TOPIC 4 – IFRS 16 – LEASES

The user of a leased asset is the lessee and the supplier/owner of the leased asset is the
lessor

What is a 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

What is an underlying asset? An asset that is the subject of a lease, for which the right to
use that asset has been provided by a lessor to a lessee.

What is a Right of Use asset? An asset that represents a lessee’s right to use an underlying
asset for the lease term.

IFRS 16 was brought in to remedy the non recognition of liabilities for assets held under
operating leases.

For lessees, IFRS 16 removes the distinction between finance and operating leases which was a
feature of IAS 17.

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.
Right to Control the use of an asset is dependent on
 D: Direction over how and for what purpose the asset is used is a right that the lessee has
 E: Economic benefits from use of the identified asset will flow to the lessee

A lessee does not control the use of an identified asset if the lessor can substitute the underlying
asset for another asset during the lease term and would benefit economically from doing so.

Accounting Treatment where a Contract contains a lease

1. At commencement date, measure the right of use asset at cost… ( Cr Lease Liability (SOFP),
Dr Right of Use Asset (SOFP).

Note: Cost comprises amount of the initial measurement of the lease liability, any lease
payments made before the commencement date less any lease incentives received, any
initial direct costs incurred by the lessee, any costs which the lessee will incur for dismantling
and removing the underlying asset or restoring the site at the end of the lease term

2. At commencement date, measure the lease liability at the present value of future lease
payments, including any expected payments at the end of the lease ….( Cr Lease Liability
((SOFP), Dr Right of Use Asset (SOFP))

1
3. Subsequent measurement of the right of use asset: The right of use asset should be
depreciated from the commencement date to the earlier of the end of the useful life of the
underlying asset and the end of the lease term……(Dr SOPL – Depreciation Expense, Cr
Right of Use Asset (SOFP)

Note: If the lease transfers ownership of the underlying asset at the end of the lease term ,
or if the cost reflects a purchase option , which the lessee is expected to exercise, then the
right of use asset should be depreciated over the useful life of the underlying asset.

Note: If the right of use asset is an investment property or belongs to a class of assets to
which the revaluation model applies, then apply the revaluation model as per IAS 40 and IAS
16

4. Subsequent measurement of Lease Liability: The carrying amount of the lease liability is
increased by interest charges on the outstanding liability (Dr SOPL - Finance Cost, Cr SOFP -
) and reduced by the lease payments made. (Cr SOFP – Bank, Dr SOFP – Lease Liability).
Then split the closing lease liability between current and non current liabilities.

Presentation in the Financial Statements

 Right of Use Assets to be presented on a separate line under Non Current Assets in the
Statement of Financial Position

 Lease Liabilities to be presented separately in Liabilities. Best practice is that liabilities should
be split between current and non current liabilities

DEPOSITS PAID
Where the lessee has paid a deposit to the lessor before the lease commences, the deposit is
used to reduce the amount of the lease liablity i.e. reduce the amount of lease finance advanced
– deposits are deemed to be all capital
The Double Entry for a deposit is

Cr Bank X
Dr Lease Liability X

In questions, where the initial payment is different in amount to the annual rentals, this is
generally taken to be an indicator of a deposit paid –
LEASE IN ARREARS
 Rental is paid on Last day

 Rentals are deemed to be composed of Interest and Capital

 No Interest Accrual

2
LEASE PAID IN ARREARS EXAMPLE
Branch acquired an item of plant and equipment on a lease on 1 January 20X1. The terms of the
agreement were as follows :

Deposit €1,150 (non refundable)

Instalments €4,000 per annum for 7 years payable in arrears

Initial Measurement of Lease Liability €20,000

The underlying asset has a useful life of 4 years and the interest rate implicit in the lease is 11%.

Required:

Prepare extracts from the SOPL and SOFP for the year ending 31 December 20X1.

1. The right of use of the underlying asset should be capitalised and included as a non
current asset. As the lease has a 4 year life, straight line depreciation for the year to 31
Dec x1 will be 25% of €20,000 = €5,000

Leasing Table - Lease Paid in Arrears (i.e. on Last Day of Period)

Year Opening Interest – Lease Closing
Lease 11% Repayment Lease
Liability Liability
31.12.X1 1 18,850 2,074 (4,000) 16,924
31.12.X2 2 16,924 1,862 (4,000) 14,786
31.12.X3 3 14,786 1,626 (4,000) 12,412
31.12.X4 4 12,412 1,365 (4,000) 9,777
31.12.X5 5 9,777 1,075 (4,000) 6,852
31.12.X6 6 6,852 754 (4,000) 3,606
31.12.X7 7 3,606 397 (4,000) -

SOPL Extract for Y/e 31.12.X1 €

Finance Charge 2,074
Depreciation 5,000

Statement of Financial Position Extract as at 31.12.X1 €

Assets
Non Current Assets
Right of Use Asset 15,000

3
Equity & Liabilities

Non Current Liabilities

Lease Liability 14,786

Current Liabilities
Lease Liability (16,924-14,786) 2,138

LEASE IN ADVANCE
Main Points
 Rental is paid on first day

 The first rental is deemed to be all capital, and as a result, an accrual will be made for
finance costs in year 1 and thereafter.

 In Year 2, the amount of capital repaid will be the lease rental less accrued interest from
Year 1 paid in Year 2 i.e. paid as part of Year 2 rental

IFRS 16 Lease Paid In Advance – Class Question & Answer

A lease rental of €20 million was paid on 1 April 2015. It is the first of 5 annual payments in
advance for the rental of an item of equipment that has a cash purchase price of €80 million. The
auditors have calculated the implicit rate in the lease as 12% per annum. The right of use is to be
depreciated on a straight line basis over the life of the lease.

(a) Show the effect on the SOPL and Statement of Financial Position for 31 March 2016
(b) Calculate the interest charge for the remaining years of the lease

4
Solution

1. The cash price of the leased plant of €80 million should be capitalised and included as
plant and equipment. As the lease has a 5 year life, straight line depreciation for the year
to 31 March 2016 will be 20% of €80 million = €16 million

Leasing Table - Lease Paid in Advance (i.e. on First Day of Period)

Year Opening Rental - Remaining Interest
Lease €000 Lease Accrual -
Liability - Liability - €000 (12%)
€000 €000
31.3.16 1 80,000 (20,000) 60,000 7200
31.3.17 2 60,000 (20,000) 47,200 5664
31.3.18 3 47,200 (20,000) 32,864 3,944
31.3.19 4 32,864 (20,000) 16,808 3192
31.3.20 5 16,808 (20,000) - -

Notes:
1. First Rental is deemed to be all capital
2. Interest for each year is calculated on the “Remaining Lease Liability”
3. The Interest Accrual in the current year is paid from the Rental of the following year with
the balance of the rental representing capital repayment

SOPL Extract for Y/e 31.3.16 €000

Finance Charge 7,200
Depreciation 16,000

Statement of Financial Position Extract as at 31.3.16 €000

Assets
Non Current Assets
Right of Use Asset 64,000

Equity & Liabilities

Non Current Liabilities

Lease Liability 47,200

Current Liabilities
Lease Liability (12800+7200) 20,000

5
Recognition Exemptions
A lessee may elect to account for lease payments as an expense on a straight line basis over the
lease term for the following two types of leases

1. Short Term leases: where the lease term is 12 months or less. This election is made by
class of underlying asset (i.e. election to be applied to all assets in a particular class)

2. Low Value Leases: Where the underlying asset (i.e. leased asset) has a low value when
new. This election can be made on a lease by lease basis.

Sale and leaseback transactions

A sale and leaseback transaction involves the sale of an asset and the leasing back
of the same asset.

 If the sale satisfies the IFRS 15 requirement to be accounted for as a sale:

The lessee measures the right of use asset arising from the leaseback at the proportion of the
previous carrying amount of the building that relates to the right of use retained. This is
calculated as the carrying amount X (Present Value of Lease Payments/Fair Value of Asset when
sold)

The lessee only recognises the amount of any gain/loss on the sale that relates to the rights
transferred to the buyer. Such gains/losses are taken directly to the SOPL.

Where the sale proceeds exceed fair value, the excess is recognised as additional financing
provided by the lessor.

Journal for a Sale and Leaseback Transaction where a Lease is created

Dr Bank (SOFP) X
Dr Right of Use Asset (SOFP) X
Cr Asset Sold (SOFP) X
Cr Lease Liability (SOFP) X
Cr Gain on Rights Transferred (SOPL) X

Subsequently Account for Lease as Normal – Depreciation of Right of Use asset ,

Interest, Capital Repaid, Split of Lease Liability between Current Liabilities and Non
Current Liabilities

6
  If the sale does not satisfy the IFRS 15 requirement to be accounted for as a sale:

Seller continues to recognise the transferred asset and the transfer proceeds are treated as a
financial liability, as per IFRS 9. The transaction is more in the nature of a secured loan.

Sale and Leaseback Example

Capital Co entered into a sale and leaseback on 1 April 20X7. It sold a lathe with a carrying amount
of €300,000 for €400,000 (i.e. its fair value) and leased it back over a five year period, equivalent
to its remaining useful life. The transaction constitutes a sale in accordance with IFRS 15.

The lease provided for a five annual payments in arrears of $90,000. The rate of interest implicit
in the lease is 5%. The present value of the lease payments is €389,652.

What are the amount to be recognised in the financial statements at 31 March 20X8 in respect of
this transaction?

Solution

 Measure the Right of Use Asset: This is calculated as the carrying amount X (Present
Value of Lease Payments/Fair Value of Asset when sold)

€300,000 * (€389652/€400,000) = €292,239

 The gain on the sale is €100,000 (€400,000-€300,000). Of this gain, the amount relating to
the rights retained is: €100,000 * (€389652/€400,000) = €97,413. Therefore the balance of
the gain on the rights transferred is taken directly to the SOPL €2,587 (€100,000 -
€97,413)

 Therefore, the initial posting can now be made as follows

Dr Bank 400,000
Cr Lathe (Asset – SOFP) 300,000
Dr Right of Use Asset 292,239
Cr Lease Liability 389,652
Cr Gain on Transfer 2,587

Being Initial posting of Right of Use Asset, Lease Liability and Gain on Rights transferred.
 Depreciate the Right of Use Asset over 5 years as follows

€292,239/5years = €58,448

Cr Right of Use Asset (SOFP) 58,448

Dr SOPL – Depreciation Expense 58,448
Being Depreciation Expense for Year Ended 31-3-X8

 Account for Lease Liability paid in Arrears as follows

7
 Date Opening Lease Interest – 5% Lease Rental Closing Lease
Liability Liability
31.3.X8 389,652 19,483 (90,000) 319,135
31.3.X9 319,135 15,957 (90,000) 245,092

Dr SOPL – Finance Cost 19,483

Cr Lease Liability 19,483
Being Finance Cost for Year Ended 31-3-X8

Cr Bank 90,000
Dr Lease Liability 90,000

Being Lease Rental paid on 31-3-X8

Cr Lease Liability – Non Current Liabilities 245,092

Dr Lease Liability – Current Liabilities 245,092
Being Maturity Analysis of Lease Liability Balance at 31-3-X8

Financial Statement Extracts

Statement of Profit or Loss for Year Ended 31-3-X8

Depreciation Expense (58,448)

Finance Cost (19,483)
Gain on Rights Transfer 2,587

Statement of Financial Position as at 31-3-X8

Assets
Non Current Assets

Right of Use Asset (€292,239 - €58,448) 233,791

Non Current Liabilities

Lease Liability 245,092
Current Liabilities
Lease Liability 74,043

8
 SUM OF THE DIGITS METHOD OF ALLOCATING INTEREST
ON A LEASE
 An means of allocating the Finance Charge over the term of a lease

 Approximates to the actuarial method

 More interest expensed in the early part of the lease and less towards the end

Procedure
 The digit 1 is assigned to the final instalment, 2 to the penultimate instalment and so on (This applies
for a Lease in Arrears. For a Lease paid in Advance, the Digit 0 is applied to the Final Instalment )

 Add the digits

 Calculate the interest charge included in each instalment by taking the total finance cost and
multiplying by the following fraction

Digit Applicable to the Instalment

Sum of the Digits
Example of Sum of the Digits Method

Burrow Ltd. Acquired a new machine from Lydon Finance Co. Ltd on a lease. Burrow Ltd has the right to use
the leased asset for the lease term. The lease terms are:

Primary Period of Lease 4 Years

Frequency of Lease Payments Annually, in Arrears
Amount of Each Rental €5,000
Cash Price €15,850
Estimated Useful Life of Asset 4 Years

Account for the above lease using the sum of the Digits as a means of allocating the finance charge

9
Solution
Finance Cost
Allocation

Total Finance (5000) * 4 –

Expense €15,850 = €4150

Instalment Digit Finance Expense

Allocation
1 4 4/10 * 4150 = 1660

2 3 3/10 * 4150 = 1245

3 2 2/10 * 4150 = 830

4 1 1/10 * 4150 = 415

10 4150

Lease (In Arrears)Table

Date Opening Capital Interest Rental Closing Capital
Obligation Obligation
Yr 1 15,850 1660 -5000 12,510
Yr 2 12,510 1245 -5000 8,755
Yr 3 8755 830 -5000 4,585
Yr 4 4585 415 -5000 -

Statement of Profit or Loss Extract for the Year End Yr 1

Finance Cost 1,660
Depreciation (15,850/4) 3,963

Statement of Financial Position Extracts As at 31/12/Yr 1

Assets
Non Current
Right of Use Asset (15,850 – 3,963) 11,887

Non Current Liabilities

Lease Obligation 8755

10
Current Liabilities
Lease Obligation (15850+1660-5000 - 3755
8755)

11
LESSOR ACCOUNTING
Note that lessor accounting is largely unchanged under IFRS 16 from the previous leasing standard, IAS 17.

As a result, for lessor accounting, IFRS 16 retains the IAS 17 distinction between finance leases and operating
leases.

Finance Lease: In substance, the risks and rewards are transferred to the lessee

Operating Lease: In substance, the risks and rewards remain with the lessor.

Finance Lease - Accounting Treatment - Lessor

SOFP…No Asset…Recognise net investment in lease…PVMLP + unguaranteed RV (i.e. Lease
Receivable)….

SOPL…Constant finance income….No depreciation expense

Operating Lease – Accounting Treatment – Lessor

SOFP…Asset is Retained in books of lessor….Depreciated over UL

SOPL…Rental income credited on a straight line basis over the lease term to the P/L…depreciation expense

12
Past Exam Questions – Past Exam Questions –
CPA P1 CPA P2

Q3 (1) April 2017, Q (B) (i) April 2017, Q1

Q2 August 2016, Q3 (7) August 2016, Q (A) April
August 2016, 2016,Q (A) April &
Q3 (3) Apr 14 August 2015
Q5 Apr 13 Q1 August 2014
Q4 Aug 11 Q (A) April 2014
Q3 Apr 11 Q (B) Aug 13

Q (a) Aug 12
Q1 Aug 11 – Issue 8
Q3 Apr 11
Q1 Apr 11 note (vi)

13