direct costs even if the other information is known, but this is unlikely to have more
than a marginal effect on the implicit interest rate.
3.5
Leases as financial instruments
In accordance with the accounting model in IAS 17, a finance lease is essentially
regarded as an entitlement to receive, and an obligation to make, a stream of payments
that are substantially the same as blended payments of principal and interest under a
loan agreement. Consequently, the lessor accounts for its investment in the amount
receivable under the lease contract rather than the leased asset itself. An operating
lease, on the other hand, is regarded primarily as an uncompleted contract committing
the lessor to provide the use of an asset in future periods in exchange for consideration
similar to a fee for a service. The lessor continues to account for the leased asset itself
rather than any amount receivable in the future under the contract.
Accordingly, a finance lease is regarded by IAS 32 – Financial Instruments: Presentation
– as a financial instrument and an operating lease is not, except as regards individual
payments currently due and payable. [IAS 32.AG9].
In general the lease rights and obligations that come about as a result of IAS 17’s
recognition and measurement rules are not included within the scope of IFRS 9.
Finance lease assets and liabilities are not necessarily stated at the same amount as they
would be if they were measured under IFRS 9. The most obvious differences are those
between the implicit interest rate and the effective interest rate. The IIR (as described
in 3.4.5 above) is the discount rate that, at the inception of the lease, causes the
1640 Chapter 23
aggregate present value of the minimum lease payments (receivable during the non-
cancellable lease term and any option periods that it is reasonably certain at inception
the lessee will exercise) and 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. [IAS 17.4]. The
effective interest rate, by contrast, is the rate that exactly discounts estimated future
cash payments or receipts through the expected life of the financial instrument (see
Chapter 46 at 3). [IFRS 9 Appendix A]. The latter may include payments that would be
considered contingent rentals, and hence excluded, from the calculation of the IIR and
may take account of cash flows over a different period.
However, paragraph 2.1(b) of IFRS 9 prior to the effective date of IFRS 16 noted that
the following aspects of accounting for leases are within the scope of IFRS 9:
(a) finance lease payables recognised by a lessee are subject to the derecognition
provisions (see 4.3.1 below);
(b) lease receivables recognised by a lessor, which are subject to the derecognition
and impairment provisions of IFRS 9 (see 4.3.2 below); and
(c) derivatives that are embedded in leases are subject to IFRS 9’s embedded
derivatives provisions (see 3.4.7 above).
IFRS
9 has little impact on traditional, straightforward leases. However, its
requirements will have to be considered in many more complex situations and in
relation to sub-leases and back-to-back leases, as described in 8 below.
4
ACCOUNTING FOR FINANCE LEASES
Lessees recognise finance leases as assets and liabilities in their statements of financial
position at the commencement of the lease term at amounts equal to the fair value of the
leased item or, if lower, at the present value of the minimum lease payments, each
determined at the inception of the lease. In calculating the present value of the minimum
lease payments the discount factor is the interest rate implicit in the lease, if this is
practicable to determine; if not, the lessee’s incremental borrowing rate should be used. Any
initial direct costs of the lessee are added to the recognised asset. [IAS 17.20, 21]. ‘Fair value’,
‘minimum lease payments’ and ‘initial direct costs’ are defined in 3.4.2, 3.4.3 and 3.4.8 above.
The fair value and the present value of the lease payments are both determined as at
the inception of the lease. At commencement, the asset and liability for the future lease
payments are recognised in the statement of financial position at the same amount
(except for any initial direct costs added to the recognised asset). [IAS 17.22]. As discussed
at 3.4.1 above, the initial calculation of the asset and liability at inception of the lease
may differ from the amount determined at lease commencement. At commencement,
both asset and liability must be recognised separately, with an appropriate distinction
between current and non-current liabilities being made. [IAS 17.23]. The terms and
calculations of initial recognition by lessees are discussed further in 4.1 below.
Lease payments made by the lessee are apportioned between the finance charge and the
reduction of the outstanding liability. The finance charge should be allocated to periods
during the lease term so as to produce a constant periodic rate of interest on the remaining
balance of the liability for each period. [IAS 17.25]. This is covered in 4.1.2 below.
Leases (IAS 17) 1641
Lessors recognise assets held under a finance lease as receivables in their statement of
financial position and present them as a receivable at an amount equal to the net
investment in the lease. [IAS 17.36]. Lessors who are not manufacturers or dealers include
costs that they have incurred in connection with arranging and negotiating a lease as
part of the initial measurement of the finance lease receivable. Initial recognition by
lessors, which is in many respects a mirror image of lessee recognition, is discussed
at 4.2 below. The recognition of finance income and other issues in connection with
subsequent measurement of the lessor’s assets arising from finance leases is dealt with
in 4.2.1 to 4.2.4 below. The consequences of terminating a finance lease are described
in 4.3 below.
Manufacturer or dealer lessors have specific issues with regard to recognition of selling
profit and finance income. These are dealt with at 4.4 below.
4.1
Accounting by lessees
4.1.1 Initial
recognition
At commencement of the lease, the asset and liability for the future lease payments are
recorded in the statement of financial position at the same amount, which is an amount
equal to the fair value of the leased asset or the present value of the minimum lease
payments, if lower, with initial direct costs of the lessee being added to the asset.
[IAS 17.22]. An example of the calculation is given in Example 23.9 at 3.4.9 above.
4.1.2
Allocation of finance costs
The standard requires that lease payments should be apportioned between the finance
charge and the reduction of the outstanding liability. The finance charge should be
allocated to periods during the lease term so as to produce a constant periodic rate of
interest on the remaining balance of the liability for each period. [IAS 17.25].
Example 23.10: Allocation of finance costs
In Example 23.9 above, the present value of the lessee’s minimum lease payments (payable at the beginning
of each period) was
calculated at €9,274 by using the implicit interest rate of 6.62%. The total finance charges
of €1,226 (total rentals paid of €10,500 less their present value of €9,274) are allocated over the lease term
as follows:
Finance charge
Liability at
Liability
(6.62% per
Liability at
Year
start of period
Rental paid
during period
annum)
end of period
€ €
€
€
€
1 9,274
2,100
7,174
475
7,649
2 7,649
2,100
5,549
368
5,917
3 5,917
2,100
3,817
253
4,070
4 4,070
2,100
1,970
130
2,100
5 2,100
2,100
–
–
–
10,500
1,226
The standard notes that, in practice, when allocating the finance charge to periods during the
lease term some form of approximation may be used to simplify the calculation. [IAS 17.26].
1642 Chapter 23
However, it provides no guidance as to the methodology that should be applied in allocating
finance charges to accounting periods.
Two methods that are used as approximations are the ‘sum of the digits’ (‘rule of 78’)
or simply taking the finance costs on a straight-line basis over the lease term. The
‘sum of digits’ method is based on allocating the finance charge based on the
cumulative number of payments still outstanding as illustrated in the example
below. These are progressively easier to apply but also give progressively less
accurate answers. There is, therefore, a trade-off to be made between the costs
versus the benefits of achieving complete accuracy, but in making this trade-off, the
question of materiality is important. If differences between allocated finance
charges under each method are immaterial, the simplest method may be used for
convenience. The converse also applies and, of course, a number of individually
immaterial differences may in aggregate be material.
The following example illustrates the implicit interest rate and sum of the digits
methods of allocating finance charges to accounting periods.
Example 23.11: Sum-of-digits allocation as compared to implicit interest rate
Continuing the lease example from Example 23.9 above, the sum of the digits method calculation is as follows:
Number of
total finance charge
Finance
rentals not
×
=
charge per
yet due
sum of number of rentals
annum
Year
€
1
4
×
€1,226 ÷ 10
=
490
2
3
×
€1,226 ÷ 10
=
368
3
2
×
€1,226 ÷ 10
=
245
4
1
×
€1,226 ÷ 10
=
123
5
–
×
€1,226 ÷ 10
=
–
10
1,226
We can now compare the finance charges in each of the five years under the implicit interest rate (IIR) as
calculated in Example 23.9 and sum of the digits methods:
Annual finance charge
Annual finance charge
as % of total rentals
Sum of
Sum of
IIR
the digits
IIR
the digits
Year €
€
%
%
1 475
490
39
40
2 368
368
30
30
3 253
245
20
20
4 130
123
11
10
5 –
–
–
–
1,226
1,226
100
100
As can be seen above, in situations where the lease term is not very long (typically not more than seven years)
and interest rates are not very high, the sum of the digits method gives an allocation of finance charges that
is close enough to that under the implicit interest rate method to allow the simpler approach to be used.
Leases (IAS 17) 1643
4.1.3
Recording the liability
The carrying amount of the liability will always be calculated in the same way, by adding
the finance charge (however calculated) to the outstanding balance and deducting cash
paid. The finance charge depends on the method used to apportion the finance costs.
If the IIR method is used, the liability in each of the years, as apportioned between the
current and non-current liability, is as follows:
Example 23.12: Lessee’s liabilities and interest expense
The entity entering into the lease in Example 23.9 will record the following liabilities and interest expense
in its statement of financial position:
Non-
Interest expense
Liability at
Current liability
current liability at
(at 6.62%)
Year
end of period
at end of period
end of period
for the period
€ €
€
€
1 7,649
2,100
5,549
475
2 5,917
2,100
3,817
368
3 4,070
2,100
1,970
253
4 2,100
2,100
–
130
5 –
–
–
–
1,226
4.1.4
Accounting for the leased asset
At commencement of the lease, the asset and liability for the future lease payments are
recorded in the statement of financial position at the same amount, with initial direct
costs of the lessee being added to the asset. [IAS 17.22]. These are costs that are directly
attributable to the lease and are added to the carrying value, [IAS 17.24], in an analogous
way to the treatment of the acquisition costs of property, plant and equipment.
Accounting for the leased asset follows the general rules for accounting for property,
plant and equipment or intangible assets. A finance lease gives rise to a depreciation
expense for depreciable assets as well as a finance expense for each accounting period.
The depreciation policy for depreciable leased assets should be consistent with that for
depreciable assets that are owned, and the depreciation recognised should be
calculated in accordance with IAS 16 (see Chapter 18) and IAS 38 (see Chapter 17).
[IAS 17.27]
. The useful life is the estimated remaining period, from the commencement of
the lease term but without the limitation of the lease term, over which the entity expects
to consume the economic benefits embodied in the asset. This is different from the
economic life which takes account of the period of time for which the asset is
economically usable by one or more users and would therefore include additional lease
terms with the same or different lessees. [IAS 17.4]. 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
its useful life or the lease term. [IAS 17.28]. IAS 17 does not address the situation in which
an entity expects to extend a lease but it is not reasonably certain at inception that it
will do so. In our view, the entity is not precluded from depreciating assets either over
the lease term or over the shorter of the asset’s useful life and the period for which the
entity expects to extend the lease. See also Chapter 18 at 5.4.
1644 Chapter 23
Because the interest expense and depreciation must be calculated separately and are
unlikely to be the same it is not appropriate simply to treat the lease payments as an
expense for the period. [IAS 17.29]. This is demonstrated in the following example.
Example 23.13: Lessee’s depreciation and interest expense
The entity that has entered into the lease agreement described in Example 23.9 will depreciate the asset
(whose initial carrying value, disregarding initial direct costs, is €9,274) on a straight-line basis over five
years in accordance with its depreciation policy for owned assets, i.e. an amount of €1,855 per annum. The
balances for asset and liability in the financial statements in each of the years 1-5 will be as follows:
Carrying
value of asset
Total liability
Total charged
at end of
at end of
to income
Lease
Year
period
period
statement*
payments
€
€
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 324