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IFRS 16 LEASES

(LECTURED BY U MYO THEIN NAING)

 IFRS 16 Leases

IFRS 16 Leases
Definitions

Lease A lease is a contract that conveys the right to use an underlying asset
for a period of time in exchange for consideration.

Lessor The entity that provides the right-of-use asset (RoU) and, in
exchange, receives consideration.

Lessee The entity that obtains use of the RoU asset and, in exchange,
transfers consideration.

Right-of-use The lessee’s right to use an underlying asset over the lease term
asset

Lessee Accounting

Recognition

At the commencement of the lease, IFRS 16 requires that the lessee recognizes a lease liability
and a right-of-use asset. (single lease accounting model)

Measurement This is the date on which a lessor makes an

underlying asset available for use by a lessee.
Initial measurement

The right-of-use asset

The right-or-use asset is initially recognised at cost.

The initial cost of the right-of-use asset comprises:

 the amount of the initial measurement of lease liability;

 any lease payments made at or before the commencement date, less any lease
incentives received;
 any initial direct costs (e.g. legal costs) incurred by the lessee
 an estimate costs of dismantling or removing the underlying asset as per the
conditions of the lease.

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 IFRS 16 Leases

The lease liability

The lease liability is initially measured at the present value of the lease payments that
have not yet been paid.

The lease payments shall be discounted using the interest rate implicit in the lease. If that
rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing
rate (the rate at which it could borrow funds to purchase a similar asset).

IFRS 16 states that lease payments include the following:

 Fixed payments
 Variable payments that depend on an index (e.g. CPI) or rate (e.g. market rent)
 Amounts expected to be payable under residual value guarantees (e.g. where a
lessee guarantees to the lessor that an asset will be worth a specified amount at the
end of the lease)
 Options to purchase the asset that are reasonably certain to be exercised

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 IFRS 16 Leases

Illustration: Lessee accounting

A company enters into a 4-year lease commencing on 1 January 20X1 (and intends to use
the asset for 4 years). The terms are 4 payments of $50,000, commencing on 1 January
20X1, and annually thereafter. The interest rate implicit in the lease is 7.5% and the present
value of lease payments not paid at 1 January 20X1 (i.e. 3 payments of $50,000) discounted
at that rate is $130,026.

Legal costs to set up the lease incurred by the company were $402.

Required

Show the lease liability from 1 January 20X1 to 31 December 20X4 and explain the
treatment of the right-of-use asset.

Solution

20X1 20X2 20X3 20X4

$ $ $ $
1 January b/d 130,026 139,778 96,512 50,000
Lease payments (0) (50,000) (50,000) (50,000)
130,026 89,778 46,512 0
Interest at 7.5% (interest in P/L) 9,752 6,734 3,488 0

31 December c/d 139,778 96,512 50,000 0

The RoU asset is recognised at the lease commencement date, 1 January 20X1 at:

$
Present value of lease payments not paid at the commencement date 130,026
Payments made at the lease commencement date 50,000
Initial direct costs 402
180,428

This is depreciated over 4 years (as lease term and useful life are both 4 years) at $45,107
($180,428/4 years) per annum.

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 IFRS 16 Leases

The lease term

To calculate the initial value of the liability and right-of-use asset, the lessee must consider the
length of the lease term. IFRS 16 says that the lease term comprises:

 Non-cancellable periods

 Periods covered by an option to extend the lease if the lessee is reasonably certain
to exercise that option; and

 Periods covered by an option to terminate the lease if the lessee is reasonably

certain not to exercise that option.

The lease term is relevant when determining the period over which a lease asset
should be depreciated.

Illustration

A lease contract is for 5 years with lease payments of $10,000 per annum. The lease
contract contains a clause which allows the lessee to extend the lease for a further period
of 3 years for a lease payment of $5 per annum (as it is unlikely the lessor would be able
to lease the asset to another party). The economic life of the asset is estimated to be
approximately 8 years.

The lessee assess it is highly likely the lease extension would be taken. The lease term is
therefore 8 years.

Test your understanding 1

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

Lease payments are $10,000 per year for the initial term and $15,000 per year for the option
period. All payments are due at the end of the year. To obtain the lease, Dynamic incurs
initial direct costs of $3,000. The lessor immediately reimburses $1,000 of these costs.

The interest rate within the lease is not readily determinable. Dynamic’s incremental rate of
borrowing is 5%.

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 IFRS 16 Leases

Required:

Calculate the initial carrying amount of the lease liability and the right-of-use asset
and provide the double entries needed to record these amounts in Dynamic’s
financial records.

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 IFRS 16 Leases

Subsequent measurement

The right-of-use asset

The right-of-use asset is measured using the cost model. This means that it is measured
at its ‘initial cost less accumulated depreciation and impairment losses’ .

Depreciation is calculated as follows:

 If ownership of the asset transfers to the lessee at the end of the lease term, then
depreciation should be charged over the asset’s remaining useful life

 Otherwise, depreciation is charged over the shorter of the useful life and the lease
term.

Alternatively, the right-of-use asset is accounted for in accordance with:

1. The revaluation model of IAS 16 (Optional where the RoU asset relates to a class
of property, plant and equipment measured under the revaluation model)

2. The fair value model of IAS 40 Investment Property (compulsory if the RoU
asset meets the definition of investment property and the lessee uses the fair value
model for its investment property).

The lease liability

The carrying amount of the lease liability is increased by the interest charge:

Dr Finance costs (P/L)

Cr Lease liability

The carrying amount of the lease liability is reduced by cash repayments:

Dr Lease liability
Cr Cash

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 IFRS 16 Leases

Test your understanding 2: Lessee Accounting

A lessee enters into a five-year lease of a building (underlying asset) which has a
remaining useful life of 10 years. Lease payments are $50,000 per annum, payable in
arrears at the end of each year.

The lessee incurs initial direct costs of $20,000 and receives lease incentives of
$5,000. There is no transfer of the asset at the end of the lease and no purchase
option available.

The interest rate implicit in the lease is 5%.

Required

Explain the accounting treatment for the above lease in the first accounting
period.

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 IFRS 16 Leases

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 IFRS 16 Leases

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 IFRS 16 Leases

Separating components
A contract may contain a lease component and a non-lease component.

The consideration in the contract should be allocated to each component based on the stand-
alone selling price of each component.

Test your understanding 3

On 1 January 20X1 Swish entered into a contract to lease a crane for three years. The
lessor agrees to maintain the crane during the three year period. The total contract cost is
$180,000. Swish must pay $60,000 each year with the payments commencing on 31
December 20X1. Swish 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 $160,000 and the standalone price for the maintenance services is $40,000.

Swish can borrow at a rate of 5% a year.

Required:

Explain how the above will be accounted for by Swish in the year ended 31 December
20X1.

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 IFRS 16 Leases

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.

IFRS 16 says that the lease liability should be re-calculated using a revised discount rate of:

 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 the reassessment should be used.

Test you understanding

On 1 January 20X1, Kingfisher enters into a four-year lease of property with annual lease
payments of $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 the Consumer Price
Index for the preceding 12 months. The Consumer Price Index 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 ear of the lease the Consumer Price Index 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.

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 IFRS 16 Leases

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 IFRS 16 Leases

Recognition exemption

If the lease is short-term (twelve months or less at the inception date) or of a low value then
a simplified treatment is allowed.

IFRS 16 does not specify a particular monetary amount below which an asset would be
considered ‘low value’ but instead gives the following examples of low value assets:

 Tablets
 Small personal computers
 Telephones
 Small items of furniture

The assessment of whether an asset qualifies as having a ‘low value’ must be made based
on its value when new. Therefore, a car would not qualify as a low value asset, even if it was
very old at the commencement of the lease.

In these cases, the lessee can choose to recognize the lease payments in profit or
loss on a straight-line basis. No lease liability or right-of-use asset would
therefore be recognised.

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 IFRS 16 Leases

Identifying a lease

A contract contains a lease if it conveys ‘the right of control the use of an identified asset for a
period of time in exchange for consideration’.

The customer controls the asset’s use if it has:

 The right to substantially all of the identified asset’s economic benefits, and

 The right to direct the identified asset’s use.

Example 1

Coffee Bean enters into a contract with the airport operator to use some space in the airport
to sell its goods from portable kiosks for a three-year period. Coffee Bean owns the portable
kiosks. The contract specifies the amount of space and states that the space may be located
at any one of several departure areas within the airport. The airport operator can change
the location of the space allocated to Coffee Bean 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?

Answer:

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 the 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.

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 IFRS 16 Leases

Example 2

AFG enters into a contract with Splash, the supplier, to use a specified ship for a five-year
period. Splash has no substitution rights. During the contract period, AFG 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 AFG from
carrying hazardous materials as cargo or from sailing the ship into waters where piracy is a
risk.

Splash operates and maintains the ship and is responsible for the safe passage of the cargo
on board the ship. AFG is prohibited from hiring another operator for the ship, and form
operating the ship itself during the term of the contract.

Required:

Does the contract contain a lease?

Answer:

AFG has the right to use an identified asset (a specific ship) for a period of time (five years).
Splash cannot substitute the specified ship for an alternative.

AFG 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 limit where
the ship can sail and what cargo can be transported, this acts to define the scope of
AFG’s right to use the ship rather than restricting AFG’s ability to direct the use of
the ship. Within the scope of its right of use, AFG makes the relevant decisions about
how and for what purpose the ship is used throughout the five-year period of use
because it decides whether, where and when the ship sails, as well as the cargo it
will transport.

Therefore, based on the above, the contract contains a lease.

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 IFRS 16 Leases

Lessee disclosures
IFRS 16 requires lessees to disclose the following amounts:

 The depreciation charged on right-of-use assets

 Interest expenses on lease liabilities

 The expense relating to short-term leases and leases of low value assets.

 Cash outflows for leased assets

 Right-of-use asset additions

 The carrying amount of right-of-use assets

 A maturity analysis of lease liabilities

Lessee presentation

Balance sheet/Statement of financial position Statement of profit or loss

Asset Lease expense

= ‘Right of use’ of underlying asset Depreciation
+
Interest
Liability
= Obligation to make lease payments = total lease expense

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 IFRS 16 Leases

Lessor Accounting

A lessor must classify its leases as finance leases or operating leases.

Definitions

Finance lease A lease where substantially all of the risks and rewards of the
underlying asset transfer to the lessee.

Operating lease A lease that does not meet the definition of a finance lease.

How to classify a lease

IFRS 16 states that a lease is probably a finance lease if one or more of the following apply:

 the lease transfers ownership of the underlying asset to the lessee by the end of the
lease term;

 the lessee has the option to purchase the underlying asset at a price that is expected
to be sufficiently lower that the fair value at the date the option becomes exercisable
for it to be reasonably certain, at the inception date, that the option will be exercised;

 the lease term is for the major part of the economic life of the underlying asset even
if 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 underlying asset; and

 the underlying asset is of such a specialised nature that only the lessee can use it
without major modifications.

 The lessee will compensate the lessor for their losses if the lease is cancelled.

 gains or losses from the fluctuation in the fair value of the residual fall to the lessee,
and

 the lessee has the ability to continue the lease for a secondary period at a rent that
is substantially lower than market rent payments.

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 IFRS 16 Leases

Test your understanding

Banana is a lessor and is drawing up a lease agreement for a building:

The building has a remaining useful life of 50 years. The lease term, which would commence
on 1 January 20X0, is for 30 years.

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

Legal title at the end of the lease remains with Banana, 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 Banana to recover its remaining investment.

Required

Per IFRS 16 leases, should the lease be classified as an operating lease or a finance
lease?

Answer:

 The lessee can continue to lease the asset at the end of the lease term for a value
that is substantially below market value.

 The lessee is also unable to cancel the lease without paying Banana. This is an
indication that Banana is guaranteed to recover its investment.

 It also seems likely that the present value of the minimum lease payments will be
substantially all of the asset’s fair value. The minimum lease payments (ignoring
discounting) equate to 40% of the fair value, payable upfront, and then another
180% (30 years x 6%) of the fair value over the lease term.

In conclusion, it would appear that the lease is a finance lease.

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 IFRS 16 Leases

Finance leases

Initial treatment
At the commencement date, the lessor derecognizes the underlying asset and recognizes a
receivable at an amount equal to its net investment in the lease.

The net investment in the lease is the sum of:

Present value of the lease payments receivable by the lessor X

Present value of any unguaranteed residual value accruing to the lessor X
X

Unguaranteed residual value arises where a lessor expects to be able to sell an asset at
the end of the lease term for more than any minimum amount guaranteed by the lessee
in the lease contract. Amounts guaranteed by the lessee are included in the ‘present
value of lease payments receivable by the lessor’ as they will always be received, so the
only the unguaranteed amount needs to be added on, which accrued to the lessor
because it owns the underlying asset.

The lessor recognizes the difference between the carrying amount of the underlying asset and
the finance lease receivable. This gain or loss is presented in profit or loss.

Journal entries:

Dr Net investment – finance lease receivables

Cr Underlying asset
Cr Gain on disposal (P/L)

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 IFRS 16 Leases

Illustration

A lessor enters into a 3 year leasing arrangement commencing on 1 January 20X3. Under
the terms of the lease, the lessee commits to pay $80,000 per annum commencing on 31
December 20X3. A residual guarantee clause requires the lessee to pay $40,000 (or
$40,000 less the asset’s residual value, if lower) at the end of the lease term if the lessor is
unable to sell the asset for more than $40,000.

The lessor expects to sell the asset based on current expectations for $50,00 at the end of
the lease.

The interest rate implicit in the lease is 9.2%. The present value of lease payments
receivable by the lessor discounted at this rate is $232,502.

Required

Show the net investment in the lease from 1 January 20X3 to 31 December 20X5 and
explain what happens to the residual value guarantee on 31 December 20X5.

Solution

The net investment in the lease (lease receivable) on 1 January 20X3 is:
$
Present value of lease payments receivable by the lessor 232,502
Present value of unguaranteed residual value 7,679
(50,000 – 40,000 = 10,000 x 1/1.0923)
240,181

The net investment in the lease (lease receivable) is as follows:

20X3 20X4 20X5

$ $ $
1 January b/d 240,181 182,278 119,048
Interest at 9.2% (interest income in P/L) 22,097 16,770 10,952
Lease instalments (80,000) (80,000) (80,000)
31 December c/d 182,278 119,048 50,000

On 31 December 20X5, the remaining $50,000 will be realized by selling the asset for
$50,000 or above, or selling it for less than $50,000 and claiming up to $40,000 from the
lessee under the residual value guarantee.

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 IFRS 16 Leases

Subsequent measurement

The subsequent treatment of the finance lease is as follows:

 The carrying amount of the lease receivable is increase by finance income earned,
which is also credited to the SOPL.

 The carrying amount of the lease receivable is reduced by cash receipts.

Journal entries

When lease payment is received:

Dr Cash
Cr Interest revenue/finance income
Cr Lease receivables

Operating leases

Lessor continues to recognize the asset under an operating lease on lease commencement.

A lessor recognizes income from an operating lease on a straight-line basis over the lease
term.

Illustration

A lessor leases a property to a lessee under an operating lease for 5 years at an annual
rate of $100,000. However, the contract states that the first 6 months are ‘rent-free’.

Solution

The benefit received from the asset is earned over the 5 years. However, in the first year,
the lessor only receives $100,000 x 6/12 = $50,000. Lease rentals of $450,000 ($500,000
+ ($100,000 x 4 years)) are received over the 5 year lease term.

Therefore, the lessor recognizes income of $90,000 per year ($450,000/5 years).

A receivable of $40,000 is recognised at the end of year 1 ($90,000 - $50,000 cash

received).

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 IFRS 16 Leases

Test your understanding

Orange hires out industrial plant on long-term operating leases. On 1 January 20X1, it
entered into a seven-year lease on a mobile crane. The terms of the lease are $175,000
payable on 1 January 20X1, followed by six rentals of $70,000 payable on 1 January 20X2-
20X7. The crane will be returned to Orange on 31 December 20X7. The Orange originally
cost $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 December 20X1.

Answer:

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

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

Lessor disclosures

Finance lease Operating lease

 Selling profit or loss  Lease income relating to variable lease

payments that do not depend on an
 Finance income on net investment in the
index or rate
lease
 Other lease income
 Significant changes in the carrying
amount of the net investment in the  Detailed maturity analysis of the
lease undiscounted lease payments to be
received.
 Detailed maturity analysis of the lease
payments receivable
 A reconciliation between the
undiscounted lease payments and the
net investment in the lease.

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 IFRS 16 Leases

Sale and Leaseback

Sale and leaseback transactions take place where an entity (the seller-lessee) transfers an
asset to another entity (the buyer-lessor) and leases that asset back from the buyer-lessor.

Assessing whether the transfer of the asset is a sale

To determine whether the transfer of an asset is accounted for as a sale an entity applies the
requirements of IFRS 15 for determining when a performance obligation is satisfied.

(a) Transfer is a sale (ie treated as a ‘part-disposal’)

The seller/lessee measures the RoU asset arising from the leaseback at the
proportion of the previous carrying amount of the asset that relates to the RoU
retained by the seller/lessee.

 The initial cost of RoU asset is measured as:

Carrying amount x PV of lease liability

FV of asset

 The seller/lessee only recognizes the amount of gain or loss on the sale that
relates to the rights transferred to the buyer, which is measured as:

Total gain on disposal = Sales proceeds – Carrying amount

Gain on right retained = Total gain x PV of lease liability

FV of asset

Gain on right transferred= Total gain – Gain on right retained

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 IFRS 16 Leases

Test your understanding

Max Co entered into a sale & leaseback on 1 April 20X7. It sold a building with a carrying
amount of $300,000 for $400,000 (equal to FV) and lease it back over a five-year period.
The transaction constitutes a sale in accordance with IFRS 15 Revenue from Contracts
with Customers.
The lease provided for five annual payment in arrears of $90,000 and the rate of interest
implicit in the lease is 5%. The annuity factor for year 1 to 5 is 4.329.
Required
What are the amounts to be recognised in FS at 31 March 20X8 in respect of the
above transaction?

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Transactions not at fair value

If the sales proceeds or lease payments are not at FV, IFRS 16 requires that:

 Below market terms (e.g. Sales proceeds < FV) are treated as a prepayment of
lease payments.

 Above market terms (e.g. Sales proceeds > FV) are treated as additional
financing.

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 IFRS 16 Leases

Example

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

Blue enters into a contract with Red for the right to use the asset for the next five years.
Annual payments of $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 $1.9 million.

Required

Explain how the transaction will be accounted for on 1 January 20X1 by both Blue
and Red.

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(b) Transfer of the asset is not a sale

If the transfer of an asset by the seller-lessee does not satisfy the requirements of IFRS
15 to be accounted for as a sale of the asset:

 the seller-lessee shall continue to recognize the transferred asset and shall
recognize a financial liability equal to the transfer proceeds. It shall account
for the financial liability applying IFRS 9.

 the buyer-lessor shall not recognize the transferred asset and shall recognize
a financial asset equal to the transfer proceeds. It shall account for the
financial asset applying IFRS 9.

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