IFRS 16 - Gripping18 Extract PDF

Gripping GAAP Leases: lessee accounting
Chapter 16
Leases: Lessee Accounting
Main References: IFRS 16
Contents Page
1. Introduction 763
2. IAS 17 ± almost history 763
3. The new IFRS 16 ± a brief overview 764
4. Scope exclusions 764
5. Identifying whether we have a lease 764
5.1 Overview 764
5.2 Is the asset identified? 765
5.2.1 Identification can be explicit or implicit 765
Example 1: Identified asset ± explicit or implicit 765
5.2.2 Portions of assets can be identified 765
Example 2: Identified asset ± capacity portions 765
5.2.3 $VVHWVDUHQRWµLGHQWLILHG¶LIVXpplier has substantive right of substitution 766
Example 3: Identified asset ± substantive right of substitution 766
5.3 'RZHKDYHWKHULJKWWRµFRQWUROWKHXVH¶RIWKHDVVHW" 767
5.3.1 Overview 767
5.3.2 The right to substantially all of the benefits 767
Example 4: Substantially all the economic benefits ± primary & by-products 768
Example 5: Substantially all the economic benefits ± portion payable to lessor 768
5.3.3 The right to direct the use 769
5.3.3.1 Overview 769
Example 6: Right to direct the use ± µKRZ IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG 769
([DPSOH5LJKWWRGLUHFWWKHXVHµKRZDQGIRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG 770
5.3.3.2 Decisions restricted to operations and maintenance 771
5.3.3.3 Protective rights 771
Example 8: Right to control the use with protective rights and maintenance 771
5.4 Flowchart: analysing the lease definition 772
6. Separating the lease components in a contract 773
Example 9: Allocating consideration to the lease and non-lease components 774
7. Combining contracts 774
8. Recognition exemptions (optional simplified approach) 775
8.1 Overview 775
8.2 Low-value asset leases and the simplified approach 775
Example 10: Exemptions and low-value assets 776
8.3 Short-term leases and the simplified approach 777
Example 11: Exemptions and short-term leases 777
9. Recognition and measurement ± necessary terminology 778
9.1 Overview 778
9.2 Lease term 778
Example 12: Lease term ± basic application 779
Example 13: Lease term ± option to extend: theory 780
9.3 Lease payments 782
9.3.1 Overview 782
9.3.2 Fixed payments 782
9.3.3 Variable lease payment 783
9.3.4 Exercise price of purchase options 784
9.3.5 Termination penalties 784
9.3.6 Residual value guarantees 784
9.3.7 Summary of the calculation of lease payment 784
9.4 Discount rate 784
10. Recognition and measurement ± the simplified approach 785
Example 14: Leases under the recognition exemption (simplified approach) 785
11. Recognition and measurement ± the general approach 786
11.1 Overview 786
Chapter 16 761
11.2 Initial recognition and measurement 786

Example 15: Initial measurement of lease liability and right-of-use asset 788
11.3 Subsequent measurement ± a summary overview 789
11.4 Subsequent measurement of the lease liability 789
11.4.1 Overview 789
11.4.2 The effective interest rate method 790
Example 16: Lease liability ± subsequent measurement 790
Example 17: Lease liability ± initial and subsequent measurement (advance lease 791
payments)
11.4.3 Remeasurements 793
11.5 Subsequent measurement of the right-of-use asset 794
11.5.1 Overview 794
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model 794
Example 18: Right-of-use asset ± subsequent measurement: depreciation 795
Example 19: Right-of-use asset ± subsequent measurement: impairments 796
11.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation 796
model
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model 796
11.6 Subsequent measurement - remeasurements due to changing lease payments 797
Example 20: Remeasurement - change in lease term 798
11.7 Subsequent measurement - lease modifications 800
Example 21: Lease modification ± scope decreases resulting in partial termination 801
12. Tax consequences 802
12.1 Overview 802
12.2 Tax treatment of leases 802
12.3 Accounting for the tax consequences where the lease is accounted for using the 803
simplified approach
12.3.1 ,IWKHWD[DXWKRULW\EHOLHYHVWKHOHDVHPHHWVWKHGHILQLWLRQRIDµUHQWDO 803
DJUHHPHQW¶RUµSDUWERIWKH,&$GHILQLWLRQ¶LHWKHOHVVHHLVUHQWLQJWKHDVVHW
Example 22: Lease under simplified approach ± tax consequences 803
12.3.2 ,IWKHWD[DXWKRULW\EHOLHYHVWKHOHDVHPHHWVµSDUWDRIWKH,&$GHILQLWLRQ¶LH 805
the lessee owns the asset)
12.4 Accounting for the tax consequences where the lease is accounted for using the 805
general approach
12.4.1 ,IWKHWD[DXWKRULW\EHOLHYHVWKHOHDVHPHHWVWKHGHILQLWLRQRIµUHQWDODJUHHPHQW¶ 806
RUµSDUWERIWKH,&$GHILQLWLRQ¶LHWKHOHVVHHLVUHQWLQJWKHDVVHW
Example 23: Lease under general approach ± tax consequences 806
12.4.2 ,IWKHWD[DXWKRULW\EHOLHYHVWKHOHDVHPHHWVWKHGHILQLWLRQRIµSDUWDRIWKH,&$ 808
GHILQLWLRQ¶LHWKHOHVVHHRZQVWKHDVVHW
12.5 Accounting for the tax consequences involving transaction taxes (VAT): lease meets 809
µSDUWERIWKH,&$¶GHILQLWLRQ
Example 24: Lease under general approach - with VAT (basic) 810
Example 25: Lease under general approach - with VAT 811
12.6 Accounting for the tax consequences involving transaction taxes (VAT): lease meets 812
WKHGHILQLWLRQRIDµUHQWDODJUHHPHQW¶
13. Presentation and disclosure requirements 813
13.1 Presentation 813
13.1.1 Presentation in the statement of financial position 813
13.1.2 Presentation in the statement of comprehensive income 814
13.1.3 Presentation in the statement of cash flows 815
13.2 Disclosure 815
14. Summary 818
762 Chapter 16
1. Introduction
A lease transaction involves one party (the lessor) that grants the right to use an asset to
another party (the lessee). In other words, a lease is characterised by the right of use of an
asset that is granted by a lessor (the owner of the asset) to a lessee (the user of the asset). This
chapter explains how to account for leases from the perspective and the next chapter

explains how to account for the lease from the perspective. In the rest of this chapter,

reference to the µHQWLW\¶PD\EHDVVXPHGWRUHIHUWRWKHlessee.
The long-awaited new standard on leases, IFRS 16 Leases, was issued during 2016, replacing
the previous standard on leases, IAS 17 Leases, and its three related interpretations (IFRIC 4,
SIC15 and SIC 27). Although IFRS 16 is only effective for periods
beginning on or after 1 January 2019, early application is possible.

Even if an entity does not choose early application, the implications

of the new IFRS 16 are potentially so significant that it is advisable ! " #
to prepare early for its implementation.

" $ ! % & ' ! " ( ) & * +
Before we proceed with how to apply IFRS 16, a little history is needed so as to understand,
in broad brush-strokes, the effects of the change from IAS 17 to IFRS 16.
2. IAS 17 ± almost history
Under IAS 17 Leases, an entity entering into a lease as a lessee must

. /
, -
0
1
decide whether the lease should be accounted for as a finance lease !
5
2 2 3 " % 4 !
or as an operating lease. This decision is based on the substance of

! " 6
2 4 ! % 2 ! " ! 7
the lease agreement (i.e. rather than its legal form). Based on its
x
! " # 8 9 " : ;
substance, the entity, as lessee, would account for the lease as: x
% " ! " 2 4 ! 8 "
x a finance lease if it concluded that the agreement effectively 5
! 4 ! " 2 6 : +
involved purchasing the asset (e.g. the entity did not expect to
return the asset to the lessor); or
x an operating lease if it concluded that the substance of the agreement effectively involved
a true borrowing of the asset (i.e. in essence, the entity would, at the end of the lease,
expect to return the asset, in working order, to the lessor).
When accounting for a finance lease (i.e. a lease, the substance of which suggested the asset
was actually purchased rather than borrowed), the lessee would immediately recognise the
item being leased as an asset and recognise the future lease instalments as a liability. On the
other hand, when accounting for an operating lease (i.e. the lease, the substance of which
suggested the asset was truly borrowed), the lessee would simply recognise the lease
instalments as an expense, as and when they were incurred. This means that, in the case of an
operating lease, the entity would not recognise the asset and nor would it recognise as a
liability its obligation to pay future lease instalments. The fact that the obligation to pay future
lease instalments would not appear as a liability in the OHVVHH¶Vfinancial statements is referred
to as µoff-balance sheet financing¶ and was the core reason behind the need to replace IAS 17.
The fact that IAS 17 offers these two different lease classifications (finance and operating
leases), has enabled entities to structure each of their lease contracts so that they would be
accounted for as either an operating lease or finance lease, depending on the specific outcome
that the entity desired. This ability to 'manipulate the situation has been causing users concern
for many years on the basis that the financial statements are not transparent. In fact, in
March 2016, the IASB estimated that leases around the world amount to US$3.3 trillion, with
µRYHURIWKHVHOHDVHVODEHOOHGDVµRSHUDWLQJOHDVHV¶DQGDUHQRWUHFRUGHGRQWKHEDODQFH
sheet.¶1 It has also been estimated that some retailers have off-balance sheet debt that is
66 times the debt currently reflected on-balance sheet. 2
Chapter 16 763
An even more extreme situation is that of Circuit City, a fascinating example that was
included in one of the ,$6%¶VIFRS 16 project updates, issued back in August 2014. Circuit
City, a US FRPSDQ\WKDWKDVVLQFHJRQHLQWRZKDWLVUHIHUUHGWRDVµ&KDSWHUOLTXLGDWLRQ¶
had, on average, operating lease commitments of $4 537 million (admittedly calculated as an
undiscounted amount) over the 5 years prLRUWRHQWHULQJµFKDSWHU¶ With these operating
lease commitments not recognised as liabilities, this company¶V EDODQFH VKHHW LQFOXGHG
reported debt of only $50 million! The operating lease commitments as a percentage of
reported debt was 9 074% (i.e. tKLVFRPSDQ\¶V true debt was more than 90 times higher than
the debt presented in its balance sheet). In other words, this company was financing itself
ZLWKµRII-EDODQFHVKHHWILQDQFLQJ¶7KHREYLRXVSUREOHPZLWKWKLVis that users were largely
unaware of these operating lease commitments because they were simply mentioned in a
footnote to the financial statements instead of being recognised as liabilities, which thus put
its investors, suppliers and creditors all at risk.
1. Shining the light on leases; by Hans Hoogervorst, IASB Chairman; IFAC Global Knowledge Gateway; 22 March 2016
2. On balance, companies would rather not show debt; by James Quinn; The Telegraph; 13 January 2016
3. The new IFRS 16 ± a brief overview
The new IFRS 16 requires that, with the exception of the scope exclusions (see section 4) and
also the optional simplifications involving short-term leases and low-value asset leases (see
section 5), the lessee must recognise the lease by recognising:
x DµULJKW-of-XVH¶asset; and
< = > ? @ > A B C D E F G H
x a lease liability. See IFRS 16.5 & .22

! 2 2 3 " % 4 !
" ! 4 ! " 2 6
8 I 4 ! ! % " ! " 2 4 !
This means that the underlying leased asset and the obligation to " 6 J 4 K L M N & O : +
pay future lease instalments will appear in the OHVVHH¶Vstatement of

financial position (i.e. the lease is recognised µRQEDODQFHVKHHW¶
4. Scope exclusions (IFRS 16.3-4)
IFRS 16 should not be applied in certain situations. These include leases involving:
a) the exploration for or use of non-regenerative resources (e.g. oil and gas);
b) biological assets within the scope of IAS 41;
c) service concession arrangements within the scope of IFRIC 12;
d) licences of intellectual property granted by a lessor falling within the scope of IFRS 15; and
e) rights under a licensing agreement falling within the scope of IAS 38 Intangible assets,
for example, films, videos, plays, patents and copyrights. See IFRS 16.3
A lessee involved in the lease of any other intangible asset other than a right under a licensing
agreement (referred to in (e) above) may choose whether or not to apply IFRS 16.
5. Identifying whether we have a lease (IFRS 16.9-17 and .B9-B33)
5.1 Overview P Q R S T R U V W X Y U Z X W [ V \
Before we apply IFRS 16, we must be sure we have a x ! 2 " ! 2 ] ! % ! 2 " ! 2 ]
lease and before we can say we have a lease, it must x 6 ! 2 " ^ _
obviously meet the definition of a lease.

6 # 6 3

! " !
The definition of a lease requires, first and foremost, that x % ! % I
we have a contract. We must analyse all contracts, at x " 9 2 6 ! " # % 2 " ! " + ` a b c d e f g g f
inception, for the possible existence of a lease, (which may be well hidden). What we are looking
for is evidence that the contract has given an entity (the customer) the right to use an asset for a
certain period of time in exchange for consideration of some kind ± which then makes that entity
a lessee. See IFRS 16 App A
764 Chapter 16
Let us return our attention to the fairly basic lease

h i j k l m n o p q r s t u r v w n x n q t n
s n y z r z v z u r t q { z r | }
definition. IFRS 16 elaborates on various aspects of this

lease definition, explaining that although the definition x ~
refers simply to:
x µDQ DVVHW¶, this asset must EH µidentified¶ DQG it x ~
also simply refers to

x the entity having the µULJKW WR XVH¶ this asset, this

µULJKWWRXVH¶WKHDVVHWPXVWWUDQVODWHLQWRWKHµULJKWWRcontrol WKHXVH¶RIWKDWDVVHW See IFRS 16.9
5.2 Is the asset identified?

w n ¡ ¢ £ ¤ ¢ ¥ ¡ ¦ § ¡ ¨ ¢ ¦ © ¦ ¡ § }
5.2.1 Identification can be explicit or implicit x ª « ¬ ¬
x ª ¬ ®
It does not matter if the asset is identified explicitly or ¬
implicitly. In other words, the contract might name a ¯
specific asset (explicit identification) or a specific asset

¬
x
could simply be implied through it being made available
° ¬ ¬

to the entity (implicit identification).See IFRS 16.B13

Example 1: Identified asset ± explicit or implicit
Entity A, a manufacturer of luxury sports cars, enters into a contract with Entity B, in terms
of which, Entity B will manufacture and supply specialised engine components to Entity A
over a period of 5 years.
The engine components have a unique design and thus Entity B needed to design, construct and install
a specialised manufacturing plant on (QWLW\ $¶V premises. There is no mention in the contract of the
specific plant that should be used by Entity B in manufacturing of the engine components.
(QWLW\ %¶V QHZO\ FRQVWUXFWHG SODQW will be used exclusively in the manufacture of these specialised
components, and, due to the specialised nature thereof, this plant will not be able to be used for any
other purpose after the end of the contract and will need to be dismantled.
Required: Explain whether there is an identified asset.
Solution 1: Identified asset ± explicit or implicit

The fact that the plant is not specified in the contract means it has not been explicitly identified.
However, this does not automatically mean that there is no identified asset. The asset can be identified
implicitly. In this case, the newly constructed plant is identified implicitly due to the fact that Entity B
had to construct the plant in order to fulfil its contractual obligations. Furthermore, the fact that the
plant was designed with the sole purpose of manufacturing the required engine components means that
there are no alternative plants that Entity B could have used. Furthermore, the cost of acquiring or
constructing another plant to be used instead would be uneconomic. Thus, we conclude that (QWLW\%¶V
specialised plant is the identified asset (in other words, if the other aspects of the lease definition are
PHW(QWLW\$ZRXOGKDYHWRDFFRXQWIRU(QWLW\%¶VSODQWDVDOHDVHG asset).
5.2.2 Portions of assets can be identified

An identified asset could be just a portion of an asset if the portion is physically distinct. An
identified asset cannot, however, simply be DSRUWLRQRIWKHDVVHW¶Vcapacity, unless the portion of
WKHDVVHW¶VFDSDFLW\LVphysically distinct or if the portion of the capacity is substantially all of the
DVVHW¶VFDSDFLW\See IFRS 16.B20
Example 2: Identified asset ± capacity portions
Entity A enters into a contract with Entity B in terms of which Entity B will supply a certain
quantity of oil each day to Entity A. The contract stipulates that the supply of oil will be
delivered to Entity A using (QWLW\%¶VRLOSLSHOLQH,QWHUPVRI WKHFRQWUDFWWKH TXDQWLW\RIRLOWREH
delivered on a daily basis constitutes 20% of the capacity of the oil pipeline.
Required: Explain whether there is an identified asset.
Chapter 16 765
Solution 2: Identified asset ± capacity portions

The contract explicitly identifies the pipeline that will be used to deliver the oil to Entity A. However,
the delivery volumes required by Entity A are such thaW RQO\ RI WKH SLSHOLQH¶V FDSDFLW\ ZLOO EH
used. Thus, the asset to be used is actually a capacity portion rather than a physically distinct asset.
Since we are dealing with a capacity portion, we must analyse whether the capacity portion is
physically distinct or, if not, whether it represents . ± ² ³ ± ´ µ ¶ ´ · µ ¸ ¸ ¹ µ ¸ ¸ º » ´ ¼ ½ µ ± ± ½ ´ ¾ ± ¿ µ À µ ¿ · ´ ¹
Although the actual pipeline is physically distinct, the 20% capacity requirement does not represent a
physically distinct portion of the pipeline. Thus, since the portion of the asset is not physically distinct,
we consider whether the capacity reflects substantially all of the capacity of the pipeline. In this case,
we are told that the portion that will be used represents only 20% of the total capacity and thus we
conclude that the capacity portion does not reflect substantially all of the capacity of the pipeline.
Conclusion:
There is no identified asset because we are dealing with a capacity portion that is neither physically
distinct nor representative of substantially all of the capacity of the asset.
5.2.3 Á Â Â Ã Ä Â Å Æ Ã Ç È Ä É Ê Ë Ã Ç Ä Ê Ì Ê Ã Ë Í Ê Ì Â Î Ï Ï Ð Ê Ã Æ Ñ Å Â Â Î Ò Â Ä Å Ç Ä Ê Ó Ã Æ Ê Ô Ñ Ä È Ì Â Î Ò Â Ä Ê Ä Î Ä Ê È Ç
An asset that is specified (explicitly or implicitly) would not be identified if the supplier thereof
has the µsubstantive right to substitute¶ assets throughout the period of use. See IFRS 16.B14
$VXSSOLHU¶VULJKWWRVXEVWLWXWHDVVHWVLVFRQVLGHUHGsubstantive if:
x the supplier not only has the practical ability to substitute the asset (e.g. if the asset is not
particularly specialised in nature and thus the
w n t Õ p p x z n Ö × t Ø ¦ Ù Ú ¢ ¢ Û
supplier has a variety of suitable assets on hand ¤ ¥ ¢ ¦ ¢ ¤ ¢ ¡ ¦ ¤ ¥ ¢ ¨ ¢ ¦ Ü ¡ z y
that it could provide or use as an alternative asset), v w n t Õ p p x z n Ö }
but
x the supplier would also benefit economically if it x Ý Þ ß à á â à ß ã ß ä â ã â á å æ
substituted the asset. See IFRS 16.B14 x ç ä è é è ê â á è à ë é ë ì â à ß ã ã å

The fact that a contract may allow, or may even require, í
â î î ï ä î á ß é á â ð è ®
a supplier to substitute one asset for another in the event é ë á â ñ è é á â ê â è ñ é ë ã è ß î è
that it needs repairs, maintenance or an upgrade, should í
not be interpreted as the supplier having the right to
substitute an asset for purposes of assessing whether the ® ç
lease definition is met. See IFRS 16.B18 é ë á
ò ó ô ò
If it is difficult to determine if a supplLHU¶V ULJKW WR

substitute is substantive or QRWZHPXVWDVVXPHWKDWWKHµVXEVWLWXWLRQULJKWLVnot VXEVWDQWLYH¶ See
IFRS 16.B19
Example 3: Identified asset ± substantive right of substitution

Adaptation of IFRS 16.IE2
Entity A is a small retailer of trendy sunglasses and Entity B owns a shopping centre.
Entity A enters into a 3-year contract with Entity B to use 16 square metres in the shopping centre for a
stand that Entity A will use to display its sunglasses.
The contract specifies that Entity A has the right to use 16 square metres on the second floor of the
shopping centre but the terms of the contract also allow Entity B to move the stand to a variety of other
suitable areas within the shopping centre.
Since it is just a space that is being rented and the stand is not permanently fixed in place, there are
minimal costs involved in the event that the stand must be moved.
Required:
Explain whether there is an identified asset.
766 Chapter 16
Solution 3: Identified asset ± substantive right of substitution

Although the contract explicitly identifies the asset in the contract, the asset having been identified as a
particular space (16 m2), and even stipulating exactly where this space is situated in the shopping centre
(on the second floor), this space can be changed by the Entity B (the supplier) at any time. The right to
FKDQJHWKHVSDFHLVZKDWLVUHIHUUHGWRDVWKHVXSSOLHU¶Vright to substitute the asset.
Since Entity B (supplier) has the right to substitute the asset, wHQHHGWRDVVHVVZKHWKHUWKHVXSSOLHU¶V
right to substitute the asset is substantive (i.e. whether the supplier has the practical ability to substitute
the asset and whether the supplier would benefit economically from substituting the asset).
In this case, there are a variety of suitable places in the shopping centre that could be used to house
(QWLW\$¶VNLRVNDQGWKXV(QWLW\%KDVWKHpractical ability to substitute the space currently allocated on
the second floor for another space elsewhere.
Since the kiosk is not permanently fixed in place and there are minimal costs in moving it, substituting
WKHVSDFHIRUDQRWKHUVSDFHHQDEOHV(QWLW\%WRPDNHµPRVWHIIHFWLYHXVHRIWKHVSDFH¶LQWKHVKRSSLQJ
centre and thus maximise its profitability. Thus, Entity B would benefit economically from substituting
the space if and when circumstances warranted it.
Conclusion: There is no identified asset because Entity B has the right to substitute the asset (the space)
and this right to substitute is substantive because Entity B has the practical ability to substitute and
would benefit economically from the substitution.
5.3 'RZHKDYHWKHULJKWWRµFRQWUROWKHXVH¶RIWKHDVVHW"
õ
n w q ö n v w n Ø ¦ Ù Ú ¢ ¢ Û ÷ Û ¨ ¢ Ø Û ø
5.3.1 Overview ¢ Ú ¡ ¤ ¡ u y q r q t t n v z y ù n w q ö n
v w n Ö z | w v v u }
7KHUH DUH WZR DVSHFWV WKDW QHHG WR EH PHW µWKURXJKRXW x
WKH SHULRG RI XVH¶ EHIRUH DQ HQWLW\ FXVWRPHU PD\
î ï ä î á ß é á â ß ã ã å ß ã ã á ú è ä è é è ê â á î
FRQFOXGHWKDWLWKDVJDLQHGWKHµULJKWWRFRQWUROWKHXVH¶ x
ß é ñ
RIWKHµLGHQWLILHGDVVHW¶)LUVWO\WKH entity must have the

ñ â Þ è à á á ú è ï î è ò
right to µobtain substantially all of the economic benefits¶ IURP WKH XVH RI WKDW DVVHW and,
secondly, the entity must have the right to µdirect the use¶RIWKDWDVVHWSee IFRS 16.B9
5.3.2 The right to substantially all of the benefits (IFRS 16.B21-23)
When assessing whether the entity (customer) has the right to obtain substantially all the
economic benefits, it does not matter whether it can obtain these benefits directly or indirectly.
This means that the entity could obtain the benefits from using the leased asset (direct usage) or,
for example, sub-leasing the asset (indirect usage). The phrase µDOO RI WKH HFRQRPLF benefits¶
refers to the benefits from both the primary output and also any secondary output (i.e. it includes
the inflows expected from, for example, the sale of by-products). See IFRS 16.B21
When assessing whether the entity (customer) has the ~ î ï ä î á ß é á â ß ã ã å ß ã ã á ú è
µright to obtain substantially all of the benefits¶ from the ä è é è ê â á î
use of the asset, we limit our assessment to the scope of x

í

the FXVWRPHU¶VULJKWVDVGHILQHGLQWKHFRQWUDFW x ª
¬ « ¬
Obviously, if an entity (customer) has the exclusive and
x
unconditional use of an asset throughout the period of
~ û ¬

use, then it would normally stand to reason that the ò ü ý ü þ
entity would have the right to all the economic benefits

from the use of the asset during that period. However, the entity does not always have exclusive
use of an asset. For example, if a contract provides a customer with the right to use a truck for a
few years, but only between 6am and 10am each morning for purposes of delivering eggs, we
ZRXOGDVVHVVZKHWKHUZHKDYHWKHµULJKWWRREWDLQVXEVWDQWLDOO\DOOWKHEHQHILWV¶E\FRQVLGHULQJLW
in relation to the total economic benefits possible from using the truck during these specified
times and for the purposes of transporting eggs (not the total economic benefits that would, for
example, have been possible if we were to use the truck 24 hours a day and to transport bars of
gold). See IFRS 16.B21-22
Chapter 16 767
Example 4: Substantially all the economic benefits ± primary & by-products

Adaptation of IFRS 16.IE9(a)
Entity A (customer) enters into a contract with Entity B (supplier).

Entity B owns a wind farm that it uses to generate electricity (green energy).
Entity B, as the owner of the farm, receives the tax benefits relating to the cost of constructing the farm
(i.e. the tax authorities allow Entity B to deduct the cost of the farm against its taxable profits).
,QWHUPVRIWKHFRQWUDFW(QWLW\$EX\V(QWLW\%¶VHQWLUHVXSSO\RIJUHHQHQHUJ\DQGVLQFH Entity A is
using green energy, it also receives renewable energy credits.
Required: Identify the primary and by-products in this scenario and conclude whether Entity A obtains
substantially all the economic benefits from the wind farm and, assuming all other criteria are met,
whether it should thus conclude that it holds the wind farm as a right-of-use asset.
Solution 4: Substantially all the economic benefits ± primary & by-products

There are three benefits referred to in the scenario:
x the electricity (the primary product),
x the renewable energy credits (a by-product) and
x the tax benefits (a by-product).
Entity A has the rights to all the electricity and the renewable energy credits (the primary product and
one of the by-products), but it does not have the rights to the tax benefits (the other by-product).
However, the electricity and the renewable energy credits actually represents 100% of the economic
benefits from the right of use of the asset because the other by-product to which it does not have the
right, the tax benefits, is not related to the use of the asset but rather to the ownership of the asset.
Conclusion: Entity A has the right to obtain substantially all the benefits from the wind farm and thus,
assuming all other criteria are met, it should conclude that it holds the wind farm as a right-of-use asset.
The fact that the contract may require the entity (customer) to pay the supplier some of the
benefits earned from using the asset does not mean that the customer has not obtained
substantially all the economic benefits from using the asset. Instead, when assessing whether we
KDYHWKHµULJKWWRUHFHLYHVXEVWDQWLDOO\DOOWKHEHQHILWV¶ZHconsider the gross benefits received by
the entity (not the benefits net of any portion thereof that must be paid over to the lessor or any
third party). If any portion of the benefits are to be paid to the supplier or some other third party,
this portion is simply accounted for as part of the consideration paid for the lease. See IFRS 16.B23
This is an important point since it prevents entities from structuring their lease contracts in such a
way that they can avoid meeting the definition of a lease and thus avoid having to account for
them on balance sheet. In other words, entities could otherwise have structured their contracts
such that all lease payments are simply based on a percentage of revenue (e.g. 30% of revenue)
and conclude that, since they only retain a portion of the revenue (e.g. the balance of 70% of
revenue), they do not have the right to substantially all the economic benefits.
Example 5: Substantially all the economic benefits ± portion payable to lessor

A contract states that the lease payments are C1 000 per month and that Entity A (the
customer) may retain only 90% of the revenue from the use of the asset, after paying 10%
thereof to the lessor.
Required: Explain whether the customer has the right to obtain substantially all the economic benefits.
Solution 5: Substantially all the economic benefits ± portion payable to lessor

The fact that Entity A (the customer) only has the right to retain 90% of the benefits does not mean that
it does not have the right to receive all the economic benefits. Instead, we conclude that the customer
has the right to receive 100% of the revenue and that the lease consideration includes the fixed lease
payments of C1 000 and the variable lease payments equal to 10% of the revenue.
768 Chapter 16
, + , , + +
% & D % % 0 / B #
C

5.3.3 The right to direct the use

#
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5.3.3.1 Overview 9 F > 9

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If a supplier has the right to direct the use of an asset, & $ 0 % & 3 < . 0 % @ 3 %
+
% 0 1 / 5 % 3 6
+ ,
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then there is no lease. However, there are three

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situations in which we would conclude that an entity

+ ( + + , + ,
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(customer) has the µright to direct the use of the asset¶.

* +
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x The first situation is if the entity (customer) µKDVWKH

, +
A & . - 0 . # ' % I K L L M N O K P Q R S P T U S P V
right to direct how and for what purpose WKHDVVHWLVXVHG¶. For example, the entity using a
factory may be able to decide what products will be manufactured in the factory, when
certain products will be manufactured and who the entity will supply.
x The second situation is, LIWKHµKRZDQGIRU ZKDW SXUSRVHWKH DVVHW LV XVHG¶ is somehow
already pre-determined i.e. neither the entity (customer) nor the supplier can make these
decisions, the entity (customer) FRXOGVWLOOEHVDLGWRKDYHµWKHULJKWWRGLUHFWWKHXVHRIWKH
DVVHW¶LIit KDVWKHµULJKWWRoperate WKHDVVHW¶RUhas the right to be able to instruct others
on how the asset should be operated).
x The third situation is, if the µKRZ DQG IRU ZKDW SXUSRVH WKH DVVHW LV XVHG¶ is somehow
already pre-determined i.e. neither the entity (customer) nor the supplier can make these
decisions, the entity (customer) FRXOGVWLOOEHVDLGWRKDYHµWKHULJKWWRGLUHFWWKHXVHRIWKH
DVVHW¶LIit actually µdesigned WKHDVVHW¶DQGZKHUHWKLVGHVLJQµpredetermines how and for
ZKDWSXUSRVHWKHDVVHWZLOOEHXVHG¶ See IFRS 16.B24 & B26
These situations can be illustrated in the following flowchart:
!
" # $ % & ' %
( ) * + , + , + , + + 7 + + + ,
% ' - . . $ / % 0 1 & 2 % ' % ' % 3 % 4 / ' / # 5 ' 6 % 4 - ' # 1 % 0 4 & 5 5 # % ' & / 3 # 3 / 0 % 4 % - ' % 8

9 : !

, 7
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;

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% 0 % 1 & < % & $ % & ' %
;

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+ , + + + ,
# % 0 4 0 / % 0 / & 1 % 6 % 0 % / ' & $ % & ' % 8
Example 6: Right to direct the use:

x µKRZDQGIRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG
(QWLW\$HQWHUVLQWRDFRQWUDFWZLWK(QWLW\%ZKHUH(QWLW\%ZLOOWUDQVSRUW(QWLW\$¶VFDUJR
from South Africa to Australia. The volume of cargo to be transported is such that it requires the
exclusive use of the ship. The contract specifies the cargo to be transported, the dates the cargo will be
transported, the detailed route that the ship will take and that Entity B will both operate the ship and be
responsible for all maintenance and safety aspects. The ship is specified in the contract.
Required:
a) Explain whether Entity A has the right to direct the use of the ship.
b) Assuming all other criteria are met, explain whether the contract contains a lease.
Solution 6: Right to direct the use ± µKRZ IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

a) Entity A (customer) does not have the right to direct the use of the asset because it does not have
the right to direct how and for what purpose the ship will be used: the details regarding the dates
and rRXWHWKDWZLOOEHWDNHQWKHµKRZ¶DQGWKHGHWDLOVRIWKHFDUJRWREHWUDQVSRUWHGWKHµSXUSRVH¶
are specified in the contract. Since the decisions regarding how and for what purpose the ship are
pre-determined in the contract, we must analyse whether Entity A either operates the ship or
designed the ship. In this case, Entity A neither operates the ship nor designed the ship.
Chapter 16 769
Conclusion: Since the decisions regarding how and for what purpose the ship will be used are
predetermined in the contract, and since Entity A neither operates the ship nor designed the ship, we
conclude that Entity A does not have the right to direct the use of the ship.
b) Since Entity A does not have the right to direct the use of the ship, it automatically means that it
does not have the right to control the use of the asset. Since Entity A does not have the right to
control the use of the asset, the contract does not involve a lease.
For your interest:
In part (b), we are told to simply assume that all other criteria were met. However, an explanation
regarding these other criteria follows:
x Is there an identified asset? In this case, the ship is explicitly specified in the contract and there
appears to be no evidence that the supplier has a substantive right to substitute the ship with another
ship. We thus conclude that there is an identified asset.
x Does Entity A (customer) have the right to substantially all the economic benefits from the use of
the ship during the period of the use? In this case, there is so much cargo being transported that it
will occupy the entire ship and thus no other parties can obtain any benefit from the use of the ship
during this period of use, with the result that we conclude that Entity A has the right to substantially
all of these benefits.
x Before we conclude that there is a lease, there must be an identified asset and Entity A must control
the use of the ship. Although there is an identified asset and although Entity A has the right to
substantially all the economic benefits during the period of use, Entity A does not have the right to
direct the use of the ship and thus Entity A does not have the right to control the use of the ship.
Hypothetically, if we had concluded that Entity A had the right to direct the use of the ship, since it
also had the right to substantially all the economic benefits, we would have concluded that it had the
right to control the use of an identified asset and would thus have concluded that the ship was leased.
However, even if we had been able to conclude that the contract included the lease of a ship, we would
not necessarily have accounted for the lease on balance sheet since the use of the ship appears to be for
one trip only and would thus have involved the right to use the ship for a period of less than a year, in
which case Entity A would have had the option to expense the lease instead (see section 8).
Example 7: Right to direct the use: µKRZDQGIRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

Entity A (customer) enters into a contract with Entity B whereby Entity A will acquire the
nuclear power generated by Entity B. Entity B owns and is the exclusive operator of the
nuclear power plant. However, this plant was specially designed by Entity A.
Required: Explain whether Entity A has the right to direct the use of the asset and, assuming all other
criteria are met, whether the nuclear plant is leased by Entity A.
Solution 7: Right to direct the use ± µKRZ IRUZKDWSXUSRVH¶LVSUHGHWHUPLQHG

Entity B operates the plant and thus Entity A, on the face of it, appears not to have anything to do with
directing the use of the plant. However, the reality is that neither the customer nor the supplier can
DFWXDOO\GHFLGHWRFKDQJHWKHµKRZDQGIRUZKDWSXUSRVH¶LHKRZWKHDVVHWLVXVHGRUIRUZKDWSXUSRVH
the asset is used). This is because the specialised nature of the plant predetermines this:
x WKHµKRZ¶LVYHU\WHFKQLFDODQGWKXVWKHUHLVRQO\RQHZD\WRRSHUDWHWKLVSODQWDQG
x WKHµIRUZKDWSXUSRVH¶LVFOHDUO\WKHSURGXFWLRQRISRZHU
7KHGHFLVLRQVUHJDUGLQJWKHµKRZand for what purpose¶ DUHWKXVµ W X Y Z Y [ Y X \ ] ^ Y Z _ .
When decisions are predetermined, we must then consider whether the customer operates the asset or
designed it and whether it was this design that predetermined these decisions.
In this case, Entity A (the customer) does not operate the plant but it had designed the plant for the
supplier and it is this design that predetermines how and for what purpose the asset is used. This fact is
thus used as evidence that the entity (customer) has, in effect, the right to direct the use of the asset.
Conclusion: (QWLW\$KDVWKHULJKWWRµGLUHFWWKHXVH¶RIWKHQXFOHDUSRZHUSODQWDQGWKXVDVVXPLQJDOO
other criteria are met, it should conclude that it holds the nuclear power plant under a lease.
770 Chapter 16
5.3.3.2 Decisions restricted to operations and maintenance
Contracts can grant either the customer or supplier the decision-making rights regarding the
operation and/or maintenance of an asset. However, although decisions regarding the operation
and maintenance of an asset have a direct impact on whether or not the use of the asset will be
efficient, they have no bearing on who has the right to direct how and for what purpose the asset
is used. In fact, the converse is true: the decisions regarding how and for what purpose the asset
is used will have a bearing on the decisions needing to be made regarding the operation and
maintenance of the asset. The only time that we should consider who has the right to operate
the asset is if the decisions regarding how and for what purpose the asset is used are
predetermined. See IFRS 16.B27
5.3.3.3 Protective rights
When assessing whether an entity (customer) has the right to direct the use of the asset, we may
come across certain restrictions. These restrictions are termed protective rights and are ignored
LIWKH\DUHPHUHO\GHVLJQHGIRUH[DPSOHµWRSURWHFWWKHVXSSOLHU¶VLQWHUHVWLQWKHDVVHWRURWKHU
DVVHWVWRSURWHFWLWVSHUVRQQHORUWRHQVXUHWKHVXSSOLHU¶VFRPSOLDQFHZLWKODZVRUUHJXODWLRQV¶
Protective rights come in many forms, such as limiting the usage of the asset for safety reasons
or requirements WKDW WKH FXVWRPHU IROORZV FHUWDLQ µRSHUDWLQJ SUDFWLFHV¶ LQ RUGHU WR HQVXUH
longevity of the asset etc. Protective rights are terms and conditions that generally simply
µdefine the scope of the FXVWRPHU¶VULJKWRIXVHEXWGRQRWLQLVRODWLRQSUHYHQWWKHFXVWRPHU
IURPKDYLQJWKHULJKWWRGLUHFWWKHXVHRIWKHDVVHW¶See IFRS 16.B30
Example 8: Right to control the use with protective rights and maintenance
Entity A enters into a contract with Entity B for the right to the exclusive use of a passenger
train to be used along a specified train route. Entity A will be able to make all the decisions
regarding when to operate the train, who it will use to operate it and how many passengers will be
transported. However, the contract specifies that Entity A may not carry more than 1 000 passengers at
a time and may not operate the train for more than a 1 200 km per day. It also specifies that Entity B
will be exclusively responsible for repairs and maintenance of the train (including the scheduling of
when maintenance takes place). If any of the train carriages requires maintenance or a repair, Entity B
will substitute the train carriage with an alternative.
Required: Indicate whether Entity A has the right to control the use of the train and thus, assuming all
other criteria are met, whether it should conclude that the train is leased.
Solution 8: Right to control the use with protective rights and maintenance
In order to decide whether Entity A (customer) has the right to control the use of the train, we must
establish whether the entity has the:
x right to substantially all the economic benefits; and
x the right to direct the use of the asset.
Entity A has exclusive use of the train along a specified route. As such, within the scope of this
contract, Entity A has the right to substantially all the economic benefits from the use of the train.
The fact that Entity A can operate the train is not relevant when assessing whether it has the right to
direct the use of the train because merely being able to operate an asset does not mean that one is able
WRPDNHWKHGHFLVLRQVUHJDUGLQJµhow and for what purpose¶WKHDVVHWZLOOEHXVHG(we only consider
whether the entity can operate the asset if the decisions regarding how and for what purpose the asset is
used are predetermined). What is relevant is that Entity A can decide when and whether to operate the
train, how far to travel (within limits) and how many people to transport (within limits), thus suggesting
that Entity A is able to direct how and for what purpose the train will be used, which means it has the
right to direct the use of the train.
The fact that Entity B is responsible for scheduling and carrying out maintenance and repairs does not
mean that Entity A does not have the right to direct the use of the train ± in fact, the converse is true:
the decisions made by Entity A regarding how and for what purpose the train will be used (e.g. to travel
1 200 km per day carrying the maximum passenger load) will affect how often the train will require
maintenance and repairs.
Chapter 16 771
Similarly, the fact that Entity B (supplier) puts restrictions on how many passengers it may carry in one
trip and how many kilometres may be travelled in one day are simply protective rights (i.e. they are
SURWHFWLQJ (QWLW\¶V % LQYHVWPHQW LQ LWV WUDLQ. These protective rights simply define the scope of
Entity $¶VULJKWWRXVH WKH WUDLQDQGGRQRWGHWUDFWIURP(QWLW\ A¶VULJKWWRGHFLGHKRZDQGIRU what
purpose the train is used. Thus, we ignore the protective rights and conclude that Entity A has the right
to direct the use of the train.
Since Entity A has the right to substantially all the economic benefits and has the right to direct the use
of the train, we conclude that it has the right to control the use of the asset. If all other criteria are met,
Entity would conclude that the train is being leased by Entity A.
For your interest: One of the other criteria that would need to be met before concluding that the
contract involves a lease is that the asset must be identified. In this case, the train is explicitly identified
in the contract and is thus an identified asset. The fact that the supplier may substitute the train or parts
thereof with another train in the event that the identified train requires repairs or maintenance is not
considered to be a substantive right to substitute the train.
5.4 Flowchart: analysing the lease definition

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772 Chapter 16
6. Separating the lease components in a contract (IFRS 16.12-16 and .B32-B33)
It can happen that one contract deals only with a lease and that this lease involves only one
underlying asset. However, a contract could, for example, deal with many aspects including
the lease of more than one asset and may even contain aspects that are not lease-related.
If a contract is a lease, or contains a lease, each lease component found in that contract must
be accounted for separately.
Furthermore, if the contract includes not only lease components but also non-lease
components, any non-lease component must be accounted for separately from the lease
component/s. However, a lessee may opt to apply what is referred to as the practical
expedient, wherein the lessee does not bother to separate the non-lease component from the
lease component. This is explained under step 2 below.
Our first step, however, is to identify each lease component:
If a contract involves the lease of a number of assets, we would identify the lease of each
asset as a separate lease component if both of the following two criteria are met:
x the entity (lessee) is able to obtain the benefit from ´ µ ¶ · ¸ ¹ ¸ º ¶ » ¼ ½ ¾ ¼ ¿ À Á Â À Ã ¼ Ã Ä Å µ
using that asset separately from other assets (or, if

¸ ¹ Å Æ Ç º º È É µ ¶ ¸ Ê É Ê Ë ¶ ¹ Ì Í Å Ê Æ
¸ µ µ ¶ º Î Ç ¶ ¹ ¶ Ï
other resources are needed to be able to use that

asset, then only if these resources µare readily x
}
DYDLODEOHWRWKHOHVVHH¶; and
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«
} ¡ ¨ Õ
x the asset is not highly interrelated with or x Ñ Ð Ó Ö Ò × Ö Ø Ù Ú

ª Û ª
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dependent on the other assets in the contract (e.g. if

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the entity could choose not to lease the asset and if

this choice would not significantly affect its right to use the other assets in the contract,
then it suggests that these underlying assets are not highly interrelated or dependent on
each other). See IFRS 16.B32
Please note that, when analysing a contract, we assess whether it µcontains a lease for each
SRWHQWLDOOHDVHFRPSRQHQW¶See IFRS 16.B12 and B32
Our second step is to allocate the consideration in the contract to each component:
If a contract is found to contain multiple components, where at least one of them is a lease
component (e.g. the contract contains two lease components or it contains a lease component
and a non-lease component), then we must allocate the consideration to each of these
components. This allocation is done on the basis of:
x the relative stand-alone price of each lease component; and
x the aggregate stand-alone price of the non-lease components. See IFRS 16.13
The stand-alone prices are based on the price that the

ç » » À ¿ ½ Ä è Ã é ¿ À Ã ¾ è ê ¼ ë ½ Ä è À Ã º È
lessor would charge the entity (lessee) if it supplied

µ ¶ · ¸ ¹ ¸ º ¶ Ì ¶ ¸ µ ¶ ì È í · È Ê ¶ Ê º µ ¸ Ê Ë
Ê È Ê î Ì ¶ ¸ µ ¶ ì È í · È Ê ¶ Ê º µ Ï
that component on a separate basis. If an observable

x
} }
price is not readily available, then the entity would } } ¡
simply estimate it. See IFRS 16.14 x

} } } }
} }
The portion of the consideration that is allocated to x

ï

}

}

}

}

}

each lease component will be accounted for in terms of } } ð ~
IFRS 16 and the portion that is allocated each of the } } }
non-lease components will be accounted for in terms ~ } } ¡
of the relevant standard. See IFRS 16.16

ß ñ ò
If a lease contains more than one lease component, there is no choice but to account for each lease
component separately, but a practical expedient exists in the case of non-lease components.
Chapter 16 773
If a lease contains a non-lease component, whilst it is recommended that the lease component
and non-lease component be separately accounted for, this is not compulsory. Instead, a
practical expedient exists which allows the lessee not to bother separating the non-lease
components. In this case, a lease component and the related non-lease component would be
accounted for as one single lease component. The option to apply the practical expedient is an
accounting policy that the entity (lessee) may choose on a class of asset basis (i.e. it may wish
to apply the practical expedient to its leased vehicles but may choose not to apply it to its
leased machinery). See IFRS 16.15
Example 9: Allocating consideration to the lease and non-lease components
Entity A (lessee) enters into a one-year contract over a plant. The lessor undertakes to insure
the plant and to maintain it by having it serviced every month. The contract stipulates that
the payments are C12 000 for the year, of which C2 000 relates to the annual insurance and C3 600
relates to the provision of the monthly services.
Similar insurance provided by third parties would normally cost C2 000 per year and the cost for the
monthly services would normally be C5 000 per year. The price to rent a similar plant for a year
(without the additional services and insurance) is C10 000.
Required: Identify the components of the lease and calculate the amount of consideration that should
be allocated to the lease component/s.
Solution 9: Allocating consideration to the lease and non-lease components

This contract provides Entity A with the right to use one asset (a plant) and monthly maintenance
services. Although the contract states that part of the consideration also includes the provision of
insurance, the insurance is not a good or service from which Entity A benefits (the lessor benefits from
the insurance) and thus the provision of insurance is not a separate component of the contract and is
disregarded when allocating the consideration to the components of the lease.
The right to use the plant represents a lease component. The provision of the maintenance services does
not represent the right to use an asset and is thus a non-lease component.
The total consideration is allocated based on the stand-alone price per lease component and the
aggregate stand-alone prices of the non-lease components (in this case there is only one non-lease
component) as follows:
Stand-alone prices
Allocation of annual contractual consideration:
C
Stand-alone prices for the non-lease component/s Given maintenance only
ó 5 000
Stand-alone price for the lease component Given plantó 10 000
Total stand-alone prices 15 000
Annual contractual consideration allocated as follows: 12 000
x Non-lease component C12 000 x 5 000 / 15 000 4 000
x Lease component C12 000 x 10 000 / 15 000 8 000
The consideration allocated to the non-lease component (C4 000) is expensed as maintenance. The
consideration allocated to the lease component (C8 000) is accounted for in terms of IFRS 16 (i.e.
using the simplified approach (see section 8 and 9.3) or using the general approach (see section 9.4)).
For your interest: if the stand-alone price of the plant was not observable, we would estimate it. One
way of estimating it would be as a balancing amount: Total consideration C12 000 ± Stand-alone price
of non-lease component C5 000 = Estimated stand-alone price of lease component: C7 000
7. Combining contracts (IFRS 16.B2)
If an entity (lessee) enters into more than one contract with the same third party, these contracts
must be accounted for as a single contract if any one of the following criteria are met:
x The assets in each contract would, together, meet the description of a single lease
component.
x The amount of consideration payable in terms of one contract would be dependent on the
price or performance of another contract.
x The contracts can only be understood if one considers them together (i.e. as a package)
and they are negotiated as a package.
774 Chapter 16
8. Recognition exemptions (optional simplified approach) (IFRS 16.5-.8 & IFRS 16.B3-.B8)
8.1 Overview (IFRS 16.5-8) ! " #
IFRS 16 offers an optional simplified approach to lessees involved x

} } $
in short-term leases and leases of low-value assets, which it refers to x

} ¥
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ÿ } % $
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&
(i.e. it does not recognise the right-of-use asset and liability), but x
} }
} ¥
simply expenses the lease instalments instead (i.e. the lease would

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currently accounted for in terms of IAS 17).

Entities choosing this simplified approach, would recognise the lease instalments either as an
expense on the straight-line basis over the period of the lease or may expense it using another
systematic basiVLILWLVµPRUHUHSUHVHQWDWLYHRIWKHSDWWHUQRIWKHOHVVHH¶VEHQHILW¶See IFRS 16.6
8.2 Low-value asset leases and the simplified approach (IFRS 16.8 & .B3-B8 & .BC100)
In the case of a lease of a low-value asset, the entity may choose to ' ( ) * + , - + " "
DSSO\WKHµVLPSOLILHGDSSURDFK¶LHH[SHQVHGLQVWHDGRIµRQEDODQFH
, + " " .
VKHHW¶RQDlease-by-lease basis. See IFRS 16.8

" , + / + 0 1
x
} } } }
û
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The assessment of whether or not an asset is considered to have a } ¦
low value is based on its value when it was new. It is not based in §
DQ\ZD\RQWKHOHDVHGDVVHW¶Vcurrent age or value. See IFRS 16.B6 x 2
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An asset can only be considered to have a low value if it also meets the following criteria:
x The lessee can benefit from either:
using it on its own, or
using it together with other readily available resources; and
x It is not highly dependent on or highly interrelated with other assets. IFRS 16.B5 (reworded)
Chapter 16 775
In addition to the abovementioned two criteria, if a lessee intends to sub-lease an asset (i.e. an
entity that is a lessee but becomes ± or intends to be ± a lessor over the same leased asset), the
entity, as lessee, may never account for the head lease as a low-value asset (i.e. the head lease
will have to be recognised on balance sheet even if it involves an asset that would otherwise
be said to have a low value). See IFRS 16.B7
Example 10: Exemptions and low-value assets
Consider the following non-related leases:
Lease A. An entity entered into a lease (as a lessee) over a new personal computer with a value of
$4 000. The retailer regards amounts greater than $2 000 to be material.
Lease B. An entity entered into a lease (as a lessee) over a second-hand computer with a current value
of $2 000 and a new value of $20 000.
Lease C. An entity entered into a lease (as a lessee) over a new tablet with a value of $2 000. The
entity intends to lease this asset to an employee.
Lease D. An entity entered into 5 separate leases (as a lessee). The first lease is over a new factory
machine with a value of $2 000. The machine is a baseline machine that comes without an
engine and certain key components, all of which must be acquired from other suppliers. The
second lease involved the lease of the new engine, with a value of $5 000. The remaining
three leases involved the three key components needed for the machine to function. Each of
the components had a value, when new, of $3 000.
Required: For each of the leases referred to above, briefly explain whether the leased asset (the
underlying asset) is a low-value asset and thus whether the lease could be accounted for in terms of the
simplified approach (i.e. whether or not the low-value asset recognition exemption is available).
Solution 10: Exemptions and low-value assets

Lease A. This lease falls beneath the threshold of $5 000 mentioned in the basis of conclusions.
+RZHYHU WKLV DPRXQW LV QRW D µKXUGOH UDWH¶ EXW VLPSO\ D URXJK JXLGHOLQH JLYHQ ZKHQ WKH
IASB discussed the proposed exemption (2015). Thus, we simply note that it is below the
threshold suggesting that it may be a low-value asset.
We are told that the retailer regards amounts above $2 000 to be material and would thus
consider the FRPSXWHU¶Vvalue ($4 000) to be material. However, if something is material, it
does not PHDQWKDW LWLVµKLJK-YDOXH¶ ± it could still be considered to be a low-value asset.
This is because the assessment of whether the leased asset has a low value must be based on
the absolute amount, meaning that it is not assessed based on its value relative WRWKHHQWLW\¶V
VL]HHWF7KXVWKHLQIRUPDWLRQUHJDUGLQJWKHHQWLW\¶VPDWHULDOLW\OHYHOVLVirrelevant.
Since IFRS 16 lists µSHUVRQDO FRPSXWHUV¶ as a possible example of a low-value asset, and
since there is no evidence provided to the contrary, it seems that this is simply an average,
relatively low value personal computer and thus the recognition exemption would be
available when accounting for this lease. The entity can thus choose to expense this lease.
Lease B. Both the current value and the value when new are provided. However, we ignore the current
value and focus on the value when new, despite the asset being second-hand. The value
when new is $20 ZKLFK LV DERYH WKH WKUHVKROG PHQWLRQHG LQ WKH µEDVLV RI
FRQFOXVLRQV¶$OWKRXJKWKLVWKUHVKROGLVQRWDGHILQLWLYHµKXUGOHUDWH¶LWVXJJHVWVWKDWLWPD\
not be a low-value asset.
We then look at the nature of the asset as well. The underlying asset is a computer, but
although IFRS 16 lists µSHUVRQDOFRPSXWHUV¶DVRQHRIWKHH[DPSOHVRIDORZ-value asset, it
can happen that a personal computer is a high-end and unusually expensive computer. If the
value of this computer ($20 000) is higher in value than the average cost of new personal
computers, then this asset would not qualify for the exemption.
Lease C. The lease would not qualify for the exemption, even if the underlying asset is a low-value
asset, because the entity intends to sub-lease the asset. IFRS 16 specifically prohibits the use
of the recognition exemption if the underlying asset will/ may be sub-leased.
Lease D. The 5 individual leases cannot be considered separately. Although each appears to have a
relatively low value, the lessee cannot benefit from the use of any one of the leased assets
separately ± they are all highly interrelated. Together, these leased assets appear to have a
high value and thus the exemption would not be available.
776 Chapter 16
8.3 Short-term leases and the simplified approach (IFRS 16.8 & Appendix A)
In the case of a short-term lease, the choice of applying the G
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be to account for all short-WHUP OHDVHV RI GHOLYHU\ YHKLFOHV µon

balance sheet or to account for all short-term leases of delivery vehicles in terms of the 6 7
exemption (i.e. using the simplified approach). Thus, an entity may choose to recognise as an
expense all short-term leases relating to delivery vehicles but, at the same time, it may choose
to recognise on balance sheet all short-term leases relating to office equipment. See IFRS 16.8
A short-term lease is one that has a lease term of 12 months or less, calculated from
commencement date, and where the lease does not include a purchase option. See IFRS 16 Appendix A
x the commencement date is simply the date from which the lessor allows the underlying
asset to be used by the lessee; and
x the lease term is:
the non-cancellable period of the lease
plus any optional extension period if the lessee is reasonably certain to exercise the option
plus any periods during which the lessee has the option to terminate the lease, but only if
the lessee is reasonably certain not to exercise the option. See IFRS 16 App A
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Example 11: Exemptions and short-term leases

Consider the following non-related leases involving delivery vehicles:
Lease A. Entity A enters into a lease where the contractual terms result in a lease term of 6 months,
with no option to purchase.
Lease B. Entity A enters into a lease where the contractual terms result in a non-cancellable lease term
of 12 months, plus an option to extend the contract for a further 6-month period. Given that
the rentals in the extended 6-month period would be significantly below market value,
management concludes that it is reasonably certain that the entity will exercise its option to
extend the contract to the full 18-months.
Lease C. Entity A enters into a lease where the contract terms result in a non-cancellable lease term of
12 months, plus a further 6 months during which Entity A may, at any stage, choose to
cancel the contract. Management considers the cancellation penalty to be insignificant and
thus concluded that it was not reasonably certain that it would not exercise its option to
terminate (i.e. it was possible that the entity could exercise its option to terminate).
Required: For each of the leases above, briefly explain whether the lease would meet the definition of
a short-term lease and whether it would thus qualify for the option to apply the recognition exemption.
Chapter 16 777
Solution 11: Exemptions and short-term leases

General comment: Even if a lease over an asset meets the definition of a short-term lease, it would not
be accounted for in terms of the recognition exemption (i.e. in terms of the simplified approach) unless
the lessee has elected as its accounting policy to always apply the recognition exemption to that
specific class of assets in the event that the lease is a short-term lease.
Lease A. This lease meets the definition of a short-term lease, since it is shorter than 12 months and
includes no purchase option. Thus, the lease costs will be expensed, assuming Entity A has
adopted the accounting policy of accounting for short-term leases over delivery vehicles
under the recognition exemption.
Lease B. This lease does not meet the definition of a short-term lease. Although the definition of a
lease term refers to the non-cancellable period, which in this case is 12 months and would
otherwise qualify the lease as a short-term lease, the GHILQLWLRQRIµOHDVHWHUP¶LQFOXGHV not
only the non-cancellable period but also any optional extension periods that are reasonably
certain of being exercised. In this case, there is an option to extend for a further 6 months
and management believes, given the economics of the lease, that it is reasonably certain the
option will be exercised. Thus, the lease term is 18 months (non-cancellable period: 12m +
reasonably certain extension period: 6m). Thus, the lease is not a short-term lease (it is not
12 months or less) and does not qualify for the recognition exemption. The lease must be
recognised on balance sheet instead.
Lease C. This lease meets the definition of a short-term lease. When calculating the lease term, we
include both the non-cancellable period and any further cancellable periods (i.e. periods
during which the lessee could terminate the contract) but only if it is reasonably certain that
the lessee would not exercise its cancellation option. Since Entity A is not reasonably certain
that it would not cancel the contract, this cancellable period is excluded from the lease term.
The lease term is thus 12 months and meets the definition of a short-term lease. The lease
costs will thus be expensed, assuming Entity A has adopted the accounting policy of
accounting for short-term leases of delivery vehicles under the recognition exemption.
9. Recognition and measurement ± necessary terminology (IFRS 16.9-17 and .B9-B33)
9.1 Overview J K L M N O P Q P M O M R S K T U K U V
There are two options regarding the recognition of leases. x W X Y X Z [ \ [ ] ] Z ^ [ _ ` a b c d e f g f c h i j k i i l
Either the lease qualifies for the optional recognition x m n o ] \ n p n X q [ ] ] Z ^ [ _ ` a b r r d e f g f c h i
exemption and the entity chooses this option (the j k i i l
simplified approach to accounting for a lease), or the lease

s
b c g t u r j k b v l d l i v w g i f j i b v f g b x d
is recognised on balance sheet (the general approach). f g z i f j j i l { |
Before we explain how to recognise and measure leases under each of these approaches, there
are a few core terms that are important, some of which are explained below.
9.2 Lease term (IFRS 16.18-21 & .B34-B41)
A lease term starts on the commencement date. The commencement date is the date that the
lessor makes the leased asset available for use by the lessee. See IFRS 16.B36
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The length of the lease term itself is the non-cancellable

period during which the entity has the right to use the x l k i Y ^ Y _ [ Y _ X \ \ [ \ X ] X Z n ^ q r b v
asset. x k u h k f g i j j i i k f j l k i v u k l l b z j i
f c z c i v g t u c f j j i l
However, the lease term may, under certain circumstances, x l b i l k i v x u l k i v u b j h b

y
i v i e t a
also include an optional renewal period or possibly even f c b l u b c l b X X Y q l k i g i f j i u r
cancellable periods (periods during which the lessee may

l k i g i j j i i u j v i f j b c f e g t h i v l f u c
l b i i v h u j i l k f l b l u b c
terminate the contract). This is explained below. f c b l u b c l b X Z o n Y [ X l k i g i f j i
u r l k i g i j j i i u j v i f j b c f e g t h i v l f u c
If the entity (lessee) has the option to extend the lease (an c b l l b i i v h u

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optional renewal period), and it is reasonably certain that it

will choose to extend the lease, then the lease term will also include these further extension
periods (non-cancellable period + renewal periods). See IFRS 16.18
778 Chapter 16
If the entity (lessee) has the option to terminate the lease (an optional cancellable period), but
is reasonably certain that it will not terminate the lease, then this further µcancellable period¶
would be included in the lease term (i.e. put another way, if there is a further period during
which the entity has the option to terminate the lease and it is likely that the entity will
terminate the lease during this period, then this period ± from the date that the termination
becomes possible ± is not included in the lease term). See IFRS 16.18
Please note that, if a lease contains a period during which there is an option to terminate
(cancel) the lease, the lessee only considers including this cancellable period if it is only the
lessee that has the option to terminate. In other words, if, for example, the lessor also has the
RSWLRQWRWHUPLQDWHWKHOHDVHGXULQJWKLVµFDQFHOODEOHSHULRG¶ZHmust not consider including
this period in the lease term, even if the lessee also has this option and is reasonably certain
that it will not exercise it. See IFRS 16.B35
Please also note that the estimation of the lease term would not be altered in the event that
certain periods during the lease term are rent-free (i.e. the fact that certain of the periods may
be rent-free is irrelevant when estimating the lease term). See IFRS 16.B36
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Example 12: Lease term ± basic application

Entity A (lessee) enters into a lease over a plant.
Consider the following scenarios:
Scenario 1. The lease is non-cancellable for a period of 3 years from commencement date after which
Entity A then has the option to extend the lease for a further 2 years. Entity A is reasonably
certain that it will exercise the renewal option.
Scenario 2. The lease is non-cancellable for a period of 3 years from commencement date after which
Entity A then has the option to extend the lease for a further 2 years. Entity A is reasonably
certain that it will not exercise the renewal option.
Scenario 3. The lease is for a 10-year period during which the first 7 years is non-cancellable. At the
end of the 7-year period, Entity A has the option to terminate the lease. Entity A is
reasonably certain that it will exercise the termination option.
end of the 7-year period, Entity A has the option to terminate the lease. Entity A is
reasonably certain that it will not exercise the termination option.
end of the 7-year period, both Entity A and the lessor have the option to terminate the
lease. Entity A is reasonably certain that it will not exercise the termination option.
Required: Calculate lease term for each of the scenarios above.
Solution 12: Lease term ± basic application

Scenario 1: Lease term = 5 years
Calculation: Lease term = non-cancellable period: 3 yrs + Optional extension period: 2 yrs = 5 years
Explanation: The optional extension period is included because Entity A (lessee) is reasonably certain
that it will exercise the option to extend the lease.
Calculation: Lease term = non-cancellable period: 3 yrs + Optional extension period: N/A = 3 years
Explanation: The optional extension period is excluded because Entity A (lessee) is not reasonably
certain that it will exercise the option to extend the lease.
Chapter 16 779

Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: N/A = 7 years
Explanation: The optional cancellable period is excluded since it is only included if there is reasonable
certainty that the option to cancel (terminate) the lease would not be exercised. However,
in this case, Entity A (lessee) is reasonably certain that it will exercise its option to cancel.
Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: 3 yrs = 10 years
Explanation: The optional cancellable period is included because we include it if we are reasonably
certain that we would not exercise our option to cancel (terminate) the lease. In this case,
Entity A (lessee) is reasonably certain that it will not wish to cancel the lease.
Calculation: Lease term = non-cancellable period: 7 yrs + Optional cancellable period: 0 yrs = 7 years
Explanation: The optional cancellable period is excluded. Although we normally include the
cancellable periods if we are reasonably certain that the option to cancel (terminate) will
not be exercised, and in this case, Entity A (lessee) is reasonably certain that it will not
wish to cancel the lease, the cancellable period is excluded because the lessor also has the
option to cancel the lease during this period.
When deciding whether it is reasonably certain that the entity (lessee) would exercise an
option to extend or terminate a lease, we must consider all relevant facts and circumstances
that might provide the necessary economic incentives. For example:
x significant penalties: if an option to terminate involves the payment of a significant
penalty, this may be a sufficient economic incentive to choose not to terminate;
x the importance of the underlying asset to the entity: if an underlying asset is critical to the
HQWLW\¶VRSHUDWLRQVDQGZLOOEHQHHGHGEH\RQGWKHQRQ-cancellable period, then this factor
may be sufficient evidence that the lessee would choose to exercise an option to extend or
would choose not to exercise an option to terminate (depending on the available options);
x significant leasehold improvements or initial installation costs: if the lessee has incurred
significant costs to install or improve an underlying leased asset, this may be sufficient
evidence that the lessee would choose to exercise an option to extend or would choose not
to exercise an option to terminate (depending on the available options)
x below market-rentals: if an option to extend a lease would result in lower than market-
related lease payments during an optional extension period, this may provide a sufficiently
large economic incentive to choose to extend the lease. See IFRS 16.19
It is important to be aware that the analysis of all facts and circumstances, in order to decide
whether an entity is reasonably certain that it would or would not exercise a renewal option or
a cancellation option, requires significant professional judgement and yet estimating the lease
term is a critical part in accounting for a lease. The correct determination of the lease term is
important because:
x it will be used to decide whether the lease is a short-term lease and thus whether it
qualifies to be recognised as an expense (in terms of the simplified approach offered by
WKHµUHFRJQLWLRQH[HPSWLRQ¶); and
x it will be used to determine which payments to include in the measurement of the lease
liability (which will then also affect the measurement of the related right-of-use asset).
Example 13: Lease term ± option to extend: theory
Entity A (lessee) enters into a lease over a plant. The lease is non-cancellable for 3 years
from commencement date, after which Entity A may extend the lease for a further 2 years.
x The lease rentals charged in the first year are market-related and will escalate at a rate of 10% pa,
with the result that the rentals in the last 2 years are expected to exceed market-related rentals.
x The plant must be installed by the lessee at the beginning of the lease and this installation cost is
considered to be significant.
x Entity A uses the plant to manufacture products that it expects will be in demand for at least 10 years.
x The cost of negotiating the lease over another plant from another supplier at the end of the initial
3 year period is expected to be insignificant.
Required: Calculate lease term and provide a brief explanation justifying your calculation.
780 Chapter 16
Solution 13: Lease term ± option to extend: theory

Answer: The lease term is 5 years calculated as:
Non-cancellable period 3 years + Extension period that is reasonably certain: 2 years = 5 years
Explanation: When estimating the lease term, we must assess all relevant facts and circumstances that
may provide the lessee with the economic incentive to exercise an option to extend or exercise an
option to terminate the contract.
In this case, the lessee has the option to extend the contract.
x The lessee expects to need the use of this plant (or a replacement plant) for a period well beyond
the expiry of the possible 5-year term of the lease, thus providing an incentive to extend the lease.
x 7KH OHDVH UHQWDOV GXULQJ WKH µRSWLRQDO -\HDU H[WHQVLRQ SHULRG¶ DUH H[SHFWHG WR EH KLJKHU WKDQ
market-related rentals and thus do not provide the lessee with an economic incentive to extend the
lease. However, we must consider all other facts and circumstances as well (see below).
x Since the entity needs to use the plant, or a replacement plant, for more than 3 years, it will mean
that if the entity does not renew the lease, it will need to source another plant. Although the cost of
negotiating the lease of another plant is expected to be insignificant, which does not constitute an
incentive to extend the lease, the cost to install the replacement plant will be a significant cost. The
significant extra installation costs provides a significant economic incentive to extend the lease.
Thus, on balance, it is submitted that the entity would be reasonably certain to renew the contract and
thus that the optional extension period should be included in the calculation of the lease term.
Please note:
Your solution could have argued that the lease term was 3 years and thus that the entity would be
reasonably certain not to extend the lease since the lease rentals would exceed market-related lease
rentals. In practice, one would have to consider whether the excessive lease rentals were outweighed by
the significant cost of installing a replacement part or vice versa.
Since the calculation of the lease term involves estimating whether it is reasonably certain that
the entity (lessee) will exercise its option to renew or that it will not exercise its option to
terminate the lease, the entity (lessee) is required to reassess these estimations if and when:
x there is a significant event or change in circumstances;
x that is within its control; and
x may affect whether the entity may be reasonably certain to exercise or not to exercise an
option that was or was not previously included in the lease term. See IFRS 16.20
Just as we did when originally estimating the lease term (i.e. at the commencement of the
contract), we must consider all relevant facts and circumstances that may create an economic
incentive for the entity (lessee) to change its original decision regarding whether it is
reasonably certain that it would exercise or not exercise an option.
For example, at commencement date, we may have concluded that it appeared reasonably
certain that we would exercise an option to extend the lease but, during the course of the
lease, something happens that creates an economic incentive for us not to extend the lease. In
other words, under the new circumstances, it now appears reasonably certain that we will not
exercise our option to extend and thus that the revised estimate of the lease term is shorter
than the original estimate thereof.
Thus, we must revise our estimated lease term whenever we have an option to extend or
terminate and there is a change in facts and circumstances during the course of the lease that
gives us an economic incentive that makes us reasonably certain that we will exercise the
option (to extend or terminate) when we originally thought we would not and vice versa.
Since the lease term has a bearing on the payments that are considered to be lease payments
for purposes of measuring the lease liability (and related underlying right-of-use asset), a
change in the lease term will require adjustments to the measurement of the lease liability and
the right-of-use asset. Please see example XX for an example that shows the adjustment
necessary due to a change in lease term. See IFRS 16.39
Chapter 16 781
9.3 Lease payments (IFRS 16.26-28 and Appendix A)
9.3.1 Overview
Lease payments is a defined term (see definition below). The definition of lease payments
differs slightly from the perspective of a lessee or lessor. In the case of a lessee, the definition
of the term lease payments refers to five possible categories of payments, which may or may
not be included in the lease payments. Depending on the particular circumstances:
x Fixed lease payments
x Certain variable lease payments
x Exercise price of purchase options
x Termination penalties
x Amounts due in terms of residual value guarantees.
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i g i h l j l b h b w e u c i c b c d g i f j i h b w b c i c l j x u l k f g i f j i h b w b c i c l f c l b f h h b z c l r b v l k i w f j f j u c g i g i f j i
¡ ¢ £ ¤ ¥ ¦ ¢ § ¨ © ª « ¨ ¬ © ¬
h b w b c i c l |
k i v i u j f j g u k l g t u r r i v i c l f v u f l u b c b c l k u j i r u c u l u b c x k i c e i u c f g u i e t f g i j j b v j i i h k É Ê { |
Apart from each of these five categories, which may or may not be included in the lease
payments (and which will be discussed in more detail below ± see sections 9.3.2 to 9.3.6), it is
also important to note that a contract could involve payments for the right to use a variety of
different underlying assets, each of which may meet the definition of a separate lease
component and may even involve payments for non-lease components.
If a contract involves payments for the right to use a variety of different assets, we would need
to determine which of these rights meet the definition of a separate lease component. If we
then find that we have more than one lease component in the contract, we must remember that
each of these lease components must be accounted for as a separate lease. Since each of these
must be accounted for as a separate lease, we will need to calculate the lease payments
relevant to each of these lease components.
Furthermore, the contract may also include payments relating to non-lease components (e.g.
the contract may require payments in return for the provision of services ± since the provision
of a service is not the provision of a right to use an asset, this aspect of the contract would not
meet the definition of a lease and would thus be referred to as a non-lease component).
Payments that are made in respect of non-lease components should not be included in the
calculation of lease payments, unless the lessee has opted to apply the practical expedient
whereby it need not bother separating the payments for the lease component from the
payments for any non-lease components. Ë Ì Í
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x
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9.3.2 Fixed payments f t w i c l j w f i e t f g i j j i i l b
f g i j j b v
x
Fixed payments is a defined term (see definition alongside),
r b v l k i v u k l l b z j i
where the definition essentially includes all payments that are

f c z c i v g t u c f j j i l
x z v u c l k i g i f j i l i v w
made in return for the right to use an asset, with the exception x X

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of all variable lease payments (see section 9.3.3 below).
782 Chapter 16
Although fixed payments are included in the calculation of Ï

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lease payments, IFRS 16 requires that, when calculating the
lease payments, we deduct from the fixed payments any x w l j w f i e t f g i j j b v l b
amounts that may have been received by (or be receivable f g i j j i i f j j b h u f l i x u l k
from) the lessor to incentivise the lessee to enter the lease. f g i f j i b v
These receipts are called lease incentives, which is yet another x l k i v i u w e z v j i w i c l b v
defined term (see definition alongside). f
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Fixed payments also include payments that are referred to as in-substance fixed payments,
which are simply payments that appear to contain variability but are, in substance,
unavoidable (e.g. where there is, in theory, a variety of payments that the lessee could make,
EXWZKHUHµRQO\RQHRIWKHVHVHWVRISD\PHQWVLVUHDOLVWLF

9.3.3 Variable lease payments

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Another category is variable lease payments, which is also a
defined term (see definition alongside). Before we look at the x l k i b v l u b c b r f t w i c l j w f i
definition of a variable lease payment, it is important to take e t f g i j j i i l b f g i j j b v
note that not all variable lease payments will be included in x r b v l k i v u k l l b z j i f c
the calculation of lease payments. This will be explained z c i v g t u c f j j i l z v u c l k i
further in a moment. g i f j i l i v w
x l k f l
y
f v u i j e i h f z j i b r h k f c i j
In terms of the definition, variable lease payments also refers

u c r f h l j b v h u v h z w j l f c h i j f r l i v
l k i h b w w i c h i w i c l f l i
to payments that are made in return for the use of the asset, but x b l k i v l k f c l k i f j j f i b r
there are two important differences from a fixed payment: l u w i |

variable payments are payments that are expected to vary but

they must also vary due to various facts or circumstances that will change after
commencement of the lease. For example:
x A lease payment that is based on a percentage of the revenue generated by a leased asset
would be a variable lease payment. This is because, since the revenue generated by the
asset will only arise after commencement date, we cannot, at commencement date, know
the amount of the payment that will be due.
x Similarly, lease payments that will be based on an index or rate (e.g. lease rentals that will
be adjusted for the changes in the consumer price index or changes in the bank lending
rates) are variable payments, since the future changes in the index or rate would not be
known at commencement date.
x Conversely, however, lease payments that will, for example, increase at a certain rate per
year, are not variable lease payments. This is because, although the lease payments will
vary from one year to the next (e.g. the lease payment may be set to increase by 10% per
year), this variance is not due to a change in the facts or circumstances that arise after
commencement date. This rate is known at commencement date. Since these payments do
not meet the definition of variable lease payments, they would meet the definition of fixed
lease payments.
Let us now return our attention to whether variable lease payments will be included in the
calculation of lease payments. In this regard, the definition of lease payments includes only
those variable payments that vary in line with an index or a rate (e.g. lease rentals that will
increase over time in tandem with the consumer price index). Thus, variable payments that
depend on, for example, the level of revenue generated from the leased asset, would not be
considered to be a lease payment.
It is interesting to note that, since the measurement of the lease liability is based on the present
value of the lease payments and since the lease payments include variable lease payments that
vary based on an index or rate, it will mean that the lease liability will require constant
remeasurement (i.e. each and every time that the index or rate changes).
Chapter 16 783
In other words, when calculating the initial measurement of the lease liability at the present
value of the lease payments, if these lease payments include variable lease payments, the
amount of the variable lease payments that must be included in the lease payments must be the
amount based on the relevant index or rate prevailing at the commencement of the lease (e.g.
the variable lease payment may start at C1 000 per year, to be increased each year at the rate
of change in the CPI ± in this case, we include C1 000 in the initial calculation of lease
payments). When the relevant index or rate changes, we re-calculate the variable lease
payment, thus altering the lease payments (e.g. if the CPI changed by 10%, then the new
amount of the variable lease payment is C1 100 and this latter amount is now included in the
lease payment calculation). Since the change in the variable lease payment will change the
lease payments, the lease liability measurement will also change. This is explained in detail in
section 11.6.
9.3.4 Exercise price of purchase options
If the lessee also has an option to purchase the leased asset, then the total lease payments must
include the exercise price of this purchase option, but only if the lessee is reasonably certain it
will exercise this option.
9.3.5 Termination penalties
If the lessee has an option to terminate the lease, then any termination penalties must be
included in the total lease payments, but only if the lessee is reasonably certain it will exercise
this option. In other words, we would only include the termination penalty if it was reasonably
certain that it would exercise the option to terminate the lease and thus that the expectation
that the lease would be terminated had also been factored into the calculation of the lease term.
9.3.6 Residual value guarantees }

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(see definition alongside). If the lessee guarantees to the x e t f f v l t z c v i g f l i l b l k i g i j j b v
x
s
lessor that the underlying asset will have a certain minimum

l k f l l k i f g z i b v f v l l k i v i b r {
x b r f c z c i v g t u c f j j i l f l l k i i c
value at the end of the lease, then any amount that is b r f g i f j i
expected to be payable as a result of this residual value x x u g g e i

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guarantee would be included as a lease payment. f w b z c l |
9.3.7 Summary of the calculation of lease payments
Thus, lease payments are calculated as follows:
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x
s
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x
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i v h u j i v u h i r b v f z v h k f j i b l u b c b c g t u r v i f j b c f e g t h i v l f u c l b i i v h u j i l k i b l u b c {
x
s
i c f g l u i j r b v f l i v w u c f l u b c b l u b c b c g t u r g i f j i l i v w h f g h z g f l i b c l k i f j j z w l u b c l k f l l k i
i c l u l t x u g g i i v h u j i l k u j b l u b c {
x
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Õ w b z c l j i i h l i l b e i f t f e g i u c l i v w j b r v i j u z f g f g z i z f v f c l i i j
9.4 Discount rate (IFRS 16.26)
The measurement of the lease liability is based on the present value of the lease payments,
calculated using an appropriate discount rate. There are two rates that may be used as the
appropriate discount rate:
x The implicit interest rate; or
x 7KHOHVVHH¶VLQFUHPHQWDOERUURZLQJUDWH
784 Chapter 16
The discount rate that we should ideally use is the interest rate implicit in the lease agreement.
However, the implicit interest rate is not always readily determinable by the lessee because, in
order to calculate the implicit interest rate (being the rate that causes the present value of the
lease payments and unguaranteed residual value to equal the sum of the fair value of the
underlying asset and any initial direct costs of the lessor) it assumes, for example, that the
lessee has knowledge of WKH OHVVRU¶V LQLWLDO GLUHFW FRVWV ,I WKH lessee cannoW µUHDGLO\
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k i v f l i b r u c l i v i j l l k f l h f z j i j a l k i v f l i b r u c l i v i j l l k i g i j j i i x b z g k f i l b f t
x x
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l b i Ù z f g x l k i r z c j c i h i j j f v t l b b e l f u c f c f j j i l b r f
x
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l k i z c i v g t u c f j j i l
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k f c b l e i i c b e l f u c i
c b l f j j z v i b v

i h i l r b v j z h k h b j l j u c h z v v i e t f
u j z f v f c l i i j b g i g t e t f f v l t v i g f l i l b

w f c z r f h l z v i v Þ i f g i v g i j j b v u c h b c c i h l u b c x u l k f

l k i g i j j b v |
r u c f c h i g i f j i |
10. Recognition and measurement ± the simplified approach
If the lease involves a low-value asset or is a short-term lease, the lease may be accounted for
in terms of the recognition exemption (if the entity chooses to apply this option). This optional
recognition exemption is a simplified approach to accounting for the lease.
If the lease is to be accounted for under the optional recognition exemption, it means that the
costs are recognised as an expense in profit or loss and measured on a straight-line basis over
the period of the lease (or using some other systematic basis).
This process of accounting involves debiting the lease expense with an amount representing
the lease payments recognised over the lease term on the straight-line basis, crediting the bank
with the lease payments actually made, and with any difference recognised as a lease payable
or lease prepaid. See IFRS 16.6
Example 14: Leases under the recognition exemption (simplified approach)

Entity A leases a computer from Entity B for a period of 24 months. This lease qualifies as
a lease of a low-value asset and thus qualifies for the recognition exemption. Entity A
chooses to apply the recognition exemption to this lease.
The lease payments are C1 000 per month for the first year and C1 300 per month for the
second year. The lease commenced on 1 April 20X1. Entity A has a 31 December year-end.
Required: Show the journal entries LQ(QWLW\$¶VJHQHUDOMRXUQDO
Solution 14: Leases under the recognition exemption (simplified approach)

Comment: Since the recognition exemption is applied to this lease, the lease rentals are recognised as
an expense on the straight-line basis over the lease term of 2 years. This means we must recognise the
lease expense at C1 150 per month (see calculation below). Since the lease payments differ from the
lease expense, it results, in this example, in a payable that reverses by the end of the lease.
Chapter 16 785
Calculations: (1 000 x 12 + 1 300 x 12) / 24 months = C1 150 per month

31 December 20X1 Debit Credit
Lease expense (low-value asset) (E) C1 150 x 9 m 10 350
Bank C1 000 x 9 m 9 000
Lease payable (L) Balancing 1 350
Lease of computer under the optional simplified approach
31 December 20X2
Lease expense (low-value asset) (E) C1 150 x 12 m 13 800
Bank C1 000 x 3 m + C1 300 x 9 m 14 700
Lease payable Balancing 900
31 December 20X3
Lease expense (low-value asset) (E) C1 150 x 3 months 3 450
Bank C1 300 x 3 months 3 900
Lease payable (L) Balancing 450
11. Recognition and measurement ± the general approach
11.1 Overview
When accounting for a lease that is not a low-value asset or a short-term lease, the lease will
not qualify for the recognition exemption. In this caVHWKHOHDVHPXVWEHDFFRXQWHGIRUµRQ-
EDODQFHVKHHW¶7KLVPHDQVWKDWZHmust recognise a right-of-use asset and a lease liability.
11.2 Initial recognition and measurement
A lease, which is not accounted for in terms of the recognition exemption, will be accounted
for at commencement date by recognising:
x a right-of-use asset, and
x a lease liability. See IFRS 16.22
ß à á â á ã ä å æ ã ç è é æ å æ à â ê ë
S K T U K S P T ì P S P Q í V
The lease liability is initially measured, at commencement x

À
Ô b r g i f j i f t w i c l j
date, at the present value of the lease payments that are x l k f l f v i j l u g g f t f e g i f l
payable on this date (i.e. it would exclude any lease x

h b w w i c h i w i c l f l i
payments that are paid in advance or had been prepaid),

u j h b z c l i z j u c i u l k i v l k i u w g u h u l
u c l i v i j l v f l i b v l k i g i j j i i º j
discounted at either the implicit interest rate or, if this is u c h v i w i c l f g e b v v b x u c v f l i
not readily determinable, then using WKH OHVVHH¶V

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incremental borrowing rate (as explained in section 9.4, it will be more likely that a lessee
would use its incremental borrowing rate). See IFRS 16.26
The right-of-use asset is initially measured at its cost, ß à á â á ã ä å æ ã ç è é æ å æ à â ê ë
where this cost includes the following: ð

P N ñ Q ò M R ò ó U K T U U K Q V
x The initial measurement of the lease liability; x

s
x Any payments made on or before commencement x

Ç i f j i g u f e u g u l t u c u l u f g w i f j z v i w i c l {
ô c u l u f g u v i h l h b j l j
date; x
À
v i f u g i f j i f t w i c l j
x Any initial direct costs incurred by the lessee; and x

s
Ô b r i j l u w f l i r z l z v i h b j l j l b
x Any estimated future costs to dismantle and remove

y
u j w f c l g i v i w b i b v v i j l b v i {
the asset, restore the site on which the asset was x

y y
Ç i j j g i f j i u c h i c l u i j v i h i u i |
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situated or restore the actual underlying asset to a

predetermined condition (i.e. we include the present value of the related costs that would
be recognised as a provision for future costs in terms of IAS 37)
x Less any lease incentives received. See IFRS 16.24
Let us look at each of the above in a bit more detail and also consider how these would appear
as journal entries.
786 Chapter 16
The lease liability is generally the primary cost in acquiring the right to use the asset and thus
the initial measurement of this liability is included in the cost of the right-of-use asset.
Lease liability (initial PV) Debit Credit

Right-of-use asset: cost (A) xxx
Lease liability (L) xxx
PV of lease liability is part of the cost of the RoU asset
When calculating the cost of the right-of-use asset, we must remember that any lease
payments that are made on or before commencement date will obviously not be part of the
lease liability, so we add these costs, if any, to the cost of the right-of-use asset.
Prepaid lease rentals Debit Credit

Right-of-use asset: cost (A) Prepaid lease rentals (e.g. xxx
Bank rentals payable in advance xxx
Prepaid lease rental (paid on or before commencement date)
is part of the cost of the RoU asset
Similarly, if the asset involves an obligation for the lessee to dismantle the asset or restore the
asset or the site on which it was situated, we must recognise this as a provision (in terms of
IAS 37), and where the initial measurement of this provision for future costs would then be
included as part of the cost of the right-of-use asset.
Provision for obligation to dismantle or restore Debit Credit

Right-of-use asset: cost (A) PV of future costs to restore, xxx
Provision (L) dismantle etc xxx
Provision for future costs is part of the cost of the RoU asset
Furthermore, any initial direct costs (being the incremental costs of obtaining the lease that
would not have been incurred had the lease not been obtained e.g. directly related legal costs)
are also considered to be part of the cost of the right-of-use asset. See IFRS 16.24
Initial direct costs Debit Credit

Right-of-use asset: cost (A) Initial direct costs paid/payable xxx
Bank/ Payable etc xxx
Initial direct costs paid or payable is part of cost of RoU asset
/HDVHLQFHQWLYHVDUHGHILQHGDVµWKHSD\PHQWVPDGHE\WKHOHVVRUWRWKHOHVVHHDVVRFLDWHGZLWK
the lease, oU WKHUHLPEXUVHPHQW RUDVVXPSWLRQ E\ D OHVVRU RIWKH FRVWV RI WKHOHVVHH¶ Lease
incentives would thus include outright receipts from the lessor, (e.g. received to simply
incentivise the lessee to enter into the lease) and also receipts from the lessor that constitute
refunds of costs, relating to the lease, that the lessee has already paid for. The lessee does not
have to actually receive an amount for there to be a lease incentive: the lessor could undertake
WR SD\ FHUWDLQ RI WKH OHVVHH¶V FRVWV RQ WKH OHVVHH¶V EHKDOI $OO lease incentives received or
receivable are credited to the cost of the right-of-use asset. However, we must be careful not
to reduce the cost of the asset by receipts or receivables that are not actually lease incentives.
For example, a receipt of a reimbursement from a lessor for leasehold improvements (e.g. the
painting of a leased building) is not considered to be a lease incentive (it does not relate
directly to the lease), and should thus not be accounted for as a reduction in the cost of the
right-of-use asset (building): the leasehold improvements would be expensed and the related
reimbursement would be accounted for as a reduction in this expense.
Lease incentives (receipts and refunds) Debit Credit

Bank/ Receivable etc Reimbursements received/ xxx
Right-of-use asset: cost (A) receivable relating to lease
ö xxx
Reimbursement received (a lease incentive) included as a
reduction to the cost of the asset
Chapter 16 787
Example 15: Initial measurement of lease liability and right-of-use asset

On 1 January 20X1, Entity A (the lessee) enters into a lease over a building, for a non-
cancellable period of four years, with Entity B (the lessor).
x The lease payments include five fixed lease payments of C10 000, with the first
payment of C10 000 payable in advance on 1 January 20X1 and the remaining four
payments of C10 000 payable annually in arrears, starting on 31 December 20X1.
x In addition, Entity A is required to pay 10% of the revenue generated from the use of
the building per year, payable annually in arrears. Entity A expects to generate revenue
of C80 000 per year from the use of the building.
x In order to obtain the lease, Entity A incurred initial direct costs of C4 000 (which it
only paid in 20X2) of which C1 000 was received as a reimbursement from the lessor.
x Entity A also paid for leasehold improvements (painting of the building) of C8 000,
70% of which were also received as a reimbursement by the lessor.
x The appropriate discount rate is 10%.
Required: 8VLQJ(QWLW\$¶VJHQHUDOMRXUQDOVhow the journals to account for the initial recognition of
the lease on 1 January 20X1.
Solution 15: Initial measurement of lease liability and right-of-use asset

Journals:
1 January 20X1 Debit Credit
Right-of-use asset: cost (A) Balancing 41 699
Lease liability (L) W1.1: PV of lease pmts payable 31 699
Bank Given: Lease pmt in advance 10 000
Initial recognition of lease of building (including a lease pmt in adv.)
Right-of-use asset: cost (A) Given 4 000
Accounts payable 4 000
Initial direct costs incurred in connection with lease of building
Bank Given 1 000
Right-of-use asset: cost (A) 1 000
Reimbursements of initial direct costs received from lessor
Painting of leased building (E) Given 8 000
Bank 8 000
Leasehold improvements in connection with lease of building
Bank 8 000 x 70% 5 600
Painting of leased building (E) 5 600
Reimbursements of leasehold improvements received from lessor
Workings:
W1.1: Present value of lease liability ± at 1 January 20X1
Date Lease payments Present value factor at 10% Present value
(see W1.2)
31/12/20X1 10 000 0.909091 9 091
31/12/20X2 10 000 0.826446 8 265
31/12/20X3 10 000 0.751315 7 513
31/12/20X4 10 000 0.683013 6 830
31 699
W1.2: Present value factors for interest rate of 10%

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Or:
PV factor for an amount received: Calculations: PVF at 10%:
Immediately (now) 1.000000
At end of year 1 1/ (1 + 0.10) 0.909091
At end of year 2 0.909091/ (1 + 0.10) 0.826446
At end of year 3 0.826446/ (1 + 0.10) 0.751315
At end of year 4 0.751315/ (1 + 0.10) 0.683013
788 Chapter 16
W1.3: Alternative calculation of present values using a financial calculator

The PV of the lease payments could be calculated with a financial calculator instead:
x n = 4 i = 10% PMT = -10 000
COMP PV ... and your answer should be: 31 699!
Comment:
x Leasehold improvements and related reimbursements incurred by the lessee are not included when
accounting for a right-of-use asset and lease liability.
x The initial direct costs are capitalised to the right-of-use asset but have nothing to do with the
measurement of the lease liability.
x The lease payments that are based on a percentage of revenue are variable lease payments but,
since they do not vary in tandem with an index or rate, they are not included in the calculation of
lease payments (as defined) and are thus not included in the measurement of the lease liability.
These variable lease payments will simply be expensed when they are incurred.
x There were 5 fixed lease payments of C10 000 each, but yet the lease liability was calculated based
on only 4 fixed lease payments. This is because the first lease payment was paid in advance and
thus is not part of the liability at commencement date. This first lease payment, paid in advance, is
accounted for as part of the right-of-use asset though.
11.3 Subsequent measurement ± a summary overview
A lease that is accounted for XQGHU,)56¶VJHQHUDODSSURDFKLVDFFRXQWHGIRUµRQ-balance

VKHHW¶ZLWKWKHUHVXOWEHLQJWKDWDOHDVHOLDELOLW\and right-of-use asset will be recognised.
The initial recognition and measurement at commencement date of both these elements was
explained in section 11.2.
The subsequent measurement, after commencement date, of each of these elements includes the
following:
x the lease liability is accounted for under the effective interest rate method, which means
that it is increased by an amount recognised as interest and decreased by the lease
payments (another way of describing this is that the lease payments are effectively
apportioned between interest expense and a reduction of the lease liability); and
x the right-of-use asset is depreciated and tested for impairments, normally under the cost
model, although the revaluation model or fair value model may, under certain
circumstances, be used instead.
The subsequent measurement of the lease liability and right-of-use asset may also involve
remeasurement adjustments. See IFRS 16.36
More detail regarding the subsequent measurement of each of these elements can be found in:
x Section 11.4 ± subsequent measurement of a lease liability
x Section 11.5 ± subsequent measurement of a right-of-use asset
x Section 11.6 ± subsequent measurement involving remeasurements
11.4 Subsequent measurement of the lease liability
11.4.1 Overview ÷ ø ù ú û ü ø û ý þ ÿ ÿ

The lease liability is initially measured at the present x
value of the lease payments that were payable at ! "
commencement date, discounted at either the interest rate x # $ % &
implicit in the lease or, if this is not readily determinable, $ ' $ & ( & )
then at WKH OHVVHH¶V LQFUHPHQWDO ERUURZLQJ UDWH.

! * + , , - . / + 0 1 2 3 1 4 2 3 5
Irrespective of which rate is used, it is must be the rate applicable at commencement date. See
section 11.2 for more detail on the initial measurement.
The subsequent measurement of the lease liability is at amortised cost i.e. using the effective
interest rate method.
Chapter 16 789
11.4.2 The effective interest rate method
The effective interest rate method is often described as apportioning the lease payments between
interest expense and a reduction in the lease liability but, effectively, it means that we:
x increase the lease liability with the interest on the liability (i.e. unwinding the discounting
that occurred at initial measurement) and recognise this interest as an interest expense; and
x we decrease the lease liability by the lease payments.
The journals we would process are as follows:

Debit Credit
Lease interest (E) xxx
Interest on lease liability calculated using the EIR method

Bank xxx
Lease payments made
Example 16: Lease liability ± subsequent measurement

Use the same information that was contained in the previous example (summarised in the
block below for your convenience) together with the following additional information:
x On 1 January 20X1, Entity A (the lessee) entered into a lease over a building, for four years.
x The lease payments include five fixed lease payments of C10 000 each, with the first being payable in
advance on 1 January 20X1 and the remaining four fixed lease payments of C10 000 each being
payable in arrears (with the first such payment being due on 31 December 20X1).
x Entity A is also required to pay 10% of the revenue generated from the use of the building per year,
payable in arrears. At commencement date, Entity A expected to generate revenue of C80 000 per year.
x In order to obtain the lease, Entity A incurred initial direct costs, in 20X1, of C4 000 of which C1 000
was received as a reimbursement by the lessor, in 20X1. These initial costs were not paid in 20X1.
x The appropriate discount rate OHVVHH¶VLQFUHPHQWDOERUURZLQJUDWHZDVDWFRPPHQFHPHQWGDWH
Additional information:
x Entity A generated revenue from the use of the building of C70 000 in 20X1 and C60 000 in 20X2
and paid the variable lease payments on due date.
x Entity A paid the initial direct costs of C4 000, (which were incurred in 20X1), in 20X2.
The implicit interest rate was not readily determinable and thus the entity uses its incremental
borrowing rate. The incremental borrowing rates were as follows:
01 January 20X1: 10%
31 December 20X1: 11%
Required: Show the journals to account for the subsequent measurement of the lease liability in Entity
$¶VJHQHUDOMRurnal for 20X1 and 20X2 assuming that Entity A has a 31 December financial year-end.
Solution 16: Lease liability ± subsequent measurement

Comments:
x At 1 January 20X1, the incremental borrowing rate was 10%. Although the incremental borrowing
rates change over the lease period, we continue to use the rate that applied at commencement date.
x The lease liability at commencement date was initially measured at its present value, discounted at
10%, of C31 699 (see W1 and journals in the previous example).
x The variable lease payments that did not vary based on an index or rate, and were thus not included
in the calculation of lease payments as defined, are expensed as they are incurred.
x There are 2 lease payments in 20X1 (C10 000 paid in advance, on commencement date, and thus
excluded from the initial measurement of the lease liability and another C10 000 paid in arrears, on
31 December 20X1).
790 Chapter 16
Journals:

Lease interest (E) W1 3 170
Lease liability (L) 3 170
Interest on lease, based on the effective interest rate method
Lease liability (L) Given (paid in arrears) 10 000
Bank 10 000
Lease payment fixed lease payment (was included in the liability and
6
thus when it is paid, it reduces the liability)

Variable lease payment (E) C70 000 x 10% 7 000
Bank 7 000
Lease payment variable lease payment (was not included in the
6
liability and thus, when it is paid or incurred, it is expensed)

31 December 20X2
Lease liability (L) Given (paid in arrears) 10 000
Bank 10 000
Lease payment fixed lease payment (was included in the liability and
6
thus when it is paid, it reduces the liability)

Variable lease payment (E) C60 000 x 10% (paid in arrears) 6 000
Bank 6 000
Lease payment variable lease payment (was not included in the
6
liability and thus, when it is paid or incurred, it is expensed)

Account payable (L) Given 2 000
Bank 2 000
Initial direct cost that was incurred in 20X1 but paid in 20X2
Workings:
W1: Lease liability ± effective interest rate table: as at 1 January 20X1 (payments in arrears)
Year (1) Balance (start) Interest at 10% Lease payments Balance (end)
20X1 (2) 31 699 3 170 (10 000) 24 869
20X2 24 869 2 487 (10 000) 17 356
20X3 17 356 1 736 (10 000) 9 092
20X4 9 092 908 (10 000) 0
8 301 (40 000)
Notes:
(1) Although lease payments for the purpose of measuring the lease liability include fixed lease
payments, we only include lease payments that are payable on commencement date (i.e. we
exclude lease payments that are paid on or before commencement date). Thus, although this
lease involves 5 fixed lease payments, the first one is paid on commencement date and thus
only 4 fixed lease payments are included in the measurement of the lease liability (see W1 in
the previous example) and thus only 4 lease payments appear in the effective interest rate
table (see W1 in this example).
(2) For the present value of the liability calculation, please see W1 in the prior example.
Example 17: Lease liability ± initial and subsequent measurement

(advance lease payments)
Entity A (lessee) entered into a contract with Entity B (lessor) to lease a plant. The lease
was for a non-cancellable period of five years. Entity A is required to make five lease instalments of
C20 000 each, payable annually in advance, with the first payment due on 1 January 20X1
(commencement date). The implicit interest rate was 16%.
Chapter 16 791
Required:
a) 6KRZWKHMRXUQDOVWRDFFRXQWIRUWKHOHDVHOLDELOLW\LQ(QWLW\$¶VJHQHUDOMRXUQDOIRU each year
affected assuming that Entity A has a 31 December financial year-end. Ignore all journals relating
to the subsequent measurement of the asset.
b) Calculate the lease liability balance to be included in the statement of financial position and the
lease interest expense to be included in the statement of comprehensive income for the year ended
31 December 20X2 and 31 December 20X4.
Solution 17: Lease liability - initial and subsequent measurement (advance lease payments)
Comments:
x The initial measurement of the lease liability includes only those lease payments that are payable on
commencement date (thus it excludes lease payments that were made on or before commencement
date). This means that the lease liability on commencement date is the present value of only 4 lease
payments, since it excludes the first lease payment that was made on commencement date.
x The right-of-use asset includes both the initial measurement of the lease liability (present value of
the 4 lease payments) plus the advance lease payment that was paid on commencement date.
a) Journals:
Right-of-use asset: cost (A) W1 75 964
Bank 20 000
Initial recognition and measurement of lease
31 December 20X1
1 January 20X2
Lease liability (L) Given (paid in advance) 20 000
Bank 20 000
Lease payment fixed lease payment
6
31 December 20X2
1 January 20X3
Bank 20 000
6
31 December 20X3
1 January 20X4
Bank 20 000
6
31 December 20X4
1 January 20X5
Bank 20 000
6
792 Chapter 16
b) Balances at year end 20X5 20X4 20X3 20X2 20X1

Lease liability 0 20 000 37 242 52 105 64 918
Lease interest expense 0 2 758 5 137 7 187 8 954
Workings:
W1: Lease liability ± present value of lease payments payable on commencement date

payable (see W1.2)
31/12/20X1 20 000 0.862069 17 242
31/12/20X2 20 000 0.743163 14 863
31/12/20X3 20 000 0.640658 12 813
31/12/20X4 20 000 0.552291 11 046
55 964

Present value factor = [1/(1+16@Q«:KHUHQ QXPEHURI\HDUVSHULRGV
Or:
At end of year 1 1/ (1 + 0.16) 0.862069
At end of year 2 0.862069/ (1 + 0.16) 0.743163
At end of year 3 0.743163/ (1 + 0.16) 0.640658
At end of year 4 0.640658/ (1 + 0.16) 0.552291

The PV of the lease payments could be calculated with a financial calculator instead:
x n = 4 i = 16% PMT = -20 000
COMP PV ... and your answer should be: 55 964
W2: Lease liability ± effective interest rate table: as at 1 January 20X1 (payments in ADVANCE)
Year (1) Balance (start) Interest at 10% Lease payments Balance (end)
20X1 (2) 55 964 8 954 64 918
20X2 64 918 (20 000) 44 918
44 918 7 187 52 105
20X3 52 105 (20 000) 32 105
32 105 5 137 37 242
20X4 37 242 (20 000) 17 242
17 242 2 758 20 000
20X5 20 000 (20 000) 0
24 036 (80 000)
11.4.3 Remeasurements
In addition to adjusting the lease liability for interest 7 8 9 8 : ; < = 8 9 8 > ? ; @
expense (increase) and payments made (decrease), the

lease liability may also require remeasurement (this could x A B C D E F E A G H G I J G E K I E L C M D H L N E A L
be an increase or a decrease). C D E O E H G E P H Q R E L C G C D H C H B B E M C G C D E
R E H G I F E R E L C S B C D E O E H G E O A H J A O A C Q
T U U V
Given that the lease liability reflects the µpresent value of x

the lease payments¶ that are payable, if there is a
W F E R E H G I F E R E L C H X Y I G C R E L C C S C D E
U U
N E L E F H O O Q F E K I A F E G C D E G H R E
subsequent change in the lease payments, then the lease H X Y I G C R E L C C S C D E Z S [
]
H
^
G
^
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_
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\
b c d e c f d e g
liability will clearly need to be remeasured. In this regard,

the lease liability would need to be remeasured if there has been a reassessment, lease
modification or a revision to the in-substance fixed lease payments. See IFRS 16.36
Chapter 16 793
If a remeasurement adjustment is made to the lease liability, the same remeasurement

adjustment is made to the right-of-use asset as well (unless the remeasurement adjustment
decreases WKH DVVHW¶V FDUU\LQJ DPRXQW DQG WKH DGMXVWPHQW exceeds WKH DVVHW¶V FDUU\LQJ
amount, in which case, the adjustment, after reducing the carrying amount to zero, will be
expensed in profit or loss instead). Remeasurements are explained in detail in section 11.6.
11.5 Subsequent measurement of the right-of-use asset
11.5.1 Overview
< i ; 8 j < 8 > ? 9 8 : ; < = 8 9 8 > ?
h
: 7 : ; ; 8 ? @
k l k m
The right-of-use asset is normally accounted for in terms x n S F R H O O Q A L C E F R G S B C D E o p q r s p t u v
of a cost model (per IFRS 16) in which case it is J I C R H Q I G E C D E w u x y v z y r { p | s p t u O
depreciated and tested for impairments (in terms of IAS

S F } y { w x y v z u s p t u v X E P E L X A L N S L
] ^ ^ _ ` a ] b c d ~ g f d e e
C D E M A F M I R G C H L M E G \
36 Impairment of assets). On occasion it may also be

subjected to a remeasurement adjustment due to a remeasurement of the lease liability.
Although the right-of-use asset is normally measured in terms of the cost model, it may be
accounted for in terms of the revaluation model (per IAS 16) or fair value model (per IAS 40)
instead, depending on the asset being leased.
Subsequent measurement of a right-of-use asset under the cost model is covered in section 11.5.2.
11.5.2 Subsequent measurement of the right-of-use asset: in terms of the cost model
< i ; 8 j < 8 > ? 9 8 : ; < = 8 9 8 > ?
As mentioned, the right-of-asset is normally measured in

h
: 7 : ; ; 8 ? > ? 8 = 9 ;
terms of the cost model described in IFRS 16. Subsequent

k l k m k l
? 8 ; ? 9 8 @
k k
measurement of the right-of-use asset in terms of this cost

x
U
model will mean that its carrying amount will be: x

S G C W M M E P F W M M R P S G G E G
x Cost (per IFRS 16 Leases)

W X Y I G C E X B S F H L Q F E R E H G I F E R E L C G
] ^ ^ _ ` a ] b c d e
x Less subsequent accumulated depreciation (similar to

,$6¶VGHSUHFLDWLRQ
x Less accumulated impairment losses (per IAS 36 Impairment of assets);
x Adjusted for remeasurements made to the lease liability (per IFRS 16 Leases). See IFRS 16.30
IFRS 16 explains that this cost model is effectively the
8 = 8 : ?
k
>
k l
: 7
k m
same cost model as described in IAS 16 Property, plant : ; ; 8 ? @
and equipment since the right-of-use asset is initially x r y w r q M S R R E L M E R E L C X H C E
measured at cost and then depreciated and tested for x

u

r p t C S F E B O E M C P H C C E F L A L D A M D
impairments in terms of IAS 36 Impairment of assets. B F S R C D E Z S
T
[ H G G E C A G
U
E
V
P E M C E X
However, although the cost model is essentially the same C S J E M S L G I R E X L S F R H O O Q
x
as the cost model described in IAS 16, the cost model
u w { p t B F S R M S R R E L M E R E L C X H C E C S

used for a right-of-XVHDVVHWKDVEHHQVOLJKWO\µWZHDNHG¶
E H F O A E F S B C D E E L X S B I G E B I O O A B E S B
C D E Z S [ H G G E C S F E L X S B O E H G E
C E F R A B S L E F G D A P { q | p r E P E M C E X
Differences between the cost model per IAS 16 and the C S C F H L G B E F
cost model per IFRS 16 include the measurement of cost E L X S B I G E B I O
T
O A B E S B C D E
and the measurement of depreciation (in terms of both

I L X E F O Q A L N H G G E C A B S L E F G D A P { q
E P E M C E X C S C F H L G B E F
when depreciation starts and the depreciation period). ] ^ ^ _ ` a ] b c d e b e ~
The initial cost of a right-of-use asset is stipulated in IFRS 16 Leases (see section 11.2). This
initial cost will be subsequently remeasured (adjusted) if and when the lease liability requires
remeasurement during the course of the lease. See IFRS 16.23-24 & .30
9 9 8 > 8 9 8 > ? : ? 8
k
With regard to depreciation, the depreciation principle in

IFRS 16 Leases is the same as that in IAS 16 Property, x ¡ D E X H C E C D E O E G G S F R H ¢ E G
plant and equipment in that the depreciation method must x C D E I L X E F O Q A L N H G G E C
reflect the pattern in which the future economic benefits x H £ H A O H J O E B S F I G E J Q H O E G G E E \
of the right-of-use asset will be consumed (thus the

] ^ ^ _ ` a ] b c ¤ ¥ ¥ ¤
straight-line method is normally appropriate). However,

differences arise in terms of when depreciation starts and the period of depreciation.
794 Chapter 16
The depreciation of a right-of-use asset start from commencement date. The commencement
date is defined as the date that the lessor makes the underlying asset available to the lessee.
This differs from depreciation per IAS 16, where an item of property, plant and equipment is
to be depreciated from the date that it first becomes available for use. This is because the
commencement date may not necessarily be the same date on which the asset first becomes
available for use. For example: the lessor may make an asset available for use to the lessee on
1 January, but the lessee may still need to install the asset, where the installation is then
complete on 1 May. In terms of IFRS 16, this right-of-use asset would be depreciated from
1 January (commencement date) and not from 1 May (the date it first became available for
use, which is the date that would be used by IAS 16).
7KHSHULRGRIGHSUHFLDWLRQGLIIHUVVOLJKWO\DVZHOO:KHUHDV,$6¶s cost model requires that

an item of property, plant and equipment be depreciated over its useful life, IFRS ¶VFRVW
model is dependent on the circumstances regarding expected ownership:
x If ownership transfers or if there is a purchase option that the lessee believes is reasonably
certain of being exercised (i.e. where the expected exercise of this purchase option is also
reflected in the measurement of the lease payments and thus in the measurement of the
lease liability and thus also in the cost of the right-of-use asset), then the depreciation
period is from commencement date to:
the end of the underlying DVVHW¶VXVHIXOOLIH
x If this is not the case (e.g. ownership of the asset is not expected to transfer to the lessee at
the end of the lease and there are no purchase options or, if there are, the lessee does not
expect to exercise them), the depreciation period of the right-of-use asset is from
commencement date to the earlier of:
the end of the right-of-use DVVHW¶VXVHIXOOLIH, and
the end of the lease term. See IFRS 16.32
Example 18: Right-of-use asset ± subsequent measurement: depreciation

On 1 January 20X1, commencement date, an entity has a right-of-use asset with a cost of
C10 000 (measured at the present value of the future lease payments payable on this date).
The underlying asset, a machine, has a useful life of 10 years. The lease covers a period of 5 years.
Consider the following scenarios:
Scenario 1: Ownership of the lease transfers at the end of the lease-term.
Scenario 2: The lease term is neither renewable nor cancellable. There are no purchase options.
Scenario 3: The lease term is neither renewable nor cancellable but the contract includes a purchase
option at the end of the 5th year that the lessee is reasonably certain it will exercise
Required: For each of the scenarios, and using the general journal, show the journal to account for the
depreciation in the year ended 31 December 20X1.
Solution 18: Right-of-use asset ± subsequent measurement: depreciation

Scenario 1:
Depreciation of RoU asset (E) 10 000 / 10 years 1 000
Right-of-use asset: acc depr (-A) 1 000
Depreciation of right-of-use asset depreciation over the useful life of the ¦
underlying asset because ownership transfers

Scenario 2:
Depreciation of right-of-use asset depreciation over the shorter of the ¦
right-of-
§ ¨ ¨ © ª « ¨ ¬ ¨ © ¬ ® ® ¯ se
© ° ± ² ³ © § ´ ¨ µ § ¶ · ª ¸ © ® © § ¨ © ª © ´ ¹ ° º ³ © § ´ ¨ µ » © ¼ § ¬
ownership does not transfer and there are no purchase options
Chapter 16 795
Scenario 3:
Depreciation of right-of-use asset depreciation over the useful life of the
¦
underlying asset because there is a purchase option that the entity is

reasonably certain will be exercised (the lease payments will have included
the exercise price of the purchase price)
When testing a right-of-use asset for impairment, we follow IAS 36 Impairment of assets.
This means that we follow the same process that we used when we tested, for example, items
of property, plant and equipment for impairment. Please see chapter 11 for further details.
Example 19: Right-of-use asset ± subsequent measurement: impairments
On 1 January 20X1, commencement date, an entity has a right-of-use asset with a cost of
C10 000 (measured at the present value of the future lease payments payable on this date).
This right-of-use asset is depreciated on the straight-line basis over the lease term of 5 years.
At 31 December 20X2, this asset is found to have a recoverable amount of C3 000.
Required: Using the general journal show the journals to account for the information provided for the
financial years ended 31 December 20X1, 20X2 and 20X3.
Solution 19: Right-of-use asset ± subsequent measurement: impairments

Journals:
Right-of-use asset: cost (A) Given 10 000
Initial recognition and measurement of lease and right-of-use asset
31 December 20X1
Depreciation of right-of-use asset
31 December 20X2
Impairment of RoU asset (E) CA (10 000 2 000 2 000)
½ ½ 3 000
Right-of-use asset: acc imp loss (-A) Less RA: 3 000 3 000
Impairment of right-of-use asset
31 December 20X3
Depreciation of RoU asset (E) CA (10 000 2 000 2 000
½ ½ ½ 3 000) 1 000
Right-of-use asset: acc depr (-A) ÷ (5 2 ) remaining years
¾ 1 000
11.5.3 Subsequent measurement of the right-of-use asset: in terms of revaluation model
If the right-of-use asset is an asset that falls within a class of property, plant and equipment to
which the lessee applies the revaluation model, then the lessee may choose to measure all
right-of-use assets falling within this class of property, plant and equipment using the
revaluation model (i.e. this is an accounting policy choice). See IFRS 16.29 & .35
11.5.4 Subsequent measurement of the right-of-use asset: in terms of fair value model
If the right-of-use asset is an asset that is investment property and if the lessee applies the fair
value model to its investment property, then the lessee must measure the right-of-use asset in
terms of the fair value model (per IAS 40). See IFRS 16.29 & .34
796 Chapter 16
11.6 Subsequent measurement - remeasurements due to changing lease payments
If there is a change in the lease payments (e.g. the lease term changes, thus resulting in extra
lease payments being included in the measurement of the lease liability or there was a
purchase option that was perhaps not previously considered reasonably certain of being
exercised but is now reasonably certain of being exercised, or vice versa), then we must
remeasure the lease liability to reflect this.
The remeasurement adjustment that is made to the lease liability will also be made to the
right-of-use asset, if the adjustment reflects an increase in the lease payments (i.e. thus
increasing the lease liability and right-of-use asset).
Debit Credit
Right-of-use asset (A) xxx
Remeasurement of lease liability and right-of-use asset due to
an increase in lease payments
However, if the adjustment reflects a decrease in the lease payments, thus necessitating a
decrease in the lease liability, then the adjustment made to the right-of-use asset (i.e.
GHFUHDVLQJ WKH DVVHW ZLOO EH OLPLWHG WR WKH H[WHQW RI WKH DVVHW¶V FDUU\LQJ DPRXQW, with any
excess recognised as an expense in profit or loss. In other words, if the remeasurement
DGMXVWPHQW H[FHHGV WKH DVVHW¶V FDUU\LQJ DPRXQW ZH VLPSO\ UHGXFH WKH DVVHW¶V FDUU\LQJ
DPRXQW WR ]HUR DQG WKH H[FHVV DGMXVWPHQW WKDW ZRXOG RWKHUZLVH GURS WKH DVVHW¶V FDUU\LQJ
amount below zero) would be recognised as an expense in profit or loss instead. See IFRS 16.39
Assuming that the decrease in the lease liability did not decrease the carrying amount of the
right-of-use asset below zero, we would process the following entry:
Debit Credit
Right-of-use asset (A) xxx
a decrease in lease payments
If the decrease in the lease liability decreased the carrying amount of the right-of-use asset
below zero, we would process the following entry:
Debit Credit
Right-of-use asset (A) Carrying amount xxx
Lease remeasurement income (I) Balancing xxx
a decrease in lease payments that resulted in a decrease in
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When remeasuring the lease liability, we calculate the present value of the revised remaining
lease payments at the date of the reassessment and will either have to use a revised discount
rate or the original discount rate.
We must use a revised discount rate if the lease payments change due to:
x a change in the estimated lease term, or
x a change in the assessment regarding whether an option to purchase will be exercised or
not (e.g. if we did not believe it was reasonably certain that a purchase option would be
exercised, then the purchase price would not have been included in the lease payments,
but if the situation changes and we now believe that a purchase option will be exercised,
then the purchase price needs to be included in the lease payments). See IFRS 16.40
Chapter 16 797
We must use the original discount rate if the remaining lease payments change due to:
x a change in the amount expected to be payable in terms of a residual value guarantee or
x a change in the variable lease payments that vary based on an index or rate
x unless the above changes resulted from a change in a floating interest rate, in which case a
revised discount rate is used instead. See IFRS 16.42-43
When using a revised discount rate, the revised discount rate must either reflect the interest
rate implicit over the remainder of the lease term (assuming this can be determined) or the
OHVVHH¶VLQFUHPHQWDOERUURZLQJUDWHDWWKHGDWHRIWKHUHDVVHVVPHQW See IFRS 16.40-41
Example 20: Remeasurement - change in lease term

Entity A (lessee) enters into a lease over a building on 1 January 20X1.
The lease covers a 4-year non-cancellable period at the end of which the lessee has the option to extend
the lease for a further 3 years.
The lease payments will be C10 000 per annum for the first 4 years and C8 000 per annum during the
extra 3 years, should the lessee opt to extend the contract. The lease payments are all payable in arrears.
At 1 January 20X1 (the commencement of the lease), the lessee felt it was reasonably certain that it
would not extend the lease, but the facts and circumstances at 31 December 20X2 made it reasonably
certain that the lease would be extended for the extra 3 years.
The implicit interest rate is not known and thus the entity uses the incremental borrowing rate. The
incremental borrowing rate is as follows:
01 January 20X1: 10%
Required:
Provide the journal entry that would be required to account for the change in lease term.
Solution 20: Remeasurement - change in lease term

Right-of-use asset (A) Revised PV C32 218 CA (current PV) C17 356
¾ 14 862
Remeasurement of lease due to change in lease payments caused by a
change in the lease term, thus PV calculated using revised discount rate
Explanation:
At 1 January 20X1, the lease term was originally estimated to be 4 years (i.e. excluding the optional
extension period) and at which point the incremental borrowing rate was 10%. The lease liability at
commencement is thus initially measured at its present value of C31 699 (see W1).
At 31 December 20X2, the total lease term is revised to be 7 years (i.e. including the optional
extension period). This means that, at this date, instead of the remaining lease term being 2 years (4
years ± 2 years), the remaining lease term is now 5 years (7 years ± 2 years).
x At this date, the actual carrying amount of the lease liability, being is its present value based upon
the original lease term and discount rate, is C17 356 (W1).
x At this date, the revised present value of the lease liability, based on the revised lease term and the
revised discount rate, is C32 218 (W2).
This means that the increase in the lease term results in an increase in the lease liability of C14 862
(C32 218 ± C17 356). Thus, after processing all the usual journals relating to the lease liability for the
year ended 31 December 20X2 (i.e. interest expense of C2 487 and the lease payment of C10 000), its
carrying amount of C17 356 is increased by C14 862 to C32 218.
See workings overleaf.
798 Chapter 16
Workings:
W1: Lease liability ± effective interest rate table: ORIGINAL as at 1 January 20X1
Year Balance (start) Interest at 10% Lease payments Balance (end)

20X1 (W1.1) 31 699 3 170 (10 000) 24 869
20X2 24 869 2 487 (10 000) 17 356
20X3 17 356 1 736 (10 000) 9 092
20X4 9 092 908 (10 000) 0
8 301 (40 000)

(see W1.2)
31/12/20X1 10 000 0.909091 9 091
31/12/20X2 10 000 0.826446 8 265
31/12/20X3 10 000 0.751315 7 513
31/12/20X4 10 000 0.683013 6 830
31 699
See previous example for calculation of present value factors for interest rate of 10%.
W2: Lease liability ± effective interest rate table: REVISED at 31 December 20X2
Year Balance (start) Interest at 12% Lease payments Balance (end)

20X3 (W2.1) 32 218 3 866 (10 000) 26 084
20X4 26 084 3 130 (10 000) 19 214
20X5 19 214 2 306 (8 000) 13 520
20X6 13 520 1 622 (8 000) 7 142
20X7 7 142 858 (8 000) 0
11 782 (44 000)
W2.1: Present value of lease liability ± at 31 December 20X2

(see W2.2)
31/12/20X3 10 000 0.892857 8 929
31/12/20X4 10 000 0.797194 7 972
31/12/20X5 8 000 0.711780 5 694
31/12/20X6 8 000 0.635518 5 084
31/12/20X7 8 000 0.567427 4 539
32 218

After one year 1/ (1 + 0.12) 0.892857
After two years 0.892857/ (1 + 0.12) 0.797194
After three years 0.797194/ (1 + 0.12) 0.711780
After four years 0.711780/ (1 + 0.12) 0.635518
After five years 0.635518/ (1 + 0.12) 0.567427
Comment:
The incremental borrowing rate at 31 December 20X1 was given but was irrelevant as we do not
continually remeasure the liability using revised discount rates. We use the original discount rate on
commencement date to initially measure the lease liability and then we use the revised discount rate on
31 December 20X2 because we are remeasuring the lease liability due to a change in lease payments
that was caused by a change in the lease term.
Chapter 16 799
11.7 Subsequent measurement - lease modifications (IFRS 16.44-46)

Lease modifications are changes to a lease that involve
Ò Ó Ô Õ Ö Ô × Ø Ù Ú Û Ú Ü Õ Ý Ú Ø Þ Ú Ö
Ù Ô Û Ú Þ Ô Ù Õ Ö ß
changes made to the original terms and conditions of

x
the lease, where either the original scope is changed x
à á â à ã ä å æ ã ç á è é å è ê à ë å à ç å ì
(e.g. adding the right-to-use another asset) or the

è ê í â å á è ã ç æ î å ï à í æ è ã ê è ï à ë å à ç å ì
x í â à í ð à ç ã è í é à ï í è ê í â å è ï æ ä æ ã à ë
original consideration is changed (e.g. changing a fixed í å ï ñ ç à ã î á è ã î æ í æ è ã ç è ê í â å ë å à ç å
payment to a payment that varies with changes in the

ò
è ï å ó à ñ é ë å ì
CPI index). x à î î æ ã ä è ï í å ï ñ æ ã à í æ ã ä í â å ï æ ä â í í è
ô ô
ç å è ã å è ï ñ è ï å ã î å ï ë õ æ ã ä
Modifications are either accounted for as: x

à ç ç å í ç ì è ï
x separate leases, or as
å ó í å ã î æ ã ä è ï ç â è ï í å ã æ ã ä í â å
x remeasurements of the existing lease.

á è ã í ï à á í à ë ë å à ç å í å ï ñ ö ÷ ø ù ú û ü ý þ ÿ ÿ
A modification will be accounted for as a separate lease if:

x the scope has been increased by adding the right-to-use another asset; and
x the consideration increases by an amount that reflects the stand-alone price for the
additional right-to-use asset/s (adjusted to reflect the circumstances of the
particular contract). See IFRS 16.44
If the modification is accounted for as a separate lease:
x we recognise a new right-of-use asset and lease liability; and
x we do not make any adjustments to the original lease.
Worked example: Lease modification ± separate lease
Entity A (lessee) enters into a 4-year lease over a truck. During the first year of the lease,
(QWLW\$¶VEXsiness begins to flourish and it thus renegotiates the lease to include a second
truck, effective from the beginning of the second year. The second truck will be leased at a market-
related lease rental, which the lessor adjusted downwards slightly due to the fact that Entity A was an
pre-existing customer.
This modification involves an increase in the scope due to the right-to-use another asset (a second
truck) and the increase in the consideration substantially reflects the stand-alone price of this additional
right-to-use asset. Thus, this modification is accounted for as a separate lease: Entity A recognises a
right-to-use asset and a lease liability. No adjustment is made to the original lease.
If a modification does not meet the criteria to be accounted for as a separate lease,
then we account for it, at the effective date of the modification, as follows:
x allocate the modified consideration to the lease components and non-lease
components (using the same principles as always);
x determine the lease term of the modified contract (use the same principles as
always);
x remeasure the lease liability to reflect the present value of the modified lease
payments, present valued using a revised discount rate, being either:
the revised implicit interest rate over the remainder of the term or
WKHOHVVHH¶VLQFUHPHQWDOERUURZLQJUDWHDWWKHHIIHFWLYHGDWHRIWKHPRGLILFDWLRQ
(if the revised implicit rate is not readily determinable). See IFRS 16.45
The above remeasurement is accounted for as follows:
x if there was a decrease in the scope that resulted in a µpartial or full termination of
the lease¶we will recognise a profit or loss on the partial or full termination:
adjust the lease liability
adjust the right-of-use asset; and
profit or loss on the partial or full termination of the lease (balancing amount).
x in all other cases (e.g. where there has been an increase in the scope without an
appropriate increase in consideration), there will be no profit or loss recognised,
and we simply:
adjust the lease liability
adjust the right-of-use asset (by the same amount we adjusted the liability).
800 Chapter 16
Example 21: Lease modification ±

scope decreases resulting in partial termination
Entity A (lessee) enters into a lease over two trucks on 1 January 20X1. The lease covers a
4-year non-cancellable period. The lease payments will be C220 000 per annum payable in arrears.
The fair value of each truck is C350 000 (C700 000 for two). The right-to-use the trucks is depreciated
on the straight-line basis over the lease term of 4 years.
At 1 January 20X2, the original lease is amended to include only one truck, effective immediately.
The lease payments will now be C110 000 per annum, in arrears. The remaining lease term remains
unchanged at 3 years (original 4 yrs ± 1 yr).
The fair value of the remaining right-of-use truck on the effective date of modification (1 January 20X2)
is C280 000.
Required: Provide the journal entry that would be required to account for the lease modification.
Solution 21: Lease modification ± scope decreases resulting in partial termination

Comment:
x The scope decreases and causes the partial termination of the contract. Separate adjustments will
thus need to be made both the lease liability and the right-of-use assets, which will thus result in the
recognition of a profit or loss on partial termination.
x We derecognise half of the depreciated right-of-use asset, carrying amount C262 500
(Cost: 350 000 ± AD: 350 000 / 4 x 1)
x We remeasure the lease liability to be C280 000. This is based on the revised lease payments over
the remaining lease term (3 trs) using the revised implicit interest rate of 8,687% (see below)
x The liability balance prior to the modification was C548 784 (W1) and thus the remeasurement to
C280 000 (W2) requires a debit of C268 784 (C548 784 - C280 000).
x Since we reduce the asset by C262 500 and reduce the liability by C268 784, we recognise a gain on
the partial termination of C6 284
x The implicit interest rate in the original contract is 9,826344%
FV = -700 000 N = 4 PMT = 220 000 Comp I = 9,826344%
x The implicit interest rate in the modified contract is 8,687602%
FV = -280 000 N = 3 PMT = 110 000 Comp I = 8,687602%
W1: Effective interest rate table: lease liability ± ORIGINAL CONTRACT

Date Interest (9,826344%) Instalment Liability balance
Beginning of year 1 700 000
End of year 1 68 784 (220 000) 548 784
End of year 2 53 925 (220 000) 382 709
End of year 3 37 606 (220 000) 200 315
End of year 4 19 685 (220 000) 0
180 000 (880 000)
W2: Effective interest rate table: lease liability ± REVISED CONTRACT

Date Interest (8,687602%) Instalment Liability balance
End of year 1 24 325 (110 000) 194 325
End of year 2 16 882 (110 000) 101 207
End of year 3 8 793 (110 000) 0
50 000 (330 000)
Journal

Lease liability (L) 548 784 ± 280 000 268 784
Right-of-use asset: cost (A) 700 000 x 50% 350 000
Right-of-use asset: acc depr (-A) 700 000 / 4yrs x 1yr x 50% 87 500
Gain on partial lease termination 6 284
Modification of a lease that led to partial termination
Chapter 16 801
12. Tax consequences
12.1 Overview

To understand the current and deferred tax consequences of

a lease, we need to first understand the consequences of the x
lease in terms of the tax legislation relevant to the country x ! " # $ % & $
in which the entity operates. " ' ( # $ )
% & $ ( ' % & $ *
12.2 Tax treatment of leases x + # # $ ' ,
* + $
In South Africa, the tax authorities look only to the legal + ' $ $ & # ' ' - + + )
form of the lease and do not consider the substance thereof. ' ' $ ( ' ' $
To this end, the income tax treatment of leases per the South ! # ! * - . / 0 - ' ' ' * )
African Income Tax Act (ITA) is interrelated with the

GHILQLWLRQV RI µLQVWDOPHQW FUHGLW DJUHHPHQW¶ ,&$ DQG

& * + $ - $ 1 2
µUHQWDO DJUHHPHQW¶ LQ WKH South African Value-Added Tax

$ " " #
- + $ $ ' 3 - + " ' -
Act (VAT Act) ± see definitions to the right. ! # ! & * - . / 0
- ' ' ' * 4
5 6 6 7 8 9 : ; < = < > ? @ A B C D B E B > F D ? G H A I J J F K B A L M N
If we have a lease (regardless of recognition approach), we

will need to assess whether it meets: O

x SDUW D RI WKH 9$7 $FW¶V GHILQLWLRQ RI an µLQVWDOPHQW
FUHGLWDJUHHPHQW¶ x
x part (b) of the VAT Act¶VGHILQLWLRQRIµLQVWDOPHQW
$
' # ! & * - . / 0 - ' ' ' 4
FUHGLWDJUHHPHQW¶RU
5 6 6 7 8 9 : ; < = < > ? @ A B C D B E B > F D ? G H A I J J F K B A L M N
x WKH9$7$FW¶VGHILQLWLRQRIDµUHQWDODJUHHPHQW¶
If the lease meets either the definition of a µUHQWDO P Q

R S T
S
Q
U V W
DJUHHPHQW¶ or the definition per µpart (b) of the ICA X Y Z [ Z \ ] Z ^ Z Z X ] X Y Z
GHILQLWLRQ¶ (per the VAT Act), then the tax authorities

_
W V ` V V a ` a W b
Z X
effectively view the asset as still belonging to the lessor and x

` ` a
\ c d Z X \ [ \ e d Z Z ^ Z X f d
merely rented to (borrowed by) the lessee. x

a W
c g \ d X h i j X Y Z k l m f
W V ` V V a ` V `
Z X X Y Z n m o m p X q
As a result, the tax authorities will neither allow the lessee a X Y Z

`
X Y Z [ Z ] ] Z Z
V
] \ ] ] r ^ Z
_
` a
deduction of allowances on the cost of the asset nor will it

_
a a s ` ` b
X X Y Z \ ] ] Z X q \ X Y r ]
allow the deduction of interest on the lease liability. Instead, x t u u v w , ' $ x &
the lessee will only be allowed to deduct the lease payments x y z t { z y z w | , ' $ x & ! x " #
when incurred/ paid (in terms of section 11(a) of the ITA). ' } 0 ~ ' " -
# ! & * - . / 0 - ' ' '
However, if the lease payments paid in cash include a lease $ 4 4 4 *
payment that has been prepaid, then this prepayment will be

allowed as a deduction on the following basis: P Q

R S T
S
Q
U V W
x It relates to lease payments that were due to be paid in

X Y Z [ Z \ ] Z ^ Z Z X ]
x
a W
c g \ d X h \ j X Y Z k l m f
the first 6 months of the following year, or _
Z
W V ` V
X
V a ` V `
X Y Z n m o m p X q
x If then this prepayment is added together with all other X Y Z

`
X Y Z [ Z ] ] Z Z
V
] \ ] ] r ^ Z
_
X
a
prepayments and the total prepayments are less than a s `
X Y Z \ ] ] Z X \
`
_
X Y r ]
b
R100 000, then all prepayments will be allowed as a x

deduction. See South African Tax Act S11(e) and S23H
t u u v w , x & - + +
+ " ' ! 4 4 *
x
If the lease meets the definition per µSDUW D RI WKH ICA
y z t { z y z w | , x & $ ' & ' $ ' & $
' - .
GHILQLWLRQ¶ (per the VAT Act), then tax authority views the asset as belonging to the lessee. In
other words, the tax authority views the asset as having been purchased by the lessee (the
lease agreement is simply financLQJWKHOHVVHH¶s purchase of the asset).
As a result, the tax authority will allow the lessee to deduct an allowance (wear and tear)
based on the cost of the asset (cash value per the VAT act) and will allow the deduction of
finance costs on the lease liability (calculated using the effective interest rate method).
802 Chapter 16
12.3 Accounting for the tax consequences where the lease is accounted for using the
simplified approach
,IWKHOHDVHLVUHFRJQLVHGE\WKHOHVVHHµoff-balance sheet¶LHWKHVLPSOLILHGDSSURDFKWKH

entity does not recognise a right-of-use asset and lease liability but simply recognises the
lease payments as an expense, calculated using the straight-line method (or another systematic
basis). The process of straight-lining the lease payments may lead to the recognition of a lease
payable (liability) or a lease prepayment (asset).
12.3.1 If the tax authority

If the lease is recogniVHGE\WKHOHVVHHµRII-EDODQFHVKHHW¶LHusing the simplified approach),

and the tax authority believes WKHOHDVHPHHWVWKHGHILQLWLRQRIDµUHQWDODJUHHPHQW¶RUWKDWLW
PHHWV µSDUW E RI WKH ,&$ GHILQLWLRQ¶ LH LI the tax authority views the lessee as simply
borrowing/ leasing the asset), then the accounting treatment and tax treatment will be similar.
This is because the accountant will expense the lease payments (simplified approach) and the
tax authority will allow the deduction of the lease payments (although possibly limited by
section 23H in the ITA, if there has been a prepayment of the
lease instalments ± see section 12.2). In other words, both the
Q
S S S

DFFRXQWDQW DQG WD[ DXWKRULWLHV µDJUHH¶ WKDW WKH HQWLW\ GRHV QRW
Q

V ¡

X f ] \
R S
S ¢
have a leased asset or a lease liability. £ ¤ ¥ ¥
v ¦ w w t § ¨ © + # - '
However, there is a slight difference between the accounting

& - x - $ $ ,
x & " 3 ,
treatment and tax treatment described above. The accounting $ # x #
treatment may result in an lease prepayment/ payable in the x + " ,
accounting records due to the straight-lining of the lease ª

$
¥

¥
# ' 4 4 " #
expense: v « v v ¬ w t § ¨ ' / 0
x
- x # # # ' ( # & $
If the straight-lining results in a lease prepaid (asset) or ! ~ ' $ *
payable (liability), deferred tax arises on the resultant temporary difference (the asset/
liability has a carrying amount but its tax base is nil).
x If the straight-lining does not lead to the recognition of a lease prepaid/ payable, then
deferred tax will not arise.
Example 22: Lease under simplified approach ± tax consequences

Abbey Limited entered into a 2-year lease on 1 April 20X1, as the lessee, over a machine
that is considered to be a low-value asset. Abbey chooses to account for the lease of this
asset in terms of the recognition exemption (i.e. using the simplified approach).
x Neither Abbey nor the lessor are registered VAT vendors.
x The following payments are due per the lease agreement:
The first year of the lease: C2 000 per month
The second year of the lease: C3 000 per month
Contingent rent: C1 per unit of output sold, payable at 31 December each year.
x Abbey sold 300 units in the 3 months between 1 January 20X3 to 31 March 20X3, 1 000 units in
20X2 and 1 500 units in 20X1 (1 April ± 31 December 20X1).
Required:
A. Journalise the lease for the years ended 31 December 20X1, 20X2 and 20X3. Ignore tax.
B. Journalise the current tax for the years ended 31 December 20X1, 20X2 and 20X3, assuming the
following additional information:
x Profit before tax and before any of the lease-related journals is C100 000 in all years
x There are no temporary or permanent differences other than those evident in the information.
x The tax authority allows the lease instalments as a deduction when paid.
x The tax rate is 30%.
C. Journalise the deferred tax for the years ended 31 December 20X1, 20X2 and 20X3, assuming the
same information provided above.
Chapter 16 803
Solution 22A: Lease under simplified approach ± journals (tax ignored)

Calculations:
x Total lease payments = (C2 000 x 12 months + C3 000 x 12 months) = C60 000.
x Straight-lining of the lease payments (assumed there was no other systematic basis that was
preferable) = C60 000 ÷ 24 months = C2 500 per month
31/12/20X1 Debit Credit
Low-value lease expense (E) C2 500 x 9 22 500
Lease payable (L) Balancing (originating) 4 500
Bank (A) C2 000 x 9 18 000
Fixed lease payments on low-value asset expensed on the straight-
line method under the recognition exemption
Variable lease payment expense (E) 1 500 x C1 1 500
Bank (A) 1 500
Variable lease payments are expensed
31/12/20X2
Lease payable (L) Balancing (reversing) 3 000
Bank (A) C2 000 x 3 + C3 000 x 9 33 000
Variable lease payment expense (E) 1 000 x C1 1 000
Bank (A) 1 000
31/12/20X3
Lease payable (L) Balancing (reversing) 1 500
Bank (A) C3 000 x 3 9 000
Variable lease payment expense (E) 300 x C1 300
Bank (A) 300
Please note: The journals above have been summarised on an annual basis but the payments are
monthly and thus, in reality, they would have been processed monthly.
Solution 22B: Lease under simplified approach ± current income tax

20X1 20X2 20X3
Journals Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
Income tax expense (E) W1 24 150 19 800 27 210
Current tax payable: income tax (L) (24 150) (19 800) (27 210)
Current income tax for the year
W1: Current income taxation 20X1 20X2 20X2
Profit before tax and before lease expenses 100 000 100 000 100 000
Low-value asset lease expense (22 500) (30 000) (7 500)
Variable lease payment expense (1 500) (1 000) (300)
Profit before tax 76 000 69 000 92 200
Temporary differences - movement:
Add back: Low-value asset lease exp. Per above 22 500 30 000 7 500
Add back: Variable lease payment exp. Per above 1 500 1 000 300
Less: lease instalments paid 20X1: (18 000 + 1 500) (19 500) (34 000) (9 300)
20X2: (33 000 + 1 000)
20X3: (9 000 + 300)
Taxable profit 80 500 66 000 90 700
Current income tax Taxable profit x 30% 24 150 19 800 27 210
Comment: The final profit before tax could have been given instead, in which case we would not have
needed to first deduct the lease expense to calculate profit before tax.
804 Chapter 16
Solution 22C: Lease under simplified approach ± deferred tax

Comment:
x Since the tax authority is treating WKLVOHDVHDVDµUHQWDODJUHHPHQW¶RUDµOHDVHDJUHHPHQW¶DVGHILQHG
LQWKHµSDUWERIWKH,&$GHILQLWLRQ¶LQWKH9$7$FWWKH\simply grant the lease instalments as
deductions when they are paid, and thus there will be no tax base for the lease payable (the payable
arising from having straight-lined the lease payments) that arises in the accounting records.
(Remember that the tax base of a liability is the carrying amount of the liability less the amount
allowed as a deduction in the future. Since the entire carrying amount of the lease payable will be
allowed as a tax deduction in the future, when it is paid, the tax base is nil)
x This example deals with an expense payable and thus a comparison of the carrying amount of the
expense payable and the nil tax base leads to a deferred tax asset.
x Had the lease rentals been prepaid instead, it would have resulted in a deferred tax liability.
20X1 20X2 20X3
Journals Dr/(Cr) Dr/(Cr) Dr/(Cr)
Deferred tax: income tax (A) W1 1 350 (900) (450)
Income tax expense (E) (1 350) 900 450
Deferred income tax arising on the low-value lease payable
W1: Deferred income tax
Carrying Tax Temporary Deferred

Lease payable
amount base difference tax
Balance: 1/1/X1 0 0 0 0
Adjustment (balancing) (4 500) 1 350 Dr DT; Cr TE
Balance: 31/12/X1 (4 500) 0 4 500 1 350 Asset
Adjustment (balancing) 3 000 (900) Cr DT; Dr TE
Balance: 31/12/X2 (1 500) 0 1 500 450 Asset
Adjustment (balancing) 1 500 (450) Cr DT; Dr TE
Balance: 31/12/X3 0 0 0 0
12.3.2 If the tax authority believes the lease meets part (a) of the ICA definition
® ¯ ° ± ² ³ ² ´ µ ³
lessee owns the asset)
,IWKHOHDVHLVUHFRJQLVHGE\WKHOHVVHHµRII-EDODQFHVKHHW¶LHWKHVLPSOLILHGDSSURDFKDQG

the tax authority believes the lease meets the definition of µSDUWaRIWKH,&$GHILQLWLRQ¶LH
the lessee deemed to own the asset), then the accounting treatment and the tax treatment
would differ.
This is because the accountant is expensing the lease payments on the straight-line method,
thus potentially resulting in an lease prepaid/ payable, whereas the tax authority treats the
lessee as being the owner of the asset and will thus allow the lessee to deduct wear and tear
and will allow the lessee to deduct finance costs (using the effective interest rate method).
Thus, since the accountant may have a carrying amount for a lease payable/ prepaid, the tax
bases would be different amounts since they would reflect the future deductions relating to
wear and tear and the future deductions of finance costs. Since the carrying amount and tax
base would differ, temporary differences will arise on which deferred tax must be recognised.
12.4 Accounting for the tax consequences where the lease is accounted for using the
general approach
If the lease is recognised by WKH OHVVHH µRQ-EDODQFH VKHHW¶ LH WKH JHQHUDO DSSURDFK WKH
entity would recognise:
x an asset (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.
Chapter 16 805
12.4.1 If the tax authority believes the lease meets the definition ¶ · ® ¸ ³ ¹ ´ º » º ¼ ¸ ³ ³ ½ ³ ¹ ´ ¯ ¶ ¸
® ¾ º ¸ ´ ° ¿ À ¶ · ´ µ ³ Á Â Ã Ä ³ · ± ¹ ± ´ ± ¶ ¹ ¯ ° ± ² ³ ² ´ µ ³ » ³ Å Å ³ ³ ± Å ¸ ³ ¹ ´ ± ¹ ¼ ´ µ ³ º Å Å ³ ´ À
,I WKH OHDVH LV UHFRJQLVHG E\ WKH OHVVHH µon-balance sheet¶ LH Æ Ç È Ç É Ê Ë Ê Ì Ì É Í Ê Î Ï Ð
the general approach), and the tax authority believes the lease Ñ Ò Ó Ô Õ Ö
Ë Ç Ê × Ç Ø Ù É Í Ú Ê
meets the definition of DµUHQWDODJUHHPHQW¶RUthat it meets µSDUW Û

Ê Ü Ì Ç É × Ì Ç Î
Û Ý Þ
Ç ß
ERIWKH,&$GHILQLWLRQ¶LHit believes that the lessee is simply à á â â ã ä å å æ ç è é ê ë ì í î ï ð ñ ò ó î
borrowing/ leasing the asset), then the accounting treatment and ô õ

ò ñ ð
õ
î é ö é í ò ñ ÷ ÷ ñ ø í ù
the tax treatment will differ.

x
ô õ õ
é ê ê é ú û ù ê ï ð ú ó é î ó ñ ü ý
þ ÿ ÿ ÿ
This is because, whereas the accountant recognises a right-of-use

x

ÿ
asset and a lease liability, the tax authority will only allow the
þ ÿ
deduction of the lease payments, subject to section 23H (ITA) ! ÿ þ " ÿ ÿ
limitations, in the event that there has been a prepayment, (see # # ! ÿ þ "
section 12.2). In other words, the tax authority does not

µUHFRJQLVH¶WKDWWKHHQWLW\KDVDQDVVHWDQGDOHDVHOLDELOLW\
Therefore, the accountant will have a:

x carrying amount for the asset, for which there is a nil tax base (the tax base of an asset
represents the future tax deductions on that asset, and since the tax authority does not
accept that the lessee has an asset, there will be no future tax deductions allowed), and a
x carrying amount for the liability, for which there is a nil tax base (the tax authority does
not accept that the lessee has a liability and will thus not allow the deduction of the
finance costs incurred on the liability).
Since the carrying amounts and tax bases of the right-of-use asset and lease liability differ,
temporary differences arise on which deferred tax will be recognised.
Example 23: Lease under general approach ± tax consequences

Dave Limited leases equipment from Maeve Limited in terms of a 6-year non-cancellable
lease agreement. Details are as follows:
x The commencement date is 1 January 20X5.
x There are 6 instalments of C166 744 each, paid annually in arrears (i.e. on 31 December).
x The present value of the lease payments, discounted at the interest rate implicit in the lease, of 9%,
is C748 000.
x Dave Limited depreciates the right-of-use asset at 25% per annum on the straight-line basis.
The following tax-related information also applies:
x Profit before tax, and before any adjustments relating to the information above, is C800 000;
x There are no differences between accounting profit and taxable profit other than those evident in
the question;
x The local South African tax authority recognises this lease as DµUHQWDODJUHHPHQW¶ in terms of part
ERIWKH GHILQLWLRQRIDQ µLQVWDOPHQWFUHGLWDJUHHPHQW¶LQWKH 6RXWK $IULFDQ9$7 $FW and thus
only allows the lease instalment as a deduction when paid;
x No VAT is included in the lease (Maeve Limited does not charge VAT).
Required:
A. 3UHSDUHWKHMRXUQDOVIRUWKH\HDUHQGHG'HFHPEHU;LQ'DYH/LPLWHG¶VERRNV.
B. Prepare the journals for WKH\HDUHQGHG'HFHPEHU;LQ'DYH/LPLWHG¶VERRNV assuming that
the lease was entered into on 1 March 20X5 (not on 1 January 20X5) and thus that the first
instalment will be payable on 28 February 20X6 (not on 31 December 20X5).
806 Chapter 16
Solution 23: Lease under general approach ± tax consequences

Ex 7A Ex 7B
01/01/20X5 Dr/ (Cr) Dr/ (Cr)
Right-of-use asset: cost (A) 748 000 748 000
Lease liability (L) PV of lease payments (given) (748 000) (748 000)
Right-of-use asset and lease liability recognised on commencement date
31/12/20X5
Lease interest expense (E) A:748 000 x 9% x 12/12 67 320 56 100
Lease liability (L) B: 748 000 x 9% x 10/12 (67 320) (56 100)
Interest payable on the lease to year-end, measured using EIRT (W1)
Lease liability (L) A: Given 166 744 N/A
Bank (A) B: 1st instalment only paid in 20X6 (166 744) N/A
Payment of instalment
Lease liability (L) A: W1: 166 744 58 372
$ 108 372 155 524
Lease liability: current portion (L) B: W1: 166 744 67 320 x 2/12
$ (108 372) (155 524)
Transfer of current portion of liability i.e. the portion of the liability
%
balance at year-end that will be paid within the next 12 months (i.e.
instalments due in next 12 months interest accrued in next 12m)
%
Depreciation ± RoU asset (E) A: 748 000 x 25% x 12/12 187 000 155 833
Right-of-use asset: acc. depr (-A) B: 748 000 x 25% x 10/12 (187 000) (155 833)
Income tax expense (E) W2 189 977 240 000
Current tax payable: income tax (L) (189 977) (240 000)
Current tax payable for the year
Deferred tax: income tax (A) W3 26 273 63 580
Income tax expense (E) (26 273) (63 580)
Deferred tax asset arising on the lease
W1: Effective interest rate table: lease liability

Date Interest (9%) Instalment Liability balance
End of year 1 67 320 (166 744) 648 576
End of year 2 58 372 (166 744) 540 204
End of year 3 48 618 (166 744) 422 078
End of year 4 37 987 (166 744) 293 321
End of year 5 26 399 (166 744) 152 976
End of year 6 13 768 (166 744) 0
252 464 (1 000 464)
W2: Current income taxation Ex 7A Ex 7B

Profit before depreciation and interest on lease Given 800 000 800 000
Depreciation Per jnl (187 000) (155 833)
Interest expense Per jnl (67 320) (56 100)
Profit before tax 545 680 588 067
Temporary differences:
Add back: Per jnl
Depreciation on RoU asset 187 000 155 833
Interest expense Per jnl 67 320 56 100
Less: lease instalment paid A: Given B: 1st instalment not yet paid (166 744) (0)
Taxable profit 633 256 800 000
Current income tax payable Taxable profit x 30% 189 977 240 000
Comment: The profit before tax could have been given after it had been adjusted for the lease
transaction in which case depreciation and finance charges would not still need to be subtracted.
Chapter 16 807
W3.1: Deferred tax ± Part A only

Lease on-balance sheet CA TB TD DT
Balance: 1/1/20X5 0 0 0 0
x Right-of-use asset 0(1) 0(4) 0 0
x Lease liability 0(1) 0(4) 0 0
Adjustment Balancing: 0 26 273 (dr deferred tax, cr tax exp)
$
26 273
Balance: 31/12/20X5 (87 576) 0 87 576 26 273 A
x Right-of-use asset 561 000(2) 0(4) (561 000) (168 300) L
x Lease liability (648 576) (3) 0(5) 648 576 194 573 A
1) CA on 01/01/20X5: Nil: the lease was not in existence at the end of 20X4.
2) CA on 31/12/20X5: Right-of-use asset: cost: 748 000 ± acc depreciation: 187 000 = 561 000
3) CA on 31/12/20X5: Lease liability: from effective interest rate table = 648 576
4) The TB of the asset is the amount allowed as a deduction in the future. This will amount to nil because
SARS EHOLHYHVWKDWWKHOHDVHPHHWVµSDUWERIWKH,&$GHILQLWLRQ¶ZLWKWKHUHVXOWWKDWWKHWD[DXWKRULW\will
not allow any deductions relating to the cost of the asset (SARS does not agree that the entity owns an asset
but rather that it is simply borrowing an asset).
5) The TB of the liability is its CA (648 576) less the amount allowed as a deduction in the future. Since the
tax authority will not deny the entity any of the instalments, the full CA will be allowed as a deduction in
future. Thus, the TB = CA: 648 579 ± Portion of CA allowed as a deduction in future: 648 579 = 0
Note: there were no VAT implications ± to see VAT implications please see example 8.
W3.2: Deferred tax ± Part B only

Lease on-balance sheet CA TB TD DT
Balance: 1/1/20X5 0 0 0 0
x Right-of-use asset 0(1) 0(4) 0 0
x Lease liability 0(1) 0(4) 0 0
Adjustment Balancing: 0 63 580 (dr deferred tax, cr tax exp)
$
63 580
Balance: 31/12/20X5 (211 933) 0 211 933 63 580 A
x Right-of-use asset 592 167(2) 0(4) (592 167) (177 650) L
x Lease liability (804 100) (3) 0(5) 804 100 241 230 A
1) CA on 01/01/20X5: Right-of-use asset & lease liability: Nil: the lease did not exist at the end of 20X4.
2) CA on 31/12/20X5: Right-of-use asset: cost: 748 000 ± acc depreciation: 155 833 = 592 167
3) CA on 31/12/20X5: Lease liability: Because the year-end does not coincide with the annual lease periods,
you cannot pick this figure off directly from effective interest rate table, thus we calculate it: 748 000 +
interest accrued: 67 320 x 10/12 ± instalment paid to date: nil = 804 100
4) The TB of the asset: is the amount deductible in the future. This will amount to nil because SARS believes
that the lease meeWVWKHGHILQLWLRQRIµSDUWERIWKH,&$GHILQLWLRQ¶ZLWKWKHUHVXOWWKDWWKHWD[DXWKRULW\
will not allow any deductions relating to the cost of the asset (SARS does not agree that the entity owns an
asset but rather that it is simply renting an asset).
5) The TB of the liability: is its CA (804 100) less the amount allowed as a deduction in the future. Since the
tax authority allows the deduction of all instalments, the full CA will be deductible and thus the TB is: CA:
804 100 ± Portion of CA allowed as a deduction in future: 804 100 = 0
12.4.2 If the tax authority believes the lease & ' ' ( ) ( * ' + ' , - . - ( - / . / , 0 part (a) of the ICA
definition 1 2 3 4 5 4 6 7 5 8 5 9 9 5 5 : ; < 9 6 7 5 = 9 9 5 6 >
,IWKHOHDVHLVUHFRJQLVHGE\WKHOHVVHHµon-balance sheet¶LHWKHJHQHUDODSSURDFK, and the

tax authority believes the lease meets the definition of µSDUWaRIWKH,&$GHILQLWLRQ¶LH. the
lessee owns the asset), then the accounting treatment and the tax treatment would be similar.
As mentioned above, the entity would recognise:

x an asset, (subsequently depreciated and impaired), and
x a lease liability, on which interest is expensed.
808 Chapter 16
In the case of a lease that meets the definition of part (a) of the ICA definition per the VAT
Act, the tax authority µDJUHHs¶WKDWWKHOHVVHHKDVDQDsset, the cost of which will be allowed as
a tax deduction (i.e. wear and tear) and that the lessee has a liability for the cost of financing
the acquisition of the asset, where these finance costs will be allowed as a tax deduction using
the same effective interest rate method used by the accountant.
Although the carrying amount and tax base have the possibility of being the same, temporary
differences would arise if the rate of the tax deduction (wear and tear) granted by the tax
authority differs from the depreciation rate. This is because the carrying amount of the asset
and the tax base thereof would then differ.
12.5 Accounting for the tax consequences involving transaction taxes (VAT): lease
meets µpart (b) of the ICA¶definition
In South Africa, a lease would be subject to an upfront payment of VAT if the lease meets
certain requirements in the definition of DQµLQVWDOPHQWFUHGLWDJUHHPHQW¶per the VAT Act. If
met, the lessor would be required to charge and pay over VAT on the cash selling price of the
underlying asset at the time of signing the lease contract. While the vendor (lessor) is required
to make an upfront payment of the VAT to the tax authority, the lessor may potentially have
to wait a relatively long time to recover this VAT from the customer (lessee).
Should the lessor be required to make an advance payment of VAT, the lessor can recover
this VAT from the lessee in one of two ways: the lessor may require the lessee to pay the
VAT to the lessor at commencement date, or the lessor may include the VAT in the lease
instalments (the lessee will be paying the VAT to the lessor gradually over the lease term).
If the lessee is a registered vendor for VAT purposes and if it uses the right-of-use asset to
make taxable supplies, the lessee may then be able to immediately claim the entire VAT
amount from the tax authority. This would mean that the right-of-use asset, which is initially
measured at cost, must exclude the VAT. However, if the VAT is not claimable (e.g. if the
lessee is not a VAT vendor or the asset is a motor car, for which VAT is not claimable), then
the right-of-use asset must include the VAT.
@ A B C D @ B E E B F G H I J @
If the lease contract requires the lessee to pay the VAT to the E H K L M B L N B O I P B K G A B
lessor, upfront on commencement date, then the lease Q

B I B K L M L R R K H L F A S H I T
payments and thus the lease liability will not include VAT. U
L M L I F B N A B B G V W
However, if the lessee is not required to pay the VAT to the X

D Y @ Z [ \ ] ^ _ ` a b c d e f g h h i i h g e
lessor upfront, then it means that the lease payments will

d i j k l m h f c n g o p f q p m o h r c d e
g o p f q p m o h s
include VAT and so will the lease liability, (being the

x
k t t h e s
present value of the lease payments). k v h w g o j k l x f i g o p f q p m o h y z
- u
k v f c g o j k l x f i c d e g o p f q p m o h y
Assuming that the tax authorityrecognises the lease as a lease - u
l { v c f o
LQ WHUPV RI µSDUW E RI WKH ,&$ GHILQLWLRQ¶ LW ZRXOG PHDQ x
- f p m f o f e } s
that, when claiming deductions for the lease payments in the

|
k v f c g o j k l
- u
calculation of taxable profit for the year, the lessee would

l { v x e d e p o ~ c p f f c t e p o q h c e t r
- e d e p o f c t e p o q h c e t y w e d e p o j k l
have to be careful to remove the VAT included in these x f i j k l g o p f q p m o h y
payments (otherwise the lessee would effectively be l { v c f o x f i j k l c d e g o p f q p m o h y
-
claiming the VAT as a deduction for income tax purposes
when the VAT had already been claimed back as a VAT input credit). However, if the lessee
was not able to claim the VAT back as a VAT input credit (e.g. the lessee was not registered
as a VAT vendor or the asset is a motor car, for which VAT is not reclaimable), then the
lessee would be allowed to deduct the full lease payment (inclusive of VAT) when calculating
its taxable profits.
When removing the VAT from lease payments, we apply section 23C of the ITA.
Section 23C requires VAT to be removed in proportion to the amounts of the lease payment
relative to the amount of the total lease payments in the lease:
Instalment ? (Total VAT x Instalment / Total instalments)
Chapter 16 809
So far the discussion has served to explain the impact on the calculation of the taxable profit
and thus current income tax if the lease contract includes VAT (and compares the situation
where the lessee is able to claim the VAT back and where the lessee is not able to claim the
VAT back). However, there are also deferred tax consequences.
Let us consider, for example, a lease that includes VAT, (that the lessee can claim back):
x that is recognised by the accountant µRQ-EDODQFHVKHHW¶LHWKHJHQHUDODSSURDFKDQG
x for which the the tax authority allows the deduction of the lease payments (where the tax
authority does not see the lessee as having an asset and liability).
In this example, there will be a:

x Carrying amount for the right-of-use asset but the tax base of this asset will be nil:
The tax base of an asset represents the future deductions that will be granted on that asset.
6LQFH WKLVOHDVHLVUHFRJQLVHG DV DµOHDVH DJUHHPHQW¶SHUWKH ,7$ the tax authority will
only allow the deduction of the lease payments made ± it does not believe the lessee has
acquired an asset and thus it will not allow any deductions relating to that asset (TB = 0).
x Carrying amount for the lease liability but the tax base of this liability will represent only
the VAT included in the carrying amount of the liability:
This is because the tax base of a liability is the portion of the carrying amount that the tax
authority will not allow as a deduction. Since the carrying amount of the lease liability
represents the full lease instalments owing and the tax authority allows the deduction of
the lease instalments paid but does not allow the deduction of the VAT included in the
instalments (because the lessee was able to claim the VAT back as a VAT input credit),
WKHWD[EDVHRIWKHOLDELOLW\UHSUHVHQWVWKH9$7WKDWLVLQFOXGHGLQWKHOLDELOLW\¶VFDUU\LQJ
amount because this will not be allowed as a deduction.
On commencement date, the tax base of the lease liability will be the entire VAT portion.
This tax base then gradually decreases to nil over the lease period, in proportion to the
payments paid.
In summary, in the above example, the impact of the VAT is as follows:
x In the current income tax calculation:
The part of the payment allowed as a deduction by the tax authority is calculated as:
Instalment (Total VAT x Instalment / Total instalments)
?
x In the deferred income tax calculation:

The tax base is calculated as follows:
Total VAT in the lease liability x Remaining instalments / Total instalments
Example 24: Lease under general approach - with VAT (basic)
Braithwaite Limited leases an asset as a lessee.
The lease agreement is for 4 years, and requires annual arrear lease payments of C17 982
(including VAT at 14%). 7KH SUHVHQW YDOXH RI WKH OHDVH SD\PHQWV GLVFRXQWHG DW WKH OHVVHH¶V
incremental borrowing rate of 10% is C57 000. Braithwaite is a VAT vendor and is able to claim the
VAT back as a VAT input credit.
Required:
A. Journalise the initial capitalisation of the right-of-use asset and lease liability.
%&DOFXODWHWKHOHDVHOLDELOLW\¶VWD[EDVHIRUHDFK\HDURIWKHOHDVHWHUP
Solution 24A: Lease under general approach ± with VAT ± initial measurement
Journal: Year 1 Debit Credit
Right-of-use asset: cost (A) 57 000 x 100/114 (excluding VAT) 50 000
VAT receivable (A) VAT input credit claimable 7 000
Lease liability (L) PV of the lease payments (incl VAT) 57 000
Recognising the leased asset, the VAT input asset and the liability
810 Chapter 16
Solution 24B: Lease under general approach ± with VAT ± tax base
&DOFXODWLRQRIWKHOHDVHOLDELOLW\¶VWD[EDVH C
Total VAT at beginning of year 1 57 000 x 14/114 7 000

Movement (1 750)
VAT remaining at end of year 1 [(17 982 x 3 years) / (17 982 x 4 years)] x 7 000 5 250
Movement (1 750)
Movement (1 750)
Movement (1 750)
VAT remaining at end of year 4 [(17 982 x 0 years) / (17 982 x 4 years)] x 7 000 0
Comment:
In the case of a VAT vendor:
x the liability tax base is: (Total instalments still to be paid / total instalments) x VAT
x the true cost of the asset is its cost less the VAT which may be claimed back from the tax authority.
Example 25: Lease under general approach - with VAT

V Limited, which has a 31 December year end, entered into a lease agreement over a
machine on 1 January 20X1, as the lessee:
Finance charges at 10% Payments Liability
01 Jan 20X1 114 000 Incl VAT at 14%
31 Dec 20X1 11 400 (35 964) 89 436
31 Dec 20X2 8 944 (35 964) 62 416
31 Dec 20X3 6 242 (35 964) 32 693
31 Dec 20X4 3 269 (35 964) 0
(143 856)
x The profit before tax is C200 000 after correctly taking the lease into account.
x V Limited depreciates the machine over the lease term.
x There are no other temporary or permanent differences.
Required:
Prepare the current and deferred income tax journals for V Limited for all 4 years.
Solution 25: Lease under general approach - with VAT
Comment:
x Notice how the introduction of VAT now creates a tax base for the liability (W2). Compare this to
example 23 where VAT was ignored and the tax base was therefore nil.
x There are a number of ways in which the tax authority may deal with the VAT. The tax base of
the asset and liability depend entirely on the relevant tax legislation
Journals: 20X1 20X2 20X3 20X4

Dr/ (Cr) Dr/ (Cr) Dr/ (Cr) Dr/ (Cr)
31 December
Income tax expense(E) W1 61 181 60 444 59 633 58 742
Current tax payable: income tax (L) (61 181) (60 444) (59 633) (58 742)
Current income tax payable
Deferred tax: income tax (A) W3 1 181 444 (367) (1 258)

Income tax expense (E) (1 181) (444) 367 1 258
Deferred income tax
Chapter 16 811
W1: Current income tax 20X1 20X2 20X3 20X4
Profit before tax 200 000 200 000 200 000 200 000
Lease interest expense 11 400 8 944 6 242 3 269
Depreciation on right-of-use asset (a) 25 000 25 000 25 000 25 000
Lease payments (b) (32 464) (32 464) (32 464) (32 464)
Taxable profit 203 936 201 480 198 778 195 805
Current tax TP x 30% 61 181 60 444 59 633 58 742
Calculations:
(a) Depreciation: (114 000 x 100 / 114 ± RV: 0) / 4 years x 12/12 = 25 000
(b) Tax deduction: Lease payment ± proportional amount of VAT
= 35 964 ± (114 000 x 14 / 114 x 35 964 / 143 856) = 35 964 ± 3 500 per year = 32 464
W2: Liability tax base working:
1/1/20X1: 114 000 X 14/114 = 14 000

31/12/20X1: [(35 964 X 3) / (35 964 X4)] X 14 000 = 10 500
31/12/20X2: [(35 964 X 2) / (35 964 X4)] X 14 000 = 7 000
31/12/20X3: [(35 964 X 1) / (35 964 X4)] X 14 000 = 3 500
31/12/20X4: [(35 964 X 0) / (35 964 X4)] X 14 000 = 0
W3: Deferred tax CA TB TD DT
Balance: 1/1/20X1 (0) (0) 0 0

x Right-of-use asset 0 0
x Lease liability (0) (0)
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 1 181
Balance: 31/12/20X1 (14 436) (10 500) 3 936 1 181 A
x Right-of-use asset 75 000 0
x Lease liability (89 436) (10 500) W2
Adjustment Jnl: debit deferred tax, credit tax expense NOTE 1 444
Balance: 31/12/20X2 (12 416) (7 000) 5 416 1 625 A
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (367)
Balance: 31/12/20X3 (7 693) (3 500) 4 193 1 258 A
Adjustment Jnl: credit deferred tax, debit tax expense NOTE 1 (1 258)
Balance: 31/12/20X4 0 0 0 0
x Right-of-use asset 0 0
x Lease liability 0 0 W2
Note 1:
The direction and amount of the journal are balancing (DT: opening balance closing balance)
12.6 Accounting for the tax consequences involving transaction taxes (VAT): lease
PHHWVWKHGHILQLWLRQRIDµUHQWDODJUHHPHQW¶
,IWKHOHDVHPHHWVWKHGHILQLWLRQRIDµUHQWDODJUHHPHQW¶WKHlessor would be required to pay

VAT on the lease payments as they are paid (i.e. it is not required to pay the VAT on the
entire lease upfront on commencement date). Each lease payment will be inclusive of VAT
and the lessee will be able to claim the VAT (assuming the lessee uses the underlying right-
of-use asset to make taxable supplies). This would mean that any lease payments claimed by
the lessee as a deduction for income tax purposes must exclude VAT.
812 Chapter 16
VAT will be removed by applying section 23C of the ITA. In this regard, VAT is calculated
by multiplying the instalment (consideration) by 14/114. However, if the VAT is not
claimable, the lease payments claimed by the lessee as a deduction for income tax purposes
will be inclusive of VAT.

Because the lease payments include VAT, the measurement
of the lease liability will be inclusive of VAT.

The deferred tax consequences are better illustrated by way

¡ ¢ £ ¤ ¥ ¦ § ¨ © ª ª « « ª © §
¦ « ¬ ® ¯ ª ¨ ¥ ° © ± ² ¨ ³ ² ¯ ± ª ´ ¥ ¦ §
of an example: consider a lease that includes VAT, (that the © ± ² ¨ ³ ² ¯ ± ª µ
lessee can claim back) and where this lease:

x is recognised by the accountant µRQ-EDODQFH VKHHW¶ LH x
¶ ¶ ª § µ
¸ ª ¹ © ± ¬ ® º ¨ « © ± ² ¨ ³ ² ¯ ± ª » ¼
-
the general approach), and -
·
¸ ¨ ¥ © ± ¬ ® º ¨ « ¥ ¦ § © ± ² ¨ ³ ² ¯ ± ª »
x is treated by the tax authority as DµUHQWDODJUHHPHQW¶

·
® ½ ¸ ¥ ¨ ±
-
x
¨ ² ¯ ¨ ± ¨ § ¿ µ
¸ ¨ ¥ © ± ¬ ®
In this example, there will be a: - ·
® ½ ¸ ¥ ¨ ± º ¨ « ¬ ® © ± ² ¨ ³ ² ¯ ± ª »
-
x Carrying amount for the right-of-use asset (which will
® ½ ¸ ¥ ¨ ± º ¨ « ¬ ® ¥ ¦ § © ± ² ¨ ³ ² ¯ ± ª »
-
exclude the VAT because the VAT was claimable) but
the tax base of this asset will be nil:
Remember that the tax base of an asset represents the future deductions that will be
granted on that asset. Since this lease is reFRJQLVHGDVDµUHQWDODJUHHPHQW¶SHUWKH,7$
the tax authority will only allow the deduction of the lease payments made ± it does not
believe the lessee has an asset and thus it will not allow any deductions relating to that
asset (thus TB = 0).
x Carrying amount for the lease liability (which will include VAT because the lease
payments include VAT) but the tax base of this liability will be nil:
The tax base of the liability will be nil because the tax base of a liability is the portion of
the carrying amount that the tax authority will not allow as a deduction. Since the
carrying amount of the lease liability represents the full lease instalments owing,
inclusive of VAT, and the tax authority will allow the deduction of all the VAT that is
included in lease payments when claiming the lease payments as a deduction in the
calculation of taxable profits, the entire carrying amount of the liability will be deductible
in the future. Thus, the tax base of the liability will be nil (carrying amount less future
deductions = nil).
In summary, in the above example, the impact of the VAT is as follows:

x In the current income tax calculation:
The part of the payment allowed as a deduction by the tax authority is calculated as:
Instalment x 14/114
x In the deferred income tax calculation:
The tax base of both the right-of-use asset and lease liability will still be nil.
13. Presentation and disclosure requirements (IFRS 16.47-60)
13.1 Presentation (IFRS 16.47-50)
13.1.1 Presentation in the statement of financial position
Where there is a lease that has been recognised on-balance sheet (i.e. the general approach),
the statement of financial position will include the right-of-use asset and the lease liability.
Chapter 16 813
The right-of-use asset may be:

x presented separately on the face of this statement; or
x disclosed in the notes to the financial statements, in which case the right-of-use asset must
be included in the line-item of the asset that it would be classified as if it were owned (e.g.
right-of-use asset where the underlying asset is plant would then be included in the
property, plant and equipment line-item). See IFRS 16.47
Exception: A right-of-use asset that meets the definition of investment property must always
be presented in the investment property line-item ± it may never be presented within the right-
of-use assets line-item. See IFRS 16.48
The lease liability may be:

x presented separately on the face of this statement; or
x disclosed in the notes, in which case the notes would need to indicate which line-item/s in
the statement of financial position include the lease liability.
Where there is a lease that has been recognised off-balance sheet (i.e. the simplified approach),
the statement of financial position may include an expense payable or expense prepaid. The
expense payaEOH ZRXOG EH LQFOXGHG LQ WKH µWUDGH DQG RWKHU SD\DEOHV¶ OLQH-item whereas an
H[SHQVHSUHSDLGZRXOGEHLQFOXGHGLQWKHµWUDGHDQGRWKHUUHFHLYDEOHV¶See IAS 1.54 (h) & (k)
Although not a requirement in IFRS 16, the lease liability should be separated into its current
and non-current portions, unless the entity presents its liabilities in order of liquidity. See IAS 1.60
Happy Limited
Statement of financial position (extracts) 20X5 20X4
As at 31 December 20X5 Note C C
ASSETS
Non-current assets
Right-of-use assets 15 xxx xxx
Investment property (if a property is leased, it must be included here) xxx xxx
EQUITY AND LIABILITIES
Non-current liabilities
Non-current portion of lease liability 16 xxx xxx
Current liabilities
Current portion of lease liability 16 xxx xxx
13.1.2 Presentation in the statement of comprehensive income
There are a number of expenses that may arise from the recognition of a lease, whether the
lease was recognised on-balance sheet (general approach) or off-balance sheet (simplified
approach). Although many of these require separate disclosure (see section 13.2), it is only the
expenses arising from a lease recognised on-balance sheet that require separate presentation:
x The lease interest expense must be presented separately from the depreciation on the right-
of-use asset; and
x This lease interest expense must be included in the finance costs line-item and be
presented separately as a component thereof.
Happy Limited
Statement of comprehensive income (extracts) 20X5 20X4
For the year ended 31 December 20X5 Note C C
Profit before finance charges (the depreciation is included here) xxx xxx
Finance charges (the lease interest expense is included here) 3 (xxx) (xxx)
Profit before tax 4 xxx xxx
814 Chapter 16
13.1.3 Presentation in the statement of cash flows

The cash paid when paying a lease payment must be separated into its constituent parts and
presented separately as follows:
x The cash payment that reduces the principal portion of the liability must be presented
under financing activities; and
x The cash payment that represents the interest charged on the liability must be presented in
the section under which interest payments are normally presented (if the entity is a
financial institution, it must present the interest payment under operating activities but in
all other cases, entities may choose between presenting it under operating activities or
financing activities). See IFRs 16.50 and IAS 7.33
Where a lease payment has not been included in the measurement of the lease liability, the
cash payments must be presented under operating activities. This would thus include cash
payments relating to:
x Short-term lease payments that were accounted for off-balance sheet;
x Low-value asset lease payments payments that were accounted for off-balance sheet; and
x Variable lease payments that do not vary in line with an index or rate. See IFRS 16.50 (c)
13.2 Disclosure (IFRS 16.51-60)
The disclosure requirements are extensive and thus only the main aspects are explained in this
text. Obviously, the general principle to apply is to disclose enough information such that the
XVHUVZLOOKDYHDVRXQGEDVLVXSRQZKLFKµWRDVVHVVWKHHIIHFWWKDWOHDVHVKDYHRQWKHILQDQFLDO
SRVLWLRQILQDQFLDOSHUIRUPDQFHDQGFDVKIORZVRIWKHOHVVHH¶ See IFRS 16.51
Lessees must have one single note that discloses all information regarding the lease that is not
already presented elsewhere in the financial statements. Where information has been
presented elsewhere, this note must include the relevant cross-reference so that users can find
this other information easily. See IFRS 16.52
The following items must be presented in this note, which must ideally be in a tabular format:
x Depreciation on the right-of-use asset, by class of asset (e.g. the depreciation on the right-
of-use asset relating to a plant should be presented separately from the depreciation on the
right-of-use asset relating to vehicles)
x Lease interest expense
x Short-term lease expense (recognised in terms of the simplified approach)
x Low-value asset lease expense (recognised in terms of the simplified approach)
x Variable lease payments that were not included in the measurement of the lease liability
(i.e. variable lease payments that do not vary in tandem with an index or rate would be
disclosed here)
x Rent income from subleasing a right-of-use asset
x Total cash outflow for leases
x Additions to right-of-use assets
x The carrying amount of the right-of-use asset at year-end, listed separately by class of
underlying asset. See IFRS 16.53-54
It is important to note that, even if one of the above items (e.g. lease interest) has been
capitalised to another asset, this must still be included in the abovementioned note. See IFRS 16.54
If a right-of-use asset is an investment property, then it will need to comply with the
disclosure requirements in terms of IAS 40 Investment properties. As a result, although
details regarding this lease must be presented in the single lease note, we will not need to
present the following for a right-of-use asset that is an investment property:
x Depreciation on the right-of-use asset
x Rent income earned on sub-leasing the right-of-use asset
x Additions to the right-of-use asset
x The carrying amount of the right-of-use asset at the end of the year. See IFRS 16.56
Chapter 16 815
If the right-of-use asset is measured in terms of the revaluation model, then the lease note
must also include disclosure of the following information required by IAS 16:
x the effective date of the revaluation;
x whether an independent valuer was involved;
x for each revalued class of property, plant and equipment, the carrying amount that would
have been recognised had the assets been carried under the cost model;
x the revaluation surplus, indicating the change for the period and any restrictions on the
distribution of the balance to shareholders. See IFRS 16.57 and IAS 16.77
The lease note PXVW DOVR LQFOXGH D µPDWXULW\ DQDO\VLV¶ IRU DQ\ OHDVH OLDELOLW\. This maturity
analysis must be presented separately from the µPDWXULW\ DQDO\VHV¶ RI RWKHU ILQDQFLDO
liabilities. The maturity analysis must be in accordance with the requirements of IFRS 7
Financial instruments: disclosures, and, in this regard, the analysis must show the remaining
contractual maturities and include a description of how the entity manages the related
liquidity risks. See IFRS 16.58 and IFRS 7.39 &.B11
7KHOHDVHQRWHPXVWDOVRLQFOXGHµDGGLWLRQDOTXDOLWDWLYHDQGTXDQWLWDWLYHLQIRUPDWLRQDERXWLWV
OHDVLQJDFWLYLWLHV¶WKDWDUHQHFHVVDU\WRHQDEOHWKHXVHUVWRDVsess the impact of the leases on
WKH HQWLW\¶V ILQDQFLDO SRVLWLRQ SHUIRUPDQFH DQG FDVK IORZV )RU H[DPSOH, the following
information would typically be considered useful:
x µWKHQDWXUHRIWKHOHVVHH¶VOHDVLQJDFWLYLWLHV
x future cash outflows to which the lessee is potentially exposed that are not reflected in the
measurement of lease liabilities. This includes exposure arising from:
variable lease payments
extension options and termination options
residual value guarantees
x leases not yet commenced to which the lessee is committed.
x restrictions or covenants imposed by leases¶IFRS 16.59 (extract, slightly reworded)
The information to be disclosed regarding the potential future cash flows to which the entity
is exposed as a result of variable lease payments, extension options and termination options
and residual value guarantees (see above) can be found in IFRS 16.B49, B50 and B51
respectively. In this regard, the type of information to be disclosed includes information such
as the reasons for using variable lease payments, their size relative to fixed lease payments,
options to extend a lease that have not been included in the measurement of the lease liability,
the reasons why a lessee has given a residual value guarantee and the amount to which the
lessee is exposed in terms of the residual value risk.
If a short-term lease or a lease over a low-value asset has been accounted for in terms of the
recognition exemption (i.e. the simplified approach), then this fact must be presented.
An example of a typical lease note is presented overleaf:
816 Chapter 16
Happy Limited
Notes to the financial statements (extracts) 20X5 20X4
For the year ended 31 December 20X5 Note C C
3. Lease note
Plant Vehicles Total
3.1 Right-of-use assets C C C
Carrying amount ± beginning of year xxx xxx xxx
Depreciation (xxx) (xxx) (xxx)
Impairments (xxx) (xxx) (xxx)
Additions xxx xxx xxx
Remeasurement due to reassessment of lease payments xxx (xxx) (xxx)
Carrying amount ± end of year xxx xxx xxx
The right-of-use asset relating to vehicles are measured under the cost model but the right-of-use assets
relating to plant are measured under the revaluation model. In this regards, the effective date of the last
revaluatLRQ LV « DQG ZDV SHUIRUPHG E\ YDOXHU ZKR LV «« LQGHSHQGHQW QRW LQGHSHQGHQW RI WKH
entity). Had the right-of-use asset over plant been measured under the cost model, its carrying amount
ZRXOGKDYHEHHQ&««
The revaluation surplus relating to the right-of-XVHDVVHWRYHUSODQW««LQFUHDVHGGHFUHDVHGGXULQJ
WKH \HDU E\ DQ DPRXQW RI &«« DQG QRZ KDV D EDODQFH RI &« RYHU ZKLFK WKHUH DUH « QR
restrictions on the distribution to shareholders/ the following restrictions over the distribution to
sharehoOGHUV«
Undiscounted
amounts
3.2 Maturity analysis of future lease payments C
Due in 20X2 xxx
Due in 20X3 xxx
Due in 20X4 xxx
Due in 20X5 xxx
Total xxx
7KHUHODWHGOLTXLGLW\ULVNVDUHPDQDJHGLQWKHIROORZLQJZD\«
3.3 Income relating to leases C

Rent income from sub-leasing right-of-use assets xxx
3.4 Other expenses relating to leases not included elsewhere in this note C
Lease interest expense (included in the finance cost line-item) xxx
Variable lease payment expense xxx
Short-term lease expense xxx
Low-value asset lease expense xxx
Happy Limited elected to apply the recognition exemption to low-value asset leases relating to
computers and to short-term leases relating to vehicles (the latter is an accounting policy choice applied
to all short-term leases relating to vehicles).
3.5 Total cash outflows relating to leases C

Cash outflows relating to leases (xxx)
Cash inflows from sub-leasing xxx
3.6 Additional qualitative and quantitative information regarding leases

There are a number of leases that have not yet commenced but to which the entity is committed. Details
WKHUHRIDUHDVIROORZV«
Future cash outflows to which the entity is exposed but which have not been included in the
PHDVXUHPHQWRIWKHOHDVHOLDELOLW\LQYROYH«HJDQH[WHQVLRQRSWLRQ7KLVKDVQRWEHHQLQFOXGHGLQ
the measurement of the lease liability on the basis that the entity is not reasonably certain of exercising
this option. The reason why the entity is not reasonably certain it will exercise this option is because
«HJWKHIXWXUHOHDVHVDUHH[SHFWHGWREHZHOODERYHWKHH[SHFWHGPDUNHW-related leases).
Chapter 16 817
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818 Chapter 16
Gripping GAAP Leases: lessor accounting
Chapter 17
Leases: Lessor Accounting
References: IFRS 16 (including any amendments to 1 December 2016)
Contents Page
1. Introduction 820
2. Lease classification 822
Example 1: Lease classification 823
3. Finance Leases 824
3.1 Overview ± basic overview of recognition 84
3.2 Overview ± various defined terms and their measurements 824
3.2.1 Gross investment and net investment in a lease 824
Example 2: Finance lease ± gross investment in the lease 825
3.2.2 Interest rate implicit in the lease 825
Example 3: Finance lease ± implicit interest rate & net investment in the lease 825
3.2.3 Initial direct costs 828
Example 4: Finance lease ± includes initial direct cost 829
3.2.4 Fair value 831
Example 5: Finance lease ± initial recognition journal (basic) 831
3.3 µ0DQXIDFWXUHUGHDOHUOHVVRUV¶YHUVXVµQRQ-PDQXIDFWXUHUGHDOHUOHVVRUV¶ 832
3.3.1 Overview 832
3.3.2 Non-manufacturer/ dealer lessor 833
3.3.3 Manufacturer/ dealer lessor 833
Example 6: Finance lease ± manufacturer/ dealer 834
3.4 Two methods to record a finance lease: gross method or net method 836
3.4.1 Overview 836
3.4.2 If the lessor is a manufacturer or dealer 837
Example 7: Finance lease: lessor is a manufacturer or dealer 837
3.4.3 If the lessor is neither a manufacturer nor a dealer 841
Example 8: Finance lease: lessor is not a manufacturer or dealer 842
3.5 Lease payments receivable in advance or in arrears 845
Example 9: Finance lease: lease payments receivable in advance 845
3.6 Lease payments receivable during the year 847
Example 10: Finance lease ± lease payments receivable during the period 848
3.7 Disclosure of a finance lease 851
3.8 Tax implications of a finance lease 852
Example 11: Deferred tax on a finance lease with no s 23A limitation, VAT ignored 853
Example 12: Deferred tax on a finance lease: s 23A limitation, VAT ignored 855
Example 13: Deferred tax on a finance lease (manuf./ dealer): s 23A limit, VAT ignored 857
4. Operating Leases 860
4.1 Recognition of an operating lease 860
4.2 Measurement of an operating lease 860
Example 14: Operating lease ± recognition and measurement 860
4.3 Tax implications of an operating lease 861
Example 15: Operating lease ± tax implications 862
4.4 Disclosure of an operating lease 864
Example 16: Operating lease ± disclosure 865
5. Lease involving both land and buildings 866
5.1 Separate classification of the elements 866
Example 17: Lease of land and building 867
5.2 How to allocate the lease payments to the separate elements: land and building 867
Example 18: Lease of land and building 868
5.3 Land and buildings that are investment properties 869
6. Change in classification: modifications versus changes in estimates 869
7. Transaction Taxes (e.g. VAT) 871
7.1 The effect of transaction taxes on a finance lease 871
Example 19: Finance lease with transaction taxes (VAT) 871
7.2 The effect of transaction taxes on an operating leDVH 873
7.2.1 Input VAT, s 23C and Interpretation Note 47 873
Example 20: Operating lease with tax and VAT 874
8. Summary 876
Chapter 17 819
1. Introduction
IFRS 16 Leases was issued during 2016 and replaces the
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three related interpretations (IFRIC 4, SIC 15 and SIC 27). X V

Y X V Z X Z
IFRS 16 is only effective for periods beginning on or after x o k j o y i o k o v h i f g o j s j h i t g l u h g t j
1 January 2019, but early application is possible. w k w u i l g j r o x
- f g h i j k l g g l t k o i h i v l p l h j l
Although when a lessee applies IFRS 16, the lease is no - i w f f g h i j k l g g l t w x l g h f o i y
longer classified separately as either a finance lease or ~ { | } ~
operating lease, this has not changed from the perspective of the lessor. In other words, in
terms of IFRS 16, the lessor continues to first classify its leases as either operating or finance
leases, accounting for each of these differently. This is quite interesting because it means that
the method of accounting fURPWKHOHVVHHDQGOHVVRUSHUVSHFWLYHLVQRWDOZD\VµV\PPHWULFDO¶
For instance, a lessor involved in an operating lease agreement continues to recognise the
leased asset in his statement of financial position, and yet, the lessee in this lease agreement
will also recognise this same asset in his statement of financial position (as a right-of-use
asset). This is a contentious area in the new IFRS 16 and was the subject of much debate
leading up to its publication.
Y X V Z X [ \ ] ^ _ [ ` ^ ] a \ e
When a lessor accounts for a lease, it first classifies it as

either an operating or finance lease. It does this by assessing x h v w i f g h v f w g x h g f w k h v w i f g h v f
the substance of the lease, rather than its legal form. When x f r h f v w i l q j f r l g o y r f f w m j l h i
assessing the substance of the lease agreement, we assess h j j l f
whether or not substantially all the risks and rewards of x k w g h x l g o w t w k f o l o i l v r h i y l
ownership transfer from the lessor: k w g v w i j o t l g h f o w i z { | } ~
x if they transfer, then the substance of the agreement is that it is really a sale agreement
in which financing has been provided by the lessor: this is a finance lease; or
x if they do not transfer, then the substance of the agreement is that it is a µtrue lease¶:
this is an operating lease. See IFRS 16.62
Many of the definitions that are relevant when accounting for a lease in the books of a lessee
are the same definitions used when accounting for a lease in the books of a lessor. However,
there are a few definitions that differ slightly and a few extra that are relevant only to lessors.
Some of these are listed below. Please revise all other definitions provided in chapter 16,
being the chapter on lessees.
The following definitions apply only to lessors:

R S T U U W
V X Y X V Z X [ \ ] ^ _ [ ` ^ ] a \ a b ^ a \ ^ c d a c e
x f g h i j k l g j
x j m n j f h i f o h p p q h p p f r l g o j s j h i t g l u h g t j o i v o t l i f h p f w w u i l g j r o x
x w k h i m i t l g p q o i y h j j l f z { | } ~

T U
` X V Y X V Z X [ \ ] ^ _ [ ` ^ ] a \ a b ^ a \ ^ c d a c e

x t w l j i w f f g h i j k l g
x j m n j f h i f o h p p q h p p f r l g o j s j h i t g l u h g t j o i v o t l i f h p f w w u i l g j r o x
x w k h i m i t l g p q o i y
T U
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j j l f z { | }
U
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T

U

d ^ Z Z X Z X X Y X V Z X [ \ ] ^ _ [ ` ^ ] a \ c d ^ Z _ e

x f r l p l h j l x h q l i f j g l v l o h n p l n q h p l j j w g m i t l g h k o i h i v l p l h j l h i t
x h i q m i y m
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h p m l h v v g m o i y f w f r l p l j j w g z { | } ~
d ^ X X Z X X Y X V Z X [ \ ] ^ _ [ ` ^ ] a \
x f r l y g w j j o i l j f l i f o i f r l p l h j l
x t o j v w m i f l t h f f r l o i f l g l j f g h f l o x p o v o f o i f r l p l h j l z { | } ~
820 Chapter 17
U U S T U U W T U W
X V X V X X [ \ ] ^ _ [ ` ^ ] a \ c d ^ ] [ _ _ ^ ^ ` ^ ^ c ^ ^ ` e
h f r l y g w j j o i l j f l i f o i f r l p l h j l h i t
n f r l i l f o i l j f l i f o i f r l p l h j l z { | } ~
The following definition applies to both lessees and lessors but differs slightly from the
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h q l i f j h t l n q h p l j j l l f w h p l j j w g g l p h f o i y f w f r l g o y r f f w m j l h i m i t l g p q o i y h j j l f t m g o i y f r l ° ± ² ³ ±
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x
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· ¸ ¹ ± º » ² ¼ ¶ ± ½ ³ ¾ o i v p m t o i y o i ¿ j m n j f h i v l k o l t x h q l i f j p l j j h i q ° ± ² ³ ± ¸ ½ À ± ½ ¸ Á ± ³
x
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x
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f r l ± ¹ ± µ À ¸ ³ ± » µ ¸ À ± Ã · ² » Ä µ À Å ² ³ ± Ã » ¸ Ã ½ o k f r l p l j j l l o j g l h j w i h n p q v l g f h o i f w l l g v o j l f r h f w x f o w i
x
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f w f l g o i h f l f r l p l h j l
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x
´
È l h j l x h q l i f j h p j w o i v p m t l µ ± ³ ¸ º Ä ² ° Á ² ° Ä ± Æ Ä ² µ ² ½ ± ± ³ x g w o t l t f w f r l p l j j w g
n q f r l p l j j l l
h x h g f q g l p h f l t f w f r l p l j j l l w g
h f r o g t x h g f q m i g l p h f l t f w f r l p l j j w g
f r h f o j k o i h i v o h p p q v h x h n p l w k t o j v r h g y o i y f r l w n p o y h f o w i j m i t l g f r l y m h g h i f l l
x
´
È l h j l x h q l i f j t w ½ Ã o i v p m t l x h q l i f j h p p w v h f l t f w i w i ¿ p l h j l v w x w i l i f j z { | } ~ É Ê Ë Ì Í Î Ï Ë Ð Ñ Ò Ó Ñ Ô Ô Õ
r l g l o j h j p o y r f p q t o k k l g l i f h g o h f o w i w i f r o j t l k o i o f o w i u r l i n l o i y h x x p o l t n q h p l j j l l ¾ j l l v r × Ø z
Some of the other important definitions that you have already covered when studying leases
from the perspective of lessees (chapter 16) are listed below. These definitions are the same
whether we are looking at the lease from the perspective of the lessee or the lessor.
W U W U S
d ^ X X X V X X
d ^ Y X V Z X X [ \ ] ^ _ [ ` ^ ] a \ e
Y X V Z X [ \ ] ^ _ [ ` ^ ] a \ e
x
x
f r l i w i ¿ v h i v l p p h n p l x l g o w t k w g u r o v r f r l p l j j l l r h j f r l
f r l t h f l w i u r o v r h p l j j w g
x
g o y r f f w m j l h i m i t l g p q o i y h j j l f
x f w y l f r l g u o f r x l g o w t j v w l g l t n q h i w x f o w i f w
h s l j h i m i t l g p q o i y h j j l f h h o p h n p l k w g m j l

n q h p l j j l l z { | } ~
l f l i t f r l p l h j l o k f r l p l j j l l o j g l h j w i h n p q v l g f h o i f w
l l g v o j l f r h f w x f o w i
f l g o i h f l f r l p l h j l o k f r l p l j j l l o j g l h j w i h n p q v l g f h o i
i w f f w l l g v o j l f r h f w x f o w i z { | } ~ É Ê Ë Ì Í Î Ï Ë Ð Ù Ô Ù Ï Ô Õ
T U T T W T
d ^ X X Z V X Y [ ` c d ^ b ^ a \ ^ [ \ ] ^ _ [ ` ^ ] a \ e
x f r l g h f l w k o i f l g l j f f r h f v h m j l j f r l ³ Ä ¶ Ã ·
Ú Ú
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x f w n l l Ý m h p f w f r l j m w k
Ú Ú
² Û f r l k h o g h p m l w k f r l m i t l g p q o i y h j j l f x p m j Â Û h i q o i o f o h p t o g l v f v w j f j w k f r l p l j j w g z { | } ~ É Ñ Ò Ó Ñ Ô Ô Ê Ë Ì Í Î Ï Ë Ð Õ
T U
d ^ X Z V Y V Y X V V X X [ \ ] ^ _ [ ` ^ ] a \ e

x h y m h g h i f l l h t l f w f r l p l j j w g
x n q h x h g f q m i g l p h f l t f w f r l p l j j w g
x f r h f f r l h p m l ¾ w g x h g f w k f r l h p m l w k h i m i t l g p q o i y h j j l f h f f r l l i t w k f r l p l h j l
x u o p p n l h f p l h j f h j x l v o k o l t h w m i f z ~ { | } ~
U U T
d ^ V V X X X Z V Y V Y X [ \ ] ^ _ [ ` ^ ] a \ e

x f r h f x w g f o w i w k f r l g l j o t m h p h p m l w k f r l m i t l g p q o i y h j j l f f r l g l h p o j h f o w i w k u r o v r n q f r l p l j j w g
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y m h g h i f l l t j w p l p q n q h x h g f q g l p h f l t f w f r l p l j j w g z { | } ~
V Y X Z Z a ^ ] ^ _ [ ` ^ ] a \ e
x o i v g l l i f h p v w j f j w k w n f h o i o i y h p l h j l
x f r h f u w m p t i w f r h l n l l i o i v m g g l t o k f r l p l h j l r h t i w f n l l i w n f h o i l t
x l v l x f k w g j m v r v w j f j o i v m g g l t n q h h i m k h v f m g l g w g t l h p l g p l j j w g o i v w i i l v f o w i u o f r h k o i h i v l p l h j l z { | } ~
Chapter 17 821
2. Lease Classification (IFRS 16.61-66)
)URPDOHVVRU¶VSHUVSHFWLYHWKHUHDUHWZRW\SHVRIOHDVHV d ^ ¢ X _
x finance leases and

b ^ a \ ^ ] ^ ß ^ ` ] \
x operating leases. ` c
T
Z à Z
`
V
U

d ^

c
X
d
á
^
V

_ ` ^ \ d [ ß d a â ^ ^ ^ `
What differentiates the one type from the other is whether the c a ` \ _ ^ ^ ] e
lease transfers substantially all the risks and rewards of ownership

of the underlying asset. x o k q l j k o i h i v l p l h j l
x o k i w f w x l g h f o i y p l h j l z
If the risks and rewards:

x are transferred from the lessor, the substance of the transaction is a sale rather than a true
lease: a finance lease;
x are not transferred from the lessor to the lessee, the substance of the transaction is a true
lease: an operating lease.
When assessing whether risks and rewards transfer, we must look

ã
k ² ½ ¼ w i l w k f r l j l
WRWKHFRQWUDFW¶Vsubstance rather than its legal form. Guidance as ± ¹ ² ¶ » ° ± ³ h g l l f
to whether risks and rewards are transferred is given in IFRS 16 by

o f o j
way of a list of examples of situations that individually, or in x i w g h p p q h · ¸ ½ ² ½ À ± ° ± ² ³ ± ä
combination, could lead to a lease being classified as a finance å
Ã
´
± æ f r o j p o j f o j i w f
lease: l r h m j f o l z
a) the lease transfers ownership of the asset to the lessee by the

end of the lease term;
b) the lessee has the option to purchase the asset at a price that is expected to be lower than
the fair value at the date the option becomes exercisable, such that it is reasonably
certain, at the inception of the lease, that the option will be exercised;
c) the lease term is for the major part of the economic life of the asset, even if title is not
transferred;
d) at the inception of the lease, the present value of the lease payments amounts to at least
substantially all of the fair value of the asset; and
e) the leased assets are of such a specialised nature that only the lessee can use them
without major modifications. IFRS 16.63 (extract)
Please note that the above list is not exhaustive. Just because a lease agreement is
characterised by some of the elements above does not, therefore, automatically imply that we
are dealing with a finance lease: if it is clear from other features that the lease does not
transfer substantially all risks and rewards incidental to ownership, the lease is classified as an
operating lease. For example, this may be the case if the contract transfers ownership of the
asset at the end of the lease but it will be transferred in exchange for a variable payment that
will be based on its fair value at the end of the lease term. See IFRS 16.65
Besides these examples, the standard gives a few extra indicators that might suggest that a
lease is a finance lease. The indicators suggested are:
a) LIWKHOHVVHHFDQFDQFHOWKHOHDVHWKHOHVVRU¶VORVVHVDVVRFLDWHGZLWKWKHFDQFHOODWLRQDUH
borne by the lessee;
b) if gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
(e.g. in the form of a rent rebate equalling most of the sales proceeds at the end of the
lease);
c) if the lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent. IFRS 16.64 (Extract)
The use of these guidance examples is best illustrated with an example.

822 Chapter 17
Example 1: Lease classification

Company A signs a contract leasing a vehicle to Company B:
x The commencement date is 1 January 20X4 and the lease term is for 4 years.
x The lease payments are C10 000 per annum, payable in arrears.
x There is no option of renewal (of the lease agreement) and no option to purchase.
x The interest rate implicit in the lease is 10%.
x The fair value of the motor at 1 January 20X4 is C31 700.
x The lease does not transfer ownership of the vehicle to Company B.
x The useful life of the vehicle is 5 years.
Required: Discuss whether the lease contract should be classified as a finance or operating lease.
Solution 1: Lease classification

We consider the substance of the scenario by assessing whether the lease transfers substantially all the
risks and rewards of ownership. In this regard, we can look to the examples provided in IFRS 16.63-64
for guidance ± however, it is not an exhaustive list of indicators.
a) Does ownership of the vehicle transfer to the lessee (Co. B) by the end of the lease? No
b) Does the lessee (Co. B) have an option to purchase the vehicle at a price expected to be
No
lower that the fair value at the date the option became exercisable?
c) Is the lease term for the major part of the economic life of the vehicle? Yes
d) At the inception of the lease, does the present value of the lease payments amount to at
Yes
least substantially all of the fair value of the leased asset (i.e. the vehicle)? (W1)
e) Is the vehicle of such a specialised nature that only the lessee (Co. B) can use it, without
No
major modifications?
f) Is there an option to extend the lease for a second period at a rental substantially below
No
market rental?
Conclusion:
On balance, although legal ownership does not transfer, and there is no option to purchase the asset at
the end of the lease term, and not even an option to renew the lease, the lease term is a major part of the
economic life of the vehicle (4yrs / 5 years = 80%) and, at inception of the lease, the present value of
the lease payments amounts to substantially all the fair value of the vehicle (31 698 / 31 700 =99%). It
is thus submitted that the lease transfers substantially all the risks and rewards of ownership and thus
the lease should be classified as a finance lease.
W1: Present value of lease payments relative to fair value at inception
Conclusion: At inception, the present value is C31 698 (W1.1) and the fair value is C31 700 (given)
and thus the present value amounts to substantially all the fair value of the asset.
W1.1: Present value of the future lease payments at inception
Date Amount Paid Present value factor (see W1.2) Present value
31/12/20X4 10 000 0.909091 9 091
31/12/20X5 10 000 0.826446 8 264
31/12/20X6 10 000 0.751315 7 513
31/12/20X7 10 000 0.683013 6 830
31 698

Present value factor = [1/(1+10%)]n «:KHUHQ QXPEHURI\HDUVSHULRGV
The PV of the MLPs could be calculated with a financial calculator instead as follows:
x n = 4 i = 10% PMT = -10 000
x COMP PV ... and your answer should be: 31 698!
Chapter 17 823
3. Finance Leases (IFRS 16.67-80)
3.1 Overview ± basic overview of recognition

When accounting for a finance lease in the books of a lessor, we must remember that the
substance of the lease is that the underlying asset has been sold and that the lessor is providing
financing to the lessee (customer) for this sale. Thus, this asset must be derecognised and the
amount owed to the lessor by the lessee must be recognised as a receivable. See IFRS 16.67
The initial journal entry, in its simplest form, is as follows:
Debit Credit
Lease receivable (DOVRFDOOHGµQet investment in the finance lease¶) xxx
Carrying amount of the underlying asset (e.g. PPE) xxx
Sale of PPE in terms of a finance lease
After this, the lessor earns interest on the receivable over the lease term (because the lessor is
providing finance to the lessee). See IFRS 16.75 This increases the lease receivable as follows:
Debit Credit
Lease receivable (Net investment in the finance lease) xxx
Interest income on finance lease xxx
Interest income earned on finance lease receivable
After this, the lessor receives lease payments from the lessee, decreasing the lease receivable :
Debit Credit
Bank xxx
Receipt of lease payment from lessee reduces the lease receivable
Notice: It may or may not be obvious to you at this ç
stage, but when we account for a finance lease in the

` ] ^ a _ [ ` a ` ^ b ^ a \ ^ £ V
Y X Z Z X Z è é ê ë ì í ë î ï ð ñ ë
books of the lessor, we do not account for depreciation ñ ò ë ð ó ó ë ñ
on the underlying asset (i.e. the asset being leased by

the lessee). This is because, when accounting for a x ô õ ö ÷ ø ù õ ú û õ ÷ ù ù õ ú ü ù ý õ þ õ ö ÿ ü ù õ ý
finance lease, it means that the significant risks and rewards of the underlying asset has, by
definition, been transferred to the lessee with the result that the asset will have been
derecognised IURPWKHOHVVRU¶VERRNVVHHWKHYHU\ILUVWMRXUQDODERYH
3.2 Overview ± various defined terms and their measurements
ë ñ ï ë ó ñ ë ñ ï ñ ò ë
3.2.1 Gross investment and net investment in a lease
ë

ð

ó ë

The receivable (referred to above) is also referred to as the x ú û õ ü ú û õ õ ÷ ù õ
µnet investment in the lease¶ 7KLV µQHW LQYHVWPHQW¶ is a x ÷ ú ú û õ ü ú õ þ õ ù ú þ ÷ ú õ
defined term (see definition alongside) and is essentially the ü ü ö ü ú ü ú û õ õ ÷ ù õ ! " # $ % & ' ( ) * * )
SUHVHQWYDOXHRIWKHµJURVVLQYHVWPHQW in the lease¶

í , ó ó ï ë ó ñ ë ñ ï
7KH WHUP µgross investment in the leasH¶ is yet another

+
ñ ò ë ë ð ó ë

defined term. If we look carefully at this definition, we can

ó . /
0
see that the µgross investment¶ LV WKH WRWDO undiscounted x ú û õ 1 2 3 2 4 þ õ ö õ ü 5 ÷ ô õ ô 6
amount of: ÷ õ ù ù ÿ þ ø ý õ þ ÷ 7 ü ÷ ö õ õ ÷ ù õ 8 ÷ ý
x the future lease payments (remember the definition of x ÷ 6 2 2 2 1 2 1
lease payments includes guaranteed residual values, ÷ ö ö þ ø ü ú ÿ ú û õ õ ù ù ÿ þ ! " # $ % & ' ( ) * * )
amongst other items ± see section 1 for the full definition) plus
x any unguaranteed residual value.
In other words, the gross investment represents the total of the expected gross inflows
(including whatever is left of the asset at the end of the lease term).
824 Chapter 17
Example 2: Finance lease ± gross investment in the lease

Company A (lessor) signs a contract leasing a plant to Company B (lessee):
x Co A classifies the lease as a finance lease.
x The commencement date is 1 January 20X0 and the lease term is 10 years.
x The lease payments receivable by Co A are C33 000 per annum, payable in arrears.
x Co A expects the plant to have a residual value of C110 000 at the end of the lease term.
x Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus there
is a portion of the residual value that is unguaranteed: C44 000.
Required:
Calculate the gross investment in the lease.
Solution 2: Finance lease ± gross investment in the lease
Gross investment:
x Lease payments 396 000
- Fixed lease payments C33 000 x 10 payments 330 000
- Guaranteed residual value Given 66 000
x Unguaranteed residual value Total RV 110 000 Guaranteed RV: 66 000
9 44 000
440 000
3.2.2 Interest rate implicit in the lease

ï

ñ ë í ë ó ñ í ð ñ ë ï ì

ï î ï ñ

: 0
As mentioned above, the net investment is the present x

value of the gross investment.
ú û õ þ ÷ ú õ ÿ 7 ü ú õ þ õ ù ú ú û ÷ ú ö ÷ ø ù õ ù
ú û õ ; <
2 > ú û õ ? @ ÿ 7 ú û õ õ ÷ ù õ ú ù ø ù
When measuring this present value, we discount the gross = A
> ú û õ ? @ ÿ 7 ú û õ ø ø ÷ þ ÷ ú õ õ ý
amounts using the interest rate implicit in the lease (see þ õ ù ü ý ø ÷ 5 ÷ ø õ
definition in section 1). x ú ÿ ô õ õ B ø ÷ ú ÿ ú û õ ù ø ÿ 7 <
2 > ú û õ 7 ÷ ü þ 5 ÷ ø õ ÿ 7 ú û õ ø ý õ þ 6 ü
This implicit interest rate is the rate that makes the: ÷ ù ù õ ú ø ù
x present value of gross investment, (i.e. the PV of the

= A
> ÷ 6 ü ü ú ü ÷ ý ü þ õ ö ú ö ÿ ù ú ù ÿ 7 ú û õ
lease payments and any unguaranteed residual value), õ ù ù ÿ þ ! " # $ % & ' ) * * ) C D E F G D H E H I J K L M N J O P
equal
x the sum of WKHDVVHW¶VIDLUYDOXHSOXVDQ\LQLWLDOGLUHFWFRVWVLQFXUUHGE\WKHOHVVRU
Yet another way of putting it, is the implicit interest rate is the rate that makes:
x the net investment equal
x the sum of the DVVHW¶Vfair value plus any initial direct costs incurred by the lessor.
Example 3: Finance lease ± implicit interest rate & net investment in the lease
This example continues from the previous example. Use the information provided in the
example above, together with the following additional information:
x The carrying amount and fair value of the plant on commencement date is C220 000.
x The initial direct costs incurred by the lessor were nil.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease.
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X0 and show
the journals in the year ended 31 December 20X9 (the last year of the lease) assuming the asset was
returned with a value of C110 000.
E. Show the journals in the year ended 31 December 20X9 assuming that the asset was returned with a
value of C50 000 and thus that the lessee had to contribute cash of C16 000 (remember that the
lessor guaranteed to return the asset with a residual value of C66 000).
Chapter 17 825
Solution 3A: Finance lease ± implicit interest rate

Answer: Implicit interest rate = 12,174776%
Comment:
x The implicit interest rate is the rate that makes the
PV of the lease payments plus the PV of the unguaranteed residual value equal
the fair value of the asset plus any initial direct costs.
x The previous example gave us the lease payments and unguaranteed residual values (C440 000)
whereas this example gave us the fair value (C220 000) and the initial direct costs (C0).
x The carrying amount of the asset is irrelevant when calculating the implicit interest rate. We use
the fair value of the asset instead. In this example, the fair value equalled the carrying amount.
Calculation of the implicit interest rate, using a financial calculator:
PV = fair value + initial direct costs = 220 000 + 0 = -220 000
PMTS = lease payments (excluding guaranteed residual values) (1) = fixed payment = 33 000
N = number of times we receive the amount that we input as being the PMT = 10
FV = guaranteed residual value + unguaranteed residual value (2) = 66 000 + 44 000 = 110 000
Compute i = 12,174776%
(1) The definition of µlease payments¶ includes µguaranteed residual values¶, but we leave this
out of the amount that we µLQSXW¶LQWRWKHFDOFXODWLRQ as the µ307¶.
This is because the PMT that we input into this calculation must be the payment that
occurs in each and every one of the years (33 000): since the µJXDUDQteed residual value¶
will only be received once, at the end of the lease term, this µJXDUDQWHHGUHVLGXDOYDOXH¶is
input as part of the future value amount µ)9¶
(2) The FV represents the future expected value of the underlying asset, whether it be
unguaranteed or guaranteed residual value (i.e. we include 100% of the residual value).
Solution 3B: Finance lease ± net investment in the lease

Answer: Net investment in lease = C220 000
Comment:
x 2QHZD\RIFDOFXODWLQJRXUµQHWLQYHVWPHQW¶LVWRstart with our gross investment, and then present
value this (being the lease payments and the unguaranteed residual values - see prior example 2)
To calculate the present value of the gross investment, we then need to know what the implicit
interest rate is (calculated in the previous example 3A). This calculation is shown below (requires
a financial calculator).
x On the other hand, the implicit interest rate is the rate that makes the net investment equal the sum
of the fair value and any initial direct costs. Thus, there are two ways of calculating our net
investment:
Net investment = FV: 220 000 + initial direct costs: 0 = 220 000
Net investment = Gross investment, discounted at the Implicit interest rate (see calc below)
Alternative calculation of the net investment, using the gross investment and the implicit interest
rate, using a financial calculator:
The NI is the present value of the GI, meaning that it is the PV of the lease payments that are receivable
at the end of every year for 10 years (PMTS = 33 000 and N = 10) plus the PV of the single lease
payment representing the guaranteed lease payment at the end of the 10th year (C66 000) plus the PV pf
the single unguaranteed residual value at the end of the 10th year (C44 000), where the latter two
amounts are input into the calculation as the residual value at the end of the lease term, reflected as the
future value (FV = C66 000 + C44 000 = C110 000).
FV = guaranteed residual values + unguaranteed residual value = 66 000 + 44 000 = 110 000
i = implicit interest rate = Sol 3A = 12,174776%
Compute PV = C220 000
826 Chapter 17
Solution 3C: Finance lease ± initial recognition journal (basic): CA = FV

Comment:
x When initially recognising the finance lease, the lessor derecognises the underlying asset (at its
carrying amount) and recognises a receivable, measured at the µnet investment in the lease¶
x In this case the carrying amount of the asset equalled its fair value (and there were no initial direct
costs), with the result that the credit to derecognise the asset at its carrying amount (220 000)
equalled the recognition of the receivable measured at the net investment of the lease (220 000).
x This meant that there was no profit to be recognised on the initial recognition of the finance lease.
Lease receivable (net investment) (A) W1 220 000
Plant: carrying amount Given 220 000
Initial recognition at commencement date of sale of plant via a FL
Solution 3D: Finance lease ± subsequent measurement journals

Comment:
x After initial recognition of the lease receivable, measured at the NI (i.e. present value of the gross
investment, the latter being the sum of the LPs and Unguaranteed RV), the lease receivable is
measured at amortised cost, thus increased by the interest income, calculated using the effective
interest rate method, and decreased by the payments received.
x This example required you to show the journals relating to the subsequent measurement of the
lease receivable in the first and last year of the lease. The journals in the years in-between would
follow the same format as the two journals shown in the first year of the lease (see below).
31/12/20X0 (first year of lease) Debit Credit

Lease interest income (I) 26 785
Interest income on the FL
Bank Given & W1 33 000
Lease receivable (net investment) (A) 33 000
Lease payment received from the lessee
31/12/20X9 (last year of lease) Debit Credit

Bank Given & W1 33 000
Plant: cost Actual residual value 110 000
Lease receivable (net investment) (A) Given 143 000
Lease payment received from the lessee plus return of the asset
W1: Effective interest rate table Finance income: Lease pmts plus Receivable balance
at 12,174776% unguaranteed RV
1 January 20X0 220 000
31 December 20X0 26 785 (33 000) 213 785
31 December 20X1 26 028 (33 000) 206 812
31 December 20X2 25 179 (33 000) 198 991
31 December 20X3 24 227 (33 000) 190 218
31 December 20X4 23 159 (33 000) 180 377
31 December 20X5 21 960 (33 000) 169 337
31 December 20X6 20 616 (33 000) 156 953
31 December 20X7 19 109 (33 000) 143 062
31 December 20X8 17 417 (33 000) 127 480
31 December 20X9 15 520 (33 000) 110 000
Residual value that is guaranteed (66 000) 44 000
Residual value that is unguaranteed (44 000) 0
220 000 (440 000)
(a) (b) (c)
Chapter 17 827
Notes:
(a) Finance income: the total of this column represents the unearned finance income at the start of the
lease and shows how this income is expected to be earned over the lease period.
(b) Lease pmts & unguaranteed RV (Gross Investment in Finance Lease: GI): the total of this column
represents the gross investment in the lease (the total amounts actually receivable from the lessee)
and shows how we expect to receive them over the lease period. The last payment includes the
cash payment that will be received from the lessee together with the receipt of the asset at the value
guaranteed by the lessee (i.e. at its guaranteed residual value): 33 000 + 66 000 = 99 000, after
which we reflect the portion of the expected residual value that was unguaranteed, of C44 000.
(c) Receivable balance (Net Investment in Finance Lease: NI): This column shows the present value
of the future lease payments (the portion of the principal sum that the lessee (debtor) will owe at
the end of each year of the lease plus the unguaranteed residual value, if any, that the underlying
asset is expected to have at the end of the lease).
Solution 3E: Finance lease ± subsequent measurement journals

Comment:
x If the lessee returns the asset with a value (C50 000) that is less than its guaranteed residual value
(C66 000), the lessee will have to contribute cash to make up the difference between the asset¶V
actual value upon its return and its guaranteed valued (in this case C66 000 ± C50 000 = C16 000).
x Thus, the last lease payment from the lessee will be C49 000, being the sum of the fixed pmt
(C33 000) and the pmt in terms of the residual value guarantee (C66 000 ± C50 000 = C16 000).

Lease receivable (net investment) (A) W1 in Sol 3D 15 520
Bank LP received 33 000 + Receipt in 49 000
terms of RV guarantee: 16 000
Plant: cost Actual residual value 50 000
Lease receivable (net investment) (A) 127 480 + 15 520 (W1) 143 000
Loss on finance lease Unguaranteed RV 44 000
Lease payment received from the lessee plus return of the asset, asset
returned at less than guaranteed RV
3.2.3 Initial direct costs
If the lessor incurs costs to obtain the lease, and if these were incremental costs that would not
have been incurred had the lease not been obtained these would normally EH FDOOHG µinitial
direct costs¶+RZHYHUWKHUHLVDQexception. The exception is that, if these incremental costs
were incurred by a lessor that is a manufacturer or dealer, Q R S T S U V W S X Y Z T Z [ \ T \ ] ^ _
then we would not call them µinitial direct costs¶ because `
_ a b c _
`
] d e
LQLWLDO FRVWV LQFXUUHG E\ µPDQXIDFWXUHU GHDOHU OHVVRUV¶ are

expressly excluded from the definition RI µLQLWLDO GLUHFW x f g h i j k j g l m n h o p l p o q o r l m s g s g t
FRVWV¶VHHGHILQLWLRQDORQJVLGH).
m n j m p j
x l u m l v o w n x g o l u m y j r j j g s g h w i i j x
This distinction between a lessor that is a µmanufacturer/

s q l u j n j m p j u m x g o l r j j g o r l m s g j x z
x
dealer¶ and a lessor that is a µnon-manufacturer/dealer¶ is
{ | } { ~ q o i p w h u h o p l p s g h w i i j x r
m k m g w q m h l w i j i x j m n j i n j p p o i
very important because it determines whether these initial

costs meet the definition of µLQLWLDOGLUHFWFRVWV¶RUQRW
s g i j n m l s o g l o m q s g m g h j n j m p j

If the costs do meet the definition of µLQLWLDO GLUHFW FRVWV¶, then they are taken into account
when calculating our implicit interest rate (look at this definition again) and thus they will
also affect the measurement of our net investment (i.e. our receivable).
If WKHFRVWVGRQRWPHHWWKHµGHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶LHEHFDXVHWKH\ZHUHLQFXUUHG
by a µmanufacturer/ dealer lessor¶), these costs would thus not be included in our implicit
interest rate and would not be included in our net investment. Instead, these µVR-called initial
GLUHFWFRVWV¶, would simply be expensed.
828 Chapter 17
7KH GLIIHUHQWLDWLRQ EHWZHHQ µPDQXIDFWXUHU GHDOHU OHVVRUV¶ DQG µQRQ-manufacturer/dealer

OHVVRUV¶ is covered in more detail in section 3.3. In the meantime, however, it is sufficient to
know that:
x A lessor that is a µmanufacturer or dealer¶ is one who normally sells the underlying asset
in the lease and thus, the substance of the lease is that he is considered to be selling
inventory and providing finance.
x A lessor that is µneither a manufacturer nor dealer¶ is one who does not normally sell the
underlying asset in the lease and thus the substance of the lease is that he is simply
providing finance.
When accounting for the initial direct costs incurred by a µmanufacturer/ dealer OHVVRU¶, the
justification for excluding WKHLQLWLDOFRVWVIURPWKHGHILQLWLRQRIµLQLWLDOGLUHFWFRVWV¶DQGWKXV
excluding it from the calculation of the implicit interest rate and the net investment
(receivable) and expensing it instead, is that, the initial direct costs are considered to be a cost
related to the sale of the goods and should be expensed at the same time that we recognise the
cost of sale expense and sales income.
The following examples assume that the lessor is a µnon-manufacturer/dealer lessor¶
Example 4: Finance lease ± includes initial direct costs

This example uses the same information provided in the previous two examples
(summarised below for your convenience), except we now assume that the initial direct
costs incurred by the lessor (a non-manufacturer/ dealer lessor) were not nil, but were
C10 000 instead:
x Co A (lessor) classifies the lease over a plant as a finance lease.
x The lease term is 10 years.
x Co A expects the plant to have a residual value of C110 000 at the end of the lease term.
Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus there
is a portion of the residual value that is unguaranteed: C44 000.
x The carrying amount and fair value of the plant on commencement date is C220 000.
x The initial direct costs incurred by the lessor were C10 000.
Required:
A. Calculate the interest rate implicit in the lease.
B. Using the implicit interest rate, calculate the net investment in the lease.
C. Journalise the initial recognition of the lease
D. Journalise the subsequent measurement of the lease in the year ended 31 December 20X9 (the
last year of the lease) assuming that the asset was returned at its full residual value of C110 000.
Solution 4A: Finance lease ± implicit interest rate (with initial direct costs)
Answer: Implicit interest rate = 11,267746%
Comment:
x The implicit interest rate is the rate that makes the
x The previous examples (examples 2 and 3) did not involve initial direct costs.
Calculation of the implicit interest rate, using a financial calculator:
PV = fair value + initial direct costs = 220 000 + 10 000 = -230 000
PMTS = lease payments (excluding guaranteed residual values) = fixed payment = 33 000
FV = guaranteed residual value + unguaranteed residual value = 66 000 + 44 000 = 110 000
Compute i = 11,267746%
Chapter 17 829
Solution 4B: Finance lease ± net investment in the lease (with initial direct costs)
Answer: Net investment in lease = C230 000
Comment:
x We can calculate the net investment (NI) by starting with our gross investment (GI), and then
present value this using the implicit interest rate (IRR) of 11,267746% (see solution 4A). Whereas
the implicit interest rate changes from the prior examples (because of the initial direct costs), the
gross investment remains unchanged from the prior examples:
lease payments: C33 000 x 10 fixed payments + C66 000 guaranteed residual value
unguaranteed residual value: C44 000
x However, since the implicit rate is the rate that makes the net investment equal the sum of the fair
value and any initial direct costs, we could simply calculate the NI as this sum. Thus, there are two
ways of calculating our net investment:
Net investment = FV: 220 000 + initial direct costs: 10 000 = 230 000
Net investment = Gross investment, discounted at the implicit interest rate (see calc below)
Alternative calculation of the NI, using the GI and the IRR, using a financial calculator:
i = implicit interest rate = Sol 4A = 11,267746%
Solution 4C: Finance lease ± initial recognition journal (with initial direct costs)
Comment:
x When initially recognising the finance lease, the lessor derecognises the underlying asset (at its
carrying amount) and recognises a receivable, (PHDVXUHGDWWKHµQHWLQYHVWPHQWLQWKHOHDVH¶).
x In this example, the lessor incurred initial direct costs, which are included in the µnet investment in
the lease¶1, The contra entry is bank (or a payable). The initial direct costs are expensed if the
lessor was a manufacturer/ dealer. See section 3.3, dealing with manufacturer/ dealer lessors.

Lease receivable (net investment) (A) Sol 4B 230 000
Bank Given 10 000
Solution 4D: Finance lease ± subsequent measurement journals

Comment:
x After initial recognition of the lease receivable, initially measured at the NI (i.e. present value of
the gross investment, the latter being the sum of the LPs and Unguaranteed RV), the lease
receivable is measured at amortised cost.
x Measurement at amortised cost means that the lease receivable will be increased by the interest
income, calculated using the effective interest rate method, and decreased by the payments
received. The fact that there were initial direct costs incurred by the lessor is simply built into the
implicit interest rate and does not affect any of the principles followed.

Bank W1 33 000
Plant: cost Given 100 000
Lease receivable (net investment) (A) 128 519 + 14 481 (W1) 143 000
Lease payment received from the lessee plus return of the asset
830 Chapter 17
W1: Effective interest rate table Finance income: Lease pmts plus Receivable
at 11,267746% unguaranteed RV balance
1 January 20X0 230 000
31 December 20X0 25 916 (33 000) 222 916
31 December 20X1 25 118 (33 000) 215 033
31 December 20X2 24 229 (33 000) 206 263
31 December 20X3 23 241 (33 000) 196 504
31 December 20X4 22 142 (33 000) 185 646
31 December 20X5 20 918 (33 000) 173 564
31 December 20X6 19 557 (33 000) 160 120
31 December 20X7 18 042 (33 000) 145 162
31 December 20X8 16 357 (33 000) 128 519
31 December 20X9 14 481 (33 000) 110 000
220 000 (440 000)
Notes: (a) (b) (c)
(b) Lease pmts + Unguaranteed RV: this column represents the gross investment in the lease (GI)
(c) Receivable balance: this column represents the net investment in the lease (NI). In other words,
this column shows the present value of the future lease payments (the portion of the principal sum
that the lessee (debtor) will owe at the end of each year of the lease plus the unguaranteed residual
value, if any, that the underlying asset is expected to have at the end of the lease.
3.2.4 Fair value
When calculating the implicit interest rate and the net investment in the lease, we have used
WKHWHUPµIDLUYDOXH¶
When using the term µIDLUYDOXH¶ in context of IFRS 16 Leases, we do not apply IFRS 13 Fair
value measurement. Instead, fair value for the purposes of IFRS 16 is simply µthe amount for
which an asset could be exchanged or a liability settled, between knowledgeable, willing
parties in an arm¶VOHQJWKWUDQVDFWLRQ¶. See IFRS 16.App A & IFRS 13.6
If the fair value of the underlying asset does not equal its carrying amount at commencement
date, then a profit or loss will arise on commencement of the lease. How we account for this
profit depends on whether the lessor is a µmanufacturer/dealer lessor¶ or a µnon-
manufacturer/dealer lessor¶. Manufacturer/dealer lessors are explained in section 3.3.
The following example assumes the lessor is a non-manufacturer/dealer lessor.
Example 5: Finance lease ± initial recognition journal (basic)

This example follows on from the prior example ± there is no new information except that
the fair value on commencement date is C244 200 and not C220 000.
Required:
Show the journalVWRDFFRXQWIRUWKHILQDQFHOHDVHLQWKHOHVVRU¶VJHQHUDOMRXUQDOIRUWKH\HDUHQGHG
December 20X0.
Solution 5: Finance lease ± LQLWLDOUHFRJQLWLRQMRXUQDO&$)9ZLWKGLUHFWFRVWV

Comment:
x The fair value on commencement date is C244 200 and thus does not equal the carrying amount of
the asset. This has no impact on the gross investment (the lease payments and unguaranteed
residual value remain unchanged). It does, however, affect the calculation of the implicit interest
rate and net investment.
Chapter 17 831
x The implicit interest rate in this example is now 9,301512% (W1)

This is because the implicit interest rate is the rate that makes the
The previous examples (examples 2, 3 and 4) involved a different fair value.
x Net investment in lease in this example is now C254 200 (W2)
Remember, this net investment can be calculated in one of two ways:
Net investment = FV: 244 200 + initial direct costs: 10 000 = 254 200
Net investment = Gross investment, discounted at the implicit interest rate (see W2 below)
Journals
Lease receivable (net investment) (A) W2 or: 244 200 + 10 000 254 200
Bank Given: initial direct costs 10 000
Profit on finance lease commencement 24 200
Lease receivable (net investment) (A) 254 200 x 9,301512% 23 644
Bank Given 33 000
W1: Implicit interest rate, calculated using a financial calculator:
PV = fair value + initial direct costs = 244 200 + 10 000 = -254 200
Compute i = 9,301512%
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
i = implicit interest rate = W1 = 9,301512%
3.3 µ0anufacturer/ dealer OHVVRUV¶YHUVXVµQRQ-PDQXIDFWXUHUGHDOHUOHVVRUV¶
3.3.1 Overview
The essential dLIIHUHQFH EHWZHHQ D µPDQXIDFWXUHUGHDOHU OHVVRU¶ DQG D µQRQ-manufacturer
GHDOHUOHVVRU¶FDQEHVXPPHGXSDVIROORZV
x A lessor that is a µmanufacturer or dealer¶ is one who normally sells the underlying asset
in the lease and thus, the substance of the lease is that he is considered to be selling
inventory and providing finance.
x A lessor that is µneither a manufacturer nor dealer¶ is one who does not normally sell the
underlying asset in the lease and thus the substance of the lease is that he is simply
providing finance.
Assessing whether a lessor is a µmanufacturer or dealer¶ or a µQRQ-manufacturer/dealer¶ is
important because it has a direct impact on how we account for the initial recognition of the
lease and it also affects the measurement of the lease because it will affect whether the initial
direct costs are expensed or included in the calculation of the implicit interest rate and net
investment in the lease (i.e. whether they are capitalised to the receivable.
832 Chapter 17
The previous examples have all been prepared on the assumption that the lessor was a non-
PDQXIDFWXUHUGHDOHUOHVVRU¶
3.3.2 Non-manufacturer/ dealer lessor
If the lessor is not D PDQXIDFWXUHU GHDOHU WKHQ LW PHDQV WKDW WKH OHVVRU¶V QRUPDO RSHUDWLQJ
activities do not revolve around dealing in (selling) goods that he has manufactured or
SXUFKDVHG,QWKLVFDVHLWPHDQVWKDWWKHDVVHWWKDWWKHOHVVRUµVROG¶XQGHUWKHILQDQFHOHDVH
will not be inventory. Instead, the asset would be, for example, an item of property, plant and
equipment. Thus, if the carrying amount of the underlying asset and the receivable differ, then
we would simply account for this difference as a profit or loss on sale of the asset (e.g. if a
UHFHLYDEOHH[FHHGVWKHDVVHW¶VFDUU\LQJDPRXQWWKHQZHZRXOGUHFRJQLVHDSURILWRQVDOe):
Debit Credit
Carrying amount of the underlying asset (e.g. PPE) xxx
Profit on sale of asset (e.g. PPE) xxx
Sale of PPE in terms of a finance lease at a profit
Thus, a finance lease from the perspective of a lessor who is neither a manufacturer nor
dealer, is regarded simply as the sale of an asset (other than inventory) where financing has
been provided to the lessee to facilitate the sale. Thus, although a profit or loss may arise on
the initial recognition of the lease, the only other lease income recognised is interest income.
The other aspect to remember (explained in section 3.2.3 and example 4) is that, if the lessor
is neither a manufacturer nor dealer, any incremental costs incurred in obtaining the lease will
PHHW WKH GHILQLWLRQ RI µLQLWLDO direct costV¶ 6LQFH µLQLWLDO GLUHFW FRVWV¶ DUH LQFOXGHG LQ WKH
definition of how we FDOFXODWHGWKHµLPSOLFLWLQWHUHVWUDWH¶these costs will be included in the
measurement of the µQHWLQYHVWPHQWLQWKHOHDVH¶WKHUHFHLYDEOH. Thus, this will also have an
effect on the measurement of the interest income thereafter (since the interest income on the
lease is measured by applying the implicit interest rate to the receivable balance).
3.3.3 Manufacturer/ dealer lessor
If lessor is a manufacturer/ dealer, it means that his normal operating activities revolve around
dealing in (selling) goods that he has either manufactured or purchased. This would mean that
WKHDVVHWµVROG¶XQGHUWKHILQDQFHOHDVHLVinventory. ¡ ¢ ¡ £ ¤ ¥ ¤ ¢ ¦ ¤ §
¨ © ª « ¬ « ¬ « ® ® ¯ °
When we derecognise the asset (inventory), it thus also

x
means that we must recognise a cost of sales expense. ± ² ³ ´ ³ µ ¶ · ³ ¸ ¹ ¶ º » º ¼ ½ » ³ ¾ » º ¿
- À Á Â Ã Ä Å Æ Ç Á Ç È É Á Ç È Å Ê Æ Å Ë Á À Á Ç Ë Æ Å Â Ã Ì Á
x
The cost of sales expense must be measured at: ± ² µ Í ¹ ³ ´ ³ µ ¶ · ³ ¸ ¹ ¶ º » º ¼ ½ » ³ ¾ » º ¿
-
x cost of the underlying asset (or carrying amount if À Á Â Ã Ä Å Æ Ç Á Ã Å É Î Æ Å Ë Á À Á Ç Ë Æ Å Â Ã Ì Á
different to cost)
x less the present value of any unguaranteed residual value. See IFRS 16.71(b)
It also means that we must recognise revenue on the sale. The revenue from the inventory
sold in terms of a finance lease must be measured at:
x the lower of the fair value of the underlying asset or
x the present value of the lease payments, discounted at a market interest rate. See IFRS 16.71(b)
2QHRWKHUDVSHFWWRUHPHPEHULVWKDWLIWKHOHVVRULVDµPDQXIDFWXUHUGHDOHUOHVVRU¶WKHLQLWLDO
incremental costs that it incurs at the time of obtaining the lease are expressly excluded from
WKHGHILQLWLRQRIµinitial direct costs¶7KLVPHDQVWKDWWKHVHFRVWVZLOOnot be included in the
calculation of the implicit interest rate and will not be included in the net investment (i.e. will
not be capitalised to the receivable). Instead, these initial costs must be expensed. This was
explained in section 3.2.3. See IFRS 16.App A
Chapter 17 833
In summary, a finance lease from the perspective of a lessor who is a manufacturer or dealer,
is actually regarded as a sale of inventory where financing has been provided to the lessee to
facilitate the sale. Thus, the lessor recognises revenue from sales (sales income) as well as the
interest income on such a lease, and of course, it also recognises the cost of sales expense and
initial incremental costs incurred at the commencement of the lease.
Example 6: Finance lease ± manufacturer/ dealer
This example follows on from the prior example ± there is no new information except that
the lessor is a manufacturer/ dealer. The example is repeated below for your convenience:
x Co A (lessor) classifies the lease over inventory as a finance lease.
x The lease term is 10 years.
x Co A expects the inventory to have a residual value of C110 000 at the end of the lease
term. Co B (lessee) has guaranteed the asset will have a residual value of C66 000 (thus
there is a portion of the residual value that is unguaranteed: C44 000.
x The carrying amount of the inventory on commencement date is C220 000 (cost).
x The fair value of the inventory on commencement date is C244 200.
x The initial direct costs incurred by the lessor were C10 000.
Required: Journalise WKHILQDQFHOHDVHLQWKHOHVVRU¶Vrecords for the year ended 31 December 20X0.
Solution 6: Finance lease ± manufacturer/ dealer

Comment:
x The fair value on commencement date is C244 200 and thus does not equal the carrying amount of
the asset. This has no impact on the gross investment (the lease payments and unguaranteed
residual value remain unchanged). It does, however, affect the calculation of the implicit interest
rate and net investment.
x The lessor in this example is a manufacturer/ dealer and thus:
the fact that the fair value of the asset exceeds the carrying amount (cost) of the asset will be
recognised as a gross profit by recognising revenue and a cost of sale (compare this to
example 5 where the profit was recognised as a net profit on sale of an item of PPE).
the initial direct costs are expensed because they are excluded from WKH GHILQLWLRQ RI µLQLWLDO
GLUHFWFRVWV¶DQd are thus excluded from the calculation of the implicit interest rate and thus
excluded from the net investment (receivable).
The cost of sale is measured at the carrying amount of the underlying asset less the present
value of the unguaranteed residual value. This present value cannot be expensed because it
has been capitalised to the lease receivable (PV of lease payments + PV of unguaranteed
residual value). (W3)
The revenue from the sale is measured at the lower of the fair value (C244 200) and the
present value of the lease payments (C227 356) (W4)
x The implicit interest rate in this example is now 10,078261% (W1)
x Net investment in lease in this example is now C244 200
Remember, this net investment can be calculated in one of two ways:
Net investment = FV: 244 200 + initial direct costs: 0 (N/A) = 244 200
Net investment = Gross investment, discounted at the implicit interest rate (W2)
Journals
Initial direct cost expense (E) Given 10 000
Bank Given: initial direct costs 10 000
Lease receivable (net investment) (A) FV: 244 200 or see W2 244 200
Cost of sales W3: CA: 220 000 PV of the
Ï 203 156
URV: 16 844 (W3)
Inventory Given 220 000
Revenue Lower of FV: 244 200 and the 227 356
PV of the LPs: 227 356
Initial recognition at commencement date of sale of inventory via a FL
for a manufacturer/dealer
834 Chapter 17
Lease receivable (net investment) (A) 244 200 x 10,078261% or W5 24 611

Bank Given 33 000
W1: Implicit interest rate, calculated using a financial calculator:
PV = fair value + initial direct costs (N/A) = 244 200 + 0 = -244 200
Compute i = 10,078261%
W2: Net investment: alternative calculation using GI and IIR, and using a financial calculator:
W3: PV of unguaranteed residual value, calculated using a financial calculator:
FV = unguaranteed residual value (given) = 44 000
N = the period at the end of which we will receive the future value = 10
W4: PV of lease payments, calculated using a financial calculator:
FV = guaranteed residual value = 66 000
W5: Effective interest rate table Finance income: Lease pmts plus Receivable balance
at 10,078261% unguaranteed RV
1 January 20X0 244 200
31 December 20X0 24 611 (33 000) 235 811
31 December 20X1 23 766 (33 000) 226 577
31 December 20X2 22 835 (33 000) 216 412
31 December 20X3 21 811 (33 000) 205 222
31 December 20X4 20 683 (33 000) 192 905
31 December 20X5 19 441 (33 000) 179 347
31 December 20X6 18 075 (33 000) 164 422
31 December 20X7 16 571 (33 000) 147 993
31 December 20X8 14 915 (33 000) 129 908
31 December 20X9 13 092 (33 000) 110 000
220 000 (440 000)
Notes: (a) (b) (c)
(b) Lease pmts + Unguaranteed RV: this column represents the gross investment in the lease (GI)
(c) Receivable balance: this column represents the net investment in the lease (NI). In other words,
this column shows the present value of the future lease payments (the portion of the principal sum
that the lessee (debtor) will owe at the end of each year of the lease plus the unguaranteed residual
value, if any, that the underlying asset is expected to have at the end of the lease.
Chapter 17 835
3.4 Two methods to record a finance lease: gross method or net method
3.4.1 Overview
There are two methods whereby a lessor can record a finance lease:
x the gross method or
x the net method.
An entity may choose which method it wishes to adopt. All prior examples have used the net
method because they are perhaps simpler to visualise, but the gross method provides more
detail, which becomes useful when preparing the disclosure (see section 3.7).
If the gross method is adopted, then we use two accounts to reflect the carrying amount of
our receivable asset (net investment in lease):
x 7KH µgross investment in lease¶ DFFRXQW (GI account): This
Ñ Ò Ó Ô Õ Ö × × Ø Ù Ú Û Ö Ü
Ó Þ ß à á â ã Ó ã ä Ò Ó
account has a debit balance and reflects the gross investment in å æ ç è æ é æ ê æ ë ì ç í å æ
the investment, measured at the sum of the undiscounted: í î ï è ë ð ñ ò ó ô ç ê ê ô ï ð ò è õ
lease payments (see previous definitions), plus the x

ë ð ì æ è ò ú æ ð ò
unguaranteed residual value (see previous definitions).

ö ÷ ø ù ù
ç ê ê ô ï ð ò û ü ý þ û ÿ þ ç ð ç ð
This gross investment account is then decreased over the lease x

ï ð æ ç é ð æ ë ð ç ð ê æ ë ð ê ô ú æ
ç ê ê ô ï ð ò û ý þ û ÿ þ
term by the lease payments received (including the guaranteed

residual value) and then by any unguaranteed residual value.
x The µunearned finance income¶ account (UFI account):
This account has a credit balance and is set-off against the µgross investment account¶ so
that our net lease receivable to be presented the statement of financial position is
PHDVXUHGDWDQDPRXQWHTXDOWRWKHµnet investment in the lease¶ (GI ± UFI = NI).
This UFI account is amortised to profit or loss as interest income over the lease term (i.e.
the UFI account is decreased over the lease term by the interest income earned).
The balance on this account, at any one point in time, can also be measured by subtracting
from the EDODQFH LQ WKH µJURVV LQYHVWPHQW LQ lease¶ account the µQHW LQYHVWPHQW LQ WKH
OHDVH¶i.e. PV of the lease payments + PV of the unguaranteed residual value, discounted
at the implicit interest rate).
If the net method is adopted, then we only use one account to reflect the carrying amount of
our receivable (net investment in lease):

Ó Þ ß à á â ã Ó ã ä Ò Ó
x 7KHµlease receivable¶ account (net investment in the lease¶).

Ý
å æ ç è æ é æ ê æ ë ì ç í å æ
This account is measured at the present value (discounted at í î ï è ë ð ñ ô ð æ ç ê ê ô ï ð ò
the interest rate implicit in the lease) of the: x

ë ð ì æ è ò ú æ ð ò û ý þ
lease payments (a defined term); plus the

æ é æ ý ü ý ý
unguaranteed residual value.

7KLV OHDVH UHFHLYDEOH DFFRXQW RU µQHWLQYHVWPHQW LQ OHDVH¶ DFFRXQW equals the µgross
investment in the lease¶ less the µunearned finance income¶:
Receivable = NI = GI ± UFI.
This receivable account (net investment account) is adjusted over the lease term as follows:
Increased by interest income earned (debit the lease receivable account), and
Decreased by lease payments received and by any unguaranteed residual value (credit
the lease receivable account).
The choice of method obviously involves different journal entries, however, under both
methods the overall effect on the assets, liabilities and income will be the same and the
disclosure requirements will be the same.
We will now illustrate the difference between these two methods for a lessor that is a µnon-
manufacturer/ dealer¶ and then for a lessor that is a µmanufacturer dealer¶
836 Chapter 17
3.4.2 If the lessor is a manufacturer or dealer
As was explained previously, lessors who are manufacturers or dealers that are offering
finance leases are effectively offering financed sales as opposed to cash sales. Since the
finance lease is considered to be a sale that has been financed, our journals must account for
the sale, cost of sale, interest income and the receipt of the lease payments.
Using the gross method:
Jnl 1. Dr Finance lease receivable: gross investment (LPs and URVs receivable)
Cr Finance lease receivable: unearned finance income
Cr Sales revenue
Jnl 2. Dr Cost of sales
Cr Inventory
Jnl 3. Dr Bank
Cr Finance lease receivable: gross invest. (LPs received)
Jnl 4. Dr Finance lease receivable: unearned finance income
Cr Finance income (interest income earned)
Using the net method:
Jnl 1. Dr Finance lease receivable: net investment (PV of GI)
Cr Sales revenue
Jnl 2. Dr Cost of sales
Cr Inventory
Jnl 3. Dr Bank
Cr Finance lease receivable: net investment
Jnl 4. Dr Finance lease receivable: net investment
Cr Finance income (interest income earned)
Just as a reminder, when accounting for a finance lease in the books of a manufacturer/dealer,
the key items are measured as follows:
x sales revenue:
is measured at the lower of (a) the fair value of the asset or (b) the present value of the
lease payments, computed using a market interest rate;
x interest income:
should be measured at (a) the rate implicit in the agreement, (or (b) the market interest
rate if the present value of the lease payments is less than the fair value of the asset
sold), multiplied by the cash sales price of the asset sold;
x any costs incurred in securing or negotiating the lease (initial direct costs):
are simply expensed at the time that the sales revenue is recognised.
Example 7: Finance lease: lessor is a manufacturer or dealer

Lemon Tree Limited is a dealer in machines, which it sells for cash or under a finance lease.
Lemon Tree sold only one machine (purchased on 1 January 20X1 for C250 000), in 20X1.
The machine was sold under a finance lease (cash sales price: C320 000), the terms of which were:
x commencement date: 1 January 20X1
x lease period: 5 years
x lease instalments: C100 000, annually in arrears, payable on 31 December of each year.
The implicit interest and market interest rate applicable is 16,9911%.
Required: Prepare Lemon Tree's journals for each of the years ended 31 December 20X1 to 20X5:
A. Using the gross method.
B. Using the net method.
C. Prepare Lemon 7UHH/LPLWHG¶V disclosure for the year ended 31 December 20X1.
Ignore tax and, when doing disclosure, ignore comparatives too.
Chapter 17 837
Solution 7: Finance lease: lessor is a manufacturer or dealer

Comment: &DOFXODWHLQWHUHVWRQSULRU\HDU¶Vreceivable¶VEDODQFHLILPs are in arrears & coincide with year-end.
W1: Analysis of total amount receivable C

Total future lease payments 100 000 x 5 years 500 000
Guaranteed residual value Not applicable in this example 0
Gross investment (GI) 500 000
Selling price (net investment) Lower of FV & PV of lease payments, both 320 000) 320 000
Gross profit 320 000 250 000 70 000
Cost of asset Given 250 000
Finance income 500 000 320 000

180 000
W2: Effective interest rate method Finance income: Lease pmts plus Receivable
16.9911% unguaranteed RV balance
01 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
Notes: (a) (b) (c)
(a) Finance income: The total of this column represents the unearned finance income (UFI) at the start of the
lease and shows how this income is expected to be earned over the lease term.
(b) Lease pmts and unguaranteed residual value, at gross amounts (GI in finance lease): The total of this column
represents the gross investment in the lease (the total amounts receivable from the lessee) and shows how we
expect to receive them over the lease period.
(c) Receivables balance (NI in finance lease): This column shows the present value of the future lease payments
and the present value of the unguaranteed residual value, if any (nil in this case).
Solution 7A: Journal entries (Gross method)

Inventory (A) 250 000
Bank 250 000
Purchase of inventory
Cost of sale (E) 250 000
Cost of machine (inventory) sold under finance lease
Finance lease receivable: gross investment (A) W1 500 000
Finance lease receivable: unearned finance income (-A) W1 180 000
Sale (I) W1 320 000
Finance lease entered into, cash sales price of C320 000 and 5 years of
arrear lease payments of C100 000 each
31/12/20X1
Bank 100 000
Finance lease receivable: gross investment (A) 100 000
Lease payment received under finance lease
Finance lease receivable: unearned finance income (-A) W2: EIRT 54 372
Lease finance income (I) 54 372
Interest income earned at 16.9911% , (using an effective int. rate table)
31/12/20X2
Bank 100 000
838 Chapter 17
31/12/20X1 FRQWLQXHG« Debit Credit

31/12/20X3
Bank (A) 100 000
31/12/20X4
Bank (A) 100 000
31/12/20X5
Bank (A) 100 000
Solution 7B: Journal entries (Net method)

Bank 250 000
Cost of machine (inventory) sold under finance lease
Finance lease receivable: net investment (A) W1: (500 000 180 000)
320 000
Sale (I) 320 000
Finance lease entered into, cash sales price of C320 000 and 5 years of
arrear lease payments of C100 000 each
31/12/20X1
Bank 100 000
Finance lease receivable: net investment (A) (A) 100 000
Finance lease receivable: net investment (A) W2: EIRT 54 372
31/12/20X2
Bank 100 000
Finance lease receivable: net investment (A) 100 000
Chapter 17 839
;FRQWLQXHG« Debit Credit

31/12/20X3
Bank 100 000
31/12/20X4
Bank 100 000
31/12/20X5
Bank 100 000
Solution 7C: Disclosure
Lemon Tree Limited

Statement of financial position
as at 31 December 20X1
20X1
Non-current assets Notes C
Finance lease receivable 41 220 990
Current assets
Finance lease receivable LP due next year: 100 000 future interest
41 53 382
income included in this LP: 46 618
Lemon Tree Limited

Notes to the financial statements (extracts)
For the year ended 31 December 20X1
20X0
28. Profit before tax C
Profit before tax has been stated after taking into account the following separately
disclosable items:
x Profit or loss on sale of asset under a finance lease (if manufacturer/ dealer) 70 000
x Finance income on net investment in lease 54 372
x Income from variable lease payments that do not depend on an index or rate 0
Other lease payments 0
840 Chapter 17
Lemon Tree Limited

Notes to the financial statements (extracts) FRQWLQXHG«
Gross investment Unearned Net
40. Maturity analysis of future lease payments (undiscounted) finance investment
receivable (undiscounted amounts) C charges (discounted)
C C
Future lease payments expected to be received (at
undiscounted amounts):
in 20X2 100 000 14 523 85 477
in 20X3 100 000 26 938 73 062
in 20X4 100 000 37 549 62 451
in 20X5 100 000 46 619 53 381
after 20X5 (all lease pmts after 20X5 shown in total) 0 0 0
Future lease payments 400 000 125 628 274 372
Unguaranteed residual value 0 0 0
Gross investment (future LPs & URV) 400 000 125 628 274 372
41. Net investment in finance lease C

Carrying amount ± beginning of year 0
Net investment of new leases commenced during current year 320 000
Finance income 54 372
Lease payments received (100 000)
Lease modifications 0
Carrying amount ± end of year 274 372
3.4.3 If the lessor is neither a manufacturer nor a dealer

As was explained previously, lessors who are neither manufacturer nor dealer are financing
the sale of assets to customers, but their business is to earn finance income. These lessors
derecognise their assets, recognise a lease receivable and then
simply recognise interest income.
! ! " # $ !
$ & #
* & + , -
If the lessor is not a manufacturer or dealer, the basic journal

'
% ( ) (
entries will be as follows: x . / 0 1 2 3 4 5 / 1 3 6 7 8 9 : ; < ; = :
8 9 > ? @ ;
Using the gross method:
Jnl 1. Dr Finance lease receivable: gross investment (instalments receivable)

Cr Finance lease receivable: unearned finance income
Cr Asset disposed of under the finance lease (cost or carrying amount)
Jnl 2. Dr Bank
Cr Finance lease receivable: gross investment (instalment received)
Jnl 3. Dr Finance lease receivable: unearned finance income

Cr Finance income (finance income earned)
Using the net method:
Jnl 1. Dr Finance lease receivable: net investment (PV of GI

Cr Asset disposed of under the finance lease (cost or carrying amount)
Jnl 2. Dr Bank
Cr Finance lease receivable: net investment
Jnl 3. Dr Finance lease receivable: net investment

Cr Finance income (finance income earned)
Chapter 17 841
-XVW DV D UHPLQGHU ZKHQ DFFRXQWLQJ IRU D ILQDQFH OHDVH LQ WKH ERRNV RI D µQRQ-
PDQXIDFWXUHUGHDOHU¶the key items are measured as follows:
x Lease receivable: The initial net lease receivable is measured at the present value of
both the lease payments (which includes the guaranteed residual value) and the
unguaranteed residual.
x Interest income: Interest income is measured by multiplying the interest rate implicit in
the agreement by the balance in the lease receivable account.
x Implicit interest rate: Initial direct costs (i.e. to secure or negotiate the lease) are added
to the lease receivable and are thus already included when calculating the implicit rate
(this will reduce the interest income recognised over the period of the lease).
Example 8: Finance lease: lessor is not a manufacturer or dealer

Orange Tree Limited is neither a dealer nor a manufacturer. Orange Tree entered into an
agreement under which Orange Tree leased a machine to Beanstalk Limited.
Orange Tree 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:
x lease term: 3 years
x lease payments: C90 000, annually in arrears, payable on 31 December of each year
x the residual value (100% guaranteed): C10 000, payable on 31 December 20X3.
The interest rate implicit in the agreement is 15.5819%.
The asset had a nil residual value at the end of the lease term.
Required:
Prepare the journal entries for each of the years ended 31 December 20X1 to 20X3 in
Orange Tree /LPLWHG¶VERRNVWKHERRNVRIWKHOHVVRU
A. Using the gross method.
B. Using the net method.
C. Prepare the disclosure for the year ended 31 December 20X1 in the financial statements of
Orange Tree Limited.
Ignore tax, and when doing disclosure, ignore comparatives too.
Solution 8: Finance lease: lessor is not a manufacturer or dealer

Comment:
Interest income is calculated on the receivable balance at year-end when instalments are in arrears and
coincide with the year-end.

Guaranteed residual value Given 10 000
Gross investment 280 000
Finance income 280 000 210 000
70 000
W2: Effective interest rate table Finance income: Lease pmts plus Receivable
at 15.5819% unguaranteed RV balance
1 January 20X1 210 000
31 December 20X1 32 722 (90 000) 152 722
31 December 20X2 23 797 (90 000) 86 519
31 December 20X3 13 481 (100 000) 0
70 000 (280 000)
UFI GI NI
842 Chapter 17
Solution 8A: Journals: gross method

Machine: cost (A) Given 210 000

Bank (A) 210 000
Purchase of machine
Finance lease receivable: gross investment (A) W2 (a) 280 000

Finance lease receivable: unearned finance income (-A) W2 (b) 70 000
Machine: cost (A) W2(c) 210 000
Finance lease entered into over a machine costing C210 000;
Total receivable: C280 000 (90 000 x 3yrs + 10 000 residual value)
31/12/20X1
Bank (A) 90 000
Lease payment received
Finance lease receivable: unearned finance income (-A) 32 722
Interest income earned, (effective interest table, W2)
31/12/20X2
Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil
Solution 8B: Journals: net method

Machine (A) Given 210 000
Bank (A) 210 000
Purchase of machine
Finance lease receivable: net investment (A) W2 (a) 210 000
Machine (A) W2(c) 210 000
Finance lease entered into over a machine costing C210 000
31/12/20X1
Bank (A) 90 000
Interest income earned, (calculated using the effective interest table)
Chapter 17 843

Bank (A) 90 000
31/12/20X3
Bank (A) 90 000 + 10 000 100 000
Lease payment received (cash pmt increased due to guaranteed residual
being 10 000 but the asset having a residual value of nil)
Solution 8C: Disclosure

Comment: When doing disclosure on the face of the Statement of Financial Position it is usually easier to draw up
the note first and then do the disclosure on the face with the information from the note.
Orange Tree Limited

20X0
disclosable items:
40. Maturity analysis of future lease payments Gross Unearned Net

receivable investment finance investment
(undiscounted) charges (discounted)
C C C
in 20X2 90 000 12 133 77 867
in 20X3 100 000 25 145 74 855
Gross investment (future LPs & URV) 190 000 32 278 152 722

Orange Tree Limited

20X1
Non-current assets Notes C
Finance lease receivable 41 86 519
Current assets
Finance lease receivable LP due next year: 90 000 future interest
A 41 66 203
income included in this LP: 23 797
844 Chapter 17
3.5 Lease payments receivable in advance or in arrears

All previous examples have dealt with lease payments that B C D E C D F G H I E J K L D H E I J F D
are receivable in arrears, but these may be receivable in M N O P Q O N R S T U O U U S O U

I
advance instead. The very first lease payment received in V W X Y V Z [ \ ] ^ X Y ^ [ \ V Y ^ _ ` a Y b
advance will reduce the principal balance owing (i.e. it will

x
X d d X ^ V Y f V Y ^ a ] a W ^ V Y \ Z a W V Y f
c c e c e
only reduce the principal balance owing by the lessee and ^ ` a g h i j X k d a l X Y m
will not include a repayment of interest).

x
m V W d \ W V Y f ^ ` a n V Y X Y a d a X W a
c c
] a a V o X k d a
If the lease payments are receivable at the end of a period

(arrears), the balance owing by the lessee (debtor) at the end of that period (i.e. the receivable
balance, or net investment in finance lease) will simply be the portion of the original principal
sum that he still owes to the lessor (i.e. the balance of the cash sum that he would have paid
had he bought the asset instead of leased it under a finance lease): the receivable balance will
not include any interest.
If, however, the lease payments are received in advance or when the lessee does not make an
lease payment on due date, the balance owing by the lessee (receivable) at the end of the
period will include not only the remaining principal sum still owing by the lessee (e.g. present
value of future lease payments) but also the interest owing between the date of the last lease
payment made and the end of the period.
Depending on whether the lease payments are payable in advance or in arrears will also affect
the disclosure of the finance lease receivable in the notes to the financial statements, since the
gross investment in the finance lease must be reconciled to the present value of the future
lease payments (principal outstanding) ± which is now no longer equal to the balance on the
finance lease receivable account (net investment in the finance lease).
Example 9: Finance lease: lease payments receivable in advance

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:
x lease payments: C80 000, annually in advance, payable on 1 January of each year
x guaranteed residual value: C10 000, payable on 31 December 20X3;
x interest rate implicit in the agreement: 18.7927%.
Required:
A. Prepare the journals for Pear Limited in each of the years affected.
B. Prepare the disclosure for Pear Limited for the year ended 31 December 20X1 . Ignore tax.
Solution 9A: Finance lease: lease payments receivable in advance
Comment:
Interest is calculated on the commencement daters opening balance adjusted for the lease payment when lease
payments are in advance and coincide with the start of the financial year.

Guaranteed residual value Given 10 000
Finance income 250 000 A 210 000 40 000
Chapter 17 845
W2: Effective interest rate table Lease Finance income Receivables

payment 18.7927% balance
01 January 20X1 210 000
01 January 20X1 (80 000) 0 130 000
31 December 20X1 24 431 154 431
01 January 20X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January 20X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
(250 000) 40 000
Journals
Debit Credit
1/1/20X1
Machine: cost (A) 210 000
Bank (A) 210 000
Purchase of machine

Machine: cost (A) W1 210 000
Finance lease entered into over machine costing C210 000; total
receivable: C250 000 (80 000 x 3 years + 10 000 residual value)
Bank (A) 80 000

Finance lease lease payment received
31/12/20X1
1/1/20X2
Bank (A) 80 000
Finance lease payment received
31/12/20X2
1/1/20X3
Bank (A) 80 000
31/12/20X3
Finance lease receivable: unearned finance income e (-A) 1 581
Bank (A) 10 000

Finance lease instalment received
846 Chapter 17
Solution 9B: Finance lease - disclosure
Pear Tree Limited

20X0
disclosable items:
40. Maturity analysis of future lease payments Gross Unearned Net investment
receivable investment finance (discounted)
(undiscounted) charges C
C C
in 20X2 80 000 0 80 000
in 20X3 90 000 15 569 74 431 (1)
Total (future lease payments & unguaranteed RV) 170 000 15 569 154 431

Net investment of new leases commenced 210 000
during current year
(1) 80 000/(1.187927) + 10 000/(1.187927)2
Pear Tree Limited

As at 31 December 20X1
Notes 20X1
Non-current assets C
Finance lease receivable: capital receivable 41 74 431
Current assets
Finance lease receivable: capital receivable LP due next year: 80 000 A 41 55 569
current interest income
included in this LP: 24 431
Finance lease receivable: interest receivable W2 41 24 431
3.6 Lease payments receivable during the year
Lease payments may be receivable during the year rather p D J I D q J r L D H E I

P s U M N t
E C D
than on either the first or last day of the year.

r D J F u
x
^ ` V W \ ] W _ ` a Y ^ ` a v a X ] w a Y m
c c e
The best way to approach this is to, when drawing up the m \ a W Y \ ^
c
\ V Y
c
V m a _ V ^ ` ^ ` a d a X W a
effective interest rate table, plot all the payments on the

[ X v Z a Y ^ m X ^ a W
dates on which they fall due. x

^ ` a ] a n \ ] a [ d \ ^ ^ ` a d a X W a [ X v Z a Y ^ W
\ Y ^ ` a g h i j X k d a X Y m x y y z { | } z ~
V Y ^ a ] a W ^
The interest that belongs to the year on which you are

reporting is then simply apportioned in a separate
calculation.
Chapter 17 847
Example 10: Finance lease ± lease payments receivable during the period
Avocado Tree Limited is a dealer in machines.
x It entered into an agreement to lease a machine to Giant Limited.
x Avocado Tree Limited purchased the machine on 1 July 20X1 at a cost of C100 000.
x The cash sales price of this machine is C210 000.
x The lease is a finance lease, the terms of which are as follows:
- commencement date: 1 July 20X1
- lease term: 5 years
- lease payments: C60 000, annually in advance, payable on 1 July of each year
- interest rate implicit in the agreement: 21.8623%.
Required:
A. Prepare the journals for Avocado for each of the years ended 31 December that are affected.
B. Disclose the above for the year ended 31 December 20X1 in Avocado Tree¶V books. Ignore tax.
Solution 10A: Finance lease - receipts during the period - journals

Guaranteed residual value Not applicable in this example 0
Selling price (net investment) Given 210 000
Gross profit 210 000 100 000 110 000
Finance income 300 000 210 000 90 000
W2: Effective interest rate table Finance income: Lease payment Receivable balance
21.8623%
1 July 20X1 210 000
1 July 20X1 (60 000) 150 000
31 Dec 20X1 32 793 X 6/12 16 397 166 397
1 July 20X2 32 793* X 6/12 16 396 (60 000) 122 793
31 Dec 20X2 26 845 X 6/12 13 423 136 216
1 July 20X3 26 845 X 6/12 13 422 (60 000) 89 638
31 Dec 20X3 19 598 X 6/12 9 799 99 437
1 July 20X4 19 598 X 6/12 9 799 (60 000) 49 236
31 Dec 20X4 10 764 X 6/12 5 382 54 618
1 July 20X5 10 764 X 6/12 5 382 (60 000) 0
90 000 (300 000)
(b) (a) (c)
(*) Rounded to allow the table to equal zero
(a) Lease payments (Gross investment in finance lease): The total of this column represents the gross investment
in the lease (the total amounts receivable from the lessee) and when we expect to receive them.
(b) Finance income: The total of this column represents the unearned finance income at the start of the lease and
shows how this income is then earned each year
(c) Receivable balance (Net investment in finance lease): This column represents the total balance receivable from
the lessee. It includes both the principal owing and the interest owing for the year, which in this example, will
be paid as part of the next lease payment.
Note: If payment occurs during the period, we must apportion the interest income to the correct period. The table
above has been adapted to show this apportionment and extract the correct year-end closing balances. This is not
necessary though (i.e. the table could be drawn up as in previous examples and the calculation of the apportionment
could simply be shown in the journals instead).
Journals Debit Credit
1/7/20X1
Bank (A) 100 000
848 Chapter 17
1/7/20X1 FRQWLQXHG« Debit Credit

Inventory sold under finance lease
1/7/20X1
Sale (I) W1 210 000
Sale of machine under finance lease
Bank (A) 60 000

31/12/20X1
Lease finance income (I) W2: 16 397 16 397
Finance income earned, effective interest rate table
1/7/20X2
Bank (A) 60 000
31/12/20X2
Lease finance income (I) W2: 16 396 + 13 423 29 819
Finance income earned, effective interest rate table:
1/7/20X3
Bank (A) 60 000
31/12/20X3
1/7/20X4
Bank (A) 60 000
31/12/20X4
1/7/20X5
Bank (A) 60 000
31/12/20X5
Lease finance income (I) W2: 5 382 5 382
Chapter 17 849
Solution 10B: Finance lease ± receipts during the period - disclosure

Avocado Tree Limited
20X1
Non-current assets Notes
Finance lease receivable: capital 41 122 793
Current assets
Finance lease receivable: capital 41 27 207
Finance lease receivable: interest 41 16 397
Avocado Tree Limited

20X1
disclosable items:
Gross Unearned Net

40. Maturity analysis of future lease payments investment finance investment
receivable (undiscounted amounts) (undiscounted) charges (discounted)
C C C
in 20X2 60 000 5 648 54 352 (1)

in 20X3 60 000 15 399 44 601 (2)
in 20X4 60 000 23 401 36 599 (3)
in 20X5 60 000 26 967 30 033 (4)
Future lease payments 240 000 (73 603) 166 397
Total (future lease payments & unguaranteed RV) 240 000 (73 603) 166 397

(1) 60 000/1.2186320,5
(2) 60 000/1.2186321,5
(3) 60 000/1.2186322,5
(4) 60 000/1.2186323,5

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£ ª ¨ ° ° ¥ ¨ © ¨ ° ¢ Ó © ¦ ¥ £ ª Ô £ ª ¨ ° ° ¥ ¨ £ ª Ó ² Ù ° ¨ ² £ ª Ó ° © ¥ ° Ö Ó © ¦ ¥ ° £ ª ¨ ° ° ¥ ¨ £ ª Ó ² Ù ° ¨ ² ¯ ° Ó ° © ¥ ° Ö
850 Chapter 17
3.7 Disclosure of a finance lease (IFRS 16.89-94)
The disclosure requirements are extensive but the general principle to apply is to disclose
enough information such that WKH XVHUV ZLOO KDYH D VRXQG EDVLV XSRQ ZKLFK µWR DVVHVV WKH
effect that leases have on the financial position, financial performance and cash flows of the
OHVVRU¶See IFRS 16.89
The following items must be disclosed by a lessor, ideally in a tabular format:

x The profit or loss on the sale of the asset under a finance lease
x Finance income earned on the net investment in the lease
x Income from any variable lease payments that are not linked to an index or rate (i.e.
income from variable lease payments that were not included in the measurement of the
net investment in the lease). See IFRS 16.90-91
In addition to the above note, which was ideally provided in a tabular format, the following
disclosures are also required (the following disclosures need not be in tabular format):
x a maturity analysis showing the undiscounted lease payments that are expected to be
received after reporting date, showing the payments that are expected to be received:
- within 5 years after reporting date RQDµSHUDQQXPEDVLV¶, and
- after 5 years IURPUHSRUWLQJGDWHDVDµtotal¶DOWKRXJK\RXFDQREYLRXVO\DOVRSUHVHQW
WKLVRQDµSHUDQQXP¶EDVLVLQVWHDGLI\RXSUHIHU.
x a reconciliation between the undiscounted lease payments (i.e. the total of the future lease
payments per the maturity analysis referred to above) and the net investment in the lease,
where the reconciliation must show the following as reconciling items:
- unearned finance income, and
- unguaranteed residual value;
x additional qualitative and quantitative information about its leasing activities that would
HQDEOH XVHUV µWR DVVHVV WKH HIIHFW WKDW OHDVHV KDYH RQ WKH ILQDQFLDO SRVLWLRQ ILQDQFLDO
SHUIRUPDQFHDQGFDVKIORZVRIWKHOHVVRU¶LQFOXGLQJIRUH[DPSOH
- µWKHQDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHV¶DQG
- µKRZ WKH OHVVRU PDQages the risk associated with any rights it retains in underlying
DVVHWV¶ LQFOXGLQJ KRZ LW SODQV WR UHGXFH WKHVH ULVNV HJ WKURXJK VWLSXODWLQJ H[WUD
variable lease payments in the event that the lessee uses the asset above certain
specified limits and the inclusion of residual value guarantees in the contract); and
- Significant changes in the carrying amount of the net investment in finance leases.
See IFRS 16.89 and .93-94
The following is a suggested layout that would satisfy the main presentation and disclosure
requirements for lessors involved in a finance lease:
Happy Limited
20X0
disclosable items:
x Profit or loss on sale of asset under a finance lease (if manufacturer/ dealer) xxx
x Finance income on net investment in lease
x Income from variable lease payments that do not depend on an index or rate xxx
Other lease payments xxx
Chapter 17 851
Happy Limited
Notes to the financial statements (extracts) FRQWLQXHG«
Gross Unearned Net
40. Maturity analysis of future lease payments investment finance investment
receivable (undiscounted) charges (discounted)
C C C
in 20X1 xxx
in 20X2 xxx
We must show expected cash inflows on a
in 20X3 xxx
per-annum basis for at least 5 years
in 20X4 xxx
in 20X5 xxx
after 20X5 (all lease pmts after 20X5 shown in total) xxx
Future lease payments xxx (xxx) xxx
Unguaranteed residual value xxx (xxx) xxx
Total (future lease payments & unguaranteed RV) xxx (xxx) xxx

Carrying amount ± beginning of year xxx
Finance income xxx
Lease payments received (xxx)
Net investment of new leases commenced during current year xxx
Lease modifications xxx
Carrying amount ± end of year xxx
42. Additional qualitative and quantitative information regarding finance leases

,QFOXGHDGHVFULSWLRQRIWKHQDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHVRSHUDWLQJDQGILQDQFHOHDVHV
The risks associated with the rights retained in the underlying asset (e.g. items of property, plant and
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7KHULVNPDQDJHPHQWVWUDWHJ\LVDVIROORZV«HJLQFRUSRUDWLRQRIUHVLGXDOYDOXHJXDUDQWHHVLQWKH
FRQWUDFWVHWF«
3.8 Tax implications of a finance lease

æ
Finance leases will generally have deferred tax implications

á â ã ä å
â é
since most tax authorities do not differentiate between finance

ç è ç è ê ë ì í è î
leases and operating leases. Rather, most tax authorities treat x

« ° ¥ ¥ ² £ ¥ ¨ ³ ° ¯ ° ° Ù ° ¯ ² ± ª °
all leases as operating leases for income tax purposes (In some -
¨ ³ ° © ¥ ¥ ° ¨ ³ © ¥ © ¨ © Ü § © ¥ °
cases, like in South Africa, the tax authorities recognise other -

¨ ³ ° « ° ¥ ¥ ² £ ¥ © « « ² ± ° ¯ ¨ © Ü
types of leases, this was discussed in detail in chapter 16).

¯ ° ¯ ¦ Ó ¨ £ ² ª ¥
x
© £ ¥ ° ¥ © ¥ ¨ ³ ° © ¥ ¥ ° ¨ ð ¥
Ò ï
This chapter will only deal with the instance where the tax
ñ ò ó ô õ ö ÷ ø ù ú ú û ü ý ü õ þ ÿ
DXWKRULW\GRHVQRWUHFRJQLVHWKHVXEVWDQFHRIWKHILQDQFHOHDVHLHWKHµVDOH¶EXWKROGVWKH

view that the asset belongs to the lessor and not the lessee.
The lessor is taxed on the lease instalments received less an annual deduction based on the
OHDVHG DVVHW¶V FRVW HJ DQ DQQXDO FDSLWDO DOORZDQFH RI
20% of the cost of the leased asset). This creates a

temporary difference because, for example:

x the lessor would immediately expense the DVVHW¶V x ÿ ÿ ö ö ÿ ô ü þ ô ÿ û õ ô ü ý ö ÿ ô ú
entire cost but the tax authorities would deduct the
þ

ü þ ! ÿ ý ü ö õ õ ú ü " ú ú ÿ ÿ ø ö ü
cost gradually through capital allowances based on a

ö ü ÿ þ ü õ ô ü #
SHUFHQWDJHRIWKHDVVHW¶VFRVWDQG x
û õ þ ö õ õ ú ÿ ú õ ô " ü þ ô $ ú ÿ ö ú
x the lessor then recognises the instalments as income

ø ù õ ö " õ ô % ÿ ö ö ÿ ô ü þ þ &
using an effective interest rate table (i.e. sale incomes, if a manufacturer or dealer, and
interest income) but the tax authorities tax the instalments received on a cash basis.
852 Chapter 17
To complicate matters further, some tax authorities do not allow the capital allowances to
exceed the taxable lease income in any one period. In South Africa, for example, section 23A
of the Income Tax Act limits certain tax allowances to taxable lease income.
See the section on transaction taxes (e.g. VAT) and its impact on a lessor in a finance lease.

' ( ) * +
, * + - ' * + . + + /
0 1 2 2 3 4 5 5 6 7 8 3 9 3 2 2 3 : 5 6 7
x
E
õ ô ÿ ô ü ö ü ÿ þ ü ý ü ü õ C ÿ ø ö ü
ý < õ ú ø ü < ý ü ú ÿ =
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-
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x

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õ ô ú ü ý ü þ ú õ ô ü ý ü C ü < ý ý < õ ú D ô ú ú ÿ ü "
ô ñ ò ÷ ø ù ú û ÿ þ ÿ
-
A
= ÿ ÿ ø ö ü ý < õ ú
Example 11: Deferred tax on a finance lease with no s 23A limitation, VAT
ignored
The facts from example 9 apply, repeated here for your convenience:
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 on 1 January 20X3). The lease
is a finance lease, the terms of which are as follows:
x guaranteed residual value: C10 000, payable on 31 December 20X3;
Assume further that the tax authorities:
x tax lease payments when received;
x allow the deduction of the cost of the asset over three years (capital allowance);
x the income tax rate is 30%.
This is the only transaction in the years ended 31 December 20X1, 20X2 and 20X3.
Required:
Prepare the current tax and deferred tax journal entry for each of the years affected. Ignore VAT.
Solution 11: Deferred tax on a finance lease with no s 23A limitation, VAT ignored
Comment:
x This example is actually based on the same basic facts as given in example 9.
x The effective interest rate table for example 9 has been repeated here for your convenience.
x Please see example 9 for any other calculation and/ or for the journals.
W1: Finance income: Lease pmts & Receivable

Effective interest rate table 18.7927% unguaranteed RV balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 (250 000)
Chapter 17 853
W2: Carrying Tax Temporary Deferred

Deferred tax on the machine amount Base difference taxation
Opening balance 20X1 0 0 0 0
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
Capital allowance 0 (70 000)
Closing balance 20X1 0 140 000 140 000 42 000 A
Closing balance 20X3 0 0 0 0
W3: Deferred tax on the Carrying Tax Temporary Deferred
finance lease receivable amount base difference taxation
New lease 210 000 0
Movement (W1) (55 569) 0
Closing balance (W1) 20X1 154 431 0 (154 431) (46 329) L
Movement (W1) (66 012) 0
Closing balance 20X2 88 419 0 (88 419) (26 526) L
Movement (W1) (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
W4: Deferred tax summary Machine Finance lease Total
(W2) receivable (W3)
Opening balance 20X1 0 0 0
Adjustment 20X1 (4 329) cr DT; dr TE
Closing balance 20X1 42 000 (46 329) (4 329) L
Adjustment 20X3 5 526 dr DT; cr TE
Closing balance 20X3 0 0 0
W5: Current tax summary 20X3 20X2 20X1 Total

C C C C
Profit before tax: finance income 1 581 13 988 24 431 40 000
Adjust for temporary differences
- less finance income (1 581) (13 988) (24 431) (40 000)
- add lease payment received 90 000 80 000 80 000 250 000
- less capital allowance (70 000) (70 000) (70 000) (210 000)
Taxable profit 20 000 10 000 10 000 40 000
Current income tax at 30% 6 000 3 000 3 000 12 000
Journals: 31/12/20X1 Debit Credit

Income tax expense (E) 3 000
Current tax payable: income tax (L) 3 000
Current tax charge (W5)
Deferred tax: income tax (L) 4 329
Deferred tax adjustment (W4)
31/12/20X2
854 Chapter 17

31/12/20X3
Example 12: Deferred tax on a finance lease: s 23A limitation, VAT ignored
The facts from example 9 apply, repeated here for your convenience, together with slightly
different tax-related information:
Pear Tree Limited is neither a dealer nor manufacturer. Pear Tree entered into an agreement in which it
leased a machine to Giant Limited (cost C210 000). The lease is a finance lease, the terms being:
x commencement date: 1 January 20X1 with the lease period being 3 years
x guaranteed residual value: C10 000, payable on 31 December 20X3
x tax lease payments when received;
x allow a capital allowance of the cost of the asset over two years;
x the tax authorities limit the capital allowance to the taxable lease income, where any excess that is
not allowed as a deduction is able to be deducted against future lease income (s 23A);
There are no temporary differences other than those evident from the information provided and there
are no non-deductible expenses and no exempt income.
Required: Prepare the current and deferred tax journals for each of the years affected. Ignore VAT.
Solution 12: Deferred tax on a finance lease with a s 23A limitation, VAT ignored
W1: Effective interest rate table Finance income: Lease pmts & Receivable
18.7927% Unguaranteed RV balance
01 January X1 210 000
01 January X1 0 (80 000) 130 000
31 December 20X1 24 431 154 431
01 January X2 (80 000) 74 431
31 December 20X2 13 988 88 419
01 January X3 (80 000) 8 419
31 December 20X3 1 581 10 000
31 December 20X3 (10 000) 0
40 000 250 000
W2: Deferred tax on the machine CA TB TD DT
Purchase 210 000 210 000
Finance lease disposal (210 000) 0
S23A limitation (W2.1) 25 000
S23A limitation (W2.1) 25 000
Capital allowance 0 0
S23A allowance (W2.1) (50 000)
Chapter 17 855
W2.1: s 23A: limitation of allowances to taxable income 20X1 20X2 20X3

Lease payment received 80 000 80 000 90 000
Less allowances
- Capital allowance (105 000) (105 000) 0
- s 23A catch-up allowance b/f: X3: 25 000 + X2: 25 000 0 (25 000) (50 000)
Taxable profit (loss) (25 000) (50 000) 40 000
- s 23A limitation c/f 25 000 50 000 0
Taxable profit after limitation 0 0 40 000
Comment: ZKHQGRLQJDµOHVVRU± ILQDQFHOHDVH¶TXHVWLRQLWPD\EHEHVWWRILUVWGRWKHV 23A check (W2.1) to
see whether or not the limitation applies.
W3: DT on the fin lease receivable CA TB TD DT

New lease (W1) 210 000 0
Movement (55 569) 0
Closing balance 20X1 154 431 0 (154 431) (46 329) Liability
Movement (66 012) 0
Closing balance (W1) 20X2 88 419 0 (88 419) (26 526) Liability
Movement (88 419) 0
Closing balance (W1) 20X3 0 0 0 0
W4: Deferred tax summary Machine (W2) Fin. lease receivable (W3) Total
Closing balance 20X1 39 000 (46 329) (7 329) Liability
Closing balance 20X2 15 000 (26 526) (11 526) Liability

Profit before tax: finance income 24 431 13 988 1 581 40 000
- less finance income (24 431) (13 988) (1 581) (40 000)
- add lease instalment received 80 000 80 000 90 000 250 000
- less capital allowance (105 000) (105 000) (0) (210 000)
- s 23A limitation 25 000 50 000 0
- s 23A catch-up allowance (0) (25 000) (50 000)
Taxable profit 0 0 40 000 40 000
Current income tax at 30% 0 0 12 000 12 000

There is no current tax charge and therefore no current tax journal (W4)
Income tax (E) 7 329
31/12/20X2
856 Chapter 17

Example 13: Deferred tax on a finance lease (manuf./ dealer):

s 23A limit, VAT ignored
The facts from example 7 apply, repeated here for your convenience, together with tax-
related information:
x Lemon Tree Limited deals in machinery, either selling for cash or under a finance lease.
x Lemon Tree Limited sold only one machine (cost C250 000) during 20X1.
x The machine was sold under a finance lease, but had a cash sales price of C320 000.
x This is the only transaction in the years ended 31 December 20X1 to 20X5.
x The terms of the lease are as follows:
commencement date: 1 January 20X1
lease period: 5 years
lease instalments: C100 000, annually in arrears, payable on 31 December of each year.
The market interest rate applicable is 16,9911%.

x charge tax on the lease instalments that are received;
x allow the deduction of the following capital allowances:
- 50% once-off allowance in the year of acquisition
- 20% per year on the balance of the cost after deducting the 50% once-off allowance (including
the year of acquisition)
x limit the capital allowance to the taxable lease income: any excess that is not allowed as a
deduction may be deducted against future lease income (s 23A);
x levy income tax rate is 30%.
Required: Prepare the current tax and deferred tax journal entry for each year affected. Ignore VAT.
Solution 13: Def tax on a finance lease (manuf./ dealer) with a s 23A limit, VAT ignored
Comment: This example is based on the same basic facts as given in example 7. The effective interest
rate table for example 7 has been repeated here for your convenience. Please see example 7 for any
other calculation and/ or for the journals.
W1: Effective interest rate table Finance income: Lease pmts & Receivable balance
16.9911% unguaranteed RV
1 Jan X1 320 000
31 Dec X1 54 372 (100 000) 274 372
31 Dec X2 46 618 (100 000) 220 990
31 Dec X3 37 549 (100 000) 158 539
31 Dec X4 26 938 (100 000) 85 477
31 Dec X5 14 523 (100 000) 0
180 000 (500 000)
W2: Current tax summary 20X5 20X4 20X3 20X2 20X1 Total
Sales income 320 000 320 000
Less cost of sale (250 000) (250 000)
Finance income earned 14 523 26 938 37 549 46 618 54 372 180 000
Profit before tax: 14 523 26 938 37 549 46 618 124 372 250 000
Calculation continued on the next page...
Chapter 17 857
W2: Current tax continued 20X5 20X4 20X3 20X2 20X1 Total
Carried forward from prior page:
Profit before tax: 14 523 26 938 37 549 46 618 124 372 250 000
- less profit on sale 0 0 0 0 (70 000) (70 000)
- less finance income earned (14 523) (26 938) (37 549) (46 618) (54 372) (180 000)
- add lease instalment received 100 000 100 000 100 000 100 000 100 000 500 000
- less 50% once-off allowance 0 0 0 0 (125 000) (125 000)
- less 20% annual allowance (25 000) (25 000) (25 000) (25 000) (25 000) (125 000)
- add back s 23A limitation 0 0 0 0 50 000 50 000
- less s 23A catch-up allowance (0) (0) (0) (50 000) (0) (50 000)
Taxable profit 75 000 75 000 75 000 25 000 0 250 000
Current income tax at 30% 22 500 22 500 22 500 7 500 0 75 000
W3: DT on fin. lease receivable CA TB TD DT

Opening balance: 20X1 0 0 0 0
New lease 320 000 0
Capital repaid (45 628) 0
Closing balance: 20X1 W1 274 372 0 (274 372) (82 311) L
Closing balance: 20X5 W1 0 0 0 0
W4: DT on the machine CA TB TD DT

Opening balance: 20X1 0 0 0 0
Purchase 250 000 250 000
Finance lease sale (250 000) 0
50% tax allowance 0 (125 000)
0 125 000
s 23 limitation W2.1 0 50 000
Closing balance: 20X1 0 150 000 150 000 45 000 A
s 23A catch-up allowance W2.1 0 (50 000)
s 23 adjustment 0 0
s 23 adjustment 0 0
s 23 adjustment 0 0
Closing balance: 20X5 0 0 0 0
W4.1: s 23A: limitation 20X5 20X4 20X3 20X2 20X1

Lease payment received 100 000 100 000 100 000 100 000 100 000
Less 50% once off allowance 0 0 0 0 (125 000)
Less Capital allowance (25 000) (25 000) (25 000) (25 000) (25 000)
Less s 23A catch-up allowance b/f (50 000) 0
Tax loss 75 000 75 000 75 000 25 000 (50 000)
- s 23A limitation c/f 0 0 0 0 50 000
Taxable profit 75 000 75 000 75 000 25 000 0
858 Chapter 17
W5: Deferred tax summary Machine (W4) Receivable (W3) Total

Journals Debit Credit

31/12/20X1

Check:
Tax expense in 20X1 will be C37 311 (CT: 0 + DT: 37 311 = 30% x accounting profit: 124 372)
31/12/20X2

Check:
Tax expense in 20X2 will be C13 986 (CT: 7 500 + DT: 6 486 = 30% x accounting profit: 46 618)
31/12/20X3

Check:
Tax expense in 20X3 will be C11 265 (CT: 22 500 G DT: 11 235 = 30% x accounting profit: 37 549)
31/12/20X4

Check:
Tax expense in 20X4 will be C8 081 (CT: 22 500 G DT: 14 419= 30% x accounting profit: 26 938)
Chapter 17 859


Check:
Tax expense in 20X4 will be C4 357 (CT: 22 500 G DT: 18 143= 30% x accounting profit: 14 523)
4. Operating Leases (IFRS 16.81-97)
4.1 Recognition of an operating lease
$QRSHUDWLQJOHDVHLVDµSXUHOHDVH¶VLQFHRZQHUVKLSRIWKHDVVHWLVQRWWUDQVIHUUHG at any stage

during the lease. The lessor therefore keeps his asset in his statement of financial position
(and presents his asset according to its nature, as he would normally, e.g. as property, plant
and equipment), and recognises:
x costs incurred on the lease as expenses over the period (e.g. depreciation on the leased
asset where the leased asset is a depreciable asset); and
x lease payments as income over the lease period, normally on a straight line basis.
4.2 Measurement of an operating lease H I J K L M N O P Q J L R J R S
The total lease income receivable should be recognised as

income evenly over the period of the lease. Measurement of x T U V U W X Y U Z [ Y U Z \ U [ W ] ^ _ W ] T T ] ] `
x
the income should be on the straight-line basis over the x
a ] \ _ b Z U T ] ` W ] X T ] U Z \ _ V ]
period of the lease (irrespective of the actual instalments

c ] X T d Y ] `
- T ^ Y X U b e ^ W U Z ] _ f ] Y W ] X T ] ^ ] Y V
receivable in each period). Only if there is a systematic - d Z W ] T T X Z _ ^ e ] Y g h g i j k l i m n
basis that more accurately reflects the pattern in which the

o
X T U T U T V _ Y ] Y ] [ Y ] T ] Z ^ X ^ U f ]
asset is used, should a basis other than the straight-line basis _ p ^ e ] d T X b ] _ p X T T ] ^ q
be used.
Costs (such as depreciation and impairment losses) are measured in terms of the relevant
standard (e.g. IAS 16 and IAS 36 respectively). The depreciation policy for depreciable
leased assets will be consistent with that used by the entity for similar assets.
Costs that are considered to be initial direct costs incurred in connection with the negotiating
and arranging the operating lease should be added to the cost of the leased asset and thereby
be expensed as the leased asset is expensed (e.g. through depreciation). However, these costs
are depreciated over the lease term ± not over the useful life of the underlying asset.
Example 14: Operating lease ± recognition and measurement

Banana Limited entered into an operating lease with Frond Limited on 1 January 20X1.
The lease was over a plant (which Banana Limited had bought on 1 January 20X1 for C300 000). The
terms of the lease is as follows:
x lease term: 3 years
x fixed lease instalments, payable as follows:
- 31 December 20X1: C100 000
- 31 December 20X2: C110 000
- 31 December 20X3: C150 000
x Frond Limited may purchase the leased asset at its market price on 31 December 20X3
x Unguaranteed residual value: C30 000.
860 Chapter 17
Frond Limited purchased the plant on 31 December 20X3 at its market price of C30 000.
Banana Limited depreciates its plant over three years on the straight-line basis.
Required: Prepare the journal entries for each of the years affected. Ignore tax.
Solution 14: Operating lease ± recognition and measurement

Comment: $VZLWKRSHUDWLQJOHDVHH[SHQVHLQWKHOHVVHH¶VUHFRUGVWRGHWHUPLQHWKHOHDVHLQFRPHLQWKH
OHVVRU¶VUHFRUGVZHDYHUDJHWKHLQVWDOPHQWVRYHUWKHSHULRGRIWKHOHDVH
Plant: cost (A) Given 300 000
Bank (A) 300 000
Purchase of plant for C300 000
31/12/20X1
Depreciation ± plant (E) (C300 000 30 000) / 3 years
r 90 000
Plant: accumulated depreciation (-A) 90 000
Depreciation of plant
Bank (A) Given 100 000

Operating lease receivable (A) 20 000
Operating lease income (I) (100 000 + 110 000 + 150 000) / 3 years 120 000
Lease income earned (lease payments straight-lined over three years)
31/12/20X2
r 90 000
Depreciation of plant:

Operating lease income (80 000 + 130 000 + 150 000) / 3 years 120 000
31/12/20X3
r 90 000
Depreciation of plant:

Operating lease income (80 000 + 130 000 + 150 000) / 3 years 120 000
Plant: accumulated depreciation (-A) 90 000 x 3 years 270 000

Plant: cost (A) Given 300 000
Sale of plant at market value (also equal to residual value)
4.3 Tax implications of an operating lease
The tax consequences of operating leases are relatively simple to understand. The tax
authorities generally:
x charge tax on the lease instalments as they are received;
x allow a deduction of the cost of the leased asset over a period of time (e.g. an annual
capital allowance of 20% on the cost of the asset).
Chapter 17 861
The accounting treatment involves:

x recognising lease income evenly over the lease term (generally on the straight-line basis);
x recognising expenses (depreciation and impairments) evenly over the lease period
(although the rate of depreciation expense may differ from the rate of the capital
allowance granted by the tax authorities).
Deferred tax consequences may therefore arise if, for example:
x the taxable lease instalment received differs from the lease income recognised;
x the costs are allowed as a tax deduction (allowances) at a faster or slower rate than they
are expensed (depreciation and impairments);
x the initial direct costs are allowed as a tax deduction in full in the year in which they are
paid while being capitalised and recognised as expenses over the lease period from an
accounting profit perspective.
s t u u
L K v S H I J K L M N O P Q J L R J R w Q J R R x K I J K R I J y M N z J {
| } ~ } } }
x T ^ U W W Y ] \ _ b Z U T ] X T T ] ^ x W
o
] X T ] U Z \ _ V ] T ^ Y X U b e
o
^ W U Z ] x \ d Y Y ] Z ^ ^ X W ]
o
X T ] U Z \ _ V ]
x W ] X T ] U Z T ^ X W V ] Z ^ T U Z \ _ V ]
X T U T _ Y T T ^ ] V X ^ U \ X T U T ^ X ] _ Z \ X T e X T U T e ] Z
x W ] X T ] \ _ T ^ T ] [ ] Z T ] T
x ] [ Y ] \ U X ^ ] X T T ] ^ U Z \ W q U Z U ^ U X W
Y ] \ ] U f ]
x
o
d ^ Y ] \ _ b Z U T ] U Z U ^ U X W U Y ] \ ^ \ _ T ^ T
U Y ] \ ^ \ _ T ^ T \ X [ U ^ X W U T ] x ] p ] Y Y ] ^ X
X T [ X Y ^ _ p ^ e ] \ _ T ^ _ p ^ e ]
x X \ \ Y d X W T _ Y [ Y ] [ X V ] Z ^
- _ Z X T T ] ^ ` ] [ Y ] \ U X ^ U _ Z f T
^ X X W W _ X Z \ ]
X d T ^ V ] Z ^ T X Y U T ] U p
W ] X T ] X T T ] ^ Y ] \ _ b Z U T ] X T
] [ Y ] \ U X ^ U _ Z _ f ] Y ^ e ] [ ] Y U _ U p
U Z T ^ X W V ] Z ^ X V _ d Z ^ U p p ] Y T
- _ Z Y ] \ ] U f ] U Z X f X Z \ ] `
X T T ] ^ _ Y
p Y _ V X V _ d Z ^ Y ] \ _ b Z U T ] X T
o o
X ] [ Y ] \ U X W ] X T T ] ^
U Z \ _ V ]
- _ Z Y ] \ ] U f X W ] ` W U X U W U ^
Example 15: Operating lease ± tax implications

The facts from example 14 (Banana and Frond) apply, with the following tax information:
The tax authorities:
x charge tax on the lease instalments that are received;
x allow the deduction of the cost of the leased asset over three years;
Required: Prepare %DQDQD¶V journals for each of the years 20X1, 20X2 and 20X3. Ignore VAT.
Solution 15: Operating lease ± tax implications
W1: DT: plant CA TB TD DT

Purchase 300 000 300 000
Depreciation/ deduction (cost/ 3yr) (90 000) (100 000)
Closing balance 20X1 210 000 200 000 (10 000) (3 000) L
Closing balance 20X2 120 000 100 000 (20 000) (6 000) L
Carrying amount of asset sold
(300 000 ± 90 000 x 3yrs) (30 000)
W2: DT: operating lease receivable CA TB TD DT

Movement 20 000 0
Movement 10 000 0
Movement (30 000) 0
862 Chapter 17
W3: Deferred tax summary Plant (W1) Op lease accrual (W2) Total
Closing balance 20X1 (3 000) (6 000) (9 000) L
Closing balance 20X2 (6 000) (9 000) (15 000) L
Closing balance 20X3 0 0 0 L

Operating lease income 120 000 120 000 120 000 360 000
Less depreciation (90 000) (90 000) (90 000) (270 000)
Add profit on sale of plant 0 0 0 0
- Proceeds on sale of plant 30 000 0 0 30 000
- Less carrying amount of plant sold (30 000) 0 0 (30 000)
Profit before tax 30 000 30 000 30 000 90 000
Adjust for temporary differences:
- less operating lease income (120 000) (120 000) (120 000) (360 000)
- add depreciation 90 000 90 000 90 000 270 000
- add lease instalment received 150 000 110 000 100 000 360 000
- less capital allowance (100 000) (100 000) (100 000) (300 000)
- add recoupment on sale
(proceeds: 30 000 ± tax base: 0) 30 000 0 0 30 000
Taxable profit 80 000 10 000 0 90 000
Current income tax at 30% 24 000 3 000 0 27 000
No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X1: be C9 000 (CT: 0 + DT: 9 000 = 30% x accounting profit: 30 000)
31/12/20X2
Check: tax expense in 20X2: C9 000 (CT: 3 000 + DT: 6 000 = 30% x accounting profit: 30 000)
31/12/20X3
No current tax journal because there is no current tax charge (W4)
Check: tax expense in 20X3: C9 000 (CT: 24 000 DT: 15 000 = 30% x accounting profit: 30 000)
Chapter 17 863
4.4 Disclosure of an operating lease (IFRS 16.89-92 and .95-97)

The disclosure requirements include:
x lease income, but we must separately present any income from variable lease payments
that do not vary in tandem with an index or a rate.
x a maturity analysis showing the undiscounted lease payments expected to be received
each year for at least 5 years, with lease payments expected to be received after 5 years to
be shown in total.
x additional qualitative and quantitative information about its leasing activities that would
enable users µto assess the effect that leases have on the financial position, financial
SHUIRUPDQFHDQGFDVKIORZVRIWKHOHVVRU¶LQFOXGLQJIRUH[DPSOH
- µWKHQDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHV¶DQG
- µKRZ WKH OHVVRU PDQDJHV WKH ULVN DVVRFLDWHG ZLWK DQ\ ULJKWV LW UHWDLQV LQ XQGHUO\LQJ
DVVHWV¶ LQFOXGLQJ KRZ LW SODQV WR UHGXFH WKHVH ULVNV HJ WKURXJK VWLSXODWLQJ H[WUD
variable lease payments in the event that the lessee uses the asset above certain
specified limits and the inclusion of residual value guarantees in the contract).
x depending on the underlying asset that is being rented out under an operating lease, the
entity would have to provide the disclosures required by the relevant IFRS:
- IAS 16 Property, plant and equipment;
- IAS 38 Intangible assets;
- IAS 40 Investment property;
- IAS 41 Agriculture.
x if the underlying asset in the operating lease is an item of property, plant and equipment,
the disclosures required by IAS 16 Property, plant and equipment (see bullet point above)
must be shown separately by class of asset (e.g. vehicles, plant etc) as follows:
- those that are owned and used by the entity; and
- those that are owned and rented out by the entity under an operating lease.
x if the underlying asset in the operating lease was impaired (or had an impairment
reversed) during the year, then the entity must provide the disclosures required by:
- IAS 36 Impairment of assets. See IFRS 16.89; 90 (b) & .92 & .95-97
Happy Limited
Owned Owned Total
and used and leased
25 Property, plant and equipment C C C
Machinery
Net carrying amount ± beginning of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)
«'HWDLORIPRYHPHQWVduring 20X0 VKRZQKHUH« (xxx) xxx (xxx)
Net carrying amount ± end of 20X0 xxx xxx xxx
Gross carrying amount xxx xxx xxx
Less accumulated depreciation and impairment losses (xxx) (xxx) (xxx)

disclosable items:
x Operating lease income from: xxx
Income from variable lease payment that do not depend on an index or rate xxx
Income from other lease payments xxx
864 Chapter 17
Happy Limited
Undiscounted
40. Maturity analysis of future lease payments receivable amounts
C
Future lease payments expected to be received (at undiscounted amounts): xxx
in 20X1 xxx
in 20X2 xxx
in 20X3 We must show expected cash inflows for at least 5 years xxx
in 20X4 xxx
in 20X5 xxx
after 20X5 (all lease payments after 20X5 shown in total) xxx
41. Additional qualitative and quantitative information regarding operating and finance leases
Include a description of the QDWXUHRIWKHOHVVRU¶VOHDVLQJDFWLYLWLHVRSHUDWLQJDQGILQDQFHOHDVHV
The risks associated with the rights retained in the underlying assets (e.g. items of property, plant and
equipment) WKDWDUHKHOGXQGHURSHUDWLQJOHDVHVDUHDVIROORZV«
7KHULVNPDQDJHPHQWVWUDWHJ\LVDVIROORZV«HJLQFRUSRUDWLRQRIUHVLGXDOYDOXHJXDUDQWHHVLQWKH
contracts etc)
Example 16: Operating lease ± disclosure
The facts from example 14 and 15 apply.
Required: Prepare the disclosure for each of the years ended 31 December 20X1, 20X2 and 20X3.
Ignore any additional qualitative disclosures
Solution 16: Operating lease ± disclosure

This is the same as example 14 and 15. Please see example 15 for the tax workings. All other
workings are in example 14.
Banana Limited
20X3 20X2 20X1
14. Plant ± owned and leased under an operating lease C C C
Net carrying amount ± 1 January 120 000 210 000 0
Gross carrying amount ± 1 January 300 000 300 000 0
Less accumulated depreciation -1 January (180 000) (90 000) 0
x Purchase 0 0 300 000
x Depreciation (90 000) (90 000) (90 000)
x Sale (30 000) 0 0
Net carrying amount ± 31 December 0 120 000 210 000
Gross carrying amount ± 31 December 0 300 000 300 000
Less accumulated depreciation ± 31 December 0 (180 000) (90 000)
15. Deferred tax liability

The deferred tax constitutes temporary differences from: 0 (15 000) (9 000)
x Plant 0 (6 000) (3 000)
x Operating lease receivable 0 (9 000) (6 000)
16. Maturity analysis of future lease payments receivable (undiscounted amounts)

Total future lease payments expected to be received : 0 150 000 260 000
x In 20X4 0 150 000 110 000
x In 20X5 0 0 150 000
x In 20X6 0 0 0
x In 20X7 0 0 0
x In 20X8 0 0 0
x After 20X8 0 0 0
Chapter 17 865
Banana Limited
20X3 20X2 20X1
C C C
17. Income tax expense
9 000 9 000 9 000
x Current income tax ± current year (Example 15 W4) 24 000 3 000 0
x Deferred income tax ± current year (Example 15 W3) (15 000) 6 000 9 000
disclosable items:
x Depreciation 90 000
x Operating lease income from:
Income from variable lease payment that do not depend on an index or rate xxx
Income from other lease payments (120 000)
Banana Limited
Statement of financial position (extracts)
Notes C C C
Non-current assets
Plant 14 0 120 000 210 000
Current assets
Operating lease receivable (20 000 + 10 000) 0 30 000 20 000
Non-current liabilities
Deferred taxation: income tax 15 0 15 000 9 000
Current liabilities
Current tax payable: income tax 24 000 3 000 0
Banana Limited
Statement of comprehensive income (extracts)
Notes C C C
Profit before tax 30 000 30 000 30 000
Taxation expense 19 9 000 9 000 9 000
Profit for the year 21 000 21 000 21 000
5. Lease involving both land and buildings (IFRS 16.B55-57)
5.1 Separate classification of the elements (IFRS 16.B55 and B56) ¡ ¢ £ ¡
¤ ¢ £ ¥
A lease of land and a lease of buildings are classified as operating or ¦ § ¨ © ª © « § ¬

¤ ® ¯
finance leases in the same way as leases of other assets. However, if a ¢ £ ¡ ¤ ° ± ¢ ¥ ¡ ²
lease agreement involves a property that combines land and buildings, x ³ ´

µ ¶ ¤ ¶ · ¢ £ ¥
IFRS 16 clarifies that classification of the lease of the property as ¢ ¯ ¶ ¡ ¯ ¯ £ ¶ ® £ ¢
either an operating or finance lease, must involve the separate

¸
¶ · ¢ £ ¡ ¡ ¤ ¹ ¶ ·
µ ® µ ® ¶ ¹ £ ¡ £ ¡ ¢
consideration and classification of the land element and the building ± ¶ £ ¥ ± ¡ º » ¤
element. This may result in a single lease agreement involving land ° ± ¢ ¥ £ ¡ ¶ · º » ¤
and buildings being recognised partly as an operating lease and partly ¶ · µ ® µ ® ¶ ¹ ¼
as a finance lease!
866 Chapter 17
Now, an interesting feature of land is that its economic life is normally deemed to be
indefinite. The fact that land normally has an indefinite economic life ½ ·
is an important consideration when determining whether the lease of ¢ £ ¡ ¡ ¤ ¹ ¶ ·
the land element should be classified as a finance lease or operating ¢ £ ¡ ¤ ¢ £ ¥ ¾ £
lease. Thus, unless we expect legal title (legal ownership) to pass to

¯ µ ® ¶ £ ¶ ¡ ¥ ® £ ¶
¡ ¶ · £ ¶ ¶ ® ¯ £ ¢ ¢ ¹ · £ ¡
the lessee at the end of the lease term, we may conclude that the £ ¥ ¤ ¶ ¯
lessee could not possibly receive substantially all the risks and ¢ ¤
rewards of ownership. As a result, we normally classify leases over

land as operating leases (which would require that the ODQGUHPDLQVUHFRJQLVHGLQWKHOHVVRU¶V
accounting records).
However, it cannot be true to say that every lease of land where legal title (ownership) does
not transfer from the lessor should automatically be accounted for by the lessor as an
operating lease 7KH µEDVLV RI FRQFOXVLRQV¶ ZLWKLQ ,)56 H[SODLQV D VFHQDULR WKDW ZDV
debated wherein a person leases land over a 999-year period. It explains that even if legal
ownership does not pass to the lessee, the lessor will have effectively handed over the risks
DQGUHZDUGVRIRZQHUVKLS6XEVWDQWLDWLQJWKLVIDFWLVWKDWIURPWKHOHVVRU¶VSHUVSHFWLYHWKH
present value of the residual value of its land would be negligible even after leasing land for
just a few decades. Thus, it may be necessary to classify a relatively long lease of land as a
finance lease (which would require the lessor to remove the land from its balance sheet as if it
had been sold).
However, as always, it is important to examine the substance of the arrangement. Where

substantially all the risks and rewards have transferred, we must account for the lease as a
finance lease, even if this is inconsistent with the legal nature of the transaction.
Example 17: Lease of land and buildings

We enter into a 999-year lease (as a lessee) over a property constituting land and a building.
The building has a useful life of 80 years. Ownership of the property does not transfer to us at the end
of the lease.
Required: Discuss the classification of the lease based purely on the information provided above.
Note that the classification of a lease combining land and buildings as either finance or operating
would not normally be restricted to the information above: all factors affecting the lease would need to
be considered (e.g. fair values versus present values of future lease payments etcetera).
Solution 17: Lease of land and buildings

x The building would be classified as a finance lease since the lease period more than covered a
major part of the economic life of the building (which was only 80 years), so thus the risks and
rewards of ownership were, in substance, transferred.
x The land would be classified as a finance lease because the long period of the lease (999-years)
means that a significant portion of the risks and rewards are transferred to the lessee and thus the
substance is that the lessor sold the land.
5.2 How to allocate the lease payments to the separate elements: land and buildings
(IFRS 16.B55 - B57)
When classifying a lease of a combination property (i.e. the property includes a land element
and a building element), the lease payments (as defined) plus any prepaid lease payments
(which are excluded from the definition of lease payments) will need to be allocated between
the two elements in proportion to the relative fair values of the leasehold interests in the land
and the building elements, measured at lease inception.See IFRS 16.B56
If the fair value of the leasehold interest in the land is immaterial, then we do not consider the
land element separately from the building element when classifying the lease. Instead, we
FODVVLI\ WKH SURSHUW\ DV µD VLQJOH XQLW¶ ,Q WKLV FDVH WKH XVHIXO OLIH RI WKH SURSHUW\ PXVW EH
assumed to be the useful life of the building. See IFRS 16.B57
Chapter 17 867
If we are not able to reliably allocate the lease payments, the entire lease is classified as:
x an operating lease, if it is clear that both the land element and the building element are
operating leases; or
x a finance lease. See IFRS 16.B56
Example 18: Lease of land and buildings
Lessor Limited leased land and buildings to Lessee Limited, the detail of which follows:
x The lease commencement date is 1 January 20X3, and the lease term is for 20 years.
x The lease payments are C200 000 per annum, payable in arrears.
x At the inception of the lease, the fair value of the leasehold interest in the land is
C5 000 000 whilst the fair value of the leasehold interest in the building is C2 240 832.
x The building had been purchased for C3 000 000 and were being depreciated over its
total estimated useful life of 30 years to a nil residual value. At inception, the buildings
had a remaining useful life of 22 years.
x Land was purchased 10 years ago for C2 200 000 and is not depreciated.
x The interest rate implicit is given at 3,293512%.
x After a careful assessment of all facts and circumstances was done, each of the elements
was correctly classified as follows:
the lease over the land was classified as an operating lease, and
the lease over the building was classified as a finance lease.
Required: 3UHSDUHWKHMRXUQDOHQWULHVIRU;DQGIRU;LQWKHOHVVRU¶VDFFRXQWLQJUHFRUGV
Solution 18: Lease of land and buildings

Comment:
x The first step would be to classify each of the elements of the lease as either operating or finance
leases. However, we are told to assume that a careful assessment of all facts and circumstances was
done and that each of the elements has been correctly classified with land classified as an operating
lease and the building classified as a finance lease.
x However, by way of example, one of the factors we would have considered is the following:
7KHOHDVHWHUPLV\HDUVZKLFKLVDPDMRUSRUWLRQRIWKHEXLOGLQJ¶VUHPDLQLQJXVHIXOOLIHWKXV
suggesting that the lease is a finance lease.
The land has an indefinite useful life and thus the lease term of 22 years does not represent a
PDMRUSRUWLRQRIWKHDVVHW¶VOLIHWKXVVXJJHVWLQJWKDWWKHOHDVHZDVDQRSHUDWLQJOHDVH
Step 1: Splitting the lease payment into operating and finance portions
Split instalments as follows: FV of the land/ building
x Lease payment
FV of the land + FV of the building
5 000 000
Land: x 500 000 = 345 264 (operating lease)
7 240 832
2 240 832
Buildings: x 500 000 = 154 736 (finance lease)
7 240 832
Step 2: Effective interest rate table: finance lease (building only)
Finance charges Finance lease Finance lease liability
3,293512 % instalment (pmt) outstanding at year end
A: C x 3,293512% B: Step 2 C: O/bal + A B¿
01/01/20X3 2 240 832

31/12/20X3 73 802 (154 736) 2 159 898
31/12/20X4 71 137 (154 736) 2 076 299
31/12/20X5 68 383 (154 736) 1 989 946
... ...
853 888 (3 094 720)
868 Chapter 17
Comment:
x This effective interest rate table shows only the years relevant to the question.
x The total payments would be 154 736 x 20 years = 3 094 720
x Total interest over 20 years: 3 094 720 original amt owed: 2 240 832 = 853 888
¿
Journals:

Gross investment in finance lease (A) 154 736 x 20 yrs 3 094 720
Unearned finance income (-A) Step 2 or 853 888
GI: 3 094 720 NI: 2 240 832
À
Building: acc depreciation (-A) (3 000 000 0)/30 x 8

À 800 000
Building: cost (A) Given 3 000 000
Profit on sale of building NI: 2 240 832 CA: (3 000 000
À 40 832
À 800 000)
Lease over building element recognised as a finance lease
31/12/20X3
Unearned finance income (-A) Step 2 73 802
Finance income (I) 73 802
Finance income earned on finance lease over building
Operating lease income (I) Step 1 345 264
Gross investment in finance lease (A) Step 1 154 736
Payment of lease instalment: apportioned based on fair values
31/12/20X4
Unearned finance income (-A) Step 2 71 137
Finance income (I) 71 137
Finance income earned on finance lease over building
Operating lease income (I) Step 1 345 264
Gross investment in finance lease (A) Step 1 154 736
Payment of lease instalment: apportioned based on fair values
Comment: Operating lease income must be recognised on the straight-line basis (or other systematic
basis) over the lease term. However, the operating lease payments remained constant over this period.
5.3 Land and buildings that are investment properties (IAS 40.5)
Investment property comprises land and buildings that are held to earn rentals or for capital
appreciation or both. Thus, land that is leased to a third party under an operating lease (thus
earning rentals) would meet the definition of investment property. Land and buildings that are
leased under an operating lease must be classified as investment property and be recognised
and measured in terms of IAS 40 Investment property.
6. Change in classification: modifications versus changes in estimates (IFRS 16.66)
The classification of a lease is decided upon at the inception Á Â Ã Ä Â Å Æ Ã Ä Ä Ç È Ç Å Ã É Ç Ê Ë Ä
of the lease. The classification should only be changed Ì

Ã Í Ë Â Â Î É Ê Å Ï Ã Ë Ð Â Ç È Ñ
during the lease period if there is a lease modification.

x Ò Ó Ô Õ Ô Ó Ö × Ø Ô Ô Ù Ö Ú Û Ù Ò Õ Ö Ú Ò
This means that if there is a change in estimate of, for

Û Ý Þ ß Þ Ú Ö Ò Þ Û Ù à Ú Ö Ù Ú Ô á Û á Ý á Ô Ö × Ô â
Ò Õ Ô Ö Ò Û Ý Þ ß Þ Ô Ý Ú Û Ù Ò Õ Ö Ú Ò Ö × Þ ß Þ Ò
example, the economic life or residual value of the ã
Ô Õ Ô Ö Ù Ô
ã
á Ô Ö × Ô ä Û Õ
underlying asset, the classification of the lease would not be x Ö Ú Û Õ Õ Ô Ú Ò Þ Û Ù Û ß Ô Õ Õ Û Õ å
changed. For example, if the useful life was re-estimated to æ
Ò Ó Ô Õ
ã
Þ × Ô Ú á Ö × × Þ ß Þ Ú Ö Ò Þ Û Ù × × Ó Û ç á Ý
be shorter than the previous estimate, such that the lease Ù Ô è Ô Õ Ú Ó Ö Ù é Ô ê Þ å Ô å Ú Ó Ö Ù é Ô × Þ Ù
term is now considered to be a substantial part of the

Ü
Ô × Ò Þ Ö Ò Ô × Ý Û Ù Û Ò á Ô Ö Ý Ò Û Ö á Ô Ö × Ô
Ú á Ö × × Þ ß Þ Ú Ö Ò Þ Û Ù Ú Ó Ö Ù é Þ Ù é ë å
Chapter 17 869
economic life of the asset and where it had previously not been a substantial part thereof and
had thus been classified as an operating lease, we would not now reclassify the lease as a
finance lease.
$ PRGLILFDWLRQ LV GHILQHG DV µD FKDQJH WR WKH VFRSH RI WKH OHDVH RU WKH FRQVLGHUDWLRQ IRU D
OHDVHWKDWZDVQRWSDUWRIWKHRULJLQDOWHUPVDQGFRQGLWLRQV¶ IFRS 16.App A
If there is a modification made to an operating lease, the original lease is considered cancelled
and the modified lease is considered to be a brand new lease from the date the modification
becomes effective. Any adjustments are processed prospectively. Any lease payments
receivable or received in advance at effective date, will be treated as if they were lease
payments of the brand new lease. See IFRS 16.87
A change made to a finance lease as a result of a modification will only be accounted for as as
separate lease if the following two criteria are met:
x µWKHPRGLILFDWLRQLQFUHDVHVWKHVFRSHE\DGGLQJWKHULJKWWRXVHRQHRUPRUHXQGHUO\LQJ
assets; and
x the consideration for the lease increases by an amount commensurate with the stand-
alone price for the increase in scope and any appropriate adjustments to that stand-alone
price to reflect the circumstances of the particular contract¶IFRS 16.79 (Extract)
If there is a modification made to a finance lease that is not accounted for as a separate lease
(because the two criteria mentioned above are not met), then the lessor:
x applies the requirements of IFRS 9 Financial instruments
x unless the finance lease would have been classified as an operating lease had the
modifications been in existence at inception of the original contract, in which case,
instead of applying IFRS 9, the lessor:
accounts for the modification as a new lease from the effective date of the
modification and
GHUHFRJQLVHVWKHEDODQFHLQWKHµQHWLQYHVWPHQWLQWKHILQDQFHOHDVH¶DFFRXQWFUHGLW
and recognises it as the carrying amount of the underlying asset (debit). See IFRS 16.80
Worked example 1: Change in the contract terms and conditions
If an 8-year lease, originally classified as an operating lease, was altered at the beginning of
year 4 such that ownership now passes to the lessee at the end of year 8, the lease will be re-
classified as a finance lease from the beginning of year 4. No changes are made to the
classification of the lease as an operating lease in the preceding 3 years.
The approach above does not apply to normal renewals and to changes in estimates, for
example changes in estimates of the useful life or the residual value of the leased property.
Worked example 2: Change in the estimated useful life
An 8-year lease was originally classified as an operating lease on the basis that the
remaining useful life of the leased asset at commencement date was 20 years. At the
beginning of year 6, the remaining useful life of the asset was re-estimated to be 3 years. At this date,
the remaining lease term is also 3 years (this also means that at commencement date, the useful life
should have been considered to be 8 years instead of 20 years). Thus, the remaining lease term of 3yrs
LVQRZDVXEVWDQWLDOSRUWLRQRIWKHDVVHW¶VXVHIXOOLIHRI\HDUV$OWKRXJKLWVXJJHVWVWKDWWKH
lease should have been classified as a finance lease at commencement date had we known the revised
estimated useful life of 8 years instead of using the original estimate of 20 years (total lease term = total
re-estimated useful life = 8 years), or that it should be classified as a finance lease at the date the useful
life is re-estimated (remaining lease term = remaining useful life = 3 years), no reclassification of the
lease may take place. The lease continues to be classified as an operating lease.
The only exception would be if, for example, an original useful life was incorrect and thus
that the subsequent change in the useful life is a correction rather than a change in estimate. In
this case, the classification of the lease would have been incorrect and we would thus need to
correct an error. If the error was material and occurred in the prior year, the correcting
adjustments would be made retrospectively, with prior years restated. See IAS8.41 - .49
870 Chapter 17
7. Transaction Taxes (e.g. VAT)
7.1 The effect of transaction taxes on a finance lease
The existence of a transaction tax (e.g. VAT) in a finance lease has certain accounting
implications. To understand these implications one must know what tax legislation applies.
In South Africa, the VAT Act requires that VAT

ì í
É î
í
É ï ð ñ ò ó ô õ ö ÷ ø ù ú û ü ò ü ò ý ò ö þ
vendors calculate and charge VAT (i.e. output

þ ù ö ó ù ô ö ÿ ò ý ö þ ò ó ö ý ò û ü Ñ
x Ø Ô Þ
VAT) on ³LQVWDOPHQW FUHGLW DJUHHPHQWs´ A
Ù é Ò Ó Ô

Û ß Ý Ö Ò Ô Û ß Ý Ô á Þ è Ô Õ Û Õ Ý Ö Ò Ô
Û ß
finance lease satiVILHVWKHFULWHULDDVDQ³LQVWDOPHQW

Ö
Ü
Ô Ù Ò å
x Ò Þ
FUHGLWDJUHHPHQW´and thus a lessor that is a VAT

× Õ Ô Ú Û é Ù Þ × Ô Ý Ö × Ö
Ö Ö Ø á Ô
vendor must charge VAT (i.e. output VAT) on a

Ü Ü
Þ Ô Ý Þ Ö Ò Ô á å
finance lease. The VAT is charged and becomes payable to the tax authorities at the
commencement date, being the earlier of delivery, or payment (see chapter 16 for detailed
discussion).
In other words, this output VAT is payable in total and upfront ± it is not payable piecemeal
based on the lease payments over the lease term. Thus this full VAT is included in the
receivables balance and credited to the VAT output account (VAT payable).
The amount is calculated by multiplying the VAT fraction by ì í
É î
í
É ï ð ñ û ü ò ü ò ý ò ö þ
the cash selling price (incl. VAT but excluding finance costs). þ ù ö ó ù ô ö ÿ ò ý ö þ ò ó ö ý ò û ü Ñ
This VAT that the lessor charges is not included in the x Ú Ö × Ó × Ô á á Þ Ù é Õ Þ Ú Ô Þ Ù Ú á å
OHVVRU¶Vtaxable income and thus income tax is not payable on

ê Ô Ú á å ß Þ Ù Ú Ó Ö Õ é Ô × ë
the VAT included in the lease instalments received. As a result, lease instalments included in
taxable profit are adjusted to exclude the proportional VAT included therein (i.e. output
9$77KLVSURSRUWLRQDO9$7LVFDOOHG³QRWLRQDO´RXWSXW9$7
The tax base of the finance lease receivable ! "
initially reflects the total VAT charged on the

lease, but as and when the lessee pays his x Û Ù # $ % &
Ü
& ' (
instalments, a portion of the instalment is Ö Ý Ý Þ Ù × Ò Ö á Ô Ù Ò á Ô × × Ù Û Ò Þ Û Ù
Ü
Ö á
recognised as a repayment of part of this original Ù Û Ò Þ Û Ù
Ü
Ö á
) Ò Ó Þ × Þ Ù × Ò Ö á Ô Ù Ò Ò Û Ò Ö á
total VAT payable. As mentioned above, the x

Þ Ù × Ò Ö á Ô Ù Ò × Û ç Ò ç Ò
portion of an instalment that is assumed to be a

Û Ù * + * & ' (
UHSD\PHQW RI 9$7 LV FDOOHG D ³QRWLRQDO´ 9$7

Ò Ó Ô Ò Ö Ø Ö × Ô Û ß á Ô Ö × Ô Õ Ô Ú Ô Þ è Ö Ø á Ô ) Ò Û Ò Ö á
Û ç Ò ç Ò
Û ç Ò × Ò Ö Ù Ý Þ Ù é Þ Ù × Ò Ö á Ô Ù Ò × Ò Û Ò Ö á
payment. These notional VAT payments reduce Þ Ù × Ò Ö á

Ü
Ô Ù Ò × ê Û Õ Ò Û Ò Ö á Û ç Ò ç Ò
á Ô × ×
the notional VAT balance still owed by the lessee Ù Û Ò Þ Û Ù Ö á Û ç Ò ç Ò

Þ Ù Ú á ç Ý Ô Ý Þ Ù á Ô Ö × Ô
(i.e. the tax base of the receivable is gradually

Ü
Þ Ù × Ò Ö á Ô Ù Ò × Ö Þ Ý Ò Û Ý Ö Ò Ô ë
reduced by the notional VAT payments until the tax base of the receivable is eventually nil).
If the lessor is not a VAT vendor, then the lessor will not charge VAT and thus the input and
output VAT adjustments referred to above do not apply. The result is that the entire
instalments are included in taxable profits and the lease receivable (lease receivable) will be
nil.
As previously discussed, the VAT Act requires that VAT is charged on the lease, payable
immediately. We recognise this entire VAT on the initial capitalisation of the lease.
Example 19: Finance lease with transaction taxes (VAT)

A Limited sold only one machine during 20X5. This machine was bought on 1 January 20X5 and
had a cost price of C570 000 (including VAT).
This machine was then sold under a finance lease, on the same day.
This is the only transaction for the year ended 31 December 20X5.
A Limited is not a manufacturer/dealer in machines.
Chapter 17 871
x The terms of the lease are as follows:

- Inception of the lease: 1 January 20X5
- Lease period: 5 years
- Lease instalments: C150 000 (incl. VAT) payable annually in arrears on 31 December each year
- Market interest rate: 9,90505% p.a.
x The tax authorities:
- Apply Interpretation Note 47
- Allow the deduction of capital allowances over 5 years.
- Limit the capital allowance to the taxable lease income, where any excess that is not allowed as a
deduction is able to be deducted against future lease income (s 23A).
- Income tax rate: 30%.
x A Limited is a VAT vendor.
Required: Prepare all the journals (including tax) for the year ended 31 December 20X5.
Solution 19: Finance lease with transaction taxes (VAT)

Comment: Section 23A of the Income Tax Act does not apply as the instalments (C150 000) exceed the
wear and tear allowance (C570 000/5 = C114 000).
Debit Credit
1/1/20X5
Machine: cost (A) 500 000
Current tax receivable: VAT input (A) 70 000
Bank (A) 570 000
Purchase of machine
Finance lease receivable: gross investment (with VAT) (A 150 000 x 5 750 000
Finance lease receivable: unearned finance income (- 750 000 570 000
,
180 000
Current tax payable: VAT output (L) 500 000 x 14% 70 000
Machine: cost Given 500 000
Finance lease entered into
31/12/20X5
Finance lease receivable - gross investment (A) 150 000
Finance lease instalment received
Finance lease receivable - unearned finance income (-A) W2 56 459
Recognition of finance income
Income tax (E) W3 10 800
Income tax (E) W4 6 138
Workings:
Total future payments 750 000

Add guaranteed residual value (N/A) 0
Cost of asset 500 000
VAT output 70 000
872 Chapter 17
W2: Effective interest rate table Instalment Finance income @ 9.90505% Balance
1 Jan 20X5 570 000
31 Dec 20X5 (150 000) 56 469 476 459
31 Dec 20X6 (150 000) 47 194 373 653
31 Dec 20X7 (150 000) 37 011 260 664
31 Dec 20X8 (150 000) 25 819 136 483
31 Dec 20X9 (150 000) 13 518 -
(750 000) 180 000
W3. Current tax calculation

Profit before tax Finance income is the only transaction (given) 56 459
Less finance income (56 459)
Less wear and tear 500 000 (excluding VAT)/ 5 years (100 000)
Add lease instalment received 150 000 Notional VAT: 70 000 x (150 000/ 750 000)
À
136 000
Taxable profit 36 000
Current income tax 36 000 x 30% 10 800
W4. Deferred income tax CA TB TD DT

W4.1 Finance lease receivable
Opening balance 0 0 0 0
New lease 570 000 (a) 70 000 (d)
Movement (93 541) (b) (14 000) (e)
Closing balance 476 459 (c) 56 000 (f) (420 459) (126 138) L
Calculations supporting 4.1

CA = Gross investment ± Unearned finance income TB = output VAT x (outstanding instalments/ total instalments)
(a) = 750 000 ± 180 000 (W2/ jnls) (d) = 70 000 output VAT x (750 000/ 750 000)
(b) = 56 459 ± 150 000 (W2/ jnls) (e) = 70 000 output VAT x (150 000/ 750 000)
(c) = 750 000 ± 180 000 ± (150 000 ± 56 459) (W2 / jnls) (f) = 70 000 output VAT x (750 000 ± 150 000)/ 750 000
Note: the initial TB of the Lease receivable asset is the CA less amts taxable in future, which is C70 000. On this initial recognition date,
the CA is 570 000, of which C500 000 will be taxed in future. Thus TB = 570 000 ± 500 000 = 70 000
W4.2 Machine CA TB TD DT
Purchase (excluding VAT) 500 000 500 000
Lease disposal (500 000) 0
Wear and tear 0 (100 000)
Closing balance 0 400 000 400 000 120 000 A
W4.3 Summary of deferred tax Receivable Machine Total

Opening balance of deferred tax 0 0 0
Movement (6 138)
Closing balance of deferred tax (126 138) 120 000 (6 138) L
7.2 The effect of transaction taxes on an operating lease
The existence of VAT in an operating lease is nowhere near as complex as in a finance lease.
The effect on the taxable profits calculation is what one might expect:
x add the operating lease income, excluding VAT;
x deduct the wear and tear, calculated on the cost of the asset, excluding VAT.
7.2.1 Input VAT, s 23C and Interpretation Note 47
When an input VAT deduction for the purchase of an asset is available for a lessor who is a
VAT vendor (i.e. when VAT paid on the purchase of an asset is reclaimable), the tax base will
exclude the amount of input VAT. Thus the tax deductions or allowances on this asset will be
calculated on the cost of the asset excluding the VAT that is reclaimable.
Chapter 17 873
If the VAT was not reclaimable (e.g. the lessor is not a VAT vendor and thus when
purchasing an asset that included VAT, the lessor was not in a position to claim the VAT
back), then the cost of the asset for purposes of calculating an allowance includes the VAT.
Example 20: Operating lease with tax and VAT

A Limited entered into an operating lease (as a lessor) with B Limited over a machine
(original cost C1 140 000 incl. 14% VAT, purchased on 1 January 20X5). The lease terms include:
x Commencement date: 1 January 20X5 with the lease period being 3 years
x Fixed lease payments due as follows (incl. VAT):
- 31 December 20X5: C433 200
- 31 December 20X6: C182 400
- 31 December 20X7: C136 800
A Limited depreciates the machine over 4 years to a nil residual value.
The tax authorities allow the cost to be deducted over 5 years. Tax is levied at 30%.
$¶VSURILWEHIRUHWD[IRU;& 000) has not been adjusted for the above lease transaction. There
are no temporary differences, no items of exempt income and no non-deductible expenses.
Assume that the tax authorities view this lease as a normal leasing agreement (i.e. not as a sale.
Required: Prepare the necessary journal entries for 20X5 in A LLPLWHG¶VERRNV
Solution 20: Operating lease with tax and VAT

Comment: Notice how in W1 we average (smooth) the lease income net of VAT.
Machine: cost (A) 1 000 000

Current tax payable: VAT input (A) 140 000
Bank (A) 1 140 000
Purchase of machine
31/12/20X5
Depreciation: machine (E) 250 000
Machine: accumulated depreciation (-A) 250 000
Depreciation charge for the year: (1 000 000 0) / 4yrs
-
Bank (A) 433 200

Rent received in advance (L) Balancing 160 000
Current tax payable: VAT output (L) 433 200 x 14/114 53 200
Operating lease income (I) W1 220 000
Lease income received (W1)

Deferred tax: income tax (A) 63 000

Deferred tax charge (W3)
W1: Operating lease income

20X5 ± actual (net of VAT) Instalment:433 200 x 100/114 380 000
660 000
Annual average lease income (net of VAT) Total instalments excl VAT: 660 000/3yrs 220 000
874 Chapter 17
W2. Current tax calculation C
Profit before tax and before accounting for the lease 400 000
Add operating lease income W1 220 000
Less depreciation [(Cost excl VAT: 1 140 000 x 100 / 114) 0] ÷ 4 yrs
. (250 000)
Profit before tax 370 000
Less operating lease income See above (220 000)
Add depreciation See above 250 000
Add rental received net of VAT 433 200 x 100 / 114 (or W1) 380 000
Less wear and tear [(Cost excl VAT: 1 140 000 x 100 / 114) ÷ 5yrs (200 000)
Taxable profit 580 000
Current income tax 580 000 x 30% 174 000
W3. Deferred income tax
W3.1 Machine CA TB TD DT
Purchase 1 000 000 1 000 000
Depreciation / wear and tear (250 000) (200 000)
Closing balance 750 000 800 000 50 000 15 000 A
W3.2 Rent received in advance CA TB TD DT

Movement (160 000) 0 160 000 48 000
Closing balance (160 000) 0 160 000 48 000 A
W3.3 Summary of deferred tax Machine IRIA Total

Opening balance of deferred tax 0 0 0
Movement 15 000 48 000 63 000 Dr DT, Cr TE
Closing balance of deferred tax 15 000 48 000 63 000 A
Chapter 17 875
/ 0 1 1 2 3 1
/ 0 4 1 0 5 6 4 1 1 7 8 7 5 4 9 7 2 :
x ; < = > = ? @ A @ > B @ C D E F G E H I J H C I K K L I K K H M N K N E E O P Q E P C E R E I J S P N T I U S V O D O T J N U V M C W O X N U
Y Y Y Y
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D O K K O T C J [ I U N V I C V D C N S a
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t t l t t l n o p q l k o p q n q q s m l n t t l t t l p o l m l p t n p p n o p q

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v u J I J f N K N I V N I V N ^ W N J V N g T M N J M N V N I U N U N S Z f N V v u J I J f N u J f O _ N b
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876 Chapter 17

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Gripping GAAP Leases: lessee accounting

11.2 Initial recognition and measurement 786

reference to the µHQWLW\¶PD\EHDVVXPHGWRUHIHUWRWKHlessee.

Even if an entity does not choose early application, the implications

of the new IFRS 16 are potentially so significant that it is advisable         !   " #

to prepare early for its implementation.

2. IAS 17 ± almost history

Under IAS 17 Leases, an entity entering into a lease as a lessee must

decide whether the lease should be accounted for as a finance lease !

or as an operating lease. This decision is based on the substance of

x a finance lease if it concluded that the agreement effectively 5

3. The new IFRS 16 ± a brief overview

x a lease liability. See IFRS 16.5 & .22

pay future lease instalments will appear in the OHVVHH¶Vstatement of

4. Scope exclusions (IFRS 16.3-4)

5. Identifying whether we have a lease (IFRS 16.9-17 and .B9-B33)

Before we apply IFRS 16, we must be sure we have a x ! 2  "  ! 2 ]    !   % ! 2  "  ! 2 ]

lease and before we can say we have a lease, it must x 6 ! 2  " ^  _ 

obviously meet the definition of a lease. 

The definition of a lease requires, first and foremost, that x %   !        %  I 

Let us return our attention to the fairly basic lease

definition. IFRS 16 elaborates on various aspects of this

refers simply to:               

x µDQ DVVHW¶, this asset must EH µidentified¶ DQG it x ~                             

also simply refers to                  

µULJKWWRXVH¶WKHDVVHWPXVWWUDQVODWHLQWRWKHµULJKWWRcontrol WKHXVH¶RIWKDWDVVHW See IFRS 16.9

5.2 Is the asset identified? 

5.2.1 Identification can be explicit or implicit x ª      « ¬        ­   ¬                  

It does not matter if the asset is identified explicitly or    ¬                    

implicitly. In other words, the contract might name a                                 ¯ 

specific asset (explicit identification) or a specific asset

to the entity (implicit identification).See IFRS 16.B13

Solution 1: Identified asset ± explicit or implicit

5.2.2 Portions of assets can be identified

Solution 2: Identified asset ± capacity portions

supplier has a variety of suitable assets on hand ¤ ¥ ¢ ¦ ¢ ¤ ¢ ¡ ¦ ¤ ¥ ¢  ¨ ¢ ¦ Ü ¡ z y

that it could provide or use as an alternative asset), v w n t Õ p p x z n Ö }

substituted the asset. See IFRS 16.B14 x ç    ä è é è ê â á è à ë é ë ì â à ß ã ã å    

The fact that a contract may allow, or may even require, í

a supplier to substitute one asset for another in the event é ë á â ñ è é á â ê â è ñ              é ë ã è ß î è 

that it needs repairs, maintenance or an upgrade, should í

not be interpreted as the supplier having the right to                                  

substitute an asset for purposes of assessing whether the                       ® ç        

lease definition is met. See IFRS 16.B18   é ë á           

If it is difficult to determine if a supplLHU¶V ULJKW WR

Example 3: Identified asset ± substantive right of substitution

Solution 3: Identified asset ± substantive right of substitution

RIWKHµLGHQWLILHGDVVHW¶)LUVWO\WKH entity must have the

µright to obtain substantially all of the benefits¶ from the ä è é è ê â á î 

use of the asset, we limit our assessment to the scope of x

Obviously, if an entity (customer) has the exclusive and                   

use, then it would normally stand to reason that the           ò ü  ý ü þ

entity would have the right to all the economic benefits

Example 4: Substantially all the economic benefits ± primary & by-products

Entity A (customer) enters into a contract with Entity B (supplier).

Solution 4: Substantially all the economic benefits ± primary & by-products

Example 5: Substantially all the economic benefits ± portion payable to lessor

Solution 5: Substantially all the economic benefits ± portion payable to lessor

5.3.3 The right to direct the use   

of the new IFRS 16 are potentially so significant that it is advisable ! " #

Before we apply IFRS 16, we must be sure we have a x ! 2 " ! 2 ] ! % ! 2 " ! 2 ]

lease and before we can say we have a lease, it must x 6 ! 2 " ^ _

obviously meet the definition of a lease.

The definition of a lease requires, first and foremost, that x % ! % I

refers simply to:

x µDQ DVVHW¶, this asset must EH µidentified¶ DQG it x ~

also simply refers to

µULJKWWRXVH¶WKHDVVHWPXVWWUDQVODWHLQWRWKHµULJKWWRcontrol WKHXVH¶RIWKDWDVVHW See IFRS 16.9

5.2 Is the asset identified?

5.2.1 Identification can be explicit or implicit x ª « ¬ ¬

It does not matter if the asset is identified explicitly or ¬

implicitly. In other words, the contract might name a ¯

supplier has a variety of suitable assets on hand ¤ ¥ ¢ ¦ ¢ ¤ ¢ ¡ ¦ ¤ ¥ ¢ ¨ ¢ ¦ Ü ¡ z y

substituted the asset. See IFRS 16.B14 x ç ä è é è ê â á è à ë é ë ì â à ß ã ã å

a supplier to substitute one asset for another in the event é ë á â ñ è é á â ê â è ñ é ë ã è ß î è

not be interpreted as the supplier having the right to

substitute an asset for purposes of assessing whether the ® ç

lease definition is met. See IFRS 16.B18 é ë á

RIWKHµLGHQWLILHGDVVHW¶)LUVWO\WKH entity must have the

µright to obtain substantially all of the benefits¶ from the ä è é è ê â á î

Obviously, if an entity (customer) has the exclusive and

use, then it would normally stand to reason that the ò ü ý ü þ

5.3.3 The right to direct the use

5.3.3.1 Overview 9 F > 9

then there is no lease. However, there are three

(customer) has the µright to direct the use of the asset¶.

x the asset is not highly interrelated with or x Ñ Ð Ó Ö Ò × Ö Ø Ù Ú

price is not readily available, then the entity would } } ¡

each lease component will be accounted for in terms of } } ð ~

IFRS 16 and the portion that is allocated each of the } } }

non-lease components will be accounted for in terms ~ } } ¡

8.1 Overview (IFRS 16.5-8) ! " #

VKHHW¶RQDlease-by-lease basis. See IFRS 16.8

The assessment of whether or not an asset is considered to have a } ¦

respect of short-WHUPOHDVHVLHWRH[SHQVHRUUHFRJQLVHµRQEDODQFH x û

VKHHW¶LVDQaccounting policy choice that would have to be applied

consistently to that entire class of asset. For example, if we have a § § }

what our accounting policy is with regard to accounting for short- $ }

term leases of delivery vehicles: our accounting policy would either } }

; < < ; á > ? @ A B C ? D E å E < C å æ

However, the lease term may, under certain circumstances, x l b i l k i v x u l k i v u b j h b

also include an optional renewal period or possibly even f c b l u b c l b X X Y q l k i g i f j i u r

terminate the contract). This is explained below. f c b l u b c l b X Z o n Y [ X l k i g i f j i

9.3.2 Fixed payments f t w i c l j w f i e t f g i j j i i l b