changes in such costs. In such a case the lessee will have to estimate the amount
paid for services and deduct them from the total. The remaining payments, which
relate solely to the right to use the asset, will then be spread on a straight-line basis
over the non-cancellable term of the lease.
5.1.2
Straight-line recognition over the lease term
Operating lease payments must be recognised on a straight-line basis over the lease
term, unless another systematic basis is more representative of the time pattern of the
user’s benefit. [IAS 17.33]. There are some lease payments that increase annually by fixed
increments intended to compensate for expected annual inflation over the lease period.
In considering the issue, the Interpretations Committee noted that IAS 17 does not
incorporate adjustments to operating lease payments to reflect the time value of money.
Except in those cases where another basis is more appropriate, it requires all operating
leases to be taken on a straight-line basis. They concluded that to allow recognition of
these increases on an annual basis would be inconsistent with the treatment of other
operating leases.10
Some leases allow for an annual increase in line with an index but with a fixed minimum
increment. As discussed in 3.4.7 above, contingent rents are excluded from the lease
payments but the fixed minimum increment will have to be spread so as to take the
payments on a straight-line basis over the lease term.
Example 23.18: Operating lease expenses with fixed annual increment
Entity A leases a property at an initial rent of €1,000,000 per annum. The lease has a non-cancellable term
of 30 years and rent increases annually in line with the Retail Prices Index (RPI) of the country in which the
property is situated but with a minimum increase of 2.5% (the estimated long-term rate of inflation in the
country in question) and a maximum of 5% per annum.
The annual increase of 2.5% must be taken into account in calculating the operating lease payment charged
to profit or loss. On a straight-line basis this will be €1,463,000 per annum. Therefore, by the end of year 15,
the entity will have paid rentals of €18 million, charged €22 million to income and will be recording an
accrual of €4 million.
If the increase in the RPI exceeds 2.5% these additional amounts will be charged to income as contingent rents.
5.1.3
Notional or actual interest paid to lessors
Lessees are sometimes required to place security deposits with lessors that are refunded
at termination to the extent that they have not been utilised by the lessor. Lessees often
receive either no or a reduced rate of interest on such deposits. The security deposit is
likely to be a financial asset in scope of IFRS 9 and will be initially measured by the
lessee at fair value. [IFRS 9.5.1.1]. If the deposit meets both the ‘business model assessment’
and ‘contractual cash flow characteristics’ tests in IFRS 9 the deposit will subsequently
be measured at amortised cost using the effective interest method. [IFRS 9.5.1.1, IFRS 9.4.1.2,
IFRS 9.5.4.1]. Accordingly, interest income would be recognised through profit and loss
Leases (IAS 17) 1655
over the life of the deposit. The ‘business model assessment’ and ‘contractual cash flow
characteristics’ tests are discussed in Chapter 44 at 5 and 6 respectively. At inception of
an operating lease, the difference between the nominal value of the deposit and its fair
value should be considered additional rent payable to the lessor. This will be expensed
on a straight-line basis over the lease term. Lessees will also need to consider the
impairment requirements of IFRS 9 in respect of the security deposit. Impairment of
financial assets is discussed in Chapter 47.
Example 23.19: Operating lease expenses reflecting interest payments to the
lessor
A lessee makes an interest-free security deposit of €1,000 on entering into a five year lease. It assesses an
appropriate rate of interest for the deposit to be 4% and accordingly the fair value of the deposit at inception
is €822. On making the deposit, it will record it as follows:
Year
€
€
1 Security
deposit
822
Advance
rentals
178
Cash
1,000
During the five years of the lease, it will record interest income and additional rental expense as follows:
Interest
Rental
Year
income
expense
Difference
1
33
(36)
(3)
2
34
(35)
(1)
3
36
(36)
–
4
37
(36)
1
5
38
(35)
3
178
(178)
5.1.4
Lease incentives – accounting by lessees
Incentives that may be given by a lessor to a lessee to enter into a new or renewed
operating lease agreement include an up-front cash payment to the lessee or the
reimbursement or assumption by the lessor of costs of the lessee, such as relocation
costs, leasehold improvements and costs associated with a pre-existing lease
commitment of the lessee. Alternatively, the lessor may grant the lessee rent-free or
reduced rent initial lease periods. [SIC-15.1].
The consensus reached by the SIC in Interpretation SIC-15 – Operating Leases –
Incentives – was that all incentives for the agreement of a new or renewed operating
lease should be recognised as an integral part of the net consideration agreed for the use
of the leased asset, irrespective of the incentive’s nature or form or the timing of
payments. [SIC-15.3]. The lessee should recognise the aggregate benefit of incentives as a
reduction of rental expense over the lease term, on a straight-line basis unless another
systematic basis is representative of the time pattern of the lessee’s benefit from the use
of the leased asset. [SIC-15.5]. Finally, SIC-15 requires costs incurred by the lessee, including
costs in connection with a pre-existing lease (for example, costs for termination,
relocation or leasehold improvements), to be accounted for by the lessee in accordance
1656 Chapter 23
with the IAS applicable to those costs, including costs which are effectively reimbursed
through an incentive arrangement. [SIC-15.6].
The following two examples, based on those in the Illustrative Examples to SIC-15,
illustrate how to apply the Interpretation:
Example 23.20: Accounting for lease incentives under SIC-15
Example 1
An entity agrees to enter into a new lease arrangement with a new lessor. As an incentive for entering into
the new lease, the lessor agrees to pay the lessee’s relocation costs. The lessee’s moving costs are €1,000.
The new lease has a term of 10 years, at a fixed rate of €2,000 per year.
The lessee recognises relocation costs of €1,000 as an expense in Year 1. Both the lessor and lessee would
recognise the net rental consideration of €19,000 (€2,000 for each
of the 10 years in the lease term, less the
€1,000 incentive) over the 10 year lease term using a single amortisation method in accordance with SIC-15.
[SIC-15.4, 5].
Example 2
An entity agrees to enter into a new lease arrangement with a new lessor. The lessor agrees to a rent-free
period for the first three years. The new lease has a term of 20 years, at a fixed rate of $5,000 per annum for
years 4 through 20.
Net consideration of $85,000 consists of $5,000 for each of 17 years in the lease term. Both the lessor and
lessee would recognise the net consideration of $85,000 over the 20-year lease term using a single
amortisation method. [SIC-15.4, 5].
One point about SIC-15 that has attracted considerable debate is its requirement to
spread incentives over the lease term. The validity of this has been questioned if rentals
are re-priced to market rates at periodic intervals. It is argued that in these
circumstances the rent-free period is being given solely to compensate for an above-
market rental in the primary period.
The Interpretations Committee rejected this view in August 2005. It did not accept that
the lease expense of a lessee after an operating lease is re-priced to market ought to be
comparable with the lease expense of an entity entering into a new lease at that same time
at market rates. Nor did it believe that the re-pricing itself would be reflective of a change
in the time patterns of the lessee’s benefit from the use of the leased asset. In other words,
incentives are seen in the context of the total cash flows under the lease and, except where
the benefit of the lease is not directly related to the time during which the entity has the
right to use the asset, IAS 17 requires these to be taken on a straight-line basis.
Leases (IAS 17) 1657
There is a similar argument when lessees assert that they should not be obliged to
spread rentals over a void period as they are not actually benefiting from the
property during this time – it is a fit-out period or a start-up so activities are yet to
increase to anticipated levels. However, the argument against this is no different to
the above: the lessee’s period of benefit from the use of the asset is the lease term,
so the rentals should be spread over the lease term, including the void period. This
was reinforced by the Interpretations Committee in September 2008, when it noted
that IAS 16 and IAS 38 require an entity to recognise the use of productive assets
using the method that best reflects ‘the pattern in which the asset’s future economic
benefits are expected to be consumed by the entity’, [IAS 16.60, IAS 38.97], but IAS 17
refers to the time pattern of the user’s benefit. [IAS 17.33]. Therefore, any alternative
to the straight-line recognition of lease expense under an operating lease must
reflect the time pattern of the use of the leased property rather than the amount of
use or other factor related to economic benefits. The Interpretations Committee
has not shown any indication that it is prepared to accept economic arguments for
other than straight-line treatment.
5.1.5 Onerous
contracts
IAS 37 prohibits the recognition of provisions for future operating losses, [IAS 37.63], but
the standard specifically addresses the issue of onerous contracts. It requires that if an
entity has a contract that is onerous, the present obligation under the contract should
be recognised and measured as a provision. [IAS 37.66].
The standard defines an onerous contract as ‘a contract in which the unavoidable costs
of meeting the obligations under it exceed the economic benefits expected to be
received under it’. [IAS 37.10]. This is taken to mean that the contract itself is onerous to
the point of being directly loss-making, not simply uneconomic by reference to current
prices. A common example of an onerous contract seen in practice relates to operating
leases for the rent of property. The Illustrative Examples to IAS 37 prior to the effective
date of IFRS 16 included the following example:
1658 Chapter 23
Example 23.21: An onerous contract
An entity operates profitably from a factory that it has leased under an operating lease. During December
20X0 the entity relocates its operations to a new factory. The lease on the old factory continues for the next
four years, it cannot be cancelled and the factory cannot be re-let to another user.
Present obligation as a result The obligating event is the signing of the lease contract, which gives rise
of a past obligating event
to a legal obligation.
Transfer of economic
When the lease becomes onerous, a transfer of economic benefits is
benefits in settlement
probable. Until then, the entity accounts for the lease by applying IAS 17.
Conclusion
A provision is recognised for the best estimate of the unavoidable lease
payments. [IAS 37.5(c), 14, 66].
Care must be taken to ensure that the lease itself is onerous. If an entity has a number of
retail outlets and one of these is loss-making, this is not sufficient to make the lease
onerous. However, if the entity vacates the premises and could reasonably sub-let them
only at an amount less than the rent it is paying, then the lease becomes onerous and the
entity should provide for its best estimate of the unavoidable lease payments. The
unavoidable costs of the lease will be the remaining lease commitment reduced by the
estimated sub-lease rentals that the entity could reasonably obtain, regardless of whether
or not the entity intends to enter into a sublease. One company which has provided for
onerous leases is Wm Morrison Supermarkets, as indicated by the following extract.
Extract 23.3: Wm Morrison Supermarkets PLC (2016/17)
Notes to the Group financial statements [extract]
5 Working capital and provisions [extract]
5.5 Provisions [extract]
Part of the onerous leases relate to sublet and vacant properties, with commitments ranging from one to 56 years. The
provision is revised regularly in response to market conditions. During the year, £38m has been charged to onerous
lease and onerous contract provisions as detailed in note 1.4. The utilisation of provisions relates to the ongoing
utilisation of onerous contracts and the assignment of onerous leases.
Accounting for onerous contracts is discussed in more detail in Chapter 27 at 6.2.
5.2
Operating leases in the financial statements of lessors
5.2.1
Accounting for assets subject to operating leases
Lessors should present assets subject to operating leases in their statement of financial
position according to the nature of the asset, i.e. usually as PP&E or as an intangible
asset. Lease income from operating leases should be recognised in income on a straight-
line basis over the lease term, unless another systematic basis is more representative of
the time pattern in which, the standard states, ‘use benefit derived from the leased asset
is diminished’. [IAS 17.49, 50]. Generally, the only other basis that is encountered is based
on unit-of-production or service.
Lease income excludes receipts for services provided such as insurance and
maintenance. IFRS 15 – Revenue from Contracts with Custo
mers – provides guidance
on how to recognise service revenue – see Chapter 28 for IFRS 15. Costs, including
Leases (IAS 17) 1659
depreciation, incurred in earning the lease income are recognised as an expense.
[IAS 17.51]. Initial direct costs incurred specifically to earn revenues from an operating
lease are added to the carrying amount of the leased asset and allocated to income over
the lease term in proportion to the recognition of lease income. [IAS 17.52]. This means
that the costs will be depreciated on a straight-line basis if this is the method of
recognising the lease income, regardless of the depreciation basis of the asset.
The depreciation policy for depreciable leased assets is to be consistent with the entity’s
policy for similar assets that are not subject to leasing arrangements and calculated in
accordance with IAS 16 or IAS 38, as appropriate. [IAS 17.53]. If the lessor does not use
similar assets in its business then the depreciation policy must be set solely by reference
to IAS 16 and IAS 38. This also means that the lessor is obliged in accordance with
IAS 16 to consider the residual value and economic life of the assets at least at each
financial year-end. [IAS 16.51]. There are similar requirements in the case of intangible
assets, although IAS 38 notes that they rarely have a residual value. [IAS 38.100]. These
matters are discussed in Chapters 17 and 18. These assets are also tested for impairment
in a manner consistent with other tangible and intangible fixed assets; IAS 17 refers to
IAS 36 (discussed in Chapter 20) in providing guidance on the need to assess the
possibility of an impairment of assets. [IAS 17.54].
5.2.2
Lease incentives – accounting by lessors
In negotiating a new or renewed operating lease, a lessor may provide incentives for
the lessee to enter into the arrangement. In the case of a property lease, the tenant may
be given a rent-free period but other types of incentive include up-front cash payments
to the lessee or the reimbursement or assumption by the lessor of lessee costs such as
relocation costs, leasehold improvements and costs associated with a pre-existing lease
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 327
