In this article, we would simplify Lessee accounting. 

The Flashback

Before IFRS 16 we had to decide whether a lease is a finance lease or an operating lease for both the lessee and the lessor. Under IAS 17 (the previous lease standard) a lease was classified as "operating" for lessees unless it transferred significant risks and rewards to the lessee. 

But under IFRS 16, almost all leases are treated as "finance leases" in the books of lesses. Now that's a drastic change that results in recognition of a right of use asset in the books of the lessee for almost every lease. Almost.

The exceptions

I say almost because IFRS 16 provides an exception for short-term and low-value items.

In the case of the above exceptions, a lease is treated as operating lease used to be accounted for in the good old days.

Life isn't all that simple anymore, is it?

The what and why of right of use asset?

Now with the exceptions out of the way, let's try to wrap our head around why it would make sense to recognize assets in our books as lessee which we don't even own. 

Once we get the "why" to make sense for us it would be a lot easier to understadnd "how". Then finally we'll get a strong grip on the lease accounting entries with an example. So let's dive in!

The Concept

Let's say, these apple slices represents the life of a Boeing 737. But don't get me wrong, the slices do not represent the physical plane BUT it's LIFE.

So the five slices mean the plane has a remaining useful life of 5 years

Our airline company enters into a contract to obtain the plane on lease for the next three years. This means we are entering into an agreement to eat the three slices and return the remaining two, after 3 years.

Although we have not purchased the asset, we have in a way purchased a portion of LIFE of that asset. The slices have a value, don't they?

This analogy works only if we are not expected to walk out of this agreement after say the first year. This means the said period of 3 years should be reasonably certain. And that's how a lease term is defined in IFRS 16.

Okay, I get it we can see an asset from a useful life perspective. And if I am entitled to a portion of that life, it has value. But why does IFRS 16 require me to recognize it in the balance sheet?

One significant risk arising from not recognizing these assets on the balance sheet is that a lot of binding contracts to make payments in the future would never appear on the balance sheet. The shareholders would never know.

Lets get into an illustrative example.

Let's say the boeing 737 you hired for a three-year lease has an annual lease payment of $100 at the end of each year to the lessor. How should this transaction be treated in your (lessee's) books assuming it meets the definition of a lease?

The best way to learn lessee accounting treatment is to think of this in terms of two separate transactions.

1- Obtaining of a loan to "purchase" 3 years of the life of the airplane

2- Recognition of the asset in the balance sheet (and subsequently depreciating it).

The first component: Obtaining a loan?

So, this commitment to make a $100 payment at the end of each year is an obligation with a pre-determined timing and amount. Which makes it hardly any different than a loan...

We recognize a loan at the present value of all the future payments that need to be made. In the case of lessee accounting, the discount rate to be used is the "interest rate implicit in the lease" and if that is not available then "lessee's incremental rate of borrowing" . 

And let's say our interest rate implicit in the lease is 5%. 

Bsed on this discount rate, 

>the $100 payment we have to make at the end of year 1 is worth $95.2 today

>the $100 payment we have to make at the end of year 2 is worth $90.7 today

>the $100 payment we have to make at the end of year 3 is worth $86.4 today

The total "Principal" amount we owe to them is a sum of the present value of all three payments which is $272.3. According to IFRS 16 we would recognize the present value of all the lease payments as our lease liability. 

So the lease liability to be recognized at initial recognition is $272.3

 "But why not the full $300?" you might ask

 Because it is natural to assume that on any deferral of payment we are compensating the lessor with a finance income. He has given us the asset upfront, and is now expecting payments on a deferred basis, so there is certainly a financial component to this transaction.

So the next thing we have to do is to compute the finance expense of this lease.

We owe 272.3 at the commencement of the lease. We made no payment for one full year, which means the interest would accrue on this amount for one whole year.

Which is $13.6. (This amount is simple 272.3*5%)

At the end of the year, we made our promised payment of $100. Out of this $100, $13.6 is our finance cost while the remaining $86.4 is the repayment of the principal. This leaves us with a balance of $185.9 at the start of year 2. This obligation of $185.9 will accrue interest of $ 9.3 until the promised payment of 100 is made at the end of year 2. When we complete our payment schedule, this leaves a balance of $0 at the end of the lease term.

Going back to our "loan" analogy, if it was a separate loan obtained from the bank, we would have passed the following accounting entries:

 Bank 272.3

 Lease liability 272.3

Note, however, that in a lease transaction we do not borrow money. So debiting the bank makes no sense. instead, we receive the asset. This means we have to debit the right of use asset. By what amount exactly, we will deal with this issue in the later part of this article.

The good news is that any subsequent accounting for the repayment of lease liability is exactly the same as a simple loan.

Consequently, at the end of year 1 we would pass the following entry

For the first installment of $100 we pay from our bank, we would credit the Bank by $100.

But what would be debited? 

If you look at the lease repayment schedule, you see the first installment is split into two components. First, is the repayment of interest accrued during the year which is $13.6. The final component is the repayment of principal which reduces our lease liability by $86.4

Here is our accounting entry at the end of year 1:

 Finance cost      13.6

 Repayment of principal 86.4

 Bank/ Payable       100

Identical entries shall be passed in year 2 and year 3 as well, based on the split between finance cost and repayment of principal in those years.

At the end of year 2

 Finance cost      9.3

 Repayment of principal 90.7

 Bank/ Payable       100

At the end of year 3

 Finance cost      4.8

 Repayment of principal 95.2

 Bank/ Payable       100

By now we know that the lease liability is simply the present value of lease payments. and we have seen an illustrative example of how to pass journal entries for subsequent repayments.

But we still have a major piece of the puzzle missing.

Right of use asset

At what value should we recognize our right of use assets? Because clearly, that lease obligation bought us that ROU, the present of lease liability is the primary component of the right of use asset.

However, a right-of-use asset also includes:

• any lease payments made at or before the commence date (because it is an amout paid for the right of use but not captured in the lease liability)
• any initial direct costs incurred u the lessee (again for similar reasons as above)
• any provision for dismantling costs. ( when we recognize a provision for dismantling an asset we credit the provision and we do not debit the expense rather debith it in the aseetet acccount. The reaosn for this is that the dismantling cost shoud be spread over the unseful life of the asset and should not be expensed out all at once.)

So let's say that in addition to lease liability, our airplane lease required us to make an advance payment of $50.

The amount to be recognized as a Right of use asset would be $272.3 + the advanced payment of $50.

Hence, we debit the right of use asset by $322.3. 

And what should we credit. 

We have already seen the liability side of the story. In essence this asset is funded by 2 sources. First is our lease liability which is S 272.3, and the second by our cash payment of $50.

So this completes our initial recognition of right of use asset.

 Right of use asset  322.3

 Lease liability    272.3

 Bank          50

We have already seen the accounting entries for subsequent repayment of the lease liability. Now all that is expected of us is to depreciate the right-of-use asset.

The only catch here is that the right of use asset should not be depreciated over tit useful or economic life. In our example, the remaining useful life of the airplane is 5 years.

And it makes perfect sense because the payment we are making is not for the entire useful life but a portion of it. There fore our assets should be fully depreciated over three years which is our lease term.

Here are the accounting entries:

At the end of year 1

 Depreciation expense  107.4

 Accumulated depreciation  107.4

At the end of year 2

 Depreciation expense  107.4

 Accumulated depreciation  107.4

At the end of year 3

 Depreciation expense  107.4

 Accumulated depreciation  107.4

And here are all the entries arranged chronologically for a final revision:

At the commencement of the lease (year 0):

 Right of use asset  322.3

 Lease liability    272.3

 Bank          50

At the end of year 1

 Finance cost      13.6

 Repayment of principal 86.4

 Bank/ Payable       100

 Depreciation expense  107.4

 Accumulated depreciation  107.4

At the end of year 2

 Finance cost      9.3

 Repayment of principal 90.7

 Bank/ Payable       100

 Depreciation expense  107.4

 Accumulated depreciation  107.4

At the end of year 3

 Finance cost      4.8

 Repayment of principal 95.2

 Bank/ Payable       100

 Depreciation expense  107.4

 Accumulated depreciation  107.4