Measurement of Finance Leases

Introduction

In a finance lease, the lessor transfers substantially all the risks and rewards incidental to legal ownership of a leased asset. A finance lease is also economically similar to borrowing money and buying an asset.

Initial recognition, measurement, and subsequent measurement of finance leases

Under IFRS, if a lessor enters into a finance lease:

• The lessor will report a lease receivable at an amount equal to the net investment in the lease i.e. the present value of the minimum lease payments receivable and any estimated unguaranteed residual value accruing to the lessor;
• The leased asset will be derecognized i.e. assets are reduced by the carrying amount of the leased asset;
• For lessors that are manufacturers or dealers, the initial direct costs are treated as an expense when the selling profit is recognized at the beginning of the lease term. The sales revenue is equal to the lower of the fair value of the asset or the present value of the minimum lease payments. The cost of sale is the carrying amount of the leased asset less the present value of the estimated unguaranteed residual value;
• Initial direct costs incurred by a lessor, other than a manufacturer or dealer lessor, are added to the receivable and reduce the amount of income recognized over the lease term;
• The lease payment is treated as a repayment of principal and finance income;
• The recognition of finance income reflects a constant periodic rate of return on the lessor’s net investment in the lease; and
• The lessor recognizes revenue whenever reasonably assured of cash collection and having performed substantially under the lease. If this revenue recognition requirement is not met, the lessor will have to report the lease as an operating lease.

A direct financing lease is distinguished from a sales-type lease based on the carrying value of the leased asset relative to the present value of lease payments. A direct financing lease is reported when the present value of lease payments is equal to the value of the leased asset to the lessor. The lease is a sales-type lease whenever the present value of lease payments exceeds the value of the leased asset. The income statement effect will therefore differ based on the type of lease.

In a direct financing lease, the lessor exchanges a lease receivable for the leased asset, and no longer reports the leased asset on its books. Additionally, the lessor’s revenue is derived from interest on the lease receivable.

In a sales-type lease, the lessor “sells” an asset to the lessee while providing financing on the sale. The lessor will therefore report revenue from the sale, cost of goods sold, profit on the sale, as well as interest revenue earned from financing the sale. The lessor will also show a profit on the transaction in the year of inception and interest revenue over the lease’s life.

From the perspective of the lessee:

• The lessee reports an asset (leased asset) and related debt (lease payable) on its balance sheet;
• The initial value of both the leased asset and lease payable is the lower of the present value of future lease payments and the fair value of the leased asset;
• On the income statement, the company reports interest expense on the debt, and if the asset acquired is depreciable, the company will report a depreciation expense; and
• On the statement of cash flows, only the portion of the lease payment relating to interest expense potentially reduces operating cash flow. Additionally, the portion of the lease payment which reduces the lease liability appears as a cash outflow in the financing section.

Question 1

A company enters into a lease agreement to acquire the use of some equipment for three years beginning on January 1, 2014. The lease requires 3 annual payments of $13,472, commencing on January 1, 2014. The useful life of the equipment is 3 years, its salvage value is $0, and its fair value is $75,000. The company accounts for the lease as a finance lease, and uses straight-line depreciation.

The amount reported on the balance sheet as a leased asset on January 1, 2014, and December 31, 2014 are closest to:

A. January 1, 2014: $75,000; December 31, 2014: $50,000

B. January 1, 2014: $0; December 31, 2014: $13,472

C. January 1, 2014: $50,000; December 31, 2014: $25,000

Solution

The correct answer is A.

The amount initially reported as a leased asset on January 1, 2014 is $75,000. Depreciation expense each year is [($75,000-$0)/3 years] = $25,000. Therefore, on December 31, 2014, the carrying amount of the leased asset = initial recognition amount – accumulated depreciation = $75,000 – $25,000 = $50,000.

Question 2

XYZ company leased a machine with a value of $100,000 at the beginning of the year. The machine has an expected lifetime of 5 years with no residual value. If the company leased that machine under an operating lease contract, it should report at the end of that year:

A. A depreciation expense of $20,000.

B. A rent expense equal to the annual rent payment for the machine.

C. None of the above.

Solution

The correct answer is B.

Under an operating lease contract, the company using the asset should report only the rent expense paid to the lessor. Under finance lease contracts, the company reports the asset’s value on its balance sheet and reports depreciation expense of the asset.

Reading 30 LOS 30h:

Determine the initial recognition, initial measurement, and subsequent measurement of finance leases