If you are thinking of transitioning from UK GAAP to IFRS you need to be aware that the accounting treatment for leases is very different under IFRS.
The relevant standard is IFRS 16, and under this standard all leases are treated as finance leases, by recognising the asset as a fixed asset and a corresponding lease liability.
There are some exemptions available if:
- The asset is deemed to have a “low” value, a general rule of thumb being less than $5,000; or
- The lease term is deemed to be “short”, i.e. less than 12 months.
Where these exemptions are taken the lease payments should be recognised as an expense over the lease term.
The leased asset
This should be recorded at ‘deemed cost’ (see below). The asset should also be depreciated over the length of the lease, so that upon completion of the lease agreement the asset would have a net book value of nil unless there is a residual value to the asset.
‘Deemed cost’ = the present value of the minimum lease payments that are outstanding at the date of recognition;
- any lease payments already incurred;
- any costs incurred in relation to acquiring the asset (e.g. any installation costs);
- any provision that may be required in relation to dismantling costs.
The lease liability
The lease liability should be recorded at the present value of the minimum lease payments. Subsequently, the liability will be reduced as and when lease payments are made. In addition the discount applied will be unwound each period such that the lease liability is uplifted by expensing this interest through the profit and loss. Therefore, at the end of the lease period the liability will have been reduced to nil with expenses being made through the P&L based on the interest charged.
Discount rate
The present value of the minimum lease payments is calculated as the value of total lease payments outstanding discounted to the recognition date using an appropriate discount rate.
The discount rate can be calculated using a variety of measures:
Using the rate implicit in the lease agreement
- This can often be written in the lease agreement if the asset is leased on hire purchase agreement; or
- Alternatively, it could be calculated so that the interest rate used will result in the present value of minimum lease payments equalling the fair value of the asset.
- Incremental borrowing rate – “the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment”. [IFRS 16:Appendix A]
Methods of Transition
A first-time adopter applying IFRS 16 is permitted to apply some transition reliefs. IFRS 1 should be read in detail to understand these reliefs.
Impact on Finance Statements
Balance Sheet
The most obvious impact will be that those assets previously classed as operating leases will now be recorded as a fixed asset and the lease liability will be recognised as a financial liability.
Income Statement
There will no longer be any lease expenses recognised directly through the profit and loss, instead these are replaced by depreciation and interest charges. This change will result in an increase in operating profit and, more importantly, EBITDA. There will be higher charges recognised in the first few periods with it gradually decreasing over the life of the asset as the interest charge decreases in line with the outstanding lease liability.
Cash Flow Statement
The change in accounting treatment will have no direct cash impact, but will increase ‘Cash Flows from Financing Activities’ and decrease ‘Cash Flows from Operating Activities’.
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