Lease Classification and the Right-of-Use Asset
Sara Contracting (IFRS 16 applies) signs a 5-year contract for a specialised piece of earth-moving equipment on 1 January 20X5. Facts: annual payments of SAR 180,000 payable in arrears; the lessor may substitute the equipment with an equivalent model at any time without Sara's consent; the equipment is highly specialised and only Sara can operate it economically; the contract includes a purchase option at SAR 250,000 at the end of year 5, when the expected fair value is SAR 600,000; Sara's incremental borrowing rate is 7%; the implicit rate is not readily determinable. The finance director has expensed all payments as operating costs and recorded no right-of-use asset, arguing the substitution right means there is no identified asset.
1. Assess whether the contract contains a lease under IFRS 16, addressing the substitution right.
Read the worked answer
Conclusion: the contract contains a lease.
IFRS 16 requires (a) an identified asset and (b) the right to control the use of that asset.
- Identified asset: A substitution right does not prevent identification if the lessor would not benefit economically from substitution. Here the equipment is highly specialised and only Sara can operate it economically; substituting it would impose practical and economic cost on the lessor. The substitution right is therefore not substantive, and the asset is identified.
- Right to control: Sara obtains substantially all the economic benefits from use (it operates the equipment and captures the output), and it directs how and for what purpose the asset is used. Control is present.
Effect: the contract is a lease. The FD's treatment (expense all payments) is incorrect for the lessee under IFRS 16, which requires recognition of a right-of-use asset and a lease liability, with depreciation and interest in place of rent expense.
Note also that the purchase option at SAR 250,000 against an expected fair value of SAR 600,000 is reasonably certain to be exercised, so the lease term should be 5 years and the option price included in the lease liability.
2. Compute the initial lease liability and right-of-use asset, and state the year-1 expense profile.
Read the worked answer
Lease liability at 1 January 20X5 = present value of 5 annual payments of SAR 180,000 at 7%, plus the PV of the purchase option of SAR 250,000 at the end of year 5.
- Annuity factor for 5 years at 7%: (1 − 1.07⁻⁵)/0.07 = 4.1002
- PV of rentals: 180,000 × 4.1002 = SAR 738,036
- PV of purchase option: 250,000 × 1.07⁻⁵ = 250,000 × 0.7130 = SAR 178,250
- Lease liability = SAR 916,286
Right-of-use asset = lease liability + initial direct costs + prepayments − incentives. Assuming no other adjustments: SAR 916,286.
Year 1 (20X5) expense profile:
- Depreciation: 916,286 / 5 = SAR 183,257
- Interest: 916,286 × 7% = SAR 64,140
- Total charge ≈ SAR 247,397, versus SAR 180,000 cash paid.
Year-end liability: 916,286 + 64,140 − 180,000 = SAR 800,426.
Presentation: split the liability between current and non-current; disclose the maturity analysis and the variable/optional payment terms.