Topic 4

IAS 17 Leases

Exam Context
Could appear both as an adjustment in the
financial statements preparation question or
as a self-contained question elsewhere in the
paper.

What is a leasing agreement?

A leasing agreement is an agreement
whereby one party, the lessee, pays lease
rentals to another party, the lessor in
order to gain the use of an asset over a
period of time.

Issue
Certain types of contracts where a company leases an
asset from another company, are very similar in
substance to the outright purchase of that asset. This is
true even if legal title to the asset never passes to the
lessee.
If these leases are accounted for in accordance with the
strict legal form a companys assets and liabilities are
likely to be understated having an impact on the
gearing and liquidity ratios.
Failing to record the true substance of the transaction is
an example of off-balance sheet financing.
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2 Types of lease
IAS 17

Finance lease
Is a lease that transfers
substantially all the risks &
rewards incidental to ownership
of an asset to the lessee.
Legal title may or may not be
transferred.
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Operating lease
A lease that is
NOT a finance
lease.

Classification of leases
To decide whether a lease is a finance or
operating lease, the first step is to assess
whether the risks and rewards of
ownership have been transferred to the
lessee.
If this is inconclusive, IAS 17 provides
additional guidance.
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Risks and rewards of ownership

Risks

Rewards

Lessee carries out repairs

and maintenance
Lessee insures asset
Lessee runs the risk of
losses from idle capacity
Lessee runs the risk of
technological
obsolescence

Lessee has the right to

use the asset for most or
all of its useful life

Finance lease indicators per IAS 17

1.

Transfer of ownership to the lessee @ end of lease

term,

2.

Lessee has the option to purchase at sufficiently <

FV @ exercise date & it is reasonably certain the
option will be exercised,

3.

Lease term is for a major part of assets economic

life even if title is not transferred,

4.

At the beginning of the lease the PVMLP is

approximately = FV of the asset,

5.

Leased asset is so specialised it can only be used by

lessee without major modifications being made.

IAS 17 - Overview
Business enters into lease agreement
Finance Lease?

Operating lease?

Treatment:
Capitalise asset, LOWER of

Treatment:
Charge rentals on
a systematic
(even) basis over
lease period to the
SOCI.

PVMLP &
FV

Set up finance lease liability

Repayments split between
finance charge & capital.
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Lease Term
The non-cancellable period for which the
lessee has contracted to lease the asset +
any further terms for which the lessee has
the OPTION of leasing the asset with or
without further payment, which option it is
reasonably certain at the inception of the
lease will be exercised.

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MLP = Minimum Lease Payments

The payments over the lease term that the lessee is
required to make.
Fair value The amount for which an asset can be exchanged or
liability settled between knowledgeable & willing
parties in an arms length transaction

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Interest rate implicit in the lease

The discount rate that at the inception of the
lease, causes the aggregate PVMLP & the unguaranteed residual value to be equal to the FV
of the leased asset.

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Accounting treatment Finance leases

At inception of lease:
Capitalise asset & recognise liability
Dr
Cr

Property, plant and equipment (NCAs)

Finance lease liability

FV leased OR
property (if lower)

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PVMLP

Lease payments
Lease payments
Capital

Interest
Total repayments
Less: PVMLP/FV

X
(X)

= Finance charge X
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Allocating the finance charge

It is important to distinguish between leases
repayable in ADVANCE & those repayable in
ARREARS. The calc. of interest differs depending
on which applies.
The basic rule is:
Interest is calculated in proportion to the capital o/s.
Thus, if the lease is payable in advance, there is
less capital o/s for the yr.

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A/C treatment
Recording the finance charge (Interest)
Dr Interest expense
X
Cr Finance lease liability

SOCI
SOFP

Recording the rental paid

Dr Finance lease liability
Cr Cash

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Cash pd

2 Scenarios
1. Payments in ARREARS
2. Payments in ADVANCE (no interest in 1st
repayment)

Note the distinction between the 2!

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Example 1
XYZ leases an asset on 1.1.2001. The terms
of the lease are to pay a non-refundable
deposit of 575 followed by seven
instalments of 2,000 payable in arrears.
The fair value of the asset (equivalent to the
present value of minimum lease payments)
on 1.1.2001 is 10,000.
The interest rate implicit in the lease is 11%.

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Required
Calculate;
1.The interest charge and the deprecation
charge to be recognised in the statement
of comprehensive income in 2001.
2.The finance lease liability in the statement
of financial position for the year ended
31.12.2001.

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Example 1
Statement of comprehensive income(extract)

Finance cost (W)

Deprecation charge (W)
Statement of financial position(extract)

Non-current liabilities
Finance lease liability (W)
Current liabilities
Finance
lease liability (W)
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Depreciating the asset

No reasonable certainty of ownership @ end of
lease

Depreciate asset over

the SHORTER of

Lease term
Useful life

Reasonable certainty of ownership

Depreciate asset over

Useful life

Accounting entries:
Dr Depreciation (SOCI) X
Cr Accumulated Deprec (SOFP)
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Disclosure
SOFP notes on NCA, NCL, CL of amounts re assets
held under finance lease.
SOCI notes on finance cost & depreciation charged
re assets held under a finance lease. Also rates,
amount, methods applied to calculate finance &
depreciation charged.
(Not specifically required by IAS 17 however
companies tend to disclose in the notes)

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Example 2
Red Ltd makes up its accounts to 31 December each
year. It enters into a lease to lease an item of
equipment with the following terms:
Inception of lease
1 January 2001
Term
5 years @ 2,000 pa
Payment terms
Payments in advance
Fair value
8,000
Useful life
8 years
Interest rate implicit in the lease is 12%.
Required
Prepare the relevant extracts in respect of the above
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lease for the year ended 31 December 2001.

Example 2 Payments in advance

Statement of comprehensive income (extract)
Depreciation
Finance cost (W)
Statement of financial position (extract)
Non-current assets
Equipment
Non-current liabilities
Finance lease liability (W)
Current liabilities
Finance lease liability (W)
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Operating leases
Per IAS 17 any lease other than a finance lease
Rental charged as an expense in the SOCI on a
straight line basis over lease term, unless other
systematic basis is more representative of the time
pattern of the users benefit.
Disclose in notes future minimum lease payments;
Within one yr
Between 1 and 5 yrs
> 5 yrs

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