Summary of IAS 17 (Leases)

IAS 17 (Leases)

IAS 17 is one of the most used standards in the financial statements. In the credit based economies companies prefer to obtain the assets on lease rather than making cash payments. IAS 17 describes the two types of leases i.e. finance lease and operating lease and its treatment in the financial statements. It’s a critical standard as treatments in the books of Lessor, Lessee differ in case of both the Operating and Finance Lease. More complexity is faced in case of sale and lease back of transactions. All these complexities and appropriate accounting treatments are described in a very effective way in the summary of IAS 17. Summary is designed in the way that after reading it, you will touch all the concepts of IAS 17 in sufficient detail.
IAS 17 (Leases) as the name suggests deals with accounting treatment of leases of non current assets. Summary of IAS 17 (Leases) is provided here in order to enable students and professionals to grasp spirit of IAS 17 (Leases) in a short span of time. It is also ensured here that this summary covers all the points of IAS 17 (Leases) in a concise way so that no concept remained undisclosed.

 

Lease Classification

IAS 17 (Leases) deals with two types of leases: Finance Lease and Operating Lease. What differentiates the one type from other is whether substantially all the risk and rewards of ownership of an asset are transferred from the lessor to the lessee. If the risk and rewards;

• are transferred from the lessor to the lessee, then the substance of the transaction is the purchase and therefore it should be treated as finance lease according to IAS 17 (Leases)
• are not transferred from the lessor to the lessee, then the substance of the transaction is the true lease [rent] and therefore it should be treated as operating lease according to IAS 17 (Leases)

Guidance as to whether risks and rewards are transferred is given in paragraph 10 of the IAS 17 (Leases) by way of a list of examples situations that individually or in combination would normally lead to a lease being classified as a finance lease:

• If the lease transfers the ownership of the asset to the lessee by the end of the lease term, it should be classified as finance lease according to IAS 17 (Leases).
• Lessee has the option to purchase the asset at a price that is expected to be lower than the fair value at the date the option becomes exercisable. It must be reasonable certain, at the inception of the lease that the option will be exercised. Lease should be classified as finance lease according to IAS 17 (Leases).
• The lease term is for the major part of the economic life of the asset, even if title is not transferred. Lease should be classified as finance lease according to IAS 17 (Leases). Normally if lessee consumes the asset for more than 75% of its useful life, asset is treated as finance lease.
• At the inception the present value of minimum lease payments amounts to at least substantially all of the fair value of the asset. Lease should be classified as finance lease according to IAS 17 (Leases). Normally if present value of minimum lease payments amounts to 90% of the fair value of the asset, it is treated as finance lease.
• The leased assets are of such a specialized nature that only the lessee can use them without major modifications. present value of minimum lease payments

Irrespective of the above mentioned criteria, remember that overriding requirement of IAS 17 (Leases) is whether substantially all the risk and rewards associated to ownership of the asset have been transferred.
The classification of the lease is determined at the inception of the lease. If the lessee and lessor agree to alter the provisions of the lease which would have changed the classification of the lease had the new provision been implemented at the inception of the lease, then the original lease is considered cancelled and the lease is considered a new one and is classified appropriately. Therefore, this does not apply to normal renewals and to change in estimates according to IAS 17 (Leases).
Land and Buildings
Where there is a lease of land and building [that is not classified as investment property in terms of IAS 40 Investment Property the classification thereof, as either an operating or finance lease must involve the separate consideration and classification of the land element and building element according to IAS 17 (Leases).
If ownership of both elements is not expected to pass to the lessee at the end of the lease;

• Land is usually classified as an operating lease due to its indefinite life
• Building could be a finance or operating lease as per criteria mentioned in paragraph 10 of IAS 17 (Leases).

If ownership of both land and building is expected to pass to the lessee by the end of the lease term, both elements are classified as finance lease.
If the lease payments cannot be allocated reliably between the two elements, the entire lease is classified as finance lease, unless it is clear that both elements are operating leases, in which case the entire lease will be classified as operating lease according to IAS 17 (Leases).
If the land element is immaterial, then the land and building may be treated a single unit for the purpose of lease classification and classified as either a finance or operating lease. The life of the building will be used as the life of the entire asset according to IAS 17 (Leases).
In accounting for the separate land and building portions, the minimum lease payments are to be allocated between the two elements in proportion to the relative fair value of the leasehold interests in the land element and the building element, as at the inception of the lease according to IAS 17 (Leases).
According to IAS 17 (Leases) If the lease of an element is recognized as finance lease then the lease payment relevant to that element must be separated into;

• A finance charge relative to the fair value of the element at the start of the lease
• A capital repayment of the fair value of the element at the start of the lease

 

In the Books of Lessee

Recognition and Measurement

Finance Lease

Journal Entry 1
At the commencement of the lease term, a lessee shall record a finance lease by recognizing an asset and corresponding liability in its statement of financial position. According to IAS 17 (Leases) these items will be raised at the lower of;

• Fair value of the leased property
• Present value of the minimum lease payments

The discount rate used to calculate the present value of the minimum lease payments is the interest rate implicit in the lease. Any initial direct costs incurred by the lessee are then added to the amount recognized as an asset according to IAS 17 (Leases).
Journal Entry 2
As asset has been recognized in the statement of financial position, a depreciation expense must be charged according to the depreciation policy of the lessee and IAS 16 (Property, Plant and Equipment). According to IAS 17 (Leases), if;

• If there is reasonable certainty that the lessee will obtain the ownership of the asset at the end of the lease term, asset should be depreciated over the useful life of the asset.
• If there is no reasonable certainty that the lessee will obtain the ownership of the asset at the end of the lease term, asset should be depreciated over shorter of the lease term and its useful life.

Journal Entry 3
The minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability according to IAS 17 (Leases). The finance charge is calculated by multiplying the remaining balance in the liability account by the appropriate discount rates.
Journal Entry 4
According to IAS 17 (Leases), the amount expected to be settled with in twelve months after reporting date is disclosed separately as a current liability.
Tax Implications
Finance lease of IAS 17 (Leases) will generally have deferred tax implication since most tax authorities do not differentiate between finance leases and operating leases. Instead, they treat all leases as operating lease for tax purpose. Tax authorities who do not recognize the substance of the transaction still believe that asset belongs to lessor and not the lessee. Therefore, lessee is not given the capital allowance against taxable income but is allowed to deduct lease installment when it is paid.
There is a temporary difference because the lessee includes the depreciation and interest in his calculation of profit and loss as per IAS 17 (Leases) and tax authorities grant a deduction for the payment of the lease installments instead.
Operating Lease
Operating leases are generally simpler than finance leases. Installments are recognized as rent expense. Although the installment amounts may vary, the rent expense must reflect the pattern of use of the leased asset. Generally speaking this will be the length of the lease period. The amount of expense will therefore be calculated by dividing the total of all the lease payments by the number of accounting periods in the lease period, regardless of how the payments are structured according to IAS 17 (Leases).
IAS 17 (Leases) states that where the installments paid during an accounting period differ from the amount that must be charged to the statement of comprehensive income, an accrual or prepayment adjustment will be made.
Tax Implications
Since only the amount paid is deductible for the tax purposes, this accrual or prepayment will also constitute a temporary difference. This must be multiplied by the tax rate according to IAS 12 to arrive at the deferred tax adjustment.

Sale and Leaseback

Finance Lease
The sale and leaseback constitutes a finance lease if it transfers substantially all the risk and rewards associated with the ownership of the asset from the lessor to the lessee according to IAS 17 (Leases). In substance, the asset will have been sold and subsequently repurchased by the lessee. Deferred profit is recorded should the asset originally be sold at the price above its carrying amount on selling date. This deferred profit is amortized over the lease term.
Ultimately, from the seller / lessee’s point of view, a sale and finance leaseback will result in the derecognition of the asset. The subsequent repurchase is then accounted for in the same manner as any other finance lease according to IAS 17 (Leases). The only difference is that the deferred profit is raised and amortized over the lease term.
Operating Lease
The sale and leaseback will not constitute a finance lease if it does not transfer substantially all the risk and rewards associated with the ownership of the asset from the lessor to the lessee according to IAS 17 (Leases). The asset have been sold and leased back by the lessee on rent.
According to IAS 17 (Leases) following happens in the books of the lessee;

• Asset is removed from the statement of financial position
• An operating lease expense is recognized in the statement of comprehensive income

Paragraph 61 of IAS 17 (Leases) provides the following guidelines for recording a sale and operating leaseback transaction.

• If the selling price equals fair value, any profit or loss is recognized immediately as per IAS 17 (Leases).
• If selling price is less than fair value, any gain or loss is recognized immediately unless there is a loss that is compensated by less than market related future lease payments, in which case loss must be deferred and amortized in proportion to the lease payments over the period in which the asset is expected to be used according to IAS 17 (Leases). Deferred loss is calculated by deducting the selling price from fair value. Profit on disposal is still recorded but is calculated as the fair value [not selling price] less carrying amount.
• If selling price is greater than fair value, the true profit and loss is recognized immediately, whereas the excess over the fair value is deferred and amortized over the period in which the asset is expected to be used. This is regardless of the fact that future lease rentals may not have been adjusted to be greater than market related according to IAS 17 (Leases). Deferred profit s calculated by deducting the fair value from the selling price. The profit on disposal is still recorded, but is calculated as the fair value [not selling price] less carrying amount.

Tax Implications
As tax authorities treat the sale as a sale and operating leaseback as operating lease so not difference in treatment arises. But if deferred gain or loss is recognized in the financial statements as per IAS 17 (Leases), the deferral of any profit or loss will lead to the temporary difference.

 

In the Books of Lessor

Recognition and Measurement

Finance Lease
Lessors, who are considered to be manufacturer or dealers, sale is considered to have taken place when the lease is a finance lease. Therefore, sales income and lease income both will be recognized in the finance lease in accordance with IAS 17 (Leases). For other lessor, the income from the lease is simply recognized as interest income. Measurement of all amounts is therefore affected by whether the lessor is considered to be a manufacturer or dealer or considered not to be a manufacturer or dealer. The journal entries in the books of the lessor will therefore differ slightly depending on the whether the lessor is a manufacturer of dealer or not.
If the lessor is manufacturer or dealer
If the lessor is manufacturer or dealer, the installment received represent two types of incomes.

• Sales Income which is measured at the lower of the fair value of the asset and present value of minimum lease payments, computed using a market interest rate.
• Interest Income is measured by multiplying the implicit interest rate by the fair value of the asset.
• Cost incurred in securing or negotiating the lease, is simply expensed at the time when the sales revenue is recognized.

Journal Entry 1

• Finance lease receivable is recognized with the amount receivable over the lease term of the asset. It is calculated by multiplying the minimum lease payment with the number of installments to be received according to IAS 17 (Leases).
• Unearned finance income is credited and recognized in the statement of financial position. It is calculated by calculating the amount of interest to be received from the lease of the asset as per IAS 17 (Leases).
• Sales revenue is also credited.

Journal Entry 2

Cost of Sales
	To Inventory

Journal Entry 3

Bank
	To Finance Lease Debtor

Journal Entry 4

Unearned Finance Income
	To Finance Income

If the lessor is not a manufacturer or dealer
IAS 17 (Leases) states that if the lessor is not a manufacturer or dealer, the installment received represent;

• The cost of the asset disposed off
• Finance income
• Any cost incurred in securing or negotiating the lease is included in the calculation of the implicit interest rate, thus automatically reducing the interest income.

Journal Entries

• In first entry, Finance lease receivable is recognized with the amount receivable over the lease term of the asset. It is calculated by multiplying the minimum lease payment with the number of installments to be received.
• Unearned finance income is credited and recognized in the statement of financial position. It is calculated by calculating the amount of interest to be received from the lease of the asset.
• IAS 17 (Leases) suggests that subsequent entries will be the same as mentioned above for the lessor who is manufacturer or dealer with the exception of Journal Entry 2 [above] which will be omitted in this case.

Installments received in advance instead of in arrears
Installments may be received in advance rather than in arrears. This fact should be kept in mind when calculating the interest income. Obviously the very first installment will reduce the capital balance owing by the lessee and will not include a repayment of interest as per IAS 17 (Leases).
Tax Implications
Finance lease treatment according to IAS 17 (Leases) gives rise to the deferred tax adjustment as mentioned above in the lessee’s books.
Operating Lease
IAS 17 (Leases) states that in operating leases, lease installments are recognized as interest income. Cost that are considered to be initial direct costs incurred in connection with the negotiating and arranging the operating lease, should be added to the cost of the asset and thereby be expensed as the leased asset is expensed. Cost e.g. depreciation (IAS 16) and impairment (IAS 36) are measured as per relevant standards.
Tax Implications
The initial direct costs are allowed as a tax deduction in full in the year in which they are paid while being capitalized and recognized as expenses over the lease period from an accounting profit. It gives rise to deferred tax adjustment.
It concludes IAS 17 (Leases). I hope it was helpful for you to have complete understanding of all concepts of IAS 17 (Leases) in short time. Please do not forget to leave your comments below.
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