How to approach it
- Lessor: classify the lease (term vs economic life, PV vs fair value). For a finance lease compute net investment = PV of lease payments + PV of unguaranteed residual, at the implicit rate.
- Lessee: discount at the implicit rate if known to the lessee, otherwise the incremental borrowing rate. Include only the amount expected to be paid under a residual value guarantee.
- Right-of-use asset = lease liability + lessee's initial direct costs; depreciate over the lease term unless ownership transfers.
- Run one-year schedules for each party and split liability/receivable into current and non-current.
Key rules to apply
- IFRS 16 lessor: finance lease if substantially all risks and rewards transfer; lease term covering the major part of economic life is a key indicator.
- Lessor's net investment includes the full residual (guaranteed and unguaranteed).
- Lessee's liability includes amounts expected to be payable under residual value guarantees, not the full guarantee.
- The implicit rate is defined so that it already reflects the lessor's initial direct costs.
Answer layout
| Extract | Lessor | Lessee |
|---|---|---|
| P&L: finance income / interest expense | ||
| P&L: depreciation | – | |
| SOFP: net investment / ROU asset | ||
| SOFP: current and non-current portions |
Common mistakes
Drawn from the examiners' comments for this sitting (summarised in our words) and from typical errors on this topic.
- Classifying the lease as operating for the lessor (examiners' point).
- Dropping one of the residual value components from the lessor's net investment.
- Putting the whole guarantee into the lessee's liability instead of the expected shortfall.
Similar question with worked solution
Written by us with our own numbers; it tests the same skills as Q2 without copying it.
Original practice question
Both sides of a finance lease
A lessor leases equipment for 4 years of its 5-year life from 1 January 2025: Rs 30m a year in arrears. The lessor expects a residual of Rs 12m, of which the lessee guarantees Rs 5m; the lessee expects the asset to be worth Rs 4m, so expects to pay Rs 1m under the guarantee. The implicit rate is 8% (it reflects the lessor's initial direct costs) but is unknown to the lessee, whose borrowing rate is 10%. The lessee's initial direct costs are Rs 0.8m.
Required: Calculate the key 2025 figures for each party.
Worked solution
| Lessor (8%) | Rs m |
|---|---|
| PV of rentals: 30 × 3.3121 | 99.36 |
| PV of residual: 12 × 0.7350 | 8.82 |
| Net investment 1 Jan 2025 | 108.18 |
| Finance income 2025: × 8% | 8.65 |
| Net investment 31 Dec 2025: 108.18 + 8.65 − 30 | 86.84 |
| … current portion | 23.05 |
| Lessee (10%) | Rs m |
|---|---|
| PV of rentals: 30 × 3.1699 | 95.10 |
| PV of expected guarantee payment: 1 × 0.6830 | 0.68 |
| Lease liability 1 Jan 2025 | 95.78 |
| Right-of-use asset: + 0.8 | 96.58 |
| Depreciation over 4 years | 24.14 |
| Interest 2025 | 9.58 |
| Liability 31 Dec 2025: 95.78 + 9.58 − 30 | 75.36 |
| … current portion | 22.46 |
Answer: Lessor: finance income Rs 8.65m, receivable Rs 86.84m. Lessee: depreciation Rs 24.14m, interest Rs 9.58m, liability Rs 75.36m, ROU asset Rs 72.43m.