Leases: definitions
IFRS 16 Leases provides the following definitions:
A lease is a contract, or part of a contract, that conveys the right to use an underlying asset for a period of time in exchange for consideration.
The lessor is the entity that provides the right-of-use asset and, in exchange, receives consideration.
The lessee is the entity that obtains use of the right-of-use asset and, in exchange, transfers consideration.
A right-of-use asset is the lessee’s right to use an underlying asset over the lease term.
2 Identifying a lease
IFRS 16 Leases requires lessees to recognise an asset and a liability for all leases, unless they are short-term or of a minimal value. As such, it is vital to assess whether a contract contains a lease, or whether it is simply a contract for a service.
A contract contains a lease if it conveys ‘the right to control the use of an identified asset for a period of time in exchange for consideration’ (IFRS 16, para 9).
For this to be the case, IFRS 16 says that the contract must give the customer:
- the right to substantially all of the identified asset’s economic benefits, and
- the right to direct the identified asset’s use.
The right to direct the use of the asset can still exist if the lessor puts restrictions on its use within a contract (such as by capping the maximum mileage of a vehicle, or limiting which countries an asset can be used in). These restrictions define the scope of a lessee’s right of use, rather than preventing them from directing use.
IFRS 16 says that a customer does not have the right to use an identified asset if the supplier has the practical ability to substitute the asset for an alternative and if it would be economically beneficial for them to do so.
Test your understanding 1 – Coffee Bean
Coffee Bean enters into a contract with an airport operator to use some space in the airport to sell its goods from portable kiosks for a three-year period. Coffee Bean owns the portable kiosks. The contract stipulates the amount of space and states that the space may be located at any one of several departure areas within the airport. The airport operator can change the location of the space allocated to Coffee Bean at any time during the period of use, and the costs that the airport operator would incur to do this would be minimal. There are many areas in the airport that are suitable for the portable kiosks.
Required:
Does the contract contain a lease?
Test your understanding 2 – AFG
AFG enters into a contract with Splash, the supplier, to use a specified ship for a five-year period. Splash has no substitution rights. During the contract period, AFG decides what cargo will be transported, when the ship will sail, and to which ports it will sail. However, there are some restrictions specified in the contract. Those restrictions prevent AFG from carrying hazardous materials as cargo or from sailing the ship into waters where piracy is a risk.
Splash operates and maintains the ship and is responsible for the safe passage of the cargo on board the ship. AFG is prohibited from hiring another operator for the ship, and from operating the ship itself during the term of the contract.
Required:
Does the contract contain a lease?
3 Lessee accounting
Basic principle
At the commencement of the lease, IFRS 16 requires that the lessee recognises a lease liability and a right-of-use asset.
Initial measurement
The liability
The lease liability is initially measured at the present value of the lease payments that have not yet been paid.
IFRS 16 states that lease payments include the following:
- Fixed payments
- Variable payments that depend on an index or rate, initially valued using the index or rate at the lease commencement date
- Amounts expected to be payable under residual value guarantees
- Options to purchase the asset that are reasonably certain to be exercised
- Termination penalties, if the lease term reflects the expectation that these will be incurred.
A residual value guarantee is when the lessor is promised that the underlying asset at the end of the lease term will not be worth less than a specified amount.
The discount rate should be the rate implicit in the lease. If this cannot be determined, then the entity should use its incremental borrowing rate (the rate at which it could borrow funds to purchase a similar asset).
The right-of-use asset
The right-of-use asset is initially recognised at cost.
IFRS 16 says that the initial cost of the right-of-use asset comprises:
- The amount of the initial measurement of the lease liability (see above)
- Lease payments made at or before the commencement date
- Initial direct costs
- The estimated costs of removing or dismantling the underlying asset as per the conditions of the lease.
The lease term
To calculate the initial value of the liability and right-of-use asset, the lessee must consider the length of the lease term. IFRS 16 says that the lease term comprises:
- Non-cancellable periods
- Periods covered by an option to extend the lease if reasonably certain to be exercised
- Periods covered by an option to terminate the lease if reasonably certain not to be exercised.
Test your understanding 3 – Dynamic
On 1 January 20X1, Dynamic entered into a two year lease for a lorry.
The contract contains an option to extend the lease term for a further year.
Dynamic believes that it is reasonably certain to exercise this option.
Lorries have a useful economic life of ten years.
Lease payments are $10,000 per year for the initial term and $15,000 per year for the option period. All payments are due at the end of the year. To obtain the lease, Dynamic incurs initial direct costs of $3,000. The lessor reimburses $1,000 of these costs.
The interest rate within the lease is not readily determinable. Dynamic’s incremental rate of borrowing is 5%.
Required:
Calculate the initial carrying amount of the lease liability and the right-of-use asset and provide the double entries needed to record these amounts in Dynamic’s financial records.
Subsequent measurement
The liability
The carrying amount of the lease liability is increased by the interest charge.
This interest is also recorded in the statement of profit or loss:
Dr Finance costs (P/L) X
Cr Lease liability X
The carrying amount of the lease liability is reduced by cash repayments:
Dr Lease liability X
Cr Cash X
The right-of-use asset
The right-of-use asset is measured using the cost model (unless another measurement model is chosen). This means that it is measured at its initial cost less accumulated depreciation and impairment losses.
Depreciation is calculated as follows:
- If ownership of the asset transfers to the lessee at the end of the lease term then depreciation should be charged over the asset’s remaining useful economic life,
- Otherwise, depreciation is charged over the shorter of the useful life and the lease term (as defined previously).
Other measurement models
If the lessee measures investment properties at fair value then IFRS 16 requires that right-of-use assets that meet the definition of investment property should also be measued using the fair value model (e.g. right-of-use assets that are sub-leased under operating leases in order to earn rental income).
If the right-of-use asset belongs to a class of property, plant and equipment that is measured using the revaluation model, an entity may apply the IAS 16 Property, Plant and Equipment revaluation model to all right-of-use assets within that class.
Test your understanding 4 – Dynamic (cont.)
This question follows on from the previous ‘test your understanding’.
Required:
Explain the subsequent treatment of Dynamic’s lease in the year ended 31 December 20X1
Separating components
A contract may contain a lease component and a non-lease component.
Unless an entity chooses otherwise, the consideration in the contract should be allocated to each component based on the stand-alone selling price of each component.
Entities can, if they prefer, choose to account for the lease and non-lease component as a single lease. This decision must be made for each class of right-of-use asset. However this choice would increase the lease liability recorded at the inception of the lease, which may negatively impact perception of the entity’s financial position.
Illustration – Separating components
On 1 January 20X1 Swish entered into a contract to lease a crane for three years. The lessor agrees to maintain the crane during the three year period. The total contract cost is $180,000. Swish must pay $60,000 each year with the payments commencing on 31 December 20X1. Swish accounts for non-lease components separately from leases.
If contracted separately it has been determined that the standalone price for the lease of the crane is $160,000 and the standalone price for the maintenance services is $40,000.
Swish can borrow at a rate of 5% a year.
Required:
Explain how the above will be accounted for by Swish in the year ended 31 December 20X1.
Solution
Allocation of payments
The annual payments of $60,000 should be allocated between the lease and non-lease components of the contract based on their standalone selling prices:
Lease of Crane: ($160/$160 + $40) × $60,000 = $48,000
Maintenance ($40/$160 + $40) × $60,000 = $12,000
Lease of Crane
The lease liability is calculated as the present value of the lease payments, as follows:
| Date | Cash flow ($) |
| 31/12/X1 | 48,000 |
| 31/12/X2 | 48,000 |
| 31/12/X3 | 48,000 |
| Discount rate | Present value ($) |
| 1/1.05 | 45,714 |
| 1/1.052 | 43,537 |
| 1/1.053 | 41,464 |
| –––––– | |
| 130,715 | |
| –––––– |
There are no direct costs so the right-of-use asset is recognised at the same amount:
| Dr Right-of-use asset | $130,715 |
| Cr Lease liability | $130,715 |
| Interest of $6,536 (W1) is charged on the lease liability. | |
| Dr Finance costs (P/L) | $6,536 |
| Cr Lease liability | $6,536 |
| The cash payment reduces the liability. | |
| Dr Lease liability | $48,000 |
| Cr Cash | $48,000 |
The liability has a carrying amount of $89,251 at the reporting date.
The right-of-use asset is depreciated over the three year lease term. This gives a charge of $43,572 ($130,715/3 years).
| Dr Depreciation (P/L) | $43,572 |
| Cr Right-of-use asset | $43,572 |
The carrying amount of the right-of-use asset will be reduced to $87,143 ($130,715 – $43,572).
(W1) Lease liability table
Year-ended Opening Interest (5%) Payments Closing
$ $ $ $
31/12/X1 130,715 6,536 (48,000) 89,251
Maintenance
The cost of one year’s maintenance will be expensed to profit or loss:
| Dr P/L | $12,000 |
| Cr Cash | $12,000 |
Reassessing the lease liability
If changes to lease payments occur then the lease liability must be re-calculated and its carrying amount adjusted. A corresponding adjustment is posted against the carrying amount of the right-of-use asset.
Recalculating the discount rate
IFRS 16 says that the lease liability should be re-calculated using a revised discount rate if:
- the lease term changes
- the entity’s assessment of an option to purchase the underlying asset changes.
The revised discount rate should be the interest rate implicit in the lease for the remainder of the lease term. If this cannot be readily determined, the lessee’s incremental borrowing rate at the date of reassessment should be used.
Test your understanding 5 – Kingfisher
On 1 January 20X1, Kingfisher enters into a four year lease of property with annual lease payments of $1 million, payable at the beginning of each year. According to the contract, lease payments will increase every year on the basis of the increase in the Consumer Price Index for the preceding 12 months. The Consumer Price Index at the commencement date is 125. The interest rate implicit in the lease is not readily determinable. Kingfisher’s incremental borrowing rate is 5 per cent per year.
At the beginning of the second year of the lease the Consumer Price Index is 140.
Required:
Discuss how the lease will be accounted for:
- during the first year of the contract
- on the first day of the second year of the contract.
Short-life and low value assets
If the lease is short-term (less than 12 months at the inception date) or of a low value then a simplified treatment is allowed.
In these cases, the lessee can choose to recognise the lease payments in profit or loss on a straight line basis. No lease liability or right-of-use asset would therefore be recognised.
Low value assets
IFRS 16 does not specify a particular monetary amount below which an asset would be considered ‘low value’.
The standard gives the following examples of low value assets:
- tablets
- small personal computers
- telephones
- small items of furniture.
The assessment of whether an asset qualifies as having a ‘low value’ must be made based on its value when new. Therefore, a car would not qualify as a low value asset, even if it was very old at the commencement of the lease.
Lessees: presentation and disclosure
If right-of-use assets are not presented separately on the face of the statement of financial position then they should be included within the line item that would have been used if the assets were owned. The entity must disclose which line item includes right-of-use assets.
IFRS 16 requires lessees to disclose the following amounts:
- The depreciation charged on right-of-use assets
- Interest expenses on lease liabilities
- The expense relating to short-term leases and leases of low value assets
- Cash outflows for leased assets
- Right-of-use asset additions
- The carrying amount of right-of-use assets
- A maturity analysis of lease liabilities.
4 Lessor accounting
A lessor must classify its leases as finance leases or operating leases.
IFRS 16 provides the following definitions:
A finance lease is a lease where the risks and rewards of the underlying asset substantially transfer to the lessee.
An operating lease is a lease that does not meet the definition of a finance lease.
How to classify a lease
IFRS 16 Leases states that a lease is probably a finance lease if one or more of the following apply:
- Ownership is transferred to the lessee at the end of the lease
- The lessee has the option to purchase the asset for less than its expected fair value at the date the option becomes exercisable and it is reasonably certain that the option will be exercised
- The lease term (including any secondary periods) is for the major part of the asset’s economic life
- At the inception of the lease, the present value of the lease payments amounts to at least substantially all of the fair value of the leased asset
- The leased assets are of a specialised nature so that only the lessee can use them without major modifications being made
- The lessee will compensate the lessor for their losses if the lease is cancelled
- Gains or losses from fluctuations in the fair value of the residual fall to the lessee (for example, by means of a rebate of lease payments)
- The lessee can continue the lease for a secondary period in exchange for substantially lower than market rent payments.
Test your understanding 6 – DanBob
DanBob is a lessor and is drawing up a lease agreement for a building.
The building has a remaining useful economic life of 50 years. The lease term, which would commence on 1 January 20X0, is for 30 years.
DanBob would receive 40% of the asset’s value upfront from the lessee. At the end of each of the 30 years, DanBob will receive 6% of the asset’s fair value as at 1 January 20X0.
Legal title at the end of the lease remains with DanBob, but the lessee can continue to lease the asset indefinitely at a rental that is substantially below its market value. If the lessee cancels the lease, it must make a payment to DanBob to recover its remaining investment.
Required:
Per IFRS 16 Leases, should the lease be classified as an operating lease or a finance lease?
Finance leases
Initial treatment
At the inception of a lease, lessors present assets held under a finance
lease as a receivable. The value of the receivable should be equal to the net investment in the lease.
IFRS 16 requires that the net investment is calculated as the present value of:
- Fixed payments
- Variable payments that depend on an index or rate, valued using the index or rate at the lease commencement date
- Residual value guarantees
- Unguaranteed residual values
- Purchase options that are reasonably certain to be exercised
- Termination penalties, if the lease term reflects the expectation that these will be incurred.
Discount rate
The discount rate used to calculate the net investment in the lease is the rate of interest implicit in the lease.
IFRS 16 requires that the discount rate incorporates any initial direct costs of the lease (this means higher initial direct costs will lead to lower income being recognised over the lease term). There is therefore no need to add any direct costs onto the net investment separately.
Illustration – Calculating the net investment
On 31 December 20X1, Rain leases a machine to Snow on a three year finance lease and will receive $10,000 per year in arrears. Snow has guaranteed that the machine will have a market value at the end of the lease term of $2,000.
The interest rate implicit in the lease is 10%.
Required:
Calculate Rain’s net investment in the lease at 31 December 20X1.
Solution
The net investment in the lease must include the present value of:
- fixed lease payments
- residual value guarantees that are expected to be paid.
| Date | Description | Amount | Discount | Present | |
| rate | value | ||||
| $ | $ | ||||
| 31/12/X2Receipt | 10,000 | 1/1.1 | 9,091 | ||
| 31/12/X3 Receipt | 10,000 | 1/1.12 | 8,264 | ||
| 31/12/X4Receipt | 10,000 | 1/1.13 | 7,513 | ||
| 31/12/X4Guaranteed residual | 2,000 | 1/1.13 | 1,503 | ||
| value | –––––– | ||||
| Net investment in lease | 26,371 | ||||
| –––––– | |||||
The net investment in the lease is $26,371. This is the value of the lease receivable that will be recognised by Rain.
Subsequent treatment
The subsequent treatment of the finance lease is as follows:
- The carrying amount of the lease receivable is increased by finance income earned, which is also credited to the statement of profit or loss.
- The carrying amount of the lease receivable is reduced by cash receipts.
Test your understanding 7 – Vache
Vache leases machinery to Toro. The lease is for four years at an annual cost of $2,000 payable annually in arrears. The present value of the lease payments is $5,710. The implicit rate of interest is 15%.
Required:
How should Vache account for their net investment in the lease?
Operating leases
A lessor recognises income from an operating lease on a straight line basis over the lease term.
Any direct costs of negotiating the lease are added to the cost of the underlying asset. The underlying asset should be depreciated in accordance with IAS 16 Property, Plant and Equipment or IAS 38 Intangible Assets.
Test your understanding 8 – Oroc
Oroc hires out industrial plant on long-term operating leases. On 1 January 20X1, it entered into a seven-year lease on a mobile crane. The terms of the lease are $175,000 payable on 1 January 20X1, followed by six rentals of $70,000 payable on 1 January 20X2 – 20X7. The crane will be returned to Oroc on 31 December 20X7. The crane originally cost $880,000 and has a 25-year useful life with no residual value.
Required:
Discuss the accounting treatment of the above in the year ended 31 December 20X1.
Lessors: presentation and disclosure
The underlying asset should be presented in the statement of financial position according to its nature.
For finance leases, IFRS 16 requires lessors to disclose:
- Profit or loss arising on the sale
- Finance income
- Data about changes in the carrying amount of the net investment in finance leases
- A maturity analysis of lease payments receivable
For operating leases, lessors should disclose a maturity analysis of undiscounted lease payments receivable.
5 Sale and leaseback
If an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) and then leases it back, IFRS 16 requires that both entities assess whether the transfer should be accounted for as a sale.
For this purpose, entities must apply IFRS 15 Revenue from Contracts with Customers to decide whether a performance obligation has been satisfied. This normally occurs when the customer obtains control of a promised asset. Control of an asset refers to the ability to obtain substantially all of the remaining benefits.
Transfer is not a sale
If the transfer is not a sale then IFRS 16 states that:
- The seller-lessee continues to recognise the transferred asset and will recognise a financial liability equal to the transfer proceeds.
- The buyer-lessor will not recognise the transferred asset and will recognise a financial asset equal to the transfer proceeds.
In simple terms, the transfer proceeds are treated as a loan. The detailed accounting treatment of financial assets and financial liabilities is covered in 1.
Transfer is a sale
If the transfer does qualify as a sale then IFRS 16 states that:
- The seller-lessee must measure the right-of-use asset as the proportion of the previous carrying amount that relates to the rights retained.
– This means that the seller-lessee will recognise a profit or loss based only on the rights transferred to the buyer-lessor.
- The buyer-lessor accounts for the asset purchase using the most applicable accounting standard (such as IAS 16 Property, Plant and Equipment). The lease is accounted for by applying lessor accounting requirements.
Test your understanding 9 – Painting
On 1 January 20X1, Painting sells an item of machinery to Collage for its fair value of $3 million. The asset had a carrying amount of $1.2 million prior to the sale. This sale represents the satisfaction of a performance obligation, in accordance with IFRS 15 Revenue from Contracts with Customers. Painting enters into a contract with Collage for the right to use the asset for the next five years. Annual payments of $500,000 are due at the end of each year. The interest rate implicit in the lease is 10%.
The present value of the annual lease payments is £1.9 million. The remaining useful economic life of the machine is much greater than the lease term.
Required:
Explain how the transaction will be accounted for on 1 January 20X1 by both Painting and Collage.
Sale and leaseback transactions not at fair value
If the sales proceeds or lease payments are not at fair value, IFRS 16 requires that:
- below market terms (e.g. when the sales proceeds are less than the asset’s fair value) are treated as a prepayment of lease payments
- above market terms (e.g. when the sales proceeds exceed the asset’s fair value) are treated as additional financing.
Illustration – Mosaic
On 1 January 20X1, Mosaic sells an item of machinery to Ceramic for $3 million. Its fair value was $2.8 million. The asset had a carrying amount of $1.2 million prior to the sale. This sale represents the satisfaction of performance obligation, in accordance with IFRS 15 Revenue from Contracts with Customers.
Mosaic enters into a contract with Ceramic for the right to use the asset for the next five years. Annual payments of $500,000 are due at the end of each year. The interest rate implicit in the lease is 10%. The present value of the annual lease payments is £1.9 million.
Required:
Explain how the transaction will be accounted for on 1 January 20X1 by both Mosaic and Ceramic.
Solution
The excess sales proceeds are $0.2 million ($3m – $2.8m). These are treated as additional financing.
The present value of the lease payments was $1.9 million. It is assumed that $0.2 million relates to the additional financing that Mosaic has been given. The remaining $1.7 million relates to the lease.
Mosaic
Mosaic must remove the carrying amount of the machine from its statement of financial position. It should instead recognise a right-of-use asset. This right-of-use asset will be measured as the proportion of the previous carrying amount that relates to the rights retained by Mosaic:
(1.7m/2.8m) × $1.2 million = $0.73 million.
| The entry required is as follows: | |
| Dr Cash | $3.00m |
| Dr Right-of-use asset | $0.73m |
| Cr Machine | $1.20m |
| Cr Lease liability | $1.70m |
| Cr Financial liability | $0.20m |
| Cr Profit or loss (bal. fig.) | $0.63m |
Note: The gain in profit or loss is the proportion of the overall $1.6 million gain on disposal ($2.8m – $1.2m) that relates to the rights transferred to Ceramic. This can be calculated as follows:
((2.8m – 1.7m)/2.8m) × $1.6 million = $0.63 million.
The right of use asset and the lease liability will then be accounted for using normal lessee accounting rules. The financial liability is accounted for in accordance with IFRS 9 Financial Instruments.
| Ceramic | |
| Ceramic will post the following: | |
| Dr Machine | $2.80m |
| Dr Financial asset | $0.20m |
| Cr Cash | $3.00m |
It will then account for the lease using normal lessor accounting rules.
Note
The payments/receipts will be allocated between the lease and the additional finance. This is based on the proportion of the total present value of the payments that they represent:
- The payment/receipt allocated to the lease will be $447,368 ((1.7/1.9) × $500,000).
- The payment/receipt allocated to the additional finance will be $52,632 ((0.2/1.9) × $500,000).
6 Other issues
Current issue: IFRS 16 Leases vs IAS 17 Leases
IFRS 16 Leases replaced IAS 17 Leases. The most important difference between the two standards relates to lessee accounting.
When entering into leasing arrangements, IAS 17 required lessees to decide if the lease was a finance lease or an operating lease.
If the lease was a finance lease then the lessee recognised the asset and a lease liability on its statement of financial position because, in substance, the lessee controlled the asset. If the lease was an operating lease then no asset or liability was recognised because, in substance, the lessee did not control the asset.
This approach was heavily criticised, most notably for its treatment of lease liabilities. Signing an operating lease agreement gave rise to a contractual obligation to make lease payments, yet no liability was recognised in the statement of financial position. This ‘off balance sheet’ financing was seen to lack transparency as it caused users of an entity’s financial statements to underestimate its gearing levels. Although operating lease commitments were disclosed in the notes to the financial statements, these disclosures lacked prominence.
The treatment of operating leases in the financial statements of lessees also caused comparability issues. Users could not easily compare entities that leased assets under operating leases with those that purchased them, thus hindering investment decisions. Moreover, the same leasing arrangement might be accounted for very differently by two entities depending upon their perception and interpretation of the relevant risks and rewards criteria.
As you have learned in this chapter, IFRS 16 addressed criticisms of lessee accounting by requiring entities to recognise an asset and a liability for all leases (unless they are short-term or of minimal value). IFRS 16 did not change lessor accounting requirements, because the cost involved was deemed to outweigh the benefits.
Test your understanding 1 – Coffee Bean
The contract does not contain a lease because there is no identified asset.
The contract is for space in the airport, and the airport operator has the practical right to substitute this during the period of use because:
- There are many areas available in the airport that would meet the contract terms, providing the operator with a practical ability to substitute
- The airport operator would benefit economically from substituting the space because there would be minimal cost associated with it. This would allow the operator to make the most effective use of its available space, thus maximising profits.
Test your understanding 2 – AFG
AFG has the right to use an identified asset (a specific ship) for a period of time (five years). Splash cannot substitute the specified ship for an alternative.
AFG has the right to control the use of the ship throughout the five-year period of use because:
- it has the right to obtain substantially all of the economic benefits from use of the ship over the five-year period due to its exclusive use of the ship throughout the period of use.
- it has the right to direct the use of the ship. Although contractual terms exist that limit where the ship can sail and what cargo can be transported, this acts to define the scope of AFG’s right to use the ship rather than restricting AFG’s ability to direct the use of the ship. Within the scope of its right of use, AFG makes the relevant decisions about how and for what purpose the ship is used throughout the five-year period of use because it decides whether, where and when the ship sails, as well as the cargo it will transport.
Splash’s operation and maintenance of the ship does not prevent AFG from directing how, and for what purpose, the ship is used.
Therefore, based on the above, the contract contains a lease.
Test your understanding 3 – Dynamic
The lease term is three years. This is because the option to extend the lease is reasonably certain to be exercised.
The lease liability calculated as follows:
| Date | Cash flow ($) | Discount rate |
| 31/12/X1 | 10,000 | 1/1.05 |
| 31/12/X2 | 10,000 | 1/1.052 |
| 31/12/X3 | 15,000 | 1/1.053 |
Present value ($)
9,524
9,070
12,958
–––––
31,552
–––––
| The initial cost of the right-of-use asset is calculated as follows: | |
| $ | |
| Initial liability value | 31,552 |
| Direct costs | 3,000 |
| Reimbursement | (1,000) |
| ––––– | |
| 33,552 | |
| ––––– | |
| The double entries to record this are as follows: | |
| Dr Right-of-use asset | $31,552 |
| Cr Lease liability | $31,552 |
| Dr Right-of-use asset | $3,000 |
| Cr Cash | $3,000 |
| Dr Cash | $1,000 |
| Cr Right-of-use asset | $1,000 |
Test your understanding 4 – Dynamic (cont.)
| Interest of $1,578 (W1) is charged on the lease liability. | |
| Dr Finance costs (P/L) | $1,578 |
| Cr Lease liability | $1,578 |
| The cash payment reduces the liability. | |
| Dr Liability | $10,000 |
| Cr Cash | $10,000 |
The liability has a carrying amount of $23,130 at the reporting date. Of this, $14,287 (W1) is non-current and $8,843 ($23,130 – $14,287) is current.
The right-of-use asset is depreciated over the three year lease term, because it is shorter than the useful economic life. This gives a charge of $11,184 ($33,552/3 years).
| Dr Depreciation (P/L) | $11,184 |
| Cr Right-of-use asset | $11,184 |
The carrying amount of the right-of-use asset will be reduced to $22,368 ($33,552 – $11,184).
(W1) Lease liability table
| Year-ended | Opening | Interest (5%) | Payments | Closing |
| $ | $ | $ | $ | |
| 31/12/X1 | 31,552 | 1,578 | (10,000) | 23,130 |
| 31/12/X2 | 23,130 | 1,157 | (10,000) | 14,287 |
Test your understanding 5 – Kingfisher
The first year
The first payment occurs on the commencement date so is included in the initial cost of the right-of-use asset:
Dr Right-of-use asset $1m
Cr Cash $1m
The liability should be measured at the present value of the lease payments not yet made. The payments are variable as they depend on an index. They should be valued using the index at the commencement date (i.e. it is assumed that the index will remain at 125 and so the payments will remain at $1 million a year).
| Date | Cash flow ($m) |
| 1/1/X2 | 1.0 |
| 1/1/X3 | 1.0 |
| 1/1/X4 | 1.0 |
Dr Right-of-use asset
Cr Lease liability
| Discount rate | Present value ($m) |
| 1/1.05 | 0.95 |
| 1/1.052 | 0.91 |
| 1/1.053 | 0.86 |
–––––
2.72
–––––
$2.72m
$2.72m
The asset is depreciated over the lease term of four years, giving a charge of $0.93 million (($1m + $2.72m)/4).
| Dr Depreciation (P/L) | $0.93m |
| Cr Right-of-use asset | $0.93m |
The asset has a carrying amount at the reporting date of $2.79 million ($1m + $2.72m – $0.93m).
| The interest charge on the liability is $0.14 million (W1). | |
| Dr Finance costs (P/L) | $0.14m |
| Cr Lease liability | $0.14m |
The liability has a carrying amount at the reporting date of $2.86m (W1).
(W1) Lease liability table
| Year-ended | Opening | Interest (5%) | Closing |
| $m | $m | $m | |
| 31/12/X1 | 2.72 | 0.14 | 2.86 |
The first day of the second year
There are three remaining payments to make. The payment for the second year that is now due is $1.12 million ($1m × 140/125). The lease liability is remeasured to reflect the revised lease payments (three payments of $1.12 million).
| Date | Cash flow ($m) | Discount rate | Present value ($m) |
| 1/1/X2 | 1.12 | 1 | 1.12 |
| 1/1/X3 | 1.12 | 1/1.05 | 1.07 |
| 1/1/X4 | 1.12 | 1/1.052 | 1.02 |
| ––––– | |||
| 3.21 | |||
| ––––– |
The lease liability must be increased by $0.35 million ($3.21 – $2.86m).
A corresponding adjustment is made to the right-of-use asset:
| Dr Right-of-use asset | $0.35m |
| Cr Lease liability | $0.35m |
| The payment of $1.12 million will then reduce the lease liability: | |
| Dr Lease liability | $1.12m |
| Cr Cash | $1.12m |
The right-of-use asset’s carrying amount of $3.14 million ($2.79 + $0.35m) will be depreciated over the remaining lease term of three years.
Test your understanding 6 – DanBob
A finance lease is defined by IFRS 16 as a lease where the risks and rewards of ownership transfer from the lessor to the lessee.
Key indications, according to IFRS 16, that a lease is a finance lease are as follows:
- The lease transfers ownership of the asset to the lessee by the end of the lease term.
- The lease term is for the major part of the asset’s economic life.
- At the inception of the lease, the present value of the lease payments amounts to at least substantially all of the fair value of the leased asset.
- If the lessee can cancel the lease, the lessor’s losses are borne by the lessee.
- The lessee can continue the lease for a secondary period in exchange for substantially lower than market rent payments.
The lease term is only for 60% (30 years/50 years) of the asset’s useful life. Legal title also does not pass at the end of the lease. These factors suggest that the lease is an operating lease.
However, the lessee can continue to lease the asset at the end of the lease term for a value that is substantially below market value. This suggests that the lessee will benefit from the building over its useful life and is therefore an indication of a finance lease.
The lessee is also unable to cancel the lease without paying DanBob. This is an indication that DanBob is guaranteed to recoup its investment and therefore that they have relinquished the risks of ownership.
It also seems likely that the present value of the minimum lease payments will be substantially all of the asset’s fair value. The minimum lease payments (ignoring discounting) equate to 40% of the fair value, payable upfront, and then another 180% (30 years × 6%) of the fair value over the lease term. Therefore this again suggests that the lease is a finance lease.
All things considered, it would appear that the lease is a finance lease.
Test your understanding 7 – Vache
Vache recognises the net investment in the lease as a receivable. This is the present value of the lease payments of $5,710.
The receivable is increased by finance income. The receivable is reduced by the cash receipts.
| YearOpeningFinance | Cash Closing | |||
| balance incomereceivedbalance | ||||
| ( 15%) | ||||
| $ | $ | $ | $ | |
| 1 | 5,710 | 856 | (2,000) | 4,566 |
| 2 | 4,566 | 685 | (2,000) | 3,251 |
| 3 | 3,251 | 488 | (2,000) | 1,739 |
| 4 | 1,739 | 261 | (2,000) | – |
Extract from the statement of financial position at the end of Year 1
$
Non-current assets:
Net investment in finance leases (see note) 3,251
–––––
Current assets:
Net investment in finance leases 1,315
–––––
Note: the current asset is the next instalment less next year’s interest ($2,000 – $685). The non-current asset is the remainder ($4,566 – $1,315).
Test your understanding 8 – Oroc
Oroc holds the crane in its statement of financial position and depreciates it over its useful life. The annual depreciation charge is $35,200 ($880,000/25 years).
Rental income must be recognised in profit or loss on a straight line basis. Total lease receipts are $595,000 ($175,000 + ($70,000 × 6 years)). Annual rental income is therefore $85,000 ($595,000/7 years). The statement of financial position includes a liability for deferred income of $90,000 ($175,000 – $85,000).
Test your understanding 9 – Painting
Painting
Painting must remove the carrying amount of the machine from its statement of financial position. It should instead recognise a right-of-use asset. This right-of-use asset will be measured as the proportion of the previous carrying amount that relates to the rights retained by Painting:
| (1.9m/3m) × $1.2 million = $0.76 million. | |
| The entry required is as follows: | |
| Dr Cash | $3.00m |
| Dr Right-of-use asset | $0.76m |
| Cr Machine | $1.20m |
| Cr Lease liability | $1.90m |
| Cr Profit or loss (bal. fig.) | $0.66m |
Note: The gain in profit or loss is the proportion of the overall $1.8 million gain on disposal ($3m – $1.2m) that relates to the rights transferred to Collage. This can be calculated as follows:
((3m – 1.9m)/3m) × $1.8m = $0.66 million.
The right of use asset and the lease liability will then be accounted for using normal lessee accounting rules.
| Collage | |
| Collage will post the following: | |
| Dr Machine | $3.00m |
| Cr Cash | $3.00m |
Normal lessor accounting rules apply. The lease is an operating lease because the present value of the lease payments is not substantially the same as the asset’s fair value, and the lease term is not for the majority of the asset’s useful life. Collage will record rental income in profit or loss on a straight line basis.
