IAS 17: Leases

Finance Lease Operating Lease

A lease that: A lease that:

- transfers - is not a finance lease

- substantially all the

- risks and rewards of ownership of an asset

- even though legal title may not necessarily

pass

Lessees

Lease classification (examples)

1. Does the lease transfer risks & rewards from lessor to lessee?

2. Does ownership transfer to the lessee by the end of the lease term?

3. Is there a bargain purchase option?

4. Is the lease term equal to the major part of the asset’s useful life?

5. Is the PV of the future min lease pmts (excl contingent rent) = substantially all of

the asset’s FV at inception of lease?

6. Is the leased asset specialised in nature such that only the lessee can use it without

major modification?
 How to use these classification examples

If answer to any of the above is: If answer to all of the above is:
Yes No
Finance lease Operating lease

Can we change the classification?

Only if there are changes to the lease that:

 are agreed to by all parties

 would have changed the classification at inception

The change in classification is made:

 prospectively

Arrangements that may be hiding a lease...IFRIC 4

Lease defined as (wording changed slightly):

 agreement

 where lessor

 gives lessee

 the right to use an asset/s

 for an agreed period of time

 in return for a payment/ series of payments

Hidden lease? Look at substance of arrangement. The arrangement includes a lease if:

 fulfilment of agreement is dependent on the use of specified asset/s AND

 the agreement gives the right to use that asset/s

 Arrangements that may be hiding a lease...IFRIC 4 Cont....

The arrangements gives the right to use an asset if any of the following applies:

 the purchaser (lessee) controls the op of the asset; or

 the purchaser has the ability/ right to control physical access to the asset; or

 only the purchaser is likely to receive a significant amount of the asset’s output and the purchaser

is not required to pay a contractually fixed price per unit of output or a price that is equal to the

current mkt price at time of delivery

Arrangements that may be hiding a lease...IFRIC 4

Cont....

When to assess if an arrangement includes a lease:

 at inception of the lease

When to re-assess if an arrangement includes a lease:

 if contractual terms are changed

 if a renewal option is exercised

 if changes result in dependency on a specific asset/s changing (no longer dependent/ now dependent)

 if substantial changes are made to the asset

Illustrative example 7.3: arrangement may contain a lease

1. A production company (the purchaser who is the potential lessee) enters into an arrangement with a
supplier to supply a minimum quantity of gas needed in its production process for a specified period
of time.
2. The supplier designs and builds a facility adjacent to the purchaser’s plant to produce the gas and
maintains ownership and control over all significant aspects of operating the facility.
3. The agreement provides that:
3.1 The facility is specifically identified and the supplier can supply gas from other sources, although
that is neither economically feasible nor practical.
3.2 The facility is designed to meet the purchaser’s needs. Although the supplier has the right to
provide gas to other customers, to remove and replace the equipment and to modify or expand the
facilities, it has no plans to do so.
3.3 The supplier is responsible for repairs, maintenance and capital expenditures and must deliver a
minimum quantity of gas each month.
3.4 The purchaser will pay a fixed monthly capacity charge and a variable charge based on usage.
3.4.1 The variable charge includes the facility’s actual energy costs, which is about 90% of
the facility’s total variable costs. The supplier is subject to increased costs resulting
from the facility’s inefficient operations.
3.4.2 The fixed charge is refundable if the stated minimum quantity is not produced.
 Solution to Illustrative example 7.4: An arrangement that may contain a lease

1 Gas Company Production Co

(supplier/ lessor)
GAS (purchaser/ lessee)

MONEY

The arrangement includes a lease if:

 1. fulfilment of agreement is dependent on the use of specified asset/s AND

o This aspect is met since:

o a purpose built facility is specified in the agreement and
o the fulfilment of the agreement is dependent on this facility since it was purpose built and
whilst other facilities may be used, this would be economically unfeasible and impractical (3.1)

 2. the agreement gives the right to use that asset/s

The right to use is clear if one of the following is met:

 the purchaser (lessee) controls the op of the asset;

- No: the supplier operates the facility (repairs, maintenance, capex etc) – (see 3.3) and
maintains ownership and control over all significant aspects of operating the facility (see 2)

 the purchaser has the ability/ right to control physical access to the asset;

- No: the supplier maintains ownership and control over all significant aspects of operating
the facility (see 2) including removing, replacing, modifying or expanding the facility etc
(see 3.2)

 only the purchaser is likely to receive a significant amount of the asset’s output and the

purchaser is not required to pay a contractually fixed price per unit of output or a price that is

equal to the current mkt price at time of delivery

- Yes: whilst the supplier has the right to provide gas to other customers, it has no plans to
do so (see 3.2) and therefore it is unlikely that anyone other than the purchaser will
receive a more than significant part of the output; AND
- whilst the purchaser must pay a fixed charge, this is not a fixed cost per unit but rather a
fixed monthly charge and it is also not equal to the current price per unit (3.4)
 Illustrative example 7.4: An arrangement that may contain a lease

1 A purchaser enters into an agreement with a supplier to supply a specified part of its
manufactured production.

2 The supplier constructs a plant next to the purchaser’s factory to produce the goods.

3 The designed capacity exceeds the purchaser’s current needs and supplier maintains
ownership and control over operations.

4 Although the supplier’s plant is specifically identified, component parts can be shipped in
from other plants, although that is uneconomic.

5 The supplier must be ready to deliver a specified quantity but the purchaser is only required
to pay the market price for each unit taken.

6 Parts can be, and have been, sold to other consumers.

Solution to Illustrative example 7.4: An arrangement that may contain a lease

 1. fulfilment of agreement is dependent on the use of specified asset/s AND

o This aspect is met since:

o Although the plant is specified in the agreement (see 4)

o the fulfilment of the agreement is dependent on this plant since it was purpose built and whilst
other plants may be used, this would be economically unfeasible and impractical (see 2 and 4)

 2. the agreement gives the right to use that asset/s

The right to use is clear if one of the following is met:

 the purchaser (lessee) controls the op of the asset;

- No: the supplier maintains ownership and control (see 3) and the supplier is capable of using
the plant for other customers (see 3 and 6)

 the purchaser has the ability/ right to control physical access to the asset;

- No: the supplier maintains ownership and control (see 3)

 only the purchaser is likely to receive a significant amount of the asset’s output and the

purchaser is not required to pay a contractually fixed price per unit of output or a price that is

equal to the current mkt price at time of delivery

- No: the capacity of the plant exceeds the requirements of the purchaser and the supplier
has the right to and has already supplied parts to other customers, and therefore it is
likely that other customers may also receive a significant part of the output; AND
- the purchaser is required to pay a market price per unit
 If the lease is: an Operating Lease

Recognition and measurement

Lease instalments are treated as rent expense

The expense must mimic asset usage

(SL: total instalments divide by lease period)

(total instalments excludes cont rent)

Lease expense (SL amt + cont rent)

Accruals or prepayment adjustments will arise if the instalment amount differs from

amount recognised as an expense

Taxation implications
Lease instalments actually paid are deductible

Prepayments/ Payables will cause DT

Do Gripping GAAP examples 9, 10 and then the following adapted example 17:

Example 17: OL with DT, VAT & Contingent rent (adapted from GG)

A Ltd entered into a 2-year operating lease on 1/1/20X1, over a plant (A Ltd = lessee).

Both A Ltd and the lessor are registered VAT vendors.

The following are due per the lease agreement:

20X1 C5 700
20X2 C17 100
Contingent rent C1.14 per unit of output

A Ltd made 1 000 units in 20X2 (20X1: 1 500 units).

All figures include 14% VAT. Tax rate = 30%.

Required:
Prepare the journal entries for Abbey Limited for both years of the operating lease
agreement.
Solution to example 17: operating lease with tax and VAT

The total of all the payments amounts to C22 800 (C5 700 in year 1, and C17 100 in year 2). If
the asset is used equally in each of the two years, the expense that must be recognised will be
C11 400 (half of the total instalments). However, since this amount is inclusive of VAT, the
portion of the C22 800 that represents VAT must first be removed and the rest of the
instalments will reflect the total expense over the period of the lease.

Year 1 Debit Credit

Operating lease exp 5 700 x 100/114 5 000
VAT account 5 700 x 14/114 700
Bank Given 5 700
Fixed rent paid

Operating lease exp 1 710 x 100 / 114 1 500

VAT account 1 710 x 14 / 114 210
Bank 1 500 x 1.14 per unit 1 710
Contingent (variable) rent paid

Operating lease expense 10 000 – 5 000 5 000

Rent payable 5 000
Accrual in respect of the straight-lining of the fixed rental
Expense should be: (5 700 + 17 100) x 100 / 114 / 24m x 12m = 10 000
Less fixed rental expensed: 5 000

Deferred tax 1 500

Tax (SOCI deferred tax) 1 500
Raising a deferred tax asset (see working 3)

Year 2
Operating lease exp 17 100 x 100/114 15 000
Vat account 17 100 x 14/114 2 100
Bank Given 17 100
Splitting the payment into VAT and operating lease expense portions

Operating lease exp 1 140 x 100 / 114 1 000

VAT account 1 140 x 14 / 114 140
Bank 1 000 x 1.14 per unit 1 140
Contingent (variable) rent paid

Rent payable 10 000 – 15 000 5 000

Operating lease expense 5 000
Accrual in respect of the straight-lining of the fixed rental
Expense should be: (5 700 + 17 100) x 100 / 114 / 24m x 12m = 10 000
Less fixed rental expensed: 15 000

Tax (SOCI deferred tax) 1 500

Deferred tax 1 500
Reversing deferred tax asset at the end of lease term (W3)

Working 1: fixed lease payment excluding VAT

 year 1: 5 700 * 100/114 = 5 000
 year 2: 17 100 x 100 /114 = 15 000

Working 2: straight-lined expense and accrual in year 1(excluding VAT): fixed rent only!
W2.1 (5 000 + 15 000) / 2 = 10 000 fixed rent expense per year
W2.2 Fixed rent expense: 10 000 – fixed rent actually paid: 5 000 = 5 000 payable at 31/12/X1
W2.3 Fixed rent expense: 10 000 – fixed rent actually paid: 15 000 = 5 000 payable at 31/12/X2
 Working 3: deferred tax
Tax Temporary Deferred
Rent payable Carrying Amount Base Difference Tax
Balance: 1/1/X1 0 0 0 0
Dr DT,
Adjustment Balancing: debit deferred tax, credit tax expense 1 500
Cr TE
Balance: 31/12/X1
(W2.2) (5 000) 0 5 000 1 500 Asset
Cr DT,
Adjustment Balancing: debit tax expense, credit deferred tax (1 500)
Dr TE
Balance 31/12/X2 0 0 0 0

Both the rent payable and the deferred tax will reverse in the second year.

If the lease is: a Finance Lease

Measurement
Initial measurement:
- Measure the leased asset and lease liability at lower of FV of asset and PV of minimum
lease payments at beginning of the lease
(use implicit interest rate/ lessee’s incremental borrowing rate)

Subsequent measurement:

- Depreciate asset

- Minimum lease payments to be apportioned between finance charges and reduction of

outstanding liability so that there is a constant periodic rate of interest on the O/S
balance
(i.e. use an EIR table)

Implicit interest rate defined as:

 The rate that causes the
 Sum of (a) the PV of the MLP and (b) the PV of the unguaranteed residual value
 To equal the
 Sum of the (i) FV of the leased asset and (ii) any initial direct costs of the lessor

Minimum lease payments defined as:

 the payments over the lease term that the lessee is or can be required to make,
 excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the
lessor,
 together with, for a lessee, any amounts guaranteed by the lessee or by a party related to the
lessee

Please note that this definition changes slightly in the case of lessors.
 If the lease is: a Finance Lease

Journals
Jnl 1.
Dr Asset: cost (capitalised lease asset)
Cr Liability: non-current (capitalised FL)

Jnl 2.
Dr Depreciation
Cr Asset: accumulated depreciation

Jnl 3.
Dr Liability: non-current
Dr Finance charges
Cr Bank

Jnl 4.
Dr Liability: non-current
Cr Liability: current portion

Now do example 3 and 4 from Gripping GAAP

If the lease is: a Finance Lease

Taxation implications
Tax perspective:
 a FL is treated the same as an OL
This means that:
 Lease payments deductible (excl VAT):
Lease pmt – VAT included; where
VAT included = lease instalment/ total lease instalments x Total VAT in the lease
 No deductions on the asset given to lessee

Now do example 16 from Gripping GAAP

Now, using the effective interest rate tables from GAAP: Graded Question 20.7 and 20.8,
extract the disclosure for the NCLiability.