Professional Documents
Culture Documents
Review questions
11.1 The major changes in how we account for leases as a result of the 2016 release of IFRS 16
(AASB 16 in Australia) relate to how we are now required to bring a great more leased
assets, and lease liabilities, onto the balance than was previously required.
Pursuant to the former accounting standard, from the perspective of the lessee, leases were
classified broadly as either finance leases or operating leases. If a lease transferred the risks
and rewards incidental to ownership of the asset from the lessor (the owner), to the lessee
(the customer), then the lease was deemed to be a finance lease and as such, both the leased
asset and lease liability were to be recognised for balance sheet purposes. If the lease was
an operating lease (meaning that it did not transfer the risks and rewards of ownership to
the lessee), then it did not have to be recognised for balance sheet purposes.
The former accounting standard provided guidance for when the risks and rewards
incidental to ownership were considered to be transferred to the lessee. For example,
paragraph 10 of the former accounting standard (AASB 117) stated:
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. 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 asset to the lessee by the end of the lease
term;
(b) the lessee has the option to purchase the 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 of the lease, that
the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if
title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialised nature that only the lessee can use
them without major modifications.
Again, if the lease was deemed to be a finance lease, then a leased asset and a lease liability
were required to be recognised on the balance sheet, otherwise no lease liability or lease
asset had to be recognised.
Under the new accounting standard (IFRS 16/AASB 16) there is no subdivision of leases
into operating and finance leases when it comes to accounting for leases by lessees. To the
extent that a lease is for a period of more than 12 months, and to the extent that the lease is
not for a low-value item (say US$5000 or less), then a lease liability and leased asset shall
be recognised to the extent that the lessee has a non-cancellable obligation to make lease
payments. This new requirement to capitalise all leases (other than those for which there
are exemptions as already noted) is consistent with the definitions of assets and liabilities
as produced within the conceptual framework. The former accounting requirements for
leases were not consistent with the conceptual framework. The new requirements mean
that many more leased assets and lease liabilities will appear on corporate balance sheets—
something that has not been popular with a lot of corporations.
The requirements for accounting for leases by lessors were not changed as a result of the
release of the new accounting standard, and the classification of finance leases and
operating leases is still used in relation to accounting for leases by lessors.
11.2 The accounting standard defines a lease—and this definition applies to both parties to a
contract, that is, to the customer (lessee) and to the supplier (lessor)—as:
A contract, or part of a contract, that conveys the right to use an asset (the
underlying asset) for a period of time in exchange for consideration.
The ‘underlying asset’ referred to above is defined as:
An asset that is the subject of a lease, for which a right to use that asset has been
conveyed to a lessee.
11.3 ‘Lease term’ is defined within the accounting standard as:
The non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably
certain not to exercise that option.
Considerations of whether something is ‘reasonably certain’ (as used in the above
paragraph) would include a number of factors, including:
whether a purchase option or lease-renewal option exists within the lease contract
and whether the nature of the pricing of the options is sufficiently favourable to
the lessee to suggest that the lessee is reasonably certain to exercise the option;
whether there has been significant customisation of the lease asset. For example, if
the lessee has leased a building and has made significant and costly modifications
to the leased building, then this might suggest that if there is an option to renew
the lease at typical market rates then the renewal option is reasonably likely to be
taken.
11.4 Basically, if a ‘lease’ exists—using the definition within the accounting standard—and if
the lease is for a period of more than 12 months, and is for an item that is not deemed to be
of low value, then a right-of-use asset and a lease liability shall be recognised by the lessee.
In recognising the lease, there is also a requirement that the lease is ‘non-cancellable’—
that is, the lessee cannot cancel the lease at short notice without some form of financial
penalty.
11.5 Pursuant to IFRS 16/AASB 16, a lessee should capitalise a lease transaction (meaning that
the leased asset and lease liability will be included within the statement of financial
position) when the lease is for a period in excess of 12 months and the lease is not for a
low-value item. A lessee is required to recognise a right-of-use asset representing its right
to use the underlying leased asset and a lease liability representing its obligations to make
lease payments.
For a lessee to be required to capitalise a lease in accordance with IFRS 16/AASB 16, the
contractual arrangement needs to satisfy the requirements in terms of being a ‘lease’. This
requires that the lease obligation be non-cancellable and that the lessee ‘controls’ the asset
for the duration of the lease, meaning that the supplier of the asset (the lessor) does not
have a ‘substantive right’ to substitute the asset throughout the period of use.
11.6 To the extent that a lease arrangement is non-cancellable and provides control of the asset
to the lessee, there is an expectation that the lessee recognise a right-of-use asset
representing its right to use the underlying leased asset and a lease liability representing its
obligations to make lease payments. Lessees can elect to exempt themselves from this
requirement when the lease is for a lease period of 12 months or less, or where the lease is
for a low-value item.
11.11 A residual value guarantee is provided by the lessee to the lessor. It provides an assurance
to the lessor that the assets being returned to the lessor will have a certain value at the end
of the lease term. A related amount will be included in the capitalised lease payments. From
the lessee’s perspective, the residual value guarantee is to be included as part of the lease
liability. It would be calculated as the present value of the difference between what value
has been guaranteed by the lessee for the asset at the end of the lease term, and what the
lessee believes the lease asset will be able to be sold for at the end of the lease given the
expected pattern of use. For example, there might be an agreement that the asset should
have a fair value of $100,000 at the end of the lease term (meaning that the lessor should
expect to realise $100,000 from the sale of the asset at the end of the lease term). If the
lessee believes that given the expected of use the asset will only have a fair value of $70,000
at the end of the lease term then the lessee will have to make up the difference – that is, the
lessee will need to pay $30,000. It is the present value of this $30,000 that would need to
be included within the total amount of the lease liability.
From the lessor’s perspective, the residual value guarantee would form part of the lease
receivable and would be measured at present value.
11.14 The accounting standard requires that a lessee capitalise its initial direct costs that relate to
a lease as part of the cost of the lease asset. Therefore, where such costs are incurred, the
lease asset comprises the present value of the lease payments plus the amount of initial
direct costs incurred. The total amount would then be subject to regular depreciation
(amortisation).
Under a direct-financing lease, the initial direct costs are, if material, to be included
as part of the lessor’s investment in the lease.
The initial direct costs relating to a lease involving a dealer or manufacturer are to
be accounted for by the lessor as a cost of sales of the financial year in which the
lease transaction occurs.
11.16 To undertake this calculation, students may use trial and error. The implicit rate is 18%,
proven as follows:
Present value of initial payment $5000 x 1.0 = $5000
Present value of yearly payments ($5500 – $500) x 4.4941 = $22 470
Fair value at lease inception $27 470
Alternatively, and more easily, we can divide the liability on 1 July 2019 (which would
exclude the payment of $5000 at lease inception) by the periodic lease payments (after
deducting the executory costs) and then search for the appropriate interest rate within the
present value tables. This is easy because of the absence of a guaranteed residual or a
bargain purchase option.
(27 470 – 5000) 5000 = 4.494
A review of the present value of an annuity table shows that $4.4941 equals the present
value of an annuity in arrears of $1 per year, for 10 years, discounted at 18%.
30 June 2021
Dr Interest expense 24 315
Dr Lease liability 31 935
Dr Service expenses 6 250
Cr Cash 62 500
Dr Depreciation expense 33 020
Cr Accumulated leasehold depreciation 33 020
[33 020 = 231 140 7]
Challenging questions
11.23 (a) The implicit rate is defined in the accounting standard as:
The rate of interest that causes the present value of (a) the lease payments and
(b) the unguaranteed residual value to equal the sum of (i) the fair value of the
underlying asset and (ii) any initial direct costs of the lessor.
1 July 2019
Dr Leased plant—aeroplane 2 428 400
Cr Lease liability 2 428 400