## Learning Outcomes

- Identify when a contract contains a lease for IFRS 16 purposes.
- Explain when a lessee recognises a right-of-use asset and lease liability.
- Calculate the initial measurement of a lease liability using the present value of unpaid lease payments.
- Calculate the initial cost of a right-of-use asset, including direct costs, prepaid amounts and incentives.
- Distinguish payments made at commencement from future lease payments included in the liability.
- Apply the short-term lease and low-value asset recognition exemptions.
- Avoid common ACCA FR errors in lease liability split and profit or loss charges.

## ACCA Financial Reporting (FR) Syllabus

In ACCA Financial Reporting, IFRS 16 Leases is commonly examined through short numerical questions and scenario-based tasks. For lessees, the key skill is to set up the lease correctly at commencement: recognise the right-of-use asset, recognise the lease liability, and know which amounts adjust the asset rather than the liability.

- Recognise the single lessee accounting model under IFRS 16.
- Identify whether an arrangement contains a lease: identified asset, economic benefits and right to direct use.
- Measure the lease liability initially at the present value of lease payments not paid at commencement.
- Measure the right-of-use asset initially by adjusting the lease liability for direct costs, prepaid payments and incentives.
- Apply the correct discount rate: rate implicit in the lease if available; otherwise the lessee’s incremental borrowing rate.
- Apply optional recognition exemptions for short-term leases and leases of low-value assets.
- Calculate related first-year finance costs and depreciation where required.
- Split a lease liability between current and non-current amounts in exam questions.

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What two items does a lessee normally recognise at the commencement date of a lease under IFRS 16?
2. A lease liability is initially measured using which cash flows: all lease payments, or only lease payments not paid at commencement?
3. How do initial direct costs, lease incentives and amounts paid on or before commencement affect the right-of-use asset?
4. When may a lessee choose to expense lease payments instead of recognising a right-of-use asset and lease liability?
5. A lease liability at commencement is $500,000 and the interest rate is 8%. The first annual payment of $140,000 is made in arrears. What is the lease liability after the first payment?

## Introduction

IFRS 16 requires lessees to bring most leases onto the statement of financial position. Instead of simply charging rental payments to profit or loss, the lessee usually recognises an asset for the right to use the leased item and a liability for the obligation to make lease payments. This approach affects both the statement of financial position and profit or loss: the asset is depreciated and the liability accrues finance cost.

For ACCA FR, the most tested issue is the initial measurement calculation. You must be able to decide which amounts are included in the lease liability and which amounts are added to, or deducted from, the right-of-use asset.

> **Key Term: Lease**
> A contract, or part of a contract, that conveys the right to use an identified asset for a period of time in exchange for consideration.

### Identifying a lease before measuring it

Before applying lessee accounting, confirm that the contract contains a lease. A contract contains a lease if the customer controls the use of an identified asset for a period of time in exchange for consideration.

This normally requires three elements.

First, there must be an identified asset. The asset may be specified in the contract, such as a named machine, vehicle, production line or floor of a building. If the supplier has a substantive right to substitute the asset throughout the period of use, the customer may not have a right to use an identified asset.

Second, the lessee must have the right to obtain substantially all of the economic benefits from use of the asset. Benefits may come from using the asset to generate revenue, reduce costs, manufacture goods, provide services, or occupy space.

Third, the lessee must have the right to direct the use of the asset. This means the lessee controls how and for what purpose the asset is used during the lease term. If the lessor directs the use of the asset, the customer is receiving a service rather than controlling an asset.

> **Key Term: Commencement date**
> The date on which the lessor makes the underlying asset available for use by the lessee.

The commencement date matters because this is when the lessee recognises the right-of-use asset and lease liability. It is not always the same as the date the contract is signed. If a contract is signed on 1 January but the equipment is made available on 1 February, initial recognition occurs on 1 February.

> **Test Tip:**
> In ACCA FR questions, do not use “substantially all of the useful life” as a test for whether a contract is a lease. That idea relates more to old finance lease classification or lessor accounting. For lessee recognition under IFRS 16, focus on identified asset, economic benefits and right to direct use.

### Initial measurement of the lease liability

At the commencement date, the lessee recognises a lease liability. This represents the obligation to make lease payments in the future.

> **Key Term: Lease liability**
> The lessee’s obligation to make lease payments, initially measured at the present value of lease payments not paid at the commencement date.

The basic rule is:

$$
\text{Initial lease liability} = \text{Present value of future lease payments not paid at commencement}
$$

The discount rate used is the interest rate implicit in the lease if it is readily determinable. If that rate cannot be readily determined, the lessee uses its incremental borrowing rate.

The lease payments included in the liability may include fixed payments, payments that are in substance fixed, certain variable payments linked to an index or rate, amounts expected to be payable under residual value guarantees, exercise price of a purchase option if the lessee is reasonably certain to exercise it, and termination penalties if the lease term reflects termination.

In many ACCA FR questions, the present value of the future lease payments is given. If it is given, use it. Do not add up the undiscounted cash payments unless the question asks you to calculate the present value.

> **Exam Warning:**
> Amounts paid on or before commencement are not included in the lease liability because they are no longer future unpaid lease payments. They are normally included in the right-of-use asset instead.

For example, suppose a lessee enters a five-year lease on 1 January 20X5. It pays $20,000 at commencement and will pay five annual instalments of $55,000 in arrears. The present value of the future instalments at commencement is $200,000. The initial lease liability is $200,000, not $220,000 and not $275,000. The $20,000 paid at commencement is dealt with as part of the right-of-use asset.

After initial recognition, the liability is increased by finance cost and reduced by lease payments. This is often tested when the examiner asks for a liability balance after one year.

> **Question:**
> A lessee recognises a lease liability of $22,745,000 at commencement. The interest rate implicit in the lease is 10%. The first annual payment of $6,000,000 is made in arrears at the end of year 1. What is the lease liability after the first payment?
>
> $$
> \text{Opening liability} = 22{,}745{,}000
> $$
>
> $$
> \text{Interest} = 22{,}745{,}000 \times 10\% = 2{,}274{,}500
> $$
>
> $$
> \text{Closing liability} = 22{,}745{,}000 + 2{,}274{,}500 - 6{,}000{,}000 = 19{,}019{,}500
> $$

So, after the first year’s payment, the liability is $19,019,500.

If the question asks for the current liability at that date, take care. The next cash payment is not always the current liability. The current liability is the amount of the closing lease liability expected to be settled within the next 12 months. A practical ACCA method is to roll the liability forward one more year and compare the balances.

Using the same figures:

$$
\text{Liability after year 1} = 19{,}019{,}500
$$

$$
\text{Interest for year 2} = 19{,}019{,}500 \times 10\% = 1{,}901{,}950
$$

$$
\text{Liability after next payment} = 19{,}019{,}500 + 1{,}901{,}950 - 6{,}000{,}000 = 14{,}921{,}450
$$

Therefore:

$$
\text{Current liability} = 19{,}019{,}500 - 14{,}921{,}450 = 4{,}098{,}050
$$

The next cash payment is $6,000,000, but part of that payment is finance cost for the next period. The reduction in the liability is only $4,098,050.

### Initial measurement of the right-of-use asset

The right-of-use asset represents the lessee’s right to use the underlying asset during the lease term.

> **Key Term: Right-of-use asset**
> An asset representing the lessee’s right to use the underlying leased asset over the lease term.

At commencement, the right-of-use asset is initially measured at cost. For ACCA FR purposes, the key formula is:

$$
\text{Right-of-use asset} =
\text{Initial lease liability}

- \text{lease payments made at or before commencement}
- \text{initial direct costs}
- \text{restoration or dismantling costs, if applicable}
- \text{lease incentives received}

$$

> **Key Term: Initial direct costs**
> Incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained.

Examples of initial direct costs may include commission or legal costs directly attributable to arranging the lease. General administrative costs are not added unless they meet the definition of initial direct costs.

> **Key Term: Lease incentive**
> A payment or benefit provided by the lessor to the lessee to encourage the lessee to enter into the lease, such as a cash contribution or rent-free benefit.

The asset and liability do not always have the same initial carrying amount. They will be the same only if there are no commencement-date payments, direct costs, incentives or restoration obligations.

> **Question:**
> A lessee enters a lease on 1 April 20X7. An initial payment of $100,000 is made on that date. The present value of future lease payments is $173,500. Initial direct costs are $20,000 and lease incentives received are $7,000. What is the initial cost of the right-of-use asset?
>
> $$
> \text{Right-of-use asset} =
> 173{,}500 + 100{,}000 + 20{,}000 - 7{,}000
> $$
>
> $$
> = 286{,}500
> $$

The lease liability is $173,500, because that is the present value of the future payments not paid at commencement. The right-of-use asset is $286,500 because it includes the commencement payment and initial direct costs, and is reduced by the incentive.

A common journal entry at commencement is:

- Dr Right-of-use asset with the full initial asset cost
- Cr Lease liability with the present value of unpaid lease payments
- Cr Cash for payments made at commencement or direct costs paid
- Dr Cash or reduce the asset for lease incentives received, depending on the facts

> **Exam Warning:**
> Do not deduct initial direct costs from the right-of-use asset. In lessee accounting, initial direct costs are added to the cost of the right-of-use asset.

After recognition, the right-of-use asset is normally depreciated. If the lease transfers ownership by the end of the lease term, or the lessee is reasonably certain to exercise a purchase option, depreciation is usually over the asset’s useful life. Otherwise, depreciation is over the shorter of the lease term and the useful life of the underlying asset.

For example, if the right-of-use asset cost is $4,695,000, the lease term is eight years and the useful life is ten years, depreciation is based on eight years:

$$
\text{Annual depreciation} = \frac{4{,}695{,}000}{8} = 586{,}875
$$

If the related lease liability is $4,657,500 and the implicit interest rate is 6%, the first year’s finance cost is:

$$
4{,}657{,}500 \times 6\% = 279{,}450
$$

Total profit or loss charge for the year is:

$$
586{,}875 + 279{,}450 = 866{,}325
$$

This demonstrates why the profit or loss charge is not normally the same as the cash payment. Under IFRS 16, lessee accounting separates the lease into depreciation of the asset and finance cost on the liability.

> **Test Tip:**
> If a question asks for the “total charge to profit or loss”, add depreciation of the right-of-use asset and finance cost on the lease liability. Do not use the lease payment as the expense unless an exemption applies.

### Recognition exemptions: when the lessee may expense payments

IFRS 16 has optional recognition exemptions. If used, the lessee does not recognise a right-of-use asset and lease liability. Instead, lease payments are charged to profit or loss, usually on a straight-line basis over the lease term or another systematic basis if more representative.

> **Key Term: Short-term lease**
> A lease with a lease term of 12 months or less at the commencement date and no purchase option.
>
> **Key Term: Low-value asset lease**
> A lease where the underlying asset is of low value when new, such as small items of office equipment, if the IFRS 16 conditions are met.

The short-term exemption is often tested. The lease term must be 12 months or less and there must be no purchase option. If a lease is for nine or ten months, the lessee may choose to expense the payments if it applies the exemption.

For low-value assets, the assessment is based on the value of the underlying asset when new, not the age or carrying amount of the asset when leased. A used item can qualify only if the asset would have been low value when new.

Rent-free periods and incentives still need care. If a short-term lease is expensed and there is a rent-free period, the total lease cost is normally spread over the lease term.

For example, a lessee enters a ten-month lease on 1 October. Payments are $1,000 per month, but the first month is rent-free. Total cash payments are $9,000. If the exemption is used, the monthly expense is:

$$
\frac{9{,}000}{10} = 900
$$

For the six months from 1 October to 31 March, the expense is:

$$
900 \times 6 = 5{,}400
$$

> **Exam Warning:**
> Do not assume a high-value asset qualifies for the low-value exemption just because the lease term is short. Short-term lease and low-value asset lease are separate exemptions with separate conditions.

Also, ownership transfer at the end of the lease term is not an exemption. If ownership transfers, the lease is not short-term for exemption purposes if there is a purchase option or transfer arrangement, and the lessee normally recognises a right-of-use asset and lease liability.

### Exam approach for initial recognition calculations

A disciplined layout prevents most errors. Use the following approach in the exam.

Step 1: Confirm whether IFRS 16 lessee recognition applies. If the arrangement is a short-term lease or low-value asset lease and the lessee elects to use the exemption, expense the payments. Otherwise, recognise a right-of-use asset and lease liability.

Step 2: Identify the commencement date. Use that date to decide which payments have already been made and which payments remain unpaid.

Step 3: Measure the lease liability. If the present value of future lease payments is given, use it directly. If not, discount the relevant payments using the implicit rate or incremental borrowing rate.

Step 4: Measure the right-of-use asset. Start with the initial lease liability, then add payments made at or before commencement and initial direct costs. Deduct lease incentives received. Add restoration or dismantling costs if the scenario gives such an obligation.

Step 5: If required, calculate first-year finance cost and depreciation. Finance cost is based on the lease liability, not the asset. Depreciation is based on the right-of-use asset cost, adjusted for the appropriate depreciation period.

Step 6: If required, calculate the closing liability. Add finance cost and deduct cash payments. For payments in arrears, interest is charged before the payment. For payments in advance, the payment reduces the liability before interest is charged for the period, depending on the exact timing.

A simple lease in arrears follows this pattern:

$$
\text{Closing liability} =
\text{Opening liability}

- \text{interest}
- \text{payment}

$$

A lease with a payment made at commencement will usually have the payment excluded from the initial liability and included in the right-of-use asset.

For example, a lease has a present value of future payments of $200,000, a commencement payment of $20,000 and no incentives or direct costs. The entries at commencement result in:

$$
\text{Lease liability} = 200{,}000
$$

$$
\text{Right-of-use asset} = 200{,}000 + 20{,}000 = 220{,}000
$$

If instead the $20,000 were wrongly added to the liability, both the statement of financial position and later finance cost would be overstated.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- A lessee normally recognises a right-of-use asset and lease liability for leases under IFRS 16.
- A contract contains a lease only if there is an identified asset, the right to substantially all economic benefits, and the right to direct use.
- Initial recognition occurs at the commencement date, when the asset is made available for use.
- The lease liability is initially measured at the present value of lease payments not paid at commencement.
- Payments made on or before commencement are excluded from the liability but added to the right-of-use asset.
- The right-of-use asset starts with the lease liability and is adjusted for direct costs, prepaid payments, restoration costs and incentives.
- Initial direct costs increase the right-of-use asset.
- Lease incentives reduce the right-of-use asset.
- Finance cost is calculated on the lease liability, not on the right-of-use asset.
- Depreciation is based on the right-of-use asset and normally uses the shorter of lease term and useful life unless ownership transfers or a purchase option is expected to be exercised.
- Short-term leases and low-value asset leases may be expensed if the lessee uses the optional exemptions.
- The current part of a lease liability is the expected reduction in the liability over the next 12 months, not necessarily the next cash payment.

## Key Terms and Concepts

- Lease
- Commencement date
- Lease liability
- Right-of-use asset
- Initial direct costs
- Lease incentive
- Short-term lease
- Low-value asset lease


Lessee accounting - Initial recognition: right-of-use asset and lease liability