Lease Classification and Measurement under IFRS 16

Under IFRS 16, a lease is a finance lease if it transfers substantially all the risks and rewards incidental to ownership. Indicators include: (a) the lease transfers ownership by the end of the lease term; (b) the lessee has an option to purchase the asset at a price sufficiently lower than fair value; (c) the lease term is for the major part of the economic life; (d) the present value of lease payments amounts to substantially all of the fair value; (e) the leased asset is of a specialized nature.

Here, Delta has a bargain purchase option (CU50,000 vs. expected fair value CU150,000), so it is reasonably certain to exercise it. This is a strong indicator of a finance lease. Additionally, the lease term is 5 years, which is 62.5% of the 8-year useful life-not a major part, but the bargain purchase option alone is sufficient. The machine is not specialized, so that indicator does not apply.

Thus, the lease is a finance lease (or under IFRS 16, the distinction is less relevant because all leases are on-balance sheet, but the classification affects subsequent measurement? Actually, IFRS 16 eliminates the classification for lessees; all leases are treated similarly. However, the question might be testing the concept of whether it's a finance lease for lessor accounting or for the purpose of the right-of-use asset. But since the question is about lessee, IFRS 16 does not distinguish between finance and operating leases for lessees. So the answer should note that under IFRS 16, lessees do not classify leases; they recognize a right-of-use asset and a lease liability for all leases (except short-term and low-value). However, the indicators still matter for determining the lease term and whether the purchase option is reasonably certain. So the lease is a finance lease in substance, but for lessee accounting, it's just a lease.

Let's calculate the lease liability: The lease payments are CU120,000 per year for 5 years, annuity due, plus the purchase option of CU50,000 at the end of year 5. The rate implicit is 6%. We use the lessee's incremental borrowing rate only if the implicit rate is not readily determinable. Here, the implicit rate is given as 6%, so use that.

Present value of lease payments:

• Annuity due of CU120,000 for 5 years at 6%: PV = 120,000 × [(1 - (1+0.06)^-5)/0.06] × (1+0.06) = 120,000 × 4.21236 × 1.06 = 120,000 × 4.46511 = 535,813.2? Let's compute accurately: PV factor for annuity due = (1 + r) × [1 - (1+r)^-n]/r = 1.06 × [1 - 1.06^-5]/0.06. 1.06^5 = 1.3382255776, so 1.06^-5 = 0.747258. [1 - 0.747258]/0.06 = 0.252742/0.06 = 4.21237. Multiply by 1.06 = 4.46511. So PV of rentals = 120,000 × 4.46511 = 535,813.2.
• PV of purchase option = 50,000 / 1.06^5 = 50,000 × 0.747258 = 37,362.9. Total lease liability = 535,813.2 + 37,362.9 = 573,176.1.

Right-of-use asset = lease liability + initial direct costs + prepayments - lease incentives. No other costs given, so ROU asset = CU573,176.

Journal entry at inception: Dr Right-of-use asset 573,176 Cr Lease liability 573,176

Note: The first payment is made at the beginning of the year, so at inception, Delta pays CU120,000. That payment reduces the lease liability. So the entry would be: Dr Right-of-use asset 573,176 Cr Lease liability 573,176 Then Dr Lease liability 120,000 Cr Cash 120,000. Alternatively, the ROU asset could be initially measured at the amount of the lease liability plus the first payment? Actually, under IFRS 16, the lease liability is initially measured at the present value of lease payments not paid at the commencement date. Since the first payment is at commencement, it is not included in the lease liability? Wait: IFRS 16 says the lease liability is the present value of lease payments that are not paid at the commencement date. So if the first payment is at the commencement date, it is not included in the lease liability. Instead, the right-of-use asset includes the initial measurement of the lease liability plus lease payments made at or before the commencement date. So the ROU asset would be the lease liability (which excludes the first payment) plus the first payment.

Let's recalc: Lease payments: 5 payments of 120,000 at the beginning of each year. The first payment is at commencement (1 Jan 20X5). So lease liability at commencement is the PV of the remaining 4 payments of 120,000 (at beginning of years 2-5) plus the purchase option of 50,000 at end of year 5. PV of 4 payments of 120,000 annuity due? Actually, payments at beginning of years 2,3,4,5: that's an annuity due of 4 payments? The first of these is at beginning of year 2, which is one year after commencement. So it's an ordinary annuity of 4 payments? Let's think: Payments at t=0,1,2,3,4 (if t=0 is commencement). The payment at t=0 is made at commencement, so not included in liability. The remaining payments are at t=1,2,3,4. That's an ordinary annuity of 4 payments. PV at t=0 = 120,000 × [1 - (1.06)^-4]/0.06 = 120,000 × 3.4651 = 415,812. PV of purchase option = 50,000 / 1.06^5 = 37,363. Total lease liability = 415,812 + 37,363 = 453,175. Then ROU asset = lease liability + first payment = 453,175 + 120,000 = 573,175. Same as before. So the total ROU asset is 573,175.

Thus, journal entries: At inception: Dr Right-of-use asset 573,175 Cr Lease liability 453,175 Cr Cash 120,000 (To recognize ROU asset and lease liability, and the first payment.)

Alternatively, if the first payment is made after inception, but the problem says due at the beginning of each year, so first payment at commencement.

So the lease is a finance lease in substance, but under IFRS 16 lessee accounting, it is simply a lease. The initial lease liability is CU453,175 and ROU asset CU573,175.

Depreciation period: If the lease transfers ownership to the lessee by the end of the lease term, or if the lessee is reasonably certain to exercise a purchase option, the lessee shall depreciate the right-of-use asset over the useful life of the underlying asset. Otherwise, over the lease term. Here, Delta is reasonably certain to exercise the purchase option, so it should depreciate over the useful life of the machine (8 years). The ROU asset is CU573,175, so annual depreciation = 573,175 / 8 = 71,646.875 ≈ CU71,647.

Lease amortization schedule (using effective interest method): Initial lease liability = CU453,175. Year 1 (20X5):

• Interest expense = 453,175 × 6% = 27,190.5
• Payment at beginning of year? Actually, the first payment was at commencement (1 Jan 20X5), so during 20X5 there is no payment at the beginning? Wait: The payments are at the beginning of each year. The first payment was at 1 Jan 20X5. The next payment is at 1 Jan 20X6. So during 20X5, no payment is made (except the initial one at commencement). So the liability at 1 Jan 20X5 after the initial payment is 453,175. Interest accrues for the year 20X5: 453,175 × 6% = 27,190.5. At 31 Dec 20X5, the liability before the next payment is 453,175 + 27,190.5 = 480,365.5. Then on 1 Jan 20X6, a payment of 120,000 is made, reducing the liability to 360,365.5.

Year 2 (20X6):

• Interest expense = 360,365.5 × 6% = 21,621.93
• Liability at 31 Dec 20X6 before payment = 360,365.5 + 21,621.93 = 381,987.43
• Payment on 1 Jan 20X7 of 120,000 reduces liability to 261,987.43.

We can present a table:

Year | Opening liability | Interest at 6% | Payment | Closing liability 20X5 | 453,175 | 27,190 | 0 | 480,365 20X6 | 480,365 | 28,822? Wait, careful: The payment on 1 Jan 20X6 occurs at the beginning of 20X6, so for the year 20X6, the opening liability after the payment is 360,365. Let's redo with dates.

Better to use a schedule with payments at beginning of year: At 1 Jan 20X5: Liability before initial payment = PV of all payments including initial? We already set initial liability after initial payment = 453,175. So at 1 Jan 20X5, after paying 120,000, liability = 453,175. During 20X5: Interest accrues: 453,175 × 6% = 27,190.5. At 31 Dec 20X5, liability = 480,365.5. On 1 Jan 20X6: Payment of 120,000. Liability after payment = 360,365.5. During 20X6: Interest = 360,365.5 × 6% = 21,621.9. At 31 Dec 20X6, liability = 381,987.4. On 1 Jan 20X7: Payment 120,000. Liability after = 261,987.4.

So the interest expense for 20X5 is CU27,190.5 and for 20X6 is CU21,621.9.

Journal entries for 20X5:

1. Initial recognition (as above): Dr Right-of-use asset 573,175 Cr Lease liability 453,175 Cr Cash 120,000

2. Depreciation for 20X5: Dr Depreciation expense 71,647 Cr Accumulated depreciation – ROU asset 71,647

3. Interest expense for 20X5: Dr Interest expense 27,190 Cr Lease liability 27,190

(No payment entry in 20X5 because the first payment was at inception; the next payment is on 1 Jan 20X6.)

Note: The interest expense is recognized over the year, so at 31 Dec 20X5, the liability includes accrued interest. The payment on 1 Jan 20X6 will reduce the liability.