[In accordance with the requirements of IAS 17 & FASB Statement 13]

FCMA, FPA, MA (Economics), BSc Dubai, United Arab Emirates

Ahmad Tariq Bhatti

Program Details
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Lease assets Key concepts Classification Definitions Calculations Accounting Advantages & disadvantages Glossary Appendix A: Leasing Soft-wares References
Leases 2

Lease Assets

Leases

Key Concepts
A lease is an agreement whereby a lessor conveys to a 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 an agreement that transfers substantially all risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. 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 a lease enters into a new agreement for the same or an equivalent asset with the same lessor; or Upon payment by a lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain. The commencement of a lease term is a date from which a lessee is entitled to exercise the right to use leased assets. The lease term is a non-cancellable period for which a lessee has signed an agreement to lease an asset.
Leases 4

Key Concepts
Minimum Lease Payments (MLPs) are payments over a lease term that a lessee is or can be required to make, excluding contingent rents, costs for services and taxes to be paid by and reimbursed to a lessor together with: For a lessee, any amounts guaranteed by him or by a party related to the lessee For a lessor, any GRV to the lessor by: The lessee A party related to the lessee or 3rd party guarantor unrelated to the lessor Fair Value (FV) is an amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties, in an arms length transaction. Economic life (EL) is either: The period over which an asset is expected to be economically usable by one or more users; or The number of production or similar units expected to be obtained from an asset by one or more users.
Leases 5

Key Concepts
Unguaranteed residual value (UGRV) is that portion of RV of a leased asset, realization of which by a lessor is not assured or is guaranteed solely by a party related to a lessor. Guaranteed residual value (GRV) is: For a lessee, that part of RV that is guaranteed by a lessee and For a lessor, that part of RV that is guaranteed by a lessee or a 3rd

party guarantor
Gross investment in a lease asset is the aggregate of: MLPs receivable by a lessor under a finance lease, and Any UGRV accruing to a lessor. Net investment in a lease asset is gross investment in a lease discounted at the required interest rate of a lessor. Initial Direct Costs (IDCs) are costs that are directly attributable to negotiating and arranging a lease. Useful life is an estimated remaining period, from commencement of a lease term, without limitation by a lease term, over which the economic benefits embodied in an asset are expected to be consumed by an entity.
Leases 6

Key Concepts
Unearned Finance Income (U/E-FI) is the difference b/w: The gross investment in the lease; and The net investment in the lease. The Implicit Interest Rate (IIR) in a lease is a discount rate that, at the inception of a lease, causes aggregate PV of: The MLPs and The UGRV to be equal to the sum of; The FV of the leased asset plus Any IDCs of the lessor. Incremental Borrowing Rate (IBR) The rate a lessee would have paid if he had borrowed funds to purchase an asset on similar lease with a similar security Contingent rent is that portion of lease payments that is not fixed in amount but is based on the future amount of factor that changes other than with the passage of time.
Leases 7

Classification
There are two main types of leases: Capital or Financing Lease Operating Lease
Capital leases are further classified into following types: 1. Financing Lease 2. Leveraged Lease 3. Sales and Lease Back 4. Direct Lease

Leases

Definitions
FINANCE LEASE Capitalization Criteria
The criteria about capitalization of leases are given in para 10 of IAS 17 as:

The lease transfers ownership of an asset to a lessee by the end of lease term; The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the FV 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 lease term is for the major part (75%) of the economic life of the asset even if title is not transferred; At the inception of the lease PV of the MLPs amounts to the FV (90%) of the leased asset; and The leased assets are of such a specialized nature that only the lessee can use without major modification.

Leases

Definitions
FINANCE LEASES Additional Capitalization Criteria
Para 11 of IAS 17 gives some more criteria that distinguish capital leases from operating leases: If the lessee can cancel the lease, the lessors losses associated with the cancellation are borne by the lessee; Gains or losses from the fluctuation in FV of RV accrue to the lessee; and the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. Para 12 IAS 17 still goes on to say that the criteria mentioned in para 10-11 are not final. For instance, it says, if it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease. __________ , FASB Statement 13 has quantified the values.
Leases 10

Definitions
OPERATING LEASE
An operating lease stands in contrast to a financial lease in almost all aspects. This lease agreement gives to a lessee only a limited right to use an asset. The lessor is responsible for upkeep and maintenance of an asset. The lessee is not given BPO at the end of the lease period. This is similar to renting of assets.

SALE & LEASE BACK

Under this arrangement, an owner of an asset sells the asset to a party (the buyer), who in turn leases back same asset to the owner in consideration for lease rentals. However, under this arrangement, assets are not physically exchanged but it all happens in records books only. Sale and lease back transaction is suitable for those assets, which are not subject to depreciation but appreciation, for instance, a piece of land in a exotic location. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of an asset and after possession of an asset convert the sale into a lease arrangement. The lessor has two sources of earnings under a sales type lease: A profit, at the lease inception date, Interest revenue over the lease term.
Leases 11

Definitions
LEVERAGED LEASING
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. A lessor borrows a part of purchase cost (say 70%) of an asset from a third party i.e., lender and the asset so purchased is held as a security against such loan. The lender is paid-off from lease rentals directly by a lessee and surplus after meeting claims of lender goes to the lessor. The lessor, the owner of an asset is allowed to record depreciation expense related with that asset.

DIRECT LEASING
Under direct leasing, a company acquires a right to use an asset from a manufacturer directly. The ownership of an asset leased-out remains with the manufacturer. Most directfinancing leases involve banks, which make profits by lending money at an interest rate specified in their contract with the lessee. These banks do not sell assets of the type being leased but merely provide finance for assets acquired for a lease. Acquisition of vehicles from the direct outlets of car manufacturers like Honda, Mercedes, Toyota, BMW, Ford, Jaguar, etc. is an example of direct leasing.
Leases 12

MLPs Calculation FASB St. 13

Yes

Check-out if the lease contract includes BPO Clause???

No

Then MLPs shall include the following: Periodic lease payments up-to the date on which BPO becomes exercisable Amount of BPO

Then MLPs shall include the following: Periodic lease payments over the lease term The amount of GRV (if any) Any payment required by the lessee for failure to renew or extend the lease at the end of lease term

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13

RV Calculation FASB St. 13 & IAS 17

Equals to EL
Check-out if the lease term equals to Economic Life (EL) of the asset??? It has RV of a leased asset only. Note: The lease contract may provide to guarantee all, part or none of assets RV.
Leases

Less than EL

It has two parts: First, cost pertaining to remaining useful life of an asset Second, RV of an asset
14

Discount Rate to be Applied by a Lessee - FASB St. 13 & IAS 17

Yes
Check-out if the lease contract provides interest rate implicit in it? IBR shall not be used when: Implicit rate is known, Implicit rate is less than IBR That means under these two conditions implicit rate shall be used. Refer to slide 17 for MLP calculations.
Leases

No

Use IBR for discounting lease liability over the lease term, if implicit rate is not determinable. Refer to slide 17 for MLP calculations.

15

Depreciation Expense Calculation FASB St. 13 & IAS 17

Yes
Check-out if the lease contract transfers ownership at the end of lease term or contains BPO Clause in it??? Depreciate lease asset over the economic life.

No

Depreciate lease asset over the lease term.

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Lessees Books

Lessors Books

Lease Payable

Lease Receivable

Lease Receivable/Payable Amount = FV - PV of GRV - PV of UGRV (If any) [Lease Payable amount represents the PV of MLPs from lessees perspective]
Leases 17

Total Lease Receivable/Payable amount = FV - PV of GRV - PV of UGRV(if any)

[ Total Lease Receivable/Payable amount PV of GRV / UGRV Where: R = r = n = FV = = =
(+)

] +

Periodical Payment Rate of interest Lease Terms (ie number of years) Fair Value of GRV at the end of lease term

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18

Implicit Rate versus IBR

FASB Statement 13 requires the lessee to use his IBR in calculating the PV of MLPs unless (1) the lessee can determine the implicit rate in the lease and (2) the implicit rate is less than the lessees IBR. IAS 17 para 20, says, the discount rate to be used in calculating the PV of the MLPs is the interest rate implicit in the lease, if this is practicable to determine, if not, then lessees IBR shall be used. Any IDCs of the lessee shall be added to the amount to be recognized as an asset. In practice, the number of instances in which the IBR should apply is small, for the following reasons: 1. Most lessors disclose the interest rate implicit in their lease agreements. 2. The lessee knows the FV of the asset being leased to him. 3. Leased asset may be subject to high rate of obsolescence, which makes expected RVs nominal. Thus, the impact on FV of the asset is negligible. Important note: The calculations for lease receivable amount by a lessor at his required rate of return on his investment in an asset are done for every lease deal separately. For a lessee, it becomes implicit interest rate. He has to calculate it or it shall be known to him by a lessor.
Lease 19

An annuity is a series of equal cash f lows occurring at equal intervals over a period of time. Ordinary Annuity: If the first cash flow occurs at the end of the first period, the annuity is called Ordinary Annuity or an Annuity in Arrears. Annuity Due: If the first cash flow occurs at the beginning of first period. The annuity is called an Annuity Due or an Annuity in Advance. [ ] + ] +
20

PV of MLPs under Ordinary Annuity =

PV of MLPs under Annuity Due

= (1+r)

Leases

Accounting
Date Description Finance Lease: Lessors Books
1/1/20xx Lease Receivable Asset

Ref.

Debit
AED.
xxx

Credit
AED.
xxx

(Lease Receivable recorded at Net Investment in Leased Asset by the lessor)

Cash Lease Receivable (On receipt of 1st lease installment) 31/12/20xx Lease Receivable Interest Income (On booking interest income earned) xxx xxx xxx xxx

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21

Accounting
Date Description Ref. Debit
AED. xxx xxx

Credit
AED.

Finance Lease: Lessees Books

1/1/20xx Lease Asset Lease Payable

[Lease asset and lease liability shall be recorded at lower of : (1) PV of MLPs or (2) FV of asset, at the inception of the lease] Lease Payable Cash 31/12/20xx Interest Expense Lease Payable Lease Payable Cash Depreciation expense Accumulated Depreciation xxx xxx xxx xxx xxx xxx xxx xxx

Depreciation of an asset is charged over: The EL of an asset, if ownership transfers to lessee at the end of lease term or there is a BPO The term of lease, if title does not transfer or there is no BPO Leases 22

Accounting
Finance or Capital Leases
Financial Statements Presentation & Disclosure Statement of Comprehensive Income
For the financial year ended December 20xx

Lessors Perspective
AED. Interest Revenue xxx

Lessees Perspective
AED. Interest Expense Depreciation Expense xxx xxx

Important note: For the information to be included in explanatory notes to the financial statements of lessee and lessor, refer to para 31 and para 47of IAS 17 respectively.
Leases 23

Accounting
Finance or Capital Leases
Financial Statements Presentation & Disclosure Statement of Financial Position As at December 31, 20xx
Lessors Perspective
ASSETS Lease Receivable AED. xxx

Lessees Perspective
ASSETS Leased Asset Less: Accumulated Dep. Net Leased Asset LIABILITIES Lease Liability
Leases

AED. xxx (xxx) xxx xxx

24

Accounting
Date Description Operating Lease: Lessors Books
1/1/20xx. Cash Lease Rental Revenue (Being the revenue earned through leased assets rental) 31/12/20xx Depreciation Expense Accumulated Depreciation (Being the depreciation of leased asset recorded) xxx xxx

Ref.

Debit
AED. xxx

Credit
AED.

xxx

Operating Lease: Lessees Books

Lease Rent Expense Cash (Being the lease rent expense paid) xxx xxx

Important note: For the information to be included in explanatory notes to the financial statements of lessor and lessee, refer to para 56 and para 35 respectively.
Leases 25

Accounting
Operating Leases
Financial Statements Presentation & Disclosure

Statement of Comprehensive Income For the financial year ended December 20xx
Lessors Perspective
AED. Lease Rental Revenue Depreciation Expense xxx xxx Lease Rental Expense

Lessees Perspective
AED. xxx

Important note: For explanatory notes to be included in the financial statements of lessor and lessee, refer to para 56 and para 35 respectively.
Leases 26

Land & Building Lease

When a lease includes both land and buildings, a company MUST consider land and building parts separately for their classification as operating or finance lease. MLPs are allocated between the land and buildings parts in proportion to the relative FVs of the leasehold interests in the land and buildings parts.

Leases

27

On January 01, 2008, AAA company leased-out a generator to BBB company . The terms and conditions of the lease are as given below:

# Description of Terms & Conditions of the lease:

1 Cost to AAA and FV of the generator is AED. 20,000

2
3 4 5

Term of lease, 4 years (covers 67% of EL of the generator)

Economic life of the asset, 6 years The lessee has guaranteed 100% RV, at the end of lease term, VIZ estimated at AED. 3,000 Implicit rate of interest used in the lease payments and lessees IBR is 12%

6
7

Annual lease payments to be made at the beginning of each year is (annuity due) are determined by the lessor as given on next slide.
The lease uses straight-line depreciation on the leased asset.

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28

Description Cost & FV of the generator PV of GRV PV of MLPs (90% i.e. 90.47%) Annual Lease Payment (Recoverable amount / PV factor) Annual Lease Payment (AED. 18,094 / 3.4018)

Amount AED. 20,000 (1,906) 18,094 5,319

( + ) PV of GRV = 3,000/(1.12)^4 = 3,000 x 0.6355 = 1,906 PV of GRV =

The aggregate PV of MLPs to be recovered is 90%, therefore, it is a capital lease.

Leases 29

Year

Annual Lease Payments (Annuity Due Method)

2

Net Receivable/P ayable outstanding during the year

3 6-2

Interest Revenue/Ex pense for the year

4 3x12% AED. -

Reduction in Receivable/Paya ble Balance

Net Receivable/Paya ble on 31 December

6 3+4 AED.

5 2-4 AED. -

AED. 01/01/08 01/01/08 01/01/09 01/01/10 01/01/11 -

AED. -

20,000 16,443 12,459 7,997 3,000 (RV)

5,319 5,319 5,319 5,319

14,681 11,124 7,140 2,678

1,762 1,335 857 322

3,557 3,984 4,462 4,997

Total

21,276

4,276
Leases

17,000
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Lessors Books [AAA Co. Books]

Description
1 Lease Receivable Lease Asset - Generator (To record capital lease on 01/01/08) 2 Cash Lease Receivable 5,319 5,319 2

Lessees Books [BBB Co. Books]

Description
1 Lease Asset- Generator Lease Liability (To record capital lease on 1/1/08) Lease Liability Cash (To record lease payment on 1/1/08) 5,319 5,319

Dr.
20,000

Cr.
20,000

Dr.
20,000

Cr.
20,000

(To record the 1st lease payment on 01/01/2008)

Lease Receivable
Interest Revenue

1,762
1,762

Interest Expense
Lease Liability

1,762
1,762

(To record interest earned on 31/12/08.) 4

(To record interest expense on 31/12/2008) Depreciation Expense Accumulated Depreciation 4,250 4,250

To record Depreciation [(20,000-3000)/4 = 4,250 p.a.]

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Lessors Books [AAA Co. Books]

Description
1 Cash Lease Receivable (To record the last lease payment) 2 Lease Receivable Interest Revenue (To record interest earned on 31/12/11) 3 Lease Asset Generator Lease Receivable (Final Settlement entry 31/12/11) 4 3,000 3,000 3 322 322 2

Lessees Books [BBB Co. Books]

Description
1 Lease Liability Cash (To record lease payment on 01/01/2011) Interest Expense Lease Liability (To record interest expense on 31/12/2011) Depreciation Expense Accumulated Depreciation 4,250 4,250 322 322

Dr.
5,319

Cr.
5,319

Dr.
5,319

Cr.
5,319

To record Depreciation [(20,000-3000)/4 = 4,250 p.a.] Accumulated Depreciation Lease Liability Lease Asset (Final settlement entry on 31/12/11) Leases 32 17,000 3,000 20,000

Advantages
1.
There is no requirement to pay entire amount upfront for an asset acquired through a lease arrangement. Further, it provides flexible payment plan suiting best to the businesses according to their income streams and cash flow patterns. The arrangement under leases provide great deal of flexibility in terms of adopting to rapid changes in technology and capacity needs from lessees point of view. It helps companies to stay competitive in business.

2.

3.
4. 5.

Leasing arrangement has resolved critical cash problem for a lessee by providing 100% financing for a leased asset.
Leases preserves credit-lines for other business pursuits like purchase of inventory of raw materials, project finance or other emergency uses. Leasing may help a manufacturer accelerate sales of his products.

Leases

33

Advantages
6.
A lessee may avoid many of restrictive covenants that are usually part of long term contracts for credit-lines. Requirements with respect to, minimum net working capital, subsequent borrowings, changes in management, mortgages or pledges on assets, nominees in Board of Directors, and so on are not normally found in lease contracts. Leasing arrangements help a lessor to prevent dilution of ownership which otherwise is inherent when equity shares or convertible bonds are issued for raising the necessary finance for acquisition of assets. The use of sale and lease back arrangements may permit a company to increase liquidity by converting an existing asset into cash that can be used as a working capital. Leasing balances usage and cost of an asset. Leasing makes sense when an asset used creates a return that exceeds its cost. It is said for this point that leases means good business sense.

7.

8.

9.

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34

Advantages
10. Leasing provides fixed rate financing. Leasing is not subject to market fluctuations
and interest rate increases. One can negotiate periodic lease payments and secure a fixed rate for the term of lease. This makes it much easier to manage project cash flows and budgets for planning purposes.

11. Leasing provides hedge against inflation. Since lease payments apply to use of an
asset and are not paid for ownership of an asset that depreciates consistently. Furthermore, cash savings can yield a return that fights inflationary pressures.

12. Leasing conserves working capital. Leasing enables a lessor to save working
capital for his company, since it covers all costs associated with capital asset purchases like maintenance, insurance, up-keep etc., etc.

13. Leasing may help a lessee to avoid the risk and cost of idle asset after required
utility of an asset is over.

Leases

35

Advantages
14. Lease mode of financing is also compared to security-tied credit. It saves capital
for other needs of a company.

15. In case of operating leases arrangement, the lessees Debt to Equity Ratio and
Return on Capital Employed (ROCE) is not increased. This is due to offbalance sheet financing of the asset.

16. Operating lease provides tax benefits to a lessor. Some leasing companies
transfer tax benefits received from ownership of assets to lessees through competitive rates and lower execution fees.

17. With a bank loan or direct purchase, a company normally claim depreciation
according to IAS 16 recommendation of useful life of an asset. Depreciation for an asset can be spread over 5 to 7 years. However, the same asset under a lease can be expensed-out 100% over the lease term selected by a company. This could, for instance, write-off an asset over 3 years instead of 5 or 7 years. This will, eventually, provide bigger tax benefits to the lessee.

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36

Disadvantages
1. 2. 3. 4. 5.
A company is unable to sell or sub-lease an asset in the event it is no longer required and cannot upgrade it to a newer or better asset without either paying-off the remaining contract dues, or paying fines to cancel the contract. A lessee loses certain tax benefits which are available to a lessor (owner) who uses the assets himself. A lessee has often to bear technological obsolescence since some lease contracts have non-cancelable clause in them. Early termination of a contract by a lessee may impose severe penalties from a lessor. Although leasing avoids paying an upfront amount, over a long period of time, it often works out considerably more expensive than outright purchase. A company pays cost of asset as well as the leasing companies charges and other dues incidental to the lease contract. Lessees are responsible for the maintenance and repair of leased asset. Some leasing companies allow lessee to cover the maintenance and repair costs for an extra sum in their lease installment.

6.

Leases

37

Glossary
1. 2. 3. 4. Lessor may be owner of an asset being leased. Lessee is a party to whom right to use an asset is being transferred. Bargain Purchase Option (BPO) refers to a provision giving the lessee the right to acquire leased asset at a price so favorable that exercise of the option appears reasonably assured at the inception of the lease. Bargain Renewal Option (BRO) refers to a provision that gives the lessee a right to renew a lease at a rental so favorable that exercise of the option appears reasonably assured at the inception of the lease. Contingent rentals means increase or decrease in lease payments after the inception of a lease that result from changes in factors on which lease payments are based. Economic Life (E/L) of a leased asset means the remaining usable life of an asset for the purpose to serve. Fair Value (FV) of a leased asset refers to normal selling price. Inception of Lease Contract refers to date of lease contract. Sublease (S/L) refers to further transfer of the right to use an asset from a lessee to a third party. It is subject to the contract between first and second party. Lease Term refers to the fixed non-cancellable term of a lease.

5.
6. 7. 8. 9. 10.

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38

Glossary
11. 12. 13. Minimum Lease Payments (MLP): Consists of all amounts that a lessee is obligated to pay under the terms of a lease agreement. It excludes contingent rents, costs for services and taxes paid by a lessor. These shall be additional payments. Estimated Residual Value (ERV) refers to FV of an asset at the end of the lease term. It has two parts namely Guaranteed Part and Unguaranteed Part. FV is calculated for two parts separately and then added to show ERV. Guaranteed Residual Value (GRV) A lessees assurance to a lessor that lessor will recover at least guaranteed amount at the end of the lease term. A lessor usually writes this clause in his contract in order to cover risk of deterioration of an asset value beyond what is mentioned in a contract. Unguaranteed Residual Value (UGRV) The portion of a leased assets RV at the end of a lease term that is not guaranteed by a lessee. Initial Direct Costs (IDCs) are costs of legal consultancy, processing of documents, negotiating the contracts etc., etc. Incremental Borrowing Rate (IBR) refers to a rate that a lessee otherwise had paid to the borrowed amount to acquire an asset under similar lease arrangement. Implicit Interest Rate (IRR) refers to the discount rate (applied to MLPs & GRV) that causes the aggregate PV to be equal to FV of leased asset to a lessee.

14. 15. 16. 17.

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Abbreviations used
# 1 2 3 4 5 Abbreviation BPO BRO b/w GRV EL Description Bargain Purchase Option Bargain Renewal Option Between Guaranteed Residual Value Economic Life

6
7 8 9 10 11 12 13 14 15

ERV
FV IBR IIR IDCs F/Y MLPs PV RV S/L UGRV U/E-FI

Estimated Residual Value

Fair Value Incremental Borrowing Rate Implicit Interest Rate Initial Direct Costs Final Year Minimum Lease Payments Present Value Residual Value Sublease Unguaranteed Residual Value Unearned Finance Income

16 17

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Appendix A

Leasing Soft-wares
# 1 2 3 4 5 6 7 8 9 10 Name SiriusPro Rental Software Dominion Leasing Software LeaseWave ProLease AMTdirect Propertyware LeaseEagle Visual Lease Skire Unifier Ryznware Software
Leases

Web address http://www.orion-soft.com http://www.dominionls.com

http://www.odessatechnologies.com http://www.proleasesoftware.com

http://www.amtdirect.com http://www.propertyware.com http://www.leaseeagle.com http://www.visuallease.com http://www.skire.com http://www.ryzn.com

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# Source
1 2 3 4 5 6 7 8 9 IAS 17 SIC-15 SIC-27 SIC-29 SIC-32 IFRIC 4 IFRIC12
FASB St. 13 Intermediate Accounting 5/e

Entitled/Author
Leases Operating leases incentives Evaluating the substance of transactions involving the legal form of a lease Service concession arrangements: Disclosures Intangible assets Website costs Determining whether an arrangement contains a lease Service concession arrangements Leases Lanny G. Chasteen, Richard E. Flaherty, Melving C. OConnor

Leases

42

FCMA, FPA, MA (Economics), BSc.

Contact: At.bhatty@gmail.com

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