IAS 17 - Leases.

IAS 17 - Leases

Typical coverage of US GAAP
General Scope Terminology and definitions Lease classification Lessee accounting Capitalization criteria Capital lease Operating lease Lessor accounting Sale and leaseback arrangements Definition Lease classification and capitalization criteria Accounting treatment Other lease considerations Disclosures

Executive summary Overall accounting for leases under IFRS and US GAAP is similar, although IFRS has fewer specific rules than US GAAP. Both IFRS and US GAAP separately discuss lessee and lessor accounting. Both IFRS and US GAAP focus on classifying leases as either operating or capital. IFRS uses the term “finance” lease, whereas US GAAP uses “capital” lease. IFRS uses more general criterion based on the substance of the lease to determine lease capitalization whereas US GAAP uses “bright line” criteria.

Primary pronouncements
US GAAP ASC 840, Leases IFRS IAS 17, Leases SIC 15, Operating Leases – Incentives

Progress on convergence
A discussion paper on leases was released in March 2009 with comments due in July In the discussion paper, the FASB and IASB proposed a possible new model for lease accounting based on the principle that all leases give rise to liabilities for future rental payments and assets (the right to use the leased asset) and should be recognized in an entity’s balance sheet. An exposure draft on leases is expected to be issued in 2010. A final pronouncement on leases is expected in mid-2011.

General Scope US GAAP IFRS
ASC 840 applies to leases for PP&E while excluding leases to exploit or explore natural resources and certain licensing arrangements. IAS 17 is similar.

General Scope US GAAP ASC 840 applies only to leases for PP&E. IFRS
IAS 17 applies to all leases broadly. IAS 17 also specifically excludes leases for investment property (covered under IAS 40) and biological assets (covered under IAS 41).

Terminology and definitions
US GAAP IFRS A lease is defined as an agreement whereby the lessor conveys a right to use an asset to a lessee for a certain period of time in return for payment. Similar A BPO is defined as an option that allows the lessee to buy the leased asset at a price significantly lower than the asset’s fair value at the end of the lease term so that the exercise of the option is reasonably assured. The assessment as to whether a BPO exists is judgmental and requires a review of facts and circumstances. Similar

US GAAP IFRS The RV is the fair value of the leased asset at the end of the lease term and can be guaranteed or unguaranteed by the lessee or a party related to the lessee. Similar MLPs are defined as payments to be made over the lease term that a lessee is or can be required to make plus any amounts guaranteed by the lessee or by a party related to the lessee (such as a guaranteed RV), as well as a BPO. MLPs exclude contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor. Similar

US GAAP IFRS A lease term is the non-cancelable term of a lease, including any additional periods when the lease can be continued that seem reasonably certain to occur at the inception of the lease. Similar Initial direct costs are incremental costs incurred by a lessor in acquiring a lease. Similar

US GAAP Uses the term “capital” lease. Provides a more expanded definition of a lease term. Provides detailed guidance on which activities and costs qualify as initial direct costs. IFRS Uses the term “finance” lease. Has a less expanded definition of a lease term. Does not provide guidance on this issue.

Lease classification US GAAP IFRS
Requires a lease to be classified as either a capital/finance lease or an operating lease at the inception date of the lease by the lessor and lessee. Similar Requires classification of a lease as a capital/finance lease when it transfers substantially all the risks and rewards incidental to ownership to the lessee. Such classification is evaluated through the use of capitalization indicators. If a lease meets one of the indicators, it is recorded as a capital/finance lease; otherwise, it is recorded as an operating lease. Similar

Lease classification For both lessors and lessees
US GAAP Uses bright line tests to determine capitalization. IFRS Uses more general criteria based on the substance of the lease to determine capitalization.

Lease classification For lessors
US GAAP Further classifies a capital lease into either sales-type (includes profit) or direct-finance leases (the fair value equals the carrying value of the leased asset). Includes accounting for leveraged leases. IFRS Does not have this classification; however, this has no practical effect on the accounting. Does not have a concept of leveraged leases.

Lessee accounting Capitalization criteria
US GAAP IFRS Lease capitalization is required if: The ownership of the asset is transferred to the lessee at the end of lease term. The lease contains a BPO. Similar

US GAAP Lease capitalization is required if: The lease term is at least 75% of the property’s remaining economic life. The NPV of MLP is 90% or more of the fair value of the leased property at the inception date. If the beginning of the lease term falls within the last 25% of the leased asset’s remaining life, then these two criteria may not be used to determine capitalization. IFRS No bright line tests. Lease capitalization is required if: The lease term is a “major part” of the property’s remaining economic life. The NVP of MLP is “substantially all” of the fair value of the leased property at the inception date. This rule is not specified in IFRS.

US GAAP These indicators are not specified. For the first three IFRS indicators, US GAAP relates to either the guarantee of RV or bargain renewal matters, which increase the likelihood of capital lease treatment, although it is not as conclusive. IFRS There are four additional finance lease indicators that individually or in combination could lead to the lease being capitalized: The leased assets are of such a specialized nature such that only the lessee can use them without major modifications being made. The lessee bears the lessor’s losses if the lessee cancels the lease. 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 (bargain renewal option).

US GAAP IFRS Ownership is transferred to the lessee by the end of the lease term. Similar. The lease contains a bargain purchase option. The lease term is equal to 75% or more of the estimated economic life of the leased property. Similar; a major part and no bright lines test. The present value of minimum lease payments equals or exceeds 90% of the fair value of the leased property. Similar; substantially all and no bright lines test. Not specified. The leased assets are of such a specialized nature such that only the lessee can use them without major modifications being made. The lessee bears the lessor’s losses if the lessee cancels the lease. The lessee absorbs the gains or losses from fluctuations in the fair value of the RV of the asset. The lessee may extend the lease for a secondary period at a rent substantially below the market rent.

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.

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)

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” * The IFRS determination is subject to interpretation and may result in a different classification (Continued on next slide.)

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.

Lessee accounting Capital/finance lease
US GAAP IFRS The RV is capitalized by the lessee if this value is guaranteed. An unguaranteed RV is not capitalized. Similar Similar A BPO is capitalized by the lessee. At the beginning of the lease term, leased assets and related liabilities are recognized at the lower of the fair value of the leased asset or the NPV of the MLP. Similar

US GAAP IFRS The current portion of a capital lease liability is calculated as the PV of MLP due in one year subsequent to the balance sheet date. The non-current portion is the difference between the current portion and the total lease obligation. Similar

US GAAP To calculate the NPV of MLP, the lessee’s incremental borrowing rate is used, unless the lessor’s implicit rate can be determined and is less. IFRS The rate implicit in the lease is used to discount MLP, if practicable to determine (this is not common in practice because it is a key factor in the lessor’s business model to determine profitability); otherwise, the incremental borrowing rate should be used. No evaluation is made regarding which rate is lower.

Lease classification for lessee including interest rate determination example
Example 2 – interest rate determination On January 1, 2010, RRI entered into a lease with Bob’s Antique Cars (BAC) for an antique roadster with the following terms: Negotiated price (fair value) of $20,000 for the antique roadster at the inception date of the lease. Term of seven years. Unguaranteed residual value of $5,124. 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 $12,000. Implicit annual interest rate (disclosed to RRI by BAC) of 5%. Incremental annual borrowing rate of 5.25%. Payments of $3,000 per year due on December 31. Remaining economic life of 10 years. Depreciation policy for the auto is the straight-line method. Ownership is not transferred at the end of the lease term. The lease may not be extended.

Part I: 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. Part II: Assume RRI had an incremental borrowing rate of 4%. Would this change the results of the lease classification, using US GAAP or IFRS? Note: Round dollar amounts to the nearest dollar when calculating the PV of MLP.

US GAAP capitalization criteria IFRS capitalization criteria
Lease classification for lessee including interest rate determination example Example 2 solution: Part I – Based on the information presented below, RRI would classify the BAC 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. $12,000 > $5,124 No. $12,000 > $5,124 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. Seven years = 70% of 10 years No.* Seven years = 70% of 10 years. Might or might not 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. $17,359** = 87% of $20,000 Yes.* $17,359** = 87% of $20,000 Might or might not be considered substantially all. (Continued on next slide.)

Lease classification for lessee including interest rate determination 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 No. The lessee bears the lessor’s losses if the lessee cancels the lease. 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. * The IFRS determination is subject to interpretation and may result in a different classification. Management would consider the results of all the criteria individually and in combination with each other and most likely would determine that the risks and rewards of the asset have transferred to RRI.

** The PV of MLP is calculated as shown below. The RV is not included as it is not guaranteed. For US GAAP, the discount rate used is the implicit interest rate of 5% as it is known and is lower than the incremental borrowing rate of 5.25%. For IFRS, the implicit interest rate of 5% is used as the discount rate since it is known, regardless of the incremental borrowing rate. Note that the last interest payments have been rounded up by $1 for the purposes of this table. Beginning balance Interest at 5% Lease payment Ending balance 2010 $17,359 $ 868 $(3,000) $15,227 2011 761 (3,000) $12,988 2012 649 $10,637 2013 532 $ 8,169 2014 408 $ 5,577 2015 279 $ 2,856 2016 144 $ – $3,641 $(21,000)

Part II – Based on the information on the next slide, RRI would classify the BAC lease as a capital lease under US GAAP and as a finance lease under IFRS. Under the change in the interest rates, for US GAAP, the incremental borrowing rate is used as the discount rate since it is lower than the implicit interest rate of 5%. This results in a PV of MLP of $18,006 as shown in the table. For IFRS, the implicit interest rate of 5% is used as the discount rate similar to part I of the example since it is known, despite being higher than the incremental borrowing rate. The PV of the MLP continues to be $17,359. Based on the new PV of MLP for US GAAP, the lease now meets the 90% test and would be classified as a capital lease. Beginning balance Interestat 4% Lease payment Ending balance 2010 $18,006 $ 720 $(3,000) $15,726 2011 629 (3,000) $13,355 2012 534 $10,889 2013 436 $ 8,325 2014 333 $ 5,658 2015 226 $ 2,884 2016 116 $ – $2,994 $(21,000) Note that the last interest payments have been rounded up by $1 for the purposes of this table.

Lease classification for lessee including interest rate determination example US GAAP capitalization criteria IFRS capitalization criteria US GAAP IFRS The PV of MLP equals or exceeds 90% of the fair value of the leased property at the inception date. The PV of MLP is substantially all of the fair value of the leased property at the inception date. Yes. $18,006 = 90% of $20,000 No.* $17,359 = 87% of $20,000 Might or might not be considered substantially all. * The IFRS determination is subject to interpretation and may result in a different classification.

Lessee accounting Capital/finance lease – depreciation of a leased asset
US GAAP IFRS Amounts capitalized for a leased asset are depreciated according to the method of the underlying asset. Similar The depreciation term is based on the capitalization indicators and the certainty of ownership. Due to the reasonable certainty of ownership for the lease ownership transfer and BPO indicators, the life of the asset is used as the depreciation term if these indicators are met. Similar

Lessee accounting Capital/finance lease – depreciation of a leased asset
US GAAP The remaining lease capitalization indicators (beyond those mentioned on the last slide) involve estimates and reasonable uncertainty of ownership. Leased assets meeting these criteria (but not the lease ownership transfer and BPO indicators) are depreciated over the lease term. IFRS Leased assets meeting the remaining lease capitalization indicators are depreciated over the shorter of the lease term or the life of the asset.

Lessee accounting Operating lease
US GAAP IFRS Lease payments are recorded as an expense when due. Similar

Lease accounting example
Example 3 – lease accounting Based on the information and lease classification determined in examples 1 and 2 (part I), prepare the journal entries for RRI for 2010, using US GAAP. Based on the information and lease classification determined in examples 1 and 2 (part I), prepare the journal entries for RRI for 2010, using IFRS.

Example 3 solution: US GAAP: Both leases are classified as an operating lease. Lease with MMT for carriage Lease expense $2,500 Cash $2,500 To record annual operating lease payment for the carriage. Lease with BAC for roadster Lease expense $3,000 Cash $3,000 To record annual operating lease payment for the roadster.

IFRS: Both leases are classified as a finance lease. Lease with MMT for carriage Carriage $6,682 Finance lease liability – current $2,099 Finance lease liability – non-current ,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 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.)

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.

Lease with BAC for roadster Roadster $18,006 Finance lease liability – current $ 2,280 Finance lease liability – non-current 15,726 To record the capital lease of the auto based on the PV of MLP (since this is lower than the fair value). The current portion is the NPV of MLP due within the next year. Finance lease liability – current $ 2,280 Interest expense Cash $3,000 To record the lease payment and related interest expense. Interest expense is calculated as 4% multiplied by PV of MLP of $18,006. (Continued on next slide)

Depreciation expense – roadster $2,572 Accumulated depreciation – roadster $2,572 To record the depreciation for the roadster over the lease term of seven years ($18,006/7) since this is shorter than the 10-year life of the asset. The depreciation is based on this term as capitalization was based on an indicator where ownership transfer is not reasonably assured. Capital lease liability – noncurrent $2,371 Capital lease liability – current $2,371 To reclassify the PV of the MLP payments due within the next year of $2,371.

Lessor accounting Capitalization criteria
US GAAP IFRS Lessors apply the same criteria as lessees except that MLPs are viewed from the perspective of the lessor. Similar

Lessor accounting Capitalization criteria
US GAAP There are two additional capital lease indicators required: The collectability of lease payments must be reasonably assured. There must be no important uncertainties surrounding the amount of non-reimbursable costs to be incurred by the lessor. IFRS While IFRS does not have these two criteria, it does require a qualitative assessment regarding the transfer of risks and rewards that addresses similar issues. This may or may not result in similar accounting treatment.

Lessor accounting Capital/finance lease (not involving real estate)
US GAAP IFRS The RV is capitalized by the lessor whether or not the value is guaranteed or unguaranteed. Similar Similar A BPO is capitalized by the lessor.

Lessor accounting Capital/finance lease (not involving real estate)
US GAAP IFRS Initial direct costs include costs to initiate the lease such as credit checks, commissions, legal fees, agent fees, etc. For direct-financing leases, these costs are capitalized as part of the net investment in the lease and amortized over the lease term to produce a constant periodic rate of return on the net investment (effective-interest method). For sales-type leases, these costs are expensed in the same period as the recognition of the gain. Similar, but for direct financing leases, these costs are first capitalized to the carrying value of the leased asset rather than being capitalized directly to the net investment in the lease, but this results in the same net investment in the lease and unearned income under both standards. IFRS does not classify finance leases as sales-type, but the guidance directs manufacturers or dealer lessors (generally transacting sales-type leases) to expense these costs.

Lessor accounting Capital/finance lease (not involving real estate) – lease receivable
US GAAP IFRS The interest rate implicit in a lease is the discount rate that, at the inception of the lease, causes the aggregate of the PV of the MLP and the residual value to be equal to the fair value of the asset, including any initial direct costs of the lessor. Similar The capital/finance lease receivable is recorded as the net investment in the lease, which is the carrying value of the leased asset including initial direct costs for non-sales-type leases. Alternatively, this net investment is calculated as the gross investment in the lease (the minimum lease payments and RV (whether guaranteed or unguaranteed)) less unearned interest income plus initial direct costs for non-sales-type leases. Similar

Lessor accounting Capital/finance lease (not involving real estate) – lease receivable
US GAAP IFRS The current portion of the capital lease receivable is receivable in one year subsequent to the balance sheet date. The non-current portion is the difference between the current portion and the total lease receivable. Similar Selling profit is recognized immediately in income. Similar Interest income is recognized over the lease term using a constant rate of return. Similar

Lessor accounting Operating lease
US GAAP IFRS Lease receipts are recognized as lease income on a straight-line basis over the period of the lease or another systematic basis. Another systematic basis is used if it is more representative of the time pattern of the benefits from the leased asset’s use. Similar

Lessor accounting Operating lease
US GAAP Initial direct costs are deferred and allocated over the lease term in proportion to the recognition of rental income. IFRS Initial direct costs are added to the carrying value of the leased assets and depreciated over the lease term on the same basis as the rental income, unless they are manufacturer or dealer lessors, in which case they must be expensed immediately. Although the deferral is recorded in different accounts, the result on income is the same.

Lessor accounting example
Example 4 – lessor accounting The same terms of the lease arrangements between MMT and BAC with RRI apply to this example, while also considering the additional information below: The collectability of the lease payments from RRI are reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT or BAC. MMT’s carrying value of the carriage ($8,000) is less than the fair value of the carriage ($10,000). MMT is a manufacturer lessor and market rates are the same as its implicit rate. MMT incurred $500 of initial costs for credit checks in executing the lease. BAC’s carrying value of the roadster is equal to the fair value of the roadster ($20,000). BAC incurred $1,000 of initial costs for legal fees and credit checks in executing the lease. BAC is neither a manufacturer or dealer lessor. Based on this information, prepare the journal entries for MMT for 2010, using US GAAP and IFRS. Round to the nearest dollar. Based on this information, prepare the journal entries for BAC for 2010, using US GAAP and IFRS. Round to the nearest dollar.

Example 4 solution: US GAAP: The MMT lease is classified as an operating lease and the BAC lease is classified as a capital lease. MMT lease for carriage Deferred initial lease costs $500 Cash $500 To record the credit check expense to initiate the lease. Lease expense $167 Deferred initial lease costs $167 To record the expense for the initial lease costs in relation to the lease income ($500 over three years). (Continued on next slide.)

Cash $2,500 Lease income $2,500 To record annual operating lease income for the carriage. Depreciation expense $2,000 Accumulated depreciation – carriage $2,000 To record annual depreciation expense on the carriage.

BAC lease for roadster Since the carrying value of the roadster equals the fair value and collectability of payments is reasonably assured, this is a direct-financing capital lease. Indirect costs should be capitalized to the net investment in the lease and amortized over the lease term. The gross investment in the lease is $26,124, calculated as the seven lease payments of $3,000 each plus the unguaranteed residual value of $5,124. The unearned income is $6,124, calculated as the gross investment in the lease less the carrying value of the equipment of $20,000. The net investment in the lease is $21,000, calculated as the gross investment of $26,124 plus capitalized initial direct costs of $1,000 and less unearned income of $6,124. The following is the amortization table producing a 5% constant periodic rate of return: Beginning balance Interest at 5% Lease payment Ending balance 2010 $21,000 $1,050 $ (3,000) $19,050 2011 953 (3,000) $17,003 2012 850 $14,853 2013 743 $12,596 2014 630 $10,226 2015 511 $ 7,737 2016 387 $ 5,124 $5,124 $(21,000)

Capital lease receivable – current $ 1,950 Capital lease receivable – non-current 19,050 Roadster $20,000 Cash ,000 To record the direct financing capital lease of the roadster based on the net investment in the lease. The current portion is the NPV of MLP due within the next year. Cash $3,000 Interest income $1,050 Capital lease receivable – current ,950 To record the lease payment and related interest income. Interest expense is calculated as 5% multiplied by the net investment in the lease of $21,000. Lease receivable – current $2,047 Lease receivable – non-current $2,047 To reclassify the lease payments due within the next year of $2,047.

IFRS: Both the MMT and BAC leases are classified as a finance lease. MMT lease for carriage The sale of the leased asset is recorded at the lower of the fair value of the leased asset ($10,000) or the PV of MLP at market rates (6%) ($6,683 as shown in the table below). The cost of goods sold is the carrying value of the leased asset of $8,000 less the PV of the unguaranteed residual value of $3,317 ($3,951 discounted at 6% for three years). The gross investment in the lease is $11,451, calculated as the three lease payments of $2,500 each plus the unguaranteed residual value of $3,951. The unearned income is $1,451, calculated as the gross investment in the lease less the fair value of the carriage of $10,000. The net investment in the lease is $10,000, calculated as the gross investment of $11,451 less unearned income of $1,451.

Net investment in lease PV of MLP Beginning balance Interest at 6% Lease payment Ending balance 2009 $10,000 $ 600 $(2,500) $8,100 $6,683 $401 $4,584 2010 $ 8,100 486 (2,500) $6,086 275 $2,359 2011 $ 6,086 365 $3,951 141 $ – $1,451 $(7,500) $817

Initial direct lease expense $500 Cash $500 To recognize the expenses for the initial direct costs of $500 as MMT is a manufacturer lessor. Finance lease receivable – current $1,900 Finance lease receivable – non-current 8,100 Cost of goods sold 4,683 Inventory – carriage $ 8,000 Sales ,683 Unearned finance income ,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).

Cash $2,500 Interest income $600 Lease receivable – current ,900 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.

BAC lease for roadster The lease is a finance lease. As BAC is not a manufacturer or dealer lessor, indirect costs first should be capitalized to the carrying value of the leased asset. The gross investment in the lease is $26,124, calculated as the seven lease payments of $3,000 each plus the unguaranteed residual value of $5,124. The unearned income is $5,124, calculated as the gross investment in the lease less the carrying value of the equipment of $21,000. The net investment in the lease is $21,000, calculated as the gross investment of $26,124 less unearned income of $5,124. The following is the amortization table producing a 5% constant periodic rate of return: Beginning balance Interest at 5% Lease payment Ending balance 2010 $21,000 $1,050 $ (3,000) $19,050 2011 953 (3,000) $17,003 2012 850 $14,853 2013 743 $12,596 2014 630 $10,226 2015 511 $ 7,737 2016 387 $ 5,124 $5,124 $(21,000)

Roadster $1,000 Cash $1,000 To capitalize the indirect costs to the carrying amount of the leased asset. Finance lease receivable – current $ 1,950 Finance lease receivable – non-current 19,050 Roadster $21,000 To record the direct financing capital lease of the roadster based on the net investment in the lease. The current portion is the NPV of MLP due within the next year. Cash $3,000 Interest income $1,050 Finance lease receivable – current ,950 To record the lease payment and related interest income. Interest expense is calculated as 5% multiplied by the net investment in the lease of $21,000. (Continued on next slide.)

Finance lease receivable – current $2,047 Finance lease receivable – non-current $2,047 To reclassify the lease payments due within the next year of $2,047.

Sales leaseback arrangements Definition
US GAAP IFRS An SLB arrangement is a transaction in which the owner of an asset sells the asset and then leases it back. Similar

Sale and leaseback arrangements Lease classification and capitalization criteria
US GAAP IFRS The same classification and capitalization criteria must be met as defined previously. Similar

Sale and leaseback arrangements Accounting treatment
US GAAP IFRS For a capital/finance SLB, if the seller does not relinquish more than a minor part (>10%) of the use of the leased asset, the gain or loss is deferred and amortized ratably over the lease term. Similar

US GAAP The accounting treatment is the same for both a capital and operating SLB arrangement. US GAAP generally tries to capture the substance of the leaseback, and the accounting follows whether or not the seller relinquishes substantially all of the use of the asset, more than a minor part of the asset or less than a minor part of the asset. Details on next slide. IFRS

US GAAP If the seller relinquishes substantially all of the use of the leased asset (>90%), then the sale and the leaseback should be accounted for as separate transactions and the entire gain or loss is recognized. If the seller relinquishes more than a minor part (>10%) of the use of the leased asset but less than substantially all (<90%), any profit of the sale amount in excess of the PV of MLP is recognized immediately in income. If the seller relinquishes less than a minor part of the asset, then the profit is deferred and amortized ratably over the lease term. If the transaction results in a loss, it is recognized immediately. IFRS

US GAAP IFRS Finance lease: Any gain or loss is deferred and amortized ratably over the lease term. If the loss indicates impairment, recognize it according to impairment rules under IAS 36 prior to sale-leaseback accounting. Operating lease If the sales price equals fair value, the gain is recognized immediately. If the sales price is greater than fair value, the difference between sales price and fair value should be deferred and amortized over the period for which the asset is expected to be used.

US GAAP IFRS Operating lease (continued): If the sales price is greater than fair value, any loss is recognized immediately except where the loss is compensated for by below-market future lease payments, in which case the loss is deferred and amortized in proportion to the lease payments over the period of expected use. Regardless of the sales price, if the fair value is less than carrying value, the loss should be recognized immediately.

Sale and leaseback arrangements Accounting treatment – decision tree
US GAAP Operating or capital IFRS Operating IFRS Finance Seller relinquishes use? Sales = FV? No Defer and amortize Yes Immediate recognition Defer and amortize If loss indicates impairment, recognize under IAS 36 prior to SLB accounting Yes No Substantially all? Sales > FV? Yes Account for separate transactions Yes Amount more than FV, defer and amortize No No More than a minor part? Immediate recognition of the amount > PV of MLP Sales < FV? Immediate recognition (if lease payments are at market) Yes Yes

Sale and leaseback example
Example 5 – sale and leaseback Part I: RRI sells a sports car to the Hot Rod Company (HRC) and then leases it back under an operating lease for a period of three years. The leaseback is estimated to be approximately 9% of the fair value of the sports car. The sales price of the sports car is $100,000 and the net book value is $80,000. The lease payments are reasonable in view of the current market conditions, and the sales price approximates the fair value of the sports car. Determine how RRI would account for the leaseback using US GAAP and IFRS.

Example 5 solution: Part I : US GAAP: RRI is retaining only a minor portion of the remaining use of the sports car (9% of the fair value); therefore, RRI would record the sale and lease as separate transactions. RRI would record the sale and recognize the gain of $20,000 as the difference in the sales price of $100,000 and the carrying value of $80,000. IFRS: The accounting treatment would be the same as US GAAP since the sales price approximates fair value.

Example 5 – sale and leaseback Part II: RRI sells a sports car to HRC and then leases it back under an operating lease for a period of three years. The sales price of the sports car is $100,000, and the net book value is $50,000. The lease payments are reasonable in view of the current market conditions. The PV of MLP is $30,000. The fair value of the sports car is $90,000. Determine how RRI would account for the leaseback, using US GAAP and IFRS.

Example 5 solution: Part II : US GAAP: RRI is retaining more than a minor portion of the remaining use of the sports car but less than substantially all. This is determined by comparing the PV of the MLP of $30,000 to the fair value of the asset of $90,000 or 30%. RRI would calculate the profit as the sales price of $100,000 less the carrying value of $50,000. A gain of $20,000 would be recognized immediately since this is the amount of the profit above the PV of MLP. The PV of MLP of $30,000 would be deferred and amortized ratably over the term of the lease. IFRS: Since the sales price of $100,000 is above the fair value of the sports car of $90,000, the excess of $10,000 would be deferred and amortized ratably over the term of the lease period (the period for which the asset is expected to be used). The remaining gain of $40,000 would be recognized immediately.

Example 5 – sale and leaseback Part III: RRI sells a sports car to HRC and then leases it back under a capital/finance lease for a period of three years. The sales price of the sports car is $100,000, which is determined to be fair value. The net book value is $50,000. The lease payments are reasonable in view of current market conditions. The PV of MLP is $95,000. Determine how RRI would account for the leaseback, using US GAAP and IFRS.

Example 5, part III solution (continued): US GAAP: RRI is retaining a substantial portion of the remaining use of the sports car. This is determined by comparing the PV of MLP of $95,000 to the fair value of the asset of $100,000 or 95%. RRI would defer the gain of $50,000, calculated as the sales price of $100,000 less the carrying value of $50,000 and amortize the amount over the term of the lease. IFRS: The accounting treatment would be the same as US GAAP.

Other lease considerations
US GAAP IFRS Lease incentives are deferred and amortized on a straight-line basis, unless a more systematic basis is more representative of the time pattern of the lessee’s benefit from the use of the leased asset: Leasehold improvements are amortized over the shorter of the lease term or their estimated useful life when there is no reasonable uncertainty that ownership will transfer by the end of the lease term. Rent holidays or rent-free periods are amortized over the lease term. Similar

Leasehold improvements example
Example 6 – leasehold improvements The Retail Company (TRC) enters into an operating lease with a lessor, Main Street Mall Inc. (MSM), for a five-year term at a monthly rental of $110. In order to induce TRC into the lease, MSM agrees to provide funding of up to $600 for leasehold improvements. TRC spends $720 on leasehold improvements having an estimated useful life of six years. What journal entries should TRC prepare during its first month of the lease, using US GAAP and IFRS?

Example 6 solution: The entries are the same for both US GAAP and IFRS: Cash $600 Lease incentive obligation $600 To record the receipt of the lease incentive. Leasehold improvements $720 Cash $720 To record the expenditure of the funds (including the $600 of funds supplied by MSM) on leasehold improvements. (Continued on next slide.)

Example 6 solution (continued): Operating lease expense $100 Lease incentive obligation Cash $110 To record monthly lease payments. The lease expense is reduced by the amortization of the lease incentive ($600) over the term of the lease of 60 months. Amortization expense $12 Accumulated leasehold improvements $12 To record monthly amortization of leasehold improvements ($720/60) over the shorter of the lease term (60 months) or estimated useful life (72 months).

Rent-free periods example
Example 7 – rent-free periods Catherine’s Internet Café (CIC) enters into a new operating lease for a 10-year term at a monthly rental of $500. To induce CIC into the lease, the lessor agreed to a free-rent period for the first year. How would lease expense for CIC differ, using US GAAP compared to IFRS in years one and two?

Rent-free periods example
Example 7 solution: The annual lease expense is the same under US GAAP and IFRS. Total consideration for rent over the lease term is $54,000 ($500 for 108 months). This consideration must be recognized on a straight-line basis (unless another systematic basis is more representative of the time pattern of the lessee’s benefit from using the leased asset) over the entire lease period of 10 years, resulting in annual lease expense of $5,400. Lease expense $5,400 Deferred rent payable $5,400 To record lease expense in year one.

Disclosures US GAAP IFRS
Generally, the disclosures vary based on the type of lease (capital/finance or operating) and whether the disclosure is for a lessee or lessor. Similar

Disclosures US GAAP Future rent disclosures are by individual year for the first five years and the aggregate amount thereafter. IFRS Future rent is disclosed for the first year, years two through five inclusive and the aggregate amount thereafter.

Assurance | Tax | Transactions | Advisory
Ernst & Young LLP Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit Ernst & Young LLP is a client-serving member firm of Ernst & Young Global and of Ernst & Young Americas operating in the US. © 2010 Ernst & Young Foundation (US). All Rights Reserved. SCORE No. MM4050C.

IAS 17 - Leases.

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IAS 17 - Leases.

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