Chapter 18 Lecture Notes

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Leases ● Lessee Accounting ● Sale and leasebacks ● Lessor Accounting ● ASPE Lessee ● Identification of a Lease ● Exemptions ● Non-lease components ● Impact on financial statements IFRS LESSEE ● Identification of a Lease ○ At inception of the contract, need to determine if contract contains lease ○ In order to be considered a lease: ■ Right to control - control the space, hours, etc ■ Specifically identified asset - specific location, defined asset ■ Specified period of time Example: Kiosk that is being moved around the mall → not a lease b/c needs a defined space that is agreed on ● Exemptions → can qualify if it is a short-term lease or low value asset, option to use an exemption or record as ROU asset ○ Short-term leases ■ Less than year ■ If renewal option consider if likely to renew - cannot use short-term lease exemption if likely to be renewed ■ No purchase option - cannot use short-term lease exemption if there is a purchase option (even if not likely to use) ○ Low value assets ■ Based on value new asset (less than $5,000 US) ■ Not dependent on or related other assets ● Ex. Equipment is dependant on other assets - a building or other machinery comes with it ○ If meet exemption option to elect to recognize as lease expense each period instead of recognizing right-of-use asset and lease liability DR Rent expense xxx CR Cash xxx As you make payments then use that entry, incur expense as asset is used Examples ● Lease used vehicle value $3,000 → Not eligible for exemption b/c it is not new ● Lease office space 8 months → Eligible for exemption as short-term lease b/c it is less than a year, no purchase option stated ● Lease employee laptop $2,500 new → Eligible for exemption as a low value asset

● Lease large piece machinery with purchase option → Not eligible for exemption, there is a purchase option ● Lease office space for 1 year with option to renew → Need to consider if it is likely that we will exercise the renewal option, it depends. If likely to renew then does not qualify, if not likely then qualifies as short-term Which of the following examples would qualify for an exemption? Lessee ● Non-Lease Components ○ If the lease contract includes non-lease components (ie. Maintenance) two options: 1. Separate out servicing portion based on stand alone fair value; (allocation based on fair values) or 2. Option to treat entire contract as a lease ● Must exclude if it is third-party costs such as insurance and property taxes - no option to include for these CASE TIPS Issue: Leases / \ ASPE IFRS / \ No exemption Yes exemption - rent expense | ROU Asset | Initial measurement | Subsequent measurement ● Accounting by Lessees - Initial Recognition ○ Recognize “right of use” asset and liability on commencement date - when asset available for use ○ Lease liability recorded at PV of lease payments PMT ○ Payments include: ■ Fixed payments over lease term (annuities) ■ Variable payments if linked to index or rate - CPI (not if linked to sales or usage) ■ FV → Residual guarantee (guarantee as lessee that value of the asset at the end of the lease will be a specified amount) if expected to pay ● Lessee is on the hook to pay if asset doesn’t amount to the guarantee → the lessee has to pay the difference

● This payment is part of the FV when you input it into your calculator ● Amount that is expected to pay ■ FV → Purchase option if expect to exercise ● This payment is part of the FV when you input it into your calculator ■ FV → Termination penalty if lease term suggests will exercise ● This payment is part of the FV when you input it into your calculator ■ Those are the three scenarios that would trigger something in the FV Example Which of the following payments would be included in PV of lease liability? ● Lease payment $5,000 per month 3 year lease → INCLUDE - fixed amount ● Car lease payment $0.20 per km → DO NOT INCLUDE - variable payment that linked to usage not index ● Residual value guarantee $20,000 → INCLUDE if expect to pay ● Lease payment 2% of sales → DO NOT INCLUDE - variable payment that is linked to sales ● Purchase option @ end of 5 year lease → INCLUDE if expect to pay ● Lease payment linked to CPI index → INCLUDE - variable payment that is linked to index N ● Accounting by Lessees - Initial Recognition Lease Liability ○ Lease terms include: ■ Non-cancellable term - all questions include this ■ Plus: Options to extend if reasonably certain (need to assess) ● Example: extending a car lease ● Consider economic incentives to extend ● Temporary space → likely not to extend, Key important space for business → likely to extent ■ Plus: Rent-free periods I/Y ○ Interest rate for discounting is: ■ Lessor’s rate implicit in the lease if known by lessee ; if not known ■ Lessee’s incremental borrowing rate (lessee would need to pay if financed by another source) ○ Right-of-use asset recorded at total of: ■ Starting point amount lease liability (the PV we calculated when doing lease liability) ■ Plus Upfront payment at or before commencement date ■ Plus Initial direct costs to arrange the lease (legal, actg) - this is not maintenance ■ Estimated decommissioning liabilities ■ Less any lease incentives received

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○ Amount recorded as lease liability will not necessarily be equal to the amount of right-of-use asset ○ Amount of lease liability is the starting point for measurement right-of-use asset Example - Part 1 ● 5 year lease starting Jan 1, 20X6 ● $100,000 per year plus 1% of sales in period ● Implicit rate not know incremental borrowing rate 5% ● Straight-line depreciation ● Lease payment end of year ● Dec 31 year-end What is the amount for ROU asset and lease liability at inception lease? N - 5 I/Y - 5% PMT - 100,000 FV - 0 CPT PV - 432,948 Journal Entry: DR ROU Asset 432,948 CR Lease Liability 432,948 Example - Part 2 How would the journal entry change if? ● Part 1 - Initial legal costs of $5,000 to obtain lease - add to the ROU asset Journal Entry: DR ROU Asset 437,948 CR Lease Liability 432,948 CR Cash 5,000 ● Part 2 - Decommissioning costs of $50,000 (PV) required by lease contract? - add to the ROU asset and set up decommissioning liability - no PV calculation given cause they already gave us the PV Journal Entry: DR ROU Asset 482,948 CR Lease liability 432,948 CR Decommissioning Liability 50,000 Lessee ● Subsequent Measurement of Right-of-use Asset ● Use cost model, revaluation model, fair value model (investment property) ○ Cost model - most common for leases ■ Initial measurement less:

● Accumulated depreciation earlier end useful life or lease term unless transfer ownership then useful life ● Accumulated impairment ● Plus or less remeasurement lease liability ○ Also option to use revaluation model or fair value model if those criteria are met ● Subsequent Measurement of Lease Liability ○ Adjust for: ■ Interest expense using effective interest method ■ Discount rate does not change unless ● Change in lease term (n) ● Change in amount payable purchase option ● In these cases we have to recompute I/Y ■ Payments made - lessee’s payments reduce lease liability ■ Remeasurements if variable lease payments linked to index or rate change or there are substantial modifications to lease (pg. 1261) ● Any remeasurements ex change in CPI index if payment linked to CPI index lease liability will also adjust amount of right-of-use asset ● Also need to adjust interest and amortization expense based on new information Journal Entries: ● Each year (if no remeasurements): ○ Record interest to bring up liability to face value Dr. Interest expense xx Cr. Lease liability xx ○ Record payments on lease Dr. Lease liability xx Cr. Cash xx ○ Record amortization of asset Dr. Amortization expense xx Cr. Acc amortization xx Example - Part 3 Using information from Part 1 what are journal entries in 20X6 if sales were $2 million? Initial entry was: Dr. ROU asset 432,948 Cr. Lease liability 432,948 5 year lease Payment 1% sales What are the journal entries we would record in 20X6: 1. Interest Expense Lease liability = 432,948 * 0.05 = 21,647 Remember - always take interest on the lease liability DR Interest Expense 21,647 CR Lease liability 21,647

2. Depreciation of ROU asset 432,948 / 5 years = 86,590 DR Depreciation expense 86,590 CR Acc Amortization 86,590 3. Lease payment 2 million in sales x 1% = 20,000 DR Lease liability 20,000 CR Cash 20,000 Example: Payments are at the beginning Calculator → change to begin Or excel → enter 1 as the type for the PV formula Recalculate lease liability after payment was made → record interest on top of that Example: Accruals (pg. 1257) IFRS - Steps ● Step 1 - Initial entry (assuming no other adjustments right-of-use asset) Dr. ROU Asset = PVMLP Cr. Lease liability = PVMLP ● Step 2 - Accrue interest (assuming no remeasurements) Dr. Interest expense Cr. Lease liability ○ = Liability @ beginning of year x interest rate ● Step 3 - Amortize asset (assuming no remeasurements) Dr. Amortization expense Cr. Accumulated amortization ● Step 4 - Recognize payments Dr. Lease liability Cr. Cash ● Step 5 - Calculate closing balance of lease liability ○ Opening bal + interest - payment Lessee ● Presentation by Lessee ○ Presentation on Statement of Financial Position ■ Lease liabilities separate line item split into current and non-current ■ Right-of-use assets together with property, plant, and equipment or as separate line item ○ Presentation on Income Statement ■ Separate line items for amortization of lease assets and interest on lease liability ○ Presentation on cash flow statement ■ Operating activities - lease payments if meet exemption, variable lease payments linked to sales or usage

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■ Principal payments financing activity ■ Interest paid consistent with other interest paid IFRS LESSEE ENDS ASPE - LESSEE ● Determine if it is an operating or capital lease ● Operating lease ○ Show lease expense each period ● Capital lease ○ Show asset and liability on B/S ○ Asset and liability recorded at PV of lease payments ○ Recognize amortization expense for asset and interest expense on liability ASPE - Operating Lease ● Lessee records periodic lease payments (same as if exemption IFRS) Dr. Rent expense xxx Cr. Cash xxx ● Lessor records periodic receipts of rent Dr. Cash xxx Cr. Rent revenue xxx ASPE - Initial costs ● Expense initial costs, do not capitalize to ROU ● Pay specified costs relating to leased asset ex delivery and construction ● Lessee charges to rent (lease) expense ● In IFRS these were added to initial measurement of right-of-use asset

ASPE - Uneven Payments ● Lessor may provide free rent or require lump sum payment @ beginning of lease ● These payments are amortized over initial lease term ● Ex. free rent for 1 year. Remaining 2 years are $1500 per year ● Step 1 - Calculate SL rent - yearly rate ○ $1500 x 2 y / 3 y = $1000 per year ● Step 2 - Entry in Year 1 Dr. Rent expense 1000 Cr. Deferred rent liability 1000 ● Step 3 - Entry in Years 2&3 - make the 1500 payment Dr. Rent expense 1000 Dr. Deferred rent liability 500 Cr. Cash 1500 Even if you have rent free periods you still have to spread out rental expense over the term of the lease ASPE - Capital Leases - Lessee ● Basic criteria: ○ “Do the terms of the lease transfer substantially all the risks and rewards of ownership from the lessor to lessee” ● Normally transferred if at least 1 criteria met ● Also consider other factors, such as insurance and nature of lessor Criteria - ASPE ● Need to discuss all four - if any one of them is met then it is a capital lease: 1. Automatic transfer of title - end of lease the asset belongs to lessee 2. Bargain purchase option - IFRS assesses if purchase option is likely, ASPE bargain purchase option - if purchase option is viewed as a “bargain” then it is automatically a capital lease ■ Would buy the asset and turn around and sell it ■ Substantially lower than market value - shows a bargain 3. Lease term is 75% or more of the asset’s economic life ■ Quantitative calculation ■ Lease term / economic life 4. PV of minimum lease payments is at least 90% of the FV of the asset @ inception of the lease ■ PV / FV of asset ASPE - Lease Term ● Includes: ○ All terms prior to exercise date of bargain purchase option - assume lessee would keep asset so can exercise BPO ○ Bargain renewal term - option to extend lease payments @ substantially less than market price ○ All renewal terms at lessor’s option - assume lessor would exercise because do not want asset returned ASPE - Minimum Lease Payments

● Exclude operating / executory costs (ie insurance or maintenance) ○ IFRS maintenance - option to exclude with stand alone fair values or include in payment, IFRS insurance is the same and is taken out (third-party rule) ● Include guaranteed residual value regardless of expectations - amount lessee guaranteed that lessor will receive on sale of asset @ end of term ● Include bargain purchase price ● Exclude contingent lease payments which are based on subsequent events (ie fee per km) - cannot estimate ASPE - interest rate ● Interest rate for discounting is lower of: ○ Lessor’s rate implicit in the lease if known by lessee; ○ Lessee’s incremental borrowing rate (lessee would need to pay if financed by another source) ● IFRS is the implicit rate unless it is not known then it is the incremental borrowing rate ASPE - Example - Part 1 On Jan 1, 2020 ABC Inc signed a 5 year lease with XYZ Inc. for office equipment. The lease calls for $6,000 per year, payable at the beginning of each year (Jan 1). The equipment has a remaining useful life of 7 years and had a FMV of $26,900. The equipment returns to XYZ at the end of the lease, unless ABC buys the equipment for $4,500, the expected residual value. The incremental borrowing rate is 8%. Is this capital or operating lease? Issue: How to account for the lease Analysis: Per ASPE, we must assess if the lease is a capital or operating lease. Criteria (have to meet one of the following criteria) 1. Automatic transfer of title → No b/c the equipment returns to XYZ at the end of the lease 2. Bargain purchase options → No b/c they would be selling it at the residual amount, for what it is worth 3. Lease term is 75% or more of the asset’s economic life → No b/c lease term (5 years), economic life (7 years) → 5/7 - 71% 4. PV of minimum lease payments is at least 90% of the FV of the asset @ inception of the lease → Yes it meets this criteria, it is above 90% N - 5 years I/Y - 8% (take lower of implicit and incremental borrowing - this case we only have borrowing) PMT - 6,000 (beginning of year) BEGIN or 1 on excel FV - 0 PV - 25,873 25,873 / 26,900 = 96%

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Note: just because it meets one criteria doesn’t mean you stop, go through all the criteria no matter what Therefore, it is a capital lease → Debit capital asset, credit lease liability ASPE - Fair Value Ceiling - doesn’t exist in IFRS ● If record as capital lease, record asset = PVMLP (PV of minimum lease payments) ○ Above example, if PV we calculated is greater than FMV of 26,900 ● The asset cannot be recorded at an amount > FMV ● Asset is capped at FMV ● Need to calculate new I/Y → implicit interest rate based on remaining inputs ● Accrete liability based on new calculated interest rate ASPE - Capital Leases - Lessee ● Steps ASPE and IFRS same if no remeasurements (pg. 1261): ● At inception of lease: ○ Record the asset as if it was purchased through debt @ PVMLP (max of FMV of asset) Dr. Asset Cr. Lease liability ● Each year: ○ Record interest to bring up liability to face value DR Interest expense CR Lease liability ○ Record payments on lease DR Lease liability CR Cash ○ Record amortization of asset DR Amortization expense CR Accumulated amortization ASPE Example - Part 2 ● Using information from Part 1 provide journal entries for year ● Payment beginning of year ● PV is 25,873 DR Capital asset under lease 25,873 CR Lease liability 25,873 Beg of Year Entry: 1. Lease payment - made at beginning of year Dr. Lease Liability 6,000 CR Cash 6,000 Year-End Entry:

2. Interest Expense 25,873 - 6,000 (beginning of year payment) = 19,873 * 8% = 1,590 Dr. Interest expense 1,590 CR Lease liability 1,590 3. Depreciation expense ROU asset - 25,873 / 5 years DR Depreciation Expense 5,175 CR Accum Depreciation 5,175 ASPE - F/S Impacts of Lease ● I/S - Amortization and interest expense ● B/S - Asset and accumulated amortization, lease liability - current and noncurrent portion ● Disclosure requirement - commitment of future lease payments for next 5 years individually and in total ASPE - Calculating Amortization ● Term of amortization ○ If no BPO or title transfer → over lease term ○ If BPO or title transfer → over life of asset ● Depreciable amount ○ PV minus guaranteed residual value ○ If residual value is not GUARANTEED then do not include it in the calculation Other Complications - ASPE and IFRS - Interest Expense ● Interest payments may not coincide with lease term, so need to accrue @ year end ● At year end: DR Interest expense xx CR Lease liability xx ● When payment made: DR Interest expense xx DR Lease liability xx CR Cash xx Other Complications - ASPE and IFRS - Residual Value ● If lessor sells asset at end lease for less than guaranteed residual value (ASPE) or expected payments residual value (IFRS) lessee needs to make up difference ● Difference is loss DR Loss on lease termination xx CR Cash xx IFRS LESSOR - Sale and Leaseback (try the example on pg.1263) ● Helps them get immediate cash ● Buyer of asset - becomes lessor, seller of asset - becomes lessee

● Step 1 - Determine is sale based on IFRS 15 ○ Performance obligation satisfied ○ Transfer control ● Step 2 - If sale lessee ○ ROU asset based previous carrying amount ○ Recognize gain or loss ● Step 2 - If sale lessor ○ Determine if finance or operating lease ○ Apply lessor accounting ASPE - Sale Leaseback (1272) ● Step 1 - Assess if leaseback is a capital or operating lease ● Step 2 - Determine how to account for gain or loss ● Step 3 - Record the sale ● Step 4 - Record the lease ● On the sale of the asset, a gain or loss is created ○ Gain to record portion of asset transferred ● Need to assess whether capital or operating lease first because has impact on how to account for the gain or loss Sale Leaseback ASPE - Actg for Gain or Loss Scenario Treatment Capital and operating lease where FV < book value at the time of sale Loss recognized immediately because represents impairment Operating lease in all other situations Defer gain/loss and amortize over the lease payments proportionately Capital lease in all other situations Defer and amortize proportionately to the depreciation of leased asset If loss from impairment → recognize immediately Defer gain or loss and amortize for all other cases Sale and Leaseback Assume ASPE if a capital lease ● Record the sale DR Cash xx DR Accumulated Depreciation xx CR Building xx CR Deferred gain xx Removed asset from books, record cash for amount received, deferred gain for difference ● Record the lease DR Lease asset xx CR Lease liability xx

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Assume ASPE capital lease ● Each year - amortize the asset DR Depreciation expense xx CR Accumulated depreciation xx ● Each year - amortize the deferred gain, this one is in proportion to the depreciation b/c it is a capital lease DR Deferred gain xx CR Depreciation expense* xx *Increases net income IFRS - Other Issues ● IFRS lessee - leases land and buildings together ● Treat land and building as one, do not separate out, entire amount gets depreciated ● Land and building will never be a short term exemption - always long-term ● Not an issue for lessee since would not separate entire lease would be ROU asset and lease liability ● Land and buildings would not qualify for exemption Other Issues ● Leases land and buildings (IFRS lessor and ASPE) ○ Land usually operating lease (doesn’t have fixed life so never going to meet that 75% or more economic life criteria) but building may be capital or operating ○ If land portion is immaterial, report as a whole ○ IFRS - segregate based FV leasehold rights (FV of benefits transferred to lessee) ○ ASPE - based on FV of properties IFRS - Lessor Accounting ● Lessor needs to determine if operating or finance lease ○ Based on transfer risks and rewards ○ Similar to ASPE lessee ● If one of primary criteria met then it is a finance lease ● Assess if lease modification IFRS - Criteria ● Primary criteria for finance lease (if we meet one): ○ Ownership transferred @ end lease or bargain purchase option ○ Lease term covers major part economic life - no percentage, only applies to ASPE ○ PV of minimum lease payments covers substantially all of FV - no percentage, only applies to ASPE ○ Asset so specific to lessee that another lessee could not use it without substantial modifications (custom, unique, specific) - main difference from ASPE ● Other secondary conditions that might lead to finance lease: ○ Losses from cancellation of lease by lessee are borne by lessee

○ Gains and losses from changes in value accrue to lessee at end of lease ○ The lessee is able to extend lease for another period at less than market value, “bargain renewal” IFRS - Operating Lease - Lessor ● Leased asset shown lessor’s f/s ● Asset is amortized ● Initial direct costs added to carrying amount asset ● Other costs expensed ● Lease revenue recognized as payments due IFRS - Finance Leases - Lessor ● If it is a finance lease then determine if direct financing or sales type ● Direct financing ○ Lessor financial intermediary - purchases an asset which is immediately leased to lessee ○ Profit comes from lease interest ● Sales type (manufacturers) ○ Lessor leases property to lessee from inventory ○ Revenue as if property sold ENTRIES FOR MANUFACTURER / SALES TYPE Dr cash Dr net investment in the lease CR sales Dr COGS CR Inventory ENTRIES FOR DIRECT FINANCING Decision 1 Finance Lease Operating Lease Direct financing Manufactur er

Dr Cash Dr Net investment in the lease / lease receivable CR Equipment ASPE LESSOR - Criteria for Capital Lease ● Step 1 - need to meet at least 1 of criteria used for lessee ○ Automatic transfer ○ Bargain purchase option ○ 75% life ○ 90% more FV ● Step 2 - need to meet 2 additional criteria: ○ Credit risk of lessee must be normal ○ Unreimbursable costs to be borne by lessor must be estimable ● We can then classify as a capital lease Interest Rate Discounting for Finance / Capital Lease ● Both ASPE and IFRS ● Interest rate for discounting is rate implicit in lease (would be known by person who owns the asset) Lessee Lessor IFRS ROU or exemptions (short- term lease or low-value asset) Finance or operating lease (finance criteria) Determine what type of finance lease ASPE Operating vs capital (capital criteria) Operating or capital

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