Identifying a lease

A contract contains, or is, a lease if the contract:

1. conveys the right to control
2. the use of
3. the identified asset
4. for a period of time
5. in exchange for consideration.

In essence, an entity needs to establish whether it has the right to obtain substantially all of the economic benefits from use of the identified asset and the right to direct the use of the identified asset.

The asset is generally specifically identified in the contract. However, care should be taken when determining the identified asset where the asset is not physically distinct. Examples of where an asset is not physically distinct could include the rental of portion of a fibre optic cable, telephone cables etc. This may indicate that the asset is not identifiable in terms of the lease definition unless the agreement represents substantially all of the capacity of the asset and thereby provides the customer right to obtain substantially all of the economic benefits from use of the asset. The classification as a lease also depends on where in the line the lease takes place e.g., end-use customer (refer to the FASB's standard ASC 842).

However, if the supplier has the substantive right to substitute the asset throughout the period of use, the entity does not have the exclusive right to control the use of the identified asset. A supplier's right to substitute an asset is substantive only if both of the following conditions exist:

1. The supplier has the practical ability to substitute alternative assets throughout the period of use; and
2. The supplier would benefit economically from the exercise of its right to substitute the asset.

It is important to note that the above can only be applied if the supplier has the right to substitute the underlying asset throughout the entire period of the contract, i.e., at the discretion of the supplier, and not only at a certain specific point in time. When assessing the above, potential future events are not considered. Generally, if the asset is located at the customer's premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier's premises and, therefore, are more likely to exceed the benefits associated with substituting the asset. The supplier's right or obligation to substitute the asset for repairs and maintenance, if the asset is not operating properly or if a technical upgrade becomes available does not preclude the customer from having the right to use an identified asset. This would typically be the case where the entity rents office furniture, such as printers and copiers, that is removed from the entity's premises every once in a while, for repairs and maintenance. Accordingly, these types of leases would not fall into the scope of the substitution exemption mentioned above.

The lessee has the right to direct the use of an identified asset throughout the period of use only if:

1. The lessee has the right to direct how and for what purpose the asset is used during the period of use; or
2. The relevant decisions about how and for what purpose the asset is used are predetermined and:
   1. The lessee has the right to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions; or
   2. The lessee designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Generally, each lease component must be accounted for separately from non-lease components unless the entity chooses to classify the entire contract as one lease component. Each lease component is allocated a stand-alone price, which is based on what the lessor, or similar supplier, would charge an entity for that component separately. If the stand-alone price is not available, the lessee must estimate the stand-alone price, maximising the use of observable information.

The standard allows the lessee to expense leases that have the following characteristics:

1. The underlying asset is of low value; or
2. The lease term is short-term in nature and does not exceed 12 months.

The lease term cannot include any options to extend or purchase the underlying asset. Accordingly, even if the lease term, including the extension or purchase options, is still less than 12 months, this exemption may not be applied.

When assessing whether the underlying asset is of low value, the entity must assess the underlying asset based on its value when it is new, regardless of the actual age of the asset when it is being leased.

While the standard does not define low value, it does provide the entity with two identifying characteristics of low value assets:

1. The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
2. The underlying asset is not highly dependent on, or highly interrelated with, other assets.

Examples provided include tablets, laptops or small items of office furniture and telephones. Entities are therefore required to assess what type of assets are significant to their business and to the financial statements.

Short term leases exemptions must be applied consistently to the same class of assets however the low value exemption may be applied on a lease-by-lease basis.

In summary, the following questions should be asked when determining whether a contract contains a lease:

1. Is there an identified asset?
2. Does the customer have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use?
3. Does the customer have the right to direct how and for what purpose the asset is used throughout the period of use?

If the answer to all three questions is Yes, the contract most likely contains a lease.

Lease term

The lease term is the non-cancellable period of a lease, together with:

1. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

The minimum lease term therefore is the non-cancellable period of the lease and is based on the enforceability of the contract. A lease is no longer enforceable when the lessee and the lessor have the right to terminate the lease without permission from the other party with no more than an insignificant penalty. It must be noted that both the lessee and the lessor should have the right to terminate the lease. However, if only the lessee has the right to terminate the lease the option is considered as part of the determination of the lease term. Alternatively, if only the lessor has the right to terminate the lease, the non-cancellable period includes the period cancelation option period. The shorter the non-cancellable period of a lease, the more likely that a lessee will exercise its option to extend the lease and not early terminate the lease. This is generally because the cost of replacing the asset is likely to be higher than the non-cancellable period of the lease.

It is furthermore important to note that the standard only refers to the legally enforceable lease term. The intention of lessees to lease an asset indefinitely (as is typical with related parties) becomes irrelevant if the lease agreement does not specifically state this.

The lease term includes any rent-free periods provided to the lessee by the lessor.

When determining whether the lessee will extend the lease or early terminate the lease, the standard provides examples of factors to consider:

1. Contractual terms and conditions for the option periods compared to market rates, such as:
   1. Amount of payments for the lease in any optional period;
   2. Amount of any variable payments for the lease or other contingent payments; and
   3. Terms and conditions of any options that are exercisable after initial optional periods;
2. 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 or terminate the lease, or to purchase the underlying asset, becomes exercisable;
3. Costs relating to the termination of the lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee's needs, costs of integrating a new asset into the lessee's operations, or termination penalties and similar costs, including costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location;
4. Importance of the underlying asset to the lessee's operations; and
5. Conditionality associated with exercising the option (i.e., when the option can be exercised only if one or more conditions are met), and the likelihood that those conditions will exist.

Initial measurement

At the commencement date of the lease, the lessee shall recognise a right-of-use asset with a corresponding lease liability. It is important to note that no distinction is made as to whether the lease transfers the risks and rewards associated with ownership or not; the lessee has the right to use the asset for a predetermined period in exchange for consideration and as such has an intangible asset.

At the initial recognition date, the entity is first required to measure the lease liability. This lease liability is the PV of the lease payments that are not paid at that date. The lease payments must be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If this rate cannot be used, the entity must use the entity's incremental borrowing rate.

In determining the lease payments, the following must be taken into account:

1. Fixed payments (including in-substance fixed payments) less any lease incentives receivable;
2. Variable lease payments that depend on an index or rate, initially measured using the index or rate as at the commencement date;
3. Amounts expected to be payable by the lessee under residual value guarantees;
4. Exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
5. Payments of penalties for terminating the lease, if the lease reflects the lessee exercising an option to terminate the lease.

It is accepted that the interest rate implicit in the lease is likely to be similar to the lessee's incremental borrowing rate in many cases. This is because both rates take into account the credit standing of the lessee, the length of the lease, the nature and quality of the collateral provided and the economic environment in which the transaction occurs. However, the interest rate implicit in the lease is generally also affected by a lessor's estimate of the residual value of the underlying asset at the end of the lease and may be affected by taxes and other factors known only to the lessor, such as any initial direct costs of the lessor. Accordingly, it is accepted that the lessee may not be able to determine the interest rate implicit in the lease due to information not being readily available to the lessee as a result of inputs required by the lessor, particularly where the asset has a significant residual value at the end of the lease.

The incremental rate is a lessee-specific rate, taking into account the creditworthiness of the lessee, the terms of the contract, the amount of the funds borrowed, the type of asset leased and the economic environment in which the lessee operates.

The incremental borrowing rate can be determined by using a rate that is readily observable, such as the standard borrowing rate or the property yield and adjusted for the specific nature of the asset and the terms and conditions contained in the lease.

It is therefore not appropriate to only use the current borrowing rate in the jurisdictional environment in which the lessee operates, even if the lessee has a good credit track record. This rate must be adjusted to reflect the asset used, the period of the contract as well as any specific conditions contained in the contract. Generally, the following rules can be applied when adjusting the discount rate:

1. The better the quality of the security provided, the lower the discount rate;
2. The higher the funds/value of the contract, the higher the discount rate; and
3. The shorter the borrowing term, the lower the discount rate.

It is also important to note that a lessee may not use its weighted average cost of capital as its incremental borrowing cost, as this incorporates all types of funding (including equity), whereas a lease is purely borrowings. It furthermore does not take into account the terms of the contract or the asset being leased. While this rate may be an appropriate starting point in determining the incremental borrowing rate, it must be adjusted for the specific requirements of the lease.

Each rate must be determined based on the inputs specific to each individual lease.

Once the lease liability has been calculated, the right-of-use asset can be calculated, which is as follows:

1. Amount of the initial measurement of the lease liability;
2. Any lease payments made at or before the commencement date, less any lease incentives received;
3. Any initial direct costs incurred by the lessee; and
4. An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions contained in the lease, unless those costs are to produce inventories.

Costs relating to the construction or design of an underlying asset must be accounted for in terms of the applicable standard, such as IAS 16, and should not be considered payments for the right to use of the underlying asset. It is also true that any payments made for the right-to-use asset should be included in the cost of the right-to-use asset and not be capitalised under IAS 16. Such payments are still made in terms of the lease contract and as such are payments for a lease, regardless of the timing of these payments.

Operating leases

The operating lease requires a less complex accounting treatment than does a finance lease. The payments received by the lessor are to be recorded as rental income in the period in which the payment is received or becomes receivable. If the rentals vary from a straight-line basis, or if the lease agreement contains a scheduled rent increase over the lease term, the revenue is nonetheless to be recognised on a straight-line basis unless an alternative basis of systematic and rational allocation is more representative of the time pattern of the earning process contained in the lease.

Additionally, if the lease agreement provides for a scheduled increase(s) in contemplation of the lessee's increased (i.e., more intensive) physical use of the leased property, the total amount of rental payments, including the scheduled increase(s), is allocated to revenue over the lease term on a straight-line basis. However, if the scheduled increase(s) is due to additional leased property (e.g., larger space, more machines), recognition should be proportional to the leased property, with the increased rents recognised over the years that the lessee has control over use of the additional leased property.

Under the leasing standard all initial direct costs incurred must be added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease income. Initial direct costs are incurred by lessors in negotiating and arranging an operating lease, and may include commissions, legal fees and those internal costs that are actually incremental (i.e., would not exist if the lease were not being negotiated) and directly attributable to negotiating and arranging the lease.

When negotiating a new or renewed lease, the lessor may provide incentives for the lessee to enter into the agreement. Such incentives include reimbursement of relocation costs, leasehold improvement costs and recognised costs associated with a pre-existing lease commitment of the lessee.

All incentives shall be 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 the payments.

The lessor shall recognise the aggregate cost of incentives as a reduction of the rental income over the lease term on a straight-line basis unless another systematic approach is more representative of the time pattern over which the benefit of the leased asset is diminished.

Depreciation of leased assets should be on a basis consistent with the lessor's normal depreciation policy for similar assets, and the depreciation expense should be computed on the basis set out in IAS 16.

Any modifications to the original lease contract must be treated as new lease contracts.

Finance leases

The accounting by the lessor for finance leases depends on which variant of finance lease is at issue. In sales-type leases, an initial profit, analogous to that earned by a manufacturer or dealer, is recognised, whereas a direct financing lease does not give rise to an initial recognition of profit.

At initial recognition, the lessor must recognise a receivable in the balance sheet equal to the net investment in the lease.

Sales-type leases

In the accounting for a sales-type lease, it is necessary for the lessor to determine the following amounts:

1. Gross investment.
2. Fair value of the leased asset.
3. Cost.

From these amounts, the remainder of the computations necessary to record and account for the lease transaction can be made. The first objective is to determine the numbers necessary to complete the following entry:

The gross investment (lease receivable) of the lessor is equal to the sum of the minimum lease payments (excluding contingent rent and executory costs) from the standpoint of the lessor, plus the unguaranteed residual value accruing to the lessor. The difference between the gross investment and the PV of the two components of gross investment (i.e., minimum lease payments and unguaranteed residual value) is recorded as “unearned finance income” (also referred to as “unearned interest revenue”). The PV is to be computed using the lease term and implicit interest rate (both of which were discussed earlier).

IFRS 16 stipulates that the resulting unearned finance income is to be amortised and recognised into income using the effective rate (or yield) interest method, which will result in a constant periodic rate of return on the “lessor's net investment” (which is computed as the “lessor's gross investment” less the “unearned finance income”).

The fair value of the leased property is by definition equal to the normal selling price of the asset adjusted by any residual amount retained (including any unguaranteed residual value, investment credit, etc.). According to IAS 17, the selling price to be used for a sales-type lease is equal to the fair value of the leased asset, or if lower the sum of the PVs of the minimum lease payment and the estimated unguaranteed residual value accruing to the lessor, discounted at a commercial rate of interest. In other words, the normal selling price less the PV of the unguaranteed residual value is equal to the PV of the minimum lease payment. (Note that this relationship is sometimes used while computing the minimum lease payment when the normal selling price and the residual value are known; this is illustrated in a case study that follows.)

Under IFRS 16, initial direct costs incurred in connection with a sales-type lease (i.e., where the lessor is a manufacturer or dealer) must be expensed as incurred. This is a reasonable requirement, since these costs offset some of the profit recognised at inception, as do other selling expenses. Thus, the costs recognised at the inception of such lease arrangements would include the carrying value of the equipment or other items being leased, as well as incidental costs of negotiating and executing the lease. The profit recognised at inception would be the gross profit on the sale of the leased asset, less all operating costs, including the initial direct costs of creating the lease arrangement.

The estimated unguaranteed residual values used in computing the lessor's gross investment in a lease should be reviewed regularly. In case of a permanent reduction (impairment) in the estimated unguaranteed residual value, the income allocation over the lease term is revised and any reduction with respect to amounts already accrued is recognised immediately.

To attract customers, manufacturer or dealer lessors sometimes quote artificially low rates of interest. This has a direct impact on the recognition of initial profit, which is an integral part of the transaction and is inversely proportional to the finance income to be generated by it. Thus, if finance income is artificially low, this results in recognition of excessive profit from the transaction at the time of the sale. Under such circumstances, the standard requires that the profit recognised at inception, analogous to a cash sale of the leased asset, be restricted to that which would have resulted had a commercial rate of interest been used in the deal. Thus, the substance, not the form, of the transaction should be reflected in the financial statements. The PV of the scheduled lease payments, discounted at the appropriate commercial rate, must be computed to derive the effective selling price of the leased asset under these circumstances.

The difference between the selling price and the amount computed as the cost of goods sold is the gross profit recognised by the lessor on the inception of the lease (sale). Manufacturer or dealer lessors often give an option to their customers of either leasing the asset (with financing provided by them) or buying the asset outright. Thus, a finance lease by a manufacturer or dealer lessor, also referred to as a sales-type lease, generates two types of revenue for the lessor:

1. The gross profit (or loss) on the sale, which is equivalent to the profit (or loss) that would have resulted from an outright sale at normal selling prices, adjusted, if necessary, for a non-commercial rate of interest.
2. The finance income or interest earned on the lease receivable to be spread over the lease term based on a pattern reflecting a constant periodic rate of return on either the lessor's net investment outstanding or the net cash investment outstanding in respect of the finance lease.

The application of these points is illustrated in the example below.

Direct financing leases

Another form of finance lease is a direct financing lease. The accounting for a direct financing lease exhibits many similarities to that for a sales-type lease. Of particular importance is that the terminology used is much the same; however, the treatment accorded these items varies greatly. Again, it is best to preface the discussion by determining the objectives in the accounting for a direct financing lease. Once the lease has been classified, it must be recorded. To do this, the following amounts must be determined:

1. Gross investment.
2. Cost.
3. Residual value.

As noted, a direct financing lease generally involves a leasing company or other financial institution and results in only interest revenue being earned by the lessor. This is because the FMV (selling price) and the cost are equal, and therefore no dealer profit is recognised on the actual lease transaction. Note how this is different from a sales-type lease, which involves both a profit on the transaction and interest revenue over the lease term. The reason for this difference is derived from the conceptual nature underlying the purpose of the lease transaction. In a sales-type lease, the manufacturer (distributor, dealer, etc.) is seeking an alternative means to finance the sale of his product, whereas a direct financing lease is a result of the consumer's need to finance an equipment purchase. Because the consumer is unable to obtain conventional financing, he or she turns to a leasing company that will purchase the desired asset and then lease it to the consumer. Here the profit on the transaction remains with the manufacturer while the interest revenue is earned by the leasing company.

Like a sales-type lease, the first objective is to determine the amounts necessary to complete the following entry:

The gross investment is still defined as the minimum amount of lease payments (from the standpoint of a lessor) exclusive of any executory costs, plus the unguaranteed residual value. The difference between the gross investment as determined above and the cost (carrying value) of the asset is to be recorded as the unearned finance income because there is no manufacturer's/dealer's profit earned on the transaction. The following entry would be made to record initial direct costs:

Under IFRS 16, the net investment in the lease is defined as the gross investment less the unearned income plus the unamortised initial direct costs related to the lease. Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors. These are to be capitalised and allocated over the lease term.

Employing initial direct cost capitalisation, the unearned lease (i.e., interest) income and the initial direct costs will be amortised to income over the lease term so that a constant periodic rate is earned either on the lessor's net investment outstanding or on the net cash investment outstanding in the finance lease (i.e., the balance of the cash outflows and inflows in respect of the lease, excluding any executory costs that are chargeable to the lessee). Thus, the effect of the initial direct costs is to reduce the implicit interest rate, or yield, to the lessor over the life of the lease.

The lease payments included in the measurement of the net investment in the lease comprise the following payments for the right to use the underlying asset during the lease term that are not received at commencement date:

1. Fixed payments (including in-substance fixed payments) less any lease incentives payable;
2. Variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date;
3. Any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee;
4. Exercise price of a purchase option if the lessee is reasonably certain to exercise the option; and
5. Payments of penalties for terminating the lease, the lease term reflects the lessee exercising an option to terminate the lease.

Subsequently, the lessor must recognise finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor's net investment in the lease.

An example follows that illustrates the preceding principles.