11.4 Leases

Leases play a crucial role in modern business, allowing companies to use assets without large upfront costs. This topic explores the accounting treatment of leases, which significantly impacts financial statements, including balance sheets, income statements, and cash flow statements.

The notes cover key aspects like lease types, lessee and lessor accounting, modifications, and disclosures. Understanding these concepts is essential for accurately reporting a company's financial position and performance in relation to leased assets.

Definition of leases

• Leases are contractual agreements that convey the right to control the use of an identified asset for a period of time in exchange for consideration
• Leases are a common financing arrangement used by companies to acquire the use of assets without the need for large upfront capital expenditures
• The accounting treatment of leases has a significant impact on a company's financial statements, including the balance sheet, income statement, and cash flow statement

Lessee vs lessor

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• A lessee is the party that obtains the right to use an asset through a lease agreement
• The lessee makes periodic payments to the lessor in exchange for the right to use the asset
• A lessor is the party that owns the asset and grants the right to use the asset to the lessee
• The lessor receives periodic payments from the lessee in exchange for providing the right to use the asset

Finance vs operating leases

• Finance leases (capital leases) transfer substantially all the risks and rewards of ownership to the lessee
• Finance leases are treated as a purchase of the asset by the lessee and a sale of the asset by the lessor
• Operating leases do not transfer substantially all the risks and rewards of ownership to the lessee
• Operating leases are treated as a rental of the asset, with the lessor retaining ownership of the asset
• The classification of a lease as finance or operating has a significant impact on the accounting treatment and financial statement presentation for both lessees and lessors

Accounting for leases by lessees

• Lessees must recognize leases on their balance sheet, with limited exceptions for short-term leases and leases of low-value assets
• The accounting treatment for lessees depends on whether the lease is classified as a finance lease or an operating lease
• Lessees must make judgments and estimates when determining the lease term, lease payments, and discount rate used to measure the lease liability and right-of-use asset

Initial recognition of leases

• At the commencement date of the lease, lessees recognize a right-of-use asset and a lease liability on their balance sheet
• The right-of-use asset represents the lessee's right to use the underlying asset over the lease term
• The lease liability represents the lessee's obligation to make lease payments over the lease term
• The right-of-use asset is initially measured at the amount of the lease liability, plus any initial direct costs incurred by the lessee and any lease payments made before the commencement date, less any lease incentives received

Subsequent measurement of leases

• After initial recognition, lessees measure the right-of-use asset using the cost model, which is the initial measurement less accumulated depreciation and any accumulated impairment losses
• The lease liability is subsequently measured at the present value of the remaining lease payments, discounted using the discount rate determined at the commencement date
• Lessees recognize interest expense on the lease liability and depreciation expense on the right-of-use asset in their income statement over the lease term

Presentation in financial statements

• Lessees present right-of-use assets separately from other assets on their balance sheet or disclose them in the notes to the financial statements
• Lease liabilities are presented separately from other liabilities on the balance sheet or disclosed in the notes
• In the income statement, lessees present interest expense on the lease liability and depreciation expense on the right-of-use asset separately from other expenses
• In the cash flow statement, lessees classify cash payments for the principal portion of the lease liability within financing activities and cash payments for the interest portion within operating activities

Accounting for leases by lessors

• Lessors classify leases as sales-type, direct financing, or operating leases based on the terms of the lease agreement
• The accounting treatment for lessors depends on the classification of the lease
• Lessors must make judgments and estimates when determining the lease classification, lease term, lease payments, and discount rate used to measure the net investment in the lease

Sales-type leases

• In a sales-type lease, the lessor transfers control of the underlying asset to the lessee and recognizes a sale
• The lessor recognizes revenue, cost of goods sold, and any selling profit or loss at the commencement date of the lease
• The lessor recognizes a net investment in the lease, which consists of the lease receivable and the unguaranteed residual value of the asset
• The lessor recognizes interest income on the net investment in the lease over the lease term

Direct financing leases

• In a direct financing lease, the lessor transfers substantially all the risks and rewards of ownership to the lessee but does not recognize a sale
• The lessor recognizes a net investment in the lease, which consists of the lease receivable and the unguaranteed residual value of the asset
• The lessor recognizes interest income on the net investment in the lease over the lease term

Operating leases

• In an operating lease, the lessor does not transfer substantially all the risks and rewards of ownership to the lessee
• The lessor continues to recognize the underlying asset on its balance sheet and depreciates it over its useful life
• The lessor recognizes lease income on a straight-line basis over the lease term

Lease modifications

• A lease modification is a change in the terms and conditions of a lease that was not part of the original terms and conditions of the lease
• Lease modifications can include changes to the lease term, lease payments, or the scope of the lease
• The accounting treatment for lease modifications depends on whether the modification is accounted for as a separate lease or as a modification of the existing lease

Lessee accounting for modifications

• If a lease modification grants the lessee an additional right of use not included in the original lease, the modification is accounted for as a separate lease
• If a lease modification does not grant the lessee an additional right of use, the modification is accounted for as a modification of the existing lease
• For modifications that are not accounted for as separate leases, the lessee remeasures the lease liability using a discount rate determined at the effective date of the modification and makes a corresponding adjustment to the right-of-use asset

Lessor accounting for modifications

• If a lease modification grants the lessee an additional right of use not included in the original lease, the modification is accounted for as a separate lease
• If a lease modification does not grant the lessee an additional right of use and the lease would have been classified as an operating lease if the modification had been in effect at the lease inception date, the modification is accounted for as a new operating lease
• If a lease modification does not grant the lessee an additional right of use and the lease would have been classified as a sales-type or direct financing lease if the modification had been in effect at the lease inception date, the lessor accounts for the modification as a new lease

Sale and leaseback transactions

• A sale and leaseback transaction involves the sale of an asset by the owner and a lease of the same asset back to the seller
• Sale and leaseback transactions can be used as a financing arrangement to raise cash while retaining the use of the asset
• The accounting treatment for sale and leaseback transactions depends on whether the transfer of the asset is a sale

Determining if transfer is a sale

• To determine if the transfer of the asset is a sale, the seller-lessee and the buyer-lessor assess whether the transfer meets the requirements for a sale under the revenue recognition standard
• The transfer is a sale if the buyer-lessor obtains control of the asset and the seller-lessee has a present right to payment
• If the transfer is not a sale, the transaction is accounted for as a financing arrangement

Accounting for sale and leaseback

• If the transfer is a sale, the seller-lessee recognizes a gain or loss on the sale and measures the right-of-use asset and lease liability in accordance with the lessee accounting model
• The gain or loss on the sale is the difference between the sales price and the carrying amount of the asset, adjusted for any deferred gain or loss on the leaseback
• If the transfer is not a sale, the seller-lessee continues to recognize the asset on its balance sheet and accounts for any amounts received as a financial liability

Disclosures for leases

• Lessees and lessors are required to provide disclosures about their leasing activities to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases
• Disclosures are required for both finance and operating leases
• Disclosures should be provided separately for finance and operating leases unless a combined presentation is more appropriate

Lessee disclosures

• Lessees are required to disclose information about the nature of their leasing activities, including:
  • A general description of the lessee's leasing arrangements
  • The basis and terms and conditions on which variable lease payments are determined
  • The existence and terms and conditions of options to extend or terminate the lease
  • The existence and terms and conditions of residual value guarantees provided by the lessee
• Lessees are also required to disclose information about the amounts recognized in the financial statements related to their leasing activities, including:
  • The carrying amount of right-of-use assets and the depreciation charge for those assets
  • The interest expense on lease liabilities
  • Short-term lease expense and low-value asset lease expense
  • Variable lease expense
  • Sublease income
  • Cash paid for amounts included in the measurement of lease liabilities, segregated between operating and financing cash flows
  • Supplemental non-cash information on lease liabilities arising from obtaining right-of-use assets
  • Weighted-average remaining lease term and weighted-average discount rate for finance and operating leases
  • Maturity analysis of lease liabilities

Lessor disclosures

• Lessors are required to disclose information about the nature of their leasing activities, including:
  • A general description of the lessor's leasing arrangements
  • The basis and terms and conditions on which variable lease payments are determined
  • The existence and terms and conditions of options to extend or terminate the lease
  • The existence and terms and conditions of options for the lessee to purchase the underlying asset
• Lessors are also required to disclose information about the amounts recognized in the financial statements related to their leasing activities, including:
  • Lease income, disaggregated into (1) profit or loss recognized at the commencement date, (2) interest income on the net investment in the lease or on the lease receivable, and (3) lease income relating to variable lease payments not included in the measurement of the net investment in the lease or the lease receivable
  • Components of the net investment in sales-type and direct financing leases, including the carrying amount of the lease receivable, unguaranteed residual asset, and deferred selling profit on direct financing leases
  • Significant changes in the balance of unguaranteed residual assets and deferred selling profit on direct financing leases
  • Maturity analysis of the undiscounted lease payments to be received for sales-type and direct financing leases and the lease payments to be received for operating leases
  • Disclosures required by the credit losses standard for lease receivables

Transition to new lease standard

• The new lease accounting standard (ASC 842) is effective for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021
• The new standard requires lessees to recognize most leases on their balance sheet and provides new guidance for lessor accounting
• Lessees and lessors are required to adopt the new standard using a modified retrospective approach

Modified retrospective approach

• Under the modified retrospective approach, lessees and lessors apply the new standard to all leases existing at the date of initial application and to leases entered into after that date
• Lessees and lessors recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach
• Lessees and lessors are not required to restate comparative periods
• Lessees and lessors are required to recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption for the impact of applying the new standard to leases that existed at the date of initial application

Practical expedients for transition

• The new standard provides several practical expedients that lessees and lessors can elect to simplify the transition to the new standard
• Practical expedients for lessees include:
  • The option to not reassess whether any expired or existing contracts are or contain leases
  • The option to not reassess the lease classification for any expired or existing leases
  • The option to not reassess initial direct costs for any existing leases
  • The option to use hindsight in determining the lease term and in assessing impairment of the right-of-use asset
• Practical expedients for lessors include:
  • The option to not reassess whether any expired or existing contracts are or contain leases
  • The option to not reassess the lease classification for any expired or existing leases
  • The option to not reassess initial direct costs for any existing leases
  • The option to exclude certain existing leases from the requirements of the new standard if they meet certain criteria