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Chapter 21: Q12IFRS (page 1264)

Daniel Hardware Co. is considering alternative financing arrangements for equipment used in its warehouses. Besides purchasing the equipment outright, Daniel is also considering a lease. Accounting for the outright purchase is fairly straightforward, but because Daniel has not used equipment leases in the past, the accounting staff is less informed about the specific accounting rules for leases. The staff is aware of some general lease rules related to 鈥渞isks and rewards,鈥� but they are unsure about the meanings of these terms in lease accounting. Daniel has asked you to conduct some research on these items related to lease capitalization criteria.

Instructions

Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)

  1. What is the objective of lease classification criteria?
  2. An important element of evaluating leases is determining whether substantially all of the risks and rewards of ownership are transferred in the lease. How is 鈥渟ubstantially all鈥� defined in the authoritative literature?
  3. Besides the non-cancelable term of the lease, name at least three other considerations in determining the 鈥渓ease term.鈥�

Short Answer

Expert verified
  1. Risk and benefit with lessor and lessee.
  2. Not defined in IAS 17.
  3. Termed as a non-cancelable period.

Step by step solution

01

Meaning of Lease

A lease is a contract that transfers land, equipment, or facilities for a specified period of time and for a set rate. The two parties involved in a lease agreement are a lessor and a lessee.

02

(a) The objective of the lease classification

According to IAS 17, paragraph 7, "The classification of leases adopted in this Standard is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. Risks 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 successful operation during the asset's economic life and of gain from appreciation in value or realization of residual value."

"A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership." says paragraph 8. If a lease does not substantially transfer all the risks and benefits associated with an ownership, it is defined as an operational lease.

03

(b) Explaining the “substantially all” which is defined in the authoritative literature

"Substantially all" is not defined in IAS 17.

Under IAS 17, leases are separated into two categories鈥攏amely, an operational lease and a financial lease. An operational lease does not transmit nearly all of the risks and rewards associated with ownership; a financial lease does. IAS 17 specifies accounting standards for lessees and lessors, as well as for disclosures, for the two types of leases.

04

(c) Explaining the three considerations in determining the “lease term”

Other factors aren't mentioned in IAS 17, but paragraph 4 defines "lease term" as "the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.鈥�

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Most popular questions from this chapter

(Lessee Accounting and Reporting) On January 1, 2017, Evans Company entered into a noncancelable lease for a machine to be used in its manufacturing operations. The lease transfers ownership of the machine to Evans by the end of the lease term. The term of the lease is 8 years. The minimum lease payment made by Evans on January 1, 2017, was one of eight equal annual payments. At the inception of the lease, the criteria established for classification as a capital lease by the lessee were met.

Instructions

(a) What is the theoretical basis for the accounting standard that requires certain long-term leases to be capitalized by the lessee? Do not discuss the specific criteria for classifying a specific lease as a capital lease.

Winston Industries and Ewing Inc. enter into an agreement that requires Ewing Inc. to build three diesel-electric engines to Winston鈥檚 specifications. Upon completion of the engines, Winston has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of \(413,971 each January 1, starting January 1, 2017.

Winston鈥檚 incremental borrowing rate is 10%. The implicit interest rate used by Ewing Inc. and known to Winston is 8%. The total cost of building the three engines is \)2,600,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Winston depreciates similar equipment on a straight-line basis. At the end of the lease, Winston assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.

Instructions

(c) Prepare the journal entry or entries to record the transaction on January 1, 2017, on the books of Ewing Inc.

(Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2017. Annual rental payments of \(40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick鈥檚 incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for \)1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment.

Instructions

(c) Prepare the journal entry or entries, with explanations, that should be recorded on December 31, 2019, by Ludwick.

(Type of Lease; Amortization Schedule) Mike Macinski Leasing Company leases a new machine that has a cost and fair value of $95,000 to Sharrer Corporation on a 3-year noncancelable contract. Sharrer Corporation agrees to assume all risks of normal ownership including such costs as insurance, taxes, and maintenance. The machine has a 3-year useful life and no residual value. The lease was signed on January 1, 2017. Mike Macinski Leasing Company expects to earn a 9% return on its investment. The annual rentals are payable on each December 31.

Instructions

(b) Prepare an amortization schedule that would be suitable for both the lessor and the lessee and that covers all the years involved.

(Lessee Entries and Balance Sheet Presentation, Capital Lease) Ludwick Steel Company as lessee signed a lease agreement for equipment for 5 years, beginning December 31, 2017. Annual rental payments of \(40,000 are to be made at the beginning of each lease year (December 31). The taxes, insurance, and the maintenance costs are the obligation of the lessee. The interest rate used by the lessor in setting the payment schedule is 9%; Ludwick鈥檚 incremental borrowing rate is 10%. Ludwick is unaware of the rate being used by the lessor. At the end of the lease, Ludwick has the option to buy the equipment for \)1, considerably below its estimated fair value at that time. The equipment has an estimated useful life of 7 years, with no salvage value. Ludwick uses the straight-line method of depreciation on similar owned equipment.

Instructions

(d) What amounts would appear on Ludwick鈥檚 December 31, 2019, balance sheet relative to the lease arrangement?
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