Chapter

Leases
Chapter learning objectives

Upon completion of this chapter you will be able to:

• account for right-of-use assets and lease liabilities in the

records of the lessee
• explain the exemption from the recognition criteria for leases
in the records of the lessee
• account for sale and leaseback agreements.

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1 Leases: Definitions (IFRS 16, Appendix A)

'A lease is a contract, or part of a contract, that conveys the right to use
an asset (the underlying asset) for a period of time in exchange for
consideration.'
The lessor is the 'entity that provides the right to use an underlying asset
in exchange for consideration.'
The lessee is the 'entity that obtains the right to use an underlying asset in
exchange for consideration.'
A right-of-use asset 'represents the lessee's rights to use an underlying
asset for the lease term.'

2 Lessee accounting
Basic principle

At the commencement of the lease, the lessee should recognise a lease liability
and a right-of-use asset.

Initial measurement

The liability (IFRS 16, para 26)

The lease liability is initially measured at the present value of the lease
payments that have not yet been paid.
Lease payments should include the following (IFRS 16, para 27):
• Fixed payments
• Amounts expected to be payable under residual value guarantees
• Options to purchase the asset that are reasonably certain to be exercised
• Termination penalties, if the lease term reflects the expectation that these
will be incurred.

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A residual value guarantee is when the lessor is guaranteed that the underlying
asset at the end of the lease term will not be worth less than a specified
amount.
The discount rate should be the rate implicit in the lease. If this cannot be
determined, then the entity should use its incremental borrowing rate (the rate
at which it could borrow funds to purchase a similar asset).

The right-of-use asset

The right-of-use asset is initially recognised at cost.
The initial cost of the right-of-use asset comprises (IFRS 16, para 24):
• The amount of the initial measurement of the lease liability (see above)
• Lease payments made at or before the commencement date
• Any initial direct costs
• The estimated costs of removing or dismantling the underlying asset as
per the conditions of the lease.

The lease term

To calculate the initial value of the liability and right-of-use asset, the lessee
must consider the length of the lease term. The lease term comprises (IFRS 16,
Appendix A):
• Non-cancellable periods
• Periods covered by an option to extend the lease if reasonably certain to
be exercised
• Periods covered by an option to terminate the lease if these are
reasonably certain not to be exercised.

Test your understanding 1 – Dynamic

On 1 January 20X1, Dynamic entered into a two year lease for a lorry.
The contract contains an option to extend the lease term for a further
year. Dynamic believes that it is reasonably certain to exercise this
option. Lorries have a useful economic life of ten years.
Lease payments are $10,000 per year for the initial term and $15,000 per
year for the option period. All payments are due at the end of the year. To
obtain the lease, Dynamic incurs initial direct costs of $3,000. The
interest rate within the lease is not readily determinable. Dynamic’s
incremental rate of borrowing is 5%.

Required:
Calculate the initial carrying amount of the lease liability and the right-of-
use asset and provide the double entries needed to record these
amounts in Dynamic's financial records.

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Subsequent measurement

The liability
The carrying amount of the lease liability is increased by the interest charge,
calculated as the outstanding liability multiplied by the discount rate of interest.
This interest is also recorded in the statement of profit or loss:
Dr Finance costs (SPL) X
Cr Lease liability (SFP) X
The carrying amount of the lease liability is reduced by cash repayments:
Dr Lease liability X
Cr Cash X
To work out the interest and year end liabilities, a lease liability table is often
used (see illustration below). The layout of the table will depend on whether
payments are made at the end of the year (in arrears) or at the start of the year
(in advance).
Payments in arrears
Year Balance b/f Interest Payment Balance c/f
1 X X (X) X
2 X X (X) X
(NCL)
Payments in advance
Year Balance b/f Payment Subtotal Interest Balance c/f
1 X (X) X X X
2 X (X) X X X
(NCL)
On the statement of financial position the total liability at the end of year 1 is
split between its non-current and current elements. For payments made in
advance or arrears the non-current liability (NCL) is represented by the balance
outstanding immediately after the payment in year 2. The difference between
the total liability at the year-end and the non-current liability will be the current
liability. Note that where payments are made in advance the non-current liability
is not the balance outstanding at the end of year 2, as this includes the interest
charge for year 2.

The right-of-use asset

The right-of-use asset is measured using the cost model (unless another
measurement model is chosen). This means that the asset is measured at its
initial cost less accumulated depreciation and impairment losses.
Depreciation is calculated as follows:
• If ownership of the asset transfers to the lessee at the end of the lease
term then depreciation should be charged over the asset's useful life,
• Otherwise, depreciation is charged over the shorter of the useful life and
the lease term (as defined previously).

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Illustration 1 – Lease payments in arrears

Riyad enters into an agreement to lease an asset. The terms of the lease
are as follows.
1 Primary period is for four years from 1 January 20X2 with a rental of
$2,000 pa payable on 31 December each year.
2 The present value of the lease payments is $5,710
3 The interest rate implicit in the lease is 15%.
What figures will be shown in the financial statements for the year
ended 31 December 20X2?

Solution
A non-current right-of-use asset is recorded at an initial value of
$5,710.
Annual depreciation charge = 1/4 × $5,710 = $1,428.
A liability is initially recorded at $5,710.
The total finance charge for the lease is calculated as the difference
between the total payments of $8,000 and the initial value of $5,710 =
$2,290. The allocation of this to each rental period is calculated using the
implicit interest rate on a lease liability table as follows:
Interest @
Period Liability b/f 15% Payment Liability c/f
20X2 5,710 857 (2,000) 4,567
20X3 4,567 685 (2,000) 3,252
20X4 3,252 488 (2,000) 1,740
20X5 1,740 260 (2,000) –
——— ———
2,290 8,000
——— ———
The format above will be used whenever the payments under a lease are
made in arrears. If the payments are due in advance, the rental paid is
deducted from the capital sum at the start of the period before the interest
is calculated.

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Extracts from financial statements for the year to 31 December 20X2

Statement of profit or loss

$
Depreciation (1,428)
Finance cost (857)

Statement of financial position

Non-current assets
Right-of-use asset (5,710 – 1,428) 4,282
Non-current liabilities
Lease 3,252
Current liabilities
Lease 1,315

Test your understanding 2 – Dynamic (continued)

This question follows on from the previous TYU.

Required:
Prepare extracts from Dynamic's financial statements in respect of the
lease agreement for the year ended 31 December 20X1.

Short-life and low value assets

If the lease is short-term (less than 12 months at the inception date) or of a low
value then a simplified treatment is allowed.
In these cases, the lessee can choose to recognise the lease payments in profit
or loss on a straight line basis. No lease liability or right-of-use asset would
therefore be recognised.

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Low value assets

IFRS 16 Leases does not specify a particular monetary amount below
which an asset would be considered ‘low value’, although the basis for
conclusion indicates a value of $5,000 as a guide
The standard also gives the following examples of low value assets:
• tablets
• small personal computers
• telephones
• small items of furniture.
The assessment of whether an asset qualifies as having a ‘low value’
must be made based on its value when new. Therefore, a car would not
qualify as a low value asset, even if it was very old at the commencement
of the lease.

Illustration 2 – Low value assets

On 1 April 20X6 Taggart acquires telephones for its sales force under a
two year lease agreement. The terms of the lease require an initial
payment of $2,000, followed by two payments of $8,000 each on 31
March 20X7 and 31 March 20X8.
Show the impact of this lease arrangement on the financial
statements of Taggart for the year ended 31 December 20X6.

Solution
IFRS 16 Leases permits a simplified treatment for assets with a lease
period of 12 months or less, or of low value. Although the standard does
not give a numerical definition of ‘low value’ it does give examples of the
types of assets that may be included, and this includes telephones. The
simplified treatment allows the lease payments to be charged as an
expense over the lease period, applying the accruals concept.
Total rentals payable $2,000 + $8,000 + $8,000
Annual lease rental expense = =
Total lease period 2 years
Total rentals payable
Annual lease rental expense = = $9,000 per annum
Total lease period
Expense to 31 December = $9,000 × 9/12 = $6,750
20X6
The expense in this period of $6,750 is not the same as the payment of
$2,000 so we need to accrue an additional expense of $4,750.

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Financial statements extract:

Statement of profit or loss for the year ended 31 December 20X6

$
Lease rental expense (6,750)

Statement of financial position 31 December 20X6

$
Current liabilities
Accrual 4,750

Mid-year entry into a lease

If a company enters into a lease part-way through the year, the depreciation
and interest will need to be time-apportioned.
The liability table is likely to need extra columns to split the table between pre-
and post-payment.

Illustration 3 – Mid-year entry into a lease

Shaeen Ltd entered into an agreement to lease an item of plant on 1
October 20X8. The lease required four annual payments of $200,000
each, commencing on 1 October 20X8. The plant has a useful life of four
years and is to be scrapped at the end of this period. The present value
of the lease payments is $700,000. The implicit interest rate within the
lease is 10%.
Prepare extracts of the financial statements in respect of the leased
asset for the year ended 31 March 20X9.

Solution
Statement of profit or loss extract $
Depreciation (W1) (87,500)
Finance costs (W2) (25,000)

Statement of financial position extract

Non-current assets
Right-of-use asset (700,000 – 87,500) 612,500

Non-current liabilities
Lease (W3) 350,000

Current liabilities
Lease (525,000 – 350,000) 175,000

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Workings
(W1) Depreciation
Depreciated over 4 years
Expense = 700,000/4 years × 6/12 = $87,500
(W2) Lease
Interest Interest
Year- @10% Initial Balance @10%
end × 6/12 balance @ 1 Oct × 6/12
Bal b/f Paid Bal c/f
31.3.X9 – 700,000 (200,000) 500,000 25,000 525,000
31.3.Y0 525,000 25,000 (200,000) 350,000
Note that there is no interest charged in the first half of the first year and
that the interest charged in the first half of the second year reflects the
interest on the balance at 1 October. Once calculated, the split for non-
current and current liabilities works as normal.

3 Sale and leaseback

If an entity (the seller-lessee) transfers an asset to another entity (the buyer-
lessor) and then leases it back from the buyer, the seller-lessee must assess
whether the transfer should be accounted for as a sale.
For this purpose, the seller must apply IFRS 15 Revenue from Contracts with
Customers to decide whether a performance obligation has been satisfied. This
normally occurs when the buyer obtains control of the asset. Control of an asset
refers to the ability to obtain substantially all of the remaining benefits.

Transfer is not a sale

If the transfer is not a sale then the seller-lessee continues to recognise the
transferred asset and will recognise a financial liability equal to the transfer
proceeds.
In simple terms, the transfer proceeds are treated as a loan. The detailed
accounting treatment of financial assets and financial liabilities is covered in
Chapter 10.

Transfer is a sale

If the transfer does qualify as a sale then the seller-lessee must measure the
right-of-use asset as the proportion of the previous carrying amount that relates
to the rights retained.
• This means that the seller-lessee will recognise a profit or loss based only
on the rights transferred to the buyer-lessor.

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Test your understanding 3 – Painting

On 1 January 20X1, Painting sells an item of machinery to Collage for its
fair value of $3 million. The asset had a carrying amount of $1.2 million
prior to the sale. This sale represents the satisfaction of a performance
obligation, in accordance with IFRS 15 Revenue from Contracts with
Customers. Painting enters into a contract with Collage for the right to
use the asset for the next five years. Annual payments of $500,000 are
due at the end of each year. The interest rate implicit in the lease is 10%.
The present value of the annual lease payments is £1.9 million. The
remaining useful life of the machine is much greater than the lease term.

Required:
Explain how Painting will account for the transaction on 1 January 20X1.

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4 Chapter summary

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Test your understanding 4 – Fryatt

Leases
The following trial balance relates to Fryatt at 31 May 20X7:
Dr Cr
$ $
Revenue 630,000
Cost of sales 324,000
Distribution costs 19,800
Administration expenses 15,600
Loan interest paid 6,800
Property – cost 240,000
Property – depreciation at 1 June 20X6 40,000
Plant and equipment – cost 140,000
Plant and equipment –
depreciation at 1 June 20X6 48,600
Trade receivables 51,200
Inventory – 31 May 20X7 19,600
Bank 4,300
Trade payables 35,200
Ordinary shares $1 25,000
Share premium 7,000
Bank Loan (repayable 31 December 20X9) 20,000
Retained earnings at 1 June 20X6 15,500
––––––– –––––––
821,300 821,300
––––––– –––––––
The following notes are relevant:
1 Owned plant and equipment is to be depreciated on the reducing
balance basis at a rate of 20% per annum. The property cost
includes land at a cost of $60,000. The building is depreciated over
30 years on a straight line basis. All depreciation is charged to cost
of sales.
2 On 1 June 20X6 Fryatt commenced using an item of plant and
machinery under a lease agreement, with three annual payments of
$29,000. The first payment was made on 31 May 20X7 and has
been charged to cost of sales. The present value of the lease
payments at 1 June 20X6 was $72,000. Under the terms of the
lease Fryatt has the option to extend the lease indefinitely at a
reduced rental at the end of the 3 years. The plant has an estimated
useful life of six years, with a negligible value at the end of this
period. The rate of interest implicit in the lease is 10%.

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3 The directors have estimated the provision for income tax for the
year to 31 May 20X7 at $7,200.

Required:
Prepare the statement of profit or loss for Fryatt for the year to 31 May
20X7 and a statement of financial position at that date, in a form suitable
for presentation to the shareholders and in accordance with the
requirements of IFRS Standards.

Test your understanding 5 – MCQ

1 An entity leases a computer with legal title of the asset passing after
two years. The entity usually depreciates computers over three
years. The entity also leases a machine for seven years but legal
title does not pass to the entity at the end of the agreement. The
entity usually depreciates machinery over ten years.
Over what period of time should the computer and machine be
depreciated?
Computer Machine
A 2 years 7 years
B 2 years 10 years
C 3 years 7 years
D 3 years 10 years

2 An entity leases a motor vehicle. The present value of the minimum

lease payments is $27,355 and the rate implicit in the lease is 10%.
The terms of the lease require three annual rentals to be paid of
$10,000 each at the start of each year.
At the end of the first year of the lease what amount will be
shown for the lease liability in the company’s statement of
financial position under the headings of current liabilities and
non-current liabilities?
Current liabilities Non-current liabilities
A $9,091 $10,000
B $10,000 $10,900
C $10,900 $10,000
D $10,000 $9,091

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3 IFRS 16 Leases permits a simplified treatment for certain assets.

For which of the following leases would the simplified
treatment not be permitted?
A Motor car with cost of $10,000, leased for 9 months
B Telephone with cost of $500, leased for 24 months
C Motor car with original cost of $10,000, current fair value of
$500, leased for 24 months
D Desk with cost of $750, leased for 24 months

4 On 1 April 20X7 Chan sells an item of plant to a finance company

and leases it back for a period of five years, at the end of which the
fair value of the plant is estimated to be nil.
Which of the following represents the correct accounting
treatment for this transaction?
A Recognise the profit on disposal in the current year, capitalise
the new lease at the present value of the lease payments
B Spread the profit on disposal over five years, capitalise the
new lease at the present value of the lease payments
C Ignore the disposal, treat the sale proceeds as a financial
liability
D Revalue the plant to the value of the sale proceeds, treat the
sale proceeds as a financial liability

5 CS acquired a machine via a lease agreement on 1 January 20X7.

The lease was for a five-year term with rentals of $20,000 per year
payable in arrears. The present value of the lease rentals was
$80,000 and the annual interest rate implicit in the lease was 7.93%.
Calculate the non-current liability and current liability figures to
be shown in CS’s statement of financial position at
31 December 20X8.
Non-current liability _________________
Current liability _________________

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