CHAPTER FIVE

Group Members (Section

3&4)
1. Liya Eyob Hamda
2. Mastewal
IAS 17 & IFRS 16 Woldemariam
3. Mekdes Gizaw
 Overview

IAS17:
 Classification of leases
 Factors which indicate a finance lease
 Accounting for operating leases
 Accounting for finance leases by the lessee
 Allocation of finance charges:
 Accounting for finance leases by the lessor
 Disclosure requirements of IAS17

IFRS16:
 Lease accounting by lessees
 Lease accounting by lessors
 What is a lease?

A lease is an agreement whereby the lessor conveys

to the lessee in return for payment or a series of
payments the right to use an asset for an agreed
period of time.
 Classification of leases (IAS17)

IAS17 defines a lease as "an agreement whereby

the lessor conveys to the lessee in return for a
payment or series of payments the right to use
an asset for an agreed period of time".
A finance lease is "a lease that transfers
substantially all the risks and rewards incidental
to ownership of an asset. Title may or may not
eventually be transferred".
An operating lease is "a lease other than a
finance lease".
 Factors which indicate a finance
lease

• 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
expected to be lower than fair value
• the lease term is for the major part of the economic life
of the asset
• the present value of the minimum lease payments
amounts to substantially the fair value of the asset
• the leased asset is of such a specialized nature that only
the lessee can use it.
Classification of Leases
Accounting for operating leases (IAS17)

The lessee
 The lessee has not taken on the risks and rewards of
ownership, so the leased item is not shown as an asset in the
lessee's financial statements.
 The lease payments are recognized as an expense over the
lease term.
The lessor
 The lessor has retained the risks and rewards of ownership,
so the leased item is shown as an asset in the lessor's
financial statements and is depreciated as usual.
 The lease payments are recognized as income over the lease
term.
Accounting for finance leases by the
lessee (IAS17)
 The lessee has acquired the risks and rewards of ownership
and so the leased item should be shown as an asset in the
lessee's financial statements, along with a corresponding
liability to the lessor.
 At the commencement of the lease term, IAS17 requires that
both the asset and the liability to the lessor should be
recognized at the lower of:
• the fair value of the leased item
• the present value of the minimum lease payments

The liability to the lessor should be split between current and non-
current liabilities, as appropriate.
This liability must not be shown as a deduction from the leased asset.
Allocation of finance charges for a finance lease

The total finance charge is the difference between:

a) the total of the minimum lease payments, and
b) the initial liability to the lessor.
IAS17 requires that this finance charge should be allocated to
accounting periods "so as to produce a constant periodic rate of
interest on the remaining balance of the liability".

Methods which could be used for allocating the finance

charge between accounting periods include the actuarial
method, the sum of digits method and the level spread
method.
 Actuarial method

The rate of interest implicit in the lease is used to

calculate the finance charge for each accounting
period.
This method is preferred by IAS17 but cannot be
used unless the interest rate is known.
If necessary, the interest rate can usually be derived
with the aid of present value tables.
 Sum of digits method

• A digit is assigned to each period during which there will be a

liability to the lessor.
• Digit 1 is assigned to the final such period,
• Digit 2 to the next-to-last period and so on.
• If lease payments are made in advance at the start of each
period, there will be no liability to the lessor in the final
period of the lease term and therefore this period is not
assigned a digit.
• The digits are totaled to give the "sum of digits".
• The finance charge for each period is calculated by dividing
the total finance charge by the sum of the digits and
then multiplying by the digit assigned to that period.
 Level spread method

This method simply allocates the finance charge to

accounting periods on a straight-line basis over the
lease term.
This is unrealistic, since the amount of the finance
charge allocated to each period should fall as the
liability to the lessor also falls.
But this method might be used if the amounts
involved are not material.
Accounting for finance leases by the lessor
(IAS17)
 The lessor has relinquished the risks and rewards of
ownership. So the leased asset should be removed from the
lessor's statement of financial position and replaced by a
receivable which represents the amount owed by the lessee.
 In general, this receivable is initially recognized at the present
value of the minimum lease payments which the lessee is
required to make.
 Subsequently, the rate of interest implicit in the lease is used
to calculate the finance income element of each lease payment.
This finance income is recognized in the lessor's statement of
comprehensive income. The remainder of the lease payment is
subtracted from the amount owed by the lessee.
IAS17 disclosure requirements (operating
leases)

The lessee
• the amount of operating lease payments recognized as
an expense during the accounting period
• analysis of the total of the future minimum lease
payments payable under non-cancellable operating
leases.
The lessor
analysis of the total of the future minimum lease
payments receivable under non-cancellable operating
leases.
IAS17 disclosure requirements (finance leases)

The lessee
• for each class of asset, the net carrying amount of
assets held under finance leases
• analysis of the total of the future minimum lease
payments payable under finance leases.
The lessor
• analysis of the total of the future minimum lease
payments receivable under finance leases
• total amount of unearned finance income
outstanding at the end of the reporting period.
IFRS 16:LEASE
 IFRS16 :LEASE

 IFRS 16 sets out the principles for the recognition,

measurement, presentation and disclosure of leases.
 The objective is to ensure that lessees and lessors provide
relevant information in a manner that faithfully represents
those transactions.
 This information gives a basis for users of financial
statements to assess the effect that leases have on the
financial position, financial performance and cash flows of
the entity.
IFRS 16 applies to contracts meeting the definition of a
lease except for:

 Leases to explore for or use minerals, oil, and natural gas;

 Leases of biological assets within the scope of (IAS 41)

 Service concession arrangements within the scope of IFRIC 12 Service

Concession Arrangements;
 Licenses of intellectual property granted by a lessor within the scope of

IFRS 15 Revenue from Contracts with Customers; and

 Rights held by a lessee under licensing agreements within the scope of IAS

38 Intangible Assets for such items as motion picture films, video

recordings, plays, manuscripts, patents and copyrights.
 IFRS 16’s Principle and Optional exceptions

Principle: A lease conveys the right to use an asset for a

period of time in exchange for cash payments.
 Lessee reports lease assets and liabilities on balance
sheet,
Optional exceptions to exclude from balance sheet (rules):
 Short-term leases
– leases for which it is not ‘reasonably certain’ that the
term will be >12 months, considering the likelihood of
exercise of extension options and termination options
 Low-value asset leases
– Leases of assets with a value when new of $5,000 or less.
Low value lease

 The assessment of ‘low value’ for a lease is to be made

on the basis of when the asset itself is new, regardless of
whether the actual asset being leased is new.
 the assessment is to be made regardless of whether the
lease is material to the particular lessee.
 Examples of low value leases, include:
tablets
personal computers,
small items of office furniture and telephones.
IFRS 16: Identifying a Lease

 A lease is 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.
 Assess whether a contract contains a lease on the
basis of whether the customer has the right to
control the use of an identified asset for a period of
time.
 Identifying lease continued…..

 Is there an identified asset?

 Does the lessee obtain the economic benefits?

 Does the lessee have the right to direct use

(the right to control the use)?

 If the contract does not contain a lease;

apply other applicable IFRSs

Identified asset-(Substitution Right)

 In many situations, it may be clear that a lease contains an

identified asset.
 In some contracts the lessors retain a substantive right to
substitute the asset throughout the period of use.
 In such cases, the ‘specified asset’ criterion would not be met
and the contract would not contain a lease.
 A supplier’s right to substitute an asset would be substantive
if both of the following conditions are met:
 The supplier has the practical ability to substitute
alternative assets throughout the period of use; and
 The supplier would benefit economically from the exercise
of its right to substitute the asset.
 Identified asset- Portions of Assets

 A capacity portion of an asset may be an identified asset if

it is physically distinct (e.g. a floor of a building).

 A capacity portion of an asset that is not distinct is not an

identified asset, unless it represents substantially all of the

capacity of the asset.
 In this latter situation, the customer in essence has the

right to obtain substantially all of the benefit from the

underlying asset itself.
 Obtaining Economic Benefits

 Analyze whether the customer has the right to

obtain substantially all of the economic benefits from
use of the asset
 Economic benefits from use of the asset include its
primary outputs (e.g. finished goods for a
manufacturer to sell) and byproducts, including
potential cash flows that derive from these items.
 Exclusive use of the asset throughout the period of
the contract or by sub-leasing the asset.
 Right to Direct Use of the Asset
 A customer has the right to direct how and for what purpose
an asset
 A customer can change how and for what purpose the asset
is used throughout the period of use.
 Examples of decision-making rights include:
 Rights to change the type of output that is produced by the asset
(e.g. What type of food certain food processing equipment
produces);
 Rights to change when the output is produced

(e.g. the regular operating hours);

 Rights to change where the output is produced

(e.g. the physical location of machinery); and

 Rights to change whether the output is produced, and the
quantity
Determining the Lease Term

 The lease term includes the following:

a) The non-cancellable period of the lease
b) Periods covered by an option to extend the lease if the
lessee is reasonably certain to exercise that option and
c) Periods covered by an option to terminate the lease if
the lessee is reasonably certain not to exercise that
option
 The lease term begins at the commencement date (i.e. the
date on which the lessor makes the underlying asset(s)
available for use by the lessee)
 The term includes any rent-free or reduced rent periods
provided to the lessee by the lessor.
Recognition and Measurement

Lease Liability – Initial Recognition

 Lease liability is measured at the present value of future
lease payments discounted at the interest rate implicit in
the lease or the lessee’s incremental borrowing rate.
 The components of future lease payments include:
 Fixed Payments
 Certain Variable Payments
 Residual Value Guaranteed
 Purchase Options
 Termination Costs
 Less Payments Made Previously
 All components of the liability are added together and
discounted at an appropriate rate
 Variable Lease Payments

 Payments that vary according to an index or rate.

 Are included in the lease liability & asset at the measurement date.
 The lease liability is re-measured when the index or rate changes
 Payments that vary based on future usage of the leased asset

 Are not included in the lease liability or asset

 Are recognized as an expense in the period in which the event or
condition that triggers the payment takes place.
Discount Rate on Initial Recognition

 All the components of the lease liability as described

are required to be discounted

 The rate is required to be the rate implicit in the

lease, unless it cannot readily be determined,
 In which case the lessee’s incremental rate of
borrowing is to be used.
Right-of-Use Asset – Initial Recognition

• The right-of-use asset’s initial value includes:

– Lease Liability
– Initial Direct Costs
• Are incremental costs of obtaining a lease that would not
have been incurred if the lease had not been obtained. E.g.
finder’s fees, commissions to agents for establishing the
lease and up-front fees.
– Removal and Restoration costs
• Some leases contain requirements for lessees to return assets
in a specified condition
• Leases of premises often require that lessee return them to a
specified state upon the termination of the lease.
– Payments Made Previously
Example – Initial Recognition of a Lease

Entity Z (the lessee) enters into a 10-year lease of a floor of a

building, with an option to extend for 5 years. Lease payments are
$50,000 a year during the initial term and $ 55,000 per year during
the optional period, all payable at the beginning of each year.
To obtain the lease, lessee incurs initial direct costs of $20,000
($ 15,000 to the former tenant occupying the floor and $ 5,000 for
real estate commissions).
The lessor agrees to reimburse the lessee the real estate commission
of $ 5,000 and provide $7,000 for leasehold improvements.
At the commencement date, the lessee concludes that it is not
reasonably certain to exercise the option to extend the lease. The rate
implicit in the lease is not readily determinable. The lessee’s
incremental rate of borrowing is 5% per annum.
 Example continued….

To record the initial value of the lease asset and liability:

Dr. Right-of-use asset 405,391a
Cr Lease liability 355,391b
Cr Cash 50,000
To record the initial direct costs:
Dr. Right-of-use asset 15,000
Dr. Receivable 5,000
Cr Cash 20,000
To record lease incentive relating to the lease:
Dr. Cash 5,000
Cr Receivables 5,000

Note that the 7,000 received for leasehold improvements is not included in the lease
accounting

a
PV of 9 payments at 50,000, discounted at 5% + 50,000
b
PV of 9 payments at 50,000, discounted at 5%.
Lease Liability – Subsequent Measurement

Lease liability= Initial Value + Interest on Carrying Value

- Lease Payments
 Interest on the lease liability is recognized in P & L,unless it is
included in the carrying amount of an asset as required by another
standard.
 Situations where interest on lease liabilities may be capitalized into
the cost of other assets include:
 The production of inventory utilizing leased equipment;

 The construction of property plant and equipment where leased

assets are a component of the construction; and
 The development of intangible assets where leased assets are a
component of the directly identifiable costs to obtain or develop
intangible assets.
Example : classifying leases payments

• On 1 January 2015 Entity enters as lessee into a 5 year

non‑cancellable lease over a machine when the machine’s
cash cost = ETB1,000,000.
• Assume straight line depreciation method
• Terms of the lease:
 5 equal annual lease payments of ETB 263,797 starting on
31/12/2015.
• The lease amortisation table is set out on the next slide…
Example : classifying lease payments
Example 2: classifying leases

 On 1 January 2015 Entity enters as lessee into a 5 year

non‑cancellable lease over a photocopier when the photocopier’s

cash cost = Br10,000.
 Terms of the lease:

 5 equal annual lease payments of Br2,638 starting on

31/12/2015 (payment in arrears)
 upon paying the final lease payment legal ownership of the
photocopier transfers from the lessor to Entity.
 The lease amortisation table is set out on the next slide…
Example 2: classifying leases
Right-of-Use Asset – Subsequent Measurement

Measurement Models:

 Cost Model (IAS 16)

 Revaluation Model (IAS 16)

 Fair Value Model Investment Property (IAS 40

Cost Model

Measures a right-of-use asset at cost:

 Less accumulated amortization and accumulated

impairment losses
 Adjusted for re-measurements
 the period to calculate amortization expense is the lease

term or useful life of the asset which ever is shorter.

 If the initial recognition contemplates purchase options -

utilise the useful life of the asset.

Revaluation Model

 If right-of-use assets relate to a class of PPE that an entity

applies the revaluation model, a lessee may elect to also apply

the revaluation model to right-of-use assets of the same class.
 An entity is not required to apply the model to leased assets of

the same class; it is optional.

 Therefore, an entity may have a group of owned assets (e.g.

heavy machinery) where it applies the revaluation model, but a

group of leased assets of the same type where it applies the cost
model.
Fair Value Model

 If an entity applies the fair value model in IAS 40, the

same classification must also be applied to right of- use

assets that meet the definition of investment property.
 In contrast to the revaluation model where its use is

optional, the fair value model must be applied to right-

of-use assets where a lessee also applies the fair value
model to owned investment property.
Re-measurement of Leases

 Initial assessment may need to be revisited if certain events

occur that modify the originally assessed assumptions used
to calculate the lease balances.
 Recognizes the effects of these re-measurements as an
adjustment to the carrying value of the lease liability and
right-of-use asset as at the time of re-measurement; prior
period figures are not adjusted.
 If the carrying value of the asset is less than the amount of
an adjustment, the carrying value is reduced to zero with
any further reductions being recognized in P & L.
Re-measurement of Leases …

Situations requiring re-measurement and their impact

are:
1. Change in original assessment of lease term or
Purchase/termination options
 Revise lease using new assumptions
 Unchanged discount rate
2. Change in estimate of residual guarantee and Change in index or
rate affecting payments
 Revise lease using new assumptions
 Revised discount rate
Lease Modifications
Modifications – Separate Leases

A lease modification is accounted for as a separate

lease if both:
a) The modification increases the scope of the lease by
adding the right to use one or more underlying assets;
and
b) The consideration for the lease increases by an amount
commensurate with the standalone price for the
increase in scope.
If both criteria are met, a lessee would follow the previous
guidance in this publication on the initial recognition and
measurement of lease liabilities and right-of-use assets.
Modifications – Not Separate Leases

 If a lease modification fails the test above (e.g.

additional assets are added, but not at a standalone

price) or
 the modification is of any other type (e.g. a decrease

in scope from the original contract),

the lessee must modify the initially recognised
components of the lease contract.
PRESENTATION

• Statement of Financial Position

– Right-of-use assets: separate from other assets or same line as
underlying asset type and disclose.
– Lease liabilities separate from other liabilities or disclose line item.

• Statement of Profit and Loss

– Interest cost with other finance costs per IAS 1.
– Amortization of right-of-use assets.
• Statement of Cash Flows
– Cash payments of lease liabilities as financing activities.

– Cash payments for interest in accordance with IAS 7’s requirements

for interest paid.
– Short-term, low-value and variable lease payments within operating
activities
DISCLOSURE

• IFRS 16 has extensive disclosure requirements for lessees in both

qualitative and quantitative form.
• Quantitative Disclosure Requirements
 Additions to right-of-use assets.
 Carrying value of right-of-use assets at the end of the reporting period by
class.
 Amortization for assets by class.
 Interest expense on lease liabilities.
 Short-term leases expensed.
 Low-value leases expensed.
 Variable lease payments expensed.
 Income from subleasing.
 Gains or losses arising from sale and leaseback transactions.
 Total cash outflow for leases.
Other disclosure requirements also include:

Commitments for short-term leases if the current period expense

is dissimilar to future commitments.
 For right-of-use assets that meet the definition of investment
property, the disclosure requirements of IAS 40, with a few
exclusions.
For right-of-use assets where the revaluation model has been
applied, the disclosure requirements of IAS 16.
 Entities applying the short-term and/or low-value lease
exemptions are required to disclose that fact.
DISCLOSURE

• A summary of the nature of the entity’s leasing

activities;
• Potential cash outflows the entity is exposed to that
are not included in the measured lease liability,
including:
– Variable lease payments;
– Extension options and termination options;
– Residual value guarantees; and
– Leases not yet commenced to which the lessee is committed.
– Restrictions or covenants imposed by leases; and
– Sale and leaseback transaction information.
LESSOR ACCOUNTING

 IFRS 16 is substantially unchanged in most respects from

IAS 17 for lessor.
 Leases are classified as:
 Finance leases
 Operating leases
 Finance leases - Leases that transfer substantially all
of the risks and rewards
 Operating lease- Risks and rewards not transferred
 For operating leases both the lessee and the lessor will
recognize an asset.
 Risks and rewards of ownership

RISKS REWARDS
• Losses may arise from: • Gains may arise from:
 Idle capacity  Generation of profits from
use of asset
 Fall in asset value due
to technological  Future sale of asset which
obsolescence has increased in value
 Cost of maintenance
and repair
 Identifying a Finance Lease

Examples of conditions that individually or in combination lead to

classification as a finance lease:
 Terms of lease such that ownership of asset transfers to lessee by end of
lease term
 Lessee has option to purchase asset at a price that makes it reasonably
certain from the inception of the lease that the option will be exercised
 Lease term is for a major part of the economic life of the asset even if legal
title is never transferred
 At inception of the lease, the present value of minimum lease payments
amounts to substantially all of the fair value of the asset
 Leased assets are of such a specialised nature that only the lessee can use
them without major modifications
Identifying a finance lease (Cont’d)

Other indicators are:

 Whether cancellation losses are borne by the lessee

 Whether fluctuations in fair value at end of the lease

accrue to the lessee

 Whether the lessee has the option to extend the lease

for a secondary period at a ‘peppercorn rent’

Example 1: Finance Vs Operating lease

Lessor L enters into a non cancelable lease contract with

company X under which X leases non specialized equipment
for 5 years. The economic life of the equipment is estimated
to be 15 years and the legal title will remain with L. The lease
contract contains no purchase, renewal or early termination
options. The fair value of the equipment is Birr1,000,000
and the present value of the lease payments amounts to Birr
500,000.
Required: is the lease contract Finance or Operating?
Accounting by the Lessor

Ex: Manchster Leasing Company signs an agreement on January 1, 2010,

to lease equipment to Harar Company. The following information relates
to this agreement.
1. The term of the non-cancelable lease is 6 years with no renewal option.
The equipment has an estimated economic life of 6 years.
2. The cost and fair value of the asset at January 1, 2010, is £343,000.
3. The asset will revert to the lessor at the end of the lease term, at which
time the asset is expected to have a residual value of £61,071, none of
which is guaranteed.
4. Harar Company assumes direct responsibility for all executory costs.
5. The agreement requires equal annual rental payments, beginning on
January 1, 2010.
Accounting by the Lessor

 Computation: Assuming the lessor desires a 10% rate of return on its

investment, calculate the amount of the annual rental payment required.
Accounting by the Lessor

 Amortization schedule that would be suitable for the lessor.

Accounting by the Lessor

Prepare all of the journal entries for the lessor for

2010.
Accounting by the Lessor

Prepare all of the journal entries for the lessor for

2011.
THANK YOU