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A company has entered into a 4 year lease for a machine, with lease rental of $150,000 payable annually in advance, and an optional secondary period ofthree years at 80%,60% and 40% of the annual rent in the primary period. the machine has useful life of 8 years.
IAS 17, one of the condition is
the lease term is for the major part of economic life of the asset even if title is not transferred.in the above example, does the company has lease term for the major part of economic life? if we include secondary period it has. can we consider the optional secondary period? since it is optional i dont think so.
i mean, should we consider both primay lease period and secondary lease period to determine whether it is a finance lease or not?
I seem to recollect an extract from the IAS that says that the lease term shall include any option period “…..where, at the inception of the lease, it is probable that the option will be exercised.”
If your post had said that years 5 to 8 could be added on “in return for the annual payment of $1” then, yes, it would seem that the additional four years should be included. In your example of 80%, 60% and 40%? I don’t know! I thinks that’s going to come down to an “argument” between the finance director and the auditor.
Sorry not to be more definitive
This is an example question from kaplan and i got so confused.
A company has entered into a 4 year lease for a machine, with lease rental of $150,000 payable annually in advance, and an optional secondary period of 3 years at rentals of 80%,60% and 40% of the annual rent in the primary period. It is agreed that these rentals represent a fair commercial rate.the machine has useful life of 8 years.= and a cash value of $600,000. would this lease agreement be a finance lease or an operating lease?
If I were faced with that situation in real life, I think I would be HEAVILY inclined towards saying it was an operating lease. The fact that the additional three years are at a commercial rate suggests that there is no incentive which, at the inception of the lease, would likely result in the lessee being probably likely to take up the three year extension opt in.
In summary, if you require me to reach a conclusion, I conclude that it’s an operating lease.
Does that help? What does Kaplan say?
kaplan say, operating lease , same conclusion as yours.
i have 2 doubts. here.
first,
can we include primary and secondary lease term to verify the condition of IAS 17
the lease term is for the major part of economic life of the asset even if title is not transferred.2nd doubt,
there are 8 conditions listed by kaplan for IAS 17.
the eight condition is,
the lessee has the ability to continue the lease for a secondary period at a rent below the market rent.
the condition in example violates the above condition. but also it can use for most of useful life. so, weightage given not for having discount from commercial rate. just bcoz they didnt get the discount can we conclude it as operating while the other condition holds, ie, the asset can be used for most of it useful life?I think I’m correct in saying that “substantially the whole of the economic life …” is generally taken to be 90% of the life. And 7 years out of 8 is only 87.5% ie < 90%
But even so, we are only committed, and only likely to be committed, for 4 years with no probability of extending. So we are only looking at four years. But as previous post says, even if we were liking at 7 years, that still isn’t substantially the whole of the estimated useful economic life!
another example, the topic is new to me, so i am asking,
On 1 june 2006 Fryatt commenced using an item of plant and machinery under a lease agreemnt , making three annual payments of $29,000. The present value of the minimum lease payment is $72000 and if Fryatt had purchased the plant it would have caost $78000. Under the terms of the lease Fryatt is responsible for repairing and insuring the plant and has the option to extend the lease at a reduced rental at the end of the 3 years. the plant has an estimated useful life of 6 years, witha negligible value at the end of period. the rate of interest implicit in the lease is 10%.
here , fair value is $78000. MLP is $72000. which is 92 5 of FV, so it is subsatnially equal to FV.
then it holds the condition of IAS 17,
at the beginning of the lease , the present value of the MLP is approximately equal to the FV of the asset.so , we can conclude it is finance lease. am i right? bcoz i didnt find any other condition hold true. kaplan takes it as finance lease.
I think you’re getting over-concerned about minutiai! Steve Scott RARELY asks a question devoted to leases. The topic will frequently come up in a question 2 where the company has incorrectly treated a finance lease as an operating lease and you have to put through the necessary corrections.
As to this most recent problem, the pv of the mlp is within 10% of the arms length value and the lease term with the probable extension is for the whole or substantially the whole of the asset’s useful life. This is likely as complicated as Steve Scott is going to get ( and Graham Holt the P2 examiner )
It’s clearly a finance lease – and in an ACCA exam, it will most probably be clearly obvious that it’s finance lease or operating lease. There will be no room for doubt.
Now, in practice ……..!
Fortunately, I have never had the “pleasure” of having to argue with a CFO where he / she claims it’s one and I have to claim it’s the other. And I don’t envy those of you out there who are daily faced with such a practical problem
🙂
However, Vipin, please don’t post again unless you have a query! I’m not in any way berating you, so don’t worry. It’s just that, when we are checking to see if there are any “new” questions, it’s easy just to check that we were the last to post on that string. If we are not the last, then there’s another question which needs answering. And when all it is is you saying “Not good to argue with CFO” or “Thank you”, then you will realize that we’ve just wasted our time.
We don’t expect thanks ( I think we probably assume that you are grateful! ) so there’s really no need for you to positively state it – but thanks anyway!
PS Please do not respond to this, unless, of course, you have another query related to your F7 studies!
Hi Mike relating to Vipins second question on minimum lease payments, the useful life of the finance lease asset is 6yrs while the finance lease is for 3yrs and to calculate the depn do u use the 6yrs or the 3yrs. The book says the shorter of ie(useful life or lease term) but in the answer it used the 6yrs to calculate depn. Can u help please. Thanks
Hi – yes, but the PROBABLE lease term is six years when you take into account the likely three year extension. So depreciate over the highly probable lease term of six years
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