3.2 Lessee accounting

Lessee accounting is a crucial aspect of financial reporting that impacts how companies record and report their lease obligations. It focuses on recognizing lease-related assets and liabilities on the balance sheet, enhancing transparency in financial statements.

This topic covers the types of leases, initial recognition, subsequent measurement, and financial statement presentation. It also delves into specific considerations like short-term and low-value asset leases, impairment testing, and sale-leaseback transactions.

Overview of lessee accounting

• Lessee accounting forms a crucial component of Intermediate Financial Accounting 2, focusing on how companies record and report lease transactions
• Emphasizes the recognition of lease-related assets and liabilities on the balance sheet, improving transparency in financial reporting
• Aligns with the FASB's goal of providing more accurate representation of a company's financial position and obligations

Types of leases

Operating leases

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• Represent short-term or low-value leases where the lessee does not assume significant risks or rewards of ownership
• Characterized by lease payments recognized as operating expenses on a straight-line basis over the lease term
• Do not transfer ownership of the underlying asset to the lessee at the end of the lease term
• Typically include leases for office equipment (copiers) or short-term real estate rentals

Finance leases

• Involve transfer of substantial risks and rewards of ownership to the lessee
• Recognized on the balance sheet as both an asset (right-of-use asset) and a liability (lease obligation)
• Amortization of the right-of-use asset and interest expense on the lease liability recorded separately in the income statement
• Often used for long-term leases of significant assets (aircraft, manufacturing equipment)

Initial recognition

Right-of-use asset

• Represents the lessee's right to use the leased asset during the lease term
• Measured at the initial amount of the lease liability, plus any lease payments made before commencement date
• Includes initial direct costs incurred by the lessee and estimated costs for dismantling or removing the asset
• Adjusted for any lease incentives received from the lessor

Lease liability

• Reflects the present value of future lease payments over the lease term
• Calculated using the interest rate implicit in the lease or the lessee's incremental borrowing rate
• Includes fixed payments, variable payments based on an index or rate, and amounts expected to be paid under residual value guarantees
• Excludes variable lease payments based on usage or performance of the asset

Subsequent measurement

Amortization of right-of-use asset

• Amortized on a straight-line basis over the shorter of the lease term or the useful life of the asset
• For finance leases, amortization expense recognized separately in the income statement
• For operating leases, combined with interest expense and presented as a single lease expense
• Adjusted for impairment losses, if any, recognized during the lease term

Interest on lease liability

• Calculated using the effective interest method, similar to other financial liabilities
• Interest expense decreases over time as the lease liability is reduced through lease payments
• For finance leases, interest expense presented separately in the income statement
• For operating leases, combined with amortization expense and presented as a single lease expense

Lease modifications

Reassessment of lease term

• Triggered by significant events or changes in circumstances within the lessee's control
• Requires re-evaluation of the likelihood of exercising renewal, termination, or purchase options
• May result in remeasurement of the lease liability and right-of-use asset
• Impacts include changes in lease classification or recognition of gain/loss on modification

Changes in lease payments

• Include modifications to fixed payments, variable payments based on an index or rate, or residual value guarantees
• Require remeasurement of the lease liability using revised lease payments and updated discount rate
• Right-of-use asset adjusted by the same amount as the lease liability, unless its carrying amount is reduced to zero
• May result in recognition of gain or loss if the modification is not accounted for as a separate lease

Presentation in financial statements

Balance sheet presentation

• Right-of-use assets presented separately or included within property, plant, and equipment
• Lease liabilities presented separately or included within other financial liabilities
• Current and non-current portions of lease liabilities distinguished based on payment schedules
• Disclosure of line items containing right-of-use assets and lease liabilities if not presented separately

Income statement presentation

• For finance leases, interest expense on lease liability and amortization of right-of-use asset presented separately
• For operating leases, single lease expense presented, typically as part of operating expenses
• Variable lease payments not included in lease liability recognized as expenses in the period incurred
• Gains or losses from sale and leaseback transactions presented separately

Disclosure requirements

Quantitative disclosures

• Total lease expense, including amounts for finance and operating leases
• Cash outflows for leases, separated by financing and operating activities
• Additions to right-of-use assets during the period
• Weighted-average remaining lease term and discount rate for finance and operating leases
• Maturity analysis of lease liabilities, showing undiscounted cash flows for a minimum of five years

Qualitative disclosures

• Nature of leasing activities, including types of assets leased and typical lease terms
• Significant judgments and assumptions made in applying lease accounting principles
• Information about variable lease payments, extension options, and termination options
• Restrictions or covenants imposed by leases
• Sale and leaseback transactions, including any gains or losses recognized

Short-term leases

Recognition exemption

• Applies to leases with a term of 12 months or less at commencement date
• Lessee can elect not to recognize right-of-use asset and lease liability for these leases
• Election made by class of underlying asset
• Requires consistent application to all short-term leases of the same asset class

Accounting treatment

• Lease payments recognized as expense on a straight-line basis over the lease term
• Alternatively, recognized on another systematic basis if more representative of the pattern of benefit
• Disclosure of short-term lease expense and commitments required if exemption is applied
• Reassessment required if lease term changes or a purchase option becomes reasonably certain to be exercised

Low-value asset leases

Recognition exemption

• Applies to leases of assets with a value of $5,000 or less when new
• Assessment made on an absolute basis, regardless of materiality to the lessee
• Examples include small IT equipment (laptops, tablets) or office furniture
• Cannot be applied to leases of assets that are highly dependent on or interrelated with other assets

Practical expedients

• Lessee can elect not to recognize right-of-use asset and lease liability for low-value asset leases
• Election can be made on a lease-by-lease basis
• Lease payments recognized as expense on a straight-line basis or another systematic basis
• Disclosure of low-value asset lease expense required if exemption is applied

Lease vs buy decision

Financial considerations

• Comparison of present value of lease payments to purchase price of the asset
• Analysis of impact on financial ratios (debt-to-equity ratio, return on assets)
• Evaluation of tax implications, including deductibility of lease payments vs depreciation and interest
• Assessment of impact on cash flow and working capital

Operational considerations

• Flexibility provided by leasing in terms of asset upgrades and technology changes
• Responsibility for maintenance and repairs under lease vs ownership
• Residual value risk and potential for obsolescence
• Impact on operational efficiency and ability to customize or modify assets

Impairment of right-of-use assets

Indicators of impairment

• Significant decline in market value of the leased asset
• Adverse changes in technology, market, economic, or legal environment
• Evidence of obsolescence or physical damage to the asset
• Changes in the manner or extent of use of the asset
• Economic performance of the asset worse than expected

Impairment testing process

• Performed in accordance with IAS 36 Impairment of Assets
• Right-of-use asset tested as part of the cash-generating unit to which it belongs
• Recoverable amount compared to carrying amount of the cash-generating unit
• Impairment loss recognized if carrying amount exceeds recoverable amount
• Allocation of impairment loss to assets of the unit, including right-of-use asset

Subleases

Classification of subleases

• Determined by reference to the right-of-use asset arising from the head lease, not the underlying asset
• Classified as finance lease if substantially all risks and rewards of the right-of-use asset are transferred
• Classified as operating lease if risks and rewards are not substantially transferred
• Assessment based on lease term, present value of lease payments, and other relevant factors

Accounting for subleases

• For finance subleases, head lease right-of-use asset derecognized and net investment in sublease recognized
• For operating subleases, head lease right-of-use asset retained and sublease income recognized
• Intermediate lessor continues to account for the head lease liability separately from the sublease
• Disclosure of sublease income and information about significant subleasing activities required

Sale and leaseback transactions

Determining sale occurrence

• Assessed based on whether the transfer of the asset qualifies as a sale under IFRS 15 Revenue from Contracts with Customers
• Consideration of whether the leaseback would result in the buyer-lessor obtaining control of the asset
• Evaluation of repurchase options or other provisions that may preclude sale accounting
• Analysis of whether the transaction is at fair value or includes off-market terms

Accounting implications

• If transfer qualifies as a sale, seller-lessee recognizes right-of-use asset based on proportion of previous carrying amount
• Gain or loss recognized only for the portion of rights transferred to the buyer-lessor
• If transfer does not qualify as a sale, transaction accounted for as a financing arrangement
• Buyer-lessor accounts for purchase of asset and financing provided to seller-lessee separately

Transition considerations

Modified retrospective approach

• Applied at the date of initial application without restating comparative information
• Right-of-use asset measured at an amount equal to the lease liability, adjusted for prepaid or accrued lease payments
• Lease liability measured at present value of remaining lease payments, discounted using lessee's incremental borrowing rate
• Practical expedients available, including use of hindsight and application of a single discount rate to a portfolio of leases

Full retrospective approach

• Applied retrospectively to each prior reporting period presented in accordance with IAS 8
• Requires restatement of comparative information as if the new standard had always been applied
• May result in more accurate trend information but can be more complex and time-consuming to implement
• Cumulative effect of initial application recognized in opening retained earnings of the earliest period presented