Comprehensive Study Guide on Accounting for Leases (AASB 16/IFRS 16)
Introduction and Scope of Lease Accounting
Definition of Leases: Leases serve as a mechanism for gaining the rights to use an asset without the necessity of owning the asset itself.
Nature of Payments: Under a lease arrangement, payments are made by the user in exchange for the right to use the asset for a specified period of time.
Regulatory Framework: The standard AASB 16/IFRS 16 Leases replaces the previous standard AASB 117/IAS 17.
Requirement for Lessees: The lessee is required to recognize all their leases on the statement of financial position (balance sheet).
Objectives of the Standard: The implementation of AASB 16/IFRS 16 is intended to result in a more faithful representation of financial position, enhanced disclosures, and greater transparency for stakeholders.
Defining a Lease (AASB 16/IFRS 16)
Formal Definition: A lease is defined as a contract, or part of a contract, that conveys the right to use an asset (referred to as the underlying asset) for a period of time in exchange for consideration.
Essential Element: The transfer of the "right to use" is the essential factor in determining whether a contract is or contains a lease.
Identified Asset: The terms "underlying asset" and "identified asset" are used interchangeably within the standard.
Customer's Ability to Direct Use: Evidence that a customer can direct the use of the asset is typically found in whether they can determine:
How and for what purpose the asset is employed.
How the asset is operated.
Who operates the asset.
Substantive Substitution Rights: If the lessor has a substantive right to substitute the asset throughout the period of use (e.g., they can replace the asset with an alternative and benefit economically from doing so), the contract is not recognized as a lease, because the right to use a specific asset has not been transferred.
Parties to the Contract:
Lessor: The owner of the asset who retains legal ownership under the lease arrangement.
Lessee: The party that obtains the right to use the asset (rather than ownership) in return for a payment or series of payments.
Non-lease Components: These can be considered as part of the agreement if they are relatively small or involve specific intangible assets.
Accounting for Leases by Lessees
Single Lessee Accounting Model: AASB 16/IFRS 16 adopts a single model for all leases with a term of more than 12 months. It requires the lessee to recognize an asset and a related liability for all leases, unless the underlying asset is of low value.
Initial Recognition: At the commencement date of the lease, the lessee must record the following journal entry:
Dr Right-of-use asset
Cr Lease liability
Measurement of Lease Liability:
The liability is measured at the present value of the lease payments that are not paid at the commencement date.
The present value () is calculated using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee's incremental borrowing rate is used.
Components of Lease Payments:
Fixed payments.
Variable lease payments.
The exercise price of a purchase option (if the lessee is reasonably certain to exercise it).
Payments of penalties for terminating the lease.
Guaranteed residual value.
Initial Measurement of Right-of-Use (ROU) Asset:
Measured initially at cost, following principles similar to AASB 116/IAS 16 Property, Plant and Equipment.
Cost elements include:
The initial amount of the lease liability.
Lease payments made at or before the commencement date.
Initial direct costs incurred by the lessee.
An estimate of costs to dismantle and remove the underlying asset or restore the site.
Implicit Interest Rate Calculation: This is the rate of interest that causes the equality of the following equation from the lessor's viewpoint:
Determining this rate often requires a process of trial and error, typically performed via spreadsheet or online formulas.
Subsequent Measurement:
Lease Liability: Over the lease term, payments must be divided into:
Interest expense incurred on the liability.
Reduction of the principal lease liability.
ROU Asset: Subsequent to initial recognition, the asset is subject to depreciation in accordance with AASB 116/IAS 16. Depreciable assets are those where benefits are expected to expire over time or through use.
Accounting for Executory Costs: The standard does not detail payments for non-lease components (e.g., additional services from the lessor). These are effectively borne by the lessee and should be recognized as an expense or a prepayment.
Adjustments and Modifications for Lessees
Lease Term Changes: Lessees must monitor leases for changes within their control. If the lease term estimates change, the lessee remeasures the lease liability using revised payments and a revised discount rate at the reassessment date. The adjustment is reflected in the ROU asset.
Variable Lease Payments: If payments are linked to a market rate or index, the lessee remeasures the liability only when the adjustment takes effect. An unchanged discount rate is usually used unless the change results from floating interest rates.
Lease Modifications: Defined as a change in scope or consideration not in the original terms (e.g., adding assets, changing the term, or changing payments).
Treatment: Modifications are treated as a new lease (rather than an adjustment) if the changes are substantively a new lease.
Exemptions: A lessee may choose not to apply the standard requirements for:
Short-term leases: Term of 12 months or less with no purchase option.
Low-value assets: Leases where the underlying asset is of low value.
Classifying and Accounting for Leases by Lessors
Classification Categories: Lessors must classify every lease as either:
Finance Lease: Transfers substantially all risks and rewards incidental to ownership.
Operating Lease: Does not transfer substantially all risks and rewards incidental to ownership.
Finance Lease Classification Guidance: AASB 16/IFRS 16 provides non-exhaustive indicators for finance lease classification. Finance leases are further divided into:
Finance leases involving a financier lessor.
Finance leases involving manufacturers or dealers.
Accounting by Financier Lessors:
Initial Recognition: The lessor must derecognize the underlying asset and record a lease receivable (net investment in the lease).
Net Investment: The gross investment discounted at the implicit interest rate.
Gross Investment: Sum of .
Subsequent Measurement: Receipts are analyzed into:
Interest revenue earned.
Reduction of the lease receivable.
Reimbursement of costs paid on behalf of the lessee.
Accounting by Manufacturer or Dealer Lessors:
These arrangements yield two income types:
Selling Profit or Loss: Similar to an outright sale, recognized at the commencement of the lease (includes sales revenue, cost of sales, and initial direct costs).
Interest Revenue/Finance Income: Recognized over the lease term.
Direct Costs: Unlike financier lessors, manufacturer/dealer lessors expense initial direct costs immediately rather than including them in the lease receivable.
Subsequent Measurement: Follows the same logic as financier lessors.
Accounting for Operating Leases by Lessors:
Income Recognition: Receipts are accounted for as income, typically on a straight-line basis over the lease term.
Initial Direct Costs: Added to the carrying amount of the underlying asset and expensed over the lease term on the same basis as lease income.
Depreciation: The underlying asset is depreciated according to the lessor's normal policy (AASB 116/IAS 16 or AASB 138/IAS 38).
Disclosure Requirements
General Requirement: AASB 16/IFRS 16 mandates extensive disclosures for both parties.
Lessor Finance Leases: Must disclose future lease payments and their present values.
Lessor Operating Leases: Must disclose the total amount and timing of lease payments.