Lease guidance 07/11/2007

Version: Final

LEASE ACCOUNTING UNDER IFRS GAAP

Caveat

This guidance only covers the main points of lease accounting expected to be of
general application. It is not a substitute for reading and applying the full standard
and interpretations. The examples given are not part of the IFRS
standards/interpretations. Paragraph references are to the standard or an
interpretation, as indicated.

Relevant standards

IFRS accounting rules for leases are given in the following standards and
interpretations:

IAS 17 Leases
SIC 15 Operating leases – incentives
SIC 27 Evaluating the substance of transactions involving the legal form of a lease
IFRIC 4 Determining whether an arrangement contains a lease

First-time adoption of IFRS

There is no exemption for first time adoption under IFRS 1 in relation to accounting
for leases. Therefore the basic principle of full retrospection applies. All leases must
be reviewed and, to determine the amounts to be included in the financial statements,
management must go back to the inception of the lease. IAS 17, paragraph 20,
requires that a lessee under a finance lease recognises assets and liabilities equal to the
fair value of the leased property or, if lower, the present value of the minimum lease
payments.

The above analysis could result in some re-analysis between finance and operating
leases (and possibly recognition of some arrangements as leases for the first time).
The figures for finance leases for the opening balance sheet (and the 2008/09
Operating Cost Statement) will have to be calculated as if the new rules had been in
place all along. Basis for Conclusion paragraph 15 of IAS 17 addresses the possible
impracticality of retrospectively analysing property leases between land and buildings
because doing so requires estimating the fair values of the two elements. Guidance is
provided for such situations in paragraph 25 of IAS 8. Retrospective application also
requires consideration of whether an arrangement contains a lease under IFRIC 4 (see
IFRS 1, paragraph 25F).

In addition to the issues highlighted above, there are two other areas that may cause
difficulties in practice:
• lessor accounting in respect of recognising income i.e. IAS 17 requires gross
investment method whereas in SSAP 21 is recognised on a net cash
investment method. This is not a significant issue for the public sector.
• SIC 15- operating lease incentives, which require the interpretation to be
adopted retrospectively whether the incentives started before or after SIC 15
came into effect.

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Finance or operating lease?

IAS 17 Leases (para 4) defines a finance lease as a lease that transfers substantially all
the risks and rewards incidental to ownership of an asset. Operating leases are any
other leases. The classification of leases between finance and operating is therefore
based on the extent to which risks and rewards incidental to ownership of a leased
asset lie with the lessor or with the lessee (para 7).

Risks include:

• the possibility of losses from idle capacity or technological obsolescence, and

• variations in return because of changing economic conditions.

Rewards are:

• the expectation of profitable operation over the asset’s economic life, and
• gain from appreciation in value or realisation of a residual value.

Whether a lease is a finance lease or an operating leases is a matter to be decided on

the substance of each case. However, paragraph 10 of IAS 17 gives examples of
situations that individually or in combination would normally lead to a lease being
classified as a finance lease:

• the lease transfers ownership of the asset to the lessee by the end of the lease term

• the lessee has an option to purchase the asset at a sufficiently favourable price that it
is reasonably certain, at the inception of the lease, that it will be exercised

• the lease term is for the major part of the economic life of the asset even if title is
not transferred

• at the inception of the lease, the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset

• the leased assets are of such a specialised nature that only the lessee can use them
without major modifications

• if the lessee can cancel the lease, the lessor’s losses associated with the cancellation
are borne by the lessee

• gains or losses from the fluctuation in the fair value of the residual accrue to the
lessee (eg in the form of a rent rebate equalling most of the sales proceeds at the end
of the lease)

• the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.

The example below shows whether the lease is a finance lease or an operating lease:

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Key facts

A government department’s agency (lessee) leases a car from a car rental company
(lessor) for 5 years. It is assumed that the residual value is going to be £2,000 at the
end of the lease term. The interest rate applied is 3.5% and other details are as
follows:

Cost of the car £ 15,000.00

Annual Paym ent £ 3,200.00
Expected Residual value on disposal £ 2,000.00
Econom ic life 7 years
Com m encem ent Date 1 April 2008
lessee's financial year end 31 M arch

This is a finance lease because the asset is leased for a major part of its economic life
and the present value of the minimum lease payments amounts to nearly all of the fair
value of the leased asset as shown in the table below:

Year
Apr-08 Apr-09 Apr-10 Apr-11 Apr-12
0 1 2 3 4 Total
Annual Payment 3,200.00 3,200.00 3,200.00 3,200.00 3,200.00

DCF 3.5% 1.00 0.97 0.93 0.90 0.87

NPV 3,200 3,092 2,987 2,886 2,789 14,954

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Is there a lease?

IFRS defines a lease as an agreement whereby the lessor conveys to the lessee the
right to use an asset for an agreed period of time in return for a payment or series of
payments. The IFRS rules are to be applied to the substance of agreements rather
than their legal form.

Whilst in many cases it will be clear when a lease exists, IFRIC 4 Determining
whether an arrangement contains a lease provides rules for when the situation is less
clear.

Paragraph 1 of IFRIC 4 refers to arrangements that convey the right to use an asset
(possibly along with related services) but which do not take the legal form of a lease.
It gives examples of outsourcing arrangements (eg outsourcing the IT functions of an
entity) and take-or-pay and similar contracts (under which purchasers must make
specified payments regardless of whether they take delivery of the contracted
products or services).

IFRIC 4 provides guidance as to whether such arrangements are, or contain, leases.

Paragraph 6 provides that there is a lease if:

• fulfilment of the arrangement is dependent on the use of a specific asset or assets;

and
• the arrangement conveys a right to use the asset.

An asset has been implicitly specified if, for example, the supplier owns or leases only
one asset with which to fulfil the obligation and it is not economically feasible or
practicable for the supplier to perform its obligation through the use of alternative
assets (para 8).

An arrangement conveys the right to use the asset if the purchaser has the right to
control the use of the underlying asset (para 9). This occurs if any one of the
following conditions is met:

• the purchaser has the ability or right to operate the asset or direct others to do so,
while controlling more than an insignificant amount of the output, or

• the purchaser has the ability or right to control physical access to the asset while
controlling more than an insignificant amount of the output, or

• it is remote that anyone other than the purchaser will take more than an insignificant
amount of the output of the asset during the arrangement and the price of the output is
neither fixed per unit of output nor equal to the market price per unit of output as at
the time of delivery.

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The diagram below summarises how to identify a lease:

Is th e re a le a s e ?

Y es
N o
A p p ly IA S
1 7 , S IC 1 5 &
27
D o e s th is
N o
a rra n g e m e n t c o n ta in
N o t a le a s e
a le a s e ? (IF R IC 4 )

Y es

N o
Is th e re a c o n tra c tu a l N o t a le a s e
re la tio n s h ip ?

Y es

N o
Is th e re s p e c ific N o t a le a s e
a s s e t?

Y es

N o
D o e s a rra n g e m e n t N o t a le a s e
c o n ta in rig h t to u s e
th e a s s e t?

Y es

L e a se – a p p ly IA S
1 7 , S IC 1 5 & S IC 2 7

Using the above diagram, the following example illustrates an arrangement that
contains a lease.

Key facts:

A government department (purchaser) enters into an agreement with a supplier to

supply printing services. The supplier must buy equipment in order to fulfil the
agreement. The ownership of the equipment remains with the supplier, which also
has control over a significant part of the operation. The capacity of the equipment is
sufficient to meet the supplier’s current needs. Currently the supplier has no spare
capacity to supply other customers.

The supplier has the right to supply other customers but this would not be possible
without significant expansion. There are no plans to expand the capacity at the
inception of the lease. The supplier is responsible for repairs, maintenance, and the
capital outlay and is also responsible for ensuring that it can supply the minimum
quantity of printing each month. Failure to do so will result in financial penalties.
The supplier can obtain supplies from other sources but this would not be economical.

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The purchaser has agreed to pay a fixed amount each month plus variable costs based
on volume.

Is this a lease arrangement?

The above example meets the criteria as laid down in IFRIC 4 for this to be a lease
and therefore it is within the scope of IAS 17. The assets can be identified explicitly
in the agreement. The supplier has the right to enter into other lease agreements, but
to do so would require a substantial and uneconomical investment. From the
information provided, it appears that the supplier can only meet the needs of the
purchaser and has no plans to expand the capacity.

Linked transactions

SIC 27 Evaluating the substance of transactions involving the legal form of a lease
requires a series of transactions that involve the legal form of a lease to be accounted
for as one transaction when the overall economic effect cannot be understood without
reference to the series as a whole. This is the case, for example, when the transactions
are closely related, negotiated as a single transaction and take place concurrently or in
a continuous sequence (para 3).

This may result in an arrangement that includes the legal form of a lease not being
treated as a lease under IAS 17. Under paragraph 5 of SIC 27, any of the following
indicate that an arrangement may not, in substance, involve a lease under IAS 17:

• an entity retains all the risks and rewards of ownership of an asset and enjoys
substantially the same rights to its use as before the arrangement

• the primary reason for the arrangement is to achieve a particular tax result

• an option is included on terms that make its exercise almost certain

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Accounting and disclosures

Lessee: finance lease disclosures

IAS 17 requires the following information to be disclosed using the example from
above:

T h e n e t b o o k a m o u n t o f m o to r v e h ic le s in c lu d e s
£ 9 ,7 7 2 ( 2 0 1 0 ) a n d £ 1 2 ,3 6 3 f o r ( 2 0 0 9 ) i n r e s p e c t o f v e h i c l e s h e l d u n d e r
fin a n c e le a s e s .
M a r -1 0 M a r -0 9
F in a n c e L e a s e s

L ia b ilitie s :
W ith in o n e y e a r 3 ,2 0 0 3 ,2 0 0
2 -5 ye a rs 6 ,4 0 0 9 ,6 0 0
A fte r 5 y e a rs - -
9 ,6 0 0 1 2 ,8 0 0
F u tu re fin a n c e c h a rg e s o n fin a n c e le a s e 321 635
p re s e n t v a lu e o f le a s e o b lig a tio n s 9 ,2 7 9 1 2 ,1 6 5

In addition to the above requirements, IAS 17 requires disclosure of the following in

relation to finance lease:

• Contingent rents recognised as an expense for the period.

• The total of 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, the following:

(a) the basis on which contingent rent payable is determined;

(b) the existence and terms of renewal or purchase options and escalation
clauses; and
(c) restrictions imposed by the lease arrangements, such as those
concerning dividends, additional debt, and further leasing.

The above example shows the IAS 17 disclosures the lessee should make in relation
to finance leases (and not the lessor). Other disclosures might be required under other
standards and Interpretations.

IAS 17 requires a number of detailed disclosures that are not required by SSAP 21.
For example, SSAP 21 does not require lessees to disclose the total amount of the
operating lease commitments to be disclosed. Instead, it requires the annual
commitment to be disclosed with an indication of the period to expiry of the
commitment. In addition to meeting the IAS 17 requirements, the lessee must also
meet the disclosure requirements of IFRS 7 where appropriate and other relevant
interpretations.

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Operating Lease disclosure

Payments under an operating lease will be recognised by the lessee as an expense over
the lease term.

In addition to complying with IFRS 7 where relevant lessees will make the following
disclosures for operating leases:

(a) the total of future minimum lease payments under non-cancellable operating
leases for each of the following periods:
(i) not later than one year;
(ii) later than one year and no later than five years;
(iii) later than five years

(b) the total of future minimum sublease payments expected to be received under
non-cancellable subleases at the balance sheet date.

(c) lease and sublease payments recognised as a expense in the period, with
separate amounts for minimum lease payments, contingent rents, and sublease
payments.

(d) a general description of the lessee’s significant leasing arrangements

including, but not limited to, the following:

(i) the basis on which contingent rent payable is determined;

(ii) the existence and terms of renewal or purchase options and escalation
clauses; and
(iii) restrictions imposed by lease arrangements, such as those concerning
dividends, additional debt and further leasing.

Operating Leases – Incentives (SIC 15)

SIC 15 provides guidance on how to recognise lease incentives, which the lessor may
give to the lessee to enter into a lease agreement. The guidance is for both lessor and
lessee. Consider the example below:

Key facts:

A department signs a lease agreement with a lessor. The lessor agrees to provide the
first two years rent-free as an incentive to the lessee for entering into the lease
arrangement. The lease term is for 15 years and the rent per annum, which is fixed, is
£500,000 starting in year 3.

The accounting for the above transaction is:

The lessee will pay in total £6.5m over the life of the lease. Both the lessee and lessor
will recognise a net consideration of £6.5m over the 15 year-lease term on a straight-
line basis. The lessor will recognise the cost of the incentives as a reduction of rental
income over the lease term. The lessee will recognise the benefits of the incentives as
a reduction of rental expense over the lease term.

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Accounting for sale and leaseback transaction

A sale and lease back involves the selling of an asset by the vendor, which is then
immediately leased back by entering into a lease with the buyer. Companies adopt
this type of approach to release cash.

The approach to sale and leaseback under IAS 17 can be seen from the example
below:

A government department owns a freehold interest in a building. The department

sells the building to a property company and leases it back for a period of 25 years.
The lease term is considered to be for the major part of the building’s economic life.
Other details about the building are set out below:

Book value of the building £20m

Proceeds from the sale £25m
Lease rentals per annum £1.1m
Present value of minimum lease payments £15m
Interest Rate implicit in lease 6%

The leaseback of the building is for the major part of the building’s economic life.
Therefore this is a finance lease in accordance with IAS 17. Where the sale and
leaseback transaction results in a finance lease, any excess of sales proceeds over the
carrying amount is not immediately recognised as income by the seller (lessee).
Instead it is deferred and amortised over the lease term as shown below:

The government department will record the following double entry:

E n tries o n S a le
Dr Cr
B ank £25m
P ro p erty & B u ild in g £20m
D eferred in co m e £5m
T o set u p th e a sset a n d lia b lility u n d er fin a n ce lea se
A sset h eld u n d er fin an ce lease £15m
F in an ce L ease cred ito r £15m

T h e d eferred in co m e trea tm en t o v er th e lea se term

D eferred in co m e (£ 5 m /2 5 years) £250k

O p eratin g C o st S tatem en t (O C S ) £250k

D ep reciatio n C h arge (£ 1 5 m /2 5 years)

D ep reciatio n (O C S ) £600k
A sset h eld u n d er fin an ce lease £600k
O th er en tries
In terest (O C S ) £826k
F in an ce lease cred ito r (B alan ce sh eet) £274K
B an k £ 1 .1 m

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Property leases

IAS 17 (para 15) requires that the land and buildings elements of a property lease
should be considered separately for lease classification, unless the land element would
be immaterial (para 17). Land normally has an indefinite economic life. Therefore,
unless title is expected to pass to the lessee by the end of the lease term, the lessee
does not receive substantially all the risks and rewards of ownership and the lease of
land is an operating lease (para 14). The buildings element is classified as a finance
or operating lease, in line with the rules above.

When splitting a property lease, the minimum lease payments are allocated between
the land and buildings elements in proportion to the fair values of the leasehold
interests in the land and building elements of the lease at its inception (para 16).
More information is given on this at BC 9-11 of IAS 17. If the lease payments cannot
be allocated reliably between the two elements, the entire property lease is classified
as a finance lease, unless it is clear that they are both operating leases.

Embedded derivatives

Embedded derivatives may be present in a lease host contract. An embedded

derivative is defined in IAS 39 as a financial instrument with all these characteristics:

• its value changes in response to changes in an ‘underlying’ price or index;

• it requires no initial net investment or an initial net investment that is smaller
than would be required to purchase the underlying instrument; and
• it is settled at a future date.

IAS 39 requires embedded derivatives to be split from the host contract and accounted
for separately. Some analysis would be required to established whether or not an
embedded derivative is present in a lease contract and if so further analysis will be
required to identify those which are closely related and those which are not closely
related.

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