Finance team: accounting for a new lease
Decide which contracts are leases, then set up a new equipment lease under IFRS 16 and explain the effect to the finance director.
ACCA exams this helps with: FR Financial Reporting See the ACCA map
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When a company signs a new contract, the finance team has to work out whether it contains a lease. If it does, they set it up on the balance sheet under IFRS 16. Just as important is explaining to managers why the numbers look different from a simple rent bill.
Example. Renting specific gym machines for 5 years is a lease. Paying a company to clean the gyms is a service, even though the cleaners bring their own equipment.
Key words
- Identified asset
- In a lease, the specific asset the contract is for, such as a named machine or a particular building.Example: A contract for “machines serial numbers 101 to 110” has identified assets. A contract for “a cleaning service” does not.
- Right to control
- In a lease, when the customer decides how an asset is used and gets almost all of the benefit from using it.Example: Northwell decides when and how its leased gym machines are used, so it has the right to control them.
- EBITDA
- A profit figure calculated before taking off interest, tax, depreciation and amortisation. Lenders and analysts use it as a rough measure of cash-like profit.Example: Operating profit £300,000 + depreciation £50,000 = EBITDA £350,000.
- Lease incentive
- A payment or benefit that the owner of an asset gives to the business renting it, to encourage it to sign the lease.Example: The lessor pays Northwell £3,000 in cash for signing the equipment lease.
- Covenant
- A condition in a loan agreement that the borrower must keep to. If it is broken, the lender may be able to demand the money back.Example: “Operating profit must be at least 3 times the interest cost.” A result of 2.63 times breaks the covenant.
Your brief and documents
You are back in the finance team at Northwell Fitness Ltd (a fictional gym chain). The year end is 31 December. The company has just signed several new contracts.
Hi,
We’ve signed a few new contracts this month. Can you check which ones are leases we need to put on the balance sheet under IFRS 16? Then please set up the new gym equipment lease, and draft a short note for the FD on how it will affect our numbers. She is used to seeing a simple rent expense.
Thanks, Jordan
Document 1: New contracts signed on 1 January
| Contract | Details |
|---|---|
| Gym equipment | 5-year lease of specific, named machines. Payments of £24,000 a year, paid at the end of each year. |
| New gym premises | 10-year lease of a building. |
| Cleaning | 3-year contract for a cleaning company to clean all sites. They choose the staff and equipment. |
| Booking software | 3-year subscription to cloud booking software run on the supplier’s servers. |
| Pop-up studio | 6-month rental of a unit for a summer promotion, with no option to extend. |
| Reception tablets | Lease of 4 tablets for the front desks. |
Document 2: Gym equipment lease details
| Item | Detail |
|---|---|
| Annual payment (in arrears) | £24,000 for 5 years |
| Rate implicit in the lease | Not known |
| Northwell’s incremental borrowing rate | 7% |
| Legal fees paid to set up the lease | £2,000 |
| Cash incentive received from the lessor on signing | £3,000 |
| Useful life of the machines | 8 years; ownership doesn’t transfer |
Watch it explained
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Videos from YouTube tutors
These videos are made by independent tutors on YouTube, not by Trial Balance. Some use US terms or older exam names (for example F7 for FR), but the principles are the same.
How a senior would approach it
- Is it a lease? A contract contains a lease if there is an identified asset and the customer has the right to control its use for a period. A service where the supplier chooses which assets to use isn’t a lease.
- Exemptions: leases of 12 months or less and low-value assets can simply be expensed.
- Discount rate: if the rate implicit in the lease isn’t known, use the incremental borrowing rate.
- Right-of-use asset: the lease liability, plus initial direct costs, minus incentives received.
- Explaining it: the finance director cares about the effect on profit, EBITDA and debt, not the technical wording. Lead with those.
Your tasks
Work through the tasks in order, using the documents in your brief. Each task is checked when you press Check answer.