17.7 Chapter Summary

LO 1: Describe leases and their role in accounting and business.

A lease is one method of financing the use of an asset. For example, when businesses want to update their equipment or expand their operations, they might lease rather than buy. A lease will provide the company with a temporary right to use an asset, over a specified period of time, in exchange for some other consideration, usually cash. Leases can be classified as either an operating lease or capitalized as a capital/finance lease, depending on whether the transaction meets the ASPE or IFRS 16 criteria, which look at the economic substance of a lease rather than its legal form. An operating lease is recorded to rental expense for the lessee and recorded to rental income for the lessor. A capitalized lease is recorded to an asset and a related obligation for the lessee, and to lease receivable as either a sale or as a financing agreement like an instalment loan for the lessor.

LO 2: Describe the criteria used for ASPE and IFRS (IAS 17) to classify a lease as a capital/finance lease.

While ASPE criteria are more prescriptive and contain specific numeric thresholds, IFRS 16 criteria are more qualitative and require more professional judgment. For ASPE, three criteria are required for capitalization classification for the lessee to occur. If any one of the following are met, classification as a capital lease is required. First, if legal ownership passes, or substantively passes, through the existence of a bargain purchase option or bargain renewal option. Second, if the lease term is at least 75% of the asset’s estimated economic or useful life. Third, if the present value of the minimum lease payments is equal to 90% or more of the fair value of the asset at that time. In the case of the lessor, the same three criteria are considered, plus two additional criteria involving collectability of lease payments and no uncertainties regarding lessor costs. If any one of the three criteria and both of the additional uncertainty and collectability criteria are met, the lessor is required to classify the lease as a capital lease. Additional analysis is required to determine if the capital lease for the lessor is a sales-type lease, where there is a profit, or a direct-financing lease for banks or finance companies.

Under IFRS 16, the lessee analysis uses a contract basis and qualitative definitions to determine if a right-of-use asset and lease liability exists. The lessor evaluation follows a classification “risks and rewards” basis the same as ASPE, but with more qualitative criteria that require professional judgement. The key criteria to consider if a right-of-use asset is to be capitalized along with the obligation for lease payments include that a specified asset exists that is physically distinct. Also, that the lessee has rights to substantially all of the capacity of that asset and its benefits and its use decision, and that the lessor has no substantive substitution rights. In summary, the impact of IFRS 16 is that virtually all lease contracts to be capitalized as finance leases, with a right-of-use asset and a lease liability recorded by the lessee (other than if deemed to be short-term or low $-value leases). If the lessor is a dealer or manufacturer, the entries will include sales and cost of goods sold, otherwise the lease will be treated as a financing lease if the lessor is a bank or financing company.

If the lease does not meet the criteria for capitalization, it is treated as an operating lease with lease payments recorded as rent expense for the lessee and rent revenue for the lessor.

LO 3: Prepare the accounting entries of a capitalized lease for both the lessee and lessor.

The accounting treatment for capitalized leases follows certain steps. These steps dictate the types and timing of the entries throughout the lease term for both the lessee and lessor. If the lease is capitalized under either ASPE or IFRS, the lessee records a leased asset and a related lease obligation, including lease payments, depreciation, and accrued interest on the debt. The lessor removes the asset from their inventory and records either a sale or a financing lease. Additionally, lease payments reduce the amount of the lessor’s lease receivable and interest is earned over the lease term. The effective interest method is applied to calculate the interest component of the lease obligation. Special items, such as economic life versus the lease term, and the lessor’s implicit interest rate versus the lessee’s incremental borrowing rate, can affect some of the lessee and lessor accounting entries. This chapter presents several examples from the perspectives of the lessee and the lessor, including unguaranteed and guaranteed residual values, a bargain purchase option, and a finance lease.

Comparing the IFRS 16 with ASPE, the differences in the journal entries for a capital lease (ASPE) compared to a right-of-use lease (IFRS) are that ASPE uses the classification basis to evaluate if the risks and rewards using specific hurdle rates has been met to require capitalization, and IFRS 16 uses a contract basis for the lessee regarding if right-of-use asset exists using qualitative criteria to capitalize. For ASPE, the results can be a mix of both operating and capital leases whereas for IFRS 16, it results in virtually all leases being capitalized other than low $-value or lease terms of twelve months or less. Another difference involves one of the amounts used in calculating the lessee’s present value of the minimum lease payments. ASPE uses of the full estimated residual value, and IFRS uses only the estimated deficiency portion of the residual value that the lessee must pay to the lessor. Some terminology is different such as “leased asset” and “lease obligation” for ASPE compared to a “right-of-use asset” and “lease liability” for IFRS. Accounts used to record the accrued interest credit entry for ASPE is the “interest payable” and for IFRS it is the “lease liability”. These differences are minor in terms of their impact on the accounting treatment. The different with the greatest potential impact would be the interest rate used for the minimum lease payments as the lower of the lessor’s implicit rate if known, and the lessee’s incremental borrowing rate for ASPE compared to using the lessor’s implicit rate if determinable, otherwise the lessee’s incremental borrowing rate (IFRS). This could result in two significantly different interest rates used to calculate the lessee’s present value of minimum lease payments.

LO 4: Prepare the accounting entries of a capitalized sale and leaseback transaction.

Another form of financing involves a sale and a leaseback. This is when a seller sells an asset and immediately leases it back from the buyer. The seller becomes the lessee and the buyer becomes the lessor. Since this transaction is in reality a bundled sale/lease transaction, care must be taken to ensure that both parties do not try to manipulate the numbers unrealistically. For this reason, capitalized sale and leaseback transactions under ASPE typically defer and amortize the gains/losses, usually on the same basis as the depreciation policy. IFRS 16 approaches this type of transaction quite differently. First, the transaction must determine if it meets the definition of a sale, which is identified in IFRS 15 (Revenue). If it is deemed a sale, the seller/lessee will derecognize the asset sold, and record a right-of-use (ROU) asset on a proportionate basis depending on how much of the asset was leased back (i.e. a building is sold but certain floors are leased back). The transaction can also result in scenarios where the sales price is less than, equal to, or greater than the fair value of the asset, each of which requires a slightly different accounting treatment. If the transaction is not a sale, the treatment will follow IFRS 9, Financial Instruments, where the seller/lessee will not derecognize the asset and will record a financial liability and the buyer-lessee will record a corresponding financial asset.

LO 5: Explain how leases are disclosed in the financial statements.

As leases are usually long-term commitments, disclosures must be in-depth enough to provide shareholders and creditors with adequate information to assess liquidity and solvency. The disclosures for ASPE and IFRS are similar, although IFRS 16 also requires additional disclosures for various classes of leases and reconciliations that assist financial statement readers to assess the amount of interest cost included in the minimum lease payments. As is the case with other long-term financial instruments, both the lease obligation and the lease receivable are separated into current and long-term balances in the balance sheet/SFP.

LO 6: Explain the similarities and differences between ASPE and IFRS 16

ASPE capitalization criteria contain numeric thresholds, making it much more prescriptive than IFRS 16. As IFRS 16 does not have the numeric thresholds, professional judgment is needed to determine if capitalization is required. For the lessor, both ASPE and IFRS have similar accounting treatments for either a lease that includes a profit element (sales, cost of goods sold, and an interest component), or as a finance lease (an interest component only). In some cases, the interest rate used when calculating the present value of the minimum lease payments can differ between ASPE and IFRS 16. While the disclosures for both standards are similar, IFRS 16 does require some additional disclosures to be made.