Chapter 10 Leases Flashcards
1.1 Introduction to IFRS 16 Leases
A lease is 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 providing the asset, lessee is the entity obtaining the right to use the asset for consideration. A right-of-use asset represents a lessee’s right to use an underlying asset for the lease term.
1.2 Identifying a lease
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. The contract must give the customer the right to substantially all of the assets economic benefits throughout the period and the right to direct the assets use.
The right to direct the use of an asset can still exist if the lessor puts restrictions on the use. A customer does not have the right to use an asset if the supplier has the ability to provide an alternative asset and if it would be economically beneficial for them to do so.
1.3 Separating components
A contract may contain a lease component and non-lease component. The lease payments under the contract should be allocated to each component based on the stand-alone selling price of each component. An entity can elect to not separate the components and treat is entirely as a lease. If made, this must be applied consistently to the entire class of assets.
2.1 Lease accounting
At inception:
- Right-of-use asset: recognise at cost, this equals initial value of lease liability, payments made at or before commencement, initial direct costs and estimated costs of asset removal
- Lease liability: recognise at PV of payments not made. This includes fixed payments, variable payments depending on an index, amounts expected to be paid under residual value guarantees, options to purchase that are reasonably certain to be exercised and termination penalties if lease term reflects expectation that they will be incurred.
To calculate the lease liability and right-of-use asset, entities must establish the length of the term. The lease term comprises non-cancellable periods, periods covered by an option to extend the lease (if reasonably certain) and periods covered by an option to terminate the lease (if reasonably certain not to be exercised).
The lease payments are discounted using the interest rate implicit in the lease, or if unavailable the lessee’s incremental borrowing rate.
2.2 The lease liability table
In arrears:
Bf Interest accrued Payment c/f
Y1 X X (X) X
Y2 X X (X) X
The current liability (balancing adjustment) plus the non current liability (equal to c/f at Y2) equals the liability at the end of year one (equal to c/f at Y1)
In advance:
Bf Payment Balance Interest accrued c/f
Y1 X (X) X X X
Y2 X (X) X X X
The current liability (balancing adjustment) plus the non-current liability (equal to balance at Y2) equals the liability at the end of year one (equal to cf at Y1).
2.3 Right-of-use asset
The lessee recognises the right-of-use asset on its SFP and must recognise a depreciation charge to SPL. The asset is depreciated:
- over the shorter of the lease term and the useful life of the asset if ownership does not transfer to the lessee or
- over the useful life of the asset if ownership does transfer to lessee
If the entity has a policy of revaluation for a class of PPE, the entity can elect to apply the revaluation model to all the right-of-use assets in that class.
2.4 Short-life and low-value assets
If the lease is short term, or of a low value, a simplified treatment is allowed. The lessee can choose to recognise the lease payments in P+L on a straight-line basis. No lease liability or right-of-use asset would therefore be recognised.
3.1 Sale and leaseback transactions
An entity sells one of its own assets and immediately leases the asset back. Both entities must assess whether the transfer should be accounted for, in substance, as a sale. They apply IFRS 15 Revenue from contracts with customers to determine whether a performance obligation has been satisfied, which occurs when control is deemed to have passed to the lessor.
If the transfer is not a sale: continue to recognise the asset and recognise a financial liability equal to proceeds received.
If transfer is a sale: derecognise the asset. Recognise a right-of-use asset as the proportion of the previous carrying amount that relates to the rights retained. Recognise a lease liability and a profit/loss on disposal will arise. When the proceeds are at FV the entries are:
Dr Cash (proceeds) Cr PPE (carrying amount) Dr Right of use asset (carrying amount x lease liability/FV) Cr Lease liability (PV of lease payments) Dr/Cr Loss/Profit on disposal (balancing amount).
When a sale and the proceeds are above FV, the difference is additional finance from the buyer:
Dr Cash (proceeds), Cr PPE (carrying amount), Dr Right of use asset (carrying amount x lease liability – additional finance/FV), Cr Lease liability (PV of lease payments) and Dr/Cr Loss/Profit on disposal (balancing amount).
4.1 Lessor accounting
IFRS 16 requires that a lessor must classify a lease at inception as a finance lease or an operating lease. Finance lease transfers substantially all the risks and rewards of the asset. IFRS 16 states a lease is a finance lease is one of the following applies:
- ownership of asset transfers at the end of the lease term
- lessee has the option to purchase the asset for less than its FV
- lease term is for the major part of the asset’s economic life
- at inception, the PV of lease payments amounts to substantially all the FV of the asset
- the leased assets are specialised
- lessee will benefit from changes in the asset’s residual value
- lessee can continue the lease for a secondary period in exchange for rent payments lower than market rates
4.2 Finance lease accounting
The asset is derecognised in the lessor’s SFP. A finance lease receivable is recognised. The lessor does:
- derecognise the asset and recognise a finance lease receivable (Dr Lease receivable Cr NCA to SPL)
- don’t depreciation the asset, as asset has been derecognised
- record interest income accruing on the lease receivable. Dr Lease receivable Cr Investment income. Use the interest rate implicit in the lease
- recognise receipt of lease payment from lessee. Dr Cash Cr Lease receivable. According to lease agreement
Net investment value: the value of the finance lease receivable is calculated as the net investment of the lease. This is measured as:
- net investment: gross investment in lease discounted at the interest rate implicit in the lease
- gross investment: minimum lease payments (including any residual value)
4.4 Operating leases
SPF: the lessor has retained the risks and rewards of ownership of the asset. The asset therefore remains in the lessor’s SFP and is depreciated as normal.
SPL: rental income is recognised in the SPL on a straight line basis over the term of the lease. Operating lease incentives given reduce this income and are recognised over the lease term on a straight-line basis. Any difference between amounts charged and paid should be reflected in the SFP as accrued or deferred income.
5.1 Audit and assurance implications of leases
Audit risks Audit tests
Incompleteness of leases recorded (lessees) Obtain schedule of leased assets and confirm that a liability recognised. Obtain management representations confirming completeness of lease contracts and resulting liabilities recognised. Review board minutes for discussion of new lease contracts. Identify any new regular payments being made to lessors and ensure a matching lease liability/right-of-use asset recognised
Incorrect measurement of initial lease liability (lessees) Recalculate PV using implicit rate contained in lease. If implicit rate unavailable obtain evidence supporting the lessee’s incremental borrowing rate. If any payments are variable, perhaps dependent on exercising an option to extend contract, consider whether extension is likely given past behaviour and obtain a management representation regarding intentions
Incorrect subsequent treatment of lease liability (lessees) Recalculate figures in lease liability table. Ensure interest rate applied is consistent with discount factor used to calculate the initial lease liability. Confirm payments made to bank transactions. Recalculate split of current and non-current liabilities
Incorrect initial measurement of right-of-use asset (lessees) Identify any initial costs incurred, to contract and bank transactions. Review contract for any obligations to remove asset at end of lease term
Incorrect depreciation (lessees) Confirm period used is lower of useful life and lease term. Recalculate depreciation charge
Incorrect treatment of sale and leaseback Determine whether control has been transferred. Confirm the fair value of the asset to supporting evidence e.g. a valuer’s report
Misclassification of lease as a finance or operating lease (specific to lessors) Review lease agreement to identify significant terms and conditions, and consider whether lessee has significant risks and rewards of ownership
Incorrect measurement of net investment in lease (specific to lessors) Agree minimum lease payments and guaranteed residual value to lease agreement. Agree any estimate of unguaranteed residual value to supporting evidence e.g. proceeds on disposal of similar assets
Inadequate disclosures Check that disclosures comply with IFRS 16 Leases
