Lease
A lease is an agreement whereby the lessor provides to
the lessee, the right to use an asset for an agreed period of time, in return
for a payment, or series of payments.
Lessor
The lessor is the owner of the leased goods, who hires
them to the user, or ‘lessee’.
Lessee
The lessee uses the leased goods, and pays a hire
charge to do so.
Finance Lease
A finance lease transfers substantially all the risks,
and rewards, of ownership of an asset. Title may, or may not, eventually be
transferred.
Operating Lease
An operating lease is a lease that is not a finance
lease.
Non-cancellable Lease
A non-cancellable lease is a lease that is cancellable
only:
(1) upon the occurrence of some remote contingency;
(2) with the permission of the lessor;
(3) if the lessee enters into a new lease for the
same, or an
equivalent asset, with the same lessor; or
(4) upon payment, by the lessee, of such a large amount
that the lease is unlikely ever to be cancelled.
Start of the Lease
The start of the lease term is the date from which the
lessee can use the leased asset.
As at this date:
(1) a lease is classified as either an operating, or a
finance, lease;
and
(2) in the case of a finance lease, the amounts to be
recorded at
the start of the lease term are determined.
Lease Term
The lease term is the non-cancellable period for which
the lessee has
contracted to lease the asset, together with any
further periods for
which the lessee has the option to continue to lease
the asset, with or
without further payment, when it is probable that the
lessee will exercise the option.
Minimum Lease Payments
Minimum lease payments are the payments over the lease
term that
the lessee must make,
excluding contingent rent, costs for services and
taxes to be paid by, and reimbursed to, the lessor,
plus:
(1) for a lessee, any amounts guaranteed by the
lessee, or by a
related party; or
(2) for a lessor, any residual value guaranteed to the
lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party, unrelated to the lessor.
However, if the lessee has an option to purchase the
asset at an attractive price at the end of the lease, so that it is probable
that the option will be exercised, the minimum lease payments will also include
the payment required to exercise the option.
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EXAMPLE - Impact of penalties or costs on calculation
of minimum lease payments (MLP)
Issue
The
calculation of the MLP should exclude contingent rent.
How
should penalties or costs, payable by the lessee for failing to continue a
lease, affect the calculation of MLP?
Background
An
entity leases office space. As part of the lease agreement, the lessor will
carry out leasehold alterations specified by the lessee up to a value of
20,000.
The
lease term is for 5 years, with the option to extend for a further 5
years. However, if the extension
option is not taken up, the lessee must pay the lessor a penalty equal to 75%
of the value of the leasehold alterations.
Solution
The
calculation of MLP should be based on the best estimate of whether the
extension period will be taken up or the penalty paid. The penalty should be
included in the calculation of the MLP if the lessee’s assessment is that the
penalty will be paid.
Conversely,
if it is reasonably certain that the lessee will renew the lease, it should
include the payments from the extension period in the calculation of the MLP
in place of the penalty fee.
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Fair Value
Fair value is the amount for which an asset could be
exchanged, or a
liability settled, between knowledgeable, independent
parties.
Economic Life
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 units expected to be
obtained from the asset.
Useful life is the estimated remaining period, over
which the economic benefits of the asset are expected to be consumed by the
undertaking.
Guaranteed Residual Value
Guaranteed residual value is:
(1) for a lessee, that part of the residual value that
is guaranteed
by the lessee, or by a related party; and
(2) for a lessor, that part of the residual value that
is guaranteed
by the lessee or by a reliable third party.
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EXAMPLE - Effect of
a guarantee of residual value by lessee on calculation of minimum lease
payments (MLP)
Issue
The
calculation of MLP includes any amount guaranteed by the lessee.
The
accrual of gains or losses from the fluctuation in the fair value of the
residual to the lessee is an indication of a finance lease.
How
should the residual risk be evaluated for lease classification purposes?
Background
An
entity (lessor) leases a truck to a customer for 3 years. The value of the
truck at the end of the lease is estimated at 40% of its original cost.
Market
data suggests that the likely range of residual values after 3 years is 40%
to 50% of original cost.
The
lessee will guarantee any fall in the truck’s residual value below 40% down
to 25% of original cost. The lessor will bear the cost of any fall in
residual value below 25% of original cost.
Solution
The
lease is a finance lease.
It
is unlikely that the truck’s residual value will fall below 25% of original
cost. The sharing of the downside of the residual value risk is therefore not
even. The risk retained by the lessor is remote and should be ignored. The
residual value risk is in substance borne by the lessee, and the lease should
therefore be classified as a finance lease.
The MLP
should include the guaranteed residual value of the truck that is 15%
(40%-25%) of original cost.
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Unguaranteed Residual Value
Unguaranteed residual value is that portion of the
residual value of
the leased asset, which is not guaranteed.
EXAMPLE- unguaranteed residual value
You lease a car to a client for 4
years.
The cost of the car is $20.000.
The anticipated residual value at the end
of the lease is $5.000.
The lease is priced at $15.000,
plus finance charges.
A dealer gives you a guarantee to purchase
the car for $4.000(at the end of the lease).
This is the guaranteed residual value.
The remaining $1.000 is the
unguaranteed residual value.
Initial Direct Costs
Initial direct costs are incremental costs that are
directly attributable to negotiating and arranging a lease, excluding such
costs incurred by manufacturer, or dealer, lessors. These may include
registration costs for property.
Gross Investment in the Lease
Gross investment in the lease is the aggregate of:
(1) the minimum lease payments receivable by the
lessor under a
finance lease, and
(2) any unguaranteed residual value accruing to the
lessor.
In practice, this amounts to the total payments
(interest and principle) made by the lessee, and received by the lessor.
Net Investment in the Lease
Net investment in the lease is the gross investment in
the lease,
discounted at the interest rate implicit in the lease.
In practice, this means the
payments of principle made by the lessee, and received by the
lessor. ‘’Discounted at the interest rate implicit in the lease’’
means that the interest portion of the payments is
deducted from the total payments, leaving only the principle payments.
Unearned Finance Income
Unearned finance income is the difference between:
(1) the gross investment in the lease, and
(2) the net investment in the lease.
In practice, this is the total
interest payments made during the term of the lease.
Interest Rate Implicit in the Lease
In practice, this is the interest rate negotiated
between lessor and lessee. If this is not known by the lessee, the lessor
should be contacted for the information.
The rate can be calculated, or confirmed, by the
following method:
The interest rate implicit in the lease is the
discount rate that, at the
start of the lease, causes the aggregate present value
of
(1) the minimum lease payments and
(2) 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.
Lease payments comprise a payment for the asset, and a
finance payment. The finance payment is a rate of interest multiplied by the
cost of the asset multiplied by the length of time of the lease.
Lessee’s Incremental Borrowing Rate of Interest
The lessee’s incremental borrowing rate of interest is
the rate of
interest the lessee would have to pay on a similar
lease or, the rate that, the lessee would incur to borrow over a similar term,
and with a similar security, the funds needed to purchase the asset.
This is the lessee’s cost of capital for the lease.
Contingent Rent
Contingent rent is additional lease payments that are based
on items such as percentage of future sales, amount of future use, future price
indices, future market rates of interest.
This is additional income for the lessor, and additional
expense for the lessee.
EXAMPLES-contingent rent
You lease a shop in an airport. You pay
$10.000 per month, plus 5%
of your sales value as contingent rent.
You lease an office. Each year, the rent
will increase by the percentage increase in the wholesale price index. The
increase is regarded as contingent rent. It will not be known until the index
is published each year, and it may show no increase.
Hire purchase
The definition of a lease includes contracts giving
the hirer an option to acquire title to the asset by paying an additional
payment, normally at the end of the contract. These contracts are hire purchase
contracts.