Chapter 14 Leases Flashcards
1.1 Introduction to leasing
A company may obtain the right to use a non-current asset through purchase or leasing. A lease is a contract conveying the right to use an asset for a period of time in exchange for consideration. The lessor provides the asset, and the lessee obtains the right to use the asset in exchange 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 identified asset’s economic benefits and the right to direct the identified asset’s use. The right to direct the use still exists if the lessor puts restrictions on its use in a contract, this just defines the scope of a customer’s right of use. 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.
2.1 Substance over form
Commercial substance should always be accounted for rather than legal form. For example, when purchasing an asset legally the entity owns the asset, commercially they have the right to use the asset, so substance equals legal form. For a lease agreement the asset belongs to the lessor, but commercially the entity has the right to use the asset for a period, so substance does not equal legal form. In both scenarios the entity should recognise the asset in its accounts.
3.1 Lessee accounting
At inception of a lease recognise a lease liability (recognise at present value of payments not yet made including fixed payments, amounts expected to be paid under residual value guarantees, options to purchase that are reasonably certain and termination penalties if lease term reflects expectation that they will be incurred) and a right-to-use asset (recognise at cost, initial value of lease liability, payments made before commencement, initial direct costs and estimated costs of asset removal as per lease conditions). The journal for right-of-use asset is:
- Dr Right of use asset (non-current assets)
- Cr Lease liability (PV of payments not yet made)
- Cr Cash/payables (initial direct costs and deposits)
To calculate the lease liability and right of use asset, entities must establish the length of the lease term. This comprises non-cancellable periods, periods covered by an option to extend 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.
3.2 Lease liability table
To calculate finance costs in the P+L and year end liability on the SFP we use a lease liability table, showing whether lease payments are in advance or arrears.
3.3 Finance costs
Finance costs are calculated using the constant periodic rate of interest method. The finance charge for a period is X% x balance of liability outstanding.
3.4 non-annual payments
Some lease agreements require half-yearly, quarterly, or even monthly repayments. Each lease period (period for which there is a repayment) is given a line in the lease liability table.
3.5 Deposits
In some cases, an initial deposit is paid at the start of the lease. The deposit is not included within the opening liability but as part of the cost of the right-of-use asset. Dr Right-of-use asset and Cr Cash. The first entry in the lease liability table will be the net lease liability after the deposit has been deducted.
3.6 Right-of-use asset
To reflect substance over form, the lessee recognises the right-of-use asset on their SFP and must recognise an annual depreciation charge in the P+L. 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 the lessee. The right of use asset is subject to an impairment review.
4.1 Short life and low value assets
If the lease is short-term (less than 12 months), or of a low value, then a simplified treatment is allowed. Sometimes the lessee can chose to recognise the lease payments in the P+L on a straight line basis. No lease liability or right of use asset would therefore be recognised.
5.1 Disclosures
The following should be disclosed depreciation charge for right-of-use assets, finance cost on lease liabilities, the expense relating to short-term leases, the expense relating to leases of low-value, total cash outflow for leases, additions to right-of-use assets and the carrying amount of right-of-use assets by class of underlying asset (if not given on the face of SFP).
6.1 Sale and leaseback
Under a sale and leaseback transaction, an entity sells one of its own assets and immediately leases the asset back. This raises finance while retaining the use of the asset. Both entities must assess whether the transfer should be accounted for, in substance as a sale. Entities apply IFRS 15 to decide whether a performance obligation has been satisfied, which occurs when control is deemed to have passed to the lessor. It would not be classified as a sale if the lessee has a substantive right to repurchase the asset. In most cases the transfer is classed as a sale.
If the transfer is not a sale continue to recognise the asset and recognise a financial liability equal to proceeds received. If the 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, then recognise a lease liability and a profit or loss on disposal will arise.
6.2 Proceeds equal FV
Where the transfer is a sale, the proceeds are at FV, the double 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
7.1 UK GAAP differences
FRS 1-2 identified two types of lease. A financial lease is 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. To account for a finance lease, record the acquisition of the asset, creating a fixed asset and equal finance lease liability (Dr Fixed asset and 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 depreciation on the fixed asset the same way as IFRS standards. Account for the liability in the same way as the liability for a right of use asset. To account for an operating lease, recognise the lease payments in the P+L on a straight line basis.
