Accounting for leases

Table of contents

List of abbreviations

List of figures

I. Introduction

II. International financial reporting for leases
A. Objectives of international financial reporting
B. Accounting for leases under IAS
1. Classification of leases
2. Accounting for leases
3. Key differences between IFRS, US GAAP and German Commercial Code

III. Improvements on current lease accounting
A. Assets and liabilities: Different perceptions
1. The IASB’s understanding of assets and liabilities
2. Should lease contracts be separated at all?
3. Leases and executory contracts
B. Measurement and accounting for leases under the new approach
1. Proposed lessee accounting under the new approach
2. Leases with optional features
3. Financial components approach vs. whole asset approach
4. Recent developments
C. Effects on profit determination and distribution
1. Operating leases vs. finance leases
2. Sale and leaseback transactions
3. Financial components approach vs. whole asset approach

IV. Conclusions

Appendices
Appendix A: Classifying lease transactions under IFRS and US GAAP
Appendix B: Accounting for finance leases under IAS
Appendix C: Accounting for leases according to German Commercial Code
Appendix D: Renewal options according to the G4+1 position paper
Appendix E: Financial components approach vs. whole asset approach

References

Other references

List of abbreviations

illustration not visible in this excerpt

List of figures

Figure 1: Objectives of financial reporting according to IFRS

Figure 2: Synoptic presentation of leases’ optional features

Figure 3: Financial components approach vs. whole asset approach

Figure 4: Treatment of sale and leaseback transactions according to IAS 17

Figure 5: Classifying lease agreements under IFRS and US GAAP

Figure 6: Additional criteria for classifying lease agreements under US GAAP

Figure 7: Accounting for finance leases under IAS 17

Figure 8: Accounting for leases according to German full amortisation contracts

Figure 9: Accounting for leases according to German partial amortisation contracts

Figure 10: Accounting for renewal options according to the G4+1 position paper

Figure 11: Financial components approach vs. whole asset approach

I. Introduction

The globalisation of capital markets is driving the increasing convergence of accounting standards worldwide. Recently, the progress toward attaining a global financial reporting framework has accelerated, and many significant steps have been taken. The most important step is the formation of the International Accounting Standards Board (IASB), which replaced the International Accounting Standards Committee (IASC), as part of a comprehensive restructuring of the international accounting standard-setting organisation in March 2001. Since then the acceptance and adoption of International Accounting Standards/International Financial Reporting Standards (IAS/IFRS), hereafter referred to as IFRS, has been growing rapidly. From 01 January 2005 all publicly traded European companies shall account for their consolidated accounts according to IFRS.^[1]

In accordance with § 292a German Commercial Code (Handelsgesetzbuch, HGB) German parent companies may account for their consolidated accounts only according to international accepted accounting standards, according to prevailing opinion such are IFRS and the United States Generally Accepted Accounting Principles (US GAAP). Due to the Accounting Law Reformation Act (Bilanzrechtsreformgesetz, BilReG) all publicly traded German companies shall account for their group accounts according to IFRS from 01 January 2005 except those that are already applying US GAAP (from 01 January 2007). Furthermore all enterprises may account for their individual accounts according to IFRS in addition to German Commercial Code which still is obligatory for tax, and profit determination and distribution purposes.

Due to the commitment of applying IFRS for consolidated accounts international financial reporting issues need to undergo a closer examination. This paper deals with the accounting for leases. First current lease accounting standards are described with a focus on IAS 17 and its key differences to US GAAP and German Commercial Code. Next proposed improvements on current lease accounting standards are dealt with, focussing on new approaches discussed in the accounting and lease literature and a possible treatment of leases with optional features. After this the proposed approaches’ effect on profit determination and distribution is discussed. The final part offers a conclusion to some of the issues raised in this paper.

II. International financial reporting for leases

A. Objectives of international financial reporting

The main objective of the IASC Foundation as described in its constitution is

“[…] to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the world’s capital markets and other users make economic decisions.”^[2]

The IASC Foundation is an independent organisation consisting of two main bodies, the Trustees and the IASB, as well as a Standards Advisory Council (SAC) and the International Financial Reporting Interpretations Committee (IFRIC). The IASB only has responsibility for setting accounting standards.^[3] In order to secure consistency the IASB Framework for the Preparation and Presentation of Financial Statements (Framework) is the basis of deducting future IFRS and revising existing IAS.^[4] The Framework first states underlying assumptions and qualitative characteristics of financial statements, and then deals with constraints on relevant and reliable information, being based on the main objective

“[…] to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.”^[5]

illustration not visible in this excerpt

Figure 1: Objectives of financial reporting according to IFRS

(Source: Compiled by the author)

To be useful the information provided in financial statements have to fulfil the qualitative characteristics which are understandability, relevance, reliability and comparability. An essential aspect in lease accounting is the principle of substance over form as element of the principle of reliability:

“If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form.”^[6]

The international harmonisation process of accounting does not only give rise to considering informational aspects but also aspects of profit determination and distribution. Even though the IASB Framework does not provide information about any other objective than providing decision useful information it can be assumed that profit determination and distribution is considered by developing accounting standards.^[7] Referring to the IASB Framework other research regarding profit determination and distribution is done by Schmidt. He comes to the conclusion that due to the fact that the IASB Framework admits the revaluation of assets but distinguishes between realised and unrealised profits, where the latter do not go through profit and loss, a possible profit determination and distribution purpose of accounting can be assumed.^[8] One can not yet foresee IFRS’s future development but it would be negligent not to consider a possible profit determination and distribution purpose. Chapter III.C of this paper addresses this aspect in detail.

After defining the general purpose of accounting the following chapter provides an overview and a comparison of current lease accounting standards.

B. Accounting for leases under IAS 17

Since the previous chapter already touched on the principle of substance over form the author now connects this principle to current lease accounting standards. Accounting for lease transactions is an outstanding example for the appliance of the principle of substance over form, embodied in the IASB Framework.^[9] According to IAS 17 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.”^[10]

IAS 17 applies to all lease agreements other than those to explore for or use minerals, oil, natural gas and similar non-regenerative resources and licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights. IAS 17 also does not apply to lessees of investment property held under finance leases, lessors of investment property leased out under operating leases,^[11] lessees of biological assets held under finance leases, or lessors of biological assets leased out under operating leases.^[12]

1. Classification of leases

The classification of a leased property is based on the extent to which risks and rewards incident to ownership of the asset lie with the lessor or the lessee.^[13] In accordance with the principle of substance over form lease transactions should not only be classified by their form of contract but also by their substance of transaction.^[14] If a lease transfers substantially all the risks and rewards incident to ownership it is classified as a finance lease, if it does not it is classified as an operating lease.^[15] IAS 17 points out several criteria which would normally lead to a lease being classified as a finance lease. These are: the transfer of ownership test, the bargain purchase option test, the economic life time test, the recovery of investment test and whether the leased property is of specialised nature^[16]. Figure 5 and figure 6 of Appendix A provide detailed information on how to classify leases under IFRS and US GAAP.

2. Accounting for leases

As discussed in the section above, a lease can be classified as a finance lease and an operating lease. The following section describes the accounting for both, finance and operating lease first by the lessee then by the lessor. Figure 7 of Appendix B contains an example of accounting for finance leases according to IAS 17.

Accounting for finance leases

According to the principle of substance over form the lessee has to capitalise the leased property at either its fair value at the inception of the lease, net of grants and tax credits receivable by the lessor, or, if lower, the present value of the minimum lease payments. Additionally the lessee has to set up a liability at the same amount. The minimum lease payments are considered to be the payments that the lessee is obligated to make or can be required to make. The present value is calculated using either the interest rate implicit in the lease or, if it is not practicable to determine, the lessee’s incremental borrowing rate.^[17] If the lease includes a bargain purchase option, the amount required to be paid under the bargain purchase option has to be included in the minimum lease payments.^[18] The annual lease payments are to be apportioned between the reduction of the outstanding obligation and the finance charge.^[19] Capitalised leased properties require the same depreciation policies as for owned assets.^[20] The depreciable amount of leased properties depends on whether there is reasonable evidence that the lessee will obtain ownership by the end of the lease term. In this case the period of expected use is the useful life of the asset, otherwise the asset is depreciated over the shorter of the lease term or its useful life. IAS 17 obliges the lessor to set up a receivable at an amount equal to the net investment in the lease.^[21] The outstanding lease payments have to be treated by the lessor as repayment of principal and finance income to reimburse and reward the lessor for its investment and services.^[22]

Accounting for operating leases

Compared to accounting for finance leases operating leases are being accounted for in a simpler way. Leased properties under lease agreements classified as operating leases shall not be recognised in the lessee’s balance sheet because the substance of the lease is merely that of a rental. The lessee will not derive any future economic benefits from the leased property beyond the lease term.^[23] Lease payments are recognised as expenses in the lessee’s income statement on a straight line basis unless another systematic basis is representative of the time pattern of the user’s benefit.^[24] Additionally SIC-15 deals with incentives relating to new or renewed operating leases provided by lessors for the lessee to enter into the agreement such as an up-front cash payment to the lessee, a reimbursement or assumption by lessors of costs of the lessee and rent-free or reduced rent periods. SIC-15 agrees that all incentives relating to the lease are to be considered in determining the total cost of the lease and should be recognised on a straight-line basis over the term of the lease.^[25] Lessors have to capitalise and depreciate the leased property in their balance sheet according to the nature of the asset.^[26] Lease payments received under an operating lease and costs, including depreciation, incurred in earning the lease income should be recognised in 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 property is diminished.^[27]

3. Key differences between IFRS, US GAAP and German Commercial Code

The following section sets out the key differences between common international accepted accounting standards and German Commercial Code starting with a comparison of IFRS and US GAAP, afterwards key differences between IFRS and German Commercial Code are addressed.

IFRS vs. US GAAP

In November 1976 the Financial Accounting Standards Board (FASB) published the Statement of Financial Accounting Standards No. 13 (SFAS 13), Accounting for Leases. Even though accounting for leases under SFAS 13 is very similar to IAS 17 there are some essential differences, starting with calling finance leases capital leases. Under SFAS 13 third-party guarantees related to the leased properties are excluded from minimum lease payments,^[28] IAS 17 includes the same.^[29] In general SFAS 13 uses the lessee’s incremental borrowing rate to discount the minimum lease payments^[30] while IAS 17 uses the lessee’s interest rate implicit in the lease.^[31] Furthermore SFAS 13 requires more detailed disclosures^[32] with respect to leases than IAS 17.^[33] Although accounting for leases is not on the agenda of the FASB’s and IASB’s joint short-term convergence project there is a long-term leasing project by the IASB which is expected to result in a fundamental change in accounting for leases.^[34] This project will be dealt with in detail in chapter III.B.4.

IFRS vs. German Commercial Code

Unlike the Anglo-Saxon accounting standards German Commercial Code does not provide any rules and regulations regarding lease agreements. The recognition of lease agreements in one’s balance sheet only results from § 246 German Commercial Code, whereby financial statements have to include all of the enterprise’s assets and liabilities.^[35] Therefore tax accounting rules set out in four decrees by the German Federal Ministry of Finance have to be applied.^[36] Hereafter the classification of lease agreements, as in IAS 17 and SFAS 13, does not depend on legal but on economic ownership.^[37] The fiscal authority’s decrees govern the accounting treatment only for finance leases. Whether the lessor’s historical costs including incidental acquisition costs are amortised over the contract period or not one has to distinguish between full and partial amortisation contracts.^[38] Figure 8 and figure 9 of Appendix C show detailed information on how to classify lease agreements according to the decrees of the German Federal Ministry of Finance. Once classified there are some differences to IAS 17. If the leased property has to be recognised in the lessee’s balance sheet the receivable shown in the lessor’s balance sheet has to be at the amount equal to the historical costs of the leased property, IAS 17 requires lessors to recognise leased properties at an amount equal to the net investment in the lease.^[39] In the same case lessees are required to capitalise the leased property in their balance sheet at the amount equal to the lessor’s historical costs, whereas under IAS 17 lessees should recognise the leased property at amounts equal to the fair value of the lease or, if lower, at the present value of the minimum lease payments.^[40] According to the decree as of 19 April 1971 depreciation of the leased property, by both lessees and lessors, should be consistent with the depreciation tables for tax purposes.^[41] IAS 17 requires in the case of the leased property shown in the balance sheet of the lessee and when there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, to depreciate the leased property over the shorter of the lease term or its useful life.^[42]

After analysing and comparing current lease accounting standards the following chapter addresses some aspects of possible improvements on current lease accounting that are discussed in the accounting literature.

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^[1] Publicly traded companies are companies, whose shares are traded on a regulated market in the EU.

^[2] IASC Foundation, Constitution (2002), par. 2.

^[3] See http://www.iasb.org/about/general.asp (13.09.2004).

^[4] See KPMG (ed.), International Financial Reporting Standards (2003), pp. 6 f.

^[5] IASB, Framework (2001), par. 12.

^[6] IASB, Framework (2001), par. 35.

^[7] See Sigloch, J., Rechnungslegung (2003), pp. 81 ff.

^[8] See Schmidt, I.M., Bilanzierung des Goodwills (2002), pp. 107 f.

^[9] See IASB, Framework (2001), par. 35, also see the previous chapter of this paper.

^[10] IASB, IAS 17 (2003), par. 3.

^[11] See IASB, IAS 40 (2003).

^[12] See IASB, IAS 41 (2000).

^[13] See IASB, IAS 17 (2003), par. 5.

^[14] See Selchert, F.W./Erhardt, M., Internationale Rechnungslegung (2003), p. 231.

^[15] See IASB, IAS 17 (2003), par. 6.

^[16] See Engel-Ciric, D., Leasing, in: Lüdenbach, N./Hoffmann, W.-D. (ed.), IAS-Kommentar (2003), § 15, Rz. 15.

^[17] See IASB, IAS 17 (2003), par. 12.

^[18] See Epstein, B.J./Mirza, A.A., IAS 2004, p. 564.

^[19] See IASB, IAS 17 (2003), par. 17.

^[20] See IASB, IAS 17 (2003), par. 19., for depreciation see IAS 16 (2003) par. 16.50 ff. and IAS 36.

^[21] See IASB, IAS 17 (2003), par. 28.

^[22] See IASB, IAS 17 (2003), par. 29.

^[23] See Epstein, B.J./Mirza, A.A., Wiley IAS 2004, p. 563.

^[24] See IASB, IAS 17 (2003), par. 25. f.

^[25] See SIC, SIC-15 (1999), par. 1. ff.

^[26] See IASB, IAS 17 (2003), par. 41.

^[27] See IASB, IAS 17 (2003), par. 42. f., also SIC, SIC-15 (1999), par. 8. ff.

^[28] See FASB, SFAS 13 (1976), par. 5j.

^[29] See IASB, IAS 17 (2003), par. 3.

^[30] See FASB, SFAS 13 (1976), par. 7d.

^[31] See IASB, IAS 17 (2003), par. 12.

^[32] See FASB, SFAS 13 (1976), par. 16. and 23.

^[33] See IASB, IAS 17 (2003), par. 23. f., 27., 39. f. and 48. f.; for disclosure requirements also see IAS 32

^[34] For further information on IASB’s active projects see http://www.iasb.org/…/iasb.asp (14.09.2004).

^[35] See § 246 HGB 1897, last modified according to law as of 06.04.2004.

^[36] See BMF-Schreiben as of 19.04.1971, BStBl. I 1971, pp. 264 ff.; BMF-Schreiben as of 21.03.1972, BStBl. I 1972, pp. 188 f.; BMF-Schreiben as of 22.12.1975, BB 1976, pp. 72 f.; BMF-Schreiben as of 23.12.1991, BStBl. I 1992, pp. 13 ff.

^[37] According to § 39 par. 2 German Fiscal Code (Abgabenordnung, AO) the economic owner of an asset is the one who is actually exercising power over the asset in a way that the legal owner is excluded from the influence on the asset.

^[38] See Ballwieser, W., Germany, in: Ordelheide, D. (ed.), Transnational Accounting, pp. 1280 f.

^[39] See IASB, IAS 17 (2003), par. 28.

^[40] See IASB, IAS 17 (2003), par. 12.

^[41] See BMF-Schreiben as of 19.04.1971, BStBl. I 1971, p. 265.

^[42] See IASB, IAS 17 (2003), par. 19.