IFRS 16 — Lease

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 Definition
Lease: A contract or part of a contract, that conveys the right to use an asset (the underlying asset)

for a period of time in exchange for consideration

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 Accounting for Lease
Accounting by Lessee

A lease is capitalized at the commencement of the lease term.

This involves the recognition of the asset that is subject to the

lease At the commencement

date, a lessee should
and a liability for the future lease payments. recognise a Right-of-use
asset and a lease liability. It is
the date on which a lessor
makes an underlying asset
available for use by a lessee

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Current and non-current elements of the lease liability

The total liability must be divided between:

the current liability (amount payable within the next 12 months), and

the non-current liability.

The easy way to do it is to use the tables to identify the current liability or the non-current liability and then find

the other as a balancing figure.

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 Recognition Exemptions

A lessee may elect not to apply the requirements of recognition and measurement of the right-of use

the leased asset and liability to:

(a) short-term leases; and

Short-term lease: A lease that at the commencement date, has a lease term of 12

months or less. A lease that contains a purchase option is not a

short-term lease.

(b) leases for which the underlying asset is of low value

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 Example - Applying the short-term lease exemption

Lessee ABC enters into a 8-year lease of a machine to be used in manufacturing parts for a plane that it
expects to remain popular with consumers until it completes development and testing of an improved model.
The cost to install the machine in DEF manufacturing facility is not significant.
ABC and DEF each have the right to terminate the lease without a penalty on each anniversary of the lease
commencement date.
The lease term consists of a one-year non-cancellable period because both ABC and DEF have a substantive
termination right
– both can terminate the lease without penalty
– and the cost to install the machine in DEF manufacturing facility is not significant.

As a result, the lease qualifies for the short-term lease exemption.

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 Example - Applying the leases of low value exemption Lessee

A is in the pharmaceutical manufacturing and distribution industry and has the following leases:
▪ leases of real estate: both office building and warehouse;
▪ leases of office furniture;
▪ leases of company cars, both for sales personnel and for senior management and of varying quality,
specification and value;
▪ leases of trucks and vans used for delivery; and
▪ leases of IT equipment such as laptops.
A determines that the leases of office furniture and laptops qualify for the recognition exemption on the basis
that the underlying assets, when they are new, are individually of low value. B elects to apply the exemption to
these leases.

As a result, it applies the recognition and measurement requirements in IFRS 16 to its leases of real estate,
company cars, trucks and vans.

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Lease term
Lease term : The non-cancellable period for which a lessee has the right to use an underlying asset,

together with both:

(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise

that option; and

(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to

exercise that option.

A lease may be split into a primary period followed by an option to extend the lease for a further

period (a secondary period).

In some cases, the lessee might be able to exercise such an option with a small rental or even for no

rental at all. If such an option exists and it is reasonably certain that the lessee will exercise the option,

the second period is part of the lease term

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 Presentation - On the balance sheet

The Right-of-use asset can be presented

either separately or

in the same line item in which the underlying asset would be presented.

The lease liability can be presented either as a separate line item or together with other financial liabilities.

If the right-of-use asset and the lease liability are not presented as separate line items,

an entity discloses in the notes the carrying amount of those items and the line item in which they are included.

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 Presentation -
In the statement of profit or loss and other comprehensive income

The depreciation charge of the right-of-use asset is presented in the same line item/items in which

similar expenses (such as depreciation of property, plant and equipment) are shown.

The interest expense on the lease liability is presented as part of finance costs.

However, the amount of interest expense on lease liabilities has to be disclosed in the notes.

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 Presentation - In the statement of cash flows

lease payments are classified consistently with payments on other financial liabilities:

The part of the lease payment that represents cash payments for the principal portion of the lease liability is

presented as a cash flow resulting from financing activities.

The part of the lease payment that represents interest portion of the lease liability is presented either as an

operating cash flow or a cash flow resulting from financing activities (in accordance with the entity’s

accounting policy regarding the presentation of interest payments).

Payments on short-term leases, for leases of low-value assets and variable lease payments not included in

the measurement of the lease liability are presented as an operating cash flow.

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 Disclosures
A lessee shall disclose information about its leases for which it is a lessee in a single note or separate section in its financial

statements. However, a lessee need not duplicate information that is already presented elsewhere in the financial

statements, provided that the information is incorporated by cross-reference in the single note or separate section about leases.

A lessee shall disclose the following amounts for the reporting period:

(a) depreciation charge for right-of-use assets by class of underlying asset;

(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not include the expense relating to leases with a lease term of one
month or less;
(d) the expense relating to leases of low-value assets. This expense shall not include the expense relating to short-term leases of low-value assets;
(e) the expense relating to variable lease payments not included in the measurement of lease liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset.

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 Lessor Accounting

Classification:
Finance lease Operating lease

A lease that transfers substantially A lease that does not transfer

substantially all the risks and rewards

all the risks and rewards incidental
incidental to ownership of an
to ownership of an underlying asset
underlying asset is known as

is known as finance lease. operating lease

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 Criteria for Finance Lease
IFRS 16 identifies two types of lease.
Classification criteria for Finance lease
Examples of situations that individually or in combination would normally lead to a lease being classified as a finance
lease are:
(a) the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
(b) 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 ;

(c) the lease term is for the major part of the economic life of the underlying asset even if title is not transferred;

(d) 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; and

(e) the underlying asset is of such a specialized nature that only the lessee can use it without major modifications .

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Indicators of situations that individually or in combination could also lead to a lease being classified as a

finance lease are:

(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the

lessee;

(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the

form of a rent rebate equaling most of the sales proceeds at the end of the lease); and

(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower

than market rent.

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The identification of a lease as a finance lease or an operating lease is crucial as it determines how a

lease is accounted for by the lessor.

Types of Lessor

▪ Finance companies (often banks and their subsidiaries)

▪ Hire companies

▪ Manufacturer/dealer lessors

▪ Property companies

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 Accounting for Finance lease

The lessor does not record the leased asset in his own financial statements because he has transferred

the risks and rewards of ownership of the leased asset to the lessee. Instead, he records the amount

due to him under the terms of the finance lease as a receivable. The receivable is described as the

net investment in the lease.

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 Accounting for Finance lease

Definitions: Gross and net investment in the lease

Gross investment in the lease is the aggregate of:

(a) the lease payments receivable by the lessor under a finance lease, and

(b) any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the

lease.

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 Accounting for Finance lease

Many of the entries to be made in the ledger accounts of the lessor are a ‘mirror image’ of those made by the

lessee in respect of his lease liability.

Debit Credit
Illustration: Double entry on Initial recognition of a finance lease

Net investment in the lease x

Cash/bank x

Illustration: Lessor receipts

Cash/bank x

Net investment in the lease x

Illustration

Net investment in the lease x

Statement of comprehensive income: finance income x

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 Subsequent Measurement Lease Receivable /Net investment in lease
Rs.

Amount of loan at the start of the lease (the amount recognised on the initial xx
recognition)
+ Interest accrued xx

- Repayments (lease payments or rentals) (xx)

Repayment of loan principal (xx)

Amount owed to lessor now xx

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 Manufacturer/dealer lessors

Manufacturers or dealers often offer to customers the choice of either buying or leasing an asset.

A finance lease of an asset by a manufacturer or dealer lessor gives rise to two types of income:

i. profit or loss equivalent to the profit or loss resulting from an outright sale of the asset being leased, at

normal selling prices, reflecting any applicable volume or trade discounts; and

ii. finance income over the lease term.

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 Manufacturer/dealer lessors

Revenue
The sales revenue recognised at the commencement of the lease term is the lower of:

▪ the fair value of the underlying asset; and

▪ the present value of the lease payments accruing to the lessor discounted at market rate of interest.

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 Manufacturer/dealer lessors
Cost of sale

The cost of sale recognised at the commencement of the lease term is the carrying amount of the underlying asset

less the present value of the unguaranteed residual value.

The deduction of the present value of the unguaranteed residual value recognises that this part of the asset is not

being sold. This amount is transferred to the lease receivable.

Lease Receivable. The balance on the lease receivable is then the present value of the amounts which the

lessor will collect off the lessee plus the present value of the unguaranteed residual value. This is the net

investment in the lease.

Costs incurred by manufacturer or dealer lessors in connection with negotiating and arranging a lease must be

recognised as an expense when the selling profit is recognised.

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 Manufacturer/dealer lessors
Profit or loss on the sale

The difference between the sales revenue and the cost of sale is the selling profit or loss. Profit or loss on these

transactions is recognised in accordance with the policy followed for recognising profit on outright sales.

The manufacturer or dealer might offer artificially low rates of interest on the finance transaction. In such cases

the selling profit is restricted to that which would apply if a market rate of interest were charged.

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Example - Manufacturer or dealer leases
Multan Motors is a car dealer. It sells cars and offers a certain model for sale by lease.

The following information is relevant:

Price of the car in a cash sale Rs.2,000,000

Cost of the car Rs.1,500,000

Finance option:

Annual rental Rs.804,320

Lease term 3 years

Interest rate 10%

Estimated residual value Rs.133,100

Lessor’s cost of setting up the lease Rs.20,000

Discount factors: t3 @ 10% 0.7513148 (written as 0.751)

t1 to t3 @ 10% 2.486852 (written as 2.487)

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Example - Manufacturer or dealer leases

W1 Rs.

Revenue; Lower of

Fair value of the asset 2,000,000

Present value of the lease payments 764,018 x 2.487 1,900,000

W2

Present value of lease payments 133,156 x 0.751 100,000

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Initial Double Entry
Debit Credit
Revenue
Lease receivable (Net investment in the lease) 1,900,000
Statement of comprehensive income 1,900,000
Cost of Sale
Statement of comprehensive income 1,400,000
Asset (inventory) 1,400,000
Transfer
Lease receivable (Net investment in the lease) 100,000
Asset (inventory) 100,000
Cost of setting up the lease
Statement of comprehensive income 20,000
Cash/ bank 20,000

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