Chapter 13 

Leases 
Introduction
 Lease is an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments, the right to use an asset for an agreed period of
time. 
Leases include hire purchase contracts (i.e., contracts for the hire of an asset
which contain a provision giving the hirer an option to acquire title to the asset upon the
fulfillment of agreed conditions.) 

Classification of Leases
1. Finance lease – is a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. 
2. Operating lease - is a lease that does not that transfer substantially all the risks
and rewards incidental to ownership of an asset. 
The classification of a lease depends on the substance of the transaction
rather than the form of the contract. 

Finance lease 
Any of the following would lead to a finance lease classification: 
a. The lease transfers ownership of the asset to the lessee by the end of the lease
term. 
b. The lessee has the option to purchase the asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception of the lease, that the option will be
exercised ('bargain purchase option'). 
c. The lease term is for the major part of the economic life of the asset even if title is
not transferred. A lease qualifies to be accounted for as finance lease if the
contract is a non-cancellable contract. 
d. 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. 
e. The leased assets are of such a specialized nature that only the lessee can use
them without major modifications.
f. The leased assets cannot easily be replaced by another asset. 
g. If the lessee can cancel the lease, the lessor's losses associated with the
cancellation are borne by the lessee. 
h. Gains or losses from the fluctuation in the fair value of the residual (leased asset)
accrue to the lessee (for example in the form of a rent rebate equalling most of
the sales proceeds at the end of the lease). 
i. The lessee has the ability to continue the lease for a secondary period at a rent
that is substantially lower than market rent. 
(GAM for NGAs, Chapter 13, Sec. 5) 
Lease of Land and Building 
When a lease includes both land and buildings elements, each element shall be
classified separately as either operating or finance lease. 
The minimum lease payments are allocated based on the relative fair values of
the leasehold interests in the land and buildings elements at the inception of the lease. 
If the lease payments cannot be allocated reliably, the entire lease is classified
as a finance lease, unless it is clear that both elements are operating leases, in which
case the entire lease is classified as an operating lease. 
If the land element is immaterial, the land and buildings may be treated as a
single unit and classified as finance or operating lease. In such case, the economic life
of the buildings is regarded as the economic life of the entire leased asset. 
as finance or e buildings is 
 
 Inception of the lease - is the earlier of the date of the lease agreement and the
date of commitment by the parties to principal provisions of the lease.
It is on this date that:
a. A lease is classified as either an operating or a finance lease; and 
b. In the case of a finance lease, the amounts to be recognized at the
commencement of the lease term are determined. 
 Commencement of the lease term - is the date from which the lessee is entitled
to exercise its right to use the leased asset. It is on this date that any asset or
liability resulting from the lease is initially recognized. 

Accounting for Finance lease by Lessees 

At the commencement date, a lessee recognizes the asset acquired under a finance
lease and the related lease liability measured at the lower of the: 
a. fair value of the leased property at inception date; and
b. present value of the minimum lease payments at inception date.

Minimum lease payments include the following: 

a. Rentals, excluding contingent rent, costs for services and taxes reimbursable to
the lessor; 
b. Bargain purchase option; and 
c. Guaranteed residual value 

 Contingent rent - is lease payment that is not fixed in amount but rather based
on the future amount of a factor that changes other than with the passage of time
(e.g., percentage of future sales, amount of future use, future price indices, future
market rates of interest). Contingent rent is recognized as expense in the period
incurred. 

The minimum lease payments are discounted using interest rate implicit in the
lease, if this is determinable; if not, the lessee's incremental borrowing rate is used. 

Initial direct costs, such as costs incurred in negotiating and securing leasing
arrangements, are capitalized as part of the asset recognized 
 The lease liability is subsequently measured similar to an amortized cost financial
liability. Accordingly, the minimum lease payments are apportioned between interest
expense and a reduction of the outstanding liability. Interest expense in each period
reflects a constant periodic rate of interest on the remaining balance of the liability. 
The leased asset is accounted for similar to an owned asset, e.g., as PPE or
investment property. Accordingly, the leased asset is depreciated using the entity's
existing depreciation policies. If there is no reasonable certainty that the lessee will
obtain ownership by the end of the lease term, the asset shall be depreciated over the
shorter of its useful life and the lease term. 

Accounting for Finance lease by Lessors 

A lessor recognizes the lease payments receivable under a finance lease at an amount
equal to the net investment in the lease. 

Initial direct costs are included in the initial measurement of the finance lease
receivable and reduce the amount of revenue recognized over the lease term. The
interest rate implicit in the lease is defined in such a way that the initial direct costs are
included automatically in the finance lease receivable. Therefore, there is no need to
add the initial direct costs separately. 

 Interest rate implicit in the lease – is the discount rate that, at the inception of
the lease, causes the aggregate present value of: 
1. The minimum lease payments; and 
2. The unguaranteed residual value,
to be equal to the sum of (a) the fair value of the leased asset and (b) any initial direct
costs of the lessor. 
The lease receivable (net investment in the lease) is subsequently measured similar
to an amortized cost financial asset. Accordingly, the lease payments are applied
against gross investment in the lease to reduce both the principal and the unearned
finance revenue. 

Operating lease
A lessee (lessor) under an operating lease recognizes the payments as expense
(income) on a straight-line basis over the lease term, unless another systematic basis
is more representative of the time pattern of the user's benefit. 

Initial direct costs incurred by lessors are added to the carrying amount of the
leased asset and recognized as expense over the lease term on the same basis as the
lease income. Initial direct costs incurred by lessees (such as lease bonus paid to the
lessor) are treated as prepaid rent and recognized as expense on the same basis as the
lease expense. 
Chapter 13 Summary: 
 A lease that transfers substantially all the risks and rewards incidental to
ownership of an asset is a finance lease; a lease that does not is an operating
lease. 
 Any of the following would lead to a financial classification: 
1. Transfer of ownership
2. Bargain purchase option
3. The lease term is for the major part of the economic life of the asset ("75%
criterion').
4. The PV of the lease payments is at least substantially all of the fair value
of the leased asset ('90% criterion) 
5. The leased asset is specialized nature. 
 Inception of the lease is the earlier of the date of the agreement and the date of
commitment by the parties to the principal provisions of the lease. Classification
measurement are done on this date. 
 Commencement of the lease term is the date from which the lessee is entitled
to exercise its right to use the leased asset. Initial recognition of any asset or
liability is made on this date.
 A lessee recognizes an asset and a liability from a finance lease.
 Lease payments are discounted using the interest rate implicit in the lease, if
this is determinable; if not, the lessee's incremental borrowing rate is used. 
 Initial direct costs are generally capitalized. 
 The lessee depreciates the leased asset under a finance lease over the shorter
of the asset's useful life and the lease term if there is no reasonable certainty that
the lessee will obtain ownership over the asset by the end of the lease term. 
 A lessor recognizes the lease payments receivable under a finance lease at an
amount equal to the net investment in the lease. 
 A lessee (lessor) under an operating lease recognizes the lease payments as
expense (income) on a straight-line basis over the lease term, unless another
systematic basis is more representative of the time pattern of the user's benefit.