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In this month’s column, PwC's Thomas Roberts and Iain Selfridge answer a technical question on accounting for a property lease

This article was first published in the January 2013 International edition of Accounting and Business magazine.

Q

ABC Ltd enters into a 12-year lease for a new property. The lease is non-cancellable and there are no extension options. The property has a remaining useful economic life of 50 years and the minimum lease payments are significantly less than the fair value of the property. The lease contract includes a six-month rent-free period at the start of the lease. A rent review will occur every three years with the rent increasing based on a local inflation index. However, the contract states that the rentals may not decrease. At the inception of the lease inflation is positive. How should the lease be accounted for under International Financial Reporting Standards?

A

IAS 17, Leases, distinguishes between finance and operating leases based on whether the lease transfers substantially all the risks and rewards of owning the asset. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction. IAS 17 contains examples of situations which would normally result in a lease being classified as a finance lease such as the lease term being the major part of the asset’s economic life and the present value of minimum lease payments amounts to substantially all the fair value of the asset. Any other lease is an operating lease.

In this case ABC is leasing the property for far less than the majority of the property’s life and the minimum lease payments are not a substantial proportion of the property’s fair value. In the absence of any other indicators the lease would be accounted for as an operating lease. IAS 17 therefore requires that the lease payments are recognised over the lease term on a straight-line basis (unless another systematic basis is more appropriate).

Under IFRS, SIC 15 requires that incentives such as a rent-free period should be recognised by the lessee as a reduction of the rental expense over the lease term on a straight-line basis, unless another systematic basis is more appropriate. This ensures that the true effective rental charge is reflected irrespective of the cashflow arrangements agreed between the two parties.

Inflation linked rentals are a common feature in leases and are an example of an embedded derivative. If the embedded derivative is not ‘closely related’ to the underlying lease (the host contract) it must be separately recognised at fair value. Where the embedded derivative is closely related, the inflation increases are examples of contingent rents that are excluded from the calculation of minimum lease payments and charged as expenses in the period in which they are incurred.

IAS 39, Financial Instruments: Recognition and Measurement, guidance on inflation linked lease rentals notes that, provided that adjustments are not a multiple of inflation and the link is to inflation in the entity's own economic environment, the embedded derivative is closely related. The floor feature also must be considered. As the upward-only feature of the rent reviews means that the rentals can never fall below the floor, the floor is always out-of-the-money; that is, the floor does not alter the expected cashflows both at inception and subsequently and so the embedded derivative is closely related.

ABC treats the property as an operating lease spreading the benefit of the six-month rent-free period over the 12-year lease term. Increases in rent due to inflation are accounted for when they occur.

Q

ABC Ltd enters into a 12-year lease for a new property. The lease is non-cancellable and there are no extension options. The property has a remaining useful economic life of 50 years and the minimum lease payments are significantly less than the fair value of the property. The lease contract includes a six-month rent-free period at the start of the lease. A rent review will occur every three years with the rent increasing based on a local inflation index. However, the contract states that the rentals may not decrease. At the inception of the lease inflation is positive. How should the lease be accounted for under International Financial Reporting Standards?

A

IAS 17, Leases, distinguishes between finance and operating leases based on whether the lease transfers substantially all the risks and rewards of owning the asset. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction. IAS 17 contains examples of situations which would normally result in a lease being classified as a finance lease such as the lease term being the major part of the asset’s economic life and the present value of minimum lease payments amounts to substantially all the fair value of the asset. Any other lease is an operating lease.

In this case ABC is leasing the property for far less than the majority of the property’s life and the minimum lease payments are not a substantial proportion of the property’s fair value. In the absence of any other indicators the lease would be accounted for as an operating lease. IAS 17 therefore requires that the lease payments are recognised over the lease term on a straight-line basis (unless another systematic basis is more appropriate).

Under IFRS, SIC 15 requires that incentives such as a rent-free period should be recognised by the lessee as a reduction of the rental expense over the lease term on a straight-line basis, unless another systematic basis is more appropriate. This ensures that the true effective rental charge is reflected irrespective of the cashflow arrangements agreed between the two parties.

Inflation linked rentals are a common feature in leases and are an example of an embedded derivative. If the embedded derivative is not ‘closely related’ to the underlying lease (the host contract) it must be separately recognised at fair value. Where the embedded derivative is closely related, the inflation increases are examples of contingent rents that are excluded from the calculation of minimum lease payments and charged as expenses in the period in which they are incurred.

IAS 39, Financial Instruments: Recognition and Measurement, guidance on inflation linked lease rentals notes that, provided that adjustments are not a multiple of inflation and the link is to inflation in the entity's own economic environment, the embedded derivative is closely related. The floor feature also must be considered. As the upward-only feature of the rent reviews means that the rentals can never fall below the floor, the floor is always out-of-the-money; that is, the floor does not alter the expected cashflows both at inception and subsequently and so the embedded derivative is closely related.

ABC treats the property as an operating lease spreading the benefit of the six-month rent-free period over the 12-year lease term. Increases in rent due to inflation are accounted for when they occur.

Manual of accounting

PwC has updated its Manual of accounting suite for 2012 year ends. This includes guidance on IFRS; ‘Narrative reporting’; and disclosure checklists for UK GAAP and IFRS for the UK (checklists only in pdf format).

This month’s solutions were compiled by Thomas Roberts and Iain Selfridge of PwC’s Accounting Consulting Services

Last updated: 3 Apr 2014