IAS 17 Leases
What is a lease? 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.
What if it has multiple elements? Porter & Co. lease delivery trucks to Lodge Inc. Porter & Co. also provide any maintenance services required on the vehicles as a separate service. How do you account for the transaction in Porter & Co. s books??
SPLIT the agreement The agreement has 2 components: Asset - Vehicle Maintenance IAS 17 Leases IAS 18 Revenue
Forms of leases There are 2 types of leases: Finance Lease Operating Lease Classification based on assessment if the lease transfers substantially all the risks and rewards incidental to ownership
Lease Classification What are the indicators of a finance lease? Standard gives indicators to help you Note: These are NOT RULES
1. Transfer of Ownership Automatically a finance lease (tantamount to a rule!!) Must look at ALL agreements substance e.g. put or call options outside of the lease contract
2. Bargain Purchase Option If the lessee has an option to purchase the asset at a price that is expected to be lower than fair value At inception, reasonably certain that it will be exercised
3. Lease Term vs. Economic Life Lease term is for major part of economic life Lease term: 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 when at the inception of the lease it is reasonably certain that the lessee will exercise the option Used to have indicator of 75% Removed but still indicative
4. Present Value of MLP s At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset Substantially all? Used to have indicator of 90% No longer there but HIGHLY indicative
5. Specialised Asset The leased assets are of such a specialised nature that only the lessee can use them without major modifications. Likely constructed to meet lessee s specifications therefore market value limited
6. Lessee bears Lessor s losses If the lessee can cancel the lease, the lessor s losses associated with the cancellation are borne by the lessee
7. Second Lease Term The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent Is it probable at inception?
8. Residual Risk Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
Lease Indicators Standard gives indicators to help you: PRIMARY INDICATORS: Transfer ownership Bargain purchase option Lease term vs. economic life PV of MLP s Specialised asset SECONDARY INDICATORS: 2nd term at below market rates Lessee bears Lessor s losses Residual risk
Final Evaluation Once final evaluation made, lease is classified as operating or finance Don t change lease classification except only done if terms are revised that would have impacted the classification at inception No change in classification due to a change in estimate of useful life or residual value
Problem arises with land and buildings Lease of Land Evaluate each separately with the assumption that land is an operating lease Lease of Building Allocate on basis of relative fair values of leasehold interests If not separable, classify all as finance leases UNLESS clearly operating
Problem Area! Leases over land of 100 years Finance or Operating??
Improvement Guidance on land lease classification REMOVED Therefore, lease of land can be either: Finance Operating How to classify? Use IAS 17 indicators Take into account that land has an indefinite life
STRAIGHT LINING OF OPERATING LEASES
Operating Leases Paragraph 33 of IAS 17 states 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.
Example Company has 2 leases: Lease 1: 5 year lease Lease payment $100,000 pa escalating at inflation Inflation for years 1 5 is 8% Lease 2: 5 year lease Lease payment $100,000 pa escalating at 8% pa to reflect inflation Inflation for years 1 5 is + 8%
Lease 1 YEAR 1: Profit or loss Lease expense 100 YEAR 3: Profit or loss Lease expense 117 Year 2: Profit or loss Lease Expense 108 Year 4: Profit or loss Lease Expense 126
Example Lease 2 5 year lease Lease payment $100,000 pa escalating at 8% pa to reflect inflation Inflation for years 1 5 is + 8%
Lease 2 YEAR 1: Profit or loss Lease expense 100 YEAR 3: Profit or loss Lease expense 117 Year 2: Profit or loss Lease Expense 108 Year 4: Profit or loss Lease Expense 126
Lease 2 As it is fixed, cash flows over 5 years are: Year 1 100 Year 2 108 Year 3 117 Year 4 126 Year 5 136 TOTAL 587 Over 5 years 117 (587 / 5)
Lease 2 YEAR 1: Profit or loss - Lease expense 117 Balance Sheet - Liability 17 YEAR 3: Profit or loss - Lease expense 117 Balance Sheet - Liability 26 Year 2: Profit or loss - Lease Expense 117 Balance Sheet - Liability 26 Year 4: Profit or loss - Lease Expense 117 Balance Sheet - Liability 17
IFRIC 4 Determining whether an Arrangement Contains a Lease
IAS 17 IFRIC 4 When does an arrangement contain a lease? An arrangement is a lease when: Its fulfillment of the arrangement is dependent on the use of specific assets; and It conveys a right to use the asset. If you meet these conditions, then apply IAS 17
Types of arrangements typically impacted by IFRIC 4 Outsourcing IT Logistics Catering Purchase/sale Franchise Retail Agreements to deliver a specific level of service
Which agreements does it apply to? An entity adopting the interpretation may either apply it: retrospectively in full; or only to arrangements existing at the start of the earliest period for which comparative information is presented on the basis of facts and circumstances existing at the start of that period. An arrangement that contains a lease is accounted for under the guidance in IAS 17. IAS 17 requires retrospective application back to the inception of the lease.
Time to think An entity with a 31 March 2014 year end has recently renewed an arrangement that involves the use of an asset. The entity was of the opinion that the arrangement did not contain a lease but the contractual terms have been altered significantly. What steps should the entity take in accounting for this arrangement?
IFRIC 4: Specific Asset Specific Asset Agreement may explicitly identify an asset, but it is not a lease if fulfillment of agreement is not dependant on specific asset Warranty / right of substitution does not preclude lease accounting Is it economically feasible to use another asset? An asset has been implicitly specified if: the supplier owns or leases only one asset with which to fulfill the obligation; and it is not economically feasible or practicable for the supplier to perform its obligation through the use of alternative assets
IFRIC 4 Right of Use Right of use Ability/ right to operate asset or direct others to operate asset in a manner it determines while obtaining/ controlling more than an insignificant amount of the output Ability/ right to control physical access while obtaining/ controlling more than an insignificant amount of the output Remote that a 3 rd party will take more than an insignificant amount of the output, and the price is neither contractually fixed per unit of output nor equal to the current market price
Time to think A packaging machine is installed into a factory shared by various companies. The machine can produce 2 types of packaging which are used by 2 different companies. Each customer enters into an arrangement whereby it will take all of the output of a specified line. Would both customers have a lease under IFRIC 4?
Time to think A packaging machine is installed into a factory shared by various companies. The machine produces standard clear packaging for the companies in the factory. 5 customers enter into an arrangement whereby they each take 20% of the packaging produced. Would all 5 customers have a lease under IFRIC 4?