IFRS/NFRS 16: Leases
Sets out the principles for the recognition, measurement, presentation and disclosure of leases.
A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration even if such a control can be exercised under certain limitations imposed by the lessor.
Rajesh and Hamaal Bank has rented a building to hold a server farm for 20 years for a monthly fee of 500,000.00 but the lessor has put forth a condition where only certain brand can be used.
Let's analyze if the agreement contains a lease:
| An identified Asset – land or a Building Space | |
| For a period (including potentially perpetual or indefinite use) – 20 Years | |
| In exchange for consideration – 500,000.00 per month | |
| Right to control the use of an Asset | ..... |
A key question needs to be asked - Does this condition limit Rajesh and Hamaal Bank's right to control the use of the asset?
If the restriction (using only a specified supplier) is related to operations within the space (e.g., using only X brand of servers or a specific installation company), but the lessee still decides when, how, and for what purpose to use the space, then control is not compromised.
IFRS/NFRS 16 is applicable
However, if the restriction substantially limits the Bank’s ability to use the space (Like controlling timing, layout or access) then the bank no longer has a right to control the use of the asset and therefore, there is no lease.
Use other relevant Standards.
The lease term is a crucial input for lease calculations. It's the period over which a lessee has the right to use an asset, and it's not always just the initial contract period.
| 1. Non-cancellable period | The base period of the lease that cannot be unilaterally cancelled by either party. In the previous example, this is the 20-year term. |
| 2. Extension Periods | Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option. |
| 3. Termination Periods | Periods after a termination option if the lessee is reasonably certain not to exercise the option to terminate. |
1. Lease for a period of 10 years, but any party can unilaterally cancel the agreement by giving a three-month notice after 5 years.
Result: The lease term is 5 years and 3 months.
2. Lease for 15 years, where the lessee has an option to cancel at any time after 7 years. The lessee has big plans for the company and therefore does not believe the agreement will be extended beyond 7 years.
Result: The lease term is 7 years.
3. Lease for 20 years, but the lessor can cancel the lease at any time by providing a notice.
Result: The lease term is 0 years, as the lessee does not have an enforceable right for any period of time.
Lessor’s Point of View: The classification of Finance Lease and Operating lease has been scrapped for a “Right to use Asset” Approach in IFRS/NFRS 16.
Initial Measurement of Right of Use Asset:
At the commencement date, a lessee shall measure the right-of-use asset at cost which comprises:
- The amount of the initial measurement of the lease liability.
- Any lease payments made at or before the commencement date, less any lease incentives received plus initial Direct cost;
- Provisions for Dismantling and Restoration Charges. (Same as in PPE)
| Year | Cash Outflow | PVF@8% | Present Value |
|---|---|---|---|
| 1 | 600,000.00 | 0.93 | 555,555.56 |
| 2 | 600,000.00 | 0.86 | 514,403.29 |
| 3 | 600,000.00 | 0.79 | 476,299.34 |
| 4 | 600,000.00 | 0.74 | 441,017.91 |
| 5 | 600,000.00 | 0.68 | 408,349.92 |
| Present value of Lease Liability: | 2,395,626.02 | ||
Right of use asset includes initial estimation of present value of future lease payments.
Building on the previous example, let's include initial direct costs and incentives.
| Item | Amount |
|---|---|
| Lease Term | 5 Years |
| Annual Payment | 600,000.00 |
| Non-Refundable Security Deposit (Initial Direct Cost) | 300,000.00 |
| Cost to Cancel Previous Lease | 225,000.00 |
| Reimbursement from Lessor for Cancellation (Incentive) | (125,000.00) |
| Discounting Rate | 8% |
1. PV of Lease Liability
This remains the same as calculated before: 2,395,626.02
2. Net Initial Costs
| Direct Costs (300,000 + 225,000) | 525,000.00 |
| Less: Incentive Received | (125,000.00) |
| Net Cost to be included in ROU Asset | 400,000.00 |
3. Total ROU Asset Cost
| PV of Lease Liability | 2,395,626.02 |
| Add: Net Initial Costs | 400,000.00 |
| Total Cost of Right-of-Use Asset | 2,795,626.02 |
Lease Liability Calculation
| Year | Cash Flows | PVF @ 7% | Present Value |
|---|---|---|---|
| 0 | 100,000.00 | 1.00 | 100,000.00 |
| 1 | 100,000.00 | 0.93 | 93,457.94 |
| 2 | 100,000.00 | 0.87 | 87,343.87 |
| 3 | 100,000.00 | 0.82 | 81,629.79 |
| 4 | 100,000.00 | 0.76 | 76,289.52 |
| 5 | 100,000.00 | 0.71 | 71,298.62 |
| 6 | 100,000.00 | 0.67 | 66,634.22 |
| 7 | 100,000.00 | 0.62 | 62,274.97 |
| 8 | 100,000.00 | 0.58 | 58,200.91 |
| 9 | 325,000.00 | 0.54 | 176,778.47 |
| Total Present value of Lease Liability | 873,908.32 | ||
Initial Journal Entry
Right of Use Asset A/c Dr. 898,908.32
To Lease Liability A/c 773,908.32
To Cash A/c (Initial Direct Cost) 25,000.00
To Cash A/c (Lease Payment at Beg) 100,000.00* Lease Liability = 873,908.32 - 100,000 (payment at beginning)
Amortization Schedule for Lease Liability
| Opening | Interest | Payment | Closing |
|---|---|---|---|
| 773,908.32 | 54,173.58 | (100,000.00) | 728,081.90 |
| 728,081.90 | 50,965.73 | (100,000.00) | 679,047.63 |
| 679,047.63 | 47,533.33 | (100,000.00) | 626,580.97 |
| 626,580.97 | 43,860.67 | (100,000.00) | 570,441.63 |
| 570,441.63 | 39,930.91 | (100,000.00) | 510,372.55 |
| 510,372.55 | 35,726.08 | (100,000.00) | 446,098.63 |
| 446,098.63 | 31,226.90 | (100,000.00) | 377,325.53 |
| 377,325.53 | 26,412.79 | (100,000.00) | 303,738.32 |
| 303,738.32 | 21,261.68 | (100,000.00) | 225,000.00 |
| 225,000.00 | 15,750.00 | (325,000.00) | (84,250.00) |
Depreciation Schedule (SLM)
| Opening | Depreciation | Net Closing |
|---|---|---|
| 898,908.32 | (89,890.83) | 809,017.49 |
| 809,017.49 | (89,890.83) | 719,126.65 |
| 719,126.65 | (89,890.83) | 629,235.82 |
| 629,235.82 | (89,890.83) | 539,344.99 |
| 539,344.99 | (89,890.83) | 449,454.16 |
| 449,454.16 | (89,890.83) | 359,563.33 |
| 359,563.33 | (89,890.83) | 269,672.50 |
| 269,672.50 | (89,890.83) | 179,781.66 |
| 179,781.66 | (89,890.83) | 89,890.83 |
| 89,890.83 | (89,890.83) | 0.00 |
Normal Scheduled Payments are not considered variable for this purpose. Variable means that are known at the initial recognition or subsequent remeasurement. Therefore a 10% increase every two years is a fixed payment as the exact amount is already known on initial recognition.
Variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date, are included in the Lease Payments.
Lessee C enters into a five-year lease of a car. The lease payments are paid at the beginning of each year and are determined as follows:
- The discount rate is 10%.
- On commencement, Treasury Bill is 4%.
- The initial fair value of the asset is 10,000.
- Annual lease payments in Years 1–4 are determined as T-Bill x 50,000, based on T-Bill at the date of payment.
- The payment in Year 5 is determined as (T-Bill x 50,000) + 50,000.
On Initial recognition:
| Year | Lease Payments | Pvf @ 10% | Present Value |
|---|---|---|---|
| 0 | 2,000.00 | 1.00 | 2,000.00 |
| 1 | 2,000.00 | 0.91 | 1,818.18 |
| 2 | 2,000.00 | 0.83 | 1,652.89 |
| 3 | 2,000.00 | 0.75 | 1,502.63 |
| 4 | 52,000.00 | 0.68 | 35,516.70 |
| Lease Liability = ROU Asset = | 42,490.40 | ||
At the beg of Y.2
Lease Liability A/c: 42,539.44
RTU Asset A/c: 33,992.32
After payment of year 2, T-Bill rate changed to 6%
| Year | Lease Payments | Pvf @ 10% | Present Value |
|---|---|---|---|
| 1 | 3,000.00 | 0.91 | 2,727.27 |
| 2 | 3,000.00 | 0.83 | 2,479.34 |
| 3 | 53,000.00 | 0.75 | 39,819.68 |
| Revised Lease Liability: | 45,026.30 | ||
| Closing Lease Liability: | 42,539.44 | ||
| Increase in Lease Liability: | 2,486.85 | ||
Such an increase in Lease Liability is charged towards Right to Use Asset A/c as:
RTU Asset A/c Dr. 2,486.85
To Lease Liability A/c 2,486.85Depreciation and the amortization Schedule of Lease Liability will be revised accordingly.
Why are such index-linked payments included in the lease liability?
Lease liabilities under IFRS 16 contain a significant financing component. The discount rate applied to measure the lease liability represents the lessor's required return. This return inherently reflects the time value of money and the credit and inflation risks associated with the lease.
When lease payments are linked to indices like CPI or the Wholesale Price Index, any fluctuation in these indices is expected to affect the lessor's required return. For example: A rise in inflation typically increases the lessor's expected return. This justifies a corresponding increase in lease payments to maintain the economic value of the contract.
Because such changes are systematic and measurable, they form part of the cost of the lease and are therefore included in the lease liability at commencement based on the index value at that date.
Why are usage- or performance-based payments excluded?
Conversely, variable payments based on usage or performance: such as operating a machine at 60% or 70% capacity — do not influence the lessor's required return. These payments depend solely on the lessee's future actions or outcomes.
Hence, such payments are not included in the lease liability. Instead, they are expensed in the period in which they are incurred, in line with the actual usage.
For a contract that contains a lease component and a non-lease components, a lessee shall allocate the consideration in the contract to each lease component on the basis of the relative stand-alone price of the lease component and the aggregate stand-alone price of the non-lease components. {Stand Alone Price : The price at which any item is sold or can be sold alone.}
e.g. Use of a specific floor in a commercial building for 5 years including monthly cleaning and janitorial services for that floor for 350,000 per Month. The lessee obtains an invoice from the Lessor as :
8/12/2025
| S.N. | Particulars | Amount |
|---|---|---|
| 1 | Rental Charge | 300,000.00 |
| 2 | Other General Service Charges | 50,000.00 |
| Total Taxable Amount | 350,000.00 | |
| VAT @ 15% | 52,500.00 | |
| Payment Due | 402,500.00 | |
The lessee here can easily identify the stand-alone prices of each Lease and Non-Lease component. 300,000 will be included in Lease Payments and 50,000 will be expensed out using other relevant standards.
| Contractual Provisions | Contains a Lease? |
|---|---|
| 1. Use of a specific floor in a commercial building for 5 years. | Yes — contains a lease. Lessee obtains control of an identified space. |
| 2. Monthly cleaning and janitorial services for that floor. | No — non-lease component. It’s a service, not the right to use an asset. |
| 3. Maintenance and repair of air-conditioning and elevators included in the rent. | No — non-lease component. These are service obligations. |
| 4. Use of 10 parking spaces in the building basement, specifically allocated to the lessee. | Yes — contains a lease. Specific, identifiable parking spaces. |
| 5. Access to shared conference rooms and cafeteria. | No — non-lease component. No exclusive control over an identified asset. |
| 6. Internet and security services provided as part of the lease bundle. | No — non-lease component. These are support services. |
This is just one example of situations where Standalone Selling Prices can be identified. The lessee may obtain such information through other means like : Just inquiring about the Standalone Selling prices of each component to Lessor, Obtain information on how lessor accounts for the transaction, obtain information from other lessors and adjusting for relevant changes.
Practical Expedient for Separating the non-Lease Component:
An entity shall account for each lease component within the contract as a lease separately from non-lease components of the contract, unless the entity applies the practical expedient.
As a practical expedient, a lessee may choose not to separate non-lease components from lease components and instead account for each lease component and any associated non-lease components as a single lease component. {This exemption is not available for the lessor as the lessor can define the standalone selling prices for themselves}
A lessee shall account for a lease modification as a separate lease if both:
- The modification increases the scope of the lease by adding the right to use one or more underlying assets and;
- 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.
(excludes exercise of option included in original lease contract)
* Right of use.
For a modification that is not a separate lease, at the effective date of the modification the lessee accounts for it by remeasuring the lease liability using a discount rate determined at that date and:
- for modifications that decrease the scope of the lease - decreasing the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease, and recognizing a gain or loss that reflects the proportionate decrease in scope; and
- for all other modifications - making a corresponding adjustment to the right-of use asset.
Actress Priyanka Karki's production company, "Priyanka Films Pvt. Ltd.," leases a small office space for its operations.
Original Lease:
- Asset: 500 sq. ft. office space.
- Monthly Rent: NPR 50,000.
Priyanka Films needs more space. The landlord offers them an additional 200 sq. ft. storage room adjacent to their office. The landlord charges NPR 20,000 per month for this new storage room.
Result: Because the modification adds a new asset (the storage room) and the increased rent (NPR 20,000) is for the stand-alone price of that new asset {50,000 for 500 Sq. ft then 20,000 for 200 sq. ft. looks like rent at it’s standalone selling price, Priyanka Films would account for the storage room lease as a separate lease. If in case, the additional rent is 15,000 which is lower than the stand alone selling price, then it shall account for the scope addition as a modification to the Lease.
Initial Lease Liability Calculation
| Year | Cash Outflow | PVF @ 9% | Present Value |
|---|---|---|---|
| 1 | 200,000.00 | 0.92 | 183,486.24 |
| 2 | 200,000.00 | 0.84 | 168,336.00 |
| 3 | 200,000.00 | 0.77 | 154,436.70 |
| 4 | 200,000.00 | 0.71 | 141,685.04 |
| 5 | 200,000.00 | 0.65 | 129,986.28 |
| 6 | 200,000.00 | 0.60 | 119,253.47 |
| 7 | 200,000.00 | 0.55 | 109,406.85 |
| 8 | 200,000.00 | 0.50 | 100,373.26 |
| 9 | 200,000.00 | 0.46 | 92,085.56 |
| 10 | 200,000.00 | 0.42 | 84,482.16 |
| Lease Liability | 1,283,531.54 | ||
Amortization Schedule
| Opening | Interest | Payment | Closing |
|---|---|---|---|
| 1,283,531.54 | 115,517.84 | (200,000.00) | 1,199,049.38 |
| 1,199,049.38 | 107,914.44 | (200,000.00) | 1,106,963.82 |
| 1,106,963.82 | 99,626.74 | (200,000.00) | 1,006,590.57 |
| 1,006,590.57 | 90,593.15 | (200,000.00) | 897,183.72 |
| 897,183.72 | 80,746.53 | (200,000.00) | 777,930.25 |
| 777,930.25 | 70,013.72 | (200,000.00) | 647,943.98 |
| 647,943.98 | 58,314.96 | (200,000.00) | 506,258.93 |
| 506,258.93 | 45,563.30 | (200,000.00) | 351,822.24 |
| 351,822.24 | 31,664.00 | (200,000.00) | 183,486.24 |
| 183,486.24 | 16,513.76 | (200,000.00) | (0.00) |
| 1,283,531.54 | 716,468.46 | (2,000,000.00) | - |
At the end of Year-7
Lease Liability: 506,258.93
ROU Assets (SLM): 385,059.46
Revised Lease Liability Calculation
| Year | Cash Flows | PVF @ 7% | PV |
|---|---|---|---|
| 1 | 200,000.00 | 0.93 | 186,915.89 |
| 2 | 200,000.00 | 0.87 | 174,687.75 |
| 3 | 200,000.00 | 0.82 | 163,259.58 |
| 4 | 200,000.00 | 0.76 | 152,579.04 |
| 5 | 200,000.00 | 0.71 | 142,597.24 |
| 6 | 200,000.00 | 0.67 | 133,268.44 |
| 7 | 200,000.00 | 0.62 | 124,549.95 |
| 8 | 200,000.00 | 0.58 | 116,401.82 |
| Revised Lease Liability | 1,194,259.70 | ||
| Lease Liability as per Original | 506,258.93 | ||
| Inc. in Lease Liability | 688,000.77 | ||
| Inc in RTU Assets | 688,000.77 | ||
RTU Assets A/c Dr. 688,000.77
To Lease Liability A/c 688,000.77Original Lease Liability (Y1-10 @ 12%)
| Year | Cash Flow | PVF@12% | PV |
|---|---|---|---|
| 1 | 500,000 | 0.89 | 446,428.57 |
| 2 | 500,000 | 0.80 | 398,596.94 |
| 3 | 500,000 | 0.71 | 355,890.12 |
| 4 | 500,000 | 0.64 | 317,759.04 |
| 5 | 500,000 | 0.57 | 283,713.43 |
| 6 | 500,000 | 0.51 | 253,315.56 |
| 7 | 500,000 | 0.45 | 226,174.61 |
| 8 | 500,000 | 0.40 | 201,941.61 |
| 9 | 500,000 | 0.36 | 180,305.01 |
| 10 | 500,000 | 0.32 | 160,986.62 |
| Total Present Value | 2,825,111.51 | ||
Balances at End of Year 5
| Lease Liability | 1,802,388.10 |
| RTU Assets | 1,412,555.76 |
Modified Lease Liability (Y6-10 @ 11%)
| Year | Cash Flow | PVF@11% | PV |
|---|---|---|---|
| 1 | 290,000 | 0.90 | 261,261.26 |
| 2 | 290,000 | 0.81 | 235,370.51 |
| 3 | 290,000 | 0.73 | 212,045.50 |
| 4 | 290,000 | 0.66 | 191,031.98 |
| 5 | 290,000 | 0.59 | 172,100.89 |
| Modified Lease Liability | 1,071,810.14 | ||
Remeasurement Calculation
| Lease Liability (Actual Balance) | 1,802,388.10 |
| Modified Lease Liability | 1,071,810.14 |
| Change in Lease Liability | (730,577.97) |
Journal Entry
| Headings | Clarification | Amounts |
|---|---|---|
| Lease Liability A/c Dr. | Modified Lease Liability | 730,577.97 |
| To RTU Assets A/c | Asset is Decreased to Half So, the value of Asset decreases to half | 706,277.88 |
| To Gain on Modification A/c | (Residual) | 24,300.09 |
The decrease in RTU asset is proportionate to the decrease in scope (50%). So, 1,412,555.76 * 50% = 706,277.88. The remaining change in lease liability is recognized as a gain.
There are two parts to this modification: a decrease in the scope (term reduction) which may result in a gain/loss, and an increase in scope (additional space) which does not.
Initial Lease Liability Calculation
| Year | CF | PVF @ 12% | PV |
|---|---|---|---|
| 1 | 500,000.00 | 0.89 | 4,45,000.00 |
| 2 | 500,000.00 | 0.80 | 4,00,000.00 |
| 3 | 500,000.00 | 0.71 | 3,55,000.00 |
| 4 | 500,000.00 | 0.64 | 3,20,000.00 |
| 5 | 500,000.00 | 0.57 | 2,85,000.00 |
| 6 | 500,000.00 | 0.51 | 2,55,000.00 |
| 7 | 500,000.00 | 0.45 | 2,25,000.00 |
| 8 | 500,000.00 | 0.40 | 2,00,000.00 |
| 9 | 500,000.00 | 0.36 | 1,80,000.00 |
| 10 | 500,000.00 | 0.32 | 1,60,000.00 |
| Lease Liability | 2,825,111.51 | ||
Balances at End of Year 5
Lease Liability: 1,802,388.10
Right to Use Asset: 1,412,555.76
1. First, calculate Gain/Loss due to reduction of lease term.
The lease term is reduced from 10 years to 8. We remeasure the liability for the remaining 3 years (Year 6-8) at the original 12% rate.
| Year | CF | Pvf @ 12% | Present value |
|---|---|---|---|
| 1 | 500,000.00 | 0.89 | 446,428.57 |
| 2 | 500,000.00 | 0.80 | 398,596.94 |
| 3 | 500,000.00 | 0.71 | 355,890.12 |
| Revised Lease Liability | 1,200,915.63 | ||
| Revised Right to Use Assets | 847,533.45 | ||
Lease Liability A/c Dr. 601,472.47
To Right to Use Asset A/c 565,022.30
To Gain on Modification A/c 36,450.162. Now, remeasure lease liability on account of increase of Scope.
The payment is now 750,000 for the remaining 3 years, and the discount rate is the new incremental rate of 14%.
| Year | Cash Flows | Pvf @ 14% | Present Value |
|---|---|---|---|
| 1 | 750,000.00 | 0.88 | 657,894.74 |
| 2 | 750,000.00 | 0.77 | 577,100.65 |
| 3 | 750,000.00 | 0.67 | 506,228.64 |
| Revised Lease Liability | 1,741,224.02 | ||
Change in Lease Liability = 1,741,224.02 - 1,200,915.63 = 540,308.39
Right to use Asset A/c Dr. 540,308.39
To Lease Liability A/c 540,308.39If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be accounted for as a sale of the asset:
the seller-lessee shall measure the right-of-use asset arising from the lease back at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. Accordingly, the seller-lessee shall recognize only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.
{Simply, retain the portion of asset in the proportion that it has been leased back(retained) and recognize gain or loss only on the proportion of asset sold(not retained).}
the buyer-lessor shall account for the purchase of the asset applying applicable Standards, and for the lease applying the lessor’s accounting requirements in this Standard.
{Purchase of Asset as per other Applicable Standard- NAS 16, NAS 40 etc. and lease Transaction as a finance Lease or Operating Lease from the point of view of Lessor}
Let’s Assume the following:
| Retained Portion | Sold Portion | |
|---|---|---|
| 58% | 42% | |
| CA | 577,263 | 422,736 |
| FV of Lease Liab. | 865,895 | 634,104 |
| Gain on Sold Portion | 211,368 |
PV Calculation
| Year | CF | PVF | PV |
|---|---|---|---|
| 1 | 500,000.00 | 0.90 | 450,450.45 |
| 2 | 500,000.00 | 0.81 | 405,811.22 |
| 3 | 500,000.00 | 0.73 | 365,595.69 |
| 4 | 500,000.00 | 0.66 | 329,365.49 |
| 5 | 500,000.00 | 0.59 | 296,725.66 |
| Total Present Value | 1,847,948.51 | ||
Gain on Sold Portion Calculation
| Retained Portion (53%) | Sold Portion (47%) | |
|---|---|---|
| CA | 1,583,955.86 | 1,416,044.14 |
| FV | 1,847,948.51 | 1,652,051.49 |
| Gain | 236,007.36 |
Note: Retained Portion = (PV of Lease Liability / FV of Asset) = 1,847,948.51 / 3,500,000 = 53%. The Sold portion is the remainder, 47%.
Journal Entry
| Bank | 3,500,000.00 | |
| RTU | 1,583,955.86 | |
| To PPE | 3,000,000.00 | |
| To Lease Liability | 1,847,948.51 | |
| To gain | 236,007.36 | |
| Total | 5,083,955.86 | 5,083,955.86 |
Why would a reasonable person sell an asset for less than its Fair Value?
Most probably with an agreement to pay less amount as rent. That means the PV of future lease payments does not adequately reflect the actual Fair Value of the Right to Use Asset. The difference between the sale price and fair value is treated as a prepayment of lease payments.
Calculate Actual Fair Value of Lease Liability
| Fair Value of Lease rent reduced by the lower Sale Price (40L - 35L) | 500,000.00 |
| FV of Reduced Lease Payments (PV of 500k for 5y @ 11%) | 1,847,948.51 |
| Actual Fair Value of Lease Liability | 2,347,948.51 |
Gain on Sold Portion Calculation
| Retained Portion (59%) | Sold Portion (41%) | |
|---|---|---|
| CA | 1,760,961.38 | 1,239,038.62 |
| FV | 2,347,948.51 | 1,652,051.49 |
| Gain | 413,012.87 |
Note: Retained Portion = (Actual FV of Lease Liability / FV of Asset) = 2,347,948.51 / 4,000,000 = 59%. The Sold portion is the remainder, 41%.
Journal Entry
| Bank A/c Dr. | 3,500,000.00 | |
| Right to Use Asset A/c Dr. | 1,760,961.38 | |
| To PPE | 3,000,000.00 | |
| To Lease Liability | 1,847,948.51 | |
| To gain on Sale | 413,012.87 | |
| Total | 5,260,961.38 | 5,260,961.38 |
Why would a reasonable person buy an asset for more than its Fair Value?
The excess amount was most probably paid to compensate by increasing the future lease payments. This excess is considered a financing component.
Calculate Actual Fair Value of Lease Liability
| PV of Lease Payments (from previous example) | 1,847,948.51 |
| Less: FV of Reduced Lease Payments (Financing Component) | (300,000.00) |
| Actual Fair Value of Lease Liability | 1,547,948.51 |
Gain on Sold Portion Calculation
| Retained Portion (48%) | Sold Portion (52%) | |
|---|---|---|
| CA | 1,451,201.73 | 1,548,798.27 |
| FV | 1,547,948.51 | 1,652,051.49 |
| Gain | 103,253.22 |
Note: Retained Portion = (Actual FV of Lease Liability / FV of Asset) = 1,547,948.51 / 3,200,000 = 48%. The Sold portion is the remainder, 52%.
Journal Entry
| Bank A/c Dr. | 3,500,000.00 | |
| Right to Use Asset A/c Dr. | 1,451,201.73 | |
| To PPE | 3,000,000.00 | |
| To Lease Liability | 1,847,948.51 | |
| To gain on Sale | 103,253.22 | |
| Total | 4,951,201.73 | 4,951,201.73 |
A lessor shall classify each of its leases as either an operating lease or a finance lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.
Examples where a lease may be considered to have transferred substantially all the risks and rewards:
- the lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lessee has the option to purchase the underlying 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 date, that the option will be exercised.
- The lease term is for the major part of the economic life of the underlying asset even if title is not transferred.
- At the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset.
- and the underlying asset is of such a specialized nature that only the lessee can use it without major modifications.
Operating Lease:
A lessor shall recognize lease payments from operating leases as income on either a straight-line basis or another systematic basis. The lessor shall apply another systematic basis if that basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished.
“Rajesh Hamaal Academy" a company that owns and leases high-end film production equipment, enters into an operating lease with a rising star's production company, "Anmol KC Films."
Payment Schedule:
- Year 1: NPR 300,000
- Year 2: NPR 400,000
- Year 3: NPR 500,000
Here, Even though the payment vary year over year, a straight line basis seems more reasonable as the increase in Rent year over year is not justified by any metric {E.g Higher usage at later periods}
A well-known event management company, "A-One," leases stage equipment to influencers and event organizers. They have a lease agreement with "Sisan Bania Events," which hosts large-scale music concerts.
| Lease Payments: | 100,000 per event the stage is used. |
| Total Scheduled Events: | 15 events over two years. |
| Total Lease Payments: | 1,500,000 |
In this case, the benefits from the stage (and therefore the income to the lessor) are directly tied to how many times it's used. A straight-line method would be inappropriate.
| Year | No. of Events | Lease Payments |
|---|---|---|
| 1 | 8 Events | 800,000 |
| 2 | 7 Events | 700,000 |
This method ensures that income is recognized in a manner that directly aligns with the economic substance of the agreement.
Finance Lease:
Eva Giri Cosmetics agreed to lease a Laser Machine to Simpal Kharel parlour on 1 January. The lease was a 6 year finance lease of a machine on with annual lease payments of 150,000, payable at the end of every year. The fair value of the machine at the commencement of the lease was Rs. 1,800,000 and Eva Giri Cosmetics incurred initial direct costs of Rs.20,000 when arranging the lease. The estimated residual value of the asset at the end of the lease is Rs.100,000. The lessee has guaranteed an amount of Rs.70,000.
| Annual Lease Pmts | 150,000.00 |
| Residual Value | 100,000.00 |
| Fair Value of The Asset | 1,800,000.00 |
| Other Direct Costs | 20,000.00 |
| Total | 1,820,000.00 |
Amortization Schedule (IRR = 10.58%)
| Year | Opening | Interest | Receipts | Closing |
|---|---|---|---|---|
| 0 | 1,820,000.00 | |||
| 1 | 1,820,000.00 | 192,536.69 | (425,000.00) | 1,587,536.69 |
| 2 | 1,587,536.69 | 167,944.54 | (425,000.00) | 1,330,481.23 |
| 3 | 1,330,481.23 | 140,750.80 | (425,000.00) | 1,046,232.02 |
| 4 | 1,046,232.02 | 110,680.25 | (425,000.00) | 731,912.27 |
| 5 | 731,912.27 | 77,428.55 | (425,000.00) | 384,340.82 |
| 6 | 384,340.82 | 40,659.18 | (425,000.00) | (0.00) |
| 1,820,000.00 | 730,000.00 | (2,550,000.00) |
Journal Entry:
Lease Receivable A/c Dr. 1,820,000.00
To Cash/Bank A/c 20,000.00
To PPE 1,800,000.00A lessee may elect not to apply the requirements in paragraphs 22–49 to:
- short-term leases {Generally considered to be less than 1 Year};
- leases for which the underlying asset is of low value:
- The underlying assets need to be of low value. Low rental expense amount is not excluded.
- The Value of the asset has be assessed as if the asset was new regardless of the age of the asset being leased.
- Para B4 states “The assessment is not affected by the size, nature or circumstances of the lessee. Accordingly, different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low value.” This effectively states that The "Low-Value" test is based on the inherent value of the asset, not on the lessee's characteristics. The Basis for conclusion clarifies that an asset is low value if, when new, its value is typically around $5,000 USD or less.
- Prevents subjective interpretations like: “This server is low-value for us because we are a billion-dollar company.”
Where a lease includes a purchase option, the lessee includes the exercise price in the lease liability only if it is reasonably certain that the option will be exercised. In such cases, the interest rate implicit in the lease is often easier to determine, as the future cash flows are more predictable. A change in the lessee’s assessment of whether the purchase option will be exercised may trigger a remeasurement of the lease liability.
Where an entity uses Fair Value Model {Not Revaluation} to measure their investment property, the Right to Use asset that meet the definition of Investment Property shall also be accounted for using Fair Value model.