Accounting Article

IAS 17- Changing Facemask

by Yasir Khan | Published on 9/30/2005

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Liven a’ big machine, IAS 17 “Leases” has ever been just a small part but stimulated a sizeable debate since its birth. IASB has finally revised the standard in the harmonization process of financial reporting standards for the new era of 2005.The harmonization and revision process by IASB portrays not only the refined reporting but also the redefined reporting in many areas. However IAS 17 is being considered a good example of more refined reporting among reporting gurus. The changes in IAS 17 are numerous and IASB has just succeeded to verbalize many undefined principles embedded in the superseded standard. However, the old and golden rule of nothing’s perfect still plays.

The changes in the IAS 17, pursuant to its revision, may well be categorized into two types. The first type changes are the inclusion and refinement of definitions. While the second type changes are the inclusion of new accounting and reporting issues, which had not been addressed by IASB even after their very presence in local reporting frameworks (like FRS, SFAS, AASB etc). All these changes can be studied under the following heads:

Inception Vs Commencement of lease term

The new definition introduced by IAS 17 is for “Commencement of lease term”. The superseded standard only attended to the term “Inception of lease” and the accountants all over the world were still unclear about the timing of the recognition of financial elements (asset, liability, income & expense). This matter wasn’t of much import as the framework provides a comprehensive guideline for this. The words “Inception” and “Commencement” surrogate each other but they may not be the representatives of the same date. The new IAS 17 clarifies the matter that the recognition stage of financial elements is not necessarily the time of inception of lease. These elements are to be recognized pursuant to the fulfillment of recognition criteria defined by the framework. Moreover, the changes in the lease terms between the date of Inception of lease and commencement of lease would be regarded applicable from the date of inception. (ibid: paras 5 & 13)

The situation may arise where the lease agreement, even after being entered into, may not complements the completion of transaction owing to prospective acquisition or construction of asset by the lessor. This problem may arise in case of manufacture’s lease. In such circumstances, the recognition criteria for financial statement elements are not fulfilled until the actual acquisition/construction of asset by the lessor and its transfer to lessee for subsequent use takes place.

Moreover, the inclusion of the term “Commencement of lease term” doesn’t change the date of lease classification for subsequent accounting and reporting. It remains the actual date of inception when the agreement is entered into by lessor and lessee. In addition, the adjustments to MLP during the intervening period of inception and commencement would be deemed to have taken place at the date of inception. Such adjustments are normally anticipated and provided for in the lease agreements under escalation clauses.

The classification of lease is to be made at the inception rather than on the commencement date. The situation may arise where the classification changes on the commencement date but it still have to be accounted for in accordance with the classification at the inception.

-  Singora Lessors plc enters into an agreement with a lessee. At the inception, the present value of MLP over the lease term equals the fair value of the leased asset. But the asset is still to be imported by Singora Lessors plc. During the intervening period of inception and commencement, the fair value of the asset increases reasonably. At the commencement of the lease term, the present value of MLP equals 65 % or say 70 % of the fair value.

-  Singora Lessors plc enters into an agreement to lease out an asset, which it has to be constructed first. All the principal provisions along with the MLP are agreed upon prior to the construction of asset. And the lease term covers the reimbursement of cost to be incurrent together with a reasonable return. Subsequently, on account of recession in market, the fair value substantially falls during the construction period. Consequently the profitable contract turns into a loss at the initial stage of sale recognition.

This new requirements included in IAS 17 (for classification of lease at the inception and the effect of escalation clauses to be taken effective form the inception date), in the opinion of IASB, better reflect the true economic considerations that entered into agreement.

Such an opinion is in parity with the long established standard developed by FASB (Financial Accounting Standard Board) of USA in 1978 as an amendment to American Accounting Standard SFAS 13 (Accounting for Leases).

Classification of leases

The second type modifications lies in the section named classification of leases. The criteria defined by revised IAS 17 are no different from those defined by earlier standard. However the loopholes in the old standard are still there which caused a huge debate among the accountants but still not addressed even by the new standard. These factors are as follows:

-  Interest rate implicit in the lease
-  Contingent rentals
-  Joint lease arrangements for land and building
-  Leases in respect of investment properties

The interest rate implicit in the lease has been defined as the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease payments and (b) the unguaranteed residual value to be equal to the sum of (i) fair value of the leased asset and (ii) any initial direct cost of the lessor. Whereas the definition of MLP specifically excludes contingent rentals to be payable over the lease term. The definitions of implicit interest rate and the MLP fail to encompass the two facts; viz

a)  the use of probability theory is the basic part of accounting estimates. The leasing arrangements where the contingent rentals are the major part of the lease rentals pose the problem of inappropriate classification of the lease term. Moreover, this has ever been regarded as a gateway to creative accounting; the reporting standards have been developed as a cure of.
 
b)  the implicit rate is the same for MLP and unguaranteed residual value where the differences in risk factors about their estimation are quite apparent.

However, the new standard also clarifies the estimation techniques which may be used by lessee at par with lessor for the recognition of interest element on finance lease over the lease term. The old standard gave the option to the lessor to use simplified method of apportioning interest income over the lease via sum of digit or any other method. While the same option was not prescribed for the lessee. (ibid: para 26)

The clarification of accounting treatment for contingent rentals over the lease term is pretty good step, though the implied accounting treatment was evident in the old standard. The contingent rents are to be recognized in the income statement in the period in the period of incurrence. (ibid: para 25)

Joint Lease Arrangements for Land and Building

In additional, an explicit guideline has been provided by the new one about the classification of leases in respect of single rental agreement of land and building. The additional guideline is the result of a long debate about the recognition process of long-term leases of land and buildings quite common in many countries. The classification of such leases as either the finance lease or operating lease has been well defined by other accomplished reporting frameworks all over the world. The new IAS also defines the quantitative techniques for the classification of lease, which serves as a good back support in complex areas.

In the financial reporting aspect of leases, its is well defined rule among the accountants all over the world that IAS 17 prescribes the qualitative characteristics a primary test for the identification of finance leases. The same primary tests are to be applied for the identification of lease type for land and building elements separately.

Qualitative Questions

1.  Does the lease transfer ownership of the asset to the lessee by the end of the lease term? (ibid: para 10-a)
2.  Does the lease give lessee the option to purchase the asset at less than open market value? (ibid: para 10-b)
3.  Does the lese contain terms that result in the gains or losses from fluctuation in the residual value of the asset accruing to the lessee? (ibid: para 11-b)
4.  At the inception of the lease, is it reasonable to assume that the lessee and lessor either (a) expected to lease term to be for the major part of economic life of the building or (b) that the residual value on expiry of the lease term would be negligible? (ibid: para 10-c)
5.  Has the payment structure of the lease been derived with reference to specific interest rates and returns on risk, which would be required by the lessor?
6.  Does the lease allow the lessee to cancel the lease and if so does the lessee have to bear the lessor’s losses, as predetermined in the lease term? (ibid: para 11-a)
7.  Is the building of such a specialized nature that only the lessee can use without major modification? (ibid: para 10-e)
8.  Whether lessee has option for secondary lease period with peppercorn rent? (ibid: para 11-c)

In addition, the following judgmental qualitative factors affirm the presence of operating lease.

1.  Are the full repairing and insuring covenants in the lease and clauses to ensure the asset is reinstated, at the expense of the tenant, to its original condition at the end of the lease?
2.  Does the lease provide for significant contingent rent variations during the term by reference to the open market turnover?
3.  Were the initial passing rent and other aspects of the lease set at prevailing market rate?
4.  Is the lease free of contractual terms, which might oblige the lessor to continue the lease at substantially less than normal market terms?
5.  Is lessee default the only grounds on which the lease reverts to the lessor?
6.  If the lessee wishes to sublet or sell (or assign) their lease rights, are there terms in the lease that allow the lessor to control the key terms of the sublet/sale?

The embedded principal in IAS 17 is to use above-mentioned qualitative measures to identify the lease type, whereas the other quantitative criteria have been defined to account for the lease transactions in the books of accounts. However the quantitative test may also be used to identify the lease type and the most prominent one is the comparison of present value of MLP with the fair value of the asset. (ibid: para 10-e)

The new IAS 17 introduces something special for identifying the lease type of where the lease involves the joint arrangements for land and building. The standard also prescribes the accounting treatment for leases involving investment properties.

The IAS 17 prescribes the same accounting treatment and identification of lease for separate contracts of leasing land and building as prescribed by the old standard. However, the joint lease arrangement is the new concept for IAS 17 which is no different from those prescribed by SFAS long ago. However in this case also, the dealing of the leasing for land and building has been defined in the separate manner.
The entire myth, as embodied in IAS 17, may be classified under four different situations.

a)  where the leasing arrangements involve the leasing of either land or building alone, they are to be dealt with in normal way. The only criteria for leasing of land to be treated as finance lease is the transfer of title at the end of the lease term owing to its infinite useful life. While the criteria for identifying lease type of building (and other assets within its scope) have been clearly prescribed by IAS 17. (ibid: para 14)

b)  where the leasing arrangement involves the leasing of land and building as a composite unit and the lease rentals are defined in composite term, the both items have to be accounted for separately unless they fall under the same classification. In case, both items falls under operating lease, they have to be accounted for compositely as operating lease unit. The lease rental are to be allocated to the both elements if necessary pertaining to quantitative criteria defined by IAS 17 which may also be of great help for classification. This classification is to be based on the leasehold interest in the land and building element. However such a quantitative exercise may not necessary in all situations. Where interest in both elements is of operating nature, the separate accounting may not be necessary and both elements can be treated as a composite unit.

For a long time, there has been the confusion whether value apportionments of land and building and residual values at lease inception, needed to be obtained as a precursor to the determination of lease classification. But there also has been a well-developed conclusion that this is unnecessary whilst a purely qualitative assessment is being made (ibid: para 16 & 18).

c)  where the leasing agreement arranges for land and building element but the leasehold interest in the land element is immaterial, both land and building elements are to be treated as a single unit and is to be treated under finance or operating lease accounting. In this situation, the economic life of the building is to be treated as the economic life of entire lease unit. In this situation, the composite unit accounting treatment, in substance, ignores the land element and the operating or finance lease accounting would be applicable. (ibid: para 17)

d)  where the headlease of both land and building is subject to further sublease as an investment property and fair value model adopted, the bifurcation and separate identification is not required. We discuss this matter under the following paragraphs. (ibid: para 18 & 19)

Singora Enterprise enters into a lease agreement to acquire a commercial unit for its administration office in the locality of Lancashire, consisting of land and building, on lease from Simon Lessors plc. The fair market values of the land and building, in the vicinity Singora Enterprise operates, have been established after due consultancy of British Property Valuers (BPV) and which come to be:

Land £ 5,000,000
Building £ 4,500,000

The lease term agreed with Simon Lessors plc covers 10 years after which the Singora Enterprise would be liable to pay only ground rent while no other payment is to be made for the lease of building. Singora Enterprise would continue to operate from the same office for next years to come.

Singora Enterprise is liable to pay 1,200,000 at the end of each year for 10 years of lease. Thereafter Singora Enterprise is liable to pay 400,000 at the end of each year as a ground rent. The required rate of return on the investment in building is 12 % whereas the required cost of capital for investment in land comes to be only 8 % owing to no risk of fall in value. Moreover, the economic life of building comes to be 20 years.

In the above case, the apparent lease classification for land element is of operating nature as it reverts back to the lessor at the end of lease term, and for further occupation the ground rent is to be paid annually. Whereas in the case of building element, the lease classification depends on the guideline given by IAS 17.

At the end of the lease term, no more payment is to be made for further use of building. The guidance given by IAS 17 refers to the finance lease type for the building element of commercial unit.

The proper accounting and reporting of the lease unit requires the bifurcation of entire MLP into MLPs relating to land and building elements. The criterion given by IAS 17 is the ratio of lessee’s interest in the leasehold property.

The lessor just requires the annual cost of capital for investment in land and doesn’t requires the true investment to be reimbursed through leasing arrangement owing to infinite economic life of land and its slipping back at the end of the lease term. The normal market rate of return in such case is 8 %. That’s the annual return (5,000,000 x 8 % = 400,000) relates to the land element while the remaining amount is to be allocated to building element to be accounted for separately.

The implicit interest rate is 12 % and the present value of MLP (5.650 x 800,000 = 4,520,000) equals the fair value of building at the inception of the lease. Thus, in effect, the MLP allocated to the building element not only covers the entire capital cost but also a reasonable market return over the investment and constituting it a finance lease arrangement.

However IAS 17 requires such allocation in the ratio of inertest in lease, the other established frameworks including that American SFAS require the use of fair value of land and buildings for such an exercise. In this regard, IAS 17 still has logical superiority over the other frameworks and this fine move by IAS 17 is a good example of giving priority the most logical solutions while working for the harmonization process.

Leases in respect of Investment Properties

The accounting treatment for Investment Properties taken on operating lease is just a drastic move that IASB takes in IAS 17. In the opinion of reporting gurus, this move seems to provide much better presentation to companies involved in long term subleasing of headleases as investment properties. Under the new standard, the investment properties taken on operating lease are permitted to be accounted for as properties held under finance lease provided that fair value model under IAS 40 is used. This change in IAS 17 is the consequence of corresponding change in IAS 40 in this regard.

This accounting treatment provides the opportunity of recognizing assets to companies involved in rather long term lease of land and buildings as investment properties. These companies were unable to recognize the assets on account of operating lease agreements. However, the adoption of such an option would also give rise to the corresponding liability in the balance sheet and consequently affecting the company’s gearing. This lack of off-balance sheet financing may hinder the application of such an accounting treatment by companies involved in letting out of buildings. On the other side, the companies involved in this business and exposed to low gearing may opt this treatment to enhance asset backing.

The normal accounting treatments defined by IAS 17 and IAS 40 are fine enough to present all transaction by a business not involved solely in investment properties. But the business of letting out of long term commercial warehouses is not uncommon in the countries like Britain and USA. In such a business, the leased out investment property is normally acquired on operating lease which are normally renewable for long enough to make them little different from finance lease agreements. Now a company having freehold investment properties and the company having only leasehold investment properties reflect the entire different positions of asset, liabilities, income and expense. However, the long term operating lease agreement in respect of investment properties, if classified under finance lease standards of IAS 17, may not pose such a huge comparison mismatch.

Moreover, the permitted accounting treatment for such investment properties is the result of worldwide insist of accountants for such kind of a business. IASB has just taken a fine step to make it optional for such businesses that are interested to make their financial statements better for comparison at parity with other companies having freehold investment properties portfolio.

The separate accounting treatment for land and building element is not necessary for above mentioned investment properties.

Article courtesy of Yasir Khan

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