Leases: IAS 17

Wiecek and Young

IFRS Primer
Chapter 24
 Leases

 Related standards
 IAS 17
 Current GAAP comparisons
 IFRS financial statement disclosures
 Looking ahead
 End-of-chapter practice

2
 Related Standards

 FAS 13 Accounting for leases

3
 Related Standards

 IAS 16 Property, plant and equipment

 IAS 36 Impairment of assets
 IAS 38 Intangible assets
 IAS 40 Investment property
 IAS 41 Agriculture

4
 IAS 17 – Overview

 Objective and scope

 Classification of leases
 Recognition and measurement by the lessee
 Recognition and measurement by the lessor
 Sale and leaseback transactions

5
 IAS 17 – Objective and Scope

 Accounting and disclosure policies

– lessees
– lessors

 Excludes leases
– for exploration and use of non-renewable natural
resources
– licensing agreements for many intangible assets
(movies, video recordings, plays, manuscripts,
etc.)
6
 IAS 17 – Classification of Leases

A lease is an agreement in which a lessor

conveys the right to use an asset for an
agreed time to a lessee in return for
payment(s).
 Lease classification
– finance lease
– operating lease
 Decision
– whether risks and rewards of ownership are
transferred from lessor to lessee
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 IAS 17 – Classification of Leases

 Risk and rewards incidental to ownership

transferred = finance lease
 Risks and rewards not transferred =
operating lease

 Use judgment to evaluate individual

circumstances and conditions

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 IAS 17 – Classification of Leases

 Classification as a finance lease supported

by
– ownership transferred by end of lease term –
could be by bargain purchase option
– lessee receives most of economic benefit of asset
(consider lease term)
– lessor obtains a return of investment in asset and
a return on investment (consider PV of lease
payments relative to asset’s fair value)
– asset is specialized to lessee’s needs, costly to
modify for other use
9
 IAS 17 – Classification of Leases

 Might lead to classification as a finance lease

– lessee bears lessor’s losses from lease
cancellation
– changes in asset’s fair value accrue to lessee at
end of lease
– lease term extendible at much less than market
rate at end of lease

10
 IAS 17 – Classification of Leases

 If not a finance lease, then is an operating

lease
 Special issues when land and building are
leased together and title is not transferred:
– land lease cannot be a finance lease; building
lease can be
– if value of leased interest in land is immaterial,
treat as building
– if material, allocate payments between land and
building based on relative values of leased
11 interests in each
 IAS 17 – Classification of Leases

 Minimum lease payments (MLP) –lessee’s

definition
1. payments over the lease term that the lessee is
required to make, excluding contingent rent,
costs for services and taxes to be paid by and
reimbursed to the lessor
2. if applicable, the payment required to exercise a
“bargain purchase” option
3. amounts guaranteed by the lessee or party
related to the lessee

12
 IAS 17 – Recognition and
Measurement by the Lessee
 Finance lease accounting
– recognize as acquisition of an asset and incurring
of a liability
– after acquisition, asset depreciation policies are
those in IAS 16 or IAS 38
– lease payments are split between interest,
principal and operating-type costs, if applicable

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 IAS 17 – Recognition and
Measurement by the Lessee
 Finance lease disclosures
– net carrying amount by class of asset
– MLP and the PV of MLP due within 1 year;
between years 2 and 5; and beyond 5 years from
B/S date
– reconciliation of total of MLP to the PV of the MLP
– contingent rents expensed in period;
– sublease payments expected in future
– information about leasing arrangements,
purchase options, contingent rents, restrictions
14
 IAS 17 – Recognition and
Measurement by the Lessee
 Operating lease accounting
– expense over lease term, usually on a straight-
line basis
 Operating lease disclosures
– total future MLP due within 1 year, between years
2 and 5; and beyond 5 years from B/S date
– sublease payments expected in future
– expense recognized in period for each of MLP,
contingent rents, sublease payments
– information about leasing arrangements,
15 purchase options, contingent rents, restrictions
 IAS 17 – Recognition and
Measurement by the Lessor
 Classification decision
– same as for lessee, but using lessor definition of
MLP
– if risks and rewards of ownership are transferred
to lessee – remove asset from lessor’s accounts
– if risks and rewards retained by lessor, asset
remains in lessor’s accounts

16
 IAS 17 – Recognition and
Measurement by the Lessor
 Lessor uses different definition of minimum
lease payments (MLP)
– the payments over the lease term that the lessee
is required to make, excluding contingent rent,
costs for services and taxes to be paid by and
reimbursed to the lessor
– if applicable, the payment required to exercise a
“bargain purchase” option
– any residual value guaranteed by a party not
related to the lessor

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 IAS 17 – Recognition and
Measurement by the Lessor
 Finance lease - lessor could be either
– a manufacturer or dealer in business to earn a
gross profit on the sale of the asset and finance
income to compensate for delayed payment
terms, or
– primarily a financial intermediary in business to
facilitate the financing of assets by others and to
earn finance income as its primary source of
income
 Situations differ – therefore entries differ
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Manufacturer/dealer lessors
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
Manufacturer/dealer lessors
At beginning of lease term Throughout lease term

Lease Receivable x Cash x

Sales x Lease Receivable x
Unearned Finance Income x To record lease payment received.
Cost of Goods Sold x Unearned Finance Income x
Inventory x Finance Income x
To record the lease transaction. To recognize finance income earned in
period.

19
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Financial intermediary lessors
At beginning of lease term Throughout lease term
Lease Receivable x Cash x
Unearned Finance Income x Lease Receivable x
Assets Purchased to Lease x To record lease payment received.
To record the lease transaction. Unearned Finance Income x
Finance Income x
To recognize finance income earned in period.

20
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Lease receivable = gross investment in the lease:
– undiscounted total of MLP + bargain purchase option, if
applicable, + guaranteed and unguaranteed residual values
by non-related parties, if applicable

 Present value of Lease Receivable = net investment

in lease

 Unearned finance income

= gross investment minus net investment
= finance income to be earned over lease term

21
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Other measurement issues
– initial direct costs of manufacturer/dealer: deduct
as expense in period sale is recognized
– initial direct costs of financial intermediary: add to
carrying amount of asset and use lower interest
rate to recognize finance income
– for manufacturer/dealer with unguaranteed
residual amount: reduce Sales and Cost of Sales
by PV of unguaranteed residual – no other
changes
– review residual values regularly
22
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Disclosures by lessors for finance leases
– gross investment in lease, PV of MLP due within
1 year, years 2 to 5, and after year 5 from B/S
date
– reconciliation between gross investment and PV
of MLP at B/S date
– unearned finance income, unguaranteed residual
values, allowance for uncollectible MLP
receivable
– contingent rent income
– information about material leasing arrangements
23
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Accounting for operating leases:
– Leased assets remain on B/S
– Recognize lease income on straight-line basis
over lease term
– Add initial direct costs to leased asset and
depreciate over lease term on same basis as
lease income is recognized
– Depreciation and impairment covered by IAS 16,
38 and 36

24
Manufacturer/dealer lessors

IAS 17 – Recognition and

Measurement by the Lessor
 Disclosures for operating leases:
– Total MLP due within 1 year, between years 2
and 5, and beyond year 5
– Contingent rental income recognized
– Description of leasing arrangements

25
Manufacturer/dealer lessors

IAS 17 – Sale and Leaseback

Transactions
 Entity owns asset
 Sells it and leases it back
 Decision by seller-lessee: finance lease or
operating lease?
 Sale and leaseback are interdependent
transactions

26
 IAS 17 – Sale and Leaseback
Transactions
 Leaseback is a finance lease
– Gain on sale is deferred
– Amortized to income over term of lease

27
 IAS 17 – Sale and Leaseback
Transactions
 Leaseback is an operating lease
– Sale made at FV - recognize gain or loss in
current income
– Sale < FV and lease payments are at FV –
recognize loss in current income
– Sale < FV and lease payments are lower to
compensate – defer loss & amortize on same
basis as lease payments
– Sale > FV excess over FV is deferred and
amortized over period of expected use
– If FV < carrying amount, impairment; recognize
28 loss currently
 Current GAAP Comparisons

 Pages 21 to 23 of 49 of
http://www.ey.com/Global/assets.nsf/Internati
onal/IFRS_US_GAAP_vs_IFRS/$file/US_GA
AP_vs_IFRS.pdf

 Pages 124 to 127 of 164 of

http://www.kpmg.co.uk/pubs/IFRScomparedt
oU.S.GAAPAnOverview(2008).pdf
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 IFRS Financial Statement
Disclosures
The Nestlé Group

http://www.nestle.com/Resource.axd?Id=24E5A5E2-93F8-43A3-
956E-0F259448CB90

Accounting policy for leased assets Page 21 of 118

Note 11, PP&E note Page 37 of 118
Note 28, lease commitments Page 73 of 118

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 Looking Ahead

 No short-term changes expected

 IASB & FASB have longer-term joint project
 IASB tentative decision – move away from
risks and rewards of ownership criterion
 Replace with defining assets as “right to use
the leased asset” and obligation to make
payments as a liability

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 Looking Ahead

 Effect – all non-cancellable lease

agreements may be recognized as assets
and liabilities, including what are now
operating leases
 Approach affected by current project on
conceptual framework
 Exposure draft expected 2010
 New lease standard expected 2011

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 End-of-Chapter Practice
24-1 Lessee Corp. entered into a non-cancellable agreement with Lessor Corp.
on May 15, 2008 to lease equipment manufactured by Lessor according to
Lessee’s specifications. If Lessee had purchased the equipment outright from
Lessor, it would have cost Lessee $100, although Lessor’s cost was only $80.
The following information is available:

Lease term May 15, 2008 – May 14, 2012

Economic life of equipment 6 years
Annual rental payment $25.8
1st payment due May 15, 2008
Estimated residual value, unguaranteed $13
Interest rate implied in lease 10%
Title transfer in lease? No
n = 4, i = 10:
PV factor, lump sum 0.68301
PV factor, annuity due 3.48685
Lessee and Lessor Corp. year ends December 31

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 End-of-Chapter Practice
24-1 Instructions (round all amounts to one decimal place)
a) Discuss the nature of this lease to Lessee Corp.
b) Discuss the nature of this lease to Lessor Corp.
c) Prepare Lessee Corp.’s entries for 2008 and 2009 assuming the lease is classified as:
( i) a finance lease
(ii) an operating lease
d) Prepare Lessor Corp.’s entries for 2008 and 2009 assuming the lease is classified as:
( i) a finance lease
(ii) an operating lease
e) Explain how your answers to parts (a) and (b) above would change, if at all, if the following
additional features were added to this lease agreement. Assume each feature is an
independent case. In addition, explain how any entries in parts (c) and (d) would differ, if at all,
from those prepared above.
( i) the lessee’s incremental borrowing rate is 12%
(ii) the residual value is guaranteed by Lessee Corp.
(iii) the residual value is guaranteed by a third party not related to Lessee Corp.
(iv) the agreement contains an option permitting Lessee Corp. to purchase the leased asset
on May 14, 2012 for $4
(v) the equipment is so specialized to Lessee Corp.’s needs that Lessor Corp.’s only option at
the end of the lease term is to sell off the component parts for the estimated residual value
34
 End-of-Chapter Practice
24-2 Prepare a decision chart or diagram to
accompany IAS 17 that can be used by seller-
lessees to determine the correct accounting for gains
and losses on disposal of an asset that is sold and
leased back. Write a brief explanation of why the
standard provides a reasonable treatment in each
situation.

35
 End-of-Chapter Practice
24-3 Jamal Corp. enters into a four-year operating lease for the
rental of two floors of a new building, and makes a payment of
$2 in advance to hold the space. The monthly rental is $10 and
Jamal qualifies for a special promotion, getting the last four
months of the lease rent-free.

Instructions
a) Determine the rent expense to be recognized each year of
the four-year lease.
b) Prepare the journal entries to record the $2 payment, the
$10 rental payment for months 1 and 2 of the lease, and
any entries required in each of months 45, 46, 47 and 48.
Round the monthly rent expense to one decimal place.
36
 End-of-Chapter Practice
24-4 On June 30, 2008 Lor Ltd., a lessor, enters into a six-year non-cancellable finance lease
that requires annual rental payments of $100 beginning June 30, 2008. In addition, the lessee
is required to make payments in advance of $12 each year to Lor Ltd. to cover a maintenance
agreement on the equipment. The equipment has an estimated residual value of $40 at the
end of the lease term. Lor Ltd. is a dealer that ordinarily sells this equipment inventory which
cost $450, for $524.50. Lor Ltd. expects to earn an 8% return on any delayed payment terms.

Instructions
a) Assuming the lessee has guaranteed the residual value, prepare Lor Ltd.’s entries on
June 30, 2008, December 31, 2008 (its year end) and June 30, 2009. Identify the
lessor’s gross investment in the lease and the net investment in the lease on December
31, 2008, and the profit or loss reported on the lease arrangement for the year that just
ended.
b) Assuming the residual value is not guaranteed, prepare Lor Ltd.’s entries on June 30,
2008, December 31, 2008 (its year end) and June 30, 2009. Identify the lessor’s gross
investment in the lease and the net investment in the lease on December 31, 2008 and
the profit or loss reported on the lease arrangement for the year that just ended.
Comment on your results in this part compared with your results in part (a).
c) Explain briefly how initial direct costs of negotiating the lease of $10 would be accounted
for on June 30, 2008 and how this would affect any subsequent entries. You are not
required to make any calculations.

37
 End-of-Chapter Practice

24-5 In this chapter, flag icons identify areas where there are
GAAP differences between IFRS requirements and national
standards.

Instructions
Access the website(s) identified on the inside back cover of this
book, and prepare a concise summary of the differences that
are flagged throughout the chapter material.

38
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