Leases

Learning Objectives
1. Differentiate between a finance lease and an operating lease.
2. Account for finance leases by lessees and by lessors.
3. 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’).
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
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.
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.