Welcome back. In this lesson,
we're going to talk about classifying leases.
So, even though our leases are now
recognized in 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 of 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 a lease?
Well, we need to know the lease term,
and that would include any purchase options,
it also includes any options to
extend the lease or to cancel the lease,
terminate the lease early.
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 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 percent example.
These lease payments are less than or
equal to 90 percent of the fair value was previous GAAP,
and now it just says substantially all.
Although the fairs we did put into
the basis for conclusions that you could continue using
the 90 percent rule and
the 75 percent as
a benchmark for the major part of the remaining economic life.
What's another new factor though,
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 least will
be renewed or that somehow they'll get their money back.
So, for example equipment that's installed on
the 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 a least term?
Well, the lease term is the non-cancelable period of the lease.
But you also have to consider whether there's an option to extend
the lease or an option to
terminate the lease and shortened lease term,
if it's reasonably certain that
the lessee will exercise that option,
or in the case of a termination option not exercise it.
So, reasonably certain is meant to be a high hurdle.
So, the lease term will be evaluated at beginning of
the lease and reassessed when there's
a triggering event but not otherwise,
so little 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.
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 its estimated life is 30 years.
So, how do you evaluate what the lease 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 could look at
other factors for example if they're renewing it
at the same rent or at
a lower rent that could provide an 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 payments?
Well, there's fixed payments, those are easy,
those would be the amount of payments that you know are
non-cancelable that you're going
to have to pay at sometime in the future,
but sometimes there's in substance fixed payments,
something that's structured as if it's a variable payment.
But when you look at it closely there's really
no opportunity to avoid making payment.
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 and we'll have to make up
any short fall you would have to put
in any expected payments under that.
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
compound if they have an incentive to do so,
then you would include the price of
the purchase option in the lease payments.
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
an external market of value in index these variable payments.
These are going if the payment is due to
changes due to a benchmark interest rate or 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 a sort of in substance fixed type 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.
I comment one of this is in retail outlets,
the lease will include a percentage of
sales being charged to the lessee every year.
Then there's other types of leases,
anybody who's had an auto lease knows that if you go
over the mileage allowance,
you're going to have a mileage charged for extra miles.
Leases of heavy equipment,
construction equipment often include a per hour charge.
These would be variable based on the use of the underlying asset.
They're considered variable payments.
These would not be included in the minimum payments.
So, if the index
is such that you're taking an 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 x. I know it's confusing.
This is a carryover 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.
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 by
the greater of three percent or
the change in the consumer price index.
Well, you know then it's going to
increase by at least three percent.
So, that would be an example of an in-substance fixed arrangement.
There's other examples, where people will
try to structure a payments so that it looks like it's 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 liability
unless the payments are in substance fixed.
If they're based on a rate or index,
are based on the current reader 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
partial attributable to the lease.
So, once 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.
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 it 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.
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 last story 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.
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 in downtown in a major city,
it's just based on the market.
If 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.
The lessor will include their indirect costs of the lessor.
They'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.
