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Lessee Ltd.

In: Business and Management

Submitted By RebekkaW
Words 1331
Pages 6
Background Lessee Ltd., a British company operating under IFRS, leased equipment from Lessor Inc. for a period of three years. Lease payments of $100,000 are paid annually by Lessee Ltd., as well as $2,000 of other expenses including insurance, taxes and maintenance. The lessee’s incremental borrowing rate is listed at 11%, and the lessor’s implicit rate is calculated at 10%. The equipment reverts back to the lessor at the termination of the lease. The equipment has a 4-year useful life and a fair value of $265,000. Additionally, the guaranteed residual value of the equipment is $20,000 and the expected salvage value is $2,000.

Issue #1: How should Lessee Ltd.’s Lease Be Classified? International Accounting Standard 17.10 states five examples of situations that “individually or in combination would normally lead to a lease being classified as a finance lease.” Two of the statements are relevant in classifying the lease as a finance lease. IAS 17.10.c says that the lease term must be for the “major part of the economic life of the asset.” Since the lease term is three years and the useful life of the equipment is four years, the lease term is 75% of the useful life of the asset which would constitute as a “major part” of the economic life of the equipment. Additionally, per IAS 17.10.d “at the inception of the lease the present value of the minimum lease payments [should] amount to at least substantially all of the fair value of the leased asset.” The present value of minimum lease payments should include the present value of the guaranteed residual value, and should be calculated using the rate implicit in the lease (further explained in issue #2). The total amount of the present value of the lease payments is “substantially all” of the fair value of the leased asset. The calculation is below:

$248,690 Present Value of Minimum Lease Payments
+$15,026 Present Value of Guaranteed Residual Value
$263,896 Total Value of Minimum Lease Payments
÷ $265,000 Fair Value of the Leased Asset
99.6% Lease Payments Are “Substantially All” of the Fair Value of the Asset

Thus, the combination of the two statements defines this lease as a finance lease. The junior accountant’s analysis is void because the lease is not an operating lease. Additionally, the senior accountant’s classification of the lease is correct based off of his conclusion using IAS 17.10.c in step one and further conclusion using 17.10.d.

Issue #2: How should the present value of minimum lease payments be calculated for a finance lease? Although the senior accountant was correct in classifying the lease as a finance lease, the rate and present value total used was incorrect. International Accounting Standard 17.20 quotes,

Lessees shall recognize 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… 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.

Since the present value of the minimum lease payment is lower than the fair value of the leased property, the lease recognizes assets and liabilities using the lease payments. Additionally, the rate implicit in the lease (10%) is used to calculate the present value of the guaranteed residual. Therefore, the senior accountant’s step two computation is incorrect. The correct treatment of the present value of the minimum lease payments should use the implicit rate and should include the guaranteed residual value bringing the total value of minimum lease payments to $263,896.

Issue #3: How should payments between interest and lease obligations be allocated? Under International Accounting Standard 17.25 the finance charge should be allocated to produce a “constant periodic rate of interest” on the remaining balance of liability. The interest rate used in step three of the senior accountant’s analysis is inconsistent, and the rate is incorrect. The chart below shows the correct computations when applying a constant periodic rate at 10% interest: Year | Cash Payment | Interest Expense (10%) | Reduction in Lease Obligation | Balance of Lease Obligation | Computation | 0 | | | | 263,896 | | 1 | 100,000 | 26,390 | 73,610 | 190,286 | 26,390 / 263,896 = 10% | 2 | 100,000 | 19,029 | 80,971 | 109,315 | 19,029 / 190,286 = 10% | 3 | 100,000 | 10,932 | 89,069 | 20,246 | 10,932 / 109,315 = 10% |

After applying a constant rate, the journal entry accounts used by the senior accountant are correct, but the amounts for interest expense and the amount for lease obligation should be updated to reflected the amounts above. The total debits and credits would still amount to $102,000. In review, the senior accountant’s classification as a finance lease in step one is correct, but the step two and step three computations are incorrect and would need to be updated as discussed in issues two and three.

Issue #4: How would the lease be classified and accounted for under U.S. GAAP? Under the Accounting Standards Codification 840-10-25-1 if a lease meets any of the four criteria in section 1, it is classified as a capital lease; the lease meets two criteria. First, ASC 840-10-25-1c states that the lease term should be equal to 75% or more of the economic life of the leased property. The term is exactly equal to 75% of the economic life. Second, 840-10-25-1d states that the present value of the minimum lease payments should be 90% or more than the fair value of the asset, and based on ASC 840-10-25-31 the lessee shall use the implicit rate since it is practical to learn the and it is less than the incremental borrowing rate. Also, ASC 840-10-25-6 says that guaranteed residual value is included in the lease payments and a constant interest rate is used on the remaining balance of the liability. Thus, the lease payments under GAAP are also 99% of the fair value of the equipment, guaranteed residual value is also included in the total value of lease payments, and the journal entries and payment allocations between interest and lease obligations are the same under U.S. GAPP as they are for IFRS.

Conclusion Under IFRS, the senior accountant’s classification of the lease as a finance lease is correct based off of the lease term being 75% of the useful life of the asset, and also the lease payments being 99% of the fair value of the equipment. However, in contrast to the senior accountant’s further analysis, guaranteed residual value is included in the present value of minimum lease payments, the implicit rate is used to calculate the present value of the lease obligation, and a constant periodic interest rate is applied to the remaining liability. All of these same attributes are applied under U.S. GAAP, but yield an opposite outcome; under ASC standards, the lease would be classified as a capital lease.

New Standard Impacts
When analyzing new standard impacts for IFRS, it is concluded that IAS 17 will be superseded by IFRS 16 as of January 1, 2019. The standard introduces a single model and requires lessees to recognize a right-of-use asset using a cost model and a lease liability for the rights and obligations created by all leases; this eliminates operating and financing lease categories. Under the cost model a right-of-use asset is measured at cost less accumulated deprecation, and a lease liability is initially measured at the present value of the lease payments discounted at an interest rate implicit in the lease and including residual value guarantees. Ultimately, the new standard requires lessees to reflect on the balance sheet the right to use an asset and the associated liability for payments.

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