Intermediate Accounting — Leases: Right-of-Use Assets and Lease Liabilities

K-IFRS 1116 Leases (IFRS 16), effective from 2019, transformed lessee accounting. Previously, operating leases were treated simply as rent expense and the liabilities did not appear in the statement of financial position. Now a right-of-use asset and a lease liability are recognized for most leases. Lessors still distinguish finance leases from operating leases as before.

1. Identifying a lease

A contract is a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Two things are examined.

Identified asset: an asset specified explicitly or implicitly in the contract. If the supplier has a substantive right to substitute the asset throughout the period of use and would benefit economically from doing so, it is not an identified asset.
Right to control use: the customer obtains substantially all the economic benefits from use and has the right to direct how and for what purpose the asset is used.

2. Lessee: initial measurement

Lease liability and right-of-use asset

\begin{aligned}\text{Lease liability} &= \text{PV}(\text{lease payments not yet paid}) \\ \text{Right-of-use asset} &= \text{Lease liability} + \text{Prepaid lease payments} + \text{Initial direct costs} + \text{Estimated restoration costs} - \text{Lease incentives received}\end{aligned}

The discount rate is the interest rate implicit in the lease if readily determinable; otherwise, the lessee's incremental borrowing rate.

Lease payments include fixed payments, variable payments that depend on an index or rate (initially measured using the index at the commencement date), amounts expected to be payable under residual value guarantees, the exercise price of a purchase option reasonably certain to be exercised, and termination penalties. Variable payments linked to sales are not included in the lease liability and are expensed as incurred.

3. Worked example

At the beginning of 20X1 company EE leased equipment for three years. Payments are ₩4 million at each year-end, the incremental borrowing rate is 8% (three-year annuity factor 2.5771), and initial direct costs are ₩200,000.

Lease liability: $400 \times 2.5771 ≈ 1{,}030.8$ (₩10,000)
Right-of-use asset: $1{,}030.8 + 20 = 1{,}050.8$

Amortization of the lease liability and expenses (unit: ₩10,000)
Year	Opening lease liability	Interest expense (8%)	Lease payment	Closing lease liability	Depreciation	Total expense
1	1,030.8	82.5	400	713.3	350.3	432.8
2	713.3	57.1	400	370.4	350.3	407.4
3	370.4	29.6	400	0	350.3	379.9

Total expense over three years is 1,220.1: the lease payments of 1,200 plus initial direct costs of 20 (ignoring rounding). Year by year, however, expense is highest in the first year and falls thereafter, because interest is proportional to the declining lease liability. Compared with the old operating lease treatment of expensing ₩4 million each year, early profit is lower.

4. Exemptions and remeasurement

Short-term leases: leases of 12 months or less with no purchase option. An entity may elect, by class of underlying asset, to expense them on a straight-line basis.
Leases of low-value assets: assets of low value when new (tablets, small office furniture, etc.). The election is made lease by lease. In the Basis for Conclusions to the standard, the IASB cited around USD 5,000 when new as an example.
Remeasurement: when the assessment of extension or termination options changes, or payments change because of an index, the lease liability is recalculated and the right-of-use asset adjusted by the difference.

5. Lessors: finance and operating leases

A lessor classifies a lease as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset, and otherwise as an operating lease. Indicators of a finance lease include transfer of ownership, a bargain purchase option, a lease term for the major part of the economic life, a present value of lease payments amounting to substantially all of the asset’s fair value, and a specialized asset.

Comparison of lessor accounting
Type	Statement of financial position	Profit or loss
Finance lease	Derecognize the underlying asset and recognize the net investment in the lease (a receivable)	Interest income by the effective interest method (manufacturer or dealer lessors also recognize revenue and cost of sales)
Operating lease	Continue to recognize and depreciate the underlying asset	Lease income, usually on a straight-line basis

Sale and leaseback: an entity sells an asset and leases it back. If the transfer meets the sale requirements of K-IFRS 1115, the seller-lessee measures the right-of-use asset at the proportion of the previous carrying amount relating to the right of use it retains, and recognizes a gain only on the rights transferred. If the sale requirements are not met, the cash received is treated as a financial liability.

Check your understanding

At the beginning of 20X1 company FF entered into a two-year lease. Payments are ₩5 million at the beginning of each year, and the first was paid on the contract date. The incremental borrowing rate is 10% (one-year single-sum factor 0.9091). What are the initial measurements of the lease liability and right-of-use asset, and interest expense and depreciation for 20X1?

The first payment was made at commencement, so the lease liability includes only the one remaining payment: $500 \times 0.9091 ≈ 454.6$ (₩10,000). The right-of-use asset is the lease liability plus the prepaid payment of 500, i.e. 954.6. Interest expense for 20X1 is $454.6 \times 10\% ≈ 45.5$ and depreciation $954.6 / 2 = 477.3$ .

References

Korea Accounting Standards Board, K-IFRS 1116 Leases
IASB, IFRS 16 Leases and Basis for Conclusions
Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 21