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Chapter 17

AFM391 Chapter Notes - Chapter 17: Personal Property, Capital Asset, Impaired Asset

Accounting & Financial Management
Course Code
Christine Wiedman

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Chapter 17: Lease Accounting
PART 1 Introduction & Lease Accounting for the Lessor
Definition of a Lease
Lease: agreement whereby the owner (the Lessor) of an asset allows another party (the Lessee)
to use that asset in return for monetary or non-monetary consideration.
Lessor is the owner of the asset in a lease.
Lessee is the renter in a lease contract.
The lease agreement specifies the terms of the contract such as:
the lease term
the amount, timing, and type of lease payments
each party’s responsibility for maintenance, insurance, and property taxes, if any;
cancellation terms, renewal terms, including payouts or the return of the leased asset at
the end of the lease term
upgrading responsibilities
Leases can be for:
Real property land and buildings;
Personal property any property that is not real property and includes both tangible
assets (e.g., machinery, equipment) and certain intangibles (e.g., patents)
Important Lease Terminologies
Guarantee Residual value an amount the lessee guarantees to the lessor that the value of the
leased asset at the end of the lease will be at least equal to.
Unguaranteed residual value value that the lessor expects to realize on sale of the asset at the
end of the lease term, but for which the lessee has no liability to ensure.
Fixed lease payments lease payments required to be paid by the lessee (excludes any variable
lease payments).
Variable lease payments lease payments that vary based on circumstances or facts (other
than passage of time) arising after the lease commences (e.g., property taxes, utilities)
Bargain Purchase option (BPO) option given to the lessee to purchase the leased asset at a
price below expected fair value at a future date
Option to terminate the lease a condition that allows the lessee to terminate the lease early
for a specified penalty payment.
Lease incentives the lessor, as part of the lease agreement, may make payments to the lessee
or agree to reimburse the lessee for specific costs incurred.
Short-term lease a lease that has a term of 12 months.
Includes leases that have no financial commitment beyond a year but may be
repeatedly renewed at market rates
Low-value asset lease a lease where the underlying asset has a low value when new (generally
under $5,000).
The underlying asset can only be classified as low-value if:
1. The lessee can benefit from use of the asset on its own or along with other
assets that are readily available

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2. The asset is not highly dependent on or highly interrelated with other assets.
Initial direct costs the costs incurred when negotiating or arranging a lease agreement (e.g.,
legal fees, commissions).
Economic life the maximum number of years that an asset can be economically productive.
Useful life the period of time that an asset is useful to a particular company
May be shorter or equal to economic life, but never longer than economic life
Implicit lease interest rate the interest rate that discounts the minimum net lease payments,
the initial direct costs and the residual value (whether guaranteed or not) to equal the fair
market value of the leased property at the beginning of the lease.
Calculated from lessor’s viewpoint.
Incremental borrowing rate (IBR) the interest rate the lessee would have to pay if they
obtained financing through the bank (or other credit sources) to buy the asset
Important Dates
1. Inception date of the lease Generally the date at which the lessor and the lessee commit to
the principal provisional terms of the lease agreement
2. Commencement date of the lease term The date upon which the lessee is entitled to the use
of the asset.
Types of Lessors
1. Manufacturer/dealer finance companies (captive leasing companies)
a. Subsidiaries whose main business is to perform leasing for the parent company (e.g.,
BMW financial services)
2. Independent finance companies
a. Act as a financial intermediaries by providing financing for transactions for
manufacturers, vendors, or distributors.
3. Traditional financial institutions
a. Subsidiaries of domestic and foreign banks
Types of Leases
1. Finance lease (IFRS) is a type of lease that transfers substantially all of an asset’s risks and
rewards of ownership from the lessor to the lessee.
a. Finance lease under ASPE is referred to as a “capital lease”
2. Operating lease is a type of lease that is not a finance lease (does NOT substantially transfer all
risks and rewards of ownership).
The Economics of Leasing Advantages of Leasing
1. “100%” financing of asset’s purchase price, which is often more than the amount that can be
obtained from a loan.
a. No down payment required
2. Protection from obsolescence

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a. Property can be upgraded
3. Payment schedules are more flexible vs. loans
a. Lease may be structured to meet different needs (e.g., cash flow)
4. 100% deductibility of lease payments from lessee’s taxable income
5. Potential lower after-tax costs due to various tax advantages
The Economics of Leasing Disadvantages of Leasing
The disadvantage of leasing is agency cost of leasing that
is reduced level of care due to the separation of an
asset’s ownership and its control.
The lessee who controls the asset during the
lease is not the owner of the asset.
When the lessor relinquishes control of the
leased property to the lessee, the lessor must
bear the risk that the lessee will not take the
utmost care of the leased property.
As a result, the property’s value at the end of the
lease will most likely be lower than what it
would be without the lease (see next slide).
Thus, the lessor must raise the rental payments accordingly to compensate for the
agency cost of leasing.
Note that if the lessor does NOT expect to regain control of the asset at the end
of the lease, then the agency cost of leasing is nil
The Importance of Agency Cost
The degree to which agency cost matters depends on:
1. Inherent nature of the asset that is leased.
2. Incentives of the lessee to maintain the condition of the leased asset.
3. Regulations that require a high degree of care.
4. Conditions negotiated between the lessor and lessee (e.g., Bargain purchase option, and
Guaranteed residual value) to mitigate agency costs.
5. The length of the lease contract.
a. As the duration of the lease increases, agency costs decrease since the lessee bears the
cost of neglecting or abusing the contract
Lease Accounting Overview
IFRS 16 replaced IAS 17.
Under IFRS 16 there are two types of leases for the lessors:
1. Finance lease
2. Capital lease
However, except for rare cases, all leases should be classified as a finance lease for the lessees
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