Part 2: What is lease, Classification of leases
Part 3: Lease including both land and building, Finance leases accounting
3 Lease including both land and building
3.1 Implications for classification of lease
When a lease includes both land and buildings elements, an entity assesses the classification of each element as a finance or an operating lease separately in accordance with the relevant provision of IAS 17 (para 7-13).
In determining whether the land element is an operating or a finance lease, an important consideration is that land normally has an indefinite economic life.
For a lease of land and buildings in which the amount that would initially be recognised for the land element is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification and classified as a finance or operating lease. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset.
3.2 Implications for minimum lease payments
Whenever necessary in order to classify and account for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront payments) are allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception of the lease.
If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both elements are operating leases, in which case the entire lease is classified as an operating lease.
4 Finance leases accounting
ACCA F7 syllabus requires accounting for leases in the books of lessee. As no clear reference has been made about the accounting for leases in the books of lessor, therefore, we will concentrate only on the accounting for leases from the perspective of lessee
4.1 Finance lease – initial recognition
Lessees shall recognise finance leases as assets and liabilities in their statements of financial position at amounts which is lower of:
- Fair value the leased property; and
- Present value of minimum lease payments
Present value of minimum lease payments is calculated using interest rate implicit in the lease. If it is impracticable then lessee’s incremental borrowing rate shall be used for discounting.
Important point to note is that recognition is done at the commencement of the lease term whereas, the values to be used for recognition are determined at the inception of lease.
4.1.1 Initial direct costs
Any initial direct costs of the lessee are added to the amount recognised as an asset.
Initial direct costs are often incurred in connection with specific leasing activities, such as negotiating and securing leasing arrangements. The costs identified as directly attributable to activities performed by the lessee for a finance lease are added to the amount recognised as an asset.
4.1.2 Presentation of liabilities for leased assets
It is not appropriate for the liabilities for leased assets to be presented in the financial statements as a deduction from the leased assets. If for the presentation of liabilities in the statement of financial position a distinction is made between current and non-current liabilities, the same distinction is made for lease liabilities.
4.2 Finance lease – subsequent measurement
4.2.1 Finance charge
Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability.
In practice, in allocating the finance charge to periods during the lease term, a lessee may use some form of approximation to simplify the calculation.
There are several methods to split finance charge and principal components in the lease rentals. However the method applicable in ACCA is exam is Actuarial method.
4.2.2 Depreciation
A finance lease gives rise to depreciation expense for depreciable asset which should be accounted for according to IAS 16 and and IAS 38.
The depreciable policy for the leased asset shall be consistent with the policy applicable to assets owned by the lessee.
If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the period of expected use is the useful life of the asset; otherwise the asset is depreciated over the shorter of the lease term and its useful life.
4.2.3 Why not simply record rentals payable as expense?
The sum of the depreciation expense for the asset and the finance expense for the period is rarely the same as the lease payments payable for the period, and it is, therefore, inappropriate simply to recognise the lease payments payable as an expense. Accordingly, the asset and the related liability are unlikely to be equal in amount after the commencement of the lease term.
4.2.4 Impairment of leased asset
To determine whether a leased asset has become impaired, an entity applies IAS 36 Impairment of Assets.
4.2.5 Contingent rent
Contingent rents shall be charged as expenses in the periods in which they are incurred