880 SECTION 3 Financial Instruments and Liabilities Additional Consideration As pointed out earlier, the management of a lessee company sometimes will try to structure a lease to avoid the criteria that would cause the lease to be classified as a capital lease in order to gain the questionable advantages of off-balance-sheet financing. On the other hand, a lessor normally would prefer recording a capital lease, other things being equal. Two ways sometimes used to structure a lease to qualify as an operating lease by the lessee, but as a capital lease by the lessor are: (1) cause the two parties to use different interest rates and (2) avoid including the residual value in the lessee’s minimum lease payments. Let’s see how they work: 1. Cause the Two Parties to Use Different Interest Rates. It was pointed out earlier that a lessee sometimes can claim to be unable to determine the lessor’s implicit rate. Not knowing the lessor’s implicit rate would permit the lessee to use its own incremental borrowing rate. If higher than the lessor’s implicit rate, the present value it produces may cause the 90% of fair value criterion not to be met for the lessee (thus an operating lease) even though the criterion is met for the lessor (thus a capital lease). 2. Avoid Including the Residual Value in the Lessee’s Minimum Lease Payments. The residual value, if guaranteed by the lessee or by a third party guarantor, is included in the minimum lease payments by the lessor when applying the 90% of fair value criterion and thus increases the likelihood that a capital lease will be recorded. However, when the residual value is guaranteed by a third-party guarantor and not by the lessee, it is not included in the lessee’s minimum lease payments. So, if a residual value is sufficiently large and guaranteed by a third-party guarantor, it may cause the 90% of fair value criterion to be met by the lessor, but not by the lessee. Both schemes are unintentionally encouraged by lease accounting rules. As long as arbitrary cutoff points are used (90% of fair value in this case), maneuvers will be devised to circumvent them. International Financial Reporting Standards Present Value of Minimum Lease Payments. Under IAS No. 17, both parties to a lease generally use the rate implicit in the lease to discount minimum lease payments.28 Under U.S. GAAP, lessors use the implicit rate and lessees use the incremental borrowing rate unless the implicit rate is known and is the lower rate. Lessor’s Initial Direct Costs The costs incurred by the lessor that are associated directly with originating a lease and are essential to acquire that lease are referred to as initial direct costs . They include legal fees, commissions, evaluating the prospective lessee’s financial condition, and preparing and processing lease documents. The method of accounting for initial direct costs depends on the nature of the lease. Remember, a lessor can classify a lease as (1) an operating lease, (2) a direct financing lease, or (3) a sales-type lease. The accounting treatment for initial direct costs by each of the three possible lease types is summarized next. 1. For operating leases, initial direct costs are recorded as assets and amortized over the term of the lease. Since the only revenue an operating lease produces is rental revenue, and that ● LO15–11 28“Leases,” International Accounting Standard No. 17 (IASCF), as amended effective January 1, 2014.
Spiceland_Inter_Accounting8e_Ch15
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