Operating lease or Finance lease? Need your help

kamranACA · 08-13-2009, 07:44 PM

Dear wsafca,

There is a good point in having different opinion based upon tested professional insight of the matter being discussed.

Would you like to throw some light what do you understand about "transferring of risks and rewards incidental to ownership" in this specific scenario? and what are the ingerdients of the criteria that will establish this fact?

Looking forward to hear from you.

Regards,

KAMRAN.

wsafca · 08-14-2009, 02:14 AM

Dear Mr. Kamran

To my understanding, risks and rewards incidental to owner ship means that; you becomes entitled to receive all the benefits from the asset, which would have been available if you have had purchase that asset like when you are entitled to obtain additional production of the asset like when you guarntee the residual value of the asset and therefore undertaking the risk of impairment and obsolesence.

I take the example of sale in this situation. Sale is considered to have been completed when the risks and rewards related to that asset pass on the buyer(some other conditions as well). If the lease is more near to this one then it is finace lease other wise operating.

50 % of Residual value is guarnteed which is not substantial.

My honour to receive your comments. looking forwards to you.

Regards

Waqas

kamranACA · 08-14-2009, 03:16 AM

Dear,

The lease period is 5 years out of total 8 years life of the asset. IFRSs have not defined the term "major". However for certain cases it has established the meanings of "significant" and "controlling" etc. Due to this the meanings of major will be taken as generalized meanings ie "substantial" or "most of". We cannot go altogether out of the "framework of IFRSs" for this purpose. Apparently, 5 years period out of 8 years is significant, substantial, most of and major portion of useful life. This establishes that that lease if finance lease.

The present value of lease payments is quite nearest (96percent plus) of the fair value of the asset. This makes it finance lease.

In case lease is terminated by lessee they have to pay fifty percent of TOTAL LEASE PAYMENT as penalty forthwith (ie even without using such asset they will be paying 50 percent of TLP). Just imagine finance cost of paying half TLP forthwith. Since the penalty is huge there are extremely minimal chances of such cancellation and if done will cause the lesse to bear such a substantial amount of loss.

If 96 percent of the fair value is to be paid, and if most of (major) the useful life of asset has to be consumed incurring all the required repairs, maintenance and insurance costs etc (that are always lessee's responsibility) and if penalty for cancellation is huge making cancellation almost impossible then what else should be required to decide whether or not risk or reward has been transferred?

Remember IAS 17 require fulfilling of only one criteria out of the list provided by it for concluding the lease as finance.

In my view three parts of the criteria met clearly in the example.

Please note transferring the risks and rewards of ownership do not at all mean actual sale of the asset or a guaranteed purchase at the end of the lease term. Here the substance is the fundamental to take the decision and not the legal reality.

For clearing the confusion I advise you to study IFRIC 4 (interpretation) and then figure out what such transfer means in fact.

Thanks for replying!

Regards,

Kamran.

wsafca · 08-14-2009, 05:47 PM

I only got the summary of IFRIC 4 and also read the Prease Release on the same interpretation. this interpretation comments that certain arrangements should be considered as lease under IAS 17, when the entity has control over that asset for a determined period of time and therefore excluding others to use that during this time

Like if i take an asset, whose useful life is 10 years, for 3 years. I have the control on the asset during those 3 years as no one else can use that asset during this period.

This interpretaion explains that like arrangements should be dealt with in accoradance with IAS 17. But it does not say that these are finance leases.

Discussion at the July 2004 IFRIC Meeting

IFRIC members generally agreed that the significance of the residual interest in the assets should be a factor in establishing who controls the assets.
IFRIC discussed other factors that indicate control, including

whether the asset was constructed by the operator
estimated useful lives and concession periods replacement assets expected to be purchased or constructed in the future (whether obliged or not and
the passing on of ownership.

This debate was in the context of the different models used in IAS 18 Revenue and IAS 17 Leases in establishing when risk and rewards are passed and therefore, who controls the assets.

You have mentioned that the IAS 17 gives the "list of critaria" for finace lease and if any one critaria is met it becomes the finance lease. THERE IS NO SUCH LIST GIVEN IN IAS - 17 if you have read quote me the standard.

Remember; the bold lines written in the IASs are the framework only. you have to comply those bold lines, rest is the guidance for practical application.

The examples like major part of useful life, PV of MLP = FV and others helps to determin whether when the sunstantial risks and rewards are transfered to the lesse or not and these are used when this is not apprarent.

You mean we classify a lease as finance lease just because we have made a poor bargain and commited abnormaly huge rentals for the assets? Confused .. See if we take an asset, whose useful life is 20 years, for three years but unfortunately rentals are so high that PV of MLP becomes equal to its FV. (your versian being used where there are number of critarias) there is clearly written in the agreement that at the end of lease term asset will be given back. Is it finance lease????? NO

there is only one critaria, i dont know why people are confused.

Regards

Waqas Shabbir

faisal_desperado · 08-15-2009, 01:06 AM

Dear Wsafca,

IAS 17 specifically indicates those situations / criteria in which lease is to be classified as a finance lease or operating lease , if any of the aforementioned situations/criteria is met, whether individually or collectively, then lease is to be classified as a finance lease regardless of meeting any other criteria out of the list provided.
The following is being quoted verbatim from IAS 17, furthermore, reference is also being provided so that it shall be sufficed and no further clarification is expected from your side.

http//www.ifrs-portal.com/Texte_englisch/Standards/Standards_aktuell/IAS_17/IAS_17_2.htm

(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) 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; and
(e) the leased assets are of such a specialized nature that only the lessee can use them without major modifications.

UNQUOTED

Now examine each of the aforesaid criteria and respond to the following queries, keeping in view that any of the criteria met shall substantiate the lease to be classified as finance Lease.
Criteria D is apparently being met, at this point, in my view, no analysis is required to be assured for further clarification with regards to the said case to be declared as finance lease.

However, look at the criteria C, âthe major part of the economic life of the assetâ has no where been defined anywhere in the standards, as per general perception, Major part means âmore than halfâ
In the above case, asset is being used for the major part of its life.

Standard also reveals another indication i.e. "A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership".
In this case, risks and rewards are also being transferred , following is being quoted for your reference for the purpose of understanding that how IAS 17 itself defines risk and rewards to be transferred.

âRisks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the assetâs economic life and of gain from appreciation in value or realization of a residual valueâ.

UNQUOTED

Risk and Rewards are apparently being transferred, ask yourself, whether they are being or not ?

Furthermore, in reply of your views, IAS 18 is not required to be followed in those cases where other standard has already mention the definition of a specific terminology, in this case it is risk and rewards, which has specifically been mentioned in IAS 17 and issue is also with regards to IAS 17.
At last, in your last Para, lease is to be classified as finance lease on the grounds that one of the situations is being met i.e. criteria D.

Differentiation in views with regards to different people is inevitable, however, purpose is not to discourage others on account of their views.

Best Regards,

Faisal

kamranACA · 08-15-2009, 03:13 AM

Dear Waqas

IFRIC 4 is mainly purposed to account for such arrangement as finance lease. This is the biggest issue being faced by IPPs (power plants) of Pakistan including KAPCO and HUBCO. You are advised to read the financials of these entities in upcoming periods.

As far as bargaining of huge rentals is concerned, mind it such a weak practice falls out of the limits of good corporate practices and there are local as well as international pronouncements to address it. Examples are IAS 24, IAS 36 and transfer pricing approvals etc in case the pricing is not determined at fair values.

In the example quoted above, fair value of asset is almost equal to the present value of rentals and implicit interest cost is also quite reasonable. You cannot term it as a problem of bargaining.

Your example of 20 and 3 also does not apply in this case. Don't forget it is 5 out of 8 and not 3 out of 20.

IAS 17 stipulates that lessee bears loss on cancellation of lease and to my apprehension in the example it really does since 50 percent of TLP is not a negligible amount. Mind it, this is penalty and not the rental. We cannot mix up the both. I referred it becoz this makes clear that cancellation may not be feasible and would be a least practicable option.

Criteria of IAS 17 is given by Faisal. We should develop a habit of reading things carefully. Risk and reward incidental to ownership has also been explained. I think there is nothing left to feel confused about.

Bold italic contents of IASs are the major guidelines (and not the framework) and cannot be interpretted without reading rest of explanatory portion. All paragraphs of an IAS or IFRS are the part of the standard. Yes, bold italic sets the real guideline. However, one by no means keep rest of paragraphs out of a given IFRS/IAS.

Framework of IAS/IFRS is given in all IFRS books seprately and is in fact the holy book for developing any such pronouncement. As no Hadees against Holy Quran can be accepted. Similarly no IFRS/IAS against Framework can be developed. I guess you need to study the framework.

Faisal,

You saved my time. Thanks a lot.

Regards,

Kamran.

wsafca · 08-15-2009, 05:00 PM

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are

(As you already quoted)

11. Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are

(Written in link you have given)

I think you could not read paragraph 12 which is reproduced below

12. The examples and indicators in paragraphs 10 and 11 are not always conclusive. If it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are contingent rents, as a result of which the lessee does not have substantially all such risks and rewards.

three things to mention

1) the bold line suggest that the concept, if the case meets any one of the examples (i wouldn't say critaria), it is finance lease, is wrong.Please reconsider!

1) Main critaria is whether risks and rewards have been transferred or not.

2)to evaluate or conclude whether risks and rewards have been transferred or not, the above mentioned examples may be used.

The above circumstances clearly indicates that we have to classify the lease in accordance with concept, Whether risks and rewards have been transferred or not.

Then we have to move forward and understand what does it mean!

So for i am talking in general terms not specific to the question being putup. Because it is not yet determined what critaria should be considered to evaluate.

Your "definition" para of risks and rewards is relevent and shall be used further in discussion.

Example

Suppose in one lease arrangement of 5 years (useful life of the asset being 8 years) PV of MLP becomes equal to its FV. penalty equal to 50% of the total lease payment is payable on cancellation.

Your two critaria being met may be 3

If the agreement includes a clause that, idle capacity losses will be borne by the lessor and similarly extra production benefit will also be enjoyed by the lessor. and the lesse has to return the asset at the end of the lease term. Repairs and maintenace costs will also be borne by the lessor.

Is it finance lease?? I dont think so.

No matter all the Examples are met main critaria is Whether Substantial risks and rewards have been transferred.

Further

Exact difinition of risks and rewards is not give i standards. In IFRIC meeting i quoted earlier the issue was also discussed in the context of IAS 18, as written in minutes

wsafca · 08-15-2009, 05:04 PM

I am not saying Risks and rewards definition from IAS 18 should be used.. No. We will discuss but first consider "if any one critaria being met, it is finance lease"

wsafca · 08-15-2009, 05:55 PM

Dear Mr. Kamran

As you said

"Bold italic contents of IASs are the major guidelines (and not the framework) and cannot be interpretted without reading rest of explanatory portion. All paragraphs of an IAS or IFRS are the part of the standard. Yes, bold italic sets the real guideline. However, one by no means keep rest of paragraphs out of a given IFRS/IAS.

Framework of IAS/IFRS is given in all IFRS books seprately and is in fact the holy book for developing any such pronouncement. As no Hadees against Holy Quran can be accepted. Similarly no IFRS/IAS against Framework can be developed. I guess you need to study the framework."

THAT IS WHAT I AM SAYING. ALL THE EXAMPLES AND INDICATORS INTENDS TO EXPLAIN WHAT IS GIVEN IN BOLD LINES. SCENARIOS MUST BE INTERPRETED IN VIEW OF THE EXAMPLES TO CONCLUDE WHETHER IT FULFILLS THE CRITARION IN BOLD LINES.

I will give you 10 Rs, if it would have rained here yesterday.
and remember followings are the indicators of rain.

1- The temperature will be around 20 C
2- Street might be little wet.
3- Humidity will around 80 %; and
4- Aslam will not be in home today beacause he leaves home next day of the rain.

You find three things and in the light conclude whether it rained yesterday.

1- you are damn sure that it didnot rained yesterday, beacuse the 99 people living i town out of 100 told you this.
2- Aslam is not in home today
3- Temprature exactly 20 C

What is the conclusion

Your two critarias are met, but not the main and actual one.

Intentions are not hurt or humiliate. I really respect your seniority.
But please consider this

Regards

Waqas Shabbir

kamranACA · 08-15-2009, 06:08 PM

Dears,

I guess there is no room/need for "ifs" and "buts" and raising dubious questions like the following

"If the agreement includes a clause that, idle capacity losses will be borne by the lessor and similarly extra production benefit will also be enjoyed by the lessor. and the lesse has to return the asset at the end of the lease term. Repairs and maintenace costs will also be borne by the lessor."

No such things have been mentioned in the query raised and we need not to conceive such ideas at our own for answering the given query which is very straight forward, clear and open. If we will start such "ifs" and "buts" by concieving the things at our own, we can give whatever direction to the discussion we may feel like.

Further, typically in majority of leasing contracts no such conditions are mentioned where by structuring the transaction to benefit the lesser for extra production and charging it for idle capacity and normal maintenance costs, as our friend has stipulated by conditioning the "if". In case we have to place such an "if" for the clarity (in case it is warranted), ideally it should be on the side where majority of leasing arrangements fall. I would appreciate if we can discuss a single real example of such a contract; say, at least in Pakistan.

Having said that, I may also remind, here we discussed the solution to a query and are not working on a research paper. Accordingly we have to remain focussed on the query. If a reasearch discussion is needed, a clear indication may please be given after which the participants may come up with detailed "if" and "but" scenarios forgetting about the query, if they can manage the time.

To my determined view this is a finance lease in the specific scenario of given query. FV of asset is substantially equal to present value of obligation, Major part of useful life of asset is being leased out and penalty for cancellation has to be borne by the lessee. Risks and rewards incidental to ownership have been transferred in the backdrop of a leasing arrangement where nothing specific "if" and "but" has been stipulated.

Difference of opinion is a common feature of financial and accounting practices and in so many cases lead to qualified opinion from the auditors. May I remind that qualification is imposed where there is a substantial difference of opinion with the management and to my apprehension this would have been a similar case, had it been a real life issue. However, contrary to these words, I would again like to remain focussed on the original query.

Regards,

KAMRAN.

kamranACA · 08-15-2009, 06:10 PM

Dear Waqas,

I can only advise you to study IFRSs/IASs deeply. I feel it would be harder for me to help you.

Thanks a lot for respecting the seniority.

Regards,

KAMRAN.

wsafca · 08-15-2009, 06:29 PM

______________________________________________________________________

kamranACA · 08-15-2009, 06:48 PM

Dear,

Do you know in Pakistan financing the land under leasing arrangements is not allowed. Just to remind local jurisidction's situation. I am not sure about rest of the world. To me this is an irrelavent question for the said reason.

Land has an indefinite period of life, has no known repair and maintenance and insurance costs, and again you cannot quote even a single example of such structured transaction in the financials of a corporatized entity (perhaps worldover). To prove your point, I would again request you to remain focussed on the possibilities, even if you like placing "ifs" and "buts".

I must refer you to study paragraph 14 of IAS-17 which specifically discusses leasing of land and states the reason why it should not generally be treated as finance lease if title is not transferred at the end of lease period. It's indefinite life period issue. If something has been specifically mentioned in IAS we have to follow it. 5 years of lease period in case of land is the thing to keep in view. (In other cases transfer of title is not a condition to treat a lease as finance since life of the asset is not indefinite.)

You also need to re-visit and edit your question which is mixing up the land with buldozer at two different places, for some one who may feel expedient replying this question.

Regards,

KAMRAN.

faisal_desperado · 08-15-2009, 07:11 PM

Dear Waqas,

Inspite of being agreed with the above discussion i.e. it is finance lease instead of operating lease.
You have started debating on a nugatory issue, which is having no importance in this particular case.

Furthermore,this is entirely another issue, which you have just raised, in my opinion, it should not be concluded unless the first issue is agreed to be a finance lease from your side.

In the end, I just would like to say that "It is easy to wake up a person who is sleeping and one can wake him up by having little efforts, however, it is very difficult to wake up a person who intentionally showing himself sleeping.

Sorry, if you have been hurt due to any of my word.

Best Regards,

Faisal

kamranACA · 08-15-2009, 07:26 PM

Faisal,

What we are witnessing is unfortunately a problem which had always been the hard luck of this forum.

The purpose should be to promote knowledge and help the professionals in need of some one's assistance. We cannot prove an illogical point by whatever efforts we make, so we should try to avoid such practices, at least on professional issues.

I know its not two plus two formula but some matters are extremely clarified and straight forward. I also believe we are not here to remove the difference of opinions if some one whishes to carry them at all costs. We can only convey what we faithfully believe is true, supported, helpful and required, with an intent of helping the others.

Regards,

KAMRAN.