Financial Accounting

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Leases (IAS 17) Chapter 11

SCOPEIAS 17 shall be applied in accounting for all leases other than:

(a) Leases to explore for or use minerals, oils, natural gas and similar non-generativeresources;

(b) Licensing agreements for such items as motion picture films, video recordings, plays,manuscripts, patents and copyrights (because they are under scope of IAS 38).

IAS 17 shall NOT be applied as the basis for measurement for leases discussed underIAS 40 (relating to Investment property) and IAS 41 (related to biological assets).

IAS 17 does NOT apply to contract of services that do not transfer the right to use assetsfrom one contracting party to the other (e.g. toll manufacturing).

DEFINITIONSA lease is an agreement whereby the lessor conveys to the lessee in return for a paymentor series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental toownership of an asset. Title may or may not be eventually transferred & an operating leaseis a lease other than finance lease.

A non-cancelable lease is a lease that is cancelable only:Ø Upon the occurrence of some remote contingency;Ø With the permission of lessor;Ø If the lessee enters into a new lease for the same or an equivalent asset with the

same lessor; orØ Upon payment by the lessee of such an additional amount that, at inception of the

lease, continuation of the lease is reasonably certain.

The inception of the lease is the earlier of the date of the lease agreement and the date ofcommitment by the parties to the principal provision of the lease. As at this date:Ø A lease is classified as either an operating or finance lease; andØ In the case of finance lease the amounts to be recognised at the commencement of

the lease term are determined.

The commencement of the lease term is the date from which the lessee is entitled toexercise its right to use the leased asset. It is the date of initial recognition of the lease (i.e.the recognition of the assets, liabilities, income or expenses resulting from the lease asappropriate.)

If lease agreement contains some provision to adjust lease payments for change in cost of asset tolessor or general price level change which takes place between inception of lease andcommencement of lease term, the same shall be deemed to have taken place at inception of lease.

The lease term is the non-cancelable period for which the lessee has contracted to leasethe asset together with any further terms of which the lessee has the option to continue tolease the asset, with or without further payment, when at the inception of the lease it isreasonably certain that the lease will exercise the option.

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Economic life is either:Ø The period over which an asset is expected to be economically usable by one or

more users; orØ The number of production or similar units expected to be obtained from the asset by

one or more users.

Useful life is the estimated remaining period, from the commencement of the lease term,without by the limitation of the lease term, over which the economic benefits embodied in theasset are expected to be consumed by the entity.

Minimum lease payments (MLP) are payments over the lease term that the lessee is orcan be required to make, excluding contingent rent, cost for services and taxes to be paid byand reimbursed to the lessor together with GRV.

If there is bargain purchase option (BPO), the value of BPO is added rather than guaranteedresidual value.

MLP = Down payment + Lease Rentals excluding contingent rent etc. + GRV or BPO

Guaranteed residual value (GRV) is:Ø For a lessee, that part of the residual value that is guaranteed by the lessee or a

party related to the lessee (the amount of the guarantee being the maximum amountthat could, in any event become payable); and

Ø For a lessor, that part of the residual value that is guaranteed by the lessee or by athird party unrelated the lessor that is financially capable of discharging theobligations under the guarantee.

Un-guaranteed residual value (UGRV) is that portion of the residual value of the leasedasset, the realization of which by the lessor is not assured or is guaranteed solely by a partyrelated to the lessor.

Initial direct costs are incremental costs that are directly attributable to negotiating andarranging a lease, except for such costs incurred by manufacturer or dealer lessors.

Gross investment in the lease (GI)GI = MLP for lessor + UGRV

Net investment in the lease (NI)NI = GI X appropriate discount factor using interest rate implicit in the lease

NI = PV of GINI = GI - UFI

Unearned finance income (UFI)UFI = GI - NI

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The Interest rate implicit in the lease is the discount rate that, at the inception of thelease, causes:

PV of GI = FV of leased asset + initial direct cost

The lessee’s incremental borrowing rate of interest is the rate of interest the lesseewould have to pay on a similar lease or, if that is not determinable, the rate that, at theinception of the lease, the lessee would incur to borrow over a similar term, and with asimilar security, the funds necessary to purchase the asset.

Contingent rent is that portion of the lease payments that is not fixed in amount but abased on the future amount of a factor that change other than with the passage of time.(E.g. percentage of future sales, amount of future use, future price indices, future marketrate of interest)

CLASSIFICATION OF LEASESWhether lease is a finance lease or an operating lease depends on the substance of thetransaction rather than form of the contract. The main factor is risk and rewards.

Examples of situations that individually or in combination would normally lead to a leasebeing classified as a finance lease are (not conclusive factors – risk and rewards are):Ø Transfer of ownership to lessee at the end of lease term;Ø The BPO or Bargain renewal option at the end of lease term;Ø The lease term in 75% (generally) or more of asset’s economic life;Ø PV of MLP is 90% (generally) or more of FV of asset;Ø The leased asset is of such specialized nature that only lessee can use it without

major modification;Ø Lessor’s losses associated with the cancellation of lease are borne by the lessee; orØ Gain or losses from the fluctuation in FV accrue to the lessee.

Lease classification is made at the inception of the lease.

It is possible that lessor classifies lease as finance lease while the same lease be classified by lesseeas operating lease. For example, lessor benefits from GRV provided by party unrelated to lessee.

CHANGE IN CLASSIFICATIONIf at any time the lessee and the lessor agree to change the provisions of the lease, otherthan by renewing the lease, in a manner that would have resulted in a different classificationof the lease, if the changed terms had been in effect at the inception of the lease, therevised agreement is regarded as a new agreement over its term.

However, changes in estimates (for example, changes in estimates of the economic life or ofthe residual value of the leased property), or changes in circumstances (for example defaultby the lessee), do not give rise to a new classification of a lease of accounting purposes.

LEASE OF LAND AND BUILDINGThe land and building elements of a lease of land and building are considered separately fora purpose of lease classification. If title to both elements is expected to pass to the lesseeby the end of the lease term, both elements are classified as a finance leases. When theland has indefinite economic life, the land element is normally classified as an operating

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lease unless title is expected to pass to the lessee by the end of the lease term. The buildingelement is classified as a finance or operating lease, as the case may be.

Whenever necessary in order to classify and account for a lease of land and buildings, theMLP are allocated between the land and the buildings elements in proportion to the relativefair value of the leasehold interest. If the MLP cannot be allocated reliably between thesetwo elements, the entire lease is classified as a finance lease, unless it is clear that bothelements are operating lease, in which case the entire lease is classified as an operatinglease.

ACCOUNTING FOR LEASES BY LESSEEFINANCE LEASE

The entry Time of recognition By the amountDr. Asset under FL Cr. Liability under FL At inception of lease

Lower of PV of MLPand FV

Dr. Asset under FL Cr. Bank/Payable

When initial direct costsare incurred Initial direct costs

Dr. P&L Cr. Asset under FL / Acc. Dep.

At year end As per depreciationpolicy

Dr. Interest expense Cr. Interest payable At year end

The interest accruedduring the year

Dr. Interest payableDr. Liability under FL Cr. Bank

At the time rental is paidInterestPrincipal amountTotal rental

Dr. Contingent rent Cr. Bank / payable

The period in which theyare incurred

As calculated underagreement

Discount rate used for calculating PV is interest rate implicit in the lease, and if this is notpracticable to determine, the lessee’s incremental borrowing rate shall be used.However, if incremental borrowing rate gives PV of MLP higher than FV of asset, we must determineimplicit interest rate.

It is not appropriate for the liabilities for leased assets to be presented in the financialstatements as a deduction from the leased assets. If for the presentation of liabilities on theface of the balance sheet, a distinction is made between current and non-current liabilities,the same distinction is made for lease liabilities.

If there is no reasonable certainty that the lessee will obtain ownership by the end of thelease term, the asset shall be fully depreciated over the shorter of the lease term and itsuseful life.

OPERATING LEASESLease payments under an operating lease shall be recognized as an expense on a straight-line basis over the lease term unless another systematic basis is more representative ofthe pattern of the user’s benefits.

Dr. Lease Expense Cr. Bank/accrual

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ACCOUNTING FOR LEASES BY LESSORFINANCE LEASE

The entry Time of recognition By the amountDr. GI Cr. UFI Cr. Asset Cr. Bank/Payables

At inception of lease

MLP + UGRVUFIFVInitial direct costs*

Dr. UFI Cr. Finance income

At year end The interest accruedduring the year

Dr. Bank Cr. GI

At the time rental isreceived Total rental

Lessors shall recognize assets held under finance lease in their balance sheets and presentthem as a receivable at an amount equal to the NI (GI – UFI).

Initial direct costs are often incurred by lessors and include amounts such as commissions,legal fee and internal costs that are incremental and directly attributable to negotiating andarranging a lease. They exclude general overheads such as those incurred by sales andmarketing team. Initial direct costs are added in GI only when it is not manufacturer or dealerlease.

MANUFACTURER OR DEALER LEASEManufacturer and dealer lessors shall recognise selling profit or loss in the period, inaccordance with the policy followed by the entity for outright sales, if artificially low rates ofinterest are quoted, selling profit shall be restricted to that which would apply if a market rateof interest were charged. Costs incurred by manufacturer or dealer lessors in connectionwith negotiating and arranging lease shall be recognized as an expense when the sellingprofit is recognized (i.e. initial direct costs are to be expensed)

The sales revenue recognized at the commencement of the lease term by a manufactureror dealer lessor is the fair value of the asset, or, if lower, the present value of the MLPaccruing to the lessor, computing at a market rate of interest. The costs of salesrecognized at the commencement of the lease term is the cost, or carrying amount ifdifferent, of the leased property less the present value of the UGRV. The differencebetween the sales revenue and the cost of sale is the selling profit, which is recognized inaccordance with the entity’s policy for outright sales.

OPERATING LEASEAsset shall be presented in balance sheet as per its nature. Lease income from operatingshall be recognized on a straight-line basis over the lease term unless another systematicbasis is more representative of benefit derived from the leased asset.

Dr. Bank/accrual Cr. Lease/Rent incomeInitial direct costs shall be added to the carrying amount of the leased asset andrecognized as an expense over the lease term on the same basis as the lease income. Thedeprecation is to be charged as per normal depreciation policy.

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DISCLOSUREFinance Lease Operating Lease

Lessee Lessor Lessee LessorNet carrying amountat the balance sheetdate for each classof assetReconciliationbetween the MLPand PV of MLP atthe balance sheetdate, for thefollowing period;Ø upto 01 year;Ø 02 to 05 years; andØ later than 05 years

Reconciliationbetween the GI andPV of GI at thebalance sheet date,for the followingperiod;Ø upto 01 year;Ø 02 to 05 years; andØ later than 05 years

MLP for each of thefollowing periodunder non-cancellable lease:Ø upto 01 year;Ø 02 to 05 years; andØ later than 05 years

MLP for each of thefollowing periodunder non-cancellable lease:Ø upto 01 year;Ø 02 to 05 years; andØ later than 05 years

UFI and UGRVContingent rentsrecognised in P&L

Contingent rentsrecognised in P&L

Contingent rentsrecognised in P&L

Contingent rentsrecognised in P&L

Total minimumsublease payment

Total minimumsublease payment

Separate disclosureof:Ø Lease paymentsØ Sublease

paymentsGeneral descriptionof significant leasingarrangements,including:Ø Basis of contingent

rentsØ Renewal and

purchase optionsand its termsØ Escalation clauseØ Financial

restrictions (forexample) ondividend, furtherleasingarrangement

General descriptionof significant leasingarrangements.

General descriptionof significant leasingarrangements,including:Ø Basis of contingent

rentsØ Renewal and

purchase optionsand its termsØ Escalation clauseØ Financial

restrictions (forexample) ondividend, furtherleasingarrangement

General descriptionof significant leasingarrangements.

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SALE AND LEASEBACKRESULTING IN FINANCE LEASEIf a sale and leaseback transaction results in a finance lease, any excess of sales proceedsover the carrying amount shall not be immediately recognised as income by a seller lessee.Instead, it shall be deferred and amortised over the lease term.

However, if carrying amount is more than sales proceeds, the difference should beimmediately recognised as an expense.

RESULTING IN OPERATING LEASE

SALE PRICE = FV CV = FV CV < FV CV > FVProfit No profit Recognise profit

immediatelyNA

Loss No loss NA Recognise lossimmediately

SALE PRICE below FVProfit No profit Recognise profit

immediatelyNo profit(note 1)

Loss NOT compensated forby future lease payments atbelow market price

Recognise lossimmediately

Recognise lossimmediately

(note 1)

Loss compensated for byfuture lease payments atbelow market price

Defer andamortise loss

Defer and amortiseloss

(note 1)

SALE PRICE above FVProfit Defer and

amortise profitDefer and amortiseexcess profit(note 3)

Defer andamortise profit(note 2)

Loss No loss No loss (note 1)

Note1. the standard requires the CV of an asset to be written down to FV when it is subject to a

sale and leaseback.2. profit is difference between FV and sale price because CV would have been written

down to CV3. the excess profit (the excess of sale price over FV is deferred and amortised). the

excess of FV over CV is recognised immediately.

I