TOPIC 4 IFRS 16 LEASES

TOPIC 4 IFRS 16 LEASES The user of a leased asset is the lessee and the supplier/owner of the leased asset is the lessor What is a lease? 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 What is an underlying asset? An asset that is the subject of a lease, for which the right to use that asset has been provided by a lessor to a lessee. What is a Right of Use asset? An asset that represents a lessee s right to use an underlying asset for the lease term. IFRS 16 was brought in to remedy the non recognition of liabilities for assets held under operating leases. For lessees, IFRS 16 removes the distinction between finance and operating leases which was a feature of IAS 17. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Right to Control the use of an asset is dependent on D: Direction over how and for what purpose the asset is used is a right that the lessee has E: Economic benefits from use of the identified asset will flow to the lessee A lessee does not control the use of an identified asset if the lessor can substitute the underlying asset for another asset during the lease term and would benefit economically from doing so. Accounting Treatment where a Contract contains a lease 1. At commencement date, measure the right of use asset at cost ( Cr Lease Liability (SOFP), Dr Right of Use Asset (SOFP). Note: Cost comprises amount of the initial measurement of the lease liability, any lease payments made before the commencement date less any lease incentives received, any initial direct costs incurred by the lessee, any costs which the lessee will incur for dismantling and removing the underlying asset or restoring the site at the end of the lease term 2. At commencement date, measure the lease liability at the present value of future lease payments, including any expected payments at the end of the lease.( Cr Lease Liability ((SOFP), Dr Right of Use Asset (SOFP)) 1

3. Subsequent measurement of the right of use asset: The right of use asset should be depreciated from the commencement date to the earlier of the end of the useful life of the underlying asset and the end of the lease term (Dr SOPL Depreciation Expense, Cr Right of Use Asset (SOFP) Note: If the lease transfers ownership of the underlying asset at the end of the lease term, or if the cost reflects a purchase option, which the lessee is expected to exercise, then the right of use asset should be depreciated over the useful life of the underlying asset. Note: If the right of use asset is an investment property or belongs to a class of assets to which the revaluation model applies, then apply the revaluation model as per IAS 40 and IAS 16 4. Subsequent measurement of Lease Liability: The carrying amount of the lease liability is increased by interest charges on the outstanding liability (Dr SOPL - Finance Cost, Cr SOFP - ) and reduced by the lease payments made. (Cr SOFP Bank, Dr SOFP Lease Liability). Then split the closing lease liability between current and non current liabilities. Presentation in the Financial Statements Right of Use Assets to be presented on a separate line under Non Current Assets in the Statement of Financial Position Lease Liabilities to be presented separately in Liabilities. Best practice is that liabilities should be split between current and non current liabilities DEPOSITS PAID Where the lessee has paid a deposit to the lessor before the lease commences, the deposit is used to reduce the amount of the lease liablity i.e. reduce the amount of lease finance advanced deposits are deemed to be all capital The Double Entry for a deposit is Cr Bank X Dr Lease Liability X In questions, where the initial payment is different in amount to the annual rentals, this is generally taken to be an indicator of a deposit paid LEASE IN ARREARS Rental is paid on Last day Rentals are deemed to be composed of Interest and Capital No Interest Accrual 2

LEASE PAID IN ARREARS EXAMPLE Branch acquired an item of plant and equipment on a lease on 1 January 20X1. The terms of the agreement were as follows : Deposit Instalments 1,150 (non refundable) 4,000 per annum for 7 years payable in arrears Initial Measurement of Lease Liability 20,000 The underlying asset has a useful life of 4 years and the interest rate implicit in the lease is 11%. Required: Prepare extracts from the SOPL and SOFP for the year ending 31 December 20X1. 1. The right of use of the underlying asset should be capitalised and included as a non current asset. As the lease has a 4 year life, straight line depreciation for the year to 31 Dec x1 will be 25% of 20,000 = 5,000 Leasing Table - Lease Paid in Arrears (i.e. on Last Day of Period) Year Opening Lease Liability Interest 11% Lease Repayment Closing Lease Liability 31.12.X1 1 18,850 2,074 (4,000) 16,924 31.12.X2 2 16,924 1,862 (4,000) 14,786 31.12.X3 3 14,786 1,626 (4,000) 12,412 31.12.X4 4 12,412 1,365 (4,000) 9,777 31.12.X5 5 9,777 1,075 (4,000) 6,852 31.12.X6 6 6,852 754 (4,000) 3,606 31.12.X7 7 3,606 397 (4,000) - SOPL Extract for Y/e 31.12.X1 Finance Charge 2,074 Depreciation 5,000 Statement of Financial Position Extract as at 31.12.X1 Assets Non Current Assets Right of Use Asset 15,000 3

Equity & Liabilities Non Current Liabilities Lease Liability 14,786 Current Liabilities Lease Liability (16,924-14,786) 2,138 LEASE IN ADVANCE Main Points Rental is paid on first day The first rental is deemed to be all capital, and as a result, an accrual will be made for finance costs in year 1 and thereafter. In Year 2, the amount of capital repaid will be the lease rental less accrued interest from Year 1 paid in Year 2 i.e. paid as part of Year 2 rental IFRS 16 Lease Paid In Advance Class Question & Answer A lease rental of 20 million was paid on 1 April 2015. It is the first of 5 annual payments in advance for the rental of an item of equipment that has a cash purchase price of 80 million. The auditors have calculated the implicit rate in the lease as 12% per annum. The right of use is to be depreciated on a straight line basis over the life of the lease. (a) Show the effect on the SOPL and Statement of Financial Position for 31 March 2016 (b) Calculate the interest charge for the remaining years of the lease 4

Solution 1. The cash price of the leased plant of 80 million should be capitalised and included as plant and equipment. As the lease has a 5 year life, straight line depreciation for the year to 31 March 2016 will be 20% of 80 million = 16 million Leasing Table - Lease Paid in Advance (i.e. on First Day of Period) Year Opening Lease Liability - 000 Rental - 000 Remaining Lease Liability - 000 Interest Accrual - 000 (12%) 31.3.16 1 80,000 (20,000) 60,000 7200 31.3.17 2 60,000 (20,000) 47,200 5664 31.3.18 3 47,200 (20,000) 32,864 3,944 31.3.19 4 32,864 (20,000) 16,808 3192 31.3.20 5 16,808 (20,000) - - Notes: 1. First Rental is deemed to be all capital 2. Interest for each year is calculated on the Remaining Lease Liability 3. The Interest Accrual in the current year is paid from the Rental of the following year with the balance of the rental representing capital repayment SOPL Extract for Y/e 31.3.16 000 Finance Charge 7,200 Depreciation 16,000 Statement of Financial Position Extract as at 31.3.16 000 Assets Non Current Assets Right of Use Asset 64,000 Equity & Liabilities Non Current Liabilities Lease Liability 47,200 Current Liabilities Lease Liability (12800+7200) 20,000 5

Recognition Exemptions A lessee may elect to account for lease payments as an expense on a straight line basis over the lease term for the following two types of leases 1. Short Term leases: where the lease term is 12 months or less. This election is made by class of underlying asset (i.e. election to be applied to all assets in a particular class) 2. Low Value Leases: Where the underlying asset (i.e. leased asset) has a low value when new. This election can be made on a lease by lease basis. Sale and leaseback transactions A sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset. If the sale satisfies the IFRS 15 requirement to be accounted for as a sale: The lessee measures the right of use asset arising from the leaseback at the proportion of the previous carrying amount of the building that relates to the right of use retained. This is calculated as the carrying amount X (Present Value of Lease Payments/Fair Value of Asset when sold) The lessee only recognises the amount of any gain/loss on the sale that relates to the rights transferred to the buyer. Such gains/losses are taken directly to the SOPL. Where the sale proceeds exceed fair value, the excess is recognised as additional financing provided by the lessor. Journal for a Sale and Leaseback Transaction where a Lease is created Dr Bank (SOFP) X Dr Right of Use Asset (SOFP) X Cr Asset Sold (SOFP) Cr Lease Liability (SOFP) Cr Gain on Rights Transferred (SOPL) X X X Subsequently Account for Lease as Normal Depreciation of Right of Use asset, Interest, Capital Repaid, Split of Lease Liability between Current Liabilities and Non Current Liabilities 6

If the sale does not satisfy the IFRS 15 requirement to be accounted for as a sale: Seller continues to recognise the transferred asset and the transfer proceeds are treated as a financial liability, as per IFRS 9. The transaction is more in the nature of a secured loan. Sale and Leaseback Example Capital Co entered into a sale and leaseback on 1 April 20X7. It sold a lathe with a carrying amount of 300,000 for 400,000 (i.e. its fair value) and leased it back over a five year period, equivalent to its remaining useful life. The transaction constitutes a sale in accordance with IFRS 15. The lease provided for a five annual payments in arrears of $90,000. The rate of interest implicit in the lease is 5%. The present value of the lease payments is 389,652. What are the amount to be recognised in the financial statements at 31 March 20X8 in respect of this transaction? Solution Measure the Right of Use Asset: This is calculated as the carrying amount X (Present Value of Lease Payments/Fair Value of Asset when sold) 300,000 * ( 389652/ 400,000) = 292,239 The gain on the sale is 100,000 ( 400,000-300,000). Of this gain, the amount relating to the rights retained is: 100,000 * ( 389652/ 400,000) = 97,413. Therefore the balance of the gain on the rights transferred is taken directly to the SOPL 2,587 ( 100,000-97,413) Therefore, the initial posting can now be made as follows Dr Bank 400,000 Cr Lathe (Asset SOFP) 300,000 Dr Right of Use Asset 292,239 Cr Lease Liability 389,652 Cr Gain on Transfer 2,587 Being Initial posting of Right of Use Asset, Lease Liability and Gain on Rights transferred. Depreciate the Right of Use Asset over 5 years as follows 292,239/5years = 58,448 Cr Right of Use Asset (SOFP) 58,448 Dr SOPL Depreciation Expense 58,448 Being Depreciation Expense for Year Ended 31-3-X8 Account for Lease Liability paid in Arrears as follows 7

Date Opening Lease Liability Interest 5% Lease Rental Closing Lease Liability 31.3.X8 389,652 19,483 (90,000) 319,135 31.3.X9 319,135 15,957 (90,000) 245,092 Dr SOPL Finance Cost 19,483 Cr Lease Liability 19,483 Being Finance Cost for Year Ended 31-3-X8 Cr Bank 90,000 Dr Lease Liability 90,000 Being Lease Rental paid on 31-3-X8 Cr Lease Liability Non Current Liabilities 245,092 Dr Lease Liability Current Liabilities 245,092 Being Maturity Analysis of Lease Liability Balance at 31-3-X8 Financial Statement Extracts Statement of Profit or Loss for Year Ended 31-3-X8 Depreciation Expense (58,448) Finance Cost (19,483) Gain on Rights Transfer 2,587 Statement of Financial Position as at 31-3-X8 Assets Non Current Assets Right of Use Asset ( 292,239-58,448) 233,791 Non Current Liabilities Lease Liability 245,092 Current Liabilities Lease Liability 74,043 8

SUM OF THE DIGITS METHOD OF ALLOCATING INTEREST ON A LEASE An means of allocating the Finance Charge over the term of a lease Approximates to the actuarial method More interest expensed in the early part of the lease and less towards the end Procedure The digit 1 is assigned to the final instalment, 2 to the penultimate instalment and so on (This applies for a Lease in Arrears. For a Lease paid in Advance, the Digit 0 is applied to the Final Instalment ) Add the digits Calculate the interest charge included in each instalment by taking the total finance cost and multiplying by the following fraction Example of Sum of the Digits Method Digit Applicable to the Instalment Sum of the Digits Burrow Ltd. Acquired a new machine from Lydon Finance Co. Ltd on a lease. Burrow Ltd has the right to use the leased asset for the lease term. The lease terms are: Primary Period of Lease 4 Years Frequency of Lease Payments Annually, in Arrears Amount of Each Rental 5,000 Cash Price 15,850 Estimated Useful Life of Asset 4 Years Account for the above lease using the sum of the Digits as a means of allocating the finance charge 9

Solution Finance Cost Allocation Total Finance Expense (5000) * 4 15,850 = 4150 Instalment Digit Finance Expense Allocation 1 4 4/10 * 4150 = 1660 2 3 3/10 * 4150 = 1245 3 2 2/10 * 4150 = 830 4 1 1/10 * 4150 = 415 10 4150 Lease (In Arrears)Table Date Opening Capital Obligation Interest Rental Closing Capital Obligation Yr 1 15,850 1660-5000 12,510 Yr 2 12,510 1245-5000 8,755 Yr 3 8755 830-5000 4,585 Yr 4 4585 415-5000 - Statement of Profit or Loss Extract for the Year End Yr 1 Finance Cost 1,660 Depreciation (15,850/4) 3,963 Statement of Financial Position Extracts As at 31/12/Yr 1 Assets Non Current Right of Use Asset (15,850 3,963) 11,887 Non Current Liabilities Lease Obligation 8755 10

Current Liabilities Lease Obligation (15850+1660-5000 - 8755) 3755 11

LESSOR ACCOUNTING Note that lessor accounting is largely unchanged under IFRS 16 from the previous leasing standard, IAS 17. As a result, for lessor accounting, IFRS 16 retains the IAS 17 distinction between finance leases and operating leases. Finance Lease: In substance, the risks and rewards are transferred to the lessee Operating Lease: In substance, the risks and rewards remain with the lessor. Finance Lease - Accounting Treatment - Lessor SOFP No Asset Recognise net investment in lease PVMLP + unguaranteed RV (i.e. Lease Receivable). SOPL Constant finance income.no depreciation expense Operating Lease Accounting Treatment Lessor SOFP Asset is Retained in books of lessor.depreciated over UL SOPL Rental income credited on a straight line basis over the lease term to the P/L depreciation expense 12

Past Exam Questions CPA P1 Past Exam Questions CPA P2 Q3 (1) April 2017, Q2 August 2016, Q3 (7) August 2016, Q3 (3) Apr 14 Q (B) (i) April 2017, Q1 August 2016, Q (A) April 2016,Q (A) April & August 2015 Q5 Apr 13 Q1 August 2014 Q4 Aug 11 Q (A) April 2014 Q3 Apr 11 Q (B) Aug 13 Q (a) Aug 12 Q1 Aug 11 Issue 8 Q3 Apr 11 Q1 Apr 11 note (vi) 13