[Leases – Article 5/5] – Transition to IFRS 16

Zampa Debattista
Posted on 22nd June 2020

 

This article is relevant to all IFRS preparers, especially those who are parties to lease contracts as lessees.

IFRS 16 ‘Leases’ is mandatory for financial periods beginning on or after 1 January 2019. This means that a company with a 31 December period-end needs to refer to the first date of its financial period before concluding that IFRS 16 is to be applied from the financial year ending 31 December 2019. In other words, a company incorporated on 1 November 2018, with a first reporting period 31 December 2019, is not obliged to apply IFRS 16 during that first period.

Having said this, IFRS 16 may be applied earlier if two conditions are satisfied:

  • IFRS 15 ‘Revenue From Contracts With Customers’ has also been implemented by the date of initial application of IFRS 16.
  • The early adoption of IFRS 16 is disclosed.

Companies that, under the superseded leases standard IAS 17, were parties to operating leases as lessees, need to be particularly aware of the changes brought about by IFRS 16. Of importance to preparers, are the transitional provisions, included in Appendix C of the standard. The bulk of the Appendix relates to the transition considerations for lessees who previously accounted for operating leases as expenses, and under IFRS 16, need to capitalise their leases. This will be illustrated below.

The lessee has two options for such transition, and the approach chosen needs to be applied consistently. In the following illustration, Company A is a 20-year old company applying IFRS 16 from 2019. It has a 31 December year-end and has never changed its financial periods.

Option 1: Full Retrospective Approach

Under this approach, financial information relating to the prior year – that is, the last year in which IAS 17 was applied, which happens to be the current year’s comparative – needs to be restated to reflect the accounting treatment under IFRS 16.

The difference arising due to the different accounting treatments is recognised through an adjustment in equity at the beginning of the earliest period presented. Therefore, Company A would reflect the adjustment in equity on 1 January 2018.

Under this option, Company A is recalculating existing operating leases as if IFRS 16 existed in the past. The adjustment to equity on 1 January 2018 reflects the pre-2018 changes resulting from recalculation. In fact, the accounting procedure under IFRS 16 causes:

  • The derecognition of past rental expenses.
  • The recognition of finance costs.
  • The recognition of depreciation.
  • The recognition of right-of-use assets and lease liabilities.

Option 2: Modified Retrospective Approach

Under the modified retrospective approach, the lessee applies IFRS 16 from the current year. Therefore, Company A reflects any adjustments to equity on 1 January 2019, and does not need to restate the prior year’s financial information.

The lease liability upon transition is measured as the present value of the remaining lease payments. The discount rate is the lessee’s incremental borrowing rate at the date of initial application.

In the case of the right-of-use assets, preparers have two options – that can be applied on a lease-by-lease basis:

Option A: the right-of-use asset is measured as if IFRS 16 had always been applied. As a result, the right-of-use asset will not be equal to the lease liability. The difference is booked to equity at 1 January 2019.

Option B: the right-of-use asset is measured at the amount of the lease liability.

A right-of-use asset accounted for as investment property is measured using the fair value model in IAS 40 from the date of initial application. No adjustments upon transition are required in this respect.

Numerical Example

Company A entered into a 5-year lease agreement on 1 January 2016 in order to use an office. Company A’s incremental borrowing rate is 5% at all points during the lease term. Company A pays €10,000 per annum in advance for rent, with the first payment dated 1 January 2016, and the last one dated 1 January 2020. Company A will be reflecting IFRS 16 as from 2019.

Option 1: Full Retrospective Approach

  1. Journal entries under IAS 17 ‘Leases’ (2016 to 2018)

1/1/2016

DR          Rent                                                      10,000

CR           Cash                                                                      10,000

Being payment of 2016 rent.

1/1/2017

DR          Rent                                                      10,000

CR           Cash                                                                      10,000

Being payment of 2017 rent.

1/1/2018

DR          Rent                                                      10,000

CR           Cash                                                                      10,000

Being payment of 2018 rent.

  1. Workings Upon Transition

Working 1: Present Value Of Future Cash Flows

Year Cash Flow DCF @ 5%
0 10,000 10,000
1 10,000 9,524
2 10,000 9,070
3 10,000 8,638
4 10,000 8227
45,460

Working 2: Amortised Cost Schedule

Bal B/D Cash Interest Bal C/D
0 45,460 – 10,000 1,773 37,232
1 37,232 – 10,000 1,362 28,594
2 28,594 – 10,000 930 19,524
3 19,524 – 10,000 476 10,000
4 10,000 – 10,000 – 0

Working 3: Hypothetical Retrospective accounting with IFRS 16 rules

1/1/2016

DR          Right-of-use Asset                           45,460

CR           Cash                                                                      10,000

CR           Lease Liability                                                     35,460

31/12/2016

DR          Finance Cost                                       1,773

CR           Lease Liability                                                     1,773

DR          Depreciation (P/L)                           9,092

CR           Right-of-use Asset                                           9,092

1/1/2017

DR          Lease Liability                                     10,000

CR           Cash                                                                      10,000

31/12/2017

DR          Finance Cost                                       1,362

CR           Lease Liability                                                     1,362

DR          Depreciation (P/L)                           9,092

CR           Right-of-use Asset                                           9,092

1/1/2018

DR          Lease Liability                                     10,000

CR           Cash                                                                      10,000

31/12/2018

DR          Finance Cost                                       930

CR           Lease Liability                                                     930

DR          Depreciation (P/L)                           9,092

CR           Right-of-use Asset                                           9,092

Summary of impact on equity at 1 January 2018:

Pre-2017 aggregate impact of IFRS 16:

IAS 17 accounting:

DR          RE                                                           20,000

CR           Cash                                                                      20,000

IFRS 16 accounting:

DR          Right-of-use Asset                           27,276

(Initial recognition of €45,460 less two years of depreciation at €9,092 p.a.)

DR          Finance Cost                                       3,135

(The sum of finance cost for 2016 and 2017, that is, €1,773 + €1,362).

DR          Depreciation (P/L)                           18,184

(Two years of depreciation)

CR           Lease Liability                                                     28,594

(Agrees to amortised cost schedule’s balance at end of 2017).

CR           Cash                                                                      20,000

(The sum of payments made at 1/1/2016 and 1/1/2017).

The adjustment required at 1 January 2018 is as follows:

DR          Retained Earnings                            1,318

DR          Right-of-use Asset                           27,276

CR           Lease Liability                                                     28,594

2018 (comparative) will reflect the following, apart from the above adjustment to equity:

Right-of-use Asset                                           18,184

(The adjustment at 1/1/2018 of €27,276 less 2018’s depreciation of €9,092).

Lease Liability                                                     19,524

(Agrees to amortised cost schedule’s balance at end of 2018).

Finance Cost                                                       930

(Agrees to amortised cost schedule’s finance cost for 2018).

Depreciation (P/L)                                           9,092

(One year’s depreciation).

  1. Journal entries under IFRS 16 ‘Leases’ (2019 and 2020)

1/1/2019

DR          Lease Liability                                     10,000

CR           Cash                                                                      10,000

31/12/2019

DR          Finance Cost                                       476

CR           Lease Liability                                                     476

DR          Depreciation (P/L)                           9,092

CR           Right-of-use Asset                                           9,092

1/1/2020

DR          Lease Liability                                     10,000

CR           Cash                                                                      10,000

31/12/2020

DR          Depreciation (P/L)                           9,092

CR           Right-of-use Asset                                           9,092

Option 2: Modified Retrospective Approach With Right-of-use Asset Triggering Equity Adjustment On Transition

Lease Liability at 1/1/2019                              19,524

Right-of-use Asset at 1/1/2019                    18,184

Equity Adjustment at 1/1/2019                   1,340

The financial statements for 2019 will show an adjustment to the opening equity amount for 2019, amounting to €1,340. The comparatives (2018) are unchanged.

Option 2: Modified Retrospective Approach With Right-of-use Asset Not Triggering Equity Adjustment On Transition

Lease Liability at 1/1/2019                            19,524

Right-of-use Asset at 1/1/2019                    19,524

Equity Adjustment at 1/1/2019                   0

The financial statements for 2019 will show no adjustment to the opening equity amount for 2019. The comparatives (2018) are unchanged.

In the meantime, should you require any assistance or advice on the subject, please contact:

John Debattista – Partner [email protected] 

Paul Zammit – Technical assistant manager [email protected]

Rebecca Marie Bezzina – Technical assistant [email protected]

For any assistance on IFRS or GAPSME-related matters, please email [email protected]

DISCLAIMER: Please note that this article is being published for information purposes only. As such it does not constitute or is to be interpreted or construed as legal advice or guidance. Zampa Debattista does not accept responsibility for or be liable to any damages arising as a result of using this information as legal advice or guidance.

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