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Draft Guideline on IFRS Lease Accounting

Draft Guideline on IFRS Lease Accounting

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Published by Kwadwo Asomaning

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Published by: Kwadwo Asomaning on Nov 24, 2010
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12/16/2009

Guideline on IFRS Lease Classification
Purpose: This guideline covers the definition and accounting treatment of operating and financial leases under International Financial Reporting Standards (IFRS). It serves as an introductory document to allow readers quick understanding of fundamental principles governing the classification. However it is not a substitute for reading and applying the full IFRS standards and APMT Finance Manual. Relevant Standards: IFRS accounting rules for leases are defined 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 IFRIC 12 Service concession agreements IFRS Official Definition: IAS 17 Leases 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. Assets under financial lease are required to be recognized on the lessee’s balance sheet while assets under operating lease are free from such balance sheet recognition. On the P&L, the financial lease payment is split between depreciation and interest expenses while the operating lease payment is booked entirely under operating expenses. Under IFRS, the classification of a lease into finance lease or operating lease is governed by substance instead of form. Paragraph 10 of IAS 17 gives examples of situations that each 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 favorable 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 specialized 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 (e.g. in the form of a rent rebate equaling 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.


In practice, if lease term exceeds 75% of economic life or NPV of minimum lease payment exceeds 90% of market value of assets, the lease arrangement is considered a finance lease. Tips for Leasing Decision:

• • • •

Business needs should prevail (e.g. do not take a long term required asset on a short term operating lease) Operating lease reduces assets on the balance sheet. But it can be expensive as lessor will charge a margin Tax benefits differ for owning assets, operating lease and financial lease Lease vs. Buy decision should be analyzed with discounted cash flow tools on an after-tax basis to determine the value proposition for shareholders 1

maintenance. Assessment: This is an operating lease as the present value of future minimum lease payment (i.Version: 1.0 • 12/16/2009 Consult your regional and global finance and accounting expert before you make a major leasing decision Four practical examples have been provided below to illustrate how the IFRS standards are applied: Practical Example 1: company cars annual lease agreement Terminal A leases 5 company cars from a local automobile leasing company. 2 . Practical Example 3: Land and quay under concession agreement Terminal C is managed by APMT and has a concession for 20 years. Assessment: This is a financial lease as the term of the lease covers the majority of the cranes’ economic useful life and the losses associated with lease cancellation are borne by terminal B. the same year the concession agreement expires. the lease assets have to be recognized on Terminal B’s balance sheet based on the present value of future lease payments. Practical Example 4: IT process outsourcing Region D has just outsourced the entire IT function to IBM for 4 years.). In addition. There is a base service fee of $10 million per year plus $5 million per year to compensate IBM for operating cost (e. Practical Example 2: Quay cranes sales and lease back Terminal B just sold 10 quay cranes to a bank and then leases them back for a fixed term of 25 years until year 2034. IFRIC 4 has specific provisions that cover similar situations. The leasing agreement is for a period of two years and the terminal is expected to hand back the cars at the end of lease period. This involves utilizing dedicated IBM servers and other IT equipment worth $30 million. Terminal A can cancel the lease agreement with one month advance notice and it has no option to purchase the car at the end of the lease. personnel. As a result. On the other hand. The crane has an economic useful life of 30 years and has just been installed in terminal B last year. quay wall and other infrastructure with a market value of $200 million. There is a clause that region D retains exclusive rights to use the servers and other IT equipment associated with the deal. The lease period is significantly lower than the economic life of cars. This highlights the need to consult your regional and global experts on the right accounting treatment. Assessment: This is an operating lease as the automobile leasing company retains the risks and rewards of the leases cars. There is a termination clause in the leasing agreement that Terminal B has to cover all the losses by the bank if the lease is terminated by Terminal B prematurely.e. Assessment: This is a complicated case with elements in normal outsourcing.g. The local Port Authority prepares land. etc. the economic useful life of land and quay walls is much longer than 20 years. fixed annual concession fee) is not material when compared with the fair market value of assets. The concession fee is fixed at $5 million per year with an additional royalty at $10 per TEU handled. there is no minimum lease payment liability and the terminal has no option to purchase the cars. operating lease and financial lease and a conclusion will require detailed analysis. IBM is protected by a $15 million early termination compensation clause in the contract.

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