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Leases Chapter 12 ACTG 6580
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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.

Jan 03, 2016

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Page 1: 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.

Leases

Chapter 12

ACTG 6580

Page 2: 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.

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

Page 3: 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.

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

Page 4: 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.

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

Page 5: 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.

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

Page 6: 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.

Classification Guidance

Page 7: 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.

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

Page 8: 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.

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

Page 9: 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.

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

Page 10: 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.

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.

Page 11: 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.

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)

Page 12: 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.

.

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”

Page 13: 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.

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.

Page 14: 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.

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.)

Page 15: 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.

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.

Page 16: 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.

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

Page 17: 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.

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

Page 18: 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.

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

Page 19: 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.

– 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:

Page 20: 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.

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).

Page 21: 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.

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)

Page 22: 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.

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).

Page 23: 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.

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.

Page 24: 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.

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

Page 25: 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.

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.

Page 26: 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.

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

Page 27: 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.

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

Page 28: 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.

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

Page 29: 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.

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

Page 30: 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.

Homework

Exercises 12.3, 12.7, and 12.9DUE THURSDAY, OCTOBER 30