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IAS 17 - Leases

IAS 17 - Leases. Executive summary. Overall accounting for leases under IFRS and US GAAP is similar, although IFRS has fewer specific rules than US GAAP. Both IFRS and US GAAP separately discuss lessee and lessor accounting.

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IAS 17 - Leases

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  1. IAS 17 - Leases

  2. Executive summary • Overall accounting for leases under IFRS and US GAAP is similar, although IFRS has fewer specific rules than US GAAP. • Both IFRS and US GAAP separately discuss lessee and lessor accounting. • Both IFRS and US GAAP focus on classifying leases as either operating or capital. IFRS uses the term “finance” lease, whereas US GAAP uses “capital” lease. • IFRS uses more general criterion based on the substance of the lease to determine lease capitalization whereas US GAAP uses “bright line” criteria.

  3. Progress on convergence An exposure draft on leases was released in August 2010 with comments due December 15, 2010. In the ED, the Boards proposed a possible new right-of-use model for lease accounting based on the principle that all leases give rise to liabilities for future rental payments and assets (the right to use the leased asset) and should be recognized in an entity’s balance sheet. The Boards held a series of roundtable discussions in late 2010 and early 2011 to discuss feedback received. As a result, the Boards elected to formally expose their joint leases proposal for a second time because they have made significant changes to the model they proposed last year. The Boards decided that lessors should apply a single approach to all leases, with a few exceptions. This represents a significant change from current lease accounting and previous proposals. The ED is expected to be issued in the latter half of 2011.

  4. GeneralScope US GAAP IFRS ASC 840 applies to leases for PP&E while excluding leases to exploit or explore natural resources and certain licensing arrangements. IAS 17 is similar.

  5. GeneralScope US GAAP • ASC 840 applies only to leases for PP&E. IFRS • IAS 17 applies to all leases broadly. • IAS 17 also specifically excludes leases for investment property (covered under IAS 40) and biological assets (covered under IAS 41).

  6. Terminology and definitions US GAAP IFRS A lease is defined as an agreement whereby the lessor conveys a right to use an asset to a lessee for a certain period of time in return for payment. Similar A BPO is defined as an option that allows the lessee to buy the leased asset at a price significantly lower than the asset’s fair value at the end of the lease term so that the exercise of the option is reasonably assured. The assessment as to whether a BPO exists is judgmental and requires a review of facts and circumstances. Similar

  7. Terminology and definitions US GAAP IFRS The RV is the fair value of the leased asset at the end of the lease term and can be guaranteed or unguaranteed by the lessee or a party related to the lessee. Similar MLPs are defined as payments to be made over the lease term that a lessee is or can be required to make plus any amounts guaranteed by the lessee or by a party related to the lessee (such as a guaranteed RV), as well as a BPO. MLPs exclude contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor. Similar

  8. Terminology and definitions US GAAP IFRS A lease term is the non-cancelable term of a lease, including any additional periods when the lease can be continued that seem reasonably certain to occur at the inception of the lease. Similar Initial direct costs are incremental costs incurred by a lessor in acquiring a lease. Similar

  9. Terminology and definitions US GAAP • Uses the term “capital” lease. • Provides a more expanded definition of a lease term. • Provides detailed guidance on which activities and costs qualify as initial direct costs. IFRS • Uses the term “finance” lease. • Has a less expanded definition of a lease term. • Does not provide guidance on this issue.

  10. Lease classification US GAAP IFRS Requires a lease to be classified as either a capital/finance lease or an operating lease at the inception date of the lease by the lessor and lessee. Similar Requires classification of a lease as a capital/finance lease when it transfers substantially all the risks and rewards incidental to ownership to the lessee. Such classification is evaluated through the use of capitalization indicators. If a lease meets one of the indicators, it is recorded as a capital/finance lease; otherwise, it is recorded as an operating lease. Similar

  11. Lease classificationFor both lessors and lessees US GAAP • Uses bright line tests to determine capitalization. IFRS • Uses more general criteria based on the substance of the lease to determine capitalization.

  12. Lease classificationFor lessors US GAAP • Further classifies a capital lease into either sales-type (includes profit) or direct-finance leases (the fair value equals the carrying value of the leased asset). • Includes accounting for leveraged leases. IFRS • Does not have this classification; however, this has no practical effect on the accounting. • Does not have a concept of leveraged leases.

  13. Lessee accountingCapitalization criteria US GAAP IFRS Lease capitalization is required if: • The ownership of the asset is transferred to the lessee at the end of lease term. • The lease contains a BPO. Similar

  14. Lessee accountingCapitalization criteria US GAAP • Lease capitalization is required if: • The lease term is at least 75% of the property’s remaining economic life. • The NPV of MLP is 90% or more of the fair value of the leased property at the inception date. • If the beginning of the lease term falls within the last 25% of the leased asset’s remaining life, then these two criteria may not be used to determine capitalization. IFRS • No bright line tests. Lease capitalization is required if: • The lease term is a “major part” of the property’s remaining economic life. • The NVP of MLP is “substantially all” of the fair value of the leased property at the inception date. • This rule is not specified in IFRS.

  15. Lessee accountingCapitalization criteria US GAAP • These indicators are not specified. • For the first three IFRS indicators, US GAAP relates to either the guarantee of RV or bargain renewal matters, which increase the likelihood of capital lease treatment, although it is not as conclusive. IFRS • There are four additional finance lease indicators that individually or in combination could lead to the lease being capitalized: • The leased assets are of such a specialized nature such that only the lessee can use them without major modifications being made. • The lessee bears the lessor’s losses if the lessee cancels the lease. • The lessee absorbs the gains or losses from fluctuations in the fair value of the residual value of the asset. • The lessee may extend the lease for a secondary period at a rent substantially below the market rent (bargain renewal option).

  16. Lessee accountingCapitalization criteria

  17. 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.

  18. 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):

  19. Example 1 solution: Based on the information presented below, RRI would classify the MMT lease as an operating lease under US GAAP and a finance lease under IFRS. Lease classification for lessee example * The IFRS determination is subject to interpretation and may result in a different classification. (Continued on next slide.)

  20. Lease classification for lessee example

  21. Lessee accountingCapital/finance lease US GAAP IFRS The RV is capitalized by the lessee if this value is guaranteed. An unguaranteed RV is not capitalized. Similar Similar A BPO is capitalized by the lessee. At the beginning of the lease term, leased assets and related liabilities are recognized at the lower of the fair value of the leased asset or the NPV of the MLP. Similar

  22. Lessee accountingCapital/finance lease US GAAP IFRS The current portion of a capital lease liability is calculated as the PV of MLP due in one year subsequent to the balance sheet date. The non-current portion is the difference between the current portion and the total lease obligation. Similar

  23. Lessee accountingCapital/finance lease US GAAP • To calculate the NPV of MLP, the lessee’s incremental borrowing rate is used, unless the lessor’s implicit rate can be determined and is less. IFRS • The rate implicit in the lease is used to discount MLP, if practicable to determine (this is not common in practice because it is a key factor in the lessor’s business model to determine profitability); otherwise, the incremental borrowing rate should be used. No evaluation is made regarding which rate is lower.

  24. Example 2 – interest rate determination On January 1, 2010, RRI entered into a lease with Bob’s Antique Cars (BAC) for an antique roadster with the following terms: Negotiated price (fair value) of $20,000 for the antique roadster at the inception date of the lease. Term of seven years. Unguaranteed residual value of $5,124. 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 $12,000. Implicit annual interest rate (disclosed to RRI by BAC) of 5%. Incremental annual borrowing rate of 5.25%. Payments of $3,000 per year due on December 31. Remaining economic life of 10 years. Depreciation policy for the auto is the straight-line method. Ownership is not transferred at the end of the lease term. The lease may not be extended. Lease classification for lessee including interest rate determination example

  25. Lease classification for lessee including interest rate determination example Part I: • 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. Part II: • Assume RRI had an incremental borrowing rate of 4%. Would this change the results of the lease classification, using US GAAP or IFRS? Note: Round dollar amounts to the nearest dollar when calculating the PV of MLP.

  26. Example 2 solution: Part I – Based on the information presented below, RRI would classify the BAC lease as an operating lease under US GAAP and a finance lease under IFRS. Lease classification for lessee including interest rate determination example (Continued on next slide.)

  27. Lease classification for lessee including interest rate determination example * The IFRS determination is subject to interpretation and may result in a different classification. Management would consider the results of all the criteria individually and in combination with each other and most likely would determine that the risks and rewards of the asset have transferred to RRI.

  28. Lease classification for lessee including interest rate determination example ** The PV of MLP is calculated as shown below. The RV is not included as it is not guaranteed. For US GAAP, the discount rate used is the implicit interest rate of 5% as it is known and is lower than the incremental borrowing rate of 5.25%. For IFRS, the implicit interest rate of 5% is used as the discount rate since it is known, regardless of the incremental borrowing rate. Note that the last interest payments have been rounded up by $1 for the purposes of this table.

  29. Lease classification for lessee including interest rate determination example Part II – Based on the information on the next slide, RRI would classify the BAC lease as a capital lease under US GAAP and as a finance lease under IFRS. Under the change in the interest rates, for US GAAP, the incremental borrowing rate is used as the discount rate since it is lower than the implicit interest rate of 5%. This results in a PV of MLP of $18,006 as shown in the table. For IFRS, the implicit interest rate of 5% is used as the discount rate similar to part I of the example since it is known, despite being higher than the incremental borrowing rate. The PV of the MLP continues to be $17,359. Based on the new PV of MLP for US GAAP, the lease now meets the 90% test and would be classified as a capital lease. Note that the last interest payments have been rounded up by $1 for the purposes of this table.

  30. Lease classification for lessee including interest rate determination example * The IFRS determination is subject to interpretation and may result in a different classification.

  31. Lessee accountingCapital/finance lease – depreciation of a leased asset US GAAP IFRS Amounts capitalized for a leased asset are depreciated according to the method of the underlying asset. Similar The depreciation term is based on the capitalization indicators and the certainty of ownership. Due to the reasonable certainty of ownership for the lease ownership transfer and BPO indicators, the life of the asset is used as the depreciation term if these indicators are met. Similar

  32. Lessee accountingCapital/finance lease – depreciation of a leased asset US GAAP • The remaining lease capitalization indicators (beyond those mentioned on the last slide) involve estimates and reasonable uncertainty of ownership. Leased assets meeting these criteria (but not the lease ownership transfer and BPO indicators) are depreciated over the lease term. IFRS • Leased assets meeting the remaining lease capitalization indicators are depreciated over the shorter of the lease term or the life of the asset.

  33. Lessee accountingOperating lease US GAAP IFRS Similar Lease payments are recorded as an expense when due.

  34. Lease accounting example Example 3 – lease accounting • Based on the information and lease classification determined in examples 1 and 2 (part I), prepare the journal entries for RRI for 2010, using US GAAP. • Based on the information and lease classification determined in examples 1 and 2 (part I), prepare the journal entries for RRI for 2010, using IFRS.

  35. Lease accounting example Example 3 solution: US GAAP: Both leases are classified as an operating lease. Lease with MMT for carriage Lease expense $2,500 Cash $2,500 To record annual operating lease payment for the carriage. Lease with BAC for roadster Lease expense $3,000 Cash $3,000 To record annual operating lease payment for the roadster.

  36. Lease accounting example IFRS: Both leases are classified as a finance lease. 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.)

  37. Lease accounting example 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.

  38. Lease accounting example Lease with BAC for roadster Roadster $17,359 Finance lease liability – current $ 2,132 Finance lease liability – non-current 15,227 To record the capital lease of the auto based on the PV of MLP (since this is lower than the fair value). The current portion is the NPV of MLP due within the next year. Finance lease liability – current $ 2,132 Interest expense 868 Cash $3,000 To record the lease payment and related interest expense. Interest expense is calculated as 5% multiplied by PV of MLP of $17,359. (Continued on next slide)

  39. Lease accounting example Depreciation expense – roadster $2,480 Accumulated depreciation – roadster $2,480 To record the depreciation for the roadster over the lease term of seven years ($17,359/7) since this is shorter than the 10-year life of the asset. The depreciation is based on this term as capitalization was based on an indicator where ownership transfer is not reasonably assured. Capital lease liability – noncurrent $2,239 Capital lease liability – current $2,239 To reclassify the PV of the MLP payments due within the next year of $2,371.

  40. Lessor accountingCapitalization criteria US GAAP IFRS Lessors apply the same criteria as lessees except that MLPs are viewed from the perspective of the lessor. Similar

  41. Lessor accountingCapitalization criteria US GAAP • There are two additional capital lease indicators required: • The collectability of lease payments must be reasonably assured. • There must be no important uncertainties surrounding the amount of non-reimbursable costs to be incurred by the lessor. IFRS • While IFRS does not have these two criteria, it does require a qualitative assessment regarding the transfer of risks and rewards that addresses similar issues. This may or may not result in similar accounting treatment.

  42. Lessor accountingCapital/finance lease (not involving real estate) US GAAP IFRS The RV is capitalized by the lessor whether or not the value is guaranteed or unguaranteed. Similar Similar A BPO is capitalized by the lessor.

  43. Lessor accountingCapital/finance lease (not involving real estate) US GAAP IFRS Similar, but for direct financing leases, these costs are first capitalized to the carrying value of the leased asset rather than being capitalized directly to the net investment in the lease, but this results in the same net investment in the lease and unearned income under both standards. IFRS does not classify finance leases as sales-type, but the guidance directs manufacturers or dealer lessors (generally transacting sales-type leases) to expense these costs. Initial direct costs include costs to initiate the lease such as credit checks, commissions, legal fees, agent fees, etc. For direct-financing leases, these costs are capitalized as part of the net investment in the lease and amortized over the lease term to produce a constant periodic rate of return on the net investment (effective-interest method). For sales-type leases, these costs are expensed in the same period as the recognition of the gain.

  44. Lessor accountingCapital/finance lease (not involving real estate) – lease receivable US GAAP IFRS The interest rate implicit in a lease is the discount rate that, at the inception of the lease, causes the aggregate of the PV of the MLP and the residual value to be equal to the fair value of the asset, including any initial direct costs of the lessor. Similar The capital/finance lease receivable is recorded as the net investment in the lease, which is the carrying value of the leased asset including initial direct costs for non-sales-type leases. Alternatively, this net investment is calculated as the gross investment in the lease (the minimum lease payments and RV (whether guaranteed or unguaranteed)) less unearned interest income plus initial direct costs for non-sales-type leases. Similar

  45. Lessor accountingCapital/finance lease (not involving real estate) – lease receivable US GAAP IFRS The current portion of the capital lease receivable is receivable in one year subsequent to the balance sheet date. The non-current portion is the difference between the current portion and the total lease receivable. Similar Selling profit is recognized immediately in income. Similar Interest income is recognized over the lease term using a constant rate of return. Similar

  46. Lessor accountingOperating lease US GAAP IFRS Lease receipts are recognized as lease income on a straight-line basis over the period of the lease or another systematic basis. Another systematic basis is used if it is more representative of the time pattern of the benefits from the leased asset’s use. Similar

  47. Lessor accountingOperating lease US GAAP • Initial direct costs are deferred and allocated over the lease term in proportion to the recognition of rental income. IFRS • Initial direct costs are added to the carrying value of the leased assets and depreciated over the lease term on the same basis as the rental income, unless they are manufacturer or dealer lessors, in which case they must be expensed immediately. Although the deferral is recorded in different accounts, the result on income is the same.

  48. The collectability of the lease payments from RRI are reasonably assured, and no uncertainties exist regarding non-reimbursable costs to be incurred by MMT or BAC. 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. BAC’s carrying value of the roadster is equal to the fair value of the roadster ($20,000). BAC incurred $1,000 of initial costs for legal fees and credit checks in executing the lease. BAC is neither a manufacturer or dealer lessor. Lessor accounting example Example 4 – lessor accounting The same terms of the lease arrangements between MMT and BAC with 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 US GAAP and IFRS. Round to the nearest dollar. • Based on this information, prepare the journal entries for BAC for 2010, using US GAAP and IFRS. Round to the nearest dollar.

  49. Lessor accounting example Example 4 solution: US GAAP: The MMT lease is classified as an operating lease and the BAC lease is classified as a capital lease. MMT lease for carriage Deferred initial lease costs $500 Cash $500 To record the credit check expense to initiate the lease. Lease expense $167 Deferred initial lease costs $167 To record the expense for the initial lease costs in relation to the lease income ($500 over three years). (Continued on next slide.)

  50. Lessor accounting example Cash $2,500 Lease income $2,500 To record annual operating lease income for the carriage. Depreciation expense $2,000 Accumulated depreciation – carriage $2,000 To record annual depreciation expense on the carriage.

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