ACCA DipIFR question papers and answers on IFRS 16 June 2014

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ACCA DipIFR question papers and answers on IFRS 16 from June 2014

All questions on IFRS 16 Leases which have appeared in ACCA DipIFR from June 2014 have been indexed here. The answers are based on the standards prevalent at the exam point in time.

Questions prior to Dec 2017 have been ignored as they pertained to the old standard on leasing.

For the benefit of the readers, we have put the following sequentially to help them understand better

  • Question - Relevant portion of the exam pertaining to the standard has been recreated
  • Answer - Answers as shared by the ACCA Examination team which was required for the question
  • Examiners Feedback - Feedback on answers given by the students for that exam, this is a critical part of learning as students can learn from mistakes which other students did

Question

IFRS 16 – Leases – was issued in January 2016 and applies to accounting periods beginning on or after 1 January 2019. However, earlier application is permitted. IFRS 16 replaces IAS 17 – Leases. IFRS 16 makes substantial changes to the requirements for the recognition of rights and obligations under leasing arrangements for lessees.

Required:
(a) Explain:
(i) Why the International Accounting Standards Board considered it necessary to make significant changes to the requirements for the recognition of rights and obligations under leasing arrangements in the financial statements of lessees. (4 marks)
(ii) How IFRS 16 requires lessees to recognise and measure rights and obligations under leasing arrangements. (4 marks)
(iii) Any exceptions to the usual requirements you have outlined in (ii) above. Your answer should briefly describe the accounting treatment required in the case of such exceptions and, where appropriate, the types of assets which these exceptions might apply to. (4 marks)


(b) Kappa prepares financial statements to 30 September each year. On 1 October 2016, Kappa began to lease a property on a 10-year lease. The annual lease payments were $500,000, payable in arrears – the first payment being made on 30 September 2017. Kappa incurred initial direct costs of $60,000 in arranging this lease. The annual rate of interest implicit in the lease is 10%. When the annual discount rate is 10%, the present value of $1 payable at the end of years 1–10 is 6·145 dollars.
Required:

Explain and show how these transactions would be reported in the financial statements of Kappa for the year ended 30 September 2017 under IFRS 16 – Leases.

Answer

(i) IAS 17 – the previous financial reporting standard dealing with leasing –distinguished between two types of lease: finance and operating. IAS 17 required lessees to recognise rights and obligations under leasing arrangements in the case of finance leases but not in the case of operating leases.  The distinction between finance leases and operating leases in IAS 17 was very subjective.  Generally speaking, classifying leases as operating leases led to financial statements of lessees reporting a more favourable picture than classifying leases as finance leases.  This incentive to treat leases as operating leases, together with the subjective nature of lease classification, meant that the requirements in IAS 17 needed amending. 


(ii) IFRS 16 requires lessees to recognise a right of use asset and an associated liability at the inception of the lease.  The initial measurement of the right of use asset and the lease liability will be the present value of the minimum lease payments. The discount rate used to measure the present value of the minimum lease payments is the rate of interest implicit in the lease – essentially the rate of return earned by the lessor on the lease asset. [NB: If this rate is not available to the lessee, then a commercial rate of interest can be used instead. The right of use asset is subsequently depreciated in accordance with IAS 16 – Property, Plant and Equipment (assuming it is a tangible asset).

The lease liability is effectively treated as a financial liability which is measured at amortised cost, using the rate of interest implicit in the lease as the effective interest rate. 


(iii) A short-term lease is a lease which, at the date of commencement, has a term of 12 months or less. Lessees can elect to treat short-term leases by recognising the lease rentals as an expense over the lease term rather than recognising a ‘right of use asset’ and a lease liability.  A similar election – on a lease-by-lease basis – can be made in respect of ‘low value assets’.  Examples of low-value underlying assets can include tablet and personal computers, small items
of office furniture and telephones. (Note: Any reasonable attempt to describe a ‘low-value’ asset would receive credit.) 


(b) The initial right of use asset and lease liability would be $3,072,500 (500,000 x 6·145).  

The initial direct costs of the lessee would be added to the right of use asset to give an initial carrying amount of $3,132,500 ($3,072,500 + $60,000). 

Depreciation would be charged over a ten-year period, so the charge for the year ended 30 September 2017 would be $313,250 ($3,132,500 x 1/10). 


The closing carrying amount of PPE in non-current assets would be $2,819,250 ($3,132,500 x 9/10). 

Kappa would recognise a finance cost in profit or loss of $307,250 ($3,072,500 x 10%).
The closing lease liability would be $2,879,750 ($3,072,500 + $307,250 – $500,000).
Next year’s finance cost will be $287,975 ($2,879,750 x 10%), so the current liability at 30 September 2017 will be $212,025 ($500,000 – $287,975).  The balance of the liability of $2,667,725 ($2,879,750 – $212,025) will be non-current.

Examiners feedback

On the whole, answers to this question were not as good as they might have been. It was obvious that many candidates were not aware of the new leasing standard or that it was examinable in December 2017. This clearly meant that such candidates scored very few marks in part (a) of this question. Candidates fared slightly better in part (b) of the question. This was because even candidates who apparently failed to appreciate the impact of the changes introduced by IFRS 16 were able to compute the present value of the minimum lease payments and identify these as creating an asset and a liability for Kappa. Such candidates were often able to gain further marks by computing a depreciation charge and a finance cost. Thus certain marks were gained in part (b) even though underlying appreciation of the impact of IFRS 16 was not always apparent. There is a clear message here that candidates for this examination should ensure that they are up
to date with the topics that are examinable in each sitting and focus their study appropriately. Candidates and tutors are advised to bear this in mind when preparing for future examination
sittings.

 

Question

Gamma prepares its financial statements to 31 March each year. Notes 1 and 2 contain information relevant to these financial statements:

Note  – Sale and leaseback of property
On 1 April 20X6, Gamma sold a property to entity A for its fair value of $1,500,000. The terms and conditions of the sale satisfy the sale and leaseback requirements of IFRS® 15 – Revenue from Contracts with Customers. The carrying amount of the property in the financial statements of Gamma at 1 April 20X6 was $1,000,000. The estimated future useful life of the property on 1 April 20X6 was 20 years. On 1 April 20X6, Gamma entered into an agreement with entity A under which Gamma leased the property back. The lease term was for  five years, with annual rentals of $100,000 payable in arrears. The annual rate of interest implicit in the lease was 10% and the present value of the minimum lease payments on 1 April 20X6 was $379,100.

 Answer

Because the sale of the building by Gamma satisfies the requirements in IFRS® 15 – Revenue from Contracts with Customers – Gamma will de-recognise the building on 1 April 20X6. Gamma will recognise a ‘right of use asset’ on 1 April 20X6. 


The right of use asset will be measured as a percentage of the previous carrying amount of $1 million which relates to the right of use retained by Gamma. This percentage is 25·27% ($379,100/$1·5 million). This means that the carrying amount of the right of use asset will be $252,700 ($1 million x 25·27%). 


The gain on sale of property to be recognised in Gamma’s statement of profit or loss is restricted to the rights transferred to entity A. The total gain is $500,000 ($1·5m – $1m). The percentage of this gain to be recognised is 74·73% (100% – 25·27%). This means that the gain which will be recognised will be $373,650 ($500,000 x 74·73%). 


The right of use asset will be depreciated over the lease term, which is five years. Therefore depreciation of $50,540 ($252,700 x 1/5) will be charged in the statement of profit or loss. The statement of financial position at 31 March 20X7 will show a right of use asset of $202,160 ($252,700 – $50,540) under non-current assets. 


Gamma will show a finance cost of $37,910 ($379,100 x 10%) in the statement of profit or loss for the year ended 31 March 20X7. The closing lease liability will be $317,010 ($379,100 + $37,910 – $100,000).

The amount of the overall liability which is current will be $68,299 ($100,000 – {$317,010 x 10%}). The balance of the liability of $248,711 ($317,010 – $68,299) will be non-current.


Tutorial note: The amount of the gain on sale which is recognised by Gamma could alternatively be
computed as follows:
The total gain x (The fair value of the asset – the lease liability) ––––––––––––––––––––––––––––––––––––––– The fair value of the asset
In this case this would give:
$500,000 x (($1,500,000 – $379,100)/$1,500,000) = $373,633 (difference to above $373,650 due solely to rounding)
Candidates who adopt an approach of this nature will receive full credit.

Feedback

In general this question was answered very well. I was particularly pleased (regarding part (a)) that the majority of candidates appeared to have studied and appreciated the requirements of IFRS 16® - Leases re: sale and leasebacks. A fairly significant minority of candidates incorrectly stated that the carrying amount of the right of use asset that was recognised by Delta following the sale and leaseback was equal to the initial carrying amount of the lease obligation. A number of candidates referred to the distinction between finance and operating leases, which is of course no longer relevant for lessees following the adoption of IFRS 16.

 

Question

Omega is a listed entity and you are the financial controller. The financial statements of Omega for the year ended 31 March 20X5 are currently being prepared. One of Omega’s directors has sent you three questions regarding the financial statements.

When I looked at the note which gave details of our property, plant and equipment, a separate component appeared for the first time this year. This component was described as a right-of-use asset. Upon further investigation, I discovered that this related to a warehouse which we started to lease on 1 October 20X4 to provide us with more capacity. The warehouse is being leased on a five-year lease contract at an annual rental of $500,000, payable in arrears. There is no option to extend the lease at the end of the five-year period. Based on current annual interest rates (10%), these rentals have a total present value of $1,895,000.

We incurred direct costs of $105,000 when arranging this lease with the owner. The carrying amount of the right-of-use asset which is shown in the financial statements is $1·8 million. I don’t understand this at all. In particular, I have three questions about this that I would like you to answer:

  • –  The warehouse would cost at least $10 million to purchase outright and has a useful life of around 25 years. How can it be presented as Omega’s asset in these circumstances?

  • –  Where does the figure of $1·8 million come from?

  • –  Apart from the right-of-use asset, how else will this transaction affect our financial statements? I don’t need detailed workings here, just explanations.

 Answer

IFRS 16 – Leases – requires a lessee to recognise a right-of-use asset in all circumstances other than for very short leases (of one year or less) or for low value assets. A warehouse lease for five years is neither of these, so recognition of a non-current asset will be required in our financial statements.

The initial carrying amount of the right-of-use asset comprises the present value of the lease payments plus any direct costs we incurred in arranging the lease.

In this case, therefore, the initial carrying amount at 1 October 20X4 will be $2 million ($1,895,000 + $105,000).

The right-of-use asset is included as a separate component of property, plant and equipment and depreciated over the lease term.

The depreciation of the asset for the year ended 31 March 20X5 will be $200,000 ($2 million x 1/5 x 6/12).

Therefore the carrying amount of the right-of-use asset at 31 March 20X5 will be $1,800,000 ($2 million – $200,000).

When the right-of-use asset is recognised, a lease liability is also recognised. It is initially measured at the present value of the lease payments – $1,895,000 in this case.

The liability will be increased by a finance cost. This cost is based on the carrying amount of the liability and the rate of interest implicit in the lease.

The finance cost will be charged as an expense in the statement of profit or loss.
When the lease rentals are paid, they will be treated as a repayment of the lease liability

Since a lease rental is due for payment six months after the year end, $500,000 of the lease liability will be treated as a current liability. The balance will be non-current.

Feedback

 This question was well answered but candidates may wish to note the following:

  • There was some evidence of wholly unnecessary references to how the asset would have been accounted for were it to have been purchased outright for $10 million.

  • Despite the fact that the question stated no numerical workings were required a number of candidates computed the finance cost on the lease liability and attempted to split the closing liability into its current and non-current components. All that was required in this case was an explanation of these features.

Question

 

On 1 October 20X4 Gamma began to lease a machine. The lease gave Gamma the sole right  to direct the use of  the machine and receive all the economic benefits arising from its use. The  lease was for a five-year term, with annual rentals of  $200,000 being payable in advance. The  first  rental  was  paid  on  1  October  20X4  and  the  final  rental  is  due  for  payment  on  1  October  20X8.  The  total  estimated  useful  life  of   the  machine  on  1  October  20X4  was  ten  years. There   are no terms in the lease agreement that allow the lease to be extended beyond the five-year  term. The annual rate of  interest implicit in the lease is 8%. On 1 October 20X4 when the first  rental was paid Gamma debited $200,000 to profit or loss. Gamma has made no other entries regarding this lease in its draft financial statements for the year ended 31 March 20X5.  

 8% discount factors which may be relevant are as follows:

Cumulative present value of  $1 payable in:

1 year

$0.926

2 years

1.783

3 years

2.577

4 years

3.312

5 years

3.993

Answer

Under the principles of IFRS® 16 – Leases – lessees need to create a ‘right of use asset’ and lease liability in respect of all leased assets, other than those leased on short-term leases or on ‘low value’ leases. Neither exception applies here.

The initial carrying amount of the right of use (RoU) asset and lease liability will be the present value of the lease payments not yet paid using the rate of interest implicit in the lease (8% in this case) with the RoU asset adjusted by the initial payment of $200,000.

This initial carrying amount of the asset will be $862,400 ($200,000 + ($200,000 x 3·312 = 662,400)).

The RoU asset will be depreciated over the shorter of lease term and the useful life of the leased assets. In this case, this means over five years from 1 October 20X4 so the depreciation charge for the year ended 31 March 20X5 will be $86,240 ($862,400 x 1/5 x 6/12).

The RoU asset at 31 March 20X5 will have a carrying amount of $776,160 ($862,400 – $86,240). This amount will be presented under non-current assets.

The incorrect debiting of $200,000 to profit or loss should be corrected by debiting to the RoU asset (see above) to calculate the correct depreciation charge.

The lease liability will attract a finance cost of $26,496 ($662,400 x 8% x 6/12).

The lease liability at 31 March 20X5 will be $688,896 ($662,400 + $26,496). $173,504 of this amount will be presented as a current liability ($200,000 less 6 months finance charge $26,496), with the balance of $515,392 being non-current.

Examiners Feedback

As far as issue one was concerned, the vast majority of candidates were aware that a right of use (ROU) asset and a lease liability should be created and then treated as a non-current asset and a loan liability in the financial statements. This enabled a reasonable number of explanation marks and ‘own figure’ marks for computations to be gained, even where other errors of principle were evident. A significant minority of candidates stated that the lease should be treated as a finance lease in the financial statements of Gamma, indicating that they were thinking of IAS 17, the former leasing standard, rather than IFRS 16 Leases, the current one. Although this error did cost them some ‘explanation marks’ they were still able to receive credit for the subsequent accounting treatment, which is of course analogous to treating the lease as a finance lease in the books of the lessee.

The most common error in answering issue one was the incorrect computation of the initial carrying amount of the ROU asset and the lease liability. The initial carrying amount of the lease liability should have been the present value of the future lease payments. The initial carrying amount of the ROU asset should have additionally included the up-front lease rental payable on the first day of the lease term. A number of different errors were noted as candidates attempted present value calculations. The most common error by far was for candidates to assume that the lease rentals were payable in arrears rather than in advance. I have already stated earlier in this report that discounting is an important concept in financial reporting Candidates for this paper should be aware that the ability to perform relatively straightforward discounting calculations is something that will be tested reasonably regularly.

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