IFRS 16 Lessor accounting

IFRS 16 Lessor accounting

Lessors continue to classify leases as finance or operating leases.

1. Lessor accounting model

The lessor follows a dual accounting approach for lease accounting. The accounting is based on whether significant risks and rewards incidental to ownership of an underlying asset are transferred to the lessee, in which case the lease is classified as a finance lease. This is similar to the previous lease accounting requirements that applied to lessors. The lessor accounting models are also essentially unchanged from IAS 17 Leases. [IFRS 16.B53, IFRS 16.BC289]

Are the lessee and lessor accounting models consistent?

No. A key consequence of the decision to retain the IAS 17 dual accounting model for lessors is a lack of consistency with the new lessee accounting model. This can be seen in the case Lease classification below:

  • the lessee applies the right-of-use model and recognises a right-of-use asset and a liability for its obligation to make lease payments; whereas
  • the lessor continues to recognise the underlying asset and does not recognise a financial asset for its right to receive lease payments.

There are also more detailed differences. For example, lessees and lessors use the same guidance for determining the lease term and assessing whether renewal and purchase options are reasonably certain to be exercised, and termination options not reasonably certain to be exercised. However, unlike lessees, lessors do not reassess their initial assessments of lease term and whether renewal and purchase options are reasonably certain to be exercised, and termination options not reasonably certain to be exercised (see changes in the lease term in the link).

Other differences are more subtle. For example, although the definition of lease payments is similar for lessors and lessees (see lease payments in the link), the difference is the amount of residual value guarantee included in the lease payments.

  • The lessor includes the full amount (regardless of the likelihood that payment will be due) of any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.
  • The lessee includes only any amounts expected to be payable to the lessor under a residual value guarantee.

Are the IFRS 16 requirements for lessors identical to IAS 17?

No. The overall accounting models are essentially unchanged. However, there are a number of changes in the details of lessor accounting. For example, lessors apply the new:

  • definition of a lease;
  • sub-lease guidance;
  • sale-and-leaseback guidance; and
  • disclosure requirements.

In addition, IFRS 16 includes specific guidance on accounting for lease modifications by lessors (see lessor modification accounting in the link).

2. Lease classification

A lessor classifies a lease as either a finance lease or an operating lease, as follows:

  • leases that transfer substantially all of the risks and rewards incidental to ownership of the underlying asset are finance leases; and
  • all other leases are operating leases. [IFRS 16.61–62, IFRS 16.B53]

The lease classification test is essentially unchanged from IAS 17.

Generally, the presence of the following indicators, either individually or in combination, leads to a lease being classified as a finance lease:

  • transfer of ownership to the lessee either during or at the end of the lease term;
  • existence of a purchase option that is reasonably certain to be exercised;
  • the lease term is for a major part of the economic life of the underlying asset;
  • the present value of the lease payments amounts to substantially all of the fair value of the underlying asset at inception of the lease; and
  • the underlying asset is specialised. [IFRS 16.63]

Lease classification is made at the inception date and is reassessed only if there is a lease modification. Changes in estimates (e.g. changes in estimates of the economic life or of the residual value of the underlying asset), or changes in circumstances (e.g. default by the lessee), do not give rise to a new classification of a lease for accounting purposes. [IFRS 16.66]

However, if the contract includes terms and conditions to adjust the lease payments for particular changes occurring between the inception date and the commencement date, then, for the purpose of classifying the lease, the effect of any such changes is deemed to have taken place at the inception date. [IFRS 16.B54]

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Case – Lease classification

Lessor L enters into a non-cancellable lease contract with Company X under which X leases non-specialised equipment for five years. The economic life of the equipment is estimated to be 15 years and legal title will remain with L. The lease contract contains no purchase, renewal or early termination options. The fair value of the equipment is 100,000 and the present value of the lease payments amounts to 50,000.

In assessing the classification of the lease, L notes that:

  • the lease does not transfer ownership of the equipment to X;
  • X has no option to purchase the equipment;
  • the lease term is for one-third of the economic life of the equipment, which is less than the major part of the economic life;
  • the present value of the lease payments amounts to 50% of the fair value of the equipment, which is less than substantially all of the fair value; and
  • the equipment is not specialised.

L notes that there are no indicators that the lease is a finance lease and that, based on an overall evaluation of the arrangement, the lease does not transfer substantially all of the risks and rewards incidental to the ownership of the equipment to X.

Therefore, L classifies the lease as an operating lease.

Are there special rules on the classification of leases of land?

No. The classification of a lease of land is assessed based on the general classification guidance. An important consideration is that land normally has an indefinite economic life. However, the fact that the lease term is normally shorter than the economic life of the land does not necessarily mean that a lease of land is always an operating lease; the other classification requirements are also considered. [IFRS 16.B55, BCZ241–BCZ244]

For example, in a 99-year lease of land with fixed lease payments, the significant risks and rewards associated with the land are transferred to the lessee during the lease term, and on lease commencement the present value of the residual value of the land would be negligible. It follows that a long lease term may indicate that a lease of land is a finance lease.

There is no bright-line threshold for the lease term above which a lease of land would always be classified as a finance lease, and assessing classification can require the use of significant judgement in some cases.

Do changes between the inception and commencement dates impact lease classification?

Yes, in some cases. Generally, the classification of a lease is determined at inception of the lease and is not revised unless the lease agreement is modified. However, the classification is updated for certain changes between inception date and commencement date that are deemed to have taken place at the inception date. [IFRS 16.66–67, IFRS 16.70–71, IFRS 16.B5]

A significant amount of time may pass between the inception date and the commencement date – e.g. when parties commit to leasing an underlying asset that has not yet been built. A lease contract may also include terms and conditions to adjust the lease payments for changes that occur between the inception date and the commencement date – e.g. a change in the lessor’s cost of the underlying asset or a change in the lessor’s cost of financing the lease.

In such cases, the calculation of the present value of lease payments used in determining the classification of the lease covers all lease payments made from the commencement of the lease term. However, if the lease payments are adjusted for contractual changes such as changes in the construction or acquisition cost of the underlying asset, general price levels or the lessor’s costs of financing the lease between the inception and commencement dates, then the effect of these changes is deemed to have taken place at inception for the purpose of classifying the lease.

It appears that the lease payments for classification purposes should also be updated for changes between the inception and commencement dates in:

  • the non-cancellable period of the lease (see the non-cancellable period in the link);
  • lease payments that depend on an index or a rate; and
  • variable payments that become in-substance fixed.

These changes are akin to contractual changes between the inception and commencement dates, and therefore the effect of these changes should be deemed to have taken place at inception for the purpose of classifying the lease. Consequently, a lessor should also update the rate implicit in the lease and its estimate of the unguaranteed residual value for classification purposes for such contractual changes.

However, for measurement purposes it appears that a lessor should update the lease payments, the rate implicit in the lease and the unguaranteed residual value for all changes between inception and commencement date. This is because a lessor measures the net investment in a finance lease, and the amount of operating lease income to be recognised, at the commencement date.

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3. Operating lease model

The lessor classifies a lease that is not a finance lease as an operating lease.

If, before lease commencement, a lessor recognises an asset in its statement of financial position and leases that asset to a lessee under an operating lease, then the lessor does not derecognise the asset on lease commencement. Generally, future contractual rental payments from the lessee are recognised as receivables over the lease term as the payments IFRS 16 Lessor accountingbecome receivable. [IFRS 16.81]

Generally, lease income from operating leases is recognised by the lessor on a straight-line basis from the commencement date over the lease term. It may be possible for the lessor to recognise lease income using another systematic basis if that is more representative of the time pattern in which the benefit from the use of the underlying asset is diminished. Similarly, increases (or decreases) in rental payments over a period of time, other than variable lease payments, are reflected in the determination of the lease income, which is recognised on a straight-line basis. [IFRS 16.81, IFRS 16.83]

The initial direct costs incurred by the lessor in arranging an operating lease are added to the carrying amount of the underlying asset and cannot be recognised immediately as an expense. These initial direct costs are recognised as an expense on the same basis as the lease income. This will not necessarily be consistent with the basis on which the underlying asset is depreciated. [IFRS 16.83]

Incentives granted to the lessee in negotiating a new or renewed operating lease are recognised as an integral part of the lease payments relating to the use of the underlying asset. They are recognised as a reduction of rental income over the lease term using the same recognition basis as for the lease income. [IFRS 16.81]

The lessor depreciates the underlying asset over the asset’s useful life in a manner that is consistent with the depreciation policy that it applies to similar owned assets. [IFRS 16.84]

A lessor applies IAS 36 to determine whether an underlying asset subject to an operating lease is impaired and to account for any impairment loss identified. In addition, the lessor applies the impairment and derecognition requirements of IFRS 9 to operating lease receivables. [IFRS 16.85, IFRS 9.2.1(b)(i)]

Should a lessor continue to recognise operating lease income on a straight-line basis if the lessee reduces actual usage of the underlying asset?

Generally, yes. [IFRS 16.8]

In most leases, the benefit conveyed by the lessor to the lessee is the right to use the underlying asset over the lease term. For this reason, operating lease income from leases is typically recognised by the lessor on a straight-line basis from the commencement date over the lease term.

IFRS 16 states that it is possible to recognise operating lease income using another systematic basis if that is more representative of the time pattern in which the benefit of the underlying property is diminished. However, it is rare that a basis other than straight-line meets this test in a lease. For example, in a real estate lease, a retailer that leases a retail store from a landlord may expect its sales at the store to vary seasonally, and may project year-on-year increases in sales.

However, the benefit that the retailer receives under the lease is the right to use the store. Therefore, if the lease payments are fixed then the landlord would recognise operating lease income on a straight-line basis in this fact pattern.

A question arises about whether this approach remains appropriate if the tenant significantly reduces sales at the store and/or the government imposes restrictions that reduce footfall at the store.

In the absence of a change in the lease agreement, the tenant’s benefit under the lease agreement remains the right to use the store. As long as the landlord continues to convey the right to use the store to the retailer, the landlord will typically continue to recognise operating lease income on a straight-line basis.

4. Finance lease model

At commencement, the lessor derecognises the underlying asset and recognises a finance lease receivable at an amount equal to its net investment in the lease, which comprises the present value of the lease payments and any unguaranteed residual value accruing to the lessor. The present value is calculated by discounting the lease payments and any unguaranteed residual value, at the interest rate implicit in the lease (see Discount rate in the link). Initial direct costs are included in the measurement of the finance lease receivable, because the interest rate implicit in the lease takes initial direct costs incurred into consideration. [IFRS 16.67–69]

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The lessor deducts any lease incentive payable from the lease payments included in the measurement of the net IFRS 16 Lessor accountinginvestment in the lease. [IFRS 16.70(a)]

The lessor recognises the difference between the carrying amount of the underlying asset and the finance lease receivable in profit or loss when recognising the finance lease receivable. This gain or loss is presented in profit or loss in the same line item as that in which the lessor presents gains or losses from sales of similar assets.

Over the lease term, the lessor accrues interest income on the net investment. The receipts under the lease are allocated between reducing the net investment and recognising finance income, to produce a constant rate of return on the net investment. [IFRS 16.75–76]

A lessor applies the derecognition and impairment requirements of IFRS 9 to the net investment in the lease. A lessor recognises any loss allowance on the finance lease receivable, applying IFRS 9. A lessor regularly reviews estimated unguaranteed residual values used in computing the gross investment in the lease. If there is a reduction in the estimated unguaranteed residual value, then the lessor revises the income allocation over the lease term without changing the discount rate and immediately recognises any reduction in respect of amounts accrued. [IFRS 16.77]

5. Presentation and disclosure

5.1 Lessor presentation

A lessor presents leases in its statement of financial position as follows.

Finance lease

Operating lease

Statement of financial position

Present assets held under a finance lease as a receivable at an amount equal to the net investment in the lease [IFRS 16.67]

Present the underlying assets subject to operating leases according to the nature of the underlying asset [IFRS 16.88]

5.2 Lessor disclosure

A lessor discloses information that provides a basis for users of financial statements to assess the effect that leases have on financial position, financial performance and cash flows. Extensive disclosures are required by lessors for finance and operating leases. [IFRS 16.89]

Normally, a lessor discloses at least the following information.

Finance lease

Operating lease

Quantitative information

[IFRS 16.90, IFRS 16.93–97]

  • Selling profit or loss
  • Finance income on the net investment in the lease
  • Lease income relating to variable lease payments not included in the net investment in the lease
  • Lease income relating to variable lease payments that do not depend on an index or rate
  • Other lease income
  • Detailed maturity analysis of the undiscounted lease payments to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years
  • Significant changes in the carrying amount of the net investment in the lease
  • Detailed maturity analysis of the lease payments receivable
  • A reconciliation between the undiscounted lease payments and the net investment in the lease, identifying the unearned finance income and any discounted unguaranteed residual value
  • If applicable, disclosures in accordance with IAS 16 (separately from other assets), IAS 36, IAS 38 Intangible Assets, IAS 40 and IAS 41 Agriculture

  • Significant changes in the carrying amount of the net investment in the lease [IFRS 16.93]

  • N/A

A lessor also discloses quantitative and qualitative information about its leasing activities, such as:

  • the nature of its leasing activities; and
  • how it manages risks associated with rights that it retains in underlying assets. [IFRS 16.92]

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