IFRS 16- Leases

Question 1

finance lease (a.k.a. normal lease)

Answer 1

• A long-term arrangement of raising finance to pay for an asset over its economic life
• The lessor transfers the risks and rewards of ownership of the asset to the lessee, but not the actual ownership
• the lessee is responsible for the upkeep of asset, or it may remain the responsibility of the lessor
• the total cost of the assets is normally covered by the lease payments over the period of the lease
• rental payments are likely to be higher than the payments for an operating lease
• at the end of the lease the lease agreement may allow the lessee to retain or purchase the assets which by this time may not be worth much (unlike the assets under an operating lease)
• if the lease or hire purchase is at least 5 years, the lessee has the right to claim capital allowances for plant and machinery under tax rules

Question 2

operating lease (a.k.a. short-term or low value item lease)

Answer 2

• A short-term arrangement where the “lessee” rents the asset from the lessor but is not given the rights of ownership
• The lease is for 12 months or less, or the lease is for an item of low value
• the assets are likely to retain residual value at the end of the lease. This means that the asset can be sold or leased out again
• rental payments are likely to be lower than the payments for a finance lease
• the lessor will normally maintain the asset (unless otherwise stated under the contract)
• if the lease is at least 5 years, the lessor claims the capital allowances for plant and machinery & the lessee sets the revenue cost of renting the asset against tax

Question 3

accounting for finance leases (a.k.a. normal leases) by lessees

Answer 3

*remember “7 points”

• SOFP:
  1. Initially recognised on the SOFP as an asset, together with a corresponding liability to the lessor
• The amount shown will be the present value of the minimum lease payments to be paid over the lease term. This will often equal the purchase cost of the asset, plus any additional indirect costs
• The discount rate to determine the present value of the lease payments is: either the “interest rate implicit” in the lease (if that can be determined readily) or “incremental borrowing rate” (if that can’t be determined).
• The carrying amount of the asset is recorded in the SOFP as a non-current asset
• the balance of the lease payments will be shown on the SOFP as a current liability (the amount due within one year) & as a non-current liability (the remaining balance)
• SOPL
• The lessee’s profits will be reduced as a result of depreciation of the asset and the implicit interest charges (finance costs) charged
• The asset is depreciated using the cost model and accumulated impairment
• The depreciation period is either the UEL (useful economic life of the asset), or over the shorter of the lease term or the UEL of the asset (only if there’s a possibility that the lessee will not obtain ownership at the end of the lease period)
• The amount of depreciation and implicit interest charges (finance costs) are to be recognised as an expense in the SOPL and other comprehensive income
• calculating interest expense and lease liability at end:
  1. (Lease liability at start) - (lease payment) = subtotal
  2. Subtotal + (interest x subtotal) = lease liability at end
• if lease payments are made at the end of the financial year, then it’s (lease liability at start) + (interest on the lease liability at start) - (lease payment) = lease liability at end
• Cashflow:
• Cash balance will not be affected by the acquisition.
• However, cash will be reduced by the lease payments
• the payments will be spread over the lease term. This aids in short-term cash flow
• Gearing:
• the gearing position will increase. Even though the asset base increases, the total debt will also increase in relation to it (in the form of the lease liability)
• this could affect the credit rating of the company and the ability to raise additional finance

Question 4

accounting for operating leases by lessees

Answer 4

-Lease payments are recognized as an expense in the SOPL and other comprehensive income on a straight-line basis over the lease term (unless another basis is more representative of the time pattern of the user’s benefit)

• SOFP
• The lease is not included as an asset and the liability for paying for the lease is not included in the liabilities
• Gearing:
• no effect as the asset and liability are not included in the SOFP
• the total debt & asset value will be unaffected by the lease. But a competent credit risk analyst will consider the size of the lease commitment when deciding to grant additional funding or credit

Question 5

classifying finance lease and operating lease

Answer 5

• Factors:
• Transfer of ownership by end of lease term
• Lessee’s option to purchase at lower than fair value
• Lease term is for major part of asset’s economic life
• Present value of minimum lease payments at least equal to fair value of asset
• Specialist asset, major modifications needed for other users
• Finance lease (if it’s a yes for one or more of the factors above)
• Operating lease (if it’s a no for one or more of the factors above)
• Additional notes*
• Other indications (for finance lease)
• if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
• gains/losses from fluctuations in the fair value of the residual value accrue to the lessee (eg by means of a rebate of lease payments)
• the lessee has the ability to continue the lease for a secondary period at substantially lower lease payments
• the two elements - land and buildings - are normally considered separately
• Land is often classified as an operating lease, unless title passes to the lessee by the end of the lease term

Question 6

lease

Answer 6

• a straight-forward form of rental agreement/contract to hire out an asset between the lessor (owner of the asset) and the lessee (who uses the asset)
• Very similar to a hire purchase agreement, except the lessor will not transfer the ownership of the asset to the lessee at the end of the agreement, but would retain ownership of the asset
• Advantages:
  1. right to use the asset
  2. The lease may be easier to arrange than obtaining finance to purchase the asset
  3. May be able to cancel the lease early or extend it if required (depending on the lease terms)
  4. Stable predictable lease payments can be budgeted for more easily
• Disadvantages:
  1. Cost of the lease may be more expensive than obtaining finance to purchase the asset
  2. may have restrictions on what can be done with the asset and where it can be used
  3. No ownership of asset
  4. Commitment to make payments over lease term

Question 7

lessee

Answer 7

the company/business that uses the leased asset in its business

Question 8

lessor

Answer 8

the owner of the asset who allows the lessee to use the asset for an agreed time period in exchange for payment

Question 9

interest rate implicit in the lease

Answer 9

the interest rate at which the present value of the minimum lease payments is equal to the fair value of the asset and any initial indirect costs incurred

Question 10

incremental borrowing rate

Answer 10

the required interest rate paid by the lessee to borrow the funds to obtain the asset

Question 11

hire purchase

Answer 11

• a type of finance lease
• Interest will be charged based on the outstanding balance, at an interest rate set at the beginning of the hire purchase agreement term
• The lessor transfers the risks and rewards of ownership of the asset to the lessee. However, the actual ownership will not be transferred until the final repayment has been made.
• the lessee will be responsible for the repairs and maintenance of the asset during the hire purchase agreement term.
• The lessee will usually retain the use and take ownership of the asset at the end of the hire period, often for a relatively small sum
• Statements:
  1. SOFP
• The hire purchase asset will be shown as an asset at its full purchase price
• The outstanding balance of the hire purchase will be shown as a liability. The amount due within 1-year will be included with the current liabilities, & the balance with the non-current liabilities
  2. SOPL
• Debit interest paid on the loan
• Gearing
• The balance of the hire purchase in the non-current liabilities will be included in the gearing calculation. under “long-term debt”
• This will increase the gearing of the company, which could affect the company’s ability to raise additional finance
• Security:
• The hire-purchase asset will not be available for other lenders to take as security because the hire purchase company will hold ownership title until the final repayment has been made

Question 12

sale and leaseback

Answer 12

• a type of leasing where an asset is sold by a business but then leased back on a long-term basis
• the business no longer owns the asset but can continue to use it
• used for non-current assets
• Advantages:
  1. use of the funds available from the sale
  2. the lessor will have the responsibility of maintaining the asset