Leases
What you must know
A lease is a contract conveying the right to control the use of an identified asset for a period in exchange for consideration. Lessees recognise a right-of-use asset and a lease liability at the present value of lease payments, discounted at the interest rate implicit in the lease or, if not readily determinable, the lessee's incremental borrowing rate. Subsequently, depreciate the right-of-use asset and accrete the liability using the effective interest method. Know the recognition exemptions for short-term leases (12 months or less) and low-value assets. Understand variable lease payments, residual value guarantees, purchase and extension options, and sale-and-leaseback accounting. Lessors classify leases as finance or operating.
Traps candidates fall into
- Discounting at the lessee's incremental borrowing rate when the implicit rate is readily determinable.
- Excluding extension periods from the lease term when exercise is reasonably certain.
- Treating variable payments based on sales as part of the lease liability; they are expensed as incurred.
- Forgetting to remeasure the liability when there is a change in lease term or a change in the index.
- Classifying a lease as operating for the lessee; lessees use a single model with limited exemptions.
- Ignoring the initial direct costs added to the right-of-use asset.
Rule of thumb
Identify the asset and whether the lessee controls its use. Measure the liability at the present value of unavoidable lease payments over the lease term, then split each payment between interest and principal.
Worked example
A 3-year lease with annual payments of 100,000 in arrears, incremental borrowing rate 10%. PV = 100,000 × 2.4869 ≈ 248,690. Year 1 interest = 24,869; principal repaid = 75,131; closing liability = 173,559. Depreciate the right-of-use asset of 248,690 over 3 years.