Financial Reporting FR

SIC-27 Evaluating the Substance of Transactions in the Legal Form of a Lease

SIC-27 Evaluating the Substance of Transactions in the Legal Form of a Lease
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SIC-27, also known as “Evaluating the Substance of Transactions in the Legal Form of a Lease,” is a guidance issued by the International Accounting Standards Committee (IASC) that provides guidance on how to evaluate and account for leases when the legal form of the lease may not reflect the underlying substance of the transaction. This includes situations where a lease may not meet the criteria for classification as a finance lease or an operating lease, but the substance of the transaction indicates that it should be accounted for as one or the other. This guidance is important for entities to ensure that the financial statements accurately reflect the economic reality of lease transactions, as opposed to solely relying on their legal form.

 

Definitions:

 

Lease: A lease is a contract that conveys the right to use an asset for a period of time in exchange for consideration.

Substance over form:

The concept of substance over form is a fundamental principle in accounting that emphasizes the economic substance of a transaction, rather than solely relying on its legal form. It requires entities to look beyond the legal form of a transaction and consider its economic substance when determining how to account for it in the financial statements.

 

Explanations:

SIC-27 provides guidance on how to evaluate the substance of lease transactions by considering the following factors:

 

Risks and rewards of ownership:

The risks and rewards of ownership are important indicators of whether a lease should be classified as a finance lease or an operating lease. If the lessee assumes substantially all the risks and rewards of ownership, the lease is likely to be a finance lease, even if the legal form of the lease may indicate otherwise.

 

Control:

Control over the use of the leased asset is a key factor in determining the classification of a lease. If the lessee has the right to control the use of the asset throughout the lease term, the lease is likely to be a finance lease. On the other hand, if the lessor retains the right to control the use of the asset, the lease is likely to be an operating lease.

Substance of the transaction: SIC-27 emphasizes that entities should look beyond the legal form of the lease and consider the substance of the transaction. This includes considering the economic benefits and risks associated with the use of the leased asset, as well as any arrangements or agreements between the parties that may impact the classification of the lease.

 

Examples:

Let’s consider an example to illustrate the application of SIC-27:

 

Company ABC enters into a lease agreement with Company XYZ for a building. The lease agreement is structured in such a way that it does not transfer the risks and rewards of ownership to Company ABC, and Company XYZ retains control over the use of the building. However, Company ABC has a side agreement with Company XYZ that provides it with an option to purchase the building at the end of the lease term at a price significantly below the fair market value. Based on the legal form of the lease, it may be classified as an operating lease, as the risks and rewards of ownership have not been transferred to Company ABC.

However, upon evaluating the substance of the transaction, it becomes evident that Company ABC has a significant economic incentive to exercise the purchase option, as the purchase price is significantly below the fair market value. This indicates that Company ABC effectively has control over the building throughout the lease term, and the lease should be accounted for as a finance lease, even though the legal form may suggest otherwise.

 

Case Studies:

There have been several real-world cases where the substance of lease transactions has been evaluated in accordance with SIC-27. One notable example is the case of Royal Bank of Scotland (RBS) and its treatment of aircraft leases.

In 2010, RBS entered into a series of aircraft lease transactions with Special Purpose Entities (SPEs), which were established to lease aircraft to RBS. The legal form of these leases appeared to be operating leases, as the risks and rewards of ownership were not transferred to RBS, and the leases were accounted for as operating leases in RBS’s financial statements.

However, upon further evaluation of the substance of the transactions, it was determined that RBS effectively had control over the aircraft throughout the lease terms. RBS had the ability to direct the use of the aircraft, and the lease payments were structured in a way that effectively transferred the risks and rewards of ownership to RBS. Additionally, RBS had entered into side agreements with the SPEs that provided it with options to purchase the aircraft at the end of the lease terms at prices significantly below their fair market values.

As a result of evaluating the substance of these transactions in accordance with SIC-27, RBS determined that the leases should be accounted for as finance leases, even though their legal form suggested otherwise. RBS restated its financial statements for the relevant periods to reflect the correct accounting treatment, resulting in significant adjustments to its financial results and financial position.

This case study highlights the importance of evaluating the substance of lease transactions in accordance with SIC-27 to ensure that the financial statements accurately reflect the economic reality of the transactions, rather than solely relying on their legal form.

 

In conclusion, SIC-27 provides guidance on how to evaluate the substance of lease transactions when the legal form of the lease may not reflect the underlying substance of the transaction. It emphasizes the importance of considering the risks and rewards of ownership, control over the use of the leased asset, and the substance of the transaction when determining how to account for leases. Examples and case studies demonstrate the practical application of this guidance in real-world situations. Entities should carefully evaluate the substance of lease transactions in accordance with SIC-27 to ensure that their financial statements accurately reflect the economic reality of the transactions and comply with applicable accounting standards.