a conventional licence described above.
3.1.2
Arrangements over intangible assets
IAS 17 applies to leases over intangible assets.
IAS 38 excludes from its scope ‘intangible assets that are within the scope of another
Standard.’ [IAS 38.2]. Paragraph 3 of IAS 38 prior to the effective date of IFRS 16
emphasised that ‘if another Standard prescribes the accounting for a specific type of
intangible asset, an entity applies that Standard instead of this Standard. For example,
this Standard does not apply to... leases that are within the scope of IAS 17 Leases.’ This
is because rights themselves arising under a number of accounting standards could be
seen as intangible assets, e.g. deferred tax assets as well as assets arising under lease
agreements. Therefore, IAS 38 excludes intangible assets that fall within the scope of
another standard from its scope, thereby avoiding any potential ambiguity about the
applicable standard. [IAS 38.3]. It does not mean that the underlying items that are the
subject of the lease arrangement are not intangible assets, but that recognition and
measurement are within scope of IAS 17. IAS 38’s clarification of the applicable
standard applies to all rights arising under lease agreements, whether over tangible or
intangible assets. Subsequent accounting for the asset, e.g. amortisation, is in
accordance with IAS 38. See 4.1.4 below.
However, there are additional issues for applying IAS 17 to rights to an intangible asset.
First, the ‘right’ must meet the definition of an intangible asset in IAS 38. Second,
because many of these rights are either acquired for an up-front sum or for a series of
periodic payments and by definition the period covered by the payments equals the life
of the right, there is divergence in practice in how to account for them, i.e. whether
they are leases (and if so, whether finance or operating leases) or whether they are
acquisitions of assets on deferred payment terms.
Many intangible assets are capable of being subdivided with some part of the whole
meeting the definition of an intangible asset (see Chapter 17 at 2.1). If the rights are
exclusive, the lease part will meet the definition of an intangible asset because it is
embodied in legal rights that allow the acquirer to control the benefits arising from
the asset. For example, an entity might sell to another entity rights to distribute its
product in a particular geographical market. If the right is not on an exclusive basis
then it may not be within the scope of IAS 38, e.g. it may be a licensing agreement
as discussed above. Other arrangements may be for services and not for a right of
use of an intangible asset.
Note that it is irrelevant to the analysis whether the original right was recognised prior
to the arrangement in the financial statements of the lessor.
Rights that meet the definition of an intangible asset usually have a finite life, e.g. a
radio station may acquire a licence that gives it a right to broadcast over specified
frequencies for a period of seven years. Yet the underlying asset on which the right
depends exists both before and after the ‘right’ has been purchased and may have
an indefinite life, as is the case with the broadcast spectrum. Many intangible rights
can be purchased for an upfront sum, which will be accounted for as the acquisition
Leases (IAS 17) 1621
of an intangible asset that is capitalised at cost. As an alternative to an up-front
purchase, an entity may pay in a series of instalments over a period of time. Does it
become an operating lease because it is only a short period out of the life of the
underlying asset? Usually the answer is no: these rights will not be accounted for as
operating leases by comparison to the total life of the underlying asset as the
arrangement is over the right in question. If the arrangement is considered to be a
lease, then it will be accounted for in accordance with IAS 17, and classified by
reference to the right rather than the underlying asset.
If, rather than as a lease, the arrangement is seen as the acquisition of an asset on
deferred payment terms, the effective interest rate method is mandated. The effective
interest rate is the rate that exactly discounts estimated future cash payments or receipts
through the expected life of the financial instrument or, when appropriate, a shorter
period, to the carrying amount of the financial asset or financial liability. This will take
account of estimated future cash payments or receipts through the expected life of the
financial instrument, to the extent required by IFRS 9, which may include some of the
‘contingent’ payments that are excluded from the measurement of finance leases
(see 3.5 below).
Therefore, there are arguments as to whether there are assets and liabilities to be
recognised and, even if recognition is accepted, measurement depends on the view that
is taken of the applicable standard.
3.2 Lease
classification
3.2.1
Finance and operating leases
A finance lease is a ‘lease that transfers substantially all the risks and rewards incidental
to ownership of an asset’, and an operating lease is ‘a lease other than a finance lease’,
[IAS 17.4], i.e. a lease that does not transfer substantially all the risks and rewards
incidental to ownership.
The individual circumstances of a lessor and lessee may differ in respect of a single
lease contract. As a result, it is perfectly possible that the application of the
definitions to the different circumstances of the lessor and lessee may result in the
same lease being classified differently by them. For example, a lease may be
classified as an operating lease by the lessee and as a finance lease receivable by the
lessor if it includes a residual value guarantee provided by a third party. [IAS 17.9].
These are discussed further at 3.4.6 below.
3.2.2
Determining the substance of transactions
The classification of leases adopted in the standard is based on the extent to which the
risks and rewards incidental to ownership of a leased asset lie with the lessor or the
lessee. ‘Risks include the possibilities of losses from idle capacity or technological
obsolescence and of variations in return due to changing economic conditions. Rewards
may be represented by the expectation of profitable operation over the asset’s
economic life and of gain from appreciation in value or realisation of a residual value.’
[IAS 17.7].
1622 Chapter 23
Some national standards include the rebuttable presumption that the transfer of
substantially all of the risks and rewards occurs if, at the inception of the lease, the
present value of the minimum lease payments amounts to substantially all (normally
90% or more) of the fair value of the leased asset. IAS 17 provides no numerical
guidelines to be applied in classifying a lease as either finance or operating. It seems
that it was a conscious decision of the (then) IASC Board not to refer to a percentage
such as 90% in the standard, as it wanted to avoid the possibility of lease classification
being reduced to a single pass or fail test.
Instead, the standard takes a more
principles-based substance over form approach. It
makes the statement that the classification of a lease depends on the substance of the
transaction rather than the form of the contract, and lists a number of examples of
situations that individually or in combination would normally lead to a lease being
classified as a finance lease: [IAS 17.10]
(a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable
such that, at the inception of the lease, it is reasonably certain that the option will
be exercised (frequently called a ‘bargain purchase’ option);
(c) the lease term is for the major part of the economic life of the asset even if title is
not transferred;
(d) 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
(e) the leased assets are of a specialised nature such that only the lessee can use them
without major modifications being made.
All of these are indicators that the lessor will only look to the lessee to obtain a return
from the leasing transaction, so it can be presumed that the lessee will, in fact, pay for
the asset.
Although the first criterion refers to title being transferred, it is clear from the standard
that title does not have to be transferred to the lessee for a lease to be classified as a
finance lease. [IAS 17.4]. The point is that the lease will almost certainly be classified as a
finance lease if title does transfer.
The lease term must be measured by reference to economic life, which is the period
for which the leased asset is expected to be usable by one or more users. The economic
life will usually be shorter than the physical life if the asset is subject to technological
obsolescence. A computer may be capable of use for six or seven years but would rarely
be used beyond three years. It is less well appreciated that buildings suffer from
technological obsolescence which means that an office building which may remain
structurally sound for sixty years may have an economic life of half of that. This is
because it becomes increasingly hard to adapt buildings to rapidly-changing IT or
energy efficiency requirements. The residual value of these assets at the end of the
economic life is minimal.
The economic life would therefore include additional lease terms with the same or
different lessees. It is not the same as the useful life which is specific to the lessee and
Leases (IAS 17) 1623
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 (see 4.1.4 below).
‘Fair value’ is defined as the amount for which an asset could be exchanged or a liability
settled, between knowledgeable, willing parties in an arm’s length transaction (see 3.4.2
below). [IAS 17.4]. IFRS 13 – Fair Value Measurement – does not apply because the IASB
states that IAS 17 uses ‘fair value’ in a way that differs in some respects from the
definition in IFRS 13. [IAS 17.6A].
Options such as those referred to under (b) above are common in lease agreements. The
bargain purchase option is designed so that the lessee will exercise it and to give the
lessor its expected lender’s return (comprising interest on its investment perhaps
together with a relatively small fee) but no more, over the life of the agreement.
Criteria (c) and (d) above also include the unquantified expressions ‘major part of’
and ‘substantially all’, which means that judgement must be used in determining
their effect on the risks and rewards of ownership. By contrast, in US GAAP the
equivalent to (c) above in ASC 8402 does quantify when a lease will be a capital
lease, the equivalent of a finance lease. In ASC 840, if the lease term is equal to 75%
or more of the estimated economic life of the leased asset, the lease will normally
be a capital lease (there is an exception if the beginning of the lease term falls within
the last 25% of the total estimated economic life of the leased property, including
earlier years of use, where this criterion is not used for purposes of classifying the
lease, plus additional criteria specific to lessors).3 However in practice, if the lease
is for the major part of the economic life of the asset then it is unlikely that the
lessor will rely on any party other than the lessee to obtain its return from the lease.
This would still not be conclusive evidence that the lease should be classified as a
finance lease. There could be other terms that indicate that the significant risks and
rewards of ownership rest with the lessor, e.g. lease payments might be reset
periodically to market rates or there might be significant technological,
obsolescence or damage risks borne by the lessor.
Similarly, whilst (d) above refers to the present value of the minimum lease payments
being at least ‘substantially all of the fair value of the asset’, it does so without putting a
percentage to it. We have already speculated as to why this may be; nevertheless, we
see no harm in practice in applying the ‘90% test’ described above as a rule of thumb
benchmark as part of the overall process in reaching a judgement as to the classification
of a lease. Clearly, though, it cannot be applied as a hard and fast rule.
For an example of the 90% test, see Example 23.9 at 3.4.9 below. In that example,
the present value of the minimum lease payments is calculated to be 92.74% of the
asset’s fair value; as this exceeds 90%, this would normally indicate that the lease is
a finance lease. Nevertheless, the other criteria discussed above would need to be
considered as well.
Consequently, we stress that the 90% test is not an explicit requirement of the standard
and should not be applied as a rule or in isolation, but it may be a useful tool to use in
practice in attempting to determine the economic substance of a lease arrangement.
1624 Chapter 23
The standard then goes on to list the following indicators of situations that, individually
or in combination, could also lead to a lease being classified as a finance lease: [IAS 17.11]
(a) if the lessee can cancel the lease, the lessor’s losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual fall to the lessee
(for example, in the form of a rent rebate equalling most of the sale proceeds at
the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent
which is substantially lower than market rent.
IAS 17 notes that these examples are only indications and are not always conclusive. A
right to purchase the residual asset for its fair value or an expectation to pay substantially
all of the fair value of the asset if contingent rents are taken into account will not
necessarily give the lessee substantially all of the risks and rewards of ownership.
[IAS 17.12].
In o
ur view, other considerations that could be made in determining the economic
substance of the lease arrangement include the following:
• are the lease rentals based on a market rate for use of the asset (which would
indicate an operating lease) or a financing rate for use of the funds, which would
be indicative of a finance lease? and
• is the existence of put and call options a feature of the lease? If so, are they
exercisable at a predetermined price or formula (indicating a finance lease) or are
they exercisable at the market price at the time the option is exercised (indicating
an operating lease)?
Note that these two considerations mean that an arrangement for the whole of an asset’s
useful life may be an operating lease, as may an agreement in which the lessee has a
right to obtain title to the asset at market value.
3.2.2.A
Residual value guarantees by the lessee
One of the indicators listed in IAS 17 that may lead to a lease being classified as a finance
lease is where gains or losses from the fluctuation in the fair value of the residual accrue
to the lessee. [IAS 17.11]. However, this does not mean that a lease where the residual
value is guaranteed by the lessee will necessarily be classified as a finance lease. The
lease itself may be structured so that the most likely outcome of events relating to the
residual value indicates that no significant risk will attach to the lessee.
Example 23.5: A lease structured such that the most likely outcome is that the
lessee has no significant residual risk
Brief details of a motor vehicle lease are:
Fair value
– €10,000
Rentals
– 20 monthly payments of €300, followed by a final rental of €2,000
At the end of the lease, the lessee sells the vehicle as an agent for the lessor and if sold for:
(i) more than €3,000, the sales proceeds are paid to the lessor and 99% of the excess is repaid to the lessee; or
Leases (IAS 17) 1625
(ii) less than €3,000, the sales proceeds are paid to the lessor and lessee pays the deficit to the lessor up to
a maximum of 4 eurocents per kilometre above 25,000 kilometres p.a. on average that the leased vehicle
has done.
The net present value of the minimum lease payments excluding the guarantee amounts to €7,365.
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 320
