Determining deferred tax TAXATION

Chapter 16 – Leases Page 202 3 Objectives, Scope and Definitions of IAS 17 IAS 17 sets out the appropriate accounting treatment and disclosures for lease transactions in the financial statements of an entity; it should be applied in accounting for all lease transactions except those that are specifically identified below. IAS 17 sets out the accounting requirements for both lessees and lessors. IAS 17 does not apply to: [IAS 17.2]  lease agreements set up for the exploration or use of minerals, oil, natural gas and similar non-regenerative resources; and  licensing agreements that are entered into for items such as motion picture films, video recordings, plays, manuscripts, patents and copyrights. In addition, the measurement basis of IAS 17 does not apply to items which, due to their unique nature, are specifically addressed in other international standards. Examples include:  properties that are recognised as investment properties in accordance with IAS 40 Investment property; and  biological assets that are held by a lessee under finance lease arrangements or provided by a lessor under an operating lease and accounted for in accordance with IAS 41 Agriculture. A ‘lease’ is a transaction between two parties, a lessor and a lessee, whereby the right to use an asset is transferred to the lessee in return for a defined series of payments to the lessor. IAS 17 applies even if under the terms of the lease the lessor provides substantial services in connection with the operation or maintenance of the asset. An example of such a service would be the provision of ongoing security arrangements for the asset. [IAS 17.3, 17.4] IAS 17 identifies two types of lease transaction: [IAS 17.4]  a finance lease which “is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. Title may or may not eventually be transferred”; and  an operating lease which is “a lease other than a finance lease”. Chapter 16 – Leases Page 203 4 Substance over Form In the IASB Framework, one of the key qualitative characteristics of financial statements is reliability. For information to be reliable, it should faithfully represent transactions, which should be recognised in accordance with their commercial substance, not merely their legal form. The accounting for a lease is an example of the application of this concept, because the classification of a lease as either a finance lease or an operating lease depends on the substance of the transaction rather than the legal form of the contract. The illustration below shows how the substance of a finance lease may differ from its legal form. Illustration 1 P needs to buy a new item of plant and machinery which would cost CU100,000 if bought for cash and which has a useful life of five years. P has no surplus cash available and has identified the following two financing options: Option 1 Borrow CU100,000 from a bank. This loan is repayable in five annual instalments of CU24,000 each each instalment including interest of CU4,000. The cash transaction will be accounted for by recording: a an asset for the purchase of the new item of plant and machinery at CU100,000; b a liability of CU100,000 to the bank; c as each annual instalment is paid, a reduction in cash of CU24,000, a reduction in the liability of CU20,000 and interest of CU4,000 recognised in profit or loss; and d depreciation of CU20,000 per annum recognised in profit or loss. Option 2 Ask the leasing division of the bank to purchase the plant and then lease it from that division in return for paying five annual lease instalments of CU24,000 each. Without IAS 17 the transaction would involve recognising in profit or loss the annual rental instalments of CU24,000 as they become payable. Issue The two accounting treatments are different and have a significant impact on the ‘picture’ presented by the financial statements. In Option 2 no asset or debt is recognised in the statement of financial position and hence no finance cost or depreciation is recognised in profit or loss. The substance of these two options is, however, the same, since P:  has possession and use of the asset for the whole of its five year useful life; and  is paying a total of CU120,000 for the use of the asset – CU20,000 more than its cash price, so CU20,000 is interest In substance, P has ‘bought’ the asset under both options, and the bank has provided the finance. The only real difference is that under Option 2 the entity never gets legal title. Option 2 would allow P to avoid showing debt in the statement of financial position and take advantage of a form of financing that is not recognised in the financial statements. Chapter 16 – Leases Page 204 Where a series of related transactions take place which involve the legal form of a lease, an entity should consider carefully whether the transactions are independent of each other or are, in fact, part of one transaction and should therefore be linked. An example of where it may be appropriate to link a series of transactions is a sale of an asset, which is then leased back to the original entity soon after the original transaction. In such circumstances the overall substance of the transaction may be considered to be one of financing rather than, for example, a sale where a profit was made and recognised. The Standing Interpretations Committee published SIC 27 Evaluating the substance of transactions involving the legal form of a lease to help preparers identify the substance of series of transactions. SIC 27 confirms that the accounting treatment for a series of linked lease transactions should be in accordance with IAS 17 where the substance of the transactions is such that there is a right to use an asset for a specified period of time. It is becoming increasingly common for businesses to enter into different types of arrangements with other businesses, often in the same industry, which although not taking the legal form of a lease, include the characteristics of a lease arrangement. An example of such an arrangement is where a supplier in the telecommunications industry provides a contractual right to purchasers to use its network capacity or where a supplier provides the use of an infrastructure asset to a purchaser. The International Financial Reporting Interpretations Committee IFRIC issued IFRIC 4 Determining whether an arrangement contains a lease to provide guidance for determining whether such arrangements contain a lease and should therefore be treated for in accordance with IAS 17. IFRIC 4 has wider applicability than just those arrangements that are called “leases”. There are elements of some supply contracts and outsourcing arrangements that, although not legally defined as a lease, have the characteristics of a lease the right to use an asset for a specified period of time for payment and hence should be recognised as such. In assessing whether an arrangement contains a lease, an entity should consider whether the arrangement is reliant on the use of a specified asset and whether the arrangement provides a right to use that specified asset. This assessment should take place at the start of any new arrangements, when there is a change in the contractual terms of the arrangement, when a renewal option has been exercised under the arrangement or when the asset that the entity has the right to use under the arrangement has substantially changed in some way. The assessment of whether a lease identified in such an arrangement is a finance or operating lease should be made, based on the guidance in IAS 17. The payments under the arrangement should be separated, based on their relative fair value to the arrangement as a whole. Illustration 2 A distributor of chemicals enters into a tolling agreement with a chemical producer. The producer agrees to build a bespoke facility to manufacture chemicals exclusively for the distributor. The useful life of the facility is estimated at ten years, which is the same period as the tolling agreement between the two parties. The facility is designed to meet only the distributor’s needs. The distributor must pay a fixed capacity charge per annum irrespective of whether it takes any of the facility’s production. It also pays a variable charge based on the actual production taken, which amounts to approximately 90 of the facility’s total variable costs. This arrangement contains a lease. The asset in the agreement is the facility and fulfilment of the agreement is dependent on that facility which is bespoke for the distributor’s requirements. The distributor has obtained the right to use the factory as it is bespoke for its needs and could not reasonably be used for another purpose. The price it will pay per unit is neither fixed nor equal to the market price at time of delivery.