ACTG 6580 Chapter 9 - LEASES (IAS17)

Classification of Leases IAS17 defines a lease as "an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time". A finance lease is "a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred". An operating lease is "a lease other than a finance lease".

Factors Which Indicate a Finance Lease The lease transfers ownership of the asset to the lessee by the end of the lease term The lessee has the option to purchase the asset at a price expected to be lower than fair value The lease term is for the major part of the economic life of the asset The present value of the minimum lease payments amounts to substantially the fair value of the asset The leased asset is of such a specialized nature that only the lessee can use it. 7. 8. (3 more criteria to be discussed later)

Accounting for Operating Leases The lessee The lessee has not taken on the risks and rewards of ownership, so the leased item is not shown as an asset in the lessee's financial statements. The lease payments are recognised as an expense over the lease term. The lessor The lessor has retained the risks and rewards of ownership, so the leased item is shown as an asset in the lessor's financial statements and is depreciated as usual. The lease payments are recognised as income over the lease term.

Accounting for Finance Leases (By the Lessee) The lessee has acquired the risks and rewards of ownership and so the leased item should be shown as an asset in the lessee's financial statements, along with a corresponding liability to the lessor. The asset should be depreciated at the shorter of useful life or lease term. At the commencement of the lease term, IAS17 requires that both the asset and the liability to the lessor should be recognized at the lower of: the fair value of the leased item the present value of the minimum lease payments. The liability to the lessor should be split between current and non-current liabilities, as appropriate. This liability must not be shown as a deduction from the leased asset.

Allocation of Finance Charges for a Finance Lease The total finance charge is the difference between: the total of the minimum lease payments, and the initial liability to the lessor. IAS17 requires that this finance charge should be allocated to accounting periods "so as to produce a constant periodic rate of interest on the remaining balance of the liability.” Methods which could be used for allocating the finance charge between accounting periods include the actuarial method (effective interest), the sum of digits method and the level spread method (straight line).

Actuarial (Effective Interest) Method The rate of interest implicit in the lease is used to calculate the finance charge element of each lease payment. This method is preferred by IAS17 but cannot be used unless the interest rate is known. If necessary, the interest rate can usually be derived with the aid of present value tables.

Sum of Digits Method A digit is assigned to each lease payment. Digit 1 is assigned to the final lease payment, digit 2 to the next- to-last payment and so on. If the first lease payment is payable in advance at the start of the lease, it is not assigned a digit. The digits are totalled to give the "sum of digits". The finance charge element of each lease payment is calculated by dividing the total finance charge by the sum of the digits and then multiplying by the digit assigned to that payment. The sum of digits method provides a reasonable approximation to the actuarial method.

Level Spread (Straight-line) Method This method simply allocates the finance charge to lease payments on a straight-line basis over the lease term. This is unrealistic, since the amount of the finance charge allocated to each payment should fall as the liability to the lessor also falls. But this method might be used if the amounts involved are not material.

Lease Classification for Lessee Example Example 1 – Lease classification for lessee RRI entered into a lease on January 1, 2010, with Magical Mobile Transport (MMT) for a customized carriage. MMT will provide a carriage to RRI that has RRI’s logo molded into the iron work of the frame, carved into various areas of the woodwork and painted on the side of the doors. Additionally, MMT is providing custom-made pulling devices on the carriage to accommodate RRI’s Clydesdale horses. See next slide for terms of the lease arrangement. Determine if RRI should record this lease as an operating or capital lease, using US GAAP. Determine if RRI should record this lease as an operating or finance lease, using IFRS.

Lease Classification for Lessee Example The following are the terms of the lease arrangement: Negotiated price (fair value) of $10,000 for the carriage at the inception date of the lease. Three-year term. Unguaranteed residual value of $3,951. RRI does not absorb any gains or losses in the fluctuations of the fair value of the residual value. End-of-term purchase option of $4,000. Remaining economic life of five years. Depreciation policy for the carriage is the straight-line method. Ownership is not transferred at the end of the lease term. The lease may not be extended. Annual lease payments of $2,500 at 6% implicit interest rate due on December 31. PV of MLP of $6,682 according to the following schedule (interest has been rounded to the nearest dollar): Beginning balance Interest at 6% Lease payment Ending balance 2010 $6,682 $401 $(2,500) $4,583 2011 275 (2,500) $2,358 2012 142 $ – $818 $(7,500)

Lease Classification for Lessee Example Example 1 solution: Based on the information presented below, RRI would classify the MMT lease as an operating lease under US GAAP and a finance lease under IFRS. US GAAP capitalization criteria IFRS capitalization criteria US GAAP IFRS Ownership is transferred to the lessee by the end of the lease term. Similar No. The lease contains a BPO. No. $4,000 > $3,951 No. $4,000 > $3,951 The lease term is equal to 75% or more of the estimated economic life of the leased property. The lease term is a major part of the estimated economic life of the leased property. No. Three years = 60% of 5 years No* Three years = 60% of five years would not generally be considered a “major part” The PV of MLP equals or exceeds 90% of the fair value of the leased property. The PV of MLP is substantially all of the fair value of the leased property. $6,682 = 67% of $10,000 $6,682 = 67% of $10,000 would generally not be considered “substantially all”

Lease Classification for Lessee Example US GAAP capitalization criteria IFRS capitalization criteria US GAAP IFRS Not specified. The leased assets are of such a specialized nature such that only the lessee can use them without major modifications being made. N/A Yes. MMT would need to make major modifications to the leased asset to have alternate uses. The lessee bears the lessor’s losses if the lessee cancels the lease. No. The lessee absorbs the gains or losses from fluctuations in the fair value of the residual value of the asset. The lessee may extend the lease for a secondary period at a rent substantially below the market rent.

Lease Accounting Example IFRS: Journal Entries - Lessee Lease with MMT for carriage Carriage $6,682 Finance lease liability – current $2,099 Finance lease liability – non-current 4,583 To record the capital lease of the auto based on the PV of the MLP (since this is lower than the fair value). Finance lease liability – current $ 2,099 Interest expense 401 Cash $2,500 To record the lease payment and related interest expense. Interest expense is calculated as 6% multiplied by the PV of MLP of $6,682. (Continued on next slide.)

Lease Accounting Example - Lessee Depreciation expense – carriage $2,227 Accumulated depreciation– carriage $2,227 To record the depreciation for the carriage over the lease term of three years ($6,682/3) given that this is shorter than the life of the asset of five years. The depreciation is based on this term as capitalization was based on an indicator where ownership transfer is not reasonably assured. Finance lease liability – non-current $2,225 Finance lease liability – current $2,225 To reclassify the PV of the MLP payments due within the next year of $2,225.

Accounting for Finance Leases (By the Lessor) The lessor has relinquished the risks and rewards of ownership. So the leased asset should be removed from the lessor's statement of financial position and replaced by a receivable which represents the amount owed by the lessee. In general, this receivable is initially recognized at the present value of the minimum lease payments which the lessee is required to make. Subsequently, the rate of interest implicit in the lease is used to calculate the finance income element of each lease payment. This finance income is recognized in the lessor's statement of comprehensive income. The remainder of the lease payment is subtracted from the amount owed by the lessee.

Lessor Accounting Example Finance lease receivable – current $2,500 Finance lease receivable – non-current 9,551 Cost of goods sold 4,683 Inventory – carriage $ 8,000 Sales 6,683 Unearned finance income 1,451 To record the sale of the leased asset for net investment in the lease (fair value of the leased asset or if lower the PV of MLP) and related cost of goods sold for the carrying value of the leased asset less the present value of the unguaranteed residual value of $3,317 ($3,951 discounted at 6% for three years).

Lessor Accounting Example Cash $2,500 Lease receivable – current 2,500 Unearned finance income $ 600 Interest income $600 To record the lease payment and related interest income. Interest expense is calculated as 6% multiplied by the net investment in the lease of $10,000. Lease receivable – current $2,014 Lease receivable – non-current $2,014 To reclassify the lease payments due within the next year of $2,014.

Main Disclosure Requirements (Operating Leases) The lessee The amount of operating lease payments recognized as an expense during the accounting period Analysis of the total of the future minimum lease payments payable under non-cancellable operating leases. The lessor Analysis of the total of the future minimum lease payments receivable under non-cancellable operating leases.

Main Disclosure Requirements (Finance Leases) The lessee For each class of asset, the net carrying amount of assets held under finance leases Analysis of the total of the future minimum lease payments payable under finance leases. The lessor Analysis of the total of the future minimum lease payments receivable under finance leases Total amount of unearned finance income outstanding at the end of the reporting period.

Proposed Changes – Effective ???? 2013, 2015 ????Never?? Lessors All leases would be accounted for under the receivable and residual (R&R) model, except for Short-term leases (12 months or less) Leases of investment property measured at fair value Lease receivable – right to receive lease payments from the lessee Residual asset – right to the return of the underlying asset at the end of the lease term Lessees Right-of-use model for all leases other than short-term leases Right-of-use asset = PV of estimated lease payments plus any initial direct costs and prepaid rent Amortized on a straight line basis Lease liability = PV of estimated lease payments