Financial Accounting II Lecture 26

A lease is 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. Lease – IAS 17

The definition of lease includes contracts for the hire of an asset which contains the provision giving the hirer option to acquire title to the asset upon fulfillment of agreed conditions. These contracts are sometimes known as hire purchase contracts. Lease – IAS 17

Lessor is the person who originally owns the rights to use the asset in other words he owns the asset and allows the lessee to use it. Lessor

Lessee is the person who utilizes the right to use the asset for a specific period against a payment or series of payments. Lessee

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

A lease is classified as an operating lease if it not transfers substantially all the risks and rewards incident to ownership. Operating Lease

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Classification of Leases

Substance Over Form: Transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

Examples of situations which individually or in combination would normally lead to a lease being classified as a finance lease are: Classification of Leases

a. Lease transfers ownership of assets by the end of lease term from lessor to lessee. Classification of Leases

b. The lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable such that, at the inception it is reasonably certain that the option will be exercised. Classification of Leases

c. The lease term is for the major part of the economic life of the asset even if title is not transferred. Classification of Leases

d. At the start of the lease the present value of minimum lease payments amount to at least substantially all of the fair value of the leased asset. Classification of Leases

e. The leased assets are of the specialized nature such that only the lessee can use them without major modifications. Classification of Leases

Finance Lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not be transferred. Finance Lease – IAS 17

Risks and rewards associated with the ownership: Unrestricted right to use the asset. Gain from appreciation in the value of the asset. Loss due to any accident or improper handling of the asset. Finance Lease

In finance lease asset is recognized in the books of the lessee because in substance the asset is owned by the lessee even if in the legal form (legal title) it is owned by the lessor.

An operating lease is a lease other than a finance lease. Operating Lease – IAS 17

Minimum Lease Payments – are the payments over the lease term that the lessee is or can be required, to make excluding contingent rent, cost of services and taxes to be paid by and reimbursed to the lessor, together with: Definitions – IAS 17

In case of lessee, any amount guaranteed by the lessee or by a party related to lessee. In case of lessor, any residual value guaranteed to the lessor by either The lessee, Any party related to lessee, or Any independent third party financially capable of meeting the guarantee. Definitions – IAS 17

It is that portion of the lease payment that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time for example. percentage of future sales, amount of future use, future price indices, future market rate of interest. Contingent Rent

Minimum Lease Payments include: Initial payment OR down payment All lease rentals Any amount that is guaranteed to be paid during or at the end of the lease term. Minimum Lease Payments

Minimum Lease Payments do not include: Contingent rent Any processing charges Taxes (such as registration fee of vehicles) paid by lessor and recovered from lessee Insurance paid by lessor and recovered from lessee Minimum Lease Payments

Fair Value – is the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arms length transaction. Definitions – IAS 17

Economic Life is either: the period over which an asset is expected to be economically usable by one or more users; or the number of production or similar units expected to be obtained from the asset by one or more users. Definitions – IAS 17

Guaranteed Residual Value In case of the lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee; and the amount of the guarantee being the maximum amount that could in any event become payable. Definitions – IAS 17

Guaranteed Residual Value – In case of the lessor, that part of the residual value which is guaranteed by the lessee or by a third party unrelated to the lessor who is financially capable of discharging the obligation. Definitions – IAS 17

Un-guaranteed Residual Value – is that portion of the residual value of the leased asset, the realization of which by the lessor is not assured, or is solely guaranteed by a party related to the lessor. Definitions – IAS 17

The interest rate implicit in the lease – is the discount rate that, at the inception of the lease causes the aggregate present value of: The minimum lease payment; and The un-guaranteed residual value To be equal to the fair value of the leased asset. Definitions – IAS 17

Classification of leases amongst Finance and Operating is based on the extent to which risks and rewards incident to ownership of the leased asset lie with the lessor or lessee. Risks include possibilities of losses from idle capacity or technological obsolescence. Classification of Leases

Variations in return due to changing economic conditions. Rewards may be represented by expectation of profitable operation over the assets economic life and of gain from the appreciation in the value or realization of residual value. Classification of Leases

Indicators of situations which individually or in combination could also lead to a lease being classified as a finance lease are: Classification of Leases

a. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee; b. Gains or losses from the fluctuation in the fair value of the residual fall to the lessee; and c. The lessee has the ability to continue the lease for a secondary period at a rent which is substantially lower than market rent. Classification of Leases