The Lease That Hid a Loan

Step 1 - Is there a sale?

IFRS 16 requires the transfer of the asset to be accounted for as a sale only if the transfer satisfies the performance obligation requirements of IFRS 15 - i.e. the customer (the bank) obtains control of the asset.

Control indicators:

• No practical alternative use. The machine is specialised and has no practical alternative use to the bank. The bank cannot redirect it.
• Repurchase obligation. Pellworth is obliged to repurchase the machine at the end of the term for £0.2m. This is a substantive repurchase right that prevents control from transferring.
• The bank's only use is to lease the machine back to Pellworth. The bank has no economic interest in the asset's output; it has an interest in the cash flows from Pellworth.

Conclusion. The bank has not obtained control. There is no sale. The arrangement is a financing - a secured borrowing of £2.0m, with the machine as collateral.

Step 2 - Accounting as a financing.

• Derecognition: the machine is not derecognised. It remains on Pellworth's statement of financial position at its carrying amount of £1.4m and continues to be depreciated.
• Liability: recognise a financial liability of £2.0m at 1 January 20X5.
• Finance cost: the implicit rate is the rate that discounts £0.48m × 5 to £2.0m. Approximate rate ≈ 6.4% (annuity factor 4.167). Interest for 20X5 ≈ £2.0m × 6.4% = £0.128m.
• Payment: £0.48m reduces the liability by £0.352m and pays £0.128m interest. Closing liability ≈ £1.648m.
• No gain. The FD's £0.6m gain is not recognised. The £0.6m 'gain' is simply the difference between fair value and carrying amount, which is irrelevant because no sale occurred.

Step 3 - The repurchase obligation. The £0.2m repurchase price is part of the financing cash flows and should be included in the liability measurement (it is a final payment). It is not a separate provision.

Evaluation of the FD's treatment.

The FD has applied the form of a sale and leaseback rather than its substance. The transaction has:

• a fixed repurchase obligation,
• a specialised asset with no alternative use to the 'buyer',
• a 'buyer' whose only economic return is the lease payments.

These are the classic indicators of a financing arrangement. Recognising a £0.6m gain:

• overstates profit by £0.6m in 20X5;
• derecognises an asset that Pellworth still controls and uses;
• understates liabilities by removing the £2.0m borrowing from the statement of financial position.

The effect is to flatter both profitability and gearing, which is precisely the risk the standard is designed to prevent.

Presentation consequences.

• Statement of financial position: machine remains at £1.4m (less depreciation); a financial liability of £2.0m is recognised, split between current and non-current portions.
• Statement of profit or loss: no gain. Depreciation of the machine continues (e.g. over its useful life). Finance cost of £0.128m replaces the 'lease' charge.
• Cash flow statement: the £2.0m received is a financing inflow, not an operating or investing inflow. The £0.48m payments are split between financing (principal) and operating (interest), consistent with the entity's policy under IAS 7.
• Gearing ratios: debt increases by £2.0m, so gearing and interest cover change materially. Analysts comparing Pellworth with peers who use genuine sale and leasebacks must be able to see the difference.

Disclosure consequences.

• Disclose the nature of the arrangement and the fact that it is accounted for as a financing.
• Disclose the carrying amount of the machine pledged as collateral.
• Disclose the maturity analysis of the liability and the effective interest rate.
• Disclose the repurchase obligation of £0.2m and its timing.
• If the FD had recognised a sale, the transition and any prior-period adjustment would need explanation.

Wider point. This is a substance-over-form judgement that the exam tests repeatedly. The existence of a repurchase obligation and the absence of alternative use are the two facts that decide the answer.