IFRS 16: Lessor Accounting

A lessor must classify each of its leases as either an operating lease or a finance lease (IFRS 16.61). This classification is based on the extent to which the lease transfers the risks and rewards resulting from ownership of an underlying asset.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards from ownership of an asset. Conversely, an operating lease is a lease that does not transfer substantially all the risks and rewards from ownership of an asset (IFRS 16.62). Risks include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value (IFRS 16.B53).

Paragraphs IFRS 16.63-65 provide examples and indicators that individually or in combination would normally lead to a lease being classified as a finance lease.

Lessees (customers) don’t need to make a distinction between operating and finance leases as they account for all leases using one ‘right-of-use’ model.

When a lease includes both land and buildings elements, a lessor should assess the classification of each element as a finance lease or an operating lease separately. Lease payments should be allocated between the land and the buildings elements in proportion to the relative fair values of the leasehold interests in the land element and buildings element of the lease at the inception date. Fair value of leasehold interest can be defined as a fair value of the underlying asset less its present value of the residual value. Allocation based on fair values of the leasehold interests better reflects compensating the lessor for the benefits ‘used up’ during a lease (IFRS 16.BCZ245-BCZ247).

IFRS 16 notes an important consideration that land normally has an indefinite economic life (IFRS 16.B55-B57), it is therefore impossible that the lease term will be for the major part of the economic life of the underlying asset. It is however possible that for very long-term leases (e.g. 99 years), the present value of the lease payments will represent substantially all of the fair value of the land.

For a lease of land and buildings in which the amount for the land element is immaterial to the lease, a lessor may treat the land and buildings as a single unit for the purpose of lease classification (IFRS 16.B57).

A sublease is a transaction for which an underlying asset is re-leased by a lessee (‘intermediate lessor’) to a third party, and the lease (‘head lease’) between the head lessor and lessee remains in effect (IFRS 16. Appendix A). An intermediate lessor shall classify the sublease as a finance lease or an operating lease as follows (IFRS 16.B58):

(a) if the head lease is a short-term lease that the entity, as a lessee, has accounted for using the practical expedient, the sublease is classified as an operating lease.

(b) otherwise, the sublease is classified by reference to the right-of-use asset arising from the head lease, rather than by reference to the underlying asset.

See also Examples 20-21 accompanying IFRS 16 and discussion contained in paragraphs IFRS 16.BC232-BC236.

Lease classification is reassessed only if there is a lease modification. Changes in estimates or circumstances do not give rise to a new classification of a lease (IFRS 16.66).

At the commencement of the lease, the lessor recognises a lease receivable at an amount equal to the net investment in the lease (IFRS 16.67). Net investment in the lease is the sum of the following items discounted at the interest rate implicit in the lease (IFRS 16.Appendix A):

(a) the lease payments receivable by a lessor under a finance lease; and

(b) any unguaranteed residual value accruing to the lessor.

Any initial direct costs are included in the net investment in the lease (with an exception of manufacturers or dealer lessors).

The underlying asset is derecognised and any difference is immediately recognised in P/L as a gain/loss on disposal of an asset (or as revenue and costs of goods sold – see specific treatment for manufacturer/dealer lessors below).

Example: accounting for a finance lease by a lessor

On 1 January 20X1 Entity A (a lessor) enters into a 5 year equipment lease contract with Entity X (a lessee). The following information is relevant for this lease:

  • annual lease payments of $20,000 are made at the end of each year
  • Entity A estimates the equipment to have fair value of $95,000 and carrying amount of $90,000
  • Economic useful life of the equipment is 7 years and Entity A estimates the residual value of the equipment to be $25,000, of which $15,000 is guaranteed by Entity X

All calculations presented in this example are available for download in an excel file.

First, Entity A calculates interest rate implicit in the lease as follows:

Note: you can scroll the table horizontally if it doesn’t fit your screen

dateamount 
8.7%Interest rate
implicit in the lease
20X1-01-01(95,000)fair value of
underlying asset
20X1-12-3120,000lease payment
20X2-12-3120,000lease payment
20X3-12-3120,000lease payment
20X4-12-3120,000lease payment
20X5-12-3120,000lease payment
20X5-12-3115,000residual value guarantee
20X5-12-3110,000unguaranteed residual value

The interest rate implicit in the lease is used to calculate the present values of lease payments:

Note: you can scroll the table horizontally if it doesn’t fit your screen

datepaymentdiscount factorpresent value
total95,000
20X1-12-3120,0000.920518,410
20X2-12-3120,0000.847116,943
20X3-12-3120,0000.779615,593
20X4-12-3120,0000.717314,347
20X5-12-3120,0000.660213,203
20X5-12-3115,0000.66029,902
20X5-12-3110,0000.66026,602

Accounting entries made be Entity A at the commencement of the lease are as follows (see how they are calculated in the excel file mentioned above):

 DRCR
Net investment in the lease95,000
Equipment held for lease90,000
Revenue88,398
Cost of goods sold83,398

The net investment in the lease will be increased by interest income recognised in P\L and decreased by payments made by the lessee as follows:

Note: you can scroll the table horizontally if it doesn’t fit your screen

yearopening
(1 Jan)
interest
income
paymentclosing
(31 Dec)
20X195,0008,203(20,000)83,203
20X283,2037,205(20,000)70,409
20X370,4096,097(20,000)56,506
20X456,5064,907(20,000)41,414
20X541,4143,586(20,000)25,000

The $25,000 that is left on 31 December 20X5 corresponds to the residual value of the equipment.


Lease payments included in the measurement of the net investment in the lease are listed in paragraph IFRS 16.70 and generally mirror those included in the measurement of lease liability by the lessee. Slightly different criteria relate to residual value guarantees, as lessor includes only 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. Unguaranteed residual value accruing to the lessor is excluded from lease payments, but it is still added to the net investment in the lease (see below).

Unguaranteed residual value accruing to the lessor is not included in lease payments but is added to the net investment in the lease. It is that portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor (IFRS 16.Appendix A).

Interest rate implicit in the lease is discussed in a lessee accounting part of IFRS 16. As noted below, initial direct cost are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term. Therefore, the interest rate implicit in the lease is defined in such a way that the initial direct costs are included automatically in the net investment in the lease (IFRS 16.69).

Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained (IFRS 16.Appendix A). The definition of initial direct costs for lessors is the same as for lessees and is discussed in sections on lessee accounting.

Initial direct cost are included in the initial measurement of the net investment in the lease and reduce the amount of income recognised over the lease term (IFRS 16.69). This does not apply to manufacturer or dealer lessors.

Lessors (suppliers) should allocate the consideration in a contract to all lease and non-lease components using criteria for allocating the transaction price to performance obligations contained 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 is in substance equivalent to the profit or loss resulting from an outright sale of the underlying asset (IFRS 16.72). Therefore, a manufacturer or dealer lessor recognises at the commencement date (IFRS 16.71):

  1. revenue equal to 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;
  2. the cost of sale equal to the cost, or carrying amount if different, of the underlying asset less the present value of the unguaranteed residual value; and
  3. selling profit or loss (equal to the difference between revenue and the cost of sale) in accordance with its policy for outright sales to which IFRS 15 applies.

As noted earlier, the present value of the lease payments accruing to the lessor should be discounted at market rate if interest, not the stated interest quoted by the lessor in a lease contract.

At the commencement date, a manufacturer or dealer lessor recognises as an expense costs incurred in connection with obtaining a finance lease as they are mainly related to earning recognised selling profit. Such costs are excluded from the net investment in the lease (IFRS 16.74).

Finance income is recognised by the lessor over the lease term using effective interest rate (IFRS 16.75). See this example.

The lessor reduces the net investment in the lease for payments received. Variable lease payments that are not included in the measurement of the net investment in the lease are recognised in P/L as they are earned. See more discussion on variable lease payments in the lessee accounting.

The net investment in the lease is subject to derecognition and impairment requirements set out in IFRS 9 (IFRS 16.77).

Estimated unguaranteed residual value should be reviewed ‘regularly’. Any reduction of this value impacts the income allocation over the remaining lease term and is recognised immediately as an adjustment to the value of net investment with a corresponding impact in P/L (IFRS 16.77).

When a lease modification occurs, lessor should assess whether such a modification should be accounted for as a separate lease. Criteria for making such assessment are given in paragraph IFRS 16.79 and are the same as for lessees.

A modification that is not treated as a separate lease is accounted for as follows (IFRS 16.80):

(a) if the lease would have been classified as an operating lease had the modification been in effect at the inception date, the lessor:

(i) accounts for the lease modification as a new lease from the effective date of the modification; and

(ii) measures the carrying amount of the underlying asset as the net investment in the lease immediately before the effective date of the lease modification.

(b) otherwise, the lessor applies the requirements of IFRS 9.

When a lease is classified as operating lease, the underlying asset stays in the statement of financial position of the lessor and is presented according it nature (IFRS 16.88).

A lessor recognises lease payments from operating leases as income on straight-line basis, unless another systematic basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished (IFRS 16.81).

Initial direct costs incurred in obtaining an operating lease are added to the carrying amount of the underlying asset and recognised in P/L over the lease term on the same basis as the lease income (IFRS 16.83).

Underlying asset subject to operating lease is depreciated under normal depreciation policy for similar assets of the lessor (IFRS 16.84). Depreciation of such an asset is recognised as an expense over the lease term on the same basis as lease income (IFRS 16.83).

Unlike for finance leases, manufacturer or dealer lessors do not recognise any selling profit on entering into an operating lease because it is not the equivalent of a sale (IFRS 16.86).

Lease modifications are accounted for by the lessor as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease (IFRS 16.87).

Disclosure requirements for lessors are set out in paragraphs IFRS 16.89-97.

See other pages relating to IFRS 16:

IFRS 16 Leases: Scope of IFRS 16

IFRS 16 Leases: Identifying a Lease

IFRS 16 Leases: Lease Term

IFRS 16 Leases: Recognition and Measurement of Leases

IFRS 16 Leases: Transition from IAS 17 to IFRS 16

 


© 2018-2019 Marek Muc

Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). The information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.