 IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

# Part 4

Example (Initial recognition and measurement of finance lease) under US GAAP

Assume a company leases a machine on 1 January 2016 for 4 years and pays 100 at the start of every year. The fair value is 350. Relevant interest rate is 10%. How should this lease be categorized? What is the impact on the financial statements? Assume straight line depreciation.

Solution:

Let us begin by drawing a timeline for the lease payments. Notice that in the case of a lease, payments are generally made at the beginning of a period. Present value of lease payments = 100 made in year 0 + present value of three lease payments from year 1 to 3 = 100 + 249 = 349. This number exceeds 90% of the fair value (350). Hence this is a finance lease.

Effect on financial statements:

Balance Sheet: At inception, the present value of lease payments is 348. An asset (machine) of 348 and a liability (lease payable) of 348 are shown on the balance sheet. Over time the asset is depreciated and liability is reduced as lease payments are made.

Cash flow statement: Lease payments are shown on the cash flow statement. The interest component of the lease payment reduces CFO and the principal component of the lease payment reduces CFF.

Income statement: The interest expense is shown on the income statement. The annual interest expense = lease liability at the start of the year * lease rate. Depreciation expense is also shown on the income statement.

The table below shows the carrying amount of the asset and the depreciation expense over the four years.

 Year Carrying amount (1 Jan) Depreciation Expense Accumulated Depreciation Carrying Amount (31 Dec) 2016 348.69 87.17 87.17 261.52 2017 261.52 87.17 174.34 174.35 2018 174.35 87.17 261.51 87.18 2019 87.18 87.17 348.68 0.01

Let us walk through the table above for 2016 to understand how each figure is calculated and presented.

 Carrying value of asset on 1 Jan 2016 = present value of lease payments = 348.69 Depreciation expense: The value of the asset at the end of four years becomes zero from the lessee’s perspective. Straight-line depreciation over 4 years = 348.69/4 = 87.17. Hence, each year the depreciation expense is 87.17. Accumulated depreciation = depreciation expense for current year + accumulated depreciation = 0 + 87.17 = 87.17. Carrying amount of asset on 31 Dec 2016 = beginning carrying amount – depreciation expense = 348.69 – 87.17 = 261.52.

The table below shows the carrying amount of the lease liability and the interest expense over the four years.

 Year Lease liability (1 Jan) Lease payment (1 Jan) Interest (at 10%; accrued in previous year) Reduction of lease liability (1 Jan) Lease Liability (31 Dec) 2016 348.69 100.00 0.00 100.00 248.69 2017 248.69 100.00 24.87 75.13 173.56 2018 173.56 100.00 17.36 82.64 90.92 2019 90.92 100.00 9.09 90.91 0.01

Let us walk through the table above for 2016 and 2017 to understand how each figure is calculated and presented.

 Lease liability on 1 Jan 2016 = present value of lease payments = 348.69 Lease payment on 1 Jan 2016 = 100 Interest at 10% accrued in previous year: In the 2016 row, we are showing the interest accrued in the previous year (2015). Since the lease was initiated on 1 Jan 2016, the interest accrued in the previous year (2015) was 0. Reduction of lease liability in 2016: The first lease payment was on 1 Jan 2016. Since lease was initiated on the same day, no interest has accrued. Hence the entire payment of 100 reduces the lease payable which comes down from 348.69 to 248.69. Lease liability on 1 Jan 2017: 248.69. This is the same as lease liability on 31 Dec 2016. Lease payment on 1 Jan 2017 = 100. Interest at 10% accrued in previous year: In the 2017 row, we are showing the interest accrued in the previous year (2016). Lease liability at the start of 2016 (after the first payment of 100) was 248.69. 10% of this number is 24.87. This represents the accrued interest expense for 2016. Reduction of lease liability in 2017: The lease payment is 100 of which 24.87 represents interest expense. The remaining amount (100 – 24.87 = 75.13) reduces the lease liability from 248.69 to 173.56.

Example (Operating lease vs. finance lease)

Assume a company leases a machine for 4 years and pays 100 at the start of every year. The fair value of the machine is 340 and relevant interest rate is 10%. Show the total expense under the two different categorizations.

Solution:

If the lease is categorized as an operating lease, then the entire lease payment of 100 is treated as an expense. 100 is considered as CFO and there is no effect on the balance sheet. Instead, if it is categorized as a finance lease, the expense consists of depreciation and interest. This can be summed up as follows:

 Operating Lease Finance Lease Year Expense Depreciation Interest Total 2016 100 87.17 24.87 112.04 2017 100 87.17 17.36 104.53 2018 100 87.17 9.09 96.26 2019 100 87.17 0.00 87.17

Interpretations based on the above example:

Some meaningful deductions can be based on the table above. This will help you in solving problems comparing the two types of leases.

• Overall expense in the initial years is higher for finance lease as interest expense is higher. The lease liability is higher in the initial years making the interest expense higher.
• Towards the end, interest expense becomes low as the lease liability becomes lower.
• Assets and debt are higher in the finance lease.
• Net income is higher in the initial years for operating lease as expense is lower.

The following table summarizes the impact of lease accounting for the lessee on the financial statements. Instead of memorizing, remember the example we have seen above to deduce what item is higher/lower in the initial and later years.

 Item Finance Lease Operating Lease Interpretation Assets Higher Lower With finance lease, the leased machine is shown as an asset, hence assets are higher. Liabilities (Current and long term) Higher Lower With finance lease, the lease payable makes long term liabilities higher. The current portion of lease payable makes current liabilities higher. Net income (in the early years) Lower Higher Lease expense for operating lease is lower than the total expense (interest expense + depreciation expense) of a finance lease in the initial years. Net income (later years) Higher Lower Interest expense, and as a result the total expense, comes down in the later years for finance lease. Net income is higher for finance lease. Total net income Same Same Over the life of the lease, the total net income is the same for both types of leases. EBIT (operating income) Higher Lower Operating income is higher for finance lease because only the depreciation part is deducted. Whereas for operating lease, the entire lease payment is considered an operating expense. In the example above, it was 87.17 for finance lease vs 100 for operating lease. Cash flow from operations Higher Lower Similarly, for CFO in the case of finance lease; it is divided into interest expense and principal amount. Only the interest expense reduces CFO whereas in an operating lease, the entire amount (100 in our example) is treated as CFO. Cash flow from financing Lower Higher The principal amount reduces CFF for finance lease. No effect on CFF in the case of an operating lease. Total cash flow Same Same Total cash flow is the same for both types of leases.

Accounting and Reporting by Lessor

Under IFRS, a lessor classifies each lease as either a finance lease or an operating lease.

Lessor accounting for a finance lease:

• At inception, the underlying leased asset is derecognized and a lease asset comprising the lease receivable and relevant residual value is recognized.
• If the lessor is a manufacturer or dealer, a revenue equal to the value of the leased asset, cost of goods sold equal to the carrying value of the leased asset, and selling profit or loss equal to the revenue minus the cost of goods sold is recognized.
• After inception, a finance income is recognized over the lease term.

Lessor accounting for an operating lease:

• Lease receipts as income and related costs, including deprecation of the leased asset, are recognized as income and as expenses, respectively.

Under US GAAP, a lessor can classify a lease in one of three categories, i.e. sales-type, operating, or direct financing. Under US GAAP, a lease is classified as a sales-type lease or directing financing using the same four recognition criteria as a lessee. If none of the criteria is met, the lease is recognized as either an operating lease or a direct financing lease.  Lessor accounting for an operating lease under US GAAP is similar to IFRS.

Accounting differences between IFRS and US GAAP for lessor accounting:

• Under IFRS, there is no distinction between sales-type leases and direct financing leases. For all leases not classified as operating lease, a lessor must recognize selling profit at the beginning of all leases.
• Under US GAAP, a lessor must recognize selling profit only on sales-type leases at the beginning of the lease term.

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

 IFRS and US GAAP operating leases IFRS finance leases and US GAAP sales-type leases US GAAP direct financing leases Balance Sheet Asset is recognized on balance sheet Asset is removed from balance sheet. Lease receivable and residual is reported. Lease asset is removed and lease receivable is reported. Income Statement Lease income & depreciation expense is reported; Interest revenue on lease receivable is reported. If applicable, revenue, cost of goods sold, and selling profit is reported. Interest revenue on lease receivable is reported. Cash Flow Statement Lease payments received are classified in operating activity. Interest portion of lease payment received is either classified as an operating or investing cash inflow under IFRS and an operating cash inflow under US GAAP. Receipt of lease principal is an investing cash inflow.   If providing leases is part of a company’s normal business activity, the cash flows related to the leases are classified as operating cash. Interest portion of lease payment received is an operating cash inflow under US GAAP Receipt of lease principal is an investing cash inflow.If providing leases is part of a company’s normal business activity, the cash flows related to the leases are classified as operating cash.

Example (Direct financing lease)

Assume you lease a machine for 4 years and receive 100 at the start of every year. Relevant interest rate is 10%. What are the accounting entries assuming a direct financing lease?

Solution:

The figures in the table below would seem familiar from our earlier example for the lessee. It is like a mirror image. Lease payable for the lessee becomes the lease receivable for the lessor. Lease receivable on 1 January 2016 is the present value of future lease payments. Lease payment consists of two parts: The principal part reduces the lease receivable. It eventually reduces to 0 at the end of four years. Interest income for lessor is calculated in the same way as interest expense for lessee.

 Year Lease Receivable (1 Jan) Lease Payment Received (1 Jan) Interest Income (at 10%; accrued in previous year) Reduction of Lease Receivable (1 Jan) Lease Receivable (31 Dec) 2016 348.69 100.00 0.00 100.00 248.69 2017 248.69 100.00 24.87 75.13 173.56 2018 173.56 100.00 17.36 82.64 90.92 2019 90.92 100.00 9.09 90.91 0.01