F1 5.07 IFRS 16 Leases

In this session we shall begin looking at IFRS 16 Leases. We shall look at what a lease is and how leases should be recognised in a business’ books and financial statements. We shall look at how a right-to-use asset and a lease liability should be measured at the start of a lease agreement and how it will be measured subsequently.

Please note that we shall only consider leases from the perspective of the lessee, not the lessor.

Leases

Leases are a very popular way to enable organizations, businesses and individuals to obtain the use of a variety of assets.

A lease is a contract, or part of a contract, that conveys the right to control an asset (referred to as the underlying asset) for a period of time in exchange for consideration.

Illustration

Berta Ltd agrees to supply Stephan with a car for 24 months as from 15th March 2020 in exchange for 24 monthly payments of £520

• The agreement between Berta Ltd and Stephan is a lease agreement
• Berta Ltd is the lessor (the entity that provides the asset)
• Stephan is the lessee (the entity that pays the consideration)
• The underlying asset is the car
• The consideration is the money that Stephan will pay over the period of the lease; i.e. 24 payments of £520
• The commencement date is 15/03/2020
• The lease term is 24 months starting on 15/03/2020

Accounting treatment

Let’s say that a company has acquired the use of two identical machines. One has been bought outright for £4,000 using a bank loan which is to be repaid at £1,000 per year over five years (so £5,000 will be paid in total, of which £1,000 is interest and £4,000 is to repay the loan). The second machine is leased for five years at £1,000 a year. It is expected that both machines will be worn out at the end of five years and will have no residual value.

The two methods of acquiring the machines are identical in terms of their cost to the company and in terms of the benefit that the company will receive.

It therefore makes sense that the accounting treatment used to record these two machines should be similar, even though the legal position with regard to the machines will be different (i.e. the company will not legally own machine if it is leased). So when a lease agreement is entered, the lessee will record:

Notes

1. The “right-of-use asset” is the ability to control the use of the underlying asset for the lease term
2. There are some types of leases that may be dealt with in a different way. These are discussed in section 5.09

Initial measurement of the lease liability

At the commencement date of the lease, the lease liability is measured at the present value of the lease payments yet to be made.

Many lease agreements include an option enabling the lessee to purchase the asset at the end of the lease term, sometimes at a considerable discount to its expected fair value at that time. If the lessee is reasonably certain that it will purchase the asset, the cost of exercising the option will be included in the calculations as an additional lease payment that is yet to be made.

Discount rate to be used when calculating the lease payments’ present value

The lease payments should be discounted to their present value using the interest rate implicit in the lease. This is the interest rate that would explain the difference between the amount that would be payable at the commencement date in order to buy the right-of-use asset and the total of the lease payments.

This interest rate implicit in the lease is sometimes included in the lease contract but if not the company might still be able to calculate. This however, is not always the case and where the interest rate implicit in the lease cannot be identified, the company should instead discount the lease payments yet to be made using its incremental borrowing rate.

A company’s incremental borrowing rate is the interest rate that the company would expect to have to pay in order to buy a similar right-of-use asset.

Illustration

A company entered into a three year lease agreement on 01/01/2020. On that date it acquired the use of a property in return for an immediate payment of £6,000 plus two additional payments of £6,000 each on 01/01/2021 and 01/01/2022.

In this instance the company was not able determine the interest rate implicit in the lease. It therefore identified its incremental borrowing rate as 5% p.a.

The company can now discount the lease payments to their present value as at 01/01/2020 using a discount rate of 5%.

• The first payment of £6,000 was made on the commencement date of 01/01/2020 and will therefore not be included in the lease liability at the start of the lease
• The second payment of £6,000 will be discounted for one year to its present value on 01/01/2020. The present value is £5,714; i.e. £6,000/1.05
• The second payment of £6,000 will be discounted for two years to its present value of £5,442; i.e. £6,000/(1.05 x 1.05)

The lease liability at the commencement date is therefore £11,156 (i.e. £5,714 plus £5,442).

Initial measurement of the right-of-use asset

This asset will be valued initially by adding the total of any lease payments made at or before the commencement date to the present value of the lease payments yet to be made (i.e. the lease liability at the start of the lease).

Illustration

If we continue with the above illustration, the right-of-use asset would be calculated as the lease payments made on or before the commencement date; that is £6,000 plus the present value of future lease payments which were calculated as £11,156. A total of £17,156.

On the commencement date, the company would therefore record the following two journals (alternatively. this could be recorded in a single journal)

• Dr Property £6,000
• Cr Bank £6,000
• Journal to record the lease payment made on 01/01/2020

• Dr Property £11,156
• Cr Lease liability £11,156
• Journal to record the initial lease liability as at 01/01/2020

The above journals result in an addition of £17,156 to the company’s property and record the initial lease liability of £11,156.

Subsequent measurement of the right-of-use asset

After the commencement date, a lessee shall measure the right-of-use asset by applying the Cost Model. This means that the asset will be depreciated and tested for impairments and its carrying value in the financial statements shall be its cost less accumulated depreciation and any accumulated impairment losses.

If the right-of-use asset relate to a class of property, plant or equipment to which the lessee applies the Revaluation Model, the lessee can choose whether or not to apply the Revaluation Model to the leased asset.

Depreciating a right-of-use asset

The right-of-use asset is normally be depreciated over the shorter of the lease term or the asset’s useful life (this is usually the lease term as there are few leases that would have a term longer than the asset’s useful life). If however, it is expected that the ownership of the asset will transfer to the lessor at the end of the lease term, the asset will be depreciated over the useful life of the underlying asset.

Impairments

Lessees should apply IAS 36 Impairments to determine whether the right-of-use asset is impaired and to account for any impairment losses that are identified.

Subsequent measurement of the lease liability

The lease liability will fall over the term of the lease as lease payments are made. It shall be calculated as following:

1. The carrying amount of the lease liability will be increased by the interest charged on the lease liability (i.e. the lease liability multiplied by the interest rate used previously when calculating the initial lease liability). This lease interest will be recorded as an expense in the Statement of Profit or Loss as a finance cost.
   1. The interest would be recorded in the company’s books by debiting lease interest and crediting lease liabilities
2. The carrying amount of the lease liability will be reduced by the lease payments made
   1. The lease payments would be recorded in the company’s books by debiting lease liabilities and crediting the bank

A cautionary note about calculating interest

When calculating interest to be charged for a period take careful note of whether the lease payments are being made in advance (at the start of a period) or in arrears (at the end of a period).

This is because interest is a charge based on time and if a lease payment is made at the start of a period, there should be no interest on the amount repaid in that period. If however, payment is made at the end of a period, there will be interest charged on the amount repaid in that period (since this amount will have been outstanding over the whole of that period).

Illustration

At the start of its financial year, a company has two lease liabilities. The first is for £4,000 and the second for £6,000. The first lease is paid at a rate of £1,000 per year with the payments being made on the first day of the company’s financial year. The second lease is paid at a rate of £1,500 per year with the payments being made on the last day of the company’s financial year. The relevant interest rate to be applied to both lease agreements is 10%.

Interest on the first lease will be calculated by multiplying the interest rate by the lease liability after we take into account the payment made on the first day of the year.

10% x (4,000 – 1,000) = £300

Interest on the second lease will be calculated by multiplying the interest rate by the lease liability at the start of the year. The lease payment made in the year will not be deducted as this was paid at the end of the year.

10% x £6,000 = £600