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IFRS -16 - Leases

ACCA KAPLAN P2 Study Text BPP F7 Study Text

Part-A KAPLAN Study Text ACCA P2 Chapter-7

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7 Leases Chapter learning objectives Upon completion of this chapter you will be able to:

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Apply and discuss the accounting for leases by lessees including the measurement of the right of use asset and liability

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Apply and discuss the accounting for leases by lessors

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Apply and discuss the reasons behind the separation of the components of a lease contract into lease and non–lease elements

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Discuss the recognition exemptions under the current leasing standard

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Account for and discuss sale and leaseback transactions.

Apply and discuss the circumstances where there may be remeasurement of the lease liability

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1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:

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the right to substantially all of the identified asset's economic benefits, and KAPLAN PUBLISHING

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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?

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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:

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Fixed payments

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Amounts expected to be payable under residual value guarantees

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Termination penalties, if the lease term reflects the expectation that these will be incurred.

Variable payments that depend on an index or rate, initially valued using the index or rate at the lease commencement date Options to purchase the asset that are reasonably certain to be exercised

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:

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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.

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chapter 7 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:

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Non- cancellable periods

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Periods covered by an option to terminate the lease if reasonably certain not to be exercised.

Periods covered by an option to extend the lease if reasonably certain 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) Cr Lease liability

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Leases The carrying amount of the lease liability is reduced by cash repayments: Dr Lease liability Cr Cash

X 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:

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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,

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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-ofuse 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

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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

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Leases Lease of Crane The lease liability is calculated as the present value of the lease payments, as follows: Date 31/12/X1 31/12/X2 31/12/X3

Cash flow ($) 48,000 48,000 48,000

Discount rate 1/1.05 1/1.05 2 1/1.05 3

Present value ($) 45,714 43,537 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 Cr Lease liability

$130,715 $130,715

Interest of $6,536 (W1) is charged on the lease liability. Dr Finance costs (P/L) Cr Lease liability

$6,536 $6,536

The cash payment reduces the liability. Dr Lease liability Cr Cash

$48,000 $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) Cr Right-of-use asset

$43,572 $43,572

The carrying amount of the right-of-use asset will be reduced to $87,143 ($130,715 – $43,572).

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chapter 7 (W1) Lease liability table Year-ended

Opening

31/12/X1

$ 130,715

Interest (5%) $ 6,536

Payments Closing $ $ (48,000) 89,251

Maintenance The cost of one year’s maintenance will be expensed to profit or loss: Dr P/L Cr Cash

$12,000 $12,000

Reassessing the lease liability If changes to lease payments occur then the lease liability must be recalculated 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:

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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.

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Leases 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:

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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:

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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.

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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:

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The depreciation charged on right-of-use assets

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Cash outflows for leased assets

Interest expenses on lease liabilities The expense relating to short-term leases and leases of low value 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:

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Ownership is transferred to the lessee at the end of the lease

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The lease term (including any secondary periods) is for the major part of the asset's economic life

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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 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

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The leased assets are of a specialised nature so that only the lessee can use them without major modifications being made

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The lessee will compensate the lessor for their losses if the lease is cancelled

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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)

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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:

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Fixed payments

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Residual value guarantees

Variable payments that depend on an index or rate, valued using the index or rate at the lease commencement date

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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...