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Definition of terms
A 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.
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred.
An operating lease is a lease other than a finance lease.
A non-cancellable lease is a lease that is cancellable only:
a. upon the occurrence of some remote contingency;
b. with the permission of the lessor;
if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or
d. upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.
The 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 provision of the lease. As at this date:
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.
The 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 the date of initial recognition of the lease (i.e., the recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate.).
The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.
Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:
a. for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or
b. for a lessor, any residual value guaranteed to the lessor by:
i. .the lessee;
ii. a party related to the lessee; or
iii. a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it.
Economic life is either:
a. the period over which an asset is expected to be economically usable by one or more useres; or
b. the number of production or similar units expected to be obtained from the asset by one or more users.
Useful life is the estimated remaining period, from the commencement of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.
Guaranteed residual value is that portion of the residual value of the leased asset, the realization of which by the lessor is not assured or is guaranteed solely by a party related to the lessor.
Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors.
Gross investment in the lease is the aggregate of:
a. the minimum lease payments receivable by the lessor under a finance lease, and
b. any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease.
Unearned finance income is the difference between:
a. the gross investment in the lease, and
b. the net investment in the lease.
The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.
The lessee's incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.
Contingent rent is that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (e.g., percentage of future sales, amount of future use, future price indices, future market rates of interest).
Classification of Leases
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incident to ownership. All other leases are classified as operating leases. Classification is made at the inception of the lease.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following:
1. the lease transfers ownership of the asset to the lessee by the end of the lease term;
2. the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised;
3. the lease term is for the major part of the economic life of the asset, even if title is not transferred;
4. at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
5. the lease assets are of a specialized nature such that only the lessee can use them without major modifications being made.
Other situations that might also lead to classification as a finance lease are:
1. If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;
2. gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments); and
3. the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent.
Lease of land and building
In classifying a lease of land and buildings, land and buildings elements would normally be separately. The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values. The land element is normally classified as an operating lease unless title passes to the lessee at the end of the lease term. The buildings element is classified as an operating or finance lease by applying the classification criteria in PAS 17. However, separate measurement of the land and buildings elements is not required if the lessee's interest in both land and buildings is classified as an investment property in accordance with PAS 40 and the fair value model is adopted.
Accounting by Lessees
The following principles should be applied in the financial statements of lessees:
1. at commencement of the lease term, finance leases should be recorded as an asset and a liability at the lower of the fair value of the asset and the present value of the minimum lease payments (discounted at the interest rate implicit in the lease, if practicable, or else at the enterprise's incremental borrowing rate);
2. finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability (the finance charge to be allocated so as to produce a constant periodic rate of interest on the remaining balance of the liability);
3. the depreciation policy for assets held under finance leases should be consistent with that for owned assets. If there is no reasonable certainty that the lessee will obtain ownership at the end of the lease-- the asset should be depreciated over the shorter of the lease term or the life of the asset; and
4. for operating leases, the lease payments should be recognized as an expense in the income statement over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the user's benefit.
Incentives for the agreement of a new or renewed operating lease should be recognized by the lessee as a reduction of the rental expense over the lease term, irrespective of the incentive's nature or form, or the timing of payments.
Accounting by Lessors
The following principles should be applied in the financial statements of lessors:
1. at commencement of the lease term, the lessor should record a finance lease in the statement of financial position as a receivable, at an amount equal to the net investment in the lease;
2. the lessor should recognize finance income based on a pattern reflecting a constant periodic nrate of return on the lessor's net investment outstanding in respect of the finance lease; and
3. assets held for operating leases should be presented in the statement of financial position of the lessor according to the nature of the asset. Lease income should be recognized over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern in which use benefit is derived from the leased asset is diminished.
Incentives for the agreement of a new or renewed operating lease should be recognized by the lessor as a reduction of the rental income over the lease term, irrespective of the rental income over the lease term, irrespective of the incentive's nature or form, or the time of payments.
Manufacturers or dealer lessors should include selling profit or loss in the same period as they would for an outright sale. If artificially low rates of interest are charged, selling profit should be restricted to that which would apply if a commercial rate of interest were charged.
Sale and Leaseback Transactions
For a sale and leaseback transaction that results in a finance lease, any excess of proceeds over the carrying amount is deferred and amortized over the lease term.
For a transaction that results in an operating lease:
1. if the transaction is clearly carried out at fair value-- the profit or loss should be recognized immediately;
2. if the sale price is below fair value-- profit or loss should be recognized immediately, except if a loss is compensated for by future rentals at below market price, the loss should be amortized over the period use;
3. if the sale price is above fair value-- the excess over fair value should be deferred and amortized over the period of use; and
4. if the fair value at the time of the transaction is less than the carrying amount-- a loss equal to the difference should be recognized immediately