Question

1. Lessor enters into a seven-year lease for equipment with Lessee. Lessor sells and leases the equipment, which is not specialized in nature and is expected to have an alternative use for Lessor at the end of the lease term. Under the lease:

• Lessor receives annual lease payments of $25,000, with the first one payable at the commencement of the lease and one payment annually at the lease anniversary date thereafter.
• Lessor expects the residual value of the equipment to be $75,000 at the end of the lease term.
• Lessee provides an RVG that protects Lessor for the first $35,000 of loss below the estimated residual value at the end of the lease term of $75,000.
• The equipment has an estimated remaining economic life of nine years, a carrying amount of $150,000 and a fair value of $160,000.
• Lessor incurred costs of $3,000 for a broker’s commission as a result of obtaining the lease. These costs qualify as initial direct costs.
• The lease does not transfer ownership of the underlying asset to Lessee at the end of the lease term or contain an option for Lessee to purchase the equipment.

At lease commencement, Lessor concludes that it is probable that it will collect the lease payments and any amount probable of being owed under the RVG provided by Lessee.

• How should Lessor classify this lease?
• Prepare the journal entries at the time of the lease commencement and for Years 1 and 2 of the lease term.

Answer 1

Let’s understand the difference between Operating & Capital Lease

	Operating Lease	Capital (Finance) Lease
Ownership	The ownership of the asset remains with the lessor for the entire lease period.	The ownership transfer option at the end of the lease period is available to the lessee. The title may or may not be transferred eventually.
Explanation	A lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called an operating lease. In this type of lease, the asset is returned by the lessee after using it for the agreed-upon lease term.	In a financial lease (also known as a capital lease), the risks and rewards related to ownership of the asset being leased are transferred to the lessee.
Lease Term	The lease term extends to less than 75% of the projected useful life of the leased asset.	The lease term is generally the substantial economic life of the asset leased.
Accounting	An operating lease is generally treated like renting. That means the lease payments are treated as operating expenses and the asset does not show on the balance sheet.	A financial lease is generally treated like loan. Here, asset ownership is considered by the lessee, so the asset appears on the balance sheet.

Determine which of Lease agreement is in between Lessor & Lessee

As per IFRS: If all the risk & rewards are transferred to lessee, then such lease is finance lease.

As per US GAAP: If any of the following condition gets fulfilled then such lease will be finance lease:

• Lessee becomes the owner of the leased asset at the end of the lease.
• Lease allows the lessee to purchase the same leased asset at a price which is less than the fair value of the asset in future.
• The term of the lease is 75% or more of the leased asset’s useful life.
• Present value of the lease payments is 90% or more of the fair market value of the asset.

In the given scenario:

Condition 1 & 2 does not meet: As it is clearly mentioned that "The lease does not transfer ownership of the underlying asset to Lessee at the end of the lease term or contain an option for Lessee to purchase the equipment."

Condition 3: The lease term of 7 years is more than 75% of total life of equipment of 9 years

Condition 4: The present value of total lease payment shall be more than 90% of Fair value of asset as of today. This cannot be checked as in question no discounting factor is provided.

Condition 3 meets the requirement of US GAAP through which lease shall be considered as Finance Lease.

As per IFRS: Lessor shall classify this asset as “Operating lease” And shall account in following manner:

In Balance Sheet: The asset shall be reflected as asset as lessor used to report earlier

In Profit & loss Statement:

1. The lease payments received from Lessee shall be provided as revenue as below:

Lease Payment   (Dr)        $25000

Cash/Bank Account (Cr)                 $25000

               Profit & Loss A/c (Dr)       $25000

               Lease Payment (Cr)                         $25000

2. Brokers cost shall be account in Profit & loss A/c as expenditure for leasing asset:

Cash/ Bank Account (Dr) $3000

Broker’s Commission (Cr)                             $3000

Broker’s Commission (Dr)                             $3000

Profit Loss Account (Cr.)                               $3000

As per US GAAP: Lessor should classify the lease as Finance Lease and shall account in following manner:

Balance Sheet: The present value of total lease payment receivable from lessee shall be reported in Balance sheet in asset side and the book value of asset shall be reduced from total asset: In the scenario the interest rate is not provided therefore present value can’t be achieved.

Profit & loss Statement: The interest revenue is reported. It is calculated on the lease receivable at the beginning using interest rate in the lease agreement.

Further, the interest component of the lease revenue is reported as an operating cash inflow and the principal component of the payment is reported as an investing cash inflow.