Key Takeaways
- IFRS 16 lessor accounting is largely unchanged from IAS 17
- Lessors classify leases as either finance leases or operating leases based on transfer of risks and rewards
- Finance leases: the lessor presents a net investment in the lease (receivable) rather than the underlying asset
- Operating leases keep the asset on the balance sheet with rental income recognised over the term
- Manufacturer/dealer lessors recognise selling profit or loss at commencement for finance leases
Overview of Lessor Accounting
While IFRS 16 significantly changed lessee accounting, lessor accounting remains substantially the same as under IAS 17. Lessors continue to classify leases as either finance leases or operating leases, with different accounting treatments for each.
The key principle is whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset to the lessee.
IFRS 16 Classification Principle
"A lessor shall classify each of its leases as either an operating lease or a finance lease. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset."
- IFRS 16.61-62
Why No Change for Lessors?
The IASB decided not to change lessor accounting because: (1) the existing model was working reasonably well, (2) changing it would impose significant costs without commensurate benefits, and (3) the project focused primarily on improving the representation of lessees' assets and liabilities.
Lease Classification
Classification is made at the inception of the lease based on the substance of the transaction rather than its legal form. The classification depends on the extent to which risks and rewards of ownership transfer to the lessee.
Finance Lease Indicators
IFRS 16.63 provides examples of situations that individually or in combination would normally lead to classification as a finance lease:
Additional Finance Lease Indicators
IFRS 16.64 provides additional indicators that may also lead to finance lease classification:
- If the lessee can cancel, the lessor's losses from cancellation are borne by the lessee
- Gains or losses from the fluctuation in the fair value of the residual accrue to the lessee
- The lessee can continue the lease for a secondary period at substantially below-market rent
| Indicator | Finance Lease | Operating Lease |
|---|---|---|
| Risks and rewards transfer | Substantially all transfer | Do not transfer |
| Lease term vs economic life | Major part (typically 75%) | Minor part |
| PV of payments vs fair value | Substantially all (typically 90%) | Less than substantially all |
| Asset specificity | Specialised for lessee | General purpose |
| Ownership transfer | Yes, or bargain purchase | No |
Judgement Required
IFRS 16 does not provide bright-line thresholds. Terms like "major part" and "substantially all" require judgement. While practice often uses 75% and 90% as indicative thresholds, these are not prescribed and must be evaluated in context. The overall assessment should focus on whether risks and rewards have transferred.
Finance Lease Lessor Accounting
When a lessor classifies a lease as a finance lease, it effectively treats the arrangement as a financing transaction, derecognising the leased asset and recognising a receivable.
Initial Recognition
At lease commencement, the lessor:
Derecognise the Underlying Asset
Remove the leased asset from property, plant and equipment (or inventory for manufacturer/dealer lessors).
Recognise Net Investment in Lease
Recognise a receivable at an amount equal to the net investment in the lease, which comprises:
- The present value of lease payments receivable
- Plus: The present value of any unguaranteed residual value
Use the Interest Rate Implicit in the Lease
Discount using the interest rate implicit in the lease, defined as the rate that causes the present value of (a) lease payments and (b) unguaranteed residual value to equal (i) fair value of the asset plus (ii) initial direct costs.
Account for Initial Direct Costs
Include initial direct costs in the measurement of the net investment. These costs reduce the amount of income recognised over the lease term.
Worked Example: Finance Lease
Scenario
Lessor Co leases equipment to Lessee Ltd:
- Carrying amount and fair value of equipment: £500,000
- Lease term: 5 years
- Annual lease payments: £120,000 (paid at year-end)
- Unguaranteed residual value: £25,000
- Initial direct costs: £5,000
- Interest rate implicit in the lease: 7.3488%
Calculate Net Investment in Lease
The present value mechanics are the same as for lessee lease liability calculations, just from the other side of the transaction.
| Component | Undiscounted | Present Value |
|---|---|---|
| Lease payments (£120k x 5) | £600,000 | £487,463 |
| Unguaranteed residual | £25,000 | £17,537 |
| Gross Investment | £625,000 | |
| Net Investment | £505,000 |
The implicit rate is the rate that makes the present value of the lease payments (£487,463) plus the present value of the unguaranteed residual (£17,537) equal the fair value (£500,000) plus initial direct costs (£5,000). That rate works out to 7.3488%.
Journal Entry at Commencement
For a non-manufacturer/dealer lessor, no selling profit or loss is recognised at commencement. The net investment simply replaces the asset on the balance sheet:
The initial direct costs are included in the net investment and effectively reduce the rate of return (finance income) recognised over the lease term.
Subsequent Measurement
After initial recognition, the lessor:
- Recognises finance income over the lease term using the effective interest method
- Applies a constant periodic rate of return on the net investment
- Reduces the net investment by lease payments received
Operating Lease Lessor Accounting
For operating leases, the lessor retains the asset on its balance sheet and recognises rental income over the lease term.
Initial Recognition
At lease commencement:
- The underlying asset remains on the balance sheet as PPE or investment property
- Initial direct costs are added to the carrying amount of the asset and recognised over the lease term
- No lease receivable is recognised
Subsequent Measurement
Over the lease term:
- Lease income: Recognised on a straight-line basis (or another systematic basis if more representative)
- Depreciation: Continue depreciating the asset consistent with similar owned assets
- Initial direct costs: Capitalised to the asset and recognised as depreciation expense over the lease term, on the same basis as lease income
Worked Example: Operating Lease
Scenario
Lessor Co leases office space to Tenant Ltd:
- Carrying amount of building: £2,000,000
- Lease term: 5 years
- Annual rent: Year 1-2: £0 (rent-free), Years 3-5: £200,000
- Total rent: £600,000
Straight-line Rental Income
Total rent over the term: £600,000
Annual straight-line income: £600,000 / 5 years = £120,000 per year
Lease Incentives
Rent-free periods are effectively a lease incentive. The cost of the incentive (foregone rent) is recognised as a reduction of rental income over the lease term on a straight-line basis. This is why income is recognised even during rent-free periods.
Lease Modifications for Lessors
A lease modification is a change in scope or consideration that was not part of the original terms. The accounting depends on the lease type and whether the modification is treated as a separate lease.
Operating Lease Modifications
For operating lease modifications, the lessor:
- Accounts for the modification as a new lease from the effective date
- Considers any prepaid or accrued lease payments as part of the new lease payments
- Re-spreads the remaining income over the modified lease term
Finance Lease Modifications
Finance lease modification accounting depends on whether criteria for a separate lease are met:
| Modification Type | Treatment |
|---|---|
| Separate lease (scope increase + commensurate consideration) | Account for the additional lease separately |
| Would have been operating lease if modified terms were in place at inception | Account as new lease from modification date; the net investment in the lease immediately before the effective date of the modification becomes the opening carrying amount of the asset |
| Otherwise | Apply IFRS 9 derecognition or modification guidance |
Manufacturer/Dealer Lessors
Manufacturer or dealer lessors often offer customers the choice between purchasing or leasing an asset. When such entities enter into finance leases, they recognise selling profit or loss at commencement, reflecting the economics of an outright sale.
Key Differences from Other Finance Lease Lessors
| Aspect | Manufacturer/Dealer Lessor | Other Finance Lease Lessor |
|---|---|---|
| Selling profit/loss at commencement | Yes - based on fair value less cost | No |
| Revenue recognition | Lower of fair value or PV of lease payments at market rate | N/A |
| Cost of sale | Cost (or carrying amount, if different) less PV of unguaranteed residual | N/A |
| Initial direct costs | Expensed immediately | Included in net investment |
Manufacturer Lessor Example
Car manufacturer leases a vehicle:
- Manufacturing cost: £25,000
- Fair value (retail price): £35,000
- Lease term: 4 years, £9,500 annual payments
- Unguaranteed residual: £5,000
- Market interest rate: 6%
Calculation
| Component | Calculation | Amount |
|---|---|---|
| PV of lease payments | £9,500 x 4 years at 6% | £32,919 |
| PV of unguaranteed residual | £5,000 / 1.064 | £3,960 |
| Net investment | £36,879 | |
| Revenue | Lower of fair value (£35,000) and PV of payments (£32,919) | £32,919 |
| Cost of sales | Manufacturing cost less PV of residual (£25,000 - £3,960) | £21,040 |
| Selling profit | £32,919 - £21,040 | £11,879 |
Journal Entry at Commencement
The selling profit of £11,879 is recognised at commencement. Finance income is then recognised over the lease term using the effective interest method on the net investment balance.
Artificially Low Interest Rates (IFRS 16.73)
If a manufacturer/dealer lessor quotes an artificially low interest rate, IFRS 16.73 requires selling profit to be restricted to the amount that would apply if a market rate of interest were charged. This prevents inflating profit at commencement through below-market financing terms.
Sale and Leaseback: Buyer-Lessor Perspective
When the buyer-lessor participates in a sale and leaseback transaction, accounting depends on whether the transfer qualifies as a sale under IFRS 15.
Transfer Qualifies as a Sale
The buyer-lessor:
- Recognises the asset acquired in accordance with applicable standards (IAS 16, IAS 40, etc.)
- Applies normal lessor accounting for the leaseback (finance or operating lease)
Transfer Does NOT Qualify as a Sale
The buyer-lessor:
- Does not recognise the "acquired" asset
- Recognises a financial asset (receivable) for the amounts paid
- Accounts for "lease" receipts as principal and interest under IFRS 9
For more detail on sale and leaseback transactions, see our Sale and Leaseback guide.
Lessor Disclosure Requirements
IFRS 16.89-97 sets out lessor disclosure requirements. The objective is to give users a basis for assessing the effect of leases on the lessor's financial position, performance, and cash flows.
Finance Lease Disclosures
Operating Lease Disclosures
Risk Management Disclosures
IFRS 16.92 requires lessors to disclose how they manage risk associated with rights they retain in underlying assets. This includes:
- Risk management strategy for residual value risk (e.g. buyback agreements, residual value insurance, variable rents tied to usage)
- Carrying amount of assets whose residual value risk is managed through these strategies
Summary: Lessor Accounting Comparison
All lease types use the same classification basis: whether substantially all risks and rewards of ownership transfer to the lessee.
| Aspect | Finance Lease | Finance Lease (Manufacturer/Dealer) | Operating Lease |
|---|---|---|---|
| Asset recognition | Derecognised | Derecognised | Retained on balance sheet |
| Receivable | Net investment in lease | Net investment in lease | None (except accrued rent) |
| Day-one profit | No selling profit | Selling profit recognised | No |
| Income pattern | Front-loaded (effective interest) | Front-loaded (effective interest) | Straight-line (typically) |
| Initial direct costs | Included in net investment | Expensed at commencement | Capitalised and amortised |
| Depreciation | None (asset derecognised) | None (asset derecognised) | Continues |
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.