Lease Guidance 1

8/8/2019 Lease Guidance 1

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Lease guidance 07/11/2007

Version: Final

LEASE ACCOUNTING UNDER IFRS GAAP

Caveat

This guidance only covers the main points of lease accounting expected to be of

general application. It is not a substitute for reading and applying the full standardand interpretations. The examples given are not part of the IFRS

standards/interpretations. Paragraph references are to the standard or an

interpretation, as indicated.

Relevant standards

IFRS accounting rules for leases are given in the following standards and

interpretations:

IAS 17Leases

SIC 15 Operatingleases incentivesSIC 27Evaluatingthe substance of transactions involving the legal form of a lease

IFRIC 4Determining whether an arrangement contains a lease

First-time adoption of IFRS

There is no exemption for first time adoption under IFRS 1 in relation to accounting

for leases. Therefore the basic principle of full retrospection applies. All leases must

be reviewed and, to determine the amounts to be included in the financial statements,

management must go back to the inception of the lease. IAS 17, paragraph 20,

requires that a lessee under a finance lease recognises assets and liabilities equal to the

fair value of the leased property or, if lower, the present value of the minimum lease

payments.

The above analysis could result in some re-analysis between finance and operating

leases (and possibly recognition of some arrangements as leases for the first time).

The figures for finance leases for the opening balance sheet (and the 2008/09

Operating Cost Statement) will have to be calculated as if the new rules had been in

place all along. Basis for Conclusion paragraph 15 of IAS 17 addresses the possible

impracticality of retrospectively analysing property leases between land and buildings

because doing so requires estimating the fair values of the two elements. Guidance is

provided for such situations in paragraph 25 of IAS 8. Retrospective application alsorequires consideration of whether an arrangement contains a lease under IFRIC 4 (see

IFRS 1, paragraph 25F).

In addition to the issues highlighted above, there are two other areas that may cause

difficulties in practice:

lessor accounting in respect of recognising income i.e. IAS 17 requires gross

investment method whereas in SSAP 21 is recognised on a net cash

investment method. This is not a significant issue for the public sector.

SIC 15- operating lease incentives, which require the interpretation to be

adopted retrospectively whether the incentives started before or after SIC 15

came into effect.

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Finance or operating lease?

IAS 17Leases (para 4) defines a finance lease as a lease that transfers substantially all

the risks and rewards incidental to ownership of an asset. Operating leases are any

other leases. The classification of leases between finance and operating is thereforebased on the extent to which risks and rewards incidental to ownership of a leased

asset lie with the lessor or with the lessee (para 7).

Risks include:

the possibility of losses from idle capacity or technological obsolescence, and

variations in return because of changing economic conditions.

Rewards are:

the expectation of profitable operation over the assets economic life, and

gain from appreciation in value or realisation of a residual value.

Whether a lease is a finance lease or an operating leases is a matter to be decided on

the substance of each case. However, paragraph 10 of IAS 17 gives examples of

situations that individually or in combination would normally lead to a lease being

classified as a finance lease:

the lease transfers ownership of the asset to the lessee by the end of the lease term

the lessee has an option to purchase the asset at a sufficiently favourable price that itis reasonably certain, at the inception of the lease, that it will be exercised

the lease term is for the major part of the economic life of the asset even if title is

not transferred

at the inception of the lease, the present value of the minimum lease payments

amounts to at least substantially all of the fair value of the leased asset

the leased assets are of such a specialised nature that only the lessee can use them

without major modifications

if the lessee can cancel the lease, the lessors losses associated with the cancellation

are borne by the lessee

gains or losses from the fluctuation in the fair value of the residual accrue to the

lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end

of the lease)

the lessee has the ability to continue the lease for a secondary period at a rent that is

substantially lower than market rent.

The example below shows whether the lease is a finance lease or an operating lease:

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Is there a lease?

IFRS defines a lease as an agreement whereby the lessor conveys to the lessee the

right to use an asset for an agreed period of time in return for a payment or series of

payments. The IFRS rules are to be applied to the substance of agreements rather

than their legal form.

Whilst in many cases it will be clear when a lease exists, IFRIC 4Determining

whether an arrangement contains a lease provides rules for when the situation is less

clear.

Paragraph 1 of IFRIC 4 refers to arrangements that convey the right to use an asset

(possibly along with related services) but which do not take the legal form of a lease.

It gives examples of outsourcing arrangements (eg outsourcing the IT functions of an

entity) and take-or-pay and similar contracts (under which purchasers must make

specified payments regardless of whether they take delivery of the contracted

products or services).

IFRIC 4 provides guidance as to whether such arrangements are, or contain, leases.

Paragraph 6 provides that there is a lease if:

fulfilment of the arrangement is dependent on the use of a specific asset or assets;

and

the arrangement conveys a right to use the asset.

An asset has been implicitly specified if, for example, the supplier owns or leases only

one asset with which to fulfil the obligation and it is not economically feasible orpracticable for the supplier to perform its obligation through the use of alternative

assets (para 8).

An arrangement conveys the right to use the asset if the purchaser has the right to

control the use of the underlying asset (para 9). This occurs if any one of the

following conditions is met:

the purchaser has the ability or right to operate the asset or direct others to do so,

while controlling more than an insignificant amount of the output, or

the purchaser has the ability or right to control physical access to the asset whilecontrolling more than an insignificant amount of the output, or

it is remote that anyone other than the purchaser will take more than an insignificant

amount of the output of the asset during the arrangement and the price of the output is

neither fixed per unit of output nor equal to the market price per unit of output as at

the time of delivery.

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The purchaser has agreed to pay a fixed amount each month plus variable costs based

on volume.

Is this a lease arrangement?

The above example meets the criteria as laid down in IFRIC 4 for this to be a leaseand therefore it is within the scope of IAS 17. The assets can be identified explicitly

in the agreement. The supplier has the right to enter into other lease agreements, but

to do so would require a substantial and uneconomical investment. From the

information provided, it appears that the supplier can only meet the needs of the

purchaser and has no plans to expand the capacity.

Linked transactions

SIC 27Evaluating the substance of transactions involving the legal form of a lease

requires a series of transactions that involve the legal form of a lease to be accounted

for as one transaction when the overall economic effect cannot be understood withoutreference to the series as a whole. This is the case, for example, when the transactions

are closely related, negotiated as a single transaction and take place concurrently or in

a continuous sequence (para 3).

This may result in an arrangement that includes the legal form of a lease not being

treated as a lease under IAS 17. Under paragraph 5 of SIC 27, any of the following

indicate that an arrangement may not, in substance, involve a lease under IAS 17:

an entity retains all the risks and rewards of ownership of an asset and enjoys

substantially the same rights to its use as before the arrangement

the primary reason for the arrangement is to achieve a particular tax result

an option is included on terms that make its exercise almost certain

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Accounting and disclosures

Lessee: finance lease disclosures

IAS 17 requires the following information to be disclosed using the example fromabove:

T h e n e t b o o k a m o u n t o f m o t o r v e h i c le s in c l u d e s

9 , 7 7 2 ( 2 0 1 0 ) a n d 1 2 , 3 6 3 f o r ( 2 0 0 9 ) i n r e s p e c t o f v e h i c l e s h e l d u n d e r

f in a n c e l e a s e s .

M a r -1 0 M a r -0 9

F i n a n c e L e a s e s

L ia b i l i t i e s :

W i th i n o n e y e a r 3 , 2 0 0 3 , 2 0 0

2 - 5 y e a r s 6 , 4 0 0 9 , 6 0 0A f te r 5 y e a r s - -

9 , 6 0 0 1 2 , 8 0 0

F u t u r e f i n a n c e c h a r g e s o n f in a n c e l e a s e 3 2 1 6 3 5

p r e s e n t v a l u e o f l e a s e o b l i g a t io n s 9 , 2 7 9 1 2 , 1 6 5

In addition to the above requirements, IAS 17 requires disclosure of the following in

relation to finance lease:

Contingent rents recognised as an expense for the period.

The total of future minimum sublease payments expected to be received under

non cancellable subleases at the balance sheet date.

A general description of the lessees material leasing arrangements including,

but not limited to, the following:

(a) the basis on which contingent rent payable is determined;

(b) the existence and terms of renewal or purchase options and escalation

clauses; and

(c) restrictions imposed by the lease arrangements, such as those

concerning dividends, additional debt, and further leasing.

The above example shows the IAS 17 disclosures the lessee should make in relation

to finance leases (and not the lessor). Other disclosures might be required under otherstandards and Interpretations.

IAS 17 requires a number of detailed disclosures that are not required by SSAP 21.

For example, SSAP 21 does not require lessees to disclose the total amount of the

operating lease commitments to be disclosed. Instead, it requires the annual

commitment to be disclosed with an indication of the period to expiry of the

commitment. In addition to meeting the IAS 17 requirements, the lessee must also

meet the disclosure requirements of IFRS 7 where appropriate and other relevant

interpretations.

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Operating Lease disclosure

Payments under an operating lease will be recognised by the lessee as an expense over

the lease term.

In addition to complying with IFRS 7 where relevant lessees will make the followingdisclosures for operating leases:

(a) the total of future minimum lease payments under non-cancellable operating

leases for each of the following periods:

(i) not later than one year;

(ii) later than one year and no later than five years;

(iii) later than five years

(b) the total of future minimum sublease payments expected to be received under

non-cancellable subleases at the balance sheet date.

(c) lease and sublease payments recognised as a expense in the period, with

separate amounts for minimum lease payments, contingent rents, and sublease

payments.

(d) a general description of the lessees 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.

Operating Leases Incentives (SIC 15)

SIC 15 provides guidance on how to recognise lease incentives, which the lessor may

give to the lessee to enter into a lease agreement. The guidance is for both lessor and

lessee. Consider the example below:

Key facts:

A department signs a lease agreement with a lessor. The lessor agrees to provide the

first two years rent-free as an incentive to the lessee for entering into the lease

arrangement. The lease term is for 15 years and the rent per annum, which is fixed, is

500,000 starting in year 3.

The accounting for the above transaction is:

The lessee will pay in total 6.5m over the life of the lease. Both the lessee and lessor

will recognise a net consideration of 6.5m over the 15 year-lease term on a straight-

line basis. The lessor will recognise the cost of the incentives as a reduction of rental

income over the lease term. The lessee will recognise the benefits of the incentives asa reduction of rental expense over the lease term.

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Accounting for sale and leaseback transaction

A sale and lease back involves the selling of an asset by the vendor, which is then

immediately leased back by entering into a lease with the buyer. Companies adopt

this type of approach to release cash.

The approach to sale and leaseback under IAS 17 can be seen from the example

below:

A government department owns a freehold interest in a building. The department

sells the building to a property company and leases it back for a period of 25 years.

The lease term is considered to be for the major part of the buildings economic life.

Other details about the building are set out below:

Book value of the building 20m

Proceeds from the sale 25m

Lease rentals per annum 1.1mPresent value of minimum lease payments 15m

Interest Rate implicit in lease 6 %

The leaseback of the building is for the major part of the buildings economic life.

Therefore this is a finance lease in accordance with IAS 17. Where the sale and

leaseback transaction results in a finance lease, any excess of sales proceeds over the

carrying amount is not immediately recognised as income by the seller (lessee).

Instead it is deferred and amortised over the lease term as shown below:

The government department will record the following double entry:

Entries on SaleD r C r

B a n k 25m

Property & Building 20m

D eferred incom e 5m

To set up th e asset and l iabli li ty under f inan ce lease

A sset held under finance lease 15m

Finance Lease creditor 15m

The deferred income treatment over the lease term

D eferred incom e (5m /25 years) 250k

O perating C ost S tatem ent (O C S) 250k

Depreciat ion Charge (15m/25 years)

D epreciation (O C S) 600k

A sset held under finance lease 600k

Other entr ies

Interest (O C S) 826k

Finance lease credito r (B alance sheet) 274K

B ank 1 .1m

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Property leases

IAS 17 (para 15) requires that the land and buildings elements of a property lease

should be considered separately for lease classification, unless the land element would

be immaterial (para 17). Land normally has an indefinite economic life. Therefore,unless title is expected to pass to the lessee by the end of the lease term, the lessee

does not receive substantially all the risks and rewards of ownership and the lease of

land is an operating lease (para 14). The buildings element is classified as a finance

or operating lease, in line with the rules above.

When splitting a property lease, the minimum lease payments are allocated between

the land and buildings elements in proportion to the fair values of the leasehold

interests in the land and building elements of the lease at its inception (para 16).

More information is given on this at BC 9-11 of IAS 17. If the lease payments cannot

be allocated reliably between the two elements, the entire property lease is classified

as a finance lease, unless it is clear that they are both operating leases.

Embedded derivatives

Embedded derivatives may be present in a lease host contract. An embedded

derivative is defined in IAS 39 as a financial instrument with all these characteristics:

its value changes in response to changes in an underlying price or index;

it requires no initial net investment or an initial net investment that is smaller

than would be required to purchase the underlying instrument; and

it is settled at a future date.

IAS 39 requires embedded derivatives to be split from the host contract and accounted

for separately. Some analysis would be required to established whether or not an

embedded derivative is present in a lease contract and if so further analysis will be

required to identify those which are closely related and those which are not closely

related.

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Lease Guidance 1