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IFT Notes for Level I CFA® Program

R24 Non-current (Long-Term) Liabilities

Part 3


 

8. Leases

A lease is a contract in which a lessor grants the lessee the exclusive right to use a specific underlying asset for a period of time in exchange for payments.

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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8.1 Examples of Leases

Not testable

8.2 Advantages of Leasing

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

  • Less cash is needed upfront. Leases typically require little to no down payment.
  • Since leases are a form of secured borrowing, they generally have low interest rates.
  • Lower risks associated with ownership such as obsolescence.

8.3 Lease Classification as Finance or Operating

Leases are classified as finance or operating. A finance lease is similar to purchasing an asset while an operating lease is similar to renting an asset.

A lease is classified as a finance lease if any of the following five criteria are met.

  1. The lease transfers ownership of the underlying asset to the lessee.
  2. The lessee has an option to purchase the underlying asset and is reasonably certain it will do so.
  3. The lease term is for a major part of the asset’s useful life.
  4. The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the asset.
  5. The underlying asset has no alternative use to the lessor.

If none of the criteria are met, then the lease is classified as an operating lease.

8.4 Financial Reporting of Leases

The financial reporting of leases depends on:

  • Whether the party is the lessee or lessor
  • Whether the party reports with IFRS or US GAAP
  • Whether the lease is a finance or operating

US GAAP and IFRS share the same accounting treatment for lessors but differ for lessees.

IFRS has a single accounting model for both operating leases and finance lease lessees, while US GAAP has different accounting models for each.

 

8.5 Lessee Accounting—IFRS

Under IFRS, there is a single accounting model for both finance and operating leases for lessees.

  • At inception, recognize a lease liability and corresponding right-of-use (ROU) asset on the balance sheet, both equal to the present value of lease payments.
  • The lease liability is subsequently reduced by each lease payment using the effective interest method. Each lease payment is composed of:
    • Interest expense = Lease liability x discount rate
    • Principal repayment = Lease payment – Interest expense
  • The right-of-use asset is amortized, often on a straight-line basis, over the lease term.

(Although the lease liability and ROU begin with the same carrying value, their balance sheet values tend to diverge over time because of the differences in the calculation of principal repayments that reduces the lease liability and the amortization expense that reduces the ROU asset.)

The following list shows how the lease transaction affects the financial statements.

  • Balance sheet: The lease liability is reported net of principal repayments and the ROU asset is reported net of accumulated amortization
  • Income statement: Interest expense and amortization expense are shown separately.
  • Cash flow statement: The principal repayment component is reported as cash outflow under financing activities. The interest expense can be reported under either operating or financing activities.

Example: Lessee Accounting – IFRS

(This is based on Example 11 from the curriculum.)

A company is offered the following terms to lease a machine: five-year lease with an implied interest rate of 10% and an annual lease payment of EUR100,000 per year payable at the end of each year. PV = EUR379,079. The asset will be amortized over the five-year lease term on a straight-line basis. The company reports under IFRS.

What would be the impact of this lease on the company’s:

  1. balance sheet at the beginning of the year?
  2. income statement during the following year?
  3. statement of cash flows during the following year?

Solution to 1:

The company will report a lease liability and a ROU asset of EUR379,079.

Solution to 2:

In Year 2, the company will report an interest expense of EUR31,699 and an amortization expense of EUR 75,816.

The calculations are shown in the tables below:

Lease Payment Interest Expense
(10% × Lease Liability)
Principal Repayment
(Payment – Interest)
Lease Liability
FO.1 FO.2 FO.3 FO.4
Year 0 379,079
Year 1 100,000 37,908 62,092 316,987
Year 2 100,000 31,699 68,301 248,685
Year 3 100,000 24,869 75,131 173,554
Year 4 100,000 17,355 82,645 90,909
Year 5 100,000 9,091 90,909 0
Total 500,000 120,921 379,079

 

Amortization Expense ROU Asset
Straight-Line F.1 F.2
Year 0 379,079
Year 1 75,816 303,263
Year 2 75,816 227,447
Year 3 75,816 151,631
Year 4 75,816 75,816
Year 5 75,816 0
Total 379,079

Solution to 3:

In Year 2, principal repayment of EUR68,301 will be reported as a cash outflow under financing activities. The interest expense of EUR31,699 may be reported under operating or financing activities depending on the company’s reporting policies.

8.6 Lessee Accounting—US GAAP

Under US GAAP, there are two accounting models for lessees: one for finance leases and another for operating leases.

The finance lease accounting model is the same as the lease accounting model for IFRS.

The operating lease accounting model is different:

  • At inception, recognize a lease liability and corresponding right-of-use asset on the balance sheet, both equal to the present value of lease payments.
  • As with the previous method, the lease liability is subsequently reduced by each lease payment using the effective interest method
  • But the amortization of the right-of-use asset is different, it is calculated as the lease payment less the interest expense.

(Since the principal repayment and amortization are calculated in the same way, the lease liability and the ROU asset will always equal each other)

The following list shows how the lease transaction affects the financial statements.

  • Balance sheet: The lease liability is reported net of principal repayments and the ROU asset is reported net of accumulated amortization
  • Income statement: Interest expense and amortization expense are shown together as a single operating expense on the income statement. They are not reported separately.
  • Cash flow statement: The entire lease payment is reported as cash outflow under operating activities. The interest and principal components are not reported separately.

For a US GAAP company classifying a lease as an operating lease instead of a finance lease affects the financial ratios as shown below:

Ratio Formula Impact of Using an Operating Lease Instead of a Finance Lease
EBITDA margin Lower: Lease expense is classified as an operating expense rather than interest and amortization.
Asset turnover Lower: Total assets are higher under an operating lease because the ROU asset is amortized at a slower pace in initial years.
Cash flow per share Lower: Cash flow from operations is lower because the entire lease payment is included in operating activities versus solely interest expense for a finance lease.

 

8.7 Lessor Accounting

The accounting for lessors is identical under IFRS and US GAAP. However, the accounting differs based on whether the lease is a finance lease or an operating lease.

Finance lease lessors (IFRS and US GAAP)

  • At inception, recognize a lease receivable asset equal to the present value of future lease payments and de-recognize the leased asset, simultaneously recognizing any difference as a gain or loss.
  • The lease receivable is subsequently reduced by each lease payment using the effective interest

The following list shows how the lease transaction affects the financial statements.

  • Balance sheet: Lease receivable net of principal proceeds is reported on the balance sheet.
  • Income statement: Interest income is reported on the income statement, typically as revenue.
  • Cash flow statement: The entire cash receipt is reported under operating activities.

Operating lease lessors (IFRS and US GAAP)

  • The lease contract is treated as a rental agreement.

The following list shows how the lease transaction affects the financial statements.

  • Balance sheet: The balance sheet is not affected. The lessor continues to recognize the underlying asset and depreciate it.
  • Income statement: Lease revenue is recognized on a straight-line basis on the income statement. The depreciation expense continues to be recognized.
  • Cash flow statement: The entire cash receipt is reported under operating activities.

Example: Lessor Accounting

(This is based on Example 13 from the curriculum.)

Let’s examine the previous example from the perspective of the lessor. Assume that the carrying value of the asset immediately prior to the lease is EUR350,000, accumulated depreciation is zero, and the lessor elects to depreciate it on a straight-line basis over five years.

How would the lessor’s financial statements be affected by the classification of the lease as a finance or operating lease?

Solution:

Balance sheet: The difference on the balance sheet is material. The present value of lease payments is well above the carrying value of the asset. The finance lease classification therefore results in a significant increase in assets.

Balance Sheet Year 1 Year 2 Year 3 Year 4 Year 5
Finance lease:
Lease receivable, net 316,987 248,685 173,554 90,909 0
Operating lease:
Property, plant, and equipment, net 280,000 210,000 140,000 70,000 0

 

Income statement: The difference on the income statement is also material.

Income Statement Year 1 Year 2 Year 3 Year 4 Year 5
Finance lease:
Interest

revenue

37,908 31,699 24,869 17,355 9,091
Operating lease

:

Lease revenue 100,000 100,000 100,000 100,000 100,000

 

Cash flow statement: The cash flow statement is the same under both options.

Statement of Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5
Finance lease:
Cash flows from operating activities 100,000 100,000 100,000 100,000 100,000
Operating lease:
Cash flows from operating activities 100,000 100,000 100,000 100,000 100,000