Accounting Standards Bitesize
Leases
Angus Kemp MA(Hons) CertAcc CA MBA Med
Island Consortium Limited
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The Financial Reporting Framework
Introduction
The importance of a conceptual framework
A conceptual framework is a set of theoretical principles and concepts that underlie the
preparation and presentation of financial statements.
If no conceptual framework existed, then accounting standards would be produced on a
haphazard basis as particular issues and circumstances arose. These accounting standards might
be inconsistent with one another, or perhaps even contradictory.
A strong conceptual framework means that there are principles in place from which all future
accounting standards draw. It also acts as a reference point for the preparers of financial
statements if no accounting standard governs a particular transaction (although this will be
extremely rare).
That is why The Conceptual Framework for Financial Reporting was issued.
Financial statements and the reporting entity
Financial statements
The Conceptual Framework notes that financial statements are a particular type of financial
report.
The purpose of financial statements is to provide information to users about an entity's:
•
assets
•
liabilities
•
equity
•
income
•
expenses.
This information is provided in:
•
a statement of financial position
•
statements of financial performance
•
other statements, such as statements of cash flows and notes.
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Financial statements are prepared on the assumption that the entity is a going concern. This
means that it will continue to operate for the foreseeable future. If this assumption is not
accurate, then the financial statements should be prepared on a different basis.
The elements of financial statements
The elements are the building blocks of financial statements:
•
statements of financial position report assets, liabilities and equity
•
statements of financial performance report income and expenses.
Definitions of the elements are as follows:
Asset – “A present economic resource controlled by an entity as a result of a past event”
Liability – “A present obligation of the entity to transfer an economic resource as a result of a
past event.”
Equity – “The residual interest in the net assets of an entity.”
Income – “Increases in assets or decreases in liabilities that result in an increase to equity
(excluding contributions from equity holders).”
Expenses - “Decreases in assets or increases in liabilities that result in decreases to equity
(excluding distributions to equity holders).”
Recognition and derecognition
Recognition
Items are only recognised in the financial statements if they meet the definition of one of the
elements.
Derecognition
Derecognition is the removal of some or all of an asset or liability from the statement of financial
position. This normally occurs when the entity:
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loses control of the asset, or
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has no present obligation for the liability
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Measurement
There are a number of measurement bases mentioned in the Accounting Standards Board's
Conceptual Framework for Financial Reporting. The main ones are:
•
Historical cost – The actual amount of cash paid or consideration given for the item
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Fair value – The amount the item would realise in an orderly arm's length disposal
•
Value in use – The discounted value of future cash flows
Some items, such as revalued assets or investments, may be revalued to fair value, being the
realisable value.
Present value may be used in respect of items with cash flows receivable/payable in a future period.
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Leases
Definitions
A lease is a contract, or part of a contract, that conveys the right to use an underlying asset for a
period of time in exchange for consideration.
The lessor is the entity that provides the right-of-use asset and, in exchange, receives
consideration.
The lessee is the entity that obtains use of the right-of-use asset and, in exchange, transfers
consideration.
A right-of-use asset is the lessee's right to use an underlying asset over the lease term.
2 Identifying a lease
A contract contains a lease if it conveys the right to control the use of an identified asset for
a period of time in exchange for consideration.
The customer controls the asset's use if it has:
•
the right to substantially all of the identified asset's economic benefits, and
•
the right to direct the identified asset's use.
Lessee accounting
Basic principles
FRS 102 requires lessees to classify leases as operating leases or finance leases and account for
them as follows:
•
Finance leases – an asset and liability is recognised at the lower of the asset's fair value
and the present value of the minimum lease payments. Depreciation on the asset and
interest on the liability is charged to profit or loss.
•
Operating leases – lease payments are recognised as an expense in profit or loss on a
straight line basis.
This means that no liability is recognised in respect of operating leases in the financial
statements of a lessee, even though it meets the definition of a liability as outlined in FRS 102.
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Initial measurement
The liability
The lease liability is initially measured at the present value of the lease payments that have not
yet been paid.
The discount rate should be the rate implicit in the lease. If this cannot be determined, then the
entity should use its incremental borrowing rate (the rate at which it could borrow funds to
purchase a similar asset).
The right-of-use asset
The right-of-use asset is initially recognised at cost.
Subsequent measurement
The liability
The carrying amount of the lease liability is increased by the interest charge. This interest is also
recorded in the statement of profit or loss.
The right-of-use asset
The right-of-use asset is measured using the cost model (unless another measurement model is
chosen). This means that it is measured at its initial cost less accumulated depreciation and
impairment losses.
Depreciation is calculated as follows:
•
If ownership of the asset transfers to the lessee at the end of the lease term then
depreciation should be charged over the asset's remaining useful life
•
Otherwise, depreciation is charged over the shorter of the useful life and the lease term
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Lessee disclosures
If right-of-use assets are not presented separately on the face of the statement of financial
position then they should be included within the line item that would have been used if the assets
were owned. The entity must disclose which line item includes right-of-use assets.
The following disclosures are required:
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The depreciation charged on right-of-use assets
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Interest expenses on lease liabilities
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The expense relating to short-term leases and leases of low value assets
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Cash outflows for leased assets
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Right-of-use asset additions
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The carrying amount of right-of-use assets
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A maturity analysis of lease liabilities.
Lessor accounting
A lessor must classify its leases as finance leases or operating leases.
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A finance lease is a lease where substantially all of the risks and rewards of the underlying asset
transfer to the lessee.
An operating lease is a lease that does not meet the definition of a finance lease.
Finance leases
Initial treatment
At the inception of a lease, lessors present assets held under a finance lease as a receivable.
Subsequent treatment
The subsequent treatment of the finance lease is as follows:
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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.
Operating leases
A lessor recognises income from an operating lease on a straight line basis over the lease term.
Lessor disclosures
The underlying asset should be presented in the statement of financial position according to its
nature.
For finance leases, the following disclosures are required:
•
Profit or loss arising on the sale
•
Finance income
•
Data about changes in the carrying amount of the net investment in finance leases
•
A maturity analysis of lease payments receivable.
For operating leases, lessors should disclose a maturity analysis of lease payments receivable.
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Short-life and low value assets
If the lease is short-term (12 months or less at the inception date) or of a low value then a simplified
treatment is allowed.
In these cases, the lessee can choose to recognise the lease payments in profit or loss on a straight
line basis. No lease liability or right-of-use asset would therefore be recognised.
IFRS 16 Leases does not specify a particular monetary amount below which an asset would be considered
'low value', although the basis for conclusion indicates a value of $5,000 as a guide.
The assessment of whether an asset qualifies as having a 'low value' must be made based on its value when
new. Therefore, a car would not qualify as a low value asset, even if it was very old at the commencement of
the le
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Example 1 – Leases: Lessor Accounting
Vache leases machinery to Toro. The lease is for four years at an annual cost of $2,000 payable
annually in arrears. The present value of the lease payments is $5,710. The implicit rate of
interest is 15%.
Required:
How should Vache account for their net investment in the lease?
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Example 2 – Leases: Operating lease
Oroc hires out industrial plant on long-term operating leases. On 1 January 20X1, it entered into
a seven-year lease on a mobile crane. The terms of the lease are $175,000 payable on 1 January
20X1, followed by six rentals of $70,000 payable on 1 January 20X2 – 20X7. The crane will be
returned to Oroc on 31 December 20X7. The crane originally cost $880,000 and has a 25-year
useful life with no residual value.
Required:
Discuss the accounting treatment of the above in the year ended 31 December 20X1.
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Example 3 - Leases
1 An entity leases a computer with legal title of the asset passing after two years. The entity usually
depreciates computers over three years. The entity also leases a machine for seven years but legal
title does not pass to the entity at the end of the agreement. The entity usually depreciates
machinery over ten years.
Over what period of time should the computer and machine be depreciated?
2 IFRS 16 Leases permits a simplified treatment for certain assets.
For which of the following leases would the simplified treatment not be permitted?
AMotor car with cost of $10,000, leased for 9 months
BTelephone with cost of $500, leased for 24 months
CMotor car with original cost of $10,000, current fair value of $500, leased for 24 months
DDesk with cost of $750, leased for 24 months
3 CS acquired a machine via a lease agreement on 1 January 20X7. The lease was for a five-year
term with rentals of $20,000 per year payable in arrears. The present value of the lease rentals was
$80,000 and the annual interest rate implicit in the lease was 7.93%.
Calculate the non-current liability and current liability figures to be shown in CS's
statement of financial position at 31 December 20X8.
Non-current liability _______________
Current liability _______________
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Solutions to lecture examples
Example 1 – Leases: Lessor Accounting
Vache recognises the net investment in the lease as a receivable. This is the present value of the
lease payments of $5,710.
The receivable is increased by finance income. The receivable is reduced by the cash receipts.
Year
Opening balance
Finance income
15%
Cash received
Closing balance
1
5,710
856
(2,000)
4,566
2
4,566
685
(2,000)
3,251
3
3,251
488
(2,000)
1,739
4
1,739
261
(2,000)
-
Extract from the statement of financial position at the end of Year 1
Non current assets:
Net investment in finance leases
3,251
Current assets:
Net investment in finance leases
1,315
Note: the current asset is the next instalment less next year's interest ($2,000 – $685). The noncurrent asset is the remainder ($4,566 – $1,315).
Example 2 – Leases: Operating lease
Oroc holds the crane in its statement of financial position and depreciates it over its useful life.
The annual depreciation charge is $35,200 ($880,000/25 years).
Rental income must be recognised in profit or loss on a straight line basis. Total lease receipts
are $595,000 ($175,000 + ($70,000 × 6 years)). Annual rental income is therefore $85,000
($595,000/7 years). The statement of financial position includes a liability for deferred income of
$90,000 ($175,000 – $85,000).
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Example 3 - Leases
1 C – Assets should usually be depreciated over the lease term. However, the ownership of the
computer transfers at the end of the lease, so the computer will be depreciated over its useful life of
3 years.
2 C – The simplified treatment under IFRS 16 Leases is permitted for assets of low-value or where
the lease period is for less than 12 months. The standard does not specify a monetary amount for
lowvalue but within the basis for conclusion indicates $5,000 or below as a guide. Low-value is
based on original cost.
3 Non-current liability – $35,697
Current liability – $15,908
Working:
The total liability at the end of 20X8 = $51,605
The non-current liability = $35,697 (amount still owing in one year's time)
The current liability = $15,908 ($51,605 – $35,697)
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