Leases: Tenth Canadian Edition

INTERMEDIATE
ACCOUNTING
TENTH CANADIAN EDITION
Kieso Weygandt Warfield Young Wiecek McConomy
CHAPTER 20
Leases
Prepared by:
Lisa Harvey, CPA, CA

Rotman School of Management,
University of Toronto
CHAPTE
20
R
LEASES
After studying this chapter, you should be able to:
Understand the importance of leases from a business perspective.
Explain the conceptual nature, economic substance, and advantages of lease transactions.
Identify and apply the criteria that are used to determine the type of lease for accounting purposes for a lessee under
the classification approach.
Calculate the lease payment that is required for a lessor to earn a specific return.
Account for a lessees basic capital (finance) lease.
Determine the effect of, and account for, residual values and bargain purchase options in a lessees capital (finance)
lease.
Account for an operating lease by a lessee and compare the operating and capitalization methods of accounting for
leases.
Determine the statement of financial position presentation of a capital (finance) lease and identify other disclosures
required.
Identify and apply the criteria that are used to determine the type of lease for a lessor under the classification
approach.
Account for and report basic financing and sales-type leases by a lessor.
Account for and report financing and sales-type leases with guaranteed residual values or a bargain purchase option
by a lessor.
Account for and report an operating lease by a lessor.
Identify differences in accounting between ASPE and IFRS, and what changes are expected in the near future.
Copyright John Wiley & Sons Canada,

Ltd.
Leases
Leasing
Basics
Importance
of leases
from a
business
perspective
Current
standards
Classification
Approach
Lessees
Classification
Approach
Lessors
Classification criteria
Determination of
Accounting for
rental payments
financing and salestype leases
Accounting for a
Accounting for
finance lease
residual values and
Accounting for
bargain purchase
residual values and
options in a financing
bargain purchase
or sales-type lease
options in a finance
Accounting for an
lease
operating lease
Accounting for an
Initial direct cost
operating lease
Finance and
Disclosure
operating leases
compared
Presentation
and John Wiley & Sons Canada,
Copyright
Ltd.
disclosure
IFRS/ASPE
Comparison
Comparison
of IFRS and
ASPE
Looking
ahead
Importance of Leases
Leasing is popular because it is a costeffective way of financing property and
equipment
This is especially true for items that become
obsolete quickly
From an accounting standpoint, leases have

been controversial because many are offbalance sheet
Standard setters have been concerned about this
lack of transparency for many years
Ltd.
Leasing Environment
A lease is a contractual agreement
between the lessor and the lessee
The lease gives the lessee the right to use
specific property (owned by the lessor)
The lease specifies also the duration of the
lease and rental payments
The obligations for taxes, insurance, and

maintenance (executory costs) may be
assumed by the lessor or the lessee or
divided
Ltd.
Leasing Environment
In Canada, there are three main types of
lessors:
Manufacturer finance companies
Subsidiaries whose main business is leasing (e.g.
Honda Canada Finance Inc.)
Independent finance companies

Financial intermediaries
Traditional financial institutions

Subsidiaries of domestic and foreign banks
Ltd.
Advantages of Leasing
100% financing at a fixed rate
No down payment required
Rate charged is fixed for the term of the lease
Protection from obsolescence

Property can be upgraded
Flexibility
Lease may be structured to meet different needs (e.g., cash
flow)
Less costly financing (lessee) and tax incentives (lessor)

Off-balance sheet financing
Does not impact ratios
Ltd.
Conceptual Nature of
Lease
1. Do not capitalize any leased assets an executory
contract approach
Since lessee does not own the property, capitalization is
considered inappropriate
Since other executory contracts are not capitalized, leases
should not be either
2. Capitalize leases that are similar to instalment

purchases a classification approach
if installment purchases are capitalized, so should leases with
similar characteristics
3. Capitalize all long-term leases a contract-based

approach
The long-term right to use property justifies its capitalization
Ltd.
Current Standards
Current IFRS, ASPE, and FASB standards are
consistent with the classification approach
A lease that transfers substantially all the benefits and
risks of property ownership should be capitalized
(classified as finance/capital lease)
A lease where benefits and risks of ownership are not
transferred is classified as operating lease
Proposed IASB and FASB converged lease accounting

standard is based on the contract-based approach
Lease contracts create assets and liabilities that should
be recognized
Finance and operating leases would be capitalized
Ltd.
Leases
Leasing
Basics
Importance
of leases
from a
business
perspective
Current
standards
Classification
Approach
Lessees
Classification
Approach
Lessors
Determination of
Accounting for
rental payments
Accounting for a
Accounting for
finance lease
residual values and
Accounting for
bargain purchase
residual values and
bargain purchase
or sales-type lease
Accounting for an
lease
operating lease
Accounting for an
Initial direct cost
operating lease
Finance and
Disclosure
operating leases
compared
Presentation
Copyright
Ltd.
disclosure
IFRS/ASPE
Comparison
Comparison
of IFRS and
ASPE
Looking
ahead
10
10
Classification Criteria
Most important factor in determining
whether a lease is capital is whether risks
and rewards have transferred from lessor
to lessee
Both IFRS and ASPE provide specific
guidelines to help determine whether risks
and rewards have transferred

Ltd.
11
11
Classification Criteria:
IFRS
Under IFRS any one of the following normally indicates a finance lease:
1. Reasonable assurance that ownership will transfer to lessee at end
of lease term
It is assumed that bargain purchase option (BPO) will be exercised by

lessee if available
2. Lease term allows lessee to get substantially all economic benefits

that could be expected from using the leased asset over its entire
life
3. Lease terms allow lessor to recover substantially all investment in
leased asset, and also earn a rate of return
If PV of minimum lease payments (MLP) is close the fair value of the

leased asset
4. Leased asset is specialized and can only be used by lessee

(without major modifications)

Ltd.
12
12
Classification Criteria:
ASPE
Under ASPE any one of the three requirements
normally indicates a capital lease:
1. Same as #1 under IFRS
2. Similar to #2 under IFRS
Additional threshold: assumed if lease term is 75%
of lease assets economic life
3. Similar to #3 under IFRS

Additional threshold: assumed if PV of minimum lease
payments (excluding executory costs) is 90% of the
fair value of the leased asset

Ltd.
13
13
Minimum Lease Payments

Minimum lease payments (lessee) defined:
Minimum rental payments +
Amounts guaranteed +
Bargain purchase option
Minimum rental payments

Regular payment made to lessor, excluding executory
costs
Executory costs include insurance, maintenance and tax
expenses
If these payments are made by the lessor, they are estimated
and excluded from the PV of minimum rental payment
calculation
Ltd.
14
14
Minimum Lease Payments

Guaranteed amounts
Guaranteed residual value (GRV): guaranteed value of
the leased asset at the end of the lease term
For lessee, maximum amount lessor can require lessee
to pay at end of the lease
Bargain Purchase Option (BPO)
An option to purchase the leased asset at the end of the
lease at a price below expected fair value

Ltd.
15
15
Discount Rate
Rate implicit in the lease: rate that makes
PV of MLP + unguaranteed residual values = FV of
leased asset
Incremental borrowing rate: the rate the lessee

would have incurred if they had borrowed the
funds to purchase the asset
Under similar term (length) and similar security (same
type of asset)
Under IFRS, use the rate implicit in the lease if it

is reasonably determinable
Under ASPE, use the lower of the two rates
Ltd.
16
16
Determining Rental
Payments
Lessor sets rental payments to earn a
specific rate of return (i.e. the implicit rate)
If the lease has a BPO or residual value,
these components do not need to be
recovered through rental payments

Ltd.
17
17
Determining Rental
Payments - Example
Given:
Lessor Corporation wants to earn a 10% return on its
investment of $100,000
Lessee Corporation is leasing the asset for five years
Annual rental payments are due at the beginning of each
year
There is no BPO or residual value at the end of the lease
Calculate the payment required to provide lessor with
required rate of return
Ltd.
18
Determining Rental Payments

- Example
Cost/FMV of asset to be recovered
$100,000
Less: PV of expected residual value
-0Amount to be recovered through
lease payments
$100,000
PV of Annuity due (n=5, i=10%)
4.16986
Payments: ($100,000/4.16986)
$23,981.62
Total lease payments:

5 x $23,981.62
= $119,908.10

Ltd.
19
19
Accounting for a Finance

Lease
Asset and liability recorded at the lower of:
1. PV of the minimum lease payments and
2. Fair value of the asset at the inception of the lease
Depreciation of the asset is amortized over:
. The economic life of the asset if ownership transfers
to lessee at the end of the lease or there is a bargain
purchase option
. The term of the lease if title does not transfer to the
lessee or there is no bargain purchase option

Ltd.
20
20

Lease
Interest expense resulting from the lease
transaction is recorded following the
effective interest method
The discount rate used to establish the initial
PV is used to amortize the lease
Each lease payment is allocated between
principal and interest

Ltd.
21
21

Lease Journal Entries
At the inception of the lease:
Dr. Asset under Lease
Cr. Obligations under Lease
To accrue interest:
Dr. Interest Expense
Cr. Interest Payable
Using the Effective

Interest Method
To record asset depreciation:

Dr. Depreciation Expense
Cr. Accumulated Depreciation
Using method
appropriate to
the asset
To record the lease payment:

Dr. Related Executory Expense (if any)
Dr. Interest Payable
Dr. Obligations under Lease
Cr. Cash
Ltd.
22
22
Finance Lease - Example

Given:
Lease term of 5 years, non-cancellable

Annual payments $25,981.62 (due at beginning of each
year, starting January 1, 2014)
Fair value of asset $100,000
Economic life = 5 years
No residual value
Lease payments include $2,000 of maintenance fees
(executory cost)
Lease has no renewal option and asset reverts to Lessor
at termination of lease
Lessees incremental borrowing rate = 11%
Lessors implicit rate =10% (known to lessee)
Similar assets are depreciated using straight-line method
Ltd.
23
23
Does this qualify as a finance lease?
Yes, under both IFRS and ASPE
Only one of the tests must be met (ASPE thresholds illustrated)

Is there a
Transfer of
Ownership
or Bargain
Purchase
Option?
No
Is Lease Term
75% of
Economic Life?
Is Present Value
of Payments
90% of Fair
Value?
Yes
Finance Lease
Yes
PV of payments (n=5, i=10%)

25,981.62 - 2000.00 =
23,981.62 x 4.16986 =
$100,000.00

Ltd.
24
24

Entry to record initial lease transaction:
Equipment under Lease
100,000
Obligations under Lease
100,000
Entry to record initial payment (Jan 1/14):
Maintenance and Repairs Expense 2,000.00
Obligations under Capital Lease
23,981.62
Cash
25,981.62
Since this is a finance lease, the following must also be
recorded (at year end or in each reporting period):
Interest expense
Asset depreciation
Ltd.
25
25

Entry to record interest (December 31, 2014):
Interest Expense 7,601.84
Interest Payable
7,601.84
(100,000-23,981.62)*10% = 7,601.84
Interest Payable is debited in all subsequent lease payment entries
since interest is accrued at year-end
Entry to record asset depreciation (December 31, 2014):
Depreciation expense
20,000
Accumulated depreciation
20,000
(100,000 / 5 years = 20,000)
There is no transfer of ownership or bargain purchase option, so
the term of the lease is used to amortize the asset
Ltd.
26
26

Financial Statement Presentation
(as at December 31, 2014)
Statement of Financial Position
Current liabilities
Interest payable
$ 7,601.84
Obligations under lease, current portion 16,379.78
Non-current liabilities
Obligations under lease
$59,638.60

Ltd.
27
27

To record lease payment on January 1, 2015:
Maintenance and Repairs Expense 2,000.00
Interest Payable
7,601.84
Obligations under Lease
16,379.78
Cash
25,981.61

Ltd.
28
28
Accounting for Residual

Values
If the residual value is guaranteed by the
lessee, its PV is included in the leased asset
and lease obligation recognized
i.e., is included in definition of minimum lease
payments
If the residual value is unguaranteed, it is not

included in the leased asset and lease
obligation recognized
i.e., is not included in the definition of minimum
lease payments
Ltd.
29
29
Accounting for Bargain

Purchase Options (BPOs)
Lessee accounting assumes bargain
option will be exercised
PV of BPO is included in asset cost and
obligation recognized
Asset is amortized over its economic life

(not the lease term)
It is assumed that BPO will be exercised and
therefore that the asset will be purchased and
continue to be used
Ltd.
30
30
Accounting for an
Operating Lease
Risks and benefits of ownership of
leased assets are not transferred to
lessee
Lease payments are treated as rent
expense:
Dr. Rent Expense/Prepaid Rent xx
Cr. Cash/Accounts Payable
xx
Lease expense is recognized on a

straight-line basis if lease inducements
are offered
Ltd.
31
31
Finance vs. Operating

Leases
Total expenses over lease term are same
regardless of accounting method (i.e. operating
vs. capital)
Timing of expenses over lease term is different
Finance leases result in higher expenses in earlier
years and lower expenses in later years compared to
operating leases
Operating leases result in lower debt-to-equity

ratio and improved total asset turnover and
return on total assets
Ltd.
32
32
Current versus NonCurrent Classification

Current portion = principal amount to be
repaid within 12 months from date of the
statement of financial position (SFP) +
interest accrued to SFP date
Long-term = principal amount not payable
within 12 months from the SFP date

Ltd.
33
33
Disclosure Finance Leases

Given that capital/finance leases give rise to a
leased asset and long-term liability, most
disclosures are covered by standards for
PP&E
Intangible assets
Financial instruments
Long-term liabilities
IFRS requires additional disclosures, including:

Net carrying amount of each class of leased asset
Reconciliations of future MLP and their PV
Various lease terms (e.g. conditions relating to
subleases and contingent rents)
Ltd.
34
34
Disclosure - Operating
Leases
Lessees must disclose:
Future minimum lease payments extending
into the future
IFRS requires additional disclosures relating
to various lease terms (e.g. conditions relating
to subleases and contingent rents)

Ltd.
35
35
Leases
Leasing
Basics
Importance
of leases
from a
business
perspective
Current
standards
Classification
Approach
Lessees
Classification
Approach
Lessors
Determination of
Accounting for
rental payments
Accounting for a
Accounting for
finance lease
residual values and
Accounting for
bargain purchase
residual values and
bargain purchase
or sales-type lease
Accounting for an
lease
operating lease
Accounting for an
Initial direct cost
operating lease
Finance and
Disclosure
operating leases
compared
Presentation
Copyright
Ltd.
disclosure
IFRS/ASPE
Comparison
Comparison
of IFRS and
ASPE
Looking
ahead
36
36
Classification Criteria Lessor

Type
ASPE
IFRS
Operating
Operating lease
Operating lease
Financing lease:
Sales-type
Sales-type lease
Manufacturer or dealer
lease
or
Financing-type
Direct financing lease
or
Finance lease

Ltd.
37
37

Under IFRS and ASPE, the lessor uses the same
criteria as the lessee
However under ASPE there are two additional revenue
recognition-based considerations that must be passed:

1. Credit risk associated with collection is normal
2. Remaining unreimbursable costs to lessor can be estimated
If required criteria are not met, the lease is accounted

for as an operating lease
Under ASPE, a lease may qualify as a finance lease by
the lessee but be an operating lease for the lessor

Ltd.
38 38

Both sales-type and financing-type leases
are finance leases
The difference is whether or not there exists a
manufacturers or dealers profit
The sales-type lease incorporates this profit

Ltd.
39
39
Accounting for a
Financing-Type Lease
Lessor replaces investment in asset to be
leased with a lease receivable
Over lease term, the receivable is
collected and interest is earned
Net investment in the lease = lease
payments receivable unearned interest
income

Ltd.
40
40
Accounting for a
Financing-Type Lease
The gross investment in the lease and lease
payments receivable are equal to:
Lease payments (net of executory costs) +
salvage/residual value or bargain purchase option
(BPO)
The net investment in the lease is equal to: the gross
investment in the lease discounted at the implicit rate
The unearned interest revenue is the difference
between the gross and net investment
Ltd.
41
41
Accounting for a
Financing-Type Lease Example
Given:
Lease term of 5 years, non-cancellable
Annual payments $25,981.62 (receivable at beginning of each year,
starting January 1, 2014)
Fair value of asset $100,000
Economic life = 5 years
No residual value
Lease payments include $2,000 of maintenance fees (executory cost)
Lease has no renewal option, and asset reverts to Lessor at
termination of lease
Lessors implicit rate (required return) =10%
Collectibillity is reasonably assured
No additional costs expected to be incurred by Lessor
Ltd.
42
42
Accounting for a
Entries to record the inception of the lease (January 1, 2014):
Equipment Acquired for Lessee
Cash
100,000
Lease Receivable
119,908.10
Equipment Acquired for Lessee
Income
19,908.10
100,000
100,000.00 Unearned Interest
Lease payments receivable (gross investment in lease):

(25,981.62 2,000) x 5 = 119,908.10
Net investment in lease:
(25,981.62 2,000) x 4.16986 (n=5, i=10%) = 100,000
Ltd.
43
43
Accounting for a
Entry to record first payment (January 1, 2014):
Cash ($23,981.62+$2,000)
25,981.62
Lease Payments Receivable
23,981.62
Maintenance and Repairs Expense
2,000.00
Entry to accrue interest earned (December 31, 2014):
Unearned Interest Income
7,601.84
Interest Income
7,601.84

Ltd.
44
44
Accounting for a
Calculation of interest earned at December 31, 2014:
Amount originally financed $100,000.00
Paid on principal Jan. 1/14
(23,981.62)
Balance outstanding
$ 76,018.38
Interest: 10% x 76,018.38 x 12/12 = $7,601.84

Ltd.
45
45
Accounting for a
Financial Statement Presentation
(as at December 31, 2014)
Statement of Financial Position
Current assets
Net investment in finance leases $23,981.62
Non-current assets
Net investment in finance leases
$59,638.60

Ltd.
46
46
Accounting for a SalesType Lease

Entries are the same as for financing-type
lease, except for:
Entry at the inception of the lease must record
the sale and cost of goods sold
Recall that the sales-type lease includes a
manufacturers/dealers profit margin
Lessor earns a gross profit on sale +

interest as the sale is financed

Ltd.
47
47
Accounting for a SalesType Lease - Example

Given:
Take the same data as the finance-type
lease example except the asset has been
recorded in the Lessors inventory at a
cost of $85,000 (FMV=$100,000)
All previous lessor entries remain the
same except for the entry at the lease
inception
Sales and Cost of Goods Sold are recorded
Ltd.
48
48
Accounting for a SalesType Lease - Example

Entries to record inception of lease (January 1, 2014):
Lease Receivable
119,908.10
19,908.10
Sales
100,000.00
Cost of Goods Sold
85,000.00
Inventory
85,000.00
Entry to record the first payment (January 1, 2014) is the same:
Cash ($23,981.62+$2,000)
25,981.62
Lease Receivable
23,981.62
Maintenance and Repairs Expense
2,000.00
Entry to accrue interest earned (December 31, 2014) is the
same:
7,601.84
Interest Income
7,601.84
Ltd.
49
49
Accounting for Residual

Values - Lessor
Whether guaranteed or unguaranteed, the residual
is included in the lessor calculations for both
financing-type leases or sales-type leases
However, for sales-type leases unguaranteed
residual values changes how it is included for
accounting purposes:
With unguaranteed residual value, the Sales Revenue
and COGS are reduced by the PV of the
unguaranteed residual value
The gross profit amount on the sale will remain the
same
Ltd.
50
50
Accounting for Bargain

Purchase Options (BPOs) Lessor
With financing-type and sales-type leases,
the bargain purchase price is included in
the lease payments receivable and the PV
of the bargain purchase option is included
in net investment calculations

Ltd.
51
51
Accounting for an
Operating Lease - Lessor
Risks and benefits of ownership of leased
assets are not transferred to lessee
Lease payments are treated as rental income
Dr. Cash
xx
Cr. Rental Income
xx
Lease asset remains on lessors books and

continues to be depreciated
Dr. Depreciation Expense xx
Cr. Accumulated Depreciation
xx

Ltd.
52
52
Initial Direct Costs of

Lessor
Costs incurred by lessor that can be directly
attributable to negotiating and arranging a specific
lease (e.g. legal fees, commissions, etc.)
General approach:
Financing-type lease allocated over lease term
Sales-type lease expensed in the year the
costs are incurred (i.e., in same period as gross
profit on sale recognized)
Operating lease deferred and allocated over
lease term
Ltd.
53
53
Disclosure - Lessor
Financing and Sales-Type Leases
Under ASPE, disclose:
Net investment in the lease and implicit rate

Carrying amount of impaired leases (and
impairment allowance)
Under IFRS, additional disclosures

including:
Reconciliation between PV of MLP and gross

investment and amounts due over time
Unearned finance income
Unguaranteed residual values
Other
Ltd.
54
54
Disclosure - Lessor
Operating Leases
Under ASPE, disclose:
Separate disclosure of the cost and accumulated
amortization of the property
Under IFRS, disclosures similar to those for

financing leases
Remember, disclosure requirements imposed by other
(related) standards also apply (e.g. PP&E, financial
instruments, impairment, etc.)

Ltd.
55
55
Leases
Leasing
Basics
Importance
of leases
from a
business
perspective
Current
standards
Classification
Approach
Lessees
Classification
Approach
Lessors
Determination of
Accounting for
rental payments
Accounting for a
Accounting for
finance lease
residual values and
Accounting for
bargain purchase
residual values and
bargain purchase
or sales-type lease
Accounting for an
lease
operating lease
Accounting for an
Initial direct cost
operating lease
Finance and
Disclosure
operating leases
compared
Presentation
Copyright
Ltd.
disclosure
IFRS/ASPE
Comparison
Comparison
of IFRS and
ASPE
Looking
ahead
56
56
Looking Ahead
Major changes are expected with the new
IFRS leasing standard that takes a more
contract-based approach (as detailed in
Appendix 20B)

Ltd.
57
57
COPYRIGHT
Copyright 2013 John Wiley & Sons Canada, Ltd. All
rights reserved. Reproduction or translation of this
work beyond that permitted by Access Copyright (The
Canadian Copyright Licensing Agency) is unlawful.
Requests for further information should be addressed
to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies
for his or her own use only and not for distribution or
resale. The author and the publisher assume no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the use
of the information contained herein.

Ltd.
58

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INTERMEDIATE

Lisa Harvey, CPA, CA

Copyright John Wiley & Sons Canada,

From an accounting standpoint, leases have

The obligations for taxes, insurance, and

Independent finance companies

Traditional financial institutions

Protection from obsolescence

Less costly financing (lessee) and tax incentives (lessor)

2. Capitalize leases that are similar to instalment

3. Capitalize all long-term leases a contract-based

Proposed IASB and FASB converged lease accounting

Copyright John Wiley & Sons Canada,

It is assumed that bargain purchase option (BPO) will be exercised by

2. Lease term allows lessee to get substantially all economic benefits

If PV of minimum lease payments (MLP) is close the fair value of the

4. Leased asset is specialized and can only be used by lessee

Copyright John Wiley & Sons Canada,

3. Similar to #3 under IFRS

Copyright John Wiley & Sons Canada,

Minimum Lease Payments

Minimum rental payments

Minimum Lease Payments

Copyright John Wiley & Sons Canada,

Incremental borrowing rate: the rate the lessee

Under IFRS, use the rate implicit in the lease if it

Copyright John Wiley & Sons Canada,

Determining Rental Payments

Total lease payments:

Copyright John Wiley & Sons Canada,

Accounting for a Finance

Copyright John Wiley & Sons Canada,

Accounting for a Finance

Copyright John Wiley & Sons Canada,

Accounting for a Finance

Using the Effective

To record asset depreciation:

To record the lease payment:

Finance Lease - Example

Lease term of 5 years, non-cancellable

Finance Lease - Example

Does this qualify as a finance lease?

Yes, under both IFRS and ASPE

Only one of the tests must be met (ASPE thresholds illustrated)

PV of payments (n=5, i=10%)

Copyright John Wiley & Sons Canada,

Finance Lease - Example

Finance Lease - Example

Finance Lease - Example

Copyright John Wiley & Sons Canada,

Finance Lease - Example

Copyright John Wiley & Sons Canada,

Accounting for Residual

If the residual value is unguaranteed, it is not

Accounting for Bargain

Asset is amortized over its economic life

Lease expense is recognized on a

Finance vs. Operating

Operating leases result in lower debt-to-equity