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 rights  Licensing 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, $4,583275(2,500)$2, $2, (2,500) $ – $818$(7,500)

. Lease Classification for Lessee Example US GAAP capitalization criteria IFRS capitalization criteria US GAAPIFRS Ownership is transferred to the lessee by the end of the lease term. SimilarNo. The lease contains a BPO. Similar 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 GAAPIFRS 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/ANo. Not specified. The lessee absorbs the gains or losses from fluctuations in the fair value of the residual value of the asset. N/ANo. Not specified. The lessee may extend the lease for a secondary period at a rent substantially below the market rent. N/ANo.

Lease Accounting Example IFRS: Journal Entries - Lessee Lease with MMT for carriage Carriage$6,682 Finance lease liability – current $2,099 Finance 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 $ 2,099 Interest 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 $2,225 Finance 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 leasePV 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, $6,683$401$(2,500)$4, $ 8,100486(2,500)$6, $4,584275(2,500)$2, $ 6, (2,500) $3, $2, (2,500)$ – $1,451$(7,500) $817$(7,500)

Lessor Accounting Example Initial direct lease expense $500 Cash $500 To recognize the expenses for the initial direct costs of $500 as MMT is a manufacturer lessor. Finance lease receivable – current$1,900 Finance lease receivable – non-current 8,100 Cost of goods sold 4,683 Inventory – carriage$ 8,000 Sales 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 $2,500 Interest income $ 600 Lease 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 $2,014 Lease 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 12.9  DUE THURSDAY, OCTOBER 30