IAS 17 – Leases

Steven Collings considers the accounting treatment of leases which have fast become a popular
means of finance for businesses. The tremendous popularity of leasing is quite understandable
as it offers great flexibility, often coupled with a range of economic advantages of ownership.

The actual accounting for lease transactions involves a number of complexities, which derive
partly from the range of alternative structures that are available to the parties involved in the
leasing transaction. For example, in many cases leases can be configured to allow manipulation
of tax benefits, with other features such as lease term and implied interest rate adjusted to
achieve the intended overall economics of the arrangement.

‘The Framework’ document issued by the International Accounting Standards Board (IASB) refers
to the concept of ‘substance over form’ and IAS 17 is probably the standard where application of
this principle is most prevalent.

When we refer to ‘substance over form’ we are talking about the commercial reality of the
transaction, rather than what it says on paper. In other words, we need to look at the
characteristics of the transaction. If the lessor essentially transfers all the ‘risks and rewards’ of
ownership of the asset to the lessee, then the asset is recognised on the balance sheet (the
statement of financial position) with a corresponding liability.

If the lessor retains the risks and rewards of ownership, then the rentals are simply charged to the
income statement (statement of comprehensive income) as and when they arise.

IAS 17 stipulates two types of lease:

• Finance lease; and

• Operating lease

A finance lease is where the risks and rewards of ownership have been transferred to the lessee.
An operating lease is where the lessor retains the risks and rewards of ownership.

Let us consider the following examples:

Example 1
Ian Lucas Security Shutters Ltd reports under IFRS. The company entered into a leasing
agreement with Cassandra Stewart Vehicles Ltd to lease six vans – the lease agreement is titled
‘Contract Hire’. Cassandra Stewart Vehicles Ltd has provisos within the lease to state that they
will maintain the vehicles and ownership of the vehicles will remain with Cassandra Stewart
Vehicles Ltd. Ian Lucas Security Shutters Ltd will not own the vehicles at the end of the lease
term.

Example 2
Ian Lucas Security Shutters Ltd reports under IFRS. The company entered into a leasing
agreement with Ethan Kai Plant and Machinery Ltd to lease an item of plant. Ian Lucas Security
Shutters Ltd will be responsible for maintenance of the machine and will own the asset at the end
of the lease term.

In example 1 Ian Lucas Security Shutters Ltd acquired six vans. On the face of it this might come
across as a capital transaction, i.e. capitalise the vehicles in the balance sheet and raise a
corresponding creditor. However, we need to apply the ‘substance over form’ principle.

If we look at the commercial reality of the transaction (the ‘substance’) we can see, quite clearly,
is that Cassandra Stewart Vehicles Ltd own those vans – not Ian Lucas Security Shutters.
Cassandra Stewart Vehicles Ltd has not transferred the ‘risks and rewards’ over to Ian Lucas
Security Shutters Ltd. There is also the fact that the agreement is titled ‘Contract Hire’ – ‘hire’
being the operative word – Ian Lucas Security Shutters are hiring an asset. Finally, the lease
provisions in example one state that Ian Lucas Security Shutters will not own the assets at the
end of the lease term. As a result, the rentals will simply be charged to the income statement in
Ian Lucas Security Shutters financial statements on an arising basis.

In example 2, Ethan Kai Plant and Machinery has transferred the ‘risks and rewards’ of ownership
over to Ian Lucas Security Shutters Ltd and they will own the asset at the end of the lease term.
As a consequence, Ian Lucas Security Shutters should recognise an asset and raise a
corresponding creditor.

The above two examples are rudimentary examples, but you can see how such a transaction can
be manipulated. ‘Off balance sheet’ finance i.e. where liabilities were conveniently ‘missed off’ the
balance sheet, was a huge problem before the issuance of a standard related to leases.

IAS 17 stipulates that substantially all of the risks or benefits of ownership are deemed to have
been transferred if any one of the following five criteria is met:

1. The lease transfers ownership to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option (an option to purchase the leased asset at a
price that is expected to be substantially lower than the fair value at the date the option becomes
exercisable) and it is reasonably certain that the option will be exercisable.
3. The lease term is for the major part of the economic life of the leased asset; title may or may
not eventually pass to the lessee.
4. The present value (PV), at the inception of the lease, of the minimum lease payments is at least
equal to substantially all of the fair value of the leased asset, net of grants and tax credits to the
lessor at that time; title may or may not eventually pass to the lessee.
5. The leased assets are of a specialized nature such that only the lessee can use them without
major modifications being made.

There are a further three indicators which may suggest that a lease might be properly considered
to be a finance lease:

1. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are to be
borne by the lessee.
2. Gains or losses resulting from the fluctuation in the fair value of the residual will accrue to the
lessee.
3. The lessee has the ability to continue the lease for a supplemental term at a rent that is
substantially lower than market rent (i.e. there is a bargain renewal option).

The first five criteria are essentially determinative in nature; the final three are more suggestive in
nature.

Let’s look at a numerical example.

Question
Ian Lucas Security Shutters Limited enters into a lease for a machine on 1 January 2008. The
machine has an expected useful life of three years at which time it will go back to the lessor. The
market value of the machine is $135,000 and three payments are due to the lessor of $50,000 per
year starting on 31 December 2008. The residual value of the machine is estimated to be
$10,000. We are required to advise Ian Lucas Security Shutters Limited as to whether the lease
is a ‘finance’ or ‘operating’ lease.

Solution
In the example above, the lease term is three years which is equal to 100% of the expected useful
life of the asset.

Using present value tables we have to work out the present value (PV) of the residual value and
the PV of the annual lease payments, so:

The PV of $1 due in three years at 10% is 0.7513 (the PV for the residual value).
The PV of an ordinary annuity of $1 for three years at 10% is 2.4869 (the PV for the annual
payments).

PV of guaranteed residual value = $10,000 x 0.7513 = $ 7,513

PV of the annual lease payments = $50,000 x 2.4869 = $124,345
Total = $131,858

The market value of the machine is $135,000 and the PV of the residual value and the annual
lease payments is $131,858, this equates to 97.7% of the market value. In this case, we should
advise Ian Lucas Security Shutters Ltd that the lease should be accounted for as a finance lease,
thus capitalising the asset and raising a corresponding liability.

IAS 17 contains the term ‘substantially all of the fair value of the leased asset’ , but what
determines ‘substantially all’?

Well IFRS does not actually state a threshold – US GAAP does in FAS 13, but it is generally
accepted that if the PV of the minimum lease payments is equal to at least 90% of the market
value of the asset, then it should be recognised as a finance lease. There is room for debate on
whether ‘substantially all’ implies a threshold of lower than 90% or even higher but it is generally
accepted that 90% is the basis figure.

For the purposes of determining this calculation, the minimum lease payments are considered to
be the payments that the lessee is obligated to make or can be required to make, excluding
contingent rent and executory costs. Executory costs are things like insurance, maintenance etc.
The minimum lease payments generally include the minimum rental payments and the PV is
computed using the incremental borrowing rate of the lessee unless it is practicable for the lessee
to determine the implicit rate computed by the lessor, in which case this is to be used.

Operating leases
Much simpler than finance leases! The rentals are simply charged to the income statement as
and when they arise, i.e.

Credit bank or cash;

Debit income statement.

Lessor accounting – operating lease

The payments received by the lessor are to be recorded as rent income in the period in which the
payment is received or becomes receivable. As with the lessee, if the rentals vary from a straight-
line basis, or if the lease agreement contains a scheduled rent increase over the lease term, the
revenue is nonetheless to be recognised on a straight-line basis unless an alternative basis of
systematic and rational allocation is more representative of the time pattern of earning process
contained in the lease.

The lessor must report the leased property on the balance sheet (or statement of financial
position) under the caption ‘Investment in leased property’ under non-current assets and
depreciation should be determined in the same manner as for the rest of the lessor’s owned
property, plant and equipment. IAS 17 states that “when a significant portion of the lessor’s
business comprises operating leases, the lessor should disclose the amount of assets by each
major class of asset together with the related accumulated depreciation at each balance sheet
date”.

Lessor accounting – finance lease

The lessor should record a trade receivable using the net investment method. The net investment
in the lease is the difference between the lessor’s gross investment in the lease and the unearned
finance income.

The gross investment (lease receivable) of the lessor is equal to the sum of the minimum lease
payments (excluding ancillary costs) from the standpoint of the lessor, plus the non-guaranteed
residual value accruing to the lessor. The difference between the gross investment and the
present value of the two components of gross investment (i.e. minimum lease payments and non-
guaranteed residual value) is recorded as ‘unearned finance income’. This is also referred to as
‘unearned interest revenue’.

In terms of unearned finance income, IAS 17 states that this is to be amortised and recognised
into income using the effective rate (or yield) interest methods, which will result in a constant
periodic rate of return on the ‘lessor’s net investment’. The effective rate is now the only
acceptable method of income recognition.

Conclusion

Prior to the issue of a standard regarding accounting for leases accounting for leases was a
mess! Off balance sheet financing was prevalent without such a standard which resulted in
hugely misleading financial statements being prepared.

It is important to understand the concept of ‘substance over form’ when looking at leases. In
practical terms, it can sometimes prove difficult explaining to non-accountants the fact that they
should recognise an asset and a liability when they say “we don’t own the asset”. Accountants
should depart from what is actually in the agreement and look closely at the commercial reality of
the transaction in question – i.e. its ‘substance’ and not its ‘legal form’.

Steven Collings is Audit Manager at Leavitt Walmsley Associates Ltd