by Juma Kisaame, 2014 (http://practicalaction.org/microleasing/docs/dfcu.pdf) 2015-04-29 IAS 17 Leases IAS 17 definition Lessor = OWNER of property 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 Lessee = USER of property Benefits of leases Accessibility - leasing can allow new businesses with limited capital and credit history or small businesses without a history of financial statements to quickly boost their operations, as long as the cash flow from operations is sufficient to cover the lease service payments Security - Since lessors own the assets and use the leased asset as the primary security, entity can still be eligible for the lease financing when bank loans would not be available. Cash limitations - enables the borrower to avoid using operating capital (cash) to purchase an asset, it can have similar results. Leasing is used as a means of off-balance-sheet financing Achieves operational objectives by facilitating asset acquisition Achieves tax objectives 1
Nature of a Lease Accounting principle SUBSTANCE OVER FORM Although technically legal title may not pass, the benefits from the use of the property do. Finance vs. Operating Lease 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 Operating vs. Finance Lease Asset Equity & Liability Fixed Assets 70 Total equity 30 Intangible Asset 20 Shareholders' Equity 21 PPE 50 Net income 9 Current Asset 30 Liabilities 70 Inventories 15 Provisions 5 Cash&Equivalents 5 Loans 50 Receivables 10 Payables 15 TOTAL 100 TOTAL 100 Debt / Equity ratio =??? ROA =?? ROE =? Company considers to lease a huge factory, which market value is 20 mln. Which form of lease accounting treatment would be more beneficiary for the company? Which form of lease would provide better picture of the company in balance sheet? 2
How to classify a lease agreement? IAS 17 stipulates that substantially all of the risks or benefits of ownership are deemed to have been transferred if any one of the following criteria has been met: 1. The lease transfers ownership to the lessee by the end of the lease term 2. The lease contains a bargain purchase option (BPO) at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable and it is reasonably certain that the option will be exercisable 3. The lease term is for the major part of the economic life the leased asset; title may or may not eventually pass to the lessee (in US GAAP is defined a threshold of 75% of the useful life) 4. The present value, at the inception of the lease, of the minimum lease payments is at least equal to substantially all of the fair value of the leased asset, net of grants and tax credits to the lessor at that time; title may or may not eventually pass to the lessee (in US GAAP the present value of minimum lease payments equalling at least 90% of fair value) 5. The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made Accounting by the Lessee Lease Agreement Transfer of Ownership No No No Bargain Purchase Leases that DO NOT meet any of the four criteria are accounted for as Operating Leases. Lease Term >= 75% PV of Payments >= 90% No O p e r a t in g Yes Yes Yes Yes Finance Lease L e a s e LO 2 Describe the accounting criteria and procedures for capitalizing leases by the lessee. A lease might be classified as finance lease 6. If the lessee can cancel the lease, the lessor s losses associated with the cancellation are to be borne by the lessee 7. Gains or losses resulting from the fluctuations in the fair value of the residual will accrue to the lessee 8. The lessee has the ability to continue the lease for a supplemental term at a rent that is substantially lower than market rent 3
Types of finance lease Direct financing lease Sale and Lease-Back Leveraged Leases Sale and Lease-Back A particular type of financial lease. Occurs when a company sells an asset it already owns to another firm and immediately leases it from them. Two sets of cash flows occur: The lessee receives cash today from the sale. The lessee agrees to make periodic lease payments, thereby retaining the use of the asset. Leveraged Leases A leveraged lease is another type of financial lease. A three-sided arrangement between the lessee, the lessor, and lenders. The lessor owns the asset and for a fee allows the lessee to use the asset. The lessor borrows to partially finance the asset. The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee. 4
A non-cancellable lease is a lease that is cancellable only: upon the occurrence of some remote contingency with the permission of the lessor if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain Inception The inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: a lease is classified as either an operating or a finance lease and in the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined Commencement The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (ie the recognition of the asset, liabilities, income or expenses resulting from the lease, as appropriate). 5
Lease term The lease term is the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. Minimum lease payments Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with: for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee or for a lessor, any residual value guaranteed to the lessor by the lessee a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee Please Note!!! However, if the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it. 6
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Economic life is either: (a) the period over which an asset is expected to be economically usable by one or more users; or (b) the number of production or similar units expected to be obtained from the asset by one or more users. Guaranteed residual value is: (a) for a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable); and (b) for a lessor, that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. 7
Unguaranteed residual value is that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor. Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. Gross investment in the lease is the aggregate of: (a) the minimum lease payments receivable by the lessor under a finance lease, and (b) any unguaranteed residual value accruing to the lessor. Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease. 8
Unearned finance income is the difference between: (a) the gross investment in the lease, and (b) the net investment in the lease. Implicit interest rate The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor. Implicit interest rate is the discount rate at which: The aggregate present value: the minimum lease payments + the unguaranteed residual value = The sum of: the fair value of the leased asset + any initial direct costs borne by the lessor 9
Example I On December 31, 2010 a construction company "A" signed an agreement with "B" company to lease to B an office building in Cracow for the period of 15 years. The market value of the building stipulated in the agreement is set to the amount of 30mln, however the construction cost is estimated at 20mln. The lease agreement specifies annual payments of 2.5mln and at the end of the lease term "B" may exercise BPO at a price of 5mln - what is assumed to be non-guaranteed residual value of leased property. We assume that the initial direct costs incurred by the lessor are not significant. What is the implicit discount rate? The lessee s incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset. Contingent rent is that portion of the lease payments 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 (eg percentage of future sales, amount of future use, future price indices, future market rates of interest). 10
Example II On December 31, 2010 a construction company "A" signed an agreement with "B" company to lease from "B" a grader asphalt machine for the period of 4 years. The lease agreement specifies annual payments of 25 000. The market value of the machine at the time of signing the contract is 105 000. The initial agreement charge is 1 500 and the guaranteed residual value is 15 000. "A" does not intend and does not have financial possibilities to exercise BPO at the end of lease term. The marginal interest rate for "A" is assumed to be 5%. Present value of minimal lease payments PERIOD PAYMENTS DISCOUNT FACTOR DISCOUNTED PAYMENTS 1 2 3 4 TOTAL Present value of minimal lease payments PERIOD PAYMENTS DISCOUNT FACTOR DISCOUNTED PAYMENTS 1 25 000 1 / (1 + 5%) 1 = 0.9524 23 810 2 25 000 1 / (1 + 5%) 2 = 0.9070 22 676 3 25 000 21 596 4 25 000 + 15 000 32 908 TOTAL 100 989 Guaranteed residual value 11
Recognition of finance lease Leased asset -??? Leased obligation (liability) -?? What else?? Recognition of finance lease Leased asset -??? Dt / 102 489 (100 989 + 1 500) Leased obligation (liability) -?? Ct / 100 989 What else?? Cash & cash equivalents Ct / 1 500 Lease costs calculation PERIOD INITIAL VALUE CASH FLOWS FINANCE INTEREST 1 100 989 25 000 2 3 4 SUM CAPITAL INTEREST ENDING VALUE 12
PRESENTATION OF LEASED OBLIGATIONS PERIOD 1 2 3 4 LEASED OBLIGATION IN TOTAL LONG-TERM LEASED OBLIGATIONS CURRENT LEASED OBLIGATIONS PRESENTATION OF LEASED ASSETS PERIOD INITIAL VALUE DEPRECIATION ENDING VALUE 1 2 3 4 PRESENTATION OF LEASED ASSETS AND OBLIGATIONS PERIOD LEASED ASSETS LEASED OBLIGATIONS 1 2 3 4 13
LEASE COSTS AND LEASE PAYMENTS PERI OD 1 2 3 4 FINANCIAL COSTS DEPRECIATION TOTAL COSTS ANNUAL PAYMENT LEASED COSTS Depreciation of leased assets Financial charge (costs) Effect on the Lessee of a Residual Value Guaranteed Residual Value The residual value of leased property is an estimate of what its commercial value will be at the end of the lease term. Sometimes the lease agreement includes a guarantee by the lessee that the lessor will recover a specified residual value when custody of the asset reverts back to the lessor at the end of the lease term. This not only reduces the lessor s risk but also provides incentive for the lessee to exercise a higher degree of care in maintaining the leased asset to preserve the residual value. 14
Classification of leases The classification of leases adopted in this Standard is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset s economic life and of gain from appreciation in value or realisation of a residual value. Leases in the financial statements Finance leases - Initial recognition At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee s incremental borrowing rate shall be used. Any initial direct costs of the lessee are added to the amount recognised as an asset. Leases in the financial statements of lessees Subsequent measurement Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents shall be charged as expenses in the periods in which they are incurred. 15
Costs A finance lease gives rise to depreciation expense for depreciable assets as well as finance expense for each accounting period. The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets that are owned, and the depreciation recognised shall be calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of the lease term and its useful life. Operating leases Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user s benefit. Leases in the financial statements of lessors Finance leases Initial recognition Lessors shall recognise assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease. 16
Subsequent measurement The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor s net investment in the finance lease. Manufacturer or dealer lessors shall recognise selling profit or loss in the period, in accordance with the policy followed by the entity for outright sales. If artificially low rates of interest are quoted, selling profit shall be restricted to that which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease shall be recognised as an expense when the selling profit is recognised. Example III Calculation of the implicit interest rate and present value of minimum lease payments. The most important points of a lease are as follows: fair value of the leased asset = 10 000 five annual rentals of 2 100 payable in the beginning of the year lessor s unguaranteed estimated residual value at end of period = 1000 lessor s initial direct costs have been excluded for simplicity Calculation of the implicit interest rate and present value of minimum lease payments Year Value at beginning of period Rental payments Capital sum Finance charge Value at end of period 2011 10 000 2 100 7 900 2012 2 100 2013 2 100 2014 2 100 2015 2 100 1 000 10 500 TOTAL 17
Questions??? 1) What is the implicit interest rate? 2) What is the present value of minimum lease payments? 3) How the lease agreement should be classified? 4) What will be the initial amount at which recognised leased asset and corresponding liability should be recognised? Accounting by lessees finance leases present value of minimum lease payments Year Period Annual payments Discount factor Discounted payment 2011 0 2 100 2012 1 2 100 2013 2 2 100 2014 3 2 100 2015 4 2 100 10 500 TOTAL Accounting by lessees finance leases recording the liability Year Liability at start of period Rental paid Liability during period Finance charge Liability at end of period 2011 2 100 2012 2 100 2013 2 100 2014 2 100 2015 2 100 0 10 500 TOTAL 18
Presenting the liability Year Liability at end of period Current liability at end of period Non-current liability at end of period Interest expense (finance cost) 2010 2011 2012 2013 2014 2015 TOTAL Accounting for the leased asset Useful life of the leased asset is shorter of the lease term or its useful life. The useful life is the estimated remaining period, from the commencement of the lease term, over which the entity expects to consume the economic benefits embodied in the asset. Example CD Date Carrying value of the leased asset Carrying value of the liability Depreciation of the leased asset Interest Expense Total charge to income statement Lease payments 1-01-2011 31-12-2011 2 100 31-12-2012 2 100 31-12-2013 2 100 31-12-2014 2 100 31-12-2015 2 100 19
Accounting by lessors finance lease The lessor s gross investment in the lease is the total rents receivable and the unguaranteed residual value. The initial carrying value of the receivable is its fair value, which is also the present value of the gross investment discounted at the interest rate implicit in the lease Example CD Year Recievables at start of period Rental received Finance income Gross investment at end of period Gross earnings allocated to future periods Receivable at end of period / net investment 2010 10 500 1500 10 000 2011 10 000 2 100 2012 2 100 2013 2 100 2014 2 100 2015 2 100 1 000 Example CD asset impairment What if estimation of unguaranteed residual value will change? Lets assume that, the lessor concludes at the end of 2011 that the residual value of the asset is only 500 and revises the income allocation over the lease term accordingly. We assume that entity continues to apply the same implicit interest rate as before. 20
Question 1 Lack of adequate lease regulations in accounting can potentially lead to presenting: a) higher return on equity b) lower debt to equity ratio c) higher debt to equity ratio d) higher return on sales ratio 21