IFRS 16

ACCOUNTING FOR LEASES

DEFINITION
•Leases: Definitions
'A lease is 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.' The lessor is the 'entity
that provides the right to use an underlying asset in
exchange for consideration.' The lessee is the 'entity that
obtains the right to use an underlying asset in exchange for
consideration.' A right-of-use asset 'represents the lessee's
rights to use an underlying asset for the lease term.'
 IDENTIFYING A LEASE
• Right to control the use of an identified asset
• Arises when the right to obtain substantially all economic benefit from use of
the asset
• The right to direct the use of the identified asset
• Identified asset is explicitly specified in the contract
• When a contract contains multiple components, consideration is
allocated to each lease and non lease component based on stand
alone prices of the components or similar components
Multiple components of a lease contract
• Lease term: the non cancellable period for which a lessee has the right
to use an underlying asset along with
• Periods covered by an option to extend the lease- and lessee reasonably
certain to exercise option
• Periods covered by an option to extend the lease- and lessee reasonably
certain not to exercise option

Eg. A lease contract is for five years with lease payments of $10,000 per annum.
The lease contract contains a clause which allows the lessee to extend the lease
for a further period of three years for a lease payment of $5 per annum (as it is
unlikely the lessor would be able to lease the asset to another party). The
economic life of the asset is estimated to be approximately eight years.The
lessee assesses it is highly likely the lease extension would be taken. The lease
term is therefore eight years.
 LESSEE ACCOUNTING
• RECOGNITION:
• On the date lessor makes the underlying asset available for use to the
lessee
• The lessee recognises a
• Lease liability
• Right of use asset
• LEASE LIABILITY: This is initially measured at the present value of future
lease payments( not paid before commencement of date) discounted to
the interest rate implicit in the lease or the lessee’s incremental borrowing
rate.
• Discounted cash flows the are discounted to include the following
• Fixed payments
• Variable payments based on an index
• Amount to be paid in residual value guarantees
• Purchase options if any

• Variable payments based on an index are accounted for as period costs in SOPL as
incurred.
• Lease liability may be subsequently measured by
• Increasing it by implicit interest
• Reducing it by lease payments made
Right of use asset
• Initial measurement
• at initial lease liability( PV of future obligations)
• Payments made before commencement of lease less any incentives received
• An estimate of dismantling and restoration costs, where such obligations exist

• Subsequent measurement: It is normally measured at cost less accumulated

depreciation less impairment losses in accordance with IAD 16 Cost model
• Right of use asset is depreciated from commencement date till the earlier of
• end of useful life
• End of lease term
• Alternatively, right if use asset may be subsequently measured under
revaluation model where it belongs to such a class of asset that is being
measured under revaluation model- which must apply to all assets of that
class.
Right of use asset
• Where right of use asset meets the definition of an Investment
Property under IAS 40, the lessee may use Cost Model or Fair model
as the case may be depending on the model he uses for the same
class of assets
• Lessee accounting revision

• A company enters into a four-year lease commencing on 1 January 20X1

(and intends to use the asset for four years). The terms are four
payments of $50,000, commencing on 1 January 20X1, and annually
thereafter. The interest rate implicit in the lease is 7.5% and the present
value of lease payments not paid at 1 January 20X1 (ie three payments
of $50,000) discounted at that rate is $130,026.Legal costs to set up the
lease incurred by the company were $402.
• Required: Show the lease liability from 1 January 20X1 to 31 December
20X4 and explain the treatment of the right-of-use asset.
• Right of use Asset is
Exemptions
A company may elect take exemption from full requirements of standard
in case of-
• Short term leases- under 12 months
• Leases for which underlying asset is very low in value eg, tablets,
personal computers etc
• If the entity elects to take exemption, lease payments are recognised as
an expense on a straight line basis over the lease term
Remeasurements
• Lease liability is remeasured if necessary for any reassessments of
amounts payable
• Revised lease payments are discounted using
• Original discount rate where change relates to expected payments

• Revised discount rate- where there is a change In lease term, purchase option
or if the payment is linked to a floating interest rate.

• Change in lease liability is recognised as an adjustment to the right of

use asset or in SOPL where Right of use has been reduced to 0
Deferred tax implications

• Under a lease, the lessee recognises a right-of-use asset and a

corresponding lease liability.
• The net of these two amounts is the carrying amount of the right-of-
use asset for deferred tax purposes.
• If an entity is granted tax relief as lease rentals are paid, a temporary
difference arises, as the tax base of the lease is zero.
• This results in a deferred tax asset. Tax deductions are allowed on the
lease rental payment made, which, at the beginning of the lease, is
lower than the combined depreciation expense and finance cost
recognised for accounting. Therefore, the future tax saving on the
additional accounting deduction is recognised now in order to apply
the accruals concept.
Lessor accounting
Lessor accounting classifies leases into two types
Finance lease –
• where lease rentals receivable is recognised in SOFP
• Where risks and rewards of incidental to ownership are transferred by end of lease term
• Lessee has the option to purchase the asset at a price expected to be sufficiently lower
than fair value at exercise date, but nothing certain whether such option will at all be
exercised
• Lease term is major part of the economic life of the underlying asset even if title is not
transferred
• The underlying asset is so specialised that none other than the lessee can use it without
major modifications
• Any losses on cancellation of the lease or changes to residual value are borne by the
lessee
Lessor accounting
• Finance lease-
• lessor derecognises the underlying asset form his books and
• Recognises a receivable at an amount equal to the net investment in the lease
equal to
• present value of lease payments receivable
• plus present value of any unguaranteed residual value accruing to the lessor
unguaranteed residual value means the amount for which the lessor expects to
be able to sell the asset at the end of the lease term for anything more than
any minimum amount guaranteed by the lessee ( this is included in PV of lease
payments) in the lease contract.
• The difference is recognised in SOPL
• Finance income is recognised over the lease period (unwinding of
interest)
• All lease obligations and depreciation is time apportioned
Operating lease-
• where lease rentals are accounted as rental income on straight line basis
• Any direct costs in obtaining the lease is added to cost of asset and depreciated as under
IAS 16
• Does not transfer risks and rewards of incidental to ownership
Sale and lease back

•If an entity (the seller-lessee) transfers an asset to

another entity (the buyer- lessor) and then leases it back
from the buyer, the seller-lessee must assess whether the
transfer should be accounted for as a sale.
•For this purpose, the seller must apply IFRS 15 Revenue
from Contracts with Customers to decide whether a
performance obligation has been satisfied. This normally
occurs when the buyer obtains control of the asset.
Control of an asset refers to the ability to obtain
substantially all of the remaining benefits.
•If the transfer is not a sale then the seller-lessee
continues to recognise the transferred asset and will
recognise a financial liability equal to the transfer
proceeds.
•In simple terms, the transfer proceeds are treated as a
loan. The detailed accounting treatment of financial
assets and financial liabilities is covered in Chapter 9.
• If sale has happened in seller lessees’ books,
• the carrying amount of the asset must be derecognised
• He recognises a right to use asset measured at proportion of previous carrying amount
that relates to Rtu RETAINED
• Gain or loss recognised in his books in relation to rights trfd to buyer lessor

If consideration recd does not equal market fair value, sale proceeds are adjusted
to fair values
a) Below market- the difference is accounted as prepayment of lease payments
and so added to RTU asset.
b) Above market terms- the difference is treated as additional financing and the
lease liability is split into lease payments and additional financing (loan)

The buyer seller accounts for the purchase as a normal purchase and for the lease
• If sale has not happened,
• Seller lessee continues to recognise trfd asset and recognises a
financial liability equal to transfer proceeds
• Buyer lessor does not recognise the asset and recognises a financial
asset equal to transfer proceeds
On 1 January 20X1, Painting sells an item of machinery to Collage
for its fair value of $3 million. The asset had a carrying amount of
$1.2 million prior to the sale. This sale represents the satisfaction of
a performance obligation, in accordance with IFRS 15 Revenue
from Contracts with Customers. Painting enters into a contract with
Collage for the right to use the asset for the next five years. Annual
payments of $500,000 are due at the end of each year. The interest
rate implicit in the lease is 10%.
•The present value of the annual lease payments is £1.9 million.
The remaining useful life of the machine is much greater than the
lease term.

•Required: Explain how Painting will account for the transaction on

1 January 20X1.
Painting must remove the carrying amount of the machine from its statement of
financial position. It should instead recognise a right-of-use asset. This right-of-use asset
will be measured as the proportion of the previous carrying amount that relates to the
rights retained by Painting:
(1.9m/3m) × $1.2 million = $0.76 million.
The entry required is as follows:
Dr Cash $3.00m
Dr Right-of-use asset $0.76m
Cr Machine $1.20m
Cr Lease liability $1.90m
Cr Profit or loss (bal. fig.) $0.66m
Note: The gain in profit or loss is the proportion of the overall $1.8 million gain on
disposal ($3m – $1.2m) that relates to the rights transferred to Collage. This can be
calculated as follows:
((3m – 1.9m)/3m) × $1.8m = $0.66 million.
The right-of-use asset and the lease liability will then be accounted for using normal
lessee accounting rules.
•If the sales proceeds or lease payments are not at fair value, IFRS 16 requires that:

• below market terms (e.g. when the sales proceeds are less than the asset’s fair value) are treated
as a prepayment of lease payments

• above market terms (e.g. when the sales proceeds exceed the asset’s fair value) are treated as
additional financing.

•On 1 January 20X1, Mosaic sells an item of machinery to Ceramic for $3 million. Its
fair value was $2.8 million. The asset had a carrying amount of $1.2 million prior to the
sale. This sale represents the satisfaction of performance obligation, in accordance
with IFRS 15 Revenue from Contracts with Customers.

•Mosaic enters into a contract with Ceramic for the right to use the asset for the next
five years. Annual payments of $500,000 are due at the end of each year. The interest
rate implicit in the lease is 10%. The present value of the annual lease payments is
$1.9 million.

•Required:
• Explain how the transaction will be accounted for on 1 January 20X1 by both Mosaic and
Ceramic
 •The excess sales proceeds are $0.2 million ($3m – $2.8m). This is treated as additional financing.

•The present value of the lease payments was $1.9 million. It is assumed that $0.2 million relates to
the additional financing that Mosaic has been given. The remaining $1.7 million relates to the
lease.

•Mosaic

•Mosaic must remove the carrying amount of the machine from its statement of financial position. It
should instead recognise a right-ofuse asset. This right-of-use asset will be measured as the
proportion of the previous carrying amount that relates to the rights retained by Mosaic:
• (1.7m/2.8m) × $1.2 million = $0.73 million.
•The entry required is as follows:

•Dr Cash $3.00m

•Dr Right-of-use asset $0.73m
•Cr Machine $1.20m

• Cr Lease liability $1.70m Cr Financial liability $0.20m

•Cr Profit or loss (bal. fig.) $0.63m
•Note: The gain in profit or loss is the proportion of the overall $1.6 million gain on disposal ($2.8m – $1.2m)
that relates to the rights transferred to Ceramic. This can be calculated as follows:

•((2.8m – 1.7m)/2.8m) × $1.6 million = $0.63 million.

•The right of use asset and the lease liability will then be accounted for using normal lessee accounting rules.
The financial liability is accounted for in accordance with IFRS 9 Financial Instruments. Ceramic

•Ceramic will post the following:

•Dr Machine $2.80m

•Dr Financial asset $0.20m
•Cr Cash $3.00m

•It will then account for the lease using normal lessor accounting rules.

•Note

•The payments/receipts will be allocated between the lease and the additional finance. This is based on the
proportion of the total present value of the payments that they represent:

• The payment/receipt allocated to the lease will be $447,368 ((1.7/1.9) × $500,000).

• The payment/receipt allocated to the additional finance will be $52,632 ((0.2/1.9) × $500,000).