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IAS 17 Summary Notes

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IAS 17 Leases

DEFINITIONS

LEASE AND ITS TYPES

Lease 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.

Finance lease

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.

Operating lease

An operating lease is a lease other than finance lease.

Non-cancelable lease

A non-cancelable lease is a lease that is cancelable only: (a) Upon the occurrence of some remote contingency; (b) With the permission of lessor; (c) If the lessee enters into a new lease for the same or an equivalent asset with

the same lessor; or (d) Upon payment by the lessee of such an additional amount that, at inception of

the lease, continuation of the lease is reasonably certain.

EXAMPLE 17A

Hameed Limited has entered into following five separate lease agreements. You are required to tell whether these lease agreement are cancelable leases or non-cancelable leases: (a) A building lease for 5 years which Hameed Limited can cancel at any time by making the

payment for the period they had occupied the building. (b) A car lease for 10 years which Hameed Limited can cancel if the market value of car gets

double the current price, the chance of which is less than one percent. (c) A plant leased for 25 years from Multan Limited which Hameed Limited can cancel if Multan

Limited so permits. (d) A car leased for 5 years which Hameed Limited can cancel if Hameed Limited enters into

another 5 year car lease of same model car with the same lessor. (e) A factory lease for 5 years which Hameed Limited can cancel at any time by making the

payment for the whole lease term of 5 years.



IMPORTANT DATES

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: (a) A lease is classified as either an operating or finance lease; and (b) In the case of finance lease the amounts to be recognised at the

commencement of the lease term are determined.

Commencement of 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.

EXAMPLE 17B

J Limited enters into a contract for the lease of a car with K Leasing Limited on January 18. K Leasing Limited agrees to transfer the car in the name of J Limited on 3rd of February. However, J Limited would have the right to use the car as at February 22. You are required to answer the following: (a) What is the date of inception of the lease? (b) What is the date of commencement of lease term?

IMPORTANT PERIODS

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 lessee will exercise the option.

Economic life

is either: (a) The period over which an asset is expected to be economically usable by one

or more users; or (b) The number of production or similar units expected to be obtained from the

asset by one or more users.

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.

EXAMPLE 17C

S Limited acquired a plant on lease for a period of 6 years. S Limited has right to extend the period of lease further 4 years at the end of first 6 years. You are required to calculate the lease term assuming that S Limited: (a) Has intention to extend the period. (b) Has no intention to extend the period.



EXAMPLE 17D

B Limited acquired a second hand plant. The total life of such plant (new) is 12 years. The plant has already been used for 4 years by previous owners. B Limited intends to use the plant for 5 years and then wants to sell it to someone else. You are required to calculate the: (a) Economic Life (b) Useful Life (c) Remaining Economic Life

FINANCE LEASE CALCULATION

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 guaranteed residual value (GRV). If there is bargain purchase option (BPO), the value of BPO is added rather than GRV. = Down payment + Lease Rentals excl. contingent rent etc. + BPO or GRV

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).

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.

HOW TO CALCULATE PRESENT VALUE (PV) DISCOUNT FACTOR

Single payment = (𝟏 + 𝒊)−𝒏

Annuity (end of period) =𝟏 − (𝟏 + 𝒊)−𝒏

𝒊

Annuity due (beginning of period) =

𝟏 − (𝟏 + 𝒊)−𝒏+𝟏

𝒊+ 𝟏



CLASSIFICATION

INTRODUCTION

Substance

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. Where repair and maintenance charges, insurance charges, the loss due to idle capacity are to be borne by lessee and the major economic benefits are to accrue to lessee, there is an indication that risk and rewards have been transferred to lessee.

Examples

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): (a) Transfer of ownership to lessee at the end of lease term; (b) The bargain purchase option or bargain renewal option at the end of lease

term; (c) The lease term in 75% (generally) or more of asset’s economic life; (d) PV of MLP is 90% (generally) or more of FV of asset; (e) The leased asset is of such specialized nature that only lessee can use it

without major modification; (f) Lessor’s losses associated with the cancellation of lease are borne by the

lessee; or (g) Gain or losses from the fluctuation in fair value accrue to the lessee.

Timing Lease classification is made at the inception of the lease.

Different classification

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

New Lease

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.

Changes in estimates

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 for accounting purposes.



LEASE OF LAND AND BUILDING

Consider separately 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 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.

Allocation of MLP The MLP are allocated between the land and the buildings elements in proportion to the relative fair value of the leasehold interest.

If MLP cannot be allocated

If the MLP cannot be allocated reliably, 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.

If land element is immaterial

The land and buildings may be treated as a single unit. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.

EXAMPLE 17E

You are required to advise regarding classification of these leases: (a) E Limited acquired a special customized engine. The engine can only be used by E Limited

unless substantial modifications are made to the engine. (b) P Limited acquired an asset on lease with fair value of $ 100,000 and present value of MLP

is $ 92,500 (c) M Limited acquired an asset on lease economic life of 20 years while M Limited wants to use

the asset only for 17 years. The company has no intention to purchase the asset at the end of its lease term.

(d) T Limited acquired an asset on lease with an option to buy the asset at the end of lease term for $ 12,000. The fair value of the asset at the end of lease term is expected to be at-least $ 55,000.

(e) R Limited acquired an asset on lease 1 January 2007. The lease term was 10 years with no option to purchase. The lease was classified as operating lease. On 1 January 2011 the lessor and lessee agreed to include a bargain purchase option and now lessee can buy the asset at the end of lease term below its fair value.

(f) S Limited acquired a building with land on lease. The building has remaining economic life of 25 years and will be transferred to S Limited at the end of lease term. However, the title of land shall not be transferred.



FINANCE LEASE – LESSEE

ACCOUNTING

Journal Entry Time of recognition By the amount

Dr. Asset under FL Cr. Liability under FL


Lower of PV of MLP and FV calculated at inception of lease

Dr. Asset under FL Cr. Bank/Payable

When initial direct costs are incurred


Dr. P&L Cr. Asset under FL / Acc. Dep.

At year end As per depreciation policy

Dr. Interest expense Cr. Interest payable

At year end The interest accrued during the year

Dr. Interest payable Dr. Liability under FL Cr. Bank

At the time rental is paid

Interest (Schedule) Principal amount (Schedule) Total rental

Dr. Contingent rent Cr. Bank / payable

The period in which they are incurred

As calculated under agreement

IMPORTANT POINTS - LESSEE

Discount rate

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.

Depreciation The asset shall be fully depreciated over the shorter of the lease term and its useful life unless it is reasonable certain that lessee shall obtain ownership of the asset in which case the asset shall be fully depreciated over its useful life.



FINANCE LEASE - LESSOR

ACCOUNTING – NORMAL LESSOR


Dr. Net investment Cr. Asset Cr. Bank/Payables


PV of (MLP + UGRV) Fair value Initial direct costs

Dr. Interest receivable Cr. Interest income


Dr. Bank Cr. Interest receivable Cr. Net Investment

At the time payment/rental is

received

Total rental Interest Principal amount (Schedule)

Dr. Bank / accrual Cr. Contingent rent



ACCOUNTING – MANUFACTURER OR DEALER LESSOR


Dr. Net investment Cr. COS Cr. Sales revenue


PV of (MLP + UGRV) PV of UGRV Lower of FV & PV of MLP at market rate

Dr. Selling exp. Cr. Cash

When incurred Initial direct costs

Dr. Interest receivable Cr. Interest income


Dr. Bank Cr. Interest receivable Cr. Net Investment

At the time payment/rental is

received

Total rental Interest Principal amount (Schedule)

Dr. Bank / accrual Cr. Contingent rent



IMPORTANT POINTS - LESSOR

All lessors Lessors shall recognize assets held under finance lease in their statement of financial position and present them as a receivable at an amount equal to the NI (GI – UFI).

Normal Lessor

The interest rate in the lease is defined in such a way that the initial direct costs are included automatically in finance lease receivable; there is no need to add them separately.

Manufacturer or dealer lessor

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 such amount as if a market rate of interest were charged.



EXAMPLE 17F

J Limited (JL) leased a plant under finance lease on 1 January 2011. The lease term is 4 years; however, JL uses similar owned assets for 5 years. The fair value of the asset is $ 11,420 and JL incurred initial direct costs of $ 580. The interest rate implicit in lease is 15%. Rentals of $ 4,000 are payable on 31 December (also financial year end) each year. Assume that contingent rent of $ 600, $ nil, $ 800, $ 750 was paid in year 2011, 2012, 2013 and 2014 respectively. You are required to give financial statements extracts along with workings.

OPERATING LEASE – LESSEE

Accounting treatment

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.

Journal entry Dr. Lease rental expense Cr. Bank / Accrual / Prepayment

EXAMPLE 17G

Faheem Limited (FL) leased an asset under operating lease of building on 1 January 2011. According to agreement, $ 1,600 was paid as initial deposit and further rental of $ 1,000 shall be paid at the end next two years and then $ 3,200 shall be paid for following two years. The lease term is also 4 years. You are required to give journal entries over the lease term.

OPERATING LEASE - LESSOR

Lease income 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.

Asset Asset shall be presented in statement of financial position as per its nature.


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.

Depreciation The deprecation is to be charged as per normal depreciation policy.

Journal entry Dr. Bank/accrual Cr. Lease/Rent income

SALE AND FINANCE LEASE BACK

Resulting in profit

The profit shall not be immediately recognised as income by a seller lessee. Instead, it shall be deferred and amortised over the lease term.

Resulting in loss

The loss shall be recognised immediately (generally as impairment loss).



EXAMPLE 17H

On January 01, 2011 Kamal Limited (KL) sold its two plant to a leasing company and leased them back under finance leases on the same date. The details are as follows:

Plant Carrying amount $ Sale price $ Lease term

I 80,000 100,000 4 years

II 50,000 40,000 5 years

Required: Journal entries on January 01, 2011

SALE AND OPERATING LEASE BACK

CA > FV? Yes Recognise impairment

loss immediately

No

SP = FV? Yes Recognise profit or

loss immediately

Yes Amortise loss over lease term

No

SP < FV? Yes Rentals

compensated?

Recognise loss immediately

No No

SP > FV ? Yes Profit up to FV is recognised immediately (FV – CA)

The excess (SP – FV) should be amortised over lease term

Example 17I

Pass the journal entries for following sale and leaseback transactions resulting in operating leases:

Situation I II III IV V VI VII VIII

Carrying amount ($) 100 100 100 100 100 100 100 100

Sale price ($) 110 80 80 125 80 70 70 80

Fair value ($) 110 110 110 110 80 80 80 70

Rental p.a. - market ($) 25 25 25 25 25 25 25 25

Rental p.a. – actual ($) 25 25 20 25 25 25 20 25

EFFECT OF INCORRECT CLASSIFICATION

If a finance lease is incorrectly treated as an operating lease it will have following impact on financial statements and ratios:

FS Ratios

Assets understated and liability understated ROCE is overstated & Gearing in understated

Depreciation not charged, Interest not charged but lease rental is charged as expense.

Negligible temporary effect on profit for the period.



ANSWER 17A

(a) Cancelable Lease (b) Non-cancelable Lease (c) Non-cancelable Lease (d) Non-cancelable Lease (e) Non-cancelable Lease

ANSWER 17B

(a) Inception of the lease January 18 (b) Commencement of lease term February 22

ANSWER 17C

(a) 10 years (b) 06 years

ANSWER 17D

(a) 12 years (b) 05 years (c) 08 years

ANSWER 17E

(a) Finance lease (b) Finance lease (c) Finance lease (d) Finance lease (e) This is case of change in classification. From January 01, 2011 the lease shall be classified

as finance lease as if it was new agreement. (f) The lease of building is finance lease while the lease of land is operating lease.



ANSWER 17F

Statement of comprehensive Income (extracts)

2011 2012 2013 2014

$ $ $ $ Depreciation expense 3,000 3,000 3,000 3,000 Interest expense 1,713 1,370 975 522 Contingent rent expense 600 - 800 750

Statement of financial position (extracts) 2011 2012 2013 2014 Non-current assets $ $ $ $ Plant under finance lease 12,000 12,000 12,000 Accumulated depreciation (3,000) (6,000) (9,000)

9,000 6,000 3,000 -

Non-current liabilities Liability under finance lease 6,503 3,478 - - Current liabilities Liability under finance lease 2,630 3,025 3,478 - Interest payable - - - -

Working 1 Finance Lease (Payments in arrears) Schedule

Payment time

Liability at

beginning

Interest @ 15%

Rental Principal Element

Liability after

payment

T Rupees

31.12.2011 11,420 1,713 4,000 (2,287) 9,133

31.12.2012 9,133 1,370 4,000 (2,630) 6,503

31.12.2013 6,503 975 4,000 (3,025) 3,478

31.12.2014 3,478 522 4,000 (3,478) -



ANSWER 17G

The journal entries are:

Date Particulars Dr. $ Cr. $

01.01.11 Prepaid lease rental 1,600 Cash 1,600

31.12.11 Lease rental expense 2,500 Cash 1,000 Prepaid lease rental 1,500

31.12.12 Lease rental expense 2.500 Cash 1,000 Prepaid lease rental 100 Accrued lease rental 1,400

31.12.13 Lease rental expense 2.500 Accrued lease rental 700 Cash 3,200

31.12.14 Lease rental expense 2.500 Accrued lease rental 700 Cash 3,200

ANSWER 17H


Date Particulars Dr. $ Cr. $

01.01.11 Cash 100,000 Plant I 80,000 Deferred income (to be amortised over lease

term) 20,000

01.01.11 Plant I under finance lease 100,000 Liability under finance lease 100,000

01.01.11 Cash 40,000 Profit or loss 10,000 Plant II 50,000

01.01.11 Plant I under finance lease 40,000 Liability under finance lease 40,000



ANSWER 17I


Situation Particulars Dr. $ Cr. $

I Cash 110 Profit or loss 10 Asset 100

II Cash 80 Profit or loss 20

Asset 100

III Cash 80 Deferred loss 20 Asset 100

IV Cash 125 Profit or loss 10 Deferred income 15 Asset 100

V Profit or loss (Impairment loss) 20 Asset 20

Cash 80 Asset 80

VI Profit or loss (Impairment loss) 20 Asset 20 Cash 70 Profit or loss 10 Asset 80

VII Profit or loss (Impairment loss) 20 Asset 20 Cash 70 Deferred loss 10 Asset 80

VIII Profit or loss (Impairment loss) 30 Asset 30 Cash 80 Deferred income 10 Asset 70

Dated: 19 August 2016

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