International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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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;
(b) for a lessor, any residual value guaranteed to the lessor by:
(i) the lessee or by a party related to the lessee; or
(ii) a third party unrelated to the lessor who is financially capable of discharging
the obligations under the guarantee.
The lessee may have an 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 so that,
at the inception of the lease, it is reasonably certain to be exercised. In this case the
minimum lease payments comprise the minimum payments payable over the lease term
to the expected date of exercise of this purchase option and the payment required to
exercise it. [IAS 17.4].
3.4.4
Lease term and non-cancellable period
The lease term is the non-cancellable period for which the lessee has contracted to lease
the asset, together with any further terms for which the lessee has the option to continue
to lease the asset, with or without further payment, if it is reasonably certain at the
inception of the lease that the lessee will exercise the option. [IAS 17.4]. A non-cancellable
lease is either a lease that has no cancellation terms or one that has terms that effectively
force the lessee to continue to use the asset for the period of the agreement. Therefore,
a lease is considered to be non-cancellable if it can be cancelled only:
Leases (IAS 17) 1635
(a) on the occurrence of a remote contingency;
(b) with the permission of the lessor;
(c) if the lessee enters into a new lease with the same lessor for the same or an
equivalent asset; or
(d) if the lessee is required to pay additional amounts that make it reasonably certain
at inception that the lessee will continue the lease. [IAS 17.4].
An example of (d) is a requirement that the lessee pays a termination payment
equivalent to the present value of the remaining lease payments.
3.4.5
Interest rate implicit in the lease and incremental borrowing rate
The interest rate implicit in the lease (‘IIR’) is 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. Example 23.9 at 3.4.9 below illustrates the calculation of the implicit interest rate.
If it is not practicable to determine this then the lessee may use its incremental
borrowing rate of interest, which it is the rate of interest the lessee would have to pay
on a similar lease or, if that is not determinable, the rate that, at the inception of the
lease, the lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to purchase the asset. [IAS 17.4].
3.4.6 Residual
value
The guaranteed residual value is:
(a) for a lessee, the part of the residual value that is guaranteed by itself or by one of
its related parties. The amount of the guarantee is the maximum amount that
could, in any event, become payable; and
(b) for a lessor, it is the part of the residual value that is guaranteed by the lessee or by
a third party unrelated to the lessor who is financially capable of discharging the
obligations under the guarantee.
The lessor’s unguaranteed residual value is any part of the residual value of the leased
asset, the realisation of which is not assured or is guaranteed solely by a party related
to it. [IAS 17.4].
If the net present value of the residual value of an asset is significant and is not guaranteed
by the lessee or a party related to it, then the lease is likely to be classified as an operating
lease by the lessee. The lessee will not bear the risks of recovering the significant residual
value; consequently it is unlikely that ‘substantially all’ of the risks and rewards of
ownership will have passed to the lessee. However, as can be seen from Example 23.5
at 3.2.2.A above, the provision of a residual value guarantee by a lessee does not
necessarily mean that the lease will not be classified as an operating lease by the lessee.
There are frequently problems of interpretation regarding the significance of residual
values in lease classification. Lessees may find it difficult to obtain information in order
1636 Chapter 23
to calculate the unguaranteed residual values. If lessees guarantee all or part of the
residual value of the asset, this has to be taken into account in the lease classification.
3.4.6.A
Residual value guarantors
A lessee and lessor may legitimately classify the same lease differently if the lessor has
received a residual value guarantee provided by a third party. [IAS 17.9]. Residual value
guarantors undertake to acquire the assets from the lessor at an agreed amount at the
end of the lease term because they can dispose of the assets on a ready and reliable
market. As a result, such a lease is an operating lease for the lessee and a finance lease
for the lessor. Residual value guarantors may be prepared to take the residual risk with
many types of assets as long as there is a second-hand market. This is particularly
common with vehicle leases where there is an efficient second-hand market, including
price guides, many car dealers and car auctions.
3.4.7
Contingent rents and embedded derivatives
Contingent rents, which are excluded from minimum lease payments, are defined in the
standard as that portion of the lease payments that are not fixed in amount, but are
based on a factor other than just the passage of time (for example, percentage of sales,
amount of usage, price indices, market rates of interest). [IAS 17.4].
Contingent rents will often meet the definition of embedded derivatives, as defined by
IFRS 9, and in that case fall within the scope of that standard. An embedded derivative
is a component of a hybrid contract that also includes a non-derivative host; with the
effect that some of the cash flows of the combined instrument vary in a way similar to
a stand-alone derivative. In other words, it causes some or all of the cash flows that
otherwise would be required by the contract to be modified according to a specified
underlying. An exception would be lease contracts where the contingency is a non-
financial variable specific to a party to the lease contract. [IFRS 9.4.3.1]. Embedded
derivatives have to be separated from the host lease contract and recognised separately
in the financial statements of the entity unless they are closely related to the economic
characteristics and risks of the host contract. [IFRS 9.4.3.3].
IFRS 9 specifically identifies the examples of contingent rents referred to in IAS 17 as
being ‘closely related’ to the lease contract and hence not separately accounted for.
[IFRS 9.B4.3.8(f)]. This means that lessees continue to expense such contingent payments
as they arise.
However, other types of contingent rent could be embedded derivatives, e.g. an index
> that relates to inflation in another economic environment or a leveraged inflation
related index. [IFRS 9.B4.3.8(f)].
A contingent rent may be subject to a cap or floor, e.g. a rental payment increases
annually in line with an inflation index but there is a maximum or minimum increase,
or both.
IFRS 9 allows embedded floors or caps on the interest rate on a debt contract to be
closely related to the host contract as long as the cap is at or above and the floor
similarly at or below current market rates of interest and they are not leveraged in
relation to the host contract. [IFRS 9.B4.3.8(b)]. Therefore, caps and floors on closely
Leases (IAS 17) 1637
related derivatives in leases that meet these criteria and are not otherwise leveraged are
themselves considered to be closely related and not accounted for separately.
In the case of more complex lease terms, reference should be made to IFRS 9
paragraphs 4.3.3 to 4.3.7. See Chapter 42 at 5.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership. [IAS 17.8]. Contingent payments will be taken into account in
assessing whether substantially all of the risks and rewards of ownership have been
transferred e.g. property rentals that are periodically reset to market rates would tend
to indicate that risks and rewards rest with the lessor – see the discussion at 3.2.2 above.
This still leaves open to debate whether a particular ‘contingency’ is in fact contingent
or is so certain that it ought to be reflected in the minimum lease payments for the
purposes of classifying the lease. IAS 17 contains no explicit guidance in this respect,
and in practice, this will be based on an assessment of the individual circumstances.
However, unlike IAS 17, IFRS 16 explicitly addresses in-substance fixed lease payments,
being those payments that may, in form, contain variability but that, in substance, are
fixed. [IFRS 16.B42]. The IASB understands that the approach to in-substance fixed lease
payments required by IFRS 16 is similar to the way in which entities apply IAS 17, even
though IAS 17 does not contain explicit requirements in this respect. [IFRS 16.BC164]. As
such, the guidance on in-substance fixed lease payments provided by IFRS 16 may be
helpful to those entities still applying IAS 17. The identification of in-substance fixed
lease payments under IFRS 16 is discussed at Chapter 24 at 4.5.1.
Lessees under finance leases need to disclose the minimum lease payments payable
under finance leases and contingent rents recognised as an expense in the period
(see 9.2 below). [IAS 17.31(b), 31(c)].
3.4.7.A Contingent
rents and operating leases
IAS 17 specifies that lessees expense contingent rents relating to finance leases in the
period in which they are incurred. [IAS 17.25]. However, the standard is not explicit in the
treatment of contingent elements of operating lease rentals.
In its May 2006 meeting, the Interpretations Committee considered whether an
estimate of contingent rents should be included in the total operating lease payments
or lease income to be recognised on a straight-line basis over the lease term. It
concluded in July 2006 that current practice was to exclude such amounts and did not,
therefore, add the matter to its agenda for further consideration. Accordingly, lease
payments or receipts under operating leases may exclude contingent amounts.
Views are divided on whether minimum lease payments determined at the inception of
the lease are revised on the occurrence of the contingency, e.g. whether minimum lease
payments change when there are rent revisions that are stipulated in the original lease
agreement, either for straight-line recognition or disclosure purposes.
Contingent property rents are common. They usually fall into one of two categories:
rents that vary in accordance with an index (e.g. a cost or retail price index) or those
that vary with turnover or a similar contingency. In the case of contingencies based on
an index, it is our view that disclosure should reflect all contingencies that have
occurred in future minimum lease disclosures. This is on the basis that the contingency
1638 Chapter 23
has occurred and IAS 17 specifies disclosure of future minimum lease payments. If the
initial payment before any indexation changes was 100 per year and at the end of year 1,
the index was 102.5, the minimum lease payments for disclosure purposes would be
102.5 for each remaining year of the lease term.
Lease disclosures relating to minimum lease payments and contingent rents are
discussed at 9 below.
3.4.8
Initial direct costs
Initial direct costs are incremental costs that are directly attributable to negotiating and
arranging a lease, except for such costs incurred by manufacturer or dealer lessors.
[IAS 17.4].
If the lessee incurs costs that are directly attributable to activities it has performed
to obtain a finance lease, these are added to the amount recognised as an asset.
[IAS 17.24]. IAS 17 is silent on the treatment of initial direct costs of operating leases
but there seems to be no restriction, in principle, to an entity selecting a policy of
recognising initial direct costs as assets and amortising them, as appropriate, over
the lease term.
Initial direct costs of lessors include amounts such as commissions, legal fees and
internal costs that are incremental and directly attributable to negotiating and
arranging a lease. Internal costs must exclude general overheads such as those
incurred by a sales or marketing team. [IAS 17.38]. The Interpretations Committee
confirmed in March 2014 that incremental costs are those that would not have been
incurred if the entity had not negotiated and arranged a lease. This means that the
fixed salary costs of permanent staff involved in negotiating and arranging new
leases (and loans) do not qualify as ‘incremental costs’. Lessors must add internal
direct costs to the carrying value of leased assets under both finance and operating
leases – see 4.2 and 5.2 below – unless they are manufacturer and dealer lessors, in
which case they must be expensed – see 4.4 below.
3.4.9
Calculation of the implicit interest rate and present value of
minimum lease payments
An entity will frequently have to calculate the net present value of the minimum
lease payments in order to classify a lease as a finance or operating lease as well as
in accounting for finance leases. Once it has the necessary information it can
calculate the implicit interest rate and present value of minimum lease payments, as
in the following example:
Example 23.9: Calculation of the implicit interest rate and present value of
minimum lease payments
Details of a non-cancellable lease are as follows:
(i) Fair value = €10,000
(ii) Five annual rentals payable in advance of €2,100
(iii) Lessor’s unguaranteed estimated residual value at end of five years = €1,000
The implicit interest rate in the lease is that which gives a present value of €10,000 for the five rentals plus
the total estimated residual value at the end of year 5. This rate can be calculat
ed as 6.62%, as follows:
Leases (IAS 17) 1639
Finance charge
Capital sum at
Capital sum
(6.62% per Capital sum at
Year
start of period
Rental paid
during period
annum)
end of period
€ €
€
€
€
1 10,000
2,100
7,900
523
8,423
2 8,423
2,100
6,323
419
6,742
3 6,742
2,100
4,642
307
4,949
4 4,949
2,100
2,849
189
3,038
5 3,038
2,100
938
62
1,000
10,500
1,500
In other words, 6.62% is the implicit interest rate that, at the inception of the lease, causes the aggregate
present value of the minimum lease payments (€10,500) and the unguaranteed residual value (€1,000) to be
equal to the fair value of the leased asset. Lessor’s initial direct costs have been excluded for simplicity.
This implicit interest rate is then used to calculate the present value of the minimum lease payments, i.e.
€10,500 discounted at 6.62%. This can be calculated at €9,274, which is 92.74% of the asset’s fair value,
indicating that the present value of the minimum lease payments is substantially all of the fair value of the
leased asset and a finance lease classification is therefore indicated.
It would be appropriate for the lessee to record the asset at €9,274 as the present value of the minimum lease
payments is lower than the fair value and this would take account of the lessor’s residual interest in the asset.
The lessor will know all of the information in the above example, as it will have been
used in the pricing decision for the lease. However, the lessee may not know either the
fair value or the unguaranteed residual value and, therefore, not know the implicit
interest rate. In such circumstances the lessee will substitute a rate from a similar lease
or its incremental borrowing rate. The lessee is also unlikely to know the lessor’s initial