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Chapter 3: Accounting for Leases
Accounting by lessees
Recognition
Lessees recognize a right-of-use asset and a corresponding lease liability for almost all lease contracts. A lease contract is the acquisition of a right to use an underlying asset, with the purchase price paid in instalments. The lessee recognizes the right-of-use asset and the lease liability initially at the commencement date.
Initial measurement – lease liability
At the commencement date, the lessee measures the lease liability at an amount equal to the present value of the lease payments during the lease term that are not paid at that date.
The discount rate that the lessee uses is the interest rate implicit in the lease, if that rate can be readily determined. This is the rate of interest that causes the present value of
(a) lease payments and
(b) the unguaranteed residual value to equal the sum of:
(i) the fair value of the underlying asset and
(ii) any initial direct costs of the lessor.
Q&A: If a lessee takes the practical expedient in paragraph 15 of IFRS 16 to not account for non-lease components separately, which lease payments should be used to calculate the interest rate implicit in the lease?
A lessee enters into a lease which includes a lease component and non-lease component. The lessee takes the practical expedient in paragraph 15 of IFRS 16 to not separate the non-lease components from lease components, and includes the full amount of the payments to the lessor as a lease. Assume that the lessee is able to readily determine the interest rate implicit in the lease, as explained.
Should the lease payments used to calculate the interest rate implicit in the lease include payments for the non-lease components?
Analysis
IFRS 16 does not clearly specify whether the lease payments used to calculate the interest rate implicit in the lease should include the non-lease components, but we believe that the non-lease components should be excluded. If the non-lease components were to be included, the calculation of the interest rate implicit in the lease would compare the fair value and residual value of the underlying asset to lease payments which include use of the underlying asset and also additional services. Excluding the non-lease components reflects how the contract is priced from the lessor’s perspective, which is the objective of IFRS 16. The interest rate implicit in the lease is specific to a lease. We think that lessees who choose not to separate non-lease components should calculate the interest rate implicit in the lease in the same way as lessors, for whom
IFRS 16 requires them to exclude non-lease components from the lease payments.
Accounting by lessee’s Initial measurement – lease liability
The lessee uses its incremental borrowing rate if the interest rate implicit in the lease cannot be readily determined.
Q&A: Which discount rate should a lessee use if the interest rate implicit in the lease is negative?
A lessee leases equipment for 10 years. The annual rent is a fixed amount of C100, 000 per annum, plus a variable amount of 2% of the revenue generated from the equipment. The unguaranteed residual value is C1, 000,000 and the fair value of the equipment is C2, 500,000. There are no initial direct costs. Because the variable payments that depend on the revenue generated are excluded from the lease payments, the calculation of the interest rate implicit in the lease gives a negative rate (–2.79%). The risk-free interest rate in the entity’s economic environment is positive.
Should the lessee use the interest rate implicit in the lease to calculate its lease liability?
According to IFRS 16, it was the objective of the IASB to specify a discount rate that reflects how the contract is priced. If the requirements in IFRS 16 result in an interest rate implicit in the lease that is negative (For example, because a significant part of the payments are variable and do not meet the definition of lease payments), that rate should not be used. Instead, the lessee should use its incremental borrowing rate.
The incremental borrowing rate 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.
Q&A: What factors should a lessee consider when determining an incremental borrowing rate?
The incremental borrowing rate 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.
Given the definition in Appendix A to IFRS 16 as well as in paragraphs BC160 to BC162 of IFRS 16, when calculating the incremental borrowing rate, a lessee should consider the following factors:
· The rate calculated should be the rate at which the entity could borrow.
· The rate should not reflect the cost of equity finance and, as such, it would be inappropriate to use a WACC (or any other rate including a component ‘cost of capital’ alongside the cost of debt).
· The use of a property yield is also not acceptable. However, there might be scenarios in which these rates can be used as a starting point, provided that appropriate adjustments are made.
· The rate should reflect the amount that the entity could borrow over the term of the lease. It should be the rate at which an entity would borrow to acquire an asset of similar value to the right-of-use asset, rather than to acquire the entire underlying asset. An exception would be where the lease term is for substantially all of the life of the underlying asset.
· The rate should reflect that of a secured borrowing for a similar asset (being the right-of-use asset, not the underlying asset), rather than an unsecured borrowing or general line of credit.
· The rate should reflect the credit standing of the entity and the rate at which it would borrow in a similar economic environment.
For example, if a company has GBP functional currency and typically borrows in GBP, but it enters into a US dollar lease, the incremental borrowing rate will reflect the cost of borrowing US dollars.
Q&A: Is the lessee required to reflect the lease payment profile when determining the IBR?
A lessee enters into a lease and cannot readily determine the interest rate implicit in the lease, so it uses its incremental borrowing rate (IBR) as the discount rate. IFRS 16 does not specify any particular methodology to estimate the IBR. Depending on the facts and circumstances, one method that a lessee might consider is to refer to a rate that is readily observable as a starting point (which it then adjusts for the factors specified in the definition of the IBR).
The IFRS Interpretations Committee ‘IC’ was asked whether a lessee’s IBR should reflect the interest rate in a loan with both a similar maturity and payment profile to the lease. [IFRIC update September 2019].
The IC noted that IFRS 16 does not explicitly require the IBR to reflect the interest rate in a loan with a similar payment profile to the lease payments. Nonetheless, in applying judgement to determine the IBR, it would be consistent with the Board’s objective when developing the definition of IBR to refer to the rate for a loan with a similar payment profile to that of the lease as a starting point, if such a rate was readily observable. Determining an IBR involves estimation considering many factors, and should consider the facts and circumstances relevant for the respective lease based on the information readily available to the entity.
The IC agenda decision refers to a readily observable rate with a ‘similar payment profile’ to the lease. If a readily observable amortizing loan rate is available to the lessee which has a similar payment profile to the lease, we would normally expect the lessee to use that rate as a starting point to determine the IBR.
However, in practice, a rate with a similar payment profile may not be readily available to the entity or it may not exactly match the payment profile of the lease. A lessee will need to exercise judgement to decide whether an observable rate that does not exactly match the payment profile of the lease is a reasonable starting point for calculating the IBR. In making this judgement a lessee could, for example, consider:
· the timing of payments: payments with significantly different timing from the lease are less likely to give a reasonable starting point;
· the maturity: a significantly different maturity is less likely to give a reasonable starting point; and
· The shape of the yield curve: if the yield curve is relatively flat, the different payment profile will have less impact, and so the rate is more likely to be a reasonable starting point.
A readily observable rate will need to be adjusted to calculate the IBR. The larger and more judgmental the adjustments, the more estimation uncertainty will exist in the final IBR. If estimating the IBR represents a critical accounting estimate, the entity should consider the IAS 1 disclosure requirements.
The following examples illustrate reasonable approaches that might be used to estimate the IBR in different scenarios but other approaches may also be acceptable:
Example 1
A lessee enters into a five-year lease with equal monthly lease payments. It can readily observe a borrowing rate for a five-year amortizing loan with equal quarterly payments. Although the timing of payments is not exactly the same, it is similar and so the observable rate could be a reasonable starting point to estimate the IBR.
Example 2
A lessee enters into a 13-month lease with equal monthly lease payments. It can readily observe a borrowing rate for a 12-month amortizing loan with equal monthly payments. Although the maturity is not exactly the same, it is similar and so the observable rate could be a reasonable starting point to estimate the IBR.
Example 3
A lessee with a poor credit rating enters into a five-year lease with equal monthly lease payments. The lessee cannot readily observe a loan with the same payment profile for an entity with a similar credit rating. It can readily observe a borrowing rate for a five-year amortizing loan with equal monthly payments for an entity with a significantly better credit rating. The lessee has recently taken out a four-year amortizing loan with equal monthly payments. The lessee is in an economic environment with relatively low risk-free rates and relatively flat yield curves, so the difference between a four- and five-year rates has less effect on the IBR than the credit adjustment that would be required to reflect the lessee’s credit rating. Although the observable five-year loan exactly matches the lease payment profile, significant adjustments could be required to the observable rate to determine the IBR and so there would be significant estimation uncertainty in the final IBR. The rate on the recent four-year loan taken out by the entity will already reflect the entity’s credit rating, and so adjusting it to estimate a five-year rate could likely create less estimation uncertainty in the final IBR. The recent four-year loan taken out by the entity could be a reasonable starting point to calculate the IBR. When determining the IBR from this starting point, an adjustment will be required to reflect the five-year lease term compared to the four-year loan term.
Example 4
A lessee enters into a nine-year lease with equal annual lease payments in arrears. The lessee cannot readily observe an amortizing loan with a maturity similar to the lease. It can readily observe amortizing loans with significantly shorter maturities. It can also readily observe bullet loans with a range of maturities (a bullet loan has periodic interest payments but the principal is only repaid at the end, so it does not reflect the timing of payments in this lease). After considering the factors listed above, the lessee decides to use the rates from the bullet loans as the starting point to calculate the IBR. The lessee could determine a discount rate that reflects the duration-specific rates from each point on the yield curve, constructed from the observable bullet loan rates. Alternatively, a single discount rate corresponding to the weighted average life of the lease payments might be a reasonable approximation if the lessee operates in an environment where the yield curve is relatively flat. In this example the weighted average life of the lease payments is five years, so the single rate corresponding to the five-year bullet loan could be a reasonable starting point to calculate the IBR.
Lease payments consist of the following components: fixed payments (including in-substance fixed payments), less any lease incentives receivable; variable lease payments that depend on an index or a rate; amounts expected to be payable by the lessee under residual value guarantees; the exercise price of a purchase option (if the lessee is reasonably certain to exercise that option); and payments of penalties for terminating the lease (if the lease term reflects the lessee exercising the option to terminate the lease).
Q&A: How should a lessee account for reimbursements from the lessor for leasehold improvements?
To determine whether a payment from the lessor to the lessee for leasehold improvements represents a lease incentive, an entity should evaluate the nature of the improvement and determine whether it represents a lessee or a lessor asset. The IFRSs do not give any precise guidance on how to make this judgement. We believe that the following approach closely follows the economics.
Generally, if a lease does not specifically require a lessee to make an improvement, the improvement should not be considered to be an asset of the lessor. If the lease requires the lessee to make an improvement, factors that could indicate that it is a lessor asset include:
· if the amount to be paid is based on the actual costs incurred by the lessee on specific improvements (conversely, if a lessor agrees to pay a fixed or formula-based amount to the lessee once the lessee provides evidence of the expenditures, regardless of their nature, it is reasonable to conclude that the improvements represent lessee assets); improvements that are not specialized to the lessee’s intended use and for which it is probable that it could be used by a subsequent lessee;
· If the improvement increases the fair value of the underlying asset from the standpoint of the lessor; and the economic life of the improvement relative to the lease term. If an improvement represents a lessee asset, the lessor payment is a lease incentive that should be recorded as a reduction to the lease payments (for lease incentives receivable) or only the right-of-use asset (for lease incentives received). On the other hand, reimbursement for an improvement that is a lessor asset is not a lease incentive; it should be recorded as a reimbursement to the lessee for the cost of the lessor asset.
Payments for the right to use the underlying asset qualify as lease payments, regardless of the timing of the payments.
Variable lease payments
There are three kinds of contingent payment, depending on the underlying variable: payments based on an index or a rate; payments not based on an index or a rate; and in-substance fixed payments.
Variable lease payments based on an index or a rate are part of the lease liability. Examples include payments linked to a consumer price index, a benchmark interest rate or a market rental rate. These payments are unavoidable from the perspective of the lessee, because any uncertainty relates only to the measurement of the liability, but not to its existence.
Variable lease payments based on an index or a rate are initially measured using the index or the rate at the commencement date. An entity does not forecast future changes of the index/rate; these changes are taken into account when the lease payments change.
Variable lease payments that are not based on an index or a rate are not part of the lease liability, but they are recognized in the income statement when the event or condition that triggers those payments occurs. As an example, lease payments that are variable based on the revenue resulting from a retail store are recognized as the revenue is earned.
Q&A: What are examples of variable payments not linked to an index or a rate?
Variable payments that are not linked to an index or a rate include, for example, payments linked to a lessee’s performance derived from the underlying asset, such as payments of a specified percentage of sales made from a retail store or based on the output of a solar or a wind farm.
Another example is payments linked to the usage of the underlying asset, such as payments if the lessee exceeds a specified mileage of a leased car.
Example 1
A car is leased under a three-year contract. The lease rentals are fixed, provided that the mileage does not exceed a specified amount during that period. Any mileage incurred above the specified amount is subject to an additional charge per mile. How should the lease payments that are included in the lease liability be calculated initially? The lease liability should only include the fixed rentals. The charges for excess mileage are variable lease payments that do not depend on an index or a rate, and they do not meet the criteria of in-substance fixed payments.
Example 2
The payments could either be viewed as payments entirely for the disposables, or they could be viewed to include an element of lease payment. Assuming that an element of the payments is viewed as being a lease payment, they would be variable payments which are not linked to an index or a rate and are not in-substance fixed, and so they would be excluded from the initial measurement of the lease liability.
Q&A: How are variable lease payments that depend on more than one variable accounted for?
Example 1
A lessee enters into a 10-year lease of a retail unit for which the lease payments contain a variable component. The variable component depends on the amount of revenue from the retail unit and on the change in market rents since the commencement date. It is calculated as follows: Lease payment = (2% × revenue from the retail unit during the last 12 months) × (market rent at the payment date ÷ market rent at the commencement date) the lease payments have to be made at the end of each year (31 December).
Are the variable payments part of the lease liability?
Analysis
Variable payments that depend on an index or a rate (such as a market rent IFRS 16) are included in the lease liabilities, whereas all other variable payments are excluded (provided that they do not meet the definition of in-substance fixed payments).
If a payment depends on several variables, at least one of which is not an index or a rate (and the variable payment does not meet the definition of an in-substance fixed lease payment), an entity has to analyses how the different variables are linked together:
If payments that depend on each variable are independent from each other, they are calculated separately. Only those payments that depend on an index or a rate (or meet the definition of in-substance fixed payments) are included in the lease liability. If payments that depend on each variable are not independent from each other, the entire payment is not part of the lease liability (unless it meets the definition of an in-substance fixed lease payment). In this example, one of the variables is not based on an index or a rate (revenue).
Furthermore, the variables are not independent from each other, because they are multiplied together. Hence, the entire variable payments are not included in the lease liability. Instead, they are recognized when they occur or become in-substance fixed.
Example 2
The fact pattern is the same as in example 1.
However, the calculation of lease payments is changed so that the variables are not multiplied together. Lease payment = (2% × revenue from the retail unit during the last 12 months) + (market rent at the payment date – market rent at the commencement date)
Analysis
Because the variables are not multiplied together, the variable payment that depends on revenue and the variable payment that depends on changes in market rents can be calculated separately. At the commencement date, the variable payment that depends on changes in market rents is included in the lease liability. Because variable lease payments that depend on an index or a rate are measured based on the index or the rate as at the commencement date, the amount of the variable lease payments that has to be included in the initial lease liability is zero. When the cash flows change because of a change in the market rent, the lessee remeasured the lease liability based on the market rent as at that date for the remaining lease term. The variable payments that depend on revenue are not based on an index or rate, and so they are not part of the lease liability. Instead, they are recognized when they occur or become in-substance fixed.
Q&A: How are variable payments of property tax and insurance measured?
A lessee is obliged to reimburse the lessor for property taxes and insurance. Applying IFRS 16, the lessee has determined that, in its specific situation, the payments for property taxes and insurance do not transfer a separate good or service, so they are not accounted for as a separate non-lease component. The lease contract has no service or other non-lease components, and so these tax and insurance payments are allocated as lease payments.
Often, payments for reimbursing the lessor for property taxes and insurances are variable. Depending on the specific facts and circumstances in each lease and each jurisdiction, there could be different causes of variability. Below we present potential types of variable payment and how they could be measured, but there is significant judgement involved.
Property tax example
The property tax is calculated as the tax value of the property multiplied by a fixed percentage. The tax value of the property is determined based on specific requirements in tax law, and hence is not a market value. The tax values are re-determined regularly. Even though the valuation of the property might take into account market indices or rates, it is not, in itself, an index or a rate. Hence, the payments should be accounted for as variable lease payments that do not depend on an index or a rate. Only the payments that are already in-substance fixed are included in the initial measurement of the lease liability.
For example, if the property taxes are known for the first year and then will be re-determined from the second year, only the property taxes for the first year would be included initially, and the payments for future periods would be recognized when they occur or become in-substance fixed.
Insurance example
The initial amount of the insurance premium is known by both parties, but it is not explicitly stated in the contract. Furthermore, the amount might change over time for reasons other than the market value (For example, if the insurance company’s assessment of risk changes or the lessor moves to another insurance company). The amount of premiums might vary in subsequent periods so the payments by the lessee meet the definition of variable lease payments. They are not, however, interpreted as being dependent on an index or a rate. Only the payments that are already in-substance fixed are included in the initial measurement of the lease liability.
For example, if the insurance premium is known for the first year and then will vary from the second year, only the insurance premium for the first year would be included initially, and the payments for future periods would be recognized when they occur or become in-substance fixed. For payments initially excluded from the lease liability, if the variability is resolved at a later point in time (For example, the insurance premiums become known and unavoidable for the upcoming year) they become in substance fixed payments at that point in time in accordance with IFRS 16.
Lease payments that, in form, contain variability but, in substance, are unavoidable are referred to as ‘in-substance’ fixed payments, and they are included in the lease liability. A lease payment structured as a variable payment is in-substance fixed if, for example, there is no genuine variability in that payment. Examples include payments which must be made if the asset is proven to be capable of operating, or payments which must be made only if an event occurs that has no genuine possibility of not occurring.
Q&A: When do variable lease payments meet the definition of in-substance fixed payments?
IFRS 16 does not contain explicit guidance that explains when variable payments meet the definition of in-substance fixed payments. Each contract has to be assessed carefully, taking into account all relevant facts. The analysis is highly judgmental. The examples below illustrate the principle of in-substance fixed payments.
Example 1
A lessee enters into a 10-year lease of retail space, for which the lease payments will be C1 per year, unless sales are more than C1, 000 for that annual period. In that case, the annual lease payment is C1, 000,000. The lessee is required to open the store during normal hours, so there is no genuine possibility of sales being below C1, 000. Does the contingent lease payment of C1, 000,000 meet the definition of an in-substance fixed payment? In this example, the payment of C1, 000,000 is an in-substance fixed payment. The lease was written so as to make the lease payments appear to be performance-based. However, since the threshold is so low, it is clear that sales of less than C1, 000 are not a genuine possibility and that the lease payments are in-substance unavoidable. Accordingly, the contract contains in-substance fixed payments of C1, 000,000 per annum.
Example 2
A lessee enters into a 10-year lease of property, for which the lease payments will be 3% of the lessee’s sales generated from the leased property. The lessee’s annual sales have been stable and have continuously exceeded C1, 000,000 in prior years, and they are expected to continue to grow for the foreseeable future.
What is the amount of the lease payments that the lessee includes in its lease liability?
Although the probability of occurrence would appear to be high, on the basis of relevant history and experience, the variable lease payments in this case are based exclusively on, and vary directly with, performance. This creates genuine variability in the payments to be made by the lessee and received by the lessor. Consequently, those payments would not be variable lease payments that are in-substance fixed.
Example 3
Entity T is a telecommunications company that has entered into a lease contract with entity S for exclusive use of a submarine cable for overseas communication. The contract is for 10 years, which corresponds to the cable’s economic life. The lease payments are dependent on the cable’s usage, subject to a ceiling amount of C10 million per year at 100% usage, and a minimum amount (floor) of C6 million per year, which corresponds to a usage of 60% or lower. Management of entity T estimates that the cable’s average usage will be approximately 85%, and the average annual lease payments are expected to be C8.5 million.
How should the lease payments be calculated?
Annual lease payments of C6 million, which is the amount that entity T is contractually required to pay, should be included when calculating the lease payments. Entity T should not include a best estimate of the variable rents in the lease payments. The additional C2.5 million that entity T expects to pay each year are variable rents, because they vary based on the future use of the leased asset.
Example 4
A utility company (customer) enters into a contract with a power company (supplier) to purchase all of the electricity produced by a solar farm for 20 years. There are no minimum purchase requirements. However, if the solar farm produces electricity, the customer is required to purchase all of the produced electricity. Whether and how much electricity the solar farm produces is solely dependent on the duration and intensity of sunshine. As consideration for the electricity supply, the parties agree on lease payments that vary directly with the produced volumes of electricity (that is, C1 per kWh). There are no fixed payments agreed. The customer has assessed the terms of the contract and concluded that the contract contains a lease, and it has a right to use the solar farm for 20 years.
Does the customer have to recognize a lease liability?
Lease payments that vary with the level of energy produced by the solar farm (which is driven by the level of sunshine) should be treated in the same way as the variable lease payments based on the lessee’s sales in Example 2. The fact that the conditions that trigger those payments are outside the control of the customer does not affect the decision. Consequently, those payments would not be variable lease payments that are in-substance fixed.
The existence of a choice for the lessee within a lease agreement can also result in an in-substance fixed payment. For example, after the initial lease term, a lessee might be obliged to choose between either extending the lease term or purchasing the underlying asset. Assuming that both choices are realistic, the lowest discounted cash outflow (either the discounted lease payments throughout the extension period, or the discounted purchase price) represents an in-substance fixed payment. The lessee cannot argue that neither the extension option nor the purchase option will be exercised. If only one of the lessee’s choices is realistic, the payments resulting from that choice are included in the lease liability.
Residual value guarantees
Amounts expected to be payable by the lessee under a residual value guarantee are also included in the initial measurement of the lease liability. A residual value guarantee captures any kind of guarantee made to the lessor that the underlying asset will have a specified minimum value at the end of the lease term.
Q&A: How is the amount payable under a residual value guarantee measured?
The Basis for Conclusions notes that the measurement of a residual value guarantee should reflect the entity’s reasonable expectation of the amount that will be paid. Measuring the residual value guarantee is an estimate, and entities should apply judgement to determine an appropriate estimate for their leases. Initial measurement – right-of-use asset
Initial measurement – right-of-use asset
At the commencement date, the lessee measures the right-ofuse asset at cost.
The cost of the right-of-use asset consists of the initial lease liability plus any lease payments made to the lessor at or before the commencement date (less any lease incentives received), plus the initial estimate of restoration costs and any initial direct costs incurred by the lessee.
Q&A: Accounting for restoration costs relating to a leased asset
A retailer leases a retail store and, as part of the lease contract, it is obliged to return the store in the same condition that it received it.
When the retailer creates a provision under IAS 37, should the corresponding entry be capitalized or recognized as an expense?
IFRS 16 states that the initial measurement of the right of-use asset includes removal and restoration costs, which is comparable to the guidance in IAS 16.
Mezzanine floor
The retailer installs a mezzanine floor and recognizes a provision under IAS 37 to remove it at the end of the lease. The retailer includes the corresponding entry as part of the right-of-use asset, applying IFRS 16. Although the guidance in paragraph 24(d) is in the initial measurement section, paragraph 25 states that the restoration costs should be recognized as part of the cost of the right-of-use asset when the retailer incurs an obligation for those costs. For example, if the mezzanine floor is installed midway through the lease term, in our view the retailer can still capitalize it into the right-of-use asset.
Wear and tear
During the lease term, the retailer incurs wear and tear damage which it will need to repair at the end of the lease term, and it recognizes a provision over the lease term. In our view, the retailer should recognize the corresponding entry as an expense. The provision for wear and tear does not create an asset. The Basis for Conclusions to IFRS 16 explains that the measurement of right-of-use assets at cost is intended to be consistent with IAS 16, which only allows restoration and removal costs to be capitalized if they relate to an asset’s installation, construction or acquisition.
Restoration costs
The lessee might be obliged to return the underlying asset to the lessor in a specific condition or to restore the site on which the underlying asset has been located. The lessee recognizes a provision in accordance with IAS 37, ‘Provisions, contingent liabilities and contingent assets’, to reflect this obligation.
The initial carrying amount of any provision is included in the measurement of the right-of-use asset when it incurs an obligation for those costs (either at the commencement date or during the term of the lease). This corresponds to the accounting for restoration costs under IAS 16, ‘Property, plant and equipment’.
Initial direct costs
Initial direct costs are defined as “… incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained …”. Such costs include commissions or some payments made to existing lessees to obtain the lease. All initial direct costs are included in the initial measurement of the right-of-use asset.
Q&A: Which costs typically qualify as initial direct costs?
IFRS 16 defines initial direct costs as “Incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained”. This means that costs which are payable regardless of whether the lease is ultimately obtained cannot be capitalized as initial direct costs. The following costs do not meet the definition of initial direct costs in IFRS 16: Internal administration and overhead costs that are not incremental. External costs (such as legal, arrangement and brokers’ fees) that are incremental but would still be payable even if the lease was not finalized.
Examples of costs which do meet the IFRS 16 definition of initial direct costs include: External legal costs to finalize the lease contract after the parties have already committed to the lease (For example, after a binding head of terms has been signed). For a lessee, arrangement and brokers’ fees payable that are only payable if the lease is signed (that is, success fees).
For a lessor, commission to an employee that is only payable if the lease is signed. Payments from a new lessee to an old lessee might also qualify as initial direct costs.
Q&A: Can a lessee capitalize costs which do not qualify as initial direct costs?
A lessee enters into a lease and incurs costs related to the leased tangible asset with a third party, for example to transport it to the initial desired location so that the lessee can use the asset as intended or to install it.
How should the lessee account for these costs?
The costs do not qualify as initial direct costs in IFRS 16 because they are not costs of obtaining the lease. The lessee should first consider whether any accounting standard applies to the costs, For example, IAS 16.
If these costs are not in the scope of any other accounting standard, IFRS 16 does not provide guidance on how to account for these costs. In our view the lessee has an accounting policy choice between either:
a) Analogizing to IAS 16
Applying IAS 8, there is a similar and related issue in IAS 16. If the costs could be capitalized in IAS 16, the lessee can capitalize equivalent costs relating to a leased asset.
Alternative A is supported by IFRS 16, which suggests that the costs capitalized for a leased asset should be comparable to a purchased asset.
b) Expensing the costs as incurred IFRS 16 provides no guidance allowing these costs to be capitalized.
Considering the definition of expenses in the Conceptual Framework, these costs could be viewed as an increase in liabilities (trade creditors) which results in a decrease in equity, and therefore expensed as incurred.
The policy chosen should be consistently applied and disclosed. If this choice represents a critical accounting judgement, the entity should consider the IAS 1 disclosure requirements.
The lessee might make payments to the lessor that do not relate to the right to use the underlying asset but instead to the (re)design or construction of the underlying asset. These payments do not qualify as lease payments. Instead, the lessee accounts for them in accordance with other applicable standards, such as IAS 16.
Subsequent measurement – lease liability
The lessee subsequently measures the lease liability using the effective interest rate method. It remeasures the carrying amount to reflect any re-assessment, lease modification, or revised in-substance fixed lease payments.
A re-assessment of the lease liability takes place if the cash flows change based on the original terms and conditions of the lease, for example if the lease term changes or lease payments change based on an index or rate. Changes that were not part of the original terms and conditions of the lease are lease modifications.
Q&A: Which events trigger a re-assessment and how does the lessee calculate the new carrying amount of the lease liability?
Lease term and associated extension and termination payments.
When?
If a lessee re-assesses the lease term, as explained.
How?
Reflect the revised payments using a revised discount rate (that is, the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined; otherwise, the incremental borrowing rate at the date of re-assessment).
Exercise of a purchase option
When?
If a significant event or change in circumstances occurs that is within the control of the lessee and affects whether the lessee is reasonably certain to exercise a purchase option.
How?
Reflect the revised payments using a revised discount rate (that is, the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined; otherwise, the incremental borrowing rate at the date of re-assessment).
Amounts expected to be payable under a residual value guarantee
When?
If there is a change in the amount expected to be paid.
How?
Include the revised residual payment using the unchanged discount rate.
Variable lease payment dependent on an index or a rate
When?
If a change in the index or rate results in a change in cash flows.
How?
Reflect the revised payments based on the index or rate at the date when the new cash flows take effect for the remainder of the term using the unchanged discount rate. (Exception: the discount rate has to be updated if the change results from a change in floating interest rates.)
Q&A: How are variable lease payments that depend on an index or a rate subsequently measured?
Example 1
An entity operating in an inflationary environment entered into a 10-year lease contract with annual lease payments of C50000, payable at the beginning of each year. Every two years, lease payments will be adjusted to reflect changes in the Consumer Price Index (CPI) for the preceding 24 months. At the commencement date, the CPI was 125. At the beginning of the third year, the CPI is 135.
When is the lease liability re-assessed?
On initial recognition, the lease liability is calculated based on the contractual lease payments of C50000 per annum. Even if the CPI changes, the entity will not re-measure its lease liability before the beginning of the third year; this is because, until then, the change in the CPI does not result in a change in cash flows. At the beginning of the third year, however, the lease liability has to be adjusted, because the contractual cash flows have changed.
How is the lease liability re-assessed?
The revised measurement of the lease liability is at the present value of the revised payments, based on the CPI at the date when the cash flows change for the remainder of the term using the unchanged discount rate (that is, C50,000 × 135 / 125 = C54,000).
Example 2
The fact pattern is the same as in example 1 but, instead of reflecting changes in CPI, the lease payments are adjusted each year to reflect LIBOR, an observable interest rate. At the commencement date, the LIBOR rate is 2.0%.
When is the lease liability re-assessed?
On initial recognition, the lease liability is calculated based on the contractual lease payments of C50,000 per annum. Even if LIBOR changes every period, the entity will not re-measure its lease liability before the beginning of the third year; this is because, until then, the change in LIBOR does not result in a change in cash flows of the lease. At the beginning of the third year, however, the lease liability has to be adjusted, because the contractual cash flows have changed.
How is the lease liability re-assessed?
The lease liability is remeasured to the present value of the revised payments based on LIBOR at the date when the cash flows change for the remainder of the lease term. Because the change in cash flows are caused by a change in floating interest rates, the lease liability is calculated using a revised discount rate.
The lease liability is also remeasured if payments initially structured as variable payments become in-substance fixed payments because of the variability being resolved at some point after the commencement date.
Q&A: How are variable lease payments that become fixed for part of the remaining lease term accounted for?
IFRS 16 explains that “payments that are initially structured as variable lease payments linked to the use of the underlying asset but for which the variability will be resolved at some point after the commencement date so that the payments become fixed for the remainder of the lease term … become in-substance fixed payments when the variability is resolved”. But the standard gives no further guidance on how the term “become fixed for the remainder of the lease term” should be interpreted.
Example
An entity enters into a lease contract to lease a piece of machinery; the lease term is 25 years. The exact capacity of the machine is unknown until it is installed and running for a year. Lease payments are calculated as follows:
Year 1: Lease payment is fixed.
Years 2 to 15: Lease payments are fixed based on the units produced by the machine in the second half of year 1.
Years 16 to 25: Lease payments vary based on the actual units produced by the machine.
Do the lease payments for years 2 to 15 become in-substance fixed lease payments at the end of year 1?
For those lease payments that are made from year 2 to year 15, any variability is resolved at the end of year 1. At the end of year 1, they therefore become in-substance fixed payments. The lease liability is re-measured and the right-of-use asset is adjusted accordingly. The fact that, after year 15, lease payments are variable again, and hence lease payments become fixed for only a part of the remaining lease term and not the entire remaining lease term, does not affect that conclusion.
Subsequent measurement – right-of-use asset
The right-of-use asset is subsequently measured at cost, less accumulated depreciation and any accumulated impairment losses. Any remeasurement of the lease liability results in a corresponding adjustment to the right-of-use asset. The adjustment can be positive or negative.
The carrying amount of the right-of-use asset cannot be negative. If it is already reduced to zero, the lessee recognizes any further reduction resulting from the remeasurement of the lease liability in the income statement.
The lessee calculates depreciation of the right-of-use asset in accordance with IAS 16. This will result in a depreciation on a straight-line basis or another systematic basis that is more representative of the pattern in which the entity expects to consume the right-of-use asset.
The right-of-use asset is depreciated over the shorter of the lease term and the useful life of the right-of-use asset, unless there is a transfer of ownership or purchase option which is reasonably certain to be exercised at the end of the lease term. If there is a transfer of ownership or purchase option which is reasonably certain to be exercised at the end of the lease term, the lessee depreciates the right-of-use asset over the useful life of the underlying asset.
Q&A: When are expenses recognized for a lease with non-consecutive periods of use?
Customer Corp enters into a lease with Supplier Corp to use a specific grain storage facility over a five-year period in the months of September and October. Customer Corp does not apply the short-term exemption to this class of underlying asset and therefore recognizes a lease liability and right-of-use asset at commencement of the lease.
Question
When are the depreciation and interest expenses recognized?
Solution
The useful life of the right-of-use asset is the periods of use (that is, the months of September and October in each of the five years). The right-of-use asset is only depreciated during the periods of use, and it is not depreciated during the periods of non-use. Interest is recognized on the lease liability during both periods of use and periods of non-use, because the discounting unwinds on the liability over the five years.
Q&A: Lessee accounting for key money
A retailer entered a long-term lease agreement for a store in a prime location. The retailer paid ‘key money’ to the incumbent tenant to take over the space. Under local law, the retailer has the right to ask for renewal of the lease at the end of the initial lease term (at rates which do not necessarily reflect market terms). If the lessor refuses the renewal, it must indemnify the lessee for the damages suffered.
Alternatively, the retailer might choose not to ask for a renewal at the end of the initial lease term, in which case it could allow a new tenant to take over the premises and would be entitled to receive key money from the new lessee. The retailer expects to be able to recover the original amount paid when it vacates the premises, through either an indemnification from the lessor or key money from a new lessee.
How should the retailer account for the key money paid?
Payments from a new lessee to an old lessee qualify as initial direct costs, and they are included in the initial measurement of the right-of-use asset.
When determining the subsequent measurement of the right-of-use asset, one acceptable approach is to treat the key money as a separate component of the right-of-use asset when applying the depreciation requirements of IAS 16, as required by IFRS 16. Such a treatment, in line with of IAS 16, recognizes that the key money provides financial benefits over a period longer than the IFRS 16 lease term.
IAS 16 states that depreciation is recognized, provided that the residual value does not exceed the asset’s carrying amount. If the retailer expects that the residual amount will be equal to, or exceed, the key money component, the depreciation charge will be zero for this component. An alternative approach is to treat the right-of-use asset (that is, including the key money) as a single asset, viewing the key money as linked to the right-of-use asset itself. The contract as a whole (including the key money) gives several rights to the tenant, which would not be distinguished under this approach, and the right-of-use asset has a residual value based on what the lessee expects to recover when it vacates the premises.
Under this approach, subsequent increases in the expected recoverable amount of the key money will therefore increase the residual value of the right-of-use asset as a whole, and hence reduce the total depreciation charge. Applying IFRS 16 to key money might represent a critical accounting judgement, in which case the lessee should consider the IAS 1 disclosure requirements.
The lessee applies the impairment requirements in IAS 36, ‘Impairment of assets’, to the right-of-use asset.
Any subsequent change in the measurement of the restoration provision, due to a revised estimation of expected restoration costs, is accounted for as an adjustment of the right-of-use asset, as required by IFRIC 1, ‘Changes in existing decommissioning, restoration and similar liabilities.
The right-of-use asset is adjusted under IFRIC 1 if the provision for restoration costs has changed due to, For example, a revised estimate of expected costs. The change in the carrying amount of the right-of-use asset would be equal to the change in the carrying amount of the provision. If adjustments result in an addition, the lessee considers whether this is an indication that the new carrying amount of the right-of-use asset might not be fully recoverable.
Other models for the subsequent measurement of right-of-use assets
There are two alternative measurement models, in addition to cost, for certain right-of-use assets. A lessee that has elected the fair value model in IAS 40 for investment property must also apply the fair value model to any right-of-use assets that are investment properties
A lessee that applies the revaluation model to a class of property, plant and equipment can elect to subsequently measure the corresponding class of right-of-use assets under the revaluation model. The election is applied to all right-of-use assets in that class.
Decrease in the scope of a lease
The scope of the lease decreases if the lease is modified to terminate the right of use of one or more underlying assets or to shorten the contractual lease term. For example, a lessee that already leases three floors of a building could decrease the scope of the lease by agreeing with the lessor to reduce the lease by one floor for the remaining lease term.
For a modification that decreases the scope of a lease, the lessee remeasures the lease liability at the effective date of the modification, using a revised discount rate. The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term. The lessee uses its incremental borrowing rate at that time if the interest rate implicit in the lease is not readily determinable.
For a modification that decreases the scope of the lease, the lessee decreases the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease. A lessee recognizes any gain or loss relating to the partial or full termination in the income statement.
Q&A: Lessee accounting for a modification that decreases the scope of a lease (example)
A lessee enters into a lease for 5,000 square meters of office space for 10 years. The lease payments are fixed at C50000 per annum. After five years, the parties amend the contract to reduce the office space by 2,500 square meters. From year 6 onwards, the annual lease payments will be C30000. At the beginning of year 6, the lessee’s incremental borrowing rate is 5% (assume that the rate implicit in the lease at that date is not readily determinable). The carrying amounts of the lease liability and right-of-use asset before modification are as follows:
Right-of-use asset C184002
Lease liability C210618
How is the modification accounted for?
The value of the lease liability after the modification is C129,884
(= C30,000/1.05 + C30,000/1.05 2 + C30,000/1.05 3 + C30,000/1.05 4 + C30,000/1.05 5).
In a first step, the right-of-use asset and the lease liability are reduced by 50%, because the original office space is reduced by 50%. The difference between these two amounts is recognized as a gain in profit or loss:
Lease liability (50% of the carrying amount before modification) C105,309
Right-of-use asset (50% of the carrying amount before modification) C92,001
Gain C13,308
In a second step, the right-of-use asset has to be adjusted to reflect the updated discount rate and the change in the consideration. Accordingly, the difference between the remaining lease liability (C105,309) and the modified lease liability (C129,884) is recognized as an adjustment to the right-of-use asset:
Right-of-use asset C24,575
Lease liability C24,575.
Increase in the scope of a lease
If a modification increases the scope of the lease by adding the right to use more underlying assets, and the increase in the lease consideration is commensurate, the modification is accounted for as a separate lease. To be commensurate, the increase in the lease consideration does not need to be equal to the stand-alone price of the increase in scope. For example, if a lessee already leases floors in a building and the modification adds the right to use an additional floor, the additional consideration could be different from the stand-alone price, because the lessor could avoid costs of looking for a new lessee (such as marketing costs).
If a modification increases the scope of the lease without adding the right to use more underlying assets, or the increase in lease consideration is not commensurate, the modification is accounted for by remeasuring the existing lease. The lessee remeasures the lease liability at the effective date of the modification, using a revised discount rate, and it makes a corresponding adjustment to the right-of-use asset. The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term. The lessee uses its incremental borrowing rate at that time if the interest rate implicit in the lease is not readily determinable.
Q&A: How is an increase in scope without a corresponding increase in the lease consideration accounted for?
A lessee enters into a lease for 5,000 square meters of office space for 10 years. The lease payments are fixed at C100000 per annum. After five years, the parties amend the contract for an additional 5,000 square meters. The annual lease payments increase to C150000. The market rent for the additional 5,000 square meters is C100000.
At the beginning of year 6, the lessee’s incremental borrowing rate is 7% (assume that the interest rate implicit in the lease at that date is not readily determinable). The parties decided to add an additional right of use (that is, for 5,000 square meters of office space) and increase the scope of the lease.
However, the additional lease payments are not commensurate with the stand-alone price for the additional office space and any appropriate adjustments. Accordingly, the modification is not accounted for as a separate lease, but as an adjustment to the original lease. The modified lease liability is calculated as the present value of the five remaining lease payments (C150000 each), discounted using the lessee’s incremental borrowing rate at the effective date of the lease modification (7%).
This results in a (revised) lease liability of C615030. The difference between this amount and the carrying amount of the lease liability immediately before the modification of the lease is recognized as an adjustment to the right-of-use asset.
If, however, the consideration for the additional office space is increased by C100000 per annum to C200,000 per annum (that is, by an amount equal to the stand-alone price for the additional right of use), the modification is instead accounted for as a second, separate lease for 5,000 square meters of office space over a five-year period. The lease of the original office space is accounted for separately and is not adjusted (For example, the discount rate is not changed).
Q&A: How to account for a modification that is not accounted for as a separate lease if the modification is not effective immediately?
A lessee enters into an agreement to modify an existing lease contract to grant the lessee the right to use additional office space. The increase in rent is not commensurate with the stand-alone price for the additional office space and any appropriate adjustments. The lease modification is therefore not accounted for as a separate lease.
How does a lessee account for the modification if the effective date of the modification is before the commencement date of the new lease component?
Since the increase in consideration is not commensurate with the standalone price for the increased space, the respective discount relates to both the new lease component (additional office space) and the existing lease component. Thus, the modification affects both the existing and the additional right of use and needs to be allocated to the respective components. The lease liability relating to the existing lease is remeasured at the date of the modification in accordance with IFRS 16.
However, with respect to the new lease component, where the commencement date deviates from the effective date of the lease modification, the measurement of the lease liability takes place at the date of the modification, whereas recognition of the additional lease component takes place at the commencement date.
Example
Lessee enters into a 10-year lease for 10,000 square feet of office space. The lease payments are C100,000 per year, paid in arrears. Lessee’s incremental borrowing rate at lease commencement is 6 percent. At the beginning of year 6, Lessee and Lessor agree to modify the contract to include an additional 10,000 square feet of office space on a different floor of the building for the final 4 years of the original 10-year lease term for a total annual fixed payment of C150,000 for the 20,000 square feet.
The increase in the lease payments (of C50,000 per year) is at a substantial discount to the market rate at the date the modification is agreed to for leases substantially similar to that for the new 10,000 square feet of office space that cannot be attributed solely to the circumstances of the contract. Consequently, Lessee does not account for the modification as a separate contract.
Instead, Lessee accounts for the modified contract, which contains 2 separate lease components—first, the original 10,000 square feet of office space and, second, the right to use the additional 10,000 square feet of office space for 4 years that commences 1 year after the effective date of the modification. There are no non-lease components of the modified contract.
The total lease payments, after the modification, are C700000 (1 payment of C100,000 + 4 payments of C150,000). Lessee allocates the lease payments in the modified contract to the 2 separate lease components on a relative standalone price basis, which, in this example, results in the allocation of C3887889 to the original space lease and C311111 to the additional space lease. The allocation is based on the remaining lease terms of each separate lease component (that is, 5 years for the original 10,000-square-foot lease and 4 years for the additional 10,000-square-foot lease).
Lessee re-measures the lease liability for the original space lease as of the effective date of the modification on the basis of all of the following:
a. A remaining lease term of 5 years.
b. Annual allocated lease payments of C77778 in years 6 through 10.
c. Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
The re-measured lease liability for the original space lease equals C318904. Lessee recognizes the difference between the carrying amount of the modified lease liability and the carrying amount of the lease liability immediately before the modification of C102332 (C421236 – C318904) as an adjustment to the right-of-use asset.
At the end of year 6, Lessee makes its lease payment of C100000, of which C77778 is allocated to the lease of the original office space and C22222 is allocated to the lease of the additional office space as a prepayment of rent. Lessee allocates the lease payment in this manner to reflect even payments for the even use of the separate lease components over their respective lease terms.
At the commencement date of the separate lease component for the additional office space, which is 1 year after the effective date of the modification, Lessee recognizes the lease liability at C244632 on the basis of all of the following:
a. A lease term of 4 years.
b. Four allocated annual payments of C72222 ([allocated lease payments of C311,111 − C22,222 rent prepayment] ÷ 4 years).
c. Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
At the commencement date, the right-of-use asset for the additional office space lease component is recognized and measured at C266854 (the sum of the lease liability of C244632 and the prepaid rent asset of C22222). During years 7–10, Lessee allocates each C150000 annual lease payment of C77778 to the original office space lease and C72222 to the additional office space lease.
No change in scope
A change in the consideration for the lease, without increasing or decreasing the scope of the lease, results in a remeasurement of the lease liability and a corresponding adjustment to the right-of-use asset. The lessee remeasures the lease liability, using the interest rate implicit in the lease for the remainder of the lease term, and it makes a corresponding adjustment to the right-of-use asset. The lessee uses its incremental borrowing rate at the effective date of modification if the interest rate implicit in the lease is not readily determinable.
For all modifications that are not accounted for as a separate lease, the lessee allocates the consideration in the modified contract between separate lease and non-lease components, and it determines the lease term of the modified lease.
Accounting by lessors
Accounting for finance leases by lessors
Recognition and measurement at the commencement date – general
Recognition and measurement – general
At the commencement date, a lessor should recognize assets held under a finance lease in its statement of financial position and present them as a receivable at an amount equal to the net investment in the lease. [IFRS 16:67]
Initially, the lessor will recognize a finance lease receivable under IFRS 16:67, at the amount equal to the net investment in the lease. Subsequently, finance income will be recognized at a constant rate on the net investment under IFRS 16:75 (see 11.1.3). During any ‘rent-free’ period, this will result in the accrued finance income increasing the finance lease receivable.
Net investment in the lease – definition
The net investment in the lease is the gross investment in the lease discounted at the interest rate implicit in the lease.
The gross investment in the lease is the sum of:
(1) lease payments receivable by the lessor under a finance lease, and
(2) any unguaranteed residual value accruing to the lessor.
The interest rate implicit in the lease is the rate of interest that causes the present value of:
(a) the lease payments, and
(b) the unguaranteed residual to equal to the sum of
(i) the fair value of the underlying asset, and
(ii) any initial direct costs of the lessor.
Impact of lease incentives on calculation of lease payments and determination of the interest rate implicit in the lease
If the lessor grants any incentives to the lessee, such as an initial rent-free period, then, at the inception of the lease, calculation of the lease payments and determination of the interest rate implicit in the lease by the lessor will factor in nil payments by the lessee during the rent-free period.
Initial direct costs
For lessors (other than a manufacturer or dealer lessor), initial direct costs are required to be included in the initial measurement of the net investment in the lease, and reduce the amount of income recognized over the lease term.
Initial direct costs are defined as the “incremental costs of 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”.
Under IAS 17, the definition of initial direct costs is “incremental costs that are directly attributable to negotiating and arranging a lease, except for such costs incurred by manufacturer or dealer lessors”. The reason for changing the definition for initial direct costs in IFRS 16 is to be consistent with the definition of ‘incremental costs of obtaining a contract’ in IFRS 15, to ensure that costs incurred by a lessor to obtain a lease are accounted for consistently with costs incurred to obtain other contracts with customers.
Initial direct costs
In the context of identifying initial direct costs, the key question is whether the costs under consideration would have been incurred irrespective of whether the lease was obtained. If the answer is ‘yes’, then the costs are not initial direct costs. Therefore, for example, the salaries of permanent staff employed to negotiate and arrange new leases are not initial direct costs because they will be incurred irrespective of whether the lease is obtained. In contrast, ‘signing commissions’ paid to employees when a specific lease is finalized, or commissions for signed lease contracts paid to agents who introduced the lessee, will qualify as initial direct costs and should be included in the initial measurement of the net investment in the lease.
Other costs frequently identified as initial direct costs are legal and other professional fees associated with the arrangement and negotiation of a lease, although these should be carefully scrutinized to ensure that they are genuinely incremental (i.e., that they do not include, for example, any ‘retainer’ element or fees of a more general nature).
This interpretation of ‘incremental’ in this context has been considered and affirmed by the IFRS Interpretations Committee (see March 2014 IFRIC Update). Although the Committee was dealing with IAS 17 at that time, the same principles apply under IFRS 16.
Note that, although the IFRS Interpretations Committee considered this issue specifically in the context of finance leases under IAS 17, the guidance applies equally to operating leases under that Standard and to both finance and operating leases under IFRS 16.
Initial measurement of the lease payments included in the net investment in the lease
At the commencement date, the lease payments included in the measurement of the net investment in the lease comprise the following payments for the right to use the underlying asset during the lease term that are not received at the commencement date: [IFRS 16:70]
- fixed payments (including in-substance fixed payments as described in IFRS 16), less any lease incentives payable;
- variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date;
- any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee;
- the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (assessed considering the factors described in IFRS 16:); and
- payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.
Recognition and measurement at the commencement date – manufacturer and dealer lessors
At the commencement date, a manufacturer or dealer lessor should recognize the following for each of its finance leases: [IFRS 16:71]
- revenue, which is the fair value of the underlying asset, or, if lower, the present value of the lease payments accruing to the lessor, discounted using a market rate of interest;
- the cost of sale, which is the cost (or carrying amount if different) of the underlying asset less the present value of the unguaranteed residual value; and
- selling profit or loss (which is the difference between revenue and the cost of sale) in accordance with its policy for outright sales to which IFRS 15 applies. The selling profit or loss on a finance lease should be recognized at the commencement date, regardless of whether the lessor transfers the underlying asset as described in IFRS 15.
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 profit or loss equivalent to the profit or loss resulting from an outright sale of the underlying asset, at normal selling prices, reflecting any applicable volume or trade discounts.
Manufacturer or dealer lessors sometimes quote artificially low rates of interest in order to attract customers. The use of such a rate would result in a lessor recognizing an excessive portion of the total income from the transaction at the commencement date. If artificially low rates of interest are quoted, the selling profit should be restricted to that which would apply if a market rate of interest were charged. [IFRS 16:73]
Costs incurred by a manufacturer or dealer lessor in connection with obtaining a finance lease should be recognized as an expense at the commencement date because they are mainly related to earning the manufacturer or dealer’s selling profit. Such costs are excluded from the definition of initial direct costs and, accordingly, are excluded from the net investment in the lease. [IFRS 16:74]
Subsequent measurement
Finance lease income recognized at a constant periodic rate of return on the net investment
The lessor recognizes finance income over the lease term so as to reflect a constant periodic rate of return on its net investment in the finance lease. [IFRS 16:75] This is achieved by allocating the rentals (net of any charges for services etc.) received by the lessor between finance income to the lessor and repayment of the debtor balance.
Derecognition and impairment
The derecognition and impairment requirements of IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) apply to a lessor’s net investment in a lease.
Impact of the allowance for expected credit losses on the recognition of finance lease income (entities that have adopted IFRS 9)
IFRS 16 requires the lessor’s net investment in the finance lease to be presented as a finance lease receivable. At initial recognition, the net investment in the finance lease is equal to the unguaranteed residual value accruing to the lessor plus the lease payments receivable, discounted at the interest rate implicit in the lease.
Subsequent to initial recognition, the lessor is required:
- to recognize finance income on its net investment in the lease reflecting a constant periodic rate of return;
- to regularly review the estimated unguaranteed residual value; and
- to apply the impairment requirements of IFRS 9 (which are included in IFRS 9), recognizing an allowance for expected credit losses on the lease receivable.
Whilst IFRS 16 is clear that a reduction in the unguaranteed residual value affects the income allocation, the Standard does not provide further guidance on whether the allowance for expected credit losses adjusts the net investment in the lease balance and thus, affects recognition of finance lease income.
In the absence of specific guidance, it is acceptable to analogies to the effective interest method applied to financial assets in accordance with IFRS 9, under which interest income is calculated with reference to the gross carrying amount (i.e., before a deduction of a loss allowance) of a financial asset, except for credit-impaired financial assets for which interest income is calculated with reference to their amortized cost (i.e., after a deduction of the loss allowance). This approach is available irrespective of whether the simplified approach in IFRS 9 of recognizing lifetime expected credit losses is applied to lease receivables.
This analogy reflects the fact that finance lease receivables are subsequently measured in a manner that is similar to financial assets measured at amortized cost (IFRS 9). However, due to notable differences in the application of the effective interest method as compared to the IFRS 16 requirements for the accounting treatment of lease receivables, other approaches may be appropriate (provided that, if the finance lease receivable is credit-impaired, interest income is recognized on the finance lease receivable after the deduction of the loss allowance).
Impact of the allowance for expected credit losses on the recognition of finance lease income (entities that have adopted IFRS 9) – example
Entity A, a lessor, leases an item of property, plant and equipment to Entity B under a 10-year finance lease. The annual lease payments are CU 1,000, of which the first is payable on the day after the lease commencement date and subsequent payments are payable on each anniversary thereafter. The interest rate implicit in the lease is 5 per cent and the unguaranteed residual value of the item is assessed to be CU150.
Entity A has chosen as its accounting policy to determine interest income with reference to the gross carrying amount of finance lease receivables (‘gross basis), except for credit-impaired finance lease receivables for which interest income is calculated with reference to their amortized cost (i.e., after a deduction of the loss allowance (‘net basis)).
At the commencement date, Entity A derecognizes the property, plant and equipment from its statement of financial position and recognizes a net investment in the lease of CU8,200, calculated as the present value of 10 annual lease payments receivable and the unguaranteed residual value, discounted using the implicit interest rate. Entity A decides not to apply the simplified impairment approach to its finance lease receivables available in IFRS 9, and therefore, until there is a significant increase in credit risk on the finance lease receivable, Entity A measures a loss allowance for 12-month expected credit losses. Entity A assesses that at initial recognition the loss allowance for 12-month expected credit losses is negligible (CU nil for simplification purposes).
At the end of Year 1, Entity A determines that there has been a significant increase in the credit risk on the finance lease receivable which triggers Entity A to start recognizing lifetime expected credit losses. In accordance with IFRS 9, to determine the expected credit losses, Entity A uses cash flows that are consistent with the cash flows used in measuring the finance lease receivable in accordance with IFRS 16 and measures the loss allowance at CU50. Entity A discloses the impairment loss in profit or loss in accordance with IAS 1:82(ba) and considers how to appropriately present this amount in its statement of financial position.
| Finance lease receivable, start of the period | Lease payment received | Finance lease income at 5% in P&L | Finance lease receivable, end of the period | Allowance for expected credit losses | |
| CU | CU | CU | CU | CU | |
| Year 1 | 8,200 | (1,000) | 360 | 7,560 | (50) |
In Year 2, Entity A continues to recognize finance lease income on a ‘gross basis’. At the end of Year 2, the loss allowance accretes to CU52.5 (in accordance with IFRS 9, expected credit losses on lease receivables are discounted using the same discount rate as that used in the measurement of the lease receivables in accordance with IFRS 16) and the loss of CU2.5 is presented as an impairment loss applying IAS 1:82(ba).
| Finance lease receivable, start of the period | Lease payment received | Finance lease income at 5% in P&L | Finance lease receivable, end of the period | Allowance for expected credit losses | |
| CU | CU | CU | CU | CU | |
| Year 2 | 7,560 | (1,000) | 328 | 6,888 | (52.5) |
During Year 3, there are no changes in Entity A’s assessment of the finance lease receivable’s credit risk and therefore, the finance lease income continues to be recognized on a ‘gross basis’. However, at the end of Year 3, Entity B defaults and Entity A assesses the net investment in the lease to be credit-impaired. Entity A assesses that the loss allowance should be increased to CU5,000, reflecting a high likelihood that only a minor portion of the lease payments will be recovered.
| Finance lease receivable, start of the period | Lease payment received | Finance lease income at 5% in P&L | Finance lease receivable, end of the period | Allowance for expected credit losses | |
| CU | CU | CU | CU | CU | |
| Year 3 | 6,888 | (1,000) | 294 | 6,182 | (5,000) |
Because it has determined at the end of Year 3 that the finance lease receivable is credit-impaired, in Year 4, the subsequent reporting period, Entity A recognizes finance lease income on a ‘net basis’.
| Amortized cost of the finance lease receivable, start of the period | Lease payment received | Finance lease income at 5% in P&L | Amortized cost of the finance lease receivable, end of the period | Allowance for expected credit losses | |
| CU | CU | CU | CU | CU | |
| Year 4 | 1,1821 |
1CU6,182 – CU5,000
2CU1,182 × 5%
3Difference between the gross carrying amount of the finance lease receivable at the end of the period (CU6,182 × 1.05) and its amortized cost at the same date (CU1,241)
Subsequently, assuming that there are no improvements to the credit risk of the finance lease receivable, Entity A continues to account for finance lease income on a ‘net basis’.
Changes in unguaranteed residual values
IFRS 16 emphasizes that estimated unguaranteed residual values used in computing the lessor’s gross investment in a lease should be reviewed regularly. When there has been a reduction in the estimated unguaranteed residual value, the income allocation over the lease term is revised and any reduction in respect of amounts already accrued is recognized immediately. [IFRS 16:77]
Changes in unguaranteed residual value
In addition to any impairment loss under IFRS 9 (or IAS 39) which arises as a result of an increase in credit risk of the lessee, losses in relation to the finance lease receivable may also arise due to decreases in the unguaranteed residual value of the leased asset in accordance with IFRS 16:77. Such a loss is not a credit loss as defined by IFRS 9.
The estimated unguaranteed residual value should be reviewed regularly for any potential reductions in the estimated amount. An entity should compare the current estimate of the unguaranteed residual value with the original estimate; any decrease in the unguaranteed residual value will be discounted using the interest rate implicit in the lease at inception to determine the loss to be recognized.
The recognition of finance income is based on a pattern reflecting a constant periodic rate of return on the net investment in the finance lease. Finance income is recognized at the rate implicit in the lease on the total net investment including the unguaranteed residual value.
Subsequent to the recognition of a loss due to a decrease in the unguaranteed residual value, interest income will be accrued using the rate implicit in the lease on the basis of the revised carrying amount. The interest rate implicit in the lease determined at the inception of the lease remains unchanged.
Asset under a finance lease classified as held for sale
When an asset under a finance lease is classified as held for sale (or included in a disposal group that is classified as held for sale) in accordance with IFRS 5, it is accounted for in accordance with that Standard.
Re-measurement of the net investment in the lease arising from a change in future lease payments due to a change in an index or a rate
IFRS 16 specifies that, for finance leases, the lease payments included in the measurement of the net investment in the lease at the commencement date include variable lease payments that depend on an index or a rate, initially measured using the index or rate as at that date.
Whilst IFRS 16 explicitly requires lessees to remeasure a lease liability when there is a change in future lease payments resulting from a change in an index or a rate used to determine those payments, IFRS 16 does not indicate whether lessors are required or permitted to remeasure finance lease receivables in similar circumstances. Accordingly, an appropriate accounting policy should be developed by lessors with finance lease receivables to be applied consistently and disclosed, if material, in accordance with IAS 1.
For example, Company A is a lessee in a contract to lease a plot of land for a period of 50 years for which the annual lease payments are 3 per cent of the underlying land market value. Subsequently, Company A enters into a sublease for the same plot of land for the remaining term of the head lease with annual lease payments being 4 per cent of the underlying land market value. For both the head lease and the sublease, the market value of the land is determined every three years which establishes the lease payments for the subsequent three years. The sublease is classified as a finance lease applying IFRS 16. The lease payments represent variable lease payments that depend on an index or a rate because they vary to reflect changes in market rentals (see IFRS 16).
Company A recognizes a lease liability for the head lease and a finance lease receivable for the net investment in the sublease.
When a market rent review adjustment is determined, Company A remeasures its lease liability applying IFRS 16 to reflect the revised future lease payments. In the absence of a sublease, the re-measurement of the lease liability would adjust the right-of-use asset in accordance with IFRS 16:39. However, because Company A has derecognised the right-of-use asset upon entering into the sublease, it is less clear where the re-measurement of the lease liability should be recognized. Further, IFRS 16 does not specify whether, and if so how, Company A remeasures the finance lease receivable to reflect the increase in the lease payments receivable from the lessee as a result of the movement in market rents.
In the absence of specific guidance in IFRS 16, Company A should develop an appropriate accounting policy to account for changes in future lease receivables following each market rent review of its finance leases, including, in the case of subleases, the interaction, if any with the re-measurement of the lease liability from the head lease.
An acceptable accounting policy would be for Company A to:
- remeasure the net investment in the sublease (the finance lease receivable) to reflect the effect on the future lease payments of changes in index or rate using the initial discount rate; and
- recognize in profit or loss the adjustment from remeasuring the lease liability and the finance lease receivable, reflecting that both are inherently linked.
The net effect is that the amount recognized in profit or loss would be the net difference between the re-measurement of the head lease liability and of the net investment in the sublease.
Modification of a lease
A lease modification is 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. Any change that is triggered by a clause that is already part of the original lease contract, including changes due to a market rent review clause or the exercise of an extension option, is a re-assessment and not a modification.
Q&A: What are examples of lease modifications?
There are many different reasons why the parties to a contract might decide to renegotiate and modify an existing lease contract during the lease term. One objective might be to extend or shorten the term of an existing contract (with or without changing the other contractual terms); another reason might be to change the underlying asset (For example, a lessee already leases two floors of a building, and the parties agree to add a third one). If the lessee is in financial difficulties, the lessor might agree to reduce lease payments as a concession to support a restructuring. New agreements could also be in-substance modifications of an existing lease.
For example, midway through a lease, the same parties enter into a new lease agreement for the same underlying asset commencing when the original lease ends. The original lease remains effective, without any changes. In substance, this is comparable to a modification of the existing lease which extends the lease term without adding the right to use more underlying assets, and it should be accounted for as a lease modification.
The accounting for a lease modification depends on how the contract is modified. There are four different scenarios:
- The modification decreases the scope of the lease.
- The modification increases the scope of the lease by adding the right to use more underlying assets, and the increase in the lease consideration is commensurate (that is, with the stand-alone price for the increase in scope and any appropriate adjustments to reflect the circumstances of the particular contract).
- The modification increases the scope of the lease without meeting the criteria above (that is, the increase does not arise from adding the right to use more underlying assets, or the increase in the lease consideration is not commensurate).
- The scope of the lease remains unchanged.
| No- Unchanged |
| Does the modification change the scope of the lease? |
| Is the change in consideration commensurate? |
| Are more underlying assets added? |
| Yes- Reduced |
| Yes- Increased |
| No |
| Yes |
| Yes |
| No |
| Separate Lease Contract |
| Remeasurement of lease liability and Adjustment of right-of-use asset |
| Remeasurement of lease liability and decrease of carrying amount of Right-of-use asset (partly profit/loss) |
The effective date of the modification is the date on which the parties agree to the modification of the lease.
Lease modifications
Modifications to finance leases accounted for as separate leases
A lessor should account for a modification to a finance lease as a separate lease if both: [IFRS 16:79]
- the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
- 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.
The Board considers that a modification meeting both of the conditions in IFRS 16:79 in substance represents the creation of a new lease that is separate from the original lease. This requirement is substantially aligned with equivalent requirements in IFRS 15 that require a seller to account for modifications that add distinct goods or services as separate contracts if those additional goods or services are priced commensurately with their stand-alone selling price.
Modifications to finance leases not accounted for as separate leases
For a modification to a finance lease that is not accounted for as a separate lease, a lessor should account for the modification as follows: [IFRS 16:80]
- if the lease would have been classified as an operating lease had the modification been in effect at the inception date, the lessor should:
o account for the lease modification as a new lease from the effective date of the modification; and
o measures the carrying amount of the underlying asset as the net investment in the lease immediately before the effective date of the lease modification;
- otherwise, the lessor should apply the requirements of IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39).
For modifications to a finance lease that are not accounted for as a separate lease (i.e., modifications that do not meet both of the conditions set out in IFRS 16), IFRS 16 requires a lessor to account for the modification applying IFRS 9 (or, for entities that have not yet adopted IFRS 9, IAS 39) unless the lease would have been classified as an operating lease if the modification had been in effect at the inception date. The Board expects that this approach will not result in any substantive change to previous lessor accounting for modifications of finance leases. This is because, although IAS 17 does not include requirements relating to lease modifications, the Board understands that a lessor generally applies an approach that is consistent with the requirements in IFRS 9 (or the equivalent requirements in IAS 39) to the net investment in a finance lease.
Modification of a finance lease
A lease modification is defined in the same way for lessees and lessors. For the definition of a lease modification.
A lessor accounts for the modification of a finance lease as a separate lease if: the modification increases the scope of the lease by adding the right to use more underlying assets; and the consideration for the lease increases by an amount that is commensurate with the stand-alone price for the increase in scope, and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For further guidance on modifications accounted for as a separate lease.
Further analysis is needed for a modification that does not result in a separate lease. The lessor assesses whether the modification would have resulted in either an operating or a finance lease if it had been in effect at inception of the lease: If the lease would have been classified as an operating lease, the lessor accounts for the modification as a new (operating) lease. It measures the carrying amount of the underlying asset that has to be recognized as the net investment in the original lease immediately before the lease modification. If the lease would have been classified as a finance lease, the lessor accounts for the lease modification in accordance with IFRS 9.
Classification of leases
Classification of leases – general
Each lease to be classified as either an operating lease or a finance lease
A lessor is required to classify each of its leases as either an operating lease or a finance lease.
The key distinction to be made by lessors in accounting for leases under IFRS 16 is whether the lease in question is either:
- a simple short-term hire arrangement (an operating lease), whereby rentals are dealt with in profit or loss with the only impact on the statement of financial position relating to the timing of payments; or
- in the nature of an arrangement for financing the acquisition of an asset (a finance lease), when the presentation in the financial statements will depart from the legal form of the transaction and be based on the economic substance (i.e. as if the underlying asset had been sold to the lessee).
Lease classification determined at the inception date
Lease classification is determined at the inception date and is reassessed only if there is a lease modification. [IFRS 16:66]
A lease modification is defined as “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)”.
Changes in estimates (e.g. changes in estimates of the economic life or of the residual value of the underlying asset), or changes in circumstances (e.g. default by the lessee), do not give rise to a new lease classification.
If a lease contract includes terms and conditions to adjust the lease payments for particular changes that occur between the inception date and the commencement date (e.g. a change in the lessor’s cost of the underlying asset or a change in the lessor’s cost of financing the lease), to classify the lease, the effect of any such changes is deemed to have taken place at inception.
There may be a time lag between the inception date and the commencement date, and the amounts involved in the lease arrangement may change between the two – most commonly when the asset is being constructed and the final cost is not known at inception.
Classification of leases acquired in a business combination
When a group acquires a new subsidiary in a business combination, the classification of the subsidiary’s leases in which it is the lessor is not reassessed at the date of the business combination for the purposes of the consolidated financial statements. The subsidiary’s leases will be classified in the consolidated financial statements on the basis of their terms at original inception, and without regard to the remaining lease term from the acquisition date. Thus, in particular, if the acquiree has appropriately treated a lease as a finance lease, that lease will also be treated as a finance lease in the consolidated financial statements, even if the majority of the lease term has expired before the acquisition date.
This treatment is required under IFRS 3 as an exception to that Standard’s general principle that an acquirer should classify the assets acquired and liabilities assumed in a business combination on the basis of conditions as they exist at the acquisition date. IFRS 3 requires the acquiree’s lease contracts in which it is the lessor to be classified on the basis of the contractual terms and other factors at the inception of the contract (or, if the terms of the contract have been modified in a manner that would change its classification, at the date of that modification, which might be the acquisition date.
Lessors classify all leases as either finance leases or operating leases.
The classification of leases under IFRS 16 is driven by whether or not the risks and rewards of ownership of a leased asset lie with the lessor. The risks associated with assets include the possibility of losses from idle capacity or technological obsolescence, and of variations in return because of changing economic conditions. Rewards might be represented by the expectation of profitable operation over the asset’s life and of gain from the appreciation in value of the asset’s residual value.
A lease is classified as a finance lease if it transfers substantially all of the risks and rewards incidental to ownership of an underlying asset.
A lease is classified as an operating lease if it does not transfer substantially all of the risks and rewards incidental to ownership of an underlying asset. A significant element of risk should remain with the lessor. An operating lease is usually for a period substantially shorter than the asset’s useful economic life. The lessor will be relying on recovering a significant proportion of its investment from either the proceeds from the asset’s sale or the asset’s further hire after the end of the lease term.
Lease classification is made at the inception of the lease and is re-assessed only if there is a lease modification. Changes in estimates (For example, regarding the economic life or the residual value of the underlying asset) or changes in circumstances (For example, default by the lessee) do not trigger a re-assessment.
The inception date of the lease is the earlier of the date of a lease agreement and the date of the commitment by the parties to the principal terms and conditions of the lease.
Q&A: What is the difference between inception date and commencement date?
A lessor signs an agreement to lease a car on 31 March, and the car is delivered to the lessee on 30 June. The classification of the lease will take place on 31 March (inception of the lease). The recognition of the lease receivable (if applicable) will not take place until 30 June (commencement date of the lease).
Some lease agreements might include a provision to adjust the lease payments for changes that occur during the period between the inception of the lease and the commencement of the lease. Examples include a change in the lessor’s cost of constructing the underlying asset or cost of financing the lease. The effect of any such changes is assumed, for the purpose of classification, to have taken place at the inception of the lease.
An intermediate lessor evaluates a sub-lease with reference to the right-of-use asset rather than the leased asset.
Q&A: Does the scope exemption for leases of intangible assets in IFRS 16 apply to the lessor in a sublease if the underlying asset is tangible?
A lessee can, but is not required to, apply IFRS 16 to leases of intangible assets other than rights held by a lessee under licensing agreements within the scope of IAS 38, ‘Intangible assets’, for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights. An entity (lessor) enters into a sublease contract to lease out property.
Can the entity apply the accounting policy choice in IFRS 16 to that sublease, by considering that the right-of-use asset of the property resulting from the lessor’s lease is an intangible asset?
No. Because the underlying asset of the sublease is a tangible asset (property), the sublease is not subject to the accounting policy choice in IFRS 16. The lessor therefore has to apply IFRS 16 to the sublease.
A sub-lease is classified as an operating lease if the head lease is a short-term lease and the intermediate lessor has applied the recognition exemption to the short-term lease.
Q&A: How does the accounting for sub-leases vary from that for regular leases?
Generally, such arrangements involve three parties:
· a head lessor, who owns the freehold asset;
· an intermediate party, who is leasing the asset from the head lessor and to the lessee; and
· the lessee.
The following sets out the broad principles that an entity should follow when accounting for sub-leases:
The head lessor
Unless the original lease agreement between the head lessor and the intermediate party is replaced by a new agreement, the head lessor’s accounting should not be affected if the intermediate party enters into a sublease.
The intermediate party
The accounting for the head lease liability is unchanged. The accounting for the right-of-use asset depends on the classification of the sub-lease.
If the sub-lease is classified as a finance lease, the intermediate party derecognizes the right-of-use asset (to the extent that it is subject to the sublease) and recognizes a lease receivable.
If the sub-lease is classified as an operating lease, the intermediate party continues to recognize the right-of-use asset. Revenue from the sub-lease is recognized over the term of the sub-lease.
The lessee
The lessee will recognize a right-of-use asset and a lease liability.
Q&A: Is an intermediate lessor permitted to offset the remaining lease liability (from the head lease) and the lease receivable (from the sub-lease)?
Since the lessor of the sub-lease is, at the same time, the lessee with respect to the head lease, it will in any case have to recognize an asset on its balance sheet – a right-of-use asset with respect to the head lease (if the sub-lease is classified as an operating lease) or a lease receivable with respect to the sub-lease (if the sub-lease is classified as a finance lease).
For a sub-lease that results in a finance lease, the intermediate lessor is not permitted to offset the remaining lease liability (from the head lease) and the lease receivable (from the sub-lease). The same is true for the lease income and lease expense relating to the head lease and sub-lease of the same underlying asset.
Q&A: How is a sub-lease accounted for if the sublease term is less than the remaining head lease term?
Entity ‘A’ (lessee) enters into a 10-year lease of a building with 10 floors from entity B. One year later, entity A sub-leases three of the 10 floors to entity C for eight years. The sub-lease is classified as a finance lease by reference to the right-of-use asset arising from the head lease. The head lease can be separated into two parts: a lease over seven floors; and a lease over three floors.
How is the transaction accounted for?
Commencement date of the head lease
At the commencement date of the head lease, the lessee recognizes a right-of-use asset and a corresponding lease liability for the 10 floors for the 10 years. Commencement date of the sub-lease Following the sub-lease being entered into, entity A de-recognizes the right-of-use asset relating to the three-floor lease component, and instead it recognizes a net investment in the lease for the eight-year sub-lease. This includes an estimate of the unguaranteed residual value accruing to entity
A as the intermediate lessor, in respect of the one-year right of use that it will have under the head lease after the sub-lease ends. The seven-floor lease component continues to be accounted for as a right-of-use asset and lease liability.
End of the sub-lease
At the end of the sub-lease, entity A would recognize the residual value as a right-of-use asset for the three-floor lease component.
Classification indicators
The following examples of situations, individually or in combination, would normally lead to a lease being classified as a finance lease:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- 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 when the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised.
- The lease term is for the major part of the economic life of the underlying asset, even if title is not transferred. 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.
- The underlying asset is of a specialized nature such that only the lessee can use it without major modifications.
Q&A: What needs to be considered when assessing a transfer of ownership or purchase options?
If the lease transfers ownership of the asset at the end of the lease term, or the lessee has an option to purchase the asset which is priced in such a way as to make exercise reasonably certain, it can be presumed that the lessor will look to recover his investment in the leased asset over the term of the lease. In substance, the arrangement will be akin to a financing.
In addition, it should be considered whether there is any other commercial compulsion for the lessee to exercise such options, even if the option appears to be priced at or above fair value. However, where an option is at market price, as determined at the end of the lease term, the residual value risk typically remains with the lessor, and such an option would not (on its own) indicate finance lease treatment. If the lessor has a put option to sell the asset at an amount that is more than the expected fair value at that date, the lease should be classified as a finance lease.
Q&A: What does ‘major part’ mean in the context of the lease term indicator for the lease classification?
If the lease term is for the major part of the economic life of the underlying asset, the agreement is viewed as a financing arrangement. There is no numerical definition of ‘major part’. Instead, judgement should be used to determine whether the lease term is for the major part of the economic life of the underlying asset.
Q&A: How much impact does the lease term classification indicator have if the lessor retains title to the asset?
If the lease term is for a major part of the asset’s economic life, the residual value risk associated with the asset is likely to be small. Therefore, the fact that the lessor retains title should not have a significant impact on the risks and rewards analysis.
Q&A: What does ‘substantially all’ mean in the context of the lease payments indicator for the lease classification?
If the present value of the lease payments amounts to substantially all of the fair value of the underlying asset, the agreement is viewed as a financing arrangement. Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. There is no numerical definition of ‘substantially all’. Instead, judgement should be used to determine whether the present value of the lease payments amounts to substantially all of the fair value of the underlying asset.
Q&A: How are leases classified if the underlying asset is of a specialized nature?
Where an underlying asset is highly specialized, the lessor is unlikely to be able to sell the asset to a third party at the end of the lease. As such, the lessor will look to recover its investment in the asset over the lease term, and the arrangement will be, in substance, a financing.
The economic life of an asset is either the period over which an asset is expected to be economically usable by one or more users, or the number of production or similar units expected to be obtained from the asset by one or more users.
Q&A: Is the economic life for lease classification purposes the same as the period over which the entity would depreciate an asset?
No, the period over which an asset is expected to be economically usable is not necessarily the same as the period over which an entity will depreciate an asset. The entity will depreciate the asset over the useful life, which is the period over which the asset is expected to be available for use by the entity.
For example, an entity might use a certain asset for two years, before it replaces the asset due to the entity’s high-performance requirements. However, another entity might be able to use the same asset for a further period, with no impact on performance. In this case, the economic life for lease classification purposes would encompass both periods, but the useful life to the entity is two years.
Q&A: How does technical obsolescence impact lease classification?
Some assets, such as IT assets, can be subject to a higher risk of technical obsolescence than other assets. Factors such as advances in technology might result in an economic life that is shorter than the hardware’s physical life. As a result, the economic value that can be obtained will be concentrated towards the start of the asset’s physical life.
Consider, for example, computer hardware which is physically capable of operating for seven years, but its economic life is only three years. A lease of this hardware for three years might qualify as a finance lease, because it is for the major part of the economic life, even though it is not for a major part of the physical life.
The following situations, individually or in combination, could also lead to a finance lease classification:
- If the lessee can cancel the lease, the lessee bears the lessor’s losses associated with the cancellation.
- Gains or losses from the fluctuation in the residual’s fair value fall to the lessee (For example, in the form of a rent rebate equaling most of the sales proceeds at the end of the lease).
- The lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent.
Other features of a lease could still lead to an operating lease classification (For example, if the lessor retains significant risks and rewards incidental to ownership through significant variable lease payments, or if the underlying asset is transferred to the lessee for fair value at the end of the lease).
Q&A: What factors require the most judgement in determining lease classification?
Whether or not a lease passes substantially all of the risks and rewards of ownership to the lessee will normally be self-evident from the terms of the lease contract and an understanding of the commercial risks taken by each party. Where the lessor takes little or no asset-related risk, other than a credit risk on the lessee, the agreement will be a finance lease.
Similarly, where the lessor is exposed to significant levels of risk relating to movements in the asset’s market value, utilization, or performance (such as on a short-term hire agreement), the agreement will be easily classified as an operating lease. The greatest difficulty and requirement to apply judgement, therefore, tends to arise in relation to classifying leases where the lessor recovers most of its investment through the terms of the lease but retains some element of risk relating to the asset’s residual value at the end of the lease term.
Q&A: How does it impact lease classification if the lessor and the lessee share the residual value?
It is not uncommon for the lessor and the lessee to share both the downside risks and potential upside benefits associated with the asset’s market value at the end of the lease term, such that the lessee is taking some, but not all, of the residual risk.
For example, the terms of the agreement might require the asset to be sold at the end of the lease term, and any profit or loss arising against anticipated values to be shared between the lessor and the lessee. Often, the profit- and loss-sharing arrangements are unevenly balanced between the parties, potentially with the lessee often taking the first tranche of loss, up to a stipulated amount, and the lessor (or other third parties) only taking losses beyond that sum. Interpreting these types of agreement can be difficult. The lessor might retain some residual value risk but, if this implies that residual values have to fall to a level substantially below that anticipated to occur in practice, even under the most pessimistic circumstances, the lessor’s risk is remote, and all of the real commercial risks rest with the lessee.
In some arrangements relating to portfolios of assets (For example, car fleets), the assessment of the commercial effects of these residual sharing arrangements can be further complicated by terms that mitigate a lessor’s risk by providing for any residual losses on individual assets to be pooled against profits on others within the same portfolio. Again, these types of arrangement will need to be considered carefully, to determine the nature of the risks borne by the lessor (and other third parties) and those transferred to the lessee.
Q&A: How are leases classified if the lessor’s residual value risk is evaluated as being remote?
Entity A (the lessor) leases a truck to entity B (the lessee) for a period of three years. Lease rentals are set by the lessor, assuming a residual value for the truck of C4, 000 at the end of the lease term. Market data suggests that the likely range of residual values at the end of three years is C4, 000 to C5, 000. The lessee will guarantee any fall in the truck’s residual value below C4, 000, down to C2, 500. The lessor will bear the cost of any fall in the residual value below C2, 500.
How should this lease be classified?
The lease should be classified as a finance lease. The sharing of the residual value risk is not even, because it is unlikely that the truck’s residual value will fall below C2, 500. The risk retained by entity A is remote and should therefore be ignored. The residual value risk is, in substance, borne by entity B.