All companies need various types of assets to make products or rend services to their customers. Any company has two options to use an asset: buy or lease. In many cases companies prefer to lease rather than to buy, as it does not require initial lamp-sum large payment. So accounting treatment for lease is often used and is a very important topic in the accounting world.
It is IAS 17 Leases that standardises the accounting treatment and disclosure of assets held under lease.
IAS 17 Leases takes the concept of substance over form and applies it to the specific accounting area of leases.
When applying this concept, it is often deemed necessary to account for the substance of a transaction – ie its commercial reality, rather than its strict legal form. In other words, the legal basis of a transaction can be used to hide the true nature of a transaction.
Why do we need to apply substance to a lease?
A lease agreement is a contract between two parties, the lessor and the lessee. The lessor is the legal owner of the asset, the lessee obtains the right to use the asset in return for rental payments.
Historically, assets that were used but not owned were not shown on the statement of financial position and therefore any associated liability was also left out of the statement – this was known as ‘off balance sheet’ finance and was a way that companies were able to keep their liabilities low, thus distorting gearing and other key financial ratios. This form of accounting did not faithfully represent the transaction.
So how does IAS 17 work?
IAS 17 states that there are two types of lease, a finance lease and an operating lease.
Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset to the lessee.
Operating lease
An operating lease is defined as being any lease other than a finance lease.
How to classify?
In order to gain classification of the type of lease you are dealing with, you must first look at the information provided within the scenario and determine if the risks and rewards associated with owning the asset are with the lessee or the lessor. If the risks and rewards lie with the lessee then it is said to be a finance lease, if the lessee does not take on the risks and rewards, then the lease is said to be an operating lease.
Finance lease indicators
The main reward is where the lessee has the right to use the asset for most of, or all of, its useful economic life. The primary risks are where the lessee pays to insure, maintain and repair the asset.
Other indicators that a lease is a finance lease include:
- At the inception of the lease the present value of the minimum lease payments* amounts to substantially all of the fair value of the asset
- The lease agreement transfers ownership of the asset to the lessee by the end of the lease
- The leased asset is of a specialised nature
- The lessee has the option to purchase the asset at a price expected to be substantially lower than the fair value at the date the option becomes exercisable
FINANCE LEASE ACCOUNTING
Initial Accounting
The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:
Debit _ Non-current assets
Credit _ Finance lease liability
(This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments.)
Subsequent Accounting
Depreciation
Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be:
Debit _ Depreciation expense
Credit _ Accumulated depreciation
Lease rental/interest
When you look at a lease agreement it should be relatively easy to see that there is a finance cost tied up within the transaction. For example, a company could buy an asset with a useful economic life of four years for $10,000 or lease it for four years paying a rental of $3,000 per annum.
If the leasing option is chosen, over a four-year period the company will have paid $12,000 in total for use of the asset ($3,000 pa x 4 years) – ie the finance charge in this example totals $2,000 (the difference between the total lease cost ($12,000) and the purchase price of the asset ($10,000)).
Land and buildings
As land has an indefinite economic life, the practice up to 2009 was to treat it as an operating lease
unless title was expected to pass at the end of the lease term. So a lease of land can be treated as a finance lease if it meets the existing criteria, specifically if the risks and rewards of ownership can be considered to have been transferred. This would be the case if the present value of the minimum lease payments in respect of the land element amounts to ‘substantially all’ of the fair value of the land.
A lease of buildings will be treated as a finance lease if it satisfies the requirements above
Example
A business has taken out a new lease on a factory building and surrounding land. The fair value of the
building is $5m and the fair value of the land is $3m. The lease is for 20 years, which is the expected life of the factory, with annual payments in arrears of $500,000. The business has a cost of capital of 8%. The annuity factor for $1 receivable every year for 20 years is 9.818.
Solution
The lease payments will be split in line with the fair values of the land and the building.
$187,500 (500,000 × 3/8) will be treated as lease payment for the land and $312,500 will be treated as
payment on a finance lease for the building. The payment for the building will be treated as a finance lease because it is for the expected useful life of the building. The present value of the minimum lease payments in respect of the land amounts to $1.84m (187,500 × 9.818). This is not ‘substantially all’ of the fair value of the land, so the lease of land will be treated as an operating lease.
Disclosure requirements for lessees
IAS 17 requires the following disclosures by lessees in respect of finance leases:
- The net carrying amount at the end of the reporting period for each class of asset
- A reconciliation between the total of minimum lease payments at the end of the reporting period, and their present value. In addition, an entity should disclose the total of minimum lease payments at the end of the reporting period, and their present value, for each of the following periods:
– Not later than one year
– Later than one year and not later than five years
– Later than five years
Operating lease accounting
As the risks and rewards of ownership of an asset are not transferred in the case of an operating lease, an asset is not recognised in the statement of financial position. Instead rentals under operating leases are charged to the statement of profit or loss on a straight-line basis over the term of the lease, any difference between amounts charged and amounts paid will be prepayments or accruals.
Example
On 1 October 2009 Alpine Ltd entered into an agreement to lease a machine that had an estimated life of 10 years. The lease period is for four years with annual rentals of $5,000 payable in advance from 1 October 2009. The machine is expected to have a nil residual value at the end of its life. The machine had a fair value of $50,000 at the inception of the lease.
How should the lease be accounted for in the financial statements of Alpine for the year end 31 March 2010?
Solution
In the absence of any further information, this transaction would be classified as an operating lease as Alpine does not get to use the asset for most of/all of the assets useful economic life and therefore it can be argued that they do not enjoy all the rewards from this asset.
The accounting for this lease should therefore be relatively straightforward and is shown below:
Rental of $5,000 paid on 1 October:
Debit _ Lease expense (statement of profit or loss) 5,000
Credit _ Bank 5,000
This rental however spans the lease period 1 October 2009 to 30 September 2010 and therefore $2,500 (the last six-months’ rental) has been prepaid at the year end 31 March 2010.
Debit _ Prepayments 2,500
Credit _ Lease expense 2,500
Disclosure requirements
For operating leases the disclosures are as follows.
The total of future minimum lease payments under non-cancellable operating leases for each of the
following periods:
– Not later than one year
– Later than one year and not later than five years
– Later than five years
New Standard IFRS 16 Lease
IAS 17 Lease is currently being replaced by IFRS 16 Leases which is developed by International Accounting Standards Board.
The most obvious and impactful difference is how operating leases will be brought onto the balance sheet. Under IAS 17, a lessee is not obligated to report assets and liabilities from operating leases on their balance sheet and they are instead referred to in the footnotes. This has typically provided financial statement users an inaccurate account of a company’s outstanding expenses, forcing them to estimate the off balance sheet obligations, which often results in overestimations. Similarly, it is difficult to compare businesses that lease assets with those that buy them as a clear indication of the operating leases are left out of the equation.
IFRS 16 changes this by requiring a lessee to recognise arising right of use (ROU) assets and lease liabilities on their balance sheet. Undoubtedly one of the biggest changes to leases accounting, the consequences of recognising operating leases will see a large difference in various financial metrics.
Difference between IAS 17 and IFRS 16?
IAS 17 vs IFRS 16 |
|
| IAS 17 is developed by International Accounting Standards Committee. | IFRS 16 is developed by International Accounting Standards Board. |
| Recognition of Lease | |
| Finance leases are recognized as assets and operating leases are recognized as expenses. | All leases are recognized as assets. |
| Focus | |
| The focus is on who bears the risks and the rewards of the lease | The focus is on who has the right to use the asset. |
Why the difference?
Improved comparability and transparency on balance sheet. Financial statement users can clearly see the effect of operating leases and have a useful basis for comparability with other companies. Currently, under IAS 17, it is difficult to compare companies who lease with those who buy.
Potential impacts:
- Financial report impact - As operating leases will be capitalised, there will be a shift in financial metrics for businesses that have a particularly large number of this type of lease.
Asset turnover, equity and operating expenses will likely see a decrease. Conversely, liabilities, reported debt, recorded assets, EBIT and EBITDA will all see an increase. - Covenants and shareholder relationships - With a change in financial metrics, ratios and liabilities, companies will need to take extra care with their disclosures to explain the shift figures. This could lead to a possible breach of financial based agreements and contracts, both internally (performance KPIs and metric based compensation payments/bonuses) and externally (bank covenants, stakeholder relationships, investor relationships).
Accountant involvement
Accounting departments will be greatly impacted by the new standard, especially in the first year of reporting. The way they interact with leasing within the company is likely to change as they need to know more information about operating leases and how their inclusion affects the financial reporting when accounting for leases under IFRS 16.
IAS 17 – The accounting treatment of operating leases is less complex than the treatment of finance leases and the volume of operating leases is predominantly higher than that of finance leases. So, currently, accounting departments have a lower volume of the challenging calculations to make.
IFRS 16 – Under the new standard, however, as all leases will be treated under the same accounting treatment, accounting departments will have a higher volume of complex amortisation calculations to perform.