## Learning Outcomes

- Calculate the subsequent carrying amount of a lease liability using the effective interest method.
- Record finance costs, lease payments and depreciation entries for a lessee.
- Explain how a right-of-use asset is measured after commencement.
- Identify when a lease liability must be remeasured under IFRS 16.
- Account for remeasurement adjustments against the right-of-use asset.
- Distinguish ordinary remeasurement from a lease modification.
- Avoid common ACCA FR errors in lease schedules, current/non-current splits and profit or loss charges.

## ACCA Financial Reporting (FR) Syllabus

In ACCA Financial Reporting, leases are tested as part of applying IFRS Accounting Standards to financial statements. For lessees, IFRS 16 requires most leases to be recognised on the statement of financial position, so candidates must be able to update both the right-of-use asset and lease liability after initial recognition.

- Apply the single lessee accounting model under IFRS 16.
- Calculate finance costs on lease liabilities using the discount rate given in the question.
- Depreciate right-of-use assets over the correct period.
- Split lease liabilities between current and non-current amounts.
- Identify remeasurement events, such as changes in lease term or index-linked payments.
- Adjust the right-of-use asset when the lease liability is remeasured.
- Recognise variable lease payments not included in the liability in profit or loss.
- Interpret the impact of leases on profit, assets, liabilities and ratios.

## 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. After initial recognition, how is the finance cost on a lease liability calculated?
2. If a lessee pays an annual lease payment in arrears, does the payment reduce the liability before or after finance cost is added?
3. Over what period should a right-of-use asset be depreciated if ownership of the underlying asset does not transfer to the lessee?
4. Name two events that require a lessee to remeasure a lease liability.
5. If a lease liability is remeasured upwards, what is the usual double entry?

## Introduction

IFRS 16 Leases requires a lessee to recognise a right-of-use asset and a lease liability for most leases. Initial recognition is only the starting point. In later accounting periods, the lessee must unwind interest on the liability, reduce the liability for payments made, depreciate the asset, and consider whether the lease measurements need to be revised.

This subtopic is highly practical. ACCA FR questions often give the present value of lease payments, the discount rate and the annual rental, then ask for carrying amounts, expenses, extracts from the financial statements, or adjustments to draft figures. Strong candidates use a clear lease liability schedule and keep the asset and liability calculations separate.

> **Key Term: right-of-use asset**
> The asset recognised by a lessee representing its right to use the underlying leased asset during the lease term.
>
> **Key Term: lease liability**
> The obligation recognised by a lessee to make future lease payments, initially measured at the present value of those payments.

### Measuring the lease liability after commencement

After commencement, the lease liability is measured in a similar way to a loan. The liability increases because interest accrues over time, and decreases when lease payments are made.

The basic formula is:

$$
\text{Opening lease liability} + \text{finance cost} - \text{lease payment} = \text{closing lease liability}
$$

The finance cost is calculated using the discount rate applied to the opening lease liability:

$$
\text{Finance cost} = \text{Opening lease liability} \times \text{discount rate}
$$

The double entries are usually:

- To record finance cost:

  Dr Finance cost
  Cr Lease liability

- To record a lease payment:

  Dr Lease liability
  Cr Cash

This means the payment is not treated as a simple rental expense. Instead, the total expense recognised in profit or loss normally consists of:

- depreciation of the right-of-use asset; and
- finance cost on the lease liability.

> **Key Term: finance cost**
> The interest expense recognised on the lease liability as the liability is unwound over the lease term.

Consider a simple example.

> **Question:**
> A lessee recognises a lease liability of $100,000 on 1 January 20X1. The lease requires annual payments of $30,000 in arrears for five years. The discount rate is 10%. What is the closing lease liability at 31 December 20X1?
The finance cost for 20X1 is:

$$
\$100,000 \times 10\% = \$10,000
$$

The closing liability is:

$$
\$100,000 + \$10,000 - \$30,000 = \$80,000
$$

So the entries for 20X1 are:

- Dr Finance cost $10,000; Cr Lease liability $10,000
- Dr Lease liability $30,000; Cr Cash $30,000

The statement of financial position will show a lease liability of $80,000 at 31 December 20X1, split between current and non-current portions if the question asks for presentation.

Payment timing is a common source of mistakes. If payments are made in arrears, interest is charged before deducting the cash payment. If payments are made in advance, the payment is deducted first, then interest is charged on the reduced liability.

> **Test Tip:**
> In ACCA FR, build a short liability schedule every time: opening liability, interest, cash paid, closing liability. This avoids mixing up the finance cost with the lease payment.

A lease liability may be split between current and non-current liabilities. The current portion is normally the amount of the liability expected to be settled within 12 months. In exam questions, a practical way to find the current liability is to prepare the lease schedule for the next year and identify the reduction in the liability caused by payments over that period, excluding interest. The remainder is non-current.

For example, if the closing liability at 31 December 20X1 is $80,000 and after the next year’s interest and payment the liability will fall to $58,000, the reduction in principal is $22,000. That $22,000 is the current liability; the remaining $58,000 is non-current.

### Depreciating and testing the right-of-use asset

The right-of-use asset is accounted for separately from the lease liability. After initial recognition, a lessee usually measures the right-of-use asset using the cost model. This means the asset is carried at cost less accumulated depreciation and impairment losses.

Depreciation is charged over the period that reflects the expected use of the asset. The usual IFRS 16 rule is:

- if ownership transfers to the lessee by the end of the lease term, depreciate over the useful life of the underlying asset;
- if the lessee is reasonably certain to exercise a purchase option, depreciate over the useful life of the underlying asset;
- otherwise, depreciate over the shorter of the lease term and the useful life of the underlying asset.

> **Key Term: lease term**
> The non-cancellable period of a lease, plus extension periods the lessee is reasonably certain to use and termination periods the lessee is reasonably certain not to use.

Assume a right-of-use asset initially costs $100,000 and the lease term is five years. Ownership will not transfer to the lessee, and there is no purchase option. If straight-line depreciation is used, annual depreciation is:

$$
\$100,000 \div 5 = \$20,000
$$

The double entry is:

Dr Depreciation expense $20,000
Cr Accumulated depreciation $20,000

If the lease liability example above is used as well, profit or loss for 20X1 includes:

- depreciation expense of $20,000; and
- finance cost of $10,000.

Total profit or loss charge: $30,000.

This total may equal the lease cash payment in the first year in this simple example, but that will not always be the case. Over a lease term, finance cost is higher in earlier years and lower in later years because the liability is falling. Depreciation may be straight-line. Therefore, IFRS 16 often produces a higher total expense in earlier years compared with a straight-line operating lease rental approach.

> **Exam Warning:**
> Do not credit cash when recording depreciation. Depreciation reduces the carrying amount of the right-of-use asset, while cash payments reduce the lease liability.

A right-of-use asset is also subject to impairment requirements. If there is an indication that the asset may be impaired, the lessee applies IAS 36 Impairment of Assets. In FR, this may appear as part of a wider non-current asset adjustment.

Some leases may contain restoration or dismantling obligations. If these were included in the initial cost of the right-of-use asset, the depreciation charge will be based on the asset cost including those obligations. The provision itself is accounted for separately under IAS 37, but the related asset component affects the depreciation calculation.

Although IFRS 16 permits other measurement approaches in certain cases, ACCA FR questions commonly focus on the cost model: cost less accumulated depreciation and impairment.

### Remeasuring lease liabilities when estimates change

A lessee does not simply continue with the original lease schedule in all circumstances. IFRS 16 requires remeasurement of the lease liability when certain estimates or contractual cash flows change.

> **Key Term: remeasurement**
> The adjustment of the lease liability after commencement to reflect revised lease payments, lease term, discount rate or other specified changes.

Common remeasurement triggers include:

- a change in the lease term;
- a change in the assessment of whether the lessee is reasonably certain to exercise a purchase option;
- a change in expected payments under a residual value guarantee;
- a change in future lease payments caused by a change in an index or rate;
- some changes in amounts payable because payments become in-substance fixed.

A change in lease term may arise if the lessee now expects to use an extension option, or no longer expects to exercise a termination option. For example, a lessee may originally sign a five-year lease with an option to extend for three years. If, after two years, the lessee becomes reasonably certain to extend, the lease liability must be remeasured to include the revised lease term.

> **Key Term: discount rate**
> The rate used to discount lease payments, being the interest rate implicit in the lease if readily determinable, or otherwise the lessee’s incremental borrowing rate.

The discount rate used on remeasurement depends on the reason for the change. For FR exam purposes, the question will usually give the rate to use. As a guide:

- changes in lease term or purchase option assessment usually use a revised discount rate;
- changes in payments due to an index or rate often use the original discount rate, unless the change is linked to a change in floating interest rates.

When the lease liability is remeasured, the usual double entry is to adjust the right-of-use asset.

If the liability increases:

Dr Right-of-use asset
Cr Lease liability

If the liability decreases:

Dr Lease liability
Cr Right-of-use asset

However, if a decrease in the lease liability is greater than the carrying amount of the right-of-use asset, the asset is reduced to zero and the excess reduction is recognised in profit or loss as a gain.

> **Test Tip:**
> In many FR questions, remeasurement is tested through the double entry. Ask: “Has the liability gone up or down?” Then put the opposite side to the right-of-use asset unless the asset would fall below zero.

Consider an index-linked payment example.

A company leases equipment and has a lease liability of $70,000 immediately before remeasurement. Lease payments are linked to an inflation index, and the present value of the revised remaining payments is $76,000 using the appropriate discount rate. The liability must increase by:

$$
\$76,000 - \$70,000 = \$6,000
$$

The entry is:

Dr Right-of-use asset $6,000
Cr Lease liability $6,000

This increases future depreciation because the carrying amount of the right-of-use asset has increased. The revised lease liability will then be unwound using the relevant discount rate over the remaining lease term.

Variable lease payments require care. Not all variable payments are included in the lease liability. Payments that depend on an index or rate are included and remeasured when the index or rate changes. By contrast, variable payments based on usage or sales are not included in the lease liability. They are recognised in profit or loss when the event or condition causing payment occurs.

For example, if a retailer pays a fixed store rental plus 2% of monthly sales, the fixed rental is included in the lease liability. The sales-based payment is expensed as incurred because it depends on future sales rather than an index or rate.

> **Key Term: variable lease payment**
> A lease payment that changes because of factors such as an index, rate, usage level or sales level.
>
> **Exam Warning:**
> Do not remeasure the lease liability for sales-based or usage-based payments that were excluded from the original lease liability. These are normally charged to profit or loss as incurred.

Remeasurement also affects later presentation. If the lease liability is revised, future finance costs change. If the right-of-use asset is adjusted, future depreciation changes. This means candidates may need to recalculate both profit or loss and statement of financial position figures.

### Lease modifications and presentation points for FR

A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions. Examples include adding extra leased space, shortening the leased area, extending the contract by agreement, or changing the contractual payments.

> **Key Term: lease modification**
> A change in the scope of a lease, or the consideration for a lease, that was not part of the original lease terms and conditions.

A modification is accounted for as a separate lease if both of the following apply:

- the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
- the lease consideration increases by an amount consistent with the stand-alone price for the increase in scope, adjusted for the circumstances of the contract.

If both conditions are met, the lessee accounts for the added right-of-use asset as a new lease.

If the modification is not a separate lease, the existing lease is adjusted. The lessee remeasures the lease liability at the modification date using a revised discount rate. The accounting then depends on the nature of the modification:

- if the modification decreases the scope of the lease, reduce the carrying amount of the right-of-use asset and recognise any gain or loss relating to the partial termination in profit or loss;
- for other modifications, adjust the right-of-use asset.

At FR level, questions are more likely to test straightforward remeasurement than complex modification accounting. Even so, candidates should recognise the distinction. A reassessment of an option under the original contract is not the same as a negotiated modification to the lease contract.

The financial statement presentation is also exam-relevant. The right-of-use asset is presented as a non-current asset, either separately or within the same line item as the underlying asset would have been presented. In many FR question extracts, it may appear as “right-of-use asset” under non-current assets. Lease liabilities are presented as current and non-current liabilities.

The statement of profit or loss includes:

- depreciation of the right-of-use asset;
- finance cost on the lease liability;
- variable lease payments not included in the lease liability, when incurred;
- impairment losses if relevant.

The statement of cash flows treatment may also appear in FR. Lease payments contain a principal element and an interest element. The principal portion is normally a financing cash flow. The interest element is classified according to the entity’s accounting policy for interest paid. If the question is focused on statement of cash flows, use the classification required by the question.

Leases also affect ratios. Recognising lease liabilities increases liabilities and may worsen gearing. Recognising right-of-use assets increases total assets and capital employed. Profit before interest may improve compared with treating the whole payment as an operating rental, because the finance cost is presented below operating profit. However, depreciation will reduce operating profit. In interpretation questions, mention these effects if leases are significant.

> **Test Tip:**
> For preparation questions, label your workings clearly: “lease liability”, “right-of-use asset”, “depreciation” and “finance cost”. Markers reward method even if one figure is wrong.

A final worked example brings the main ideas together.

> **Question:**
> On 1 January 20X1, a company recognises a right-of-use asset and lease liability of $50,000. The lease lasts five years, payments of $13,190 are made annually in arrears, and the discount rate is 10%. The asset is depreciated straight-line over five years. What are the profit or loss charges and closing carrying amounts for the year ended 31 December 20X1?
Finance cost:

$$
\$50,000 \times 10\% = \$5,000
$$

Closing lease liability:

$$
\$50,000 + \$5,000 - \$13,190 = \$41,810
$$

Depreciation:

$$
\$50,000 \div 5 = \$10,000
$$

Carrying amount of right-of-use asset:

$$
\$50,000 - \$10,000 = \$40,000
$$

Profit or loss charges are:

- depreciation: $10,000
- finance cost: $5,000

Statement of financial position amounts are:

- right-of-use asset: $40,000
- lease liability: $41,810, split between current and non-current if required

The key is to avoid netting the asset and liability. They are separate items and follow different measurement rules after commencement.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- A lessee normally recognises both a right-of-use asset and a lease liability under IFRS 16.
- The lease liability is subsequently measured by adding finance cost and deducting lease payments.
- Finance cost is calculated using the discount rate applied to the opening lease liability.
- Payments in arrears are deducted after finance cost; payments in advance are deducted before finance cost.
- The right-of-use asset is usually measured at cost less accumulated depreciation and impairment.
- Depreciation is over the shorter of lease term and useful life unless ownership transfers or a purchase option is reasonably certain.
- Remeasurement is needed for changes in lease term, purchase option assessment, residual value guarantee estimates and some index-linked payments.
- Remeasurement adjustments usually change both the lease liability and the right-of-use asset.
- Variable payments based on sales or usage are usually expensed as incurred, not included in the lease liability.
- Lease modifications may be accounted for as separate leases if they add rights of use at an appropriate stand-alone price.
- Lease liabilities are split between current and non-current liabilities in the statement of financial position.
- ACCA FR lease questions often require separate workings for finance cost, depreciation, closing asset and closing liability.

## Key Terms and Concepts

- right-of-use asset
- lease liability
- finance cost
- lease term
- remeasurement
- discount rate
- variable lease payment
- lease modification


Lessee accounting - Subsequent measurement and remeasurement