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.
