IFRS16+IAS16

ABC Corp. is facing a lawsuit from a former employee for wrongful termination. The lawsuit claims damages of $1 million. ABC Corp. believes there is a 60% chance of losing the case. According to IAS 37, how should ABC Corp. account for this lawsuit?

• Recognize a provision of $1 million because the amount is probable.

• Disclose the lawsuit in the notes to the financial statements but do not recognize any provision.

• Recognize a provision of $600,000 because it reflects the best estimate of the amount required to settle the lawsuit.

• Ignore the lawsuit until the outcome is certain.

Answer explanation

According to IAS 37.14, “a provision should be recognized when:

-  There is a present obligation (legal or constructive) as a result of a past event.

-  It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation.

-  A reliable estimate can be made of the amount of the obligation.”

In the question above:

-  ABC Corp. is facing a lawsuit where the amount claimed is $1 million.

-  They estimate there is a 60% chance (probable) they will lose the case and be required to pay damages.

-  The best estimate of the amount required to settle the lawsuit is $600,000 (60% of $1 million). 

Therefore, option C is correct because it aligns with the requirements of IAS 37 to recognize a provision when it is probable, and a reliable estimate can be made. It reflects the amount that ABC Corp. would provision for in their financial statements related to this lawsuit. Options A, B, and D are all incorrect.

According to IFRS 16, what is not an example of a situation where the lease would be classified as a finance lease?

• the lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

• the lessee has the option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised.

• if ownership of the underlying asset transfers at the end of the lease for a variable payment equal to its then fair value.

• at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset.

Answer explanation

According to IFRS 16. 65, “if ownership of the underlying asset transfers at the end of the lease for a variable payment equal to its then fair value”, then it would be classified as an operating lease rather than a finance lease.  

Options A, B, and D are all from IFRS 16.63, which provides examples of a lease that is classified as a finance lease.

Company XYZ has leased a building for 10 years. At the commencement of the lease, which of the following statements is correct under IFRS 16?

• The leased building is recognized as an asset and a liability on XYZ's balance sheet.

• The leased building is recognized only as an asset on XYZ's balance sheet.

• The leased building is expensed immediately on XYZ's income statement.

• The leased building is recognized as a liability but not as an asset on XYZ's balance sheet.

Answer explanation

Under IFRS 16, lessees recognize leased assets and lease liabilities on their balance sheets for all leases, unless the lease term is 12 months or less or the underlying asset is of low value.

This is stated in IFRS 16.5, which states that “a lessee may elect not to apply the requirements in paragraph 22-49 to:

a) Short-term leases; and

b) Leases for which the underlying asset is of low value (as described in paragraphs B3-B8).”

According to IFRS 16.22, “at the commencement date, a lessee shall recognize a right-of-use asset and a lease liability.” This reflects the lessee's right to use the asset and the obligation to make lease payments.

Options B, C, and D are all incorrect because B and D only included one part of the requirements while C mentioned how the leased building should be expensed on the company’s income statement, which is not closely related to IFRS 16.

Under IFRS 16, which of the following lease types does NOT require recognition of an asset and a liability on the lessee's balance sheet?

• A 9-month lease of office space.

• A 15-month lease of manufacturing equipment.

• A lease of a delivery truck for 3 years.

• A lease of a warehouse for 5 years.

Answer explanation

According to IFRS 16, leases with a lease term of 12 months or less are considered short-term leases and do not require recognition of right-of-use assets and lease liabilities on the lessee's balance sheet.

According to IFRS 16.5, “a lessee may elect not to apply the requirements in paragraphs 22-49 to:

a) Short-term leases; and

b) Leases for which the underlying asset is of low value (as described in paragraphs B3-B8).” 

According to Appendix A of IFRS 16, a short-term lease is “a lease that, at the commencement date, has a lease term of 12 months or less.”

Options B, C, and D are all incorrect because they are over the 12-month period as stated in the requirements.

Company ABC leases machinery under a 3-year lease agreement. Midway through year 2, the terms of the lease are modified, extending the lease term by an additional year. How should Company ABC account for this lease modification under IFRS 16?

• Recalculate the lease liability and adjust the right-of-use asset to reflect the extended lease term.

• Ignore the lease modification since it does not change the total lease payments.

• Recognize a new lease liability and adjust the right-of-use asset, based on the revised lease term and payments.

• Recognize a new lease liability and adjust the right-of-use asset, based on the revised lease term and payments.

Answer explanation

When there is a lease modification that increases the scope of the lease (such as extending the lease term), IFRS 16 requires a lessee to account for the modification by recognizing a new lease liability and adjusting the right-of-use asset to reflect the revised lease term and payments.

According to IFRS 16.44, “a lessee shall account for a lease modification as a separate lease if both:

a) The modification increases the scope of the lease by adding the right to use one or more underlying assets; and

b) The consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract.”

According to IFRS 16.39, “a lessee shall apply paragraphs 40-43 to remeasure the lease liability to reflect changes to the lease payments. A lessee shall recognize the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset.” Option C closely matches the requirements while options A, B, and D are all incorrect.

How should a lessee determine the lease term for a lease that contains renewal options under IFRS 16?

• Only include the initial lease term in the calculation.

• Include the average of all possible lease terms in the calculation.

• Include the renewal options that are reasonably certain to be exercised.

• Include the maximum possible lease term in the calculation.

Answer explanation

According to IFRS16, paragraph 20, a lessee should consider the lease term to include renewal options that are reasonably certain to be exercised under IFRS 16.

Which of the following scenarios illustrates the recognition criteria for an item of property, plant, or equipment under IAS 16?

• A company purchases a new factory building for use in its manufacturing operations.

• A company leases a vehicle for transporting goods to cutomers.

• A company hires temporary office space for a one-month project.

• A company purchases inventory for resale in its retail stores.

Answer explanation

According to IAS 16.6, “property, plant and equipment are tangible items that:

a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and

b) are expected to be used during more than one period.

Option A best fits this criterion as it involves a tangible asset (factory building) being acquired for use in manufacturing operations.

Options B, C, and D are incorrect. Option B is incorrect because even though it involves the use of a tangible asset (the vehicle), leasing relates more closely with IFRS 16 or IAS 17, not IAS 16. Option C is incorrect because “temporary office space” is not considered to be property, plant, and equipment. Option D is incorrect because inventory purchased for resale is classified as inventory under IAS 2, not as property, plant, and equipment under IAS 16. Inventory is held for sale, is intended to be sold in the short term and not used in production or administrative activities.

Under IAS 16, which of the following costs should be capitalized as part of the initial measurement of property, plant, and equipment?

• Routine maintenance costs to keep equipment in good working condition.

• Costs incurred for staff training related to the operation of new equipment.

• Costs of dismantling and removing an old building to make way for new construction.

• Costs of legal fees incurred in defending the title of a property.

Answer explanation

According to IAS 16.16, “the cost of an item of property, plant and equipment comprises:

1. a) its purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

2. b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

3. c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.

Option C directly relates to the requirements as stated above.

Options A, B, and D are incorrect. Option A is incorrect because routine maintenance costs are generally expensed as incurred rather than capitalized. Option B is incorrect because costs related to training staff are also generally expensed as incurred. Option D is incorrect because, similar to the two other incorrect options above, legal fees incurred in defending the title of a property are typically expensed as incurred.

Which of the following expenditures should be expensed as incurred rather than capitalized as property, plant, and equipment under IAS 16?

• Major overhaul to extend the useful life of a machine.

• Costs of testing a newly acquired machine to ensure it is in working condition.

• Costs of relocating machinery to a new factory location.

• Costs of replacing a component of a machine to extend its useful life beyond its originally assessed standard of performance.

Answer explanation

According to IAS 16.12, “Under the recognition principle in paragraph 7, an entity does not recognise in the carrying amount of an item of property, plant and equipment the costs of the day-to-day servicing of the item. Rather, these costs are recognised in profit or loss as incurred.”

The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

a) it is probable that future economic benefits associated with the item will flow to the entity; and

b) the cost of the item can be measured reliably.

Option B involves testing to ensure the machine's functionality, which is typically part of the process of getting the asset ready for use and does not increase its future economic benefits beyond its originally assessed standard of performance.

Options A, C, and D are all incorrect. Option A is incorrect because costs incurred for a major overhaul that significantly extends its useful life or beyond its originally assessed standard of performance should be capitalized. Costs related to relocating machinery to a new factory location are considered to be directly attributable costs and such costs are generally capitalized as part of the asset rather than expensed. Option D is incorrect because similar to option A, costs incurred to replace a component of a machine to extend its useful life should be capitalized rather than expensed as incurred.

According to IAS 16, which of the following is not considered in determining the useful life of an asset?

• Expected usage of the asset. Usage is assessed by reference to the asset's expected capacity or physical output.

• Legal or similar limits on the use of the asset, such as the expiry dates of related leases.

• Expected physical wear and tear, which depends on operational factors such as the number of shifts for which the asset is to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle.

• Administration and other general overhead costs.

Answer explanation

According to IAS 16.19, “administrative and other general overhead costs” is part of the criteria for “examples of costs that are not costs of an item of property, plant and equipment”, which is not directly related to what is being assessed in this particular question.

Options A, B, and C are all incorrect because they can all be found under IAS 16.56, which provides examples of the different factors that are considered when determining the useful life of an asset.