Leasing

Dr. Georgios Georgakopoulos, [email protected]

International Financial Reporting Standards (IFRS)

Leasing (IAS 17)

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

Substance over Form

Finance leaseA lease is a finance lease if it

transfers substantially all the risks and rewards

incident to ownership

Operating leaseA lease is an operating lease if it does not transfer substantially

all the risks and rewardsincidental to ownership

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 asset’s 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

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.

Specialised nature

NPV of MLPMajor part ofeconomic life

Bargain price

Transfer of ownership

RISKS & REWARDS

Finance lease versus operating lease

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)

* Defined on following slides

Commonly referred to as executory costs: The lessee reimburses the lessor for the lessor's expense payments

Commonly referred to as executory costs: The lessee reimburses the lessor for the lessor's expense payments

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


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


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

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 leasePVMLPs + 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 latter’s profit

IDC: Include commission and legal fees and internal costs Exclude general overheads (sales/marketing), and IDC of manufacturers or dealer lessors => relate to the latter’s profit

Perhaps different than the commencement date of the lease term which is a date set by the agreement

Perhaps different than the commencement date of the lease term which is a date set by the agreement

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.

•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.

Referred to as “executory costs”Referred to as “executory costs”


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 asset’s economic life?


Is the lease non-cancellable? The lease is cancellable, but a significant monetary penalty

will apply – therefore the lease is deemed to be non-cancellable

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 asset’s economic life? The lease term is for 67% of the economic life of the asset

(4/6 years) Unlikely that this would be considered to be a major part of

the asset’s life

Text book uses > 75% as a benchmarkText book uses > 75% as a benchmark


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

Does the lessee bear substantially all ownership risks and rewards?

Conclusion:


Does the PV of MLP represent substantially the FV of the asset? (85,457/(89,721 + 1,457)) = 93.7% 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

Textbook uses > 90% as a benchmarkTextbook uses > 90% as a benchmark

Example 2

Lease commencing on 1 January 20X1Term 3 yearsPurchase price of asset 16,500Annual payments (in advance) 6,000Borrowing rate 15%

Required: Determine if it is a finance/ operating lease

Example 2

Lease commencing on 1 January 20X1Term 3 yearsPurchase price of asset 16,500Annual payments (in advance) 6,000Borrowing rate 15%

Required: Determine if it is a finance/ operating lease

Fair Value of asset 16,500PV (6000 + 6000/1.15 + 6000/(1.15)2) 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 asset’s 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 lessee’s 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 Operating leaseTransfer of substantially all risks and rewards of ownership

No transfer of substantially all risks and rewards of ownership

Transfer of ownership at the end of lease term

No transfer of ownership at the end of lease term

Option to purchase the asset at a price expected to be exercised

No option to purchase the asset, or option to purchase not expected to be exercised

Present value of MLPs equals to substantially all of the FV of the asset

Present value of MLPs differs substantially from the FV of the asset

Leased asset’s nature only suitable for lessee

There can be several users of the asset

Key for classification: substance over form


Lease type Balance Sheet Income Statement

Finance – Lessee AssetAccumulated depreciationLease obligationReduction in lease obligation

Depreciation expenseFinance expense

Finance – Lessor ReceivableReduction in receivable

Sale of assetFinance income

Operating – Lessee Off balance sheet Rental expense

Operating – Lessor Asset Accumulated depreciation

Rental incomeDepreciation 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

– Obligation to return the asset at end of the lease term

Asset

Liability

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 & liabilityRecorded 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

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

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

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

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 Glenellen’s 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 3.685then Present Value of Lease Payments =

Capitalisation Journal Entry

Is This a Finance Lease?

If discounting factor for the whole period (6 years) is 3.685then 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 14,740

Capital Lease obligation 14,740To 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 yearDep.Exp. - Capital Lease Equipment 2,457

Accum.Dep. - Capital Lease Equipment 2,457To record dep.exp on capital lease

Payment Schedule on 16% Capital Lease

The last year’s 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 yearInterest Exp. $2,358Capital Lease Obligations $1,642

Cash $4,000 Made payment on capital lease

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 lessee’s gain/(loss) from the sale of

the asset is deferred and amortised over the term of the lease– Under an operating lease the lessee’s 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

• Land and buildings are dealt with separately.

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

Accounting for the lease of land and buildings

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.

Leasing

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