CMA Intermediate · Financial Accounting

Lease Accounting: formula sheet

Full chapter guide

Key formulas

Lease: Lease = agreement + right to use an asset + agreed period + payment(s); All four elements must be present. The lessor conveys the right to use the asset to the lessee.
Lease term: Lease term = non-cancellable period + further periods under options that the lessee is reasonably certain to exercise at inception; Options that are merely possible are excluded. Cancellable periods are excluded unless covered by a reasonably certain option.
Finance lease: Finance lease = lease that transfers substantially all risks and rewards incident to ownership; Decided by substance, not by whether title passes.
Operating lease: Operating lease = any lease that is not a finance lease; Define it by exclusion. Do not look for separate tests.
Timing of classification: Classify at inception of the lease; A change in estimates (economic life, residual value) or circumstances (lessee default) does not change the classification.
Change in lease provisions: Changed terms that would have caused a different classification at inception = new agreement over its revised term; Renewing the lease does not count as such a change.
Lessee depreciation (finance lease): If ownership is not reasonably certain: depreciate fully over the shorter of lease term and useful life; The depreciation policy must be consistent with that for owned depreciable assets, following AS 10.
Lessee payments (finance lease): Lease payment = finance charge + reduction in outstanding liability; The finance charge produces a constant periodic rate on the remaining liability.
Finance lease definition: Finance lease = lease that transfers substantially all risks and rewards incident to ownership; Title may or may not eventually be transferred.
Operating lease definition: Operating lease = any lease other than a finance lease; If substantially all risks and rewards are not transferred, it is operating.
Situations that normally lead to a finance lease (para 8): (a) ownership transferred by end of lease term; (b) purchase option reasonably certain to be exercised; (c) lease term for major part of economic life; (d) PV of minimum lease payments at least substantially all of fair value; (e) specialised asset usable only by lessee without major modifications; Memorise all five. Any one normally points to finance lease.
Further indicators (para 9): (a) lessee bears lessor's cancellation losses; (b) residual value fluctuations fall to lessee; (c) secondary period at rent substantially lower than market rent; These can lead to finance classification individually or in combination.
Timing of classification: Classify at inception of the lease; Changed terms that would have changed classification make a new agreement over the revised term. Changes in estimates or circumstances (such as lessee default) do not.
Minimum lease payments (lessee): MLP = lease payments over the lease term (excluding contingent rent, service costs, reimbursed taxes) + residual value guaranteed by or on behalf of the lessee; If a purchase option is reasonably certain to be exercised, include the exercise price instead of a residual value.
Minimum lease payments (lessor): MLP = lease payments over the lease term (same exclusions) + residual value guaranteed by the lessee or by a financially capable independent third party; The lessor's MLP can be larger than the lessee's because a third-party guarantee counts for the lessor only.
Unguaranteed residual value: URV = residual value − guaranteed residual value; Residual value is the estimated fair value of the asset at the end of the lease term.
Gross investment in the lease: Gross investment = MLP (lessor) + URV; It is a total of undiscounted amounts.
Interest rate implicit in the lease: PV of (MLP (lessor) + URV) at the implicit rate = fair value of the asset at inception; Find it by trial and error, then interpolation. The result is usually approximate.
Unearned finance income: Unearned finance income = Gross investment − PV of (MLP (lessor) + URV) at the implicit rate; Because that PV equals fair value at inception, unearned income is gross investment − fair value (ignoring initial direct costs).
Net investment in the lease: Net investment = Gross investment − Unearned finance income; At inception it equals the PV of MLP plus URV at the implicit rate.
Lessee's initial recognition: Asset and liability = lower of (fair value, PV of lessee's MLP); Discount at the implicit rate if practicable to determine; otherwise at the lessee's incremental borrowing rate.
Initial recognition amount: Asset = Liability = lower of (Fair value, PV of minimum lease payments); PV is from the lessee's standpoint. Use the implicit rate if practicable, otherwise the incremental borrowing rate.
Present value of payments: PV = Σ Payment ÷ (1 + r)ⁿ, plus PV of any guaranteed residual value; Use the discount factors given in the question. Include the residual value the lessee has guaranteed.
Finance charge for a period: Finance charge = Opening liability × implicit rate; If the payment is made at the end of the year, interest runs on the full opening balance.
Reduction in liability: Reduction = Lease payment − Finance charge; Closing liability = Opening liability − Reduction.
Depreciation when ownership is not certain: Depreciation per year = (Asset value − expected residual value) ÷ shorter of lease term and useful life; Where ownership is reasonably certain, use the useful life instead. Follow the depreciation method used for owned assets.
Total charge to P&L over the lease: Total depreciation + Total finance charge = Total lease payments (when there is no residual value); Use this as a quick check of your schedule.
Gross investment in the lease: Gross investment = Minimum lease payments receivable + Unguaranteed residual value (accruing to lessor); With no unguaranteed residual value, it is just the total of the lease payments receivable.
Net investment in the lease (para 3.16): Net investment = Gross investment − Unearned finance income; This is the amount shown as lease receivable (para 26). It equals the present value of the gross investment at the rate implicit in the lease.
Unearned finance income: Unearned finance income = Gross investment − Present value of gross investment at the implicit rate; Total finance income over the lease term. It is recognised gradually, not at inception.
Finance income for a period (paras 28, 29): Finance income = Opening net investment × Implicit rate (for the period); Constant periodic rate on the net investment outstanding. For payments at year end, opening net investment is the balance after the previous payment.
Closing net investment: Closing net investment = Opening + Finance income − Lease payment received; The payment reduces both the receivable and the unearned finance income (para 29).
Annual payment from present value: Annual payment = Net investment ÷ Annuity factor (rate, years); Use when the question gives fair value and rate but not the instalment. For 10% and 3 years the factor is about 2.48685 for payments at year end.
Residual value rule (para 30): Reduction in estimated unguaranteed residual value: revise income, recognise reduction immediately. No upward adjustment.; Applies when the unguaranteed residual value is reviewed.
Lessee rent expense (operating lease): Annual expense = Total lease payments over the lease term ÷ Number of years in the lease term; Use this when rent is uneven and no other systematic basis is more representative. Exclude service charges such as insurance and maintenance.
Lessor rent income (operating lease): Annual income = Total lease rentals over the lease term ÷ Number of years in the lease term; Lessor also charges depreciation on the leased asset as an expense.
Prepaid or accrued rent: Difference = Straight-line expense − Cash paid in the year; If expense is more than cash paid, it is an accrued liability. If cash paid is more, it is a prepayment.
Sale and leaseback: finance lease: Profit or loss = Sale price − Carrying amount, deferred and amortised over the lease term in proportion to depreciation; Applies to the seller-lessee. It is not recognised immediately.
Sale and leaseback: operating lease, at fair value: Profit or loss = Sale price − Carrying amount, recognised immediately; Applies when it is clear the transaction is at fair value.
Sale and leaseback: operating lease, sale price below fair value: Profit or loss recognised immediately; a loss compensated by below-market future rentals is deferred and amortised in proportion to lease payments over the expected period of use; Check whether the loss is compensated by below-market rentals before deferring.
Sale and leaseback: operating lease, sale price above fair value: Excess of sale price over fair value = deferred and amortised over the expected period of use; The part up to fair value (Fair value − Carrying amount) is recognised immediately.
Sale and leaseback: operating lease, fair value below carrying amount: Loss recognised immediately = Carrying amount − Fair value; Applies to operating leases where fair value at the time of sale is below carrying amount.

Quick revision

A lease conveys the right to use an asset for an agreed period in return for payment or payments.
An operating lease is any lease other than a finance lease.
Classify the lease at inception.
Changes in estimates, such as of residual value, or in circumstances, such as lessee default, do not change the classification.
If the lessee and lessor agree to changed terms that would have given a different classification, treat it as a new agreement over its revised term.
Residual value is the estimated fair value of the asset at the end of the lease term.
Lessee recognises asset and liability at fair value, or at the present value of its minimum lease payments if that is lower.
Discount rate: the implicit rate if practicable to determine; otherwise the lessee's incremental borrowing rate.
Split each payment into finance charge and reduction of liability, giving a constant periodic rate on the remaining balance.
Finance charge = opening liability × rate. Example: ₹2,35,500 × 16% = ₹37,680.
Unearned finance income = gross investment less the present value of minimum lease payments and unguaranteed residual value at the implicit rate.
In sale and leaseback with an operating leaseback at fair value, recognise profit or loss immediately; if the sale price is above fair value, defer and amortise the excess.

Common mistakes

Treating a finance lease as one where legal title must pass to the lessee. Fix: Use the definition: the test is transfer of substantially all risks and rewards, whether or not title passes.
Adding every renewal option to the lease term. Fix: Include an option period only if, at inception, it is reasonably certain the lessee will exercise it.
Classifying by the legal form or the name in the agreement. Fix: Remember AS 19 looks at substance. Title may or may not transfer in a finance lease.
Saying a lease is operating just because ownership does not pass. Fix: Check the lease term versus economic life and PV versus fair value too. Any of the para 8 situations can make it a finance lease.
Adding the whole residual value to MLP Fix: Only the guaranteed part goes into MLP. The unguaranteed part is added later, to get gross investment (lessor only).
Using the same MLP for lessee and lessor Fix: Prepare MLP separately. For the lessee, include only residual value guaranteed by or on behalf of the lessee.
Charging the full lease rent to the P&L as an expense. Fix: For a finance lease, charge only depreciation and finance charge. The payment itself reduces the liability, as para 20 explains.
Recording the asset at the fair value even when the present value of the minimum lease payments is lower. Fix: Always compute both figures and take the lower one for both the asset and the liability.
Showing the receivable at gross investment (total of payments) instead of net investment on the balance sheet. Fix: Receivable = gross investment − unearned finance income (para 3.16 and 26). If you debit gross at inception, always credit Unearned finance income for the difference.
Treating the whole lease payment as income. Fix: Under a finance lease each payment is principal repayment plus finance income (para 27). Only the finance income part goes to the profit and loss account.

Exam tips

For definition questions, quote the key words: right to use an asset, agreed period, payment or series of payments, and substantially all risks and rewards.
In lease-term numericals, state which options you include and why. The words 'reasonably certain' earn the mark.
Write the classification date. Say 'classified at inception' so the examiner sees you know changes in estimates do not reclassify.
Name the standard you are applying, AS 19 or Ind AS 116, in the first line of a written answer.
In MCQs, watch for options saying title must pass or that estimates trigger reclassification. Both are wrong under the standard.
Write the full definition of finance lease first, then apply it. This earns easy marks.
In theory questions, list all five para 8 situations and mention the para 9 indicators.
In MCQs, spot the single decisive fact, such as a bargain purchase option or a specialised asset.