IFRS 16 Leases.

Lessor(s), Lessee(s), Lease(s)

IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases. The objective is to ensure that
lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis
for users of FS to assess the effect that leases have on the financial position, financial performance and cash flows of an entity

Identify a lease
 A lease is a contract, or part of a contract, that conveys the right to use an asset for a period of time in exchange for consideration.
 Underlying asset: an asset that is the subject of a lease, for which the right to use the asset has been provided by a lessor to a lessee

 At inception of a contract, an entity must identify whether a contract contains a lease, which is the case if the contract conveys the
right to control the use of an identified asset for a period of time in exchange for consideration. The right to control the use of an
identified assets depends on the lessee having:
1. The right to obtain substantially all the economic benefits from use of the identified asset
2. The supplier does not have the substantive right to substitute the asset throughout the period of use, unless the asset needs service or
repairs.
3. The right to direct the use of the identified asset, if:
a) The customer has the right to direct how and for what purpose the asset is used during the whole term of usage
b) Relevant decisions about how and for what purpose the asset is used are pre-determined and:
 The customer can operate the asset without the supplier having the right to change those operating instructions
 The customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the
period of use, for example a piece of factory equipment designed to the specifications of the customer.

 Some contracts may contain elements that are not leases, such as service contracts.
 These must be separated out from the lease and accounted for separately
 Lessees shall allocate the consideration payable on the basis of the relative stand-alone prices, which shall be estimated if
observable prices are not readily available.

Recognition Exemptions: IFRS 16 provides an optional exemption from the full requirements of the standard for:

1. Short-term leases: leases with a lease term of 12 months or less.

 The election is made by class of underlying assets
 A class of underlying assets is a grouping of underlying assets of a similar nature and use in an entity’s operation
 A lease that contains a purchase option cannot be a short-term lease

2. Low value leases: where the underlying asset has a low value when new.
 This election is be made on a lease-by-lease basis.
 IFRS 16 does not give an amount which is considered to be “low value” but it does give examples of items that would be considered
to be low value, including tablet and personal computers, small items of office furniture and telephones.
 The assessment of whether an underlying asset is of low value is not dependent on the size, nature or circumstances of the lessee:
different lessees are expected to reach the same conclusion about whether a particular asset is of low value

 An underlying asset qualifies as low value only if two conditions apply:

1. The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the
lessee
2. The underlying asset is not highly depended on, or highly interrelated with other assets.

 If the entity elects to take the exemption, lease payments (not PV, market value is irrelevant) associated with the lease are recognised
as an expense on a straight-line basis over the lease term, or another systematic basis, if more representative of the pattern of the
lessee’s benefits.
 The remaining lease payments (not related to current year) are recognised as a prepayment in the SOFP: if the payment is in
advanced.
 Difference between recognised income for the year and the cash received from the client = Receivable, current assets

Recognition, Measurement and Presentation

 IFRS 16 requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying
asset is of low value.
 At commencement date, which is the date on which the lessor makes the underlying asset available for use by the lessee, the lessee
recognises a Right-of–use asset and a lease liability.
 No exception applies here.
Right-of-use Asset
Right-of-use Asset: An asset that represents a lessee’s right to use the underlying asset for the lease term.
 Lease term is the non-cancellable period for which a lessee has the right to use an underlying asset together with both:
 Period covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
 Period covered by an option to terminate the lease if the lessee is reasonably certain not to exercise the option

Right-of-use asset is initially measured at cost, which includes:

1. + The amount of initial measurement of the lease liability
2. + Any lease payments made at or before the commencement date - less any lease incentives received
3. + Any initial direct costs incurred by the lessee: incremental costs of obtaining a lease that would not otherwise have been incurred
if the lease had not been obtained. Example of costs: commissions, legal fees, cost of arranging collateral, negotiating lease terms and
conditions, payments to existing tenants to obtain the lease
4. + Any cost which the lessee will incur for dismantling and removing the underlying asset, restoring the site on which it is located or
restoring the underlying asset to the condition required by the terms of the lease, at the end of the lease term

Subsequently the right-of-use asset is normally measured at cost less any accumulated depreciation and impairment losses in accordance
with cost model of IAS 16. Under Cost model, the right-of-use asset is depreciated from the commencement date to the earlier of: end
of its useful life or end of the lease term. If ownership of the underlying asset is expected to be transferred to the lessee at the end of the
lease, the right-of-use asset should be depreciated over the useful life of the underlying asset.
Alternatively, the right-of-use asset is accounted for in accordance with:
1. Revaluation model of IAS 16. This is optional where the right-of-use asset relates to a class of PPE which is measured under
revaluation model, and where elected must apply to all right-of-use assets relating to that class
2. Fair Value model of IAS 40. This is compulsory if the right-of-use asset meets the definition of Investment property and the lessee
uses the fair value model for its investment property

Presentation: In the SOFP: right of use assets can be presented as a separate line under non-current assets or they can be included in
the total of corresponding underlying assets and disclosed in the notes.

Lease Liability: Lease liability represents the obligation to make lease payments

The lease liability is initially measured at the present value of lease payments not paid at the commencement date, discounted at the
interest rate implicit in the lease. If the rate cannot be readily determined, the lessee’s incremental borrowing rate should be used.
Payment 1 Payment 2 Payment n Residual value gu aranteed
PV = 1
+ 2
+…+ +
(1+ %) (1+% ) ( 1+ % )n (1+ %)
n

 Interest rate implicit in the lease: the discount rate that, at the inception of the lease, causes the aggregate present value of the lease
payments and the unguaranteed residual value to be equal to the sum of fair value of the underlying asset and any initial direct
costs of the lessor
 Lessee’s incremental borrowing rate: the rate of interest that a lessee would have to pay to borrow over a similar term, and with a
similar security, the funds necessary to obtain an asset for similar value to the right of use asset in a similar economic environment
 Lease incentives: payments made by the lessor to the lessee, or the reimbursement or assumption by a lessor of costs of the lessee.
The lease liability includes:
1. + Fixed payments, less any lease incentives receivable
2. + Variable lease payments that depend on an index (consumer price index) or a rate (market rent)
3. + Amounts expected to be payable by the lessee under residual value guarantee
4. + The exercise price of a purchase option if reasonably certain to be exercised
5. + Payments of penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease

6. Other variable payments (that arise due to level of use of the asset) are accounted for as period costs in profit or loss as incurred
a. Payments for services

After the commencement date, the CA of lease liability is increased by interest charges on the outstanding liability and reduced by lease
payments made.
Presentation: In the SOFP: the lease liability should be either presented separately from other liabilities or disclosed in the notes. IFRS
16 does not specify that lease liabilities should be split between current and non-current liabilities but this should be done as a best
practice.

Allocating the finance charge

 As the company benefits from paying the lease over a period of time, the total amount paid will include capital and interest
payments. The interest is referred to as an interest charge or finance charge.
 IFRS 16 requires the finance charge to be allocated to periods during the lease term so as to produce a constant periodic rate of
interest on the remaining balance of the liability for each period – applying the interest rate implicit in the lease (the lease’s internal
rate of return) to the amount of capital outstanding to calculate the finance charge for the period (the lessee’s incremental borrowing
rate may be used if the interest rate implicit in the lease cannot be determined).
 Consequently, at the start of the lease, the finance charge will be larger as the outstanding lease liability is large.
 Towards the end of the lease’s life, finance charge will be smaller as the outstanding lease liability is smaller. This is commonly
called actuarial method.
A Sale and leaseback transaction involves the sale of an asset and the leasing back of the same asset

A. Transaction is a Sale. The transfer satisfies the IFRS 15 requirements to be accounted for a sale:
1. The seller-lessee derecognise the asset at its carrying amount and apply the lessee accounting requirements

2. The seller-lessee calculate the lease liability at commencement of the lease

Total Lease liability = the cumulative present value of the future lease payments.
From the lease liability we deduct the additional financing and this will be the amount used as “present value of lease payments”
→ Interest charge will be calculated on the total lease liability. Lease liability would be split between:
 Related to the lease: PV of lease payments→ this will be used to calculate Right-of-use asset and Gain relating to right retained
 Additional financing /prepayment

If the fair value of consideration (cash received) for the sale does not equal the fair value of the asset, or if the lease payments are not at
market rates, the following adjustments should be made:
 Any below market terms: Sales price < Fair value of the asset → should be accounted for as a prepayment of lease payments.
Treated as a lease payment made by the lessee, add (+) to the CA of the right-of use asset (increase in depreciation)
 Any above market terms Sales price > Fair value of the asset → should be accounted for as additional financing provided by the
buyer-lessor. Treated as additional liability, not a gain on the sale

The adjustment shall be measured as difference between:

 fair value of consideration for the sale and fair value of the asset
 present value of the contractual payments for the lease and present value of the payments for the lease at market rates

3. The seller-lessee measure the right-of-use asset arising from the leaseback at the proportion of the previous CA of the asset that
Present Value of lease payments
relates to the right of use retained by the seller-lessee RoU =Carrying amount ×
Fair value
The right-of-use asset continues to be depreciated as normal, although a revision of its remaining useful life may be necessary to
restrict it to the lease term. Debit: P/L = Credit: Right-of-use asset

4. The seller-lessee only recognises the amount of any gain or loss on the sale that relates to the rights transferred to the buyer
 Total Gain = Fair Value – Carrying amount. Attention: It is fair value not consideration received/cash
Present Value of lease payments
 Gain related to the rights retained ¿ Total Gain ×
Fair value
 Gain related to the rights transferred is the balancing figure = Total Gain – Gain related to the rights retained

 Gain will be recognised in profit or loss

 The total financial liability will be increased (+) each year by the interest charge and reduced (-) by the lease payments
Debit: Cash – consideration received = Credit: Property Asset = Carrying amount. The asset is derecognised
Debit: Right of use asset Credit: Lease Liability = Present value
Credit: Gain on sale – transferred (P/L)
B. Transaction is not a sale
The seller-lessee continues to recognise the transferred asset The buyer-lessor shall not recognise the transferred asset.
Received proceeds are treated as a financial liability accounted for in Transfer proceeds are treated as a financial asset accounted for in
accordance with IFRS 9. This transaction is more in the nature of a accordance with IFRS 9.
secured loan

Lessor Accounting
 A lessor shall classify each of its leases as either an operating lease or a finance lease. The distinction between finance and
operating leases applies only to lessors not lessees. Whether a lease is a finance or an operating lease depends on the substance of
the transaction rather than the form of the contract. The determining factor is who has the risks and rewards of ownership

 Gross investment in the lease is the sum of:

1. Lease payments receivable by the lessor under a finance lease
2. 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
 Unearned Finance Income is the difference between: Gross investment in the lease and Net investment in the lease

 Guaranteed residual value is:

1. For a lessee, that part of the residual value which is guaranteed by the lessee or by a party related to the lessee (the amount of
the guarantee being the maximum amount that could, in any event became payable)
2. For a lessor, that part of the residual value which is guaranteed by the lessee or by a third party unrelated to the lessor whose is
financially capable of discharging the obligations under the guarantee.

 Unguaranteed residual value is that portion of the residual value of the underlying asset, the realisation of which by the lessor is
not assured or is guaranteed solely by a party related to the lessor
 Finance Leases: maintenance and repairs: lessee Operating Leases: retain the risks and reward
Lease term: for a small portion
A finance lease is a lease that transfers substantially all the risks and An operating lease is a lease that does not transfers
rewards incidental to ownership of an underlying asset. Only risks of substantially all the risks and rewards incidental to
ownership no other types of risk. It can be considered to be, like a hire ownership of an underlying asset. It can be
purchase, a form of instalment credit. considered to be like a rental income
The leased asset is recorded in the books of the lessee together with a
corresponding lease liability An asset held for use in operating leases by a lessor
should be recorded as a long-term asset and
Risks of ownership include the possibility of losses from idle capacity, or depreciated over its useful life not lease term
technological obsolescence or variations in return due to changing economic
condition. The basis for depreciation should be consistent with
The rewards are represented by expectation of profitable operation over the asset the lessor’s policy on similar non-lease assets and
economic life and also any gain from appreciation in value or realization of a residual
follow the guidance in IAS 16. Lessors should refer
value.
to IAS 36 in order to determine whether a leased
asset has become impaired
A lessor shall recognise assets held under a finance lease in its SOFP and
present them as a receivable at the amount of the net investment in the lease
Net investment in the lease:
= Purchase cost of the asset (FV of the asset) + initial direct costs OR
= PV of: (lease payments + unguaranteed residual value)
Initial direct costs incurred by lessors that are directly attributable to Initial direct costs incurred by lessors that are
negotiation and arranging a finance lease (commissions, legal fees and other directly attributable to negotiation and arranging an
costs) are included in the initial measurement of the net investment in the operating lease (commissions, legal fees and other
lease and reduce the amount of income recognised over the lease term costs) should be added to the CA of the leased asset
The interest rate implicit in the lease is defined in such a way that the initial and recognise those costs as an expense over the
direct costs are included automatically in the net investment in the lease. lease term on the same basis as the lease income
There is no need to add them separately (capitalized and amortized over the lease term)

The recognition of finance income over the lease term under a finance lease The lease payments from an operating lease,
should normally be based on a pattern to give a constant periodic rate of (excluding charges for services such as insurance
return on the lessor’s net investment in the lease. In arriving at the constant and maintenance) should be recognised as income on
rate of return, a reasonable approximation may be made. a straight-line basis, over the period of the lease
The lease payments (excluding costs for services) relating to the accounting (even if receipts are not on such a basis), unless
period should be applied against gross investment in the lease, to reduce both another systematic and rational basis is more
the principal and the unearned finance income representative of the time pattern in which the
benefit from the leased asset is receivable
The estimated unguaranteed residual value used to calculate the lessor’s
gross investment in a lease should be reviewed regularly. If there has been a Total lease payments that will be received
reduction in the estimated unguaranteed residual value, then the income Allocated over the lease term
allocation over the lease term must be revised and any reduction in respect of -Income recognised of the year
amounts already accrued should be recognized immediately -Cash received in the year
= Difference = Receivable

Where manufacturers/dealers offer customers the choice of either buying or A lessor who is a manufacturer/dealer should not
leasing an asset there will be two types of income under such a lease recognize any selling profit on entering into an
1.Profit or loss equivalent to the profit or loss resulting from an outright sale operating lease because it is not the equivalent of a
of the underlying asset, at normal selling prices less any discounts sale
2.Finance income over the lease term
IFRS 16 requires the following treatment:
1. Recognize the selling profit or loss in income for the period as if it was an outright sale
2. If Interest rates are artificially low, restrict the selling profit to that which would apply if a market rate of interest were charged
3. Recognize the costs incurred in connection with negotiating and arranging a lease as an expense when the selling profit is recognized (at the
start of the lease term)

Situations that lead to a finance lease

1. The lease transfers ownership of the asset to the lessee at the end of the lease term
2. The lessee has the option to purchase the asset at a price that is expected to be sufficiently lower than the fair value at the exercise
date, that is reasonably certain at the inception date that the option will be exercised
3. The asset is of such specialised nature that only the lessee can use it without major modifications
4. The lease term is for the major part of the economic life of the asset even if the title is not transferred
5. At the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the asset.
  PV should be at least equal to FV. If it is more than 90% can be considered to be substantially.
6. If the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee
7. Gains or loss from the fluctuation in the fair value of the residual accrue to the lessee
8. The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
Liability split between current and non-current when the EOP is different from payment date
The payment that will be made within 12 months of the reporting date
 will be first applied to the outstanding finance cost at the date of payment (all finance cost not only the one accrued at th EOP)
 any amounts over and above the outstanding finance cost will be applied to a reduction in the principal amount owning.

The current liability would include: The principal repayment and the finance cost outstanding at the EOP (not the total cost)
The non current liability will be the difference between the Total liability at the end of reporting period and current liability

For leases where the annual rental is payable in advance, the current liability is the next payment.
For leases where the annual rental is payable in arrears, the current liability is the difference: EOP year 2 – EOP year 1

Interest rate implicit in the lease: PV lease + Unguaranteed RD = FV + Direct costs

OP Lease: benefits received in earned over the lease term. Total lease payments received should be spread on a straight line basis