Financial Accounting

Leases (IAS 17) Chapter 11

SCOPE
IAS 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-generative
resources; Page | 1
(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 under
IAS 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 assets
from one contracting party to the other (e.g. toll manufacturing).

DEFINITIONS
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment
or 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 to
ownership of an asset. Title may or may not be eventually transferred & an operating lease
is 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; or
Ø 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 of
commitment 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; and
Ø 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 to
exercise 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 as
appropriate.)

If lease agreement contains some provision to adjust lease payments for change in cost of asset to
lessor or general price level change which takes place between inception of lease and
commencement 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 lease
the asset together with any further terms of which the lessee has the option to continue to
lease the asset, with or without further payment, when at the inception of the lease it is
reasonably 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; or
Ø The number of production or similar units expected to be obtained from the asset by
one or more users.
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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 the
asset are expected to be consumed by the entity.

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

If there is bargain purchase option (BPO), the value of BPO is added rather than guaranteed
residual 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 amount
that 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 a
third party unrelated the lessor that is financially capable of discharging the
obligations under the guarantee.

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

Initial direct costs are incremental costs that are directly attributable to negotiating and
arranging 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 GI
NI = GI - UFI

Unearned finance income (UFI)

UFI = GI - NI

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 Financial Accounting

The Interest rate implicit in the lease is the discount rate that, at the inception of the
lease, 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 lessee
would have to pay on a similar lease or, if that is not determinable, the rate that, at the Page | 3
inception of the lease, the lessee would incur to borrow over a similar term, and with a
similar security, the funds necessary to purchase the asset.

Contingent rent is that portion of the lease payments that is not fixed in amount but a
based 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 market
rate of interest)

CLASSIFICATION OF LEASES
Whether lease is a finance lease or an operating lease depends on the substance of the
transaction 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 lease

being 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; or
Ø 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 lessee
as operating lease. For example, lessor benefits from GRV provided by party unrelated to lessee.

CHANGE IN CLASSIFICATION
If at any time the lessee and the lessor agree to change the provisions of the lease, other
than by renewing the lease, in a manner that would have resulted in a different classification
of the lease, if the changed terms had been in effect at the inception of the lease, the
revised agreement is regarded as a new agreement over its term.
However, changes in estimates (for example, changes in estimates of the economic life or of
the residual value of the leased property), or changes in circumstances (for example default
by the lessee), do not give rise to a new classification of a lease of accounting purposes.
LEASE OF LAND AND BUILDING
The land and building elements of a lease of land and building are considered separately for
a purpose of lease classification. If title to both elements is expected to pass to the lessee
by the end of the lease term, both elements are classified as a finance leases. When the
land 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 building
element 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, the
MLP are allocated between the land and the buildings elements in proportion to the relative
Page | 4 fair value of the leasehold interest. If the MLP cannot be allocated reliably between these
two elements, the entire lease is classified as a finance lease, unless it is clear that both
elements are operating lease, in which case the entire lease is classified as an operating
lease.

ACCOUNTING FOR LEASES BY LESSEE

FINANCE LEASE
The entry Time of recognition By the amount
Dr. Asset under FL Lower of PV of MLP
At inception of lease
Cr. Liability under FL and FV
Dr. Asset under FL When initial direct costs
Initial direct costs
Cr. Bank/Payable are incurred
Dr. P&L As per depreciation
At year end
Cr. Asset under FL / Acc. Dep. policy
Dr. Interest expense The interest accrued
At year end
Cr. Interest payable during the year
Dr. Interest payable Interest
Dr. Liability under FL At the time rental is paid Principal amount
Cr. Bank Total rental
Dr. Contingent rent The period in which they As calculated under
Cr. Bank / payable are incurred agreement

Discount rate used for calculating PV is interest rate implicit in the lease, and if this is not
practicable 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 determine
implicit interest rate.
It is not appropriate for the liabilities for leased assets to be presented in the financial
statements as a deduction from the leased assets. If for the presentation of liabilities on the
face 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 the
lease term, the asset shall be fully depreciated over the shorter of the lease term and its
useful life.
OPERATING LEASES
Lease 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 of
the pattern of the user’s benefits.
Dr. Lease Expense
Cr. Bank/accrual

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 Financial Accounting

ACCOUNTING FOR LEASES BY LESSOR

FINANCE LEASE
The entry Time of recognition By the amount
Dr. GI MLP + UGRV
Cr. UFI UFI
Cr. Asset
At inception of lease
FV Page | 5
Cr. Bank/Payables Initial direct costs*
Dr. UFI The interest accrued
At year end
Cr. Finance income during the year
Dr. Bank At the time rental is
Total rental
Cr. GI received
Lessors shall recognize assets held under finance lease in their balance sheets and present
them 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 and
arranging a lease. They exclude general overheads such as those incurred by sales and
marketing team. Initial direct costs are added in GI only when it is not manufacturer or dealer
lease.

MANUFACTURER OR DEALER LEASE

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

The sales revenue recognized at the commencement of the lease term by a manufacturer
or dealer lessor is the fair value of the asset, or, if lower, the present value of the MLP
accruing to the lessor, computing at a market rate of interest. The costs of sales
recognized at the commencement of the lease term is the cost, or carrying amount if
different, of the leased property less the present value of the UGRV. The difference
between the sales revenue and the cost of sale is the selling profit, which is recognized in
accordance with the entity’s policy for outright sales.

OPERATING LEASE
Asset shall be presented in balance sheet as per its nature. Lease income from operating
shall be recognized on a straight-line basis over the lease term unless another systematic
basis is more representative of benefit derived from the leased asset.
Dr. Bank/accrual
Cr. Lease/Rent income
Initial direct costs shall be added to the carrying amount of the leased asset and
recognized as an expense over the lease term on the same basis as the lease income. The
deprecation is to be charged as per normal depreciation policy.

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DISCLOSURE
Finance Lease Operating Lease
Lessee Lessor Lessee Lessor
Net carrying amount
Page | 6 at the balance sheet
date for each class
of asset
Reconciliation Reconciliation MLP for each of the MLP for each of the
between the MLP between the GI and following period following period
and PV of MLP at PV of GI at the under non- under non-
the balance sheet balance sheet date, cancellable lease: cancellable lease:
date, for the for the following Øupto 01 year; Øupto 01 year;
following period; period; Ø02 to 05 years; and Ø02 to 05 years; and
Ø upto 01 year; Øupto 01 year; Ølater than 05 years Ølater than 05 years
Ø 02 to 05 years; and Ø02 to 05 years; and
Ø later than 05 years Ølater than 05 years
UFI and UGRV
Contingent rents Contingent rents Contingent rents Contingent rents
recognised in P&L recognised in P&L recognised in P&L recognised in P&L
Total minimum Total minimum
sublease payment sublease payment

Separate disclosure
of:
ØLease payments
ØSublease
payments
General description General description General description General description
of significant leasing of significant leasing of significant leasing of significant leasing
arrangements, arrangements. arrangements, arrangements.
including: including:
Ø Basis of contingent Ø Basis of contingent
rents rents
Ø Renewal and Ø Renewal and
purchase options purchase options
and its terms and its terms
Ø Escalation clause Ø Escalation clause
ØFinancial ØFinancial
restrictions (for restrictions (for
example) on example) on
dividend, further dividend, further
leasing leasing
arrangement arrangement

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 Financial Accounting

SALE AND LEASEBACK

RESULTING IN FINANCE LEASE
If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds
over 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.
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However, if carrying amount is more than sales proceeds, the difference should be
immediately recognised as an expense.

RESULTING IN OPERATING LEASE

SALE PRICE = FV CV = FV CV < FV CV > FV

Profit No profit Recognise profit NA
immediately
Loss No loss NA Recognise loss
immediately
SALE PRICE below FV
Profit No profit Recognise profit No profit(note 1)
immediately
Loss NOT compensated for Recognise loss Recognise loss (note 1)
by future lease payments at immediately immediately
below market price
Loss compensated for by Defer and Defer and amortise (note 1)
future lease payments at amortise loss loss
below market price
SALE PRICE above FV
Profit Defer and Defer and amortise Defer and
amortise profit excess profit amortise profit
(note 3) (note 2)
Loss No loss No loss (note 1)

Note
1. 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 CV
3. the excess profit (the excess of sale price over FV is deferred and amortised). the
excess of FV over CV is recognised immediately.

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