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Chapter 12. Leases. ACTG 6580. Objectives. Discuss the characteristics of a lease Explain the difference between a finance and operating lease Use IAS 17 to correctly classify leases Discuss the incentives to misclassify leases. Objectives.

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Chapter 12

Leases

ACTG 6580


Objectives
Objectives

  • Discuss the characteristics of a lease

  • Explain the difference between a finance and operating lease

  • Use IAS 17 to correctly classify leases

  • Discuss the incentives to misclassify leases


Objectives1
Objectives

  • Account for finance leases from the perspective of both lessee and lessor

  • Account for finance leases by manufacturer or dealer lessors

  • Account for operating leases from the perspective of both lessee and lessor

  • Recognize and account for sale and leaseback transactions

  • Discuss possible future changes to lease accounting


What is a lease
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
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 leaseis a lease other than a finance lease



  • Incentives to misclassify leases
    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
    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 lessees1
    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


    Lease classification for lessee example

    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.


  • Lease classification for lessee example1

    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):


    Lease classification for lessee example2

    .

    Lease Classification for Lessee Example



    Lease accounting example
    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
    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
    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 lessors1
    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
    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 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


    Lessor accounting example

    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

    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:

    • Based on this information, prepare the journal entries for MMT for 2010, using IFRS. Round to the nearest dollar.


    Lessor accounting example1
    Lessor Accounting Example reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    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 example2
    Lessor Accounting Example reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.


    Lessor accounting example3
    Lessor Accounting Example reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    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 example4
    Lessor Accounting Example reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    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
    Accounting For Operating Leases reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    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 lessee on the same basis as for similar assets held by the lessee


    Accounting for lease incentives
    Accounting For Lease Incentives reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • 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
    Accounting For Sale & Leaseback Transactions reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • 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
    Sale & Leaseback Transactions reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • 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
    Future Developments reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • 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
    Proposed Changes – Effective ???? 2013, 2015 ????Never?? reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • 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
    Homework reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT.

    • Exercises 12.3, 12.7, and 12.9

    • DUE THURSDAY, NOVEMBER 7


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