Week 3

Week 3

1. New accounting requirements for leases

   • New lease format (AASB 116/ IAS 16)
     • Released on Jan 2016. The core principle of the new accounting standard is that an entity shall recognize assets and liabilities arising from a lease 'to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions'. The new approach would treat all lease contracts as the acquisition of a 'RIGHT TO USE' the leased item for the lease term. The lessee would recognise the following: - an asset representing its right to use the leased for the lease term. - a liability for its obligation to pay rent.
     • Rights to use: transfer of ownership (lessor) to another person (lessee).
   • Old lease format (AASB 117 / IAS 17)
     • If a lease contract was considered to transfer substantially all the 'risks and rewards incidental to ownership of an asset' to the lessee, then it was classified as a 'finance lease'. It must fit the criteria and be non-cancellable. If the lease did not fit the criteria of 'risks and rewards incidental to ownership of an asset', then it would be considered an 'operating lease' (lease terns that would not use most of the assets economic life) regardless if the lease was non-cancellable. This has meant that the associated assets and liabilities of the lease was not being recorded in the balance sheet (between 7% to 90% of debt being left unrecorded in the balance sheet).
     • Example: A machine leased for a fixed term of 5 years; expected life is 10 years. - non-cancellable - no rights to extend the lease term (purchasing machine at end of term) - no guarantees This lease would be deemed 'operating lease; from former accounting standards (AASB 117/ IAS 17) because the term is only 50% of the life of the asset therefore, would not satisfy the requirements to be a 'finance lease' (requires major part of economic life of asset; more then 50%). In turn, no asset or liability would be recognised in the balance sheet. 

2. Core principles of the new leasing format

   • The core principle of the new accounting standard is that an entity shall recognise assets and liabilities arising from a lease. To achieve this objective, it requires assets and liabilities to be recognised by lessee for all leases of more than 12 months - with the asset being a nature of 'right to use' (described in new lease format above) that provides the right to use the lease asset for the term of the lease, including its liabilities. 
   • Exemptions of leases 12 months or less
     • Exceptions that are not included in the new standard are: 1. Leases less then 12 months. 2. Leases of low value assets ($5,000 or less) These exceptions are not recognised to lease-related assets and liabilities. These will be recognised as expenses.
   • Implications of the new accounting standard
     •  For some organisations (e.g. particularly large retailers who lease many retail outlets) many more leased assets and lease liabilities will need to be recognised.   This will increase their reported debt and assets and this will increase their reported leverage. The increased leverage could have implications for various accounting-based debt covenants.  The new leasing standard also means that the expenses tend to be ‘front loaded’—that is, they are higher in the earlier years. This will have implications for reported profits and also for contractual arrangements that use reported profits.     

3. What is a lease?

   • Definition of lease: A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. Underlying asset definition: An asset that is the subject of a lease, for which the right to use that asset has been conveyed to a lessee.
   • When an asset is not deemed a lease
     • A lease exists when the customer (lessee) controls the use of the underlying asset throughout the period. However, if a customer does not have the right to use an identified asset if the supplier has the 'substantive right' to substitute the asset throughout the period, it would not be deemed a lease.  A lease requires an 'identified asset' and there is no 'identified asset' if the supplier has a 'substantive right' to substitute the asset. Substitute right to substitute asset exists when: - the supplier has practical ability to substitute the asset - the supplier can benefit from substituting the asset
   • Lessee
     • An entity that enters into a contract to obtain the right to use an underlying asset for a period of time in exchange for consideration.
   • Lessor
     • An entity that enters into a contract to provide the right to use an underlying asset for a period of time in exchange for consideration.

4. When to recognise a lease

   • At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. Commencement date is defined as: The date on which a lessor makes an underlying asset available for use by a lessee. Usually a fixed point in time defined by the contractual arrangement made in relation to the lease.    
   • Right-of-use asset
     • Right-of-use asset is an asset consistent with the conceptual framework (when to recognize an asset).
   • Liabilities
     • Obligation to make a lease payment is a liability consistent with the conceptual framework.

5. Accounting for leases by lessees

   • Initial measurement
     • At commencement date, a lessee shall recognise a right-to-use asset and lease liability. Commencement date: At commencement date, a lessee will measure the liability as present value of the lease payments that are not yet paid. Lease payments is discounted using the interest rate in the lease, if the rate can be determined. If not, the lessee will use the incremental borrowing rate. 
     • The requirements for 'lease payments' and 'interest rate implicit in the lease' are considered below...
     • 1. Fixed payment
       • fixed payments less any lease incentives receivable. 
     • 2. rate
       • rate is measured using the index or rate as at commencement date.
     • 3. residual value guarantee
       • Residual value guarantee: A guarantee made to a lessor by party unrelated to the lessor that the value of the underlying asset at the end of a lease will be at least a specified amount. It provides an assurance to the lessor that the assets to the lessor will have a certain value at the end of the lease term.
       • Unguaranteed residual value: The amount that the underlying asset is expected to be valued at when the lease is over, but this amount is not guaranteed by the lessee, meaning that the risks related to asset value at the end of the lease are borne by the lessor (lessor must determine how it manages this risk).
     • 4. purchase option
       • Bargain purchase option: If there is an option within the lease contract that provides the lessee the right, usually at the end of the term, to acquire the underlying asset at the amount well below its expected fair value then the expectation would be that the lessee would exercise that option to acquire the underlying asset.
     • 5. payments to terminate the lease
   • Interest rate to be applied
     • The interest rate implicit in the lease is to be used to discount the lease payments if it can be determined; if not,, the lessee's incremental borrowing rate is to be used.
     • Rate implicit in the lease: This is the rate of interest being charges by the lessor and is defined in the accounting standards as: - The rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.     
     • Incremental borrowing rate: (basically use the index sheet) The lessee's incremental borrowing rate is the rate of interest that a lessee would have to pay to borrower a similar term, and with similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.
   • Subsequent measurement
     • Accounting standards requires the lease liability and asset to be accounted for in a manner consistent with how other financial liabilities and assets are accounted for: - Liabilities are accounted for on an amortised cost basis; this means the liability will be reduced each period. - Assets should be amortised using the amortisation (depreciation) policies. Failure to amortise the leased asset could mean that the leased asset remains in the accounts indefinitely. 
     • With bargain purchase: Asset should be depreciated over the useful life of the asset. Without bargain purchase: Asset should be depreciated over the lease term.
     • Amortisation vs. Depreciation Tangible assets are depreciated over the useful life of the asset whereas intangible assets are amortised. 
     • calculating interest rate
       • Interest rate = Present value * relevant interest rate
     • Calculating amortisation
       • Amortisation = Cost of asset / term of the lease using straight-line method

6. Service component of a contract

   • Contracts for the use of an asset often also include associated services (a service agreement).  E.g.A customer might sign a contract to lease a car and the contract could include a requirement that the lessee pay a specific ongoing amount to have the car maintained and serviced by a particular service provider.  The lease contract is considered seperate from the service contract. The service cost component is not treated as part of the ‘lease’ and therefore is not capitalised as part of the lease liability or lease asset.    
   • With a service
     • With a service, the supplier controls the use of the item.
   • With a lease
     • With a lease, the customer controls the use of the item.

7. The meaning of 'lease term'

   • Lease term is defined within the accounting standards as: The non-cancellable period for which a lessee has the right to use an underlying asset, together with both: (a) periods covered by an option to extent the lease if the lessee is reasonably certain to exercise that option; (b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.