IFRS 16 set to have substantial impacts on the financial statements of lessees
IFRS 16 Leases (“IFRS 16”), which comes into effect for financial reporting periods beginning on or after 1 January 2019, will fundamentally change the manner in which lessees account for leases.The following example of a simple building lease demonstrates just how significant that change will be.
Example:
Lessor Company owns a building that it agrees to lease out to Company A under a lease with the following terms:- The lease will be for a period of five years
- The annual rental will be $155,000, payable annually in arrears
- Lessor Company will give Company A $100,000 cash prior to the commencement of the tenancy to enable Company A to fit out the premises to Company A’s specifications.
The present value of annual rentals of $155,000 payable annually in arrears at a discount rate of 5.9% is $654,696.
The information provided below summarises how the accounting differs under IAS 17 Leases (“IAS 17”) and IFRS 16.
IAS 17
Under IAS 17, Company A recognises the lease expense, net of incentives provided by Lessor Company, on a straight-line basis over the term of the lease.The total rent payable over the five-year lease term is $675,000 ([$155,000 x 5] - $100,000). The annual lease expense is therefore $135,000 ($675,000/5).
The journal entries are as follows:
Inception of the lease
| Dr | Cr | |
| Cash | $100,000 | |
| Lease incentive liability (fit out) | $100,000 |
End of Year one
| Dr | Cr | |
| Lease incentive liability ($100,000 X 1/5) | $20,000 | |
| Rental expense | $135,000 | |
| Cash (rent paid) | $155,000 |
Years two to five
In years two to five, the journal entry will be:
| Dr | Cr | |
| Lease incentive liability ($100,000 X 1/5) | $20,000 | |
| Rental expense | $135,000 | |
| Cash (rent paid) | $155,000 |
The net annual rental expense recognised in profit or loss is therefore $135,000.
IFRS 16
At the commencement date of a lease being accounted for under IFRS 16:
- The lessee must recognise a right-of-use (ROU) asset and a lease liability
- The lease liability must be measured at the present value of the lease payments that are not paid at that date
- The ROU asset must be measured at cost, which is the sum of:
- The amount of the initial measurement of the lease liability
- Any lease payments made at or before the commencement date, less any lease incentives received
- Any initial direct costs incurred by the lessee, and
- An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located, or restoring the underlying asset to the condition required by the terms and conditions of the lease (unless those costs are incurred to produce inventories).
Following initial recognition, the lessee must measure the lease liability by:
- Increasing the carrying amount to reflect interest on the lease liability
- Reducing the carrying amount to reflect the lease payments made
- Remeasuring the carrying amount to reflect any reassessment or lease modifications, or to reflect revised in-substance fixed lease payments.
Following initial recognition, a lessee must generally measure the ROU asset by applying the cost model (i.e. cost less accumulated depreciation and accumulated impairment losses).
Therefore, for Company A, at the inception of the lease, the lease liability is $654,696 (the present value of the lease payments) and the ROU asset is $554,696, calculated as follows:
| Component of initial measurement | |
| Initial measurement of the lease liability | $654,696 |
| Plus: Lease payments made at or before commencement date | Nil |
| Plus: Initial direct costs incurred by the lessee | Nil |
| Plus: Estimated restoration costs | Nil |
| Less: Lease incentives received | ($100,000) |
| Total | $554,696 |
At the commencement of the lease, Lessor Company pays Company A $100,000 cash. This means that Company A’s journal entry at the inception of the lease will be:
| Dr | Cr | |
| Cash | $100,000 | |
| ROU asset | $554,696 | |
| Lease liability | $654,696 |
Each year, Company A will make a cash payment of $155,000. The lease liability will decrease over the period of the lease as follows:
| Year | Opening value | Interest expense (5.9% x opening value) | Cash paid | Closing value (opening value + interest – cash paid) |
| 1 | $654,696 | $38,627 | $155,000 | $538,323 |
| 2 | $538,323 | $31,761 | $155,000 | $415,084 |
| 3 | $415,084 | $24,490 | $155,000 | $284,574 |
| 4 | $284,574 | $16,790 | $155,000 | $146,364 |
| 5 | $146,364 | $8,636 | $155,000 | Nil |
Assuming no impairment of the right-of-use asset, and the depreciation of the ROU asset on a straight-line basis over the five-year lease period, the ROU asset will decrease by $110,939 ($554,696/5) in each year of the lease.
The journal entries over the remaining period of the lease are as follows:
End of Year one
| Dr | Cr | |
| Depreciation | $110,939 | |
| ROU asset | $110,939 |
| Dr | Cr | |
| Interest expense | $38,627 | |
| Lease liability ($155,000-$38,627) | $116,373 | |
| Cash | $155,000 |
At the end of Year one, Company A will have the following ROU asset and lease liability:
| Right-of-use asset (cost less accumulated depreciation) | $443,757 |
| Lease liability (carrying value per the table above) | $538,323 |
End of Year two
| Dr | Cr | |
| Depreciation | $110,939 | |
| ROU asset | $110,939 |
| Dr | Cr | |
| Interest expense | $31,761 | |
| Lease liability ($155,000-$31,761) | $123,239 | |
| Cash | $155,000 |
At the end of Year two, Company A will have the following ROU asset and lease liability:
| Right-of-use asset (cost less accumulated depreciation) | $332,818 |
| Lease liability (carrying value per the table above) | $415,084 |
End of Year three
| Dr | Cr | |
| Depreciation | $110,939 | |
| ROU asset | $110,939 |
| Dr | Cr | |
| Interest expense | $24,490 | |
| Lease liability ($155,000-$24,490) | $130,510 | |
| Cash | $155,000 |
At the end of Year three, Company A will have the following ROU asset and lease liability:
| Right-of-use asset (cost less accumulated depreciation) | $221,879 |
| Lease liability (carrying value per the table above) | $284,574 |
End of Year four
| Dr | Cr | |
| Depreciation | $110,939 | |
| ROU asset | $110,939 |
| Dr | Cr | |
| Interest expense | $16,790 | |
| Lease liability ($155,000-$16,790) | $138,210 | |
| Cash | $155,000 |
At the end of year four, Company A will have the following ROU asset and lease liability:
| Right-of-use asset (cost less accumulated depreciation) | $110,940 |
| Lease liability (carrying value per the table above) | $146,364 |
End of Year five
| Dr | Cr | |
| Depreciation | $110,940 | |
| ROU asset | $110,940 |
| Dr | Cr | |
| Interest expense | $8,636 | |
| Lease liability ($155,000-$8,636) | $146,364 | |
| Cash | $155,000 |
Concluding thoughts
As can be seen from the example above, the introduction of IFRS 16 will have a substantial impact on the financial statements and key financial metrics of lessees:- Statement of financial position ratios will change due to the recognition of right-of-use assets and lease liabilities
- The current year portion of the lease liability will be a current liability, which will impact working capital and associated ratios
- The even lease expense recognised under IAS 17 will be replaced by interest expense (which will decrease over time) and depreciation – this will mean a larger impact on profit or loss at the beginning of a lease than at later stages of a lease
- Earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation and amortisation (EBITDA) will increase due to an operating expense being replaced by depreciation and interest expense
- An operating cash flow for lease payments will be replaced by a financing cash flow for the reduction in the lease liability and an operating or financing cash flow for the interest expense.
For more on the above, please contact your local BDO representative.