Lease Accounting - IAS 17 - Accounts

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An entity leases an asset from another entity. The F.V of the asset is Rs.100,000, and the lease rentals are Rs.18,000, payable half yearly. The first payment is made on the delivery of the asset. The unguaranteed residual value of the asset after the 3yr lease period is Rs. 4,000. The implicit interest rate in the lease is 9.3%, and the P.V of the minimum lease payment is Rs. 96,936. Show how this lease would be accounted for in the accounts of the lessee.

The number of payments is six with a total value of $108,000. The use of the approximate implicit interest rate will give a rounding error.

Payment Balance Finance Charge Payment Lease Liability

1 96,936 0 (18,000) 78,936

2 78,936 3,670 (18,000) 64,606

3 64,606 3,004 (18,000) 49,610

4 49,610 2,306 (18,000) 33,916

5 33,916 1,577 (18,000) 17,493

6 17,493 507 (813 – 306) (18,000) 0

There is a rounding error of 306, which would be taken off the last finance charge to be taken to the income statement.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Accounting for Operating leases

Operating lease should not be capitalised. Lease payments under operating leases shall be recognized as an expense on a straight-line basis over the lease term unless another basis is more representative of the pattern of the user’s benefit, even if the payments follow a different pattern.

It should be noted that lease payments exclude costs for services such as insurance and maintenance. The requirement to spread the lease rentals on a Straight line basis over the lease term applies even if the payments are not made on such a basis.

SIC 15 deals with “Operating leases- Incentives”.

It is important to recognize the impact of incentives in operating leases. Often incentives to enter into operating leases take the form of up-front payments, rent-free periods, and the like. These need to be appropriately recognized over the lease term from its commencement.

Thus, a rent-free period does not mean that the lessee avoids a rent charge in its income statement. It has to apportion the rent for the entire lease over the entire period, resulting in a reduced annual charge.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- Jay has entered into a lease of property whereby the title to the land does not pass to the entity at the end of the lease but the title to the building passes after 15 years.

The lease commenced on July 1, 20X5, when the value of the land was 54 minr & the building value was 18 minr. Annual lease rentals paid in arrears commencing on June 30,20X6, are 6 minr for land & 2 minr for buildings. The entity has allocated the rentals on the basis of their relative F.V at the start of the lease.

The payments under the lease terms are reduced after every 6 years, and the minimum lease term is 30 years. The net P.V of the MLP at July 1, 20X5, was 40 minr for land & 17 minr for buildings. The buildings are written off on the straight-line basis over their useful life of 15 years.

Assume an effective interest rate of 7%.

Discuss how Jay should treat this lease under IAS 17 ?

IAS 17 requires the substance of the transaction to be reviewed and the extent to which the risks and rewards of ownership of the leased asset are transferred to be determined. If the risks and rewards of ownership are substantially transferred to the lessee, then the lease is a finance lease.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

The Standard requires the land and buildings elements to be considered separately. Normally a lease of land will be regarded as an operating lease unless the title passes to the lessee.

In this case the title does not pass and the P.V of the lease payments is only 74% of the F.V of the land, which does not constitute substantially all of the fair value of the leased asset, one of the criteria for the determination of a finance lease.

In the case of the buildings, the title passes after 15 years, and the lease runs for the whole of its economic life, which indicates a finance lease. The P.V of the MLP is 94% of the fair value of the lease at its inception, an amount that indicates that the lessee is effectively purchasing the building.

Thus it would appear to be a finance lease. Property, plant, and equipment would increase by 17 minr with a corresponding increase in non current liabilities. The non current liability (17 minr) will be reduced by the payment on June 30, 20X6 (2 minr), and increased by the interest charge (17 minr × 0.07, or 1.2 minr).

The land will not appear on the balance sheet and the operating lease rentals will be charged to the income statement.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Sale and leaseback transaction

In sale and leaseback transaction, the entity sells the asset to a third party, receives proceeds for the sale and then leases the asset back and pays rentals for its use. A sale and leaseback transaction can result in a finance or operating lease, depending on the substance of the transaction.

If the lease is identified as a Finance Lease, Finance has been provided and the asset has been given as security for that finance. The excess of sale proceeds over the carrying amount of the asset at the date of the transaction is deferred in the Financial statement and amortised through P/L over the period of the lease.

If the lease is identified as an Operating Lease and sale price are established at FV, any profit made on the sale should be recognised immediately in P/L.

If, however, the sale price is below fair value, then any loss arising should be deferred to the extent that future rental payments are below market value. The loss will be recognised in profit or loss as the rentals are recognised.

If the sale price was above FV, the excess profit over fair value should be deferred and recognised in the period over which the asset is expected to be utilised.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Where an operating lease results and the fair value of the asset is less than its carrying amount at the time of the sale, then this loss should be recognised immediately. A loss arising in such circumstances is essentially an impairment of the asset (i.e. a decrease in the recoverable amount of the asset).

Example :- An entity sells a piece of plant to a 100% owned subsidiary and leases it back over a period of 4 years. The remaining useful life of the plant is 10 years. The selling price of the plant was 20% below its carrying and MV. The lease rentals were based on market rates. The entity has no right to buy the plant back.

The lease will almost certainly be an operating lease, as the lease period is not for the majority of the plant’s life and the rentals are based on market rates. However, the selling price was below the carrying and MV, and this loss has not been compensated by future rentals. Therefore, the loss should be recognized immediately.

The transaction will be eliminated on consolidation, but the individual entity accounts will recognize it. Also, the entities are related parties; therefore, the substance of the transaction will have to be scrutinized. Although the entity has no right to reacquire the asset, it can exercise the right

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An entity leases a motor vehicle over a period of five years. The economic life of the vehicle is estimated at seven years. The entity has the right to buy the vehicle at the end of the lease term for 50% of its market value plus a nominal payment of 0.5% of the market value at that date. This nominal payment is to cover the selling costs of the vehicle.

How should the lease be classified in the financial statements of the entity?

The lease will be a finance lease as the entity is likely to buy the vehicle at the price stated because it will be sold at 50% of the market value of the vehicle plus a nominal charge.

SIC 15, Operating Lease— Incentives, clarifies the recognition of incentives related to operating leases by both the lessee and lessor. Lease incentives should be considered an integral part of the consideration for the use of the leased asset.

IAS 17 requires an entity to treat incentives as a reduction of lease income or lease expense. Incentives should be recognized by both the lessor and the lessee over the lease term, using a single amortization method applied to the net consideration.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Accounting by Lessor– Accounting for finance lease

Under a finance lease the amount receivable should recognise as an asset, rather than the leased item as a non-current asset. The receivables should be measured at the net investment in the lease. Over the lease term, rentals are apportioned between a reduction in the net investment in the lease and finance income. The net investment in the lease is the aggregate of the minimum lease payments and any unguaranteed residual value (the “gross investment”) discounted at the rate implicit in the lease.

IAS 17 requires that the recognition of finance income should be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment The method of allocating gross earning to accounting periods is referred to the “actuarial method”. The actuarial method allocate rentals such a way that finance income and repayment of capital in each accounting period in such a way that finance income will emerge as a constant rate of return on the lessor’s net investment in the lease.

Lessor who are manufacturers or dealers should recognize profit on the transaction in the same way as for normal sales of the entity. Thus a finance lease will create a profit or loss from the sale of the asset at normal selling prices and a finance income over the lease term. If artificially low rates of interest are quoted, profit is calculated using market interest rates.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Operating Lease

Lessors shall show assets subject to operating leases in the financial statement in accordance with the nature of the assets. Lease income from operating leases shall be recognized in the income statement on a straight-line basis over the lease term unless another basis reflects better the nature of the benefit received. As mentioned earlier, any incentives should be considered.

Depreciation on the asset subject to a lease is recognized as an expense and should be determined in the same manner as similar assets of the lessor. Additionally, the lessor should apply the principles of IAS 16, 36, and 38 as appropriate.

Initial direct costs of negotiating and arranging the lease shall be added to the cost of the asset and expensed over the lease term in the same pattern as the income is recognized. Only incremental costs may be treated as initial direct costs.

Internal costs that are not incremental such as administration, selling expenses and generally overheads should be written off as incurred.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Manufacturer/dealer lessor

IAS 17 distinguishes manufacturer/dealer lessors from other lessors. Cost makes the different manufacturer/ dealer lessor to normal lessor.

The manufacturer obtains the asset at its cost of manufacture or at a wholesale price, its cost will be below a normal arm’s length selling price.

Where the manufacturer/ dealer enters into an operating lease, no selling profit should be recognised. This is because the risks and rewards associated with the asset’s ownership have not passed to the customer.

Where a manufacturer enters into a finance lease with a customer, the manufacturer should recognised selling P/L in income for the period in accordance with the policy followed by the entity for outright sales. This is because the asset’s risks and rewards of ownership have passed to the customer.

A finance lease of an asset by a manufacturer gives rise to two type of income :- Finance income and a profit or loss equivalent to that arising on an outright sale.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

--

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Service Concession Arrangements IFRIC 12

A service concession is the provision of services that give the public access to major economic and social facilities, Ex:- telecommunication networks, bridges.

Within such arrangements there are two parties, a concession operator (a private sector entity) and a grantor (a public sector entity), who is the party that grants the service arrangement. The operator is paid for its services over the period of the arrangement and in return has the obligation to provide public services.

At the end of the arrangement the residual interest in any infrastructure constructed as part of the arrangement, is controlled by the grantor, not the operator. Such arrangements have many of the characteristics of a lease contract & the acquisition of a non-current asset but also may include an executory contract.

The Interpretation sets out that infrastructure assets are not items of property, plant and equipment of the concession operator, because control over them lies with the grantor. Instead the operator recognises the fair value of the consideration receivable as a financial asset or an intangible asset (or both). Where both a financial asset and an intangible asset exist, the consideration should be separated.

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

A financial asset should be recognised by the concession operator where it has a guaranteed contractual right to receive a specified amount of cash (or other financial asset) over the life of the arrangement.

For example, where an operator constructs or upgrades the public sector asset and then operates it for a fixed period of time for an agreed amount. Under this method the payments received by the operator are recognised as partial repayments of the financial asset.

An intangible asset should be recognised by the concession operator where it receives a right, such as a license, to charge users for the public service that it is providing but the revenue receivable is not agreed in advance but is dependant on the public’s usage of the asset.

Such arrangements typically exist where after the public sector asset has been constructed or upgraded it is operated by the private sector body for a specified period of time

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Example :- An entity agrees to construct and operate a section of motorway on behalf of the national roads authority. The construction cost of 300 minr is payable at the end of Year 1 when the construction will be complete. The operating term of the section of motorway is 10 years and will commence at the start of Year 2. The annual operating costs are 40 minr, payable at the end of each of Years 2 to 11.

The entity will generate revenue from tolls charged to users of the road. The entity estimates that the annual revenue will be 120 minr per annum. The cost of constructing the section of motorway is recognised as a non-current asset, but as an intangible asset (the right to collect tolls) rather than property, plant and equipment (the motorway itself). This intangible is then amortised over its 10-year useful life.

Assuming revenue is as estimated the financial statements will contain the following:

§Year 1 Statement of financial position Intangible asset 300 minr

§Year 2 Statement of financial position Intangible asset 270 minr (300 less 1/10)

§Statement of comprehensive income Revenue120 minr Operating costs 40 minr Amortisation 30 minr

CA. Amit Daga

Finance Controller CA. CS. CFA. CIFRS.

9017 Points Joined October 2007

Dear All,

This is the summary of IAS 17 which is very much in line of our standard AS 19. But still there are few diferences which i will post later on. Its my request to all of you. Kindly go through and discuss and please share your knowledge or if you have any query kindly ask

Thanks in advance

Amit Daga