Lease in The Financial Statements Of Lessee

Following on my previous post about definition and classification of leases, in this post we will discuss about lease treatment in the financial statement of leassee and lessor. Read on…

 
Finance Lease In The Financial Statement Of Lessee

At the commencement of the lease term, a lessee shall recognize an asset and a liability at the fair value of the leased asset or, if lower, at the present value of the minimum lease payments. The appropriate discount rate in the present value calculation is the rate implicit in the finance lease—that rate which discounts the lease payments to the fair value of the asset plus any initial direct costs of the lessor.

The impact of this treatment is to reflect the economic substance of the transaction. The lessee has acquired an asset for the substantial part of its useful life and expects to obtain substantially all the benefits from its use. In other words, the lease arrangement is merely a financing vehicle for the acquisition of an asset.

Subsequent to initial recognition, the lease payments are apportioned between the repayment of the outstanding liability and the finance charge so as to reflect a constant periodic rate of interest on the liability. Methods of calculation vary and include sum of the digits, which is a rough approximation, and more complex amortization models.

The asset needs to be depreciated over its expected useful life under IAS 16, using rates for similar assets. However, if there is no reasonable certainty that ownership will transfer to the lessee, then the shorter of the lease term and the useful life should be used.

 
Disclosures for Finance Lease In The Financial Statement Of Lessee

The following disclosures for finance leases are required in addition to those required by the financial instruments standards:

  • For each class of asset, the net carrying value at the balance sheet date
  • A reconciliation between the total of the minimum lease payments and their present value
  • The total of the future minimum lease payments analyzed as to
  • Not later than one year;
  • Later than one year but not later than five years; and
  • Later than five years
  • Contingent rents
  • Total future minimum lease payments expected to be received under noncancelable subleases
  • A general description of the lessee’s material leasing arrangements

 
Operating Leases In The Financial Statements Of Lessee

Lease payments under operating leases shall be recognized as an expense on a straight-line basis over the lease term unless another basis is more representative of the pattern of the user’s benefit, even if the payments follow a different pattern. It is important to recognize the impact of incentives in operating leases. Often incentives to enter into operating leases take the form of up-front payments, rent-free periods, and the like. These need to be appropriately recognized over the lease term from its commencement. Thus, a rent-free period does not mean that the lessee avoids a rent charge in its income statement. It has to apportion the rent for the entire lease over the entire period, resulting in a reduced annual charge.

 

Case Example:

Lie has entered into a lease of property whereby the title to the land does not pass to the entity at the end of the lease but the title to the building passes after 15 years. The lease commenced on July 1, 20X8, when the value of the land was $54 million and the building value was $18 million. Annual lease rentals paid in arrears commencing on June 30, 20X9, are $6 million for land and $2 million for buildings. The entity has allocated the rentals on the basis of their relative fair values at the start of the lease. The payments under the lease terms are reduced after every 6 years, and the minimum lease term is 30 years. The net present value of the minimum lease payments at July 1, 20X8, was $40 million for land and $17 million for buildings. The buildings are written off on the straight-line basis over their useful life of 15 years. Assume an effective interest rate of 7%.

The question is; How should Lie treat this lease under IAS 17?

IAS 17 requires the substance of the transaction to be reviewed and the extent to which the risks and rewards of ownership of the leased asset are transferred to be determined. If the risks and rewards of ownership are substantially transferred to the lessee, then the lease is a finance lease. The standard requires the land and buildings elements to be considered separately. Normally a lease of land will be regarded as an operating lease unless the title passes to the lessee. In this case the title does not pass and the present value of the lease payments is only 74% of the fair value of the land, which does not constitute substantially all of the fair value of the leased asset, one of the criteria for the determination of a finance lease.

In the case of the buildings, the title passes after 15 years, and the lease runs for the whole of its economic life, which indicates a finance lease. The present value of the minimum lease payments is 94% of the fair value of the lease at its inception, an amount that indicates that the lessee is effectively purchasing the building. Thus it would appear to be a finance lease. Property, plant, and equipment would increase by $17 million with a corresponding increase in noncurrent liabilities. The noncurrent liability ($17 million) will be reduced by the payment on June 30, 20X9 ($2 million), and increased by the interest charge ($17 million × 0.07, or $1.2 million).

The land will not appear on the balance sheet and the operating lease rentals will be charged to the income statement.

 

 

Disclosures for Operating Lease In The Financial Statements Of Lessee

In addition to the disclosures required by the financial instruments standards, these disclosures are required:

  • Total future minimum lease payments under noncancelable operating leases for each of the following:
  • Not later than one year;
  • Later than one year and not later than five years; and
  • Later than five years.
  • Total future minimum lease payments expected to be received under noncancelable subleases
  • Lease and sublease payments and contingent rents recognized as an expense
  • A general description of the significant leasing arrangements

 
Case Example:

An entity enters into a finance lease to lease a truck from another entity. The truck’s fair value is $140,000. The lease rentals are payable monthly, and the lease term is five years. The present value of the minimum lease payments are the inception of the lease is $132,000 and the unguaranteed residual value of the truck is estimated at $20,000.

The question is: At which amount will the lease liability be recorded in the financial accounts at the inception of the lease?

The lease asset and liability will be recorded at $132,000, which is the present value of the minimum lease payments. A lease liability should be recorded at the lower of the fair value of the leased asset and the present value of the minimum lease payment. The difference between the minimum lease payments and the fair value of $8,000 will represent the present value of the unguaranteed residual value ($20,000).

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

4 thoughts on “Lease in The Financial Statements Of Lessee”

  1. 10x Putra..I am a regular reader of this blog. I now have a better understanding of leases (very good explaination by you..).

    Just one question: When preparing the “Schedule of payments under finance lease”, which interest rate does the lessee use to calculate the Interest Expense(financing charge)? Do you use the interest rate implicit in the lease?

  2. How do you account for rent holidays under capital leases? Everything researched leads back to the treatment under an operating lease. For example, assume a 10 year lease, with 6 months of free rent and payments of $5000. Asset and liability recorded at FV which was less than PV of lease payments.

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