Leases



KAS 13 - LEASES

EXPLANATORY NOTE

Explanatory notes to the Kosovo Accounting Standards are intended to provide additional understanding of the standards and technical guidance as to their use and application. In case of any divergence between Explanatory Notes and Standards, the Standards prevail.

1. A lease is an agreement between two parties, the lessor and the lessee. The lessor agrees to give the right to use an asset to the lessee for an agreed period of time in return for compensation.

2. There are two classifications of leases:

Finance lease: A lease that in substance transfers all risks and rewards of ownership to the lessee.

Operating lease: A lease that does not transfer substantially all risks and rewards of ownership rights to the lessee. In other words, all leases that do not meet the definition of a finance lease.

Classifying Leases

Finance Leases

3. A lease that meets any of the following five criteria is considered a finance lease. If none of the criteria are met, the lease is an operating lease. Criteria used in determining whether a lease is a finance lease are:

1. By the end of the lease period the right of lease asset ownership passes to the lessee.

2. The lease includes a purchase option giving the lessee the right to purchase the asset at a price that makes it reasonably certain that the purchase option will be exercised. The purchase option is considered as reasonably certain to be exercised if it is a good bargain to the purchaser. This essentially means the option is priced at an amount that is less than the expected fair market value of the asset at the time the option becomes exercisable. This price is called a bargain purchase option.

3. The lease period covers most of the economical useful life of the leased asset. This is generally interpreted to mean a period that covers 75% or more of the economical useful life.

4. The present value[1] of minimum lease payments is 90% or more of the fair market value of the leased asset at the start of the lease. Minimum lease payments are the total of contractual lease payments; guaranteed amounts, and; a bargain purchase option, if present. Guaranteed amounts are payments that are required in the contract in addition to the lease payments. For example, the contract may require that the lessee guarantee that the sale value of the asset is a certain minimum amount at the end of lease. If the asset is in poor condition the lessee must pay a guaranteed amount.

5. The leased asset is so specialized for the lessee’s use that it could only be used by another party if major modifications are made.

Operating Leases

4. A lease that does not meet at least one of the criteria listed above is classified, by default, as an operating lease. An operating lease is accounted for as a rental agreement.

5. For reporting purposes by the lessee, the expense recognized under an operating lease is the actual rental expense incurred for the accounting period, utilizing the accrual basis.

Example of Lessee Reporting - Operating Lease

Company A paid 12,000 in advance to lease warehouse space for six months. Company A will recognize rent expense of 2,000 each month during the lease period.

Example of Lessor Reporting - Operating Lease

Company B received 12,000 in advance for leasing warehouse space for six months. Company B will recognize rent income of 2,000 each month during the lease period.

For reporting by the lessor, rental income should be recognized on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the earnings process contained in the lease.

Assets used for operating leases should be recognized as property, plant, and equipment in the balance sheet of lessors. The lessor should record the depreciation of leased assets on a basis consistent with the lessor's normal depreciation policy for similar assets, and the depreciation charge should be calculated on the basis described in KAS 3, Property, Plant, and Equipment.

Operating Leases - Land

6. A characteristic of land is that it normally has an indefinite useful life and, if title is not expected to pass to the lessee by the end of the lease term, then the lessee does not receive substantially all of the risks and rewards incident to ownership and the lease is therefore properly classified as an operating lease.

Operating Leases - Sale and Leaseback

7. A sale and leaseback transaction occurs when an enterprise sells an asset to another party, then continues to use the asset under a lease agreement.

8. A sale and leaseback transaction occurs when an asset is sold, but the seller immediately enters into a lease transaction and continues to use the asset. In a sale and leaseback finance lease transaction, typically the asset is sold at market value. In many cases sale and leaseback transactions are used to provide cash to the selling enterprise.

9. When a sale and leaseback results in an operating lease, and it is clear that the transaction is established at fair value, any profit or loss on the asset sale should be recognized immediately by the lessee. In the case of a sale and leaseback transaction the party that has sold the asset and continues to use it is the lessee. The lessee recognizes a profit or loss from selling the asset.

Profit or loss = [(carrying amount of the asset) - (fair value)]

The lessor in a sale and leaseback transaction should account for it in the following manner:

1. Record the purchase of the asset

2. Record the operating lease payments as rental income

3. Depreciate the leased asset

Example of Sale and Leaseback, Lessee Reporting at Fair Value– Operating Lease

Company A sells its office building to Company B and the enterprises sign a lease agreement which allows Company A to continue using the building for a monthly payment of 4,000. The lease does not meet the criteria for a finance lease and is therefore an operating lease for Company A.

The sale price of the building is 250,000 and is equal to the fair value of the building. The cost of the building on Company A’s accounting records is 400,000 and the accumulated depreciation is 180,000. Therefore, the carrying value of the office building on Company A’s records is 220,000. Company A will record the following transaction when the building is sold:

Debit Cash 250,000

Debit Accumulated depreciation on building 180,000

Credit Building 400,000

Credit Gain on sale of building 30,000

Company A will record the following transaction each month to recognize the rental expense for the building under the operating lease:

Debit Lease rental expense 4,000

Credit Cash 4,000

Company B will record the purchase of the building asset for 250,000 and will recognize depreciation expense on the building. Company B will also recognize rental income each month as follows:

Debit Cash 4,000

Credit Lease rental revenue 4,000

If the sale price is below fair value, then any profit or loss should be recognized immediately. However, if the loss is compensated by future rentals at below market price, it should be deferred and amortized by the lessee in proportion to the rental payments over the period that the asset is expected to be used.

Example of Sale and Leaseback Lessee Reporting with Deferred Loss– Operating Lease

Company A sells its office building to Company B and the enterprises sign a lease agreement which allows Company A to continue using the building for a monthly payment of 3,000. The normal market price for leasing a similar asset is 4,000. The lease does not meet the criteria for a finance lease and is therefore an operating lease.

The sale price of the building is 200,000. This is less than the fair value of the building, which is 250,000. The cost of the building on Company A’s accounting records is 400,000 and the accumulated depreciation is 180,000. Therefore, the carrying value of the office building on Company A’s records is 220,000. Since the loss on selling the building is compensated by future rental payments that are below market price, Company A will defer the loss and amortize it over the lease period in proportion to the rental payments. Alternatively, if the fair value at the time of the transaction is less than the carrying amount, a loss equal to the difference should be recognized immediately if the loss is not compensated by future rental payments below market value. Company A will record the following transaction when the building is sold:

Debit Cash 200,000

Debit Accumulated depreciation on building 180,000

Debit Deferred loss on sale of building 20,000

Credit Building 400,000

Company A will record the following transactions each month to recognize the rental expense for the building under the operating lease and to amortize the deferred loss. The term of the lease is for five years:

Debit Lease rental expense 3,000

Credit Cash 3,000

Debit Loss on sale of building (20,000 / 60 months) 3,333

Credit Deferred loss on sale of building 3,333

Company B will record the purchase of the building asset for 200,000 and will recognize depreciation expense on the building. Company B will also recognize rental income each month as follows:

Debit Cash 3,000

Credit Lease rental revenue 3,000

If the sale price is above fair value, then the excess over fair value should be deferred and amortized by the lessee over the period that the asset is expected to be used.

Summary of Reporting Requirements for Sales-Leaseback Transactions

Sale and Leaseback - Lessee Reporting

10. In a sale and leaseback transaction the seller is the party that becomes the lessee. The following guidelines apply to accounting by the lessee:

1. Sale of the asset is recorded

2. The asset is removed from the balance sheet accounting records

3. The balance of any accumulated depreciation on the asset is eliminated

4. Gain or loss is recognized on the sale, calculated as the difference between the fair value and carrying amount of the asset at time of sale

11. If the sale proceeds are greater than the seller’s carrying amount of the asset, the seller should not report the entire gain in the reporting period of the sale. Instead, the gain should be deferred and recognized over the term of the lease.

Sale and Leaseback - Lessor Reporting

12. For the lessor, treatment of this type of lease transaction is identical to other finance leases and should be accounted for as follows:

• The balance of the lessor’s net investment in the lease is reported as a receivable.

• The recognition of finance income should be based on a schedule reflecting a steady effective yield on the lessor’s net investment outstanding.

• Lease payments received should be apportioned between a reduction of the receivable and finance income.

Finance Leases

13. A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset to lessee, who keeps the asset in working condition. A finance lease is a contract for use of an asset over a period of time. Although the terms of the contract may not state so, if certain criteria that have been previously discussed are met the lease is presumed to transfer ownership of the asset from the lessor to the lessee.

14. The amount of lease payments that exceed the fair value of the asset are reported as interest. On a finance lease, the lessor is presumed to sell an asset and earn interest revenue. The lessee is presumed to purchase the asset and pay interest charges.

Finance Leases: Basic Accounting Concepts

15. Following are the basic concepts of accounting for finance leases:

• A finance lease is considered to be a sale of the asset by the lessor and a purchase of the asset by the lessee.

• The lessee enters the asset on its accounting records and depreciates it according to the enterprise’s fixed asset policy.

• The lessor removes the fixed asset from its records when the lease is originated.

• The lease acts as a type of financing instrument, which the lessee pays off through periodic lease payments.

• The lessee establishes a payable and the lessor a receivable for the present value of the lease payments.

• Lease payments are apportioned between a reduction of the outstanding payable and a finance charge, recorded as interest.

Finance Leases - Lessee

16. The lessee in a finance lease arrangement should account for it in the following manner:

• A finance lease should be recognized as a fixed asset and a lease payable liability in the balance sheet of a lessee. It should be reported at the lesser amount of the asset’s fair value or the present value of the minimum lease payments. Minimum lease payments are the total of rental payments plus any guaranteed amounts that are required to be paid, or bargain purchase option.

• At the inception of the lease, the asset and the liability are recognized at the same amounts.

• In following periods, the asset value is reduced by the amount of depreciation charge. The liability is reduced by the allocated amount of payments made.

• The long term and short term portions of the lease obligation are shown separately on the balance sheet.

• A finance lease results in a depreciation expense for the asset as well as a finance expense for each accounting period. The depreciation policy for leased assets should be consistent with that for depreciable assets that are owned by the enterprise.

• If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset should be fully depreciated over the shorter of the lease term or its useful life.

• Lease payments should be split into their two components, interest expense on the outstanding lease liability and a reduction of the lease liability balance.

• The amount recognized as interest expense should be calculated as the amount that will create a level effective yield over the lease term. Some form of approximation may be used.

Example of Finance Lease - Lessee

On January 1, XXX1 Company A and Company B entered an agreement in which Company B (the lessor) leased to Company A (the lessee) a machine with a fair value of 10,000. The term of the lease is five years and Company A is required to pay 3,000 each year at the end of the year. The machine will be leased for its entire useful life and is expected to have no residual value at the end of the lease. The lease cannot be canceled by the lessee.

The total of minimum lease payments is15,000 (3,000 per year for five years). Since the fair value of the machine is 10,000, the total finance charge associated with the lease is 5,000.

When the lease begins, Company A (the lessee) recognizes on its accounting records:

5. A fixed asset of 10,000

6. A liability of 10,000 for the lease obligation

In each year, Company A records 2,000 of depreciation on the fixed asset. Company A uses the straight-line depreciation method and the machine has a 10 year useful life.

Each rental payment of 3,000 is allocated between the finance charge and reduction of the lease payable liability. The implicit interest rate is determined to be 15.24%. This is the rate that brings the net present value of the lease payments equal to the asset’s fair value of 10,000.

The following schedule shows the allocation of each 3,000 payment during the term of the lease.

Allocation Schedule for Lease Payments

|Year |Liability at beginning of year|Finance Charge for the year|Payment |Liability at end of year |

| | | | | |

|01 Jan 1 |10,000 |1,524 |3,000 |8,524 |

|31 Dec 2 |8,524 |1,299 |3,000 |6,823 |

|31 Dec 3 |6,823 |1,040 |3,000 |4,863 |

|31 Dec 4 |4,863 |741 |3,000 |2,604 |

|31 Dec 5 |2,604 |396 |3,000 |--- |

Total finance charge over the lease term 5,000

The initial entry to record the lease for the lessee company is as follows

Debit Machinery 10,000

Credit Lease obligation 8,524

Credit Current portion of long term debt[2] 1,476

Payment of the first year lease amount (assume that finance charges have NOT been accrued each month)

Debit Interest expense-lease 1,524

Debit Lease obligation 1,476

Credit Cash 3,000

Payment of the second year lease payment

Debit Interest expense-lease 1299

Debit Lease obligation 1701

Credit Cash 3,000

Note: Adjusting entries are used at year-end to move the amount of principal payment due within the next year to the current liability account.

First year depreciation on the leased asset (2nd year entry will be identical)

Debit Depreciation expense 2,000

Credit Accumulated depreciation-machinery 2,000

The balances in certain accounts on the lessee’s balance sheet at the end of the second year, before adjustment for the current portion of the liability, are as follows:

Accumulated depreciation: 4,000

Lease obligation : 6,823

Fixed asset (machine): 10,000

Finance Leases – Lessee Balance Sheet Presentation

17. In calculating the discounted value of minimum lease payments, the determining factor is the interest rate implicit in the lease, if this is practicable to determine. If not, the lessee’s incremental borrowing rate is used. The incremental borrowing rate is the interest rate that the lessee would be required to pay to a bank in order to borrow funds necessary for the acquisition of this asset.

18. The present (discounted) value amount of the minimum lease payments should be recorded as an asset in the balance sheet of lessee. The leased property may be combined with other fixed assets on the balance sheet, but the cost of the leased property and its depreciation should be indicated in the footnotes.

19. Lease liabilities should be shown in the “Liabilities” section of the balance sheet. Within the liability section of the balance sheet, the principal payment amount of the lease obligation due within one year should be shown as a short-term liability and the remaining balance due as a long-term liability. Based on the above example, the 31 December 2 Balance Sheet would look as follows:

|ASSETS |LIABILITIES |

|Fixed assets at the initial cost* |10,000 |Short-term liabilities on finance lease |1,040 |

|Less: accrued depreciation |(4,000) | | |

|Net cost of fixed assets |6,000 |Long-term liabilities on finance lease |4,863 |

| |

|* Note, in a normal balance sheet, the leased fixed asset would be merely added to the fixed asset balances of similar assets |

|owned by the company. The note to fixed assets would highlight the amount of leased fixed assets |

Finance Leases - Lessor

20. The lessor in a finance lease arrangement should account for it in the following manner:

• An asset that is used by another party under a finance lease agreement should not be included on the lessor’s balance sheet as property, plant and equipment. Instead, the balance of the lessor’s net investment in the lease is reported as a receivable. The lessor’s net investment in the lease is the total of minimum lease payments plus any residual amount that is not guaranteed to be received minus the total amount of finance income to be received over the term of the lease.

• The recognition of finance income should be based on a schedule reflecting a steady effective yield on the lessor’s outstanding net receivable.

• Lease payments received should be apportioned between a reduction of the receivable and finance income.

Example of Finance Lease - Lessor

On January 1, XXX1 Company A and Company B entered an agreement in which Company B (the lessor) leased to Company A (the lessee) a machine with a fair value of 10,000. The term of the lease is five years and Company A is required to pay 3,000 each year at the end of the year. The machine will be leased for its entire useful life and is expected to have no residual value at the end of the lease. The lease cannot be canceled by the lessee.

Gross investment in the lease is 15,000. This is comprised of total of minimum lease payments is15,000 (3,000 per year for five years) andthere is no unguaranteed residual value. Since the fair value of the machine is 10,000, the total unearned finance income associated with the lease is 5,000. Therefore, the net investment in the lease is 10,000. The interest rate implicit in the lease is 15.24%.

When the lease begins, Company B (the lessor) recognizes for accounting:

7. A receivable of 10,000

8. A credit for their cost of the leased asset

In each year, Company B allocates each payment of 3,000 between interest income and a reduction of the receivable.

The following schedule shows the allocation of each 3,000 payment during the term of the lease.

Allocation Schedule for Lease Payments

|Year |Liability at beginning of year|Finance Charge for the year|Payment |Liability at end of year |

| | | | | |

|01 Jan 1 |10,000 |1,524 |3,000 |8,524 |

|31 Dec 2 |8,524 |1,299 |3,000 |6,823 |

|31 Dec 3 |6,823 |1,040 |3,000 |4,863 |

|31 Dec 4 |4,863 |741 |3,000 |2,604 |

|31 Dec 5 |2,604 |396 |3,000 |--- |

Unearned finance income over the lease term is 5,000

The initial entries to account for the lease by the lessor company are as follows (assume machine is newly purchased and no depreciation has been recorded by the lessor)s:

Debit Long term receivables 8524

Debit Current portion of long term receivables. 1476

Credit Machinery 10,000

Receipt of the first year payment (assume that finance income has NOT been accrued each month) by the lessor

Debit Bank 3,000

Credit Current portion of long term receivables 1,476

Credit Finance income on lease 1,524

Receipt of the second year payment by the lessor

Debit Bank 3,000

Credit Current portion of long term receivables 1,701

Credit Finance income on lease 1,299

Summary of Finance Lease Accounting

|LESSOR | |LESSEE | |

| | | | |

|Rental payment by the lessee over the lease term |A |Rental payment by the lessee over the lease term |A |

|Residual value guaranteed by the lessee + |B |Residual value guaranteed by the lessee |B |

|unguaranteed residual | | | |

|Gross investment in the lease (Minimum lease |C |Minimum lease payments (A+B) |C |

|payments A | | | |

|+B) | | | |

|Unearned finance income |D |Finance charge |D |

|Net investment in the lease (C-D) |E |Acquisition cost of asset (C-D) |E |

LESSOR ACCOUNTING:

• Net investment in the lease E is recorded as a receivable

• Unearned finance income D is recorded as interest income during the term of the lease

• Rental payments A are allocated to reduce the receivable and credit the interest income

LESSEE ACCOUNTING:

• Acquisition cost E is recorded as a fixed asset and a liability

• Finance charge D is charged as interest expense during the term of the lease

• Rental payments A are allocated to reduce the liability and pay the interest

• Depreciation is calculated and recorded on E as a fixed asset

Finance Leases - Finance Leasing by Manufacturers or Dealers

21. For the lessor, two types of revenue result from the sale of an asset under a lease agreement by manufacturers or dealers:

1. Finance income, calculated and reported similar to other finance leases ,and

2. Sales profit, calculated as the profit that would result from an outright sale of the asset being leased and reflecting any normal discounts. Sales profit is recorded in full at the time of lease inception. The unearned finance income is recorded as earned as payments are received over the life of the lease.

-----------------------

[1] See the Present Value section of this Explanatory Note for further discussion and illustration of present value.

[2] Note: payment of principal for the lease liability that is due within one year from the balance sheet date is a current liability. The first payment of 3,000 will be allocated between a finance charge and payment of the lease principal. As the chart indicates, 1,524 of the payment is for interest. The remaining 1,476 will reduce the balance of the initial 10,000 lease liability balance.

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