How to approach it
- Lease liability: PV of payments not yet made at commencement (the first rental in advance is paid on day one) plus the purchase option if reasonably certain, at the lessee's rate per period.
- ROU asset = liability + payments made at or before commencement + initial direct costs.
- Depreciation over useful life if the option is reasonably certain to be exercised.
- Revaluation: depreciate first, then compare with fair value. A first decrease goes to P&L; a later increase reverses that loss through P&L first.
- Liability schedule by half-year; accrue interest to the year-end; current portion = amount that will be paid off within 12 months, excluding future interest.
Key rules to apply
- IFRS 16: use the implicit rate only if the lessee can readily determine it; otherwise the incremental borrowing rate.
- Purchase options reasonably certain of exercise are lease payments.
- The revaluation model may be applied to ROU assets in a class of PPE carried at revaluation.
Common mistakes
Drawn from the examiners' comments for this sitting (summarised in our words) and from typical errors on this topic.
- Using the lessor's implicit rate the lessee did not know, or treating advance rentals as arrears (examiners' point).
- Not accruing interest for the last half-year, understating the year-end liability.
- Current portion taken as the next two rentals in full.
Similar question with worked solution
Written by us with our own numbers; it tests the same skills as Q7 without copying it.
Original practice question
Lease with rentals in advance and a purchase option
From 1 January 2024 a company leases a machine: five half-yearly rentals of Rs 20m in advance (1 January 2024 to 1 January 2026) and a purchase option of Rs 30m on 30 June 2026 that it will exercise. Rate 4% per half-year. Initial direct costs Rs 2m. Useful life 6 years, residual Rs 5m. Revaluation model: fair value Rs 85m at 31 December 2024 and Rs 75m at 31 December 2025.
Required: Calculate the ROU asset and lease liability figures for 2024 and 2025.
Worked solution
| Lease liability | Rs m |
|---|---|
| PV at 1 Jan 2024 of 4 rentals + option | 97.256 |
| Interest 2024 | 7.136 |
| Paid 1 Jul 2024 | (20.000) |
| 31 Dec 2024 | 84.392 |
| … current (paid off by 1 Jul 2025) | 37.424 |
| … non-current | 46.967 |
| Interest 2025 | 4.454 |
| Paid 1 Jan and 1 Jul 2025 | (40.000) |
| 31 Dec 2025 (all current) | 48.846 |
| ROU asset | Rs m |
|---|---|
| Cost: 97.256 + 20 + 2 | 119.256 |
| Depreciation 2024: (119.256 − 5) ÷ 6 | (19.043) |
| Carrying amount before revaluation | 100.213 |
| Revaluation loss 2024 to P&L | (15.213) |
| 31 Dec 2024 | 85.000 |
| Depreciation 2025: (85 − 5) ÷ 5 | (16.000) |
| Revaluation gain 2025 to P&L (reverses part of 2024 loss) | 6.000 |
| 31 Dec 2025 | 75.000 |
Answer: Liability Rs 84.392m (2024) and Rs 48.846m (2025); ROU asset Rs 85m and Rs 75m.