C. REPORTING THE FINANCIAL PERFORMANCE OF A RANGE OF ENTITIES - LEASES

Question 1

IFRS 16 Leases

Answer 1

IFRS 16 Leases requires lessees and lessors to provide relevant information in a manner that faithfully represents those transactions. The accounting treatment in the lessee’s book is driven by the Conceptual Framework’s definitions of assets and liabilities rather than legal form of the lease. The legal form of a lease is that the title to the underlying asset remains with the lessor during the period of the lease.

Question 2

Lease:

Answer 2

Lease: 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. A lease arises where the customer obtains the right to use the asset. Where it is the supplier that controls the asset used, a service rather than lease arises.

Question 3

Identifying a lease.

Answer 3

Identifying a lease. An entity must identify whether a contract contains a lease, which is the case if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. The right to control an asset arises where, throughout the period of use, the customer has:
 The right to obtain substantially all of the economic benefits from use of the identified asset; and
 The right to direct the use of the identified asset.

Question 4

identified asset

Answer 4

The identified asset is typically explicitly specified in a contract. However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer. 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.

Question 5

Lease term:

Answer 5

Lease term: ’then non-cancellable period for which a lessee has the right to use an underlying asset, together with both:
 Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
 Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
The lease term is relevant when determining the period over which a leased asset should be depreciated.

Question 6

Recognition lessee

Answer 6

Recognition. At the commencement date (the date the lessor makes the underlying asset available for use by the lessee), the lessee recognizes:
 A lease liability
 A right-of-use asset

Question 7

Lease liability initial measurement

Answer 7

Lease liability. The lease liability is initially measured at the present value of lease payments not paid at the commencement date, discounted at the interest rate implicit in the lease (or the lessee’s incremental borrowing rate if not readily determinable).
The lease liability cash flows to be discounted include the following:
 Fixed payments
 Variable payments that depend on an index (CPI) or rate (market rent)
 Amounts expected to be payable under residual value guarantees (eg where a lessee guarantees to the lessor that an asset will be worth a specified amount at the end of lease)
 Purchase options (if reasonably certain to be exercised)
Other variable payments (eg payments that arise due to level of use of the asset) are accounted for as period costs in profit or loss as incurred.

Question 8

The lease liability is subsequently measured by:

Answer 8

The lease liability is subsequently measured by:
 Increasing it by interest on the lease liability
 Reducing it by lease payments made

Question 9

Right-of-use asset initial measurement

Answer 9

Right-of-use asset. The right-of-use asset is initially measured at its cost, which includes:
 The amount of the initial measurement of the lease liability (the present value of lease payments not paid at the commencement date)
 Payments made at\before the lease commencement date (less any lease incentives received)
 Initial direct costs (eg legal costs) incurred by the lessee
 An estimate of dismantling and restoration costs (where an obligation exists)

Question 10

The right-of-use asset is normally measured subsequently

Answer 10

The right-of-use asset is normally measured subsequently at cost less accumulated depreciation and impairment losses in accordance with the cost model of IAS 16 PPE. The right-of-use asset is depreciated from the commencement date to the earlier of the end of its useful life or end of lease term (end of its useful life if ownership is expected to be transferred).
Alternatively, the right-of-use asset is accounted for in accordance with:
 The revaluation model of IAS 16 (optional where the right-of-use asset relates to a class of property, plant and equipment measured under the revaluation model, and where elected, must apply to all right-of-use assets relating to that classs)
 The fair value model of IAS 40 Investment property (compulsory if the right-of-use asset meets the definition of investment property and the lessee uses the fair value model for its investment property)
Right-of-use assets are presented either as a separate line item in the statement of financial position or by disclosing which line items include right-of-use assets.

Question 11

Deferred tax implications lessee.

Answer 11

Deferred tax implications. Under a lease, the lessee recognizes a right-of-use asset and a corresponding lease liability. This net figure represents the carrying amount. If the entity is granted tax relief as lease rentals are paid, a temporary difference arises, as the tax base of the lease is zero. This results in a deferred tax asset. Tax deductions are allowed on the lease rental payments made, which at the beginning of the lease, is lower than the combined depreciation expense and finance cost recognized for accounting. Therefore, the future tax saving on the additional accounting deduction is recognized now in order to apply accruals concept.

Question 12

The approach to lessor accounting classifies leases into two types:

Answer 12

 Finance leases (where a lease receivable is recognized in the statement of financial position); and
 Operating leases (which are accounted for a rental income).

Question 13

Finance lease:

Answer 13

Finance lease: a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset.

Question 14

Operating lease:

Answer 14

Operating lease: a lease that does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

Question 15

IFRS 16 identifies five examples of situations which would normally lead to a lease being classified as a finance lease:

Answer 15

 The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
 The lessee has the option to purchase the underlying asset at a price expected to be sufficiently lower than fair value at the exercise date, that it is reasonably certain, at the inception date, that the option will be exercised.
 The lease term is for a major part of the economic life of the underlying asset even if title is not transferred
 The present value of the lease payments at the inception date amounts to at least substantially all of the fair value of the underlying asset.
 The underlying asset is of such specialise nature that only the lessee can use it without major modifications.
Additionally, the following situations which could lead to a lease being classified as a finance lease:
 Any losses on cancellation are borne by the lessee
 Gains/losses on changes in residual value accrue to the lessee
 The lessee can continue to lease for a secondary term at a rent substantially lower than market rent

Question 16

Finance leases - recognition and measurement.

Answer 16

Finance leases - recognition and measurement. At the commencement date (the date the lessor makes the underlying asset available for use by the lessee), the lessor derecognizes the underlying asset and recognizes a receivable at an amount equal to the net investment in the lease.
The net investment in the lease is the sum of:
 Present value of lease payments receivable by the lessor
 Present value of any unguaranteed residual value accruing to the lessor
The unguaranteed residual value is that portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor.
Finance income is recognized over the lease term based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the lease.
The derecognition and impairment requirements of IFRS 9 Financial Instruments are applied to the net investment in the lease.

Question 17

Manufacturer - lessor.

Answer 17

Manufacturer. A lessor which is a manufacturer or dealer of the underlying assets needs to recognize entries for finance leases in similar way to items sold outright (as well as the lease receivable:
Revenue – fair value of underlying asset (or present value of lease payments if lower) X
Cost of sales – cost (or carrying amount) of the underlying asset less present value of the unguaranteed residual value (X)
Gross profit X

Question 18

Operating lease.

Answer 18

Operating lease. Lease payments from operating leases are recognised as income on either a straight lines basis or another systematic basis. Any initial direct costs incurred in obtaining the lease are added to the carrying amount of the underlying asset. IAS16 PPE or IAS38 Intangible assets then then applies to the depreciation or amortisation of the underlying asset as appropriate.

Question 19

Separation of the components of a lease contract into lease and non-lease elements.

Answer 19

A contract may contain both a lease component and a non-lease component. In other words, it may include and amount payable by the lessee for activities and costs that do not transfer goods or services to the lessee (such as maintenance, repairs or cleaning). IFRS 16 requires entities to account for the lease component of the contract separately from non-lease component.
The entity must split the rental or lease payment and:
 Account for the lease component under IFRS 16; and
 Account for the service element separately, generally as an expense in profit or loss.
The consideration in the contract is allocated on the basis of the stand-alone prices of the lease components and the non-lease components.

Question 20

recognition exemptions under the current leasing standard

Answer 20

IFRS 16 provides an optional exemption from full requirements of the standard for:
 Short-term leases (leases with a lease term of 12 months or fewer)
 Leases for which the underlying asset is low value (eg tablet and personal computers, small items of furniture and telephones).
If the entity elects to take the exemption, lease payments are recognized as an expense on a straight-line basis over the lease term or another systematic basis (if more representative of the pattern of the lessee’s benefits).
The assessment of whether an underlying asset is low value is performed on an absolute basis based on the value of the asset when it is new. It is not a question of materiality: different lessees should come to the same conclusion about whether assets are low value, regardless of the entity’s size.

Question 21

A sale and leaseback transactions

Answer 21

A sale and leaseback transactions arise where an entity (the seller-lessee) transfers (‘sells’) an asset to another entity (the buyer-lessor) and then leases it back. The entity applies the requirements of IFRS 15 Revenue from Contracts with customers to determine whether in substance a sale occurs (ie whether a performance obligation is satisfied or not).

Question 22

Transfer of the asset is in substance a sale.

Answer 22

As a sale has occurred, in the seller-lessee’s books, the carrying amount of the asset must be derecognized. The seller-lessee recognises a right-of-use asset measured at the proportion of the previous carrying amount that relates to the right of use retained. A gain/loss is recognized in the seller-lessee’s financial statements in relation to the rights transferred to the buyer-lessor.
If the consideration received for the sale of the asset does not equal that asset’s fair value (or if lease payments are not at market rates, the sale proceeds are adjusted to fair value as follows:
 Below-market terms. The difference is treated for as a prepayment of lease payments and so is added to the right-of-use asset as per the normal IFRS 16 treatment for initial measurement of a right-of-use asset.
 Above-market terms. The difference is treated as additional financing provided by the buyer-lessor for the seller-lessee. The lease liability is originally recorded at the present value of lease payments. This amount is then split between:
o The present value of lease payments at market rates; and
o The additional financing (the difference) which is in substance a loan
The buyer-lessor accounts for the purchase as a normal purchase and for the lease in accordance with IFRS 16.

Question 23

Transfer of the asset is NOT in substance a sale.

Answer 23

The seller-lessee continues to recognize the transferred asset and recognizes a financial liability equal to the transfer proceeds (and accounts for it in accordance with IFRS 9 Financial Instruments).
The buyer-lessor does not recognize the transferred asset and recognizes a financial asset equal to the transfer proceeds (and accounts for it in accordance with IFRS 9 Financial Instruments).