Audit Partner at RSM Poland
The last time we discussed lease contract modifications. The next thing that should be addressed and is present in the economic reality is the leaseback. It is very often the case that entities first purchase a given fixed asset (a building, specialist equipment or manufacturing machine) but then, given the lack of funds or as a consequence of streamlining the financing of their investments, decide to sell this asset and lease it back later.
A contract with the lessor (entity C) is aimed at spreading payments over time. The lessor purchases a given asset from the future lessee (entity B), and then the lessee enjoys the right to use the underlying asset. The reason why the lessee (B) sells the asset to their later lessor (C) is to restore the liquidity (to cover expenses connected with the purchase of a given asset from the producer (entity A).
One could say that this is business as usual and generally speaking there is nothing strange about it, also when it comes to the accounting treatment. One could not be more wrong.
Firstly, the sale of the asset by the future lessee (B) to their later lessor (C) should be considered in the light of IFRS 15. We must bear it in mind that if IFRS 15 provisions concerning revenue recognition are not complied with, i.e. in the case of a failure to satisfy the performance obligation through a transfer of the promised goods (or a service), a given asset is recognised by entity B as a fixed asset purchased from entity A. On the other hand, liabilities towards C are being accounted for, because C paid B for the hypothetical purchase of the asset. This is hypothetical, because the IFRS 15 requirements have not been met.
In turn, if the revenues are recognised following a transaction between B and C under the IFRS 15 regulation, then the signed lease contract causes entity B to recognise the right to use the asset. In an ideal treatment, the asset purchased by entity B for a given amount, e.g. 100 units, is being sold right away (without depreciation costs) for 100 units (assuming that this is the fair value), and then leased and measured at discounted future payments. Unfortunately, in reality the value of transaction to entity C takes a value other than the fair value, and the net value of the asset in entity B at the moment of sale to C is different from the fair value and the transaction value.
In such a case, IFRS 16 suggests the following solution in a couple of steps:
- determine whether a sale has occurred (IFRS 15 criteria);
- eliminate the asset from the balance sheet of the seller, provided that a sale has occurred in line with IFRS 15;
- record the leaseback like any usual lease contract, i.e. recognise the right-of-use asset and lease liability in the lessee’s balance sheet,
- account for differences between the fair value and the consideration for the sale:
- if the payment (consideration for the sale) is lower than the fair value, then this difference shall be accounted for as a prepayment of lease payments;
- if payments (consideration for the sale) exceed the fair value, then this difference shall be accounted for as additional financing provided for by the lessor.
What is interesting, the value of the right-of-use assets shall be calculated as a product of the proportion of the book value of the asset to the fair value (1) and the calculated value of lease liability (2).
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Leaseback – example
Entity A disposed of a building of book value of 250 units to entity B for 500 units. The agreed fair value was 450 units. A signed a contract with B to use the building for 18 years in return for annual payments of 30 units. Let us assume a discount rate at the level of 4.5%. These economic events should be accounted for in both entities.
Assuming that the sale has occurred, we calculate the necessary components in line with IFRS 15:
- difference between fair value and the net book value: 450u – 250u = 200u;
- value of liability: 540u; after discounting: 364u
- transaction value: 500j; surplus over the fair value: 50u
- value of additional financing provided to the lessee: 50u
- value of the right-of-use (ROU) asset is a proportion of the net value to the fair value, i.e. 0.56 multiplied by the value of lease liability in the amount of 314u (i.e. all discounted liabilities (364u) reduced by additional financing liability in the amount of 50u) = 0,56*314 = 174u
Then we can make first entries in the books of entity A:
|Cr||gain on transferred rights||60u|
and first entries in the books of entity B:
Thus, we have reached a moment in which we must mention how the lease is accounted for by the financing party. For the lessor, the lease is only slightly modified by the regulations of IFRS 16 as compared with IAS 17. The lessor still recognises the asset either as their own fixed asset (operational lease) or as a separate item in the balance sheet known as the net lease investment. In the above example, the lessor has booked the purchased building of the fair value of 450u on the asset side (a sale was concluded to have occurred in line with IFRS 15). However, the consideration amounted to 500u. Thus, the lessor recognises 50u as a source of financing (a loan granted to the lessee).
In the last few articles we have tried to guide you through the issues of IFRS 16. We are aware that the series of articles on lease in the light of IFRS 16 might have failed to exhaust the topic of lease and address many other events occurring in the economic reality (like e.g. sublease or lease takeover following a merger). Therefore, if you have any questions or wish to discuss other cases or extend the scope presented on the blog, we encourage you to contact us.
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