The following Frequently Asked Questions relate to Australian accounting standard AASB 117. For FAQs on other accounting standards and other reporting issues refer to the Financial Reporting FAQ’s page.
My client has taken out a chattel mortgage. Should this be accounted for as a finance lease under AASB 117 Leases?
The treatment of a chattel mortgage will depend on an analysis of the terms and conditions of the particular contractual arrangement.
Chattel mortgages are used as a form of financing in similar situations to hire purchase contracts, often to obtain tax benefits. AASB 117.6 states that hire purchase contracts are included in the definition of a lease; however neither AASB 117 nor AASB 139 Financial Instruments: Recognition and Measurement specifically addresses a chattel mortgage.
Interpretation 4 Determining Whether an Arrangement contains a Lease provides guidance on how to assess an arrangement to determine if it is, or contains a lease as defined in AASB 117. Members should use this guidance to assess individual arrangements. If the arrangement does not constitute or contain a lease, it would be accounted for as a financial liability.
Has there been a recent change to the appropriate classification of a lease of land? If so, how should land now be classified?
Updated December 2010
Yes. The AASB made changes to AASB 117 Leases. Paragraphs 14 and 15, which state that a lease of land with an indefinite economic life would be classified as an operating lease unless title is expected to pass to the lessee at the end of the lease term, have been deleted.
The change corresponds to a decision taken by the IASB as part of its second improvements project.
The IASB was of the view that this guidance is inconsistent with the requirements of AASB 117. Therefore, its removal would constitute such an improvement to the current standard so as to warrant its inclusion now, rather than wait for the conclusion of the Board’s major project on lease accounting (which is not due to result in a new standard until 2011).
Although the revisions still require land and buildings to be considered as separate assets for the purpose of classification, each must now be assessed as either ‘finance’ or ‘operating’ in exactly the same way as any other asset (i.e. based on the transfer of risks and rewards of ownership). However, the new paragraph 15A does state that an important consideration in that assessment is that land normally has an indefinite economic life.
The change means that land leases with a term of several decades or more could now be considered as finance leases if the arrangement transferred substantially all risks and rewards and the present value of the residual value of the leased asset was negligible.
The amendment is contained in AASB 2009-5 and is effective for annual periods beginning on or after 1 January 2010. The transitional provisions require that if leases are reclassified from ‘operating’ to ‘finance’ as a result of the amendment, reclassification is to be effected retrospectively. However, if the necessary information is not available to apply the change retrospectively, the transitional provisions allow the classification to be based on the facts and circumstances that exist at the date of the adoption of the amendment. The asset and liability are to be recognised at their respective fair values with any differences between those fair values being recognised in retained earnings.
My client is a not-for-profit club which has its club facilities on land leased from a government body. The lease is renewed every 10 years. The club has been on this site for over 50 years and we have no indication that the land-owner would evict the club and repossess the land, but because we cannot get any written assurance from the land-owner that they will renew the lease, we are concerned that AASBs 116 and 117 require us to depreciate all the club facilities over the remainder of the lease.
Updated December 2010
There are many arrangements like this in the not-for-profit sector and each must be examined on its own merits.
As you say, AASB 117 para 27 states that 'if there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term' depreciation should be calculated in accordance with AASB 116. AASB 116 para 56 lists some factors to be 'considered' in determining the useful life of the asset, such as 'legal or similar limits on the use of the asset, such as the expiry dates of related leases'. 'Lease term', however, is defined as 'the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with our without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.'
Based on the current pattern of behaviour by the lessor and lessee to date the substance of this transaction would appear to give the lessee an option to lease the asset for longer than just the current 10-year period to the next renewal. It would also appear reasonably certain the lessee would exercise this option if necessary and therefore a longer term (reflecting the nature of the asset) is likely to be more appropriate for depreciation purposes than the 10-year lease term.
However if the club were to receive an indication from the land-owner that it wishes to repossess the site at the end of the next lease term then at that point the issue of impairment should be considered and the facilities written-off over the remaining life of the lease.
Capitalised leasehold improvements associated with a five year building lease have an estimated useful life of five years. However, we can exit the lease after three years without penalty or the permission of the lessor. What period should be used to depreciate these improvements?
In accordance with paragraph 27 of IAS 17 Leases (issued in Australia as AASB 117 and New Zealand as NZ IFRS 17), leasehold improvements need to be fully depreciated over the shorter of the lease term and their useful life when there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term. For the purposes of IAS 17 ‘lease term’ is defined as the ‘non-cancellable’ period over which the lessee is contracted to lease the asset, together with any further terms over which the lessee has the option to continue to lease the asset, with or without further payment. However this latter portion of the term can only be included when, at the inception of the lease, it is reasonably certain that the lessee will exercise the option (IAS 17.4).
A non-cancellable lease is a lease that is cancellable only on the occurrence of one of the following circumstances. These are a remote contingency, with the permission of the lessor, if the lessee enters into an equivalent lease or on payment of a penalty such that continuation of the lease is reasonably certain (IAS 17.4). In this specific case, the non-cancellable period of the lease is three years because after this period the lessee can cancel the lease without the lessor’s permission and without incurring a penalty. This makes the substance of the arrangement one where the lessee has a three year lease with an option to extend for a further two years (five years in total).
If the lessee is reasonably certain that they will exercise the option when the lease is entered into, then this additional period may be included in the depreciation calculations. However IAS 17 does not define or provide guidance on what is ‘reasonably certain’ – it requires judgement of the individual facts and circumstances at inception of the lease. Factors to consider in this case could include the significance of the lease and leased assets to the entity’s business model, the cost and useful life of the assets, the ability of the entity to recover those costs and expected market lease rentals for the two year extended period compared to the contracted rate.
I have heard that the IASB is proposing some major changes to the way in which leases are accounted for. Can you give me some more details please?
The way leases are accounted for has been the subject of extensive criticism over many years, particularly for their role in 'off balance sheet' financing. The IASB and FASB have had a long-standing project to improve this area, which gained higher priority as part of their 2011 convergence work programme deadlines. This work is now nearing completion, with the release in August 2010 of ED 202 Leases - the AASB equivalent of the IASB ED 2010/9 (reissued as ED202R with minor corrections). The comment period to the IASB closed on 15 December 2010 to the IASB.
The aim of the leasing project was to develop a new single approach to lease accounting that would ensure that all assets and liabilities arising under lease contracts are recognised in the statement of financial position (balance sheet). It will therefore have a significant effect on all those entities that currently use operating leases, requiring them to value and disclose leases on the face of their statements of financial position (balance sheets), rather than in the notes. The changes will also affect the income statements, as rental expense will now be replaced by depreciation and interest charges. Disclosure requirements are also being amended, and a modified retrospective approach to initial adoption will be required.
This fundamental shift in approach for leases affects both lessees and lessors and will have a widespread impact. The changes to the balance sheet/statement of financial position also have the potential to pose problems for existing and future debt covenants, as well as other funding arrangements. Members are therefore encouraged, and should encourage their clients, to familiarise themselves with the proposals and consider the impact on their individual current accounting practices, disclosures and debt covenants.
Practical steps should also be put in place now to address the effects of the changes. The new standard implementing these changes is expected to be released mid 2011, but as yet no operative date has been proposed. The IASB intends to seek feedback on when these changes should be implemented, but at this stage a date before 2013 would appear unlikely.
For more information on the leasing ED, visit the leasing project page of the IASB website. The IASB is aware of the significance of its proposals and has prepared a range of resources to explain the rationale behind the standard and the impacts it will have.
Should my client company be capitalising and amortising employees' motor vehicles covered by novated leases?
Updated December 2010
With any lease, it is always a case of looking at the agreement as leases can differ from each other in subtle detail. However, the usual novated lease is designed in such a way that the car belongs to the employee.
If the employee leaves, he or she takes the car and has continued responsibility for the lease payments. The company is only responsible for the lease payments as long as the staff member continues to work there.
Consequently, the substance of the arrangement is that the lease payments are a staff cost with the staff member being paid in kind, rather than in cash. The payments are not within the scope of AASB 117 Leases and should be shown as part of wages and salaries. The company should also disclose its commitments under these arrangements in a commitment note.