892 SECTION 3 Financial Instruments and Liabilities Leases of Land Only Because the useful life of land is indefinite, the risks and rewards of ownership cannot be presumed transferred from the lessor to the lessee unless title to the land is expected to transfer—outright or by the expected exercise of a bargain purchase option (criterion 1 or criterion 2). Since the useful life is undefined, the third and fourth criteria are not applicable. Relatedly, because the leased asset is land, depreciation is inappropriate. Leases of Land and Building When the leased property includes both land and a building and the lease transfers ownership or is expected to by exercise of a BPO, the lessee should record each leased asset separately. The present value of the minimum lease payments is allocated between the leased land and leased building accounts on the basis of their relative fair values. When neither of the first two capital lease criteria is met, the question arises as to whether the third and fourth criteria apply. Because they logically should apply to the building (because its life is limited) but not to the land (because its life is unlimited), the profession employs an arbitrary guideline. If the fair value of the land is less than 25% of the combined fair value, it is in effect ignored and both the lessee and the lessor treat the land and building as a single unit. The single leased asset is depreciated as if land were not involved. If the fair value of the land is 25% or more of the combined fair value, both the lessee and the lessor treat the land and building as two separate leases. Thus, the land lease is an operating lease, and the building lease is classified and accounted for in the manner described in the chapter. Leases of Only Part of a Building Some of the most common of leases involve leasing only part of a building. For instance, businesses frequently lease space in an office building or individual stores in a shopping mall. Practical difficulties arise when applying lease accounting procedures in these situations. What is the cost of the third shop from the entrance in a $14 million mall? What is the fair value of a sixth floor office suite in a 40-floor office complex? Despite practical difficulties, usual lease accounting treatment applies. It may, however, be necessary to employ real estate appraisals or replacement cost information to arrive at reasonable estimates of cost or fair value. When (a) the leased property includes both land and a building, (b) neither of the first two criteria is met, and (c) the fair value of the land is 25% or more of the combined fair value, both the lessee and the lessor treat the land as an operating lease and the building as any other lease. Usual lease accounting procedures apply to leases that involve only part of a building, although extra effort may be needed to arrive at reasonable estimates of cost and fair value. International Financial Reporting Standards Leases of Land and Buildings. Under IAS No. 17, land and building elements are considered separately unless the land element is not material.34 This often results in classification of the land component as an operating lease. Under U.S. GAAP, land and building elements generally are accounted for as a single unit, unless land represents more than 25% of the total fair value of the leased property. ● LO15–11 34“Leases,” International Accounting Standard No. 17 (IASCF), as amended effective January 1, 2014. Financial Reporting Case Solution 1. How would HG’s revenues “take a hit” as a result of more customers leasing than buying labeling machines? (p. 860) When HG leases machines under operating leases, it reports revenue as it collects “rent” over the lease term. When HG sells machines, on the other hand, it recognizes revenue “up front” in the year of sales. Actually, total revenues are not necessarily less with a lease, but are spread out over the several
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