Revaluations Recognition criteria: further issues

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. Chapter 16 – Leases Page 205 5 Distinguishing Between Finance and Operating Leases In Illustration 1 above, it is clear that Option 2 is a financing arrangement and should therefore be classified as a finance lease. However, if P only leased the plant and machinery for one year, paying a total of CU24,000, it would have use of the asset for only a small proportion of its useful life and is not therefore effectively ‘buying’ the asset. In this scenario the arrangement would not be a financing transaction but instead a rental transaction, and should therefore be treated as an operating lease. The accounting treatment varies according to which type of lease the lessee holds. It is sometimes difficult in practice to distinguish between the two types of lease transaction, since arrangements can be very different and often have characteristics of both financing and rental. IAS 17 therefore provides detailed guidance to assist an entity in making the correct distinction.

5.1 Risks and rewards

The classification of a lease is based on the extent to which risks and rewards associated with ownership are transferred from the lessor to the lessee. If a lease transfers substantially all the risks and rewards normally associated with the ownership of an asset it should be classified as a finance lease; otherwise, it should be classified as an operating lease. [IAS 17.8] Examples of the key risks and rewards that arise from the ownership of an asset are shown in the following table. Illustration 3 Risk Reward Losses may arise:  where the asset stands idle for some time due to lack of sufficient demand;  from a fall in the value of the asset through technical obsolescence; and  from meeting the costs of maintaining and repairing the asset. Gains may arise from:  the generation of profits from use of the asset;  use of the asset for substantially the whole of its useful life; and  a potential gain arising on the future sale of the asset where it increases in value.

5.2 Situations indicating the existence of a finance lease

In addition to the guidance described above, IAS 17 also sets out specific situations that, individually or collectively, would normally lead to a lease being classified as a finance lease. Such situations include where:  ownership of the asset transfers to the lessee by the end of the lease term such arrangements are sometimes known as a hire purchase;  although ownership of the asset does not automatically pass to the lessee at the end of the agreement, the lessee has an option to purchase the asset. The price at which