Operating Leases

11 Key excerpts on "Operating Leases"

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  Intermediate Accounting

  • Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  In an operating lease, a lessee obtains the right to use the underlying asset but not ownership of the asset itself. For example, a lease may convey use of one floor of an office building for five years. At the end of the lease, the lessee vacates the floor and the lessor can then lease the floor to another tenant. So this lease (an operating lease) conveys right-of-use but not ownership; the lessee controls the leased asset only during the five-year lease. As we will see, the accounting for a lease classified as a finance lease (transfer of control or ownership) or an operating lease (transfer of right-of-use) reflects differences in control conveyed in a lease arrangement. Illustration 21.2 presents the lease classification tests, which are used to determine whether a company should use the finance lease approach or the operating lease approach. Underlying Concepts The issue of how to report leases is the classic case of substance versus form. Although legal title does not technically pass in lease transactions, the benefits from the use of the property do transfer. 1 The FASB believes that the reporting of an asset and liability for a lease arrangement is consistent with its concep- tual framework definition of assets and liabilities. That is, assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. See “Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB, December 1985), pp. ix and x. 21-8 CHAPTER 21 Accounting for Leases For a lease to be a finance lease, it must be non-cancelable and meet at least one of the five tests listed in Illustration 21.2.

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  Evaluating Capital Projects

  • Ahmed Riahi-Belkaoui(Author)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  146 Evaluating Capital Projects TYPES OF LEASING ARRANGEMENTS Although it is possible to describe major forms of lease arrangements, the options, terms, and conditions may vary from contract to contract, giving a firm great flexibility in the adaptation of leasing as a financing method. Operating versus Financial Leases The first distinction to be made in leasing is between operating and financial leases. Under both contracts, the lessee agrees to make periodic rental payments. An operating lease is a short-term contract that is cancelable given proper notice at the option of the lessee, whereby the lessor gives the lessee the use of property in exchange for rental payments and at the same time retains the usual ownership risks (such as obsolescence) and rewards (such as a gain from appreciation in value at the end of the lease period). To compensate the lessor for assuming the ownership risks, the periodic rental payments of an operating lease will include a return on investment plus most ownership costs, such as maintenance, taxes, depreciation, obsolescence, casualty losses, and so forth. Examples of Operating Leases include car rentals, apartment rentals, telephone service, and space rental in shopping centers. A financial lease is a comparatively long-term contract that is noncancelable by the lessor, who assumes little or no ownership costs. As a result, the periodic rental may include only a return on investment, and the lessee may be required to pay most of the ownership costs. At the termination of the lease, options may exist allowing the lessee to acquire the asset at either a nominal cost or no cost at all. The financial lease allows the lessor to recover the investment and even realize a profit through the lessee's continuous rental payments over the period specified by the contract. The financial lease gives the lessee continuous use of the asset at a certain cost and, consequently, is a means of financing the use (and not the ownership) of the asset.

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  Intermediate Accounting

  • Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  A lease is a contractual agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific property, which is owned by the lessor, for a specified period of time. In return for the use of the property, the lessee makes rental payments over the lease term to the lessor. [1] (See the FASB Codification References near the end of the chapter.) If you have ever leased a car or an apartment, you are the lessee, and the car dealer or property owner is the lessor. Without even knowing it, you have probably been party to a lease transaction! A Look at the Lessee Aristotle once said, “Wealth does not lie in ownership but in the use of things.” Clearly, many U.S. companies have decided that Aristotle is right, as they have become heavily involved in leasing assets rather than owning them. Indeed, leasing is a multi-trillion dollar industry! That is a lot of lease contracts. What types of assets are being leased? Maybe the better question is what assets are not leased? Any type of property, plant, and equipment can be leased, such as buildings, land, railcars, helicopters, bulldozers, barges, CT scanners, and computers. Illustration 20.1 summarizes what several major companies are leasing.

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  Corporate Financial Reporting and Analysis

  A Global Perspective

  • S. David Young, Jacob Cohen, Daniel A. Bens(Authors)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  225 11 Introduction A lease is an agreement between two parties for the rent of an asset. The lessor is the legal owner of the asset who then rents out the asset to the lessee. At the end of the lease period, the asset is usually, but not always, returned to the lessor. The lessee pays a periodic (monthly, quarterly, yearly) rental fee to the lessor in return for use of the asset. In this chapter, we address the accounting treatment for leases and off-balance-sheet debt. The discussion is limited to the les- see’s perspective. Leasing is a critically important topic for the financial statement reader because in many industries it is the most common form of asset financing. The economic rationale for such a large industry is complex, and beyond the scope of this book, but accounting practice has certainly played an important role in the pervasive use of leasing. Lease accounting is in the midst of a profound transformation. To put that transformation into context, we begin with an examination of lease accounting before 2019 (when the new account- ing standard is scheduled to come into effect). Several of these elements will be retained, while others will no longer apply. After we have presented the pre-2019 treatment, we will discuss the recent changes. Leasing Accounting Before 2018: Capital vs. Operating Leases US GAAP and IFRS distinguished between two types of leases: capital and operating. In the case of the former, future lease payments were capitalized at an appropriate borrowing rate, with the present value appearing as both an asset and a liability on the balance sheet. Operating Leases were treated as rental contracts, with the periodic lease payments recorded as operating expenses. The present value of the lease does not appear on the balance sheet as either an asset or a liability. In fact, Operating Leases were the most common form of off-balance-sheet (OBS) financing.

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  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  (3) Those leases that do not meet the characteristics identified in (1) should be accounted for as rental agreements (Operating Leases). It has been suggested that the choice of structuring a lease as either an operating or a capital lease is not independent of the original nature of leasing as opposed to buying the asset. As indi- cated earlier, companies engaging in lease transactions may attempt to transfer the benefits of owning assets to the lease party in the higher tax bracket. In addition, Smith and Wakeman iden- tified eight nontax factors that make leasing more attractive than purchasing: 3 1. The period of use is short relative to the overall life of the asset. 2. The lessor has a comparative advantage over the lessee in reselling the asset. 3. Corporate bond covenants of the lessee contain restrictions relating to financial policies the firm must follow (maximum debt‐to‐equity ratios). 4. Management compensation contracts contain provisions expressing compensation as a function of return on invested capital. 5. Lessee ownership is closely held, so that risk reduction is important. 6. The lessor (manufacturer) has market power and can thus generate higher profits by leasing the asset (and controlling the terms of the lease) than by selling the asset. 7. The asset is not specialized to the firm. 8. The asset’s value is not sensitive to use or abuse (the owner takes better care of the asset than does the lessee). Obviously, some of these reasons are not subject to lessee choice but are motivated by the lessor and/or the type of asset involved. However, short periods of use and the resale factor favor the accounting treatment of a lease as operating, whereas the bond covenant and management compensation incentives favor a structuring of the lease as a capital lease. In addition, lessors 2 Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 13, “Accounting for Leases” (Stamford, CT: FASB, 1976), para.

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  Wiley IFRS 2017

  Interpretation and Application of IFRS Standards

  • (Author)
  • 2017(Publication Date)
  • Wiley

    (Publisher)

  Lease liabilities are secured over property, plant and equipment as disclosed in note 15. These assets will revert back to the lessor in the event of a default.The company leases certain items of property, plant and equipment under lease agreements with a 5-year term. These bear interest at between 2% and 4, 5% and are repayable in equal monthly instalments IAS17 p31(e)

  33. Operating lease commitments
  As a lessee:It is group policy to rent certain items of office equipment and premises under operating lease agreements. The lease terms of these agreements vary between 3 and 10 years. No contingent rent is payable.
  20XX	20XX-1	IAS17 p35
  As a lessee:
  Future minimum lease payments under non-cancellable Operating Leases:
  Within one year	X	X
  From one to five years	X	X
  After five years	X	X
  X	X
  The group does not sublease any of its leased premises.
  Lease payments recognised in profit for the period amounted to £ X (20XX-1: £ X).
  As a lessor:
  The company leases its Investment Property to various third parties under operating lease agreements. The average lease term was ten years, with annual escalation set at 2%.
  20XX	20XX-1	IAS17 p56
  Future minimum lease receipts under non-cancellable Operating Leases:
  Within one year	X	X
  From one to five years	X	X
  After five years	X	X
  X	X
  No contingent rentals were recognised in income.

  Future Developments

  IFRS 16 Leases was issued in January 2016 with a mandatory effective date for all periods beginning on or after 1 January 2019. IFRS 16 creates new principles to identify a lease based on control. The new standard replaces the following existing standards:

  1. IAS 17, Leases
  2. IFRIC 4, Determining whether an Arrangement contains a Lease
  3. SIC 15, Operating Leases – Incentives
  4. SIC 27, Evaluating the Substance of Transactions Involving the Legal Form of a Lease

  IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a lease term of more than 12 months, unless the underlying value of the leased asset is of low and short-term leases. The distinction between operating and finance is therefore removed. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

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  Intermediate Accounting, Student Practice and Solutions Manual

  • Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Advantages of Leasing In discussing the advantages of leasing arrangements, advo- cates point out that leasing allows for the lessee: (a) 100% financing, (b) protection against obsolescence, (c) flexibility, and (d) less costly financing. For the lessor, it allows: (a) profitable interest margins, (b) sales stimulation, (c) tax benefits, and (d) return of high residual value. *Note: All asterisked (*) items relate to material contained in the Appendices to the chapter. Chapter 21 Review 21-2 A variety of opinions exist regarding the manner in which certain long-term lease arrange- ments should be accounted for. These opinions range from total capitalization of all long-term leases to the belief that leases represent executory contracts that should not be capitalized. The FASB recently required that all long-term leases be capitalized. The only exception to capitalization is leases covering a term of less than one year. Finance and Operating Leases (Lessee) Companies classify lease arrange- ments as either finance or operating. In either case, companies capitalize all leased assets and liabilities. Therefore, the balance sheet for a company that uses either a finance lease or an operating lease will be the same. However, for income statement purposes, the reporting of financial information depends on whether the lease is classified as a finance lease or oper- ating lease. For a finance lease, the lessee recognizes interest expense on the lease liability over the life of the lease using the effective-interest method and records amortization expense on the right-of-use asset generally on a straight-line basis. In an operating lease, the lessee also measures interest expense using the effective- interest method. However, the lessee amortizes the right-of-use asset such that the total lease expense is the same from period to period.

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  Wiley Interpretation and Application of IFRS Standards 2020

  • (Author)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  533 22 INTRODUCTION Leasing has long been a popular financing option for the acquisition of business property. During the past few decades, however, the business of leasing has experienced staggering growth, and much of this volume is reported in the statements of financial position. The tremendous popularity of leasing is quite understandable, as it offers great flexibility, often coupled with a range of economic advantages over ownership. Thus, with leasing, a lessee (borrower) is typically able to obtain 100% financing, whereas under a tradi- tional credit purchase arrangement the buyer would generally have to make an initial equity investment. In many jurisdictions, a leasing arrangement offers tax benefits compared to the purchase option. The lessee is protected to an extent from the risk of obsolescence, although the lease terms will vary based on the extent to which the lessor bears this risk. For the les- sor, there will be a regular stream of lease payments, which include interests that often will be at rates above commercial lending rates, and, at the end of the lease term, usually some residual value. The IASB issued a new leases standard which supersedes the previous leases stand- ard. The previous leases standard, IAS 17, focused on identifying when a lease is eco- nomically similar to purchasing the asset being leased. When a lease was determined to be economically similar to the purchase of the asset being leased, the lease was classified as a finance lease and reported on the balance sheet. An asset was recognised to bring into account the underlying asset effectively purchased, together with the corresponding liability of the lease. All other leases were classified as Operating Leases and not reported on the company’s balance sheet, i.e., the expense was reported in the income statement as and when incurred.

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  Financial Reporting

  • Janice Loftus, Ken Leo, Sorin Daniliuc, Belinda Luke, Hong Nee Ang, Mike Bradbury, Dean Hanlon, Noel Boys, Karyn Byrnes(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  The objective is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of an entity. 11.1.1 What is a lease? Appendix A of AASB 16/IFRS 16 defines a lease as follows. A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Paragraphs B9 to B31 of AASB 16/IFRS 16 provide detailed guidance to help in assessing whether a contract is, or contains, a lease. The transfer of the right to use is essential in the definition and therefore the guidance focuses on clarifying the concept of the right to use. According to paragraph B9, that includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30). Right to obtain benefts from use of the asset The lessee may obtain the benefits either directly (e.g. by holding and using the asset itself) or indirectly (e.g. by subleasing the asset to another entity). A lessee is considered not to have the right to obtain benefits from the asset if they can only derive benefits by using the asset in conjunction with other goods and services provided by the supplier (and not available for separate purchase from the supplier or alternative suppliers). ILLUSTRATIVE EXAMPLE 11.1 Use of an asset in conjunction with other goods Neighbours Ltd, a healthcare provider, enter into a 4‐year contract with Refex Ltd, a supplier for specialised diag- nostic radiography equipment. Neighbours Ltd will hold and use the equipment at one of its private hospitals.

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  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Accounting by Lessors Lessors will classify each lease as an operating lease or a finance lease. A lease is classified as a financing lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. 19 Otherwise a lease is classified as an operating lease. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease include: • the lease transfers ownership of the asset to the lessee by the end of the lease term • the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised • the lease term is for the major part of the economic life of the asset, even if title is not transferred • at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset • the leased assets are of a specialized nature such that only the lessee can use them without major modifications being made At the inception of a lease, lessors are to recognize assets held under financing leases as receiv- ables at an amount equal to the net investment in the lease. Lessors are to recognize financing lease income over the lease term of a financing lease, based on a pattern reflecting a constant periodic rate of return on the net investment. At the inception of a lease, a manufacturer or dealer lessor will recognize selling profit or loss in accordance with its policy for outright sales to which IFRS No. 15 applies. A lessor will recognize operating lease receipts as income on a straight-line basis or, if more representative of the pattern in which benefit from use of the underlying asset is diminished, another systematic basis.

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  Financial Accounting Theory and Analysis

  Text and Cases

  • Richard G. Schroeder, Myrtle W. Clark, Jack M. Cathey(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  Finally, on the statement of cash flows, operating cash outflows decreased, and financing cash outflows increased. The use of Operating Leases is highly concentrated within some industry sectors. Among the industries identified by the IASB that have significant Operating Leases are 509 International Accounting Standards airlines, retailers, travel and leisure, transport, telecommunications, energy, media, distributors, information technology, and health care. The implementation of IFRS No. 16 had a major impact on these industries. Accounting by Lessors Lessors classify each lease as an operating lease or a finance lease. A lease is classified as a financing lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. 16 Otherwise a lease is classified as an operating lease. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease include: • The lease transfers ownership of the asset to the lessee by the end of the lease term • The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised • The lease term is for the major part of the economic life of the asset, even if title is not transferred • At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset • The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made At the inception of a lease, lessors are to recognize assets held under financing leases as receiv- ables at an amount equal to the net investment in the lease.

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