IFRS -16 LEASES

Identifying a lease

A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for
consideration.

If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for
that portion of the term.

At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. An entity shall reassess whether a contract is, or
contains, a lease only if the terms and conditions of the contract are changed.

1. Right to control

The customer should have both of the following:

a) the right to obtain substantially all of the economic benefits from use of the identified asset; and
b) the right to direct the use of the identified asset

Right to obtain economic benefits from use

A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding or sub-leasing the
asset.

An entity shall consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset.
That is, if the contract limits the scope of usage of asset then consider only those economic benefits that are within the scope of the contract.

If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use of an asset as consideration,
those cash flows paid as consideration shall be considered to be part of the economic benefits that the customer obtains from use of the asset.
Right to direct the use
In assessing whether a
customer has the right to direct
A customer has the right to direct the use of an identified asset throughout the period of use only if either: the use of an asset, an entity
a) the customer has the right to direct how and for what purpose the asset is used throughout the period of shall consider only rights to
make decisions about the use
use; or of the asset during the period
b) the relevant decisions about how and for what purpose the asset is used are predetermined. of use.

2. Identified asset

An asset is typically identified by being explicitly specified in a contract.

An identified asset can be a physically distinct portion of a larger asset, such as one floor of a multi-level building or physically distinct dark fibres
within a cable.

Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute
the asset throughout the period of use.

Replacement asset
The supplier’s right or obligation to substitute the asset for repairs and maintenance, if the asset is not operating properly or if a technical
upgrade becomes available does not preclude the customer from having the right to use an identified asset.

If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.
 3. Lease Term
An entity shall determine the lease term as the non-cancellable period of a lease, together with both:

a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

Example I
A customer enters into a contract with a telecommunications company for network services. To supply the services, it is necessary to install a
server at the customer’s premises. The supplier can reconfigure or replace the server, when needed, to continuously provide the network services;
the customer does not operate the server, nor does it make any significant decisions about its use.

The telecommunication company determines the speed and the quality of data transportation in the network using the servers. The
telecommunication company has the right to control the use of the server because it makes all the relevant decisions about the use of the server
throughout the period of use. It decides how the data is transported, whether to reconfigure the servers and whether to use the servers for another
purpose. The customer only decides about the level of network services (that is the output of the servers) before the period of use.

This arrangement does not contain a lease.

Example II
A customer enters into a contract that conveys the right to use an explicitly specified retail unit for a period of five years. The property owner can
require the customer to move into another retail unit; there are several retail units of similar quality and specification available.
As the property owner has to pay for any relocation costs it can benefit economically from relocating the customer only if there is a new tenant that
wants to occupy a large amount of retail space at a rate that is sufficient to cover the relocation costs. Those circumstances may arise, but they
are not considered likely to occur.
The contract requires the customer to sell his goods during the opening hours of the larger retail space. The customer decides on the mix of goods
sold, the pricing of the goods sold and the quantities of inventory held. He further controls physical access to the retail unit throughout the five-year
period of use. The rent that the customer has to pay includes a fixed amount plus a percentage of the sales from the retail unit.

Is there an identified asset?

The retail unit is explicitly specified in the contract. The property owner has a right to substitute the asset. But, because it would benefit from the
exercise of the right only under certain circumstances that are not considered likely to occur, the substitution right is not substantive. Hence, the
retail unit is an identified asset.

Has the customer the right to obtain substantially all of the economic benefits from the use of the retail unit? The customer has the exclusive use
of the retail unit throughout the period of use. The fact that a part of the cash flows received from the use are passed to the property owner as
consideration does not prevent the customer from having the right to substantially all of the economic benefits from the use of the retail unit.
Has the customer the right to direct the use of the retail unit?
During the period of use, all decisions on how and for what purpose the retail unit is used are made by the customer. The restriction that goods
can only be sold during the opening hours of the larger retail space defines the scope of the contract, but it does not limit the customer’s right to
direct the use of the retail unit.

Conclusion: The contract contains a lease of retail space.

ACCOUNTING FOR LESSEE BOOKS

Initial Recognition
At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability.

Subsequent measurement for RUA

After the commencement date, a lessee shall measure the right-of-use asset applying:
· cost model under IAS-16
· revaluation model under IAS-16
· fair value model under IAS-40.

Subsequent measurement of the lease liability

After the commencement date, a lessee shall measure the lease liability by:
(a) increasing the carrying amount to reflect interest on the lease liability;
(b) reducing the carrying amount to reflect the lease payments made; and
(c) remeasuring the carrying amount to reflect any reassessment or lease modifications or to reflect revised in-substance fixed lease payments.

Exemptions allowed under IFRS-16

- Lease Term is less than 12 months
- Low value assets
Basic Examples:

Example
A company acquired an item of plant under a lease on 1 April 20X7. The present value of the lease payments was $15.6 million and the rentals
are $6 million per annum paid in arrears for three years on 31 March each year.

The interest rate implicit in the lease is 8% per annum.

Example
On 1 January 20X6 Fellini hired a machine under a five-year lease. The present value of the lease payments was $3.3 million. Instalments of
$700,000 are payable annually in advance with the first payment made on 1 January 20X6.

The interest rate implicit in the lease is 6%.

What would be the lease liability after 2 years?

Example
On 1 January 20X6 Platinum entered into a lease agreement. The initial lease liability was $360,000 and the terms of the lease were a deposit of
$120,000 payable on 1 January 20X6 and three further instalments of $100,000 payable on 31 December 20X6, 31 December 20X7 and 31
December 20X8.

The rate of interest implicit in the lease is 12%.

Example – variable rent

Lessee enters into a 15-year lease of retail space in a shopping centre. The minimum rent is CU 100 per annum, unless sales exceed CU 1,000
per annum. If sales revenue exceeds CU 1,000 per annum, the lease payments are CU 50,000. The lessee has historically generated sales revenue
at its retail locations of between CU 150,000 and CU 250,000 per annum. The store must operate within certain specified regular operating hours.
Analysis – The lease contract technically specifies variable payments in that rental payments can be either CU 100 or CU 50,000. However, it is
not realistically possible that the lessee will have less than CU 1,000 in sales per annum given its history with past retail locations. In this case,
there is no true variability in the lease payments as only one outcome is realistically probable to occur. The lessee would include the lease payments
of CU 50,000 per annum in its initial measurement of the lease contract.
LESSOR BOOKS
Classification of leases
A lessor shall classify each of its leases as either a finance lease or an operating lease.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset.

Examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease are:

§ the lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
§ the lease consists of bargain purchase option (i.e. lessee has the option to purchase the underlying asset at a price that is expected to be
sufficiently lower than the fair value);
§ 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; and
§ the underlying asset is of such a specialized nature that only the lessee can use it without major modifications.

Lease classification is made at the inception date and is reassessed only if there is a lease modification.

A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying
asset.

Initial measurement
For a finance lease, the lessor recognizes a receivable at an amount equal to the net investment in the lease which is the present value of the
aggregate of lease payments receivable by the lessor and any unguaranteed residual value.
If the contract is classified as an operating lease, the lessor continues to present the underlying assets.

Subsequent measurement
A lessor shall apply the lease payments relating to the period against the gross investment in the lease to reduce both the principal and the
unearned finance income.
Example # 1
Orange Tree Limited is neither a dealer nor a manufacturer. Orange Tree Limited entered into an agreement under which Orange Tree Limited
leased a machine to Beanstalk Limited. Orange Tree Limited purchased this machine on 1 January 20X1 at a cost of C210 000.
The lease is a finance lease, the terms of which are as follows:
§ inception of lease: 1 January 20X1
§ lease period: 3 years
§ lease instalments: C90 000, annually in arrears, payable on 31 December of each year
§ guaranteed residual value: C10 000, payable on 31 December 20X3.
The interest rate implicit in the agreement is 15.5819%.
Required: Solve above scenario for lessor books.
Example # 2
Pear Tree Limited is neither a dealer nor a manufacturer. Pear Tree Limited entered into an agreement in which Pear Tree leased a machine to
Giant Limited (cost C210 000).
The lease is a finance lease, the terms of which are as follows:
§ inception of lease: 1 January 20X1
§ lease period: 3 years
§ lease instalments: C80 000, annually in advance, payable on 1 January of each year
§ guaranteed residual value: C10 000, payable on 31 December 20X3;
Interest rate implicit in the agreement: 18.7927%.
Required: Solve above scenario for lessor books
Example # 3
On 1 January 20X1, Oryx entered into a contract to lease a specialised machine for three years. The contract contains an option to extend the
lease term for a further year. Oryx believes that it is reasonably certain to exercise this option. The machine has a useful life of ten years. Oryx will
make lease payments of $1 million per year for the initial term and $0.8 million per year for the option period. All payments are due at the end of
the year. To obtain the lease, Oryx incurs initial direct costs of $0.1 million.

The interest rate within the lease is not readily determinable. Oryx’s incremental rate of borrowing is 10%.

Explain how Oryx should account for the above transaction in accordance with IFRS 16 Leases for the year ended 31 December 20X1.
Example # 4 Operating Lease – Recognition and Measurement
Banana Tree Limited entered into an operating lease with Frond Limited on 1 January 20X1. Frond Limited agreed to lease a plant from Banana
Tree Limited (which had cost Banana Tree Limited C300 000 on 1 January 20X1) on the following terms:
§ inception of lease: 1 January 20X1
§ lease period: 3 years
§ lease instalments, payable as follows: -
o 31 December 20X1: C100 000
o 31 December 20X2: C110 000
o 31 December 20X3: C150 000

§ Frond Limited may purchase the leased asset at its market price on 31 December 20X3
§ Unguaranteed residual value: C30 000.
Frond Limited purchased the plant on 31 December 20X3 at its market price of C30 000.
Banana Tree Limited depreciates its plant over three years on the straight-line basis.
This is the only transaction in the years ended 31 December 20X1, 20X2 and 20X3.
Required: Prepare the journal entries for each of the years affected. Ignore tax.
MANUFACTURER OR DEALER LESSORS

Initial Measurement

For lessors who are manufacturers or dealers offering finance leases (i.e. instead of a cash sale), the instalments received represent two types of
income:
1. sales income; and
2. interest income.

Receivables xxx Cost of Sales xxx

Sales xxx Inventory xxx

Para 71 (IFRS-16): A manufacturer or dealer lessor shall recognise selling profit or loss on a finance lease at the commencement date, regardless
of whether the lessor transfers the underlying asset as described in IFRS 15.

A manufacturer or dealer lessor shall recognise as an expense costs incurred in connection with obtaining a finance lease at the commencement
date because they are mainly related to earning the manufacturer or dealer’s selling profit.
Example # 4
Avocado Tree Limited is a dealer in machines. Avocado Tree Limited entered into an agreement under which Avocado Tree Limited leased a
machine to Giant Limited. This machine was purchased by Avocado Tree Limited on 1 July 20X1 at a cost of C100 000. The cash sales price of
this machine is C210 000.
The lease is a finance lease, the terms of which are as follows:
§ inception of lease: 1 July 20X1
§ lease period: 5 years
§ lease instalments: C60 000, annually in advance, payable on 1 July of each year
§ interest rate implicit in the agreement: 21.8623%.
Required: Prepare the journal entries and disclosure for each of the years ended 31 December 20X1 to 20X5 in Avocado Tree Limited’s
books (the books of the lessor).
LEASE MODIFICATION
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.
Modification for Lessee Books

Modification for Lessor Books

Modification of an operating lease
The modification of an operating lease should be accounted for as a new lease by the lessor. Any prepaid or accrued lease payments are considered
to be payments for the new lease (that is, they will be spread over the new term of the modified lease).

Modification of a finance lease

A lessor accounts for the modification of a finance lease as a separate lease if:
§ the modification increases the scope of the lease; and
§ the consideration for the lease increases by an amount commensurate with the stand-alone price.
SALE AND LEASEBACK TRANSACTIONS (SALTs)

What is Sale and Leaseback?

- Lessee requires finance but cannot generate finance through traditional means (loan note or share issue)
- In such case lessee sells its asset (for example: Real Estate or Plant & Machinery) and leases it back in order to continue using it and
also generate finance for future expansion or liquidity

Advantages to Lessee
- Immediate availability of finance without increasing number of shareholders
- Retains the ‘Right to Use’ asset even after sale (so the business continues)

Advantages to Lessor
- Acquires legal right to asset (therefore reduces credit risk)
- Charges finance cost over rentals

Accounting for SALTs

Step # 1 – Determine if the sale qualifies as a ‘genuine sale’ under IFRS -15 (i.e. performance obligation criteria is met?).
Step # 2 – Calculate lease liability (lease liability is the PVMLP).
Step # 3 – Measure the Right-to-Use Asset as proportion of the previous carrying amount that is retained.
Step # 4 – Make entry. Carrying Amount x Lease Liability
Fair Value of Asset

Question scenarios
1. Consideration is equal to fair value
2. Consideration is higher or lower than fair value
CASE # 1 - CONSIDERATION IS EQUAL TO FAIR VALUE

Example # 1
A seller (lessee) sells its building to a buyer (lessor) for $2,000,000. Before the transaction occurs, the building had a carrying value of $1,000,000.
The fair value of the building at the time of sale is $2,000,000.

Simultaneously, the seller (lessee) leases the building back from the buyer (lessor) for a period of 18 years with annual lease payments at the end
of each year of $120,000. The interest rate implicit in the lease is determined to be 4.5% per annum.

a) Prepare accounting entry assuming criteria under IFRS-15 is met.

b) Prepare entry assuming the sale does not meet the criteria under IFRS-15
CASE # 2 - CONSIDERATION IS HIGHER OR LOWER THAN FAIR VALUE

· Sales proceeds below market terms would mean a prepayment of lease payments by lessee
· Sales proceeds above market terms would mean additional financing obtained by lessee

Note: Right to Use shall be calculated based on actual lease liability

Example # 2
A seller (lessee) sells its building to a buyer (lessor) for $2,000,000. Before the transaction occurs, the building had a carrying value of $1,000,000.
The fair value of the building at the time of sale is $1,800,000.

Simultaneously, the seller (lessee) leases the building back from the buyer (lessor) for a period of 18 years with annual lease payments at the end
of each year of $120,000. The interest rate implicit in the lease is determined to be 4.5% per annum.

The sale meets the criteria of IFRS 15 to be accounted for as a sale.

a) Prepare accounting entry for SALT