Determining Direct Costs

Direct costs are incremental costs that are incurred in the process of obtaining the lease. Other costs incurred irrespectively of whether the lease contract is entered into or not are not considered to be initial direct costs.

Direct costs incurred at the initial stage of the lease are accounted for as part of the right of use asset.

An example of a direct cost is legal fees incurred upon drafting of the legally binding lease agreement. This is because such costs are incremental and result from the contract being entered into.

On the other hand fees such as external legal fees paid by the lessee for negotiating the lease and that are incurred regardless of whether the lease is executed or not, are not considered as initial direct costs, and are therefore expensed.

Lessor Accounting

There were no major changes in the general accounting treatment of the lessor from the previous standard IAS 17. A distinction between finance leases and operating leases is necessary under both IAS 17 and IFRS 16.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to the ownership of an underlying asset. All other leases are operating leases.

The accounting treatment for an operating lease is to recognise the lease payment as income on an accruals basis.

The accounting treatment for a finance lease is to derecognise the tangible asset being leased out and recognise a net investment in the lease, which is a financial asset representing the outstanding amount to be received from the lessee.

Manufacturer Or Dealer Lessors

Manufacturers or dealers have the options of either selling or leasing assets.

At commencement date, the following should be recognised:

  • Revenue: Revenue is measured as the lower of the fair value of the underlying asset and the present value of lease payments accruing to the lessor after being discounted using the market rate of interest.
  • Cost of sale: This is measured as the carrying amount of the underlying asset less the present value of unguaranteed residual value.
  • Selling profit or loss: The selling profit or loss results from the difference between the revenue and the cost of sale. It should be recognised at commencement date regardless of whether the lessor transfers the underlying asset or not.

Costs incurred for obtaining a finance lease are recognised as an expense at commencement date. These are not treated as initial direct costs and thus are not part of the net investment of the lease.


A sub-leasing arrangement involves three parties:

  • A head lessor, that is the party owning the freehold asset.
  • An intermediate party who is leasing the asset from the head lessor and leasing it out to the lessee.
  • the lessee that is the party who has the right to use the asset.

Suppose the contract between the head lessor and the intermediate lessor is contract Y. Also, suppose that the contract between the intermediate lessor and the lessee is contract Z.

From the head lessor’s point of view, lessor accounting applies and this will change only if the sub-lease triggers a modification in contract Y. Otherwise the accounting of the lessor remains unaffected.

Similarly, the accounting treatment concerning the intermediate party relating to contract Y will remain unchanged in respect of the lease liability. On the other hand, the accounting treatment for the right-of-use asset is determined by how the intermediate lessor classifies the sub-lease. If the sub-lease is classified as a finance lease, the intermediate party de-recognises the right-of-use asset and recognises a lease receivable. In this case an off-setting of the remaining lease liability relating to contract Y with the lease receivable relating to contract Z is not permitted.

If the sub-lease is classified as an operating lease, the intermediate party continues to recognise the right-of-use asset. Revenue from the sub-lease is recognised over the term of the sub-lease.

Lease expense from contract Y (that is, finance costs and depreciation) and lease income from contract Z concerning the same underlying asset cannot be offset against each other.

The lessee will account for the lease by recognising a right-of-use asset and a lease liability.

Lease Incentives

Lease incentives are payments made by the lessor to the lessee covering costs associated with a lease that are incurred by the lessee. If the payments are associated with obligations other than the lease, these payments are not classified as lease incentives.

A rent-free period is an example of a lease incentive provided by the lessor to attract lessees. The accounting treatment adopted by the lessor when a rent-free period is included in the lease is shown below.

Suppose company A provides an operating lease to company B for 4 years charging rent of €10,000 per year except for the first year of the lease where the lessor changes €0 rent.

It is incorrect to account for no rent during the first year and then €10,000 for each of the following 3 years. The correct accounting treatment is to aggregate the rent payments to be received over the whole lease term and then spread them evenly throughout the whole lease term.

Thus, the accounting entries for the above scenario should be:

Year 1

DR    Receivables                           €7,500                                                       [(€10,000 x 3yrs)/4yrs]

CR    Rental income                                          €7,500

Year 2

DR    Cash                                         €10,000

CR    Rental income                                          €7,500

CR    Receivables                                               €2,500

Year 3

DR    Cash                                         €10,000

CR    Rental income                                          €7,500

CR    Receivables                                               €2,500

Year 4

DR    Cash                                         €10,000

CR    Rental income                                          €7,500

CR    Receivables                                               €2,500

In the meantime, should you require any assistance or advice on the subject, please contact:

John Debattista – Partner jd@zampadebattista.com 

Paul Zammit – Technical assistant manager pz@zampadebattista.com

Rebecca Marie Bezzina – Technical assistant rmb@zampadebattista.com

For any assistance on IFRS or GAPSME-related matters, please email ifrshelpdesk@zampadebattista.com

DISCLAIMER: Please note that this article is being published for information purposes only. As such it does not constitute or is to be interpreted or construed as legal advice or guidance. Zampa Debattista does not accept responsibility for or be liable to any damages arising as a result of using this information as legal advice or guidance.