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As the title suggests, I am having difficult reconciling IAS 17’s treatment of operating leases with the definition of a liability under the framework.
Suppose a contract is entered for 5 years under which an operating lease will be entered for each year in the period. Then why is it incorrect to say an obligation exists, as a result of past events, resulting in the probable outflow of economic benefits from the entity?
Thanks so much!
Hi,
A operating lease wont create a obligation. Ideally operating lease contract is entered on year to year basis. So ideally its quite equal to rental paid the lessor.
As per you example if contract is entered for 5 year, it could be treated as finance lease if the risk and rewards is transfered to the lessee.
We have to refer framework only in case if there are not any specific guidance available for treatement of those expense.
Hope it does help.
Regards
Rajrent of operating lease is an expense.
if not paid by the end of the period it becomes accured expense which is current liability.Hi
I believe you could be confusing obligations under finance leases with commitments under operating leases.
Until the recent revision of finance lease criteria, a lease was considered a finance lease if substantially the whole of the risks and rewards were transferred to the lessee. But there was no definition of “substantial”. This was developed by the accounting profession to mean not less than 90%. Applying this to a lease situation, the present value of the minimum lease payments should not be less than 90% of the fair value of the asset. In addition, the lease term should be not less than 90% of the expected useful life of the asset.
But IASB never intended that such strict rules should be applied. If they had wanted strich rules, they could have written them into the IAS. It was intended that individual situations should be treated individually on their own merits.
If a lease doesn’t satisfy the definition of a finance lease, then it’s an operating lease. And if it’s an operating lease, the lease costs should be expensed each year.
In a finance lease, for substantially the whole of the asset’s useful life, there is an obligation to continue to pay for the asset for periods into the future.
In an operating lease situation, ( in theory ) the lessee is able to rent almost on a monthly basis. So there really isn’t any long term obligation. Even though it may say in a question “The company entered into a 4 year lease ….” In theory, the company could stop the lease and is not obligated to continue to pay for the remainder of the lease term.
I don’t know if that clears up your concerns at all. It’s all a very subjective area and even the recent revisions which invite the profession to consider the reality rather than the “90%” rule don’t totally resolve the position.
Thank you very much, that helps clear some things up.
@MikeLittle I understand the IAS, I’m just not too sure I fully agree with it actually. Especially if operating lease commitments turn out to be binding (surely they may in some jurisdictions?). The Aug 2010 Exposure Draft on leases also makes interesting reading of the issue, and personally I would lean on preferring the proposed right-of-use model. But thanks for clearing it up!
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