Chapter 16 – Leases Page 207
6 The Accounting Treatment by Lessees
6.1 An overview
The following section provides a basic overview of the recognition requirements for the two types of lease.
Finance lease recognition Statement of financial position
Recognise a non-current asset Recognise a liability for the lease obligation i.e. the total payments outstanding
including repayment instalments and finance charges accrued to date Statement of comprehensive income
Recognise a charge for the depreciation of the non-current asset Recognise a finance charge for the year
Operating lease recognition Statement of comprehensive income
Recognise the lease instalment charge for the year. The classification of a lease as finance or operating is made at the inception of the lease and
should only be revisited if changes to the lease conditions are made which, if made at the outset, would have resulted in a different classification.
The ‘inception’ of the lease is the earlier of: [IAS 17.4] the date of the lease agreement; and
the date that a commitment is made by the parties to the principal provisions under the lease agreement.
The inception date is also of particular importance for a finance lease as it is the date at which the values for the asset and liability are determined.
The ‘lease term’ is the non-cancellable period for which the lessee has contracted to lease the asset, plus any extension which is likely to be taken up by the lessee. This period is the useful
life for a finance lease asset’s depreciation charges and the period over which operating lease payments are recognised in profit or loss.
6.2 Finance lease recognition
6.2.1 Initial recognition
A lessee should recognise an asset and liability in its statement of financial position at the commencement of the lease term. The amounts should be recorded at the fair value of the
asset or, if lower, the present value of the minimum lease payments, determined at the inception of the lease. [IAS 17.20]
The present value of the minimum lease payments is calculated by establishing the minimum lease payments due under the lease, as explained above, and discounting them to take
account of the time value of money. [IAS 17.20]
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If the minimum lease payments under the lease including any unguaranteed residual value, i.e. the amount that the asset could be sold for at the end of the lease term that is not
guaranteed by the lessee are discounted at the ‘interest rate implicit in the lease’, the result should equal the fair value of the leased asset. Any initial indirect costs incurred by the lessee
are added to the asset’s cost. [IAS 17.4, 17.20]
Initial direct costs are incremental costs that are directly attributable to “negotiating and arranging a lease”. [IAS 17.4]
6.2.2 Depreciation
Since under a finance lease a non-current asset is recognised in the lessee’s statement of financial position, IAS 17 also requires the asset to be depreciated in accordance with IAS 16
Property, plant and equipment. The asset should be depreciated over its useful life or, if there is no reasonable certainty that the lessee will obtain ownership of the asset at the end of the
lease term, the period of the lease if that is shorter. The depreciation policy for leased assets should be consistent with those of legally owned assets. [IAS 17.27]
Illustration 4
On 1 January 2007 an entity enters into a finance lease for a photocopier with a fair value of CU8,000. The lease term is for 3 years, with no option to extend, and the copier will be
returned to the lessor at the end of the 3 years. The present value of the minimum lease payments is CU7,600.
The copier should therefore be initially recognised at CU7,600, which is the lower of the fair value and the present value of the minimum lease payments.
The useful life of the copier is estimated to be 4 years with a nil residual value. The entity operates a straight-line method of depreciation.
The depreciation charge on the copier in 2007 is: CU7,600 3 years = CU2,533
Because the lessee will not gain ownership at the end of the 3 year period, the copier is depreciated over a 3 year period being the shorter of the lease term and the asset’s useful
life.
6.2.3 Finance charge
Each instalment made under a finance lease consists of a mixture of a finance charge and the repayment of capital. [IAS 1 7.25]
The total finance charge over the total period of the lease is: CU
Total lease rentals X
Less: initial finance lease obligation being the lower of fair
value and PV of the minimum lease payments X
Total finance charges X
The total interest cost should be recognised in profit or loss over the accounting periods for which the lease liability is in existence. This is from the start of the lease until the last
repayment is made.
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The period over which the lease liability is in existence is not necessarily the same as the term of the lease. For example, if lease rentals are paid annually in advance, the lease
finance will be paid off when the final payment is made at the start of the last year, but the lease term will include the last year, even though no liability will remain.
6.2.4 Methods of allocating finance charges
IAS 17 requires the total finance charge to be allocated over accounting periods so as to produce a constant periodic rate of interest on the outstanding lease obligation. [IAS 17.25]
The two main ways of allocating the finance charge to accounting periods are the actuarial method and the sum of digits methods. The sum of digits method provides an approximation
to the actuarial method. This approximation is permitted on the grounds of practicality.
6.2.4.1 Actuarial method
The actuarial method charges interest at a constant percentage on the outstanding liability and therefore matches the interest to the ‘loan’ balance. This is the most accurate method,
but to apply it, the rate of interest implicit in the lease is required.
The interest charge for each period is the interest rate multiplied by the balance remaining immediately after a rental payment has been made.
Illustration 5
An entity entered into a five year finance lease on 1 January 2007. The fair value of the leased asset was CU11,500. Lease rentals of CU3,034 are payable annually in arrears on
31 December each year. The rate of interest implicit in the lease is 10.
The asset is included in non-current assets at its fair value of CU11,500 and depreciated over the five year term.
The finance charge for the year to 31 December 2007 is calculated on the outstanding balance of CU11,500. The finance cost will be CU1,150.
At 31 December 2007 the lease liability of CU9,616 is calculated as the initial amount of CU11,500 plus the accrued interest of CU1,150 less the repayment of CU3,034.
6.2.4.2 Sum of digits method
The sum of digits method approximates the interest charge for each period by weighting the periods in reverse order, so that most interest is charged in earlier periods.
6.2.5 Disclosures for finance leases
IAS 17 requires a number of disclosures to be made in relation to the effect that a finance lease has had on an entity’s financial statements during a period. Reference should also be
made to IFRS 7 Financial instruments: disclosure.
For each class of assets, for example land, buildings, plant and machinery, an entity should disclose the net carrying amount that relates to assets held under finance leases. An entity
should present a reconciliation of the future minimum lease payments due at the end of the reporting period to their present value. These minimum lease payments and their present
value should also be allocated over the periods in which payments will be made, as follows: [IAS 17.31]
within one year;
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within two to five years; and after more than five years.
Disclosure should be made of any contingent rents that have been recognised as an expense during the period and the amount of any payments expected to be received under non-
cancellable subleases. Contingent rents are the part of the lease payments which varies by reference to a factor other than time, such as a percentage of sales generated from use of the
leased asset. [IAS 17.31]
A description of an entity’s significant leasing arrangements should be presented. Such information will normally include the basis on which contingent rents are determined, the
existence and terms of any options to extend the lease term or purchase the asset and any restrictions that are imposed on the lease arrangements. [IAS 17.31]
6.3 Accounting treatment of operating leases
The definition of an operating lease, as detailed at the start of this chapter, is any lease other than a finance lease.
IAS 17 requires lease payments made under an operating lease to be charged as an expense directly in profit or loss on a systematic basis over the lease term. A straight-line basis should
be used unless another basis is more representative of the timing of the benefits obtained by the user of the asset. [IAS 17.33]
Illustration 6
An entity enters into an operating lease arrangement for the use of a piece of machinery for a period of three years. The useful life of the asset is estimated as being around 15 years.
The entity will pay annual rentals of CU1,000 over the three years.
The entity expects the machinery to be used evenly over the three year period so the annual rental of CU1,000 should be recognised in each of the three years.
6.3.1 Operating lease incentives
It is not uncommon for a form of lease incentive to be provided to a lessee to encourage it to enter into a particular leasing arrangement. Incentives take various forms, such as a rent-free
period and lump sum payments either on entering the lease or as a reimbursement for leasehold improvements. IAS 17 does not address such issues and therefore the Standing
Interpretations Committee issued SIC 15 Operating leases – incentives to address the Issue.
SIC 15 requires that where a lease incentive is provided it is recognised as an integral part of the net consideration payable under the lease arrangement irrespective of the reason behind
the incentive payment. The lessee should therefore treat the incentive payment as a reduction of its rental expense on a straight-line basis, unless a different basis is more appropriate.
6.3.2 Disclosures for operating leases
IAS 17 requires a number of disclosures to be made in relation to any operating leases. Reference should also be made to IFRS 7.
An entity should disclose the outstanding payments under non-cancellable operating leases allocated between the following periods: [IAS 17.35]
within one year;
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within two to five years; and after more than five years.
Where an entity expects to receive sub-lease rentals under an operating lease arrangement the total minimum payments at the end of the reporting period should be disclosed.
[IAS 17.35]
The total amount recognised in profit or loss for amounts under operating leases, including subleases, should be disclosed identifying amounts representing the minimum lease
payments, contingent rents and sublease amounts. [IAS 17.35]
A description of an entity’s significant leasing arrangements should be presented. Such information will normally include the basis on which any contingent rents are payable, the
existence and terms of any options to extend the lease term, any escalation clauses or purchase options and any restrictions that are imposed on the lease arrangements.
[IAS 17.35]
Illustration 7
An entity has the following outstanding non-cancellable operating lease commitments at the end of its reporting period:
rental on buildings of CU100,000 per annum for 15 years; rental on plant of CU30,000 per annum for 3 years; and
rental on cars of CU40,000 for 11 months. The operating lease commitment note should include:
The minimum lease payments under non-cancellable operating leases are: CU
within 1 year 100,000 + 30,000 + 40,000
170,000 within 2 – 5 years
100,000 x 4yrs + 30,000 x 2yrs 460,000
after 5 years 100,000 x 10yrs
1,000,000 1,630,000
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7 The Accounting Treatment by Lessors
7.1 Finance leases
Just as a lessee accounts for the substance, not form, of a finance lease, so should a lessor. Under a finance lease the lessor is entitled to a stream of leasing receipts, so it should
recognise as an asset the amounts receivable, rather than the leased item as a non-current asset. The receivables should be measured at the net investment in the lease. [IAS 17.36]
The net investment in the lease is defined as being the “gross investment in the lease discounted at the interest rate implicit in the lease”. This gross investment is calculated as the
lessee’s minimum lease payments which includes any residual value guaranteed by the lessee plus any unguaranteed amount accruing to the lessor. [IAS 17.4]
The interest rate implicit in the lease is the same as that explained in relation to the lessee. The way that it is calculated automatically includes any initial direct costs incurred by the
lessor in the amounts receivable from the lessee, so they should not be added separately.
The income receivable under a finance lease arrangement should be recognised based on “a pattern reflecting a constant period rate of return on the lessor’s net investment in the finance
lease”. [IAS 17.39]
A manufacturer or dealer lessor effectively has income arising from two sources, being: the profit or loss that would have arisen from an outright sale of an asset; and
the finance income over the lease term. The selling profit or loss should be recognised in the same period as it would have been
recognised in had the asset been sold without the financing arrangements, so a consistent policy is adopted for the recognition of selling profit or losses. [IAS 17.42]
If the interest rate charged by a manufacturer or dealer lessor on the financing of the purchase of an asset is artificially low, then the selling profit should be adjusted so that a
market rate of interest is charged. This will result in a deferral of some of the selling profit. [IAS 17.42]
Any incremental costs incurred in negotiating a lease by a manufacturer or dealer lessor should be recognised as an expense when the selling profit is recognised.
7.1.1 Disclosure by a lessor for finance lease arrangements
A number of disclosure requirements should be presented in the financial statements of a lessor in respect of finance lease arrangements. Reference should also be made to IFRS 7.
A lessor should provide a general description of its significant leasing arrangements. [IAS 17.47]
A lessor should present a reconciliation of the gross investment in finance leases to the present value of the future minimum lease receipts due under them at the end of the reporting
period. The gross investment in the lease and the present value of the minimum lease payments for each of the following periods should also be disclosed: [IAS 17.47]
within one year; within two to five years; and
after more than five years.
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In addition, a lessor should disclose any unearned finance income, any unguaranteed residual values that accrue to the lessor the amount that the asset will be worth at the end of
its useful life and contingent rents received during the period. [IAS 17.47]
A lessor should also identify any allowance that has been made for uncollectable lease payments receivable. [IAS 17.47]
7.2 Operating leases
A lessor should recognise assets that are leased under operating leases in its statement of financial position according to the nature of the asset. Where it is the lease of a photocopier,
for example, it would be presented as a non-current asset as part of property, plant and equipment. [IAS 17.49]
The lessor will recognise depreciation on depreciable non-current assets under operating lease arrangements in accordance with IAS 16. The depreciation policy for leased assets
should be consistent with that for other non-current assets held by the lessor that are not subject to lease arrangements. [IAS 17.53]
Initial direct costs, as described above, should be added to the carrying amount of the asset and will therefore be recognised as an expense over the period of the useful life of the asset
as it is depreciated. [IAS 17.52]
The income received under an operating lease should be recognised in the lessor’s profit or loss based on a straight-line basis over the lease term. A different systematic basis of
recognition should be used where it represents more fairly the timing of the benefits derived from the asset as the lessee uses it. [IAS 17.50]
7.2.1 Disclosure by a lessor for operating lease arrangements
A number of disclosures should be made by a lessor in its financial statements as required by IAS 17 in respect of operating lease arrangements. Reference should also be made to
IFRS 7.
Disclosures should include a general description of the entity’s leasing arrangements and the amount of contingent rents received in the period. [IAS 17.56]
A lessor should disclose the future minimum receipts under non-cancellable operating leases allocated between the following periods: [IAS 17.56]
within one year; within two to five years; and
after more than five years.
7.2.2 Operating lease incentives
Where a lessor has provided an incentive to a lessee as described above, it should recognise the aggregate cost of the incentive as a reduction in the rental income over the period of the
lease. The incentive should normally be recognised on a straight-line basis, unless a different method is more appropriate. [SIC 15]
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8 Sale and Leaseback Transactions
An entity may enter into a financing arrangement to improve its liquidity through what is commonly referred to as a sale and leaseback transaction. In such circumstances, the entity
sells the asset to a third party, receives proceeds for the sale and then leases the asset back and pays rentals for its use.
A sale and leaseback transaction can result in a finance or operating lease, depending on the substance of the transaction.
If the lease is identified as a finance lease, finance has been provided and the asset has been given as security for that finance. Any profit made on the sale of the asset is deferred. The
excess of sale proceeds over the carrying amount of the asset at the date of the transaction is deferred in the statement of financial position and amortised through profit or loss over the
period of the lease. [IAS 17.59]
If the lease is identified as an operating lease and the lease payments and the sale price are established at fair value, any profit made on the sale should be recognised immediately in
profit or loss for the period. [IAS 17.61]
If, however, the sale price is below fair value, then any loss arising should be deferred to the extent that future rental payments are below market value. The loss will be recognised in
profit or loss as the rentals are recognised. If the sale price was above fair value, the excess profit over fair value should be deferred and recognised in the period over which the asset is
expected to be utilised. [IAS 17.61]
Where an operating lease results and the fair value of the asset is less than its carrying amount at the time of the sale, then this loss should be recognised immediately. A loss arising
in such circumstances is essentially an impairment of the asset i.e. a decrease in the recoverable amount of the asset. [IAS 17.63]
Illustration 8
An entity had two sale and leaseback transactions during the year. 1 It sold a non-current asset with a carrying amount of CU20,000 for its fair value of
CU24,000 under a finance leaseback arrangement. The lease period was for five years at an annual rental of CU7,000. The machine has a useful life of five years.
2 It sold a property under an operating leaseback arrangement for its fair value of CU40,000 when the property had a carrying amount of CU36,000. The annual operating
leaseback payments are CU10,000 per annum for three years, which reflect market rentals.
Transaction 1 Although the machine has been sold at fair value, no profit is recognised as the machine
remains a non-current asset. The proceeds are recognised as a liability and the finance charge of CU11,000 CU7,000 x 5 less CU24,000 is allocated over the five year period.
Transaction 2 The gain on disposal of the property of CU4,000 CU40,000 less CU36,000 is recognised
immediately, because the sale price and the rentals are at fair value. The operating lease rentals are recognised as an expense.
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