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Technical updates - Published 8th January 2018

Introduction to IFRS 16 – Leases

IFRS 16 leases - accounting compliance

For accounting periods beginning on or after 1 January 2019 there is a new treatment of leases which you may need to be aware of.

IFRS 16 removes the difference between operating and finance leases for accounting purposes, and as such they are all treated as if they are 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
    1. This can often be written in the lease agreement if the asset is leased on hire purchase agreement; or
    2. 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.
    3. 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

For accounts that are required to adopt IFRS 16 there are two methods of transitioning.

  1. Retrospectively  – i.e. prepare the accounts as if IFRS 16 had always been in place; or
  2. Cumulative – i.e. this allows you to leave the comparative figures untouched and uplift the asset and liabilities to the correct brought forward position via adjustments to reserves. The asset can be valued by either applying the standard as if:
  3. It had always been applied (the present value at commencement of lease); or
  4. Equal to the value of the liability at the transition date.

 


Effect on your accounts

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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For further information on IFRS 16, please contact Miriam Hanley by email at mhanley@menzies.co.uk or call 01784 497116.

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Miriam Hanley - ACA

Technical Manager

Miriam Hanley is a Technical Manager at Menzies Heathrow office specialising in technical audit and accounts compliance for accountancy services.