Lessee Ltd. Case

FACTS

Lessee Ltd. is a British company that uses IFRSs when dealing with accounting issues. On January 1, 2007, Lessee Ltd. leased equipment from Lessor Inc. for a period of 3 years. Lessee Ltd. is scheduled to make lease payments of $100,000 to Lessor Inc. each year. Other expenses (insurance, taxes, maintenance) in 2007 totaled to be $2,000. The $2,000 amount is paid annually to Lessor Inc., for the remainder of the lease life. The lease does not contain a purchase option or any renewal options, and the equipment reverts back to Lessor Inc. at the termination of the lease. Therefore, the lease does not need to be accounted for as a Bargain Purchase Option. The equipment's remaining useful life is four years. At the inception of the lease, the FV of the equipment was $265,000. Lessee Ltd. has guaranteed $20,000 as the residual value at the lease's termination date. This amount represents the estimated value of the equipment at the end of the lease term. The expected salvage value of the equipment is $2,000. The Lessor's implicit rate was 10% and is calculable by Lessee Ltd. at the beginning of the lease agreement. Lessee's incremental borrowing rate was listed at 11%. Two accountants of Lessee Ltd. have completed analysis on the agreement and made what they thought were the proper computations. The junior accountant classified the lease as an Operating Lease. The senior accountant classifies the lease as a Finance Lease and bases his computations off of that classification.

ISSUE(S)

As the Financial Controller of Lessee Ltd. we have looked over your computations and analysis. There are some major differences between the two. The junior accountant incorrectly identified the lease as an Operating Lease. While the senior accountant used the correct three-step process, but didn't use the correct interest rate and fair value of the liability as well as excluded the depreciation and year zero journal entries. We need to determine the answers to a few questions.

* What kind of lease is the lease from Lessor Ltd.?

* How do we account for this lease under IFRS?

* How would the accounting be different under GAAP?

CONCLUSION

According to IAS 17, paragraph 10, this lease would be classified as a Finance Lease. To be classified as a finance lease, the lease term must be a majority of the leased asset's economic life. In this situation, it is 3 out of 4 years or 75%. Also, at the inception of the lease, the present value (PV) of the minimum lease payments (MLP) amounts to "at least substantially all of the fair value (FV) of the leased asset." The PV of the lease payments is $263,711 and the FV is $265,000, so the payments amount to 99.5% of the FV. After classifying the lease, we must determine the present value of the minimum lease payments to determine the value of the lease asset and obligation. According to IAS 17,