IAS 17 LEASES (Key Notes)

Definition of lease types:

Finance lease-lease that transfers substantially all the risks and rewards to the lessee

Operating lease-any other lease

Indicators of Finance Lease

The main indicator is that the lease term is for the major part of the useful economic life of the asset. And the indicators are:

-          at the beginning of the lease, the present value of the minimum lease payments is approximately equal to the fair value of the asset

-          The lease transfers ownership of the asset to the lessee by the end of lease term  

-          The lessee has the option to buy the asset at a price expected to be lower than fair value at the time the option is exercised

-          The lease asset is of specialized nature

Substance over form

Accounts are generally required to reflect commercial substance (reflects the financial reality of the transaction) rather than legal form (legal reality of the transaction).

IAS 17 deals with the accounting for finance lease which follow the definition of an asset in the IASB Framework for the Preparation and Presentation of Financial Statements: “an asset is a resource controlled by the entity as a result of the past events and from which future economic benefits are expected to flow the entity”. Ownership is not necessary, control is the essential feature.

 IAS 17 thus argues that an asset leased under a finance lease must be recorded as an asset and corresponding liability in the lessee’s accounting records.

ACCOUNTING ENTRIES

A.      Finance Lease

01.   At the beginning of the lease

Dr. Non-Current Asset

Cr. Finance Lease Liability

Initial recording-

NCA: at the fair value (or, if lower, the present value of the minimum lease payment)

Finance Lease Liability: liability for finance leases spilt between current liabilities and non-current liabilities

02.   At the end of each period of the lease

Dr. Depreciation expenses (Income Statement)

Cr. Non-current Asset-accumulated depreciation

(NCA should be depreciated over the shorter of the useful life and the lease term)

03.   As each rental paid

Dr. Interest Expenses (Income Statement)

Cr. Finance Lease Liability

(with the finance charge)

Dr. Finance Lease Liability

Cr. Bank/Cash

(with the rental payment)

B.      Operating Lease

Only rental payment under operating leases are charged to the income statement on straight-line-basis over the term of the lease  

Note: If a finance lease asset is incorrectly treated as an operating lease it will have the following effects on the financial statements:

- assets understated so Return on capital employed will be overstated

- liabilities understated so gearing understated

- little effect on income statement (profit will be overstated)