IFRS 16: LEASES

Chapter 8
Leases: Definitions
IFRS 16 leases provides the following definitions:
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.
The lessor is the entity that provides the right-of-use and, in
exchange, receives consideration.
Leases: Definitions (Cont’d)
The lessee is the entity that obtains use of the right-of-use
and, in exchange, transfers consideration.

A right-of-use asset is the lessee’s right to use an underlying

asset over the lease term.
Identifying a Lease:
• IFRS 16 Leases requires lessees to recognize an asset
and a liability for all leases, unless they are short-term or
of a minimal value.
• As such, it is vital to assess whether a contract contains a
lease, or whether it is simply a contract for a service.
•A contract 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’ (IFRS 16, para 9).
Identifying a Lease (Cont’d):
For this to be the case, IFRS 16 says that the contract
must give the customer:
The right to substantially all of the identified asset’s
economic benefits, and
The right to direct the identified asset’s use.
Identifying a Lease (Cont’d):
The right to direct the use of
the asset can still exist if the
lessor puts restrictions on
its use within a contract
(such as by capping the
maximum mileage of a
vehicle)
IFRS 16 says that a customer
does not have the right to
use an identified asset if the
supplier has the practical
ability to substitute the asset
for an alternative and if it
would be economically
beneficial for them to do so.
Problem 1:
Coffee Bean enters in a contract with an 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 stipulates 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
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?
Lessee Accounting: Basic Principle
At the commencement of the lease IFRS 16
requires that the lessee recognizes a lease liability
and a right-of-use asset.
Initial Measurement: The liability
The lease liability is initially measured at the present
value of the lease payments that have not yet been paid.
Lessee Accounting: Initial Measurement
The Liability:
IFRS 16 states that lease payments include the following:
 Fixed payments
 Variable payments that depend on an index or rate,
initially valued using the index or rate at the lease
commencement date
 Amounts expected to be payable under residual value
guarantees
 Lessee Accounting: Initial Measurement
(Cont’d)
Residual Value Guarantee:
…….is when the lessor is promised that the
underlying asset at the end of the lease term
will not be worth less than a specified amount.
Discount Rate:
It should be the rate implicit in the lease. If this cannot be
determined, then the entity should use its incremental
borrowing rate (the rate at which it could borrow funds to
purchase a similar asset).
 Lessee Accounting: Initial Measurement
(Cont’d)
 Options to purchase the asset that are reasonably
certain to be exercised
 Termination penalties. If the lease term reflects the
expectation that these will be incurred.
 Lessee Accounting: Initial Measurement
(Cont’d)
The right-of-use asset:
The right-of-use asset is initially recognized at cost. IFRS 16
says that the initial cost of the right-of-use asset comprises:
oThe amount of the initial measurement of the lease
liability (see above)
oLease payments made at or before the commencement
date
 Lessee Accounting: Initial Measurement
(Cont’d)
oInitial direct costs
oThe estimated costs of removing or dismantling
the underlying asset as per the conditions of the
lease.
 Lessee Accounting: Initial Measurement
(Cont’d)
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
 Periodscovered by an option to extend the lease if
necessary certain to be exercised.
 Periodscovered by an option to terminate the lease if
reasonably certain not to be exercised.
Problem 2:
On 1 January 2017, 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. Lorries have a
useful economic 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 $3000. The lessor immediately
reimburses $1000 of these costs.
Problem 2:
The interest rate within the lease is not readily
determinable. Dynamic’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 the double entries
needed to record these amounts in Dynamic’s financial
records.
 Lessee Accounting: Subsequent
Measurement
The liability:
The carrying amount of the lease liability is increased by
the interest charge. This interest is also recorded in the
statement of profit or loss:
Finance costs (P/L)………Dr. XX
Lease liability…………..Cr. XX
 Lessee Accounting: Subsequent
Measurement (Cont’d)
The carrying amount of the lease liability is reduced by
cash payments:
Lease liability……………….Dr. XX
Cash……………………………Cr. XX
 Lessee Accounting: Subsequent
Measurement (Cont’d)
The right-of-use asset
The right-of-use asset is measured using the cost model
(unless another model is chosen). This means that it is
measured at its initial cost less accumulated depreciation
and impairment losses.
 Lessee Accounting: Subsequent
Measurement (Cont’d)
The right-of-use asset
Depreciation is calculated as follows:
Ifownership 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 (as defined previously)
Problem 3:
This question follows on from Problem 2.

Required:
Explain the subsequent treatment of Dynamic’s lease in
the year ended 31 December 2017.
 Lessee Accounting: 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.
[See illustration 1 at page. 149]
 Lessee Accounting: Separating
Components
Entities can, if they prefer, choose to account for the
lease and non-lease component as a single lease. The
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 perception of the entity’s financial
position.
Lessee Accounting: Reassessing the Lease
Liability
If changes to lease payments occur then the lease liability
must be recalculated and its carrying amount adjusted.
A corresponding adjustment is posted against the
carrying amount of the right-of-use asset.
Lessee Accounting: Reassessing the Lease
Liability (Cont’d)
IFRS 16 says that the lease liability should be re-calculated
using a revised discount rate if:
 The lease term changes
 Theentity’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.
Problem 4:
On 1 January 2016, 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.
Problem 4 (Cont’d)
At the beginning of the second year of the lease the
Consumer Price Index is 140.
Required:
Discuss how the lease will be accounted for:
a) During the first year of the contract
b) On the first day of second year of the contract
Solution 4: The first year
The first payment occurs on the commencement date so
is included in the initial cost of the right-of-use asset:
Right-of-use asset………………………..Dr $1m

Cash………………………Cr $1m
Solution 4: The first year (Cont’d)
Date Cash flow Discount PV ($m)
($m) rate
1/1/2017
1/1/2017 1.0
1.0 1/1.05
1/1.05 0.95
0.95
1/1/2018 1.0 1/ 0.91
1/1/2018 1.0 0.91
1/1/2019 1.0 1/ 0.86
1/1/2019 1.0 0.86
2.72
2.72
Solution 4: The first year (Cont’d)
Right-of-use asset…………Dr. $2.72
Lease Liability……………Cr. $2.72
The asset is depreciated over the lease term of four
years, giving a charge of $0.93m ($1m+2.72m)/4.
Depreciation (P/L)………..Dr. $0.93m
Right-of-use asset…………Cr. $0.93m
The asset has a carrying amount at the reporting date
of $2.79m ($1m+2.72m-0.93m)
Solution 4: The first year (Cont’d)
The interest charge on the liability is $0.14m (W1).
Finance costs (P/L) ……………………Dr. $0.14m
Lease liability…………………………….Cr. $0.14m
(W1) Lease liability table
Year-ended Opening Interest Closing
(5%)
31/12/2016 $2.72m $0.14m $2.86m
 Solution 4: 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
$1.12 million ($1m × 140/125). The lease liability is
remeasured to reflect the revised lease payments
(three payments of $1.12 million)
Solution 4: The first day of the second
year (Cont’d)
Date Cash flow Discount PV ($m)
($m) rate
1/1/2017
1/1/2017 1.12
1.12 11 1.12
1.12
1/1/2018 1.12 1/ 1.07
1/1/2018 1.12 1.07
1/1/2019 1.12 1/ 1.02
1/1/2019 1.12 1.02
3.21
3.21
 Solution 4: The first day of the second
year (Cont’d)
The lease liability must be increased by $0.35m ($3.21-
2.86m). A corresponding adjustment is made to the right-
of-use asset.
Right-of-use asset ………….Dr. $0.35m
Lease liability………………….Cr. $0.35m
 Solution 4: The first day of the second
year (Cont’d)
The payment of $1.12m will then reduce the lease
liability:
Lease liability………………Dr. $1.12m
Cash…………………………..Cr. $1.12m

The right-of-use asset’s carrying amount of

$3.14m ($2.79+$0.35m) will be depreciated
over the remaining lease term of three years.
 Lessee Accounting: Short-life and low
value assets
If the asset is short-term (less than 12 months at the
inception date) or of a low value then a simplified
treatment is allowed.
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
recognized.
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.
Lessor Accounting:
A lessor must classify its leases as finance leases or
operating leases.
IFRS 16 provides the following definitions:
A finance lease is a lease where the risks and rewards of the
underlying asset substantially transfer to the lessee.
An operating lease is a lease that does not meet the
definition of a finance lease.
How to Classify a Lease: Finance Lease
IFRS 16 Leases states that a lease is probably a finance
lease if one or more of the following apply:
 Ownership is transferred to the lessee at the end of the
lease.
 The lessee has the option to purchase the asset for less
than its expected fair value at the date the option
becomes exercisable and it is reasonably certain that the
option will be exercised.
 How to Classify a Lease: Finance Lease
(Cont’d)
• The lease term (including any secondary periods) is for the
major part of the asset’s economic life.
• At the inception of the lease, the present value of the
lease payments amounts to at least substantially all of the
fair value of the leased asset.
• Theleased assets are of a specialized nature so that only
the lessee can use them without major modifications
being made.
 How to Classify a Lease: Finance Lease
(Cont’d)
• The lessee will compensate the lessor for their losses if the
lease is cancelled.
• Gainsor losses from fluctuations in the fair value of the
residual fall to the lessee
• The lessee can continue the lease for a secondary period in
exchange for substantially lower than market rent
payments.
Problem 5:
DanBob 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
1 January 2016 is for 30 years.
DanBob would receive 40% of the asset’s value upfront
from the lessee. At the end of each of the 30 years, DanBob
will receive 6% of the asset’s fair value as at 1 January 2016.
Problem 5 (Cont’d):
Legal title at the end of the lease remains with DanBob,
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 DanBob
to recover its remaining investment.
Required:
Per IFRS 16 Leases, should the lease be classified as an
operating lease or a finance lease?
Finance Leases: Initial Treatment
At the inception of a lease, lessors present assets held
under a finance lease as a receivable. The value of the
receivable is calculated as the present value of:
 Fixed payments
Variable payments that depend on an index or rate, valued
using the index or rate at the lease commencement date
 Residual value guarantees
Finance Leases: Initial Treatment (Cont.)
• Unguaranteed residual values (refers to the worth of a
lease property at the end of the agreement’s term that is
not the responsibility of the lessee)
• Purchase options that are reasonably certain to be
exercised
• Termination penalties, if the lease term reflects the
expectation that these will be incurred.
Finance Leases: Subsequent Treatment
The subsequent treatment of the finance lease is as follows:
 The carrying amount of the lease receivable is increased
by finance income earned, which is also credited to the
statement of profit or loss.
 The carrying amount of the lease receivable is reduced by
cash receipts.
Problem 6:
James leases machinery to Judy. The lease is for four years
at an annual cost of $2000 payable annually in arrears. The
present value of the lease payments is $5710. The implicit
rate of interest is 15%.

Required:
How should James account for their net investment in the
lease?
Operating Leases
• A lessor recognizes income from an operating lease on a
straight line basis over the lease term.
• Any direct costs of negotiating the lease are added to the
cost of the underlying asset.
• The underlying asset should be depreciated in accordance
with IAS 16 or IAS 38.
Problem 7:
Orange hires out industrial plant on long-term operating
leases. On 1 January 2001, it entered into a seven-year
lease on a mobile crane. The terms of the lease are
$175,000 payable on 1 January 2001, followed by six rentals
of $70,000 payable on 1 January 2002-2007. The crane will
be retuned to Orange on 31 December 2007. The crane
originally cost $880,000 and has a 25-year useful life with
no residual value.
Problem 7 (Cont.)

Required:
Discuss the accounting treatment of the above in the year
ended 31 December 2001.
Sale and Leaseback:
• Ifan entity (the seller-lessee) transfers an asset to another entity
(the buyer-lessor) and then leases it back. IFRS 16 requires that both
entities assess whether the transfer should be accounted for as a
sale.
• For this purpose, entities must apply IFRS 15 Revenue from
Contracts with Customers to decide whether a performance
obligation has been satisfied. This normally occurs when the
customer obtains control of a promised asset. Control of an asset
refers to the ability to obtain substantially all of the remaining
benefits.
Sale and Leaseback: Transfer is not a Sale
If the transfer is not a sale then IFRS 16 states that:
 The seller-lessee continues to recognize the transferred
asset and will recognize a financial liability equal to the
transfer proceeds.
 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.
Sale and Leaseback: Transfer is a Sale
If the transfer does qualify as a sale then IFRS 16 states that:
The seller-lessee must measure the right-of-use asset as the
proportion of the previous carrying amount that relates to
the rights retained.
- This means that the seller-lessee will recognize a profit
or loss based only on the rights transferred to the
buyer-lessor.
 Sale and Leaseback: Transfer is a Sale
(Cont.)
 The buyer-lessor accounts for the asset purchase using the
most applicable accounting standard (Such as IAS 16). The
lease is accounted for by applying lessor accounting
requirements.
Problem 8:
On 1 January 2001, Painting sells an item of machinery to
Collage for its fair value of $3 million. The asset had a carrying
amount of $1.2 million prior to the sale. This sale represents
the satisfaction of a performance obligation, in accordance
with IFRS 15 Revenue from Contracts with Customers.
Painting enters into a contract with Collage for the right to
use the asset for the next five years. Annual payments of
$500,000 are due to end of each year. The interest rate
implicit in the lease is 10%.
Problem 8:
The present value of the annual lease payments is $1.9 million.
The remaining useful economic life of the machine is much
greater than the lease term.

Required:
Explain how the transaction will be accounted for on 1
January 2001 by both Painting and Collage.
Solution 8:
Painting:
 Painting must remove the carrying amount of the machine
from its statement of financial position.
 It should instead recognize a right-of-use asset.
 The right-of-use asset will be measured as the proportion of
the previous carrying amount that relates to the rights
retained by Painting:  

× 1.2m = 0.76m
Solution 8 (Cont.)
The entry is required as follows:
Cash Dr. $3.00m
Right-of-use asset Dr. $0.76m
Machine Cr. 1.20m
Lease Liability Cr. 1.90m
Profit or loss (bal. fig) Cr. 0.66m
Solution 8 (Cont.)
Note: The gain in profit or loss is the proportion of the overall
$1.8 million gain on disposal (3m – 1.2m) that relates to the
rights transferred to Collage. This can be calculated as
follows:
((3m – 1.9m)/3m) × 1.8m = 0.66m
The right of use asset and the lease liability will then be
accounted for using normal lessee rules.
Solution 8 (Cont.)
Collage:
Collage will post the following:
Machine Dr. 3.00m
Cash Dr. 3.00m
Normal lessor accounting rules apply. The lease is an operating
lease because the present value of the lease payments is not
substantially the same as the asset’s fair value, and the lease term is
not for the majority of the asset’s useful life. Collage will record
rental income in profit or loss on a straight line basis.
Difference between IAS 17 and IFRS 16
IAS 17 IFRS 16
Development Developed by International Developed by
Accounting Standards International Accounting
Committee. Standards Board.
Recognition of Finance leases are recognized as All leases are recognized
Lease assets and operating leases are as assets.
recognized as expenses.
Focus The focus is one who bears the The focus is on who has
risks and rewards of the lease. the right to use the
asset.
Why is the difference?
Improved comparability and transparency on balance sheet.
Financial statement users can clearly see the effect of
operating leases and have a useful basis for comparability
with other companies.
Currently, under IAS 17, it is difficult to compare companies
who lease with those who buy.
Potential Impacts:
• Financial report impact: As operating leases will be
capitalized, there will be a shift in financial metrics for
businesses that have a particularly large number of this
type of lease.
• Asset turnover, equity, and operating expenses will
likely see a decrease. Conversely, liabilities, reported
debt, recorded assets, EBIT and EBITDA will see an
increase.
Potential Impacts (Cont.)
• Covenants and shareholder relationships – With a
change in financial metrics, ratios and liabilities,
companies will need to take extra care with their
disclosures to explain the shift figures.