QUESTION:

Company ABC enters into a lease agreement for a building for a period of 5 years, with an option to renew for an additional 5 years. The lease agreement requires ABC to make lease payments of $10,000 per month, with the first payment due at the beginning of the lease term. Under IFRS, how should ABC account for this lease agreement?

ANSWER:

Under IFRS, leases are classified as either finance leases or operating leases, based on the substance of the agreement.

If the lease transfers substantially all the risks and rewards incidental to ownership of the asset to the lessee, it is classified as a finance lease. Otherwise, it is classified as an operating lease.

In this case, it is not clear whether the lease agreement transfers substantially all the risks and rewards incidental to ownership of the building to ABC. Therefore, ABC should apply the following criteria to determine whether the lease is a finance lease or an operating lease:

1. Transfer of ownership: Does the lease transfer ownership of the building to ABC by the end of the lease term?
2. Purchase option: Does the lease contain a purchase option that the lessee is reasonably certain to exercise?
3. Lease term: Is the lease term for the major part of the economic life of the building?
4. Present value of lease payments: Are the present value of lease payments equal to or greater than substantially all of the fair value of the building?

If any one of the above criteria is met, the lease is classified as a finance lease. If none of the criteria are met, the lease is classified as an operating lease.

Assuming that none of the above criteria are met, the lease agreement would be classified as an operating lease. Under IFRS 16, lessees are required to recognize a right-of-use asset and a lease liability for all leases with a term of more than 12 months, unless the underlying asset is of low value. Therefore, ABC should record the lease as follows:

At the beginning of the lease term:

Debit Right-of-use asset for the present value of the lease payments

Credit Lease liability for the present value of the lease payments

At the end of each month:

Debit Lease expense for the lease payment

Credit Cash for the lease payment

The lease liability will be reduced each month by the amount of the lease payment, and the right-of-use asset will be amortized over the lease term.

It is important to note that the lease liability and right-of-use asset should be remeasured periodically, and any adjustments should be recorded in the financial statements.

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