slide 9.1 alan melville, international financial reporting, 3rd edition, © pearson education...

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Alan Melville, International Financial Reporting, 3rd Edition, © Pearson Education Limited 2011

Chapter 9 - LEASES(IAS17)

ACTG 6580

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Classification of Leases

IAS17 defines a lease as "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".

A finance lease is "a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred".

An operating lease is "a lease other than a finance lease".

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Factors Which Indicate a FinanceLease

1. The lease transfers ownership of the asset to the lessee by the end of the lease term

2. The lessee has the option to purchase the asset at a price expected to be lower than fair value

3. The lease term is for the major part of the economic life of the asset

4. The present value of the minimum lease payments amounts to substantially the fair value of the asset

5. The leased asset is of such a specialized nature that only the lessee can use it.

6. 7. 8. (3 more criteria to be discussed later)

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Accounting for Operating Leases

The lesseeThe lessee has not taken on the risks and rewards of ownership, so the leased item is not shown as an asset in the lessee's financial statements. The lease payments are recognised as an expense over the lease term.

The lessorThe lessor has retained the risks and rewards of ownership, so the leased item is shown as an asset in the lessor's financial statements and is depreciated as usual. The lease payments are recognised as income over the lease term.

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Accounting for Finance Leases(By the Lessee)

• the fair value of the leased item• the present value of the minimum lease payments.

• The lessee has acquired the risks and rewards of ownership and so the leased item should be shown as an asset in the lessee's financial statements, along with a corresponding liability to the lessor. The asset should be depreciated at the shorter of useful life or lease term.

• At the commencement of the lease term, IAS17 requires that both the asset and the liability to the lessor should be recognized at the lower of:

• The liability to the lessor should be split between current and non-current liabilities, as appropriate. This liability must not be shown as a deduction from the leased asset.

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Allocation of Finance Charges for a Finance Lease

a) the total of the minimum lease payments, andb) the initial liability to the lessor.

The total finance charge is the difference between:

Methods which could be used for allocating the finance charge between accounting periods include the actuarial method (effective interest), the sum of digits method and the level spread method (straight line).

IAS17 requires that this finance charge should be allocated to accounting periods "so as to produce a constant periodic rate of interest on the remaining balance of the liability.”

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Actuarial (Effective Interest) Method

• The rate of interest implicit in the lease is used to calculate the finance charge element of each lease payment.

• This method is preferred by IAS17 but cannot be used unless the interest rate is known.

• If necessary, the interest rate can usually be derived with the aid of present value tables.

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Sum of Digits Method

• A digit is assigned to each lease payment. Digit 1 is assigned to the final lease payment, digit 2 to the next-to-last payment and so on. If the first lease payment is payable in advance at the start of the lease, it is not assigned a digit.

• The digits are totalled to give the "sum of digits".• The finance charge element of each lease payment is

calculated by dividing the total finance charge by the sum of the digits and then multiplying by the digit assigned to that payment.

The sum of digits method provides a reasonable approximation to the actuarial method.

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Level Spread (Straight-line) Method

• This method simply allocates the finance charge to lease payments on a straight-line basis over the lease term.

• This is unrealistic, since the amount of the finance charge allocated to each payment should fall as the liability to the lessor also falls.

• But this method might be used if the amounts involved are not material.

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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.

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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) $4,583

2011 $4,583 275 (2,500) $2,358

2012 $2,358 142 (2,500) $ –

$818 $(7,500)

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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

US GAAP capitalization

criteria

IFRS capitalization

criteriaUS GAAP IFRS

Ownership is transferred to the lessee by the end of the lease term.

Similar No. No.

The lease contains a BPO. Similar No. $4,000 >

$3,951 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”

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”

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Lease Classification for Lessee ExampleUS GAAP

capitalization criteria

IFRS capitalization criteria US GAAP IFRS

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/A No.

Not specified.

The lessee absorbs the gains or losses from fluctuations in the fair value of the residual value of the asset.

N/A No.

Not specified.

The lessee may extend the lease for a secondary period at a rent substantially below the market rent.

N/A No.

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Lease Accounting Example

IFRS: Journal Entries - Lessee

Lease with MMT for carriage

Carriage $6,682Finance lease liability – current $2,099Finance 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 $ 2,099Interest 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.)

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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 $2,225Finance lease liability – current $2,225

To reclassify the PV of the MLP payments due within the next year of $2,225.

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Accounting for Finance Leases(By the Lessor)

• The lessor has relinquished the risks and rewards of ownership. So the leased asset should be removed from the lessor's statement of financial position and replaced by a receivable which represents the amount owed by the lessee.

• In general, this receivable is initially recognized at the present value of the minimum lease payments which the lessee is required to make.

• Subsequently, the rate of interest implicit in the lease is used to calculate the finance income element of each lease payment. This finance income is recognized in the lessor's statement of comprehensive income. The remainder of the lease payment is subtracted from the amount owed by the lessee.

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Lessor Accounting Example

Finance lease receivable – current $2,500Finance lease receivable – non-current 9,551Cost of goods sold 4,683

Inventory – carriage $ 8,000Sales 6,683Unearned finance income 1,451

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).

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Lessor Accounting ExampleCash $2,500

Lease receivable – current 2,500Unearned finance income $ 600

Interest income $600

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 $2,014Lease receivable – non-current $2,014

To reclassify the lease payments due within the next year of $2,014.

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Main Disclosure Requirements(Operating Leases)

The lessee• The amount of operating lease payments

recognized as an expense during the accounting period

• Analysis of the total of the future minimum lease payments payable under non-cancellable operating leases.

The lessor• Analysis of the total of the future minimum lease

payments receivable under non-cancellable operating leases.

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Main Disclosure Requirements(Finance Leases)

The lessee• For each class of asset, the net carrying amount of

assets held under finance leases• Analysis of the total of the future minimum lease

payments payable under finance leases.

The lessor

• Analysis of the total of the future minimum lease payments receivable under finance leases

• Total amount of unearned finance income outstanding at the end of the reporting period.

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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

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