(Posted February 2025)
Accounting for leases tends to be a commonly tested topic on the CPA Common Final Examination (CFE). The treatment is very different depending on both the role – whether you are the lessee or the lessor – and also the framework – whether reporting under ASPE or IFRS® Standards.
This blog focuses on the key technical considerations relating to the accounting treatment for lessees under both ASPE and IFRS Standards. The lessee is the party that rents the asset from the owner (the lessor). Candidates sometimes use the “lessor” criteria when evaluating the lease treatment for the lessee, which is technically inaccurate. For more information on the accounting treatment for lessors, see our follow-up blog.
ASPE
Relevant Technical
The accounting for leases from the lessee’s perspective is governed by ASPE 3065, Leases. Leases are classified as either being capital or operating in nature. Three criteria need to be assessed to make this determination:
- Reasonable assurance exists that ownership of the asset will transfer to the lessee by the end of the lease term, either by a transfer of title at the end of the lease term or the existence of a bargain purchase option. A bargain purchase option is defined as any option to purchase the asset at the end of the lease at a price that is below the expected market value at the end of the lease.
- The lease term is of such a duration that the lessee will receive substantially all of the economic benefits that are expected to be derived from the use of the leased property over its remaining useful life. Some analysis may be required to determine the proper lease term to use. For example, if a bargain renewal option exists (e.g., a renewal at below market rates at the time of renewal, which could be a renewal at the same rate as the initial term), this should be included in the total lease term used in the assessment. The guideline for “substantially all” is 75% of the asset’s remaining useful life.
- The present value of the minimum lease payments represents substantially all of the fair value of the asset at lease inception. If a residual value (the fair market value of the asset at the end of the lease term) is provided in the case, this should only be included in the present value calculation if there is a bargain purchase option or transfer of title expected at the end of the lease term (e.g., the amount is guaranteed). Incorrectly including (or excluding) this amount can have a major impact on the present value amount calculated, which can result in an inappropriate conclusion on the lease treatment. The guideline for “substantially all” is 90% or more of the asset’s fair value. Ensure that you compare the present value of minimum payments to the fair value of the leased asset now (at lease inception), rather than its expected future fair value (if provided in the case).
The percentage guidelines noted above are not definitive requirements. Judgment should be exercised in determining their application (e.g., an amount just below 90% may be considered “substantially all” for the PV criteria).
Initial Treatment
It is a capital lease if one of the above criteria is met. In this situation, both an asset and liability are recognized using the present value of the minimum lease payments that the lessee will pay over the lease term. The discount rate to be used is the lower of the implicit lease rate and the entity’s incremental borrowing rate. The leased asset cannot be recognized at an amount greater than the asset’s fair value.
If none of the criteria are met, it is an operating lease. This requires that the lease payments are expensed as incurred on a straight-line basis over the lease term. This is a much simpler accounting treatment than the capital lease alternative.
Subsequent Treatment
If the lease is determined to be capital in nature, the asset recognized must be depreciated over time. The depreciation period is typically the lease term, unless there is a bargain purchase option or ownership transfer at the end of the lease, in which case the asset is depreciated over the useful life of the asset. Subsequent payments made for the lease are allocated between interest (using the discount rate applied for the initial treatment) and principal, with adjustments made to the lease liability initially recognized.
How to Write on the CFE
While you must adapt to the issue and case facts presented to you, there is an approach that can often be taken to develop sufficient depth in your analysis.
Step 1: Use case facts to assess the type of lease
Analyze all three criteria explained above using case facts to determine if any of the relevant criteria are met, keeping in mind that only one must be met to be considered a capital lease. For the “economic life” (second) and “PV” (third) criterion, ensure you calculate the percentages and explicitly compare them to the respective guidelines (i.e., 75% and 90%, respectively) to support your conclusions. Conclude definitively whether the lease is a capital or operating lease, consistent with your analysis.
Step 2: Assess the financial reporting implications
Using your conclusion from Step 1, explain the financial statement impact both for the initial treatment (e.g., if capital, record a lease asset and lease liability) and subsequent treatment (e.g., if capital, consider depreciation for the lease asset and interest for the lease liability). Be sure to quantify the amounts to record, considering both the initial and subsequent treatment.
Ensure consistency in the inputs used for the present value calculation. For example, if a monthly rate is used in the formula, ensure that both the period and payment are in monthly terms (not annual). This is a common error made by candidates, whereby one or more of the inputs is not consistent with others, which materially impacts the calculation. You may also need to integrate your results into a summary calculation, such as revised financial statements, a materiality calculation, or financial ratios.
IFRS
Relevant Technical
The accounting for leases from the lessee’s perspective is governed by IFRS 16, Leases, and is much different than the application of ASPE 3065 explained above. Rather than assessing the type of lease that exists to determine the financial statement classification, IFRS 16 requires that the lessee focus primarily on whether a transaction contains a lease and uses this to quantify the related implications.
For a lease to exist, the following two criteria must be met:
- The customer has the right to obtain substantially all of the economic benefits from use of the identified asset
- The customer has the right to direct the use of the identified asset
Initial Treatment
If both criteria noted above are met, then a lease exists, and a right of use (ROU) asset and lease liability must be recorded initially. The ROU asset is recognized at cost, which includes the following:
- The initial measurement of the lease liability
- Any lease payments made on or before the commencement date of the lease, less lease incentives received
- Any initial direct costs
Unlike a capital lease recorded under ASPE, an ROU asset can exceed, and be recorded above, its fair value.
The lease liability is measured initially at the present value of the total lease payments, using the interest rate implicit in the lease, or, if not determinable, the entity’s incremental borrowing rate. The amount to be recorded generally includes each of the following, if applicable:
- The fixed lease payments
- Variable lease payments that are based on an index or a rate
- Bargain purchase option
- Guaranteed residual value (if both a bargain purchase option and guaranteed residual value exist, only the bargain purchase option is considered in the calculation)
- Termination penalties
Only include the future purchase value in your present value calculation if a bargain purchase option or guaranteed residual value exists. Incorrectly including (or excluding) this amount can have a major impact on the present value amount calculated, which impacts both the ROU asset and lease liability.
Some analysis may be required to determine the proper lease term to use. For example, if an option to extend the lease is provided and it is reasonably certain that the lessee will exercise it (e.g., it is a bargain compared to fair value), this should be included in the total lease term used in the assessment.
Recognition Exemptions
A lessee can elect not to record an ROU asset and lease liability, as described above, and can instead expense lease payments, provided one of the two following exemptions are met:
- The lease is considered “short-term” (i.e., one year or less).
- The lease is considered a “low value” lease. The term “low value” is not defined under IFRS 16 but is generally regarded as below $5,000. Further, to be considered “low value”, the asset must be new, the lessee must be able to benefit from the asset’s use on its own or together with readily available resources, and the asset must not be highly dependent on or highly integrated with other assets.
If one of the exemptions noted above is met, and the company elects to expense the lease payments, this must be done on either a straight-line basis or a systematic basis over the lease term.
Subsequent Treatment
If a lease exists and an ROU asset is recorded, the entity can subsequently measure the asset using the cost or revaluation model. If the cost model is used, the asset must be depreciated over time. The depreciation period is typically the lease term, unless the lease transfers ownership, in which case the asset is depreciated over the useful life of the asset. Lease payments made are recorded as a reduction of the lease liability, while interest expense must be recorded annually, using the same discount rate applied on initial treatment, which increases the lease liability over time.
How to Write on the CFE
While you must adapt to the issue and case facts presented to you, there is a common approach that can often be taken to develop sufficient depth in your analysis.
Step 1: Use case facts to assess whether a lease exists
Analyze each of the two criteria explained above using case facts to determine if a lease exists. If one does exist, consider whether either of the exemptions exist using case facts. If they do not exist, conclude on the need to record an ROU asset and lease liability, or if an exemption is met, consider whether the entity should elect to expense the lease payments.
Step 2: Assess the financial reporting implications
Using your conclusion from Step 1, explain the financial statement impact both for the initial treatment and subsequent treatment. Be sure to quantify the amounts to record (ensuring consistency in the inputs used, as discussed above), considering both the initial and subsequent treatment.