Chapter 18 Leasing

By the end of this chapter, you should be able to: understand IFRS 16 account for leases by the lessee

IFRS 16 The approach taken in IFRS 16 is to define a lease based upon economic substance rather than legal form. A contract does not need to be legally established as a lease for the contract to be regarded as a lease for financial reporting purposes.

IFRS 16 defines a lease as A contract, or part of a contract, that conveys the right to use an asset for a period of time in exchange for consideration’. In order for such a contract to exist, IFRS 16 states that the customer (user of the ‘identified asset’) needs to have the right to: Obtain substantially all of the economic benefits from the use of the asset The right to direct the use of the asset.

Right to direct use IFRS 16 or the customer has the right to direct how and for what purpose the asset is used throughout its period of use; the relevant decisions about use are pre-determined and the customer has the right to operate the asset throughout the period of use without the supplier having the right to change these operating instructions. or

Measuring a ‘right of use asset’ IFRS 16 A ‘right of use asset’ should initially be measured at the present value of the minimum lease payments. The discount rate used to determine present value should be the rate of interest implicit in the lease. This is basically identical to the old ‘IAS 17 approach for finance leases.

Measuring a ‘right of use asset’ IFRS 16 However the ‘right of use asset’ would also include the following amounts, where relevant: Any payments made to the lessor at, or before, the commencement date of the lease, less any lease incentives received. Any initial direct costs incurred by the lessee. An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying asset, or restoring the site on which it is located if obligations are recognised under IAS 37 – Provisions, Contingent Liabilities and Contingent Assets.

Option 1 You will occupy a certain area of XY cubic meters, but the specific place will be determined by the owner of the warehouse, based on actual usage of the warehouse and free storage. Option 1 does not contain any lease, because no asset can be identified. The reason is that the supplier (warehouse owner) can exchange one place for another and you lease only certain capacity. Therefore, you would account for rental payments as for expenses in profit or loss.

Option 2 You will occupy the unit no. 13 of XY cubic meters in the sector A of that warehouse. This place is assigned to you and no one can change it during the duration of the contract. Option 2 does contain a lease, because an underlying asset can be identified– you are leasing the unit no. 13 of XY cubic meters in the sector A. Therefore, you need to account for this contract as for the lease and it means recognizing some asset and a liability in your balance sheet.

Present value (PV) lease payments or Fair value Asset cost lowest of Depreciation period shortest of Estimated useful life Or Lease period Carrying value = Asset cost – Acc. Depreciation Liability at a lease date = Asset cost

Finance charge = Total minimun lease payments Less Asset cost Finance charge allocated over the term of the lease Acturial Sum of digits Straight line Liability reduced by (Payment - finance charge)

This spreads the finance charge equally over the period of the lease. Acturial This applies a constant periodic charge to the balance of the leasing obligation and is calculated by applying present value factors to the annual lease payments Sum of the digits This method (‘Rule of 78’) is much easier to apply than the actuarial method. The finance charge is apportioned to accounting periods on a reducing scale – method used by Elliott & Elliott Straight line This spreads the finance charge equally over the period of the lease.

Illustration Boonaloo Ltd entered into a lease on following terms: Fair value of the leased asset 20,000 Term of the lease 5 years Annual lease payments in arrears £4,500 Expected value of asset at lease end nil Implicit rate of interest 4%

Boonaloo Ltd - Compare FV with PV of minimum lease payment FV of lease £ 20,000 PV of instalments: 4500(PVIFA4%,5) = 4500 x 4.452 = 20,034 Lowest of fair value and PV is 20,000.

Boonaloo Ltd – step approach Step 1 Capitalise lease at FV = £20,000 Step 2 Straight-line depreciation = £4,000 Step 3 Asset in statement of financial position Carrying Depreciation Carrying Year 1 20,000 – 4,000 = £16,000 Year 2 16,000 – 4,000 = £12,000 Year 3 12,000 – 4,000 = £8,000 Year 4 8,000 – 4,000 = £4,000 Year 5 4,000 – 4,000 = 0

Boonaloo Ltd – step approach Step 4 Obligation at inception £20,000 Step 5 Finance charge (sum of digits) Sum of digits = 1 + 2 + 3 + 4 + 5 = 15 Total to be paid (4,500 x 5) = £22,500 Fair value of asset -£20,000 Finance charge £2,500 Allocate as follows: Year 1 5/(15) × 2,500 £833 Year 2 4/(15) × 2,500 £667 Year 3 3/(15) × 2,500 £500 Year 4 2/(15) × 2,500 £333 Year 5 1/(15) × 2,500 £167 Take note: If payments were made in advance, there would be only 4 years to be considered .

Boonaloo Ltd – step approach Step 6 Reduce the obligation Cost payment balance finance charge balance c/f 20000 4500 15500 833 16333 11833 667 12500 8000 500 8500 4000 333 4333 -167 167

Boonaloo Ltd– income statement Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation 4,000 4,000 4,000 4,000 4,000 Finance charge 833 667 500 333 167

Balance sheet presentation year 1 year 2 year 3 year 4 year 5 Non Current Asset right to use Cost 20000 Accumulated depreciation 4000 8000 12000 16000 Carrying value Current liability 3833 4167 4333 Non-current liability 12500 8500