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IFT Notes for Level I CFA® Program

R28 Non-current (Long-Term) Liabilities

Part 3


 

3.  Leases

A lease is a contract between a lessor (owner) and a lessee (who wants to use the asset). Below is a pictorial representation of what constitutes a lease. An asset’s owner is called a lessor. The entity or person wishing to use the asset is called the lessee. The lessor allows the lessee to use the asset for a pre-determined period. In return, the lessee makes periodic payments to the lessor over the period for the right to use the asset. This period can be as long as 20 years, or as short as a month.

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Following are some of the advantages to leasing an asset compared to purchasing it.

  • Leases can provide a lessee with less costly financing as they usually require little down payment;
  • Leases are often at fixed interest rates.
  • The negotiated lease contract may have less restrictive provisions compared with other forms of borrowing. The lease also reduces the lessee’s exposure to risks of obsolescence, residual value, and disposition as the asset is not owned by the lessee.

3.1 Lessee accounting

Under IFRS: Under IFRS, a lessee’s treatment of lease is similar to purchasing a long-term asset which is financed by a long-term interest-bearing liability. At inception, a lessee must report the present value of future lease payments as an asset and a lease liability on its balance sheet. After inception, the lease treatment is as follows:

  • A depreciation expense is recorded on the right-of-use asset;
  • An interest expense is recognized on the lease liability;
  • The balance of lease liability is reduced for the portion of the lease payment that represents repayment of the lease liability. In effect, the lease treatment is similar to having purchased a long-term asset, financed by a long-term interest-bearing liability.

Like IFRS, under US GAAP, a lessee is required to report an asset and a lease liability on its balance sheet at inception. However, after inception, the lease treatment depends on lease categorization, i.e. a finance lease or an operating lease. A finance lease is similar to purchasing an asset while an operating lease is similar to renting an asset.

Finance Lease Criteria under US GAAP:

A lease must be classified by lessee as a finance lease if any one of the following four criteria is met:

  • Ownership transfer: If the lease transfers ownership of the asset to the lessee by the end of the lease term.
  • Bargain purchase option: The lessee has an option to purchase the asset at a price lower than the fair value.
  • Lease term: If lease term is 75% or more of the useful life of the leased asset
  • Minimum lease payment: If the present value of lease payments is 90% or more of the fair value of leased asset.

If none of the above criteria are met, the lessor reports the lease as an operating lease.

A lessee’s accounting for a finance lease under US GAAP is similar to that of IFRS.

For an operating lease after inception, under US GAAP, the lessee recognizes a single lease expense, i.e. straight-line depreciation expense.

Note: Under IFRS, for short-term and low value leases, the lessee is not required to recognize an asset and liability and instead records lease payments as an expense when paid.

Accounting and Reporting by Lessee

The table below describes how leases are treated on the financial statements for the lessee under IFRS and US GAAP.

  IFRS US GAAP
Balance Sheet Equivalent to borrowing money to buy an asset. At inception, the present value of future lease payments is recognized as an asset and related debt as a liability.

Asset is depreciated; lease payable is amortized.

Similar treatment for finance lease; for operating lease, no entry on the balance sheet as it is like renting an asset. Operating lease is an off-balance-sheet transaction.
Income Statement Interest expense = liability at the beginning of period * interest rate Similar for finance lease.

For operating lease: Rent expense equal to lease payment. It would be an operating expense.

Cash Flow Statement Interest portion of lease payment can be classified within operating, investing, or financing activities. Interest portion of lease payment is classified as an operating activity.


FRA Non-Current (Long-Term) Liabilities Part 3