Lease accounting

A lease is an arrangement under which a lessor agrees to allow a lessee to control the use of identified property, plant, and equipment for a stated period of time in exchange for one or more payments.

There are several types of lease designations, which differ if an entity is the lessee or the lessor. The choices for a lessee are that a lease can be designated as either a finance lease or an operating lease. A lessee should classify a lease as a finance lease when any of the following criteria are met:

  • Ownership of the underlying asset is shifted to the lessee by the end of the lease term.
  • The lessee has a purchase option to buy the leased asset, and is reasonably certain to use it.
  • The lease term covers the major part of the underlying asset’s remaining economic life. This is considered to be 75% or more of the remaining economic life of the underlying asset.
  • The present value of the sum of all lease payments and any lessee-guaranteed residual value matches or exceeds the fair value of the underlying asset.
  • The asset is so specialized that it has no alternative use for the lessor following the lease term.

When none of the preceding criteria are met, the lessee must classify a lease as an operating lease.

The choices for a lessor are that a lease can be designated as a sales-type lease, direct finance lease, or operating lease. If all of the preceding conditions just noted for a lessee’s finance lease are met by a lease, then the lessor designates it as a sales-type lease. If this is not the case, then the lessor has a choice of designating a lease as either a direct financing lease or an operating lease. The lessor should designate any remaining lease as a direct financing lease when both of the following criteria are met:

  • The present value of the lease payments and any residual asset value that is guaranteed by the lessee or any other party matches or exceeds substantially all of the fair value of the underlying asset. In this context, “substantially” means 90% or more of the fair value of the underlying asset.
  • The lessor will probably collect the lease payments, as well as any additional amount needed to satisfy the residual value guarantee.

When none of these additional criteria are met, the lessor classifies a lease as an operating lease.

As of the commencement date of a lease, the lessee measures the liability and the right-of-use asset associated with the lease. These measurements are derived as follows:

  • Lease liability. The present value of the lease payments, discounted at the discount rate for the lease. This rate is the rate implicit in the lease when that rate is readily determinable. If not, the lessee instead uses its incremental borrowing rate.
  • Right-of-use asset. The initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.

When a lessee has designated a lease as a finance lease, it should recognize the following over the term of the lease:

  • The ongoing amortization of the right-of-use asset
  • The ongoing amortization of the interest on the lease liability
  • Any variable lease payments that are not included in the lease liability
  • Any impairment of the right-of-use asset

When a lessee has designated a lease as an operating lease, the lessee should recognize the following over the term of the lease:

  • A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis.
  • Any variable lease payments that are not included in the lease liability
  • Any impairment of the right-of-use asset

In a sales-type lease, the lessor is assumed to be selling a product to the lessee, which calls for the recognition of a profit or loss on the sale. Consequently, this results in the following accounting at the commencement date of the lease:

  • The lessor derecognizes the underlying asset, since it is assumed to have been sold to the lessee.
  • The lessor recognizes a net investment in the lease. This investment includes the following:
    • The present value of lease payments not yet received
    • The present value of the guaranteed amount of the underlying asset’s residual value at the end of the lease term
    • The present value of the unguaranteed amount of the underlying asset’s residual value at the end of the lease term
    • The lessor recognizes any selling profit or loss caused by the lease.
    • The lessor recognizes any initial direct costs as an expense, if there is a difference between the carrying amount of the underlying asset and its fair value. If the fair value of the underlying asset is instead equal to its carrying amount, then defer the initial direct costs and include them in the measurement of the lessor’s investment in the lease.

In addition, the lessor must account for the following items subsequent to the commencement date of the lease:

  • The ongoing amount of interest earned on the net investment in the lease.
  • If there are any variable lease payments that were not included in the net investment in the lease, record them in profit or loss in the same reporting period as the events that triggered the payments.
  • Recognize any impairment of the net investment in the lease.
  • Adjust the balance of the net investment in the lease by adding interest income and subtracting any lease payments collected during the period.

At the commencement date of a direct financing lease, the lessor engages in the following activities:

  • Recognize the net investment in the lease. This includes the selling profit and any initial direct costs for which recognition is deferred.
  • Recognize a selling loss caused by the lease arrangement, if this has occurred
  • Derecognize the underlying asset

In addition, the lessor must account for the following items subsequent to the commencement date of the lease:

  • Record the ongoing amount of interest earned on the net investment in the lease.
  • If there are any variable lease payments that were not included in the net investment in the lease, record them in profit or loss in the same reporting period as the events that triggered the payments.
  • Record any impairment of the net investment in the lease.
  • Adjust the balance of the net investment in the lease by adding interest income and subtracting any lease payments collected during the period.