Class Notes

IFRS 16 Leases
08
INTRODUCTION AND DEFINITIONS | 85

LEASE
A contract or part of a contract that conveys the right to use an asset (the underlying asset)
for a period of time in exchange for consideration.
LEASE ACCOUNTING (FOR LESSEE)
A lessee is required to recognise a right-of-use asset representing its
General right to use the underlying leased asset and a lease liability
representing its obligation to make lease payments.
Those having a term of 12 months or less, including the effect of
Short term
extension options. The election for short term leases is by class of
leases
asset.
The leases for which the underlying asset is of low value (eg telephones,
Low value
laptop computers, and office furniture). The election for low value leases
leases
can be made on a lease-by-lease basis.
LEASE TYPES (FOR LESSOR)
A lease that transfers substantially all the risks and rewards incidental to
Finance lease
ownership of an underlying asset is known as finance lease.
A lease that does not transfer substantially all the risks and rewards
Operating lease incidental to ownership of an underlying asset is known as operating
lease.
IMPORTANT DATES
The earlier of the date of a lease agreement and the date of commitment
by the parties to the principal terms and conditions of the lease.
Inception date
of the lease
[The type of lease is identified on this date].

The date on which a lessor makes an underlying asset available for use
Commencement by a lessee.
date of the
lease [The accounting treatment is applied from this date]

CLASS ILLUSTRATION 8.1

J Limited enters into a contract for the lease of a car with K Leasing Limited on January 18.
K Leasing Limited agrees to transfer the car in the name of J Limited on 3 rd of February.
However, J Limited would have the right to use the car as at February 22. You are required
to answer the following:

What is the date of inception of the lease? January 18

What is the date of commencement of lease term? February 22

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

IMPORTANT TIME PERIODS

The non-cancellable period for which a lessee has the right to use an
underlying asset, together with both:
(a) periods covered by an option to extend the lease if the lessee is
Lease term
reasonably certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee
86| is reasonably certain not to exercise that option.
Economic life is either:
(a) the period over which an asset is expected to be economically
Economic life usable by one or more users; or
(b) the number of production or similar units expected to be obtained
from the asset by one or more users.
Useful life is the period over which an asset is expected to be available
Useful life for use by an entity; or the number of production or similar units
expected to be obtained from an asset by an entity.

CLASS ILLUSTRATION 8.2

S Limited acquired a plant on lease for a period of 6 years. S Limited has right to extend the
period of lease further 4 years at the end of first 6 years. You are required to calculate the
lease term assuming that S Limited:

Has no intention to extend the period. 06 Years

Has intention to extend the period. 10 Years

CLASS ILLUSTRATION 8.3

B Limited acquired a second hand plant. The total life of such plant (new) is 12 years. The
plant has already been used for 4 years by previous owners. B Limited intends to use the
plant for 5 years and then wants to sell it to someone else. You are required to calculate the:

Total Economic Life 12 Years

Useful Life 05 Years
Remaining Economic Life 08 Years

RESIDUAL VALUE
Unguaranteed residual value is that portion of the residual value of the
Unguaranteed
underlying asset, the realisation of which by the lessor is not assured or
residual value
is guaranteed solely by a party related to the lessor.
Residual value guarantee is a guarantee made to a lessor by a party
Residual value
unrelated to the lessor that the value (or part of the value) of an
guarantee
underlying asset at the end of a lease will be at least a specified amount.
Part of residual value guaranteed by: For lessee For Lessor
Lessee GRV GRV
Related party of lessee GRV GRV
Third party unrelated to lessee and lessor - GRV
Related party of lessor - UGRV
None - UGRV

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 Class Notes

FINANCE LEASE CALCULATION

Payments made by a lessee to a lessor relating to the right to use an
underlying asset during the lease term, comprising the following:
(a) fixed payments (including in-substance fixed payments), less
any lease incentives;
Lease payments (b) variable lease payments that depend on an index or a rate;
(LP) (c) the exercise price of a purchase option if the lessee is | 87
reasonably certain to exercise that option; and
(d) payments of penalties for terminating the lease, if the lease
term reflects the lessee exercising an option to terminate the
lease.
are incremental costs for obtaining a lease that would not have
been incurred if the lease had not been obtained, except for such
Initial direct costs
costs incurred by a manufacturer or dealer lessor in connection with
a finance lease.
Gross investment
GI = LP for lessor + Unguaranteed residual value (UGRV)
in the lease (GI)
NI = GI x Discount Factor using interest rate implicit in the lease
Net investment in
NI = PV of GI
the lease (NI)
NI = GI - UFI
Unearned finance
UFI = GI - NI
income (UFI)
Interest rate is the discount rate that, at the inception of the lease, causes:
implicit in the lease PV of GI = FV of leased asset + initial direct cost of lessor
The lessee's incremental borrowing rate of interest is the rate of
Lessee’s
interest that a lessee would have to pay to borrow over a similar
incremental
term, and with a similar security, the funds necessary to obtain an
borrowing rate of
asset of a similar value to the right-of use asset in a similar economic
interest
environment.

HOW TO CALCULATE PRESENT VALUE (PV) DISCOUNT FACTOR

Single payment =( + )
( + )
Annuity (end of period) =
Annuity due (beginning of ( + )
period) = +

CLASS ILLUSTRATION 8.4

C Limited acquired a machine on lease from L Limited on following terms:
Down Payment Rs. 50,000
Annual Payments (in arrears) Rs. 80,000
Lease Term 05 years

The residual value at end of lease term is estimated to be Rs.15,000. C Limited guaranteed
L Limited to purchase the asset at the end of lease term at Rs.10,000 if L Limited so desire.
M Limited (manufacturer of machine) has guaranteed L Limited to purchase the machine at
the end of lease term at Rs.13,000 if L Limited so desire.

You are required to calculate the:

GRV – Lessee Rs. 10,000
GRV – Lessor Rs. 13,000
UGRV Rs. 2,000
LP for Lessee Rs. (50,000 + (80,000 x 5) + 10,000) = Rs.460,000
LP for Lessor Rs. (50,000 + (80,000 x 5) + 13,000) = Rs.463,000

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

CLASS ILLUSTRATION 8.5

B Limited acquired a plant on lease from L Limited on following terms:
Down Payment Rs. 10,000
Annual Payments (at end of year) Rs. 20,000
Lease Term 05 years
88| Interest rate implicit in the lease 10% per annum
Residual value guaranteed by B Limited Rs. 10,000
Estimated residual value at end of lease term Rs. 15,000

You are required to calculate the following for L Limited:

LP for lessee Rs. (10,000 + (20,000 x 5) + 10,000) = Rs. 120,000

LP for lessor Rs. (10,000 + (20,000 x 5) + 10,000) = Rs. 120,000

Gross Investment in Lease Rs. 120,000 + 5,000 = Rs. 125,000

Net Investment in Lease w1 Rs. 95,130

Unearned Finance Income Rs. 125,000 – 95,130 = Rs. 29,870

W1
Time Description Cash flow PV Factor PV
0 Down payment 10,000 1.0000 10,000
1-5 Rentals 20,000 3.7908 75,816
5 GRV 10,000 0.6209 6,209
5 UGRV 5,000 0.6209 3,105
95,130

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 Class Notes

LEASE CLASSIFICATION (FOR LESSOR)

Whether lease is a finance lease or an operating lease depends on the
substance of the transaction rather than form of the contract. The main
factor is risk and rewards. Where repair and maintenance charges,
Substance
insurance charges, the loss due to idle capacity are to be borne by lessee
and the major economic benefits are to accrue to lessee, there is an | 89
indication that risk and rewards have been transferred to lessee.
Examples of situations that individually or in combination would normally
lead to a lease being classified as a finance lease are (not conclusive
factors – risk and rewards are):
(a) Transfer of ownership to lessee at the end of lease term;
(b) The bargain purchase option or bargain renewal option at the end of
lease term;
(c) The lease term is 75% (generally) or more of asset’s economic life;
Examples (d) PV of MLP is 90% (generally) or more of FV of asset;
(e) The leased asset is of such specialized nature that only lessee can
use it without major modification;
(f) Lessor’s losses associated with the cancellation of lease are borne
by the lessee;
(g) Gain or losses from the fluctuation in fair value accrue to the lessee.
(h) The lessee has the ability to continue the lease for secondary period
at a rent that is substantially lower than market rent.

CLASS ILLUSTRATION 8.6

You are required to advise regarding classification of these leases:
Type
(a) E Limited acquired a special customized engine. The engine can only
Finance
be used by E Limited unless substantial modifications are made to
Lease
the engine.
(b) P Limited acquired an asset on lease with fair value of Rs. 100,000 Finance
and present value of MLP is Rs. 92,500 Lease
(c) M Limited acquired an asset on lease economic life of 20 years while
Finance
M Limited wants to use the asset only for 17 years. The company has
Lease
no intention to purchase the asset at the end of its lease term.
(d) T Limited acquired an asset on lease with an option to buy the asset
Finance
at the end of lease term for Rs. 12,000. The fair value of the asset at
Lease
the end of lease term is expected to be at least Rs. 55,000.

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

ACCOUNTING FOR LEASE BY LESSEE

INITIAL RECOGNITION AND MEASUREMENT
Dr. Right of use
Cr. Lease liability
Cr. Bank (amount already paid)
90| Cr. Bank (initial direct costs)
Cr. Provision (IAS 37)
Right of use asset
At the commencement date of the lease, a lessee recognises a right-of-use asset at cost,
comprising:
(a) The amount of the lease liability recognised;
(b) Any lease payments made at or before the commencement date, less any lease
incentives;
(c) Any initial direct costs incurred; and
(d) An estimate of costs to be incurred to dismantle and remove an asset and restore the
site based on the terms and conditions of the lease.

Lease Liability
At the commencement date of the lease, a lessee recognises a lease liability for the unpaid
portion of payments (and guaranteed residual value, if any), discounted at the rate implicit in
the lease or, if this is not readily determinable, the incremental rate of borrowing.

SUBSEQUENT MEASUREMENT – RIGHT OF USE ASSET (THREE OPTIONS)

Dr. Depreciation expense
Cr. Right to use asset / Acc. Depreciation
Revaluation model Investment property
Cost model (IAS 16)
(IAS 16) (IAS 40)
Apply IAS 16 to record depreciation. If lessee applies the If a lessee applies the
Depreciation period is the useful life of revaluation model to a fair value model to its
the asset if the lease transfers class of asset, it may investment property,
ownership of the underlying asset; elect to apply that the lessee is required
otherwise earlier of the asset’s useful model to the same to apply that model to
life and lease term. class of right-of-use right-of-use assets that
Adjust carrying value based on any re- assets. meet the definition of
measurements as required from investment property in
reassessment of the lease liability. IAS 40.
Apply IAS 36 Impairment of Assets to
measure impairment.

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 Class Notes

SUBSEQUENT MEASUREMENT – LEASE LIABILITY

Dr. Interest expense
Cr. Interest payable / Lease liability
Dr. Interest payable
Dr. Lease liability (principal)
Cr. Bank (total rental)
| 91
Dr. Contingent rent expense
Cr. Bank / payable
After the commencement date, a lessee re-measures the lease liability by:
(a) Increasing the carrying amount to reflect interest on the lease liability;
(b) Reducing the carrying amount to reflect the lease payments made; and
The lease term is updated if there is a change in the non-cancellable period of the lease
when the lessee:
(a) Exercises an existing option not previously included in the determination of the lease
term;
(b) Does not exercise an option that was previously included in the determination of the
lease term;
(c) An event occurs that obliges the lessee to exercise an option not previously included
in the determination of the lease term; or
(d) An event occurs that contractually prohibits the lessee from exercising an option
previously included in the previous determination of the lease term.
Variable lease payments that have not been included in the initial measurement of the
lease liability are recognised in the period in which the event or condition that triggers the
payments occurs.
Lease modifications: a lessee accounts for a lease modification as a separate lease if:
(a) the modification increases the scope of the lease by adding the right to use one or
more additional underlying assets; and
(b) the consideration for the lease increases by an amount commensurate with the
stand-alone price for the increase in scope (including any appropriate adjustments to
reflect the circumstances of that contract).
PRESENTATION
Right-of-use assets:
(a) Present right-of-use assets separately from other assets; or
(b) Include right-of-use assets within the same line item as the
underlying asset
Statement of
financial The requirement in (a) does not apply to right-of-use-assets that meet
position the definition of investment property, which shall be presented in the
statement of financial position as investment property.
Lease liabilities: present separately from other liabilities or disclose the
line item in which they are included.
Statement of
Interest expense on the lease liability is presented separately from
comprehensive
depreciation of the right-of-use asset, as a component of finance costs.
income
Principal payments on the lease liability as financing activities.
Payments of interest in accordance with guidance for interest
Statement of paid in IAS 7 Statement of Cash Flow.
cash flows Short-term and low-value asset leases and variable lease
payments that are not included in the measurement of lease
liabilities are classified within operating activities.

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

DISCLOSURES
A lessee shall disclose information about its leases for which it is a
lessee in a single note or separate section in its financial statements.
However, a lessee need not duplicate information that is already
General
presented elsewhere in the financial statements, provided that the
information is incorporated by cross-reference in the single note or
92| separate section about leases.
A lessee shall disclose the following amounts for the reporting period:
(a) depreciation charge for right-of-use assets by class of underlying
asset;
(b) interest expense on lease liabilities;
(c) the expense relating to short-term leases. This expense need not
include the expense relating to leases with a lease term of one
month or less;
(d) the expense relating to leases of low-value assets. This expense
Specific shall not include the expense relating to short-term leases of low-
disclosures value assets;
(e) the expense relating to variable lease payments not included in
the measurement of lease liabilities;
(f) income from subleasing right-of-use assets;
(g) total cash outflow for leases;
(h) additions to right-of-use assets;
(i) gains or losses arising from sale and leaseback transactions; and
(j) the carrying amount of right-of-use assets at the end of the
reporting period by class of underlying asset.
A lessee shall provide the disclosures specified in a tabular format,
unless another format is more appropriate. The amounts disclosed shall
Tabular format
include costs that a lessee has included in the carrying amount of
another asset during the reporting period.
A lessee shall disclose the amount of its lease commitments for short-
Lease
term leases accounted if the portfolio of short-term leases to which it is
commitment
committed at the end of the reporting period is dissimilar to the portfolio
and portfolio
of short-term leases to which the short-term lease expense disclosed.
When If a lessee measures right-of-use assets at revalued amounts applying
revaluation IAS 16, the lessee shall disclose the information specified in relevant
model is used disclosure of IAS 16 for those right of use assets.
Under IFRS 16 the financial liability of lessee under lease arrangement
requires a maturity analysis that is dealt by IFRS 7. According to IFRS 7,
the lessee is required to disclose maturity analysis of lease liability for
remaining contractual maturities. The contractual maturities are the
Maturity
future lease payments (without discounting).
Analysis
Moreover, application guidance (B11) of IFRS 7, Financial Instruments:
Disclosures requires that in preparing the maturity analysis, a lessee
uses its judgment to determine an appropriate number of time bands.

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 Class Notes

CLASS ILLUSTRATION 8.7

On 1 Jan 2017, Pervez Limited (PL) leases a plant from a bank. PL is required to pay an
annual instalment of Rs.1 million at the end of each year for seven years. First payment was
made on 23 December 2017

Solution - based on the judgment of Pervez Limited (Option 1)

Maturity analysis – contractual undiscounted lease payments Rs. in 000 | 93
Less than one year 1,000
Two to five years 4,000
More than five years 1,000
Total undiscounted lease payments 6,000

Solution - based on the judgment of Pervez Limited (Option 2 alternative)

As at 31 December 2017
Maturity analysis – contractual undiscounted lease payments Rs. in 000
Less than 1 year 1,000
One to two years 1,000
Two to three years 1,000
Three to four years 1,000
Four to five years 1,000
More than five years 1,000
Total undiscounted lease payments 6,000

CLASS ILLUSTRATION 8.8

J Limited (JL) leased a plant on 1 January 2011. The lease term is 4 years; however, JL
uses similar owned assets for 5 years. The fair value of the asset is Rs. 11,420 and JL
incurred initial direct costs of Rs. 580. The interest rate implicit in lease is 15%. Rentals of
Rs. 4,000 are payable on 31 December (also financial year end) each year. Assume that
contingent rent of Rs. 600, Rs. nil, Rs. 800, Rs. 750 was paid in year 2011, 2012, 2013 and
2014 respectively. You are required to give financial statements extracts and workings.

ANSWER

Statement of comprehensive Income 2011 2012 2013 2014

(extracts) Rs. Rs. Rs. Rs.
Depreciation expense 3,000 3,000 3,000 3,000
Interest expense 1,713 1,370 975 522
Contingent rent expense 600 - 800 750

Statement of financial position (extracts) 2011 2012 2013 2014

Non-current assets Rs. Rs. Rs. Rs.
Right of use asset 12,000 12,000 12,000
Accumulated depreciation (3,000) (6,000) (9,000)
9,000 6,000 3,000 -

Non-current liabilities
Lease liability 6,503 3,478 - -

Current liabilities
Lease liability 2,630 3,025 3,478 -
Interest payable - - - -

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

Working 1 Lease (Payments in arrears) Schedule

Liability Liability
Payment Interest Principal
at Rental after
time @ 15% Element
beginning payment
T Rupees

94| 2011 11,420 1,713 4,000 (2,287) 9,133

2012 9,133 1,370 4,000 (2,630) 6,503

2013 6,503 975 4,000 (3,025) 3,478

2014 3,478 522 4,000 (3,478) -

CLASS ILLUSTRATION 8.9

Poonam Limited (PL) entered into a four-year lease on 1 January 2011 for a machine with a
fair value of Rs. 69,738. Rentals are Rs. 20,000 per annum payable in advance. PL is
responsible for insurance and maintenance costs. The rate of interest implicit in the lease is
10%. You are required to give financial statements extracts and workings.

ANSWER
Statement of comprehensive Income 2011 2012 2013 2014
(extracts) Rs. Rs. Rs. Rs.
Depreciation expense 17,434.5 17,434.5 17,434.5 17,434.5
Interest expense 4,974 3,471 1,817 -

Statement of financial position (extracts) 2011 2012 2013 2014

Non-current assets Rs. Rs. Rs. Rs.
Right of use asset 69,738 69,738 69,738
Accumulated depreciation (17,434.5) (34,869) (52,303.5)
52,303.5 34,869 17,434.5 -

Non-current liabilities
Lease liability 34,712 18,183 - -

Current liabilities
Lease liability 15,026 16,529 18,183 -
Interest payable 4,974 3,471 1,817 -

Working 1 Lease (Payments in advance) Schedule

Liability
Payment Principal Liability after Interest @
at Rental
time Element payment 10%
beginning
T Rupees

2011 69,738 (20,000) (20,000) 49,738 4,974

2012 49,738 (20,000) (15,026) 34,712 3,471

2013 34,712 (20,000) (16,529) 18,183 1,817

2014 18,183 (20,000) (18,183) - -

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 Class Notes

ACCOUNTING FOR LEASE BY LESSOR

FINANCE LEASE ACCOUNTING – NORMAL LESSOR
Journal Entry Time of recognition By the amount
Dr. Net investment PV of (LP + UGRV)
Commencement of lease
Cr. Asset Fair value
term
Cr. Bank/Payables Initial direct costs | 95
Dr. Interest receivable The interest accrued during the
At year end
Cr. Interest income year
Dr. Bank At the time Total rental
Cr. Interest receivable payment/rental is Interest
Cr. Net Investment received Principal amount (Schedule)
Dr. Bank / accrual The period in which they
As calculated under agreement
Cr. Variable rent are incurred

FINANCE LEASE ACCOUNTING – MANUFACTURER OR DEALER LESSOR

Journal Entry Time of recognition By the amount
Dr. Net investment PV of (LP + UGRV)
Cr. COS PV of UGRV
Commencement of
Cr. Sales revenue PV of LP at market rate*
lease term
Dr. COS
Cost of goods leased
Cr. Inventory
Dr. Selling exp.
When incurred Initial direct costs
Cr. Cash
Dr. Interest receivable At year end The interest accrued during the year
Cr. Interest income
Dr. Bank At the time Total rental
Cr. Interest receivable payment/rental is Interest
Cr. Net Investment received Principal amount (Schedule)
Dr. Bank / accrual The period in which
As calculated under agreement
Cr. Variable rent they are incurred
*or at fair value if it is significantly lower.

IMPORTANT POINTS - LESSOR

Lessors shall recognize assets held under finance lease in their statement
All lessors of financial position and present them as a receivable at an amount equal to
the NI (GI – UFI).
The interest rate in the lease is defined in such a way that the initial direct
Normal
costs are included automatically in finance lease receivable; there is no
Lessor
need to add them separately.
Manufacturer and dealer lessors shall recognise selling profit or loss in the
Manufacturer
period, in accordance with the policy followed by the entity for outright sales,
or dealer
if artificially low rates of interest are quoted, selling profit shall be restricted
lessor
to such amount as if a market rate of interest were charged.

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

DISCLOSURES
Selling profit or loss
Finance income on the net investment in the lease
Income relating to variable lease payments not included in the
measurement of the net investment in the lease
Qualitative and quantitative explanation of the significant changes in the
96| Finance carrying amount of the net investment in the lease
lease Maturity analysis of undiscounted lease payment receivable for a minimum
of each of the first five years plus a total amount for the remaining years.
A lessor shall reconcile the undiscounted lease payments to the net
investment in the lease. The reconciliation shall identify the unearned
finance income relating to the lease payments receivable and any
discounted unguaranteed residual value.
Lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or a rate.
Maturity analysis of undiscounted lease payments to be received for a
minimum of each of the first five years plus a total amount for the
Operating
remaining years
lease
Disclosure requirements in IAS 36, IAS 38, IAS 40 and IAS 41 for assets
subject to operating leases
Disclosure requirements in IAS 16 for items of property, plant and
equipment subject to an operating lease
Nature of the lessor‘s leasing activities
Qualitative
Management of the risk associated with any rights that the lessor retains
disclosures
in underlying assets.
all leases

CLASS ILLUSTRATION 8.10

On 1 Jan 2017, Oscar Bank Limited (OBL) gave a machine on finance lease to Pervez
Limited (PL). Instalment of Rs.5.714 million at the end of each year is receivable for seven
years. First payment was received on 23 December 2017. The interest rate implicit in the
lease is 6%.

ANSWER

Maturity analysis – contractual undiscounted cash flows Rs. in 000

Less than 1 Year 5,714
One to two years 5,714
Two to three years 5,714
Three to four years 5,714
Four to five years 5,714
More than 5 years 5,714
Total undiscounted lease receivable 34,284
Reconciliation Rs. in 000
Total lease receivable 34,284
Add: Un-guaranteed Residual Value -
Gross investment in lease 34,284
Less: Unearned finance income (6,255)
Net investment in lease 28,025

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 Class Notes

CLASS ILLUSTRATION 8.11

On 1 Jan 2017, Genuine Properties Ltd. (GPL) leased a building to Faheem Limited (FL) at
Rs.5.714 per annum. Lease term is for seven years and economic life of the building is
twenty five years. First payment was received on 23 December 2017.

ANSWER
| 97
Maturity analysis – contractual undiscounted cash flows Rs. in 000
Less than 1 Year 5,714
One to two years 5,714
Two to three years 5,714
Three to four years 5,714
Four to five years 5,714
More than 5 years 5,714
Total undiscounted lease receivable 34,284

CLASS ILLUSTRATION 8.12

Jalal Leasing Limited (JLL) gave a plant under finance lease on 1 January 2011 to a
customer. The lease term is 4 years. The fair value of the asset is Rs. 11,000 and JL
incurred initial direct costs of Rs. 420. The interest rate implicit in lease is 15%. Rentals of
Rs. 4,000 are receivable on 31 December (also financial year end) each year. Assume that
contingent rent of Rs. 600, Rs. nil, Rs. 800, Rs. 750 was received in year 2011, 2012, 2013
and 2014 respectively. You are required to give financial statements extracts along with
reconciliation disclosure and workings.

ANSWER

Statement of comprehensive Income 2011 2012 2013 2014

(extracts) Rs. Rs. Rs. Rs.
Interest Income 1,713 1,370 975 522
Contingent rent income 600 - 800 750

Statement of financial position (extracts) 2011 2012 2013 2014

Non-current assets Rs. Rs. Rs. Rs.
Gross Investment in lease 8,000 4,000 - -
Unearned finance income (1,497) (522) - -
Net Investment in lease 6,503 3,478 - -

Current assets
Gross Investment in lease 4,000 4,000 4,000 -
Unearned finance income (1,370) (975) (522) -
Net investment in lease 2,630 3,025 3,478 -
Working 1 Finance Lease (Receipt in arrears) Schedule
Receipt Receivable Interest Principal Receivable
Rental
time at beginning @ 15% Element after receipt
T Rupees
31.12.2011 11,420 1,713 4,000 (2,287) 9,133
31.12.2012 9,133 1,370 4,000 (2,630) 6,503
31.12.2013 6,503 975 4,000 (3,025) 3,478
31.12.2014 3,478 522 4,000 (3,478) -

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

CLASS ILLUSTRATION 8.13

Kamil Limited (KL) is engaged in manufacturing of plants. The following data relates to an
asset leased out by the company on January 01, 2011.
Cost Rs. 200,000
Sales price (quoted) Rs. 240,000
98| Installment at the end of each year Rs. 40,000
Lease term 7 years
Unguaranteed residual value Rs. 2,000
Initial direct costs Rs. 1,000
Rate of interest (quoted) 4% (the artificially low rate is quoted to attract customers)
Market rate of interest 7%

Required:
Pass the journal entries.

ANSWER
The journal entries are:
Date Particulars Dr. Rs Cr. Rs

01.01.11 Selling expense 1,000

Cash / payable 1,000

01.01.11 Net investment w1 + w2 216,818

Cost of sales w1 1,246

Sales revenue w2 215,572

01.01.11 Cost of sales 200,000

Inventory 200,000

W1 PV of MLP Rs. 40,000 x 5.3893 discount factor @7% = Rs. 215,572

W2 PV of UGRV Rs. 2,000 x 0.6227 discount factor @7% = Rs. 1,246

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 Class Notes

OPERATING LEASE - LESSOR

Lease income from operating lease shall be recognized on a straight-line
Lease income basis over the lease term unless another systematic basis is more
representative of benefit derived from the leased asset.
Asset shall be presented in statement of financial position as per its
Asset
nature.
Initial direct costs shall be added to the carrying amount of the leased | 99
Initial direct
asset and recognized as an expense over the lease term on the same
costs
basis as the lease income.
Depreciation The deprecation is to be charged as per normal depreciation policy.
Dr. Bank/accrual
Journal entry
Cr. Lease/Rent income

CLASS ILLUSTRATION 8.14

Faheem Limited (FL) leased out its building on 1 January 2011under an operating lease.
The carrying value of building is Rs. 23,900 and its remaining useful life is 25 years with no
residual value. FL also incurred Rs. 1,100 as initial direct costs. According to agreement, Rs.
1,600 was paid by lessee as initial deposit and further rental of Rs. 1,000 p.a. shall be paid
at the end next two years and then Rs. 3,200 p.a. shall be paid for following two years. The
lease term is also 4 years. You are required to give journal entries for year 1.

ANSWER
The journal entries are:
Date Particulars Dr. Rs Cr. Rs

01.01.11 Cash 1,600

Unearned lease income 1,600

Building (initial direct costs) 1,100

Cash 1,100

31.12.11 Depreciation 1,231

Accumulated depreciation 1,231

[1100 / 4 yeas] + [23,900 / 25 years]

31.12.11 Cash 1,000

Unearned lease income 1,500

Lease income 2,500

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

SALE AND LEASE BACK TRANSACTIONS

SELLER – LESSEE
Follow IFRS 15 guidance if the transaction is a sale of the underlying asset or not.
TRANSFER IS A SALE TRANSFER IS NOT A SALE
The right-of-use asset is recorded in proportion to the The asset continues to be
100| previous carrying amount of the asset that relates to the recognised and a
right of use retained. financial liability is
recognised equal to the
= ×
proceeds transferred.
Gains and losses are limited to the amount relating to The financial liability is
the rights transferred. accounted for in
accordance with IFRS 9.
=[ ]×
Adjustments required if sale is not at fair value or lease
payments are not at market rates
The amount above fair value is considered loan
The amount below fair value is considered
prepayment of lease liability

CLASS ILLUSTRATION 8.15

A company sold a machine for Rs.1.5 million which is also fair value and leased it back
under a five-year lease. The asset has a carrying value of Rs.1 million. The lease payments
made by the lessee is Rs.200,000 p.a. paid at the end of the year. The interest rate implicit
in the lease is 5% p.a. Assume that the transfer of machine by the seller-lessee satisfies the
requirements of IFRS 15 to be accounted for as a sale
ANSWER

Debit (Rs.) Credit (Rs.)

Cash 1,500,000
Right of-use 577,263
Asset 1,000,000
Liability - PV of lease payment 865,895
Gain 211,368
W1 – Calculations Rs.
PV of payments (PV of 200,000 p.a. for 5 years @ 5%) 865,895
Add/(less): Adjustment fair value – sales price 0
NPV 865,895

865,895
= 1,000,000 × = 577,263
1,500,000
1,500,000 865,895
( ) = [1,500,000 1,000,000] × = 211,368
1,500,000

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 Class Notes

CLASS ILLUSTRATION 8.16

A company sold a machine for Rs.1.5 million which is also fair value and leased it back
under a five-year lease. The asset has a carrying value of Rs.1 million. The lease payments
made by the lessee is Rs.346,462 p.a. paid at the end of the year. The buyer-lessor interest
rate implicit in the lease is 5% p.a. The machine has a remaining economic life of 6 years.
Lessee has the right to purchase the machine at Rs.50,000 at the end of the lease term.
Initial direct costs are ignored. | 101

ANSWER
Accounting in the books of seller-lessee (Transfer of asset is not a sale)
Cash 1,500,000
Financial liability 1,500,000

CLASS ILLUSTRATION 8.17

A company sold an asset for Rs.1.5 million and leased it back under a five-year lease. The
asset had a carrying value of Rs.1 million. The fair value of the asset at the date of sale is
Rs.1.2 million. The lease payments made by the lessee is Rs.100,000 p.a. paid at the end of
the year. The interest rate implicit in the lease is 5% p.a. Assume that the transfer of asset
by the seller-lessee satisfies the requirements of IFRS 15 to be accounted for as a sale

ANSWER

Debit Credit
Rs. Rs.
Cash 1,500,000
Right-of-use 110,789
Asset 1,000,000
Lease Liability 132,947
Financial liability (loan) 300,000
Gain 177,842
W1 – Calculations Rs.
PV of payments (PV of 100,000 p.a. for 5 years @ 5%) 432,947
Add/(less): Adjustment fair value – sales price (300,000)
NPV 132,947

132,947
= 1,000,000 × = 110,789
1,200,000
1,200,000 132,947
( ) = [1,200,000 1,000,000] × = 177,842
1,200,000

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

CLASS ILLUSTRATION 8.18

Atlas Ltd. sells its manufacturing equipment at a price of Rs.5,500,000 to Hybrid Leasing Co.
(buyer-lessor). The fair value of the equipment at time of sale is Rs.6,000,000 and the
carrying value is Rs.3,000,000. The seller-lessee leases back the equipment for 10 years in
exchange for annual rent payments of Rs.400,000 payable at the end of each year. The
seller-lessee’s incremental borrowing rate is 6%. Assume that the transfer of equipment by
102| the seller lessee satisfies the requirements of IFRS 15 to be accounted for as a sale.

ANSWER
Debit Credit
Rs. Rs.
Cash 5,500,000
Right-of-use asset 1,722,017
Equipment 3,000,000
Lease Liability (PV of Lease payments) 2,944,034
Gain 1,277,983
W1 – Calculations Rs.
PV of payments (PV of 400,000 p.a. for 10 years @ 6%) 2,944,034
Add/(less): Adjustment fair value – sales price 500,000
NPV 3,444,034

3,444,034
= 3,000,000 × = 1,722,017
6,000,000
6,000,000 3,444,034
( ) = [6,000,000 3,000,000] × = 1,277,983
6,000,000

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 Class Notes

BUYER – LESSOR
Follow IFRS 15 guidance to determine if the transaction is a sale of the underlying asset or
not.
TRANSFER IS A SALE TRANSFER IS NOT A SALE
Account for the purchase of the asset Do not recognise the transferred asset
applying the applicable IFRS. and recognise a financial asset equal to
Account for the lease under the the transfer proceeds. | 103
lessor accounting requirements of The financial asset is accounted for in
IFRS 16. accordance with IFRS 9.

CLASS ILLUSTRATION 8.19

A company bought a machine for Rs.1.5 million and leased it back under a four year lease.
The lease payments made by the lessee is Rs.200,000 p.a. paid at the end of the year. The
useful life is 4 years and after that remaining economic life of an asset is 8 years. The
interest rate implicit in the lease is 5% p.a. Assume that the transfer of machine by the seller-
lessee satisfies the requirements of IFRS 15 to be accounted for as a sale.
ANSWER
Accounting from perspective of Buyer-Lessor (Transfer is a sale)
The asset is recognized as per IAS 16:
Property, plant and equipment Rs.1,500,000
Cash Rs.1,500,000

Subsequently after end of each year:

- Asset will be depreciated over the remaining economic life in accordance with IAS 16.
- The operating lease payments will be recognized as income over the lease term.
Cash Rs.200,000
Income Rs.200,000
Depreciation expense (over 12 years) Rs.125,000
Accumulated depreciation Rs.125,000

CLASS ILLUSTRATION 8.20

A company sold a machine for Rs.1.5 million which is also fair value and leased it back
under a five-year lease. The asset has a carrying value of Rs.1 million. The lease payments
made by the lessee is Rs.346,462 p.a. paid at the end of the year. The buyer-lessor interest
rate implicit in the lease is 5% p.a. The machine has a remaining economic life of 6 years. A
lessor determines that the machine is of such a specialize nature that only the lessee can
use it without major modification. Lessee has a right purchase the machine at Rs.50,000 at
the end of the lease term. Initial direct costs are ignored.

ANSWER
Accounting in the books of buyer lessor (Transfer of asset is not a sale)
The buyer-lessor shall account for lease as a financial asset (in accordance with IFRS 9):
Debit (Rs.) Credit (Rs.)
Financial asset 1,500,000
Cash 1,500,000

Subsequently:
Cash Rs.346,462 (Dr.)
Financial asset Rs.271,462 (Cr.)
Interest receivable Rs.75,000 (Cr.)
Lease amortisation schedule will need to be made to account for Principal (Financial asset)
and interest (income) over the useful life of a machine.

4th Edition
 ICAP CAF 7 Financial Accounting and Reporting II

CLASS ILLUSTRATION 8.21

A company sold the furniture for Rs.200,000 and leased it back under a ten months lease at
Rs.4,000 per month. The asset had a carrying value of Rs.160,000 and fair value of
Rs.200,000.
ANSWER
104| Sale and leaseback – Sales at Fair Value (Short term lease)
Debit (Rs.) Credit (Rs.)
Cash 200,000
Asset – Furntiture (CV) 160,000
Gain 40,000

When the lessee make payment to lessor over ten month, the lessee shall account for the
payments in equal installments (straight line basis). The following entry will take place;
Expense 4,000
Cash 4,000
This entry is made for ten accounting periods

CLASS ILLUSTRATION 8.22

A company sold the furniture for Rs.200,000 and leased it back under a ten months lease at
Rs.4,000 per month. The asset had a carrying value of Rs.160,000 and fair value of
Rs.180,000.

ANSWER
Sale and leaseback – Sales above Fair Value (Short term lease)
Debit (Rs.) Credit (Rs.)
Cash 200,000
Asset – Furntiture (CV) 160,000
Gain 40,000
When the lessee makes payments to lessor over ten months, the lessee shall account for
the payments in equal installments (straight line basis). The following entry will take place;
Expense 4,000
Cash 4,000
This entry is made for ten accounting periods by the lessee

CLASS ILLUSTRATION 8.23

A company sold a computer for Rs.35,000 and leased it back under a ten months lease at
Rs.4,000 per month The asset had a carrying value of Rs.40,000. The fair value of the asset
was Rs.45,000.
ANSWER
Sale and leaseback – Sale below fair value (Low value asset)
Debit (Rs.) Credit (Rs.)
Cash 35,000
Statement of comprehensive income 5,000
Asset 40,000
When the lessee makes payments to lessor over ten months, the lessee shall account for
the payments in equal installments (straight line basis). The following entry will take place;
Expense 4,000 (Dr.)
Cash 4,000 (Cr.)
This entry is made for ten accounting periods by the lessee

End of Chapter

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