INTRODUCTION
Leasing represents a very common and important method of acquiring non-current assets. A lease can offer very significant cash flow advantages, as the payment of the full cost of an asset on acquisition is avoided.
Under a lease agreement, the lessee enters into a contract with the lessor in which an asset is essentially hired by the lessee. For the duration of the lease, legal ownership of the asset does not pass from the lessor to lessee. In fact, legal ownership might never pass to the lessee, title remaining with the lessor indefinitely.
However, IAS 17 takes the view that the substance of the transaction should be considered over its legal form. If the risks and rewards of ownership pass substantially to the lessee, IAS 17 states that the leased asset should be capitalised in the balance sheet and a liability created to reflect the outstanding debt due to the lessor.
On the other hand, if the risks and rewards are not transferred to the lessee, then the leased asset should not be capitalised. Instead, lease payments are simply expensed to the Statement of Comprehensive Income in the period in which they occur.
TYPES OF LEASES
There are two broad categories of leases.
- 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 a finance lease.
Because the accounting treatment of these leases is very different, it is important to be able to distinguish between them. To this end, IAS 17 gives examples of situations that, either individually or in combination, would normally lead to a lease being classified as a finance lease. These are where:
- The lease transfers ownership of the asset to the lessee by the end of the lease term
- The lessee has the option to purchase the asset at a price expected to be lower than the fair value at the date the option becomes exercisable, so that the exercise of the option is reasonably certain
- The lease term is for the major part of the economic life of the asset
- At the start of the lease the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset
- The leased assets are of a specialised nature so that only the lessee can use them without major modifications
- Gains or losses from fluctuations in the fair value accrue to the lessee
- The lessee has the ability to continue the lease for a secondary period at a rent that is substantially below market rent
ACCOUNTING TREATMENT OF LEASES
- Operating Lease
Lease payments should be recognised as an expense on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern of the users benefit.
Hence, the treatment of operating leases is straightforward as the lease payments appear in the Statement of Comprehensive Income as an expense.
Finance Leases
The treatment of finance leases is more complicated. In summary, the main points are:
- The leased asset is capitalised in the balance sheet and is subsequently depreciated
- A liability is created at the start of the lease in respect of the amount outstanding to the lessor
- The lease payments are split into their interest portion and capital portion. The interest is treated as a finance charge in the Statement of Comprehensive Income. The capital portion reduces the liability in the balance sheet.
- By the end of the lease term the asset will be fully depreciated and the liability cleared from the balance sheet
DETAILED TREATEMENT OF FINANCE LEASES
On commencement of the lease, the asset concerned must first be valued so that the asset and liability can initially be measured.
IAS 17 states that the asset, and thus the liability, should initially be recorded at the lower of: (a) The fair value; and
- The present value of the minimum lease payments. (In essence, these are the payments the lessee is required to make over the entire lease, discounted at the implicit interest rate of the lease. If this interest rate cannot be determined, the incremental borrowing rate of the lessee is used).
Therefore, at the start of the lease:
Dr Non-Current Assets
Cr Leasing Obligation
With fair value of the leased asset (or the present value of the minimum lease payments, if lower)
The leased asset is subsequently depreciated over the shorter of:
The useful economic life of the asset; or The lease term
[Note: The lease term may comprise both a primary period and a secondary period. The secondary period is included in the lease term if it is reasonably certain at the beginning of the lease that this period will be exercised]
As the lease progresses, the finance charge included in the lease payments must be calculated and charged to the Statement of Comprehensive Income.
This means that the lease payment must be split into its component parts:
Finance cost, charged to Statement of Comprehensive
Income
Lease Payment
Capital portion, reducing balance sheet liability
Thus, for each lease payment under a finance lease:
Dr Statement of Comprehensive Income (interest element) Dr Leasing obligation in balance sheet (capital element)
Cr Bank
In calculating the amount of the finance charge, there are two main methods:
- The actuarial method
- The sum of digits method, also known as the Rule of 78
The aim of each method is to allocate the finance cost in such a way as to produce a reasonably constant periodic rate of return on the outstanding balance of the leasing obligation.
PAYMENTS IN ADVANCE
In the examples used so far, the lease payments were “in arrears” i.e. the payment is made on the last day of the period.
If the payments are made in advance, i.e. on the first day of the period, the calculation of interest and therefore the closing balance of the lease obligation is different.
Actuarial Method
RECORDING FINANCE AND OPERATING LEASES IN THE BOOKS OF THE LESSOR
If an asset has been acquired under a lease agreement by the lessee, the treatment of the lease in the books of the lessor will be the converse of that adopted by the lessee.
Thus, as we have seen, in a finance lease the lessee treats the asset in a similar way to an owned asset. It is capitalised and depreciated. Taking this substance over form concept to its logical conclusion, the lessor has provided finance to the lessee. This means that in the lessor’s books, the finance lease should be treated as being equivalent to the provision of finance.
It follows that the operating lease should be accounted for by the lessor by capitalising and depreciating the asset.
The differences between the two types of leases can be summarised as follows:
| Statement | Finance Lease | Operating Lease |
| Statement of Financial Position | Show a receivable in respect of the Net Investment in Finance Lease | Show the asset at cost less depreciation, as property held for Operating Leases |
| Statement of Comprehensive Income | Finance Income, allocated to give a constant periodic return on investment | Rental Income, Depreciation |
In treating the finance lease, the lessor will create a receivable in the balance sheet, in respect of the net investment in the lease. This is the cost of the asset less any grants receivable.
The lease rentals that the lessor then receives must be split into:
- Interest element, shown then as gross earnings in the Statement of Comprehensive Income; and
- The repayment of capital, reducing the receivable in the balance sheet
In other words, the lessor treatment of the finance lease is the mirror image of the lessee’s treatment of the same lease.
In the case of an operating lease, the lessor will show the asset in its balance sheet. Lease rentals from the lease should be shown in the Statement of Comprehensive Income on a straight-line basis over the life of the lease. Depreciation of the asset should also be provided for.
DISCLOSURE REQUIREMENTS FOR LESSEES
Finance Leases
In addition to complying with IAS 32 Financial Instruments, the following information must be disclosed for finance leases:
- The net carrying amount in the balance sheet for each class of asset
- A reconciliation between the total future minimum lease payments and their present value, at the balance sheet date.
In addition, disclose the future minimum lease payments and their present value, analysed 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
- Contingent rents recognised as an expense in the period.
- The total future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date
- A general description of the lessee’s material leasing arrangements, including but not limited to: (i) The basis on which contingent rent payable is determined
- The existence and terms of renewal or purchase options and escalation clauses
- Restrictions imposed by lease agreements, such as those concerning dividends, additional debt and further leasing
Operating Leases
In addition to meeting the requirements of IAS 32, the following information must be disclosed for operating leases:
- The total future minimum lease payments under non-cancellable operating leases 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
- The total future minimum sublease payments expected to be received under non-cancellable subleases at the balance sheet date
- Lease and sublease payments recognised as an expense in the period with separate amounts for minimum lease payments, contingent rents and sublease payments
- A general description of the lessee’s significant leasing arrangements including, but not limited to:
- The basis on which contingent rent payable is determined
- The existence and terms of renewal or purchase options and escalation clauses
- Restrictions imposed by lease arrangements, such as those concerning dividends, additional debt and further leasing
DISCLOSURE REQUIREMENTS FOR LESSORS
Finance Leases
In addition to meeting the requirements in IAS 32, the following must be disclosed:
- A reconciliation between the gross investment in the lease at the balance sheet date and the present value of minimum lease payments receivable at the balance sheet date.
In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the balance sheet date, for each of the following periods: (i) Not later than one year
- Later than one year and not later than five years
- Later than five years
- Unearned finance income
- Unguaranteed residual values accruing to the benefit of the lessor
- The accumulated allowance for uncollectible minimum lease payments receivable
- Contingent rents recognised as income in the period
- A general description of the lessors material leasing arrangements
Operating Leases
In addition to meeting the requirements of IAS 32, the following must be disclosed:
- The future minimum lease payments under non-cancellable operating leases in 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
- The total contingent rents recognised as income in the period
- A general description of the lessors leasing arrangements
SALE AND LEASEBACK TRANSACTIONS
If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount should be deferred and amortised over the lease term. The excess therefore should not be immediately recognised as income by the seller-lessee.
This is because the transaction is a means whereby the lessor provides finance to the lessee, with the asset as security. It would not be appropriate therefore to recognise the excess as income.
If the sale and leaseback transaction results in an operating lease and it is clear that the transaction reflects fair value, any profit or loss should be recognised immediately.
If the sale price is below fair value, any profit or loss shall be recognised immediately, unless the loss is compensated for by below market price future lease payments. If this is the case, it should be deferred and amortised in proportion to the lease payments over the period which the asset is to be used.
If the sale price is above fair value, the excess over fair value should be deferred and amortised over the period which the asset is to be used.
In the case of operating leases, if the fair value at the time of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference should be recognised immediately.
