commitment of the lessee. SIC-15 states that the lessor should recognise the aggregate
cost of incentives as a reduction of rental income over the lease term, on a straight-line
basis unless another systematic basis is representative of the time pattern over which
the benefit of the leased asset is diminished. [SIC-15.4]. The SIC rejected the argument
that lease incentives for lessors are part of the initial direct costs of negotiating or
arranging the contract; instead concluding that they are in substance, related to the
amount of consideration received by the lessor for the use of the asset. This view was
confirmed in the IASB’s 2003 revision of IAS 17, which requires initial direct costs to be
capitalised as part of the carrying value of the asset – see 3.4.8 above. Lessor accounting
is, therefore, the mirror image of lessee accounting for the incentives, as described
in 5.1.4 above.
5.3
Payments made in connection with the termination of operating
leases
Payments for terminating operating leases or payments between a lessee and a third
party regarding a lease are common but not all are directly addressed by either
IAS 17 or SIC-15. In addition, neither statement addresses payments made between
a lessee and a third party in connection with a lease. The following example
addresses a variety of payments that might arise in connection with terminating an
operating lease over a property:
1660 Chapter 23
Example 23.22: Payments made in connection with terminating an operating
lease
Treatment in the financial statements of
Transaction
Lessor
Old tenant
New tenant
Lessor pays
Old tenant – lessor
Expense immediately;
Recognise income
intends to renovate the
or
immediately (note 1).
building.
Capitalise as part of the
carrying amount of the
leased asset if the
payment meets the
definition of
construction costs in
IAS 16 (note 1).
Old tenant – new lease
Expense immediately
Recognise income
with higher quality
(note 1).
immediately (note 1).
tenant.
New tenant – an
Deferred lease incentive
Deferred lease incentive
incentive to occupy.
amortised over the lease
amortised over the lease
term on a straight-line
term on a straight-line
basis under SIC-15
basis under SIC-15
(see 5.2.2 above).
(see 5.1.4 above).
Building alterations
Deferred lease incentive
Leasehold
specific to the tenant
amortised over the lease
improvements
with no further value to term on a straight-line
capitalised and
the lessor after
basis under SIC-15
depreciated.
completion of the lease
(see 5.2.2 above).
Deferred lease incentive
period.
amortised over the lease
term on a straight-line
basis under SIC-15
(see 5.1.4 above).
Transaction
Lessor
Old tenant
New tenant
Old tenant pays
Lessor, to vacate the
Recognised as income
Recognised as expense
leased premises early.
immediately to the
immediately to the
extent not already
extent not already
recognised (note 2).
recognised (note 2).
Leases (IAS 17) 1661
New tenant to take over
Recognise as an
Recognise as income
the lease.
expense immediately
immediately, unless
(note 3).
compensation for above
market rentals, in which
case amortise over
expected lease term
(note 3).
New tenant pays
Lessor to secure the
Recognise as deferred
Recognise as a
right to obtain a lease
revenue under IAS 17
prepayment under
agreement.
and amortise over the
IAS 17 and amortise
lease term on a straight-
over the lease term on a
line basis (see 5.2.1
straight-line basis
above).
(see 5.1.2 above).
Old tenant to buy out
Recognise as a gain
Recognised as an
the lease agreement.
immediately (note 4).
intangible asset with a
finite economic life
(note 4).
Note 1
A payment by a lessor to a lessee to terminate the lease is not dealt with under IAS 17 or
SIC-15. If the lessor’s payment meets the definition of a cost of an item of PP&E, which
might be the case if the lessor intends to renovate, it must be capitalised. [IAS 16.7]. If not, the
payment will be expensed, as it does not meet the definition of an intangible asset in IAS 38.
[IAS 38.8]. A payment by a lessor to a lessee to terminate the lease in order to re-let it to another
tenant does not meet the definition of initial direct costs for arranging a new lease. [IAS 17.4].
This is because the cost is incurred in relation to the lease with the old tenant, and is not
directly related to the new lease, even if the new lease has been entered into. As the lessee
has no further performance obligation the receipt should be income.
Note 2
A payment made by the lessee to the lessor to get out of a lease agreement does not meet the
appropriate definitions of an asset in IAS 16 or IAS 38 and does not fall within IAS 17 as there
is no longer a lease – the payments are not for the use of the asset. Therefore it should be
expensed. Similarly, from the lessor’s perspective, income should be recorded. However, if the
payment to the lessor to vacate the premises was already stipulated in the original lease contract
and the payment was assessed as probable during the life of the contract, both the lessee and
lessor would have accrued this over the lease term in accordance with the principles of IAS 17.
Note 3
A payment made by an existing tenant to a new tenant to take over the lease would also not
meet the definition of an asset under IAS 16 or IAS 38 (see notes above) and falls outside
IAS 17 as the lease no longer exists. The old tenant must expense the cost. The new tenant
will recognise the payment as income except to the extent that it is compensation for an
above-market rental (similar in nature to an incentive to enter into a lease), in which case the
receipt is deferred and amortised over the lease term (see 5.1.4 above).
Note 4
The new tenant has made a payment to an old tenant, and while it is in connection with the lease
arrangements, it is not directly related to the actual lease as it was made to a party outside the
lease contract. Therefore it cannot be accounted
for under IAS 17. The old tenant will treat the
receipt as a gain immediately. Any remaining balances of the lease will be removed and a net
gain (or loss) recorded. The payment by the lessee will generally meet the definition of an
intangible asset in IAS 38 and therefore will be amortised over the useful life, usually the term
of the lease. However, if other conditions and circumstances in the arrangement mean that this
definition is not met, the payment will be expensed in the period in which it is incurred.
1662 Chapter 23
5.3.1
Compensation for loss of profits
Compensation amounts paid by lessors to lessees are sometimes described as ‘compensation
for loss of profits’ or some similar term. This is a method of calculating the amount to be paid
and the receipt is not a substitute for the revenue or profits that the lessee would otherwise
have earned. The description will not affect the treatment described above.
6
MODIFYING THE TERMS OF LEASES
Lessees may renegotiate lease terms for a variety of reasons. They may wish to extend
the term over which they have a right to use the asset or to alter the number of assets
that they have a right to use. They may consider that the lease is too expensive by
comparison with current market terms. The renegotiations may deal with several such
issues simultaneously.
Lessors may also renegotiate leases, for example one lessor may sell the lease to another
that offers to provide a cheaper lease service to the lessee, usually because the new
lessor’s transactions have different tax consequences. Lease contracts may allow for
changes in payments if specified contingencies occur, for example a change in taxation
or interest rates.
6.1
IAS 17 and accounting for renegotiations
The standard has little to say on the consequences of such renegotiations. It states:
‘If at any time the lessee and the lessor agree to change the provisions of the lease,
other than by renewing the lease, in a manner that would have resulted in a
different classification of the lease ... if the changed terms had been in effect at the
inception of the lease, the revised agreement is regarded as a new agreement over
its term.’ [IAS 17.13].
As described at 3.2.3 above, the consequences of a different classification are clear. A
revised agreement that is reclassified (e.g. an operating lease is reassessed as a finance
lease or vice versa) is accounted for prospectively in accordance with the revised terms.
However, IAS 17 leaves many questions of application unanswered. It provides no
practical guidance on what to take into account to determine whether there would have
been a different classification. It does not explain how to account for the consequences
of modifications, and whether or not they would lead to a different classification. These
matters are described below.
Other changes to lease terms that do not lead to reclassification but that nevertheless
need to be accounted for, for example variations due to changes in rates of taxation or
interest rates, are discussed in 6.1.4 below.
Changes in estimates, for example changes in estimates of the economic life or of the
residual value of the leased item, or changes in circumstances, for example default by
the lessee, do not result in a different classification. [IAS 17.13]. Changes in estimates also
include the renewal of a lease or the execution of a purchase option, if these were not
considered reasonably certain at the inception of the lease (see 3.2.3 above).
Leases (IAS 17) 1663
6.1.1
Determining whether there is a different classification
This section addresses various approaches to determining whether lease classification
has changed as a result of changes to its terms. It does not address accounting for the
reclassified lease, which is considered at 6.1.2 below, if there is a revised classification.
For a modification to result in a change in classification, it must be one that affects the
risks and rewards incidental to ownership of the asset by changing the terms and cash
flows of the existing lease, for example a renegotiation that changes the duration and/or
the payments due under the lease.
One of the indicators used in practice to determine whether a modified lease results in
a different classification from the original lease is an assessment of the net present value
of the minimum lease payments and whether or not these amount to substantially all of
the fair value of the leased asset. An entity might use this test to help assess whether the
revised lease is a finance or operating lease, in conjunction with a reassessment of the
other factors described at 3.2.2 above. The entity might use one of the following
methods to calculate the net present value:
(a) recalculate as per the original date of inception of the lease the net present value
based on the revised lease term and cash flows (and revised residual value, if
relevant), which will result in a different implicit interest rate to that used in the
original calculation;
(b) take into consideration the changes in the agreement but calculate the present
value of the asset and liability using the interest rate implicit in the original lease.
This approach is consistent with the remeasurement of the carrying value of
financial instruments applying the effective interest rate method, as required by
IFRS 9; [IFRS 9.5.4.3] or
(c) consider the revised agreement to be a new lease and assess the classification
based on the terms of the new agreement and the fair value and useful life of the
asset at the date of the revision. The inference of this method, unlike (a) and (b)
above, is that the entity already considers that there is likely to be a new
classification to the lease, based on an assessment of other factors, e.g. as a result
of the revised terms, the lease term is now the whole of the economic life of the
asset or a bargain purchase option has been introduced.
A lessee under an operating lease will be able to apply method (c) but methods (a) and
(b) will not be available to it unless it has sufficient information to be able to calculate
the IIR at the inception of the original lease, which includes the fair value of the asset
at inception. Lessees that are party to more complex leases or sale and leaseback
arrangements are more likely to have the necessary information available to them.
It must be stressed that all features of any arrangement must be considered in order to
assess whether or not the modified lease transfers substantially all of the risks and
rewards of ownership.
Each of these three approaches is likely to lead to a different net present value for the
minimum lease payments.
They are compared in the following example.
1664 Chapter 23
Example 23.23: Modifying the terms of leases
Details of a non-cancellable lease taken out on the first day of the year are as follows:
(i) Fair value = €25,000
(ii) Estimated useful life of asset = 8 years
(iii) Five annual rentals payable in advance of €4,200
(iv) At the end of year 5, the asset must be sold and all proceeds up to €8,292 taken by the lessor. If any
amount in exce
ss of €8,292 is received, 99% of the excess is repaid to the lessee.
The lease does not contain any renewal options.
The lessee assesses this as an operating lease because the terms suggest that substantially all of the risks and
rewards of ownership have not been transferred to it – the lease term is only 62.5% of the useful life of the
asset and there is clearly significant residual value.
At the end of year 2, the parties renegotiate the lease, with the changes coming into effect on the first day of
year 3. The lease term is to be extended for a further two years, making the term seven years in total. Payments
for the four years 3-6 have been reduced to €4,000 and €1,850 is payable for year 7. At the time of the
renegotiation the estimated fair value of the asset is €17,500 and its residual value at the end of year 7 is €1,850.
The implicit interest rate in the original lease can be calculated because the maximum amount receivable by
the lessor on the sale of the asset at the end of the lease term is the residual value (on the assumption that the
lessor disregards any potential upside in its contingent 1%); the IIR is 5.92%, as follows:
Finance charge
Capital sum at
Capital sum
(IIR 5.92%
Capital sum at
Year
start of period
Rental paid
during period
per annum)
end of period
€ €
€
€ €
1 25,000 4,200
20,800
1,231 22,031
2 22,031 4,200
17,831
1,056 18,887
3 18,887 4,200
14,687
869 15,556
4 15,556 4,200
11,356
672 12,028
5 12,028 4,200
7,828
464
8,292
21,000
4,292
This supports the lessee’s assessment that this is an operating lease as the present value of the minimum lease
payments (the rentals to be paid over the term discounted at the IIR of 5.92%) is €18,780, which is 75% of
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 328
