TIP: Leases are frequently tested on the CFE (CPA Canada Board exams).
Superficially, leases seem like they should be considered expenses for the entity leasing the asset (e.g. office space, equipment, etc..). However, over the years, entities have invented increasingly complex leasing structures and some of these structures more closely resemble financed purchases of the asset, instead of traditional leases.
Because of these more complex leasing structures, we need a method to determine what should be considered an expense-type lease, in the traditional sense of the term, and what kind of transaction would be more akin to a financed-purchase of an asset. We need to understand how the lease is structured in order to determine how the lease should be accounted for in both the lessor (entity that leases out their property to others) and lessee’s (entity that leases the property for their use) books.
ASPE 3065 addresses accounting practices for leases under Accounting Standards for Private Enterprises (Canadian standards). In this article we simplify the ASPE (ASPE 3065) standards, by reviewing the core teachings.
Classification
ASPE 3065 (paragraphs 4 and 6) defines two different categories of leases, from the perspective of the lessee:
Capital Lease: This is where the lessor transfers all or substantially all of the risks and rewards of ownership of the asset. In other words - this is treated as though the lessee purchased the asset, and is paying for the asset in installments of principal + interest to the lessor.
Operating Lease: Any lease that is not a capital lease. These are the leases that more-closely resemble what most consider a traditional lease.
How to determine the Lease type
ASPE 3065 provide criteria to determine if a Lease should be considered Operating or Capital in nature. In order to be considered a Capital lease, only one of the following criteria must be met:
1. Reasonable assurance the lessee will obtain ownership at end of lease. Reasonable assurance can include: a title transfer at the end of the lease term, or a bargain purchase option. A bargain purchase option happens if the lessee has the right to buy the asset, at the end of the lease term, at below fair market value.
2. Lease term is equal to >= 75% of economic life of asset.
3. Present Value (PV) of the minimum lease payments is 90% or more of the Fair Value (FV) of the leased property. When calculating the PV of the lease payments, the discount rate to use for lessee is the lower of:
Lessee’s rate for incremental borrowing and
Rate implicit in the lease (if known)
The lessor should always use the rate implicit in the lease if this is known.
If none of these conditions are met, the lease should be accounted for as an Operating lease.
Calculations
Step 1: Calculate the Rate implicit in the lease
Using your financial Calculator:
[BGN] or Type: Set your calculator to BGN (Type = 1) if the payments start at the beginning of the period, or leave it as is (Type = 0) if the payments are made at the end of the period.
PMT = Lease payment amount per period. Payments should not include any executory costs (e.g. legal fees, insurance, etc..).
N = Number of lease payments in the term.
PV = Current present value of the asset. When finding the rate, we MUST include the asset’s residual value in the PV number.
FV = Residual Value. Residual Value is the fair market value of the asset at the end of the lease term. We must always include the Residual value when calculating the rate implicit in the lease.
CPT I/Y = ?
Excel Formula for the Rate Implicit in the Lease:
See Calculator section above for explanation of terms.
=Rate (N, -PMT, PV, -FV, 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of "payment" and "residual".
Step 2: Calculate the PV of Minimum lease payments
Using your financial Calculator:
Set to [BGN] if the lease payments start at the beginning of the term (ie: 1rst day of term).
I/Y = discount rate of the lease
Lessor should always use the rate implicit in the lease.
Discount rate to use for lessee is the lower of:
Lessee’s rate for incremental borrowing
Rate implicit in the lease, if known (from Step 1, above).
N = Full potential lease term (primary term + any secondary term if it is reasonably certain they will take it on)
PMT = Lease payments. Payments should not include any executory costs (e.g. legal fees, etc..).
FV = Residual amount or "0"
Residual Value is the fair market value of the asset at the end of the lease term. Residual is only included in the calculation if there is a bargain purchase option or if the asset it expected to remain with the lessee at the end of the term. A bargain purchase option happens if the lessee has the right to buy the asset at below market value, at the end of the lease term. We do not include the bargain purchase price for FV. We only include the residual IF there is a bargain purchase.
If there is no bargain purchase option, then you should not include the residual in the calculation.
CPT PV = ?
TIP: Remember, when using your financial calculator, to use the appropriate signs (+ or -) for each component of the calculation. Using the wrong sign can dramatically change your calculations. To review signage, see this article on how to use your financial calculator.
Note: When calculating the PV of minimum lease payments, we do not include any effects of tax or tax shields.
Excel Formula for PV of minimum lease payments:
See Calculator section above for explanation of terms.
Bargain Purchase Option, or the asset is expected to remain with the lessee:
=PV (I/Y, N, -PMT, -FV, 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of PMT and FV (residual).
If there is no Bargain Purchase Option, or there is no expectation that the asset will stay with the lessee:
=PV (I/Y, N, -PMT, , 1)
Use 1 if the lease is paid at the beginning of the month, or 0, if it is paid at the end of the period. Note the negative signs in front of PMT.
How to Account for the Different Lease Types
ASPE 3065 provide guidance on how to account for both a Capital Lease and an Operating Lease.
Capital Lease
Because Capital Leases are similar to an asset purchases, they are broken down into a capital element and an interest element.
Initial Recognition:
Recognition should start at the beginning of the lease term, when the lessee is entitled to start using the asset.
The asset should be written in the books of the lessee, on the Statement of Financial Position/Balance Sheet in a category entitled “Asset under Capital Lease” or “Leased Property”.
The asset should initially be recognized at the lower of:
Fair Value of the asset and
PV of minimum lease payments
Initial direct costs of associated with the asset (such as costs attributed to arranging the lease) should be added to the asset, as outlined in this article about what is included in the cost of PPE.
Lessee's Books:
Journal Entry for Initial Recognition:
The difference between the lease payments and the Fair Value of the asset is the interest paid. The interest should be included as an “Interest Expense” in the Income Statement, as it accrues.
Interest Expense = (remaining lease obligation) x (interest rate)
Journal Entry for Subsequent Recognition:
If the lease was paid monthly, then each month, the Lessee would record the following journal entry:
Depreciation:
Because this is considered an asset, we will also need to record a depreciation expense, just as we would for any other asset. For more information about Depreciation, click here.
The period of depreciation should be the shorter of:
Lease term (primary term + any secondary term if it is reasonably certain they will take it on),
Asset’s economic life
If there is a bargain purchase option or the asset is expected to stay with the lessee at the end of the term, the asset is depreciated over its useful economic life.
Depreciation Expense = (Cost - residual at end of full expected lease) ÷ (Shorter of lease term and useful life)
Depreciation is typically calculated using a straight-line basis for leases.
Journal Entry for Depreciation:
At the end of each payment term, a depreciation expense can be booked, as follows:
Lessor’s Books:
The lessor should not recognize the lease as an asset in their books/ balance sheet, since the asset already exists on the lessee’s books.
The lessor’s books will mirror the lessee’s books, and uses a Lease Receivable account instead of a Lease Obligation account
The lessor should always use the actual discount rate implicit in the lease.
The lessor should always account for any residual when calculating the PV of minimum lease payments (whereas the lessee should only include it under bargain purchase, mentioned above).
Note that the exact amounts might be different in the books of the lessee and those of the lessor, since the lessor might have their own expenses associated with the lease. Also - while the lessor will always know the rate implicit in the lease, the lessee may not, and might be using their own borrowing rate.
Initial and Subsequent Recognition:
The Lessor must present the lease as a receivable -> an amount equal to the net investment in the lease. The net investment is the net present value (NPV) of the gross investment:
Net Investment = total of the minimum lease payments + any residual value
Sample Journal Entries:
Beginning of Year 1:
We record the Sale of the asset.
* Because the asset is no longer on the company’s books, it is as though it was sold, with payments made periodically, for the cost of the asset.
We must also record the cost of the asset in our Cost of Goods Sold account.
Remember that inventory is valued at lower of cost and Net Realizable Value (NRV). For more information, click here.
Beginning of Year 2:
Operating Lease
Operating leases are much simpler to calculate and account for in the both the lessor and lessee’s book. Operating leases should be charged as an “Expense” in the Income Statement of the lessee.
The charge should be done systematically (usually on a straight-line basis), even if cash is paid in a different pattern.
Despite that most leases are bound by contracts and cannot be broken, no liability is created or recorded for the lease in the lessee’s books nor should a receivable be created in the lessor’s books, even though a liability/receivable may exist.
Lease expense per period = Total lease payments ÷ Number of periods
Lessee’s Books:
Journal Entry Example: If the lessee pays the lease on a straight-line basis, consistently, then the journal entry would look something like this:
Each Year:
If the lessee paid less in the first year, and then more in subsequent years for the lease payments, journal entries will look like the following:
Year 1:
Year 2 and onward:
Similarly, if the Lessee paid more in the first year and less in subsequent years, then the journal entries would look
Journal Entries for Lessee:
Year 1
Year 2 and onward:
Lessor's Books:
The asset remains on the lessor’s books at cost, less depreciation, as is standard.
Revenue from the lease should be recognized in the Income Statement on a straight-line basis, mirroring the lessee’s books, over the term of the lease.
Costs associated with leasing, such as maintenance, insurance and property taxes, etc… are written as expenses, and not netted from the lease payments received.
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