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Welcome back, in this lesson we're going to talk about classifying leases.

So even though, all leases are now recognized on the statement of financial

position, it's still necessary to classify leases as operating or finance leases.

So classification does not affect the initial measurement for a lessee.

All leases are measured the same at commencement.

But it will determine the subsequent measurement of the right to use asset,

because it's going to determine how you amortize the right of use asset

over the period of the lease term.

So an operating lease will be different from a finance lease.

Now, the IFRS accounting for

a lease does not include classification by the lessee.

All leases are considered to be a finance lease under IFRS, so

this is strictly a US GAAP procedure.

So what do we need in order to classify lease?

Well, we need to know the lease term and that will include any purchase options,

it also includes any options to extend the lease or to cancel the lease,

terminate the lease early.

And then we need to know the useful life of the asset.

We need to know the amount of the lease payments,

including some of the variable payments.

Some variable payments are going to be included in the capitalized amount of

the lease and some are not.

We need to know if there's are any lease incentives or

guarantees of the residual value of the leased asset.

We need to know the discount rate, and

we need to know whether the asset is specialized and has no alternative use.

So here's a chart that shows the process we're going to go through.

It's fairly similar to current GAAP.

The changes ironically are those that were previously existing in IFRS,

this is the model from IAS 17, leases.

It takes off the bright lines in particular for 90% example.

The discounted lease payments less than or equal to 90% of the fair value

was a previous GAAP and now it just says substantially all.

Although the fares we did put into the basis for

conclusions that you could continue using the 90% rule and

the 75% as a benchmark for the major part of the remaining economic life.

What's another new factor though is, is the underlying asset,

specialized asset with no alternative use.

This was in previous IFRS, but it's new to US GAAP, so what is a specialized asset.

Well again,

it's an asset with no alternative use to the lessor at the end of the lease.

So under assumptions of economic rationality,

the lessor must somehow be reasonably certain that the lease will be renewed.

Or that somehow they'll get their money back.

So for example, equipment that's installed on a lessee's property that cannot be

relocated or reused would be

equipment with no alternative use to the lessor at the end of the lease.

Maybe a pipeline that's installed on the lessee's property would be an example.

So what is the lease term?

Well the lease term is the non-cancellable period of the lease.

But you also have to consider where there's an option to extend the lease or

an option to terminate the lease and shorten the lease term.

If it's reasonably certainly the lessee will exercise that option or

in the case of termination option not exercising it.

So reasonably certain is meant to be a high hurdle.

So the lease term would be evaluated at the beginning of the lease and

reassessed when there is a triggering event, but not otherwise.

So we'll know more on this later.

Let's look at an example of the lease term.

So in our example here, Makeshift Motors leases land for a new factory.

And the initial term is 15 years with a 15-year renewal option.

Makeshift Motors plans to construct a factory on the leased land.

And the cost of that building will be significant, and

it's estimate life is 30 years.

So how do you evaluate what the least term is?

Well, think of it this way.

If Makeshift doesn't renew the lease of the land,

they will lose the use of that building, which is significantly expensive.

So they would have a significant incentive to renew the ground lease.

Also you can look at other factors.

For example, if they're renewing it at the same rent or

at a lower rent, that could provide and incentive to renew.

Usually renewal at market rates is not considered an incentive.

Again, unless it's maybe it's absolutely necessary to their business to do so.

What's the point here?

You're going to have to use judgment.

It is a high hurdle, but

the lease term may not always be just the non-cancellable term.

You also have to look at the existence of options to renew the lease, or

to terminate the lease.

What about the type of lease payment?

Well, there's fixed payments.

Those are easy.

Those would be the amount of payments that you know are non-cancellable,

that you know you're going to have to pay at some time in the future.

But sometimes there is in-subtance fixed payments, something that's

structured, it's a variable payment.

But when you look at it closely,

there's really no opportunity to avoid making payment.

And then there's variable lease payments that depend on an index or

a rate, we'll talk about that in a minute.

How sometimes you're going to use the amount based on the current index

in order to calculate the minimum lease payments or the rental payments.

Sometimes you don't though, and it's based on a change in that rate.

Expected payments too, under a residual value guarantee.

This is if you've guaranteed that the lessor will obtain a certain price for

the asset at the end of a lease.

If the lessee is guaranteeing that amount, then we'll have to make up any short fall,

you would have to put in any expected payments under that.

And then there's the exercise price of a purchase option.

If it's reasonably certain that they'll exercise a purchase option.

If it looks like a bargain, for example, or

they can be economically compelled with, they have an incentive to do so.

Then you would include the price of the purchase option in the lease payments.

And then any penalties for terminating the payment or not extending it,

if you decide to take that into account when determining the lease term.

So if we expect that the lessee will terminate the lease and

we use that shorter lease term to evaluate the lease,

then we're going to include the termination penalty.

If it's not reasonably certain they'll terminate,

we'll use the longer lease period and all of the payments in that period.

So what about price changes due to changes in the external market or value of index,

these variable payments.

If the payment is due to changes ,due to a benchmark

interest rate of consumer price index.

If it's due to a change in the index, you don't include it.

But if it's based upon that index to calculate the price,

in other words it's sort of a substance fixed tape arrangement,

you use it based upon the current rate.

Other variable payments would be, payments where the lessee's performance

derives from the use of the underlying asset.

A common one of this is in retail outlets, the lease will include

a percentage of sales would be charged to the lessee every year.

And then there's other types of leases.

Anybody who has had an auto lease knows that if you go over the mileage allowance,

you're going to have a mileage charge for extra miles.

Leases of heavy equipment, construction equipment,

often include a per hour charge.

This would be variable based on the use of the underlying assets.

They are considered variable payments.

This would not be included in the minimum payments.

So, if the index is such that you're taking on amount increases by LIBOR

times the current rent, then you would use the current LIBOR as a multiplier for

each future period and include that amount in lease payments.

But if it's based on a change in the index, then all changes are variable,

and they're not included in the index.

I know it's kind of confusing, this is a carry over from existing GAAP,

and it's always been a source of confusion in practice.

But it makes a difference whether you're using an index or a change in an index.

And then there's in-substance fixed, this is a form that may

appear to contain variability, but they're in effect unavoidable.

Say the lease will increase the lesser of 3% or

the change in the consumer price index.

Well, you know then it's going to increase by at least 3%.

So that would be an example of an in-substance fixed arrangement.

There's other examples where people will try to structure payments, so that

it looks like its variable, but there's really no way to avoid the payment.

That would be in-substance fixed.

Okay, so variable rents are not included in the measure of the liability

unless the payments are in-substance fixed.

If they're based on a rate of index or based on the current rate of index.

If they're based on other variable payments again

they're not included in the index.

A lessor is going to include variable payments in the lease component even if

it's only partiable attributable to the lease.

So as we determine the total lease payments, then we're going to discount

them in order to determine the liability or the lease obligation as we call it.

And to do that we have to decide what discount rate to use.

So the lessee is going to use the rate that the lessor charges the lessee.

Well, what if the lessor doesn't let them know,

what if it's not explicit in the lease, or it cannot be readily determined.

Then the lessee can use its incremental borrowing rate.

And that incremental borrowing rate is going to be the rate that you would

obtain to borrow money to buy a similar asset for a similar term.

So the lessor doesn't have a choice.

So they're going to have to use the rate implicit in the lease.

The IASB and

the FASB both assume that the lessor will have all the necessary information.

That may not be true all the time for office leases or real-estate leases.

And a lot of times these leases are not priced based upon

an expected return on the asset which is very common in equipment leases, but

in real estate leases especially like say office space downtown in a major city.

It's just based on the market and it's whatever the market can bear.

So the lessor is going to have to be backing into that amount as well, but

they're assuming that you will have the information to do that.

And the last store will include their indirect costs of the lessor.

That'll be included in determining the rate implicit in the lease.

So this is the information you're going to need to classify.

You should assemble all that information and be ready to document it as you get

ready to initiate a lease and we'll talk about how to classify next.

Classification of Leases

Accounting Analysis II: Measurement and Disclosure of Liabilities

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