- IAS 17: Leases
Classification of Leases
- Finance leases (substantially all of the risks and rewards of ownership are transferred to the lessee)
- Operating leases (otherwise)
- Note that because Land has indefinite useful life, it is typically classified as an operating lease
Calculating Total Finance Charge over Lease Term
- Total minimum lease payments (cash)
- – Cost of the asset (i.e. lower of fair value and PV of minimum lease payments)
- = Total finance charge
Accounting for Operating Leases
Accounting for Operating Leases as Lessee
- Lease expense recognised in P&L.
- Note that lease expense is an accrual item, not a cash item. It is calculated as the total lease payments (cash, incorporating any discounts or deposits) under the contract, spread evenly over the lease term.
- Lease payment typically covers both interest and principal payments (just like a mortgage)
- Balance sheet
- Recognise an asset item (for pre-payments) or liability item (accrual for lease) due to the timing differences between cash payments and lease expense.
Accounting in Operating Leases as Lessor
- Continue to hold the asset in its books and depreciate as per normal.
- Recognise the rental as income, accrual item on the income statement.
- Differences in timing between cash and accrual of rental income is captured as either accrued income (asset) or deferred income (liability).
Accounting for Finance Leases
Accounting for Finance Leases as Lessee
- Carried on the Balance Sheet as a Non-Current Asset, and a Finance Lease Liability (as though the asset was bought but the purchase price is gradually paid back through the liability)
- Initial recognition
- Dr Non-Current Asset, Cr Finance Lease Liability with Lower of
- Fair value of asset; and
- Present value of the minimum lease payments.
- Subsequent treatment
- Depreciate the Non-Current Asset over the Shorter of
- Useful life of the asset; and
- Lease term (including any secondary lease term for less than market rent)
- Increase Finance Lease Liability (Balance Sheet) with accrued interest (Dr Finance Cost in P&L), and decrease Finance Lease Liability with cash repayments (Cr Cash). This is done in the same way as accounting for provisions under IAS 37.
- Note that if cash is paid in advance, then interest is calculated on the remaining balance, else interest is calculating on the starting balance.
Accounting for Finance Leases as Lessor
- If Lessor is not the manufacturer/dealer
- Remove the asset from its books
- Add a ‘Lease Receivable’ asset = PV of payments receivable under the lease + PV of residual value at the end of the lease if any
- Payments received are split between Finance Income (in Income Statement) and partial repayment of Lease Receivable (in Balance Sheet)
- If Lessor is the manufacturer/dealer
- Recognise sales revenue
- Lower of Fair Value and PV of future lease receipts discounted at a market rate of interest
- Cost of sale
- Carrying value of the asset – PV of any residual amount expected to be received by the Lessor at the end of the lease
- Recognise Finance Income as per usual.
- [My note: I don’t see it in IAS 17 but I suspect that the Lessor will recognise an interest-generating receivable asset item for the item sold through a finance lease.]
Sale and Leaseback Transactions
First determine if the substance of the transaction constitutes a Finance Lease or an Operating Lease.
Sale and Leaseback (Finance Lease)
Two ways of accounting:
- Account for the Sale/Disposal, then account for the Finance Lease
- First the sale,
- Dr Cash with sales price, Cr Non-Current Asset with carrying value, Cr Deferred Income [asset is removed from balance sheet]
- Deferred Income is credited with the amount by which the sale price exceeds the carrying value. This deferred income is amortised to P&L over the lease term.
- The reason why this is not immediately recognised in P&L is that this is essentially a secured loan transaction, the loan proceeds do not reflect the fair value of the asset hence are not the true sales proceeds.
- Next the Finance Lease
- Dr Non-Current Asset, Cr Finance Lease Liability with the lower of (FV and PV of future lease receipts) [asset is placed back onto the balance sheet].
- No sale recorded because this is essentially a secured loan.
- Asset remains on the balance sheet.
- Record the “sale proceeds” as a Loan under Balance Sheet liability.
- Future repayments are to repay the loan and interest payments.
Sale and Leaseback (Operating Lease)
Accounting for the sale (true sale, since it is not an operating lease)
- Remove asset from Balance Sheet
- If (fair value < carrying value), write down the carrying value to fair value, and immediately recognise the difference as a loss.
- Three scenarios
- Sale price = fair value
- Recognise Gain/(loss) on disposal in P&L = (sale price – carrying value)
- If lease rentals are below fair market cost, then the loss on disposal (if any) is deferred and amortised in proportion to the lease payments over the lease term.
- Else, recognise Gain/(loss) on disposal in P&L = (sales price – carrying value)
- Recognise Gain/(loss) on disposal in P&L = (fair value – carrying value)
- The excess profit (sale price – fair value) is deferred and amortised over the lease term.
- Accounting entries
- Dr Cash with sale price
- Cr Non-Current Asset with carrying value
- Cr Income Statement with (fair value – carrying value)
- Cr Deferred Income with (sale price – fair value).