Summary of "CFAP 01 | Sir Nasir Abbas AAFR | Lecture 85 | June 2024 | Advance Accounting and Financial Reporting"
Context
Lecture on lease accounting (CFAP / Advance Accounting & Financial Reporting) covering:
- Lease term and classification
- Composition of lease payments
- Measurement (present value)
- Lessor accounting for finance leases
The lecturer frequently referred to the textbook (chapter pages 3–7) and worked examples.
Key concepts and lessons
1. Lease term (least term)
Definition:
The non‑cancellable period for which the lessee has the right to use the asset, plus any optional periods that are included because it is “reasonably certain” they will be exercised.
Notes:
- Two kinds of optional periods:
- Extension/renewal options (e.g., 8 years + optional 3 years = either 8 or 11 depending on reasonable certainty).
- Early termination options (e.g., contract for 6 years but lessee may terminate at 5 — treat the non‑cancellable period as the base).
- Practical rule: include optional periods only when it is reasonably certain they will be exercised (or that the lessee will not terminate). If uncertain, exclude them.
2. Dates: inception vs commencement
- Inception: date when the parties agree the lease contract.
- Commencement: date when the asset is made available to the lessee.
- Measurement (PV) is performed “standing at” inception, though accounting and cash flows often start at or after commencement.
3. Components included in “lease payments”
Lease payments = amounts the lessee must pay to the lessor plus amounts guaranteed to the lessor (residual value guarantees).
Typical included items:
- Fixed payments (including amounts that are “in substance” fixed).
- Variable payments that depend on an index or a rate (e.g., CPI, KIBOR).
- Amounts the lessee is reasonably certain to pay under a bargain purchase option (BPO).
- Termination penalties if the lease term includes the period that triggers the penalty (i.e., when reasonably certain).
- Amounts payable under residual value guarantees (RV guarantees).
Typical excluded items:
- Variable payments linked to the lessee’s future performance (e.g., sales‑based) unless they are in‑substance fixed or otherwise included by contract rules.
4. Residual value guarantees (RV)
- Purpose: protect the lessor against lower than expected proceeds on disposal.
- Can be provided by the lessee, a related party, or a third party (e.g., manufacturer or insurer).
- Accounting treatment:
- Guaranteed amounts are included in lease payments.
- Unguaranteed residual value (the lessor’s estimate of resale value above guarantees) is treated separately when calculating gross/net investment.
5. Types of payments — textbook boxes A / B / C / D
- A — Fixed payments (including “in‑substance fixed”): economically fixed amounts even if wording suggests variability.
- B — Variable payments linked to an index or a market rate (index‑linked or rate‑linked payments).
- C — Bargain purchase option (BPO): stated purchase price at end that Lessee is reasonably certain to exercise — include if reasonably certain.
- D — Termination and break options / penalties: included if the lease term is set to include the period that triggers penalty (dependent on reasonable certainty).
Practical guidance: if a payment appears variable but the lessor effectively knows the amount (e.g., inspection criteria almost certainly met), treat it as in‑substance fixed.
6. Measurement and investment in lease (lessor perspective)
- Gross investment in lease = total lease payments receivable + unguaranteed residual value (UG RV).
- Net investment in lease = present value (PV) of the gross investment (discounted at the implicit rate).
- PV of lease payments (standalone) is calculated for the payments that are clearly lease payments.
- Implicit rate: the discount rate that makes the PV of lease payments (and UG RV) equal to the fair value of the leased asset plus any initial direct costs (IDCs). If implicit rate is used, net investment equals fair value + IDC.
Calculation approach (example structure used in lecture):
- Discount each scheduled payment to present using the implicit rate to get PV of lease payments.
- Discount PV of UG RV and add to get Net Investment.
- Alternatively, sum gross receipts first (Gross Investment) then discount to Net Investment.
7. Lessor accounting entries (finance lessor / dealer‑manufacturer)
- On commencement a finance lessor records a receivable (net investment in lease) equal to PV of lease payments + PV(UG RV) as applicable.
- If the lessor purchased the asset for leasing, cash paid for the asset and IDC are recognized; lease receivable equals fair value + IDC when using implicit rate.
- Subsequent measurement:
- Recognize interest income by unwinding the discount on the lease receivable (amortized cost).
- When cash payments are received, reduce the receivable.
- Dealer/manufacturer lessor: could recognize sale and receivable (different ledger treatments: gross vs net recognition).
8. Lease incentives and security deposits
- Lease incentives (cash, reimbursements) are usually netted against lease payments rather than separately expensed by the lessor (treatment depends on the standard and context).
- Security deposits: apply general accounting concepts. If interest/time value exists, account for PV and recognize interest income on the deposit as appropriate.
9. Practical computational notes emphasized
- Discount each payment to the appropriate time; multi‑stage discounting may be required when payments change over periods.
- For streams with differing rentals, discount each stream separately and sum.
- When computing PV of lease payments and net investment at inception, ensure you:
- Determine lease term (reasonable certainty for options).
- Identify which payments to include.
- Choose discount rate (implicit rate if known; otherwise lessee incremental borrowing rate for lessee or lessor’s required rate for lessor).
- Compute PV of lease payments and add PV(UG RV) or compute gross and then discount.
Methodology — step‑by‑step checklist (exam / worked questions)
- Determine lease term:
- Start with the non‑cancellable period.
- Add renewal/extension periods only if reasonably certain to be exercised.
- Account for early termination options if reasonably certain to be exercised.
- Identify lease payments to include:
- Fixed payments and in‑substance fixed amounts.
- Variable payments indexed to CPI or market rates (include using expected index/rate outcomes when required).
- Termination penalties if the lease term includes that triggering period.
- Bargain purchase option price if exercise reasonably certain.
- Expected amounts payable under residual value guarantees.
- Exclude contingent payments based purely on lessee performance unless in‑substance fixed.
- Compute Gross Investment in Lease (lessor):
- Sum contractual lease payments + unguaranteed residual value (UG RV).
- Compute Net Investment in Lease:
- Discount the gross investment using the implicit rate to get PV at inception.
- Compute PV of lease payments separately if required:
- Discount scheduled payments (including included penalties and guaranteed amounts).
- Lessor accounting:
- Recognize lease receivable / net investment (debit receivable) and appropriate credit (sale / cash outflow) depending on lessor type.
- Over time, unwind discount as interest income and reduce receivable as cash is received.
- Disclose and explain assumptions:
- State assumptions about reasonable certainty, chosen discount rate, treatment of variable items, and RV guarantees.
Practical examples used (illustrative)
Worked example in lecture:
- Rentals: 75,000 p.a. for first 4 years, 60,000 p.a. for next 4 years.
- Termination option after year 6 with penalty 15,000.
- Guaranteed / unguaranteed residual values included.
- Lecturer assumed lease term = 6 years (reasonable certainty of termination at year 6).
- Steps:
- Discount rentals and penalty to get PV of lease payments.
- Discount UG RV and add to get net investment in lease.
Other emphasis: in‑substance fixed payments — if a payment appears variable but outcome is effectively known, treat it as fixed.
Exam / revision emphasis
- Key topics: reassessment, lease modification, sale and transfer (important for CFP exam).
- Practice areas: determining lease term, classifying payments, calculating PV (discounting), differentiating gross vs net investment, preparing lessor ledger entries.
- Revise discounting techniques and amortized‑cost unwinding of receivables.
Speakers / sources
- Primary lecturer: Sir Nasir Abbas (AAF R) — CFAP 01, Lecture 85.
- Textbook references: chapter pages 3–7 (specific point numbers referenced in lecture).
- IAS/IFRS concepts and standards referenced throughout.
- Minor background notes: class interjections and background audio (music / breaks / prayer times).
Category
Educational
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