IFRS 16 : Leases Part 2 Flashcards
LESSOR ACCOUNTING
IFRS 16 substantially carries forward the lessor accounting model in IAS 17. The significant
differences between the lessor accounting requirements in IFRS 16 and those in IAS 17 are
primarily a consequence of decisions reached about the lessee accounting model in IFRS 16. IFRS 16 does change certain aspects of the lessor accounting model, including changes to the accounting for subleases, initial direct costs and lessor disclosures.
Lease classification - Lease classification
At inception date of the lease, a lessor classifies each of its leases as either an operating lease or a finance lease. [IFRS 16.61]. The classification of leases under IFRS 16 is the same as under IAS 17. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards of ownership of an underlying asset. [IFRS 16.62].
Lease classification - Criteria for lease classification 1
The classification of leases is based on the extent to which the lease transfers the risks and rewards incidental to ownership of an underlying asset. Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations
in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the underlying asset’s economic life and of gain from appreciation in value or realisation of a residual value. [IFRS 16.B53].
Lease classification - Criteria for lease classification 2
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract.
Whether a lease is a finance lease or an operating lease depends on the substance of the transaction rather than the form of the contract. The legal form of a finance lease is that the lessor is the legal owner of the leased asset. The economic substance of a finance lease is that the lessee has all the benefits and costs associated with ownership of the asset. The finance lessee is in the same position as it would have been if it had borrowed money to buy the asset itself. That is why such leases are called finance leases; they provide finance for the use of an asset.
Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:
(a) the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be
reasonably certain, at the inception date, that
the option will be exercised;
(c) the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;
(d) at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset; and
(e) the underlying asset is of such a specialised
nature that only the lessee can use it without major modifications. [IFRS 16.63].
Lease classification - Criteria for lease classification 3
Indicators of situations that individually or in combination could also lead to a lease being
classified as a finance lease are: (a) if the lessee can cancel the lease, the lessor’s
losses associated with the cancellation are bear by
the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example,
in the form of a rent rebate equalling most of the sales
proceeds at the end of the lease);
and
(c) the lessee has the ability to continue the lease
for a secondary period at a rent that is substantially lower than market rent. [IFRS 16.64].
The examples and indicators above are not always conclusive. If it is clear from other features that the lease does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset, the lease is classified as an operating lease. For example, this may be the case if ownership of the underlying asset transfers at the end of the lease for a variable payment equal to its then fair value, or if there are variable lease payments, as a result of which the lessor does not transfer substantially all such risks and rewards. [IFRS 16.65].
Lease classification - Criteria for lease classification 4
In our view, other considerations that could be made in determining the economic substance of the lease arrangement include the following:
(a) Are the lease rentals based on a market rate for use of the asset (which would indicate an operating lease) or a financing rate for use of the funds, which would
be indicative of a finance lease?
(b) Is the existence of put and call options a feature of the lease? If so, are they exercisable at a predetermined price or formula (indicating a finance lease) or are
they exercisable at the market price at the time the option is exercised (indicating an operating lease)?
Lease classification - Criteria for lease classification 5
A lease contract may include terms and conditions to adjust the lease payments for particular changes that occur between the inception date and the commencement date (such as a change in the lessor’s cost of the underlying asset or a change in the lessor’s
cost of financing the lease).
In that case, for the purposes of classifying the lease, the effect of any such changes is deemed to have taken place at the inception date.[IFRS 16.B54].
Lease classification - Lease classification test for land and buildings 1
When a lease includes both land and buildings elements, a lessor assesses the classification of each element as a finance lease or an operating lease separately. In determining whether the land element is an operating lease or a finance lease, an important consideration is that land normally has an indefinite economic life. [IFRS 16.B55].
Whenever necessary in order to classify and account for a lease of land and buildings, a lessor allocates lease payments (including any lump-sum upfront payments) between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception date.
EX : Leases of land and buildings Emile Woolf
Lease classification - Lease classification test for land and buildings 2
If the lease payments cannot be allocated reliably between these two elements, the entire lease is classified as a finance lease, unless it is clear that both
elements are operating leases, in which case the entire lease is classified as an operating lease.
[IFRS 16.B56].
For a lease of land and buildings in which the amount for the land element is immaterial to the lease, a lessor may treat the land and buildings as a single unit for the purpose of lease classification and classify it as a finance lease or an operating lease. In such a case, a lessor regards the economic life of the buildings as the economic life of the entire underlying asset.
[IFRS 16.B57].
Lease classification - Residual value guarantees included in the lease classification test
In evaluating IFRS 16’s lease classification criteria, lessors are required to include in the ‘substantially all’ test any (i.e. the maximum obligation) residual value guarantees provided by both lessees and any other
third party unrelated to the lessor.
Lease classification - Reassessment of lease classification
Lease classification is made at the inception date and is reassessed only if there is a lease modification. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the underlying asset), or changes in circumstances (for example, default by the lessee), do not give rise to a new classification of a lease for accounting purposes. [IFRS 16.66]. Lessors reassess lease classification as at the effective date of the modification using the modified conditions at that date. If a lease modification results in a separate new lease, that new lease would be classified in the same manner as any new lease.
Finance leases
At commencement date, a lessor recognises assets held under a finance lease in its statement of financial position and presents them as a receivable at an amount equal to the net investment in the lease. [IFRS 16.67].
The net investment in the lease is defined as ‘the gross investment in the lease discounted at the interest rate implicit in the lease’. [IFRS 16 Appendix A]. The gross investment in the lease is ‘the sum of (a) the lease payments receivable by a lessor under
a finance lease and (b) any unguaranteed residual value accruing to the lessor.’ [IFRS 16 Appendix A].
Finance leases - Initial measurement 1
At lease commencement, a lessor accounts for a finance lease, as follows:
(a) derecognises the carrying amount of the
underlying asset;
(b) recognises the net investment in the lease; and
(c) recognises, in profit or loss, any selling profit
or selling loss.
The lessor uses the interest rate implicit in the lease to measure the net investment in the lease. In the case of a sublease, if the interest rate implicit in the sublease cannot be readily determined, an intermediate lessor may use the discount rate used for the head
lease (adjusted for any initial direct costs associated with the sublease) to measure the net investment in the sublease. [IFRS 16.68].
Finance leases - Initial measurement 2
Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included in the initial measurement of the net investment in the
lease and reduce the amount of income
recognised over the lease term.
The interest rate implicit in the lease is defined in such a way that the initial direct costs are included automatically in the net investment in the lease; there is no need to add them separately. [IFRS 16.69].
Finance leases - Initial measurement 3
At the commencement date, the lease payments included in the measurement of the net investment in the lease comprise the following payments for the right to use the underlying asset during the lease term that are not received at the commencement date:
(a) fixed payments (including in-substance fixed payments), less any lease incentives payable;
(b) variable lease payments that depend on an index
or a rate, initially measured using the index or rate
as at the commencement date;
(c) any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of
discharging the obligations under the guarantee;
(d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
(e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease. [IFRS 16.70].
Finance leases - Manufacturer or dealer lessors 1
At the commencement date, a manufacturer or dealer lessor recognises the following for each of its finance leases:
(a) revenue being the fair value of the underlying asset, or, if lower, the present value of the lease payments accruing to the lessor, discounted using a market rate of interest;
(b) the cost of sale being the cost, or carrying amount’ if different, of the underlying asset less the present value of the unguaranteed residual value; and
(c) selling profit or loss (being the difference between revenue and the cost of sale) in accordance with its policy for outright sales to which IFRS 15 applies. A
manufacturer or dealer lessor recognises selling profit or loss on a finance lease at the commencement date, regardless of whether the lessor transfers the underlying
asset as described in IFRS 15. [IFRS 16.71].
Finance leases - Manufacturer or dealer lessors 2
Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor gives rise to profit or loss equivalent to that resulting from an outright sale of the underlying asset, at
normal selling prices, reflecting any applicable volume
or trade discounts. [IFRS 16.72].
Manufacturer or dealer lessors sometimes quote artificially low rates of interest in order to attract customers. The use of such a rate would result in a lessor recognising an excessive portion of the total income from the transaction at the commencement date. If artificially low rates of interest are quoted, a manufacturer or dealer lessor restricts selling profit to that which would apply if a market rate of interest were charged. [IFRS 16.73].
Finance leases - Manufacturer or dealer lessors 3
A manufacturer or dealer lessor recognises as an expense costs incurred in connection with obtaining
a finance lease at the commencement date because they are mainly related to earning the manufacturer
or dealer’s selling profit.
Costs incurred by manufacturer or dealer lessors in connection with obtaining a finance lease are excluded from the definition of initial direct costs and, thus, are excluded from the net investment in the lease.
[IFRS 16.74].
Finance leases -Subsequent measurement 1
After commencement a lessor recognises finance income over the lease term, based on a pattern reflecting a constant periodic rate of return on the lessor’s net investment in the lease. [IFRS 16.75]. A lessor aims to allocate finance income over the lease term on a systematic and rational basis. A lessor applies the lease payments relating to the period
against the gross investment in the lease to reduce both the principal and the unearned finance income. [IFRS 16.76]. Thus, the lessor reduces the net investment in the lease for lease payments received (net of interest income calculated above).
The lessor also recognises income from variable payments that are not included in the net investment in the lease (e.g. performance or usage based variable payments) separately in the period in which the income is earned.
The subsequent treatment of the finance lease is as follows:
• The carrying amount of the lease receivable is increased by finance income earned, which is also credited to the statement of profit or loss.
• The carrying amount of the lease receivable is reduced by cash receipts.
Finance leases - Subsequent measurement 2
A lessor applies the derecognition and impairment requirements in IFRS 9 to the net investment in the lease. The lessor reviews regularly estimated unguaranteed residual values used in computing the gross investment in the lease. If there has been a reduction in the estimated unguaranteed residual value, the lessor revises the income allocation over the
lease term and recognise immediately any reduction
in respect of amounts accrued. [IFRS 16.77].
A lessor that classifies an asset under a finance lease as held for sale (or includes it in a disposal group that is classified as held for sale) applies IFRS 5 – Non-current Assets Held for Sale and Discontinued Operations. [IFRS 16.78].
An earlier section explained that the interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes:
• the aggregate present value of the lease payments and the unguaranteed residual value; to be equal to
• the sum of the fair value of the leased asset and any initial direct costs of the lessor.
Therefore the net investment in the lease is the sum of the fair value of the asset plus the initial direct costs.
Finance leases - Remeasurement of the net
investment in the lease
After lease commencement, the net investment in a lease is not remeasured unless:
• the lease is modified (i.e. a change in the scope of the lease, or the consideration for the lease, that was not part of the original terms and conditions of the lease) and the modified lease is not accounted for as a separate contract (see Lease modifications below);
or
• the lease term is revised when there is a change in the non-cancellable period of the lease (see Lease modifications above).
Operating leases 1
Under IFRS 16, lessors account for operating leases in a manner similar to the requirements under IAS 17. That is, they continue to recognise the underlying asset and do not recognise a net investment in the lease on the balance sheet or initial profit (if
any) on the income statement. The underlying asset continues to be accounted for in accordance with applicable accounting standards (e.g. IAS 16).
Lessors recognise lease payments as income on either a straight-line basis or another systematic basis if that basis is more representative of the pattern in which benefit derived from the use of the underlying asset is diminished. [IFRS 16.81]. After lease commencement, lessors recognise variable lease payments that do not depend on an index or rate (e.g. performance- or usage-based payments) as they are earned.