European Union Accounting Rule 8 Leases PDF

EUROPEAN COMMISSION Budget Budget execution Accounting EUROPEAN UNION ACCOUNTING RULE 8 Leases  EUROPEAN COMMISSION Budget Budget execution Accounti...

EUROPEAN COMMISSION Budget Budget execution Accounting EUROPEAN UNION ACCOUNTING RULE 8 Leases  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 2 of 16 INDEX 1. Objective.......................................................................................................................................3 2. Scope.............................................................................................................................................3 3. Definitions.....................................................................................................................................3 4. Classification of leases..................................................................................................................6 5. Lessee accounting..........................................................................................................................8 5.1 Finance Leases......................................................................................................................8 5.2 Operating Leases..................................................................................................................9 6. Lessor accounting..........................................................................................................................9 6.1 Finance Leases......................................................................................................................9 6.2 Operating Leases................................................................................................................10 7. Sale and Leaseback Transactions................................................................................................11 8. Disclosures..................................................................................................................................11 9. Effective date...............................................................................................................................14 10. Reference to other rules...............................................................................................................14  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 3 of 16 1. Objective The objective of this EU accounting rule is to prescribe, for lessees and lessors, the appropriate accounting policies and disclosures to apply in relation to finance and operating leases. 2. Scope This EU accounting rule applies to accounting for all leases in the financial statements of the European Union and its consolidated entities, except:  Licensing agreements for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights;  Investment property (in general not applicable in the EU); and  Biological assets. 3. Definitions The following terms are used in this rule with the meanings specified: 1) Assets are resources controlled by an entity as a result of past events and from which future economic benefits or service potential are expected to flow to the entity. 2) A lease is 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. 3) A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred. 4) An operating lease is a lease other than a finance lease. 5) Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. 6) The commencement of the lease term is the date from which the lessee is entitled to exercise its right to use the leased asset. It is the date of initial recognition of the lease (i.e. the recognition of the assets, liabilities, revenue or expenses resulting from the lease, as appropriate). 7) 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 the passage of time (e.g., percentage of future sales, amount of future use, future price indices, future market rates of interest). 8) Economic life is either: (a) The period over which an asset is expected to yield economic benefits or service potential to one or more users; or  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 4 of 16 (b) The number of production or similar units expected to be obtained from the asset by one or more users. 9) 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. 10) Guaranteed residual value is: (c) For a lessee, that part of the residual value that is guaranteed by the lessee or by a party related to the lessee (the amount of the guarantee being the maximum amount that could, in any event, become payable); and (d) For a lessor, that part of the residual value that is guaranteed by the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. 11) The inception of the lease is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal provisions of the lease. As at this date: (a) A lease is classified as either an operating or a finance lease; and (b) In the case of a finance lease, the amounts to be recognised at the commencement of the lease term are determined. 12) Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or trader lessors. 13) The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of: (a) The minimum lease payments; and (b) The unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor. 14) The lease term is 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 or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option. 15) The lessee’s incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 5 of 16 16) 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, where appropriate, 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) An independent third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee. However, if the lessee has an 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, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it. 17) Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease. 18) A non-cancellable lease is a lease that is cancellable only: (a) Upon the occurrence of some remote contingency; (b) With the permission of the lessor; (c) If the lessee enters into a new lease for the same or an equivalent asset with the same lessor; or (d) Upon payment by the lessee of such an additional amount that, at inception of the lease, continuation of the lease is reasonably certain. 19) Unearned finance revenue is the difference between: (a) The gross investment in the lease; and (b) The net investment in the lease. 20) 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. 21) Useful life is the estimated remaining period, from the commencement of the lease term, without limitation by the lease term, over which the economic benefits or service potential embodied in the asset are expected to be consumed by the entity. 22) A lease agreement or commitment may include a provision to adjust the lease payments for changes in the construction or acquisition cost of the leased property or for changes in some other measure of cost or value, such as general price levels, or in the lessor’s costs of financing the lease, during the period between the inception of the lease and the commencement of the  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 6 of 16 lease term. If so, the effect of any such changes shall be deemed to have taken place at the inception of the lease. 23) The definition of a lease includes contracts for the hire of an asset which contain a provision giving the hirer an option to acquire title to the asset upon the fulfillment of agreed conditions. These contracts are sometimes known as hire purchase contracts. 4. Classification of leases 1) A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership. Risks include the possibilities of losses from idle capacity, technological obsolescence or changes in value because of changing economic conditions. Rewards may be represented by the expectation of service potential or profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value. 2) Because the transaction between a lessor and a lessee is based on a lease agreement between them, it is appropriate to use consistent definitions. The application of these definitions to the differing circumstances of the lessor and lessee may result in the same lease being classified differently by them. For example, this may be the case if the lessor benefits from a residual value guarantee provided by a party unrelated to the lessee. 3) Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Although the following are examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease, a lease does not need to meet all these criteria in order to be classified as a finance lease: (a) The lease transfers ownership of the asset to the lessee by the end of the lease term; (b) 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; (c) The lease term is for the major part of the economic life of the asset even if title is not transferred; (d) 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; (e) The leased assets are of such a specialised nature that only the lessee can use them without major modifications; and (f) The leased assets cannot easily be replaced by another asset. 4) Other indicators that individually or in combination could also lead to a lease being classified as a finance lease are:  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 7 of 16 (a) If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee; (b) 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 equaling most of the sales proceeds at the end of the lease); and (c) The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent. 5) Lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 1 to 4 if the changed terms had been in effect at the inception of the lease, the revised agreement is regarded as a new agreement over its term. However, changes in estimates (for example, changes in estimates of the economic life or the residual value of the leased property) or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes. 6) Leases of land and buildings are classified as operating or finance leases in the same way as leases of other assets. However, a characteristic of land is that it normally has an indefinite economic life and, if title is not expected to pass to the lessee by the end of the lease term, the lessee normally does not receive substantially all of the risks and rewards incidental to ownership, in which case the lease of land will be an operating lease. A payment made on entering into or acquiring a leasehold that is accounted for as an operating lease represents pre- paid lease payments that are amortised over the lease term in accordance with the pattern of benefits provided. 7) The land and buildings elements of a lease of land and buildings are considered separately for the purposes of lease classification. If title to both elements is expected to pass to the lessee by the end of the lease term, both elements are classified as a finance lease, whether analysed as one lease or as two leases, unless it is clear from other features that the lease does not transfer substantially all risks and rewards incidental to ownership of one or both elements. When the land has an indefinite economic life, the land element is normally classified as an operating lease unless title is expected to pass to the lessee by the end of the lease term. The buildings element is classified as a finance or operating lease in accordance with paragraphs 1-4. 8) Whenever necessary in order 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 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. If the lease payments cannot be allocated reliably between these two 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.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 8 of 16 9) For a lease of land and buildings in which the amount that would initially be recognised for the land element, in accordance with paragraph 1 of point 5.1, is immaterial, the land and buildings may be treated as a single unit for the purpose of lease classification and classified as a finance or operating lease in accordance with paragraphs 1-7. In such a case, the economic life of the buildings is regarded as the economic life of the entire leased asset. 10) A contract may consist solely of an agreement to lease an asset. However, a lease may also be one element in a broader set of agreements with private sector entities to construct, own, operate and/or transfer assets. Where an arrangement contains an identifiable operating lease or finance lease as defined in this accounting rule, the provisions of this accounting rule are applied in accounting for the lease component of the arrangement. 5. Lessee accounting 5.1 Finance Leases 1) At the commencement of the lease term lessees shall recognise assets acquired under finance leases as assets and the associated lease obligations as liabilities in their statements of financial position (balance sheet). The assets and liabilities shall be recognised at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall be used. 2) Transactions and other events are accounted for and presented in accordance with their substance and financial reality and not merely with legal form. Although the legal form of a lease agreement is that the lessee may acquire no legal title to the leased asset, in the case of finance leases the substance and financial reality are that the lessee acquires the economic benefits or service potential of the use of the leased asset for the major part of its economic life in return for entering into an obligation to pay for that right an amount approximating, at the inception of the lease, the fair value of the asset and the related finance charge. 3) If such lease transactions are not reflected in the lessee’s financial statements, the assets and liabilities of an entity are understated. Therefore, it is appropriate for a finance lease to be recognised in the lessee’s financial statements both as an asset and as an obligation to pay future lease payments. At the commencement of the lease term, the asset and the liability for the future lease payments are recognised in the financial statements at the same amounts except for any initial direct costs of the lessee that are added to the amount recognised as an asset. 4) Liabilities for leased assets shall not be presented in the financial statements as a deduction from the leased assets. If for the presentation of liabilities on the face of the statement of financial position a distinction is made between current and non-current liabilities, the same distinction is made for lease liabilities.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 9 of 16 5) Initial direct costs are often incurred in connection with specific leasing activities, such as negotiating and securing leasing arrangements. The costs identified as directly attributable to activities performed by the lessee for a finance lease are added to the amount recognised as an asset. 6) Minimum lease payments shall be apportioned between the finance charge and the reduction of the outstanding liability. The finance charge shall be allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents shall be charged as expenses in which they are incurred. In practice, in allocating the finance charge to periods during the lease term, a lessee may use some form of approximation to simplify the calculation. 7) A finance lease gives rise to a depreciation expense for depreciable assets as well as a finance expense for each accounting period. The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets that are owned, and the depreciation recognised shall be calculated in accordance with EU accounting rules 6: Intangible assets and 7: Property, plant and equipment, which has been adopted by the entity. 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 or its useful life. 8) The depreciable amount of a leased asset is allocated to each accounting period during the period of expected use on a systematic basis consistent with the depreciation policy the lessee adopts for depreciable assets that are owned. If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, 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. 9) The sum of the depreciation expense for the asset and the finance expense for the period is rarely the same as the lease payments payable for the period, and it is therefore inappropriate simply to recognise the lease payments payable as an expense. Accordingly, the asset and the related liability are unlikely to be equal in amount after the commencement of the lease term. 10) To determine whether a leased asset has become impaired an EU entity applies relevant impairment tests in EU accounting rule 18: Impairment of assets. 5.2 Operating Leases 1) Lease payments under an operating lease shall be recognised as an expense on a straight line basis over the lease term unless another systematic basis is representative of the time pattern of the user’s benefit. 2) For operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense on a straight-line basis unless another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 10 of 16 6. Lessor accounting 6.1 Finance Leases 1) EU entities may enter into finance leases as a lessor under a variety of circumstances. These Lessors shall recognise lease payments receivable under a finance lease as assets in their statements of financial position. They shall present such assets as a receivable at an amount equal to the net investment in the lease. Under a finance lease, substantially all the risks and rewards incidental to legal ownership are transferred by the lessor, and thus the lease payment receivable is treated by the lessor as repayment of principal and finance revenue to reimburse and reward the lessor for its investment and services. 2) Initial direct costs are often incurred by lessors and include amounts such as commissions, legal fees and internal costs that are incremental and directly attributable to negotiating and arranging a lease. They exclude general overheads such as those incurred by a sales and marketing team. For finance leases other than those involving manufacturer or trader lessors, initial direct costs are included in the initial measurement of the finance lease receivable and reduce the amount of revenue recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs are included automatically in the finance lease receivable; there is no need to add them separately. 3) The recognition of finance revenue shall be based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the finance lease. 4) A lessor aims to allocate finance revenue over the lease term on a systematic and rational basis. This revenue allocation is based on a pattern reflecting a constant periodic return on the lessor’s net investment in the finance lease. Lease payments relating to the accounting period, excluding costs for services, are applied against the gross investment in the lease to reduce both the principal and the unearned finance revenue. 5) Estimated unguaranteed residual values used in computing the lessor’s gross investment in a lease are reviewed regularly. If there has been a reduction in the estimated unguaranteed residual value, the revenue allocation over the lease term is revised and any reduction in respect of amounts already accrued is recognised immediately. 6) Initial direct costs are recognised as an expense at the commencement of the lease term because they are mainly related to earning the manufacturer’s or trader’s gain or loss on sale. 6.2 Operating Leases 1) Lessors shall present assets subject to operating leases in their statements of financial position according to the nature of the asset.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 11 of 16 2) Lease revenue from operating leases shall be recognised as revenue on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which benefits derived from the leased asset is diminished. 3) Costs, including depreciation, incurred in earning the lease revenue are recognised as an expense. Lease revenue (excluding receipts for services provided such as insurance and maintenance) is recognised as revenue on a straight line basis over the lease term even if the receipts are not on such a basis, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished. 4) Initial direct costs incurred by lessors in negotiating and arranging an operating lease shall be added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease revenue. 5) The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal depreciation policy for similar assets, and depreciation shall be calculated in accordance with EU accounting rules 6 & 7 that have been adopted by the entity. 6) To determine whether a leased asset has become impaired, an EU entity applies EU accounting rule 18. 7. Sale and Leaseback Transactions 1) A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negotiated as a package. The accounting treatment of a sale and leaseback transaction depends upon the type of lease involved. 2) If a sale and leaseback transaction results in a finance lease, any excess of sales proceeds over the carrying amount shall not be immediately recognised as revenue by a seller-lessee. Instead, it shall be deferred and amortised over the lease term. 3) If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance to the lessee, with the asset as security. For this reason it is not appropriate to regard an excess of sales proceeds over the carrying amount as revenue. Such excess is deferred and amortised over the lease term. 4) If a sale and leaseback transaction results in an operating lease, and it is clear that the transaction is established at fair value, any gain or loss shall be recognised immediately. If the sale price is below fair value, any gain or loss shall be recognised immediately except that, if the loss is compensated by future lease payments at below market price, it shall be deferred and amortised in proportion to the lease payments over the period for which the asset is expected to be used. If the sale price is above fair value, the excess over fair value shall be deferred and amortised over the period for which the asset is expected to be used.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 12 of 16 5) If the leaseback is an operating lease, and the lease payments and the sale price are at fair value, there has in effect been a normal sale transaction and any gain or loss is recognised immediately. 6) For operating leases, if the fair value at the time of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the amount of the difference between the carrying amount and fair value shall be recognised immediately. 7) For finance leases, no such adjustment is necessary unless there has been an impairment in value and that impairment is required to be recognised by EU accounting rule 18: Impairment of assets. 8. Disclosures 1) Lessees shall disclose the following for finance leases: (a) For each class of asset, the net carrying amount at the reporting date; (b) A reconciliation between the total of future minimum lease payments at the reporting date, and their present value. (c) In addition, an entity shall disclose the total of future minimum lease payments at the reporting 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; and (iii) Later than five years; and 2) Lessees shall disclose the 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; and (iii) Later than five years; (b) The total of future minimum sublease payments expected to be received under non- cancelable subleases at the reporting date; 3) Lessors shall disclose the following for finance leases: (a) A reconciliation between the total gross investment in the lease at the reporting date, and the present value of minimum lease payments receivable at the reporting date. In addition, an entity shall disclose the gross investment in the lease and the present value of minimum lease payments receivable at the reporting date, for each of the following periods: (i) Not later than one year; (ii) Later than one year and not later than five years; and  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 13 of 16 (iii) Later than five years; (b) Unearned finance revenue; (c) The unguaranteed residual values accruing to the benefit of the lessor; (d) The accumulated allowance for uncollectible minimum lease payments receivable; and (e) A general description of the lessor’s material leasing arrangements. 4) Lessors shall disclose the following for operating leases: (a) The future minimum lease payments under non-cancelable 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; and (iii) Later than five years; and (b) A general description of the lessor’s leasing arrangements. 5) Disclosure requirements for lessees and lessors apply equally to sale and leaseback transactions.  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 14 of 16 9. Effective date This rule shall be effective for annual financial statements covering periods beginning on or after 1 January 2012. 10. Reference to other rules This accounting rule is based on the following IPSAS standard: IPSAS 13 "Leases"  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 15 of 16 Annex 1: Classification of a lease The purpose of the following chart is to assist in classifying a lease as either a finance lease or an operating lease. Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. Classification of a lease Situations that would normally lead to a lease being classified as a finance lease. Applicable individually or in combination: Ownership transferred by end of lease term Lease contains bargain purchase option Lease term is for the major part of asset’s economic life Yes Present value of minimum lease payments amounts to substantially all of the asset’s fair value Specialised nature Not easily replaced Is the substance of the transaction that of a finance lease? No Other indicators which individually or in combination could also lead to a lease being classified as a finance lease: Lessee bears lessor’s cancellation losses Ye Lessee bears gains/losses from changes in the ses fair value of residual Lessee has option to extend rental at lower than market rent No Operating lease Finance lease  EUROPEAN COMMISSION Budget Budget execution Accounting Version: 3 EU ACCOUNTING RULE 8: LEASES Date: December 2011 Page 16 of 16 Annex 2: Accounting for a finance lease by a lessee