Leases
IAS 17
Technical Notes
Leases
IAS 17
Level Tested on CPA PEP
| Exam | Level Tested | Importance (low, medium, or high) |
| Core 1 Module | Level A | High |
| Assurance Elective | Level A | High |
Scope
Amendments to IAS 17 – Starting January 1, 2019
The current IAS 17 will be replaced with IFRS 16 for the accounting of leases effective for calendars years beginning on or after January 1, 2019.
IAS 17 is still relevant until January 1, 2019 for the CPA exams.
This section (IAS 17) does NOT apply to the following:
- Investment properties held by lessees (finance or operating) that are accounted for as an investment property (see IAS 40)
- Investment propertied provided by lessors under operating leases
- Biological assets held by lessees under a finance lease
- Biological assets provided by lessors under an operating lease
- Licencing agreements (motion pictures, plays, manuscripts, patents, copyrights)
Definition
- Lessee = party that has gained access to the asset
- Lessor = the party that provided the asset
- A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. If a lease is a finance lease then you will record an asset and liability on the balance sheet as you have purchased the asset
- An operating lease is a lease other than a finance lease
- interest rate implicit in the lease is such that the Fair Value of leased asset + initial direct costs = Present Value of (Minimum Lease Payments + unguaranteed Residual value)
Classification of leases - from lessee's perspective
- The classification of lease (as finance or operating) is determined on the date of inception
- Date of inception = earlier of date of lease agreement and the date of commitment by the parties to the lease
- The lease is recognized in the books on the commencement of the lease term
- Commencement of the lease term = the date when the lessee has the right to use the asset
A lease with both land and buildings elements
- When a lease includes both land and a building together, you need to assess each element separately using the criteria below to determine if it is a finance lease or operating lease
- An important thing to consider is that land has an indefinite life (this may lead to the conclusion that land element is an operating lease)
- The minimum lease payments are allocated between the land and the building in proportion to the relative fair value of the lease attributable to the land and building
- If the lease payments cannot be allocated reliably between the land and the building, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases
- Note that the relative fair value of the lease attributable to land and building is not the same as the relative fair value of the physical land and building
- Fair value of the lease is the present value of the benefits we are expecting to get from the leased land and building
- If the amount recognized for the land (lower of FV or the present value of MLP) is immaterial, the land and the building may be treated as a single unit
Finance Lease (under ASPE it is called capital lease)
- A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership
- A lease is a finance lease if any one of the following conditions are met:
- the lease transfers ownership of the asset to the lessee by the end of the lease term
- the lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable (bargain purchase option)
- the lease term is for the major part of the economic life of the asset even if title is not transferred (It requires a judgement under IFRS as no quantitative criteria like ASPE available)
- at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset(It requires a judgement under IFRS as no quantitative criteria like ASPE available)
- Calculation of PV of minimum lease payments is discussed later in the notes.
- the leased assets are of such a specialized nature that only the lessee can use them without major modifications
- secondary factors that could also lead to a lease being classified as a finance lease are:
- if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
- gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and
- the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent
- under IFRS, judgement is required to determine what constitutes a major part of the economic life and what constitutes substantially all of the fair market value
- these above 8 criteria are not conclusive; if other factors indicate that substantially all the risks and rewards have not been transferred, the lease will not be classified as a finance lease
- The criteria above is used by both lessor and lessee but they could come with the different classification i.e. no consistency required
Classification of leases
Finance Lease
- At the commencement of the lease term, the lessee should recognize a finance lease as an asset and a liability on the balance sheet at the lower of:
- Fair value of the leased property; or
- The present value of the minimum lease payments (MLP)
- The discount rate to use in the present value = interest implicit in the lease
- If the interest implicit in the lease is not determinable use the lessee’s incremental borrowing rate
- ASPE has different criteria – refer to ASPE notes
- Initial direct costs of the lease (i.e. cost of negotiating/arranging lease) are added to the amount of asset recognized
Minimum lease payments (MLP) of the Lessee
- Minimum lease payments for lessee include the following:
- Minimum lease payments = the payments over the lease term that the lessee is required to make + amounts guaranteed by the lessee or by a party related to the lessee + bargain purchase options (or guaranteed residual value)
- If there is both bargain purchase option and a guaranteed residual value, the BPO is used.
- Lease incentives are also included in the MLP
- Minimum lease payments exclude the following:
- contingent rent + costs for services and taxes to be paid by and reimbursed to the lessor
Subsequent Measurement
- the minimum lease payments are allocated between principal (reduction to the lease liability) and interest
- contingent rent is expensed when it is incurred
- the asset recorded under a finance lease by the lessee must be amortized
- if the lessee is not reasonably certain that he/she will obtain ownership @ the end of the lease – amortize over the shorter of lease term and useful life
- if the lessee is reasonably certain that he/she will obtain ownership @ the end of the lease – amortize over the useful life
- note you can obtain ownership via a bargain purchase option also
Operating leases
- lease payments for an operating lease is expensed on a straight line basis
- lease expense per term = net lease payments over lease ÷ lease terms
Depreciation - Finance lease
- If the asset is recorded because the lease is considered a finance lease the amortization period will depend on bargain purchase option (BPO) as below.
- Amortize over useful life of the asset If BPO or transfer of ownership is present. Otherwise, amortize it over lease term.
Example
M&M Inc. requires a non-specialized equipment to manufacture a candy. The purchase price of the asset is $800,000. Due to cash difficulties, management has decided to lease the asset instead. The following information is available.
Lease term – 8 years; Useful life – 10 years; Implicit interest rate – 8%; Incremental borrowing rate – 10%.
The unguaranteed residual value of the equipment is $200,000. The annual payment is $100,000 and is payable at the beginning of each year. At the end of the lease, M&M has the option to purchase the asset for $50,000, which is the estimated fair value at that time.
Required:
Determine whether this lease should be recorded as a finance or an operating lease.
Prepare the journal entries for the first year for the lessee (including depreciation).
Leases in the financial statements of lessors
Classification of leases - from lessors's perspective
- Accounting for leases from the lessor’s perspective involves similar analysis as of the lessees. All of the criteria above to determine finance vs. operating lease is same under IFRS.
- Generally, a lease that is considered a finance lease from the point of view of the lessee will also be a finance lease from the point of view of the lessor.
Finance Lease
- For a finance lease, lessors recognize an asset and present this as a receivable equal to the net investment in the lease
- Net investment in the lease = present value of the gross investment in the lease discounted @ the interest rate implicit in the lease
- Gross investment in the lease = total minimum lease payments receivable by the lessor over the lease + and unguaranteed residual value
- Deferred finance income (this represents the interest) = gross investment – net investment
- Please see below for sample journal entry
- Initial direct costs are often incurred by lessors and include amounts such as commissions, legal fees and internal costs to negotiate and arrange a lease
- For finance leases other than those involving manufacturer or dealer lessors, initial direct costs are included in the initial measurement of the finance lease receivable
- For a manufacturer/dealer lessor, initial direct costs are expensed
Minimum lease payments for lessors
- Minimum lease payments for lessors = the payments over the lease term that the lessee is required to make + residual value guaranteed by the lessee or by a party related to the lessee or a third party unrelated to the lessee + bargain purchase options
- Minimum lease payments exclude the following:
- contingent rent + costs for services and taxes to be paid by and reimbursed to the lessor
Special Rule for Manufacturer and dealer lessors
- Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset
- The manufacturer/dealer lessors will recognize 2 types of income
- “sales revenue” and “cost of goods sold” initially; and
- Interest income over the lease term
- Sales revenue = lower of (a) fair value of the asset and (b) the present value of the minimum lease payments computed at the market interest rate
- The reason why IFRS does this is because it doesn’t want lessors to quote artificially low implicit rates in the lease to overstate sales revenue
- Remember PV of the MLP using rate implicit in the lease = Fair Value
- Cost of goods sold = carrying amount of the leased property (i.e. the inventory) less the PV of unguaranteed residual value
- To understand this better please see the journal entries below
Sample journal entries for lessor
- Financing Type Lease vs. Manufacturer/Dealer Lease
- Annual payment = 10,000 per year for 10 yrs.
- RV=5,000
- PV (annual PMT) = 80,000
- PV (RV) =1,000
- BV of leased PPE = 50,000
- FV of the leased asset = 81,000
Case 1: If residual value is unguaranteed
| Direct Financing Lease | manufacturer/dealer lease | |
| Gross receivable (dr.) | 10,000*10 + 5,000=105,000 | 10,000*10 + 5,000=105,000 |
| Deferred Finance Income (cr.) | = 105,000-81,000=24,000 | = 105,000-81,000=24,000 |
| Credit entry | FV of Asset Leased = PV (annual pmt, RV) = 81,000 | Sales = lower of: 1. PV (MLP) = 80,000; 2. FV of leased Asset = 81,000 |
| Debit entry | COGS=BV of leased asset – PV(ungur. RV)= 50,000-1,000=49,000 |
| Direct Financing Lease | Sales Type Lease |
| Dr. Gross investment……….….105K Cr. Deferred finance income……………..24K Cr. Leased asset……………………………81K | Dr. Gross investment……….105KDr. Cost of goods sold……..…49K Cr. Deferred finance income…………….24K Cr. Inventory………………………………..50K Cr. Sales……………………..…..….…….…80K |
Case 2: If residual value is guaranteed
| Direct Financing Lease | Sales Type Lease | |
| Gross receivable (dr.) | 10,000*10 + 5,000=105,000 | 10,000*10 + 5,000=105,000 |
| Deferred Finance Income (cr.) | = 105,000-81,000=24,000 | = 105,000-81,000=24,000 |
| Credit entry | FV of Asset Leased = PV (annual pmt, RV) = 81,000 | Sales = lower of:
|
| Debit entry | COGS=BV of leased asset – PV(Ungur. RV)= 50,000-0=50,000 |
| Direct Financing Lease | Sales Type Lease |
| Dr. Gross investment……….105KCr. Deferred finance income…………24KCr. Leased asset……………………….81K | Dr. Gross investment……….105KDr. Cost of goods sold……..…50KCr. Deferred finance income………………24KCr. Inventory………………………………….50KCr. Sales……………………..…………….…81K |
Operating leases
- Income from operating leases are recognized in income over a straight lines basis
- Income recognized per term= net lease payments over the lease term ÷ lease term
- Initial direct costs on an operating lease are added to the carrying value of the leased asset and amortized to expense over the lease term
Leases in the financial statements of lessors
A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset
Sale-Leaseback: Operating Lease
If the transaction is established at fair value | any profit or loss shall be recognized immediately |
If the sale price is below fair value | any profit or loss shall be recognized immediately except if the loss is compensated for by future lease payments at below market price, it is deferred and amortized over the period for which the asset is expected to be used |
If the sale price is above fair value
| the excess over fair value is deferred and amortized over the period for which the asset is expected to be used
the fair value less carrying value is recognized immediately |
if the fair value at the time of a sale and leaseback is less than the carrying amount of the asset | loss = carrying amount less fair value shall be recognized immediately |
Sale-Leaseback: Finance Lease
- If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount is not immediately recognised as income by a seller-lessee.
- Instead, it is deferred and amortised over the lease term
Advanced topic: Investment property held under an operating lease by lessee
- under IAS 40, the lessee has the option to treat an investment property held under an operating lease as an investment property (i.e. say it subleases the property)
- when this is done, the lease is automatically treated as a finance lease, and per IAS 40, the fair value model MUST be used
- this classification/measurement is held intact, even if the property ceases to be an investment property in the future
Comparison to ASPE
- Leases are covered under ASPE 3065
- The terminology is different; a finance lease is called a capital lease
- Under ASPE, the criteria to classify a lease as a capital lease is more defined (for instance the present value of the minimum lease payments must be ≥90% of the fair market value). Also, the useful life must be ≥75% of the economic life
- Under ASPE, the secondary conditions to determine whether a lease is finance lease mentioned in IFRS are not mentioned
- Under ASPE, for a lease with a land and building –
- Under ASPE, you do not need to split the land and the building unless
- Ownership transfers @ the end of the lease or there is a bargain purchase option; or
- The fair value of the land is major in relation to the fair value of the leased property
- the land will be considered a capital lease only if the title passes at the end of the lease or if there is a bargain purchase option
- the minimum lease payments are allocated based on the relative fair values of the physical land and building as opposed to the relative fair values of the lease attributable to the land/building
- Under ASPE, you do not need to split the land and the building unless
- under ASPE, the minimum lease payments are discounted at the lower of the borrowing rate or the rate implicit in the lease
- under ASPE, initial direct costs are only mentioned for lessors; initial direct costs are expensed and an equal amount will be charged to revenue (therefore no impact on net income)
- under ASPE, costs for services and taxes to be paid by and reimbursed to the lessor is called executor costs and are also excluded from the MLP
- under ASPE, manufacturer/dealer leases are called a sales-type lease
- under ASPE, initial direct costs from an operating lease are recognized as a separate asset and amortized to expense over the lease term
- under ASPE, accounting sales and leaseback transactions is different
- Under ASPE, the criteria to determine whether it is a finance lease for lessor and lessee is not exactly the same as it is in the IFRS