Leases FA3 – Lesson 5
Leases
A lease is a conveyance of property rights by a lessor to a lessee for an
agreed rent or other compensation. If the property rights are minor, or
temporary, a simple rental relationship is reflected in the financial
statements of both parties. If the arrangement, in substance, conveys
the risks and rewards of ownership to the lessee, the lessee must reflect
an asset and liability and related expenses in the financial statements.
The lessor’s financial statements must show the receivable obtained
and measure revenues according to the substance of the financing
contract. This lesson deals with the intricacies of such lease
arrangements.
Leases FA3 – Lesson 5
Memory Hook
Lessor
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u
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Lessor Receives Revenue
Lessee
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p
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s
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Lessee has Expense
Leases FA3 – Lesson 5
Conditional Sales Agreement (CSA)
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A Company acquires a capital asset
The acquisition is financed by the Vendor or Finance
Company with a CSA
The Vendor or Finance Company retains title to the capital
asset
Title passes to the Company when the last payment is
made
The Company accounts for the CSA as purchase of
Capital Assets and a Long-Term Liability
Leases FA3 – Lesson 5
What happens with a capital lease?
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Lease agreements may represent, in substance,
the purchase/sale of an asset, and a
corresponding obligation/lease receivable.
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This happens when the risks and rewards of
ownership pass to the lessee.
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If this is the case, the lessor takes the asset off
its books, and replaces it with a loan receivable.
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The lessee records both an asset and a liability.
Leases FA3 – Lesson 5
What is an operating lease?
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Leases that are not capital leases are classified
as operating leases.
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For operating leases:
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The contract is a simple rental agreement.
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The lease does not give rise to property rights.
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Payments are expensed as time passes or
benefits are received.
Leases FA3 – Lesson 5
New Terms
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MLPs
BPO
UngR
GR
IBR
IIR
ITC
CCA
Minimum Lease Payments
Bargain Purchase Option
Unguaranteed Residual
Guaranteed Residual
Incremental Borrowing Rate (lessee’s rate)
Implicit Interest Rate (lessor’s rate)
Investment Tax Credit
Capital Cost Allowance
Leases FA3 – Lesson 5
When is a lease a capital lease for the lessee?
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A lease is a capital lease if it meets one of the
following conditions:
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Title passes to lessee by end of lease.
There is a bargain purchase option. (BPO)
The lease covers 75% or more of the life of
the asset.
The present value of the lease payments is
90% or more of the fair value of the asset at
inception of the lease.
Leases FA3 – Lesson 5
When is a lease a capital lease for the lessor?
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One of the four previous criteria has been met,
plus:
There must be an acceptable credit risk
associated with the lease payments and no
unreimbursable or unestimatable costs.
It is a direct financing lease if lessor is a financing
company.
It is a sales type lease if lessor is a
manufacturer/trader.
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Leases FA3 – Lesson 5
What happens on the lessee's books?
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A leased asset and a lease liability are
recognized at the PV of lease payments.
(PV of MLPs using lower of IIR and IBR)
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A leased asset is used by the lessee over the
lease term and is amortized like any other owned
asset. A lease obligation, like any other interestbearing obligation, is increased by interest each
period and reduced by payments made.
Leases FA3 – Lesson 5
What are some of the advantages
and disadvantages of leases?
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Leasing is an attractive form of financing, providing:
 flexible access to assets,
 protection from interest rate changes,
 100% financing,
 off-balance sheet financing for operating leases, &
 some possible tax advantages.
A lease may be more expensive than traditional
lending arrangements and may lock the lessee into a
long-term obligation.
Leases FA3 – Lesson 5
What happens on the lessor’s books?
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The lessor records:
 the lease payments receivable from the lessee,
 a contra account for unearned interest revenue, &
 removes the leased asset from its books.
In a sales-type lease, cost of sales and sales revenue
are also recorded. (same as a normal sale)
Cash received reduces the receivable, and interest
earned on the net balance is recognized as time
passes.
Leases FA3 – Lesson 5
What is unique about real estate leases?
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Land might be one of the leased assets. A land
lease is only classified as a capital lease if title
passes or if there is a bargain purchase option.
Otherwise, it is an operating lease.
If a lease covers more than one asset, the lease
payments must be allocated to each asset based
on relative fair values.
Leases FA3 – Lesson 5
How do the tax and accounting treatments of
leases differ?
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Tax and accounting treatments of leases are
often different, causing “future income taxes” to
be recorded.
A lease is a capital lease for tax purposes only if
title passes.
A lessee with a capital lease for tax purposes
would be eligible for CCA and ITCs.
Leases FA3 – Lesson 5
How does Canada’s treatment of leases compare
to international standards?
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There is a lot of diversity around the world
regarding lease accounting.
While some countries follow capitalization rules,
it is also common for all leases to be treated as
rental contracts.
Leases FA3 – Lesson 5
How are leases disclosed on financial statements?
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Financial statement disclosure for the lessee
includes segregating assets under capital lease
from other assets and disclosing accumulated
amortization.
Liability is shown for both short- and
long-term portions.
Amortization and interest expense are disclosed.
continued...
Leases FA3 – Lesson 5
How are leases disclosed on financial statements?
(continued)
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Notes include amortization policy, terms of the
liability, and a five-year cash flow schedule.
For the lessor, the balance sheet reflects net
receivables and the income statement, finance
revenue.
Disclosure of terms and conditions and five-year
cash flow is required.
Leases FA3 – Lesson 5
How are leases recognized on the cash flow
statement?
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Initial recognition of a leased asset is a non-cash
transaction.
Payment of the liability is a financing outflow.
Amortization is added back in operations if
indirect method is used.