Applying IFRS 16
IFRS 16 requires all lessees to bring their leases (with some exceptions) on balance sheet. It leaves the lessor accounting predominantly unchanged. IFRS 16 is effective for annual periods beginning on or after 1 January 2019.
In initially applying IFRS 16, lessees can adopt either of the following approaches:
- retrospectively to each prior reporting period presented applying IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors (also called full-retrospective approach); or
- retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application (also called modified retrospective approach).
Other standards such as IFRS 15 Revenue, IFRS 9 Financial Instruments, etc. also allows similar adoption options.
Example: initially applying IFRS 16
Assume you work at a utility company whose year-end falls on 31 December. As at 1 January 2019 you had the following leases:
- Lease A: A 4-year lease for office space which commenced on 1 July 2017. You pay annual rentals of $200,000 under the lease at the start of each year. You accounted for this as an operating lease under IAS 17.
- Lease B: A 10-year lease for a delivery truck which commenced on 1 January 2019 and which has been accounted for as a finance lease under IAS 17.
Assume your incremental borrowing rate is 12%.
With the adoption of IFRS 16, you must capitalize Lease A which was earlier off-balance-sheet. Under the modified retrospective approach, you determine what your statement of financial position would have looked like as at 1 January 2019 had you applied IFRS 16 from the commencement date. We need to do a few calculations to get this picture. You do not need to do anything regarding Lease B because it is already on-balance-sheet. However, you would need to apply IFRS 16 going forward.
First, we need to find out the right of use asset and lease liability that you ought to recognize on 1 July 2017. This is calculated as follows:
$$ \text{Lease Liability}\ \\= \text{\$100,000}\ \times \frac{\text{1}-(\text{1}+\text{1%})^{-\text{12}\times \text{4}}}{\text{1%}}\times (\text{1}+\text{1%})\\=\text{\$680,366} $$
Alternatively, this can be calculated as follows:
| Payment | Amount | Discount Factor | PV |
|---|---|---|---|
| 1 | $200,000 | 1.000 | $200,000 |
| 2 | $200,000 | 0.893 | $178,571 |
| 3 | $200,000 | 0.797 | $159,439 |
| 4 | $200,000 | 0.712 | $142,356 |
| Total | $680,366 |
Using the following amortization schedule, you can see that by 31 December 2018, your liability balance would be $360,469.
| Date | Opening Liability | Finance Cost | Payment | Closing Liability |
|---|---|---|---|---|
| 1-Jul-17 | $680,366 | $- | $200,000 | $480,366 |
| 31-Dec-17 | $480,366 | $29,059 | $- | $509,425 |
| 1-Jul-18 | $509,425 | $30,482 | $200,000 | $339,907 |
| 31-Dec-18 | $339,907 | $20,562 | $- | $360,469 |
| 1-Jul-19 | $360,469 | $21,569 | $200,000 | $182,038 |
| 31-Dec-19 | $182,038 | $11,012 | $- | $193,050 |
| 1-Jul-20 | $193,050 | $6,950 | $200,000 | $(0) |
| 30-Jun-21 | $(0) | $- | - | $(0) |
If you depreciate your right of use asset over the 4-year lease term, the carrying amount of your lease asset would at 31 January 2018 be $425,229.
$$ \text{Carrying Amount} = \frac{\text{\$680,366}}{\text{4}}\times \text{1.5}=\text{\$425,229} $$
This process would result in recognition of a depreciation charge and finance cost and reversal of the rent expense. A summary of year-wise impact is shown below
| Financial year | 2019 | 2018 | 2017 |
|---|---|---|---|
| Right of use asset as at 31 Dec | $255,137 | $425,229 | $595,320 |
| Lease liability as at 31 Dec | $193,050 | $360,469 | $509,425 |
| Rent expense reversed | $200,000 | $200,000 | $100,000 |
| Finance cost charged | $32,581 | $51,044 | $29,059 |
| Depreciation charged | 170,092 | 170,092 | 85,046 |
| Net impact on profit or loss | $(2,672) | $(21,135) | $(14,105) |
Modified retrospective approach
This is where the difference between modified and full-retrospective approaches creep in. Under the modified retrospective approach, the net impact on right of use asset, lease liability and profit or loss is recognized as at 1 January 2019. No adjustment is made to prior-year figures. This involves the following journal entry (as at 1 January 2019):
| Right of use asset | 425,229 | |
| Retained earnings | 35,240 | |
| Prepayment | 100,000 | |
| Lease liability | 360,469 |
In using the modified retrospective approach, a lessee can measure the right of use asset either at:
- It carrying amount had the standard been applied since commencement date.
- Its lease liability recognized on initial application adjusted for any prepayment or accruals.
Full retrospective approach
There is no difference in the balances in the statement of financial position as at 1 January 2019 under the modified retrospective and the full retrospective approaches. The difference arise from the fact that while the modified retrospective approach make a single adjustment to the statement of financial position at the start of the year in which the standard is adopted while the full retrospective approach would need restatement of figures for 2018 and adjustment to statement of financial position as at 1 January 2018.
Under the modified retrospective approach, the following journal entry would be need to reflect the effect in statement of financial position as at 31 Dec 2017.
| Right of use asset | 595,320 | |
| Retained earnings | 14105 | |
| Prepayment | 100,000 | |
| Lease liability | 509,425 |
The following journal entry would be made in the books/financial statements of 2018:
| Finance cost | 51,044 | |
| Depreciation | 170,092 | |
| Rent expense | 200,000 | |
| Right of use asset | 170,092 | |
| Lease liability | 148,956 |
Other transition options
IFRS 16 allows other transition options such as:
- Not reassessing leases entered into before 1 January 2019 in accordance with the new definition. It means that a company adopting this practical expedient will apply requirements of IFRS 16 only to leases commencing before the effective date.
- Not applying the standard to leases whose term ends within 12 months of the date of initial application.
- Use a single discount rate for a portfolio of similar leases.
- Exclude initial direct cost from measurement of right of use assets.
- Use hindsight in determining lease term.
by Obaidullah Jan, ACA, CFA and last modified on