Week 8: Leasing
Part 1:The “Substance over Form” principle & The issues caused by IAS 17
Leases (the old leasing standard).
What is a lease?
-A lease is an agreement whereby the lessor conveys to the lessee the
right to use an asset for an agreed period of time, in return for a payment
or a series of payments.
-Lessor: the legal owner of the asset.
-Lessee: the user of the asset (who bears the economic benefit).
Legal ownership vs economic substance!
The Substance over Form principle:
-Key accounting principle under IFRS
Transactions should be recorded according to their underlying economic
substance,
rather than just their legal form.
Example 1 of the Substance over Form principle:
• Extreme Ltd, a small adventure company in Italy wants to expand its
operations and buys a fleet of vans using a five-year period lease
agreement from the bank. After the end of the lease the vans will be
legally owned by Extreme Ltd. Despite Extreme Ltd legally owning the
vans from an ‘economic point of view’, the company will not be
recognized as the ‘legal owner’ until it pays the final instalment at the end
of the fifth year.
Example II of the Substance over Form principle:
• A large estate agency in London is looking to expand. It signs a contract
to lease a building in Piccadilly for 30 years, where the economic useful
life of the building is estimated to be 35 years. If the lease agreement
states at the end of the lease period, the ownership title of the building
will be transferred to the lessee (estate agent) then the building is owned
by the “lessee” in economic reality.
• This is because although the building is legally owned by the lessor, the
estate agency controls the building and derives maximum benefits from it.
In practical terms: What is the main difference?
Imagine you are considering buying or leasing a car…
Two options:
Buy the car: it costs £60,000 and you need to take a loan to fund its
purchase (assume no interest charges). On your SOFP, you acquire an
asset and a borrowing liability.
Lease the car: you enter a 5-year lease contract / exclusive right to use
the car / lease payments of £12,000 per annum. Do you have an asset
and a borrowing liability in this case?
Two types of leases recognised under IAS17 (old standard):
Finance leases: the lease transfers ownership of the asset to the lessee by
the end of the lease term
, -Capitalised in the lessee's accounts, that is:
◦ the leased item was recorded as an asset in the SoFP; and
◦ the obligation for future payments was recorded as a liability in the SoFP
Operating leases: permits the use of an asset
without transferring the ownership rights of asset.
-Lessee was required to expense the annual payments as a rental through
the income statement. Leases were not recorded on the SOFP.
Leasing under IAS 17 (old standard):A form of off-balance sheet funding!
-Operating leases offered the opportunity of off- balance sheet
recognition!
-Loophole/issue: Companies were tempted to structure their leases mainly
as operating leases, to avoid recognising leased assets and leasing
liabilities on the SOFP.
-Advantage of this approach?
◦ The company appeared less geared and higher performing could thus
attract more and/or cheaper debt.
Distortion caused by operating leases under IAS 17:
Key performance ratios in financial analysis,such as:
❑ the Return on Capital Employed (ROCE)
❑ the Gearing ratio
Become distorted and unreliable when operating leases form a major part
of a company’s financing.
-The IASB reported in 2016 that over 14,000 companies (of about 30,000
listed companies) had off-balance sheet funding through operating leases.
-The amount of off-balance sheet funding is estimated to be $2.18 trillion
USD in present value terms!
-Main sectors impacted: airlines, retailers, travel and leisure, transport
companies
-Main regions impacted: US, Europe, Asia/Pacific
Example of distortion caused by operating leases under IAS 17: Buy vs
Lease decision:
Part 1:The “Substance over Form” principle & The issues caused by IAS 17
Leases (the old leasing standard).
What is a lease?
-A lease is an agreement whereby the lessor conveys to the lessee the
right to use an asset for an agreed period of time, in return for a payment
or a series of payments.
-Lessor: the legal owner of the asset.
-Lessee: the user of the asset (who bears the economic benefit).
Legal ownership vs economic substance!
The Substance over Form principle:
-Key accounting principle under IFRS
Transactions should be recorded according to their underlying economic
substance,
rather than just their legal form.
Example 1 of the Substance over Form principle:
• Extreme Ltd, a small adventure company in Italy wants to expand its
operations and buys a fleet of vans using a five-year period lease
agreement from the bank. After the end of the lease the vans will be
legally owned by Extreme Ltd. Despite Extreme Ltd legally owning the
vans from an ‘economic point of view’, the company will not be
recognized as the ‘legal owner’ until it pays the final instalment at the end
of the fifth year.
Example II of the Substance over Form principle:
• A large estate agency in London is looking to expand. It signs a contract
to lease a building in Piccadilly for 30 years, where the economic useful
life of the building is estimated to be 35 years. If the lease agreement
states at the end of the lease period, the ownership title of the building
will be transferred to the lessee (estate agent) then the building is owned
by the “lessee” in economic reality.
• This is because although the building is legally owned by the lessor, the
estate agency controls the building and derives maximum benefits from it.
In practical terms: What is the main difference?
Imagine you are considering buying or leasing a car…
Two options:
Buy the car: it costs £60,000 and you need to take a loan to fund its
purchase (assume no interest charges). On your SOFP, you acquire an
asset and a borrowing liability.
Lease the car: you enter a 5-year lease contract / exclusive right to use
the car / lease payments of £12,000 per annum. Do you have an asset
and a borrowing liability in this case?
Two types of leases recognised under IAS17 (old standard):
Finance leases: the lease transfers ownership of the asset to the lessee by
the end of the lease term
, -Capitalised in the lessee's accounts, that is:
◦ the leased item was recorded as an asset in the SoFP; and
◦ the obligation for future payments was recorded as a liability in the SoFP
Operating leases: permits the use of an asset
without transferring the ownership rights of asset.
-Lessee was required to expense the annual payments as a rental through
the income statement. Leases were not recorded on the SOFP.
Leasing under IAS 17 (old standard):A form of off-balance sheet funding!
-Operating leases offered the opportunity of off- balance sheet
recognition!
-Loophole/issue: Companies were tempted to structure their leases mainly
as operating leases, to avoid recognising leased assets and leasing
liabilities on the SOFP.
-Advantage of this approach?
◦ The company appeared less geared and higher performing could thus
attract more and/or cheaper debt.
Distortion caused by operating leases under IAS 17:
Key performance ratios in financial analysis,such as:
❑ the Return on Capital Employed (ROCE)
❑ the Gearing ratio
Become distorted and unreliable when operating leases form a major part
of a company’s financing.
-The IASB reported in 2016 that over 14,000 companies (of about 30,000
listed companies) had off-balance sheet funding through operating leases.
-The amount of off-balance sheet funding is estimated to be $2.18 trillion
USD in present value terms!
-Main sectors impacted: airlines, retailers, travel and leisure, transport
companies
-Main regions impacted: US, Europe, Asia/Pacific
Example of distortion caused by operating leases under IAS 17: Buy vs
Lease decision:
