Chapter 12: Leases

Question 1

When does a contract contain a lease?

Answer 1

‘Use the asset for a period of time in exchange for consideration’

For this to be the case, the contract must give the customer:
 the right to substantially all of the identified asset’s economic benefits
 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 in a contract.

These restrictions define the scope of a customer’s right of use.

Question 2

When does a customer NOT have the right to use an identified asset?

Answer 2

A customer does not have the right to use an identified asset if the supplier has the practical ability to provide an alternative asset and if it would be economically beneficial for them to do so.

Question 3

What should you recognise at the inception of the lease? (Lease liability)

Answer 3

Recognise at present value of payments not yet made:
 fixed payments
 amounts expected to be paid under residual value guarantees
 options to purchase that are reasonably certain to be exercised
 termination penalties if lease term reflects expectation that they will be incurred.

Question 4

What should you recognise at the inception of the lease? (Right-of-use asset)

Answer 4

Recognise at cost, which equals:
 initial value of lease liability
 payments made at or before commencement
(deposits/advance payments)
 initial direct costs
 estimated costs of asset removal or dismantling as per lease conditions

Question 5

What are the journal entries to record a right-of-use asset?

Answer 5

Dr Right-of-use asset (NCA)
Cr Lease liability (PV of payments not yet made)
Cr Cash/payables (initial direct costs and deposits/advance payments)

Question 6

What does the lease term comprise?

Answer 6

 non-cancellable periods
 periods covered by an option to extend the lease if reasonably certain to be exercised
 periods covered by an option to terminate the lease if reasonably certain not to be exercised.

Question 7

How are lease payments discounted?

Answer 7

 interest rate implicit in the lease, or if unavailable

 the lessee’s incremental borrowing rate.

Question 8

What are the headings for the lease liability table when payments are in arrears?

Answer 8

B/f Interest accrued Payment C/f

(finance costs)

Question 9

What are the headings for the lease liability table when payments are in advance?

Answer 9

B/f Payment Balance Interest Accrued C/f
(Finance costs)

We do not show the advance payment at the beginning of the first year as it was not recognised as part of the lease liability b/f. Remember, the lease liability b/f represents the PV of payments not yet made

Question 10

How are finance costs calculated?

Answer 10

Using the ‘constant periodic rate of interest’:

• The finance charge for a period is calculated as:
  X% x balance of liability outstanding
• The percentage will be given in the exam and should be the rate initially used to discount the cash flows to present value

Question 11

What do you do when payments are non-annual?

Answer 11

When the payments are half-yearly, quarterly, or even monthly, each lease period (period for which there is a repayment) is given a line in the lease liability table

Question 12

How do you deal with deposits?

Answer 12

• In some cases an initial deposit is paid at the start of the lease
• The deposit is not included within the opening liability but instead as part of the cost of the right-of-use asset:

Dr Right-of-use asset
Cr Cash

• The first entry in the lease liability table will be the net lease liability after the deposit has been deducted

Question 13

How would you answer this question?

An entity enters into a lease agreement which requires three annual lease payments of £10,000 in arrears plus an initial deposit of £4,000. The present value of the three annual lease payments is £27,232 discounted at 5%.

Answer 13

The double entry to initially recognise the lease is:
Dr Right of use asset £31,232
Cr Liability £27,232
Cr Cash £4,000

The lease liability table would look like this:
B/f Interest 5% Payment C/f
27,232 1,362 (10,000) 18,594

Question 14

How do you deal with incentives?

Answer 14

Incentives received before/on commencement of the lease are deducted to arrive at the initial right-of-use asset figure.

This would show itself in a deduction to the cash credit

Question 15

How do you present the lease liability on the SOFP?

Answer 15

The lease liability is split on the statement of financial position between its current and non-current elements.

In arrears:
Year 1 c/f = CL
Year 2 c/f = NCL

In advance:
Year 1 c/f = CL
Year 2 balance figure = NCL

Question 16

How does the treatment of a right-of-use asset reflect substance over form?

Answer 16

To reflect substance over form, the lessee recognises the right-of-use asset on their statement of financial position and hence must recognise an annual depreciation charge in the statement of profit or loss

Question 17

How is the right-of-use asset depreciated? What if the ROA belongs to a revalued class of assets?

Answer 17

• Over the shorter of the lease term and the useful life of the asset if ownership does not transfer to the lessee at the end of the lease term, or
• Over the useful life of the asset if ownership does transfer to the lessee

The ROA is subject to an impairment review.

If the ROA belongs to a revalued class of assets, then it may also be revalued. If revalued, it is the fair value of the right of use which is relevant (not the underlying asset’s fair value)

Question 18

What happens if the lease is short-term or of a low value?

Answer 18

If the lease is short-term (12 months or less at the inception date), or of a low value, then a simplified treatment is allowed.

Can:

• Recognise the lease payments in the SPL on a straight line basis
• No lease liability or ROA would therefore be recognised

IFRS 16 does not define the amount it considers to be low

Question 19

What is the election to use the exemption for short-term leases?

Answer 19

The election to use the exemption:

• Must be made by asset class for short-term leases
• Can be made on a lease-by-lease basis for low-value assets

Question 20

What should be disclosed?

Answer 20

 depreciation charge for right-of-use assets
 finance cost on lease liabilities
 expense relating to short-term leases
 expense relating to leases of low-value
 total cash outflow for leases
 additions to right-of-use assets
 carrying amount of right-of-use assets by class of underlying asset (if not given on the face of SFP)

Question 21

What happens in a sale and leaseback transaction?

Answer 21

 Under a sale and leaseback transaction, an entity sells one of its own assets and immediately leases the asset back.
 This is a common way of raising finance whilst retaining the use of the related asset. The buyer/lessor is normally a bank

Question 22

How do you determine whether it was a sale?

Answer 22

Entities must apply IFRS 15 Revenue from Contracts with Customers to decide whether a performance obligation has been satisfied, which occurs when control is deemed to have passed to the lessor.

An example of where the transfer is not classed as a sale would be if the lessee has a substantive right to repurchase the asset.

However, in most cases, the transfer will be classed as a sale.

Question 23

How do you account for a leaseback that is not a sale?

Answer 23

• Continue to recognise the asset

- Recognise a financial liability equal to proceeds received

Question 24

How do you account for a leaseback that is a sale?

Answer 24

• 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
• A profit or loss on disposal will arise

Question 25

What are the double entries when the transfer is a sale and the proceeds are at fair value?

Answer 25

Dr Cash (Proceeds)
Cr PPE (CA)

Dr ROA
(Carrying amount x Lease liability/FV)
Cr Lease Liability
(PV of lease payments)

Dr/Cr Loss/Profit on disposal (balancing figure)

Question 26

What should you be wary of?

Answer 26

Incorrect application of the sale and leaseback requirements: the professional competence and due car, integrity and objectivity of the preparer of the information should be questioned.
Consider if it is an error or deliberate manipulation of the financial statements

Question 27

What does FRS 102 identify as a lease?

Answer 27

Two types:

• A finance lease: A lease that transfers substantially all the risks and rewards of ownership to the party using the asset
• An operating lease: Is any lease other than a finance lease

Question 28

How do you account for a finance lease under FRS 102?

Answer 28

• Record the acquisition of the asset, creating a fixed asset and equal finance lease liability:
  Dr Fixed Asset
  Cr Finance Lease Liability
  The amount recorded should be the lower of the fair (cash) value of the asset and the present value of minimum lease payments
• Charge the annual depreciation on the fixed asset in the same way as under IFRS standards
• Subsequently, account for the liability in the same way as the liability for a right-of-use asset

Question 29

How do you account for an operating lease under FRS 102?

Answer 29

• Recognise the lease payments in P&L on a straight-line basis