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4 Lessors' disclosures for finance leases

4 Lessors' disclosures for finance leases

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3.5 Operating leases

3.5.1 Accounting treatment

An asset held for use in operating leases by a lessor should be recorded as a long-term asset and

depreciated over its useful life. The basis for depreciation should be consistent with the lessor's policy on

similar non-lease assets and follow the guidance in IAS 16.

Income from an operating lease, excluding charges for services such as insurance and maintenance,

should be recognised on a straight-line basis over the period of the lease (even if the receipts are not on

such a basis), unless another systematic and rational basis is more representative of the time pattern in

which the benefit from the leased asset is receivable.

Initial direct costs incurred by lessors in negotiating and arranging an operating lease should be added to

the carrying amount of the leased asset and recognised as an expense over the lease term on the same

basis as lease income, ie capitalised and amortised over the lease term.

Lessors should refer to IAS 36 in order to determine whether a leased asset has become impaired.

A lessor who is a manufacturer or dealer should not recognise any selling profit on entering into an

operating lease because it is not the equivalent of a sale.



3.5.2 Lessors' disclosures for operating leases

The following should be disclosed (on top of IAS 32 requirements).





For each class of asset, the gross carrying amount, the accumulated depreciation and accumulated

impairment losses at the year end:









Depreciation recognised in income for the period

Impairment losses recognised in income for the period

Impairment losses reversed in income for the period







The future minimum lease payments under non-cancellable operating leases in the aggregate and

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







Total contingent rents recognised in income







A general description of the lessor's leasing arrangements



3.6 Sale and leaseback transactions



6/12, 12/13



In a sale and leaseback transaction, an asset is sold by a vendor and then the same asset is leased back

to the same vendor. The lease payment and sale price are normally interdependent because they are

negotiated as part of the same package. The accounting treatment for the lessee or seller should be as

follows, depending on the type of lease involved.



252



(a)



In a sale and leaseback transaction which results in a finance lease, any apparent profit or loss

(that is, the difference between the sale price and the previous carrying value) should be deferred

and amortised in the financial statements of the seller/lessee over the lease term. It should not be

recognised as income immediately.



(b)



If the leaseback is an operating lease:

(i)



Any profit or loss should be recognised immediately, provided it is clear that the transaction

is established at a fair value.



(ii)



Where the sale price is below fair value, any profit or loss should be recognised

immediately except that if the apparent loss is compensated by future lease payments at

below market price it should to that extent be deferred and amortised over the period for

which the asset is expected to be used.



8: Leases  Part B Accounting standards



(iii)



If the sale price is above fair value, the excess over fair value should be deferred and

amortised over the period over which the asset is expected to be used.



In addition, for an operating lease where the fair value of the asset at the time of the sale is less than the

carrying amount, the loss (carrying value less fair value) should be recognised immediately.

The buyer or lessor should account for a sale and leaseback in the same way as other leases.

The disclosure requirements for both lessees and lessors should force disclosure of sale and leaseback

transactions. IAS 1 should be considered.



4 Criticism and proposed changes

FAST FORWARD



6/10



IAS 17 (revised) closed many loopholes, but some still argue that it is open to manipulation. An Exposure

Draft has been issued to remedy some of the abuses.

IAS 17 has not been without its critics. The original standard closed many loopholes in the treatment of

leases, but it has been open to abuse and manipulation. A great deal of this topic is tied up in the off

balance sheet finance and creative accounting debate discussed in Chapter 10.



4.1 Treatment of operating leases unsatisfactory?

The different accounting treatment of finance and operating leases has been criticised for a number of

reasons.

(a)



Many users of financial statements believe that all lease contracts give rise to assets and

liabilities that should be recognised in the financial statements of lessees. Therefore, these

users routinely adjust the recognised amounts in the statement of financial position in an attempt

to assess the effect of the assets and liabilities resulting from operating lease contracts.



(b)



The split between finance leases and operating leases can result in similar transactions being

accounted for very differently, reducing comparability for users of financial statements.



(c)



The difference in the accounting treatment of finance leases and operating leases also provides

opportunities to structure transactions so as to achieve a particular lease classification.



It is also argued that the current accounting treatment of operating leases is inconsistent with the

definition of assets and liabilities in the IASB's Conceptual Framework. An operating lease contract

confers a valuable right to use a leased item. This right meets the Conceptual Framework’s definition of an

asset, and the liability of the lessee to pay rentals meets the Conceptual Framework’s definition of a

liability. However, the right and obligation are not recognised for operating leases.

Lease accounting is scoped out of IAS 32 and IFRS 9, which means that there are considerable

differences in the treatment of leases and other contractual arrangements.



4.2 IASB Exposure Draft

As mentioned earlier, leasing is the subject of a wider IASB project. Many believe that the current lease

accounting is too reliant on bright lines and subjective judgements that may result in economically similar

transactions being accounted for differently. The IASB and FASB published a Discussion Paper in March

2009 which focused on lessee accounting and have since decided to address both lessee and lessor

accounting. This resulted in an Exposure Draft Leases, issued in 2010, which, in effect, required all

leases to be shown on the statement of financial position. The proposals would result in a consistent

approach to lease accounting for both lessees and lessors – a ‘right-of-use’ approach. Among other

changes, this approach would result in the liability for payments arising under the lease contract and the

right to use the underlying asset being included in the lessee’s statement of financial position, thus

providing more complete and useful information to investors and other users of financial statements.



Part B Accounting standards  8: Leases



253



Feedback on the 2010 ED was mixed, with many respondents viewing the proposals as too complex,

particularly with regard to lessor accounting. Feedback indicated that the profit or loss impact of the lessee

model did not reflect useful information as a result of so-called ‘front-loading’ to profit or loss. Frontloading is caused by the combination of a decreasing interest charge over time as the lease liability is

repaid and the straight line amortisation of the right-of-use asset. Accordingly, the proposals were

simplified and re-exposed, taking account of feedback, in May 2013.



4.2.1 Basic principle of May 2013 ED – recognition in the statement of financial

position

A lessee is required to recognise a right-of-use asset and a lease liability for all leases of more than

twelve months.

For leases of twelve months or less, a lessee is not required to recognise a right-of-use asset and a lease

liability, but may choose to do so. This concession was one of the ways in which the 2013 ED addressed

concerns about cost and complexity raised in response to the earlier ED.



4.2.2 Scope

The scope of the proposed standard is similar to that of existing lease accounting standards; therefore,

most contracts currently accounted for as leases would be subject to the new guidance as well. The ED

will not apply to leases of intangible assets, biological assets, exploration rights, and service concessions

within the scope of IFRIC 12 Service concession arrangements.

In addition, the ED includes conditions for use in determining whether an arrangement contains a lease

(currently in IFRIC 4).



4.2.3 Measuring lease assets and liabilities

The lease liability is measured at the present value of the fixed lease payments less any lease

incentives receivable from the lessor. This includes:

(a)

(b)



Any variable payments that may be linked to an index or rate

Any amounts payable under residual value guarantees



It excludes variable rents based on performance or usage, which are recognised in profit or loss as

incurred. The lease liability is measured in the same way regardless of the nature of the underlying asset.

The right-of-use asset is measured at cost, based on the amount of the lease liability plus lease

prepayments less any lease incentives received. The right-of-use asset also includes any costs incurred

that are directly related to entering into the lease.



4.2.4 Lease term

The lease term is the non-cancellable lease term together with renewal option periods where there is

significant economic incentive to extend the lease. The question of significant economic incentive may

require judgment.



4.2.5 Dual recognition approach

A single accounting model for lessees would not reflect the true economics of different assets.

Accordingly, the IASB developed a dual approach, where the type of lease is based on the amount of

consumption of the underlying asset.

Type A leases

Type A leases are leases where the lessee pays for the part of the asset that it consumes. They are leases

of depreciating assets, for example vehicles or equipment, whose value declines over its useful life,

generally faster in the earlier years. Type A leases normally mean that the underlying asset is not

property. However, property will be classified as a Type A lease in either of the following circumstances.



254



8: Leases  Part B Accounting standards



(a)



The lease term is for the major part of the remaining economic life of the underlying asset.



(b)



The present value of the lease payments accounts for substantially all of the fair value of the

underlying asset at the commencement date.



Type B leases

Type B leases are leases for which the lessee pays for use, consuming only an insignificant part of the

asset. Type B leases normally mean the underlying asset is property. However, leases other than property

leases will be classified as type B leases in either of the following circumstances.

(a)



The lease term is for an insignificant part of the total economic life of the underlying asset.



(b)



The present value of the lease payments is insignificant relative to the fair value of the underlying

asset at the commencement date of the lease.



4.2.6 Recognition of lease expenses and cash outflows

After commencement date, the liability is increased by the unwinding of interest and reduced by lease

payments made to the lessor. If there is a change in the expected amount of lease payments, the lease

liability is reassessed. The right-of-use asset will be subject to impairment.

The following amounts are recognised in profit or loss:

(a)



For type A leases, the unwinding of the discount on the lease liability as interest and the

amortisation of the right-of-use asset. The amortisation of the right-of-use asset would be

presented in the same line as similar expenses, such as PPE depreciation, and interest on the lease

liability in the same line as interest on other, similar, financial liabilities. This would generally result

in a front loading of the expense.



(b)



For type B leases, the lease payments will be recognised in profit or loss on a straight-line

basis over the lease term and reflected in profit or loss as a single lease cost. The single lease

cost will be allocated to the actual unwinding of interest on the liability and any remaining lease

cost is allocated to the amortisation of the right-of-use asset. These represent amounts paid to

provide the lessor with a return on its investment in the underlying assets, and the return will

probably be relatively even over the term of the lease.



4.2.7 Lessor accounting

Lessor accounting for finance leases will be similar to the existing IAS 17 model. For operating leases, a

lessor will need to distinguish between property and equipment in a similar way to lessees.

For operating leases of property (type B), the accounting is essentially unchanged. The leased asset

continues to be recognised and rental income is reported in profit or loss.

For operating leases of vehicles or equipment (type A), the lessor will need to:

(a)



Recognise a lease receivable



(b)



Recognise a residual asset being the sum of the present value of any unguaranteed residual,

variable lease payments not included in the lease receivable and an allocation of profit relating to

the residual asset



(c)



Recognise the profit on the portion of the asset leased immediately in profit or loss



(d)



Recognise the unwinding of interest on the lease receivable and residual asset in profit or loss over

the lease term



4.2.8 Impact

The proposals have met with and will continue to be met with some opposition, not least because the old

distinction between operating and finance leases would disappear and companies will be required to

report larger amounts of assets and liabilities in their statements of financial position. For example, many

airlines lease their planes and show no assets or liabilities for their future commitments. Under the ED, an



Part B Accounting standards  8: Leases



255



airline entering into a lease for an aircraft would show an asset for the 'right to use' the aircraft and an

equal liability based on the current value of the lease payments it has promised to make. Possibly, as a

result, loan covenants may be breached and have to be renegotiated.

Although companies may welcome the simplification from the 2010 ED, they are less likely to welcome the

new front-loaded approach for vehicles and equipment.



4.3 Unguaranteed residual value

This was defined in Section 1 above. As we have already seen, to qualify as a finance lease the risks and

rewards of ownership must be transferred to the lessee. One reward of ownership is any residual value in

the asset at the end of the primary period. If the asset is returned to the lessor then it is he who receives

this reward of ownership, not the lessee. This might prevent the lease from being a finance lease if this

reward is significant (IAS 17 allows insubstantial ownership risks and rewards not to pass).

IAS 17 does not state at what point it should normally be presumed that a transfer of substantially all the

risks and rewards of ownership has occurred. To judge the issue it is necessary to compare the present

value of the minimum lease payments against the fair value of the leased assets. This is an application of

discounting principles to financial statements. The discounting equation is:

Present value of

minimum lease

payment



+



Present value of

unguaranteed

residual amount

accruing to lessor



=



Fair value of

leased asset



Note. Any guaranteed residual amount accruing to the lessor will be included in the minimum lease

payments.

You should now be able to see the scope for manipulation involving lease classification. Whether or not a

lease is classified as a finance lease can hinge on the size of the unguaranteed residual amount due to the

lessor, and that figure will only be an estimate. A lessor might be persuaded to estimate a larger residual

amount than he would otherwise have done and cause the lease to fail the test on present value of lease

payments approximating to the asset's fair value, rather than lose the business.



4.4 Example: Unguaranteed residual value

A company enters into two leasing agreements. Let us assume that it has a 90% line to estimate whether

the PV of the lease payments are 'substantially' equal to the fair value of the asset.



Fair value of asset

Estimated residual value (due to lessor)

Minimum lease payments



Lease A

$'000

210

21

238



Lease B

$'000

120

30

108



How should each lease be classified?



Solution

You should note that it is unnecessary to perform any calculations for discounting in this example.

Lease A: it is obvious that the present value of the unguaranteed lease payments is less than $21,000, and

therefore less than 10% of the fair value of the asset. This means that the present value of the minimum

lease payments is over 90% of the fair value of the asset. Lease A is therefore a finance lease.

Lease B: the present value of the minimum lease payments is obviously less than $108,000 and therefore

less than 90% of the fair value of the asset. Lease B is therefore an operating lease.



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8: Leases  Part B Accounting standards



4.5 Implicit interest rate

It will often be the case that the lessee does not know the unguaranteed residual value placed on the asset

by the lessor and he is therefore unaware of the interest rate implicit in the lease. In such a case, IAS 17

allows the lessee to provide his own estimate, to calculate the implicit interest rate and perform the test

comparing the PV of the lease payments with fair value of the asset. It is obviously very easy to estimate a

residual amount which fails the test. This situation would also lead to different results for the lessee and

the lessor.



Part B Accounting standards  8: Leases



257



Chapter Roundup





IAS 17 covers the accounting under lease transactions for both lessees and lessors.







There are two forms of lease:







Finance leases

Operating leases







The definition of a finance lease is very important: it is a lease that transfers all the risks and rewards of

ownership of the asset, regardless of whether legal title passes.







Make sure you learn these important definitions from IAS 17:























Lessee accounting:





Finance leases: record an asset in the statement of financial position and a liability to pay for it

(fair value or PV of minimum lease payments), apportion the finance charge to give a constant

periodic rate of return.







Operating leases: write off rentals on a straight line basis.



Lessor accounting:





Finance leases: record the amount due from the lessor in the statement of financial position at the

net investment in the lease, recognise finance income to give a constant periodic rate of return.







Operating leases: record as long-term asset and depreciate over useful life, record income on a

straight-line basis over the lease term.



You should also know how to deal with:











Minimum lease payments

Interest rate implicit in the lease

Guaranteed/unguaranteed residual values

Gross net investments in the lease



Manufacturer/dealer lessors

Sale and leaseback transactions



IAS 17 (revised) closed many loopholes, but some still argue that it is open to manipulation. An Exposure

Draft has been issued to remedy some of the abuses.



Quick Quiz



258



1



Distinguish between a finance lease and an operating lease.



2



List the disclosure requirements for lessees under finance leases.



3



What are the arguments both for and against lessees capitalising leased assets?



4



How should manufacturer or dealer lessors account for finance leases?



5



Why is the treatment of operating leases considered to be unsatisfactory?



8: Leases  Part B Accounting standards



Answers to Quick Quiz

1



(a)



A finance lease transfers substantially all the risks and rewards incident to ownership of an asset.

Title may or may not be transferred eventually.



(b)



An operating lease is a lease other than a finance lease.



2



See Paragraph 2.3.1



3



For

(a)



Substance over form



Against



4



5



(a)

(b)

(c)

(d)



Legal position

Complexity

Subjectivity

Presentation



(a)



Recognise the selling profit/loss in income for the period as if it were an outright sale.



(b)



If interest rates are artificially low, restrict the selling price to that applying on a commercial rate of

interest.



(c)



Recognise indirect costs as an expense at the lease's start.



See Paragraph 4.1.



Now try the question below from the Practice Question Bank



Number



Level



Marks



Time



Q13



Examination



25



49 mins



Part B Accounting standards  8: Leases



259



260



8: Leases  Part B Accounting standards



Share-based

payment



Topic list



Syllabus reference



1 IFRS 2 Share-based payment



C10



2 Deferred tax implications



C10



Introduction

This chapter deals with IFRS 2 on share based payment, a favourite P2 topic.



261



Study guide

Intellectual level

C10



Share-based payment



(a)



Apply and discuss the recognition and measurement criteria for share-based

payment transactions



3



(b)



Account for modifications, cancellations and settlements of share-based

payment transactions



2



Exam guide

This examiner is fond of testing share-based payment as part of a scenario question.

One of the competences you need to fulfil Objective 10 of the Practical Experience Requirement (PER) is to

compile financial statements and accounts in line with appropriate standards and guidelines. You can

apply the knowledge you obtain from this chapter, on share-based payment, to demonstrate this

competence.



1 IFRS 2 Share-based payment



Pilot paper, 12/08, 12/10, 6/12,



12/13, 6/14

FAST FORWARD



Share-based payment transactions should be recognised in the financial statements. You need to

understand and be able to advise on:









Recognition

Measurement

Disclosure



of both equity settled and cash settled transactions.



1.1 Background

Transactions whereby entities purchase goods or services from other parties, such as suppliers and

employees, by issuing shares or share options to those other parties are increasingly common. Share

schemes are a common feature of director and executive remuneration and in some countries the

authorities may offer tax incentives to encourage more companies to offer shares to employees.

Companies whose shares or share options are regarded as a valuable 'currency' commonly use sharebased payment to obtain employee and professional services.

The increasing use of share-based payment has raised questions about the accounting treatment of such

transactions in company financial statements.

Share options are often granted to employees at an exercise price that is equal to or higher than the

market price of the shares at the date the option is granted. Consequently, the options have no intrinsic

value and so no transaction is recorded in the financial statements.

This leads to an anomaly: if a company pays its employees in cash, an expense is recognised in profit or

loss, but if the payment is in share options, no expense is recognised.



1.1.1 Arguments against recognition of share-based payment in the financial

statements

There are a number of arguments against recognition. The IASB has considered and rejected the

arguments below.



262



9: Share-based payment  Part B Accounting standards



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