Leases, Income Taxes and Foreign Currency Transactions

Introduction and context

Modern financial reporting increasingly requires accountants to represent arrangements whose legal form does not fully reveal their economic substance. A lease may transfer the right to control the use of an asset without transferring legal ownership. Tax expense may differ substantially from tax paid because accounting and tax rules recognise income and expenditure at different times. Foreign currency transactions may create gains or losses even when the underlying commercial transaction is profitable. Foreign operations add a further translation problem because their financial statements must be expressed in the presentation currency of the reporting entity.

This chapter examines these issues primarily through the requirements and logic of IFRS 16 Leases, IAS 12 Income Taxes and IAS 21 The Effects of Changes in Foreign Exchange Rates. The principles are also useful when analysing substantially converged national standards, although jurisdiction-specific tax law, exemptions and presentation rules must always be verified.

Learning objectives

After studying this chapter, the reader should be able to:

• identify a lease and distinguish lessee and lessor accounting;
• measure and subsequently account for right-of-use assets and lease liabilities;
• explain current tax, deferred tax and temporary differences;
• calculate deferred tax assets and liabilities and assess recognition restrictions;
• account for foreign-currency transactions and exchange differences;
• translate the financial statements of a foreign operation;
• evaluate the effects of leases, taxes and currency movements on performance, risk and financial ratios; and
• apply the standards to complex professional situations with appropriate judgement and documentation.

1. Lease accounting: substance, control and scope

1.1 Identifying a lease

A contract contains a lease when it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Control requires both:

1. the right to obtain substantially all of the economic benefits from use of the identified asset; and
2. the right to direct how and for what purpose the asset is used.

An asset is normally identified when it is explicitly or implicitly specified and the supplier cannot practically substitute it, or would not benefit economically from doing so. A physically distinct portion of a larger asset may also be identified.

The analysis is based on facts and circumstances at contract inception. A customer’s right to make decisions that protect the supplier’s interests is not, by itself, a right to direct use. Similarly, a contract for capacity is not necessarily a lease if the supplier controls the asset and the customer receives only an output or service.

1.2 Lease term and payments

The lease term includes the non-cancellable period, periods covered by an extension option reasonably certain to be exercised, and periods covered by a termination option reasonably certain not to be exercised. Judgement considers economic incentives, the importance of the underlying asset, relocation costs, leasehold improvements and the consequences of failing to exercise an option.

Lease payments may include fixed payments, in-substance fixed payments, payments linked to an index or rate, residual-value guarantees and purchase or termination option amounts when exercise is reasonably certain. Variable payments linked to usage or performance are generally excluded from initial lease liability measurement and recognised in profit or loss when the triggering event occurs.

2. Lessee accounting under IFRS 16

2.1 The right-of-use model

At commencement, a lessee generally recognises:

• a right-of-use (ROU) asset; and
• a lease liability.

This model replaces the former distinction between operating and finance leases for most lessees. Exemptions are available for short-term leases and leases of low-value assets, subject to the standard’s conditions. A short-term lease normally has a lease term of 12 months or less and contains no purchase option.

2.2 Initial measurement

The lease liability is the present value of unpaid lease payments at commencement. If the interest rate implicit in the lease is readily determinable, it is used. Otherwise, the lessee uses its incremental borrowing rate: the rate the lessee would pay to borrow, over a similar term and with similar security, funds necessary to obtain an asset of similar value in a similar economic environment.

Here, LL₀ is the initial lease liability, Pₜ is the lease payment due at time t, r is the applicable periodic discount rate, and t is the number of periods until payment. The formula assumes payments and the rate are expressed on the same periodic basis. Payments made at commencement are not discounted and are included directly in the ROU asset rather than in the liability.

The initial ROU asset generally comprises the initial lease liability, payments made at or before commencement less incentives received, initial direct costs, and an estimate of dismantling, removal or restoration costs when an obligation exists.

P₀ represents payments made at or before commencement, I is lease incentives received, D is qualifying initial direct costs and R is the present estimate of restoration or removal costs. The equation applies to the ordinary lessee model and must be adapted where a specific exemption or transaction structure applies.

2.3 Subsequent measurement

After commencement, the lease liability is increased by interest, reduced by payments and remeasured when required by the standard.

The ROU asset is normally depreciated, often on a straight-line basis over the shorter of the lease term and the useful life of the underlying asset, unless ownership transfers or a purchase option is reasonably certain to be exercised. It is also tested for impairment under IAS 36.

For a lease with no ownership transfer and no reasonably certain purchase option:

For most leased assets the residual value for the lessee is zero, but the correct amount depends on the relevant facts. Interest expense and depreciation are presented separately, producing a front-loaded total expense pattern when payments are level.

2.4 Remeasurement and modifications

A lessee remeasures the lease liability when there is a change in lease term, assessment of a purchase option, expected payments under a residual-value guarantee, or payments resulting from changes in an index or rate, where required. The revised liability is generally recorded against the ROU asset.

A lease modification is treated as a separate lease when it grants an additional right of use and consideration increases by an amount commensurate with the stand-alone price. Otherwise, the existing lease is modified by adjusting the liability and ROU asset; a reduction in scope may require partial derecognition and recognition of a gain or loss.

Worked example 1: lessee measurement

An entity enters a four-year lease. Payments of CU 30,000 are made at each year-end. The incremental borrowing rate is 8%, and there are no incentives, initial direct costs or restoration obligations. The present-value factor for a four-year ordinary annuity at 8% is approximately 3.3121.

Initial liability:

Assume the ROU asset also equals CU 99,363. Year-one interest is:

The year-one closing liability is:

Straight-line depreciation is CU 99,363 ÷ 4 = CU 24,841 per year. Therefore, year-one profit or loss includes depreciation of approximately CU 24,841 and interest of CU 7,949, while the closing ROU asset is approximately CU 74,522 before impairment.

2.5 Presentation and ratios

A lessee presents the ROU asset and lease liability separately or within relevant asset and liability classes with appropriate disclosure. Principal lease payments are generally financing cash flows, interest follows the entity’s policy under IAS 7, and short-term, low-value and certain variable payments are operating cash flows.

Capitalising leases increases reported assets and liabilities, EBITDA and often operating profit compared with old operating-lease accounting, while increasing depreciation and finance costs. Analysts must therefore consider accounting-policy changes before comparing leverage, asset turnover and EBITDA across periods or entities.

3. Lessor accounting

3.1 Finance and operating leases

A lessor classifies a lease as a finance lease when it transfers substantially all risks and rewards incidental to ownership. Indicators include transfer of ownership, a purchase option reasonably certain to be exercised, a lease term representing a major part of economic life, present value of payments amounting substantially to fair value, or an asset so specialised that it has no practical alternative use to the lessor.

Classification depends on the substance of the arrangement, not a single numerical threshold. A lease that does not transfer substantially all risks and rewards is an operating lease.

3.2 Finance lease accounting

At commencement, a lessor recognises a net investment in the lease, generally comprising the present value of lease payments and any unguaranteed residual value discounted at the interest rate implicit in the lease. Finance income is recognised over the lease term to produce a constant periodic rate of return on the net investment. A manufacturer or dealer lessor may also recognise selling profit or loss at commencement, subject to the applicable requirements.

3.3 Operating lease accounting

The lessor retains the underlying asset, continues to depreciate it, and recognises lease income generally on a straight-line basis unless another systematic basis better represents the pattern of benefit. Initial direct costs are added to the carrying amount of the underlying asset and recognised as expense over the lease term on the same basis as lease income, subject to the standard.

3.4 Sale-and-leaseback transactions

A seller-lessee first determines whether the transfer qualifies as a sale under IFRS 15. If it does, the seller-lessee recognises the retained right of use and only the gain relating to rights transferred to the buyer-lessor. If it does not qualify as a sale, the transaction is accounted for as financing: the asset remains recognised and a financial liability is recorded.

4. Income taxes: current and deferred taxation

4.1 Current tax

Current tax is the amount of income tax payable or recoverable in respect of taxable profit or tax loss for a period. Taxable profit is determined under tax law, not simply by adjusting accounting profit informally. Current tax liabilities and assets are measured using tax rates enacted or substantively enacted by the reporting date.

A simplified calculation is:

This is a presentation aid rather than a substitute for the tax return. Progressive rates, minimum taxes, withholding taxes, uncertain tax treatments and jurisdictional rules may require a more detailed calculation.

4.2 Temporary differences

A temporary difference is the difference between the carrying amount of an asset or liability in the statement of financial position and its tax base. It is not the same as a permanent difference, which affects accounting profit or taxable profit but will never reverse, such as certain permanently disallowed expenses.

The tax base of an asset is the amount deductible for tax purposes against future taxable economic benefits recovered through the asset. The tax base of a liability is its carrying amount less amounts deductible for tax purposes in future periods; for revenue received in advance, it is generally the carrying amount less any amount of revenue that will not be taxable in the future.

4.3 Deferred tax liability and asset

A taxable temporary difference generally creates a deferred tax liability (DTL), because future recovery or settlement is expected to increase taxable profit. A deductible temporary difference generally creates a deferred tax asset (DTA), because future reversal is expected to reduce taxable profit.

The tax rate must be enacted or substantively enacted at the reporting date and appropriate to the manner of recovery or settlement. Deferred tax is normally recognised in profit or loss, but it is recognised in other comprehensive income or directly in equity when the underlying transaction was recognised there.

A DTA is recognised only to the extent that it is probable that taxable profit will be available against which the deductible difference or tax loss can be utilised. Evidence such as recent losses, expiry periods, reliable forecasts, tax-planning opportunities and reversal of existing taxable temporary differences is relevant.

4.4 Recognition exceptions and special matters

Important exceptions include certain initial-recognition situations, investments in subsidiaries, associates and joint arrangements, and goodwill. The initial-recognition exception has been narrowed by amendments requiring recognition where equal taxable and deductible temporary differences arise, such as some leases and decommissioning obligations.

Deferred tax is not discounted. It is measured using expected tax consequences, including whether an asset will be recovered through use, sale or a combination. Tax laws concerning capital gains, indexation and different rates may therefore affect measurement.

Worked example 2: temporary differences

An asset has a carrying amount of CU 500,000 and a tax base of CU 380,000. The enacted tax rate expected on recovery is 25%.

The taxable temporary difference is CU 120,000. Assuming no recognition exception applies:

If a liability has a carrying amount of CU 80,000 but only CU 20,000 will be deductible in future, its tax base is CU 60,000. The deductible temporary difference is CU 20,000 and the potential DTA is CU 5,000 at 25%, subject to the probability-of-utilisation test.

4.5 Tax reconciliation and effective tax rate

The effective tax rate (ETR) is commonly analysed as:

The ETR may differ from the statutory rate because of permanent differences, tax incentives, different jurisdictional rates, withholding taxes, uncertain tax positions, changes in DTA recognition and prior-period adjustments. A low ETR is not automatically evidence of aggressive tax behaviour, but unexplained fluctuations require investigation and disclosure.

5. Foreign currency transactions

5.1 Functional currency

An entity’s functional currency is the currency of the primary economic environment in which it operates. Indicators include the currency mainly influencing sales prices and labour, material and other costs, financing currency, and the currency in which operating receipts are retained. Management does not choose functional currency merely for reporting convenience.

A reporting entity may present financial statements in a presentation currency different from its functional currency. The distinction is fundamental: functional currency reflects economic substance; presentation currency is a reporting choice subject to appropriate translation.

5.2 Initial recognition and subsequent measurement

A foreign-currency transaction is initially recorded in the functional currency using the spot exchange rate at the transaction date. For practical reasons, an average rate may be used when rates do not fluctuate significantly.

At each reporting date:

• foreign-currency monetary items are translated at the closing rate;
• non-monetary items measured at historical cost use the transaction-date rate; and
• non-monetary items measured at fair value use the rate when fair value was measured.

Exchange differences on monetary items are generally recognised in profit or loss, except where another standard requires recognition in other comprehensive income or incorporation into the cost of a qualifying asset. For non-monetary items, the location of the related gain or loss determines the treatment of the exchange component.

Worked example 3: monetary payable

An entity purchases inventory for USD 100,000 when the spot rate is CU 1.20 per USD. Initial recognition is CU 120,000. At year-end, the closing rate is CU 1.25 per USD and the payable remains unpaid.

Year-end liability:

The CU 5,000 increase is an exchange loss in profit or loss, assuming no hedge accounting or other applicable exception. When the payable is settled at CU 1.23 per USD, the settlement amount is CU 123,000. The entity then recognises a CU 2,000 exchange gain relative to the year-end carrying amount.

6. Foreign operations and translation

A foreign operation is an entity, branch or other operation whose activities are based or conducted in a country or currency different from those of the reporting entity. Its financial statements are translated into the presentation currency for consolidation or, where relevant, equity accounting.

Under the ordinary translation method:

• assets and liabilities are translated at the closing rate at the reporting date;
• income and expenses are translated at transaction-date rates, or suitable averages when rates are stable; and
• resulting exchange differences are recognised in other comprehensive income and accumulated in a separate component of equity.

On disposal of the foreign operation, the cumulative amount relating to that operation is reclassified from equity to profit or loss when required by the standard. A partial disposal may result in proportional reclassification or retention depending on whether control, significant influence or joint control is lost.

Goodwill and fair-value adjustments arising on acquisition of a foreign operation are treated as assets and liabilities of that operation and translated at the closing rate. This rule can create significant translation differences even when local-currency performance is stable.

Net investment and intragroup balances

A monetary item receivable from or payable to a foreign operation may form part of the reporting entity’s net investment when settlement is neither planned nor likely in the foreseeable future. Exchange differences are recognised in profit or loss in separate financial statements but in other comprehensive income in consolidated financial statements until disposal of the foreign operation.

7. Integrated case: Northstar Group

The following is an illustrative case, not a report on a real entity.

Background

Northstar Group, whose presentation currency is CU, enters a five-year property lease for a distribution centre. Annual payments of CU 200,000 are made in arrears. The incremental borrowing rate is 6%. Northstar also purchases inventory from a US supplier for USD 400,000. Finally, its wholly owned subsidiary in Country F has the local currency FC as its functional currency.

Problem

Management must determine the lease liability and ROU asset, account for the foreign-currency payable, and translate the subsidiary’s results. The group also needs to assess deferred tax arising from the lease.

Analysis and approach

The lease contains an identified property and gives Northstar the right to direct its use. It is therefore a lease. The present-value annuity factor for five year-end payments at 6% is approximately 4.2124.

With no incentives or other adjustments, the initial ROU asset is CU 842,480. Year-one interest is CU 50,549, and the year-one closing liability is:

Straight-line depreciation over five years is CU 168,496 annually. Northstar therefore recognises separate depreciation and interest rather than a single rent expense.

Assume the USD payable arose when the rate was CU 1.10 per USD and the year-end rate is CU 1.14. Initial recognition is CU 440,000; closing measurement is CU 456,000. The CU 16,000 exchange loss is recognised in profit or loss unless a specific exception applies.

For Country F, assets and liabilities are translated at the closing rate, while income and expenses use transaction-date rates or a reliable average. The resulting translation difference is reported in other comprehensive income and accumulated in the foreign-currency translation reserve.

The lease may also create temporary differences because the carrying amounts of the ROU asset and lease liability do not necessarily equal their tax bases. Northstar calculates each temporary difference separately and recognises the related DTA or DTL subject to the applicable initial-recognition and probability requirements.

Outcome and learning points

Northstar’s accounting reflects three distinct measurement systems: present-value measurement for the lease, tax-base analysis for deferred tax, and exchange-rate measurement for foreign currency. A failure to distinguish these systems could result in omitted liabilities, incorrect tax expense or an exchange difference recorded in the wrong statement.

The case also illustrates why accounting entries should be supported by contract registers, tax-base schedules, exchange-rate evidence, functional-currency assessments and consolidation worksheets. Professional judgement must be documented rather than hidden in spreadsheet formulas.

8. Governance, technology and contemporary practice

Lease portfolios are often too large for manual control. Contract-management systems can extract payment dates, index clauses, renewal options and termination provisions, while accounting platforms calculate amortisation schedules. However, artificial intelligence and automated extraction do not replace the accountant’s responsibility to validate identified assets, enforceability, options, discount rates and modifications. Model outputs require controls, version history and human review.

Tax reporting requires reconciliation between the general ledger, tax computation and deferred-tax roll-forward. Governance should address uncertain tax treatments, transfer pricing, tax incentives, country-by-country reporting and the risk that tax planning conflicts with the entity’s ethical commitments or substance requirements.

Foreign-exchange controls should include approved rate sources, cutoff testing, remeasurement routines, hedge documentation and segregation of duties. Exchange-rate volatility can materially affect covenants, liquidity forecasts and reported earnings even when operating cash flows are unchanged.

Contemporary reporting increasingly emphasises transparency about significant judgements, estimation uncertainty, liquidity risk, maturity analyses, sensitivity to rates and the nature of foreign-exchange exposure. Users need to understand not only the recognised amounts but also the assumptions that could change them.

Challenges and limitations

Several areas remain judgement-intensive:

• identifying whether a supplier has substantive substitution rights;
• assessing whether renewal or purchase options are reasonably certain;
• selecting an incremental borrowing rate for a non-standard lease;
• determining the tax base under complex or changing tax legislation;
• forecasting sufficient taxable profit to support a DTA;
• determining functional currency in a multinational group; and
• deciding whether an intragroup balance forms part of a net investment.

Standards-based accounting also has limitations. Present values depend on estimates, tax accounting depends on legislation that may change, and translation differences can obscure underlying operating performance. Comparability may be reduced by different judgements even where entities apply the same standards. These limitations reinforce the need for sensitivity analysis, clear disclosure and robust professional scepticism.

Best-practice checklist

A high-quality close process should:

1. maintain a complete lease inventory, including embedded leases;
2. reassess options, modifications and index-linked payments at each reporting date;
3. reconcile lease subledgers to the general ledger and cash payments;
4. maintain a temporary-difference matrix by asset, liability and jurisdiction;
5. support DTA recognition with documented forecasts and expiry analysis;
6. approve functional-currency conclusions using economic indicators;
7. use consistent, independently sourced exchange rates;
8. reconcile foreign-operation translation reserves; and
9. disclose significant judgements, maturity information and sensitivity where material.

Chapter Summary

Lease accounting focuses on the economic right to control an identified asset. Most lessees recognise a right-of-use asset and a lease liability measured using discounted lease payments. Subsequent accounting separates depreciation from interest and requires reassessment for specified changes. Lessors classify leases according to whether risks and rewards are transferred, applying net-investment accounting for finance leases and retaining the asset for operating leases.

Current tax is based on taxable profit under tax law. Deferred tax arises from temporary differences between carrying amounts and tax bases. Taxable temporary differences generally produce deferred tax liabilities, while deductible differences produce deferred tax assets only when future taxable profit is probable. Measurement uses enacted or substantively enacted rates expected on reversal, and deferred tax is not discounted.

Foreign-currency transactions are initially recorded at the transaction-date rate. Monetary items are retranslated at closing rates, with exchange differences generally recognised in profit or loss. Foreign operations are translated using closing rates for assets and liabilities and transaction-date or suitable average rates for income and expenses; resulting translation differences normally enter other comprehensive income until disposal. Across all three topics, reliable accounting depends on substance, disciplined estimates, documented judgement and effective systems of control.

Key Terms

Functional currency: The currency of the primary economic environment in which an entity operates.

Presentation currency: The currency in which financial statements are presented.

Lease: A contract conveying the right to control use of an identified asset for a period in exchange for consideration.

Right-of-use asset: A lessee’s recognised asset representing the right to use an underlying asset.

Lease liability: A lessee’s present obligation to make lease payments.

Incremental borrowing rate: The rate a lessee would pay to borrow funds for a similar asset, term and economic environment.

Finance lease: A lease transferring substantially all risks and rewards incidental to ownership.

Operating lease: A lessor lease that does not transfer substantially all such risks and rewards.

Lease modification: A change in scope or consideration not included in the original terms and conditions.

Current tax: Tax payable or recoverable for taxable profit or loss of the current or prior periods.

Tax base: The amount attributed to an asset or liability for tax purposes.

Temporary difference: The difference between an item’s carrying amount and tax base.

Deferred tax liability: Tax expected to be payable from reversal of taxable temporary differences.

Deferred tax asset: Future tax benefit from deductible temporary differences, unused losses or credits, subject to recognition criteria.

Permanent difference: A difference that will not reverse in future periods.

Exchange difference: The difference arising when the same foreign-currency amount is translated at different exchange rates.

Closing rate: The spot exchange rate at the reporting date.

Foreign operation: An entity, branch or operation whose activities are based in a different country or currency environment.

Translation reserve: Equity component accumulating qualifying exchange differences from translating a foreign operation.

Net investment in a foreign operation: A long-term monetary interest whose settlement is neither planned nor likely in the foreseeable future.

Review Questions

Short Answer Questions

1. What two conditions must exist for a contract to contain a lease?
2. Define a temporary difference and distinguish it from a permanent difference.
3. When is a deferred tax asset recognised?
4. How are foreign-currency monetary items measured at the reporting date?
5. What is the difference between functional currency and presentation currency?

Long Answer Questions

1. Explain the initial and subsequent accounting for a lessee under the right-of-use model, including the role of the discount rate.
2. Compare finance-lease and operating-lease accounting from a lessor’s perspective.
3. Explain the tax-base approach to deferred tax, including recognition, measurement and presentation.
4. Discuss the translation process for a foreign operation and the treatment of resulting exchange differences.
5. Evaluate how lease capitalisation affects EBITDA, leverage and comparability between entities.

Analytical / Application Questions

1. A company signs a six-year lease with renewal options, index-linked payments and a restoration obligation. Design a process for determining the lease term, initial liability and ROU asset, identifying the judgements that require documentation.
2. An entity reports accounting profit despite recent tax losses and has several deductible temporary differences. Analyse the evidence required before recognising a deferred tax asset.
3. A foreign subsidiary has stable local-currency profits but produces a large translation loss for the group. Explain how this can occur and assess the implications for performance analysis and risk management.

Multiple Choice Questions with Answers

Question 1

Which condition is essential for a contract to contain a lease?

A. The customer obtains legal ownership of the asset.

B. The customer controls the use of an identified asset.

C. The supplier guarantees a fixed profit.

D. The contract lasts more than twelve months.

Correct Answer: B. The customer controls the use of an identified asset.

Question 2

A lease liability is initially measured primarily as:

A. The fair value of the underlying asset

B. The total undiscounted lease payments

C. The present value of unpaid lease payments

D. The supplier’s carrying amount of the asset

Correct Answer: C. The present value of unpaid lease payments

Question 3

Using an 8% rate, what is the first-year interest on a lease liability of CU 99,363?

A. CU 7,949

B. CU 8,736

C. CU 24,841

D. CU 30,000

Correct Answer: A. CU 7,949

Question 4

A taxable temporary difference generally gives rise to a:

A. Current tax credit

B. Deferred tax liability

C. Permanent difference

D. Deferred revenue balance

Correct Answer: B. Deferred tax liability

Question 5

A deferred tax asset is recognised only to the extent that:

A. The entity has paid tax in advance

B. The temporary difference is permanent

C. Future taxable profit is probable for utilisation

D. The tax rate is zero

Correct Answer: C. Future taxable profit is probable for utilisation

Question 6

An asset has a carrying amount of CU 500,000 and a tax base of CU 380,000. At 25%, the deferred tax liability is:

A. CU 20,000

B. CU 25,000

C. CU 30,000

D. CU 120,000

Correct Answer: C. CU 30,000

Question 7

At initial recognition, a foreign-currency transaction is normally recorded using:

A. The closing rate at year-end

B. The transaction-date spot rate

C. The average rate for the previous year

D. The tax authority’s rate only

Correct Answer: B. The transaction-date spot rate

Question 8

A foreign-currency monetary payable is generally retranslated at:

A. The historical transaction-date rate

B. The closing rate at the reporting date

C. The rate used for non-monetary historical-cost assets

D. The rate stated in the supplier’s budget

Correct Answer: B. The closing rate at the reporting date

Question 9

For translating a foreign operation, assets and liabilities are generally translated at:

A. The closing rate

B. The transaction-date rate only

C. The average rate for all prior years

D. The rate at acquisition only

Correct Answer: A. The closing rate

Question 10

Exchange differences arising from translating a foreign operation are generally first recognised in:

A. Inventory

B. Profit or loss in all cases

C. Other comprehensive income

D. Current tax expense

Correct Answer: C. Other comprehensive income