IFRS 16: Leases

The present report is developed for providing an understanding of the process used for accounting for finance leases by business entities. A lease can be defined as a contract in which an asset such as property is transferred to another for using that asset for achieving specific returns such as money or assets. There are two major types of leases used in accounting these are operating and financial leases. In this context, a finance lease can be described as a lease for transferring the overall risks and rewards associated with a leased asset to the lessee. IASB (International Accounting Standard Board) has advocated the use of IFRS 16 for reporting of the accounting transaction related to lease.

The standard has eliminated the need for classifying the leases separately under operating or finance leases for a lessee. The leases are recorded by recognition of the present value of lease payments and depicting them either as lease assets or in combination with properly, plant or equipment. The recognition of lease payments in the financial reports of a company ensures that it meets its financial liability as they become due. In this context, the present assessment is undertaken for present a discussion in relation to the accounting for finance leases by manufactures or dealer lessors. In addition to this, it has prepared journal entries for Gali Ltd in relation to the impairment loses that it has incurred by using the information provided in context of carrying amount of the assets.

The standards of IFRS 16 are developed mainly to provide guidance for both the lessees and the lessor in relation to the application of accounting policies for reporting leases. The finance leases are different from that of an operating lease as it involves pre-determination of the amount to be realized after completion of the lease term. The lease term can be sated as the time-period between the dates from which lessee possess the authority to use the lease asset without any further payment (IFRS 16 Leases, 2018). The accounting for finance leases during the financial reporting consists of the process of initial recognition, measurement and disclosure as stated as follows:

Recognition

• The lessees are entities to recognize the finance leases as an asset or liability in its balance sheet at the fair value of the leased property
• The non-recognition of the lease transaction in the balance sheet can lead to understating the economic resource of an entity by understating its financial position

Measurement

• The minimum lease payments should be determined between the finance charge and the reduction of the outstanding liability.
• The amount of depreciation incurred on a leased asset need is attributed to the accounting period during which an asset is used

Disclosure

• The net carrying amount of the finance leases need to be disclosed at the end of a reporting period for each asset class
• Contingent rents should be recognized as expense in the accounting period (IFRS 16, Leases, 2017)

The accounting of finance leases has been provided in accounting standard IFRS 16: Leases. To initial recognize the finance leases in the books of accounts, lessor should take the value of lease in their balance sheet under the heading receivables. The value of leases should be equal to the net investment in leases. In general, all the risks and rewards related to the legal ownership, under the finance lease have been transferred by the lessor to the lessee. The payment received under lease tenure is treated as repayment of principle amount, finance income that has to be reimbursed and rewards that lessor received for providing the lessee the lease assets and providing services (Effects Analysis International Financial Reporting Standard, 2016).

To calculate the value of lease, the lessor has to determine the initial direct cost that has been levied under the lease arrangement. The initial direct cost includes the amount such as commissions, legal fees, and other internal cost that is incremental in nature and that is directly attributable to negotiating and arranging the lease agreement. The direct cost of lease does not cover the expenses that are occurred in relation to arrangement of lease by the sales and marketing team. After calculating the value of lease that has to be initial recognised in the balance sheet the treatment in books or manufacture or dealers have been specially provided in IFRS 16. As per IFRS 16, the cost incurred by the manufacturers and dealers lessor in relation to negotiating and also arranging the lease has to be excluded from the value of initial direct cost. It means the net investment in lease does not include direct cost occurred in relation to the leases. All the direct cost incurred in relation to the arrangement and negotiating lease is taken to the income statement as expenses in the period when the revenue against that has been recognised (IFRS 16 – The new leases standard, 2016). The value of lease has to be initial recognised at net investment value in lease. In case of manufacturers or dealer lessor the value of net investment here means total values less any cost incurred in arranging or negotiating the lease. As provided earlier in this para that any direct expenses that have incurred by manufacturer or dealer lessor has to be taken to income statement as expenses (IFRS 16, Leases, 2017).

Accounting for Finance Leases in the Books of Accounts of Manufacturers or Dealer Lessor

Manufacturing or dealer lessors receive the finance income from the finance leases which they made agreement with. As per IFRS 16, the recognition of income from the finance income is typically based on the pattern that reflects a constant rate of return on the net investment in leases by lessor. As per the accounting method, lessor has to prepare a chart that allocates the finance income, received from the lessee, over the terms of lease in systematic and prorate basis (rational basis). The lease payments from the lessee (excluding the cost of services) have to apply to the gross investment value shown in balance sheet in order to reduce the value of principle and unearned finance income. It will offset the value of lease assets and liabilities together. As per IFRS 16, lessor has to be periodically review the value of unguaranteed residual values (used in calculating the value of lease) in order to recognize the any reduction in value to the value of income allocated over the useful lease term. In case of manufacturers or dealers lessor the value of selling profit or loss as per the policies that has been used by the entity as outright sales. In case lessor intentionally quotes the low interest rates the value of selling profit has to be restricted to the market interest rate. There is option with the manufacturer or dealer lessor to make offer to the lessee to either buy or lessee the asset at the end of lease term. These transactions will give rise to accounting of two types of income. Firstly, the profit or loss from the sale of lease asset at normal selling price less any trade discounts and secondly finance income over the lease terms.

Sales revenue recognised by manufacturer or dealer lessor in book of accounts lower of fair value of assets or the present value of minimum lease payments that is computed at the market rate of interest. The cost of sale related to the lease assets is calculated as cost (carrying amount) less the present of unguaranteed residual value. The difference that arises due to sale revenue and cost of sales is known as selling profit and it should be recognised as company policy of outright sales (IFRS 16 Leases, 2018).

Lessor has to made disclosers regarding the value of finance lease in relation of all the finance lease held by them and bifurcate them as the lease payments that has to be received in three board categories i.e. not later than one year, later than one year but not later than one year and later than five years.

Impairment loss can be stated as reduction occurred in the net carrying value of an asset. The value of an asset is impaired when the estimated future cash inflow from an asset is less that in its book value. The loss realized by an entity due to asset impairment need to be debited as Loss on Impairment through a journal entry (Impairment accounting – the basics of IAS 36 Impairment of Assets, 2010). The journal entries for impairment loss of Gali Ltd are calculated by adjusting the fixed assets of the company. It is calculated by deduction of value in use from the net carrying value of an asset. The calculation does not involve consideration of investor and it is attributed primarily by allocating it completely to the goodwill and then dividing it among other assets on a pro rata basis (IAS 36 Impairment of Assets, 2017). 

Assets	Carrying Amount
Equipment	$               578,700.00
Franchise	$               133,000.00
Furniture	$                 84,000.00
Inventory	$                 36,000.00
Goodwill	$                 30,000.00
Total CA	$               861,700.00

Gali Ltd calculated the value in use of the division to be:	$                     771,700.00
Fair value of equipment  less cost of disposal is	$                     556,882.00

Assets	Carrying Value of assets	Impairment on pro rata basis	Impairment Loss	Carrying Value (Adjusted)
Items not to be adjusted
Goodwill	$                      30,000.00		$                       30,000.00	$                       –
Items to be adjusted
Equipment	$                   578,700.00	578700/795700*60000	$                       43,637.05	$      535,062.95
Franchise	$                   133,000.00	133000/795700*60000	$                       10,028.91	$      122,971.09
Furniture	$                      84,000.00	84000/795700*60000	$                          6,334.05	$        77,665.95
			$                       60,000.00
Value in use before adjustment after goodwill	$                   795,700.00		Value in use after adjustment after goodwill*	$      735,700.00

* Value in use of division after deducting the value of inventory	$                     735,700.00
Therefore adjustment to be made is as follows	$                       60,000.00

As the fair value of equipment is greater than the revaluation value so it is need to be adjusted
Assets	Carrying Amount	Pro Rata	Impairment Loss/ gain	Adj. CA
Equipment	535062.95		21819.05	556882.00
Franchise	122971.09	122971.09/200637.05*21819.0	-13372.97	109598.13
Furniture	77665.95	77665.95/200637.05*21819.0	-8446.08	69219.87
	200637.05			735700.00

(IAS 36 Impairment of Assets, 2017)

Detailed Display of impairment  and adjusted value of assets
Assets	Carrying Amount	Impairment Loss	Adj. CA
Goodwill	$            30,000.00	$                                                     30,000	$                                       –
Equipment	$          578,700.00	$                                      21,818.00	$                     556,882.00
Franchise	$          133,000.00	$                                      23,401.87	$                     109,598.13
Furniture	$            84,000.00	$                                      14,780.13	$                       69,219.87
	$          825,700.00	$                                      60,000.00	$                     735,700.00

Impairment loss on assets of CGU   Dr $ 90000.00

To Goodwill $30000.00

To Impairment Loss Equipment $21818.00

To Impairment Loss Franchise $23401.87

To Impairment Loss Furniture $14,780.13

(IAS 36 Impairment of Assets, 2017)

Conclusion:

The accounting of finance lease in book lessor has been defined in IFRS 16 and under this accounting lessor has to show complete lease information in book of accounts. The accounting of finance leases in book of lessor is divided in three broad categories. First there is need to initial recognize the value of lease, after that there is need to make changes in value of leases due to change in value of different items in lease accounting and lastly there is need to make the disclosures in book of accounts.

References:

Effects Analysis International Financial Reporting Standard. 2016. IFRS 16 Leases. [Online]. Available at: https://www.ifrs.org/-/media/project/leases/ifrs/published-documents/ifrs16-effects-analysis.pdf [Accessed on: 28 September 2018].

IAS 36 Impairment of Assets. 2017. [Online] Available at: https://www.ifrs.org/issued-standards/list-of-standards/ias-36-impairment-of-assets/ [Accessed on: 28 September 2018].

IFRS 16 – The new leases standard. 2016. [Online]. Available at: https://www.pwc.com/gx/en/services/audit-assurance/assets/ifrs-16-new-leases.pdf [Accessed on: 28 September 2018].

IFRS 16 Leases. 2018. [Online]. Available at: https://www.ifrs.org/issued-standards/list-of-standards/ifrs-16-leases/#about [Accessed on: 28 September 2018].

IFRS 16, Leases. 2017. [Online]. Available at: https://www.accaglobal.com/an/en/student/exam-support-resources/fundamentals-exams-study-resources/f7/technical-articles/ifrs16.html [Accessed on: 28 September 2018].

Impairment accounting – the basics of IAS 36 Impairment of Assets. 2010. [Online] Available at: https://www.ey.com/Publication/vwLUAssets/Impairment_accounting_the_basics_of_IAS_36_Impairment_of_Assets/$FILE/Impairment_accounting_IAS_36.pdf  [Accessed on: 28 September 2018].