for Accounting Professionals
IAS 17 Leasing
2011
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IAS 17 Leasing
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Moscow, Russia
2011 Updated
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IAS 17 Leasing
IFRIC 4 - frequently asked questions ......................... 37
CONTENTS
Introduction
3
Outsourcing contracts: an accidental business
combination? .............. 40
IAS 17 – Impact for Banks
4
Multiple choice questions
Scope
5
Answers to multiple choice questions ...................... 47
Definitions
5
Classification of Leases
11
Land and Buildings
15
Leases in the Financial Statements of Lessees ........ 19
Subsequent Measurement
21
Operating Leases
22
Leases in the Financial Statements of Lessors ........ 23
Subsequent Measurement
24
Subsequent Measurement - Manufacturer or dealer
lessors ......................... 25
Lessors - Disclosure
26
Operating Leases
27
Finance Leasing – Accounting Steps ........................ 29
Sale and Leaseback Transactions ............................. 30
Sale and Leaseback with options – collaterised
borrowings .................. 33
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............................ 43
Introduction
Aim
The aim of this workbook is to assist the individual in understanding
the IFRS accounting treatment and disclosures of Leases, as
detailed in IAS 17.
Background
Leases involve the owner of an asset renting it to others for
payment. Short-term rental agreements are mostly accounted for
as ‘operating leases’, in the same way as rental payments are
booked.
Long-term rentals (‘finance leases’) have seen dramatic growth
over the last 50 years.
The user of the rented asset can benefit from paying by
instalments, rather than an initial capital outlay. Some tax benefits
have been realised by leasing, in various countries.
The major concern of the IASB has been the distortion created by
leasing in financial statements. Previously, balance sheets
recorded neither the asset being used, nor the full lease liabilities.
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IAS 17 Leasing
Rather than taking out a loan, and purchasing an asset, firms were
offered ‘off-balance-sheet’ financing, in the form of leasing.
consistent growth. IAS 17 is a major step forward for reporting, but
will not be the last word.
IAS 17 addresses this issue by accounting for finance (longerterm) leases in a similar manner to the purchase of an asset,
matched by a collateralised loan for the same amount. The
asset appears on the lessee’s balance sheet, even though the
lessee does not own it.
Banks and other lenders are the main beneficiaries of IAS 17. IAS
17 prescribes that finance (long-term) leases be accounted for
in a manner similar to that of collaterised loans by both lessor
and lessee, with the asset and liability appearing on the
balance sheet, rather than as an off-balance-sheet item,
merely referred to in the notes.
A form of leasing is the sale and leaseback. Here, the lessee owns
an asset that it does not wish to lose. However, the lessee wishes
to raise cash.
The lessee sells the asset to the lessor, who then leases it back to
the lessee. The lessee has given up ownership of the asset, and
must pay rent (in the form of lease payments) in return for the
money received from the lessor.
For the period of the lease, in economic terms, it is the same as
having a loan, secured on an asset. At the end of the period of the
lease, the lessee either extends the lease, buys back the asset
from the lessor, or relinquishes the asset.
Since 2006, IFRIC 4, Determining whether an Arrangement
contains a Lease, has been effective. This IASB interpretation
states that IAS 17 should be used more widely than many had
believed where specific assets are under the control (though not
directly owned) by a bank or company. Outsourcing arrangements
need to be reviewed with this interpretation.
Sale and leaseback transactions may also take the character of
collaterised loans.
One of the major selling points of leasing was that readers of
financial statements would not see the additional debt, nor take it
into account when calculating financial ratios, such as gearing (US:
leverage).
Whilst this has been addressed for finance leases, there remains a
number of operating leases (short-term rentals) for which the
reporting has remained virtually unchanged.
For example, leased vehicles and aircraft that do not become the
property of the lessee at the end of the lease are predominantly
operating leases, with the loan liabilities remaining off balance
sheet. IASB has repeatedly discussed this issue, voicing its
concern, but has yet to amend the standard.
IAS 17 – Impact for Banks
When considering the viability of client businesses, banks need to
take into account that financial problems may result in vital
equipment being repossessed by leasing companies, jeopardising
the business’s ability to continue operations.
Leasing remains a flexible, user-friendly method of borrowing. In
most countries, once any legal and tax issues have been resolved,
the leasing industry (often led by banking groups) has shown
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IFRIC 4, Determining whether an Arrangement contains a
Lease is relevant for banks which outsource operations, especially
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IAS 17 Leasing
where they are the predominant user of assets of the outsourced
operations.
EXAMPLE- lessor providing services
You rent a fully-serviced office. The owner provides secretarial
services and all office equipment. This is covered by IAS 17.
Scope
This Standard shall be applied in accounting for all leases other
than:
(1) leases to explore for or use minerals, oil, natural gas and
similar non-regenerative resources; and
(2) licensing agreements for such items as motion picture films,
video recordings, plays, manuscripts, patents and
copyrights.
However, IAS 17 shall not be applied as the basis of measurement
for:
(1) property held by lessees that is accounted for as investment
property (see IAS 40 Investment Property);
(2) investment property provided by lessors under operating
leases (see IAS 40);
(3) biological assets held by lessees under finance leases (see
IAS 41 Agriculture); or
(4) biological assets provided by lessors under operating leases
(see IAS 41).
IAS 17 applies to agreements that transfer the right to use assets,
even though the lessor may provide services in connection with the
operation, or maintenance, of such assets.
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IAS 17 does not apply to agreements that are for services, that do
not transfer the right to use assets, from one contracting party to
the other.
Definitions
For bankers, understanding a finance lease as a collaterised
loan is key to understanding this classification of lease. The
terminology of IAS 17 may appear new, and is best translated into
banking terms, such as principal and finance/interest charges.
Accounting for a collaterised loan (12%)
1. In the books of the borrower (equivalent to the lessee)
Assets
Vehicle
10.000
Liablilties
10.000
Loan payable
2. In the books of the bank (equivalent to the lessor)
Assets
Loan receivable 10.000
Borrower
1.
The borrower amortises the vehicle over its economic life.
(In the case of a lease, this will be reduced to the term of the lease,
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IAS 17 Leasing
if the term is less than the economic life and the asset will be
returned to the lessor at the end of the lease.),
2.
The borrower makes monthly payments of identical amounts
but, at the start, the larger part of each payment is an interest
payment. Only a small part of the earlier payments repays the
principal of the loan:
Split of total payments made each month
Total
payment
each
month
Payments of principal
Interest
Payments
Time
In later payments, the interest portion is less and the larger part is
the payment of principal.
The split of the payment between interest and principal is based on
the interest payment of 12% per year (in this example) on the
outstanding principal of the loan.
3. The borrower charges the interest payment (part of the total
payment) to the income statement and the payment of principal
reduces the loan.
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Bank
1. On receipt of each monthly payment, the bank mirrors the
accounting treatment of the borrower:
2. The interest part of the total receipt is credited to the income
statement as interest income.
3. The repayment of principal reduces the loan receivable.
4. The split of the payment between interest and principal is based
on the interest payment of 12% per year (in this example) on the
outstanding principal of the loan.
5. The asset that is the subject of the loan (vehicle in this example)
does not appear on the bank’s balance sheet unless the borrower
defaults.
A finance lease has the same accounting treatment for both parties,
except that the lessee states that the vehicle is a leased asset
rather than one that is owned.
Also, at the end of the lease, if the lessor regains control of the
asset (vehicle) then the lessor records it on its balance sheet from
the time it regains control and amortises it until it disposes of the
asset.
Lease
A lease is an agreement whereby the lessor provides to the lessee,
the right to use an asset for an agreed period of time, in return for a
payment, or series of payments.
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IAS 17 Leasing
Lessor
The lessor is the owner of the leased goods, who hires them to the
user, or ‘lessee’.
Lessee
The lessee uses the leased goods, and pays a hire charge to do so.
Finance Lease
A finance lease transfers substantially all the risks, and rewards, of
ownership of an asset. Title may, or may not, eventually be
transferred.
Operating Lease
An operating lease is a lease that is not a finance lease.
Non-cancellable Lease
A non-cancellable lease is a lease that is cancellable only:
(1) upon the occurrence of some remote contingency;
(2) with the permission of the lessor;
(1) a lease is classified as either an operating, or a finance, lease;
and
(2) in the case of a finance lease, the amounts to be recorded at
the start of the lease term are determined.
Lease Term
The lease term is the non-cancellable period for which the lessee
has
contracted to lease the asset, together with any further periods for
which the lessee has the option to continue to lease the asset, with
or
without further payment, when it is probable that the lessee will
exercise the option.
Minimum Lease Payments
Minimum lease payments are the payments over the lease term
that
the lessee must make,
excluding contingent rent, costs for services and taxes to be paid
by, and reimbursed to, the lessor,
(3) if the lessee enters into a new lease for the same, or an
equivalent asset, with the same lessor; or
plus:
(4) upon payment, by the lessee, of such a large amount that the
lease is unlikely ever to be cancelled.
(1) for a lessee, any amounts guaranteed by the lessee, or by a
related party; or
Start of the Lease
The start of the lease term is the date from which the lessee can
use the leased asset.
(2) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee;
(ii) a party related to the lessee; or
(iii) a third party, unrelated to the lessor.
As at this date:
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IAS 17 Leasing
However, if the lessee has an option to purchase the asset at an
attractive price at the end of the lease, so that it is probable that the
option will be exercised, the minimum lease payments will also
include the payment required to exercise the option.
Fair Value
The price that would be received to sell an asset, or paid to
transfer a liability, in an orderly transaction between market
participants at the measurement date. (IFRS 13)
EXAMPLE - Impact of penalties or costs on calculation of
minimum lease payments (MLP)
Economic Life
Economic life is either:
Issue
The calculation of the MLP should exclude contingent rent.
(1) the period over which an asset is expected to be economically
usable, by one or more users; or
How should penalties or costs, payable by the lessee for failing to
continue a lease, affect the calculation of MLP?
(2) the number of production units expected to be obtained from the
asset.
Background
An undertaking leases office space. As part of the lease agreement,
the lessor will carry out leasehold alterations specified by the lessee
up to a value of 20,000.
Useful life is the estimated remaining period, over which the
economic benefits of the asset are expected to be consumed by the
undertaking.
Guaranteed Residual Value
Guaranteed residual value is:
(1) for a lessee, that part of the residual value that is guaranteed
by the lessee, or by a related party; and
(2) for a lessor, that part of the residual value that is guaranteed
by the lessee or by a reliable third party.
The lease term is for 5 years, with the option to extend for a further
5 years. However, if the extension option is not taken up, the
lessee must pay the lessor a penalty equal to 75% of the value of
the leasehold alterations.
Solution
The calculation of MLP should be based on the best estimate of
whether the extension period will be taken up or the penalty paid.
The penalty should be included in the calculation of the MLP if the
lessee’s assessment is that the penalty will be paid.
Conversely, if it is reasonably certain that the lessee will renew the
lease, it should include the payments from the extension period in
the calculation of the MLP in place of the penalty fee.
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EXAMPLE - Effect of a guarantee of residual value by lessee
on calculation of minimum lease payments (MLP)
Issue
The calculation of MLP includes any amount guaranteed by the
lessee.
The accrual of gains or losses from the fluctuation in the fair value
of the residual to the lessee is an indication of a finance lease.
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IAS 17 Leasing
How should the residual risk be evaluated for lease classification
purposes?
Background
An undertaking (lessor) leases a truck to a customer for 3 years.
The value of the truck at the end of the lease is estimated at 40% of
its original cost.
Market data suggests that the likely range of residual values after 3
years is 40% to 50% of original cost.
The lessee will guarantee any fall in the truck’s residual value below
40% down to 25% of original cost. The lessor will bear the cost of
any fall in residual value below 25% of original cost.
Solution
The lease is a finance lease.
It is unlikely that the truck’s residual value will fall below 25% of
original cost. The sharing of the downside of the residual value risk
is therefore not even. The risk retained by the lessor is remote and
should be ignored. The residual value risk is in substance borne by
the lessee, and the lease should therefore be classified as a
finance lease.
The MLP should include the guaranteed residual value of the truck
that is 15% (40%-25%) of original cost.
Unguaranteed Residual Value
Unguaranteed residual value is that portion of the residual value of
the leased asset, which is not guaranteed.
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EXAMPLE- unguaranteed residual value
You lease a car to a client for 4 years.
The cost of the car is $20.000.
The anticipated residual value at the end of the lease is $5.000.
The lease is priced at $15.000, plus finance charges.
A dealer gives you a guarantee to purchase the car for $4.000(at
the end of the lease).
This is the guaranteed residual value.
The remaining $1.000 is the unguaranteed residual value.
Initial Direct Costs
Initial direct costs are incremental costs that are directly attributable
to negotiating and arranging a lease, excluding such costs incurred
by manufacturer, or dealer, lessors. These may include registration
costs for property.
Gross Investment in the Lease
Gross investment in the lease is the aggregate of:
(1) the minimum lease payments receivable by the lessor under a
finance lease, and
(2) any unguaranteed residual value accruing to the lessor.
In practice, this amounts to the total payments (interest and
principal) made by the lessee, and received by the lessor.
Net Investment in the Lease
Net investment in the lease is the gross investment in the lease,
discounted at the interest rate implicit in the lease.
In practice, this means the payments of principal made by the
lessee, and received by the lessor. ‘’Discounted at the interest rate
implicit in the lease’’
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IAS 17 Leasing
means that the interest portion of the payments is deducted from
the total payments, leaving only the principal payments.
Unearned Finance Income
Unearned finance income is the difference between:
(1) the gross investment in the lease, and
(2) the net investment in the lease.
In practice, this is the total interest payments made during the term
of the lease.
Interest Rate Implicit in the Lease
In practice, this is the interest rate negotiated between lessor and
lessee. If this is not known by the lessee, the lessor should be
contacted for the information.
The rate can be calculated, or confirmed, by the following method:
The interest rate implicit in the lease is the discount rate that, at the
start of the lease, causes the aggregate present value of
(1) the minimum lease payments and
(2) the unguaranteed residual value
to be equal to the sum of
(i)
the fair value of the leased asset and
(ii)
any initial direct costs of the lessor.
Lease payments comprise a payment for the asset, and a finance
payment. The finance payment is a rate of interest multiplied by the
cost of the asset multiplied by the length of time of the lease.
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Lessee’s Incremental Borrowing Rate of Interest
The lessee’s incremental borrowing rate of interest is the rate of
interest the lessee would have to pay on a similar lease or, the rate
that, the lessee would incur to borrow over a similar term, and with
a similar security, the funds needed to purchase the asset.
This is the lessee’s cost of capital for the lease.
Contingent Rent
Contingent rent is additional lease payments that are based on
items such as percentage of future sales, amount of future use,
future price indices, future market rates of interest.
This is additional income for the lessor, and additional expense for
the lessee.
EXAMPLES-contingent rent
You lease a shop in an airport. You pay $10.000 per month, plus
5%
of your sales value as contingent rent.
You lease an office. Each year, the rent will increase by the
percentage increase in the wholesale price index. The increase is
regarded as contingent rent. It will not be known until the index is
published each year, and it may show no increase.
Hire purchase
The definition of a lease includes contracts giving the hirer an
option to acquire title to the asset by paying an additional payment,
normally at the end of the contract. These contracts are hire
purchase contracts.
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IAS 17 Leasing
Classification of Leases
In very simple terms, short-term rentals are classified as operating
leases and are accounted for as expenses, as they are under most
national accounting systems.
Long-term leases, which last for most of the asset life, are
treated as finance leases, and accounted for as collateralised
loans.
The classification of leases is based on the extent to which risks,
and rewards, of a leased asset, lie with the lessor, or the lessee.
the lessor, nor the lessee has any risk, nor additional reward
relating to residual value.
The lessee may treat the agreement as a finance lease, and the
lessor may treat the same agreement as an operating lease.
The classification of a lease depends on the substance of the
transaction, rather than the form of the contract.
EXAMPLE- Identification of risks - rapid obsolescence
Issue
Risks include the possibilities of losses from idle capacity,
technological obsolescence, and of changing economic conditions.
Rewards may be represented by the expectation of profitable
operation over the asset’s economic life, and of gain from
appreciation in a residual value.
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.
The application of these definitions to the lessor and lessee may
result in the same lease being classified differently by them.
EXAMPLE-same lease, different classifications
The lessor benefits from a residual value guarantee, provided by a
party unrelated to the lessee and unrelated to the lessor. Neither
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Certain assets, including IT assets, can be subject to a higher risk
of technical obsolescence than other assets. How does this affect
the classification of leases of such assets?
Background
A manufacturing undertaking leases computer hardware. The
hardware is capable of operating for at least 7 years. The leaseterm is 3 years.
Solution
The lease will probably qualify as a finance lease.
The physical life of the computer hardware is estimated at 7 years.
Certain factors will however result in a different economic life, such
as:
i) advances in technology;
ii) improvements in working practices;
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IAS 17 Leasing
iii) competition and the effects that may have on efficiency; and
lease term for 20,000. The fair value of the asset at the end of the
lease term is expected to be 18,000.
iv) growth or contraction of the undertaking’s operations.
The economic value that can be obtained from the computer
hardware will be concentrated in the first few years of the asset’s
life. The lease for 3 years will therefore be for a major part of the
asset’s economic life.
Solution
The lease should be classified as a finance lease.
Title is expected to transfer because A is expected to exercise its
option to sell the asset at an amount which is more than the
expected fair value at that date.
From the lessor’s perspective, it is unlikely to be able to lease
computer hardware that is more than 3 years old for more than a
token rent, other than to the original lessee.
Undertaking B will therefore be exposed to the residual value risk of
the equipment through the transfer of title to it.
Examples of situations that would normally lead to a lease being
considered to be a finance lease are:
(2) the lessee has the option to purchase the asset at an attractive
price;
(1) the lease transfers ownership of the asset to the lessee by the
end of the lease;
(3) the lease term is for the major part of the economic life of the
asset, even if title is not transferred ( >75%);
EXAMPLE -Lease classification where lessor holds a put
option requiring the lessee to acquire the asset
(4) the present value of the minimum lease payments (the
payments of principal made in the lease payments – the present
value means that the finance charges are ignored) amounts to
substantially all of the fair value of the leased asset (>90%); and
Issue
A lease that transfers ownership of the asset to the lessee should
normally be classified as a finance lease.
How should the lease be classified where transfer of ownership is
at the lessor’s option?
Background
Undertaking A leases equipment to undertaking B for 8 years. The
economic life of the asset is assessed as 20 years. Undertaking A
has the option to require B to purchase the asset at the end of the
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(5) the leased assets are of such a specialised nature that only the
lessee can use them, without major modifications.
In practice, if the asset is specialised so that the lessor is unlikely to
find a new client at the end of the lease, the lessor will ensure that
the lease payments made by the lessee will pay for the asset, the
lessor’s cost of finance and the lessor’s profit.
The lease term will be for the major part of the economic life of the
asset and therefore be classified as a finance lease.
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IAS 17 Leasing
(The percentages quoted in the above paragraph are US GAAP
figures. IFRS provides no figures on these issues).
EXAMPLE- Use of numerical thresholds to classify leases
Issue
A lease will normally be classified as a finance lease if the present
value of the minimum lease payments (MLP) amounts to
substantially all of the fair value of the leased asset.
Some GAAPs provide a numerical test to determine the
classification of a lease as finance or operating. Should a numerical
test be used in evaluating a lease under IFRS?
Background
Undertaking A leases a machine from undertaking B. The
machine’s fair value is 79,994. The applicable annual discount rate
is 6%. Lease rentals are payable every 6 months, starting on the
date the asset is delivered. The lease term is 9 years.
A small change in the guaranteed and unguaranteed residual value
would change the classification from finance lease to operating
lease if a 90% threshold test had been used in this example.
However, there is very little difference in the economics of the two
leases.
The net present value of the MLP should be one of the factors
considered in lease evaluation. IFRS does not provide a definitive
numerical interpretation of "substantially all". Both quantitative and
qualitative evidence should be considered and professional
judgement exercised to determine the substance of the transaction.
Indicators of situations that could also lead to a lease being
classified as a finance lease are:
(1) if the lessee can cancel the lease, the lessor’s losses associated
with the cancellation are borne by the lessee;
The net present value of the minimum lease payments is 90.2% of
the asset’s fair value at inception of the lease, if the lease payments
are 4,750 every 6 months with a guaranteed and unguaranteed
residual value of 8,000 and 13,000 respectively.
EXAMPLE-cancellation-cost to the lessee
You lease a photocopier for 7 years. If you cancel the lease, you
must pay all the remaining payments (till the end of the lease). This
is a finance lease, as there is no method of paying a reduced rental
for just the time elapsed since the start of the lease.
The net present value of the minimum lease payments is 88.7% of
the asset’s fair value at inception of the lease, if the lease payments
are 4,750 every 6 months with a guaranteed and unguaranteed
residual value of 6,000 and 15,000 respectively.
(2) gains, or losses, from the change in the fair value of the residual
accrue to the lessee (for example, in the form of a rent rebate
equalling most of the sales proceeds at the end of the lease); and
Solution
A numerical test should not be the primary determinant of lease
classification.
EXAMPLE-sale proceeds to the lessee
You lease a car, for your use, for 4 years. The cost of the car is
$20.000. The anticipated residual value at the end of the lease is
$5.000. The lease is priced at $15.000, plus finance charges.
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IAS 17 Leasing
If the car’s residual value is more than $5.000, when it is sold, you
will receive the extra money.
If it is less than $5.000, you will have to pay the lessor the shortfall.
(3) the lessee has the ability to continue the lease for a secondary
period, at a rent that is substantially lower than market rent.
This generally indicates that the lessor has no wish to take back the
asset and only wishes to finance the transaction
EXAMPLE-lease for a secondary period
You lease a photocopier for 7 years for a commercial rent. At the
end of that period (when the photocopier is obsolete) you can
continue to rent it for $10 per year, and you must sign a service
contract.
The lessor has made his profit in the first 7 years, and does not
want the copier back. He would prefer to leave it with you for a
nominal rent, and earn a profit on the service contract.
This is a finance lease, as the lessor wants you to enjoy all of the
economic life of the photocopier.
If the lease does not transfer substantially all risks and rewards of
ownership, the lease is classified as an operating lease and is
treated as a simple rental agreement.
Lease classification is made at the start of the lease. If the lessee
and the lessor agree to change the provisions of the lease, so as to
change the lease classification, the revised agreement is regarded
as a new agreement.
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However, changes in estimates of the economic life, the residual
value of the leased property, or default by the lessee, do not create
to a new classification of a lease.
EXAMPLE - Impact on lease classification of low rentals for
optional rental period
Issue
An indicator that the lease should be classified as a finance lease is
when the lessee has the ability to extend the lease for a secondary
period at a rent that is substantially lower than market rent.
Why should this characteristic lead to a finance lease classification?
Background
A manufacturing undertaking leases production-line equipment for
15 years. The annual lease payments are 20,000 a year. At the end
of the lease term, the undertaking has the option to extend the
lease on an annual basis for an annual fee of 100.
Solution
The lease should be classified as a finance lease.
The decline in the lease payments after the end of the initial lease
term suggests that the major part of the asset’s value has been
used during the initial term. Substantially all the risks and rewards
of ownership can therefore be presumed to have passed to the
lessee during the period of the lease.
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IAS 17 Leasing
EXAMPLE - Lessor exposed to changes in the asset’s market
value
Issue
A lease that exposes a lessee to fluctuations in the fair value of the
residual should normally be classified as a finance lease.
How does the exposure of the lessor to changes in the asset’s
market value affect the classification of the lease?
Background
Undertaking A leases an injection-moulding machine to undertaking
B. The machine’s economic life is estimated at 15 years and the
lease is for 8 years. Therefore the lease does not cover the major
part of the machine’s economic life. At the end of the lease the
lessee has the right of first refusal to purchase the asset at the
market price, or may renew the lease at a market rent. The machine
has not been modified to the lessee’s specifications.
Land and Buildings
Leases of land and of buildings are classified as operating, or
finance, leases in the same way as leases of other assets.
However, land normally has an indefinite economic life and, if title is
not to pass to the lessee by the end of the lease term, the lessee
normally does not receive substantially all of the risks and rewards
incidental to ownership, and the lease of land will be an operating
lease.
A payment made on acquiring a leasehold (on day 1), that is
accounted for as an operating lease, represents prepaid lease
payments that are amortised over the lease term matching the
benefits provided.
In the following examples, I/B refer to Income Statement and
Balance Sheet (SFP).
Solution
The lease will probably qualify as an operating lease.
The lease exposes the lessor to the risks and rewards of changes in
the asset’s market value. This is one of the significant risks
associated with ownership. The lessor has not transferred this risk to
the lessee, as the lessee has the option and not the obligation to
purchase the asset at market value.
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IAS 17 Leasing
EXAMPLE-prepaid lease payments
You lease an office for a year. You make an immediate payment of
$24.000, plus monthly payments of $6.000. The $24.000 should be
treated as a prepaid lease payment, and added, at $2.000 per
month, to the monthly rent charge.
I/B
I
B
B
Rent payable
Cash
Lease prepayment
This records the initial payment,
and allocation of the first month’s
rent
Rent payable
I
Cash
B
Lease prepayment
B
This records the second monthly
payment, and allocation of the
lease prepayment to the rent
charge.
DR
8.000
CR
pass to the lessee. The buildings element is classified as a finance,
or operating, lease depending on the agreement.
EXAMPLE- land and buildings-spilt lease 1
You have a 50-year lease for land and buildings. The buildings
have an economic life of 50 years, so will be accounted for under a
finance lease. The land has an indefinite economic life, so will be
accounted for under an operating lease.
30.000
22.000
To classify and account for a lease of land and buildings, the
minimum lease payments (including any lump-sum upfront
payments) – this is the principal of the lease - are split between the
land and the buildings elements, in proportion to the relative fair
values of the land element and buildings element of the lease.
8.000
6.000
2.000
The land and buildings elements of a lease are considered
separately
for the purposes of lease classification. If title to both elements is
expected to pass to the lessee, both elements are classified as a
finance lease, whether analysed as one lease or as two leases.
EXAMPLE-land and buildings-purchase option
You lease land and buildings, with an attractive option to purchase
both at the end of the lease. This may be treated as a finance
lease.
When the land has an indefinite economic life, the land element is
normally classified as an operating lease, unless title is expected to
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EXAMPLE- land and buildings-spilt lease 2
You have a lease for land and buildings. The fair value of the land
is 60% of the total value. You pay $0,4 million at the start of the
lease. The present value of the minimum lease payments is $1,6
million (the principal of the lease).
The value of the land is $1,2 million (60% of $2 million), and the
buildings represent the remaining $0,8 million.
I/B
DR
CR
Property, plant & equipment (land)
B
$1,2
million
Property, plant & equipment
B
$0,8
(building)
million
Cash
B
$0,4
million
Lease creditor
B
$1,6
million
Recording the lease of land and
building
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IAS 17 Leasing
If the lease payments cannot be split reliably between these two
elements, the entire lease is classified as a finance lease.
Alternatively, the entire lease can be classified as an operating
lease.
EXAMPLE - land and buildings-fair values 1
You have a lease for land and buildings. The fair values of the
land
and buildings cannot be reliably estimated separately.
If the lease is a short lease, say for 10 years, you treat it as an
operating lease. If the lease has an attractive purchase option,
treat it as a finance lease.
If the land element, is immaterial, the economic life of the buildings
is taken as the economic life of the entire leased asset.
EXAMPLE land and buildings-fair values 2
You have a $100 million lease for land and buildings. The fair value
of the land is only 1% of the total value, as the buildings are new,
and extremely attractive (in terms of market value). The economic
life of the buildings should be taken as the life of the combined asset.
I/B
Property, plant & equipment (building) B
Lease creditor
DR
$100
million
B
CR
$100
million
Recording the lease of land and
building as building only.
Separate measurement of the land and buildings elements is not
required when the lessee’s interest in both land and buildings is
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classified as an investment property under IAS 40, and the fair
value model is adopted.
EXAMPLE-investment property 1
You have a lease for land and buildings. You sublease them to a
third party and classify them as investment property under IAS 40.
You may treat the land and buildings (which stand on the land) as
one asset. (See examples in the IAS 40 Investment Property
workbook.)
Under IAS 40, a lessee can classify a property interest, held under
an operating lease, as an investment property. The property
interest is accounted for as if it were a finance lease, and the fair
value model is used for the asset recognised. The lessee shall
continue to account for the lease as a finance lease, even if it
ceases to be investment property.
EXAMPLE-investment property 2
You have an operating lease of a building. You classify it as
investment property. You may treat it as a finance lease, and fair
value the building under IAS 40.
EXAMPLE -Impact on classification of lease of extension of
lease period
Issue
Changes in estimates or renewals of leases should not result in a
change in the classification of a lease. However, changes to the
provisions of a lease may require the classification to be
reassessed.
An operating lease is extended to cover the asset’s remaining
economic life. Does an extension of a lease mean that classification
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IAS 17 Leasing
should be reconsidered?
EXAMPLE - Is it possible to lease a building and not the land?
Background
Issue
Leases of land and buildings should be classified as operating or
finance leases following the same criteria as for other assets. The
lessee of land does not receive substantially all the risks and
rewards of ownership if title is not expected to pass to the lessee.
A lease over buildings was entered into where the term of the lease
was 30 years and the estimated economic life of the buildings 45
years. The lease was classified as an operating lease. Now,
nearing the end of the 30 years, the lease has been renegotiated
and the new lease term is 20 years, which is equal to the revised
estimated remaining life of these buildings.
Should the lessor and lessee continue to account for this renewed
agreement as for an operating lease?
Solution
No. The lease should now be classified as a finance lease.
Changes in the lease agreement that result in a different
classification of the lease require the revised agreement to be
regarded as a new agreement over its term. The lease term of the
new agreement covers the whole remaining useful life of the
buildings, and therefore it should be classified as a finance lease.
Changes in estimates (for example, regarding the leased property’s
remaining economic life or residual value) do not give rise to a new
classification of a lease for accounting purposes. For example, if it
had emerged during the first lease that the economic life of those
buildings was not 45 years but only 30, the original classification as
operating lease would not have been revised.
Is it possible to lease a building without also leasing the land on
which it stands?
Background
Undertaking A enters into a lease for one floor of a ten-floor office
building in London, England, for 20 years. The useful life of the
building is assessed as 20 years. The annual rental is 50,000.
Undertaking A also enters into a lease for one floor of a similar tenfloor office building in Edmonton, Canada, for 20 years. The useful
life of the building is assessed as 20 years. The annual rental is
10,000.
Each lease only refers to the rental of the buildings and not to the
rental of the land on which the buildings stand. Management
therefore maintain that the leases solely relate to the lease of
buildings and do not include the lease of land. Management
therefore propose that the total present value of the minimum lease
payments is capitalised.
Solution
It is not possible to lease a building without also leasing the land on
which it stands.
The difference in the rentals paid in London and Edmonton reflects
their different locations, which is solely a characteristic of the land
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IAS 17 Leasing
and not of the buildings. Each lease therefore represents a lease of
10% of the building and the lease of a 10% interest in the land on
which the building stands.
Management must therefore separate the lease of the land from the
lease of the buildings. The buildings are each leased for all of their
remaining economic lives and will therefore likely be classified as
finance leases. Management should, however, treat the leases of
the land as operating leases.
EXAMPLE - Leases in the North Pole
Father Christmas has a company, Christmas Industries, that
manufacturers Christmas presents for distribution to children
around the world. Christmas Industries is considering some of the
implications of applying IFRS in its
financial statements.
Christmas Industries leases, on a 50-year lease, one of its
manufacturing sites in the North Pole. It is considering the
requirements in IAS 17 to consider the lease of land and the lease
of the building separately, when determining whether they are a
finance lease or an operating lease. It does not have the option to
buy any element of the factory at the end of the lease.
The standard requires the land element to be considered separately
from the buildings element. But the factory leased in the North Pole
is built on ice
(frozen ocean) and not land. So, how should IAS 17 be applied?
Although the factory is built on ice and not on land, the lease of the
ice and the lease of the factory should be considered separately.
The classification of each element of the lease should be
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determined on its own merits.
However, we consider that there may be a key difference between
a lease in the North Pole and a lease of land in most other areas in
the world.
When the land has an indefinite economic life, the land element is
normally classified as an operating lease. Many environmental
scientists believe that the ice caps of the North Pole have a limited
life. It is therefore important that Father Christmas and the rest of
the board at Christmas industries assess whether they believe,
given the available evidence, that the ice at the North Pole has an
indefinite economic life.
If it is concluded that the ice cap does not have an indefinite
economic
life, then the presumption that a lease of land is an operating lease
may be
rebutted and an analysis of the risks and rewards of the ice cap will
be
required, in the same way as the company analyses the risks and
returns of the factory.
Leases in the Financial Statements of Lessees
Finance Leases-Initial Recognition (see Accounting for a
collaterised loan on page 4)
At the start of the lease term, lessees shall record finance leases as
assets, and liabilities, in their balance sheets at amounts equal to
the fair value of the leased item (market price) or, if lower, the
present value of the minimum lease payments (the principal of the
loan without interest payments).
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IAS 17 Leasing
Normally, the liability will equal the fair value of the lease item. If
not, the minimum lease payments (the total payments of the lease –
principal and interest) need to be split between the capital and
interest elements of the loan.
Calculation of the net present value removes the interest
component. A discount rate is needed to do this.
The discount rate to be used in calculating the present value of the
minimum lease payments is the interest rate implicit in the lease, if
known; if not, the lessee’s incremental borrowing rate shall be used.
In practice, this is the rate of the lease agreed by the parties.
Any initial direct costs of the lessee, such as negotiating and
securing leasing arrangements, are added to the amount recorded
as an asset. These are rare, or not material, except for costs
involved in leases of land and buildings such as legal and
registration costs.
Leases are accounted for in accordance with their substance and
financial reality, and not merely with the legal form.
Although the lessee may acquire no legal title to the leased asset,
in a finance lease, the lessee acquires the benefits of the leased
asset for most of its economic life, therefore controlling the asset for
the period of the lease, in return for paying the fair value of the
asset and the related finance charge.
is identified in the notes to the financial statements, in the details of
financial leases.
The asset is matched by an obligation to pay future lease
payments, showing the principal payments as a liability, but not the
interest payments, which are charged to the income statement over
the period of the lease. (After the start of the lease, the asset and
liability will probably differ in amounts, as their accounting
processes differ, as detailed earlier in this book.)
If such finance lease transactions are not reflected in the lessee’s
balance sheet, the assets and liabilities of an undertaking are
understated, thereby distorting financial ratios.
At the start of the lease term, the asset and the liability for the future
lease payments are normally presented in the balance sheet at the
same amounts, except for any initial direct costs of the lessee that
are added to the amount recorded as an asset.
Liabilities for leased assets should not be presented in the financial
statements as a deduction from the leased assets, but shown as
liabilities in full. Where the presentation of liabilities in the balance
sheet shows a distinction between current and non-current
liabilities, the same distinction is made for lease liabilities.
This is a major innovation for most accounting systems. Most limit
the assets and liabilities, shown on the balance sheet, to those
owned and owed by the firm.
Under a finance lease, the lessee controls an asset, which it shows
on the balance sheet, but it does not own it. The lack of ownership
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IAS 17 Leasing
EXAMPLE-contingent rent
You lease a shop. You must pay a fixed amount ($25.000), plus
6% of your turnover. The 6% is a contingent rent. It should be
calculated and added to the fixed rent, in each period. In the first
period, your turnover = $100.000.
I/B
DR
CR
Rent expense
I
31.000
Cash
B
25.000
Lease creditor (current)
B
6.000
Recording the rent payment and the
accrual for the contingent rent.
Subsequent Measurement
Lease payments shall be split between the finance charge, and the
reduction of the outstanding liability. The finance charge shall be
allocated to each period during the lease term, so as to produce a
constant periodic rate of interest on the remaining balance of the
liability.
If the agreed rate of interest is 12%, 12% interest per year will be
charged on the remaining balance of the principal of the lease
throughout the term of the lease. This amount will reduce each
period as each payment reduces the principal of the lease.
EXAMPLE-current and non-current liabilities
You have leased an item for 4 years for $20 million. You spilt the
capital repayments between those payable within the first year:
$3 million (current liability), and those payable in years 2-4 (noncurrent liability): $17 million.
Property, plant & equipment
Lease creditor (current)
Lease creditor (non-current)
I/B
B
B
B
DR
$20 million
CR
$3 million
$17million
Recording the lease and the split
between current and non-current
creditors
The schedule of payments, spilt between capital and interest, is
normally available from the lessor. If not, in allocating the finance
charge to periods during the lease term, a lessee may estimate to
simplify the calculation, knowing the cost and finance totals of the
lease.
Contingent rents must be charged as expenses, in the periods in
which they are incurred.
Most lease payments remain unchanged (in total) throughout the
lease.
For the lessee, a finance lease gives rise to depreciation expense
for depreciable
At the start of the lease, most of the payment is interest, with a
small element of capital being repaid. As the lease continues, the
capital repayment increases, and the interest portion is smaller.
assets, as well as finance expense, for each accounting period. The
depreciation policy shall match that for depreciable assets that are
owned, and the depreciation recognised shall be calculated in
accordance with IAS 16 Property, Plant and Equipment and IAS 38
Intangible Assets. Lease of intangible assets are a minority of lease
transactions.
The capital has been reduced, so if the interest rate is constant, you
will pay less interest each month.
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IAS 17 Leasing
If there is reasonable certainty that the lessee will obtain ownership
by the end of the lease term, the period of expected use is the
useful life of the asset; otherwise the asset is depreciated over the
shorter of the lease term, and its useful life.
(The useful life of the asset cannot be longer than the lease term,
as the asset will have to be returned to the lessor, at the end of the
lease, if ownership is not secured, or there is no probability that the
lease will be extended.)
The sum of the depreciation expense for the asset and the finance
expense for the period is rarely the same as the lease payments
payable for the period, and it is, therefore, inappropriate simply to
recognise the lease payments payable as an expense. Accordingly,
the asset and the related liability are unlikely to be equal in amount
after the start of the lease term.
To determine whether a leased asset has become impaired, an
undertaking applies IAS 36 Impairment of Assets.
(ii) later than one year and not later than five years;
(iii) later than five years.
(3) contingent rents recorded as an expense in the period.
(4) the total of future minimum sublease payments (total payments)
expected to be received, under non-cancellable subleases, at the
balance sheet date.
(5) a general description of the lessee’s material leasing
arrangements including, the following:
(i) the basis on which contingent rent payable is determined;
(ii) the existence and terms of renewal or purchase options and
escalation clauses; and
Lessees shall make the following disclosures for finance leases:
(iii) restrictions imposed by lease arrangements, such as those
concerning dividends, additional debt, and further leasing.
(1) for each class of asset, the net carrying amount at the balance
sheet date. The classes are listed in IAS 16.
In addition, the requirements of IAS 16, IAS 36, IAS 38, IAS 40 and
IAS 41 apply to lessees, for assets leased under finance leases.
(2) a reconciliation between the total of future minimum lease
payments at the balance sheet date, and their present value.
Operating Leases
In addition, an undertaking shall disclose the total of future
minimum lease payments (total payments) at the balance sheet
date, and their present value (the value excluding interest
payments), for each of the following periods:
(i) not later than one year;
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These are accounted for as short-term rentals as an expense for
the lessee. This is similar to the methods of national accounting for
short-term leases.
Lease payments under an operating lease shall be recorded as an
expense, on a straight-line basis, over the lease term, unless
another basis is more representative of the user’s benefit.
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IAS 17 Leasing
For operating leases, lease payments (excluding costs for services,
such as insurance and maintenance) are recognised as an expense
on a straight-line basis, even if the payments are not on that basis.
Lessees shall make the following disclosures for operating leases:
(1) the total of future minimum lease payments (total payments)
under non-cancellable operating leases for each of the following
periods:
(i) not later than one year;
(ii) later than one year and not later than five years;
(iii) later than five years.
(2) the total of future minimum sublease payments (total payments)
expected to be received under non-cancellable subleases at the
balance sheet date.
(3) lease, and sublease, payments recognised as an expense in the
period, with separate amounts for minimum lease payments,
contingent rents, and sublease payments.
(4) a general description of the lessee’s significant leasing
arrangements including, but not limited to, the following:
(i) the basis on which contingent rent payable is determined;
(ii) the existence and terms of renewal or purchase options and
escalation clauses; and
(iii) restrictions imposed by lease arrangements, such as those
concerning dividends, additional debt and further leasing.
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EXAMPLE-prepaid lease expense
You lease a car for 3 years for $500 per month. The first 4 months’
rental is payable on day 1, and no rental is paid in months 34-36.
Treat I month’s rental as an expense in the first month, and the
other 3 months’ rental as a prepayment, which will be expensed in
months 34-36.
Lease expense
Cash
Prepaid Lease
Recording the lease payment in
month 1.
Lease expense
Prepaid Lease
Recording the lease expense in
month 34,
(which will be repeated in months
35 & 36).
I/B
I
B
B
I
B
DR
CR
500
2.000
1.500
500
500
Leases in the Financial Statements of Lessors
Finance Leases - Initial Recognition (see Accounting for a
collaterised loan on page 4)
Lessors shall record assets, held under a finance lease, in their
balance sheets, and present them as a receivable at an amount
equal to the net investment in the lease.
The net investment in the lease (principal amount, excluding
interest) removes the interest element of the payments that will be
received, leaving the capital portion. This is shown as an account
receivable.
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IAS 17 Leasing
When the interest is received, as part of the lease payment, it will
be shown as interest received in the income statement in the
period.
Under a finance lease, the lease payment receivable is treated by
the lessor as repayment of principal in the balance sheet, and
finance income in the income statement.
Initial direct costs are often incurred by lessors, and include
amounts
such as commissions, legal fees and internal costs that are
incremental, and directly attributable to negotiating, and arranging,
a lease. They exclude general overheads, such as those incurred
by a sales team.
For finance leases, other than those involving manufacturer or
dealer lessors, initial direct costs are included in the initial
measurement of the finance lease receivable and reduce the
amount of income recorded over the lease term. They are spread
over the period of the lease, rather than expensed immediately.
The interest rate, implicit in the lease, is defined so that the initial
direct costs are included automatically in the finance lease
receivable; there is no need to add them separately.
Costs incurred by manufacturer, or dealer lessors, in connection
with negotiating and arranging a lease, are excluded from the
definition of initial direct costs. They are recorded as an expense in
the income statement at the start of the lease term.
This is when the selling profit is recognised.
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Subsequent Measurement
The recognition of finance income shall reflect a constant periodic
rate of return on the lessor’s net investment in the finance lease.
If the agreed rate of interest is 12%, 12% interest per year will be
charged on the remaining balance of the principal of the lease
throughout the term of the lease. This amount will reduce each
period as each payment reduces the principal of the lease.
Most lease receipts remain unchanged throughout the lease. The
lessee pays the same amount each month, although by agreement
may prepay some extra months’ payments at the start of the lease.
At the start of the lease, most of the receipt is interest, with a small
element of capital being repaid. As the lease continues, the capital
receipt increases, and the interest portion is smaller.
The capital has been reduced, so if the interest rate is constant, you
will receive less interest each month and a larger repayment of
capital.
A lessor aims to allocate finance income over the lease term, on a
systematic basis. This income allocation is based on a constant
periodic return on the lessor’s net investment in the finance lease.
Each month, the lessor credits the lessee’s account in the balance
sheet and credits interest receivable in the income statement, for
the month’s finance charge.
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IAS 17 Leasing
Lease payments relating to the period, excluding costs for services,
are applied against the account receivable in the balance sheet to
reduce the capital of the lease.
Estimated unguaranteed residual values (the value the lessor
expects to realise for the sale of the asset at the end of the lease),
used in computing the lessor’s gross investment, in a lease are
reviewed regularly.
If there has been a reduction in the estimated unguaranteed
residual value, the income allocation over the lease term is revised,
and any reduction in respect of amounts accrued is recognised
immediately.
Subsequent Measurement - Manufacturer or dealer lessors
Manufacturer or dealer lessors shall recognise selling profit, or loss,
in
the period, matching the policy for outright sales. If artificially low
rates of interest are quoted, selling profit shall be restricted to that
which would be made if a market rate of interest were charged.
Background
A shipping undertaking (the lessee) leases ships for 5 to 8 years.
The leases include a bargain purchase option. Although the
undertaking would not be able to finance the purchase and usage
of all the ships held under lease, the undertaking’s past practice
and future intent is to exercise the purchase option then sell the
ship, recording a gain on disposal.
Solution
The lease should be classified as a finance lease and the bargain
purchase option should be included in the calculation of the MLP.
Although the undertaking does not intend to continue to use the
asset, it has the ability to exercise the purchase option, dispose of
the ship and enjoy a financial benefit from the gain on sale. The
lessee will enjoy the benefit of each ship’s residual value.
Manufacturers, or dealers, often offer to customers the choice of
either buying, or leasing, an asset. A finance lease of an asset by a
manufacturer or dealer lessor gives rise to two types of income:
EXAMPLE - Effect of bargain purchase option on calculation of
minimum lease payments (MLP)
(1) profit equivalent to that resulting from the sale of the asset being
leased, at normal selling prices; and
Issue
The calculation of MLP includes an optional amount payable by the
lessee to purchase the asset if the purchase price is expected to be
so much lower than fair value at the exercise date that the lessee
can be reasonably expected to exercise the purchase option.
(2) finance income over the lease term.
Should all bargain purchase options be included in the calculation
of MLP if the undertaking’s ability to hold the assets is limited?
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The sales revenue recognised at the start of the lease term, by a
manufacturer, or dealer lessor, is the fair value of the asset, or, if
lower, the present value of the minimum lease payments (total
payments), computed at a market rate of interest.
The cost of sale recognised at the start of the lease term is the cost,
or carrying amount if different, of the leased property, less the
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IAS 17 Leasing
present value of the unguaranteed residual value (the value the
lessor expects to realise for the sale of the asset at the end of the
lease, discounted by the rate of the lease). The difference between
the sales revenue and the cost of sale is the selling profit, which is
recorded as a normal sale.
dealers.
Costs incurred by a manufacturer, or dealer, lessor, in connection
with negotiating and arranging a finance lease, are recorded as an
expense, at the start of the lease, as they are mainly related to
earning the manufacturer’s or dealer’s selling profit.
The SPU will be consolidated in the manufacturer’s financial
statements, in accordance with SIC-12, and the cars brought back
onto the manufacturer’s balance sheet as assets leased out under
operating leases.
EXAMPLE - Leasing of assets through a special purpose
undertaking
The manufacturer is required to consolidate the SPU in accordance
with SIC-12 because it retains all of the risks and gains 50% of the
benefits of the SPU’s activities.
Issue
A lessor which leases out an asset under an operating lease should
continue to present that asset in the balance sheet according to the
nature of the asset.
How would the accounting for a lease change if the asset were sold
first to an SPU, which in turn leases that asset under an operating
lease to a third party?
Background
A car manufacturer operates a lease scheme for dealers through a
special purpose undertaking. The manufacturer sells a fleet of cars
to the SPU at selling prices with a trade discount. The SPU then
leases the cars to customers or the dealers for 3 years under
operating leases.
At the end of the lease the cars are sold at market prices. Any loss
on individual cars is offset against any profit on other cars in the
fleet. The manufacturer guarantees the net loss on sale, and any
net profit is shared evenly between the manufacturer and the
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Solution
The manufacturer, at the individual undertaking level, will record the
sale of the cars to the SPU.
Lessors - Disclosure
Lessors shall disclose the following for finance leases:
(1) a reconciliation between the gross investment in the lease (total
payments still to be received), at the balance sheet date, and the
present value of minimum lease payments receivable (payments of
principal still to be received), at the balance sheet date.
Also, an undertaking shall disclose the gross investment in the
lease (total payments to be received), and the present value of
minimum lease payments (payments of principal to be
received)receivable at the balance sheet date, for each of the
following
periods:
(i) not later than one year;
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IAS 17 Leasing
(ii) later than one year and not later than five years;
(5) contingent rents recognised as income in the period.
(iii) later than five years.
(6) a general description of the lessor’s material leasing
arrangements.
EXAMPLE – prepaid lease income
You are the lessor of a car for 3 years, for $500 per month. The
first 4 months’ rental is receivable on day 1, and no rental is
received in months 34-36. Treat I month’s rental as income in the
first month, and the other 3 months’ rental as a payment in
advance, which will be treated as income in months 34-36.
The repayment of capital for month 1= $20, and month 34 =
$445.
I/B
I
B
B
B
DR
CR
480
20
Finance income
Lease – capital repayment
Cash
2.000
Prepaid Lease Income
1.500
Recording the lease income in
month 1.
Finance income
I
60
Lease – capital repayment
B
440
Prepaid Lease Income
B
500
Recording the lease income in
month 34.
(2) unearned finance income (interest payments yet to be received).
(3) the unguaranteed residual values accruing to the benefit of the
lessor.
(4) the accumulated allowance for uncollectible minimum lease
payments receivable (bad debt reserve for lease receipts).
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It is useful also to disclose the gross investment, less unearned
income, (payments of principal to be received) in new business
added during the period, after deducting the amounts for cancelled
leases.
Sale of Assets held for Rental
Leasing companies should show the sale of assets held for rental
as revenue, (rather than gains or losses) following a decision by the
IASB in the 2007 Annual Improvements Process.
Operating Leases
Lessors shall present assets subject to operating leases, in their
balance sheets, by asset class. The classes are defined in IAS 16.
Lessors’ income from operating leases shall be recognised in
income on a straight-line basis over the lease term, unless another
basis is more representative of asset use.
EXAMPLE -Operating lease stepped increases
E Ltd has adopted IFRS and occupies a building under an
operating lease. The lease is for 25 years and the terms allow for
an annual rental increase of 2%.
How should E Ltd account for the future increases in rental
expense?
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IAS 17 Leasing
Payments made under operating leases should be recognised as
an expense on a straight-line basis over the lease term, unless
another systematic basis is more representative of the time pattern
of the user’ s benefit.
Initial direct costs incurred by lessors, in negotiating and arranging
an operating lease, shall be added to the carrying amount of the
leased asset, and recorded as an expense, spread over the lease
term on the same basis as the lease income.
In this case the future rental costs include a fixed increase. The
fixed 2% increase should be included in the spreading calculation of
the lease costs at inception.
The depreciation policy for leased assets shall match the lessor’s
normal depreciation policy for similar assets, and depreciation shall
be calculated in accordance with IAS 16, and IAS 38 (for intangible
assets).
As the lease is for 25 years, E Ltd wishes to take into consideration
the time value of money in calculating the spreading of the fixed 2%
increase in the annual rental expense and discount it over the life of
the lease. Is this appropriate?
To determine whether a leased asset has become impaired, an
undertaking applies IAS 36.
This issue was discussed by the International Financial Reporting
Interpretations Committee (IFRIC) in November 2005.
EXAMPLE - Restoration of assets held under an operating
lease
Issue
The IFRIC noted that IAS 17 does not address adjustments to
reflect the time value of money. As stated above, IAS 17 requires a
straightline pattern of recognition of operating lease rental
expenses over the life of the lease unless another basis is more
representative of the time pattern of the users benefit.
Recognising income or expense (for example, discounting) arising
from fixed annual increases as they arise rather than on a straightline basis is not consistent with the time pattern of the user’s
benefit, therefore it is not appropriate to discount future fixed rental
increases.
Costs, including depreciation, incurred in earning lease income, are
recognised as an expense. Lease income (excluding receipts for
services, such as insurance and maintenance) is recognised on a
straight-line basis over the lease term, even if the receipts are not
on such a basis.
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Auld Lang Syne, a toy manufacturer, leases a factory for a period of
10 years, with an option to extend the lease contract.
The lease contract specifies that Auld Lang Syne has the obligation
to restore the building to its original condition at the end of the lease
term.
If management of Auld Lang Syne does not restore the building, it
will have to pay a penalty calculated as a reasonable amount
required by third parties to restore the building to its original
condition.
When should management provide for the cost of restoration?
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IAS 17 Leasing
Solution
IAS 37, Provisions, Contingent Liabilities and Contingent Assets,
states that an undertaking should recognise a provision when it has
a present obligation as a result of a past event. Management
should recognise a provision when any damage occurs to the
building or when any alterations are made. That is the moment
when the obligation arises, because the repairs are due.
In addition, the disclosure requirements in IAS 32, IAS 16, IAS 36,
IAS 38, IAS 40 and IAS 41 apply to lessors for assets provided
under operating leases.
Finance Leasing – Accounting Steps
1. Establish the cost of the asset, including any initial direct costs.
2. Calculate the useful life of the asset.
There is no present obligation at inception of the lease to make any
expenditure, independent of management’s future actions. There is
a probability that management will have to make expenditure in the
future regarding the restoration for any normal damages that may
occur, but the expenditure is not due at the moment of entering the
lease agreement.
No liability is recorded until that damage has been incurred.
3. Decide the depreciation method, and the charges over the life of
the asset.
4. Calculate the total loan principal and the total interest payable
over the term of the lease.
5. Write a schedule of payments, splitting each into principal and
interest, or obtain it from the lessor.
Lessors shall disclose the following for operating leases:
(1) the future minimum lease payments (total receipts) under noncancellable operating leases in total, and for each of the following
periods:
(i) not later than one year;
6.
Calculate the first year’s principal payments. This is the
short–term liability.
7.
The remaining principal payments are the long-term liability.
(iii) later than five years.
8.
When monthly payments are made, refer to the payments
schedule in (5) above for the split between principal and interest.
Debit finance charges in the income statement and long-term loan
principal in the balance sheet..
Recalculate the short–term liability from the schedule.
(2) total contingent rents recognised as income in the period.
9.
(3) a general description of the lessor’s leasing arrangements.
Notes:
(ii) later than one year and not later than five years;
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Charge depreciation monthly according to the schedule in 3.
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IAS 17 Leasing
1. The total principal value of the loan will either be the same as the
cost of the asset, or lower. If it is lower, take the minimum lease
payments, and remove the interest component.
The owner sells the asset to the lessor, who leases it to the
previous owner, who now becomes the lessee. If the lease amounts
to a short-term rental, it is on operating lease.
2. The asset and liabilities should be accounted for separately.
If the lease is for 6 years with a purchase option, and the useful life
is 10 years, then the liability will disappear after 6 years, leaving 4
more years of depreciation of the asset to be charged.
If the lease continues until the economic life of the asset expires,
then it is a finance lease.
3. Each lease payment reduces the long-term liability, until there
are only 12 monthly payments left. As the principal element of each
payment may differ, the short-term liability should be recalculated
after each lease payment.
4. Most lease payments remain unchanged (in total) throughout the
lease.
At the start of the lease, most of the payment is interest, with a
small element of principal being repaid. As the lease continues, the
principal repayment increases, and the interest portion is smaller.
The principal has been reduced, so if the interest rate is constant,
you will pay less interest each month and more principal.
A sale and leaseback transaction involves the sale of an asset, and
the leasing back of the same asset. The lease payment and the
sale price are usually interdependent, as they are negotiated as a
package. The accounting treatment of a sale and leaseback
transaction depends upon the type of lease involved.
If a sale and leaseback transaction results in a finance lease, any
excess of sales proceeds over the carrying amount shall not be
immediately recognised as income by a seller-lessee. Instead, it
shall be deferred, and amortised, over the lease term.
5. Basic information regarding the principal and interest amounts
should be included in the lease documentation. Payment schedules
identifying the monthly split of principal and finance charge are
normally available from the lessors.
Sale and Leaseback Transactions
Sale and leaseback transactions have the purpose of raising capital
for the owner of an asset without losing the use of the asset.
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IAS 17 Leasing
EXAMPLE-sale and leaseback-finance lease
You have a property, which has a carrying value of $1 million in
your books. You organise a sale and leaseback of the property,
and receive $1,4 million. You will account for it as a finance lease.
The $0,4 million premium will be amortised over the lease term.
The current lease payment, included in the total lease= $0,1
million.
I/B
DR
CR
Property, plant & equipment
B
$1 million
Cash
B
$1,4
million
Deferred gain
B
$0,4
million
The asset sale, and recognition of
the gain.
This gain will be amortised over the
lease term.
Property, plant & equipment
B
$1,4
million
Lease creditor (current)
B
$0,1
million
Lease creditor (non-current)
B
$1,3
million
Recording the lease and the split
between current and non-current
creditors
EXAMPLE-sale and leaseback-operating lease
You have a property, which has a carrying value of $1 million in
your books. You organise a sale and leaseback of the property,
and receive $1,2 million, the agreed fair value of the property.
You will account for it as an operating lease. The $0,2 million
premium will be recorded as profit immediately.
I/B
DR
CR
Property, plant & equipment
B
$1 million
Cash
B
$1,2
million
Gain on disposal
I
$0,2
million
Recording the sale and
recognition of the gain.
If the sale price is below fair value, any profit or loss shall be
recognised immediately except that, if the loss is compensated for
by future lease payments at below market price, it shall be deferred
and amortised in proportion to the lease payments over the period
for which the asset is expected to be used.
If a sale and leaseback transaction results in an operating lease,
and it is clear that the transaction is established at fair value, any
profit or loss shall be recognised immediately
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IAS 17 Leasing
EXAMPLE-sale and leaseback-finance lease – reduced
payments
You have a property, which has a carrying value of $1 million in
your books. You organise a sale and leaseback of the property,
and receive $0,8 million.
You will pay reduced lease payments due to this discount.
The $0,2 million discount will be amortised over the lease term.
The current lease payment, included in the total lease= $0,1
million.
I/B
DR
CR
Property, plant & equipment
B
$1 million
Cash
B
$0,8
million
Deferred loss
B
$0,2
million
The asset sale, and recognition of
the loss.
This loss will be amortised over the
lease term.
Property, plant & equipment
B
$0,8
million
Lease creditor (current)
B
$0,1
million
Lease creditor (non-current)
B
$0,7
million
Recording the lease and the split
between current and non-current
creditors
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EXAMPLE-sale and leaseback-operating lease
You have a property, which has a carrying value of $1 million in
your books. You organise a sale and leaseback of the property,
and receive $0,9 million, the agreed fair value of the property. You
will account for it as an operating lease. The $0,1 million discount
will be recorded as a loss immediately.
Property, plant & equipment
Cash
Loss on disposal
I/B
B
B
I
DR
CR
$1 million
$0,9
million
$0,1
million
Recording the sale and recognition
of the loss.
For operating leases, if the fair value at the time of a sale and
leaseback transaction is less than the carrying amount of the asset,
a loss equal to the amount of the difference between the carrying
amount and fair value shall be recognised immediately.
For finance leases, no such adjustment is necessary unless there
has been an impairment in value, in which case the carrying
amount is reduced to recoverable amount, in accordance with IAS
36.
Disclosure requirements for lessees, and lessors, apply equally to
sale and leaseback transactions. The required description of
material leasing arrangements leads to disclosure of unique, or
unusual, provisions of the agreement, or terms of the sale and
leaseback transactions.
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IAS 17 Leasing
Sale and leaseback transactions may trigger the separate
disclosure criteria in IAS 1 Presentation of Financial Statements.
Sale and Leaseback with options – collaterised borrowings
The existence of options held by the purchaser to put the asset
back to the seller/lessee and by the seller/lessee to call the asset
from the purchaser/lessor at a pre-determined price indicates that it
is inevitable that one of the two parties will exercise the option.
Management should apply SIC-27 in these circumstances only,
instead of IAS 17. SIC-27 states that the substance of these
transactions is that there is no sale and leaseback transaction as
defined by IAS 17. This approach results in the recognition of a
financing transaction (collateralised borrowing).
The purchaser should record a financial asset and the seller a
financial liability without considering the lease classification, and
follow IFRS guidance on sale and leaseback transactions.
The existence of an option allowing the seller/lessee to call the
asset back at a pre-determined price or at fair value is addressed
within the guidance of IAS 17 for lease classification. In establishing
lease classification:
Management should consider whether the pre-determined price is
expected to be sufficiently lower than its fair value. The lease
should be classified as a finance lease if the answer is yes. If the
answer is no, the lease should be classified as operating in the
absence of other finance lease indicators; and
The lease is likely to be classified as operating in the absence of
other finance lease indicators. The option to buy at fair value is not
an indicator of a finance lease.
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EXAMPLE - Sale and repurchase agreement
Undertaking C manufactures trucks. C sells a fleet of trucks to
undertaking D and provides a volume discount of 25% from the
market price of the trucks. The size of the volume discount is typical
for the market.
As part of the sales transaction, C grants D a repurchase option.
This option entitles D to require C to repurchase the vehicles after
six years for 30% of the price paid by D. The expected economic
life of the trucks is 15 years and at the date of the sales transaction,
the repurchase option is expected to be in the money.
How should undertakings C and D each account for the
transaction?
Accounting by undertaking C: Undertaking C should account for
the transaction as an operating lease, and continue to recognise
the trucks as PPE. C has not transferred the significant risks and
rewards of ownership that would be required by IAS 18, Revenue,
in order to recognise a sale. This is because C retains the residual
value risk associated with the trucks.
Accounting by undertaking D: Undertaking D should also account
for the transaction as an operating lease in accordance with IAS 17.
It should recognise the amount paid net of the repurchase option
price as an operating lease prepayment, which should be amortised
on a straightline basis over the six years to the option exercise
date.
The repurchase option meets the definition of a receivable under
IFRS 9 and D should measure it at amortised cost.
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IAS 17 Leasing
EXAMPLE - Lease and leaseback
Issue
A series of transactions involving the legal form of a lease should
be considered to be linked and it should be accounted for as one
transaction. The overall economic effect of that transaction cannot
be understood without reference to the series of transactions as a
whole. The accounting for such transactions should reflect the
substance of the arrangement [SIC-27].
How should a transaction that has a number of linked elements be
recognised in financial statements?
Background
Undertaking A leases an aircraft to an investor B (the headlease)
and leases the same asset back for a shorter period of time (the
sublease). Once the sublease period has expired, undertaking A
has the right to repurchase the aircraft from investor B under a
purchase option. If undertaking A does not exercise its purchase
option, investor B may put the aircraft back to undertaking A or
require undertaking A to provide a return on the investment in the
headlease.
The main purpose of the arrangement is to achieve a tax advantage
for investor B which is shared with undertaking A. Investor B pays
a fee to undertaking A, representing a portion of the tax savings,
and prepays the lease payment obligations under the headlease.
These prepayments are held in a separate investment account
outside undertaking A’s control. The separate investment account is
used to pay the sublease payments, and any shortfall of funds in
that account is met by undertaking A.
Solution
Undertaking A should continue to recognise the asset.
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The substance of the arrangement is that undertaking A receives a
fee (calculated as a share of the tax benefits) for entering into the
arrangement, but it retains the risks and rewards incident to
ownership of the asset.
EXAMPLE - Property sale and leaseback with an option for the
lessee to re-acquire the property
Issue
A sale and leaseback transaction should be accounted for
according to the type of lease involved.
The lease should normally be classified as a finance lease if the
lessee has the option to purchase the asset at a price which is
expected to be so much lower than fair value at the date the
purchase option becomes exercisable that it is reasonably certain
that the option will be exercised.
How should a property sale and leaseback transaction be
accounted for where the lessee has the option to re-acquire the
property?
Background
Undertaking A sells a building to Bank B for the market value of 10
million (book value of the building is 8 million).
The undertaking then leases the building back from B and over the
next 7 years, A pays B rental, which is equivalent to a lender’s
return, being LIBOR+2%, calculated on 10 million.
At year 7, A has the option to purchase back the building for 10
million plus 25% of any increase in the market value since year 1.
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IAS 17 Leasing
If the market value has gone down, and A is not willing to exercise
the purchase option, the lease will continue for another 13 years,
with B continuing to earn a lender’s return of LIBOR+2%.
value of the property and to pay interest rather than market rents.
A has operating rights of the building for 20 years and must
maintain it.
Undertaking A entered into an agreement to lease an existing
building from undertaking B in 1995.The lease term was 20 years.
At the inception of the lease the present value of the lease
payments represented substantially all of the fair value of the
building.
Solution
The lease will probably qualify as a finance lease.
It appears that A keeps substantially all the risks and returns
incident to ownership and thus this should be classified as a finance
lease. The reasoning for this is as follows:
i) until year 7 A retains the majority of rewards of the increase in the
market value and all rewards of the use of the building;
ii) over the entire 20 years A retains risks - if the market value
decreases, A is forced to continue to pay rental, which may be
above the market rental;
iii) B is receiving a lender’s rate of return, and only a small portion
of the rewards up to year 7 if the market value increases;
iv) over the entire 20 years B does not bear the residual value risk if the market value has decreased by year 7, it will continue to
receive a lender’s rate of return until year 20, at a rate which
compensates it for the risk of a fall in market value.
If A wanted to sell its asset and pay market rent for the property it
could enter into a 20-year lease agreement at market rentals. The
option to buy the property back (in substance at less than market
value) and the replacement of market rentals by interest-based
payments demonstrate that A is keen to retain an interest in the
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EXAMPLE - Reassessment of lease when terms changed
The lease was therefore classified as a finance lease.
A and B agreed to change the terms of the lease in 2005.This
allows A to terminate the lease early in 2009 in exchange for an
immediate additional one-off payment to the lessor in 2005 and a
reduction in the monthly lease payments until 2009. A will therefore
vacate the property in 2009.
Reassessing the lease terms in accordance with IAS 17, using the
revised lease terms as if they had been in effect at the inception of
the lease in 1995 continues to result in a finance lease
classification. That is, the change in the lease terms does not result
in a change in the classification of the lease.
Management has also reassessed all of the revised terms of the
lease liability as required by IFRS 9, Financial Instruments, and
concluded that the new terms are not substantially different from
the original ones. The change in terms of the lease liability is a
modification and not an extinguishment.
How should undertaking A reflect the change in the lease terms in
its 2005 financial statements?
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IAS 17 Leasing
The building continues to be accounted for as property, plant and
equipment and the carrying amount is not adjusted. However, the
remaining useful life of the building should be revised to reflect the
shorter lease term. This will result in the carrying amount being
depreciated over a shorter period.
This change to the depreciation period is applied prospectively. The
lease liability must be assessed under the guidance for
derecognition of financial liabilities in IFRS 9.
As a modification rather than an extinguishment, the lease liability is
amended by deducting from the current carrying amount the
additional one-off payment that is made immediately together with
the transaction costs.
The lease liability is then re-measured to the present value of the
revised future cashflows, discounted using the original effective
interest rate (IAS 39).
Any adjustment made in remeasuring the lease liability results in
the amount of the adjustment being recognised immediately as a
profit or loss in the income statement.
EXAMPLE- Sale and leaseback between related parties
Issue
A sale and leaseback transaction should be accounted for
according to the type of lease involved. The substance of the
transaction rather than the form of the agreement determines the
classification of the lease.
How should the fact that the sale and leaseback is between related
parties affect the classification of the arrangement?
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Background
Undertaking A sells a property to its subsidiary, B, and leases it
back. The property’s remaining useful life is 35 years and the lease
term is 5 years. The sales value and the lease rentals were
determined according to market values for similar properties in the
same area.
The lessee has no right under the terms of the lease to re-acquire
the property.
Solution
The lease will qualify as an operating lease.
The transaction will be eliminated in the consolidated financial
statements and the lease classification is irrelevant. However, the
single undertaking financial statements for each undertaking will
recognise the transaction. The duration of the lease is only a small
part of the property’s useful life, and the rent is set according to
market rates. The lease therefore appears to be an operating lease.
However, a characteristic of related party transactions is that they
are frequently conducted on non-arms length terms. Caution should
be exercised when determining if the criteria for an operating
leaseback have been met.
EXAMPLE- Sale and leaseback of a unique warehouse classification of a lease
Issue
A lease that transfers substantially all the risks and rewards of
ownership to the lessee should be classified as a finance lease.
Title may or may not eventually be transferred. An operating lease
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IAS 17 Leasing
is a lease other than a finance lease.
How should management classify a sale and leaseback of a unique
warehouse?
Background
Undertaking A, a supplier, developed a unique distribution
warehouse in a central location in the Netherlands. The distribution
warehouse was tailored for undertaking A, for example freezers,
fresh department and cross-docking stations.
The warehouse was sold to a finance undertaking, B, once it was
completed, and then leased back for a period of ten years. The
economic life of the warehouse is 30 years. Undertaking A should
return the building to undertaking B at the end of the lease term.
Significant alterations would need to be made to make the
warehouse suitable for use by others if it was leased to a different
user. A’s management expects to extend the lease.
Solution
Management should classify the lease as a finance lease at the
inception of the contract.
The warehouse has been developed for undertaking A and the
opportunities for alternative use are limited. The leased asset is of a
specialised nature such that only the lessee can use it without
major modifications being made. This is one of the reasons to
classify the agreement as a finance lease.
Agreements where the lessor is a finance undertaking rather than a
property developer may suggest that the lease is a finance lease.
The role of the finance undertaking is to provide A with financing
rather than to incur the risk of ownership.
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It is important to clarify that if the building were to be put back to
undertaking A at the end of the lease term, the arrangement would
be such that A borrows cash secured by the building. There is no
change of risks and rewards and there is no sale and no lease
[SIC-27].
IFRIC 4 - frequently asked questions (IFRS News - November
2006)
IFRIC 4, Determining whether an Arrangement contains a
Lease, was published on 2 December 2004 and applies to
annual periods beginning on or after 1 January 2006. Jan
Buisman and Kevin Klein look at some of the common issues
arising from practical application of the interpretation.
Many arrangements that are not leases in legal form convey the
right to use an asset for an agreed period of time. IFRIC 4 provides
guidance for determining whether these arrangements contain a
lease. The interpretation specifies that an arrangement contains a
lease if it depends on the use of a specific asset and conveys a
right to control the use of that asset. Current experiences indicate
that companies do not realise the broad impact of IFRIC 4, and the
transition guidance is not straight forward.
Which types of arrangements frequently contain a right of
use?
The interpretation is relevant to various types of arrangement,
including outsourcing (such as IT, logistics and catering),
purchase/sale, franchise and retail agreements. Many
arrangements require the use of assets to deliver a specific level of
service or product. Such arrangements must be reviewed in detail
to determine whether specific assets are utilised to deliver the
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IAS 17 Leasing
required level of service or produce, and which party to the
arrangement controls the assets.
IFRIC 4 – frequently asked questions
Solutions to some of the more frequently asked questions arising
from applying the interpretation are outlined below.
Application of the transition guidance
An undertaking adopting the interpretation may either apply it
(IFRIC4.17):
Specific asset
Is a specific asset the same as a uniquely identifiable asset?
(a) retrospectively in full; or
(b) only to arrangements existing at the start of the earliest period
for which comparative information is presented on the basis of facts
and circumstances existing at the start of that period.
An arrangement that contains a lease is accounted for under the
guidance in IAS 17. IAS 17 requires retrospective application back
to the inception of the lease.
The following is an example of the application of option (b) in
practice:
An undertaking with a year end of 31 December 2006 has an
arrangement that has been in existence since 1990. It may apply
IFRIC 4’s criteria in determining whether that arrangement
contained a lease on the basis of facts and circumstances at 1
January 2005 (the beginning of the comparative year).
Where the undertaking concludes that the arrangement contains a
lease, the classification of the lease is based on the facts and
circumstances in 1990; the transition adjustments recorded at 1
January 2005 are based on the application of IAS 17 since the
inception of the lease in 1990.
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No. A uniquely identifiable asset is a specific asset in terms of
IFRIC 4, but an asset does not need to be uniquely identifiable in
order to qualify as specific under IFRIC 4.
Can fulfilment of an arrangement be dependent on the use of a
specific asset if the supplier/service provider has the right to
substitute another asset when the specified asset is not
operating properly?
Yes. A warranty obligation that permits or requires the substitution
of the same or similar asset when the specific asset is not operating
properly does not provide relief from lease treatment. For example,
undertaking A leases aircraft 101 to undertaking B for a period of
five years. Undertaking A has the right to provide undertaking B an
identical substitute aircraft from its fleet in the event aircraft 101 is
not operating properly. This clause does not provide relief from
lease treatment.
Does the fact that an asset is explicitly mentioned in an
agreement make fulfilment of the arrangement dependent on a
specific asset?
Not necessarily, if the fulfilment of the agreement is not dependent
on the use has the right and the ability to use a different asset not
specified in the agreement for providing the services, the
arrangement would not be dependent on a specific asset.
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IAS 17 Leasing
An arrangement is not dependent on the use of a specific
asset if the supplier can use a different asset.
Does this mean that it must be probable that the supplier will
use a different asset?
No. The supplier must have the right and the ability to use a
different asset. The supplier has the ability to use a different asset if
it is commercially feasible and practical to use a different asset.
Ability or right to operate the asset or direct others to operate
the asset
IFRIC 4.9(a) refers to the purchaser’s ability or right to operate
the asset or direct others to operate the asset.
How can the purchaser direct others to operate the asset?
The ability or right to direct others to operate a specific asset is
distinct from adherence to agreed supply terms and goes further
than that. Examples of situations where the ability or right to direct
the operations of an asset is conveyed are:
-the purchaser has the ability to hire, fire or replace the operator;
-the purchaser has the ability to specify significant operating
policies and procedures in the arrangement (as opposed to the
right to monitor the supplier’s activities) with the supplier having
no ability to change such policies and procedures; and
-just-in-time delivery and the purchaser has the right to manage
and change deliveries on a very short-term basis (for example,
daily or hourly).
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Pricing
IFRIC 4.9(c) does not consider that an arrangement contains a
lease if the price paid is contractually fixed per unit of output.
How is a take-or-pay contract (ie, where a fixed amount is
payable each period irrespective of the output taken) treated
under IFRIC 4?
The price per unit of output in a take or pay contract is variable,
because the fixed amount is divided by a variable amount of output.
Can a price that is based on a formula where all the
parameters are outside the control of the contracting parties
be treated as contractually fixed per unit of output?
Is a price fixed for the purpose of IFRIC 4 if it is escalated with
a fixed increment or determinable based on a fixed formula?
No. ‘Contractually fixed per unit of output’ is interpreted literally – ie,
as a fixed monetary amount per unit of output that does not change
during the contract period.
A price based on a formula – such as a fixed increment – is not
contractually fixed per unit of output if the volume taken is not fixed.
For example, a price escalation clause based on inflation would not
meet the requirement for a ‘contractually fixed price per unit of
output’.
IFRIC 4.9(c) does not consider that an arrangement contains a
lease if the price paid is equal to the current market price per unit of
output at the time of delivery.
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IAS 17 Leasing
If the arrangement provides for pricing equal to the current
market price but is subject to a minimum (floor) or a maximum
(cap), would the pricing be considered to be ‘current market
price’?
No. Pricing arrangements including caps/floors would not be
considered to reflect the ‘current market price’ at the time of
delivery, because the price at delivery might be different from the
spot market price.
Portions of an asset, unit of account A supply contract where one
undertaking takes all of the output of an asset is in the scope of
IFRIC 4.9(c), provided that the price is not fixed per unit of output or
current market price.
Portions of an asset, unit of account
A supply contract where one undertaking takes all of the
output of an asset is in the scope of IFRIC 4.9(c), provided that
the price is not fixed per unit of output or current market price.
What happens if two parties take together all of the output,
50% each?
IFRIC 4 does not address the issue of portions; it has been
deliberately excluded from the scope of IFRIC 4. The above
situation does not necessarily constitute a lease, unless the
contract is caught under IFRIC4.9(a) or IFRIC4.9(b).
However, IFRIC 4.9(c) should be applied to arrangements in which
the underlying asset would represent a unit of account in either IAS
16 or IAS 38.
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Example
A power plant has two turbines and two customers. Each customer
enters into an arrangement whereby it will take all of the output of a
specified turbine.
Would both customers have a lease under IFRIC 4.9(c)?
Yes. Each of the two arrangements contains a lease. The situation
is different if each customer has an undivided interest in the whole
power plant.
Final thoughts
These frequently asked questions demonstrate that a detailed
analysis of a company’s arrangements against the criteria in IFRIC
4 is necessary in order to conclude whether an arrangement
conveys the right to use an asset that is accounted for as a lease
under IAS 17. Although there has been an increase in IFRIC 4
activity, there appear to be arrangements in various industries
waiting their turn to be analysed.
Outsourcing contracts: an accidental business combination?
IFRS News - March 2006
Dusty Stallings and Matthieu Moussy of PwC’s Global
Accounting Services group examine the financial reporting
implications of outsourcing contracts.
Outsourcing contracts are common. Many companies use
outsourcing contracts to reduce costs, increase efficiency and focus
on the core business. There are many different types of outsourcing
arrangements, and the financial reporting of them can be complex.
The expected outcome is generally that the outsourcing
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IAS 17 Leasing
arrangement will be treated as a service arrangement, but an
outsourcing contract may be classified as a business combination,
lease or service concession. Whether it is a business combination,
a lease, a construction contract or a service arrangement will
depend on the contract with the customer; but the assessment
requires management’s judgment.
Companies may outsource any or all functions they consider can be
done more efficiently by a third party. This can be a function as
peripheral as catering for a large head office or IT management for
a law firm. Other less obvious outsourcing contracts might be
private finance initiatives, contract drug manufacturing, prison
management and waste management services.
Financial reporting of these contracts raises several questions: is
there a business combination? How should upfront payments by
the outsourcer be treated? How should revenue and costs be
recognised? What are the potential implications of IFRIC 4? IFRIC
debated some of these questions as part of the Service Concession
Arrangements exposure draft; however, none have been definitively
answered, and the completion of an interpretation is not expected
soon.
Have you acquired a business ?
The first step in analysing an outsourcing transaction is to
determine whether a business combination has taken place. A large
outsourcing contract usually includes some of a company’s
significant processes. The company transfers assets, staff and
processes to the outsourcer. These three in combination should be
able to provide output on their own, which is a business as defined
by IFRS 3.
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Some factors such as a limited contract life can refute the business
combination conclusion. The transaction will give rise to a business
combination if full control is transferred to the outsourcer for the
expected useful life of the assets. A business combination is more
likely where the ‘outsourcee’ is assembling similar contracts to
extract synergies and asset efficiency. A business combination
results in the outsourcer recording assets and liabilities at fair value
and goodwill.
Accidental business combinations are seldom welcomed by senior
management or the investor community. It is difficult to assess
whether or not a contract results in a business combination,
particularly when existing customer processes are combined with
the existing processes of the outsourcer. The outsourcer should
therefore carefully assess agreements as they are being structured
to avoid unintended financial reporting effects.
Build and run components
A contract may require the outsourcer to build a platform to deliver
the service (for example, an IT platform, plant or large equipment).
This is often referred to as the ‘build’ phase of the contract, to be
followed by the ‘run’ phase. Management should assess whether
the build and run phases should be accounted for separately.
Factors to consider are whether the asset and the service are to be
delivered separately ie, the customer can use the asset separately
from the service and whether a reliable measure of revenue for the
asset and the service can be obtained.
The build element, when separable, is generally recognised in
accordance with IAS 11, Construction Contracts, as the item is
being built to the specifications of the customer as a result of a
negotiated contract. The run element is generally recognised as a
service contract in accordance with IAS 18, Revenue.
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IAS 17 Leasing
Run revenues and costs
Activities to be delivered under a run component of a bundled
outsourcing contract are usually services, either discrete or
continuous. Revenue should be recorded on a percentage-ofcompletion basis. However, the measurement of completion, given
the nature of the services delivered, is usually based on ‘output’
indicators (volumes of transactions, survey of interventions and
similar measures).
which of these up-front expenses relate to the implementation of a
specific contract, as opposed to costs incurred at its discretion to
modify or transform its own business.
This may depend on the maturity of the outsourcer’s business.
Some historical outsourcers are developing their structures to face
this demand; other corporations are setting up new outsourcing
businesses, often starting with their existing IT functions, while
many existing IT companies are expanding into outsourcing.
Measures of completion based on input measures such as costs
(cost-to-cost method) is not appropriate for such contracts, as it is
unlikely that cost incurred represents the progress of the service to
date. Revenue is generally recorded on a straight-line basis if
services to be delivered are performed by an ‘indeterminate number
of acts’.
For expenses that relate to the services to be delivered, work in
progress is recognised if the costs are recoverable. There will also
be numerous other costs (employee restructuring, transfer to a new
location, development of new processes) that are normal operating
costs of the business that should be expensed as incurred or that
may give rise to intangible or tangible fixed assets.
Certain contracts include the payment of an upfront amount by the
outsourcer to the customer. When services received for such a
payment are not identifiable, the payment usually represents the
granting of a discount. This is recognised as a reduction of revenue
over the service period of the contract.
Implications of IFRIC 4
Recognition of costs may be even more challenging than
recognition of revenue. Contract revenue and expenses ‘are
recognised respectively by reference to the stage of completion of
the contract activity’. Expenses in an outsourcing contract because
of the necessary start-up activities are often front-loaded.
Outsourcing is a developing industry, with an increasing number of
processes being transferred to outsourcers and requiring start-up
activities with significant front-loaded expenses. New contracts may
be signed at the same time as the outsourcer is adapting its
structure to offer new services. The outsourcer should determine
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IFRIC 4, Determining whether an Arrangement contains a
Lease, is effective from 1 January 2006. Most outsourcing
contracts include assets; these outsourcers will need to determine
whether their outsourcing contracts include a lease.
The challenge is to assess whether specific assets exist in the
arrangement. This determination should be made on an asset-byasset analysis. This includes obtaining a precise understanding of
the use of the asset: is the service based on that specific asset, or
could it be delivered, in accordance with the terms of the contract
by other means?
For example, a catering outsourcer may provide meals for a
customer from its central facilities, which are also used for other
customers; conversely, it may use a dedicated facility constructed
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IAS 17 Leasing
solely for the purpose of that customer’s contract. If the asset is
used solely for the company, it would be a lease of the specific
asset by the customer. The asset is not deemed specific to the
customer if the outsourcer uses the asset for a number of
customers, and no lease would exist.
If the Easter Bunny is an asset of the distributor, the first criterion
will be met as the distributor can use only the Easter Bunny to
deliver the eggs.
Example - Arrangement containing a lease
The manufacturer is effectively paying for the availability of the
Easter
Bunny for the period from January to May therefore also has a right
to use that asset.
An Easter egg manufacturer outsources distribution of its products.
The outsource agreement specifies that the eggs are to be
delivered by the
Easter Bunny, and gives the manufacturer exclusive use of the
Easter Bunny from January to May for a fixed fee for the period.
The arrangement contains an operating lease so the lease element
of the arrangement should be accounted for under IAS 17.
Multiple choice questions
Is this an arrangement that should be accounted for in accordance
with IAS 17?
Yes. IFRIC 4, Determining Whether an Arrangement Contains a
Lease, is based on the substance of the arrangement and requires
an assessment of whether:
■ fulfilment of the arrangement is dependent on the use of a
specified asset or assets; and
■ the arrangement conveys a right to use the asset (IFRIC 4.6).
1. A non-cancellable lease is a lease that is cancellable only:
1. Upon the occurrence of some remote contingency.
2. With the permission of the lessor.
3. If the lessee enters into a new lease for the same, or an
equivalent asset, with the same lessor.
4. Upon payment, by the lessee, of such a large amount that
the lease is unlikely ever to be cancelled.
5. Any of 1-4.
The manufacturer will first need to determine whether the Easter
Bunny is an asset of the distributor.
The definition of an asset includes a requirement for the
undertaking to control that resource. A rabbit would meet the
definition of a biological asset in IAS 41, Agriculture; therefore the
distributor can be deemed to ‘control’ the
Easter Bunny.
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IAS 17 Leasing
2. Minimum lease payments are:
(i). Payments over the lease term for the goods leased.
(ii) Finance charges.
(iii) Amounts guaranteed by the lessee.
(iv) Contingent rent.
(v) Costs for services.
(vi) Taxes
1.
2.
3.
4.
5.
6.
(i)
(i)-(ii)
(i)-(iii)
(i)-(iv)
(i)-(v)
(i)-(vi)
3. You lease a car to a client for 4 years. The cost of the car is
$40.000. The anticipated residual value at the end of the lease
is $10.000. A dealer gives you a guarantee to purchase the car
for $8.000 (at the end of the lease). The remaining $2.000 is:
1. Contingent rent.
2. The unguaranteed residual value.
3. The fair value.
(i) The lease transfers ownership of the asset to the lessee by the
end of the lease.
(ii) The lessee has the option to purchase the asset at an attractive
price.
(iii) The lease term is for the major part of the economic life of the
asset, even if title is not transferred ( >75%).
(iv) The present value of the minimum lease payments amounts to
substantially all of the fair value of the leased asset (>90%).
(v) The leased assets are of such a specialised nature that only the
lessee can use them, without major modifications.
1.
2.
3.
4.
5.
(i)
(i)-(ii)
(i)-(iii)
(i)-(iv)
(i)-(v)
4. Gross investment in the lease is the
1. Aggregate of:
2. Higher of:
3. Lower of:
4. Average of:
the minimum lease payments receivable by the lessor under a
finance lease, and
any unguaranteed residual value accruing to the lessor.
5. Examples of situations that would normally lead to a lease
being considered to be a finance lease are:
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IAS 17 Leasing
6. Indicators of situations that could also lead to a lease being
classified as a finance lease are:
(i) If the lessee can cancel the lease, the lessor’s losses associated
with the cancellation are borne by the lessee.
(ii) Gains, or losses, from the change in the fair value of the residual
accrue to the lessee (for example, in the form of a rent rebate
equalling most of the sales proceeds at the end of the lease).
(iii) The lessee has the ability to continue the lease for a secondary
period, at a rent that is substantially lower than market rent.
(iv) If the lease does not transfer substantially all risks and rewards
of ownership.
1.
2.
3.
4.
(i)
(i)-(ii)
(i)-(iii)
(i)-(iv)
7. Leases of land and of buildings are classified as:
1. Operating leases.
2. Finance leases.
3. Either.
8. For the purposes of lease classification, the land and
buildings elements of a lease are considered:
1. Separately.
2. Together.
3. Either 1 or 2.
9. The minimum lease payments are split between the land and
the buildings elements, in proportion to their:
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1. Contingent rents.
2. Relative fair values.
3. Economic lives.
10. Calculation of the net present value removes the:
1. Interest component of a lease.
2. Capital component of a lease.
3. Both components.
11. Leased assets appear on the balance sheet in the case of:
1. Operating leases.
2. Finance leases.
3. All leases.
12. Lease liabilities are:
1. Current liabilities.
2. Non-current liabilities.
3. Split between 1 and 2.
13. Any initial direct costs of the lessee, such as negotiating
and securing finance leasing arrangements, are:
1. Added to the amount recorded as an asset.
2. Expensed immediately by the lessee.
3. Added to contingent rent.
14. At the start of the lease:
1. Most of the payment is capital, with a small element of
interest.
2. Most of the payment is interest, with a small element of
capital.
3. The capital and interest payments are equal.
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IAS 17 Leasing
15. Contingent rents must be:
1. Charged as expense.
2. Added to the lease liability.
3. Prepaid at the start of the lease.
16. A finance lease gives rise to depreciation expense for
depreciable assets. The depreciation policy shall:
1. Match the period of the lease.
2. Match that for depreciable assets that are owned.
3. Be the average of 1 & 2.
17. If the lessee will not obtain ownership by the end of the
lease term, the asset is depreciated over the:
1. Shorter of the lease term, and its useful life.
2. Longer of the lease term, and its useful life.
3. The average of 1 & 2.
18. An undertaking shall disclose the total of future
minimum lease payments at the balance sheet date, and their
present value, for each of the following periods:
(i) Not later than one year;
(ii) Later than one year and not later than five years;
(iii) Later than five years.
1. (i)
2. (i)-(ii)
3. (i)-(iii)
19. Lessors shall record assets, held under a finance lease:
1. As a receivable.
2. As held-for-sale assets.
3. As a leased asset.
20. Costs incurred by manufacturer, or dealer lessors, in
connection with negotiating and arranging a lease, are:
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1. Included in the definition of initial direct costs.
2. Recorded as an expense at the start of the lease term.
3. Added to the residual value.
21. The sales revenue recognised at the start of the lease term,
by a manufacturer, or dealer lessor, is:
1. The fair value of the asset.
2. The present value of the minimum lease payments,
computed at a market rate of interest.
3. The higher of 1 & 2.
4. The lower of 1 & 2.
22. If a sale and leaseback transaction results in a finance
lease, any excess of sales proceeds over the carrying amount
shall:
1. Be immediately recognised as income by a seller-lessee.
2. Be deferred, and amortised, over the lease term.
3. Be recognised at the end of the lease.
23. If a sale and leaseback transaction results in an operating
lease, and
it is clear that the transaction is established at fair value, any
profit or
loss shall:
1. Be recognised immediately.
2. Be deferred, and amortised, over the lease term.
3. Be recognised at the end of the lease.
24. For operating leases, if the fair value at the time of a sale
and leaseback transaction is less than the carrying amount of
the asset, a loss equal to the amount of the difference between
the carrying amount and fair value shall:
1. Be recognised immediately.
2. Be deferred, and amortised, over the lease term.
3. Be recognised at the end of the lease.
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IAS 17 Leasing
Answers to multiple choice questions
Question
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
Answer
5
3
2
1
5
3
3
1
2
1
2
3
1
2
1
2
1
3
1
2
4
2
1
1
Note: Material from the following PricewaterhouseCoopers publications has been
used in this workbook:
-Applying IFRS
-IFRS News
-Accounting Solutions
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