Alta Velocidad Esperanza de L'Argentina, Sociedad Anónima (AVE), a high-speed railway operator domiciled in Rio Norte, Argentina, is a Foreign Private Issuer as defined by the U.S. Securities and Exchange Commission. AVE currently files Form 20-F annually with the Commission in which it reconciles its calendar year financial reporting to U.S. GAAP from Argentine GAAP. Rather than waiting until 2012 when Argentina switches to IFRS, AVE is considering early adoption of IFRS. This would allow AVE to take advantage of SEC Release No. 33-8879. Under such a plan, AVE would be eligible to file financial statements with the Commission prepared in accordance with International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB) without reconciliation to generally accepted accounting principles (GAAP) as used in the United States.
Conmuchas Dudas, AVE Chief Financial Officer, has hesitated making the move to IFRS because she is unsure what impact, if any, IFRS adoption will have on the company's financial position. Ms. Dudas has asked you to determine if there is a difference in the accounting treatment between U.S. GAAP and IFRS for the following transaction:
On April 1, 2011, AVE, entered into a non-cancelable agreement with Gastos Financieros Reál (GFR), to lease five new high-speed locomotives for a period of eight years. The economic life of this type of powered rolling stock is 11 years on average, assuming no residual value. However, there is a significant market for second-hand locomotives that allows AVE to estimate what the expected residual value of the locomotives might be. Ms. Dudas projects that this amount will be 20% of the fair value on April 1, 2011.
The lease term will commence once the locomotives have been delivered to AVE's train depot and have been accepted by an independent inspection company that will test whether the powered cars meet the minimum conditions. This is expected to take place on the same day as the lease signing -- April 1, 2011.
At the beginning of each month, AVE will pay a total monthly lease payment of US$120,000 for the five locomotives. AVE's incremental monthly borrowing rate is 0.447%. In an uncustomary display of candor, GFR disclosed the monthly implicit interest rate on this lease to be 0.460%.
At the expiration of the lease agreement, AVE has the option to buy the locomotives at an exercise price of 17% of the fair value determined at the beginning of the lease. On April 1, 2011, the total fair value of the five high-speed locomotives was estimated at US$10.5 million.
According to plan, AVE took possession of the new locomotives on April 1, 2011, when the bullet train engines were delivered, tested and found to be in conformity with specifications.
Ms.Dudas would like you to recommend the proper classification of the lease under both U.S. GAAP and IFRS. As part of your research, she expects you to develop the necessary journal entries for the first month of the lease. If capitalization is recommended, she would like to know what the impact would be on AVE's classified balance sheet at fiscal yearend (December 31st). Finally, based on your analysis of the lease agreement, Conmuchas would like to know whether you recommend AVE pursue early adoption of IFRS or wait until 2012 when IFRS becomes mandatory for publicly-traded Argentine corporations. AVE has a healthy balance sheet and is currently a "darling" of Wall Street bond traders.