IFRS - 16 Leases

 

What is lease – Lease is a Contract between owner of the asset and the other party who want to take that asset on rent for use.

What is difference between rent and lease

Simply you can understand that rent is a short-term deal (6-month, 11 Month) and lease is a long term (3 Years, 5 years, 10 years) deal between owner and tenant.

There are two parties In Lease transaction

Lessee – who takes the asset on lease and pays rent payments.

lessor – Who gives the asset on lease and receive rent payments

Example – Company ABC takes a care on lease from XYZ Car Leasing Ltd.

Company ABC – Lessee (ABC will use the asset and pay the rent)

XYZ Car leasing Ltd – Lessor (Owner of the asset, earn rent).

Now we will understand the lease agreement by the example of Rent. But remember if it is short term then it will be rent agreement and if it is for long term agreement then it will be lease.

What happened in Rent agreement one person takes a property on rent he/she pays the rent and use the asset, so he get the right of use but not the ownership of the asset.

Now how to identify it is lease transaction or not

IFRS 16 – Definition of Lease (IFRS16 Para 9)

A lease exists when a contract gives below to customer

1.    The right to control the use of …

2.    An identifies asset …

3.    For a period of time …

4.    In exchange of consideration (Payment)

*** Even a owner adds some protective clauses in the contract, it does not mean that the lessee lost the control.

Accounting process for Lessee

Initial measurement – when you enter in a lease agreement you will get a asset but not owner so we will write it as a Right to use. We will do Debit right to use instead of asset. And we will credit Lease Liability.

Journal Entry

Right to use A/C              Dr.     45000

To Lease Liability            Cr.      40000 (Present Value of all future payments)

To Cash                           Cr.     5000 (Initial Payment)

At the initial stage of lease, the lessee recognises a right to use asset and a lease liability.

Right of Use asset	Lease liability
Measure at the amount of the lease liability plus any initial direct cost incurred by the lessee.	Measured at the present value of lease payments payable over the lease term, discounted at the rate implicit in the lease
Lease Liability          Initial direct cost          Estimated cost for dismantlement         Payments less incentives before commencement date	Fixed payments less incentives Variable payment (E.q CPI/ Rate Consumer per index) Expected residual value guarantee Penalty for terminating (if reasonably Certain) Note: - if the rate implicit in the lease can not be determined. The lessee shall use their incremental borrowing rate.

Subsequent measurement

Right of Use asset	Lease liability
Cost less accumulated depreciation Note:  Depreciation is based on the earlier of the useful life & lease term, unless ownership transfers in which case use of the useful life.	Financial Liability at amortised cost

 

Asset – Depreciation (Asset life – 10 years, lease – 6 years) which ever is shorter

Lease liability – Opening Lease liability + interest (-) payment = closing balance 

Optional Recognition Exemptions

IFRS 16 normally requires lessees to recognise ROU asset & liabilities. But for simplicity, 2 exemptions allowed:

Type	Conditions	Example
Short term	Lease less then or equal 12 month & no purchase option.	Renting a printer for 6 months
Low value	Asset value is low when new (around $5000 or less )	Tables, laptops, office furniture

Why IFRS 16 Was Introduced

Before IFRS 16, companies used to keep many leases off the balance sheet. That made financial statements look stronger than reality.

For example, airlines lease aircraft worth billions, but earlier those obligations were not visible on balance sheets.

Now: Assets increase, Liabilities increase, EBITDA increases, Interest expense increases, Debt ratios change

This gives a more realistic picture of financial position.

Optional Recognition Exemptions

IFRS 16 provides two practical exemptions for lessees:

1. Short-Term Lease

If lease term is 12 months or less and there is no purchase option, companies can expense payments directly.

Example: Renting a printer for 6 months.

2. Low-Value Asset

If the asset value is low when new (around $5,000 or less), recognition of ROU and liability is not required.

Examples: Laptops, Office furniture, Small equipment

These can be treated as normal expense.

Financial Statement Impact

Lease accounting affects:

• Balance Sheet
• Increase in assets (ROU)
• Increase in liabilities (Lease Liability)
• Profit & Loss
• Depreciation expense
• Interest expense

Earlier, lease payments were fully shown as operating expense. Now expense pattern changes.

Practical Understanding

From a business perspective, leasing helps companies:

• Preserve cash
• Avoid large upfront investment
• Use updated assets
• Maintain flexibility
• From an accounting perspective, IFRS 16 ensures:
• Transparency
• Better comparability
• Accurate debt representation

Final Thoughts

Lease accounting may look technical, but the logic is simple:

If you are using an asset for a long time and committing to future payments, that commitment should appear in your financial statements.

You may not own the asset legally, but economically you are controlling it.

That’s why IFRS 16 recognises:

•       Right of Use Asset
•       Lease Liability

Understanding lease accounting is important not only for exams but also for analysing companies properly. Many businesses today depend heavily on leased assets.

When you read financial statements next time, check:

How much lease liability is there?

What is the lease term?

How does it impact cash flow and profit?

Because sometimes, the biggest obligations are hidden in plain sight.

And finance is all about understanding those hidden commitments clearly.

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IFRS9 – Financial Instrument

Definition 1 - Financial Instrument or Asset is any asset that is Cash, any Equity instrument (e.g., Shares) of another company & a contractual right to receive Cash.

Definition 2 - It covers a contract between two parties which gives to one party financial asset & to other party financial liability & Equity. The simple words, financial asset means right to receive Cash.  

Definition 3 - In Simplest Language – In IFRS9 you Show financial assets at today’s market value, and decide whether the gain goes to profit or a separate place (OCI), based on why you bought the asset.

What type of assets are covered in IFRS 9?

1.     Shares                         -           Buying Tata / Apple shares

2.     Bonds / Debentures    -           Giving loan to a company

3.     FD / Loan given          -           Bank FD or money lent to someone

4.     Mutual Funds              -           Equity or debt MF

5.     Derivatives                  -           Gold future, dollar contract

Note - Land, building, car, inventory is not covered here 

Now Understand what is fair value in very simple manner

Fair Value means today’s market price. Forget about the purchase price, how much you paid. Only ask “If you sell it today, how much money will you get?”

Example - You bought a share at ₹2,000

Today’s market price = ₹2,300

Fair Value = ₹2,300

Now the question comes where to show this ₹300 Gain or loss (if any). Then you have to identify. Why did you buy this asset? Based on your answer, the profit goes to different places.

Case 1: You bought shares to make quick profit. With a though of “Price will go up. I will sell and earn”.

Example: Buy share at ₹1,500. Year-end price = ₹1,800. Gain = ₹300

This ₹300 is shown directly as profit

This is called - Fair Value through Profit & Loss (FVTPL)

Case 2: You bought shares as long-term investment. With a though of “I will keep it for many years”.

Example - Buy share at ₹1,000, Year-end value = ₹1,200. Gain = ₹200

This ₹200 is not treated as normal profit. As you have not booked it yet. It is shown in a separate box, not in profit. This separate box is called OCI (Other Comprehensive Income).

This method is called:

Fair Value through OCI (FVTOCI)

Case 3: Now understand FD / Loans / Bonds

Example: You give ₹1,00,000 to a bank or company. You expect Fixed interest every year & Full money back at the end. Here no daily buying or selling. no market guessing. So, in this case IFRS 9 says “Do NOT change its value daily”. You just show interest income & keep the original amount

SPPI Test - SPPI only asks ONE simple question:

Will you receive only my money + interest?

If you will get Simple interest type return SPPI Test pass. But if you will get Market-linked return then SPPI test is fail.

SPPI – Pass >>> Examples: Bank FD, Simple loan Fixed-interest bond

SPPI – failed >>> Examples: Return depends on share price, Return depends on gold or dollar price

How do you get Fair Value - Real market numbers

Level 1 – Direct market price for Listed shares and Mutual fund NAV >>> Stock exchange price

Level 2 – You have to do Market comparison for Unlisted bond from Similar interest rate data >>>RBI rates, bank yields

Level 3 – in Case of Startup investments Estimated value for Private company shares >>> Expected future profits (best estimate)

What you bought	Why you bought	Value based on	Shown where
Shares (trading)	Quick profit	Market price	Profit
Shares (long term)	Investment	Market price	Separate box (OCI)
FD / Loan	Interest	Original amount	Interest income
Derivatives	Speculation	Market price	Profit

Okay now we are going to connect the real word accounting with what we have learnt. Here we are going to learn about Two Financial Assets.

Investment in Equity instrument – IFRS9

Method	When Applicable
1. Fair Value through P&L	Default option for all Equity Investments
2. Fair Value through OCI	Irrevocable Election at initial recognition (non trading Only) Simple – If management decided the URGL of particular equity will go to OCI. Then 2 conditions need to Follow 1.      The decision will be irrevocable for URGL transfer to OCI 2.      If the Equity will be sold in future, then realised gain or loss will not transfer to P&L. it will go to Retained earnings

Fair Value through P&L (FVTPL)

·       Default classification

·       Mandatory for equity Instruments held for Trading

·       Also used when entity does not make OCI election

·       Example – investing in shares of listed company for short term gain (Intraday or swing trading)  

Fair Value Through OCI (FVTOCI)

·       Only for equity instruments not held for trading.

·       Requires an irrevocable election at the time of initial recognition.

·       Suitable when investment is made for strategic reasons or long-term holding.

·       Example: Investment in shares of a business partner company for long-term strategic interest. 

Important Point

·       Equity shares do not have fixed or contractual payments like principal and interest.

·       Returns (like dividends or capital appreciation) are not predictable or contractual.

·       There's no maturity or repayment obligation in shares.

·       Conclusion: Equity investments cannot be measured at amortised cost under IFRS9 -

they must be measured at fair value (either through P&L or OCI).

Accounting for Equity Investments- Comparison (FVTPL vs FVTOCI)

 

Aspect	Fair Value Through P&L (FVTPL)	Fair Value Through OCI (FVTOCI)
Initial Measurement	At fair value + Transaction costs →P&L (expensed)	At fair value+ Transaction costs → Capitalised
Subsequent Measurement	Fair value changes -> P&L (gain/loss)	Fair value changes → OCI (gain/loss)
Dividend income	Goes to P&L if it represents return on investment	Goes to P&L if it represents return on investment

 

Accounting for Investment in Debt instrument – IFRS9
Debt instrument (e.g. Bonds, Debentures Can be classified under three Measurement Categories)
1.     Fair Value through P&L (FVTPL)
2.     Fair Value through OCI (FVTOCI) 

3.     Amortisation Cost  

  For accounting of investment in debt instrument you have to check two test

1. BMT – Business Model test – Whether the business model is to hold the asset to collect the contractual Cash flows  

2.     CCFT (SPPI)– Contractual cash flow test – are the Cash flow from the asset solely payments of principal and Interest (SPPI) if you are going to received Interest and principal amount at maturity

Three Accounting methods for financial Asset Debt instruments

1.     If BMT & CCFT both test Pass then show at amortisation cost means ignore fair Value (Held to collect cash flows)
2.     If BMT fails and CCFT test Pass then show as FVTOCI (Held to Collect + Sell)
3.     Fails CCFT or Default Category will go in FVTPL (Trading / Complex Instruments)

For any query regarding the post or if you want to learn any topic you can write me on

rohitjain8jan@gmail.com

rohitjainroyalr@gmail.com

Website : - https://rohitjain.royalrichie.com

Follow on Linked in - https://www.linkedin.com/in/rohit-jain45298380/

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Thank you for reading & keep learning.