Lessor accounting under IFRS 16: finance and operating leases

How do the two models differ?

How is a lease classified?

By substance, at the inception of the lease. These situations usually point to a finance lease:

• Ownership of the asset transfers to the lessee by the end of the lease.
• The lessee has an option to buy the asset at a price expected to be well below fair value, making exercise reasonably certain.
• The lease term covers the major part of the asset's economic life.
• The present value of the lease payments amounts to at least substantially all of the asset's fair value.
• The asset is so specialised that only the lessee can use it without major modification.

Other indicators include the lessee bearing the lessor's losses on cancellation, or gains and losses from changes in the residual value falling to the lessee. If none applies, the lease is an operating lease.

How is a finance lease accounted for?

At commencement the lessor derecognises the asset and recognises a net investment in the lease: the present value of the lease payments and any unguaranteed residual value, at the rate implicit in the lease. Finance income is then recognised at a constant rate on that net investment.

Example: an equipment lessor leases a machine with a fair value of CU 432,948 for five years at CU 100,000 a year. The present value of the payments at 5% equals the fair value, so it is a finance lease. The lessor records a receivable of CU 432,948, earns finance income of CU 21,647 in year 1, and reduces the receivable by the rest of the payment, CU 78,353. It mirrors the lessee's liability in lessee accounting step by step.

The net investment is a receivable subject to the expected credit loss rules of IFRS 9. A manufacturer or dealer that leases its own products recognises selling profit at commencement, as if it had sold the asset outright, then finance income over the lease.

How is an operating lease accounted for?

The lessor keeps the asset on its balance sheet and depreciates it under IAS 16 or IAS 38, or measures it under IAS 40 if it is investment property. It recognises lease income on a straight-line basis, or another systematic basis if that better reflects how the benefit from the asset diminishes. Initial direct costs are added to the asset and expensed over the lease term.

Example: a property company leases offices for five years at CU 100,000 a year, with the first six months rent-free. Total rent is CU 450,000, so it recognises CU 90,000 a year, building up an accrued income balance during the rent-free period.

What about subleases?

An intermediate lessor classifies a sublease by reference to the right-of-use asset arising from the head lease, not the underlying asset. A sublease of an office for the whole remaining head lease term is therefore usually a finance lease.

How does US GAAP compare?

ASC 842 has three lessor models: sales-type, direct financing and operating; see ASC 842 lessor accounting. The classification criteria are similar, but US GAAP uses more specific thresholds in practice.

This guide is general information. It is not tax or legal advice for your situation.