OPERATING LEASE

OPERATING LEASE IN THE BOOKS OF THE LEASE:

Recognition and Measurement

a. The lease will not recognize the leased asset.

b. Rentals under operating lease should be charged to the income statement on
a straight-line basis over the term of the lease unless another systematic and
rational basis is more appropriate.
c. Any difference between the amounts charged and amount paid should be
adjusted to prepayments or accruals.
d. Any incentives given by the lessor should also be recognized over the lease
term.
e. Any leasehold improvement is depreciated the shorter of the life of the
improvement and the remaining lease term or remaining extended lease term
(for a lease with a renewal option and the likelihood of renewal option is highly
probable).

OPERATING LEASE IN THE BOOKS OF THE LEASE:

Recognition and Measurement

a. The lessor will continue to recognize the leased assets. They are normally
classified as non-current assets held for hiring out under operating leases.
They will be depreciated in the normal way.
b. Rental income from operating leases will be recognized in the income
statement on a straight-line basis over the term of the lease, unless another
systematic and rational basis is more appropriate.
c. Any difference between amounts realized and amounts received should be
adjusted to receivables or deferred income.
d. The initial direct costs of the lease may be spread over the life of the lease or
charged when injured.
e. Any incentives given by the lessor should be recognized over the life of the
lease on a straight-line basis. Typical incentives include rent-free periods or
contributions of the lessor to the lessee’s relocation costs.
f. Any lease bonus received is recognized as additional rental income over the
lease term.

LEASE INCENTIVES

In order to induce prospective lessees to enter into non-cancelable operating leases,

lessors may offer lease incentives such as rent-free periods, upfront cash payments
or contributions towards lessee expenses such as fit-out or removal costs. However
attractive these incentives appear, it is unlikely that they are truly free because the
lessor will structure the rental payments so as to recover the costs of the incentives
over the lease term. Thus, rental payments will be higher that do not offer incentives.

PAS 17 is silent about incentives, and deals only with accounting for the rental
payments under the operating lease agreement. As a result, SIC 15 Operating
Leases – Incentives was issued to provide guidance on accounting for incentives by
both lessors and lessees. The interpretations require that all incentives associated
with an operating lease should be regarded as part of the net consideration agreed
for the use of the leased asset, irrespective of the nature or form of the incentive of
the timing of the lease payments.

For lessors – the aggregate cost of the incentives is treated as a reduction in rental
income over the lease term on a straight-line basis.

For lessees – the aggregate benefit of incentives is treated as a reduction in rental

expense over the lease term on a straight-line basis.

In both cases, another systematic basis can be used if it better represents the
diminishment of the leased asset.

This broad-brush approach assumes that all incentives are the same, but a number
of issues need to be addressed. In particular:

1. The need to distinguish between “capital” incentives such as property fit-outs,

particularly in the retail industry, and “cash” incentives such as rent-free
periods.
2. The need to distinguish between property fit-outs that became part of the
structure of a leased property and were owned by the lessor, and fit-outs that
were owned by the lessee.