Leasing of immovable property is a common phenomenon. Now a day’s companies take laptops, furniture, etc. on lease. “LEASE” is the contract that conveys the right to use the asset for a period of time in exchange of consideration.
Under the lease contract, Lessor conveys the right to use the assets for a period of time to lessee. Lessee does not own the asset but it is being used to generate future economic benefit. IFRS-16 ensures that all the assets are shown on the statement of financial position including leased assets. To reflect substance of the transaction and to meet conceptual framework characteristics of faithful presentation, it is required to reflect all the assets including leased assets in the statement of financial position.
In other words, the resources are not owned by the entity but they are getting used in generating the economic benefit, and the purpose of IFRS -16 is to ensure that, the Statement of financial position reflects the assets which are used by the entity in generating the economic benefit.
One of the characteristics of the conceptual framework of financial reporting is a true and fair view of the financial position. The resources are not owned by the entity but it is used by the entity.
How to identify that an arrangement is a lease contract?
Below are the characteristics of lease arrangement:
- Assets should be identified: The asset under the arrangement should be identified either explicitly or implicitly. It should be clearly identified which asset is leased out by the lessor.
- Right to control the asset: The arrangement should convey the right to control the asset which can be evidenced by.
- The right to obtain substantially all of the economic benefits from the identified asset, and
- The right to direct the use of the identified asset.
- Lessor does not have substantive right to substitute the identified asset. In other words, the lessor does not have the right to substitute/replace the asset to obtain economic benefits. In case leased asset is not functioning properly and it is replaced/Substituted by lessor in such circumstances the right is not substantive because it is not to obtain economic benefit.
IFRS-16-Leases set out the principles for recognistion, measurement, presentation and disclosures of leases. In this article we will discuss about the treatment of leases in details.
Initial recogition: On the date of commencement, The lessee to recognise Right to use asset and lease liability in the books when the asset is available for use.
Some important definition:
Right to use assets (ROU): A asset that represents right to use an identified asset for a lease term.
Lease liability: Lease liability is measured as present value of lease payment not paid on date of commencement. To measure the present value, Interest rate implict in the lease is used.
Lease term: The non cancellable period for which lessee has the right to use the identified asset.
Optional Exemption: IFRS-16 provides optional exemption from the full requirement of the standard for Short term leases and low value leases. Entity elects to optional exemption, lease payment recognized as an expense over the lease term using straight line method or any other method reflecting the pattern of consumption of benefit.
In other words, entity not required to recognize Right to use asset and lease liability in books.
Measurement: Under this section, we will discuss how to measure/compute the Right to use assets and lease liability.
Short term lease: These are the leases having lease term of 12 months or less.
Low value lease: Leases where the identified asset has a low value. However standard doesnot give an amount which is considered as low value.
Measurement of Right to Use asset
Right to use assets = Initial measurement of Lease liability* + Lease payment made in advance or on the date of commencement + Any direct cost (incurred by lessee) + Any cost incurred by lessee for dismantling and removing the underlying asset or for restoring site (this is as per IAS-37- Provision, contingent liabilities and contingent assets)** – lease incentive
*Initial measurement of lease liability is present value of minimum lease payment (PVMLP)on the date of commencement.
** Cost incurred for restoring the site is capitalized and corresponding provision is created as per the principles of IAS-37.
Subsequent Measurement of Right to use assets
Subsequently, it is measured at cost less accumulated depreciation and impairment losses.
Depreciation on right to use assets starts from the date of commencement of lease. It is depreciated for a period which is earlier of end of its useful life or end of lease term.
Measurement of Lease liability
Lease liability initially measured at the present value of minimum lease payment not paid on the date of commencement.
The present value is computed using the interest rate implicit in the lease.
For example: XYZ Ltd. entered into lease agreement for 5 years. As per the terms of agreement, $10K per year to paid as lease rental. The discounting rate is 10%.
On the date of commencement, the lease liability is recognized as present value of minimum lease payment which is computed using the discount rate i.e. 10%.
| Year | Present value factor @10% ((1/(1+R)^n) | Year Lease payment | PVMLP |
| 1 | 0.909 | 10,000 | 9,090 |
| 2 | 0.826 | 10,000 | 8,260 |
| 3 | 0.751 | 10,000 | 7,510 |
| 4 | 0.683 | 10,000 | 6,830 |
| 5 | 0.621 | 10,000 | 6,210 |
| Total | 50,000 | 37,900 |
On the date of commencement, Lease liability is recognized at $37,900.
After the commencement date, the value of lease liability increased by interest charges and reduced by lease payment.
Continuing the above example, on the reporting date, the lease liability is computed as
| Particulars | Amount (In $) |
| Opening lease liability | 37,900 |
| Add: Finance cost @10% | 3,790 |
| Less: Lease payment* | 10,000 |
| Closing lease liability | 31,690 |
(*Here we are assuming that lease payment made in arrears)
Presentation
In the statement of financial position, the right to use assets can be presented on a separate line under Non-current assets.
The lease liability can be presented under other liabilities. It should be split between current and non-current liability and accordingly presented.
Lessor Accounting
For the purpose of lessor accounting, IFRS-16 distinguish between Operating lease and Finance lease.
Finance lease: A lease that transfer substantially all risk and rewards incidental to the ownership of an asset. Indicators that risk and rewards are transferred such as
- When the lease term is majority of economic/useful life of an underlying asset.
- The present value of minimum lease payment is substantially equal to fair value of an asset.
- Bargain purchase option is available at the end of lease term.
- Ownership transfer at the end of lease term.
- Lease asset is specialized
Accounting treatment
The underlying asset to be derecognized and lease receivable is recognized in the statement of financial position.
Any initial direct costs incurred by lessor are included in initial measurement of finance lease receivables.
Operating Lease: A lease that does not transfer substantially all risk and rewards incidental to the ownership of an underlying asset.
Accounting treatment
An asset under the operating lease is continued to be recognized in the books of lessor and depreciation to be charged over its useful life.
The income from operating lease should be recognized on straight line basis over the lease term.
Any initial direct costs incurred by lessor are added to the carrying amount of an asset and will be charged as expense over the lease term.
Sub-Lease
A lessee may sub lease the asset and in turn become the lessor. For example: X is the lessor and Y is the lessee. Y took the asset on lease and sub leased it to Z. In such case Y is turned as lessor. The treatment in Y books depends on whether it is financial lease of operating lease.
In some cases, Subsidiary took the asset on lease and sub leased it to parent entity. Here, subsidiary analyses the facts of the cases in the context of right to use asset whether it is operating lease of finance lease.
Presentation
The entity expected to present the qualitative and quantitative disclosures in the notes to financial statement.
The quantitative disclosures required by IFRS-16 are as:
- The carrying amount of ROU at the end of reporting period
- Depreciation expense on ROU asset
- Total interest expense on lease liability in the reporting period
- Sublease income earned during reporting period
- Total cash outflow for leases
- Any ROU addition during the reporting period
- A maturity analysis of all lease liabilities at the end of reporting period.
The qualitative disclosure provides information about the leases and leasing activities. It includes:
- Summary of leasing activities
- Commitment for leases not yet commenced
