Deegan FA 8e SM Ch11 PDF

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Chapter 11 Accounting for leases Review questions 11.1

The major changes in how we account for leases as a result of the 2016 release of IFRS 16 (AASB 16 in Australia) relate to how we are now required to bring a great more leased assets, and lease liabilities, onto the balance than was previously required. Pursuant to the former accounting standard, from the perspective of the lessee, leases were classified broadly as either finance leases or operating leases. If a lease transferred the risks and rewards incidental to ownership of the asset from the lessor (the owner), to the lessee (the customer), then the lease was deemed to be a finance lease and as such, both the leased asset and lease liability were to be recognised for balance sheet purposes. If the lease was an operating lease (meaning that it did not transfer the risks and rewards of ownership to the lessee), then it did not have to be recognised for balance sheet purposes. The former accounting standard provided guidance for when the risks and rewards incidental to ownership were considered to be transferred to the lessee. For example, paragraph 10 of the former accounting standard (AASB 117) stated: 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. Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are: (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; and (e) the leased assets are of such a specialised nature that only the lessee can use them without major modifications. Again, if the lease was deemed to be a finance lease, then a leased asset and a lease liability were required to be recognised on the balance sheet, otherwise no lease liability or lease asset had to be recognised. Under the new accounting standard (IFRS 16/AASB 16) there is no subdivision of leases into operating and finance leases when it comes to accounting for leases by lessees. To the extent that a lease is for a period of more than 12 months, and to the extent that the lease is not for a low-value item (say US$5000 or less), then a lease liability and leased asset shall be recognised to the extent that the lessee has a non-cancellable obligation to make lease payments. This new requirement to capitalise all leases (other than those for which there are exemptions as already noted) is consistent with the definitions of assets and liabilities as produced within the conceptual framework. The former accounting requirements for leases were not consistent with the conceptual framework. The new requirements mean that many Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 11–1

more leased assets and lease liabilities will appear on corporate balance sheets—something that has not been popular with a lot of corporations. The requirements for accounting for leases by lessors were not changed as a result of the release of the new accounting standard, and the classification of finance leases and operating leases is still used in relation to accounting for leases by lessors. 11.2

The accounting standard defines a lease—and this definition applies to both parties to a contract, that is, to the customer (lessee) and to the supplier (lessor)—as: A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. The ‘underlying asset’ referred to above is defined as: An asset that is the subject of a lease, for which a right to use that asset has been conveyed to a lessee.

11.3

‘Lease term’ is defined within the accounting standard as: The non-cancellable period for which a lessee has the right to use an underlying asset, together with both: (a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and (b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. Considerations of whether something is ‘reasonably certain’ (as used in the above paragraph) would include a number of factors, including: whether a purchase option or lease-renewal option exists within the lease contract and whether the nature of the pricing of the options is sufficiently favourable to the lessee to suggest that the lessee is reasonably certain to exercise the option;  whether there has been significant customisation of the lease asset. For example, if the lessee has leased a building and has made significant and costly modifications to the leased building, then this might suggest that if there is an option to renew the lease at typical market rates then the renewal option is reasonably likely to be taken. 

11.4

Basically, if a ‘lease’ exists—using the definition within the accounting standard—and if the lease is for a period of more than 12 months, and is for an item that is not deemed to be of low value, then a right-of-use asset and a lease liability shall be recognised by the lessee. What needs to be determined, however, is whether a ‘lease’ exists in terms of the requirements of IFRS16/AASB 16. According to the accounting standard, a lease exists when the customer controls the use of the underlying asset throughout the period of use. This requires the customer to be able to:  obtain substantially all of the economic benefits from the use of the identified asset throughout the contracted period of use; and  direct the use of the identified asset throughout that period of use, which means the customer has the ability to change how, and for what purpose, the asset is used during the contractual term. If the supplier of the asset (the lessor) has a ‘substantive right’ to substitute the asset throughout the period of use, then an ‘identified asset’ would not be deemed to exist and the requirements of the accounting standard would not apply, with the result that a lease asset Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 11–2

and lease liability would not be recognised and the periodic lease payments would simply be treated as an expense. As paragraph B14 of AASB 16 states: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist: (a) the supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting the asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time); and (b) the supplier would benefit economically from the exercise of its right to substitute the asset (ie the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset). The lease would not include any service component (unless the component is deemed to be immaterial). In recognising the lease, there is also a requirement that the lease is ‘non-cancellable’—that is, the lessee cannot cancel the lease at short notice without some form of financial penalty. 11.5

Pursuant to IFRS 16/AASB 16, a lessee should capitalise a lease transaction (meaning that the leased asset and lease liability will be included within the statement of financial position) when the lease is for a period in excess of 12 months and the lease is not for a low-value item. A lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligations to make lease payments. For a lessee to be required to capitalise a lease in accordance with IFRS 16/AASB 16, the contractual arrangement needs to satisfy the requirements in terms of being a ‘lease’. This requires that the lease obligation be non-cancellable and that the lessee ‘controls’ the asset for the duration of the lease, meaning that the supplier of the asset (the lessor) does not have a ‘substantive right’ to substitute the asset throughout the period of use.

11.6

To the extent that a lease arrangement is non-cancellable and provides control of the asset to the lessee, there is an expectation that the lessee recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligations to make lease payments. Lessees can elect to exempt themselves from this requirement when the lease is for a lease period of 12 months or less, or where the lease is for a low-value item.

11.7

This difference is relevant from the perspective of the lessor. A direct-financing lease is a lease in which the lessor provides the financial resources to acquire the asset. The lessor typically acquires the asset, giving the lessor legal title, and then enters a lease agreement to lease the asset to the lessee, who may subsequently control the asset. No sale is recorded. Rather, the lessor derives income through periodic interest revenue. The lessor substitutes a lease receivable for the underlying asset. A manufacturer or dealers-type lease is one in which the fair value of the property at the inception of the lease differs from its cost to the lessor (with the lessor being the dealer or manufacturer). In effect, where this type of lease is involved, there are two parts to the transaction. First, there is a sale with a resulting gain (being the difference between the fair value of the asset and the cost to the dealer or manufacturer). There is also a lease Solutions Manual t/a Financial Accounting 8e by Craig Deegan Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd 11–3

11.8

transaction, which will provide interest revenue over the period of the lease. In a lease involving a dealer or manufacturer, the lessor’s investment in the lease would be accounted for in the same manner as for a direct-financing lease. The value of the sale would be recorded as the fair value of the asset at the date of sale, which would also equal the present value of the lease payments. The accounting standard requires that the lease component of the contract must be considered separately from the service contract. The customer does not obtain control of a resource as part of a service component. Rather, it commits to purchasing services that it will receive in the future and the supplier retains control of the use of any items needed to deliver the particular service. Therefore:  

11.9

with a lease, the customer controls the use of the item; and with a service, the supplier controls the use of the item delivering the service.

The general principle is that service contracts are not to be capitalised on the balance sheet. Because contracts often contain both a lease and a service component, it is necessary for a lessee to separate the amounts for the lease from the amounts to be paid in respect of the service arrangement. A lessee would then recognise on the balance sheet only the amounts that relate to the lease component. The allocation of amounts for the lease and non-lease (service) components would be based on relative stand-alone prices—that is, on the basis of prices that the lessor, or another similar supplier, would charge on a separate basis for a similar lease, and for a similar service arrangement. If observable prices are unavailable then the lessee shall estimate stand-alone prices. The accounting standard also allows, in apparent response to requests for simplicity, that the lessee can choose not to separate the services from the lease and treat the whole contract as the lease. Entities would be expected to make this choice only when the service component of the contract is relatively small. In terms of the initial measurement of the lease liability, paragraph 26 of the accounting standard requires that: At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate. In considering the above requirement, we need further guidance on what to include as part of ‘lease payments’ and we also need further information about what is meant by ‘interest rate implicit in the lease’. In relation to the lease payments that need to be included as part of the lease liability (and it will be their present value that will be calculated), paragraph 27 states: At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the underlying asset during the lease term that are not paid at the commencement date: (a) fixed payments (including in-substance fixed payments as described in paragraph B42), less any lease incentives receivable; (b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date (as described in paragraph 28); (c) amounts expected to be payable by the lessee under residual value guarantees;

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(d)

(e)

the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (assessed considering the factors described in paragraphs B37–B40); and payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

In terms of the leased asset, at the commencement date, a lessee shall measure the rightof-use asset at cost. This requirement obviously necessitates that we need to understand what is to be included within ‘cost’. In this regard, paragraph 24 states: The cost of the right-of-use asset shall comprise: (a) the amount of the initial measurement of the lease liability, as described in paragraph 26; (b) any lease payments made at or before the commencement date, less any lease incentives received; (c) any initial direct costs incurred by the lessee; and (d) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period. As we can see, ‘initial direct costs’ are referred to in (c) above as forming part of the cost of the ‘right-of-use asset’. Initial direct costs are defined in the accounting standard as: Incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained, except for such costs incurred by a manufacturer or dealer lessor in connection with a finance lease. 11.10 This is often referred to as having the costs ‘front-loaded’ because capitalising a lease—and therefore complying with the accounting standard—creates higher expenses in earlier years. This is because the interest expense is higher in earlier years as the lease liability is higher. If some form of accelerated depreciation is used (which recognises more amortisation in the earlier years), then expense recognition would have been even greater in the earlier years. 11.11 A residual value guarantee is provided by the lessee to the lessor. It provides an assurance to the lessor that the assets being returned to the lessor will have a certain value at the end of the lease term. A related amount will be included in the capitalised lease payments. From the lessee’s perspective, the residual value guarantee is to be included as part of the lease liability. It would be calculated as the present value of the difference between what value has been guaranteed by the lessee for the asset at the end of the lease term, and what the lessee believes the lease asset will be able to be sold for at the end of the lease given the expected pattern of use. For example, there might be an agreement that the asset should have a fair value of $100,000 at the end of the lease term (meaning that the lessor should expect to realise $100,000 from the sale of the asset at the end of the lease term). If the lessee believes that given the expected of use the asset will only have a fair value of $70,000 at the end of the lease term then the lessee will have to make up the difference – that is, the lessee will need to pay $30,000. It is the present value of this $30,000 that would need to be included within the total amount of the lease liability.

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From the lessor’s perspective, the residual value guarantee would form part of the lease receivable and would be measured at present value. 11.12 ‘Lease term’ is defined within the accounting standard as: The non-cancellable period for which a lessee has the right to use an underlying asset, together with both: (a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and (b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. Considerations of whether something is ‘reasonably certain’ (as used in the above paragraph) would include a number of factors, including:  

whether a purchase option or lease-renewal option exists within the lease contract and whether the nature of the pricing of the options is sufficiently favourable to the lessee to suggest that the lessee is reasonably certain to exercise the option; whether there has been significant customisation of the lease asset. For example, if the lessee has leased a building and has made significant and costly modifications to the leased building, then this might suggest that if there is an option to renew the lease at typical market rates then the renewal option is reasonably likely to be taken.

Applying the above information to the question, the answers would be as follows: Agreement 1 The lease term in this case is 12 months, as at the date of lease commencement, Leoni Ltd would not be reasonably certain to exercise the option as there is no obvious financial benefit in doing so given that the rates being offered are normal market rates. Because the lease term is 12 months or less, Leoni Ltd can elect not to recognise the lease liability and lease asset and simply treat the monthly lease payments as an expense, as incurred. Agreement 2 The lease term in this case is 24 months as at the lease commencement date Leoni Ltd would be reasonably certain to exercise the option to extend the lease given that the subsequent rates are well below market rates. Agreement 3 The initial three years would satisfy the condition for being the lease term. The two-year extension would not, however, as either party could unilaterally decide not to extend the arrangement without incurring any significant financial penalty. Agreement 4 The le...