PRACTICAL GUIDE IAS 17: LEASES

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1 PRACTICAL GUIDE IAS 17: LEASES ConsultasIFRS is an online firm specialized in advisory on IFRS.

2 PRACTICAL GUIDE IAS 17 Leases Our only goal is to exceed your expectations The objective of this Standard is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosure to apply in relation to leases. The classification of leases adopted in this Standard is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership. Leases in the financial statements of lessees Over 4,000 accounting questions and answers "online" on IFRS Operating Leases Lease payments under an operating lease shall 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. Finance Leases Quality, excellence, and dedication, our key intangible asset At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee s incremental borrowing rate shall be used. Any initial direct costs of the lessee are added to the amount recognised as an asset. Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents shall be charged as expenses in the periods in which they are incurred. A finance lease gives rise to depreciation expense for depreciable assets as well as finance expense for each accounting period. The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets that are owned, and

3 the depreciation recognised shall be calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of the lease term and its useful life. Leases in the financial statements of lessors Operating Leases Lessors shall present assets subject to operating leases in their statements of financial position according to the nature of the asset. The depreciation policy for depreciable leased assets shall be consistent with the lessor s normal depreciation policy for similar assets, and depreciation shall be calculated in accordance with IAS 16 and IAS 38. Lease income from operating leases shall 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 use benefit derived from the leased asset is diminished. Finance Leases Lessors shall recognise assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease. The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor s net investment in the finance lease. Manufacturer or dealer lessors shall recognise selling profit or loss in the period, in accordance with the policy followed by the entity for outright sales. If artificially low rates of interest are quoted, selling profit shall be restricted to that which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease shall be recognised as an expense when the selling profit is recognised. Sale and leaseback transactions A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package. The accounting treatment of a sale and leaseback transaction depends upon the type of lease involved. Accounting for finance leases - Lessee Background 1. The lease is non-cancellable and is initiated on 01/01/X1 for equipment with an expected useful life of five years

4 2. Three payments are due to the lessor of the amount of 51,000 per year beginning 31/12/X1. Included in the lease payments is a sum of 1,000, to be paid annually by the lessee for insurance. 3. The lessee guarantees a 10,000 residual value on 31/12/X3 to the lessor. 4. The lessor is willing to sell the asset to the lessee at the end of the lease term, on 31/12/X3 for 5, Irrespective of the 10,000 residual value guarantee, the leased asset is expected to have only a 9,000 residual value to the lessee at the end of the lease term. 6. Lessee company depreciates similar equipment that it owns on a straight-line basis. 7. The fair value of the equipment at 01/01/X1 is 131, The lessee s incremental borrowing rate is 11%. 9. The lessor s implicit rate is 10%. This fact is known to the lessee company. Questions 1. How should lessee s company classify and record the lease transaction at its inception on 01/01/X1 (indicate journal entries)? 2. What are the journal entries the lessee is required to make to record the lease payments and the interest, insurance and depreciation expenses on 31/12/X1 through 31/12/X3? 3. What entry should the lessee make on 31/12/X3 to record the guaranteed residual value payment (assuming an estimated residual value of 1,000) and to clear the lease related accounts from the lessee s books? Solution Question 1 The lease should be classified as a finance lease by the lessee: - all the risks and rewards incident to ownership are transferred from lessor to lessee; - the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable; - the original intention of the parties is that cancellation is not expected to occur; The present value of the minimum lease payments is calculated using the lessor s implicit interest rate of 10%, because it is known

5 PV of guaranteed residual value: 10,000 / (1+10%) 3 = 7,513 PV of annual payments: 50,000 / (1+10%) + 50,000 / (1+10%) ,000 / (1+10%) 3 = 124,345 Present value of minimum lease payments: 131,858 Minimum lease payments 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. The sum of 1,000 to be paid annually by the lessee for insurance is not included in the minimum lease payment. The present value of the minimum lease payments amounts to the fair value of the leased asset, this is another indication that the lease is a finance lease. The journal entries at 01/01/X1 are as follows: 01/01/X1 Debit Credit Equipment 131,858 Lease obligation 131,858 Question 2 Journal entries at 31/12/X1, 31/12/X2 and 31/12/X3 31/12/X1 31/12/X2 31/12/X3 Debit Credit Debit Credit Debit Credit Insurance expense 1,000 1,000 1,000 Lease obligation (1) 36,814 40,496 44,548 Interest expense (1) 13,186 9,504 5,452 Cash 51,000 51,000 51,000 Depreciation expense (2) 43,619 43,619 43,620 Accumulated depreciation 43,619 43,619 43,620 (1) Refer to the amortisation schedule for the lessee, presented below. (2) (131,858-1,000) /

6 Amortization of the lease obligation using the effective interest method Date Lease payment Interest expense (10%) Reduction in lease obligation Lease obligation 01/01/X1 131,858 31/12/X1 50,000 13,186 36,814 95,044 31/12/X2 50,000 9,504 40,496 54,548 31/12/X3 50,000 5,452 44,548 10,000 Question 3 Guaranteed residual value The required journal entries on 31/12/X3 are: Debit Credit Obligation under finance lease 10,000 Accumulated depreciation 130,858 Cash 9,000 Leased equipment 131,858 IFRIC Interpretation 4 Determining whether an Arrangement An entity may enter into an arrangement, comprising a transaction or a series of related transactions, that does not take the legal form of a lease but conveys a right to use an asset (eg an item of property, plant or equipment) in return for a payment or series of payments. Examples of arrangements in which one entity (the supplier) may convey such a right to use an asset to another entity (the purchaser), often together with related services, include: outsourcing arrangements (eg the outsourcing of the data processing functions of an entity). arrangements in the telecommunications industry, in which suppliers of network capacity enter into contracts to provide purchasers with rights to capacity. take-or-pay and similar contracts, in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services (eg a take-or-pay contract to acquire substantially all of the output of a supplier`s power generator). This Interpretation provides guidance for determining whether such arrangements are, or contain, leases that should be accounted for in accordance with IAS 17. It does not provide guidance for determining how such a lease should be classified under that Standard

7 In some arrangements, the underlying asset that is the subject of the lease is a portion of a larger asset. This Interpretation does not address how to determine when a portion of a larger asset is itself the underlying asset for the purposes of applying IAS 17. Nevertheless, arrangements in which the underlying asset would represent a unit of account in either IAS 16 or IAS 38 are within the scope of this Interpretation. This Interpretation does not apply to arrangements that: (a) are, or contain, leases excluded from the scope of IAS 17; or (b) are public-to-private service concession arrangements within the scope of The issues addressed in this Interpretation are: (a) how to determine whether an arrangement is, or contains, a lease as defined in IAS 17; (b) when the assessment or a reassessment of whether an arrangement is, or contains, a lease should be made; and (c) if an arrangement is, or contains, a lease, how the payments for the lease should be separated from payments for any other elements in the arrangement. Determining whether an arrangement is, or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether: (a) fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and (b) the arrangement conveys a right to use the asset. Although a specific asset may 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. For example, if the supplier is obliged to deliver a specified quantity of goods or services and has the right and ability to provide those goods or services using other assets not specified in the arrangement, then fulfilment of the arrangement is not dependent on the specified asset and the arrangement does not contain a lease. A warranty obligation that permits or requires the substitution of the same or similar assets when the specified asset is not operating properly does not preclude lease treatment. In addition, a contractual provision (contingent or otherwise) permitting or requiring the supplier to substitute other assets for any reason on or after a specified date does not preclude lease treatment before the date of substitution

8 An asset has been implicitly specified if, for example, the supplier owns or leases only one asset with which to fulfil the obligation and it is not economically feasible or practicable for the supplier to perform its obligation through the use of alternative assets. An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser (lessee) the right to control the use of the underlying asset. The right to control the use of the underlying asset is conveyed if any one of the following conditions is met: (a) The purchaser has the ability or right to operate the asset or direct others to operate the asset in a manner it determines while obtaining or controlling more than an insignificant amount of the output or other utility of the asset. (b) The purchaser has the ability or right to control physical access to the underlying asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset. (c) Facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement, and the price that the purchaser will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output. The assessment of whether an arrangement contains a lease shall be made at the inception of the arrangement, being the earlier of the date of the arrangement and the date of commitment by the parties to the principal terms of the arrangement, on the basis of all of the facts and circumstances. A reassessment of whether the arrangement contains a lease after the inception of the arrangement shall be made only if any one of the following conditions is met: (a) There is a change in the contractual terms, unless the change only renews or extends the arrangement. (b) 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 paragraph 4 of IAS 17. A renewal or extension of the arrangement that does not include modification of any of the terms in the original arrangement before the end of the term of the original arrangement shall be evaluated under paragraphs 6 9 only with respect to the renewal or extension period. (c) There is a change in the determination of whether fulfilment is dependent on a specified asset. (d) There is a substantial change to the asset, for example a substantial physical change to property, plant or equipment. A reassessment of an arrangement shall be based on the facts and circumstances as of the date of reassessment, including the remaining term of the arrangement. Changes in estimate (for example,

9 the estimated amount of output to be delivered to the purchaser or other potential purchasers) would not trigger a reassessment. If an arrangement is reassessed and is determined to contain a lease (or not to contain a lease), lease accounting shall be applied (or cease to apply) from: (a) in the case of (a), (c) or (d) in paragraph 10, when the change in circumstances giving rise to the reassessment occurs; (b) in the case of (b) in paragraph 10, the inception of the renewal or extension period. If an arrangement contains a lease, the parties to the arrangement shall apply the requirements of IAS 17 to the lease element of the arrangement, unless exempted from those requirements in accordance with paragraph 2 of IAS 17. Accordingly, if an arrangement contains a lease, that lease shall be classified as a finance lease or an operating lease in accordance with paragraphs 7 19 of IAS 17. Other elements of the arrangement not within the scope of IAS 17 shall be accounted for in accordance with other Standards. For the purpose 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 a reassessment of the arrangement into those for the lease and those for other elements on the basis of their relative fair values. The minimum lease payments as defined in paragraph 4 of IAS 17 include only payments for the lease (ie the right to use the asset) and exclude payments for other elements in the arrangement (eg for services and the cost of inputs). In some cases, separating the payments for the lease from payments for other elements in the arrangement will require the purchaser to use an estimation technique. For example, a purchaser may estimate the lease payments by reference to a lease agreement for a comparable asset that contains no other elements, or by estimating the payments for the other elements in the arrangement by reference to comparable agreements and then deducting these payments from the total payments under the arrangement. If a purchaser concludes that it is impracticable to separate the payments reliably, it shall: (a) in the case of a finance lease, recognise an asset and a liability at an amount equal to the fair value1 of the underlying asset that was identified in paragraphs 7 and 8 as the subject of the lease. Subsequently the liability shall be reduced as payments are made and an imputed finance charge on the liability recognised using the purchaser`s incremental borrowing rate of interest. (b) in the case of an operating lease, treat all payments under the arrangement as lease payments for the purposes of complying with the disclosure requirements of IAS 17, but (i) disclose those payments separately from minimum lease payments of other arrangements that do not include payments for non-lease elements, and

10 (ii) state that the disclosed payments also include payments for non-lease elements in the arrangement. Example Company A enters into a three-year agreement to provide internet access to Company B. The agreement requires Company B to make monthly payments and specifies the amount of bandwidth Company B needs. In order to provide Company B with the necessary bandwidth, Company A installs a router on Company B`s premises. The router is not explicitly specified in the agreement, but is necessary to provide the required service and bandwidth to Company B. Company A has 24- hour access to the router to undertake any necessary maintenance or service. The useful life of the router is estimated to be three years. Company A can replace the router at any time during the contract period provided that the replacement can provide the same service. Generally, Company A would only replace the router if it is damaged or needs to be upgraded. Company A has an excess inventory of these routers and does not have a history of replacing or exchanging the routers before the end of the contracts. Is fulfilment of the agreement for the provision of internet access "dependent on the use of a specific asset" (i.e. are the requirements of IFRIC 4.6(a) met so that it should be concluded that the arrangement incorporates a lease of the router)? Solution Fulfilment of the agreement will only be considered to be dependent on the use of a specific asset if the asset is explicitly identified in the arrangement or it has been implicitly identified (if, for example, the supplier owns or leases only one such asset and it is not economically practicable for the supplier to meet its obligation through the use of alternative assets). [IFRIC 4.8] In the circumstances described, Company A`s 24-hour access to the router, immediate access to replacement routers and contractual permission to change the router at any time indicate that the router installed on Company B`s premises has not been implicitly identified in the arrangement. In effect, Company A can choose (1) which router to use in providing Company B with internet access for the three-year contract period and (2) whether to replace that router. When fulfilment of the agreement to provide internet access does not depend on the use of a specific asset (i.e. the requirements of IFRIC 4.6(a) are not met), the agreement does not contain a lease. In such cases, the agreement is a contract for the provision of services and should be accounted for in accordance with relevant Standards. SIC Interpretation 15 Operating Leases Incentives In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee to enter into the agreement. Examples of such incentives are an up-front cash payment to the lessee or the reimbursement or assumption by the lessor of costs of the lessee (such as relocation costs,

11 leasehold improvements and costs associated with a pre-existing lease commitment of the lessee). Alternatively, initial periods of the lease term may be agreed to be rent-free or at a reduced rent. The issue is how incentives in an operating lease should be recognised in the financial statements of both the lessee and the lessor. All incentives for the agreement of a new or renewed operating lease shall be recognised as an integral part of the net consideration agreed for the use of the leased asset, irrespective of the incentive`s nature or form or the timing of payments. The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern over which the benefit of the leased asset is diminished. The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern of the lessee`s benefit from the use of the leased asset. Costs incurred by the lessee, including costs in connection with a pre-existing lease (for example costs for termination, relocation or leasehold improvements), shall be accounted for by the lessee in accordance with the Standards applicable to those costs, including costs which are effectively reimbursed through an incentive arrangement. Example The total payments under an operating lease are as follows: Years 1 to 5: 200 per year Years 6 to 20: 100 per year In addition, the lessor provides a lease incentive with a value of 500. The lessee`s benefit under the lease arises on a straight-line basis over the full lease term. Applying IAS 17 Leases to the lease payments: Total payments: (200 5) + (100 15) = 2,500 Length of lease: 20 years Lease expense per year: 125 Applying SIC-15 to the incentive: 500 / 20 years = reduction of 25 per year Net lease expense per year = =

12 Bargain renewal options IAS Indicators of situations that individually or in combination could also lead to a lease being classified as a finance lease are: a. if the lessee can cancel the lease, the lessor s losses associated with the cancellation are borne by the lessee; b. gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and c. the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. A bargain renewal option exists when a lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. The rent for a secondary period would be considered substantially lower than market rent if it would be economically rational for the lessee to continue the lease at that lower rent. Rental for a secondary period either at a nominal amount or substantially below market rates suggests both: (1) that the lessor has received the required return from its initial investment and (2) that the lessee is likely to choose to enter into such a secondary period. Factors to consider in determining whether a renewal option represents a bargain include: the nature of the leased asset; the possibility of technological obsolescence; the possibility of higher operating and maintenance costs over the secondary rent period; and costs to be incurred by the lessor to find a new lessee and to prepare the asset for a new lessee. For example, a lessee has a renewal option for a secondary rent period. The lease payments during any renewal periods are indexed to the Consumer Price Index (CPI) at 75 per cent of the CPI existing at the time of the renewal. A 25 per cent discount may, depending on circumstances, be regarded as significant savings that would lead to classification of the renewal option as a bargain. Assume that the rental payments in the renewal period are equal to a specified percentage of the original monthly payments. One approach to assessing whether this represents a bargain would be to compare the implicit interest rates determined by assuming that:

13 (1) the lease is terminated at the end of the original lease term and (2) the lease is renewed at the reduced rental payments. Appropriate estimates of the residual value of the asset at the end of the original term and at the end of the renewal period should be included in the computations. If the implicit interest rate increases or remains substantially the same when the renewal option is assumed to be exercised, it is appropriate to conclude that the renewal option is not a bargain. The assessment of whether the interest rate differential is a bargain is made at the inception of the lease and will depend on both the economic conditions prevailing in the relevant jurisdiction and the circumstances of the parties to the lease agreement. Accounting for sale and leaseback transactions 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. Such transactions are a popular method of releasing cash funds for new investment as an alternative of borrowing. Sometimes instead of selling the asset outright, the original owner may lease to the investor and leases the same asset back. Such transaction is referred to as a lease and lease-back transaction and has similar effects. Under IAS 17, the accounting treatment depends on the type of lease entered to. It also depends on whether the sale and the subsequent leaseback transactions require careful consideration of all factors in order to arrive at the correct accounting. Practical Example Sale and leaseback of a business premise CAP is a department store and needs borrowing in order to accomplish its expansion program among the US. For that reason, CAP sells a business premise to Battery Bank for the market value of $ 20,000,000 (book value the business premise is $ 16,000,000). The entity then leases the business premise back form Battery Bank and, over the next seven years, CAP pays Battery Bank a rental, which is equivalent to a lender s return, being 3.75% calculated on $ 20,000,000. At year seven, CAP has the option to purchase back the business premise for $ 20,000,000 plus 25% of any increase in the market value since year one. If market value has gone down, and CAP is not willing to exercise the purchase option, the lease will continue for another 13 years, with Battery Bank continuing to earn a lender s return of 3,75%. CAP has operating rights of the business premise for 20 years and must maintain it. What is the correct classification of the leaseback? The lease will probably qualify as a finance lease. It appears that CAP keeps substantially all the risks and returns incident to ownership and this should be classified as finance lease. If CAP wanted to sell its asset and pay market rent for the property it could enter into 20 year lease agreement at market rentals. The option to buy the property back (in substance at less than market value) and the replacement of market rentals by interest-based payments demonstrate that CAP is keen to retain an interest in the value of the property and to pay interest rather than market rents. Where the seller enters into a finance leaseback, the transaction is essentially a financing operation. The seller/lessee never disposes of the risks and rewards of ownership of the asset and so it should

14 not recognize a profit or loss on the sale. Any apparent profit (difference between the sale price and the carrying amount) should be deferred and amortized over the lease term. This treatment will have the effect of adjusting the overall charge to the profit and loss account for the depreciation of the asset to an amount consistent with the asset s carrying amount before the leaseback. The Technical summary has been prepared by IFRS Foundation staff and has not been approved by the IASB. For the requirements reference must be made to International Financial Reporting Standard which can be obtained if pay the subscription to IASB The examples included in this application guide have been prepared by ConsultasIFRS team. You are not allowed to copy, forward, edit, translate, modify, use or copy any content

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