substance of the transaction rather than the form of the contract.1 Examples of situations that individually or in combination would normally lead to a lease
being classified as a finance lease are:
the lease transfers ownership of the asset to the lessee by the end of the
lease term;
the lessee has the option to purchase the asset at a price that is expected
to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of
the lease, that the option will be exercised;
the lease term is for the major part of the economic life of the asset even
if title is not transferred;
at the inception of the lease the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the
leased asset; and
the leased assets are of such a specialised nature that only the lessee can
use them without major modifications.
Indicators of situations that individually or in combination could also lead to a
lease being classified as a finance lease are:
if the lessee can cancel the lease, the lessor's losses associated with the
cancellation are borne by the lessee;
gains or losses from the fluctuation in the fair value of the residual
accrue to the lessee (for example, in the form of a rent rebate equalling
most of the sales proceeds at the end of the lease); and
the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
The examples and indicators in paragraphs 10 and 11 are not always conclusive. If it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership, the lease is classified as an operating lease. For example, this may be the case if ownership of the asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are contingent rents, as a result of which the lessee does not have substantially all such risks and rewards.
Lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 7-12 if the changed terms had been in effect at the inception of the lease, the revised agreement is regarded as a new agreement over its term. However, changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased property), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes.
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When a lease includes both land and buildings elements, an entity assesses the
classification of each element as a finance or an operating lease separately in accordance with paragraphs 7-13. In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life.
For a lease of land and buildings in which the amount that would initially be recognised for the land element, in accordance with paragraph 20, is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification and classified as a finance or operating lease in accordance with paragraphs 7-13. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.
Separate measurement of the land and buildings elements is not required when the lessee's interest in both land and buildings is classified as an investment property in accordance with IAS 40 and the fair value model is adopted. Detailed calculations are required for this assessment only if the classification of one or both elements is otherwise uncertain.
In accordance with IAS 40, it is possible for a lessee to classify a property interest held under an operating lease as an investment property. If it does, the property interest is accounted for as if it were a finance lease and, in addition, the fair value model is used for the asset recognised. The lessee shall continue to account for the lease as a finance lease, even if a subsequent event changes the nature of the lessee's property interest so that it is no longer classified as
investment property. This will be the case if, for example, the lessee:
occupies the property, which is then transferred to owner-occupied property at a deemed cost equal to its fair value at the date of change in
use; or
grants a sublease that transfers substantially all of the risks and rewards
incidental to ownership of the interest to an unrelated third party. Such a sublease is accounted for by the lessee as a finance lease to the third party, although it may be accounted for as an operating lease by the third party.
Leases in the financial statements of lessees
Finance leases
Initial recognition
At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee's incremental borrowing rate shall be used. Any initial direct costs of the lessee are added to the amount recognised as an asset.
Transactions and other events are accounted for and presented in accordance with their substance and financial reality and not merely with legal form. Although the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its economic life in return for entering into an obligation to pay for that right an amount approximating, at the inception of the lease, the fair value of the asset and the related finance charge.
If such lease transactions are not reflected in the lessee's statement of financial position, the economic resources and the level of obligations of an entity are understated, thereby distorting financial ratios. Therefore, it is appropriate for a finance lease to be recognised in the lessee's statement of financial position both as an asset and as an obligation to pay future lease payments. At the commencement of the lease term, the asset and the liability for the future lease payments are recognised in the statement of financial position at the same amounts except for any initial direct costs of the lessee that are added to the amount recognised as an asset.
It is not appropriate for the liabilities for leased assets to be presented in the financial statements as a deduction from the leased assets. If for the presentation of liabilities in the statement of financial position a distinction is made between current and non-current liabilities, the same distinction is made for lease liabilities.
Initial direct costs are often incurred in connection with specific leasing activities, such as negotiating and securing leasing arrangements. The costs identified as directly attributable to activities performed by the lessee for a finance lease are added to the amount recognised as an asset.
Subsequent measurement
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 rents shall be charged as expenses in the periods in which they are incurred.
In practice, in allocating the finance charge to periods during the lease term, a lessee may use some form of approximation to simplify the calculation.
A finance lease gives rise to depreciation expense for depreciable assets as well as finance expense for each accounting period. The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets that are owned, and the depreciation recognised shall be calculated in accordance with IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets. If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall
be fully depreciated over the shorter of the lease term and its useful life.
The depreciable amount of a leased asset is allocated to each accounting period during the period of expected use on a systematic basis consistent with the depreciation policy the lessee adopts for depreciable assets that are owned. If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the period of expected use is the useful life of the asset; otherwise the asset is depreciated over the shorter of the lease term and its useful life.
To determine whether a leased asset has become impaired, an entity applies IAS 36 Impairment of Assets.
Disclosures
Lessees shall, in addition to meeting the requirements of IFRS 7 Financial Instruments: Disclosures, make the following disclosures for finance
leases:
for each class of asset, the net carrying amount at the end of the
reporting period.
a reconciliation between the total of future minimum lease payments at the end of the reporting period, and their present value. In addition, an entity shall disclose the total of future minimum lease payments at the end of the reporting period, and their present value,
for each of the following periods:
not later than one year;
later than one year and not later than five years;
later than five years.
contingent rents recognised as an expense in the period.
the total of future minimum sublease payments expected to be
received under non-cancellable subleases at the end of the reporting period.
a general description of the lessee's material leasing arrangements
including, but not limited to, the following:
the basis on which contingent rent payable is determined;
the existence and terms of renewal or purchase options and
escalation clauses; and
restrictions imposed by lease arrangements, such as those
concerning dividends, additional debt, and further leasing.
In addition, the requirements for disclosure in accordance with IAS 16, IAS 36,
IAS 38, IAS 40 and IAS 41 apply to lessees for assets leased under finance leases.
Operating leases
Lease payments under an operating lease shall be recognised as an
expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user's
benefit.2
For operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense on a straight-line basis unless another systematic basis is representative of the time pattern of the user's benefit, even if the payments are not on that basis.
Disclosures
Lessees shall, in addition to meeting the requirements of IFRS 7, make the
following disclosures for operating leases:
the total of future minimum lease payments under non-cancellable
operating leases for each of the following periods:
not later than one year;
later than one year and not later than five years;
later than five years.
the total of future minimum sublease payments expected to be received under non-cancellable subleases at the end of the reporting period.
lease and sublease payments recognised as an expense in the
period, with separate amounts for minimum lease payments, contingent rents, and sublease payments.
a general description of the lessee's significant leasing
arrangements including, but not limited to, the following:
the basis on which contingent rent payable is determined;
the existence and terms of renewal or purchase options and
escalation clauses; and
restrictions imposed by lease arrangements, such as those
concerning dividends, additional debt and further leasing.
Leases in the financial statements of lessors
Finance leases
Initial recognition
Lessors shall recognise assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease.
Under a finance lease substantially all the risks and rewards incidental to legal ownership are transferred by the lessor, and thus the lease payment receivable is treated by the lessor as repayment of principal and finance income to reimburse and reward the lessor for its investment and services.
Initial direct costs are often incurred by lessors and include amounts such as commissions, legal fees and internal costs that are incremental and directly attributable to negotiating and arranging a lease. They exclude general overheads such as those incurred by a sales and marketing team. For finance leases other than those involving manufacturer or dealer lessors, initial direct costs are included in the initial measurement of the finance lease receivable and reduce the amount of income recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs are included automatically in the finance lease receivable; there is no need to add them separately. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease are excluded from the definition of initial direct costs. As a result, they are excluded from the net investment in the lease and are recognised as an expense when the selling profit is recognised, which for a finance lease is normally at the commencement of the lease term.
Subsequent measurement
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.
A lessor aims to allocate finance income over the lease term on a systematic and rational basis. This income allocation is based on a pattern reflecting a constant periodic return on the lessor's net investment in the finance lease. Lease payments relating to the period, excluding costs for services, are applied against the gross investment in the lease to reduce both the principal and the unearned finance income.
Estimated unguaranteed residual values used in computing the lessor's gross investment in the lease are reviewed regularly. If there has been a reduction in the estimated unguaranteed residual value, the income allocation over the lease term is revised and any reduction in respect of amounts accrued is recognised immediately.
An asset under a finance lease that is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations shall be accounted for in
accordance with that IFRS.
Manufacturer or dealer lessors shall recognise selling profit or loss in the period, in accordance with the policy followed by the entity for outright sales. If artificially low rates of interest are quoted, selling profit shall be restricted to that which would apply if a market rate of interest were charged. Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease shall be recognised as an expense when the selling profit is recognised.
Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor
gives rise to two types of income:
profit or loss equivalent to the profit or loss resulting from an outright
sale of the asset being leased, at normal selling prices, reflecting any
applicable volume or trade discounts; and
finance income over the lease term.
The sales revenue recognised at the commencement of the lease term by a manufacturer or dealer lessor is the fair value of the asset, or, if lower, the present value of the minimum lease payments accruing to the lessor, computed at a market rate of interest. The cost of sale recognised at the commencement of the lease term is the cost, or carrying amount if different, of the leased property less the present value of the unguaranteed residual value. The difference between the sales revenue and the cost of sale is the selling profit, which is recognised in accordance with the entity's policy for outright sales.
Manufacturer or dealer lessors sometimes quote artificially low rates of interest in order to attract customers. The use of such a rate would result in an excessive portion of the total income from the transaction being recognised at the time of sale. If artificially low rates of interest are quoted, selling profit is restricted to that which would apply if a market rate of interest were charged.
Costs incurred by a manufacturer or dealer lessor in connection with negotiating and arranging a finance lease are recognised as an expense at the commencement of the lease term because they are mainly related to earning the manufacturer's or dealer's selling profit.
Disclosures
Lessors shall, in addition to meeting the requirements in IFRS 7, disclose
the following for finance leases:
a reconciliation between the gross investment in the lease at the
end of the reporting period, and the present value of minimum lease payments receivable at the end of the reporting period. In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the end of the
reporting period, for each of the following periods:
not later than one year;
later than one year and not later than five years;
later than five years.
unearned finance income.
the unguaranteed residual values accruing to the benefit of the
lessor.
the accumulated allowance for uncollectible minimum lease
payments receivable.
contingent rents recognised as income in the period.
a general description of the lessor's material leasing
arrangements.
As an indicator of growth it is often useful also to disclose the gross investment less unearned income in new business added during the period, after deducting the relevant amounts for cancelled leases.
Operating leases
Lessors shall present assets subject to operating leases in their
statements of financial position according to the nature of the asset.
Lease income from operating leases shall be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived
from the leased asset is diminished.3
Costs, including depreciation, incurred in earning the lease income are recognised as an expense. Lease income (excluding receipts for services provided such as insurance and maintenance) is recognised on a straight-line basis over the lease term even if the receipts are not on such a basis, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished.
Initial direct costs incurred by lessors in negotiating and arranging an operating lease shall be added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease income.
The depreciation policy for depreciable leased assets shall be consistent with the lessor's normal depreciation policy for similar assets, and
depreciation shall be calculated in accordance with IAS 16 and IAS 38.
To determine whether a leased asset has become impaired, an entity applies IAS 36.
A manufacturer or dealer lessor does not recognise any selling profit on entering into an operating lease because it is not the equivalent of a sale.
Disclosures
Lessors shall, in addition to meeting the requirements of IFRS 7, disclose
the following for operating leases:
the future minimum lease payments under non-cancellable
operating leases in the aggregate and for each of the following periods:
not later than one year;
later than one year and not later than five years;
later than five years.
total contingent rents recognised as income in the period.
a general description of the lessor's leasing arrangements.
In addition, the disclosure requirements in IAS 16, IAS 36, IAS 38, IAS 40 and
IAS 41 apply to lessors for assets provided under operating leases.
Sale and leaseback transactions
A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package. The accounting treatment of a sale and leaseback transaction depends upon the type of lease involved.
If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount shall not be immediately recognised as income by a seller-lessee. Instead, it shall be deferred and amortised over the lease term.