Question

On 1 January 20X8, Grabbit plc entered into an agreement to lease a widgeting machine for general use in the business. The agreement, which may not be terminated by either party to it, runs for six years and provides for Grabbit to make an annual rental payment of £92,500 on 31 December each year. The cost of the machine to the lessor was £350,000, and it has no residual value. The machine has a useful economic life of eight years and Grabbit depreciates its property, plant and equipment using the straight-line method.

Required:

(a) Show how Grabbit plc will account for the above transaction in its statement of financial position at 31 December 20X8, and in its statement of comprehensive income for the year then ended, if it capitalizes the leased asset in accordance with the principles laid down in IAS 17.

(b) Explain why the standard setters considered accounting for leases to be an area in need of standardization and discuss the rationale behind the approach adopted in the standard.

(c) The lessor has suggested that the lease could be drawn up with a minimum payment period of one year and an option to renew. Discuss why this might be attractive to the lessee.

Answer 1

a) The lessee Grabbit plc should recognize a right of use asset and liability for lease in its financial statements. This right of use asset and liability is recognized at a fair value of the lease, which is equal to the present value of minimum lease payments over the lease period. The fair value of the lease is calculated as follows:-

Fair value of lease = Annual payment * PVAF(15\%,6 yrs)

\(=£ 92,500^{*} 3.7845=£ 350,066\)

Thus Grabbit plc will recognize the right of use asset and liability at \(£ 350,066 .\) The right of use asset is depreciated on a straight-line basis over 6 years. The year's depreciation ended 31 December,20X8 will be \(£ 58,344(350,066 / 6\) years). The Interest expense for the year ended 31 , December, \(20 \times 8\) will be \(£\) \(52,510\left(350,066^{*} 15 \%\right)\)

The closing Balance of liability in the balance sheet will be \(£ 310,076(350,066+52,510-92,500)\). The closing balance of the right of use asset will be \(£ 291,722(350,066-58,344)\).

b) The accounting for leases becomes complicated due to various terms involved like minimum lease payments, guaranteed residual value, etc. Thus a standardized approach is required to differentiate between financing lease and operating lease and accounting for each type of lease differently. The lessee is required to recognize both rights of use asset and liability in his financial statements because due to control of the asset, a right is acquired by him for the lease term, and he is also liable to pay agreed annual lease payments to the lessor over the lease period.

c) As per IFRS \(16,\) a lessee may elect to account for lease payments as an expense or kept it "off-balance-sheet" for the following two types of leases:

- leases with a lease term of 12 months or less and containing no purchase options

- leases where the underlying asset has a low value when new (such as personal computers or small office furniture items).

In the given case, the lease period is for a minimum of one year. Thus, it can be kept off-balance the sheet as it is covered in the above point. Still, there is an option of renewing, which means it can exceed over 1 year. Thus, he needs to capitalize it on his balance sheet.