Question

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 “risks and rewards,” 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 “substantially all” defined in the authoritative literature?
3. Besides the non-cancelable term of the lease, name at least three other considerations in determining the “lease term.”

Short answer

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

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.

(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.

(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—namely, 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.

(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.”