Classification of leases
Finance lease vs operating lease
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.
Classification of leases as operating or finance leases was carried forward from IAS 17 and therefore I won’t go into detail here. In general, 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.
Lease of land and buildings
When a lease includes both land and buildings, 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. IASB believes that 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 emphasises 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):
- 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.
- 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 in paragraphs IFRS 16.BC232-BC236.
Reassessment of lease classification
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).
Finance leases: initial recognition and measurement
Summary of the initial recognition and measurement
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):
- the lease payments receivable by a lessor under a finance lease; and
- 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).
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. You can scroll tables presented below horizontally if they don’t fit your screen.
First, Entity A calculates interest rate implicit in the lease as follows:
|20X1-01-01||(95,000)||fair value of
|20X5-12-31||15,000||residual value guarantee|
|20X5-12-31||10,000||unguaranteed residual value|
implicit in the lease
The interest rate implicit in the lease is used to calculate the present values of lease payments and residual value:
|date||payment||discount factor||present value|
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):
|Net investment in the lease||95,000|
|Equipment held for lease||90,000|
|Cost of goods sold||83,398|
Each year, 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:
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
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
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
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.
Separating components of a contract by a lessor
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.
Finance leases: manufacturer or dealer lessors
Summary of accounting by manufacturer or dealer lessors
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):
- 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;
- 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
- 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.
Market rate of interest
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.
Costs of obtaining a lease
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). This is approach is different from non-manufacturer/dealer lessors.
Finance leases: subsequent measurement
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.
Derecognition and impairment
The net investment in the lease is subject to derecognition and impairment requirements set out in IFRS 9 (IFRS 16.77).
Unguaranteed residual value
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
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). In other words, IAS 16 or IAS 38 apply.
Manufacturer or dealer lessor
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.
More about IFRS 16
See other pages relating to IFRS 16: