Ifrs 16 Pak

Certified Finance and Accounting Professional
CHAPTER
Advanced accounting and financial reporting
11
IFRS 16: Leases
Contents
1 Introduction and definitions
2 Lease classification
3 Accounting for lease by Lessee
4 Accounting for a finance lease: Lessor accounting
5 Accounting for an operating lease
6 Sale and leaseback transactions
7 Impact on presentation
© Emile Woolf International 235 The Institute of Chartered Accountants of Pakistan

INTRODUCTION
Objective
To develop an in-depth understanding of, and the ability to apply the requirements of
international pronouncements, the Companies Ordinance, 1984, and other applicable
regulatory requirements in respect of financial reporting and the presentation of financial
statements.
Learning outcomes
LO 1 Prepare financial statements in accordance with the
international pronouncements and under the Companies
Ordinance, 1984.
LO 2 Evaluate and analyse financial data in order to arrive at firm
decisions on the accounting treatment and reporting of the
same.
FINANCIAL REPORTING AND ETHICS
Financial reporting
B (a) 18 IFRS 16: Leases

Chapter 11: IFRS 16: Leases
1 INTRODUCTION AND DEFINITIONS
Section overview
Introduction
Leases
Types of lessor
Inception and commencement
Defined periods
Residual values
Lease payments
Interest rate implicit in the lease
Initial direct costs
Lessee's incremental borrowing rate of interest
1.1 Introduction
The previous accounting model for leases as per IAS 17 required lessees and
lessors to classify their leases as either finance leases or operating leases and
account for those two types of leases differently. That model was criticised for
failing to meet the needs of users of financial statements because it did not
always provide a faithful representation of leasing transactions. In particular, it did
not require lessees to recognise assets and liabilities arising from operating
leases.
IFRS 16 introduces a single lessee accounting model and requires a lessee to
recognise assets and liabilities for all leases with a term of more than 12 months,
unless the underlying asset is of low value. A lessee is required to recognise a
right-of-use asset representing its right to use the underlying leased asset and a
lease liability representing its obligation to make lease payments.
1.2 Leases
IFRS 16 prescribes the accounting treatment of leased assets in the financial
statements of lessees and lessors.
Definition: Lease
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.
A lease is a way of obtaining a use of an asset, such as a machine, without

purchasing it outright. The company that owns the asset (the lessor) allows
another party (the lessee) to use the asset for a specified period of time in return
for a series of rental payments.
Types of lease
IFRS 16 identifies two types of lease.
Definitions
A lease that transfers substantially all the risks and rewards incidental to
ownership of an underlying asset is known as finance lease.

A lease that does not transfer substantially all the risks and rewards incidental to
ownership of an underlying asset is known as operating lease.
The identification of a lease as a finance lease or an operating lease is crucial as

it determines how a lease is accounted for by the lessor.
This is explained in more detail in later sections.
1.3 Types of lessors

Companies might be lessors as a result of a variety of business models.
Finance companies (often banks and their subsidiaries)
Finance companies provide finance for the purchase of assets. In addition they
might finance the use of assets through leases.
Finance companies are often associated with finance leases but they also fund
large operating leases. Many airlines have use of aircraft through operating
leases through finance companies.
Hire companies
These companies own a stock of capital assets which they will lease out for
varying periods.
They include:
tool hire companies;
plant hire companies; and
car hire companies
Hire companies are usually involved in operating leases.
Manufacturer/dealer lessors
Some companies make or buy assets to sell. They may offer to lease the asset
out as an alternative to outright sale.
Many motor vehicle manufacturers and dealers do this. Such leases would
usually be finance leases (but not necessarily).
Property companies
Many companies own properties which they lease out to others. These
companies might apply IAS 40: Investment Properties to these assets.
1.4 Inception and commencement
Definitions: Inception date of the lease

The earlier of the date of a lease agreement and the date of commitment by the
parties to the principal terms and conditions of the lease.
The type of lease in a contract (finance or operating) is identified at the date of

inception. This is where the parties to the lease contract commit to the terms of
the contract.
Definition: Commencement date of the lease

The date on which a lessor makes an underlying asset available for use by a
lessee.

The accounting treatment required is applied to a lease at the date of

commencement. This is the date that a lessee starts to use the asset or, at least,
is entitled to start to use the asset.
A lease agreement may allow for an adjustment to the terms of the lease contract
during the period between the inception of the lease and the commencement of
the lease term. Such adjustments might be to take account of unexpected
changes in costs (for example the lessor’s costs of making the asset that is the
subject of the lease).
In such cases, the effect of any such changes is deemed to have taken place at
the inception of the lease.
1.5 Defined periods

IFRS 16 refers to different periods when describing its rules.
Definition: Lease term

The non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably
certain not to exercise that option.
A lease may be split into a primary period followed by an option to extend the
lease for a further period (a secondary period).
In some cases, the lessee might be able to exercise such an option with a small
rental or even for no rental at all. If such an option exists and it is reasonably
certain that the lessee will exercise the option, the second period is part of the
lease term.
Definitions: Economic and useful life

Economic life is either:
(a) the period over which an asset is expected to be economically usable by one
or more users; or
(b) the number of production or similar units expected to be obtained from the
asset by one or more users.
Useful life is the period over which an asset is expected to be available for use by
an entity; or the number of production or similar units expected to be obtained
from an asset by an entity.
Economic life relates to the life of the asset whereas useful life relates to the
period that a party will obtain benefits from that asset.
1.6 Residual values

When a company that owns an asset leases it to another party they have two
interests in that asset:
It gives them a right to receive a series of rentals over the lease
term; and
They own the asset at the end of the lease.

The value of the asset at the end of the lease is called its residual value. This
figure might be guaranteed by the lessee. This means that if the asset is not
worth the amount guaranteed, the lessee must pay the lessor the shortfall.
On the other hand, the residual value might not be guaranteed.
Definition: Unguaranteed residual value and residual value guarantee

Unguaranteed residual value is that portion of the residual value of the underlying
asset, the realisation of which by the lessor is not assured or is guaranteed solely
by a party related to the lessor.
Residual value guarantee is a guarantee made to a lessor by a party unrelated to
the lessor that the value (or part of the value) of an underlying asset at the end of
a lease will be at least a specified amount.
1.7 Lease payments

In essence, the term lease payments refers to the payments that a lessee
expects to make over a lease term or to the receipts that a lessor expects over
the economic life of the asset.
In a straight forward example the lease payments that a lessee expects to make
and a lessor expects to receive are same. However, this is not always the case.
The definition of lease payments takes that into account.
Definition: Lease payments

Payments made by a lessee to a lessor relating to the right to use an underlying
asset during the lease term, comprising the following:
(a) fixed payments (including in-substance fixed payments), less any lease
incentives;
(b) variable lease payments that depend on an index or a rate;
(c) the exercise price of a purchase option if the lessee is reasonably certain to
exercise that option; and
(d) payments of penalties for terminating the lease, if the lease term reflects
the lessee exercising an option to terminate the lease.
1.8 Interest rate implicit in the lease
Definition: Interest rate implicit in the lease

The interest rate implicit in the lease is the interest rate that causes the present
value of (a) the lease payments and (b) the unguaranteed residual value to be
equal to the sum of (i) the fair value of the underlying asset and (ii) any initial
direct costs of the lessor.
The interest rate implicit in the lease is the IRR of the cash flows from the lessor’s
viewpoint. It is the rate that equates the future cash inflows for the lessor to the
amount that the lessor invested in the asset.

Example:: Interest rate implicit in the lease

A finance company has purchased an asset for Rs. 50,000 and will lease it out in
a series of leases as follows:
The first lease is to Company A for a period of 5 years at an annual rental of Rs.
10,000.
After the end of the lease to Company A the asset will be leased to Company B for
1 year at a rental of Rs. 10,000. Company B is a party related to Company A.
After the end of the lease to Company B the asset will be leased to Company C for
1 year at a rental of Rs. 10,000. Company C is not related to Companies A and B.
At the end of this lease the asset is expected to have an unguaranteed residual
value of Rs. 2,573.
The interest rate implicit in the lease is 10%.
Proof
Time Narrative Lessor’s cash Discount Present
flows factor (10%) value
0 Fair value of the asset (50,000) 1 (50,000)
1 to 7 Lessor’s MLPs 10,000 4.868 48,680
Unguaranteed
7 residual value 2,573 0.513 1,320
50,000
nil
The interest rate implicit in the lease (its IRR) was given in the above example. In
an exam question you might have to calculate it in the usual way.
1.9 Initial direct costs
The definition of interest rate implicit in the lease makes reference to incremental
initial direct costs.
Definition: Initial direct costs
Initial direct costs are incremental costs for obtaining a lease that would not have
been incurred if the lease had not been obtained, except for such costs incurred by
a manufacturer or dealer lessor in connection with a finance lease.
The accounting treatment for initial direct costs will be explained later.
1.10 Lessee's incremental borrowing rate of interest
The interest rate implicit in the lease might be important in deciding whether a
lease is a finance lease or an operating lease.
It is calculated from the lessor’s viewpoint. Sometimes, the lessee might not be
able to ascertain the interest rate implicit in the lease. In that case, it would use
the lessee’s incremental borrowing cost instead.
Definition: Lessee's incremental borrowing rate of interest
The lessee's incremental borrowing rate of interest is the rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the right-of-
use asset in a similar economic environment.
Further definitions important to finance lessor accounting will be provided in that

section.

2 LEASE CLASSIFICATION
Section overview
Finance leases and operating leases

Identifying a finance lease
Commentary on finance lease indicators
2.1 Finance leases and operating leases

IFRS 16 describes two types of lease (with each type being accounted for in a
different way):
finance leases and
operating leases
A lessor shall classify each of its leases as either an operating lease or a finance
lease.
A lease is classified as a finance lease if it transfers substantially all the risks and
rewards incidental to ownership. A lease is classified as an operating lease if it
does not transfer substantially all the risks and rewards incidental to ownership.
Risks may be represented by the possibility of losses from:
idle capacity;
technological obsolescence;
variations in return caused by changes in economic conditions.
Rewards may be represented by the expectation of;
profitable use of the asset over its economic life;
gains from increases in value or profits on disposal.
Substance over form
Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than the form of the contract.
The legal form of a finance lease is that the lessor is the legal owner of the
underlying asset.
The economic substance of a finance lease is that the lessee has all the benefits
and costs associated with ownership of the asset. The finance lessee is in the
same position as it would have been if it had borrowed money to buy the asset
itself. That is why such leases are called finance leases; they provide finance for
the use of an asset.
Example – Substantive substitution right

ABC Ltd enters into a 5 year contract with a freight carrier (XYZ Ltd.) to transport a
specified quantity of goods. XYZ Ltd. uses rail cars of a particular specification,
and has a large pool of similar rail cars that can be used to fulfil the requirements
of the contract. The rail cars and engines are stored at XYZ Ltd. premises when
they are not being used to transport goods. Costs associated with substituting the
rail cars are minimal for XYZ Ltd.

In this case, because the rail cars are stored at XYZ Ltd. premises, it has a large
pool of similar rail cars and substitution costs are minimal, the benefits to XYZ
Ltd. of substituting the rail cars would exceed the costs of substituting the cars.
Therefore, XYZ Ltd. substitution rights are substantive and the arrangement does
not contain a lease.
2.2 Identifying a finance lease

At inception of a contract, an entity shall assess whether the contract is, or
contains, a lease. A contract is, or contains, a lease if the contract conveys the
right to control the use of an identified asset for a period of time in exchange for
consideration.
Examples of situations that individually or in combination would normally lead to a
lease being classified as a finance lease are:
(a) the lease transfers ownership of the underlying asset to the lessee by the
end of the lease term;
(b) the lessee has the option to purchase the underlying 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 date,
that the option will be exercised;
(c) the lease term is for the major part of the economic life of the underlying
asset even if title is not transferred;
(d) at the inception date, the present value of the lease payments amounts to at
least substantially all of the fair value of the underlying asset; and
(e) the underlying asset is of such a specialised nature that only the lessee can
use it without major modifications.
Indicators of situations that individually or in combination could also lead to a
lease being classified as a finance lease are:
(a) if the lessee can cancel the lease, the lessor’s losses associated with the
cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to
the lessee (for example, in the form of a rent rebate equaling most of the
sales proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a
rent that is substantially lower than market rent.
In all these situations, it can normally be concluded that substantially all the risks
and rewards incidental to ownership are transferred to the lessee.
These indicators are not always conclusive. Classification should always be
based on the substance of the agreement taking account of all information.
Leases are classified at the inception of the lease. Sometimes, a lessee and
lessor agree to change the provisions of a lease and the changes might be of a
sort that would have changed the lease classification if the new terms had been in

effect at the inception of the lease. In these cases, the revised agreement is
regarded as a new agreement over its term.
However, changes in estimates (for example, changes in estimates of the
economic life or of the residual value of the leased property), or changes in
circumstances (for example, default by the lessee), do not give rise to a new
classification of a lease for accounting purposes.
The following flowchart may assist entities in making the assessment of whether a
contract is, or contains, a lease.

2.3 Commentary on finance lease indicators

It is not always obvious why the above circumstances indicate that a lease is a
finance lease. This section provides an explanation on some of these.
To understand these, it is useful to think of the terms from the lessor’s viewpoint.
Purchase option
If a lease includes a term whereby the lessee can buy the underlying asset at a
bargain price at the end of the lease that lease is a finance lease.
If the lessor includes this term in the lease, the lessor would expect the lessee to
take advantage of it. Therefore, the lessor knows that it needs to make sure to
recover the cost of the asset together with any related interest during the lease
term. The rentals and final sale price are set at a level which allows it to do this.
If the lease transfers ownership of the underlying asset to the lessee by the end
of the lease term or if the cost of the right-of-use asset reflects that the lessee will
exercise a purchase option, the lessee shall depreciate the right-of-use asset
from the commencement date to the end of the useful life of the underlying asset.
Therefore, the lessee will pay the full cash price of the asset together with related
finance expense over the lease term.
The lessee would only do this if it had access to the risks and benefits of
ownership
In substance, this is just like borrowing the cash and buying the asset
Therefore, the lease is a finance lease.
If there is a change in the assessment of an option to purchase the underlying
asset, a lessee shall determine the revised lease payments to reflect the change
in amounts payable under the purchase option.
Lease is for a major part of the expected economic life of the asset
If the lessor includes this term in the lease, the lessor knows that when the asset
is given back to it at the end of the lease, the asset will only have a small value.
Therefore, the lessor knows that it needs to make sure to recover the cost of the
asset together with any related interest during the lease term. The rentals are set
at a level which allows it to do this.
ownership
In substance, this is just like borrowing the cash and buying the asset
Specialised nature of the asset
If the lessor includes this term in the lease, the lessor knows that when the lease
comes to an end, it will be unable to lease the asset on to another party.
Therefore, the lessor knows that it needs to make sure to recover the cost of the
asset together with any related interest during the lease term. The rentals are set
at a level which allows it to do this.

ownership.
In substance, this is just like borrowing the cash and buying the asset.
PV of future lease payments amounts to substantially all of the fair value of the
underlying asset
A lease is a finance lease if at the inception of the lease, the present value of all
the future lease payments amounts to substantially all of the fair value of the
underlying asset, or more. (The discount rate to be used in calculating the
present value of the lease payments is the interest rate implicit in the lease).
In this case, the lessee is paying the full cash price of the asset together with
related finance expense over the lease term.
Example: PV of future lease payments

A finance company has purchased an asset to lease out to a manufacturing
company.
The asset cost for Rs. 500,000 and has an economic life of 10 years.
The lease is for 9 years at an annual rental (in arrears) of Rs. 87,000 per annum.
Analysis: Lessor’s view
Discount Present
Time Narrative Cash flows factor (10%) value
1 to 9 Lessor’s LPs 87,000 5.759 501,033
This is more than the fair value of the asset. This lease is a finance lease
(also note that the lease is for the major part of the expected economic
life of the asset which is another finance lease indicator).
Discount Present
1 to 9 Lessee’s LPs 87,000 5.759 501,033
This is more than the fair value of the asset. This lease is a finance lease
(also note that the lease is for the major part of the expected economic
life of the asset which is another finance lease indicator).
In the above example the lessee and the lessor have the same view of the lease.
This is not necessarily the case.

Example: PV of future lease payments

A finance company has purchased an asset for Rs. 50,000 and will lease it out in a
series of leases as follows:
The first lease is to Company A for a period of 4 years at an annual rental of Rs.
10,000.
After the end of the lease to Company A the asset will be leased to Company B for
3 years at a rental of Rs. 10,000. Company B is not related to Company A.
At the end of this lease the asset is expected to have an unguaranteed residual
value of Rs. 2,573.
The Interest rate implicit in the lease is 10%.
Analysis: Lessor’s view

Discount Present
1 to 7 Lessor’s MLPs 10,000 4.868 48,680
This is 97.4% (48,680/50,000 u 100) of the fair value of the asset.
Most would agree that this was substantially all of the fair value of the
asset (though IFRS 16 does not give a numerical benchmark).
This lease is a finance lease.
Discount Present
1 to 4 Lessor’s MLPs 10,000 3.170 31,700
This is 63.4% (31,700/50,000 u 100) of the fair value of the asset.
Most would agree that this is not substantially all of the fair value of the
asset (though IFRS 16 does not give a numerical benchmark).
This lease is an operating lease.
Practice question 1
Jhang Construction has leased a cement lorry.
The cash price of the lorry would be Rs. 3,000,000.
The lease is for 6 years at an annual rental (in arrears) of Rs. 600,000. The
asset is believed to have an economic life of 7 years.
Jhang Construction is responsible for maintaining and insuring the asset.
Required
State with reasons the kind of lease Jhang has entered into.

3 ACCOUNTING FOR LEASE BY LESSEE
Section overview
Substance over form

Lease accounting: Initial recognition
Lease accounting: Subsequent measurement of the asset
Lease accounting: Subsequent measurement of the liability
Calculating and allocating finance charges (interest)
Current and non-current elements of the finance lease liability
Lease payments made in advance
Disclosure
3.1 Substance over form

An earlier section explained that whether a lease is a finance lease or an
operating lease depends on the substance of the contract rather than its form.
The economic substance of a finance lease is that the lessee in effect has all the
benefits and costs associated with ownership of the asset. In substance it is as if
the lessee borrowed money to buy the asset.
Similarly, the lessor no longer has the benefits and costs associated with
ownership. The lessor should not account for the asset in its books. In substance,
the lessor has lent money to another party to enable them to buy the asset. The
lessor accounts for a receivable in its books being the right to receive a future
flow of rentals.
3.2 Lease accounting: Initial recognition

A lease is capitalised at the commencement of the lease term. This involves the
recognition of the asset that is subject to the lease and a liability for the future
lease payments.
At the commencement date, a lessee should recognise a right-of-use asset and a
lease liability. It is the date on which a lessor makes an underlying asset available
for use by a lessee.
At the commencement date, a lessee should measure the right-of-use asset at
cost.
The cost of the right-of-use asset should comprise:
(a) the amount of the initial measurement of the lease liability;
(b) any lease payments made at or before the commencement date, less any
lease incentives received;
(c) any initial direct costs incurred by the lessee;
(d) an estimate of costs to be incurred by the lessee in dismantling and
removing the underlying asset, restoring the site on which it is located or
restoring the underlying asset to the condition required by the terms and
conditions of the lease, unless those costs are incurred to produce
inventories.

At the commencement date, a lessee shall measure the lease liability at the
present value of the lease payments that are not paid at that date. The lease
payments shall be discounted using the interest rate implicit in the lease, if that
rate can be readily determined. If that rate cannot be readily determined, the
lessee shall use the lessee’s incremental borrowing rate.
Lease liability + Initial direct costs + Prepaid lease payments + Estimated costs to
dismantle, remove or restore, measured - Lease incentives received = Right-of-
use asset
Illustration: Double entry on initial recognition of a lease

(Assumes that the leased asset is an item of property, plant and equipment)
Debit Credit
Property, plant and equipment – (at cost) X
Liabilities: lease obligations X
Initial direct costs are often incurred in connection with specific leasing activities,
such as negotiating and securing leasing arrangements.
Any initial direct costs of the lessee are added to the amount recognised as an
asset.
Typical initial direct costs of a lessee includes;
– Commissions
– Legal fees*
– Costs of negotiating lease terms and conditions*
– Costs of arranging collateral
– Payments made to existing tenants to obtain the lease
* If they are contingent on origination of the lease
Illustration:
Debit Credit
Property, plant and equipment – (at cost) X
Cash/bank X
Example:
Jhang Construction enters into a 6 year lease of a machine on 1 January Year 1.
The fair value of the machine at the commencement of the lease was Rs. 80,000
and Jhang Construction incurred initial direct costs of Rs. 2,000 when arranging
the lease.
Double entry:
Debit Credit
Property, plant and machinery – (at cost) 80,000
Liabilities: lease obligations 80,000
Property, plant and machinery – (at cost) 2,000
Cash/bank 2,000

Recognition exemptions
A lessee may elect not to apply the requirements to recognise and measurment
the right-of-use the leased asset and liability to:
(a) short-term leases; and
(b) leases for which the underlying asset is of low value
Short-term lease
A lease that, at the commencement date, has a lease term of 12 months or less.
A lease that contains a purchase option is not a short-term lease.
Example - Applying the short term lease exemption

Lessee ABC enters into a 8-year lease of a machine to be used in manufacturing
parts for a plane that it expects to remain popular with consumers until it
completes development and testing of an improved model. The cost to install the
machine in DEF manufacturing facility is not significant. ABC and DEF each have
the right to terminate the lease without a penalty on each anniversary of the lease
commencement date.
The lease term consists of a one-year non-cancellable period because both ABC
and DEF have a substantive termination right
ABC and DEF have a substantive termination right
– both can terminate the lease without penalty
– and the cost to install the machine in DEF manufacturing facility is not
significant.
As a result, the lease qualifies for the short-term lease exemption.
Example – Applying the leases of low value exemption
Lessee A is in the pharmaceutical manufacturing and distribution industry and has
the following leases:
– leases of real estate: both office building and warehouse;
– leases of office furniture;
– leases of company cars, both for sales personnel and for senior management
and of varying quality, specification and value;
– leases of trucks and vans used for delivery; and
– leases of IT equipment such as laptops.
A determines that the leases of office furniture and laptops qualify for the
recognition exemption on the basis that the underlying assets, when they are new,
are individually of low value. B elects to apply the exemption to these leases.
As a result, it applies the recognition and measurement requirements in IFRS 16 to
its leases of real estate, company cars, trucks and vans.

3.3 Lease accounting: Subsequent measurement of the asset

After the commencement date, a lessee should measure the right-of-use asset
applying a cost model, unless it applies either of the measurement models
described below
Cost model
To apply a cost model, a lessee should measure the right-of-use asset at cost:
(a) less any accumulated depreciation and any accumulated impairment losses;
and
(b) adjusted for any re-measurement of the lease liability.
A lessee should apply the depreciation requirements in IAS 16 Property, Plant
and Equipment in depreciating the right-of-use asset
If the lease transfers ownership of the underlying asset to the lessee by the end
of the lease term or if the cost of the right-of-use asset reflects that the lessee will
exercise a purchase option, the lessee should depreciate the right-of-use asset
from the commencement date to the end of the useful life of the underlying asset.
Otherwise, the lessee should depreciate the right-of-use asset from the
commencement date to the earlier of the end of the useful life of the right-of-use
asset or the end of the lease term.
Other measurement models
If a lessee applies the fair value model in IAS 40 Investment Property to its
investment property, the lessee shall also apply that fair value model to right-of
use assets that meet the definition of investment property in IAS 40.
If right-of-use assets relate to a class of property, plant and equipment to which
the lessee applies the revaluation model in IAS 16, a lessee may elect to apply
that revaluation model to all of the right-of-use assets that relate to that class of
property, plant and equipment.
Illustration:
Debit Credit
Statement of comprehensive income (depreciation
expense) X
Accumulated depreciation X
Example:
the lease.
The estimated residual value of the asset at the end of the lease is Rs. 8,000.
The estimated useful life of the asset is 5 years.
The accounting policy for similar owned machines is to depreciate them over their
useful life on a straight line basis.

Annual depreciation charge:

Initial cost: Rs.
Fair value of the machine 80,000
Initial direct costs 2,000
82,000
Residual value (8,000)
Depreciable amount 74,000
Useful life (shorter of the lease term and the useful life) 5 years
Annual depreciation charge 14,800
The underlying asset is included in the statement of financial position at its

carrying amount (cost less accumulated depreciation less any accumulated
impairment loss (if any)) in the same way as similar assets.
Example:
Year 1 Year 2 Year 3 Year 4 Year 5

Rs.. Rs. Rs. Rs. Rs.
Cost 82,000 82,000 82,000 82,000 82,000
Accumulated
depreciation:
Brought forward nil 14,800 29,600 44,400 59,200
Charge for the
year 14,800 14,800 14,800 14,800 14,800
Carried forward 14,800 29,600 44,400 59,200 74,000
Carrying amount 67,200 52,400 37,600 22,800 8,000
The asset is depreciated down to a carrying amount at the end of the asset’s
useful life that is the estimated residual value
3.4 Lease accounting: Subsequent measurement of the liability

After the commencement date, a lessee should measure the lease liability by:
(a) increasing the carrying amount to reflect interest on the lease liability;
(b) reducing the carrying amount to reflect the lease payments made; and
(c) re-measuring the carrying amount to reflect any reassessment or lease
modifications
After initial recognition, the lease liability is measured at amortised cost using the
effective interest method.

After the commencement date, a lessee should recognise in profit or loss, unless
the costs are included in the carrying amount of another asset applying other
applicable Standards, both:
(a) interest on the lease liability; and
(b) variable lease payments not included in the measurement of the lease liability
in the period in which the event or condition that triggers those payments
occurs.
Reassessment of the lease liability
After the commencement date, a lessee should re-measure the lease liability by
using either unchanged discount rate or should re-measure the lease liability by
discounting the revised discount rate to reflect changes to the lease payments. A
lessee should recognise the amount of the re-measurement of the lease liability
as an adjustment to the right-of-use asset.
However, if the carrying amount of the right-of-use asset is reduced to zero and
there is a further reduction in the measurement of the lease liability, a lessee
should recognise any remaining amount of the re-measurement in profit or loss.
During each year, the lessee makes one or more lease payments. The payment
is recorded in the ledger account as follows.
Illustration:
Debit Credit
Cash/bank X
A lease liability is measured in the same way as any other liability. The balance at
any point in time is as follows:
Illustration:
Rs.
Amount borrowed at the start of the lease (the amount X
recognised on initial recognition of the lease)
Plus: Interest accrued X
Minus: Repayments (lease payments or rentals) (X)
Repayment of loan principal (X)
Amount owed now. X
In effect, each lease payment consists of two elements:

a finance charge (interest charge) on the liability to the lessor, and
a partial repayment of the liability (the lease obligation).
The finance charge is treated as a finance cost in profit or loss for the period. The
partial repayment of the lease obligation reduces the amount of the liability that
remains unpaid.

A lessee shall re-measure 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. A lessee shall determine the revised
lease payments on the basis of the revised lease term; or
(b) there is a change in the assessment of an option to purchase the
underlying asset, assessed considering the events and circumstances in
the context of a purchase option. A lessee shall determine the revised
lease payments to reflect the change in amounts payable under the
purchase option.
Finance charge
The total rental payments over the life of the lease will be more than the amount
initially recognised as a liability. The difference is finance charge.
The total finance charge that arises over the life term is the difference between
the amount initially recognised as the lease liability and the sum of the lease
payments from the standpoint of the lessee.
Illustration: Total finance charge

Rs.
Lessee’s lease payments (sum of all payments made by the
lessee to the lessor) X
Amount on initial recognition (X)
Total finance charge X
Example: Total finance charge

the lease.
The annual lease payments are Rs. 18,000, payable at the end of each year.
The estimated residual value of the asset at the end of the lease is Rs. 8,000 and
Jhang Construction has guaranteed this amount.
The interest rate implicit in the lease is 11.176751%.
Total finance charge
Lessee’s lease payments: Rs.
Annual rentals (6 u 18,000) 108,000
Guaranteed residual value 8,000
116,000
Amount on initial recognition (80,000)*
Total finance charge (interest) 36,000
* This is the amount of the liability, The asset is recognised at Rs. 82,000

The finance charge (interest) is recognised over the life of the lease by adding a
periodic charge to the liability for the lease obligation with the other side of the
entry as an expense in profit or loss for the year.
Illustration: Debit Credit

Statement of comprehensive income: interest
expense X
Lease modification
Definition: Lease modification

A change in the scope of a lease, or the consideration for a lease, that was not
part of the original terms and conditions of the lease (for example, adding or
terminating the right to use one or more underlying assets, or extending or
shortening the contractual lease term).
A lessee should account for a lease modification 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 stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
For a lease modification that is not accounted for as a separate lease, at the
effective date of the lease modification a lessee should:
(a) allocate the consideration in the modified contract. Following is the guidance
for allocating the consideration received;
i. For a contract that contains a lease component and one or more
additional lease or non-lease components, a lessee should allocate the
consideration in the contract to each lease component on the basis of the
relative stand-alone price of the lease component and the aggregate
stand-alone price of the non-lease components.
ii. The relative stand-alone price of lease and non-lease components should
be determined on the basis of the price the lessor, or a similar supplier,
would charge an entity for that component, or a similar component,
separately. If an observable stand-alone price is not readily available, the
lessee should estimate the stand-alone price, maximising the use of
observable information.
However, as a practical expedient, a lessee may elect, by class of
underlying asset, not to separate non-lease components from lease
components, and instead account for each lease component and any
associated non-lease components as a single lease component.
(b) determine the lease term of the modified lease; and

(c) remeasure the lease liability by discounting the revised lease payments using
a revised discount rate. The revised discount rate is determined as the
interest rate implicit in the lease for the remainder of the lease term, if that
rate can be readily determined, or the lessee’s incremental borrowing rate at
the effective date of the modification, if the interest rate implicit in the lease
cannot be readily determined.
For a lease modification that is not accounted for as a separate lease, the lessee
should account for the re-measurement of the lease liability by:
(a) decreasing the carrying amount of the right-of-use asset to reflect the partial
or full termination of the lease for lease modifications that decrease the scope
of the lease. The lessee should recognise in profit or loss any gain or loss
relating to the partial or full termination of the lease.
(b) making a corresponding adjustment to the right-of-use asset for all other
lease modifications.
Lease term
An entity should determine the lease term as the non-cancellable period of a
lease, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option.
(c) re-measure the lease liability by discounting the revised lease payments
using a revised discount rate. The revised discount rate is determined as the
interest rate implicit in the lease for the remainder of the lease term, if that
rate can be readily determined, or the lessee’s incremental borrowing rate at
the effective date of the modification, if the interest rate implicit in the lease
cannot be readily determined.
3.5 Calculating and allocating finance charges (interest)

The total finance charge for a leased asset is allocated “so as to provide a
constant rate of charge on the outstanding obligation”.
This means that as the lease liability decreases at each year-end, the interest
charge for the next year will be lower than it was for the previous year.
The method implied by the IFRS 16 guidance is to use an interest rate to allocate
the interest. This method is called the actuarial method. (The sum of digits
method usually gives an acceptable approximation to the actuarial method).
Questions in your exam are likely to require the use of an interest rate (which you
may have to calculate as the interest rate implicit in the lease).
Actuarial method
The actuarial method uses discounting arithmetic to establish the interest rate
that is implicit in the lease. This interest rate is then applied to the opening
balance of the lease liability at the start of each period, in order to calculate the
finance charge.

Example: Allocation of the finance charge

the lease.
The annual lease payments are Rs. 18,000, payable at the end of each year.
Lease liability:
Opening Interest Lease Closing

Year liability (11.176751%) payments liability
1 80,000 8,941 (18,000) 70,941
2 70,941 7,929 (18,000) 60,870
3 60,870 6,803 (18,000) 49,674
4 49,674 5,552 (18,000) 37,226
5 37,226 4,161 (18,000) 23,386
6 23,386 2,614 (26,000) 0
36,000
The interest expense is calculated by multiplying the opening liability by
11.176751% in each year (so as to provide a constant rate of charge on the
outstanding obligation).
The lease obligation consists of the capital balance outstanding. This can be
shown as follows:
Example:
Lease liability:
Opening Lease Capital Closing

Year balance payments Interest repayments balance
1 80,000 (18,000) 8,941 (9,059) 70,941
2 70,941 (18,000) 7,929 (10,071) 60,870
3 60,870 (18,000) 6,803 (11,197) 49,674
4 49,674 (18,000) 5,552 (12,448) 37,226
5 37,226 (18,000) 4,161 (13,839) 23,386
6 23,386 (26,000) 2,614 (23,386) 0

The final payment

In the above example the final payment by the lessee is Rs. 26,000. This is in fact
made up of two amounts, the final rental of Rs. 18,000 and the guaranteed
residual value of Rs. 8,000.
It is worth considering the payment in respect of the guaranteed residual value in
a little more detail.
At the end of the lease, the asset that is the subject of the lease is transferred
back to the lessor. It has been depreciated down to its estimated residual value of
Rs. 8,000.
The transfer is recorded as follows:
Example: Final payment in respect of the guaranteed residual value

Debit Credit
Leased Asset 8,000
In other words, the Rs. 8,000 part of the final year payment to the lessor of Rs.
26,000 is not cash but the transfer of the asset.
If the asset is worth less that Rs. 8,000 the lessee must make good any shortfall.
In this case the asset is written down to its value at the date of the transfer (as
agreed between the lessee and the lessor) and the lessee will pay cash to the
lessor to compensate for any difference.
Example (continued): Final payment in respect of the guaranteed residual value

The asset has a carrying amount of Rs. 8,000 at the end of the lease but is only
worth Rs. 5,000.
The lessee would make the following double entries.
Write down the asset Debit Credit
Statement of comprehensive income 3,000
Leased Asset 3,000
Pay the lessor the guaranteed residual value
Leased Asset 5,000
Cash/bank 3,000
Example:
A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are
to pay:
x A non-refundable deposit of Rs. 5,800 on inception.
x Six annual instalments of Rs. 16,000 payable in arrears.
The fair value of the asset (equivalent to the present value of minimum lease
payments) on 1 January 20X1 is Rs. 80,000. Its useful life to the company is five
years.

As part of the lease agreement the company guaranteed to the lessor that the asset
could be sold for Rs. 8,000 at the end of the lease term. It also incurred Rs. 2,000 of
costs in setting up the lease agreement.
The interest rate implicit in the lease has been calculated as 10.0%.
Requirements
(a) Prepare the relevant extracts from the financial statements (excluding notes)
in respect of the above lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by
the lessor:
i. For Rs. 10,000
ii. For only Rs. 6,000
(a) Financial statement extracts

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31
DECEMBER 20X1 (EXTRACT)
Rs.
Depreciation [(80,000 + 2,000 - 8,000)/5)] 14,800
Finance costs (Working) 7,420
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1

(EXTRACT)
Non-current assets Rs.

Leased asset [(80,000 + 2,000) - ((80,000 + 67,200
2,000 - 8,000)/5)]
Finance lease liability (Working) 56,182
Current liabilities
Finance lease liability (Working) (65,620 - 9,438
56,182)
WORKING Bal b/f Interest accrued Payment 31 Bal c/f 31

Rs. at 10% Dec Dec
Rs. Rs. Rs.
80,000
(5,800)
20X1 74,200 7,420 (16,000) 65,620
20X2 65,620 6,562 (16,000) 56,182
(b) Treatment of guaranteed residual value
At the end of the lease, the lessee will have an asset at residual value of
Rs. 8,000 in its statement of financial position and a finance lease
liability of Rs. 8,000 representing the residual value guaranteed to the
lessor.

i. If the lessor is able to sell the asset for more than the value guaranteed
by the lessee, the lessee has no further liability and derecognises the
asset and lease liability:
Dr Finance lease liability Rs. 8,000
Cr Asset carrying amount Rs. 8,000
ii. If the lessor is unable to sell the asset for the value guaranteed by the
lessee, the lessee has a liability to make up the difference of Rs. 8,000 -
Rs. 6,000 = Rs. 2,000:
Recognise impairment loss on asset (as soon as known during the lease
term):
Dr Profit or loss Rs. 2,000
Make guaranteed payment to lessor and derecognise the asset and
lease liability:
Dr Finance lease liability Rs. 8,000
Cr Cash Rs. 2,000
3.6 Current and non-current elements of the lease liability

The total liability must be divided between:
the current liability (amount payable within the next 12 months), and
the non-current liability.
The easy way to do it is to use the tables to identify the current liability or the non-
current liability and then find the other as a balancing figure.
Example: Split of current and non-current liability at the end of year 1

1 80,000 (18,000) 8,941 (9,059) 70,941
2 70,941 (18,000) 7,929 (10,071) 60,870
n n
This is the This is the
current non-current
liability liability
Liability: Rs.
Current liability 10,071
Non-current liability 60,870
Total liability (for proof) 70,941

3.7 Lease payments made in advance

When the lease payments for a lease are made at the start of each period instead
of the end of the period, the total finance charge is the same (because neither the
amount borrowed nor the total rentals have changed) but the interest must be
recognised over a shorter period. This is because the liability is paid off one
period earlier.
This means that the interest rate used for payments in advance will be bigger
than that used for the same payments in arrears.
Also note that when the lease payments for a lease are made at the start of each
period, the opening liability for the lease obligation is reduced by the lease
payment at the beginning of the year, and the interest charge must be applied to
the remaining balance.
Example: Allocation of finance charge

the lease.
The annual lease payments are Rs. 18,000, payable at the start of each year.
Lease liability:
(Note: “Year 0” is the first day of year 1. It would be better to think of it as time 0).
Liability
Opening Lease after day 1 Interest at Closing
Year liability payments payment 16.1434%. liability
0 80,000 (18,000) 62,000 10,009 72,009
1 72,009 (18,000) 54,009 8,719 62,728
2 62,728 (18,000) 44,728 7,221 51,948
3 51,948 (18,000) 33,948 5,480 39,429
4 39,429 (18,000) 21,429 3,459 24,888
5 24,888 (18,000) 6,888 1,112 8,000
6 8,000 (8,000) 0
36,000
The interest expense is calculated by multiplying the opening liability by
16.1434% in each year (so as to provide a constant rate of charge on the
outstanding obligation).
In the above example the first payment of Rs. 18,000 is made on the first day of
the lease term. Therefore it does not include any interest and is a repayment of
capital.
The year 1 interest of Rs. 10,009 is recognised at the end of year 1 (31
December Year 1). It is paid the next day by the payment of Rs. 18,000 made on
1 January Year 2.
The closing liability at the end of year 1 is made up of the interest accrued in year
1 and an amount of capital which will be paid off in year 2.

This can be shown for all of the years below.
Example: Capital repayments

Schedule to show repayment of capital:

1 80,000 (18,000) - (18,000) 62,000
2 62,000 (18,000) 10,009 (7,991) 54,009
3 51,948 (18,000) 8,719 (9,281) 44,728
4 39,429 (18,000) 7,221 (10,779) 33,948
5 24,888 (18,000) 5,480 (12,520) 21,429
6 (start) 8,000 (18,000) 3,459 (14,541) 6,888
6 (end) 6,888 (8,000) 1,112 (6,888) 0
Current and non-current liability

If payments are made annually in advance, the next payment is a current liability.
Therefore in the above example the Rs. 18,000 paid on 1 January Year 2 is a
current liability.
However, this is made up of two elements, interest of Rs. 10,009 and a capital
repayment of Rs. 7,991. These elements could be shown separately.
This means that the closing liability at the end of year 1 as identified on the
previous page (Rs. 72,009) is made up of three parts:
the interest recognised in year 1 but unpaid at the year-end (Rs. 10,009);
the current element of the capital owed on the lease (Rs. 7,991); and
the non-current element of the capital owed on the lease (Rs. 54,009).
Example: Current and non-current liability

1 80,000 (18,000) - (18,000) 62,000
2 62,000 (18,000) 10,009 (7,991) 54,009
↑ ↑ ↑
Interest
expense lease lease non-
current current current
liability liability liability
Liability: Rs.
Current liabilities
Interest expense 10,009
Current part of lease liability 7,991
Non-current liability
Non-current part of lease liability 54,009
Total lease liability (for proof) 62,000
Total liability (for proof) 72,009

Practice question 2
The fair value of aleased asset, lease commencing on 1 January Year 1 is Rs.
10,000.
The lease is for three years with payments of Rs. 4,021 annually on 1 January Year
1, Year 2 and Year 3.
Required
Complete the lease payment table for all three years 1 to 3, and calculate the
current liability and the non-current liability at 31 December Year 1 under the
actuarial method.
3.8 Disclosures
A lessee shall disclose information about its leases for which it is a lessee in a
single note or separate section in its financial statements. However, a lessee
need not duplicate information that is already presented elsewhere in the financial
statements, provided that the information is incorporated by cross-reference in
the single note or separate section about leases.
A lessee shall disclose the following amounts for the reporting period:
(a) depreciation charge for right-of-use assets by class of underlying asset;
(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not include the
expense relating to leases with a lease term of one month or less;
(d) the expense relating to leases of low-value assets. This expense shall not
include the expense relating to short-term leases of low-value assets;
(e) the expense relating to variable lease payments not included in the
measurement of lease liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the reporting period
by class of underlying asset.
A lessee shall provide the disclosures specified in paragraph 53 in a tabular
format, unless another format is more appropriate. The amounts disclosed shall
include costs that a lessee has included in the carrying amount of another asset
during the reporting period.
A lessee shall disclose the amount of its lease commitments for short-term leases
accounted for applying paragraph 6 if the portfolio of short-term leases to which it
is committed at the end of the reporting period is dissimilar to the portfolio of

short-term leases to which the short-term lease expense disclosed applying

paragraph 53(c) relates.
If right-of-use assets meet the definition of investment property, a lessee shall
apply the disclosure requirements in IAS 40. In that case, a lessee is not required
to provide the disclosures in paragraph 53(a), (f), (h) or (j) for those right-of-use
assets.
If a lessee measures right-of-use assets at revalued amounts applying IAS 16,
the lessee shall disclose the information required by paragraph 77 of IAS 16 for
those right-of-use assets.
ABC Ltd. is a retailer of men apparel. They have entered into a 5 year lease of shop
premises with a XYZ Ltd. on 1 July 2015.
The lease requires 5 yearly payments in advance of Rs. 100,000 (the first payment
is 1 July 2015 and subsequent payments are 30 June).
The interest rate implicit in the lease is 10%
The ABC Ltd. uses straight line depreciation method
IFRS 16 treatment
Years 0 1 2 3 4 5 TOTAL
------------------------------------- Rs -------------------------------------
Payments 100,000 100,000 100,000 100,000 100,000 - 500,000
PV 100,000 90,909 82,645 75,131 68,301 - 416,987
Lease liability
(CY = Prior year PV -
Payment during the
year + Interest exp) 316,987 248,685 173,554 90,909 - -
Right to use asset (CY

= Preceding year lease
liability - CY
depreciation) 416,987 333,630 250,273 166,917 83,560 -
Intest expense - A (CY =

Preceding year lease
liability * Int. rate) - 31,699 24,869 17,355 9,091 - 83,013
Depreciation - B (Right
to use at year 0/ useful
life) - 83,357 83,357 83,357 83,357 83,357 416,783
P&L Impact = A+B 115,055 108,225 100,712 92,448 83,357 499,796

Journal Enteries
At 1 July 2015 Debit Credit
Right to use asset 416,987

Lease liabilty 416,987
Lease Liabilty 100,000
Cash 100,000
At 30 June 2016
Depreciation expense 83,357
Acc. Depreciation 83,357
Intest expense 31,699
Lease Liability 68,301
Cash 100,000

4 ACCOUNTING FOR A FINANCE LEASE: LESS0R ACCOUNTING
Section overview
Definitions
Finance lease accounting
Manufacturer/dealer leases
Finance lessor disclosures
4.1 Definitions
The lessor does not record the leased asset in his own financial statements
because he has transferred the risks and rewards of ownership of the leased
asset to the lessee. Instead, he records the amount due to him under the terms of
the finance lease as a receivable.
The receivable is described as the net investment in the lease.
Definitions: Gross and net investment in the lease

Gross investment in the lease is the aggregate of:
(a) the lease payments receivable by the lessor under a finance lease, and
(b) any unguaranteed residual value accruing to the lessor.
Net investment in the lease is the gross investment in the lease discounted at the
interest rate implicit in the lease.
An earlier section explained that the interest rate implicit in the lease is the
discount rate that, at the inception of the lease, causes:
the present value of the lease payments and the unguaranteed residual
value; to be equal to
the sum of the fair value of the underlying asset and any initial direct costs of
the lessor.
Therefore the net investment in the lease is the sum of the fair value of the asset
plus the initial direct costs.
Definitions:
Un
nearned finance The difference between:
income (a) the gross investment in the lease; and
(b) the net investment in the lease.
4.2 Finance lease accounting

Many of the entries to be made in the ledger accounts of the lessor are a ‘mirror
image’ of those made by the lessee in respect of his lease liability.
Lessee Lessor
Initial recognition & lease payments payable Finance lease receivable
measurement (net investment in the
lease)

Lessee Lessor
Subsequent Finance cost Finance income
measurement
Pattern of So as to provide a So as to provide a
recognition constant periodic rate of constant periodic rate of
charge on the outstanding return on the net
obligation investment in the lease.
Initial recognition
The lessor records a receivable for the capital amount owed by the lessee. This
should be stated at the amount of the ‘net investment in the lease’.
Illustration: Double entry on Initial recognition of a finance lease

Debit Credit
Net investment in the lease X
Cash/bank X
For finance leases other than those involving manufacturer or dealer lessors,
initial direct costs are included in the initial measurement of the finance lease
receivable thus reducing the amount of income recognised over the lease term to
below what it would have been had the costs not been treated in this way. The
result of this is that the initial direct costs are recognised over the lease term as
part of the income recognition process.
Initial direct costs of manufacturer or dealer lessors in connection with negotiating
and arranging a lease are excluded from the definition of initial direct costs. As a
result, they are excluded from the net investment in the lease.
The treatment of similar costs incurred by manufacturers and dealers is explained
later.
Subsequent measurement of the receivable
During each year, the lessor receives payments from the lessee. Each receipt is
recorded in the ledger account as follows.
Illustration: Lessor receipts Debit Credit
Cash/bank X
A finance lease receivable (net investment in the lease) is measured in the same
way as any other financial asset. The balance at any point in time is as follows:
Illustration: Net investment in the lease Rs.

Amount of loan at the start of the lease (the amount recognised X
on initial recognition of the lease)
Plus: Interest accrued X
Minus: Repayments (lease payments or rentals) (X)
Repayment of loan principal (X)
Amount owed to the lessor now. X

In effect, each lease receipt consists of two elements:

finance income on the receivable; and
a partial repayment of the receivable (net investment in the lease).
The finance charge is recognised as income in profit or loss for the period. The
partial repayment of the lease receivable reduces the amount owed to the lessor.
Finance income
The total rental receipts over the life of the lease will be more than the amount
initially recognised as a receivable. The difference is finance income.
The total finance income that arises over the life of the lease is the difference
between the amount invested in the lease (the amount loaned plus the initial
direct costs) and the sum of all receipts.
Illustration: Total finance income

Rs.
Lessor’s lease payments X
Initial direct costs X
X
Amount on initial recognition (X)
Total finance income X
Example: Total finance income

Sialkot Finance agreed to lease a machine to Jhang Construction commencing on
1 January Year 1.
The lease was a 6 year finance lease of a machine on 1 January Year 1 with annual
lease payments of Rs. 18,000, payable in arrears.
and Sialkot Finance incurred initial direct costs of Rs. 2,000 when arranging the
lease.
The estimated residual value of the asset at the end of the lease is Rs. 10,000. The
lessee has guaranteed an amount of Rs. 8,000.
Total finance income
Lessor’s lease payments: Rs.

Unguaranteed residual value 2,000
118,000
Amount on initial recognition (80,000)
Initial direct costs (2,000)
(82,000)
Total finance income 36,000

The finance income is recognised over the life of the lease by adding a periodic
return to the net investment in the lease with the other side of the entry as income
in profit or loss for the year.
Illustration:
Debit Credit
Statement of comprehensive income: finance income X
Calculating and allocating finance income

Finance income is recognised so as to give a constant periodic rate of return on
the lessor's net investment in the finance lease.
Example: Calculating and allocating finance income

1 January Year 1.
lease.
The estimated residual value of the asset at the end of the lease is Rs. 10,000. The
lessee has guaranteed an amount of Rs. 8,000.
Proof that interest rate implicit in the lease is 10.798%
Discount
Cash factor Present
Year Narrative flow (10.798%) value
lease payments
1 to 6 Annual rentals 18,000 4.2553 76,595
6 Guaranteed residual value 8,000 0.54052 4,324
Unguaranteed residual
6 value 2,000 0.54052 1,081
82,000
Fair value of the asset 80,000

Initial direct costs 2,000
82,000

Example: Calculating and allocating finance income

1 January Year 1.
lease.
the lessee has guaranteed Rs. 8,000 of this amount.
Net investment in the lease
Opening net Interest Lease Closing net
Year investment (10.798%) receipts investment
1 82,000 8,854 (18,000) 72,854
2 72,854 7,867 (18,000) 62,721
3 62,721 6,773 (18,000) 51,494
4 51,494 5,560 (18,000) 39,054
5 39,054 4,217 (18,000) 25,271
6 25,271 2,729 (26,000) 2,000
36,000
The interest income is calculated by multiplying the opening receivable by 10.798%
in each year (so as to provide a constant rate of return on the net investment in the
lease).
The final balance on the account is the unguaranteed residual value.
Finance lease accounting – alternative double entry

There is an alternative approach to finance lessor double entry. Instead of
recognising “net investment in a lease” as an asset, a company could recognise
the “gross investment in a lease” as an asset and “unearned finance income” as a
liability. The balances on these two accounts would be netted off to give the net
investment in a lease at each reporting date.
Illustration: Double entry on Initial recognition of a finance lease

Debit Credit
Gross investment in the lease X
Unearned finance income X
Cash/bank (or payable) X
The rental receipts reduce the “gross investment in the lease”. In addition, the
interest income in the period is transferred from the unearned finance income
account to the statement of profit or loss.

Illustration: Double entry on receipt date

Debit Credit
Cash X
Gross investment in the lease X
Unearned finance income X

Statement of profit or loss X
It is still necessary to construct an amortisation table in order to identify the

interest income.
Example: Finance lessor accounting – alternative double entry

Facts as before (key points reproduced for your convenience)
Lease commences on 1 January Year 1.
lease payments of Rs.18,000, payable in arrears.
and the lessor incurred initial direct costs of Rs. 2,000 when arranging the lease.
the lessee has guaranteed this amount.
Gross investment in the lease
Rs.
Unguaranteed residual value 1,000
118,000
Amount on initial recognition (80,000)
Initial direct costs (2,000)
(82,000)
Total finance income 36,000
The double entry at the start of the lease would be as follows:

Start of year 1 Debit Credit
Lease receivable (gross investment in the lease) 118,000
Unearned finance income 36,000
Cash (or payable) 82,000
Being the initial recognition of the lease

End of year 1
Cash 18,000
Lease receivable (gross investment in the lease) 18,000
Being the receipt of the year 1 rental
Unearned finance income 8,854

Finance income (statement of profit or loss) W 8,854
Being the recognition of finance income
Opening net Interest Lease Closing net
Year investment (10.798%) receipts investment
1 82,000 8,854 (18,000) 72,854
2 72,854 7,867 (18,000) 62,721
The net investment in the lease is found be netting the unearned finance income
against the lease receivable (gross investment in the lease) at each point in time.
The following table shows the balance on the two accounts at the start and at each
year end and the resulting net figures.
Finance lease Unearned Net investment

Year receivable finance income in the lease
0 118,000 36,000 82,000
(18,000) (8,854)
1 100,000 27,146 72,854
(18,000) (7,867)
2 82,000 19,279 62,721
(18,000) (6,773)
3 64,000 12,506 51,494
(18,000) (5,560)
4 46,000 6,946 39,054
(18,000) (4,217)
5 28,000 2,729 25,271
(27,000) (2,729)
6 1,000 1,000
Note that the net investment in the lease is the same as before.

Example:
A company leased an asset to another company on 1 January 20X1 on the following
terms.
Lease term 4 years

Inception of lease 1.1.X1
Annual instalments in advance Rs. 22,000
Residual value of asset as guaranteed by lessee Rs. 10,000
Expected residual value at end of lease Rs. 12,000
Fair value of the asset Rs. 82,966
Initial direct costs incurred by the lessor Rs. 700
Interest rate implicit in the lease 11%
Requirements
a) Calculate the unguaranteed residual value and the net investment in the lease
as at 1 January 20X1
b) Prepare extracts from the financial statements of the lessor for the year ended
31.12.X1 (excluding notes)
a) Unguaranteed residual value and net investment in the lease at 1 January

20X1
Date Gross Discount Net

investment factor investment
Rs. (11%) Rs.
1.1.X1 Instalment 22,000 1 22,000
1.1.X2 Instalment 22,000 0.901 19,822
1.1.X3 Instalment 22,000 0.812 17,864
1.1.X4 Instalment 22,000 0.731 16,082
Guaranteed residual
31.12.X4 10,000 0.659 6,590
value
Minimum lease 98,000 82,358 Lessee's
payments liability
Unguaranteed
31.12.X4 2,000 0.659 1,318
residual value
Investment in the Lessor's
100,000 83,676
lease asset
Note: The net investment in the lease is equal to the fair value of the asset of
Rs. 82,966 plus the lessor's costs of Rs. 700. In this instance there is a
rounding difference of Rs. 10.

b) Financial statement extracts

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31
DECEMBER 20X1 (EXTRACT)
Rs.
Finance income (Working) 6,784
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
Rs
Non-current assets
Net investment in finance lease (Working) 46,460
Current assets
Net investment in finance lease (Working) (68,460 - 46,460) 22,000
WORKING
Net investment in finance lease
Interest
Instalments Bal c/f 31
Bal b/f c/f income at
in advance Dec
11%
Rs. Rs. Rs. Rs. Rs.
20X1 83,676 (22,000) 61,676 6,784 68,460
20X2 68,460 (22,000) 46,460
For many years an entity has owned a freehold building which it has recognised
as an investment property under the fair value model of IAS 40. This requires
that the property is revalued to fair value at each reporting date with any gains
or losses recognised in profit or loss. At 31 December 20X4, the carrying
amount of the building was Rs. 5 million.
On 1 January 20X5, the entity leased it out under a 40-year finance lease. The
lease included a clause transferring title to the lessee at the end of the lease;
the lease was therefore recognised as a single finance lease comprising both
the land and building elements.
The annual rental is Rs. 400,000 payable in advance and the interest rate
implicit in the lease has been calculated as 8.3%.
Requirement
How should the transaction be recognised on 1 January 20X5 and in the year
ending 31 December 20X5?
The transaction will be recognised by the entity as follows.
1 January 20X5 Derecognise Rs. 5 million investment property asset
Recognise Rs. 5 million finance lease receivable
Recognise Rs. 400,000 cash received as a reduction in the
receivable
Note that the net investment in the lease is equal to the fair value of the asset
plus any costs incurred by the lessor. In this case there were no such costs and
therefore the fair value of the asset is the net investment in the lease.
31 December 20X5 Increase the receivable by Rs. 381,800
(8.3% x (Rs. 5,000,000 - Rs. 400,000))
Recognise finance income of Rs. 381,800 in profit
or loss

Lease modifications
A lessor shall account for a modification to a finance lease 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 stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the
particular contract.
For a modification to a finance lease that is not accounted for as a separate

lease, a lessor shall account for the modification as follows:
a. if the lease would have been classified as an operating lease had the
modification been in effect at the inception date, the lessor shall:
i. account for the lease modification as a new lease from the effective date
of the modification; and
ii. measure the carrying amount of the underlying asset as the net
investment in the lease immediately before the effective date of the lease
modification.
b. otherwise, the lessor shall apply the requirements of IFRS 9.
4.3 Manufacturer/dealer lessors

Manufacturers or dealers often offer to customers the choice of either buying or
leasing an asset. A finance lease of an asset by a manufacturer or dealer lessor
gives rise to two types of income:
profit or loss equivalent to the profit or loss resulting from an outright sale of
the asset being leased, at normal selling prices, reflecting any applicable
volume or trade discounts; and
finance income over the lease term.
Revenue
The sales revenue recognised at the commencement of the lease term is the lower of:
the fair value of the underlying asset; and
the present value of the lease payments accruing to the lessor discounted at
market rate of interest.
Cost of sale
The cost of sale recognised at the commencement of the lease term is the
carrying amount of the underlying asset less the present value of the
unguaranteed residual value.
The deduction of the present value of the unguaranteed residual value
recognises that this part of the asset is not being sold. This amount is transferred
to the lease receivable. The balance on the lease receivable is then the present
value of the amounts which the lessor will collect off the lessee plus the present
value of the unguaranteed residual value. This is the net investment in the lease
as defined in section 5.2.

Costs incurred by manufacturer or dealer lessors in connection with negotiating

and arranging a lease must be recognised as an expense when the selling profit
is recognised.
Profit or loss on the sale
The difference between the sales revenue and the cost of sale is the selling profit
or loss. Profit or loss on these transactions is recognised in accordance with the
policy followed for recognising profit on outright sales.
The manufacturer or dealer might offer artificially low rates of interest on the
finance transaction. In such cases the selling profit is restricted to that which
would apply if a market rate of interest were charged.
Example: Manufacturer or dealer leases

Multan Motors is a car dealer.
It sells cars and offers a certain model for sale by lease.
The following information is relevant:
Price of the car in a cash sale Rs. 2,000,000

Cost of the car Rs. 1,500,000
Finance option:
Annual rental Rs. 804,230
Lease term 3 years
Interest rate 10%
Estimated residual value nil
Lessor’s cost of setting up the lease Rs. 20,000
Discount factor
t1 to t3 @ 10% 2.486852 (written as 2.487)
Working: Revenue – lower of: Rs.

Fair value of the asset 2,000,000
Present value of the lease payments
804,230 u 2.487 2,000,000
Initial double entry:

Revenue Debit Credit
Lease receivable (Net investment in the lease) 2,000,000
Statement of comprehensive income 2,000,000
Cost of sale
Asset (Inventory) 1,500,000
Cost of setting up the lease
Cash/bank 20,000

Example: Manufacturer or dealer lease (continued)

Net investment in the lease (over its life):
Opening net Lease Closing net

Year investment Interest (10%) receipts investment
1 2,000,000 200,000 (804,230) 1,395,770
2 1,395,770 139,577 (804,230) 731,117
3 731,117 73,113 (804,230) nil
The interest income is calculated by multiplying the opening receivable

by 10% in each year (so as to provide a constant rate of return on the net
investment in the lease).
Summary of double entry in year 1:
Net
investment in
Bank Inventory the lease Profit or loss
B/f 1,500,000Dr
Revenue 2,000,000Dr 2,000,000Cr
Cost of sales (1,500,000)Cr (1,500,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr
Lease income 200,000Dr 200,000Cr

Lease rental 804,230Dr (804,230)Cr
1,395,770Dr 680,000Cr
Example: Manufacturer or dealer leases with unguaranteed residual value

The following information is relevant:
Price of the car in a cash sale Rs. 2,000,000

Cost of the car Rs. 1,500,000
Finance option:
Annual rental Rs. 764,018
Lease term 3 years
Interest rate 10%
Estimated residual value Rs. 133,100
Lessor’s cost of setting up the lease Rs. 20,000
Discount factors:
t3 @ 10% 0.7513148 (written as 0.751)
t1 to t3 @ 10% 2.486852 (written as 2.487)

Workings
W1: Revenue – lower of: Rs.
Fair value of the asset 2,000,000
764,018u 2.487 1,900,000
W2: Present value of the unguaranteed residual value Rs.

133,156 u 0.751 100,000
Initial double entry:

Revenue Debit Credit
Lease receivable (Net investment in the lease) 1,900,000
Cost of sale
Asset (Inventory) 1,400,000
Transfer
Lease receivable (Net investment in the lease) 100,000
Asset (Inventory) 100,000
Cost of setting up the lease
Cash/bank 20,000
Opening net Lease Closing net
Year investment Interest (10%) receipts investment
1 1,900,000
100,000
2,000,000 200,000 (764,018) 1,435,982
2 1,435,982 143,598 (764,018) 815,562
3 815,562 81,556 (764,018) 133,100
The interest income is calculated by multiplying the opening receivable by

10% in each year (so as to provide a constant rate of return on the net
investment in the lease).
The balance on the account at the end of the lease term is the unguranteed
residual value.

Example: Manufacturer or dealer lease (continued)

Net investment in the lease (over its life):
Summary of double entry in year 1:
Net
investment in
Bank Inventory the lease Profit or loss
B/f 1,500,000Dr
Revenue 1,900,000Dr 1,900,000Cr
Cost of sales (1,400,000)Cr (1,400,000)Dr
Set up cost (20,000)Cr (20,000)Dr
Profit on sale 480,000Cr
Transfer (100,000)Cr 100,000Dr
Lease income 200,000Dr 200,000Cr

Lease rental 764,018Dr (764,018)Cr
1,435,982Dr 680,000Cr
A motor dealer acquires vehicles of a particular model from the manufacturer for
Rs. 21,000, a 20% discount on the recommended retail price of Rs. 26,250. It
offers them for sale at the recommended retail price with 0% finance over three
years, provided three annual payments of Rs. 8,750 are made in advance. The
market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an
outright sale and a finance lease. The present value of the minimum lease
payments is treated as the consideration for the outright sale and at 8% is
calculated as follows:
Year Cash flow Discount factor at 8% Present value
Rs. Rs.
20X5 8,750 1.000 8,750
1
20X6 8,750 8,102
(1.08)= 0.926
1
20X7 8,750 7,499
(1.08) =0.857
2
24,351
Requirement
How should the transaction be recognised by the dealer in the year ending 31
December 20X5?
Statement of comprehensive income
Revenue (lower of FV Rs. 26,250 and PV of MLPs Rs. 24,351) 24,351
Cost of sales (lower of cost and CV — PV of unguaranteed residual (21,000)
value)
Profit 3,351
Finance income: (Working) 1,248
Statement of financial position
Receivable (Working) 16,849

WORKING
Bal b/f Instalments c/f Interest Bal c/f 8%
in advance income at 31 Dec
Rs. Rs. Rs. Rs. Rs.
20X5 24,351 (8,750) 15,601 1,248 16,849
4.4 Finance lessor disclosures

A finance lessor must disclose the following:
selling profit or loss;
finance income on the net investment in the lease; and
income relating to variable lease payments not included in the measurement
of the net investment in the lease.
a reconciliation between the gross investment in the lease at the end of the
reporting period, and the present value of lease payments receivable at the
end of the reporting period;
the gross investment in the lease and the present value of lease payments
receivable at the end of the reporting period, for each of the following periods:
x not later than one year;
x later than one year and not later than five years;
x later than five years;
unearned finance income;
the unguaranteed residual values accruing to the benefit of the lessor;
the accumulated allowance for uncollectible lease payments receivable;
contingent rents recognised as income in the period;
a general description of the lessor's material leasing arrangements.
Maturity analysis of lease payment receivables
A lessor shall provide a qualitative and quantitative explanation of the significant
changes in the carrying amount of the net investment in finance leases.
A lessor shall disclose additional qualitative and quantitative information about;
the nature of the lessor’s leasing activities; and
how the lessor manages the risk associated with any rights it retains in
underlying assets. In particular, a lessor shall disclose its risk management
strategy for the rights it retains in underlying assets, including any means by
which the lessor reduces that risk.

5 ACCOUNTING FOR AN OPERATING LEASE
Section overview
Operating leases in the financial statements of the lessor

Operating lessor disclosures
5.1 Operating leases in the financial statements of the lessor

Because the lessor has not transferred the risks and rewards of ownership of the
physical asset to the lessee, the lessor shows the leased asset as a non-current
asset in its statement of financial position.
It will be shown in an appropriate category of property, plant and equipment as an
investment property at its carrying value (cost/valuation minus accumulated
depreciation).
In respect of the leased asset, the lessor’s annual statement of comprehensive
income will include in profit or loss:
depreciation on the asset as an expense, and
rental income (as for the lessee, this is usually calculated on a straight-line
basis).
Lease income from operating leases is recognised in income on a straight-line
basis over the lease term, unless another systematic basis is more representative
of the time pattern in which use benefit derived from the leased asset is
diminished.
Initial direct costs incurred by lessors in negotiating and arranging an operating
lease are added to the carrying amount of the leased asset and recognised as an
expense over the lease term on the same basis as the lease income.
The depreciation policy for depreciable leased assets must be consistent with the
lessor's normal depreciation policy for similar assets, and calculated in
accordance with IAS 16 and IAS 38.
A lessor shall apply IAS 36 to determine whether an underlying asset subject to
an operating lease is impaired and to account for any impairment loss identified.
Manufacturer/dealer leases
A manufacturer or dealer lessor must not recognise any selling profit on entering
into an operating lease. It is not the equivalent of a sale as the risks and benefits
of ownership do not pass.
A lessor shall account for a modification to an operating lease as a new lease
from the effective date of the modification, considering any prepaid or accrued
lease payments relating to the original lease as part of the lease payments for the
new lease.

5.2 Operating lessor presentation and disclosures

A lessor shall present underlying assets subject to operating leases in its
statement of financial position according to the nature of the underlying asset.
Operating lessors must disclose the following:
the future lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods:
x not later than one year;
x later than one year and not later than five years;
x later than five years.
total contingent rents recognised as income in the period.
a general description of the lessor's leasing arrangements.

6 SALE AND LEASEBACK TRANSACTIONS AND SUB-LEASE
Section overview
Sale and leaseback transactions

Sale and finance leaseback (finance lease)
Sale and operating leaseback (operating lease)
Sub-lease
6.1 Sale and leaseback transactions

Sale and leaseback transactions involve one entity selling an asset, normally to a
bank or finance company, and then immediately leasing it back. The main
purpose is to allow the entity to release cash that is ‘tied up’ in the asset, whilst
retaining use of the asset.
For example, a company may own an office building that it uses for its
administrative operations. It may decide to sell and lease back the building, to
raise cash. By selling the building, it raises cash. By leasing back the building, it
retains the use of the building for its operational activities.
The leaseback could be arranged either as a finance lease or an operating lease,
and this will affect the accounting treatment of the transaction.
6.2 Sale and finance leaseback (finance lease)

To determine how to account for a sale-and-leaseback transaction, a company
first considers whether the initial transfer of the underlying asset from the seller-
lessee to the buyer-lessor is a sale. The company applies IFRS 15 to determine
whether a sale has taken place. This assessment determines the accounting by
both the seller-lessee and the buyer-lessor, as follows.
Lessee (Seller) Lessor (Buyer)
Transfer to buyer-lessor – Derecognise the – Recognise the
is a sale underlying asset and underlying asset and
apply the lessee apply the lessor
accounting model to the accounting model to the
leaseback leaseback
– Measure the ROU
asset at the retained
portion of the previous
carrying amount (i.e. at
cost)
– Recognise a gain or
loss related to the rights
transferred to the lessor
Transfer to buyer-lessor – Continue to recognise – Do not recognise the
is not a sale the underlying asset underlying asset
– Recognise a financial – Recognise a financial
liability under IFRS 9 for asset under IFRS 9 for
any amount received any amount paid to the
from the buyer-lessor seller-lessee

Before the transaction, the owner has the risks and rewards of ownership. The
owner sells the asset and then leases it back under a finance lease. The owner
has retained the risks and rewards of ownership. In substance this is not a sale
so profit should not be recognised. The accounting treatment is as follows.
There are two stages, the disposal (sale) and the finance leaseback:
The sale:
x On disposal, the asset should be removed from the seller’s statement
of financial position.
x Any surplus from the sale in excess of the carrying amount should be
deferred and amortised over the term (life) of the lease.
x Any deficit from the sale in shortage of the carrying amount should
also be deferred and amortised over the term (life) of the lease. (IFRS
16 does not prescribe any treatment for a loss on such transactions
but in practice it is also deferred).
The leaseback: The normal finance lease rules are then applied, to
reintroduce the asset to the statement of financial position of the lessee at its
fair value, and to establish a leasing obligation.
Example: Sale and finance leaseback

In 20X6 a company sold an asset and leased it back under a finance lease. The
asset had a carrying value of Rs. 70,000 and was sold for its market value of Rs.
120,000.
At the date of sale it had a remaining life of five years and was leased back for
the whole of this period at a rental of Rs. 28,000 per annum in arrears.
Debit Credit
The sale Rs. Rs.
Cash 120,000
Asset 70,000
Deferred income 50,000
The leaseback
Asset 120,000
Lease obligation 120,000
6.3 Sale and operating leaseback (operating lease)

Again, there are two stages to the transaction, the sale and the operating
leaseback. The substance and legal form of the transaction are the same. The
asset has been sold by the lessee (known as the seller/lessee) and the risks and
rewards have been permanently transferred to the lessor as the leaseback is an
operating lease in nature.
On sale, the asset should be removed from the seller/lessee’s statement of
financial position.
The gain or loss on disposal should be recognised in profit or loss. (See
below for details of how the gain is calculated).
The normal operating lease rules are then applied to account for the rental
payments.

IFRS 16 outlines specifies treatments for accounting for the profit or on the sale
of the asset, depending on whether the asset was sold for its fair value, for more
than fair value or for less than fair value and depending on whether the fair value
is less than the carrying amount of the asset that is the subject of the transaction.
Sale at fair value
This is just a normal sale. If an asset is sold at fair value, the gain or loss on
disposal is recognised immediately in profit or loss in the usual way.
Example: Sale and operating leaseback – Sale at fair value

In early 20X7 a company sold an asset for Rs. 1.5 million and leased it back
under a five-year operating lease.
The asset had a carrying value of Rs. 1 million.
Debit Credit
Rs. Rs.
Cash 1,500,000
Asset 1,000,000
Sale at more than fair value (fair value greater that carrying amount)
If an asset is sold at more than fair value, the normal gain or loss on disposal
(based on the difference between the carrying amount and fair value) is
recognised immediately in profit or loss.
The excess profit (based on the difference between the fair value and actual sale
value) should be deferred and released to profit or loss over the expected period
of use (the lease period).
Example: Sale and operating leaseback – Sale above fair value

The asset had a carrying value of Rs. 1 million and a remaining useful life of ten
years.
The fair value of the asset at the date of sale was Rs. 1.2 million.
Debit Credit
Rs. Rs.
Cash 1,500,000
Asset 1,000,000
(Normal profit of Rs. 1.2m – Rs. 1m) 200,000
Cr Deferred income
(Excess profit: this is Rs. 1.5m – Rs. 1.2m) 300,000
Note: The deferred income will be released to profit or loss over the lease term of
5 years.

Sale at less than fair value (fair value greater that carrying amount)
If an asset is sold at less than fair value, the gain or loss on disposal is
recognised immediately in profit or loss.
However, if the sale makes a loss and this is compensated for by future lease
payments at below market price, the loss should not be recognised immediately,
but deferred and then released to profit or loss over the expected period of use
(the lease period).
Example: Sale and operating leaseback – Sale below fair value

years.
The fair value of the asset was Rs. 2.1 million.
Debit Credit
Rs. Rs.
Cash 1,500,000
Asset 2,000,000
Example: Sale and operating leaseback – Sale below fair value compensated by
lower future rentals
years.
The company accepted an offer below the fair value of the asset because it was
able to negotiate rentals at below the market rate in compensation.
Debit Credit
Rs. Rs.
Cash 1,500,000
Asset 2,000,000
Deferred loss (on the statement of financial position) 500,000
The deferred loss amortised in proportion to the lease payments over the period
for which the asset is expected to be used.
In each case above the difference between the fair value of the asset and the
carrying amount is not recognised.
Sale where fair value is less than carrying amount
If the fair value at the time of a sale and leaseback transaction is less than the
carrying amount of the asset, the difference must be recognised immediately as a
loss. This means that the asset is written down to its fair vale before accounting
for the sale and operating leaseback. The earlier rules concerning the recognition
of a profit or loss on disposal then apply.

This only applies to sale and operating leaseback transactions.
Example: Sale and operating leaseback – Fair value less than carrying amount
and sale at more than fair value.
years.
Debit Credit
Rs. Rs.
Step 1: Write down the asset:
(Rs. 2m – Rs. 1.7m) 300,000
Asset 300,000
Step 2: Sale and leaseback:
Cash 1,800,000
Asset 1,700,000
Cr Deferred income
(Excess profit: this is Rs. 1.8m – Rs. 1.7m) 100,000
(Profit is deferred as the sale proceeds are above fair value)
Example: Sale and operating leaseback – Fair value less than carrying amount
and sale at less than fair value.
years.
Debit Credit
Rs. Rs.
Step 1: Write down the asset:
(Rs. 2m – Rs. 1.7m) 300,000
Asset 300,000
Step 2: Sale and leaseback:
Cash 1,600,000
Asset 1,700,000
(The loss would be deferred if it were compensated by lower future rentals)

6.4 Sub-lease
A sub-lease is a transaction in which a lessee (or ‘intermediate lessor’) grants a
right to use the underlying asset to a third party, and the lease (or ‘head lease’)
between the original lessor and lessee remains in effect.
A company applies IFRS 16 to all leases of right-of-use assets in a sub-lease.
The intermediate lessor accounts for the head lease and the sub-lease as two
different contracts.
Head Office
↓
Original lessee/intermediate lessor
↓
Sub-lessee
An intermediate lessor classifies the sub-lease as a finance lease or as an
operating lease with reference to the right-of-use asset arising from the head
lease. That is, the intermediate lessor treats the right-of-use asset as the
underlying asset in the sub-lease, not the item of property, plant or equipment
that it leases from the head lessor.
At the commencement date of the sub-lease, if the intermediate lessor cannot
readily determine the rate implicit in the sub-lease, then it uses the discount rate
that it uses for the head lease to account for the sub-lease, adjusted for any initial
direct costs associated with the sub-lease.
However, if the head lease is a short-term lease for which the company, as a
lessee, has elected the short-term lease exemption, then as an intermediate
lessor the company classifies the sub-lease as an operating lease.
Example – Sub-lease classified as a finance lease with reference to the right-of-

use asset in the head lease
Head lease: Intermediate lessor L enters into a five-year lease for 5,000 million of
office space (the head lease) with Company M (the head lessor).
Sub-lease: At the beginning of Year 3, L sub-leases the 5,000 M of office space for
the remaining three years of the head lease to Sub-lessee N.office
L classifies the sub-lease with reference to the right-of-use asset arising from the
head lease. Because the sub-lease is for the whole of the remaining term of the
head lease – i.e. the sub-lease is for the major part of the useful life of the right-
of-use asset – L classifies it as a finance lease.
At the commencement date of the sub-lease, L:
– derecognises the right-of-use asset relating to the head lease that it transfers
to N and recognises the net investment in the sub-lease;
– recognises any difference between the carrying amounts of the right-of-use
asset and the net investment in the sub-lease in profit or loss; and
– continues to recognise the lease liability relating to the head lease, which
represents the lease payments owed to the head lessor.
During the term of the sub-lease, L recognises both interest income on the
sublease and interest expense on the head lease.

7 IMPACT ON PRESENTATION
Section overview
The effect of classifying a lease incorrectly
7.1 The effect of classifying a lease incorrectly

If a finance lease is treated as an operating lease, the financial statements do not
fairly present the financial position of the entity:
The leased asset is not recognised in the statement of financial position, even
though the substance of the lease is that the entity owns it.
The liability for the lease payments is not recognised in the statement of
financial position.
Therefore both assets and liabilities are understated. The lease becomes a form
of ‘off balance sheet finance’, hidden from the users of the financial statements.
The entity’s (lessee’s) liabilities can appear to be much lower than they actually
are.
Classifying a lease incorrectly affects the numbers in the financial statements.
An example seen earlier in the chapter is used to illustrate this.
Example:
The fair value of a leased asset, commencing on 1 January Year 1 is Rs. 12,886.
The lease is for three years with payments of Rs. 5,000 annually in arrears on 31
December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.
Lease liability (given again for your convenience)
Opening Interest Lease Closing
Year balance (8%) payment balance
1 12,886 1,031 (5,000) 8,917
2 8,917 713 (5,000) 4,630
3 4,630 370 (5,000) –
2,114
The numbers that would appear in the financial statements for year 1 if
the lease were treated as finance lease or as an operating lease are
shown below:
Finance Operating
Statement of financial position lease lease
Non-current asset Rs.

Leased Asset
[(12,886 – (1/3 of 12,866= 4,289)] 8,597

Example:
The fair value of a leased asset, commencing on 1 January Year 1 is Rs. 12,886.
The lease is for three years with payments of Rs. 5,000 annually in arrears on 31
December Year 1, Year 2 and Year 3. The interest rate implicit in the lease is 8%.
Lease liability (given again for your convenience)
Liability: Rs.
Non-current liability 4,630
Current liability 4,287
Total liability 8,917

Depreciation charge (1/3 of 12,866) 4,289
Finance charge 1,013
Rental 5,000
5,302 5,000

SOLUTIONS TO PRACTICE QUESTIONS

Solution 1
The lease is a finance lease.
Reasons
The lease is for a major part of the life of the asset (6 out of 7 years).
Jhang Construction must ensure the asset. It is exposed to one of the
major risks of ownership of the asset (its loss).
The present value of the lease payments is 95.3%
(4.767 u 600,000/3,000,000) of the fair value of the asset at the inception of the
lease.
Solution 2
Rs.
Total lease payments (3 × Rs. 4,021) 12,063
Minus: Cash price of the asset (10,000)
––––––––
Total finance charge 2,063
––––––––
Actuarial method
Year ended
Opening Lease Capital Interest at Closing
31
balance payment outstanding 22.25% balance
December
Rs. Rs. Rs. Rs. Rs.
Year 1 10,000 (4,021) 5,979 1,330 7,309
Year 2 7,309 (4,021) 3,288 733 4,021
Year 3 4,021 (4,021) – – –
The year-end liability at the end of Year 1 is Rs. 7,309 in total.
The non-current liability is the liability at the start of the next year after
deducting the first payment (Rs. 3,288).
The current liability is the payment in year 2 less any interest contained in it
that has not yet accrued.
Rs.
Current liability, end of Year 1 4,021*
Non-current liability, end of Year 1 3,288
Total liability, end of Year 1 7,309
* 4,021 can be divided into 1,330 of interest payable and 2691 of principal
payable

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Certified Finance and Accounting Professional

© Emile Woolf International 235 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 236 The Institute of Chartered Accountants of Pakistan

1 INTRODUCTION AND DEFINITIONS

A lease is a way of obtaining a use of an asset, such as a machine, without

© Emile Woolf International 237 The Institute of Chartered Accountants of Pakistan

The identification of a lease as a finance lease or an operating lease is crucial as

1.3 Types of lessors

1.4 Inception and commencement

Definitions: Inception date of the lease

The type of lease in a contract (finance or operating) is identified at the date of

Definition: Commencement date of the lease

© Emile Woolf International 238 The Institute of Chartered Accountants of Pakistan

The accounting treatment required is applied to a lease at the date of

1.5 Defined periods

Definition: Lease term

Definitions: Economic and useful life

1.6 Residual values

© Emile Woolf International 239 The Institute of Chartered Accountants of Pakistan

Definition: Unguaranteed residual value and residual value guarantee

1.7 Lease payments

Definition: Lease payments

1.8 Interest rate implicit in the lease

Definition: Interest rate implicit in the lease

© Emile Woolf International 240 The Institute of Chartered Accountants of Pakistan

Example:: Interest rate implicit in the lease

Further definitions important to finance lessor accounting will be provided in that

© Emile Woolf International 241 The Institute of Chartered Accountants of Pakistan

 Finance leases and operating leases

2.1 Finance leases and operating leases

Example – Substantive substitution right

© Emile Woolf International 242 The Institute of Chartered Accountants of Pakistan

2.2 Identifying a finance lease

© Emile Woolf International 243 The Institute of Chartered Accountants of Pakistan

© Emile Woolf International 244 The Institute of Chartered Accountants of Pakistan

2.3 Commentary on finance lease indicators

© Emile Woolf International 245 The Institute of Chartered Accountants of Pakistan

Example: PV of future lease payments

© Emile Woolf International 246 The Institute of Chartered Accountants of Pakistan

Example: PV of future lease payments

Analysis: Lessor’s view

© Emile Woolf International 247 The Institute of Chartered Accountants of Pakistan

3 ACCOUNTING FOR LEASE BY LESSEE

 Substance over form

3.1 Substance over form

3.2 Lease accounting: Initial recognition

© Emile Woolf International 248 The Institute of Chartered Accountants of Pakistan

Illustration: Double entry on initial recognition of a lease

© Emile Woolf International 249 The Institute of Chartered Accountants of Pakistan

Example - Applying the short term lease exemption

© Emile Woolf International 250 The Institute of Chartered Accountants of Pakistan

3.3 Lease accounting: Subsequent measurement of the asset

© Emile Woolf International 251 The Institute of Chartered Accountants of Pakistan

Annual depreciation charge:

The underlying asset is included in the statement of financial position at its

Year 1 Year 2 Year 3 Year 4 Year 5

3.4 Lease accounting: Subsequent measurement of the liability

© Emile Woolf International 252 The Institute of Chartered Accountants of Pakistan

In effect, each lease payment consists of two elements:

Finance leases and operating leases

Substance over form