Example: How to Adopt IFRS 16 Leases
In my last article I tried to outline the strategy and your choices when implementing the new lease standard
IFRS 16 Leases.
I am grateful for many responses and comments I got from you. Almost
all e-mails I received from you asked me to publish solved numerical
example to see how to implement IFRS 16 in practice.
Therefore, unlike in my other usual articles, this time I’ll solve one example with one specific lease contract for you.
You might well know that the IFRS 16 affects mostly
lessees who are involved in operating leases, because under the new rules they need to bring the assets from off-balance sheet to the daily light.
In other words, they will no longer be permitted to book all rental
expenses from operating leases in profit or loss, but they will need to
recognize the
lease liability and the right of use asset.
Therefore, in this article, I illustrate the application of the full
retrospective approach and modified retrospective approach to IFRS 16
adoption.
Ready for the example? Here you go!
Example: Operating lease in the lessee’s accounts under IFRS 16
ABC, the manufacturing company, needs to adopt the new standard IFRS 16 Leases in the reporting period ending 31 December 2019.
During the preparatory works, ABC discovered that the operating lease
contract related to a machine might require some adjustments.
ABC entered into the contract on 1 January 2017 for 5 years, annual
rental payments are CU 100 000 in arrears (that is, 31 December each
year) and at the end of the lease term, the machine will be returned
back to the lessor. The economic life of a machine is 10 years.
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How can ABC restate the contract under IFRS 16 using both full retrospective and modified retrospective approach?
Use the discount rate of 3%.
Little note about the discount rate
If you are a lessee, then be careful about the selection of the
appropriate discount rate, because its definition in IAS 17 no longer
applies.
Here, the new definition in IFRS 16 says that you should derive the interest rate implicit in the lease from:
- The lease payments,
- The unguaranteed residual value,
- The fair value of the underlying asset and
- The initial direct costs of the lessor.
This is very hard and sometimes unrealistic, because most lessors
won’t share the unguaranteed residual values and their initial direct
costs.
Therefore, most lessees will need to use the
incremental borrowing rate – that is, the rate at which they would be able to get the new borrowings for acquisition of the same asset with similar terms.
This is quite judgmental, but at least it’s more realistic than asking your lessor for additional information in most cases.
In this numerical example, let’s assume that given 3% is the ABC’s incremental borrowing rate.
Presenting the contract under IAS 17 and IFRS 16
Before you start drafting your journal entries to adopt IFRS 16 and
cease reporting the contract under IAS 17, you need to see clearly how
you reported that contract under both sets of rules.
Operating lease contract under IAS 17
Here, it’s very simple and straightforward: ABC accounted for all the lease payments from the operating lease
directly in profit or loss.
Operating lease contract under IFRS 16
Under IFRS 16, ABC needs to recognize the
right of use asset and the lease liability.
The lease liability is calculated as all the lease payments not paid
at the commencement date discounted by the interest rate implicit in the
lease or incremental borrowing rate.
I have done that for you in the following table:
Note: Discount factor in the first year is calculated as 1/((1+3%) to the power of year 1), etc.
Fine, we have the lease liability.
The right of use asset equals to the lease liability at the
commencement date, plus lessee’s initial direct costs, plus some other
things – but in this case, we have nothing like that, so let’s just say
it’s the same as the lease liability.
Under IFRS 16, the initial journal entry would be:
Subsequently, ABC needs to take care about 2 things:
- Depreciation of the ROU asset: Let’s say it’s straight line over the lease term of 5 years, thus it’s CU 91 594 per year (CU 457 971/5).
- Lease payments: Each lease payment of CU 100 000 is split between the repayment of the lease liability and interest.
I’ve done that in the following table:
Compare the accounting under IAS 17 and IFRS 16
To calculate the adjustment in equity related to this contract, let’s
summarize the profit or loss impact of the lease in individual years
under both IAS 17 and IFRS 16:
As you can see, total profit or loss impact of both IAS 17 and IFRS 16
application is the same CU 500 000, however, the timing is a bit
different.
So, now we have set everything and let’s see how to make adjustment
in equity and how to present the restatement under both full and
modified retrospective approaches.
I d
escribed both approaches in this article, so I won’t repeat it here and let me focus on numbers.
Full retrospective approach
ABC adopts IFRS 16 in its financial statements for the year ending 31 December 2019, and that means that
the transition date is 1 January 2018.
We need to restate all numbers for the comparative period, too.
Most of the work has been done above (see tables 1-3), so I’ll draft the journal entries here:
- Restatement of opening balances of the earliest period presented (that is: BEFORE 1 January 2018):
- a) Recognizing ROU asset and lease liability:
- b) Reversal of the lease payments before 1 January 2018 under IAS 17 (there was just one):
I know, I know! No cash moved! Wait until we are done with this
exercise. This is just to illustrate that in fact, you are reversing the
“old entries” and then making the “new entries”.
And why retained earnings and not profit or loss?
Because you are making this entry on 1 January 2018 and at this date,
all profit or loss accounts from 2017 were transferred to the retained
earnings.
- c) Accounting for the lease payments before 1 January 2018 under IFRS 16 (there was just one):
Note: The numbers come from table 2 for the year 1 (2017).
- d) Accounting for the depreciation of the ROU asset before 1 January 2018 under IFRS 16 (there was just one year):
In fact, you can do all 4 entries in one adjustment and it would look something like:
-
Debit ROU asset: CU 366 377 (CU 457 971 less depreciation of CU 91 594)
-
Debit Retained earnings in equity: CU 5 333 (-100 000+13 739+91 594, or see table 3 for the year 1)
-
Credit Lease liability: CU 371 710 (CU 457 971 less the lease liability repayment of CU 86 261, or see table 2 for the year 1)
In reality, you would adjust in in 1 single entry, but I wanted to show the rationale behind, its breakdown and logic.
- Restatement of the comparative period (year 2018):
Here, you are only restating the 2nd lease payment made. As I’ve
illustrated the breakdown of all entries above, let me show you just one
summarizing entry here:
-
Debit Lease liability: CU 88 849
-
Debit Interest (profit or loss of 2018): CU 11 151
-
Debit Depreciation (profit or loss of 2018): CU 91 594
-
Credit ROU asset: CU 91 594
-
Credit Operating lease expenses (profit or loss of 2018): 100 000
The numbers come from table 2 for the year 2 (2018).
- Restatement of the current period (year 2019):
Normally, you would have already applied IFRS 16 in 2019, but if not
and you are doing everything during the closing works, here’s the entry:
-
Debit Lease liability: CU 91 514
-
Debit Interest (profit or loss of 2019): CU 8 486
-
Debit Depreciation (profit or loss of 2019): CU 91 594
-
Credit ROU asset: CU 91 594
-
Credit Operating lease expenses (profit or loss of 2019): 100 000
OK, that’s for the entries and adjustments.
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If you apply the full retrospective approach, the problem is that you have to
report the comparative period – year 2018 in this case – under both IAS 17 and IFRS 16:
- In the financial statements for the year ended 31 December 2018, you
are still applying IAS 17, so your current numbers for 2018 are under
IAS 17, but
- In the financial statements for the year ended 31 December 2019,
you apply the new IFRS 16 and also your comparatives need to be stated
under the same rules – thus you need to book the above entries n. 1 and
n.2 carefully.
How would your financial statements look like?
Here you go:
The statement of financial position (extract) is here:
All the numbers related to the lease liability come from table 2 above.
The extract from profit or loss statement:
Now, let’s show the modified approach.
Modified retrospective approach
Under the modified approach, ABC needs to make an
equity adjustment on 1 January 2019 – that is at the beginning of the current reporting period.
Comparative numbers remain the same as presented before – so no restatement.
This is a way easier method to apply than the full retrospective approach, because
you do not restate the previous years’ numbers.
However, the price for this relief is
lower comparability.
It is quite difficult to compare current year under IFRS 16 with the
previous year under IAS 17 and it does not say much about how your
leases developed.
Just see it for yourself in the below extracts from the financial statements.
But first, let’s draft the journal entries:
- Restatement of opening balances at 1 January 2019:
- a) Recognizing ROU asset and lease liability:
- b) Reversal of the lease payments before 1 January 2019 under IAS 17 (there were two):
- c) Accounting for the lease payments before 1 January 2019 under IFRS 16 (there were two):
Note: The numbers come from table 2 for the years 1 and 2 – you need to make a total for these 2 years (2017 and 2018).
- d)Accounting for the depreciation of the ROU asset before 1 January 2019 under IFRS 16 (there were 2 years):
Similarly as with the full approach, you can make just one aggregate entry instead of these four:
-
Debit ROU asset: CU 274 782 (CU 457 971 less depreciation of CU 91 594*2)
-
Debit Retained earnings in equity: CU 8 079 (-200 000+24 890+183 188, or see table 3 for the years 1 and 2)
-
Credit Lease liability: CU 282 861 (CU 457 971 less
the lease liability repayments of CU 86 261 and CU 88 849, or see table
2 for the years 1 and 2)
Note: Here, I measured the ROU asset as if IFRS 16 has always been
applied – in this case, it was easier for me as I have already
calculated all the numbers above.
However, you can measure your ROU asset in the amount of the lease
liability. This would be even easier, because you would not have to
recalculate ROU asset in the past. You would simply calculate the lease
liability (=present value of the remaining lease payments) and that’s
it.
- Restatement of the current period (year 2019):
It’s the same as under the full retrospective approach and if you
have accounted for your operating leases under IAS 17 during the whole
2019, then you need to do this adjustment:
-
Debit Lease liability: CU 91 514
-
Debit Interest (profit or loss of 2019): CU 8 486
-
Debit Depreciation (profit or loss of 2019): CU 91 594
-
Credit ROU asset: CU 91 594
-
Credit Operating lease expenses (profit or loss of 2019): 100 000
What about the ABC’s financial statements?
Here you go:
The extract from the statement of financial position:
Please note that there are zeros for the comparative year 2018 – the
reason is obvious. We are presenting the previous year under IAS 17 and
there was no lease liability and right of use asset under IAS 17.
The extract from profit or loss:
This was just a basic example with a very simple and straightforward
contract. If you’d like to learn more about IFRS 16, its application,
adoption and see many practical examples solved in Excel, then I
recommend checking out
my IFRS Kit – IFRS 16 is extensively covered!
Any questions or comments?
Let me know below – thanks!
The new lease standard IFRS 16 is exactly one of these earthshaking things that can make your head spin around.
