Ifrs Finance Lease Example

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A finance lease, under IFRS 16, is a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee. This is essentially treating the leased asset as if the lessee had purchased it outright. Let’s illustrate this with an example:

Example: Crane Lease

Assume ABC Company needs a specialized crane for a large construction project. Instead of buying the crane outright, they enter into a lease agreement with XYZ Leasing for a period of 5 years. The following details are relevant:

• Lease term: 5 years
• Annual lease payments: $50,000, payable at the beginning of each year
• Useful life of the crane: 7 years
• Fair value of the crane at the inception of the lease: $220,000
• Implicit interest rate in the lease (if readily determinable): 10% per annum. If not readily determinable, ABC Company’s incremental borrowing rate is 11%. We’ll use 11% for this example.
• ABC Company intends to use the crane for its entire useful life.
• Ownership of the crane does not transfer to ABC Company at the end of the lease term.

Analysis:

Several factors point to this being a finance lease:

• Lease term covering major part of the asset’s life: The lease term of 5 years covers a significant portion (71%) of the crane’s useful life of 7 years.
• Present value of lease payments approximates fair value: We need to calculate the present value of the lease payments to determine if it is close to the crane’s fair value. Using ABC Company’s incremental borrowing rate of 11%, the present value of the 5 annual payments of $50,000 (payable at the beginning of the year) is approximately $205,903. This is close to the fair value of $220,000. (A present value calculation, often done in spreadsheets, discounts future payments to their value today, considering the time value of money).
• Specialized Asset: The description mentions the crane is specialized, implying its utility might be significantly diminished to other users at the end of the lease term.

Accounting Treatment:

ABC Company, as the lessee, will record the following at the commencement of the lease:

• Right-of-Use (ROU) Asset: An asset representing their right to use the crane. This is initially measured at the present value of the lease payments ($205,903 in this example).
• Lease Liability: A liability representing their obligation to make lease payments. This is also initially measured at the present value of the lease payments ($205,903).

Over the lease term, ABC Company will:

• Depreciate the ROU asset: The ROU asset is depreciated over the 5-year lease term, assuming the lease term is shorter than the asset’s useful life and ownership doesn’t transfer at the end of the lease. In this case, depreciation expense would be $205,903 / 5 = $41,180.60 per year.
• Recognize interest expense: Interest expense is calculated on the outstanding lease liability balance using the effective interest method.
• Reduce the lease liability: Each lease payment is allocated between interest expense and a reduction of the lease liability.

XYZ Leasing (the lessor) would classify this as a finance lease and derecognize the crane from their balance sheet, recognizing a lease receivable instead. They would then recognize interest income over the lease term.

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