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CHAPTER 18

Leases
INTRODUCTION
Air Canada operated 200 aircraft in its operating fleet at the end of 2014, either as part of its mainline fleet or
through Air Canada Rouge. Of these, only 91 aircraft are owned outright. Another 17 are under finance leases, 15
are owned by special purpose entities, and 77 are rented by Air Canada, under the terms of operating leases.
The aircraft fleet is obviously a critical asset for a company like Air Canada. Equally obviously, there are different
arrangements that can be put in place to gain use of aircraft. These arrangements have a significant impact on the
financial statements of the company.
What is the difference between an operating lease and a finance lease?
Accounting for a rental agreement such as a lease may appear to be straightforward. After all, the lessee is paying
rent to the lessor, so on the surface it would appear that the lessee simply recognizes rent expense, while the
lessor reports rent revenue. However, things are not always what they seem.
The purpose of this chapter is to explain the circumstances under which a lease is treated as a form of financing,
instead of a simple rental agreement, and how operating and financing leases should be reported by lessees
under current accounting standards. An appendix to this chapter describes the more complex lessor accounting
arrangements. In a second appendix to this chapter, we explain forthcoming changes in lease accounting that will
have a profound impact on financial statements.

DEFINITION OF A LEASE
A lease s a rental contract that transfers the right to use an asset in return for the payment of rent. In the commonly used
sense of the term, a lease is a fee-for-usage contract between an owner of property and a renter. The lessor owns the asset,
and the lessee uses the asset. The lease specifies the terms under which the lessee has the right to use the owner’s property
and the compensation to be paid to the lessor in exchange.
 Chapter 18 Leases 1243

Leased assets can include both real property and personal property. Real property means real estate: land and buildings.
Personal property is any property that is not real property and includes both tangible assets (e.g., machinery, equipment, or
transportation vehicles) and certain intangibles (e.g., patents).

THE LEASING CONTINUUM

Some leases are more or less standard contracts, but each lease is individual. Every lease requires separate negotiation, and
the lease contract must be signed by both the lessor and the lessee.
In the process of negotiation, the parties reach agreement on many contractual terms, such as:
• The length of the lease (the lease term);
• The amount and timing of lease payments;
• Each party’s responsibility for maintenance, insurance, and property taxes, if any;
• Cancellation terms, including payouts or the return of the leased asset at the end of the lease term;
• Upgrading responsibilities; and so on.
The leasing continuum goes from very short term leases (hourly or daily rental) to very long term leases (multi-year/
multi-decade rentals), with many lease terms in the middle. As the lease term lengthens, in relationship to an asset’s
economic life, more of the risks and rewards of ownership pass from the lessor to the lessee. Accordingly, the risk premium
associated with the lease payments typically declines when the term lengthens.
For example, consider a car rental arrangement. If the term of the rental arrangements is for one month, the monthly rental
is set on one scale that provides return to the lessor based on constant, but risky, re-rental of the unit. If the lease term is
four years, and has a guaranteed buyout of the asset at the end of the fourth year, the average monthly rental rate is far lower
because re-rental is no longer a risk factor. However, the total rent paid by the lessee is clearly higher with a four-year lease.
This four-year lease provides return to the lessor based on a completely different risk profile. At some point in the term and
price continuum, the lessee essentially agrees to pay the full value of the car via the rent payments and final payout.
To recognize the dividing line along this continuum, the accounting standards have used two classifications for leases:
• Finance leases, wherein the lessor transfers substantially all of the risks and rewards of ownership to the lessee; and
• Operating leases, wherein the lessor does not transfer substantially all of the risks and rewards of ownership to the
lessee.
Note that an operating lease is not defined directly. Essentially, an operating lease is a lease that does not fit the definition
of a finance lease. If it’s not one, it has to be the other!
Accounting treatment for each of these two lease classifications is very, very different, in an effort to portray the substance
of a lease agreement in the financial statements. Unfortunately, this has provided an incentive to structure leases as operating
leases. Accountants must be able to exercise their professional judgement and discern substance over form so that financial
statements are not misleading.

Operating Leases
A lessee enters into an operating lease to essentially obtain temporary use of an asset without having to buy it. This might be
appropriate when there is no long-term need for an asset or when the lessee’s business is volatile and there is no continuous
need for the asset. The key to designating a lease as operating is not the actual length of the lease in time—it is the length of
the lease in relation to the asset’s economic life. An operating lease term covers a relatively small proportion of the asset’s
economic life.
Because an operating lease provides only a relatively short-term return to the lessor, the lessor bears the risk of ownership.
If the lessee returns the asset after the rental period and the lessor cannot find another lessee, then the lessor incurs the costs
not only of maintaining the asset but also of watching it sink slowly into obsolescence.
1244 Chapter 18 Leases

Finance Leases
At the other end of the leasing continuum, a finance lease gives the lessee substantially all of the benefits of ownership. The
lessee also has to bear most of the risks of ownership. For example, the lessee is committed to the lease contract, even if the
lessee has no further use for the asset.
When a lease transfers substantially all of the benefits and risks of ownership to the lessee, the lessee might as well have
purchased the asset outright. Indeed, purchasing the asset would give more flexibility—there are no restrictions on what the
owner does with an owned asset but a lease may well include restrictions.
We will return to the criteria that determine whether a lease is a finance lease later in the chapter. First, however, we will
look at operating lease accounting.

OPERATING LEASES
Remember, an operating lease is a lease that is not a finance lease. Accounting for operating leases is not complicated; the
lessee simply has rent expense over the life of the lease.

Rent Expense
The lessee makes periodic lease payments that are accounted for as operating expenses by the lessee. For example, assume
that:
• Empire Equipment Ltd. (EEL) buys a crane on 6 January for $1,580,000. The crane has an estimated useful life of 10
years and an estimated residual value of $260,000.
• On 25 January, Builders Inc. enters into a 10-month lease contract with EEL for the use of the crane. The monthly rent
is $20,000. The crane will be delivered to Builders Inc. on 1 February.
• EEL charges Builders Inc. a standard fee of $15,000 for the cost of the crane’s assembly, disassembly, and transport
cost.
Builders Inc. records the following entries:

25 January—inception of the lease:

No entry

1 February—payment of installation fee:

Rent expense—crane* 15,000

Cash 15,000

*May also be debited to prepaid expense and recognized over 10 months, as

discussed below.

Monthly entry—payment of monthly rent

Rent expense—crane 20,000

Cash 20,000

This monthly entry is made ten times, once per month. The crane itself does not appear on Builder Inc.’s books.
 Chapter 18 Leases 1245

Dates
Note that there are two dates for the lease:
• The inception of the lease, which is the date at which the lessor and lessee commit to the principal provisions of the
lease; this usually coincides with the signing of the lease agreement but could be earlier, such as in a memorandum of
agreement; and
• The commencement of the lease term, which is the date upon which the lessee is entitled to use the asset.
For the lease above, the inception of the lease is 25 January, while the commencement of the lease term is 1 February.
The date of inception is the date when the accounting treatment of the lease as either an operating lease or a finance lease
is determined. A substantial period of time can elapse between inception and commencement, such as when the asset must
be constructed before the lease can commence (e.g., aircraft ordered under lease agreement that will not be delivered for
several years). However, no formal entries are made in the accounting records until the lease commences.

Executory Costs
Many operating leases require the lessee to pay specified costs relating to the leased asset during the lease term. These are
known as executory costs. In this example, the lessee is required to pay $15,000 for the lessor’s delivery and construction of
the crane. For the lessee, this is just part of the cost of renting the crane and is charged to rent expense. This amount might
be treated as a prepaid expense, and then expensed over the life of the lease, but executory expenses for operating leases are
usually expensed immediately because of the short lease term.

Uneven Payments
Sometimes the operating lease payments are uneven. For example, a lessee may be required to make an initial lump-sum
1
payment in addition to the periodic rent payment. If there is a large payment at the beginning (or inception) of the lease,
the special payment is amortized over the period of time that the lessee is required to make lease payments. This period of
time is called the initial lease term. The lease may be renewable, but since there is no obligation on the part of the lessee
to renew the lease, the amortization period is limited to the initial term. For example, if a tenant pays $10,000 as an upfront
fee on a five-year operating lease of storage facility, the $10,000 is accounted for as a prepaid expense and recognized in the
amount of $2,000 per year.
An alternative arrangement that also occurs, particularly for office real estate rentals, is that the lessor will “forgive”
lease payments for a specific, limited period of time at the beginning of the lease. For example, in a market that has
excess supply, a lessor may attract a lessee by agreeing that lease payments will not begin until six months after the
lease starts. These forgiven payments also are amortized over the initial term of the lease. The lessee must determine
the total cash paid over the lease term, and expense the same amount each period, regardless of whether a payment is
made that period.
For example, assume that F212 Ltd. leases space in an office building for five years for an annual rental of $100,000.
Because the office rental market is “soft,” the lessor agrees that F212 need not begin paying rent until the second year; the
first year’s rent is forgiven. The substance of this deal is that F212 agrees to pay a total of $400,000 for five years; this
averages out to an effective rental rate of $80,000 per year. For the first year, there is no cash flow for rent, but F212 will
record an expense of $80,000, which is offset by a deferred credit:

Rent expense 80,000

Deferred rent liability 80,000

For each of the next four years, the $80,000 will be adjusted to rent expense, thereby reducing rent expense from the cash
outflow of $100,000 to the average annual expense of $80,000. The annual entry on F212’s books will be:

1. When the rental contract is for real estate, such payments sometimes are known as key money and may be prohibited in some jurisdictions, particularly
in those with rent controls on residential properties.
1246 Chapter 18 Leases

Rent expense 80,000

Deferred rent liability 20,000

Cash 100,000

The deferred rent will be reported as a liability on the SFP, allocated between short-term and long-term liabilities, and
usually combined with other provisions. Discounting may also be appropriate.
A fundamental question remains: When is a lease an operating lease? To understand the distinction between an operating
lease and a finance lease, we must examine the guidelines for designating a lease as a finance lease.

FINANCE LEASES
A finance lease is defined as any lease that transfers substantially all of the risks and rewards of ownership from the lessor
to the lessee. The lessor agrees to purchase an asset and lease it immediately to a lessee for substantially all of the economic
life of the asset. When that happens, the lessor is not interested in using the asset, even though the lessor will hold legal
title. A finance lease is a form of financing because the lessee acquires essentially full benefits of the leased asset without
actually having to buy it. The lessor is providing an asset to the lessee in return for a cash flow stream that enables the lessor
to recover its investment in the asset as well as earn a reasonable rate of return on the investment. Finance leases are also
referred to as capital leases.

Classification as a Finance Lease

The basis for designating a lease as a finance lease is judgemental: Do the terms of the lease transfer substantially all of
the benefits and risks of ownership from the lessor to the lessee? However, the exercise of professional judgement requires
criteria or guidelines. There are circumstances that individually or in combination indicate that substantially all of the risks
and rewards of ownership are being passed to the lessee.
If any one of the following guidelines is satisfied, the lease should be classified as a finance lease:
1. Is there reasonable certainty that the lessee will obtain ownership of the leased property at the end of the lease term?
This occurs (1) if the lease provides for automatic transfer of title to the lessee at the end of the lease, or (2) if the lessee
is entitled to buy the asset at the end of the lease term at a price significantly lower than the expected fair value at that
time (this is called a bargain purchase option).
2. Will the lessee receive substantially all of the economic benefits expected to be derived through use of the leased
property? This normally is indicated by a lease term that covers most of the asset’s economic life. Since the economic
benefit of assets goes down over time (through deterioration and obsolescence), substantially all of the economic
benefit can be derived during a lease term that falls short of the full physical life of the asset. Although not included in
the standard, the normal rule of thumb is (in the range of) 75%.
3. Will the lessor be assured of recovering substantially all of the investment in the leased property, plus a return on
the investment, over the lease term? This is determined by calculating the present value of the minimum net lease
payments. Although not included in the standard, the normal rule of thumb is that the test is met if the present value is
(in the range of) 90% or more of the fair value of the leased asset at the inception of the lease. The discount rate is the
interest rate implicit in the lease, or, if this rate is not known by the lessee, the lessee’s incremental borrowing rate.
4. Is the leased asset so highly specialized that only the lessee can obtain the benefit without substantial modification?
This is particularly true of assets that are fixed in place and cannot be moved without incurring costs that probably
would exceed the asset’s remaining benefits. If the lessee is the only possible user of the asset, the lease is a finance
lease.
 Chapter 18 Leases 1247

No Bright Lines
The classification guidelines established by IFRS standards include some numeric suggestions—“in the range of 75% of
economic life” for the term of the lease, and “in the range of 90% of fair value” when comparing discounted cash flow to fair
value. It is important to understand that these are not hard-and-fast limits. Hard-and-fast limits are sometimes called bright
lines, meaning that they are not negotiable. For example, if the present value of the minimum lease payments were 89.4% of
fair value, and 90% was interpreted as a bright line, the test would not be met and the lease would not be a financing lease
based on this guideline. Since the numeric limits are ranges, or suggestions, though, 89.4% might be interpreted as very
close indeed to the judgemental spirit of the guideline and the lease might be classified as a financing lease. The 75% and
90% numbers are from FASB and ASPE standards, where they are interpreted as bright lines.

Definitions
The guidelines and this discussion use certain terms, which must be clearly defined.
• A bargain purchase option exists when there is a stated or determinable buyout price given in the lease that is sufficiently
lower than the expected fair value of the leased asset at the option’s exercise date to make it probable that the lessee
will exercise the option. Even if the lessee does not really want the asset after the end of the lease term, it would be
advantageous to exercise a bargain purchase option and then resell the asset at its higher fair value. While “bargain
purchase option” is not an explicit term in the accounting standard, it is a useful shorthand expression that is well
understood in practice.
• A bargain renewal term is one or more periods for which the lessee has the option of extending the lease at lease
payments that are substantially less than would normally be expected for an asset of that age and type. “Bargain renewal
term” is a term used in practice because it captures the essence of renewal terms that would strongly entice a lessee to
renew.
• The lease term includes:
– All terms prior to the exercise date of a bargain purchase option;
– All bargain renewal terms; and
– All renewal terms at the lessor’s option.
• A guaranteed residual value is an amount that the lessee promises that the lessor can receive for the asset by selling
it to a third party at the end of the lease term. If there is any deficiency in the sales proceeds when the lessor sells
the asset, the lessee must make up the difference. The guaranteed residual value is decided when the lease contract is
negotiated. A high guaranteed residual value will effectively reduce the periodic lease payments, while a low guarantee
will increase the lease payments that a lessor will require to recover the lessor’s investment in the asset.
• In contrast, the lessee may not guarantee the residual value, in which instance there is an unguaranteed residual value.
This is the value that the lessor expects to realize on sale of the asset at the end of the lease term. The lessee has no
liability for such an amount, and in fact would usually be unaware of the dollar amount. However, the size of the lessor’s
expected residual value will have a direct impact on the size of the lease payments.
• The lessee’s minimum net lease payments are all payments that the lessee is required to make over the lease term,
as described above (i.e., including bargain renewal terms), net of any operating or executory costs that are implicitly
included in the lease payment, plus any guaranteed residual value. A bargain purchase option value (if any) also is
included.
It is important to deduct operating costs from the lease payments to find the net lease payments. For example, if the lessor
pays insurance on the asset, the lessor includes an estimate of the cost of insurance premiums when setting the lease
payments. The insurance is not a cost of acquiring the asset; however, it is a cost of using the asset. Therefore, any operating
costs that are implicitly included in the lease payments must be estimated and subtracted to find the amount of the payments
that represent, in substance, the cost of acquiring the asset.
The lessee’s minimum net lease payments also exclude any amounts for contingent lease payments, which are additional
lease payments that are based on subsequent events, such as payments calculated on a percentage of a lessee’s gross sales
revenue.
1248 Chapter 18 Leases

• Initial direct costs are the costs incurred when negotiating and arranging a lease. For a lessor, these costs may include
not only negotiations with the lessee but also negotiations with the vendor or manufacturer from whom the lessor will
obtain the asset to be leased.
• The implicit lease interest rate is the interest rate that equates:
• The minimum net lease payments, the initial direct costs, the residual value (whether guaranteed or not), and the
tax cash flows; and
• The fair value of the leased property at the beginning of the lease.
This rate is calculated from the lessor’s point of view—the estimated cash flows of the lessor over the minimum lease
term (as defined above).
• The lessee’s incremental borrowing rate (IBR) is the interest rate that the lessee would have to pay to obtain financing
through a financial institution to buy the asset.

Guaranteed versus Unguaranteed Residual Values

It is important to understand the different roles of guaranteed and unguaranteed residual values in finance lease accounting:
• A guaranteed residual value is part of the definition of net lease payments for both the lessee and the lessor.
• The lessee uses only the guaranteed residual value as part of its discounted cash flow because the lessee is committed
to pay it if the lessor is not able to recover that amount by disposal of the asset at the end of the lease. An unguaranteed
residual is excluded from net minimum lease payments for the lessee.

Discount Rate
The interest rate used for discounting the net lease payments is the lessor’s interest rate implicit in the lease, if known by the
lessee. When the lessee does not know the lessor’s interest rate implicit in the lease, the lessee’s incremental borrowing rate
is used.
Sometimes, lending legislation requires that the lessee be informed of the interest rate implicit in the lease. In other cases, the
rate is not disclosed. If the lessor does not disclose an implicit interest rate, the lessee usually would not be able to calculate
it, because:
• The lessee will not know the lessor’s direct costs of the lease;
• The lessee does not know the lessor’s estimated unguaranteed residual value;
• The lessor takes into account the expected value of any contingent rent when negotiating the lease terms, but the lessor’s
estimate of these expected amounts is not known to the lessee; and
• The lessor normally calculates the lease payments with an eye to obtaining an after-tax rate of return, and the lessor’s
tax status is not known to the lessee.

Contingent Rent
Contingent rent is rent that depends on specified future events. Leases for retail space offer a common example of
contingent rent—in addition to basic rent, the lessee (i.e., a retailer) usually agrees to pay a percentage of the store’s gross
sales to the lessor. Contingent rent may also be based on factors such as an asset’s volume of use, on variations in the lessor’s
operating expenses (including property taxes) in connection with the lease, on price indices, or on market interest rates, to
name a few.
Contingent rent is excluded from accounting lease calculations for both lessor and lessee. However, contingent rent
arrangements are a very important part of decision analysis for both the lessor and the lessee. Indeed, some lease agreements,
especially for retail space, depend on achieving a certain volume of activity; if that volume is not achieved, the lessor may
have the right to terminate the lease.
Contingent rents are reported as operating expenses in the period that they are incurred rather than when they are paid.
Sometimes this will require the lessee to accrue estimated contingent rent payments on a quarterly or monthly basis, even
though the exact amount will not be known until after the end of the lease year.
 Chapter 18 Leases 1249

Economic versus Useful Life

The economic life of an asset is the maximum number of years that it can be economically productive. The useful life to a
particular company may be shorter. For example, desktop computers may be useful for six years, but a company may choose
to keep its desktop computers no more than four years to stay up-to-date. The economic life is six years, while the useful life
is four years. Useful life can never be longer than economic life.

Fair-Value Ceiling
In no case may an asset be recorded at higher than its fair value. Consider a simple example. Consider an equipment lease,
where a lessee agrees to pay the lessor $100,000 at the end of each year for four years. The fair value of the equipment being
leased is $300,000, and the asset has a four-year useful life. This is a financing lease because it covers the entire useful life
of the equipment. The lessor’s implicit rate of return is unknown, and therefore the lessee’s IBR of 10% is used in present
value calculations. At 10%, the present value of the lease payments is $316,987:

PV $100,000 × (P/A, 10%, 4) $316,987

If the lessee uses its IBR, the book value of the asset will be higher than the fair value of the asset. In such a case, the lessee
must:
1. Record the asset at its fair value, or $300,000; and
2. Increase the interest rate to a rate that discounts the lease payments to the $300,000 fair value of the asset. The equation is:

$300,000 $100,000 × (P/A, i, 4)

This must be solved for the value of i.

The interest rate that solves this equation is 12.6%. The implicit rate can be quickly calculated with a financial calculator or
with an Excel spreadsheet. An explanation of present value calculations can be found on Connect.

An Informal Guideline
When interpreting the guidelines, the basic issue is whether, in substance, the risks and benefits have been transferred from
the lessor to the lessee.
One criterion that is not explicitly cited by the standard setters but that is very useful in practice is to look at the nature of
the lessor. The nature of the lessor may be important to determining whether the lease is a finance lease or an operating
lease.
To fully realize the tax advantages that often are the driving force behind finance leases, a lessor must qualify as a lessor
under the income tax regulations. That means that a lessor must derive at least 90% of its revenues from lease transactions.
Any company that meets this criterion is a financial intermediary. Any lease that such a financial institution enters into
can be assumed to be a finance lease, even if financial lease classification is not clear when the four finance lease guidelines
have been applied.
For example, if the lessor is the leasing subsidiary of a financial institution, it should be clear that the lease is not an operating
lease. Financial institutions have financial assets, not operating assets (except for their own tangible operating assets, of
course) on their SFPs. The leasing division of a financial institution will not assume the risks of owning an asset, even
though it has legal title to many thousands of them through lease contracts.

Land Leases
Land is a unique asset in that it has an indefinite useful life. Land would be expected to hold its value over its life, and
be generally useful to a number of business operations. As a result, a land lease would always fail the guideline that deals
1250 Chapter 18 Leases

with a comparison of the lease term with the life of the asset, portion of fair value represented by the lease payments, and
specialized asset. Accordingly, land leases are operating leases unless title passes to the lessee.

CONCEPT REVIEW

1. What is the basic judgemental criterion that determines whether a lease is a finance lease?
2. List the four guidelines that help determine whether a lease is a finance lease. Are the
numeric suggestions bright lines or general guidance?
3. When are operating lease rental payments expensed in periods other than in the period of
payment?
4. Define the following terms:
• Bargain renewal options;
• Incremental borrowing rate; and
• Lease term.
5. How can the nature of the lessor influence the lease classification?

ACCOUNTING FOR FINANCE LEASES—LESSEE

If a long-term lease qualifies as a finance lease for accounting purposes, the asset is recorded on the lessee’s books as
though it had been purchased and financed by instalment debt. An outline of the accounting treatment is described briefly
below:
• The present value of the lease payments is determined by using the following:
– The discount rate is the lessor’s implicit rate, if known, and otherwise the lessee’s IBR.
– The cash flows to be discounted are the net minimum lease payments over the initial term, plus net lease
payments for any bargain renewal terms, plus net lease payments for any term prior to a bargain purchase option,
plus any renewal terms at the lessor’s option, and plus any guaranteed residual value or any bargain purchase
price.
• The present value is recorded as the cost of the asset and is classified as a tangible or intangible capital asset. The
recorded cost cannot be higher than the asset’s fair value. If recorded cost is capped at fair value, the discount rate must
be increased.
• The offsetting credit is to a lease liability account.
• Interest is accrued for each period, charged to interest expense, and credited to the lease liability account. Interest is
based on the discount rate.
• Lease payments are debited to the lease liability account, reducing the liability.
• The asset is depreciated or amortized over its useful life using the company’s normal depreciation or amortization policy
for that type of asset. However, the depreciation or amortization period cannot exceed the lease term unless the lease
contains a bargain purchase option or automatic transfer of title at the end of the lease. Otherwise, the asset will be
depreciated or amortized over the lease term (including bargain renewal terms).
• Depreciation can be calculated to the nearest month, or an accounting convention, such as the half-year rule, may be
used for simplicity.
 Chapter 18 Leases 1251

Depreciation
The depreciation period is the period of time that the lessee will use the asset: its useful life to the company. This may be
limited by the lease term and conditions. Consider the following cases:

Case 1 Case 2 Case 3

Lease term, including bargain renewals 5 years 5 years 5 years

Economic life of the leased asset 8 years 8 years 4 years

Bargain purchase option included in lease contract No Yes No

Choice of depreciation term 5 years 8 years 4 years

In Case 1, the asset will last 8 years, but the lessee has use of it for only 5 years, so depreciation is taken over 5 years. In
Case 2, the lessee has a bargain purchase option and so will control the asset after the end of the lease term. Assuming
that the lessee will continue to use it, the asset would be depreciated over 8 years. If not, it will have a shorter useful life
and some estimated residual value on sale. In Case 3, the economic life is 4 years, and this is the maximum depreciation
period.
In practice, Case 3 is highly unlikely—economic life is typically longer than the lease term. After all, why agree to pay for
an asset after it has stopped being useful? However, things happen. Perhaps an asset becomes obsolete during its lease term,
or the lessee changes the nature of its business and no longer needs that asset. In any case, the lessee may need to change the
estimate of useful life for depreciation; these estimates are revisited annually.
The really important point is that the depreciation period can never be longer than the lease term unless the lessee will obtain
title to the asset at the end of the lease, either automatically or by exercising a bargain purchase option.
Depreciation is based on the recorded asset value, minus any estimate of residual value at the end of its useful life. This
residual value is either:
• The guaranteed residual value, if any; or
• A normal estimate of residual value at the end of the asset’s life, if the lessee keeps/buys the asset at the end of the lease;
or
• Zero, if the asset reverts to the lessor with an unguaranteed residual.

LEASES IN THE STATEMENT OF CASH FLOWS

Lease capitalization has an interesting impact on the statement of cash flows. If a lease is reported as an operating lease, the
lease payments are deducted as an expense. Since the expense represents a cash flow, the impact of the lease payments stays
in the cash flow from operations.
The only exception arises when the cash flows are uneven or differ from the pattern of rent expense recognition. If lease
payments in a year are different from the amount expensed, the difference will be an adjustment to cash flow from operations
because of the change in the prepaid or deferral account (if the indirect approach is used).
If a lease is capitalized, on the other hand, the effects on the statement of cash flows are quite different:
• Although the initial lease agreement is viewed, in substance, as a purchase, the transaction is not shown on the SCF
as an investing activity or financing activity because it is a non-cash transaction—a lease obligation is exchanged for a
leased asset. This non-cash transaction must be disclosed in the notes.
• Expenses relating to the leased asset are removed from earnings when determining cash flow from operations:
1252 Chapter 18 Leases

– Depreciation expense relating to the leased asset is added back to net income; and
– Interest expense is segregated on the statement of cash flows as part of interest expense relating to long-term
obligations; the interest paid can be classified as either operating or financing.
• The principal repayment portion of the lease payments is shown as a financing activity (i.e., as a reduction of a liability).
The overall effect of lease capitalization is that the lessee can remove the lease payments from operating cash flow and
reclassify them as financing activities.

FINANCE LEASE ILLUSTRATION—BASIC EXAMPLE

We will begin our illustration of accounting for finance leases with a fairly simple example that focuses on the most
significant aspects of lease accounting.
Assume that Lessee Ltd. wishes to acquire equipment that has an expected economic life of eight years and a fair value of
$66,000. Instead of buying the asset outright, the company enters into a lease with Borat Corp., a Canadian finance company
that specializes in asset-based financing. The facts are shown in Exhibit 18-1.

EXHIBIT 18-1

LEASE TERMS—BASIC EXAMPLE

• The fair value of the asset is $66,000.

• The lease begins on 1 January 20X2.
• The initial lease term is three years.
• The economic life of the asset is eight years.
• Payments over the initial lease term are $20,000 per year, payable at the beginning of each lease year
(i.e., on 1 January 20X2, 20X3, and 20X4).
• At the end of the initial lease term, the lease is renewable for another two years at Lessee’s option for
$5,000 per year. Assume that the normal rental cost of three-year-old equipment of this type is almost
$10,000 per year.
• Lessee is responsible for insuring and maintaining the equipment.
• The asset reverts to the lessor at the end of the lease; the lease agreement contains no obligation for
Lessee to guarantee the residual value. The lessee does not know the amount of the unguaranteed
residual value.
• Lessee does not know the lessor’s implicit rate of interest in the lease. Lessee’s incremental borrowing
rate is 8%.

In this example, the important elements for analysis are as follows:

• The lease term is five years—the initial lease term of three years plus the bargain renewal term of two years. Five years
is 63% of the asset’s estimated economic life of eight years.
• The minimum net lease payments are $20,000 for each of the first three years and $5,000 per year for the fourth and
fifth years, for a total of $70,000. The present value of the minimum lease payments is $63,310:

PV $20,000 (P/AD, 8%, 3) + $5,000 (P/AD, 8%, 2) (P/F, 8%, 3)

PV $55,666 + $7,644
PV $63,310
 Chapter 18 Leases 1253

Note: P/AD means “present value of an annuity due,” which is an annuity that requires payments at the beginning
of each period. It is common for lease payments to be required at the beginning of each period. If payments were at
the end of each period, the present value would be based on the “present value of an ordinary annuity,” or (P/A).

Classification: Applying Lease Guidelines

Does this lease qualify for classification as a finance lease? Exhibit 18-2 applies the four finance lease classification
guidelines to this example. Only one guideline needs to be met for the lease to qualify as a finance lease. The first and fourth
guidelines clearly do not apply. Looking at the lease term relative to the asset’s economic life, the lease covers much (5/8, or
63%) of the asset’s economic life, but clearly not the full life. However, the lease clearly meets the third guideline, based on
present value, because the present value is over 90% of the fair value at the inception of the lease. Lessee should classify the
lease as a finance lease.

EXHIBIT 18-2

APPLYING THE FINANCE LEASE GUIDELINES—BASIC EXAMPLE

Guideline Analysis

1. Does the lease transfer ownership to the No. The lease contains no purchase option
lessee at the end of the lease, either and ownership of the asset will not transfer to
automatically or by provision for a the lessee at any time.
bargain purchase option?

2. Is the lease term for the major part of the Perhaps. The lease covers 5/8 of the asset’s
economic life of the asset? economic life, which is a majority of the years.

3. Does the PV of the minimum lease Yes. The PV of minimum lease payments is
payments amount to substantially all of 96% of the asset’s fair value. ($63,310 ÷
the asset’s fair value? $66,000)

4. Is the leased asset highly specialized to No. The lessor estimates a significant residual
the lessee? value, which would not be the case if the asset
were highly specialized to the lessee’s use.

Liability Amortization Table

A liability amortization table is useful in lease accounting. This amortization table is similar to the tables illustrated in
Chapter 13 for long-term debt issued at a discount or premium. For leases, the payments are blended payments—part interest
and part principal. The purpose of the table is to determine how much of each year’s cash lease payment goes to (1) interest
expense and (2) reduction of principal.
A liability amortization table for this lease example is shown in Exhibit 18-3. The beginning-of-year cash flows are placed
in the fourth column, and the net lease present value (at 8%) is placed at the beginning of the second column (“outstanding
balance”).
The first payment is made at the commencement of the lease, 1 January 20X2. Since this is the first day of the lease, there
has been no elapsed time and therefore no interest element. The table shows that this first payment is all principal.
On 1 January 20X3, the payment must be divided between interest and principal payment. Exhibit 18-3 shows that interest
is $3,465 (i.e., $43,310 × 8%), which means that of the second $20,000 lease payment, $3,465 is charged to interest, and the
remaining $16,535 of the lease payment will go to reducing the outstanding principal balance.
1254 Chapter 18 Leases

Notice for each payment, there is an allocation to interest based on the opening liability balance, and the remainder is a
principal reduction. Principal outstanding is reduced to zero at the end of the payment stream. The payment stream includes
all five cash payments included in the discounting calculation.

EXHIBIT 18-3

LEASE LIABILITY AMORTIZATION TABLE

Net Lease 31
Outstanding Interest Payment Decrease December
1 January Balance at 8% 1 January in Balance Balance

20X2 $63,310 $ — $20,000 $(20,000) $43,310

20X3 43,310 3,465 20,000 (16,535) 26,775

20X4 26,775 2,142 20,000 (17,858) 8,917

20X5 8,917 713 5,000 (4,287) 4,630

20X6 4,630 370 5,000 (4,630) 0

Totals $6,690 $70,000 $ (63,310)

The lines of the table must be interpreted carefully—they represent lease payments, not fiscal years. For example, the top
line of the table is related to the 1 January 20X2 payment. Interest expense for 20X2, though, is $3,465 (from the 20X3 line).
This is 8% of the liability of $43,310 that was outstanding from 2 January 20X2 to 31 December 20X2.

Proofs
At any point in time, the outstanding balance in the table is equal to the present value of the remaining payments. This is a
convenient way to check a table as you progress, or to begin a table in mid-stream, if needed.
To illustrate, the opening balance in the table is $63,310:

PV $20,000 (P/AD, 8%, 3) + $5,000 (P/AD, 8%, 2) (P/F, 8%, 3)

PV $55,666 + $7,644
PV $63,310

After two payments, the balance is now $26,775:

PV $20,000(P/F, 8%, 1) + $5,000 (P/AD, 8%, 2) (P/F, 8%, 2)

PV $18,519 + $8,256
PV $26,775

After four payments, the balance is now $4,630:

PV $5,000 (P/F, 8%, 1)

PV $4,630
 Chapter 18 Leases 1255

Note that the cash flows and interest rate used are not changed, but the payment stream may have changed from an annuity
to a lump sum, and n changes, both of which reflect the actual cash flow pattern remaining.

Initial Recognition
The principal amount at the inception of the lease, 2 January 20X2, is the full present value of $63,310. (This is lower than
fair value of $66,000—there is no fair value cap.) The lease will be recorded as follows:

Asset under finance lease 63,310

Lease liability 63,310

The first lease payment is made on this date:

Lease liability 20,000

Cash 20,000

Year-End Adjustments
The interest that has accrued through 20X2 must be recorded at year-end:

Interest expense 3,465

Lease liability 3,465

Note that the credit is recorded to the lease liability account, which adds an element of accrued interest to the account.
Accrued interest payable is an alternative account choice. We will use the lease liability account for interest accrual because
subsequent entries are less complicated.
In addition, Lessee must depreciate the asset. The asset will be held and used by the company for five years, and it reverts
back to the lessor at that time with an unguaranteed residual value. If we assume that Lessee’s accounting policy for this type
of asset is to depreciate it on the straight-line basis with a full year’s depreciation taken in the first year, then the depreciation
of the leased equipment on 31 December 20X2 will be $12,662 (i.e., $63,310 ÷ 5). There is no residual value because the
amount is unguaranteed. The entry is:

Depreciation expense 12,662

Accumulated depreciation-asset under lease 12,662

20X3 Entries
On 1 January 20X3, Lessee makes the second lease payment:

Lease liability 20,000

Cash 20,000
1256 Chapter 18 Leases

Note that the 31 December 20X2 interest accrual is credited directly to the lease liability account. If the accrued interest
had been credited to accrued interest payable, the debit in this entry would be broken down between interest payable and
principal.
The interest that has accrued through 20X3 must be recorded at year-end; note that this is from the 20X4 line of the table:

Interest expense 2,142

Lease liability 2,142

The depreciation entry is unchanged:

Depreciation expense 12,662

Accumulated depreciation—asset under lease 12,662

Remaining Entries
Exhibit 18-4 shows all of Lessee’s entries for the lease. The final column of the exhibit shows the accumulated balance of
the total lease liability account. The year-end interest accruals increase the balance, while the lease payments reduce the
balance. The final lease payment, on 1 January 20X6, reduces the balance to zero.

EXHIBIT 18-4

LESSEE’S RECORDING OF FINANCE LEASE—BASIC EXAMPLE

Lease Liability
Dr. Cr. Balance
1 January 20X2
Asset under finance lease 63,310
Lease liability 63,310 63,310
Lease liability 20,000 43,310
Cash 20,000
31 December 20X2
Interest expense 3,465
Lease liability 3,465 46,775
Depreciation expense 12,662
Accumulated depreciation—asset under lease 12,662
1 January 20X3
Lease liability 20,000 26,775
Cash 20,000
 Chapter 18 Leases 1257

Lease Liability
Dr. Cr. Balance
31 December 20X3
Interest expense 2,142
Lease liability 2,142 28,917
Depreciation expense 12,662
Accumulated depreciation asset under lease 12,662
1 January 20X4
Lease liability 20,000 8,917
Cash 20,000
31 December 20X4
Interest expense 713
Lease liability 713 9,630
Depreciation expense 12,662
Accumulated depreciation—asset under lease 12,662
1 January 20X5
Lease liability 5,000 4,630
Cash 5,000
31 December 20X5
Interest expense 370
Lease liability 370 5,000
Depreciation expense 12,662
Accumulated depreciation—asset under lease 12,662
1 January 20X6
Lease liability 5,000 0
Cash 5,000
31 December 20X5
Depreciation expense 12,662
Accumulated depreciation—asset under lease 12,662

Observe that the lease liability balance after each lease payment is exactly the same amount as shown in the final column
(year-end balance) of Exhibit 18-3. These amounts are shown in bold type in both exhibits.
1258 Chapter 18 Leases

End of Lease Term

At the end of the lease term, when the asset is returned to the lessor, Lessee must write off the fully depreciated asset:

Accumulated
depreciation—asset under lease 63,310

Asset under finance lease 63,310

Financial Statement Impact—Lessee

Statement of Financial Position
At the end of 20X2, the outstanding principal balance in the lease liability account is $43,310 (before any accrued interest),
as shown in both Exhibits 18-3 and 18-4. With interest, this is $46,775 at 31 December 20X2.
This liability is divided between the short-term portion and the long-term portion on the SFP. The short-term portion is:
1. Any interest accrual included in the liability balance; and
2. The principal portion of any payment made in the next fiscal period.

The reminder is long term, and will correspond to a table value.

In our example, the short-term portion is interest of $3,465 and the principal portion of the 20X3 payment, or $16,535. This
is equal to $20,000. The long-term portion is $26,775, per the second line of the table in Exhibit 18-3. The SFP reflects the
following:

Current liability $20,000

Long-term liability 26,775

Total $46,775

Although the full amount of the next payment, $20,000, is classified as current in this simple example, that situation will
arise only when the payment is due immediately after the reporting date. That is, the current liability is not normally the full
amount of the next payment due.
On the asset side, the leased equipment will be shown either separately (if material) or as a part of the general equipment
account. Similarly, the accumulated depreciation will be shown either separately or combined with the accumulated
depreciation of similar assets. If the leased asset and its accumulated depreciation are shown on the face of the SFP as
part of property, plant, and equipment, the company must disclose the amounts pertaining to leased assets in a disclosure
note.
As usual, of course, the equipment can be shown net of accumulated depreciation on the face of the SFP with the gross
amount and accumulated depreciation shown in a note.

Statement of Comprehensive Income

The net earnings section of the SCI will include depreciation expense and interest expense. For 20X2, the amounts relating
to the lease are:

Depreciation expense $12,662

Interest expense 3,465

 Chapter 18 Leases 1259

Each of these expenses can be combined with similar costs; the expenses relating to leased assets need not be reported
separately. The interest expense for the lease will, however, be included with other long-term interest, which is reported
separately from interest on short-term obligations.

Statement of Cash Flows

Points to note:
• At the inception of the lease, an asset and liability were recorded. This is a non-cash transaction and is excluded from
the SCF. However, note disclosure of this non-cash transaction will be required.
• If the indirect approach to operating cash flow is used, depreciation expense ($12,662) will be added back as an
adjustment to earnings to determine the cash flow from operations. Similarly, earnings includes $3,465 in interest
expense that was not a cash outflow in 20X2 and the change to the current liability for interest will adjust for this.
• The amount of principal repayment ($20,000, at the beginning of 20X2) will be shown as a financing outflow.

Notes to Financial Statements

The notes should disclose the commitment for future finance lease payments, both in total and individually for each of the
next five years. The payments due under all of the reporting enterprise’s finance leases can be added together and reported
in the aggregate, of course.

Deferred Income Taxes

In Canada, leases normally are taxed in accordance with their legal form. The tax deduction is the amount of lease payments
made during the tax year. The fact that a lease may be accounted for as a finance lease does not change the tax treatment.
Therefore, leases that are accounted for as finance leases are generally taxed by CRA as an operating lease. This difference
in treatment will give rise to a temporary difference. Accounting for deferred income taxes and temporary differences was
explained in Chapter 16.

CONCEPT REVIEW

1. How is an annual lease payment split between principal and interest in a lease liability
amortization table?
2. How would you prove the closing liability balance that was recorded after the fourth payment,
in a six-payment lease liability amortization table?
3. How much of a lease liability is a current liability on the SFP?

Accounting by Lessees—Modified Example

The prior example was fairly simple because (1) the lease year coincided with the lessee’s reporting year, (2) there was
no guaranteed residual value, (3) the present value was less than the fair value, and (4) the lease included no provisions
for operating costs. To explore lessee accounting a little more realistically, we will use an example that removes those
simplifying assumptions.
The terms of the lease are given in Exhibit 18-5. In this example, the net lease payments are $180,000 per year—the $200,000
annual lease payment minus the annual insurance cost included therein. Executory costs must be excluded from the discounted
cash flows. The present value of the lease includes both the net lease payments and the guaranteed residual value, even though
the likelihood of having to pay that full guaranteed residual value is low. The present value calculation is:

PV $180,000(P/AD, 8%, 5) + $75,000(P/F, 8%, 5)

PV $776,183 + $51,044 $827,227
1260 Chapter 18 Leases

EXHIBIT 18-5

LEASE TERMS—MODIFIED EXAMPLE

• The fair value of the equipment is $800,000 at the inception of the lease.
• The lease term is five years. The lease commences on 1 April 20X2.
• There is no renewal option.
• Annual lease payments are $200,000 per year. Payments are due at the beginning of each lease year.
• The lease payments include the cost of insurance, estimated at $20,000 per year; these are called
executory costs and are annual operating costs that are paid by the lessor but built into annual lease
payments.
• The lessee guarantees a residual value of $75,000; the lessor promises to exercise due diligence to
get the highest residual value on the open market at the end of the lease.
• The lessee does not know the lessor’s implicit rate of interest in the lease. The lessee’s incremental
borrowing rate is 8%.
• The lessee’s fiscal year ends on 31 December.

Observe that the guaranteed residual value increases the present value by about 7%, even though the lessee may not have to
pay all or any of this amount. This additional amount will affect the implicit interest cost implicit in the annual payments.
The present value is higher than the asset’s fair value of $800,000.

Fair-Value Cap and Initial Entry

The fair value of the leased asset is the upper limit of the amount that can be recorded as an asset and liability. In this
example, the lessee’s IBR yields a present value higher than the fair value. Therefore, the lessee must record the leased asset
and liability initially at $800,000:

Asset under finance lease 800,000

Lease liability 800,000

Implicit Interest Rate and Amortization Table

Because the fair-value cap was applied, the lessee must increase the interest rate applied to the lease payments. The interest
rate must be the discount rate that equates the lease payments (plus residual value) to the $800,000 fair value.

$800,000 $180,000(P/AD, i, 5) + $75,000(P/F, i, 5)

i 9.8034%

This calculation has been done in Excel; implicit interest rates seldom work out to round numbers!
Exhibit 18-6 shows the amortization table for this lease liability, using the interest rate implicit in the lease. Notice that the
$75,000 guaranteed residual value has its own line, and is treated like any other payment—part interest, part principal.
 Chapter 18 Leases 1261

EXHIBIT 18-6

LESSEE LIABILITY AMORTIZATION TABLE—MODIFIED EXAMPLE

Lease
Year Net Lease
Change
Ending Outstanding Interest at Payment (Decrease) Ending
31 March Balance 9.8034% 31 March in Balance Balance

20X2 $800,000 $ — $180,000 $ (180,000) $620,000

20X3 620,000 60,781 180,000 (119,219) 500,781

20X4 500,781 49,094 180,000 (130,906) 369,875

20X5 369,875 36,260 180,000 (143,740) 226,135

20X6 226,135 22,169 180,000 (157,831) 68,304

20X7 68,304 6,696 75,000 (68,304) 0

Totals $175,000 $975,000 $(800,000)

Annual Entries—20X2
Payment When the lessee makes the lease payment, the insurance cost is debited to an expense account. The amount may
be debited to a prepaid expense asset account, but it will be adjusted at reporting dates regardless of the initial entry made.
The entry for the initial payment on 1 April 20X2:

Insurance expense 20,000

Lease liability 180,000

Cash 200,000

The insurance expense debit is for the originally estimated amount and not for the actual amount, even if the lessor actually
pays a different amount for insurance. The reason is that the estimate was used to determine the net lease payments, which
then were discounted to find the present value. The only way that the liability accounting will work out is to stick to the
predetermined net lease payments, even though the actual cost to the lessor may be different.

Interest
At the end of 20X2, the lessee must accrue interest. In this modified example, the lease year starts in April while the fiscal
year starts in January. This is normal, of course—leases are not arranged for accountants’ convenience at the beginning or
end of a fiscal year.
The outstanding balance from 2 April to 31 December is $620,000. Interest for the full year is $60,781 (Exhibit 18-6), and
for 9 months is $45,586. The entry on 31 December 20X2 is:
1262 Chapter 18 Leases

Interest expense ($60,781 × 9/12) 45,586

Lease liability 45,586

After this interest accrual, the balance of the lease liability is $620,000 + $45,586 = $665,586.

Depreciation
The example contains a guaranteed residual value of $75,000. When determining the asset’s depreciable cost, this guaranteed
residual amount must be treated in exactly the same manner as a residual amount for an asset had been purchased rather than
leased.
Accordingly, depreciation is based on $725,000 (i.e., $800,000 − $75,000). Annual depreciation will be $145,000 per lease
year. Assuming that the company charges depreciation to the nearest month:

Depreciation expense ($145,000 × 9/12) 108,750

Accumulated depreciation—asset under lease 108,750

Insurance Adjustment
Insurance must be allocated to the appropriate fiscal year:

Prepaid insurance ($20,000 × 3/12) 5,000

Insurance expense 5,000

Annual Entries—20X3
Interest On 1 April 20X3, the interest expense must be updated, completing the recording of the $60,781 interest related to
the first 12 months of the lease:

Interest expense ($60,781 × 3/12) 15,195

Lease liability 15,195

Notice that there is no recalculation of the $60,781 interest amount, because that would involve compounding. Interest
is determined for each 12-month period after a payment is made and then allocated out per month until it is exhausted.
Specifically, our calculation is ($60,781 × 3/12), NOT (($620,000 + $45,586 = $665,586) (balance at the end of the prior
fiscal year) × 9.8034% × 3/12.) The latter calculation is wrong because is recompounds/recalculates the liability balance and
that is done only after a payment.
Payment The payment is recorded as before:

Insurance expense 20,000

Lease liability 180,000

Cash 200,000
 Chapter 18 Leases 1263

Year-end adjustments The depreciation entry is recorded at the end of the reporting period, for a full year this time:

Depreciation expense 145,000

Accumulated depreciation—asset under lease 145,000

The recorded insurance expense is $20,000, and the prepaid amount is unchanged from 20X2 at $5,000. These balances are
correct and no further adjustment is needed.
Finally, interest must be recorded for the final 9 months of the year:

Interest expense ($49,094 × 9/12) 36,821

Lease liability 36,821

Notice again that we use the amortization table interest amount, and pro-rate it for the appropriate number of months in the
fiscal year.

Allocating Interest to Fiscal Years

It bears repeating: the lease liability amortization table is for the lease year, not for the fiscal year. The table shows 12
months of interest attached to a particular payment. Each of these amounts is fully recorded in the appropriate fiscal year.
Exhibit 18-7 shows the interest allocation that will occur over the five-year lease term, which affects six fiscal periods
because of the overlap between the lease year and fiscal year.

Disposal at End of Lease

At the end of the lease term, the lessee returns the leased asset to the lessor, which is responsible for selling it to a third
party. The lessee has guaranteed that the lessor will receive $75,000 in this transaction.
First, depreciation and interest are recorded up-to-date.
The leased asset ($800,000) and its accumulated depreciation ($145,000 × 5 = $725,000) must be removed from the books.
At this point, the liability has a carrying value of $75,000 ($68,304 + $6,696 of interest; see Exhibit 18-6), and it must also
be removed from the books. The entry, if the lessor is successful in resale at $75,000:

Lease liability 75,000

Accumulated depreciation—leased asset 725,000

Asset under finance lease 800,000

Notice that the lessee returns an asset to the lessor with a net book value of $75,000, and cancels the $75,000 lease liability.
No cash changes hands.
Assume now that at the end of the lease, the lessor is able to sell the asset to a third party for only $50,000. The lessee
will have to pay the $25,000 difference between the guarantee and the actual value. This amount must be recorded as a loss
because the lease has ended—there is no future benefit to be gained from this payment.
1264 Chapter 18 Leases

The entries to record the return of the asset to the lessor and this loss will be as follows:

Lease liability 75,000

Accumulated depreciation—leased asset 725,000
Loss on lease termination 25,000
Asset under finance lease 800,000
Cash 25,000
 Chapter 18 Leases 1265

Full Set of Entries

All of the journal entries to record both the leased asset and the lease liability over the entire five-year lease term are shown
in Exhibit 18-8. The last column shows the lease liability balance at each date. The amounts highlighted in blue show the
balance after each payment; these amounts match the ending lease-year balances shown on the amortization table in Exhibit
18-6. The amounts highlighted in green show the liability balance at the end of each fiscal year.

Current Portion
On the SFP, the total will be divided into current and long-term portions, as described earlier in the chapter. Consider
the 31 December 20X3 liability balance of $537,602 (see Exhibit 18-8). The short-term portion is interest of $36,821
and the principal portion of the 20X4 payment, or $130,906 (refer to Exhibit 18-6 for the principal portion of the 20X4
payment). This is equal to $167,727. The long-term portion is $369,875, per the table in Exhibit 18-6. The SFP reflects
the following:

Current liability $ 167,727

Long-term liability 369,875

Total $537,602

EXHIBIT 18-8

LESSEE’S RECORDING OF FINANCE LEASE—MODIFIED EXAMPLE

Lease Liability
Dr. Cr. Balance

1 April 20X2

Asset under finance lease 800,000

Lease liability 800,000

Insurance expense 20,000

Lease liability 180,000 620,000

Cash 200,000

31 December 20X2

Interest expense 45,586

Lease liability 45,586 665,586

Depreciation expense (9 months) 108,750

Accumulated depreciation 108,750

Prepaid insurance 5,000

Insurance expense 5,000

1266 Chapter 18 Leases

Lease Liability
Dr. Cr. Balance
1 April 20X3

Interest expense 15,195

Lease liability 15,195

Insurance expense 20,000

Lease liability 180,000 500,781

Cash 200,000
31 December 20X3

Interest expense 36,821

Lease liability 36,821 537,602

Depreciation expense 145,000

Accumulated depreciation 145,000

1 April 20X4

Interest expense 12,273

Lease liability 12,273

Insurance expense 20,000

Lease liability 180,000 369,875

Cash 200,000

31 December 20X4

Interest expense 27,195

Lease liability 27,195 397,070

Depreciation expense 145,000

Accumulated depreciation 145,000

1 April 20X5

Interest expense 9,065

Lease liability 9,065

Insurance expense 20,000

Lease liability 180,000 226,135

Cash 200,000
 Chapter 18 Leases 1267

Lease Liability
Dr. Cr. Balance
31 December 20X5

Interest expense 16,627

Lease liability 16,627 242,762

Depreciation expense 145,000

Accumulated depreciation 145,000

1 April 20X6

Interest expense 5,542

Lease liability 5,542

Insurance expense 20,000

Lease liability 180,000 68,304

Cash 200,000
31 December 20X6

Interest expense 5,022

Lease liability 5,022 73,326

Depreciation expense 145,000

Accumulated depreciation 145,000

1 April 20X7

Interest expense 1,674

Lease liability 1,674

Depreciation expense (3 months) 36,250

Accumulated depreciation 36,250

Insurance expense 5,000

Prepaid insurance 5,000

Lease liability 75,000 0

Accumulated depreciation 725,000

Loss on lease termination 25,000

Asset under finance lease 800,000

Cash (return of asset) 25,000

1268 Chapter 18 Leases

CONCEPT REVIEW

1. Why are insurance and executory costs subtracted from annual lease payments before the
present value is determined?
2. When lease payment dates do not coincide with the company’s reporting periods, how is
interest expense calculated?
3. How does a guaranteed residual value affect the lessee’s accounting for the lease?

SALE AND LEASEBACK

A sale and leaseback is an arrangement whereby a company sells an asset to a lessor and simultaneously leases it back from
the lessor. This is a linked set of two transactions:
1. The seller transfers title to the asset to the lessor for a certain price, and the lessor pays the cash proceeds to the seller;
2. Simultaneously, the seller becomes a lessee and leases the exact same asset back, signing a lease arrangement with a
series of periodic payments to the lessor.

Sale and leaseback arrangements are most common for real property. A sale and leaseback gives an immediate cash inflow
to the seller. The cash can be used to retire debt (particularly any outstanding debt on the asset, such as a mortgage or a
collateral loan), used for operating purposes, or used for any other purpose that management wishes (e.g., paying a dividend).
However, the seller is now committed to a series of periodic payments to the lessor—usually a financing lease over a long
period.
Bear in mind that the original cash proceeds need not be fair value. The cash proceeds may be more or less than fair value,
since the proceeds are in reality linked to repayment arrangements via the lease arrangement. The cash proceeds often reflect
the cash needs of the vendor for other projects, combined with the lender’s credit policies. However, an accounting gain or
loss is determined by the relationship between (1) the proceeds and (2) the asset’s net book value. Fair value might not come
into it—it is quite possible for the sales price to be above or below fair value and trigger a gain or loss.
The seller must evaluate the lease and identify it as being either a finance lease or an operating lease. The criteria for this
decision are exactly as described in earlier sections of this chapter.

Defer the Gain on a Finance Lease

The sale element of the transaction is initially recorded just like any other sale, with a gain or loss recorded for the difference
between the net proceeds from the sale and the asset’s net book value. However, accounting standards require that if the lease
element of the sale-and-leaseback arrangement is a finance lease, any gain or loss is deferred and amortized in proportion
to the lease payments over the lease term.
The objective of deferring the gain is to prevent earnings manipulation. Without this restriction, a company could sell
property and then lease it back under a finance lease, thereby recognizing a gain in the period of the sale. In fact, what the
company really would be doing is using the property as collateral for a loan that is in the form of a lease. Therefore, any gain
(except as noted below for certain operating leases) must be deferred and amortized over the lease term.

Decision on the Gain on an Operating Lease

If the lease is an operating lease, the treatment of the gain or loss depends on the relationship between the selling price of
the asset and its fair value at the date of sale:
 Chapter 18 Leases 1269

• If the sale price is equal to the fair value, the gain or loss is recognized immediately.
• If the sale price is greater than fair value, the excess over fair value is deferred and amortized over the term that the
asset is expected to be used (i.e., the lease term).
• If the sale price is less than the asset’s fair value, any gain or loss is recognized in earnings immediately unless the lease
payments are less than market lease terms, in which case the gain or loss is deferred and amortized over the lease term.

Recording a Sale and Leaseback

Assume that Vendeur Ltd. owns a building in central Montreal. Vendeur enters into an agreement with Bailleur Inc., whereby
Vendeur sells the building—but not the land on which it sits—to Bailleur and simultaneously leases it back. The details are
as follows:
• The original cost of the building was $10,000,000; it is 60% depreciated on Vendeur’s books.
• Bailleur agrees to pay Vendeur $8,500,000 for the building, which is the fair value at the time of the sale.
• Bailleur agrees to lease the building to Vendeur for 20 years. The annual lease payment is $850,000, payable at the end
of each lease year.
• There is no guaranteed residual value.
• Vendeur will pay all of the building’s operating and maintenance costs, including property taxes and insurance.
• The effective date of the agreement is 1 January 20X1.
• Vendeur’s incremental borrowing rate is 9%.
• Bailleur’s interest rate implicit in the lease is computed after tax and is not disclosed to Vendeur.
• Vendeur uses straight-line depreciation for its buildings, with full-year depreciation in the year of acquisition.
The building has a net book value, after accumulated depreciation, of $4,000,000. Since the selling price is $8,500,000,
Vendeur realizes a gain of $4,500,000 on the transaction. The treatment of the gain depends on whether the lease qualifies
as a finance lease or as an operating lease.

Finance Lease
If the lease qualifies as a finance lease, the gain must be deferred and amortized over the lease term. Applying the four tests:
1. Is it likely that the lessee will obtain ownership of the leased property at the end of the lease? No. There is no transfer
of title or bargain purchase option.
2. Will the lessee receive substantially all of the economic benefits of the building? Uncertain. The building was 60%
depreciated at the time of the sale, indicating that it is not a new building. The 20-year lease term could well be a major
part of the remaining economic life of the building.
3. Is the lessor assured of recovering the investment in the leased property, plus a return on the investment, over the lease
term? Probably, because the present value of the lease payments is $7,759,264 at 9%, which is more than 90% of the
sales price of the building.
4. Is the leased asset highly specialized to the lessee? No, there is no indication to that effect.

Since at least one of the guidelines for classifying the lease as a finance lease appears to be satisfied, the lease should be
recorded as a finance lease. As a result, the gain must be deferred and amortized over the 20-year lease term.
The journal entry to record this sale on 1 January 20X1 is:

Cash 8,500,000

Accumulated depreciation, building 6,000,000

Building 10,000,000

Deferred gain on sale and leaseback of building 4,500,000

1270 Chapter 18 Leases

Using Vendeur’s IBR of 9% yields a present value of the 20-year stream of end-of-year payments equal to $7,759,264. The
lease is recorded as follows:

Building under finance lease 7,759,264

Lease liability 7,759,264

At the end of 20X1, Vendeur will:

• Record the interest expense (at 9%);
• Pay the $850,000 annual lease payment to Bailleur;
• Depreciate the asset; and
• Amortize the deferred gain.
On 31 December 20X1, the interest expense and the lease payment will be recorded as follows:

Interest expense ($7,759,264 × 9%) 698,334

Lease liability 698,334

Lease liability 850,000

Cash 850,000

Vendeur uses straight-line depreciation with a full year’s depreciation in the year of acquisition. Since the lease term is 20
years, the straight-line rate is 5%. The entry to record depreciation of the leased building will be as follows, assuming no
residual value:

Depreciation expense, building under finance lease 387,963

Accumulated depreciation, building under finance lease

387,963

Finally, the deferred gain on the sale must be amortized. The gain will be amortized over the lease term in proportion to the
lease payments. Since the payments are straight-line over 20 years, the gain must similarly be amortized straight-line over
20 years:

Deferred gain on sale and leaseback of building 225,000

Depreciation expense, leased building ($4,500,000 ÷ 20)

225,000

The amortization of the gain is credited to the depreciation expense charged for the asset. The reason is that the
sale and leaseback transaction had the effect of taking a building with a $4,000,000 book value and re-recording it
on Vendeur’s books at $7,759,264, close to its fair value. By offsetting the gain against the asset depreciation, the
depreciation expense is reduced to $162,963, which is closer to the amount the building depreciation would have been
if it had not been sold.
 Chapter 18 Leases 1271

Operating Lease
If the lease did not qualify as a finance lease, then by default it would be an operating lease. When the lease is an operating
lease, the treatment of the gain or loss depends on the relationships between (1) the carrying value (or net book value) of
the asset being sold, (2) the fair value of the asset sold, and (3) the transaction price assigned to the asset in the sale and
leaseback:
• If the sale transaction is at fair value, any gain or loss would be recognized immediately and not deferred.
• If the sale transaction price is above fair value, the difference between carrying value and the transaction price would
be treated in two segments:
– The difference between carrying value and fair value would be recognized immediately as a gain or loss; and
– The difference between fair value and the transaction price would be deferred and amortized over the period during
which the asset is expected to be used.
• If the transaction price is below fair value, the difference between carrying value and fair value is recognized
immediately, except when the lease has sub-market-rate lease payments that compensate the lessee for the loss. In that
case, the difference between the transaction price and the carrying value is deferred and amortized over the period of
expected use of the asset.
The first situation—a fair-value transaction—is highly likely to occur in arms-length transactions. Other types of deals are
likely to occur only between related parties, thereby raising many questions concerning accounting manipulation and tax
avoidance, as well as potential ethical issues.

Leases for Land plus Buildings

A single long-term lease may cover the lease of a building as well as the land it is on. When accounting for such a lease,
accounting standards require that the minimum lease payments be allocated between the land and building on the basis of
“relative fair values of the leasehold interests in the land element and buildings element of the lease.” This statement is
easily misunderstood. It does not mean that the fair values of the land and building are the basis for the allocation. Instead,
it means the fair value of each asset’s benefits are being transferred to the lessee.
Perhaps the simplest way of grasping this concept is look at the land first. Land does not normally lose its economic value
over time. There is no need for the lessor to be compensated for land deterioration, provided that the land is not being
polluted and thereby becoming less valuable during the lease term. The lessor simply needs to earn a return on the investment
in the land.
Buildings are different. Over the course of a long lease term, there is bound to be significant deterioration in a building,
as well as obsolescence. For example, old multi-floor industrial buildings are largely obsolete now. Modern production
generally requires vast floor spaces on a single level. Thus, those old buildings end up either getting torn down, or (if they
are in good locations), they are converted for residential use, which has far less value. A long-term lease for a building,
therefore, must compensate the lessor for significant loss of economic value.
Once the lease cash flows have been allocated to land and buildings, each component is accounted for separately.
Land leases are finance leases only if title reverts to the lessor at the end of the lease term. Otherwise, the land lease is
reported as an operating lease, since the lease does not cover the major part of the land’s life (being infinite) nor does the
land-related portion of the lease payments cover most of the land’s value.
The building, however, may be reported as either an operating lease or a finance lease. The guidelines for that reporting
decision are the same as we have discussed above.
If the land portion of the lease is immaterial, or if there is no basis on which to allocate the land and building portions, the
lease can be accounted for as a whole without separate regard for the land portion.
1272 Chapter 18 Leases

CONCEPT REVIEW

1. If a company sells an asset at a gain and then leases the asset back, how should the gain be
recognized for financial reporting purposes?
2. When is a land lease a financing lease?

LESSEE DISCLOSURE
Operating Leases
In the notes to the financial statements, lessees should give a general description of their significant leasing arrangements,
including the basis on which contingent rent (if any) is determined and whether there are any renewal and/or purchase
options. If any lessor has imposed financial restrictions on the lessee, such as limitations on additional debt or on dividend
distributions, those should be disclosed.
Quantitatively, lessees should disclose lease payments recognized as expense in the current period, separated into (1)
minimum lease payments and (2) contingent rents. Lessees should also disclose the company’s obligation for operating lease
payments (1) for the next year, (2) in total for the next four years, and (3) in total for all later years.

Finance Leases
Leased assets and the related lease obligations must be reported separately from “regular” assets and liabilities, either on
the face of the SFP or in a disclosure note. This disclosure is required because the lessee does not have the same rights of
ownership for a leased asset as compared to an owned asset, even though the lessee bears substantially all of the risks and
benefits of ownership.
The current portion of the lease liability should be shown separately, as has been described earlier in this chapter.
Other disclosures are:
• A general description of the lessee’s significant finance lease arrangements, including:
– The basis for contingent rent, if any;
– Any renewal terms, purchase options, or escalation clauses; and
– Any financial restrictions imposed by the lessor, such as limits on dividend payments, additional debt, or additional
leasing.
• The amount of any contingent rents recognized as expense during the period.
• For each class of leased asset, the net carrying value at the reporting date.
• The total of future minimum lease payments and their present value for:
– The coming year;
– Future years 2 through 5; and
– All years (in aggregate) after year 5.
• A reconciliation between total future minimum lease payments and their present value.
Leases are financial instruments. Therefore, leases must conform to the general disclosure requirements for financial
instruments, as discussed in Chapter 13.
 Chapter 18 Leases 1273

Disclosure Example
An example of a finance lease disclosure note is shown in Exhibit 18-9. Air Canada has finance leases for two types
of assets—aircraft and facilities. The company also has significant operating leases. Disclosure shows that the company
is committed to total future payments of $397 million on the year-end 2014 finance leases. The present value of that
commitment is $283 million. For operating leases, the total cash commitments are $1,633 million. This demonstrates that
operating lease commitments are a significant element of the financial strategy.

EXHIBIT 18-9

EXTRACTS FROM AIR CANADA FINANCIAL STATEMENTS

LEASE ELEMENTS

(dollar amounts in millions)

4. PROPERTY AND EQUIPMENT

As at December 31, 2014, property and equipment included finance leased assets including 17 aircraft (2013
– 18) with a net book value of $145 (2013 – $150) and facilities with a net book value of $42 (2013 – $45).
8. LONG-TERM DEBT AND FINANCE LEASES

Final Maturity Weighted Average Interest Rate (%) 2014 2013

Long-term debt

Finance lease obligations (f) 2015 – 2033 10.08 283 328

(f) Finance leases, related to facilities and aircraft, total $283 ($73 and US$181) (2013 – $328
($76 and US$237)). During 2014, the Corporation recorded interest expense on finance lease
obligations of $32 (2013 – $46). The carrying value of aircraft and facilities under finance leases
amounted to $145 and $42 respectively (2013 – $150 and $45).
Air Canada has aircraft leasing transactions with a number of structured entities. Air Canada
controls and consolidates leasing entities covering 22 aircraft as at December 31, 2014. This
debt amount includes any guarantee by Air Canada in the residual value of the aircraft upon
expiry of the lease. The related aircraft are charged as collateral against the debt by the
owners thereof. The creditors under these leasing arrangements have recourse to Air Canada,
as lessee, in the event of default or early termination of the lease.
Certain aircraft and other secured finance agreements contain collateral fair value tests. Under the
tests, Air Canada may be required to provide additional collateral or prepay part of the financings.
The maximum amount payable in 2015, assuming the collateral is worth nil, is $212 (US$183). The
maximum amount payable declines over time in relation to the outstanding principal. Total collateral
as at December 31, 2014 is $12 (US$11) (2013 – $5(US$5)) in the form of cash deposits, included in
Deposits and other assets, has been provided under the fair value test for certain of these aircraft
leases.
Cash interest paid on Long-term debt and finance leases in 2014 by the Corporation was $287
(2013 – $345).
Refer to Note 16 for the Corporation’s principal and interest repayment requirements as at December
31, 2014.
1274 Chapter 18 Leases

16. COMMITMENTS
...
Operating Lease and Capital Commitments
The estimated aggregate cost of the future firm Boeing 787, Boeing 777 and Boeing 737 MAX aircraft
deliveries and other capital purchase commitments as at December 31, 2014 approximates $8,256.
US dollar amounts are converted using the December 31, 2014 closing rate of CDN$1.1601. The
estimated aggregate cost of aircraft is based on delivery prices that include estimated escalation
and, where applicable, deferred price delivery payment interest calculated based on the 90-day US
LIBOR rate at December 31, 2014.

2015 2016 2017 2018 2019 Thereafter Total

Capital $ 1,067 $ 2,122 $ 1,598 $ 1,362 $ 1,066 $ 1,041 $ 8,256

commitments

As at December 31, 2014 the future minimum lease payments under existing operating leases of aircraft
and other property amount to $1,633 using year end exchange rates.

2015 2016 2017 2018 2019 Thereafter Total

Aircraft $ 313 $ 268 $ 238 $ 204 $ 172 $ 145 $ 1,340

Other property 46 32 28 23 13 151 293

Total $ 359 $ 300 $ 266 $ 227 $ 185 $ 296 $ 1,633

Maturity Analysis
...
The following is a maturity analysis, based on contractual undiscounted cash flows, for financial liabilities.
The analysis includes both the principal and interest component of the payment obligations on long-term
debt and is based on interest rates and the applicable foreign exchange rate effective as at December 31,
2014.

2015 2016 2017 2018 2019 Thereafter Total

...

Finance lease obligations 91 48 46 46 46 120 397

...

Source: Air Canada, 2014 Consolidated financial statements. www.sedar.com, posted 11 February, 2015.
 Chapter 18 Leases 1275

LONG-TERM LEASES: PROS AND CONS

Transfer of Income Tax Benefits
The transfer of income tax benefits from the lessee to the lessor is often the driving force behind finance leases. The legal
owner of an asset can deduct CCA. But if the owner is not able to use the CCA deduction or the full benefit of that deduction,
the company would be better off having another party take title, get the tax advantages, and pass that on to the lessee through
lower annual cash payments. Some examples of such a situation are:
• The owner is a nonprofit organization, such as a school, hospital, or charity.
• The owner is a for-profit business but either is losing money or is not earning enough to use the full amount of the
available CCA.
• The owner is profitable but pays taxes at a lower rate than potential lessors.

If any of these conditions exist, then the CCA is more valuable to a lessor than to the potential user of the asset. Lessors
calculate their return on investment on an after-tax basis, and lease industry competition forces the lessor to pass the benefit
of any tax reduction on to the lessee in the form of lower lease payments. Therefore, the asset can often be leased for a cash
flow present value that is less than the amount the lessee would pay to buy the asset.
Long-term leasing has several other potential advantages over buying an asset. However, the perceived advantages to the
lessee also have offsetting disadvantages. For each factor, we will look at the apparent benefits first (Pro), and then at the
related disadvantages (Con).

Off-Balance-Sheet Financing
Pro
If a company enters a long-term lease and that lease does not qualify as a finance lease for accounting purposes, the company
effectively has obtained financing for an asset without having to show the asset (and any related liability) on its SFP.
Airlines often enter into operating leases for a substantial proportion of their aircraft and vehicle fleet. Lessees may view
off-balance-sheet financing as an advantage because they effectively incur debt that does not appear on the SFP. This may
allow the company to meet debt covenants imposed by other lenders.

Con
The shorter the lease, the greater is the cost to the lessee. In shorter leases, more of the risk remains with the lessor. The
lessor does not accept this risk out of generosity. The cost is passed back to the lessee in the form of higher annual lease
payments and/or heavy cancellation penalties if the lessee does not renew. Therefore, a lessee may obtain off-balance-sheet
financing, but at a real economic cost in higher expenses and operating cash flow expenditures.

100% Financing
Pro
Financial institutions will not lend a buyer the full amount of an asset purchase price. Normally, financing can be obtained
for no more than 75% or 80% of the cost of the asset. In contrast, a lease can effectively provide full financing, since there is
no substantial down payment to be made at the inception of the lease.
1276 Chapter 18 Leases

Con
This advantage exists only for assets that are readily transferable if the lessee defaults (e.g., automobiles, airplanes) and
only to lessees that have high credit ratings. For other assets and less creditworthy lessees, the lessor covers the risk by
forward-weighting the lease payments; that is, most of the cash flow for lease payments is in the early years of the lease.
Also, since lease payments are payable at the beginning of each period, the first payment is, in effect, a down payment.

Protection against Obsolescence

Pro
The shorter the lease term, the easier it is for the lessee to stay up-to-date with the latest technology. If a new product or
process becomes available, the lessee can refuse to renew the existing lease and move to the newer product. An alternative
is for the lessor to provide upgrade privileges in the lease. For example, an existing leased photocopier may be replaced
by a newer model, or a leased automobile may be “rolled over” to a new model every second or third year. Such lease
arrangements help the lessee guard against obsolescence.

Con
Flexibility comes at a price. The risk of obsolescence falls on the lessor, and the lessor will compensate for the added risk
by charging higher lease payments. Lessor-provided upgrades can help provide flexibility, but they lock the lessee into the
lessor’s product. As well, automatic upgrades are expensive. Many companies find it much less costly to skip a product
generation unless it is crucial to be on the cutting edge of technology.

Protection against Interest Rate Changes

Pro
Lease payments are always determined on the basis of fixed interest rates, even when the lease contains escalation clauses
or contingent payments. Therefore, a long-term or finance lease can protect the lessee from interest rate fluctuations.

Con
If the lessee’s business fluctuates in response to economic conditions, it may be better to use variable-rate loans from
financial institutions to finance the assets. When the economy is down, interest rates are down, thereby not locking the
company into a high implicit interest rate.

CONCEPT REVIEW

1. What is meant by off-balance-sheet financing?

2. Who holds legal title to a leased asset?
3. How can a lease be used to transfer CCA tax benefits from the lessee to the lessor?
 Chapter 18 Leases 1277

AVOIDING LEASE CAPITALIZATION

Accounting standards establish guidelines for determining a financing lease. Determined minds can devise creative contracts
that appear to be capitalization-avoidance techniques. In fact, a whole industry is dedicated to devising ways of leasing assets
to companies while avoiding the capitalization criteria. Four common methods of avoiding capitalization are discussed below.

Use Contingent Rent

Contingent rent is an amount that is dependent on future events, such as the sales volume for the retail occupant in a shopping
mall. Contingent rent is not included in present value calculations when the lease is being evaluated as a possible finance
lease. Therefore, the larger the amount of rental that can be made dependent on future events, the lower the minimum net
lease payments will be.

Insert a Third Party

The true nature of a lease can be disguised by inserting a third party between the lessee and the lessor. The most common
approach is for the lessee to form a separate company, the purpose of which is to lease assets to the operating company. The
separate company enters into the formal lease agreement with the lessor, obligating itself to pay for the full cost of the asset
over the lease term, and then enters into a year-by-year lease with the operating lessee.

Impose a Substantial Penalty for Non-Renewal

Corporations may lease major and crucial operating assets under lease agreements that provide for a year-by-year renewal
(at the lessee’s option) or for lease terms that are considerably shorter than the economic life of the asset. The lessor’s offset
for assuming higher risk is to insert very high cancellation or non-renewal penalties, which are not included in minimum
lease payments. However, the substance of this contract must be discerned to classify it properly.

Side Letter
Corporations may lease assets on a year-by-year lease. They might simultaneously sign a side letter that commits them
to renewal for a certain period. The lease on its own is an operating lease, but the term and thus the classification is far
different when the side letter is also considered. If a corporation follows this approach, and fails to disclose the presence
of a side letter, there is a serious breach of ethics. Fortunately, this once-popular approach is rarely encountered in today’s
environment.

ETHICAL ISSUES

The accounting standard for leases offers multiple opportunities for managers to commit actions to deliberately
mislead financial statement users. The most obvious and widespread is the simple expedient of leasing long-term
assets through a series of relatively short-term leases. Accounting standards were not intended to make lease
capitalization an option. The intent was to require companies to report leases according to their substance.

In practice, though, managers often choose the reporting method for long-term leased assets and then negotiate
the lease to accomplish that reporting goal. By carefully structuring lease provisions, management (with the
encouragement of the leasing industry) can obtain long-term use of assets while still reporting the leases as
operating leases.

For managers who are trying to meet short-term profit goals, this practice has two primary advantages. When
leases are classified as operating leases:

• Both the leased assets and the related liabilities are kept off the balance sheet; and
• The lease-related expenses flowing into earnings will be lower in the early years of the lease contracts.
1278 Chapter 18 Leases

This is a practice known as “window dressing”—making the financial position of the company look better than it
really is. Since the intent is to mislead financial statement readers, it is clearly an unethical practice.

Leasing also provides an opportunity for unethical behaviour through the use of related parties. Leasing through
a related third party, such as through a company controlled by an officer or shareholder of the lessee, provides
an opportunity for the third party to skim off profits through inflated lease payments. The requirements for
consolidating special purpose entities are intended to keep a company from hiding leases off-balance-sheet, but
this intent can be circumvented by unethical managers.

Finally, sale-and-leaseback arrangements provide an opportunity to manipulate earnings. This can be done by (1)
either selling an entire asset and then leasing only part of it back, or (2) leasing it via a series of operating leases
that permit the selling company to recognize gains from the transaction in net income.

Looking Forward
Standard setters’ attempts to deal with substance over form for lease accounting has long been problematic. The challenge
is that, while there is a continuum of lease terms in economic terms, there are only two (very different) approaches to lease
accounting—operating leases and finance leases. The outcome is that many shades of grey are classified as either black or
white. And unfortunately, a whole new industry sprouted, one that was dedicated to devising leases that were finance leases
in substance but that avoided classification as such under the accounting standards.
Widespread dissatisfaction with lease accounting has led accounting standard setters to reconsider lease accounting. The
approach has been to eliminate the operating-finance distinction and to treat all lease commitments in the same way,
reporting them on the SFP at the present value of the lease commitment. This will result in capitalization of most leases.
This approach is described in an appendix to this chapter.
The process has been much delayed, though; the current feeling is that revised lease accounting standard will not be
implemented before 2019.

Accounting Standards for Private Enterprises

The leasing standard under ASPE is, in substance, the same as for IFRS. However, there
are some differences. One difference is that ASPE uses the term capital lease rather
than the IASB term finance lease. This is not a substantive difference because the terms
capital lease, finance lease, and financial lease (the term used in the finance industry)
all mean the same thing and are interchangeable.
Criteria for Lease Capitalization
The basic guidelines (or criteria) for classifying a lease as a capital lease are essentially the same under
ASPE and IFRS except:

• ASPE does not have a guideline that addresses “specialized use asset”; this is the fourth guideline
under IFRS and ASPE has only three guidelines.
• ASPE establishes quantitative bright lines that are only suggestions under IFRS:
– When assessing the lease term as compared to the asset’s economic life, the bright line is
“usually 75% or more.”
– When assessing the present value of minimum lease payments as compared to the fair value of
the asset, the bright line is “usually 90% or more.”
 Chapter 18 Leases 1279

Although the IFRS standard deliberately avoids specifying quantitative bright lines, those thresholds
continue to be used in practice in most entities, public and private, because they provide a target of
“reasonableness” that tends to promote consistency. Nevertheless, the intended overall guiding principle
for capital/finance leases continues to be whether the lease transfers substantially all of the risks and
rewards of ownership to the lessee.
Interest Rate for Discounting
Under IFRS, the discount rate is the lessor’s rate implicit in the lease, if known, and otherwise the lessee’s
IBR. In contrast, ASPE requires that the lower of the two rates be used. If the lessor’s implicit pretax rate
of return is not known, the distinction may have little significance in general practice.
Leases of Land and Buildings
When a lease involves land and buildings, the lease payments are segregated between the land and
buildings on the basis of the fair values of the underlying properties. This differs from IFRS, in which the
allocation is based on the fair values of the leasehold rights, not on the land and buildings themselves.

Disclosure
The disclosure requirements are relatively modest under ASPE:

Operating leases For leases lasting more than one year, disclose the future minimum lease payments (1)
for each of the next five years and (2) in total.

Capital Leases
For capital leases, the following should be disclosed:

• The total amount of payments required for each of the next five years;
• The interest rate, maturity date, and amount outstanding for capital leases;
• The aggregate amount of interest expense, disclosed either separately or as part of interest on
long-term debt;
• Whether leases are secured (e.g., by other assets of the entity); and
• For the leased asset(s), the cost (i.e., initial discounted present value), the depreciation method being
used, and the amount of accumulated depreciation.

Sale and Leaseback

The ASPE requirements for reporting any gain or loss arising from the sale in a sale and leaseback
transactions differ from those of IFRS as follows:

• If the lease is a capital lease, any gain or loss from the sale transaction should be capitalized and
amortized proportionate to the depreciation on the leased asset (i.e., not over the term of the lease
as required by IFRS).
• If the asset’s fair value is less than its carrying value at the time of the sale, the loss should be
recognized immediately because the asset was impaired at the date of sale. This applies to operating
leases as well as capital leases.
• If the lease is an operating lease, any gain or loss from the sale transaction should be capitalized and
amortized proportionate to the rental payments over the lease term (i.e., not immediately recognized
as allowed by IFRS under most circumstances).
1280 Chapter 18 Leases

RELEVANT STANDARDS

CPA Canada Handbook, Part I (IFRS):

• IAS 17, Leases
CPA Canada Handbook, Part II (ASPE):
• Section 3065, Leases

SUMMARY OF KEY
POINTS

1. A lease is an agreement that conveys from a lessor to a lessee the right to use an asset for a contracted price per
period.

2. A lease for a relatively short period of an asset’s useful life that does not transfer substantially all of the asset’s
risks and benefits to the lessee is classified as an operating lease. Under an operating lease arrangement, rent
payments are reported by the lessee as an expense as the asset is used.

3. A lease that transfers substantially all of the risks and benefits of ownership to the lessee is called a finance
lease. One of four guidelines must be met for a lease to be a finance lease: (1) do the terms of the lease make it
highly likely that title to the asset will transfer to the lessee at the end of the lease; (2) does the lessee have the
use of the asset over the major part of its economic life; (3) is the lessee committing to lease payments that will
return substantially all of the lessor’s investment in the leased asset plus a return on the investment; or (4) is the
asset so specialized for the lessee that it would have little benefit to others?

4. Finance leases are recorded by the lessee as though the asset had been purchased. The net minimum lease
payments over the lease term are discounted, using the interest rate implicit in the lease, or, if this rate is
unknown, at the lessee’s incremental borrowing rate. The present value amount is recorded as both an asset and
a liability. Once recorded, the asset and the liability are accounted for independently.

5. The asset is depreciated in accordance with the lessee’s policy for other assets of that type except that the
depreciation period must be evaluated as the period that the lessee will use the asset. This is limited to the
minimum lease term (including bargain renewal terms) unless there is a bargain purchase option or other transfer
of title to the lessee at the end of the lease term.

6. The lease liability is accounted for as an instalment loan with blended payments. Interest expense is calculated
at the same rate as was used for discounting the payments; the excess of payments over interest expense reduces
the outstanding liability balance.

7. The current portion of the lessee’s lease liability consists of (1) accrued interest to the SFP date plus (2) the
amount of principal that will be paid over the next year.

8. A sale and leaseback arrangement is an agreement in which the owner of an asset sells it to a lessor and
simultaneously leases it back. The subsequent lease is accounted for as either finance or operating, as for other
leases. For a finance lease, any gain or loss on the sale is deferred and amortized over the lease term. For an
operating lease, the accounting treatment of the gain or loss depends on the relationship between the selling
price of the asset and its fair value at the date of sale.
 Chapter 18 Leases 1281

9. The amount of finance lease obligations and assets held under finance leases should be separately disclosed.
Cash commitments under operating leases and under finance leases for the next year, for the next four years in
total, and then the aggregate amount for all remaining years must also be disclosed.

10. Under ASPE, there are bright lines set for lease classification guidelines (75% of economic life and 90% of fair
value). There is no guideline at all regarding specialized equipment. The discount rate used is the lower of the
interest rate implicit in the lease, and the lessee’s incremental borrowing rate.

Key Terms

bargain purchase option lease

bargain renewal terms lease term
bright lines lessee
capital lease lessor
contingent lease payments minimum net lease payments
contingent rent off-balance-sheet financing
economic life operating lease
executory costs personal property
finance lease real property
financial intermediary sale and leaseback
guaranteed residual value unguaranteed residual value
implicit lease interest rate useful life
incremental borrowing rate (IBR)
initial direct costs
initial lease term

Review Problem 18-1

Orion leased a computer to Lenox Silver Inc. on 1 April 20X5. The terms of the lease are as follows:

• Lease term (fixed and noncancellable) 3 years

• Estimated economic life of the computer 5 years

• Fair market value of the asset at lease inception $5,000

• Bargain purchase offer None

• Transfer of title None

1282 Chapter 18 Leases

• Guaranteed residual value by lessee, 1 April 20X8 $1,000

• Lessee’s normal depreciation method* straight line

• Lessee’s incremental borrowing rate 11%

• Executory costs included in lease payments None

• Initial direct costs None

• Annual lease payment, beginning of each lease year $1,620

• Lessor’s implicit interest rate 10%

• Lessee’s fiscal year-end 31 December

*Lenox Silver Inc. charges a half-year depreciation in the year of acquisition and a half-year in the
year of disposition, regardless of the actual dates of acquisition and disposal.

Required:
1. Classify the lease from the perspective of the lessee.
2. Provide entries for the lease from 1 April 20X5 through 31 December 20X6.
3. Show how the leased asset and the lease obligation will be shown on the lessee’s SFP at 31 December 20X6.
4. Suppose that at the end of the lease, the lessor tells the lessee to dispose of the asset, and to keep any proceeds in
excess of the guaranteed residual value. Provide entries for the lessee on 1 April 20X8, assuming that the lessee
sells the asset for $1,200 and remits the required $1,000 payment to the lessor.

REVIEW PROBLEM 18-1—SOLUTION

1. The lessor’s implicit rate is known, and therefore is used as the discount rate. Discounting the minimum lease
payments, including the guaranteed residual value of $1,000, yields:
P $1,620 (P/A due, 10%, 3) + $1,000(P/F, 10%, 3)
$4,432 + $751 $5,183

Clearly, the lease is a finance lease because the present value of the minimum lease payments, $5,183, is greater
than the $5,000 fair value of the leased property.
2. The asset and the related liability must be capitalized. The capitalized value of the leased asset cannot be greater
than the asset’s fair value, and therefore the fair value of $5,000 must be used instead of the present value of
$5,183. The entries at the inception of the lease will be:

1 April 20X5—commencement of the lease

Asset under finance lease 5,000

Lease liability 5,000

 Chapter 18 Leases 1283

1 April 20X5—first payment

Lease liability 1,620

Cash 1,620

Since the lessee’s IBR yields a present value that is higher than the fair value of the asset, it cannot be used
for further accounting for the lease. Instead, the implicit rate to the lessee must be calculated by solving the
following equation for i, the implicit interest rate:

$5,000 $1,620 (P/A due, i, 3) + $1,000 (P/F, i, 3)

By using a computer spreadsheet, or a financial calculator, we can find the implicit rate of 13.29%. This rate
must then be used to accrue the interest and to record the components of the annual lease payments. The liability
amortization table for the lease obligation is as follows:

Beginning Interest Expense Cash Reduction Ending

Year Balance at 13.29% Payment of Principal Balance

20X5 $5,000 $ 0 $1,620 $1,620 $3,380

20X6 3,380 449 1,620 1,171 2,209

20X7 2,209 294 1,620 1,326 883

20X8 883 117 1,000 883 0

The entries to record the depreciation, interest accrual, and payments through 31 December 20X6 are shown
below.

31 December 20X5—adjusting entries

Depreciation expense 667
Accumulated depreciation 667
[($5,000 $1,000) ÷ 3 × 1/2 $667]
Interest expense 337
Lease liability 337

[$449 × 9/12 $337]

1 April 20X6—interest accrual
Interest expense 112
Lease liability 112
[$449 × 3/12 $112]
1284 Chapter 18 Leases

1 April 20X6—second payment

Lease liability 1,620
Cash 1,620
31 December 20X6—adjusting entries
Depreciation expense 1,333
Accumulated depreciation 1,333
[($5,000 $1000) ÷ 3]
Interest expense 221
Lease liability 221
[$294 × 9/12]

3. The lessee’s SFP at 31 December 20X6 will include the following amounts:

Capital assets
Asset under finance lease $ 5,000
Less accumulated depreciation (2,000)
$ 3,000
Current liabilities
Current portion of finance lease liability $ 1,547

[$221 accrued interest at 31 December 20X6, plus $1,326 principal

portion of the next payment ]

Long-term liabilities
Obligation under finance lease $ 883

4. 1 April 20X8—sale of asset

Cash (received from sale) 1,200

Lease liability 1,000
Accumulated depreciation 4,000
Asset under finance lease 5,000
Cash (paid to lessor) 1,000
Gain on disposal of leased asset 200

This entry assumes that adjustments have already been made to (1) accrue the last of the interest and (2) record de-
preciation for 20X8.
 Chapter 18 Leases 1285

CASES: CASE 18-1

PREMIUM BLINDS LTD.

Premium Blinds Ltd. specializes in the manufacture of custom and pre-finished blinds and drapes for windows and
doors. The firm was founded by Bill Khadim, who retired 10 years ago and now lives in Orlando, Florida. When he
retired, Bill assigned 60% of the shares of the corporation to Sara Khadim, his daughter. Much of Bill’s retirement
income comes from the dividends he receives on his remaining Premium Blinds shares. Premium Blinds is now
run by Sara. There are no other shareholders.

The custom window covering industry has been a highly competitive industry for many years, challenged by
overcapacity and by less expensive on-line options. Premium Blinds has generally been able to attain reasonable
profit levels in most years by specializing in higher quality installations with select builders and window
manufacturers across Canada. During lean years, Premium Blinds has been able to rely on its credit union, the
Town Credit Union (TCU), for loan support. As a result, a close working relationship has developed between TCU
and Premium Blinds.

In the spring of 20X2, Sara decided that the firm needed to acquire some new, technologically improved
production equipment in order to stay up-to-date and to protect the company’s already-thin profit margins. The
equipment has a list price of $350,000, although Sara thought that it would be possible to bargain the price down
to about $330,000.

After discussing the purchase with the credit union, Sara realized that the company had two options for acquiring
the equipment. One option was to buy the equipment directly, with financing for 100% of the purchase price
provided by means of a ten-year term loan from the credit union, to be repaid at $33,000 per year for ten years,
with interest at 6% per annum due each year-end.

The second option was to lease the equipment from LeaseCorp, the leasing subsidiary of a major Canadian bank.
LeaseCorp would buy the equipment on behalf of Premium Blinds and would then lease it to Premium for 10 years,
with beginning-of-year lease payment of $36,000 per year. After the expiration of the initial lease term, Premium
would have the option of continuing the lease by paying $1,000 per year for as long as Premium wishes to retain the
equipment. Such equipment normally has a useful life of 15 to 20 years, although the later years of the useful life are
marked by decreasing productivity due to continuing technological improvement in equipment design.

Premium’s thin profit margins made it quite possible that the firm would not be able to get the quickest possible
tax advantage from CCA on the new equipment if the firm bought the equipment directly. On the other hand, if
LeaseCorp held title under a lease the lessor could use the depreciation to reduce its income taxes, and the tax
benefits would be passed on to Premium Blinds in the form of an after-tax implicit interest rate of 4%, less than
the 6% rate that Premium would have to pay on the term loan from the bank.

Before deciding on the financing method, Sara wants a report from her accountant, David Geroux, on the cash
flow and financial reporting implications of the alternatives. She also wants David to make a recommendation on
the most appropriate accounting policies to adopt should the lease option be chosen. Sara is hoping Premium will
be acquired by a public company, as part of industry consolidation in the next year or two, and she does not want
to take actions that might prove detrimental to the company’s reported results.

Required:
Assume the role of David Geroux, and prepare a report to Sara Khadim.
1286 Chapter 18 Leases

CASE 18-2

BRING-IT-HOME INC.

Bring-It-Home Inc. (BIHI) is a Canadian corporation based and operating in Nova Scotia. BIHI’s wide-ranging
products and services are targeted at enhancing customers’ quality of living, not only in their own homes
but also within their communities. The company has enjoyed considerable growth due to the insight of its
management team and creative talents of some key employees. BIHI is majority-owned by Flanagan’s Inc., a
Nova Scotia–based holding company. Flanagan’s prepares its financial statements in accordance with International
Financial Reporting Standards (IFRS), as does BIHI.

It is 15 February 20X5, and you, as a professional accountant with the accounting firm Mansbridge & Lang, have
been asked by BIHI’s president, Steve Power, to fill in as acting controller at BIHI. The current controller, Marcel
Crosby, has gone on extended leave from BIHI for medical reasons. Mr. Crosby joined BIHI partway through the
current fiscal year, replacing the former controller who moved to another province with her family.

The one constant in BIHI’s accounting department has been the assistant controller, Rick McIlroy. Although Rick
is not a professional accountant, he is very energetic and willing to work extra hours when needed. Rick feels that
the head office staff’s bonus based on pre-tax income is a nice perk and he wants to make sure he is doing his best
to help out his co-workers.

Mr. Power wants you to review the draft condensed financial statement for 31 December 20X4 (Exhibit 1). You
also have reviewed the accounting for certain transactions underlying the draft statement (Exhibit 2). If you feel
that any adjustments are needed, you are to explain the reason(s) and draft any necessary adjusting journal entries.
You should then prepare a revised statement of financial position.

EXHIBIT 1

BRING-IT-HOME INC.

Condensed Draft Financial Statement (unaudited) 31 December 20X4

(prepared by Rick McIlroy)
31 December 20X4

Statement of Financial Position

Current assets $ 44,725

Greenhouse, net 81,000

Other property plant, and equipment (net) 143,365

Total assets $269,090

Current liabilities $ 8,250

 Chapter 18 Leases 1287

Loan payable, government agency 90,000

Other long-term liabilities 67,000

Total liabilities 165,250

Common shares 7,000

Retained earnings 96,840

Total shareholders’ equity 103,840

Total liabilities and shareholders’ equity $269,090

EXHIBIT 2

NOTES ON THE DRAFT FINANCIAL STATEMENTS

1. Bank Indebtedness
BIHI has a $60,000 long-term loan payable to Canadiana Bank. BIHI is to provide Canadiana with
its audited financial statements, prepared in accordance with IFRS, within 90 days of its year-end.
The loan bears interest at 10% and is callable if the company’s debt to equity ratio exceeds 3:1.
The 10% interest rate Canadiana charged BIHI on its own creditworthiness exceeds the 7%
that Flanagan normally pays on its bank loans because BIHI’s parent company deals with an
international consortium of banks and thus is able to negotiate a better rate than BIHI.

2. Lease
On 2 January 20X4, BIHI acquired equipment via a five-year lease that requires annual payments
of $25,000, due at the beginning of each year. The first payment was made on 2 January 20X4
and was charged to rent expense. The present value of the five payments, based on the 10%
rate implicit in the lease, was $104,250 while the fair value of the equipment at the inception of
the lease was $132,000. Because the equipment was custom-made for BIHI’s needs, there is no
residual value at the end of the five-year lease. The lease covers only five of the equipment’s
estimated physical life of eight years and is, therefore, being recorded as an operating lease.

3. Community Vegetable Greenhouse

On 1 July 20X4, BIHI acquired ownership of a large community greenhouse through a provincial
government lending agency. To facilitate acquisition of the greenhouse, BIHI signed an agreement
that requires the company to pay $90,000 to the lending agency on 30 June 20X9. As well, BIHI
must pay simple interest of 3% on the loan, or $2,700 per year, on each of 30 June 20X5 through
30 June 20X9.
1288 Chapter 18 Leases

Acquisition of the greenhouse qualified for federal government assistance as the greenhouse
was located in an economically challenged area of the province. After signing the paperwork
to acquire the greenhouse on 1 July 20X4, BIHI received $15,000 from a federal government
agency. The company expects to use the greenhouse for five years after which it should be almost
worthless. Rick diligently made the following related entries during the current fiscal year:

1 July 20X4
Greenhouse 90,000
Loan payable 90,000
To record acquisition of the greenhouse
Cash 15,000
Head office expenses 15,000
To record receipt of government grant
31 December 20X4
Depreciation expense 9,000
Accumulated depreciation, greenhouse 9,000
To record six months of depreciation under the straight-line method
Interest expense 1,350
Interest payable 1,350
To accrue six months of interest owing

4. Sales
Until late 20X4, BIHI had an arrangement with Crafty Cabinets Ltd. (Crafty) to design kitchen
cabinets requested by BIHI’s customers. Crafty manufactures the cabinets as specified by BIHI.
BIHI asks Crafty to hold these products in its warehouse for delivery to BIHI or to BIHI’s customers,
as specified. There is a fixed schedule for delivery of the goods to BIHI or its customers. Crafty
notifies BIHI of all shipments from Crafty to BIHI or any of BIHI’s customers.
In December, Rick recorded sales of $10,000 and a related cost of goods sold of $7,360 for goods
manufactured by Crafty for one of BIHI’s customers, John Doyle. BIHI had ordered the goods on
behalf of Doyle. In mid-December, John emailed BIHI and copied Crafty, asking that the goods
not be shipped until January 20X5. John will still pay BIHI according to the original schedule
and terms but, due to unforeseen circumstances, will not be available to receive the goods in
December.

5. Patent
BIHI is interested in expanding its manufacturing of customized kitchen cabinets and counter
tops. In mid-December 20X4, BIHI was approached by Skerwink Designs Ltd., which was were
interested in swapping a parcel of land that would allow BIHI the space needed for expansion. The
land was recorded at $12,000 on the books of Skerwink. In November, Skerwink had received an
 Chapter 18 Leases 1289

offer from another company to purchase this land for $14,400. BIHI’s land was recorded at $15,125
and had recently been professionally appraised at $18,750. The exchange was completed on 29
December 20X4. Rick recorded the trade by capitalizing the new land at $18,750 and recording a
gain on the trade of $3,625.

Required:
Prepare the information requested by Mr. Power. BIHI’s combined federal and provincial tax rate is 20%.
(Judy Cumby; adapted)

CASE 18-3

WARMTH HOME COMFORT LTD.

Warmth Home Comfort Ltd. (WHCL) is a Canadian manufacturer of furnaces and air-conditioning units. The
company was acquired by a group of 15 investors eight years ago. Three of the investors are senior managers with
the company, including Jacob Kovacs, who is president and chief executive officer.

Over the years WHCL had been quite successful, but it has struggled in the face of increasing competition from
overseas competitors. The owners believe that three years from now WHCL will be poised to be a major player
in the Canadian and the U.S. heating and cooling markets and may consider going public. Summary financial
statements are provided in Exhibit 1. Kovacs points out that the company’s financial performance seems to be
improving, given the smaller loss in 20X7 and the increasing revenues after two years of falling sales.

EXHIBIT 1

WARMTH HOME COMFORT LIMITED

Extracts from the Draft Financial Statements Balance Sheet

As at December 31 (in thousands of dollars)

20X7 20X6
(Unaudited) (Audited)

Assets

Current:

Cash $ 15 $ 100

Accounts receivable 875 587

1290 Chapter 18 Leases

Inventory 500 540

Other current assets 56 120

1,446 1,347

Capital assets 2,606 2,256

Accumulated depreciation (1,071) (926)

1,535 1,330

Total assets $2,981 $2,677

Liabilities

Current:

Bank indebtedness $ 450 $ 400

Accounts payable 581 395

Other current liabilities 118 100

1,149 895

Long-term debt 825 525

1,974 1,420

Shareholders’ equity:

Share capital 100 100

Retained earnings 907 1,157

1,007 1,257

Total liabilities and shareholders’ equity $2,981 $2,677

Your firm has been auditor of WHCL since its first audit in 20X0. It is now January 20X8. This is the first year
that you are in charge of the audit. Yesterday, you visited WHCL and met with key personnel to discuss the
forthcoming audit engagement. You obtained the following information.

1. In early fiscal 20X7, the company increased its debt load significantly by borrowing $300,000 from Colo
Investors Ltd. Excerpts from the loan agreement are as follows:
Warmth Home Comfort Ltd. (the borrower) covenants that:
a. A current ratio of 1.2 or higher will be maintained; and
b. The debt-to-equity ratio will not exceed 2:1. Debt is defined as all liabilities of the company.
 Chapter 18 Leases 1291

2. In 20X1, WHCL introduced a new model of gas furnace that is popular with consumers because its reduced
gas consumption results in lower heating bills. The furnace design has remained virtually unchanged since it
was introduced. The furnaces are sold with 10-year warranties on parts and labour. Historically, claims have
been minimal.
In the summer of 20X7, several warranty claims were made against WHCL. Routine inspections by
gas-company employees revealed cracked heat exchangers, which could leak gases that might cause health
problems when mixed with warm air inside the house. Thirty claims were made, and WHCL paid for repairs.
The cost of repairing each furnace was $150, which was expensed by WHCL.
Jacob Kovacs believes that the furnaces were damaged because of poor installation by contractors. He cannot
see more than an additional 40 or 50 units being damaged. The 30 repaired furnaces were manufactured in
20X5 and 20X6. Over 10,000 units of this model have been sold over the past seven years.
Later, in a discussion with the chief engineer, you learn that she had examined the heat exchanger used in
the gas-furnace model in question and saw no evidence of a design flaw. However, she expressed concern
that the problem might be due to heavy use of the furnace. She noted that the 30 reported problems were in
northern locations where the demands on the equipment are considerable. Between 1,500 and 2,000 furnaces
were installed in houses in those locations.
3. In January 20X7, WHCL bid on and won a $1.05 million contract to supply heating and air conditioning
equipment for a large commercial and residential project. Construction on the project began in March 20X7.
The fixed-price contract calls for WHCL to start delivering and installing the equipment in early
September 20X7. In addition, WHCL has agreed to pay a penalty if the project is delayed because WHCL
is unable to meet the agreed-to timetable. A brief strike by its factory employees has caused production
and delivery to lag about two weeks behind schedule, so WHCL is shipping units as soon as they are
produced. According to the agreement, half of the equipment has to be shipped and installed at the project
site by the end of February 20X8. Jacob Kovacs is confident that WHCL will be able to catch up to the
promised timetable.
In 20X7, WHCL recognized $350,000 of revenue based on the number of units shipped to year-end. WHCL
has received $50,000 for the units that have been installed by year-end.
4. Starting in February 20X8, WHCL will begin offering customers the option of paying a monthly fee for the use
of a furnace. At the end of a certain number of years, the customer can purchase the unit for a nominal amount
or ask for a replacement furnace and continue with the monthly payments. WHCL will do all maintenance at
no cost until a customer purchases the unit. This scheme is intended to help WHCL remain competitive. The
terms for such arrangements have not been finalized, but Jacob Kovacs is confident that they will increase sales
revenue. Jacob has asked for advice on how to account for this arrangement.
Your partner asks you to prepare a memo for him outlining the accounting issues that came to your attention
as a result of your visit, applying IFRS.

Required:
Prepare the memo.
(Source: The Canadian Institute of Chartered Accountants, © 2010)
1292 Chapter 18 Leases

TECHNICAL REVIEW

TR18-1 Lease Classification:

Information has been gathered for three leases:

Lease A B C

Fair value of equipment $240,000 $110,000 $230,000

Title passes no no no

Bargain purchase option no no no

Useful life of equipment 10 years 7 years 9 years

Lease term 3 years 5 years 8 years

PV of minimum lease payments $ 94,400 $95,000 $ 230,000

Residual, guaranteed, end of term lease no no $ 5,000

Residual, unguaranteed, end of term lease unknown unknown no

Required:
None of the leased assets are specialized for the lessee. Classify each lease as an operating lease or a
finance lease. Provide a rationale for each decision.

TR18-2 Operating Lease:

Argyle Ltd. signed a 36-month lease to rent a computer system for $5,400 per month. The value of the
computer equipment is $400,000. The lease will commence on 1 November 20X1. As encouragement to
lease the system, the lessor waived the first six months’ rent. The remaining 30 payments will be due at
the beginning of each month, starting on 1 May 20X2. Argyle Ltd.’s fiscal year-end is 31 December.

Required:
Prepare summary journal entries for Argyle for 20X1 and 20X2.
 Chapter 18 Leases 1293

TR18-3 Present Value:

Information has been gathered for two leases:

LEASE A

• The fair value of the equipment is $800,000 at the inception of the lease.
• The lease term is five years, and there is a three-year renewal term at the option of the lessor.
• Annual lease payments are $145,000 per year for the first five years and $100,000 for the next three
years. Payments are due at the beginning of each lease year.
• All lease payments include the cost of insurance, estimated at $15,000 per year.
• The lessee guarantees a residual value of $40,000 at the end of the eighth year.
• The lessee does not know the lessor’s implicit rate of interest in the lease. The lessee’s incremental
borrowing rate is 8%.
LEASE B

• The fair value of the equipment is $700,000 at the inception of the lease.
• The lease term is five years.
• Annual lease payments are $145,000 per year. Payments are due at the beginning of each lease year.
• The lessee is permitted to purchase the asset for $18,000 at the end of the lease term. This is
considered a bargain.
• The lease payments include the cost of insurance, estimated at $12,000 per year.
• The lessor’s implicit rate of interest in the lease is 6%. The lessee’s incremental borrowing rate is 8%.

Required:
Calculate the present value of the minimum lease payments for each lease.

TR18-4 Lease Liability Amortization Table:

Peridis Inc. has entered into a contract with an asset-based finance company to acquire some specialized
equipment. The lease payments are $20,000 per year for eight years, with payments commencing at the
start of each lease year. . At the end of the lease, Peridis guarantees to either (1) acquire the equipment
from the lessor for $10,000 or (2) pay for the lessor’s cost of removing the equipment, which also is
estimated at $10,000. Peridis’s incremental borrowing rate for this amount and term is estimated to be
8%. Peridis’s fiscal year ends on 31 December.

Required:
1. Determine the present value of the lease payments.
2. Prepare a liability amortization table for this lease for Peridis.
3. Assume that the lease starts on 1 January 20X1. How much interest expense will Peridis report for
each of 20X1 and 20X2?
4. Assume instead that the lease starts on 1 October 20X1. How much interest should the company
record for each of 20X1 and 20X2?
1294 Chapter 18 Leases

TR18-5 Lease Liability Amortization Table:

The following lease liability amortization table was developed for Smith Company and Lease 34T:

LEASE LIABILITY AMORTIZATION TABLE

Lease Outstanding Incr/(Decr) Ending

Year Balance Interest Payment in balance Balance

Aug. 1 20X1 $40,000 $ 11,720 ($11,720) $28,280

Aug. 1 20X2 28,280 1,980 $ 11,720 (9,740) 18,540

Aug. 1 20X3 18,540 1,298 $ 11,720 (10,422) 8,117

Aug. 1 20X4 8,117 568 $ 4,490 (3,922) 4,196

Aug. 1 20X5 4,196 294 $ 4,490 (4,196) (0)

Required:
1. Provide an independent proof of the $18,540 liability balance after the second payment.
2. Smith has a 31 December fiscal year-end. How much interest expense is recorded in 20X3?
3. What is the balance in the lease liability account at 31 December 20X3? How much of this is a current
liability versus a long-term liability?

TR18-6 Depreciation Period:

Information has been gathered for three finance lease assets that will be accounted for through
straight-line depreciation:

Lease 1 Lease 2 Lease 3

Initial lease term 6 years 6 years 5 years

Renewal option, lessor’s option n/a 3 years n/a

Renewal term, lessee’s option n/a n/a 4 years

Economic life of the leased asset 7 years 10 years 10 years

Bargain purchase option included in lease contract Yes No No

 Chapter 18 Leases 1295

Required:
For each leased asset, choose a depreciation period. Explain your choice.

TR18-7 Finance Lease:

Niko Ltd. signed a lease for a five-year term that requires yearly, beginning-of-year payments of $104,000,
including $9,600 of annual maintenance and property taxes. Niko guarantees a residual value of $26,500
at the end of the lease term, although both parties expect the asset to be sold as used equipment for
approximately $35,000 at that time.

Required:
1. How much are Niko’s minimum lease payments, before discounting, as defined for lease accounting
purposes?
2. If Niko’s IBR is 10%, what amount will Niko record as an asset?
3. How much will Niko record as an asset if the residual value is unguaranteed?
4. Suppose that the fair value of the leased asset is $375,000 at the inception of the lease. How would
this fact affect the amount recorded for the leased asset and the interest rate?

TR18-8 Finance Lease:

Return to the lease liability amortization table developed for Smith Co. and Lease 34T in TR 18-5. Each
lease payment also includes $1,000 of estimated insurance. That is, the cash payment is $1,000 higher
than that listed in the table. The asset reverts to the lessor at the end of the lease term, and the residual
value is unguaranteed.

Required:
Provide journal entries for Smith for 20X1 and 20X2. Smith has a 31 December fiscal year-end. Smith
uses straight-line depreciation for similar assets, with a half-year of deprecation recorded in the year of
acquisition.

TR18-9 Appendix A; Lessor:

On 1 January 20X1, Canada Leasing Inc. acquired an asset on behalf of Magnum Ltd. for $100,000.
Canada Leasing and Magnum enter into a six-year lease for the asset, effective 1 January 20X1, with equal
payments at the beginning of each lease year. Canada Leasing will earn 8% (before taxes) on the lease.
Canada Leasing has a 31 December fiscal year-end.
1296 Chapter 18 Leases

Required:
1. Determine the amount of each lease payment.
2. Make the journal entries that would appear in Canada Leasing Inc.’s accounts for 20X1, 20X2, and
20X3, using the net method of recording.
3. Repeat requirement 2, but use the gross method of recording the lease.
4. What amount(s) relating to the lease will be shown on Canada Leasing Inc.’s SFP on 31 December
20X3?

TR18-10 Appendix B; Lease Recognition:

On 1 March 20X4, Machine Manufacturing Co. leased a machine to Dry Goods through a three-year lease.
The machine has an eight-year estimated useful life and no residual value at the end of the eighth year.
The annual lease payments of $25,000 start on 1 March 20X4, and continue for three years. There is a
guaranteed residual value of $18,000 at the end of the three-year lease term. The interest rate implicit
in the lease is 8%, which is known. The incremental borrowing rate for Dry Goods is 6%. The accounting
period ends on December 31.

Required:
1. Under the new lease standard, what amount will Dry Goods recognize as an asset on 1 March 20X4?
2. Is there any way to avoid recognition of the right-of-use asset for this lease?

ASSIGNMENTS

A18-1 Classify Two Leases:

GBT Corp. has signed two leases in the past year. One lease is for handling equipment, the other for a truck.

HANDLING EQUIPMENT:
The handling equipment has a fair market value of $548,000. Lease payments are made each 2 January, the date
the lease was signed. The lease is for four years and requires payments of $110,000 per year on each 2 January
and can be renewed at the lessee’s option for subsequent one-year terms up to three times, at a cost of $46,000 per
year. At the end of any lease term, the equipment reverts to the lessor if GBT does not exercise its renewal option.
Annual maintenance and insurance costs are paid by the lessor and are estimated to be $10,000 per year for the
first four years and $6,000 per year thereafter. These costs are included in the lease payments. GBT estimates that
the equipment has an economic life of eight to 10 years before it becomes obsolete.
 Chapter 18 Leases 1297

TRUCK:
The truck has a list price of $270,000 but could be purchased with cash for 10% less. The truck lease runs for four
years and has an annual lease payment of $40,000, due at the beginning of each year. The lease commences on 1
January. If the truck is used for more than 50,000 kilometres in any 12-month period, a payment of $0.50 per extra
kilometre must be paid in addition to the annual rental. GBT is responsible for all operating and maintenance costs.

At the end of the four-year lease agreement, GBT may, at its option, renew the lease for an additional period; term
and payments to be negotiated at that time.

GBT has an 8% incremental borrowing rate. The company uses straight-line depreciation for all of its tangible
capital assets, using the half-year convention (i.e., a half-year depreciation in the first and last years). The truck has
an estimated useful life of 10 years.

Required:
Classify each lease as a finance or operating lease. Justify your response.

A18-2 Terminology; Classification; Entries:

Plaid Ltd. has a 6% incremental borrowing rate. On 1 January 20X1, Plaid signed a lease agreement for a piece
of equipment. The equipment has a fair value of $38,000 and a 12-year economic life. Other information is as
follows:

• The noncancellable lease is for eight years.

• The lease payment is $4,800 annually, payable at the beginning of each lease year.
• Lease payments include $720 of maintenance expense annually.
• At the end of the lease term, the leased asset reverts to the lessor.
Other information:

• Plaid has a fiscal year that ends on 31 December.

• Plaid uses straight-line depreciation for similar fixed assets.

Required:
1. For this lease, provide the:
a. Lease term;
b. Guaranteed residual value;
c. Unguaranteed residual value;
d. Bargain purchase option; and
e. Minimum net lease payment.
If these amounts do not exist in the above lease, enter “none” as your response. State any assumptions.
2. Is this lease an operating lease or a finance lease for the lessee? Explain your reasoning.
3. Prepare the journal entries for the first year of the lease on Plaid’s books.
4. Would your answer to requirement 2 change if the lease contained a guaranteed residual value of $10,000?
Explain.
1298 Chapter 18 Leases

A18-3 Terminology; Classification; Entries:

Canadian Leasing Inc. leased a piece of machinery to Ornamental Concrete Ltd., with the following terms:

• The lease is for five years; Ornamental cannot cancel the lease during this period.
• The lease payment is $79,600 per year. Included in this is $7,900 in estimated insurance costs.
• At the end of the five-year initial lease term, Ornamental can elect to renew the lease for one additional
five-year term at a price of $29,500, including $2,500 of estimated insurance costs. Market rentals are
approximately twice as expensive.
• At the end of the first or second lease term, the leased asset reverts to the lessor.
• Lease payments are due at the beginning of each lease year.
Other information:

• Ornamental could borrow money to buy this asset at an interest rate of 8%.
• The equipment has a fair market value of $430,000 at the beginning of the lease term and a useful life of
approximately 12 years.
• The lease term corresponds to the fiscal year.
• Ornamental uses straight-line depreciation for all capital assets.

Required:
1. For this lease, provide the:
a. Lease term;
b. Guaranteed residual value;
c. Unguaranteed residual value;
d. Bargain purchase option;
e. Bargain renewal terms;
f. Minimum net lease payment; and
g. Incremental borrowing rate.
If these amounts do not exist in the above lease, enter “none” as your response. State any assumptions.
2. Is this lease an operating lease or a finance lease for the lessee? Why?
3. Prepare journal entries for the first year of the lease on Ornamental’s books.

A18-4 Lease Classification and Operating Lease:

Lockhart Co. complies with IFRS reporting standards. Lockhart signed a lease for a truck on November 1, 20X1
that had the following terms:

• The lease payments are $34,700 per year, payable each November 1 for nine years. (However, the lease term
is 12 years. See below)
• The lease payments include $2,100 for insurance expense.
• After the lease payment on November 1, Year 9, the lessee can keep the asset for free until November 1,
20X13.
 Chapter 18 Leases 1299

• The asset will be returned to the lessor on November 1, 20X13, and the lessor will sell the asset. If the lessor
does not receive at least $30,000, then Lockhart will make up the difference.
• The leased asset has a useful life of 20 years and a fair value of $400,000.
• The interest rate implicit in the lease is 6%. Lockhart has a normal borrowing rate of 7%.

Required:
1. Classify the lease as an operating lease or a finance lease.
2. Assume this is an operating lease and calculate the total rent expense for the year ended 31 December 20X1.

A18-5 Operating Lease; Lessee Inducement:

Legal Services Inc. leases space in an office complex and has recently signed a new, four-year lease, at the rate of
$9,200 per month. However, the lessor offered six months “free” rent at the beginning of the lease as an inducement
to sign the lease agreement.

The lease agreement was signed on 1 October 20X1; the lease will commence on 1 November 20X1. The company
has a 31 December fiscal year-end. Rent is due on the first day of each month.

Required:
1. Prepare journal entries for the first, sixth, and seventh months of the lease. Assume that financial statements
are prepared monthly.
2. What amounts would be shown on the company’s SCI and SFP for this lease as of 31 December 20X2?

A18-6 Finance Lease; Lessee Liability

Amortization Table and Entries
On 31 December 20X0, Columbia Inc. entered into an agreement with Scotia Ltd. to lease equipment. Columbia
Inc. will make four equal payments of $80,000 at the beginning of each lease year. Columbia Ltd. anticipates that
the equipment will have a residual value of $64,000 at the end of the lease, net of removal costs. Columbia Inc. has
the option of (1) paying $64,000 to retain the equipment or (2) allowing Scotia Ltd. to remove it.

Scotia Ltd.’s implicit interest rate in this lease is 7%. Columbia Inc.’s incremental borrowing rate is 8%. Columbia Inc.
depreciates the leased equipment on a straight-line basis over four years. The lease commences on 1 January 20X1.
Assume that the fair value of the equipment on the open market is greater than the present value of the lease payments.

Required:
1. Prepare a lease liability amortization table for this lease for Columbia Inc.
2. Prepare all entries that Columbia Inc. will record for this lease and the leased equipment for 20X1 and 20X2.
1300 Chapter 18 Leases

A18-7 Finance Lease:

On 2 January 20X4, Yvan Ltd., a public company, entered into a five-year equipment lease with Jeffery Leasing
Inc. The lease calls for annual lease payments of $150,000, payable at the beginning of each lease year. Yvan’s IBR
is 7%. Yvan does not know the lessor’s interest rate. The fair value of the equipment is $675,000. Yvan depreciates
equipment on a straight-line basis, taking a full year’s depreciation in the year of acquisition.

Required:
1. Prepare the lease liability amortization schedule for Yvan.
2. Prepare the journal entries relating to the leased asset and the lease liability for 20X4 and 20X5 for Yvan.
3. What amounts will appear on Yvan’s statement of financial position, statement of comprehensive income,
and statement of cash flows as of 31 December 20X4?

A18-8 Finance Lease; Fair Value Cap:

On 31 December 20X1, Lessee Ltd. entered into a lease agreement by which Lessee leased a jutling machine for
six years. Annual lease payments are $20,000, payable at the beginning of each lease year (31 December). At the
end of the lease, possession of the machine will revert to the lessor. The normal economic life for this type of
machine is 8 to 10 years.

At the time of the lease agreement, jutling machines could be purchased for approximately $90,000 cash.
Equivalent financing for the machine could have been obtained from Lessee’s bank at 14%.

Lessee’s fiscal year coincides with the calendar year. Lessee uses straight-line depreciation for its jutling machines.

Required:
1. Prepare a lease liability amortization table for the lease, assuming that Lessee accounts for it as a finance
lease.
2. Prepare all journal entries relating to the lease and the leased asset for 20X1, 20X2, and 20X3.
3. How would the amounts relating to the leased asset and lease liability be shown on Lessee’s statement of
financial position at 31 December 20X4?
4. Repeat requirement 2 assuming that the fair market value of the equipment was $77,273 at the inception of
the lease.

A18-9 Finance Lease:

Watson Co. entered into a financing lease for a truck on 1 April 20X2 that had the following terms:
 Chapter 18 Leases 1301

• The lease payments are $12,500 per year, payable each 1 April for four years.
• The lease may be renewed at the option of the lessor for a further five years for $3,600 per year.
• The initial lease term payments include $1,200 for maintenance expenses, but there is no maintenance built
into the second lease payment stream.
• There is a guaranteed residual value of $15,000 at the end of the first lease term and $5,000 at the end of the
second lease term. (These are not bargain purchase options.)
• The leased asset has a useful life of ten years and a fair value of $70,000.
• The interest rate implicit in the lease is 7%.

Required:
1. The residual values are not bargain purchase options, as stated above. What evidence would be collected to
support this conclusion?
2. The lessee doesn’t own this truck. Why is it an asset on its SFP?
3. Calculate the present value of the minimum lease payments.
4. Prepare a lease liability amortization table for only the first four payments.
5. List the items that would appear in the lessee’s SCI for the year ended 31 December 20X3.
6. What is the amount of the total lease liability on the balance sheet on 31 December 20X3? Split this amount
into the current and long-term portions.

A18-10 Lessee Liability Amortization Table;

Entries:
Jain Corp. has negotiated a lease for new machinery. The machinery has a fair value of $412,500 and an expected
economic life of seven years. The lease has a five-year term. Annual rental is paid at the beginning of the lease
year, in the amount of $78,225. Insurance and operating costs, approximately $15,000, are paid directly by Jain
and are not included in the lease payments. At the end of the lease term, the machinery will revert to the lessor,
which will sell it for an expected $56,250. If the lessor does not realize $56,250 in the sale, then Jain has agreed to
make up the difference. Jain does not know the lessor’s implicit interest rate.

Required:
1. Prepare a lease liability amortization table for the lease. Jain’s IBR is 10%.
2. Assume that the lease was entered into on 1 January 20X2. Jain has a 31 December fiscal year-end. Prepare
journal entries for the lease for 20X2, including depreciation.
3. Assume that at the end of the lease, the lessor is able to sell the asset for $45,000 and that Jain makes up the
shortfall. Prepare Jain’s entry to record the lease termination (after first recording interest to the date of the
transaction).

A18-11 Finance Lease:

Griffiths Ltd. has a five-year financing lease, and the following lease liability amortization table was prepared
when the lease was originally signed, using an 8% interest rate. Note the presence of a guaranteed residual value at
the end of the lease term.
1302 Chapter 18 Leases

SCHEDULE OF LEASE LIABILITY AMORTIZATION

Outstanding Incr./(Decr.) in
Lease Payment Balance Interest Payment Balance Ending Balance
Opening; first $59,000 -- $ 13,000 ($13,000) $46,000
second 46,000 $3,680 13,000 (9,320) 36,680
third 36,680 2,934 13,000 (10,066) 26,614
fourth 26,614 2,129 13,000 (10,871) 15,744
fifth 15,744 1,259 13,000 (11,741) 4,003
final 4,003 320 4,323 (4,003) 0

Required:
1. The lease was entered into on 1 March 20X5. Give the journal entries for 20X5, up to and including the 31
December 20X5 adjusting journal entries for the end of the fiscal year. The company uses the half-year rule
for depreciation.
2. It is now 31 December 20X7. All payments have been made on schedule, and all entries have been made
correctly. Calculate 20X7 total interest expense, and the amount that will appear on the 31 December 20X7
SFP with respect to the lease liability. Show the current and long-term amounts separately.
3. The residual value, guaranteed by Griffiths, was $4,323, and this was felt to be a valid estimate all during
the lease life. However, at the end of the fifth lease year, the asset was sold for $2,700, and the appropriate
amount was remitted to the lessor. Provide all journal entries that would be made on this date with respect to
interest, depreciation, the sale and final payment to the lessor.

A18-12 Lessee Liability Amortization Table;

Entries:
Bombay Ltd. is expanding and needs more manufacturing equipment. The company has been offered a lease
contract for equipment with a fair value of $260,000. The lease has a five-year term, with beginning-of-year
payments. The lease is renewable for a further two years at the option of the lessee. Annual rental for the first
term is $57,200, for the second, $23,000. The inception of the lease is 1 January, and payments are made each 1
January. The first term rental includes $5,200 for maintenance and insurance, the second, $3,000. Lease payments
are close to market lease rates for both the first and second terms. At the end of the second term, Bombay can buy
the asset for $1. The machinery has an expected life of 10 years. Bombay has an incremental borrowing rate of
10%. Bombay has been told that the interest rate implicit in the lease is 8%.

Required:
1. Prepare a lease liability amortization table for the lease.
2. Assume that the lease was entered into on 1 January 20X2. Bombay has a 31 December fiscal year-end.
Prepare journal entries for the lease for 20X2, including any entries relating to the asset.
3. Prepare the entry or entries necessary on 31 December 20X9, assuming Bombay exercises the bargain
purchase option.
 Chapter 18 Leases 1303

A18-13 Finance Lease:

Sondheim Ltd. entered into a finance lease with New Age Leasing Corp. The lease is for new specialized factory
equipment that has a fair value of $3,200,000. The expected useful life of the equipment is 10 years, although
its physical life is far greater. The initial lease term begins on 1 April 20X2 and runs for 10 years. Annual lease
payments are $400,000, payable at the beginning of each lease year. After the initial lease term, Sondheim has the
option of renewing the lease on a year-by-year basis for as long as Sondheim wishes. Since the equipment will
be obsolete by that time, the renewal is set at $10,000 per year, which is expected to be a fair rental value for
equipment of that age. Other information is as follows:

• The interest rate implicit in the lease is 7%; Sondheim’s incremental borrowing rate is 6%.
• Sondheim will amortize the equipment on a straight-line basis over the lease term and has a 31 December
fiscal year-end.

Required:
1. Prepare the journal entries relating to the lease liability and the leased equipment for Sondheim for 20X2,
including all appropriate adjusting entries.
2. What amounts will appear on Sondheim’s SFP and SCF for the year ended 31 December 20X2?

A18-14 Finance Lease; Lessee Reporting:

Videos-to-Go signed a lease for a vehicle that had an expected economic life of eight years and a fair value of
$18,000. The lessor is the leasing subsidiary of a national car manufacturer. The terms of the lease are as follows:

• The lease term begins on 1 January 20X2 and runs for five years.
• The lease requires payments of $5,800 each 1 January, including $1,700 for maintenance and insurance costs.
• At the end of the lease term, the lease is renewable for three one-year periods, for $2,600 per year, including
$2,100 for maintenance and insurance. The normal rental costs for a similar used vehicle would be
approximately double this amount.
• At the end of any lease term, if Videos-to-Go does not renew the contract, the vehicle reverts to the lessor. The
lessor may choose to leave the vehicle with Videos-to-Go if its value is low.
Videos-to-Go does not know the interest rate implicit in the lease from the lessor’s perspective but has an incremental
borrowing rate of 12%. Videos-to-Go has a 31 December year-end and uses straight-line depreciation for all assets.

Required:
1. Prepare a lease liability amortization schedule.
2. Prepare journal entries for 20X2 and 20X3.
3. Show how the lease would be reflected on the SFP, SCI, and SCF for 20X2 and 20X3. Segregate debt
between its current and noncurrent components.
4. How much interest expense would be reported on the SCI in each year from 20X2 to 20X9 if Videos-to-Go
has a 31 May fiscal year-end?
1304 Chapter 18 Leases

A18-15 Finance Lease; Guaranteed Residual:

Lessee Ltd. agreed to a noncancellable lease for which the following information is available:

a. The asset is new at the inception of the lease term and is worth $160,000.
b. Lease term is four years, starting 1 January 20X1.
c. Estimated useful life of the leased asset is six years.
d. The residual value of the leased asset will be $30,000 at the end of the lease term. The residual value is
guaranteed by Lessee.
e. The declining-balance depreciation method is used for the leased asset, at a rate of 30% per year.
f. Lessee’s incremental borrowing rate is 10%.
g. Four annual lease payments will be made each 1 January during the lease term, and the first payment, due at
inception of the lease term, is $43,130, including $5,500 of maintenance costs.
h. Lessee has a 31 December fiscal year-end.

Required:
1. Is this an operating lease or a finance lease? Explain.
2. Prepare a table showing how the lease liability reduces over the lease term.
3. Record the entries for 20X1.
4. Prepare the financial statement presentation of all lease-related accounts as they would appear in the financial
statements of the lessee at 31 December 20X1.

A18-16 Sale and Leaseback:

On 31 March 20X2, Supergrocery Inc. sold its major distribution facility, with a 30-year remaining life, to a
real estate investment trust (REIT) for $9,000,000 cash. The facility had an original cost of $10,400,000 and
accumulated depreciation of $3,600,000 on the date of sale.

Also on 31 March 20X2, Supergrocery signed a 20-year lease agreement with the REIT, leasing the property back.
At the end of the 20-year lease term, legal title to the facility will be transferred to Supergrocery. Annual payments,
beginning on 31 March 20X2, are $875,000. Maintenance and repair costs are the responsibility of Supergrocery.
Supergrocery has an incremental borrowing rate of 9%. The company uses straight-line depreciation and has a 31
December year-end. Supergrocery records a part-year’s depreciation on buildings, based on the date of acquisition.

Required:
1. Give the 20X2 entries that Supergrocery would make to record the sale and the lease.
2. Show how the SFP and SCI would reflect the transactions at the end of 20X2. Do not segregate statement of
financial position items between current and noncurrent items.
 Chapter 18 Leases 1305

A18-17 Sale and Leaseback:

Central Purchasing Ltd. (CPL) owns the building it uses; it had an original cost of $825,000 and a net book value
of $250,000 as of 1 January 20X2. On this date, the building was sold to a real estate investment trust (REIT) for
$500,000, which also was the building’s fair value, and simultaneously leased back to CPL.

The lease has a guaranteed, 12-year term and required payments on 31 December of each year. The payments are
$76,500, and the lease allows the property to revert to the lessee at the end of the lease. CPL could have mortgaged
this property under similar terms at an interest rate of 9%. The REIT will pay property taxes estimated to be
$16,200 per year. These costs are included in the lease payment. CPL will pay maintenance and operating costs.
The building is being depreciated straight-line, with an estimated remaining life of 16 years.

Required:
1. Prepare entries to record the sale and leaseback of the building.
2. Prepare year-end adjusting entries for 20X2.
3. Show how all amounts related to the sale and leaseback will be presented on the statement of financial
position and statement of comprehensive income in 20X2.

A18-18 Sale and Leaseback:

Sportco Ltd. is suffering temporary cash flow difficulties due to poor economic conditions. To raise sufficient
finances to allow operations to continue until economic conditions improve, Sportco entered into an agreement
with a major lease corporation, Leaseco. On 1 January 20X2, Sportco sold its largest manufacturing property to
Leaseco at its fair market value, $1,750,000. The property had a net book value of $250,000 at the time of the sale.

Sportco, in turn, leased back the property from Leaseco for 15 years. The annual rent was $175,000, due each year
starting on 1 January 20X2. Sportco can repurchase the property from Leaseco at the end of the lease term for $1.
The land value is estimated to be 40% of the total fair market value of the property, while the building represents
the other 60%. Sportco amortizes its buildings at a declining-balance rate of 10%.

Sportco’s incremental borrowing rate is 7%. Its financial statements are prepared in accordance with generally
accepted accounting principles.

Required:
How should Sportco account for this transaction in its financial statements for the year ending 31 December 20X2?
Be specific, and explain the approach that you have chosen.
(Source: The Canadian Institute of Chartered Accountants, © 2010)

A18-19 Statement of Cash Flows; Review:

Each of the following items must be considered in preparing a statement of cash flows for Phillie Fashions Inc. for
the year ended 31 December 20X6:

1. Fixed assets that had a cost of $10,000 6½ years before and were being depreciated straight line on a 10-year
basis, with no estimated scrap value, were sold for $3,125.
2. Phillie leased an asset in lieu of buying it. Phillie recognized an asset and liability of $25,400 at the end of
the year. No interest or depreciation was recorded because the transaction took place at the end of the fiscal
1306 Chapter 18 Leases

year. The first lease payment of $7,000 was made at the end of the fiscal year, reducing the lease liability to
$18,400.
3. During the year, goodwill of $5,000 was completely written off to expense.
4. During the year, 250 shares of common stock were issued for $32 per share.
5. Fixed asset depreciation amounted to $1,000 and patent amortization was $200.
6. Bonds payable with a par value of $12,000, on which there was an unamortized bond premium of $360, were
redeemed at 103.
7. Phillie, as lessee, reported a net lease liability of $14,678 at the end of 20X6 in relation to equipment that
had been leased since 20X4. In 20X5, the liability had been $15,766. The current portion of the liability was
$2,410 each year.

Required:
For each item, state what would be included in the statement of cash flows, whether it is an inflow or outflow, and
the amount(s). Assume that correct entries were made for all transactions as they took place and that the indirect
method is to be used to disclose cash flow from operations. In your response, use a three-column format as follows:

Operating/Investing/Financing Inflow/Outflow Amount

A18-20 ASPE; Lessee:

Refer to the information in A18-13. Assume that Sondheim is a private enterprise that has chosen to use ASPE.

Required:
1. Determine the present value of Sondheim’s lease payments.
2. What amounts relating to the lease (and the leased asset) will Sondheim report in the company’s statement of
financial position and its statement of comprehensive income for the year ending 31 December 20X2?
3. If A18-13 has been solved, explain the relative impact of using ASPE, as compared with IFRS.

A18-21 ASPE; Lessee:

On 24 February 20X1, Ready Distributing Ltd., a private company, signed a lease for conveyor equipment. This is
specialized equipment that can be used only in Ready’s manufacturing plant. The fair value of the leased equipment
is $500,000.

The lease will commence on 1 October 20X1. The lease is for four years with lease payments of $120,000 per
year, due at the beginning of each year. The lessor does not require a residual value guarantee. The equipment’s
estimated economic life is 10 years.

Ready’s incremental borrowing rate is a nominal 6% per annum, and the interest rate implicit in the lease is 7%.

Required:
Classify the lease under IFRS, and then under ASPE. Include an evaluation of all guidelines.
 Chapter 18 Leases 1307

A18-22 ASPE; Lessee and Lessor:

On 10 December 20X0, Noel Inc. entered into a six-year equipment lease with Williams Ltd. The terms of the
lease are as follows:

• The lease will term begin on 1 January 20X1.

• The fair value of the equipment at the inception of the lease is $120,000. The equipment’s expected useful life
is six or seven years.
• Noel Inc.’s incremental borrowing rate is 11%.
• Lease payments are $25,000 per year, payable at the end of each lease year. That is, the first payment will be
due by 31 December 20X1.
• Because of Noel Inc.’s shaky financial condition, Williams Ltd. determined the lease payments based on a
12% return, which is higher than Williams Ltd.’s normal return, Noel Inc. is aware of Williams Ltd.’s rate.
Both Noel and Williams apply ASPE accounting standards.

Required:
1. Should Noel account for this lease as a capital lease or an operating lease? Explain fully and evaluate all
guidelines.
2. How should Williams report this lease? Explain fully.
3. What anomaly arises under ASPE when the lessor is bearing a higher-than-normal risk of default by the
lessee?

A18-23 Appendix A; Finance Lease; Lessor;

Amortization Table; Gross and Net Method
Entries
Refer to the information in A18-6.

Required:
1. Prepare an amortization table for this lease for the lessor.
2. Prepare all entries that the lessor will record for this lease over its full term, using the gross method. Assume
that the lessee exercises the purchase option.
3. On the lessor’s 31 December 20X2 SFP, what amount will appear for the net lease receivable?
4. Prepare all entries that the lessor will record for this lease for the first two years, using the net method.

A18-24 Appendix A; Finance Lease; Lessor:

Refer to the information in A18-7. Jeffrey Leasing Inc. is a public company. Jeffrey’s implicit interest rate in the
Yvan lease is 6%.
1308 Chapter 18 Leases

Required:
1. Prepare the lease net receivable amortization schedule for Jeffrey.
2. Prepare the journal entries relating to the lease for Jeffrey for 20X4 and 20X5, using the net method of
recording the leased asset.
3. Repeat requirement 2, using the gross method.

A18-25 Appendix A; Sales-Type Lease;

Lessor:
Jordin is an equipment dealer that occasionally uses leasing as a means of selling its products. On 1 January 20X1,
Jordin leased equipment to Easten Corp. The lease term was four years with annual lease payments of $5,769 to be
paid on each 31 December. The equipment has an estimated zero residual value at the end of the lease term. The
equipment was carried in Jordin’s accounts at a cost of $15,000. Jordin expects to collect all rentals from Easten,
and there were no material cost uncertainties at the inception of the lease. The implicit interest rate in the lease was
11%.

Required:
1. Why is this a sales-type lease for Jordin?
2. How much is the gross profit or loss recognized by Jordin? The finance revenue recognized over the life of
the lease?
3. Assume that the implicit interest rate is 4% (not 11%). How much is the gross profit or loss recognized by
Jordin? The finance revenue recognized over the life of the lease?
4. Give the entries made by Jordin (based on the 11% rate) at the inception of the lease. Use the gross method.
5. Based on requirement 4, show all lease-related accounts as they would appear in the SFP and SCI of the
lessor at 31 December 20X1, for the year then ended. The lessor’s SFP is unclassified.

A18-26 Appendix A; Sales-Type Lease; Lessor:

On 14 June 20X1, Bruckner Corp. entered into an agreement to lease materials-handling equipment from Mahler
Inc. The five-year lease commences on 1 July 20X1. Bruckner will pay lease payments of $100,000 at the
beginning of each lease year. Bruckner also guarantees a residual value of $50,000.

Mahler is the manufacturer of the equipment Bruckner is leasing. The standard cost of manufacture is $350,000.
The leased equipment normally sells for $480,000. When Mahler negotiates a lease with a customer, the company’s
expected rate of return varies with economic conditions and the cost of capital; currently, Mahler negotiates leases
to obtain a return of 8%.

Required:
Prepare the appropriate entries for Mahler for 20X1 and 20X2 to record this lease, including the receipt of
payments and the recognition of any revenue and expense. Mahler has a 31 December fiscal year-end.
 Chapter 18 Leases 1309

A18-27 Appendix B; Equipment; Lessee:

On 18 December 20X1, Kushner Construction Ltd. leased a crane from Schultz Equipment Inc. for use in a
building project. The lease is for three years. The lease commences on 1 January 20X2. Annual lease payments are
$150,000, payable at the beginning of each year. In addition, Kushner must pay $45,000 for delivery and set-up of
the crane and another $45,000 at the end of the lease term for deconstruction and removal of the crane. The lease
is not renewable. Schultz will lease the crane to other construction companies after Kushner’s project is finished.
The crane has a fair value of $700,000 and a useful life of ten years. Kushner’s incremental borrowing rate is 8%.

Required:
1. Classify the lease under the existing lease standard, and then under the new standard.
2. Using the new standard, calculate the amount that would be recorded as a right-of-use asset on 1 January
20X2.

A18-28 Appendix B; Equipment; Lessee:

Keener Construction Ltd. leased equipment from Dominion Leasing Inc. for use in a building project. The lease
is for five years and Keener has a bargain purchase option of $5,000 at the end of the five-year term. The lease
commences on 1 January 20X5. Annual lease payments are $100,000, payable at the beginning of each year. In
addition, Keener must pay $30,000 for delivery and set-up of the equipment. The equipment has a fair value of
$600,000 and a useful life of six years. Keener’s incremental borrowing rate is 6%.

Required:
1. Classify the lease under the existing lease standard, and then under the new standard.
2. Using the new standard, calculate the amount that would be recorded as a right-of-use asset on 1 January
20X5.

A18-29 Appendix B; Building; Lessee:

Mackenzie Ltd. leased a building from Brooklong Inc. The lease term was four years; the annual rent was $60,000
due at the start of each lease year. The lease commenced on 1 January 20X1. The building has an expected useful
life of 40 years. Mackenzie’s incremental borrowing rate is 6%.

Required:
1. Classify the lease under the existing lease standard, and then under the new standard.
2. Using the new standard, calculate the amount that would be recorded as a right-of-use asset on 1 January
20X1.

A18-30 Appendix B; Equipment; Lessee:

Open Ltd. leased equipment from Hamilton Rent-It Inc. The lease term was three years; the annual rent was
$40,000 due at the start of each lease year. Initial costs for installation were $20,000, paid by Open. The equipment
has an expected useful life of eight years and a fair value of $250,000. The lease commenced on 1 January 20X4.
Open’s incremental borrowing rate is 5%.
1310 Chapter 18 Leases

Required:
1. Classify the lease under the existing lease standard, and then under the new standard.
2. Using the new standard, calculate the amount that would be recorded as a right-of-use asset on 1 January
20X4.

APPENDIX 1

LESSOR ACCOUNTING
Lessors: A Finance Industry
Lessors constitute a highly concentrated specialized industry. The specialized nature of leasing is the result of
the provisions of the Income Tax Act. Only companies that derive at least 90% of their revenue from leasing are
permitted to deduct CCA in excess of rental revenue—a crucial aspect of successful lessor activity. Often, lessors
are subsidiaries of broader financial institutions, such as chartered banks or asset-based lending institutions. There
are no separate publicly listed lessors in Canada.

Captive Finance Companies

A lessor may also be a finance subsidiary of a manufacturer that was set up to facilitate sales of the manufacturer’s
products. These subsidiaries are known as captive leasing companies. For example, private-company Daimler
Chrysler Financial Services Inc. offers sales financing through its subsidiaries, Chrysler Financial Canada,
Mercedes-Benz Credit Canada, and Truck Finance Canada.

A manufacturing company also may carry out leasing services by incorporating a special purpose entity (SPE) that
is then consolidated into the parent company’s financial statements.

Lessor accounting is very complex, and this overview is meant to lightly cover the major issues.

First, a lessor may have an operating lease or a finance lease. The lessor uses the same classification criteria as the
lessee, although the interest rate used for discounting is always the interest rate implicit in the lease. If the lease is
a finance lease, the lease may either be a straight finance lease or a sales-type lease.

LESSOR ACCOUNTING— OPERATING LEASES

Operating Lease—Lessor Accounting
A lease is an operating lease if it is not a finance lease. When the lease is an operating lease, the lessor receives the periodic
rent payment and credits rental income or lease income. The lessor credits the cash receipts to an income account, such as
rent revenue (or other income if leasing is not one of the company’s mainstream business activities.) Returning to the crane
rental example earlier in the chapter, the $20,000 monthly payment is recorded by Empire Equipment Ltd. (EEL), the lessor:
 Chapter 18 Leases 1311

Cash 20,000

Rent revenue—crane 20,000

However, the lessor must acquire a piece of equipment before it can be leased out. The crane cost $1,580,000 to purchase
and is expected to be useful for 10 years. The crane will appear on the lessor’s SFP as “equipment available for lease” and
will be depreciated over its estimated useful life.
In our example, the lessee also paid $15,000 for initial costs of having the crane moved and installed, ready for use. For the
lessor, the payment is reimbursement for labour and transportation costs that the lessor incurs to make sure that the crane
is handled and assembled safely. The lessor would have capitalized these costs to the crane asset account, and now cash
received is credited to this account.
The lessor entries are summarized in Exhibit 18A-1. There are no special complications for this revenue stream.

EXHIBIT 18A-1

LESSOR ACCOUNTING OPERATING LEASES

Lessor Accounting—Empire Equipment Ltd.

6 January—purchase of crane:

Equipment for available for lease 1,580,000

Cash 1,580,000

January—installation costs (assumed):

Equipment for available for lease 15,000

Cash 15,000

1 February—receipt of installation fee:

Cash 15,000

Equipment for available for lease 15,000

Summary entry—receipt of rent:

Cash 200,000

Lease revenue ($20,000 × 10 months) 200,000

1312 Chapter 18 Leases

31 December—depreciation of crane

Depreciation expense* 132,000

Accumulated depreciation— crane 132,000

*$1,580,000 $260,000 residual value, assumed ÷ 10 years $132,000

LESSOR ACCOUNTING—FINANCE LEASES

A lease is a finance lease if it transfers the risks and rewards of ownership to the lessee. Meeting any one of the four
guidelines explained in the chapter provides evidence of a finance lease.

Differences between Lessee’s and Lessor’s Net Cash Flows

The lessor will work with the same basic set of lease terms, except that the lessor must use the interest rate that is implicit
in the lease. This is the rate of return that equates the present value of the lease payments, plus the present value of the tax
savings, to the cost of acquiring the asset. Asset cost includes any direct costs incurred in negotiations and any incidental
costs to acquire the asset (e.g., transportation, commissions, etc.). There are some aspects of the lease that do not apply to the
lessee and that therefore differentiate the lessor’s net cash flow from that of the lessee. The three most important differences
are:
1. The initial cost of the asset. The lessor may obtain a more favourable price on the asset, often by bulk buying. For
example, lessors that deal in aircraft leasing usually buy a large number of planes from the manufacturer and then lease
them in smaller quantities to a several individual airlines. By bulk buying, the lessor can negotiate especially favourable
prices that would not be available to individual airlines. Therefore, an asset’s cost to the lessor may be significantly less
than the asset’s fair value as perceived by the lessee.
2. Residual value. The lessor may expect a significant residual value. For example, when an airplane’s lease with a
mainline carrier ends, the residual value of the plane may still be quite high because smaller carriers, charter airlines,
and cargo lines will use older planes.
3. Tax shield. The lessor can gain a significant tax shield from the aircraft’s depreciation. The early tax cash flow savings
from deducting tax depreciation (CCA) will increase the after-tax cash flow from the lease, especially in the early
years, greatly affecting the internal rate of return (IRR) on the lease.

We will not incorporate tax implications in this discussion, because it is a highly specialized topic.

Internal Rate of Return

The lessor accounts for the lease by the effective interest method. It may seem apparent that the lessor would automatically
know the interest rate that it is charging the lessee. However, leases are negotiated, and since the lessor’s cash flows will not
be exact mirrors of the lessee’s cash flow, the lessor’s effective interest rate may not be obvious. Therefore, we must first
determine the interest rate implicit in the lease, which represents the internal rate of return (IRR) that a lessor is earning
(before tax) in this lease.
Return to the basic example in the chapter; we will now look at this lease from the perspective of Borat Corp, the lessor. The
facts of the example are repeated here, in Exhibit 18A-2. Additional facts:
• Borat negotiated a purchase price of $60,000 for the asset, although the list price is higher, at $66,000. Additional direct
costs amounted to $1,500.
• The expected unguaranteed residual value at the end of the lease term (i.e., five years), unknown to the lessee, is $4,300.
 Chapter 18 Leases 1313

EXHIBIT 18A-2

LEASE TERMS—BASIC EXAMPLE

• The fair value of the asset is $66,000.

• The lease begins on 1 January 20X2.
• The initial lease term is three years.
• Payments over the initial lease term are $20,000 per year, payable at the beginning of each lease year
(i.e., on 1 January 20X2, 20X3, and 20X4).
• At the end of the initial lease term, the lease is renewable for another two years at Lessee’s option for
$5,000 per year. Assume that the normal rental cost of three-year-old equipment of this type is almost
$10,000 per year.
• Lessee is responsible for insuring and maintaining the equipment.
• The asset reverts to the lessor at the end of the lease; the lease agreement contains no obligation for
Lessee to guarantee the residual value.
• Lessee does not know the lessor’s implicit rate of interest in the lease. Lessee’s incremental borrowing
rate is 8%.

The lessor uses the estimate of residual value when determining the lease’s implicit interest rate, regardless of whether it is
guaranteed or unguaranteed by the lessee. The best estimate of residual value is used in the IRR calculation, whether it is
guaranteed or unguaranteed.
To find the internal rate of return, we find the value of i in the following equation:

$60,000 + $1,500 $20,000 (P/AD, i, 3) + $5,000 (P/AD, i, 2) (P/F, i, 3) +

$4,300(P/F, i, 5)

This equation can be solved by using or an Excel spreadsheet or a financial calculator.

The value of i that satisfies this equation is 14%. The lessor’s rate of return is significantly higher than the 8%
cost to Lessee. The higher rate is due to the lower purchase price that the lessor was able to negotiate, plus (to
a lesser extent) the unguaranteed residual value. This phenomenon is what can make leasing quite attractive in the
right circumstances.

FINANCE LEASE ACCOUNTING— LESSOR

The first type of lease we shall examine from the lessor’s perspective is a finance lease.

Finance Lease Lessor Accounting—Net Lease Basis

Initial Recording
As we discussed previously, finance leasing companies are often financial institutions or financial intermediaries. Their
business is to provide financing for an entity’s asset acquisition, financing that is in the form of a lease rather than purchase
financing, such as a direct loan. The lessor really does not want any physical assets—the lessor’s assets are financial assets.
Thus, when a lessor acquires an asset on behalf of a lessee, the asset is delivered directly to the lessee.
1314 Chapter 18 Leases

Instead of recording the physical asset, the lessor records the net lease receivable. The net lease receivable is the present
value of the lease payment agreement, including the guaranteed or unguaranteed residual, discounted at the interest rate
implicit in the lease. It is also equal to the amount that the lessor spent (or owes) for the asset and associated direct costs.
After all, the lessor negotiates a lease agreement with the lessee that will enable the lessor to recover all of the investment in
the leased asset as well as earn interest. The entry for Borat would appear as follows:

Net lease receivable 61,500

Cash (and/or accounts payable)* 61,500

* This entry assumes that the asset is purchased simultaneously with

the lease contract. If the leased asset were already on the books of
the lessor, the asset would be credited instead of cash.

After initially recording the lease, Borat will account for each lease payment as a combination of (1) interest income and
(2) principal payments to reduce the outstanding lease receivable. This is the reverse of the lessee’s lease liability, but the
amounts usually will be different because the lessor has a somewhat different cash flow. A receivable amortization table will
clarify the lessor’s accounting.

Receivable Amortization Table

The receivable amortization table for Borat Corp. is shown in Exhibit 18A-3. This leaves $41,500 as the lease receivable
throughout 20X2. At the end of 20X2, Borat must record the accrued interest, which is $41,500 × 14%, or $5,810, as
indicated in the amortization table. The remaining amount of the payment, $14,190, reduces the net lease receivable. Again,
remember that the table is for the lease year, not the fiscal year.

EXHIBIT 18A-3

LESSOR RECEIVABLE AMORTIZATION TABLE—BASIC EXAMPLE

Lease Payment Lease Lease

1 Receivable Interest at Received, Receivable Receivable
January Before Payment 14% 1 January Change After Payment

20X2 $61,500 $ — $20,000 $(20,000) $41,500

20X3 41,500 5,810 20,000 (14,190) 27,310

20X4 27,310 3,823 20,000 (16,177) 11,133

20X5 11,133 1,559 5,000 (3,441) 7,692

20X6 7,692 1,077 5,000 (3,923) 3,769

20X7 3,769 531* 4,300 (3,769) 0

Totals $12,800 $74,300 $(61,500)

*Rounded up by $3 to balance.
 Chapter 18 Leases 1315

Recording by the Net Method

The series of entries recorded by Borat is shown in Exhibit 18A-4. These entries are in some respects the reverse of the
lessee’s entries, except that Borat uses a different interest rate, has no depreciation, and accounts for the receipt of the
residual value at the end of the lease.

EXHIBIT 18A-4

LESSOR RECORDING OF FINANCE LEASE—BASIC EXAMPLE

Net Lease
Receivable
Dr. Cr. Balance—Dr.

31 December 20X1

Lease receivable 61,500

Cash, accounts payable 61,500 $61,500

[Delivery of equipment and commencement of the lease]

1 January 20X2

Cash 20,000

Lease receivable 20,000 $41,500

31 December 20X2

Lease receivable 5,810 $ 47,310

Finance revenue—leases ($41,500 × 14%) 5,810

1 January 20X3

Cash 20,000

Lease receivable 20,000 $ 27,310

31 December 20X3

Lease receivable 3,823 $ 31,133

Finance revenue—leases ($27,310 × 14%) 3,823

1 January 20X4

Cash 20,000

Lease receivable 20,000 $ 11,133

1316 Chapter 18 Leases

31 December 20X4

Lease receivable 1,559

Finance revenue—leases ($11,133 × 14%) 1,559

1 January 20X5

Cash 5,000

Lease receivable 5,000 $ 7,692

31 December 20X5

Lease receivable 1,077 $ 8,769

Finance revenue—leases ($7,692 × 14%) 1,077

1 January 20X6

Cash 5,000

Lease receivable 5,000 $ 3,769

31 December 20X6

Lease receivable 531 $ 4,300

Finance revenue—leases ($3,769 × 14%) 531

1 January 20X7

Cash 4,300

Lease receivable* 4,300 $ 0

(to record the receipt of the residual value)

*The actual value received would be recorded, not the estimate. Any gain or loss is reported in
earnings.

The first two entries are to record the lease at its commencement and to record the first lease payment. At the end of 20X2,
Borat must accrue the finance revenue earned on the principal balance of $41,500 that was outstanding throughout 20X2,
computed by the implicit interest rate of 14%. The accrued revenue is debited to the lease receivable balance rather than
being recorded as accrued finance revenue. Receipt of the 1 January 20X3 lease payment is then credited in its entirety to
the lease receivable.
Throughout the life of the lease, Borat records the lease payments and accrues interest on the outstanding balance. The net
lease receivable balances are shown in the final column of Exhibit 18A-4. The balances shown in boldface type are those
at the end of the lease year, and correspond directly to the end-of-year balances shown in Exhibit 18A-2. The nonbolded
amounts are the lease balances that will be shown on Borat’s SFP at the end of each fiscal year.
 Chapter 18 Leases 1317

Current—Noncurrent Distinction
Companies that negotiate leases are financial intermediaries. Financial institutions do not classify their assets on a current/
noncurrent basis—the classification usually is in order of liquidity. Therefore, there is no need to determine the current
balance of the net lease receivable on the SFP.

Finance Lease Lessor Accounting—Gross Lease Basis

It is easy to see that lessor accounting is essentially just the reverse of lessee accounting, if the net lease basis is used.
However, lessors usually record their lease receivables on a gross lease basis. Under the gross lease basis, the lessor records
a gross receivable, the undiscounted cash flows offset by a contra account for unearned finance revenue. At each reporting
date, the lessor calculates the amount of finance revenue that has been earned for the reporting period, and recognizes a
portion of the unearned finance revenue.
For reporting, the lessor will show only the net amount on the SFP. That is, the net asset is the remaining undiscounted lease
payments minus the remaining unearned finance revenue. As a result, the gross method will be presented in an identical way
as the net method on the SFP.

Example
Using the example above, the beginning net lease receivable consists of two amounts—(1) the total undiscounted cash flows
that the lessor expects to receive, reduced by (2) the amount of interest that the lessor will recognize over the lease term:

Lease payments receivable $70,000

Estimated residual value 4,300

Gross lease receivable (see Exhibit 18A-3) 74,300

Less: Unearned finance revenue (i.e., interest) (see

Exhibit 18A-3) 12,800

Net lease receivable $61,500

The initial entry for Borat would appear as follows:

Gross lease receivable 74,300

Unearned finance revenue 12,800

Cash (and/or accounts payable) 61,500

Subsequent entries are as follows:

1 January 20X2

Cash 20,000

Lease receivable 20,000

1318 Chapter 18 Leases

31 December 20X2

Unearned finance revenue 5,810

Finance revenue 5,810

1 January 20X3

Cash 20,000

Lease receivable 20,000

Compare these to the entries for the net method in Exhibit 18A-4 and notice the use of the unearned revenue account in the
gross method.
At the end of 20X2, the balance of the lease receivable, netted with unearned revenue, is:

Lease receivable ($74,300 $20,000) $54,300

Less unearned finance revenue ($12,800 $5,810) 6,990

Net lease receivable $ 47,310

This is the same amount shown in Exhibit 18A-4 as the net lease receivable on 31 December 20X2. After the second $20,000
lease payment is made, the net balance drops to $27,310, which also can be verified by referring to Exhibit 18A-3.

Why Use the Gross Method?

The gross and net methods yield the same results for the lessor’s financial reporting. The net method is simpler and
corresponds to the method normally used by lessees, and thus one might wonder why lessors prefer the gross method for
recording.
Like many of the accounts shown on a SFP, the leases receivable account is a control account. The SFP amount is a total;
underlying that total is a large number of individual leases. For good internal control, a control account must be readily
reconciled to the underlying subsidiary records. For leases receivable, that means that the receivables for the individual
leases can be added up to verify the balance in the control account. The gross method makes that reconciliation easier. The
gross method has the additional advantage of separating the control account function (via the lease payments receivable)
from the revenue recognition function (via the unearned finance revenue).
Lessors will have thousands, perhaps tens of thousands, of individual leases. Since the amounts in the lease payments
receivable account are gross amounts, the balance can be verified by adding the remaining gross payments shown on all of
the individual leases.
In contrast, under the net method it is necessary to compute the present value of each lease at a particular point of time
to perform the reconciliation. Some of the leases may be in arrears, and the present values may not correspond with their
planned amortization schedules. Reconciliation on the net method would be a major headache. Therefore, the gross method
is used.
 Chapter 18 Leases 1319

CONCEPT REVIEW

1. Why do lessors use the gross method rather than the net method of accounting for finance
leases?
2. Where does the unearned finance revenue account appear on the SFP?

SALES-TYPE LEASE ACCOUNTING — LESSOR

A finance lease may be simply a finance lease, or it may be a sales-type lease.

Leases by Manufacturers and Dealers

Basic Nature
Manufacturers and dealers may use leasing as a way of making sales. We all are familiar with the automobile advertising that
prominently features low interest rates for leasing cars, sometimes 0%. But automobiles are not the only products sold heavily via
leases. Other examples include computer equipment, office equipment, many types of industrial equipment, and airplanes.
A sales-type lease is a finance lease that, from the lessor’s point of view, represents the sale of an item of inventory. The
real point of the lease arrangement is to “move” the product. IFRS refers to this as a manufacturer’s lease, although such
leases are used by dealers as well as by manufacturers.
The distinguishing features of a sales-type lease are:
1. The lessor is a manufacturer/dealer; and
2. The leased asset has a carrying value (cost) that is different than fair value.

For the lessee’s financial reporting, it does not matter whether the lessor is the producer of the product or whether the lessor
is simply a financial intermediary. For the lessor’s financial reporting, however, a finance lease involves only finance revenue
recognized over the lease term. A sales-type lease, on the other hand, is viewed as two distinct (but linked) transactions:
1. The sale of the product, with recognition of a profit or loss on the sale; and
2. The financing of the sale through a finance lease, with finance revenue recognized over the lease term.

The new aspect in the accounting for a sales-type lease, as compared to a finance lease, is the initial entry to recognize the
lease. The sale is recorded at the fair value of the asset being sold, cost of goods sold is the carrying value of the asset,
and accordingly, gross profit is recorded on the lease/sale. The lease itself is accounted for by recognizing the present value
of the lease payments, either through the gross method or the net method, as you would see in a finance lease. The lease
payments and finance revenue are then accounted for exactly as for a finance lease.

Example—Sales-Type Lease
Assume that on 31 December 20X1, Binary Corp. (BC), a computer manufacturer, leases a large computer to a local university
for five years at $200,000 per year, payable at the beginning of each lease year. The normal cash sales price of the computer is
$820,000. This is also the present value of the lease payments receivable. The computer cost BC $500,000 to build. The lease
states that the computer will remain with the lessee at the end of the lease. Because of this, the lease is a finance lease.
1320 Chapter 18 Leases

The implicit interest rate that discounts the lease payments to the $820,000 fair value of the computer is 11.04%. Because
the lessor is the manufacturer of the product and because the computer is carried on BC’s books at a value that is less than
fair value, the lease clearly is a sales-type lease.
The sale component of the transaction will be recorded as follows, using the net method for the lease payments receivable:

31 December 20X1

Lease payments receivable 820,000

Sales revenue 820,000

Cost of goods sold 500,000

Computer inventory 500,000

If the gross method were used, the first entry would reflect a debit to the lease payment receivable account of $1,000,000
($200,000 × 5 payments), and a credit to unearned revenue of $180,000.
The first payment (at the inception of the lease) will be recorded as:

31 December 20X1

Cash 200,000

Lease payments receivable 200,000

The SCI for 20X1 will include a gross profit of $320,000 relating to the lease transaction, which is the profit on the sale.
The SFP on 31 December 20X1 will include a net lease receivable of $620,000.
In 20X2 and following years, the lease will be accounted for exactly as illustrated above for direct financing leases. Finance
revenue (or interest revenue) will be accrued each reporting period at the rate of 11.04% on the net balance of the receivable.
Payments will be credited directly to the lease payments receivable account. The SFP will include the net balance of the
receivable.

Gross Profit versus Finance Revenue

In the example above, there is a total revenue/gain amount of $500,000 over the life of the lease ($1,000,000 ($200,000
× 5 payments) less the cost of $500,000). Setting the fair value at $820,000 means that $320,000 of this revenue/gain is
recognized at the beginning of the lease as gross profit, and then the rest, $180,000, is finance revenue recognized slowly
over the life of the lease.
But what if the fair value were $900,000? Then, the split would be $400,000 for gross profit, taken immediately, and
$100,000 is finance revenue over the life of the lease. The total is the same, but the pattern is very different. The fair value
of the asset at the inception of the lease is the dividing line—and is a very important number for this reason.

Determination of Fair Value

In practice, the fair value or “cash price” may not be obvious. The problem arises because many products that are sold via
sales-type leases are subject to discounts or special deals wherein the actual price is less than the stated list price. In fact,
the asset may never be sold outright—all sales may involve leases with various payment terms. What is the fair value of the
asset when there are no reference transactions?
This value is often determined by taking the present value of the minimum lease payments. This is a reasonable way to
approximate sales value. However, the discount rate must be one that reflects market lending conditions.
 Chapter 18 Leases 1321

Another way to circle around this fair value is to determine if the discount rate is appropriate. For example, a common tactic
in long-term automobile leasing is to advertise a very low rate of interest (e.g., 0.9%), a rate that clearly is below the market
rate of interest. A super-low rate really represents a decrease in the price of the car. A potential lessee can see what price he
or she is getting by discounting the lease payments at whatever rate the bank would be willing to finance the car (i.e., at the
borrower’s incremental borrowing rate).
This essentially is the solution offered by the accounting standard—the sales amount should be measured as the lower of:
• The selling price as recorded for outright sales; or
• The present value of the minimum lease payments accruing to the lessor, discounted at the market rate of interest.
The actual determination of the revenue split (and profit split) between the sale and the lease components of the transaction
is a matter of considerable judgement. The split will affect (1) gross profit on the sale in the current period and (2) finance
revenue in future periods. Management is likely to define the sales price in a way that best suits its reporting needs. If the
statements are audited, the auditor must test the reasonableness of management’s sales price definition.

CONCEPT REVIEW

1. What is the basic difference between a sales-type lease and a straightforward finance lease?
2. In a sales-type lease, why is it often difficult to determine objectively the sales price of the
item being “sold”?

Disclosure for Lessors

Lessors with finance leases must disclose the following:
• A general description of the lessor’s leasing arrangements;
• The aggregate future minimum lease payments receivable (i.e., the gross amount) and the total amount of unearned
finance revenue, reconciled to the present value of leases as shown on the SFP;
• The gross lease payments and present value of future minimum lease payments for each of the following periods:
– Within the next year;
– The total for years two through five; and
– Later than the fifth year, in total.
• Any contingent rentals that have been taken into earnings;
• The estimated amount of unguaranteed residual values; and
• The accumulated allowance for uncollectible lease payments.

Accounting Standards for Private Enterprises

Lessor Classification
Whereas IFRS uses the same criteria for both lessees and lessors, ASPE imposes
additional requirements before the lessor can classify a lease as a capital lease:
1322 Chapter 18 Leases

• The lessor’s credit risk relating to the lease and the lessee is normal and is compared with the
collectibility of similar receivables; and
• The lessor’s unreimbursable costs can be reasonably estimated.
Both of these additional requirements must be satisfied. If not, then the lease is reported as an operating
lease rather than a capital lease.

An interesting result of this additional requirement is that the lease can end up being reported
asymmetrically. If the lessee reports the lease as a finance lease while the lessor reports it as an operating
lease, the asset will be reported on the SFP of both the lessee and the lessor.

If the criteria for capitalization are met, a lessor then must classify the lease as either a direct financing
lease or as a sale-type lease. A direct financing lease is essentially the same as a finance lease under
IFRS.

Initial Direct Costs

Under IFRS, the lessor’s initial direct costs (e.g., commissions or legal fees) for finance leases are
capitalized as part of the lessor’s cash flow and amortized over the lease period. In contrast, ASPE
says that the lessor’s initial direct costs should be expensed, both for a direct financing lease and a
sales-type lease. However, ASPE also requires that an equivalent amount of the unearned lease income
be recognized. The net effect is that there is no difference in the impact on earnings.

For operating leases, initial direct costs are deferred and amortized over the lease term.

SUMMARY OF KEY
POINTS

1. A lease that does not transfer substantially all of the asset’s risks and benefits to the lessee is classified as an
operating lease. Rent payments are reported by the lessor as rental revenue.
2. The interest rate used in lessor accounting for a finance lease is the rate implicit in the lease.
3. Finance leases are recorded by the lessor as an increase to a financial asset, lease payments receivable. This may
be at the gross amount, with an unearned revenue contra account used. Alternatively, the asset may be recorded
at its net amount. The net method and the gross method give the same results in the financial statements. Lessors
normally use the gross method of recording finance leases to make it easier to reconcile the portfolio of leases
to the summary amount in the SFP control account.
4. Annual payments received by the lessor reduce the lease receivable asset. Finance revenue is earned with the
passage of time.
5. A lessor must classify a finance lease as either a straightforward finance lease or as a sales-type lease. A direct
financing lease arises when a lessor acts purely as a financial intermediary. A sales-type lease arises when a
manufacturer or dealer uses leasing as a means of selling a product, and the book value of the asset is not its fair
value. A sales-type lease has two profit components for the lessor: (1) the profit or loss from the sale and (2)
interest revenue from the lease financing.
6. Under ASPE, a lessor treats a lease as a capital lease if, in addition to transferring substantially all of the risks
and rewards of ownership to the lessee, two other criteria are met: (1) the credit risk is normal and (2) all
executory and operating costs included in the lease payments can be reasonably estimated.
 Chapter 18 Leases 1323

Key Terms

gross lease basis net lease receivable

internal rate of return (IRR) sales-type lease
manufacturer’s lease
net lease basis

Review Problem 18A-1

Orion leased a computer to the Lenox Silver Co. on 1 January 20X5. The terms of the lease and other related infor-
mation are as follows:

• Lease term (fixed and noncancellable) 3 years

• Estimated economic life of the equipment 4 years
• Fair market value of the computer at lease inception $5,000
• Lessor’s cost of asset $5,000
• Bargain purchase price none
• Transfer of title none
• Guaranteed residual value by lessee (excess to lessee) 1 January 20X8 $1,000
• Collectibility of rental payments assured
• Annual rental (first payment 1 January 20X5) $1,620

Required:
1. Assuming this is a financing lease, provide entries for the lessor from 1 January 20X5 through 1 January 20X6,
using the net method of recording.
2. Provide the lessor’s journal entry at the termination of the lease on 1 January 20X8, assuming that the asset is
sold by the lessee on that date for $1,200.
3. Prepare the entries at the commencement of the lease (i.e., 1 January 20X5), assuming that the gross method is
used instead.

REVIEW PROBLEM 18A-1—SOLUTION

The lease is a finance lease because the lease term (three years) is a major part of the economic life of the asset. The
lessor must account for the lease by using the interest rate implicit in the lease. The interest rate that discounts the
lease cash flows to $5,000 is 13.29% (before tax) (solved by spreadsheet).
1324 Chapter 18 Leases

1. Lease entries, net method:

1 January 20X5—commencement of lease
Lease receivable 5,000
Cash, Inventory, etc. 5,000
1 January 20X5—first payment
Cash 1,620
Lease receivable 1,620

31 December 20X5—interest accrual

Lease receivable 449
Finance revenue 449
($5,000 $1,620) × 13.29% $449
1 January 20X6—second payment
Cash 1,620
Lease receivable 1,620

2. Termination of lease
1 January 20X8—receipt of guaranteed residual value from
lessee

Cash 1,000

Lease receivable 1,000

The fact that the lessee was able to sell the asset for $1,200 is irrelevant. The lessee keeps the extra $200.

3. Lease commencement, gross method:

1 January 20X5—commencement of lease

Lease receivable [($1,620 × 3) + $1,000] 5,860

Unearned finance revenue 860

Cash, Inventory, etc. 5,000

1 January 20X5—first payment

Cash 1,620

Lease receivable 1,620

 Chapter 18 Leases 1325

APPENDIX 2
IFRS 16—LEASES
Overview
The issue of leasing has been under consideration by the IASB since 2006. There has been widespread dissatisfaction
with the current operating/finance lease distinction. In particular, financial statement users (and many accountants)
have been dissatisfied with preparers’ practice of acquiring long-term use of major assets by entering into financing
leases that are disguised as operating leases.

The IASB issued IFRS 16, Leases, in 2016, effective for years beginning on or after 1 January 2019. This standard
has incorporated changes that have been under consideration for several years, although the IASB and FASB aban-
doned efforts to issue a harmonized standard for lease accounting.

The most significant feature of the proposed standard is that it will eliminate the distinction between an operating
lease and a finance lease for the lessee. Instead, all leases will be reflected on the SFP of the lessee as “right-of-use”
assets, accompanied by a related liability. The lessee may use an optional exemption for short-term and low-value as-
sets, and simply expense rent paid over the lease term. For lessors, the emphasis is on accounting for the performance
obligation, consistent with the approach adoption in IFRS 15, Revenue from Contracts with Customers. However,
the classification for the lessor continue to rest on the transfer of the risks and rewards of ownership, with the same
judgemental criteria applied. A lessor with a finance lease has either a financing lease or a sales-type lease.

We will focus on lessee accounting in this appendix, because this is the area in which the changes will have the great-
est consequences.

LEASE IDENTIFICATION
Control
A contract is a lease if the contract conveys control over the use of an identified asset for a period of time in exchange for
consideration. Control gives the lessee the right to direct use of the asset and obtain substantially all the economic benefits
from the use of the asset.
Control is critical. For example, if a corporation contracts for a computer server to be used specifically and exclusively by
that corporation, the contract is a lease because the corporation controls use of the server. In contrast, if the corporation
contracts to use a server that also is used for other clients, the owner of the server controls the asset, or its allocation of
space; this contract is not a lease but is simply a supply-of-services contract.

SHORT-TERM AND LOW-VALUE LEASES

A short-term lease is one that has a maximum term of no more than 12 months. “Short term” refers to the maximum
term over which the lessee has made a binding commitment. The maximum term includes any period of time that gives the
lessee economic incentive to exercise renewal or purchase options. Short-term leases include leases that have no financial
commitment beyond a year but may be repeatedly renewed at market rates. Accordingly, the lease term does not include
continuing monthly or annual rental renewals because the lessee has no binding commitment until the renewal actually
happens. This might be typical in an annual rental contract for office space.
1326 Chapter 18 Leases

However, if the lessee has strong economic incentive to extend the term of a lease beyond 12 months, the lease automatically
becomes a long-term lease for accounting purposes. Any lease that has onerous nonrenewal penalties built into the lease
would be long term, as would a lease with a bargain renewal term or a bargain purchase option.
A low-value lease is one where the underlying asset has a low value when new. Items such as personal computers or pieces
of office furniture are examples.

Accounting for Short-Term and Low-Value Leases

Lessees may avoid the requirement to record a value-in-use asset and related liability by taking advantage of an optional
exemption in IFRS 16. This must be chosen for an entire class of assets for short-term leases (e.g., all construction
equipment on short-term leases) but can be chosen on an asset-by-asset basis for low-value leases.
If the election is chosen, lessees will account for short-term leases by recognizing the lease payments as an expense,
normally allocated on a straight-line basis. If another allocation scheme is more logical when considering the benefits
received during the lease, then the pattern of benefit is used.
If lease payments do not have a straight-line pattern, the accounting treatment would include accruals or deferrals to affect
the expense pattern. Otherwise, the lessee does not recognize any liability or asset relating to the lease contract. This is
current practice for an operating lease.

LONG-TERM LEASES
Basic Approach
The basic rule is simple—at the commencement of a lease, the lessee recognizes two elements:
• A right-of-use asset; and
• A liability for the lease payments, including any initial direct costs paid by the lessee.
The two elements are measured at the present value of the cash flow stream. The discount rate is the pre-tax rate the
lessor charges the lessee if it is readily determinable; this is the interest rate implicit in the lease. If this rate is not readily
determinable, the present value is based on the lessee’s incremental borrowing rate.
Lease payments included in the cash flow stream are the amounts set by contract. If these are inflation-adjusted, then the
adjusted amounts (i.e., any amounts set with reference to an index) are included. Guaranteed residual amounts are also included.
Variable lease payments based on usage (mileage on a vehicle, for example) are expensed when they are incurred.
The right-of-use asset is also increased by any initial direct costs paid to enter into the lease, such as a commission paid to
enter into the lease. The right-of-use asset also includes asset retirement obligations, measured at the present value of the
expected payment.
After recognition, the asset and liability are accounted for separately. That is, over the term of the lease, the lessee will:
• Amortize or depreciate the asset as appropriate for that type of asset; and
• Account for the liability by the effective interest method.
This is the same as current accounting for finance leases except that the judgemental criteria for lease classification have
been removed. Essentially, all leases will be accounted for as finance leases, as described in the main body of this chapter.

Definitions
The lease term is the noncancellable period during which the lessee may use the asset, plus:
1. Any periods covered by an extension option if exercise of that option is reasonably certain; and
2. Periods covered by a termination option, as long as the lessee is reasonably certain not to exercise that option.
 Chapter 18 Leases 1327

For example, a lease might be for three years, but include a clause that allows the lessee to pay a termination fee and end the
lease after the first year. As long as the lessee is reasonably certain to not exercise the termination option, the lease term is
three years.
The lessee’s incremental borrowing rate is the cost of borrowed funds for a similar term and similar security, consistent with
existing lease standards.

Example of Right-of-Use Asset Approach

While the lease capitalization under IFRS 16 is identical to that shown in the chapter, one further example is provided as
reinforcement.
Speedy Ltd., a courier company, leases a storage building for a five-year period at $10,000 per year, payable at the beginning
of each year, starting on 2 January 20X1. Speedy is required to pay for adapting the building for its purposes, a cost of
$5,000. The interest rate implicit in the lease is 6%.
The building has a 40-year life, and this lease would likely be an operating lease under existing rules. However, it does not
qualify for an optional exemption under IFRS 16, because the term is longer than a year, and the underlying asset, a building,
is not low value. Accordingly, Speedy must record the value-in-use asset.
The present value calculation is:

PV $5,000 + ($10,000 × (P/A, 6%, 5)) $49,651

A liability amortization table must be completed, as shown in Exhibit 18B-1. Interest expense will total $5,349 over the life
of the payment stream.

EXHIBIT 18B-1

LESSEE AMORTIZATION TABLE—SPEEDY LTD.

Lease Lease
Liability Interest at Payments, Liability
1 January Before Payment 6% 2 January After Payment

20X1 $49,651 $ — $ 15,000 $34,651

20X2 34,651 2,079 10,000 26,730

20X3 26,730 1,604 10,000 18,334

20X4 18,334 1,100 10,000 9,434

20X5 9,434 566 10,000 0

Totals $5,349 $55,000

In addition, the asset must be depreciated. Straight-line depreciation is $9,930 ($49,651 ÷ 5).
At commencement, Speedy would record the lease as follows:

2 January 20X1—commencement of the lease

Right-of-use asset under lease—delivery van 49,651

Lease liability 49,651

1328 Chapter 18 Leases

2 January 20X1—first payment of $10,000 plus initial direct

cost of $5,000

Lease liability 15,000

Cash 15,000

The lease liability declines to $34,651 after the initial payment. At the end of 20X1, interest will have accrued on that
outstanding balance:

31 December 20X1—interest accrual

Interest expense 2,079

Lease liability 2,079

($34,651 × 6% $2,079 per Exhibit 18B-1)

31 December 20X1—asset depreciation

Depreciation expense 9,930

Accumulated depreciation 9,930

Reassessment of the Lease Liability

An important aspect of the new standard is that it specifically provides for the possibility that economic circumstances will
change and either the lease payments or the discount rate will change. For example:
• Market factors concerning the leased asset (e.g., changing technology) may make a bargain purchase option or renewal
option no longer favourable. The lessee can then remeasure the value imputed to the right-of-use asset by reassessing
the lease without the additional purchase or renewal payments originally envisioned.
• Similarly, market interest rates may have changed so that the lessee no longer has incentive to exercise a purchase option
or renewal option.
The lessee reports the amount of the change in a right-of-use asset (and liability) value due to circumstances in the reporting
period, in earnings (i.e., a gain or loss will be reported).
To be specific, lease amounts are remeasured if:
1. The lease term changes; a revised discount rate as of the remeasurement date is applied;
2. The likelihood of exercising a purchase option changes: a revised discount rate is applied in this case, as well;
3. The amount to be paid under a guaranteed residual value changes; the discount rate is NOT changed in this case; and
4. The indexed amount of payments is reassessed; the discount rate is NOT changed in this case.

Sale and Leaseback

A transaction will be accounted for as a sale and leaseback only if a performance obligation is satisfied, using the framework
established in IFRS 15, Revenue from Contracts with Customers.
If there is a sale, then the seller measures the right-of-use asset as the portion of the previous carrying value that relates
to the right of use retained. That is, if only 30% of the building subject to a sale and leaseback is retained through a lease
agreement, then 30% of the existing book value is retained. Any gain for the portion retained is not recognized. However, a
gain is recognized based on the sale of the remaining 70%.
 Chapter 18 Leases 1329

LESSOR ACCOUNTING
Lessor Classification of Leases
As stated in the current standard, a lessor classifies a lease as either an operating lease or a finance lease. A lease is a
finance lease if it transfers substantially all the risks and rewards of ownership related to ownership of the underlying asset.
Otherwise, the lease is an operating lease.
The transfer of risks and rewards is set out as in the current standard, with consideration given to transfer of title, the presence
of a bargain purchase option, the length of the lease, the present value of the minimum lease payments as compared to
fair value, and whether the leased assets are specialized for the lessee. If none of these conditions are met, the lease is an
operating lease.

Inconsistency of Classification
The lessee uses one set of capitalization criteria, and the lessor uses another. This may result in assets subject to lease
agreements appearing on both the lessee’s SFP and the lessor’s SFP. For example, the Speedy example shown above results
in a right-of-use asset on Speedy’s books. Because the asset has a long life, the lease terms are unlikely to qualify as a
finance lease for the lessor, and the building will also be on the lessor’s SFP.
Financial statement users will have to adapt to this new reality!

Lessor Accounting for Operating Leases

The lessor recognizes lease revenue in earnings over the term of the lease. The leased asset is depreciated as appropriate for
its nature and intended life cycle. This is largely unchanged from the existing standard for operating leases.

Lessor Accounting for Finance Leases

Lessor accounting for finance leases is different in certain technical areas under IFRS 16, but is largely unchanged:
• A lessor recognizes an asset equal to the net investment (present value) of the lease, and recognizes finance revenue
over the life of the lease using the effective interest method.
• If the lease is a sales-type lease, the lessor is a manufacturer or dealer, and will recognized gross profit at the inception
of the lease in a manner that is consistent with outright sales of the asset.

Looking Forward
At the time of preparing this edition, the new standard has been released with a 2019 implementation date. However, the
IASB has had a history of delayed implementation dates when standards have proven contentious, and also a history of
amending new standards prior to implementation. Accordingly, the technical details may well shift. The new standard,
though, is the result of many years of study and discussion by the IASB—and FASB—and is a clear indication of the future
direction.
One thing is abundantly clear—for the lessee, more capitalization will be required. For any lease term longer than one year,
all lease payments (plus the amounts of any end-of-lease payments and/or renewals) will be discounted to present value.
Stay tuned for future developments.

KEY TERMS

long-term lease right-of-use asset

low-value lease short-term lease
1330 Chapter 18 Leases

SUMMARY OF KEY
POINTS

1. A new lease accounting standard has been released by the IASB, with implementation in 2019.
2. All leases are accounted for by the lessee as a right-of-use asset, and a liability. Lease term and payments include
terms and amounts where the actions of the lessee are reasonably certain.
3. Short-term leases and low-value leases may be accounted for as operating leases. This is an optional decision
on the part of the lessee that must be applied to all short-term assets of a given class, but can be applied to any
individual asset if the underlying asset is low value.
4. A right-of use asset and related liability are measured at discounted cash flow. The discount rate is the interest
rate implicit in the lease, if known, or the lessee’s IBR.
5. Lessor accounting retains the operating versus financing criteria and classifications. Emphasis is on accounting
for performance obligations.