ACCOUNTING FOR LEASES

IFRS 16
ACCT 320
Spring 2023
Samia Ali
LO1 :Explain the nature, economic substance, and advantages of
lease transactions

LO 2: Lessee accounting

LO 3: Lessee disclosures

LO 4: Lessor accounting

LO 5: Lessor disclosures

LO 6: Special Issues

LO 7: Sale and leaseback

 LO 1
Explain the nature, economic substance, and
advantages of lease transactions
“Wealth does not lie in ownership
but in the use of things!”
 The Leasing Environment

A lease is a contractual agreement between a lessor and a lessee,

that gives the lessee the right to use specific asset/property, owned
by the lessor, for a specified period of time.

Examples of leased equipment

Information technology equipment, Transportation (planes, trucks, aircraft, rail)
Lessor Lessee
(Banks, Leasing companies, Right to use asset Uses the asset
Individuals) over the lease term
Owns the Asset 100% Financing at fixed rates
Flexibility
Profitable interest margin Less costly financing
Stimulate sales Lease payment $
Protection from obsolescence
Tax benefit
Gain on residual value
 LO 2
Accounting Criteria and procedure - LESSEE
 Lease Accounting

'the right to control the use of an identified asset for a

period of time in exchange for consideration’
IASB requires lessees to capitalize all leases.

Only exceptions:
leases covering a term of less than one year or
lease of property with a low value. ($5000)

Right to use property – ASSET

Lessee’s obligation to make payments - LIABILITY

SUBSTANCE OVER FORM
 Identify a lease
 Recognize/Measure the lease (initial recognition)
 Subsequent measurement
 Purchase/Terminate/Expiry
 Identify a lease

The customer controls the asset’s use if it has:

• the right to substantially all of the identified asset's

economic benefits, and

• the right to direct the identified asset's use.

NOTE 1: Restrictions in the contract by the lessor are allowed (right to use still
exists) e.g Mileage, purpose, restrict location of use.

NOTE 2: A customer does not have the right to use an identified asset if the
supplier has the practical ability to substitute the asset for an alternative and if
it would be economically beneficial for them to do so
 Identify a lease
Gloria Jeans enters into a contract with A enters into a contract with B, the supplier,
LUMS to use some space in LUMS to to use a specified truck for a five-year
sell its goods from portable kiosks for a period. B has no substitution rights.
three-year period. During the contract period, A decides what
Gloria Jeans owns the portable kiosks. cargo will be transported, when the truck
The contract stipulates the amount of will transport and to which cities it will
space and states that the space may be transport.
located outside any one of several However, there are some restrictions
departments. LUMS can change the specified in the contract. Those restrictions
location of the space allocated to Gloria prevent A from carrying hazardous
Jeans at any time during the period of materials as cargo.
use. B operates and maintains the truck.
There are many areas in LUMS that are A is prohibited from hiring another trucking
suitable for the portable kiosks. Co., and from operating the truck itself
during the term of the contract.
Lease? Lease?

No Yes
Lease Accounting

The lessee
 recognizes interest expense on the lease liability using
the effective-interest method and
 records depreciation expense on the right-of-use asset.

This accounting (finance lease) is applied whether the lease

is effectively
 a purchase of the asset or
 when the lessee only controls the use of the asset.
Lease Accounting
Lease Term
 The fixed, non-cancelable term of the lease.

 Bargain-renewal option can extend this period.

Lease Payments

 Fixed payments.

 Variable payments that are based on an index or a rate. (If not know at the start of
the lease do no include these, expense as incurred)

 Residual value (Guaranteed or unguaranteed)

 Payments related to purchase or termination options that the lessee is reasonably

certain to exercise. Bargain purchase option
Discount Rate

• Preferably use implicit interest rate.

• If not known use incremental borrowing rate.

 Test your understanding
Lease Term
Jamal leases a car from the bank for Rs
70,000/month for two years and has the option to
subsequently lease the car for Rs7,000/month for
another year.
Is this a bargain renewal option? Yes

Lease term should be considered to be? 3 years

 Lease Accounting
Lease Payments

 Fixed payments.

 Variable payments that are based on an index or a rate. (If not know at
the start of the lease do no include these, expense as incurred)

 Residual value (Guaranteed or unguaranteed)

 Payments related to purchase or termination options that the lessee is

reasonably certain to exercise. Bargain purchase option
Guaranteed residual value:
the lessee has an obligation to not only return the leased asset at the end of the
lease term but also to guarantee that the residual value will be a certain
amount. Only include any amount about expected residual value.
Unguaranteed residual value:
the lessee does not have any obligation to the lessor at the end of the lease,
except to return the leased asset to the lessor
 Test your understanding

Lease Payments – example 1

Jamal Textile leases a machine from Farhan for 3 years.

Jamal agrees to pay Rs100,000/month and 1% of sales in
excess of Rs 10,000,000. Historically Jamal has had net
sales in excess of Rs 10,000,000 every year and is
forecasted to continue for the next 5 years. It is highly likely
that Jamal will be making payments of Rs 100,000 every
year.
Lease payment that should be used to record this lease?
100,000 only
 Test your understanding

Lease Payments – example 2

Jamal leases a machine from Farhan for a term of 5 years. Annual lease
payments are going to be Rs 350,000/- . The expected residual value of the
machine is Rs100,000/
1. Jamal is not guaranteeing any residual value to Farhan.
Lease liability should include which amounts?
PV of Rs 350,000 / yr

2. Lease liability should include which amounts if expected residual value is Rs

100,000/- and Jamal guarantees it? PV of Rs 350,000 / yr

3. Lease liability should include which amounts if expected residual value is Rs

100,000/- and Jamal guarantees a residual payment of Rs 150,000/-?
PV of
Rs 350,000 / yr
+
Rs 50,000 at the end of the lease
Lease Accounting

Lease Payments
 Fixed payments.
 Variable payments that are based on an index or a rate. (If not
know at the start of the lease do no include these, expense as
incurred)
 Residual value (Guaranteed or unguaranteed)
 Payments related to purchase or termination options that the
lessee is reasonably certain to exercise. Bargain purchase option
 Test your understanding

Lease Payments – example 3

Jamal leases a machine from Farhan for a term of 5 years. Annual
lease payments are going to be Rs 350,000/- . The lease gives Jamal
the right to purchase the machine at the end of the 5 years for
Rs100,000/-. Jamal is certain that at the end of the lease the Fair value
of leased machine will be much higher than Rs 100,000/-
Total lease payments?

PV of (Rs 350,000 / yr + Rs 100,000/)-

Lease Accounting
Lease Term
 The fixed, non-cancelable term of the lease.

 Bargain-renewal option can extend this period.

Lease Payments

 Fixed payments.

 Variable payments that are based on an index or a rate. (If not know at the start of
the lease do no include these, expense as incurred)

 Residual value (Guaranteed or unguaranteed)

 Payments related to purchase or termination options that the lessee is reasonably

certain to exercise. Bargain purchase option
Discount Rate

• Preferably use implicit interest rate (lessor). It is the rate at which

PV of lease payments (include unguaranteed residual value) = Fair Value of leased asset

• If not known use incremental borrowing rate.

 Test your understanding

Discount Rate
Jamal leases a machine from Farhan for a term of 5 years on 31st
December 2020. Annual lease payments are going to be Rs 350,000/-
starting from 31st December 2020. The expected residual value of the
machine is Rs100,000/-, Jamal is not guaranteeing any residual value
to Farhan. Discount rate is 5%

What amount should Jamal record as it lease liability on 31st December

2020 lease payments?

350,000 x 4.546 (PV of annuity due of 1 for 5 periods at 5%)

= 1,591,100/-

The residual value is not guaranteed hence not added to lease

payments
 Lease Accounting – Initial Measurement

Right of use Asset

• The amount of the initial measurement of the lease liability

• Lease payments made at or before the commencement date

• Initial direct costs

• The estimated costs of removing or dismantling the underlying asset as

per the conditions of the lease
 Example
 Alto Leases a car on 1st Jan 2020 for 2 years
 Option to extend 1 more year (reasonably certain
to exercise)
 Useful life 10 years
 Lease payments $10,000/ year for 2 years
 Lease payment $15,000 for extension (1 year)
 Direct costs of $3,000
 Interest rate is 5%
 All payments are due at the end of the year

Determine initial carrying amount asset and liability

 Solution

PV (10,000, 10,000, 15,000) 5% = 31,552

Add direct costs = 3,000
34,552

Right of use asset 31,552

Liability 31,552

Right of use asset 3,000

Cash 3,000
Lease Accounting – Subsequent Measurement
Right of use Asset Lease Liability

Initial cost – Depreciation - Impairment Carrying value of liability

Depreciation is calculated as follows:

- Interest expense
1) Asset transfers to the lessee at the end - Cash payment
of the lease term then depreciation
should be charged over the asset's
remaining useful life

Or

2) Otherwise, depreciation is charged over

the shorter of the useful life and the lease
term
 Example continued - Liability

Date Payment Interest 5% Reduction in Carrying

lease liability value
1st Jan 2020 31,552

31st Dec 2020 10,000 1,578 8,422 23,130

1st Jan 2022 10,000 1,157 8,843 14,287

Dr Finance Cost 1,578

Cr Lease liability 1,578

Dr Lease liability 10,000

Cr Cash 10,000

Lease liability due within 1 year – Current

 Example continued - Asset

Depreciation is lease life in the example

34,552 / 3 = 10,517

Carrying value of Asset = 21,035

Depreciation 11,517
Right of use asset 11,517
 Example continued – purchase at end
If Alto purchases the car at the termination of the lease at a price of
4,000 and the estimated remaining life of the equipment is two years, it
makes the following entry.

Car 4,000
Cash 4,000
Example continued – Residual value below
guaranteed residual value

Car had guaranteed residual value 5,000

Expected residual value 3,000

Difference 2,000

Add PV of 2,000 as an additional lease payment to lease

liability and right of use asset

Lease liability = 31,552 + PV of (2,000,5%,3)

Example continued: Residual Value Loss
Assume that due to poor maintenance of the car, the fair value of
the asset is zero upon returning the car.

Alto reports a loss in the amount of payment to be made

Loss on Lease xx
Cash xx

(3,000 in this case)

 LO 3
LESSEE DISCLOSURES
 Lessee Disclosures
Either present separately or aggregate with assets were
owned.

The entity must disclose which asset includes right-of-use

assets.

• The depreciation charged on right-of-use assets

• Interest expenses on lease liabilities
• The expense relating to short-term leases and leases of
low value assets
• Cash outflows for leased assets
• Right-of-use asset additions
• The carrying amount of right-of-use assets
• A maturity analysis of lease liabilities.
 LESSEE DISCLSOURES

Presentation
Summary of how the lessee reports the information related to
finance and operating leases in the financial statements.

ILLUSTRATION 21.35
Presentation in Financial Statements—Lessee
Subsequent Lease Accounting

To illustrate the accounting for a lease using the finance

lease method, assume that CNH Capital (NLD) (a subsidiary
of CNH Global) and Ivanhoe Mines Ltd. (CAN) sign a lease
agreement dated January 1, 2019, that calls for CNH to
lease a backhoe to Ivanhoe beginning January 1, 2019.

The terms and provisions of the lease agreement and other

pertinent data are as follows.

LO 2
Terms and provisions of the lease agreement:
• The term of the lease is five years. The lease agreement is non-
cancelable, requiring equal rental payments of €20,711.11 at the
beginning of each year (annuity-due basis).
• The backhoe has a fair value at the commencement of the lease of
€100,000, an estimated economic life of five years, and a
guaranteed residual value of €5,000. (Ivanhoe expects that it is
probable that the expected value of the residual value at the end of
the lease will be greater than the guaranteed amount of €5,000.)
• The lease contains no renewal options. The backhoe reverts to
CNH Capital at the termination of the lease.
• Ivanhoe’s incremental borrowing rate is 5 percent per year.
• Ivanhoe depreciates its equipment on a straight-line basis.
• CNH sets the annual rental rate to earn a rate of return of 4 percent
per year; Ivanhoe is aware of this rate.
LO 2
Lessee Accounting: Example 1

Ivanhoe computes the lease liability and the amount capitalized

as a right-of-use asset as follows:

Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments €95,890.35 *

Ivanhoe uses CNH's implicit interest rate of 4 percent instead of its

incremental borrowing rate of 5 percent because it is known to
Ivanhoe.

* Rounded by €0.02. LO 2
Lessee Accounting: Example 1

Ivanhoe records the finance lease on its books on January 1, 2019,

as:

Right-of-Use Asset 95,890.35

Lease Liability 95,890.35

Ivanhoe records the first lease payment on January 1, 2019, as

follows.

Lease Liability 20,711.11

Cash 20,711.11

LO 2
ILLUSTRATION 21.7
Lease Amortization Schedule—Lessee

LO 2
 ILLUSTRATION 21.7

Prepare the entry to record accrued interest at Dec. 31, 2019.

Interest Expense 3,007.17

Lease Liability 3,007.14

* rounding LO 2
Lessee Accounting: Example 1

Depreciation of the right-of-use asset over the five-year lease

term, applying Ivanhoe’s normal depreciation policy (straight-line
method), results in the following entry at December 31, 2019.

Depreciation Expense 19,178.07

Right-of-Use Asset (€95,890.35 ÷ 5 years) 19,178.07

LO 2
 Lessee Accounting: Example 1

The statement of financial position as it relates to lease

transactions at December 31, 2019.
ILLUSTRATION 21.8
Statement of Financial
Position Presentation

On its December 31, 2019, income statement, Ivanhoe reports,

ILLUSTRATION 21.9
Income Statement
presentation
 ILLUSTRATION 21.7

Ivanhoe records the second lease payment as follows.

Lease Liability (€3,007.17 + €17,703.95) 20,711.11

Cash 20,711.11

* rounding LO 2
 ILLUSTRATION 21.7

If Ivanhoe purchases the equipment from CNH at the termination of

the lease at a price of €5,000 and the estimated remaining life of the
equipment is two years, it makes the following entry.

Equipment 5,000
Cash 5,000
* rounding LO 2
Lessee Accounting: Example 2

To illustrate a situation where the expected residual value is

below the guaranteed residual value, assume in the earlier
CNH/Ivanhoe example that it is probable that the residual
value will be €3,000 instead of the guaranteed amount of
€5,000. If Ivanhoe estimates the residual value of the backhoe
at the end of the lease to be €3,000, Ivanhoe includes €2,000
(€5,000 − €3,000) as an additional lease payment in
determining the lease liability and right-of-use asset.

LO 2
Lessee Accounting: Example 2

Ivanhoe computes the lease liability and the amount capitalized

as a right-of-use asset as follows:

Payment € 20,711.11
Present value factor (i=4%,n=5) x 4.62990
PV of lease payments € 95,890.35 *
Probable residual value € 2,000,00
PV factor (i=4,n=5) x .82193
PV of probable residual value 1,643.86
Lessee’s lease liability/right-of-use asset € 97,534.21

* Rounded by €0.02. LO 2
Lessee Accounting: Example 2

Ivanhoe makes the following entries to record the lease and the
first payment on January 1, 2019, as:

Right-of-Use Asset 97,534.21

Lease Liability 97,534.21

Lease Liability 20,711.11

Cash 20,711.11

LO 2
ILLUSTRATION 21.11
Lease Amortization Schedule—Lessee
LO 2
ILLUSTRATION 21.12
Journal Entries—Guaranteed Residual Value

LO 2
Example 2: Residual Value Loss

Assume that due to poor maintenance of the backhoe, Ivanhoe

and CNH agree that the fair value of the asset is zero upon
returning the backhoe to CNH on January 1, 2024. In this case,
Ivanhoe reports a loss of €3,000. Under the expected payment
scenario, Ivanhoe makes the following entry.

Loss on Lease (€5,000 − €2,000) 3,000

Cash 3,000

Under the no expected payment scenario, Ivanhoe makes the

following entry.
Loss on Lease (€5,000 − €0) 5,000
Cash 5,000
LO 2
Lessee Accounting: Example 3

Unguaranteed Residual Value: Assume that Hathaway Disposal

(lessor) and Marks and Spencer plc (M&S) (GBR) (the lessee)
sign a lease agreement dated January 1, 2019. The lease
agreement specifies that Hathaway will grant right-of-use of one
of its standard cardboard compactors for use at one of M&S’s
stores. Information relevant to the lease is as follows.
 Lease term is three years, non-cancelable, requires rental
payments of £17,620.08 at the beginning of each year.
 Compactor has a cost and fair value at commencement of
the lease of £60,000, an estimated economic life of seven
years, and an expected residual value of £12,000, which is
unguaranteed.
LO 2
Lessee Accounting: Example 3

Unguaranteed Residual Value: Assume that Hathaway Disposal

(lessor) and Marks and Spencer plc (M&S) (GBR) (the lessee)
sign a lease agreement dated January 1, 2019. The lease
agreement specifies that Hathaway will grant right-of-use of one
of its standard cardboard compactors for use at one of M&S’s
stores. Information relevant to the lease is as follows.
 Lease contains no renewal options, the compactor reverts
to Hathaway at the termination of the lease.
 Implicit rate of the lessor is not known by M&S. M&S’s
incremental borrowing rate is 6 percent.

LO 2
Lessee Accounting: Example 3

The present value of the lease payments for M&S in this situation
is £49,924.56 (£17,620.08 × 2.83339 (PVF = AD 3,6%)).

The lease liability of £49,924.56 does not include any payments

related to the unguaranteed residual value.

M&S makes the following entries.

January 1, 2019
Right-of-Use Asset 49,924.56
Lease Liability 49,924.56

Lease Liability 17,620.08

Cash 17,620.08
LO 2
ILLUSTRATION 21.14
Lease Amortization Schedule—Lessee

LO 2
ILLUSTRATION 21.15 Journal Entries by Lessee LO 2