Operating lease or Finance lease? Need your help

[huu_tung87]

Purple Ltd has entered into an agreement to lease a D9 bulldozer to Lemon Ltd. The lease agreement details are as follows

Length of lease 5 years
Commencement date 1 July 2008
Annual lease payment, payable 30 June
each year commencing 30 June 2009 $8,000
Fair value of the bulldozer at 1 July 2008 $34,797
Estimated economic life of the bulldozer 8 years
Estimated residual value of the plant at the end
of its economic life $2,000
Residual value at the end of the lease term,
Of which 50% is guaranteed by Lemon Ltd $7,200
Interest rate implicit in the lease 9%

The lease is cancellable, but a penalty equal to 50% of the total lease payment is payable on cancellation. Lemon Ltd does not intend to buy the bulldozer at the end of the lease term. Purple Ltd incurred $1,000 to negotiate and execute the lease agreement. Purple Ltd purchased the bulldozer for $34,797 just before the inception of the lease.

Required

A. State how both companies should classify the lease. Give reasons for your answer. (1.5 Marks)
Please help me |

I think it operating lease because of it's cancellable with limited cost. It means that there is a limited risks . Then it must be opearating !

[kamranACA]

To my first hand understanding it is a finance lease.

The penalty on cancellation is severe, the lease term is 5 years which is major portion of the total economic life of the asset (i.e. 8 years) and there is guarantee of 50% of residual value at the end of lease term.

Regards

[Star]

Dear all,

I m giving my point of view on the basis of my limited knowledge.

Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form. Situations that would normally lead to a lease being classified as a finance lease include the following

<b>1</b> the lease transfers ownership of the asset to the lessee by the end of the lease term;

No such condition prescribed

criteria not met

<b>2</b> the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than fair value at the date the option becomes exercisable that, at the inception of the lease, it is reasonably certain that the option will be exercised;

Lemon Ltd does not intend to buy the bulldozer at the end of the lease term.

criteria not met

<b>3</b> the lease term is for the major part of the economic life of the asset, even if title is not transferred;

Lease period is 62.5% of the economic life of the asset which is not major part of the life. IAS has not defined the word "major" anywhere however, in US GAAP it is the 75% or more.

criteria not met

<b>4</b> 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

Substantially is also not defined in IAS, however as per US GAAP it is more than 90%. Present value comes 89.42% (Rupees 31,117) which is not substantially equal to the fair value at the inception of the lease.

criteria not met

<b>5.</b> the lease assets are of a specialised nature such that only the lessee can use them without major modifications being made.

Not applicable

criteria not met

Other situations that might also lead to classification as a finance lease are

<b>6.</b> If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;

The lease is cancellable, but a penalty equal to 50% of the total lease payment is payable on cancellation. Lessor understands that the loss would be 50%

Criteria met

<b>7. </b> gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments); and

No such condition prescribed

criteria not met

<b>8.</b> the lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent.

No such condition prescribed

criteria not met

Regards,

*

[huu_tung87]

4 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

Substantially is also not defined in IAS, however as per US GAAP it is more than 90%. Present value comes 89.42% (Rupees 31,117) which is not substantially equal to the fair value at the inception of the lease.


As you said, I really wonder about the number" 89.42 % ". My calculation is 96.14%. Under my understanding, we should use minimum lease payment not minimum rental payment . And here ASSB 117 state that " minimum lease payment includes rental payment and guaranteed residual ", in this exercise guaranteed residual is 3600 = 7200/2. Is this right !

I saw that you using US standards and I using Australian standards, is there any differences ( I just want to confirm )

Another point--
6. If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;

The lease is cancellable, but a penalty equal to 50% of the total lease payment is payable on cancellation. Lessor understands that the loss would be 50%

Criteria met

At the first moment, I thought like you but I see that there is a limited cost ( which is 50% of total payment ). That means the lessee has limited risks, which lead to fail in Definition of finance lease " A lease in which the terms of the lease agreement transfer the risks and benefits of ownership form lessor to the lessee ", Craig Deegan, 2007, Australian Financial Accounting, chapter 11, page 397. ISBN 0070136777

[Star]

Dear huu_tung87,

I have replied you in the context of International Accounting Standards - 17 as applicable in Pakistan. I think there is no differenc of definition of MLP as you quoted in ASSB 117 and IAS-17.

Agree. It comes to 96.14%. I ommited the Present value of GRV which should also become the part of MLP and according to that criteria no. 3 mentioned in earlier post it should be classfied as finance lease.

As per IAS-17, Leases, if any one of the criteria mentioned (1-8) in my earlier post, is met the lease should be accounted for as finance lease.

Therefore in my opinion it should be classified as finance lease because one criteria has been met.

Actually the word "major" and "substantial" is not defined in International Accounting Standards therefore i quoted the reference of US GAAP.

Hope it shall serve your purpose.

Regards,

*

[huu_tung87]

Dear star,

Thank you so much for your sharing knowledge. It's very useful for me in concluding that the lease is a finance lease. By the way, My teacher also come from Pakistan ( but not Financial accounting subject ), He teaches us about Ethical in accounting, and I love him. That's why I chose a forum in your country to participate. Thanks so much

Regards,

[Star]

Dear huu_tung87,

Warm Welcome on this forum. I hope that you will be present and share your knowledge on this forum in future also.

I also want to share and expess before you that all my accounting knowledge is due to my boss who is a chartered accountant.

Regards,

*

[kamranACA]

Dears,

It has been a nice discussion. Star wonderful analysis. Keep it up.

I again confirm that to my apprehension it is finance lease. However, your pointwise analysis was good for the readers.

Regards,


KAMRAN.

[NYP]

I want to ask a question is this case. As I've learned, the MLP excludes the executory costs. So, should the $1000 incurred to negotiate and execute the lease agreement be excluded from the $8000 of annual lease payment (i.e. 8000-1000=7000) ?

[Star]

Dear,

If executory cost are paid by lessor then these are not part of MLP for the purpose of calculation of PV of MLP.

If executory cost are paid by lessee then these become part of MLP for the purpose of calculation of PV of MLP.


Regards,

*

[NYP]

So, do you mean that the $1000 here should be excluded from the lease payment, i.e. 8000-1000=7000?

[Star]

Dear,

If you are at lessor side and beard the executory cost then surely u are right.

Regards,

*

[Abdur.Rehman]

Dear star,
my understanding regarding the executory costs is a bit different...
if lessor incurs such costs he includes impact of such costs in interest rate... so impact comes on MLP
and if lessee incurs such costs he includes them in cost of asset... so no impact on MLP...
Correct me if im wrong...with specific references...

[wsafca1]

<blockquote id="quote"><font size="1" face="Verdana, Arial, Helvetica, san" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by huu_tung87</i>
<br />4 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

Substantially is also not defined in IAS, however as per US GAAP it is more than 90%. Present value comes 89.42% (Rupees 31,117) which is not substantially equal to the fair value at the inception of the lease.


As you said, I really wonder about the number" 89.42 % ". My calculation is 96.14%. Under my understanding, we should use minimum lease payment not minimum rental payment . And here ASSB 117 state that " minimum lease payment includes rental payment and guaranteed residual ", in this exercise guaranteed residual is 3600 = 7200/2. Is this right !

I saw that you using US standards and I using Australian standards, is there any differences ( I just want to confirm )

Another point--
6. If the lessee is entitled to cancel the lease, the lessor's losses associated with the cancellation are borne by the lessee;

The lease is cancellable, but a penalty equal to 50% of the total lease payment is payable on cancellation. Lessor understands that the loss would be 50%

Criteria met

At the first moment, I thought like you but I see that there is a limited cost ( which is 50% of total payment ). That means the lessee has limited risks, which lead to fail in Definition of finance lease " A lease in which the terms of the lease agreement transfer the risks and benefits of ownership form lessor to the lessee ", Craig Deegan, 2007, Australian Financial Accounting, chapter 11, page 397. ISBN 0070136777

<hr height="1" noshade id="quote"></font id="quote"></blockquote id="quote">

[wsafca]

It is not the Finance Lease.

There is only one condition for the classification of lease given in standards which is reproduced below

"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 it doesnot transfers the risks and rewards incidental to ownership substantialy to the lessee.