CHAPTER 12: OPERATING LEASE – LESSOR

IFRS 16, par. 61: A lessor shall classify leases as either operating lease or finance lease.
o Operating Lease – a lease that does not transfer substantially all the risks and rewards incidental to ownership of
an underlying asset.
o Finance Lease – a lease that transfers substantially all the risks and rewards incidental to ownership of an
underlying asset; depends on the substance of the transaction rather than the form of the contract; any of the
following situations would lead to lease contract being classified as finance lease by the lessor:
a. The lease transfers ownership of the underlying asset to the lessee at the end of the lease term.
b. The lessee has an option to purchase the asset at a price sufficiently lower than the fair value at the date
the option becomes exercisable.
c. The lease term is for the major part of the economic life of the underlying asset even if title is not
transferred. (Major part – the new lease standard does not provide a definition on this but in USA GAAP,
major part means at least 75% of the asset’s economic life.)
d. The present value of the lease payments amounts to substantially all of the fair value of the underlying
asset at the inception of the lease. (Substantially all – the new lease standard does not provide a definition
on this but in USA GAAP, substantially all means at least 90% of the leased asset’s fair value.)
e. Other criteria (suggestive in nature):
▪ The underlying asset is of such specialized nature that only the lessee can use it without major
modification.
▪ If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by
the lessee.
▪ Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee.
▪ The lessee has the ability to continue the lease for a secondary period at a rent that is substantially
lower than market rent.

Land and Building Lease

• In classifying a lease on land and building, a lessor normally considers the land and building elements separately.
The important consideration in determining whether the land element is an operating lease or a finance lease is
the land’s indefinite economic life.
• The lease payments are allocated between the land and building elements in proportion to the relative fair value
of the leasehold interest in the land and building elements at the inception of the lease. However, if the lease
payments cannot be allocated between the two elements, the entire lease is classified as a finance lease unless it
is clear that both elements are operating leases.
• If the amount for the land element is immaterial to the lease, a lessor may treat the land and building as a single
unit. The single lease is classified as either a finance lease or an operating lease applying the lease classification
criteria for lessor. The economic life of the building is regarded as the economic life of the entire underlying asset.

Operating Lease – Lessor

• IFRS 16, par. 81: a lessor shall recognize lease payments from operating lease as income either on a straight-line
basis or another systematic basis. Simply stated, the periodic rental received by the lessor in an operating lease is
simply recognized as rental income.
• A lessor shall present an underlying asset in a statement of financial position according to the nature of the asset.
• The underlying asset remains as an asset of the lessor which means that the lessor bears all ownership or executory
costs of such asset.
• The depreciation policy for depreciable leased assets shall be consistent with the lessor’s normal depreciation for
similar assets.
• Initial Direct Costs – incurred by the lessor; added to the carrying amount of the underlying asset; recognized as
an expense over the lease term.
 • Security Deposit Refundable – liability by the lessor
• Lease Bonus – received by the lessor; recognized as unearned rent income to be amortized over the lease term
• If the operating lease requires unequal cash payments, the total cash payments for the lease term shall be
amortized uniformly on a straight-line basis as rent income over the lease term.

Pro-forma Entry
• Acquisition of the asset:
Asset* xxx
Cash/Accounts Payable xxx
*subject to depreciation

• Leased the asset:

Cash/Rent Receivable xxx
Rent Income xxx

• Received a Security Deposit Refundable:

Cash xxx
Liability for Rent Deposit xxx

• Received lease bonus from the lessee:

Cash xxx
Unearned Rent Income xxx

• The lessor incurred Initial Direct Costs in an operating lease:

Deferred Initial Direct Costs xxx
Cash xxx

• Amortization of Lease Bonus:

Unearned Rent Income xxx
Rent Income xxx

• Recognized Initial Direct Costs as an expense over the lease term:

Amortization of Initial Direct Costs xxx
Deferred Initial Direct Costs** xxx
**The balance of Deferred Initial Direct Costs account is added to the carrying amount of the underlying asset.