LEASES: LESSOR PERSPECTIVE

IFRS 16
The standard directs that the lessor should account for a lease contract as either operating or finance lease.
This classification is based to the extent to which risks and rewards incidental to the ownership of the
underlying assets are transferred from the lessor to the lessee.
✔ Risks include the possibilities of losses from idle capacity or technology obsolesce and variation
in return due to changing economic conditions.
✔ Rewards include the expectation of profitable operation over the asset’s economic life and of
gain from appreciation of value or realisation of residual value.
An operating lease is defined as the lease contract which does not transfer substantially all risks and
rewards incidental to the ownership of the leased asset from the lessor to the lessee.
A finance lease is defined as the lease contract which transfer substantially all risks and rewards
incidental to the leased asset from the lessor to the lessee.
WHEN IS THE RISKS AND REWARDS TRANSFERRED?
IFRS 16 provides that the lease transaction for the lessor to be accounted for according to the substance
and not merely the legal form, hence, the application of – substance over form. The transfer of the risks
and rewards is evidenced through the following:
✔ The leased asset is of a specialised nature such that only the lessee can use it without major
modification
✔ The lease transfers ownership of the asset to the lessee at the end of the lease term
✔ The lease term is for major part of economic life of the asset even if the title is not transferred
✔ At the inception date the present value of the lease payments amounts to at least substantially all
of the fair value of the leased asset.
✔ The lessee has the option to purchase the asset at a price which is expected to be sufficiently
lower than the fair value at the date the option becomes exercisable such that, at the inception
date, it is reasonably certain that the lessee will exercise the option.
Additionally, the following indicator when combined or individually could be used to determine if
risks and rewards transfer:
✔ If the lessee cancels the lease, the lessor’s losses associated with the cancellation will be
borne by the lessee
✔ Gains or losses from fluctuation in the fair value of the residual accrue to the lessee
✔ The lessee has the ability to continue the lease for secondary period at a rent which is
substantially lower than market rent.

Illustrative example 1.1

XYZ Ltd leases a machine with a total economic life of 10 years from XXR Ltd for a period of 5 years.
XYZ Ltd has the option to continue the lease for another three years without any payment during this
three years period. It is reasonably certain that XYZ Ltd will exercise this option.
Required: Determine whether the lease contract should be classified as finance or operating lease.
SUGGESTED SOLUTION
Recognise the finance lease if the lease definition of a lease is met and all the risks and rewards incidental
to the ownership of the leased asset is substantially transferred. Transfer of risks and rewards incidental to
the ownership of the machine is evidenced through XYZ Ltd 1 ability to continue with the lease for
another three years at a rent which is substantially lower than the market rent, and 2 the lease term would
be eight years (which is five years + three year option to extend the contract, in which case it is
reasonable certain XYZ will exercise the option) – these eight years represent 80% of the asset economic
life of the machine, which is considered to be major part of the machine’s economic life.
Illustrative example 1.2
XYZ Ltd leases a machine from XXR Ltd for a period of five years. The monthly lease payment amounts
to N$4,000 payable in arrears. It is expected that the machine will have an unguaranteed residual value of
N$100,000 at the end of the lease term. The FV of the machine is N$207,000 at the beginning of the
lease.
Required: Determine whether the lease contract should be classified as finance or operating lease.
SUGGESTED SOLUTION
The interest implicit in the lease is the rate that discount the monthly instalment of N$4,000 and the
unguaranteed residual value of N$100,000 back to the present value of N$207,000 at the beginning of the
lease. This rate amounts to (n = 5; PMTs = N$48,000; FV = N$100,000; PV = N$-207,000; i? = 15.61%).
Continue…
Lease Payment = N$158,606.64 (PV? n = 5; PMTs = N$48,000) = represent 76.62% of the FV amount.
Recognise finance lease if the definition of the finance lease is met, that is the leased contract transfer
substantially all risks and rewards incidental to the ownership of the underlying asset. Risk and rewards
are transferred when at the inception date the present value of the lease payments amounts to at least
substantially all of the fair value of the leased asset. When we assess the case scenario, the lease payment
amounts to N$158,606.64 which represent 76.62 % (158,606.64/ 207,000) × 100 of the leased assets
which could not be considered to have substantially represent all of the FV of the leased asset, therefore,
the asset is not a financial asset but rather an operating lease.
Note: The standard clearly stated that the above indicators are not always inclusive, although one or two
of these indicators may be present, other feature of the lease may clearly indicate that risk and rewards of
ownership are not transferred in which case the lease is classified as an operating lease.
As held in the notes for the lecture, the author is of the opinion that when testing the significance, the
90% to be used, but that is merely a percentage and not a hard-core rule.

INITIAL RECOGNITION: FINANCE LEASE

Dr Lease receivable xxx
Cr Underlying Asset xxx
SUBSEQUENT MEASUREMENT
Dr Lease receivable xxx
Cr Lease interest income xxx
Dr Bank xxx
Cr Lease receivable xxx

Gross investment in the lease - the gross investment in the lease is the sum of the lease payment
receivable by the lessor under a finance lease and any unguaranteed residual value accruing to the lessor.
Net investment in the lease on the one hand is the gross investment discounted using the interest implicit
in the lease or the incremental borrowing rate.
Unearned investment – the unearned investment is the difference between the gross investment in the
lease and the net investment in the lease.

Illustrative example 1.3

Company XYZ Ltd (lessor) signs a contract leasing a plant to Company XXR Ltd(lessee):
• XYZ Ltd classifies the lease as a finance lease.
• The commencement date is 1 January 20X4 and the lease term is 10 years.
• The lease payments receivable by XYZ Ltd are N$33 000 per annum, payable in arrears.
• XYZ Ltd expects the plant to have a residual value of N$110 000 at the end of the lease term.
• XXR Ltd (lessee) has guaranteed the asset will have a residual value of N$66 000 (thus there is
a portion of the residual value that is unguaranteed: N$44 000
Required: Calculate the gross investment in the lease.
Gross Investment:
✔ Lease payments 396,000
● Fixed lease payment (N$33,000 × 10 years) 330,000
● Guaranteed residual value 66,000
✔ Unguaranteed residual value (Total RV – Guaranteed RV) 44,000
440,000

Illustrative example 1.4

This example continues from the previous example. Use the information provided in the prior
example, together with the following additional information:
• The plant’s carrying amount and fair value on commencement date is N$220 000.
• The initial direct costs incurred by the lessor were nil.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease.
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X4 and show
the journals in the year ended 31 December 2X13 (the last year of the lease) assuming the asset was
returned with a value of N$110 000.
E. Show the journals in the year ended 31 December 2X13 assuming that the asset was returned with a
value of N$50 000 and thus that the lessee had to contribute cash of N$16 000 (remember that the lessor
guaranteed to return the asset with a residual value of N$66 000)
SUGGESTED SOLUTION
A. Interest implicit in the lease is 12.17% (Using Sharp EL – 738F)
PV = N$-220,000; PMT = N$33,000; FV = N$110,000; N = 10; i? = 12.17%
B. Net investment in the lease = N$220,000
PV? = N$220,000; PMT = N$33,000; FV = N$110,000; N = 10; i = 12.17%
C.
Dr Lease receivable N$220,000
Cr Plant N$220,000
Initial recognition of a sale of a plant via finance lease

D.
On 31 December 20X4
Dr Bank N$33,000
Cr Lease receivable N$ 6,215
Cr Lease interest income N$26,785
Interest income on the lease and lease payment received on the lease
On 31 December 2X13
Dr Bank N$33,000
Cr Lease receivable N$17,480
Cr Lease interest income N$15,520
E.
On 31 December 2X13
Dr Lease receivable N$15,520
Cr Lease interest income N$15,520
Interest income on the lease
Dr Bank N$49,000
Dr Plant N$50,000
Dr Loss on Finance lease N$44,000
Cr Lease receivable N$143,000
Lease payment received from the lease and return of the asset at lower RV than guaranteed.

W1: Effective interest rate table Finance income:

Finance Income Lease pmts plus Receivable balance
unguaranteed RV
1 January 20X4 220 000
31 December 20X4 26 785 (33 000) 213 785
31 December 20X5 26 028 (33 000) 206 812
31 December 20X6 25 179 (33 000) 198 991
31 December 20X7 24 227 (33 000) 190 218
31 December 20X8 23 159 (33 000) 180 377
31 December 20X9 21 960 (33 000) 169 337
31 December 2X10 20 616 (33 000) 156 953
31 December 2X11 19 109 (33 000) 143 062
31 December 2X12 17 417 (33 000) 127 480
31 December 2X13 15 520 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)

Finance Lease if the lessor is a manufacturer or dealer

X Ltd leased a new item of plant to Z Ltd on 01 Jan 20x3 in return for 5 annual payments in arrears of
N$90,000 each as well as a balloon payment of N$100,000 payable 31 December 20x7. The plant was
manufactured by X Ltd at a cost of N$320,000. The terms of the lease indicate that ownership of the asset
will pass to Z Ltd upon payment of the balloon payment and that interest rate implicit in the lease is
10.2846%. The plant has the FV of N$400,000 on 01 Jan 20x3

Date Perio Balance b/d Payment Capital Interest Balance c/d

d

31 Dec x3 1 400,000 (90,000) 48,862 41,138 351,138

x4 2 351,138 (90,000) 53,887 36,133 297,251

x5 3 297,251 (90,000) 59,429 30,571 237,822

x6 4 237,822 (90,000) 65,541 24,459 172,281

x7 5 172,281 (90,000) 72,281 17,719 100,000

 x7 5 100,000 (100,000) 100,000

550,000 150,000

Required: Provide the journal entries for the year end 31 December 20x3

Dr Gross investment in lease 550,000

Dr Cost of sales 320,000
Cr Unearned finance income 150,000
Cr Revenue 400,000
Cr Inventories 320,000
Recording investment in the lease

Dr Bank 90,000
Cr Lease receivable 48,862
Cr Lease interest income 41,138
Interest income received on the lease receivable

Illustrative example 1.5

UNAM Limited (lessor) signed an operating lease with NUST Limited (lessee) on 1 January 20X1.
The lease was over a plant, which UNAM had bought on 1 January 20X1 for N$240 000.
The terms of the lease are as follows:
✔ commencement date: 1 January 20X1
✔ lease term: 2 years
✔ fixed lease instalments, payable as follows:
⮚ 31 December 20X1: N$120 000
⮚ 31 December 20X2: N$140 000
✔ NUST may purchase the leased asset at its market price on 31 December 20X2.
✔ Unguaranteed residual value: N$30 000. UNAM considers this to equal residual value for
depreciation purposes.
Other information:
⮚ UNAM incurred legal fees of N$8 000 on 1 January 20X1 to obtain the lease (initial
direct costs).
⮚ NUST paid both lease instalments on due date.
⮚ NUST purchased the plant on 31 December 20X2 at its market price of N$200 000.
⮚ UNAM depreciates its plant over ten years on the straight-line basis.

Required: Prepare the journal entries for each of the years affected. Ignore tax

D C Details N$ N$
r r

On 01 Jan 20x1

D Plant: Cost 240,000

r
 Cr Bank 240,000

Purchases of plant

D Plant: Direct cost 8,000

r

Cr Bank 8,000

Initial directly attributable cost

31 December 20x1

D Depreciation 25,000
r

Cr Accumulated depreciation 25,000

Depreciation of the plant

D Bank 120,000
r

D Operating lease receivable 10,000

r

Cr Operating lease income (average) 130,000

Lease income earned

31 December 20x2

D Depreciation (240+8)/10 25,000

r

Cr Accumulated dep 25,000

Depreciating the plant

D Bank 140,000
r

Cr Operating lease income 130,000

Cr Operating Lease receivable 10,000

Lease income earned

 D Accumulated dep 50,000
r

D Bank 200,000
r

Cr Plant 240,000

Cr Direct cost 8,000

Cr Profit on disposal of asset 2,000

Disposal of the plant

Showing the notes to the financial statements

Notes to FS for the year ended 31 December 20x1

1. Profit before tax include the following disclosure as separate account
Profit on sale of lease asset xxx
Finance income on net investment in the lease xxx
Income on variable lease payments not depending on index rate xxx

2. Investment income
Carrying amount b/d xxx
Finance income xxx
Lease payment received (xxx)
Net investment of new lease commenced the current year xxx
Lease modification xxx
Carrying amount c/d xxx

TAX IMPLICATION
The finance lease will generally have a deferred tax implication due to variation in the CA and the TB of
the asset. This will result in temporary different which could create a deferred tax asset or liability. From
the lessor perspective the taxable profit includes the lease instalment it receives less tax deduction which
is the allowance on the cost of the leased asset (in Namibia 1/3 is allowed as allowance). This creates a
temporary difference, because from the accounting profit, the lessor derecognises the entire asset at the
inception of the lease but tax authority lean on the fact that the asset still is with lessor.

Activity 1.1
Use the information in illustrative example 1.4 to provide the tax notes expense.

THE END