IAS 17: Leases Finance & Operating Prepared by Nathaniel Brown. 2015

Definition of a Lease & Why they are used A lease is an agreement whereby the owner of an asset (the lessor) hires the asset to the user of the asset (the lessee) for an agreed period of time. Many entities choose to use leases to finance their purchases of assets as it allows them to spread the cash outflow over several accounting periods. Lessor = The supplier of the asset Lessee = The customer who is hiring the asset

Two types of Leases & Definitions transfers substantially all of the risks and rewards of ownership of an asset to the lessee. However, ownership may or may not eventually be transferred. Finance Lease:- Operating Lease:- any lease that does not fall into a Finance Lease. It is similar to a rental agreement.

Classification of a Finance Lease If all or some of the following apply: The Lease transfers ownership of the asset to the lessee by the end of the lease term. The lessee has the option to purchase the asset and it is reasonably certain that this will happen. The lease contract is for all or most of the asset’s useful life, even if ownership is not transferred. The minimum lease payments amount to substantially all of the fair value of the leased asset – minimum lease payments are the total payments that the lessee is or can be required to make over the lease term. The leased assets are specialised so that only the lessee can use them without major modifications.

Continued… Could be a finance lease if either of the following apply: If the lease is cancelled, the lessee bears any losses incurred as a result of the cancellation. After the initial terms ends, there is an option for continuing to lease at a rate that is substantially lower than the market rent.

Classification of an Operating Lease These tend to be in a similar form to a rental agreement. It is an Operating Lease if the lease did not fall into any of the previous criteria of a Finance Lease.

Question Witney Ltd leases an item of plant. Under the terms of the lease, Witney Ltd makes payments of £20,000 each year for five years. The present value of the minimum lease payments is £95,500. The plant has a useful life of five years and would cost £98,000 to purchase outright. This lease is an operating lease. Is this statement True or False

Accounting for Finance Leases Recognised in the lessee’s SFP at its fair value, or the present value of the minimum lease payments. Whichever is lower. Fair value – amount for which an asset could be exchanged/liability settled in an arm’s length transaction. Lessee recognises liability for the loan – same amount as the value of the asset.

Arriving at the Minimum Lease Payment Interest rate implicit in the lease:- The discount rate at the start of the lease making the total present value of the minimum lease payments equal to the fair value of the leased asset. Incremental borrowing rate:- Used if Interest rate is not possible The rate of interest that the lessee would have to pay on a similar lease/sum of money over a similar timescale.

Over the term of the lease The asset is depreciated over its useful life. Useful Life:- The estimated remaining period over which the economic benefits embodied in the asset are expected to be consumed by the entity. The lease payments are split between capital and interest. Capital portion reduces outstanding liability and the interest is charged to Profit or Loss.

Accounting for Operating Leases The payments are charged to profit or loss on a straight line basis. Not recognised in the Statement of Financial Position - Information is instead disclosed in the notes to the financial statement

For a working example: step-by-step Follow Faringdon Ltd – Page 209