Overview
Lessor accounting under IFRS 16 starts with one decision: is the lease a finance lease or an operating lease? The answer determines everything that follows.
- Finance lease – the lessor derecognises the underlying asset, recognises a lease receivable equal to the net investment in the lease, and recognises finance income over the lease term.
- Operating lease – the lessor keeps the asset on its balance sheet, depreciates it, and recognises lease income on a straight-line basis.
Unlike lessees, who recognise almost every lease on balance sheet, lessors retain the dual model carried over from IAS 17. This guide covers each step in order and forms part of our complete IFRS 16 guide.
Step 1: Classify the Lease
A lease is a finance lease if it transfers substantially all the risks and rewards incidental to ownership of the underlying asset (IFRS 16.62). Classification is made at the inception date and is based on substance rather than form. The indicators in IFRS 16.63 are:
| Indicator | Points to a finance lease when… |
|---|---|
| Ownership | Ownership transfers to the lessee by the end of the lease term |
| Purchase option | The lessee has an option priced low enough that exercise is reasonably certain |
| Lease term | The term covers the major part of the asset's economic life |
| Present value | The present value of the lease payments amounts to substantially all of the asset's fair value |
| Specialised asset | Only the lessee can use the asset without major modification |
These are indicators, not a checklist. A lease that meets one of them can still be an operating lease if other features show that substantially all the risks and rewards have not transferred.
Two points arise frequently in practice:
- Land and buildings are classified as separate elements, which often produces an operating lease over the land and a finance lease over the building in the same contract.
- Reclassification happens only on a lease modification. A change in the estimated residual value or economic life does not change the classification (IFRS 16.66).
Our article on finance leases vs operating leases covers each indicator in detail.
Finance Leases: Initial Measurement
At the commencement date, the lessor derecognises the underlying asset and recognises a receivable equal to the net investment in the lease (IFRS 16.67).
Gross investment, net investment and unearned finance income
| Term | Meaning |
|---|---|
| Gross investment | Undiscounted lease payments receivable plus any unguaranteed residual value |
| Net investment | The gross investment discounted at the interest rate implicit in the lease |
| Unearned finance income | Gross investment less net investment – the finance income still to be recognised |
The discount rate
The net investment is measured using the interest rate implicit in the lease: the rate at which the present value of the lease payments and the unguaranteed residual value equals the fair value of the asset plus the lessor's initial direct costs. For an intermediate lessor in a sublease, the head lease discount rate may be used if the sublease rate cannot be readily determined (IFRS 16.68).
Lease payments included
For a lessor, lease payments comprise (IFRS 16.70):
- fixed payments, including in-substance fixed payments, less any lease incentives payable;
- variable payments that depend on an index or rate, measured using the index or rate at commencement;
- residual value guarantees provided by the lessee, a party related to the lessee, or an unrelated third party that is financially capable of meeting the guarantee;
- the exercise price of a purchase option the lessee is reasonably certain to exercise; and
- termination penalties, if the lease term reflects the lessee exercising a termination option.
Note that the lessor recognises residual value guarantees from third parties, which a lessee's lease liability would never include.
Initial direct costs need no separate entry
Because the implicit rate is defined to include initial direct costs, they are already inside the net investment. They reduce the finance income recognised over the term rather than being expensed up front (IFRS 16.69).
Finance Leases: Subsequent Measurement
After commencement, the lessor:
- Recognises finance income at a constant periodic rate of return on the net investment (IFRS 16.75). Income is highest early in the lease and declines as the receivable reduces.
- Applies each lease payment against the gross investment, reducing both the principal and the unearned finance income (IFRS 16.76).
- Applies IFRS 9 impairment to the net investment, recognising a loss allowance for expected credit losses. Lessors may elect the simplified approach, measuring lifetime expected credit losses (IFRS 9.5.5.15).
- Reviews the unguaranteed residual value regularly. If it has reduced, the lessor revises the income allocation over the remaining term and immediately recognises any reduction relating to amounts already accrued (IFRS 16.77). Increases are not recognised.
Variable payments that do not depend on an index or rate, such as turnover-based rent, are excluded from the net investment and recognised as income in the period they arise.
Practical Example: Finance Lease
Northfield Leasing buys a production machine for 500,000 and immediately leases it to a customer on these terms:
- Lease term: 4 years; economic life of the machine: 5 years
- Annual payments of 140,000, in arrears
- Initial direct costs paid by Northfield: 10,000 (broker commission)
- Expected residual value at the end of year 4: 60,000, unguaranteed
- No purchase option; the machine returns to Northfield at the end of the lease
Implicit rate and classification
The implicit rate is the rate at which 140,000 a year for 4 years plus 60,000 in year 4 discounts to 510,000 (fair value of 500,000 plus initial direct costs of 10,000). Solving gives 7.82%.
The present value of the lease payments alone, excluding the unguaranteed residual, is 465,597, or 93% of fair value. With the lease term also covering 80% of the economic life, the lease is a finance lease.
Gross and net investment
| Item | Amount |
|---|---|
| Lease payments (4 × 140,000) | 560,000 |
| Unguaranteed residual value | 60,000 |
| Gross investment | 620,000 |
| Unearned finance income | (110,000) |
| Net investment at commencement | 510,000 |
Lease receivable schedule
| Year | Opening | Finance income (7.82%) | Payment received | Closing |
|---|---|---|---|---|
| 1 | 510,000 | 39,865 | (140,000) | 409,865 |
| 2 | 409,865 | 32,037 | (140,000) | 301,902 |
| 3 | 301,902 | 23,598 | (140,000) | 185,500 |
| 4 | 185,500 | 14,500 | (140,000) | 60,000 |
| Total | 110,000 | (560,000) |
The closing balance of 60,000 equals the unguaranteed residual value, which Northfield recovers by taking back the machine. Total finance income equals the unearned finance income of 110,000.
Journal entries
Commencement – derecognise the machine and recognise the receivable, including the initial direct costs paid:
Dr Net investment in the lease 510,000
Cr Machinery 500,000
Cr Bank (initial direct costs) 10,000
Year 1 – finance income and the first payment:
Dr Net investment in the lease 39,865
Cr Finance income 39,865
Dr Bank 140,000
Cr Net investment in the lease 140,000
End of year 4 – the machine is returned:
Dr Machinery 60,000
Cr Net investment in the lease 60,000
Operating Leases
In an operating lease the lessor has not given up the risks and rewards of ownership, so it accounts for the asset as its own and treats the lease as a stream of rental income.
| Statement of financial position | Profit or loss |
|---|---|
| The underlying asset stays in property, plant and equipment (or investment property) | Lease income, recognised on a straight-line basis over the lease term (IFRS 16.81) |
| Initial direct costs are added to the carrying amount of the asset (IFRS 16.83) | Initial direct costs, expensed over the lease term on the same basis as the income |
| An accrued or deferred lease income balance for the difference between cash received and income recognised | Depreciation of the asset under the lessor's normal policy (IFRS 16.84), and any IAS 36 impairment |
No receivable is recognised for future rentals. Escalations, rent-free periods and incentives are spread evenly over the term, so cash and income differ from year to year. Land and buildings held to earn rentals are investment property under IAS 40.
Example: operating lease with escalating rentals
Coastline Equipment owns a crane that cost 300,000, with a remaining useful life of 10 years and no residual value. It leases the crane to a contractor for 3 years, paying a broker 6,000 to arrange the lease. The rentals, received at the end of each year, escalate:
- Year 1: 50,000
- Year 2: 55,000
- Year 3: 60,000
The lease covers only 3 of 10 years of the crane's life, so it is an operating lease.
Lease income is the total rentals of 165,000 spread evenly: 55,000 a year. Initial direct costs of 6,000 are expensed at 2,000 a year, and depreciation is 30,000 a year (300,000 / 10).
| Year | Cash received | Lease income | Accrued lease income (closing) | Depreciation and initial direct costs | Profit |
|---|---|---|---|---|---|
| 1 | 50,000 | 55,000 | 5,000 | (32,000) | 23,000 |
| 2 | 55,000 | 55,000 | 5,000 | (32,000) | 23,000 |
| 3 | 60,000 | 55,000 | – | (32,000) | 23,000 |
| Total | 165,000 | 165,000 | (96,000) | 69,000 |
The 5,000 of year 1 income not yet received is carried as accrued lease income and reverses in year 3, when cash exceeds income. Profit is the same every year.
Commencement – capitalise the broker's fee:
Dr Crane (initial direct costs) 6,000
Cr Bank 6,000
Year 1 – lease income, depreciation and initial direct costs:
Dr Bank 50,000
Dr Accrued lease income 5,000
Cr Lease income 55,000
Dr Depreciation 30,000
Dr Initial direct costs expense 2,000
Cr Crane – accumulated depreciation 32,000
At the end of the lease, the crane is carried at 210,000 (306,000 less 96,000) and remains available to lease again. Had this been a finance lease, the crane would have been derecognised and Coastline would instead report finance income that declines each year.
A manufacturer or dealer does not recognise selling profit on entering an operating lease (IFRS 16.86). On a finance lease it does – see manufacturer or dealer lessors.
Modifications
The lessor accounting for a lease modification depends on the classification.
Finance leases – a modification is a separate lease if it adds the right to use one or more underlying assets and the consideration increases by an amount commensurate with the stand-alone price (IFRS 16.79). Otherwise (IFRS 16.80):
- if the lease would have been an operating lease had the modification been in effect at inception, the lessor accounts for it as a new operating lease from the effective date, with the underlying asset measured at the net investment immediately before that date;
- in all other cases, the lessor applies the modification requirements of IFRS 9.
Operating leases – a modification is accounted for as a new lease from the effective date. Any accrued or prepaid lease payments on the original lease are treated as part of the lease payments for the new lease (IFRS 16.87).
Presentation and Disclosure
A finance lessor presents the net investment as a receivable and discloses selling profit or loss, finance income, income from variable payments not in the net investment, and a maturity analysis of undiscounted lease payments for each of the first five years and a total thereafter, reconciled to the net investment (IFRS 16.90–94).
An operating lessor presents the underlying asset according to its nature and discloses lease income, separately identifying variable payments not based on an index or rate, and a maturity analysis of undiscounted lease payments to be received (IFRS 16.88–97). See IFRS 16 disclosures for the full requirements.
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Conclusion
Lessor accounting under IFRS 16 follows from the classification made at inception. A finance lease replaces the asset with a net investment in the lease, measured at the implicit rate and unwound through finance income, subject to IFRS 9 impairment and regular review of the unguaranteed residual value. An operating lease leaves the asset in place and spreads the lease income, incentives and initial direct costs evenly over the lease term.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.