IFRS 16 Leases
A lease is a contract that gives one party the right to use an asset owned by another for a period of time, in exchange for payment. The party that owns the asset is the lessor; the party that uses it is the lessee. IFRS 16 Leases governs both sides of that contract, but it does not treat them symmetrically, and F1 and F2 divide the standard along the same seam.
F1 Chapter 11 covers the lessee: the single lessee accounting model, under which every lease that is not short-term or of a low-value asset puts a right-of-use asset and a lease liability on the statement of financial position. This chapter covers the lessor — the classification decision the lessee no longer has to make, and the two quite different sets of accounting entries that follow from it.
IFRS 16 Lessor accounting (introduction): it uses IAS 17 vocabulary (“minimum lease payment”); it says the lessor will “just expense that straight line over the life of the lease”, which is a wording slip; it says nothing about IFRS 18 — see “Where this appears under IFRS 18” at the end of this chapter; and three items it omits are taught here.
1 Why the two sides are different
Before IFRS 16, both parties classified a lease as either a finance lease or an operating lease. That let lessees keep operating leases off the statement of financial position altogether — an airline could commit itself to years of unavoidable payments on a fleet of aircraft and show neither the aircraft nor the obligation anywhere. IFRS 16 removed the distinction for lessees and replaced it with one model.
It left the lessor model broadly as it was. The asymmetry is deliberate: off balance sheet finance was a lessee problem, and lessors were already recognising either an asset or a receivable, so there was nothing hidden to bring on. A lessor therefore still has to classify.
Lessee (F1 Chapter 11) | Lessor (this chapter) | |
Classification | None. One model for every lease, subject to two optional exemptions. | Finance lease or operating lease. The classification drives everything that follows. |
On the statement of financial position | Right-of-use asset and lease liability. | Finance lease: a receivable at the net investment in the lease, and the asset is gone. Operating lease: the asset stays, in property, plant and equipment. |
In profit or loss | Depreciation of the right-of-use asset and interest on the lease liability. | Finance lease: finance income. Operating lease: rental income and depreciation. |
One rule, two rulebooks
Do not carry the lessee's single model across to the lessor. A lessor that has transferred the risks and rewards of ownership has, in substance, sold the asset and lent the money; a lessor that has not is simply renting an asset out. Those are different transactions and IFRS 16 accounts for them differently.
2 Classifying the lease
A lease is a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee. The risks are the risks of ownership — the asset breaking down, becoming obsolete, or being idle. The rewards are the economic benefits from using the asset over the major part of its life.
An operating lease is any lease that is not a finance lease. There is no separate set of criteria for it and there is no third type of lease: if the classification test is failed, the lease is an operating lease by default.
2.1 The five situations that point to a finance lease
IFRS 16 gives five examples of situations that individually or in combination would normally lead to a lease being classified as a finance lease. None of them is a test to be passed on its own; each is evidence of where the risks and rewards have gone.
Situation | Why it points to a finance lease |
Ownership of the asset transfers to the lessee by the end of the lease term. | The lessee ends up owning the asset, so it takes all the risks and all the rewards. |
The lessee has an option to purchase the asset at a price sufficiently below fair value that, at inception, it is reasonably certain the option will be exercised. | Economically the lessee will buy the asset, so the outcome is the same as an outright transfer of ownership. |
The lease term is for the major part of the economic life of the asset, even if title is not transferred. | The lessee consumes most of the benefits the asset will ever produce. The lessor gets back something with little value left in it. |
At inception, the present value of the lease payments amounts to at least substantially all of the fair value of the asset. | The lessee is paying for the asset. Paying for something is the strongest evidence that it is yours in substance. |
The asset is of such a specialised nature that only the lessee can use it without major modifications. | The lessor could not re-let or sell it to anyone else, so the lessor is not exposed to the asset's residual risk in any real sense. |
Three further indicators may also, individually or in combination, lead to finance lease classification:
If the lessee can cancel the lease, the lessor's losses on cancellation are borne by the lessee.
Gains or losses from movements in the fair value of the residual accrue to the lessee — for example through a rent rebate equal to most of the sale proceeds at the end of the lease.
The lessee can continue the lease for a secondary period at a rent substantially below market rent.
Classification is made at the inception date and is not revisited. It is reassessed only if the lease is modified — a change in the lease that was not part of the original terms. A change in estimate (of the asset's economic life, or of its residual value) or a change in circumstances (the lessee defaulting, for instance) does not give rise to a new classification.
In a computational question you will be told which kind of lease it is. The classification test is examined the other way round — a narrative scenario in which you have to identify which of the situations above are present and reach a conclusion. Name the situation you are relying on; do not just assert the answer.
Lessor – operating lease: “we credit income five hundred” — the $500 credit is to accrued income. The recording says nothing about IFRS 18, and initial direct costs are not mentioned.
3 Operating leases: the lessor's accounting
The risks and rewards have not moved, so in substance the asset is still the lessor's. Nothing is derecognised.
The asset stays in property, plant and equipment and is depreciated over its useful life, on the lessor's normal depreciation policy for similar assets. The lease term is irrelevant to that calculation.
The lease payments are recognised as income on a straight-line basis over the lease term (or another systematic basis, if that is more representative of the pattern in which the benefit of the asset is diminished).
Initial direct costs of obtaining the lease are added to the carrying amount of the asset and recognised as an expense over the lease term on the same basis as the lease income.
Annual lease income = Total payments receivable over the lease term ÷ Number of years in the lease term
The straight-line trap
“Straight line over the lease term” means the total of the payments divided by the number of years — not the amount received in each individual year. Rent-free periods and other incentives are spread across the whole term, so the income and the cash rarely match. The difference sits on the statement of financial position as accrued income (income ahead of cash) or deferred income (cash ahead of income).
Operating lease (lessor)
Banana leases out a machine to Mango under a four year operating lease. The terms of the lease are that the annual lease rentals are $2,000 payable in arrears. As an incentive, Banana grants Mango a rent free period in the first year.
Explain how Banana would account for the lease in its financial statements over the four years.
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This is the mirror image of F1 Chapter 11 Example 1, where the same contract is looked at from Mango's side. Mango, having elected the low-value exemption, charges $1,500 a year to profit or loss and carries an accrual; Banana credits $1,500 a year and carries accrued income. The two sets of entries are the same figures in opposite directions.
IFRS 16 Lessor accounting – finance lease: the worked table on screen leaves the $1,600 guaranteed residual value out of the lease payments. It is a lease payment, so it belongs in both figures: the gross investment is $27,000, not $25,400, and the net investment is $24,799, not $23,484. Example 2 sets out the corrected working, and “The residual value trap” explains it. The recording also uses IAS 17’s “minimum lease payments” for what IFRS 16 calls the lease payments.
4 Finance leases: the lessor's accounting
The risks and rewards have moved to the lessee, so in substance the lessor no longer controls the asset. What the lessor holds instead is a claim to a stream of future receipts — an investment, not a machine.
Derecognise the asset and recognise a receivable measured at the net investment in the lease.
Recognise finance income over the lease term at a constant periodic rate of return on the net investment.
Apply the receipts against the receivable, reducing both the outstanding principal and the unearned finance income.
4.1 Measuring the net investment
Two definitions
Gross investment in the lease — the lease payments receivable by the lessor, plus any unguaranteed residual value accruing to the lessor. It is an undiscounted total of cash.
Net investment in the lease — the gross investment discounted at the interest rate implicit in the lease. It is what the receivable is recognised at.
Gross investment = Lease payments receivable + Unguaranteed residual value
Net investment = Gross investment discounted at the rate implicit in the lease
The interest rate implicit in the lease is the rate that makes the present value of the lease payments and of the unguaranteed residual value equal to the fair value of the asset plus the lessor's initial direct costs. In an exam question it is given.
For a lessor, the lease payments receivable are:
Included in the lease payments | Comment |
Fixed payments, less any lease incentives payable | The rentals themselves. |
Variable payments that depend on an index or a rate | Measured using the index or rate at the commencement date. |
Any residual value guarantee given to the lessor | By the lessee, a party related to the lessee, or an unrelated third party financially capable of meeting the guarantee. The lessor includes the full guaranteed amount. |
The exercise price of a purchase option | Only where the lessee is reasonably certain to exercise it. |
Penalties for terminating the lease | Only where the lease term reflects the lessee exercising an option to terminate. |
The residual value trap. At the end of the lease the asset comes back to the lessor with some value left in it. Part of that value is usually guaranteed to the lessor; the rest is unguaranteed. The two are treated the same way in the end — both are discounted into the net investment — but they arrive there by different routes: the guaranteed part is a lease payment, the unguaranteed part is the second limb of the gross investment. Neither may be left out. Deducting the guaranteed amount from the total residual value and then discounting only the difference understates the receivable.
The older standard, IAS 17, used the term minimum lease payments for what IFRS 16 calls the lease payments. The phrase still appears in older material and in some question banks. It means the same thing here: the rentals plus the guaranteed residual value.
Finance lease (lessor)
Cherry leases out an item of property, plant and equipment under a 5 year finance lease. The lease commenced on 1 January 20X5 and the rate implicit in the lease is 4%. The annual lease rentals of $5,000 are paid at the start of each year of the lease.
Cherry estimates that the residual value of the item of property, plant and equipment at the end of the lease will be $2,000, of which $1,600 is guaranteed to Cherry by the lessee.
Discount factors at 4% are: year 1 0.962, year 2 0.925, year 3 0.889, year 4 0.855, year 5 0.822.
Calculate Cherry's gross investment and net investment in the lease at 1 January 20X5, showing the guaranteed and the unguaranteed residual amounts separately.
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unwinding Cherry's receivable
The requirement in Example 2 stops at the commencement date. In the exam you may be asked to carry the receivable forward. The rentals are received in advance, so each year's receipt comes out first and finance income is charged on what is left outstanding:
Year | B/f $ | Rental received $ | Outstanding $ | Finance income at 4% $ | C/f $ |
1 | 24,799 | (5,000) | 19,799 | 792 | 20,591 |
2 | 20,591 | (5,000) | 15,591 | 624 | 16,215 |
3 | 16,215 | (5,000) | 11,215 | 449 | 11,664 |
4 | 11,664 | (5,000) | 6,664 | 267 | 6,931 |
5 | 6,931 | (5,000) | 1,931 | 69 | 2,000 |
The closing balance of $2,000 is the residual value, recovered when the asset comes back at the end of the lease. Total finance income of $2,201 equals the unearned finance income calculated above — which is the arithmetic check on the whole table.
Year 5's finance income is taken as the balancing figure. Charging 4% on $1,931 would give $77; the $8 difference is the accumulated effect of using discount factors rounded to three decimal places. Never let a rounding difference of a few dollars send you hunting for an error.
5 Manufacturer or dealer lessors
A manufacturer or dealer that leases out the goods it makes or sells is doing two things at once: making a sale, and financing it. IFRS 16 requires both to be recognised.
At the commencement date | Amount |
Revenue | The lower of the fair value of the asset and the present value of the lease payments discounted at a market rate of interest. |
Cost of sale | The cost (or carrying amount, if different) of the asset, less the present value of the unguaranteed residual value. |
Selling profit or loss | The difference between the two, recognised in profit or loss at the commencement date whichever kind of lease it is. |
Finance income | Recognised over the lease term, exactly as for any other finance lease. |
Two anti-avoidance points follow. Where an artificially low rate of interest is quoted, the selling profit is restricted to the amount that would arise had a market rate been charged — otherwise a lessor could turn future finance income into an immediate sale. And the costs of obtaining the lease are recognised as an expense at the commencement date, because they relate mainly to earning the selling profit; they are not rolled into the net investment as they are for other lessors.
6 Sale and leaseback
In a sale and leaseback the owner of an asset sells it and immediately leases it back. The seller becomes the lessee; the buyer becomes the lessor. The question IFRS 16 asks first is not a lease question at all.
Has a sale taken place? Apply the IFRS 15 requirements for a performance obligation satisfied at a point in time — has control of the asset passed to the buyer?
If it has, the seller-lessee derecognises the asset and recognises a right-of-use asset measured at the proportion of the previous carrying amount that relates to the right of use it has retained. Gain or loss is recognised only on the rights transferred to the buyer. The buyer-lessor accounts for the purchase under the standard applying to that asset and for the lease under the lessor rules in this chapter.
If it has not, there has been no sale, only a secured borrowing. The seller-lessee keeps the asset on its statement of financial position and recognises a financial liability equal to the proceeds under IFRS 9. The buyer-lessor recognises a financial asset, not the asset itself.
The whole gain is not recognised on a sale and leaseback that qualifies as a sale. The seller has kept the right to use the asset, so it has only sold part of it, and only that part's gain is realised. Recognising the full difference between proceeds and carrying amount is the classic error — and it was exactly the abuse the rule was written to stop.
7 Presentation and disclosure by a lessor
Finance lease | Operating lease | |
Statement of financial position | The net investment in the lease, presented as a receivable and split between current and non-current. | The underlying asset, presented according to its nature — normally within property, plant and equipment. |
Statement of profit or loss | Finance income on the net investment. Selling profit or loss as well, for a manufacturer or dealer lessor. | Lease income, and the depreciation charge on the underlying asset. |
A lessor also discloses selling profit or loss, finance income on the net investment, income from variable lease payments not included in the net investment, and — for operating leases — lease income, separately identifying income from variable payments that do not depend on an index or rate. A maturity analysis of the undiscounted lease payments receivable is required for each of at least the first five years and in total thereafter, reconciled to the net investment for finance leases. So is a qualitative and quantitative explanation of significant changes in the net investment, and of how the lessor manages the risk it retains in the residual value of its assets.
8 Where this appears under IFRS 18
IFRS 18 Presentation and Disclosure in Financial Statements replaces IAS 1 for accounting periods beginning on or after 1 January 2027. It changes presentation only: nothing in this chapter is recognised or measured differently because of it. Leases are still IFRS 16.
The one point worth carrying away here is the exception IFRS 18 makes for entities with a specified main business activity. An entity whose main business activity is providing financing to customers — a leasing company, for instance — classifies in the operating category income and expenses that an ordinary trading company would classify in the investing or financing categories, and is not required to present the second required subtotal. For a manufacturer that happens to lease out a surplus machine, that exception does not apply. The categories themselves are taught in the group chapters.
On the lessee's side of the same contract IFRS 18 does bite: depreciation of the right-of-use asset falls in the operating category and interest on the lease liability in the financing category, so the two halves of what used to be a single rent expense now appear in different parts of the statement of profit or loss. F1 Chapter 11 carries that read-across.
A lessor classifies every lease. It is a finance lease if substantially all the risks and rewards of ownership pass to the lessee — five situations point to that, and the classification is fixed at inception. Otherwise it is an operating lease, and there is no third kind. Under an operating lease the lessor keeps and depreciates the asset and spreads the total rentals straight line over the lease term, with the difference between income and cash carried as accrued or deferred income. Under a finance lease the lessor derecognises the asset and recognises a receivable at the net investment — the lease payments (including any guaranteed residual value) plus the unguaranteed residual value, all discounted at the rate implicit in the lease — then recognises finance income at a constant rate of return on it as the receipts come in. A manufacturer or dealer lessor also recognises a selling profit at the commencement date. IFRS 18 changes none of this; it changes only where the resulting amounts are presented.
9 Test your knowledge
IFRS 16 Leases
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