International Financial Reporting Standards (IFRS)

Leasing (IAS 17)

Dr. Georgios Georgakopoulos, M1.05 g.georgakopoulos@uva.nl

Introduction

Lease classification based on substance of the arrangement Classification drives accounting treatment Significant effects

What Is a Lease?
A lease is an agreement where a lessor conveys to a lessee the right to use an asset for an agreed period of time in return for a payment or series of payments The lessee does not acquire an asset, merely a right to use an asset for a period of time May result in the eventual transfer of ownership eg hire purchase agreement IAS 17 excludes: Service agreements - as they do not involve the use of an asset Resource exploration rights Licensing agreements - eg for films, patents etc

Classification Of Leases
IAS 17 recognises the following types of leases: Finance lease Operating lease Accounting treatment and disclosures required differ substantially for finance and operating leases A finance lease is a lease which transfers substantially all ownership risk and rewards, with or without eventual title transfer Risks of ownership include obsolescence, idle capacity,
uninsured damage etc.

Rewards of ownership include benefits from use of the

asset, appreciation in value of the asset

An operating lease is a lease other than a finance lease

Finance Lease Vs Operating Lease

Finance lease A lease is a finance lease if it transfers substantially all the risks and rewards incident to ownership

Operating lease A lease is an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership

Substance over Form

Classification Of Finance Leases

The lease is a finance lease if one or a combination of the following apply: The lease transfers ownership of the asset at the end of the lease term The lessee has the option to purchase the asset at a price substantially lower than the fair value at the date the option become exercisable, so that it is reasonably certain that the option will be exercised The lease covers a major part of the assets economic life The present value of minimum lease payments (MLPs) represents substantially the fair value of the asset
IAS 17 does not contain a definition or further guidance as to what major part and substantially mean- therefore judgment required

Classification Of Finance Leases (cont)

The leased asset is of a specialised nature that only the lessee can use them without major modification The lease is non-cancellable The lessee has the ability to continue the lease for a secondary period at a rental that is substantially less than market value.

Finance lease versus operating lease

Transfer of ownership

Specialised nature
RISKS & REWARDS

Bargain price

NPV of MLP

Major part of economic life

Minimum Lease Payments (MLPs)

MLPs = Payments over lease term + Guaranteed residual value * + Bargain purchase option * Contingent rent * Reimbursement of costs paid by lessor (e.g. maintenance, insurance, taxes)
Commonly referred to as executory costs: The lessee reimburses the lessor for the lessor's expense payments

* Defined on following slides

Minimum Lease Payments (MLPs): Definitions

Guaranteed residual value

At the commencement of the lease, the lessor estimates the residual value of the asset at the end of the lease term (based on market conditions) Under a finance lease the lessee guarantees that the lessor will realise that amount The guarantee may range from 1% to 100% of the residual value The existence of a guaranteed residual value indicates that the lessor has transferred risks associated with movements in the residual value to the lessee

Minimum Lease Payments (MLPs): Definitions

Bargain purchase option
A clause in the lease agreement allowing the lessee to purchase the asset at the end of the lease term for a pre-set amount (which is less than the expected residual value) The option price is normally to be sufficiently lower than expected fair value resulting in the exercising of the option becoming reasonably certain

Minimum Lease Payments (MLPs): Definitions

Contingent rent
Additional payments arising from increases/decreases in the schedule lease payments due to the occurrence of particular events specified in the lease agreement Eg. lease of a photocopier may specify additional payments if the number of photocopies exceeds a certain amount in a month

Minimum Lease Payments (MLPs): Determining Present Value

The present value (PV) of MLPs is determined by applying an appropriate discount rate at the inception date of the lease
Perhaps different than the commencement date of the lease term which is a date set by the agreement

Discounting is not necessary if the lease agreement contains a 100% guaranteed residual value (as the PV of MLP = FV of the asset in such cases The discount rate is based on the interest rate implicit in the lease PVMLPs + Unguaranteed Residual Value = FV + IDC
IDC: Include commission and legal fees and internal costs Exclude general overheads (sales/marketing), and IDC of manufacturers or dealer lessors => relate to the latters profit

Classification Of Lease: Example 1

On 30 June 2008 E Ltd leased a vehicle to C Ltd. The FV of the vehicle at the inception of the lease was $89,721. Lease establishment costs incurred by E Ltd totalled $1,457. The lease agreement is for 4 years and the economic life of the vehicle is 6 years. The annual lease payments (payable in advance on 30 June each year) are $23,900. This

includes $1,900, representing a reimbursement of insurance and maintenance costs paid by the lessor.
Referred to as executory costs
The lease is cancellable, but will incur a penalty equal to 2 years lease payments. The PV of MLP has been calculated to be $85,457. The estimated residual value of the asset at the end of the lease term is $15,000 and the

guaranteed residual value is $7,500. C Ltd intends on returning the asset to E Ltd at the end of the lease term. The interest rate implicit in the lease is 7%. Required: Determine whether the lease is an operating or finance lease per IAS 17.

Classification Of Lease: Example 1

Is the lease non-cancellable?

Is ownership to be transferred at end of the lease term?

Does the term of the lease cover a major part of the assets economic life?

Classification Of Lease: Example 1

Is the lease non-cancellable? The lease is cancellable, but a significant monetary penalty will apply therefore the lease is deemed to be noncancellable Is ownership to be transferred at end of the lease term? No C Ltd expects to return the asset to the lessor
Does the term of the lease cover a major part of the assets economic life? The lease term is for 67% of the economic life of the asset (4/6 years) Text book uses > 75% as a benchmark Unlikely that this would be considered to be a major part of the assets life

Classification Of Lease: Example 1

Does the PV of MLP represent substantially the FV of the asset?

Does the lessee bear substantially all ownership risks and rewards?

Conclusion:

Classification Of Lease: Example 1

Does the PV of MLP represent substantially the FV of the asset? (85,457/(89,721 + 1,457)) = 93.7% Textbook uses > 90% as a benchmark This represents substantially all the FV of the lease asset. Does the lessee bear substantially all ownership risks and rewards? It appears so

Conclusion: In spite of the mixed signals above, the lease should be classified as a finance lease as substantially all the risks and rewards of ownership pass to the lessee

Example 2
Lease commencing on 1 January 20X1 Term Purchase price of asset Annual payments (in advance) Borrowing rate
3 years 16,500 6,000 15%

Required: Determine if it is a finance/ operating lease

Example 2
Lease commencing on 1 January 20X1 Term Purchase price of asset Annual payments (in advance) Borrowing rate
3 years 16,500 6,000 15%

Required: Determine if it is a finance/ operating lease Fair Value of asset PV (6000 + 6000/1.15 + 6000/(1.15)2) 16,500 15,754

PV is approx 95% and it amounts to at least substantially all of the fair value of the leased asset

Example 3: Operating lease illustration

Clifford plc negotiates a lease to begin on 1 January 20X1 with the following terms: Terms of lease 5 years Estimated useful life of machine 9 years Age of machine on inception of lease 4 years FV of machine $75,000 Annual payments $8,000

Operating lease illustration (cont)

Classify as an lease because:

The amount of the annual rental paid..

Operating lease illustration (cont)

Classify as an operating lease because:

it applies only to a part of the assets useful life, and the present value of the lease payments does not constitute substantially all of the fair value.

The amount of the annual rental paid $8,000 p.a. will be charged to the income statement and disclosed. There will also be a disclosure of the ongoing commitment with a note that $8,000 is payable within one year and $24,000 within two to five years.

Incentives To Misclassify Leases

Divergent accounting treatments provide an incentive to misclassify leases as operating leases Classification as a finance lease may have the following adverse impacts on a lessees financial statements: Increases non-current assets thus reducing return on asset ratios Increases non-current liabilities adversely affecting debt/equity ratios Depreciation and interest charges may exceed lease payment in early years of lease resulting in lower profits

Incentives To Misclassify Leases

In an attempt to avoid misclassification of leases as operating leases additional guidance is contained within the following: SIC 27 - Evaluating the Substance of Transactions Involving the Legal Form of a Lease

Interpretation 4 -Determining Whether an Arrangement Contains a Lease

International Financial Reporting Interpretation Committee (IFRIC 4) - Determining Whether an Arrangement Contains a Lease.
IFRIC 4.1: An entity may enter into an arrangement, that does not take the legal form of a lease but conveys a right to use an asset in return for a payment or series of payments. Examples: outsourcing arrangements arrangements in the telecommunications industry, in which suppliers of network capacity enter into contracts to provide purchasers with rights to capacity take-or-pay and similar contracts, in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services

IFRIC 4 - Criteria
Fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset):
Specific asset identified in the agreement; or Implicitly specified: not economically feasible or practicable for the supplier to perform its obligation through the use of alternative assets.

AND: The arrangement conveys a right to use the asset:

ability or right to operate the asset; or ability or right to control physical access; or remote that other parties will take more an insignificant amount of the output and the price to be paid is not a fixed or market price per unit output

Finance lease versus operating lease

Finance lease
Transfer of substantially all risks and rewards of ownership
Transfer of ownership at the end of lease term Option to purchase the asset at a price expected to be exercised Present value of MLPs equals to substantially all of the FV of the asset Leased assets nature only suitable for lessee

Operating lease
No transfer of substantially all risks and rewards of ownership
No transfer of ownership at the end of lease term No option to purchase the asset, or option to purchase not expected to be exercised Present value of MLPs differs substantially from the FV of the asset There can be several users of the asset

Key for classification: substance over form

Finance lease versus operating lease

Lease type
Finance Lessee

Balance Sheet
Asset Accumulated depreciation Lease obligation Reduction in lease obligation Receivable Reduction in receivable

Income Statement
Depreciation expense Finance expense

Finance Lessor

Sale of asset Finance income Rental expense

Operating Lessee Off balance sheet

Operating Lessor

Asset Accumulated depreciation

Rental income Depreciation expense

Future of Leasing: Putting all lease rights and obligations on the balance sheet
Proposed changes to IAS 17 In 2008 the IASB presented a project plan for the development of a new leasing standard as part of the IASB/FASB joint project Aim is to have a new standard by 2011 which is more principles based and results in more relevant information regarding lease transactions
Objectives Develop a common approach to lease accounting that would ensure that all assets and liabilities arising under lease contracts are recognised on balance sheet DP: 17/7/2009 (300 comments received); ED: 17/8/2010; Comment period for ED completed: 15/12/2011; New standard scheduled for June 2011 but rescheduled for Q4 2011; Standard will apply in 2015 (probably) with comparing figures of 2014

Leases new proposals for lessees

Q: What is an asset?
A: IASB Framework: The entity controls an economic resource or benefit It arises out of a past event Future economic benefits are expected to flow to the entity

Leases new proposals for lessees

Q: What is a liability?
A: IASB Framework: There exists a present obligation of the entity The obligation arises out of a past event The obligation is expected to result in an outflow of economic benefits

Leases new proposals

Lessee rights Right to use the asset for the lease term Lessee obligations Obligation to pay rentals

Asset
Liability

Obligation to return the asset at end of the lease term Neither

Further complexities
Considering additional components Options to extend the lease term Options to terminate the lease early Options to purchase the leased asset Obligations to pay variable rentals Residual value guarantees Will affect Expected lease term Expected payments under the lease contract

Leases Summary of new proposals

All leases on balance sheet Estimates required to reflect uncertainties regarding lease term, use of options and contingent rentals on balance with annual re-assessment required Will require more extensive IFRIC 4 analyses. Many companies waived majority of analyses since they were expected to be operating leases anyway Will improve some measures/ratios and worsen other, impact on covenants should be investigated Likely to affect business models and business propositions

Accounting For Finance Leases By Lessees

Initial recognition Initially determine and recognise a lease asset & liability Recorded at the lower of the FV of the asset and the PV of MLP

Accounting For Finance Leases By Lessees

Subsequent measurement
For assets, determine depreciation (over the useful life of the asset to the entity) any impairment If the lessee intends on returning the asset at the
end of the lease period the useful life will be the term of the lease. Where the lessee intends on purchasing the asset at the end of the lease term, the useful life will be the economic life of the asset

For liabilities, lease payment to be allocated between reduction of the lease liability interest expense incurred reimbursement of lessor costs contingent rent

Example 4
Glenellen Manufacturing enters into a long term lease for a machine. The value of the machine is $14,740
The lease terms call for an annual payment of $4,000 for 6 years which approximates the useful life of the machine. At the end of the lease period the title to the machine passes to Clenellen. (Indication of a Finance Lease)

If Glenellens interest cost for the unpaid part of the obligation is 16%, then make a payment schedule of the lease.

Is This a Finance Lease?

If discounting factor for the whole period (6 years) is 3.685 then Present Value of Lease Payments =

Capitalisation Journal Entry

Is This a Finance Lease?

If discounting factor for the whole period (6 years) is 3.685 then Present Value of Lease Payments = Periodic Payment x Discount Factor
= $4,000 x 3.685 = $14,740 => Capital Lease!! Capitalisation Journal Entry Capital Lease Equipment Capital Lease obligation

14,740
14,740

To record capital lease on machinery

Depreciation
Each year depreciation must be recorded on the leased asset. Assuming straight-line depreciation, with a 6 year life and no residual value then Annual Deprec =
Depr. Journal Entry after one year

Depreciation
Each year depreciation must be recorded on the leased asset. Assuming straight-line depreciation, with a 6 year life and no residual value then Annual Deprec = $14,740 / 6 = $2,457
Depr. Journal Entry after one year Dep.Exp. - Capital Lease Equipment Accum.Dep. - Capital Lease Equipment
To record dep.exp on capital lease

2,457

2,457

Payment Schedule on 16% Capital Lease

The last years interest equals $549 ($4,000 - $3,450).

Interest Expense
The interest expense for each year is computed by multiplying the interest rate (16%) by the amount of remaining lease obligation.
Lease Payment Journal Entry after one year

Interest Expense
The interest expense for each year is computed by multiplying the interest rate (16%) by the amount of remaining lease obligation.
Lease Payment Journal Entry after one year Interest Exp. $2,358 Capital Lease Obligations $1,642 Cash
Made payment on capital lease

$4,000

Accounting For Operating Lease Incentives

SIC 15 Operating Leases Incentives provides guidance for lessees and lessors in accounting for operating lease incentives.
Incentives include rent free periods, a lessor making a contribution towards fit out costs, removal costs, etc. Lessors the cost of the incentives is treated as a reduction in rental income over the term of the lease on a straight line basis Lessees - the benefit of the incentives is treated as a reduction in rental expense over the term of the lease on a straight line basis

Sale & Leaseback Transactions

Involves the sale of an asset that is then leased back from the purchaser for all or part of the remaining economic life of the asset
Used to generate immediate cash flow while retaining asset use

Creates accounting problems for lessees

Lease component of the transaction is accounted for in the same way as normal lease transactions The sale component transaction differs, depending on whether it is classified as a finance or operating lease Under a finance lease the lessees gain/(loss) from the sale of the asset is deferred and amortised over the term of the lease Under an operating lease the lessees gain/(loss) is: recognised immediately if sale is calculated at fair value excess/reduced gains/(losses) are deferred and amortised over the term of the lease

Accounting for the lease of land and buildings

Land and buildings are dealt with separately.

Each has to be reviewed to determine whether to classify as an operating or finance lease.

Example

The Warehouse Company Ltd, whose borrowing rate was 10% per annum, entered into a 10-year lease under which it made payments of $106,886 annually in advance. The present value of the land was $500,000 and of the buildings was $500,000. The value of the land at the end of ten years was $670,000 and the value of the buildings was $50,000.

The Warehouse Company Classifying the land segment of the lease

As there is no contract to pass title at the end of the contract and the land is expected to increase in value The land segment of the contract does not involve the lessor transferring the risk and benefits to the lessee This means that the lessee has to account for the lease of the land as an operating lease.

The Warehouse Company Classifying the building segment of the lease

The building segment of the lease is different.
The residual value has fallen to $50,000 PV = $19,275 (50,000 x 0.3855). 96% of the benefit has been transferred (500,000 - 19,275 = 480,725) The building segment is, therefore, a finance lease.

The Warehouse Company apportioning the lease payment in the income statement
Split the payment at commencement of lease according to the fair value of components
The present value of the land is $500,000 of which $258,285 (670,000X0.3855) represents the present value of the land at the end of the contract So - the balance of $241,715 represents the present value of the operating lease. Similarly the amount covered by the finance lease is $480,725.

Split the lease payment of $106,886 in those proportions (241,715:480,725)

This gives $35,272 for the land component and $71,614 for the finance lease representing the buildings leased.

The Warehouse Company How to report in the balance sheet

For the finance lease covering the building : The lessee will have to show a $480,725 asset initially This will be depreciated over the ten years of the lease according to the normal depreciation policy At the same time a liability representing an obligation to the legal owner of the buildings (the lessor) for the same amount will be created. As lease payments are made the interest component will be treated as an expense and the balance will be used to reduce the liability.