Prepared by: CA Arun Babu Ghimire

NFRS 16 LEASES
Why NFRS 16?
NFRS 16 was brought in to ensure that all assets are shown in the statement of financial
position including leased assets. Under previous standard NAS 17, the assets acquired under
operating lease were not recognized as assets of the reporting entity and as such did not
meet Conceptual Framework’s characteristics of faithful representation.

Major Differences:
S.No. NFRS 16 NAS 17
1 Check whether it is in the books of Lessor or First of all, segregate whether it is
Lessee and treat them accordingly. In the Finance Lease or Operating Lease.
books of Lessee, no need to differentiate Then, pass entries accordingly in the
whether it is Finance Lease or Operating books of Lessor and Lessee.
Lease. In the books of Lessor, treatment is as
per NAS 17 i.e. segregating whether it is
Finance or Operating Lease; other treatment
same.

Main Features:
1. NFRS 16 requires a lessee to recognize assets and liabilities for all leases with a term of
more than 12 months, unless the underlying asset is of low value. For short term leases
or low value assets (like tablet, personal computers, small items of office furniture and
telephones) the lease payments are simply charged to profit or loss as an expense. Note
that NFRS 16 does not define a ‘low value asset’.
2. For all other leases, the lessee recognizes a right-of-use asset, representing its right to
use the underlying asset and a lease liability representing its obligation to make lease
payments. However, lessor is required to classify leases into finance and operating leases
and act as per NAS 17.

Definitions
1. A lease is a contract, or part of a contract that conveys the right to use an underlying
asset for a period of time in exchange for consideration.
2. The lessor is the entity that provides the right-of-use asset and in exchange receives
consideration.
3. The lessee is the entity that obtains use of the right-of-use asset and in exchange
transfers consideration.
4. The right-of-use asset is the lessee’s right to use an underlying asset over the lease term.

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Identifying a lease
An entity must identity 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 asset depends on the lessee having:
a. The right to obtain substantially all of the economic benefits from the use of the
identified asset, and
b. The right to direct the use of the identified asset.
Also, the right to direct the use of the asset will arise when either:
i. The customer has the right to direct how and for what purpose the asset is used
during the whole term of usage; or
ii. Relevant decisions about the use of the asset are pre-determined and the customer
can operate the asset without the supplier having the right to change those operating
instructions, or 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.

Example 1: To identify whether it is a lease or not:

ABC Council Ltd has entered into a five year contract with PQR supplier Ltd under which the
supplier co supplies the council with 10 vehicles for the purpose of community transport.
PQR Co owns the relevant vehicles, all 10 of which are specified in the contract. ABC
determines the routes taken for community transport and the charges and eligibility for
discounts. The council can choose to use the vehicles for purposes other than community
transport. When the vehicles are not being used, they are kept at the council’s offices and
cannot be retrieved by PQR unless ABC defaults on payment. If a vehicle needs to be
services or repaired, PQR is obliged to provide a temporary replacement vehicle of same
type.
Solution: This is a lease. There is identifiable asset, the 10 vehicles specified in the contract.
The council has a right to use the vehicles for the period of the contract. PQR does not have
the right to substitute any of the vehicles unless they are being serviced or repaired.
Therefore ABC Council Ltd. would need to recognize a right of use asset and a lease liability
in its statement of financial position.
Students please be noted that if the vehicles which shall be used by ABC Council are not
specified in the contract and can get exchanged with one another, then there would not be
identifiable asset. Thus, ABC shall account for the rental payments as an expense in profit
or loss.

Example 2: Identifying whether contract constitutes lease.

Bikash enters into a contract with an airport operator to use some space in the airport to
sell its goods from portable kiosks (stall) for a three year period. Bikash owns the portable
kiosks. The contract stipulates the amount of space and states that the space may be

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located at any one of the several departure areas within the airport. The airport operator
can change the location of the space allocated to Bikash at any time during the period of
use, and the costs that the airport operator would incur to do this would be minimal. There
are many areas in the airport that are suitable for the portable kiosks.
Required: Does the contract contain a lease?
Solution:
The contract does not contain a lease because there is no identified asset. The contract is
for space in the airport, and the airport operator has practical right to substitute this during
the period of use because:
 There are many areas available in the airport that would meet the contract terms,
providing the operator with a practical ability to substitute.
 The airport operator would benefit economically from substituting the space
because there would be minimal cost associated with it. This would allow the
operator to make the most effective use of its available space, thus maximizing
profits.

Example 3: Identification of lease contract.

ABC enters into a contract with Sash, the supplier, to use a specified ship for a five year
period. Sash has no substitution rights. During the contract period, ABC decides what cargo
will be transported, when the ship will sail, and to which ports it will sail. However, there are
some restrictions specified in the contract. Those restrictions prevent ABC from carrying
hazardous materials as cargo or from sailing the ship into waters where piracy is a risk.

Sash operates and maintains the ship and is responsible for the safe passage of the cargo on
board the ship. ABC is prohibited from hiring another operator for the ship, and from
operating the ship itself during the term of the contract.
Required: Does the contract contain a lease?

Solution:
ABC has the right to use an identified asset (a specific ship) for a period of time (five years).
Sash cannot substitute the specified ship for an alternative.
ABC has the right to control the use of the ship throughout the five year period of use
because:
 It has the right to obtain substantially all of the economic benefits from use of the ship
over the five year period due to its exclusive use of the ship throughout the period of
use.
 It has the right to direct the use of the ship. Although contractual terms exists that limit
where the ship can sail and what cargo can be transported, this acts to define the scope
of ABC’s right to use the ship rather than restricting ABC’s ability to direct the use of the
ship.

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Sash’s operation and maintenance of the ship does not prevent ABC from directing how
and for what purpose the ship is used. Therefore, based on the above, the contract
contains a lease.

A. LESSEE ACCOUNTING
At the commencement of lease, the lessee recognizes a right of use asset and a lease
liability.

I. Lease liability
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 that rate cannot
be readily determined, the lessee’s incremental borrowing rate should be used. After the
commencement date the carrying amount of lease liability is increased by interest charges
on the outstanding liability and reduced by lease payments made.

Interest rate implicit is the discount rate that, at the inception of lease, causes the
aggregate present value of the lease payments (including guaranteed residual value) and
unguaranteed residual value to be equal to the sum of the fair value of the underlying asset
and any initial direct costs. Also, the incremental borrowing rate is the rate of interest that
a lessee would have to pay to borrow a similar term, and with a similar security, the funds
necessary to obtain an asset of similar value to the right of use asset in a similar economic
environment.

II. Right of use asset

The right of use asset is initially measured at cost, which includes:
a. The amount of the initial measurement of lease liability
b. Any lease payments made at/before the commencement date
c. Any initial direct costs incurred by lessee
d. Any cost which the lessee will incur for dismantling and removing the underlying asset or
restoring the site at the end of the lease term.
Subsequently, the right of use asset is normally measured at cost less accumulated
depreciation and impairment losses in accordance with the cost model of NAS 16 PPE.

Under this model, the right of use asset is depreciated from the commencement date to the
earlier of the end of its useful life or end of the lease term. However, 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:

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a. The revaluation model of NAS 16: This is optional where the right of use asset relates to a
class of property, plant and equipment which is measured under the revaluation model,
and where elected, must apply to all right of use assets relating to that class; or
b. The fair value model of NAS 40 Investment Property: This is compulsory if the right of use
assets meets the definition of Investment Property and lessee uses the fair value model
for its investment property.

Presentation and allocation of finance charge

In the statement of financial position, right of use assets can be presented on a separate line
under non-current assets and lease liabilities scan be presented separately from other
liabilities. Also, total instalments payment includes principal and interest payments. So,
apply the interest rate implicit in the lease to the amount of capital outstanding to calculate
finance charge (old concept).

Example: On 1st January 20X1, Deepak entered into a two year lease for a lorry. The contract
contains an option to extend the lease term for a further year. Deepak believes that it is
reasonably certain to exercise this option. Lorries have a useful economic life of ten years.

Lease payments are Rs.10,000 per year for the initial term and Rs.15,000 per year for the
option period. All payments are due at the end of the year. To obtain the lease, Deepak
incurs initial direct costs of Rs.3,000. The lessor immediately reimburses Rs.1,000 of these
costs. The interest rate within the lease is not readily determinable. Deepak’s incremental
rate of borrowing is 5%.
Required: Calculate the initial carrying amount of the lease liability and the right of use
asset and provide double entries needed to record these amounts in Deepak’s financial
records.

Solution:
The lease term is three years. This is because the option to extend the lease is reasonably
certain to be exercised.
The lease liability is calculated as follows:
Date Cash Flow (Rs.) Discount Rate Present Value
31/12/20X1 10,000.00 1/1.05 9,524.00
31/12/20X2 10,000.00 1/1.05^2 9,070.00
31/12/20X3 15,000.00 1/1.05^3 12,958.00
Total 31,552.00

The initial cost of the right of use asset is calculated as follows:

Initial Liability Value 31,552.00
Direct costs 3,000.00
Reimbursements - 1,000.00
Total 33,552.00

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The accounting entry to record this are:

Right to use asset A/c Dr 33,552.00
Cash A/c Dr (Reimbursements) 1,000.00
To Lease liability 31,552.00
To Cash (Initial Direct Costs) 3000
34,552.00 34,552.00

Lease Liability Table

Year ended Opening Interest (5%) Installments Closing
31/12/20X1 31,552.00 1,578.00 - 10,000.00 23,130.00
31/12/20X2 23,130.00 1,157.00 - 10,000.00 14,287.00

At the end of Year 1:

Finance Cost A/c Dr 1,578
Lease liability A/c Dr 8,422
To Cash 10,000.00

The liability as a carrying amount of Rs.23,130 at the end of reporting period. The right of
use asset is depreciated over the three years lease term because it is shorter than the useful
economic life. Thus, depreciation amounts to Rs. 11,184 (Rs.33,552/3 years).
Depreciation A/c Dr 11,184
To Right of use Asset 11,184

Separating Components
A contract may contain a lease component and a non-lease component. Unless an entity
chooses otherwise, the consideration in the contract should be allocated to each
component based on the stand alone selling price of each component. Entities can, if they
prefer, choose to account for the lease and non-lease component as a single lease. This
decision must be made for each class of right of use asset. However, this choice would
increase the lease liability recorded at the inception of the lease, which may negatively
impact the perception of the entity’s financial position.

Example: On 1st January 20X1, Sirin entered into a contact to lease a crane for three years.
The lessor agrees to maintain the crane during the three year period. The total contract cost
is Rs.180,000. Sirin must pay Rs.60,000 each year with the payments commencing 31 st
December 20X1. Sirin accounts for non-lease components separately from leases.

If contracted separately it has been determined that the standalone price for the lease of
the crane is Rs.160,000 and the standalone price for the maintenance services is Rs.40,000.
Sirin can borrow at a rate of 5% per annum.
Required: Explain how the above will be accounted for by Sirin in the year ended 31 st
December 20X1.

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Solution:
Allocation of payments:
The annual payments of Rs.60,000 should be allocated between the lease and non-lease
components of the contract based on their standalone selling prices:
Lease of Crane: (160/160+40)*Rs.60,000 = Rs.48,000
Maintenance: (40/160+40)*Rs.60,000 = Rs.12,000

Lease of Crane:
The lease liability is calculated as the present value of the lease payments as follows:
Date Cash Flows Discount Rate Present Value
31/12/20X1 48,000.00 1/1.05 45,714.00
31/12/20X2 48,000.00 1/1.05^2 43,537.00
31/12/20X3 48,000.00 1/1.05^3 41,464.00
Total 130,715.00

There are no direct costs so the right of use asset is recognized at the same amount.
1. Right of Use Asset A/c Dr 130,715.00
To Lease Liability 130,715.00

2. Lease liability A/c Dr 41,464.00

Finance costs A/c Dr 6,536.00
To Cash 48000

The right of use asset is depreciated over the three years i.e. depreciation of Rs.43,572 each
year (Rs.130,715/3years).

Maintenance
The cost of one year’s maintenance will be expensed to profit or loss:
Profit/Loss A/c Dr 12,000
To Cash 12,000

Reassessing the lease liability

If changes to lease payments occur then the lease liability must be re-calculated and its
carrying amount adjusted. A corresponding adjustment is posted against the carrying
amount of the right of use asset. NFRS 16 says that the lease liability should be re-calculated
using a revised discount rate if:
 The lease term changes
 The entity’s assessment of an option to purchase the underlying asset changes.
The revised discount rate should be the interest rate implicit in the lease for the remainder
of the lease term. If this cannot be readily determined, the lessee’s incremental borrowing
rate at the date of reassessment should be used.

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Example: On 1st January 20X1, Kingfisher enters into a four year lease of property with
annual lease payments of Rs.1 million, payable at the beginning of each year. According to
the contract, lease payments will increase every year on the basis of the increase in
Consumer Price Index for the preceding 12 months. The CPI at the commencement date is
125. The interest rate implicit in the lease is not readily determinable. Kingfisher’s
incremental borrowing rate is 5% per year. At the beginning of the second year of the lease,
the CPI is 140.
Required: Discuss how the lease will be accounted for:
 During the first year of the contract
 On the first day of the second year of the contract.

Solution:
 The first year of the contract:
The first payment occurs on the commencement date so is included in the initial cost of
right of use asset.
Right of use asset A/c Dr Rs.1 million
To Cash A/c Rs. 1 million
The liability should be measured at the present value of lease payments not yet made. The
payments are variable as they depend on an index. They should be valued using the index at
the commencement date (i.e. it is assumed that the index will remain at 125-since future
cannot be predicted and so the payments will remain at Rs.1 million a year).
Date Cash Flow (mio) Discount Rate Present Value (mio)
1/1/20X2 1 1/1.05 0.95
1/1/20X3 1 1/1.05^2 0.91
1/1/20X3 1 1/1.05^3 0.86
Total 2.72

Right of use asset A/c Dr Rs.2.72 million

To Lease Liability Rs. 2.72 million
The asset is depreciated over the lease term of four years i.e. Rs. 0.93 million
[(Rs.1m+Rs.2.72m)/4 years].
Depreciation A/c Dr Rs. 0.93 million
To Right of use asset Rs. 0.93 million
Thus, carrying amount of Right of use asset is Rs. 2.79 million (1m+2.72m-0.93m).

Lease Liability Table:

Year Ended Opening (mio) Interest (5%) Payment Closing
31/12/20X1 2.72 0.14 0 (since at beginning) 2.86
The interest charge on the liability Rs. 0.14 million.
Finance Cost (P/L) Dr Rs. 0.14 million
To Lease liability Rs.0.14 million

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Thus, carrying amount of lease liability at the end of reporting date is Rs. 2.86 million.

 The first day of the second year

There are three remaining payments to make. The payment for the second year that is now
due is Rs.1.12 million (Rs.1 million * 140/125). The lease liability is re-measured to reflect
the revised lease payments (three payments of Rs.1.12 million).
Date Cash Flow (mio) Discount Rate Present Value (mio)
1/1/20X2 1.12 1 1.12
1/1/20X3 1.12 1/1.05 1.07
1/1/20X3 1.12 1/1.05^2 1.02
Total 3.21

The lease liability must be increased by Rs.0.35 million (Rs.3.21 million – Rs.2.86 million). A
corresponding adjustment is made to the right of use asset:
Right of use asset A/c Dr Rs.0.35 million
To Lease Liability A/c Rs. 0.35 million
The payment of Rs.1.12 million will then reduce the lease liability:
Lease Liability A/c Dr Rs.1.12 million
To Cash A/c Rs.1.12 million
The right of use asset’s carrying amount of Rs.3.14 million (Rs.2.79 million+Rs.0.35 million)
will be depreciated over the remaining lease term of three years.

Lessee Disclosures:
 The depreciation charged on right of use assets.
 Interest expenses on lease liabilities
 The expenses relating to short term lease and leases of low value
 Cash outflows for leased assets
 Right of use asset additions
 The carrying amount of right of use assets
 A maturity analysis of lease liabilities.

Sale and leaseback

A sale and leaseback involves the sale of an asset and the leasing back of the same asset.
The key question in determining the accounting treatment is does the transaction constitute
a sale? This is determined by considering when the performance obligation is satisfied in
accordance with NFRS 15-Revenue from contract with customers.

If an entity (seller-lessee) transfers an asset to another entity (buyer-lessor) and then leases
it back, NFRS-16 required that both entities assess whether the transfer should be
accounted for as a sale.

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Case 1: If transfer is a sale as per NFRS 15:

For Seller-Lessee
a. The seller/lessee measures the right of use asset arising from the leaseback at the
proportion of the previous carrying amount of the asset that relates to the right of use
retained by the seller/lessee. This is calculated as:
Carrying Amount x Present value of lease payments
Fair Value
b. The seller/lessee only recognizes the amount of any gain or loss on the sale that relates
to the rights transferred to the buyer. This can be calculated in three steps:
Step 1: Calculate the total gain i.e. Total Gain = Fair Value – Carrying Amount
Step 2: Calulate the gain that relates to the rights retained:
Gain x Present value of lease payments
Fair Value
Step 3: The gain relating to rights transferred is the balancing figure:
Gain on rights transferred = Total Gain – Gain on rights retained
The right of use asset continues to be depreciated as normal.

For Buyer-Lessor
The buyer-lessor accounts for the asset purchase using NAS 16 “Property, Plant and
Equipment”. The lease is accounted for by applying lessor accounting requirements.

Example: Normal Case of Sale and Leaseback

On 1st April 20X2, ABC Co bought a production plant for Rs.600,000. The carrying amount of
the plant as at 31st March 20X3 was Rs.500,000. On 1st April 20X3, ABC sold it to Hulas Co for
Rs.740,000, its fair value. ABC Co immediately leased the plant back for 5 years, the
remainder of its useful life, at Rs.160,000 p.a. payable in arrears. The present value of the
annual lease payments is Rs.700,000 and the transaction satisfies NFRS 15 criteria to be
recognized as a sale.
Required:
What gain should ABC Co recognize for the year ended 31st March 20X4 as a result of the
sale and leaseback?
Solution:
Total Gain on the sale = Fair Value – Carrying Amount
= 740,000 – 500,000
= 240,000
Gain relating to the rights retained = Gain x present value of lease payments
Fair Value
= (240,000 X 700,000/740,000)
= 227,027
Gain relating to the rights transferred = total gain – gains on rights retained

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= 240,000-227,027
= 12,973
Hence, ABC should recognize the gain of Rs.12,973 for the year ended 31 st march 20X4 as a
result of sale and leaseback.
Accounting Entry shall be:
Bank Dr 740,000
Right of Use Assets Dr 472,973 (500,000 X 700,000/740,000)
To PPE 500,000
To Lease Liability 700,000
To Gain as a result of sale & leaseback 12,973

Also, Hulas Co shall debit PPE at Rs.740,000 and cash is credited by same amount. Here,
normal lessor accounting rules apply. The lease is classified as finance lease because the
present value of the lease payments covers substantial amount of fair value of asset.

WHAT IF TRANSACTIONS NOT AT FAIR VALUE??

If the sales proceeds or lease payments are not at fair value, NFRS 16 requires that:
a. Below market terms (e.g. when the sales proceeds are less that the asset’s fair value) are
treated as a prepayment of lease payments.
b. Above market terms (e.g. when the sales proceeds exceed the asset’s fair value) are
treated as additional financing.

Example: When sales proceeds exceed the asset’s fair value

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

Monica enters into a contract with Catrina for the right to use the asset for the next five
years. Annual payments of Rs. 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 Rs.1.9 million.
Required:
Explain how the transaction will be accounted for on 1st January 20X1 by both Monica and
Catrina.

Solution:
The excess sales proceeds are Rs.0.2 million (Rs.3 million – Rs.2.8 million). This is treated as
additional financing. The present value of the lease payments was Rs.1.9 million. It is
assumed that Rs.0.2 million relates to the additional financing that Monica has been given.
The remaining Rs.1.7 million relates to the lease.

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For Monica (Seller-Lessee)

Monica must remove the carrying amount of the machine from its statement of financial
position. It should instead recognize 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 Monica i.e.
(1.7m/2.8m)*Rs.1.2 million = Rs.728,571.

Total Gain on the sale = Fair Value – Carrying Amount

= 2,800,000 – 1,200,000
= 1,600,000
Gain relating to the rights retained = Gain x present value of lease payments – additional financing
Fair Value
= 1,600,000 X 1,700,000/2,800,000)
= 971,428
Gain relating to the rights transferred = total gain – gains on rights retained
= 1,600,000-971,429
= 628,571
Hence, Monica should recognize the gain of Rs.628,572 for the year ended 31st December
20X1 as a result of sale and leaseback.
Accounting Entry shall be:
Bank Dr 3,000,000
Right of Use Assets Dr 728,571
To PPE 1,200,000
To Lease Liability 1,700,000
To Financial Liability 200,000
To Gain as a result of sale & leaseback 628,571

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 NFRS 9 Financial
Instruments.

For Catrina (Buyer-lessor)

Catrina shall pass following journal entry:
Property, Plant & Equipment A/c Dr Rs. 2,800,000
Financial Asset A/c Dr Rs. 200,000
To Cash A/c Rs. 3,000,000
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:

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 The payment/receipt allocated to the lease will be Rs. 447,368 {(1.7/1.9)*Rs.500,000}.

 The payment/receipt allocated to the additional finance will be Rs.52,632
{(0.2/1.9)*Rs.500,000}.

Example: When sales proceeds is less than the asset’s fair value
Diva is an entity which prepares financial statements to 31 st March each year. The financial
statements for the year ended 31st March 20X5 are to be authorized for issue on 30th June
20X5. The following events are relevant to these financial statements.

On 1st April 20X4, Diva sold a property for Rs.48 million to raise cash to expand its business.
The transaction constituted a sale under NFRS 15 Revenue from Contract with Customers.
The carrying amount of the property on 1st April 20X4 was Rs. 50 million and its fair value
was Rs.55 million. The estimated future useful life of the property on 1 st April 20X4 was 40
years. On 1st April 20X4, Diva began to lease this property on a ten years lease. The annual
lease rentals for the first five years of the lease were set at Rs. 1 million. For the final five
years of the lease, the rentals were set at Rs.1.5 million. Both of these rental amounts were
below the market rental for a property of this nature. The present value of the lease
payments is Rs.9 million and the implicit interest rate in the lease is 5.9%.

Required: Explain and show how the above event should be reported in the financial
statements of Diva for the year ended 31st March 20X5.

Solution:
As a sale has occurred, the carrying amount of the asset of Rs.50 million must be
derecognized. As per NFRS 16, a right of use asset should be recognized at the proportion of
the previous carrying amount that relates to the right of use retained. This amounts to
Rs.8.2 million {Rs.50 million (carrying amount) * Rs.9 million (present value of lease
payments) / Rs.55 million (fair value)}.

As the fair value of Rs.55 million is in excess of the proceeds of Rs.48 million, NFRS 16
requires the excess of Rs.7 million (Rs.55 million – Rs. 48 million) to be treated as a
prepayment of the lease rentals. Therefore, Rs.7 million prepayment must be added to the
right of use asset, bringing the right of use asset to Rs.15.2 million (Rs. 8.2 million + Rs.7
million).

A lease liability must also be recorded at the present value of the lease payment of Rs. 9
million.
Total Gain on the sale = Fair Value – Carrying Amount
= 55 mio – 50 mio
= 5 mio
Gain relating to the rights retained = Gain x present value of lease payments
Fair Value

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= (5 mio X 9 mio/55 mio)

= Rs. 0.8 mio
Gain relating to the rights transferred = total gain – gains on rights retained
= 5 mio – 0.8 mio
= Rs. 4.20 mio
Hence, Diva should recognize the gain of Rs.4.20 million for the year ended 31st march
20X5 as a result of sale and leaseback.
Accounting Entry shall be:
Bank Dr 48 million
Right of Use Assets Dr 15.2 million
To PPE 50 million
To Lease Liability 9 million
To Gain as a result of sale & leaseback 4.2 million

The lease liability is increased for interest and reduced for the lease liability, giving a
carrying amount of the lease liability at 31st March 20X5 of Rs. 8.53 million (WN1). The
interest of Rs. 0.53 million is charged to profit or loss as a fiancé cost.

The proportion of the carrying amount of the property relating to the right of use retained
of Rs. 15.2 million (including the Rs.7 million lease pre-payment) remains as a right of use
asset in the statement of financial position and is depreciated over the lease term:
Profit / Loss A/c Dr (15.2m / 10 years) Rs.1.52 million
To Right of use asset Rs. 1.52 million

Working Note: Lease liability for the year ending 31st March 20X5:
Opening Balance Rs.9 million
Interest (9m*5.9%) Rs. 0.53 million
Lease payments Rs. 1 million
Closing Balance Rs. 8.53 million

Case II: If transfer is not a sale as per NFRS 15:

If the transfer does not satisfy the NFRS 15 requirements to be accounted for as a sale:
 The seller-lessee continues to recognize the transferred asset, and the transfer proceeds
are treated as financial liability, accounted for in accordance with NFRS 9 FI.
 The buyer-lessor will not recognize the transferred asset and will recognize a financial
asset equal to the transfer proceeds.
In simple terms, the transfer proceeds are treated as a loan.

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B. LESSOR ACCOUNTING
Similar concept to that of NAS 17 Leases. Also, the definition of vocabularies used in NAS-17
like Guaranteed Residual Value, Minimum Lease Payments, Gross Investment in Lease,
Lease Period has been slightly changed in NFRS-16. The term “Guaranteed Residual Value”
has been replaced by “Residual Value Guarantee”. Also, the term “Minimum Lease
Payments” cannot be observed in NFRS 16; it has been replaced by “Lease Payments”. The
meaning of these terminologies has also been updated.

Definitions
1. Residual Value Guarantee: A guarantee made to a lessor by a party unrelated to the
lessor that the value of an underlying asset at the end of the lease will be at least a
specified amount.
2. Unguaranteed Residual Value: That portion of the residual value of the underlying asset,
the realization of which by a lessor is not assured or is guaranteed solely by a party
related to the lessor.
3. Lease Payments: 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;
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
d. Payments of penalties for terminating the lease, if the lease term reflects the lessee
exercising an option to terminate the lease.
S.No. For Lessee: For Lessor:
1. Lease payments also include Lease payments also includes any residual
amounts expected to be payable by value guarantees provided to the lessor by
the lessee only (not party related to the lessee, a party related to the lessee or
lessee) under residual value a third party unrelated to lessor that is
guarantees. {see definition of financially capable of discharging the
Residual Value Guarantees}. If party obligations under the guarantee.
related to lessee gives guarantee, it
won’t be included as lease
payments for lessee.
2. Lease payments do not include Lease payments do not include payments
payments allocated to non-lease allocated to non-lease components.
components of a contract, unless
the lessee elects to combine non-
lease components with a lease
component and to account for
them as a single lease component.
3 Thus, lease payments from the point of view of lessor and lessee varies.

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4. Gross Investment in Lease: The sum of:

a. The lease payments receivable by a lessor under a finance lease; and
b. Any unguaranteed residual value accruing to the lessor.
5. Net Investment in Lease: The gross investment in lease discounted at the interest rate
implicit in the lease.
6. Inception Date: 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.
7. Initial Direct Costs: 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.
8. Lease incentives: Payments made by a lessor to a lessee associated with a lease, or the
reimbursement or assumption by a lessor of costs of a lessee.
9. Lease modification: A change in the scope of a lease, or the consideration for a lease,
that was not part of the original terms and conditions of the lease (for example: adding or
terminating the right to use one or more underlying assets or extending or shortening the
contractual lease term).
10. Lease term: The non-cancellable period for which a lessee has a 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 if reasonably certain
not to exercise that option.
11. Sublease: A transaction for which an underlying asset is re-leased by a lessee
(“intermediate lessor”) to a third party, and the lease (“head lease”) between head
lessor and lessee remains in effect.

A lessor must classify its leases as finance lease and operating lease.

How to classify a lease?

Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form of the contract. 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 of the lease, that the option will be exercised;
c. the lease term is for the major part of the economic life of the asset even if title is not
transferred;
d. at the inception of the lease, the present value of lease payments amounts to at least
substantially all of the fair value of the lease asset; and

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e. the leased assets are of such a specialized nature that only the lessee can use them
without major modifications.

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 equalling 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.

The examples and indicators mentioned above are not always conclusive. If it is clear from
other features that the lease does not transfer substantially all the risks and rewards
incidental to ownership of an underlying asset, the lease is classified as an operating lease.
For example: this may be the case if ownership of the underlying asset transfers at the end
of the lease for a variable payment equal to its then fair value, or if there are variable lease
payments, as a result of which the lessor does not transfer substantially all such risk and
rewards.
Lease classification is made at the inception date and is reassessed only if there is a lease
modification. Changes in estimates (for example: changes in estimates of the economic life
or of the residual value of the underlying asset), or changes in circumstances (for example:
default by the lessee) do not give rise to a new classification of a lease for accounting
purpose.

Example: Deny is a lessor and is drawing up a lease agreement for a building. The building
has a remaining useful economic life of 50 years. The lease term, which would commence
on 1st January 20X0 is for 30 years.

Deny would receive 40% of the assets value upfront from the lessee. At the end of each of
the 30 years, Deny will receive 6% of the asset’s fair value as at 1st January 20X0.

Legal title at the end of the lease remains with Deny, but the lessee can continue to lease
the asset indefinitely at a rental that is substantially below its market value. If the lessee
cancels the lease, it must make a payment to Deny to recover its remaining investment.
Required:
As per NFRS 16 Lease, should the lease be classified as an operating or finance lease?

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Solution:
The lease term is only for 60% (30years/50years) of the assets useful life. Legal title also
does not pass at the end of the lease. These factors suggest that the lease is an operating
lease. However, the lessee can continue to lease the asset at the end of the lease term for a
value that is substantially below market value. This suggests that the lessee will benefit from
the building over its useful life and is therefore an indication of a finance lease.

The lessee is also unable to cancel the lease without paying Deny. This is an indication that
Deny is guaranteed to recoup its investment and therefore Deny has relinquished (given
up)/transferred the risks of ownership to lessee.

It also seems likely that the present value of the lease payments will be substantially all of
the asset’s fair value. The lease payments (ignoring discounting) equates to 40% of fair
value, payable upfront and then another 180% (30 years *6%) of the fair value over the
lease term. Therefore, this again suggests that the lease is a finance lease. [Since, PV of LP
will cover substantial portion of fair value of asset].

If we consider all above points, it would appear that the lease is a finance lease.

A. Finance Lease:
It is a lease where the risks and rewards of the underlying asset substantially transfer to the
lessee.
Recognition and Measurement
At the commencement date, a lessor shall recognize assets held under a finance lease in its
statement of financial position and present them as a receivable at an amount equal to the
net investment in lease.

Example: Vunu leases machinery to Tori. The lease is for four years at an annual cost of Rs.
2,000 payable annually in arrears. The present value of the lease payments is Rs. 5,710. The
implicit rate of interest is 15%.
Required: How should Vunu account for their net investment in lease?

Solution:
Vunu recognizes the net investment in the lease as a receivable. This is the present value of
the lease payments of Rs.5,710. The receivable is increased by finance income. The
receivable is reduced by the cash receipts.
Year Opening Balance Finance income Installment Closing Balance
1 5,710 856 2,000 4,566
2 4,566 685 2,000 3,251
3 3,251 488 2,000 1,739
4 1,739 261 2,000 -

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Initial measurement
The lessor shall use the interest rate implicit in the lease to measure the net investment in
lease. In the case of sublease, if the interest rate implicit in the sublease cannot be readily
determined, an intermediate lessor may use the discount rate used for the head lease
(adjusted for any initial directs costs associated with the sublease) to measure net
investment in the sublease.

Initial direct costs, other than those incurred by manufacturer or dealer lessor, are included
in the initial measurement of the net investment in the lease and reduce the amount of
income recognized over the lease term. The interest rate implicit in the lease is defined in
such a way that the initial direct costs are included automatically in the net investment in
the lease; there is no need to add them separately.

Subsequent measurement
A lessor shall recognize finance income over the lease term, based on a pattern reflecting a
constant periodic rate of return on the lessor’s net investment in the lease. A lessor shall
review regularly estimated unguaranteed residual values used in computing the gross
investment in the lease. If there has been a reduction in the estimated unguaranteed
residual value, the lessor shall revise that income allocation over the lease term and
recognize immediately any reduction in respect of amounts accrued. (However, silent if
increment in estimated unguaranteed residual value. Thus, no revision of income allocation
shall be made).

B. Operating Lease:
It is a lease that does not meet the definition of a finance lease.

A lessor shall recognize lease payments from operating leases as income on either straight
line basis or another systematic basis. The lessor shall apply another systematic basis if that
basis is more representative of the pattern in which benefit from the use of the underlying
asset is diminished.

A lessor shall recognize costs, including depreciation, incurred in earning the lease income
as an expense. A lessor shall add initial direct costs incurred in obtaining an operating lease
to the carrying amount of the underlying asset and recognize those costs as an expense over
the lease term on the same basis as the lease income.

The depreciation policy for depreciable underlying assets subject to operating leases shall
be consistent with the lessor’s normal depreciation policy for similar assets. A lessor shall
calculate depreciation in accordance with NAS 16. A lessor shall apply NAS 36 to determine
whether an underlying asset subject to an operating lease is impaired and to account for
any impairment loss identified.

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A manufacturer or dealer lessor does not recognize any selling profit on entering into an
operating lease because it is not the equivalent of a sale.

Example: Nidhi hires out industrial plant on long-term operating lease. On 1st January 20X1,
it entered into a seven year lease on a mobile crane. The terms of the lease are Rs.175,000
payable on 1st January 20X1, followed by six rentals of Rs. 70,000 payable on 1 st January
20X2-20X7. The crane will be returned to Nidhi on 31 st December 20X7. The crane originally
cost Rs. 880,000 and has a 25 year useful life with no residual value.
Required:
Discuss the accounting treatment of the above in the year ended 31 st December 20X1.

Solution:
Nidhi holds the crane in its statement of financial position and depreciates it over its useful
life. The annual depreciation charge is Rs.35,200 (Rs.880,000/25 years).

Rental income must be recognized in profit or loss on a straight line basis. Total lease
receipts are Rs.595,000 (Rs.175,000+Rs.70,000*6 years). Annual rental income is therefore
Rs.85,000 (Rs.595,000/7 years). The statement of financial position includes liability for
deferred income of Rs.90,000 (Rs.175,000-Rs.85,000).

Lease Modifications
A lessor shall account for a modification to an operating lease as a new lease from the
effective date of the modification, considering any prepaid or accrued lease payments
relating to the original lease as part of the lease payments for the new lease.

Lessor’s Disclosure
A lessor shall disclose the following amounts for the reporting period:
a. For finance lease:
i. Selling profit or loss;
ii. Finance income on the net investment in lease; and
iii. Income relating to variable lease payments not included in the measurement of the
net investment in the lease.
b. For operating lease: lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or a rate.

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