payments
  • Lessees use the implicit rate in the lease if readily determinable, otherwise, they use their incremental borrowing rate

Types of Leases

• Operating lease: a lease that does not transfer substantially all the risks and rewards incidental to ownership of the underlying asset
  • Lessee recognizes lease payments as an expense on a straight-line basis over the lease term
  • Lessor continues to recognize the underlying asset on its balance sheet
• Finance lease: a lease that transfers substantially all the risks and rewards incidental to ownership of the underlying asset
  • Lessee recognizes a right-of-use asset and a lease liability on its balance sheet
  • Lessor derecognizes the underlying asset and recognizes a lease receivable and residual asset
• Short-term lease: a lease with a lease term of 12 months or less and does not include a purchase option
  • Lessees may elect not to recognize a right-of-use asset and lease liability for short-term leases
• Sublease: a transaction in which the original lessee becomes the lessor and leases the underlying asset to a third party
  • The original lessee accounts for the head lease and sublease as separate contracts

Accounting for Operating Leases

• Lessee accounting:
  • Recognize lease payments as an expense on a straight-line basis over the lease term
  • Disclose future minimum lease payments in the notes to the financial statements
• Lessor accounting:
  • Continue to recognize the underlying asset on the balance sheet
  • Recognize lease income on a straight-line basis over the lease term
  • Depreciate the underlying asset over its useful life
• Example: Company A leases office space for a 5-year term with annual lease payments of $100,000
  • Company A (lessee) recognizes annual lease expense of $100,000
  • The lessor recognizes annual lease income of $100,000 and continues to depreciate the office building

Accounting for Finance Leases

• Lessee accounting:
  • Recognize a right-of-use asset and lease liability at the commencement date of the lease
    • Right-of-use asset: measured at the initial amount of the lease liability, plus any initial direct costs and prepaid lease payments, minus any lease incentives received
    • Lease liability: measured at the present value of lease payments, discounted using the appropriate discount rate
  • Depreciate the right-of-use asset over the shorter of the lease term or the useful life of the underlying asset
  • Recognize interest expense on the lease liability using the effective interest method
• Lessor accounting:
  • Derecognize the underlying asset and recognize a lease receivable and residual asset
    • Lease receivable: measured at the present value of lease payments, discounted using the implicit rate in the lease
    • Residual asset: measured at the present value of the expected residual value of the underlying asset at the end of the lease term
  • Recognize interest income on the lease receivable using the effective interest method
  • Recognize any profit or loss on the transaction at the commencement date
• Example: Company B leases equipment for a 4-year term with annual lease payments of $50,000 and an implicit rate of 6%
  • Company B (lessee) recognizes a right-of-use asset and lease liability of $173,554 (present value of lease payments at 6%)
  • The lessor derecognizes the equipment and recognizes a lease receivable of $173,554 and a residual asset

Lease Modifications and Reassessments

• Lease modification: a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions
  • Accounted for as a separate lease if the modification grants the lessee an additional right-of-use and the consideration for the lease increases commensurate with the standalone price for the additional right-of-use
  • If not accounted for as a separate lease, the lessee remeasures the lease liability using a revised discount rate and makes a corresponding adjustment to the right-of-use asset
• Reassessment of lease term or purchase option: required when there is a significant event or change in circumstances that is within the control of the lessee
  • Lessee remeasures the lease liability using a revised discount rate and makes a corresponding adjustment to the right-of-use asset
• Example: Company C modifies its lease agreement to extend the lease term by 2 years and increase the annual lease payments by $10,000
  • If the modification is not accounted for as a separate lease, Company C remeasures the lease liability using a revised discount rate and adjusts the right-of-use asset accordingly

Financial Statement Impact

• Balance sheet:
  • Lessees recognize right-of-use assets and lease liabilities for finance leases
  • Lessors recognize lease receivables and residual assets for finance leases
• Income statement:
  • Lessees recognize lease expense (operating leases) or depreciation and interest expense (finance leases)
  • Lessors recognize lease income (operating leases) or interest income and any profit or loss (finance leases)
• Statement of cash flows:
  • Lease payments are classified as operating activities (operating leases) or financing activities (finance leases)
• Notes to the financial statements:
  • Disclose information about the nature of leases, significant judgments made, and amounts recognized in the financial statements
  • Provide a maturity analysis of lease liabilities (lessees) or lease receivables (lessors)

Real-World Applications

• Retail and commercial real estate: many businesses lease store locations, offices, and warehouses
  • Understanding lease accounting is crucial for accurately reporting financial performance and making informed decisions about leasing versus buying properties
• Equipment and vehicle leasing: companies often lease equipment (construction, manufacturing) and vehicles (fleet management) instead of purchasing them outright
  • Lease accounting helps companies assess the financial impact of leasing decisions and compare the costs and benefits of different leasing arrangements
• Airlines and transportation: airlines lease a significant portion of their aircraft fleet
  • Proper lease accounting is essential for airlines to manage their balance sheets, assess their financial leverage, and make strategic decisions about fleet composition
• Telecommunications and technology: companies in these industries often lease network infrastructure, data centers, and IT equipment
  • Lease accounting enables these companies to accurately reflect the costs and obligations associated with leased assets in their financial statements