Lecture 4 - Leases

Question 1

What is leasing?

Answer 1

An organisation can:
•	use cash to acquire asset,
•	borrow to acquire asset,
•	use hire purchase to acquire asset, or
•	lease to acquire asset
	Lease - contract between:
	lessor who owns asset but leases it to
	lessee who uses asset for an agreed period of time in return for payment of rentals

Question 2

Whats the critical difference between leasing and other methods of acquiring an asset?

Answer 2

with leasing legal title never (?) passes from the lessor (the legal owner) to the lessee (the user of the asset)
Potentially, therefore, with certain types of lease this gives rise to a conflict between the form and the substance of the transaction.

Question 3

Assets potentially leased

Answer 3

• Cars, trucks, planes
• Trains
• Copiers, computers
• Shops, offices
• Schools, hospitals
• University residences
• Almost anything!

Question 4

Advantages of leasing over purchasing

Answer 4

• operating flexibility,
• cash flow,
• tax,
• Off-B/S finance.
• The cost of assets acquired for leasing rose from £288 million in 1973 to £2,894 million in 1983 to £10,200 million in 1991 (UK Financing and Leasing Association Statistics)
• Much of this increase was due to tax advantages over this period

Question 5

Lease Accounting

Answer 5

With ‘traditional’ accounting the lessor would capitalise and depreciate the asset with the lessee recognising only the periodic lease payments as an expense
But conflict here potentially between ‘legal form’ and ‘substance’
The [very!] basic idea is that a finance lease is rather like a hire-purchase contract

Question 6

Finance vs Operating Lease (1a)

Answer 6

Finance lease
lease transfers to lessee ‘substantially all the risks and rewards of ownership’
Risks might include:
Losses from idle capacity or
Variations in return due to changing economic conditions
Rewards being:
profitable operation over the asset’s economic life
gain from appreciation in value or realisation of residual value
Operating lease
all other leases

Question 7

Finance vs Operating Lease (1b)

Answer 7

IAS 17 does NOT define ‘substantially all’
but gives examples of situations pointing to transference of ‘substantially all’
Some national GAAPs take a more numerical approach
US/Germany require PV of minimum lease payments (MLP) ≥ 90% of fair value of leased asset
UK ≥ 90% gives ‘presumption’ of finance lease but other factors important

Question 8

IAS 17: Situations that ‘would normally’ point to finance lease

Answer 8

1. ownership of asset transferred to lessee by end of lease [But is this really a lease ???]
2. option to purchase the asset at a price that is expected to be sufficiently lower than the fair value (i.e. bargain purchase option)
3. lease term is a major part of economic life of asset
4. PV of min lease payments amounts to substantially all of the asset fair value
5. leased assets of a specialised nature

Question 9

IAS 17: Situations that ‘could’ point to finance lease

Answer 9

1. if lessee cancels lease, lessee bears lessor’s losses associated with cancellation
2. gains/losses from fluctuations in the fair value of the residual fall to lessee
3. lessee can continue lease for secondary period at lower rent (bargain rental option)

Question 10

IAS 17- Finance vs Operating Lease (2): Some Terminology

Answer 10

Lease Term
period over which the lessee has contracted to lease the asset plus any further period for which the lessee has an option to extend the lease term with or without further payment (assuming it is reasonably certain option will be exercised)
Minimum Lease Payment (MLP)
payments over the lease term that the lessee is required to make, excluding costs for services and tax paid or reimbursed by lessor [plus certain guaranteed payments]
Interest Rate Implicit in the Lease
discount rate of interest which at inception causes the aggregate PV of MLP and PV of unguaranteed residual value to be equal to Fair value of the asset

FAIR VALUE OF LEASED ASSET (a) = PRESENT VALUE OF MINIMUM LEASE PAYMENTS (b) + PRESENT VALUE OF UNGUARANTEED RESIDUAL AMOUNT ACCRUING TO LESSOR

Question 11

IAS 17- Finance vs Operating Lease (3a): Accounting Treatment

Answer 11

Finance lease
Lessee treats the leased asset as if owned, resulting in:

Balance sheet effect
recognition of asset on balance sheet
record future lease liability under current and non-current liabilities on balance sheet

Income Statement
depreciate asset
Charge interest on finance lease ‘loan’ in income statement

Operating lease
These are all other leases
charges annual lease rental payment against profit [straight line]
disclosure of liability in notes to accounts
3 categories: amounts due in next yr, years 2-5, and thereafter

Question 12

Accounting for finance lease by Lessee: Summary

Answer 12

➢ Recognise asset at fair value or, if lower, PV of minimum lease payments (MLP)
➢ discount factor: interest rate implicit in lease
(if not known: lessee’s incremental borrowing rate)
➢ split capital lease payment between interest and capital repayment
➢ asset depreciated as owned fixed assets
(over shorter of economic life and lease term)
➢ MLP
includes residual value guaranteed by lessee
excludes contingent rentals (e.g. based on sales)
excludes any service element (e.g. maintenance)

Question 13

Accounting for finance leases – lessor

Answer 13

• The assets themselves are not shown in the Statement of Financial Position (because they are in the lessee’s a/cs)
• Instead, the net investment in the lease is shown as a debtor/receivable
• Gross revenue is shown in Income Statement

Question 14

IAS 17: Issues and Debates

Answer 14

Leaves door open for creative accounting due to unclear distinction between operating and finance leases
Numerical approach (e.g. the ‘90% test’) has problems too!
Note that (b) includes any guaranteed residual payment by lessee to lessor.
Therefore if lessor estimates (c) as greater than 10% of fair value, the contract is an operating lease.
FAIR VALUE OF LEASED ASSET (a) = PRESENT VALUE OF MINIMUM LEASE PAYMENTS (b) + PRESENT VALUE OF UNGUARANTEED RESIDUAL AMOUNT ACCRUING TO LESSOR
Rights and obligations under operating leases are not recognised in lessee’s accounts
Long term finance leases packaged as operating leases represent examples of the ‘off-balance sheet’ finance problem!

Question 15

Financial leases - Disclosures: leases

Answer 15

IAS 17 requires disclosure of:
1. for each class of asset, the net carrying amount at the end of the reporting period.
a reconciliation between the total of future minimum lease payments at the end of
the reporting period, and their present value.
2. In addition, an entity shall disclose the total of future minimum lease payments at the end of the reporting period, and their present value, for each of the following periods:
not later than one year;
later than one year and not later than five years;
later than five years.
3. the total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period.
4. contingent rents recognised as an expense in the period.

Question 16

Material Leasing Arrangement

Answer 16

For each material leasing arrangement, a general description is also required including: the basis on which contingent rent payable is determined; the existence and terms of renewal or purchase options and escalation clauses; and restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.

Question 17

Operating leases - Disclosures: leases

Answer 17

IAS 17 requires disclosure of:

1. the future minimum operating lease payments using time bands that are similar to those for finance leases (see above).
2. total future minimum sublease payments receivable and lease and sublease payments recognised as an expense in the period, with separate amounts for minimum lease payments, contingent rents, and sublease payments.
3. The general description for significant leasing arrangement required for finance lease (see above) also applies to a operating lease.

Question 18

IFRS 16 Leases – It is applicable for

annual reporting periods beginning on or after 1 January 2019

Answer 18

Shift away from ‘matching’ income and expenditure
towards balance sheet ‘fair value’ approach
definitions of assets/liabilities are key
assets
rights or other access to future economic benefits controlled by an entity as a result of past transactions or events
liabilities
obligations to transfer economic benefits …
Captures most lease transactions!

Question 19

IFRS 16 Leases (2)

Answer 19

• A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time for consideration.
• IFRS 16 defines the inception date of the contract as the earlier date of a lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease.
It is essential that the following elements are present
(1) An entity has the right to control the use of
(2) an identified asset
(3) for a period of time in exchange for
(4) a consideration
a) In response to concerns expressed about cost and complexity, a lessee is not required to recognise assets and liabilities for leases of 12 months or less.
b) A lessee is not required to recognise leases of small assets (such as laptops and office furniture).

Question 20

IFRS 16 Lease Accounting by Lessors

Answer 20

• The lessor (supplier of the lease contract) will continue to classify a lease as finance lease or an operating lease and will account for these two types of leases differently
• A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset
• A lease is classified as on operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset

Question 21

Different views among FASB and IASB

Answer 21

a) FASB: dual model.
- Depreciation of the right-of-use asset would be recognized separate from interest on the lease liability.
- Operating leases would still be recorded on the balance sheet, but would retain a straight-line expense recognition pattern. Expense would be recognized in a single line in the income statement.
b) IASB: single model
- A financial reporting model similar to finance leases today. Depreciation of the right-of-use asset would be recognized separate from interest on the lease liability.

Question 22

Implications

Answer 22

The requirement that lessees treat all leases as finance leases will affect all companies that lease assets.
Three key considerations for management include the potential impact of the proposed accounting standard on….:
• The lessee’s Statement of Financial Position
• The lessee’s Income Statement
• The lessee’s earnings before interest, tax and depreciation

Question 23

The lessee’s Statement of Financial Position.

Answer 23

Lessees would be required to recognise assets and liabilities for all leased assets, not just finance leases.

Question 24

The lessee’s Income Statement.

Answer 24

Although the total expense over the life of the lease will equal the total amount of the lease payments, regardless of whether the lease is accounted for as an operating lease or a finance lease, the timing of the expenses is different under the two methods.
operating leases - lease expenses remain constant through the term of the lease (i.e., they are accounted for using the straight-line method)
finance expenses under finance leases are higher in earlier years of the lease than in later years.

Question 25

The lessee’s earnings before interest, tax and depreciation (EBITD).

Answer 25

EBITD of the lessee would probably increase as a result of the proposed lease accounting change since rent expense will be replaced with interest and depreciation expense, both of which are not included in EBITD.

Question 26

Overall effect

Answer 26

These changes affecting a lessee’s financial statements and other financial measurements could also have an impact on a large number of corporate agreements, including debt agreements and bonus payments.

Question 27

Sale and Leaseback Transaction

Answer 27

• Entities very often enter into complex financing arrangements such as a sale and lease back transaction.
• An asset may be sold to a financier and leased back to the original owner (sale and lease back)
• Apply ‘substance over form’ principle to determine if a sale and lease back transaction leads to:
– Either a finance lease or
– An operating lease