Accounting for
leases
Chapter 11
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11-1
Learning objectives
•
Distinguish between operating and financial leases
• Demonstrate how the interest rate for PV of minimum
lease payments is calculated
• Explain how lessors and lessees should account for:
– financial leases
– operating leases
•
•
Demonstrate how a sale and leaseback transaction
would be accounted for
Explain the implications for accounting based
contracts.
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11-2
Introduction
NZ IAS 17 applies to accounting for leases other than:
– Leases to explore for or use minerals, oil, natural gas and
similar non-regenerative assets
– Licensing agreements for such items as motion picture
films, video recordings, plays, manuscripts and copyrights
Lease defined:
‘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’
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11-3
Introduction
Central accounting issue:
• Should the leased assets and associated
commitments relating to the lease appear in the
reporting entity’s financial postion?
• Should lack of legal ownership preclude the
lessee’s reporting of the asset and the related
liability in the balance sheet?
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11-4
Introduction
Question of ‘control’ and not ‘ownership’
•A firm may recognise assets it does not own
– as long as it is able to control their use.
•Do
leases transfer control of the asset to the lessee?
– Depends on the terms of the lease agreement
– It is, in fact, possible for control of the asset to be vested in
the lessee.
•Central
issue concerns whether lease is:
– A finance lease; or
– An operating lease.
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11-5
Introduction
•
Finance leases must be disclosed in the financial
position:
– Lease asset
– Corresponding lease liability.
•
Finance lease
– A lease that transfers substantially all the risks and rewards
incidental to ownership of an asset.
– Title may or may not be eventually transferred.
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11-6
Introduction
Risks and rewards of ownership central to
the application of NZ IAS 17
• If the lessee holds the risks and rewards of
ownership:
– the lessee’s risk exposure is basically what it would be
if the lessee acquired the asset by way of a purchase
transaction.
•
If the risks and benefits of ownership are transferred
in substance to the lessee:
•
the lessee’s risk exposure in relation to holding the asset is
basically equivalent to what it would have been if the lessee
had acquired the asset for cash or by way of a loan.
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11-7
Introduction
•
•
•
Not always straightforward to determine whether
the risks and rewards incidental to ownership have
passed substantially to the lessee.
Requires professional judgment.
Guidance offered in NZ IAS 17 (pars 10–12).
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11-8
Introduction
NZ IAS 17 (par. 10):
•
•
Whether a lease is a finance lease or an operating lease
depends on the substance of the transaction rather than the form
of the contract.
Examples of situations that, individually or in combination, would
normally lead to a lease being classified a finance lease are:
a) The lease transfers ownership of the asset to the lessee by the end
of the lease term
b) The lessee has the option to purchase the asset at a price that is
expected to be sufficiently lower than the 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
c) The lease term is for the major part of the economic life of the asset
even if the title is not transferred.
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11-9
Introduction
NZ IAS 17 (par. 11):
• Indicators of situations that, individually or in
combination, could also lead to a lease being
classified a finance lease are:
a) If the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the lessee
b) Gains or losses from the fluctuation in the fair value of the
residual accrue to the lessee (for example, in the form of a
rent rebate equalling most of the sale proceeds at the end
of the lease); and
c) The lessee has the ability to continue the lease for
a secondary period at a rent that is substantially lower
than the market rent.
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11-10
Introduction
Note (NZ IAS 17, par. 12):
•The examples and indicators in paragraphs 10
and 11 are not always conclusive.
•If it is clear from other features of the lease that
the lease does not transfer all risks and rewards
incidental to ownership, the lease is classified an
operating lease.
•For example, if ownership of the asset transfers at the
end of the lease for a variable payment equal to its then
fair value or if there are contingent rents, as a result of
which the lessee does not bear substantially all such
risks and rewards.
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11-11
Key terms
1.
Fair value:
a) The amount for which an asset could be exchanged or a
liability settled between knowledgeable, willing parties in
an arm’s length transaction.
b) Necessary for determining the amount to be included for
the leased asset in the balance sheet of the lessee.
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11-12
Key terms
2. Non-cancellability
A non-cancellable lease is a lease that is cancellable only:
a) Upon occurrence of some remote contingency
b) With the permission of the lessor
c) 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
If the lessee was able to cancel the lease at short notice
 with limited penalty
 the lessee would not be considered to be holding the risks and
rewards associated with asset ownership.
ii. If lease cancellable—regardless of remaining terms the lease
would be considered to be an operating lease.
i.
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11-13
Key terms
3. Contingent
rent (NZ IAS 17, par. 4)
That portion of the lease payments that is not fixed in amount:
– 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).
Why important?
– When the amount of rent paid by the lessee is contingent
upon the amount of future sales, future use, future interest
rates, etc., there is effectively a shift of some of the risks and
rewards of ownership back to the lessor.
– ‘Contingent rent’ therefore decreases the likelihood that the
lease will be a ‘finance’ lease.
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Key terms
4. Transfer
of ownership
– If lease transfers ownership of the asset to the lessee
at the end of the lease term it is considered a finance lease.
– If the lease is also non-cancellable, the lease is really
only another type of debt agreement with title passing after
last payment is made.
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Key terms
5. Bargain
purchase option
– A provision that allows a lessee to purchase a leased
property

for a price expected to be far lower than the expected fair value
of the property
 at the date the option becomes exercisable
– Difference between the option price and expected fair
market value must be large enough to make exercise of the
option reasonably assured

evaluation made at inception of lease
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11-16
Key terms
5. Bargain
purchase option continued:
– If exercise of option is likely (bargain) it is also likely that
transfer of ownership will occur

risks and rewards of ownership are assumed to be transferred
– Included in the calculation of minimum lease payments
because the exercise of a ‘bargain’ option is reasonably
assured and it is therefore probable that the amount will
ultimately be paid by the lessee
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11-17
Key terms
6. Lease
term
– 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.
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11-18
Key terms
7. Economic
life
– Either:

The period over which an asset is expected to be economically
usable by one or more users; or
 the number of production or similar units expected to be
obtained from the asset by one or more users.
– Why important?

If the non-cancellable lease term is for the major part of the
economic life of the asset the lease is generally considered a
finance lease.
Note:
‘Major part’ not defined but generally accepted that if lease term is
greater than or equal to 75% of the economic life of the leased
asset risks and rewards are effectively transferred to the lessee
(finance lease).
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Key terms
8. Minimum
lease payments
– The payments over the lease term what the lessee is or can
be required to make excluding contingent rent, costs for
services and taxes paid by and reimbursed to the lessor
together with:

For the lessee, any amounts guaranteed by the lessee or by a
party related to the lessee; or
 for a lessor, any residual value guaranteed to the lessor by:
• the lessee
• a party related to the lessee; or
• a third party unrelated to the lessor that is financially capable
of discharging the obligations under the guarantee.
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Key terms
8.Minimum lease payments continued:
– Why important?

PV of minimum lease payments determines whether a lease is
a finance or operating lease:
• If at the inception of the lease the present value of the
minimum lease payments amounts to at lease substantially
all of the fair value of the asset
– normally leads to lease classified as ‘finance’-type lease
• If a finance lease the amount to be initially recognised in the
balance sheet for the asset and liability is (par. 20) the fair
value of the leased property or, if lower, the present value of
the minimum lease payments as determined at inception of
lease.
– Expressly excludes contingent rent.
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Key terms
8. Minimum
lease payments continued:
– Include guaranteed residual values
Guaranteed residual value defined for the lessee:
i. That part of the residual value that is guaranteed by the
lessee or by a party related to the lessee (the amount of the
guarantee being the maximum amount that could in any
event become payable.
b) Guaranteed residual value defined for the lessor:
i. That part of the residual value that is guaranteed by the
lessee or by a third party unrelated to the lessor that is
financially capable of discharging the obligations under the
guarantee.
a)
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Key terms
8. Minimum
c)
lease payments continued:
Amount of a guaranteed residual value:
i.
The amount that the lessor has the right to require the
lessee or a related party to the lessee to pay at the end of
the lease term
ii. Payment of this residual will often lead to the asset being
legally transferred to the lessee.
– Minimum lease payments

Do not include costs for services and taxes (executory costs) that are
paid to the lessor in reimbursement.
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Key terms
9. Guaranteed/unguaranteed
residual
a) Guaranteed residual
i.
The maximum amount that could become payable—included in
the minimum lease payments as its payment is reasonably
assured.
b) Unguaranteed residual
i.
Not included in minimum lease payments as there is not
sufficient certainty that the amount will be paid.
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Interest rate for determining PV of
minimum lease payments
Why interest in PV of minimum lease payments?
• Lessees recognise finance leases as assets and
liabilities:
– at amounts equal to the fair value of the leased property; or
– (if lower) the present value of the minimum lease payments
•
Discount rate to be used in calculating present
value:
– Interest rate implicit in the lease (if stated); or
– The lessee’s incremental borrowing rate.
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11-25
Interest rate for determining PV of
minimum lease payments
•
Interest rate implicit in the lease:
– The aggregate present value of:

the minimum lease payments +
 the unguaranteed residual value to be equal to the sum of:
• the fair value of the leased asset +
• any initial direct costs of the lessor.
•
Where fair value of asset cannot be determined by
lessee:
– Implicit interest rate cannot then be determined
– Lessee discounts minimum lease payments by using
incremental borrowing rates

The rate they would pay on a similar lease.
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Finance or operating lease
Lease
Finance lease
Operating lease
yes
yes
Non-cancellable?
no
Risks and rewards
transferred to
lessee?
yes
Ownership
transferred at
end?
yes
yes
Term major part of
economic life?
yes
PV of payments
substantially fair
value of asset?
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Accounting for lessee leases
•
Similar to acquiring assets by long-term loan.
• Lessee records an asset (leased) and a lease
liability.
• Asset and liability recorded at fair value
– Or (where lower) at PV of minimum lease payments.
•
•
Consideration is given to PV of future cash flows.
Unguaranteed residual excluded in financial
statements of lessee.
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Accounting for lessee leases
•
Rental payments include:
– payment of principal +
– interest—to be apportioned by lessee.
•
•
Interest expense calculated by applying the interest
rate implicit in the lease to outstanding lease liability
at beginning of each lease period.
Balance of payment represents a reduction of
principal of lease liability.
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Depreciation of leased assets
•
•
Leased assets should be depreciated (amortised)
using similar policies to regular assets.
Depreciation period =
– number of accounting periods to end of lease term or useful
life, whichever is shorter.
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Depreciation of leased assets
Journal entries
Dr
Leased asset
Cr
Lease liability
Recording the leased asset and the lease liability at start of lease term
Dr
Lease depreciation expense
Cr
Accumulated depreciation leased asset
Recording the lease depreciation expense
Dr
Lease liability
Dr
Interest expense
Cr
Cash
Recording the lease payment with allocation between principle and
interest
Dr
Executory expenses
Cr
Cash
Recording the payment of executory costs (eg rates/maintenance)
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Initial direct costs
•
•
•
•
Costs directly associated with negotiating and
executing a lease agreement.
Include commissions, legal fees, costs of preparing
and processing documentation.
Initial direct costs relating to a finance lease must be
capitalised as part of the leased asset.
Where such costs are incurred the lease asset
comprises the present value of the minimum lease
payments and the amount of the initial direct costs
incurred—total amount subject to amortisation.
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Lessee accounting for operating
leases
•
•
•
Leases that do not substantially transfer all risks
and rewards of ownership to the lessee.
Lease payments are expensed on a basis
representative of the pattern of benefits derived
from the leased asset.
If lease payments do not represent prepayments:
– they are expensed in the period made.
•
Rental expense of an operating lease to be
recognised on a straight-line basis over the lease
term:
– unless another systematic basis is more representative of
the time pattern of the user’s benefits.
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Lessee accounting for operating
leases
Journal entry:
Dr Rental expense
Cr
Cash
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Lessee accounting for
sale and leaseback transactions
•
•
•
Occurs when the owner of a property sells property
to another and simultaneously leases it back from
the purchaser/lessor (the legal owner).
Seller does not lose control of the asset if a finance
lease.
Property often sold at a price equal to or greater
than current market value:
– leased back for a term approximating useful life.
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Lessee accounting for
sale and leaseback transactions
•
•
•
Lease payments sufficient to repay the buyer for
cash invested plus reasonable return on
investment.
Lessee typically pays all executory costs as if title
remained with lessee.
Often considered a useful way of obtaining funds
while allowing recipient of the funds to maintain
control of the asset.
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Lessee accounting for
sale and leaseback transactions
Finance lease
•Where substantially all risks and rewards incidental
to ownership remain with lessee
– represents refinancing of an asset.
•Any
profit or loss on sale deferred in the balance
sheet and amortised to the profit and loss over the
term of the lease.
•Asset considered not to have been ‘sold’ to lessor,
therefore inappropriate to recognise profit or loss.
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Lessee accounting for
sale and leaseback transactions
Operating lease
• Where substantially all risks and rewards incidental
to ownership effectively pass to lessor.
Treatment:
• Transaction established at fair value
– any profit and loss shall be recognised immediately.
•
If sale price is below fair value:
– Any profit or loss shall be recognised immediately
– Unless the loss is compensated for by future lease
payments at below market price, it shall be deferred and
amortised in proportion to the lease payments over the
period for which the asset is expected to be used.
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Lessee accounting for
sale and leaseback transactions
•
If sale price is above fair value
– Excess over fair value is deferred and amortised over the
period for which the asset is expected to be used.
•
If fair value at the time of the transaction is less than
the carrying amount of the asset
– a loss equal to the amount of the difference between the
carrying amount and fair value is to be recognised
immediately.
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Lessee disclosure requirements
•
Finance lease
– Numerous disclosures required—Refer to NZ IAS 17,
par. 31.
•
Operating lease
– Numerous disclosures required—Refer to NZ IAS 17,
par. 35.
•
See exhibits 11.1 and 11.2 for examples.
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Accounting by lessors
Lessor’s perspective:
•Leases classified either as operating leases or
finance leases.
•Adoption of same criteria for non-cancellable lease
as for lessee.
•Factors addressed in NZ IAS 17, pars 10–12.
Finance leases can be further classified into:
•Leases involving manufacturers or dealers.
•Direct finance leases.
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Accounting by lessors
Direct financing lease:
•
•
•
•
•
•
A lease where the lessor provides the financial resources to
acquire the asset.
Lessor typically acquires the asset, giving the lessor legal title,
then enters a lease agreement to lease the asset to the lessee,
who subsequently controls the asset.
No sale is recorded.
Lessor derives income through periodic interest revenue.
Where risks and rewards of ownership are held by the lessee,
the lessor substitutes lease receivable for the underlying asset.
Lessors recognise assets held under a finance lease in their
respective balance sheets and present them as a receivable at
an amount equal to the net investment in the lease.
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Accounting by lessors
Net investment in lease
•The gross investment in the lease discounted at the
interest rate implicit in the lease.
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Accounting by lessors
Gross investment in the lease
• The aggregate of:
– the minimum lease payments receivable by the lessor under
a finance lease; and
– any unregulated residual value accruing to the lessor
•
Interest earned by lessor over lease term
– Difference between fair value of leased asset and sum of
the undiscounted minimum lease payments and any
unregulated residual value.
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Accounting by lessors
Gross investment in the lease continued:
• Initial indirect costs incurred by lessor
– Incremental costs that are directly attributable to negotiating
and arranging a lease, except for such costs incurred by
manufacturer or dealer lessors
– Includes commissions, legal fees, and costs associated with
processing new leases

If material, are to be included in the lessor’s investment in the lease
Recovery of executory costs:
• Costs are related to operation and maintenance of leased
property
– e.g. insurance, maintenance and repairs
– Should be treated as revenue by lessor in financial years in
which related costs are incurred.
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Accounting by lessors
Direct financing lease – Net vs. gross method
• Either net method or gross method can be used.
Net method
• Most commonly used.
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Accounting by lessors
Gross method
• Lease receivable recorded at the sum of the
undiscounted minimum lease payments and the
unguaranteed residual.
• Unearned interest revenue also recorded (contra
account) and amortised to interest revenue over the
lease term.
• Unearned interest revenue is subtracted from lease
receivable to determined carrying (present value) of
the lease receivable.
• Receivable recorded at its present value and does
not use contra account (unearned interest revenue).
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Accounting by lessors – journal
entries
Net method
To record initial acquisition of asset:
Dr
Asset
Cr
Cash/payables etc
To record lease receivable at inception:
Dr
Lease receivable
Cr
Asset
To record receipt of lease payments:
Dr
Cash
Cr
Lease receivable
Cr
Interest revenue
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Accounting by lessors – journal
entries
Gross method
To record initial acquisition of asset:
Dr
Asset
Cr
Cash/payables etc
To record lease receivable:
Dr
Lease receivable
Cr
Asset
Cr
Unearned interest revenue
To record receipt of lease payment:
Dr
Cash
Dr
Unearned interest revenue
Cr
Lease receivable
Cr
Interest revenue
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Lessor disclosure requirements for
finance leases
NZ IAS 32 disclosures:
a)A reconciliation between the gross investment in the
lease at the balance sheet date, and present value of
minimum lease payments receivable at the balance
sheet date. In addition, an entity shall disclose the
gross investment in the lease and the present value
of minimum lease payments receivable at the balance
sheet date, for each of the following periods:
– not later than one year
– later than one year and not later than five years
– later than five years.
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Lessor disclosure requirements for
finance leases
NZ IAS 32 disclosures continued:
b)Unearned finance income.
c)The unguaranteed residual values accruing to the
benefit of the lessor.
d)The accumulated allowance for uncollectible
minimum lease payments receivable.
e)Contingent rents recognised as income in the
period.
f)A general description of the lessor’s material leasing
arrangements.
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Accounting for lessors that are
manufacturers or dealers of leased assets
Where fair value of the property at the inception of the
lease differs from its cost to the lessor
•Represents a finance lease.
Two parts of the transaction:
•A sale with a resulting gain
– fair value vs. cost to dealer/manufacturer.
•A
lease transaction that will provide interest revenue
over the period of the lease.
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Accounting for lessors that are
manufacturers or dealers of leased assets
Lessor’s investment in lease accounted for in same
manner as direct financing lease:
•Value of sale recorded as fair value of asset at date of
sale
– equal to present value of minimum lease payments).
•Indirect
costs
– e.g. commissions, legal fees, etc.
– accounted for by lessor as a cost of sales in year in which
transaction occurs

not as part of net investment in lease receivable.
•Lease
rentals representing a recovery of executory
costs (if material) to be treated by lessor as revenue in
year in which costs incurred.
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11-53
Lessor’s journal entries for a lease
involving a dealer or manufacturer
Net method
To record receipt of lease payment:
Dr
Cash
Cr
Lease receivable
Cr
Interest revenue
To record sale and lease receivable:
Dr
Lease receivable
Dr
Cost of goods sold
Cr
Inventory
Cr
Sales
•Cost of sales represent cost of the asset to lessor
– assumed that asset being sold was part of the inventory of the
lessor.
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Lessor’s journal entries for a lease
involving a dealer or manufacturer
Gross method
To record sale and lease receivable:
Dr
Lease receivable
Dr
Cost of goods sold
Cr
Inventory
Cr
Sales
Cr
Unearned interest revenue
•Cost
of sales represents the cost of the asset to the
lessor—unearned interest revenue represents the gross
amount of interest to be earned throughout the term of the
lease.
PowerPoint slides to accompany New Zealand Financial Accounting 5e by Samkin
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11-55
Lessor’s journal entries for a lease
involving a dealer or manufacturer
To record receipt of lease payment:
Dr
Cash
Cr
Lease receivable
Dr
Unearned interest revenue
Cr
Interest revenue
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11-56
Lessor accounting for operating leases
•
•
•
Leased property accounted for as a non-current
asset.
Required to depreciate if a depreciable asset.
Lease receipts treated as rental revenue.
•
NZ IAS 17 (par. 53)
The depreciation policy for depreciable leased assets
is to be consistent with the lessor’s normal
depreciation policy for similar assets, and
depreciation is to be calculated in accordance with
NZ IAS 16 and NZ IAS 38.
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Leases involving land and buildings
•
•
•
•
•
Land is an asset with an indefinite life.
Risks and benefits of land cannot be transferred to
lessee unless the lease will, at completion, transfer
ownership or has a bargain purchase option.
Treated as operating lease unless reasonably
assured of transferring ownership.
Minimum lease payments must be allocated
between land and buildings in proportion to their
relative fair values at lease inception.
If lease not assured of transferring ownership of
land and buildings at end of lease, lease payments
allocated to land to be treated as operating lease.
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Leases involving land and buildings
•
Payments allocated to building (operating or finance
lease) will depend on whether lease transfers risks
and benefits of ownership to lessee
– Exception: Where fair value of land is immaterial in relation
to the fair value of total property, it may be treated as a unit
for classification purposes and so land component may be
ignored.
•
If lease then appears to transfer risks and benefits
of ownership the total lease for land and buildings
may be treated as a finance lease otherwise
operating.
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Lessee accounting for lease incentives
under a non-cancellable operating lease
Incentives by lessor
• May offer incentives to enter non-cancellable
operating leases (particularly for buildings)
–
–
–
–
Initial rent-free periods
Financial assistance for fitting out offices
Up-front cash incentives
Financial assistance to terminate existing lease
agreements.
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11-60
Lessee accounting for lease incentives
under a non-cancellable operating lease
•
•
•
Lease incentives not specifically dealt with by NZ
IAS 17.
Generally in exchange for benefits, lessee pays
higher lease payments than if no lease incentive
were provided.
NZ SIC-15 provides guidance
– Paragraph 3 states:

Incentives for the agreement of a new or renewed operating
lease should be recognised as an integral part of the net
consideration agreed for the use of the leased asset,
irrespective of the incentive’s nature or form or the timing of
payments.
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11-61
Future changes in accounting for
leases
•
•
IASB and US FASB working on revised standards for
leases.
Criticisms of current accounting treatment include:
– Adjustments made to values of leases are not fully explained
by notes
– The financial and operating lease accounting treatments are
very different for similar transactions, therefore issue of
comparability
– Transactions can be structured to achieve a particular leasing
classification

•
This is an unrecognised source of finance difficult for users to
understand.
7 Dec 2006 Media statement provided in exhibit 11.3.
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Implications for accounting-based
contracts
•
•
•
Classification as finance rather than operating lease
will affect debt–asset constraints.
Introduction of accounting standards requiring
capitalisation of finance leases have negative cashflow effects on firms.
Negative cash-flow effects found to have negative
impact on security prices.
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Summary
•
•
Leases are classified as operating or finance
leases.
Transfer of risks and benefits from lessor to lessee
is considered a finance lease
– Resulting asset and liability need to be disclosed by lessee.
•
Where leases are capitilised, the amount capitalised
is the PV of minimum lease payments or fair value
of asset (lower of):
– Lesee apportions payments between interest payment and
repayment of liability
– Must also amortise the leased asset over its expected
economic life.
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Summary
•
Operating leases raise no asset or liability in the
lessee:
– Treated as an expense by lessee
– Treated as revenue by lessor.
•
Lessor finance leases are further classified as
involving dealers or manufacturers or as direct
finance leases.
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11-65