IAS 17 - Leases (detailed review)

Wednesday, February 5, 2014 Print Email

Objective

This Standard deals with the accounting treatment of Leases for lessor and lessee and
related disclosure requirements.

Scope

-  The requirements of this standard are applicable for the accounting treatment of leases, except for the following:

(a) The lease contracts to explore for or use minerals, oil, natural gas and similar non- regenerative resources; and

(b) The licensing agreements for intangible items such as picture films, plays, patents and copyrights

 

-  Following are not covered by the measurement requirements of this standard

(a) The property held by lessee which is accounted for as investment property, covered under IAS 40

(b) The investment property leased out by lessor under one or more operating leases, covered under IAS 40)

(c) The biological assets held by lessee under finance leases, which are covered under IAS 41

(d) The biological assets leased out by lessor under operating leases see IAS 41

 

Definitions

Lease

It is a contract under which one party (Lessor) conveys the right of use of asset to another party (Lessee), against rental or series of rents, for a specified time period.

Finance Lease

It is when risk and rewards related to the ownership of asset are substantially transferred to lessee under the lease contract.

Operating lease

Any lease contract other than finance lease.

Non-Cancellable Lease

It is a lease, which is cancellable under the following few circumstances:

(a) By the mutual consent of lessor and lessee both

(b) Upon the happening of a remote contingency

(c) If the lessee enters into a replacement lease contract, with the same lessor for an equivalent asset

(d) Upon payment of damages by lessee specified in the lease contract

Inception Date

It is the date when lessor and lessee both agree on, regarding the material terms and conditions of the lease contract such as the nature of the lease, rentals, interest rate and lease term. It is normally before the agreement and commencement date.

Commencement Date

It is the date when lessee starts the use of asset, and both parties to the lease contract will start lease accounting in their respective books such as recognition of lease asset, liability, income and expenses.

Lease Term

It is the period of the lease contract. It has two parts

  • Non-Cancelable Part: It is the time period, for which lessee has entered into the lease contract. It is also called Primary Period.
  • Optional Part:It is offered by lessor, for which lessee has the option to re-lease the asset at the end of primary period. It will become the part of lease term, if on the date of inception it is reasonably certain that lessee will avail this optional part.

Minimum Lease Payments

These are the payments over the lease term. These are determined as follows

If asset revert back to the lessor at the end of lease term, MLP’s will be:

(a) For lessor. Payments over the lease term plus guarantee residual value by lessee, any party related to lessor or any third party unrelated to lessee

(b) For lessee. Payments over the lease term plus guarantee residual value by lessee or any party related to lessee

If title of the asset will transfer to the lessee or bargain option exists

(a) For lessor. Payments over the lease term plus bargain purchase price, if any

(b) For lessee. Payments over the lease term plus bargain purchase price, if any

However, contingent rentals and any service costs related to asset are not the part of minimum lease payments. Theses will be recorded separately in the relevant period.

Contingent Rental

It is the payment that is not fixed in amount and is dependent upon some future factor which changes other than with the passage of time such as future use and future market rates of interest.

Fair value:

It is the amount that is expected to be received to sell an asset or required to be paid to transfer a liability in an orderly transaction between market participants at the date of measurement (IFRS 13).

Useful Life:

It is the period of time, from the start of the lease term for which asset will be used by the management.

Guaranteed Residual Value

  • For Lessee: The portion of residual value, which is guaranteed by lessee, or any party related to lessee and could be payable upon a specified event
  • For lessor:  The portion of residual value, which is guaranteed by lessee, or any party related to lessee, or any third party unrelated to lessor.

Initial Direct Costs

The costs which arise directly in negotiating and arranging the lease contract, except for the costs incurred by the manufacturer or dealer lessor

Gross Investment into Lease

It is the sum of minimum lease payments receivable by the lessor under a finance lease and any unguaranteed residual value.

Net Investment into lease

 It is the present value of gross investment in the lease, discounted using the interest rate implicit in the lease.

Unearned Finance Income

It is determined as the difference between the gross investment in the lease and the net investment in the lease.

Interest Rate implicit in the Lease

It is the discount rate at which the present value of:

(a) The sum of the minimum lease payments and the unguaranteed residual value becomes equal to

(b) The sum of the fair value of leased asset and any initial direct costs of the lessor

Lessee’s incremental Borrowing Rate of Interest

It is the rate of interest that the lessee would have to pay on a similar lease or the lessee would have to incur to borrow the funds necessary to purchase the asset on similar terms at the inception date.

Classification of Leases

  • The classification of leases depends upon which party (lessor or lessee) owns the risks and rewards related to the leased asset.
  • The contract will be finance lease if substantial risks and rewards related to the ownership of the asset are transferred to the lessee along with the asset.
  • The contract will be operating lease if the substantial risks and rewards related to the ownership of the asset are not transferred to lessee and rest with lessor.
  • The contract will be classified as finance lease if it satisfies one of the following conditions:

(a) The title of the asset will be transferred to the lessee at the end of lease term

(b) Lessee has the bargain purchase option in the lease contract

(c) Lessee uses the major part of economic life of the asset

(d) The present value of MLP’s is significantly equal to the fair value of asset.

(e) The leased asset is specialized in nature.

The following also indicates the nature of the lease to be finance lease

(a) The lessee is required to pay damages if the lease contract is cancelled

(b) The lessee has participation in the increase or decrease of the residual value of leased asset

(c) The lessee has optional part in the lease contract

  • The above mentioned conditions for finance lease are not conclusive. If the facts and circumstances indicate that the substantial risks and rewards related to the ownership are not transferred then the contract will be classified as operating lease.
  • The classification of Lease is determined on the date of inception
  • If during the lease term the lessor and lessee both agree to change the terms of the lease contract, other than the renewal of lease, and such change in terms results in a different classification of the lease contract, then the revised agreement is regarded as a new lease contract over its term.
  • Any lease contract, other than finance lease is called operating lease.

Leases of Land & Building

  • For the contracts involving both land and building elements, the lease classification will be determined for each element separately.The land element will be regarded as operating lease as the land has indefinite economic benefits, unless and until the title of such land is transferred to the lessee at the end of the lease term and the building element will be classified as per the nature of the contract. The rental paid will be divided between the land and building elements on the basis of their relative fair value of each element at the date of inception and will be accounted for in accordance with the nature of each element separately.
  • If the lease rental cannot be allocated reliably between these two elements, then the whole contract will be classified as finance lease, unless it is clear that both elements are operating leases. In such a case the whole contract will be classified as operating lease.
  • For the contracts involving land and building element both, if the land element has immaterial cost, then in such a case both land and building element will be treated as single unit for the purpose of lease classification, and the economic life of the building element will be deemed as the life of entire lease contract.

Finance Lease in the Financial Statements of Lessee

Initial Recognition and Measurement

(a) The fair value of asset and

(b) The present value of minimum lease payments at inception date

  • The entity will determine the present value of minimum lease payments using interest rate implicit in the lease. If interest rate implicit in the lease is not determinable then the entity will use lessee’s incremental borrowing rate.
  • Any directly related cost in negotiating the lease contract will be added to the cost of asset.

Subsequent Measurement

  • At Reporting date, the lease rental paid will be allocated between the principal amount and the finance charge. The principal amount will reduce the recognized lease liability and the finance charge will be reported in the statement of profit or loss. Any remaining lease liability will be classified into current and non-current portion and will be presented in the statement of financial position.
  • Any contingent rental paid will be recorded as separate expense in the statement of profit or loss.
  • The leased asset will be depreciated as per the appropriate method using the rules of IAS 16 for depreciation.
  • If asset will revert back to the lessor at the end of lease term , then asset will be depreciated at lower of: (a) Lease term; (b) Useful life of the asset.
  • If title of the asset will transfer to the lessee at the end of lease term, then the asset will be depreciated over its useful life.

Operating Lease in the Financial Statements of Lessee

  • The lessee will not recognize any lease asset or liability for operating lease as the substantial risks and rewards rest with the lessor.
  • The lessee will only recognize the lease rental as expense on the statement of profit or loss on straight line basis over the lease term.

Disclosure

  • The Standard requires the entity to disclose the following:
  • The carrying value of asset for each class of asset at reporting date
  • Statement showing reconciliation between the total future minimum lease payments and their present value
  • Any contingent rental recognized as expense in the current reporting period
  • Any expected future receipts from sublease
  • A description of the lease contract terms such as renewal option and bargain purchase option
  • For operating leases, any expense recognized in the current period

 

Finance Lease in the Financial Statements of Lessor

Initial Recognition and Measurement

  • The leased asset will be no more reflected in the financial statements of the lessor as the substantial risk and rewards related to the ownership of the asset are transferred to the lessee along with the asset.
  • The lessor will only recognize lease receivable equal to net investment in the lease in its statement of financial position.
  • In case of financial institute as a lessor, the initial direct cost will be added in the amount of lease receivables. However, for manufacturer dealer lessor, such initial direct cost will be charged to the statement of profit or loss as an expense.
  • In case of manufacturer dealer lessor the asset under lease agreement will be treated as the sale of the lessor therefore, the manufacturer dealer lessor will also recognize the profit or loss on the sale in the relevant accounting period as per the accounting policy of the entity.

Subsequent Measurement:

The lease rental received will be allocated between the principal portion and finance income using the lessor’s rate of return on the net investment. The principal portion will reduce the lease receivables and the finance income will be recognized in the statement of profit or loss.

Operating Lease in the Financial Statements of Lessor

  • The asset subject to lease will continue to be recognized in the statement of financial position of lessor as the substantial risk and rewards related to the ownership of the asset are not transferred to the lessee and rest with the lessor.
  • The lessor will only recognize the lease rental receivable as income in the statement of profit or loss, on straight line basis over the lease term.
  • The lessor will depreciate the leased asset using appropriate method using the rules of IAS 16.

Disclosures

  • The Standard requires the entity to disclose the following:
  • Statement showing reconciliation between the amount of gross investment in the lease and the present value of minimum lease installment receivable at the end of the accounting period.
  • The amount of unearned finance income
  • The amount of Un-guaranteed residual value
  • Any allowance for irrecoverable lease receivable
  • Any contingent rental recognized in the current reporting period as income
  • An explanation of the lease contract terms such as renewal option and bargain purchase option

 

Sale and Leaseback transactions

  • A sale and leaseback transaction involves the sale of an asset and the leasing back the same asset from the new owner. The entity will account for such arrangements as per the type of lease involved.
  • If a sale and leaseback arrangement results in finance lease back arrangement, the asset will be recorded as leased asset in the financial statements of the seller (lessee) with a correspondent lease liability, and any excess of sale proceeds over the carrying value will not be immediately recognized as income by the seller (lessee). Instead, it will be deferred and amortized as income over the lease term.
  • If a sale and lease back transaction results in an operating lease, this will be treated as disposal of the asset as the risks and rewards are transferred to the new owner, and the resulting gain or loss will be treated as follows:

(a) If the sale proceeds are equal to fair value, any profit or loss will be recognized in statement of profit or loss.

(b) If the sale proceeds are less than the fair value, any profit or loss on disposal will be recognized immediately in statement of profit or loss. However in case of loss, if there is compensation available in the form of low future rentals than market terms, then the loss will be deferred and it will be recognized over the lease term.

(c) If the sale proceeds are above the fair value, the gain or loss up to the extent of fair value will be recognize immediately, however the excess over fair value will be deferred and amortized over the lease term.

  • In case of sale and operating leaseback arrangement, if the fair value of asset at the time of sale and leaseback is less than its carrying value, then the difference will be treated as impairment loss.

 

Worked Examples

Example-1 (Finance lease in the books of lessee)

AB Ltd. acquired a Plant on a finance lease on 1 January 20X5. The terms of the lease contract were as follows:

Initial Deposit: $2,300 (non-refundable)
Lease Installments: $8,000 p.a. for seven years payable in arrears
Fair Value of Asset: $40,000

The asset has useful life of four years and the interest rate implicit in the lease is 11%.

Required

Prepare extracts of the statement of profit or loss and statement of financial position for AB Ltd. for the year ending 31 December 20X5.

Solution:

STATEMENT OF PROFIT OR LOSS

31-12-X5

 

$

Depreciation (W1)

(10,000)

Finance costs (W2)

(4,147)

 

 

STATEMENT OF FINANCIAL POSITION

 

Assets

 

Non-current assets

 

Leased Asset ($40,000 – ($40,000/4))

30,000

Non-current liabilities

 

Finance lease liabilities (W2)

29,572

 

 

Current liabilities

 

Finance lease liabilities ($8,000 - $3,727)

4,277

 

Workings

(W1) Depreciation Expense = $40, 000 / 4years = $10,000 pa

(W2) Lease Repayment Schedule for theyear ended 31 December 20X5

 

 

Liability at 1.1.X5

40,000

Initial Deposit at 1.1.X5

(2,300)

   

37,700 

Interest Expense1.1.X1 – 31.12.X5 at 11%

4,147

Lease Installment at 31.12.X5

(8,000)

Liability c/dat 31.12.X5

33,847

Year ended 31 December 20X6

 

Interest Expense 1.1.X6 – 31.12.X6at 11%

3,723

Lease Installmentat 31.12.X6

(8,000)

Liability c/dat 31.12.X6

29,572

 

Example 2

AB Ltd. owns an office building on which it decided to raise finance. Therefore, the entity sold the office building for $10 million to a finance house on 1 January 2013 when the office building was valued at $7 million. On the same date, the entity leased back the same office building from the finance house for a period of 20 years, which constitutes to be equivalent to the majority of the asset’s economic life. The lease rentals for the period are $882,000 payable annually in arrears. The interest rate implicit in the lease is 7%. The present value of the minimum lease payments is the same as the sale proceeds.

Required
How the property will be accounted for in the financial statements of AB Ltd. for the year ended 31-12-2013.

Solution:

A lease is classified as a finance lease if substantial risks and rewards related to ownership are transferred to the lessee. All other leases are classified as operating leases. Following are the situations which normally lead to a lease being classified as a finance lease:

(a) The title of the asset will be transferred to lessee at the end of lease term

(b) Lessee has the bargain purchase option in the lease contract

(c) Lessee uses the major part of economic life of the asset

(d) The present value of MLP’s is significantly equal to the fair value of asset.

(e) The leased asset is specialized in nature.

The classification is made on the date of inception.

  • In this case, as the lease back of the building is for the major part of the building’s economic life and the present value of the minimum lease payments amounts to all of the fair value of the leased asset. Therefore the lease should be recorded as a finance lease.
  • The building will be de-recognized with its carrying value and then will be reinstated as leased building at its fair value of $10 million with a correspondent lease liability with the same amount. The disposal gain of $3 million ($10m – $7m), on this transaction will be deferred and it will be recognize over the lease term.
  • The leased building will be depreciated over the useful life of20 years.
  • The lease rental paid will be allocated between the principal amount and the finance charge, the principal amount will reduce the recognized lease liability and the finance charge will be reported in the statement of profit or loss. Any remaining lease liability will be classified into current and non-current portion and will be presented in the statement of financial position as follows:

STATEMENT OF PROFIT OR LOSS

31-12-13

 

$’000

Depreciation (W1)

(500)

Finance costs (W2)

(700)

Amortization of Disposal Gain

150

 

 

STATEMENT OF FINANCIAL POSITION

 

Assets

 

Non-current assets

 

Leased Asset ($10,000 – ($10,000/20))

9,500

 

 

Non-current liabilities

 

Finance lease liabilities (W2)

9,623

Defer Gain ($3,000 - $150)

2,850

 

 

Current liabilities

 

Finance lease liabilities ($882 - $687)

195

 

Workings

(W1) Depreciation Expense = $10,000 / 20 years = $500 pa

(W2) Lease Repayment Schedule for the year ended 31 December 2013

 

$

Liability at 1.1.13

10,000

Interest Expense1.1.13 – 31.12.13 at 7%

700

Lease Installment at 31.12.13

(882)

Liability c/dat 31.12.13

9,818

Year ended 31 December 2014

 

Interest Expense 1.1.14 – 31.12.14 at 7%

687

Lease Installment at 31.12.13(882)

 

Liability c/d at 31.12.13

9,623

 

 (W3) Amortization of Disposal Gain = $3000 / 20years = $150

 

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