LEASING

Introduction
A lease is an agreement whereby the lessor (the legal owner of an asset) conveys to the lessee
(the user of the asset) the right to use an asset for an agreed period of time in return for a
payment or series of payments. An alternative method of obtaining the use of an asset is to
purchase the asset outright. Unless the lessee has surplus cash the asset purchase must be
financed in some way, either by a share issue or (more likely) by borrowing. From a legal
perspective, the two methods of obtaining asset use (leasing or outright purchase) are
completely different. In the case of leasing, no asset is owned by the lessee so (from a legal
perspective) no asset is recognised by the lessee. Clearly the opposite is true in the case of
outright purchase of an asset. In the case of outright purchase the purchaser will recognise the
asset it legally owns plus (in many cases) an associated liability.

One of the fundamental characteristics of useful financial information is that it faithfully

represents the transactions reported within it. Another way of saying this is that useful financial
information should reflect the economic substance of transactions. Where this ‘economic
substance’ differs from the legal form then the economic substance will prevail. We will see in
this topic that the issue of ‘substance over form’ is a key factor when we consider the financial
reporting of leasing transactions in the financial statements of both lessor and lessee.

Objectives
By the end of this topic, you should be able to:
 Evaluate the ‘substance over form’ issue identified in the introduction and so identify
why an accounting standard on leasing is necessary;
 Distinguish between finance leases and operating leases as made in IAS 17 leases;
 Critically discuss why a replacement standard for IAS 17 was necessary;
 Explain how a lease is identified in IFRS 16 leases – issued in January 2016;
 Account for leases in the financial statements of lessees under IFRS 16;
 Account for leases in the financial statements of lessors under IFRS 16;
 Account for sale and leaseback transactions in the financial statements of both the
seller/lessee and the buyer/lessor;
 Discuss the economic impact of IFRS 16 on the extent to which leasing is used as a
means of asset procurement.

Need for an accounting standard on leasing

In the introduction we explained that where an entity needed the use of an asset leasing was an
alternative to outright purchase. The two options have very different legal consequences and
also (if accounted for in accordance with their legal form) different impacts on the financial
statements.
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EXAMPLE
The summarised statement of financial position of an entity at the start of its accounting period
(all accounting periods in this example are of one year’s duration) is as follows:
Shs “000”
Non-current assets 60,000
Current assets 40,000
100,000
Equity 40,000
Non-current liabilities (loans) 40,000
Current liabilities (no loans included) 20,000
100,000

Suppose the entity needs to obtain the use of an item of plant that would cost shs 40 million to
purchase outright. The estimated useful economic life of the plant is five years, with no
estimated residual value. The entity has no surplus cash to finance the purchase and it has two
options available:
 To finance the purchase with a five-year loan carrying an annual finance cost of 5%. The
loan is repayable in five annual amounts of shs 9,240,000, payable at the end of each of
the next five years.
 To lease the asset on a five-year lease with annual rentals of shs 9,240,000, payable in
arrears. The lease has no escape clauses.

In order to help us with some of the figures we are going to demonstrate, it would be good to
show the profile of the loan over the five-year term:

Period Opening balance Finance cost (5%) Rental Closing balance

shs 000 shs 000 shs 000 shs 000
1 40,000 2,000 (9,240) 32,760
2 32,760 1,638 (9,240) 25,158
3 25,158 1,258 (9,240) 17,176
4 17,176 859 (9,240) 8,795
5 8,795 440 (9,240) (5)
(a rounding
difference)

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This means that the loan balances at the beginning and end of period 1 will be as follows:

Start of period End of period Comment

shs 000 shs 000
Current 7,240 7,602 The amount by which the overall
loan balance reduces in the
following period
(32,760 - 25,158)

Non-current 32,760 25,158

Total 40,000 32,760 The overall loan balance

Impact on gearing ratio

Let’s compare the impact on the statement of financial position under the purchase option and
the lease option, assuming the lease option is accounted for according to its legal form,
i.e. no asset or liability recognised:

Lease option Purchase option Comment

shs 000 shs 000
Non-current assets 60,000 100,000
Current assets 40,000 40,000
100,000 140,000

Equity 40,000 40,000

Non-current liabilities
(loans) 40,000 72,760 Including the non-
current portion
of the loan (32,760)

Current liabilities 20,000 27,240 Including the current

portion of the loan
(7,240)
100,000 140,000

Gearing ratio
(loans/loans + equity) 50% 64.5%

The two options show a significantly different gearing ratio – the ‘purchase option’ showing a
significantly higher (and probably less acceptable) ratio.

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Statements of financial performance and position assuming asset was leased
Let’s further assume that the summarised statement of profit or loss of the entity (there is no
other comprehensive income) for the period immediately following the acquisition of the asset
(and assuming for the moment the asset is leased and the associated asset and any liability is
not recognised) is as follows:

shs 000
Revenue 80,000
Operating costs (68,000) Includes the lease payment of shs 9.24m
Operating profit 12,000
Finance costs (2,000)
Pre-tax profit 10,000
Tax (2,000)
Post-tax profit 8,000

Assuming also that no additional shares had been issued during the period, then the statement
of financial position at the end of the period would appear as:

shs 000
Non-current assets 66,000
Current assets 44,000
110,000
Equity 48,000
Non-current liabilities (loans) 40,000
Current liabilities 22,000 Includes the tax liability
110,000

Compare financial statements under both lease and purchase options

Let’s compare the profit or loss for the period and the closing statement of financial position
under the leasing option and the purchase option. We’ll start with the statements of profit or
loss:
Lease option Purchase option Comment
shs 000 shs 000
Revenue 80,000 80,000
Operating costs (68,000) (66,760) Rental of shs 9.24 million not
included but depreciation of shs 8
million added in
Operating profit 12,000 13,240
Finance costs (2,000) (4,000) Includes interest of 5% on additional
shs 40 million loan

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Pre-tax profit 10,000 9,240
Tax (2,000) (1,848) Assumes changed treatment is
allowed
for tax purposes
Post-tax profit 8,000 7,392

We now proceed to a comparison of the statements of financial position:

Lease option Purchase option Comment
shs 000 shs 000
Non-current assets 66,000 98,000 Includes asset purchased for shs
40m at the start of the year less 20%
depreciation
Current assets 44,000 44,000
110,000 142,000

Equity 48,000 47,392

Non-current liabilities
(loans) 40,000 65,158 Includes the non-current portion of
the loan (25,158)

Current liabilities 22,000 29,450 Reduced by the slightly lower tax

charge(152) but includes the current
portion of the loan (7,602)
110,000 142,000

Impact on return on capital employed

As a final step, let’s compare some accounting ratios under the two options for the period
immediately following the acquisition of the asset. This is done in the following table:

Lease option Purchase option Comment

Closing equity (shs 000) 48,000 47,392
Closing loans (shs 000) 40,000 72,760 Includes both current and
noncurrent elements of the
loan (32,760)
Closing capital
employed (shs 000) 88,000 120,152

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Closing gearing ratio 45% 61% Measuring gearing as loans
expressed as a percentage of
capital employed (Loans plus
equity)
Operating profit 12,000 13,240
(shs 000)
Return on capital
Employed 14% 11% Measuring return on capital
employed as operating
profit expressed as a
percentage of capital
employed

This example shows that under the leasing option we report lower borrowing ratios and higher
returns on capital. Both those factors would be regarded as indicating a superior performance
when compared to the purchase option.

The argument could of course be made that the two scenarios are different. However, when you
analyse the underlying commercial effect of the two options they are basically identical; under
both options the entity is given the use of an asset for its entire useful economic life and under
both options identical payments are made at the end of each accounting period. It would,
therefore, be misleading to users for the two options to be reported differently under scenarios
such as the one we have illustrated in the above example.

This is the reason, therefore, why it was necessary to develop an accounting standard which
ensured that the financial reporting of lease arrangements adequately met the needs of users by
appropriately recognising assets and liabilities associated with leasing transactions.

Distinction between finance leases and operating leases

In the previous section we reviewed an example in which the commercial effect of leasing an
asset was essentially exactly the same as purchasing the asset outright with the aid of a loan.
In such circumstances it does seem reasonable that the two arrangements should be accounted
for in the same manner. However, in other types of leasing arrangements the economic effect of
leasing is arguably very different to outright purchase.

The approach initially adopted by the International Accounting Standards Committee in IAS 17
Leases was to distinguish between two types of lease. Leases (such as the one illustrated in the
example above) that represented in substance an outright purchase of the asset by the lessee

Page 6 of 23
financed by a loan from the lessor were classified as finance leases. All other leases were
classified as operating leases. Specifically, the distinction was made in IAS 17 as follows:

 Finance lease: a lease that transfers substantially all the risks and rewards of ownership
of an asset. Title may or may not eventually be transferred.
 Operating lease: a lease other than a finance lease.
NB: we will see later that, where relevant, the classification of leases into finance and
operating in IFRS 16 – the successor standard to IAS 17 – is virtually identical to that in
IAS 17.
 The classification criteria we have just mentioned – risks and rewards of ownership – are
basically subjective.

IASB guidance
In order to aid application of the criteria by users. IAS 17 included some guidance material.
IAS 17 included examples of situations that, individually or in combination would normally
lead to a lease being classified as a finance lease (these examples are essentially replicated in
IFRS 16 – the successor standard). These were:
a) The lease transfers ownership of the asset to the lessee by the end of the lease term;
b) 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;
c) The lease term is for the major part of the economic life of the asset even if title is not
transferred;
d) At the inception of the lease the present value of the minimum lease payments amounts
to at least substantially all of the fair value of the leased asset; and
e) The leased assets are of such a specialised nature that only the lessee can use them
without major modifications.

Reason for a replacement standard for IAS 17

In the last two examples we have seen the following:
 Key financial ratios, such as return on capital employed and gearing, indicate a more
favourable position for lessees when recognizing leased assets and associated liabilities
in the statement of financial position compared with non-recognition of such assets and
liabilities (in accordance with the strict legal form).

 The distinction made in IAS 17 between operating leases (where no assets or liabilities
were recognized by the lessee) and finance leases (where they were) was based on
criteria that were inherently subjective (whether or not the ‘risks and rewards of
ownership’ were effectively transferred from the lessor to the lessee). This made the
classification problematic for preparers of financial statements.
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Given the above two factors there was a clear incentive for preparers of lessee’s financial
statements to ‘argue’ that leases should be classified as operating rather than finance in order to
enable lease assets and liabilities to be left out of the financial statements and so improve
performance. In the introduction to IFRS 16 (the replacement standard for IAS 17) the IASB
stated that the significance of the missing information varied by industry and region and
between companies. However, for many companies, the effect on reported assets and financial
leverage was substantial.

For example, it estimated that the long-term liabilities of the heaviest users of off-balance sheet
leases were understated by: 27% in Africa/Middle East; 32% in Asia/Pacific; 26% in Europe;
45% in Latin America and 22% in North America.

Its estimate was based on a sample of 1,022 listed companies reporting under IFRS or US
GAAP. These companies each have estimated off-balance-sheet leases of more than USshs 300
million, calculated on a discounted basis. The percentages represent estimated off-balance sheet
leases (discounted) compared to long-term liabilities reported on the balance sheet, by region.

The absence of information about leases on the balance sheet meant that investors and analysts
did not have a complete picture of the financial position of a company, and were unable to
properly compare companies that borrow to buy assets with those that lease assets, without
making adjustments.

Accordingly, the International Accounting Standards Board (IASB) and the US national
standard-setter, the Financial Accounting Standards Board (FASB), initiated a joint project to
develop a new approach to lease accounting that requires a lessee to recognise assets and liabilities
for the rights and obligations created by leases. This approach will result in a more faithful
representation of a lessee’s assets and liabilities and, together with enhanced disclosures, will
provide greater transparency of a lessee’s financial leverage and capital employed.

The approach taken in IFRS 16 is to define a lease based upon economic substance rather than
legal form. In other words, a contract does not need to be legally established as a lease for the
contract to be regarded as a lease for accounting purposes.

This new standard – IFRS 16 Leases – will be discussed in the sections that follow.

Page 8 of 23
IFRS 16 Leases – the criteria that determine whether it’s a lease

Lease definition in IFRS 16

IFRS 16 defines a lease as ‘A contract, or part of a contract, that conveys the right to use an asset
for a period of time in exchange for consideration’. In order for such a contract to exist,
IFRS 16 states that the customer (user of the ‘identified asset’) needs to have the right to:
 Obtain substantially all of the economic benefits from the use of the asset; and
 The right to direct the use of the asset.

An ‘identified asset’
An essential feature of a lease is that there is an ‘identified asset’. This normally takes place
through the asset being specified in a contract, or part of a contract. For the asset to be
‘identified’ the supplier of the asset must not have the right to substitute the asset throughout
its period of use.

Right to substitute
This ‘right to substitute’ only exists if, at the inception of the contract:
 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.

The fact that the supplier of the asset has the right or the obligation to substitute the asset when
a repair is necessary does not disqualify the asset from being an ‘identified asset’.

The right to obtain economic benefits from use

IFRS 16 states that a customer can potentially obtain economic benefits from the use of an asset
in many ways, including using an asset directly or by sub-leasing the asset. If there is any
restriction on the right of the customer to use the asset, the customer should assess this
condition with reference to the economic benefits obtainable from using the asset within the
defined scope for the use of the asset.

The right to direct the use of the asset

IFRS 16 states that a customer has the right to direct the use of an identified asset if either:
 The customer has the right to direct how and for what purpose the asset is used
throughout its period of use; or
 The relevant decisions about use are pre-determined and the customer has the right to
operate the asset throughout the period of use without the supplier having the right to
change these operating instructions

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EXAMPLE • Based on one of the illustrative examples in IFRS 16

Part (a): The contract terms

A customer (C) enters into a contract with a ship owner (S) for the transportation of cargo from
Rotterdam to Sydney on a specified ship. The ship is explicitly specified in the contract and S
does not have substitution rights. The cargo will occupy substantially all of the capacity of the
ship. The contract specifies the cargo to be transported on the ship and the dates of pickup and
delivery.

S operates and maintains the ship and is responsible for the safe passage of the cargo on board
the ship. C is prohibited from hiring another operator for the ship or operating the ship itself
during the term of the contract.

Question is: Does this contract contain a lease?

Let us consider if it satisfies the criteria:
 There is an identified asset:
 the ship is explicitly specified in the contract, and
 S does not have the right to substitute that specified ship.

 C does have the right to:

 obtain substantially all of the economic benefits from use of the ship over the period of
use. Its cargo will occupy substantially all of the capacity of the ship, thereby preventing
other parties from obtaining economic benefits from use of the ship.

● However, C does not have the right to:

 control the use of the ship because it does not have the right to direct its use; and
 direct how and for what purpose the ship is used.

DECISION: This contract does not contain a lease.

Basis for the decision

 How and for what purpose the ship will be used (i.e. the transportation of specified
cargo from Rotterdam to Sydney within a specified timeframe) is predetermined in the
contract.
 C has no right to change how and for what purpose the ship is used during the period of
use.
 C has no other decision-making rights about the use of the ship during the period of use
(for example, it does not have the right to operate the ship).
 C has only the same rights regarding the use of the ship as if it were one of many
customers transporting cargo on the ship.

Page 10 of 23
Part (b)
C enters into a contract with S for the use of an explicitly specified ship for a five-year period
and S does not have substitution rights. C decides what cargo will be transported, and whether,
when and to which ports the ship will sail, throughout the five-year period of use, subject to
restrictions specified in the contract. Those restrictions prevent C from sailing the ship into
waters at a high risk of piracy or carrying hazardous materials as cargo. S operates and
maintains the ship and is responsible for the safe passage of the cargo on board the ship. C is
prohibited from operating the ship itself during the term of the contract.

Question is: Does this contract contain a lease?

 There is an identified asset:
 the ship is explicitly specified in the contract, and
 S does not have the right to substitute that specified ship.

 C does have the right to:

 obtain substantially all of the economic benefits from use of the ship over the five-year
period of use.

 C does have the right to:

 control the use of the ship throughout the five-year period;
 the exclusive use of the ship throughout the period of use; and
 direct the use of the ship because C directs how and for what purpose the ship is used.

How is the decision affected by the restrictions?

The contractual restrictions about where the ship can sail and the cargo to be transported by the
ship define the scope of C’s right to use the ship. These are protective rights that protect S’s
investment in the ship and S’s personnel and do not give S the right to substitute or determine
how the ship is used.

DECISION: The contract does contain a lease.

Basis for the decision

 C has the right to use the ship for five years.
 Within the scope of its right of use, it is C that:
 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; and

 has the right to change these decisions throughout the five-year period of use.

Page 11 of 23
  Although the operation and maintenance of the ship are essential to its efficient use, S’s
decisions in this regard do not give it the right to direct how and for what purpose the
ship is used. Instead, S’s decisions are dependent upon Cs decisions about how and for
what purpose the ship is used.

LEASES IN THE FINANCIAL STATEMENTS OF LESSEES

Problems with the previous approach

The ‘IAS 17 treatment’ of leased assets in the financial statements of lessees was entirely
dependent on the extremely subjective classification of the lease agreement as operating or
finance. It was entirely possible that two leasing agreements that were essentially the same in
nature were accounted for differently by two entities depending on their respective perception
of the risks and rewards inherent in the arrangement.

IAS 17 was also criticised for possible inconsistencies with the IASB’s Conceptual Framework.
The Framework’s definition of a liability is an obligation to transfer economic benefits as a result
of past events. As operating leases are often non-cancellable there is a strong argument that
operating lease commitments in those circumstances do meet the definition of a liability.
However, no liability was required to be recognised in the lessee’s financial statements.

The IFRS 16 solution to the perceived problems

With a very few exceptions IFRS 16 basically abolishes the distinction between an operating
lease and a finance lease in the books of lessees. Lessees will recognise a right of use asset and
an associated liability at the inception of the lease.

The initial measurement of the asset and liability will be similar to the basis previously used for
finance leases in IAS 17:

IFRS 16 basically requires that the ‘right of use asset’ should initially be measured at the present
value of the minimum lease payments. The discount rate used to determine present value
should be the rate of interest implicit in the lease. This is basically identical to the old IAS 17
approach for finance leases.

However, the ‘right of use asset’ would also include the following amounts, where relevant:
 Any payments made to the lessor at, or before, the commencement date of the lease, less
any lease incentives received.
 Any initial direct costs incurred by the lessee.
 An estimate of any costs to be incurred by the lessee in dismantling and removing the
underlying asset, or restoring the site on which it is located if obligations are recognized
under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Page 12 of 23
  The right of use asset is subsequently depreciated in accordance with IAS 16 Property,
Plant and Equipment (assuming it is a tangible asset).

The lease liability is effectively treated as a financial liability which is measured at amortised
cost, using the rate of interest implicit in the lease as the effective interest rate.

A numerical example (based on one of the IFRS 16 Illustrative examples)

A lessee enters into a 10-year lease of a floor of a building, with an option to extend for a further
five years. Lease payments are shs 50,000 per year during the initial term and shs 55,000 per
year during the optional period, all payable at the beginning of each year.

To obtain the lease, the lessee incurred initial direct costs of shs 20,000 of which shs 15,000
relates to a payment to a former tenant occupying that floor of the building and shs 5,000 relates
to a commission paid to the property agent that arranged the lease. As an incentive to the lessee
for entering into the lease, the lessor agreed to reimburse to the lessee the agent’s commission of
shs 5,000.

At the commencement date the lessee:

 Concluded that it is not reasonably certain to exercise the option to extend the lease and,
therefore, determined that the lease term is 10 years;
 Calculates the interest rate implicit in the lease at 5% per annum;
 Makes the lease payment for the first year, incurs initial direct costs, receives lease
incentives from the lessor;
 Calculates the lease liability to be shs 355,400 being the present value of the remaining
nine payments of shs 50,000, discounted at the interest rate of 5% per annum; and
 Makes the following accounting entries:

DR CR
shs shs

Right of use asset 405,400

Cash (up front rental payment) 50,000
Lease liability (present value of future lease payments 355,400

Right of use asset 20,000

Cash (initial direct costs) 20,000

Cash (lease incentive) 5,000

Right of use asset 5,000

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The carrying amount of the right of use asset after these entries is shs 420,400 (shs 405,400 + shs
20,000 - shs 5,000) and consequently the annual depreciation charge will be shs 42,040 (shs
420,400 × 1/10).

The lease liability will be measured using amortised cost principles. In order to help us with the
example in the following section, we will measure the lease liability up to and including the end
of year 6. This is done in the following table (note that in the case of year 1 the opening liability
includes the up-front payment and so it is shs 405,400 (shs 355,400 + shs 50,000) :

Year Balance b/fwd Rental Balance in period Finance Cost (5%) Balance c/fwd
shs shs shs shs shs
1 405,400 (50,000) 355,400 17,770 373,170
2 373,170 (50,000) 323,170 16,159 339,329
3 339,329 (50,000) 289,329 14,466 303,795
4 303,795 (50,000) 253,795 12,690 266,485
5 266,485 (50,000) 216,485 10,824 227,309
6 227,309 (50,000) 177,309 8,865 186,174

The carrying value of the right of use asset at the end of year 6 will be shs 168,160
(shs 420,400 - 6 × shs 42,040).

The lease liability at the end of year 6 is shs 186,174.

Lease modifications
A lessee should remeasure the lease liability by discounting the revised lease payments using a
revised discount rate, if either:
a) There is a change in the lease term, or
b) There is a change in the assessment of an option to purchase the underlying asset,
assessed considering relevant events and circumstances in the context of a purchase
option.

In both cases, the lessee should:

 Revise its estimate of the present value of the future lease payments using the revised
implicit interest rate;
 Adjust the lease liability; and
 Make a corresponding adjustment to the right of use asset.

The only exception here is if the adjustment would reduce the right of use asset to a negative
carrying amount. In such circumstances, the right of use asset would be reduced to a carrying
amount of nil and any further adjustment would be recognised in profit or loss.
Page 14 of 23
Illustration where option to extend is exercised
Let us continue the example we started above with the addition of the following information at
the end of year 6 of the original lease:
 At the end of year 6 the lessee acquires a new business and requires additional office
space. This creates an incentive for the lessee to exercise its option to extend the lease for
a further five years after the end of the primary lease term at the revised rental of shs
55,000.

The impact of this reassessment is to increase the remaining lease term to nine years (four years
left of the primary lease term plus the five year option term). The revised rate of interest implicit
in the lease is 6% per annum.

Lease liability is remeasured

The lease liability at the end of year 6 will now be the present value of four annual payments in
advance of shs 50,000 plus the present value of five subsequent annual payments in advance of
shs 55,000.

The present value of the four annual payments of shs 50,000 using an annual discount rate of
6% would be shs 183,650 [shs 50,000 + (shs 50,000 × 2.673)].

Similarly, the present value of the five annual payments of shs 55,000 starting in four years,
would be shs 194,495 [shs 55,000 + (shs 55,000 × 3.465) (the present value of four payments of
shs 1 in arrears at an annual discount rate of 6%)] × 0.792 (the present value of shs 1 payable in
four years’ time at an annual discount rate of 6%).

So the total revised lease liability would be remeasured to shs 378,145 (shs 183,650 + shs
194,495).

As the liability at the end of year six was shs 186,174, the increase will be shs 191,971 (shs
378,145 - shs 186,174).

The right of use asset will be increased by the same amount and so will be carried at a revised
amount of shs 360,131 (shs 168,160 + shs 191,971). Assuming an even consumption of economic
benefits future deprecation charges will be on a straight-line basis over a nine-year period and
will be shs 40,015 (shs 360,131 × 1/9)

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The change in the revised lease liability going forward will be as follows:
Year Balance b/fwd Rental Balance in period Finance cost (6%) Balance c/fwd
shs shs shs shs shs
7 378,145 (50,000) 328,145 19,689 347,834
8 347,834 (50,000) 297,834 17,870 315,704
9 315,704 (50,000) 265,704 15,942 281,646
10 281,646 (50,000) 231,646 13,899 245,545
11 245,545 (55,000) 190,545 11,433 201,978
12 201,978 (55,000) 146,978 8,819 155,797
13 155,797 (55,000) 100,797 6,048 106,845
14 106,845 (55,000) 51,845 3,111 54,956
15 54,956 (55,000) (44) 44 Nil
The amount of 44 is a rounding difference.

A simplified approach for short-term or low-value leases

A short-term lease is a lease that, at the date of commencement, has a term of 12 months or less.
Lessees can elect to treat short-term leases by recognising the lease rentals as an expense over
the lease term rather than recognising a ‘right of use asset’ and a lease liability. The election
needs to be made for relevant leased assets on a ‘class-by-class’ basis. For this purpose, a class of
underlying asset is a grouping of underlying assets of a similar nature and use in an entity’s
operations.

This effectively allows lessees to continue to treat short-term leases as they would have treated
operating leases under the old IAS 17 leasing standard. Note that a lease that contains a purchase
option cannot be a short-term lease.

A similar election – on a lease-by-lease basis – can be made in respect of ‘low-value assets’.

The assessment of whether an underlying asset is of low value is performed on an absolute

basis. Leases of low-value assets qualify for the simplified accounting treatment explained
above regardless of whether those leases are material to the lessee. The assessment is not
affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are
expected to reach the same conclusions about whether a particular underlying asset is of low
value.

An underlying asset can be of low value only if:

a) The lessee can benefit from use of the underlying asset on its own or together with other
resources that are readily available to the lessee; and

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 b) The underlying asset is not highly dependent on, or highly interrelated with, other
assets.

A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the
asset is such that, when new, the asset is typically not of low value. For example, leases of cars
would not qualify as leases of low-value assets because a new car would typically not be of low
value.

Examples of low-value underlying assets can include tablet and personal computers, small
items of office furniture and telephones.

LEASES IN THE FINANCIAL STATEMENTS OF LESSORS

Introduction
Accounting for leases in the financial statements of lessors is essentially unchanged from IAS 17
and the distinction between finance and operating leases is still highly relevant. We have
already discussed this distinction.

Finance leases in the books of the lessor

The lessor does not recognise the leased asset as property, plant and equipment but instead
recognises a lease receivable equal to the present value of the minimum lease payments plus
any expected residual value at the end of the lease that is not guaranteed by the lessee (in many
finance leases this latter amount is nil). Given that the discount rate to compute present value is
the rate of interest implicit in the lease this measure captures any initial direct costs incurred by
the lessor.

Example where the lessor purchases the assets that is leased

Assume a lessor has purchased an item of plant for shs 60,000 and leased it to a lessee on a five
year finance lease. Annual lease rentals, payable in arrears, were shs 15,000. The life of the plant
was estimated at five years and there was no estimated residual value at the end of the five year
period. The lessor incurred direct cost of shs 2,000 in arranging the lease.

The rate of interest implicit in the lease is the discount rate that must be applied to the lease
payments to make their present value equal (shs 60,000 + shs 2,000). By trial and error, this
percentage can be computed as approximately 6.7%. The reader may wish to confirm that, at a
discount rate of 6.7%, the present value of five payments of shs 15,000 in arrears is
approximately shs 62,000 (the fair value of the asset plus the initial direct costs of the lessor.
Therefore, assuming the lessor has purchased the asset for leasing on to the lessee, the lessor
makes the following accounting entry:

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 Debit: Net investment in finance leases (shown as a lease receivable)
Credit: Cash shs 62,000 (shs 60,000 + shs 2,000)

Over the five-year lease term the net investment in the finance lease is increased by the finance
lease income (which is taken to profit or loss) and reduced by the lease rentals received, as
shown in the following table:

Year Balance b/fwd Finance income (6.7%) Rental Balance c/fwd

shs shs shs shs
1 62,000 4,154 (15,000) 51,154
2 51,154 3,427 (15,000) 39,581
3 39,581 2,652 (15,000) 27,233
4 27,233 1,825 (15,000) 14,058
5 14,058 942 (15,000) Nil

Example where lessor manufactures the asset that is leased

The above example assumes the asset was purchased by the lessor for leasing on to the lessee.
If the lessor has manufactured the asset then at the inception of the lease the lessor recognizes a
selling profit based on the fair value of the asset at the date of the lease or, if lower, the present
value of the minimum lease payments.

Suppose, in the previous example, that the lessor had manufactured the leased asset at a total
manufacturing cost of shs 48,000. The lessor would make the following accounting entries at the
commencement of the finance lease:

Debit Credit Comment

Net investment 60,000 Recording the ‘sale’ of the asset at the lower
Revenue 60,000 of its fair value (shs 60,000) and the present
value of the minimum lease payments (shs
62,000)

Cost of sales 48,000 Recording a cost of sale of shs 48,000 and

Inventory 48,000 therefore a gross profit of shs 12,000 (shs
60,000 – shs 48,000)

Net investment in 2,000 Recording the initial direct costs of

finance lease establishing the lease as part of the net
Cash 2,000 investment in finance leases

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The remainder of the accounting is as shown in the example above.

Operating leases in the books of the lessor

Where the lease is an operating lease the relevant asset is recorded as property, plant and
equipment by the lessor. Lease rentals are recognised as income over the lease term, normally
on a straight-line basis.

Example
A property company lets out two floors of an office block on a three-year operating lease. The
lessee made an up-front payment of shs 120,000 followed by three annual payments of shs
70,000, payable in arrears.

The property would remain as property, plant and equipment of the lessor. The total lease
rentals of shs 330,000 (shs 120,000 + 3 × shs 70,000) would be recognised as lease income over
the three-year period at an amount of shs 110,000 each year. In year one, the lessor would make
the following accounting entry:

Debit: Cash shs 190,000 (shs 120,000 + shs 70,000)

Credit: Profit or loss shs 110,000
Credit: Deferred income shs 80,000

In each of years two and three the lessor would make the following accounting entry:
Debit: Cash shs 70,000
Debit: Deferred income shs 40,000 (shs 80,000 × 1/2)
Credit: Profit or loss shs 110,000

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SALE AND LEASEBACK TRANSACTIONS
Introduction
The treatment of sale and leaseback transactions depends on whether or not the ‘sale’
constitutes the satisfaction of a relevant performance obligation under IFRS 15 Revenue from
Contracts with Customers. The relevant performance obligation would be the effective ‘transfer’
of the asset to the lessor by the previous owner (now the lessee).

Transaction constituting a sale

If the transaction does constitute a ‘sale’ under IFRS 15 then the treatment is as follows:
 The seller-lessee shall measure the right-of-use asset arising from the leaseback at the
proportion of the previous carrying amount of the asset that relates to the right of use
retained by the seller-lessee. Accordingly, the seller-lessee shall recognise only the
amount of any gain or loss that relates to the rights transferred to the buyer-lessor.
 The buyer-lessor shall account for the purchase of the asset applying applicable
Standards, and for the lease applying the lessor accounting requirements in IFRS 16.

If the fair value of the consideration for the sale of an asset does not equal the fair value of the
asset, or if the payments for the lease are not at market rates, an entity shall make the following
adjustments to measure the sale proceeds at fair value:
 Any below-market terms shall be accounted for as a prepayment of lease payments; and
 Any above-market terms shall be accounted for as additional financing provided by the
buyer-lessor to the seller-lessee.

The entity shall measure any potential adjustment required by the above process on the basis of
the more readily determinable of:
 The difference between the fair value of the consideration for the sale and the fair value
of the asset; and
 The difference between the present value of the contractual payments for the lease and
the present value of payments for the lease at market rates.

A numerical example (based on one of the IFRS 16 Illustrative examples)

Entity A sells a building to entity B for cash of shs 2,000,000. The terms and conditions of the
transaction are such that the transfer of the building by A satisfies the requirements for
determining when a performance obligation is satisfied in IFRS 15 Revenue from Contracts with
Customers, i.e. it can be recognised as a sale.

Accordingly, A and B account for the transaction as a sale and leaseback with A entering into a
contract with B for the right to use the building for 18 years, with annual payments of shs
120,000 payable at the end of each year.

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Immediately before the transaction, the building is carried at a cost of shs 1,000,000 and its fair
value at the date of sale is shs 1,800,000. The amount of the excess sale price of shs 200,000 (shs
2,000,000 - shs 1,800,000) is recognised as additional financing provided by B to A.

Because the consideration for the sale of the building is not at fair value, A and B make
adjustments to measure the sale proceeds at fair value. The annual interest rate implicit in the
lease is 4.5%. The present value of the annual payments (18 payments of shs 120,000, discounted
at 4.5%) amounts to shs 1,459,200. This is made up of the shs 200,000 additional financing and
shs 1,259,200 (shs 1,459,200 - shs 200,000), which relates to the lease (as adjusted for the fair
value difference already identified).

The annual payment that would be required to be made for 18 times in arrears to repay
additional financing of shs 200,000 when the rate of interest is 4.5% per annum would be shs
16,447 (shs 120,000 × shs 200,000/shs 1,459,200). Therefore the residual would be regarded as a
‘lease rental’ at an amount of shs 103,553 (shs 120,000 - shs 16,447).

Given the IFRS 15 treatment as a ‘sale’ B would almost certainly regard the lease of the building
as an operating lease.

Accounting by A
At the commencement date, A measures the right-of-use asset and the gain on sale.

Right of use asset

A measures the right-of-use asset arising from the leaseback of the building at the proportion of
the previous carrying amount of the building that relates to the right of use retained by A. This
is calculated as shs 699,555 (shs 1,000,000 (the carrying amount of the building), shs 1,800,000
(the fair value of the building) × shs 1,259,200 (the discounted lease payments for the 18-year
right-of-use asset).

Gain on sale
A recognises as a gain on sale only the amount that relates to the rights transferred to B. This
gain is shs 240,355 computed as follows:
The overall gain on sale of building (based on fair value since the financing component
is being recognised separately) amounts to shs 800,000 (shs 1,800,000 - shs 1,000,000).

A portion of this ‘gain’ relates to the continued right of A to use the asset and this portion (shs
559,645) is not recognised. It can be computed as follows:

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 [shs 1,259,200 (the present value of the payments for the use of the asset)/
shs 1,800,000 (the fair value of the asset in total)] × shs 800,000 = shs 559,645

This means that of the shs 800,000 gain on sale only shs 240,355 is recognised.

Accounting entries
Overall, on the sale and leaseback A would make the following accounting entry:

Debit: Cash shs 2,000,000

Debit: Right of use asset shs 699,555
Credit: Building shs 1,000,000
Credit: Financial liability shs 1,459,200 (shs 1,259,200 + shs 200,000)
Credit: Gain on rights transferred shs 240,355

Accounting by B
At the commencement date, B accounts for the transaction as follows:

Debit: Building shs 1,800,000 (recognizing the acquired building at fair value)
Debit: Financial asset shs 200,000 (the ‘financing’ element of the transaction)
Credit: Cash shs 2,000,000

Going forward, B will account for the lease by treating shs 103,553 (see above for a derivation of
this figure) of the annual payments of shs 120,000 as lease payments. The remaining shs 16,447
(shs 120,000 - shs 103,553) of annual payments received from A are accounted for as payments
received to settle the financial asset of shs 200,000 and interest revenue. The split is illustrated
below (the first five years only for illustrative purposes):

Year Balance b/fwd Finance income (4.5%) Rental Balance c/fwd

shs shs shs shs
1 200,000 9,000 (16,447) 192,553
2 51,154 3,427 (16,447) 39,581
3 39,581 2,652 (16,447) 27,233
4 27,233 1,825 (16,447) 14,058
5 14,058 942 (16,447) Nil

Transaction not constituting a ‘sale’

In these circumstances the seller does not ‘transfer’ the asset and continues to recognise it. The
‘sales proceeds’ are recognised as a financial liability and accounted for by applying IFRS 9
Financial Instruments. This is similar, but not identical to, the treatment of sale and leasebacks
that resulted in a finance lease under IAS 17. The difference from IAS 17 is that the leased asset

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is not automatically recognised at fair value at the date of ‘sale’, with the ‘profit’ deferred and
recognised over the lease term.

In the same circumstances, the buyer recognises a financial asset equal to the ‘sales proceeds’.
This is identical to the IAS 17 treatment of sale and leasebacks that resulted in a finance lease in
the books of lessors.

An evaluation of the new IFRS 16

The requirements of IFRS 16 will have significant impacts on key accounting ratios of lessees as
the recognition of leased assets and lease liabilities on the statement of financial position will
reduce return on capital employed and increase gearing.

New industry norms will be established and it is too early to say whether the requirements of
IFRS 16 will affect the popularity of leasing. The commercial need for finance still remains, of
course, so in the opinion there is no reason to suppose that the leasing industry will be
adversely affected. It may well be, though, that short-term leases become more popular, given
that they are likely to be treated as currently under IAS 17.

Summary
US Securities and Exchange Commission (SEC) estimated that US public companies may have
approximately US $ 1.25 trillion of off-balance-sheet leases.

Under IAS 17 there were concerns about the lack of transparency of information about lease
obligations and the objective was that a customer (lessee) leasing assets should recognise assets
and liabilities arising from those leases. Although at the start of a lease a lessee obtained the
right to use an asset for a period of time and, if payments are made over time, incurs a liability
to make lease payments, most leasing transactions were not reported on a lessee’s balance sheet.

For many companies, the effect on reported assets and financial leverage was substantial with
some industries such as airlines and retailers significantly affected. The absence of information
about leases on the balance sheet meant that investors and analysts were not able to properly
compare companies that borrow to buy assets with those that lease assets, without making
adjustments. IFRS 16 is expected to change the balance sheet, income statement and cash flow
statement for companies with material off-balance-sheet leases.
Applying IFRS 16, a company is required for all leases, except leases of low-value assets, to:
a) Recognise lease assets and lease liabilities in the balance sheet, initially measured at the
present value of unavoidable future lease payments;
b) Recognise depreciation of lease assets and interest on lease liabilities in the income
statement over the lease term; and
c) Separate the total amount of cash paid into a principal portion (presented within
financing activities) and interest (typically presented within either operating or
financing activities) in the cash flow statement.

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