Financial Reporting and Accounting Newsletter - January 2016

By Kylee Byrne - January 28, 2016

In this month’s newsletter, we provide an overview of the requirements of the new IFRS 16 Leases.

Most entities lease one or more assets for use in their business. The most common examples are the lease of office premises, equipment and vehicles. Lessees often enter into operating leases to gain access to assets, obtain finance and reduce the entity’s exposure to the risks of asset ownership.

The current accounting treatment of operating leases in the records of lessees is well understood and quite simple. Currently operating lease payments are recognised as an expense on a straight-line basis over the lease term. However, the brand new IFRS 16 Leases is about to change that.

For financial years beginning on or after 1 January 2019, the new IFRS 16 introduces a single lessee accounting model where all leases will be accounted for in a similar manner to the way in which finance leases are currently accounted for. 

In this month’s newsletter, we provide an overview of the requirements of the new IFRS 16, compare the new IFRS 16 with the current AASB 117 Leases and consider the potential impact of the new IFRS 16 on lessees of operating lease agreements.

1.    Current Accounting Treatment of Operating Leases in the Records of Lessees

AASB 117 Leases distinguishes between finance and operating leases. The classification of a lease as either a finance lease or an operating lease is based on the extent to which risks and rewards incidental to ownership of a leased asset lie with the lessor or the lessee. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership from the lessor to the lessee. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership from the lessor to the lessee.

AASB 117 requires that lease payments under an operating lease be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.


Example One

Background Information

Entity A entered into a 3 year lease of an administration building with the following lease payments, payable at the beginning of each month:

  • $5,000 per month for the first 12 months;
  • $6,000 per month for the next 12 months; and
  • $7,000 per month for the last 12 months

Entity A’s incremental borrowing rate is 10% per annum

Accounting Treatment in terms of the current AASB 117

Under AASB 117, the lease is classified as an operating lease, because the lease does not transfer substantially all the risks and rewards incidental to ownership of the building to the lessee. 

The straight-line operating lease expense over the 3 years of the operating lease can be calculated as follows:

Lease payments in year 1 ($5,000 x 12 months)

$60,000

Lease payments in year 2 ($6,000 x 12 months)

$72,000

Lease payments in year 3 ($7,000 x 12 months)                

$84,000

Total lease payments over the lease term

$216,000

 

Straight-line operating lease expense for years 1 to 3 ($216,000 / 3 years)        

 

$72,000

Journal entries for year 1

Dr             Operating lease expense

$60,000

 

                  Cr             Bank

 

$60,000

Dr             Operating lease expense             

$12,000

 

                  Cr             Accrual (Liability)

 

$12,000

Journal entries for year 2

Dr             Operating lease expense

$72,000

 

                  Cr             Bank

 

$72,000

Journal entries for year 3

Dr             Operating lease expense

$84,000

 

                  Cr             Bank

 

$84,000

Dr             Accrual (Liability)             

$12,000

 

                  Cr             Operating lease expense

 

$12,000


2.    Requirements of IFRS 16 applicable to Lessees

IFRS 16 introduces a single lessee accounting model (all leases, finance and operating leases, will be accounted for in the same way) and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of 'low value'. For financial years beginning on or after 1 January 2019, a lessee is required to recognise a right-of-use asset representing its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments. Assets and liabilities arising from a lease are initially measured on a present value basis. As a consequence, a lessee recognises depreciation of the right-of-use asset and interest on the lease liability.

It should be noted that IFRS 16 allows for two recognition exemptions, where a lessee may elect not to recognise the right-to-use asset and accompanying lease liability:

  • Short-term leases; and
  • Leases for which the underlying asset is of a 'low value'.

A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less. It is also stated that a lease that contains a purchase option is no a short-term lease. IFRS 16 provide the following examples of low-value underlying assets: tablet and personal computers, small items of office furniture and telephones.

Using the same fact pattern as example one, the following example illustrates some of the accounting implications of IFRS16.


Example Two

Background Information

Same as above.

Accounting Treatment in terms of the new IFRS 16

At commencement date of all leases, the lessee shall recognise a right-of-use asset at cost and a lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the incremental borrowing rate.

Opening Balance

Cash Lease Payments

Interest Expense

Principal Repaid

Closing Balance

0

-

-

-

185,426

1

60,000

14,896

45,104

140,321

2

72,000

11,300

60,700

79,622

3

84,000

4,378

79,622

-

Total

216,000

30,574

185,426

-

A financial calculator or excel could be used to prepare the following amortisation table, using entity A’s incremental borrowing rate of 10% per annum.

Journal entry at commencement of the lease

Dr             Right-of-use asset (building)

$185,426

 

                  Cr             Lease liability

 

$185,426

Journal entries for year 1

Dr         Interest expense

$14,896

 

Dr         Lease liability

$45,104

 

               Cr        Bank

 

$60,000

Dr         Amortisation expense re right-of-use asset

$61,809

 

              Cr         Accumulated amortisation re right-of-use asset

 

$61,809

($185,426 / 3 years = 61,809)

 

 

Journal entries for year 2

Dr         Interest expense

$11,300

 

Dr         Lease liability

$60,700

 

               Cr        Bank

 

$72,000

Dr         Amortisation expense re right-of-use asset

$61,809

 

              Cr         Accumulated amortisation re right-of-use asset

 

$61,809

($185,426 / 3 years = 61,809)

 

 

Journal entries for year 3

Dr         Interest expense

$4,378

 

Dr         Lease liability

$79,622

 

               Cr        Bank

 

$84,000

Dr         Amortisation expense re right-of-use asset

$61,809

 

              Cr         Accumulated amortisation re right-of-use asset

 

$61,809

($185,426 / 3 years = 61,809)

 

 


3.    Potential implications of IFRS 16 for accounting for operating leases

The new IFRS 16 is expected to have a negative impact on lessees' profit before tax in the initial years of an operating lease, because the current even operating expense over the period of the operating lease will be replaced by depreciation of the leased asset (capitalised right-of-use asset) and an interest expense on the lease liability, which will decrease over the period of the lease as the capital amount of the lease liability is repaid.

The following table demonstrates the impact of the current AASB 117 and the new IFRS 16 on the statement of comprehensive income outlined in the above example:

Statement of Comprehensive Income

 

Year 1

 

Year 2

 

Year 3

 

New IFRS 16

Current AASB 117

New IFRS 16

Current AASB 117

New IFRS 16

Current AASB 117

Operating lease expense

 

72,000

 

72,000

 

72,000

Interest expense

14,896

 

11,300

 

4,378

 

Amortisation expense

61,809

 

61,809

 

61,809

 

Total expense

76,705

72,000

73,109

72,000

66,187

72,000

The new IFRS 16 will lead to an increase in assets and liabilities in the lessees' statement of financial position due to the initial recognition of a right-to-use asset (which will be depreciated over the useful life of the right-to-use asset) and a lease liability (which will be repaid over the period of the lease through lease instalments). The current AASB 117 does not lead to the recognition of any assets or liabilities as a result of operating leases. In some cases, the recognition of both a lease asset and lease liability will have no economic implications for a lessee. Nevertheless, as with the potential impact on reported profits, lessees should now be considering the potential impact of IFRS 16 on, for instance, any loan covenants and/or management compensation arrangements they might have in place in 2019 and beyond. 


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