SLFRS 16

Leases

Lesson Content
1. Introduction and definitions
2. Lessee accounting
3. Lessee accounting: reassessment and modification

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4. Lessors: Lease classification
5. Lessor accounting

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6. Sale and leaseback transactions

1. INTRODUCTION AND DEFINITIONS

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1.1 LEASES

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SLFRS 16 prescribes the accounting treatment of leased assets in the financial statements
of lessees and lessors.

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Definition: Lease
Lease: A contract, or part of a contract, that conveys the right to use an asset (the
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underlying asset) for a period of time in exchange for consideration.
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A lease is a way of obtaining use of an asset, such as a machine, without purchasing it
outright. The company that owns the asset (the lessor) allows another party (the lessee)
to use the asset for a specified period of time in return for a series of rental payments.
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Definition: Sublease
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A transaction for which an underlying asset is released by a lessee (intermediate lessor)

to a third party and the lease (head lease) between the head lessor and lessee remains in
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effect
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Example
Interliss enters into a ten-year lease for 6,000 square metres of office space (the head
lease) with Headliss, (the head lessor). At the beginning of Year 5, Interliss subleases the
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6,000 square metres of office space for the remaining six years of the head lease to a
Subliss.
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1.2 BACKGROUND TO SLFRS 16

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The problem
Operating leases gave lessees the right to use assets and impose obligations on the lessee
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to pay for this right in the same way as finance leases. The rights and obligations under
operating leases often satisfied the definitions of assets and liabilities set out in the
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conceptual framework yet these were not recognised on the statement of financial
position. Consequently, a lessee’s statement of financial position provided a misleading
picture about leverage and the assets that the lessee uses in its operations.
 Conclusion
The distinction between operating and financial leases is arbitrary and unsatisfactory.
LKAS 17 did not provide for the recognition in lessees’ balance sheets of material assets
and liabilities arising from operating leases.

Comparability (and hence usefulness) of financial statements will be enhanced by

replacing the old treatment with an approach that applied the same requirements to all

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leases. SLFRS 16 removes the finance lease, operating lease distinction for lessees. The
new rules require a lessee to recognise all leases on its statement of financial position

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(with certain exceptions).

Impact on Financial Statement

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SLFRS 16 does not change how lessors should account for leases. Lessors must still
classify leases as either finance leases or operating leases and account for them

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accordingly in the same way as before.

The new standard will have an impact on the statement of financial position, statement
of profit or loss and statement of cash flows when fully effective for accounting periods

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starting on or after 1 January 2019.

Statement of Financial Statement

LKAS 17
N SLFRS 16
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Finance Lease Operating Leases All Leases
Assets   
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Liabilities   
Off Balance Sheet   
Rights/Obligations
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Statement of Profit or Loss

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LKAS 17 SLFRS 16
Finance Lease Operating Leases All Leases
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Revenue   
Operating Cost   
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Depreciation   
Finance Cost   
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1.3 SCOPE OF SLFRS 16

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SLFRS 16 applies to all leases except for:

 leases to explore for or use minerals, oil etc.;
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 leases of biological assets (LKAS 41)

 service concession arrangements (IFRIC 12)
 licences of intellectual property granted by a lessor (within the scope of IFRS 15);
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and
 Rights held by a lessee under licensing arrangements within the scope of LKAS 38
Intangible Assets for such items as motion picture films, video recordings, plays,
manuscripts, patents and copyrights. SLFRS 16 may be, but is not required to be,
applied to leases of intangible assets other than those mentioned above.
 SLFRS 16 specifies the accounting for an individual lease. However, as a practical
expedient the rules can be applied to a portfolio of leases with similar characteristics as
long as there is a reasonable expectation that the effects on the financial statements
would not differ materially from applying the rules to the individual leases of the
portfolio.

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A lease might cover the use of several assets. Such a lease might be split into separate
lease components. The right to use an asset is a separate lease component if both:

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 the lessee can benefit from use of the underlying asset either on its own or
together with other resources that are readily available to it; and
 the asset is neither highly dependent on, nor highly interrelated with, the other

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underlying assets in the contract.

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1.4 IDENTIFICATION OF LEASE CONTRACTS

SLFRS 16 states that a contract is, or contains, a lease if the contract conveys the right to
control the use of an identified asset for a period of time in exchange for consideration.

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The description of a lease contract given above has four key elements:

1)
2)
It must convey the right to control
It must relate to an identified asset
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3) It must be for a period of time
4) It must be in exchange for consideration
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Some contracts that are legally defined as a lease do not possess these elements and
therefore are not within the scope of SLFRS 16; equally some contracts that do not take
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the legal form of a lease do possess these elements and so are within the scope of the
standard.
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Determining whether a contract is, or contains, a lease is therefore the first step when
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applying SLFRS 16.

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Right to control
The right to control the use of an identified asset depends on the lessee having two rights:
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a) The right to obtain substantially all of the economic benefits from use of the
identified asset. This may be through holding, using or sub-letting the asset. Where
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use of the asset is restricted by the contract only the economic benefits within that
restriction are considered. For example, if a contract restricts use of a vehicle to
10,000 km per annum, only the economic benefits relating to 10,000 km are
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relevant to the assessment of control.

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b) The right to direct the use of the identified asset. This arises if either:
i. The customer has the right to direct how and for what purpose the asset is
used during the whole of its period of use
ii. The relevant decisions about use are pre-determined and the customer can
operate the asset without the supplier having the right to change those
operating instructions
 The supplier of an asset may restrict the use of an asset to protect it or ensure compliance
with laws. For example, the supplier of a vehicle may prevent the customer from using it
to transport explosives. Such a protective right does not prevent the customer from being
able to direct use of the asset.

Identified asset

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The asset must be identified in the contract; it may be part of an asset, provided that the
part is physically distinct (eg a floor of a property).

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A contract is not a lease if the lessor can substitute the underlying asset for another asset
during the lease term and would benefit economically from doing so.

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Period of time

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The right to control an asset may only relate to part of the term of a contract. In that case
the lease is for only part of the term of the contract. A period of time can be described in
terms of use of the underlying asset eg a contract to use a vehicle to drive 100,000 km.

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Question 1 – Lease Contact

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Beira Baskets (Pvt) Ltd has entered into a five-year contract with Carefleet Co, under
which Carefleet supplies Beira Baskets with ten delivery vehicles. Carefleet owns the
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relevant vehicles, all ten of which are specified in the contract. Beira Baskets determines
the routes taken for delivery transport and the charges and eligibility for discounts. Beira
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Baskets can choose to use the vehicles for purposes other than delivery. When the
vehicles are not being used, they are kept at the the company's offices and cannot be
retrieved by Carefleet unless Beira Baskets defaults on payment. If a vehicle needs to be
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serviced or repaired, Carefleet is obliged to provide a temporary replacement vehicle of

the same type.
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Required
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Does the contract contain a lease?

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Question 2 – Lease Contact

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Puttalam Transport Ltd has recently made substantial cuts to its community transport
service. It will now provide such services only in cases of great need, assessed on a case
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by case basis. It has entered into a two-year contract with Fleetcar Co for the use of one
of its minibuses for this purpose. The minibus must seat ten people, but Fleetcar Co
canuse any of its ten-seater minibuses when required.
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Required
Does the contract contain a lease?
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 Question 3 – Lease Contact

Kabal enters into a ten-year contract with a utilities company (Telenew) for the right to
use three specified, physically distinct dark fibres within a larger cable connecting North
Town to South Town. Kabal makes the decisions about the use of the fibres by connecting
each end of the fibres to its electronic equipment (ie Kabal 'lights' the fibres and decides
what data, and how much data, those fibres will transport). If the fibres are damaged,

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Telenew is responsible for the repairs and maintenance. Telenew owns extra fibres but
can substitute those for Kabal's fibres only for reasons of repairs, maintenance or

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malfunction (and is obliged to substitute the fibres in these cases).

Required

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Does the contract contain a lease?

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1.5 SEPARATING COMPONENTS OF A CONTRACT

A contract may contain:

 Lease components

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 Non-lease components (eg an agreement to provide maintenance, repairs or
cleaning)
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It may also include other activities that are not a component of the contract (eg an
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agreement to pay a contract administrative fee).
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SLFRS 16 requires entities to separate any lease components of the contract from non-
lease components at inception, allocate consideration to them and:
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 Account for lease components by applying SLFRS 16

 Account for non-lease components separately, generally as an expense in profit or
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loss
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When allocating consideration between lease and non-lease components:

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 The lessee should consider non-lease components in aggregate; consideration is

allocated to individual lease components and the total of non-lease components
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on the basis of stand-alone prices

 The lessor should apply SLFRS 15 criteria for allocating transaction price to
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performance obligations

Question 4 – Separating components of a contract

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Livery Co leases a delivery van from Vanlease Co for three years at Rs. 200,000 per year.
This payment includes servicing costs. Livery could lease the same make and model of
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van for Rs. 180,000 per year and pay Rs. 30,000 a year for servicing.

Required
How this should be treated as per SLFRS 16?
 1.6 INCEPTION AND COMMENCEMENT

Definition: Inception date of the lease

The earlier of the date of a lease agreement and the date of commitment by the parties to
the principal terms and conditions of the lease.

This is where the parties to the lease contract commit to the terms of the contract.

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 Contracts must be assessed at the inception date to find out if they are a lease or if
they contain a lease.

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 A lessor must identify the type of lease in a contract (finance or operating) at the
date of inception.

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Definition: Commencement date of a lease
The date on which a lessor makes an underlying asset available for use by a lessee. This

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is the date that a lessee starts to use the asset or, at least, is entitled to start to use the
asset. The accounting treatment required is applied to a lease at the commencement date.

1.7 LEASE TERM

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Definition: Lease term
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The non-cancellable period for which a lessee has the right to use an underlying asset,
together with both:
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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
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certain not to exercise that option.

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A lease may be split into a primary period followed by an option to extend the lease for a
further period (a secondary period).
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In some cases, the lessee might be able to exercise such an option with a small rental or
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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. (Within the control of
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lesee)
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A lease may allow a lessee to terminate the lease before its end. The period covered by
the termination option is included in lease term if it is reasonably certain that the lessee
will not exercise that option.
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Question 5 – Lease Term

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X plc signed a contract for the lease of an asset

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Terms include:
Non-cancellable term = 5 years at an annual rental of Rs. 100,000
Option to extend for a further 5 years at an annual rental of Rs. 1

Required
What is the lease term?
 Question 6 – Lease Term

X plc signed a contract for the lease of an asset

Terms include:
Non-cancellable term = 5 years at an annual rental of Rs. 100,000
Option to extend for a further 5 years at an annual rental of Rs. 200,000

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Required

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What is the lease term?

1.8 LEASE PAYMENTS

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Definition: Lease payments

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Payments made by a lessee to a lessor relating to the right to use an underlying asset
during the lease term, comprising the following:

a) fixed payments less any lease incentives;

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b) variable lease payments that depend on an index or a rate;
c) the exercise price of a purchase option if the lessee is reasonably certain to
exercise that option; and N
d) payments of penalties for terminating the lease, if the lease term reflects the lessee
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exercising an option to terminate the lease.
e) Residual value guarantees.
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Variable lease payments that do not depend on an index or a rate are not lease payments
as defined. For example, a lease term that required the payment of a percentage of lessee’s
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sales revenue to the lessor is not a lease payment. Such amounts would be recognised in
profit or loss and would not be part of lease accounting.
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Question 7 – Variable lease payments

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Y Plc leases an asset to X plc.

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X Plc must pay five annual rentals of Rs. 100,000 in arrears. This fixed fee increases by
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the inflation rate once in two years.

Further they agreed to pay annual fee 1% of sales revenue
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Assumptions at the commencement date

 Sales will be Rs. 200,000 per year
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 Inflation will be 2% per year

Required
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How this is accounted in SLFRS 16?

 1.9 RESIDUAL VALUES

When a company that owns an asset leases it to another party they have two interests in
that asset:

a) It gives them a right to receive a series of rentals over the lease term; and
b) They own the asset at the end of the lease.

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The value of the asset at the end of the lease is called its residual value. This figure might

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be guaranteed by the lessee. This means that if the asset is not worth the amount
guaranteed, the lessee must pay the lessor the shortfall. On the other hand the residual
value might not be guaranteed.

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Definition: Residual value guarantee and unguaranteed residual value

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Residual value guarantee: A guarantee made to a lessor by a party unrelated to the
lessor that the value (or part of the value) of an underlying asset at the end of a lease will
be at least a specified amount.

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Unguaranteed residual value: That portion of the residual value of the underlying asset,
the realisation of which by a lessor is not assured or is guaranteed solely by a party
related to the lessor. N
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1.10 INTEREST RATE IMPLICIT IN THE LEASE

Definition: Interest rate implicit in the lease

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Interest rate implicit in the lease: The rate of interest that causes:
a) the present value of the lease payments and the unguaranteed residual value; to
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equal
b) the sum of the fair value of the underlying asset and any initial direct costs of the
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lessor.
The interest rate implicit in the lease is the IRR of the cash flows from the lessor’s
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viewpoint. It is the rate that equates the present value of the future cash inflows for the
lessor to the amount that the lessor invested in the asset.
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Question 8 – Interest rate inherent in the lease (Rent paid in arrears)

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Y Plc leases an asset to X plc.

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The asset cost Y Plc Rs. 426,494.

X Plc must pay five annual rentals of Rs. 100,000 in arrears.
X Plc must also guarantee the residual value of the asset at the end of the lease term to be
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Rs. 40,000.
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Required
What is the interest rate inherent in the lease?
 Question 9 – Interest rate inherent in the lease (Rent paid in advance)

Y Plc leases an asset to X plc.

The asset cost Y Plc Rs. 426,494.

X Plc must pay five annual rentals of Rs. 100,000 in advance.
X Plc must also guarantee the residual value of the asset at the end of the lease term to be

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Rs. 40,000.

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Required
What is the interest rate inherent in the lease?

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1.11 INITIAL DIRECT COSTS

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The definition of interest rate implicit in the lease makes reference to incremental initial
direct costs.

Definition: Initial direct costs

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Incremental costs of obtaining a lease that would not have been incurred if the lease had
not been obtained, except for such costs incurred by a manufacturer or dealer lessor in
connection with a finance lease. N
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Both the lessor and the lessee might incur initial direct costs. The calculation of the
interest rate implicit in the lease is from the lessor’s viewpoint. Therefore, the initial
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direct costs that feature in this calculation are those of the lessor. The accounting
treatment for initial direct costs will be explained later.
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