Explain how a lessor accounts for leases
The idea
The lessor still classifies each lease under both standards — finance or operating under IFRS, and sales-type, direct financing or operating under US GAAP — unlike the single on-balance-sheet model for lessees under IFRS 16. A lease that transfers substantially all the risks and rewards of the asset is a finance lease under IFRS; US GAAP calls the equivalent a sales-type lease, with a direct financing lease for cases that fall short of transferring control but still pass the economic substance to the lessee with the help of a third-party residual guarantee. In a finance or sales-type lease the lessor derecognises the asset, records a lease receivable (the net investment) and earns interest income on it at the implicit rate; a manufacturer or dealer also books selling profit at commencement. In a US GAAP direct financing lease the asset is also derecognised, but any selling profit is deferred and recognised through interest income over the term. In an operating lease the asset stays on the lessor's balance sheet and is depreciated, and lease income is recognised on a straight-line basis over the term, even when payments escalate.
A practice question
In an operating lease, the lessor:
- derecognises the asset at commencementWhy not: That is the treatment for a finance or sales-type lease, where the risks and rewards pass to the lessee.
- keeps the asset and depreciates it — correct
- records a lease liability for the paymentsWhy not: The lessee records the liability. The lessor is receiving payments, not owing them.
In an operating lease the asset stays on the lessor's balance sheet and is depreciated, and lease income is recognised on a straight-line basis over the term.
A harder one
Under IFRS, a lessor's finance lease requires five annual payments of 10,000 in arrears, and the rate implicit in the lease is 8%. The lessor's interest income in year 1 is closest to:
- 3,194 — correct
- 10,000Why not: Treats the whole payment as income, as in an operating lease. Most of it reduces the receivable.
- 2,015Why not: Spreads total interest of about 10,073 evenly. Interest is charged on the outstanding balance, so it is higher early.
Net investment = PV of 10,000 for 5 years at 8% = 39,927. Year 1 interest = 0.08 x 39,927 = 3,194; the rest of the payment, 6,806, reduces the receivable.
The hardest tier
Under US GAAP, a manufacturer enters a sales-type lease for equipment that cost it 35,000. The lessee pays 12,000 at each year-end for 4 years; the implicit rate is 6% and there is no residual value. Total year 1 income from the lease is closest to:
- 2,495Why not: Counts only interest income. A sales-type lease also recognises selling profit of 6,581 at commencement.
- 3,250Why not: Treats it as an operating lease: 12,000 of rent less 8,750 of depreciation.
- 9,076 — correct
Net investment = PV of 12,000 for 4 years at 6% = 41,581. Selling profit = 41,581 - 35,000 = 6,581. Year 1 interest = 0.06 x 41,581 = 2,495. Total = 9,076.
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