Leases (IFRS 16)

A lease exists when a contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Three elements:

1. Identified asset: The asset is either explicitly specified (e.g., a specific vehicle registration, a specific piece of equipment) or implicitly specified (only one asset can fulfil the contract). A supplier has a substantive substitution right — and therefore the asset is NOT identified — only if: (a) the supplier has the practical ability to substitute, AND (b) the supplier would benefit economically from substitution.
2. Right to obtain substantially all the economic benefits from use of the asset throughout the period
3. Right to direct the use of the asset — the customer has the right to decide how and for what purpose the asset is used (e.g., what it produces, when, where, and how operated). If both parties have predetermined how the asset is used, the customer directs the use if they operate the asset, or if the customer designed the asset.

Practical examples:

• Yes — lease: A company rents a specific office floor in a building for 10 years, can decide the layout and usage. Identified asset ✓, obtains economic benefits ✓, directs use ✓.
• No — service contract: A logistics company provides "shipping services" using any of its 200 lorries. No identified asset (supplier has practical substitution right and benefits from optimising its fleet).
• No — service element only: Cloud computing services where the customer doesn't control specific physical servers. Even if a "data centre" is identified, the customer doesn't direct the use — the supplier determines which servers, how they are operated, etc.

Separating lease and non-lease components: If a contract contains both a lease and a service (e.g., equipment lease with maintenance services), the consideration is allocated between components based on relative stand-alone prices. Practical expedient for lessees: may elect, by class of underlying asset, not to separate — accounting for the combined contract as a single lease (which increases the ROU asset and lease liability).

IFRS 16 introduced a single on-balance-sheet model for lessees. At the commencement date, the lessee recognises:

• A right-of-use (ROU) asset — representing the lessee's right to use the underlying asset
• A lease liability — representing the obligation to make lease payments

Initial measurement of the lease liability:

PV of lease payments not yet paid at the commencement date, discounted using the interest rate implicit in the lease (if readily determinable) or the lessee's incremental borrowing rate (IBR).

Lease payments included:

• Fixed payments (less any lease incentives receivable)
• Variable lease payments that depend on an index or rate (measured at the initial index/rate)
• Amounts expected to be payable under residual value guarantees
• The exercise price of a purchase option if reasonably certain to be exercised
• Termination penalties if the lease term reflects exercising the termination option

Lease payments excluded:

• Variable payments based on performance or usage (e.g., percentage of sales) — these go to P/L as incurred
• Non-lease components (service costs)

Initial measurement of the ROU asset:

Right-of-use asset:

• Measured at cost less accumulated depreciation and impairment (cost model)
• Depreciated from the commencement date to the earlier of: (a) the end of the useful life of the ROU asset, or (b) the end of the lease term. If the lessee is reasonably certain to exercise a purchase option, depreciate over the useful life of the underlying asset.
• Subject to IAS 36 impairment testing
• Revaluation model also permitted (if IAS 16 revaluation is applied to the class of owned assets) or fair value model (if the ROU asset meets the definition of investment property and IAS 40 fair value model is used)

Lease liability:

• Measured at amortised cost using the effective interest method — similar to a financial liability
• Each period: interest expense recognised in P/L = carrying amount × discount rate; cash payments reduce the liability (interest portion + principal portion)
• The interest expense is front-loaded — higher in early years, lower in later years (the liability is highest at the start)

Combined P/L effect: The lessee recognises depreciation (typically straight-line over the lease term) AND interest expense (front-loaded). This means total lease expense is front-loaded — higher in early years and lower in later years. This contrasts with the old operating lease model (straight-line rental expense).

The lease liability must be remeasured when certain changes occur. The remeasurement adjusts the lease liability and the ROU asset in equal amounts (with any negative excess to P/L).

Changes requiring remeasurement using a REVISED discount rate:

• Change in the lease term (e.g., lessee exercises an option not previously expected, or extends the term)
• Change in the assessment of a purchase option (now or no longer reasonably certain to exercise)

Changes requiring remeasurement using the ORIGINAL discount rate:

• Change in expected residual value guarantee amounts
• Change in future lease payments resulting from a change in an index or rate used to determine those payments (e.g., CPI adjustment to rent)

Lease modifications:

• Separate lease: If the modification increases the scope by adding the right to use one or more underlying assets AND the consideration reflects the stand-alone price → treat as a new, separate lease (no remeasurement of the original)
• Not a separate lease: All other modifications → remeasure the liability using the revised discount rate, adjust the ROU asset. If the modification reduces scope (e.g., reduces the leased area or shortens the term), recognise a gain/loss for the partial termination in P/L.

A lessee may elect NOT to apply the ROU asset + lease liability model to two types of leases:

1. Short-term leases:

• A lease that, at commencement, has a lease term of 12 months or less
• Does NOT include a purchase option
• Election made by class of underlying asset

2. Low-value asset leases:

• Leases of assets that are low in value when new. IFRS 16 does not specify a monetary threshold, but the IASB Basis for Conclusions suggests assets worth approximately US$5,000 or less when new
• Examples: tablets, laptops, small office furniture, telephones, small printers
• NOT eligible if: the underlying asset depends on other assets for use, or the lessee sub-leases the asset
• Election made on a lease-by-lease basis

Accounting when exemption is applied: Lease payments are recognised as an expense in P/L on a straight-line basis (or another systematic basis if more representative) over the lease term. No asset or liability recognised. This is similar to the old operating lease accounting under IAS 17.

A sale and leaseback occurs when an entity sells an asset to another party and simultaneously leases it back. IFRS 16 bases the accounting on whether the transaction is a sale under IFRS 15.

If the transfer IS a sale (under IFRS 15):

• Seller-lessee: Derecognise the underlying asset. Recognise the ROU asset as the proportion of the previous carrying amount relating to the rights retained. Recognise a partial gain or loss — only on the portion of the asset transferred to the buyer (not on the portion the seller retains via the leaseback)
• Buyer-lessor: Apply normal lessor accounting — recognise the asset purchased and account for the lease as either operating or finance
• If the fair value of consideration does not equal the fair value of the asset (or the lease payments are not at market rates), adjust for any below-market or above-market payments (treated as prepayment or additional financing)

If the transfer is NOT a sale (e.g., the seller retains substantial rights amounting to control — often when there is an option to repurchase):

• Seller-lessee: Continue to recognise the underlying asset. Recognise a financial liability equal to the transfer proceeds (treated as secured borrowing)
• Buyer-lessor: Recognise a financial asset for the proceeds (not the underlying asset)

Why sale and leaseback? Common reasons: the seller-lessee wants to release cash tied up in owned assets while retaining use; tax efficiency (the buyer may have tax attributes the seller doesn't); improving apparent balance sheet metrics (though IFRS 16's on-balance-sheet lessee model has reduced this benefit).

Lessor accounting under IFRS 16 retains the dual model from IAS 17 (unlike lessees). Lessors classify each lease as either:

Finance lease: Transfers substantially all the risks and rewards incidental to ownership of the underlying asset.

Operating lease: Does NOT transfer substantially all the risks and rewards (a residual category).

Indicators of a finance lease (individually or in combination):

• Lease transfers ownership to the lessee by the end of the lease term
• Lessee has a bargain purchase option reasonably certain to be exercised
• Lease term is for the major part of the economic life of the asset
• At inception, the PV of lease payments amounts to substantially all the fair value of the asset
• The asset is of a specialised nature such that only the lessee can use it without major modifications
• If the lessee can cancel, the lessor's losses are borne by the lessee
• Gains/losses from residual value fluctuations accrue to the lessee
• Lessee has the ability to continue the lease for a secondary period at a rent substantially below market

Finance lease — lessor accounting:

• Derecognise the underlying asset
• Recognise a net investment in the lease = PV of lease payments + unguaranteed residual value, discounted at the rate implicit in the lease
• Recognise finance income over the lease term (using the effective interest method, producing a constant periodic rate of return on the net investment)
• Lease payments received reduce the gross investment in the lease
• For a manufacturer or dealer lessor: additionally recognise revenue (FV of asset, or PV of lease payments if lower) and cost of sales (carrying amount minus PV of unguaranteed residual value) at commencement

Operating lease — lessor accounting:

• The underlying asset remains on the lessor's balance sheet — no derecognition
• Depreciate the asset under IAS 16
• Recognise lease income on a straight-line basis (or another systematic basis if more representative) over the lease term
• Initial direct costs are added to the carrying amount of the asset and expensed over the lease term on the same basis as the lease income

A sublease is a transaction where the original lessee (the intermediate lessor) re-leases the underlying asset to a third party. The original lease (head lease) remains in effect.

Intermediate lessor accounting:

• Classify the sublease as a finance lease or operating lease by reference to the ROU asset arising from the head lease (NOT the underlying asset)
• If the sublease is for substantially all the remaining term of the head lease → typically a finance lease (the intermediate lessor has transferred substantially all rights and rewards of its ROU asset)
• If the sublease is for a shorter period → typically an operating lease (the intermediate lessor retains the ROU asset for the remaining period)

If the sublease is a finance lease:

• Derecognise the ROU asset (from the head lease)
• Recognise a net investment in the sublease (a finance lease receivable)
• Continue to recognise the head lease liability (interest expense on this)
• Recognise finance income on the sublease
• Recognise any difference on derecognition in P/L

If the sublease is an operating lease:

• Continue to recognise the ROU asset from the head lease (depreciated normally)
• Continue to recognise the head lease liability (interest expense normally)
• Recognise sublease income on a straight-line basis