IAS 17 Leases Effective for annual periods beginning on or after 1 January 2005

Essential Features of a Lease 2 parties  Lessee and lessor Lessee  acquires the right to use an asset for an agreed period of time  i.e. future economic benefits  Not legal ownership  In return for a series of payments

Outline 1.Objective of IAS 17 2.Scope of IAS 17 3.Classification of Leases  Transfer of risks and rewards of ownership  Indicators of finance leases 4.Accounting & Disclosure by Lessees 5.Accounting & Disclosure by Lessors  Including Manufacturer [or Dealer] Lessors 6.Sale and Lease-back 7.Possible Future Changes to Lease Accounting

OBJECTIVE

Objective of IAS 17 Prescribes accounting policies and disclosures  for finance and operating leases  by lessees and lessors 2 distinctions 1.Relatively easy to identify lessee and lessor 2.Distinction between finance and operating leases  may be more contentious  could significantly impact financial performance and financial position

Impact of Classification ItemAffected byFinanceOperating Profit & EPSLease ExpenseN.A.Higher* InterestHigher*N.A. DepreciationHigher*N.A. Total AssetsCapitalisation of leased asset HigherLower ROAProfit/AssetsLowerHigher Total Liabilities Recognition of lease liability HigherLower GearingLiabilities/EquityHigherLower * Indicates impact on expense items (opposite impact on Profit & EPS)

Incentives to misclassify leases Finance leases 1.reduce EPS and ROA  Suggest lower profitability 2.reduce current ratio [through current lease liability]  Indicate lower liquidity 3.increase gearing ratios  Risk of breaching debt covenants Incentive to classify leases as operating [off-balance sheet]  IAS 17 provides managers with discretion over what constitutes a ‘substantial transfer’ of risks and rewards ’

SCOPE

Application of IAS 17 In general IAS 17 applies to all leases  other than lease agreements for: 1.Minerals, oil, natural gas and similar non- regenerative resources; and 2.Licensing agreements for films, videos, plays, manuscripts, patents, copyrights and similar items

IAS 17 does NOT apply to … AssetDetails Investment property (See IAS 40) held by lessees and accounted for using the fair value model provided by lessors under operating leases Biological assets (see IAS 41) held by lessees under finance leases provided by lessors under operating leases

CLASSIFICATION OF LEASES Operating or Finance

Classification Made at the inception of the lease  depends on substance rather than form  i.e. accounting treatment can differ from legal classification Classify a lease as 1.finance lease, if it transfers substantially all risks and rewards relating to ownership 2.Operating lease otherwise

Potential Risks of Ownership 1Unsatisfactory performance The asset may be unable to provide benefits or service at the expected level or quality. 2ObsolescenceEspecially development of more technically advanced items. 3Idle capacityDue to low demand, natural disasters etc. 4Decline in residual value Or losses on eventual sale of the asset. 5Uninsured damage And condemnation of the asset.

Potential Rewards of Ownership 1Economic benefits From using the asset to generate products and services. 2ControlRight to schedule use of the asset and restrict access. 3Appreciation in residual value Or gains on eventual sale of the asset.

Indicators of Finance Lease 1Asset ownership is transferred to the lessee  by the end of the lease term. 2The lessee has an option to buy the asset  at a price which is expected to be sufficiently lower than fair value when exercised.  at inception, it’s reasonably certain that the option will be exercised. 3The lease term covers the majority of the asset’s economic life even if title is not transferred. 4At inception  the present value of MLP  is substantially equal to the asset’s fair value. Bargain purchase option

Indicators of Finance Lease 5The leased asset has a specialised nature  only the lessee can use it without major modifications. 6The lessee bears the lessor’s losses associated with the cancellation (if cancellation is permitted)*** 7Gains or losses from fluctuations in the fair value of the residual fall to the lessee e.g. by means of a rebate of lease payments. 8The lessee is entitled to continue leasing for a secondary period  at a rent that is substantially lower than market rent.

Exercise 1 On 1 July 2012, Christchurch Ltd leased a processing plant to Wellington Ltd.  Christchurch purchased the plant on 1 July 2012 for its fair value of $  Wellington Ltd intends to return the processing plant to the lessor at the end of the lease term.

Exercise 1 Lease term3 years Economic life of plant5 years Annual rent payment  commencing 30/06/2013 $150,000 Residual value at end of the lease term$90,000 Residual value guaranteed by lessee$60,000 Implicit interest rate7% The lease is cancellable only with the permission of the lessor. The lease agreement contained the following terms:

Ex 1A. Classify this lease

Lease of Land & Buildings Leases may cover both land and buildings. In general, 1.Land treated as an operating lease  Indefinite life 2.Buildings treated as finance lease Allocate MLP between land and building  In proportion to relative fair values at inception

ACCOUNTING BY LESSEES

Finance Leases At inception Record an asset and a liability at lower of 1.Fair value and 2.PV of Minimum lease payments (MLP)  discounted at implicit interest rate ;  or else the entity’s incremental borrowing rate

Finance Leases ItemRequirementDetails Lease Liability Allocate lease payments to: Finance charge, using a constant periodic interest rate Principal reduction (i.e. outstanding liability Leased Asset Depreciate over shorter of Lease term Useful life. Also used if there’s reasonable surety that lessee will obtain ownership at the end of the lease.

Ex 1 B.1 PV of MLP (Lessee) Annual Lease Payments Less executory costs = Annuity x Annuity factor = Y Residual Value guaranteed by lessee x Present Value factor = Z Present Value of MLP (Y + Z) Discounted at the implicit rate of interest

Ex 1 B.2 Lease Payment Schedule Opening Balance Interest 7% Net Payment PrincipalClosing Balance Discounted at the implicit rate of interest

Ex 1 B.3 Journal Entries DateParticularsDrCr For year ended

Operating Leases Lease payments recognised as an expense in the Income Statement over the lease term  on a straight-line basis  Unless another systematic basis is more representative of the time pattern of the user’s benefit

Operating Leases Any incentives for the agreement of a new or renewed operating lease  Recognised as a reduction of rental expense over the lease term  irrespective of the incentive’s nature, form or the timing of payments

DISCLOSURE BY LESSEES

For all Leases General description of significant leasing arrangements, including 1.contingent rent provisions,  e.g. premium for heavy usage, rebate for under-usage 2.renewal or purchase options 3.restrictions imposed on dividends, borrowings, or further leasing

Finance Leases 1Carrying amount of the asset 2Reconciliation between MLPs at Balance Sheet date and the Present Value thereof, divided into  The next year  Years 2 to 5 combined  Beyond 5 years 3Contingent rent recognised as an expense 4Total future minimum sublease income under non-cancellable subleases

Operating Leases 1Amounts of MLPs at Balance Sheet date under non-cancellable operating leases for  The next year  Years 2 to 5 combined  Beyond 5 years 2Contingent rent recognised as an expense 3Total future minimum sublease income under non-cancellable subleases 4Lease and sublease payments recognised in income for the period

ACCOUNTING BY LESSORS

Finance Leases At inception Record a receivable at  An amount equal to net investment in the lease  i.e. MLPs + unguaranteed residual value Lease Receivable recognised by lessor  Differs from Lease Liability recognised by lessee  Due to unguaranteed residual

Finance Leases Recognise finance income  based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment outstanding in respect of the lease Recognise initial direct and incremental costs incurred in negotiating leases  over the lease term

Ex 1 C.1 Net Investment in Lease Annual Lease Payments Less executory costs = Annuity x Annuity factor = Y Residual Value (total) x Present Value factor = Z Present Value of MLP (Y + Z) Discounted at the implicit rate of interest

Ex 1 C.2 Lease Receipt Schedule Opening Balance Interest 7% Net Payment PrincipalClosing Balance Discounted at the implicit rate of interest

Ex 1 C.3 Journal Entries DateParticularsDrCr For year ended

Operating Leases Assets held for operating leases should be presented in the lessor’s Balance Sheet  According to nature of the asset Lease income should be recognised over the lease term  on a straight-line basis  Unless another systematic basis is more representative of the time pattern of the user’s benefit

Operating Leases Incentives for the agreement of a new or renewed operating lease  Recognised by the lessor as a reduction of rental income over the lease term  irrespective of the incentive’s nature, form or the timing of payments

Manufacturer [or Dealer] Lessors Sell items and also provide direct financing Include selling profit or loss  In the same period they would for an outright sale If artificially low rates of interest are charged,  selling profit should be restricted  to that which would apply if a commercial rate of interest were charged

Manufacturer [or Dealer] Lessors ItemCalculation/Treatment Lease ReceivableFair Value Sales RevenueLower of Fair Value and PV of MLP Cost of Goods SoldCost or Carrying Amount Less PV of unguaranteed residual Initial direct costs to negotiate lease Recognised as an expense  when the selling profit is recognised

Exercise 2 Auckland Ltd manufactures specialized moulding machinery for both sale and lease.  On 1 July 2010, Auckland Ltd leased a machine to Christchurch Ltd, incurring $1500 in costs to prepare and execute the lease document.  The machine being leased cost Auckland Ltd $ to make and its fair value at 1 July 2007 is considered to be $  Christchurch Ltd intends to lease a new machine at the end of the lease term.

Exercise 2 Lease term, commencing 01/07/20105 years Estimated useful life of machine  scrap value $2,500 8 years Annual lease payments  Commencing 01/07/2011 $57,500 Residual value at end of the lease term$37,000 Residual value guaranteed by lessee$25,000 Implicit interest rate10% Christchurch Ltd may cancel the lease but will incur a penalty equivalent to 2 years payments if it does so. The lease agreement contained the following terms: The annual lease payment includes $7,500 to cover annual maintenance and insurance costs.

Ex 2.A Net Investment in Lease Annual Lease Payments Less executory costs = Annuity x Annuity factor = Y Residual Value (total) x Present Value factor = Z Present Value of MLP (Y + Z) Discounted at the implicit rate of interest

Ex 2.B Lease Receipts Schedule Opening Balance Interest 10% Net Payment PrincipalClosing Balance Discounted at the implicit rate of interest

Ex 2.C Journal Entries DateParticularsDrCr For year ended

DISCLOSURE BY LESSORS

For all Leases General description of significant leasing arrangements, including 1.contingent rent provisions 2.renewal or purchase options 3.restrictions imposed on dividends, borrowings, or further leasing

Finance Leases 1Reconciliation between gross investment in the lease and the Present Value of MLPs 2Gross investment and Present Value of MLPs receivable for:  The next year  Years 2 to 5 combined  Beyond 5 years 3Unearned finance income 4Unguaranteed residual values 5Accumulated allowance for uncollectible lease payments receivable 6Contingent rent recognised in income

Operating Leases 1Amounts of MLPs at Balance Sheet date under non-cancellable operating leases in total and for  The next year  Years 2 to 5 combined  Beyond 5 years 2Contingent rent recognised as income

SALE AND LEASE-BACK Owner sells an asset and immediately leases it back i.e. physical asset doesn’t move

Sale & Finance Leases Any excess of proceeds over the carrying amount  i.e. profit on the sale  deferred and amortised over the lease term

Exercise 3 Ultramarine Ltd is asset rich but cash poor.  It entered into an agreement on 1 July 2013 to sell its processing plant to Wanganui Ltd for $  At the date of sale, the plant had a carrying amount of $ and a future useful life of 5 years.  Wanganui Ltd immediately leased the processing plant back to Ultramarine Ltd. Wanganui Ltd incurred $9414 in legal fees and stamp duty costs.  The lease is cancellable, but only with the permission of the lessor.  At the end of the lease term, the plant is to be returned to Wanganui Ltd.

Exercise 3 The lease agreement contained the following terms: ***The annual rental payment includes $ to reimburse the lessor for maintenance costs incurred on behalf of the lessee. Lease term3 years Economic life of plant5 years Annual rent payment  commencing 30/06/2014 $165,000 Residual value at end of the lease term$90,000 Residual value guaranteed by lessee$60,000 Implicit interest rate6%

Ex 3.A Classify this lease

Ex 3.A PV of MLP (Lessee) Annual Lease Payments Less executory costs = Annuity x Annuity factor = Y Residual Value guaranteed by lessee x Present Value factor = Z Present Value of MLP (Y + Z) Discounted at the implicit rate of interest

Ex 3.A Net Investment (Lessor) Annual Lease Payments Less executory costs = Annuity x Annuity factor = Y Residual Value (total) x Present Value factor = Z Present Value of MLP (Y + Z) Discounted at the implicit rate of interest

Ex 3 B.1 Lease Payment Schedule Opening Balance Interest 6% Net Payment PrincipalClosing Balance Discounted at the implicit rate of interest

Ex 3 B.2 Journal Entries DateParticularsDrCr For year ended

Ex 3 C.1 Lease Payment Schedule Opening Balance Interest 6% Net Payment PrincipalClosing Balance Discounted at the implicit rate of interest

Ex 3 C.2 Journal Entries DateParticularsDrCr For year ended

Sale & Operating Leases If the transaction is clearly carried out at fair value  Recognise profit or loss immediately If the fair value at the time of the transaction is less than the carrying amount  Recognise a loss equal to the difference immediately.

Sale & Operating Leases If SP < FVIf SP > FV Recognise profit or loss immediately  except if a loss is compensated for by future rentals at below market price  Amortise the loss over the period of use Defer excess over fair value  amortise over period of use

POSSIBLE FUTURE CHANGES TO LEASE ACCOUNTING

Remove existing distinction Remove distinction between finance and operating  Current distinction is additional [and contradictory] to conceptual framework  Proposed distinction between property (Type B) and non-property (Type A) Reduce scope for different treatment of similar items based on management discretion  More principles-based (remove reliance on rules)  Reduce off-balance sheet reporting of liabilities

For all Leases RecogniseRepresenting LesseeAn assetright to use the item over the lease term A LiabilityObligation to make lease payments LessorAn assetRight to receive lease payments Another asset Residual value only [De-recognition approach]

Introduce a new distinction Between 1.Property (Type B) 2.and non-property (Type A) For Type A  Lessee amortises asset and recognises interest For Type B  Lessee recognises a single lease cost, combining amortisation and unwinding of discount on liability

Other Changes Leases of 12 months or less  May apply simplified requirements For all leases  Assume longest possible lease term that is most likely to occur  Considering options to extend or terminate the lease etc

Additional Resources IASB Exposure Draft on Leasing projects/iasb-projects/leases/exposure- draft-may-2013/documents/ed-leases- standard-may-2013.pdf Video Clip on Accounting for Leases eUhX998

IAS 17 Leases Effective for annual periods beginning on or after 1 January 2005