Chapter 20 - Leases

Question 1

What is a lease?

Answer 1

A lease is a contractual obligation between a lessor and a lessee that gives the lessee the right to a certain asset owned by the lessor for a specified time, in return for stipulated payments.

Question 2

What should lease terms include?

Answer 2

1. Any periods covered by renewal options.
2. Any periods for which the failure to renew would result in a penalty that at the time of inception, the lessee would want to avoid.

Question 3

What are executory costs?

Answer 3

These may be provisions within the lease where the lessee has to pay for taxes, maintenance and insurance.

Question 4

What may happen at the end of the lease?

Answer 4

At the end of the lease, they may purchased the leased asset. This could be at a bargain (significantly below the fair value) or fair value.

Question 5

What are five advantages of leasing?

Answer 5

1. 100% financing at a fixed rate. (No upfront payment required)
2. Protection against obsolescence.
3. Flexibility
4. Less costly financing
5. Off balance sheet financing - No need to report obligations for future lease payments under certain circumstances.

Question 6

What is an operating lease under ASPE from the perspective of the lessee?

Answer 6

This is the most simple type of lease, where the lessee company will record a rent expense each month.

Question 7

What is a capital lease under ASPE? What is the capital lease equivalent from the perspective of the lessor?

Answer 7

When a lessee gains a significant portion of the risk and benefits of ownership, it will record the leased assets on its books, and an offsetting liability known as a lease obligation. From the perspective of the lessor, it is known as a sales type o direct financing lease.

Question 8

What is the approach used under ASPE to determine if a lease if operating or capital?

Answer 8

It applies the classification approach

Question 9

What is the approach used under IFRS for leases?

Answer 9

It applies the contract based approach, however it does not differentiate between capital lease and the operating lease. It capitalizes all leased assets because a contract exists between the lessor and lessee. It is consistent with the revenue recognition standards.

Question 10

What are four possible criteria for determining if a lease is capital under ASPE? How many must be met to capitalize it?

Answer 10

1. Lease transfers ownership of the asset to the lessee by the end of the lease term.
2. Lease contains a bargain purchase option.
3. The lease term is 75% or more of the estimated economic life of the asset at the beginning of the term.
4. The PV of the minimum lease payment at the inception of the lease is 90% or more of the fair value of the leased asset.

We only need to meet one of the four criteria.

Question 11

What is the minimum rental payment (MRP)? Who determines these payments?

Answer 11

These are the periodic rental payments for the asset and do not include executory costs. The lessor determines these payments.

Question 12

What is the guaranteed residual value? Who else can guarantee this value besides the lessee?

Answer 12

The lessee guarantees this value to the lessor, which is the amount of residual value the asset will have at the end of the lease term. A third party who has a relationship with the lessee can guarantee this value.h

Question 13

What is a bargain purchase option?

Answer 13

The asset is sold at less than 90% of the fair value of the asset at the end of the lease.

Question 14

What are the four aspects of the Minimum Lease Payment?

Answer 14

1. Minimum rental payment.
2. Guaranteed residual value
3. Penalty for failure to extend or renew the lease.
4. Bargain purchase option.

Question 15

What do we do if the guaranteed residual value is unguaranteed?

Answer 15

We will not include it in the minimum lease payment for the lessee. We do this because it is not certain.

Question 16

What rate is used to calculate the present value of the minimum lease payments? Why do we use the lower rates?

Answer 16

It is the lesser of the lessees incremental borrowing rate or the rate which is the implicit rate on the lease if that is known. We do this because we will record the lease obligation at a higher amount, making the financial statement more conservative.

Question 17

What is the advantage of using the implicit interest rate?

Answer 17

It is less prone to estimation, who may have an incentive to not capitalize the lease.

Question 18

What is the incremental borrowing rate?

Answer 18

It is the rate of interest, that a lender would charge a lessee to borrow funds for a similar term and a similar security, to purchase the asset.

Question 19

What is the implicit rate?

Answer 19

It is the rate in which, when applied to the minimum lease payments and the unguaranteed residual value accrued, caused the PV to be equal to the fair value of the lease asset at the inception of the lease.

Question 20

How do we account for a capital lease?

Answer 20

1. The lessee will record the asset at the PV calculation of the minimum lease payment, unless the value exceeds fair value, in which the asset would be recorded at fair value.
2. We record an offsetting lease obligation.
3. When we make lease payments, a portion of the payment goes to the interest and the other portion to the principal through the effective interest rate method.

Question 21

How do we account for depreciation on a capital lease?

Answer 21

1. If the asset is not going to be passed to the lessee, we will use any depreciation method we deem as appropriate over the life of the lease.
2. If the asset is likely to be passed due to the existence of a bargain, or the other 3 criteria, it should be over the economic life.

Question 22

T or F: We can group assets for efficiency when accounting for leased assets?

Answer 22

True.

Question 23

T or F: Regardless if the lease is operating or capital, they have the same overall net effect on the statement of income

Answer 23

True

Question 24

Which type of lease has higher expenses and why?

Answer 24

The capital lease has the higher expense as the amount of the obligation is larger and thus more interest will be earned on it, however as time goes on it has less and less expense. The operating leases expense stays constant.

Question 25

What statement if the most impacted by the difference in operating and capital leases and why?

Answer 25

The statement of financial position is the most impacted, and this is caused by the fact that for operating leases only the cash and rent expense are impacted. Whereas for the capital lease, the PPE and the current and long term liabilities are also affected by the lease. This increases the debt to equity ratio, and causes the current ratio to fall.

Question 26

T or F: Most businesses would prefer to capitalize their leases rather than operate

Answer 26

False

Question 27

What are the impacts on the statement of cash flow between an operating and a capital lease?

Answer 27

For operating, the expense for rent would be treated as an operating expense. For capital lease, the interest expense is treated as a financing/ operating expense under IFRS (or operating expense under ASPE) and the principal payments are financing, therefore you end up with higher operating cash flows under a capital lease.

Question 28

How do we account for leases under IFRS?

Answer 28

1. Determine if the contract entered into has a lease. 2. At the commencement of the lease, they will recognize a right of use asset and a lease liability. We capitalize all leases under IFRS.

Question 29

How do we determine if the contract entered into has a lease? (IFRS treatment) What is a provision that the lessor could implement that would not classify this as a lease?

Answer 29

Determine if the contract provides a right to control a specified asset for a specified time, in exchange for consideration. If the lessor has a substantive right to substitute the asset at any time.

Question 30

In general, IFRS will always capitalize a lease. What situations would we not classify a lease as capital?

Answer 30

1. Lease duration is one year or less. 2. Leased asset is of low value.

Question 31

What does a low valued leased asset mean?

Answer 31

1. Low value when the asset is new. 2. The lease is not dependent with other assets. 3. Benefit from the asset on its own or with other resources.

Question 32

How do we measure the lease liability under IFRS? What does IFRS state about the costs to be included?

Answer 32

The present value of the future payments under the lease discounted if the implicit rate is known. It does not have specific names, but costs pertaining to the lease must be in the PV calculation, as these are future payments the lessee is likely to make.

Question 33

What do lease components exclude?

Answer 33

They are exactly similar to the executory costs under ASPE, which include maintenance, insurance, cleaning, and security, water, and energy use. These are not related to the renting of the asset.

Question 34

What rate is used under IFRS if the implicit rate is unknown?

Answer 34

If the implicit rate is unknown, the incremental borrowing rate will be used.

Question 35

The minimum lease payment definition for a lessor is almost identical to the lessee. What is the difference? What is the goal of the lessor by entering into this agreement?

Answer 35

It includes all the aspects from ASPE's definition of an MLP, but also the guaranteed residual from a third party not related to the lessee. To recover the fair value of the asset.

Question 36

What are the three reasons a lessor will enter into a lease?

Answer 36

1. Source of interest income 2. Spread out the taxable income over more than one year, rather than all at the time of the sale. 3. Title of the asset remains with the lessor.

Question 37

What are the three different types of leases for a lessor?

Answer 37

1. Operating lease 2. Capital Lease - Direct Financing 3. Capital Lease - Sale

Question 38

How does a lessor determine if they should account for a lease as a capital lease under ASPE?

Answer 38

They apply the same four criteria as the lessee where one of them must be met, but also they must: 1. Credit risk is normal when compared to the risk of collection with other similar receivables. 2. Lessor can estimate the costs of un-reimbursable costs that are likely to occur.

Question 39

How does a lessor determine if they should account for a lease as a capital lease under IFRS?

Answer 39

They apply the same four criteria as the lessee under ASPE, In addition to the need to capitalize the lease if the asset is specialized, and the lessee can only use it with major modifications.

Question 40

What happens to the lessor if the capital criteria are met, but the fair value is not equal to the carrying amount at inception?

Answer 40

We will treated as a sales type lease, 1. recording a gains or loss which is the difference of the fair value and the carrying amount 2. Sales transactions and 3. COGS transaction 4. Deferred interest income entry.

Question 41

What happens to the lessor if the capital criteria are met, and the fair value of the asset is equal to the carrying amount at the time of inception.

Answer 41

We will treat it as a direct financing lease. The reward is earning interest income throughout the life of the asset / lease.

Question 42

How do we account for direct financing leases (ASPE) / financing leases (IFRS)? 1. Initial Transactions 2. Payments are received 3. Any amount that remain at the end of the transaction

Answer 42

Initial Transaction: 1. Lessor remove the asset by crediting the account. 2. Lessor debits lease payments receivable which consists of the minimum lease payments. 3. Lessor will record a unearned finance (interest) revenue, which is the difference between the fair value of the asset and the lease payment receivable. Payments are Received: 1. Debit cash and credit the lease payment receivable as the payments arrive until value is zero. Any Remaining amounts: 1. Debit cash and credit the account for the relevant situation when the payment for that is received or if the lessor sells the leased asset.

Question 43

How do we present theses values on the statement of financial position?

Answer 43

The unearned finance revenue less the lease payments receivable provides the net investment in the lease.

Question 44

What does it mean if at the end of the payment periods, a value is still present?

Answer 44

This represents the guaranteed/ un-guaranteed residual value, purchase agreement, or the penalty.

Question 45

How do we calculate interest expense for the lessor?

Answer 45

We apply the effective interest rate method using the implicit interest rate.

Question 46

How do we account for a sales type lease (ASPE) / Manufacturer/Dealer Lease (IFRS)

Answer 46

The only difference is that the carrying amount is different from the fair value of the leased asset. 1. Recognize sales revenue equal to the fair value of the asset 2. Recognize COGS as the carrying amount of the leased asset. 3. Derecognize the asset account 4. Recognize an unearned interest revenue 5. Recognize a lease payments receivable for the undercounted value of the consideration that the lessor will get from the lessee.

Question 47

Describe the guaranteed and un-guaranteed residual values from the perspective of the lessee.

Answer 47

When you amortize the leased asset, the guaranteed residual value must also be amortized. You do not account for the un-guaranteed residual value from the perspective of the lessee.

Question 48

Describe the bargain purchase option from the perspective of the lessee. What are similarities? What are differences?

Answer 48

They are similar and almost identical to the guaranteed residual value as they are included in the component of the FV for the minimum lease payment and are paid out at the end of the lease term. If there is a bargain purchase agreement the lessee would likely want to use this asset for the entire economic life. Thus amortization happens over the economic life rather than the lease term.

Question 49

How do we account for a guaranteed residual value under the lessors perspective? When does the lessor record a gain? When does the lessor record a loss?

Answer 49

The guaranteed residual value is part of the lease payments receivable, they will receive it at the end of the lease when it sells the asset. A gain will be recorded when the company receives more than the guaranteed residual value at the sale. They will not record a loss since if the lessor receives less than the amount of the guaranteed residual value, the lessee will make up for it.

Question 50

How do we account for unguranteed residual value under the lessors perspective? What are the effects of the unguranted residual value on the unearned finance income account?

Answer 50

The lessor considers it as relevant and includes it in calculating the amount of the lease payment, thus the unguranteed residual value is in the lease payments receivable account. It will make it such that the lease payment receivable is the same as the unearned finance income account at the inception of the lease, whether it is guaranteed or not.

Question 51

How do we account for the unguaranteed residual value on a sales type lease?

Answer 51

The lessor should not include the residual value because there is uncertainty in its collection, which is a criteria for revenue recognition. The lessor will subtract the PV of the unguaranteed residual value from the sales and COGS.

Question 52

How do we account for bargain purchase options from the perspective of the lessor?

Answer 52

This is a form of consideration that the lessor receives at the end of the lease term. It has the same effect on the calculation of rental payments and the lease rental receivable.

Question 53

What are executory costs? Where do we not include these costs?

Answer 53

These costs are related to the operation of the leased asset such as insurance, maintenance, and property taxes. These costs are not included in the minimum rental payments and the lease payment receivable account.

Question 54

How do we account for executory costs under the lessor and the lessees perspectives?

Answer 54

Lessor: DR - Cash CR - Related Expense Lessee: DR - Related Expense CR - Cash

Question 55

What are initial direct costs?

Answer 55

These are costs paid by the lessor to third parties such as legal costs, independent appraisals, and other costs incurred prior to entering the lease.

Question 56

What are internal direct costs? What costs must not be included?

Answer 56

These are costs incurred by the lessor internally such as evaluating the lessee's financial condition, processing the lease, and investigating collateral. We must not include indirect costs that cannot be directly attributed to a lease, such as an advertising expense to get a lessee.

Question 57

What is the accounting policy with the initial direct costs for operating lease?

Answer 57

1. Either we will defer it and amortize it over the life of the lease like we would for rental income 2. Capitalize it and amortize it over the life of the lease like we would for rental income

Question 58

What is the accounting policy with the initial direct costs for sales type lease?

Answer 58

Expense the initial direct cost at the same period when they recorded the sale, usually at the inception of the lease.

Question 59

What is the accounting policy with indirect costs for direct financing leases?

Answer 59

Capitalize the initial direct costs and amortize them using the effective interest rate method.

Question 60

What is the accounting policy with indirect costs for direct financing leases under the CPA Canada Handbook? What is the impact on net income and finance income?

Answer 60

Recognize the initial direct costs as income, and have an equal amount of unearned finance income at the inception of the lease. It has no impact on the current net income but affects the amount of finance revenue that can be recognized in the future. This has the same result as if we used the other method.

Question 61

What is a sale lease back transaction?

Answer 61

The company will sell an asset, and then lease it back from the purchaser.

Question 62

What are the three different types of leases that could be applied under ASPE?

Answer 62

1. Direct financing lease 2. Operating lease 3. Sales type lease

Question 63

What accounting steps must be taken when we classify a leaseback as a capital lease? - ASPE What is the exception to this rule?

Answer 63

1. Defer the profit from the sale 2. Amortize it in proportion to the depreciation on the leased asset. 1. If we are dealing with land we amortize it over the lease term on a straight line basis.

Question 64

What accounting steps must be taken when we classify a leaseback as a operating lease?

Answer 64

1. Defer the profit from the sale 2. Amortize it in proportion to the rental payments of the leased term.

Question 65

What are the two differences between the IFRS and ASPE treatment for accounting on the initial sellers side?

Answer 65

1. The seller can record the gain on the inception of the lease to the extent that it does not lease back a portion of the asset got sold (therefore there is recognition of the gain on the portion sold and not leased back) 2. The buyer does not record the right off use asset at its fair value, rather the buyer records the assets carrying amount (or a portion thereof it not renting the entire asset back). Carrying amount is the PC of the lease payments less the deferred gain on this portion of the asset.

Question 66

Under ASPE, how do you account for real estate assets when there are terms that allow for ownership to pass or a bargain purchase option? Under ASPE, how do you account for real estate assets when there are terms that do not allow for ownership to pass or a bargain purchase option or the fair value of the land is minor.

Answer 66

You capitalize the land separately from the buildings, in proportion to their fair values at the inception of the lease. The lessee will treat the land as a single unit. The economic life of the building becomes the economic life of the unit.

Question 67

Under ASPE, how do you account for real estate assets when there are terms that do not allow for ownership to pass or a bargain purchase option but the fair value of the land is significant?

Answer 67

You account for the assets separately. You then allocate the minimum lease payment to the land and building in proportion to their fair values. Both parties will classify the portion of the lease applicable to land as an operating lease.