Notes on Leases and IFRS 16

Overview of Leases

• New Standard: IFRS 16, effective January 1, 2019.
• Definition of Lease: A contract conveying the right to use an underlying asset for a period in exchange for consideration (payment).
• Substance over Form: Although leases may appear as rental transactions, they can have different implications.

Key Concepts

Right to Control the Asset

1. Economic Benefits: Lessee must obtain substantially all economic benefits from the use of the asset.
2. Directing Use: Lessee has the right to direct how and for what purpose the asset is used throughout the lease term.

Types of Leases

1. Operating Lease

• Definition: A lease that does not transfer substantially all risks and rewards of ownership.
• Ownership: The lessor retains ownership of the asset.
• Accounting: Lease payments recognized as rental income on a straight-line basis.

2. Finance Lease

• Definition: A lease that transfers substantially all risks and rewards of ownership.
• Substance: Treated as a sale transaction, with lease payments considered installment payments.
• Criteria for Classification:
  • Transfer of Ownership: If the lease transfers ownership of the asset at the end of the lease term.
  • Option to Purchase: If lessee has an option to purchase at a price significantly lower than fair value.
  • Material Lease Term: Lease term covers a major part (75% or more) of the asset’s economic life.
  • Present Value of Payments: Present value of lease payments must be at least 90% of the asset’s fair value.

Accounting for Leases

• Lessors' Accounting: Recognize lease payments on a straight-line basis or other systematic basis.
• Initial Direct Costs: Expenses incurred by the lessor are recognized over the lease term.
• Executory Costs: Costs associated with maintaining the asset are expensed as incurred.
• Refundable Security Deposits: Classified as liabilities, not recognized as income until refunded.
• Lease Bonuses: Additional payments are treated as unearned revenue and recognized as income over the lease term.

Illustrative Problems

Problem 1

• Scenario: Leasing office space under an operating lease with a low occupancy rate.
• Rent Income Calculation: Total rent over three years is divided to find annual income.
• Final Answer: 1.8 million reported for the year ended December 30, 2022.

Problem 2

• Scenario: Lease with a rent incentive.
• Rent Income Calculation: Total rent income divided by the lease term to find annual income.
• Final Answer: 1.8 million reported for the year.

Problem 3

• Scenario: Monthly rentals over four years.
• Rent Receivable Calculation: Total rentals received from 2017 to 2018.
• Final Answer: 1.2 million for December 31, 2018.

Problem 4

• Scenario: Lease with initial direct costs and executory costs.
• Net Rent Income Calculation: Annual rent income minus expenses.
• Final Answer: 275,000 for 2022.

Problem 5

• Scenario: Lease with a bonus and security deposit.
• Rent Income Calculation: Total rent income plus amortized bonus.
• Final Answer: 1 million for the year.

Conclusion

• Understanding the distinctions between operating and finance leases is crucial for accurate accounting.
• Effective application of IFRS 16 is essential for financial reporting and compliance.