LECTURE 6

FRS 117
Leases

© 2008 Nelson Lam and Peter Lau Intermediate Financial Reporting: An IFRS Perspective (Chapter 4) - 1
 Learning Outcomes

At the end of this lecture, you should be able to:

• Understand the scope of FRS 117
• Understand the classification of leases into finance leases
and operating leases
• Understand the classification of leases of land and
building
• Accounting for leases in the financial statements of
lessees
• Leases in the Financial Statements of Lessors
• Sale and Leaseback Transactions

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 Applicable Standard and Scope

• Lease is accounted for in accordance with FRS 117 Leases.

• A lease is defined 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.
• An entity is required to apply FRS 117 in accounting for all
leases other than:
1. Leases to explore for or use minerals, oil, natural gas
and similar non-regenerative resources; and
2. Licensing agreements for such items as motion picture
films, video recordings, plays, manuscripts, patents and
copyrights.

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 Applicable Standard and Scope
• Some leases should be classified in accordance with FRS 117
but they are not measured in accordance with FRS 117. In other
words, FRS 117 is not applied as the basis of measurement for
these leases, including:
1. Property held by lessees that is accounted for as investment
property under FRS 140 Investment Property ;
2. Investment property provided by lessors under operating
leases to be accounted for under FRS 140;
3. Biological assets held by lessees under finance leases (under
IAS 41 Agriculture); or
4. Biological assets provided by lessors under operating leases
(under IAS 41).

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 Classification of Leases
The classification of leases adopted in FRS 117
Risks and
 Is based on the extent to which risks and Rewards
rewards incidental to ownership of a leased
asset lie the the lessor or the leseee.

• A finance lease
Finance – is a lease that transfers substantially all the
Lease
risks and rewards incidental to ownership of an
asset.
– Title may or may not eventually be transferred.
Operating
Lease • An operating lease
– is a lease other than a finance lease

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 Factors that Determine a Finance Lease

1. the lease transfers ownership of the asset to the lessee by the

end of the lease term;
2. 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;
3. the lease term is for the major part of the economic life of the
asset even if title is not transferred;
4. 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; and
5. the leased assets are of such a specialised nature that only the
lessee can use them without major modifications.

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 Other Finance Lease Indicators

• Other financial lease indicators :

6. if the lessee can cancel the lease, the lessor’s losses
associated with the cancellation are borne by the lessee;
7. gains or losses from the fluctuation in the fair value of
the residual 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
8. the lessee has the ability to continue the lease for a
secondary period at a rent that is substantially lower
than market rent.

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 Operating Lease
• Is a lease other than a finance lease
• The risks and rewards associated with the asset
are not transferred to the lessee.
• The legal and beneficial owner is the lessor.

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 Minimum Lease Payments
Minimum lease payments are
• the payments over the lease term that the lessee is or can be required to
make, excluding
– contingent rent,
– costs for services and
– taxes to be paid by and reimbursed to the lessor,
• together with:
a) for a lessee, any amounts guaranteed by the lessee or by a party
related to the lessee; or
b) for a lessor, any residual value guaranteed to the lessor by:
i) the lessee;
ii) a party related to the lessee; or
iii) a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee.

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 Minimum Lease Payment Example

• Determine the minimum lease

payment (MLP) of the following lease
to the lessee and the lessor:
– AJS Ltd. has a 5-year lease to For the lessee, AJS, the MLP is:
rent its office with an annual – Payments over the lease term
payment of $100,000. $100,000  6 $ 600,000
– It makes a guarantee to the – Guarantee
lessor, C & P Inc., that the office (incl. the one from parent)
should have a value not less than $10,000 + $12,000 120,000
$100,000. $720,000
– It’s parent, AJS Holding Inc., also
makes a further guarantee of For the lessor, C& P, the MLP is:
$20,000 – MPL as above $720,000
– C & P Inc. in turn has obtained an – Guarantee from agent
(130k – 100k – 20k) 10,000
additional guarantee of $130,000
$730,000
from the property agent.
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 Minimum Lease Payment Example
• Assume the interest rate implicit in the lease is 8%

The present value of the minimum lease payment is $580,941 as

calculated below:
Minimum Discount Present
lease payment factor value
1 ÷ (1 + 8%)T
Payments over the lease term
2 January 2008 (T = 0) $ 100,000 1.000000 $ 100,000
31 December 2008 (T = 1) 100,000 0.925926 92,593
31 December 2009 (T = 2) 100,000 0.857339 85,734
31 December 2010 (T = 3) 100,000 0.793832 79,383
31 December 2011 (T = 4) 100,000 0.735030 73,503
31 December 2012 (T = 5) 100,000 0.680583 68,058
Guarantee made at the end of 2012 (T = 5) by:
AJS 100,000 0.680583 68,058
JSA, the parent of AJS 20,000 0.680583 13,612
$ 720,000 $ 580,941

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 Leases of Land and Building
Lease of land Lease of land and buildings

• Lease of land and of buildings are classified

as operating or finance leases
 in the same way as leases of other assets
 but ……

Building
only

Land only
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 Leases of Land and Building
Lease of land

Land normally has an indefinite economic life

• If title of leasehold land is not expected to pass to the lessee
 Lessee normally does not receive substantially all of the
risks and rewards incidental to the ownership
 In which case the lease of land will be an operating lease
• payment acquiring such leasehold represents
prepaid lease payments
• amortised over the lease term in accordance with
the pattern of benefits provided

Land only
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 Leases of Land and Building
Lease of land Lease of land and buildings

Separate
measurement
(of the land and
buildings elements)

Land and
Building

Building
only

Land only
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 Leases of Land and Building
Lease of land and buildings

• 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 Relative Fair Value
– 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
Building
only

Land only
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 Leases of Land and Building

If a lease contains land and buildings Lease of land and buildings

elements
 2 elements are considered
separately for lease classification
If title of both elements is expected to
pass to the lessee
 Both elements are classified as
finance lease

If title of land or both elements is NOT

expected to pass to the lessee
 The land element alone (as having
indefinite life) is normally classified
as an operating lease
 The building element is considered
separately

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 Leases of Land and Building
Lease of land and buildings

• If the lease payments cannot be allocated reliably between the

2 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
• For a lease of land and building if the land is immaterial
– The lease may be treated as a single unit and
classified as finance or operating leases
Building
only

Land only
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 Leases of Land and Building
Lease of land and buildings

Minimum lease payment

allocated in proportion to the
relative fair values of land
and building elements

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 Investment Property

Separate measurement of land and building not required

• The lessee is not required to separately classify and measure the land
and building elements of a lease of land and building if
– The lessee’s interest in both the land and buildings is classified as
an investment property in accordance with FRS 140 and the fair
value model is adopted
• In the case where an operating lease is classified as an investment
property under FRS 140:
– the whole property interest is accounted for as if it were a finance
lease and
– the fair value model is to be adopted.
• The lessee can continue to account for such property interest as a
finance lease, even if a subsequent event leads to the property interest
no longer be classified as investment property.

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 Accounting for Finance Lease

Initial • At lease commencement, lessees are

Recognition and required to recognise finance leases as
Measurement
assets and liabilities in their balance
sheets at amounts equal to
a) the fair value of the asset, or
Finance
b) if lower, the present value of the
Lease minimum lease payments,
each determined at the inception of the
lease.
• Any initial direct costs of securing the lease
are added to the amount recognised as an
asset.

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 Apportionment of Finance Lease Payments

• A lesee is required to apportion minimum lease payments of a

finance lease between
a) the finance charge and
b) the reduction of the outstanding liability.
• Finance charge allocated to each period during the lease
– so as to produce a constant periodic rate of interest on the
remaining balance of the liability.
• Contingent rents charged as expenses in the periods in which
they are incurred.
• Contingent rent is that portion of the lease payments
– that is not fixed in amount
– but is based on the future amount of a factor that changes other than with the
passage of time
e.g. percentage of future sales, amount of future use, future price indices, future
market rates of interest

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 Depreciation of Finance Lease

• A finance lease gives rise to

– depreciation expense for depreciable assets as well as
– finance expense for each accounting period
• The depreciation policy for depreciable leased assets
– consistent with that for depreciable assets that are
owned, and
– the depreciation recognised shall be calculated in
accordance with FRS 116 and FRS 138
• If there is no reasonable certainty that the lessee will obtain
ownership by the end of the lease term
– the asset shall be fully depreciated over the shorter of
• the lease term and
• its useful life
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 Accounting for Finance Lease - Example

Review Example 1 on page 398

of Lazar & Huang

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 Disclosures of Finance Leases by Lessee

• The following disclosures for finance leases are required:

a) for each class of asset, the net carrying amount at the balance sheet
date.
b) a reconciliation between the total of minimum lease payments at the
balance sheet date, and their present value.
c) the total of minimum lease payments at the balance sheet date, and
their present value, for each of the following periods:
i) not later than one year;
ii) later than one year and not later than five years;
iii) later than five years.
c) contingent rents recognised as an expense in the period.
d) the total of future minimum sublease payments expected to be
received under non-cancellable subleases at the balance sheet date.
e) a general description of the lessee’s material leasing arrangements.

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 Accounting for Operating Leases in Lessees’
Fin. Statements
Recognition • Lease payments under an operating lease
(Initial and – shall be recognised as an expense on a
Subsequent)
straight-line basis over the lease term
– unless another systematic basis is more
representative of the time pattern of the
user’s benefit

Operating
Lease

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 Disclosure of Operating Leases in Lessees’
Fin. Statements
• Lessees shall make the following disclosures for operating leases:
a) the total of future minimum lease payments under non-
cancellable operating leases for each of the following periods:
i) not later than one year;
ii) later than one year and not later than five years;
iii) later than five years.
b) the total of future minimum sublease payments expected to be
received under non-cancellable subleases at the balance sheet
date.
c) lease and sublease payments recognised as an expense in the
period, with separate amounts for minimum lease payments,
contingent rents, and sublease payments.
d) a general description of the lessee’s significant leasing
arrangements.

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 Accounting for Finance Lease by the Lessor

The lessor is required to

a) recognise assets held under a finance lease in their balance sheets
as a receivable at an amount equal to the net investment in the
lease.
– Net investment in the lease is
• the gross investment in the lease discounted at the interest
rate implicit in the lease.
– Gross investment in the lease is the aggregate of:
a) the minimum lease payments receivable by the lessor under
a finance lease, and
b) any unguaranteed residual value accruing to the lessor
– Unguaranteed residual value is that portion of the residual value
of the leased asset, the realisation of which by the lessor is not
assured or is guaranteed solely by a party related to the lessor.

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 Finance Income & Initial Direct Costs

• Each instalment received by the lessor will comprise

principal and finance income.
• The recognition of finance income shall be based on a
pattern reflecting a constant periodic rate of return on the
lessor's net investment in the finance lease
• Initial direct costs (e.g. legal fees and internal costs
attributable to negotiating / arranging a lease) are included
in the initial measurement of the finance lease receivable,
and reduce the finance income recognised over the lease
term
Examples 2 and 3 of text

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 Finance Leases for Manufacturer or Dealer
Lessor

• Manufacturer or dealer lessors

– shall recognise selling profit or loss in the period as they
would for outright sales.
• If artificially low rates of interest are quoted, selling profit
shall be restricted to that which would apply if a market rate
of interest were charged.
• The finance income is spread over the lease term
• Initial direct costs incurred by manufacturer or dealer
lessors in connection with negotiating and arranging a
lease shall be recognised as an expense when the selling
profit is recognised.
Examples 4 & 5 of text

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 Disclosure of Finance Leases by the Lessor

Lessors shall disclose the following for finance leases:

a) a reconciliation between the gross investment in the lease at the
balance sheet date, and the present value of minimum lease payments
receivable at the balance sheet date.
b) the gross investment in the lease and the present value of minimum
lease payments receivable at the balance sheet date, for each of the
following periods:
i) not later than one year;
ii) later than one year and not later than five years;
iii) later than five years.
b) unearned finance income.
c) the unguaranteed residual values accruing to the benefit of the lessor.
d) the accumulated allowance for uncollectible minimum lease payments
receivable.
e) contingent rents recognised as income in the period.
f) a general description of material leasing arrangements

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 Accounting for Operating Lease by the Lessor

• The leased asset will be recognised as an asset at fair value

and depreciation shall be calculated in accordance with FRS
116 and FRS 138
• Lease or rental income shall be recognised as income
- on a straight-line basis over the lease term
- unless another systematic basis is more representative of
the time pattern in which use benefit derived from the leased
asset is diminished
• Initial direct costs shall be added to the carrying amount of
the leased asset and recognised as expense over the lease
term on the same basis as the lease income.

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 Disclosures of Operating Leases by the Lessor

• Lessors shall disclose the following for operating leases:

a) the future minimum lease payments under non-
cancellable operating leases in the aggregate and for
each of the following periods:
i) not later than one year;
ii) later than one year and not later than five years;
iii) later than five years.
b) total contingent rents recognised
as income in the period.
c) a general description of the
lessor’s leasing arrangements.

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 Sale and Leaseback Transactions

If a sale and leaseback transaction results in Finance

Lease

• Any excess of sales proceeds over the carrying amount

– shall not be immediately recognised as income by a
seller-lessee
• Instead, it shall be deferred and amortised over the lease
term

Example 7 of text

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 Sale and Leaseback Transactions
Operating
If a sale and leaseback transaction results in
Lease

• The asset’s Sales Price is compared with its Fair Value

Sales Price = Fair Value • Profit / loss shall be recognised immediately

Sales Price < Fair Value • Profit / loss shall be recognised immediately
except that:
If the loss is compensated by future lease
payments at below market price
 The loss shall be deferred and
amortised in proportion to the lease
payments over the period for which the
asset is expected to be used.
Sales Price > Fair Value • The excess over fair value shall be deferred
and amortised over the period for which the
asset is expected to be used
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 6. Sale and Leaseback Transactions
Operating
If a sale and leaseback transaction results in
Lease

• The asset’s Sales Price is compared with its Fair Value

• If the Fair Value at the time of a sale and leaseback transaction is less
than the Carrying Amount of the asset

Fair Value < Carrying Amount

• a loss equal to the amount of the difference between the carrying

amount and fair value shall be recognised immediately

Example 9 of text

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 Sale and Leaseback Transactions

Disclosure in respect of sale and leaseback

transactions
• Disclosure requirements for lessees and lessors apply
equally to sale and leaseback transactions.
• The required description of material leasing
arrangements leads to disclosure of unique or unusual
provisions of the agreement or terms of the sale and
leaseback transactions.

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