Leases Chapter 12 ACTG 6580
Jan 03, 2016
Leases
Chapter 12
ACTG 6580
Objectives
1. Discuss the characteristics of a lease
2. Explain the difference between a finance and operating lease
3. Use IAS 17 to correctly classify leases
4. Discuss the incentives to misclassify leases
Objectives
5. Account for finance leases from the perspective of both lessee and lessor
6. Account for finance leases by manufacturer or dealer lessors
7. Account for operating leases from the perspective of both lessee and lessor
8. Recognize and account for sale and leaseback transactions
9. Discuss possible future changes to lease accounting
What Is a Lease?
“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”
(IAS 17 para 4)
May result in the eventual transfer of ownership Hire purchase agreement
IAS 17 excludes:Resource exploration rightsLicensing agreements
Classification Of Leases
IAS 17 recognizes the following types of leases: Finance lease Operating lease
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, loss on sale Rewards of ownership include – use of asset, gains on
sale
An operating lease is a lease other than a finance lease
Classification Guidance
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 – reducing ROA 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
Accounting for Finance Leases by Lessees
Initial recognition
Initially determine and recognize a lease asset & liability (IAS 17 para 20)
Recorded at the fair value of the asset or if lower the present value of the minimum lease payments Lease payments net of cost reimbursement Contingent rental Guaranteed residual value
Accounting for Finance Leases by Lessees
Subsequent measurement
For assets Depreciation – Calculated in accordance with IAS 16 Impairment – need to apply IAS 36
For liabilities Lease payment to be allocated between:
Reduction of the lease liability Interest expense incurred Reimbursement of lessor costs Contingent rent
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.
Lease Classification for Lessee Example
► 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.
Lease Classification for Lessee Example
► 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 $4,583 275 (2,500) $2,358
2012 $2,358 142 (2,500) $ –
$818 $(7,500)
.
Lease Classification for Lessee Example
US GAAP capitalization
criteria
IFRS capitalization
criteriaUS GAAP IFRS
Ownership is transferred to the lessee by the end of the lease term.
Similar No. No.
The lease contains a BPO. Similar 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”*Manager’s Discretion
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.
No.
$6,682 = 67% of $10,000
No*
$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.
Not specified. The lessee bears the lessor’s losses if the lessee cancels the lease.
N/A No.
Not specified.
The lessee absorbs the gains or losses from fluctuations in the fair value of the residual value of the asset.
N/A No.
Not specified.
The lessee may extend the lease for a secondary period at a rent substantially below the market rent.
N/A No.
Lease Accounting Example
IFRS: Journal Entries - Lessee
Lease with MMT for carriage
Carriage $6,682Finance lease liability – current $2,099Finance 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 $ 2,099Interest 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 $2,225Finance 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 Lessors
Initial recognition
IAS 17 para 36 requires lessor to recognize assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the net investment in the lease The minimum lease payments receivable by the lessor Any unguaranteed residual value
Accounting for Finance leases by Lessors
Subsequent measurement
Receipts from lessee need to be allocated between: Reduction of the lease receivable Interest revenue earned Reimbursement of costs paid on behalf of the lessee Receipt of contingent rent
Accounting For Finance Leases By Manufacturer or Dealer
Lessors
When manufacturers or dealers offer customers the choice of either buying or leasing an asset, the lease gives rise to two types of income: Profit or loss equivalent to the outright sale of the
asset being leased Finance (interest) income over the lease term
As well as recording the lease receivable, a profit or loss on sale is also recorded at the commencement of the lease
– The collectability of the lease payments from RRI are reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.
– 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.
Lessor Accounting Example
► Based on this information, prepare the journal entries for MMT for 2010, using IFRS. Round to the nearest dollar.
Example 2 – lessor accounting
The same terms of the lease arrangements between MMT and RRI apply to this example, while also considering the additional information below:
Lessor Accounting Example
IFRS: The MMT lease is 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 net investment in the lease is $10,000, calculated as the PV of the three lease payments of $2,500 each ($6,683)plus the PV of the unguaranteed residual value of $3,951 ($3,317).
Lessor Accounting Example
Net investment in lease PV of MLP
Begin-ning
balance
Inter-est at
6%Lease
payment
Ending bal-ance
Begin-ning bal-ance
Inter-est at
6%Lease
payment
Ending bal-ance
2009 $10,000 $ 600 $(2,500) $8,100 2009 $6,683 $401 $(2,500) $4,584
2010 $ 8,100 486 (2,500) $6,086 2010 $4,584 275 (2,500) $2,359
2011 $ 6,086 365 (2,500) $3,951 2011 $2,359 141 (2,500) $ –
$1,451 $(7,500) $817 $(7,500)
Lessor Accounting Example
Initial direct lease expense $500Cash $500
To recognize the expenses for the initial direct costs of $500 as MMT is a manufacturer lessor.
Finance lease receivable – current $1,900Finance lease receivable – non-current 8,100Cost of goods sold 4,683
Inventory – carriage $ 8,000Sales 6,683
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 $2,500Interest income $ 600Lease receivable – current 1,900
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 $2,014Lease receivable – non-current $2,014
To reclassify the lease payments due within the next year of $2,014.
Accounting For Operating Leases
Lessees Lease payments are expensed on a straight line
basis over the term of the lease (IAS 17 para 33)
Lessors Lease receipts are recognized as revenue on a
straight line basis over the term of the lease
Initial direct costs relating to the lease are capitalized as part of the carrying amount of the asset being leased and are expensed over the lease term on the same basis as the lease income is recognized
The asset is depreciated by the lessor on the same basis as for similar assets held by the lessor
Accounting For Lease Incentives
Lessors may offer lease incentives to encourage lessees to enter into non-cancellable operating leases: Rent-free periods, Upfront cash payments Contributions towards lessee expenses such as fit-out
costs
They are rarely truly free as rental payments are normally higher than for leases that do not offer incentives
Interpretation 115 Operating Leases -Incentives provides guidance on accounting for incentives by both lessors and lessees.
Accounting For 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
Sale & Leaseback Transactions
Under a finance lease - the lessee’s gain or loss from the sale of the asset is deferred and amortized over the term of the lease
Under an operating lease - the lessee’s gain or loss is: Recognized immediately if ‘sale’ is calculated at fair
value Deferred and amortized over the term of the lease when
the sale price is above or below fair value
Future Developments
IASB and FASB have released an ED on leases
Converged standard will result in significant changes to current accounting methods
Key objective is to ensure asset and liabilities arising from lease contracts are recognized on the balance sheet
Proposed model will eliminate off balance sheet accounting and remove the distinction between operating and finance leases
No agreement has been reached as to the scope and timing of changes
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
Homework
Exercises 12.3, 12.7, and 12.9DUE THURSDAY, OCTOBER 30