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IAS 17 Leasing 2011

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IAS 17 Leasing

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TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and edited the first two versions. We are proud to realise his vision. Robin Joyce Professor of the Chair of International Banking and Finance Financial University under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2011 Updated

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IAS 17 Leasing

CONTENTS

Introduction 3IAS 17 – Impact for Banks 4Scope 5Definitions 5Classification of Leases 11Land and Buildings 15Leases in the Financial Statements of Lessees.........19Subsequent Measurement 21Operating Leases 22Leases in the Financial Statements of Lessors.........23Subsequent Measurement 24Subsequent Measurement - Manufacturer or dealer lessors 25Lessors - Disclosure 26Operating Leases 27Finance Leasing – Accounting Steps.........................29Sale and Leaseback Transactions..............................30Sale and Leaseback with options – collaterised borrowings 33IFRIC 4 - frequently asked questions..........................37



IAS 17 Leasing

Outsourcing contracts: an accidental business combination? 40Multiple choice questions .............................43Answers to multiple choice questions.............................47

IntroductionAimThe aim of this workbook is to assist the individual in understanding the IFRS accounting treatment and disclosures of Leases, as detailed in IAS 17.

BackgroundLeases 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. Rather than taking out a loan, and purchasing an

asset, firms were offered ‘off-balance-sheet’ financing, in the form of leasing.

IAS 17 addresses this issue by accounting for finance (longer-term) 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.

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.



IAS 17 Leasing

IAS 17 – Impact for Banks

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 consistent growth. IAS 17 is a major step forward for reporting, but will not be the last word.

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.

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.

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.

IFRIC 4, Determining whether an Arrangement contains a Lease is relevant for banks which outsource operations, especially where they are the predominant user of assets of the outsourced operations.

Scope

This Standard shall be applied in accounting for all leases other than:

(1) leases to explore for or use minerals, oil, natural gas andsimilar 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 investmentproperty (see IAS 40 Investment Property);

(2) investment property provided by lessors under operatingleases (see IAS 40);

(3) biological assets held by lessees under finance leases (see



IAS 17 Leasing

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.

EXAMPLE- lessor providing servicesYou rent a fully-serviced office. The owner provides secretarial services and all office equipment. This is covered by IAS 17.

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.

DefinitionsFor 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 Liablilties

Vehicle 10.000 Loan payable 10.000

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, 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



IAS 17 Leasing

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.

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.

LeaseA 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.

LessorThe lessor is the owner of the leased goods, who hires them to the user, or ‘lessee’.

LesseeThe lessee uses the leased goods, and pays a hire charge to do so.

Finance LeaseA finance lease transfers substantially all the risks, and rewards, of ownership of an asset. Title may, or may not, eventually be transferred.

Operating LeaseAn operating lease is a lease that is not a finance lease.



IAS 17 Leasing

Non-cancellable LeaseA 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 anequivalent asset, with the same lessor; or

(4) upon payment, by the lessee, of such a large amount that the lease is unlikely ever to be cancelled.

Start of the LeaseThe start of the lease term is the date from which the lessee can use the leased asset.

As at this date:

(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 atthe start of the lease term are determined.

Lease TermThe lease term is the non-cancellable period for which the lessee hascontracted to lease the asset, together with any further periods forwhich 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 PaymentsMinimum lease payments are the payments over the lease term thatthe lessee must make,

excluding contingent rent, costs for services and taxes to be paid by, and reimbursed to, the lessor,

plus:

(1) for a lessee, any amounts guaranteed by the lessee, or by arelated party; or

(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.

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.

EXAMPLE - Impact of penalties or costs on calculation of minimum lease payments (MLP)

Issue The calculation of the MLP should exclude contingent rent.

How should penalties or costs, payable by the lessee for failing to



IAS 17 Leasing

continue a lease, affect the calculation of MLP?

BackgroundAn 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.

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.

SolutionThe 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.

Fair ValueThe 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)

Economic LifeEconomic life is either:

(1) the period over which an asset is expected to be economicallyusable, by one or more users; or

(2) the number of production units expected to be obtained from the asset.

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 ValueGuaranteed residual value is:(1) for a lessee, that part of the residual value that is guaranteedby the lessee, or by a related party; and(2) for a lessor, that part of the residual value that is guaranteedby the lessee or by a reliable third party.

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.

How should the residual risk be evaluated for lease classification purposes?

BackgroundAn 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



IAS 17 Leasing

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.

SolutionThe 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 ValueUnguaranteed residual value is that portion of the residual value ofthe leased asset, which is not guaranteed.

EXAMPLE- unguaranteed residual valueYou 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 CostsInitial 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 LeaseGross investment in the lease is the aggregate of:(1) the minimum lease payments receivable by the lessor under afinance 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 LeaseNet 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’’means that the interest portion of the payments is deducted from the total payments, leaving only the principal payments.

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IAS 17 Leasing

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 thestart 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.

Lessee’s Incremental Borrowing Rate of InterestThe lessee’s incremental borrowing rate of interest is the rate ofinterest 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 RentContingent 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 rentYou 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 purchaseThe 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.



IAS 17 Leasing

Classification of LeasesIn 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.

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 allthe 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 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

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?

BackgroundA manufacturing undertaking leases computer hardware. The hardware is capable of operating for at least 7 years. The lease-term is 3 years.

SolutionThe 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;



IAS 17 Leasing

ii) improvements in working practices;

iii) competition and the effects that may have on efficiency; and

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.

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.

Examples of situations that would normally lead to a lease being considered to be a finance lease are:

(1) the lease transfers ownership of the asset to the lessee by theend of the lease;

EXAMPLE -Lease classification where lessor holds a put option requiring the lessee to acquire the asset

IssueA 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 lease term for 20,000. The fair value of the asset at the end of the lease term is expected to be 18,000.

SolutionThe 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.

Undertaking B will therefore be exposed to the residual value risk of the equipment through the transfer of title to it.

(2) the lessee has the option to purchase the asset at an attractive price;

(3) the lease term is for the major part of the economic life of theasset, even if title is not transferred ( >75%);

(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

(5) the leased assets are of such a specialised nature that only thelessee 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



IAS 17 Leasing

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.(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?

BackgroundUndertaking 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.

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.

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.

SolutionA numerical test should not be the primary determinant of lease classification.

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 associatedwith the cancellation are borne by the lessee;

EXAMPLE-cancellation-cost to the lesseeYou 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.



IAS 17 Leasing

(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

EXAMPLE-sale proceeds to the lesseeYou 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.

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 secondaryperiod, 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 periodYou 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.

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?

BackgroundA 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.

SolutionThe lease should be classified as a finance lease.



IAS 17 Leasing

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.

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?

BackgroundUndertaking 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.

SolutionThe 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.



IAS 17 Leasing

Land and BuildingsLeases 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).

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 optionYou 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 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 1You 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.

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.


EXAMPLE-prepaid lease paymentsYou 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 DR CRRent payable I 8.000Cash B 30.000Lease prepayment B 22.000This records the initial payment, and allocation of the first month’s rentRent payable I 8.000Cash B 6.000Lease prepayment B 2.000This records the second monthly payment, and allocation of the lease prepayment to the rent charge.

17


IAS 17 Leasing

EXAMPLE- land and buildings-spilt lease 2You 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 CRProperty, plant & equipment (land) B $1,2

millionProperty, plant & equipment (building)

B $0,8 million

Cash B $0,4 million

Lease creditor B $1,6 million

Recording the lease of land and buildingIf 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 1You have a lease for land and buildings. The fair values of the landand 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 2You 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 DR CRProperty, plant & equipment (building) B $100

millionLease creditor B $100

millionRecording 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 classified as an investment property under IAS 40, and the fair value model is adopted.

EXAMPLE-investment property 1You 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.)



IAS 17 Leasing

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 2You 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 should be reconsidered?

Background

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?

SolutionNo. 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.

EXAMPLE - Is it possible to lease a building and not the land?

IssueLeases 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.

Is it possible to lease a building without also leasing the land on which it stands?



IAS 17 Leasing

BackgroundUndertaking 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 ten-floor 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.

SolutionIt 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 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 itsfinancial 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 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



IAS 17 Leasing

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 economiclife, then the presumption that a lease of land is an operating lease may berebutted and an analysis of the risks and rewards of the ice cap will berequired, in the same way as the company analyses the risks and returns of the factory.

Leases in the Financial Statements of LesseesFinance 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).

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.

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 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



IAS 17 Leasing

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.

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.

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 capital being repaid. As the lease continues, the capital repayment increases, and the interest portion is smaller.

The capital has been reduced, so if the interest rate is constant, you will pay less interest each month.

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.


EXAMPLE-current and non-current liabilitiesYou 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 (non-current liability): $17 million.

I/B DR CRProperty, plant & equipment B $20 millionLease creditor (current) B $3 millionLease creditor (non-current) B $17million

Recording the lease and the split between current and non-current creditors 22


IAS 17 Leasing

For the lessee, a finance lease gives rise to depreciation expense for depreciable

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.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 financeexpense 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.

Lessees shall make the following disclosures for finance leases:

(1) for each class of asset, the net carrying amount at the balancesheet date. The classes are listed in IAS 16.

(2) a reconciliation between the total of future minimum lease payments at the balance sheet date, and their present value.

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;

(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.


EXAMPLE-contingent rentYou 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 CRRent expense I 31.000Cash B 25.000Lease creditor (current) B 6.000Recording the rent payment and the accrual for the contingent rent.

23


IAS 17 Leasing

(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

(iii) restrictions imposed by lease arrangements, such as those concerning dividends, additional debt, and further leasing.

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.

Operating Leases

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.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:




(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.



IAS 17 Leasing

Leases in the Financial Statements of LessorsFinance 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. 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 amountssuch 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.


EXAMPLE-prepaid lease expenseYou 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.

I/B DR CRLease expense I 500Cash B 2.000Prepaid Lease B 1.500Recording the lease payment in month 1. Lease expense I 500Prepaid Lease B 500Recording the lease expense in month 34,(which will be repeated in months 35 & 36).

25


IAS 17 Leasing

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.

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, inthe 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.

EXAMPLE - Effect of bargain purchase option on calculation of minimum lease payments (MLP)

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



IAS 17 Leasing

so much lower than fair value at the exercise date that the lessee can be reasonably expected to exercise the purchase option.

Should all bargain purchase options be included in the calculation of MLP if the undertaking’s ability to hold the assets is limited?

BackgroundA 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.

SolutionThe 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:

(1) profit equivalent to that resulting from the sale of the asset being leased, at normal selling prices; and

(2) finance income over the lease term.

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 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.

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.

EXAMPLE - Leasing of assets through a special purpose undertaking

IssueA 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?

BackgroundA car manufacturer operates a lease scheme for dealers through a



IAS 17 Leasing

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 dealers.

SolutionThe manufacturer, at the individual undertaking level, will record the sale of the cars to the SPU.

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.

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.

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 followingperiods:




(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).

(5) contingent rents recognised as income in the period.

(6) a general description of the lessor’s material leasing arrangements.

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.



IAS 17 Leasing

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?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.

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.

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?

This issue was discussed by the International Financial Reporting Interpretations Committee (IFRIC) in November 2005.

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 straight-line 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.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.


EXAMPLE – prepaid lease incomeYou 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 DR CRFinance income I 480Lease – capital repayment B 20Cash B 2.000Prepaid Lease Income B 1.500Recording the lease income in month 1. Finance income I 60Lease – capital repayment B 440Prepaid Lease Income B 500Recording the lease income in month 34.

29


IAS 17 Leasing

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).

To determine whether a leased asset has become impaired, an undertaking applies IAS 36.

EXAMPLE - Restoration of assets held under an operating lease

Issue

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?

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.

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.

Lessors shall disclose the following for operating leases:

(1) the future minimum lease payments (total receipts) under non-cancellable operating leases in total, and for each of the following periods:




(2) total contingent rents recognised as income in the period.

(3) a general description of the lessor’s leasing arrangements.

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.



IAS 17 Leasing

Finance Leasing – Accounting Steps

1. Establish the cost of the asset, including any initial direct costs.

2. Calculate the useful life of the asset.

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.

6. Calculate the first year’s principal payments. This is the short–term liability.

7. The remaining principal payments are the long-term liability.

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.

9. Charge depreciation monthly according to the schedule in 3.

Notes:

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.

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.

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.

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



IAS 17 Leasing

Sale and leaseback transactions have the purpose of raising capital for the owner of an asset without losing the use of the asset.

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.

If the lease continues until the economic life of the asset expires, then it is a finance lease.

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.

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


EXAMPLE-sale and leaseback-finance leaseYou 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 CRProperty, plant & equipment B $1 millionCash B $1,4

millionDeferred gain B $0,4

millionThe asset sale, and recognition of the gain.This gain will be amortised over the lease term.Property, plant & equipment B $1,4

millionLease creditor (current) B $0,1

millionLease creditor (non-current) B $1,3

millionRecording 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.


millionGain on disposal I $0,2

millionRecording the sale and recognition of the gain.

32


IAS 17 Leasing

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.

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.


EXAMPLE-sale and leaseback-finance lease – reduced paymentsYou 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.


millionDeferred loss B $0,2

millionThe asset sale, and recognition of the loss.This loss will be amortised over the lease term.Property, plant & equipment B $0,8

millionLease creditor (current) B $0,1

millionLease creditor (non-current) B $0,7

millionRecording 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 $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.


millionLoss on disposal I $0,1

millionRecording the sale and recognition of the loss.

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IAS 17 Leasing

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.

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.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



IAS 17 Leasing

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.

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?

BackgroundUndertaking 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.

SolutionUndertaking A should continue to recognise the asset.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?



IAS 17 Leasing

BackgroundUndertaking 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.

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%.

A has operating rights of the building for 20 years and must maintain it.

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 value of the property and to pay interest rather than market rents.

EXAMPLE - Reassessment of lease when terms changed

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.

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



IAS 17 Leasing

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?

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?BackgroundUndertaking 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.

SolutionThe 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 http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 37


IAS 17 Leasing

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

IssueA 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 is a lease other than a finance lease.

How should management classify a sale and leaseback of a unique warehouse?

BackgroundUndertaking 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.

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



IAS 17 Leasing

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 required level of service or produce, and which party to the arrangement controls the assets.

Application of the transition guidanceAn undertaking adopting the interpretation may either apply it (IFRIC4.17):

(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.

IFRIC 4 – frequently asked questionsSolutions to some of the more frequently asked questions arising from applying the interpretation are outlined below.

Specific asset

Is a specific asset the same as a uniquely identifiable asset?

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



IAS 17 Leasing

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.

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).

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.



IAS 17 Leasing

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.

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.



IAS 17 Leasing

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 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



IAS 17 Leasing

combination should be able to provide output on their own, which is a business as defined by IFRS 3.

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.

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-of-completion 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).

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’.

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.

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



IAS 17 Leasing

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 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.

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.

Implications of IFRIC 4

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-by-asset 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 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.

Example - Arrangement containing a lease

An Easter egg manufacturer outsources distribution of its products. The outsource agreement specifies that the eggs are to be delivered by theEaster Bunny, and gives the manufacturer exclusive use of the Easter Bunny from January to May for a fixed fee for the period.

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).



IAS 17 Leasing

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’ theEaster Bunny.

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.

The manufacturer is effectively paying for the availability of the EasterBunny for the period from January to May therefore also has a right to use that asset.

The arrangement contains an operating lease so the lease element of the arrangement should be accounted for under IAS 17.

Multiple choice questions

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.

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. (i)2. (i)-(ii)3. (i)-(iii)4. (i)-(iv)5. (i)-(v)6. (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.



IAS 17 Leasing

2. The unguaranteed residual value.3. The fair value.

4. Gross investment in the lease is the1. Aggregate of:2. Higher of:3. Lower of:4. Average of:

the minimum lease payments receivable by the lessor under afinance lease, andany 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:(i) The lease transfers ownership of the asset to the lessee by theend 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 theasset, 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 thelessee can use them, without major modifications.

1. (i)2. (i)-(ii)3. (i)-(iii)4. (i)-(iv)5. (i)-(v)

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.



IAS 17 Leasing

(iv) If the lease does not transfer substantially all risks and rewards of ownership.

1. (i)2. (i)-(ii)3. (i)-(iii)4. (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:

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.

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.



IAS 17 Leasing

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 futureminimum lease payments at the balance sheet date, and theirpresent 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:

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, andit is clear that the transaction is established at fair value, any profit orloss 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.



IAS 17 Leasing

Answers to multiple choice questions

Question Answer1. 52. 33. 24. 15. 56. 37. 38. 19. 210. 111. 212. 313. 114. 215. 116. 217. 118. 319. 120. 221. 422. 223. 124. 1

Note: Material from the following PricewaterhouseCoopers publications has been used in this workbook:

-Applying IFRS -IFRS News

-Accounting Solutions



Documents

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