IAS 17 ‘LEASES’

1.                Accounting for Leases – IAS 17

Enquiry  

I would like to draw the attention of the Committee to a problem which being faced by many organizations these days in accounting for lease transactions. Leasing companies and financial institutions have adopted the practice of leasing the asset on a floating rate basis rather than on fixed rate. The floating rate is based on KIBOR. Due to floating rate of interest, the lease rentals in future years are subject to revision and I have seen many cases where the lease rentals have been revised upward or downward by the leasing company consequent to change in their base rate. Now the questions arise as follows:

a) Whether the transactions of acquiring an asset on a floating rate basis will be classified as a lease transaction. The agreement contains the bargain purchase option and all other things are the same except that the IRR is not constant. IAS 17 defines the interest rate implicit in the lease as the discount rate that, at the inception of the lease, causes the aggregate present value of a) the minimum lease payments and b) the unguaranteed residual value to be equal to the sum of the fair value of the leased asset and any initial direct costs of the lessor. As is apparent from the definition, the implicit interest rate of lease will be a constant rate that will equal the sum of the aggregate present value of MLP and unguaranteed residual value to the sum of fair value of leased assets and initial direct cost. The question is still the same whether the transaction involving a floating rate of interest will be classified as a lease transaction.

b) If the transaction is classified as a lease transaction, what will be the treatment of a change in lease rental due to a change in interest rate? The rentals were revised after 12 months and I have treated the problem by using two approaches. In treatment 1, I have used a constant periodic rate in spite of change in lease rental due to change in IRR. This has resulted in difference in opening balance. In treatment 2, I have treated the present value of MLP at the time of revision as a new finance and recomputed the IRR once again on the remaining period of lease. This will only affect the future periods. Now, my question is that which of the treatment adopted is correct. If there is any other treatment to be adopted for this case, please mention that treatment in your opinion.

Opinion 

Your attention is drawn to the following paragraph 4 of definition of IAS 17                       ‘Leases’:

A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or a series of payments the right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. 

An operating lease is a lease other than a finance lease

The Committee is of the opinion that if a transaction fulfills the above criteria then it should be classified as either finance / operating lease.

Further with regard to your view ‘the implicit interest rate of lease will be a constant rate’ the Committee likes to draw your attention to following paragraph of IAS 17

  • Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rentals shall be charged as an expense in the periods in which they are incurred.

From the above paragraph it appears that the term ‘constant’ referred to above does not mean that lease rental cannot be changed. Instead it requires that allocation of finance charge is to be made on the basis of a constant periodic rate of interest on the remaining balance of minimum lease payment which may change if the future rentals are to be calculated on the basis of floating interest rate as per the lease agreement.

With regard to your second enquiry the Committee is of the opinion that at each repricing date the revised rentals are to be worked out for the remaining period of the lease term which may also result in change in Minimum Lease Payments.

(January 5, 2007)

2.Recognition of Income by Leasing Companies

Enquiry:

I request the kind advice/opinion of the Technical Committee on the recognition of finance income by Leasing Companies in compliance with revised IAS 17. I hereby give some brief facts that may be helpful for the Committee in forming the opinion.

HISTORY

IAS 17 (reformatted 1994)
Reference: Para 30

Subject to the consideration of prudence, the recognition of finance income should be based on a pattern reflecting a constant periodic rate of return on either the lessor’s net investment outstanding or the net cash investment outstanding in respect of the finance lease. The method used should be applied consistently to leases of similar financial character.

ICAP CIRCULAR JAN 11, 1997 REGARDING CLARIFICATION TO IAS-17
SELECTED OPINION (LEASES- ACCOUNTING FOR –FURTHER CLARIFICATION REGARDING IAS-17) BY ICAP 

OPINION

REFERENCE: Para 2

It may also be noted that IAS 17 states that income included in monthly rentals should be allocated either on the basis of Net Investment Outstanding or Net Cash Investment Outstanding in the leases. You may also note that former method assumes recovery of guaranteed residual value and payment of lease key money at end of a lease term contrary to the latter method, which assumes the same at the time of lease execution. You will appreciate that as majority of leasing companies in Pakistan follow the former method of income allocation therefore, to make income allocation basis in conformity with the industry practice Markup in both schedules is allocated on the basis of Net Investment Outstanding in the Lease.

IAS 17 REVISED (EFFECTIVE FROM 01 JAN 1999)
Reference: Para 6 of Introduction of revised IAS 17
IAS 17 (revised) requires that the recognition of finance income should be based reflecting a constant periodic rate of return basing on one method, namely the lessor’s net investment outstanding in respect of the finance lease.

IAS 17 LEASES (EFFECTIVE FROM 01 JAN 2005)

IAS 17 Leases replaced IAS 17 leases (revised in 1997) with the same criteria of recognition of finance income as in revised IAS 17.

UK SSAP 21
UK SSAP 21 requires that total income receivable be allocated over the period of the lease to give a constant rate of interest on the net cash investment. (Present status of SSAP is not known)

PRACTICAL CASE

 

Lease Amount                                                  292,000,000
Down Payment / Lease Key Money @ 30%      87,600,000
Residual Value                                                    87,600,000                                     
IRR                                                             14% P.A
Monthly Rental in Advance                            6,905,345
No of Months                                                       36
Implicit rate of return (as per IAS 17 Leases)            8.32% P.A
Spread (IRR-Borrowing Cost) (14-12)                            2% P.A

Assumptions

  • The Company recognizes finance income based on pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease.
  • The Company borrows fund for lease with fixed rate of return of 12%.
  • The Company pays off its borrowing by payment of KLM and First rent received in advance.  

Net profit in Financial Statement after one year

YEARS

PROFIT AT IMPLICIT RATE IN FINANCIAL STATEMENTS

ACTUAL PROFIT

01

(375,370)

3,423,547

02

2,058,763

2,166,955

03

4,629,810

722,701

TOTAL

6,313,204

6,313,204

3.  ENQUIRY
As per my understanding  recognition of finance income by Leasing Companies based on pattern reflecting a constant periodic rate of return on the lessor’s net investment :

  • reflects loss in the financial statements of the Company in first year despite of spread of 2% and enhanced profit in subsequent years which impair qualitative characteristics and the objective of the Financial Statements that is to provide information about the financial position of an entity that is useful to a wide range of users in making economic decisions.
  • does not present true and fair view of financial position and performance of Leasing Companies.
  • recognition of borrowing cost in Financial Statement of Leasing Companies, impairs the concept of matching cost with revenue as borrowing cost is recorded on the outstanding principal based on IRR and income is recognized on implicit rate of return.

 

In view of the above you are requested to confirm my understanding regarding recognition of income and its impact on the Financial Statements of Leasing Companies and if Committee agrees with my understanding please suggest whether IAS 17 requires any amendment to recognition criteria of Finance Income or whether there is any other remedy   available to Leasing Company in this regard.

Opinion        Based on the background of the above query raised, the committee draws attention to some paragraphs of the International Accounting Standard 17 ‘Leases’ (IAS 17), which in the Committee’s opinion are pertinent to this transaction.

As per paragraph 4 of IAS 17 the minimum lease payments (MLP) and gross investment in lease are:

Minimum lease payments are the payments over the lease term that the lessee is or can be required to make, excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:

(a)    for a lessee, any amounts guaranteed by the lessee or by a party related to the lessee; or

(b)    for a lessor, any residual value guaranteed to the lessor by:

  • the lessee;
  • a party related to the lessee; or
  • a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

                                                                  (underlining is ours)

Gross investment in the lease is the aggregate of:

  • the minimum lease payments receivable by the lessor under a finance lease, and (underlining is ours)

 

(b) any unguaranteed residual value accruing to the lessor.

Based on the above definition, the MLP in the above query is the sum of the 36 monthly rentals of Rs. 6,905,345/month and Rs. 87,600,000 guaranteed residual value, which has been paid in advance by the lessee in the form of a security deposit.

Since there is no unguaranteed residual value in the given example gross investment in lease would be the same as the MLP calculated above.

Leasing companies disclose the residual value as asset in their financial statements under the caption “Net Investment in Lease Finance”. Lease Key Money / Security Deposit is disclosed in the financial statements of the lessor as Liability till the lease maturity. It may be noted that the provision with regard to the utilization of Lease Key Money and recovery of Residual Value is generally contained in the lease documents.

Now in order to address the query regarding the pattern of income recognition in the example given above, refer to the lease finance income recognition criteria provided in paragraph 39 of IAS 17. This paragraph requires that:

The recognition of finance income shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease. (underlining is ours)

Based on the requirements of the above paragraph a constant rate of return on the lessor’s net investment in finance lease needs to be calculated. This rate has been defined as the ‘interest rate implicit in lease’ in paragraph 4 of IAS 17 as follows:

The interest rate implicit in the leaseis the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.

As per the requirements of the above paragraph, implicit rate in lease is calculated based on MLP, which as described above includes monthly rentals and any guaranteed residual value (i.e. the security deposit). This should be calculated keeping in view the methodology for working out discounted present value which requires that cash inflows and outflows are discounted based on the timing of the receipts and for payment.

The example forming part of the query comprises the following two different rates for income recognition:

    • Implicit rate of return of 8.32% per annum under ‘net investment outstanding method’
    • IRR of 14% per annum under ‘net cash investment method’.

 

The difference between the workings in deriving the two rates calculated in the given example is the treatment accorded to the guaranteed residual value (i.e. the security deposit received in advance), where in (a) above the guaranteed residual value has been discounted at the end of the lease term and in (b) it has been discounted at the beginning.

The Committee is of the opinion that the guaranteed residual value (being the security deposit received in advance) should be discounted upfront (in accordance with the timing of its receipt) in (a) above for calculating the implicit rate of return to make it in accordance with the methodology for working out the discounted present values as discussed above. In this manner, the anomaly pointed out in the above query would cease to occur.
(November 4, 2006)

 

3.                Revaluation of Leasehold Land

Enquiry:       A reference to the annual accounts of some listed companies has revealed that these companies have revalued leasehold land as part of their fixed assets and have recognized revaluation surplus in their balance sheet. This treatment reflects positively on the Companies’ state of affairs, as overall equity position is improved. Moreover, the revalued leasehold land is not being amortized, as a result of which the balance sheet footing is inflated and the companies’ profits are overstated.

International Accounting Standard 17 on Leases provides guidance on accounting treatment of leasehold assets. Para 14 of the said IAS specifically deals with recognition and amortization of leasehold land and state as under:-

“Leases of land and of buildings are classified as operating or finance leases in the same way as leases of other assets. However, a characteristic of land is that it normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease. A payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents prepaid lease payments that are amortized over the lease term in accordance with the pattern of benefits provided.”

On the other hand, para (1)(a) part II of Fourth Schedule to the Companies Ordinance, 1984 requires that leasehold land should be reported under fixed assets. ICAP had given a Selected Opinion (Opinion 1.8 of Volume III) regarding this apparent conflict in which it is stated that:

“In the case of leasehold land the risks and rewards are not transferred to the lessee, the leasehold land as per International Accounting Standard 17, Accounting for Leases, is classified as an operating lease. However, in Pakistan, paragraph 1 (i)(a) of Part II of the Fourth Schedule to the Companies Ordinance, 1984, requires that the leasehold land should be classified under fixed assets and as the Companies Ordinance, 1984 prevails over International Accounting Standards, the leasehold land is accounted for as part of fixed assets and not as an operating lease. It is to be noted that in majority of leases, the lease costs, where the government is lessor, are immaterial. The published accounts of different companies show that where the lease costs are considered to be material by the Management, these are being amortized and in the opinion of the Committee these should be amortized”.

Although the question of recognition of leasehold land and charge of amortization thereon has been somewhat dealt with in the above opinion of ICAP, the following points still need to be considered and clarified:

a)    Whether leasehold land can be revalued with particular reference to the fact that the company does not hold title of the land, but in substance on its treatment as finance lease it is recognized as an asset like other assets of the Company.

b)    If yes, whether the value of land and revaluation surplus which so arises should be depreciated/amortized as provided in Section 235 of the Ordinance read with SRO 45(I) /2003 .

The matters have been examined and we are of the opinion that:-

i)     There is no divergence between IAS 17 and Fourth Schedule. Fourth Schedule requires “freehold land” and “leasehold land” to be separately disclosed. Obviously this is intended to warn the reader of financial statements as to the ownership of land. IAS 17 goes a step further and requires “leasehold land” to be differentiated between “finance lease” and “operating lease”.

ii)    Methods for depreciation or amortization of lease payments in either of the two cases are discussed in IAS 17. The charge for depreciation in case of revaluation are discussed and provided in paragraphs 31 to 42 of IAS 16.  

iii)   A reference to paragraph 35 of Framework for Preparation and Presentation of Financial Statements is required at this stage. This paragraph provides that information and transactions should be accounted for and presented in accordance with their substance and economic reality and not merely their legal form. This paragraph also gives an example which further elaborates how substance of a transaction can be different from its apparent form. Drawing on this principle we have to look at the “finance lease” and “operating lease” according to the nature and substance of these two leases.

iv)    IAS 17 after analysis of different factors has categorized “finance lease” to consist of two elements. First, the expense that is to be depreciated and, second, the expense which is to be charged as finance expense. Naturally the portion of the finance lease which can at all be considered for revaluation is the depreciable part. Operating lease, in any case, is different and is to be charged or amortized somewhat differently although the underlying idea in determination of the treatment is the same.

v)     In the aforesaid background from the point of recognition of “substance” of a transaction rather than its “form” it has been determined by the IAS 16 and IAS 17 that leased assets are the assets where the risks and rewards relating to its ownership remain with the lessor and are not passed on to the lessee.

vi)    In both the cases of “finance lease” and “operating lease” the risks and rewards of ownership do not pass to the lessee at lease till a future date. This being so, the substance of the arrangement of leases (more particularly finance leases) is that the lessee is not an owner in “substance” but in “form” only and consequently should not have the right to avail the attendant reward or be burdened with the attendant risk. Accordingly, the lesee should not have a right to claim that his financial interest in that lease has increased in value and recognize the same as revaluation. This right is attached to the real owner of the property. Therefore, there is no ground to recognize revaluation of leasehold and whether it is further categorized as “finance lease” or “operating lease”.

It is requested that ICAP may reconsider the issue and circulate an appropriate opinion for the guidance of its members.

Opinion:       As per paragraph 14 of IAS 17 quoted by you in the above enquiry, the lessee should not record the leasehold land in its books as an asset unless title is expected to pass to the lessee by the end of the lease term. On the other hand the treatment prescribed in Clause 1 (i)(a) of Part II of the Fourth Schedule to the Companies Ordinance, 1984 is somewhat different than that required by IAS 17 and leasehold land is required to be shown as fixed asset irrespective of transfer of title.

Strictly speaking IAS 17 does not deal with those leasing arrangements where land is leased for a long term period. Like in many countries including Pakistan the period is 99 years. IASB itself in the following paragraphs of Basis for Conclusion of IAS 17 has acknowledged that:

BC4.   Paragraph 14 of the Standard requires a lease of land with an indefinite economic life to be normally classified as an operating lease, unless title is expected to pass to the lessee by the end of the lease term. The previous version of IAS 17 was not explicit about how to classify a lease of land and buildings.

BC5.   This is a matter of concern in countries where property rights are obtained under long-term leases and the substance of those leases differs little from buying a property. Therefore, the Board decided to deal with this matter in its Improvements project and not to defer its resolution until the more fundamental project on leases was completed.

Now the question arises as to what is the appropriate accounting treatment for such leasehold land in the books of lessee. The Committee after detailed deliberation reached a consensus that because of the peculiar nature of leasehold land the treatment prescribed in the Fourth Schedule is appropriate for the following reasons:-
Recording as operating leases the transactions involving long leasehold interests does not accord with the economic reality underlying such transactions. Cases involving purchases of such leasehold interests which typically contain a large component of land costs, usually have the following characteristics:-
(i)      the buyer (or lessee) has in fact acquired an asset with an upfront payment;
(ii)     the lessee has acquired the right to do a variety of things with the leasehold interests just as if these leasehold interests were outright purchases, like freehold properties;
(iii)    the lessee’s interest is for a reasonable long definite period of time;
(iv)     the time factor does not have a material impact on the fair value of the property on a year to year basis (unless the expiry period is short);
(v)      the lessee can transfer his interest and obligations to others without any restrictions;
(vi)     further the legal structure governing the convincing of long leasehold interests in Pakistan effectively treats a sale and purchase of such interests as a complete transfer of risks and rewards incident to ownership of those interests which is the acid test for recognition of an asset. A lessee can receive risk and rewards in two ways. 1) by using the land itself or by renting it out 2) it can assign the remaining lease to a sub-lessee and make a gain or loss.
A lease of long leasehold interests differs very little from buying a property outright. It may also be noted here that majority of lands are leasehold land.

In view of the above reasons and particularly owing to the transfer of risks and rewards to the lessee which are incidental to the leasehold land, the Committee is of the view that leasehold land may be carried in the balance sheet at revalued amount.

The Committee is also of the view that since long-term leasehold land is in commercial substance owned by the lessee and since the lessee has the right to continue to indefinitely extend the lease by payment of a token amount (when compared to the market value of the lease) of lease renewal charges every 99 years, the useful life of this asset becomes infinite. On the other hand, the theoretical residual value estimated for the land would not be less than the purchase cost. This would result in zero depreciation. Hence, in the opinion of the Committee the question of charging any amortization or depreciation to surplus on revaluation cannot arise.

(July 27, 2006)

 

 

4.                Sale and Leaseback

Enquiry:       We are in the process of finalizing our annual financial statements and we have come across some problem in the context of sale and leaseback in the context of IAS 17.  Problem is as follows:

Scenario

ABC Ltd sold and leased back an asset from DEF Ltd – a leasing company

                                                                    Rs

Purchase cost of asset incurred by ABC                         100
Sold and leased back at                                       90

Treatment 1

As per para 64 of IAS 17, no loss would be recognized on such “sale and leaseback” being a financing arrangement (para 60) unless there has been an impairment in value of the asset. Entries would be as follows:

Sr

Description

 

Debit

Credit

 

 

 

 

 

1

Bank

 

90

 

 

 

Lease liability

 

90

 

(Finance received against leaseback)

 

 

 

 

 

 

 

2

Leased asset

 

100

 

 

 

Owned asset

 

100

 

(Sale of owned asset)

 

 

Consequence:

If we pass the above entries, it goes against para 20 of IAS 17, which states that at inception of lease term, leased asset and liability both should be recognized at equal amount.

Treatment 2

If we assume that such sale and leaseback is just financing arrangement and by the same token, bank has provided 90% finance against the asset having a fair value of Rs 100, then we should credit owned asset with Rs 90 only considering 90% asset subject to finance lease. As a result, no gain/loss will arise on such transactions. Scheme of entries would be as follows:

Sr

Description

 

Debit

Credit

 

 

 

 

 

1

Bank

 

90

 

 

 

Lease liability

 

90

 

(Finance received against lease back)

 

 

 

 

 

 

 

2

Leased asset

 

90

 

 

 

Owned asset

 

90

 

(Sale of owned asset)

 

 

Consequence:

In case of default, will leasing company either forfeit the 100% asset or sell and repay the 10% share in sale proceed to ABC?

Treatment 3

Sale and leaseback are two separate independent transactions:

  • Sale of asset (as title is transferred to leasing co)
  • Leasing back the asset

 

If it is so, we should recognize gain/loss on such transaction. In above scenario, we have sold the asset at Rs 90 having the book value of Rs 100 resulting in a loss of Rs 10. Entries would then be as follows:

Sr

Description

 

Debit

Credit

 

 

 

 

 

1

Bank

 

90

 

 

Loss on sale

 

10

 

 

 

Owned asset

 

100

 

(Sale of owned asset at less than carrying amount)

 

 

 

 

 

 

 

2

Leased asset

 

90

 

 

 

Lease liability

 

90

 

(Booking of lease asset & related liability)

 

 

Keeping in view the above, your valuable opinion is sought that which of the above or some else treatment would be correct?

Your early response would be highly appreciated for timely completion of our financial statements.

Opinion:  

   First of all the appropriate Committee of the Institute would like to draw your attention towards following paragraphs of IAS 17:

63    For operating leases, if the fair value at the time of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair value should be recognized immediately.
64    For finance leases, no such adjustment is necessary unless there has been impairment in value, in which case the carrying amount is reduced to recoverable amount in accordance with the International Accounting Standards dealing with impairment of assets.

In the light of above paragraphs the Committee is of the view that if there is no impairment in the value of fixed asset then the treatment 1 as given in your above enquiry appears to be appropriate.

However, the Committee does not agree with your concern that the leased asset and the liability both should be recognized at equal amount as the Committee is of the view that paragraph 20 of IAS 17 also states that “Any initial direct costs of the lessee are added to the amount recognized as an asset”.

(March 5, 2005)