IFRS for SMEs:
Leases
Definition
A lease in an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.
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Classification of leases
There are two types of leases. Finance leases and operating leases.
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Finance leases are leases that substantially transfers all the risks and rewards incidental to ownership of the asset from the lessor to the lessee.
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Operating leases are leases that aren't finance leases.
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Accounting treatment of an operating lease
Lessor
- Leased asset remains on the balance sheet, and depreciated
- Lease income is recognized on income statement
Lessee
- Leased asset isn't recognized on balance sheet
- Lease expense is recognized on income statement
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Accounting treatment of a finance lease
Lessor
- Leased asset is derecognized from balance sheet
- Lease receivable is recognized
- Only the finance income portion of the payments received is recognized on income statement
- Residual value of the leased asset is recognized on the balance sheet at the end of the lease term
Lessee
- Leased asset is recognized on balance sheet, and depreciated over the lease term
- Lease liability is recognized
- Only the finance expense portion of the payments made is recognized on income statement
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Indicators of a finance lease
Primary indicators
- Ownership of the asset gets transferred from lessor to lessee at the end of the lease term
- Lease term is for the major part of the economic useful life of the asset
- At the start of the lease, the present value of minimum lease payments totals to at least substantially all of the fair value of the leased asset
- Lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable, and it is reasonable certain, at the start of the lease, that the option will be exercised.
- Leased asset is of such a specialized nature that only the lessee can use them without major modifications
Secondary indicators
- The lessee can cancel the lease, and the losses associated with cancellation are borne by the lessee
- Lessee has the ability to continue the lease for a second period at a lease amount that is substantially lower than the market rate.
- Gains or losses from fluctuation in residual value of the leased asset accrue to the lessee
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Note: These are indicators. They don't guarantee that the lease is a finance lease. A judgement has to be made based on the agreement between the lessor and lessee.
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Financial statement of lessee
Operating lease
- Lease payments are recognized as an expense in the income statement
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Finance lease
- Lease asset is recognized on balance sheet at the lower of the fair value of the leased asset and the present value of minimum lease payments.
- Direct costs incurred in arranging the lease are included in the carrying value of the asset
- Present value of minimum lease payments should be calculated using the interest rate implicit in the lease. If this rate cannot be determined, the lessee's incremental borrowing rate should be used.
- Interest rate implicit in the lease is determined at the start of the lease by calculating the rate that causes the sum of the minimum lease payments and the (unguaranteed) residual value of the asset to be equal to the sum of the fair value of the leased asset and any initial direct costs of the lessor. This involves calculating internal rate of return (IRR) and using it to discount future cash flows.
- Lease asset is depreciated over the lease period
- Lease liability is recognized on the balance sheet at the same value as the lease asset.
- Lease liability is reduced as payments are made to the lessor. The interest (finance) portion of the lease payment is calculated based on the interest rate implicit in the lease, and recorded as a finance expense. The remaining amount is deducted from lease liability.
- The residual amount of lease liability remaining at the end of the lease is derecognized, as the asset is given back to the lessor.
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Financial statement of lessor
Operating lease
- Lease payments are recognized as an income in the income statement
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Finance lease
- Leased asset is derecognized from the balance sheet and recorded as expense
- Lease receivable is recognized in the balance sheet and recorded as income
- Direct costs incurred in arranging the lease are included in the carrying value of the lease receivable, and amortized over the lease term
- Lease receivable amount is an amount equal to the net investment in the lease. This is the lessor's gross investment in the lease, discounted at the interest rate implicit in the lease.
- The gross investment in the lease is the sum of, the minimum lease payments receivable by the lessor, and any (unguaranteed) residual value of the leased asset to the lessor.
- Lease receivable is reduced as payments are received by the lessee. The interest (finance) portion of the lease payment is calculated based on a constant periodic rate of return on the lessor's net investment in the finance lease (lease receivable), and recorded as a finance income. The remaining amount is deducted from lease receivable.
- The residual amount of lease receivable remaining at the end of the lease is transferred to another asset account, as the asset is received back by the lessor.
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Manufacturer or dealer lessors (finance lease)
These are manufacturers who accept installment payments from customers who want to make a purchase. The ownership of the asset get transferred to the customer at the end of the lease period.
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- Leased asset is derecognized from the balance sheet and recorded as expense
- Sales revenue is recognized at the lower of the asset's fair value, and the present value of minimum lease payments computed at a market rate of interest
- Lease receivable is recognized at the same value as sales revenue
- Lease receivable is reduced as payments are received by the customer. The interest (finance) portion is calculated based on the market rate of interest, and recorded as a finance income. The remaining amount is deducted from lease receivable.
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Note: The interest rate used in calculation of the above has to be the market rate, even if a lower interest rate was actually charged on the customer.
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Sale and leaseback
When an entity is looking to raise finance, it can enter into a sale and leaseback transaction. This is where an entity sells and asset that it owns and leases it back by making payments in installments. This way, the entity still gets to use the asset.
(Note: I have not included extra details on this - might include later if I feel like it)