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ORIGINAL RESEARCH DRAFT IAS 17 Leases IAS 40 Investment Powered By Docstoc
					                       ORIGINAL RESEARCH DRAFT

                IAS 17 Leases & IAS 40 Investment Property

    Guidance Notes on the Application to UK Investment Properties


1.1 The IASB issued final revised standards published on 15th December 2003, and have
made it clear that they do not intend to issue any further guidance notes on the practical
application of the above standards to Investment Properties.

1.2 The objective of these notes is to give guidance on the application, in a UK context,
of these standards, in order to achieve a consistent approach by BPF members. These
notes are written specifically for the UK investment property market, with particular
reference to the standard UK lease structures. Many of the proposals set out below take
into account discussions with IASB staff and the major accounting practices.

Guidance Note 1. The Classification of leases.


1.1 Paragraph 14 of IAS 40 states: “Judgement is needed to determine whether a property
qualifies as investment property. An entity develops criteria so that it can exercise that
judgement consistently in accordance with the definition of investment property and with
the related guidance in paragraphs 7-13. Paragraph 75(c) requires an entity to disclose
these criteria when classification is difficult.” The issue that has provoked most
discussion and uncertainty in the smooth transition to adapting to IAS relates to the
classification of leases as either finance leases or operating leases. There has been debate
as to whether certain leases-out which reflect the UK tradition of longer terms of 15 years
or more at a full market rent, subject to upward only rent review and on a full repairing
and insuring basis, might fall to be reclassified as finance leases. This would preclude
lessors from treating property let in this way as investment property under IAS 40. One of
the principal aims of this paper is to aid the judgement required. A practical and robust
method is proposed to achieve a quick, consistent and reliable classification of leases
under IAS 17 for investment property. A two stage process is proposed, firstly an entirely
qualitative analysis of land and building elements of a lease, progressing to a more
detailed, and sometimes quantitative, analysis where a possible finance lease is indicated.

(References to the standards are denoted as follows: Standard Number/paragraph (s)
e.g. 40/2(a)


2.1 Qualitative Assessment.

2.1.1 This should be undertaken using IAS 17 to determine whether a property is
precluded from recognition by an investment owner under IAS 40 because it is
determined to have been leased-out under a finance lease when classified under IAS 17.
This would apply equally to freehold and leasehold property. The project team have made
extensive enquiry with IASB, leading accountancy practices and BPF members to
develop criteria, based on IAS 17, to aid the logical assessment and classification of
leases. The proforma checklist at Appendix A comprises a central element of this paper.
In particular the team were reassured, through meetings with representatives from IASB
that “detailed calculations (and therefore valuations) are required only if operating lease
classification is not obvious” (at meeting with EPRA members 24th November 2003). It is
the conclusion of this paper that conventional UK occupational leases will, in the main,
be operating leases. By undertaking the qualitative routine set out in Appendix A, in
respect of each lease-out, investors will be led to the identification of possible finance
leases, which then should fall to much more detailed consideration in deciding the
appropriate accounting treatment.

2.1.2 Land and Building apportionments.
Land and building elements to a lease are always considered separately in undertaking a
lease classification. 17/15. During the development and improvement of IAS and the
familiarisation process by preparers of accounts there has been much uncertainty as to
whether value apportionments of land and buildings and residual values, at lease
inception, needed to be obtained as a precursor to the determination of lease
classification. It is the conclusion of the project team that this is unnecessary whilst a
purely qualitative assessment is being made (17/16 & 18). Only once a possible finance
lease is indicated might it become necessary to obtain such values in order to undertake a
mathematically based analysis, and ultimately use it in applying finance lease accounting
(which is also applied to leasehold investment property held under operating lease).

2.1.3 Routine for Identification of Possible Finance Leases. The table included at Appendix A is designed so that if the answer “yes” is given
to any question in the Primary Questions List it will lead to the rebuttable assumption that
the lease element is a finance lease. All the questions appearing in the table are based on references in IAS 17,
adapted, or inverted, to produce answers in each of the columns. They are drawn in the
context and knowledge of UK leasing conventions with the specific purpose of
identifying characteristics indicative of finance leases. In rebutting a finance lease assumption the prompts appearing after the table, if
answered affirmatively, may indicate operating lease characteristics.

Recommendation 1. Leases should initially be assessed on a purely qualitative basis in
accordance with IAS 17 using the criteria set out in Appendix A to identify possible
finance leases which may then be submitted to quantitative test.

2.2 Quantitative Assessment of Possible Finance Leases.

2.2.1 IAS 17 paragraph 10(d) Test. Possible finance leases should be reviewed under the
test set out in 17/10(d), which states that if “at the inception of the lease the present value
of the minimum lease payments amounts to substantially all of the fair value of the leased
asset” then it will be indicative of a finance lease. Some areas of uncertainty arise on
valuation issues in connection with the practical application of this test and these are
referred to in Appendix B.

2.2.2 Land and Buildings. The Standard is clear that land and building elements of the
lease should be considered separately (17/15).

2.2.3 There are four elements to the quantitative test, the lease term, minimum lease
payments, a discount rate and a residual value for the asset at lease end.

                                                                                             3 Minimum Lease Payments.
       These are defined in IAS 17 as “the payments over the lease term that the lessee is
       or can be required to make, excluding contingent rent……”. Some uncertainty has
       been expressed as to whether minimum lease payments might include certain
       expected future increases in rent. Discount Rates.
       As noted above, one indicator that a lease would normally be a finance lease is
       that 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 (17/10(d)).
       There is no clear guidance within 17/7 – 19 as to how the present value of the
       minimum lease payments is determined for this purpose. However, the use of
       “present value” without further qualification implies that a true present value is
       required. Assuming that the lease is negotiated in an arm’s-length transaction, the
       discount rate(s) used should in principle be such that the present value of the
       minimum lease payments, together with any unguaranteed residual value and any
       expected contingent rents (including future expected rent increases) equal the fair
       value of the asset at inception (plus the lessor’s initial direct costs). It would be
       appropriate to discount any unguaranteed residual value and expected contingent
       rents at higher rate(s) than the minimum lease payments, because they are less

     It is acknowledged that estimating the discount rate to be used
              for the minimum lease payments will not always be straightforward.
              Paragraph 20, which deals with the accounting for finance leases in the
              financial statements of lessees, states that the “interest rate implicit in the
              lease”, a feature typical of a more conventional finance lease, should be
              used to measure the asset and liability. If this is not practicable to
              determine then “the lessee’s incremental borrowing rate” should be used.
              However, it is important to note that this applies to the accounting only,
              and not to the classification process itself. Unfortunately, IAS 17’s
              definition of the interest rate implicit in the lease excludes contingent
              rents. For many straightforward finance leases, the true discount rate and
              the implicit rate will be the same, but, if contingent rents are significant,
              the implicit rate will tend to be lower than the true discount rate. In these
              circumstances, applying the implicit rate to the minimum lease payments
              is likely to be misleading for the purpose of classifying the lease, and the
              lessee’s incremental borrowing rate is likely to be a better approximation
              to the true rate.

Recommendation 2. If practicable, the true discount rate(s) implied by the transaction
should be determined for the purpose of the quantitative assessment. If this is
practicable, it will also be practicable to determine the “interest rate implicit in the
lease” as defined in IAS 17 (which may be different), which should be used for any
subsequent accounting.

Recommendation 3. Where it is not practicable to determine the true discount rate(s)
implied by the transaction, which may be the case if the minimum lease payments at
inception are known to be low relative to market rents, and the lease is subject to
contingent rents payable from commencement, it may be more appropriate to use the
lessees incremental cost of borrowing both for the quantitative assessment and for any
subsequent accounting. If so, it is suggested that the following process should be

              1. Ascertain the Gilt rate applicable at the inception of the lease for the
              period of the lease.
              2. Determine the covenant strength of the tenant and determine a
              margin over the gilt rate that the tenant would have to pay for a
              borrowing of the term of the lease.
              3. Use this rate to discount the minimum lease payments for the period
              of the lease. Residual Values. In order to deduce the “interest rate implicit in the lease”
       it would be necessary at inception for companies to assess the residual value on
       expiry of the lease (17/4) where this has not been agreed as part of the lease
       negotiation. This requires them to envisage the building in the condition it would
       then be in at the end of the lease with no assumption made as to refurbishment
       expenditure beyond general repair and maintenance as required under the tenant’s

Recommendation 4. The definition of the term “substantially all of the fair value”(see
paragraph 10 (d) should be interpreted as an amount in excess of 90%.

Recommendation 5. If the calculations indicate it is a finance lease, this should be
considered in the round with all the other tests and a decision made on all the

      Appendix A

                                      Classifying leases under IAS 17

      This proposed assessment routine is intended for use by lessors, taking into account the specific
      nature of the UK investment property market:

               •   the purpose of the routine is to identify which party to the lease, lessor or lessee,
                   enjoys substantially all the risks and rewards of ownership of the different elements
                   to the lease;
               •   the land and building elements are considered separately;
               •   IAS 17 looks at the substance of the transaction rather than the legal form;
               •   the assessment to classify the lease is from the date of the inception of the lease;

      Primary Questions to be applied to land and building elements separately

                                                                                                          Yes No
1 Does the lease transfer ownership of the asset to the lessee by the end of the lease term? 17/10(a)
2 Does the lease give the lessee the option to purchase the asset at less than open market value?
3 Does the lease contain terms that result in the gains or losses from fluctuations in the residual
  value of the asset accruing to the lessee? 17/11(b)
4 At the inception of the lease, is it reasonable to assume that the lessee and lessor either (a)
  expected the lease term to be for the major part of the economic life of the building, or (b) or that
  the residual value on expiry of the lease term would be negligible? 17/10(c)
5 Has the payment structure of the lease been derived with reference to specific interest rates and
  returns on risk which would be required by a lender?*
6 Does the lease allow the lessee to cancel the lease and if so does the lessee have to bear the
  lessor’s losses, as predetermined in the lease terms? 17/11(a)
7 Are the buildings of such a specialised nature that only the lessee can use them without major
  modification? 17/10(e)

      *If the lease were part of a broader transaction, such as a PFI project, structured to reflect a
      lender’s risk and returns, this would be indicative of a possible finance lease. A rent substantially
      in excess of normal market rents, set in a sale and leaseback transaction might indicate a finance

      If the answer to all the questions is no, no further work is required and the lease is considered an
      operating lease, unless there are other features of the lease that clearly show that the property
      risks and rewards remain substantially with the tenant.

      If the answer to one or more of the questions is "yes", there is a possibility that the lease should
      be classified as a finance lease and a further review, including the numeric test set out in IAS
      17/10d, may be required to determine whether the lease is indeed a finance lease.

      Accordingly, in order for a lease subject to this further review to qualify nonetheless as an
      operating lease, it must be clearly demonstrated that the landlord retains substantially all the

property related risks and rewards. The following prompts, if answered in the affirmative, might
be suggestive of operating lease attributes:

        •   are there full repairing and insuring covenants in the lease and clauses to ensure the
            asset is reinstated, at the expense of the tenant, to its original condition at the end of
            the lease?
        •   does the lease provide for significant contingent rent variations during the term by
            reference to an open market or turnover?**
        •   were the initial passing rent and other aspects of the lease set at prevailing market
        •   is the lease free of contractual terms which might oblige the lessor to continue the
            lease at substantially less than normal market terms? 17/11(c)
        •   is lessee default the only grounds on which the lease would revert to the lessor?
        •   if the lessee wishes to sublet or sell (or assign) their lease rights, are there terms in
            the lease that allow the lessor to control the key terms of the sublet / sale?

        ** If the lease were to provide for fixed increases or increases linked to a non property
        market index, this might be indicative of a finance lease.

                                    Practical Issues

1. Property and Valuation Issues.

      1.1 Land and Buildings apportionments. There is no market evidential basis in
      the UK for splitting leases between land and building elements. Furthermore, with
      no historic requirement to register and retain data on land values related to lease
      inception dates there are potential problems in producing retrospective valuations
      of land. Companies will show varying ability to retrieve historic records of such
      data as historic valuations, original costs and reinstatement estimates dating back
      to inception of leases. Nonetheless, it is expected that only relatively few
      buildings will exhibit finance lease characteristics, and of these, most that were
      knowingly entered into as finance leases should have access to the necessary data.

      For the remaining suspect finance leases companies should be able to evolve
      methods to derive land and building apportionments although this could be a
      theoretical exercise, and potentially unreliable and inconsistent, particularly for
      leasehold property. It might entail looking at prices of land ripe for development
      and adjusting for the actual circumstances of the subject holding. Alternatively
      historic building costs or reinstatement assessments might give indications on
      building cost even though the balance between that and valuation would be
      wholly unreliable as an indicator of land value.

      1.2 Residual Values. Residual value is not a concept generally applicable to
      investment property. The kind of properties where a possible finance lease might
      be indicated will tend to be let for a long term and at inception it would be almost
      impossible to predict the likely value at lease end. This estimate, even where it
      could be made, would not be of the same quality as estimating the value of a
      three-year-old car where a sophisticated market has developed for resale of fleet
      vehicles. For certain types of property it may be possible to look at an old
      property of similar characteristics which is at a stage in its life cycle that the
      subject property is expected to be in at the end of the lease. However, for most
      property, due to changing fashions, economic circumstances and construction
      techniques, future uses many years hence are usually unpredictable with
      reliability or consistency. Companies may have to use the best proxies available
      to arrive at a best estimate. In most situations it would be inappropriate to merely
      assume that a building had no residual value at lease end for the following
               a) Tenants are obliged to maintain buildings in good repair under their
               b) The tenant may choose to renew the lease.

              c) There is always a potential “after use” for a building. It is usually the
              stage in an economic cycle which determines if redevelopment is a viable
              d) For leasehold investment property, the investor is unlikely to be
              permitted to redevelop without landlord’s consent, which would
              frequently entail revision of the headlease terms.

       1.3 The Economic Life of an Asset. Determination of the economic life of a
       building is unreliable and can vary with the point in economic cycles and fashion.
       At a point when a building is, to all appearances, obsolete there are still choices
       between repair and redevelopment. It may not therefore be possible to determine
       reliably if the lease is for the whole or major part of the remaining economic life
       of the building and it will equally be unreliable to make this assessment long in
       advance at the inception of the lease. Buildings can have their economic life
       almost indefinitely extended through refurbishment as is testified by many older
       buildings still in beneficial use.

       Recommendation 6. Companies should consider the kind of economic life they
       expect for subject buildings by relating them to similar buildings of an age
       identical or close to the term of the lease granted. This will be a qualitative
       judgment taking into account, amongst other things, the degree of certainty
       attaching to the prospect of redevelopment at lease end.

       1.4 Multi-tenanted Investment Property. In the vast majority of multilet
       investment properties all the underleases will be of a similar classification, usually
       operating leases, and thus accounting is straightforward. Occasionally, and
       typically for retail centres, a few tenants may lease the site but meet the building
       cost themselves leading to finance lease characteristics. The effect of such an
       underletting might be to preclude that element from treatment as investment
       property (40/9(e)). However, most such cases will either occupy clearly
       delineable sites of their own capable of separate treatment, or the rent and value
       attributable to the site will amount to only a relatively immaterial part of the
       whole investment.
               1.4.1 Mixed commercial and residential properties either tend to have the
               residential units let out under operating leases (Assured Shorthold
               Tenancies) or sold on long leases subject to ground rents. In the latter
               case, the investment retained by the lessor would effectively be the
               operating lease of the land element and this is usually all that is reflected
               in the reported market valuation and can be accounted for alongside the
               commercial parts.

 Recommendation 7. Where, in a multi-let property, substantially all the income
arises from Operating leases, the remaining leases should be treated, on grounds of
materiality, as Operating Leases where it is impractical / impossible to satisfactorily
split the valuation accurately for small parts of the building. In reality, it is usual in
such situations, if any rent is reserved in relation to the finance lease asset, it will

relate to the land element and should properly be accounted for as an operating
lease along with all the rest of the income.

Guidance Note 2. Lease Accounting for Investment Property


1.1 Lessor Accounting.

1.1.1 Where a finance lease-out is identified, this is treated as an effective sale of the
building element of the lease. The building element is no longer reflected in the balance
sheet and the lessee is treated as a debtor. The land element normally remains on the
balance sheet as an asset leased-out under an operating lease.

1.2 Lessee Accounting and IAS 40 Valuation of Leasehold Investment Properties

1.2.1 The IASB have amended IAS 40 to permit Leasehold investment properties to be
carried at “Fair Value” provided that the lease under which an investment is held, and
which is classified as an operating lease, is nonetheless accounted for under IAS 17 as
though it were a finance lease.

1.2.2 Separate measurement of land and buildings elements is not required when the
lessee’s interest in both land and buildings is classified as investment property in
accordance with IAS 40 and the fair value model is adopted. 17/18.

1.2.3 The interest should be valued by reference to expected cash flows, both inflows and
outflows, but without deduction for any outflows that are separately recognised in the
balance sheet as a liability. 40/40. “Accordingly, if the valuation obtained for the property
is net of all payments expected to be made, it will be necessary to add back any
recognised lease liability. A reconciliation should be provided between the valuer’s net
valuation and the valuation in the financial statements”. 40/50(d)

Recommendation 1. The amount provided in the balance sheet for leasehold liabilities,
as required under IAS 17, should be added to the valuation of the properties in the
property note in the notes to the financial statements and the gross amount shown on
the face of the balance sheet.

1.2.4 Quantification of Leasehold Liabilities in the Balance Sheet. IAS 17 quite clearly
states that the Balance Sheet must contain a liability for the lease payments, which is
represented by the Net Present Value of the future minimum lease payments. 17/20
states: “At the commencement of the lease term, lessees shall recognise finance leases as
assets and liabilities in their balance sheets 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.
Any initial direct costs of the lessee are added to the amount recognised as an asset.”

Recommendation 2. For new properties minimum lease payments should be strictly
interpreted in accordance with the definition and no estimates should be made with
regard to future expected rent increases. For older properties where inception is taken
as a date of ownership transfer minimum lease payments would reflect the rent in
payment, or where there is an unagreed but past rent review, an estimated rental value. Straightforward Finance Leases. These will in probability carry an
       identifiable “implicit rate of interest” in which case that is used to capitalise the
       minimum lease payments in determining the liability to be recognised. “Masked” Finance Leases. An attempt may be made to deduce the implicit
       rate by iterative process applied to the discounted future residual value and the
       present values of the minimum lease payments. However, as IAS 17 excludes
       contingent rents this may produce a misleading and incorrect result if significant
       contingent rents are a prospect at lease inception. See Guidance Note 1 paragraph . If significant contingent rents are involved it is less likely that the lease is
       a finance lease anyway. If deduction is unrealistic, the lessees incremental cost of
       borrowing is used. Operating Leases Accounted for as Finance Leases. These should be
       accounted for in accordance with recommendation 3 below.

Recommendation 3. The alternative rate of “the lessee’s incremental borrowing rate”
should generally be used when accounting for headleases (operating leases of
investment property accounted for as finance leases) when implementing IAS 17.

1.2.5 Once a company has elected to value even a single leasehold investment at fair
value, it must apply the same model to all such leasehold property. 40/IN6. It follows on
that if one investment property is valued all the rest should also be valued.


2.1 Accounting Policies. Members should adopt a consistent approach and use a
common statement with regard to finance leases. A draft common policy will be issued
prior to the beginning of the interim reporting period in autumn 2004 .

2.2 In 17/31 (b) Finance Leases, Lessees are required to give details of future minimum
lease payments broken down into various future periods. It should be noted that it is very
unlikely that finance leases will have market rent reviews.

Recommendation 4. These figures should be based on the passing rent at the Balance
Sheet date.
2.3 In 17/31 (b) the standard requires that reconciliation between the total of the
minimum lease payments at the balance sheet date and their present value should be
provided. It also asks for contingent rents recognised in the period in 17/31 (c).

Recommendation 5. Additional income received following the agreement of a rent
review is defined as a contingent rent together with all turnover and profit rents.

2.4 In 17/31 (e) the standard requires a general description of the lessee’s material leasing
arrangements and sets out some minimum requirements.

Recommendation 6. Where a landlord has many leases only a general description need
be given.

2.5 In 17/35(Operating Leases-Lessees), 17/47(Finance Leases-Lessors) and
17/56(Operating Leases-Lessors), similar information to that required in17/31 has to be

Recommendation 7. The principles of recommendations number 12-14 should be
followed on a consistent basis for these disclosures.

3. Transitional Provisions

3.1 These are set out in paragraphs 17/67-68 and 40/80-84 where it is confirmed
retrospective application is encouraged but not required for those already reporting under
IAS. However for first time adoption of IAS, IFRS 1 applies as there is no exemption for
IAS 17. This standard effectively requires retrospective application of IAS 17 to lease
classification and the split of Land & Buildings for finance leases. This conclusion is
confirmed by 17/BC15, which also refers to IAS 8/50-53, which gives guidance on when
it is impracticable to apply retrospectively a change in an accounting standard.
3.2 Grandfathering only applies to those who have previously prepared accounts using
IAS. This implies that if data is too hard to obtain in order to do a land and building split,
the default will be finance lease accounting for the entire lease. The data requirements for
finance lease accounting are much easier to obtain and hence, even if this is unpalatable,
it will be possible retrospectively to adopt IAS 17 by using 17/16 as a finance lease
default clause.

The project team would welcome enquiry and feed back into any of the other wider
aspects of the paper which Members may feel are likely to be troublesome and could be
usefully expanded to ensure proper adherence to IAS and a consistent approach amongst
the Membership. Such responses should be made no later than 30th September 2004.

24 June 2004

Research for this project was undertaken by:
Nick Moore, FCA               ( 01428 724804)
John Rich, MA FRICS           ( 01825 790450)