This is part 1 of a series of articles five articles dealing with Leases under the IFRS for SMEs and also the VAT and Income Tax treatment thereof.
The new IFRS 16 Leases changed the accounting treatment of leases for entities applying the full International Financial Reporting Standards. However, lease accounting under the IFRS for SMEs was not affected and stayed the same. In periods of change it is often good to just sit back and remember the things we know. The purpose of this series of articles is to take you back to the basics of lease accounting under the IFRS for SMEs by revisiting the lease accounting principles we know. So, sit back in front of the fireplace, kick out your shoes, take a sip of your hot chocolate and remember the good old lease accounting (which is still relevant for SMEs)!
What is a lease?
Lease agreements are quite common in business and our personal lives, ranging from leases/rentals of office space or accommodation, office equipment, cell phone contracts, car rentals, etc. A lease is defined in the IFRS for SMEs as “an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time”. It is important to the note that the definition incorporates any agreement (legal lease agreements and others) whereby the right of use of an asset is transferred to the lessee. Such “other” agreements may in substance be a lease of an asset (irrespective of the legal form thereof). Accountants need to be aware of the possibility that other agreements may in fact be, or contain a lease, and account for it accordingly. An example may be outsourcing arrangements whereby, in substance, the company is obtaining the right to use an asset, in addition to other services being received.
Both parties to a lease should classify a lease as a finance or operating lease at the inception of the lease, while considering the substance of the lease agreement:
- A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.
A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.
From these definitions it is clear that the main consideration is whether the risks and rewards incidental to ownership are transferred from the lessor to the lessee. This basically means that a finance lease is treated as a sale/purchase of an asset, with financing (a loan) that is paid off over a period of time.
In addition to the overall consideration in the classification of a lease, specific guidance and examples are also given in Section 20 of the IFRS for SMEs to assist accountants in classifying a lease. The following aspects may indicate that the lease is to be classified as a finance lease (please note that in the right hand column the examples below the table are considered against these indicators):
|Indicators / Example||Example 1: Plant||Example 2: Offices|
|The lease transfers ownership of the asset to the lessee by the end of the lease term (other than a market related purchase thereof at the end of the lease term);||Ownership is not transferred.||Ownership is not transferred.|
|The lessee has the 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 for it to be reasonably certain, at the inception of the lease, that the option will be exercised;||Not applicable.||Not applicable.|
|The lease term is for the major part of the economic life of the asset even if title is not transferred;||6 / 7 years is a major part of the economic life.||5 / 40 years is not a major part of the economic life.|
|At the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset;||The present value is calculated to be R791 835 (1), which is considered to be substantially all of the fair value (R800 000).||The present value is calculated to be R2 525 100 (2), which is not substantially all of the fair value (R10 000 000).|
|The leased asset is of such a specialised nature that only the lessee can use it without major modifications;||The asset was indeed modified to suit the unique needs of the lessee.||The offices are standard and can be used by anyone.|
|If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;||Cancellation will result in substantial penalties to be paid by the lessee.||Cancellation will result in penalties, but it would not be substantial.|
|Gains or losses from the fluctuation in the residual value of the leased asset accrue to the lessee (for example, in the form of a rent rebate equalling most of the sales proceeds at the end of the lease); and||Not applicable.||Not applicable.|
|The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.||Not applicable.||Not applicable.|
(1) using a financial calculator: PMT = 13 500, n = 72 months (12 pmt/year), i = 7%, FV = 0, PV = ?)
(2) using a financial calculator: PMT = 50 000, n = 60 months (12 pmt/year), i = 7%, FV = 0, PV = ?)
Consider the following example of a lease:
A company entered into a lease agreement for the use of an item of plant. The current market price when buying such item is R800 000. The economic life of the plant is 7 years, while the lease term is 6 years. The plant was specifically modified by the supplier to suit the lessee’s unique needs. Lease payments of R13 500 are payable monthly in arrears. The interest rate implicit in the lease is 7% per annum. Cancellation of the lease will result in substantial penalties to be paid by the lessee.
From this it would seem that the lease is a finance lease as the lease transfers substantially all the risks and rewards incidental to ownership. The indicators are also considered in the table above. It is important to note that it is not necessary to meet all or even most of the indicators above. In some cases meeting only one of the indicators may be sufficient for the classification as a finance lease, keeping the overall consideration in mind. Classification always requires professional judgement in applying the accounting principles.
The classification of the lease as a finance lease implies that the lessor would in substance treat the lease as an initial sale of the asset to the lessee and derecognise the asset. The lessor will instead recognise a “net investment in the lease” which is basically a loan receivable (long-term debtor) on which finance income (interest) will be earned. The payments received will reduce the outstanding balance of the loan accordingly.
The lessee, on the other hand, will recognise the leased asset (as if it was purchased) with a corresponding lease liability (loan payable). Depreciation will be recognised on the leased asset over the useful life (period the asset is available for use, which will be the lease term in this scenario). Finance costs (interest) should be recognised on the lease liability and payments made will reduce the loan accordingly.
The detailed accounting treatment of finance leases will be explained in a next article Part 2 – Finance lease of a lessee.
Consider the following example of a lease:
A company entered into a lease agreement for the use of ten offices in an office park. The current market price when buying such 10 offices is R10 000 000. The economic life of the offices is 40 years, while the lease term is 5 years. Lease payments of R50 000 are payable monthly in arrears. The interest rate implicit in the lease is 7% per annum. Cancellation of the lease will result in penalties to be paid by the lessee.
From this it would seem that the lease is an operating lease as the lease does not transfers substantially all the risks and rewards incidental to ownership. The indicators are also considered in the table above. The lessee does not effectively obtain ownership of the economic benefits of the offices and is merely renting it for a period of time.
The detailed accounting treatment of operating leases will be explained in a next article Part 3 – Operating lease of a lessee.
The first step in accounting for a lease is to consider whether any agreement may, in substance, actually meet the definition of a lease. Professional judgement (and even perhaps a long debate between the client and the accountant – pour another hot chocolate for both of you) may be needed with complex agreements. The next step is to classify the lease as a finance or operating lease based upon whether substantially all the risks and rewards incidental to ownership of the asset is transferred from the lessor to the lessee. Once the classification is sorted out, the lease should be recognised and measured accordingly, which is illustrated in the next articles in this series.
Prof Cobus Rossouw CA(SA) is an associate professor and subject head for Financial Accounting, School of Accountancy, University of the Free State.