In January 2016, the International Accounting Standards Board issued a new financial reporting standard on leases (IFRS 16) which requires all leases falling within its scope to be on the balance sheets of lessees. This will not only substantially change the accounting by most companies (as lessees) but the information that customers may request will also have an impact on lessors.
IFRS 16 will be effective for accounting periods beginning on or after 1 January 2019 and the changes do not just affect new leases but also existing leases. This article considers the options available to lessees for accounting for existing leases.
Transition accounting
To illustrate the options available, the following assumptions are used:
- The lessee’s accounting period ends on 31 December
- The lease was initially for ten years and commenced on 1 July 2008
- The interest rate implicit in the lease was 7% per annum
- Initial direct costs of 30,000 were incurred by the lessee
- Lease payments were 100,000 annually in advance
- On 1 July 2017, the lessee exercised an option to increase the lease term to 20 years (which was originally not considered reasonably certain). This resulted in lease payments of 130,000 from 1 July 2018. The lessee’s incremental borrowing rate at the exercise date was 6% per annum
- The lessee’s incremental borrowing rate is assumed to be 5% per annum on 1 January 2019
The following calculations have been carried out using a spreadsheet add-in for the Classic lease evaluation software that enables the IFRS 16 accounting to be carried out easily for entire portfolios of leases. This add-in also provides a suitable template for lessors to provide lease data to lessees to assist them in carrying out the calculations.
Under existing accounting, the lessee would simply have recognised an annual expense of 100,000 from 1 July 2008 and then increased this to 130,000 from 1 July 2018. The initial direct costs may have been expensed immediately or spread over the initial lease term (giving an extra annual expense of 3,000).
Under IFRS 16, a lease liability and a right-of-use asset are recognised. For existing leases, there are the following options for doing this:
1. Fully retrospective
Under this approach, one accounts for the lease as though IFRS 16 had always applied. At the lease commencement (1 July 2008), a lease liability is recognised equal to the present value of the future lease payments (100,000 per year), discounted at either the interest rate implicit in the lease (7% per annum) or, if not known, the lessee’s incremental borrowing rate. This gives an initial lease liability of 651,433. This subsequently reduces as lease payments are received and an interest expense is recognised thereon.
A right-of-use asset is recognised equal to the lease liability (651,433) plus the lease payment incurred at the lease commencement (100,000) plus initial direct costs (30,000), giving 781,433. This is then depreciated evenly over the lease term.
On 1 July 2017, there was a change in lease term. On this date, one re-measures the lease liability based on the present value of the remaining lease payments at the incremental borrowing rate at that date (6% per annum), giving an increase in lease liability of 956,651. This amount is added to the right-of-use asset.
Note that to carry out the above calculations, one needs to know the original interest rate, initial direct costs and past lease payments. One also needs to be able to determine what judgements would have been made about past options etc. Furthermore, this approach must be applied consistently to all leases in the group. In practice, the necessary information may not be readily available for all leases and so the modified approach below may be more appropriate.
2. Modified retrospective
Under this approach one, determines the lease liability at the date of initial application (1 January 2019) by present valuing the future lease payments. One must also use the incremental borrowing rate at this date (namely 5%). This gives a lease liability of 946,588.
To determine the right-of-use asset, one can, on a lease by lease basis, either:
- Make it equal to the lease liability (946,588) plus any previous prepaid or accrued lease payments (64,466) at the date of initial application (giving 1,011,054); or
- Calculate it from the lease commencement. This still requires one to know the history of the lease payments etc but there are several practical expedients that can be applied (on a lease by lease basis), the relevant ones for this illustration being:
– Ignore the initial direct costs
– Use hindsight in determining changes to the lease term and past lease payments (namely account for the lease extension from the lease commencement)
Applying these practical expedients gives an initial right-of use asset of 1,457,521 which, after depreciation, gives 692,223 as of 1 January 2019.
Methods compared
This gives the following for the above illustration:
| Existing accounting | Fully retrospective | Modified retrospective (a) | Modified retrospective (b) | |
| At initial recognition (1 January 2019) | ||||
| Prepaid lease payments | 64,466 | |||
| Lease liability | 910,789 | 946,588 | 946,588 | |
| Right-of-use asset | 893,353 | 1,011,054 | 692,223 | |
| Reduction in reserves | 81,902 | 0 | 318,832 | |
| Reduction / (Increase) in lease expense (compared to existing accounting) | ||||
| 2019 | (14,945) | (21,265) | 12,301 | |
| Thereafter | 96,847 | 21,265 | 306,531 | |
Given the significant effect of the various options on reserves and future profitability, to determine suitable accounting policies, companies need to assess what information they have available and assess the impact of the various options, as soon as possible.