That transaction contains lease arrangement!

Reference:

-          IFRIC4

-          Intermediate accounting – Kieso Weygandt and Warfield (2012)

As stated in IFRIC 4, an entity may enter into an arrangement, comprising a transaction or a series of related transactions that does not take legal form of a lease but conveys a right to use an asset (for example an item of property, plant or equipment) in return for a payment or series or payments.

To summarize the statement, sometimes an entity may enter into transactions that contain lease. Based on my experience, this type of transactions usually happens in automotive or other related industries. For example, there is a Company XXX that produces lamps for motorcycle and car-makers. This Company needs to prepare a specific dies to produce these lamps. These dies are prepared based on the design of each lamp therefore each type of lamp needs a specific dies. The Company charges the cost to prepare these dies to the customers by adding the depreciation cost into the sales price.

Usually the Company treats these transactions as ordinary sales transactions. However, there is lease arrangement inside this transaction.

Based on IFRIC 4, to determine whether an arrangement is or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether:

(a)   Fulfillment of the arrangement is dependent on the use of a specific asset or assets

(b)   The arrangement conveys a right to use the asset

Analyzing the previous condition of Company XXX, we can see that the sales transaction contains lease arrangement because:

-          The arrangement is dependent on the use of a specific dies.

Lamp type 010 for Customer A needs dies specifically prepared for lamp type 010.

-          The arrangement conveys a right to use the asset

Dies prepared for type 010 for Customer A may not be used to produce lamps for Customer B. Because this dies was prepared based on lamp design from Customer A. Producing lamps for Customer B using Customer A’s dies may breach the confidentiality arrangement between Company X and Customer A.

Then what do we do if these sales transactions contain lease arrangement?

Assessment should be made to determine whether the sales transactions are classified as financial or operating lease. Based on IFRS 17 (lease), a lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

FASB gives this guidance, as explained in Kieso, Weygandt and Warfield (2012):

A lease arrangement is classified as financial lease if one or more of these criteria is met:

The arrangement between Company XXX and Customer A must be assessed using the above 4 criteria.

What to do after the lease category assessment?

The results might be:

1.     The arrangement is categorized as operating lease

The Company treats the cost of dies usage as common rent. The cost of rent is charged through the depreciation cost which is included into the sales price.

2.     The arrangement is categorized as finance lease

Company may not recognize the dies as the Company’s assets, but it needs to recognize this as lease receivable instead. The Company also needs to prepare the amortization schedule for the arrangement. The amortization schedule is similar to the amortization schedule for loan. Please read the reference for finance lease treatment to learn further about the calculation.