Lessee Ltd.

Case 11-6 deals with Lessee Ltd., a company that operates in Britain and uses IFRS. The question in this case is how to classify a lease that Lessee, Ltd. acquired from Lessor Inc. The accounting standard that deals with leases under IFRS is IAS 17. IAS 17 was originally issued in September 1982 and was reissued in December 2003. It classifies leases as either finance leases or operating leases. Finance leases make it so that the lessee recognizes an asset and a liability and the lessor recognizes a receivable, basically transferring all the risks and benefits of ownership. Under operating leases, the lessor still recognizes the asset and the lessee recognizes an expense.

The first question in this case is if the junior accountant’s analysis was correct. The junior accountant classified the lease as an operating lease. The junior accountant is incorrect because under IAS 17.10 this lease should be classified as a finance lease. IAS 17.10 lists out 5 situations that would normally result in a lease being classified as a finance lease and this lease meets 2 of those situations. The lease term for this lease is for “the major part of the economic life of the asset” and “at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset”. The lease term is 3 years, while the economic life of the equipment is 4 years and the present value of the lease payments are only about $20,000 off from the fair value of the equipment at lease inception.

The second question in this case is if the senior accountant’s analysis was correct. From the paragraph above, this lease should be classified as a finance lease. The senior accountant correctly classified this lease as a finance lease. However, the senior accountant did not use the correct discount rate for the present value calculation of the minimum payments. IAS 17.20 says that the payments should be “discounted at the interest rate implicit in the lease, if practicable, or else at the entity’s incremental borrowing rate.” The senior chose the lessee’s incremental borrowing rate when he should have used the lessor’s implicit rate from the lease.

The third and final question from the case is how would the lease classification change under U.S. GAAP. The FASB codification that deals with leases is ASC 840. U.S. GAAP classifies leases as operating leases or capital leases and it has a section for sale-leaseback transactions as well. Under U.S. GAAP, the lease in this case would be classified as a capital lease. This is because ASC 840-10-25-29 says, “If at its inception a lease meets any of the four lease classification criteria in paragraph 840-10-25-1, the lease shall be classified by the lessee as a capital lease.” This lease meets two of those criterions.

The lease term is equal to 75% of the economic life of the equipment (3 year lease term / 4 year economic life of equipment = .75 or 75%) and the present value of the minimum lease payments “equals or exceeds 90 percent of the excess of the fair value of the lease property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor” (ASC 840-10-25-1d). The present value of the minimum lease payments does in fact equal or exceed 90 percent of the fair value of the equipment ($248,690 / $265,000 = .94 or 94%). Under ASC 840-10-25-31, the lessee should use the implicit rate to calculate the present value of the lease payments because the lessee already knew it and the implicit rate is less than the lessee’s incremental borrowing rate.

Works Cited

“IAS 17 – Leases.” IAS Plus. Web. 25 Mar. 2015. .

“ASC 840.” Accounting Standards Codification. FASB. Web. 25 Mar. 2015. .