IFRS 16

Leases

21-1
 Accounting for Leases

21-2
 The
The Leasing
Leasing Environment
Environment

A lease is a contractual agreement between a lessor and a

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

Largest group of leased equipment involves:

 Information technology
 Transportation (trucks, aircraft, rail)
 Construction
 Agriculture

21-3
 The
The Leasing
Leasing Environment
Environment

Advantages of Leasing - Lessees

1. 100% financing at fixed rates.

2. Protection against obsolescence.

3. Flexibility.

4. Less costly financing.

21-4
 The Leasing Environment

Advantages of Leasing—Lessor
1. Often provides profitable interest margins.

2. It can stimulate sales of a lessor’s product.

3. It often provides tax benefits to various parties in the

lease.

4. It can provide a high residual value to the lessor.

21-5
 Lease Accounting

Conveys the right to control the use of identified property,

plant or equipment (an identified asset) for a period of time
in exchange for consideration.”

The various views on capitalization of leases are as

follows.
1.Do not capitalize any leased assets.

2.Capitalize leases that are similar to installment purchases.

3.Capitalize all long-term leases.

4.Capitalize firm leases where the penalty for non-performance is

substantial.
21-6 LO 2
 Lease Accounting

IASB requires lessees to capitalize all leases.

Only exceptions:
leases covering a term of less than one year or
lease of property with a value less than $5,000.

Right to use property under the lease is an

asset, and
lessee’s obligation to make payments is a liability.

21-7 LO 2
 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.

21-8 LO 2
 Measurement of the Lease Liability and
Lease Asset

Lease Term
 The fixed, non-cancelable term of the lease.
 Bargain-renewal option can extend this period.
 At the commencement of the lease, the difference
between the renewal rental and the expected fair rental
must be great enough to make exercise of the option to
renew reasonably certain.

21-9 LO 2
 Measurement of the Lease Liability and
Lease Asset

Lease Payments
 Fixed payments.
 Variable payments that are based on an index or a rate.
 Guaranteed residual value.
 Payments related to purchase or termination options
that the lessee is reasonably certain to exercise.

21-10 LO 2
 Measurement of the Lease Liability and
Lease Asset

Discount Rate
Lessee should compute the present value of the lease
payments using the implicit interest rate.
► This rate, at commencement of the lease, which causes
the aggregate present value of the lease payments and
unguaranteed residual value to be equal to the fair value
of the leased asset.

In the event that it is impracticable to determine the

implicit rate, the lessee uses its incremental
21-11 borrowing rate. LO 2
 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.

21-12 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.
21-13 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.

21-14 * 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

21-15 LO 2
 ILLUSTRATION 21.7
Lease Amortization Schedule—Lessee

21-16 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

21-17 * 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

21-18 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

21-19
 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

21-20 * 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
21-21 * 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.

21-22 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

21-23 * 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

21-24 LO 2
 ILLUSTRATION 21.11
Lease Amortization Schedule—Lessee
21-25 LO 2
ILLUSTRATION 21.12
Journal Entries—Guaranteed Residual Value

21-26 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
21-27 LO 2
 Example 2: Bargain Purchase Option

Bargain purchase option allows the lessee to purchase the

leased property for a future price that is substantially lower than
the asset’s expected future fair value.
 Lessee must increase the present value of the lease
payments by the present value of the option price.
 Affects the accounting in the same way as a guaranteed
residual value with a probable amount to be owed.

21-28 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.
21-29 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.

21-30 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
21-31 LO 2
ILLUSTRATION 21.14
Lease Amortization Schedule—Lessee

21-32 LO 2
21-33 ILLUSTRATION 21.15 Journal Entries by Lessee LO 2
 Low-Value and Short-Term Leases

IASB provided an exception to required capitalization of all

leases:
1.Low-Value Leases (underlying assets with values of $5,000
or less), lessee may elect to expense lease payments as
incurred.
2.Short-Term Leases (lease term of 12 months or less),
lessee may elect to expense lease payments as incurred.

21-34 LO 2
 Lessor Accounting

Economics of Leasing
Lessor determines the amount of the rental payment, not
the lessee.
 Determines payment using rate of return (implicit rate).
 Considers credit standing of lessee.
 Length of the lease.
 Status of the residual value (guaranteed versus
unguaranteed).

21-35 LO 3
 Lessor Accounting

Economics of Leasing
In Examples 1 and 2, CNH determined the implicit rate to be 4
percent, the fair value of the equipment to be €100,000, and the
residual value to be $5,000. CNH then computes the lease
payment as shown.

Fair value of leased equipment €100,000.00

Less: Present value of the residual value
(€5,000 × .82193 (PVF 5,4%))
4,109.65
Amount to be recovered by lessor through
lease payments
€ 95,890.35
Five beginning-of-year lease payments to earn a
21-36 LO 3
4% return (€95,890.35 ÷ 4.62990) (PVF-AD 5,4%))
 Classification of Leases by the Lessor

For accounting purposes, the lessor classifies leases as a

 Finance lease or an,
 Operating lease.
For a finance lease, it must be non-cancelable and meet at least
one of five tests in Illustration 21.18.

To meet one of these five tests, the lessor must transfer

control of a substantial portion of the underlying asset to the
lessee or provide ownership of the underlying asset to the lessee.

21-37 LO 3
 For a finance lease,
•must be non-
cancelable and
•meet at least one of
the five tests.

ILLUSTRATION 21.218
Lease Classification Tests
21-38 LO 3
 Classification of Leases by the Lessor

Transfer of Ownership Test

 If the lease transfers ownership of the asset to the lessee, it
is a finance lease.

Purchase Option Test

 The lease purchase option allows the lessee to
purchase the property for a price that is significantly
lower than the underlying asset’s expected fair value
at the date the option becomes exercisable (bargain
purchase option).

21-39 LO 3
 Classification of Leases by the Lessor

Lease Term Test

 When the lease term is a major part of the remaining
economic life of the leased asset, companies should use the
finance method.
 Guideline: If the lease term is 75 percent or greater of the
economic life of the leased asset, the lease meets the lease
term test.

21-40 LO 3
 Classification of Leases by the Lessor

Present Value Test

 If the present value of the lease payments is
reasonably close to the fair value of the asset, the
lessee should use the finance method.
 Guideline: if the present value of the lease payments
equals or exceeds 90 percent of the fair value of the
asset, then a lessee should use the finance method.

21-41 LO 3
 Classification of Leases by the Lessor

Lease Payments
Generally include:

1.Fixed payments.

2.Variable payments.

3.Residual values (guaranteed or not).

4.Payments the lessee is reasonably certain to exercise.

21-42 LO 3
 Classification of Leases by the Lessor

Discount Rate
 Implicit rate should be used to determine the present
value of the payments.
 Defined as the discount rate that, at commencement
of the lease, causes the present value of the lease
payments and unguaranteed residual value to be
equal to the fair value of the leased asset.

21-43 LO 3
 Alternative Use Test

If at the end of the lease term the lessor does not have an
alternative use for the asset, the lessee classifies the lease
as a finance lease.

The assumption is that the lessee uses all the benefits from
the leased asset and therefore the lessee has essentially
purchased the asset.

21-44 LO 3
 Classification of Leases by the Lessor

Accounting Measurement and Presentation

For a sales-type lease,
 the lessor accounts for the lease in a manner similar to the
sale of an asset.
 the lessor generally records a Lease Receivable and
eliminates the leased asset.
 the lease receivable is computed as shown.

21-45 ILLUSTRATION 21.19 LO 3

 Finance (Sales-Type) Lease Example

Illustration: CNH Financial Services Corp. (a subsidiary of CNH) and Ivanhoe

Construction 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.
•The term of the lease is five years. The lease agreement is non-cancelable,
requiring equal rental payments 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
(which is less than the expected residual value of the backhoe at the end of the
lease). Further, assume the underlying asset (the backhoe) has an €85,000 cost to
the dealer, CNH.
•The lease contains no renewal options. The backhoe reverts to CNH at the
termination of the lease.
•Collectibility of payments by CNH is probable.

21-46 LO 3
 Finance (Sales-Type) Lease Example

Illustration: CNH Financial Services Corp. (a subsidiary of CNH) and Ivanhoe

Construction 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.
•CNH sets the annual rental payment to earn a rate of return of 4 percent per year
(implicit rate) on its investment as shown in Illustration 21.20.

ILLUSTRATION 21.20
Lease Payment Calculation

21-47 LO 3
 Finance (Sales-Type) Lease Example

The lease meets the criteria for classification as a finance

(sales-type) lease because
1.Lease term is equal to the economic life of the asset.

2.Present value of the lease payments is €100,000*, which is

100% (greater than or equal to 90%) of the fair value of the
backhoe.

That is, Ivanhoe will consume substantially the entire underlying

asset over the lease term.

21-48 LO 3
 Finance (Sales-Type) Lease Example

CNH computes the lease receivable as shown. ILLUSTRATION 21.22

Lease Receivable Calculation

The journal entries on January 1, 2019, are as follows.

Lease Receivable 100,000
Sales Revenue 100,000
Cost of Goods Sold 85,000
Inventory 85,000
21-49 LO 3
 Finance (Sales-Type) Lease Example

ILLUSTRATION 21.23
Lease Amortization Schedule

21-50 LO 3
 ILLUSTRATION 21.23

On January 1, 2019, CNH records receipt of the first year’s lease

payment as follows.
Ivanhoe records accrued interest on December 31, 2019
Cash 20,711.11
Lease Receivable 20,711.11
21-51 * rounding LO 3
 ILLUSTRATION 21.23

On December 31, 2019, CNH recognizes the interest revenue on the

lease receivable during the first year through the following entry.

Lease Receivable 3,171.56

Interest Revenue 3,171.56
21-52 * rounding LO 3
 Finance (Sales-Type) Lease Example

The balance sheet as it relates to lease transactions at December

31, 2019.

ILLUSTRATION 21.24
Balance Sheet
Presentation

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

ILLUSTRATION 21.25
Income Statement
presentation

21-53 LO 3
 ILLUSTRATION 21.23

The following entries record receipt of the second year’s lease

payment and recognition of the interest revenue in 2020.

Jan. 1 Cash 20,711.11

Lease Receivable 20,711.11
Ivanhoe records accrued interest on December 31, 2019
Dec. 31 Lease Receivable 2,469.97
Interest Revenue 2,469.97
21-54 * rounding LO 3
 ILLUSTRATION 21.23

CNH makes the following entry on December 31, 2023.

Ivanhoe records accrued interest on December

Lease Receivable 192.1931, 2019
Lease Revenue 192.19

21-55 * rounding LO 3
 ILLUSTRATION 21.23

At January 1, 2024, when the leased asset is returned to CNH.

Inventory 5,000
Lease Receivable 5,000

21-56 * rounding LO 3
 Lessor—Guaranteed Residual Value

In the Ivanhoe/CNH example, Ivanhoe guaranteed a residual value of

€5,000. In computing the amount to be recovered from the rental
payments, the present value of the residual value was subtracted from
the fair value of the backhoe to arrive at the amount to be recovered
by the lessor. Illustration 21.26 shows this computation.
ILLUSTRATION 21.26

Computation is same whether residual value is guaranteed or

unguaranteed.
21-57 LO 3
 Lessor—Unguaranteed Residual Value

In this case, there is less certainty that the unguaranteed residual

portion of the asset has been “sold.”
 The lessor recognizes sales revenue and cost of goods sold
only for the portion of the asset for which recovery is assured.
 Both sales revenue and cost of goods sold are reduced by the
present value of the unguaranteed residual value.
 The gross profit computed will still be the same amount as
when a guaranteed residual value exists.

21-58 LO 3
 Lessor—Unguaranteed Residual Value

To compare a sales-type lease with a guaranteed residual value

to one with an unguaranteed residual value, assume the same
facts as in the CNH/Ivanhoe lease situation. That is:

1.The sales price is €100,000.

2.The expected residual value is €5,000 (the present value of

which is €4,109.65).

3.The leased equipment has an €85,000 cost to the dealer, CNH.

21-59 LO 3
 Lessor—Unguaranteed Residual Value

Computation of Lease Amounts by CNH

Financial—Sales-Type Lease

ILLUSTRATION 21.27
Computation of Lease Amounts by CNH—Sales-Type Lease

21-60 LO 3
 ILLUSTRATION 21.28
21-61 Entries for Guaranteed and Unguaranteed Residual Values — Sales-Type Lease LO 3
 Lessor Accounting for Operating
Leases
The following data relates to a lease agreement between Hathaway Disposal
Ltd. and M&S for the use of one of Hathaway’s standard cardboard
compactors. Information relevant to the lease is as follows.
•The term of the lease is three years. The lease agreement is non-
cancelable, requiring three annual rental payments of £17,620.08, with the
first payment on January 1, 2019 (annuity-due basis).
•The compactor has a cost and fair value at commencement of the lease of
£60,000, an estimated economic life of five years, and a residual value at the
end of the lease of £12,000 (unguaranteed).
•The lease contains no renewal options. The compactor reverts to Hathaway
at the termination of the lease.
•The implicit rate of the lessor is known by M&S. Traylor’s incremental
borrowing rate is 6 percent. Hathaway sets the annual rental rate to earn a
rate of return of 6 percent per year (implicit rate) on its investment.
21-62 LO 3
 Lessor Accounting for Operating Leases

Hathaway classifies the lease as an operating lease because none of

the finance lease tests are met.

ILLUSTRATION 21.30
Lease Classification Tests
21-63 LO 3
 Lessor Accounting for Operating Leases

Under the operating method, Hathawary (the lessor)

 continues to recognize the asset on its statement of
financial position and recognizes lease revenue (generally
on a straight-line basis) in each period.
 continues to depreciate the leased asset.

21-64 LO 3
 Lessor Accounting for Operating Leases

To illustrate the operating method for the Hathaway/M&S lease,

Hathaway records the lease payment on a straight-line basis on
January 1, 2019, 2020, and 2021, as follows.

Cash 17,620.08
Unearned Lease Revenue 17,620.08

On December 31, 2019, 2020, and 2021, Hathaway records the

recognition of the revenue each period as follows.

Unearned Lease Revenue 17,620.08

Lease Revenue 17,620.08

21-65 LO 3
 Lessor Accounting for Operating Leases

Hathaway also records depreciation expense on the leased

equipment (assuming double-declining-balance, given a cost basis
of £60,000, and a five-year economic life), as follows.

Depreciation Expense (£60,000 × 40%) 24,000.00

Accumulated Depreciation—Equipment 24,000.00

Hathaway records other costs related to the lease arrangement,

such as insurance, maintenance, and taxes in the period incurred.

21-66 LO 3