Module 3

3.1 Lease

A lease is a contract outlining the terms under which one party agrees to rent property owned by another party. It
guarantees the lessee (Links to an external site.) , also known as the tenant, use of an asset and guarantees
the lessor (Links to an external site.) , the property owner or landlord, regular payments for a specified period in exchange.
Both the lessee and the lessor face consequences if they fail to uphold the terms of the contract. It is a form of incorporeal
right (Links to an external site.).

3.1.1 Understanding a Lease

Leases are legal and binding contracts that set forth the terms of rental agreements in real estate and real and personal
property. These contracts stipulate the duties of each party to effect and maintain the agreement and are enforceable by
each. For example, a residential property lease includes the address of the property, landlord responsibilities, and tenant
responsibilities, such as the rent amount, a required security deposit (Links to an external site.), rent due date,
consequences for breach of contract, the duration of the lease, pet policies, and any other essential information.
Not all leases are designed the same, but there are some common features: rent amount, due date, lessee and lessor, etc.
The landlord (Links to an external site.)  requires the tenant to sign the lease, thereby agreeing to its terms before occupying
the property. Leases for commercial properties, on the other hand, are usually negotiated in accordance with the specific
lessee and typically run from one to 10 years, with larger tenants often having longer, complex lease agreements. The
landlord and tenant should retain a copy of the lease for their records. This is especially helpful when disputes arise.

3.1.2 Identifying Lease

IFRS 16 represents the first major overhaul of lease accounting in over 30 years. The new Standard will affect most
companies that report under IFRS and are involved in leasing, and will have a substantial impact on the financial statements
of lessees of property and high value equipment. 
Since accounting for leases under IFRS 16 results in substantially all leases being recognized on a lessee’s balance sheet,
the evaluation of whether a contract is (or contains) a lease becomes even more important than it is under IAS 17 and
IFRIC 4. In practice, the main impact will be on contracts that are not in the legal form of a lease but involve the use of a
specific asset and therefore might contain a lease – such as outsourcing, contract manufacturing, transportation and
power supply agreements. Currently, this evaluation is based on IFRIC 4; however, IFRS 16 replaces IFRIC 4 with new
guidance that differs in some important respects.
IFRS 16 changes the definition of a lease and provides guidance on how to apply this new definition. As a result, some
contracts that do not contain a lease today will meet the definition of a lease under IFRS 16, and vice versa. 
Under IFRS 16 a lease is defined as ‘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’.
A contract can be (or contain) a lease only if the underlying asset is ‘identified’. Having the right to control the use of an
identified asset means having the right to direct, and obtain all of the economic benefits from, the use of that asset. These
rights must be in place for a period of time, which may also be determined by a specified amount of use. Put simply, if the
customer controls the use of an identified asset for a period of time, then the contract contains a lease. This will be the case
if the customer can make the important decisions about the use of the asset in a similar way it makes decisions about the
use of assets it owns outright. In such cases, the customer (ie the lessee) is required to recognize these rights on its
balance sheet as a ‘right-of-use’ asset. In contrast, in a service contract, the supplier controls the use of any assets used to
deliver the service and so there is no right-of-use asset to recognize.

3.1.2.1 Lease Evaluation

Let’s examine each of these in more detail.
Is there an identified asset?

An identified asset is an asset that is either:

 explicitly identified in the contract, or

 is implicitly specified by being identified at the time that the asset is made available for use by the customer.

Even if an asset is explicitly specified, a customer does not have the right to use an identified asset if the supplier has a
substantive substitution right throughout the period of use.
What is a substantive substitution right?
A substantive substitution right exists if the supplier has the practical ability to substitute alternative assets throughout the
period of use and the economic benefits of substituting the asset would exceed the cost (or in other words, the supplier
would benefit economically from substituting the asset). When the asset is located at the customer’s premises, the costs
associated with substituting the asset are likely to be higher, making it less likely that the supplier would economically
benefit from making a substitution.
The assessment of whether a supplier’s substitution right is substantive is based on facts and circumstances present at
inception of the contract. This means that the customer ignores events that are not likely to occur in future such as:

 an agreement by a future customer to pay an above-market rate for use of the asset
 the introduction of new technology that is not substantially developed at inception of the contract
 a substantial difference between the performance or customer’s use of an asset, and the use or performance
considered likely at inception of the contract, and
 a substantial difference between the actual market price of the asset during the period of use, and the market price
considered likely at inception of the contract.

If the supplier has the right or obligation to substitute the asset for repair purposes or to provide routine maintenance
services (eg, to allow it to install a technical upgrade that has become available), a customer is not precluded from having
the right to use an identified asset. A customer is also not required to perform an exhaustive search to determine if a
supplier has a substantive substitution right. If a customer cannot readily determine whether a supplier has such a right, it
may conclude that a right does not exist.
3.1.3 Recognition and Measurement of Leases

At the commencement date (Links to an external site.) , a lessee (a customer) recognizes a right-of-use asset and a lease
liability (IFRS 16.22). Right-of-use is an asset representing lessee’s right to use the leased asset (Links to an external
site.) during the lease term (Links to an external site.) .

3.1.3.1 Initial measurement of the right-of-use asset

Components of the right-of-use asset

The right-of-use (‘RoU’) asset is measured at cost at the commencement date (Links to an external site.) . The cost of RoU
comprises (IFRS 16.24):

1. the amount equal to the lease liability at its initial recognition,  (Links to an external site.)
2. lease payments made at or before the commencement of the lease (less any lease incentives (Links to an external
site.) received),
3. any initial direct costs (Links to an external site.) incurred by the lessee; and
4. an estimate of costs to be incurred by the lessee in 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 and conditions of the lease,
unless those costs are incurred to produce inventories (recognized under IAS 37 (Links to an external site.)).

Example: initial measurement of the right-of-use asset and lease liability

Let’s work through a calculation example on initial measurement of a lease based on the following assumptions:
Commencement date: 20X1-01-01
Discount rate: 5%
Initial direct costs: $20,000
Lease incentives: $5,000
Upfront lease payment for year 20X1: $50,000
Future payments for the lease are listed in the table below. For each payment, the discount factor is calculated in order to
determine the total present value of the lease liability. Initial measurement of a lease liability amounts to $355,391 and is
calculated as follows:
commencement date discount rate
 01/01/2001 5%

payments at the commencement of the lease

20,000 Initial direct costs

(5,000) Lease incentives

50,000 Upfront lease payment for year 2001

future payments

payment date of payment discount factor discounted amount

1 50,000 01/01/2002 0.9524 47,619.05

2 50,000 01/01/2003 0.9070 45,351.47

3 50,000 01/01/2004 0.8638 43,191.88

4 50,000 01/01/2005 0.8227 41,135.12

5 50,000 01/01/2006 0.7835 39,176.31

6 50,000 01/01/2007 0.7462 37,310.77

7 50,000 01/01/2008 0.7107 35,534.07

8 50,000 01/01/2009 0.6768 33,841.97

9 50,000 01/01/2010 0.6446 32,230.45

 
The right-of-use (‘RoU’) asset at initial recognition amounts to $420,391:

355,391 Initial measurement of the lease liability

20,000 Initial direct costs

(5,000) Lease incentives

50,000 Upfront lease payment for year 20X1

420,391 Total: right-of-use asset

The schedules for accounting in subsequent years for the lease liability and RoU are presented below.
Lease liability increases every year due to unwinding of discount (charged as finance costs in P/L) and decreases with each
payment made:
year opening (1 Jan) payment (1 Jan) discount closing (31 Dec)

2001 355,391 - 17,770 373,161

2002 373,161 (50,000) 16,158 339,319

2003 339,319 (50,000) 14,466 303,785

2004 303,785 (50,000) 12,689 266,474

2005 266,474 (50,000) 10,824 227,298

2006 227,298 (50,000) 8,865 186,162

2007 186,162 (50,000) 6,808 142,971

2008 142,971 (50,000) 4,649 97,619

2009 97,619 (50,000) 2,381 50,000

2010 50,000 (50,000) - -

 
The carrying amount of the right-of-use asset decreases with depreciation charged each year:

year NBV opening (1 Jan) depreciation NBV closing (31 Dec)

2001 420,391 (42,039) 378,352

2002 378,352 (42,039) 336,313

2003 336,313 (42,039) 294,274

2004 294,274 (42,039) 252,235

2005 252,235 (42,039) 210,196

2006 210,196 (42,039) 168,156

2007 168,156 (42,039) 126,117

2008 126,117 (42,039) 84,078

2009 84,078 (42,039) 42,039

2010 42,039 (42,039) -

As we can see, total lease payments amount to $515,000 (this includes initial direct costs, lease incentives and upfront
lease payment for year 20X1). Total expense recognized during the lease term amounts to $515,000 as well and is split
between depreciation expense ($420,391) and discounting expense ($94,609).
 
Example: rent-free period
It sometimes happens that a lease starts with a rent-free period. The way that the requirements of IFRS 16 are set out
results in depreciation and interest charges being spread throughout the lease period (including rent-free periods) without
any manual adjustments to general recognition model. Below is an example for a 2-year lease that starts on 20X1-01-01
with a rent of $30,000 paid quarterly up-front, but where the first two quarters are rent-free. The discount rate in this
example is 4%. See the previous example for more detailed explanations on how to account for a lease.
As usual, we start with laying out all lease payments:

01/01/2001 commencement date discount rate

31/12/2002 end of lease term 4% per annum

future payments

quarter (Q) payment date of payment discount factor discounted amount

1 0 01/01/2001 1.0000 0 rent-free quarter

2 0 01/04/2001 0.9904 0 rent-free quarter

3 30,000 01/07/2001 0.9807 29,422

4 30,000 01/10/2001 0.9711 29,133

5 30,000 01/01/2002 0.9615 28,846

6 30,000 01/04/2002 0.9523 28,569

7 30,000 01/07/2002 0.9430 28,291

8 30,000 01/10/2002 0.9337 28,012

In this example, let’s assume that there are no initial direct costs or lease incentives received, therefore the right-of-use
asset at initial recognition equals the initial measurement of the lease liability and amounts to $172,272.
The subsequent accounting is the same as for a lease without rent-free periods. The right-of-use asset is depreciated every
year and the interest expense is accrued on lease liability. The only difference (when compared to a lease without any rent-
free periods) relates to repayments of lease liability, because there are none during the first two quarters. Therefore, the
carrying amount of a lease liability increases during these rent-free periods due to accrued interest (discount).
This is how the subsequent accounting for a lease liability looks like:

Liability Schedule before reassessment of lease term

 172,272.37 Lease liability at initial recognition

quarter (Q) opening payment discount closing

1 172,272 - 1,674 173,946

2 173,946 - 1,709 175,656

3 175,656 (30,000) 1,447 147,103

4 147,103 (30,000) 1,163 118,266

5 118,266 (30,000) 858 89,124

6 89,124 (30,000) 581 59,705

7 59,705 (30,000) 295 30,000

8 30,000 (30,000) 0 -

The carrying amount of the right-of-use asset decreases with depreciation charged each year as usual:

Asset Schedule before reassessment of lease term

172,272 Gross book value of the righ-of use asset at initial recognition

quarter (Q) NBV opening depreciation NBV closing

1 172,272 (21,534) 150,738

2 150,738 (21,534) 129,204

3 129,204 (21,534) 107,670

4 107,670 (21,534) 86,136

5 86,136 (21,534) 64,602

6 64,602 (21,534) 43,068

7 43,068 (21,534) 21,534

8 21,534 (21,534) -

3.1.3.1.1Initial Measurement Cost Components

Initial direct costs
Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been
obtained (IFRS 16.Appendix A). The definition of initial direct costs is essentially the same as for incremental costs of
obtaining a contract (Links to an external site.)  in IFRS 15.
Examples of initial direct costs that are included in the cost of RoU asset are:

 commissions to employees or external agents that arranged a lease, which are payable only if the lease contract is
signed,
 legal costs incurred when signing the contract (e.g. stamp duties).

Examples of initial direct costs that can’t be included in the cost of RoU asset are:

 allocation of overheads,
 advisory fees that are incremental, but would have been incurred irrespective of whether a lease contract is eventually
concluded or not.

There is also another type of initial direct costs which IFRS 16 is silent about. These are costs directly attributable to
bringing a right-of-use asset to the location and condition necessary for it to be capable of operating in the manner intended
by management. In other words, we’re talking about ‘asset costs’, not ‘contract costs’. As you can tell, I’m making a direct
link to IAS 16 (Links to an external site.)  here, which explicitly allows including such costs in the cost of PP&E. This
approach can also be adopted for right-of-use assets and paragraph IFRS 16.BC149 implicitly supports this view.
Lease payments made at or before the commencement date

Lease payments made at or before the commencement date are obviously not included in the lease liability, but they are
included in the measurement of the right-of-use assets.
Security deposits paid
Some lessors require a payment of security deposits (collaterals) that will be refunded when the leased asset is returned by
the lessee. Such deposits are treated as a separate financial asset at amortized cost under IFRS 9. Those deposits are
usually interest-free, therefore their fair value at initial recognition (Links to an external site.)  is lower than cash paid at the
commencement of the lease. This difference should be treated as initial direct cost (Links to an external site.) and added to
the RoU asset (see a similar example  (Links to an external site.) with security deposit paid by a contractor).
Lease incentives

Lease incentives are payments made by a lessor (supplier) to a lessee (customer) associated with a lease, or the
reimbursement by a lessor of costs of a lessee (IFRS 16. Appendix A). Lease incentives are accounted for as a reduction of
the right-of-use asset.
REIMBURSEMENT OF LEASEHOLD IMPROVEMENTS
Recently, IASB decided (Links to an external site.) to amend Illustrative Example 13 to IFRS 16 which said that the
reimbursements of leasehold improvements are not lease incentives as they relate to an asset recognized under IAS 16.
IASB stated that it cannot be automatically assumed that all reimbursements of leasehold improvements are not lease
incentives.
If such payments economically represent reimbursement for improvements made to the lessor’s asset, then yes – they are
not lease incentives. Factors indicating that leasehold improvements are made to the lessor’s asset include:

 leasehold improvements would be necessary to use the leased asset by most entities (e.g. installing walls in a building),
 assets constructed in the leasehold improvement process do not result from specialized needs of the lessee,
 economic useful life of leasehold improvements exceeds enforceable lease term.
Leasehold improvements are recognized separately under IAS 16 (Links to an external site.) . If the reimbursement is not
treated as a lease incentive, it is treated as a reduction of their cost. (Links to an external site.)
On the other hand, if the leasehold improvements are in fact an asset of the lessee, then any reimbursement made by the
lessor should be treated as a lease incentive and accounted for as a reduction of the right-of-use asset recognized under
IFRS 16.

3.1.3.2 Initial measurement of the lease liability

Components of the lease liability

The lease liability should be initially recognized and measured at the present value of the lease payments (IFRS 16.26).
Lease payments comprise (IFRS 16.27):

1. fixed payments (Links to an external site.), less any lease incentives receivable,

2. variable lease payments (Links to an external site.)  that depend on an index or a rate,
3. amounts expected to be payable by the lessee under residual value guarantees, (Links to an external site.)
4. the exercise price of a purchase option (Links to an external site.) if the lessee is reasonably certain to exercise that
option; and
5. payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate
the lease.

3.1.3.2.1 Fixed payments

Fixed payments are payments made by a lessee to a lessor for the right to use an underlying asset during the lease term,
excluding variable lease payments.
In-substance fixed lease payments

Fixed payments include also payments that may, in form, contain variability but that, in substance, are unavoidable. Such
payments are called ‘in-substance fixed lease payments.
Example: In-substance fixed lease payments
Scenario A
Retailer A enters into a 5-year lease of retail space. Fixed monthly lease payments amount to $50 only, but they increase to
$1,000 if revenue generated in the point of sales located on the leased space exceeds $3,000 per month. Retailer A is
required to keep the point of sales open during at least 8 hours a day. The probability that revenue won’t exceed $3,000 per
month is remote.
As stated in paragraph IFRS 16.B42(a)(ii), in substance fixed payments are also payments that are initially structured as
variable lease payments linked to the use of the underlying asset but for which the variability will be resolved at some point
after the commencement date so that the payments become fixed for the remainder of the lease term. Those payments
become in-substance fixed payments when the variability is resolved and recognized in the lease liability and right-of-use
asset.
In the scenario outlined above, Retailer A recognizes a lease liability consisting of monthly lease payments of $1,000 as
there is no genuine variability in those lease payments.
Scenario B
Retailer B enters into a 4-year lease of retail space with no fixed lease payments. Instead, Retailer B pays the lessor a
variable lease fee amounting to 4% of revenue generated in the point of sales located on the leased space.
In this scenario, there is genuine variability in lease payments. Therefore, there are no lease payments to be included in the
measurement of lease liability. Instead, variable lease fee is charged directly to P/L every month.

3.1.3.2.2 Variable lease payments

Variable lease payments are the portion of payments made by a lessee to a lessor during the lease term that varies
because of changes in facts or circumstances occurring after the commencement date, other than the passage of time
(IFRS 16.appendix A). It is important to note that not all variable fixed payments are included in the measurement of lease
liability and right-of-use asset. The initial (and subsequent) measurement includes only those variable payments that
depend on an index or a rate. Such payments may be linked to predetermined index (e.g. CPI), benchmark rate (e.g.
LIBOR) or may vary to reflect changes in market rental rates (IFRS 16.28).
For initial recognition of the lease liability, variable lease payments are measured using the actual value of an index or a rate
as at the commencement date (IFRS 16.27(b)). In other words, lessee cannot use forward rates or forecasting techniques in
measuring variable lease payments (IFRS 16.BC166).
Variable payments that do not depend on an index or a rate, and those that depend on future activity of a lessee or an
underlying asset in particular, are not included in the measurement of lease liability and right-of-use (RoU) asset. They are
recognized in P&L (or capitalized in the cost of another asset) in the period in which the event or condition that triggers
those payments occurs (IFRS 16.38(b)). Typical examples of such payments recognized in P&L as they occur are:

 payments that depend on performance of the underlying asset (e.g. specified % of revenue, physical output of the
leased asset),
 payments for the specified units relating to future usage (e.g. specified mileage of a leased car),
 payments that are linked to taxes or levies imposed on the leased asset 

3.1 Illustrative Problem

Example 1 – Rail cars

In a contract between a customer and a supplier, the supplier needs to transport goods using a particular type of rail car in
line with a specified timetable over a three-year period. The timetable and quantity of goods stipulated are equivalent to the
customer having the use of six rail cars for three years. The supplier makes available the cars, driver and engines as part of
the arrangement. The supplier has a large supply of similar cars and engines that are available to fulfil the obligations of the
arrangement. The rail cars and engines are kept at the supplier’s premises when they are not being used to transport the
goods.
Analysis
The contract does not contain a lease of either rail cars or engines.
The rail cars and engines used to transport the customer’s goods are not identified assets. The supplier has a substantive
substitution right to replace the rail cars and engines as a result of:

 the supplier having the practical ability to substitute each car and engine throughout the period of use. Alternative cars
and engines are readily available to the supplier and these can be substituted without the customer’s approval, and
 the supplier being able to economically benefit from substituting each car and engine. There would be very little cost
associated with substituting these assets as the cars and engines are stored at the supplier’s premises and the supplier
has a large pool of similar cars and engines.

Therefore, the customer does not have the right to obtain substantially all of the economic benefits from the use of an
identified rail car or an engine or directs their use. The supplier chooses which rail cars and engines are used for each
delivery and therefore directs them. It has substantially all of the economic benefits from use of the rail cars and engines.

3.2 Illustrative Problem

Example 2 – Fibre-optic cable

A customer enters into a 10-year contract with a utilities company (the supplier) for the right to use five individually specified,
physically distinct fibre-optic strands (fibres) within a larger cable running between New York and London. The customer
makes all relevant decisions concerning the use of the individual fibres by connecting them to its own electronic equipment
(ie, the customer ‘lights’ the fibres) and deciding what data, and how much data, each strand will carry. If any of the strands
are damaged, the supplier is responsible for effecting any necessary repairs. The supplier owns additional fibres both within
the same cable and in adjacent cables but can only substitute those for the customer’s strands when performing ongoing
maintenance or effecting necessary repairs.
Analysis
The contract represents a lease of unlit fibre-optic strands (the identified assets).
The fibre optic strands are identified assets because they are explicitly specified in the contract and are physically distinct
from other fibres within the cable. The supplier cannot substitute the fibres for reasons other than repair, maintenance or
malfunction.
Conversely, if the customer was entitled only to use an amount of capacity equivalent to five fibres within a cable made up
of 15 strands, but not five specific strands, the contract would contain neither an identified asset nor a lease because the
capacity represented by five fibres does not represent substantially all the capacity of the 15-strand cable. In this case, the
supplier would only be providing data capacity (ie, a service).

3.3 Illustrative Problem

Example 3 – Ship

A customer enters into a contract with a shipping company (the supplier) to transport cars from Tokyo to Singapore. The
contract specifies the particular ship to be used, the dates of pick-up and delivery, and the cars to be transported (which will
occupy the full capacity of the ship). The supplier operates and maintains the ship and is responsible for the safe passage
of the cars. The customer is not able to make changes (ie to either the destination or the nature of the cargo) once the
contract has been signed.
Analysis
The contract does not contain a lease.
After signing the contract, the customer is not able to direct how and for what purpose the ship is used and does not
therefore control the use of the asset. The contract pre-determines how and for what purpose the ship will be used and
customer neither operates nor designed the ship.