Introduction

Publication date: 17 Nov 2018

15A.1 IAS 17 is supplemented by the following three interpretations:

  • IFRIC 4, which extends IAS 17’s scope to arrangements that do not take the legal form of a lease but convey a right to use an asset.
  • SIC 27, which deals with accounting for complex transactions that have the legal form of a lease but whose substance is different.
  • SIC 15, which deals with accounting for lease incentives provided by a lessor.

Objective and scope

Publication date: 17 Nov 2018

15A.2 The objective of IAS 17 is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosures to apply in relation to leases.

[IAS 17 para 1].

15A.3 A lease is defined as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.

[IAS 17 para 4].

15A.4 The definition of a lease also includes hire purchase contracts. These are contracts for the hire of an asset that give the hirer an option to acquire title to the asset and conditional sale agreements where title automatically passes to the lessee on making the final lease payment.

[IAS 17 para 6].

15A.5 The standard excludes from its scope:   

  • Lease agreements to explore for or use minerals, oil, natural gas and similar non-regenerative resources.
  • Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

[IAS 17 para 2].

15A.6 The standard’s measurement rules do not apply to:

  • Property held by lessees that is accounted for as investment property or investment property provided by lessors under operating leases. The measurement rules of IAS 40 apply in these situations. Refer to chapter 23 para 4 for further details.
  • Biological assets held by lessees under finance leases or biological assets provided by lessors under operating leases, which are dealt within IAS 41. Refer to chapter 33 para 13 for further details.

[IAS 17 para 2].

15A.7 Measurement of interests in properties which are leased out to another party under an operating lease could meet the definition of an investment property. If so, IAS 40 covers the measurement accounting for such properties. Refer to chapter 23 para 4 for further details. If the property leased to a third party is under a finance lease, it cannot be treated by the lessor as investment property and so the IAS 17 measurement rules apply.

15A.8 IAS 17 also applies to agreements that transfer the right to use assets that contain substantial service elements.

[IAS 17 para 3].

FAQ 15A.8.1 – Contract which contains a right to use an asset and a substantial service element

Objective and scope - Determining whether an arrangement contains a lease

Publication date: 17 Nov 2018

15A.9 Entities sometimes enter into arrangements that do not take the legal form of a lease but which nevertheless convey a right to use an asset in return for a payment or series of payments. Examples include:

  • Outsourcing arrangements.
  • Rights to use capacity in the telecommunications industry.
  • Take or pay contracts.

[IFRIC 4 para 1].

15A.10 IFRIC 4 provides guidance on where such arrangements are, or contain, leases. IFRIC 4 also addresses where the assessment or re-assessment should be made and how payments for the lease should be separated from payments for other elements of the arrangement.

[IFRIC 4 para 5].

15A.11 Determining whether an arrangement is, or contains, a lease is based on the substance of the arrangement, which means assessing if:

  • 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 or assets.

[IFRIC 4 para 6].

15A.12 IFRIC 4 does not address how to determine whether a portion of a larger asset is itself the underlying asset that is the subject of the lease. However, it does say that arrangements in which the underlying asset would represent a unit of account (for instance, for the purpose of depreciating the asset) in either IAS 16 or IAS 38 are within IFRIC 4’s scope.

[IFRIC 4 para 3].

15A.13 The asset on which fulfilment of the arrangement is dependent does not need to be explicitly identified in the contractual arrangement. Rather, it might be implicitly specified, because it is not economically feasible or practical for the supplier to fulfil the arrangement using alternative assets. Some factors that might impact the assessment of whether it is economically feasible or practical to use alternative assets are: the assets’ location; the availability of alternative assets; the assets’ cost of installation; any interruption to customer service as a result of replacing the assets; whether the replaced assets could be used by other customers; and any asset replacement patterns specified in the contract.

[IFRIC 4 para 8].

FAQ 15A.13.1 – Evaluation of whether fulfilment of arrangement is dependent on use of a specific asset

15A.14 Although a specific asset might be explicitly identified in an arrangement, it is not the subject of a lease if fulfilment of the arrangement is not dependent on the use of the specified asset. This is the case where the supplier has the right and ability to provide goods or services using other assets not specified in the arrangement. However, a warranty obligation that permits or requires the substitution of the same or similar assets, where the specified asset is not operating properly, does not preclude lease treatment. The use of fungible assets to provide the goods or services does not preclude an asset from being specific to the arrangement.

[IFRIC 4 para 7].

FAQ 15A.14.1 – Do protective clauses have an impact on the determination of the existence of a lease?

15A.15 An arrangement conveys a right to use an asset if the purchaser (lessee) has the right to control the asset’s use. A right to control is conveyed if any of the following conditions are met:

  • The purchaser has the ability or right to operate the asset or direct others to operate the asset whilst obtaining or controlling more than an insignificant amount of the asset’s output.
  • The purchaser has the ability or right to control physical access to the asset whilst obtaining or controlling more than an insignificant amount of the asset’s output.
  • There is only a remote possibility that parties other than the purchaser will take more than an insignificant amount of the asset’s output and the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery.

[IFRIC 4 para 9].

FAQ 15A.15.1 – Examples of situations where the purchaser has the ability or right to operate the asset or direct others to do so
FAQ 15A.15.2 – What is the rationale of the criteria neither ‘fixed per unit of output’ nor ‘equal to the current market price’?
FAQ 15A.15.3 – How should ‘fixed per unit of output’ be interpreted?
FAQ 15A.15.4 – Are pricing mechanisms based on formulae considered to be fixed per unit of output or equal to the current market price?
FAQ 15A.15.5 – How to determine whether it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output?

15A.16 This diagram illustrates the application of the conditions in IFRIC 4 for determining whether an arrangement is a lease.

imoa19_redrawn


[IFRIC 4 para 6].

15A.17 The initial assessment of whether an arrangement is, or contains, a lease should be made at the inception of the lease. This initial assessment is only revisited if any one of the following four conditions are met:

  • There is a change in the contractual terms, unless the change only renews or extends the arrangement.
  • A renewal option is exercised or an extension is agreed to by the parties to the arrangement, unless the term of the renewal or extension had initially been included in the lease term in accordance with the requirements of IAS 17.
  • There is a change in determining whether fulfilment is dependent on a specified asset.
  • There is a substantial change to the asset (for example, a substantial physical change to property, plant or equipment).

[IFRIC 4 para 10].

15A.18 Lease payments should be split from other payments made under the arrangement. 

[IFRIC 4 para 13].

15A.19 This split is made on the basis of the relative fair values of the lease and other elements of the arrangement, or by using an estimation technique.

[IFRIC 4 paras 13, 14].

15A.20 Where it is impracticable for the purchaser to separate the payments reliably, the purchaser is required:

  • With a finance lease, to recognise an asset and liability equal to the fair value of the underlying asset being leased. Interest is accrued on the liability recognised at the lessee’s incremental borrowing rate.
  • With an operating lease, to treat all payments made under the arrangement as if they were lease payments. Such amounts should be disclosed separately from other lease arrangements that do not include payments for non-lease elements.

[IFRIC 4 para 15].

The substance of transactions with the legal form of a lease

Publication date: 17 Nov 2018

15A.21 An entity might enter into a transaction or a series of structured transactions that involves the legal form of a lease. For example, an entity might lease assets to an investor and lease the same assets back, or alternatively, legally sell assets and lease the same assets back. The arrangement might be designed to achieve a tax advantage for the investor that is shared with the entity in the form of a fee, and not to convey the right to use an asset. SIC 27 sets out the required accounting for transactions with the legal form of a lease. The basic principle is that a series of transactions that involve the legal form of a lease should be accounted for in accordance with their substance. Accounting for transactions of this type can be complex. When considering the most appropriate treatment, analysis should consider the effect of all aspects of the agreement, including any guarantees or options.

[SIC 27 para 4].

15A.22 Where the overall economic effect of a series of transactions cannot be understood without reference to the series of transactions as a whole, the transactions should be accounted as a single transaction.

[SIC 27 para 3].

15A.23 SIC 27 sets out the following indicators that individually demonstrate that an arrangement might not, in substance, involve a lease:

  • An entity retains all the risks and rewards incident to ownership of the underlying 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 and does not convey the right to use an asset.
  • An option is included on terms that make its exercise almost certain.

[SIC 27 para 5].

15A.24 Where an entity enters into a transaction similar to the type described in SIC 27, the entity retaining use of the asset should determine whether, in substance, it has a separate investment account and lease payment obligation. The principles used in determining whether the entity has an asset and liability are the same as for the recognition of any asset or liability. However, the following indicators are given which, when taken together, suggest that the investment account and the lease payment obligations do not meet the definitions of an asset and a liability:

  • The entity is not able to control the investment account in pursuit of its own objectives and is not obliged to pay the lease payments.
  • The entity has only a remote risk of reimbursing the entire amount of any fee received from the investor.
  • Other than the initial cash flows at inception, the only cash flows expected are the lease payments that are satisfied solely from funds withdrawn from the separate investment account.

[SIC 27 para 6].

15A.25 Guarantees provided and obligations incurred upon early termination shall be accounted for under IAS 37, IFRS 4, or IAS 39/ IFRS 9, depending on their terms.

[SIC 27 para 7].

FAQ 15A.25.1 – Substance of the transaction does not represent a lease (1)
FAQ 15A.25.2 – Substance of the transaction does not represent a lease (2)

Classification of leases

Publication date: 17 Nov 2018

15A.26 All leases must be classified as either finance leases or operating leases. The classification of leases under IAS 17 is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. The risks associated with assets include the possibilities of losses from idle capacity or technological obsolescence and of variations in return, because of changing economic conditions. Rewards might be represented by the expectation of profitable operation over the asset’s life and of gain from the appreciation in value of the asset’s residual value.

[IAS 17 para 7].

15A.27 A finance lease is defined as “... a lease that transfers substantially all the risks and rewards incidental to ownership of an asset”. Thus, a finance lease is an arrangement that has the substance of a financing transaction for the lessee to acquire effective economic ownership of an asset.

[IAS 17 para 4].

15A.28 An operating lease is “... a lease other than a finance lease”.

[IAS 17 para 4].

15A.29 In practice, this means that a significant element of risk should therefore remain with the lessor or some party other than the lessee. Consequently, an operating lease is usually for a period substantially shorter than the asset’s useful economic life, and the lessor will be relying on recovering a significant proportion of their investment from either the proceeds from the asset’s sale or the asset’s further hire after the end of the lease term.

[IAS 17 para 8].

Classification of leases - Lease term

Publication date: 17 Nov 2018

15A.30 The lease term is key to classifying a lease and is defined as “... the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option”.

[IAS 17 para 4].

FAQ 15A.30.1 – What factors require the most judgement in determining the lease term?
FAQ 15A.30.2 – What factors to consider when determining whether a lessee is reasonably certain to exercise a renewal option?
FAQ 15A.30.3 – How is the lease term impacted by break clauses?

15A.31 A non-cancellable lease is defined as one that is cancellable only:

  • upon the occurrence of some remote contingency;
  • with the lessor’s permission;
  • if the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or
  • upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain.

[IAS 17 para 4].

Classification of leases - Classification indicators

Publication date: 17 Nov 2018

15A.32 The following examples of situations, 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 the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option 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 a specialised nature such that only the lessee can use them without major modifications being made.

[IAS 17 para 10].

FAQ 15A.32.1 – What needs to be considered when assessing transfer of ownership or purchase options?
FAQ 15A.32.2 – What does ‘substantially all’ mean in the context of the present value of minimum lease payments classification indicator?
FAQ 15A.32.3 – How do specialised assets impact the lease classification?

15A.33 The economic life of an asset is defined as either the period over which an asset is expected to be economically usable by one or more users, or the number of production or similar units expected to be obtained from the asset by one or more users. There is no detailed guidance on what is meant by a major part of the economic life.

[IAS 17 para 4].

FAQ 15A.33.1 – Should the fact that the lessor retains title to the asset impact the lease classification?
FAQ 15A.33.2 – The impact of technical obsolescence on the lease classification
FAQ 15A.33.3 – Is the economic life for lease classification purposes the same as the period over which the entity would depreciate an asset?

15A.34 The following situations, individually or in combination, could also lead to a finance lease classification:

  • If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee.
  • Gains or losses from the fluctuation in the residual’s fair value fall to the lessee (for example, 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.

[IAS 17 para 11].

FAQ 15A.34.1 – What requires the most judgement in determining lease classification?
FAQ 15A.34.2 – If lessor and lessee share the residual value, how does this impact lease classification?
FAQ 15A.34.3 – Finance lease classification where lessor risk is evaluated as remote

15A.35 The definitions of finance leases and operating leases are the same for both the lessee and the lessor. However, the application of these definitions to the differing circumstances of the lessor and the lessee can result in the same lease being classified differently. This might be the case if the lessor benefits from a residual value guarantee provided by a party unrelated to the lessee (for example, the asset’s manufacturer).

[IAS 17 para 9].

Classification of leases - Inception and commencement of the lease

Publication date: 17 Nov 2018

15A.36 Lease classification is made at the inception of the lease.

[IAS 17 para 13].

15A.37 The inception of the lease is the earlier of the date of the lease agreement and the date of the parties’ commitment to the lease’s principal provisions. In the case of a finance lease, the assets and liabilities to be recognised at the commencement of the lease term are determined at the date of inception. The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset, and it is also the date of initial recognition of the lease assets and liabilities.

[IAS 17 para 4].

FAQ 15A.37.1 – The difference between lease inception and lease commencement

15A.38 Some lease agreements might include a provision to adjust the lease payments for changes in the construction or acquisition cost of the leased property, or for changes in some other measure of cost or value during the period between the inception of the lease and the commencement of the lease term. If this is the case, the effect of any such changes is deemed to have taken place at the inception of the lease, both for the purposes of lease classification and for calculation of the amounts to be included in the balance sheet in respect of the finance lease.

[IAS 17 para 5].

Accounting by lessees - Accounting for finance leases

Publication date: 17 Nov 2018

15A.39 A finance lease should be recorded in a lessee’s balance sheet both as an asset and as an obligation to pay future rentals. At the commencement of the lease term, the sum to be recognised both as an asset and as a liability should be the lower of the fair value of the leased asset and the present value of the minimum lease payments; both of these values are determined at the inception of the lease.

[IAS 17 para 20].

15A.40 Leased assets and leased liabilities are presented separately and gross in the balance sheet. They represent separate assets and liabilities. If a distinction is made between current and non-current liabilities for the purposes of presentation of liabilities on the face of the balance sheet, the current portion of the lease liability is presented separately from the non-current portion.

[IAS 17 para 23].

15A.41 The minimum lease payments for a lessee are the payments over the lease term that the lessee is, or can be, required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with any amounts guaranteed by the lessee or any party related to the lessee (for example, another group entity). In addition, if a lessee has an option to purchase the asset at a price that makes it reasonably certain, at the inception of the lease, that the option will be exercised, the lessee should include the payment to exercise the option in its calculation of the minimum lease payments. If it is not reasonably certain that the option will be exercised, any penalty for non-exercise should be included in the minimum lease payments.

[IAS 17 para 4].

FAQ 15A.41.1 – Should a commitment of the lessee to pay for remediation of pre-existing damage be taken into account in the calculation of the minimum lease payments?

15A.42 In calculating the present value of the minimum lease payments, the discount factor is the interest rate implicit in the lease, if this is practicable to determine, if not, the lessee’s incremental borrowing rate shall be used.

[IAS 17 para 20].

15A.43 The interest rate implicit in the lease is defined as “... the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) 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”. That is, the interest rate implicit in the lease is the lessor’s internal rate of return from the lease, taking into account the normal cash price of the leased asset, rentals and the amount that the lessor expects to recover from the residual value. In practice, the interest rate implicit in the lease is unlikely to be stipulated in the agreement and, unless the lessor volunteers the information to the lessee, the lessee will need to derive an estimate of the rate from information available.

[IAS 17 para 4].

15A.44 A lessee can normally derive a reasonable estimate of the interest rate implicit in a lease where it knows, or can make a reasonable estimate of, the cost of the asset and the anticipated residual value of the asset at the end of the lease term. Where this is not practicable, the lessee should use its incremental borrowing rate to determine the present value of the minimum lease payments.

[IAS 17 para 20].

15A.45 The lessee’s incremental borrowing rate is the rate that the lessee would have to pay on a similar lease or, if that is not determinable, the rate at the inception of the lease that the lessee would incur on borrowings over a similar term with a similar security the funds necessary to purchase the asset.

[IAS 17 para 4].

15A.46 Any initial direct costs of the lessee are added to the amount recognised as an asset. Initial direct costs are defined as “... incremental costs that are directly attributable to negotiating and arranging a lease...”. Costs identified as directly attributable to activities performed by the lessee in arranging a finance lease are initial direct costs. Internal fixed costs do not qualify as incremental costs.

[IAS 17 paras 4, 24].

15A.47 An asset leased under a finance lease should be depreciated over the shorter of the lease term and its useful life, unless there is a reasonable certainty that the lessee will obtain ownership of the asset by the end of the lease term, in which case it should be depreciated over its useful life. The depreciation policy used should be consistent with that for other depreciable assets that are owned by the entity.

[IAS 17 para 27].

15A.48 The useful life of an asset is defined as the estimated remaining period, from commencement of the lease term, without limitation by the lease term, over which the economic benefits embodied in the asset are expected to be consumed by the entity.

[IAS 17 para 4].

15A.49 An entity applies IAS 36 to determine whether a leased asset has become impaired in the same way as for assets that are owned by the entity.

[IAS 17 para 30].

15A.50 Finance lease payables are outside the scope of IAS 39 or IFRS 9, because IAS 17 provides the rules for recognition and measurement of these liabilities. The only exception to this is where an entity wishes to de-recognise a finance lease liability. The de-recognition rules of IAS 39 or IFRS 9 apply. Accordingly, if, in future periods following the commencement of a lease, a premium is paid on early redemption of a finance lease liability, it should be accounted for in accordance with IAS 39 or IFRS 9.

[IAS 39 para 2; IFRS 9 para 2.1].

FAQ 15A.50.1 – Can a premium paid on early redemption of a finance lease liability be capitalised?

15A.51 Lease payments should be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge should be allocated to periods during the lease term, so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period.

[IAS 17 para 25].

FAQ 15A.51.1 – Finance lease accounting by a lessee

15A.52 In practice, some form of approximation might need to be used to simplify the calculation of the allocation.

[IAS 17 para 26].

15A.53 The sum of the depreciation expense for a leased asset and the finance expense for the period is rarely the same as the lease payments payable for the period. It is therefore inappropriate to recognise the lease payments payable as an expense. As such, the asset and the related liability are unlikely to be equal in amount after the commencement of the lease term.

[IAS 17 para 29].

Accounting by lessees - Accounting for finance leases - Contingent rents

Publication date: 17 Nov 2018

15A.54 Contingent rent is defined as “...that portion of the lease payments that is not fixed in amount but is based on the future amount of a factor that changes other than with the passage of time (for example percentage of future sales, amount of future use, future price indices, future market rates of interest)”. Sometimes, a lease contract might contain a clause that requires the lessee to pay contingent rent, such as for some of the rental paid by the lessee to be contingent on the lessee’s sales, particularly in the retail sector.

[IAS 17 para 4].

FAQ 15A.54.1 – Can contingent rents sometimes be disguised minimum lease payments?
FAQ 15A.54.2 – Additional payments if a specific mileage of a leased car is exceeded
FAQ 15A.54.3 – Rental payments based on usage, with a cap and a floor
FAQ 15A.54.4 – Inflation adjustments treated as contingent rentals

15A.55 Contingent rentals are excluded from the calculation of minimum lease payments and are simply charged as expenses in the periods in which they are incurred.

[IAS 17 para 25].

Accounting by lessees - Accounting for operating leases

Publication date: 17 Nov 2018

15A.56 Operating leases should not be capitalised. Lease 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.

[IAS 17 para 33].

15A.57 The requirement to spread the lease payments on a straight-line basis over the lease term applies even if the payments are not made on such a basis. Lease payments exclude costs for services such as insurance and maintenance.

[IAS 17 para 34].

FAQ 15A.57.1 – How should lease payments be spread if there is a pre-determined rate of increase in the lease payments?
FAQ 15A.57.2 – Situations regarding lease payments made where the lessee is not using the leased asset

15A.58 Initial direct costs are defined as ‘incremental costs directly attributable to negotiating and arranging a lease’. IAS 17 provides guidance as to how lessors and lessees should treat initial direct costs in a finance lease, but it is silent on the accounting of such costs by lessees in operating leases.

[IAS 17 para 4].

FAQ 15A.58.1 – How should initial direct costs in an operating lease be accounted for?

Accounting by lessees - Accounting for operating leases - Operating lease incentives

Publication date: 17 Nov 2018

15A.59 Lease incentives are often given to lessees to incentivise them to sign operating leases. Guidance is provided in SIC 15.

[SIC 15 para 1].

15A.60 Lease incentives might include:

  • contributions to relocation or start-up costs;
  • the assumption of liabilities, such as the rentals under an old lease which would otherwise become a vacant property;
  • the gift of an asset, such as the lessor bearing directly all of the costs of fitting out the property to the lessee’s specifications; and
  • giving rent-free or reduced rental periods for an initial period of the lease.

The same treatment is required for all operating lease incentives, regardless of their form, cash flow effect or whether they arise from new or renewed leases.

[SIC 15 para 3].

15A.61 The aggregate benefit of incentives should be recognised by the lessee as a reduction of the rental expense over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern of the lessee’s benefit from the use of the leased asset. This requirement seeks to ensure that the income statement reflects the true effective rental charge for the property, irrespective of the particular cash flow arrangements agreed between the two parties.

[SIC 15 para 5].

FAQ 15A.61.1 – Can a rent free period granted by the lessor during the fit-out of a store be spread over the fit-out period?
FAQ 15A.61.2 – How should payments between the lessor, new tenant and old tenant be accounted for?

15A.62 Costs incurred by a lessee, including costs in connection with a pre-existing lease (for example, costs for termination, relocation or leasehold improvements), should be accounted for in accordance with the standard applicable to those costs. This includes costs which are effectively reimbursed through an incentive arrangement.

[SIC 15 para 6].

FAQ 15A.62.1 – Accounting for costs in connection with pre-existing leases

Accounting by lessees - Accounting for sale and leaseback transactions

Publication date: 17 Nov 2018

15A.63 A sale and leaseback transaction arises when a vendor sells an asset and immediately re-acquires the use of the asset by entering into a lease with the buyer. The original owner might also lease the asset to the investor and lease the same asset back. Such a transaction is referred to as a ‘lease and lease-back transaction’ and has similar effects. The accounting depends on the type of lease entered into. Leaseback transactions require careful consideration of all factors in order to arrive at the correct accounting.

[IAS 17 para 58].

FAQ 15A.63.1 – Sale and leaseback of a building

Accounting by lessees - Accounting for sale and leaseback transactions - Finance leasebacks

Publication date: 17 Nov 2018

15A.64 A finance leaseback is essentially a financing operation for the seller. The seller/lessee never disposes of the risks and rewards of ownership of the asset, and so it should not recognise a profit or loss on the sale. Any apparent profit (that is, the difference between the sale price and the previous carrying value) should be deferred and amortised over the lease term. This treatment will have the effect of adjusting the overall charge to the income statement, for the depreciation of the asset, to an amount consistent with the asset’s carrying value before the leaseback.

[IAS 17 para 59].

FAQ 15A.64.1 – Accounting for a sale and finance leaseback

15A.65 Normally, the carrying value of an item of property, plant and equipment before a sale and finance leaseback will not exceed the leased asset’s fair value. If it did, it would need to be tested for impairment under IAS 36. Any such adjustment to the asset’s carrying value should be made before determining the apparent profit or loss on the sale and leaseback transaction.

[IAS 17 para 64].

FAQ 15A.65.1 – How is a sale and finance leaseback accounted for where the sales proceeds are less than the fair value of the asset due to subsequent rentals being on a basis other than arm’s length?

Accounting by lessees - Accounting for sale and leaseback transactions - Operating leasebacks

Publication date: 17 Nov 2018

15A.66 The seller in a sale and operating leaseback effectively disposes of substantially all the risks and rewards of owning the asset in the sale transaction. It might re-acquire some of the risks and rewards of ownership in the leaseback, but it does not re-acquire substantially all of them. Accordingly, the transaction should be treated as a disposal, and any profit or loss should be recognised immediately in the income statement if the transaction is established at fair value.

[IAS 17 para 61].

15A.67 If the fair value of an asset at the time of a sale and operating leaseback transaction is less than the carrying amount of the asset, a loss equal to the difference between the carrying amount of the asset and its fair value should be recognised immediately. Accordingly, any pre-existing impairment in the carrying value of the asset is recognised immediately.

[IAS 17 para 63].

15A.68 Any profit on the sale where the sale transaction is established at fair value should be recognised immediately, because this is, in effect, a normal sales transaction.

[IAS 17 para 61].

15A.69 A sales price in excess of the fair value does not represent a genuine profit. The rentals payable in future years are almost certain to be inflated above the market value. The excess of the sales proceeds over the fair value should be deferred and amortised over the period for which the asset is expected to be used. This treatment will have the effect of reducing the annual expense for rentals to a basis consistent with market value rentals.

[IAS 17 para 61].

15A.70 Any profit or loss on sales price below fair value should be recognised immediately. The entity might simply have negotiated a poor bargain. An exception is made, however, where a loss is compensated by future lease payments that are below market levels. The loss, to the extent that it is compensated by future rentals below market levels, should be deferred and amortised over the period for which the asset is expected to be used. The deferral reverses the effect of an artificial loss created by establishing the sale price and the subsequent rental artificially. A similar adjustment is not required where the profit that is made is lower than would be expected if the sales price and the subsequent rentals were established on an arm’s length basis.

[IAS 17 para 61].

15A.71 A useful summary of various circumstances encountered with sale and leaseback transactions which result in operating leases is provided in IAS 17’s Implementation Guidance section.

[IAS 17 Illustrative Examples].

Sale and leaseback transactions with repurchase agreements

Publication date: 17 Nov 2018

15A.72 IAS 17 provides specific guidance with respect to sale and leaseback transactions. Consequently, it is not necessary to consider whether the conditions for recognition of a sale have been met before a transaction is accounted for as a sale and leaseback transaction. However, if, applying the criteria in SIC 27 and IFRIC 4, an entity determines that a sale and leaseback arrangement does not convey ‘a right of use’, the transaction is outside IAS 17’s scope, and the sale and leaseback accounting in IAS 17 should not be applied.

[IAS 17 para 58].

15A.73 Sale and leaseback transactions might include a variety of repurchase agreements or options where circumstances are complex. The substance of such arrangements needs to be carefully considered, to determine whether or not the transaction is in the scope of IAS 17. A distinction needs to be drawn between sale and leaseback transactions that include repurchase agreements and those that include repurchase options.

[SIC 27 para 5].

Repurchase agreements – Unconditional commitment to repurchase

Publication date: 17 Nov 2018

15A.74 Any type of unconditional commitment for the seller to repurchase means that, although the transaction has the legal form of a sale and leaseback, there has been no sale and no leaseback. The seller/lessee has the right to use the asset for the whole of its life before the sale and leaseback and retains that right after the transaction. Sale and leaseback accounting does not apply.

[SIC 27 para 5].

FAQ 15A.74.1 – Does a pre-determined repurchase price indicate that the substance might not be that of a sale and leaseback?
FAQ 15A.74.2 – Does a market value repurchase price indicate that the substance is that of a sale and leaseback?

Repurchase options – ‘Almost certain’ to be exercised

Publication date: 17 Nov 2018

15A.75 Leases could contain an option for the seller/lessee to repurchase, or the buyer/lessor to resell to the seller, or a combination of these. It is necessary to determine why the parties have agreed to such terms and assess the option’s commercial effect. This includes assessing whether the seller has a commercial need to repurchase. If it is almost certain the option will be exercised, the seller/lessee never, in substance, parts with its right to use the asset. Therefore, the transaction is outside IAS 17’s scope.

[SIC 27 para 5].

FAQ 15A.75.1 – Sale and leaseback transactions with a repurchase option that might not, in substance, involve a lease

Repurchase options – Not ‘almost certain’ to be exercised

Publication date: 17 Nov 2018

15A.76 A sale and leaseback transaction that includes a repurchase option contains a lease where the exercise of the option by the seller/lessee is not ‘almost certain’. No right of use is conveyed by the leaseback to the seller/lessee beyond the lease term. Accordingly, such an arrangement is properly accounted for as sale and leaseback transaction.

[SIC 27 para 5].

FAQ 15A.76.1 – Sale and leaseback transactions with a repurchase option that would be considered to involve a lease

Disclosures by lessees

Publication date: 17 Nov 2018

15A.77 The disclosure requirements for lessees in respect of finance leases are set out in paragraph 31 of IAS 17.

[IAS 17 para 31].

15A.78 Although obligations under finance leases are excluded from the scope of IAS 39 or IFRS 9, they are financial instruments and should be included in the disclosures required by IFRS 7.

[IAS 17 para 31].

15A.79 Lessees of assets held under a finance lease should give the disclosures required by IAS 16, IAS 36, IAS 38, IAS 40 and IAS 41, as appropriate, in respect of those assets.

[IAS 17 para 32].

15A.80 The disclosure requirements for lessees in respect of operating leases are set out in paragraph 35 of IAS 17.

[IAS 17 para 35].

FAQ 15A.80.1 – Are more disclosures required if there is a significant difference between the actual cash commitments disclosed and the income statement impact?
FAQ 15A.80.2 – Disclosure of minimum lease payments

Accounting by lessors - Accounting for finance leases

Publication date: 17 Nov 2018

15A.81 The amount due from the lessee under a finance lease should be recognised in the lessor’s balance sheet as a receivable at an amount equal to the lessor’s net investment in the lease.

[IAS 17 para 36].

15A.82 IAS 39 does not apply to finance lease receivables, other than their de-recognition and impairment.

[IAS 39 para 2]. [IFRS 9 para 2.1].

15A.83 A lessor’s net investment in a lease is its gross investment in the lease discounted at the interest rate implicit in the lease. The gross investment in the lease is equal to the minimum lease payments plus any unguaranteed residual accruing to the lessor. At any time during the lease term, the net investment in the lease will represent the remaining minimum lease payments (the amounts that the lessor is guaranteed to receive under the lease from either the lessee or third parties) less that part of the minimum lease payments that is attributable to future gross earnings (namely, interest).

[IAS 17 para 4].

15A.84 The definition of minimum lease payments for a lessor incorporates the minimum lease payments of the lessee plus any guaranteed residual value. Minimum lease payments of the lessee are the payments over the lease term that the lessee is, or can be, required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with any amounts guaranteed by the lessee or any party related to the lessee (for example, another group entity). The lessor will include any residual value that has been guaranteed whether by the lessee, a party related to the lessee or an independent third party (for example, the asset’s manufacturer).

[IAS 17 para 4].

15A.85 Unguaranteed residual values are defined as “... that portion of the residual value of the leased asset, the realisation of which by the lessor is not assured or is guaranteed solely by a party related to the lessor”. The unguaranteed residual value, which will be small in a finance lease, represents the amount the lessor expects to recover from the value of the leased asset at the end of the lease term that is not guaranteed in any way either by the lessee or third parties. Unguaranteed residual values can have a significant impact on the profitability of a lease transaction for a lessor.

[IAS 17 para 4].

FAQ 15A.85.1 – What does the unguaranteed residual depend upon?

15A.86 Rentals are apportioned between a reduction in the net investment in the lease and finance income over the lease term.

[IAS 17 para 40].

15A.87 The recognition of finance income is based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease. The remainder of rentals reduces the net investment in the lease.

[IAS 17 para 39].

FAQ 15A.87.1 – Calculation of lessor finance income

15A.88 The estimated unguaranteed residual should be reviewed regularly. Where there has been a reduction in the expected residual value, the income allocation over the lease term should be revised, and any reduction in respect of amounts already accrued is recognised immediately.

[IAS 17 para 41].

FAQ 15A.88.1 – Re-appraisal of unguaranteed residual value

15A.89 Assets held under a finance lease that are classified as held for sale, or assets held under a finance lease that are included in a disposal group (as defined by IFRS 5), should be accounted for in accordance with that standard.

[IAS 17 para 41A].

Accounting by lessors - Accounting for operating leases

Publication date: 17 Nov 2018

15A.90 A lessor should present assets subject to operating leases in its balance sheet according to the nature of the asset, usually as property, plant and equipment or investment property.

[IAS 17 para 49].

15A.91 Depreciable leased assets should be depreciated on a basis consistent with the lessor’s normal depreciation policy for similar assets, and depreciation should be calculated in accordance with IAS 16 or IAS 38.

[IAS 17 para 53].

15A.92 To determine whether a leased asset has become impaired, an entity applies IAS 36 in the same way as for assets that are owned by the entity.

[IAS 17 para 54].

15A.93 Lease income from operating leases (excluding receipts for services provided, such as insurance and maintenance) should be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which benefit derived from the leased asset is diminished. This is irrespective of when the payments are due. In practice, the use of a systematic basis other than straight-line should be rare.

[IAS 17 para 50].

FAQ 15A.93.1 – Lease income recognised on a straight-line basis

15A.94 There is no detailed guidance on unguaranteed residuals where the asset is held for use under an operating lease. However, assets subject to operating leases are required to be presented in the lessor’s balance sheet in accordance with their nature. This means that where an asset falls to be treated as property, plant and equipment, the requirements of IAS 16 will apply. IAS 16 requires assets to be depreciated down to their residual value over the asset’s useful life. Therefore, the estimated residual value will affect the amount of depreciation charged to income in each period. The effect of residuals on depreciation is discussed further in chapter 22 para 91.

[IAS 17 para 49].

15A.95 If an asset meets the definition of an investment property, the accounting in IAS 40 will apply. IAS 40 requires investment properties to be held either at fair value or at depreciated cost. Where properties are held at depreciated cost, IAS 16 will apply. Where properties are held at fair value, estimated residual values will not directly impact the income statement.

[IAS 40 para 30].

Accounting by lessors - Accounting for operating leases - Operating lease incentives

Publication date: 17 Nov 2018

15A.96 All incentives, regardless of their nature, form or timing (be it a payment, assumption of liabilities or a rent-free or reduced-rent period), given by lessors for the benefit of lessees to sign a new or renewed operating lease should be recognised as an integral part of the net consideration agreed for the use of the leased asset.

[SIC 15 para 3].

15A.97 The aggregate cost of incentives should be treated as a reduction of rental income over the lease term. The cost should be recognised on a straight-line basis, unless another systematic basis is more representative of the time pattern over which the benefit from the leased asset is diminished. In practice, the use of an allocation basis other than straight-line is rare.

[SIC 15 para 4].

FAQ 15A.97.1 – Accounting for operating lease incentives
FAQ 15A.97.2 – Can operating lease incentives be impaired?
FAQ 15A.97.3 – Are there situations where payments made by the lessor to the old tenant can be capitalised rather than expensed?

Accounting by lessors - Initial direct costs

Publication date: 17 Nov 2018

15A.98 Initial direct costs are often incurred by lessors in negotiating and arranging a lease and are defined as “... incremental costs that are directly attributable to negotiating and arranging a lease ...”.

[IAS 17 para 4].

15A.99 Only incremental costs can be treated as initial direct costs. Internal costs that are not incremental (such as administration, selling expenses and general overheads) should be expensed as incurred. The following expenses will normally qualify as initial direct costs:

  • External costs such as commission, legal, arrangement and brokers’ fees. For example, letting fees paid to agents for negotiating and arranging an lease would meet the definition of initial direct costs.
  • Other commissions and bonuses paid to procure business that are based upon reaching sales volumes.

[IAS 17 para 38].

15A.100 Initial direct costs incurred by lessors (other than manufacturer/ dealer lessors) in negotiating and arranging a finance lease are included in the initial measurement of the finance lease receivable. The definition of the interest rate implicit in the lease ensures that initial direct costs are automatically included in the finance lease receivable. There is no need to add them separately. This results in the amount of income that is recognised over the lease term being reduced by the impact of the initial direct costs.

[IAS 17 para 38].

15A.101 Initial direct costs incurred by lessors in negotiating and arranging an operating lease are added to the carrying amount of the leased asset, and they are recognised as an expense over the lease term on the same basis as the lease income. Initial direct costs are therefore amortised separately from the asset. They will be recognised as an expense over the lease term rather than over the life of the asset. Recognition of initial direct costs as an immediate expense is not permitted.

[IAS 17 para 52].

Accounting by lessors - Manufacturer/dealer lessors

Publication date: 17 Nov 2018

15A.102 Manufacturer/dealer lessors are distinguished from other lessors. A manufacturer/dealer lessor is a lessor that either manufactures the leased asset or acquires the leased asset as part of its dealing activities. The difference as compared to a ‘normal’ lessor is the cost at which the lessor acquires an asset for lease: the manufacturer/dealer obtains the asset at its cost of manufacture or at a wholesale price, so its cost will be below a normal selling price to other customers. The accounting issue is whether the manufacturer/dealer lessor should recognise a normal sale profit, and this will depend on the lease classification.

[IAS 17 para 42].

15A.103 No selling profit should be recognised where the manufacturer/dealer enters into an operating lease. The risks and rewards associated with the asset’s ownership have not passed to the customer and the transaction is not equivalent to a sale. The manufacturer/dealer will account for the lease in the same way as any other operating lessor.

[IAS 17 para 55].

15A.104 A finance lease of an asset by a manufacturer/dealer gives rise to two types of income: finance income over the lease term; and a profit or loss equivalent to that arising on an outright sale.

[IAS 17 para 43].

15A.105 Where a manufacturer/dealer enters into a finance lease with a customer, the manufacturer/dealer should recognise selling profit or loss in income for the period in accordance with the policy followed by the entity for outright sales. This is because the asset’s risks and rewards of ownership have passed to the customer.

[IAS 17 paras 42, 43].

15A.106 The sales revenue recorded by a manufacturer/dealer is the lower of the asset’s fair value or the present value of the minimum lease payments computed at a market rate of interest.

[IAS 17 para 44].

FAQ 15A.106.1 – Sale of an asset by a manufacturer lessor under a finance lease
FAQ 15A.106.2 – Sale of asset by a manufacturer lessor with advance deposit payment by the lessee
FAQ 15A.106.3 – Sale of asset by a manufacturer lessor with manufacturing cost overruns and no adjustment to lease payments
FAQ 15A.106.4 – Sale of asset by a manufacturer lessor with manufacturing cost overruns with adjustment to lease payments

15A.107 Manufacturer/dealer lessors sometimes quote artificially low rates of interest in order to attract customers. A market rate of interest should be used, to avoid an excessive amount of income being recognised at the time of the sale.

[IAS 17 para 45].

15A.108 Sales revenue, the cost of sale and selling profit are recognised at the commencement of the lease term. The cost of sale is the cost of the leased asset (or carrying amount of the asset, if different) less the present value of any unguaranteed residual value.

[IAS 17 para 44].

15A.109 Initial direct costs incurred by a manufacturer/dealer lessor in connection with the arrangement of a finance lease should be recognised as an expense at the commencement of the lease term as they mainly relate to earning the selling profit.

[IAS 17 para 46].

Disclosure by lessors

Publication date: 17 Nov 2018

15A.110 The disclosure requirements for lessors in respect of finance leases are set out in paragraph 47 of IAS 17.

[IAS 17 para 47].

FAQ 15A.110.1 – Are there any additional disclosures that entities with significant leasing activities should consider providing?

15A.111 Lessors are encouraged to disclose the gross investment less unearned income in new businesses added during the period, after deducting the relevant amounts for cancelled leases. This disclosure provides a useful indicator of growth.

[IAS 17 para 48].

15A.112 Finance lease receivables meet the definition of financial assets and should be included in the disclosures required by IFRS 7.

[IAS 17 para 48].

15A.113 The disclosure requirements for lessors in respect of operating leases are set out in paragraph 56 of IAS 17.

[IAS 17 para 56].

15A.114 A lessor is also required to meet the requirements of IFRS 7 in respect of any receivables that it has under operating leases.

[IAS 17 para 56].

15A.115 Lessors of assets provided under operating leases should give the disclosures required by IAS 16, IAS 36, IAS 38, IAS 40 and IAS 41, as appropriate, in respect of those assets.

[IAS 17 para 57].

Practical application - Classification of leases – Change in estimates, renewal and modification of a lease agreement

Publication date: 17 Nov 2018

15A.116 A lessee and a lessor could agree to change the provisions of the lease, other than by renewing the lease. If the changed terms would have resulted in a different classification of the lease if they had been in effect at the inception of the lease, the revised lease agreement is regarded as a new agreement and is accounted for prospectively in accordance with the revised lease terms.

[IAS 17 para 13].

FAQ 15A.116.1 – Can the exercise of a renewal option be considered to be a modification of a lease agreement?
FAQ 15A.116.2 – Example of a lease renegotiation resulting in reclassification of an operating lease as a finance lease

15A.117 However, the changes might not always give rise to reclassification of the lease. In addition, there is no detailed guidance on how to assess whether a modification of a lease agreement requires a different classification.

[IAS 17 para 13].

FAQ 15A.117.1 – How should an entity assess whether a modification of a lease agreement requires a different classification?

15A.118 Changes in estimates (for example, changes in estimates of the economic life or the leased property’s residual value), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.

[IAS 17 para 13].

Practical application - Classification of leases – Change in estimates, renewal and modification of a lease agreement - Classification of leases – Accounting for reclassified leases

Publication date: 17 Nov 2018

15A.119 IAS 17 states that the revised agreement is regarded as a new agreement over its term. However, no specific guidance is given on how to account for the consequences of modifications in the lease agreement that result in reclassification, such as how to measure assets and liabilities as at the reclassification date. This section presents acceptable interpretations in this respect.

[IAS 17 para 13].

15A.120 A modification that causes an operating lease to be reclassified as a finance lease results in the balances related to the finance leases being recognised for the first time by the lessee. Therefore, the lessee will recognise the leased asset and a related finance lease liability prospectively. The new lease should be recognised based on the present value of the remaining minimum lease payments or, if lower, the fair value of the leased asset as at the date of the modification.

[IAS 17 para 20].

15A.121 Where the modification results in an operating lease being reclassified as a finance lease, a lessor de-recognises the leased asset and recognise the remaining net investment in the lease. The new accounting treatment should be applied prospectively and any profit or loss arising on the recognition of the finance lease receivable and de-recognition of the leased asset should be recognised in the income statement.

[IAS 17 para 36].

Practical application - Classification of leases – Change in estimates, renewal and modification of a lease agreement - Classification of leases - Accounting for modifications to the terms of finance leases by lessees

Publication date: 17 Nov 2018

15A.122 There is no specific guidance on how a lessee should account for modifications that do not result in reclassification of the lease. With respect to finance leases, we consider that the lessee can either account for the revised agreement as if it was a new lease, or apply the IAS 39 de-recognition guidance to decide whether the finance lease liability should be de-recognised and the modified agreement accounted for as a new lease.

[IAS 17 para 13].

FAQ 15A.122.1 – How should a lessee account for modifications that do not result in reclassification of the lease?

Practical application - Classification of leases – Change in estimates, renewal and modification of a lease agreement - Classification of leases - Accounting for modifications to the terms of finance leases by lessors

Publication date: 17 Nov 2018

15A.123 There is also no specific guidance on how a lessor should account for modifications that do not result in reclassification of the lease. With respect to finance leases, we consider that the lessor can either account for the revised agreement as if it was a new lease or apply the IAS 39 de-recognition guidance to decide whether the lease receivable should be de-recognised and the modified agreement accounted for as a new lease.

[IAS 17 para 13].

FAQ 15A.123.1 – How should a lessor account for modifications that do not result in reclassification of the lease?

15A.124 Lease payments made under operating leases are recognised as an expense on a straight-line basis over the lease term. Future minimum lease payments in a modification should be accounted for prospectively on a straight-line basis over the remaining revised lease term. Lease payments made under operating leases are recognised as an expense on a straight-line basis over the lease term.

[IAS 17 para 33].

Practical application - Property leases - Classification

Publication date: 17 Nov 2018

15A.125 The land and the buildings elements of a lease of land and buildings are considered separately for the purposes of lease classification, unless one of the exceptions to this requirement is met.

[IAS 17 para 15A].

15A.126 If the amount that would initially be recognised for the land element is immaterial, the land and the buildings elements can be treated together for the purpose of lease classification. The economic life of the buildings is regarded as the economic life of the entire leased asset.

[IAS 17 para 17].

15A.127 Separate measurement of the land and the buildings elements is not required where the lessee’s interest in both the land and the building is classified as an investment property under IAS 40 and the fair value model is adopted.

[IAS 17 para 18].

15A.128 It is possible for a lessee to classify a property interest held under an operating lease as an investment property. If it does, the property interest is accounted for as if it were a finance lease and, in addition, the fair value model is used for the asset recognised. The lessee should continue to treat the lease as a finance lease, even if a subsequent event results in the property no longer being classified as an investment property. This will be the case if, for example, the lessee occupies the property, which is then transferred to owner-occupied property at a deemed cost equal to its fair value at the date of change in use; or if the lessee grants a sub-lease that transfers substantially all of the risks and rewards incidental to ownership of the interest to an unrelated third party. Such a sub-lease is accounted for by the lessee as a finance lease to the third party, although it might be accounted for as an operating lease by the third party.

[IAS 17 para 19].

15A.129 The separate land and building elements of leases should be classified as finance leases or operating leases in the same way as leases of other assets. Leases that transfer substantially all the risks and rewards incidental to ownership of the asset are classified as finance leases. All other leases are classified as operating leases.

[IAS 17 para 15A].

FAQ 15A.129.1 – Can the lease classification of the building be determined without performing a detailed split of the rentals?
FAQ 15A.129.2 – Lease classification using qualitative criteria

15A.130 An important consideration in determining whether a lease of land is an operating or finance lease is that land normally has an indefinite economic life. However, a n example of a 999-year lease of land and buildings is given in the basis for conclusions. In this situation, significant risks and rewards associated with the land during the lease term have been transferred to the lessee, despite there being no transfer of title. The lessee is in a position economically similar to an entity that has purchased the land and buildings. The present value of the property’s residual value would be negligible.

[IAS 17 para 15A].

Practical application - Property leases - Splitting the rental

Publication date: 17 Nov 2018

15A.131 The rentals payable under the lease should be split between two elements, if it is determined that the classifications of the land and the buildings elements of the lease are different, or if the classification of the buildings element is not clear. The minimum lease payments (including any up-front lump sum payments) under the lease are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests at inception of the lease.

[IAS 17 para 16].

FAQ 15A.131.1 – Why are the minimum lease payments allocated between the land and buildings in proportion to the relative fair values of the leasehold interests?
FAQ 15A.131.2 – How is the fair value of the lessee’s leasehold interest calculated?
FAQ 15A.131.3 – Example of rental allocation

15A.132 It should be possible to obtain a reasonable split of the lease rentals. However, if the lease payments cannot be allocated reliably between the element in respect of the land and the element in respect of the building, the entire lease should be classified as a finance lease unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease.

[IAS 17 para 16].

Practical application - Back-to-back and sub-leases

Publication date: 17 Nov 2018

15A.133 The terms ‘back-to-back’ and ‘sub-lease’ can be used to describe a variety of different agreements, each of which has different legal and tax implications. It is difficult to prescribe specific accounting treatments for each variation, and there is no detailed guidance regarding sub-leases.

[IAS 17 para 4].

FAQ 15A.133.1 – How does the accounting for back-to-back and sub-leases vary from that for regular leases?

Practical application - Embedded options

Publication date: 17 Nov 2018

15A.134 IAS 39 or IFRS 9 applies to derivatives that are embedded in lease contracts. Parties to a lease should review the terms carefully, to determine whether it contains an embedded derivative. Refer to chapter 6.3A para 68 or chapter 41 para 52 for more detailed guidance on embedded derivatives.

[IAS 39 para 2(b); IFRS 9 para 2.1].

Practical application - Future developments

Publication date: 17 Nov 2018

15A.135 IFRS 16, ‘Leases’, was released in January 2016 and will be effective for periods beginning on or after 1 January 2019.The new standard permits early application but it cannot be applied before an entity also applies IFRS 15. IFRS 16 will replace IAS 17, IFRIC 4, SIC 15 and SIC 27. The key objective of issuing the new standard was to ensure that, for lessees, assets and liabilities arising from lease contracts are recognised on the balance sheet. For further detailed information, refer to our In depth publication, ‘IFRS 16 – A new area of lease accounting’.

Illustrative text - Objective and scope - FAQ 15A.8.1 – Contract which contains a right to use an asset and a substantial service element

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 3
Reference to standing text: 15A.8
Industry:


Entity A enters into an agreement to rent photocopiers from entity B. As part of that agreement, entity B agrees to provide maintenance services for the copiers. The fact that entity B has agreed to provide maintenance services does not change the fact that the part of the agreement that deals with the provision of the copiers should be treated as a lease.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.13.1 – Evaluation of whether fulfilment of arrangement is dependent on use of a specific asset

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 8
Reference to standing text: 15A.13
Industry:


Example 1:

Entity A enters into an agreement to sell electricity to a steel works. In order to fulfil this agreement, entity A builds a power station next to the steel works. Entity A does not have access to any other electricity-generating assets.

In this case, it is clear that fulfilment of the agreement is dependent on the use of the power station built next to the steel works.

Example 2:

The supplier/service provider has the right to substitute another asset when the specified asset is not operating properly. Can fulfilment of the arrangement be dependent on the use of a specific asset?

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.

Example 3:

The asset is explicitly mentioned in an agreement. Does that imply that the arrangement is dependent on a specific asset?

Not necessarily, if the fulfilment of the agreement is not dependent on the use of that asset. If, for instance, the supplier 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.

Example 4:

The supplier can use a different asset to fulfil the arrangement. To conclude that the arrangement is not dependent on the use of a specific asset, should it 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 to use a different asset.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.14.1 – Do protective clauses have an impact on the determination of the existence of a lease?

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 7
Reference to standing text: 15A.14
Industry:


Arrangements often contain contractual clauses governing the assets used to provide goods or services. Such clauses are designed to protect the customer.

The underlying reason for clauses governing the assets used in an arrangement might be: to ensure continued provision of goods or services at the end of an arrangement; to protect the customer’s interests, through protecting image or data; or to ensure that the assets deliver the appropriate quality and are fit for purpose.

Such clauses will often have the result that the assets governed by them are specific to the arrangement.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.15.1 – Examples of situations where the purchaser has the ability or right to operate the asset or direct others to do so

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 9
Reference to standing text: 15A.15
Industry:


The ability or right to direct others to operate a specific asset is distinct from adherence to agreed supply terms, and it goes further than that. Examples of situations where the ability or right to direct has been conveyed to the purchaser are where:

  • the purchaser has the ability to hire, fire or replace the operator and the ability to specify significant operating policies and procedures in the arrangement;
  • 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
  • in respect of just-in-time delivery situations, the purchaser has the right to manage and change deliveries on a very short-term basis (for example, daily or hourly).

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.15.2 – What is the rationale of the criteria neither ‘fixed per unit of output’ nor ‘equal to the current market price’?

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 9
Reference to standing text: 15A.15
Industry:


Where the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery, it indicates that the purchaser is effectively paying for the asset’s availability rather than its output and therefore that the arrangement could convey a right to use the underlying asset.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.15.3 – How should ‘fixed per unit of output’ be interpreted?

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 9
Reference to standing text: 15A.15
Industry:


In our view, the phrase ‘fixed per unit of output’ in IFRIC 4 is satisfied where, at the inception of the arrangement, the parties can determine the exact price charged at each point throughout the contract. That is, the price is fixed if it is contractually pre-determined and the only variable in determining the price is time.

Despite our view, a more literal interpretation is permissible (that is, the fixed price per unit should not change during the contract period). Hence, an entity has an accounting policy choice, which should be applied consistently. If an entity changes its accounting policy, the requirements of IAS 8 should be applied. Changes in accounting policy are discussed in detail in chapter 3 para 15.

Example – Pricing is contractually pre-determined and it is considered that the ‘fixed per unit of output’ condition is met

In the following scenarios, we believe that the price per unit of output can be considered to be ‘fixed’, because it is contractually pre-determined at a point in time. In each case, pricing per unit of output does not vary with volume of electricity produced and does not depend on fluctuations in the producer’s costs:

  • A power purchase arrangement under which the purchaser will pay C40 for each megawatt-hour (MWh) of electricity received during the first year of the arrangement. The price per MWh will increase by 2.5% during each subsequent year of the arrangement.
  • A power purchase arrangement under which the purchaser will pay C75 for each MWh of electricity received during peak hours and C45 for each MWh of electricity received during off-peak hours. Peak hours are defined in the agreement in a manner whereby it can be determined at the inception of the arrangement whether each point in time will be considered peak or off-peak. An example would be peak hours being considered from noon to 10:00pm each day during July and August, with all other times being considered off-peak.

Example – Pricing is not contractually pre-determined and it is considered that the ‘fixed per unit of output’ condition is not met

Conversely, we do not believe that the price per unit of output can be considered to be ‘fixed’ in the following scenarios:

  • A power purchase arrangement under which the purchaser will pay C40 for each megawatt-hour (MWh) of electricity received during the first year of the arrangement. The price per MWh will increase during each subsequent year of the arrangement based on the annual change in the consumer price index. This price is not fixed, because the price to be charged from the second year of the arrangement is not pre-determined at inception. It can be argued that the economics are similar to the first example where it is expected that the consumer price index will increase by 2.5% per year. However, in that example the price is pre-determined, whereas prices here will vary with inflation.
  • A power purchase arrangement under which the purchaser will pay C75 for each MWh of electricity received during peak hours and C45 for each MWh of electricity received during off-peak hours. However, unlike the first example, peak and off-peak hours are not pre-determined at the inception of the arrangement. Instead, peak pricing will apply whenever the demand for electricity exceeds 10,000 MWh. Off-peak pricing will apply at all other times. Since peak demand could arise at any time, the price is not pre-determined at inception.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.15.4 – Are pricing mechanisms based on formulae considered to be fixed per unit of output or equal to the current market price?

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 9
Reference to standing text: 15A.15
Industry:


It can be complex to determine whether the price is fixed per unit of output or equal to the current market price.

There is a strong presumption that a price based on a formula (such as a fixed increment) is not regarded as contractually fixed per unit of output if the increment depends on the volume taken.

Similarly, 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.

The average price during the delivery/billing period might be equivalent to the spot price and therefore qualify as the current market price in certain circumstances (for example, where the purchaser takes delivery of the output approximately evenly during the period, such that the average price during the period is equivalent to the average spot price of purchases).

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.15.5 – How to determine whether it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output?

Publication date: 17 Nov 2018

Reference to standard: IFRIC 4 para 9
Reference to standing text: 15A.15
Industry:


If the purchaser is the first and currently only customer, both parties to the agreement need to assess whether:

  • the pricing for that purchaser is consistent with the expectation that there will be other purchasers;
  • it is realistic to anticipate other purchasers;
  • other potential purchasers are currently considering locating a manufacturing facility in the area; and
  • the supplier would be able to provide ‘more than an insignificant amount of the output’ from existing capacity, or with minor modifications to its facilities, to one or more other potential purchasers.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.25.1 – Substance of the transaction does not represent a lease (1)

Publication date: 17 Nov 2018

Reference to standard: SIC 27 paras 4–6
Reference to standing text: 15A.25
Industry:


Entity A (an airline) leases an aircraft to investor B for a period of 10 years (the head lease), and it leases the same aircraft back for seven years (the sub-lease). Once the seven-year sub-lease period has expired, entity A has the right to repurchase the aircraft from investor B. If entity A does not exercise its right, investor B can put the aircraft back to entity A or require entity A to provide a return on the investment in the head lease.

The main purpose of this arrangement is to achieve a tax advantage for investor B, which it shares with entity A. Investor B pays a fee to entity A, representing a portion of the tax savings, and pre-pays the lease obligations under the head lease. These pre-payments are held in a separate investment account outside the control of entity A. The separate investment account is used to make the sub-lease payments. Entity A meets any shortfall of funds in the investment account for the sub-lease payments.

How should this series of transactions be accounted for?

Taken as a whole, the substance of the arrangement is not that of a leasing transaction. Entity A receives a fee (calculated as a share of the tax benefits) for entering into the arrangement, but it retains the risks and rewards of ownership of the asset. Commercially, entity A would not enter in the head lease without the sub-lease (with the purchase options) being in place, because it still requires use of the aircraft for its operations.

When looking at the indicators set out in paragraph 5 of SIC 27:

  • Entity A retains all the risks and rewards of the aircraft’s ownership.
  • Investor B has no right to use the asset in the scenario above. For both investor B and entity A, the main reason for entering into the transaction is the tax advantage that can be achieved.
  • The existence of the put and call option makes return of the aircraft to entity A at the end of the sub-lease virtually certain.

Subject to certain indicators, entity A would not recognise the investment account or the obligation to make payments under the sub-lease. Rather, entity A would continue to recognise an asset of the aircraft and record the fee received from investor B in income.

When looking at the indicators set out in paragraph 6 of SIC 27:

  • Entity A is not able to control the investment account in pursuit of its own objectives and is not obliged to pay the lease payments. This is because the investment account can only be used to pay investor B and cannot be used by entity A for any other purpose.
  • Entity A has a remote risk of reimbursing the entire amount of any fee received from investor B if the pre-paid amount is required to be invested in risk-free assets (for example, a deposit account with a bank of good credit rating).
  • Other than the initial cash flows at inception, the only cash flows expected are the lease payments that are satisfied solely from funds withdrawn from the separate investment account.

The entity retaining use of the asset should also determine when to recognise a fee as income in accordance with the criteria in paragraph 20 of IAS 18. This issue is considered further in chapter 9A para 34.

Illustrative text - Determining whether an arrangement contains a lease - FAQ 15A.25.2 – Substance of the transaction does not represent a lease (2)

Publication date: 17 Nov 2018

Reference to standard: SIC 27 para 5
Reference to standing text: 15A.25
Industry:


An example of a situation where a contractual lease agreement will not be accounted for as a lease is where the lessee has been granted a purchase option at a fixed price at the end of the lease term and the lessor has been granted a corresponding put option with identical terms.

Whatever the value of the asset at the end of the lease term, it is virtually certain that one party will exercise its option and so, in substance, the lessee has purchased the asset subject to the lease arrangement.

Consequently, the entity shall account for the contract a financing arrangement.

Illustrative text - Lease term - FAQ 15A.30.1 – What factors require the most judgement in determining the lease term?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.30
Industry:


Factors that require judgement are those parts of the lease that deal with: the lease’s non-cancellable period (sometimes referred to as the ‘primary period’); cancellation (or ‘break’) clauses; exchange and upgrade conditions; and options to extend the lease.

Illustrative text - Lease term - FAQ 15A.30.2 – What factors to consider when determining whether a lessee is reasonably certain to exercise a renewal option?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.30
Industry:


An entity should consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option to extend the lease term beyond the non-cancellable period. Examples of factors to consider include, but are not limited to:

  • contractual terms and conditions for the optional periods compared with market rates (lease payment for a secondary period, termination penalties, residual value guarantees, purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates…);

    For example, where the terms of renewal are set at what is anticipated to be significantly below a fair market rental, it is reasonable to assume that the lessee will act in his own commercial interests and extend the lease. In these situations, the lease term would include both the minimum period and the renewal period. Where the rentals in the secondary period are based on a fair market basis, such that there is no compelling commercial reason why the lessee should extend the lease, the lease term will normally exclude the secondary period, in absence of any other economic incentives;

  • significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract that are expected to have significant economic benefit for the lessee when the option to extend becomes exercisable;

  • costs relating to the termination of the lease (negotiation costs, relocation costs, costs associated with returning the underlying asset in a contractually specified condition…)

    For example, if the return conditions stipulated in the lease are unduly unfavourable, it might be to the lessee’s advantage to continue to lease the asset.

    the importance of that underlying asset to the lessee’s operations. If the lessee’s business is dependent on the asset such that the cost of its removal and disruption of business are disproportionate to the costs of continuing the lease, the secondary period would be included in the lease term.

  • any other form of commercial compulsion.

Illustrative text - Lease term - FAQ 15A.30.3 – How is the lease term impacted by break clauses?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.30
Industry:


If a lease contains a clean break clause (that is, where the lessee is free to walk away from the lease agreement after a certain time without penalty), the lease term for accounting purposes will normally be the period between the commencement of the lease and the earliest point at which the break option is exercisable by the lessee.

If a lease contains an early termination clause that requires the lessee to make a termination payment to compensate the lessor (sometimes referred to as the ‘stipulated loss value’) such that the recovery of the lessor’s remaining investment in the lease was assured, the termination clause would normally be disregarded in determining the lease term.

Where there are break clauses that transfer some economic risk to the lessor but, at the same time, give the lessor some protection from financial loss, the interpretation becomes more difficult. For example, certain computer lessors include ‘right to exchange’ clauses in leases that would otherwise be classified as finance leases. These give lessees the right to return equipment, or a proportion of the equipment, at certain times during the primary lease term, but normally on condition that a replacement lease is entered into on the new and remaining equipment.

On the one hand, the effect could be the replacement of one finance lease by another, analogous to an outright purchase of equipment with a right to trade in for new equipment at a future date. This will be particularly so where the commercial loss on early termination (that is, the difference between market value and the lessor’s book value) is effectively rolled into the new lease agreement, either through higher rentals or through an extension of the term on the remaining pool of assets not subject to the exchange. On the other hand, if the lessor takes a genuine residual value risk under the exchange conditions and such losses are not passed on to the lessee, this could justify classification as an operating lease.

Illustrative text - Classification indicators - FAQ 15A.32.1 – What needs to be considered when assessing transfer of ownership or purchase options?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 10
Reference to standing text: 15A.32
Industry:


Where the lease transfers ownership of the asset at the end of the lease term, or the lessee has an option to purchase the asset which is priced in such a way as to make exercise reasonably certain, it can be presumed that the lessor will look to recover his investment in the leased asset over the term of the lease. In substance, the arrangement will be akin to a financing.

Similarly, where the lessor has a put option to sell the asset at an amount that is more than the expected fair value at that date, the lease should be classified as a finance lease.

Where the lessee has a call option of the asset, the exercise price should be considered, together with any other commercial compulsion for the lessee to exercise such options (even where the option appears to be priced at or above fair value). To assess whether the exercise of the option is reasonably certain, and similarly to the determination of the lease term (inclusion or not of a renewal option in the lease term as discussed in FAQ 15A.30.2), all facts and circumstances that create an economic incentive for the lessee to exercise the option need to be considered.

Where an option is at market price, as determined at the end of the lease term, the residual value risk typically remains with the lessor, and such an option would not (on its own) indicate finance lease treatment.

Illustrative text - Classification indicators - FAQ 15A.32.2 – What does ‘substantially all’ mean in the context of the present value of minimum lease payments classification indicator?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 10
Reference to standing text: 15A.32
Industry:


If the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset, the agreement is viewed as a financing arrangement.

Fair value is defined as the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.

There is no numerical definition of what is meant by ‘substantially all’. Instead, judgement should be used to determine whether the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset.

Illustrative text - Classification indicators - FAQ 15A.32.3 – How do specialised assets impact the lease classification?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 10
Reference to standing text: 15A.32
Industry:


Where a leased asset is highly specialised, the lessor is unlikely to be able to sell the asset to a third party at the end of the lease. As such, the lessor will look to recover its investment in the asset over the lease term, and the arrangement will be, in substance, a financing.

Illustrative text - Classification indicators - FAQ 15A.33.1 – Should the fact that the lessor retains title to the asset impact the lease classification?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.33
Industry:


Where the lease term is for a major part of the asset’s economic life, the residual value risk associated with the asset is likely to be small.

Therefore, the fact that the lessor retains title should not have a significant impact on the risks and rewards analysis, and the arrangement will be, in substance, a financing.

Illustrative text - Classification indicators - FAQ 15A.33.2 – The impact of technical obsolescence on the lease classification

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.33
Industry:


Some assets, such as IT assets, can be subject to a higher risk of technical obsolescence than other assets. For example, an entity might lease computer hardware, that is capable of operating for seven years, for a period of only three years. Such a lease could probably qualify as a finance lease. This is because various factors, such as advances in technology, result in an economic life that is shorter than the hardware’s physical life.

As a result, the economic value that can be obtained from the computer hardware will be concentrated in the first few years of the asset’s physical life.

Illustrative text - Classification indicators - FAQ 15A.33.3 – Is the economic life for lease classification purposes the same as the period over which the entity would depreciate an asset?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.33
Industry:


No, the period over which an asset is expected to be economically usable is not necessarily the same as the period over which an entity will depreciate an asset.

The entity will depreciate the asset over the useful life, which is the period over which the asset is expected to be available for use by the entity. For example, an entity might use a certain asset for two years before it replaces the asset due to the entity’s high performance requirements. However, another entity might be able to use the same asset for a further period with no impact on performance. In this case, the economic life for lease classification purposes would encompass both periods, but the useful life to the entity is two years.

Illustrative text - Classification indicators - FAQ 15A.34.1 – What requires the most judgement in determining lease classification?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 11
Reference to standing text: 15A.34
Industry:


Whether or not a lease passes substantially all of the risks and rewards of ownership to the lessee will normally be self-evident from the terms of the lease contract and an understanding of the commercial risks taken by each party. Where the lessor takes little or no asset-related risk, other than a credit risk on the lessee, the agreement will be a finance lease. Similarly, where the lessor is exposed to significant levels of risks relating to movements in the asset’s market value, utilisation, or performance, such as on a short-term hire agreement, the agreement will be easily classified as an operating lease.

The greatest difficulty and requirement to apply judgement, therefore, tends to arise in relation to classifying leases where the lessor recovers most of its investment through the terms of the lease but retains some element of risk relating to the asset’s residual value at the end of the lease term.

Illustrative text - Classification indicators - FAQ 15A.34.2 – If lessor and lessee share the residual value, how does this impact lease classification?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 11
Reference to standing text: 15A.34
Industry:


It is not uncommon for the lessee and lessor to share both the downside risks and potential upside benefits associated with the asset’s market value at the end of the lease term, such that the lessee is taking some, but not all, of the residual risk.

For example, the terms of the agreement might require the asset to be sold at the end of the lease term and any profit and loss arising against anticipated values to be shared between the lessor and lessee. Often, the profit- and loss-sharing arrangements are unevenly balanced between the parties, potentially with the lessee often taking the first tranche of loss up to a stipulated amount, with the lessor (or other third parties) only taking losses beyond that sum.

Interpreting these types of agreement can be difficult. The lessor might retain some residual value risk but, if this implies that residual values have to fall to a level substantially below that anticipated to occur in practice, even under the most pessimistic circumstances, the lessor’s risk is remote and all of the real commercial risks rest with the lessee.

In some arrangements relating to portfolios of assets (for example, car fleets), the assessment of the commercial effects of these residual sharing arrangements can be further complicated by terms that mitigate a lessor’s risk by providing for any residual losses on individual assets to be pooled against profits on others within the same portfolio. Again, these types of arrangement will need to be considered carefully to determine the nature of the risks borne by the lessor (and other third parties) and those transferred to the lessee.

Illustrative text - Classification indicators - FAQ 15A.34.3 – Finance lease classification where lessor risk is evaluated as remote

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 11
Reference to standing text: 15A.34
Industry:


Entity A (the lessor) leases a truck to entity B (the lessee) for a period of three years. Lease rentals are set by the lessor, assuming a residual value for the truck of C4,000 at the end of the lease term. Market data suggests that the likely range of residual values at the end of three years is C4,000 to C5,000. The lessee will guarantee any fall in the truck’s residual value below C4,000 down to C2,500. The lessor will bear the cost of any fall in the residual value below C2,500. How should this lease be classified?

The lease should be classified as a finance lease. The sharing of the residual value risk is not even, because it is unlikely that the truck’s residual value will fall below C2,500. The risk retained by entity A is remote and should therefore be ignored. The residual value risk is, in substance, borne by entity B.

The calculation of the minimum lease payment should include the amount guaranteed by the lessee (C1,500).

Illustrative text - Inception and commencement of the lease - FAQ 15A.37.1 – The difference between lease inception and lease commencement

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.37
Industry:


A lessee signs an agreement to lease a car on 31 March but does not take delivery of the car until 30 June. The classification of the lease and the measurement of the related assets and liabilities (if the lease is a finance lease) will take place on 31 March (inception of the lease). The recognition of the finance lease assets and liabilities (if applicable) will not take place until 30 June (commencement of the lease term).

Illustrative text - Inception and commencement of the lease - FAQ 15A.41.1 – Should a commitment of the lessee to pay for remediation of pre-existing damage be taken into account in the calculation of the minimum lease payments?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text:
15A.41
Industry:


Entity A has entered into a lease agreement in relation to a warehouse. Entity A leases the warehouse for an initial term of 15 years. The rent payments are below market rents, but entity A has committed to pay for remediation of asbestos damage existing at the inception of the lease.

Should a commitment of the lessee to pay for remediation of pre-existing damage be taken into account in the calculation of the minimum lease payments?

Yes. Management should consider the expenditure for the remediation of the asbestos damage as part of the minimum lease payments, because entity A can be required to make these payments under the terms of the lease arrangement.

Entity A’s responsibility to pay for the remediation of pre-existing damage is compensated through below-market rent payments. The below-market rents, combined with the remediation expenditure, should approximate a market rent for the leased asset.

Illustrative text - Accounting by lessees - Accounting for finance leases - FAQ 15A.50.1 – Can a premium paid on early redemption of a finance lease liability be capitalised?

Publication date: 17 Nov 2018

Reference to standard: IAS 39 para 2; IFRS 9 para 2.1
Reference to standing text: 15A.50
Industry:


A premium paid on early redemption of a finance lease liability should be accounted for in accordance with IAS 39 or IFRS 9. Therefore, it is not a cost that would be eligible for capitalisation under IAS 16; this is because it is not part of the purchase price of the asset or a directly attributable cost of bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

Illustrative text - Accounting by lessees - Accounting for finance leases - FAQ 15A.51.1 – Finance lease accounting by a lessee

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 25
Reference to standing text: 15A.51
Industry:


Consider a lease with the following details:

Cost of leased asset C100,000
Lease term 5 years
Rental six-monthly in advance C12,000
Expected residual on disposal at the end of the lease term C10,000
Lessee’s interest in residual proceeds 97%
Useful life 8 years
Inception and commencement date 1 January 20X4
Lessee’s financial year end 31 December


Initial direct costs are ignored for the purpose of this example.

In this example, the lease is clearly a finance lease, because the lessor has only an insignificant interest in the residual value (3%).

The amounts that the lessor expects to receive and retain comprise the rentals, plus 3% of the residual at the end of the lease term. These amounts can be used to determine the interest rate implicit in the lease and the present value of the lessee’s minimum lease payments as follows:

    Present value factor Present value at 4.3535%
      C
Lessee’s minimum lease payments:      
January 20X4 (1 period) C12,000 1.0000 12,000
June 20X4 – Jan 20X8 (9 periods) C12,000 7.31701 87,804

      99,804
December 20X8 (C10,000 – C9,700) C300 0.65302 196

Fair value     100,000


Notes
1 1/0.043535 × (1 − 1/(1.043535) 9) = 7.3170
2 1/(1.043535)10 = 0.6530

The interest rate that amortises these amounts is 4.3535%, compounded on a six-monthly basis.

The amount that is capitalised as both an asset and an obligation at the commencement of the lease is, therefore, C99,804.

The finance charge can now be allocated to each accounting period. In this example, the actuarial method has been used:

Period commencing Obligation at start of period Rental paid Obligation after payment Finance charge at 4.3535% Obligation at end of period
  C C C C C
January 20X4 99,804 (12,000) 87,804 3,823 91,627
June 20X4 91,627 (12,000) 79,627 3,467 83,094
January 20X5 83,094 (12,000) 71,094 3,095 74,189
June 20X5 74,189 (12,000) 62,189 2,707 64,896
January 20X6 64,896 (12,000) 52,896 2,303 55,199
June 20X6 55,199 (12,000) 43,199 1,881 45,080
January 20X7 45,080 (12,000) 33,080 1,440 34,520
June 20X7 34,520 (12,000) 22,520 980 23,500
January 20X8 23,500 (12,000) 11,500 500 12,000
June 20X8 12,000 (12,000)


    (120,000)   20,196  



The finance charges for each year and, by deduction, the capital repayment element of the rental can now be summarised as follows:

  Rental Finance charges Capital repayment
  C C C
20X4 24,000 7,290 16,710
20X5 24,000 5,802 18,198
20X6 24,000 4,184 19,816
20X7 24,000 2,420 21,580
20X8 24,000 500 23,500



120,000 20,196 99,804




In this example, the lessee’s financial year end coincides with the end of a rental period and so no interest accrual is necessary.

Depreciation can now be calculated as follows:

Lease term = 5 years

Useful life = 8 years

Lessee’s interest in the proceeds of the residual = C9,700

Therefore, the depreciation charge on a straight-line basis is:

C99,804 –
C9,700
 

= C18,021 per annum
5 years  


The effects on the lessee’s balance sheet and income statement for each year are summarised as follows:

  Obligations under finance leases Net book value of leased assets Depreciation Finance charges Total charges
  C C C C C
Start 99,804 99,804      
20X4 83,094 81,783 18,021 7,290 25,311
20X5 64,896 63,762 18,021 5,802 23,823
20X6 45,080 45,741 18,021 4,184 22,205
20X7 23,500 27,720 18,021 2,420 20,441
20X8 9,700 18,020 500 18,520



      90,104 20,196 110,300




This example illustrates that, in addition to its impact on the lessee’s balance sheet, lease capitalisation can also have a significant impact on the lessee’s income statement. The lease rentals are C24,000 per annum, but the combined charge for depreciation and interest varies from C25,311 to C18,520 per annum. These differences between rental payments and income statement charges will be more pronounced on assets subject to long economic lives and leases with short primary lease periods but which might have secondary periods at peppercorn rents.

Illustrative text - Accounting by lessees - Contingent rents - FAQ 15A.54.1 – Can contingent rents sometimes be disguised minimum lease payments?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.54
Industry:


Contingent rent is excluded from the measurement of finance lease assets and liabilities, except where it is clear that the contingency is not genuine. As such, there should be an assessment of whether the contingent rentals lack economic substance and are, instead, disguised minimum lease payments.

For example, a lessor might charge fixed rents that are significantly below market rents, plus an element that is contingent on the happening of a specific event. If it is assessed that the contingent event is likely to occur, it would be necessary to question why the fixed rents are set at a level below market rents, because this could be determined to be a non-genuine contingency.

Illustrative text - Accounting by lessees - Contingent rents - FAQ 15A.54.2 – Additional payments if a specific mileage of a leased car is exceeded

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.54
Industry:


A car is leased under a three-year contract. The lease rentals are fixed, provided the mileage does not exceed a maximum amount during that period. Any mileage incurred above the maximum is subject to an additional charge. How should the minimum lease rentals be calculated?

The minimum lease payments should include only the fixed rent. The charges for excess mileage are contingent rental payments and should not be included in the minimum lease payments.

Illustrative text - Accounting by lessees - Contingent rents - FAQ 15A.54.3 – Rental payments based on usage, with a cap and a floor

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.54
Industry:


Entity T is a telecom business and has entered into a lease contract with entity S for exclusive use of a submarine cable for overseas communication. The contract is for 10 years, which corresponds to the cable’s economic life. The lease payments are dependent on the cable’s usage. The ceiling amount is C10 million per year at 100% usage, and the minimum amount (floor) is C6 million per year, which corresponds to a usage of 60% or lower.

Management of entity T estimates that the cable’s average usage will be approximately 85% and the average annual lease payments are expected to be C8.5 million. How should the minimum lease payments be calculated?

The undiscounted amount of the minimum lease payment is C60 million, which is the amount that entity T is contractually required to pay. Entity T should not include a best estimate of the contingent rents in the minimum lease payments. The additional C25 million that T expects to pay over the term of the contract are contingent rents, because this amount varies based on the future use of the leased asset.

Illustrative text - Accounting by lessees - Contingent rents - FAQ 15A.54.4 – Inflation adjustments treated as contingent rentals

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.54
Industry:


Entity D and entity E operate in an inflationary environment of 6% over the last 12 months. Entity D (the lessor) enters into a three-year operating lease agreement with entity E (the lessee). Lease rentals are fixed as C20,000 per month for the first year. The inflation adjustment will occur at the end of 12 and 24 months. Should escalations in lease payments linked to inflation be recognised in the period in which they occur?

Inflation adjustments should be recognised in the period in which they occur, since they meet the definition of contingent rent and, as such, are not included in the minimum lease payments.

Operating lease rentals would be recognised in the income statements of entities D and E as follows:

  • In each of the first 12 months (1-12), entities D and E will recognise C20,000.
  • In each of the second 12 months (12-24), entities D and E will recognise C20,000 plus the actual inflation adjustment at month 13.
  • In each of the last 12 months (24-36), entities D and E will recognise C20,000 plus the actual inflation adjustment at month 13, plus the inflation adjustment at month 25.

Illustrative text - Accounting by lessees - Accounting for operating leases - FAQ 15A.57.1 – How should lease payments be spread if there is a pre-determined rate of increase in the lease payments?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 33
Reference to standing text: 15A.57
Industry:


Where the lease contains a pre-determined rate of increase in the lease payments, the lease payments over the life of the operating lease should be recognised on a straight-line basis, even if the rate of increase in lease rentals is designed to approximate, or be the best estimate of, expected inflation. An accrual should be built up to provide for the difference between the cash payment and the expense over broadly the earlier part of the lease, to be utilised over the later part of the lease.

Illustrative text - Accounting by lessees - Accounting for operating leases - FAQ 15A.57.2 – Situations regarding lease payments made where the lessee is not using the leased asset

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 34; IAS 16 paras 16(b), 19
Reference to standing text: 15A.57
Industry:


The requirement to spread the lease payments on a straight-line basis over the lease term also applies where the lessee is not using the leased asset. However, the lease payments might represent costs that are directly attributable to bringing an item of property, plant and equipment to the location and condition necessary for it to be capable of operating in the manner intended by management. Such costs would be included in the asset’s carrying amount. Further guidance on what is included in the cost of an item of property, plant and equipment is provided in chapter 22 para 19.

Illustrative text - Accounting by lessees - Accounting for operating leases - FAQ 15A.58.1 – How should initial direct costs in an operating lease be accounted for?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.58
Industry:


Initial direct costs include commissions, legal fees, registration fees and stamp duties; they exclude general overheads, such as those incurred by a sales and marketing team. In our view, such costs should be capitalised and expensed over the lease term on a straight-line basis to the income statement. This accounting treatment mirrors the accounting of the lessor in an operating lease.

In the absence of explicit guidance on the accounting of such costs by lessees in an operating lease, lessees could capitalise initial direct costs and expense them over the lease term on a straight-line basis. This accounting treatment mirrors the accounting of the lessor in an operating lease. 

Alternatively, lessees in an operating lease could expense initial direct costs as incurred. 

Lessees should select one approach and apply it consistently to all similar arrangements.

Illustrative text - Accounting by lessees - Operating lease incentives - FAQ 15A.61.1 – Can a rent free period granted by the lessor during the fit-out of a store be spread over the fit-out period?

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 5
Reference to standing text: 15A.61
Industry:


The use of a basis other than straight-line to spread the incentive should be rare.

In particular, this is not a permission to recognise all of the benefit of the incentive in a start-up period, with none recognised over the remaining lease period, because that would not be consistent with the requirement for a ‘systematic’ basis.

For example, a retailer might lease a new store for a five-year period, with an initial rent-free period of six months. Although the retailer might not open the store for the first six months, due to a fit-out period, the retailer still has the benefit of the use and enjoyment of the leased property during that initial period, as well as for the rest of the lease, and so the incentive should be spread over the five years of the lease period from the commencement of the lease term on a straight-line basis.

Illustrative text - Accounting by lessees - Operating lease incentives - FAQ 15A.61.2 – How should payments between the lessor, new tenant and old tenant be accounted for?

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 5
Reference to standing text: 15A.61
Industry:


Some contracts require the lessor, new tenant and old tenant to make payments when entering into an operating lease contract or during the lease term. Accounting for these payments might differ, depending on the contractual arrangements and on the substance of the transaction. The following table sets out the principles of lease accounting for payments between these parties:

  Lessor New tenant Old tenant
Lessor pays sums to:   Payment made to a new tenant at the inception of the lease is a lease incentive, which should be accounted for under SIC 15. This is a cost associated with cancelling the old lease, so it is generally expensed by the lessor. However there are situations where the payment can be capitalised (refer to FAQ 15A.97.3). The old tenant should recognise the receipt as income (assuming that all conditions for receipt have been met).
New tenant pays sums to: This is a pre-payment of rentals under the lease. The lessor and lessee should recognise the pre-payment and income/expense on a straight-line basis over the lease term.   This might be a premium paid by the new tenant to gain access to a property located in a specific location. The new tenant accounts for this as an intangible asset. The old tenant should recognise the receipt as income (assuming that all conditions for receipt have been met).
Old tenant pays sums to: This is income arising from the old lease, so it should be recognised as income by the lessor. This is a cost of exiting the old lease and should be expensed by the old tenant. This is a cost of exiting the lease for the old tenant and should be expensed. This is analogous to a lease incentive for the new tenant, which should be accounted for under SIC 15.  

Illustrative text - Accounting by lessees - Operating lease incentives - FAQ 15A.62.1 – Accounting for costs in connection with pre-existing leases

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 6
Reference to standing text: 15A.62
Industry:


An entity decides to move out of an existing leasehold property and incurs a termination penalty in order to move into a new property at lower rentals. The termination penalty should be expensed, because it does not meet the definition of an asset.

Illustrative text - Accounting by lessees - Accounting for sale and leaseback transactions - FAQ 15A.63.1 – Sale and leaseback of a building

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 58
Reference to standing text: 15A.63
Industry:


Entity A sells a building to bank B for the market value of C10m (book value of the building is C8m). For the purpose of this example, disregard the lease of land. The entity then leases the building back from bank B and, over the next seven years, entity A pays bank B a market rental. At year 7, entity A has the option to purchase back the building for C10 m less the rentals paid at that date plus interest on the initial investment and 25% of any increase in the market value since year 1. If the market value has gone down and entity A is not willing to exercise the purchase option, the lease will continue for another 13 years, with entity A paying a rental that makes bank B recover its initial investment (C10m) as well as a return of LIBOR + 2% on it at the end of year 20,. Entity A has operating rights of the building for 20 years and is required to maintain it. What is the correct classification of the leaseback?

imoa1885_redrawn


It appears that entity A keeps substantially all of the risks and returns incident to ownership, and the lease should be classified as a finance lease. If entity 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), the structure of rentals from year 8 and the fact that bank B recovers the value of its investment as well as a return on it in all scenarios demonstrate that entity A is keen to retain an interest in the value of the property and to pay interest rather than market rents.

Illustrative text - Finance leasebacks - FAQ 15A.64.1 – Accounting for a sale and finance leaseback

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 59
Reference to standing text: 15A.64
Industry:


The IAS 17 approach to sale and finance leaseback transactions is demonstrated in the following example:

Entity A owns a freehold interest in a building. Entity A sells the building to bank B and leases it back for a period of 20 years. This is believed to be a major part of the building’s economic life. The main facts about the building and the lease are as follows:

Book value of the building C700,000
Sales proceeds C1,000,000
Lease rentals years 1 - 20 C88,218
Interest rate implicit in lease 7%
Present value of minimum lease payments C1,000,000


The leaseback of the building is for a major part of the building’s economic life, and so the lease should be treated as a finance lease. Entity A will therefore record the following double entries:

On sale:    
Dr Cash C1,000,000  
      Cr Building   C700,000
      Cr Deferred income   C300,000
     
to recognise the sale of the building.  
     
Dr Assets held under finance lease C1,000,000  
      Cr Finance lease creditor   C1,000,000
     
to set up the finance leased asset and liability.    
     
Years 1-20:    
Dr Deferred income C15,000  
      Cr Profit & loss   C15,000
     
to release the deferred income over the lease term (C300,000/20).
     
Dr Depreciation C50,000  
      Cr Assets held under finance lease   C50,000
     
to recognise depreciation on the leased asset (C1,000,000/20).
     
Dr Interest (profit & loss) X  
Dr Finance lease creditor (88,218 − X)  
      Cr Cash   88,218
     
to record rentals paid.    

Illustrative text - Finance leasebacks - FAQ 15A.65.1 – How is a sale and finance leaseback accounted for where the sales proceeds are less than the fair value of the asset due to subsequent rentals being on a basis other than arm’s length?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 58
Reference to standing text: 15A.65
Industry:


Where subsequent rentals are determined other than on an arm’s length basis, it is possible that the sales proceeds will be less than the fair value of the asset. IAS 17 is silent on how any loss arising in this circumstance should be treated. We believe that any apparent loss should be treated in the same way as any profit, by being deferred and amortised over the lease term.

Illustrative text - Repurchase agreements – Unconditional commitment to repurchase - FAQ 15A.74.1 – Does a pre-determined repurchase price indicate that the substance might not be that of a sale and leaseback?

Publication date: 17 Nov 2018

Reference to standard: SIC 27 para 5
Reference to standing text: 15A.74
Industry:


Yes, a repurchase price that is pre-determined at the outset will usually be the sum of the original sale price, plus any costs incurred by the buyer/lessor (for example, insurance during the period of use if not borne by the seller/lessee) and a lender’s return (comprising interest on the original sale price). In this case, the repurchase price clearly indicates that the transaction’s substance is that of a collateralised borrowing.

Illustrative text - Repurchase agreements – Unconditional commitment to repurchase - FAQ 15A.74.2 – Does a market value repurchase price indicate that the substance is that of a sale and leaseback?

Publication date: 17 Nov 2018

Reference to standard: SIC 27 para 5
Reference to standing text: 15A.74
Industry:


Yes; if the repurchase price is set at market value, this indicates that the buyer/lessor is bearing substantive residual value risk such that the seller/lessee has not retained the original asset. In this situation, normal sale and leaseback accounting would apply.

Illustrative text - Repurchase options – ‘Almost certain to be exercised’ - FAQ 15A.75.1 – Sale and leaseback transactions with a repurchase option that might not, in substance, involve a lease

Publication date: 17 Nov 2018

Reference to standard: SIC 27 para 5
Reference to standing text: 15A.75
Industry:


Sale and leaseback transactions with a repurchase option that might not, in substance, involve a lease include:

  • A call option that is set at a significant discount to the expected fair value when it becomes exercisable and other factors indicate that the seller needs the asset to use on an ongoing basis (seller/lessee effectively controls the asset). Even in the absence of a significant discount to the call option, there might be other factors that would compel the seller/lessee to exercise the option to repurchase (economic compulsion).
  • A put option that is set at a price that is significantly higher than the expected fair value when it becomes exercisable. Indeed, it would be unusual for the seller/lessee in a sale and leaseback transaction to guarantee an amount in excess of the asset’s fair value. It appears that the seller/lessee has retained all of the residual interests in the asset and the buyer/lessor has no interest in the asset. Consequently, such an arrangement does not convey a right to use the asset during the lease term.
  • Call and put options held by both seller/lessee and buyer/lessor on the same terms and at a pre-determined price other than fair value. In this situation, it is more or less inevitable that one of the two parties will exercise the option to secure a profit or avoid a loss. As such, it is clear that the asset will revert back to the seller/lessee, since the seller/lessee retains all of the asset’s risks and rewards of ownership and enjoys substantially the same rights to its use as before the arrangement. Even after the end of the lease term, the seller/lessee will continue to retain the risks and rewards of ownership. Consequently, there is no sale and leaseback accounting, and the transaction should be accounted for as a secured borrowing.
  • A put option that is exercisable at a pre-determined price. The existence of an option held by the buyer/lessor to put the asset back to the seller/lessee at a pre-determined price means that the seller/lessee has transferred the rewards of ownership to the buyer but has retained the risks. This is because the buyer will only put the asset back if the fair value falls below the put exercise price. As such, the seller/lessee has effectively guaranteed the asset’s residual value below the put exercise price. Therefore, if the arrangement’s other terms indicate that the option is ‘almost certain’ to be exercised, the seller/lessee bears the risks and rewards beyond the lease term. Since the seller never parts with its right to use the asset, the transaction is outside the scope of IAS 17.

Illustrative text - Repurchase options - Not ‘almost certain’ to be exercised - FAQ 15A.76.1 – Sale and leaseback transactions with a repurchase option that would be considered to involve a lease

Publication date: 17 Nov 2018

Reference to standard: SIC 27 para 5
Reference to standing text: 15A.76
Industry:


Circumstances that indicate that sale and leaseback transactions with a repurchase option convey a right of use, and are therefore within IAS 17’s scope, include:

  • A call option that is exercisable at fair value at the date of exercise and the arrangement’s terms indicate that it is not ‘almost certain’ that the option will be exercised. In this situation, the arrangement conveys the right to use an asset for an agreed period of time. In other words, the risks and rewards inherent in the asset’s residual value have clearly passed to the buyer/lessor. The option amounts to a right of first refusal to the seller/lessee. Consequently, sale and leaseback accounting will apply.
  • A call option that can be exercised at a price that is expected to be sufficiently lower than the fair value at the date of exercise (bargain purchase option) and other factors indicate that it is not ‘almost certain’, but reasonably certain, that the option would be exercised. An arrangement of this type indicates that the seller/lessee has disposed of the risks of a fall in the asset’s value below the option exercise price, but has retained the rewards of ownership if the asset’s fair value at the date of exercise exceeds the repurchase price. Given that the option is not almost certain to be exercised, the arrangement conveys a right of use during the lease term.

Illustrative text - Disclosures by lessees - FAQ 15A.80.1 – Are more disclosures required if there is a significant difference between the actual cash commitments disclosed and the income statement impact?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 35
Reference to standing text: 15A.80
Industry:


If the difference between the actual cash commitments disclosed and the income statement impact is significant (due to the spreading of incentives, the effect of contingent rentals or onerous lease provisions), we consider that the effect should be disclosed. Disclosure of this effect is not required, but it is considered to be best practice.

Illustrative text - Disclosures by lessees - FAQ 15A.80.2 – Disclosure of minimum lease payments

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 35
Reference to standing text: 15A.80
Industry:


Entity A leases a building under a 15-year operating lease. At the inception of the lease in 20X3, the minimum lease payments were set at C1 million per annum. The lease is subject to rent reviews every five years, for the first time in 20X8. At each rent review, the rentals are revised to market rates, subject to the proviso that rentals cannot be decreased (upwards-only rent review). The annual minimum lease payments were increased to C1.25 million during the year 20X8 and they will never be less than C1.25 million.

How should the requirement to disclose future minimum lease payments be interpreted where a lease is subject to upwards-only market rent reviews?

The minimum lease payments at inception of this lease were C1 million per annum. At inception, the increases due to rent reviews were contingent rent. However, at the balance sheet date, these increases are no longer contingent. Therefore, the amounts disclosed under paragraph 35 of IAS 17 should reflect these increases.

An example of the required disclosures is shown below.

The total of the future minimum lease payments payable under the entity’s non-cancellable operating lease for each of the following periods is as follows:

  20X8 20X7
Not later than one year 1,250,000 1,000,000
Later than one year and not later than five years 5,000,000 4,000,000
Later than five years 6,250,000 6,000,000

Illustrative text - Accounting by lessors - Accounting for finance leases - FAQ 15A.85.1 – What does the unguaranteed residual depend upon?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.85
Industry:


The expected residual will depend upon several factors including:

  • The nature of the asset under consideration.
  • The known volatility of second-hand values.
  • The rate of technological change.
  • Competitive conditions.
  • The asset’s economic life relative to the lease’s primary period.

For both finance leases and operating leases, the lessor will have to estimate the expected residual value at the end of the lease. However, the accounting treatment of unguaranteed residuals will depend upon the classification of the lease.

Illustrative text - Accounting by lessors - Accounting for finance leases - FAQ 15A.87.1 – Calculation of lessor finance income

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 39
Reference to standing text: 15A.87
Industry:


The method for allocating gross earnings to accounting periods is referred to as the ‘actuarial method’. The actuarial method allocates rentals between finance income and repayment of capital in each accounting period in such a way that finance income will emerge as a constant rate of return on the lessor’s net investment in the lease.

Lease term 7 years from 31 March 20X2
Rental payments C1,787 payable annually in advance
Asset cost C10,000
Expected residual value Nil
Lessor’s year end date 30 September


The first step is to calculate the interest rate implicit in the lease. The calculation of an annual interest rate of 8.1928% is shown below:

    Interest  
Date Cash flows 8.1928% Balance
  C C C
31 March 20X2 10,000 10,000
31 March 20X2 (1,787) 8,213
31 March 20X3 (1,787) 673 7,099
31 March 20X4 (1,787) 582 5,894
31 March 20X5 (1,787) 483 4,590
31 March 20X6 (1,787) 376 3,179
31 March 20X7 (1,787) 260 1,652
31 March 20X8 (1,787) 135

  (2,509) 2,509  


This equates to a 6-monthly interest rate of 4.0158% ((1.081928)1/2 = 1.040158).

Once the interest rate implicit in the lease is known, finance income can be allocated to the appropriate accounting periods:

Date Net investment at start of period Interest income at 4.0158% Rental Net investment at end of period Annual finance income
  C C C C C
30 September 20X2 8,213 330 8,543 330
31 March 20X3 8,543 343 (1,787) 7,099
30 September 20X3 7,099 285 7,384 628
31 March 20X4 7,384 297 (1,787) 5,894
30 September 20X4 5,894 237 6,131 534
31 March 20X5 6,131 246 (1,787) 4,590
30 September 20X5 4,590 184 4,774 430
31 March 20X6 4,774 192 (1,787) 3,179
30 September 20X6 3,179 128 3,307 320
31 March 20X7 3,307 133 (1,787) 1,653
30 September 20X7 1,653 66 1,719 199
31 March 20X8 1,719 68 (1,787)
30 September 20X8 68

          2,509

Illustrative text - Accounting by lessors - Accounting for finance leases - FAQ 15A.88.1 – Re-appraisal of unguaranteed residual value

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 41
Reference to standing text: 15A.88
Industry:


Entity A is a lessor and a party to a finance lease. The lease term is five years, and the fair value of the leased asset is C10,000. Rental payments of C2,249 are made annually in advance. At inception of the lease, the lessor estimates the unguaranteed residual value to be C1,000. The interest rate implicit in the lease is 10%. The table shows the net investment in the lease and the allocation of interest income over the lease term:

  Year 1 Year 2 Year 3 Year 4 Year 5
Opening 10,000 8,526 6,904 5,120 3,158
Rental receipt (2,249) (2,249) (2,249) (2,249) (2,249)

  7,751 6,277 4,655 2,871 909
Interest income 775 627 465 287 91

Closing 8,526 6,904 5,120 3,158 1,000


At the end of year 3, entity A reviews its estimate of the value of the unguaranteed residual and determines that it has fallen to C800. The income allocation over the lease term is recalculated based upon the revised estimate of the residual value. This is done by calculating the difference between the net present value, at the end of year 3, of the original estimated residual value and the revised estimate of the residual value. This calculation is shown below:

  Year 3 Year 3  
  Original Revised Difference
Gross residual 1,000 800 (200)
Discount factor – 1/(1.1)2 0.82645 0.82645  

Net present value 826 661 165


The difference of C165 is recognised immediately as a loss, with a corresponding decrease in the net investment in the lease, as shown below:

  Year 1 Year 2 Year 3 Year 4 Year 5
Opening 10,000 8,526 6,904 4,955 2,976
Rental receipt (2,249) (2,249) (2,249) (2,249) (2,249)

  7,751 6,277 4,655 2,706 727
Interest income 775 627 465 270 73
Residual value loss (165)

Closing 8,526 6,904 4,955 2,976 800

Illustrative text - Accounting by lessors - Accounting for operating leases - FAQ 15A.93.1 – Lease income recognised on a straight-line basis

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 50
Reference to standing text: 15A.93
Industry:


Entities A and B operate in an inflationary environment of 6% over the last 12 months. Entity A (the lessor) enters into an operating lease agreement with entity B (the lessee). The term of the lease agreement is three years. The lease is fixed for C20,000 per month for the first year, with an automatic fixed inflation adjustment of 6% at the end of years 1 and 2. Therefore, the lease rentals payable are fixed as follows:

  • Year 1: C20,000 per month.
  • Year 2: C21,400 per month.
  • Year 3: C23,110 per month.

The lease rentals payable by the lessee are not linked to an inflation index. However, practice in the local economy is that these annual escalations reflect the potential increases in price levels over the period of the lease agreement. If the parties had to enter into annual lease agreements, it is unlikely that entity B would successfully negotiate to pay C20,000 a month – as a result of inflationary increases, the monthly rentals payable would increase.

Should a fixed increase in lease payments stipulated in a lease agreement, which are a quasi-compensation for inflation-related increases, be recognised in the period in which they occur?

No. The fixed annual increases in lease payments are part of the minimum lease payments and are spread on a straight-line basis over the lease term. The amounts are not discounted. Entity A recognises a monthly rental income of C21,503.33, which is the average of the three years’ lease payments. Entity B recognises an equivalent rental expense.

If the new lease rentals payable were linked to an inflation index, the annual increases would be treated as contingent rents.

Illustrative text - Accounting by lessors - Operating lease incentives - FAQ 15A.97.1 – Accounting for operating lease incentives

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 4
Reference to standing text: 15A.97
Industry:


Costs incurred by the lessor as incentives for the agreement of new or renewed operating leases are not considered to be part of the initial costs that are added to the carrying amount of a leased asset.

Example 1 – Operating lease incentive – rent-free period

Under a 10-year lease agreement, the lessor gives a one-year, rent-free period followed by a fixed rent of C1.1m per annum for nine years. This is equivalent to 10 years’ rent of C0.99m per annum. The cost of the incentive should be spread over the lease term. Therefore, C0.99m of rental income will be recognised each year in the income statement. At the end of the first year, the lessor will recognise accrued rent receivable of C0.99m, which will be reduced by C0.11m each year for the next nine years.

Example 2 – Operating lease incentive – lessor contribution to lessee fit-out costs

Under a 10-year lease agreement, the lessor agrees with the lessee to make an upfront cash payment of C1m to contribute towards the lessee’s own fit-out costs, with a fixed annual rental of C1.1m per annum for the 10-year lease. This is equivalent to an annual rent of C1m per annum net of the incentive. Therefore, C1m will be recognised as net rental income each year of the lease. The C1m incentive will initially be recognised as a debtor (accrued rent receivable), which will be amortised by C0.1m each year to the income statement.

Illustrative text - Accounting by lessors - Operating lease incentives - FAQ 15A.97.2 – Can operating lease incentives be impaired?

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 3
Reference to standing text: 15A.97
Industry:


As with any asset, the amount recognised as a receivable in respect of an operating lease incentive should be written down to the extent that it is impaired.

Illustrative text - Accounting by lessors - Operating lease incentives - FAQ 15A.97.3 – Are there situations where payments made by the lessor to the old tenant can be capitalised rather than expensed?

Publication date: 17 Nov 2018

Reference to standard: SIC 15 para 4
Reference to standing text: 15A.97
Industry:


Payments between the lessor and the old tenant, sometimes described as ‘surrender premiums’, are not uncommon in leases of real estate (for example, where the lessor needs to convince the tenants to move out in order to redevelop the property). Depending on the specific facts, these amounts can be capitalised rather than expensed, as contrasted in the following examples.

Example 1 – Surrender premium paid by a lessor to remove existing tenants in order to redevelop an investment property

Entity A has authorisation to redevelop and significantly enhance an investment property but cannot carry out the work until the property is vacated. Entity A pays a surrender premium to remove existing tenants to enable the redevelopment to proceed.

Paragraph BC40 of IAS 40 notes that an entity should determine whether subsequent expenditure should be capitalised using similar principles to those used for owner-occupied property. In this case, the costs of redevelopment fulfil the recognition criteria and, because no work is possible until the existing tenants move out, the surrender premium is also capitalised.

Example 2 – Surrender premium paid by a lessor to remove existing tenants in order to allow new tenants to occupy an investment property

Entity B pays a surrender premium to its existing tenants in order to remove them and let the property to different tenants on more profitable terms.

In this case, the surrender premium does not represent a cost of the underlying leased property. It also does not represent an initial direct cost of entering into a new lease – it is actually a cost of terminating an existing lease. Hence, it should be expensed as incurred.

Illustrative text - Accounting by lessors - Manufacturer/dealer lessors - FAQ 15A.106.1 – Sale of an asset by a manufacturer lessor under a finance lease

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 43
Reference to standing text: 15A.106
Industry:


Entity A manufactures trucks. It offers customers a choice of either buying the trucks outright or of leasing them under a finance lease. Trucks cost C25,000 to manufacture. If the trucks are purchased outright, they are sold for C30,000. If a customer chooses to lease the trucks, they are leased for a period of 20 years at an annual rental of C2,809 payable annually in advance. Entity A believes that the truck’s residual value at the end of the 20-year lease term will be C1,000. A market rate of interest on leases of this type is 8%. The present value of the minimum lease payments is C29,786 and the present value of the residual is C214.

Therefore, entity A will record sales revenue equal to the lower of the fair value of the asset (C30,000) and the present value of the minimum lease payments (C29,786). The cost of sales will be equal to the truck’s carrying value (C25,000) less the present value of the residual (C214). Therefore, on entering into the lease, entity A will make the following accounting entries:

Dr Lease receivable 29,786  
Cr Revenue   29,786
Dr Cost of sales 24,786  
Dr Lease receivable – interest in residual 214  
Cr Inventory   25,000


Entity A will recognise a selling profit of C5,000 (C29,786 – C24,786). It will also recognise a lease receivable of C30,000, being the present value of the minimum lease payments plus the present value of the unguaranteed residual (the net investment in the lease). The net investment will amortise to a residual value of C1,000 over the 20-year lease as the lessor applies each lease rental to reduce the receivable and recognise income at a constant periodic rate of return on the net investment.

Illustrative text - Accounting by lessors - Manufacturer/dealer lessors - FAQ 15A.106.2 – Sale of asset by a manufacturer lessor with advance deposit payment by the lessee

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 44
Reference to standing text: 15A.106
Industry:


Entity A (a manufacturer/lessor) signed an agreement on 1 January 20X8 to lease specific equipment to entity B (the lessee). Entity A committed to deliver the equipment to entity B on 1 January 20X9. Entity A will manufacture the equipment and estimates that the fair value will be C15,000. The estimated cost to build the asset is C10,000. The lessor has not incurred any initial direct costs in negotiating and arranging the lease. The term of the arrangement is four years, commencing when the equipment is delivered. The estimated useful life of the asset is four years and there is no residual value. The lessee is obliged to make an upfront payment of C5,000 upon signing the contract and four annual payments of C2,619, payable on 1 January of each year. The first annual payment is due on 1 January 20X9.

Inception of the lease is on 1 January 20X8, when the lease agreement is signed, and commencement of the lease is on 1 January 20X9, when the leased asset is made available for use to the lessee.

There is no detailed guidance on how to account for lease payments pre-paid at inception but before the commencement date. In our view, at inception, the lessor recognises the upfront payment of C5,000 as a liability and accretes it over the time between inception and commencement (when the asset is ready for use) of the lease. The upfront payment is, in substance, a prepayment or a loan that the lessee provides to the lessor during the construction period. The lessor should recognise finance expense as the upfront payment accretes until commencement.

Entity A determines the interest rate implicit in the lease on 1 January 20X8 by comparing the present value of minimum lease payments discounted to 1 January 20X9 and the estimated fair value of the asset on 1 January 20X9 (in this example, the residual value and initial direct costs are assumed to be zero). Assuming that the interest rate implicit in the lease is 5%, the liability accretes over the time between inception and commencement (1 January 20X9) to C5,250.

The accreted pre-payment of C5,250 is treated as part of the minimum lease payments. At commencement of the lease on 1 January 20X9, the lessor is expecting to initially recognise a profit on disposal amounting to C5,000 and a finance lease receivable of C9,750, being the discounted amount of the future minimum lease payments amounting to C15,000 less the set-off of C5,250 liability.

Illustrative text - Accounting by lessors - Manufacturer/dealer lessors - FAQ 15A.106.3 – Sale of asset by a manufacturer lessor with manufacturing cost overruns and no adjustment to lease payments

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 44
Reference to standing text: 15A.106
Industry:


The facts are the same as in FAQ 15A.106.2 except that, on 1 January 20X9, entity A has incurred actual costs to construct the asset of C12,000.

As in FAQ 15A.106.2, inception of the lease is on 1 January 20X8 and commencement of the lease is on 1 January 20X9.

On 1 January 20X9, entity A recognises a lease receivable of C9,750 (which corresponds to the net present value of the minimum lease payments less the upfront payment) and a profit on sale of C3,000, rather than C5,000 as originally estimated.

At inception, entity A had estimated the profit on sale to be C5,000. Entity A incurred a cost overrun of C2,000 which it absorbs by reducing the initial profit, and not by reducing the interest earned on the lease receivable.

Illustrative text - Accounting by lessors - Manufacturer/dealer lessors - FAQ 15A.106.4 – Sale of asset by a manufacturer lessor with manufacturing cost overruns with adjustment to lease payments

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 44
Reference to standing text: 15A.106
Industry:


The facts are the same as in FAQ 15A.106.2, except that the lease payments are adjusted for cost overruns in excess of 10% of the estimated fair value of C15,000. The portion of cost overruns up to 10% is absorbed by entity A. On 1 January 20X9, entity A has incurred actual costs to construct the asset of C12,000.

As in FAQ 15A.106.2, inception of the lease is on 1 January 20X8 and commencement of the lease is on 1 January 20X9.

On 1 January 20X9, entity A recognises a lease receivable of C10,250 and a profit on sale of C3,500. At inception, entity A had estimated the profit on sale to be C5,000. Entity A incurred a cost overrun of C2,000, of which it absorbs C1,500 (the portion up to 10% of the original fair value estimate). The remaining C500 of the cost overrun is passed through to the lessee by an increase of the first rental due, and the lease receivable is increased by C500. This adjustment is deemed to have taken place at inception of the lease.

Entity A therefore calculates the interest rate implicit in the lease by comparing the revised present value of minimum lease payments discounted to 1 January 20X9 and the revised fair value of the asset on 1 January 20X9 (in this example, the residual value and initial direct costs are assumed to be zero). Entity A does not re-assess the lease classification.

Illustrative text - Disclosures - FAQ 15A.110.1 – Are there any additional disclosures that entities with significant leasing activities should consider providing?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 47
Reference to standing text: 15A.110
Industry:


In addition to the limited disclosures required by IAS 17, entities with significant leasing activities should consider providing additional information to users. The following disclosures would improve users’ understanding of the lessor’s business and associated risks for both operating and finance leases:

  • A maturity analysis of residual value exposures.
  • Details of contingent liabilities arising from lease transactions, unless the possibility of any outflow in settlement is remote (this disclosure is required by IAS 37).
  • Initial selling profits recognised by manufacturer or dealer lessors and the basis for determining them.

Illustrative text - Classification of leases – Change in estimates, renewal and modification of a lease agreement - FAQ 15A.116.1 – Can the exercise of a renewal option be considered to be a modification of a lease agreement?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 13
Reference to standing text: 15A.116
Industry:


Renewing a lease includes situations where a renewal option is exercised in accordance with the provisions existing in the original lease agreement. In that case, the lease is not considered as being modified.

However, if the renewal option is exercised and the parties also agree to change other provisions of the lease, such changes should be treated as modifications of the original lease agreement.

Illustrative text - Classification of leases – Change in estimates, renewal and modification of a lease agreement - FAQ 15A.116.2 – Example of a lease renegotiation resulting in reclassification of an operating lease as a finance lease

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 13
Reference to standing text: 15A.116
Industry:


Changes to the provisions of a lease are those where the terms and cash flows of the existing lease are modified, affecting the risks and rewards incidental to the ownership of the underlying asset. Such changes differ from a renewal of a lease and require the classification to be re-assessed.

Entity A leases a building. The original term of the lease was 30 years, and the estimated useful and economic life of the building at the start of the lease was 45 years. At inception, the lease was classified as an operating lease. Now, nearing the end of the twentieth year, the lease has been renegotiated. The new lease term is 25 years, which is equal to the expected remaining economic life of the building. Rentals have been modified and now the present value of the minimum lease payments amounts to substantially all of the fair value of the building.

Should the classification of the lease be re-assessed?

The provisions of the lease have changed significantly. The lease is now for a major part of the economic life of the asset, and the present value of the minimum lease payments represents substantially all of the fair value of the building. A lease of this type would normally be classified as a finance lease. Therefore, the classification of the lease should be re-assessed.

This contrasts with the treatment of a change in estimate, where the lease classification would not be revisited. For example, if it had emerged during the first lease that the economic life of the building was not 45 years, but only 35 years, the original classification as an operating lease should continue until the end of the lease term.

Illustrative text - Classification of leases – Change in estimates, renewal and modification of a lease agreement - FAQ 15A.117.1 – How should an entity assess whether a modification of a lease agreement requires a different classification?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 13
Reference to standing text: 15A.117
Industry:


In practice, the analysis of whether the new net present value of the minimum lease payments is substantially all of the fair value of the leased asset, in conjunction with the analysis of whether the new lease term is for the major part of the economic life of the asset, helps to assess whether the revised lease is a finance or operating lease. This assessment can be performed using at least three different approaches. An entity should select and apply one approach consistently for similar transactions:

  1. an approach based on the new terms of the agreement and the fair value and useful life of the leased asset at the date of the modification as if the revised agreement was a new lease;
  2. an approach taking into consideration the original implicit interest rate to calculate the present value of the new minimum lease payments (this approach is consistent with para AG8 of IAS 39); or
  3. an approach considering the revised lease term and cash flows to recalculate the present value of the minimum lease payments as well as the fair value and useful life of the leased asset at the inception of the lease. This approach will result in a different implicit interest rate when compared to that used in the original calculation.

[IAS 8 para 13].

These approaches are illustrated in the following examples. The analysis should be performed with the re-assessment of the lease classification indicators set out in paragraphs 10 and 11 of IAS 17.

Example – Calculation of the new net present value of the minimum lease payments: approach (i)

Entity A enters into a five-year agreement to lease an asset whose estimated useful life is nine years. The fair value of the asset at the commencement of the lease is C56,000, and entity A is required to pay five annual rentals of C9,200, payable in advance at the beginning of each year. The estimated residual value is C15,400, and all proceeds from selling the asset at the end of the agreement are taken by the lessor.

Entity A’s assessment indicated that it is an operating lease, as substantially all of the risks and rewards of ownership have been retained by the lessor (the lease term is 56% of the useful life of the asset and there is a significant residual value).

The parties renegotiated the lease at the end of the first year, with changes coming into effect at the beginning of the subsequent year. The renegotiated terms are: i) lease term has been extended to eight years in total (three additional years); and ii) annual payments have been reduced from C9,200 to C8,500. At the time of renegotiation, the fair value of the asset is C54,000 and the residual value at the end of the new lease term is C3,000.

Should the lease be reclassified?

The implicit interest rate (IIR) and net present value (NPV) of the minimum lease payments, based on the original terms of the lease agreement, are calculated as follows:

Original period Original payments Original minimum lease payments

1 −56,000 -  
1 9,200 - 9,200
2 9,200 - 9,200
3 9,200 - 9,200
4 9,200 - 9,200
5 9,200 - 9,200
6 15,400 -  

Original IIR 3.47% Original NPV 43,017


The implicit interest rate in the original lease is 3.47% and the present value of the minimum lease payments is C43,017, which represents 77% of the fair value of the leased asset.

However, if the revised agreement was a new lease, the implicit interest rate (calculated prospectively over the new remaining term) would have been 4.85%. Consequently, the present value of the modified minimum lease payments is calculated as follows:

Modified period Modified payments Modified minimum lease payments

2 −54,000 -  
2 8,500 - 8,500
3 8,500 - 8,500
4 8,500 - 8,500
5 8,500 - 8,500
6 8,500 - 8,500
7 8,500 - 8,500
8 8,500 - 8,500
9 3,000 -  

Modified IIR 4.85% Modified NPV 51,851


The present value of the modified minimum lease payments would be C51,851, which is 96% of the fair value of the asset at the date of the modification. The remaining term of the revised agreement is seven years and the remaining useful life of the asset is eight years, resulting in a new lease term that represents 88% of the remaining useful life of the asset. Therefore, the modification should result in the reclassification of the operating lease as a finance lease.

Example – Calculation of the new net present value of the minimum lease payments: approach (ii)

Assume the same details as in approach (i). This second approach considers the original implicit interest rate to calculate the present value of the new minimum lease payments. Therefore, if the lessee had used the original implicit interest rate of 3.47%, the present value of the modified minimum lease payments would have been calculated as follows:

Modified period Modified minimum lease payments

2 8,500
3 8,500
4 8,500
5 8,500
6 8,500
7 8,500
8 8,500

Modified NPV 53,838
Original IIR 3.47%


The present value of the modified minimum lease payments would be C53,838, which is approximately 100% of the fair value of the asset at the date of the modification, and the new lease term represents 88% of the remaining useful life of the asset. In this case, the modification would also result in the reclassification of the operating lease as a finance lease.

Example – Calculation of the new net present value of the minimum lease payments: approach (iii)

The details are the same as in approach (i). This third approach uses the revised lease term and cash flows to recalculate the new implicit interest rate as if the revised terms were in place at the inception of the lease. Assume that the residual value at the end of year 9, as estimated at inception, is C3,000. Therefore, using the new implicit interest rate of 7.44%, the present value of the modified minimum lease payments is calculated as follows:

Modified period Modified payments Modified minimum lease payments

1 −56,000 -  
1 9,200 - 9,200
2 8,500 - 8,500
3 8,500 - 8,500
4 8,500 - 8,500
5 8,500 - 8,500
6 8,500 - 8,500
7 8,500 - 8,500
8 8,500 - 8,500
9 3,000 - -

Modified IIR 7.44% Modified NPV 54,315


The present value of the modified minimum lease payments would be C54,315, which is 97% of the fair value of the asset at the commencement of the lease.

Consistent with the concept that the revised terms are considered as if they were in place at the inception of the lease, the analysis of whether the new lease term is for the major part of the economic life of the asset should be based on the new lease term (total of eight years) and the estimated useful life of the asset at the commencement of the lease (nine years). As a result, the new lease term would represent 89% of the useful life of the asset. Therefore, the modification should also result in the reclassification of the operating lease as a finance lease.

Illustrative text - Classification of leases - Accounting for modifications to the terms of finance leases by lessees - FAQ 15A.122.1 – How should a lessee account for modifications that do not result in reclassification of the lease?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 13
Reference to standing text: 15A.122
Industry:


With respect to finance leases, two acceptable methods are:

  1. account for the revised agreement as if it was a new lease; the initial amount is calculated based on the revised minimum lease payments discounted at the new implicit interest rate of the lease (which is calculated based on the fair value and estimated residual value of the leased asset at the date of the modification); this will affect the carrying value of the leased asset and the leased liability; or
  2. apply the IAS 39 de-recognition guidance to decide whether the finance lease liability should be de-recognised and the modified agreement accounted for as a new lease.

Both methods are illustrated in the following examples.

Example 1 – Accounting for modifications to finance leases: method (a)

Assume the same details as in the example for approach (i) of FAQ 15A.117.1, but now the original lease term is seven years instead of five years. The fair value of the asset at the commencement of the lease is C56,000 and the annual rentals are C9,200, payable in advance at the beginning of each year. The estimated residual value is C15,400, and all proceeds from selling the asset at the end of the agreement are taken by the lessor.

The present value of the minimum lease payments is now C48,451, representing 87% of the fair value of the asset at the commencement of the lease. The implicit interest rate is 10.71%, as demonstrated below:

Period Obligation at start of period Rental paid Obligation after payment Finance charge at 10.71% Obligation at end of period

1 48,451 (9,200) 39,251 4,203 43,454
2 43,454 (9,200) 34,254 3,668 37,922
3 37,922 (9,200) 28,722 3,075 31,797
4 31,797 (9,200) 22,597 2,420 25,017
5 25,017 (9,200) 15,817 1,694 17,510
6 17,510 (9,200) 8,310 890 9,200
7 9,200 (9,200) 0 0 0


Entity A assessed the terms of the lease and concluded that it is a finance lease. At the end of the first year, the parties renegotiated the lease, when the lease liability was C43,454, as calculated above, and the carrying amount of the asset was C41,529 (the asset’s useful life is nine years and it is depreciated on a straight-line basis over seven years, being the shorter of the useful life of the asset and the lease term), as demonstrated below:

C48,451 * 6/7 = C41,529

The renegotiated terms are: i) lease term has been extended to eight years in total; and ii) annual payments have been reduced from C9,200 to C8,500. At the time of the renegotiation, the fair value of the asset is C54,000 and the estimated residual value at the end of the new lease term is C3,000.

The modification could be accounted for using the revised fair value of C54,000 and the new implicit interest rate of 4.85%. The present value of the remaining lease payments of C51,851 is calculated as in approach (i) of FAQ 15A.117.1. The effects of the modification of the lease are demonstrated below:

Period Obligation at start of period Rental paid Obligation after payment Finance charge at 4.85% Obligation at end of period

2 51,851 (8,500) 43,351 2,103 45,453
3 45,453 (8,500) 36,953 1,792 38,746
4 38,746 (8,500) 30,246 1,467 31,713
5 31,713 (8,500) 23,213 1,126 24,339
6 24,339 (8,500) 15,839 768 16,607
7 16,607 (8,500) 8,107 393 8,500
8 8,500 (8,500) 0 0 0


Entity A will then proceed with the following accounting entries:

1) De-recognition of the existing lease

Dr – Finance lease liability: 43,454
Cr – Fixed assets: 41,529
Cr – Income statement: 1,925

2) Recognition of the revised lease (note that the present value of the revised minimum lease payments is lower than the fair value of the asset at the modification date)

Cr – Finance lease liability: 51,851
Dr – Fixed assets: 51,851

The asset will be depreciated over the remaining term of the revised lease agreement (that is, seven years).

Example 2 – Accounting for modifications to finance leases: method (b)

Method (b) applies IAS 39 guidance, given that finance lease payables recognised by a lessee are subject to the de-recognition provisions of IAS 39. [IAS 39 para 2(b)(ii)]. The objective is to decide whether the new terms are substantially different. If they are substantially different, the original finance lease should be extinguished and the revised agreement accounted for as a new lease.

The terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid (net of any fees received and discounted using the original effective interest rate), is at least 10% different from the discounted present value of the remaining cash flows of the original financial liability. [IAS 39 para AG62].

Assume the same modification details as in method (a). The first step is to calculate the present value of the modified lease payments based on the original implicit interest rate of 10.71%:

Modified period Modified minimum lease payments

2 8,500
3 8,500
4 8,500
5 8,500
6 8,500
7 8,500
8 8,500

Modified NPV 44,764
Original IIR 10.71%


The present value of the modified minimum lease payments is C44,764, and the carrying amount of the original lease liability at the end of the first period (date of the modification of the lease) is C43,454. The original implicit interest rate of 10.71% and the carrying amount of the original lease liability of C43,454 are calculated in the example on method (a). Applying the 10% test on this basis results in entity A continuing to recognise the original lease liability, because the modification resulted in new lease liability that is 3.0% different from the original lease liability.

The question arises as to how to account for the present value difference of C1,310 (C44,764 – C43,454) arising from the renegotiation. One approach would be to recognise the difference immediately in profit or loss, by adjusting the previous carrying amount of the lease liability from C43,454 to C44,764. This approach is supported by paragraph AG8 of IAS 39 (see also chapter 44 para 105).

Another possible way would be to adjust the carrying amount of the leased asset based on IFRIC 1 guidance where, if the related asset is measured using the cost model, changes in the liability are added to, or deducted from, the cost of the related asset in the current period (see chapter 22 para 27 for further information on IFRIC 1 guidance).

Another approach would be to recognise the difference over the remaining life of the instrument by adjusting the implicit interest rate of the lease consistent with the guidance in paragraph AG62 of IAS 39. If this policy was followed, the new implicit interest rate that will amortise the modification over the remaining term of the lease liability would be calculated as follows:

Modified period Modified minimum lease payments

2 −43,454
2 8,500
3 8,500
4 8,500
5 8,500
6 8,500
7 8,500
8 8,500

Modified IIR 11.99%


The modification could be accounted for using the carrying amount of the original lease liability of C43,454 and the new implicit interest rate of 11.99%. The effects of the modification of the lease under this approach are demonstrated below:

Period Obligation at start of period Rental paid Obligation after payment Finance charge at 11.99% Obligation at end of period

2 43,454 (8,500) 34,954 4,192 39,146
3 39,146 (8,500) 30,646 3,675 34,321
4 34,321 (8,500) 25,821 3,097 28,918
5 28,918 (8,500) 20,418 2,449 22,867
6 22,867 (8,500) 14,367 1,723 16,090
7 16,090 (8,500) 7,590 910 8,500
8 8,500 (8,500) 0 0 0


The asset remains unchanged and will be depreciated over the remaining term of the revised lease agreement (seven years).

However, if the modification had resulted in a new lease liability that is substantially different from the original lease liability, the modification would be accounted for as an extinguishment, and any costs or fees incurred would be recognised as part of the gain or loss on the extinguishment. This would also affect the carrying value of the leased asset. The accounting would be the same as illustrated in the example on method (a), where any modification is treated as if the revised agreement was a new lease.

Illustrative text - Classification of leases - Accounting for modifications to the terms of finance leases by lessors - FAQ 15A.123.1 – How should a lessor account for modifications that do not result in reclassification of the lease?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 13
Reference to standing text: 15A.123
Industry:


Regarding finance leases, two acceptable methods are:

  1. account for the revised agreement as if it was a new lease; or 
  2. apply the IAS 39 de-recognition guidance to decide whether the lease receivable should be de-recognised and the modified agreement accounted for as a new lease. This method is supported by paragraph 2(b)(i) of IAS 39, which states that lease receivables recognised by a lessor are subject to the de-recognition provisions of IAS 39.

Method (a) is illustrated in example 1 of FAQ 15A.122.1. With respect to method (b), detailed information on IAS 39 de-recognition guidance for renegotiated financial assets are discussed in chapter 44 para 26.

Illustrative text - Property leases - Classification - FAQ 15A.129.1 – Can the lease classification of the building be determined without performing a detailed split of the rentals?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 15A
Reference to standing text: 15A.129
Industry:


Classifying the buildings element is often more difficult than the land element. In many cases, it is possible to determine the classification of the lease of the building without performing a detailed split of the rentals between the land element and the building element of the lease. With the exception of the present value test, the criteria for lease classification can be considered without obtaining a split of the rentals. For example, a building with a relatively short life, perhaps built to a customer’s specification or for a specific use, might well be treated as being held under a finance lease. Long leases of a building (usually 99 to 999 years) are likely to be finance leases.

Illustrative text - Property leases - Classification - FAQ 15A.129.2 – Lease classification using qualitative criteria

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 15A
Reference to standing text: 15A.129
Industry:


In some circumstances, it might be possible to determine that a lease of a building is an operating lease using only the qualitative classification criteria in IAS 17. Consider the following lease:

Property type Non-specialised office building
Lease term 25 years
Economic life 50 years
Initial rentals Market rates
Rent reviews Every 5 years, upwards only, to market rates
Options to purchase None
Residual value guarantees None
Cancellation clauses None
Option to extend Lessee can extend lease by 5 years on payment of market rentals


It is relatively clear that the lessee does not have substantially all of the risks and rewards of the building’s ownership. The lease term is not for a major part of the asset’s economic life, the lessee has no interest in the residual, and rentals are set at market rates. It would therefore be reasonable to conclude, without performing a present value test, that both the lease of the land and the lease of the building are operating leases.

Illustrative text - Property leases - Splitting the rental - FAQ 15A.131.1 – Why are the minimum lease payments allocated between the land and buildings in proportion to the relative fair values of the leasehold interests?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 16
Reference to standing text: 15A.131
Industry:


The fair value of a leasehold interest in land or buildings is different from the fair value of the land or buildings themselves. Allocating the minimum lease payments simply by reference to the relative fair values of the land and buildings would not reflect the fact that land often has an indefinite economic life and would be expected to maintain its value beyond the lease term. In contrast, the future economic benefits of a building are likely to be used up, at least to some extent, over the lease term.

Therefore, it would be reasonable to expect that the lease payments relating to the building would be set at a level that enabled the lessor to make a return on initial investment and recoup the value of the building used up over the term of the lease. That is why the allocation of the minimum lease payments should be weighted to reflect their role in compensating the lessor and not by reference to the relative fair values of the land and buildings. In other words, the weighting should reflect the lessee’s leasehold interest in the land and the buildings.

Illustrative text - Property leases - Splitting the rental - FAQ 15A.131.2 – How is the fair value of the lessee’s leasehold interest calculated?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 16
Reference to standing text: 15A.131
Industry:


The fair value of the lessee’s leasehold interest is derived from the following equation:

Fair value of leasehold interest = Fair value of freehold interest Present value of the residual interest at inception of the lease


In the case of the fair value of a freehold building, the residual value might be lower, pro rata, than the land, due to obsolescence; therefore, in order for the equation to balance, it follows that the fair value of the leasehold interest in the building will be higher, pro rata, than the land. This results in the minimum lease payments being weighted towards the building.

There is no detailed guidance on how to determine the fair value of the lessee’s leasehold interests. Nonetheless, there are several different ways in which this calculation can be approached. Whichever method is used, it is likely that the valuation inputs will remain the same, namely:

  • The property’s fair value at the lease’s inception.
  • A split of this fair value between land and buildings.
  • The property’s residual value upon expiry of the lease.

Whichever method is adopted, the input of property valuation specialists will be required.

Illustrative text - Property leases - Splitting the rental - FAQ 15A.131.3 – Example of rental allocation

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 16
Reference to standing text: 15A.131
Industry:


The inputs discussed in FAQ 15A.131.2 need to be analysed further in order to split the minimum lease payments. The underlying rationale for the rental split is that the land component is unlikely to depreciate and, therefore, any diminution in value between the fair value at inception of the lease and the residual value at lease expiry is usually a measure of the loss in value of the buildings during the lease period. Consider the following example:

Example 1 – Rental allocated on a leasehold value basis

Freehold value of property C100m
Value of land at inception C40m
Lease term 25 years
Initial annual rental paid in advance C6.25m
Expected residual value of property C65m (today’s prices)
Expected real return on property 6.0%


If it is assumed that all of the loss in value of the property over the lease term is attributable to the building, and the residual values are discounted using the expected real return on the property, the rentals can be split as follows:

    Land Buildings Total
    (Cm) (Cm) (Cm)
i Freehold value 40 60 100
ii Residual value 40 25 65
iii Present value of residual 9 6 15

i – iii Leasehold value 31 (36%) 54 (64%) 85 (100%)

  Rent allocation (% × C6.25m) 2.25 4.00 6.25


Example 2 – Rental allocated on a capital value basis

An alternative methodology is to assess the loss in value of the buildings during the lease period and, thereafter, to calculate what proportion of the rentals needs to be allocated to compensate the lessor for the loss in building value during the lease period. In the example below, a rate of 6% has been used to determine the amount of rent allocated to amortisation.

In practice, property valuation specialists might vary in their views as to what is the most appropriate rate to be used to allocate rent. For example, a government bond rate or a real return rate might be considered appropriate. It is therefore important to seek guidance from property specialists when determining the rate to be used.

    Land Buildings Total
  (Cm) (Cm) (Cm)
i Freehold value 40 (40%) 60 (60%) 100
ii Residual value 40 25 65

i – ii Amortisation 0 35 35

  Rental      
iii Rent allocated for amortisation (C0.60m) 0.60 0.60
iv Balance (% × C5.65m) 2.26 3.39 5.65

iii + iv Rent allocation (Cm) 2.26 3.99 6.25


C0.60m is the annual rental paid in advance which, when compounded over the 25-year lease term at the expected real return on property of 6%, results in C35m, the difference between the freehold value and the building’s residual value.

Illustrative text - Back-to-back and sub-leases - FAQ 15A.133.1 – How does the accounting for back-to-back and sub-leases vary from that for regular leases?

Publication date: 17 Nov 2018

Reference to standard: IAS 17 para 4
Reference to standing text: 15A.133
Industry:


Generally, such arrangements involve three parties: a head lessor, who owns the freehold asset; an intermediate party, who is leasing the asset from the head lessor (and might be either a lessor under a sub-lease to the lessee or merely an agent for the head lessor); and the lessee. The following sets out the broad principles that an entity should follow when accounting for back-to-back leases and sub-leases:

The head lessor Unless the original lease agreement between the head lessor and the intermediate party is replaced by a new agreement, the head lessor’s accounting should not be affected if the intermediate party enters into a sub-lease.
The intermediate party

The form that the accounting takes will depend on the classification of both the head lease and the sub-lease.

Where the head lease is an operating lease, the sub-lease should also be an operating lease. In most situations, the intermediate party will record income in respect of the sub-lease on a straight-line basis over the term of the sub-lease and will continue to record an expense in respect of the head lease. However, if the intermediate party’s role is genuinely, in substance, that of a broker or agent for the head lessor, such that the intermediate party has no significant commercial benefits or risks associated with the sub-lease, it would be inappropriate for the intermediate party to record either income or expense in respect of the two leases, since the intermediate party is acting as an agent.

Where the head lease is a finance lease, the sub-lease could be either a finance lease or an operating lease. Where the sub-lease is an operating lease, the intermediate party will retain both the finance leased asset and the finance lease liability on balance sheet and record income in respect of the sub-lease on a straight-line basis over the lease term. However, where the sub-lease is a finance lease, the intermediate party will de-recognise the leased asset and recognise a finance lease receivable in respect of the sub-lease. The finance lease liability is retained in the books of the intermediate party, unless the de-recognition criteria in IAS 39/IFRS 9 are met (that is, the liability is discharged, is cancelled or expires) or the offset criteria of IAS 32 are met.

The lessee The lessee will account for the lease as an operating lease or finance lease in the normal way.
 
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