1. IAS 17: Leases
Roshankumar Pimpalkar
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2. Objective
The objective of IAS 17 is to prescribe for lessees and lessors, the appropriate
accounting policies and disclosures to apply in relation to finance and operating
leases.
Lease is an agreement whereby the lessor gives the lessee the right to use an asset
for an agreed period of time in return for a payment or a series of payments.
The guidance in IAS 17 must be used to determine the classification of lease and not
the agreement of the lease. When a contract includes both asset and services, IAS
17 applies to the part relating to use of the asset.
IAS 17 applies to all leases except for certain specialised types of leases where
more specific industry guidance is generally applied. IFRIC 4 provides guidance on
whether an arrangement is, or contains, a lease that should be accounted for in
accordance with IAS 17.
IFRIC 4 does not apply to arrangements that:
Are, or contain leases excluded from the scope of IAS 17: or
Are public-to-private service concession arrangements within the scope of
IFRIC 12
Factors to be considered to determine whether an arrangement contains a lease
1. Depends on the substance of the arrangement
2. The fulfilment of the arrangement depends on the use of a specific asset(s);
AND
3. The arrangement conveys the right to use (control the use of) the asset i.e.
a. Right to operate the asset/direct others to operate the asset in a
manner it determines.
b. Right to control physical access to underlying asset
c. Purchaser will take a significant amount of output and price paid not
contractually fixed per unit nor equal to the current market price.
Timing of assessment of arrangement
1. At the inception of arrangement
2. Reassess when:
a. Contractual terms have changed.
b. A renewal option or extension is exercised which was not initially
included in lease
c. A change in the determination of whether fulfilment is dependent on a
specific asset
d. Substantial change to asset.
Lease accounting shall be applied or cease to apply from when the change in
circumstances giving rise to reassessment occurred or from the inception of the
renewal or extension period.
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3. For the purposes of applying the requirements of IAS 17, payments and other
consideration required by the arrangement shall be separated at the inception of the
arrangement, or upon reassessment of the arrangement, into those for the lease and
those for other elements on the basis of their relative fair values and purchaser’s
estimation.
IAS 17 is not applicable to:
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 should not be applied to measurement by:
Property held by lessee that is accounted for as investment property
Investment property provided by lessors under operating leases
Biological assets held by lessees under financial leases
Biological assets provided by lessors under operating leases
A lease is a Finance lease if substantially all the risk and rewards incident to
ownership of the asset are transferred to the lessee. Finance lease are in substance
the purchase of an asset using a loan secured on that asset.
An operating lease is any lease that is not a finance lease.
The classification of the lease as a finance or operating depends on the substance,
rather than the legal form of transaction.
Examples of Risks and Reward:
Risks:
Idle capacity
Technological obsolescence
Unsatisfactory performance
Rewards:
Expectation of profits over assets economic life
Gain from appreciation in value
Gain from realisation of a residual value
If anyone or more of the following five situations exists in a lease, it can normally be
classified as finance lease
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4. The ownership of the asset transfers to the lessee by the end of the lease
term.
The lessee has the option to purchase the asset at the price which is
substantially lower than the fair value.
The lease term is for the major part of the economic life of the asset.
The present value of minimum lease payments amounts to substantially all of
the fair value of the leased asset.
The leased assets are of the specialised nature so that only lessee can use it
without major modification being made.
IAS 17 also describes the three additional situations, that, individually or in
combination, could lead to a lease being classified as a finance lease even if none of
the above five indicators apply
If the lessee can cancel the lease it will bear the lessors losses associated
with cancellation
The gains or losses from the fluctuation in the fair value of the residual value
fall to the lessee
The lessee has the ability to continue the lease for a secondary period at a
rent that is substantially lower than the market rent
1. The ownership is transferred when the legal title is transferred. The legal title
may transfer either:
a. As a result of lease agreement; or
b. Within a separate agreement that forms part of the overall leasing
transaction
The condition will be met, in substance, where the lessor has the put option
requiring the lessee to acquire the asset and the lessor is expected to
exercise the option.
2. Lease term is the total of:
The non-cancellable period for which the lessee has contracted to
lease the asset
Any further terms for which the lessee has the option to continue to
lease the asset, with or without further payment, and at the inception of
lease it is reasonably certain that the lessee will exercise the option
In general when a lease term is for at least 75% of the economic life, it is
highly classified that the lease will be classified as finance lease. The
economic life may be represented by time, or in the manner that best reflects
the use of asset.
3. Inception of lease
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5. The earlier of the date of the lease agreement or of a commitment by
parties to the main provisions of lease
4. Minimum lease payments (MLP)
The payments over the lease term that the lessee is or, can be required, to
make excluding contingent rent, cost for services and taxes to be paid by and
reimbursed to the lessor, together with:
In case of lessee any amounts guaranteed by the lessee or by a party
related to the lessee; or
In case of the lessor any residual value guaranteed to the lessor by
either:
o The lessee
o Any party related to the lessee
OR
o A third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.
If the lessee has the option to purchase the asset at the end of the
lease term and the lessee is expected to exercise the option then the
MLP will include the payment to be made to exercise such option.
Refundable security deposit.
Termination penalties (if reasonable certain that the lessee will
terminate the lease)
Rentals on renewal of lease (if reasonable certain it will be renewed)
Payments to exclude
Contingent rent i.e. the portion of the lease payments that is not fixed in
amount but is based on a factor other than just passage of time e.g.
percentage of sales
Cost of services e.g. maintenance
Executory cost e.g. administration cost
Payments made by the lessee to a third party unless the recipient is
related to the lessor
Discount factor to be used to determine present value
The discount factor to be used is the interest rate implicit in the lease. If it
cannot be determined then the lessee’s incremental borrowing rate, which
reflects the risk inherent in the specific asset should be used.
The interest rate implicit in the lease is the discount rate that, at the inception
of the lease, causes the aggregate present value of
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6. The minimum lease payments and
The unguaranteed residual value to be equal to the sum of;
The fair value of the leased asset and
Any initial direct cost to the lessor
Fair Value of Leased Asset
1. Lessor is a manufacturer or dealer
The fair value of asset should be its normal selling price reflecting any
applicable volume or trade discounts.
2. Lessor is not a manufacturer or dealer
In general fair value will be the cost of asset reflecting any applicable
volume or trade discounts. If the lessor acquired the asset long time ago
the market conditions at the inception of the lease must be considered
when determining the fair value. These may indicate the fair value is
below/above the cost or carrying amount.
3. Leased asset is a used asset
If the leased asset is used asset and the fair market value is not
determinable, the fair value should be based on a depreciated
replacement cost of a comparable new asset.
Finance lease- Accounting- Lessee
Lessee must recognise the an asset and a liability in the statement of financial
position at the lower of, at the inception of the lease,
Fair value of the asset
Present value of minimum lease payments
The initial direct costs, such as negotiating and securing leasing arrangements, are
often incurred in connection with specific leasing activities. Such direct costs are
included in the carrying amount of leased asset.
The lease payments should be allocated between:
A finance charge, allocated to periods during the lease terms to produce a
constant periodic rate of interest on the outstanding balance of the liability for
each period (payment of interest) and
A reduction of the outstanding lease liability (repayment of capital)
Operating lease- Accounting- Lessee
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7. The lease payments are recognised as an expense in the statement of
comprehensive income on a straight line basis over the lease term unless
another systematic basis is more representative of the time pattern of the
lessee’s benefit’s from the asset
No asset or liability will be created in the statement of financial position except
for receivable and payables if the actual payments do not match the charge in
the statement of comprehensive income
Lease payments do not include any costs for services such as insurance and
maintenance
During the negotiation of the new lease or the renewal of an existing lease the lessor
may offer certain incentives to encourage the lessee to sign the agreement. SIC 15
is an interpretation relating to IAS 17. It deals with the recognition of incentives in an
operating lease.
Incentives include rent free periods, reduced rentals over a period of time,
upfront cash payments etc
All incentives are recognised at the inception of the lease as an integral part
of the net consideration. They are treated as the reduction of the rental
expenses over the lease term
Land and Buildings Leases
Land and building should be classified separately in accordance with the
substance of the transaction.
Minimum lease payments are allocated between the two elements, in
proportion to their relative fair value.
Land and buildings are not separated when
o The title on both elements passes to the lessee. In this case entire
lease is classified as finance lease.
o The land element is immaterial at the inception of the lease
o The lease payments cannot be allocated reliably. In this case, the
entire lease is a finance lease, unless it is clear that both elements are
operating leases.
Finance lease- Accounting- Lessor
Lessor recognises a receivable in the statement of financial position at an
amount equal to the net investment in the lease.
Net investment in lease = MLP(from standpoint of lessor)+unguaranteed
residual value(usually know by the lessor)-unearned interest
Unguaranteed residual value is that portion of residual value of leased asset,
the realisation of which by the lessor is not assured or is guaranteed solely by
a party related to the lessor.
The lease payments should be allocated by a lessor between:
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8. o A finance income, recognised in a pattern reflecting constant periodic
rate of return on the net investment (receipt of interest) and
o Repayment of principal (reduction in lease debtor)
Initial direct costs such as, commissions and legal fees, are often incurred by
lessors when negotiating and arranging a lease. For finance lease these
costs:
o Are included in the initial measurement of finance lease receivable;
and
o Reduce the amount of income recognised over the lease term, as such
costs are considered while determining interest rate implicit in the
lease.
However if the lessor is the manufacturer or dealer, costs incurred in
connection with negotiating and arranging a lease are expensed at the
inception of the lease term as they are mainly related to earning a selling
profit.
Manufacturers or Dealers
o Unlike others, manufacturers or dealers acquire the asset at the cost of
manufacture or at a wholesale price, so cost will usually be below an arm’s
length price.
o in this case finance lease will give rise to two types of income:
o profit or loss equivalent to that resulting from an outright sale of the
asset being leased, at normal selling prices; and
o The finance income over the lease term.
o IAS 17 requires that the selling profit be restricted to that resulting from the
use of a commercial rate of interest to calculate the net investment in the
lease. Any additional profit is deferred over the lease period in the
proportion to finance income.
Operating lease- Accounting- Lessor
Lessors present assets that are subject to operating leases as normal in their
statements of financial position. These assets are subject to depreciation
Manufacturer or dealer does not recognise any profit or loss
Lease income is usually recognised in the statement of comprehensive
income on straight line basis over lease term or any other systematic basis
which is more relevant
Initial direct costs such as, commissions and legal fees, incurred by lessors in
negotiating and arranging an operating lease are:
o Added to carrying amount of leased asset; and
o Recognised as an expense over the lease term on the same basis as
lease income.
SIC 15: Operating Lease incentives require the lessor to recognise the total
cost of incentives as reduction of rental income over lease term. Recognition
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9. is on straight line basis unless another systematic basis is more
representative.
Incentives do not include costs such as maintenance or cost to restore the
property to leasable condition after the previous lease.
Sale and Leaseback transaction
1. Finance lease Back
a. Substantially all the risks and rewards of ownership of the an asset
remain with the seller
b. In substance the transaction is a way for the lessor to provide finance
to lessee, using the asset as security
c. For the above reason any excess of sale proceeds over the carrying
amount is not immediately recognised as income by the seller.
d. The excess is deferred within the obligations so it is automatically
spread over the lease term.
e. The asset remains at its current value (unless impaired) and is
amortised as it has been in past.
2. Operating lease back
a. Substantially all the risks and rewards of ownership of an asset are
transferred to the purchaser.
b. Sale price at fair value. Lease payments at market value. Profit/loss is
recognised immediately
c. Sale price is below fair value
i. if lease payments are at market value profit/loss is recognised
immediately
ii. if lease payments are below market value, any loss is deferred
and amortised over the lease term as it is compensated by
future payments below market rate.
d. Sale price is above fair value the excess over fair value is deferred and
amortised over the lease term.
e. Carrying amount is above fair value. A loss equal to the difference
between the carrying amount and fair value is recognised immediately.
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