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ACCT3321 Financial Accounting Theory and Practice Leases Group questions: In your group: 1) Explain the differences in accounting for leases by lessees and lessors. 2) Discuss how a lessor goes about deciding whether a lease is a finance or operating lease? 3) For finance leases, will the journal entries for lessees and lessors correspond? Why not? Soln: The lessee will value the right-of-use asset at the present value of the lease payments plus any directly attributable costs (including the initial direct costs incurred by the lessee), whereas the lease receivable will be valued at the net investment in the lease by the lessor, which is the present value of the lease payments plus the present value of the unguaranteed residual value, all discounted at the interest rate implicit in the lease. One circumstance is where there is an unguaranteed residual value in the lease contract. A second circumstance is where the lessee has incurred initial direct costs or may incur any other directly attributable costs. 4) What is the difference between a financier lessor and manufacturer lessor?

Comprehension questions 1. What characteristics should a contract have to be considered a lease? Appendix A of AASB 16/IFRS 16 defines a lease as follows. “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.” Paragraphs B9–B31 provides detailed guidance to help in assessing whether a contract is, or contains, a lease. The transfer of the right to use is essential in the definition and therefore the guidance focuses on clarifying the concept of the right to use. According to paragraph B9, that includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30).

2. Explain the ‘right to use’ of an identified asset. According to paragraph B9 of AASB 16/IFRS 16, the right to use an identified asset includes: (a) the right to obtain substantially all of the economic benefits from use of the identified asset (as described in paragraphs B21–B23); and (b) the right to direct the use of the identified asset (as described in paragraphs B24–B30). The customer’s ability to derive benefits from use of the underlying asset refers to substantially the whole of the potential economic benefits throughout the lease term. The customer can obtain the benefits either directly (e.g. by holding and using the asset itself) or indirectly (e.g. by subleasing the asset to another entity). A customer does not have the ability to derive benefits from the underlying asset if the benefits can only be derived by using the asset in conjunction with other goods and services provided by the supplier (and not available for separate purchase from the supplier or alternative suppliers). The customer’s ability to direct the use of an asset is determined by its ability to make the decisions that are most significant to the derivation of the economic benefits from the underlying asset during the lease term. The customer’s ability to direct the use of the underlying asset would normally be evident in whether it can determine:  how and for what purpose the asset is employed  how the asset is operated  the operator of the asset. Note that if the lessor has a substantive right to substitute the asset, the contract cannot be recognised as a lease as the right to use the asset cannot be considered to have been transferred. A substantive right to substitute the asset would exist if the lessor has the practical ability to substitute the asset at any time without needing the lessee’s approval and can benefit from substituting the asset. Note that a substantive right does not exist if the underlying asset can be substituted only when the asset is not operating properly or when a technical upgrade is available — therefore, in those cases, the contract can be recognised as a lease.

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3. What are ‘lease payments’? Lease payments are defined in Appendix A of AASB 16/IFRS 16 as payments for the right to use the underlying asset made during the lease term and include:     

fixed payments, less any lease incentives variable lease payments, calculated based on an index or a rate the purchase option, if it is reasonably expected to be exercised by the lessee penalties for terminating the lease, if the lease payments are calculated on early termination residual value guarantees expected to be payable by the lessee.

If any of the payments are made at commencement date, they are still considered lease payments, but they are not included in the initial amount recognised for the lease liability (as the obligation to pay the amount was already settled). If any of the payments above include a payment for executory costs (i.e. insurance, maintenance, consumable supplies, replacement parts and rates) reimbursed by the lessee after being paid by the lessor on behalf of the lessee, those costs should be deducted before calculating the lease payments. That is because those costs are related to additional services provided by the lessor that are not related to the right to use the underlying asset and therefore are not considered lease components. Fixed payments include payments by the lessee for the right to use the asset that do not change throughout the lease term and are adjusted for payments made or reimbursements by the lessor to the lessee (i.e. lease incentives). Variable lease payments may be increased or decreased during the lease term because of changes in facts and circumstances occurring after the asset is made available to the lessee to use, other than the passage of time. To be included in the lease payments, the purchase option should allow the lessee to purchase the asset at the end of the lease for a pre-set amount, significantly less than the expected residual value at the end of the lease term (as such, it is normally referred to as a bargain purchase option). The residual value guarantee, in general, is that part of the residual value of the underlying asset guaranteed by the lessee, a party related to the lessee or a third party unrelated to the lessor. The lessor will estimate the residual value of the underlying asset at the end of the lease term based on market conditions at the inception of the lease, and the lessee, a party related to the lessee or a third party unrelated to the lessor will guarantee that, when the asset is returned to the lessor, it will realise at least that amount. The guarantee may range from 1% to 100% of the residual value and is a matter for negotiation between lessor and lessee or a third party unrelated to the lessor. Where a lessee guarantees some or all of the residual value of the asset, the lessor has transferred risks associated with movements in the residual value to the lessee. The lessee will recognise as part of the lease payments only the residual value guarantees expected to be payable by them. The part of the residual value that the lessor is not assured that will be realised or that is guaranteed solely by a party related to the lessor is identified as the unguaranteed residual value.

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4. If a lease agreement states that ‘the lessee guarantees a residual value, at the end of the lease term, of $20 000’, what does this mean?

The residual value guarantee is that part of the residual value of the leased asset guaranteed by the lessee, a party related to the lessee or a third party unrelated to the lessor (AASB 16/IFRS16, Appendix A). The lessor will estimate the residual value of the leased asset at the end of the lease term based on market conditions at the inception of the lease and the lessee may guarantee that, when the asset is returned to the lessor, it will realise at least a part of that amount. If the lessee guarantees a residual value, at the end of the lease term, of $20 000, the lessee has to make sure that the value of the leased asset at the end of the lease is at least $20 000 – if the value is less, the lessee may need to make up the difference in cash for example. The guarantee may range from 1% to 100% of the residual value estimated by the lessor and is a matter for negotiation between lessor and lessee. Where a lessee guarantees some or all of the residual value of the asset, the lessor has transferred risks associated with movements in the residual value to the lessee.

5. What is meant by ‘the interest rate implicit in a lease’ and ‘the lessee’s incremental borrowing rate’? The interest rate implicit in a lease is defined in AASB 16/IFRS16, Appendix A as the rate of interest that causes the present value of: (a) the lease payments; and (b) the unguaranteed residual value To equal the sum of: (i) the fair value of the underlying asset, and (ii) any initial direct costs of the lessor. This interest rate is used to discount the lease payments to their present value for recognition purposes. This discount rate is implicit in the lease because it is the terms of the lease (number, timing and quantum of repayments, residual value guarantee or purchase option) that determine its value. The lessee’s incremental borrowing rate is defined in AASB 16/IFRS16, Appendix A as the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

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6. Where a lessor incurs initial direct costs in establishing a lease agreement, how are these costs to be accounted for? Initial direct costs are incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors in connection with a finance lease (AASB 16/IFRS16, Appendix A). Examples include commission, legal fees and internal costs, but exclude general overheads such as those incurred by a sale and marketing team. Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term. The interest rate implicit in the lease is defined in such a way that the initial direct costs of the lessor are included automatically in the net investment in the lease; there is no need to add them separately. The accounting treatment for initial direct costs differs depending on whether the lease is classified as operating or finance, and if finance, whether the lessor is a manufacturer/dealer. Finance lease:  Non-manufacturer/dealer lessor: initial direct costs are included in the finance lease receivable and are recovered via payments received over the lease term.  Manufacturer/dealer lessor: initial direct costs are recognised as an expense at the commencement of the lease when the profit or loss on ‘sale’ of the leased asset is recognised. Operating lease:  Any initial direct costs incurred by lessors in negotiating operating leases are added to the carrying amount of the leased asset and recognised as an expense over the lease term on the same basis as the lease income (paragraph 83).

7. Where a lessee incurs initial direct costs in establishing a lease agreement, how a are these costs to be accounted for? The initial direct costs incurred by the lessee are conceptually similar to the initial direct costs of the lessor — they are incremental costs that are directly attributable to negotiating and arranging a lease, but they are incurred by the lessee. The lessee needs to recognise those costs as directly attributable costs to the right-to-use asset. As such, the right-to-use asset will be recognised at cost and that will include:  the amount recognised as the lease liability (i.e. the present value of the lease payments that are not paid at that date)  any lease payments made before or at the commencement date, less any lease incentives received  any initial direct costs incurred by the lessee  an estimate of the costs to dismantle and remove the underlying asset, to restore the site on which it is located and to restore the asset to the conditions required by the lease contract.

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8. How are leases to be accounted for by lessees according to AASB 16/IFRS 16? AASB 16/IFRS 16 adopts a single lessee accounting model for all leases with a term of more than 12 months and requires the lessee to recognise an asset and a related liability for all their leases, unless the underlying asset is of low value. Paragraphs 23 and 26 of AASB 16/IFRS 16 require the lessee, at the commencement date of the lease, to recognise a right-of-use asset and a related liability. According to the Preface of AASB 16/IFRS 16: “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.” The commencement of the lease is the date from which the lessee is entitled to exercise its right to use the underlying asset. The liability is to be measured at the present value of the lease payments that are not paid at the commencement date of the lease. The present value is calculated based on the interest rate implicit in the lease, or, if the implicit rate is not readily determined, the lessee’s incremental borrowing rate. The initial measurement of the right-of-use asset is very similar to the initial measurement of an item of property, plant and equipment prescribed by AASB 116/IAS 16 Property, Plant and Equipment. The right-to-use asset should be measured as cost and that will include:  the amount recognised as the lease liability (i.e. the present value of the lease payments that are not paid at that date)  any lease payments made before or at the commencement date, less any lease incentives received  any initial direct costs incurred by the lessee  an estimate of the costs to dismantle and remove the underlying asset, to restore the site on which it is located and to restore the asset to the conditions required by the lease contract. After initial recognition:  the right-of-use asset is depreciated over its useful life – generally the lease term – in a pattern reflecting the consumption or loss of the rewards embodied in the asset.  the lease liability is reduced as the lessee makes lease payments. Interest expense is determined by applying the interest rate implicit in the lease to the lease liability at the beginning of the period. The lease payment is divided into interest expense and reduction in lease liability.

9. What are operating and finance leases? Paragraph 61 of AASB 16/IFRS 16 requires lessors to classify each lease as either a finance lease or an operating lease. A finance lease is defined in Appendix A of AASB 16/IFRS 16 as lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Appendix A defines an operating lease as a lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

10. How are finance leases to be accounted for by lessors? 6

In accounting for a finance lease, the lessor derecognises the leased asset and records a lease receivable. The initial measurement of the lease receivable is at fair value of the leased asset plus initial direct costs incurred by the lessor. On receipt of lease payments from the lessee, the lessor records lease rental revenue and reduces the lease receivable, based on an application of the interest rate implicit in the lease. It is important to note that finance leases need to further be classified into (a) finance leases involving a financier lessor and (b) leases involving manufacturers or dealers, as the accounting standard prescribes different accounting requirements for those two types of finance leases. With financier lessors, the lessor acquires the asset at fair value and then enters into a lease arrangement with the lessee and will only recognise income periodically throughout the lease term. With manufacturer/dealer lessors, the assets are normally being carried in the records of the lessor at an amount (cost) different from fair value. At the beginning of the lease, manufacturer/dealer lessors will recognise a selling profit. 11. How does the accounting treatment for a finance lease change if the lessor is a manufacturer/dealer lessor? If the lessor is a manufacturer/dealer, the lessor in a finance lease makes two profits, namely gross profit on sale and interest on the receivable over time. Accounting for the lease is identical to that required by financier lessors except for an initial entry to recognise profit or loss and the fact that initial direct costs are not included in the lease receivable amount (and not used in the calculation of the implicit rate in the lease). The manufacturer dealer lessor recognises sales revenue at the commencement of the lease equal to the present value of the lease payments, (which equals fair value minus the present value of any unguaranteed residual value). Cost of sales is recorded as the cost minus the present value of any unguaranteed residual value, which the lessor may have to recover by a future sale after the end of the lease agreement. Initial costs to establish a lease agreement do not satisfy the definition of initial direct costs in the standard. Instead, these initial establishment costs must be treated as an expense when the selling profit is recorded. As a consequence of the definition of the interest rate implicit in the lease, these costs are not included in the formula, unlike the initial direct costs incurred by a lessor as financier. Hence, the calculation of the interest rate implicit in the lease for a manufacturer/dealer lessor is different from the calculation for a financier lessor. The establishment costs of a manufacturer/dealer lessor are to be treated as an expense.

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12. How are operating leases to be accounted for by lessors? Paragraph 81 of AASB 16/IFRS 16 requires lessors to account for receipts from operating leases as income on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern in which the benefit derived from the underlying asset is diminished. According to paragraph 83 of AASB 16/IFRS 16, any initial direct costs incurred by lessors in negotiating operating leases are to be added to the carrying amount of the underlying asset and recognised as an expense over the lease term on the same basis as the lease income. Given that the underlying asset is to be depreciated over the useful life (which in operating leases is normally longer that the lease term), while the initial direct costs are to be recognised as an expense over the lease term, the initial direct costs are capitalised into a separate deferred costs account; however, the balance of that account is nevertheless included in the calculation of the carrying amount of the underlying asset, just like the balance of the accumulated depreciation is taken into consideration when calculating that carrying amount. According to paragraph 84 of AASB 16/IFRS 16, depreciation of underlying assets provided under operating leases should be consistent with the lessor’s normal depreciation policy for similar assets, and should be calculated in accordance with AASB 116/IAS 16 Property, Plant and Equipment and AASB 138/IAS 38 Intangible Assets.

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Case studies Case study 10.1 Accounting for leases by lessee Farm Ltd leases some parcels of land from their owner for a period of 10 years at a time. The lease agreement can be cancelled, but a significant penalty will be incurred by Farm Ltd. The lease payments required include a payment up-front of $300 000, followed by another 9 payments of equal value at the end of every year up to the end of the ninth year. The implicit rate in the lease is 10%. Required Prepare the journal entries for Farm Ltd to recognise the lease under AASB 16/IFRS 16.

Journal entries by Farm Ltd under AASB 16/IFRS 16: Recognise right-of-us...