Lecture #1:
Leases = Off-Balance
Sheet Items?
Leases are a very perfect example of “off-balance sheet” financing if
not recorded properly in the financial statements. Why?
Because although the contract may say that a company leases an asset
from another company, in fact, the contract’s conditions may be very
similar to purchase.
For example, the lessee (or company who takes an asset under the lease)
will lease an asset for almost all of its useful life, will be responsible for
maintaining and repairs, etc.
IAS 17 Leases requires you to record such a transaction not in
accordance with the strict legal form (legally, the owner of an asset
remains the lessor), but in line with the “substance over form”principle.
Of course, there was the new standard IFRS 16 issued with respect to
leases and it will apply in the near future. This lecture talks about it at the
end.
Which leases shall be recorded in
line with
“substance over form”?
IAS 17 classifies leases into 2 types:
Finance lease – this is a lease that transfers substantially all the risks
and rewards incident to ownership of an asset to the lessee, while legal
title does not necessarily need to be transferred. Exactly this type of lease
shall be recorded in line with substance over form principle.
Operating lease – this is a lease other than finance lease and is
accounted for as regular rent.
How shall we determine whether the
lease is finance or operating?
Standard IAS 17 lists 5 basic situations that normally lead to a finance
lease:
1. The lease transfers the ownership of an asset to the lessee by
the end of the lease term.
2. The lessee has an option to purchase the asset at a price
sufficiently lower than its fair value at the date of purchase (for
example, lessee can purchase leased asset for 1 EUR at the end of
the lease term).
3. The lease term is for the major part of the economic life of the
asset even if the title is not transferred (for example, a car is leased
for 3 years, while its economic life is 4 years).
4. At the inception of the lease, present value of the minimum
lease payments comes close to the fair value of the leased
asset.
5. Leased assets are of such specialized nature that only the lessee
can use them without major modifications.
If any of these situations happens, then the lease is almost for sure
a finance lease.
How to account for finance leases
(lessee)
1. Lease at the inception:
At the inception of the lease, the lessee acquires an asset under the
lease which is in fact a loan. Therefore, the accounting entry is:
The amount of the accounting entry is lower of the fair value of the
leased property and the present value of the minimum lease
payments.
2. Lease payments
Each lease payment also contains the interest, as the finance lease
is in fact a loan. Therefore:
Each fixed installment therefore needs to be split between interest
paid and loan repayment. This split must be done as to produce
a constant periodic rate of interest on the remaining balance of
the liability for each period.
Actuarial method does this best – it uses the interest rate implicit
in the lease (internal rate of return of the lease) to calculate the
finance charge for the period based on the amount of outstanding
finance lease liability.
Please watch the following video with the demonstration of actuarial
method:
You can download the file with the example here.
The interest charge is recorded as:
The actual repayment or installment is recorded as:
3. Depreciation
As the lessee acquires the non-current asset, it must be depreciated
over the shorter of the lease term and asset’s useful life.
Depreciation entry is as follows:
How to account for finance leases
(lessor)
The concept of lessor accounting for finance leases is the same as for the
lessee, but the perspective is a bit different. The capital part of the lease
payments is a receivable in the lessor’s financial statements and the
interest part is a finance income.
How to account for operating leases
Here, as no asset is acquired by the lessee, the rental payments should be
recognized as an expense in the income statement, most of the time on a
straight line basis.
Is the some change in the lease
accounting in the near future?
Oh yes. IASB issued the new standard about leases in 2016 – IFRS 16
Leases and as a result, the lease reporting will change substantially,
especially when it comes to the lesees’ accounting.
For more information about the new standard IFRS 16, we
recommend reading this article.
If you want to take a short look at IAS 17, please watch the video
summarizing current IAS 17 and new developments here:
Want to learn more? Check out IFRS
Kit so you