IFRS 16 Complete Guide

Where to start

IFRS 16 is the new leasing standard, superseding IAS 17. The earliest period it is effective from is January 1st, 2019 (check your local jurisdiction). IFRS 16 has caused a lot of commotion due to the implementation and adherence to the standard’s requirements.

What has changed?

We still have the lessee & lessor classification. For lessors and lesses alike, most remains the same. However, the main change comes if you have an operating lease under IAS 17. In this case, you’re in for some major changes in how you’re currently accounting for those contracts under IFRS 16.

Those contracts will essentially become finance leases, which means they come on balance sheet. Under IFRS 16, the first thing you’ll do is recognize:

  • A right-of-use asset - this represents the value of the item being leased
  • Lease liability - the present value of the minimum future lease payments

Compared to IAS 17, there’s a lot more work involved for the finance teams to handle. With the new accounting standard, can have a tangible impact on how you run your business, including:

  • New internal processes required for contract management
  • Increased communication between finance teams and property & asset management teams
  • Increased time for staff adhering to the financial reporting requirements
  • Significant impact to your financial statements and reporting ratios i.e. EBITA

Most, if not all, business decisions are made with the accounting impacts considered later, and IFRS 16 is no different. What is important to understand, is how your finance team will continue to be in compliance with IFRS and IFRS’s new leasing standard.

Change of focus

Under IFRS 16 your auditors will no longer be concerned with whether it’s an operating or finance lease, but put the main focus on the step prior to that, to determine if it is this a contract lease and if it is in scope of IFRS 16.

New lease definition & practical expedients

IFRS 16 brings a new lease definition which you’ll have to adjust to your head around initially, however the standard setters have conveniently given you the option to grandfather in your previous assessments, if the contract contains a lease. In other words, you don’t have to retrospectively go back over all contracts and decide if they meet the definition of a lease under IFRS 16, which allows for you to apply a practical expedient.

Low value & Short term

The standard gives you two options where the lessee is not required to apply the lessee accounting model:

  • Low value - the lease is for a low value item, thus the lessee can elect not to apply the new on-balance sheet
  • accounting model. The value of the item that is to be assessed is the value of the asset when new the IASB have said this value is ~5k USD
  • Short term - relates to short-term leases – i.e. leases with the term of 12 months or less, this can be applied from transition date.
Diagram identifying scope

IFRS 16 is in scope, what now?

Is it a lease?

So the above practical expedients can’t be used, so now we’ll go through the following steps that apply with deciding if the contract meets the definition of a lease, under IFRS 16.

Is there an Identified asset?
Criteria to be metExplanation
Implicitly or explicitly statedThe lease contract does not have to specify an asset. For example, a specialised piece of machinery that manufactures customized products.
Physically distinct / majority of the total capacityThe asset must be physically distinct. For example, floor 52 on a hundred floor building.If that’s is not the case, the lessee must have the right to substantial all of the capacity i.e. 95% of the warehouse floor space
No substitution rights from lessorLessor has the right to substitute the asset throughout the life of the lease and the lessor would benefit economically from substitution
Does the lessee obtain substantially all of the economic benefits?
Criteria to be metExplanation
Customer has the right to substantially all of the economic benefits from use To determine this, the following considerations need to be made:
  • Primary output and any by-products
  • Benefits from use - not ownership of asset
  • Other economic benefits - e.g. sub-leasing the asset
Does the lessee direct the use?
Criteria to be metExplanation
The customer makes the ‘how and what purpose decisions’ in order to make the contract is a leaseIf the customer makes the ‘how and what purpose decisions’ then the contract is considered a lease. Conversely, if the supplier makes those decisions, then the contract is not a lease, but a service contract.

All of the above criteria must be met for it to be considered a lease under IFRS 16.

Lease Components

Lessees will often enter into a contract with lessors that includes a right to use multiple underlying assets. So when the underlying asset is considered to be a ‘separate lease component’, that is, a separate lease.

How to identify a separate lease component

Requirements for a separate lease component

Both of the above criteria must be met to be considered a separate lease component.

Non-lease components

It is not uncommon for a lease to contain a non-lease components. For example, a cleaning service offered in the renting of a building. There is no right of use asset available to the lessee for the service of cleaning. As a result, the standard allows you to calculate the stand alone selling price (if needed) of that service and remove those payments from the present value of future lease payments.

As a practical expedient, the lessee can elect, by class of underlying asset, is to not separate the non-lease components from lease components, and instead account for the entire arrangement as a single lease component (lease). This practical expedient can provide relief to lessees by reducing cost and complexity in some cases, however it will also result in higher lease liability and ROU Asset.

Initial recognition

Initial recognition - lease liability

Once the contract is deemed to be in the scope of IFRS 16, there are a number of considerations to make, which will have a direct impact on your debits and credits. Firstly, we’ll focus on the lease liability.

Lease liability formula diagram

The lease liability consists of three inputs:

  • lease payments: these are the contractually agreed upon future payments the lessee will pay to the lessor
  • Lease term: the most reasonably likely period of time the lessee expects to use the ROU Asset.
  • Discount rate: the rate used to present value the future lease payments

Lease payments

One of the key inputs to the lease liability is the present value of the future lease payments known at initial recognition. They consist of:

  • Fixed payments less incentives
  • Variable lease payments - this only includes index (CPI), market rent review (MRR) or rate (Libor)
  • Residual value guarantee
  • Exercise price of the purchase option - if reasonably certain
  • Termination penalties - if reasonably certain

The above is information is what the lessee has at the commencement of the lease that they are reasonably certain to exercise. Future market rent reviews, CPI & LIBOR increases cannot be accounted for at initial recognition as these increases are not known at the commencement of the lease.

Variable lease payments
Payments that are included in lease liability diagram

The standard is confusing as it names variable lease payments to be included the future payments of the lease liability. If the payments are truly variable i.e. % of sales you will not know what you owe the lessor until communicated. These payments are expensed when incurred in the profit and loss and have no impact on the lease liability.

As mentioned above, for CPI, MRR & Libor, when the increased amount is communicated from the lessor, it will result in remeasurement of the lease liability as you update the NPV calculation to reflect these future increases in payments.

Initial recognition diagram

Lease Term

One of the key judgemental areas auditors will focus on is the lease term. The lease term starts when the lessee takes control of the underlying asset. It also includes any rent-free periods provided under the lease contract.

The term also consists of the non-cancellable period plus the periods the lessee is “reasonably likely” to renew. If the lessee is reasonably certain to terminate the lease that would mark the end date of the lease.

When determining “reasonably likely”, the lessee also takes into consideration if there is any ‘economic incentives’ to exercise or not exercise an option. For example, in a property lease, significant leasehold improvements undertaken at inception that have a significant economic benefits for the lessee over the period covered by the option period.

The lessee does not reassess lease term unless a significant event or change in circumstances occurs that is within lessee’s control.

Discount Rate

Once the lease payments & term are set, there’s one last input to finish the NPV calculation and that’s the discount rate. This input is highly judgemental which will mean your auditors will love understanding why you chose 3% instead of 3.5%.

The standard instructs you to use the “rate implicit in the lease”, however if that can't be determined, it is acceptable to use the “incremental borrowing rate”. These are the same definitions found in IAS 17.

The rate implicit in the lease, can be extremely difficult for the lessee to determine, as you need to understand within the lease payment you’re making, what portion is for using the actual asset and what portion is the interest (as you didn’t pay all upfront).

The lessee's incremental borrowing rate is the rate that a lessee would have to pay on the initial recognition date of the lease for a loan of a similar term, and with similar security, to obtain an asset of similar value to the ROU asset in a similar economic environment.

With the 3 inputs mentioned above, you get a lease liability, allowing you to now tackle the right of use asset.

Initial recognition - Right of use asset (ROU Asset)

Detailed diagram of the connection between lease liability and rou asset

The above diagram is a great illustration of what values you input into the measurement of the ROU Asset. We’ll now go through eac of those inputs you need to consider when recognising your ROU Asset on the balance sheet.

Lease Liability

This is what you’ve just worked out, the foundation of the ROU Asset is the NPV calculation of the lease liability. As a result, if your lease liability is wrong your ROU Asset will be too!

Initial direct costs

A lessee’s initial direct costs are the incremental costs of obtaining a lease that would otherwise not have been incurred. These include examples such as:

  • commissions
  • legal fees (if contingent on origination of the lease)
  • costs of negotiating lease terms and conditions (if contingent on origination of the lease)
  • costs of arranging collateral

Items that are not considered to be an initial direct costs include:

  • allocation of internal overhead costs e.g. those incurred by a sales or marketing;
  • costs of evaluating a prospective lessee’s financial condition and costs to obtain offers for potential leases

Costs to dismantle and remove an underlying asset

The costs to dismantle and remove an underlying asset at the end of the lease term that are imposed by the lease agreement are also included in ROU asset if there is a provision to be recognised under IAS 137. For example, in many cases, the lessee is obliged to return the underlying asset to the lessor in a specific condition or to restore the site on which the underlying asset has been located. The lessee recognises a provision in accordance with IAS 137 with the other side of the entry to the ROU asset.

Incentives

The lessor may offer incentives to the lessee to sign the lease agreement. These lease incentives include both of the following:

  • Payments made to or on behalf of the lessee in relation to a lease; and
  • Assumption by a lessor of costs of a lessee. For example as a result of assuming a lessee’s pre-existing lease with a third party.

Once the above considerations have been made you then have the inputs to calculate ROU Asset. Consistent with IAS 16, the ROU Asset is depreciated on a systematic basis based on the useful life of the asset. In most cases this will be the end date of the lease, but there are exceptions to this. For example, if there’s a purchase option at the end of the lease term and you depreciate based on the total use of the asset which will extend beyond the lease term.

Transition options

If the lease starts after transition date, there’s no election to be made and you account for the lease following the above steps. For all leases that start before your transition date, you have a few decisions to make which will affect your lease liability and right of use asset calculations.

Diagram showing the steps to transition a lease for IFRS 16

You must apply your decision to your entire lease portfolio, there’s no picking and choosing. If the lessee selects modified retrospective there are some practical expedients you can apply on a lease by lease basis.

As mentioned earlier, before you get to the choices of what transition method to use, there are a number of practical expedients that you can apply that may or may not take you out of the scope of IFRS 16.

Full retrospective

If the lessee selects the full retrospective transition option, it assumes you have always accounted with IFRS 16 in effect. The most complicated aspect of adopting this transition method is that you will have to reverse all accounting under IAS 17, and given you’re applying the standard retrospectively, you must do so in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors which:

  • applies the standard to all leases in which it is a lessee
  • restates its prior financial information
  • recognises an adjustment in equity at the beginning of the earliest period presented
  • makes the disclosures required by paragraph 28 of IAS 8 on a change in accounting policy

Why would you want to adopt a fully retrospective model? Well, it’s actually the most accurate transition method. It does require more work, however, it means your lease data has been captured from commencement for all active leases.

Refer to the below example to help illustrate the impact of the full retrospective model.

Example 1 - initial measurement of lease liability

York Enterprises enters into an agreement at the start of 2014 with Greenwood Ltd to lease a yacht. The lease is for 10 years, with $1,200 paid at the end of each year. To help entice York Enterprises to sign, Greenwood provided a rent free period of 6 months. York enterprises deems the agreement in the scope of iFRS 16 and they are the lessee in the arrangement, they determine the incremental borrowing rate at 2014 was 5%. Yorke’s transition date is 1 July 2019.

What is the NPV of the lease liability at commencement?

Year 1Year 2Year 3Year 4Year 5Year 6Year 7Year 8Year 9Year 10
$600*$1,200$1,200$1,200$1,200$1,200$1,200$1,200$1,200$1,200
*600 due to the 6 month rent free period

XNPV: $8,694.45 which is the value of the lease liability at commencement date.

What is the value of the ROU Asset?

Given there are no ROU Asset specific inputs (direct costs, make good provision, incentives before commencement) the ROU Asset value is $8,694.45

What is the value of the lease liability and ROU Asset at transition to IFRS 16?

The lease liability value at transition will be the minimum future lease payments at 1 July 2019. Assuming there’s no modifications to the lease, the ROU Asset will be the recognised value at commencement less depreciation.

Modified retrospective

The standard setters have given some allowances when adopting IFRS 16 and those are available when the modified retrospective approach is adopted. The extent of these allowances will depend on what practical expedients you decide to take. Here at Cradle, we’ve called them the “simplified” method or the “modified retrospective”.

Different modified retrospective options

Simplified method

Adopting this method is the easiest way to get ahead of IFRS 16. As per the above diagram the ROU Asset is calculated from transition date. What does this mean? You only need prospective lease information from the date of transition, so no digging through files to find modifications of a lease that commenced 20 years ago! The lease liability is also only calculated from transition date.

Diagram detailing the simplified method

There’s only a few other inputs you need to consider when dealing with ROU Asset when using the simplified method: Prepayments: Let’s say when you where accounting for the lease under IAS 17 and your transition date is 1 January 2019. In December 2018, you made a prepaid you lease payment, before you consumed all of that prepaid asset, transition happened? Well it’s simple reverse out that prepayment and add it to your ROU Asset. Accrued payments: This is the exact same principle above, but instead of making a prepayment, you did not pay a lease payment when due, in that case, the amount owed is subtracted from the ROU asset. Onerous lease provision: You have an onerous lease provision raised against your current lease under IAS 17. Reverse the amount out and subtract from the ROU Asset (saves you having to impair it in the future)

If none of the above is applicable, all you need to do is work out the NPV of the lease liability at transition date and you’ve got your ROU Asset as well.

So, what are the drawbacks of adopting the simplified approach?

Accuracy : you could technically argue that the accuracy of your lease will not be spot on, but if it was going to be “material” the standard setters would of never given you the option.

The positives are:

  • No historic data required: account for all of your lease prospectively with the information you have at hand, at transition date.
  • Cost: no need to dig up historical records, to do any other method you need to know what was happening between commencement and the transition date
  • Restatement of financial statements: no need to apply IAS 8
  • Uncomplicated: no need to start modification accounting until they occur after the transition date.
Example 2 - initial measurement of the lease liability and right of use asset

Richards Ltd. signs an agreement with Jagger Corp to lease studio space for 4 years. The agreement commenced on 1 January 2018 with payments of $2,000 to be made every six month in advance. The contract stipulates that Richards must refurbish the studio at the end of the lease, Richards estimates that will be a cost of $5,000. Richards incremental borrowing rate is 4% at 1 January 2019.

On 1 July 2018, Richards pays in advance the next 6 months of $2,000 but also prepays the next portion of $2,000 from 1 January to 30 June 2019. Under IAS 17, Richards recognises a prepayment for that amount. Richards is adopting the modified retrospective - simplified method of adoption. Their transition date is 1 January 2019.

What is the NPV of the lease liability on transition?

$9,432.60

That is the present value of 5 payments of $2000 (1 January 2019 amount not included as that was prepaid) using a discount rate of 4%.

What is the value of the ROU Asset?

$Description
$9,432.60Lease liability
$4,575.71Make good provision
$2000.00Prepayment
$16,008.31Total ROU Asset value

Modified retrospective method

The modified retrospective method is a more intensive method of adoption compared to simplified. As per the diagram you need to start accounting for the ROU Asset at commencement, but what that means is you also need to calculate the lease liability as that is the key input in the ROU Asset. By doing this from a calculation perspective you’re essentially following the exact process of full retrospective the only difference being you’ll use a discount rate at transition.

You’ll have to keep track of all modifications of the lease liability between commencement and transition as they impact the ROU Asset. As a result, this requires a far greater amount of work then simplified.

When transition happens you’ll pick up a ROU Asset value that’s not in-line with the lease liability, that’s a result of the ROU Asset being depreciated from commencement. The difference between those two values goes to retained earnings.

Example 3 - transition under modified retrospective

Young Private enters into a lease agreement with Crosby Ltd, which commences one 1 January 2014. The agreement is for 10 years, being in advance at the start of each year. Young’s incremental borrowing rate is 5% at 1 January 2019 and 4% at 1 January 2014, Young’s accounting policy is to depreciate ROU Asset on a straight-line basis over the lease term and will transition to IFRS 16 on 1 January 2019.

What is the value of the lease liability on transition?

$5,195.52 is the NPV of the minimum lease payments at 1/1/2019 being 4 payments of $1,200 using the transition discount rate of 5%.

What is the value of the ROU asset on transition?

$4,632.98

The NPV of the lease liability at commencement date is $9,266. This amount is straight line depreciated over 10 years ($927 p.a.) this results in the carrying amount of the ROU asset at transition of $4,632.98

What are the journals on transition date?

DateAccountDebitCredit
1/1/2019ROU Asset$4,632.98
Lease liability$55,195.52
Retained earnings$562.54

As you can see, the modified retrospective from a calculation perspective mirrors full retrospective in terms of what information you need. The only difference being, you apply a transition discount rate and you have a retained earnings adjustment.

The work is not done once you recognized your lease liability and ROU asset. At the very least, you need to unwind and depreciate the asset and liability to zero. If there’s a modification to the contractual terms, you’ll have to account for those changes to the lease liability and ROU Asset.

Subsequent measurement and modifications

When does modification accounting occur?

A lease modification is a change in the scope of a lease, or the consideration for a lease that was not part of its original terms and conditions. From a lease liability perspective, the key inputs that can be modified are:

  • lease payments
  • lease term

The standard classifies these contractual changes as either an increase or decrease in scope. An increase in scope results in the lessee having greater access to the underlying asset(s) either due to increase in term (control the asset for a longer period of time) or the scope of the asset has increased i.e. an extra vehicle. A decrease in scope is the opposite to the above, the lessee has a decrease in the right to use the asset either being the physical use i.e. one less vehicle or reduction in the lease term.

Does the modification result in a new lease?

Before applying modification accounting a key judgement needs to be made, does this result in a new lease?

A lessee accounts for a lease modification as a separate lease if both the following conditions exist:

  • The modification results in a right to use one or more assets
  • The consideration for the lease increase is equivalent to the stand-alone selling price (same definition as IFRS 15) for the increase in scope

If the above criteria are met, the lessee accounts for the modification as a new lease no different to any other lease.

If the conclusion is made that it is not a new lease, modification accounting is required.

Flowchart detailing if a lease should be treated as a new lease or not

Increase and decrease in scope

The accounting for increase and decrease in scope is different, so the first step is to work out if it’s an increase or decrease in scope. As noted above, an increase in scope is either an increase in lease payments or term and a decrease is a reduction of one of the two. For example:

  • Increasing the scope: Adding the right to use one or more underlying assets, for example, an extra floor of a building
  • Decreasing the scope: Removing the right to use one or more underlying assets – reducing the space rented in an office building.
  • Increasing the scope: Extending the contractual lease term.
  • Decreasing the scope: reducing the lease term of the leased asset

Decrease in scope

All decreases in scope affect both the lease liability and ROU Asset if there’s no impact on the ROU Asset - by either what you have the right to access (asset size) or a reduction in the term, it’s not a decrease in scope. For example, a decrease in fixed payments due to renegotiation of pricing which has no impact on the lease term or asset size, then you simply remeasure the lease liability and the balancing credit will go to the ROU Asset.

A decrease in the term length is accounted for differently to a decrease in the asset size.

Decrease in scope - decrease in term length

An example of this is the original lease agreement was 10 years, in year 2 of the lease it’s modified to 7 years. Correspondingly, the lease will now end in year 7, that’s 3 years less you no longer can access the ROU Asset. That decrease in scope would be calculated as 30% decrease (10 less 7 = 3 / 10 = 30%) in the ROU Asset.

Most importantly, with any decrease in scope, term length or reduction in asset size, the percentage decrease of the right to use the asset of the right of use asset must be captured.

Using Cradle with decreases in term length, we automatically calculate the decrease of the ROU Asset percentage for you.

Decrease in term length calculation methodology

There are two key aspects of the calculation:

  1. Calculate the gain or loss of the decrease in scope, which is driven by the difference between the ROU asset and lease liability applying the ROU percentage decrease.
  2. The remeasurement of the lease liability using an updated discount rate.

The steps are:

  1. Calculate the ROU asset carrying value before modification
  2. Calculate and apply the ROU asset % reduction to the ROU asset
  3. Calculate the lease liability carrying value pre-modification & post modification using the current discount rate
  4. Calculate gain and loss: this is the balancing entry between the difference between the lease liability and right of use asset.
  5. True up the lease liability based on a new discount rate based on the mvflp with the balancing side to the right of use asset

That may seem confusing, so let’s walk through an example of how to calculate the decrease in scope for a reduction in the lease term.

Example 4 - decrease in scope: decreasing lease term

Dylan Ltd enters into a lease agreement with J Cash Private to rent 3 floors of commercial office space. The agreement commenced on 1 July 2019, with Dylan transitioning to IFRS 16 on 1 January 2019. The length of the agreement is 5 years with $12,000 paid at the start of each year, the incremental borrowing rate for Dylan is 4%

At the start of year 2 (1/7/2020) Dylan continues to undergo major growth as a company and only requires the property until the end of year 3 (30/6/2022), the lessor J Cash Private agrees to these terms. The incremental borrowing rate at the time is 5%.

What are the initial recognition entries for the lease liability and ROU Asset at 1 July 2019?

DateAccountDebitCredit
1/7/2019ROU asset$55,554.06
Lease liability$55,554.06

The above is the NPV of 5 payments of $12,000 over 5 years using a 4% discount rate

What are the entries for the decrease in scope lease term at 1/7/2020?

DateAccountDebitCredit
1/7/2020Lease liability$21,762.63
ROU Asset$22,242.93
Gain/loss$465.08 balancing entry
DateAccountDebitCredit
1/7/2020Lease liability$109.89
ROU Asset$109.89

Workings:

Step 1 - Calculate ROU before modification

Calculate the carrying amount of ROU Asset value before modification $44,425.01

ROU Asset carrying amount at 1 July 2020

Total days depreciation days at Initial recognition1827y
ROU Asset value at Initial recognition$55,554.06x
Daily depreciation rate$30.41y / x
366 x $30.41 Depreciation per annum
(1 July 2020 less 1 July 2019)
$11,129.06z
ROU Asset$44,425.01x - z

Step 2 - apply the ROU asset % reduction

ROU Asset$44,425.01p
Remaining days before modification1461v
Remaining days after modification730j
% decrease of ROU Asset50.03%(1 - j / v)
ROU Asset % amount$22,227.71p x 50.03%

Step 3 - calculate the lease liability pre and post-modification

Minimum future lease payments before modification

Year 2
1 July 2020
Year 3
1 July 2021
Year 4
1 July 2022
Year 5
1 July 2023
$12,000$12,000$12,000$12,000

Discount rate: 4%

Net present value: $45,301

Minimum future lease payments after modification

Year 2 - 1 July 2020Year 3 - 1 July 2021
$12,000$12,000

Discount rate: 4%

Net present value: $23,538

Lease liability movement journal: $21,672.63 ($45,301-$23,538)

Step 4 - calculate the gain/loss

In this case the lease liability journal $21,762.63 is less then the ROU asset $22,242.93 therefore the difference $465.08 is a dr entry.

Step 5 - true-up of the lease liability

Apply the updated discount rate to the future lease payments post the modification

Year 2 - 1 July 2020Year 3 - 1 July 2021
$12,000$12,000

Discount rate: 5%

Lease liability post modification$23,538NPV using updated discount rate
Lease liability carrying amount$23,429Step 3
Journal$109.89($23,538 - $23,429)

Decrease in scope - asset size

The other type of decrease in scope is decrease in asset size. For example, the original lease agreement was for 2 floors in a building, turns out you only need one floor and renegotiate new terms with the lessor to remove the additional floor. This is a decrease in the scope of asset size, in this case, a 50% reduction of the ROU Asset. The standard has prescriptive guidance on how to account for these scenarios and like a decrease in the lease term, a gain/loss calculation to the profit and loss is required. Followed by a true-up of the lease liability using the latest discount rate.

The steps are:

  • Calculate the ROU asset pre-modification
  • Calculate the ROU asset % decrease and apply to ROU asset
  • Calculate lease liability pre-modification amount & apply % asset decrease to lease liability
  • Calculate the gain/loss
  • True up the lease liability based on the mvflp
Example 5 decrease in scope - decrease in asset size

Aphex Enterprises enters into a lease agreement with JAAR Ltd to rent 3 floors of commercial office space. The agreement commenced on 1 July 2019, with Aphex transitioning to IFRS 16 on 1 January 2019. The length of the agreement is 5 years with $12,000 paid each year at the start of each month, the incremental borrowing rate for Aphex is 4%

At the start of year 2 (1/7/2020) Aphex has to make three-quarters of their staff redundant, as a company and only requires 1 floor for the remainder of the term, the lessor JAAR Ltd agrees to a reduction in floor space with fixed payments being $375 per year. The incremental borrowing rate at the time is 5%.

What are the initial recognition entries for the lease liability and ROU Asset?

DateAccountDebitCredit
1/7/2019ROU Asset$55,554,06
Lease liability$55,554,06

What are the journal entries for the decrease in scope - asset size at 1/7/2020?

DateAccountDebitCredit
1/7/2020Lease liability$30,351.73
ROU Asset$29,764.75
Gain/loss$586.98 balancing entry
DateAccountDebitCredit
1/7/2020Lease liability$13,553.14
ROU Asset$13,553.14

Workings:

Step 1 - Calculate ROU before modification

Total days depreciation days at Initial recognition1827y
ROU Asset value at Initial recognition$55,554.06x
Daily depreciation rate$30.41y / x
366 x $30.41 Depreciation per annum
(1 July 2020 less 1 July 2019)
$11.129.06z
ROU Asset$44,425.01x - z

Step 2 - apply the ROU asset % reduction

ROU Asset$44,425.01p
Asset reduction33%3 years / 1 year
Apply % reduction$14,660.25p x 33%
Journal$29,764.75$44,425.01 - $14,660.25

Asset has reduced from 3 floors to 1 floor resulting in a 33% decrease.

Step 3 - calculate the lease liability pre-modification and apply ROU % adjustment

Year 2 - 1 July 2020Year 3 1 July 2021Year 4 1 July 2022Year 5 1 July 2023
$12,000$12,000$12,000$12,000

Discount rate: 4%

Lease liability before modification$44,301.09p
Asset reduction33%3 years / 1 year
Apply % reduction$14,949.36p x 33%
Journal$30,351.73$44,301.09 - $14,949.36

Step 4 - calculate gain/loss

Lease liability reduction a Dr of $30,551 whilst the ROU asset Cr is $29,764, as a result, the balancing entry will be a Cr of $586.98

Step 5 - lease liability true-up

Year 2 - 1 July 2020Year 3 1 July 2021Year 4 1 July 2022Year 5 1 July 2023
$375$375$375$375

Discount rate: 5%

Lease liability after modification$1,396.22NPV using updated discount rate and future payments
Lease liability value after ROU %$14,949.36ROU Carrying amount post asset % decrease
Journal$13,553.14($14,949.36 - $1,396)

Based on the above remeasurement there is a debit to the lease liability of $13,553.14 and the balancing entry goes to the ROU asset.

Increase in scope

Assuming the modification does not result in a new lease, the lessee’s ability to use the right of use asset has increased, unlike decrease in scope all increases are accounted for the same way, that is an increase in asset size i.e. leasing an additional floor of office space or increasing the term of the lease. When this occurs, the lessee remeasures the lease liability based on the updated future payments to be incurred, this will increase the liability and in turn, the other side of the journal (Dr) will go to increasing the ROU Asset.

Example 6 - increase in scope

Elvis Ltd enters into a lease agreement with Wonder Inc to rent 3 floors of commercial office space. The agreement commenced on 1 July 2019, with Elvis transitioning to IFRS 16 on 1 January 2019. The length of the agreement is 5 years with $12,000 paid at the start of each year, the incremental borrowing rate for Elvis is 4%.

At the start of year 2 (1/7/2020) Elvis continues to undergo major growth as a company and requires 3 more floors, the lessor agrees to these terms with an increase to $24,000 per annum. The incremental borrowing rate at the time is 3%.

What are the initial recognition entries for the lease liability and ROU Asset?

DateAccountDebitCredit
1/7/2019Lease liability$55,554,06
ROU Asset$55,554.06

What are the journal entries for the increase in scope at 1/7/2020?

DateAccountDebitCredit
1/7/2020Lease liability$46,585.58
ROU Asset$46,585.58

Workings:

This figure is driven by the remeasurement of the lease liability

Year 2 - 1 July 2020Year 3 - 1 July 2021Year 4 - 1 July 2022Year 5- 1 July 2023
$24,000$24,000$24,000$24,000

Discount rate: 3%

Lease liability after modification$91,887.67NPV using updated discount rate & lease payments
Lease liability pre modification$45,301.09NPV using previous discount rate & lease payments
Journal$46,585.58($91,887.67 - $45,301.07)

IFRS 16 adoption process

After digesting the information above, you may have even more questions than answers. The first question might be where to start and what to do with all my leases currently under IAS 17 as operating leases?

Where to start

The first thing you’ll need to do is select your transition method. If the simplified method is adopted you’ll need no historic information, if any other method is chosen (full or modified retro) you’ll need all historic leasing details to account under IFRS 16 correctly.

Process and record keeping

One of the biggest challenges of IFRS 16 will be ensuring your company’s processes and record-keeping are adequate. Previously under IAS 17, changes under operating leases didn’t require much attention, the invoice was paid and there was a lease expense recognised in the P&L.

This has all changed under IFRS 16, changes to lease contracts need to be tracked and accounted for (not just by accounts payable), as these changes can have a material impact on a company’s financial statements. Who is going to manage the lease portfolio? Do you have a lease management team or is the finance team going to do it?

Regardless, a member of the finance team will need to perform the initial recognition NPV calculations for all leases previously classified as operating leases under IAS 17 which isn’t a step to take lightly.

To perform these tasks is going to require a significant amount of time, that’s the reason why Cradle will do it all for you, literally.

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