Derecognition

The expression " operating lease" is somewhat confusing as it has a different meaning based on the
context that is under consideration. From a product characteristic stand point, this type of a lease, as
distinguished from a finance lease, is one where the lessor takes larger residual risk, whereas finance
leases have no or a very low residual value position. As such, the operating lease is non full payout. From
an accounting stand point, this type of lease (if it fails to meet varied criteria that define a finance lease)
results in off balance sheet financing which can be advantageous for companies in terms of gearing and
other accounting ratios.

The determination of whether a lease is a finance (also called capital) lease or an operating lease from an
accounting point of view is defined in the United States by Statement of Financial Accounting Standards
No. 13 (FAS 13). In countries covered by International Financial Reporting Standards, the tests are
defined in IAS 17. In July 2006, the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively
reconsider lease accounting. In July 2008, the boards decided to defer any changes to lessor accounting,
while continuing with the project for lessee accounting, with the stated intention to recognise an asset
and liability for all lessee leases (in essence, eliminating operating lease accounting). This culminated in
the issuance of IFRS 16 and FASB Topic 842. Both are effective January 1,2019. The similarity in the two
pronouncements is that leases, which previously qualified as operating leases- and hence resulted in off
balance sheet treatment, are now to be capitalized by the lessee.

Unlike a finance lease (differs by geography & whether a small residual value), at the end of the
operating lease the title to the asset does not pass to the lessee, but remains with the lessor.
Accordingly, at the end of an operating lease, the lessee has several options:

Return of the equipment

Renewal of the lease

Purchase of the equipment (not available in all geographies)

Operating leases, where the lessor takes a residual position, offer a host of benefits to the lessee the
type of which finance leases do not

An asset is derecognized upon its disposal, or when no future economic benefits can be expected from
its use or disposal. Derecognition can arise from a variety of events, such as an asset’s sale, scrapping, or
donation.
A gain or loss can be recognized from an asset’s derecognition, though a gain on derecognition cannot be
recorded as revenue. The gain or loss on derecognition is calculated as the net disposal proceeds, minus
the asset’s carrying value.

Derecognition refers to the removal of an asset or liability (or a portion thereof) from an entity's balance
sheet. Derecognition questions can arise with respect to all types of assets and liabilities. This project
focuses on financial instruments. Questions regarding derecognition of assets and liabilities often arise in
the context of certain special purpose entities and whether those entities should be included in a set of
consolidated financial statements.

The IASB agreed to consider both a comprehensive project on derecognition or all types of assets and
liabilities and also a separate, narrower scope project that would explore the need to revise guidance in
IAS 39 Financial Instruments: Recognition and Measurement in the area of derecognition of financial
instruments. This limited scope project would address questions that have arisen with regard to the
application of conflicting aspects of IAS 39's guidance on derecognition. The project would result in an
amendment to IAS 39 possibly through issuance of a separate standard on derecognition that
supersedes that section of IAS 39.

Current status of the project

The IASB had originally proposed to replace the existing derecognition model in IAS 39 Financial
Instruments: Recognition and Measurement and the associated disclosure requirements in IFRS 7
Financial Instruments: Disclosures. However, in light of the feedback received during the consultation
process, the IASB decided to retain the existing derecognition requirements and to finalise improved
disclosure requirements.

Derecognition of financial assets

Derecognition is the removal of a previously recognised financial asset (or financial liability) from an
entity’s statement of financial position. In general, IFRS 9 criteria for derecognition of a financial asset
aim to answer the question whether an asset has been sold and should be derecognised or whether an
entity obtained a kind of financing against this asset and simply a financial liability should be recognised.

Derecognition criteria for financial assets are summarised in the decision tree below reproduced from
paragraph IFRS 9.B3.2.1. This is a very useful framework that helps go through the discussion that
follows.
Derecognition criteria applied to a part or all of an asset

Derecognition criteria in IFRS 9 should be applied to a part of an asset if, and only if, the part being
considered for derecognition meets one of the following three conditions (IFRS 9.3.2.2):

a/ The part comprises only specifically identified cash flows from a financial asset or a group of similar
financial assets.

b/ The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset
or a group of similar financial assets.

c/ The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from
a financial asset or a group of similar financial assets.

These conditions should be applied strictly as is illustrated in examples given in paragraph IFRS
9.3.2.2(b). If none of them is met, derecognition criteria are applied to the financial asset in its entirety.

The subsequent discussion on derecognition will refer to ‘a financial asset’ but is important to keep in
mind that ‘a financial asset’ may refer to a part of an asset if the criteria above are met.

A group of similar financial assets.

The criteria to decide whether derecognition criteria should be applied to the financial asset in its
entirety or to a part of it refer also to ‘a group of similar financial assets’. It is not further explained in
IFRS 9 what is meant by a group of similar financial assets and IASB acknowledged that there is a
diversity in determining what a group of similar financial assets is. It is quite common that non-derivative
assets (e.g. loans) are transferred together with derivative financial instruments (e.g. interest rate
swaps). The September 2006 IASB update indicated that derecognition tests in IAS 39 (now in IFRS 9)
should be applied to non-derivative financial assets (or groups of similar non-derivative financial assets)
and derivative financial assets (or groups of similar derivative financial assets) separately, even if they are
transferred at the same time. The IASB also indicated that transferred derivatives that could be assets or
liabilities (such as interest rate swaps) and are transferred would have to meet both the financial asset
and the financial liability derecognition tests. However, there is no binding interpretation addressing this
issue, therefore entities can develop their own accounting policies in this respect.

Derecognition of financial assets has drawn a lot of attention in the Enron scandal. Enron used special
purpose entities—limited partnerships or companies created to fulfil a temporary or specific purpose to
fund or manage risks associated with specific (financial and/or non-financial) assets. Derecognition of
financial assets

On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to
2000 were necessary to correct accounting violations. The restatements for the period reduced earnings
by $613 million (or 23% of reported profits during the period), increased liabilities at the end of 2000 by
$628 million (6% of reported liabilities and 5.5% of reported equity), and reduced equity at the end of
2000 by $1.2 billion (10% of reported equity).

financial asset is derecognised only when the contractual rights to the cash flows from the financial asset
expire or when the financial asset is transferred and the transfer meets certain specified conditions (‘the
asset transfer test’). Derecognition of financial assets

An entity derecognises a transferred financial asset if it transfers substantially all of the risks and rewards
of ownership (‘the risks and reward test‘). An entity does not derecognise a transferred financial asset if
it retains substantially all of the risks and rewards of ownership.

A financial asset is derecognised only when the contractual rights to the cash flows from the financial
asset expire or when the financial asset is transferred and the transfer meets certain specified
conditions: Derecognition of financial assets

An entity derecognises a transferred financial asset if it transfers substantially all of the risks and rewards
of ownership. An entity does not derecognise a transferred financial asset if it retains substantially all of
the risks and rewards of ownership.

An entity continues to recognise a transferred financial asset to the extent of its continuing involvement
if it has neither retained nor transferred substantially all of the risks and rewards of ownership, and it has
retained control of the financial asset.

Derecognition of Long-lived Assets

Sales of Long-lived Assets

The gain or loss on the sale of a long-lived asset (for example, property, plan, and equipment) is
computed as the sales proceed less the carrying amount of the asset at the time of sale. The gain or loss
is disclosed on the income statement, either as a component of other gains and losses or in a separate
line item when the amount is considered to be material.

Disposal of Long-lived Assets other than by a Sale

Long-lived assets which are to be disposed of other than by a sale (for example, abandoned, exchanged
for another asset, or distributed to owners in a spin-off) are classified as held for use until disposal. The
long-lived assets will, therefore, continue to be depreciated and tested for impairment, unless their
carrying amount is zero, as required for other long-lived assets owned by the company.

When an asset is retired or abandoned, the asset value is reduced by the carrying amount of the asset at
the time of retirement or abandonment, and a loss equal to the asset’s carrying amount is recorded.

When an asset is exchanged, the carrying amount of the asset given up is removed from the balance
sheet, the fair value of the asset acquired is added, and any difference between the carrying amount and
the fair value is reported as a gain or loss.

In a spin-off, an entire cash generating unit of a company with all of its assets is spun-off.

Question 1

Which of the following statements is least accurate?

A. An asset that is derecognized is not expected to provide any future benefits from either its use or
disposal

B. The asset value is increased by the carrying amount of an asset at the time of its retirement or
abandonment
C. The gain or loss on the sale of a long-lived asset is equal to the sales proceed less the carrying amount
of the asset at the time of sale.

Solution

The correct answer is B.

The asset value is reduced, not increased, by the carrying amount of an asset at the time of its
retirement or abandonment. Choices A and C provide accurate statements.

Question 2

The profit/loss made out of the derecognition of a long-lived asset is reported on the income statement
under:

A. Other comprehensive income.

B. A separate line item.

C. Either A or B.

Solution

The correct answer is C