Accounting for Leases BACT 212

ACCOUNTING FOR LEASES

A lease is a contract in which the property owner (lessor) permits another person (lessee) to use
that property in exchange of money. Example of leases include house rent, car, photocopier etc.
Classification of Leases-Lessor
There are two types of leases: Finance lease and operating lease. A lease is classified as a finance
lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying
asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and
rewards incidental to ownership of an underlying asset. A finance lease is further characterized by
the following:
1. The agreement specifies that ownership of the asset transfers to the lessee.
2. The agreement contains a purchase option that the lessee is reasonably certain to exercise.
3. The lease term is for the “major part” of the remaining economic life of the underlying asset.
4. The present value of the total of the lease payments equals or exceeds “substantially all” of
the fair value of the underlying asset.
5. The underlying asset is of such a specialized nature that it is expected to have no alternative
use to the lessor at the end of the lease term.

Accounting for Operating Leases-Lessor

▪ Irrespective of the timing of the cash flows, income earned from operating leases is normally
recognized on the statement of comprehensive income on a straight-line basis over the term of
the lease.
▪ Costs incurred to earn the lease income (e.g., maintenance, insurance, and deprecation) are
expensed.
▪ Costs associated with negotiating and arranging the lease are initially added to the carrying
amount of the asset (capitalized) and subsequently recognized as an expense over the lease
term.
▪ The lessor reports assets leased out under operating leases on its statement of financial position
similar to assets acquired for the company’s own use.
▪ Assets under operating leases are depreciated or amortized over their useful lives similar to
those held for the company’s own use.

Illustration
On January 1, 2019, RMT Ltd purchased drafting equipment for sh.60,000 cash and immediately
leased it for the three years ending December 31, 2021, to Elis. Elis made a payment of sh.8,000
when it took delivery of the equipment, and is required to make payments of sh.9,500 each on
January 1, 2020, and January 1, 2021.
Other pertinent information:
• The equipment is non-specialized and can be used by other entities without significant
modification.
• At the end of the lease term, Elis. must return the equipment to RMT Ltd.
• The economic life of the equipment is estimated to be 10 years.
• The expected residual value of the equipment is sh.0.
• Both companies have a December 31 year end.
• RMT `ltd. paid sh.3,000 cash for equipment maintenance on June 30, 2020.
• RMT Ltd. depreciates all equipment on a straight-line basis.
• The present value of the lease payments (PVLP) using RMT ltd expected rate of return
on transactions of this nature is approximately sh.24,000.
Required: Make journal entries for the above transaction

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Accounting for Leases BACT 212

Accounting for Finance leases-Lessor

Yes
Yes
Is there transfer Finance(capital) Is there a profit
Manufacturer
of risks and lease margin on the
lease
rewards sale

No NO

Operating Lease Operating Lease

For a finance lease, the initial accounting for the lease is affected by whether there is a profit margin
on the sale of the asset. Where there is a profit margin, the lease is a manufacturer/ dealer lease.
Where the sale price is equal to the cost of the asset to the lessor, then the lease is a direct financing
lease.
Recognition and initial measurement of lease liabilities
The lessee’s liability for a lease at any point in time is the present value of the lease payments not
yet made. The lease liability initially recognized consists of the present value of the lease payments
that have not yet been paid at the commencement date of the lease, which is the date on which
the leased asset is first available for use by the lessee. Lease payments include:
a. Fixed payments less lease incentives-Fixed lease payments are the amount stipulated in the
lease contract that are paid on a regular basis (e.g., monthly or annually) for the right to use the
underlying asset. These payments include fixed lease payments but exclude lease incentives and
consideration for any non-lease components included in the lease contract. Amounts paid by
the lessee to the lessor for services provided by outside suppliers (e.g., property taxes or
insurance) that the lessor purchases or pays for on behalf of the lessee are also excluded from
the fixed payment amount.
b. Certain variable lease payments-Variable lease payments are lease payments where the
amount may change depending on facts or circumstances occurring after the commencement
date of the lease. For example, leases of retail space often include a requirement that the lessee
pay the lessor a percentage of its sales; the variable amount required to be paid depends on
future sales, which are not known until after the commencement date.
c. Any amount expected to be paid out under residual value guarantees-Residual value
guarantees are guarantees made by the lessee to the lessor that the value of the leased asset at
the end of the lease will be greater than or equal to the guaranteed amount.
d. The exercise price of a bargain purchase option-Bargain purchase options (BPO) allow the
lessee to purchase leased assets at a price below their expected market value at the end of the
lease. The exercise price of a BPO is included as a lease payment as it is expected that the option
will be exercised.
e. Penalties for terminating the lease-Penalties for terminating the lease are only included if
the lessee is expected to exercise its option to cancel.
Interest rate used by the lessee in present-value calculations
The implicit interest rate is used to calculate the lessee present value. It factors the cash flow stream
expected by the lessor and the fair value of the leased property. The lessor should always be able
to determine this rate, so the lessor must use the implicit rate. In this case, under IFRS, the lessee
uses incremental borrowing rate. Thus, under IFRS, the interest rate for the lessee is determined
using the implicit rate if available; otherwise, the incremental rate is used.

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1. Recognition and initial measurement of right-of-use assets-Lessor

The lessee initially measures its right-of-use asset (ROU asset) at cost. The cost of a ROU asset is
the present value of payments necessary to ‘acquire’ the ROU asset and to ‘dispose’ of it at the end
of the lease. The cost of ROU asset is calculated as follows:
a. The present value of the lease payments-The present value of the lease liability (PVLP)
includes all payments due under the lease. Payments made on or before commencement
date are also included in the determination of the cost of the ROU asset. In the absence
of initial direct costs, the cost of the ROU asset usually equals the PVLP.
b. Any initial direct costs incurred by the lessee-Initial direct costs are the incremental costs
of obtaining a lease that were incurred to obtain the lease e.g., legal fees and commissions.
c. The estimated costs of decommissioning and site restoration obligations, less- The present
value of the estimated decommissioning cost is added to the cost of the asset.
d. lease incentives received-Lease incentives are payments made by the lessor to the lessee as
an incentive to enter into the lease contract or to reimburse the lessee for costs incurred.

2. Applying the recognition and initial measurement criteria for ROU assets and lease
liabilities-Lessee
Upon commencement of the lease, the lessee initially measures and recognizes a ROU asset and
lease liability given the terms stipulated in the lease contract.
Illustration
Suppose that on January 1, 2019, Rachel leased an asset to Daniel for five years. The fair value of
the equipment, which could not be used elsewhere without significant modification, was
SH.250,000. The estimated economic life of the equipment is six years. Rachel required rate of
return on leases is 5%. Daniel incremental borrowing cost is 6%. Both companies have a
December 31 year end. Show the journal entries under the following scenerios
Scenario 1
• Rachel is a finance company and the lease is a direct financing lease.
• Payments of sh.51,547 are due annually with the first payment due on the commencement
date of the lease.
• Daniel has an option to purchase the asset at the end of the lease term for sh.20,000. The
estimated residual value at that time is sh.30,000.
• Daniel does not know the interest rate implicit in the lease.
Scenario 2
• Rachel is a finance company and the lease is a direct financing lease.
• Payments of sh.51,410 are due annually with the first payment due on December 31, 2019
• Daniel provides a residual value guarantee of sh.35,000.
• Daniel expects to pay out sh.5,000 on the residual value guarantee.
• Daniel knows the interest rate implicit in the lease.
Scenario 3
• Rachel is a finance company and the lease is a direct financing lease.
• Payments of sh.57,994 are due annually with the first payment due on the commencement
date of the lease. The sh.57,994 includes the sh.3,000 for the non-lease component
described below.
• The lease contract provides that Rachel will maintain the asset during the life of the lease.
Rachel normally charges sh.3,000 per year for this service, which is a non-lease component.
• Daniel does not elect to adopt the practical expedient available to it regarding accounting
for the lease component and related non-lease component as a single lease component.
• Ownership of the asset transfers automatically to Daniel at the end of the lease term.
• Daniel does not know the interest rate implicit in the lease.

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Scenario 4
• Rachel is a manufacturer and the lease is a manufacturer/dealer lease.
• The asset cost Rachel sh.200,000 to manufacture.
• Payments of 55,934 are due annually with the first payment due on December 31, 2019.
• Daniel has an option to purchase the asset at the end of the lease term for sh.10,000. The
estimated residual value at that time is sh.15,000.
• Daniel pays its lawyers sh.2,000 to review the lease documents. The sh.2,000 paid is an
initial direct cost (IDC).
• Daniel knows the interest rate implicit in the lease.

Scenario 5
• Rachel is a manufacturer and the lease is a manufacturer/dealer lease.
• The asset cost Rachel sh.190,000 to manufacture.
• Payments of sh.50,685 are due annually with the first payment due on the
commencement date of the lease.
• The unguaranteed residual value of the asset is sh.25,000.
• Daniel does not know the interest rate implicit in the lease.

3. Subsequent measurement of lease liabilities

Subsequent to the commencement date, the lessee must re-measure the two statement of financial
position items that arise from lease contracts: the ROU asset and the corresponding lease liability.
Lease liabilities are subsequently measured at amortized cost using the effective interest method.
For lessees, the effective rate of interest is the same rate used to measure the lease liability initially
i.e., the implicit rate, if readily determinable by the lessee, or the incremental borrowing rate.
Interest expense is recognized using the following formula:

Interest expense for the period = Opening lease liability × The effective rate of interest ×
Number of months in period / 12.

Re-measurements: Lease liabilities need to be re-measured if lease payments change. These

changes can be due to reassessments or modifications of the lease. A reassessment occurs when
the variable lease consideration differs from that originally estimated and a modification of the
lease transpires when the lessor and lessee agree to change the original terms. In both instances,
the lease liability must be adjusted to reflect the amended payment stream and the ROU asset must
be changed by the same amount.
4. Subsequent measurement of right of use
Right-of-use assets will normally be subsequently measured using the cost model
which is:
original cost - accumulated depreciation- accumulated impairment losses, and
adjusted for re-measurements of the lease liability.

Most lessees depreciate the ROU asset using the straight-line method. The two aspects that must
be considered are:
a. Depreciable amount- The depreciable amount of an asset is its cost less its residual value.
The residual value is the value of the asset, less disposal costs, that the entity expects to
obtain at the end of the asset’s useful life.
• If the leased asset transfers to the lessee at the end of the lease term, then the residual
value at the end of the asset’s useful life should be used to determine the ROU asset’s
depreciable amount.

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Accounting for Leases BACT 212

• If the leased asset does not transfer to the lessee at the end of the lease term, then a
residual value of sh.0 should be used to determine the ROU asset’s depreciable
amount.
b. Depreciation period-The process of depreciation is a method of allocating the depreciable
amount of the asset over its useful life, where useful life is defined as the period over which
an asset is expected to be available for use by the entity.
• When the lessee gains title to the asset at the end of the lease term, then the period of
expected use is the asset’s useful life.
• If title does not transfer, the ROU asset is depreciated over the shorter of the lease term
and its useful life.
5. Applying the subsequent measurement criteria for right-of-use assets and lease
liabilities
Use scenario 1, scenario 3 and scenario 4 above to prepare the journal entries to account for
ROU assets and lease liabilities.

6. Practical Expedients
The lessee normally accounts for leases by recognizing a right-of-use asset and a lease liability. In
limited circumstances, however, IFRS permits the lessee to deviate from this approach and simply
expense the entire lease payment. Additionally, lessees may elect to account for the lease and
related non-lease components as a combined item, rather than accounting for them separately.
These options are referred to as practical expedients
a. The lease may elect to expense short-term leases
The total expense for the lease is recognized as an expense using the straight-line method over the
term of the lease. A short-term lease is defined as one that, at the commencement date:
• Has a maximum term of one year, including renewal options that the lessee is reasonably
certain to exercise; and
• does not include an option to purchase..
The IASB offered an exemption to lessees from the normal capitalization requirements for short-
term leases due to cost-benefit considerations.

Illustration
Canaan limited (CL) leases office furnishings from an office supply outlet for a one year period.
The lease does not include a renewal option, nor does it include an option to purchase. Payments
of sh.1,000 per month are first due on January 1, 2019, the commencement date of the lease. CL
has a 6% incremental borrowing rate for this type of asset (0.5% per month) and cannot easily
determine the interest rate implicit in the lease.
Required: Prepare journal entries for the above transaction

b. The lessee may elect to expense leases of low-value assets

Lessees may also elect to expense leases of low-value assets.
c. The lessee need not separately account for the lease and related non-lease components
in a lease contract
Lease contracts often include two or more components. Sometimes, the other component is
another lease or it can include a lease and a related non-lease component. For example, a lease of
office equipment often includes a clause that the lessor will regularly service the equipment.
Component practical expedient allows the equipment lease and service contract to be combined
for accounting purposes.
Illustration
Using scenario 3 show the journal entries as a single component

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Accounting for Leases BACT 212

7. Derecognition
The three most common scenarios for derecognising a lease at the end of the lease term are:
a. the asset is returned to the lessor-In the absence of a BPO or residual value guarantee, the
lease liability should have a sh.0 balance and a fully depreciated asset will be returned to the
lessor. Derecognition of the ROU assets involves debiting the accumulated depreciation
account—ROU asset and crediting the ROU asset account for the same amount.
Illustration
A ROU asset that was originally recognized at sh.20,000 is returned to the lessor. Show the journal
entry to derecognize the ROU asset

If the lease agreement includes a BPO, but the lessee does not elect to exercise the option, the
ROU asset will have not been fully depreciated and the balance of the lease liability will be the
option exercise price. The procedure is to remove the ROU asset and accumulated depreciation
from the lessee’s books and derecognize the remaining lease liability. The difference, if any, will
be reported as a gain or loss on derecognition of the lease liability.
Illustration
Assuming balances of: ROU asset sh.50,000; accumulated depreciation sh.40,000; and lease
liability (the option exercise price) sh.6,000, show the entry to derecognize the ROU asset and
liability

if a lease agreement includes a residual value guarantee, the amount to be paid out under the
guarantee may differ from that previously expected. The process for derecognition is to remove
the ROU asset and accumulated depreciation from the lessee’s books, and derecognize the
remaining lease liability.
• A gain or loss will never be recorded on disposition of the asset as the asset has been fully
depreciated and its net book value, when returned, is 0. If the residual asset is worth more
than the guaranteed amount, the excess accrues to the lessor, rather than the lessee.
• The cash payment required under the guarantee must be recognized with the net difference
between it and the remaining liability—the previously expected payout under the
guarantee—being reported as a gain or loss on derecognition of the lease liability.
Illustration
A lessee is required to pay out sh. 12,000 under a residual value guarantee, which is more than the
sh.7,000 previously estimated. Assuming an ROU asset balance of sh. 50,000 and accumulated
depreciation of sh.50,000.
i. Show the entry to derecognize the ROU asset and liability
ii. Show the journal entry to derecognize the ROU asset assuming that the required payout is
only sh.4,000.

b) The lessee obtains title to the ROU asset

The lessee can gain title to the ROU asset at the end of the lease term when there is a contract
provision that provides for the transfer, or when the lessee exercises an option to purchase, which
is not necessarily a bargain purchase option. The accounting treatment for title transfers is to
derecognize the ROU asset and related accumulated depreciation and to recognize an owned asset
for the net of these amounts. For BPOs, the remaining lease liability will equal the option exercise
price and the liability will be derecognized when the lessee pays this amount to the lessor. For
explicit transfers, the lease liability should be sh.0 as it would have been derecognized when the
last payment was made.

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Accounting for Leases BACT 212

Illustration
Consider a situation where there is a sh.10,000 BPO. Assume an ROU asset balance of sh.50,000
and accumulated depreciation of sh.35,000. Show the entry to derecognize the ROU asset and
liability

c) The lease term is extended and the lessee continues to lease the ROU asset.
When the lease term is extended, neither the ROU asset or lease liability is derecognized. Rather,
the lease liability is re-measured as set out in IFRS 16 and the ROU asset is revalued.
Lessee timing Journal entries
At start of lease Recognize ROU asset
Recognize lease liability
Lease payment paid, if applicable
During lease Lease payments paid
Interest expense
Depreciation/Amortization expense
At end of lease Derecognize ROU asset and accumulated depreciation
Derecognize lease liability, if applicable

8. Presentation and disclosure of leases – Lessee

1. Presentation
Right-of-use assets are either reported separately on the statement of financial position (SFP) or
included with other assets that are owned. If the ROU assets are not separately reported, the lessee
must disclose which line items on the SFP include ROU assets. The current and non-current
portion of the lease liability are either reported separately on the SFP or included with other
liabilities. If the lease liabilities are not separately reported, then the lessee must disclose which line
items on the SFP include lease liabilities. The determination of the current and non-current portion
of the lease liability is made in the same manner as that of the lessor’s lease receivable
2. Disclosure
Lessees must report comprehensive information about the nature of the leases they are party to.
Summary of lessee disclosure requirements for leases
Statement of financial position (SFP)
• A schedule setting out the maturity dates of lease liabilities grouped into appropriate time
bands (e.g., not later than one year; later than one year and not greater than two years…).
• Additions to ROU assets during the year.
• The carrying value of ROU assets at SFP date segregated as to class of asset.
Statement of comprehensive income
• Depreciation expense segregated as to class of asset.
• Interest expense on lease liabilities.
• Expense for short-term leases accounted for using the practical expedient.
• Expense for leases of low-value assets accounted for using the practical expedient.
• Gains and losses on sales-leaseback transactions

8. Accounting for sale and leaseback transactions

A company that is short of cash but that has substantial fixed assets can obtain financing through
sale and leaseback arrangements without affecting its operating capabilities. A sale and leaseback
involves the sale of an asset and immediate leasing of that asset from the new owner. The prior
owner of the asset becomes the lessee, and the buyer is the lessor. The problem in a sale and
leaseback is that the two transactions are bundled, with the same two parties involved in both
transactions. As a result, the sales price may not reflect the fair value of the asset, as the buyer-

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Accounting for Leases BACT 212

lessor can adjust the future lease payments to compensate for the difference. There are two
important determinations that need to be made for a sale and leaseback contract:
a. Does the transfer of assets in the sale and leaseback arrangement qualify as a sale?- A sale is
recognized when the the seller-lessee satisfies the performance obligation by transferring the
promised good or service (the asset in the sale leaseback agreement) to the customer (the
buyer-lessor) and the customer takes control of the asset. A sale is not recognized if the sale
and leaseback agreement includes any of the following
• The seller-lessee has an option to repurchase the asset at a price stipulated in the sale
and leaseback agreement.
• The seller-lessee must subsequently repurchase the asset at a price stipulated in the
sale and leaseback agreement.
• The seller-lessee must repurchase the asset if requested to do so by the buyer lessor
and the stipulated price is lower than the original selling price of the asset.
• The seller-lessee must repurchase the asset if requested to do so by the buyer lessor
and the stipulated price is equal to or greater than the original selling price and is more
than the expected market value of the asset at the time of repurchase.
b. If the transfer of assets is a sale, does the buyer/lessor account for the lease as an operating
lease or finance lease? the buyer-lessor uses the same criteria to determine whether the lease
is an operating lease or a finance lease as those used by other lessors.

9.Accounting for a sale and leaseback transaction- Sales criteria met

Buyer-Lessor
When the sales criteria are met in a sale and leaseback transaction, the buyer-lessor records the
purchase in the normal manner. The buyer-lessor accounts for the leaseback as an operating lease
or finance lease.
Illustration
IAF Ltd. (IAF), the buyer-lessor, purchased equipment from JLH ltd (JLH), the seller-lessee, for
sh.500,000 cash on January 1, 2019, and entered into an agreement that grants JLH the right to
use that equipment for five years. Relevant information includes:
▪ Payments under the lease are sh.80,000 per year, first payable on December 31, 2019.
▪ The interest rate implicit in the lease is 6%, and JLH is able to readily determine this.
▪ The fair value of the equipment at the time of sale was sh.500,000.
▪ The required lease payments reflect market rates.
▪ The estimated remaining useful life of the equipment at the time of sale was 10 years. The
estimated residual value at the end of its useful life is sh.0.
▪ The book value of the equipment at the time of sale was sh.600,000 cost less sh.200,000
accumulated depreciation.
▪ Both companies have December 31 year ends.
▪ In Scenario 1, JLH must return the leased asset to IAF at the end of the lease term;
however, the residual value is not guaranteed.
▪ In Scenario 2, JLH must return the leased asset to IAF at the end of the lease term and
guarantees the residual value of the asset will be sh.218,145. The expected payout under
the guarantee is sh.0
.
Seller-lessee
Because of its right to use the asset during the lease term, the seller-lessee does not transfer 100%
of its claim on the asset to the purchaser-lessor. Thus, the seller-lessee can only recognize the
portion of the gain on sale that relates to the ownership rights that were transferred to the buyer-
lessor. The process of allocating the gain on sale between the two claims is as follows. Determine
the value of the ROU asset

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Accounting for Leases BACT 212

1. Calculate the seller-lessee’s remaining interest in the equipment:

2. Determine the buyer-lessor’s interest in the equipment:
3. Compute the gain on sale relating to the rights transferred to the buyer-lessor to be recognized
by the seller-lessee:
Illustration
Use Scenario 1 to apply the above process

Accounting for a sale and leaseback transaction- Sales criteria not met
Buyer-lessor
The buyer-lessor does not recognize either a lease receivable or an asset purchase. Rather, it
recognizes a financial asset. Typically, the buyer-lessor will report the financial asset at amortized
cost. The lease payments stipulated in the lease agreement are accounted for as payments received
on the loan
Seller – Lessee
The seller-lessee does not recognize a sale. Rather, it continues to report the underlying asset on
its statement of financial position and depreciates it in the same manner as before. The
consideration received from the buyer-lessor for the sale is accounted for as a loan. A financial
liability is recognized and is normally reported at amortized cost. The lease payments stipulated in
the lease agreement are accounted for as payments made on the loan.
Illustration
Graydon Hunnicutt ltd (GHL) previously owned its land and office building. On January 1, 2019,
the firm entered into a sale and leaseback arrangement on the building with W.Arch ltd (WBI) to
secure the funds required to buy out two retiring partners. Pertinent details are as follows:
▪ The sales price was sh.16 million, which was the fair market value of the asset.
▪ GHL must repurchase the land and building at the end of the lease term for sh.5 million.
▪ GHL committed to rent the space for the remaining 20 years of the building’s useful life for
sh.1,297,497 per year first due on the commencement date. These payments imply an interest
rate implicit in the lease of 7.0%, which is known to both parties. This lease payment reflects
market rents.
▪ Before the sale and leaseback, the respective net book value of GHL’s land and building were
sh.1 million and sh.2 million (sh.5 million cost, less accumulated depreciation of sh.3 million).
GHL depreciates its building using the straight-line method; the estimated residual value at
the end of its useful life is sh.0.
▪ Both companies’ year ends are December 31
Show the journal entries to record this transaction at the commencement date of the lease and
December 31, 2019, for both the buyer-lessor and the seller-lessee.

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