ACCOUNTING FOR LIABILITIES - ACCOUNTING FOR LEASES

Overview
IFRS 16 specifies how an International Financial Reporting Standard (IFRS), reporter will:
 recognize,
 measure,
 present and
 disclose leases.
The standard provides a single lessee accounting model, requiring lessees to recognize assets and
liabilities for all leases unless the lease term is 12 months or less or the underlying asset has a
low value.
Terminologies in Lease:
Interest rate implicit in the lease: The interest rate that yields a present value of
(a) the lease payments and
(b) the unguaranteed residual value equal to the sum of:
(i) the fair value of the underlying asset and
(ii) any initial direct costs of the lessor.

Lease term: The non-cancellable period for which a lessee has the right to use an underlying
asset, plus:
a) periods covered by an extension option if exercise of that option by the lessee is
reasonably certain; and
b) periods covered by a termination option if the lessee is reasonably certain not to exercise
that option
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 of
a similar value to the right-of-use asset in a similar economic environment.

Finance lease
Is an agreement that transfer substantially all the risks and rewards incidental to ownership of an
asset. Title may or may not eventually be transferred.

Characteristics of a finance lease

i. The lessor transfers ownership of the asset to the lessee at the end of the lease term.
ii. 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 date the option becomes exercisable for it to be reasonably
certain at the inception of the lease that the option will be exercised.
iii. The lease term is for major part of economic life of the asset even if the title is not
transferred.

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 iv. At the inception of the lease, the present value of minimum lease payment approximates
the fair value above 90%.
v. If the leased asset is of a specialized nature such that it is only the lessee who can use it
without any major modification.
vi. If the lessee cancels the lease agreement at any time, any cancellation losses incurred by
the
vii. lessor will be borne by the lessee.
If fluctuations gain or losses in relation to the residue value will be borne by the lessee.

Operating lease
This is an agreement that do not transfer all risks and rewards incidental to ownership of an asset.
Title would number be transferred to the other party i.e. the asset remains as owned by the owner
therefore an operating lease is a lease other than a finance lease.
Minimum lease payments
These are payments over the lease term that the lease is or can be required to make excluding
contingent, rent, costs for services and taxes to be paid by and reimbursed to the lessor.
Guaranteed residual value
i. For a lessee, that part of the residue value that is guaranteed by the lessee or by a party
related to the lessee (the amount of the guarantee being the maximum amount that would
be in even event become payable)
ii. For a lessor, that part of a residue value that is guaranteed by the lessee or by a third party
and related to the lessor i.e. financial capable of discharging the obligations under the
guarantee.
Unguaranteed residual value
Is that portion of the residual value of the lease asset, the realization of which by the lessor, is not
assured or is guaranteed solely by a party related to the lessor.
Gross investment to the lease
This is the aggregate of:
i. Minimum lease payments receivable by the lessor under a finance lease.
ii. Any unguaranteed residue value accruing to the lessor
Interest rate implicit in the lease
This is the discount rate at the inception of the lease causes the aggregate Present Value (PV) of:
a) The minimum lease payments
b) The unguaranteed residue, value to be equal to the sum of:
i) The fair value of the leased asset
ii) Any initial direct cost of the lessor
- Unearned residue:
This is the difference between:
a. The gross investment to the lease
b. The net investment to the lease

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Scope
IFRS 16 Leases applies to all leases, including subleases, except for:
(i) Leases to explore for or use minerals, oil, natural gas and similar non-regenerative
resources;
(ii) Leases of biological assets held by a lessee (see IAS 41 Agriculture);
(iii) Service concession arrangements (see IFRIC 12 Service Concession Arrangements);
(iv) Licenses of intellectual property granted by a lessor (see IFRS 15 Revenue from
Contracts with Customers); and
(v) Rights held by a lessee under licensing agreements for items such as films, videos, plays,
manuscripts, patents and copyrights within the scope of IAS 38 Intangible Assets
A lessee can elect to apply IFRS 16 to leases of intangible assets, other than those items listed
above.
RECOGNITION OF LEASES:
The standard divides recognition of leases into:
(a) Leases of 12 months or lesser periods.
(b) Leases of more than 12 months, of course with the above items that are not included in
the IFRS 16.
Instead of applying the recognition requirements of IFRS 16, a lessee may elect to account for
lease payments as an expense on a straight-line basis over the lease term or another systematic
basis for the following two types of leases:
i) Leases with a lease term of 12 months or less and containing no purchase options – this
election is made by class of underlying asset; and

ii) Leases where the underlying asset has a low value when new (such as personal computers or
small items of office furniture) – this election can be made on a lease-by-lease basis.
Identifying a Lease:
A contract is, or contains, a lease if it conveys the right to control the use of an identified asset
for a period of time in exchange for consideration e.g. payment of rent under the agreement.
Control is conveyed where the customer has both the right to direct the identified asset’s use and
to obtain substantially all the economic benefits from that use.
For example, where a supplier has a substantive right of substitution throughout the period of
use, a customer does not have a right to use an identified asset. A supplier’s right of substitution
is only considered substantive if the supplier has both the practical ability to substitute alternative
assets throughout the period of use and they would economically benefit from substitution.
A capacity portion of an asset is still an identified asset if it is physically distinct (e.g. a floor of
a building). A capacity or other portion of an asset that is not physically distinct (e.g. a capacity

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portion of a fibre optic cable) is not an identified asset, unless it represents substantially all the
capacity such that the customer obtains substantially all the economic benefits from using the
asset.

ACCOUNTING BY LESSEES
 Upon lease commencement a lessee recognizes a right-of-use asset and a lease liability.
The right-of-use asset is initially measured at the amount of the lease liability plus any
initial direct costs incurred by the lessee. Adjustments may also be required for lease
incentives, payments at or prior to commencement and restoration obligations or similar.
 After lease commencement, a lessee shall measure the right-of-use asset using a cost
model, unless:
i) the right-of-use asset is an investment property and the lessee fair values its investment
property under IAS 40;
ii) the right-of-use asset relates to a class of (Property, Plant and Equipment (PPE) to
which the lessee applies IAS 16’s revaluation model, in which case all right-of-use
assets relating to that class of PPE can be revalued.

 Under the cost model a right-of-use asset is measured at cost less accumulated
depreciation and accumulated impairment.

 The lease liability is initially measured at the present value of the lease payments payable
over the lease term, discounted at the rate implicit in the lease if that can be readily
determined. If that rate cannot be readily determined, the lessee shall use their
incremental borrowing rate.

 Variable lease payments that depend on an index or a rate are included in the initial
measurement of the lease liability and are initially measured using the index or rate as at
the commencement date. Amounts expected to be payable by the lessee under residual
value guarantees are also included.

 Variable lease payments that are not included in the measurement of the lease liability are
recognized in profit or loss in the period in which the event or condition that triggers
payment occurs, unless the costs are included in the carrying amount of another asset
under another Standard.

 The lease liability is subsequently re-measured to reflect changes in:

(i) the lease term (using a revised discount rate);
(ii) the assessment of a purchase option (using a revised discount rate);
(iii) the amounts expected to be payable under residual value guarantees (using an
unchanged discount rate); or future lease payments resulting from a change in an
index or a rate used to determine those payments (using an unchanged discount rate).
 The re-measurements are treated as adjustments to the right-of-use asset.

 Lease modifications may also prompt re-measurement of the lease liability unless they
are to be treated as separate leases.

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ACCOUNTING BY LESSORS
 Lessors shall classify each lease as an operating lease or a finance lease.
 A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership of an underlying asset. Otherwise a lease is classified as an
operating lease.

 Examples of situations that individually or in combination would normally lead to a lease

being classified as a finance lease are:

(i) The lease transfers ownership of the asset to the lessee by the end of the lease term
the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable that, at
the inception of the lease,
(ii) It is reasonably certain that the option will be exercised the lease term is for the
major part of the economic life of the asset, even if title is not transferred at the
inception of the lease,

(iii) The present value of the minimum lease payments amounts to at least
substantially all of the fair value of the leased asset the leased assets are of a
specialized nature such that only the lessee can use them without major modifications
being made
 Upon lease commencement, a lessor shall recognize assets held under a finance lease as a
receivable at an amount equal to the net investment in the lease.
 A lessor recognizes finance income over the lease term of a finance lease, based on a
pattern reflecting a constant periodic rate of return on the net investment.
 At the commencement date, a manufacturer or dealer lessor recognizes selling profit or
loss in accordance with its policy for outright sales to which IFRS 15 applies.
 A lessor recognizes operating lease payments as income on a straight-line basis or, if
more representative of the pattern in which benefit from use of the underlying asset is
diminished, another systematic basis.

DISCLOSURE
The objective of IFRS 16’s disclosures is for information to be provided in the notes that,
together with information provided in the statement of financial position, statement of profit or
loss and statement of cash flows, gives a basis for users to assess the effect that leases have.
Paragraphs 52 to 60 of IFRS 16 set out detailed requirements for lessees to meet this objective
and paragraphs 90 to 97 set out the detailed requirements for lessors. [IFRS 16:51, 89]

Disclosure requirements for finance lease as per IAS 17:

1) A reconciliation between the total future minimum lease payments and their present
value. In addition, an entity shall disclose the total of future minimum lease payments at
the balance sheet dates and their present value for each of the following period: -
i) Not later than one year
ii) Later than one year and not later than 5 years

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 iii) Later than five years
2. For each class of assets, the net carrying amount at the balance sheet date.
3. Contingent rents recognized as an expense.
4. The total of the future minimum sub-leases payment expected to be received under non-
cancellable sub-leases as at the balance sheet date.
5. A general description of significant leasing arrangements.

In the case of finance lease, the financial statements should include:

 The gross investment in the lease depicted by the sum of the minimum lease payments and
the estimated residual value
 The difference between the gross investment and its present value as unearned income to be
recognized as earned over the life of the lease
The sale price will be shown at the present value of the minimum lease payments deducting from
the same, the cost of sale comprising of the cost of the leased property and other initial direct
cost
incidental to the same less the present value of the residual.

Presentation of financial statements: Disclosures in the financial statements of lessor

In the case of finance lease, the financial statements should include:
 The gross investment in the lease depicted by the sum of the minimum lease payments
and the estimated residual value
 The difference between the gross investment and its present value as unearned income to
be recognized as earned over the life of the lease
 The sale price will be shown at the present value of the minimum lease payments
deducting from the same, the cost of sale comprising of the cost of the leased property
and other initial
 direct cost incidental to the same less the present value of the residual.

Disclosures in the financial statements of lessee

 Disclosures should be made of the amount of the assets that are subject of finance leases
at each balance sheet date. Liabilities, differentiating between the current and long-term
portions.
 Commitments for minimum lease payments under finance leases and under non-
cancellable operating lease with a term of more than one year should be disclosed in
summary form giving
 the amounts and periods in which the payments will become due.
 Disclosures should be made of significant financing restrictions, renewal or purchase
options, contingent rentals and other contingencies arising from leases.
 Disclosures should be made of the basis used for allocating income so as to produce a
constant periodic rate of return, indicating whether the return relates to the net investment
outstanding or the net cash investment outstanding in the lease. If more than one basis is
used, the bases should be disclosed.
 When a significant part of the lessor’s business comprises operating leases, the lessor
should disclose the amount of assets by each major class of asset together with the related
depreciation at each balance sheet date.

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Apart from the disclosures recommended above the lessor should disclose the accounting
policies followed with regard to accounting for income under finance lease, valuation of assets
given on the lease and charge for depreciation.

ADVANTAGES OF LEASING
 The lessee’s capital is not tied up in fixed assets, so a cash flow advantage accrues.
 Liquidity is improved as no down-payment is required.
 The lessor can obtain capital allowances and pass the benefit to the lessee in the form of
lower lease rentals. This is especially important for a company with insufficient taxable
profits.
 The whole of the rental payment is tax deductible.
 Security is usually the asset concerned. Other assets are free for other forms of
borrowing.
 Traditional forms of borrowing often impose restrictive covenants.
 The cost of other forms of borrowing may exceed the cost of leasing.

ACCOUNTING ENTRIES IN THE BOOKS OF THE LESSOR

1. Gross Investment in the Lease

This is the total of:
a) The minimum lease payments receivable by the lessor under finance leases.
b) Any unguaranteed residue value accruing to the lessor.

2. Net Investment in The Lease

This is the gross investment in the lease discounted at the interest rate implicit in the lease i.e. it
is
the present value of the gross investment discounted at the interest rate implicit in the lease.

3. Un Earned Finance Income

This is the difference between the gross investment in the lease and the net investment in the
lease:
NB
(i) The lessor should recognize the assets under finance leases in their balance sheet and present
them as receivables at an amount equal to the gross investment.
(ii) The initial direct costs that may be incurred by the lessor e.g. legal fees for negotiating
and securing a lease agreement, commission etc. should be included in the initial
measurement of the finance lease receivable. Subsequently, the amounts received by the
lessor should be allocated over the lease term on a systematic basis.

JOURNAL ENTRIES

Accounting entries in the books of the lessor

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When the equipment is purchased on lease
Dr: Equipment A/c
Cr: Cash A/c

When the contract is signed and property leased out to the lessee
Dr: Rent receivable A/c
Cr: Equipment a/c

When first instalment on lease is received

Dr: Cash A/c
Cr: Rent receivable A/c

At end of first year

When interest becomes receivable

Dr: Interest receivable a/c
Cr: Interest a/c

When the amount is received in respect of interest and rent

Dr: Cash a/c
Cr: Rent receivable a/c
Cr: Interest receivable a/c
These entries are repeated in subsequent years

At the end of last year

When the equipment is sold and lease is terminated

Dr: Cash a/c
Cr: Income on sale of equipment a/c

At the end of last year

When the equipment is purchased and lease is terminated

Dr: Equipment a/c
Cr: Cash a/c

When accumulated depreciation is transferred to equipment a/c at the time of termination

of the lease and purchase of the asset
Dr: Accumulated depreciation a/c
Cr: Equipment a/c