 Hello and welcome to the session. This is Professor Farhad and this session will look at IFRS 16 that deals with leases. This topic is covered an international accounting course, the CPA exam, as well as the ACCA exam. As always, I would like to remind you, my viewers, to connect with me on LinkedIn. Life is too short. Let's get to know each other. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lecture. Please like my videos. Just click on the like button. It helps tremendously. Share them. Put them in playlists. Let the world know about them. If you're benefiting, if you're listening to me, it means other people might benefit as well. So share the wealth. This is my Instagram account. Please follow me on Instagram as I'm trying to grow my following to reach more people. This is my Facebook and this is my website. On my website, you will find a link you can have to contribute. If you'd like to support, donate to the channel. Also on my website, I often have offers right now. CPA is offering $1000 off of the Becker Bundle CPA. It's unlimited. It's unlimited access. In other words, you can have the course as long as you need to. Although you may not be studying for the exam now, you can take advantage of their 10,000 multiple choice, hundreds of hours of lectures, exercises and CPA simulations. Now you don't have to buy the whole thing. You can buy parts of the exam. Also, if you decided to buy, Becker does offer free financing so you can make payments. If you're considering the CPA exam, this is the best course you can have. Let's talk about leases. So we're going to talk a little bit about operating leases just as a background discussion, which is operating leases technically don't exist anymore. But I want to talk about the operating leases as an introduction to our discussion. But before we proceed, you're not going to like this as always. I have a link in the description below. And leases is covered in my intermediate accounting chapter 21. So if you go into my intermediate accounting chapter 21 and I have more than 10 lectures, 10 plus lectures that cover leases, this topic. So I'm going to be maybe spending 30, 25 to 30 minutes in this lecture. That's not enough. This is not an intermediate accounting course. This is an international accounting course. The assumption here is you know what leases are and we are building on that knowledge to illustrate the difference between US GAAP and IFRS. Okay, just want to let you know that's the case. So what is a lease? Let's talk about a lease first. A lease is a contract. Basically, it's a lease agreement. It's a contract that conveys to LSC the right to use the asset for a period of time in exchange for consideration paid to the asset owner, the less sore. So think about you want to buy a car. This is the car dealer. The car dealer is the less sore. And if you are buying the car, you are the less C. You are the less C. If you're buying the car, the less sore is the dealer. The less sore is going to hand you the key. Okay, so it's a contract between someone who's buying the car and the dealer. The dealer is the less sore. The less sore retain legal type title to the asset. Now, originally, here's what used to happen. This is what we're going to talk about operating leases. Accounting model treated such contract as mutually and executed at signing. What does it mean mutually and executed? It means merely signing a lease does not obligate the less C to record a lease liability on the balance sheet for the future lease payment. So what they, what the way they used to construct the contract is mutually and executed. It means there shouldn't be any liability because no obligation, no liability should be accounted for in the future. Instead, the less C, the buyer of the buyer of the car accounts for these payments as rent expense. So every time the less C makes a payment, it's considered a rent expense. These type of leases that don't exist anymore, they're called operating lease. So an operating lease is when you treat your payment as rent expense. Now, why would you treat your payment as rent expense? Because you did not need the other qualification, which we'll talk about the qualification to be not to be an operating lease. Why? Because the lease is mutually and executed at signing. So it's designed in a way to be treated as an operating lease. So operating lease, what happened is resulted in many abuses. And what are the abuses? The main abuse is off balance sheet financing. What does that mean? So the operating lease, you bought a car or you bought a building or you bought a warehouse or a piece of equipment and you signed the lease. Technically, what you did is you are borrowing money. The lease is technically a loan. But since you treat it as an operating lease, you don't have a loan. All that you have is an expense. Every time you make a payment, it's a rental payment. You make a payment, you debit expense, you credit cash. As a result is your liabilities. The lease is technically is a liability, but it's not recorded. So it's an off balance sheet financing. So operating lease would allow the company to have a loan, a liability without recording that liability. So companies commonly structure lease agreement to make them eligible for operating lease accounting. So they will make the contract in a way. They will draft the contract in a way to meet the operating lease. In other words, to fail other criteria's to make it something other than operating lease, thereby avoiding to recognize lease related that under balance sheet. So this is the background. So now we understand that the operating lease is was the operating lease was good for the company because you did not have to record the liability, but that's no longer the case. So IFRS 16, what happened is was enacted in 2016. It's in response to the problems inherent in the operating lease model. So IFRS 16 now require all leases to be accounted for as a finance lease model. It doesn't matter how you structure the agreement. When you sign the agreement, we're going to consider it the executory lease. We're going to consider it as an asset and as a liability under this model. Signing a lease triggers the balance sheet recognition of both the right of use asset, generally term lease hold asset outside the US, which is the asset and the corresponding lease liability. So simply put, once you sign a lease, it doesn't matter how you drafted that lease. As soon as you sign it, you have to debit an asset and you have to credit a corresponding liability. Now the asset in the US is called, in the US it's called ROU, right of use. Outside the US, since this is an international accounting course, they call it lease hold asset. So you debit an asset, you debit an asset and you credit the liability and it will be equal to the present value of the lease payment because you discount the lease payment just like any other liability. You find the present value of the lease, you find the present value of the liabilities and that's your liability. Okay, then once you have the asset, guess what? You're going to depreciate the asset. You're going to appreciate the right of use over the lease term. So you're going to depreciate this lease hold asset. How are you going to depreciate it? Either over the shorter of the useful life in the lease term. Now, if it's reasonably certain that the lease will obtain ownership of the asset at the end of the lease, then you will go over the expected life of the asset. So some leases at the end of the lease, they hand you the key. It's yours. If that's the case, then you can depreciate the asset over the life of the asset rather than the shorter of the lease or the asset. The finance lease model, which is the new model, account for the lease obligation in a manner similar to a home loan. Basically, you have a home loan. When you make a payment, they are a portion. They are separated between interest, expense and the reduction in the loan. So every time you make a cash payment, part of the cash payment is considered interest, expense. And part of it goes toward the principal amount of the loan using the effective interest rate method, using the effective interest rate method. Also, IAS 36, which is the impairment of asset, apply to those type of assets, apply to the right of use or the lease hold asset, just like you have an asset, regular asset. IFRS was approved in 2016 and takes effect in 2019. Let's take a look at an example to see how this worked. Suppose that Speedy delivery service signed a three-year lease contract for 10 years delivery van on January 1st, year one. Now, if Speedy purchased the van outright, it would have to pay $30,000 per vehicle. Each vehicle has an economic use for the life of eight years. All right. So for simplicity, let's assume that the contract obligates the company to make an annual payment, although that's not true because you make monthly payment, but it doesn't matter. An annual lease payment of $60,000 at the end of each year, okay, for December 1st, 2nd, and 3rd. So you're going to make $60,000 payment for those 10 new delivery truck. We will assume that Speedy borrowing rate is 8%. Under the assumption, the present value of the lease payment, which Speedy is committed, is $154,626. And this is based on the discounting the payment to the present value using 8%, discounting the annuity. The annuity is $60,000 and equal to three, I equal to eight. And you go to the present value of ordinary annuity. Okay, you'd use the stable multiplied by the factor. So the present value is $154,626. Now, if we're using the old method, if we're using the old method, we would not have this lease. We would have an operating lease which would not have an asset and which would not have a liability. Okay, let's keep going. Under IAS 17, lease resembling, Speedy are generally accounted for under the operating lease method. So IAS 17 is the old rule. So IFRS 16 replaced this IAS 17. Okay, so we would use the old rules because it would have met A at the operating lease. This is because the lease term of three years is substantially shorter than the van useful life because we're gonna assume the useful life of the van is 10 years. So three out of 10, it represents only 30% of their life. And this is one of the criteria not to be an operating lease. You have to have the lease life has to be at least 75%, 75%. I believe, I don't know the exact percentages yet. I believe it's 75%, 75%. 30%, you would say this is an operating lease. Okay, but it doesn't matter now whether you said it's an operating or a financing. Under the operating lease method, Speedy would record no right of use or liability at signing. During the lease term, Speedy would simply recognize a rent expense of 60,000 every year. That's not the case anymore. Under IFRS 16, we would have debit an asset, delivery van lease hold. This is an asset 154,626 and we will credit a liability in obligation, a liability. Under the old rules, this entry will not exist. We will not debit an asset. We will not debit a liability. All what we do at the end of every year, we pay 60,000, we debit an expense and we credit cash. Now, because we have an asset, the finance lease would require Speedy to recognize periodic depreciation on the leased asset. Normally with the useful life set equal to the length of the lease contracts, it's three years. So we're going to take the amount of the asset divided by three and every year we will debit 51,542 for depreciation expense. We will credit accumulated depreciation for the same amount to book depreciation. So just basically it's an asset. Then when we make the lease payment, we will debit interest expense 12,371, okay. We will debit lease obligation 47, 47,630 and we'll credit cash 60,000. I believe this should be 70, not 12,370. So you might be asking, how did we come up with this figure? Well, it's the liability, the beginning balance of the liability times 8%. Let me show you. So this way you know where this number coming from. So if we take 154,626, which is the liability times 0.08, this is the interest expense 12,370. 12,370. Then we would reduce this liability by 47,630 and we will credit cash for 60,000. Then obviously the following payment will be different. So this is the schedule. So this is the first payment. The second payment when we booked the second payment, we would credit cash also 60,000. Interest expense is 8,000. This is year two, 8,560,000. 8,560 and the loan, the obligation is debited 51,440. So we have less of interest expense and we are contributing more to the loan. Then the third payment will pay, you know, it's again less interest component more to the loan because the principal is going down. Also, this is the depreciation expense computation. This is the interest expense per year. This is the total, okay, between the two. So notice we have interest expense and we have depreciation expense. We have interest expense and depreciation expense. We have interest expense and depreciation expense, interest expense and depreciation expense. If you notice under the operating lease, if we're treating this as an operating lease, we would have debited 60,60,60 in total 180. If we are treating it as a finance lease, which is the new method, finance lease, those are all total expenses, 63,912, 60,100 to 55,986, the total also 180. So notice the total expense is the same, whether it's a lease under IFRS, which is under the IFRS, or lease under the IAS-16. The total is the same. However, under IFRS we have an interest component and we have a depreciation component. Under the IAS-17 it was only rent expense. But the main difference, I want you to remember to pay attention to under IFRS-16, we have a liability. We recorded a liability. We recorded a liability on the box. Here, we have no liability. We did not have a liability on the box. Now, let's compare IFRS-16 to ACS-842, which is the US standard. Now, you have to understand that ACS-842 preserved the distinction between an operating and a financing. So under the US standard, we still have an operating lease. However, although we have an operating lease, the difference now is we do record an asset and a liability initially. Although it's an operating lease, but we still have that category. So let's take a look at the criteria that make the lease as not an operating lease, which is a finance lease. In fact, the standard classification criteria are virtually identical to that used by the US accountant for many years. So the standard, the way GAP and IFRS look at is this an operating lease or a finance lease, the standard are the same. So they look at the following. And you have to meet one of these criteria. The lease term transfers ownership of the asset to the LSE by the end of the lease term. If this criteria is met, if we say in the lease that at the end of the lease, you'll get the asset, it becomes a non-operating, it becomes a finance lease. If the LSE has the option to purchase the lease at a price less than the market, we call it the bargain purchase, then guess what? You don't have an operating lease, you have a finance lease. You only have to meet one of those. One, the lease term is for the major part of the lease asset economic life. Now, they don't define what's the major life, but anything above 75%, it's called for the major life. So let's go back to those veins. Assuming we have the lease for three years, we divide three years by 10, that's 30% of their life. Under US standard, we'll call this, it doesn't meet the finance lease here, because 30% is less than 75%. Again, they don't tell you what's the major life, but anything above 75%, we can go with it. So if you own an asset more than 75% of its life, then technically you own it. You cannot be considered an operating lease. The present value of the minimum lease payment at the inception of the lease equal to substantially all the fair value of the lease asset, here what they do is 90%, is usually the number that you can use. So when you compute the present value of the payments, if the present value equal to 90%, if the present value equal to 90% of fair value, then basically you bought the asset because you're gonna be paying 90% of the price of the asset. Therefore, you own the asset. And the fifth criteria is the lease is of specialized nature such that only the less see can use it without any major modification. Simply put, you bought a lease, you leased an asset and no one else can use it. Guess what? You bought it, because no one else can use it. It was made for you. Therefore, you technically bought it. What are we saying with these five criteria? You just have to meet one out of five to classify the lease as non-operating. To be an operating lease, it has to fail all of them. To a lease be considered an operating lease, it has to fail all these five criteria. In other words, it doesn't meet criteria one, two, three, four, five. It doesn't meet any of them, then it's called an operating lease. Although it's an operating lease, now in the US we still debit an asset and credit liability, but we treat it differently for the payment. See my other lectures. For the international standard, it doesn't matter. Operating lease don't exist anymore. In the US, they kept that criteria because the way you make payments, it's going to be different. Instead of eliminating the operating lease category, the US achieves in fact similar to that of IFRS 16 by requiring lease assets in lease liability to be recorded for both operating and financing leases. So again, although we're going to call it operating lease, we're going to record an asset and record the liability. So applying the same example under US GAAP, we would still debit an asset. We would still credit a liability. Although in the US, we call this an operating lease. Now the payments, the way we do the payments is a little bit different. Nevertheless, it's an operating lease. The difference lies in the income statement treatment. The US standard require a straight line expense that spread total lease payment evenly over the lease term. So basically every year we will debit rent expense, credit cash. I would say if you really want to learn US GAAP, go to my standard. Go to my standard. Go to my chapter 21 and intermediate accounting. Because it's a little bit more complicated than this entry. But basically you're going to debit expense of 60,000. But you will see how in detail. Let's recap IFRS versus GAAP. This is your expenses under US GAAP 60,000. 60,000, 60,000. Under IFRS, you're going to expense 63,000, 912, 60,000, 102, and 55,968. In total, obviously they equal to each other. But under IFRS, you expense more early on. So it's more conservative treatment because you expense more early on. Now when they were developing the IFRS 16, they coordinated with FASB. And that's why FASB and ASC are very, very similar, very similar. But FASB choose to modify the operating lease method rather than eliminate it. So under US GAAP, we still have operating lease, but it's technically treated like a finance lease. But that's a divergence between US GAAP and IFRS. So the US retention of the operating lease category introduce presentational differences. Now when you discuss the lease and the notes, you're going to discuss it differently. IFRS 16 mandate either a separate presentation or footnote disclosure of leasehold asset as well as a separate reporting of depreciation and interest expense. So this is what IFRS want you to disclose. In the cash flow statement, the portion of the lease payment allocated to principal reduction is a financing outflow. So this is when it comes to the cash flow statement. Remember the payment part of it principal, part of it interest. The principal is considered financing. That's how you're financing the company. The portion allocated to the interest, it's either operating or financing. Usually it's operating depending on how the entity elected under IAS 7, which we'll see in the statement of cash flow next. So remember you make a cash payment. Remember under IFRS, the cash payment is split between interest and principal. The principal is financing the principal on the cash flow statement. The interest, it's going to either operating or financing depending of the asset ready or not ready for its intended use. Under the U.S. standard, the last C must provide balance sheet or footnote disclosure of operating in a finance lease assets and liability. Obviously those are the disclosure. In contrast, the IFRS last C must present the lease expense as a single operating expense. They should present lease payment as operating cash flow, unless the payment are necessary to prepare the asset for its intended use. In that case, it's investing. We just told you this second earlier. I don't know why I put this twice. Well, we'll talk about the cash flow in a separate recording, but this is basically an overview of leases, IFRS versus USGAP. Once again, if you're interested in more learning about USGAP, which is very similar to IFRS, go to my chapter 21 intermediate accounting. I will have the link in the description below. If you're studying for your exam, study hard, good luck, and see you on the other side of success.