In this topic 9 sections
- 23Identify the lease before calculating it
- 24Lessee exemptions and payment boundaries
- 25Build the opening liability and right-of-use asset separately
- 26Original example: payments at each year end
- 27What changes when payments are in advance?
- 28Residual guarantees: lessee and lessor differ
- 29Lessor classification and entries
- 30Subsequent changes and disclosures
- 31Sources and further reading
Identify the lease before calculating it
A contract contains a lease when it gives the customer control over the use of an identified asset for a period in exchange for consideration. Assess the contract at inception. Recognition occurs at commencement, when the asset is available for use. These dates may differ.
Control requires the right to obtain substantially all economic benefits from use and the right to direct use. A supplier's substantive substitution right may mean no identified asset exists. Protective restrictions alone do not necessarily prevent the customer from controlling use.
The lease term includes the non-cancellable period and relevant option periods: extension periods when exercise is reasonably certain, and termination-option periods when non-exercise is reasonably certain. Consider economic incentives and the full circumstances, not only management's unsupported intention.
Lessee exemptions and payment boundaries
| Question | Treatment to investigate |
|---|---|
| Lease term is 12 months or less at commencement, with no purchase option | A short-term exemption may be elected by class of underlying asset |
| Underlying asset is low value when new and meets the relevant independence conditions | A low-value exemption may be elected lease by lease |
| Payments depend on an index or rate | Include using the commencement-date index or rate; subsequent changes can require remeasurement |
| Payments depend only on sales or usage | Generally exclude from the initial liability and recognise when the triggering event occurs, unless in-substance fixed |
| Contract includes maintenance or another service | Separate lease and non-lease components, unless the permitted class-based practical expedient is elected |
An exemption is not automatic. For an elected exemption, recognise the payments as expense on a straight-line or other representative systematic basis. A second-hand expensive asset does not become low value merely because its current price is small. IFRS 16 does not prescribe a universal dollar cut-off for the exemption.
Build the opening liability and right-of-use asset separately
The lessee's initial liability is the present value of unpaid lease payments at commencement. Use the implicit rate if readily determinable; otherwise use the lessee's incremental borrowing rate. Include fixed and in-substance fixed payments net of relevant incentives, qualifying index/rate-linked payments, expected amounts payable under residual guarantees, and qualifying purchase-option or termination payments.
| Right-of-use asset component | Add or subtract? |
|---|---|
| Initial lease liability | Add |
| Lease payments made at or before commencement | Add |
| Incentives already received | Subtract |
| Qualifying lessee initial direct costs | Add |
| Recognised estimate of restoration or dismantling obligations | Add, subject to the relevant requirements |
Do not include a payment made at commencement in both the unpaid liability and the prepaid amount. Do not import the lessor's initial direct costs into the lessee's asset. Initial direct costs must be incremental costs that would not have arisen if the lease had not been obtained; not every legal or negotiation cost qualifies.
Original example: payments at each year end
Arden Services leases equipment for three years. It pays $12,000 at the end of each year. The appropriate annual rate is 6%. There are no incentives, services, residual guarantees, options, initial direct costs or restoration obligations. Ownership does not transfer. The equipment's useful life is five years.
The liability is $12,000 × [1 - 1.06^(-3)] / 0.06 = $32,076.14. The initial right-of-use asset is the same amount. Since ownership does not transfer and no purchase option is reasonably certain, depreciate over the shorter of useful life and lease term: three years here.
| Date | Opening liability | Interest | Cash paid | Closing liability |
|---|---|---|---|---|
| Commencement | — | — | — | 32,076.14 |
| Year 1 end | 32,076.14 | 1,924.57 | (12,000.00) | 22,000.71 |
| Year 2 end | 22,000.71 | 1,320.04 | (12,000.00) | 11,320.75 |
| Year 3 end | 11,320.75 | 679.25 | (12,000.00) | 0.00 |
| Entry | Debit | Credit |
|---|---|---|
| Commencement | Right-of-use asset 32,076.14 | Lease liability 32,076.14 |
| Year 1 interest | Finance expense 1,924.57 | Lease liability 1,924.57 |
| Year 1 payment | Lease liability 12,000.00 | Cash 12,000.00 |
| Year 1 depreciation | Depreciation expense 10,692.05 | Accumulated depreciation 10,692.05 |
Repeat the interest/payment sequence using each year's opening liability. Use unrounded schedules internally and adjust final displayed cents when necessary. Total interest is $36,000 - $32,076.14 = $3,923.86. The liability reaches zero after the final payment, and cumulative depreciation removes the asset over three years.
What changes when payments are in advance?
Keep the same three $12,000 payments and 6% rate, but pay at commencement, at the end of Year 1 and at the end of Year 2. Only the latter two payments are unpaid at commencement.
| Amount | Calculation | Result |
|---|---|---|
| Initial liability | 12,000 / 1.06 + 12,000 / 1.06² | 22,000.71 |
| Initial right-of-use asset | 22,000.71 + 12,000 paid immediately | 34,000.71 |
| Year 1 closing liability | 22,000.71 + 1,320.04 - 12,000 | 11,320.75 |
| Year 2 closing liability | 11,320.75 + 679.25 - 12,000 | 0.00 |
The commencement journal is debit right-of-use asset $34,000.71, credit lease liability $22,000.71 and credit cash $12,000. There is no interest on the payment made immediately. The asset still provides use throughout Year 3 even though the liability has already been paid off. Liability settlement and asset consumption are different timelines.
Residual guarantees: lessee and lessor differ
For a lessee, include the amount expected to be payable under a residual value guarantee, not automatically the guarantee's full face amount. An unguaranteed residual accruing to the lessor is not a lessee payment.
For a lessor's finance lease, the net investment includes discounted lease payments under the lessor rules plus the discounted unguaranteed residual accruing to the lessor. Qualifying guarantees and initial direct costs must be handled under those rules. This is one reason the lessor receivable and lessee liability need not match.
Lessor classification and entries
The lessor still classifies leases as finance or operating. A finance lease transfers substantially all risks and rewards of ownership; an operating lease does not. Indicators include transfer of ownership, a favourable purchase option likely to be exercised, a major part of economic life, substantially all fair value recovered through payments, specialised assets and cancellation risk. There is no automatic 75% or 90% bright-line test in IFRS 16.
| Lessor finance lease | Lessor operating lease |
|---|---|
| Recognise net investment rather than the underlying asset, subject to the applicable requirements | Continue recognising the underlying asset |
| Recognise finance income to produce a constant periodic return on net investment | Recognise lease income on a straight-line or other representative systematic basis |
| Reduce the receivable for cash collected; assess impairment under relevant financial-instrument rules | Depreciate and assess impairment of the asset |
| Manufacturer/dealer lessors have additional selling-profit and cost rules | Add qualifying initial direct costs to the asset and expense over the lease term on the income basis |
For the finance example above, an ordinary lessor initially debits net investment $28,946.30 and credits the underlying asset for the same amount under the stated assumptions. Year 1 interest is $2,315.70: debit net investment and credit finance income. On receiving $10,000, debit cash and credit net investment. Preserve precision in the workings: displayed rounded figures may differ by one cent from a sequential rounded calculation.
Subsequent changes and disclosures
The cost-model right-of-use asset is reduced by depreciation and impairment, and adjusted for applicable liability remeasurements. Ownership transfer or a reasonably certain purchase option changes the depreciation horizon to useful life. Qualifying investment-property or revaluation requirements may lead to another asset model.
A lease liability increases for interest, decreases for payments and is remeasured when the standard requires it. Not every reassessment uses a new discount rate: the reason for remeasurement matters. Present right-of-use assets and lease liabilities separately or give the required note identification. Interest and depreciation remain distinct. Explain lease activities, cash-flow exposure and significant judgements; lessor disclosures also address retained asset risk.
Sources and further reading
Study guide: CPA Australia, Financial Reporting study guide, sixth edition, October 2022, Module 1, section 1.6, printed pages 38–44. Download lease timelines, schedules and journals. All figures here use original examples, independently recalculated.
Concept sources: AASB 16, December 2021 compilation, paragraphs 5–8, 9–21, 22–43, 47–60, 61–97, Appendix A and B3–B33. Read IFRS 16 alongside the Australian equivalent where Australian provisions are relevant.