residual was not expected to become payable by the lessee, then the depreciation charge
may have been calculated to give a net book value at the end of the lease term equal to
the residual element not expected to become payable. If this estimate was correct then
the remaining obligation will equal the net book value of the relevant asset, so that the
gain on derecognition of the liability will be equal to the loss on derecognition of the asset.
Example 23.16: Early termination of finance leases by lessees
In Example 23.5 above there is effectively a guarantee of a residual of €3,000 dependent on the mileage
driven by the leased vehicle. Assuming the lease is capitalised as a finance lease, if the lessee considered, at
the lease inception, that the guarantee will not be called on, the vehicle will be depreciated to an estimated
residual value of €3,000 over the lease term. In the event that this estimate is found to be correct, the loss on
disposal of the asset at its written down value will be equal and opposite to the gain on derecognition of the
lease obligation of €3,000. However, if, for example, €1,000 of the guarantee was called on, then the net
book value of €3,000 (which assumes that the lessee had not previously adjusted the residual value of the
leased asset for depreciation purposes, nor impaired the leased asset) and the unused guarantee of €2,000 will
both be derecognised. As a result, a loss of €1,000 will be recorded on disposal of the vehicle.
4.3.2
Termination and impairment of finance leases by lessors
Although lease receivables are not financial instruments within scope of IFRS 9, the
carrying amounts recognised by a lessor are subject to the derecognition and
impairment provisions of those standards. Generally, a financial asset is derecognised
when the contractual rights to the cash flows from that asset have expired. [IFRS 9.3.2.3,].
This will apply to most leases at the end of the term when the lessor has no more right
to cash flows from the lessee.
If the cash flows from the financial asset have not expired, it is derecognised when, and
only when, the entity ‘transfers’ the asset within the specified meaning of the term in
IFRS 9, and the transfer has the effect that the entity has either:
(a) transferred substantially all the risks and rewards of the asset; or
(b) neither transferred nor retained substantially all the risks and rewards of the asset
and has not retained control of the asset. [IFRS 9.3.2.3]. If the rights to the cash are
retained then there are other tests that must be met. [IFRS 9.3.2.5].
These requirements are relevant to common lease situations such as sub-leases and
back-to-back leases, dealt with at 8 below. Derecognition of financial assets is a
complex area discussed in Chapter 48 at 3.
4.3.2.A
Impairment of lease receivables
For lease receivables, prior to the effective date of IFRS 16 paragraph 5.5.15(b) of IFRS 9
allows a policy choice to apply either the general impairment approach or the simplified
approach separately to finance and operating lease receivables. Under the general
approach, at each reporting date, the lessor recognises a loss allowance based on either
12-month expected credit losses or lifetime expected credit losses, depending on
whether there has been a significant increase in credit risk on the lease receivable since
initial recognition. [IFRS 9.5.5.3, IFRS 9.5.5.5]. The simplified approach does not require the
lessor to track changes in credit risk, but instead requires the lessor to recognise a loss
1650 Chapter 23
allowance based on lifetime expected credit losses at each reporting date. [IFRS 9.5.5.15].
When measuring a loss allowance for a lease receivable, paragraphs B5.5.34 and B5.5.46
of IFRS 9 prior to the effective date of IFRS 16 require that the cash flows used for
determining the expected credit losses should be consistent with the cash flows used
for measuring the lease receivable in accordance with IAS 17 and using the same
discount rate used in the measurement of the lease receivable. Therefore, if the lessor
modifies the lease and reschedules and/or reduces amounts due under the lease, the
loss is measured by reference to the new carrying amount of the receivable, calculated
by discounting the estimated future cash flows at the original implicit interest rate. We
do not believe that the unguaranteed residual value of the asset subject to a finance
lease should be included in the calculation of expected credit losses under IFRS 9.
Impairment of lease receivables under IFRS 9 is discussed further in Chapter 47 at 10.2.
4.3.2.B
Early termination of finance leases for lessors
Any termination payment received by a lessor on an early termination will reduce the lessor’s
net investment in the lease shown as a receivable. The recognition of a gain or loss on early
termination will depend upon the amount of termination payment received, and the value
of the leased asset returned to the lessor on termination of the lease. If the sum of the
termination payment and value of asset returned is greater than the carrying amount of the
net investment, the lessor will account for a gain on derecognition of the lease; conversely,
if the sum of the termination payment and the value of the leased asset returned is smaller
than the net investment, a loss will be shown. If the leased asset is retained by the lessee on
early termination of the lease, the gain or loss recognised by the lessor will depend upon
whether the termination payments is greater or smaller than the net investment in the lease.
Losses on termination in the ordinary course of business are less likely to arise because
a finance lease usually has termination terms so that the lessor is compensated fully for
early termination and the lessor has legal title to the asset. The lessor can continue to
include the asset in current assets as a receivable to the extent that sales proceeds or
new finance lease receivables are expected to arise. If the asset is then re-leased under
an operating lease, the asset may be transferred to property, plant and equipment
(PP&E) and depreciated over its remaining useful life. There is no guidance about the
amount at which the asset is recognised in PP&E. Although paragraph 2.1(b) of IFRS 9
prior to the effective date of IFRS 16 notes that the net investment (i.e. the lease
receivable recognised by the lessor) is not a financial instrument within scope of IFRS 9,
in general we expect that entities would use the carrying amount of the net investment
as the cost of the reacquired item of PP&E. However, in the absence of authoritative
guidance we would expect there to be divergence in practice. If the asset is designated
as held for sale then the requirements of IFRS 5 will apply (see Chapter 4). The aspects
of lease assets and liabilities that are within scope of IFRS 9 are described at 3.5 above.
Leases (IAS 17) 1651
4.4
Manufacturer or dealer lessors
Manufacturers or dealers often offer customers the choice of either buying or leasing
an asset. While there is no selling profit on entering into an operating lease because it is
not the equivalent of a sale, [IAS 17.55], a finance lease of an asset by a manufacturer or
dealer lessor gives rise to two types of income:
the asset being leased, at normal selling prices, reflecting any applicable volume or
trade discounts; and
(b) the finance income over the lease term. [IAS 17.43].
If the customer is offered the choice of paying the cash price for the asset
immediately or paying for it on deferred credit terms then, as long as the credit
terms are the manufacturer or dealer’s normal terms, the cash price (after taking
account of applicable or volume discounts) can be used to determine the selling
profit. [IAS 17.42]. However, in many cases such an approach should not be followed
as the manufacturer or dealer’s marketing considerations often influence the terms
of the lease. For example, a car dealer may offer 0% finance deals instead of
reducing the normal selling price of his cars. It would be inappropriate in this
instance for the dealer to record a profit on the sale of the car and no finance income
under the lease.
The standard, therefore, requires sales revenue to be based on the fair value of the asset
(i.e. the cash price) or, if lower, the present value of the minimum lease payments
computed at a market rate of interest. As a result, if artificially low rates of interest are
quoted, selling profit is restricted to that which would apply if a commercial rate of
interest were charged. [IAS 17.44-45]. The cost of sales is reduced to the extent that the
lessor retains an unguaranteed residual interest in the asset. [IAS 17.44].
Initial direct costs should be recognised as an expense in the income statement at
the inception of the lease. This is not the same as the treatment when a lessor
arranges a finance lease where the costs are added to the finance lease receivable;
the standard argues that this is because the costs are related mainly to earning the
selling profit. [IAS 17.46]. If the manufacturer or dealer is in the position of incurring
an overall loss because the total rentals receivable under the finance lease are less
than the cost to it of the asset then, this loss should be taken to profit or loss at
the inception of the lease. IAS 17 assumes that the manufacturer or dealer will
have a normal implicit interest rate based on its other leasing activity. However,
in other situations where the manufacturer or dealer does not conduct other
leasing business, an estimate will have to be made of the implicit rate for the
leasing activity.
1652 Chapter 23
Example 23.17: Manufacturer or dealer lessors
A company manufactures specialised machinery. The company offers customers the choice of either buying
or leasing the machinery. A customer chooses to lease the machinery. Details of the arrangement are as
follows:
(i) The lease commences on 1 January 20X1 and lasts for three years.
(ii) The lessee makes three annual rentals payable in arrears of €57,500.
(iii) The leased machinery is returned to the lessor at the end of the lease.
(iv) Fair value of the machinery is €150,000, which is equivalent to the selling price of the machinery.
(v) The machinery cost €100,000 to manufacture. The lessor incurred costs of €2,500 to negotiate and
arrange the lease.
(vi) The expected useful life of the machinery is 3 years. The machinery has an expected residual value of
€10,000 at the end of year three. The estimated residual value does not change over the term of the lease.
(vii) The interest rate implicit in the lease is 10.19%.
The lessor classifies the lease as a finance lease.
The cost to the lessor of providing the machinery for lease consists of the book cost of the machinery
(€100,000), plus the initial direct costs associated with entering into the lease (€2,500), less the future income
expected from disposing of the machinery at the end of the lease (the present value of the unguaranteed
residual value of €10,000, being €7,475). This gives a cost of sale of €95,025.
The lessor records the following entries at the commencement of the lease:
Debit
Credit
€
€
Lease receivable
150,000
Cost of sales
95,025
Inventory
100,000
Revenue
142,525
Creditors / cash (initial direct costs)
2,500
The sales profit recognised by the lessor at the commencement of the lease is therefore €47,500 (€142,525 –
€95,025). This is equal to the fair value of the machinery of €150,000, less the book value of the machinery
(€100,000) and the initial direct costs of entering into the lease (€2,500). Revenue is equal to the lease
receivable (€150,000), less the present value of the unguaranteed residual value (€7,475).
Lease payments received from the lessee will then be allocated over the lease term as follows:
Year Lease
Lease
Interest
Decrease
Lease
receivable at
payments (€)
income
in lease
receivable at
the start of the
(10.19% per
receivable (€)
the end of the
year (€)
annum) (€)
year (€)
(a)
(b)
(c)
(d)=(b)–(c) (e)=(a)–(d)
1 150,000
57,500
15,280
42,220
107,780
2
107,780 57,500
10,979
46,521 61,260
3
61,260 57,500
6,240
51,260 10,000
The lessor will record the following entries:
Debit
Credit
€
€
Year 1
Cash
57,500
Lease
receivable
42,220
Interest
income
15,280
Leases (IAS 17) 1653
Debit
Credit
€
€
Year 2
Cash
57,500
Lease
receivable
46,521
Interest
income
10,979
Year 3
Cash
57,500
Lease
receivable
51,260
Interest
income
6,240
At the end of the three year lease term, the leased machinery will be returned to the lessor, who will record
the following entries:
Inventory 10,000
Lease receivable
10,000
5
ACCOUNTING FOR OPERATING LEASES
5.1
Operating leases in the financial statements of lessees
IAS 17 requires lease payments under an operating lease, excluding costs for services
such as insurance and maintenance, to be recognised as an expense on a straight-line
basis over the lease term unless another systematic basis is representative of the time
pattern of the user’s benefit, even if the payments are not on that basis. [IAS 17.33, 34].
Generally, the only other acceptable bases are where rentals are based on a unit of
use
or unit of production.
IAS 17 requires a straight-line recognition of the lease expenses even when amounts
are not payable on this basis. This does not require the entity to anticipate
contingent rental increases, such as those that will result from a periodic re-pricing
to market rates or those that are based on some other index (see 3.4.7 above).
However, lease payments may vary over time for other reasons that will have to be
taken into account in calculating the annual charge. Described in more detail below
are some examples: leases that are inclusive of services, leases with increments
intended to substitute for inflation and security deposits made with lessors that
attract low or no interest. Lease incentives are another feature that may affect the
cash flows under a lease; they are dealt with in more detail in 5.1.4 (for lessees)
and 5.2.2 (for lessors) below. Operating leases often contain clauses which specify
that the lessee should incur periodic charges for maintenance, make good
dilapidations or other damage occurring during the rental period or return the asset
to the configuration that existed as at inception of the lease. The accounting for
these obligations is addressed in Chapter 27 at 6.9.
5.1.1
Leases that include payments for services
There is a wide range of services that can be subsumed into a single ‘lease’ payment.
For a vehicle, the payment may include maintenance and servicing. Property leases
could include cleaning, security, reception services, gardening, utilities and local
and property taxes. Single payments for operating facilities may include lease
payments for the plant and the costs of operating them, as discussed in the context
of IFRIC 4; see Example 23.1 at 2.1.3 above. IAS 17 says in the definition of minimum
1654 Chapter 23
lease payments that the costs of services should be excluded to arrive at the lease
payments. [IAS 17.4]. This is straightforward enough if the payments are made by the
lessor and quantified in the payments made by the lessee. It will be somewhat less
so if, for example, the lessor makes all maintenance payments but does not specify
the amounts; instead, payments are increased periodically to take account of
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 326
