TIP: Leases are frequently tested on the CFE (CPA Canada Board exams).
As of writing this article, accounting for leases under IFRS (International Reporting Standards for all publicly traded companies), has changed substantially. IFRS 16 now replaces IAS 17 guidance in how entities should report leases.
In order to properly account for a lease, we need to understand how the lease is structured. Let’s start with some basic definitions: The lessor is the entity that leases out their property to others, and lessee’s is the entity that leases the property for their use.
In this article, we simplify, summarize and break down lease accounting under IFRS (IFRS 16) into the following sections:
Identifying and defining a Lease
Separating the Components of a Contract
Defining the Lease Term
Recognizing the Lease: both for the Lessee and Lessor
There are a number of exceptions to using the IFRS 16 standards. These can be found in IFRS 16 paragraphs 5-8, and include short-term leases, low value assets and others. This article covers the topic in the general case, and does not address leases under specific cases (e.g. leasing of biological assets, intangibles such as intellectual property, short term leases, etc..).
Identifying and Defining a Lease:
In order to be defined as a lease, IFRS 16 states that the contract must give the lessee the right to control the use of an identified asset for a certain period of time.
Broken down into the component parts, the definition is as follows:
1) The contract must give the lessee:
a) the right to control the use of the asset, which means the lessee should have:
“the right to obtain substantially all of the economic benefits” AND
“the right to direct the use of the identified asset” (IFRS 16, paragraph B9). This includes: the customer being able to determine how to use the asset and how, what, when and where the output from the asset is produced.
b) an identified asset
Identifying an asset can be done explicitly, in the contract, or implicitly (for example, if lessor cannot fulfill the contract without a specified asset).
c) the rights for a certain period of time
2) This must be done in exchange for consideration (e.g. cash).
A simplified flow chart, found below, can be used to determine if a lease exists within a contract. This chart is adapted from IFRS 16 paragraph B31.
Once we have identified that a lease exists, we must ensure we separate the lease into any separable components.
Separating Components of the Contract:
Contracts may contain several different components, some of which might be defined as leases and others which may not (for example - the payment of maintenance on a building, in addition to the lease of the office space). In cases where there are multiple items in a contract, the items should be separated and accounted for as follows:
The lessee should allocate the prices of the separate components based on the relative stand-alone price of the lease component and the aggregate stand-alone price of the non-lease components.
The stand alone prices should be based on market value of the separable components.
If the stand-alone price is not available, the lessee should make an estimate.
To summarize IFRS 15, we have the option to use the: adjusted market assessment approach, expected cost plus a margin approach, or the residual approach, along with the allocation of any discounts.
Defining the Lease Term:
The lease term is based on the non-cancellable portion of the lease term, and includes the following:
Any additional period covered by an option to extend the lease term, if the lessee is reasonably certain to take that option. For example, if the lessee enters into a 5 year lease, with the option to extend that lease for another 2 years, the lease term would be 7 years IF the lessee is reasonably certain to take the extension. AND
Any additional period covered by an option to terminate the lease, in the case that the lessee has reasonable certainty that they will not terminate the lease. Yep - a mouthful. So here's an example: Let's assume the lease term is 5 years, but the lessee has (in the initial contract) the option to terminate the lease 3 years into the lease. In this situation, if the lessee is reasonably certain NOT to exercise their option to terminate after 3 years, then we would consider the lease term to be the full 5 years.
Determining whether or not it is reasonable that the lessee extends the lease can be a matter of judgement. For example, it may be reasonable to assume the lessee will extend their lease if they are paying below market value for the leased asset.
The lease term is determined at the very beginning of the lease.
Recognizing the Lease:
Unlike previous IAS 17 lease criteria - which categorized leases as either “Finance leases” (similar to Capital Lease in ASPE) or “Operating leases,” IFRS 16 requires that we account for all leases in the lessee's books essentially as Finance Leases.
At the very beginning of the lease, the lessee will need to recognize a new asset called “Right-of-Use” asset, along with a lease liability. This Right of Use asset shows up on the Statement of Financial Position, as an asset. Instead of “Asset under Finance Lease” or “Asset under Capital Lease”, we now use the term “Right-of-Use” asset. In simplified terms, we can think of the lessee as purchasing the rights to use an asset, over a certain period of time, and paying for this right in installments. This is similar to how we might recognize a licencing agreement as an asset.
Right of Use Asset:
The cost of the Right-of-Use Asset includes costs that should typically be capitalized into property, plant and equipment (PPE). For a review of costs to be capitalized (included in the cost of PPE), click here. These costs include:
The initial lease liability amount (described below)
Any lease payments that have been made at or before the commencement of the lease (less any lease incentives received);
Initial direct costs incurred by the lessee (e.g. legal costs, realtor fees, etc..), and
An estimate of the costs to be incurred by the lessee of decommissioning the asset, and returning the site to its original condition. Remember that when we determine decommissioning costs, we must use the Present Value of the future costs. (We review asset decommissioning in this article about PPE.)
Similar to a capital lease, the lessee will also need to record a lease liability. This lease liability is measured using:
Present Value of minimum lease payments that have not yet been paid. In other words - we do not include the payment we have made prior to or on the lease commencement date in the calculation of this liability. We’ve already paid this amount, so it would not make sense to include it in the liability.
Always use the rate implicit in the lease to calculate the Present Value amount.
If the rate implicit in the lease is not known, then we can use the lessee’s incremental borrowing rate.
To learn how to calculate the rate implicit in the lease, and PV of minimum lease payments, see calculations in the section, below.
Step 1: Calculate the Rate implicit in the lease
Using your financial Calculator:
[BGN] or Type: Set your calculator to BGN (Type = 1) if the payments start at the beginning of the period, or leave it as is (Type = 0) if the payments are made at the end of the period.
PMT = Lease payment amount per period. Payments should not include any ongoing executory costs (e.g. legal fees, insurance, etc..).
N = Number of lease payments in the term.
PV = Current present value of the asset. When finding the rate, we MUST include the asset’s residual value in the PV number (i.e. do not exclude it).
FV = Residual Value. Residual Value is the fair market value of the asset at the end of the lease term. We must always include the Residual value when calculating the rate implicit in the lease.
CPT I/Y = ?
Excel Formula for the Rate Implicit in the Lease: See Calculator section above for explanation of terms.
=Rate (N, -PMT, PV, -FV, 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of PMT and FV.
Step 2: Calculate the PV of Minimum lease payments
Using your financial Calculator:
Set to [BGN] if the lease payments start at the beginning of the term (ie: 1rst day of term).
I/Y = discount rate of the lease
Always use the rate implicit in the lease if known (from Step 1, above). If not known, use the Lessee’s rate for incremental borrowing
N = Full potential lease term (primary term + any secondary term if it is reasonably certain they will take it on)
PMT = Lease payments. Payments should not include any ongoing executory costs (e.g. legal fees, insurance, etc..).
FV = Residual amount or "0"
Residual Value is the fair market value of the asset at the end of the lease term. Residual is only included in the calculation if there is a bargain purchase option or if the asset it expected to remain with the lessee at the end of the term. A bargain purchase option happens if the lessee has the right to buy the asset at below market value, at the end of the lease term. We do not include the bargain purchase price for FV. We only include the residual IF there is a bargain purchase.
If there is no bargain purchase option, then you should not include the residual in the calculation.
CPT PV = ?
TIP: Remember, when using your financial calculator, to use the appropriate signs (+ or -) for each component of the calculation. Using the wrong sign can dramatically change your calculations. To review signage, see this article about how to use your financial calculator.
Note: When calculating the PV of minimum lease payments, we do not include any effects of tax or tax shields.
Excel Formula for PV of minimum lease payments: See Calculator section above for explanation of terms.
Bargain Purchase Option, or the asset is expected to remain with the lessee:
=PV (I/Y, N, -PMT, -FV, 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of PMT and FV (residual).
If there is no Bargain Purchase Option, or there is no expectation that the asset will stay with the lessee:
=PV (I/Y, N, -PMT, , 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of PMT.
Decommissioning Cost Notes:
Note that we have not explicitly included decommissioning costs in the calculations above. Decommissioning costs are a long topic and will be covered in a later article. However, for the purposes of this article, it's important to know that the rate used to discount the decommissioning costs may be different from the rate implicit in the lease. And this makes sense, since the decommissioning costs are separate from the lease and the lease payments.
As such, the decommissioning costs can be calculated separately and then added to the Right-of-Use Asset and Lease Obligation. In order to calculate decommissioning costs, we use IAS 37 to determine the appropriate rate to use. According to IAS 37 the discount rate used should be pre-tax, and "should reflect the current market assessment of the time value of money and the risks specific to the liability." In many cases this can simply be the company's weighted average cost of capital. To account for this, we can create a separate Liability for the cost of decommissioning. But we should remember that the decommissioning costs will still need to be added to the Right-of-Use Asset. A sample journal entry can be found, below.
Journal Entry for Initial Recognition (Lessee):
The difference between the lease payments and the Fair Value of the asset is the interest paid. The interest should be included as an “Interest Expense” in the Income Statement, as it accrues.
Interest Expense = (remaining lease obligation) x (interest rate)
Journal Entry for Subsequent Recognition (Lessee):
After the start of the lease, the lessee should continue to recognize the lease by decreasing the lease liability based on payments made, and incurring a lease expense.
If the lease was paid monthly, then each month, the lessee would record the following journal entry:
Because the Right-of-Use asset is considered an asset, we will also need to record a depreciation expense, just as we would for any other asset. For more information about Depreciation, click here.
The period of depreciation should be the shorter of:
Lease term (primary term + any secondary term if it is reasonably certain they will take it on),
Asset’s economic life
If there is a bargain purchase option or the asset is expected to stay with the lessee at the end of the term, the asset is depreciated over its useful economic life.
Depreciation Expense = (Cost - residual at end of full expected lease) ÷ (Shorter of lease term and useful life)
Depreciation is done using a systematic approach, which reflects the pattern in which the Right-of-Use asset is used.
Journal Entry for Depreciation:
At the end of each payment term, a depreciation expense can be booked, as follows:
While the lessee should always create a new asset (Right-of-Use Asset) and essentially treat the lease as one would treat a Finance (also called "Capital Lease" under ASPE), under IFRS 16, the Lessor will need to make the differentiation between a Finance Lease and an Operating Lease.
Similar to ASPE 3065, with IFRS 16 there are two types of leases:
Finance Lease: This is where the lessor transfers all or substantially all of the risks and rewards of ownership of the asset. In other words - this is treated as though the lessee purchased the asset, and is paying for the asset in installments of principal + interest to the lessor.
Operating Lease: Any lease that is not a finance lease. These are the leases that more-closely resemble what most consider a traditional lease.
Determining Lease Type:
The IFRS 16 criteria includes ASPE criteria, but has two additional criteria.
In order to be considered a Finance lease, only one of the following criteria must be met:
1. Reasonable assurance the lessee will obtain ownership at end of lease.
2. Lease term is equal to >= 75% of economic life of asset.
3. Present Value (PV) of the minimum lease payments is 90% or more of the Fair Value (FV) of the leased property. When calculating the PV of the lease payments, the discount rate to use for the lessor is the rate implicit in the lease.
4. There is a bargain purchase option. This means that there is an option to buy the asset at less than the Fair Value at the date the option can be exercised. In other words - the lessee can buy the asset at the end of the term at a lower price than a reasonable market rate. (IFRS only / IFRS 16)
5. Leased asset is of specialized nature. For example: custom equipment that can only be used by the lessee. (IFRS only / IFRS 16)
It is important to know that there may be other indicators that the lease should be classified as a Finance lease. This can often be a matter of judgement. IFRS 16 provides examples of other situations where the lease may be considered a Finance Lease. However, for the purposes of your examinations and/or simplification the criteria above are used in the general case.
The type of lease is determined at the beginning of the lease (lease inception) and is not re-categorized unless there are changes to the lease.
Initial Measurement: Finance Lease
At the beginning of the lease, the lessor should present the asset under finance lease as a Receivable on the Statement of Financial Position, at an amount that reflects the net investment in the asset.
Initial direct costs of associated with the asset (such as costs attributed to arranging the lease) should be added to the asset, as outlined in this article about what is included in the cost of PPE.
The lessor’s books will mirror the lessee’s books, and uses a Lease Receivable account instead of a Lease Obligation account
The lessor should always use the actual discount rate implicit in the lease when calculating the Receivable. Note that this might result in a difference between the lessee's and lessor's books.
The lessor should always account for any residual when calculating the PV of minimum lease payments (whereas the lessee should only include it under bargain purchase, mentioned above).
We can use the steps outlined in Step 1 and 2, above, to calculate the PV of minimum lease payments for the Receivable.
Subsequent Measurement: Finance Lease
Initial and Subsequent Measurement: Operating Lease
When the asset is considered an Operating Lease, then the asset remains in the lessor's books as PPE, and the amount received from the lessee should be considered Income (shown in the Income Statement). In this case, the asset is treated like any other PPE asset in the lessor's books.
The lease payments should be shown systematically (usually on a straight-line basis), even if cash is paid in a different pattern.
Despite that most leases are bound by contracts and cannot be broken, no receivable is created or recorded for an Operating lease, in the lessor’s books, even though a liability/receivable may exist.
The lessor will continue to recognize depreciation on the asset, as is typical of PPE (except for land). The depreciation policy should remain the same as though the asset was not being leased.
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