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Valuation of an extension option

Real options valuation

IFRS 16, Leases 1. The purpose of this article is to summarise the key changes introduced by IFRS 16 from the perspective of the lessee and how these impact on their financial reporting.

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A lease is an agreement whereby the lessor the legal valuation of an extension option of an asset conveys to the lessee the user of the asset the right to use an asset for an agreed period of time in return for a payment or series of payments. The approach of IAS 17 was to distinguish between two types of lease.

Leases that transfer substantially all the risks and rewards of ownership of an asset were classified as finance leases. All other leases were classified as operating leases.

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It was for this reason that IFRS 16 was introduced. In order for such a contract to exist the user of the asset needs to have the right to: Obtain substantially all of the economic benefits from the use of the asset.

Types of real options[ edit ] Simple Examples Investment This simple example shows the relevance of the real option to delay investment and wait for further information, and is adapted from "Investment Example". Consider a firm that has the option to invest in a new factory. It can invest this year or next year. The question is: when should the firm invest?

The right to direct the use of the asset. This normally takes place through the asset being specified in a contract, or part of a contract. Example — identified assets Under a contract between a local government authority L and a private sector provider PP provides L with 20 trucks to be used for refuse collection on behalf of L for a 6-year period.

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The trucks, which are owned by P, are specified in the contract. L determines how they are used in the refuse collection process.

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L can use the trucks for another purposes if it so chooses. If a particular truck needs to be serviced or repaired, P is required to substitute a truck of the same type. Otherwise, and other than on default by L, P cannot retrieve the trucks during the six-year period.

Conclusion: The contract is a lease.

Real options valuation

L has the right to use the 20 trucks for six years which are identified and explicitly specified in the contract. Once delivered to L, the trucks can be substituted only when they need to be serviced or repaired.

How to Extend A Lease \u0026 Make Money from Short Leasehold Property- Lease Extension Valuation Training

Example — the right to direct the use of an asset A customer C enters into a contract with a road haulier H for the transportation of goods from London to Edinburgh on a specified truck. The truck is explicitly specified in the contract and H does not have substitution rights.

IFRS 16, Leases

The goods will occupy substantially all of the capacity of the truck. The contract specifies the goods to be transported on the truck and the dates of pickup and delivery.

H operates and maintains the truck and is responsible for the safe delivery of the goods. C is prohibited from hiring another haulier to transport the goods or operating the truck itself.

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Conclusion: This contract does not contain a lease. There is an identified asset. The truck is explicitly specified in the contract and H does not have the right to substitute that specified truck.

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C does have the right to obtain substantially all of the economic benefits from use of the truck over the contract period. Its goods will occupy substantially all of the capacity of the truck, thereby preventing other parties from obtaining economic benefits from use of the truck.

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However, C does not have the right to control the use of the truck because C does not have the right to direct its use. C does not have the right to direct how and for what purpose the truck is used. How and for what purpose the truck will be used i.

C has the same rights regarding the use of the truck as if it were one of many customers transporting goods using the truck.

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Accounting for leases With a very few exceptions see section 3. Lessees will recognise a right of use asset and an associated liability at the inception of the lease. The discount rate used to determine present value should be the rate of interest implicit in the lease. Any initial direct costs incurred by the lessee.

IFRS 16, Leases | F7 Financial Reporting | ACCA Qualification | Students | ACCA Global

An estimate of any costs to be incurred by the lessee in dismantling and removing the underlying asset, or restoring the site on which it is located unless the costs are incurred to produce inventories, in which case they would be accounted for in accordance with IAS 2 — Inventories. Costs of valuation of an extension option nature are recognised only when an entity incurs an obligation for them. Depreciation is over the shorter of the useful life of the asset and the lease term, unless the title to the asset transfers at the end of the lease term, in which case depreciation is over the useful life.

Example — accounting for leases A lessee enters into a year lease of one floor of a building, with an option to extend for a further five years.

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The lease liability will be measured using amortised cost principles. In order to help us with the example in the following section, we will measure the lease liability up to and including the end of year ten. This is done in the following table: Year.

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