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Lease

Introduction: Lease is a contractual agreement between the lessor (who own the asset) and the lessee (who will get benefit from this agreement). So, this agreement will give the lessee the right to use the property that owned by the lessor for a period of time. The lessors always be one of the three categories which are Bank, Captive leasing companies or Independents. Banks is the largest player in the leasing business because they low-cost fund that gives them the advantages to buy the asset at less cost compare to their competitors. Captive leasing companies are the subsidiaries from the fundamental business to do the leasing business for the parent company for example the IBM company has a subsidiary to perform all sales product to the customer and treat with them. Also, the captive leasing company has an advantage which is the point-of-sale that help the company to find the leasing customer as soon as the subsidiary receive the order from the parent company so, its facilitate the work. Independents are good in developing innovative contract for leasing. Recently, the independents are become work like a captive leasing companies for the companies that they do not have any subsidiary.

There are many reasons that make the companies prefer the lease instead any kind of finance. Leasing make the financing at a fixed rate. Which can protect the lessee from the inflation and the increase in the cost of money and increase the revenue for the lessor if the value of asset goes down. Also, it protects the lessee against the obsolescence (is the reduce the value of the asset its happen because of the availability of other choices that perform better), for example under the lease contract the lessee can cancel the old contract and start with a new one to update the assets. The lessor can protect him self too

via make the lessee pay higher rental payment. The lease has a flexibility advantage that allowing the lessee to customize a program to address needs and requirements depending on their needs. It is much better than the normal debt because the normal debt such as loan from the ban has lots of restriction. Also, help them to choose the period of lease. So, they have flexibility in time. The most important reason that makes the companies lease that the leasing provide the company with assets less costly financing. Lease financing gives the lessee a purchasing power to acquire more and higher-end equipment. Especially the new companies by provide them with lots of asset at the same time they will not spend much money. Also, it is gives the company the tax advantages by capitalize the leased assets and depreciate it to reduce its taxes. Off-balance sheet financing is the most interest part in the lease subject for all companies because they do not report any additional debt on the statement of financial position. Also, it dose not effect the financial ratios but only with the operating lease if the lease was financial lease the have to capitalize it and report the liabilities and I will explain more about the different between two these type later.

There are two types of leasing which are financing lease and operating lease. Financial lease is treated like a loan because that asset is treated as being owned by the lessee so; it stays on the statement of financial position. In contrast, operating lease is treated like renting payments are considered operational expense and the asset being leased is not reported on the statement of financial position. Financial lease has special requirements to record the lease as a financial lease. However, if the lease agreement dose not fit with these requirements its automatically become a operating lease and I will explain more

and I will show you these requirements and the differences between the US-GAAP and the international financial reporting standards (IFRS). IFRS: As I mention before the leasing has two types that are operating and financial lease. Under the IFRS there are a four criteria if one of them fit with the companys agreement should record this asset as a financial leasing. These four are transfer the ownership that is mean the asset is transfer to the lessee after the leased term. The second criteria are the Bargain purchase option is the option that allows the lessee to purchase the equipment at the end of lease period at the price much less than its fair value because of this situation the bargain purchase option in a lease automatically classify as a capital lease. For the ownership is stay for the lessor during the leased period but the lessee has a chance to own the asset if the condition is met. Third criteria are the economic life test that is when the lessee leases the asset for a major part of the assets economic life. Also, the lessor transfers the risk and the benefit of ownership to the lessee so; its considering as financial lease and reports it on the statement of financial position. The IFRS did not put any specific percentage that decides the criteria it depend on the professional judgment. The last criteria are the recovery of the investment test this criterion will meet if the minimum lease payment (is the payment that is include the minimum rental payment, guaranteed residual value which is the estimated fair value of the asset at the end of lease term, the penalty for failed of extend the lease and bargain purchase option) become equal or exceed the assets fair value. Also, in the fourth criteria is depend on the professional judgment. These are the criteria that make the leased as a financial lease under the IFRS. Moreover, there is an additional criterion that if the company orders to

lease specific features for its asset should report it as a financial lease. The lessee uses the implicit rate (is the discount rate at the beginning of the lease causes when add the present value of the minimum lease payment and unguaranteed residual value to be equal to fair value) when computed the present minimum lease payment. However, if the implicit rate was impracticable the lessee can use incremental borrowing rate (the lessee will pay as a similar lease agreement or the lessee check with the similar term funds to purchase the asset such as Banks). The lessee has an option to record the asset and liability either on present value of minimum lease payment or on the fair value of the asset. For the depreciation there are two situations. If the lease contract deals to transfer the assets ownership (criteria 1) or the contract contain the bargain-purchase option (criteria 2) the lessee has to depreciate the asset over its economic life. However, if the lease contract dose not contains the criteria 1or2 the lessee depreciates the asset over the term of lease. Also. The lessee will use the effective-interest method under finance lease to allocate principal payment plus the interest payment and the lessee have to use the discount rate that he uses it with present value of the minimum lease payment. There will be some differences between the two methods. When you use for example finance method instead of operating lease the differences will be increase in the debt, increase in total asset and income will decrease at the early stage of the asset life, therefor the retain earning will decrease too. Because of these differences companies complaint that the financial lease impact negatively in their financial position by increase debt ratio and decrease rate of return on total assets. In fact, both methods generate some amount of cash at the end of the lease term. However, the managers argue against the financial lease just because it will violate the loan covenants and will make their companies less

attractive for the investors. When the company wants to lease a real estate (land, building) it has to consider them separately when evaluating all indicators but if the amount that recognizes at the beginning will be immaterial so, it can avoid the separation. The company (seller-lessee) recognizes of gain or loss under the leaseback operating (leaseback is the agreement between the seller and the purchaser that the seller sell the asset and then lease the same asset from the purchaser it is also called sale-leaseback) immediately when there is a difference between the fair value and the sales price. However, the company (seller-lessee) will deferred loss or gain from the sale of the asset and amortized the gain or loss over the lease term under the financial leaseback. For the lessor, the lessor will get three benefits from the lease agreement which are, interest revenue, tax incentives (it will help the lessor only when lessor keep the asset and make the lessee recorded as an operating lease to get benefit from the depreciation of the asset to reduce the tax) and high residual value (this become an advantage only when the lessor return its asset and can sell it more than the residual value) for example when the lessor return its asset and its become worth 5000 SR but the lessor sell it for 15000 SR. Also, the lessor can classify the lease contract as finance lease or operating lease. The finance lease has two subdivided which are direct-finance and sales-type leases. Sales-type lease is always include manufacture or dealer profit such as, car manufacture will lease its car to another companies but if its not a manufacture or dealer it will become directfinancing. However, some times the lease agreement does not follow both sales-type or direct-finance lease so, the lessor will recorded as operating lease. Under the directfinancing leases the lessor will change the account name of the leased asset to lease receivable (it is the present value of the minimum lease payment) because he will

generate profit from this leasing agreement. The assets cost equals the assets fair value. When the lessor pay an executor cost the rental payment should reduce. The company has to record of lease receivable in the statement of financial position either in in the noncurrent or current. It is depending on what time that the company will get the payment. However, the sales-type leases as I mention above the primary difference with the direct financing is the manufactures or dealers profit. The assets cost under sales-type it does not equal the assets fair value opposite of the direct-financing method so, it will get gross profit (or loss). This method is including residual value whether its guaranteed or not. Because its lease receivable include the present value of the minimum lease payment and present value of unguaranteed residual value. Under the sales-type lease with the guaranteed residual value the lessor can consider it as a portion of the revenue because the lessor sure that the asset has been sold. However, with the unguaranteed residual value the certainly decrease because the lessor dose not sure that the unguaranteed residual is a part of the asset that has been sold. As a result, the lessor recognizes the cost of goods sold and sales just if the realization is assured. For the operating lease is same as lessee but the lessor debit cash and credit rental revenue because companys cash will increase and this cash come from the rent payment. US-GAAP: Under US-GAAP because of there are lots of similarities with IFRS I will talk about the difference standards. First of all, the US-GAAP used terminology capital lease to refer to finance lease. The main difference that the US-GAAP use a bright-line criteria (clear criteria or guidelines to follow) rather than IFRS is more general. For example, differences in criteria 3 and 4. The difference at criteria 3 that the US-GAAP decided to

make a specific percentage which is 75% instead of majority under IFRS. At the criteria 4 the present value of minimum lease payment should become at least 90% of the fair value. Lease of real estate if the lease contain transfer of ownership or contain bargainpurchase power the lessee will classify the lease as capital lease regardless of the value of the real estate. When the fair value of the real estate at the beginning become less than 25% of the fair value of the lease agreement the lessee will account for the building and land without separation as a one unit by ignore the land and treat the land as building to make the test of criteria 3 (which is 75%) and 4 (which is 90%) but if the land equal or more than 25% it will be separated. Also, under the leaseback the company accounted for the sell when the fair value of the asset equal or exceed the currying amount so, the gain or loss will deferred and amortized over the lease term and this acceptable on both capital and operating lease. Sale-leaseback for a real estate is not allowed under the US-GAAP but it dose not discuses under the IFRS about disallowance the sale-leaseback real estate. The US-GAAP used the incremental rate however, if the implicit rate are known by the lessee and lower than incremental rate opposite of IFRS that is dose not care if the implicit lower or higher than incremental so, the lessee will use the implicit. Saleleaseback the company will defer and amortize the gain or loss over the lease term for both operating and finance leaseback. Pros. And cons. Of current standards: There are advantages and disadvantages for the standards of IFRS and US-GAAP. Criteria 1 it helps to know who use and get the benefit of the asset more and have the right of used. A criterion 3 under the IFRS is if the lessee use the majority of the assets economic life its considering financial lease. The IFRS depend in this criterion on the

professional judgment. So, the IFRS make it more general. This has advantage and disadvantage. The advantage is to fit with most of situation because the main purpose of the IFRS is to implement the consistency around the word and help the company to provide faithfully representation information that is free from error because the standard is not rigid so, its does not needs to manipulate. However, the disadvantages that will take more time to make the decision and will cost more money. The criterion under the USGAAP is if the lessee use the 75% of the assets economic life its consider as capital lease. So, the US-GAAP does not make this criterion more general because its put a specific percentage. As IFRS this has advantage and disadvantage. The advantage is that this criterion becomes clearer by the percentage and the lessee does not need to make a professional judgment. However, it will make the problem because the lessee can make many adjustments and manipulate the numbers to reach or avoid that percentage depend on its need. For example, if the company lease a truck and he wants to record it as an expense and at the same time it wants to lease for long life possible so, the company will lease it for less than 75% and will renew it when the life of contract finish. I think the IFRS criterion more powerful because it will provide more faithfully representation and relevant information for the investor. Also, will help most of the companies because the situation and circumstances always changes and will eliminate the manipulation. Also, it is the same with fourth criterion. There is a specific percentage for US-GAAP and the IFRS made it more flexible and based on judgment.

Sale-leaseback stander has many advantages. It helps the seller to refinance with a lower amount. It will improve the working capital (it measure if the company can cover its

current liabilities by its current asset) of the company specially when the liquidity is low. Also, it helps the company to shift the risk of property to the purchaser because when the property become obsolete it will be difficult to sell it and at the same time will be useless. Moreover, It will help with tax too, by deducting the monthly rental payment on its tax. From my point of view, I think the IFRS provide more flexible standers that help the company with most of circumstances than US-GAAP. Because always there are conditions that put the company in bad situation if there are a specific rules like what USGAAP has and will enforce some managers to make some manipulation so, they will not produce faithfully representation information that reflect what happen exactly inside the firm. Also, the flexibilities help the international investments because nowadays most of the companies think to become international so, the follow IFRS standers will make the company more flexible to deal with different kind of investors. However, there is small problem with IFRS. Because it make most of its standards base on judgment so, that will make the investor sometimes face that the same asset with same condition but treated in the different way for example, the company record the asset as operating but another company will treat it as finance. Even though, there will be the problem with IFRS but is still better than US-GAAP because there are no standards or rules that will solve all the problems but IFRS at least will eliminate most of problem. Moreover, IFRS or USGAAP can not set a standards that will make all the investors understand them specially the beginner investors it will be difficult for them with any standard old or new but with IFRS goals it will help the other types of investors. Also the IFRS standards allow for more creativity from the management because its based on judgment. US-GAAP is

opposite of IFRS because its set a specific rules so, its decrease the creativity and increase the rigid standards. Future standards: In the future, there are some changes that will happen for the lease standards under both IFRS and US-GAAP. The main reasons that make both organization make adjustment to the standards is to impose the lessees and lessors to recognize asset and liabilities and reduce the operating lease to avoid off-balance sheet. Also, provide the users with understandable and completely picture of the lease accounting inside the firms. Actually, both organizations become together to issue and adjust standards and they focus on the consumption of the asset over the lease life. Based on the consumption they create the new models for the lessees and lessors. First of all, they will impose the organizations to record the right-of-use as an asset and the obligation payments as liabilities to all lease agreement. So, this will affect the organization that use lots of operating lease because they have to make lots of changes on their statement of financial position such as asset and liabilities. This new standard will help the companies and investors. Companies by provide more relevant and faithfully representation information for the investors. Investors by receive useful information and they can make a good picture for the company situation at the recent and future period. Also, will increase the companys obligations and will affect their bank covenants for loans because of increase its liabilities. The Boards have decided to make the both lessor and lessee to apply some new method to increase the useful information that delivered to the users and become more relevant and faithfully representation. The lessor has two approaches to record the leases either use performance obligation or derecognition approaches. Performance obligation

the lessor will use it when the lessor acquire the significant benefits or risks that related to the asset during the lease life. Also, the lessor will record under asset that shows the lease payments that he has a right to receive them from the lessee. It shows like an economic recourse for the lessor. Also, it shows the right to receive payments and the obligation that gives the lessee the permit to use the asset. With this approach the lessor does not loss his control on the asset and in the same time he continue to record the asset in the statement of financial position. The lessor has the right to get the payment for transfer the right of use the asset to the lessee.

Derecognition approach will use it when the lessor does not acquire the significant benefits or risks with the asset during lease life. The lessor under this approach will record under asset that shows the lease payments that he has a right to receive them from the lessee, too. The lessor will derecognize the economic benefit and he will classify the remaining of economic benefit, which is the residual interest (the remaining benefit for the lessor) as a residual asset in his statement of financial position. The lessor can recognize the full gain and the residual asset from the first day because of this recognition the most of Boards members reject this approach, even though just the part of the asset has been transfer. I think the derecognition has similarities with the operating that make the company in good financial position and does not transfer a relevant or faithful information to the users. Under derocognition the residual asset (its companys asset after all obligation that have been paid) show the lessor right to use the asset after the end of lease life. The reason that makes the lessor has an obligation under the both approaches for the permit the lessee to use the asset is the obligation that comes from the past that

will make a result to outflow the benefits of the future economic from the lessor. Moreover, The both organization make some changes for the lessors by make them apply the receivable and residual approach. The lessors will apply this method when the lessee consume or acquire a significant part of the asset over the life of lease. To apply this method the lessor have to measure the right to receive payments at the present value of the lease payments and use the rate that the lessor give it to the lessee. Then, measure the residual asset (how much the value of the asset at the end of lease life) it contain on two amount, a) gross residual is the estimated residual value at the end of lease life at present value using the same rate that charge it to the lessee, b) deferred profit is the difference between the currying amount of the asset and the gross residual asset. The lessor will not record any deferred profit whether gain or loss until the lessor release or sale the residual asset.so, this will help the company to provide a useful information because if the lessor retain the asset and he does not sale or release it the estimate that he has made it will change. The information that he will provide it becomes more relevant and faithfully representation because it will be timely and free from error. The last step for the lessor is to represent the net residual asset by combine both gross residual asset and deferred profit. The Boards make a decision that the lessor should evaluate the net residual asset and currying amount of the lease receivable after any impairments when re-record the asset on termination of the lease before the end of the lease life of the to provide accurate information With the new exposure the both organization agree to make the short leasing as a rent expense so, will recorded as a expense in the income statement and will affect more in net income and will reduce taxes. The Boards give the lessee some models to apply.

Accelerated model, Interest and Amortization (I&A) model and Straight-line model (SLM). Under these models the lessees have to record and recognize the right-of-use asset with each lease. This decision will make all leases on the statement of financial position. The reason that make the Boards decide to make the lessees do the initial measurement are to measure the right of use asset at amount equal to the lease liability and measure the lease liability at the present value of lease payments. When the lessee wants to apply the Accelerated model he should firstly measure amortize the lease liability at amortization cost and recognize the interest expense in the income statement. Then, the lessee has to amortize the right of use on the straight-line basis and recognize the amortization cost in the income statement. So, after recognize of expenses it will goes under the total lease expense and it will recognize on the accelerated basis. (I&A) approach will make the lessee firstly recognize the liabilities to make the lease payment and the right of used asset. The lessee will measure them at the present value of the lease payment. Then, use the effective interest method to make the lease payment and amortize the right of use asset on the systematic way depends on the consumption that reflects the expected future economic benefits. The lessee has to record the interest expense and amortization expense as different account in the income statement. The second approach that use (SLM) its the same (I&A) approach but there are two difference which are, the lessee has to measure the right of use of asset each period to check that the lease expense recorded on the straight line method without looking to the time of payment. Also, record the lease expense as a single amount not like the previous method that separates the interest expense and amortization expense in the income statement. The nature of the assets who will decide which model will use with them. The real state leases is

recognized by using the straight line model in the income statement but if the lease life become for the major part of the economic life of the asset or if the present value of the asset cover the majority or substantially all the fair value of the asset it will recognize in the statement of financial position. However, other lease assets will recognize by using the accelerated model in the income statement, too. Except for the assets that has lease term for insignificant part from the assets economic life or the present value of lease payment not cover a significant part from the assets fair value. Also, The Boards talk about the sublease (it is when the lessee release the asset to the another lessee). They have decided that the normal leases and a subleases should account the as a separate account and transection. The lessee of the first lease (head lease) agreement has to account for its assets and liabilities that come from the first agreement. Also, the lessee that becomes a lessor from the sublease has to account for its assets and liabilities that come from the sublease. All these details that the Boards impose them on the firm to attempt to make the information relevant and faithful representation as much as possible. As I mention above the advantage of the lease is always fix but there are two condition that the Boards allow them to include the variable lease payment at the measurement of the receivable or liability. These conditions are when the variable lease payment based on the index (is the measurement of security market and the economy) and the variable payment that solve the threshold of high reliability. When the lease agreement depend on the index should be from the beginning its measure on the index and reassessment at the end of each period. Also, the lessee has to reflect the changes in the measurement of lease payment at the net income to give the users the clearer picture that the changes are for the current year report and the changes in the right of use asset to make them know that will

be relating with the future report to be more timely with information that you will deliver to the users. Unfortunately, the latest exposure draft does not include the intangible asset because they have not had considered until now accounting for intangible assets more broadly. The both organization said it is not coherent with the IFRS and US-GAAP practices even though, there are no evidence from the conceptual framework to prove that they should exclude it. However the opposite is true they have to issue standards for intangible asset to force the company to give the investors the clearer picture and that will support the relevant and faithful representation conceptual. Also, its same for the lease of natural resources. I think if the IFRS and US-GAAP implement the new standard it will help the investor more because the will see more information and more details. With the new standards and approaches the information it will be more timely, completely and predictively so, the information will be more relevant and faithfully representative. It solve some problem of the old standards such as the operating lease because it help the company with offbalance sheet that make the statement of financial position does not reflect the correct situation of the company. The Boards solve most the problem by implementing the measure of right of use to enforce the lessee and lessor to recognize their assets and liabilities. The new standards have some problems. The companies have to make reassessment for their lease term this will cost money, time and work. Also, will affect on the companies that depend on leasing by making their liabilities looks huge. From my opinion the biggest loss is the telecom companies because the always depend on leases such as, lease satellite broadcast, capacity contract, equipment, IT outsource agreement and so on. So, their statement of financial position will looks bad and they ratios, too.

However, their earning before interest, tax, depreciation and amortization (EBITDA) will increase because most of their leases in the statement of financial position and this will increase their tax. The income statement will affect too, because with the new standards the charges that was calculated on the straight line over the period over the period of lease its become contain interest and amortization components. There are some of new standards help the lessee and lessor such as the sublease for example if the lessee lease the apartment and suddenly he impose to leave the city and the lease contract will finish after 8 months so, he can release it if the contract allow to a new lessee.

Conclusion: In conclusion, the lease is one of the most important topic for all the company because its help to finance most of the project without loss lots of cash. Also, it has lots of advantages for the company such as, fix rate, protect from obsolescence, tax, and offbalance sheet and so on. However the problem with second type of lease, which is the operating, lease that hide lots of information from the investors. Lease is become more useful when become finance/capital lease for the investors. The new standards that recognize the right of use asset help the investors by making the companies to recognize their assets and liabilities that are related to the lease. Also, to be the information that delivered more relevant and faithfully representative. If we compare between the IFRS and US-GAAP with recent standards the IFRS become better than US-GAAP. The recent standards for the lease have some disadvantages such, off-balance sheet. However with the new standards help the to reduce these disadvantages by recording the right of use, accelerate approach, receivable and residual approach and so on. The convergence mostly will happen because the most of the standards at the exposure paper the both organization agree on them. However, some people said the US-GAAP would not start to follow the IFRS its wants from IFRS follow US-GAAP because the US prestige. The biggest problem with the new standards is that make the companies make more work for each year to reassess.

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