MODULE ACCOUNTING FOR GOVERNMENT AND NON-PROFIT ORGANIZATIONS

CHAPTER 13 LEASES

Learning Objectives

Differentiate between a finance lease and an

operating lease.

Account for finance leases by lessees and by

lessors.

Account for operating leases by lessees and

by lessors.

Definition of a Lease

 Lease is an agreement whereby the lessor conveys

to the lessee, in return for a payment or series of
payments, the right to use an asset for an agreed
period of time.

Classification of Leases

1. Finance lease – is a lease that transfers

substantially all the risks and rewards incidental to
ownership of an asset.

2. Operating lease – is a lease that does not transfer substantially all the risks and
rewards incidental to ownership of an asset.

Finance lease

Any of the following would lead to a finance lease classification:

1. Transfer of ownership

2. Bargain purchase option

3. The lease term is for the major part of the economic life of the asset (‘75%
criterion’).

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4. The present value of the minimum lease payments is at least substantially all of
the fair value of the leased asset (‘90% criterion’).

5. The leased asset is specialized nature.

Lease of Land and Building

 The land and building elements of a lease contract are classified separately as
either operating or finance lease.

 Lease payments are allocated based on relative fair values.

 If no reliable allocation basis exists, the entire lease is classified as a finance

lease, unless it is clear that both elements are operating leases.

 If the land element is immaterial, both elements are treated as a single unit and
classified as finance or operating lease. The economic life of the buildings is
regarded as the economic life of the entire leased asset.

Inception and Commencement

 Inception of the lease – is the earlier of the date of the lease agreement and the
date of commitment by the parties to the principal provisions of the lease. It is on
this date that:

a. A lease is classified as either an operating or a finance lease; and

b. In the case of a finance lease, the amounts to be recognized at the

commencement of the lease term are determined.

 Commencement of the lease term – is the date from which the lessee is entitled
to exercise its right to use the leased asset. It is on this date that any asset or
liability resulting from the lease is initially recognized.

Accounting for Finance lease by Lessees

 At the commencement date, a lessee recognizes the asset acquired under a

finance lease and the related lease liability measured at the lower of the:

a. fair value of the leased property at inception date; and

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b. present value of the minimum lease payments at inception date

Minimum Lease Payments

 Minimum lease payments include the following:

1. Rentals, excluding contingent rent, costs for services and taxes

reimbursable to the lessor;

2. Bargain purchase option; and

3. Guaranteed residual value

 The MLP are discounted using the interest rate implicit in the lease, if this is
determinable; if not, the lessee’s incremental borrowing rate is used.

 Initial direct costs are capitalized as part of the asset recognized.

Subsequent measurement

 The lease liability is subsequently measured at amortized cost.

 The leased asset is accounted for similar to an owned asset. Accordingly, the
leased asset is depreciated using the entity’s existing depreciation policies.

 If there is no reasonable certainty that the lessee will obtain ownership by the
end of the lease term, the asset shall be depreciated over the shorter of its
useful life and the lease term.

Accounting for Finance lease by Lessors

 A lessor recognizes the lease payments receivable under a finance lease at an

amount equal to the net investment in the lease.

 Initial direct costs are included in the initial measurement of the finance lease
receivable and reduce the amount of revenue recognized over the lease term.
The interest rate implicit in the lease is defined in such a way that the initial direct
costs are included automatically in the finance lease receivable. Therefore, there
is no need to add the initial direct costs separately.

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Interest rate implicit in the lease

 Interest rate implicit in the lease – is the discount rate that, at the inception of the
lease, causes the aggregate present value of:

1. The minimum lease payments; and

2. The unguaranteed residual value,

To be equal to the sum of (a) the fair value of the leased asset and (b) any initial direct
costs of the lessor.

 The lease receivable (net investment) is subsequently measured at amortized

cost.

Operating lease

 A lessee (lessor) under an operating lease recognizes the lease payments as

expense (income) on a straight line basis over the lease term, unless another
systematic basis is more representative of the time pattern of the user’s benefit.

 Initial direct costs incurred by lessors are added to the carrying amount of the
leased asset and recognized as expense over the lease term on the same basis
as the lease income.

 Initial direct costs incurred by lessees (such as lease bonus paid to the lessor)
are treated as prepaid rent and recognized as expense on the same basis as the
lease expense.

To know more information about CHAPTER 13-LEASES- PLEASE CLICK THE LINK:
https://www.youtube.com/watch?v=bv9gF69NJrE

To know more information about CHAPTER 13-Financial and operating lease- PLEASE
CLICK THE LINK: https://www.youtube.com/watch?v=g2EGvxAVh1I

Reference:

Accounting for Government and Non-profit Organization by Zeus Vernon B.

Millan

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