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Lease Accounting - IAS 17

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)

11 August 2009

Lease (IAS 17)

A ‘lease’ is a transaction between two parties, a lessor and a lessee, where by the right to use an asset is transferred to the lessee in return for a defined series of payments to the lessor.

Its a way of gaining the right to use an asset usually without having to pay the full amount upfront. Its very much important source or medium and long term financing for entities.

Finance lease. A lease that transfers substantially all the risks and rewards of ownership of an asset. Title need not necessarily be eventually transferred.

Operating lease. A lease that is not a finance lease.

Minimum lease payments. The minimum lease payments are the minimum amount that is payable by the lessee to the lessor under a lease agreement.

For a lessee, this includes any amounts guaranteed to be paid;

For a lessor, this includes any residual value guaranteed to the lessor.

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CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Arrangement Contains a lease– IFRIC 4

IFRIC 4, Determining Whether an Arrangement Contains a Lease deals with agreements that do not take the legal form of a lease but which give rights to use assets in return for payment. Such agreements would include outsourcing arrangements and telecommunication contracts.

If the agreement conveys a right to control the use of the underlying asset then it should be accounted for under IAS 17. This is the case if any of the following conditions are met:

• The purchaser in the arrangement has the ability or right to operate the asset or direct others to operate the asset.

• The purchaser has the ability or right to control physical access to the asset.

• There is only a remote possibility that parties other than the purchaser will take more than an insignificant amount of the asset’s output.

Where the price that the purchaser will pay is neither fixed per unit of output nor equal to the current market price at the time of delivery, this indicates that the purchaser is effectively paying for the asset’s availability, rather than its output.

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CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

The initial assessment of whether an arrangement is a lease should be made at the inception of the lease, although special rules apply for first time adopters of IFRS. In addition IFRIC 4’s transitional rules allow an exemption from the general requirement under IAS 8 for full retrospective adoption.

If an entity takes advantage of this exemption in IFRIC 4, then the assessment of whether an arrangement is lease should be made on the basis of facts and circumstances exiting at the start of the earliest period for which comparative information is presented. The initial assessment is only revisited if one of the following condition are met :

• 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 to the arrangement unless the term or renewal or extension had initially been included in the lease term

• There is a change in determining whether fulfillment is dependent on a specified assets

• There is a substantial change to the asset.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

In Order to apply IAS 17 requirements, payment made for the lease must be split from other payments made under the arrangement. This split is made on the basis of the relative fair values of the lease and other elements of the arrangement.

Where its impracticable for the purchaser to separate the payments reliably, the purchaser is required :

• In case of Finance lease, to recognise an asset and liability equal to the fair value of the underlying asset that is the subject of the lease. Interest is accrued on the liability recognised at the purchaser’s/lessee’s incremental borrowing rate.

• In case of Operating lease, to treat all payments made under the arrangement as if they were lease payments. Such amounts should be disclosed separately from other arrangements that do not include payments for non-lease elements.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Example :- A distributor of chemicals enters into a tolling agreement with a chemical producer. The producer agrees to build a bespoke facility to manufacture chemicals exclusively for the distributor. The useful life of the facility is estimated at ten years, which is the same period as the tolling agreement between the two parties. The facility is designed to meet only the distributor’s needs.

The distributor must pay a fixed capacity charge per annum irrespective of whether it takes any of the facility’s production. It also pays a variable charge based on the actual production taken, which amounts to approximately 90% of the facility’s total variable costs.

This arrangement contains a lease. The asset in the agreement is the facility and fulfillment of the agreement is dependent on that facility which is bespoke for the distributor’ requirements.

The distributor has obtained the right to use the factory as it is bespoke for its needs and could not reasonably be used for another purpose. The price it will pay per unit is neither fixed nor equal to the market price at time of delivery.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Substance of transaction involving legal form SIC 27

SIC 27 “ Evaluating the substance of transaction involving the legal form of a lease”.

The SIC sets out the following indicators that individually demonstrate that an arrangement may not, in substance, involve a lease:

§ An entity retains all the risks and rewards incident to ownership of the underlying asset and enjoys substantially the same right to its use as before the arrangement.

§ The primary reason for arrangement is to achieve a particular tax result and does not convey the right to use an asset.

§ An option is included on terms and make its exercise almost certain.

Where a contractual lease agreement will not be accounted for as a lease is when the lessee has been granted a purchase option at a fixed price at the end of the lease term and lessor has been granted a corresponding put option with identical terms.

Whatever the value of the asset at the end of the lease term, its virtually certain that one party will exercise its option and, hence, in substance the lessee has purchased the asset subject to the lease arrangement.

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CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Classification of leases

The classification of a lease as either a finance lease or an operating lease is critical as significantly different accounting treatments are required for the different types of lease. The classification is based on the extent to which risks and rewards of ownership of the leased asset are transferred to the lessee or remain with the lessor.

Risks include technological obsolescence, loss from idle capacity, and variations in return. Rewards include rights to sell the asset and gain from its capital value.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards of ownership to the lessee. If it does not, then it is an operating lease.

When classifying a lease, it is important to recognize the substance of the agreement and not just its legal form. The commercial reality is important.

Conditions in the lease may indicate that an entity has only a limited exposure to the risks and benefits of the leased asset. However, the substance of the agreement may indicate otherwise.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Finance lease include

§ Transfer of ownership 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 lower than its fair value such that the option is likely to be exercised.

§ The lease term is for a major part of the economic life of the asset, even if title to the asset is not transferred.

§ The PV of the MLP is equal to substantially all of the FV of the asset.

§ The leased assets are of a specialized nature such that only the lessee can use them without significant modification.

§ If the lessee can cancel the lease, and the lessor’s losses associated with cancellation are borne by the lessee

§ Gains or losses from changes in the fair value of the residual value of the asset accrue to the lessee.

§ The lessee has the option to continue the lease for a secondary term at substantially below market rent.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Example:- An entity enters into a lease agreement on Jul1, 07, that lasts for 7 years. The asset’s economic life is 7.5 years. The F.V of the asset is 5 MINR, and lease payments is Rs.4.5 laces are payable every six months commencing Jan 1, 08.

The P.V of the MLP is 4.6 MINR. The lease payments were originally due to commence on Jul 1, 07, but the lessor has agreed to postpone the first payment until Jan 1, 08. The asset was received by the entity on Jul 1, 07.

Describe how the lease agreement should be treated for the year ended Jan 31,2008.

The lease liability should be recognized when the asset is received by the entity and the lease agreement commences, which is Jul 1, 07. The lease is a finance lease because it is for substantially all the asset’s economic life and the PV of the minimum lease payments is substantially all (92%) of the fair value of the asset.

During the 6-month period before the commencement of the lease payments, interest will be accrued on the lease liability using the interest rate implicit in the lease. In the period to Jan 31,08, seven months of interest will be accrued. The cash payment on Jan 1, 08, will be apportioned as to the repayment of the lease liability and payment of accrued interest. The asset will be depreciated over the lease term (7 years) in accordance with the depreciation policy for “owned” assets.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Lease Term

A non-cancellable lease can be cancellable only…………..

• Upon the occurrence of some remote contingency,

• With the permission of the lessor

• If the lessee enters into a new lease for the same or an equivalent asset with the same lessor

• Upon Payment by the lessee of such and additional amount that, at inception of the lease, continuation of the lease is reasonably certain.

If a lease contains a clean break clause, where the lessee is free to walk away from the lease agreement after a certain time without penalty, then the lease term for accounting purposes will normally be the period between the commencement of the lease and the earliest point at which the break option is exercisable by the lessee.

If a lease contains an early termination clause the requires the lessee to make a termination payment to compensate the lessor such that the recovery of the lessor’s remaining investment in the lease was assured, then the termination clause would normally be disregarded in determining the lease term.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Classification Indicators

Example :- 1 Entity A (the lessor) leases a truck to entity B (the lessee) for a period of 3 years. Lease rentals are set by the lessor assuming a residual value for the truck of 4 MINR at the end of the lease term. Market data suggest that the likely range of residual values at the end of 3 years is 4 to 5 MINR. The lessee will guarantee any fall in the residual value of the truck below 4 down to 2.5 MINR of the original cost. The lessor will bear the cost of any fall in the residual value below 2.5 MINR. How should this lease be classified ?

The lease should be classified as a finance lease. The sharing of the residual value risk is not even as it is unlikely that the residual value of the truck will fall bellow 2.5 MINR. The risk retained by the entity A is remote and should, therefore, be ignored. The residual value risk is in substance borne by entity B.

Example :- 2 Entity A borrows C 1.5 MINR from a bank to acquire property. Entity A leases the property to entity C for a 10 yr. Entity C provides a guarantee to the bank in respect of loan. The terms of the loan require repayment over 40 yrs, property estimated useful life. Title of the property will pass from entity A to entity C in the even of entity C being called on to meet its guarantee.

The lease will qualify as a finance lease although the term is only for 10 out of 40 yrs. This is because the guarantee is, in substance, a residual value guarantee and is, therefore, part of the minimum lease payments.

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CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Accounting by Lessees– Accounting for finance lease

At the commencement of the lease term, a lessee shall recognize an asset and a liability at the F.V of the leased asset or, if lower, at the P.V of the minimum lease payments. The appropriate discount rate in the present value calculation is the rate implicit in the finance lease—that rate which discounts the lease payments to the fair value of the asset plus any initial direct costs of the lessor.

However, where this is not possible, the standard requires the lessee to use his incremental borrowing rate to determine the PV of the minimum lease payments.

Subsequent to initial recognition, the lease payments are apportioned between the repayment of the outstanding liability and the finance charge so as to reflect a constant periodic rate of interest on the liability. Methods of calculation vary and include sum of the digits, which is a rough approximation, and more complex amortization models.

The asset needs to be depreciated over its expected useful life under IAS 16, using rates for similar assets. However, if there is no reasonable certainty that ownership will transfer to the lessee, then the shorter of the lease term and the useful life should be used.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Example :- On 1 January 2008 an entity enters into a finance lease for a photocopier with a fair value of Rs. 8,000.

The lease term is for 3 years, with no option to extend, and the copier will be returned to the lessor at the end of the 3 years. The present value of the minimum lease payments is Rs. 7,600.

The copier should therefore be initially recognised at Rs. 7,600, which is the lower of the fair value and the present value of the minimum lease payments.

The useful life of the copier is estimated to be 4 years with a nil residual value. The entity operates a straight-line method of depreciation.

The depreciation charge on the copier in 2008 is:

Rs. 7,600 / 3 years = Rs. 2,533

Because the lessee will not gain ownership at the end of the 3 year period, the copier is depreciated over a 3 year period being the shorter of the lease term and the asset’s useful life..

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Finance Charge

Finance charge :- Each installment made under a finance lease consists of a mixture of a finance charge and the repayment of capital.

The total finance charge over the total period of the lease is:

Total lease rentals X

Less: initial finance lease obligation being the lower of fair value and PV of the minimum lease payments (X)

Total finance charges X

The total interest cost should be recognised in profit or loss over the accounting periods for which the lease liability is in existence. This is from the start of the lease until the last repayment is made.

The period over which the lease liability is in existence is not necessarily the same as the term of the lease. For example, if lease rentals are paid annually in advance, the lease finance will be paid off when the final payment is made at the start of the last year, but the lease term will include the last year, even though no liability will remain.

CA. Amit Daga (Finance Controller CA. CS. CFA. CIFRS. M.COM. ) (9017 Points)
Replied 11 August 2009

Accounting for finance lease

Example :- Entity T is a telecom company and has entered into a lease contract with entity S for exclusive use of submarine cable for overseas communication. The contract is for 10 years, which corresponds to the economic life of the cable. Ownership transfers at the arrangement for no additional consideration. The lease payments are dependent on the usage of the cable. The ceiling amount is 10 MINR per year at 100% usage and the minimum amount (floor) is 6 MINR per year, which correspondence to a usage of 60% of lower.

Management of entity T estimates that the average usage of the cable will be approximately 85% and the average annual lease payments are expected to be 8.5 MINR. How should be minimum lease payments (MLP) be calculated ?

The undiscounted MLP is 60 MINR. Entity T should not include a best estimate of the contingent rents in the MLP. The additional 25 MINR that expects to pay over term of the contract are contingent rents, because this amount varies based on the future use of the leases asset.

Contingent rent are expensed as incurred. Its excluded from the measurement of finance lease assets and liabilities except in circumstances where its clear that the contingency is not genuine. In any circumstances where a lease does not appear to make economic sense or either party to the contract, the facts should be challenged and further investigated.