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Principles of lease classification and accounting
A lease arrangement involves a lessor conveying
the right to a lessee to use a leased asset for
an agreed period of time in return for a series
of payments [IAS17.4(R.05)] [SIC-27.5] .
Lease classification is a key element in lease
accounting because it determines how the lessee
and lessor account for the leased asset [IAS17.7-14(R.05)].
Leases that meet specified criteria are classified
as finance leases. Those criteria relate to the
transfer of substantially all the risks and rewards
incident to ownership by the lessor, to the lessee
[IAS17.4,7-8(R.05)]. Leases that are not finance leases
are operating leases [IAS17.4(R.05)].
Lease classification is made at the inception of
the lease. The classification should only be re-considered
if the provisions of the lease are changed. The
classification should not be revised for changes
to estimates or renewals of the lease [IAS17.4,13(R.05)]
.
Assets subject to a finance lease are recognised
on the lessee's balance sheet together with payments
due to the lessor [IAS17.20-23(R.05)]. Those subject
to an operating lease remain on the lessor's balance
sheet [IAS17.49(R.05)]. In both cases, the depreciation
policy for the assets should be consistent with that for depreciable assets that are owned and
the depreciation recognised shall be calculated in accordance with IAS 16 and IAS 38 [IAS17.27,53(R.05)
.
A lessor of an asset subject to an operating lease should recognise the cost
of a lease incentive over the lease period as a
reduction of the lease revenue [SIC-15.3-6].
Classification of lease arrangements
IFRS do not define the term "substantially all"
when considering risks and rewards of ownership [IAS17.4,8(R.05)]
or provide a series of bright line numerical tests.
Quantitative and qualitative evidence should be considered
when assessing risks and rewards of ownership .
Analysis of lease arrangements
Analysis of a lease must be based on its substance
or commercial reality [F.35] [IAS8.10(b)(ii)(R.05)] [IAS17.10,11,21(R.05)].
The conditions of the lease may suggest an entity
has only limited exposure to the risks and benefits
of a leased asset, whereas commercial reality may
suggest otherwise .
The following aspects of lease arrangements and
leased assets are relevant to lease classification.
Risks and rewards
Fundamental to lease classification is the identification
of potential risks and rewards of leased assets,
and the way they are borne/enjoyed by the parties
to a lease. All assets have a unique capacity to
expose an entity to risks and rewards. For example,
assets such as IT equipment are subject to rapid
technological change and exposed to a higher risk
of technical obsolescence than other assets [IAS17.7,8(R.05)]
.
More emphasis is usually put on risks that the
lessor retains, than on benefits associated with
the ownership or use of the asset. Where the lessor
retains little or no asset-related risk, the agreement
is likely to be a finance lease. By comparison,
when the lease exposes the lessor to movements in
the asset's market value, utilisation or performance,
the lease is usually an operating lease .
Economic objectives
An entity's objectives in entering into a lease
arrangement will often be a guide to the appropriate
lease classification. For example, lease arrangements
involving financial institutions are usually finance
lease arrangements as financial institutions seldom
wish to retain the risks and rewards of ownership
of physical assets .
Lease term
IFRS define the lease term as including the non-cancellable
term of the lease plus all optional renewal periods.
Which, at the inception of the lease, it is reasonably
certain that the lessee will exercise the option
[IAS17R.4(R.05)].
A lessee may or may not exercise an option to extend
a lease, based on the financial incentive included
in the lease. For example:
| a) |
option period rentals are lower than the
property's expected fair market rental at the
date on which the option becomes exercisable
[IAS17.11(c)(R.05)] ; or |
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| b) |
option periods for which a failure to renew
the lease imposes a penalty on the lessee in
an amount such that, at the inception of the
lease, renewal appears to be reasonably certain
[IAS17.11(a)(R.05)] . |
The entity's need to continue using the asset in
its operations should be considered .
Entities are likely to renew lease arrangements
for specialised assets critical to their operations,
for which no ready market exists [IAS17.10(e)(R.05)]
.
Many lease arrangements include options to cancel.
Where the lessee is likely to exercise such an option,
the lease is an operating lease. However, options
to cancel should be disregarded if they can occur
only [IAS17.4(R.05)] :
| a) |
on the occurrence of some remote contingency; |
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| b) |
if the lessor gives permission; |
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| c) |
if the lessee enters into a
new lease with the same lessor; or |
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| d) |
on payment by the lessee of
a penalty in an amount such that at the inception
of the lease, continuation of the lease seems
reasonably certain. |
Present value of minimum lease payments (MLP)
The MLP should include the payments required under
the lease, and consideration of:
| a) |
penalties, or costs - payable by the lessee
for failing to continue the lease. If a lessee
forecasts that it will break the lease and incur
the penalty or incur costs, they should be included
in the MLP. Otherwise, if renewal of the lease
is reasonably certain, the secondary period
is included in the lease term, but the immediate
penalties are ignored ; |
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| b) |
bargain purchase option - usually
provides a financial incentive to purchase the
asset and should be included in the MLP where
it is reasonably certain of being exercised.
However, the lessee's business need for the
asset must be considered [IAS17.4(R.05)] ; |
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| c) |
a guarantee - by the lessee
(or party related to the lessee) to the lessor.
These may be guarantees of the leased asset's
residual value or guarantees to incur significant
expenditures in respect of the asset [IAS17.4(R.05)]
; |
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| d) |
an in-substance guarantee -
of the residual value of the leased asset by
the lessee, its related party (or, in the case
of the lessor, by an independent third party).
For example, a lessee's guarantee of a lessor's
non-recourse debt, secured by the leased asset,
may function, in substance, as a guarantee of
residual value [IAS17.4(R.05)] ; |
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| e) |
contingent rent - some leases
require the lessee to pay additional rent that
is not fixed in advance, but is based on factors
other than passage of time, such as turnover,
amount of usage or price indices. MLPs do not
usually include contingent rent; such rent often
represents a genuine incremental element in
the lease payments that depend on the outcome
of uncertain future events [IAS17.4(R.05)] . |
A lessor should immediately recognise a change in
the estimate of the unguaranteed residual value
in the income statement [IAS8.36(R.05)] .
Lease agreements normally considered to be finance leases
Lease classification is often complex, as the substance
of arrangements can be unclear. Nevertheless, the
following circumstances are usually indicative of
finance leases.
| a) |
Transfer of ownership at the end of the
lease term to a lessee [IAS17.10(a)(R.05)].
The lease is usually a finance lease, as the
lessee will have the use of the asset over its
entire economic life. A transfer of ownership
can be achieved where the lessor holds a put
option requiring the lessee to acquire the asset,
and the lessor is expected to exercise this
option .
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| b) |
The lessee has a bargain purchase
option [IAS17.10(b)(R.05)].
A bargain purchase option, if the lessee exercises
it, is another means of obtaining ownership
of the leased asset. A reference to an option
at a fixed price, or by reference to the asset's
depreciated cost, may indicate a bargain purchase
option, which is likely to be less than the
asset's fair value at exercise date, and likely
to be exercised . A statutory right to buy the asset does not by itself result in the classification as a finance lease. Facts and circumstnces decide whether the right is a bargain or not
However, the financial incentive does not always
determine the lessee's behaviour. Changed business
circumstances may render a cheaply priced asset
surplus to the lessee's requirements. |
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| c) |
The lease term covers the major
part of the asset's economic life [IAS17.10(c)(R.05)].
There might be a presumption (not conclusion)
that the lease is a finance lease if a lessee
has use of the leased asset for a major part
of its economic life. The term major is not
specified in the standard; however, leases that
cover seventy five percent of an asset's useful
life are usually finance leases, since proportionally
more economic benefit is derived in the earlier
years of an asset's life than in the later ones
.
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| d) |
The present value of the MLP
at the beginning of the lease amounts to substantially
all of the fair value of the asset [IAS17.10(d)(R.05)].
Payments made by a lessee that are a substantial
portion of a leased asset's fair value might
be presumed to give rise to a finance lease
.
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| e) |
The leased asset is constructed
to the lessee's specification and could not
be used by others without significant modification
[IAS17.10(e)(R.05)] .
Such an asset will have limited market value,
and the lessor will typically have to recover
its initial investment during the primary lease
term, or by giving the lessee a call option
that it is likely to exercise. Both are likely
to lead to finance lease treatment .
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Classification of sale and leaseback transactions
A sale and leaseback transaction arises when a vendor
sells an asset and immediately re-acquires the use
of it by entering into a lease with the buyer. A
feature of sale and leaseback arrangements is that
the lease payment and the sale price are usually
interdependent [IAS17.58(R.05)].
The key question is whether the transaction is
a genuine sale, where all major risks and rewards
transfer to the buyer, while the seller continues
to use the asset exposed to some, but not substantially
all, of the risks and rewards. Alternatively, the
transaction may be effected for financing, tax or
some other special purposes only, and in substance,
the seller/lessee never disposes of the risks and
rewards of owning the asset .
A sale and leaseback transaction is composed of two distinct operations that need to be accounted for separately The gain on a sale arising in respect of a sale
and finance leaseback should be deferred and amortised
over the lease term [IAS17.59-60(R.05)]. The gain on
a sale arising in respect of an operating leaseback,
however, should be recognised immediately, provided
the transaction has been conducted at fair value
[IAS17.61(R.05)].
The following conditions should be fulfilled, in
order to classify a sale and leaseback transaction
as an operating lease [IAS17.7-14(R.05)]:
| a) |
a sale has genuinely occurred, where all
major risks and rewards were transferred to
the buyer; |
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| b) |
the buyer (lessor) cannot transfer
the leased asset back to the seller (lessee); |
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| c) |
the lessee has no bargain repurchase
option and the lessor assumes the exposure to
risk that the value of the leased asset will
fall ; |
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| d) |
the lessee has no option to
prolong the lease agreement at conditions significantly
more favourable than the market conditions; |
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| e) |
the fair value of assets sold
and leased is substantially higher than the
present value of the minimum lease payments; |
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| f) |
the lessor is more than simply
a lender - the lessor's income and exposure
to gain and loss is related to property market
conditions (for example, rental prices and property
values), not just interest rates. |
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The transaction should be accounted for as a finance
lease if any of the conditions above is not fulfilled.
The commerciality of sale and leaseback transactions
between related parties in particular should be
considered to determine the appropriate lease classification
[IAS17.10,21(R.05)] .
Property sale and leaseback
Entities may seek to raise additional finance by
selling their freehold or long-term leasehold properties
to banks and finance companies in exchange for a
lease. The sellers/lessees often wish to retain
an interest in the property in these circumstances,
and to have the ability to extend the lease period
for a very long time, whereas the buyers/lessors
(lending institutions) try to leave the substantial
portion of the ownership risk with the sellers.
Many of these arrangements are, in substance, collateralised
borrowings; consequently, they should result in
recognition of a loan and an asset (property) on
the lessee's balance sheet.
Arrangements where sale accounting would clearly
be inappropriate include:
| a) |
the lessee has a call option to reacquire
the property at a specified future date at a
value that does not reflect arm's length value
[IAS17.10(b)(R.05)] ; and |
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| b) |
the lessee has a renewal option
exercisable at a specified date, where the rental
payments do not reflect market value at that
date [IAS17.11(c)(R.05)]. |
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Sale and leaseback with special purpose
entities
A common structure of a sale and leaseback transaction
involves the transfer and leaseback of an asset
by a seller (lessee), to a special purpose entity
(lessor) that is wholly or partly funded by bank
borrowings or debt securities, such as commercial
paper. Determining the accounting treatment of sale
and leaseback of transactions involving special
purpose entities is complex [IAS17.58(R.05)].
An entity should consolidate a special purpose
entity when the substance of the relationship between
the entity and the SPE indicates that the SPE is
controlled by that entity [SIC-12.8-10]. An entity
should consolidate a SPE when it is exposed to a
majority of the SPE's or its asset's risks and rewards
[SIC-12.10(d)]. Therefore, it is possible for a
seller to derecognise an asset (under lease accounting
guidance) on the basis that it did not control substantially
all the risks and rewards of the asset, yet consolidate
the SPE when it is exposed to a majority of risks
and rewards of ownership (Solution 22.12) .
Lease and leaseback
Lease accounting relies on the substance of risks
and rewards to determine the accounting treatment
of all leases, but tax authorities generally have
specific rules to determine what is a finance lease
for tax purposes. Occasionally such distortions
give rise to structures which involve leasing an
asset to a third party for a certain period with
an up-front rental payment and leasing it back (a
sub-lease) for a shorter period, with annual rental
payments together with an option to extend the lease.
Such arrangements do not result in the transfer
of title and the clear presumption is that the sub-lease
will be renewed; thus the transaction is usually
treated as a finance arrangement [SIC-27] .
Leases of land and buildings
Entities should classify leases of land and buildings
in the same way as leases of other assets and normally
consider the land and buildings elements separately.
The land element is normally classified as an operating
lease unless title passes to the lessee at the end
of the lease term . The building
element is classified as an operating or finance
lease by applying the guidance set out in Section
18.3 [IAS17.14-15(R.05)]
.
Presentation and disclosure
The presentation and disclosure requirements that
relate to leases in the financial statements of
lessors and lessees are presented in sections 71
and 53 .
Accounting for payments between the lessor, new tenant and old tenant
Some contracts require the lessor, new tenant and old tenant to make payments when entering into an operating least contract or during the lease term. Accounting for these payments may differ depending on the contractual arrangements and on the substance of the transaction.
The following table presents the principles of lease accounting for payments between these parties:
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LESSOR |
NEW TENANT |
OLD TENANT |
| LESSOR PAYS KEY MONEY TO: |
|
This is a lease incentive which should be accounted for under SIC 15.
|
This is a cost associated with cancelling the old lease so it should be
expensed by the lessor. The old tenant should recognise the receipt as income
(assuming all conditions for receipt have been met). |
| NEW TENANT PAYS KEY MONEY TO: |
This is a prepayment of rentals under the lease. The lessor and lessee
should recognise the prepayment and income/expense on a straight-line basis
over the lease term. |
|
This is a cost of entering into the lease for the new tenant which should
be spread on a straight-line basis over the lease term.
The old tenant should recognise the receipt as income (assuming all conditions
for receipt have been met). |
| OLD TENANT PAYS KEY MONEY TO: |
This is income arising from the old lease so should be recognised as income
by the lessor.
This is a cost of exiting the old lease and should be expensed by the old
tenant. |
This is a cost of exiting the lease for the old tenant and should be expensed.
This is a lease incentive for the new tenant which should be accounted for
under SIC 15.
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Payments between the lessor and the old lessee, sometimes addressed as “surrender premiums” are not uncommon in the leases for real estate, for example where the lessor needs to convince the tenants to move out in order to redevelop the property. Depending on the specific facts these amounts can be capitalised rather than expensed. See Investment Property Industry and the relevant guidance.
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