Chapter 11

Accounting for leases

Review questions
11.1 The major changes in how we account for leases as a result of the 2016 release of IFRS 16
(AASB 16 in Australia) relate to how we are now required to bring a great more leased
assets, and lease liabilities, onto the balance than was previously required.
Pursuant to the former accounting standard, from the perspective of the lessee, leases were
classified broadly as either finance leases or operating leases. If a lease transferred the risks
and rewards incidental to ownership of the asset from the lessor (the owner), to the lessee
(the customer), then the lease was deemed to be a finance lease and as such, both the leased
asset and lease liability were to be recognised for balance sheet purposes. If the lease was
an operating lease (meaning that it did not transfer the risks and rewards of ownership to
the lessee), then it did not have to be recognised for balance sheet purposes.
The former accounting standard provided guidance for when the risks and rewards
incidental to ownership were considered to be transferred to the lessee. For example,
paragraph 10 of the former accounting standard (AASB 117) stated:
Whether a lease is a finance lease or an operating lease depends on the substance
of the transaction rather than the form of the contract. Examples of situations that
individually or in combination would normally lead to a lease being classified as
a finance lease are:
(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
sufficiently lower than the fair value at the date the option becomes
exercisable for it to be 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 minimum lease payments
amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialised nature that only the lessee can use
them without major modifications.
Again, if the lease was deemed to be a finance lease, then a leased asset and a lease liability
were required to be recognised on the balance sheet, otherwise no lease liability or lease
asset had to be recognised.
Under the new accounting standard (IFRS 16/AASB 16) there is no subdivision of leases
into operating and finance leases when it comes to accounting for leases by lessees. To the
extent that a lease is for a period of more than 12 months, and to the extent that the lease is
not for a low-value item (say US$5000 or less), then a lease liability and leased asset shall
be recognised to the extent that the lessee has a non-cancellable obligation to make lease
payments. This new requirement to capitalise all leases (other than those for which there
 are exemptions as already noted) is consistent with the definitions of assets and liabilities
as produced within the conceptual framework. The former accounting requirements for
leases were not consistent with the conceptual framework. The new requirements mean
that many more leased assets and lease liabilities will appear on corporate balance sheets—
something that has not been popular with a lot of corporations.
The requirements for accounting for leases by lessors were not changed as a result of the
release of the new accounting standard, and the classification of finance leases and
operating leases is still used in relation to accounting for leases by lessors.
11.2 The accounting standard defines a lease—and this definition applies to both parties to a
contract, that is, to the customer (lessee) and to the supplier (lessor)—as:
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.
The ‘underlying asset’ referred to above is defined as:

An asset that is the subject of a lease, for which a right to use that asset has been
conveyed to a lessee.
11.3 ‘Lease term’ is defined within the accounting standard as:
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 reasonably
certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably
certain not to exercise that option.
Considerations of whether something is ‘reasonably certain’ (as used in the above
paragraph) would include a number of factors, including:
 whether a purchase option or lease-renewal option exists within the lease contract
and whether the nature of the pricing of the options is sufficiently favourable to
the lessee to suggest that the lessee is reasonably certain to exercise the option;
 whether there has been significant customisation of the lease asset. For example, if
the lessee has leased a building and has made significant and costly modifications
to the leased building, then this might suggest that if there is an option to renew
the lease at typical market rates then the renewal option is reasonably likely to be
taken.

11.4 Basically, if a ‘lease’ exists—using the definition within the accounting standard—and if
the lease is for a period of more than 12 months, and is for an item that is not deemed to be
of low value, then a right-of-use asset and a lease liability shall be recognised by the lessee.

What needs to be determined, however, is whether a ‘lease’ exists in terms of the

requirements of IFRS16/AASB 16.
According to the accounting standard, a lease exists when the customer controls the use of
the underlying asset throughout the period of use. This requires the customer to be able to:
  obtain substantially all of the economic benefits from the use of the identified asset
throughout the contracted period of use; and
 direct the use of the identified asset throughout that period of use, which means the
customer has the ability to change how, and for what purpose, the asset is used
during the contractual term.
If the supplier of the asset (the lessor) has a ‘substantive right’ to substitute the asset
throughout the period of use, then an ‘identified asset’ would not be deemed to exist and
the requirements of the accounting standard would not apply, with the result that a lease
asset and lease liability would not be recognised and the periodic lease payments would
simply be treated as an expense. As paragraph B14 of AASB 16 states:
Even if an asset is specified, a customer does not have the right to use an identified
asset if the supplier has the substantive right to substitute the asset throughout the
period of use. A supplier’s right to substitute an asset is substantive only if both of
the following conditions exist:
(a) the supplier has the practical ability to substitute alternative assets throughout
the period of use (for example, the customer cannot prevent the supplier from
substituting the asset and alternative assets are readily available to the
supplier or could be sourced by the supplier within a reasonable period of
time); and
(b) the supplier would benefit economically from the exercise of its right to substitute
the asset (ie the economic benefits associated with substituting the asset are
expected to exceed the costs associated with substituting the asset).
The lease would not include any service component (unless the component is deemed
to be immaterial).

In recognising the lease, there is also a requirement that the lease is ‘non-cancellable’—
that is, the lessee cannot cancel the lease at short notice without some form of financial
penalty.

11.5 Pursuant to IFRS 16/AASB 16, a lessee should capitalise a lease transaction (meaning that
the leased asset and lease liability will be included within the statement of financial
position) when the lease is for a period in excess of 12 months and the lease is not for a
low-value item. A lessee is required to recognise a right-of-use asset representing its right
to use the underlying leased asset and a lease liability representing its obligations to make
lease payments.
For a lessee to be required to capitalise a lease in accordance with IFRS 16/AASB 16, the
contractual arrangement needs to satisfy the requirements in terms of being a ‘lease’. This
requires that the lease obligation be non-cancellable and that the lessee ‘controls’ the asset
for the duration of the lease, meaning that the supplier of the asset (the lessor) does not
have a ‘substantive right’ to substitute the asset throughout the period of use.

11.6 To the extent that a lease arrangement is non-cancellable and provides control of the asset
to the lessee, there is an expectation that the lessee recognise a right-of-use asset
representing its right to use the underlying leased asset and a lease liability representing its
obligations to make lease payments. Lessees can elect to exempt themselves from this
 requirement when the lease is for a lease period of 12 months or less, or where the lease is
for a low-value item.

11.11 A residual value guarantee is provided by the lessee to the lessor. It provides an assurance
to the lessor that the assets being returned to the lessor will have a certain value at the end
of the lease term. A related amount will be included in the capitalised lease payments. From
the lessee’s perspective, the residual value guarantee is to be included as part of the lease
liability. It would be calculated as the present value of the difference between what value
has been guaranteed by the lessee for the asset at the end of the lease term, and what the
lessee believes the lease asset will be able to be sold for at the end of the lease given the
expected pattern of use. For example, there might be an agreement that the asset should
have a fair value of $100,000 at the end of the lease term (meaning that the lessor should
expect to realise $100,000 from the sale of the asset at the end of the lease term). If the
lessee believes that given the expected of use the asset will only have a fair value of $70,000
at the end of the lease term then the lessee will have to make up the difference – that is, the
lessee will need to pay $30,000. It is the present value of this $30,000 that would need to
be included within the total amount of the lease liability.

From the lessor’s perspective, the residual value guarantee would form part of the lease
receivable and would be measured at present value.
11.14 The accounting standard requires that a lessee capitalise its initial direct costs that relate to
a lease as part of the cost of the lease asset. Therefore, where such costs are incurred, the
lease asset comprises the present value of the lease payments plus the amount of initial
direct costs incurred. The total amount would then be subject to regular depreciation
(amortisation).

From the lessor’s perspective:

 Under a direct-financing lease, the initial direct costs are, if material, to be included
as part of the lessor’s investment in the lease.
 The initial direct costs relating to a lease involving a dealer or manufacturer are to
be accounted for by the lessor as a cost of sales of the financial year in which the
lease transaction occurs.

11.16 To undertake this calculation, students may use trial and error. The implicit rate is 18%,
proven as follows:
Present value of initial payment $5000 x 1.0 = $5000
Present value of yearly payments ($5500 – $500) x 4.4941 = $22 470
Fair value at lease inception $27 470
Alternatively, and more easily, we can divide the liability on 1 July 2019 (which would
exclude the payment of $5000 at lease inception) by the periodic lease payments (after
deducting the executory costs) and then search for the appropriate interest rate within the
present value tables. This is easy because of the absence of a guaranteed residual or a
bargain purchase option.
 (27 470 – 5000)  5000 = 4.494
A review of the present value of an annuity table shows that $4.4941 equals the present
value of an annuity in arrears of $1 per year, for 10 years, discounted at 18%.

11.18 (a) Present value of the lease payments:

(62 500 – 6250) x 3.6048 = 202 770
50 000 x 0.5674 = 28 370
Present value of minimum lease payments 231 140

Books of Sanders using the net method

1 July 2019
Dr Lease receivable 231 140
Dr Cost of sales 200 000
Cr Inventory 200 000
Cr Sales 231 140
30 June 2020
Dr Cash 62 500
Cr Service expenses recoupment (statement of 6 250
profit or loss and other comprehensive
income)
Cr Interest revenue 27 737
Cr Lease receivable 28 513
[27 737 = 231 140 x 0.12]
30 June 2021
Dr Cash 62 500
Cr Service expenses recoupment (statement of 6 250
profit or loss and other comprehensive
income)
Cr Interest revenue 24 315
Cr Lease receivable 31 935
[24 315 = (231 140 – 28 513) x 0.12]

(b) Books of Gregory Ltd

1 July 2019
Dr Leased machinery 231 140
Cr Lease liability 231 140
 30 June 2020
Dr Interest expense 27 737
Dr Lease liability 28 513
Dr Service expenses 6 250
Cr Cash 62 500
Dr Depreciation expense 33 020
Cr Accumulated leasehold depreciation 33 020
[33 020 = 231 140  7]

30 June 2021
Dr Interest expense 24 315
Dr Lease liability 31 935
Dr Service expenses 6 250
Cr Cash 62 500
Dr Depreciation expense 33 020
Cr Accumulated leasehold depreciation 33 020
[33 020 = 231 140  7]

Challenging questions
11.23 (a) The implicit rate is defined in the accounting standard as:

The rate of interest that causes the present value of (a) the lease payments and
(b) the unguaranteed residual value to equal the sum of (i) the fair value of the
underlying asset and (ii) any initial direct costs of the lessor.

The implicit rate is 10 per cent, proven as follows:

Periodic lease payments ($375 000 – $25 000) x 4.8684 = $1 703 940
Unguaranteed residual $500 000 x 0.5132 = $256 600
Fair value of leased land and buildings $1 960 540*
* $10 rounding error

(b) Journal entries for Iselin Ltd—the lessee

At the commencement of the lease we are required to calculate the present value of
the expected future lease payments over the period of the lease. We do not include
the unguaranteed residual. We discount the expected payments using the rate of
interest implicit in the lease, which in this example is 10%. To determine the interest
expense in each period we can use the following table:
 Date Lease Interest Principal Outstanding
payment for expense reduction balance
building
1 July 2019 1 703 940
30 June 2020 350 000 170 394 179 606 1 524 334
30 June 2021 350 000 152 433 197 567 1 326 767
30 June 2022 350 000 132 677 217 323 1 109 444
30 June 2023 350 000 110 944 239 056 870 388
30 June 2024 350 000 87 039 262 961 607 427
30 June 2025 350 000 60 743 289 257 318 170
30 June 2026 350 000 31 817 318 183 (13)*
* $13 rounding error
1 July 2019
Dr Leased property 1 703 940
Cr Lease liability 1703 940
(To record the asset and liability at the inception of the finance lease.)
30 June 2020
Dr Service expenses 25 000
Dr Interest expense 170 394
Dr Lease liability 179 606
Cr Cash 375 000
(To record the lease payment)

Dr Lease amortisation expense 243420

Cr Accumulated lease amortisation 243420
(To record depreciation expense [1703940 ÷ 7]. As the lessee does not appear
likely to retain the asset, the life of the lease is used for depreciation.)
30 June 2021
Dr Service expenses 25 000
Dr Interest expense 152 433
Dr Lease liability 197 567
Cr Cash 375 000
(To record the lease payment)

Dr Lease depreciation expense 243 420

 Cr Accumulated depreciation 243420

(c) Journal entries for Weber Ltd—the lessor

Accounting for leases by lessors has not changed from the requirements of the
former accounting standard as a result of the release of IFRS 16/AASB 16. Lessors
are required to classify a lease as a finance lease or an operating lease.
When a lease includes both land and buildings elements, the lessor assesses the
classification of each element as a finance or an operating lease separately. In
determining whether the land element is an operating or a finance lease, an
important consideration—as indicated at paragraph B55 of AASB 16—is that land
normally has an indefinite economic life.
Secondly, whenever necessary in order to classify and account for a lease of land
and buildings from the perspective of the lessor, the lease payments (including any
lump-sum up-front payments) are allocated between the land and the buildings
elements in proportion to the relative fair values of the leasehold interests in the
land element and buildings element of the lease at the inception of the lease.
Thirdly, for a lease of land and buildings in which the amount that would initially
be recognised for the land element is immaterial, paragraph B57 of AASB 16 allows
the land and buildings to be treated as a single unit for the purpose of lessor lease
classification and classified as a finance or operating lease. In this example the
amount attributed to land is not considered to be immaterial and therefore it must
be accounted for separately.
As indicated above, the lease payments should be allocated on the basis of the fair
values of the assets at the inception of the lease. Therefore the allocation of lease
payments is:
Land = 350 000 x (588 160/1 960 530) = $105 000
Building = 350 000 x (1 372 370/1 960 530) = $245 000
The present value of the expected lease payments (which excludes the unguaranteed
residual) relating to the building is:
$245 000 x 4.8684 = $1 192 758
The present value of the residual asset (that is, the building when it is returned in 7
years) is $350 000 x 0.513177 = 179 612
Date Lease Interest Principal Outstanding
payment for revenue reduction balance
building
1 July 2019 1 192 758
30 June 2020 245 000 119 276 125 724 1 067 034
30 June 2021 245 000 106 703 138 297 928 737
30 June 2022 245 000 92 874 152 126 776 611
 30 June 2023 245 000 77 661 167 339 609 272
30 June 2024 245 000 60 927 184 073 425 199
30 June 2025 245 000 42 520 202 480 222 719
30 June 2026 245 000 22 272 222 728 (9)*
* $10 rounding error
1 July 2019
Dr Land 588 160
Dr Buildings 1 372 370
Cr Cash 1 960 530
Dr Lease receivable 1 192 758
Dr Residual asset 179 612
Cr Buildings 1 372 370
(To capitalise the present value of the lease payments and the unguaranteed
residual pertaining to the building.)
30 June 2020
Dr Cash 375 000
Cr Lease rental income – land 105 000
Cr Lease receivable 125 724
Cr Interest revenue 119 276
Cr Service expenses recouped 25 000

Dr Residual asset 17 961

Cr Interest revenue 17 961
[17 961 = 179 612 x 0.10]
30 June 2021
Dr Cash 375 000
Cr Lease rental income - land 105 000
Cr Lease receivable 138 297
Cr Interest revenue 106 703
Cr Service expenses recouped 25 000

Dr Residual asset 19 757

Cr Interest revenue 19 757
 [(179 612 + 17 961) x 0.10 = 19 757]

11.29 (a) Flyer Ltd

First, although not required by the question, we can prove that the interest rate
implicit in the lease is 10 per cent:
$300 000 x 1.0 = $300 000
$250 000 x 8.5136 = $2 128 400
$2 428 400

1 July 2019
Dr Leased plant—aeroplane 2 428 400
Cr Lease liability 2 428 400

Dr Lease liability 300 000

Cr Cash 300 000
(b) Finance Ltd
1 July 2019
Dr Plant and machinery—aeroplane 2 428 400
Cr Cash 2 428 400

Dr Lease receivable 2 428 400

Cr Plant and machinery—aeroplane 2 428 400

Dr Cash 300 000

Cr Lease receivable 300 000

(c) Flyer Ltd

To determine the entry for the final lease payment we must determine the present
value of one payment of $250 000 in one year discounted at 10 per cent. The present
value is $250 000 x 0.9091 = $227 275.
Dr Interest expense 22 725
Dr Lease liability 227 275
Cr Cash 250 000

Dr Lease depreciation expense 121 420

Cr Accumulated depreciation 121 420
 (121 420 = 2 428 400  20)
(d) Finance Ltd
Dr Cash 250 000
Cr Interest revenue 22 725
Cr Lease receivable 227 275