Lease Accounting & Foreign Currency Transactions
Lease Accounting
Area Lease
Description
Leasing is a form of contract where the landlord grants the tenant the right to use an asset for a specific period, in exchange for payment. This agreement holds true regardless of the legal instruments involved and whether the landlord provides operational or maintenance services.
When the rental agreement’s economic terms transfer substantially all risks and rewards of asset ownership, it should be classified as a finance lease.
Recording and Valuation Standards
Two scenarios exist for recording and valuing leases:
Option to Purchase
If a purchase option exists, the transfer of ownership risks and rewards is presumed when there’s no reasonable doubt the option will be exercised.
No Option to Purchase
Even without a purchase option, this transfer is presumed (unless proven otherwise) in the following circumstances:
- Asset ownership transfers to the lessee at the lease term’s end, or the contract clearly indicates this transfer.
- The lease term covers most of the asset’s economic life, and the agreed conditions have clear economic rationale.
- Minimum lease payments at the start of the lease represent almost the asset’s entire fair value.
- The leased asset’s special characteristics restrict its use to the lessee.
- The lessee can cancel the lease, assuming any lessor losses.
- Fluctuations in the residual value’s fair value impact the tenant.
- The lessee can extend the lease for a second term at significantly below-market payments.
Foreign Currency Transactions
Definition
A foreign currency transaction requires settlement in a currency different from the functional currency (the primary economic environment’s currency where the firm operates).
Initial Measurement
Initial Recognition
Foreign currency is converted to the functional currency using the spot exchange rate.
Spot Exchange Rate
The spot exchange rate is used for cash transactions between two currencies on the transaction date.
Transaction Date
The transaction date is when recognition criteria are met.
Exchange Rate Used
A period’s average exchange rate (maximum monthly) can be used for all transactions within that period, unless significant rate variations occur.
Subsequent Measurement
1. Monetary Items
General Rule
Monetary items are valued using the closing exchange rate (the average cash exchange rate on that date).
Exchange Differences
Exchange differences (positive or negative) from this process and asset/liability liquidation are recognized in the profit and loss account.
Monetary Financial Assets Available for Sale
Exchange differences are calculated as if these assets were valued at amortized cost in foreign currency. These differences are recognized in the profit and loss account, while other carrying amount changes are recognized directly in equity.
2. Non-Monetary Items
Non-monetary items are treated differently depending on whether they are valued at historical cost or fair value.
2.1. Non-Monetary Items at Historical Cost
General Rule
Valued at the exchange rate on the transaction date.
Depreciation of Foreign Currency Assets
Depreciation is calculated in the functional currency using the original transaction date’s exchange rate. This shouldn’t exceed the recoverable amount at the closing exchange rate. Exchange rate changes don’t affect historical cost or depreciation.
Equity of Joint Ventures
The closing exchange rate is applied to equity and unrealized gains at the valuation date.
High Inflation Cases
For companies in high-inflation environments, financial statements must comply with standards for adjustments due to high inflation rates before conversion. High inflation indicators include:
- Cumulative three-year inflation nearing or exceeding 100%.
- Preference for holding wealth in non-monetary assets or stable foreign currencies.
- Monetary amounts referenced in a stable foreign currency.
- Credit sales/purchases priced to offset expected purchasing power loss.
- Interest rates, wages, and prices linked to a price index.
2.2. Non-Monetary Items at Fair Value
General Rule
Valued at the exchange rate on the fair value determination date.
Direct Equity Recognition of Gains/Losses
For available-for-sale equity investments, exchange gains/losses are recognized directly in equity. For held-for-trading equity investments or fair value assets with changes in profit/loss, exchange differences are also recognized in profit/loss.