What IPSAS 43 Is About
Public entities use assets they do not own. A ministry occupies rented offices, a state corporation runs leased vehicles, a hospital uses leased medical equipment, and a university lets out a hall. IPSAS 43 sets out how to account for these arrangements, both when the entity uses an asset (the lessee) and when it lets one out (the lessor).
For a lessee, the key idea is that a lease gives the right to use an asset for a period, and that right is itself an asset, while the promise to pay for it is a liability. Both go on the statement of financial position. For a lessor, the question is whether the asset has really been handed over in substance, or only rented out for a while.
Identifying a Lease
Not every contract that mentions an asset is a lease. A contract is, or contains, a lease when it gives the right to control the use of an identified asset for a period of time in exchange for consideration. Two things must be present: the asset must be identified, and the entity must control its use.
| Test | What it means | Public-entity example |
|---|---|---|
| Identified asset | A specific asset the supplier cannot freely substitute | A particular building, vehicle or machine |
| Right to the benefits | The entity takes substantially all the economic benefits from using it | The ministry alone occupies the offices |
| Right to direct use | The entity decides how and for what purpose the asset is used | The corporation sets the routes its leased trucks run |
Example: Is it a lease?
A national hospital contracts for a specific MRI scanner installed on its premises for four years. The supplier cannot substitute the scanner, and the hospital decides when and how it is used. This is a lease, because the scanner is an identified asset that cannot be swapped, and the hospital takes the benefits and directs the use. If the supplier could substitute the scanner at will, there would be no identified asset, and the contract would be a service, not a lease.
The Lease Term
The lease term is the non-cancellable period, plus any extension option the entity is reasonably certain to take, plus any early-termination option it is reasonably certain not to take. The judgement is about economic incentives, not just the paperwork. A five-year lease with a five-year extension the entity will almost certainly use has a ten-year lease term.
Two Optional Shortcuts
A lessee may choose not to put two kinds of lease on the books, and instead simply expense the payments, usually straight-line over the term.
When the lessee can expense instead of capitalise
Short-term leases: a term of twelve months or less, with no purchase option.
Leases of low-value assets: small items such as laptops, tablets or office furniture.
The short-term choice is made by class of asset; the low-value choice is made lease by lease.
Example: a short-term lease
A ministry leases a standby generator for eight months at KSh 150,000 a month, with no purchase option, and takes the short-term exemption. No right-of-use asset and no lease liability arise; the cost is simply an expense over the term.
8 months x KSh 150,000 = KSh 1,200,000 expense
Lessee Accounting
A lessee uses a single model. At the commencement date it recognises a right-of-use asset and a lease liability. There is no split into finance and operating leases for a lessee; almost every lease comes on balance sheet.
Measuring the lease liability
The lease liability is the present value of the lease payments that have not yet been paid, discounted at the interest rate implicit in the lease where that can be readily determined, and otherwise at the lessee’s incremental borrowing rate. The payments include the fixed payments, variable payments that depend on an index or rate, amounts expected under residual value guarantees, the price of a purchase option the entity is reasonably certain to exercise, and any termination penalties.
Building the right-of-use asset
The right-of-use asset starts at cost, built up from the parts below.
| Component of the right-of-use asset | Effect |
|---|---|
| The initial lease liability | Add |
| Lease payments made at or before commencement | Add |
| Lease incentives received | Deduct |
| Initial direct costs of the lessee | Add |
| Estimated dismantling and site-restoration costs | Add |
After commencement, the right-of-use asset is depreciated, normally over the shorter of the lease term and the asset’s useful life, and the lease liability grows by interest and falls by the payments. The depreciation and the interest are shown separately, not as a single rent expense.
Example 1: A state corporation leases vehicles
A state corporation leases a fleet for four years, paying KSh 1,200,000 at the end of each year. The rate implicit in the lease is not known, so it uses its incremental borrowing rate of 10%. The present value of four payments of KSh 1,200,000 at 10% is about KSh 3,803,880, which is both the lease liability and, with no other costs, the right-of-use asset.
Dr Right-of-use asset 3,803,880 Cr Lease liability 3,803,880
In year one, interest is KSh 380,388 (3,803,880 at 10%) and depreciation is KSh 950,970 (3,803,880 over four years).
Dr Interest expense 380,388Dr Lease liability 819,612 Cr Cash 1,200,000
Dr Depreciation 950,970 Cr Accumulated depreciation 950,970
The amortisation schedule
Interest is highest at the start, when the balance is largest, and the liability winds down to zero by the end.
| Year | Opening | Interest 10% | Payment | Closing |
|---|---|---|---|---|
| 1 | 3,803,880 | 380,388 | (1,200,000) | 2,984,268 |
| 2 | 2,984,268 | 298,427 | (1,200,000) | 2,082,695 |
| 3 | 2,082,695 | 208,269 | (1,200,000) | 1,090,964 |
| 4 | 1,090,964 | 109,036 | (1,200,000) | 0 |
If the same payments were made at the start of each year, the first payment would not be discounted, and the present value would rise to about KSh 4,184,280. Timing matters.
Example 2: The full asset build-up
A ministry leases a building. The lease liability is KSh 8,000,000, it pays KSh 500,000 before the start, receives an incentive of KSh 300,000, incurs initial direct costs of KSh 150,000, and estimates dismantling costs of KSh 400,000.
Lease liability + 8,000,000 Payment before commencement + 500,000 Lease incentive received – 300,000 Initial direct costs + 150,000 Dismantling and restoration + 400,000 Right-of-use asset = 8,750,000
Concessionary Leases
In the public sector an entity is often allowed to use an asset at a rent well below the market rate, or at a nominal rent, as a matter of policy. This is a concessionary lease, and it carries a concession component.
A lessee that receives a concessionary lease still recognises a right-of-use asset and a lease liability, but it measures them differently. The lease liability is the present value of the actual contractual payments, which are low. The right-of-use asset is measured at the present value of payments at market rates for the current use of the asset. The difference is the concession, which the lessee recognises as revenue, because it has received a benefit through a non-exchange transaction.
Example 3: A hospital granted office space
A public agency grants a hospital office space for five years at a nominal rent of KSh 100,000 a year, when the market rent for similar space is KSh 1,000,000 a year. Discounting at 8%, the present value of the contractual payments is about KSh 399,270, while the present value of the market-rate payments is about KSh 3,992,700.
Right-of-use asset (market PV) = KSh 3,992,700 Lease liability (contractual PV) = KSh 399,270 Concession (the difference) = KSh 3,593,430
Dr Right-of-use asset 3,992,700 Cr Lease liability 399,270 Cr Revenue (concession) 3,593,430
Where the market-rate payments cannot reasonably be determined, the lessee measures the right-of-use asset in the ordinary way, at the present value of the contractual payments.
Lessor Accounting
A lessor keeps the two-model approach. Each lease is classified, at inception, as either a finance lease or an operating lease, and the classification turns on substance, not form. A lease is a finance lease if it transfers substantially all the risks and rewards of owning the asset, and an operating lease if it does not.
| Pointer to a finance lease | Why it transfers risks and rewards |
|---|---|
| Ownership transfers by the end of the term | The lessee ends up owning the asset |
| A bargain purchase option exists | The lessee is almost certain to buy it |
| The term covers the major part of the asset’s life | The lessee uses up most of the asset |
| Present value of payments is near the full fair value | The lessee effectively pays for the asset |
| The asset is specialised to the lessee | Only the lessee can use it without changes |
Example: finance or operating?
A water authority leases out a treatment plant for eighteen years, when the plant has a useful life of twenty years. The lessee maintains the plant, bears its risks, and has an option to buy it for a token amount at the end. This is a finance lease: the term covers the major part of the asset’s life, the token option means ownership will pass, and substantially all the risks and rewards have moved to the lessee. Had the plant been let out for only three years and taken back, the lease would be operating.
Finance lease: the lessor
Under a finance lease the lessor has, in substance, sold the asset and financed it. It removes the asset from its books and recognises a receivable equal to its net investment in the lease. Over the term it recognises finance revenue at a constant periodic rate on the net investment, and the payments received reduce the receivable.
Example 4: Leasing out specialised equipment
A state corporation leases out specialised equipment that cost KSh 5,000,000 for its whole useful life, with ownership passing at the end. Substantially all the risks and rewards pass, so this is a finance lease. The corporation derecognises the equipment and recognises a net investment of KSh 5,000,000.
Dr Net investment in lease 5,000,000 Cr Equipment 5,000,000
The finance revenue is the gap between the cash the lessor will receive and the present value of that cash. If a corporation leases out equipment for five years, receiving KSh 1,400,000 at the end of each year at an implicit rate of 12%:
Net investment (receivable) = 1,400,000 x 3.6048 = KSh 5,046,720 Gross investment = 5 x 1,400,000 = KSh 7,000,000 Unearned finance income = 7,000,000 – 5,046,720 = KSh 1,953,280
Operating lease: the lessor
Under an operating lease the lessor has only rented the asset out for a while. It keeps the asset on its books and goes on depreciating it, and it recognises the rent as revenue, normally straight-line over the term, even when the cash is uneven.
Example 5: A rent-free period
A public university lets a shop for four years, with year one rent-free and years two to four at KSh 900,000 each. The risks and rewards stay with the university, so this is an operating lease. The total rent of KSh 2,700,000 is spread over four years, giving income of KSh 675,000 a year. In year one, income of KSh 675,000 is recognised even though no cash is received.
Dr Lease receivable 675,000 Cr Rental revenue 675,000
Lease Modifications
When the terms of a lease change, the entity asks whether the change adds a separate new right of use priced at a stand-alone rate. If it does, it is treated as a new, separate lease. If it does not, the existing lease is remeasured: a lessee discounts the revised payments at a revised rate and adjusts the right-of-use asset and the liability.
Example 6: Extending a lease
A ministry extends its office lease. The present value of the revised payments is KSh 2,600,000, against an existing liability of KSh 2,000,000. The increase of KSh 600,000 is added to both the lease liability and the right-of-use asset.
Dr Right-of-use asset 600,000 Cr Lease liability 600,000
Sale and Leaseback
Sometimes an entity sells an asset and immediately leases it back. The first question is whether the sale is genuine, meaning whether control of the asset has really passed to the buyer. If it has, the seller-lessee recognises a right-of-use asset for the portion it has kept, and only the gain relating to the rights transferred. If control has not passed, there is no sale: the arrangement is simply financing secured on the asset.
Presentation and Disclosure
The disclosures aim to let a reader see the effect of leases on position, performance and cash flows.
| Disclosure area | What is shown |
|---|---|
| Lessee amounts | Depreciation, interest, short-term and low-value expense, total cash outflow |
| Right-of-use assets | Carrying amount and additions, by class of asset |
| Maturity analysis | When the lease liabilities fall due |
| Concessionary leases | The concession on initial recognition and its terms |
| Lessor | Finance revenue, operating lease income, and the nature of the activity |
Common Mistakes
| Mistake | The correct position |
|---|---|
| Treating every lessee lease as a rent expense | A lessee capitalises almost all leases as a right-of-use asset |
| Booking a concession at the low contractual rent | Measure the right-of-use asset at market-rate present value |
| Splitting a lessee lease into finance and operating | The lessee uses a single model; only the lessor classifies |
| Keeping a finance-leased asset on the lessor’s books | A finance lessor derecognises the asset and books a receivable |
| Recognising operating-lease income as it is invoiced | Recognise it straight-line over the term |
Key Lines to Remember
- A lease gives control of an identified asset for a period, in exchange for payment.
- A lessee recognises a right-of-use asset and a lease liability for almost every lease.
- The liability is the present value of the payments; the asset is built on top of it.
- Short-term and low-value leases may simply be expensed.
- A concessionary lessee measures the asset at market-rate present value and books the concession.
- A lessor classifies each lease as finance or operating by who carries the risks and rewards.
