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22
Leases

Introduction
Definitions of Terms
1. Minimum Lease Payments (MLP)
Classification of Leases
Recognition and Measurement
Disclosure Requirements Under IAS 17
1. Lessee Disclosures
2. Lessor Disclosures
Examples of Financial Statement Disclosures
Future Developments
US GAAP Comparison
Appendix A: Special Situations Not Addressed by IAS 17 but which have been Interpreted Under US GAAP
Appendix B: Leveraged Leases Under US GAAP

Introduction

Leasing has long been a popular financing option for the acquisition of business property. During the past few decades, however, the business of leasing has experienced staggering growth, and much of this volume is reported in the statements of financial position. The tremendous popularity of leasing is quite understandable, as it offers great flexibility, often coupled with a range of economic advantages over ownership. Thus, with leasing, a lessee (borrower) is typically able to obtain 100% financing, whereas under a traditional credit purchase arrangement the buyer would generally have to make an initial equity investment. In many jurisdictions, a leasing arrangement offers tax benefits compared to the purchase option. The lessee is protected to an extent from the risk of obsolescence, although the lease terms will vary based on the extent to which the lessor bears this risk. For the lessor, there will be a regular stream of lease payments, which include interest that often will be at rates above commercial lending rates, and, at the end of the lease term, usually some residual value.

The accounting for lease transactions involves a number of complexities, which derive partly from the range of alternative structures that are available to the parties. For example, in many cases leases can be configured to allow manipulation of the tax benefits, with other features such as lease term and implied interest rate adjusted to achieve the intended overall economics of the arrangement. Leases can be used to transfer ownership of the leased asset, and they can be used to transfer some or all of the risks normally associated with ownership. The financial reporting challenge is to have the economic substance of the transaction dictate the accounting treatment.

The accounting for lease transactions is one of the best examples of the application of the principle of substance over form, as set forth in the IASB's Framework. If the transaction effectively transfers ownership to the lessee, the substance of the transaction is that of a sale of the underlying property, which should be recognised as such even though the transaction takes the contractual form of a lease, which is only a right to use the property at issue.

The guidance on lease accounting under IFRS is not as fully elaborated as is that provided under certain national GAAP, consistent with the somewhat more “principles-based” approach of the international standards. Even applying such an approach, however, IFRS still does not result in the capitalisation (treatment as assets and related debt) of all lease arrangements, and variations can be made to lease terms that can achieve operating (non-capitalisation) treatment, which is often desired by lessees.

While almost any type of arrangement that satisfies the definition of a lease is covered by this standard, the following specialised types of lease agreements are specifically excluded:

Lease agreements to explore for or use natural resources, such as oil, gas, timber, metals and other mineral rights.
Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

The accounting for rights to explore and develop natural resources has yet to be formally addressed by IFRS; IFRS 6, which deals with exploration and evaluation assets arising in the mineral exploration process, offers no accounting guidance for leases. Licensing agreements are addressed by IAS 38, which is discussed in Chapter 11.

Definitions of Terms

Bargain purchase option (BPO). A provision in the lease agreement allowing the lessee the option of purchasing the leased property for an amount that is sufficiently lower than the fair value of the property at the date the option becomes exercisable. Exercise of the option must appear reasonably assured at the inception of the lease.

Commencement of the lease term. The date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease, i.e., recognition of the assets, liabilities, income or expenses resulting from the lease, as appropriate.

Contingent rentals. Those lease rentals that are not fixed in amount but are based on a factor other than simply the passage of time; for example, if based on percentage of sales, price indices, market rates of interest or degree of use of the leased asset.

Economic life of leased property. Either the period over which the 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 leased asset by one or more users.

Executory costs. Costs such as insurance, maintenance and taxes incurred for leased property, pertaining to the current period, whether paid by the lessor or lessee. If the obligation of the lessee, these are excluded from the minimum lease payments.

Fair value of leased property (FMV). The amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm's-length transaction. When the lessor is a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its normal selling price, net of any volume or trade discounts. When the lessor is not a manufacturer or dealer, the fair value of the property at the inception of the lease will ordinarily be its cost to the lessor, unless a significant amount of time has elapsed between the acquisition of the property by the lessor and the inception of the lease, in which case fair value should be determined in light of market conditions prevailing at the inception of the lease. Thus, fair value may be greater or less than the lessor's cost or the carrying amount of the property.

Finance lease. A lease that transfers substantially all the risks and rewards associated with the ownership of an asset. The risks related to ownership of an asset include the possibilities of losses from idle capacity or technological obsolescence, and that flowing from variations in return due to changing economic conditions; rewards incidental to ownership of an asset include an expectation of profitable operations over the asset's economic life and expectation of gain from appreciation in value or the ultimate realisation of the residual value. Title may or may not eventually be transferred to the lessee under finance lease arrangements.

Gross investment in the lease. The sum total of (1) the minimum lease payments under a finance lease (from the standpoint of the lessor), plus (2) any unguaranteed residual value accruing to the lessor.

Guaranteed residual value.

From the standpoint of the lessee: that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable).
From the standpoint of the lessor: that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Inception of the lease. The earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date:

A lease is classified as either an operating or a finance lease; and
In the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined.

Initial direct costs. Initial direct costs, such as commissions and legal fees, incurred by lessors in negotiating and arranging a lease. These generally include (1) costs to originate a lease incurred in transactions with independent third parties that (a) result directly from and are essential to acquire that lease, and (b) would not have been incurred had that leasing transaction not occurred; and (2) certain costs directly related to specified activities performed by the lessor for that lease, such as evaluating the prospective lessee's financial condition; evaluating and recording guarantees, collateral and other security arrangements; negotiating lease terms; preparing and processing lease documents; and closing the transaction.

Lease. An agreement whereby a lessor conveys to the lessee, in return for payment or series of payments, the right to use an asset (property, plant, equipment or land) for an agreed-upon period of time. Other arrangements essentially similar to leases, such as hire-purchase contracts, instalment sale agreements, bare-boat charters and so on, are also considered leases for purposes of the standard.

Lease term. 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.

Lessee's incremental borrowing rate. The interest rate that the lessee would have to pay on a similar lease, or, if that is not determinable, the rate that at the inception of the lease the lessee would have incurred to borrow over a similar term (i.e., a loan term equal to the lease term), and with a similar security, the funds necessary to purchase the leased asset.

Minimum Lease Payments (MLP)

From the standpoint of the lessee. The payments over the lease term that the lessee is or can be required to make in connection with the leased property. The lessee's obligation to pay executory costs (e.g., insurance, maintenance or taxes) and contingent rents are excluded from minimum lease payments. If the lease contains a bargain purchase option, the minimum rental payments over the lease term plus the payment called for in the bargain purchase option are included in minimum lease payments.
If no such provision regarding a bargain purchase option is included in the lease contract, the minimum lease payments include the following:
1. The minimum rental payments called for by the lease over the lease contract over the term of the lease (excluding any executory costs); plus
2. Any guarantee of residual value, at the expiration of the lease term, to be paid by the lessee or a party related to the lessee.
From the standpoint of the lessor. The payments described above plus any guarantee of the residual value of the leased asset by a third party unrelated to either the lessee or lessor (provided that the third party is financially capable of discharging the guaranteed obligation).

Net investment in the lease. The difference between the lessor's gross investment in the lease and the unearned finance income.

Non-cancellable lease. A lease that is cancellable only:

On occurrence of some remote contingency;
With the concurrence (permission) of the lessor;
If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or
On payment by the lessee of an additional amount such that at inception, continuation of the lease appears reasonably assured.

Operating lease. A lease that does not meet the criteria prescribed for a finance lease.

Penalty. Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to pay cash, incur or assume a liability, perform services, surrender or transfer an asset or rights to an asset, or otherwise forgo an economic benefit or suffer an economic detriment.

Rate implicit in the lease. The discount rate that at the inception of the lease, when applied to the minimum lease payments, and the unguaranteed residual value accruing to the benefit of the lessor, causes the aggregate present value to be equal to the fair value of the leased property to the lessor and any initial direct costs of the lessor.

Related parties in leasing transactions. Entities that are in a relationship where one party has the ability to control the other party or exercise significant influence over the operating and financial policies of the related party. Examples include the following:

A parent company and its subsidiaries.
An owner company and its joint ventures and partnerships.
An investor and its investees.

Renewal or extension of a lease. The continuation of a lease agreement beyond the original lease term, including a new lease where the lessee continues to use the same property.

Residual value of leased property. The fair value, estimated at the inception of the lease, that the enterprise expects to obtain from the leased property at the end of the lease term.

Sale and leaseback accounting. A method of accounting for a sale-leaseback transaction in which the seller-lessee records the sale, removes all property and related liabilities from its statement of financial position, recognises gain or loss from the sale and classifies the leaseback in accordance with IAS 17.

Unearned finance income. The excess of the lessor's gross investment in the lease over its present value.

Unguaranteed residual value. Part of the residual value of the leased asset (estimated at the inception of the lease) the realisation of which by the lessor is not assured or is guaranteed by a party related to the lessor.

Useful life. The estimated period over which the economic benefits embodied by the asset are expected to be consumed, without being limited to the lease term.

Classification of Leases

Classification of Leases—Lessee

For accounting and reporting purposes a lessee has two alternatives in classifying a lease:

Operating.
Finance.

Finance leases (which are known as capital leases under the corresponding US GAAP, because such leased property is treated as owned, and accordingly, capitalised in the statement of financial position) are those that essentially are alternative means of financing the acquisition of property or of substantially all the service potential represented by the property.

The proper classification of a lease is determined by the circumstances surrounding the leasing transaction. According to IAS 17, whether a lease is a finance lease or not will have to be judged based on the substance of the transaction, rather than on its mere form. If substantially all of the benefits and risks of ownership will be transferred to the lessee, the lease should be classified as a finance lease; such a lease is normally non-cancellable and the lessor is assured (subject to normal credit risk) of recovery of the capital invested plus a reasonable return on its investment. IAS 17 stipulates that substantially all of the risks or benefits of ownership are deemed to have been transferred if any one of the following five criteria has been met:

The lease transfers ownership to the lessee by the end of the lease term.
The lease contains a bargain purchase option (an option to purchase the leased asset at a price that is expected to be substantially lower than the fair value at the date the option becomes exercisable) and it is reasonably certain that the option will be exercisable.
The lease term is for the major part of the economic life of the leased asset.
The present value (PV), at the inception of the lease, of the minimum lease payments is at least equal to substantially all of the fair value of the leased asset, net of grants and tax credits to the lessor at that time; title may or may not eventually pass to the lessee.
The leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.
Further indicators which suggest that a lease might be properly considered to be a finance lease are:
If the lessee can cancel the lease, the lessor's losses that are associated with the cancellation are to be borne by the lessee.
Gains or losses resulting from the fluctuations in the fair value of the residual will accrue to the lessee.
The lessee has the ability to continue the lease for a supplemental term at a rent that is substantially lower than market rent (i.e., there is a bargain renewal option).

Thus, under IAS 17, an evaluation of all eight of the foregoing criteria would be required to properly assess whether there is sufficient evidence to conclude that a given arrangement should be accounted for as a finance lease. Of the eight criteria set forth in the standard, the first five are essentially determinative in nature; that is, meeting any one of these would normally result in concluding that a given arrangement is in fact a finance lease. The final three criteria, however, are more suggestive in nature, and the standard states that these could lead to classification as a finance lease.

The interest rate used to compute the present value should be the lessee's incremental borrowing rate, unless it is practicable to determine the rate implicit in the lease, in which case that implicit rate should be used.

The language used in the third and fourth lease accounting criteria, as set forth above, makes them rather subjective and somewhat difficult to apply in practice. Thus, given the same set of facts, it is possible for two reporting entities to reach different conclusions regarding the classification of a given lease.

The purpose of the third criterion is to define leases covering essentially all of the asset's useful life as being financing arrangements. Under the current US GAAP standard, a clearly defined threshold of 75% of the useful life has been specified as one of the criteria for classifying a lease as a finance lease, which thus creates a “bright line” test that can be applied mechanically. The corresponding language under IAS 17 stipulates that capitalisation results when the lease covers a “major part of the economic life” of the asset. Reasonable persons obviously can debate whether “major part” implies a proportion lower than 75% (say, as little as 51%), or implies a higher proportion (such as 90%). It should be noted that the previous version of IAS 17 had these “bright lines” in the standard, but these were removed in favour of a more principle-based approach.

The fourth criterion defines arrangements to fully compensate the lessor for the entire value of the leased property as financing arrangements. In contrast to US GAAP, this quantitative threshold is not provided under IFRS. A threshold, “the present value of minimum lease payments equaling at least 90% of leased asset fair value,” is set as one of the criteria under the US standard, while the corresponding language, “substantially all of the fair value of the leased asset,” is employed under IFRS. Again, there is room for debate over whether “substantially all” implies a threshold lower than 90% or, less likely, an even higher one. Once again, the IASB chose to remove the 90% from the previous IAS 17 standard.

IAS 17 addresses the issue of change in lease classification resulting from alterations in lease terms, stating that if the parties agree to revise the terms of the lease, other than by means of renewing the lease, in a manner that would have resulted in a different classification of the lease had the changed terms been in effect at inception of the lease, then the revised lease is to be considered a new lease agreement.

Leases Involving Land and Buildings

IAS 17 addresses leases involving both land and buildings. A lessee therefore has to analyse both the land and building components of the lease separately to determine whether each component is a finance or operating lease. The standard states that when analysing a land lease under the IAS 17 requirements, the criteria requiring that the lease be for the majority of the useful life would probably not be met as land has an indefinite economic life.

Under IAS 17, the minimum lease payments at the inception of a lease of land and buildings (including any upfront payments) are to be allocated between the land and the buildings elements in proportion to their relative fair values at the inception of the lease. In those circumstances where the lease payments cannot be allocated reliably between these two elements, the entire lease is to be classified as a finance lease, unless it is clear that both elements are operating leases.

Furthermore, IAS 17 specifies that for a lease of land and buildings in which the value of the land element at the inception of the lease is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification, in which case the criteria set forth in IAS 17 will govern the classification as a finance or operating lease. If this is done, the economic life of the buildings is regarded as the economic life of the entire leased asset.

Additional guidance, drawn from US GAAP, and an example of accounting for a combined land and building lease, are presented in Appendix A.

Classification of Leases—Lessor

The lessor has the following alternatives in classifying a lease:

Operating lease.
Finance lease.

Different Types of Finance Leases

Finance leases can have various forms. Some common examples are sales-type, direct financing and leveraged leases.

A lease is classified as a sales-type lease when the criteria set forth above have been met and the lease transaction is structured such that the lessor (generally a manufacturer or dealer) recognises a profit or loss on the transaction in addition to interest revenue. For this to occur, the fair value of the property, or if lower the sum of the present values of the minimum lease payments and the estimated unguaranteed residual value, must differ from the cost (or carrying value, if different). The essential substance of this transaction is that of a sale, thus its name. Common examples of sales-type leases: (1) when an automobile dealership opts to lease a car to its customers in lieu of making an actual sale, and (2) the re-lease of equipment coming off an expiring lease.

A direct financing lease differs from a sales-type lease in that the lessor does not realise a profit or loss on the transaction other than the interest revenue to be earned over the lease term. In a direct financing lease, the fair value of the property at the inception of the lease is equal to the cost (or carrying value, if the property is not new). This type of lease transaction most often involves entities regularly engaged in financing operations. The lessor (usually a bank or other financial institution) purchases the asset and then leases the asset to the lessee. This mode of transaction is merely a replacement for the conventional lending transaction, where the borrower uses the borrowed funds to purchase the asset.

There are many economic reasons why a lease transaction may be considered. These include:

The lessee (borrower) is often able to obtain 100% financing.
There may be tax benefits for the lessee, such as the ability to expense the asset over its lease term, instead of over a longer depreciable life.
The lessor receives the equivalent of interest as well as an asset with some remaining value at the end of the lease term (unless title transfers as a condition of the lease).
The lessee is protected from risk of obsolescence (although presumably this risk protection is priced into the lease terms).

One specialised form of a direct financing lease is a leveraged lease. This type is mentioned separately both here and in the following section on how to account for leases because it is to receive a different accounting treatment by a lessor. A leveraged lease meets all the definitional criteria of a direct financing lease, but differs because it involves at least three parties: a lessee, a long-term creditor and a lessor (commonly referred to as the equity participant). Other characteristics of a leveraged lease are as follows:

The financing provided by the long-term creditor must be without recourse as to the general credit of the lessor, although the creditor may hold recourse with respect to the leased property. The amount of the financing must provide the lessor with substantial leverage in the transaction.
The lessor's net investment declines during the early years and rises during the later years of the lease term before its elimination.

Recognition and Measurement

Accounting for Leases—Lessee

As discussed in the preceding section, there are two classifications under IAS 17 that apply to a lease transaction in the financial statements of the lessee. They are as follows:

Operating.
Finance.

Operating Leases

The accounting treatment accorded an operating lease is relatively simple; rental expense should be charged to profit or loss as the payments are made or become payable. IAS 17 stipulates that rental expense be “recognised on a systematic basis that is representative of the time pattern of the user's benefits, even if the payments are not on that basis.” In many cases, the lease payments are being made on a straight-line basis (i.e., equal payments per period over the lease term), and recognition of rental expense would normally also be on a straight-line basis.

However, even if the lease agreement calls for an alternative payment schedule or a scheduled rent increase over the lease term, the lease expense should still be recognised on a straight-line basis unless another systematic and rational basis is a better representation of actual physical use of the leased property. In such instances it will be necessary to create either a prepaid asset or a liability, depending on the structure of the payment schedule. In SIC 15, it has been held that all incentives relating to a new or renewed operating lease are to be considered in determining the total cost of the lease, to be recognised on a straight-line basis over the term of the lease. Thus, for example, a rent-free period of six months, offered as part of a five-year lease commitment, would not result in the reporting of only six months' rent expense during the first full year. Rather, four and one-half years' rent would be allocated over the full five-year term, such that monthly expense would equal 90% (= 54 months' payments/60-month term) of the stated monthly rental payments that begin after the holiday ends.

The accounting would differ if rental increases were directly tied to expanded space utilisation, however, but not if related merely to the extent that the property were being used. For example, 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 (e.g., more sustained usage of machinery after an initial set-up period), the total amount of rental payments, including the scheduled increase(s), should be charged to expense over the lease term on a straight-line basis; the increased rent should not impact the accounting. On the other hand, if the scheduled increase(s) is due to additional leased property (e.g., expanding to adjacent space after two years), recognition should be proportional to the amount of leased property, with the increased rents recognised over the years that the lessee has control over the use of the additional leased property. Scheduled increases could envision more than one of these events occurring, making the accounting more complex.

Notice that in the case of an operating lease there is no recognition in the statement of financial position of the leased asset because the substance of the lease is merely that of a rental. There is no reason to expect that the lessee will derive any future economic benefit from the leased asset beyond the lease term. There may, however, be a deferred charge or credit in the statement of financial position if the payment schedule under terms of the lease does not correspond with the expense recognition, as suggested in the preceding paragraph.

Example of Straight Lining of Lease Payments

Rockwood Limited has 2 leases:

Lease 1:

3-year lease
Lease payment €100,000 p.a. escalating at inflation
Inflation for years 1–3 is 8%

Lease 2:

3-year lease
Lease payment €100,000 p.a. escalating at 8% p.a. to reflect inflation
Inflation for years 1–3 is ±8%

Accounting for Lease 1:

*Year 1*
Statement of Comprehensive Income – Lease Expense	€100,000
Bank		€100,000
*Year 2*
Statement of Comprehensive Income – Lease Expense	€108,000
Bank		€108,000
*Year 3*
Statement of Comprehensive Income – Lease Expense	€116,640
Bank		€116,640

Accounting for Lease 2:

As the escalation is a fixed percentage, and not a contingent amount as per Lease 1 (note that inflation is considered contingent), then the lease payments must be straight lined. Note that the difference between the amount charged to the statement of comprehensive income and the amount paid to the lessor should be recognised in the statement of financial provision as a liability.

Total lease payments over lease term:

Year 1		€100,000
Year 2		108,000
Year 3		116,640
Total		324,640
Therefore the annual charge will be 324,640/3 =		€108,213
Year 1
Statement of Comprehensive Income – Lease Expense	€108,213
Bank		€100,000
Operating Lease Provision (SoFP)		8,213
Year 2
Statement of Comprehensive Income – Lease Expense	€108,213
Bank		€108,000
Operating Lease Provision (SoFP)		213
Year 3
Statement of Comprehensive Income – Lease Expense	€108,214
Bank		€116,640
Operating Lease Provision (SoFP)	8,426

It is important to note that at the end of the lease the operating lease asset or provision would have reversed in its entirety as the economic benefits of the lease have now been consumed by the lessee.

Finance leases. Assuming that the lease agreement satisfies the criteria set forth above for finance lease accounting, it must be accounted for as a finance lease.

According to IAS 17, the lessee is to record a finance lease as an asset and an obligation (liability) at an amount equal to the lesser of (1) the fair value of the leased property at the inception of the lease, net of grants and tax credits receivable by the lessors, or (2) the present value of the minimum lease payments.

For purposes of this computation, the minimum lease payments are considered to be the payments that the lessee is obligated to make or can be required to make, excluding contingent rent and executory costs such as insurance, maintenance and taxes. The minimum lease payments generally include the minimum rental payments, and any guarantee of the residual value made by the lessee or a party related to the lessee. If the lease includes a bargain purchase option (“BPO”), the amount required to be paid under the BPO is included in the minimum lease payments. The present value shall be computed using the incremental borrowing rate of the lessee unless it is practicable for the lessee to determine the implicit rate computed by the lessor, in which case it is to be employed, whether higher or lower than the incremental borrowing rate.

The lease term to be used in the present value computation is the fixed, non-cancellable term of the lease, plus any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, provided that it is reasonably certain, as of the beginning of the lease, that the lessee will exercise such a renewal option.

The cost of the leased asset is therefore derived from the cost of financing.

Depreciation of leased assets. The depreciation of the leased asset will depend on which criterion resulted in the lease being qualified as a finance lease. If the lease transaction met the criteria as either transferring ownership or containing a bargain purchase option, the asset arising from the transaction is to be depreciated over the estimated useful life of the leased property, which will, after all, be used by the lessee (most likely) after the lease term expires. If the transaction qualifies as a finance lease because it met either the criterion of encompassing the major part of the asset's economic life, or because the present value of the minimum lease payments represented substantially all of the fair value of the underlying asset, then it must be depreciated over the shorter of the lease term or the useful life of the leased property. The conceptual rationale for this differentiated treatment arises because of the substance of the transaction. Under the first two criteria, the asset actually becomes the property of the lessee at the end of the lease term (or on exercise of the BPO). In the latter situations, title to the property remains with the lessor.

Thus, the leased asset is to be depreciated (amortised) over the shorter of the lease term or its useful life if title does not transfer to the lessee, but when it is reasonably certain that the lessee will obtain ownership by the end of the lease term, the leased asset is to be depreciated over the asset's useful life. The manner in which depreciation is computed should be consistent with the lessee's normal depreciation policy for other depreciable assets owned by the lessee, recognising depreciation on the basis set out in IAS 16. Therefore, the accounting treatment and method used to depreciate (amortise) the leased asset is very similar to that used for an owned asset.

In some instances when the property is to revert back to the lessor, there may be a guaranteed residual value. This is the value at lease termination that the lessee guarantees to the lessor. If the fair value of the asset at the end of the lease term is greater than or equal to the guaranteed residual amount, the lessee incurs no additional obligation. On the other hand, if the fair value of the leased asset is less than the guaranteed residual value, the lessee must make up the difference, usually with a cash payment. The guaranteed residual value is often used as a device to reduce the periodic payments by substituting the lump-sum amount at the end of the term that results from the guarantee. In any event the depreciation (amortisation) must still be based on the estimated residual value. This results in a rational and systematic allocation of the expense through the periods and avoids having to recognise a disproportionately large expense (or loss) in the last period as a result of the guarantee.

The annual (periodic) rent payments made during the lease term are to be apportioned between the reduction in the obligation and the finance charge (interest expense) in a manner such that the finance charge (interest expense) represents a constant periodic rate of interest on the remaining balance of the lease obligation. This is commonly referred to as the effective rate interest method. However, it is to be noted that IAS 17 also recognises that an approximation of this pattern can be made as an alternative. The effective rate method, which is used in many other applications, such as mortgage amortisation, is almost universally understood, and therefore should be applied in virtually all cases.

At the inception of the lease the asset and the liability relating to the future rental obligation are reported in the statement of financial position of the lessee at the same amounts. However, since the depreciation charge for use of the leased asset and the finance expense during the lease term differ due to different policies being used to recognise them, as explained above, it is likely that the asset and related liability balances would not be equal in amount after inception of the lease.

The following examples illustrate the treatment described in the foregoing paragraphs.

Example of Accounting for a Finance Lease—Asset Returned to Lessor at Termination

Assume the following:

The lease is initiated on January 1, 20XX, for equipment with an expected useful life of three years. The equipment reverts back to the lessor on expiration of the lease agreement.
The FMV of the equipment is €135,000.
Three payments are due to the lessor in the amount of €50,000 per year beginning December 31, 20XX. An additional sum of €1,000 is to be paid annually by the lessee for insurance.
Lessee guarantees a €10,000 residual value on December 31, 20XX+2, to the lessor.
Irrespective of the €10,000 residual value guarantee, the leased asset is expected to have only a €1,000 salvage value on December 31, 20XX+2.
The lessee's incremental borrowing rate is 10% (implicit rate is unknown).

The present value of the lease obligation is as follows:

PV of guaranteed residual value	=	€10,000 × 0.7513^*	=	€7,513
PV of annual payments	=	€50,000 × 2.4869^**	=	124,345
				€131,858
* The present value of an amount of €1 due in three periods at 10% is 0.7513.
*. The present value of an ordinary annuity of €1 for three periods at 10% is 2.4869*.

The first step in accounting for any lease transaction is to classify the lease. In this case, the lease term is for three years, which is equal to 100% of the expected useful life of the asset. Notice that the test of fair value versus present value is also fulfilled, as the PV of the minimum lease payments (€131,858) could easily be considered as being equal to substantially all the FMV (€135,000), being equal to 97.7% of the FMV. Thus, this lease should be accounted for as a finance lease.

In assumption 7 above, the present value of the lease obligation is computed. Note that the executory costs (insurance) are not included in the minimum lease payments and that the incremental borrowing rate of the lessee was used to determine the present value. This rate was used because the implicit rate was not determinable.

The entry necessary to record the lease on January 1, 201X is:

Leased equipment	€131,858
Lease obligation		€131,858

Note that the lease is recorded at the present value of the minimum lease payments, which in this case is less than the fair value of the asset. If the present value of the minimum lease payments had exceeded the fair value, the lease would be recorded at the fair value.

The next step is to determine the proper allocation between interest and a reduction in the lease obligation for each lease payment. This is done using the effective interest method as illustrated below.

Year	Cash payment	Interest expense	Reduction in lease obligation	Balance of lease obligation
Inception of lease				€131,858
1	€50,000	€13,186	€36,814	€95,044
2	€50,000	€9,504	€40,496	€54,548
3	€50,000	€5,452	€44,548	€10,000

The interest is calculated at 10% (the incremental borrowing rate) of the balance of the lease obligation for each period, and the remainder of the €50,000 payment is allocated to a reduction in the lease obligation. The lessee is also required to pay €1,000 for insurance on an annual basis. The entries necessary to record all payments relative to the lease for each of the three years are shown below.

	December 31, 20XX	December 31, 201X+1	December 31, 20XX+2
Insurance expense	1,000	1,000	1,000
Interest expense	13,186	9,504	5,452
Lease obligation	36,184	40,496	44,548
Cash	51,000	51,000	51,000

The leased equipment recorded as an asset must also be amortised (depreciated). The balance of this account is €131,858; however, as with any other asset, it cannot be depreciated below the estimated residual value of €1,000 (note that it is depreciated down to the actual estimated residual value, not the guaranteed residual value). In this case, the straight-line depreciation method is applied over a period of three years. This three-year period represents the lease term, not the life of the asset, because the asset reverts back to the lessor at the end of the lease term. Therefore, the following entry will be made at the end of each year:

Depreciation expense	€43,619
Accumulated depreciation		43,619 [(€131,858 − €1,000) ÷ 3]

Finally, on December 31, 20XX+2, we must recognise the fact that ownership of the property has reverted back to the owner (lessor). The lessee made a guarantee that the residual value would be €10,000 on December 31, 20XX+2; as a result, the lessee must make up the difference between the guaranteed residual value and the actual residual value with a cash payment to the lessor. The following entry illustrates the removal of the leased asset and obligation from the books of the lessee:

Lease obligation	€10,000
Accumulated depreciation	€130,858
Cash		€9,000
Leased equipment		€131,858

The foregoing example illustrated a situation where the asset was to be returned to the lessor. Another situation exists (where there is a bargain purchase option or automatic transfer of title) where the asset is expected to remain with the lessee. Recall that, under IAS 17, leased assets are amortised over their useful life when title transfers or a bargain purchase option exists. In such a circumstance, the lease liability may not be amortised completely as of the termination date of the lease. At the end of the lease, the balance of the lease obligation should equal the guaranteed residual value, the bargain purchase option price or a termination penalty.

Example of Accounting for a Finance Lease—Asset Ownership Transferred to Lessee and Fair Market Value of Leased Asset Lower than Present Value of Minimum Lease Payments

Assume the following:

A three-year lease is initiated on January 1, 20XX, for equipment with an expected useful life of five years.
Three annual lease payments of €52,000 are required beginning on January 1, 20XX (note that the payment at the beginning of the year changes the PV computation). The lessor pays €2,000 per year for insurance on the equipment.
The lessee can exercise a bargain purchase option on December 31, 20XX+2, for €10,000. The expected residual value at December 31, 20XX+4, is €1,000.
The lessee's incremental borrowing rate is 10% (implicit rate is unknown).
The fair market value of the property leased is €140,000.

Once again, the classification of the lease must take place prior to the accounting for it. This lease is classified as a finance lease because it contains a bargain purchase option (BPO). Note that in this case, the PV versus FMV test is also clearly fulfilled.

The PV of the lease obligation is computed as follows:

PV of bargain purchase option	=	€10,000	× 0.7513^*	=	€7,513
PV of annual payments	=	(€52,000 − €2,000)	× 2.7355^**	=	136,755
					€144,288
*The present value of an amount of €1 due in three periods at 10% is 0.7513.
**The present value of an annuity due of €1 for three periods at 10% is 2.7355.

Notice that in the example above, the present value of the lease obligation is greater than the fair value of the asset. Also notice that since the lessor pays €2,000 a year for insurance, this payment is treated as executory costs and hence excluded from calculation of the present value of annual payments. Since the PV is greater than the fair value, the lease obligation (as well as the leased asset) must be recorded at the fair value of the asset leased (being the lower of the two). The entry on January 1, 20XX, is as follows:

Leased equipment	€140,000
Obligation under finance lease		€140,000

According to IAS 17, the apportionment between interest and principal is to be such that interest recognised reflects the use of a constant periodic rate of interest applied to the remaining balance of the obligation. When the PV exceeds the fair value of the leased asset, a new, effective rate must be computed which will be applied to the liability. Note, however, that if an impairment were subsequently recognised on the asset as an expense in the period of the impairment, following the procedures set forth in IAS 36, this would not affect the recorded amount of the lease obligation (i.e., the liability) and thus would not alter the initially determined interest rate. In this example, the interest rate was determined to be 13.265%. The amortisation of the lease takes place as follows:

Year	Cash payment	Interest expense	Reduction in lease obligation	Balance of lease obligation
Inception of lease				€140,000
January 1, 20XX	€50,000	€–	€50,000	90,000
January 1, 20XX+1	50,000	11,939	38,061	51,939
January 1, 20XX+2	50,000	6,890	43,110	8,829
December 31, 20XX+2	10,000	1,171	8,829	–

The following entries are required in years 201X through 201X+2 to recognise the payment and depreciation (amortisation).

		20XX		20X+1		20XX+2
January 1	Operating expense	2,000		2,000		2,000
	Obligation under finance lease	50,000		38,061		43,110
	Accrued interest payable	11,939		6,890
	Cash		52,000		52,000		52,000
December 31	Interest expense	11,939		6,890		1,171
	Accrued interest payable		11,939		6,890
	Obligation under finance lease						1,171
December 31	Depreciation expense	27,800		27,800		27,800
	Accumulated depreciation (€139,000, five years)		27,800		27,800		27,800
December 31	Obligation under finance lease					10,000
	Cash						10,000

Impairment of leased asset

IAS 17 did not originally address the issue of how impairments of leased assets are to be assessed or, if determined to have occurred, how they would need to be accounted for. Subsequently, IAS 17 was revised to note that the provisions of IAS 36 should be applied to leased assets in the same manner as they would be applied to owned assets. Impairments to the leased asset (occurring after the inception of the lease) are recognised by charges to expense in the current reporting period. IAS 36 is discussed more fully in Chapter 9.

Accounting for Leases—Lessor

As illustrated above, there are two classifications of leases with which a lessor must be concerned:

Operating.
Finance.

Operating leases

As is the case for the lessee, 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. As with the lessee, 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 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.

Example of Straight Lining of Lease Income

SandStone PLC leases 2 buildings to Rockwood Limited. The details are as follows:

Lease 1:

3-year lease
Lease payment €100,000 p.a. escalating at inflation
Inflation for years 1–3 is 8%

Lease 2:

3-year lease
Lease payment €100,000 p.a. escalating at 8% p.a. to reflect inflation
Inflation for years 1–3 is −8%

Accounting for Lease 1:

Year 1
Bank	€100,000
Statement of Comprehensive Income – Lease Income		€100,000
Year 2
Bank	€108,000
Statement of Comprehensive Income – Lease Income		€108,000
Year 3
Bank	€116,640
Statement of Comprehensive Income – Lease Income		€116,640

Accounting for Lease 2:

As the escalation is a fixed percentage, and not a contingent amount as per Lease 1 (note that inflation is considered contingent), then the lease income must be straight lined. Note that the difference between the amount charged to the statement of comprehensive income and the amount received from the lessee should be recognised in the statement of financial provision as an asset.

Total lease payments over lease term:

Year 1		€100,000
Year 2		€108,000
Year 3		€116,640
Total		€324,640
Therefore the annual charge will be 324,640/3 =		€108,213
Year 1
Bank	€100,000
Operating Lease Provision (SoFP)	€8,213
Statement of Comprehensive Income – Lease Income		€108,213
Year 2
Bank	€108,000
Operating Lease Provision (SoFP)	€213
Statement of Comprehensive Income – Lease Income		€108,213
Year 3
Bank	€116,640
Operating Lease Provision (SoFP)		€8,426
Statement of Comprehensive Income – Lease Income		€108,214

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.

Sales-Type Leases

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

Gross investment.
Fair value of the leased asset.
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:

Lease receivable	xx
Cost of goods sold	xx
Sales		xx
Inventory		xx
Unearned finance income		xx

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 present value 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 present value is to be computed using the lease term and implicit interest rate (both of which were discussed earlier).

IAS 17 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”).

Recall that 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 present values of the MLP 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 present value of the unguaranteed residual value is equal to the present value of the MLP. (Note that this relationship is sometimes used while computing the MLP when the normal selling price and the residual value are known; this is illustrated in a case study that follows.)

Under IAS 17, 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 present value 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:

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.
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.

Example of Accounting for a Sales-Type Lease

XYZ Inc. is a manufacturer of specialised equipment. Many of its customers do not have the necessary funds or financing available for outright purchase. Because of this, XYZ offers a leasing alternative. The data relative to a typical lease are as follows:

The non-cancellable fixed portion of the lease term is five years. The lessor has the option to renew the lease for an additional three years at the same rental. The estimated useful life of the asset is 10 years. The lessee guarantees a residual value of €40,000 at the end of five years, but the guarantee lapses if the full three-year renewal period is exercised.
The lessor is to receive equal annual payments over the term of the lease. The leased property reverts back to the lessor on termination of the lease.
The lease is initiated on January 1, 20XX. Payments are due on December 31 for the duration of the lease term.
The cost of the equipment to XYZ Inc. is €100,000. The lessor incurs cost associated with the inception of the lease in the amount of €2,500.
The selling price of the equipment for an outright purchase is €150,000.
The equipment is expected to have a residual value of €15,000 at the end of five years and €10,000 at the end of eight years.
The lessor desires a return of 12% (the implicit rate).

The first step is to calculate the annual payment due to the lessor. Recall that the present value (PV) of the minimum lease payments is equal to the selling price adjusted for the present value of the residual amount. The present value is to be computed using the implicit interest rate and the lease term. In this case, the implicit rate is given as 12% and the lease term is eight years (which includes the fixed non-cancellable portion plus the renewal period, since the lessee guarantee terms make renewal virtually inevitable). Thus, the structure of the computation would be as follows:

Normal selling price − PV of residual value = PV of minimum lease payment

Or, in this case,

€150,000	−(0.40388^* × €10,000)	= 4.96764^** × Minimum lease payment
€145,961.20	÷ 4.96764	= Minimum lease payment
	€29,382.40	= Minimum lease payment
*0.40388 is the present value of an amount of €1 due in eight periods at a 12% interest rate.
**4.96764 is the present value of an annuity of €1 for eight periods at a 12% interest rate.

Prior to examining the accounting implications of a lease, we must determine the lease classification. In this example, the lease term is eight years (discussed above) while the estimated useful life of the asset is 10 years; thus, this lease qualifies as something other than an operating lease. Note that the lease also meets the FMV versus PV criterion because the PV of the minimum lease payments of €145,961.20, which is 97% of the FMV [€150,000], could be considered to be equal to substantially all of the fair value of the leased asset. Now it must be determined if this is a sales-type or direct financing lease. To do this, examine the FMV or selling price of the asset and compare it to the cost. Because the two are not equal, we can determine this to be a sales-type lease.

Next, obtain the figures necessary to record the entry on the books of the lessor. The gross investment is the total minimum lease payments plus the unguaranteed residual value, or

The cost of goods sold is the historical cost of the inventory (€100,000) plus any initial direct costs (€2,500) less the PV of the unguaranteed residual value (€10,000 × 0.40388). Thus, the cost of goods sold amount is €98,461.20 (€100,000 + €2,500 − €4,038.80). Note that the initial direct costs will require a credit entry to some account, usually accounts payable or cash. The inventory account is credited for the carrying value of the asset, in this case €100,000.

The adjusted selling price is equal to the PV of the minimum payments, or €145,961.20. Finally, the unearned finance income is equal to the gross investment (i.e., lease receivable) less the present value of the components making up the gross investment (the minimum lease payment of €29,382.40 and the unguaranteed residual of €10,000). The present value of these items is €150,000 [(€29,382.40 × 4.96764) + (€10,000 × 0.40388)]. Therefore, the entry necessary to record the lease is:

Lease receivable	€245,059.20
Cost of goods sold	€98,461.20
Inventory		€100,000.00
Sales		€145,961.20
Unearned finance income		€95,059.20
Accounts payable (initial direct costs)		€2,500.00

The next step in accounting for a sales-type lease is to determine proper handling of the payment. Both principal and interest are included in each payment. According to IAS 17, interest is recognised on a basis such that a constant periodic rate of return is earned over the term of the lease. This will require setting up an amortisation schedule as illustrated below.

Date or year ended	Cash payment	Interest	Reduction in principal	Balance of net investment
January 1, 20XX				€150,000.00
December 31, 20XX+1	€29,382.40	€18,000.00	€11,382.40	€138,617.00
December 31, 20XX+2	€29,382.40	€16,634.11	€12,748.29	€125,869.31
December 31, 20XX+3	€29,382.40	€15,104.32	€14,278.08	€111,591.23
December 31, 20XX+4	€29,382.40	€13,390.95	€15,991.45	€95,599.78
December 31, 20XX+5	€29,382.40	€11,471.97	€17,910.43	€77,689.35
December 31, 20XX+6	€29,382.40	€9,322.72	€20,059.68	€57,629.67
December 31, 20XX+7	€29,382.40	€6,915.56	€22,466.84	€35,162.83
December 31, 20XX+8	€29,382.40	€4,219.57	€25,162.83	€10,000.00
	€235,059.20	€95,059.20	€140,000.00

A few of the columns need to be elaborated on. First, the net investment is the gross investment (lease receivable) less the unearned finance income. Notice that at the end of the lease term, the net investment is equal to the estimated residual value. Also note that the total interest earned over the lease term is equal to the unearned interest (unearned finance income) at the beginning of the lease term.

The entries below illustrate the proper treatment to record the receipt of the lease payment and the amortisation of the unearned finance income in the year ended December 31, 20XX+1.

Cash	€29,382.40
Lease receivable		€29,382.40
Unearned finance income	18,000.00
Interest revenue		18,000.00

Notice that there is no explicit entry to recognise the principal reduction. This is done automatically when the net investment is reduced by decreasing the lease receivable (gross investment) by €29,382.40 and the unearned finance income account by only €18,000. The €18,000 is 12% (implicit rate) of the net investment. These entries are to be made over the life of the lease.

At the end of the lease term, December 31, 20XX+8, the asset is returned to the lessor and the following entry is required:

Asset	€10,000
Leased receivable		€10,000

If the estimated residual value has changed during the lease term, the accounting computations would have also changed to reflect this.

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:

Gross investment.
Cost.
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:

Lease receivable	xxx
Asset		xxx
Unearned finance income		xxx

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:

Initial direct costs	xxx
Cash		xxx

Under IAS 17, 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.

An example follows that illustrates the preceding principles.

Example of Accounting for a Direct Financing Lease

Emirates Refining needs new equipment to expand its manufacturing operation; however, it does not have sufficient capital to purchase the asset at this time. Because of this, Emirates Refining has employed Consolidated Leasing to purchase the asset. In turn, Emirates will lease the asset from Consolidated. The following information applies to the terms of the lease:

A three-year lease is initiated on January 1, 20XX, for equipment costing €131,858, with an expected useful life of five years. FMV at January 1, 20XX, of equipment is €131,858.
Three annual payments are due to the lessor beginning December 31, 20XX. The property reverts back to the lessor on termination of the lease.
The unguaranteed residual value at the end of year three is estimated to be €10,000.
The annual payments are calculated to give the lessor a 10% return (the implicit rate).
The lease payments and unguaranteed residual value have a PV equal to €131,858 (FMV of asset) at the stipulated discount rate.

The annual payment to the lessor is computed as follows:

PV of residual value	= €10,000 × .7513^* = €7,513
PV of lease payments	= Selling price − PV of residual value
	= €131,858 − €7,513 = €124,345
Annual payment	= €124,345 ÷ 2.4869^** = €50,000
* 7,513 is the PV of an amount due in three periods at 10%.
** 2.4869 is the PV of an ordinary annuity of €1 per period for three periods, at 10% interest.

Initial direct costs of €7,500 are incurred by ABC in the lease transaction.As with any lease transaction, the first step must be to classify the lease appropriately. In this case, the PV of the lease payments (€124,345) is equal to 94% of the FMV (€131,858), thus it could be considered as equal to substantially all of the FMV of the leased asset. Next, the unearned interest and the net investment in lease are to be determined.

Gross investment in lease [(3 × €50,000) + €10,000] €160,000

Cost of leased property €131,858

Unearned finance income €28,142

The unamortised initial direct costs are to be added to the gross investment in the lease, and the unearned finance income is to be deducted to arrive at the net investment in the lease. The net investment in the lease for this example is determined as follows:

Gross investment in lease	€160,000
Add:
Unamortised initial direct costs	€7,500
Less:
Unearned finance income	€28,142
Net investment in lease	€139,358

The net investment in the lease (Gross investment – Unearned finance income) has been increased by the amount of initial direct costs. Therefore, the implicit rate is no longer 10%, and the implicit rate must be recomputed, which is the result of performing an internal rate of return calculation. The lease payments are to be €50,000 per annum and a residual value of €10,000 is available at the end of the lease term. In return for these payments (inflows), the lessor is giving up equipment (an outflow) and incurring initial direct costs (also an outflow), with a net investment of €139,358 (€131,858 + €7,500). The way to obtain the new implicit rate is to employ a calculator or computer routine that does this iterative computation automatically.

Where: i = implicit rate of interest

In this case, the implicit rate is equal to 7.008%. Thus, the amortisation table would be set up as follows:

	(a) Lease payments	(b) Reduction in unearned interest	(c) PV × Implicit rate (7.008%)	(d) Reduction in initial direct costs (b–c)	(e) Reduction in PVI net investment (a–b + d)	(f) PVI net investment in lease (f)(n+1) = (f)n – (e)
At inception						€139,358
20XX	€50,000	€13,186 (1)	€9,766	€3,420	€40,234	€99,124
20XX+1	€50,000	€9,504 (2)	€6,947	€2,557	€43,053	€56,071
20XX+2	€50,000	€5,455 (3)	€3,929	€1,526	€46,071	€10,000
	€150,000	€28,145^*	€20,642	€7,503	€129,358
*Rounded

(b.1) €131,858 × 10% = €13,186
(b.2) [€131,858 − (€50,000 − 13,186)] × 10% = €9,504
(b.3) [€95,044 − (€50,000 − 9,504)] × 10% = €5,455

Here the interest is computed as 7.008% of the net investment. Note again that the net investment at the end of the lease term is equal to the estimated residual value.

The entry made initially to record the lease is as follows:

Lease receivable^** [(€50,000 × 3) + €10,000]	€160,000
Asset acquired for leasing		€131,858
Unearned lease revenue	€28,142

When the payment (or obligation to pay) of the initial direct costs occurs, the following entry must be made:

Initial direct costs	€7,500
Cash		€7,500

Using the schedule above, the following entries would be made during each of the indicated years:

	20XX		20XX+1 €		20XX+2
	€201X
Cash	50,000		50,000		50,000
Lease receivable^**		50,000		50,000		50,000
Unearned finance income	13,186		9,504		5,455
Initial direct costs		3,420		2,557		1,526
Interest income		9,766		6,947		3,929
^**Also commonly referred to as the “gross investment in lease.”

Finally, when the asset is returned to the lessor at the end of the lease term, it must be recorded on the books. The necessary entry is as follows:

Property, plant and equipment	€10,000
Lease receivable		€10,000

Leveraged leases

Leveraged leases are discussed in detail in Appendix B of this chapter because of the complexity involved in the accounting treatment based on guidance available under US GAAP, where this topic has been given extensive coverage. Under IFRS, this concept has been defined, but with only a very brief outline of the treatment to be accorded to this kind of lease. A leveraged lease is defined as a finance lease which is structured such that there are at least three parties involved: the lessee, the lessor and one or more long-term creditors who provide part of the acquisition finance for the leased asset, usually without any general recourse to the lessor. Succinctly, this type of a lease is given the following unique accounting treatment:

The lessor records his or her investment in the lease net of the non-recourse debt and the related finance costs to the third-party creditor(s).
The recognition of the finance income is based on the lessor's net cash investment outstanding in respect of the lease.

Sale-Leaseback Transactions

Sale-leaseback describes a transaction where the owner of property (the seller-lessee) sells the property and then immediately leases all or part of it back from the new owner (the buyer-lessor). These transactions may occur when the seller-lessee is experiencing cash flow or financing problems or because there are tax advantages in such an arrangement in the lessee's tax jurisdiction. The important consideration in this type of transaction is recognition of two separate and distinct economic transactions. However, it is important to note that there is not a physical transfer of property. First, there is a sale of property, and second, there is a lease agreement for the same property in which the original seller is the lessee and the original buyer is the lessor. This is illustrated as follows:

A sale-leaseback transaction is usually structured such that the sales price of the asset is greater than or equal to the current market value. The higher sales price has the concomitant effect of a higher periodic rental payment over the lease term than would otherwise have been negotiated. The transaction is usually attractive because of the tax benefits associated with it, and because it provides financing to the lessee. The seller-lessee benefits from the higher price because of the increased gain on the sale of the property and the deductibility of the lease payments, which are usually larger than the depreciation that was previously being taken. The buyer-lessor benefits from both the higher rental payments and the larger depreciable basis.

Under IAS 17, the accounting treatment depends on whether the leaseback results in a finance lease or an operating lease. If it results in a finance lease, any excess of sale proceeds over previous carrying value may not be recognised immediately as income in the financial statements of the seller-lessee. Rather, it is to be deferred and amortised over the lease term.

Accounting for a sale-leaseback that involves the creation of an operating lease depends on whether the sale portion of the compound transaction was on arm's-length terms. If the leaseback results in an operating lease, and it is evident that the transaction is established at fair value, then any profit or loss should be recognised immediately. On the other hand, if the sale price is not established at fair value, then:

If sale price is below fair value, any profit or loss should be recognised immediately, except that when a loss is to be compensated by below fair market future rentals, the loss should be deferred and amortised in proportion to the rental payments over the period the asset is expected to be used.
If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period for which the asset is expected to be used.

IAS 17 stipulates that, in case of operating leasebacks, if at the date of the sale and leaseback transaction the fair value is less than the carrying amount of the leased asset, the difference between the fair value and the carrying amount should immediately be recognised. In other words, impairment is recognised first, before the actual sale-leaseback transaction is given recognition. This logically follows from the fact that impairments are essentially catch-up depreciation charges, belated recognition that the consumption of the utility of the assets had not been correctly recognised in earlier periods.

However, in case the sale and leaseback result in a finance lease, no such adjustment is considered necessary unless there has been an impairment in value, in which case the carrying value should be reduced to the recoverable amount in accordance with the provisions of IAS 36.

The guidance under IFRS pertaining to sale-leaseback transactions is limited, and many variations in terms and conditions are found in actual practice. To provide further insight, albeit not with the suggestion that this constitutes IFRS, selected guidance found under US GAAP is offered in Appendix A to this chapter.

Other Leasing Guidance

SIC 27 addresses arrangements between an enterprise and an investor that involve the legal form of a lease. SIC 27 establishes that the accounting for such arrangements is in all instances to reflect the substance of the relationship. All aspects of the arrangement are to be evaluated to determine its substance, with particular emphasis on those that have an economic effect. To assist in doing this, SIC 27 identifies certain indicators that may demonstrate that an arrangement might not involve a lease under IAS 17. For example, a series of linked transactions that in substance do not transfer control over the asset, and which keep the right to receive the benefits of ownership with the transferor, would not be a lease. Also, transactions arranged for specific objectives, such as the transfer of tax attributes, would generally not be accounted for as leases.

SIC 27 deals most specifically with those arrangements that have characteristics of leases coupled with corollary subleases, whereby the lessor is the sublessee and the lessee is the sub-lessor, which may also involve a purchase option. The financing party (the lessee-sublessor) is often guaranteed a certain economic return on such transactions, further revealing that the substance might in fact be that of a secured borrowing rather than a series of lease arrangements. Since nominal lease and sublease payments will net to zero, the exchange of funds is often limited to the fee given by the property owner to the party providing financing; tax advantages are often the principal objective of these transactions. Accounting questions arising from the transactions include recognition of fees received by the financing party; the presentation of separate investment and sublease payment obligation accounts as an asset and a liability, respectively; and the accounting for resulting obligations.

SIC 27 imposes a substance over form solution to this problem. Accordingly, when an arrangement is found not to meet the definition of a lease, a separate investment account and a lease payment obligation would not meet the definitions of an asset and a liability, and should not be recognised by the entity. It presents certain indicators which imply that a given arrangement is not a lease (e.g., when the right to use the property for a given term is not in fact transferred to the nominal lessee) and that lease accounting cannot be applied.

The interpretation provides that the fee paid to the financing provider should be recognised in accordance with IAS 18. Fees received in advance would generally be deferred and recognised over the lease term when future performance is required in order to retain the fee, when limitations are placed on the use of the underlying asset or when the non-remote likelihood of early termination would necessitate some fee repayment.

Finally, SIC 27 identifies certain factors that would suggest that other obligations of an arrangement, including any guarantees provided and obligations incurred upon early termination, should be accounted for under either IAS 37 (contingent liabilities) or IAS 39 (financial obligations), depending on the terms.

IFRIC 4 describes arrangements, comprising transactions or series of related transactions, that do not take the legal form of a lease, but which convey rights to use assets in return for series of payments. Examples of such arrangements include:

Outsourcing arrangements (e.g., the outsourcing of the data processing functions of an entity).
Various arrangements in the telecommunications industry, in which suppliers of network capacity enter into contracts to provide other entities 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 (these are often styled as capacity contracts, giving one party exclusive rights to the counterparty's output).

IFRIC 4 provides guidance for determining whether such arrangements are, or contain, leases that should be accounted for in accordance with IAS 17. It does not address how such arrangements, if determined to be leases, should be classified. In some of these arrangements, the underlying asset that is the subject of the lease is a portion of a larger asset. IFRIC 4 does not address how to ascertain if the portion of a larger asset is itself the underlying asset for the purposes of applying IAS 17. However, arrangements in which the underlying asset would represent a unit of account under either IAS 16 or IAS 38 are within the scope of this interpretation. Leases which would be excluded from IAS 17 (as noted earlier in this chapter) are not subject to the provisions of IFRIC 4.

Determining whether an arrangement is, or contains, a lease is required to be based on the substance of the arrangement. It requires an assessment of whether:

Fulfilment of the arrangement is dependent on the use of a specific asset or assets; and
The arrangement conveys a right to use the asset.

An arrangement is not the subject of a lease if its fulfilment is not dependent on the use of the specified asset. Thus, if terms call for delivery of a specified quantity of goods or services, and the entity has the right and ability to provide those goods or services using other assets not specified in the arrangement, it is not subject to this interpretation. On the other hand, a warranty obligation that permits or requires the substitution of the same or similar assets when the specified asset is not operating properly, or a contractual provision (whether or not contingent) permitting or requiring the supplier to substitute other assets for any reason on or after a specified date, do not preclude lease treatment before the date of substitution.

IFRIC 4 states that 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 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 (putatively, the lessee) the right to control the use of the underlying asset. This occurs if:

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 value of the asset;
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; or
Facts and circumstances suggest that it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output of the asset, or other value 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.

According to IFRIC 4, the assessment of whether an arrangement contains a lease is to be made at the inception of the arrangement. This is defined as the earlier of the date of the arrangement or the date the parties commit to the principal terms of the arrangement, on the basis of all of the facts and circumstances. Once determined, a reassessment is permitted only if:

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, unless the term of the renewal or extension had initially been included in the lease term in accordance with 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 is to be evaluated only with respect to the renewal or extension period);
There is a change in the determination of whether fulfilment is dependent on a specified asset; or
There is a substantial change to the asset (e.g., a substantial physical change to property, plant or equipment).

Any reassessment of an arrangement is to be based on the facts and circumstances as of the date of reassessment, including the remaining term of the arrangement. Changes in estimate (e.g., as to the expected output to be delivered) may not be used to trigger a reassessment. If the reassessment concludes that the arrangement contains (or does not contain) a lease, lease accounting is to be applied (or cease to be applied) from when the change in circumstances giving rise to the reassessment occurs (if other than exercise of a renewal or extension), or the inception of the renewal or extension period.

If an arrangement is determined to contain a lease, both parties are to apply the requirements of IAS 17 to the lease element of the arrangement. Accordingly, the lease must be classified as a finance lease or an operating lease. Other elements of the arrangement, not within the scope of that standard, are to be accounted for as required by the relevant IFRS. For the purpose of applying IAS 17, payments and other consideration required must be separated, at inception or upon a reassessment of the arrangement, into that being made for the lease and that applicable to the other elements, on the basis of relative fair values. Minimum lease payments (per IAS 17) include only payments for the lease itself.

In some instances it will be necessary to make assumptions and estimates in order to separate the payments for the lease from payments for the other elements. IFRIC 4 suggests that a purchaser might estimate the lease payment portion by reference to a lease for a comparable asset that contains no other elements, or might estimate the payments for the other elements by reference to comparable agreements, deriving the payments for the other component by deduction. However, if a purchaser concludes that it is impracticable to separate the payments reliably, the procedure to be followed depends on whether the lease is operating or finance in nature.

If a finance lease, the purchaser/lessee is to recognise an asset and a liability at an amount equal to the fair value of the underlying asset that was identified as being the subject of the lease. As payments are later made, the liability will be reduced and an imputed finance charge on the liability will be recognised using the purchaser's incremental borrowing rate of interest (as described earlier in this chapter).

If an operating lease, the purchaser/lessee is to treat all payments as lease payments for the purposes of complying with the disclosure requirements of IAS 17, but (1) disclose those payments separately from minimum lease payments of other arrangements that do not include payments for non-lease elements, and (2) state that the disclosed payments also include payments for non-lease elements in the arrangement.

Disclosure Requirements Under IAS 17

Lessee Disclosures

Finance Leases
IAS 17 mandates the following disclosures for lessees under finance leases, in addition to disclosures required under IFRS 7 for all financial instruments:
1. For each class of asset, the net carrying amount at the end of the reporting period (the date of the statement of financial position).
2. A reconciliation between the total of minimum lease payments at the end of the reporting period, and their present value. In addition, an enterprise should disclose the total of the minimum lease payments at the end of the reporting period, their present value, for each of the following periods:
  1. Due in one year or less.
  2. Due in more than one but no more than five years.
  3. Due in more than five years.
3. Contingent rents included in profit or loss for the period.
4. The total of minimum sublease payments to be received in the future under non-cancellable subleases at the end of the reporting period.
5. A general description of the lessee's significant leasing arrangements including, but not necessarily limited to the following:
  1. The basis for determining contingent rentals.
  2. The existence and terms of renewal or purchase options and escalation clauses.
  3. Restrictions imposed by lease arrangements such as on dividends or assumptions of further debt or further leasing.
Operating Leases
IAS 17 sets forth in greater detail the disclosure requirements that will be applicable to lessees under operating leases.

Lessees should, in addition to the requirements of IFRS 7, make the following disclosures for operating leases:
1. Total of the future minimum lease payments under non-cancellable operating leases for each of the following periods:
  1. Due in one year or less.
  2. Due in more than one year but no more than five years.
  3. Due in more than five years.
2. The total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period.
3. Lease and sublease payments included in profit or loss for the period, with separate amounts of minimum lease payments, contingent rents and sublease payments.
4. A general description of the lessee's significant leasing arrangements including, but not necessarily limited to, the following:
  1. The basis for determining contingent rentals.
  2. The existence and terms of renewal or purchase options escalation clauses.
  3. Restrictions imposed by lease arrangements such as on dividends or assumption of further debt or on further leasing.

Lessor Disclosures

Finance Leases
IAS 17 requires enhanced disclosures compared to the original standard. Lessors under finance leases are required to disclose, in addition to disclosures under IFRS 7, the following:
1. A reconciliation between the total gross investment in the lease at the end of the reporting period and the present value of minimum lease payments receivable at the end of the reporting period, categorised into:
  1. Those due in one year or less.
  2. Those due in more than one year but not more than five years.
  3. Those due beyond five years.
2. Unearned finance income.
3. The unguaranteed residual values accruing to the benefit of the lessor.
4. The accumulated allowance for uncollectible minimum lease payments receivable.
5. Total contingent rentals included in income.
6. A general description of the lessor's significant leasing arrangements.
Operating Leases
For lessors under operating leases, IAS 17 has prescribed the following expanded disclosures:
1. The future minimum lease payments under non-cancellable operating leases, in the aggregate and classified into:
  1. Those due in no more than one year.
  2. Those due in more than one but not more than five years.
  3. Those due in more than five years.
2. Total contingent rentals included in profit or loss for the period.
3. A general description of leasing arrangements to which it is a party.
In addition to the above, the disclosure requirements relating to the assets recognised by the lessor or lessee required in the respective standards governing the accounting for those assets should be given. These include IAS 16, IAS 38, IAS 40 and IAS 41. These disclosure requirements are detailed in the respective chapters looking at each of these sections.

Examples of Financial Statement Disclosures

Exemplum Reporting PLC Financial Statements For the Year Ended 31 December 20XX
2. Accounting policies
2.13 Leases
Leases are classified as finance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership to the lessee. All other leases are classified as operating leases.	IAS17 p33
2.13.1 As Lessor
Operating leases	IAS17 p20
Rental income from operating leases is recognised on a straight-line basis over the term of the relevant lease. Any balloon payments and rent-free periods are taken into account when determining the straight-line charge.
2.13.2 As lessee	IAS17 p27
Finance leases
Assets held under finance leases are recognised as assets of the Group at the fair value at the inception of the lease or if lower at the present value of the minimum lease payments. The related liability to the lessor is included in the statement of financial position as a finance lease obligation.
Lease payments are apportioned between interest expenses and capital redemption of the liability. Interest is recognised immediately in profit or loss, unless attributable to qualifying assets, in which case it is capitalised to the cost of those assets.
Contingent rentals are recognised as expenses in the periods in which they are incurred.
Operating leases
Operating lease payments are recognised as an expense on a straight-line basis over the lease term, except if another systematic basis is more representative of the time pattern in which economic benefits will flow to the Group.
Contingent rentals arising under operating leases are recognised in the period in which they are incurred.
Lease incentives and similar arrangements of incentives are taken into account when calculating the straight-line expense.
3.2 Critical judgements in applying the group's accounting policies
Retail stores refurbishment The group has recognised a provision for store refurbishment in the statement of financial position as at 31 December 20XX. As management were considered to be fully committed to the expenditure and the group has obligations in terms of its lease agreements to affect the refurbishments, they believe that the appropriate accounting treatment is to make a provision in the statement of financial position as at 31 December 20XX.	IAS1 p122
Operating lease commitments The group has entered into property leases over a number of retail stores. As management have determined that the group has not obtained substantially all the risks and rewards of ownership of these properties, the leases have been classified as operating leases and accounted for accordingly.	IAS1 p122

6. Disclosure of expenses
	20XX	20XX-1
The following amounts were expensed or credited during the year:
Operating lease expense	X	X	IAS17 p35(c)

15. Property, Plant and Equipment
…..….. (continued)
Plant and machinery includes the following amounts where the group is a lessee under a finance lease:	IAS 17 p31(a)

	20XX	20XX-1
Cost − capitalised finance leases	X	X
Accumulated depreciation	X	X
Net book value	X	X

24. Notes to the statement of cash flows
24.1 Significant non-cash transactions
During the period the group acquired property, plant and equipment with a total cost of £X of which £Y was acquired by means of finance leases.	IAS7 p43

27. Finance lease liabilities
	20XX	20XX-1
Gross finance lease liabilities − minimum lease payments:			IAS17 p31(b)
Within 1 year	X	X
Later than 1 year and no later than 5 years	X	X
Later than 5 years	X	X
	X	X
Future finance charges on finance leases	X	X
Present value of finance lease liabilities	X	X
The present value of finance lease liabilities is analysed as follows:			IAS17 p31(b)
Within 1 year	X	X
Later than 1 year and no later than 5 years	X	X
Later than 5 years	X	X
	X	X
Lease liabilities are secured over property, plant and equipment as disclosed in note 15. These assets will revert back to the lessor in the event of a default.The company leases certain items of property, plant and equipment under lease agreements with a 5-year term. These bear interest at between 2% and 4.5% and are repayable in equal monthly instalments.			IAS17 p31(e)

33. Operating lease commitments
As a lessee: It is group policy to rent certain items of office equipment and premises under operating lease agreements. The lease terms of these agreements vary between 3 and 10 years. No contingent rent is payable.
	20XX	20XX-1	IAS17 p35
As a lessee:
Future minimum lease payments under non-cancellable operating leases:
Within one year	X	X
From one to five years	X	X
After five years	X	X
	X	X
The group does not sublease any of its leased premises.
Lease payments recognised in profit for the period amounted to £X (20XX-1: £X).
As a lessor:
The company leases its Investment Property to various third parties under operating lease agreements. The average lease term was 10 years, with annual escalation set at 2%.
	20XX	20XX-1	IAS17 p56
Future minimum lease receipts under non-cancellable operating leases:
Within one year	X	X
From one to five years	X	X
After five years	X	X
	X	X
No contingent rentals were recognised in income.

Future Developments

IFRS 16, Leases, was issued in January 2016 with a mandatory effective date for all periods beginning on or after 1 January 2019. IFRS 16 creates new principles to identify a lease based on control. The new standard replaces the following existing standards:

IAS 17, Leases
IFRIC 4, Determining whether an Arrangement contains a Lease
SIC 15, Operating Leases—Incentives
SIC 27, Evaluating the Substance of Transactions Involving the Legal Form of a Lease

IFRS 16 introduces a single lessee accounting model and requires a lessee to recognise assets and liabilities for all leases with a lease term of more than 12 months, unless the underlying value of the leased asset is of low and short-term leases. The distinction between operating and finance is therefore removed. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments.

After initial recognition a lessee measures right-of-use assets similarly to other non-financial assets (such as property, plant and equipment) and lease liabilities similarly to other financial liabilities. As a consequence, a lessee recognises depreciation of the right-of-use asset over the shorter of its useful life and lease term and interest on the lease liability, and also classifies cash repayments of the lease liability into a principal portion and an interest portion and presents them in the statement of cash flows as such.

This standard contains expanded disclosure requirements for lessees. However, lessees will need to apply judgement in deciding upon the information to disclose to meet the objective of providing a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of the lessee.

IFRS 16 carries forward the lessor accounting requirements in IAS 17. Accordingly, a lessor continues to classify its leases as operating leases or finance leases, and to account for those two types of leases differently. It also requires enhanced disclosures to be provided by lessors that will improve information disclosed about a lessor's risk exposure, particularly to residual value risk.

US GAAP Comparison

US GAAP accounting and criteria for leases is very similar. See Appendix A attached to this chapter for specific US interpretations. However, US GAAP uses quantitative criteria to classify a lease as either operating or capital. IFRS is based on the substance of the transaction to assess whether a substantial amount of the value or useful life of the asset is conveyed to the lessee.

Third-party guarantees are not included in the minimum lease payments (nor measurement of the obligation and asset). Leases of land and buildings are accounted for together unless land is greater than 25% of the property value.

US GAAP does not contain the direct guidance about identifying an embedded derivative in the lease if the lessee has a stake in the market value of the asset.

IFRS 16 “Leases” was issued in January 2016 with a mandatory effective date of 1 January 2019. A corresponding new Topic 824 “Leases” was added to ASC in February 2016, which is effective for fiscal years beginning after 15 December 2018.

Although IFRS 16 and Topic 824 was a joint project of IASB and FASB, and many requirements of the two standards are the same, a number of differences remain. The main differences are relating to the lessee accounting since Topic 842 continues to distinguish between finance leases and operating leases, but IFRS 16 requires lessees to account for all leases similarly, except for short-term or low-value leases. Consequently, lessees will account for many leases differently if they are classified as operating leases under Topic 842. While many current differences between IFRS and US GAAP may no longer be relevant when the two new standards become effective in 2019, new differences will follow.

Appendix A: Special Situations Not Addressed by IAS 17 but which have been Interpreted Under US GAAP

In the following section, a number of interesting and common problem areas that have not yet been addressed by IFRS are briefly considered. The guidance found in US GAAP is referenced, as this is likely to represent the most comprehensive source of insight into these matters. However, it should be understood that this constitutes only possible approaches to selected fact situations and is not authoritative guidance. Some of these matters may be more fully addressed by IFRS if the proposed amendments to IAS 17 are brought to fruition.

Sale-Leaseback Transactions

The accounting treatment from the seller-lessee's perspective will depend on the degree of rights to use retained by the seller-lessee. The degree of rights to use retained may be categorised as follows:

Substantially all.
Minor.
More than minor but less than substantially all.

The guideline for the determination “substantially all” is based on the classification criteria presented for the lease transaction. For example, a test based on the 90% recovery criterion seems appropriate. That is, if the present value of fair rental payments is equal to 90% or more of the fair value of the sold asset, the seller-lessee is presumed to have retained substantially all the rights to use the sold property. The test for retaining minor rights would be to substitute 10% or less for 90% or more in the preceding sentence.

If substantially all the rights to use the property are retained by the seller-lessee and the agreement meets at least one of the criteria for capital lease treatment, the seller-lessee should account for the leaseback as a capital lease, and any profit on the sale should be deferred and either amortised over the life of the property or treated as a reduction of depreciation expense. If the leaseback is classified as an operating lease, it should be accounted for as one, and any profit or loss on the sale should be deferred and amortised over the lease term. Any loss on the sale would also be deferred unless the loss were perceived to be a real economic loss, in which case the loss would be recognised immediately and not deferred.

If only a minor portion of the rights to use are retained by the seller-lessee, the sale and the leaseback should be accounted for separately. However, if the rental payments appear unreasonable based on the existing market conditions at the inception of the lease, the profit or loss should be adjusted so that the rentals are at a reasonable amount. The amount created by the adjustment should be deferred and amortised over the life of the property if a capital lease is involved or over the lease term if an operating lease is involved.

If the seller-lessee retains more than a minor portion but less than substantially all the rights to use the property, any excess profit on the sale should be recognised on the date of the sale. For purposes of this paragraph, excess profit is derived as follows:

If the leaseback is classified as an operating lease, the excess profit is the profit that exceeds the present value of the minimum lease payments over the lease term. The seller-lessee should use its incremental borrowing rate to compute the present value of the minimum lease payments. If the implicit rate of interest in the lease is known, it should be used to compute the present value of the minimum lease payments.
If the leaseback is classified as a capital (i.e., finance) lease, the excess profit is the amount greater than the recorded amount of the leased asset.

When the fair value of the property at the time of the leaseback is less than its undepreciated cost, the seller-lessee should immediately recognise a loss for the difference. In the example below, the sales price is less than the book value of the property. However, there is no economic loss because the FMV is greater than the book value.

Figure depicting sales price ($85000), artificial loss ($5,000), book value ($90,000), and FMV and PVz ($100,000).

The artificial loss must be deferred and amortised as an addition to depreciation. The following diagram summarises the accounting for sale-leaseback transactions.

Figure summarises the accounting for sale-leaseback transactions.

In the foregoing circumstances, when the leased asset is land only, any amortisation should be on a straight-line basis over the lease term, regardless of whether the lease is classified as a capital or an operating lease.

Executory costs are not to be included in the calculation of profit to be deferred in a sale-leaseback transaction. The buyer-lessor should account for the transaction as a purchase and a direct financing lease if the agreement meets the criteria of either a direct financing lease or a sales-type lease. Otherwise, the agreement should be accounted for as a purchase and an operating lease.

Sale-Leaseback Involving Real Estate

Under US GAAP, three requirements are necessary for a sale-leaseback involving real estate (including real estate with equipment) to qualify for sale-leaseback accounting treatment. Those sale-leaseback transactions not meeting the three requirements should be accounted for as a deposit or as a financing. The three requirements are:

The lease must be a normal leaseback.
Payment terms and provisions must adequately demonstrate the buyer-lessor's initial and continuing investment in the property.
Payment terms and provisions must transfer all the risks and rewards of ownership as demonstrated by a lack of continuing involvement by the seller-lessee.

A normal leaseback involves active use of the leased property in the seller-lessee's trade or business during the lease term.

The buyer-lessor's initial investment is adequate if it demonstrates the buyer-lessor's commitment to pay for the property and indicates a reasonable likelihood that the seller-lessee will collect any receivable related to the leased property. The buyer-lessor's continuing investment is adequate if the buyer is contractually obligated to pay an annual amount at least equal to the level of annual payment needed to pay that debt and interest over no more than (1) 20 years for land, and (2) the customary term of a first mortgage loan for other real estate.

Any continuing involvement by the seller-lessee other than normal leaseback disqualifies the lease from sale-leaseback accounting treatment. Some examples of continuing involvement other than normal leaseback include:

The seller-lessee has an obligation or option (excluding the right of first refusal) to repurchase the property.
The seller-lessee (or party related to the seller-lessee) guarantees the buyer-lessor's investment or debt related to that investment or a return on that investment.
The seller-lessee is required to reimburse the buyer-lessor for a decline in the fair value of the property below estimated residual value at the end of the lease term based on other than excess wear and tear.
The seller-lessee remains liable for an existing debt related to the property.
The seller-lessee's rental payments are contingent on some predetermined level of future operations of the buyer-lessor.
The seller-lessee provides collateral on behalf of the buyer-lessor other than the property directly involved in the sale-leaseback.
The seller-lessee provides non-recourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is the leased asset.
The seller-lessee enters into a sale-leaseback involving property improvements or integral equipment without leasing the underlying land to the buyer-lessor.
The buyer-lessor is obligated to share any portion of the appreciation of the property with the seller-lessee.
Any other provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or appreciation of the leased property.

Example of Accounting for a Sale-Leaseback Transaction

To illustrate the accounting treatment in a sale-leaseback transaction, suppose that Lessee Corporation sells equipment that has a book value of €80,000 and a fair value of €100,000 to Lessor Corporation, and then immediately leases it back under the following conditions:

The sale date is January 1, 20XX, and the equipment has a fair value of €100,000 on that date and an estimated useful life of 15 years.
The lease term is 15 years, non-cancellable, and requires equal rental payments of €13,109 at the beginning of each year.
Lessee Corp. has the option annually to renew the lease at the same rental payments on expiration of the original lease.
Lessee Corp. has the obligation to pay all executory costs.
The annual rental payments provide the lessor with a 12% return on investment.
The incremental borrowing rate of Lessee Corp. is 12%.
Lessee Corp. depreciates similar equipment on a straight-line basis.

Lessee Corp. should classify the agreement as a capital lease since the lease term exceeds 75% (which is deemed to be a major part) of the estimated economic life of the equipment, and because the present value of the lease payments is greater than 90% (deemed to be substantially all) of the fair value of the equipment. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist concerning the amount of non-reimbursable costs yet to be incurred by the lessor, Lessor Corp. should classify the transaction as a direct financing lease because the present value of the minimum lease payments is equal to the fair market value of €100,000 (€13,109 × 7.62817).

Lessee Corp. and Lessor Corp. would normally make the following journal entries during the first year:

Upon Sale of Equipment on January 1, 20XX
	Lessee Corp.		Lessor Corp.
Cash	€100,000		Equipment	€100,000
Equipment^*		€80,000		Cash	€100,000
Unearned profit on sale-leaseback		20,000
Leased equipment	100,000		Lease receivable
Lease obligations		100,000	(€13,109 × 15)	196,635
			Equipment		100,000
			Unearned interest		96,635
*Assumes new equipment.

To Record First Payment on January 1, 20XX
	Lessee Corp.		Lessor Corp.
Lease obligations	€13,109			€13,109
Cash		€13,109	Lease receivable		€13,109

To Record Incurrence and Payment of Executory Costs
	Lessee Corp.		Lessor Corp.
Insurance, taxes, etc.	xxx		(No entry)
Cash (accounts payable)		xxx
To Record Depreciation Expense on the Equipment, December 31, 20XX
	Lessee Corp.		Lessor Corp.
Depreciation expense	€6,667		(No entry)
Accum. depr.— capital leases (€100,000 ÷ 15)		€6,667
To Amortise Profit on Sale-Leaseback by Lessee Corp., December 31, 20XX
	Lessee Corp.		Lessor Corp.
Unearned profit onsale-leaseback	€1,333		(No entry)
Depr. expense (€20,000 ÷ 15)		€1,333

To Record Interest for December 31, 20XX
	Lessee Corp.			Lessor Corp.
Interest expense	€10,427		Unearned interest income	€10,427
Accrued interest payable		€10,427	Interest income		€10,427

Partial Lease Amortisation Schedule
Date	Cash payment	Interest expense	Reduction of obligation	Lease obligation
Inception of lease			€100,000
January 1, 20XX	€13,109	€–	€13,109	€86,891
January 1, 20XX+1	€13,109	€10,427	€2,682	€84,209

Leases Involving Real Estate—Guidance Under US GAAP

While required practice regarding lease accounting is rather clearly set forth under IAS 17, as is typical under IFRS this is presented in rather general terms. US GAAP, by contrast, offers a great deal of very specific guidance on this topic. It is instructive to at least consider the US GAAP rules for lease accounting, which may provide some further insight and, in some circumstances, offer operational guidance to those attempting to apply IAS 17 to particular fact situations. Under US GAAP (which consists of many discrete standards and a large volume of interpretive literature), leases involving real estate are categorised into four groups:

Leases involving land only.
Leases involving land and building(s).
Leases involving real estate and equipment.
Leases involving only part of a building.

Leases Involving Land Only

Lessee accounting. If the lease agreement meets the criteria for transfers of ownership or contains a bargain purchase option, the lessee should account for the lease as a capital lease and record an asset and related liability in an amount equal to the present value of the minimum lease payments after deducting executor costs. If the lease agreement does not transfer ownership or contain a bargain purchase option, the lessee should account for the lease as an operating lease.

Lessor accounting. If the lease gives rise to dealer's profit (or loss) and transfers ownership (i.e., title), the standards require that the lease shall be classified as a sales-type lease and accounted for under the provisions of the US standard dealing with sales of real estate, in the same manner as would a seller of the same property. If the lease transfers ownership, both the collectibility and the no material uncertainties criteria are met, but if it does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing or leveraged lease, as appropriate. If the lease contains a bargain purchase option and both the collectibility and no material uncertainties criteria are met, the lease should be accounted for as a direct financing, leveraged or operating lease as appropriate. If the lease does not meet the collectibility and/or no material uncertainties criteria, the lease should be accounted for as an operating lease.

Leases Involving Land and Building

Lessee accounting. Under US GAAP, if the agreement meets the transfer of ownership criteria or contains a bargain purchase option, the lessee should account for the agreement by separating the land and building components and capitalise each separately. The land and building elements should be allocated on the basis of their relative fair market values measured at the inception of the lease. The land and building components are accounted for separately because the lessee is expected to own the real estate by the end of the lease term. The building should be depreciated over its estimated useful life without regard to the lease term.

When the lease agreement neither transfers title nor contains a bargain purchase option, the fair value of the land must be determined in relation to the fair value of the aggregate properties included in the lease agreement. If the fair value of the land is less than 25% of the fair value of the leased properties in aggregate, the land is considered immaterial. Conversely, if the fair value of the land is 25% or greater of the fair value of the leased properties in aggregate, the land is considered material.

When the land component of the lease agreement is considered immaterial (FMV land < 25% total FMV), the lease should be accounted for as a single lease unit. The lessee should capitalise the lease if one of the following occurs:

The term of the lease is 75% or more of the economic useful life of the real estate.
The present value of the minimum lease payments equals 90% or more of the fair market value of the leased real estate less any lessor tax credits.

If neither of the two criteria above is met, the lessee should account for the lease agreement as a single operating lease.

When the land component of the lease agreement is considered material (FMV land < 25% total FMV), the land and building components should be separated. By applying the lessee's incremental borrowing rate to the fair market value of the land, the annual minimum lease payment attributed to land is computed. The remaining payments are attributed to the building. The division of minimum lease payments between land and building is essential for both the lessee and lessor. The lease involving the land should always be accounted for as an operating lease. Under US GAAP, the lease involving the building(s) must meet either the 75% (of useful life) or 90% (of fair value) test to be treated as a capital lease. If neither of the two criteria is met, the building(s) will also be accounted for as an operating lease.

Lessor accounting. The lessor's accounting depends on whether the lease transfers ownership, contains a bargain purchase option or does neither of the two. If the lease transfers ownership and gives rise to dealer's profit (or loss), US GAAP requires that the lessor classify the lease as a sales-type lease and account for the lease as a single unit under the provisions of FAS 66 in the same manner as a seller of the same property. If the lease transfers ownership, meets both the collectibility and no important uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing or leveraged lease as appropriate.

If the lease contains a bargain purchase option and gives rise to dealer's profit (or loss), the lease should be classified as an operating lease. If the lease contains a bargain purchase option, meets both the collectibility and no material uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing lease or a leveraged lease, as appropriate.

If the lease agreement neither transfers ownership nor contains a bargain purchase option, the lessor should follow the same rules as the lessee in accounting for real estate leases involving land and building(s).

However, the collectibility and the no material uncertainties criteria must be met before the lessor can account for the agreement as a direct financing lease, and in no such case may the lease be classified as a sales-type lease (i.e., ownership must be transferred).

The treatment of a lease involving both land and building can be illustrated in the following examples.

Example of Accounting for Land and Building Lease Containing Transfer of Title

Assume the following:

The lessee enters into a 10-year non-cancellable lease for a parcel of land and a building for use in its operations. The building has an estimated useful life of 12 years.
The FMV of the land is €75,000, while the FMV of the building is €310,000.
A payment of €50,000 is due to the lessor at the beginning of each of the 10 years of the lease.
The lessee's incremental borrowing rate is 10%. (Lessor's implicit rate is unknown.)
Ownership will transfer to the lessee at the end of the lease.

The present value of the minimum lease payments is €337,951 (€50,000 × 6.75902*). The portion of the present value of the minimum lease payments that should be capitalised for each of the two components of the lease is computed as follows:

FMV of land	€75,000
FMV of building	€310,000
Total FMV of leased property	€385,000
Portion of PV allocated to land
Portion of PV allocated to building
Total PV to be capitalised	€337,951

The entry made to record the lease initially is as follows:

Leased land	€65,835
Leased building	€272,116
Lease obligation		€337,951
*6.75902 is the PV of an annuity due for 10 periods at 10%.

Subsequently, the obligation will be decreased in accordance with the effective interest method. The leased building will be amortised over its expected useful life.

Example of Accounting for Land and Building Lease without Transfer of Title or Bargain Purchase Option

Assume the same facts as in the previous example except that title does not transfer at the end of the lease.

The lease is still a capital lease because the lease term is more than 75% of the useful life. Since the FMV of the land is less than 25% of the leased properties in aggregate (€75,000/€385,000 = 19%), the land component is considered immaterial and the lease will be accounted for as a single lease. The entry to record the lease is as follows:

Leased property	€337,951
Lease obligation		€337,951

Assume the same facts as in the previous example except that the FMV of the land is €110,000 and the FMV of the building is €275,000. Once again, title does not transfer.

Because the FMV of the land exceeds 25% of the leased properties in aggregate (€110,000/€385,000 = 28%), the land component is considered material and the lease would be separated into two components. The annual minimum lease payment attributed to the land is computed as follows:

The remaining portion of the annual payment is attributed to the building.

Annual payment	€50,000
Less amount attributed to land	(16,275)
Annual payment attributed to building	€33,725

The present value of the minimum annual lease payments attributed to the building is then computed as follows:

Minimum annual lease payment attributed to building		€33,725
PV factor		× 6.75902^*
PV of minimum annual lease payments attributed to building		€ 227,948
The entry to record the capital portion of the lease is as follows:
Leased building	€227,948
Lease obligation		€227,948
*6.75902 is the PV of an annuity due for 10 periods at 10%.

There would be no computation of the present value of the minimum annual lease payment attributed to the land since the land component of the lease will be treated as an operating lease. For this reason, each year, €16,275 of the €50,000 lease payment will be recorded as land rental expense. The remainder of the annual payment (€33,725) will be applied against the lease obligation using the effective interest method.

Leases Involving Real Estate and Equipment

When real estate leases also involve equipment or machinery, the equipment component should be separated and accounted for as a separate lease agreement by both lessees and lessors. According to US GAAP, “the portion of the minimum lease payments applicable to the equipment element of the lease shall be estimated by whatever means are appropriate in the circumstances.” The lessee and lessor should apply the capitalisation requirements to the equipment lease independently of accounting for the real estate lease(s). The real estate leases should be handled as discussed in the preceding two sections. In a sale-leaseback transaction involving real estate with equipment, the equipment and land are not separated.

Treatment of selected items in accounting for leases under US GAAP
	Operating	Lessor direct financing and sales-type	Operating	Lessee capital
Initial direct costs	Capitalise and amortise over lease term in proportion to rent revenue recognised (normally SL basis)	Direct financing:Record in separate accountAdd to net investment in leaseCompute new effective rate that equates gross amt. of min. lease payments and unguar. residual value with net invest.	N/A	N/A
		Amortise so as to produce constant rate of return over lease term
		Sales-type:
		Expense in period incurred
Investment tax credit retained by lessor	N/A	Reduces FMV of leased asset for 90% test	N/A	Reduces FMV of leased asset for 90% test
Bargain purchase option	N/A	Include in: Minimum lease payments 90% test	N/A	Include in: Minimum lease payments 90% test
Guaranteed residual value	N/A	Include in: Minimum lease payments 90% test	N/A	Include in: Minimum lease payments 90% test
Sales-type: Include PV in sales revenues
Unguaranteed residual value	N/A	Include in: “Gross Investment in Lease”	N/A	Include in: Minimum lease payments 90% test
		Not included in: 90% test
		Sales-type:Exclude from sales revenueDeduct PV from cost of sales
Contingent rentals	Revenue in period earned	Not part of minimum lease payments; revenue in period earned	Expense in period incurred	Not part of minimum lease payments; expense in period incurred
Amortisation period	Amortise down to estimated residual value over estimated economic life of asset	N/A	N/A	Amortise down to estimated residual value over lease term or estimated economic life^c
Revenue (expense)^a	Rent revenue (normally SL basis)	Direct financing:Interest revenue on net investment in lease (gross investment less unearned interest income)	Rent expense (normally SL basis)^b	Interest expense and depreciation expense
	Amortisation (depreciation expense)	Sales-type:Dealer profit in period of sale (sales revenue less cost of leased asset)Interest revenue on net investment in lease
aElements of revenue (expense) listed for the items above are not repeated here (e.g., treatment of initial direct costs).
bIf payments are not on an SL basis, recognise rent expense on an SL basis unless another systematic and rational method is more representative of use benefit obtained from the property, in which case the other method should be used.
cIf lease has automatic passage of title or bargain purchase option, use estimated economic life; otherwise, use the lease term.

Leases Involving Only Part of a Building

It is common to find lease agreements that involve only part of a building, as, for example, when a floor of an office building is leased or when a store in a shopping mall is leased. A difficulty that arises in this situation is that the cost and/or fair market value of the leased portion of the whole may not be determinable objectively.

For the lessee, if the fair value of the leased property is objectively determinable, the lessee should follow the rules and account for the lease as described in “leases involving land and building.” If the fair value of the leased property cannot be determined objectively but the agreement satisfies the 75% test, the estimated economic life of the building in which the leased premises are located should be used. If this test is not met, the lessee should account for the agreement as an operating lease.

From the lessor's position, both the cost and fair value of the leased property must be objectively determinable before the procedures described under “leases involving land and building” will apply. If either the cost or the fair value cannot be determined objectively, the lessor should account for the agreement as an operating lease.

Termination of a Lease

The lessor shall remove the remaining net investment from his or her books and record the leased equipment as an asset at the lower of its original cost, present fair value or current carrying value. The net adjustment is reflected in income of the current period.

The lessee is also affected by the terminated agreement because he or she has been relieved of the obligation. If the lease is a capital lease, the lessee should remove both the obligation and the asset from his or her accounts and charge any adjustment to the current period income. If accounted for as an operating lease, no accounting adjustment is required.

Renewal or Extension of an Existing Lease

The renewal or extension of an existing lease agreement affects the accounting of both the lessee and the lessor. US GAAP specifies two basic situations in this regard: (1) the renewal occurs and makes a residual guarantee or penalty provision inoperative, or (2) the renewal agreement does not do the foregoing and the renewal is to be treated as a new agreement. The accounting treatment prescribed under the latter situation for a lessee is as follows:

If the renewal or extension is classified as a capital lease, the (present) current balances of the asset and related obligation should be adjusted by an amount equal to the difference between the present value of the future minimum lease payments under the revised agreement and the (present) current balance of the obligation. The present value of the minimum lease payments under the revised agreement should be computed using the interest rate that was in effect at the inception of the original lease.
If the renewal or extension is classified as an operating lease, the current balances in the asset and liability accounts are removed from the books and a gain (loss) recognised for the difference. The new lease agreement resulting from a renewal or extension is accounted for in the same manner as other operating leases.

Under the same circumstances, US GAAP prescribes the following treatment to be followed by the lessor:

If the renewal or extension is classified as a direct financing lease, then the existing balances of the lease receivable and the estimated residual value accounts should be adjusted for the changes resulting from the revised agreement.
The net adjustment should be charged or credited to an unearned income account.
If the renewal or extension is classified as an operating lease, the remaining net investment under the existing sales-type lease or direct financing lease is removed from the books and the leased asset recorded as an asset at the lower of its original cost, present fair value or current carrying amount. The difference between the net investment and the amount recorded for the leased asset is charged to profit or loss of the period. The renewal or extension is then accounted for as for any other operating lease.
If the renewal or extension is classified as a sales-type lease and it occurs at or near the end of the existing lease term, the renewal or extension should be accounted for as a sales-type lease.

If the renewal or extension causes the guarantee or penalty provision to be inoperative, the lessee adjusts the current balance of the leased asset and the lease obligation to the present value of the future minimum lease payments (according to the relevant standard, “by an amount equal to the difference between the PV of future minimum lease payments under the revised agreement and the present balance of the obligation”). The PV of the future minimum lease payments is computed using the implicit rate used in the original lease agreement.

Given the same circumstances, the lessor adjusts the existing balance of the lease receivable and estimated residual value accounts to reflect the changes of the revised agreement (remember, no upward adjustments to the residual value). The net adjustment is charged (or credited) to unearned income.

Leases between Related Parties

Leases between related parties are classified and accounted for as though the parties are unrelated, except in cases where it is clear that the terms and conditions of the agreement have been influenced significantly by the fact of the relationship. When this is the case, the classification and/or accounting is modified to reflect the true economic substance of the transaction rather than the legal form.

If a subsidiary's principal business activity is leasing property to its parent or other affiliated companies, consolidated financial statements are presented. The US GAAP standard on related parties requires that the nature and extent of leasing activities between related parties be disclosed.

Accounting for Leases in a Business Combination

A business combination, in and of itself, has no effect on the classification of a lease. However, if, in connection with a business combination, the lease agreement is modified to change the original classification of the lease, it should be considered a new agreement and reclassified according to the revised provisions.

In most cases, a business combination that is accounted for by the pooling-of-interest method or by the purchase method will not affect the previous classification of a lease unless the provisions have been modified as indicated in the preceding paragraph.

The acquiring company should apply the following procedures to account for a leveraged lease in a business combination accounted for by the purchase method:

The classification of leveraged lease should be kept.
The net investment in the leveraged lease should be given a fair market value (present value, net of tax) based on the remaining future cash flows. Also, the estimated tax effects of the cash flows should be given recognition.
The net investment should be broken down into three components: net rentals receivable, estimated residual value and unearned income.
Thereafter, the leveraged lease should be accounted for as described above in the section on leveraged leases.

Sale or Assignment to Third Parties—Non-Recourse Financing

The sale or assignment of a lease or of property subject to a lease that was originally accounted for as a sales-type lease or a direct financing lease will not affect the original accounting treatment of the lease. Any profit or loss on the sale or assignment should be recognised at the time of transaction except under the following two circumstances:

When the sale or assignment is between related parties, apply the provisions presented above under “Leases between Related Parties.”
When the sale or assignment is with recourse, it should be accounted for using the provisions of the US GAAP standard on sale of receivables with recourse.

The sale of property subject to an operating lease should not be treated as a sale if the seller (or any related party to the seller) retains substantial risks of ownership in the leased property. A seller may retain substantial risks of ownership by various arrangements. For example, if the lessee defaults on the lease agreement or if the lease terminates, the seller may arrange to do one of the following:

Acquire the property or the lease.
Substitute an existing lease.
Secure a replacement lessee or a buyer for the property under a remarketing agreement.

A seller will not retain substantial risks of ownership by arrangements where one of the following occurs:

A remarketing agreement includes a reasonable fee to be paid to the seller.
The seller is not required to give priority to the releasing or disposition of the property owned by the third party over similar property owned by the seller.

When the sale of property subject to an operating lease is not accounted for as a sale because the substantial risk factor is present, it should be accounted for as a borrowing. The proceeds from the sale should be recorded as an obligation on the seller's books. Rental payments made by the lessee under the operating lease should be recorded as revenue by the seller even if the payments are paid to the third-party purchaser. The seller shall account for each rental payment by allocating a portion to interest expense (to be imputed in accordance with the provisions of APB 21), and the remainder will reduce the existing obligation. Other normal accounting procedures for operating leases should be applied except that the depreciation term for the leased asset is limited to the amortisation period of the obligation.

The sale or assignment of lease payments under an operating lease by the lessor should be accounted for as a borrowing as described above.

Non-recourse financing is a common occurrence in the leasing industry whereby the stream of lease payments on a lease is discounted on a non-recourse basis at a financial institution with the lease payments collateralising the debt. The proceeds are then used to finance future leasing transactions. Even though the discounting is on a non-recourse basis, US GAAP prohibits the offsetting of the debt against the related lease receivable unless a legal right of offset exists or the lease qualified as a leveraged lease at its inception.

Money-Over-Money Lease Transactions

In cases where a lessor obtains non-recourse financing in excess of the leased asset's cost, a technical bulletin states that the borrowing and leasing are separate transactions and should not be offset against each other unless a right of offset exists. Only dealer profit in sales-type leases may be recognised at the beginning of the lease term.

Acquisition of Interest in Residual Value

Recently, there has been an increase in the acquisition of interests in residual values of leased assets by companies whose primary business is other than leasing or financing. This generally occurs through the outright purchase of the right to own the leased asset or the right to receive the proceeds from the sale of a leased asset at the end of its lease term.

In instances such as these, the rights should be recorded by the purchaser at the fair value of the assets surrendered. Recognition of increases in the value of the interest in the residual (i.e., residual value accretion) to the end of the lease term is prohibited. However, a non-temporary write-down of the residual value interest should be recognised as a loss. This guidance also applies to lessors who sell the related minimum lease payments but retain the interest in the residual value. Guaranteed residual values also have no effect on this guidance.

Accounting for a Sublease

A sublease is used to describe the situation where the original lessee re-leases the leased property to a third party (the sublessee), and the original lessee acts as a sublessor. Normally, the nature of a sublease agreement does not affect the original lease agreement, and the original lessee/sublessor retains primary liability.

The original lease remains in effect, and the original lessor continues to account for the lease as before. The original lessee/sublessor accounts for the lease as follows:

If the original lease agreement transfers ownership or contains a bargain purchase option and if the new lease meets any one of the four criteria specified in US GAAP (i.e., transfers ownership, BPO, the 75% test or the 90% test) and both the collectibility and uncertainties criteria, the sublessor should classify the new lease as a sales-type or direct financing lease; otherwise, as an operating lease. In either situation, the original lessee/sublessor should continue accounting for the original lease obligation as before.
If the original lease agreement does not transfer ownership or contain a bargain purchase option, but it still qualified as a capital lease, the original lessee/sublessor should (with one exception) apply the usual criteria set by US GAAP in classifying the new agreement as a capital or operating lease. If the new lease qualifies for capital treatment, the original lessee/sublessor should account for it as a direct financing lease, with the unamortised balance of the asset under the original lease being treated as the cost of the leased property. The one exception arises when the circumstances surrounding the sublease suggest that the sublease agreement was an important part of a predetermined plan in which the original lessee played only an intermediate role between the original lessor and the sublessee. In this situation, the sublease should be classified by the 75% and 90% criteria as well as collectibility and uncertainties criteria. In applying the 90% criterion, the fair value for the leased property will be the fair value to the original lessor at the inception of the original lease. Under all circumstances, the original lessee should continue accounting for the original lease obligation as before. If the new lease agreement (sublease) does not meet the capitalisation requirements imposed for subleases, the new lease should be accounted for as an operating lease.
If the original lease is an operating lease, the original lessee/sublessor should account for the new lease as an operating lease and account for the original operating lease as before.

Appendix B: Leveraged Leases Under US GAAP

One of the most complex accounting subjects regarding leases is the accounting for a leveraged lease. Once again, as with both sales-type and direct financing, the classification of the lease by the lessor has no effect on the accounting treatment accorded the lease by the lessee. The lessee simply treats it as any other lease and thus is interested only in whether the lease qualifies as an operating or a capital lease. The lessor's accounting problem is substantially more complex than that of the lessee.

Leveraged leases are not directly addressed under IFRS. However, such three-party leasing transactions may be encountered occasionally. This guidance under US GAAP is therefore offered to fill a void in IFRS literature.

To qualify as a leveraged lease, a lease agreement must meet the following requirements, and the lessor must account for the investment tax credit (when in effect) in the manner described below.

The lease must meet the definition of a direct financing lease. (The 90% of FMV criterion does not apply.)¹ A direct financing lease must have its cost or carrying value equal to the fair value of the asset at the inception of the lease. Thus, even if the amounts are not significantly different, leveraged lease accounting should not be used.
The lease must involve at least three parties:
1. An owner-lessor (equity participant).
2. A lessee.
3. A long-term creditor (debt participant).
The financing provided by the creditor is non-recourse as to the general credit of the lessor and is sufficient to provide the lessor with substantial leverage.
The lessor's net investment (defined below) decreases in the early years and increases in the later years until it is eliminated.

The last characteristic (item 4) poses the accounting problem.The leveraged lease arose as a result of an effort to maximise the tax benefits associated with a lease transaction. To accomplish this, it was necessary to involve a third party to the lease transaction (in addition to the lessor and lessee), a long-term creditor. The following diagram illustrates the existing relationships in a leveraged lease agreement:

The leveraged lease arrangement^*

^* Adapted from “A Straightforward Approach to Leveraged Leasing” by Pierce R. Smith, The Journal of Commercial Bank Lending, July 1973, pp. 40–47.

The owner-lessor secures long-term financing from the creditor, generally in excess of 50% of the purchase price. US GAAP indicates that the lessor must be provided with sufficient leverage in the transaction; thus the 50%.
The owner then uses this financing along with his or her own funds to purchase the asset from the manufacturer.
The manufacturer delivers the asset to the lessee.
The lessee remits the periodic rent to the lessor.
The debt is guaranteed by either using the equipment as collateral, the assignment of the lease payments, or both, depending on the demands established by the creditor.

The FASB concluded that the entire lease agreement be accounted for as a single transaction and not a direct financing lease plus a debt transaction. The feeling was that the latter did not readily convey the net investment in the lease to the user of the financial statements. Thus, the lessor is to record the investment as a net amount. The gross investment is calculated as a combination of the following amounts:

The rentals receivable from the lessee, net of the principal and interest payments due to the long-term creditor.
A receivable for the amount of the investment tax credit (ITC) to be realised on the transaction (repealed in the United States but may yet exist in other jurisdictions).
The estimated residual value of the leased asset.
The unearned and deferred income, consisting of:
1. The estimated pre-tax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income.
2. The ITC remaining to be allocated to profit or loss over the remaining term of the lease.

The first three amounts described above are readily obtainable; however, the last amount, the unearned and deferred income, requires additional computations. To derive this amount, it is necessary to create a cash flow (income) analysis by year for the entire lease term. As described in item 4 above, the unearned and deferred income consists of the pre-tax lease income (Gross lease rentals – Depreciation – Loan interest) and the unamortised investment tax credit. The total of these two amounts for all the periods in the lease term represents the unearned and deferred income at the inception of the lease.

The amount computed as the gross investment in the lease (foregoing paragraphs) less the deferred taxes relative to the difference between pre-tax lease income and taxable lease income is the net investment for purposes of computing profit or loss for the period. To compute the periodic profit or loss, another schedule must be completed that uses the cash flows derived in the first schedule and allocates them between income and a reduction in the net investment.

The amount of profit or loss is first determined by applying a rate to the net investment. The rate to be used is the rate that will allocate the entire amount of cash flow (income) when applied in the years in which the net investment is positive. In other words, the rate is derived in much the same way as the implicit rate (trial and error), except that only the years in which there is a positive net investment are considered. Thus, income is recognised only in the years in which there is a positive net investment.

The profit or loss recognised is divided among the following three elements:

Pre-tax accounting income.
Amortisation of investment tax credit.
The tax effect of the pre-tax accounting income.

The first two are allocated in proportionate amounts from the unearned and deferred income included in calculation of the net investment. In other words, the unearned and deferred income consists of pre-tax lease accounting income and any investment tax credit. Each of these is recognised during the period in the proportion that the current period's allocated income is to the total income (cash flow). The last item, the tax effect, is recognised in the tax expense for the year. The tax effect of any difference between pre-tax lease accounting income and taxable lease income is charged (or credited) to deferred taxes.

When tax rates change, all components of a leveraged lease must be recalculated from the inception of the lease, using the revised after-tax cash flows arising from the revised tax rates.

If, in any case, the projected cash receipts (income) are less than the initial investment, the deficiency is to be recognised as a loss at the inception of the lease. Similarly, if at any time during the lease period the aforementioned method of recognising income would result in a future period loss, the loss shall be recognised immediately.

This situation may arise as a result of the circumstances surrounding the lease changing. Therefore, any estimated residual value and other important assumptions must be reviewed on a periodic basis (at least annually). Any change is to be incorporated into the income computations; however, there is to be no upward revision of the estimated residual value.

The following example illustrates the application of these principles to a leveraged lease.

Example of Simplified Leveraged Lease

Assume the following:

A lessor acquires an asset for €100,000 with an estimated useful life of three years in exchange for a €25,000 down payment and a €75,000 three-year note with equal payments due on December 31 each year. The interest rate is 18%.
The asset has no residual value.
The PV of an ordinary annuity of €1 for three years at 18% is 2.17427.
The asset is leased for three years with annual payments due to the lessor on December 31 in the amount of €45,000.
The lessor uses the ACRS method of depreciation for tax purposes and elects to reduce the ITC rate to 4%, as opposed to reducing the depreciable basis.
Assume a constant tax rate throughout the life of the lease of 40%.

Chart 1 analyses the cash flows generated by the leveraged leasing activities. Chart 2 allocates the cash flows between the investment in leveraged leased assets and income from leveraged leasing activities. The allocation requires finding that rate of return which, when applied to the investment balance at the beginning of each year that the investment amount is positive, will allocate the net cash flow fully to net income over the term of the lease. This rate can be found only by a computer program or by an iterative trial-and-error process. The example that follows has a positive investment value in each of the three years, and thus the allocation takes place in each time period. Leveraged leases usually have periods where the investment account turns negative and is below zero.

Allocating principal and interest on the loan payments is as follows:

€75,000 ÷ 2.17427 = €34,494
Year	Payment	Interest 18%	Principal	Balance
Inception of lease	€ –	€ –	€ –	€75,000
1	€34,494	€13,500	€20,994	€54,006
2	€34,494	€9,721	€24,773	€29,233
3	€34,494	€5,261	€29,233	–

Chart 1
	A	B	C	D	E	F	G	H	I
	Rent	Depr.	Interest on loan	Taxable income (A−B−C)	Income tax payable (rcvbl.) Dx40%	Loan principal payments	ITC	Cash flow (A+G−C−E−F)	Cumulative cash flow
Initial	€ –	€ –	€ –	€ –	€ –	€ –	€ –	€(25,000)	€(25,000)
Year 1	45,000	25,000	13,500	6,500	2,600	0,994	4,000	11,906	(13,094)
Year 2	45,000	38,000	9,721	(2,721)	(1,088)	24,773	–	11,594	(1,500)
Year 3	45,000	37,000	5,261	2,739	1,096	29,233	–	9,410	7,910
Total	€135,000	€100,000	€28,482	€6,518	€2,608	€75,000	€4,000	€7,910

The chart below allocates the cash flows determined above between the net investment in the lease and income. Recall that the income is then allocated between pre-tax accounting income and the amortisation of the investment for credit. The income tax expense for the period is a result of applying the tax rate to the current periodic pre-tax accounting income.

The amount to be allocated in total in each period is the net cash flow determined in column H above. The investment at the beginning of year 1 is the initial down payment of €25,000. This investment is then reduced on an annual basis by the amount of the cash flow not allocated to income.

Chart 2
	1	2	3	4	5	6	7
	Flow Cash flow Assumption				Income Analysis
	Investment beginning of year	Cash flow	Allocated to investment	Allocated to income	Pre-tax income	Income tax expense	Investment tax credit
Year 1	€25,000	€11,906	€7,964	€3,942	€3,248	€1,300	€1,994
Year 2	€17,036	€11,594	€8,908	€2,686	€2,213	€885	€1,358
Year 3	€8,128	€9,410	€8,128	€1,282	€1,057	€423	€648
		€32,910	€25,000	€7,910	€6,518	€2,608	€4,000
Rate of return = 15.77%

Column 2 is the net cash flow after the initial investment, and Columns 3 and 4 are the allocation based on the 15.77% rate of return. The total of Column 4 is the same as the total of Column H in Chart 1.
Column 5 allocates Column D in Chart 1 based on the allocations in Column 4. Column 6 allocates Column E in Chart 1, and Column 7 allocates Column G in Chart 1 in the same basis.

The journal entries below illustrate the proper recording and accounting for the leveraged lease transaction. The initial entry represents the cash down payment, investment tax credit receivable, the unearned and deferred revenue and the net cash to be received over the term of the lease.

The remaining journal entries recognise the annual transactions that include the net receipt of cash and the amortisation of income.

	Year 1	Year 2	Year 3
Rents receivable [Chart 1 (A−C−F)]	€31,518
Investment tax credit receivable	4,000
Cash		€25,000
Unearned and deferred income		10,518
[Initial investment, Chart 2 (5+7) totals]

	Year 1 €		Year 2 €	Year 3 €
Cash	10,506		10,506		10,506
Rent receivable		10,506		10,506		10,506
[Net for all cash transactions, Chart 1 (A−C−F) line by line for each year]
Income tax receivable (cash)	4,000
Investment tax credit receivable		4,000
Unearned and deferred income	5,242		3,571		1,705
Income from leveraged leases		5,242		3,571		1,705

[Amortisation of unearned income, Chart 2 (5+7) line by line for each year]

The following schedules illustrate the computation of deferred income tax amount. The annual amount is a result of the temporary difference created due to the difference in the timing of the recognition of income for book and tax purposes. The income for tax purposes can be found in Column D in Chart 1, while the income for book purposes is found in Column 5 of Chart 2. The actual amount of deferred tax is the difference between the tax computed with the temporary difference and the tax computed without the temporary difference. These amounts are represented by the income tax payable or receivable as shown in Column E of Chart 1 and the income tax expense as shown in Column 6 of Chart 2. A check of this figure is provided by multiplying the difference between book and tax income by the annual rate.

	Year 1	€	€
Income tax payable		2,600
Income tax expense		(1,300)
Deferred income tax (Dr)			1,300
Taxable income		6,500
Pre-tax accounting income		(3,248)
Difference			3,252
€3,252 × 40% = €1,300
	Year 2
Income tax receivable		1,088
Income tax expense		885
Deferred income tax (Cr)			1,973
Taxable loss		2,721
Pre-tax accounting income		2,213
Difference			4,934
€4,934 × 40% = €1,973
	Year 3
Income tax payable		1,096
Income tax expense		(423)
Deferred income tax (Dr)			673
Taxable income		2,739
Pre-tax accounting income		(1,057)
Difference			1,682
€1,682 × 40% = €673

Note

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Sources of IFRS
IAS 17, 24, 36	SIC 15, 27	IFRIC 4

Table of Contents for Chapter 22: Leases

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Introduction

Definitions of Terms

Minimum Lease Payments (MLP)

Classification of Leases

Classification of Leases—Lessee

Leases Involving Land and Buildings

Classification of Leases—Lessor

Different Types of Finance Leases

Recognition and Measurement

Accounting for Leases—Lessee

Operating Leases

Impairment of leased asset

Accounting for Leases—Lessor

Operating leases

Finance Leases

Sales-Type Leases

Direct Financing Leases

Leveraged leases

Sale-Leaseback Transactions

Other Leasing Guidance

Disclosure Requirements Under IAS 17

Lessee Disclosures

Lessor Disclosures

Examples of Financial Statement Disclosures

Future Developments

US GAAP Comparison

Appendix A: Special Situations Not Addressed by IAS 17 but which have been Interpreted Under US GAAP

Sale-Leaseback Transactions

Sale-Leaseback Involving Real Estate

Leases Involving Real Estate—Guidance Under US GAAP

Leases Involving Land Only

Leases Involving Land and Building

Leases Involving Real Estate and Equipment

Leases Involving Only Part of a Building

Termination of a Lease

Renewal or Extension of an Existing Lease

Leases between Related Parties

Accounting for Leases in a Business Combination

Sale or Assignment to Third Parties—Non-Recourse Financing

Money-Over-Money Lease Transactions

Acquisition of Interest in Residual Value

Accounting for a Sublease

Appendix B: Leveraged Leases Under US GAAP

Note

Table of Contents for
Chapter 22: Leases